Rite Aid's (RAD) CEO John Standley on Q3 2015 Results - Earnings Call Transcript

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Rite Aid Corporation (NYSE:RAD) Q3 2015 Results Earnings Conference Call December 18, 2014 8:30 AM ET

Executives

Matt Schroeder - Group Vice President, Strategy, Investor Relations and Treasurer

John Standley - Chairman and CEO

Ken Martindale - President and COO

Darren Karst - Chief Financial Officer

Analysts

Lisa Gill - J.P. Morgan

Edward Kelly - Credit Suisse

George Hill - Deutsche Bank

Mark Wiltamuth - Jefferies

Robert Jones - Goldman Sachs

John Heinbockel - Guggenheim Securities

Ross Muken - Evercore ISI

Charles Rhyee - Cowen and Company

Steven Valiquette - UBS

John Ransom - Raymond James

Meredith Adler - Barclays

Operator

Good morning. My name is Angie, and I will be your conference operator today. At this time, I would like to welcome everyone to the Rite Aid Third Quarter Earnings 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, Angie, and good morning, everyone. We welcome you to our third quarter conference call. On the call with me are John Standley, our Chairman and Chief Executive Officer; Ken Martindale, our President and Chief Operating Officer; and Darren Karst, our Chief Financial Officer.

On today's call, John will give an overview of our third quarter results and discuss our business. Ken will give an update on some of our key initiatives. Darren 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. 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 third quarter of fiscal 2015. A key highlight was our 5.4% increase in total same-store sales, which was driven by a 4.5% increase in same-store prescription count.

Continuing the trends we’ve seen throughout the year, our script count was fueled by higher utilization in Medicaid expansion states and the success of our various pharmacy initiatives. We also benefited from an increase in flu shots administered during the quarter.

As we generated topline momentum, we also did a good job of managing expenses to effectively leverage our sales increase and drive gross profit. These factors helped us to achieve net income of the $104.8 million and adjusted EBITDA of $332.8 million, both of which are solid increases over the prior year period.

As you know, one of our most important initiatives of the year has been our conversion to a new drug distribution and purchasing process with McKesson, which is providing us with purchasing efficiencies and direct-to-store delivery for all our pharmacy products. As reported, during our last earnings call, all stores and our four pharmacy distribution centers were converted to this new distribution process by early in the third quarter.

With all of our stores receiving direct-to-store delivery five days a week, we expected to generate working capital benefits and improved in-stock positions to better serve our customers. These benefits were in line with our expectations during the third quarter.

In addition, our new purchasing agreement yielded savings during the quarter. These purchasing savings, in addition to our higher pharmacy revenue, help fuel our increase in pharmacy gross profit.

We continue to face significant reimbursement rate pressure. However, we were able to mitigate this pressure during the quarter. We expected this reimbursement rate pressure will continue to pose a challenge heading forward and are working hard as a team to meet this challenge head on.

Based upon our stronger-than-expected performance for the quarter, we have raised our guidance for the year. As we concentrate on our day-to-day operations and providing outstanding service to our customers, we’re also highly focused on transforming Rite Aid into a growing retail healthcare company, while continuing to pursue opportunities for long-term growth.

A key part of our strategy is to expand our healthcare offering to provide a higher level of care to the communities we serve. We made significant progress in this area during the third quarter as we continue to strengthen our portfolio of health and wellness services. Two great examples are the Quit For You smoking cessation program and our initiative add to HealthSpot Stations to select Rite Aid stores. And Ken will share more details about those programs during his remarks.

Meanwhile, our initiative to add RediClinics to Rite Aid stores is gaining tremendous momentum. We have opened our first RediClinics in Philadelphia and Baltimore and will be announcing additional openings in the near future. In many instances, we are leveraging our highly successful wellness stores to create an even more engaging overall customer experience.

We’re really excited about this opportunity to deliver yet another convenient layer of healthcare support to the communities through RediClinic. As we continue to expand our healthcare offering, we’re also making tremendous progress with our store development program.

Our team is doing an excellent job of executing our wellness store remodels as we build up our real estate pipeline to support our relocation and new store initiatives over the next several years.

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 everyone for joining us on the call this morning. In the third quarter, we achieved excellent results with many of our long-standing initiatives. We’re launching new programs to further strengthen our position as a convenient destination for health and wellness.

As John mentioned earlier, our long-term strategy centers around the continued expansion of our healthcare offering. So that we can deliver a higher level of care to the communities we serve. A great example of how we’re expanding our efforts around immunizations as we continue to grow this area of our business.

We’ve exceeded 3 million flu shots for the year. And we continue to work diligently to engage our patients as we educate them about the value of this convenient health and wellness service. Beyond flu shots, we believe that raising awareness about other immunizations represents a great opportunity to help protect the health of the communities we serve and demonstrate our value as a health and wellness provider.

To capitalize on this opportunity in the third quarter, we launched a comprehensive offering of tools and resources known as Vaccine Central. Through Vaccine Central, customers can visit Riteaid.com or any Rite Aid store and take a comprehensive immunization evaluation that helps determine their specific vaccination needs.

