Is Rite Aid Still Cheap After a 500% Gain?

After a one-year 500% return, any suggestion that Rite Aid (NYSE: RAD  ) is cheap might sound ludicrous. Yet two metrics in particular indicate that Rite Aid is still significantly cheaper than its peers Walgreen (NYSE: WAG  ) and CVS Caremark (NYSE: CVS  )  and has more room to improve.

What's behind the rally?
After a half-decade of net losses and increased debt, Rite Aid has produced four consecutive quarters of net income. The company has consistently crushed its own estimates while having to increase guidance on a quarterly basis. As a result, its stock has soared higher, and investors are believing in its turnaround.

Now, in reality, Rite Aid's story from rags to riches has little to do with some great operational change on behalf of management. Instead, Rite Aid has been the beneficiary of the patent cliff, a period of five years in which more than $130 billion of brand-name drugs are losing patent protection.

Currently, we are in year three of this five-year period, and many of the market's biggest blockbuster drugs, like Nexium, Abilify, and Crestor, have yet to lose patent protection. But the reason Rite Aid has benefited from new generic introductions to date is because generic drugs pay high margins to pharmacies.

Rite Aid has explained this process thoroughly in each of its last four conference calls and 10-K filings, as has Walgreen and CVS. It is for this reason that Rite Aid's profit margin has soared to 1.2% from negative 1% over the past year.

Is Rite Aid still cheap?
Rite Aid is not the only pharmacy that has benefited from new generic introductions. Both Walgreen and CVS have reaped the benefits as well.

Over the past year, CVS and Walgreen have seen their stocks soar 47% and 80%, respectively. While all three pharmacies have seen same-store sales rise, Walgreen and CVS both have grown at significantly greater rates and have also seen strong margin improvements.

However, Rite Aid has traded higher than either of its peers because of the way it was priced last year, almost in anticipation of a bankruptcy more so than a turnaround. Hence, the unexpected turnaround and consistent profits are what have forced Wall Street to reassess and appropriately value Rite Aid.

With that said, is it possible that Rite Aid is still cheap? If we look at its price-to-earnings multiple of 18, it is cheaper than Walgreen at 23 times earnings and CVS at 19 times earnings. However, using price-to-earnings is a bit misleading because Rite Aid's margins are so much lower than its peers and because of the speed at which margins are improving in the entire industry.

Moreover, Walgreen and CVS have profit margins that are about three times greater than Rite Aid's, putting both on a higher level but also leaving Rite Aid more room to improve.

Therefore, I am more concerned with sales as a valuation metric. It is sales that create profit and will make Rite Aid cheaper if margins continue to improve. Also, I want to look at operational cash flow, which gives us an idea of the money being earned from day-to-day operations. Hence, check out Rite Aid's price-to-sales and price-to-operating cash flow ratio compared to its peers, and this after its one-year 500% return.

Company

Price-to-Sales Ratio

Operating Cash Flow

Rite Aid

0.21

7.1

CVS

0.63

13.4

Walgreen

0.78

13.1

Clearly, Rite Aid is still the cheapest of the three large pharmacies.

On a price-to-sales comparison, CVS and Walgreen are three to four times more expensive than Rite Aid. And despite the fact that CVS and Walgreen have significantly greater margins and profitability, Rite Aid is also cheaper on an operating-cash-flow basis.

This fact brings up an interesting point: If new generics continue to be introduced into the market, and margins rise further, Rite Aid not only has the most to gain in terms of profitability, but its stock will stay attractive despite large future gains.

Final thoughts
The bottom line is that fundamentals, macro shifts, and valuations suggest that Rite Aid is still cheap after a 500% one-year gain.

This is a perfect illustration of stock performance not being an indication of value in the market. To put this another way, Rite Aid could double from current levels and it would still be significantly cheaper compared to sales and comparable to its peers in operating cash flow.

With that said, the majority of Rite Aid's gains have come and gone. We are unlikely to see another 500% rally unless the profit margin increases from 1% to 3%. But nonetheless, at this point in time, Rite Aid is still the best value in the pharmacy space and is still cheap. 

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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 30, 2013, at 9:44 AM, bluesky64 wrote:

    Brian,

    RAD has done well the real question can you poick the next one. Between AMD $ 3.62 and ALU $ 4.32 and RAD $ 5.92 there's a contest who will reach $10 first. My guess AMD and it's the cheapest. Both RAD and ALU are well into there turnaround story. But it was just Wednesday that put AMD into there second inning of there turnaround story. The Xbox and play stations have been selling like hot cakes. So the question could AMD handle the next wave of chips a much larger order than the past. The answer is yes and be profitable to the point of raising guidance. This news took the wind out of the sails of the short theses. AMD has the lowest Float 500 million and Largest short 140 Million. and the most news to come from the greater than expected sales of game consoles. AMD has the best financials of the 3. I believe all 3 will hit $ 10 by Dec 2014 but AMD will get there first.

  • Report this Comment On November 30, 2013, at 1:40 PM, truevaluetoday wrote:

    Brian,

    Thanks for the informative article on RAD as always your insights are very helpful. I have been long on RAD and thankful for the ongoing turnaround in motion. I was curious what you thought would be a realistic best case and worst case scenario for RAD by 12/31/14. Best case could we see this double and be up another 100% by end of 2014?

    If RAD has very good ER on December 19, 2013 could we see $7.00 by 12/31/13? Followed by larger institutional buying and analyst upgrades?

    Also curious on your thoughts of being Long RAD without a hedge to protect from any downside risk?

    Thanks!

  • Report this Comment On November 30, 2013, at 8:10 PM, BrianNichols wrote:

    My price target for 2013 was $5 and for 2015 it was $7. However, I did not anticipate this level of optimism or acceptance on Wall Street. Worst case: Obama Care has some negative affect on pharmacies and Rite Aid's margins do not rise with new generics. Then, I'd say stock could either trade flat or see downside of 10%-15% next year. If not, I think my $7 target will be surpassed easily and RAD could top $10 rather quickly.

  • Report this Comment On November 30, 2013, at 8:11 PM, BrianNichols wrote:

    All of which can be seen on my NicholsToday site

  • Report this Comment On December 01, 2013, at 5:25 AM, bluesky64 wrote:

    Brian,

    It's seem you've covered everything If Rad goes down or sideways or up. This means your correct no matter what. Very clever. I say AMD and ALU and RAD hit $ 10 by Dec 2014 But AMD gets there first.

    AMD will triple ALU will double and RAD will rise 60%

    Not bad. AMD you will return the most.

  • Report this Comment On December 02, 2013, at 12:51 PM, truevaluetoday wrote:

    Brian,

    Thank you for your response and update on your website. Looks very good.

    Any idea on the projected Whisper number for RAD's forthcoming ER on 12/19?

    It appears they are making the right strategic moves and driving in more business.

    Fantastic call on RAD for sure!

    Thanks!

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