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Rite Aid Corporation (NYSE:RAD)

F3Q09 Earnings Call

December 18, 2008 8:30 am ET

Executives

Frank Vitrano – Chief Financial Officer & Chief Administrative Officer

Mary F. Sammons – Chairman of the Board & Chief Executive Officer

John T. Standley – President & Chief Operating Officer

Analysts

John Heinbockel - Goldman Sachs

Lisa Gill - J.P. Morgan

Edward Kelly - Credit Suisse

Mark Wiltamuth – Morgan Stanley

Robert Willoughby - Banc of America Securities

Bryan Hunt – Wachovia Securities LLC

[Caru Martinson] - Deutsche Bank Securities

Karen Eldridge - Goldman Sachs

Emily Shanks - Barclays Capital

Operator

My name is Chris and I will be your conference operator today. At this time I would like to welcome everyone to the Rite Aid’s third quarter fiscal 2009 conference call. All lines have been placed on mute to prevent any background noise. After the speakers remarks there will be a question and answer session. (Operator Instructions) I will now turn the call over to Chief Financial Officer Frank Vitrano.

Frank Vitrano

We welcome you to our third quarter conference call. On the call with me are Mary Sammons, our Chairman and CEO, John Standley, our President and Chief Operating Officer. On today’s call Mary will give an overview of our third quarter results and I will discuss the key financial highlights. John will have some comments and then we’ll turn it over for questions.

Before we start I’d like to remind you that today’s conference call includes certain forward-looking statements. These forward-looking statements are made in the context of certain risks and uncertainty that can cause actual results to differ. Also, we will be using a non-GAAP financial measure. The risks, uncertainties and definitions of non-GAAP financial measure along with the reconciliation to the relating GAAP measurements are described in our press release.

I would also encourage you to reference our SEC filings for more details. With these remarks I’d now like to turn it over to Mary.

Mary F. Sammons

Thank you for joining us today. As you can see from our release this morning, our operating performance, the best indicator of our progress and future success improved significantly in the third quarter. We increased same store sales, improved margin rates and most importantly achieved an 8.5% increase in adjusted EBITDA over last year and in an economy dramatically weaker than it was in the last third quarter.

With the integration of Brooks Eckerd behind us early in the quarter, our team has been totally focused on delivering profitable sales and taking unnecessary costs out of the business and its working. We had good sales in core Rite Aid stores, especially in the pharmacy despite the industry wide slowdown in prescription growth.

We saw good improvement in the acquired stores with positive front end sales trend throughout the quarter and improving pharmacy trends for the first two months with a slight pull back in November as experienced by most retailers including drug stores. I’m happy to report that so far December pharmacy sales trends are much stronger. The acquired stores are modestly positive and core stores continue to show even better gains than the third quarter.

While we promoted to bring customers to our stores, we didn’t give our business away making sure to balance markdowns with sales to deliver a better gross margin rate. In these unprecedented times, it’s important to focus on what we can control and our team did an excellent job of doing just that. We made significant progress on reducing costs by improving operating efficiency throughout our company. In the stores, distribution centers and corporate office we significantly reduced working capital and reasonably paired cap ex.

We did a better job of managing labor to sales while at the same time continued to improve our customer satisfaction scores year-over-year and quarter-over-quarter. Just as our company focused on tightening our belt, we also helped our customers weather the economic storm. Sales of Rite Aid brand products which save our customers money while delivering higher margins to us continued to grow.

Our RX prescription savings card with no membership fee and available nationwide for only a few months now has really taken off because it not only saves patients money on prescriptions, it also saves them money on Rite Aid brand items and more than 1,500 OTC medications. And, great news for us, more than 30% of those using the card are new patients to Rite Aid.

We have a lot more news to share with you this morning but I want to say just a few words about the leaders you’ll hear from. Just a few months ago, in fact, on our Q2 earnings call I announced that John Standley had returned to our company accepting the position of President and Chief Operating Officer and that Frank Vitrano had also joined our team as Chief Administrative Officer and Chief Financial Officer.

You will hear from both John and Frank in just a minute and you’ll like what you hear. Our entire teams commitment made earlier this year to deliver profitable sales and take unnecessary costs out of the business has really happened, in fact, intensified with John and Frank leading the effort. Besides enjoying working with them the past few months, I’m impressed with how quickly they have had a positive impact on our company and its result.

Managing our business as efficiently as possible will be even more important in the continued tough economic environment that everyone expects. With that said, I will turn it over to Frank for the financial details on the quarter.

Frank Vitrano

I’m very happy to be here in central Pennsylvania and excited about the Rite Aid opportunity. Today I plan to walk through the financial results, provide an update on the capital expenditure program, discuss our liquidity position as well as review the status of our AR securitization facility. Finally, I will discuss our updated guidance.

This morning we reported revenues for the quarter of $6.47 billion as compared to $6.5 billion for the third quarter last year. The decrease in total sales was primarily driven by a reduction in total store count. In the quarter we closed 29 stores and quarter-over-quarter we had 175 fewer stores. The year-over-year reduction in store count reflect combining acquired stores in close proximity to other stores and stores closed due to underperformance.

Same store sales increased 140 basis points which reflect positive core Rite Aid trends and improving trends in BE stores. Front end same store sales increased 2.3% and pharmacy same store sales increased 1% during the quarter. Pharmacy sales included an approximately 269 basis point negative impact from new generic drugs. Pharmacy scripts decreased 1% negatively impacted by the Brooks Eckerd stores.

Excluding the acquired Brooks Eckerd stores, same store sales for the 13 week quarter increased 2.6% over the prior year with front end increasing 1.9% and pharmacy growing 3%. At the Brooks Eckerd stores same-store sales decreased 1% during the quarter while front end increased 3.7%. Pharmacy decreased 2.6% in the quarter compared to a second quarter decrease of 4.6%. Same-store sales trends were weakest in November reflecting the holiday shift and a weaker cough/cold month than last year. Zyrtec negatively impacted RX sales in the quarter by 67 basis points.

