Rite Aid Corporation Falls: Did The News Warrant The Response?

Rite Aid Corporation (NYSE: RAD  ) lost up to 10% of its valuation on Thursday June 5, 2014 after the company revised guidance downward. The company's outlook revolves around partner McKesson Corporation (NYSE: MCK  ) , and is viewed as especially alarming given the incredible fundamental data of peer Walgreen Company (NYSE: WAG  ) on Wednesday. Nonetheless, investors are reacting harshly to the news, but does this reaction create an investment opportunity?

A solvable problem?
According to Rite Aid, its profit for both the current quarter and fiscal 2015 is expected to be below prior estimates. Rite Aid notes that higher-than-expected drug costs are to blame .

Specifically, there is a delay in price reductions for the generic drugs that Rite Aid is attempting to purchase, and reimbursement rates are taking longer than anticipated. As Jim Cramer noted, this is a direct issue with partner McKesson involving generics, or a mishap in the supply chain.

McKesson essentially acts as a middleman for Rite Aid and other pharmacies, by processing, purchasing, and then shipping new and current generic drugs from the supplier to the pharmacy; several months ago, Rite Aid enhanced its partnership with McKesson.

Now, in retrospect this news is not all that surprising. As explained in a previous article , the pharmacy business is right in the middle of an enormous transition where $133 billion in brand-drug sales lose patent protection, and new generics are introduced. While this bodes well for pharmacies in terms of profitability, it also poses a challenge, as generics are purchased in bulk and often require more scale.

Not to mention, 2014 was already expected to be a significant year for new generic introductions, with $12.6 billion in branded blockbuster drugs sales losing patent protection. This, combined with prior years of patent expirations, essentially proves that 2014 was going to have some challenges, but with McKesson being a top distribution company, it's a problem that's undoubtedly solvable.

Moreover, this problem on behalf of McKesson proves that volume is high for the company, which is a positive for shareholders.

What's the impact?
So, to what degree will this news affect Rite Aid? According to the company, it now expects net income between $298 and $408 million for the year, or an EPS of $0.30 to $0.40 per diluted share. Now, here's the kicker: Rite Aid's prior guidance was for an EPS of $0.31 to $0.41, meaning that Rite Aid has essentially lowered its full-year outlook by less than $10 million. Yet, this $10 million differential has been responsible for valuation losses in excess of $700 million!

Clearly, the math doesn't add up, but when you consider that Rite Aid is still up more than 650% from its 2012 stock lows, it might have been due for a pullback. This is a company that has beat analyst expectations in each of the last six quarters, and has revised guidance upwards on many occasions. Therefore, investors had high expectations for Rite Aid.

High expectations are well-deserved
In addition to Rite Aid having such high expectations, Walgreen's 6% increase in revenue during the month of May probably didn't help Rite Aid much, as it shows weakness in an industry that is apparently performing beyond all expectations. However, it's worth noting that Rite Aid announced a same-store sales increase of 3.5% in the May , adding to the 4.9% increase it saw in April, and further showing that Rite Aid, like Walgreen, is now a growth company.

In regards to Walgreen, its stock has more than doubled since 2013, and at 26.5 times earnings, it too has high expectations. While the high hopes are well deserved, Rite Aid's distribution problem with generics appear to be macro-related, and it'll be interesting to see if Walgreen also experiences some EPS pressure.

Foolish Thoughts
If you step back and actually read Rite Aid's updated outlook, it's really not that bad, and there are no reasons to believe it's a long-term problem. Moreover, it's a rather insignificant problem from a fundamental perspective, therefore Rite Aid's reaction is more based on panic, rather than the actual meaning of the news.

Albeit, at 0.32 times sales Rite Aid remains far cheaper than its two larger peers, and continues to report large profits. Therefore, with a surplus of new generics hitting the market, investors have to like Rite Aid's prospects long-term, and the value created with Thursday's loss.

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