Is Rite Aid Headed the Right Way?

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

Note: This article has been corrected to reflect accurate valuation metrics for Rite Aid.

The healthcare retail market isn’t showing many signs of growth so far, but this didn’t hold back shares of Rite Aid (NYSE: RAD) from rallying this year: the company’s stock jumped by a staggering 140% (to-date). Besides the company’s recovery, many investors are expecting that Obamacare will boost the healthcare retail market next year. Is Rite Aid the right move for this kind of circumstance? Will the company’s rally persist, or is it time to take some of the profits off the table? 

Betting on Obamacare

Many analysts think the healthcare-retail market will see a sharp rise in sales in 2014 as more Americans will benefit from health services under Obamacare. Up to now, however, the health and personal-care market hasn’t increased by a high rate.

Some investors might bet that Rite Aid will benefit from the implementation of Obamacare, but in this case I tend to agree with CNBC's Jim Cramer: I think that if you were to bet on the positive effects Obamacare will have on the healthcare retail market, why not go with the healthcare retail leader – CVS Caremark (NYSE: CVS). The company is the leader in terms of prescription revenue and market cap, even though it is the second-largest in terms of the number of pharmacy stores after Walgreen (NYSE: WAG).

Speaking of Walgreen, it is also a very strong company that has maintained its growth and profit margins in recent years. Therefore, Walgreen is also a good investment that is likely to payoff when Obamacare further expands. Nonetheless, let’s return to Rite Aid and examine its recent developments.

Rite Aid’s profitability

One the reasons for the rally in shares of Rite Aid is the company’s rise in profitability in recent quarters. The chart below shows the profit margins of Rite Aid, CVS Caremark and Walgreen.

The chart shows that CVS Caremark and Walgreen are still leading the way in terms of profitability. Walgreen expanded its profit margin to 5.4% in the recent quarter, while CVS Caremark has a similar profit margin. Furthermore, if Obamacare continues to progress, these companies’ revenue and profit margins are likely to keep rising.

Recently, CVS Caremark slightly improved its 2013 EPS outlook: projections went from adjusted EPS in the range of $3.86-$4.00 to a range of $3.89-$4.00. This represents a moderate improvement to its profit margins that could positively affect the company’s stock price.

Rite Aid’s revenue

Despite the rise in Rite Aid's profitability, its revenue continues to fall: by the first quarter of 2014 (fiscal year), revenue declined by 2.7% (year-over-year). A closer view of the company’s quarterly report reveals that most of the drop in sales was related to the 3.8% decline in pharmacy sales.

Valuation and financial stability

At a first glance, Rite Aid’s P/E doesn’t seem too high at 13.1 compared to the Pharmacy Services market average of 13.9 or compared to CVS’s P/E of 17.6. But after considering Rite Aid’s debt, cash and earning before interest and taxes, the company’s Enterprise-Value-to-EBIT ratio presents a partly different story.

The table below summarizes the EV-to-EBIT ratio of CVS, Rite Aid and Walgreens.

The table below summarizes the EV-to-EBIT ratio of CVS Caremark, Rite Aid and Walgreen.

As seen above, the Rite Aid’s ratio is at 12.6. In comparison, CVS’s ratio is only 10.9, which is also close to the market average. These calculations are crude and only provide a basic ballpark for the slightly high valuation of Rite Aid due to its low operating earnings (EBIT) and its relatively high debt. Moreover, Rite Aid still has the deficit in its equity, which is likely to refrain from distributing dividend anytime soon. Conversely, other health care companies such as CVS and Walgreens have a low debt-to-equity ratio of 0.25 and 0.35, respectively.

Moreover, Rite Aid still has the deficit in its equity, which is likely to refrain it from distributing dividends anytime soon. Conversely, other healthcare companies such as CVS Caremark and Walgreen have low debt-to-equity ratios of 0.2 and 0.3, respectively. 

Expanding operations

Rite Aid hasn’t expanded its reach in terms of stores, as its total number of stores reached by the end of the recent quarter was 4,615, compared to 4,623 stores in the preceding quarter. The company continues to remodel and relocate its stores in order to improve customer experience and raise its profitability. 

Rite Aid is looking to expand its operations by collaborating with other leading companies such as GNC. GNC currently has nearly 2,200 Rite Aid franchise store-within-a-store locations. During the first half of the year, GNC opened a net of eight stores in Rite Aid’s stores. If GNC continues to increase its number of stores in Rite Aids at a faster pace, this could also positively affect Rite Aid’s revenue in the coming years. 

Walgreen is also looking to expand its operations mainly by opening new drugstores: in the past quarter, the company acquired 39 stores. Nonetheless, Walgreen acquired 68 drugstores this year, compared to 87 last year. The slowdown in its acquisition rate might suggest the company’s growth in operations will diminish this year compared to the previous year. 

CVS Caremark keeps expanding its reach, and during the first quarter the company opened a net of 28 stores and relocated 15. These types of measures are likely to keep augmenting its revenue and widen its profit margins.  

Bottom line

Rite Aid’s recovery in terms of profitability and the measures it took to improve its business has impressed investors. But the company’s ongoing fall in revenues, relatively low profit margin, slightly high valuation and equity deficit might make this company a less attractive investment. Companies such as CVS might be a better fit especially if you think Obamacare will augment this sector’s sales in 2014.

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Lior Cohen has no position in any stocks mentioned. 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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