Adjusted EBITDA came in at a strong $252 million or 3.9% of revenues for the third quarter. This is a $19.7 million or 8.5% increase over last year’s third quarter of $232 million or 3.6%. Higher gross margin and better focus on SG&A costs drove the improvement.

Net loss for the quarter was $243 million or $0.30 per diluted share compared to last year’s third quarter net loss of $84.8 million or $0.12 per diluted share. The increase in net loss was driven by an increase in store closing and impairment charges of $79.8 million over the prior year and an $82.3 million increase in income tax expense. The $79.8 million store closing and impairment charges include a $59.2 million noncash impairment charge related to underperforming stores. We recorded a $27.1 million noncash charge for additional valuation allowance against our deferred tax assets compared to a tax benefit of $53.5 million last year.

The company experienced product cost increases which resulted in an additional noncash LIFO charge as compared to last year’s third quarter. The LIFO charge was $59.8 million this year or $43.8 million higher than last year’s charge of $16 million. The three noncash charges LIFO, store impairment and the tax valuation allowance totaled $130.1 million or $0.15 per share.

Interest expense was $126.6 million or $3.7 million lower than the prior year quarter due to a drop in the LIBOR rate.

As Mary previously mentioned, the integration of Brooks Eckerd was completed during the quarter. Integration expense was $8.6 million in the quarter versus $53.3 million last year. Integration costs in the fourth quarter are expected to be insignificant.

Gross margin dollars in the quarter were virtually flat to last year’s third quarter. This includes the $43.8 million incremental LIFO charge I previously spoke about. On a FIFO basis gross margin increased 53 basis points. The increase was driven by improved front end mix, lower front end shrink and better markdown control partially offset by lower photo gross margin.

Product handling and distribution center expense as a percent of sales improved due to operational efficiency improvements and lower fuel costs.

Selling, general and administrative expense for the quarter was lower as a percent of sales by 16 basis points compared to last year. SG&A charges not reflected in adjusted EBITDA were lower by 40 basis points primarily driven by $44.7 million in lower integration costs partially offset by $10.5 million of severance costs related to workforce reduction and management changes which occurred during the quarter as well as higher depreciation and amortization costs.

During the quarter the company realized the benefit of various cost-saving initiatives that had been put in place as well as those implemented in the quarter. The SG&A improvement was driven by better labor controls and lower corporate admin costs, lower general liability expense and lower Rite Aid administered medical costs partially offset by higher union welfare and health and welfare contributions as well as occupancy costs. Total utility costs were down as well.

We also recorded a provision for the settlement of the DEA record keeping matter which was discussed in the second quarter 10Q.

Overall we are very pleased with the progress we made and expect continuing improvements in the coming quarters.

Turning to the quarterly cash flow statement net cash provided by operating activity was $44.3 million as compared to $276.7 million used by operating activity in last year’s third quarter. Inventory grew by $87 million in the quarter as compared to $305 million in the same quarter last year. Net cash used in investing activities for the quarter was $108 million versus $139 million last year.

During the quarter we opened 13 net new stores, relocated 23 stores and closed 29 stores. Our cash capital expenditures was $112.5 million which includes $19.3 million spent in completing the integration related remodels and $14 million to acquire script files as compared to $11 million in script file purchases last year.

On a year-to-date basis we have opened 26 net new stores, relocated 46 stores, acquired 9 and closed 181 stores. Our cash capital expenditures were $477 million which includes $129 million spent on integration related activities and $75 million to acquire script files.

Now let’s talk about liquidity. At the end of the third quarter we had $1.146 billion outstanding under our $1.75 billion senior secured credit facility. We also had $174 million of outstanding letters of credit. At the end of the quarter we utilized the securitization agreement for $445 million. At the end of the quarter we had $430 million of availability under our credit facility and today we have $495 million available. The increase from quarter end reflects accounts receivable collections as well as seasonally adjusted inventory sell-through. We expect to see continued increase in our availability throughout the fourth quarter.

On September 16, 2008 we completed an amendment to the securitization agreement whereby credit commercial paper vehicle entities renew their commitment to fund the purchase of our pharmacy related receivables until January 15, 2009. We are in discussions with our three bank partners to once again extend the facility and fully expect to do so albeit at a higher rate. It should be noted that the securitization agreement continues to be fully backstopped by stand-alone bank commitments through September 2010 which we could use for funding the commercial paper vehicle entities if they are not renewed.

Now let’s turn to guidance. Based on current sales trends, a weaker economy, an increase in store impairment charges, higher LIFO charges and an increase in our tax asset valuation allowance we are confirming guidance for total sales and adjusted EBITDA and lowering guidance for same-store sales and increasing net loss for fiscal 2009 which ends on February 28, 2009.

The company continues to expect total sales to be in the range of $26 billion to $26.5 billion and continues to expect adjusted EBITDA to be between $950 million and $1.025 billion for fiscal ’09. Same-store sales are expected to improve 50 basis points to 150 basis points over fiscal ’08 as compared to our previous guidance which was 150 basis points to a 350 basis point increase. Net loss for fiscal 2009 is expected to be between $593 million and $773 million or a loss per diluted share of $0.74 to $0.95 compared to our previous guidance of $445 million to $535 million or a loss per diluted share of $0.56 to $0.67.

The company continues to expect capital expenditures excluding proceeds from sale and leaseback transactions to be approximately $550 million and continues to expect proceeds from sale and leaseback transactions to be approximately $200 million. In fact, the sale leaseback transactions had already been completed earlier in the year.

The guidance does not include a provision for incremental store closures.

That concludes my portion of the presentation and I‘d now like to turn it over to John.

