Shares of Rite Aid (RAD) have now been rallying for 5 months. Here is my explanation of why it has rallied, and why the rally may be or become over-extended.

Why RAD rallied

In my opinion, investors priced RAD prior to the rally in the ~$1 range mostly due to bankruptcy risk from high debt and negative earnings, a common fate of many penny stocks. Institutional investors constitute the majority of this phenomenon as they cannot involve clients' money in risky assets such as RAD.

Things clearly began to change during 2011 when profit margins took a very gradual, but upward trajectory. I believe that this was the result of good management because sales were not up. They were simply closing unprofitable stores from the acquisition of the Brooks and Eckerd stores in 2007.

Finally, in late 2012 Rite Aid posted its first quarterly gains in a while and share prices began to take off as Rite Aid's credit recovered and long term debt was refinanced at a lower rate. Rite Aid finally looks healthy and RAD shares achieved institutional investment worthiness resulting in an influx of large scale buyers and thus in this rally.

Why a continued rally is still unwarranted

As those opposing austerity argue, growth does not come from cutting; Rite Aid can perform only as well as its best performing store if it continues down this path. The fundamental issue Rite Aid aimed to tackle in its take over of Brooks and Eckerd was its lack of competitiveness in size. Now that Rite Aid has grown AND overcome its growth pains, it's ready to take on the giants CVS (CVS) and Walgreens (WAG). Yet, they failed to hit the ground running; same store sales continue to fall. Rite Aid is ready to compete, but they are not competing... In their letters to investors, they claim to be working on various fronts to capture market share, but they are yet without results. I do admit though, that the website is no longer unbearable to look at.

Growth is more difficult to achieve than austerity with good reason. Growth requires the generation of value, especially in retail where competition for market share is fierce. Shoppers need a reason to go to Rite Aid vs its competitors. Furthermore, Rite Aid needs to achieve this without relying too heavily on discounts as it would hurt their margins and earnings. Innovation is in need.

Summary

Unless Rite Aid begins capturing market share from its competitors soon the possibility of correction from an extended rally increasingly concerns me. However, I speculate from Rite Aid's lead in customer loyalty program against Walgreens (wellness+ rewards program), that Rite Aid is in fact capable of achieving growth through innovation.

I will closely monitor their same store sales together with profit margin to see where this company goes.

Disclosure: I have owned RAD from $1.38 and since then I have reduced my position by 50% as a lower risk long term position.