Rite Aid’s Earnings Preview: Higher Drug Costs To Impact Margins

Backed by its store re-modeling initiative, efficient cost management and customer loyalty programs, leading U.S. drugstore chain, Rite Aid (NYSE: RAD), reported its sixth consecutive quarter of positive net income in fiscal Q4 2014 (ended with February). Fiscal 2014 was the company’s second profitable year in more than five years as it benefited from its ongoing health and wellness transformation.

Rite Aid is set to announce its Q1 2015 earnings on June 19. Though the company expects its positive growth momentum to continue in the quarter, its preliminary results show that earnings and EBITDA will be under pressure on account of disappointing pharmacy trends. Rite Aid has even lowered its guidance for fiscal year 2015. It now expects adjusted EBITDA to be between $1.28 to $1.35 billion, net income in the range of $298 and $408 million, and income per diluted share between $0.30 and $0.40.

Controlling costs and making operational progress remain key focus areas for Rite Aid, as it aims to build a unique brand focused on health and wellness. In fiscal 2014, the company completed additional refinancing to extend maturities and reduce its interest expense, factors that give it the required flexibility to better execute its business plan. Though Rite Aid is highly leveraged, no significant amount of debt is due before 2018.

We will update our price estimate for Rite Aid after the Q1 2015 earnings release.

View our detailed analysis for Rite Aid

Q1 2015 Sales Results

Rite Aid reported its sales results for Q1 2015 earlier this month. Total drugstore sales and same store sales for the company increased 2.6% and 3.1% annually, respectively. While pharmacy sales grew 4.6%, front-end sales were flat for the quarter. Prescription sales accounted for 68.4% of the total drugstore sales. Prescription count at comparable stores increased 2.3%. The company expects adjusted EBITDA for the quarter to be between $275 and $285 million, net income to be between $35 million and $45 million, and income per diluted share to be $.04 compared to $0.06 last quarter.

Agreement With McKesson To Increase Generic Purchasing Power; Ease Pressure Off Margins

Rite Aid anticipates its adjusted EBITDA margin for Q1 2015 will be lower compared to Q1 2014, due to higher than expected drug costs resulting from a delay in realizing the level of expected generic purchase price reductions and a faster than expected decline in reimbursement rates paid by pharmacy benefit managers.

In the last few years, the U.S. market for medicines has shifted more towards generic drugs as a significant number of patents expired for major brand names. The generic wave peaked in Q1 2013 and hit a trough in Q1 2014. Despite slower substitution in the last few quarters, an estimated $15 billion worth of branded products will come off patent in the next two to three years, opening them to competition from generic drugs. ^[1] Generic drugs are comparatively lower priced but offer higher gross margins (approximately 50% higher) than branded drugs, for both wholesalers and retailers.

Rite Aid recently announced an expanded tie-up with McKesson Corporation (MCK), the largest distributor of pharmaceutical and medical supplies in the U.S., to source and distribute generic pharmaceuticals for Rite Aid. The agreement, which has been extended until March 2019, is expected to lower purchasing cost of generic drugs for Rite Aid. The company (standalone) has an estimated generic purchasing power of $1.5 billion, which is significantly lower than its peers. ^[2]

Wellness Store Remodels Remains A Key Growth Strategy

Loyalty programs such as the Wellness+ program have been one of the key factors driving growth in Rite Aid’s pharmacy sales, as well as front-end sales. The Wellness+ program helps strengthen relationships with customers, which in turn increases the number of loyalty shoppers at Rite Aid.  It remains a key component of Rite Aid’s health and wellness offering. The company made significant progress in transforming its stores into true neighborhood destinations for health and wellness in fiscal 2014.

The Wellness store continues to outperform the non-wellness stores in terms of same-store front-end sales and script count. In fiscal 2014, front-end same-store sales in the wellness stores exceeded the non-wellness stores by 3.2 percentage point and script growth in the wellness stores exceeded the non-wellness stores by 1 percentage point.

Last year, Rite Aid successfully launched its Wellness65+ program, which is aimed at senior patients who are known to be higher spenders in the pharmacy category. By the end of fiscal 2014, 1.7 million senior citizens had enrolled in the program and Rite Aid claims that the program is attracting new customers as well as strengthening the loyalty of its existing members. According to a 2012 RAND Health study, wellness programs are the rage in corporate America, with half of surveyed companies offering wellness promotion programs. ^[3]

Rite Aid’s immunization program is another key component of its chain-wide wellness program. It exceeded its chain-wide goal by immunizing more than 3.2 million patients against the flu last year. Its Wellness stores, which feature the Wellness ambassadors, averaged 38% more flu shots than non-wellness stores.

Wellness stores will continue to be a key part of Rite Aid’s growth strategy over the next few years.

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1. CVS Caremark’s CEO Discusses Q2 2013 Results – Earnings Call Transcript, Seeking Alpha, August 6, 2013 [↩]
2. Quantifying Generic Buying Power for McKesson-Celesio, Drug Channels, October 23, 2013 [↩]
3. Has This Drugstore Chain Found A Winning Strategy, Daily Finance, August 27, 2013 [↩]