Customers can also use Vaccine Central to track their personal immunization history and access educational resources. Customer response and engagement through Vaccine Central has been very positive thus far and we believe that this program further demonstrates how committed we are to actively working with our customers to keep them well.

Another key addition to our portfolio of Wellness services is our Quit For You Smoking Cessation Program. As discussed on last quarter's conference call, this free program leverages the counseling skills of our pharmacists to help customers develop and complete a personalized quit plan. We’ve been pleased with the customer engagement thus far, as well as how this program empowers our pharmacists to provide additional care beyond prescriptions.

In January, we will launch further enhancements to Quit For You in time for the New Year's quit season, including personalized text message support for quit tips and positive affirmations.

We’re also enhancing our online support available at riteaid.com by adding video tutorials, a quit calendar and an evaluation tool to identify our customers best nicotine replacement therapy option.

Another exciting initiative announced in the third quarter is our agreement to bring private walk-in HealthSpot stations to select Rite Aid stores in three Ohio markets in the near future.

Though these conveniently accessible health stations, customers will be able to use videoconferencing and interactive medical devices to connect with medical professionals and be treated for common health conditions. A key benefit is that most insurance plans will be accepted for these appointments.

Adding HealthSpot stations serves as a natural extension to our existing suite of Health and Wellness services and offers a convenient solution for accessing quality healthcare in a professional setting.

As John mentioned earlier, we have added our first RediClinics to Rite Aid stores to further expand the level of care that we can provide to our customers. We currently have 18 RediClinics open in our Philadelphia and Baltimore markets, and we will open our first RediClinics in Seattle in the next few months.

By early spring, we expect to have 35 RediClinics open in these three markets. As we add clinics to the Rite Aid stores, we also plan to open additional locations in Texas where RediClinic is already a leading provider of convenient care services.

As you can see, we're making excellent progress with our strategy to introduce new programs that further expand our healthcare offering. At the same time, we’re making great progress with existing programs to continue to help grow our business and strengthen our unique brand of Health and Wellness.

We remained very focused on our ongoing Wellness store remodel program. During the quarter, we achieved a significant milestone as more than a third of our entire store base now operates as a Wellness store. At the end of the third quarter, we had a grand total of 1,529 Wellness stores.

These stores continue to outperform the rest of the chain in terms of same-store front-end sales and script count. We continue to work with our supplier partners to pilot innovative merchandising solutions that deliver an engaging customer experience.

Another key to our Wellness format is the higher level of service provided by more than 2,000 wellness ambassadors. As we move forward, we’re also expanding the level of service that we can provide in the beauty category. We now have 50 Wellness stores with expanded beauty departments that feature a broader selection of prestige brands and specially trained beauty advisors.

Much like our wellness ambassadors, our beauty advisor are position to further engage customers and they achieve this through product demonstrations, helpful tips and personalized service.

Our customers continue to respond positively to our offering of private brand products, with private brand penetration increasing to 18.5% during the quarter. Looking to 2015, we are focused on harnessing the same innovative spirit that is fueled our success with Wellness store merchandising initiatives to create a world-class private brand that delivers quality and value to the consumer.

And we continue to aggressively pursue opportunities to expand our script File Buy initiative. During the third quarter, we completed $39.6 million in File Buys and these acquisitions are making positive contributions to our script count performance. Based on our third quarter activity and expectations for the balance of the year, we have increased our File Buy target from $90 million to $100 million.

To sum it up, our key initiatives continue to deliver strong results, while positioning us to deliver a more comprehensive and engaging Health and Wellness experience. We look forward to building on this success heading forward by further expanding our portfolio of services to delivering even higher level of care the communities that we serve.

At this time, I will turn it over to our Chief Financial Officer, Darren Karst, who will provide additional details about our financial results. Darren?

Darren Karst

Thanks, Ken, and good morning, everyone. Our third quarter results reflect strong script count and front-end trends, improvements in gross profit, good cost control and continued progress on our business initiatives.

Gross profit was improved from last year’s third quarter due to a lower LIFO charge and cost reductions from our purchasing arrangement with McKesson, but that was partially offset by continuing reimbursement rate pressure.

On the call this morning, I will walk through our third quarter financial results, discuss our liquidity, certain balance sheet items, our capital expenditure program and finally, review our updated fiscal 2015 annual guidance.

Revenue for the quarter was $6.7 billion, which was $335 million or 5.3% higher than last year's third quarter. The increase was primarily due to higher pharmacy sales. Overall, same-store sales increased 5.4% in the quarter, which was driven mostly by higher pharmacy script count.

Front-end same-store sales increased by 1.6%. Pharmacy same-store sales were higher by 7.2%, which included an approximate 228 basis point negative impact from new generic drugs. Pharmacy same-store script count was up 4.5% reflecting higher utilization in Medicaid expansion states and an increase in flu shots.

