Rite Aid (NYSE:RAD) released its definitive results for the first quarter after warning earlier this month that the results would not be as strong as anticipated.
The company is facing what I believe are hiccups in its impressive recovery and is entering a medium-term consolidation phase. If the economy remains solid, however, the company's shares have the potential to approach the $10 mark later this year.
Official First Quarter Results
Rite Aid posted revenues of $6.46 billion, up 2.7% compared to the year before. Adjusted EBITDA came in at $282.6 million, the equivalent of 4.4% of total sales.
Despite the modest revenue growth, earnings tumbled. Earnings were down by nearly 54% to $41.4 million. As such, earnings per diluted share fell from nine cents to just four cents.
A few weeks ago, Rite Aid guided for GAAP earnings of $35 million to $45 million, and adjusted EBITDA of $275 million to $285 million. As such, the official results are in line with the preliminary results.
Looking Into The Results
As telegraphed before, Rite Aid saw solid growth in same store sales and same store prescription counts. Same store sales were up by 3.1%, driven by a 4.6% increase in same store pharmacy sales, which was offset by flat front-end sales. Generic introductions limited same store sales growth, offset by more subscriptions being filled.
Yet the higher than expected drug costs and pressure on reimbursement rates have impacted gross margins from both sides.
As such, gross margins compressed by 95 basis points to 27.9%. Modest sales growth and cost consciousness allowed Rite Aid to cut selling, general and administrative expenses by 16 basis points to 25.4% of sales.
Yet the gross margin compression had huge consequences for reported earnings with net profit margins being just 0.6% of total sales. This is down nearly 0.8 percentage points compared to last year.
Valuing Rite Aid
The company managed to slightly reduce its leveraged balance sheet, cutting its total debt position from $5.9 billion to $5.7 billion. Cash and equivalents balances were up slightly to $166 million, resulting in a net debt position of about $5.5 billion.
Based on the current path, annual revenues are seen between $26 billion and $26.5 billion as Rite Aid reiterates its 2015 earnings outlook for earnings of $298 million to $408 million. This is equivalent to earnings of $0.30 to $0.40 per share. This came as no surprise to analysts, whose expectations were in line with Rite Aid's outlook, looking for revenues of $26.2 billion for 2016.
At $7.20 per share, Rite Aid's equity is valued at $7 billion, or 0.27 times anticipated sales and 20-21 times earnings.
Struggles During The Recovery
Rite Aid is making a nice comeback recently, although it appears to be struggling with falling reimbursement rates, a trend continuing in the second quarter as the company is unable to negotiate lower drug costs.
These short-term struggles have resulted in a modest sell-off in its shares after witnessing a huge run-up over the past year. The continued improvements in comparable store sales driven by the remodeling of the stores and the set up of the wellness concept drives appeal. Some 1,325 of Rite Aid's 4,581 total stores have such a wellness segment as of the end of the first quarter. The company's loyalty initiatives have been well received by its customers as well.
The aging population and introduction of the Affordable Care Act have been very much welcome tailwinds for the business during this transition phase.
The years of operational struggles left the company quite leveraged with a net debt position of about $5.5 billion. Fortunately, no significant amounts of debt are due before 2018.
The continued improvements in its operations have driven the momentum in Rite Aid's stock over the past year. Bears have long pointed out the leverage and troubled past of the chain, which is still facing a huge battle with its two major competitors Walgreen (WAG) and CVS Caremark (NYSE:CVS). Yet industry growth, an improved economy and the Affordable Care Act have enlarged the pie for all three companies.
Walgreen's shares have risen 55% over the past year on the back of market sentiment, the improved conditions and the Boots deal. It is now valued at $71 billion, or 1.0 times revenues and 28 times 2013's earnings of $2.5 billion. Note that significant earnings growth is anticipated at Walgreen on the back of the Boots deal, related synergies and a potential inversion move.
CVS Caremark saw its shares rise by 37% over the same time frame, pushing the valuation to $91 billion. This values this company's equity at 0.7 times annual revenues and roughly 20 times earnings.
Shares of Rite Aid have risen 150%, but shares still trade below 0.3 times annual revenues. Part of this huge revenue discount is the fact that Rite Aid employs much more leverage on a relative basis. The second reason is the fact that its competitors earn after-tax profit margins of 3-4% versus just 1-2% for Rite Aid. Part of the profit differential is explained by superior execution, part is scale and part is leverage.
Those thinking that Rite Aid has the potential to close the revenue valuation gap are too optimistic. More upside might be ahead, but I see margins topping out at 2%-3% for the firm, which allows Rite Aid to reduce leverage. Even then, it limits earnings to some $700 million per annum, potentially attainable in 2016 if all goes well.
This will provide enough of a push to send the stock price toward $10-$12 per share if the market and economy continue to be solid. Be aware, however, that if operational issues become more persistent, or if the economy takes a downward turn, the leverage results as an accelerator to the downside as well, of course.
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