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Executives

Mary Sammons - Chairman & Chief Executive Officer

John Standley - President & Chief Operating Officer

Frank Vitrano - Chief Financial Officer & Chief Administrative Officer

Chris Hall - Investor Relations

Analysts

John Heinbockel - Goldman Sachs

Ed Kelly - Credit Suisse

Bryan Hunt - Wells Fargo Securities

Emily Shanks - Barclays Capital

Karu Martesen - Deutsche Bank

Mary Gilbert - Imperial Capital

[Michael Schabacker - Long Baker]

[Colleen Burns] - Oppenheimer & Co.

Rite Aid Corporation (RAD) F3Q10 Earnings Call December 17, 2009 8:30 AM ET

Operator

Good morning. My name is Crystal and I’ll be your conference operator today. At this time, I’d like to welcome everyone to Rite Aid’s third quarter fiscal 2010 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’ll now turn the conference over to Mr. Chris Hall; please go ahead sir.

Chris Hall

Thank you, Crystal and good morning everyone. 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; and Frank Vitrano, our Chief Financial and Chief Administrative Officer.

On today’s call, Mary will give an overview of our third quarter results, Frank will discuss the key financial highlights in fiscal 2010 outlook. John will discuss our business 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, 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’ll 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 results to differ. Also we will be using a non-GAAP financial measure.

The definitions of the non-GAAP financial measure along with the reconciliations to related GAAP measures are described in our press release. I’d also like to 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

Thanks, Chris and good morning everyone. Thanks for joining us and happy holidays. As you can see from our release this morning, we continue to make progress on many of our key initiatives. We are in a much stronger financial position today than a year ago with more than 900 million of liquidity at quarter end and the refinancing of all of our September 2010 debt maturities completed in October.

With strong liquidity and no major debt coming during into late 2012, we cannot only weather the current economic storm, but improve our results long term with the growth and profit strategies we have identified. As for the quarter, net loss decreased significantly and we delivered adjusted EBITDA similar to last years number even with lower front-end sales and continued pressure on pharmacy margins.

Our team did a great job combating those headwinds by operating more efficiently and even though we held tight on expenses, customer satisfaction ratings in both the pharmacy and front-end were substantially higher than last years third quarter. As our store associates made good use of scheduling and replenishment tools as well as increased personal service.

Our renewed focus on making Rite Aid a better place to work, and as a result a better place to shop is having a positive impact. The economy, the 10% unemployment rate and the increasingly competitive environment continue to hurt front-end sales, as customers search for bargains and cut back on discretionary items. This shift in behavior affected all of the major events in the quarter, including the finish to back-to-school, Halloween and Black Friday.

Customers are likely to be more cautious with their holiday spending to, making it even more important for us to continue to emphasize value. Our stepped up commitment to Rite Aid brand keeps paying off, too, with sales growing substantially as a percent of front-end sales again in the third quarter.

Our marketing and merchandising features special promotions like our gift of savings holiday program, which are drawing more customers than last year, and we rolled out new in store signage that highlights special buyers and customer savings. Our pharmacy teams once again increased the numbers of prescriptions filled by 1.4% this quarter, helping to offset some of the pharmacy margin rate decrease.

Our RX Savings Card now with over 4.3 million unique users, are stepped up compliance programs including automated courtesy resale and targeted prescription growth programs for under performing stores contributed to the growth and our pharmacists continue to help our patients save money as our generic dispense rate grew again to almost 71%.

Our nearly 2,000 immunizing pharmacists were busy during the quarter, too administering 84% more flu shots than last year, with heavy demand that started in early September, slowing only because of a nationwide storage of regular flu vaccine by the second half of October.

We received a substantial number of doses since then, so if demand for regular flu vaccine picks up after the holidays, we’re ready. As for H1N1, select Rite Aid pharmacies in 13 states have received the vaccine, and most are stem in stock as availability continues to increase.

In mid October, we launched our new loyalty program called wellness+. In four test markets, supporting it with a comprehensive marketing plan that included TV and radio advertising and while we’ve been in those markets for only about two months now, I’m pleased to report, our new tiered benefit customer rewards program is doing very well in test. John will be give you more details later.

We expect to aggressively launch wellness+ nationally next year, and are excited about the potential it offers our business. Even with the good news in our business, we remain cautious about the business for the quarter we are now in. Cough, cold, and flu got off to a good start in Q3, but slowed significantly in the last part of the quarter, that trend has continued into December and the timing of the economic recovery remains as uncertain as it did last quarter, and margin pressure will continue for both front-end and pharmacy.

With this in mind and only about 10 weeks left to finish out the year, we have narrowed our guidance accordingly. We expect our liquidity to remain strong throughout the rest of the fiscal year and that we will finish fiscal 2010 cash flow positive and having reduced our debt.

Our priorities remain growing profitable sales, as well as operating as efficiently as possible in a challenging regional environment that could last for sometime. We will continue to be actively involved in the healthcare debate, ready to capitalize on expertise of our pharmacists to help get the most out of reform. Assuming Congress or even these days just the Senate can agree on a plan.

I will now turn it over to Frank for more financial detail. Frank.