Adjusted EBITDA in the quarter was $332.8 million or 5% of revenues, which was $50.5 million higher than last year's third quarter of $282.3 million or 4.4% of revenues. The current quarter's results were primarily driven by improved sales and gross profit, offset in part by higher SG&A which was also the result of higher sales.

Net income for the quarter was $104.8 million or $0.10 per diluted share, compared to last year's third quarter net income of $71.5 million or $0.04 per diluted share. The increase was driven by the $50.5 million improvement in adjusted EBITDA and a lower LIFO provision, partially offset by an $18.5 million charge for the early redemption of our 10.25% senior secured notes that were due October 2019.

This loss on debt retirement had an impact of $0.02 per diluted earnings per share for the current quarter. The prior year diluted earnings per share were negatively impacted by $0.03 due to the redemption of the company's Series G and H Preferred Stock in the prior year third quarter.

Income tax expense relates to certain state income taxes. The lower LIFO charge was primarily the result of a partial LIFO liquidation, resulting from the decrease in pharmacy inventory levels, which reduced the effect and inflation otherwise had on our LIFO charge.

Total gross profit dollars in the quarter were $122.6 million, better than last year's third quarter and 42 basis points higher as a percent of revenues.

Adjusted EBITDA gross profit, which excludes specific items, was favorable to the prior year third quarter by $103.4 million or 12 basis points as a percent of revenues.

Pharmacy gross profit dollars were higher and margin rate was flat. Pharmacy gross profit was positively impacted by our increased prescription count and negatively impacted by continued reimbursement rate pressure, which we were able to offset through purchasing efficiencies. We continue to expect to see margin pressure from reimbursement rate reductions in the fourth quarter.

Front-end gross profit dollars were flat to the prior year and rate was unfavorable. Adjusted EBITDA gross profit was also favorably impacted by additional revenues from Health Dialog and RediClinic, which were acquired earlier in the current year.

Selling, general and administrative expenses for the quarter were higher by $60.1 million, but 39 basis points lower as a percent of revenues, compared to last year. Adjusted EBITDA SG&A dollars, which excludes specific items, were higher by $52.9 million, but 41 basis points lower as a percent of revenues, compared to last year, as we were able to leverage the increase in sales through our various expense control initiatives.

The increase in dollars was driven in part by incremental operating costs related to our acquisitions of Health Dialog and RediClinic with payroll and benefit costs related to our higher sales volume driving the balance of the dollar increase.

FIFO inventory was lower than the third quarter of last year by approximately $255 million, driven by a reduction in pharmacy inventory resulting from our transition to direct store delivery from McKesson.

Our cash flow statement for the quarter shows a net source of cash from operating activities of $112 million as compared to a source of $247 million in last year's third quarter with working capital timing differences driving most of that difference. Net cash used in investing activities for the quarter was $166 million versus $97 million last year.

During the third quarter, we remodeled 103 stores, we expanded one store, we acquired six stores, we relocated three stores and we closed six stores. At the end of the third quarter, we had completed and grand reopened 1,529 wellness stores.

For the third quarter, front-end same-store sales in our wellness stores that have been remodeled in the past 24 months were approximately 321 basis points higher than our non-wellness stores and script growth in these stores was 278 basis points higher.

Now let's discuss liquidity. At the end of the third quarter, we had $944 million of liquidity. Our liquidity has decreased by $184 million year-over-year due primarily to the fact that in October, we used borrowings on our revolving credit facility to fund the early redemption and payment of the full $270 million of our 10.25% senior secured notes.

We had $780 million of borrowings outstanding under our $1.8 billion revolving credit facility, and had $71 million of outstanding letters of credit. Total debt net of invested cash was lower by $91 million from last year's third quarter. Our leverage ratio defined as total debt less invested cash over LTM adjusted EBITDA, improved to 4.4 times from 4.5 times as compared to last year's third quarter.

In December, we launched the financing transaction to re-price and upsize our revolving credit facility. We expect to increase the amount of the facility to $3 billion and to use the additional proceeds to repay the $1.15 billion of first lien term loans that our currently outstanding. We expect this transaction to close in early January and expect annual interest savings of approximately $20 million as a result.

Now let's turn to the current year guidance. Based on our results for the third quarter, we are raising our guidance for the full year. Our guidance reflects our current expectations for continued reimbursement rate pressure and the benefits from the McKesson purchasing arrangement as well as the anticipated benefits of our wellness remodel program, customer loyalty program, and other initiatives to grow sales and drive operational efficiencies.

We expect the current competitive environment to remain promotional. Our guidance for the remainder of the year also reflects the cycling of a favorable reimbursement rate adjustment that benefited last year's fourth quarter margin and was related to a decision by California to exclude certain drugs from a retroactive MediCal reimbursement rate adjustment. We expect a working capital benefit of approximately $250 million as a result of the McKesson agreement.

We expect script growth to benefit from the Affordable Care Act, favorable demographics filed by acquisitions, growth in immunizations, and other initiatives. We expect total sales to be between $26.25 billion and $26.4 billion and adjusted EBITDA to be between $1.275 billion and $1.305 billion for fiscal 2015.

