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Rite Aid Corporation (NYSE:RAD)

Q1 2015 Earnings Conference Call

June 19, 2014, 08:30 AM ET

Executives

Matt Schroeder - Investor Relations

John Standley - Chairman and Chief Executive Officer

Ken Martindale - President and Chief Operating Officer

Frank Vitrano - Chief Financial and Administrative Officer

Analysts

Lisa Gill - JPMorgan

Judah Frommer - Credit Suisse

Bryan Hunt - Wells Fargo Securities

Robert Jones - Goldman Sachs

John Heinbockel - Guggenheim Securities

George Hill - Deutsche Bank

Steven Valiquette - UBS

Carla Casella - JPMorgan

Karru Martinson - Deutsche Bank

Karen Eltrich - Mitsubishi

Operator

Good morning. My name is Jackie and I will be your conference operator today. At this time, I would like to welcome everyone to the Rite Aid First Quarter Fiscal 2015 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)

Thank you. Mr. Schroeder, you may begin your conference.

Matt Schroeder

Thank you, Jackie, and good morning, everyone. We welcome you to our first quarter conference call. On the call with me are John Standley, our Chairman and Chief Executive Officer; Martindale, our President and Chief Operating Officer; and Frank Vitrano, our Chief Financial and Chief Administrative Officer.

On today's call, John will give an overview of our first quarter results and discuss our business. Ken will give an update on some of our key initiatives. Frank will discuss the key financial highlights and fiscal 2015 outlook. 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. These slides include annual earnings and sales guidance. These slides are provided on our website, www.riteaid.com, under the Investor Relations Information tab for conference calls. This guidance is a point-in-time estimate and the company expressly disclaims any current intention to update it.

This conference call and the related slides will be available on the company's website until the next earnings call, unless the company withdraws them earlier, and should not be relied upon thereafter. We will not be referring to the slides 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 uncertainties that can cause actual results to differ. These risks and uncertainties are described in our press release, in Item 1A of our most recent annual report on Form 10-K and other documents we file or furnish to the Securities and Exchange Commission.

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 measure, are described in our press release. Also included in our slides are the non-GAAP financial measures of adjusted EBITDA gross profit and adjusted EBITDA SG&A and the reconciliations of those measures to their respective GAAP financial measure.

With these remarks, I'd now like to turn it over to John.

John Standley

Thanks, Matt, and thank you all for joining us to review our results for the first quarter of fiscal 2015. Our store operating performance for the quarter was strong, though results for net income and adjusted EBITDA trailed our expectations. We delivered our seventh consecutive quarter of profitability by generating $41.4 million in net income compared to $89.7 million during last year's first quarter. A decrease in adjusted EBITDA and higher income tax expense contributed to this result. And these factors were partially offset by lower interest expense and a lower LIFO charge.

Adjusted EBITDA for the quarter was $282.6 million as compared to $344.8 million during the prior-year period. This result was driven by a reduction in pharmacy gross profit due to lower reimbursement rates that were not offset with reductions in generic drug costs. We also had higher salary and payroll related expenses, as we continue to make investments in our business. As announced in February, we are transitioning to a new drug sourcing and distribution process through our expanded partnership with McKesson. This new process is expected to deliver long-term drug cost savings and will provide our pharmacies with direct to store delivery five days a week, which will provide significant working capital benefits.

As we transition to our new purchasing model, we expect lower pharmacy gross margin during the transition period, because we are unable to negotiate lower drug cost as we normally would do to offset reimbursement rate pressure and generic drug cost increases. This increased vulnerability to reimbursement rate changes and generic drug cost increases will continue during a portion of the second quarter as we complete the transition.

A significant portion of the change we made to our fiscal 2015 guidance on June 5th reflects that the negative gross margin impact of this transition, which is greater than we anticipated because reimbursement rate pressures were more significant than we expected and the timing of savings realized from the McKesson agreement is slower than our original estimates. Although this transition is longer than we expected, this new sourcing and distribution model is a groundbreaking opportunity for us. And as we work through this transition, I'm confident this is the right strategic step to drive our long-term success. We're really excited about how this partnership will allow us to achieve supply chain efficiencies, provide even better service to our customers and generate additional cash flow to fuel our long-term growth.

As I mentioned earlier, we delivered a strong store operating performance during the quarter, including solid revenue growth and positive comps for same-store sales and prescription count. We also held the line on front-end same-store sales, which were flat for the quarter as we strike a balance between maintaining front-end margins and remaining competitive in a highly promotional environment.

In terms of our script count, there're indications that the Affordable Care Act is beginning to have a positive impact as we're experiencing growth in states that have expanded Medicaid. In addition, we're seeing high utilization among our patients. We continue to make significant progress with our key initiatives, as we transition our strategy to more aggressively pursuing opportunities for long-term growth. In a few moments, Ken will talk more about our Wellness store program and the continued success of our remodeling efforts.

From a strategic standpoint, it's important to note that our Wellness stores will serve as a primary vehicle for launching innovative merchandising solutions, expanded healthcare offerings, and over the next few years our relocation and new store program. Next, we will hold the grand reopening of a Wellness store on North Canon Drive and Beverly Hills that illustrates how we're aggressively evolving the format to identify additional features that can be broadly applied to future remodels and other features that can be implemented in select stores with specific growth opportunities. Wellness stores will also serve as the foundation for expanding our healthcare offering, including our Rite Aid Health Alliance program for patients with chronic and poly-chronic conditions as well as adding Rite Aid clinics to Rite Aid stores.