John T. Standley

As both Mary and Frank mentioned, it was a good quarter from a sales and adjusted EBITDA perspective that unfortunately is somewhat masked by asset impairment, tax valuation and LIFO charges. I’m pleased with the significant amount of progress we made in a very short period of time and I’m very pleased with how focused our team has been so far.

I’m very excited that Ken Martindale has joined our team as Senior Vice President of Merchandising, Marketing and Logistics. Ken is a very experienced retail operator and an outstanding merchant and he is a great addition to our team.

After 13 weeks on the job we have identified significantly more opportunity to improve our results than Mary, Frank and I originally thought which makes me even more optimistic about our future prospects. The third quarter benefited from some of these opportunities with solid sales results, improved front end gross profit and tight expense control.

As Frank mentioned, third quarter front end same-store sales increased 2.3% over the prior year with core Rite Aid increasing 1.9% and the Brooks Eckerd stores increasing 3.7%. More specifically on front end sales core drugstore categories including over-the-counter medications, HBC and vitamins along with consumables showed good sales growth in the quarter while photo, seasonal and toys showed some weakness.

Seasonal, toys and November sales in total were negatively impacted by a later Thanksgiving compared to last year which reduced the number of Christmas selling days in the quarter. Photo was negatively impacted by the continuing decline in one-hour photo development and our conversion from Kodak to Fuji partially offset by an increase in digital photo sales.

Third quarter pharmacy same-store sales increased 1% over the prior year with core Rite Aid increasing 3% and pharmacy decreasing 2.6% in the acquired Brooks Eckerd stores. Total script count declined 1% in the quarter. Script count grew in the core Rite Aid stores but declined in the Brooks Eckerd stores although the decline was a lower rate than the second quarter. Script count in the quarter was held by the successful launch of our RX savings card and courtesy refill programs.

The RX savings card loyalty program launched in September and rolled out across the chain during the third quarter. To date over 700,000 unique users have filled prescriptions with the card with about 1/3 of those patients being new customers to Rite Aid.

We also continue to see growth at our loyalty programs for seniors, Living More, with 4 million seniors enrolled in the program at the end of the quarter.

Softer front end sales trends in November have continued into December. Front end same-store sales for December through yesterday were down 5% due largely to continuing softness in seasonal which is in part due to the fact that Christmas is two days later this year and a weak economy. Pharmacy same-store sales are up 3.5% making total comps a positive 0.4% so far in December.

We report December sales on January 5. We expect front end sales to improve in January and February as sales mix turns away from seasonal products and moves towards traditional drugstore categories.

Front end gross margin for the third quarter improved 133 basis points over the prior year on a FIFO basis or excluding the LIFO provision due to better control over markdowns and retail pricing, lower shrink expense and an improvement in product mix resulting in part from an increase in private label penetration. Private label penetration was 12.7% in the third quarter this year versus 11.7% in the third quarter last year as customers increasingly look for value in this challenging economy.

Pharmacy margin was flat in the quarter with an improvement in generic mix and improved drug purchasing offsetting reimbursement rate declines. Generic mix improved to 68.4% this year versus 64.9% last year.

FIFO gross margin also benefited from a 16 basis point reduction in distribution costs as a percent of total sales versus the prior year. Distribution costs declined due to better labor productivity in the warehouses that was due in part to the reduction of 100 administrative jobs in the facilities during the quarter and better labor and expense management that was due in part to a $223 million reduction of FIFO inventory versus the third quarter last year.

Overall third quarter FIFO gross margin increased 53 basis points over the prior year and we managed to get 34 basis points of that to the adjusted EBITDA line by successfully managing our SG&A expenses. In fact, for the quarter we dramatically reduced the rate of the year-over-year increase in SG&A.

Focusing on SG&A expenses that are included in adjusted EBITDA, SG&A in the second quarter increased 88 basis points versus the prior year. In the third quarter SG&A included and adjusted EBITDA increased only 24 basis points over the prior year, a 64 basis point reduction in the rate of increase in the second quarter.

Third quarter retail wages were flat to last year versus a $14 million increase over the prior year in the second quarter illustrating the significant improvement we made in labor management in the quarter. We also saw good progress in non-union benefit costs, advertising, corporate administrative costs and store supplies.

Consistent with our approach in prior years we completed our workers’ comp and general liability evaluation in the third quarter and due to favorable claims development, workers’ comp and general liability expenses were $21 million lower than last year in the quarter. Partially offsetting this improvement in workers’ comp and general liability was an $11 million increase in union benefits resulting from a health and welfare suspension in the prior year.

Putting it all together, EBITDA increased $19.7 million from $232 million or 3.6% of sales last year to $252 million or 3.9% of sales this year. In addition to the EBITDA improvement we made significant headway with working capital. As I mentioned a moment ago, on a FIFO basis we reduced inventory by $223 million versus the prior year. The reduction in inventory versus the third quarter last year helped us with a number of expense lines including markdowns, store labor, distribution costs, returns expenses and shrink just to name a few.

Looking forward we see significant opportunities to improve our business.

Similar to the third quarter our initiatives for the fourth quarter and next year revolve around improving store productivity. The key to unlocking store productivity in our front end business is to improve our merchandising and marketing processes, where Ken Martindale will be a big asset so that we can tailor our consumer offering to meet the needs of a cluster of segments or segments of stores. This approach will allow us to focus our investments in labor, inventory, advertising, promotional markdowns and distribution costs in the stores that will provide the highest returns for those investments.

The following initiatives are enabled by this approach: Inventory reduction and customer focused merchandising through SKU rationalization, improved labor management, focused advertising and markdown spend, and efficient product delivery schedules and truck routing.

Ultimately the benefits of these initiatives show up in sales growth because we have the right merchandise, lower inventory investment because of SKU rationalization, lower distribution costs because of less inventory, less labor to handle less inventory, lower markdowns needed to deal with unproductive inventory and less returns expense because we have less unproductive merchandise to handle.