Frank Vitrano

Thanks, Mary. Good morning, everyone. Third quarter continued the challenging sales and margin trends experienced in the second quarter. However, we were able to largely mitigate their impact with our various initiatives. Company’s better position for long term growth with the September 10 maturities refinancing completed, improved liquidity as a result of working capital initiatives, and reduced capital expenditures, continued improvement in lower end or operating costs, and implementation of the segment work in other initiatives that John will discuss in more detail.

On the call this morning, I plan to walk through our third quarter financial results, provide an update on capital expenditure program, discuss our liquidity position, and review the rent reduction dark store programs. Finally, we discuss our fiscal 10 guidance, which resigns the full year range.

This morning, we reported revenues for the quarter of $6.352 billion, compared to $6.468 billion for the third quarter of last year. The decrease in total sales was primarily driven by a reduction in total store count and front-end sales. In the quarter, we closed 14 stores, and year-to-date we closed 116 stores.

On a quarter-over-quarter basis, we had 113 fewer stores. Same store sales declined by 50 basis points reflecting soft front-end sales, but positive pharmacy script growth. Front-end same store sales were down 250 basis points and pharmacy sales were higher by 40 basis points during the quarter. Pharmacy sales included approximately 192 basis point negative impact for new generic drugs. Pharmacy scripts increased 150 basis points.

Adjusted EBITDA in a quarter came in at $254.2 million or 4% of revenues, 2% below last year’s third quarter of $259.6 million. The results were driven by lower sales and lower FIFO gross margin dollars, mostly offset by lower SG&A dollars. SG&A dollars adjusted for non-EBITDA expenses was $78.3 million lower and 80 basis points lower as a percent of sales, despite the $116 million or 180 basis point decline in quarter-over-quarter total revenues.

Net loss for the quarter was $83.9 million or $0.10 per diluted share, compared to last year’s third quarter loss of $243 million or $0.30 per diluted share. The decrease in net loss was driven by a $66.5 million reduction in lease termination and impairment charges, a $45 million reduction in the LIFO provision, and lower income tax expense of $33.8 million.

The lease termination charge of $35.1 million includes 12 stores for which we record a closing provision during the third quarter. We now expect to close a total of 134 stores in fiscal ‘10. The LIFO charge of $14.8 million is consistent with the first and the second quarters of fiscal ‘10 and lower than last year by $45 million.

Interest and securitization expense was $144.1 million, which is $9.9 million increase over the $134 million last year and resulted a refinancing of the September ‘10 maturities. Later in my remarks, I will review the accounts receivable securitization refinancing completed in October. Net cash interest primarily debt issuance cost amortization and workers compensation interest accretion was $11.3 million.

Total gross margin dollars in the quarter was $39.1 million lower than last year’s third quarter, or 13 basis points. FIFO gross margin dollars were lower by $84.1 million, or 82 basis points, which was higher than the 65 basis point decline we saw in the second quarter. The front-end dollar margin shortfall was driven by the sales decline and increase in a percent of items sold on promotion and lower inventory capitalization cost due to lower inventory levels and reduced distribution center costs.

Pharmacy margin dollars were lower, driven by lower RX reimbursement rates, including the AWP rollback, which were into effect on September 26, and is costing us approximately $1 million per week in reimbursements on Medicaid scripts. Fewer new generics and less benefit from generic product cost improvements. The margin dollar shortfall was partially offset by lower distribution center cost, and lower front-end and RX shrink.

Product handling and distribution as a percent to sales improved 16 basis points due to operational efficiencies improvements and lower fuel costs. Selling, general and administrative for the quarter were lower by $106.7 million, or 119 basis points as a percent of sales compared to last year. SG&A expenses not reflected in adjusted EBITDA were lower by $28.4 million, or 40 basis points, primarily driven by lower depreciation and amortization, no integration costs in the quarter and severance charges in the prior year of $10.5 million.

Adjusted EBITDA, SG&A dollars, which excludes specific items the details of which are included in the third quarter fiscal ‘10 earnings supplemental information, which you can find on our website, were lower by $78.3 million or 80 basis points as a percent of sales. This reduction in dollars reflects the aggressive cost saving initiatives that have been implemented over the past 12 months.

The SG&A improvement was driven by better labor controls, and lower field controllable cost, including supplies, as well as utility costs. Corporate expenses were also lower. I should point out that total worker’s compensation and general liability claim costs were flat in the quarter. However, the third quarter of this year, as well as the third quarter of fiscal ‘09, benefited from actuarial adjustments of approximately $39 million, to reflect favorable prior year’s claims experience.

As previously mentioned, our liquidity is strong as a result of the various working capital initiatives and lower capital expenditures. As compared to the third quarter of fiscal ‘09, FIFO inventory is lower by $268.8 million, of which 70% is due to the various initiatives and the balance is due to store closings. FIFO inventory increased in the third quarter from the beginning of the year by $110 million, reflecting normal seasonal bills.

Our cash flow statement results for the quarter show net cash from operating activities in the quarter, as a use of $435 million, as compared to a source of cash of $44.3 million in last year’s third quarter. Repayment of the accounts receivable securitization of $400 million and normal seasonal inventory billed of $166 million, partially offset by an increase in accounts payable were to drivers.

