Rite Aid Poised For Long-term Growth But Short-term Concerns Remain.

Between 2009  and 2012, market leaders such as CVS Health (NYSE:CVS) and Walgreens (NASDAQ: WBA) were able to achieve a revenue growth (CAGR) of 6% and 2% respectively. However, Rite Aid‘s (NYSE: RAD) revenues remained flat and it devised a turnaround plan to set a new course. While the topline was stressed during this period, higher interest costs due to an over-leveraged capital structure and higher costs (due to inefficient operations) kept earnings down. This was a challenging period for the pharmacy retail industry altogether primarily because of lower reimbursement rates which led to lower profit margins.

In 2013, Rite Aid’s revenues plateaued as the number of its stores remained fairly stable. However, its strategic initiatives started paying off and the company returned to profitability which drove the company’s stock price up from $1.30 at the start of 2013 to a $7.50 at present.

Our price estimate of $6.27 for Rite Aid is at about a 15% discount to the current market price. We believe that the current Trefis estimate fairly represents the growth potential that Rite Aid holds.

View our detailed analysis for Rite Aid

Management Confident Of Turnaround Amidst Favorable External Conditions

The U.S. Census Bureau projects a 60% increase in the number of Americans age 65 and older between the years 2000 and 2020, who fill almost thrice as many prescriptions as those filled by the younger group (younger than 65 years of age). Considering that prescription drugs constitutes about 70% of Rite Aid’s revenues, the future holds immense potential for growth in this segment. Additionally, ObamaCare is further driving the demand for affordable, high-quality health care and is estimated to bring another 30 million people under health insurance coverage.

An Impending Patent Cliff And Increase in Availability of Generics Bodes Well For Pharmacy Retailers

From 2015 through 2018, a total of $78 billion ^[1] is expected to be exposed to generic competition. While this significantly impacts drug manufacturers’ sales negatively, it is going to be all smiles for drug retailers. Even though branded drugs contribute a significant portion to a drug retailer’s topline, generics have historically provided higher margins. With higher availability of generics, they will form a higher proportion of the topline and will provide some support to the company’s margins, which have been under pressure due to rising generic costs. During the recently concluded JP Morgan Healthcare Conference, Rite Aid CEO John Standley noted ^[2] that there are “a few question marks in terms of how a couple of drugs may play out,” possibly referring to the delay in FDA approval for the manufacture of generic copies of AstraZeneca’s heartburn drug Nexium and Roche Holding’s antiviral Valcyte. Inspite of such occurences, we are confident the that the generic boom would still remain intact and is going to help Rite Aid generate higher profitability.

More Efficient Distribution Process To Support Margins

Conversion to a new drug distribution and purchasing process with McKesson Corporation (MCK), the largest distributor of pharmaceutical and medical supplies in the U.S., is providing Rite Aid with purchasing efficiencies and direct-to-store delivery for all its pharmacy products. Early in Q3’15, all its stores and four pharmacy distribution centers were converted to this new distribution process and the benefits have started to be reflected in the income statement in the form of higher gross profits, arising from increased pharmacy revenue and the purchasing savings made. With time, we expect further optimization in their distribution process will push costs further down. This in turn helps Rite Aid reduce working capital requirements due to lower pharmacy and distribution center inventories.

Source: ^[3]

Reimbursement Rate Pressure To Continue

Rite Aid anticipates negative pharmacy sales impact of approximately 208 basis points in FY15 ^[4] from new generic introductions and continued reimbursement rate pressure. While Obamacare is expected to benefit the pharmacy industry by bringing in millions of patients under coverage, it also means that a larger proportion of patients will be covered by government insurance plans rather than private insurers. As reimbursement rates provided by government insurance are less-friendly relative to that provided by private insurers, there will be added pressure on the reimbursement rates. Even though Rite Aid expects the reimbursement rate pressure to continue to pose a challenge in the future, we believe that the cost savings from the new distribution and purchasing process with McKesson will help ease pressure off the company’s bottom line.

Overall, we believe Rite Aid is well poised to turn its operations around amidst favorable conditions for the industry. While the challenges it is facing such as reimbursement pressure or generic inflation are short-term in nature, it has strategies in place to secure its long-term growth. The firm believes that with so many factors in their favor, they are well placed to overcome the headwinds of reimbursement pressure and continue to register strong growth.

View Interactive Institutional Research (Powered by Trefis):

Global Large Cap | U.S. Mid & Small Cap | European Large & Mid Cap
More Trefis Research

1. 5 Reasons Rite Aid Corporation’s Rebound Isn’t Over Yet, The Motley Fool, January 17, 2015 [↩]
2. 3 Can’t Miss Quotes from Rite Aid Corporation’s CEO, The Motley Fool, December 28, 2014 [↩]
3. How Rite Aid is Benefiting from Its New McKesson Relationship, Drug Channels, January 6, 2015 [↩]
4. Rite Aid’s CEO John Standley on Q3 2015 Results – Earnings Call Transcript, Seeking Alpha, December 18, 2014 [↩]