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Rite Aid (NYSE:RAD)

Q2 2013 Earnings Call

September 20, 2012 8:30 am ET

Executives

Matt Schroeder - Group Vice President of Strategy & Investor Relations and Treasurer

John T. Standley - Chairman, Chief Executive Officer, President and Member of Executive Committee

Frank G. Vitrano - Chief Administrative Officer, Chief Financial Officer and Senior Executive Vice President

Analysts

John Heinbockel - Guggenheim Securities, LLC, Research Division

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

Karru Martinson - Deutsche Bank AG, Research Division

Carla Casella - JP Morgan Chase & Co, Research Division

Mark Wiltamuth - Morgan Stanley, Research Division

Edward J. Kelly - Crédit Suisse AG, Research Division

Karen H. Eltrich - Goldman Sachs Group Inc., Research Division

Steven Valiquette - UBS Investment Bank, Research Division

Joseph Stauff - Susquehanna Financial Group, LLLP, Research Division

Jason DeRise - UBS Investment Bank, Research Division

Operator

Good morning. My name is Kimberly, and I will be your conference operator today. At this time, I would like to welcome everyone to the Rite Aid Second Quarter Fiscal 2013 Conference Call. [Operator Instructions]

Mr. Matt Schroeder, you may begin your conference.

Matt Schroeder

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

On today's call, John will give an overview of our second quarter results and discuss our business. Frank will discuss the key financial highlights and fiscal 2013 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, including annual earnings and sales guidance, on our website, www.riteaid.com, under the Investor Relations Information tab for conference calls. This guidance is a point-in-time estimate made early in the fiscal year. 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 will find them helpful, as they summarize some of the key points made on the call.

Before we start, I'd like to remind you that today's conference call includes certain forward-looking statements. These forward-looking statements are made in the context of certain risks and 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.

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

John T. Standley

Thank you, Matt, and thank you all for joining us this morning to review our fiscal 2013 second quarter results. We are pleased with our results for the quarter as we continue to make significant progress in our turnaround efforts. We have continued strong growth in front end, same-store sales and prescription count. We have also grown adjusted EBITDA and same-store prescription count for 7 consecutive quarters thanks to our chain-wide focus on executing key sales initiatives, operating more efficiently and providing a superior customer experience.

Our adjusted EBITDA was $218.7 million for the quarter, an increase of $34.4 million or 19% year-over-year. We also decreased net loss by $53.5 million compared to the second quarter of last year. Loss per share improved from $0.11 per share in the prior year second quarter to $0.05 per share this quarter. Same-store sales were flat due to a 1.4% increase in front end, offset by a 0.7% decrease in the pharmacy. Prescriptions filled at same stores increased 4% over the prior year period, which includes the benefit of additional prescriptions resulting from the Express Scripts/Walgreens dispute.

A key trend during the quarter was the impact of new generic medications. This wave of generics has negatively impacted top line pharmacy sales by approximately 750 basis points. This is compared to a negative impact of approximately 148 basis points during last year's second quarter. At the same time, these new generics are having a positive impact on pharmacy gross margin, which has been a key driver for increasing adjusted EBITDA. Our generic penetration grew to nearly 80% during the quarter, a 4% increase over last year's second quarter, and we continue to work diligently to contain generic drug purchasing cost.

Another key development was the continued success of our flu immunization program. Since flu shots arrived in our stores in late July, our teams have done a great job of reaching out to our customers in communities to promote how convenient it is to get a flu shot at Rite Aid. We are already well ahead of last year's pace, and our goal is to administer 2 million flu shots this year compared to nearly 1.5 million last year.

Our pharmacy and store teams are highly engaged in their communities, raising awareness of our Flu Shot program. We also will be supporting our flu immunization efforts with a comprehensive marketing campaign that includes TV and radio ads.

Our wellness+ customer loyalty program continues to have tremendous impact on our business. At the end of the quarter, we had approximately 25 million active members defined as those who have used their card at least twice in the past 6 months. This represented an 8% increase over the prior year. While total active members have remained consistent with the end of our first quarter, the number of gold and silver members, our most valuable and most satisfied customers, continues to increase.

Card usage continued to be strong as wellness+ members accounted for 74% of front end sales in the second quarter compared to 69% in the prior year period. Members also accounted for 68% of prescriptions filled, up from 67% in last year second quarter.

