Balm for Your Portfolio

 | Oct 09, 2013 | 10:00 AM EDT
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Nearly 18 months ago, I recommended Rite-Aid (RAD) after I researched the stocks based on the recommendation of an extremely smart friend and insightful investor. (He is the chief financial officer of a publicly traded company, to boot!) As is often the case, patience is being rewarded. The stock treaded water for the next nine months, but Rite-Aid has been a rocket ship this year, with shares up nearly 500%. Naturally, that sort of appreciation raises the question of whether I should lock in profits or let my winners run.

Rite Aid (RAD) -- Daily
Source: Yahoo! Finance

As is usually the case when a stock is soaring, striking earnings performance is usually the cause. Rite-Aid recently reported blow-out earnings, with a 45% rise in earnings before interest, taxes, depreciation and amortization -- to $318 million -- in the second quarter. That's far ahead of the Street consensus of $238 million. Management also raised full-year guidance by 10% due to this momentum, and the company now expects to book more than $1.2 billion in EBITDA.

Strong results are really a margin story, since fiscal 2014 revenue expectations of $25.4 billion are not appreciably higher than the 2013 actual top line of $25.39 billion. Demonstrating the margin potential, second-quarter gross margin was up 132 basis points year over year. That came as more generic drugs, better front-end performance and cost controls squeezed more profit out of each revenue dollar. Low interest costs have not hurt, either, especially given Rite-Aid's still-high debt load. Interest expense declined 17% year over year despite debt that remained nearly flat.

Both pharmacy and front end are benefitting from good foot traffic. The thesis 18 months ago was that the Walgreen (WAG)-Express Scripts dispute would drive customer traffic to competitors, and Rite Aid has done a great job of retaining those customers. Management noted that the company has retained 75% of the customers gained from that period, and those customers are now being "monetized" as they visit the stores.

The positive 2014-and-beyond guidance is due in large part to the success of an ongoing store renovation program. Stores that have been refreshed into the "Wellness" concept are outperforming the corporate average in both pharmacy and front end, which indicates customer acceptance of the concept. Rite Aid expects to complete 1,200 remodels by the end of the fiscal year.

At $5, the share valuation is reasonable if future earnings only meet expectations. But, of course, if the company continues to blow out numbers, the stock could move higher. With enterprise value of around $10 billion against the EBITDA of $1.2 billion, the valuation is at around 8 -- probably a touch high for this industry and balance sheet.

So the stock could take a short-term breather. Still, there's the prospect of another wave of generic drugs coming on-market next year, the continuing Wellness store refresh, additional cost-cutting and interest expense reduction, as well as a (presumably) positive contribution from Obamacare. All of this should drive better-than-expected results for the next few quarters.

After its near-death experience in 2009, and several more years of "wandering in the wilderness," I am willing to let this one run a bit longer now that it is working.

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