Rite Aid (NYSE:RAD) has been on a good run up despite the recent challenges in the market. In the last one year, the stock is up by 196% and year-to-date it is up by about 50%, outperforming the market greatly. As the company's price nears the 52-week high, many people think that it still has room to go up. This article will look at whether this is reasonable from a valuation standpoint.
In the last 30 years, there were some defining moments for Rite Aid. The first moment that comes to mind is the mid-to-late 1990s as the company's revenues jumped from about $5 billion to $12 billion within a short term. The second defining moment happened exactly a decade later as the company's revenues took another jump from $17 billion to $27 billion. After that, the company entered in a slowing period where revenues started to decline at a slow but steady rate and there were other developments worrying the investors, which led to a strong sell off. Currently, the investors are feeling more comfortable about the company's chances of survival and growth.
The first worry about Rite Aid was the company's margins. To be honest, over the years, the company's gross margins have been rather stable or predictable even though there were some speed bumps along the way. For the most part, the company's gross margins ranged between 27% and 30% with some exceptions here and there (for example, the company's gross margin was as low as 22% in the early 2000s). In the last few quarters, gross margins improved nicely as they jumped from 26% to nearly 29% and many investors are hopeful and this trend will hold up.
When we look at the operating margin and net profit margin, we find out that the company "enjoyed" negative margins for a good chunk of the last decade. Even at peak, the company's profit margin barely hit 7.5% and its operating margin barely touched 3%. While things have been improving since 2009, the company's last decade was not always profitable and the slightest mess-up could (and would) swing the company back to the loss territory.
As a result, Rite Aid did not always pile up profits. As you can see in the chart below, things are showing slow and somewhat steady improvement since 2009. Between 2010 and this year, Rite Aid has been becoming more and more profitable each quarter. In the last 12 months, the company posted a tiny profit of 18 cents and many people view this as a good start.
Now we are going to look at how all this affects the company's share price in order to have a better understanding of what lies ahead. The best predictor of the future behavior is the past behavior and the market tends to repeat itself over time. Historically, Rite Aid almost always enjoyed very low price-to-sales ratios because of the company's low profit margins. When a company's margins increase, so does its price-to-sales metric because each dollar generated in revenues have a higher chance of converting into net profits when margins are higher. Before the recession Rite Aid's average price-to-sales ratio was 0.15 whereas this figure fell to 0.05 during and shortly after the recession. Currently, the company enjoys a price-to-sales ratio of 0.29 which is the highest in the last decade even though it looks like a very tiny number.
As for profits, since Rite Aid hasn't always been profitable, it is somewhat meaningless to look at the company's P/E averages through the history. Instead, we can look at the company's price-to-CFO (cash flow from operations) ratios in the last decade. If we exclude a couple swings in each direction as outliers, we find that the company's historical price-to-CFO ratio is about 10-11 which is roughly in line with where this metric is right now.
Having said all this, we also need to look at the company's future to have a better picture of its valuation. If Rite Aid's future looks brighter than its past (or present), it makes sense to assign a higher valuation on the company. For the next two years, the analysts expect Rite Aid to grow its revenues strongly (the blue line in the chart below). By the end of next fiscal year, Rite Aid is expected to generate as much as $26.5 billion in revenues.
Moreover, the analysts expect the company to be much more profitable than it has been in the recent years as we move forward. As you can see in the blue line below, the analysts expect Rite Aid to triple its net income in the next 3 years (up from 23 cents per share to 63 cents per share). If this happens the company will have a P/E in low teens as of Friday's closing price.
There are several exciting things happening at Rite Aid that might improve its chances of meeting these targets. First, the company's loyalty card program is doing pretty well and it is expected to continue the improving trend in the next few years. This ensures a lot of repeat customers, which the company was lacking for a while. This is evident in the company's improving same-store comparisons that are getting better each year. If the trend continues, Rite Aid will regain some of the market share it lost in the last decade.
Furthermore, the company continues to close down inefficient store locations and remodeling a bunch of its locations as Wellness Stores. These stores are an improvement to the old model both in terms of store layout and customer service. Rite Aid is definitely getting better at hiring and training the employees that are more likely to provide a customer service which ensures that customers will keep coming back. This has been one of the main themes in the company's turnaround efforts in the recent years. The healthcare reform might also have some beneficial effects on the company, even though it is too early to tell at this point in time.
Rite Aid is not the only company that's been trying to gain market share aggressively in the pharmacy market. The competition has been tough and it's been getting even tougher. As big chains like Wal-Mart (NYSE:WMT) join the race and the Walgreen Company (WAG) steps up its game, Rite Aid will have to work harder than ever to ensure that its turnaround story doesn't lose steam.
In conclusion, Rite Aid looks fairly valued compared to its historical valuation; however, things have been improving for the company and it might warrant a better valuation than it has enjoyed for the last decade. Investors who believe in the turnaround story of Rite Aid might still find some value in the company's shares even though it usually pays to be cautious after a strong rally like what this company has seen in the last year.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.