We believe that our award-winning wellness+ program continues to be the most robust customer loyalty program offering in our industry, providing customers with an unparalleled combination of wellness and savings benefits. And we continue to find new ways to make this innovative program even better. Earlier this month, we launched a new feature that loads +UP rewards directly to the card of wellness+ members who earn them. This new Load2Card feature is an added convenience for our members, who no longer have to remember to bring receipts back to the store to redeem their +UPs. We will continue to strengthen wellness+ in order to attract new customers while keeping it fresh and relevant for our most loyal shoppers. We also have an extensive marketing campaign planned for the second half of the year that reinforces the incredible value that our wellness+ program provides.

Also in the second quarter, we continued to convert additional stores to our innovative new Wellness store format. We converted 147 stores during the quarter, and we now have a grand total of 570 Wellness stores. We remain on pace to convert about 500 stores during the fiscal year, which will increase our total to 780 Wellness stores. We now have 815 trained Wellness Ambassadors to work on our stores and are pleased with how these associates are providing a level of service that differentiates us from the competition. We continue to see a positive impact on our front end sales in these stores compared to the rest of the chain.

The Wellness store format is another area of our business that we are constantly looking to refine. We have recently made significant enhancements to the format, which were reflected in a recently remodeled Wellness store located in the Harrisburg market. This remodeled store features new interior decor, additional Wellness items and unique merchandising presentations. We are receiving tremendous feedback from customers. It's the latest example of how this innovative store format will continue to evolve as we look to deliver the right mix of products, services and convenience to our customers.

Our new and improved Rite Aid brand architecture continued to gain traction in the second quarter as customers take advantage of the value offered by private brand items. Private brand penetration was 18.4%, an increase of 1.2% over the prior year period. Also during the quarter, we completed $11 million in prescription file purchases.

As we look forward, maintaining the new patients we receive due to the ESI/Walgreens dispute will certainly continue to be a top priority, and rolling these patients into the wellness+ program has been a key focus for our store teams. And we believe that the tremendous value we offer through the program will give our customers a compelling reason to keep their business at Rite Aid.

As we work diligently to continue to provide a superior customer experience for all of our customers and patients, we are also implementing a comprehensive and targeted communication plan to reinforce the full value that we offer, including wellness+ and an outstanding neighborhood pharmacy experience.

Before I wrap up, I'd like to acknowledge that we recently celebrated our company's 50th anniversary on September 12. We are commemorating this significant milestone by hosting 50 “Acts of Wellness” in major Rite Aid markets across the country to recognize Rite Aid's long-standing tradition of providing personal health care services, health and wellness products and community partnerships. We launched our special RA50 campaign here in the Harrisburg, PA market last week by hosting a wellness fair for state employees at the capital. Rite Aid associate teams also visited the Harrisburg public schools and restocked the nurses' offices throughout the district with wellness and first aid supplies.

At Rite Aid, we're proud of our strong tradition of providing personal service and supporting health and wellness in the communities we serve. We think the RA50 campaign is a perfect way to thank the many communities that have helped us grow throughout the years.

With that, I'll turn it over to Frank, but I'd just like to say that I'm proud of the hard work that our entire Rite Aid team continues to put forth as we look to deliver a one-of-a-kind drugstore experience to our customers and patients.

Frank?

Frank G. Vitrano

Thanks, John. Good morning, everyone. As John mentioned, the second quarter front end sales, script growth and earnings were strong, reflecting good progress in our turnaround and the benefit to the various initiatives we have been working on as well as new ESI business. This is the seventh consecutive quarter of EBITDA growth, and we continue to grow our front end sales and pharmacy scripts.

On the call this morning, I plan to walk through our second quarter financial results, discuss our liquidity position, certain balance sheet items, our capital expenditure program and finally, update fiscal '13 guidance.

Previously reported, revenues for the quarter were $6.2 billion, which was $40 million or 65 basis points lower than last year's second quarter. The decrease was primarily due to higher percent of generic sales. In the quarter, we closed 9 stores and did not open any net new stores. On a year-over-year basis, we operated 54 net fewer stores.

Same-store sales were flat in the quarter, reflecting the positive impact of wellness+, a new ESI business, offset by a much higher generic penetration rate.

