Rite Aid Corporation F1Q10 (Qtr End 05/30/09) Earnings Call Transcript

Jun.24.09 | About: Rite Aid (RAD)

Rite Aid Corporation (NYSE:RAD)

F1Q10 Earnings Call

June 24, 2009 8:30 am ET

Executives

Chris Hall - Senior Vice President, Strategic Business Development

Mary Sammons - Chairman and CEO

John Standley - President and Chief Operating Officer

Frank Vitrano – Chief Financial Officer and Chief Administrative Officer

Analysts

John Heinbockel - Goldman Sachs

Meredith Adler – Barclays Capital

Lisa Gill – JP Morgan

John Ransom – Raymond James

Mark Wiltamuth – Morgan Stanley

Bryan Hunt – Wachovia

Carla Casella – JP Morgan

Emily Shanks - Barclays Capital

Operator

(Operator Instructions) Welcome everyone to Rite Aid’s First Quarter Fiscal 2010 Conference Call. I will now turn the call over to Mr. Chris Hall.

Chris Hall

We welcome you to our first quarter conference call. On the call with me are Mary Sammons, our Chairman and CEO, John Standley, our President and Chief Operating Officer, and Frank Vitrano, our Chief Financial and Chief Administrative Officer.

On today’s call Mary will give an overview of our first quarter results and Frank will discuss the key financial highlights, John will then provide some more detail on the quarter as well as talk about the progress we are making on some of our initiatives and then we will take questions.

As we mentioned in our release we are providing slides related to the material we will be discussing today on our website at www.RiteAid.com under the investor relations information tab for conference calls. We will not be referring to them directly in our remarks but hope you will find them helpful as they summarize some of the key points made on the call.

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 definition of the non-GAAP financial measure, along with the reconciliations to the related GAAP measurements are described in our press release. I would also encourage you to reference our SEC filings for more detail.

With these remarks I’d now like to turn it over to Mary.

Mary Sammons

As you can see from our first quarter results, we continue to improve our performance and build on the positive momentum we achieved in our business over the last few quarters. Adjusted EBITDA increased and improved as a percent of sales over last year and we significantly narrowed our loss compared to the prior first quarter.

The financial position of our company is a lot stronger today too with a significant increase in liquidity to more than $900 million at the end of the quarter. Thanks to a substantial increase in cash flow from operations we were able to pay back debt on our revolver by more than $300 million. This is the first time we’ve been able to reduce our debt so significantly since the Brooks Eckerd acquisition. Improving our leverage is a top priority for us now and moving forward.

The refinancing of our September 2010 debt maturities that we launched in the first quarter and substantially completed earlier this month also strengthens our financial position. You’ll remember that one of the major concerns about our company was that we wouldn’t be able to refinance this debt before it became due.

We have already replaced a portion of that debt with new facilities that mature in 2015 and 2016 and we have receive commitments for $960 million of a proposed new $1 billion senior secured revolving credit facility due September 2012 which will be used to refinance the remainder of the existing revolving credit facility. We expect to close on the new revolver shortly. Frank will give you more details in just a few minutes.

This refinancing gives us more time to improve our results with the initiatives we have planned as well as those that are in place and have already started to work. We are confident we will also be able to extend the maturities on our accounts receivable refinancing before it matures in September 2010. When that’s done we expect to have no significant debt coming due over the next three years.

We know we have a lot of hard work ahead especially as we continue to face the challenging economic environment but we are optimistic that the improvements we’ve seen in the last three quarters is only the beginning as our team continues to focus on unlocking the value of Rite Aid. Our initiatives to grow sales, improve operating efficiency, and take unnecessary cost out of the business are the right ones to deliver solid returns in the future just as they did in this quarter.

We grew both pharmacy same store sales and prescription counts thanks to our enhanced compliance programs, courtesy refill services, our living more senior loyalty program and our free RX savings card which makes prescriptions more affordable and continues to attract new patients to Rite Aid. Enrollment in the card continues to grow dramatically with 2.6 million unique users today compared to 1.7 million only three months ago. It’s just the start of an exciting pharmacy loyalty initiative we expect to launch later this year.

Front end sales should improve as we benefit from the segmentation and assortment initiatives John will update you on and as the economy begins to recover. All of our merchandise, marketing, and operational initiatives will also help us improve the contribution from the former Brooks Eckerd stores. Although their sales results are still negative, they are already closing the gap on private brand penetration and generic dispensing and script count trends are getting better every month.

We lowered SG&A costs as a percent of sales compared to last year reducing costs in our stores, distribution centers and the corporate office. At the same time we reduced operating costs our customer satisfaction ratings improved. Our associates continue to work hard to make Rite Aid a better place to shop and our ratings coming from the customers we serve show they are succeeding. We kept our shelf stock and didn’t disrupt the shopping experience even as our team once again did an exceptional job at reducing inventory year over year and over the fourth quarter.

I’ll now turn it over to Frank and then come back after John’s remarks to talk a little about one of the hottest topics in our industry and in the country today, healthcare reform.

Frank Vitrano

We made solid progress on a number of fronts during the first quarter. Although opportunities and challenges lie ahead, we are better positioned for long term growth with the refinancing well on its way to completion, two, the improved liquidity as a result of working capital initiatives and reduced capital expenditures, three, continued improvement in lowering our operating costs and four, beginning to implement some of the segmentation work that John will discuss in more detail.

On the call this morning I plan to walk through our first quarter financial results, provide an update on the capital expenditure program, discuss our liquidity position, review our rent reduction program, as well as talk about the credit facility refinancing, finally I will discuss our updated fiscal ’10 guidance reflecting the interest increase due to the anticipated refinancing.

This morning we reported revenues for the quarter of $6.5 billion compared to $6.6 billion for the first quarter last year. The decrease in total sales was primarily driven by a reduction in total store count. In the quarter we closed 86 stores and quarter over quarter we had 179 fewer stores. Same store sales increased 60 basis points reflecting soft front end sales and strengthening pharmacy script growth. Front end same store sales were down 160 basis points and pharmacy sales were up 160 basis points during the quarter.

Pharmacy sales included an approximate 448 basis point negative impact from new generic drugs. Pharmacy script increased 220 basis points. Excluding the acquired Brooks Eckerd stores, same store sales for the 13 weeks first quarter increased 150 basis points over the prior year with front end decreasing 140 basis points and pharmacy growing 310 basis points. At the Brooks Eckerd stores, same store sales decreased 1.3% during the quarter while front end decreased 2%, pharmacy decreased 1% in the quarter.

