This Struggling Pharmacy Ended 2012 On a High Note

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Rite Aid (NYSE: RAD) investors finally got their turnaround signal, as generic drug sales and efficiency gains helped return the pharmacy chain to profitability last quarter. A profitable Rite Aid poses a bigger challenge for CVS (NYSE: CVS) and Walgreens (NYSE: WAG) as well, and these competitors can also benefit from a major trend that helped Rite Aid during the quarter. Rite Aid has three main arguments in its favor right now.

Valuation

Rite Aid looks very cheap for a major, national drugstore chain. The pharmacy traded below $1 a share several times in 2012. On Dec. 19, 2012, before its earnings release, the pharmacy's shares traded at $1.04. The earnings release the next day started an uptrend in Rite Aid's shares, and Rite Aid held on to most of its gains, closing at $1.36 on Dec. 31, 2012.

Because of Rite Aid's past losses, forecasts based on the drugstore's prior earnings history might not account for its current potential. Going by the price to sales metric, Rite Aid only costs about a tenth of what its competitors cost right now. Rite Aid currently has a P/S of 0.05, while CVS has a 0.5 P/S and Walgreens has a 0.49 P/S. As a big box chain that also operates pharmacies, Wal-Mart (NYSE: WMT) also offers a valid comparison here, and Wal-Mart’s 0.49 P/S comes out very similar to Walgreens' and CVS' figures. Rite Aid does need to maintain its margins to qualify as a true bargain.

Margins

Rite Aid now has a positive profit margin, at least in the short term. During the past three years, Rite Aid brought in over $6 billion in revenue each quarter, so the drugstore didn't achieve profitability because of a temporary sales spike. Rite Aid's revenue actually fell by 1.2% last quarter, although this decline may mean better margins for the pharmacy. An Associated Press article explained that pharmacy patients switched to generic drugs, boosting Rite Aid's profits but reducing the drugstore's overall sales somewhat.

Higher generic drug sales provide a reason to invest in any pharmacy, not just Rite Aid, because CVS, Walgreens, and Wal-Mart can also achieve higher profit margins by selling generic drugs. The generics trend also has implications for every pharmacy's future earnings releases, as well as discounters and grocery stores with major pharmacy operations. A weaker quarterly revenue figure for any pharmacy might not necessarily mean a miss on earnings going forward. Higher generic drug sales could have bigger effects on Rite Aid's financial figures because of the chain's weak past performance, though.

Competition

Rite Aid had a major opportunity in 2012 when Walgreens got into an argument with Express Scripts, which resulted in lost sales for Walgreens throughout the year. Generic drug sales weren't enough to help Walgreens turn in a good showing last quarter either, as the drugstore ended 2012 with 4.6% weaker revenue and a 25.5% drop in earnings. Although these results look bad, Walgreens has a new deal with Express Scripts now, so Rite Aid's easy opportunity to gain market share has ended. Rite Aid's continued profitability may now depend on keeping the former Walgreens patients around.

Takeaway

Rite Aid's results last quarter answered one of the main bear arguments about this drugstore, its history of big losses. Although the drugstore still lost money overall in 2012, it has demonstrated a trend toward lower losses over the past few years and now looks ready for a profitable 2013. Rite Aid still has $6.15 billion in debt to deal with, but it now has $352 million in free cash flow to deal with its debt burden. This drugstore stock still looks speculative, but it may be a risk worth taking now.   


Eric Novinson owns shares of CVS. The Motley Fool has no positions in the stocks mentioned above. 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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