Front end same-store sales were up 140 basis points, and pharmacy same-store sales were lower, 70 basis points. Pharmacy same-store comp scripts were positive 400 basis points, primarily driven by new ESI script growth. Pharmacy same-store sales were positively impacted by strong script growth, but included an approximate 750 basis points negative impact from new generic drugs. We expect the negative sales impact of new generic drugs to increase even further in the third quarter.

Adjusted EBITDA in the quarter was $218.7 million or 3.5% of revenues, which was a $34.4 million or 19% higher than last year's second quarter of $184.3 million or 2.9% of revenues. Overall results were driven by favorable front end sales, script growth and improved gross margin trends, partially offset by higher SG&A. New incremental ESI adjusted EBITDA benefit in the quarter is estimated to be $18 million to $22 million. We continue to believe we receive our fair share of new ESI scripts.

Net loss for the quarter decreased to $38.8 million or $0.05 loss per diluted share compared to last year's second quarter net loss of $92.3 million or $0.11 loss per diluted share. The net loss improvement was driven by higher adjusted EBITDA, a lower LIFO charge of $11.2 million, lower lease termination and impairment charge of $7.3 million as well as lower depreciation and amortization expense of $6.7 million.

Total gross profit dollars in the quarter were $61.5 million higher than last year's second quarter and 116 basis points higher as a percent of sales. FIFO gross margin dollars were higher by $50.2 million or 98 basis points.

Adjusted EBITDA gross profit, which excludes specific items, primarily LIFO and wellness+ revenue deferral, the details of which are included in the second quarter fiscal '13 earnings supplemental information which you can find on our website, was favorable to the prior year second quarter by $47.9 million and 94 basis points as a percentage of revenues.

Front end gross profit was lower, driven by higher-tier discount investments related to the wellness+ customer loyalty program and higher ad markdowns, partially offset by strong Rite Aid brand penetration.

Pharmacy gross profit dollars and rate were both higher due to script count growth and the benefit of new generics, partially offset by continued pharmacy reimbursement rate pressure.

Selling, general and administrative expenses for the quarter were higher by $14.4 million or 40 basis points as a percent to revenues compared to last year. Adjusted EBITDA SG&A dollars, again, which excludes specific items, the details of which are included in the second quarter earnings supplement information package, were higher by $13.5 million or 37 basis points as a percentage of revenues. The increase in dollars reflects wage and benefit increases as well as higher layer cost associated with incremental pharmacy hours with the added script volume and costs associated with the Wellness remodel program, partially offset by lower holiday pay, as Memorial Day fell in the first quarter of fiscal '13 but was in the second quarter of fiscal '12. Without the Memorial Day shift, adjusted EBITDA would have increased 13%.

Turning to the balance sheet. FIFO inventory was $91.9 million lower than the second quarter of last year and $88.2 million lower than the fourth quarter of '12. Relative to the second quarter of last year, the decrease reflects more generic inventory, which is valued at a lower cost, and inventory reduction initiative. Our cash flow statement results for the quarter showed net cash from operating activities in the quarter as a use of $32.9 million as compared to a use of $131 million in last year's second quarter.

Higher payable this year as well as higher inventory last year influenced the balance. Net cash used in investing activities for the quarter were $72.7 million versus $49 million last year and also includes proceeds from script files sales. During the second quarter, we relocated 4 stores, remodeled 147 stores and closed 9 stores. We have now completed and grand-reopened 570 Wellness remodel stores and expect to have 780 completed by fiscal '13 year end. Front end sales in the remodeled stores continue to improve above the chain average.

Now let's discuss liquidity. At the end of the second quarter, we had $1.05 billion of liquidity. We had no revolver borrowing under our $1.175 billion Senior Secured Credit facility with $125 million of outstanding letters of credit. Today, we have $1.256 billion of liquidity. Total debt net of invested cash was lower by $32 million from last year's second quarter. Our leverage ratio, defined as total debt less invested cash over LTM adjusted EBITDA, improved to 6.2x from 7.1x.

Now let's turn to fiscal '13 guidance. We're updating our guidance based on current sales trends and SG&A cost increases, the benefits of new generics, a challenging reimbursement rate environment, continued investment in our customer loyalty program to grow sales as well as an assumption that we will retain a portion of the ESI scripts.

