Rite Aid (NYSE:RAD) is in the midst of a massive restructuring that includes selling over 1,900 stores to Walgreens Boots Alliance (NASDAQ:WBA), stabilizing insurance reimbursement rates, and increasing profitability. The challenges facing Rite Aid are big, and there's still a lot of work to be done, but management is making progress. This week, the company updated investors on its latest quarterly performance, so let's take a closer look and see how its turnaround is going so far.
What's happening with its debt
Perhaps the biggest obstacle to Rite Aid's profitability is its mountainous debt, so that's as good a place as any to look first to see if the company is making progress in its restructuring.
As a refresher, Rite Aid initially hoped to sell itself lock, stock, and barrel to Walgreens, but regulators objected to concentrating so much market share in the hands of one company, and as a result, a new agreement was inked in which Rite Aid is selling 1,932 stores to Walgreens in exchange for $4.375 billion in cash.
Rite Aid's management has said that it plans to net about $4 billion after expenses from that asset sale and that much of that newfound wealth will be used to reduce the more than $7 billion in debt sitting on its balance sheet. Doing so could have big profit-friendly implications because the cost of servicing that debt is high. In fiscal 2017, the company's interest expense totaled $432 million.
So far, Rite Aid has transferred 357 stores to Walgreens and received about $715 million, but fiscal third-quarter financial results only reflect the sale of 97 stores and proceeds of $241 million. Rite Aid used that $241 million to reduce its net debt to $6.7 billion last quarter. However, savings haven't yet trickled through to interest expense, which still totaled $109 million last quarter, up from $106 million last year.
Tailwinds to profitability associated with paying down debt should accelerate over the next four quarters, though, and according to management, interest expense will be "somewhere around $200 million" per year going forward.
Are sales and profit stabilizing yet?
In the past, uncertainty over its future has taken a toll on foot traffic and caused a corresponding drop in pharmacy and front-end sales and profit. Unfortunately, those trends continued last quarter.
In the period, Rite Aid's revenue declined 5.6% year over year to $5.4 billion and its net loss was $18.2 million or $0.02 per share, down from net income of $23.6 million or $0.02 per share last year. Adjusted net income of $1.6 million, or $0.00 per share, was down from adjusted net income of $26.8 million, or $0.03 per share, too.
Retail store sales were $4 billion, down $123 million, or 3% from a year ago. Same-store sales dropped 2.5% as front-end sales dipped 0.5% and pharmacy same-store sales decreased by 3.5%. Roughly 2% of the decline in pharmacy same-store sales was due to the launch of new, less expensive generic drugs, but even so, pharmacy scripts still fell 2.4% on a same-store basis due in part to "being excluded from certain pharmacy networks where we were able to participate last year."
Clearly, revenue and profit aren't yet moving in the right direction, and there's a lot of work still to be done. A big piece of that work involves renegotiating with drug payers and stabilizing and growing the company's network. According to management, progress is being made with payers and headwinds associated with a smaller member network should be mostly cycled by the end of the second quarter of fiscal 2019.
If that's true, then easier comparisons could allow the company to begin reporting positive growth figures next year, and if efforts to boost foot traffic pan out, then sales growth could provide leverage due to the company's cost-cutting efforts. Last quarter, selling, general, and administrative expenses (SG&A) in its retail business fell $8.6 million from one year ago. That drop wasn't big enough to offset negative impacts associated with declining revenue, but it's conceivable that lower SG&A expenses will provide a profit tailwind at some point in 2019.
Switching gears to the company's pharmacy benefits (PBM) business, pharmacy services revenue was $1.4 billion, down $201 million, or 12.2% year over year. On the surface, that's bad news, too, because its PBM business, Envision Rx, offers better profit margins than its retail business, so its growth is critical to Rite Aid's success. The drop in sales, however, wasn't surprising. Management began reducing exposure to less profitable low-income membership in fiscal 2017 and that's shrunk segment revenue.
Serving fewer, more profit-friendly members could be a better strategy for the company and investors should discover if that's the case over the next year or two. In the past year, Envision Rx's Medicare Part D membership has grown by more than 100,000 lives to 500,000, and expectations are that figure will grow by another 100,000 into fiscal 2019.
What to watch from here
Rite Aid believes that its ability to negotiate reimbursement and land new PBM business was hampered by uncertainty surrounding its now-failed merger with Walgreens. Now that Rite Aid's future as a stand-alone business has been established, it believes it will be able to cut more favorable terms with payers and sign up more PBM customers.
Because Rite Aid is the preferred pharmacy for Envision Rx PBM customers, any growth in that side of its business should support in-store script volume and front-end sales. To make the most of that potential increase in foot traffic, the company plans to renovate more stores to its Wellness format. Currently, about 60% of its stores have been remodeled to the Wellness format and front-end same-store sales were about 1.8% higher and script growth was 2.5% higher at those stores than they were at non-wellness stores last quarter.
Growing foot traffic and renovations won't guarantee Rite Aid's profitability without more progress on costs, though. Fortunately, Rite Aid should be able to squeeze out savings on drug costs next year.
As part of its deal with Walgreens, Rite Aid negotiated an option that allows it to purchase generic drugs at Walgreens cost for 10 years. Currently, Rite Aid has to buy its drugs through McKesson until March 2019. In order to maintain volume, McKesson may be willing to ink a better deal than Rite Aid can get from Walgreens, but even if McKesson isn't willing to do that, Rite Aid's drug costs should start improving after it executes its option with Walgreens in 2019.
Overall, the potential to kick-start profit at Rite Aid exists if interest expense falls as planned, the PBM business grows and boosts foot traffic, and costs slide. Admittedly, that's a lot of "ifs." Nevertheless, Rite Aid could become a 2,569-store, over $22 billion in sales, and profitable regional pharmacy over the next two years and that makes its progress worth watching.
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