Rite Aid (NYSE:RAD) soared nearly 4 percent on Friday with the absence of any major news. The stock is now moving back toward 52-week highs, and if history repeats itself, will likely create new highs in the immediate future. With that said, Rite Aid’s remarkable rally from $1 to nearly $6 is a demonstration of how far the company has come in such a short period of time. However, even at $6, is Rite Aid still presenting a buying opportunity?
The Rite Aid story
To summarize the Rite Aid recovery I’d say that a surplus of new generic drugs — $133 billion worth of brand drug sales are losing or will have lost patent protection between 2011 and 2016 — hit the shelves at pharmacies and led to higher margins. As a result, Rite Aid, after a half-decade of net loss, once more became profitable.
However, this isn’t just a Rite Aid story: The entire industry has seen a boost in margins, and over the next few years, this trend is expected to continue as more and more new generics are introduced to the market. With that said, generics pay higher premiums to pharmacies because of how they’re purchased (in bulk) and the flexibility of pricing due to increased supply and markups.
Room to improve
Needless to say, the entire industry has and is changing. But since Rite Aid was so far behind its peers operationally, it now has so much room to make up; in other words, it has room to improve.
Since 2011, Rite Aid’s annual profit has soared from -$545.5 million to +$280.4 million. That represents a massive change in profit margin from -2.2 percent to +1.25 percent. But despite this massive increase, there are more than a few reasons to believe that there’s room for improvement.
Company profit margin
As you can see, Walgreen (NYSE:WAG) and CVS (NYSE:CVS) are both significantly more efficient than Rite Aid in terms of margins. Both Walgreen and CVS have made major strides with margin improvements and have operated with a high level of efficiency for many years.
As a result, one might conclude that if Rite Aid continues to make operational improvements such as closing inefficient stores, remodeling for efficiency, and forming partnerships that create synergy, that profit margins in the range of 3.5 percent to 3.75 percent might be attainable, given these three companies operate a near-identical business model.
However, that room for improvement might actually be greater. First off, as I explained in this article, 2014 will actually be one of the best if not the best year for new generic introductions during the patent cliff era. Hence, margins should naturally rise.
This belief goes hand in hand with the fact that neither Walgreen nor CVS has hit its limit with margins.
Specifically, let’s look at CVS: If we consider operating margins, then it is the most efficient pharmacy in the U.S. — operating margin of 6.4 percent, versus 5.2 percent for Walgreen. With CVS operating at such a high level, some might think that it has very little room to improve.
Yet if we look at CVS’s recent 2014 guidance, this is a company that’s expecting to grow its earnings by 10 percent to 14 percent, while revenue growth expectations are just 4.9 percent. Hence, with 4.9 percent top-line growth and a 12 percent improvement to the bottom line, we are talking about major margin improvements for a company that is by far the most efficient within the industry.
As a result, with Walgreen also improving its profit at a record pace and Rite Aid executing its turnaround, there are real reasons to be optimistic and to believe that not only Rite Aid but CVS and Walgreen’s stock could be driven significantly higher throughout this year.
Room for gains
Last year, all three pharmacies significantly outperformed the S&P 500. Walgreen and CVS saw gains around 50 percent while Rite Aid soared an industry-best 300 percent. Toward the end of 2013, many considered Rite Aid a good shorting opportunity, given the large gains it had produced. However, those people must not have considered its operational room for improvement or its valuation relative to peers.
Everyone understands a P/E ratio, and when you compare these companies all trade at about 18-20 times earnings. Now, with Walgreen and CVS this makes sense, as both have near identical profit margins. However, Walgreen and CVS margins are three times greater than Rite Aid, thus implying that it trades at a cheaper multiple to sales.
Company price/sales ratio
Now, what I find very interesting about the metric above is the degree at which Rite Aid is discounted, coupled with its room for improvement.
Rite Aid, even after a 300 percent year, is three times cheaper than its peers, which, conveniently, also mirrors its margin performance relative to its peers. With that said, the fact that Rite Aid’s margin is three times less than its peers, as is its price/sales multiple, one can almost assume that Rite Aid’s stock is dependent upon its margin improvements in 2014.
Luckily for shareholders, 2014 is expected to be a great year for new generics, and margins should continue to rise. With that said, I would like to make one final observation from the notion that valuation multiples in this space are in large part derived from margin performance: CVS has without question the best margins yet is cheaper than Walgreen compared to both sales and earnings. This likely implies that in 2014, CVS is a better investment option than Walgreen. Now, what about Rite Aid?
Is Rite Aid a buy?
Yes, Rite Aid is significantly cheaper than its peers — despite its gains — and no, it does not operate with the same level of efficiency. Still, the room that’s present for Rite Aid to improve operationally implies that it will in fact continue to trade higher. Essentially, 2013 was year two of its turnaround effort, and we have seen a near-$800 million differential in profits.
With that said, even at $6 per share and approaching new highs, Rite Aid is still a great value investment opportunity. This is a company that stayed down for so long, priced for bankruptcy, that once improvements began to occur, there was a lot of space to trade higher. Luckily, much of that space is still in front of Rite Aid, making it very attractive.