NEW YORK (TheStreet) -- Rite Aid (RAD), the third-largest U.S. drugstore chain, delivered an impressive performance in 2013. It has cranked out profits for five consecutive quarters, along with a 260% increase in its share price. However, by mid-December, the company's stock plummeted by 10% due to weak earnings guidance for the current fiscal year. The business's shares have now fully recovered, closing at $5.85 on Friday. Some of this recovery can be attributed to positive commentary by Deutsche Bank, followed by an upgrade by J.P. Morgan.
There are troubling aspects to the business, too. Rite Aid's sales growth has slowed amid the rise of generic drugs.
Despite the slowdown, a weak guidance and the massive rally in 2013, I believe Rite Aid's shares are still attractive for long term investors.
The company has a solid track record of meeting or breaking the market's revenue and earnings expectations. It has been working to increase its revenues and earnings, while its financial health has been improving. The company has delivered a strong performance in the previous quarters and may continue to do so in the coming years.
In the previous quarter, Rite Aid's revenue rose 1.9% year over year to $6.36 billion, above Wall Street's expectations of $6.32 billion. This growth was due to the 2.3% increase in same-store sales, led by a 3.5% increase in pharmacy sales.
Meanwhile, Rite Aid's net income rose 15.6% from the same quarter a year ago to $71.5 million, or 4 cents per share. This improvement came after a drop in interest expenses and lease termination and impairment charges. On the other hand, Rite Aid's adjusted earnings dropped by 4.4% from the prior year to $282.3 million. However, the prior year's results also include an $18.1 million benefit from a litigation settlement.
For the full year, Rite Aid has lowered its earnings guidance from 18 cents to 27 cents per share to 17 cents to 23 cents per share. This was particularly disappointing because even the high end of the guidance is 1 cent below the market's consensus estimate. Moreover, some of its other primary competitors, such as the industry leader CVS Caremark (CVS), are expecting improvements in sales and earnings in the future. CVS Caremark is expecting annual adjusted earnings of between $4.36 and $4.50 per share, which, unlike Rite Aid's guidance, is in line with the market's profit expectations of $4.47 per share.
For the full year, Rite Aid is expecting to generate revenues of between $25.3 billion and $25.4 billion, which is in line with market consensus revenue estimates of $25.36 billion. This will come on top of a modest 0.35% to 0.85% increase in same-store sales. If Rite Aid manages to meet market expectations, then its revenues will be largely flat from last year's $25.39 billion.
Rise of Generics
For Rite Aid, the drop in earnings estimate was due to Medicare reimbursement cuts and the higher cost of some generic drugs. The last couple of years have witnessed the expiration of patents on some leading drugs, which not only had an adverse impact on the top and bottom line growth of pharmaceutical companies, but also changed the business environment for drugstore chain operators.
The relatively cheaper generic drugs were a perfect match for the post-financial crisis period, when organizations were looking for ways to reduce their health care expenditure. As a result, generic drugs have taken over the American market and now account for nearly 80% of all subscriptions filled.
The industry has been shifting toward generics, but the pace of that shift has been slowing down. That being said, it should also be noted that around $15 billion in branded drugs will come off patent in the next couple of years. This means that despite the slow pace, generics could continue to slowly increase their share of the market with the addition of these new and previously unavailable generic drugs.
Although these drugs carry higher margins, they are considerably lower priced. As a result, the rise of generics has an adverse impact on the top-line growth of the big drugstore chains: Rite Aid, Walgreen (WAG) and CVS Caremark. The slowdown in the introduction of generics and increasing competition in this category could be a drag on the bottom line as well.
These were some of the reasons behind Rite Aid's reduction of its earnings forecast. The second biggest player in the industry, Walgreen, is facing similar problems. In its previous quarterly results, Walgreen reported an increase in earnings but its gross margin slipped 1.3 percentage points, to 28.1%.
Three Reasons For Optimism
Although Rite Aid could struggle with top-line growth, there is still a lot to look forward to.
Firstly, the business has been working on its cost-control measures to drive its earnings growth. Its selling, general and administrative expenses, as a percentage of sales, have fallen to 25.6% in the previous quarter from 26.1% in the prior year. Further improvements will lead to better profitability.
Secondly, Rite Aid has been remodeling its stores into the new Wellness format, with more pharmacy services and healthier products. A typical Wellness store has 3.2% better front-end same-store sales than a non-Wellness store. The business has so far converted a quarter of its 4,600 stores into Wellness stores. They will convert nearly 500 more stores to Wellness by next fiscal year. This will give a boost to Rite Aid's revenues and earnings in the coming years.
Thirdly, Rite Aid's poor financial health has been a cause for concern, but the business has been moving in the right direction. In the previous quarter, the company cut its total debt by $44.1 million. Its debt is a lofty 4.5 times its adjusted earnings ratio. But that has improved significantly, from 5.6 times in the same quarter of fiscal 2013. With its strong ability to generate free cash flow, Rite Aid could significantly reduce its debt in the next three to five years.
In short, I still like Rite Aid.
At the time of publication, the author held no positions in any of the stocks mentioned.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.