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How Impressive Is Rite Aid's Earnings Increase?

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On Thursday morning, Rite Aid (NYSE: RAD  ) reported significant improvement in first-quarter earnings. The company reported its third consecutive profitable quarter, with EPS of $0.09, up from a loss of $0.03 per share in the same quarter last year. Results hit the high end of the company's recently updated guidance for EPS of $0.08 to $0.09.

As I have discussed in a series of recent articles, Rite Aid's revenue has recently been pressured by a resurgence at top competitor Walgreen (NASDAQ: WBA  ) . Rite Aid has been able to deliver strong profit growth despite that headwind due to the margin benefit from new generic-drug introductions. However, this benefit will drop off sharply later this year. Investors should monitor the company's results carefully over the next several quarters, to see if Rite Aid will be able to stay in the black after the tailwind from generics dissipates.

Rough seas ahead
Rite Aid has achieved a remarkable turnaround, considering that the business seemed to be on the verge of bankruptcy just a few years ago. However, the company clearly got an assist from last year's dispute between Walgreen and Express Scripts, as well as from the ongoing shift from brand-name drugs to generics. The growth in generic drugs hurts sales, but provides a significant margin benefit to drugstores, improving profitability.

Rite Aid's management has issued a very cautious outlook, because the generic-drug benefit is starting to wind down. Furthermore, Rite Aid is experiencing significant "reimbursement rate pressure" as Medicare, Medicaid, and insurance companies try to save money on prescription drug costs. On multiple occasions during its recent earnings call, Rite Aid's management highlighted these two factors, noting that they will have a significant (negative) impact on gross margin, particularly in the second half of the fiscal year.

In fact, the midpoint of Rite Aid's guidance assumes that the company will break even over the remaining three quarters of the fiscal year. That implies that the recent trend of improving earnings will reverse soon. One cause is a $60 million charge the company has recently incurred in order to refinance approximately $1.3 billion of debt. While Rite Aid's various refinancing transactions will dilute earnings this year, they will ultimately reduce annual interest expense by $85 million, boosting cash flow.

Under pressure?
To some extent, Rite Aid executives may also be trying to manage expectations on Wall Street. The company's stock has tripled since December, and with lots of moving parts -- i.e., changes in the brand-name/generic mix, changes in reimbursement rates, market share changes, etc. -- it's probably prudent to give conservative guidance.

Nevertheless, these factors all present very real challenges for Rite Aid. While generic-drug introductions can provide a short-term lift to margins, ultimately insurance providers will try to take back most or all of that incremental margin in order to lower their own costs.

Rite Aid also faces particular challenges as the smallest of the three major pharmacy chains. Walgreen and CVS Caremark (NYSE: CVS  ) already offer much broader pharmacy networks than Rite Aid and have ample capital to expand onto Rite Aid's turf, whereas Rite Aid is shrinking. This process could lead to a growing cost gap that would hurt Rite Aid's long-term competitiveness.

What to look for
Going forward, the key for investors lies in Rite Aid's ability to manage the expected margin pressure later this year while maintaining market share vis-a-vis Walgreen and CVS. If Rite Aid can weather this storm and beat its guidance, that would be a good signal that its recent earnings improvements are sustainable.

However, I am still fairly skeptical that this will happen. Rite Aid seems to be losing market share to Walgreen and CVS again, and this process could accelerate as Walgreen continues to win back Express Scripts customers. I would need to see solid earnings results for the rest of this fiscal year to believe that the Rite Aid turnaround is the "real deal."

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Read/Post Comments (4) | Recommend This Article (1)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 21, 2013, at 12:26 PM, ghstflame wrote:

    What about the generational shift of boomers retiring over the next 10 years. More and more people will be on prescriptions, the tide is coming in and RAD will be bouyed just alongside CVS and WAG. RAD is certainly undervalued and has a lot of share price improvement ahead of it.

  • Report this Comment On June 21, 2013, at 11:06 PM, ctyank99 wrote:

    The "Fools" have always beaten up Rite Aid. The company has had a tremendous turnaround and that will conrinue. Stop bashing the #3 retail phamacy in America! RAD is Fortune 500 company that I believe is still undervalued...

  • Report this Comment On June 21, 2013, at 11:17 PM, ctyank99 wrote:

    Take a look at a professional, unbiased analysis of Rite Aids earnings:

  • Report this Comment On June 24, 2013, at 8:38 PM, TMFGemHunter wrote:

    @ghstflame: The problem is that CVS and Walgreens are so much larger than Rite Aid and better capitalized to boot. That gives them a cost advantage which could widen as they expand further.

    If the whole sector does well due to the aging of the population, CVS and Walgreens will have even stronger reasons to expand. As they expand their footprints, fewer people will find Rite Aid to be the most convenient drugstore. And convenience is the #1 driver of traffic to these stores. That's ultimately why I'm bearish on Rite Aid.

    If you're looking for a highly leveraged bet on the drugstore sector, I think you're better off buying WAG LEAPS options over Rite Aid stock.


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