Adjusted EBITDA came in at $249 million or 3.82% of revenues for the first quarter. This compared to last year’s first quarter of $241.1 million or 3.65% or a 3.4% reduction. The improvement was driven by lower SG&A dollars, partially offset by lower sales and lower FIFO gross margin dollars. SG&A dollars adjusted for non-EBITDA expenses were $39.2 million lower or 30 basis points lower as a percent of sales. This improvement reflects the various cost saving initiatives which John will talk about including store labor management, field controllable expenses, distribution center and indirect procurement savings.

Net loss for the quarter was $98.4 million or $0.11 per diluted share compared to last year’s first quarter net loss of $156.6 million or $0.20 per diluted share. The decrease in net loss was driven by no integration costs in the quarter compared to $44.5 million last year and a gain on sale of assets partially offset by higher store closing charges.

The lease termination charge of $67 million relates to 86 stores which were closed during the quarter. As I mentioned on the last call, we expect to close 117 stores in fiscal ’10. The exact number of store closings will be predicated on the outcome of the rent reduction initiative. The LIFO charge of $14.8 million is consistent with the first quarter of last year.

Interest and securitization expense was $123.9 million which was essentially flat to last year. Lower Libor rates under the credit facility were offset by the increase in securitization expense from the second lien term loan facility renewed in February. Later in my remarks I will outline the interest expense impact on the credit facility refinancing. Non-cash interest primarily debt issuance cost amortization and workers compensation interest accretion was $7.7 million.

Gross margin dollars in the quarter were $34 million lower then last year or 18 basis points. FIFO gross margin percent is also lower by 18 basis points which is consistent with the gross margin trend we saw in the fourth quarter. Two thirds of the decrease in dollars was driven by lower sales with the balance resulting from lower RX reimbursement rates in RX billing margins as well as lower promotional funds on the front end due to lower purchases, partially offset by lower distribution center costs and lower front end and RX shrink.

Product handling and distribution expense as a percent to sales improved due to the operational efficiency improvements and lower fuel costs. John will review the proactive measures implemented by the distribution center team in the quarter to drive these improvements.

Selling, General and Administrative expenses for the quarter were lower by $82.3 million or 92 basis points as a percent to sales as compared to the prior year. SG&A expense not reflected in adjusted EBITDA was lower by $43 million or 62 basis points primarily driven by no integration costs in the quarter as compared to $44 million last year.

Adjusted EBITDA SG&A dollars the details of which are included in the first quarter fiscal ’10 earning supplement information which you can find on our website, excluding the specific items were lower by $39 million or 30 basis points as a percent to sales. This reduction in dollars reflects the aggressive cost saving initiatives that have been implemented over the past several months.

The SG&A improvements were driven by better labor controls and lower field controllable costs including supply costs, partially offset by higher rent costs as a result of the sale lease back transactions that were completed last year. Corporate expenses were also lower due to a reduction in consulting fees.

On the sequential quarter over quarter basis we reduced adjusted EBITDA SG&A from being 92 basis points unfavorable in the second quarter to 20 of last year to 25 basis points unfavorable in the third quarter last year to an eight basis point positive expense leverage in the fourth quarter and now 30 basis points in the first quarter. Overall we are very pleased with the progress made and expect continued improvement in the coming quarters to maintain a positive sales leverage.

As I mentioned in my opening remarks, we made significant improvement in our working capital initiative. Total balance sheet inventory on a FIFO basis was reduced by $139 million over the fourth quarter with $100 million coming from the working capital initiative and the balance a result of store closings. As compared to the first quarter of fiscal ’09 FIFO inventory is lower by $405 million. As you can see the results on the cash flow statement for the quarter net cash provided by operating activities was $357.6 million as compared to a use of cash of $105 million in last year’s first quarter.

Inventory generated cash of $138 million as compared to a use of $51 million last year. Other assets and liabilities was a source of $141 million caused by a reduction in pre-paid rent paid as compared to the year end as well as accrued interest. You will recall that other assets and liability were a use of $177 million in the fourth quarter caused by the timing of the rent checks and interest payments.

Accounts payable was a source of cash at $53 million in the quarter. Our days payable outstanding in the quarter was 24.1 days, this compares to 23 days in the fourth quarter and 24.9 days in the first quarter of last year. The increase from the fourth quarter to the first quarter reflects the historical trends. The inventory reduction initiative has influenced our DPO as both purchases and payables were lower as we didn’t replace all the inventory that was sold.

Our vendor partners continue to be very supportive. Net cash used in investing activities for the quarter was $15.4 million versus $93.8 million last year. This reflects our proactive plan to trim capital expenditures. It also includes proceeds from script files and other asset sales.

During our first quarter we opened 10 new stores, relocated 17 stores and closed 86 stores. Our cash capital expenditures were $44.3 million which includes $1.7 million spent on completing remodels and $1.9 million to acquire script files.

Now let’s discuss liquidity which is an area that we continue to make significant progress. At the end of the first quarter we had $535 million outstanding under our $1.75 billion senior secured facility paying down $303 million of revolver borrowing from the fourth quarter. We had $188 million of outstanding letters of credit and $520 million drawn on our first and second lien accounts receivable securitization facilities.

At the end of the first quarter we had $902 million of availability under our credit facility which was net of $126 million borrowing base deficiency. Yesterday we had availability of $907 million under our facility. Total debt including AR securitization was lower by $349 million from the fourth quarter. The company’s overall debt leverage including the off balance sheet AR securitization decreased from 6.6 times in the fourth quarter to 6.2 times at the end of the first quarter.

Lowering our overall leverage and improving our credit maturity profile is a top priority for the company and as you will hear in a moment, we made good progress over the past several weeks in substantially completing a comprehensive plan to refinance our September ’10 credit facility maturities.

As we discussed on the last earnings call we have had been exploring various strategies to refinance the September ’10 maturities which include a $1.75 billion revolver credit facility, $145 million tranche one term loan and a $570 million AR facility. Late last month we decided to pursue a staggered strategy to refinance the revolver credit facility and tranche term loan to take advantage of a window of opportunity created by the strength of the credit markets and our improved operating performance.