Same-store sales are expected to be in a range from an increase of 3.75% to 4.25%, including an anticipated negative pharmacy sales impact of approximately 208 basis points from new generic introductions and continued reimbursement rate pressure. We expect a range of net income of $315 million to $370 million and earnings per diluted share to be in a range of $0.31 to $0.37. The range of guidance is primarily driven by our same-store sales range and pharmacy margin expectations.

Our fiscal 2015 capital expenditure plan is to spend approximately $525 million, with approximately $250 million related to remodels and approximately $100 million for file buys. We are planning to open three new stores, acquire eight stores, complete 16 relocations and remodel 450 wellness stores in all of fiscal 2015.

We expect free cash flow to be in a range of $325 million to $375 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 33 stores, of which the guidance includes a store lease closing provision for 15 of those stores, with a balance of the stores closing upon lease expiration.

This completes my portion of the presentation, and I’d like to now turn it back to John, John?

John Standley

Thank you, Darren. Before we open the phone lines for questions, I'd like to thank our 90,000 Rite Aid associates for their great work during the quarter and their continued dedication to ensuring that our key initiatives and new programs lead to a stronger customer experience in our stores.

Looking ahead, we will continue to focus on strengthening our position as a convenient destination for health and wellness, by delivering innovative services that have a positive impact on the health of our patients. We believe that this strategy provides the best opportunity to fuel long-term growth, while meeting the healthcare needs of 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] Your first question comes from the line of Lisa Gill of J.P. Morgan.

Lisa Gill

Good morning. Darren, can you help me understand that the McKesson, the one-time where you talk about it in the second quarter, what reversal you saw here in the third quarter? Just trying to figure out the run rate, as we go into the fourth quarter around the McKesson relationship and those one times that you called out last quarter?

Darren Karst

Yeah. And we’ve taken a little bit harder look at that. I mean, the reality is there wasn’t much impact in this quarter in terms of a reversal. And at least at this point, we don't see much impact of the fourth quarter either.

Lisa Gill

So you expect that the run rate that you are seeing to continue and we won’t see a reversal. Is that…?

Darren Karst

I think that’s accurate, yeah. So it’s kind of a second quarter event.

Lisa Gill

And what’s changed from your point of view in the second quarter to now around the relationship and the run rate?

John Standley

Lisa, this is John. And I think a couple of things. Obviously, we had to do a fair amount of estimating to lay this whole thing out across the fiscal year. And in terms of inventory turns and valuation allowances and how they would reverse themselves through the numbers. And we move to some debt net accounting in terms of how we are purchasing. So we moved some allowances and the inventories. We had a lot of things, kind of moving back and forth through this whole process as we made the transition. So based on the way things kind of shake out in the third quarter, we feel like what we saw in third quarter is more of a -- what our typical kind of run rate experience is going to be with McKesson. And that’s what will our expectation will be in the fourth quarter as well.

Lisa Gill

Okay. Great. And then it looks like reimbursement was a little bit better in the quarter, but, John, you did say you continue to see significant reimbursement rate pressure. As we think about the fourth quarter, will there be more pressure come 1/1/15, as contract terms change?

John Standley

Yes.

Lisa Gill

Okay. So we would expect that obviously for the month of December, maybe similar to what we saw in this quarter. But two out of these three months for the next quarter, you’ll see increased reimbursement pressure, is that the right way to think about it?

John Standley

It is. Yes.

Lisa Gill

Okay. Great. Thank you.

John Standley

Welcome.

Operator

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

Edward Kelly

Yeah. Hi guys. Good morning.

John Standley

Good morning.

Edward Kelly

So, I wanted to just ask you about the third quarter and then maybe how this plays into guidance. But Q3 obviously was better than what the market expected, seems like it’s better than what you expected as well, given that the guidance came back up. Could you maybe just provide a little bit more color around the areas that surprised you on the upside and what the real drivers of the improved guidance is at this point?

John Standley

Well. I mean, I think probably a few things. One, the topline of our business remained strong. So we had good volume in the quarter, both in script count and front-end same-store sales. I think we did a nice job on the gross profit line in both pharmacy and honestly in front-end parts of our business. And in the pharmacy, we continued to work with closely with McKesson to implement the program. So we saw, I think good improvement and strength in terms of what we are doing with McKesson.

We’ve continued to work hard everyday on the reimbursement rate issue. On the front-end side, again, we had solid volume on the front-end which helped. And then we were able to do a really good job on the SG&A side quite honestly to leverage all that to get it to the bottom line. So it came from a number of different areas throughout the business. It was a pretty solid operating quarter for us.

Edward Kelly

Okay. And then just to confirm on the McKesson side, you expected this $40 million of benefit, I guess in the second half that’s not coming through. So as we think about your guidance, the improvement in EBITDA actually, I guess is even better than what it appeared and that’s not rolling through now. Is that fair way to think about, I just want to confirm that?

