Rite Aid’s Incredible Turnaround: Beyond the Numbers

We've all seen the retail pharmacies -- more than a few of them, for sure. They're on every corner, some of which even share adjoining properties. With health care needs on the rise, and all the reforms to insurance, retail pharmacies are trying to pull us in at every turn.

Join Michael Douglass and Kristine Harjes as they take a deep dive on Rite Aid's strategic initiatives to shed light on what's great -- and not so great -- about the models of the industry that are taking health care options by storm. They'll compare the value and cost in this booming niche, and offer some advice on what to avoid before taking the leap into investing in this rapidly growing model.

A full transcript follows the video.

Michael Douglass: Rite Aid's (RAD 24.00%) prescription for growth. This is Industry Focus.

Hi, folks! Healthcare analyst Michael Douglass here. I am joined today by special guest Kristine Harjes who's a health care analyst here at The Motley Fool. Kristine, welcome to the show.

Kristine Harjes: Thanks a bunch, Michael. Happy to be here.

Douglass: All right. I should say, Kristine actually runs our financials industry focus with John Maxfield on Mondays. It is a lot of fun, just a really great program. I highly recommend you give it a listen. So, be sure to check back for the weekly financial industry's focus on Mondays. All right. Now that I've finished plugging her episode of the show, let's get right down to it. Rite Aid -- retail pharmacy, a very high interest stock, I think a company a lot of people have been watching very closely. Really rough timing with Eckerd acquisition in 2007.

They bought out this competitor, the stores that they bought from Eckerd essentially cannibalized Rite Aid sales because as you've noticed with a lot of retail pharmacies, the stores are across the street. Then of course, the financial crisis happened and they took on a lot of debt, and they have just really begun digging out from under that. They have been implementing a lot of really interesting strategies to try and juice growth and really move the needle so Rite Aid can get out from under that debt.

Maybe even one day join CVS (CVS -0.94%) and Walgreens (WBA -0.98%) in initiating a dividend. Here's something to hope for in the distant future. I really wanted to spend some time today talking about those specific strategies. So, Kristine; why don't we start with the Wellness Store remodels?

Harjes: Right. As you previously eluded to, Rite Aid is somewhat of a turnaround story and we saw fiscal 2015 results that just came out and a lot of attention has been paid to the numbers there. What I really found interesting was digging into the earnings goal itself and listening to the executives talk about all of these different transitions that they're looking to make, and they're different strategic initiatives. So, first and foremost; this Wellness Store initiative.

This is kind of a big copycat move from CVS, but the thing is, it's proven to work. A remodeling of these stores to a wellness format makes them so much more profitable. So, Rite Aid is looking to take a cue from CVS by doing some of its own remodeling to their new Wellness Store concept. They're planning on doing 400 more of these remodels in fiscal 2016. All of its newly remodeled Wellness Stores will end up having the new Ready Clinic in it.

These stores are destroying the legacy stores. They're outperforming the last quarter by 3.5% in front end sales, and somewhere around 2.25% in pharmacy script growth. So, clearly this is a really profitable initiative. It makes sense that this is something that Rite Aid is really driving.

Douglass: Yeah. You could see it in the front end, same store sales, right? 348 basis points higher than non-Wellness Stores at the front, and 226 basis points higher in script. When you look at -- as a percentage of overall stores -- about 36% of their stores are in the wellness remodel. That's about 1600 stores. Clearly, an easy way for them to grow topline growth. It's very much a proven success for them. Let's talk Ready Clinics.

It's definitely a copycat move with CVS and Walgreens with these in store clinics, and this opportunity to make a stickier relationship where you prescribe something and "Hey, you're already here. You might as well go ahead and pick up the prescription. Our pharmacist would love to help."

Harjes: And maybe you'll stop by and grab a pack of gum or something on your way out, too.

Douglass: Right. Or, unlike CVS, a pack of cigarettes.

Harjes: Better.

Douglass: So, definitely, the Ready Clinic is an interesting opportunity. Their scale with Rite Aid clinic is going to be so much smaller than Walgreens and CVS, but there is a similar opp. When you look at Minute Clinics at CVS they've driven so much revenue growth on their own, also in addition to help the stores. Of course, there are going to be these issues at Rite Aid introduces this new concept. They're expecting and guiding that they're going to probably not make money on it initially because they're going to have to figure out what makes sense in the store footprint.

Harjes: Sure. There are going to be hiccups with any new initiative from a store. However, I would conjecture that Rite Aid actually has a shortened learning curve here when you compare it to some of its big competitors that's trying to do the same 'in store, health care clinic' focus, because they acquired this whole Ready Clinic thing from a group of stores that were operating in the Texas retiree market by operating out of these HEB grocery stores. So, these stores have a proven model. They can continue to expand in more grocery stores. So, it doesn't even need to be actual Rite Aids, or Rite Aid can bring the clinics into their own existing stores.

