This High-Flyer Is Still Too Cheap!

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

Rite Aid (NYSE: RAD) rallied 15% in Thursday’s early session after posting an incredible Q4 earnings report. For the last four months I have been saying to buy this stock, and now that it has surpassed $2.00 and has provided full-year guidance, I say the stock still has lots of room ahead to rally higher.

A look at the quarter

Rite Aid’s quarter was simply amazing. The company posted revenue of $6.5 billion, which was a slight beat over expectations. However, the real progress, and the reason for its rally, was in EPS, where the company posted an EPS of $0.13 compared to expectations of $0.01! The company did see a 2% drop in same-store sales but its large profit was due to the generic shift that I have discussed on so many occasions.

For the first time in more than five years, Rite Aid is a profitable business. The company ended fiscal 2013 with net income of $118.1 million compared to a net loss of $368.6 million in the year prior. This was in part due to improved efficiency and a very long restructuring program that has been in place for the last three years. It is also due to the fact that generic drugs produce higher margins, and because of the patent cliff we have seen an upsurge in generic drugs. As a result, it does appear as though the company’s years of losses are a thing of the past, as they guide for fiscal 2014 net income between $45 million and $200 million (significantly better than previous guidance).

Value that far exceeds its Industry

For the full year, Rite Aid has revenue of $25.4 billion and net income of $118.1 million. If we translate these two numbers into metrics, Rite Aid is trading with a price/sales ratio of 0.07 and a P/E ratio of 15.84. If we consider the fact that Rite Aid has continued to outperform all expectations, and use the top end of its fiscal 2014 guidance, then it is trading with a forward P/E ratio of about 9.35. Therefore, despite more than doubling its price since last December, the stock is still cheap, although I’m not sure people realize just how cheap the stock is trading.

With Rite Aid’s efficiency improving rapidly, and it seeing such strong bottom line growth, it is very likely that it will become the preferred stock in the pharmaceutical space. CVS Caremark (NYSE: CVS) and Walgreens (NYSE: WAG) are larger businesses, yet the three companies operate the same business strategy. With that said, I am looking at four key metrics that the market often uses to assess value. These metrics will no doubt be watched closely in the coming weeks/months when assessing the space, and is the basis for upside in shares of Rite Aid.

<table> <thead> <tr><th> </th><th> </th><th> <p>Rite Aid*</p> </th><th> <p>Walgreen</p> </th><th> <p>CVS Caremark</p> </th></tr> </thead> <tbody> <tr> <td> <p>1.</p> </td> <td> <p>P/E Ratio</p> </td> <td> <p>15.84</p> </td> <td> <p>21.72</p> </td> <td> <p>19.06</p> </td> </tr> <tr> <td> <p>2.</p> </td> <td> <p>Forward P/E Ratio</p> </td> <td> <p>9.35</p> </td> <td> <p>13.24</p> </td> <td> <p>13.07</p> </td> </tr> <tr> <td> <p>3.</p> </td> <td> <p>Price/Sales</p> </td> <td> <p>0.07</p> </td> <td> <p>0.64</p> </td> <td> <p>0.57</p> </td> </tr> <tr> <td> <p>4.</p> </td> <td> <p>Profit Margin</p> </td> <td> <p>0.5%</p> </td> <td> <p>2.91%</p> </td> <td> <p>6.93%</p> </td> </tr> </tbody> </table>

*All information based on Thursday’s quarter report

1. The P/E ratio is one of the most watched metrics among retail investors. Rite Aid hadn’t seen a positive P/E ratio in more than five years, but after a great year of progress has instantly become the cheapest of the three large pharmacy companies. This not only shows the level of value present in shares of Rite Aid, but also shows how quickly the company can go from loss to profit due to the pure size of its company.

2. The forward P/E ratio compared to the P/E ratio shows bottom line expected progress. Prior to recent guidance, Rite Aid traded with a forward P/E ratio of 69.83. Now, it is the cheapest of the bunch. This is yet more proof of the company’s progress and the fact that it is improving beyond Wall Street’s ability to predict growth.

3. The price/sales ratio is my favorite of the “home page” metrics; a company can always improve in efficiency for better margins, but it is harder to produce sales. Rite Aid has a market cap of just $1.87 billion yet sales of more than $24 billion. It is a massive large cap company trading as a small cap stock. In the past, this has been due to inefficiency, but now that the company is profitable, there is no reason to believe that Rite Aid can’t trade with the same valuation/fundamentals as both CVS and Walgreens. Currently, it is not even close, as the larger competitors are 8-9 times more expensive compared to sales.

4. The profit margin is where you can see Rite Aid’s room for improvement. Due to the company being so large, it needed just a 0.5% profit margin to catapult itself from fundamental loss to being the cheapest in terms of profit/valuation in the space. Both Walgreens and CVS have margins that are greatly higher than Rite Aid, and like I said, this has been the catalyst for Walgreen and CVS’ higher valuation. Rite Aid has continued to improve in these metrics for eight consecutive quarters, and with more generics coming onto the market, I would expect even better margins and higher profits in the years ahead.

Conclusion

In my book, “Taking Charge With Value Investing (McGraw-Hill, 2013)” one of the most cited investment strategies for success in a new age market is to seek large companies with small valuations that have massive room for improvement. Rite Aid is a perfect example, as the stock still trades with a 65% loss over the last six years. It has been pushed drastically lower as the inability to produce a profit has created excessive pessimism. Yet slowly and surely, the company has very quietly made progress, and has been making strides for the last eight quarters towards achieving profitability. Now that it is a profitable company, many investors will take notice, and much like it was pushed lower for years, it will now realign with unrealized fundamental gains, and will trade significantly higher for many quarters to come. 


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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