Rite Aid’s Q2’15 Earnings Preview: Gross Margin To Remain Under Pressure

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Rite Aid (NYSE: RAD), the third largest drugstore chain in the U.S., will release its Q2 2015 earnings on September 18. Fiscal 2014 (ended February) was the company’s second profitable year in more than five years as it benefited from its ongoing health and wellness transformation. Rite Aid reported its biggest quarterly sales gain in fiscal Q1 2015, but its bottom line shrunk drastically as the company witnessed stronger than expected decline in reimbursement rates paid by pharmacy benefit managers and higher than expected drug costs resulting from a delay in realizing the level of expected generic purchase price reductions.

Nevertheless, Q1 2015 was Rite Aid’s seventh consecutive quarter of positive net income. The company reported a 3.7% annual growth in its Q2 2015 drugstore sales earlier this month. Year to date, it reported a 3.2% growth in total drugstore sales (to $12.91 billion) and a 3.6% annual increase in same-store sales. Though Rite Aid expected continued pressure on reimbursement rates and more drug cost increases than normal in Q2 2015 as well, it believes the situation will improve in the second half of the year.

Rite Aid continues to focus on its store re-modeling initiative, efficient cost management and customer loyalty programs. Controlling costs and making operational progress remain key focus areas for the company, as it aims to build a unique brand focused on health and wellness. The Affordable Care Act is having a positive impact and Rite Aid claims to be experiencing growth in states which have expanded Medicaid.

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View our detailed analysis for Rite Aid

Wellness Stores Are At The Center Of Rite Aid’s 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.

Wellness stores continue to outperform the non-wellness stores in terms of same-store front-end sales and script counts. In Q1 2015, front-end same-store sales in the wellness stores exceeded the non-wellness stores by 2.65% and script growth in the wellness stores exceeded the non-wellness stores by 1.2%. As of the end of Q1 2015, Rite Aid has completed 1,325 Wellness remodels, 29% of its total store count.

Some pilot concepts, such as an enhanced OTC presentation that features educational materials, interactive product displays, etc.,  have done well in existing Wellness stores and will be applied to other Wellness stores in the future. Additionally, Rite Aid is also testing new concepts such as the day cafe to enhance customer experience at its stores.

New Drug Sourcing And Distribution Process Can Ease Pressure Off Margins

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. Since the company is still in the process of transitioning to the new distribution pattern, its pharmacy gross margin declined in Q1 2015 and Rite Aid expected the negative impact to persist in Q2 2015 as well. However, it believes that the partnership will allow it to achieve supply chain efficiencies and derive additional cash flow to fuel long term growth.

The agreement, which has been extended until March 2019, is expected to lower the purchasing cost of generic drugs for Rite Aid, providing the company with long term drug savings. The expanded partnership offers significant working capital benefits by providing Rite Aid pharmacies with direct to store delivery five days a week.

Rite Aid on a standalone basis has an estimated generic purchasing power of $1.5 billion, which is significantly lower than its peers. [1]

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. [2]

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Notes:
  1. Quantifying Generic Buying Power for McKesson-Celesio, Drug Channels, October 23, 2013 []
  2. CVS Caremark’s CEO Discusses Q2 2013 Results – Earnings Call Transcript, Seeking Alpha, August 6, 2013 []