As part of the refinancing strategy on June 5th we received consent from our credit facility lenders to permit the refinancing of $1.895 million in senior lien indebtedness maturing in September ’10 with first lien secured debt. We also received the necessary two thirds vote to give us the option to bring the AR securitization on balance sheet. On June 10th we closed and funded a $525 million net proceeds of which were $504 million, tranche four term loan due June 10, 2015. The term loan was upsized from $400 million due to market demand.

The pricing on the loan is Libor plus 650 with a 300 basis point Libor floor. It had a 96% OID to yield 10.5%. Proceeds were used to pay down the $145 million tranche one term loan, to pay expenses and permanently reduce the revolver by $350 million.

On June 12th we closed and funded a $410 million senior secured lien note due June 10, 2016. The note has a 9.75 coupon with an OID of 98.2 to yield 10 and one eighth. The proceeds for the note were used to pay expenses and permanently reduce the revolver by another $403 million. The combination of these two transactions left approximately $1 billion of availability under the credit facility.

At the present time $188 million of letter of credit are outstanding under the facility. It should be noted that we have a borrowing base deficiency of $126 million at current inventory levels. I expect to periodically have borrowing base deficiencies during the year as we experience seasonal inventory swings as well as continue to reduced inventory from the various working capital initiatives. Obviously every dollar reduction in inventory provides more cash availability for the company then what would be available under the borrowing base calculations.

We launched a retail syndication of the new $1 billion revolver facility which will expire on September 30, 2012. The pricing on the new facility is Libor plus 450 with a 300 basis Libor floor. We have received $960 million of commitments for the facility and expect to wrap it up shortly.

That will conclude the comprehensive refinancing that we have embarked upon. We will look to refinance the first and second lien AR securitization later in 2009 or the beginning of ’10. We have several options to consider, including one, refinance it with a new conduit, although I think this is probably the least likely execution given the receivables conduit market.

Two, we can refinance with a special purpose entity non-recourse off balance sheet as a first loan ABL or term loan. Such a refinancing is permitted under our medi-credit facility. Or three, we can refinance with a combination of first and second lien debt on balance sheet. We are limited to $3.7 billion of first lien debt which would restrict our ability to refinance the entire $570 million of AR with first lien debt. Given the quality of the collateral we are very confident that the AR facility will be refinanced.

At the close of the new credit facility we will have $320 million of incremental first lien capacity. Total secured capacity on a pro-forma basis would be $1.1 billion, however, if you assume full draw on the revolver and full use of the AR securitization and if you assume full drawing on the letters of credit, we actually would not have any incremental secured capacity left.

Now let’s turn to fiscal ’10 guidance. We have updated our guidance to reflect higher interest expense from the refinancing just discussed. Total interest guidance is now expected to increase $55 million over the previous range. The new guidance for interest and securitization costs is $570 to $585 million. This translates into a $0.07 increase in EPS loss to a range of $0.33 to $0.59. The net loss is now expected to be in a range of $265 to $490 million.

We continue to expect total sales to be between $26.3 and $26.7 billion and expect adjusted EBITDA to be between $1.025 and $1.125 billion for fiscal ’10. Same store sales are expected to improve 50 to 250 basis points and capital expenditures are projected to be $250 million. We expect to generate $325 million in free cash flow for the year which is higher then previously disclosed due to higher inventory reduction opportunities and the asset sales completed in the first quarter. As mentioned earlier, the guidance does include a provision to close 117 stores as well as well as the Atlanta, Georgia distribution center.

Finally, I’d like to discuss the landlord rent reduction initiative. We have contracted with a nationwide real estate firm to assist us in working with the landlords of our worst performing stores to seek rent concessions. These are locations under review for possible closure and we are seeking rent concessions from our landlords to improve the overall profitability and viability of the store. We are in the early stages of our discussion and expect to be able to report on our progress on the next earnings call.

That completes my portion of the presentation now I’d like to turn it over to John.

John Standley

In addition to the great progress on the refinancing, the following were also significant accomplishments in the quarter; script count in comparable stores grew 2.2% for the quarter, the RX savings card enrollment has now grown to over 2.6 million members. EBITDA for the quarter increased $8.1 million from the prior year to $249.2 million. SG&A declined 92 basis points to 26.2% of sales compared to 27.1% of sales last year. Thirty basis points of the 92 basis point decline were EBITDA expenses.

Distribution costs were 1.48% of sales, our third consecutive quarter of improvement versus the prior year. FIFO inventory was $405 million lower this year versus last year and $140 million lower then year end. Cash flow from operations for the quarter was $358 million and debt, including the accounts receivable securitization declined $345 million in the quarter versus year end. Total availability increased to $902 million at the end of the first quarter.

As Frank mentioned, total comps for the quarter were off 60 basis points. First quarter front end same store sales decreased 1.6% over the prior year with core Rite Aid decreasing 1.4% and the acquired Brooks Eckerd stores declining 2%. Front end sales were soft in most categories and were impacted by the weak economy and because we didn’t repeat several Brooks Eckerd integration ads we ran last year.

Front end sales may also have been impacted somewhat by the SG&A and working capital initiatives we have implemented over the last three quarters. Front end sales have softened further in June, especially in our seasonal categories.

Script count grew 2.2% in comparable stores and pharmacy same store sales increased 1.6% in the quarter. Core Rite Aid pharmacy sales grew 3.1% and the BE stores declined 1.1% in the quarter. The BE stores continue to show sequential quarter over quarter improvement.

Our significant improvement in script count this quarter resulted primarily from the growth of our RX savings card with over 2.6 million customers enrolled as of the end of the quarter, the benefit from our grass roots marketing initiative which has driven script count growth in our high volume front end, low volume pharmacy stores, our automated refill reminder program and the growth in our courtesy refill program with 2.2 million customers enrolled as of the end of the quarter. Script count growth has remained strong in June.

As Frank mentioned, FIFO gross margin declined 18 basis points in the quarter driven by a reduction in pharmacy margin that was mostly offset by a reduction in distribution expenses and a slight improvement in front end margin. The front end margin increased slightly in the quarter because of solid improvement in shrink and a 1.7% increase in private brand penetration to 14.5% of front end sales this year versus 12.8% of sales last year, partially offset by lower vendor allowances resulting from these purchases.

