Rite Aid’s (NYSE: RAD) revenue growth slowed in the last few years as the pharmaceutical industry in the U.S. was plagued with slowing sales owing to a decline in new blockbuster drugs, a longer FDA approval process, drug safety concerns and the loss of individual health insurance with the rise of unemployment in the country. Additionally, the declining store count and a rising proportion of generic (non-branded) drugs, which are priced lower compared to branded drugs, put pressure on Rite Aid’s top line.
However, the company marked its first profitable year in fiscal 2013 (ending March 2, 2013) as it benefited from its store re-modeling initiative, efficient cost management, customer loyalty programs, as well as higher margins from generic drugs. Rite Aid’s operating margin improved from 6.2% in 2008 to 8.3% in 2012 (calendar year). Earning $33 million as net income, compared to a net loss of $39 million a year ago, Rite Aid marked its third consecutive quarter of profitable growth in Q2 2014, as it focused on cost savings to improve its profitability and cash flow.
We expect Rite Aid’s margins to improve slightly this year but remain stagnant thereon for the rest of our review period.
Our price estimate of $2.95 for Rite Aid is at a significant discount to the current market price (~50%). 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, Rite Aid continues to operate under heavy debt of approximately $6 billion.
Rite Aid recorded its 11th consecutive quarter of year-over-year growth in adjusted EBITDA in Q2 2014, which was 56% higher compared to Q2 2013. The key factors driving improvement in margins : 1) the increasing proportion of generic drugs; 2) strong pharmacy margins; 3) improving front-end margins; 4) strong expense control; and, 5) the recovery of $23.5 million from the settlement of a prescription drug antitrust case. Additionally, Rite Aid’s debt refinancing initiative in July 2013, to take advantage of the low interest rate scenario and to extend the maturity of its existing debt, lowered its interest expense.
In addition to competition from Walgreen and CVS, below are some factors that can limit Rite Aid’s profitability in the future:
Lower Generic Substitution Impacts Margins Growth
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 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.
However, in its earnings call Rite Aid mentioned that the pace of generic drugs substitution has slowed down recently, which can limit the future growth in pharmacy gross margins. The introduction of new generic drugs had a 2.49% negative impact on Rite Aid’s top line growth in Q2 2014 as compared to a 7.5% negative impact in Q2 2013. Lower generic substitution combined with the expected flat front-end gross margins this year will have a negative impact on Rite Aid’s bottom line in the second half of fiscal 2014.
Nevertheless, an estimated $15 billion worth of branded products will come off patent in the next three years, opening them to competition from generic drugs.  Thus, we believe that Rite Aid will manage to retain margins at the current level.
Declining Reimbursement Rates Can Put Pressure On Margins
The reimbursement rate by US Medicaid and Medicare Plan D, as well as health insurance providers, is expected to decline in line with the rising proportion of generic drugs. To address the mounting fiscal cliff, the U.S. government has been forced to lower medical reimbursement rates. In April’s budget sequester, it reduced the medicare payments to doctors, hospitals and other healthcare providers by 2%. Lower reimbursement rates impact the margins of pharmacy service providers and drug manufacturers.
Additionally, the ongoing consolidation in the Pharmacy Benefit Management (PBM) industry, like the merger of two of U.S.’s largest pharmacy benefit managers (Express Scripts and Medco Health Solutions), can increase reimbursement rate pressure over drug retailers.Notes:
- CVS Caremark’s CEO Discusses Q2 2013 Results – Earnings Call Transcript, Seeking Alpha, August 6, 2013 [↩]