Douglass: Yeah. Definitely something that investors are going to watch very closely. CVS, again, has gotten tremendous scale with these. Walgreens is still many, many multiples of Rite Aid, even though it has fewer of its health care clinics than CVS. On that, let's head back toward the front of the store a little bit. Let's talk about that loyalty program. It's a unique loyalty program, and something they announced at the earnings call.

Harjes: Yeah, this was a super interesting tidbit. They talked about how they wanted to -- or how they're going to start-up with this new program called Plenty. It's a partnership through which their rewards program is now going to be linked with a ton of different, big retailers and companies like Exxon (XOM -0.80%), and Macy's (M -1.63%), AT&T (T -1.73%), Nationwide, American Express (AXP -1.31%) -- I'm sure I'm missing some here -- but basically it's the first U.S. based coalition loyalty program.

So, it's not going to cost customers anything, but now instead of having just a Wellness plus loyalty program within your Rite Aid stores you're going to get -- as a customer -- benefits through all of the stores. So, not only does that make your Wellness Plus, Plenty membership more valuable to you; it will also take previous customers who wouldn't have gone to a Rite Aid that are part of this program due to their loyalty through other stores that are now going to say "Hey, Rite Aid is on this list. I get benefits here. So, I'm going to stop there to pick up my prescription." Or whatever the case may be.

Douglass: Yeah. I think it's interesting because I think the loyalty program highlights Rite Aid's continual focus on the retail side of things, which is something you don't see so much from a CVS -- which is clearly expanding a lot more in the health care area. Rite Aid is still thinking -- not that CVS isn't -- but I think Rite Aid is more emphasizing foot traffic into its stores. Which makes sense. That's its entire business model, whereas CVS has the PBM, has a lot of other different irons in the fire that I think flow in well with its mission statement, but also it has different levers to pull than Rite Aid. So, it's definitely a really interesting development. Something that people are going to want to watch and I think it has a lot of opportunity for upside in taking what's essentially -- let's face it -- a pretty non-moated industry. Rite Aid's across from Walgreens, is across from CVS. The same street corner -- or opposite street corners. It will be interesting to see if they will be able to start differentiating that way.

Harjes: Of course, that is the point of these loyalty programs and all these different initiatives. It's "How do we get customers to choose our store when they could easily go next door?"

Douglass: Yeah. Interestingly though -- since I was mentioned CVS' business model and their PBM (Pharmacy Benefits Manager) -- Rite Aid bought a PBM of its own recently.

Harjes: Yeah. Just announced in February that they are going to acquire EnvisionRx. It's a super interesting decision on their part. I think it gave investors a little bit of a bad flash back to the Eckerd acquisition when they first heard the news that Rite Aid was going to be taking on debt to make another acquisition. Yet, personally, I think this is going to be a lot better of a situation for the company. first off, the debt is at a much better interest rate than it was back when they acquired Eckerd, and also moving into the PMB space, I think it's going to be pretty valuable for the company.

Douglass: It certainly could be. One of the issues with PBMs is -- just for those who aren't familiar with them -- PBMs essentially are hired by insurers and health plans to negotiate with the big pharmas and the biotechs. So, you might have a PBM say "You've got this really great drug which we want to include on our formulary. We have 100 million members between the various Wal-Marts (WMT 0.11%) and X, Y, and Z insurers. We would love to include it on our formulary. We could give you a guaranteed market. Could you cut us a little bit of a discount there?" And the PBM is then able to leverage its size to hopefully get a more attractive price for its members. Then also, they pocket a little bit of the difference so they're able to -- that's how they make their money. It's a low margin, but very high volume business, as you can imagine, where size really counts. Of course, EnvisionRx is not nearly as big as OptumRx which is the number three PBM -- which is owned by United Health Group (UNH 1.33%). Caremark, which is number two, owned by CVS and Express Scripts (ESRX) -- the number one PBM.

Harjes: Yet they still have an estimated $5 billion of sales coming in 2015. So, not exactly a tiny deal here. One of the other interesting points about EnvisionRx is that they're really big into prescription drug plans for seniors enrolled in Medicare Part D, which is one of the fastest growing markets. So, there's a real opportunity with this deal.

Douglass: Yeah, and let's face it; greying of America is going to be a really big opportunity for a lot of health care companies. It's one of the things that's really interesting about the space is you've got these big tailwind -- demographic tailwinds -- that should really help them do really well. A couple other smaller things; they've got the health dialogue program which is working with health coaches to talk through helping people with chronic diseases.

So, that might be -- nutritional coaching for somebody who's diabetic for example. Certainly a move to make Rite Aid a little bit more of a focal point -- of a health care focal point.

