Backed by its store re-modeling initiative, efficient cost management and customer loyalty programs Rite Aid (NYSE: RAD), one of the leading drugstore chain in the U.S., witnessed another quarter of strong performance in Q3 2014. Reporting $6.4 billion in sales, a 1.9% year-over-year growth, the company marked a 2.3% rise in its same store sales for Q3 2014. Though front-end sales declined by 0.2%, pharmacy same store sales grew by 3.5% year-over-year.
Rite Aid’s net income increased by 14%, to $71.5 million, driven by strong EBITDA growth and lower interest expense. Higher pharmacy gross profits, driven by script count growth and generic purchasing efficiencies, along with strong expense control, helped Rite Aid report a positive net income for the fifth consecutive quarter. Higher same-store prescription count and pharmacy inflation resulted in an increase in Rite Aid’s pharmacy same-store sales. However, the front-end earnings were negatively impacted by cautious consumer spending in a competitive promotional environment.
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. Rite Aid brand penetration increased to 18.4% in Q3 2014, a 0.3% year-over-year growth. 
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All in all it was a positive report, albeit as EPS guidance for next quarter of $0.17 to $0.23 was just shy of the consensus $0.24, producing some pressure (likely transient) on the stock. Management tied this to the impact of new generic introductions and continuing reimbursement rate pressure on same store sales guidance.
We believe that the Rite Aid 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. Though its leverage ratio improved in Q3 2013 it continues to operate under heavy debt.
We are in the process of updating our price estimate of $2.95 for Rite Aid, which is at a significant discount to the current market price (~40%).
Health & Wellness Stores To Strengthen Rite Aid’s Image
Loyalty programs such as the Wellness+ program has helped improve Rite Aid’s pharmacy sales as well as front-end sales in the last few quarters. The Wellness+ program helps strengthen the relationship with customers in turn increasing the number of loyalty shoppers at Rite Aid. For Q3 2014, front-end same-store sales in the Wellness Stores exceeded the non-Wellness Stores by 3.2%, whereas script growth in the Wellness Stores was 1.4% higher compared to the non-Wellness Stores.
Loyalty programs remain 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 Q3 2014. During the quarter, Rite Aid remodeled 94 stores and relocated 4 stores bringing the total to 1,117 wellness stores, which now represents one-fourth of its stores. It remains on track to reach its target of 1,200 Wellness Stores by the end of this year.
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 Q3 2014, about 1.3 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. 
Rite Aid has more than 1,900 Wellness Ambassadors providing personalized levels of customer service in its Wellness Stores. Wellness Ambassadors continue to play a critical role in driving flu shot awareness, wellness65+ enrollment and its community engagement efforts.
Milder Flu Season Can Impact Prescription Growth In The Future
Rising flu immunization was the key factor responsible for the 0.7% increase in Rite Aid’s pharmacy same-store prescription count in Q3 2014. So far, Rite Aid pharmacists have administered over 2.4 million flu shots and it expects to meet its goal of 2.5 million by the end of 2013. However, the company expects a soft flu season going forward which can impact its prescription growth in fiscal 2014.
Lower Generic Substitution To Benefit Top Line Growth
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. The negative impact of generic drugs substitution on pharmacy same-store sales declined from 9.24% in Q3 2013 to 0.88% in Q3 2014. The pace of generic drugs substitution has slowed down recently and the trend is expected to continue in 2014. Generic drugs have comparatively lower prices compared to branded drugs and thus their rising proportion in prescriptions impacts Rite Aid’s top-line growth. We expect the pressure to ease off in the future.
Fiscal 2014 Outlook
– Total sales in the range of $25.3 billion to $25.4 billion.
– Adjusted EBITDA to be between $1.25 billion and $1.28 billion.
– 0.35% to 0.85% growth in same-store sales, which reflects a 2.4% negative pharmacy sales impact from new generic introductions and continued reimbursement rate pressure.
– Expected diluted EPS of $0.17 to $0.23.
– Capital expenditure of $415 million.
– Rite Aid plans to open 1 new store, complete 14 relocation, remodel 400 Wellness Stores and close 35 stores.
– Free cash flow between $250 million to $300 million.Notes:
- Rite Aid Management Discusses Q3 2014 Results – Earnings Call Transcript, Seeking Alpha, December 19, 2013 [↩]
- Has This Drugstore Chain Found A Winning Strategy, Daily Finance, August 27, 2013 [↩]