A Cautionary Approach to Rite Aid

 | Jun 18, 2013 | 11:00 AM EDT  | Comments
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Stock quotes in this article:

rad

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cvs

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wag

Since Rite Aid (RAD) shares crossed $1.20 with its first quarterly profit in six years, I have been its loudest cheerleader. I have written countless bullish articles on Seeking Alpha, Nichols Today, and Motley Fool explaining why it is the cheapest of the pharmacy stocks and why it will continue to trade higher now that the macro condition has changed. Yet, while my long-term outlook and target of $7 remains the same, I am offering an outlook not seen in my previous postings, only available here on Real Money, and that is the possibility of selling into the final six months of this year.

Rite Aid has been driven higher for two reasons: It is now profitable and because it was remarkably cheaper than its competitors. Rite Aid is seeing year-over-year revenue losses, but because of its price-to-sales ratio, revenue is irrelevant. The company had traded at just 0.05x sales due to carrying a larger amount of debt relative to assets and its lack of profit compared to its competitors. Now, with the company profitable, its P/S has risen to 0.11 with a 200% six-month gain -- still 6x cheaper than CVS (CVS) and Walgreen (WAG).

The value presented in shares of Rite Aid is unprecedented. The company still carries a large debt load, therefore, it is not worth the same premium as its larger competitors. Yet, I still say that it's worth every penny of 0.3x sales, still just half of its competitors. But this is a long-term target based on a shifting macro environment in which the company is the beneficiary.

Due to the patent cliff in the pharma space, Rite Aid has become a profitable company. The patent cliff was thoroughly discussed in 2011/2012 and is expected to occur for the next two years. With generic drugs, pharmacies are paid a higher premium from the drug developers, producing higher gross margins.

The problem is that after a 200% six-month gain and two massive quarterly beats, investors are growing accustomed to better-than-expected performance. On June 7, the company raised its expectations again. The company said that for the fiscal first-quarter 2014 it's expecting earnings between $75 million and $90 million, or $0.08 to $0.09 per share. Analysts expect $0.04 per share, on average.

Then, towards the bottom of the press release, the company updated 2014 full-year net income guidance to between $0.04 and $0.19 per share, or $49 million to $189 million. Granted, the company has exceeded all of its own estimates and has made a habit of over-delivering. My fear is how the stock might respond if the bulk of earnings occur in this current quarter and then we see one or two quarters of weak performance.

The company already said that it's expecting results in the second half of its fiscal year to be negatively impacted by fewer generic introductions. Therefore, its performance becomes a question of volume and how well the company performs on a month-to-month basis. I view this as bothersome, and I believe that it could indicate a three to six month period of consolidation.

Unfortunately, no stock trades higher on a continuous basis. There are always going to be periods of profit-taking and slight pullbacks, even during a broader trend to the upside. In Rite Aid's case, this is possible. Therefore, I am trimming my position this week. I currently own 15,000 shares (10,000 shares at $1.21 and 5,000 shares at $1.86). Thus, I am cutting 5,000 shares. If I am right and the stock pulls back on a weak second or third quarter, then I will hope to buy back around $2.50. If I am wrong, I will continue to hold and ride this stock higher long-term to my goal of $7 because my long-term target is unchanged.

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