We also expect to incur additional costs to retain the ESI business. The company expects total sales to be between $25.1 billion and $25.4 billion and expects adjusted EBITDA to be between $965 million and $1.025 billion in fiscal '13. Same-store sales are expected to be in the range from a decrease of 100 basis points to an increase of 25 basis points, which reflects the anticipated negative pharmacy sales impact of approximately 650 basis points from new generic introductions and continued reimbursement rate pressure.

Net loss for fiscal '13 is expected to be between $196 million and $69 million or a loss per diluted share of $0.23 to $0.09.

Our fiscal '13 capital expenditure plan remained at $300 million, with $140 million allocated to remodels and $50 million to file buys. We are planning to complete 13 relocations and remodel 500 Wellness stores. We expect to be free cash flow positive for the year. We expect to close a total of 50 stores, of which the guidance includes a store lease closing provision to close 20, with the balance of the stores closing on lease expiration.

This completes my portion of the presentation. I'll now open the lines to questions. Thank you. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of John Heinbockel with Guggenheim Securities.

John Heinbockel - Guggenheim Securities, LLC, Research Division

So on the new wellness+ prototype, I guess you would call it, what is the cost, and how would the expected front-end lift compare to the older version?

John T. Standley

Well, the prototype costs more, as prototypes usually do. And I think after we engineer it down, it'll probably still be more expensive than the current prototype stores, so we may not use it in every location that we do a Wellness store in. In terms of the sales lift, we have it in one store, John, and that's comping very well. But we would expect it is going to get a better comp than what we're getting in the existing Wellness store.

John Heinbockel - Guggenheim Securities, LLC, Research Division

So is the idea to do this in higher-volume, higher-potential stores?

John T. Standley

It is. It is. We're going to probably stratify the locations that we're remodeling a little bit based on some different criteria, and it'll go in some locations, but not all. And then I think there'll be variations of it that work into the rest of the Wellness stores.

John Heinbockel - Guggenheim Securities, LLC, Research Division

Would you -- is there a way to spend a little less -- so spend a little more on the high-potential location, spend a little less on the other ones and get a better return?

John T. Standley

That's basically the idea.

John Heinbockel - Guggenheim Securities, LLC, Research Division

Okay. All right. Secondly, if I think about your guidance, I don't know if you want to say, but embedded in that is what assumption for ESI retention? Do you have an idea?

John T. Standley

Frank, I'll let you handle that.

Frank G. Vitrano

John, the range, the $60 million range, and basically what we're saying here is on the low end of the range, we're expecting to retain less of the ESI customers and probably have a higher reimbursement rate, see higher reimbursement rate pressures. And to the high end of the range is an expectation here that we're going to retain a pretty good portion of those ESI customers as well as see better impacts from new generics. And that's basically the range. We're not going to necessarily pinpoint a number for you, but that's kind of the spread.

John Heinbockel - Guggenheim Securities, LLC, Research Division

All right. And then, as I recall, I don't think this changed, the litigation charge from the first quarter is included as a negative to that guidance. Is that right?

Frank G. Vitrano

It's included in our guidance. That's correct, John.

John Heinbockel - Guggenheim Securities, LLC, Research Division

All right. And then finally, when you -- the ESI benefit, is there an indirect benefit in there from -- are you including the front-end purchases that you make? And then if they sign up to be Silver and Gold customers -- become Silver and Gold customers, the benefits you'd get from that? Or is it just purely the pharmacy benefit?

John T. Standley

They're in our run rate, John, so they're reflected in our guidance the way they've been behaving. That's our -- what we built our expectations around in the guidance.

John Heinbockel - Guggenheim Securities, LLC, Research Division

So it's largely pharmacy, but there's a little front end in there as well.

John T. Standley

There is front-end benefit.

Operator

Your next question comes from the line of Matthew Fassler with Goldman Sachs.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

So 2 questions. First of all, as we look at the penetration of wellness+ relative to front end and relative to script growth, if I'm reading my numbers right, this was the first period when you had -- actually not the very first period, but I think there was a sequential decline in front-end penetration and in script growth for the first time in a while. How do you think about the maturation curve of these programs? And are there ways for you to extract economic benefits from ongoing penetration if these numbers are sort of hitting their plateau?

