Two Potential Hits in a Rocky Year

01/17/2008 12:00 am EST

Focus: STOCKS

John Dessauer

President, John Dessauer Investments, Inc.

John Dessauer, editor of John Dessauer’s Investor’s World, doesn’t expect big gains from the market this year, but he finds two stocks he thinks will hold up well.

This year is a challenge—more so than usual. I am not expecting much more than 12% growth from the broad market, so I am looking for solid companies that are just too cheap.

Cardinal Health (NYSE: CAH) is a stock with significant upside potential. Cardinal is the nation’s second-largest drug distribution company, and drug distribution is 80% of company revenues. Cardinal is delivering growth on both the top and bottom lines. In the first fiscal quarter, revenues rose 9%, and earnings rose 15%.

Management’s guidance for the current fiscal year, which ends next June 30, is $3.95 to $4.15 a share. The long-run average P/E is 20x, indicating a stock price of $79 to $83. Of course, 12 months from now the focus will be on earnings expectations for fiscal 2009. I expect those estimates will be at least 15% better than this year, indicating a 12-month potential of $93.

Wall Street is mixed on Cardinal. Skeptics worry about profit margins and efficiencies in the drug distribution business. Those worries were reinforced by recent regulatory actions suspending distribution of controlled substances at three of Cardinal’s 25 distribution centers. The problem has to do with rogue Internet pharmacies. Cardinal is cooperating with officials to resolve the issues. I am sure the suspensions will be lifted shortly.

Wall Street’s low expectations have opened up an opportunity for us. [Meanwhile,] in November, Cardinal’s chairman and chief executive officer bought 20,000 shares at $57.50, at a [total] cost of more than $1.1 million. That is a clear statement of his belief that the stock is undervalued. (It closed above $61 Wednesday—Editor.)

Rite Aid (NYSE: RAD) fell sharply after news of a bigger-than-expected loss in the third fiscal quarter. That is an understandable knee-jerk reaction. But looking at the details says the sellers got this one wrong. The acquisition of Brooks and Eckerd stores gives Rite Aid a better opportunity to increase sales and profits than [was] originally believed. At the moment, sales at those stores are declining.

Furthermore, front-end sales are only 70% of a typical Rite Aid store. Accomplishing that goal requires no more than basic Retailing 101. Management is already changing the signage, appearance and merchandising in the Brooks and Eckerd Stores to a Rite Aid plan. Changing 1,850 stores is expensive and time-consuming, but management is making good progress. They have realized about two-thirds of the $200 million in synergies expected this fiscal year, meaning there are $300 million more expected in the new [February 2009] fiscal year.

One analyst says this could add $2 billion in sales, so he raised his rating to a Buy, with a $4.00 target. Morningstarhas a $6.00 fair value on Rite Aid. I agree and believe the long-term potential is much higher. (It closed at around $2.00 Wednesday—Editor.)

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