After a 25% Post-Earnings Rally, Is This Stock Overvalued or Pricey?

After a 25% Post-Earnings Rally, Is This Stock Overvalued or Pricey?

It's completely normal for analysts and bloggers to say, "Don't jump in" after Rite Aid's impressive 230% gain year to date. However, what these people fail to realize is that Rite Aid is in fact cheap, I mean SUPER CHEAP, and Q2 was yet another example.

What did we learn from Q2?
If there's one thing we've learned from Rite Aid's second quarter - which caused the stock to rally 25% -- it's that this company is fundamentally improving at a rate that management cannot predict. Indeed, management has increased guidance in three of the last four quarters.

The U.S.' third-largest pharmacy significantly increased its bottom-line guidance for 2013, now guiding for a midpoint of $225 million. Prior to the company's report, its midpoint net income guidance was just $104 million!

While a $100 million difference in guidance is huge, it represents a difference in profit margin of just 0.4%! Moreover, the company's $225 million in net income guidance may also look incredible - considering its $118 million gain last year and its loss of $368 million in the year prior - but it represents a profit margin of only 0.9%!

Compared to Walgreen and CVS Caremark , which have profit margins of 3% and 3.4% respectively, Rite Aid still has a long way to go before it matches the efficiency of its larger peers. Yet, if the company is successful in creating a full-year profit margin of 0.9%, it will trade at 18.6 times earnings.

What's most impressive?
With that said, I think what's most appealing about Rite Aid is the amount of upside that exists (ie: room for improvement). Also, Rite Aid is not growing revenue at all but is rather benefiting from a natural shift from brand drugs to generics due to the patent cliff in health care.

The company spoke about this shift on its conference call, saying that better margins are being created from a higher mix of generic drugs, as generic drugs have higher payouts to pharmacies. Thus, the company simply sits back, makes minor changes to its existing stores, and then profits with higher margins.

Now, among the many Rite Aid articles that I have published since the stock was trading at $1.20, one was on June 26 entitled "Make No Mistake, the Best Days Are Yet to Come in This Space." In the article, I explained, and gave a chart, of the countless blockbuster drugs that are set to lose patents in the next three years. The point being Rite Aid has seen its margins skyrocket, along with its stock, but its large gains along with those of Walgreen and CVS Caremark have been from higher margins.

In the past, pharmacies were lucky to have break-even margins. However, over the last two years, we have watched as Rite Aid's profit margin has gone from negative 1.4% in 2011 to an expected profit of 1% in 2013. And because of Rite Aid's pure size - revenue of more than $25 billion - that small differential has reflected a near $600 million bottom-line improvement over the last two years.

Reasons to be encouraged
Rite Aid has performed nicely as of late, but I don't think its gains are anywhere near complete. There are still countless high-profile drugs to lose patents in the years ahead, including Nexium, Cymbalta, Abilify, Gleevec, and Cresticor. While these five drugs are only a fraction of those to lose patents, these noted medicines earned nearly $25 billion in sales last year. As these drugs, and others, lose patents, generics will be created, and pharmacies are likely to see margins rise even further.

Therefore, the reasons to be bullish on the entire pharmacy space are quite plentiful. Already in 2013, Rite Aid has seen massive gains, but Walgreen and CVS Caremark have also rallied 50% and 25%, respectively. Moreover, both CVS Caremark and Walgreen have boosted guidance, seen strong same-store sales gains, and experienced a rise in monthly scripts in recent months.

While Rite Aid's same-store sales growth is about 1%, and its debt-to-assets ratio far exceeds that of either Walgreen or CVS Caremark, the one metric that really sticks out to me is Rite Aid's price/sales ratio. Even after Rite Aid's massive 25% gain after earnings, it still trades at just about 0.2 times guided revenue.

On the other hand, Walgreen and CVS Caremark trade at 0.7 and 0.6 times sales, respectively. Thus, Rite Aid is significantly cheaper than its competitors, and has been able to create large profits with minor improvements.

Final thoughts
Rite Aid is a $25-billion-a-year company with a market capitalization of only $4.2 billion. Hence, even a marginal profit from $25 billion in sales will look good to a $4.2 billion company. With that said, as new generics are introduced and margins rise further, I think Rite Aid, along with its peers, will also trade higher. And because of Rite Aid's level of value relative to its peers, I don't think its rally is anywhere near being done.

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