John T. Standley

Yes, I think the program, it's 2-plus years into it, 2.5 years into it, I think it is maturing. We are out, I think we're going to be out aggressively continuing to explain the benefits of the program to try and attract new customers with it. It's definitely helping us retain existing customers, I mean, you can see comp store sales have behaved very well here, both front end and pharmacy. And we definitely have a very significant opportunity to continue to work with our existing customers to grow their relationship with us.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

Okay. And then second question, you addressed reimbursement to some degree. Can you give us your updated thoughts on where you think that is heading? And in particular, are you seeing reimbursement pressure move directionally in any way with generic penetration, which is clearly or seems to be surprising to the upside and having a very nice impact on profitability?

John T. Standley

Yes, I think we're going to continue to see reimbursement rate pressures coming from a variety of different directions. We got a lot of government things going on that could impact us, and the third-party business remains very competitive. And I think as the newer generics mature, they're going to continue to be under pressure as their costs decline. And our challenge is to make sure we keep our costs as low as we can as those rates come off.

Operator

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

Karru Martinson - Deutsche Bank AG, Research Division

When we look at the ESI gains that you have now, you had 2 quarters here running around $20 million. So the total if we were looking at it would be about $80 million benefit right now if you were to retain everybody. Correct?

John T. Standley

Yes.

Karru Martinson - Deutsche Bank AG, Research Division

Okay. And then when we look at the year-ago flu season, that was with the warm winter. That was a soft season, correct?

John T. Standley

Yes. I think it was. Generally, I saw -- it was a very late season, I'll tell you that, yes. And probably softer, yes.

Karru Martinson - Deutsche Bank AG, Research Division

All right. And then when we look at the wellness+, certainly recognizing 2.5 years, we're kind of hitting a maturation point. But do you feel when you look at kind of like the wallet spend of your member, what's the opportunity to increase that going forward?

John T. Standley

Well, that's really what we think is kind of the untapped opportunity for us in the program. We've been working hard to develop those relationships with customers and develop our ability to understand those relationships and appeal to the needs of our customers. But we're still very early in that process. And so we have a lot of work to do. And so we think that's one of our very large ongoing opportunities as we look forward.

Karru Martinson - Deutsche Bank AG, Research Division

Okay. And just lastly, certainly an expensive capital structure for parts of it that were put in very different times in your history. Some of that has become callable. What's the mindset here for how you guys will address your capital structure going forward?

John T. Standley

Karru, I mean that's -- we're always kind of looking at what's happening. Obviously, in the first half for the year, we completed 2 transactions. We don't have anything coming due now to '16 from a first- and second-lien perspective. And that's really something that we're looking at what the rate we think we can get versus what the call premium is going to be. Obviously, that does step down next year. Those are just some of the things that we're looking at and thinking about. With regard to our tranche 2 term loan, again, that comes due in June of '14, and that's something that we'll look to address probably at the beginning of next year.

Operator

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

Carla Casella - JP Morgan Chase & Co, Research Division

One just housekeeping item. Your LIFO forecast for the year is still $60 million to $90 million. I didn't see any change there.

Frank G. Vitrano

No, it isn't. It's $40 million to $70 million...

John T. Standley

$40 million to $70 million.

Frank G. Vitrano

$40 million to $70 million, Carla.

Carla Casella - JP Morgan Chase & Co, Research Division

Okay. Sorry about that. And then now that we've had generics ramping up for a few months now, can you just talk about the generic pricing cycle and if you're seeing any change? I think on the last 2 calls, you've been talking about the best profitability coming in the first 6 months of a generic. Is that still the same, or is that shortening or lengthening at all?

John T. Standley

Yes, we haven't -- I think that didn't come from us. What we have tried to explain to folks is that because of some contract structures we have, our generic profitability is probably a little more evenly spread across the first year. And so we have some contracts that are more profitable in the first half of a drug's life cycle and some where it's more profitable in the second half, depending on the contract structure. And we kind of have a blend of contracts that sort of even it out over time. And that seems to be remaining fairly consistent. I don't know if that was helpful or not.

Carla Casella - JP Morgan Chase & Co, Research Division

Okay, great. Yes, I know, that is, thank you for clarifying. And then on Walgreen, we saw the $25 gift card to get people to come back into the store. You mentioned marketing up in the back half. I'm sorry, you mentioned marketing for that competition in the back half. Are you increasing the marketing budget or just shifting it from one thing to another? I'm just trying to clarify what the marketing in the back half is for and whether it's going to be up or not. The wellness+ focus, is it more focused on attracting back customers?