Year-to-date, net cash provided by operating activities was a use of $224 million of cash, which reflects the $555 million repayment of the accounts receivable securitization facility. Net of the accounts receivable repayment, net cash provided by operating activities was a source of $330 million.

Accounts payable in the quarter was a source of cash of $92 million, as a result of increased purchases at the end of the quarter for seasonal inventory builds. Our days payable outstanding in the quarter was 26.2 days. This compares to 24.2 days in the second quarter and 25.2 days in the third quarter of last year.

Net cash used in investing activities for the quarter was $42 million, versus $108 million last year. This reflects our proactive plan to trim capital expenditures. It also includes proceeds from script file and other asset sales. Year-to-date net cash used in investing activity was $84 million. During our third quarter, we opened three net new stores, relocated 11 stores, and closed 14. Our cash capital expenditures were $45.6 million.

Now let’s turn to liquidity. At the end of the third quarter, we had $903 million of total availability including $882 million of availability under the credit facility and $21 million of invested cash. We had $124 million revolver borrowings outstanding under our $1.175 billion senior secured credit facility, with $169 million of outstanding letters of credit. Today, we have $922 million of availability.

Total debt including the accounts receivable securitization facility, was lower by $145 million from year end, and $471 million lower than the end of the prior year third quarter. Lowering our overall leverage and improving our credit maturity profile continues to be a priority for the company. The company’s overall debt leverage decreased from seven times at the end of the priors third quarter to 6.5 times at the end of the third quarter this year.

During the quarter, we completed the refinancing of the first and second lien accounts receivable securitization facilities due in September ‘10, thereby completing the refinancing for all our September ‘10 debt maturities. The $570 million accounts receivable facilities were replaced with increased commitments from the revolver portion of the credit facility, going from $1 billion to $1.175 billion, an increase in the trench for term loan from $525 million to $650 million and the issuance of $270 million second lien bond due in 2019.

We do not have any significant maturities until September of ‘12, giving us sufficient runway to execute our business plan. Now I’d like to discuss the landlord rent reduction and dark store initiatives. Our internal real estate group and a national wide real estate firm having been working with just under 700 stores that either have options coming up for renewal in the next three years, or are underperforming stores.

The underperforming stores are under review for possible closure, and we are seeking rent concessions from our landlords to improve the overall profitability and viability of the stores. To-date, these two groups have achieved rent concessions in approximately 20% of the locations, with annual rent reductions of $3 million per year to be realized over the next six to seven years. We continued to work with our landlord partners to arrive at a satisfactory outcome.

Early this month, with the assistance of an auction service, we listed 34 surplus real estate properties for sale. We sold 27 of the surplus properties netting $10 million in proceeds. Finally, we are working with the landlords in our previously closed dark stores to prepay the remaining rent at a discount.

Now let’s turn to our fiscal ‘10 guidance, we have narrowed our full year guidance to reflect only one remaining quarter. We now expect the EPS loss to be in a range of a $0.50 loss to $0.66 loss. The net loss is expected to be in a range of $413 million to $542 million. We expect total sales to be between $25.6 billion and $25.9 billion and expect adjusted EBITDA to be between $925 million and $975 million for fiscal 10. Same store sales are expected in a range of up 50 basis points to down a 100 basis points over the prior year.

Capital expenditures are now projected to be $220 million, as compared to the original $250 million estimate. The reduction was due to lower store cost for some of our new and relocated stores. Fewer remodels projected to be completed this year, and less file buys than what we had hoped to get completed in the year.

We expect to generate $200 million in free cash flow for the year. The guidance includes a provision to close 134 stores. We are projecting fourth quarter sales to continue the trend seen in the third quarter, with an increase in pharmacy margin pressure as a result of the AWP rollback, reduction in reimbursement rates, and the lack of new generics.

The various expense initiatives we introduced began to show up in the fourth quarter of fiscal ‘09 results and it will be more difficult for us to fully offset the gross margin shortfall with SG&A reductions as we have been able to do so in the last three quarters. That completes my portion of the presentation.

Now, I’d like to turn it over to John.

John Standley

Thank you, Frank. For an outstanding job on that refinancing by you and the rest of the finance team, so okay, similar to last quarter, the third quarter was difficult from a front-end and pharmacy perspective. We did a good job managing our expenses and holding EBITDA very close to last year’s number. The following were significant accomplishments in the quarter.

First, we successfully launched our wellness+ card based loyalty card program in four test markets. We completed the bid process for our pharmaceutical supply agreement. We grew script count in comparable stores 1.5% in the quarter. The RX Savings Card enrollment has now grown to over 4.3 million numbers.

We reduced our SG&A, 119 basis points to 25.3% of sales in the third quarter, compared to 26.5% last year. 80 basis points of the 119 basis points decline were in EBITDA expenses. Distribution costs were 1.53% of sales, our fifth consecutive quarter of improvement versus the prior year. FIFO inventory was $269 million lower than last year, and finally availability under the revolver combined with invested cash provided us with $903 million of liquidity at the earned of the quarter.