John Standley

I’m not sure, I’m a little -- I might segment it and try and maybe somebody else can help me sort of pick up the thread. We did see some one-time benefit in the second quarter, as we changed our accounting to deal with the way we are purchasing from McKesson. We thought there might be some flip back from that in the third quarter, which there was not. And we also thought there might be some impact in the fourth and we are not expecting that either. So, I think what you see is that the third quarter reflects a good benefit from the McKesson relationship, that’s clearly one of the drivers that had a significant impact on the quarter. Is that?

Edward Kelly

Yes. Now, clear. Got you. Okay. And the last question for you, I don’t know, John, at this point of time if there is any thoughts on next year? I know it’s kind of early for that, but at the end of the day, there are some puts and takes for the business next year. Lisa asked about reimbursement rate pressure, clearly we are going to see some of that but that's kind of normal. Is there anything else here that you can maybe help us to think about next year and things that we should be contemplating?

John Standley

I think reimbursement rate will -- as you said, it's a normal part of our business but it will continue to be a factor next year. I think we are still kind of digesting a lot of rate pressure that is followed a long behind the previous generic wave and we will see some of that roll into next year. So that’s going to continue to be a factor. We are going to continue to work very closely with McKesson on the purchasing side, continue to be an efficient provider and be a good partner with all of our global PBM and other healthcare plans that we work with. On that side, we are going to see maybe a little bit of a pickup here potentially depending on how Nexium plays and some other couple of other new generics. We are going to see -- I think we are going to see a little bit better new generic environment for next year.

On the script count side, it will be interesting to see what year two looks like in a lot of states that had Medicaid expansion that will continue to grow. It is probably some decent chance of that. We have at least one other state, Pennsylvania, where we think Medicaid is going to roll and expansion is going to roll on January 1. So that will be helpful. There are couple of plans that we were in this year that we are not in next year that maybe cost us a little bit, maybe a percent or percent and a half of script count growth. And we have more wellness stores coming over the next and more exciting initiatives that we are going to be rolling next year. So we’ve got some give-and-take, but I’d say overall we remain positive and focused.

Edward Kelly

Great. Thank you.

John Standley

Welcome.

Operator

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

George Hill

Good morning, guys and thanks for taking the question. John, maybe can you provide a little bit more color? It sounds like in certain pockets of the business you got some reimbursement relief, I guess. Can you talk a little bit about that and maybe either by script type or by payor type and maybe just kind of tell us where the little bit of the relief there came from?

John Standley

Relief is a strong word, I’m not sure -- I’m not sure what that means. Again, there is always a lot of dynamics in reimbursement rate. There are contracts that are renewing all the time. So some are better than others and can impact the numbers one way or the other.

There is always again the mix of business and all those kinds of things going on in any given quarter. So I think this quarter was a fairly good one for us in terms of some of the things that we worked on but I’m not sure I can see any better than that.

George Hill

Okay. And then maybe just a quick follow-up. Some of your competitors have pretty aggressive preferred network strategies in Med D for the start-up of 2015. Are you expecting that to have any share impact on you guys from a script perspective or is there anything that you guys [indiscernible] I know that you guys aren’t as aggressively participating in their preferred networks?

John Standley

Yeah. I think it's a combination of really two things on preferred networks. There are some that were in, probably three or so this coming year. There are few that we looked at and we just couldn’t come to terms to sort of get there financially. And there is a lot of others where we weren’t invited to the table. So you have that kind of component of it.

There are a lot of preferred networks out there. This year, I think, there are probably more than last year for sure. And so we'll just have to see what the financial impact is on us related to that as we get into the year. We have great programs like wellness65+ that are really designed to help us to combat those kinds of things. So we’ll just have to get into a little bit, sort of, see how it goes here.

George Hill

You guys are really carrying the filter up from the stores that patients are trying to transfer script out -- scripts out ahead of the benefit design changes?

John Standley

Not yet.

George Hill

Okay. All right. Thank you.

John Standley

Welcome.

Operator

Then next question comes from the line of Mark Wiltamuth of Jefferies.

Mark Wiltamuth

Just on next year, what are your thoughts right now on timing and are you expecting it to be a sizable initial impact or is it going to be more into fiscal ‘17 on the boost you get from margins?

John Standley

I think the timing is just -- it's just a little bit hard to figure out right now. We’re going -- we probably have to reach a solid conclusion about that 1Q guidance but we’re continuing to gather information and kind of look at it. There are some dates that are being floated around out there. But it has been difficult to peg as it slipped several times.

So I guess I'm a little hesitant to get out there with a date at this point until probably till we bought down guidance for next year. It is -- as it stands right now, it is going to depend on how it comes to market. Right now, it looks like it's an exclusive -- whether that plays out that way or not. It just depends, I guess, on a number of different factors. But in which case, we’ll get probably -- it just depends on when it falls because we will go through a period of time where it’s a less profitable and then it will become much more profitable.

So if it happens earlier in the year, which is still a possibility then by the end of the year, we’ll be seeing some good profitability from it. If it happens later in the year, it probably pushes in more of the financial impact than the fiscal year ‘17.

