- Key investment notes from Rite Aid’s fiscal 2014 10K review.
- Disclosure and footnote analysis to assess the “numbers behind the numbers”.
- 10K filings provide clues to verify “strength” of operating results vs. accounting gimmicks.
On April 10th, Rite Aid (NYSE:RAD) reported 4th quarter and fiscal 2014 results which marked another year of growth in sales and profits. The guidance for fiscal 2015 was strong as well and management has shifted the emphasis from turning around operations to accelerating growth. The company continues to invest in the wellness remodeling of its stores. The recent Health Dialog and RediClinic acquisitions will further enhance Rite Aid's entrance into the wellness provider arena. For those interested in my analysis of Rite Aid's most recent Earnings Release, please read my article here.
Reviewing a company's 10k filing can be too mundane and tedious for 21st century investors, who oftentimes prefer to skim through earnings releases, conference call replays and online research articles. I believe reviewing a company's 10k filing, is still a mandatory step to partake before investing in any individual stock. Despite my personal beliefs, I know there are many investors who will benefit from a summary of the key details from the 10K. My goal in this article is to provide pertinent details not found in Rite Aid's latest earnings release and subsequent conference call and would be beneficial information for current (and potential) Rite Aid investors. I have outlined this article to loosely follow the sections of Rite Aid's 10K Filing (filed on April 23rd, 2014); please note all tables and items in bold italics are taken directly from the company's 10K filing.
This section of the 10k is a great starting point for potential investors of the company; for current investors most of this information should be redundant information except for a few details:
· Average store size is 12,600 feet (Average selling size is 10,000 square feet). In the retail industry, sales per square foot is a key metric for optimizing profits. Rite Aid has not discussed this metric recently, but it provides a comparative sales yard stick for large vs. small stores and is used to justify and optimize store size.
· As of March 1, 2014, the Rite Aid Health Alliance program was active in three markets and we intend to expand the program to additional markets and stores throughout fiscal 2015. We are committed to continue to grow and develop our pharmacy and healthcare related service offerings to better meet the needs of customers and further strengthen our brand of health and wellness, both organically and through our recent acquisitions of Health Dialog and RediClinic. This paragraph clearly demonstrates the company's strategic commitment to transforming itself into a wellness provider. Once implemented, these initiatives will effectively convert transform Rite Aid from a drug store into a wellness clinic. RediClinic will be a huge step up from just providing flu shots and vaccines in the stores. Health Dialog will provide wellness coaches, clinical informatics and IT infrastructure to enable Rite Aid to be a value added wellness provider. These acquisitions, combined with the Rite Aid Health Alliance program and multiplied by Rite Aid's 4,587 stores, investors can begin to understand the growth opportunity. Prior to these programs, potential investors viewed Rite-Aid as a turn-around story and as an under-valued competitor to Walgreen and CVS. As these initiatives start to ramp-up and investors see the true nature of the company's transformation, it will completely change the investment thesis and return potential for Rite Aid investors.
· We have a strategic alliance with GNC under which we have opened over 2,200 GNC stores within Rite Aid store as of March 1, 2014 and have a contractual commitment to open at least 300 additional GNC stores within Rite Aid stores by December 2019. The company previously reported an expanded relationship with GNC and this notes the current breadth and future plans of the partnership.
The risk section of a 10k can be a foreboding and ominous read for investors, but after reading a few, one realizes the "boiler-plate" nature of these disclosures. This section seems more like a legalese document than a true risk assessment. The risks can be classified as generic, (applicable to all companies, e.g. legal lawsuit risk), industry-specific (e.g. medical malpractice) and company specific. The real key is assessing the impact and likelihood of these risks. Unfortunately, investors have to make this assessment on their own. In theory, there are concrete ways to go about assessing this risk, but in reality, it is not very practical for most investors. To assess the legitimate risks for a company, I recommend thorough research from several independent sources and then based on the totality of your discoveries, following your best judgment. No matter how much research one does, investing still entails taking a monetary risk for a potential reward. I'd like to reiterate that I am only providing 10K details not noted or easily discovered from reviewing the earnings releases and financial statements, filling the gaps so to speak, rather than a full length research article. 1 item seemed relevant from this section:
· Borrowings under our senior secured credit facility are based upon variable rates of interest, which could result in higher expense in the event of increases in interest rates. As of March 1, 2014, approximately $2.5 billion of our outstanding indebtedness bore interest at a rate that varies depending upon the London Interbank Offered Rate (''LIBOR''). Rite Aid is a highly leveraged company and has negative tangible book value. A rise in interest rates, which economists are predicting will happen at some point in the next few years, would have a negative impact on Rite Aid's financial performance. The actual financial impact will depend on future debt levels, fixed vs. variable debt and magnitude of the rate increase.