John T. Standley

It's really focused on a couple of different -- it is up in the back half. We're going to be out with our flu program, and so we're making some investments from a marketing perspective there. We're going to be -- we talked a little bit about the maturation of wellness+, and so we're going to be out really trying to make sure everybody understands how wellness+ works and the value of it, because we think it is the strongest program in the marketplace. And then, obviously, we're going to do what we need to do to protect our business from competitive threats. So we will be -- marketing budget is up, and we will be out there in the back half of the year.

Carla Casella - JP Morgan Chase & Co, Research Division

And you haven't quantified how much it's going to be up?

John T. Standley

No. It is included in our guidance.

Operator

Your next question comes from the line of Mark Wiltamuth with Morgan Stanley.

Mark Wiltamuth - Morgan Stanley, Research Division

I wanted to ask on the reimbursement rate pressure issue. You kind of alluded to that in your sales guidance a little bit there. Has anything been changing there? Because in the past, it sounded like that environment was at least stable.

John T. Standley

I think -- one factor I know and reflected in the guidance, Frank, is just this very strong generic penetration, and the deflationary impact is probably a little greater than we expected. And some of that's mix and some of that is just reimbursement rate pressure. So I wouldn't say there's any dramatic change in the environment, but it's just a continued sort of tightening that we feel in our business.

Mark Wiltamuth - Morgan Stanley, Research Division

And just to add a little bit to the generic commentary, where do you think we are in terms of being in the peak period of margin? And how long does that extend as we roll through the generic wave? Because it sounds like the volumes of generics are still coming to be greater in the second half.

John T. Standley

Yes. Most of the big launches were actually in the first half of the year. We got a couple of stragglers that will come in, in the back half. But when you think about the way they sort of waterfall out, we're going to clearly see some good benefit in the back half of this year and I think into the beginning part of next year. But as we get into the later part of next year, that's when there's probably going to slow down quite a bit in terms of the impact.

Mark Wiltamuth - Morgan Stanley, Research Division

Okay. And then you're talking fiscal years or calendar years there?

John T. Standley

Our fiscal years.

Mark Wiltamuth - Morgan Stanley, Research Division

Okay. And as you're looking at that Express customer base that you've retained so far, what percentage of the Express customers are on the wellness+ program?

John T. Standley

It's very similar to the total program in terms of the penetration that we achieved.

Mark Wiltamuth - Morgan Stanley, Research Division

Okay. And at this point, does it look like the battle for those Express customers is more one along the lines of loyalty card activity, or do you think there's going to be anything in-store in terms of discounting?

John T. Standley

I think there'd be a lot of different activity out there. I'm not sure which way this is all headed. We'll have to see how it sort of develops. For us, we believe in the strength of our program, and getting people enrolled and getting engaged with the program and providing them value through the program is really a direct way that we can communicate with our patients and our customers. So we think that's, for us, important part of the whole thing.

Mark Wiltamuth - Morgan Stanley, Research Division

Okay. And you'll probably communicate directly with those that are Express customers, is that fair to say?

John T. Standley

We -- yes, we communicate directly with all of our customers. But we'll be thinking about those Express customers quite a bit.

Operator

Your next question comes from the line of Edward Kelly with Crédit Suisse.

Edward J. Kelly - Crédit Suisse AG, Research Division

So a few questions for you. Can you maybe start off with the gross margin? And on the front end, maybe talk a little bit about the decline in the front end related to the investment in the loyalty card and exactly what's going on, on that front. What is that investment related to? And does any of it -- does any of it pertain to new Walgreens customers?

John T. Standley

Yes. So I think on the front end, there's a few different factors that impacted gross margin. Obviously, the -- when you look at the year-over-year increases that we see in the penetration on the loyalty card, that's reflected in the tiered discounts. So you have that showing up in the gross margin numbers as the program is maturing on a year-over-year basis. So that's a piece of it. Clearly, as we brought more customers into the program and grew it sort of in totality, that grows the tiered markdown as well. There were slightly higher ad markdowns and some other discounts in the quarter as well and some other factors in the front end gross margin. But those are the big components.

Edward J. Kelly - Crédit Suisse AG, Research Division

All right. And then could you maybe give us a little bit more color on how you end up retaining Walgreens scripts? Maybe start with how sticky do you think the scripts will be just naturally to start. What are some of the things that you can do to ensure that you keep them? And what do you think they'll see from Walgreens other than $25 gift cards and a lot of advertising?

