Huge Hedge Fund Interest In Rite Aid Corp. (RAD)

Beating the market can be difficult when picking stocks on your own. One common source of alpha can be focusing on small cap stocks, which tend to outperform its larger peers over time. Another source of alpha can be following the smart money, by mimicking the trades of professional investors. Our research has shown that, by combining these two approaches – buying the most popular small-cap stocks recently purchased by hedge funds – investors outperformed the market by 18 percentage points per year on average (read the details here).

Rite Aid Corporation (NYSE:RAD)

Rite Aid Corp. (NYSE:RAD) was one of the more heavily bought stocks by hedge funds recently, with Peter Rathjens‘ Arrowstreet Capital, David E. Shaw‘s of D E Shaw and Ken Griffin‘s Citadel Investment Group increasing their stakes significantly during the fourth quarter of 2013. In addition, Jerome L. Simon of Lonestar Capital Management initiated a new position during the quarter, while Phill Gross / Robert Atchinson of Adage Capital Management and Sander Gerber of Hudson Bay Capital Management added to their positions.

Rite Aid Corp. (NYSE:RAD) is a $6.4 billion market capitalization company that is the third largest drug retailer in the United States, with 4,592 stores located in both the East and West Coasts and annual revenue of $25.4 billion. The stock has rallied strongly since December 2012, when it reported its first quarterly profit in years, thanks for making good progress on its turnaround plan. RAD has continued to execute on its plan ever since (including during the most recent fiscal third quarter ended November 30, 2013, when it increased its forward guidance above consensus expectations), increasing its EBITDA (Earnings Before Interest, Tax, Depreciation and Amortization) from a low of $859 million in fiscal year 2011 to $1.3 billion for the last 12 months through its third quarter of fiscal year 2014, through a combination of reinvigorated top-line growth, reduced selling, general and administrative expenses and refinancing of its debt.

In addition to its fundamental improvement, Rite Aid Corp. (NYSE:RAD) could be a participant in the ongoing transformation of the drug industry in the U.S. Prescription drug distributors have formed alliances with retail pharmacies to gain more pricing leverage with drug manufactures while obtaining larger scale in higher-growth international markets. The trend started in 2012, when drug retailer Walgreen Co. (NYSE:WAG) acquired a 45% stake in privately-held Alliance Boots GmbH, a U.K-based wholesaler and retailer. Shortly thereafter, the two firms formed a partnership with drug distributor AmerisourceBergen Corp. (NYSE:ABC). Naturally, speculation began on the Street regarding the next possible deal, with some expecting Rite Aid Corp. (NYSE:RAD) to be acquired by U.S. drug distributor McKesson Corp. (NYSE:MCK). Those hopes were subsequently dashed when MCK agreed to buy German pharmacy Celesio AG (DB: CLS1) for $8.4 billion in October 2013. However, the possibility of another suitor is still in the cards.

The shares are not cheap, trading at forward P/E and EV/EBITDA multiples of 22.3X (versus 19.1X for peer group) and 9.6X (versus 9.9X for peers), respectively. However, with continued progress on its turnaround plan, Rite Aid Corp. (NYSE:RAD) offers a way to gain exposure to favorable secular trends – including an aging population that tends to fills their prescriptions at retail pharmacies and expansion of prescription drug insurance coverage due to the Affordable Care Act (ACA) – at a reasonable valuation. A potential acquisition by another drug distributor would be an added bonus, but not central to the investment thesis on the stock.

Disclosure: none

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