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After a Two-Day Rally, Is there More Upside Here?

Brian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In the last two days shares of Rite Aid (NYSE: RAD) have rallied 11% without any news. In fact, its last piece of news was perceived as disappointing, as same store sales for February fell 3.6%, with a 4.7% decline in the pharmacy. While most of this decline was due to a 695 basis point negative impact from new generic introductions, it may still lead investors to wonder why the stock is breaking out higher into a new range, and if it’s now worth buying.

What is the Catalyst?

Strangely enough, what pushed shares of Rite Aid higher was an industry wide rally that was sparked by a Walgreen (NYSE: WAG) upgrade to “Buy” from UBS. According to UBS, Walgreen could see stronger gross margins with increased generic presence and believes the Alliance Boots transaction makes its business much stronger.

While the Alliance Boots transaction does not fundamentally strengthen Rite Aid, the guidance for higher margins due to an increase in generic drugs could positively impact Rite Aid. Because after all, this is a company with operating margins of just 1.44%, and with it being a known fact that generics carry higher margins, this shift could be what boosts the company to consistent profitability.

Can this Rally Continue?

Rite Aid’s large rally began on Dec. 20 as the stock posted a gain of 20% following earnings, and has since rallied 80% total. Prior to this quarter the company had not seen profitability in many years, but posted net income of $61.9 million for that quarter. This vast improvement combined with guidance shows that the company’s restructuring efforts are in fact working.

The improved performance of Rite Aid over the last year has been remarkable. The company has posted eight consecutive quarters of increased adjusted EBITDA. It continues to see revenue decline as new generics are introduced and now there is a possibility of the company achieving profitability for the full year of 2013.

In fact, during its most recent quarter, the company saw a 924 basis point decline in pharmacy sales due to increased generic scripts. This decrease resulted in profitability, therefore the company’s February sales where it saw a 695 basis point decline could be a good indication that margins will be stronger than expected. Yet despite this news, and all of its progress, the stock continues to be one of the most undervalued in the entire market.

How Should I Value Rite Aid?

Rite Aid is in a position where it doesn’t need to grow its top line, it only needs to improve its bottom line. The company has a lot of room for error, and needs very slight improvements in order to see large upside. For example, take a look at how it stacks up to its competitors, and you’ll see the upside potential.

 

Rite Aid

CVS Caremark
(NYSE: CVS)

Walgreen

Market Cap (billions)

$1.66

$65.5

$40.29

Revenue (billions)

$26.08

$123.13

$70.79

Price/Sales

0.06

0.53

0.57

Forward P/E Ratio

93.25

12.07

11.59

Operating Margin

1.44%

5.87%

4.78%

Profit Margin

(0.64%)

3.15%

2.81%

As you can see, Rite Aid is a much larger business than its market cap implies. The company’s price/sales ratio of 0.06 is much more favorable to either Walgreen's or CVS’ average 0.55 ratio. In fact, Rite Aid’s larger competitors are more than 9 times as expensive, and this premium is awarded thanks to stronger margins and profitability. Therefore, if Rite Aid can achieve profitability, how will the market value its turnaround?

Due to increased generic pressure and the closing of unprofitable stores, Rite Aid will continue to lose revenue, yet because of its value/margins the market will not care. Therefore, let’s say that it loses 10% of its top line over the next three years and returns revenue around $23 billion. Rite Aid still has some work to do, and is nowhere near the efficiency of either Walgreen or CVS. However, it is highly likely that during this time the company can achieve a profit margin of 1.5% with an increase in generics.

If Rite Aid can achieve a profit margin of 1.5% (roughly half of competitors) and sales of $23 billion by the end of 2015, and then trades with the industry average P/E ratio of 18 times current earnings, then a market cap of $6.20 billion, price of $6.85, is mathematically possible, and likely.

While a $6.85 price target may sound farfetched, you must remember that for this year the company’s high-end guidance is for net income of $33 million. Therefore, after eight quarters of improvement, net income of $330 million is very possible with the rate of new generics that are being introduced to the market. Also, keep in mind, if my 10% revenue loss is accurate this would still leave RAD trading with a price/sales ratio that is just 0.27, which is about half of Walgreen and CVS. Therefore, the stock would still be cheap even at $6.85.

Conclusion

In my book, Taking Charge With Value Investing (McGraw-Hill, 2013), I lay out what is needed for a good speculative investment to return the largest gains. Rite Aid falls under the category of a speculative investment, but has (1) recent fundamental proof of improvement, (2) a business that is worth several times more than its market capitalization (sales/market cap), (3) a willingness among management to see and fix problems, and (4) a clear cut path toward efficiency, among several others. In my opinion, Rite Aid has all the makings of the perfect speculative value investment, and as long as the plan stays on path, I think it’s a near can’t miss for very large returns. 


Brian Nichols is long RAD. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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