Rite Aid's outperformance was driven by its return to (seemingly) sustainable profitability and its extremely low share price coming into the year. However, the company faces a more challenging outlook heading into 2014. With Walgreen in particular ramping up discounts and pharmacy profitability coming under pressure, Rite Aid may have trouble growing earnings going forward.
Headwinds creep up
One of the major factors boosting Rite Aid's profitability this year was a wave of high-margin generic drug introductions. Through the first half of the fiscal year, gross margin increased from 27.2% to 28.9%. Combined with solid cost control, this allowed Rite Aid to grow its adjusted EBITDA margin from 3.9% to 5.5%.
However, Rite Aid now faces a more difficult business climate. The company's recent third-quarter earnings report showed a much more modest improvement in profit than in the previous few quarters. Gross margin pulled back from 29% in the prior fiscal year's third quarter to 28.3%. This contributed to a small decline in the adjusted EBITDA margin.
On top of this, Rite Aid earlier this month modestly reduced its guidance for the 2014 fiscal year that ends two months from now. CFO Frank Vitrano stated on a recent conference call that the front-end (i.e., nonprescription) promotional environment worsened in the third quarter and that Rite Aid had been hit with unexpected generic drug price increases during that period.
Now comes the hard part
Investors were disappointed by this sobering news, causing the stock to drop more than 15% from the multiyear high it hit earlier this month. However, it's worth noting that Rite Aid is still in much better position today than it was at the beginning of the fiscal year.
Back in April, the company provided initial guidance for adjusted EBITDA between $1.075 billion and $1.175 billion for the fiscal year. Even after the recent guidance adjustment, management expects adjusted EBITDA between $1.25 billion and $1.28 billion, significantly above the top of the original range.
That said, investors need to recognize that Rite Aid's surge to profitability in the last two years has been aided by one-time factors that will not recur. First, a contract dispute between Walgreen and pharmacy benefits manager Express Scripts (NASDAQ:ESRX) forced many Walgreen's customers to find new pharmacies in 2012.
Walgreen rejoined the Express Scripts network in September 2012 and quickly began regaining customers. By then, Rite Aid was profiting from a second tailwind -- the introduction of several important generic drugs, carrying much higher margins than their brand-name counterparts.
Today, Rite Aid needs to work hard to maintain the business it gained from former Walgreen loyalists during the 2012 dispute. Additionally, it must find operational efficiencies to offset the efforts of pharmacy benefits managers to drive down prescription drug reimbursement rates. Lastly, it has to contend with robust competition from its larger and better capitalized rivals: Walgreens and CVS.
In short, Rite Aid's momentum is bound to slow down in 2014 as it faces a more challenging competitive environment. The company now must try to offset the headwinds noted above by using its loyalty program to drive repeat visits and by remodeling stores to create a more inviting atmosphere. Rite Aid's 2014 performance will provide some big clues about the long-term sustainability of its turnaround.
Adam Levine-Weinberg is long January 2014 $4 puts on Rite Aid. The Motley Fool recommends Express Scripts. The Motley Fool owns shares of Express Scripts. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.