If this sounds familiar, it’s because we just talked about this a few minutes ago when we discussed third quarter results. I think the third quarter results validate that the things we are working on can significantly improve our operating results. To put it a different way, we have 4,900 stores that are all a little different for some reason or another. Clearing out which reasons are important and grouping customers and stores with common attributes gives us a powerful way to invest our limited resources so that we can significantly improve our results.

As we get further into this opportunity over the next few months we can provide more insight into the magnitude of the opportunity from this but we think it will be very significant.

Improving pharmacy productivity is focused around growing scripts. We have a number of initiatives ongoing that we continue to focus on including improving our customer service, targeted marketing programs, acquiring script files and customer support programs focusing on compliance.

With that, I’ll turn the call back to Mary for final comments.

Mary F. Sammons

We delivered a solid operating quarter with good same-store sales growth, improved margin rate and a substantial increase in adjusted EBITDA of 8.5%. Core Rite Aid stores performed well and sales in the acquired stores continue to improve as our associates company-wide work together to execute our plans. We made significant progress on our cost-savings initiatives and I believe we’ve only seen the beginning of the benefits we’ll get from our initiatives to take unnecessary costs out of the business.

The business environment is likely to be even more challenging going forward than it is today. Our focus will continue to be on profitable sales by providing good value and the best service to our customers and patients and on continuing to operate our business more efficiently. We have the right team in the stores and field, the distribution centers and corporate to do both and the liquidity to support our business plans. We expect to continue improving our operating results as we did in the third quarter.

Before we turn it over for questions, I’d like to wish you all Happy Holidays and the best for the new year. Operator, we would be happy now to take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from John Heinbockel - Goldman Sachs.

John Heinbockel - Goldman Sachs

If you look at December just core OTC HBA, core drugstore categories, is that business holding up well and how would it compare to November?

John T. Standley

It’s probably similar to November but a little soft. I think we’re just seeing fewer trips on the seasonal which is having some impact across the store.

John Heinbockel - Goldman Sachs

Secondly, if you look at your implied fourth quarter EBITDA range, it’s pretty wide ranging maybe from a decline of 8% to an increase of 16%. Is that uncertainty because of the macro or is it conservatism? It looks like some of the expense things you saw in the third quarter should pick up a little bit of steam and I guess we’d be surprised if EBITDA was down in the fourth quarter, but talk about that range a little bit.

John T. Standley

Frank, do you want to narrow the range?

I remain confident about what we’re doing. I think we’re doing the right things so I think we have a lot of momentum here. We’re fighting a tough economy at the moment. I think it’s going to come back a little bit as we get later into the quarter but honestly we just don’t know yet. We’re going to get a little farther into sales here, get through Christmas and kind of see what we’ve got. But on the expense side, you’re right. We’re making a lot of progress here. We’ve got a lot of things underway and I feel very good about those things. So we continue to kind of push our way through it here and we’re making a lot of progress.

Mary F. Sammons

It’s just really important that we be as reasonable or realistic on the top line as we can because that also makes sure that we make the best decisions all the way through operating the rest of our plan to deliver the most value to the bottom line. The way December has started out on the front end I think it’s important that we take a more realistic view of what could happen even believing that things could be better.

John Heinbockel - Goldman Sachs

Do you think your expense performance which you can control would be better in the fourth quarter than the third? Do you think that’s fair?

Mary F. Sammons

Yes. We should continue to see momentum on our expense initiatives because they have just more time to have gotten traction and new ones identified even over the last several months.

John T. Standley

I think the question is: Are sales results going to pressure the SG&A percent if you’re using a percent? That’s going to be the question and I think as we see how sales develop; sales in December we’re going to have two monster days here where the change in calendar is right at the end of the month. So it’s a little weird where this call falls right in the middle of the month and we’ve got a calendar shift going on, so like you we’re trying to work our way through what it really means in terms of where we’re at for December sales right now. But again with everything we’ve got going on, I feel good about where we’re going.

John Heinbockel - Goldman Sachs

Is the seasonal inventory lean enough where you’re not that worried about markdowns?

John T. Standley

We did buy down on seasonal this year so we’re going to do our best to try and push it through over the next couple weeks and hopefully we’ll be in a good position with that when Christmas is done.

John Heinbockel - Goldman Sachs

Finally if you look out to next year obviously you’re not giving guidance now, but when you think philosophically about cap ex and free cash and debt reduction, what do you see going forward because I think it would be nice to reduce the debt burden a little bit? Where does that go going forward and do you think there’ll be an opportunity to raise the dollar amount dedicated to file buys if independents are under pressure from the economy?

John T. Standley

We think file buys are very important. I’ll just say that first of all. The way we’re approaching capital as you would expect is prioritizing where the spend is going to go and file buys is at the very tippy top of the list so that’s important to us. We’re going to continue to do that. In terms of where we’re going with capital, it’s going to be a lot lower. We are going to really tighten it down.

We’re committed here to getting some debt reduction and generate some free cash flow next year. That’s our plan. So we’re going to work that cap ex down, we’re going to stay focused on inventory, and get some more working capital out of this thing which we’re very focused on, and we’re going to keep pushing on sales growth and cost reduction. When we stir all that together we think we’re going to be able to generate some free cash flow and get some debt down next year. That’s our goal.

Mary F. Sammons

We just invested significant capital dollars this past year with all of the activity that went on around the acquired stores and we are going to focus on improving the productivity out of those stores.

John Heinbockel - Goldman Sachs

Do you see any signs of the independents being under duress or not really yet from the macro?

John T. Standley

Chris is sitting here and he’s saying there’s some action out there.

John Heinbockel - Goldman Sachs

An uptick right?

John T. Standley

Yes, an uptick.

Operator

Our next question comes from Lisa Gill - J.P. Morgan.

