Rite Aid Corporation's Turnaround Just Hit a Speed Bump

Rite Aid Corporation (NYSE: RAD  ) was on the brink of bankruptcy just a few years ago, but it has made a remarkable turnaround since then. Rite Aid has surged back to profitability with some impressive earnings beats.

However, the company took a step backward last week, cutting its FY15 earnings guidance just 3 months into the new fiscal year. As a result, Rite Aid shares dropped more than 7% on Thursday. The stock is still up more than 50% year-to-date, though.

RAD Chart

Rite Aid YTD Stock Chart, data by YCharts

Rite Aid told investors that reimbursement rates paid by pharmacy benefit managers have fallen faster than it expected, while sourcing efficiencies have not fully kicked in yet. This represents a "speed bump" rather than a major setback. Despite stiff competition from rivals like Walgreen (NYSE: WAG  ) , Rite Aid's long-term viability is not a real concern anymore.

Rite Aid's big comeback
In the past 2-3 years, Rite Aid has benefited from several trends. First, a tidal wave of high-margin generic drug introductions has boosted profitability throughout the pharmacy industry. Second, a dispute between top rival Walgreens and a major pharmacy benefit manager allowed Rite Aid to gain market share in 2012. Third, the availability of cheap debt financing has allowed Rite Aid to reduce its interest expense.

Rite Aid has kept many of the customers it won from Walgreens in 2012

Nevertheless, these factors alone cannot explain Rite Aid's resiliency. Walgreen resolved its pharmacy benefit manager dispute later in 2012, the generic drug wave has slowed down in the last few quarters, and much of Rite Aid's debt remains at high interest rates. Rite Aid's management deserves kudos for strong cost control, which has remained a constant strength.

The bump in the road
A big challenge for drugstores like Rite Aid and Walgreen is that the pharmacy benefit managers that pay for most prescriptions in the U.S. are constantly squeezing them for price reductions. As a result, while drugstores benefit from higher gross margins when new generic drugs hit the market, the cost savings largely get passed on to PBMs in the long run.

Rite Aid has consistently described the reimbursement rate environment as "challenging" for the last couple of years. (Walgreen has reported similar conditions.) However, the reimbursement climate took a turn for the worse in May, and Rite Aid expects the pressure to continue for the foreseeable future.

No need to worry
Investors shouldn't worry too much about Rite Aid's guidance cut. In the grand scheme of things, Rite Aid's turnaround is still on track. In April, management forecast that FY15 EPS would come in a range of $0.31-$0.42. On Thursday, that range was reduced to $0.30-$0.40. This is not an especially significant change in the outlook.

Rite Aid cut its earnings guidance last week, but not by very much

Looking beyond this year, Rite Aid and Walgreen will benefit from additional generic drug introductions later this year. Both companies have also reached partnership agreements with major drug distributors, taking advantage of their purchasing scale to reduce drug costs. This should allow Rite Aid to continue improving its profit margin in the next year or two.

Foolish bottom line
Turnarounds are usually messy, but up until last week, Rite Aid had maintained a virtually spotless record for more than 2 years. It wasn't that surprising to see Rite Aid hit a speed bump in the form of additional reimbursement rate pressure. Fortunately for Rite Aid investors, it also isn't much of a concern.

I expect Rite Aid to continue executing its cost control initiatives and thereby offset most of the reimbursement rate pressure in the next year or two. Longer-term, Rite Aid's efforts to rebuild its balance sheet will reduce risk, making the stock more valuable.

Rite Aid still has a disadvantageous position compared to Walgreen, which is much larger, but it has proven in the last few years that it can be solidly profitable despite its smaller size. The recent guidance cut does not compromise that long-term outlook.

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