Eight weeks ago, we launched our wellness+ loyalty program in four test markets. Wellness+ is a card based program that rewards loyal customers with increasing levels of front-end discounts and health benefits based on the dollar amount of front-end purchases and the number of scripts filled.

The four test markets included three markets, where we can offer rewards for both front-end and pharmacy purchases and one market, where we can only offer rewards on front-end purchases. The test has gone extremely well. Last week, 49% of front-end sales in the four test markets were from customers using the wellness+ card. In the three markets were scripts are include inspected the program, 41% of scripts filled last week were for customers using the wellness+ card.

This level of customer usage is very impressive, given that we’re only eight weeks since the rollout, and shows good customer acceptance of the program. Besides building customer loyalty with our existing customers, wellness+ will provide its valuable customer data and help us attract new front-end and pharmacy customers.

Also during the quarter, we completed the bid for our branded pharmaceutical purchases. We had multiple interested bears and ultimately award of the contract to our existing supplier McKesson. The new contract expires in April 2013, and provides better economic terms in our previous contract.

Moving to a discussion of third quarter results, total comps for the third quarter were down 54 basis points. For the quarter, front-end same store sales decreased 2.5% over the prior year. Front-end sales were strong in our vitamin and internal OTC categories, but were soft in seasonal, personal care and consumables. The OTC categories were helped by early spike in flu.

As we previously discussed, front-end sales may also have been somewhat impacted by the SG&A and working capital initiatives that we’ve implemented over the last four quarter. The 1800 bi-weekly delivery stores negatively impacted our front-end costs 67 basis points in the quarter. The good news is, however, is that EBITDA, excluding pharmacy margin in those stores showed continued progress increasing $13.5 million over the prior year.

Script count grew 1.5% in comparable stores, and pharmacy same store sales increased 40 basis points in the quarter. Contributing to script count growth in the in quarter were one the low volume pharmacies with high volume front-end that continue to respond well to our targeted marketing efforts.

Two, the RX Savings Card, which continues to grow and three, as Mary mentioned, we continue to take good care of customers with strong customer services in the quarter. In terms of recent trends, December sales so far have been softer than last quarter results in both front-end and pharmacy.

We expect front-end sales to remain challenging through the holidays, mostly due to soft seasonal sales, which reflect weak consumer demand and our seasonal inventory position. Although script count has been a little soft so far in December, particularly in flu related categories, we are expecting script count growth this quarter to be similar to last quarter.

FIFO gross margin declined 82 basis points in the quarter, driven by a 59% basis point decline in pharmacy margin and 157 basis points reduction in front-end margin that was partially offset by a reduction in distribution expenses. Front-end margin declined in the quarter mostly due to one increased promotional markdowns as a percent to sales resulting from modest increase in promotional spending on lower sales and, two lower vendor allowances.

Although vender allowances are down on a year-over-year basis, they are improving from the trend of the last few quarters as our purchases or stable diseases. Partially offsetting these negatives were continuing improvements in shrink expense and a 180 basis point increase in private brand penetration in the quarter, increasing private brand penetration to 15.1% of front-end sales.

Helping private brand sales was the introduction of 210 new items so far this year. Pharmacy margin declined 59 basis points in the quarter, modest improvement from last quarter’s rate of decline. The decline was due to reductions in reimbursement rates; including $7 million from reductions in Medicaid reimbursements resulting from AWP rollback that we were unable to fully offset with generic product cost improvements and the benefit of new generics.

Generic penetration did increase 227 basis points in the quarter, but that compares to an increase of 344 basis points in the prior year third quarter. Generic penetration for the quarter was 70.62%. Looking forward on margins, front-end margin will continue to be pressured in the fourth quarter, because we expect the economic downturn for continue to impact customers making it more difficult to drive foot traffic into our stores.

Pharmacy margin will continue to be pressured by lower reimbursement rates. Medicaid pharmacy margin will be reduced an estimated $13 million from the AWP rollback in the fourth quarter. Also impacting pharmacy in the fourth quarter is the cycling of a number of significant new generics that were introduced during the first, second and third quarters last year.

This will hurt our margins because they are becoming less profitable as they mature, because they’re getting macked and because they are now in our run-rate so they are not going to help us offset current year rate reductions from third party payers. Other significant factors that will hurt pharmacy margin in the fourth quarter include the industry wide tightening of the generic supply market, making it more difficult to find cost savings and the fewer number of new generics coming to market.

The positive trend to distribution expenses continued in the third quarter. The improvements is due to the initiatives we started last year and continue to rollout this year, including more efficient transportation routing, the biweekly deliveries and the 1800 low volume stores, and reduction in administrative headcount in our distribution facilities and lower product handling costs resulting from a significant reduction in inventory.

FIFO inventory was $269 million lower than last year. The inventory reductions was not quite as much as last quarter because we built some front-end and pharmacy inventory to be prepared for the flu season, and increased safety stock on some item’s. Ongoing initiatives include our back-room inventory reduction program and our SKU optimization initiative.