Pharmacy margin declined in the quarter due to reduction in reimbursement rates that were at levels similar to last year but we were unable to fully offset the impact of these reductions with generic product cost reductions and improvement in generic penetration. Generic penetration did increase 268 basis points to 69.9% in the quarter.

The positive trend in distribution expenses continued in the first quarter, the improvement is due to the initiatives we started last year and continue to roll out this year including more efficient transportation routing, bi-weekly deliveries in 1,245 low volume stores, bi-weekly delivery on certain central pick items across the chain, a reduction in administrative headcount in our distribution facilities, lower fuel costs, and lower product handling costs resulting from a significant reduction in inventory. Also, Bohemia, Long Island facility was closed in the quarter and the Atlanta facility will close in September.

Our significant improvement in SG&A was largely driven by our continued improvement in managing our store labor expense. Reductions in store expenses including supplies and security costs, lower consulting and other professional fees and lower corporate administrative expenses. Similar to last quarter, the labor improvement came from adherence to our labor standards and use of our labor scheduling tool in both the front end and the pharmacy.

FIFO inventory was $405 million lower this year versus last year and $140 million lower then year end. Since we stated the inventory reduction initiative last year, we’ve reduced our sku count by 3,300 skus or a little more than 10%. We are also focusing on lower back room inventory, reducing in store safety stock in certain stores and categories, and displaying smaller amount of promotional inventory in lower volume stores. In addition to helping us reduce our store and distribution labor, our lower inventory investment contributed to the improvement in our liquidity in the quarter.

I remain very excited about the opportunities we identified on the fourth quarter call to grow profitable sales in both front end and pharmacy, reduce our costs, increase our cash flow, and improve our capital structure. I’m very pleased with the progress we made this quarter on implementing these initiatives. As we discussed on the fourth quarter call, our operating initiatives include savings that are based on the segmentation of our diverse store base, as well as initiatives that impact all stores that may include some component of segmentation.

Some of the significant accomplishments in the first quarter on these initiatives are as follows; we completed the rollout of our new field supervision structure which is designed to meet the different levels of supervision required for different types of stores and included a realignment of all levels of field supervision above store manager.

We implemented a new management structure in 1,750 low volume stores. We eliminated the salary assistant store manager position and added an hourly shift supervisor position. We also changed the store manager position to an hourly position from a salary position. These changes will give us significantly more flexibility with labor scheduling which will allow us to better match our labor spend with the workload in these stores.

We also increased the number of low volume stores, as I mentioned earlier, on the bi-weekly delivery to 1,245 stores from 440 at year end. We completed the rollout of our new metro store operating model including changes to store labor, ad format and merchandising in one metro market and expect that we will roll this out to more metro markets once we are comfortable with the results.

We finished developing new labor standards for certain operational tasks at our high volume stores and we are rolling these out right now. We are also building some additional analytical tools to help us identify and implement our best ball initiative in our higher volume stores.

As I mentioned a moment ago, we have made significant progress with sku optimization with a 10% sku reduction since the project started. We completed the test of our new pricing application in one metro market and we are almost done rolling it out to the remaining metro markets. We have also started to roll it out in our suburban stores and we should be mostly done with the entire rollout by the end of this quarter or early next quarter.

Promotional forecasting is moving forward with systems development underway and portions moving into test mode in the next couple of weeks. Our RX loyalty program is taking shape and we should be in test middle to late next quarter. We launched our new ad format this week and we will have some additional improvements over the next few weeks as we work the kinks out.

The grass roots pharmacy marketing initiative seems to be working and we are seeing good response in the stores we identified as the biggest opportunity because of high front end sales and low pharmacy sales. These operating initiatives are gaining traction and are helping our results as evidenced by our strong script count growth, SG&A and working capital performance in this quarter. Overall I am pleased with the results for the quarter and the progress we made improving our financial condition.

While we are facing some headwinds, the benefits from the initiatives combined with other actions we are taking should help us overcome these issues.

I will how turn the call back to Mary for some closing comments.

Mary Sammons

A little bit about healthcare. While healthcare reform appears to be getting closer, it’s easy to understand why it may take longer to get final draft of the healthcare reform bills later than originally promised. The Senate proposal is more than 600 pages and the House’s versus more than 800 pages. Nobody is sure right now of a vote on the final bill will make it to the President’s desk by the October deadline.

We, along with others in our industry, have lobbied for the important role community pharmacy can play in providing accessible and affordable healthcare for some time. We agree that providing coverage for the uninsured and helping seniors in the donut hole would benefit patients and our business. We have made it very clear in our discussions with members of congress that pharmacy needs a fair reimbursement for the prescriptions it dispenses, especially Medicaid prescriptions. We know we have a number of legislators in both parties who support community pharmacy and understand our concerns.

We also focused on expanding the pharmacist’s role in fee for service medication therapy management or MTM which can improve the quality of care and reduce long term healthcare costs, both goals of healthcare reform. We know that face to face counseling by pharmacists can improve compliance. In fact, we have 660 pharmacists already trained in MTM working in state funded programs for conditions like diabetes and heart disease. Those programs have demonstrated that medication therapy management by the neighborhood pharmacist can save costs.

Since the proposals continue to change, the proposals on reform, it’s hard to pin down specifics this early. Even though we don’t know the details we do expect the legislation will impact Rite Aid as a provider of one of the most accessible and affordable forms of healthcare as I mentioned earlier, the community pharmacy.

Let’s move on now to the question time period.

Question-and-Answer Session

Operator

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

John Heinbockel - Goldman Sachs

Can you give us a little bit of a generic time table for the three big buckets of EBITDA, potential improvement and how those will play out because obviously they’re going to have different time tables in terms of how quickly they come in or how slowly? What’s the time table for each and what’s going to be the most impactful in 2009 do you think?

John Standley

We’re the furthest along on the low volume store, we have the largest number of initiatives cooking in that bucket. You can tell by the things that we’ve getting done here that that’s going to be probably the most impactful to this year. We’re making some progress on the high volume stores particularly on the labor side with the labor standards and things that we got done here in this quarter but I think that one is probably going to take the longest to get done. It’s actually a little more complex in that the things that you want to address can vary from store to store and so that one is going to take a little bit longer to execute. I think the low volume store one will certainly be the most impactful.