I could bore my readers and list the specific lawsuits Rite Aid is involved in but I would prefer your valuable time be spent reading the rest of this article. However, since lawsuits can have a material adverse impact, I will summarize this section in my own words:
· The company is being sued by various employees in multiple jurisdictions over various Wage issues (e.g. unpaid overtime) as well as other lawsuits and investigations by regulatory and government agencies. Rite Aid has recorded a liability for one of them but for most of these lawsuits, the company states "are not able to either predict the outcome of these lawsuits or estimate a potential range of loss with respect to the lawsuits." Lawsuits are a matter of fact in the US and for businesses it is an expected and normal business expense. Lawsuits in and of themselves are not surprising or unusual, but until the case is finalized it really is difficult to assess the financial loss.
MANAGEMENT DISCUSSION AND ANALYSIS
The most interesting facts about the company and its operations are generally found in this section. As I have stated previously, my goal is to only provide additional details not prominently disclosed in Rite Aid's earnings releases or conference calls.
· We also own a 55,800 square foot ice cream manufacturing facility and lease a 32,000 square foot storage facility located in El Monte, California. If you knew that Rite Aid owned an ice cream manufacturing facility, give yourself a gold star! This facility has been owned for a long time but I have not heard management discuss any strategic initiative regarding ice-cream. Perhaps the company will develop healthy smoothie products as part of the wellness transformation, but in my opinion, it appears to be a non-strategic asset.
· When we reduce in size, close or relocate a store or close distribution center facilities, we often continue to have leasing obligations or own the property. We attempt to sublease this space. As of March 1, 2014, we had 7,383,081 square feet of excess space, 5,101,190 square feet of which was subleased. Rite Aid has closed a lot of unprofitable stores and the company is paying rent on this excess space - over 7.8 million square feet. This excess space is a reduction from 2013's 10K, where the company reported "7,864,223 square feet of excess space, of 5,179,212 square feet was subleased". This should continue to trend lower in future years as the lease term expires. In addition, the number of stores closed each year is trending lower and frequently is occurring at the end of the lease rather than mid-term.
· Lease Termination and Impairment Charges: We recorded lease termination and impairment charges of $41.3 million in fiscal 2014 compared to $70.9 million in fiscal 2013. The company accrues the dollar amount associated with lease terminations at the time the store is closed (or when the impairment occurs). These charges include the present value of future rents to be paid (if any).
· Full year cost and expense trends. The table below summaries the annual cost trends for the last 3 years vs. the earnings releases which provides quarterly and year to date results compared to the prior year. This data can be extrapolated from the various earning releases; however, this table is a convenient and useful summary of the full year cost trends with associated percentages (which are not always included in the earnings releases). This table also shows cost of goods sold (COGS) on a FIFO basis, which in my view, more accurately represents the true movement of COGS for the retail industry. In addition, the FIFO valuation method is less subject to large adjustments than the LIFO method.
|Costs and Expenses|
|(Dollars in thousands)||(52 Weeks)||(52 Weeks)||(53 Weeks)|
|Costs of goods sold||$18,202,679||$18,073,987||$19,327,887|
|FIFO gross profit||$7,427,876||$7,170,394||$6,982,057|
|FIFO gross margin||29.1%||28.2%||26.7%|
|Selling, general and administrative expenses||$6,561,162||$6,600,765||$6,531,411|
|Selling, general & administrative expenses as a percentage of revenues||25.7%||26.0%||25.0%|
|Lease termination and impairment charges||$41,304||$70,859||$100,053|
|Loss on debt retirements, net||$62,443||$140,502||$33,576|
|Gain on sale of assets, net||($15,984)||($16,776)||($8,703)|
|Source Rite Aid Fiscal 2014 10K Filing, Page 28|
· SG&A expenses decreased by $39.6 million in fiscal 2014 compared to fiscal 2013 due primarily to a lower reversal of certain tax indemnification assets, lower litigation costs and legal and professional fees, advertising, and depreciation and amortization. These amounts are partially offset by increased salary and benefit costs as well as the prior year $18.1 million favorable payment card interchange fee litigation settlement. Rite Aid states the items causing the reduction in SG&A expenses and notes that salary and benefit costs in SG&A are increasing. Other than the reduction in depreciation and amortization, it is unlikely similar reductions (or tax reversals) will re-occur in 2015, thus investors should expect an increase in SG&A next year.
