Rite Aid (NYSE:RAD) seems to have found a bottom. After a 13% bounce in Monday’s roaring market, RAD stock has doubled from where it closed on Dec. 17.

That close came one day before Rite Aid delivered a solid fiscal third quarter earnings report that sent its stock soaring. RAD stock gained 43% the following day. A parabolic rally past $20 went a bit too far, but Rite Aid stock has settled in, trading flat so far this year despite broad market weakness.

One quarter doesn’t necessarily change the story here, which remains fraught with risk. Rite Aid has a heavily leveraged balance sheet. Pressures on the pharmacy sector persist. I’ve been a skeptic toward RAD for years now, and I’m not quite ready to flip bullish.

But I admittedly didn’t see the post-Q3 rally coming, either. I wrote in September that RAD stock seemed like a strong pick only for a ‘blue sky’ scenario. From a short-term standpoint, that’s exactly what Rite Aid has seen.

And from a long-term perspective, recent developments suggest optimism for reasons that go beyond the simple fact that third quarter earnings topped Wall Street expectations. It’s worth considering those developments, while also keeping a sober eye on the myriad risks that face Rite Aid going forward.

Rite Aid’s Struggles

Part of my argument in September was that, from a risk/reward standpoint, Rite Aid stock wasn’t that attractive even for investors who leaned bullish toward the company and its industry. Many RAD bulls have laid the company’s troubles at the feet of former chief executive officer John Standley, who supposedly ran the company into the ground. It’s not that simple.

The headwinds facing Rite Aid are facing the entire sector as well. Insurance providers have lowered reimbursement rates in a bid to protect their own margins. Cost savings from generic drugs have disappointed. In fact, in June 2018, when Rite Aid updated fiscal 2019 guidance during its planned merger with Albertsons (before it fell through), the company estimated that purchasing efficiencies alone had come in some $80 million below expectations.

Over the past two years RAD stock has declined 60%. But Walgreens Boots Alliance (NASDAQ:WBA) is down 32%. The difference isn’t necessarily that Rite Aid has performed more poorly than its larger rival, to which it sold over 2,000 stores. Rather, Rite Aid simply has more debt and a smaller portion of its enterprise value in equity.

In fact, over that stretch, Rite Aid’s enterprise value (net debt plus market capitalization) actually has declined by less than that of Walgreens. To be sure, both stocks have underperformed CVS Health (NYSE:CVS), whose numbers are impacted by the late 2018 acquisition of Aetna.

Rite Aid’s problem isn’t that its value has declined further than that of Walgreens because of poor performance. In fact, its front-end sales growth actually has been better than that of its two rivals. The problem has been that the entire sector has struggled, which has made Rite Aid’s debt an anchor.

RAD Stock Outperforms

That debt looked like a significant issue last year. And it left RAD as a seemingly difficult choice.

After all, for Rite Aid to rally, the sector likely had to rally as well. Presumably, it would take an easing of industry headwinds — higher reimbursement and/or lower generic drug prices — to boost Rite Aid’s profits and valuations. In that scenario, RAD stock might outperform, but shares of Walgreens and CVS would rally as well.

Interestingly, that hasn’t happened. Rite Aid stock has significantly outperformed. Since Dec. 17, RAD stock is up 101%. CVS is down 17%, and WBA 14%.

That’s good news looking backwards, obviously. But it’s good news looking forward as well. Rite Aid’s third quarter results improved without much, if any, help from its industry. It wasn’t sales that improved year-over-year in the third quarter. It was margins.

For the retail business, Adjusted EBITDA (earnings before interest, taxes, depreciation and amortization) was 2.78% of revenue in Q3 FY20, against 2.55% the year before. In Pharmacy Services (the EnvisionRxOptions business), margins expanded 35 bps year-over-year.

That doesn’t sound like much. But with annual revenue over $20 billion, that kind of expansion can have an enormous impact. Indeed, it was margins, not sales, that drove the beat relative to Street expectations in Q3. Earnings per share were a full 39 cents higher than the average analyst estimate. Revenue was essentially in line.

What makes RAD stock interesting after the quarter is precisely the fact that it doesn’t appear to have received much outside help. If it can expand margins in this environment, what happens if and when external pressures ease?

Bonds Rally

Rite Aid stock has outperformed another of the alternatives cited last year, though to an extent that suggests optimism toward that alternative wasn’t far off.

While Rite Aid stock has doubled since December, its lower-risk bonds have rallied sharply as well. The 7.7% notes due in February 2027 traded below 50 in early October. They’ve rallied 71% since.

That’s good news for a number of reasons. First, strength in the bond market at least supports the optimism seen in the equity market. Debt investors aren’t necessarily smarter than equity investors. But they are more focused on risk.

And particularly given RAD’s thin float following its reverse split, there’s the possibility for the equity to outrun its fundamentals. The gains in the bonds shows that even more cautious institutional investors in the bond market have seen recent results as materially changing the story.

Second, Rite Aid is going to need to refinance its debt at some point. The company doesn’t have a significant maturity until 2023, so it has time. But a bond price below 50 makes refinancing discussions all but impossible. Above 80, Rite Aid at least is moving in the right direction. As refinancing risk comes down, RAD stock should move in the opposite direction.

Finally, the rally in the bonds undercuts precisely the case I made in September. Back then, Rite Aid’s debt seemed a potentially better risk-adjusted play, given that there is likely some recovery value even in the worst-case scenario.

That’s a tougher case to make now. Bulls still can buy the bonds, but they’re incrementally more likely to buy RAD stock.

Still, Some Caution

There’s real optimism here. But there’s real risk, too.

Rite Aid’s net debt, pro forma for the sale of two distribution centers as part of the amended Walgreens deal, still sits near 6x EBITDA. That’s a dangerous level. As thin as margins are, a reversal of recent performance could expand that ratio, send bond prices plunging, and trigger fears of a restructuring.

Meanwhile, the simple bull case here — that Rite Aid simply needed a change in management — is a little too simple. RAD stock soared in Standley’s first few years as CEO after the financial crisis. He steered the company to the Walgreens deal before worries about antitrust approval scuttled it. (Standley was dramatically overpaid, but that’s sadly not a problem confined to Rite Aid.)

There’s optimism toward new CEO Heyward Donigan. I’m loath to give him too much credit for the Q3 performance, however, given that he took over only 19 days before the quarter started. I’m not quite ready to see Rite Aid as a turnaround story along the lines of General Electric (NYSE:GE) or, to use a more successful example, Bausch Health (NYSE:BHC), in which a charismatic CEO changes the culture and fixes the balance sheet.

There’s a lot of work left to do. And Rite Aid likely still needs external help at some point.

Still, the optimism of late makes some sense. There’s real good news for the first time since the Walgreens deal broke. And there’s a path to huge upside if the momentum continues.

Vince Martin has covered the financial industry for close to a decade for InvestorPlace.com and other outlets. He has no positions in any securities mentioned.