On the sales growth initiatives between the front end and the pharmacy, the pharmacy one is moving the quickest. We’ve made the most progress there and as I mentioned in my comments, we’ve seen a good response in the high volume front end store, low volume pharmacy stores, those stores pharmacies are growing stronger then the rest of the chain at the moment. I think we’ve got good traction there.

Conversely on the lower volume front end store and the higher volume pharmacy stores, we’re still working our way through that. The RX loyalty program I think will help us address that but that’s coming a little bit later in the year so we’ll probably get a little bit less benefit from that bucket this year. I think that’s kind of how it plays out.

John Heinbockel - Goldman Sachs

If you look at the pharmacy has held up incredibly well despite rising unemployment and in fact lately much, much higher generic hit so you’re taking share, it looks like you’re taking share, where do you think that’s coming from is that all independent or supermarkets or where do you think its coming from?

John Standley

It’s probably coming from a little bit of everybody. I’m certain that independents are feeling the same pressures we are on the margin side, that’s probably a little bit as well. I think also we’re much more competitive today in the cash part of the business so I think that’s where we’re probably gaining some share from folks who had probably higher mix of cash business we’re getting some of that business today.

John Heinbockel - Goldman Sachs

Front end can be negative as long as pharmacy is progressing, what is the level at which front end being negative becomes an issue.

John Standley

I don’t know if I have an exact number for you. I think I mentioned June is a little bit softer and probably where it is we don’t want to be much more than that. I think we’re kind of at those levels.

Mary Sammons

Its another reason why keeping balance and watching the margin on the front end becomes important too pushing private brand, the value items because the customer is being a little tougher on what they buy there. I think the things that we’re doing there show value and as economy improves and John’s initiatives are around segmentation and assortments kick in I think you’ll see improvement there.

John Standley

The other thing too, on the front end, similar to what we saw on the holidays, summer is a seasonal time for us, we saw a lot of summer seasonal and those categories have been soft in June. I think weather has been a part of that but just in general they’re soft.

John Heinbockel - Goldman Sachs

The rent reduction initiative, roughly how many stores are you talking about?

Frank Vitrano

It’s just under 500 stores is what we’re looking at right now.

John Heinbockel - Goldman Sachs

It’s not a case with those 500 we need to get reductions or we’ll close them. Maybe some of them are like that but are all of them like that?

Frank Vitrano

All of them are not like that. Clearly those are ones that are not entirely profitable for us and the ones that are on the list for us to consider to potentially close. We’re not talking about closing 500 stores but these are stores that if we don’t see a change in the overall profitability there future viability becomes questionable.

Operator

Your next question comes from Meredith Adler – Barclays Capital

Meredith Adler – Barclays Capital

I’d like to talk a little bit about, a number of sort of random issues; you mentioned that because your purchases were lower you got lower vendor allowances. Vendors remain supportive in terms of credit terms, do you think that concerns about liquidity would have had an impact on vendor allowances and now that you’ve done the bank facility you might get more support from vendors.

John Standley

We certainly dwelled on that quite a bit. As we look at our allowance funds as it relates to purchases that appears to be okay as a percentage. It really seems to be tied to the fact that we’ve ramped inventory down. As purchasing returns to normal levels which it will as we get to the bottom here, then we’d expect those monies to stay steady as a percent of purchases and we’d be back to more normal levels.

Mary Sammons

A lot of the arrangements like that with suppliers you have different tiers based on what you purchase. Obviously our inventory reduction initiative is going to cause some fall off from that but in the end we’ll still have better kind of inventory to be working with and a better program. Our overall profitability should improve.

Meredith Adler – Barclays Capital

If you do a sku reduction program does it allow you to buy more volume from fewer vendors and does that help their support as well?

John Standley

I think ultimately does. The thing about this kind of a program is I think it gets us focused on buying successful inventory. Sometimes you can buy inventory, you get an allowance, and you think you’re doing great then it doesn’t sell, you mark it down, you send it backwards, you salvage it and really by the time you add up all the labor and distribution costs and every other thing that happens you’re really kind of sorry you did that.

The lesson for us is there were some dead wood in here, we’re clearing it out, there’s obviously a little pain to do that but we’re getting it done. As we go forward I think we’re much more cognizant, Ken’s working on a bunch of analytical tools and processes to help us be smart about what inventory we put in these stores going forward.

Meredith Adler – Barclays Capital

There was some mention about both labor scheduling and labor standards at the stores. Remind us, did you roll out a new labor scheduling system and did you always have some labor standards that were not being adhered to or is that a new effort.

John Standley

Its both. We did have labor standards and a labor scheduling tool. We have upgraded those tools for the store teams to use and actually probably should have said we’ve gotten that rolled out in this quarter. We have that. Just in general I think like anything it’s a matter of focus and attention to it. You have these tools and if people don’t use them you’re generally not going to hit your labor numbers. Brian, in the store operations team have done a really great job of embracing these tools, measuring adherence and compliance with those tools.

Its not so much even just about getting labor out, its about having labor in the stores when you want it there to meet the needs of your customers, that’s really the most important things. I think it’s been a real benefit to us to use these tools and get focused on them.

Mary Sammons

The other thing I’d add too is changing the operating model for the low volume stores, changing frequency of delivery, changing the promotional inventory, has changed the work needs too. There’s a whole different operating model for those stores and I think that makes a huge difference. It’s not something that goes away either over time.

John Standley

That’s been a big effort and its going to be an important contributor to the rest of the year is that new operating model in the low volume stores.

Meredith Adler – Barclays Capital

The receivables financing let’s say that it does go back on balance sheet, what would that mean for revolver availability? I think your collateral would go up so what would you say that you would have as total borrowing capacity and what would be peak borrowing under the revolver?

Frank Vitrano

The game plan here would be basically keep same level of overall availability that we have today. If we were to bring it on books it would have to be some combination of first lien and second lien. Right now based upon the first lien restriction we would be able to take on about $320 million of the total $570 million as first lien and then the second piece of that would have to be a second lien facility.

John Standley

It’s important to understand that how the banks have to treat this doesn’t dictate our accounting. We can leave it structured off balance sheet and still do a number of different things with it.

Meredith Adler – Barclays Capital

You did a small file buy by about two million worth of file buys in the quarter. Cash flow seems to be good, you’re selling some assets, is there any plan to increase the number of file buys? The returns are so high on those.

John Standley

The rumor is Frank is going to give me another nickel.

