Rite Aid Slides 30% After Earnings Fall, In A Move We Deem Overdone

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Rite Aid

Rite Aid‘s (NYSE:RAD) performance in the most recent quarter (ended August) wasn’t too bad. In an expanding pharmacy retail market, the drugstore chain is making the right moves to not only capture growth, but to also protect itself from headwinds affecting almost every other pharmacy retailer. However, this story seems out of place when one looks at the company’s stock price in the last couple of weeks. In just 8 weekdays after the company’s Q2 earnings release last week, the stock dropped by a whopping 30%.

There have been various explanations making the rounds to justify the steep fall. Some point at the company’s slowing sales, some at the contracting gross margins, and a few others at the increased debt. While all of these are potential causes for concern, we believe there’s nothing to be worried about. We still believe that Rite Aid’s business is just as strong as it was and the decisions it has made in the recent past will take it past these tough times.

Our price estimate of $8.74 for Rite Aid might change after the company provides detailed financial data regarding its post-acquisition structure. What will not change, though, is our view of the underlying trends, which we discuss below.

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View our detailed analysis for Rite Aid

Net Income Fell Mostly Due To One-Time Expenses

The sell-off in the stock was triggered by an earnings miss on September 17th, when Rite Aid announced its Q2 2016 results. Net income fell to $21.5 million compared to $127.8 million in last year’s second quarter. However, most of this decline was caused by charges related to the acquisition of EnvisionRx or other one-time expenses, which were expected.

To be specific, of the $106 million drop in net income, $33 million was due to early debt retirement, $27 million related to the acquisition of EnvisionRx and an incremental interest expense of $15 million on acquisition related debt. In fact, the refinancing of long-term debt, which the company completed along with the acquisition, is expected to result in annual interest expense savings of approximately $30 million, going forward.

Therefore, this drop in net income is only temporary and we believe the company’s earnings will recover as incremental benefits from the acquisition catch up with incremental costs incurred.

Margin Concerns – Better Times Ahead

For quite some time now, reimbursement pressure has been one of the primary concerns for pharmacy retailers. As generic drugs kept getting more expensive, reimbursement rates did not keep up, negatively impacting gross margins for drug stores. What is important to note is that almost every drug retailer is facing this pressure and it is not a company-specific concern.

Moreover, generic inflation is starting to slow down, as we discussed in another post earlier. While this is going to benefit the industry at large, Rite Aid has taken additional steps to improve its gross margins. The acquisition of EnvisionRx, a US-based pharmacy benefit management (PBM) company, is expected to provide Rite Aid with increased negotiating power with drug manufacturers and therefore lower drug acquisition costs. Per the company’s earnings release, [1] this investment has already started to pay off by partially offsetting losses due to low reimbursement rates. As EnvisionRx grows in size, the resulting negotiating power will provide further relief for Rite Aid on margins.

Sales Slowdown Is Probably The Only Valid Concern

Growth in same-store sales took a hit in the recent quarter. According to Rite Aid’s monthly sales releases [2], same-store sales growth averaged 2.1% year over year in the quarter ended August, compared to 3.5% during the previous five months (Jan to May). While some of this decline was due to an increase in generic introductions, the company’s reduced guidance on this score is worrisome. From a previous guidance range of 2.5% to 4%, Rite Aid narrowed the range to 1.5% to 2.5%.

Again, it is likely that this is a short-term dip in sales. As Rite Aid remodels more of its stores to the Wellness format, which are performing better than the rest of the chain, its top line will likely gain some momentum. But, only time will tell whether this will be enough to offset the broader slowdown in same-store sales.

Conclusion

Despite a fall in earnings, lowered management guidance and negative earnings estimate revisions by various analysts, [3] we continue to stand by our view of Rite Aid. While narrowing margins, increased debt and slowing sales are not good signs for any company, in Rite Aid’s case, we believe the concerns are only short-term in nature and the company’s inherently strong model will help it tread through rough waters.

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Notes:
  1. Seeking Alpha Earnings Call Transcript []
  2. Rite Aid News Releases []
  3. What Falling Estimates & Price Mean for Rite Aid, Nasdaq []