We recently expanded our Health Alliance pilot by announcing a new partnership with Penn State Hershey Health System in Hershey, Pennsylvania. We are encouraged by the initial results of our pilot, which are now active in four markets. We continue to focus on forming partnerships with additional medical practices as we look to provide a higher level of care and support patients with chronic and poly-chronic conditions. In addition, the integration of Health Dialog into the Rite Aid family has been smooth thus far and this new subsidiary is providing the in-store care coaches to support the Health Alliance program in these new markets. We're also making strong progress as we integrate RediClinic into our operating structure. We're now actively engaged in site selection for adding our first RediClinic to Rite Aid stores.

At this time, I'd like to turn it over to our President and Chief Operating Officer, Ken Martindale, who has additional information regarding our key initiatives. Ken?

Ken Martindale

Thanks, John, and thanks to everyone for joining us on the call this morning. As John said, we continue to make significant progress with the key initiatives that will fuel our transition into becoming a growing retail healthcare company. Our Wellness store program is a foundational element of this strategy as we continue our remodeling efforts and build up our real estate pipeline for relocations and new stores.

We now have completed 1,325 Wellness remodels, which represents 29% of all Rite Aid locations. These stores continue to outperform the rest of the chain in terms of same-store front-end sales and script count, and we continue to push the envelope in leveraging these stores to launch and expand innovative merchandising solutions. A great example is the Beverly Hills store that John mentioned earlier. It includes concepts that have performed well in pilot and will be broadly applied to future Wellness stores like our enhanced OTC presentation that features educational materials, interactive product displays and creative fixturing.

The store also features concepts that we're just beginning to test such as Fresh Day Café that serves coffee, pastries, breakfast sandwiches and Rite Aid's very own Thrifty Ice Cream. And finally, this store includes an expanded and enhanced beauty department staffed by a terrific beauty advisor. This project is a great example of the ongoing evolution of our Wellness format. We are striving to continually apply innovative merchandising, increased education and personalized service to drive a more engaging consumer experience.

At the same time, we continue to align our front-end offering to further support our expanded healthcare offering. We are currently working to further strengthen our smoking cessation program by developing a best-in-class consumer solution. We have also launched the nutritional labeling system to help shoppers easily find food items that are a better fit for their wellness needs.

Our highly successful immunization program continues to be a point of emphasis throughout our company. Our store, clinical and field supervision teams are already actively engaged with organizations in their local communities to secure additional flu shot clinics for the upcoming season. We've also ramped up our efforts to raise awareness about our full complement of other immunizations to further promote Rite Aid as a destination to meet all of our patients' immunization needs.

Our Wellness 65+ loyalty program for seniors is gaining additional traction as well. Membership in the program is approaching 2 million and our Wellness 65+ Wednesday events continue to give seniors a compelling reason to visit their local Rite Aid and explore the vast offering of wellness benefits available to them. In addition, the broader Wellness+ loyalty program continues to perform as well and customers respond positively to the program's unique combination of exclusive savings and wellness benefits.

As we look to further engage our 25 million active members, our customer relationship management program continues to gain momentum and strengthening loyalty among our best customers by using individualized targeted offers. We are in the process of expanding these efforts to social, mobile and other digital channels and expect our broader CRM program to service foundation for future growth at Rite Aid.

Customers continue to respond positively to the value delivered by our private brand items with private brand penetration increasing 31 basis points over the prior year to nearly 18% during the first quarter. Our ongoing prescription file buy initiative remains very active and continues to produce strong results. During the quarter, we completed $19.6 million in file buys and we're on pace to achieve our goal of $90 million for the fiscal year. As we more aggressively pursue opportunities for growth, we're prepared to increase our allocation for file buys if additional opportunities arise throughout the fiscal year.

To sum it up, we're pleased with the progress of our key Wellness and growth initiatives and look forward to further strengthening these programs, while delivering on our promise to actively work with our customers to keep them well.

At this time, I'll turn it over to our Chief Financial and Administrative Officer, Frank Vitrano, who will provide additional details about our financial results. Frank?

Frank Vitrano

Thanks, Ken, and good morning, everyone. First quarter results reflect pharmacy product cost and reimbursement rate challenges despite strengthening script count and front-end trends as well as continued progress from our various initiatives. On the call this morning, I plan to walk through our first quarter financial results, discuss our liquidity position, certain balance sheet items, our capital expenditure plan and finally review our fiscal '15 annual guidance.

Revenue for the quarter was $6.5 billion, which was $172 million or 2.7% higher than last year's first quarter. The increase was due to higher pharmacy sales. Overall same-store sales increased 3.1% in the quarter, reflecting higher pharmacy script count and inflation rate. Front-end same-store sales were flat compared to last year. Pharmacy same-store sales were higher by 4.6%, which included an approximate 143 basis point negative impact from new generic drugs compared to 450 basis point negative impact from new generic drugs in the prior year's first quarter. Pharmacy same-store comp scripts were up 230 basis points, reflecting higher utilization, particularly in Medicaid expansion states.

Adjusted EBITDA in the quarter was $282.6 million or 4.4% of revenues, which was $62.2 million lower than last year's first quarter of $344.8 million or 5.5% of revenues. The current quarter's results were primarily driven by lower pharmacy gross profit due to lower reimbursement rates that we were unable to offset with reductions in generic cost as well as higher SG&A.