Harjes: Right. This is part of their Rite Aid Health Alliance program. As you mentioned already, it's that they're providing coaches. The upside here is that it's getting people, again, in the store. That shows they're focused on driving those front store sales.

Douglass: So, when you take this all together, it's really an interesting set of strategic initiatives. You've got the store focus like the Wellness Store remodels, the Ready Clinic, Health Dialogue, Health Alliances, and loyalty program. Then you've got this side piece which is the PBM. I think you can tell Rite Aid has a lot of irons in the fire. They've got a lot of things that they're trying and I think their real opportunity here is going to be to scale out what works like they've done with the Wellness Store remodels.

Perhaps, to jettison the things that don't work, or at least to deprioritize them a little compared to whatever is working. So, speaking of which, this is The Motley Fool, right? We always try to not just talk about the past, but to think about the future. What do you think is the strategic initiative Rite Aid investors should be most closely watching moving forward? The next quarter, the next year, the next couple of years.

Harjes: Personally I think the one that investors need to keep the most of an eye on would be the EnvisionRx integration because we don't really have a lot of information about this just yet. The deal hasn't officially gone through yet, we're expecting it to go through in September. So, forecasts don' currently include the upside from this, or the downside of that interest expense.

If it does fall through it's -- something to keep in mind that the debt that they took on is a lot lower interest than some of their existing debt. So, they could use that as a refinancing mechanism. That would be interesting, too. Of course, if you're rooting for this PBM acquisition you're going to want to see it go all the way through.

Douglass: Right.

Harjes: At that point we just want to keep an eye on exactly what sort of synergies are being created, and pricing advantages that Rite Aid is seeing as a result of fully incorporating EnvisionRx.

Douglass: Yeah. I'll just add to that; I think the Ready Clinic rollout is just going to be really, really big and really interesting for folks to watch. By the second quarter of their fiscal quarter of 2016 -- which is Calendar years 2015 -- they expect to have 25 Rite Aid based Ready Clinics. Ready Clinics in Rite Aids. This is -- CVS, again [...] what a tremendous opportunity this is for Rite Aid because it's worked so well at CVS. They'll want to see if they're able to execute well on it.

If things don't go as well as expected -- for example: a sourcing deal with McKesson (MCK 0.41%) that took a few quarters to really ramp up and start showing them some cost synergies. We're going to want to watch to see very closely what management has to say about it, and about the opportunity. So Kristine, final question for you -- perhaps the key question, the question on everyone's mind -- is Rite Aid a buy?

Harjes: Honestly, for me, it's a little bit too speculative at this point. If I were to buy into this space which -- as you pointed out -- this is a great space to be buying into given your demographic tailwind, given your health care revolution going on in this country. I definitely think it's an intriguing couple of companies that we're looking at. When we're talking about Rite Aid and CVS, and Walgreens; but for me I wouldn't personally want to be buying into the turnaround story of them.

Especially when it's not particularly cheap when you're looking at valuation, and it's got all this debt, it's got all these initiatives that have yet to prove themselves as 'going to pan out'. So, it's not a buy for me, but it's definitely a story to keep an eye on.

Douglass: Yeah. I think that it's funny because in health care, generally, we don't talk too much about valuation because, how do you value something that could throw off billions of dollars of cash in the future, or go completely out of business? It's kind of hard to do that. But when you've established businesses like the retail pharmacies, valuation does come into play.

Rite Aid's expensive by any metric, especially when you can compare, consider that it doesn't offer a dividend like CVS and Walgreens. They've got a lot of irons in the fire, but we don't have too much clarity yet in which ones seem likely to work. I think we'll have better clarity about that in the next year, or two. I think that's a good time for investors to reassess. For me, it's definitely a watch list pick. It's on my watch list, but I'm not yet prepared to take the jump either.

Harjes: Yeah. It's certainly an interesting story, at the very least.

Douglass: Oh, yeah. No, a lot of fun to talk about, too. Just really interesting to see what they do and to see what works out for them. All right. So folks, that's all the time we've got today. Thanks, as always, for listening and I want to emphasize something. Here at The Motley Fool we're all about people doing their own investment resource. That means that you should never, ever make an investment decision -- a buy, a sell, a short, or whatever -- based on just what you hear.

Make sure you do your own research. The Motley Fool may have active recommendations, or may own shares in stocks that we talk about on the program, and Kristine and I may own shares. Although, I don't think we own any of the companies that we talked about today.

Harjes: We do not.

Douglass: We do not. Yeah. Thanks for keeping track of my holdings, too. Just always keep that in mind. Do your own research. It's the foolish way to do things, and we're all about long term investing and being smart about our stock research. For The Motley Fool, I'm Michael Douglass. Thanks so much for listening, and check into Fool.com for all of your investing -- health care and otherwise -- needs and Fool on!