$RAD Optimists Not Wrong This Time on Rite Aid Shares of

$RAD Optimists Not Wrong This Time on Rite Aid

Shares of Rite Aid Corp. RAD -0.64%are up sharply in 2013, as investors bet that the pharmacy chain can emerge from its multiyear profit slump. This year's 130% gain is faster than those of nearly 60% in the first half of both 2011 and 2012.

Will the company be able to hang on to the gains this time?

On face value, the change in Rite Aid's fortunes is good but not striking. After 21 quarters in a row of losses, the company is expected to report its third consecutive set of positive earnings per share on Thursday. Analysts polled by FactSet predict a profit of nine cents a share in the period through May, compared with a loss of three cents a year earlier.
That sort of swing wouldn't normally justify an incremental $1.80 on a company's share price in just six months unless there is the promise of plenty more to come, and soon.

On valuation alone though, Rite Aid may deserve the benefit of the doubt.

Any comparison with peers has to take Rite Aid's bloated balance sheet into account. Rite Aid's valuation multiple of debt-adjusted market value to revenue of just 0.35 times is only half that of CVS Caremark Corp. CVS -1.37%and Walgreen Co. WAG -1.32%
Rite Aid's debt-to-asset ratio of 85% also is about six times that of its two rivals, a legacy of large acquisitions made just before the financial crisis. The company's recent efforts to retire high-interest borrowings may speed its earnings recovery.

The environment for all drugstores has been tough. They are losing lucrative "front of store" business to discounters such as Dollar General Corp. DG -1.84%and face heightened competition filling prescriptions from supermarkets and national nondrug chains such as Wal-Mart Stores Inc. WMT -1.68%and Costco Wholesale Corp. COST -1.69%
The news isn't all bad, though. Pharmacies are adding services such as clinics and are turning to more profitable store formats. And a shift to generic prescriptions has depressed sales but helped margins.

The more Rite Aid whittles away at its debt-servicing costs, the more it will be able to invest and keep pace with peers as the sector tries to reinvent itself.

Even after its recent rally, Rite Aid has by far the most potential in a sector struggling to find its footing.
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