Mark Wiltamuth

Okay. And then the other wild card, is the, I guess, magnitude of the McKesson savings. Obviously the first half of the year, you’re still going to have easier growth comparisons to show. But then in the second half, you’ll start lapping some of the improvements you're seeing in these results you just posted today. Is there a building of savings that’s going to be happening? So you could still see year-over-year gains in the second half of the year.

John Standley

I think there is. Yeah, that’s what we’re working to do. We are working through honestly the bid process right now. And so again as we know get into next year and give guidance, I think we’ll have some visibility into how that process is playing out. But we are working very closely with McKesson right now on next year’s drug cost.

Mark Wiltamuth

Okay. So do you think, within the next quarter or two, you will know roughly where you are going to be on cost?

John Standley

Yeah. We’ll have much better insight. It’s always -- we're always driving everyday to lower cost but a big chunk of it we will know.

Mark Wiltamuth

Okay. And the $40 million that was discussed here is not going to be reversing here in the second half. Do you think that ends up being a factor into 2016 or not?

John Standley

No. I think we’ve passed it.

Mark Wiltamuth

Okay. Thank you very much.

John Standley

You’re welcome.

Operator

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

Robert Jones

Thanks for the question. Just a follow-up on McKesson, obviously this is the first full quarter you had with the McKesson relationship. I’m wondering if you can give any more perspective on just how much that contributed to the improvement, the noticeable improvement in gross margin. And then just a follow-up on the previous question, it is my understanding that you would benefit as McKesson’s pricing improved and obviously we've seen them now closed the Celesio deal. They brought on Omnicare. How does that factor enter the benefit that you’ll see as you go through next year?

John Standley

It should help us. I mean, the more volume we put through this process, I think, the better it’s going to be for all of us. So those are all exciting developments that should help us both, McKesson and Rite Aid, I think become more efficient purchasers in the marketplace. So we’re pretty excited about that. So that helps.

Robert Jones

So we really shouldn’t necessarily think of this as a run rate of savings that you experience for McKesson?

John Standley

I mean, I think the way to think about it is every year I’ve been here, we have always found a way to purchase a little better than the year before and that’s our expectation that those trends will continue. And reimbursement rates will inevitably come down to some degree over that same period of time. And the balancing act that we always talk about is trying to get cost and reimbursement rate to line up.

Robert Jones

Got it. And look, I know you guys did pepper on the reimbursement question. But if I think back to last quarter, John, it sounded like there were some renewals kind of up in the air at that point. Are those discussions still ongoing or do you have any more comfort or visibility into any major specific contracts that would affect fiscal ‘16?

John Standley

There are significant contracts that renew during fiscal ‘16 like there is in any year.

Robert Jones

Any more comfort relative to last quarter?

John Standley

No.

Robert Jones

Okay.

John Standley

It’s the same. I mean, there is just -- I guess, I try to get across to everybody is, there is a fairly constant level of activity at all any point in time on reimbursement rates.

Robert Jones

Okay. Thanks.

John Standley

This is the best way I can answer.

Operator

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

John Heinbockel

So a couple of things. Just -- am I right in assuming the change in guidance from last quarter to this? I know that you have mentioned the bulk of it but a lot of that was just not having the offset to the $40 million. Is that a big -- it’s got to be a large piece of it, right?

John Standley

Maybe a little bit of it, John, but I think, we did I think, much better than we expected with on the McKesson side.

John Heinbockel

Yeah.

John Standley

One of the factors again, we talked about script count has been strong. So I think it was largely driven by a much better operating performance.

John Heinbockel

Okay. When you think about the Jan 1 resets or rate changes?

John Standley

And I guess, John, the other comment I make on this $40 million.

John Heinbockel

Yeah.

John Standley

It wasn’t our expectation that it would be fully offset by charges. We just didn't think that the net impact of it was going to be material to the fiscal year. So I think a lot of people said, based on our comments last quarter, maybe that’s the conclusion that it was 40 and 2, so it’s going to be 40 and 3 and 4, which also was never our expectation. We just thought the net of it wasn’t going to be very material to the fiscal year and so that’s kind of what we were talking about.

John Heinbockel

Okay. When I look at the Jan 1 resets, is that more Med D commercial, commercial be more that Med D?

John Standley

It’s sum of both. We have some commercial contracts on Jan 1 and we have Med D on Jan 1.

John Heinbockel

But one not more than the other?

John Standley

It’s a bunch of both.

John Heinbockel

Okay. And then tying that in, when you think about Rite be on this back side of the generic wave. Generally speaking, when do you think, we see a peak in reimbursement pressure or maybe a trough in pharmacy margin. Is it sort of seems like plus of the timing of next. It might be third quarter of next year, sometime in the early second half of next year, is that fair?

John Standley

And that’s pretty close.

John Heinbockel

All right. And then lastly just transition to the front end, you said front-end margins were down a little bit. Where do you think that goes from the perspective? It looks like a lot of guys from your competitors are kind of going in different ways. But the notion that front-end gross profit dollars is really critical. You don’t get a lot on spending front-end gross profit dollars on promotion. Is this kind of a temporary dip down or you think this is more secular?

