Rite Aid Corporation (RAD, Financial) is a retail drugstore chain in the U.S. In the company’s stores, it sells prescription drugs and a range of other merchandise, which it calls front-end products. Front-end products include over-the-counter medications, health and beauty aids, personal care items, cosmetics, household items, beverages, convenience foods, greeting cards, seasonal merchandise and other everyday and convenience products, as well as photo processing.
Recent Results
Rite Aid just reported a second straight annual profit, and it is forecasting solid earnings growth for the year ahead. Even with some sales metrics remaining weak, Rite Aid has boosted its margins through drug-sourcing efficiencies. Rite Aid and other pharmacy chains benefited from a big wave of new generic drugs that began in 2012 and continued into 2013. Generic drugs carry significantly higher profit margins than brand-name drugs. This helped drive gross margin (excluding LIFO charges related to inventory valuation) up from 26.7% in fiscal 2012 to 28.2% in fiscal 2013.
Rite Aid's same-store prescription count fell 0.3% last year, and lower traffic also led to a 0.2% decrease in front-end (i.e. non-pharmacy) same-store sales. However, Rite Aid offset this relatively weak sales performance with another increase in gross margin, from 28.2% to 29.1%. Rite Aid's gross margin performance was remarkable because the company faced two headwinds in the back half of fiscal 2014: fewer new generic drug introductions and a highly promotional sales environment for the front end. According to Rite Aid's management, purchasing efficiencies related to generic drugs helped the company weather that storm.
Rite Aid's recent deal for McKesson (MCK, Financial) to source all of its generic drugs should further reduce the company's costs, creating an opportunity for additional margin expansion. As one of the biggest buyers of generic drugs, McKesson can take advantage of its scale to negotiate better prices with manufacturers.
Additionally, Rite Aid will not have to carry as much inventory under its deal with McKesson. This reduces its working capital, and will provide a one-time boost to free cash flow this year of about $150 million. This will allow Rite Aid to pay down high-cost debt, saving money on future interest payments while also improving its credit profile.
Peers
The company is up by an explosive 55% year to date, as the company continues implementing a remarkable turnaround. Furthermore, when considering Rite Aid's room for improvement and potential valuation versus bigger peers such as Walgreen (WAG, Financial) and CVS Caremark (CVS, Financial), the company is still offering substantial room for gains in the years ahead.
Rite Aid has clearly been moving in the right direction over the last several years. The company has produced material improvements in financial performance by closing unprofitable stores and implementing an ambitious plan to relocate and remodel locations.
Explosive Turnaround
Rite Aid has transformed 1,215 stores into its wellness format so far, and management plans to remodel an additional 450 stores during the current year. According to the company, front-end same-store sales in the wellness stores exceeded the non-wellness stores by 320 basis points, and script growth in the wellness stores exceeded the non-wellness stores by 1% during the company's fiscal 2014 year ended on March 1. Considering these statistics, the wellness format seems to be having a considerably positive impact on performance.
The company is successfully growing its Wellness 65+ loyalty program, targeting the key senior demographic. Rite Aid has enrolled more than 1.7 million members in its Wellness 65+ loyalty program as of the end of the last quarter, and this bodes remarkably well in terms of competitive strengths and growth opportunities over the coming years, as seniors are an essential demographic segment in terms of health care demand.
Rite Aid has also expanded its partnership with McKesson for the sourcing and distribution of generic pharmaceuticals as part of McKesson's One Stop proprietary generics program. This will generate important efficiencies in terms of lower purchasing costs and reduced working capital requirements for Rite Aid; management estimates the agreement will cut capital requirements by $150 million during the coming year.
Financial performance has materially improved over the last several years, with both sales and earnings consistently rising. April sales data was particularly encouraging, as Rite Aid announced a strong increase of 5% in same-store sales versus the same month in the prior year.
Acquisition Plans
Rite Aid announced the acquisition of RediClinic, a Houston-based retail clinic chain. The brand has 30 locations found in grocery stores in Houston, Austin, and San Antonio. From the press release, RediClinic has provided health care help to over 1.5 million people. The acquisition was done by Rite Aid "to expand the current footprint in Texas and, in the near future, begin to bring its expertise in delivering convenient healthcare and wellness programs to Rite Aid customers in select Rite Aid market."
RediClinics are staffed by board certified nurses and feature physician assistants as well. The clinics can provide treatment for 30 common conditions and also write prescriptions for customers. A weight management program under the "Weigh Forward" brand name is also owned by RediClinic. This investment by Rite Aid makes perfect sense and is another step in the right direction to increase its sales and win over customers by providing a complete experience.
To End
Essentially, pharmacy stocks are a hot ticket. The industry as a whole has produced significantly larger gains than the S&P 500 while Rite Aid has been one of the best performing stocks in the market since the fourth quarter of 2012. As the company is making efforts to improve its cost structure and remodel its stores, these efforts will help it improve its profitability and cash flows.
If Rite Aid can continue generating growing sales, and the company manages to increase profit margins to levels more in line with those of industry peers, the stock should deserve a considerably higher valuation. Potential for gains is hardly over for investors in Rite Aid. Rite Aid is clearly moving in the right direction, and the company looks ready to leave the turnaround phase in the past in order to focus on growth opportunities during the years ahead. These moves will create shareholder return in the times to come.