John T. Standley

I can't -- I certainly can't comment about Walgreens, what Walgreens is going to do. That's a great question for Walgreens. They're a great competitor. I know they're going to work hard to do what's right for their business. What we're doing is we are communicating with our customers and patients through wellness+, trying to engage them in a dialogue. We've communicated with them in the pharmacy. We've communicated them -- with them through some other means. And we've provided, I think, a great value offering for those patients. And I think we've worked really hard to provide great service over the last several months. And we hope the combination of those things will encourage those patients to stick with us.

Edward J. Kelly - Crédit Suisse AG, Research Division

One of your competitors, not named Walgreens, is optimistic about the amount of scripts that they'll end up keeping. Is that a fair way to characterize how you think about -- not trying to put words in your mouth, but are you optimistic? Are you pessimistic? I mean, are you bound like -- how should we think about it?

John T. Standley

Well, we're working really hard, and we're going to do our best to keep all the patients we can. And so we feel good about what we're going to do, and I hope we can retain a good portion of these patients. I know we're getting a lot of questions around how much you're going to retain or how do you feel about it. One thing that's a little bit different than us compared to some of our other competitors is we are going to provide you monthly report card, monthly sales, you're going to see exactly what's going on, which is why we don't feel as much pressure to probably put a stake in the ground here. You're going to see how it evolves as it plays out.

Edward J. Kelly - Crédit Suisse AG, Research Division

How long do you think it is before we have a report card on it? Do you think by the end of the year, a lot of the movement that's going to take place happens, or is it longer than that?

John T. Standley

I would think that's a reasonable time frame to see kind of how things shake out. Again, I don't know what Walgreens will do. So let's see how it sort of plays out.

Edward J. Kelly - Crédit Suisse AG, Research Division

Do you have any sense as to how many plans will continue to exclude Walgreens? I mean, we know the DoD is there. I mean, not naming names, but do you know of other contracts that are going to be along those same lines?

John T. Standley

We do, but that's really a question for Express Scripts or Walgreens. I don't think I can answer that question contractually, but. . .

Edward J. Kelly - Crédit Suisse AG, Research Division

Is it a material number?

John T. Standley

I'm a little nervous going there.

Edward J. Kelly - Crédit Suisse AG, Research Division

All right. And the last question for you on the -- just getting back to the gross margin in the pharmacy, if we didn't have this pickup in generics, what do you think the gross margin in pharmacy would be doing right now? Because I've heard the term reimbursement rate pressure numerous times on the call. Clearly, that's a longer-term issue. But I'm just curious as to if we didn't have the wave right now, what would the gross margin in pharmacy look like?

John T. Standley

We would probably be down. Having said that, I don't know if some of the reimbursement things that are going on would be as aggressive as they are if we didn't have the new generics. It's hard to split the 2 apart a little bit. Because I think it's obviously been a lot of discussion around who should benefit from the profitability of new generics, right?

Operator

Your next question comes the line of Karen Eltrich with Goldman Sachs.

Karen H. Eltrich - Goldman Sachs Group Inc., Research Division

You mentioned penetration trends with the wellness+ Gold, Silver. What are you seeing in terms of frequency of shopping as well as average check? And how does that compare to the store average -- sorry, to the company average?

John T. Standley

It's -- they're much more frequent. We see about half of those Gold and Silver customers every week. The basket size is in total or 40% to 50% larger than the non-Wellness members, so it is a significant factor. And they are clearly our best customers, and they -- that's all [ph] very highly and make a good portion of our sales.

Karen H. Eltrich - Goldman Sachs Group Inc., Research Division

And are you seeing that trend upwards generally as people get more familiar with the program?

John T. Standley

We are.

Karen H. Eltrich - Goldman Sachs Group Inc., Research Division

Great. And you've talked a lot about the Wellness remodel programs. One thing we haven't heard about for a while is the discount format. Is that still in the cards, and how does the return on -- and if so, how does the return on capital for those remodels compare?

John T. Standley

Yes, that's still in the cards. Those stores are actually doing pretty well. Probably like most organizations, we're kind of focused on the wellness format right now, so we slowed down the efforts on the value stores and really shifted a lot of our energy into the wellness format, which will continue to be the case for the next year or so. We are continuing to work with it a little bit. And you'll hear us talk about some additional concepts probably over the next couple of quarters, as we have a couple of newer things we're going to bring to the marketplace probably in the next 6 to 9 months.