Net income for the quarter was $41.4 million or $0.04 per diluted share compared to last year's first quarter net income of $89.7 million or $0.09 per diluted share. The decline was driven by the $62.2 million decline in adjusted EBITDA and higher income tax expense, partially offset by lower interest expense, LIFO and lease termination and impairment charges as compared to the last year.

Income tax expense was recorded to maintain a full tax valuation allowance for the company's deferred tax assets. The increase was driven by higher stock-based compensation expense for tax purposes. The valuation allowance increased the non-cash item. Refinancing is completed in March of this year and June of '13 drove the reduction in interest expense. The lower LIFO charge was driven by an expected decrease in inventory levels.

Total gross profit dollars in the quarter were $18 million lower than last year's first quarter and 105 basis points lower as a percent of revenues. Adjusted EBITDA gross profit, which excludes specific items, primarily LIFO and the Wellness+ revenue deferral, was unfavorable to the prior year's first quarter by $28.7 million and lower by 123 basis points as a percent of revenues. Pharmacy gross profit dollars and margin rate were lower. Pharmacy gross profit was impacted by continued reimbursement rate pressure that we were unable to offset with reductions in generic cost due to a delay in realizing the level of generic price reductions we expected from our purchasing arrangement. Front-end gross profit dollars and rate were flat to last year. These items were partially offset by the inclusion of Health Dialog and RediClinic revenues in this year's results.

Selling, general and administrative expenses for the quarter were higher by $35.1 million and 14 basis points lower as a percent of revenues compared to last year. Adjusted EBITDA SG&A dollars, which excludes specific items, were higher by $33.4 million and 12 basis points lower as a percent of revenues compared to last year. The increase was driven by $14.7 million in operating and deal cost related to the recent acquisition of Health Dialog and RediClinic. Wages and benefit increases drove a balance of the year, partially offset by our various expense control initiatives.

FIFO inventory was lower than the first quarter of last year by $110 million, primarily driven by initiatives to better manage inventory levels. Our cash flow statement results for the quarter shows net cash from operating activities as the source of $239.7 million as compared to a source of $184.5 million in last year's first quarter, with lower inventory and timing differences in accounts payable driving the variance.

Net cash used in investing activities for the quarter was $177.4 million versus $82.1 million last year. During the quarter, we remodeled 105 stores, expanded one stores, relocated three stores and closed seven stores. At the end of the first quarter fiscal 2015, we have completed and grand reopened 1,325 Wellness stores. In the first quarter of fiscal '15, front-end same-store sales in the Wellness stores exceeded the non-Wellness stores by 265 basis points and script growth in the Wellness stores exceeded the non-Wellness stores by 120 basis points.

Now let's discuss liquidity. At the end of the first quarter, we had $1.368 billion of liquidity. Our liquidity has increased $226 million over the last year. We had $351 million of borrowing outstanding under our $1.8 billion senior secured facility, with $88 million of outstanding letters of credit.

Total debt net of invested cash was lower by $208 million from last year's first quarter. Our leverage ratio, defined as total debt less invested cash, over LTM adjusted EBITDA, improved to 4.5 times from 4.9 times as compared to the first quarter of fiscal 2014.

Now let's turn to fiscal '15 guidance, which was released on June 5th with our May sales results. We updated our guidance based upon a shortfall in the first quarter earnings, which was primarily driven by pharmacy margin trends, as discussed before, as well as an updated timeline to achieve the lower generic purchase price reductions from our purchasing arrangement. We also adjusted for delays in the introduction of certain new generics as well as the impact of January 1st plan changes. The guidance also reflects continued reimbursement rate pressure and more drug cost increases than normal. We have also updated our assumptions concerning AMP as we now expect that it'll not be implemented in fiscal '15.

The guidance includes incremental expense control initiatives to partially offset the pharmacy margin pressures. We updated our LIFO provision for the year based upon the anticipated reduction in pharmacy inventory, both at the stores and DCs. Our guidance does include the anticipated benefit of our Wellness remodel program, customer loyalty program and other initiatives to grow sales and drive operating efficiencies. We expect the current competitive environment to remain promotional. We also consider planned wages and benefit increases.

We increased our expected working capital benefit to $250 million from $150 million as a result of the McKesson agreement. We are seeing early results reflecting lower store pharmacy inventory as a result of more frequent direct store deliveries. Previous guidance only included the distribution center inventory reductions. The working capital benefit will not be fully realized until the fourth quarter of fiscal '15.

We expect script growth benefits from ACA favorable demographics, filed buy acquisitions, growth in immunizations and other initiatives. As was mentioned on the fiscal '15 earnings call in April, we expect that the second half of fiscal '15 to be stronger than the first two quarters due in part to the strength of fiscal '14's first half as well as the introduction of new generics in the second half of fiscal '15. Our second quarter comparison to the comparable quarter last year will be impacted by the previously disclosed $23.5 million prescription drug antitrust settlement in last year's second quarter as well as the timing in realizing the run rate benefits of the expanded partnership with McKesson.