Lisa Gill - J.P. Morgan

I’m just wondering if you’re seeing any impact on the pharmacy side as far as unemployment trends. Are you seeing people trade down to buying more of the over-the-counter products than picking up a prescription?

Secondly, I know the question was asked around EBITDA but I’m just trying to understand. You only have one quarter left. Do you really think things could get that bad that you could be closer to the lower end of your guidance range for EBITDA? Can you maybe just walk us through how things would have to turn over the next couple of months?

Lastly, I think Frank you had made a comment about reimbursement rates. What are your expectations for AMP as we go forward? Are you still expecting that it’s going to come out in 2009? Do you have any updates out of Washington?

John T. Standley

I’ll start with reimbursement rates. Reimbursement rates continue to be under a little bit of pressure. We’ve seen a few federal upper limit things come by here in the last quarter; probably three of those or so. On the other hand, generic mix is doing very nicely and that combined with some really good jobs by our guys on the purchasing side has made a nice difference for us; held up the pharmacy margin.

We tried to go back and do some looking in pharmacy to see if there was something that indicated to us that people were not refilling prescriptions or doing something different, and looking at our business we don’t see it so far. We looked at refills as a ratio of total fills and that kind of thing, and I can’t see what a lot of people are asking so far. It doesn’t mean it’s not coming but right now I don’t see it in our numbers.

I would tell you that pharmacy sales remain very good although front end sales are soft. In December pharmacy’s actually very strong and it’s very strong both in the core Rite Aid stores and in the Brooks Eckerd stores. So we’re seeing a very nice month right now in pharmacy. I would say the pharmacy business so far seems pretty good.

Lisa Gill - J.P. Morgan

Just to revisit the EBITDA, I just want to try to understand how much worse things would have to get in order to be towards that lower end of the range because you have made such nice progression?

John T. Standley

Let me just make one comment there. We don’t know of anything right now. There’s no bomb or anything; nothing like that. The one issue that we’re staring at is sales and that’s it. Otherwise everything is pretty good and there’s not something hiding here that we know of right now that we’re trying to keep that low end of the guidance or whatever. We’re just watching sales. That’s it.

Frank Vitrano

That’s clearly the driver here obviously on the SG&A side. Those are things that are more in our control and continue to focus on that. But where we are right now on sales is really the variable.

Operator

Our next question comes from Edward Kelly - Credit Suisse.

Edward Kelly - Credit Suisse

Could you talk a little bit about what are the key variables to driving better EBITDA as we look out into next year? How much of it is sales driven versus execution on costs or something else? And then to what extent does your leverage constrain your ability to achieve those opportunities, because if you look out in the next year it seems like you’re going to under-spend probably depreciation? How difficult is it going to be to drive higher EBITDA under that scenario?

John T. Standley

I’m really excited about what we have here to work with in terms of the store base and what we’re looking at.

Next year’s plan is not a capital intensive plan. The things that we need to do to make our business better from a merchandising, a marketing and store level execution; they’re not capital intensive things. They’re a lot about just basic retail operating and we have lots and lots of stuff to work with to make our numbers better without needing a big capital investment or something here. While we are going to under-spend depreciation next year, we see so much opportunity in the base business that does not concern us.

What concerns us is focusing on day-to-day business, improving our execution, making our customer service right, getting our merchandising right; those are the kinds of things that are really going to make a difference for next year.

Sales growth is important next year. We are going to tone down our expectations a little bit for next year from where we were running earlier this year but we still think there’s going to be a little bit of sales growth next year and that clearly will help next year’s plan. We’re also going to be very focused on making this thing more efficient. That’s going to be a big part of next year’s deal.

Mary F. Sammons

Just like we mentioned earlier too that being really realistic on the top line really causes the whole team to stay as focused as they need to be on all the pieces below that whether we’re talking about margin or SG&A expense to really deliver the value on the bottom line. That’s what everyone’s really focused on.

Edward Kelly - Credit Suisse

Could you just talk a little bit about what you’re seeing from a competitive standpoint out there? The front end comp went down 5% is a little hard to interpret given the calendar issue but is any of that from increased promotions from competitors?

John T. Standley

I think it is a little promotional out there but this time of year generally is. I think we’ve seen a lot of other channels get very aggressive. You see department stores and other channels out there really pushing hard to find holiday sales. In terms of our little space I think it’s a little competitive out there to try and get sales and I think people are trying to find it but it’s the nature of the economy we’re in right now. It’s a little bit tougher holiday season than I think we’ve seen in a while.

Edward Kelly - Credit Suisse

Store closing opportunities; John since you’ve been there I don’t know to what extent you’ve taken a look but it seems like maybe there’s been a little bit more store closings this year than we would have expected previously. Is there a bigger opportunity in this area?

John T. Standley

It’s something we are going to continue to look at very carefully as we evaluate store-by-store where we’re going. You have to kind of stir in the liquidity impacts of store closures. You also want to stir in what you think are the benefits of the various initiatives that you’re going to do. Some stores that aren’t working today if we can get some things straightened out may work in the future. We’re kind of trying to stir all those things together to look at it.

I do think there probably will be some additional store closures and it’ll probably come in pieces. I don’t think there’s like one big thing. It’s a series of processes that you work through to figure it out. So you’ll see probably some clumps here and there; closures as we work our way through it.

Edward Kelly - Credit Suisse

Some of the closures that you’ve done so far, have any of those been negative EBITDA closures?

John T. Standley

Yes, absolutely.

Edward Kelly - Credit Suisse

Is there more opportunity like that?

John T. Standley

There is but you have to balance it with the liquidity impact. The way we look at it is on a cash flow basis. We try to get what the incremental cash flow of the store is. So a store might be a negative EBITDA store on the P&L but it’s covering some portion of its rent so we’re not going to close that store unless we can do a better job covering the rents from a surplus perspective. That’s really how we think about it. There are some negative EBITDA stores in our numbers and there probably is in any chain honestly.

