Better Buy: Rite Aid vs. Walgreens Boots Alliance

If you weren't an investor, you might think neighborhood convenience stores like the two we're analyzing today -- Walgreens Boots Alliance (WBA 27.55%) and Rite Aid (RAD) -- made their dough selling snacks, soda, and household items. But the truth is that the pharmacaies within the stores are their golden goose.

Over the past five years, neither company's stock has come close to beating the market. That said, Walgreens' shareholders have fared much better, earning 19% returns versus an enormous 88% loss for Rite Aid over the same time frame.

Image source: Getty Images

But that's the past, and the stock market cares more about the future than anything else. While it's impossible to know for certain which company is a better buy at today's prices, let's evaluate these two on three different facets to see which comes out ahead.

Financial fortitude

When I talk about financial fortitude, what I really want to know is this: How would the company be affected by an immediate and fairly long-lasting financial downturn? Companies with lots of debt and little cash flow are apt to fold, but those in the opposite circumstances -- lots of cash, little debt, and strong cash flows -- can actually grow stronger, acquiring rivals and grabbing market share while weaker players are forced out.

Keeping in mind that Walgreens is valued many multiples higher (over 80X) than Rite Aid, here's how the two stack up.

Data source: Yahoo! Finance. Cash includes long and short-term investments. Free cash flow presented on trailing twelve-month basis.

This is really no contest. While Walgreens technically has a bigger debt load -- with a net cash position of negative $4 billion versus Rite Aid's negative $3 billion -- we need to look at the bigger picture. Walgreens has massive free cash flows coming in the front door, making debt payments an easy task to handle. Rite Aid does not, which helps explain why the company is in such dire straits.

Winner = Walgreens

Valuation

Next we have the murky science of valuation. There's no single variable that will tell you which of two stocks is "cheaper" or more "expensive". But if we consult a number of different variables, we can get a good enough picture that we feel comfortable making a call between two companies.

Data source: Yahoo! Finance, E*Trade. P/E presented using non-GAAP earnings when applicable. 

It's no contest. Rite Aid is unprofitable, has negative free cash flow, and doesn't offer investors a dividend. Walgreens trades for just 13 times earnings and 11 time free cash flow. That P/E puts the company at a 35% discount to the S&P 500! 

Walgreens also offers a moderate dividend that only eats up 28% of the company's free cash flow. That means it is both very safe and has lots of room to grow over time.

Winner = Walgreens.

Sustainable competitive advantages

Finally the most important thing to investigate: a company's sustainable competitive advantages, or its moat. When it comes to convenience/drug stores, the primary moat a company can have is high switching costs.

Technically, it doesn't take that much for a person to change where they get their prescriptions. But just like we always talk about changing our banks but never do because it's too much of a hassle, once we start getting medication at one pharmacy location we tend to stick with it until we move to a different physical location.

One crucial thing to understand about this comparison is that Rite Aid has been furiously trying to sell or merge with another company for over two years. Momentarily, it appeared Walgreens might buy Rite Aid, but that deal fell through because of antitrust concerns. Instead, Walgreens purchased more than 1,900 Rite Aid locations for $4.4 billion in 2017. Last year it also looked like Rite Aid would merge with privately held Albertsons, but that deal fell apart too.

Both companies have relationships with drug manufacturers that bolster their positions, and both face pressure from CVS Health, which is diversifying by entering the health insurance market via the Aetna acquisition.

In the end, the real difference between the two is the fact that Walgreens has over 9,400 locations in total, versus just over 2,500 for Rite Aid. But I wouldn't consider either's moat to be terribly large: Amazon has already signaled its interest in entering the prescription market, and the company could quickly erode any advantages the brick-and-mortar locations have. Who doesn't love getting things delivered to their doorstep?

Between the two, Walgreens wins, but I'm not optimistic about either's moat.

Winner = Walgreens

And my winner is...

So there you have it: Walgreens has a slightly wider moat, and a much better balance sheet. It's the clear favorite.

But I don't own Walgreens, nor have I made an out-perform call on my CAPS profile. That's because I think the possibility for Amazon to disrupt the prescription industry is too great, and I don't think my money would be well-invested in any of these players over the long-term.