· The annual weighted average interest rates on our indebtedness in fiscal 2014, 2013 and 2012 were 6.4%, 7.1% and 7.4%, respectively. Rite Aid's has numerous debt agreements at various interest rates, as well as fixed vs. variable debt, as a result the weighted average interest rate for the company as a whole is useful in projecting interest expense. In 2015, this metric should continue to trend lower due to a planned refinancing in the 2nd half of the year.
· The table below outlines the total stock options outstanding and the corresponding option price. It is critical for investors to account for the dilutive effects of outstanding stock options in their EPS projections. Almost all of Rite Aid's stock options are significantly in the money due to the recent stock price appreciation. This increases the probability that these will be exercised and the shares will be sold in the near future.
|Strike price||Outstanding Stock Options *||Convertible Notes||Total|
|$0.99 and under||3,419||-||3,419|
|$1.00 to $1.99||43,373||-||43,373|
|$2.00 to $2.99||4,768||24,800||29,568|
|$3.00 to $3.99||383||-||383|
|$4.00 to $4.99||1,549||-||1,549|
|$5.00 to $5.99||663||-||663|
|$6.00 and over||1,811||-||1,811|
|Total issuable shares||55,966||24,800||80,766|
|* The exercise of these options would provide cash of $92.5 million.|
|Source Rite Aid Fiscal 2014 10K Filing, Page 34|
· The table below summarizes Rite Aid's accounts receivable charge-offs. Retail companies generally have little bad debt expense due to being a cash business (or credit cards where the banks deal with the financial risk of uncollected accounts). The drugstore chains have 3rd party payers (insurance companies) that are billed for a large percentage of the Rx sales and are generally very credit worthy companies. This write-off has increased significantly since fiscal 2012 and is an item of concern. Fraudulent use of health insurance cards, either stolen or where the member's insurance has expired might be a possible cause. This would be an item where I would pose a question to investor relations as to the underlying cause.
|SCHEDULE II-VALUATION AND QUALIFYING ACCOUNTS|
|For the Years Ended March 1, 2014, March 2, 2013 and March 3, 2012|
|(dollars in thousands)|
|Allowances deducted from accounts receivable for estimated uncollectible amounts:||Beginning Period Balance||Additions Charged to Costs & Expenses||Deductions||Ending Balance|
|Year ended March 1, 2014||$28,271||$43,524||$44,922||$26,873|
|Year ended March 2, 2013||$28,832||$36,397||$36,958||$28,271|
|Year ended March 3, 2012||$25,116||$18,274||$14,558||$28,832|
|Source Rite Aid Fiscal 2014 10K Filing, Page 112|
· The Company paid a combined amount of $86.0 million and assumed debt of $2.5 million related to the acquisitions noted above. This is the acquisition price of RediClinic and Health Dialog. Previously, Rite Aid had only disclosed that the combined cost was less than $100 million.
· Lease Termination Charges… In fiscal 2014, 2013 and 2012, the Company recorded lease termination charges of $28,227, $45,967 and $48,055, respectively. These charges related to changes in future assumptions, interest accretion and provisions for 15 stores in fiscal 2014, 14 stores in fiscal 2013, and 23 stores in fiscal 2012. Of the approximate 40 store closures for fiscal 2015, the Company anticipates that 15 will require a store lease closing provision. This disclosure notes that the company is estimating 2015 lease termination charges for 15 stores - the same number of stores as 2014. As Rite Aid has been increasing same store sales for the last couple of years, I personally had expected the trend to continue lower vs. remaining flat with fiscal 2014.
My review of Rite Aid's 10K filing substantiate the operational improvements that management has made in the last several years. The company continues to make investments that will transform Rite Aid into a wellness provider/destination. Sales are increasing and interest expense is trending lower due to the company reducing and refinancing existing debt. SG&A efficiencies appear to have bottomed out and I anticipate SG&A costs to continue rising, particularly in Q1, 2015 due to the RediClinic and Health Dialog acquisition. However, I do not expect SG&A costs to outpace revenue growth for the full year.
I consider reviewing a company's 10K filing as required due diligence for investing in individual stocks. The details in the 10K allow for investor verification and analysis of the earnings releases presented by management. For those investors who rely on other sources for their due diligence, I hope these additional details from the 10K are of value. If you are interested in detailed analysis of under-valued stocks, I invite you to follow me by clicking on the "+ Follow" icon at the top of this article. The settings in your seekingalpha.com profile can also be adjusted to receive e-mail alerts when I have posted a new article.