The company expects sales to be between $26 billion and $26.5 billion and expected adjusted EBITDA to be between $1.275 billion and $1.35 billion for fiscal '15. Same-store sales are expected to be in a range of an increase of 2.5% to 4.5%, included the anticipated negative pharmacy sales impact of approximately 240 basis points from new generic introductions and continued reimbursement rate pressure. We expect a fiscal '15 earnings range of net income of $298 million or earnings per diluted share of $0.30 to a net income of $408 million and earnings per diluted share of $0.40. The range of guidance is primarily driven by our same-store sales range and pharmacy margin. Our guidance includes investments to integrate both RediClinic and Health Dialog, and we plan to open an additional 70 RediClinics over the next 18 months.

Fiscal 2015 capital expenditure plan is to spend $525 million with $225 million allocated to remodels and $90 million to file buys. We're planning to open one new store, complete 19 relocations and remodel 450 Wellness stores in fiscal '15.

We expect free cash flow to be in the range of $400 million to $450 million for the year, including the benefit of lower pharmacy inventory and the acquisition of RediClinic and Health Dialog. We expect to close a total of 40 stores, of which the guidance includes a store lease closing provision for 15, with the balance closing upon lease expiration. The guidance also assumes that we will call and prepay our 10.25 second lien notes due in 2019 sometime after the next call premium step-down in October.

That completes my portion of the presentation. And now I'd like to turn it back to John.

John Standley

Thank you, Frank. Before we open the phone lines for questions, I'd just like to thank our dedicated associates for their commitment to executing our key initiatives and their contributions to our strong store operating performing during the first quarter.

Looking ahead, we believe that our strategy to expand our healthcare offering is the right strategy for positioning Rite Aid for growth in this changing healthcare environment and delivering long-term value for our stakeholders. We will continue to focus on further developing our existing programs, while aggressively pursuing new opportunities to deliver convenient, affordable and effective healthcare solutions to the communities we serve.

That concludes our prepared remarks for this morning. We will now open the phone lines for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Lisa Gill with JPMorgan.

Lisa Gill - JPMorgan

I was wondering if maybe we could just talk about reimbursement pressure a little bit more. Is this really more of a shift to more Medicaid patients where generally reimbursement is lower based on your comments around ACA, or did you have a change in any of your contracting with the PBMs or managed care companies? Just trying to understand the reimbursement pressure that you saw in the first quarter.

John Standley

Sure. I guess a couple of things. The lower reimbursement rate we talked about related to ACA was primarily driven by the migration to AMP really was for Medicaid reimbursement rates. As you may have noticed, that has been delayed. We're not sure what precisely the implementation date will be for the implementation of AMP, but we expect that it's likely going to be outside of this fiscal year. So as it relates to the Affordable Care Act, I think that was really kind of where we were going there.

In terms of reimbursement rate pressures, I guess there's a few things. We're always dealing with a competitive reimbursement rate environment. Things that can develop differently than our plans would include just a mix of business amongst and within plans, so migration to narrow networks and business moving between different types of plans can have an impact on reimbursement rates. We also still have certain contracts that are not in a kind of guaranteed rate. We call those MAC contracts. So those can be a little bit more volatile. So it's really, I think, kind of a combination of those things, where we saw some reimbursement rate pressure in this particular quarter that was greater than our expectation.

Lisa Gill - JPMorgan

And so, John, so if I hear you correctly, it sounds like it wasn't that you had an issue of people with more Medicaid coming in, but rather it was the mix within your commercial book of business and you still have a number of your commercial contracts that have MAC rates. And therefore, just given where you were able to buy the generic versus the way that whether it's the PBM or managed care company could MAC you, it's the difference in that that was different than your expectation when you gave us guidance in April, is that correct?

John Standley

Yeah. So that's definitely a piece of it. In terms of the way we see Medicaid prescriptions come through today, there're still some Medicaid that are managed directly by states and there is a lot of Medicaid that is now actually managed by third-party plans. And when you blend all that together, our overall Medicaid rates don't look a lot different than our managed care rates today. So that increase in Medicaid was not a significant driver in changing our reimbursement rate expectation. You talked about some MAC-ing activity. That is definitely a piece of the puzzle. Planned mix is the other piece, so I'll just reemphasize again as well.

Lisa Gill - JPMorgan

And then just secondly, you gave guidance in April. I am just curious about the timing around McKesson and procurement of generics. Did you have a different expectation when you gave the guidance in April, or is it just that we, on the Street, perhaps have modeled it wrong sequentially through the quarters and got the first quarter incorrect based on your commentary?

John Standley

I think we had a different expectation. I know a lot of people called McKesson and what did they say and what did Rite Aid say and how does it all fit together. One thing I would tell you is that this is a very significant transition for us. Generic purchasing is a very big part of our business. We went into this agreement with our eyes wide open about the complexity of it and what would be involved. And when we gave our guidance originally, we mentioned that we thought the first half was going to be softer for a few reasons. And this was definitely one of them, because during the transition period of moving from managing the cost ourselves to having McKesson manage our cost, there is just a period of vulnerability that occurs here where we don't have as much leverage in the marketplace. So there are a couple of different things going on.

One, the savings that we got on our own bids last year erode over time, because there are cost increases that occurred that gradually begin to offset that. And we no longer have our hands on the levers that allow us to manage cost day-to-day. So this sort of in-between period is allowing reimbursement rate pressure and generic cost increases to kind of get right through into the margin fairly quickly, where in the past, we would have had more levers to work with internally to slow those things down. When we gave our guidance, we built it around the expectation that towards the end of the first quarter, these savings would be available to us to help offset those pressures. The timing has turned out to be a little slower than that. And so that's kind of a piece of how we got to where we are.