Mary F. Sammons

Plus we’ve just gone through a year of tremendous activity and work activity on a lot of stores and on our whole team. So we need to also give the plans that are in place to improve the operational execution in these stores to take hold. We will be judicious as we look at these stores but there will always some that need to be closed.

Operator

Our next question comes from Mark Wiltamuth – Morgan Stanley.

Mark Wiltamuth – Morgan Stanley

I wanted to follow up a little more on the store closure issue. If you look back, I can’t really remember a quarter when there weren’t some major store closures or impairments. When do you think you really start to come to the end of that? I know Ed was kind of focusing on are there more to go, but at some point when do you settle down to the asset base and really get back to operating the stores that you’ve got?

John T. Standley

That’s where we are right now. We’re back to the operating base and operating stores we have. But having said that we’re continuously looking at store performance and I think for a little while we’re still going to continue to have some closure activity. The impairment stuff’s a little bit different that we took in this quarter. That’s really a result of some lower earnings numbers over the last couple quarters. That’s what gets you to that situation. Frank, in terms of impairment there’s still some more to go, right?

Frank G. Vitrano

That’s right. In our guidance we took an impairment on a group of stores in the third quarter and in the fourth quarter we’re going to continue to do an evaluation which will in all likelihood include incremental impairments which is in our guidance range today. It’s really an accounting methodology that we go through in order to make sure that the future cash flow will be significant to cover the assets on the books.

John T. Standley

So as we recover and our cash flow gets better, we would think next year in terms of just a straight impairment with no closure we would hope there would be less of that. I just don’t like boxing myself in on the closure thing because when a store needs to be closed, I want to close it. We’ll continue to work through that over time.

Mark Wiltamuth – Morgan Stanley

Just to look at the Brooks Eckerd base if you could contrast for the stores that are doing well versus those that still have a lot of room to improve, what do you think the big difference between those two groups would be?

John T. Standley

Probably sales trends. Some stores were more impacted through the integration than others so what we have right now is we have a group of BE stores that really had some sales loss as they came through the integration. We’ve put a plan together. We’ve got extra management down in those markets; we’ve got some marketing plans; we’re doing some training; we’ve got our staffing kind of straightened up in those markets; but those are the things that really impacted those stores through the integration. That’s really what’s caused a group of those stores to need some additional work.

Mark Wiltamuth – Morgan Stanley

How are all those stores doing on the Rite Aid systems?

John T. Standley

Much better. I’ve been down to those markets. Frank, Brian, all those sitting here with us; we’ve all been down to those markets and these stores. I’ve got to tell you sitting in those pharmacies and talking to the pharmacists, they feel much better today about where they are versus a year ago as they came through that systems conversion.

Just looking at our numbers, and we get a lot of statistics out of the system about how stores are performing, we can see in our metrics that those stores have gotten just a lot, lot better in customer service. You can see the script fill times and things and it’s much better in those markets than it was a year ago.

Mary F. Sammons

And we’ll be kicking in some additional marketing for certain of these stores in areas too. As again the operational performance has really gotten steady and improved we believe it’s time to do that. Our competitors were pretty active in going after our customers during the conversion activities so we need to really get these customers back into our stores so that they can see the experience is very positive.

Operator

Our next question comes from Robert Willoughby - Banc of America Securities.

Robert Willoughby - Banc of America Securities

I’m just only looking for the pace of new store openings. Is the experience in the current quarter something you think we can carry forward indefinitely in our models or does that pick up meaningfully any time soon?

John T. Standley

Next year we would expect to have about 75 net new stores and relo’s.

Robert Willoughby - Banc of America Securities

To the earlier question, maybe the biggest leverage point to GAAP earnings next year, would it just be a much lower impairment number or we just can’t comment on that as yet?

John T. Standley

We think impairments are going to come down. I don’t think we’re prepared to guide on next year but again as our EBITDA recovers we think that that impairment will settle down. I think another driver is EBITDA for next year in terms of GAAP performance.

Robert Willoughby - Banc of America Securities

But the impairment charge number itself; the improvement on that front would be bigger than a bread box in your view?

John T. Standley

Probably for next year or make our EBITDA numbers. They’re tied together.

Operator

Our next question comes from Mark Wiltamuth – Morgan Stanley.

Mark Wiltamuth – Morgan Stanley

Can you give us a sense for what impact the store closings have had on your same-store sales from either getting rid of negative comp stores or from transferring customers from those stores into a nearby Rite Aid?

Mary F. Sammons

It’s still not going to be a significant impact because if you just look at the number of stores we’ve closed against the total base; it’s just not enough to really increase the comps that much for other stores. You’ll get an individual store that’ll get a comp increase but you’re not going to see something significant across the company.

John T. Standley

Not only that but they’re not exactly the highest volume stores that we’re closing.

Mark Wiltamuth – Morgan Stanley

On the distribution center front have you looked any further into potential consolidation there or give a sense of a timeframe when you may be able to come to a decision on that front?

John T. Standley

We’re looking at the ways to make our distribution network as efficient as we possibly can. There are facilities; there are also satellite facilities and those kinds of things. The driver on this whole thing is to get this inventory down which we’ve made great progress on in the quarter. We’re going to continue to focus on working that inventory down. As we do I think the way it works is we get to get out of those satellite facilities and over time we’ll create an opportunity to look at the distribution network. I think as we come to give you guidance for next year we can give you more clarity on that point.

Mark Wiltamuth – Morgan Stanley

Do you see significant working capital opportunities in the near term? When should we start seeing working capital as a positive generator of cash?

John T. Standley

We’re down significantly in this quarter on inventory; $233 million on a FIFO basis; and I think you’ll continue to see improvement from us in the fourth quarter.

