Rite Aid Q2 Earnings Review: Reimbursement Pressure Eats Into Margins As Remodeled Stores To Drive Sales Growth

Rite Aid (NYSE:RAD), the third largest drugstore chain in the U.S.,  announced its earnings for the quarter ended August 31st on September 17th. ^[1] (Fiscal years end with February.) Starting this quarter, the company will report its business in two segments, namely retail pharmacy and pharmacy services, which essentially represent the erstwhile Rite Aid and the recently acquired EnvisionRx, respectively.

A Snapshot of Q2 2016 Earnings

Excluding the incremental revenues from EnvisionRx, Rite Aid’s revenues grew by 2% year over year, compared to a 4% growth registered in the same year-ago period. The slowdown in revenue growth is a reflection of the decline in the company’s same-store-sales growth. Coupled with a fall in retail pharmacy gross margin, due to lower pharmacy reimbursement, the EBITDA margin decreased to 4.5% in Q2 2016, compared to 5.6% in the year ago period. In fact, lower drug acquisition costs partially offset the negative impact of reimbursement rates and prevented a steeper decline in EBITDA margins. In addition to these factors, higher interest and transaction costs incurred in connection with the acquisition of EnvisionRx further dragged down the bottom line to $22 million, compared to $128 million the last year’s second quarter.

Our price estimate for Rite Aid currently stands at $8.74 per share, which is slightly above the current market price. We are in the process of updating our model per the earnings release.

View our detailed analysis for Rite Aid

Reimbursement Pressure Continues Across the Sector

As the Affordable Care Act brings in more people under insurance coverage, pharmacies are increasingly facing the pressure of low reimbursement rates. The margin pressure is caused by a combination of lower reimbursement rates on Medicare Part D plans and an increase in insurance coverage. Uninsured people have always had to pay the full price for drugs, while those with coverage managed to get a lower price because of negotiations by PBMs on their behalf. As retailers make higher margins on purchases from uninsured customers, a smaller proportion of uninsured population converts to lower gross margins for retailers and vice versa.

Store Remodeling and Plenti Program Will Drive Top Line Growth

Rite Aid has been making significant investments into remodeling its stores into what it calls the wellness format. While the company had a total of 1,634 wellness stores (35% of all Rite Aid stores) at the end of February, the number increased to 1859 stores (41%) by the end of August (Q2), keeping the company on track with its target of 400 remodeled stores in fiscal 2016. Considering that remodeled stores are outperforming the rest of the chain in terms of both front-end and prescription sales, we expect the company’s revenues to grow driven by these investments.

Also, Rite Aid recently introduced an enhanced version of its rewards program, called “Wellness+ with Plenti”. Customers enrolled in the program can earn Plenti points on their purchases and redeem them across all Plenti partners including retailers such as AT&T, ExxonMobil, Macy’s, Hulu, etc. As members will continue to earn wellness+ points, they will effectively earn two kinds of points using one card. As of February 28, 2015, the wellness+ program had nearly 25 million active members, who accounted for 78% of front-end sales and 67% of prescriptions filled in fiscal 2015. The partnership with Plenti is expected to significantly increase the appeal of the already successful loyalty program, which will likely drive customers to shop at Rite Aid more often.

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1. Rite Aid Investor Relations [↩]