Lisa Gill - JPMorgan

But it sounds like these are transient, that once you are able to work towards this relationship starting more so, if I remember correctly, it's around August 1st, which is where more of this will happen, that this is really just a timing issue. Am I thinking about that correctly?

John Standley

Yeah, I think there is a very significant timing issue here involved, no question about it. I'm not sure we gave that date, August 1st. So I'll not confirm that day. But what we have said is that the savings will build during the second quarter.

Operator

Our next question comes from the line of Edward Kelly with Credit Suisse.

Judah Frommer - Credit Suisse

This is actually Judah on for Ed. I wanted to touch a little more on the reimbursement pressure. How much of this do you think is related to generics coming in later than you expected? You mentioned kind of adjusting the timing for the roll-in of some big generics. Would we be talking as much about this if you had some of those big generics in there right now?

Ken Martindale

Yeah. I mean we originally anticipated Nexium was going to come in earlier in the year. And as we updated our guidance here in June in our forecast, we pushed that out, do not expect it come to much later in the year.

Judah Frommer - Credit Suisse

And the reimbursement pressure, how much would you say is specific to Rite Aid based on whether it's MAC contracts or other factors, and how much is just kind of general pricing pressure in the marketplace?

Ken Martindale

That's a question I cannot answer for you. We're certainly privy to what happens here, but I have no idea what other companies' contracts are, what they look like or how they work. The timing of renewals, that kind of thing.

Operator

Our next question comes from the line of Bryan Hunt with Wells Fargo Securities.

Bryan Hunt - Wells Fargo Securities

First question, I was wondering, when you look at a RediClinic remodel or putting a RediClinic in a store versus a traditional Wellness remodel, what's the difference in cost of that relative remodeling, and what type of lift in sales are you anticipating versus the lifts you're getting today of roughly 265 bps on the front-end and 120 on scripts?

John Standley

The answer to the question is we think RediClinic is going to provide not only revenue through the clinic, but additional script count as well. So we sort of get a pickup in both spots. So in terms of a Wellness renovation, it would significantly help us on comp side in terms of cost associated with it...

Frank Vitrano

In fact right now we're estimating about $200,000 to put a RediClinic in. And that would assume, Bryan, that we have to put a bathroom in as well.

Bryan Hunt - Wells Fargo Securities

Very good. And next, more of a capital structure question. It sounds like you're going to pay off these 10.25% with cash and you'll generate plenty of free cash flow to manage that process. When you look at your capital structure going forward, I mean you've got first lien debt, second lien debt, secured debt and unsecured debt. And I'm just wondering, can you give us just maybe a little look into what your plan would be for, one, managing the level of leverage; and two, kind of what your optimal secured and unsecured capital structure would look like?

Frank Vitrano

We are always looking at the capital structure. And with regard to leverage here, we talked about on prior calls that we would like to get to a leverage ratio that has a three handle on it. And that's something that we're continuing to strive for. This year, we are forecasting to generate $400 million to $450 million of free cash flow that'll help us to begin to pay down our debt here. And with regard to our capital structure, that's something that we continue to look at and to monitor on our long-term basis here. Obviously we've seen some fairly significant improvement in our unsecured rates, which become more attractive, and that might be something that we would consider looking to access the unsecured market at some point in the future. But I think in the short term, the opportunity that we have is really looking at the higher coupon indentures that we have and looking at the call premiums and see what's the appropriate time for us to refinance them.

Bryan Hunt - Wells Fargo Securities

And my last question, as you approach that 3 times leverage ratio, I mean you made some small acquisitions of RediClinic and some other businesses and you're looking at script growth, is there anything that would prevent you all or do you feel more comfortable as leverage drops to maybe start to get into the storefront acquisition game? Would you consider end markets or would you talk about expanding markets?

Frank Vitrano

Both. That's a Frank very John discussion right there.

Bryan Hunt - Wells Fargo Securities

Can they battle it out on the call?

Frank Vitrano

Yeah, we can definitely do that for you. I think we've said all along we're very opportunistically minded. We want to do the right things for our company and our business. And if there's something that makes sense to us, we could be in existing market, maybe it could be outside an existing market, we'd take a hard look at it.

Operator

Our next question comes from the line of Robert Jones with Goldman Sachs.

Robert Jones - Goldman Sachs

Somewhat lost in the announcement from June 5th was the fact that same-store sales continued to improve. And in particular, same-store sales scripts seem to be accelerating month-over-month so far this year. Could you guys maybe talk a little bit about what's embedded in your full year same-store sales guidance as it relates to script growth? And I guess just as a part of that, maybe any update on assumptions around what you're seeing or expect to see from exchange lives and Medicaid expansion.

Ken Martindale

In terms of same-store sales assumptions, as we mentioned, we're looking to see 2.5% approx to 4.5% increases. We don't really provide any more specific color around specific script growth. However, we're clearly encouraged by the script growth as well as the front-end trends that we're seeing here.

John Standley

What was the second half of that Medicaid question?

Robert Jones - Goldman Sachs

As we've seen same-store scripts improve month-over-month and looking at the full year total same-store sales, I'm just curious as we have seen the script growth, is there anything that you're seeing today contributing directly from Medicaid expansion or exchange lives and what's the assumption for the remainder of the year as it relates to script growth?

