Last week, Rite Aid (RAD) reported a Q2 loss of five cents per share, which was a significant improvement over the prior year Q2 loss of 11 cents per share. This exceeded the consensus estimate for a loss of seven cents per share. While revenue declined, this was primarily the result of the introduction of new generic drugs, which are cheaper but have a higher margin than brand name drugs. The company also updated its full-year guidance, slightly raising its earnings and EBIDTA targets.
While Rite Aid posted a decent quarter (at least by its own low standards), I expect the company to continue limping along on the edge of bankruptcy for the foreseeable future. Any downturn in business, either from competitor actions or from the macro environment, could send the stock to zero. In March, Rite Aid shares briefly jumped above $2 on speculation that Walgreen (WAG) might purchase the company to gain leverage in its dispute with Express Scripts (ESRX). At the time, I wrote that Walgreen was highly unlikely to purchase Rite Aid because of the latter's high debt load and lack of profitability. I therefore recommended selling or shorting Rite Aid stock.
Since then, Rite Aid shares have declined by nearly 40%, and have been trading in a range from $1.20 to $1.40 over the summer. Furthermore, the rumor that Walgreen might come riding to Rite Aid's rescue has been definitively squelched. First, Walgreen announced in June that it would pay $6.7 billion to take a 45% stake in European pharmacy chain Alliance Boots. Walgreen also has an option to buy Alliance Boots outright in 2015. After making such a large acquisition, Walgreen clearly will not have the ability to acquire Rite Aid (let alone the interest). Second, Walgreen and Express Scripts settled their long-running dispute in July, and Walgreen began filling Express Scripts prescriptions again as of September 15. With a multi-year agreement locked up, Walgreen does not need to acquire another U.S. drugstore chain to prevent customer defections.
Rite Aid will thus be forced to find its own way to profitability. However, while the company is projecting adjusted EBIDTA of roughly $1 billion for this year, roughly half of that figure goes to cover interest payments on the company's more than $6 billion of debt. This heavy debt load also creates a drag on Rite Aid's ability to invest in its stores. Recently, the company has been rolling out a new "Wellness" store format, and management claims that these stores have been outperforming the company average in sales growth. Rite Aid plans to convert 500 stores to this new format in the current fiscal year. However, at that rate the company will not have converted its full store base until early 2020! Unfortunately, between the company's high debt level and modest cash flow, there is little room to increase the pace of remodeling activity.
Rite Aid has over $1 billion in liquidity today, so there is no immediate risk of bankruptcy. However, over the next several years, there is a good chance that the company will be forced to file in order to lighten its debt load and get a fresh start. During that time period, Rite Aid will face increasing competitive pressure, particularly from Walgreen. Much of Rite Aid's improved performance this year was the result of gaining pharmacy customers from the Walgreen-Express Scripts dispute (mentioned above). However, these customers can now return to filling their prescriptions at Walgreen if they prefer to do so. Inertia will help Rite Aid maintain some "conquest" customers, but many Express Scripts customers probably preferred Walgreen for a reason (more convenient, better shopping experience, etc.). Transferring prescriptions is not very difficult, and is not enough of a barrier to constitute a "moat" for Rite Aid.
Perhaps more importantly, Walgreen just rolled out a loyalty program last week, called Balance Rewards. By contrast, CVS (CVS) has had a loyalty program for more than a decade, and Rite Aid's wellness+ card is more than two years old. Walgreen has nearly twice as many stores as Rite Aid, and its new loyalty program will encourage customers to do more of their shopping at Walgreen in the future. The new loyalty card may actually help Walgreen to recapture a lot of the business it lost to Rite Aid during the Express Scripts dispute.
It's not yet clear what impact these recent developments will have on Rite Aid's sales and earnings. However, Rite Aid can barely make ends meet as things stand, and just a small loss of business to Walgreen could nullify the company's turnaround efforts. Therefore Rite Aid remains a sell or short even at the current depressed share price. CVS and Walgreen are much better options for investors looking for solid returns in the pharmacy sector.