Shares of struggling pharmacy retail operator Rite Aid (NYSE:RAD) have sprung back to life in a big way over the past few months, as investors are growing more optimistic on the company’s turnaround plans, but RAD stock still has some hurdles to clear.
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Specifically, Rite Aid reported blowout third-quarter numbers in late December that included positive revenue growth for the first time in a year, and profit margin expansion for the first time in several years.
Investors extrapolated from the uniquely positive results that new management’s turnaround initiatives are starting to take hold. RAD stock nearly tripled from $8 to over $20 in just a few days.
But, when it comes to this big rally in Rite Aid stock, I’d tread carefully.
Although Rite Aid’s third-quarter numbers were better than usual, they still weren’t good. Revenues and margins barely rose. And, while management is doing the right things to stabilize sales and margins, the company is cash-strapped. Further changes will be executed with limited resources. That’s not a recipe for success, especially when competitors CVS (NYSE:CVS) and Walgreens (NASDAQ:WBA) have far more resources.
It’s also concerning that CVS appears to be firing on all cylinders with its new HealthHUBs. That presumably means CVS is stealing traffic from Rite Aid. At the same time, it’s concerning that Rite Aid stock trades at 50-times next year’s earnings estimates. That’s a huge multiple for a struggling pharmacy retail stock.
In other words, a lot of turnaround hope is priced into shares, and I’m not sure all that hope is warranted.
Rite Aid Still Has Problems
Rite Aid’s problems didn’t just disappear because the company reported positive revenue growth and margin expansion in its third-quarter earnings report.
Sure, the new management team is doing everything they should be doing, which is changing the company from head-to-toe. They are revamping stores, overhauling the company’s digital operations, expanding omnichannel capabilities, improving pharmacist-client relations, and expanding an in-store-pickup partnership with Amazon (NASDAQ:AMZN). These changes are working.
But, even with all those changes, revenues rose just 0.2% year-over-year, while profit margins expanded less than 30 basis points. Next quarter, revenues are expected to rise by more than 1%. But, profit margins are expected to compress.
And that’s the big problem with Rite Aid. For years, this company has slid into retail pharmacy irrelevancy. In order to spring back into relevancy and drive positive revenue growth, the company is going to have to make some big changes and investments.
That requires a lot of cash, which Rite Aid doesn’t have much of (only $290 million in cash on the balance sheet, with negative cash flows over the past 12 months). It also requires an increase in opex, which means Rite Aid’s margins will likely go back to falling over the next few quarters.
So, going forward, Rite Aid is going to have to cut into its already cash-strapped balance sheet and pull down its already low-profit margins. There’s no guarantee that these changes will drive positive sales growth. And, any sales growth they do drive, will likely be very mild.
Big picture — this is a slow turnaround on unsure footing. But, you would never guess that by looking at Rite Aid stock.
Rite Aid Stock Is Expensive
According to Wall Street consensus estimates, Rite Aid projects to do about 28 cents in earnings per share in fiscal 2021 (calendar 2020). Rite Aid stock presently trades hands at $13.50. That means this stock is trading at nearly 50-times next year’s earnings estimates.
That’s a huge multiple. According to Yardeni Research, drug retail stocks normally trade around 9-times forward earnings. Clearly, a lot of optimism regarding management’s ability to turn this sinking ship around is priced into the stock.
That optimism appears misplaced. This turnaround is moving at a snail’s pace. It’s fueled by big investments, yet management doesn’t have enough resources to keep funding big investments. Competitors have a ton of momentum right now, and much deeper pockets to accelerate that momentum. Margin headwinds are projected to stick around for at least the next few quarters.
Overall, this doesn’t feel like a stock that should be trading at 50-times next year’s earnings estimates. So, from a valuation perspective alone, I’d caution against chasing the recent rally in Rite Aid stock.
Bottom Line on RAD Stock
Things are getting better at Rite Aid. But not that much better. This is a specialty pharmacy retailer that should be able to stabilize sales and margins over the next few years. But, what’s priced into the stock at this point in time is so much more than that, and that makes shares unnecessarily risky at current levels.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.
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