These two initiatives will provide some smaller more gradual inventory reduction next year, and should help us put the disciplines in place to keep our inventory under control going forward. SG&A declined 119 basis points from the prior year, of which 80 basis points were EBITDA expenses. The reduction in SG&A expenses resulted from reductions in store labor, other store expenses including supplies, repair and maintenance, utilities, advertising expenses, and lower corporate administrative expenses.

The reduction labor and other store expenses was driven by the initiatives we introduced over the last several quarters, including the low volume store initiative, our best ball efforts, effective use of our new labor scheduling tool and improve labor standards for certain store activities.

Looking forward to the fourth quarter, we will begin to cycle the changes we put in place in the third and fourth quarter last year, making it more difficult to achieve the kind of year-over-year SG&A improvement that we obtained in the third quarter and making it harder to offset the front-end sales and pharmacy margin impacts. A combination of all of these factors is reflected in the guidance Frank discussed.

Next year we should continue to see significant benefit from our segmentation initiatives, we have some exciting merchandising initiatives under development, particular for our low volume stores, we have the chain wide rollout of our wellness+ loyalty program and a project we’re working on to make our stores easier for our associates to offering.

The combination of these initiatives with some additional store operations, distribution center and marketing initiatives that are under development should help us grow profitable sales and further improve our cost structure next year.

Operator, we’re now ready for questions.

Question-and-Answer Session

Operator

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

John Heinbockel - Goldman Sachs

To what degree is wellness+ boosting comps today or we’re not seeing a lot of that yet, it’s more building loyalty and what we’ll see that down the road?

Frank Vitrano

Its really wellness+, I’m really pleased with the way that has gotten started. Right now it’s really getting people, signed up and engaged in the program. There’s not a tremendous amount of any short term in kind of economic or marketing benefit. It’s really, building points and loyalty at this point, so it’s not a huge driver in terms of comps, and obviously it’s only in four test markets, but it’s really gone off to a great start.

Ken and I were looking at number this morning. If we obtain, they kind of penetration in the rest of our stores that we got in just these four test markets, we’d already be at 12 million people engaged in the program, so it’s really gotten off to a very solid start.

John Heinbockel - Goldman Sachs

I guess there’s no evidence yet that people are consolidating purchases either front-end or pharmacy and giving you more business, to get the economic benefit of the program?

Frank Vitrano

The only thing I can tell you right now is that the transaction size, for these customers, is larger than all other customers, so that much you can see out of the gate, but remember it started it zero, in week one and has built at this level just over eight weeks, so we’re going to get a better sense for it as we go, but if we can engage that number of people, then we really have, I think, a great opportunity to drive some comps and build some loyalty with this thing.

Mary Sammons

John, the incentive is really there for them to two cross shop, because that’s how they build points faster and get the higher rewards that our tier program offers.

Frank Vitrano

Yes, think what’s really exciting is the level of pharmacy customers that have engaged in this thing right out of the get-go.

John Heinbockel - Goldman Sachs

When do you think you’ll have this chain wide? Mid-year, or?

Frank Vitrano

Yes, probably in that range, we want to make sure we fully vest this thing and get a good look at the test, but it’s gone as good as we could have expected so far.

John Heinbockel - Goldman Sachs

If you look at the, your buckets of cost savings, where do you think we’re going to in 2010 for the full year out of that, 550 or so you targeted?

Frank Vitrano

I think what we said on the last call; I think we’re still kind of in that range, $150 million out of the 550 in this fiscal year ‘10.

John Heinbockel - Goldman Sachs

That number has not changed much during the last quarter?

Frank Vitrano

No, it’s probably right in that rang so

John Heinbockel - Goldman Sachs

Do you think we get another 100 million next year?

Frank Vitrano

I think we’re going to find some good stuff for next year, but we’re going to hit that guidance of little bit later.

John Heinbockel - Goldman Sachs

Does the 550 number I guess it always moving target is that number go up overtime?

Frank Vitrano

We’re not adding to that number today, but we still feel good about that number and we think, the traction that we’ve gotten with these initiatives out of the gate encourage us that we’re going to find some more value there.

John Heinbockel - Goldman Sachs

What concern do you have with them macro that you do the 550 to kind of stay in place, as opposed to, take EBITDA to another level entirely?

Frank Vitrano

I do think the economy is going to get better. I think it’s going to be gradual, it’s not going to happen overnight, so I think between that and things we’re doing with them wellness+ and some other things, I think we’ll get sales moving here. It’s just going to take a little while to get it where we want it, but so I don’t think we’re going to spend it all to hold steady. I think we’re going to get that positive here.

Mary Sammons

Yes, I think it’s important to remember that we’ve really focused on sustainable expenses coming out of the business, and so as we begin to improve the top line with the initiatives we’ve got underway and planned, we’re going to be able to bring the benefit of those to the bottom line, and that’s really what our intent is.

John Heinbockel - Goldman Sachs

Finally, of the 157 of the front margin pressure, can you roughly break that down between the promotional spend and the vendor allowances? I imagine it’s not 50/50?

John Standley

The promotional spend is the biggest piece of that, and really our promotional spend is up very modestly in dollars, we spent what we spent a little more than we spent last year on a slightly lower sales base, that’s what drives it up on terms of the margin impact.

