Rite Aid Surprises With a Q2 Profit

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On Thursday morning, Rite Aid (NYSE: RAD  ) reported a surprise profit, with EPS of $0.03, beating the average analyst estimate for a loss of $0.04 per share. That also represented a significant improvement from last year's loss of $0.05 per share in Q2.

For many years, Rite Aid has seemed to be in danger of being crushed by its larger rivals, Walgreen (NYSE: WAG  ) and CVS Caremark. Indeed, both competitors still pose a significant threat to Rite Aid's business in the long term. However, Rite Aid's solid performance for the past several quarters makes it seem more likely that the company will manage to overcome these competitive threats.

Margin outperformance
As has been the case for most of the last two years, margin improvement was the big key to Rite Aid's success last quarter. Revenue of $6.28 billion was up less than 1% year over year. However, Rite Aid's cost of goods sold declined more than 1%, causing gross margin to expand from 27.5% to 28.9%.

I was particularly surprised by this margin improvement because Walgreen had signaled in June that it was ramping up discounts in the front-end to drive higher customer traffic. I expected this to force at least some pricing response from Rite Aid, weighing on gross margin.

However, while Walgreen did grow sales much faster than Rite Aid last quarter, the impact on Rite Aid's gross margin was apparently minimal. Rite Aid's gross margin of 28.9% in Q2 was flat compared to Q1.

Steady improvement
Rite Aid's Q2 earnings would have looked even better except for a $62.2 million special charge that was related to debt refinancing. This was partially offset by a $23.5 million benefit related to a legal settlement, but the net effect of these two items was to depress EPS by approximately $0.04.

Rite Aid's debt refinancing last quarter was just the latest in a string of refinancing actions. Over the past year, Rite Aid has taken advantage of its improved operating results, and the low interest rate environment, to significantly reduce its interest expense. Rite Aid's interest expense in Q2 was down by more than $22 million year over year, accounting for $0.02 of the company's EPS improvement.

Threats linger
While Rite Aid's quarterly report was very positive, and the company even raised its full-year earnings guidance, management still warned that earnings would fall year over year in the second half of FY14. The press release highlighted "continued reimbursement rate pressure, pharmaceutical cost increases and a significantly lower benefit from new generics" as headwinds going forward.

Rite Aid has undoubtedly benefited from a favorable industry environment in 2012 and 2013. It's not clear, yet, whether the headwinds management cites are temporary or more permanent in nature. With lower interest expense, and a more solid base of profitability, it now seems more likely that Rite Aid will successfully navigate these upcoming challenges. Still, with the stock having nearly quintupled since late 2012, I don't think the likely rewards justify the risks of buying Rite Aid now.

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Read/Post Comments (7) | Recommend This Article (2)

Comments from our Foolish Readers

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  • Report this Comment On September 21, 2013, at 6:26 AM, wallystock2 wrote:

    one day after they i think post potential upside they recant and say dont invest. i haccumulated 1500 shares of wendys at av of 4.6 get a div and have doubled almost.

    believe in a company and you will be rewarded. my buddy in the 90's crash i told him about beav at 3 and sbac at .30 i know he has passed now. he laughed. beav 77 sbac about 70. i had it all along but know one would go with me.

  • Report this Comment On September 21, 2013, at 10:48 AM, gabejack wrote:

    Hoping the writer could elaborate a little bit on his opinion to not purchase into Rite Aid now? If it seems likely that Rite Aid will successfully navigate its upcoming challenges, and the stock already having quintupled since late 2012, why does he think the rewards not justify the risks in such an inexpensive stock that is showing consistent profitability? Seems like a value stock with a lot of upwards potential.

  • Report this Comment On September 21, 2013, at 2:20 PM, bluesky64 wrote:

    Adam,

    It was clear weeks back that RAD would post positive .03. I posted it.

    Simple math by adding the 3 months of SSS.

    RAD still has a price target of $ 5.50 by Dec. 2013 and $ 8 by Dec 2014.

    I do see some head winds but over all there are 3 times the tail winds and the momentum has just started. There are going to be price corrections. WAG and CVS are coming down and RAD is going up. Institutions want big % winners and analyst want to claim big winners. RAD stay long and be a big winner. THX

  • Report this Comment On September 21, 2013, at 11:44 PM, TMFGemHunter wrote:

    @gabejack: I'm not sure what you mean by inexpensive. It is not expensive in terms of the dollar price, or in terms of its market value relative to Walgreens or CVS.

    But on a P/E ratio basis, it's pretty comparable to those companies, and Rite Aid does not have nearly as strong a competitive position as either. It also continues to have a very high debt load relative to its earnings.

    What we've seen in the past year is the power of leverage to amplify returns. What I mean by that is that Rite Aid has around $6 billion of debt and last year the market cap (the value of all its stock) was just $1 billion. So the total enterprise value was $7 billion. With the solid -- but not earth-shattering -- improvement seen since then, the enterprise value has gone up 50%, to around $10.5 billion. But since the value of the debt is fixed, all of that increase goes to stockholders, and the result is a nearly 400% gain.

    Hope that helps you understand my reasoning! I think there's a reasonable case to be made for owning the stock at this point. But the risks are too big from my perspective, especially when management continues to guide that earnings will start in the next quarter or two. Perhaps it will just be a temporary dip, but that's not guaranteed.

    Adam

  • Report this Comment On September 21, 2013, at 11:56 PM, Trumpace wrote:

    The reason RAD posted a positive number is simple. They closed many non performing stores and refinanced some of their debt. The real surprise is the revenue growth considering the closings. Anytime a company can grow the top line and reduce the cost on the bottom line that will work all the time. Management is turning around the company and if they continue to improve as they should they can get to $7.50 within six months or sooner and $9-10 in 12 months. The question will be, will they be taken out by a buyout? It is possible, but at what price.

  • Report this Comment On September 22, 2013, at 8:40 AM, bluesky64 wrote:

    Adam,

    Remember institutions need to show big returns so most will drop WAG and CVS and use margin and take very large positions in RAD. and get a double before the end of the yr.

  • Report this Comment On November 09, 2013, at 2:03 AM, RyanPeckyno wrote:

    Briefly:

    1. Debt refinancing really helped RAD out;

    2. If RAD can improve product mix, then that will be huge, too (store navigation and front end are important as well);

    3. The stock is going to be very volatile;

    4. I would expect the stock to stabilize at around $5 - $5.50;

    5. RAD is a solid turnaround play

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