Shares of struggling pharmacy retailer Rite Aid (NYSE:RAD) staged a huge rally in late 2019 on the heels of a strong third -quarter earnings report. The results indicated that the turnaround plan of the company’s new management is off to a good start. In less than five trading days after the results were released, RAD stock nearly tripled, soaring from $8 to over $20.
I don’t believe that investors should be fooled by the huge rally of Rite Aid stock. Indeed, RAD stock has already tumbled to about $13.50. But I think it will drop much further.
Sure, the outlook of Rite Aid stock has improved. Its new management is doing all the right things to stabilize the company’s sales and margin trends and give it a shot at sustainable profitability in the long run.
But things weren’t good enough to justify a 200% rally in a few days. This company is still the worst-in-class retailer in a tough pharmacy segment. The Q3 results indicated that the company may actually survive. But its turnaround will be slow and weak.
So I believe that the big spike of RAD stock in late 2019 is unsustainable. It was just a head fake, as momentum shorts who were piling on the stock and betting on bankruptcy were forced to cover as the bankruptcy thesis was thrown out the window. This short covering will eventually subside. As it does, the buying power which had pushed Rite Aid stock up above $20 will also weaken, pushing the shares down.
RAD stock won’t stop dropping until its valuation matches the reality that Rite Aid is a low-growth company with limited ability to increase its profits. Unfortunately, that won’t happen until RAD stock features an $11 price tag. As a result, the shares will likely keep dropping before they find support.
Rite Aid’s Fundamentals Are Improving
Rite Aid’s fundamentals are definitely meaningfully improving, as its new management is charting a course that will enable it to avoid bankruptcy and stay alive for a little while longer.
In 2019, Rite Aid put in place a new management team. This new management team is trying to change the company from head to toe. That’s a good thing. Rite Aid could use change everywhere because the last few years have been defined by negative revenue growth, margin erosion, and a consistent slide into irrelevancy.
Management’s changes have included revamping stores, overhauling the company’s digital operations, expanding its omnichannel capabilities, improving its pharmacist-client relations, and expanding its in-store-pickup partnership with Amazon (NASDAQ:AMZN). These changes are working. In Q3, its revenues rose over 0.2% year-over-year, while its EBITDA, excluding some items, rose $15 million. Those were its biggest revenue and EBITDA increases in several quarters.
Management is in stage one of its planned turnaround. Consequently, as RAD’s top executives continue to effect change throughout the entire company over the next several years, the company’s revenue and profit trends should continue to improve.
But Not By That Much
While Rite Aid’s fundamentals are improving, they aren’t improving by that much.
Its revenue growth trends are improving, thanks to management’s comprehensive changes. But there are two catches. The first catch is that Rite Aid is playing catch-up in a very tough and competitive pharmacy segment that includes much bigger, deeper-pocketed, and more resourceful competitors like Walgreens (NASDAQ:WBA), CVS (NYSE:CVS), Walmart (NYSE:WMT), Target (NYSE:TGT), and Amazon.
Rite Aid may be able to survive in that competitive environment. But, it will never thrive, especially because consumers are increasingly pivoting towards all-in-one shopping destinations like Walmart and Target. Thus, while RAD’s revenue growth trends will improve, its revenue growth will forever remain very low.
The second catch is that all of this change requires investments. A better e-commerce site requires more expensive developers. Remodeling stores costs lots of money. So, while RAD’s management is taking all the necessary steps to stabilize its sales, all of those steps are expensive. Indeed, in Q4, RAD’s expenses are expected to increase at the fastest rate in several years.
So Rite Aid’s fundamentals are improving, but its revenue growth rates will remain sluggish and rising expenses may keep its margins stuck in neutral.
Rite Aid Stock Is Overvalued
A realistic assessment of Rite Aid’s turnaround potential reveals that RAD stock is overvalued at its current levels.
Analysts, on average, expect Rite Aid’s revenue to climb just over 2% in Q4. Importantly, in Q4 of 2018, RAD’s revenue fell. Going forward, Rite Aid’s revenue comparisons will get tougher, as the company’s revenue rose in 2019 versus 2018.
These tougher comparisons, coupled with a fiercely competitive landscape, will keep the company’s revenue growth rates stuck in the 0.5% to 1% range over the next few years.
At the same time, Rite Aid’s operating expenses, which have been shrinking, will start rising again because management’s proposed changes require higher spending. Over the next few years, Rite Aid will likely combine 0.5% to 1% revenue growth with roughly 0.5% spending increases.
If that’s the case, then Rite Aid will be a slower revenue grower with some, but not a lot, of room for profit margin expansion. My modeling suggests that this combination will push its earnings per share towards $1 by 2025. Using a 2025 price-earnings multiple of 16 times earnings, which is average for the market, I arrive at a 2024 price target for RAD stock of $16. Discounted back by 10% per year, that equates to a 2020 price target of just under $11.
The Bottom Line on RAD Stock
Rite Aid is in the early stages of a turnaround. But its weak turnaround is moving slowly. During its huge rally, Rite Aid stock was trading as if it was in the midst of a quick, strong turnaround. That mismatch was the result of short covering.
Unfortunately for bulls, that means Rite Aid stock will keep dropping before it finds support.
As of this writing, Luke Lango was long WMT.
