On Thursday morning, Rite Aid (NYSE:RAD) reported significant improvement in first-quarter earnings. The company reported its third consecutive profitable quarter, with EPS of $0.09, up from a loss of $0.03 per share in the same quarter last year. Results hit the high end of the company's recently updated guidance for EPS of $0.08 to $0.09.
As I have discussed in a series of recent articles, Rite Aid's revenue has recently been pressured by a resurgence at top competitor Walgreen (NASDAQ:WBA). Rite Aid has been able to deliver strong profit growth despite that headwind due to the margin benefit from new generic-drug introductions. However, this benefit will drop off sharply later this year. Investors should monitor the company's results carefully over the next several quarters, to see if Rite Aid will be able to stay in the black after the tailwind from generics dissipates.
Rough seas ahead
Rite Aid has achieved a remarkable turnaround, considering that the business seemed to be on the verge of bankruptcy just a few years ago. However, the company clearly got an assist from last year's dispute between Walgreen and Express Scripts, as well as from the ongoing shift from brand-name drugs to generics. The growth in generic drugs hurts sales, but provides a significant margin benefit to drugstores, improving profitability.
Rite Aid's management has issued a very cautious outlook, because the generic-drug benefit is starting to wind down. Furthermore, Rite Aid is experiencing significant "reimbursement rate pressure" as Medicare, Medicaid, and insurance companies try to save money on prescription drug costs. On multiple occasions during its recent earnings call, Rite Aid's management highlighted these two factors, noting that they will have a significant (negative) impact on gross margin, particularly in the second half of the fiscal year.
In fact, the midpoint of Rite Aid's guidance assumes that the company will break even over the remaining three quarters of the fiscal year. That implies that the recent trend of improving earnings will reverse soon. One cause is a $60 million charge the company has recently incurred in order to refinance approximately $1.3 billion of debt. While Rite Aid's various refinancing transactions will dilute earnings this year, they will ultimately reduce annual interest expense by $85 million, boosting cash flow.
To some extent, Rite Aid executives may also be trying to manage expectations on Wall Street. The company's stock has tripled since December, and with lots of moving parts -- i.e., changes in the brand-name/generic mix, changes in reimbursement rates, market share changes, etc. -- it's probably prudent to give conservative guidance.
Nevertheless, these factors all present very real challenges for Rite Aid. While generic-drug introductions can provide a short-term lift to margins, ultimately insurance providers will try to take back most or all of that incremental margin in order to lower their own costs.
Rite Aid also faces particular challenges as the smallest of the three major pharmacy chains. Walgreen and CVS Caremark (NYSE:CVS) already offer much broader pharmacy networks than Rite Aid and have ample capital to expand onto Rite Aid's turf, whereas Rite Aid is shrinking. This process could lead to a growing cost gap that would hurt Rite Aid's long-term competitiveness.
What to look for
Going forward, the key for investors lies in Rite Aid's ability to manage the expected margin pressure later this year while maintaining market share vis-a-vis Walgreen and CVS. If Rite Aid can weather this storm and beat its guidance, that would be a good signal that its recent earnings improvements are sustainable.
However, I am still fairly skeptical that this will happen. Rite Aid seems to be losing market share to Walgreen and CVS again, and this process could accelerate as Walgreen continues to win back Express Scripts customers. I would need to see solid earnings results for the rest of this fiscal year to believe that the Rite Aid turnaround is the "real deal."
Fool contributor Adam Levine-Weinberg is long Oct 2013 $2.5 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.