Frank Vitrano

It’s something we talk about pretty regularly internally. We’re still planning on spending about $250 million overall CapEx. We will actually be opening less new stores this year then what we had originally forecast, probably 10 or 12 less new stores. Our total capital expenditures for new stores will go down about $10 million. Right now we’re planning on allocating those dollars to remodels but it’s an ongoing discussion internally.

Meredith Adler – Barclays Capital

In September AMP is supposed to be coming back to life. I think most smart people understand that it’s counterproductive for the Medicaid program to put AMP in place but any sense of how that gets handled. Does Congress actually have to put a new bill in place to make AMP go away?

Mary Sammons

I think the industry believes that you do need a legislative solution to really make the definition correct. There are varying kinds of languages floating around right now and the different bills about how that will shake out. I think again, until we see a little more clarity around it, it was one of the points that we pressed pretty hard when we were in Washington DC last week while bills were in market to really make sure that our view on AMP was clearly understood and what needed to happen there. I think we got good understanding of what pharmacy needs and I think you’ll see some changes there.

Operator

Your next question comes from Lisa Gill – JP Morgan

Lisa Gill – JP Morgan

Some of your other competitors have talked about pressure with Medicaid. Can you talk about any kind of pressure that you’re seeing in the Medicaid market? Secondly just going back to RX growth, can you talk about some of the drivers; is this that the comps are getting easier as well? As Zyrtec has now run through comps over the last year is that part of it.

Thirdly, when you think about your membership program is that primarily the seniors that are falling into the donut hole so if this new Pharma plan does go into effect what are your expectations around what will happen with some of those members that are currently falling into the donut hole?

John Standley

In terms of what’s going on with Medicaid, I think there are probably four quick things I could touch on. One is we’ve got an ongoing situation, Delaware, that we’re working our way through. We’ve seen some action in both Washington and California. We’ve had some successful litigation in both instances that helped us stave off some changes to reimbursement rate there. There have been a number of Federal upper limit changes that have come through, there was a little bit of a backlog and I think they kind of caught up. We’ve seen a number of those come through over the last few months. That’s pretty much the big things that are flying around in Medicaid over the last several weeks I think.

Mary Sammons

States are under a lot of budget pressure and we’ve been dealing with Medicaid issues any number of years now and that’s why I think the whole issue of healthcare reform becomes so important is to be able to help address some of these issues too.

Lisa Gill – JP Morgan

Do you think that this could have an impact on margins? If you look at Medicaid, if I understand correctly Medicaid is 10% or 11% of your total pharmacy sales. If you have a couple of states who are moving in this direction is the anticipation that other states are also looking to cut Medicaid. I think that one of your competitors has been pretty vocal about trying to step out of some of those programs because of the reimbursement cuts. Are you doing the same or is it you’re just taking the cut and hoping to work with the states?

Mary Sammons

When Medicaid cuts come about we really watch what happens with individual stores because the percentage of Medicaid scripts could vary widely from store to store in a given state or market area. We’ve taken action in the past relative to stores that have a real issue there. When you serve a lot of Medicaid patients they take a lot more time to serve too because they’re generally patients that have more healthcare issues and what not. The whole reimbursement there becomes part of making it profitable to serve those patients or not serve them.

Medicaid reimbursement is an issue and part of the pharmacy reimbursement issues that John mentioned in his remarks too and Frank.

Lisa Gill – JP Morgan

The other questions were just around, as referring to anniversary things like Zyrtec, is that helping the comp? Secondly if you want to just talk about your RX program right now is that primarily seniors that are falling into the donut hole and thoughts around the new Pharma program that’s been proposed.

Mary Sammons

We look at script count probably even more than sales for pharmacy because if you sell more generics it can negatively impact the sales number and our script count has been good. Initially when Zyrtec left the pharmacy area it would have impacted your comp comparison but you have cycled that in terms of sales. Again you’ve got to look at scripts. I

If we look at our script growth we actually have picked up script growth in lots of different age groupings, because we look at it by demographics and we’ve always had a strong senior business. What we’ve seen I think with the new initiatives that John has in place that we are seeing more growth in a lot of the different segments and I think that’s very healthy for our business. Still growth in the senior segment but growth coming out of the other segments too.

John Standley

When OTC took scripts out we don’t get them back so it doesn’t make the comps any easier for sure. I don’t think that’s the case. I think we have gained a lot of traction from a number of places. One thing is the BE stores are getting steadily better, that’s helped. I think that’s happened because we made a lot of progress from a customer service perspective in those stores. Staffing is good; a lot of training has been done. I’ve been in a number of those stores, I feel good about how we’re working with our customers in those stores. I expect that those are going to continue to get better so that’s a piece of it.

Then I think we’ve gotten a lot of traction with a number of these different things that we’re going, the grass roots marketing imitative, the RX savings cards has clearly been a win from a script growth perspective. We’ve got the courtesy refill program cooking here so I think there are a number of different things that are helping us drive the script count today. We’re focused on it as we think it’s really important. We’re going to keep pounding on it and I feel pretty good about where we are in June with it as well.

Lisa Gill – JP Morgan

Any thoughts on the donut hole and Pharma planning to fill that, does that help you?

John Standley

I think it does.

Mary Sammons

Anything that makes it more affordable for patients helps us in terms of if we’re doing a good job out there in serving customers in pharmacy and have good programs overall then we should get our fair share of those patients that maybe are not taking their medicines when they get into that donut hole.

John Standley

Maybe it’ll take some pressure off of reimbursement rates ultimately.

Operator

Your next question comes from John Ransom – Raymond James

John Ransom – Raymond James

Can you talk a little bit about the generic margins? You made some commentary about it but I wasn’t sure that I quite understood what you were saying. Specifically is this a temporary issue or is this just a permanent change in the landscape with regard to the margins for generics.

John Standley

Here’s what our situation is. Every year there’s pressure on reimbursement rates both from Medicaid managed care and what not. We’ve seen that pressure this year just like we have quite frankly in every year before this that I’ve been involved with this thing. The level of pressure I don’t think is dramatically worse, it’s probably a little worse then Medicaid, managed care is pretty steady. We probably did also have some margin impact from the RX savings card because we probably converted some cash customers to that offer.

All those things combined put some pressure on reimbursement rates but it happens every year. What we normally are able to do each year is we get enough increase in generic penetration, as generics are more profitable then brand drugs from new generics as well as savings on the cost side on the purchasing side of generics.