Ken Martindale

Hey, John, it’s Ken. I think on the front-end margin, it was probably not indicative of a good run rate. We took some fairly big markdowns when we repositioned our tobacco and cigarettes to expand smoking cessation. That was one of the big hits that we took.

And I think going forward, we’re just going to be a lot smarter about the markdowns. It’s going to be a long process but we’re going to have to move those markdowns from the circular to a more personalized delivery.

And so, I think, we are just going to spend them a lot’s smaller. So, if anything, I think, there might be some long-term upside, but overall, I don’t think, it’s a big shift. I don’t think the negative that you saw is going to be indicative of where we are.

John Heinbockel

Okay. Thank you.

Operator

Your next question comes from the line of Ross Muken of Evercore ISI.

Ross Muken

Good morning, gentlemen. Maybe just talk a little bit about where you think we are sort of the in the real estate transition and then, in general, as you think about these sort of improving comps and what you have done on the remodels, et cetera? How are we seeing sort of various trend at kind of some in the legacy stores versus maybe some of those which you have revamped over the last 12 or 24 months?

John Standley

Yeah. I think like anything you would expect that we get the biggest bang right after we are doing. We see a reasonably good tail on comps. But, clearly, the stores that were now four years old, they are running substantially less than the ones that we are doing today.

I think, Darren, gave you some numbers on the stores that we have opened or remodeled last 24 months. We are very bullish on the progress that we are making in these stores and we think the remodels continue to get better and the consumer continues to react appropriately.

Ross Muken

Yes. My question is more. So if we think about some of the underperforming stores or the more challenge stores sort of market growth improves overall? Is that enough even if we're not seeing the revamp to sort of improve the profitability of that part of the fleet or, are we seeing the bigger outside changes where we are getting the comp bump on the remodel and then we are also kind of getting the improved sort of overall underlying market?

John Standley

I think the non-remodeled stores, if this is your question. They continue to grow with the overall company. So if the company, if we post better comps, those stores are moving with it, but they clearly don't perform, as well as the remodel stores.

I think we have said before, one of the strategies is to ramp up these relocation. So as we do that, we will be taking a lot of those underperforming stores that we still have the fleet and reposition them to a better location which we think will help the topline a lot.

Ross Muken

Great. Thanks.

Operator

Your next question comes from a line of Charles Rhyee of Cowen and Company.

Charles Rhyee

Thanks for taking question guys. Darren, maybe if I can go back to your comment about the LIFO charge real quick, I think you made, if I heard you correctly, part of reason for lower and expected LIFO, you are kind of dipping into your LIFO layers and that offset some of the inflation that you saw? First, did I hear that correctly?

And then second, how should we think -- how much longer does that play out, now that you kind of transition to the McKesson agreement and afterwards, how should we think about the LIFO charge as we -- maybe going to fiscal ’16?

Darren Karst

Yeah. You did hear that correctly. So, if -- and the reduction in inventory has sort of offset most of whatever inflation effect there would be. So, I think, going forward, there will be some LIFO charge. We still have some opportunity I would say particularly on the store side.

I mean, what we have done so far is largely taken out distribution center inventory. So there is still some opportunity to take out some more inventory next year on the store side. So we could still see some of that offsetting activity next year as well.

Charles Rhyee

So as McKesson has gone to the direct store delivery for you guys. You are carrying -- are you still carrying some excess inventory than at the store level? But could you maybe size that for us little bit, where you think -- how much you think we could still take out?

Darren Karst

Well, the answer is, yeah, we still are maintaining inventory. I don’t think we are prepared to size that at this point. We are still doing some work around that and sort of developing plans to address that.

Charles Rhyee

Okay. Great. Maybe on two other things that, Ken, you have talked about was sort of Vaccine Central and the Smoking Cessation, as well as beauty advisors? You have any metrics on, so what kind of impact that’s driving in terms of, any kind of sales metrics or maybe flow-through to the pharmacy desk?

Ken Martindale

We do have metrics. We really haven't release them and probably won't on initiative -- by initiative basis. But, I think, clearly, we are seeing some benefit -- the one that we have been in the longest is the wellness ambassadors. We start rolling them out four years ago when we did these things. We are now -- we have get 2,000 of those people on the floor.

One of the areas where we really seeing an impact, for example, is with flu shots because there are on the floor and they are engaging our customers and they're also having communities engaging businesses. So we wouldn't keep doing it. We are pretty excited about the early read on the Beauty Advisors. We are being a little more selective on those, but we are trying to strategically put people against initiatives that we think we can get a return and so far the early read is really positive.

Charles Rhyee

Great. And the last question here around the clinic. Assume the target for the number of clinics you are expecting sort of either, I guess is really just having start but maybe in a year or two years either out, what do you think it will be in terms of either RediClinics or HealthSpot kiosks?