John Heinbockel - Goldman Sachs

You think Christmas will be more promotional this year than last, as it stands now, a little bit?

John Standley

We got to see, how it plays out then you have our good ways into it, but we still have a stretch to go here. We bought down inventory going into the holiday, so that’s a little bit of the factor in terms of what sales we’re seeing in sales right now. We have sold through better to-date we have spent significantly to your markdowns to do that. So, Christmas actually loss, from a sales perspective, we’d like to be better from an economic perspective, we’re doing pretty well with it so far.

Operator

Your next question comes from Ed Kelly - Credit Suisse.

Ed Kelly - Credit Suisse

A question on your inventory, is there a room to reduce inventory further next year? What do you think the drivers are?

John Standley

There are two things that were focused on for next year. One is, that rolled out and Brian Fiala was sitting here. We did a great job. We put back from inventory system in the place and it’s really working very good in stores that are using, which is most in stores at this point.

What that is doing is, it’s allowing us have better insight it’s what in our backrooms and work at the floor virtually everyday. We think that’s going to help us work back through inventory level down overtime and how better in stock conditions in stores. So we’re excited about that program.

When you look at what we did on the overall inventory reduction side, we took a bite out of our skew count with a pretty massive one-time kind of inventory reduction. As we do plan it around, we’re trying to really kind of look at skew optimization methodologies going forward, and so that gets in the whole combined of decision tree and that sort of thing.

So as we go through next year, we think we’ll have some more kind of nibbles, but don’t think it’s going to be anywhere near the size of what we took out this year.

Ed Kelly - Credit Suisse

Your outlook next year for store closings, could it be as large as it was in the current year?

Frank Vitrano

At this point, that would be probably on the high end I would think have.

Ed Kelly - Credit Suisse

Just as you think about CapEx, I mean, this is obviously not the level that you want to continue at over the long term, and probably even next year would be my guest. How much of the decision on what you spend next year on CapEx is going to be determined by whether you can grow EBITDA next year or not?

John Standley

I think we’re at a fairly low level of CapEx, so I think we expect that CapEx is going to be a little bit higher next year, but I’m hesitant to go too far with that, because I don’t want to give you guidance, because we’re not prepared to do that today, but we think we’re going to be able to lift CapEx a little bit next year.

Mary Sammons

I think that we’ve commented in some other conference calls that, over the next number of years, we would expect that to continue to go up somewhat each year as our results get stronger and the economy improves and we can directionally determine where we’re going to put extra dollars.

Operator

Your next question comes from Bryan Hunt - Wells Fargo Securities.

Bryan Hunt - Wells Fargo Securities

I was wondering if you could help us segment so that stores that are low volume or losing money into those two buckets, as well as just help us understand the overall loss associated with those stores, and I’ve got a follow-up.

John Standley

I’m not sure I got that question in its entirety. I mean, in terms of stores that are losing money? Was that the question?

Bryan Hunt - Wells Fargo Securities

Yes, you’ve got supposedly, based on the earlier comments here, 700 stores. We have options over the next three years that are low volume or losing money. Could you kind of help us slice the 700 stores into the ones with closing options or that are unprofitable?

Frank Vitrano

Sure, I could Bryan. Is that to 200 of the 700 stores that have option closings in the next couple of years. Okay and the 500 or so, just another 500 are the ones that we’ve identified as underperforming, and the ones that we had targeted to and try to improve the overall profitability from a number of different perspectives. One is from an operating perspective, trying to target those underperforming stores, as well as going back to our landlords in order to seek rent concessions.

Bryan Hunt - Wells Fargo Securities

Could you give us an idea of within those ones that are losing money, the magnitude of the loss annually at this point?

Frank Vitrano

It’s not a significant amount of money from an overall perspective, it’s not significant dollars.

Bryan Hunt - Wells Fargo Securities

Then switching gears and looking at the new McKesson contract. Its help you all out in terms of the terms year-over-year. Could you talk about where the terms improved and maybe the magnitude of the savings on a go forward basis?

Frank Vitrano

I wanted to give you an update and tell you that it’s done and tell you that we made some progress there, but the contract is subject to some confidentiality clauses. So I can’t get into the specifics of it, but we did make a little bit of progress.

John Standley

I think the benefits are will be reflected in our guidance next year.

Frank Vitrano

Right, they’ll be reflected in our guidance.

Operator

Your next question comes from Emily Shanks - Barclays Capital.

Emily Shanks - Barclays Capital

I was wondering if you could give us a breakout of what traffic versus ticket was for front-end comps, please.

Frank Vitrano

They’re pretty close.

Emily Shanks - Barclays Capital

Then in terms of the lower reimbursement rates as it relates to medicate hitting about $1 million a week, can you give us them exact date that you’ll cycle that?

Mary Sammons

September 25 next year, that’s been it went into effect.

Emily Shanks - Barclays Capital

Then in terms of next year’s store plans, two questions. One, do you have a rough number of the closure count yet? Two, what are your new store plans for fiscal year 11?

Frank Vitrano

I mean, I guess, Emily at this point we’re still fine tuning that. As I mentioned earlier, in terms of the overall store closing, what we closed this year would probably be on the high end of what we would expect to close next year and on the next call we’ll give some more color around what the new and relocated store program is going to look at. Just generally, it’s not going to be significantly different than what we saw this year.

