Rite Aid’s Q2 Results Will Show Improving Profitability

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Rite Aid

Quick Take

  • Fiscal 2013 was Rite Aid’s first profitable year in five years. The positive trend continued in Q1 2014 as well, as higher margins on generic medicines boosted its net income.
  • The higher proportion of generic drugs, declining store count and Walgreen’s dispute resolution with Express Scripts will limit Rite Aid’s top line growth.
  • However, the company’s store modelling initiative, expanding member base for its Wellness+ card-based loyalty program, its debt refinancing initiative and higher margin generic drugs will help improve its profitability.
  • Rite Aid added about $70 million to its top line as customers shifted from Walgreen (post its dispute with Express Scripts) to Rite Aid. However, its management estimates some customers to shift back to their original drug vendor gradually.
  • The rise in generic penetration has enabled Rite Aid to become more profitable in spite of lower sales as generic drugs offer over 50% higher margins compared to branded drugs.
  • Its debt refinancing plan completed in July 2013, is expected to have a positive effect on the company’s bottom line in this financial year.

Rite Aid (NYSE: RAD), one of the leading drugstore chain in the U.S., will report its Q2 2014 earnings on September 19. Despite a lower revenue base, the company’s continued efforts to revive its business resulted in net income of $118 million in fiscal 2013, its first profitable year in five years. The positive trend continued in Q1 2014 as well. Although its Q1 2014 revenues declined by 2.7%, higher margins on generic medicines boosted its net income for the quarter to $89.7 million.

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Rite Aid reported its sales figure for quarter ended August 31, last week. Its same store sales increased by 1% whereas the front-end same store sales declined by 0.3% annually. The company reported 0.7% (y-o-y) growth in its total drugstore sales ($2.4 billion) for the quarter and prescription sales accounted for 67.9% of the total drugstore sales.

We expect the rising proportion of low-cost generic drugs, declining store count and Walgreen’s dispute resolution with Express Scripts to limit Rite Aid’s top line growth. However, we believe that the company’s store re-modelling initiative, expanding member base for its Wellness+ card-based loyalty program, its debt refinancing initiative and higher margin generic drugs will enable it to post another profitable quarter.

View our detailed analysis for Rite Aid

Walgreen’s Dispute Resolution With Express Scripts Has A Negative Impact On Rite Aid

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.

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. [1]

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 and August 2013.

Generic Drugs To Lower Revenue Growth But Improve Profitability

The rise in generic penetration has enabled Rite Aid to become more profitable in spite of lower sales, as generic drugs offer over 50% higher margins compared to branded drugs. The introduction of new generic drugs had a 4.58% negative impact on Rite Aid’s top line growth last quarter. However, its gross margins improved from 26% in fiscal 2012 to 28.8% in fiscal 2013 and 28.9% in Q1 2014.

The total generic dispensing rate, which implies the percentage of generic drugs in a consumer’s prescription, grew to 78.5% in 2012 (calendar year), from 74.1% and 71.5% in 2011 and 2010, respectively. Though the substitution of generic drugs will continue for the next three to five years, the pace is expected to slow down. Nevertheless, an estimated $15 billion worth of branded product will come off patent in the next three years, opening them to competition from generic drugs. [2]

Debt Refinancing Initiative To Improve Profitability

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.

Despite inherent costs in retiring older debt, the refinancing program is expected to have a positive effect on the company’s bottom line in this financial year.

We will update our price estimate of $2.58 for Rite Aid after its Q2 2014 earnings release on September 19, 2013.

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Notes:
  1. Rite Aid Management Discusses Q4 2013 Results – Earnings Call Transcript, April 11, 2013 []
  2. CVS Caremark’s CEO Discusses Q2 2013 Results – Earnings Call Transcript, Seeking Alpha, August 6, 2013 []