Back in June, Walgreen (NASDAQ:WBA) reported an earnings miss as the company continued to have trouble driving customer traffic. At the time, Walgreen executives vowed to fight back by ramping up promotional behavior: i.e., offering bigger discounts.
Since then, Walgreen has come roaring back. The company delivered steady -- if not stellar -- sales growth in its recently ended quarter. Walgreen's return to a more promotional stance is starting to damage smaller rival Rite Aid (NYSE:RAD). A price war plays to Walgreen's strength as the largest drugstore chain in the country, while it could further undermine Rite Aid's already-meager profit margin.
Walgreen: return to sales growth
While many retailers have performed poorly this summer, Walgreen had no such problems. Front-end (i.e., non-pharmacy) sales in comparable stores increased by 0.8% in June. Sales momentum improved thereafter; comparable-store front-end sales grew 2.3% and 2.2% in July and August, respectively.
For the full quarter, front-end comparable-store sales were up 1.7%. That may not seem very impressive, but it represents a significant sequential improvement compared to the 0.4% gain Walgreen registered in the May quarter. Moreover, Walgreen had posted declines in the four previous quarters. Comparable-store prescription count was up an even stronger 6.8% for the quarter, as Express Scripts (NASDAQ:ESRX) customers continued to return to Walgreens stores.
Rite Aid is peaking
The story is quite different at Rite Aid. While Rite Aid was the biggest beneficiary of the Walgreen-Express Scripts dispute last year, it's now losing market share to Walgreen once again. Whereas Walgreen reported a 6.8% jump in comparable-store prescription count for the August quarter, the same measure was flat at Rite Aid.
This loss of prescription market share has afflicted Rite Aid for many months now. However, the company is now starting to feel pressure from Walgreen's front-end price initiatives as well.
In June, Rite Aid's front-end comparable store sales grew 0.4%, in-line with the company's trend for this year. In July, this figure ticked up by 30 basis points sequentially to 0.7%, whereas Walgreen saw a much stronger 150-basis-point sequential improvement. Most disturbingly, whereas Walgreen's comparable-store front-end sales growth remained above 2% in August, Rite Aid last week reported a 1.7% drop in that measure for August.
Walgreen and Rite Aid are both expected to report quarterly earnings later this month. Based on the two companies' relative sales performance, Walgreen investors are likely to be much happier than Rite Aid investors when all is said and done.
Rite Aid has improved its profitability significantly over the past several quarters through margin improvements. However, the benefit from new higher-margin generic drugs is fading now, and pharmacy benefits managers are constantly cutting back on reimbursement rates. An increase in price competition from Walgreen will put even more pressure on Rite Aid's bottom line.
Nevertheless, Rite Aid has little choice but to fight back with its own margin-sapping discounts. Otherwise, it will continue to lose share in the front end. That would be fatal, as front-end sales are a more reliable contributor to profitability than the prescription business, where insurers and pharmacy benefits managers have all the leverage (and take most of the profit). Bottom line: If Walgreen maintains its cutthroat strategy, Rite Aid could be in big trouble.
Adam Levine-Weinberg is long October 2013 $2.5 puts on Rite Aid. The Motley Fool recommends and owns shares of Express Scripts. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.