What’s a little bit different right now is we’ve been a little bit slower versus last year in terms of getting those purchasing savings. We made some good progress towards the end of the quarter but during the quarter they weren’t in place. We continue to see pharmacy margin pressure in the second quarter. Is it permanent? I don’t know but I think we’re going to continue to see some pressure as we work our way across the year.

We’re working very hard to find some additional purchasing savings if we can to work with growing script count because the more scripts we grow that’ll offset some of the shortfall in rate. We’re looking at a couple of other things as well to try and offset some of what we lost in reimbursement rates here this year.

John Ransom – Raymond James

Are you having to source more from the Tevas of the world and less from say India because of the FDA crackdown? Has there been a firming of the acquisition price on your end or is it different then that.

John Standley

I don’t know if it’s necessarily, the crackdown from the FDA has impacted supply of certain drugs. There are some more difficult to manufacture, generics have become single source, maybe two sources. That has definitely been an impact. There was one big one that was significant there. In general there’s been some consolidation of generic manufacture market as well so that’s had a little bit of an impact. I would say that generic manufacturers have a little bit more pricing power today then they did a year ago. That’s certainly a part of the equation I think in terms of how we look at it.

Mary Sammons

Our buying of generics is really through people like Teva. We don’t go direct to India ourselves. I think there are a lot of safety issues still at work there and we believe that the relationships we have with people like Teva are important for safety concerns for our patients.

John Standley

It’s not an India sourcing issue it’s actually a US sourcing issue. A manufacturer had a plant that was unable to continue to manufacture generics. Those are the kinds of instances that we see out there.

John Ransom – Raymond James

Let’s say at times zero pro-forma for the acquisition you’re running at a $950 million to $1 billion EBITDA number and you’ve mentioned $500 million in opportunity over let’s say three to four years. I know that’s a gross number, that’s not necessarily a net number. In terms of the net EBITDA that you expect to get over the next three years, how much of that is realizable this year versus how much is realizable next year and the next year. I know you’re not giving specific guidance but we’re just trying to think about the timing of when you layer these things in and a little more granularity.

John Standley

I think indirectly you’re asking me for long term guidance something I try not to do. I think what we’ve said is we have about $100 million that we’re shooting for in EBTIDA improvement this year. I don’t think it’s wildly different then that probably the following couple years something in that range is probably a reasonable guess.

John Ransom – Raymond James

Net $100 million for the next couple years.

John Standley

I think that’s probably. I’m not going to go any further.

John Ransom – Raymond James

Being an SEC grad I like simple answers like that. I can actually understand those answers.

My third question is what are you spending now on lease expense for stores that are not operating and what would that number be once you get through your 118 stores that you’re thinking about closing for this year. How much dead rent expense do you have right now?

Frank Vitrano

Right now it’s just under $100 million will be the dead rent expense.

John Ransom – Raymond James

Do you have a goal for this program that you mentioned today, engaging with the real estate firm; is there a goal that you have there that you can talk about?

Frank Vitrano

We do have an internal goal but at this point we’re not prepared to talk a little bit more about it only because we’re really in the beginning stages of having discussions with the landlord. We will certainly give you guys an update next quarter.

John Ransom – Raymond James

On the interest expense line I know you talked about for the year, but what is the annualized interest expense number once you get all of your refinancing done. How much of that is non-cash interest expense?

Frank Vitrano

On a pro-forma basis cash interest the increase will be about $70 million in cash and total interest including the non-cash piece will be around $84 million. Obviously the delta there is really driven by the OID amortization on the new debt that we put on.

John Ransom – Raymond James

Netting for the accounting change, what kind of interest expense number does that look like, let’s say by the August quarter when you’re on a full run rate or maybe even the November quarter what’s a run rate interest expense?

Frank Vitrano

It’s within the range of guidance that we gave. The range for the year is $570 to $585 million.

John Ransom – Raymond James

You had about a quarter of lower interest expense in that number so if we were to net, so take three quarters of the higher net against the lower.

Frank Vitrano

That’s probably good math.

Operator

Your next question comes from Mark Wiltamuth – Morgan Stanley

Mark Wiltamuth – Morgan Stanley

I know a lot of us have been focused on the Brooks Eckerd comp trends but clearly there are some operating environment pressures also on those. Could you talk to how the profitability has changed for those stores since you acquired them? I know your private label has improved there and you’ve made some other changes. Have the margins gotten better?

John Standley

The margins were significantly impacted by sales declines. Whenever we profitably did in terms of private label, there was advertising savings and those kinds of things that were specifically related to those store P&Ls. Then you had the sales pressures. In the big picture though when you sort of look at it, there was a significant savings in terms of purchasing of generics and that honestly went across all store P&Ls so it didn’t go directly to the BE stores. When you look at it from probably where we started the BE stores are probably a little soft versus what we bought in totaling it.

Mary Sammons

We have also seen improvement in generic penetration which helps the overall margin. We’ve seen reduction in shrink from what their prior trends have been so their moving in the right direction.

John Standley

To Mary’s point, a bunch of stuff we’re doing like the low volume stores and other things we think are really going to move these things along from a profitability perspective.

Mark Wiltamuth – Morgan Stanley

Any guess on when you think the comp will solidly turn positive on those Brooks Eckerd?

John Standley

The front end is pretty close to what’s happening in our core Rite Aid stores, its following fairly closely with that so whatever we do in total is probably where the front end is going to be. On the pharmacy it’s making nice steady improvement. I thought we were kind of there then it softened up a little bit so I’m hesitant to say we’re there. I think we’re getting very close to the cross over here in the BE pharmacies and I think if our script count holds up a few more months the way we’re running right now I think we’re going to be right on top of it.

Mark Wiltamuth – Morgan Stanley

I know you really had to squeeze the debt down to get into this refinancing and congratulation on the refinancing. Do you think we’re going to probably not see much in the way of debt reduction in the next five years because you’re cleared off all the maturities or is there an opportunity for some debt reduction over that window?

Frank Vitrano

I do think there’s an opportunity as we continue to improve our overall operating performance here. I clearly think there are opportunities for us to be able to further pay down debt. Obviously that’ll be somewhat offset by increases in capital expenditures from our current levels. There’s a number of initiatives that we have in place here in order for us to free up cash, there’s still some more opportunity for us on the inventory side, certainly on the rent reduction initiative. There are a couple more places where we can dig around here to get some cash out of here to pay down some debt further.