Emily Shanks - Barclays Capital

Is there a specific number of store leases that you’re already looked into for fiscal year 11?

Frank Vitrano

4000, you’re talking about new stores, right?

Emily Shanks - Barclays Capital

Yes, I am.

Frank Vitrano

We don’t have a large number of contractual obligations to open stores next year.

Operator

Your next question comes from Karu Martesen - Deutsche Bank.

Karu Martesen - Deutsche Bank

With the liquidity that you guys have and no near term materials, why not step up the capital expenditures right now for new and relocated stores?

Frank Vitrano

I think couple of reasons. One, we think the liquidity is important to have today, just where the economy is and everything else, and we will overtime, I think gradually increase the level of CapEx.

Karu Martesen - Deutsche Bank

In terms of the script files falling a little bit short, is that just availability there or the pricing wasn’t favorable, or what was behind that?

Frank Vitrano

Kuru, it was really just a ramp up. We had kind of shut that down earlier in the year and now we’re in the process of ramping it up. So we had people, kind of teams of people starting to make phone calls and getting inbound calls, and where we had hoped, we were going to ramp it up a little sooner than what we had thought. It just takes a little longer, but the opportunities are clearly still out there.

Mary Sammons

We did about double the number of file buys in Q3 as we had in the prior quarter. So we did start to get some movement there. It just takes a while to develop out that file buy, and we want to make sure it’s still following the criteria that we set in place for what kind obviously file buy we want and what our ROI is.

Karu Martesen - Deutsche Bank

So we’ll see that continue into next year, correct?

Frank Vitrano

Correct.

Karu Martesen - Deutsche Bank

There’s been a lot of talk that PVMs themselves are getting purchased. Are you seeing that flow through into your reimbursement rates from them?

Frank Vitrano

Reimbursement rates, environment has been difficult, it’s been difficult all year. So I guess my answer to that is, I guess yes, would be the answer to that. One of the things that’s going on that may help a little bit on the reimbursement rate side overtime is just, it’s kind of the good and the bad.

There are fewer new generics right now. A lot of reimbursement rate loss that occurs is when those new generics get macked. So we’ve been through a pretty tough cycle here, where there were a lot of a strong generics that came out in the second quarter and third quarter last year that have been getting hit pretty hard this year, that could slow down a little bit, because we just won’t have as many new generics.

So that could help us a little bit on the reimbursement rate side, but unfortunately we’ll be a little shorter on the new generic side, but I would say it’s been a difficult reimbursement environment. So we do see some of those pressures kind of moving through our numbers.

Karu Martesen - Deutsche Bank

Just lastly, on the free cash flow, the $200 million, the priority here is still debt repayment, correct?

Frank Vitrano

Yes, I mean, it’s really a balance Kuru, between paying down debt, as well as being able to invest back into the business.

Operator

Your next question comes from Mary Gilbert - Imperial Capital.

Mary Gilbert - Imperial Capital

Could you give us an update on dark rent? So you were able to achieve $3 million of annual savings on dark rent. So this year, we’re going to be at like a $100 million, and then next year it was supposed to ramp down to $90 million. So does that mean its $87 million and with the 20% achievement, where do you expect to ultimately get with these negotiations?

Frank Vitrano

Mary, the number this year is still right around that $100 million, and has about a 10 year amortization on it. So naturally it will come off of $90 million next year, and then in the various initiatives we have will be on top of that with the addition of any closed stores we decide for next year would decrease the number. So, your math is pretty good.

Mary Gilbert - Imperial Capital

Also with regard to private label brands, you had 215 new introductions this year. What about in 2010? Have you identified additional opportunities there and incrementally, what do you think that could mean for sales?

Frank Vitrano

I think there’s probably another 200 or so-plus items for maybe for next year that we can kind of get at from a private label perspective. I think we’ve said, we think overtime that we can get private label penetration up to as high as 18%, but I would think we can achieve 100 basis points plus, maybe more of improvement next year over this year’s increase. So there’s still a pretty good opportunity, I think for private label.

Mary Sammons

Our team has a great tiered architecture plan that they’re working through right now on private brand that’s going to offer, I think, even more value and differentiation as we move forward. So I think it’s really going to be exciting over the next few years.

Mary Gilbert - Imperial Capital

Then with regard to CapEx, and I know you’re not going to give us a number, but could you give us a breakdown of the components of what CapEx spend would be for next year? For example, what present would represent file buys? What percent would be in systems in that sort of thing?

Frank Vitrano

Mary at this point, I’m not sure we can break it out as specifically as that. I guess in term of just components though, okay. We would look to increase some dollars allocated to the remodels. We’re going to look to allocate more dollars to file buys, and technology would be the three buckets that we would look to increase next year.

Mary Gilbert - Imperial Capital

Then just to confirm on the working capital side, it sounds like you see additional cash generation from working capital, because there are still further opportunities to improve your inventory efficiencies within the store. Is that correct?

