Rite-Aid's a Prescription for Trouble

The Stocks Under $10 newsletter is about more than just finding the next Microsoft (MSFT) or Intel (INTC)early in its life cycle. Making money in low-dollar stocks also requires a keen sense of what not to buy. Here's a rundown of how we spotted one rotten apple among the bunch earlier this year, saving readers from a potential catastrophe.

Since our first bearish report on May 21, Rite Aid (RAD) has lowered profit guidance twice, and missed monthly comp sales estimates. Management delivered its most recent shortfall last week, saying that increased competition from mail-order prescriptions caused Rite Aid to fall short of the revenue level it reached in 2003, when the company saw increased traffic during the California grocery workers' strike.

In addition, the company cut its 2005 sales forecast and said it now sees earnings coming in between 3 cent and 12 cents a share versus its previous guidance of 16 cent to 22 cents a share. This, on top of a Morgan Stanley downgraded and a Merrill Lynch sell recommendation earlier in the week pushed the stock near its 52-week low at $3.36 a share, 28% below its May price.

When we were first putting the newsletter together in May, searching through stacks of pages full of stocks trading under $10, we noticed a lot of familiar names. For one, there were dozens of former highflying technology behemoths like Sun Microsystems (SUNW), Nortel (NT) and Lucent (LU)but those stocks had already had their boom day in the late 1990s. There were a handful of airlines like Delta (DAL)and UAL (UALAQ:OTC BB), but these stocks seem to be permanently mired by high-fuel expenses, exorbitant labor costs and defined pension liabilities.

Rite Aid was also on that list. Shares of the country's third largest pharmacy chain had been down since an accounting scandal was uncovered in 1999, when the stock was trading around $50. But value investors were circling around Rite Aid in May, as the stock had recovered more than 30% in the past year, and the industry was consolidating.