Rite Aid (NYSE: RAD), one of the leading drugstore chain in the U.S, will announce its Q3 2014 earnings on December 19. Fiscal 2013 was the company’s first profitable year in five years and it has seen the positive trend continue so far this year. (Fiscal Years end with February.) Backed by its store re-modeling initiative, efficient cost management and customer loyalty programs, Rite Aid claims that it has seen a better-than-expected performance in the first two quarters of fiscal 2014. It reported its third consecutive quarter of profitable growth in Q2 2014. Though Rite Aid believes that its growth in the second half will slow down, it remains confident about its long-term prospects as its turnaround strategy continues to reap benefits for the company.
Earlier this month, Rite Aid reported a 2.3% year-over-year rise in its same store sales for Q3 2014. Though front-end sales declined by 0.2%, it marked a 3.5% year-over-year growth in its pharmacy same store sales. At $6.33 billion, total Q3 2014 drugstore sales came in 1.9% higher compared to Q3 2013.
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: 1) the aging U.S. population; 2) new drug therapies; and, 3) 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.
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Lower Generic Substitution Will Impact Gross Margins
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 last 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.
Health & Wellness Stores To Strengthen Rite Aid’s Image
Rite Aid aims to transform majority of its stores into neighborhood destinations for health and wellness. At the end of Q2 2014, the company had remodeled a total of 1,019 stores and remains on track to complete 1,200 by the end of this year. Rite Aid claims that its Wellness stores outperformed all its other stores last quarter. Front-end same-store sales in the Wellness Stores exceeded the non-Wellness Stores by 3.4% and script growth in the Wellness Stores exceeded the non-Wellness Stores by 0.9%.
Loyalty programs such as the Wellness+ program has helped improve its front-end as well as pharmacy sales in the last few quarters. And they remain a key component of Rite Aid’s health and wellness offering. The Welness+ program helps strengthen the relationship with customers in turn increasing the number of loyalty shoppers at Rite Aid. At present the company has more than 25 million active Wellness+ members.
Rite Aid recently launched its Wellness65+ program aimed at senior patients who are known to be higher spenders in the pharmacy category. By the end of Q2 2014, more than 930,000 senior citizens had enrolled in the program.
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 can enable Rite Aid to broaden its customer base.Notes:
- CVS Caremark’s CEO Discusses Q2 2013 Results – Earnings Call Transcript, Seeking Alpha, August 6, 2013 [↩]
- Has This Drugstore Chain Found A Winning Strategy, Daily Finance, August 27, 2013 [↩]