Frank G. Vitrano

In the fourth quarter we’re clearly going to see that as a source.

John T. Standley

Then next year I think we’ll continue to work it down further so we should get some pretty good working capital opportunities.

Mark Wiltamuth – Morgan Stanley

On that same front with respect to your vendors, has anything changed in terms of the number of vendors or the timing of the payments for the vendors? Are you able to take advantage of any discounts for paying vendors sooner, etc.?

Frank G. Vitrano

We continue to have good relationships with the vendors and they continue to be very supportive.

John T. Standley

And we love cash discounts.

Mark Wiltamuth – Morgan Stanley

I think on one of the prior calls the team had indicated that they weren’t paying sooner to take advantage of discounts; they would rather just keep the payment terms the same as they’ve always been.

John T. Standley

[Inaudible] terms, I mean terms have not changed in any significant way.

Frank G. Vitrano

No, they haven’t. We have one or two vendors that wanted to give us some ridiculous discount because they had some cash issues so we obviously did take advantage of that. But really there’s been no change in the overall terms.

Operator

Our next question comes from Bryan Hunt – Wachovia Securities LLC.

Bryan Hunt – Wachovia Securities LLC

I was wondering if you could just talk about maybe regional sales performance in light of some of the economic problems in the Upper Midwest in the automotive economies? And how do you plan on adjusting your inventories and your marketing in light of those economic changes?

John T. Standley

We have great focus right now on private label. I think that’s a great way that we can bring value to today’s consumer. It offers us a great price point in the store at still a very, very good margin. In terms of regional results I don’t think so far we’ve seen anything too crazy in the Midwest per se. I would tell you that as we saw seasonal get soft, we do a lot of seasonal business in the West so we probably saw some impact out there as the seasonal slowed down. But regionally it’s probably fairly consistent I’d say.

Mary F. Sammons

And if you think back a few months ago when we piloted our pharmacy savings card, we launched it in some of the more economically depressed areas first and it had a positive impact so we began to roll that out. I think that’s been a real positive for us across the country. We’re really trying to use things like that to deliver value on the pharmacy side as well as the front end side of the business.

Bryan Hunt – Wachovia Securities LLC

When you look at your payables number Frank, it’s down $230 million year-over-year or four days approximately. Do you feel like that’s a normalized number? Are you tight on payables? Was there just a timing issue at the end of the quarter?

Frank G. Vitrano

Really if you take a look at the timing between the second and the third quarter, actually payables was a use in the second quarter of about $133 million. So it’s really a timing difference of what’s going on between the second and the third quarter.

John T. Standley

Payables kind of bounced just based on the balance sheet cutoff date. It’s a source in the second quarter and the third kind of washes out.

Bryan Hunt – Wachovia Securities LLC

John you sound pretty electric about the opportunities you have in front of you. Is there any way you could throw a couple of the larger ones in a bucket for us so we can maybe better understand the potential financial impact of some of the initiatives that you guys are targeting?

John T. Standley

Sure. I tried to kind of go through that a little bit in my talk and maybe didn’t do a very good job of it. It’s hard to sometimes get through these things on a call versus a face-to-face.

I think we see a real opportunity just in the big perspective of this thing when we look at our sales opportunity, we look at our cost structure.

When we look store-to-store we really have some different groups of stores out there behaving differently; higher volume stores, lower volume stores, urban, suburban, rural, those kinds of things; and when we stand back and look at this thing we see a great opportunity to look at how we’re putting inventory in the stores, how we’re spending markdowns, how we’re using labor and there’s just a lot of stuff to work with here to get at I think driving sales and improving customer service and getting right in costs in this thing.

So understanding the needs of the different kinds of customers and tailoring the way we’re going to market a little bit to meet those different needs is just a really big opportunity for us.

And as it works its way through this whole thing I’m really excited about that and I think it just enables us to get at a lot of things that we have historically not been able to get at, and we haven’t gotten at them because there’s been mergers and this and that things going on. Now that things are kind of settling down we can really focus on day-to-day business. I think we’ve got a great opportunity to tackle some of these things that can really bring some value to us.

It’s probably going to show up in margins in terms of getting our inventory a little bit more efficient and not having the same level of markdowns that we used to to drive our business. I think it shows up in labor because we can provide some better service by having the right inventory in the store and that helps us use our labor more efficiently in the stores.

I think it shows up in distribution centers as we work with this inventory investment and get it down a little bit, as we talked about I think it really makes these warehouses more efficient. We really, really saw that in this last quarter. The difference year-over-year in terms of productivity in our warehouses was very, very significant and that in large part is due to the fact that we’ve done a much better job on inventory this year than we did last year.

Bryan Hunt – Wachovia Securities LLC

When I look at your efforts to drive store performance and maybe rationalize SKUs and pay down debt, is there any focus on maybe segmenting some markets out and selling some stores? You’ve got a few states where you just have a handful of stores like in Colorado, Nevada, and Idaho. It doesn’t seem like you can really leverage any scale in those markets with just a handful of stores. Is that a thought process that’s taken place as well?

John T. Standley

We look at this thing all the time. We’re very open-minded about what opportunities are out there for us. We’re always going to do what makes the most sense for shareholders and all of our stakeholders in terms of maximizing the value of this thing. So we look at stores, we look at markets, we twist and turn this thing every which way. If there’s something that makes sense, we’re going to take a very careful look at it. But right now we don’t have any plans to sell a small clump of stores or anything.

Operator

Our next question comes from [Caru Martinson] - Deutsche Bank Securities.

[Caru Martinson] - Deutsche Bank Securities

In terms of the cap ex, to harp on this one a little bit more, if we look at the integration costs of roughly $129 million so far this year, can we just kind of back that out for next year and start with that as our base or is there something else we should look at?

John T. Standley

We’re done with the integration thing.

