Shareholders in drugstore chain Rite Aid (NYSE: RAD) have been enjoying strong price appreciation over the past five years, with the company's shares up more than 200%. Rite Aid has benefited from a solid improvement in its adjusted operating profitability during that period, primarily due to its success at growing higher-margin pharmacy sales at its stores, which has positively impacted its overall gross margin, as illustrated in the below table.
Source: Rite Aid 2014 10K Report
However, Rite Aid's favorable stock price trajectory took a bit of a U-turn in September, after it lowered its profit expectation for the current fiscal year, a revision that management attributed to margin pressure on pharmacy sales, especially in the generic drug category. On the upside, though, the company has continued to post top-line growth in the current fiscal year, up 3.3%, a positive trend that bodes well for its ability to generate further profit growth in the future. So, at its discounted price, is Rite Aid a good bet for investors?
What's the value?
Rite Aid is one of the major players in the drugstore space, operating a network of roughly 4,500 stores around the country, mostly concentrated on the East and West coasts. Like its major competitors, Rite Aid has anecdotally benefited from the rising prescription needs of an aging population, a trend that has positively impacted its customer transaction volumes and tilted its sales mix toward higher-margin pharmacy sales. The net result for Rite Aid has been a sharp increase in its adjusted operating profitability over the past five fiscal years, leading to a more than tripling of its operating income.
In its latest fiscal year, it was more of the same for Rite Aid, evidenced by a roughly 80 basis point increase in its adjusted operating margin that helped to fuel a 17.4% increase in its operating income. During the period, the company's profitability was positively impacted by higher comparable store sales of pharmacy products, up 1.2%, as well by overhead efficiencies that were a by-product of recent cost saving programs, especially in the purchasing area. Not surprisingly, Rite Aid continued to generate relatively strong cash flow, providing capital to fortify its debt-heavy balance sheet, while allowing it to invest in its growth initiatives, including a larger footprint for its walk-in clinic business.
Looking into the crystal ball
The question for investors is whether Rite Aid can continue to post profit growth going forward, thereby creating a solid foundation for a higher market valuation. On that score, things aren't looking so good, judging by the company's 5.8% decrease in adjusted operating income in the current fiscal year. Rite Aid was hurt during the period by margin pressure on its sales of prescription drugs, which account for nearly 69% of its total sales. More importantly, as previously mentioned, management is expecting that margin pressure to continue going forward, bringing into question whether the company will be able to engineer profit growth in the current fiscal year.
A better way to go
Given Rite Aid's near-term profit growth challenges, investors looking for gains in the sector should probably stick with a player that continues to deliver solid growth in the current environment, like CVS Health (NYSE: CVS). While the company has not been immune to the prescription drug pricing pressures affecting the industry, it has negated them by finding cost-efficiencies in its overhead support infrastructure, partly through cost sharing with its large and growing pharmacy benefit manager unit, an advantage not available to smaller competitors like Rite Aid. The net result for CVS Health has been an uptick in operating margin in FY2014, up 40 basis points, culminating in a 15.4% increase in operating income.
The bottom line
Rite Aid is certainly cheaper than it was just a few short months ago, after a sharp decline that has the company's stock price sitting near a 52-week low. However, even after that decline, Rite Aid still sports a forward P/E multiple of roughly 19, a level that seems a bit pricey for a company that has failed to generate an increase in operating profit to-date in the current fiscal year. As such, Rite Aid seems to have more downside risk than upside potential at current prices, and investors should probably avoid the story.
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