John Standley

So the first half of the question, I think I can answer, which is in terms of what we've seen from the Affordable Care Act. It's fairly consistent with, I think, what we said in our last call, which is in terms of exchange-based plans, probably 70% of the people that we can identify related to an exchange-based plan came from another plan where we already had them as customers. So the net incremental piece of that was much smaller. And those people, those net incremental patients haven't been huge utilizer as yet. So the utilization as a percentage of those plans is probably less than the average.

A little bit of a different story in the Medicaid. In the Medicaid expansion states, we've seen strong script growth, as Frank mentioned in his comments, particularly when you compare them to the non-Medicaid expansion states, where there isn't much growth. So it's clearly had an impact. And it was a pretty strong contributor, we think, to the trends that you're seeing on our script count right now. As it relates to guidance right now, probably script count is in line with our expectations. I guess that's probably the right way to say it.

Robert Jones - Goldman Sachs

No, that's fair. And then I guess just one follow-up on the reimbursement pressure that you guys highlighted. I know your competitors have talked a lot about trying to insulate themselves away from these types of contracts that can change so abruptly. Any update on how you've been progressing and moving away from this type of contracting?

Standley

We worked hard over the last several years to move to fewer contracts where we don't have as much visibility into how rates will behave over time, but we do still have some left that we're working on. Probably 60% to 70% of our managed care contracts are now on more sort of guaranteed rate type contracts. And I'll just emphasize one more time, we definitely have some volatility in the MAC-ing contracts. It's also some mix issues kind of rolling around here as well.

Operator

Our next question comes from the line of John Heinbockel with Guggenheim Securities.

John Heinbockel - Guggenheim Securities

So a couple of things. On reimbursement, how would you compare the volatility and what you saw this year to last year or the year before, was there more this year, was it harder to judge it this year than past years?

John Standley

I'd say two things to that, John. In terms of the overall rate decline versus, say, a year ago, if you looked at the first quarter last year versus the first quarter this year, the rate decline this year is less, which makes common sense, because we don't have any significant LOEs or new generics or anything that are coming around where there should be a significant rate decline. However, I would say that in terms of volatility or predictability, probably a little bit worse for us. We have some things going on, I think, this quarter that will probably be different than what we saw last quarter.

And the last piece I would tell you is last year when we saw that, because we had direct control over generic purchasing at that time, we were able to react in ways to help offset it, where right now until we get this thing fully transitioned, we're a little stuck in the middle.

John Heinbockel - Guggenheim Securities

Well, because it sounds like that's a bigger piece is not that the plan design changed on you, you had no flexibility to do normal midcourse corrections that you did a year ago or before that? Is that fair?

John Standley

Sum of all, but both are important.

John Heinbockel - Guggenheim Securities

Because if that's true, the follow-up to that would be because the 28% gross margin, I don't want to say it is not realistic, but it's sort of not apples-to-apples because of your hamstring ability to do direct buying yourself. Is that fair? And is there a catch-up or are those gross profit dollars lost or when you get this thing with McKesson ramped, some of that flows back in later quarters?

John Standley

So I think what you said initially is correct in terms of there is definitely a piece of this that's related specifically, because we're stuck in the middle here. Based on the way you see us suggesting our guidance, I think you can include that a piece of it, we think, is lost for the fiscal year, we don't get it back.

John Heinbockel - Guggenheim Securities

I mean you would get a ramp in McKesson normally, but there is not a bulky catch-up ever from this?

John Standley

That's correct. I think we believed there was going to be a transition period and there was going to be some cost associated with it. It was a cost that was a little bit difficult to quantify, and it's not an expense item on the P&L. It's coming through a lower-margin rate. But it just is more than we expected when we started this thing. But even considering kind of where we've come out, when we look at the overall benefits of the relationship, still very, very strong believers that we're headed in the right direction, even though we got a little bit of painful period to work through to get there.

John Heinbockel - Guggenheim Securities

And then lastly, I mean you guys have never quantified and you're not going to, but from where you sit today, putting the transition period aside, is it more than you thought, the same, less than you thought, say, three, four months ago?

John Standley

In line with our expectations.

Operator

Our next question comes from the line of George Hill with Deutsche Bank.

George Hill - Deutsche Bank

Frank, with respect to the planned changes and the plan mix, should we think of there being like a significant, I would call, the prior period purchase adjustment where you renegotiated payer plans somewhere I would guess between April 10th and June 5th that had to be retroactive to the quarter that drove kind of a portion of the negative revision?

John Standley

You made a bunch of leaks there that I wouldn't make. Also we have contracts negotiating all the time. So whatever that's worth, there's contract negotiations all the time. But I think what we sort of talked about is we have some contracts that are still MAC-based contracts that didn't behave well during the quarter. We have change in plan mix amongst plans in the quarter. So I'm not sure I follow the retroactive thing you said.

George Hill - Deutsche Bank

Yeah, well, I guess what I'm trying to figure out is what changed between April 10th when you guys gave the guidance for the year and June 5th when the revision was announced?

John Standley

Yeah, so a couple of things. We were hopeful, as we entered into the quarter and gave our guidance, that there were going to be some savings from our McKesson relationship that would help us manage some issues that were showing up in our numbers, more difficult reimbursement rates than we expected, some higher generic drug cost. And unfortunately, due to a number of different things, those savings were just showing up a little bit later than we expected. So we were not able to offset some of the things that were developing in the quarter in a way we thought was possible at the time we gave that guidance.