[Caru Martinson] - Deutsche Bank Securities

So we can basically back that out for next year and start with zero?

John T. Standley

Yes. There’s no integration stuff next year.

[Caru Martinson] - Deutsche Bank Securities

In terms of the thoughts on sale leasebacks to the environment, currently what you’re seeing and kind of looking forward for 2009, are you seeing material changes on that front?

Mary F. Sammons

We completed the sale leasebacks that we targeted this year but that overall market is really not out there right now. It’s pretty frozen up and we aren’t going to be planning that we’re going to be getting them for next year.

[Caru Martinson] - Deutsche Bank Securities

In terms of the reaction at the Brooks pharmacies to the new marketing programs where you have the density of that, are you seeing a material shift in the sales trends in those versus the ones that let’s say were remodeled at the end of the cycle? What I’m trying to say is the one thing you did first where you have the density of a market, have you seen those guys performing more like a core Rite Aid and the others that you did kind of at the end of say September are playing catch-up to that or are they all moving together?

Mary F. Sammons

I think some of it depends really just on the market itself. Remember all of the systems conversions were completed by the end of May so we’re getting further and further away from that piece of the activity. So really a lot of it is making sure that each market is working operationally and I think John mentioned earlier that the people are very accustomed now to the system and all those KPIs are improving. Really in some markets we probably aren’t as known in as others so there we need to do more marketing to really get customers into the stores.

[Caru Martinson] - Deutsche Bank Securities

To follow up on Brian’s questions about regional results, I was wondering what you were seeing in the markets where you have the auto exposure?

Mary F. Sammons

Thos markets that have the auto exposure were really some of the first ones too that we did launch that pharmacy savings card and it really was related to the fact that it was more depressed. It really had a positive impact on those areas.

John T. Standley

They’re fine. They’re performing like the rest of the chain right now. Who knows what’s coming. If we have 3 million people lose their jobs, it’s actually going to be a little bit of an issue for those stores. But right now when I look at the trends and where they’re at today, their behaving very similar to the rest of the chain.

Operator

Our next question comes from Karen Eldridge - Goldman Sachs.

Karen Eldridge - Goldman Sachs

Just a clarification. Are the Brooks Eckerd pharmacy stores comping positive in December on the pharmacy side?

Mary F. Sammons

They are modestly positive through the first few weeks. Now again that’s a few weeks of the month but that’s definitely an improvement over the prior month’s trend.

Karen Eldridge - Goldman Sachs

John you mentioned you do have three tiers so to speak of stores and some of them at the lower volume. Brooks Eckerd stores particularly, what percentage of the store base would you say are on that cusp of potentially cash flow positive as you alter how you service the store versus outright closing it?

John T. Standley

I think the indirect question is how many negative cash flow stores are there?

Karen Eldridge - Goldman Sachs

Not even negative but as much on lower performing volume that you feel that you could improve as you alter how you service the store.

John T. Standley

Our average store volume just in general is lower than our competitors so while we have a group of very high volume and high performing stores, you can tell from our average that we have a good group of also lower volume stores mixed in. So it’s not a small number of stores.

Karen Eldridge - Goldman Sachs

Last time we had talked you had mentioned that you guys were testing I think it was alternate deliveries to that group to once every one and a half weeks versus once every week. Do you have enough data to get a sense of if that’s a successful worthwhile initiative or not?

John T. Standley

I think it’s one of those things we just talked about the small group of stores and I think it’s something we continue to work with and we’ll see how it develops over time. I don’t think it’s had a significantly negative impact on those stores but we’re not far enough into it yet to really reach a conclusion about it.

Karen Eldridge - Goldman Sachs

For two of your departments, how is GNC doing in this economy? It’s obviously a higher ticket item. Second, photo; is that improving trends? Are you kind of getting to where you need to be in that category?

John T. Standley

We’ve still got work to do on photo. I’d say it’s not where it needs to be. The conversion from Kodak to Fuji really took a bite out of us. We’re still working our way through it. We have a significant amount of the equipment functioning today but we just have some work to do to restore confidence with the consumer that our photo’s where it needs to be. That remains a big opportunity for us.

GNC and vitamins generally have done very well so far so we haven’t seen as of yet a significant drop-off in GNC at this point.

Mary F. Sammons

Some of our strongest categories in fact are those categories.

John T. Standley

Chris, we’ll take one more question.

Operator

Our final question comes from Emily Shanks - Barclays Capital.

Emily Shanks - Barclays Capital

I was hoping that you could just give me a little bit more [inaudible] explanation about the dramatic increases versus your plan around the LIFO charge? I know in your prepared remarks you noted that it had to do with product cost increases. Could you just give us a little bit more detail and how we should think about it going into next year?

Frank G. Vitrano

We track what the increase in cost is over a year-over-year basis both for front end product as well as for RX product. We had forecasted that we were going to see an X percent increase year-over-year. Basically what we’ve seen is that 200 basis point increase in our original estimate. So on front end and RX the product cost increases is running at about 200 basis points higher than what we had anticipated, and as we kind of roll that through our LIFO model that’s basically what generated this charge.

Obviously this is purely driven by cost increases and as I listened to some of the more recent results that came out in terms of where deflation’s going to be that will obviously reverse that. But in inflationary time we’re going to get these product cost increases and it will run through here.

Emily Shanks - Barclays Capital

In terms of the AR securitization can you speak to what the terms are of that backstop; i.e. how’s the pricing determined? Is that a mark-to-market or how does that occur if for some reason you’re unable to roll?

John T. Standley

It’s actually predetermined. It’s a predetermined rate at L + 550.

Mary F. Sammons

Thank you very much everyone. Thanks for your interest and again happy holidays to all of you.

Operator

This concludes today’s conference call. You may now disconnect.

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Source: Rite Aid Corporation F3Q09 (Quarter End 11/29/08) Earnings Call Transcript
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