Rite Aid: Patience Is Sweet

| About: Rite Aid (RAD)
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Rite Aid was finally able to shed the negative factors that were temporarily stymieing its stock price.

Previously, I outlined a number of short-term, negligible factors that lead to an undervaluation and explain them here to allow readers to identify similar ones in other stocks.

RAD is certainly not as undervalued as it was a few weeks ago, but remains a prudent investment.

Patience is bitter, but its fruit is sweet. - Jean-Jacques Rousseau

Rite Aid (NYSE:RAD) had been castigated by the market for numerous reasons. Over the past few months, I have written numerous articles on RAD, with a common theme - a confluence of short-term factors are stymieing the stock temporarily. After the most recent quarterly report, it appears that my sentiment was on point.

Quick Quarter Primer

In the 3rd quarter, RAD reported revenue of $6.69 billion (+5.2% Y/Y), beating estimates by $40 million. Revenue was boosted by same-store sales rising 5.4% in the quarter. Moreover, it reported EPS of $0.10, blowing away estimates by $0.05 per share. Investors also rejoiced on the news of full year guidance being raised.

To give some insight into my investment thesis and why I thought the poor performance would be temporary, I will provide some commentary on the factors I identified. Hopefully seeing these factors will allow you to identify similar ones in the future that don't have long-term implications on a stock.

Short-Term Factors Outlined

1. McKesson Agreement Delay

The first and most salient factor that I identified was the delay of the McKesson distribution agreement which temporarily reduced profitability. Management was a bit overzealous with their projections for the McKesson agreement implementation, which led to a lowering of guidance. The lowered guidance sparked a tremendous sell-off, and I purchased shares at that point. In the long run, the slightly reduced profitability was not going to have a large impact and was just a small blip for RAD. You have to consider how important a few million dollars will inevitably be in the long run.

Here is evidence that the McKesson agreement being implemented was important for the quarter's outperformance:

The improved pharmacy gross profit was driven by the increase in pharmacy prescription revenues and a reduction in generic drug costs, driven by the company's transition to its new drug purchasing and delivery arrangement with McKesson, partially offset by lower reimbursement rates." Source: Press Release

2. Walgreen Deal with Alliance Boots (a corollary to the McKesson factor)

Here is an excerpt from my October 1st article on RAD, when it traded at $5.09 per share:

Last month, when Walgreen (WAG) announced a deal with Alliance Boots, RAD fell 6%. There were two unwarranted reasons for the decline after the announcement. First, investors believed the merger, which will give WAG a tremendous footprint, will allow it to benefit from improved buying power and undercut RAD. However, RAD's deal with McKesson mitigates this risk, as McKesson has enormous buying power. Moreover, the selloff was also a function of the two stocks being correlated to each other. As you can see, WAG announced positive earnings Tuesday morning and RAD went up as a result."

This negative catalyst involved more market sentiment than actionable information that would influence a stock.

3. "Smart" Money Exit

On July 28th, RAD slipped 5% amid news that David Einhorn's Green Light Capital sold their stake in RAD. Einhorn cited RAD being fully valued as his reason for unloading the shares. However, institutional selling is not a statistically significant event on the future prospects of a company. Moreover, RAD traded as high as $8.50 during the quarter, so Einhorn may have unloaded at much higher level than $5 price that resulted after the news was announced.

This factor shows how influential market sentiment is on stocks and is the epitome of how emotions can alter a stock when fundamentally nothing has changed.

Final excerpt from my October 1st article:

Investors should rejoice with the series of negative events that have merely short-term implications for Rite Aid. This pullback provides investors with an opportunity to average down, which I have been taking advantage of over the past few days. Rite Aid is unlikely to stay at this level and those who fail to accumulate shares now will be kicking themselves in the future."

Conclusion on RAD case study:

I am not outlining my strategy to tell readers, "I told you so" or to get praise for my thesis. The thrust of this article was to allow readers see a case study to identify and distinguish factors that have important implications from the ones that only have short-term effects. Investing for the long term and tuning out these insignificant factors can have substantial positive effects on your investing success. I hope this provided some insight into how to avoid falling prey to the ubiquitous myopic nature of the stock market.

Conclusion on RAD's future:

Although the cat is out of the bag, and RAD has fallen back into the favor of Mr. Market and is not as undervalued as it was a few weeks ago, there is still reason for optimism.

RAD is set to experience a tailwind from a boon to the industry as a whole. The passage of the Affordable Care Act will allow for millions of Americans that were previously unable to afford health insurance to obtain it. That will result in RX counts increasing and traffic to stores improving as well, which should benefit front end sales. Additionally, there will be a shift to generic drugs which have wider margins for drug stores. The final benefit to the industry will be the aging baby-boomer demographic, which is rapidly entering senior age. The elderly have a much higher dependence on pharmaceuticals, so RX sales will rise.

Moreover, besides the industry tailwinds, RAD will become more lean and improve profitability moving forward. RAD will be able to pay down its debt (over $5 billion currently) with its improving cash flow, which will reduce interest expenses ($97 million in Q3 alone).

Although RAD has gapped up recently, it still remains a prudent investment and will continue to occupy a percentage of my portfolio for the considerable future.

Disclosure: The author is long RAD.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.