George Hill - Deutsche Bank

And I guess if we think about like the reimbursement perspective, we talk about plan specific items, with an example of that being ESI having written their contracts that they get to determine what's a generic drug, what's a branded generic, what's a branded drug and force that upon you, and like that's a term that you guys are trying to negotiate out of future contracts. I guess I'm trying to understand examples of kind of what drove the negative reimbursement pressure.

John Standley

Sure. So I'll go back to kind of two basic examples. The first one would be around some contracts, we saw more volatility than we expected. So we might have a contract where on generic drugs, there is a proprietary MAC list that PBM uses. They don't often provide us their proprietary MAC list. And so they have some flexibility to adjust generic drug cost as they go. So sometimes we have a little bit difficulty getting good insight as to how that's going to behave over time. And some of those contracts did behave well during the quarter. So that's one example of something that we saw related to generic purchasing or generic reimbursement rates.

Another situation would be we might have a contract with a PBM where we're in different plans. One is a very narrow plan. One is a medium plan and one is the broad plan. And we might see as we come through into the fiscal year gradually as there's utilization that the PBM has migrated patients from the broad plan, which has the highest reimbursement rate, to either the middle plan or the lowest reimbursement rate plan. And we call that a change in plan mix. And so we saw some of that activity as well. Those things tend to develop over time. When a plan with change goes into effect January 1st, you need utilization, you need time, you need claims to really see how these things are going to develop.

Oftentimes as we come through January/February, we don't always have great insight as to where rates are really trending in the year, because there's so much activity between patients moving between PBMs and patients moving within plans inside of PBMs. And the way PBMs are passing, reimbursement rate back to us quite honestly that it takes a little while until you get real visibility into where you are. And so you got to stir all that together and combine it with the fact that in the past, again, we would have probably been a little more active on the purchasing side in terms of driving some cost out to try and react to those things that we were unable to do in a particular timeframe.

George Hill - Deutsche Bank

And then maybe just the last quick follow-up. Is the narrow network trend then on the PBM side negatively impacting you guys, and do you guys have the scale to participate and compete against PBMs that want to draw up narrow pharmacy networks?

John Standley

I do think the narrow network thing continues to build a little bit. And I think we see it not only in our managed care plans, but also probably in Medicare Part D plans as well. And it's right back to one of the important strategic reasons why we need to be very competitive on our drug cost, which is why we started down the road on this McKesson relationship to begin with. The combined purchasing power, we think, over the long term will make us a competitive provider of solid drug prescription delivery over the long term, which is really kind of where we're going with the McKesson relationship. That's why we're there.

Operator

Your next question comes from the line of Steven Valiquette with UBS.

Steven Valiquette - UBS

So I guess in this case, I apologize in advance for a sort of granular business mechanics question, but just want to make sure I understand this. I guess the discussion on the call suggests that historically if you start to get MAC-ed a little bit, you kind of imply you can quickly go to manufacturers and buy it cheaper to partially offset this. So you are saying that temporarily you can do this under the McKesson transition. So I guess two questions would be, one, did you lose some maybe some special relationships with generic manufacturers and that's why you are a little bit handcuffed right now? But also, question number two, what will change I guess just mechanically with McKesson in the future that will allow you and McKesson again to quickly adapt to Rite Aid's specific reimbursement changes? I'm curious if some of the generic buying is just specifically tied to MAC prices. But just any extra color around this would definitely be helpful.

John Standley

Yeah, sure. So quickly is a relative term. I mean you can't do it in days, but certainly in weeks and months you can. And again, probably the difference would be as we came through the first quarter, if we saw coming out the reimbursement rates were going to be tough to the extent we had visibility to it, we would be actively in place trying to figure out why that is, why somebody MAC-ing us, is there a cost available in the marketplace to help us offset that. And we would be working that throughout the quarter. So it's not instantaneous. It's isn't reimbursement rates are low today, I want to call somebody and find the lower cost. I don't want to necessarily imply that.

But it is a bit of a hand-and-glove process that you have to work through to manage both sides of the equation to get everything to kind of work together, which right now until we make the full transition here is a little bit more difficult to do. So in terms of relationships with manufacturers, our team is working hard with McKesson to continue to build the valuable relationships that we've built over the years. And I think McKesson understands our business needs in terms of how we need to manage our business and we're hopeful that as we together with them as a team, we'll be able to achieve the savings over the long term and that we need to manage our business. How quickly we can move collectively as a team, those things will work out over time. But in the long run, we still believe strategically this is the right way to go.

Steven Valiquette - UBS

So in the future you will just have to be more aggressive on communicating with them if you are getting MAC-ed and then hopefully they can make the adjustments? Okay.

Operator

Your next question comes from the line of Carla Casella with JPMorgan.

Carla Casella - JPMorgan

You talked a bit about the working capital benefits from the new McKesson arrangement. Are you expecting working capital to be a source of cash for the year, because it looks like payables came down with the inventory this quarter causing less of a source than we would have expected.

Frank Vitrano

We got $100 million benefit from inventory. The payable was really just a timing issue in terms of from fourth quarter to first quarter here. But we do expect that we're going to get a net working capital benefit from the McKesson agreement, $150 million of which should come primarily out of the distribution centers. And then right now, we're expecting another $100 million or so that would come out of the stores.