Frank Vitrano

Mary, I think certainly not to the degree that that what we’ve seen over the past 12 months, but through the initiatives that John alluded to before, the back door inventory system, and some of the things we’re doing on kind of rationalizing from the SKU, there’s some opportunity for us to get some further improvement there, but certainly not to the degree that what we’ve seen here in last 12 months.

Mary Gilbert - Imperial Capital

One last thing, is there a weighted to eliminate the back room inventory concept? It seems like some other retailers had talked about where they virtually eliminate that concept and it’s always inventory moving straight out to the shelf?

John Standley

I mean, I think one issue we have is the number of SKUs that we carry and the shelf space that we have. Also we run a promotional program, so we have to have, enough inventory in the store with our delivery frequency to support our ads. So I don’t think we’ll ever be able to do a 100% eliminate back room inventory.

However, I think we can be much more than efficient with it, and get it from the floor a lot better than we do or have historically, and I think Brian and his team are making some great progress there with what we’re working with.

Mary Sammons

I would add one point that with the program in place to really sell through seasonal inventories even more fully in the store at the end of the season, you see less and less of any kind of carryover, and I think that’s a component of what’s been part of that back room inventory, and if anything go in the back rooms, and they really are cleaned up and working very efficiently with what we’ve done in the stores to make that program work.

John Standley

Back rooms definitely look a lot better. We’re making a ton of progress.

Operator

Your next question comes from [Michael Schabacker - Long Baker].

Michael Schabacker - Long Baker

We’re just wondering, the $220 million of CapEx you have for this year, so that’s implying about $80 million for the fourth quarter? Is that right?

John Standley

Correct.

Michael Schabacker - Long Baker

That’s a lot higher than the previous three quarters. What is that being invested into, and why such the significant change relative to the previous three quarters?

John Standley

It’s just the way the time and the projects rolled out this year.

Michael Schabacker - Long Baker

Then one other question on SG&A, did you say there was an actuarial adjustment of $49 million that favorably impacted SG&A?

Frank Vitrano

It was an actuarial adjustment that of $39 million that impacted this year’s quarter, as well as last year’s quarter.

John Standley

So we had similar adjustments in both years.

Frank Vitrano

In both years.

Operator

Your final question comes from [Colleen Burns] - Oppenheimer & Co.

Colleen Burns - Oppenheimer & Co.

On the gross margin side as you look out to 2010, if the environment stays the way it is today, given the new McKesson contract and some of the other initiatives that you’ve done. Do you see an opportunity to increase gross margin, or do you still expect that will stay in kind of this below 27% range?

John Standley

I’m trying hard not to guide for next year. We’re going to continue to see, at least on the pharmacy side, we’re going to continue to, see reimbursement rate pressure next year I’m sure. I’m sure for all of the reasons we’ve been discussing, though, recent dynamics there.

Over the last quarter and a half, we have made some progress on the generic purchasing sides. So we’ve seen some good generic purchasing reduction. So we’re working on that. We have the McKesson agreement. So I think to on the cost side, we’re doing some things there to kind of help ourselves.

On front-end, it’s going to depend a little bit on the economy, kind of how things will turn here, but overtime, I really expect our wellness plus program to help us find profitable sales in terms of next year. So think there are some positive things to think about and there are some continuing negative factors as well, but we’ll give guidance what we do that at next to call.

Colleen Burns - Oppenheimer & Co.

Then I guess just generally as you kind of look out to 2010, do you see the biggest opportunity being getting the top line improvement? I know this year you’ve kind of been focusing a lot on the cost reduction efforts I have to imagine a lot of the easy low-hanging fruits stuff you’ve kind of capitalized on.

John Standley

I wouldn’t call it easy, I can tell you that. I think it’s going to be a little bit of both. I don’t think sales are going to just turn around overnight, so it will be more, it will gradual and so we’re going to have to continue to be smart on the cost side to make progress here.

Colleen Burns - Oppenheimer & Co.

Then as you look out to next year kind of, or basically even in the fourth quarter, I know you said your inventory purchases were down, you’re kind of planning next year kind of in the same vein to kind of be low on inventory?

John Standley

No, I don’t think so. I think we’re sort of flattening out. So it will probably be kind of in line with this year, or if the economy is doing better, maybe slightly up a little bit.

Mary Sammons

Really, I think that comment was on seasonal inventory and purchases as what we planned down, and, again, that’s one of the areas that customers can easily decide not to buy in a tough economy, and I think it was important to finish up clean on the season, and Ken and his team did a great job on those plans they put together for seasonal.

John Standley

Yes, I think right now it feels good in terms of where we are.

Colleen Burns - Oppenheimer & Co.

Then just lastly on the CapEx, on that $80 million in the fourth quarter, does that include a number of file buys? Does seemed like a pretty big jump.

Frank Vitrano

That will include lots in buys.

Colleen Burns - Oppenheimer & Co.

It does?

Frank Vitrano

Alright, we’d like to thank everyone for participating in the call this morning, and we’ll talk to you in another quarter.

Mary Sammons

Happy holidays, everyone.

Operator

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

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Source: Rite Aid Corp. F3Q10 (Qtr End 28/11/09) Earnings Call Transcript
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