Rite Aid’s (NYSE: RAD) stock price has increased by more than 250% since the end of 2012, from around $1 in December 2012 to approximately $3.50 at present. Slowing pharmacy sales in the U.S., a longer FDA approval process, drug safety concerns and the loss of individual health insurance with the rise of unemployment are key factors that have negatively impacted the pharmaceutical industry in the last few years. Additionally, the declining store count, lower consumer spending and rising proportion of generic (non-branded) drugs, which are priced lower compared to branded drugs, have put pressure on Rite Aid’s top line.
However, Rite Aid’s continued efforts to revive profits resulted in net income of $118 million in fiscal 2013, its first profitable year in five years, and the positive trend continued in Q1 2014 as well. In the last few quarters, the company has closed its under-performing stores and remodeled many of its existing stores. The expanding member base for its Wellness+ card-based loyalty program and its strategic alliance with GNC has also contributed to the positive market sentiment around the company.
Our price estimate of $2.60 for Rite Aid is at a significant discount to the current market price (>20%). We believe that the company will benefit from positive trends in the pharmaceutical industry – the aging U.S. population, new drug therapies and the Affordable Care Act expanding insurance to millions of Americans. However, we think that the intense competition from relatively larger players including Walgreen (NYSE:WAG) and CVS Caremark (NYSE:CVS) can limit Rite Aid’s growth potential in the future. Additionally, the company continues to operate under heavy debt of $5.8 billion.
In this article we discuss the various factors that have contributed to the positive sentiment around Rite Aid’s stock in the last 10 months.
1. Improving Gross Margins Due To Higher Proportion Of Generic Drugs
Rite Aid’s gross margins improved from 26% in fiscal 2012 to 28.8% in fiscal 2013 and 28.9% in Q1 2014. Though the rising proportion of lower priced generic drugs put pressure on Rite Aid’s top line, they offer higher margins compared to branded drugs, over 50% higher. ((Rite Aid’s Impressive Stock Run Should Continue To Gain Steam, Seeking Alpha, August 23, 2013))
The total generic dispensing rate, which implies the percentage of generic drugs in a consumer’s prescription, grew to 78.5% in 2012, from 74.1% and 71.5% in 2011 and 2010, respectively. The rise in generic penetration has enabled Rite Aid to become more profitable in spite of lower sales.
Over the next five years, around $80 billion worth of drugs will lose patent protection opening them to competition from generics. As more drugs come off patents, sales will decline, but profits are expected to continue rising.
2. Benefitting From Walgreen’s Dispute With Express Scripts
The dispute between Walgreen (NYSE: WAG) and pharmacy-benefits manager Express Scripts last year saw many of Walgreen’s customers switching over to competing pharmacies including Rite Aid and CVS Caremark (NYSE:CVS). Handling prescriptions for millions of people, Express Scripts runs prescription drug plans for employers, insurers and other customers. As a result of the dispute, many of Walgreen’s customers switched over to its competitors, which led to a loss of a major chunk of the 90 million prescriptions for the first nine months of 2012.
Rite Aid added about $70 million to its top line as customers shifted from Walgreen to Rite Aid in order to continue filling prescriptions under their existing plans. Rite Aid’s management estimates retaining about 75%-80% of the customers gained during the period but expect some more customers to shift back to their original drug vendor gradually. 
Walgreen and Express Scripts entered into a fresh agreement in September 2012 which allows Express customers to fill prescriptions at Walgreen stores. Walgreen claims to be winning back old customers post the deal and declared that the proportion of Express Scripts prescriptions returning to its stores continued to rise in July 2013.
3. Growing Success Of The Wellness Program
Rite Aid’s loyalty programs such as the Wellness+ program has helped improve its front-end as well as pharmacy sales in the last few quarters. The improving results can be partly attributed to the rising number of Wellness Ambassadors employed by the company to provide its customers with more personalized services and partly to take advantage of savings offered by the Wellness+ customer loyalty program. Rite Aid has more than 25 million active Wellness+ members, which accounted for about 79% of its total front-end sales in 2012. 
Rite Aid recently launched its Wellness65+ program aimed at senior patients who are known to be higher spenders in the pharmacy category. The company is trying to position itself as a health and wellness outlet. According to a 2012 RAND Health study, wellness programs are the rage in corporate America, with half of surveyed companies offering wellness promotion programs.  Such loyalty programs and similar initiatives has enabled Rite Aid to broaden its customer base.
4. Debt Refinancing
In July 2013, Rite Aid completed its debt refinancing plan to refinance $400 million worth of its outstanding debt on books to take advantage of the low interest rate scenario and to extend the maturity of its existing debt. The company offered a new series of senior notes of $810 million carrying a coupon rate of 6.75% and maturing in 2021. The proceeds from the offering along with its existing cash and borrowings will be used to redeem an equivalent amount of senior notes bearing an interest rate of 9.5% that were coming due 2017. The refinancing program is expected to have a positive effect on the company’s bottom line in this financial year.
- Rite Aid Management Discusses Q4 2013 Results – Earnings Call Transcript, April 11, 2013 [↩] [↩]
- Has This Drugstore Chain Found A Winning Strategy, Daily Finance, August 27, 2013 [↩]