Ken Martindale

And, Carla, we haven't guided into the details of any kind of impact that has on payables, but that $250 million is net of any payable impact.

Carla Casella - JPMorgan

And then you've talked a lot about the Affordable Care Act, but how do you expect that to impact you on the cost side? How many of your employees are eligible?

John Standley

So a couple of years ago, we really migrated our plans to a compliant structure. So we've absorbed those cost changes in our plans over the last couple of years. I don't think there's anything significant this year. By 2018, we'll have to make some further plan changes to avoid excise taxes and that kind of stuff, but it's not significant this fiscal year.

Carla Casella - JPMorgan

You talked about some of the new formats or new tests you're trying, the Fresh Day Café, enhanced beauty, how many stores are in the test for those and what's the timeframe? When you find something that works, how long does it take to roll it out to all the Wellness stores?

John Standley

That's a fairly complicated question. Some of these have application to all stores if they do well. And there are bits and pieces of some of these things that we'll roll out in all stores. Beauty is a good example. Over the last couple of years, we've fairly dramatically changed the way that we merchandise and we roll the beauty departments out. There are some things that we're rolling out backwards into other Wellness stores, like our nail bars. We've gone backwards and put them into a bunch of stores, because we saw they were very, very effective in growing that business.

Other things like some of the new merchandising displays that we've got in Beverly Hills will be more on a go-forward basis on some of the higher potential stores. So it's really a mix. It depends on what the initiative is and what the cost is to get it implemented. So it's almost an initiative by an initiative basis.

Operator

Our next question comes from the line of Karru Martinson with Deutsche Bank.

Karru Martinson - Deutsche Bank

I realize this is significantly less relevant than it used to be, but just wanted to get a sense of the script file valuations. I mean are we still in kind of the $10 to $20 range when we're out purchasing scripts?

Frank Vitrano

Yeah, I would say maybe it's inched up a little bit, Karru. So maybe it's $13 to $20 or something like that. But that's generally the range.

Karru Martinson - Deutsche Bank

And then where are these file buys coming from? I mean how much of the overall market still remains local or mom-and-pop?

Frank Vitrano

You look at the stats, there's still about 10% of kind of the total doors that are out there that are independent. And we continue to send out flyers, knock on doors. And I guess for some of these smaller guys, they are continuing to see reimbursement rate pressure and what not and deciding it's time to move on to something different. Or in some instances, come work for us.

Karru Martinson - Deutsche Bank

And when you look at some of the more regional players or some of the alternative channels, grocery stores with pharmacies and so forth, as reimbursement rate pressure rises, do you see some of these guys getting out of the business? Is that an opportunity, or is that just going to continue to be a part of their business?

Frank Vitrano

No, I mean we have seen some small changes, three or four or five grocery stores that decided to either close or get out of the business. Those have been some of the opportunities. And then there's some been K-Marts out there that are on the market. But generally, it's generally more the independents is who we're buying it from.

Karru Martinson - Deutsche Bank

And then just lastly, you guys mentioned increasing your smoking cessation programs. If you could just remind us, what's the view right now in terms of tobacco sales within the chain?

John Standley

Well, at this point, we've got a lot of our customers and patients that are currently buying tobacco products. And for whatever personal reason they had, they've made that decision. And at this point, we think that we can probably deliver the great solution for those customers when they decide to quit smoking. The one thing that we do know is the vast majority tobacco users at some point make that decision, and we think that we're uniquely positioned to deliver for those folks. So we're trying to develop a program that integrates all of the resources that we have available to us to provide them with the most extensive support system that we possibly can. So we're looking forward to rolling that out late summer, and we think it's going to be pretty exciting.

Operator

Your final question comes from the line of Karen Eltrich with Mitsubishi.

Karen Eltrich - Mitsubishi

A couple of questions. As you add these new departments and you add the MediClinics, what's coming out? How are you making room for these things and what are the categories that are kind of going to shrink?

John Standley

I think in general, it's probably consistent with what's been happening in the Wellness stores. As we look to further build out the healthcare services that we're providing to our patients back in the pharmacy area, it does put pressure on the front-end. And typically, we're growing the footprint on the front-end in health and beauty and vitamins and better-for-you foods and the things that support living a healthy lifestyle. And so it clearly puts pressure on some of the general merchandise categories and miscellaneous categories that don't as closely support that. So I think what you've seen in the Wellness stores will probably continue as the evolution rolls forward.

Karen Eltrich - Mitsubishi

Is there a potential with MediClinics to also provide dialysis services?

Ken Martindale

Not with where we're heading with RediClinic.

Karen Eltrich - Mitsubishi

And I'm sorry if I missed this, did you say how many store closures we should expect this year?

Ken Martindale

40, Karen.

Karen Eltrich - Mitsubishi

And final question. I saw this ad on TV and I thought it was an intriguing app, but GoodRx, which does pharmacy comparisons and coupons for prescriptions, and they did specifically list you guys as someone who is kind of a participant in this. Is this something that could have an impact on the industry?

John Standley

I'd have to look at that more carefully. Honestly, I'm not sure. Much of our business is insured. I just have to see what it does.

Okay. Thanks, everyone, for joining us today. I appreciate it.

Operator

Thank you. This concludes today's conference call. You may now disconnect.

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Source: Rite Aid's (RAD) CEO John Standley on Q1 2015 Results - Earnings Call Transcript
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