Mark Wiltamuth – Morgan Stanley

Those are opportunities but is that really part of the formal plan right now?

Frank Vitrano

Those are things that we’re clearly working on. It might be an internal plan but those are things that we’re clearly working on.

Operator

Your next question comes from Bryan Hunt – Wachovia

Bryan Hunt – Wachovia

Could you talk about how much further you think you could take inventory down and do you believe the cuts are having any impact on the same store sales trend especially in June?

Frank Vitrano

Right now as we look at it we thought there was a total of about a $240 million opportunity for the year. We probably got $100 million of that in the first quarter. As we look it again there’s probably another $40 million above that. In total, we’re probably looking at $280 million inventory opportunity for us.

Bryan Hunt – Wachovia

Is that mostly tied to the lower volume store initiative or how are you carving up that opportunity?

John Standley

Its in much different places, the biggest single thing has been sku reduction so far. There clearly are some changes we made in the lower volume stores and we are working on some things in some test stores to monkey with the inventory assortment to see what further there might be there. There’s also been some work on safety stock on certain items. Backroom inventory has been a big focus for us so there are a number of different areas that we’re going to, to get at this inventory.

Frank Vitrano

The other thing is even out inventory between stores. Looking at pharmacy inventory between stores making sure that we have the right amount of inventory in each store.

John Standley

That one there is a big opportunity that we’ve been kind of working on because you can get a drug in the store you have a patient for and for whatever reason that script goes away you can have excess inventory that’s not getting utilized. We have a nearby store that may be filling those kinds of scripts. There’s a real opportunity to efficiently manage pharmacy inventory between stores and we think that’s a good opportunity as well.

Frank Vitrano

In terms of does it have some impact on sales; I think it certainly does nibble on it. As we continue to look at ways for us to be able to reduce the inventory sometimes we go a little too far. There’s one particular category in the cosmetics area, for example, where we adjusted, we really went too far, recognized that there was some holes that came out and we increased inventory by about $7 million. It’s a little bit of a trial and error here. It probably has some impact but the long term benefit is clearly a net positive.

Bryan Hunt – Wachovia

If you can give us a little bit more color on that example, how fast were you able to realize you were short on cosmetics and go back and adjust your inventory? Was it a month, six weeks?

John Standley

Like a month, month and a half to straighten the whole thing out.

Bryan Hunt – Wachovia

When you recently rolled out your pricing initiative in a major market, when you look at that pricing tool did it have a gross impact higher or lower on pricing or could you just talk about what the pricing philosophy is behind that tool.

John Standley

There are a number of philosophies behind it but in that particular instance we probably were slightly margin ahead. Ultimately though besides successfully managing gross margin we think there’s a real opportunity to improving our price image as part of this application as well because we are much more focus, rather than applying some margin rates to a whole bunch of items we’re really focused on how the consumer first sees pricing and what’s important to the consumer in getting those prices right. It’s a combination of price perception and balancing our margin equation.

Bryan Hunt – Wachovia

Have you had that tool in place long enough to see any acceleration or deceleration in sales or is it just too early in the process?

John Standley

I don’t think it’s had any impact one way or the other in the particular market that we tested it in. I think it could potentially help sales in other markets where we use it.

Operator

Your next question comes from Carla Casella – JP Morgan

Carla Casella – JP Morgan

The AR facility, how much of the outstanding balance is first versus second lien? Remind us when that second lien portion is callable.

Frank Vitrano

The second lien is callable in August of this year and the second lien component was $225 million.

Carla Casella – JP Morgan

The dark store rent question that came up before, the $100 million dark store rent what’s the average age on those leases and should that actually go up this year as you close more stores or should we start to see that number tick down, the dark store rent?

Frank Vitrano

The dark store rent based upon the closures that we currently have planned is actually going to start to decrease. Right now it’s just under $100 million and should decrease probably around $7, $8, or $9 million per year.

John Standley

The rent last year was about $85 million, it’ll grow to $100 million this year as we close stores then it has about a 10 year bleed off.

Carla Casella – JP Morgan

When you look at the high volume versus low volume stores that was a big number of the increase in the low volume stores. What are the average leases on those low volume stores and if you could close a low volume store tomorrow would you do it? Are these all just underperformers or some of them just a different business model?

John Standley

I think it’s a different business model. We think there’s a lot of opportunity in these lower volume stores to make some good cash flow and make some good money here. Changes in the operating model, some things that we’re doing to help the sales a little bit, merchandising opportunities, we think there are some things to do here in these stores. Yes, it’s not our intention to close these lower volume stores we just think they should run with a different model.

I think we talked about before the pharmacies in a lot of these stores are actually very; very profitable where we are a little sideways is with the front end. It’s really getting that front end to work in combination with that pharmacy that’ll make these really good stores.

Carla Casella – JP Morgan

You mentioned in the same store sales comments that you are anniversarying some promotional activity of the Brooks Eckerd stores. As we look into June and the summer months, last year you were nearing the end of the integration, do we have some more tough comparisons to big promotions from last year.

John Standley

I think June has another tough comparison then it settles down after that.

Mary Sammons

We cycle when we will have run those ads.

Operator

Your last question comes from Emily Shanks - Barclays Capital

Emily Shanks - Barclays Capital

I was hoping you could give me what the full drawn amount on the revolver was at the end of the first quarter please?

Frank Vitrano

$535 million.

Emily Shanks - Barclays Capital

The $126 million of deficiency related to the borrowing base, that is specific to the, versus the $1.75 billion existing revolver correct?

Frank Vitrano

That’s correct.

Emily Shanks - Barclays Capital

Around the existing commitment for the new revolver do you plan to go up to the $1 billion or does it sound like its going to shake out at $960 million?

Frank Vitrano

We’re kind of at the end of the line here in terms of; we’re still talking to a couple of more potential lenders. We went to the retail syndication portion of this which just takes a little bit longer but we’re making some pretty good progress here in wrapping this thing up and would expect to do that in the not too distant future.

Emily Shanks - Barclays Capital

It could be like a 2Q, in the next month or two?

Frank Vitrano

Yes, definitely.

Mary Sammons

Thank you very much everyone.

Operator

Thank you for participating in today’s conference. You may now disconnect.

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