Karen H. Eltrich - Goldman Sachs Group Inc., Research Division

Great. And final question, following up on the increase in marketing, how is that going to split between digital print media? And as in you've had the loyalty card for a couple of years, you've built quite a database. How much can you exploit that?

John T. Standley

That -- well, that opportunity, I think, as we said is very significant for us. But we're pretty young in that process and building capabilities as we go. But I think there's a lot of opportunity for us to continue to build those relationships with our customers. In terms of the spending in the back half, I don't really want to break it out, per se. But we're going to make an appropriate investment for the things that we want to do.

Karen H. Eltrich - Goldman Sachs Group Inc., Research Division

Is it safe to say that you'll be touching all 3 areas?

John T. Standley

Yes.

Operator

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

Steven Valiquette - UBS Investment Bank, Research Division

So your current contract with the primary drug wholesaler expires in April of '13. So I guess assuming that you have not negotiated the new contract yet, just curious, is this something that you plan to negotiate directly with McKesson on the Renewal, or are you considering doing a full RFP with all major wholesalers for this go-around?

John T. Standley

Yes, we're working to that process right now. And I think we'll have more to talk about in another couple of months, right?

Steven Valiquette - UBS Investment Bank, Research Division

Okay. Well, just the way that you approach it, though, is there a change in your policy or approach on the way you're negotiating this one versus the way you've done it previously, or...

John T. Standley

No, no. We generally use an RFP process, and that's consistent with where we are now.

Operator

Your next question comes from the line of Joe Stauff with Susquehanna.

Joseph Stauff - Susquehanna Financial Group, LLLP, Research Division

Two questions. Are you able to give us a breakdown in terms of percentage of gross profit, the quarter they came from, your front end versus pharmacy?

John T. Standley

Yes, Frank, I think you gave the increased numbers.

Joseph Stauff - Susquehanna Financial Group, LLLP, Research Division

I'm sorry, I think missed it, then.

Frank G. Vitrano

What we said was that front end was down -- front end gross profit was down and that pharmacy was up. And the total GP increase was $48 million.

Joseph Stauff - Susquehanna Financial Group, LLLP, Research Division

And I'm sorry, did you give the split versus the 2 buckets?

Frank G. Vitrano

We did not. We did not quantify it.

John T. Standley

But we said that -- we said the increase came out of pharmacy.

Frank G. Vitrano

The increase was all pharmacy. Front end was down.

John T. Standley

So that kind of should get you to where you want to go.

Joseph Stauff - Susquehanna Financial Group, LLLP, Research Division

Okay. And just kind to of zoom out quickly, the headwind from generic for the year, obviously you're guiding to about 650 basis points. I think you started the year, you're around 500. Can you just talk about some of the drivers that, as you reconcile the generics and why it's so much stronger than anticipated, obviously, for you and for your competitors, what is driving that just generally, do you think?

John T. Standley

I think versus our expectation, I would say costs have been -- we've seen some lower costs than we expected, which led to lower reimbursement rates. Not necessarily lower profitability, but lower reimbursement rates. And that, combined with pretty solid penetration, maybe slightly higher than we expected, those 2 factors have increased the deflationary impact versus our original expectation.

Operator

Your final question comes from the line of Jason DeRise with UBS.

Jason DeRise - UBS Investment Bank, Research Division

It's Jason DeRise, UBS. I know you took Steve's. So I'll -- he obviously did the drug side, I'll do the retail side. In terms of the gross margin, obviously we're talking a lot about the generics and then the competition on the front end. Do you think your gross margin percentage is going to be up or down versus Q2 in the back half of the year?

John T. Standley

We would expect it to be up.

Jason DeRise - UBS Investment Bank, Research Division

Okay. And then in terms of the phasing in Q3, you did say that the generics were going to accelerate. I guess, to go back to the guidance, they're going to fade a bit in Q4. What is the impact of that as it starts to roll over?

John T. Standley

I think what we were really talking about was into next year. Had some conversation about the -- where we were in the generic way, we feel pretty good about the impact for this year and how it'll play out through this year. But we see it slowing down next year.

[Technical Difficulty]

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