John Standley

Well, right now, our target by early spring, we should have 75 clinics running between the ones that we have in Texas in H.E.B. stores and the ones that we will open in these first three markets. And I think that’s pretty much on target with what we told you guys we would do and we are going to aggressively expand from there.

Charles Rhyee

Okay. Great. Thanks guys.

Operator

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

Steven Valiquette

Yeah, first, congratulations on these phenomenal results, I definitely can dreamed up better results myself. Now for fiscal 4Q -- for fiscal 4Q, I definitely hear what you are saying on the pharmacy reimbursement changes going into effect for 1/1/15. But I do just want to sort of check the box on some of the positive contributors for fiscal 4Q as well and thinking about sequential EBITDA. I guess, for me, there is four things that kind of stick out right now.

First is that flu prevalence is now up year-over-year. We obviously just got generic Celebrex approved. You should start getting a decent holiday boost sequentially in fiscal 4Q versus fiscal 3Q. And then again, I think myself there with McKesson getting operational controls, so let’s see how you would think that you guys might get some better generic COGS consequentially in 4Q tied to that unless it’s too early. But I guess the question is do you agree that all these should be helpful factors when thinking about sequential EBITDA ramp in fiscal 4Q?

John Standley

We’ve got a seat for you right here at the table. There is a chair for you right here. I think those are all good. I would just caution a little bit. It’s really for McKesson to talk about in terms of Celestial. It is a fairly recent event for them to get the nomination there. And so I know, they're working hard on that. But I'm not sure -- I don't know exactly what that timing is yet. I think the fourth quarter might be a little premature for us to see that benefit. But I do think and know for fiscal year ’16 that is hopefully a boost for us. So that one maybe a little bit premature, but I think all those other items that you mentioned are all helpful in the fourth quarter.

Steven Valiquette

Okay. And then just quickly, one of your competitors also talked about that anniversarying of that favorable adjustment related to California Medicaid. Is there anyway to quantify that just for that delta year-over-year for you guys? Is it greater than or less than, let’s say, I don’t know $15 million year-over-year as far as that tough comparison you have there?

John Standley

Yeah. I don't think we have disclosed that number, but it is greater than -- it is greater than $15 million, is probably in the $25 million to $30 million range.

Steven Valiquette

Okay. That's helpful. Perfect. Okay. Thanks.

Operator

Your next question comes from the line of John Ransom of Raymond James.

John Ransom

Hi. Good morning. I'm going to demonstrate when I came, but still if you look at last year, your sequential EBITDA was up about $74 million. This year, the implied guidance is down about $30 million, a little about $23 million. So there is a roughly a $97 million change in the sequential picture. Is all of that contract resets because it seems like a lot of good guys, as we just talked about going into the fourth quarter? So we think about that $100 million swing per quarter and contract rates offsetting all the good stuff?

John Standley

So, I'm not sure I got the math but I’m going to take a stab at it.

John Ransom

So you had $282 million of EBITDA and it went to $356 million from November to February. February is usually your strongest quarter of the year. This year, your implied guidance has EBITDA down by $23 million. So instead of being up by $76 million, it’s down by $23 million. So, I’m just saying that’s a $100 million quarterly swing.

John Standley

Okay.

John Ransom

Is all that just saying, we are getting a $400 million rate reset on an annualized basis, starting first day of the fourth quarter?

John Ransom

Okay. Got it. Okay. So, I guess we can reconcile in any number of different directions. So, I will take a stab at a couple of different directions with Darren supervising me closely. So if we take a look at the fourth quarter of last year and trying to reconcile from there, I mean, one thing to understand is that we did have the retroactive California adjustment in the fourth quarter of last year.

And so, if you take that into affect and looked at our guidance, I think, the higher end of our guidance has this pretty much onto last years EBITDA number. So we’d be basically at the high-end sort of flattish to last year.

When looking from the third quarter current run rate today to the fourth quarter, in terms of the guidance, again the high-end of the guidance has this kind of inline with where we were or in the third quarter, we do have some plan changes that go into effect in January and February, which we’ve talked about, which is normal.

But given that it is late in the bid cycle for us, we tend to have less room to offset those and so, as our bid comes to completion at the beginning of the fiscal year, we normally pickup a little momentum back on the cost side in the gross margin. So I think those are some of the big sort of larger dynamics that are rolling through the number. I have no idea if I answered your question, but that’s probably the best I can do.

John Ransom

So just looking at your numbers, they are very -- they jump around quite a bit from quarter-to-quarter, I am thinking, for example, February of last year to May? And then, of course, this quarter, which was above our expectation? Should we -- it seems to me like a lot of things in your business are relatively constant like reimbursement pressure and script trends and what have you? Is the difference that in a quarter where you don't get a gigantic generic inflation surprise that you produced a quarter like this or is it more…

John Standley

Yeah. There are just so many more factors than that. I mean, if we walk across the volatility of those numbers in the first quarter, we are in a massive transition to move from self distribution to McKesson, which we believe had a pretty negative impact on our numbers in the second quarter. I think we really started to recover from that. We did have some adjustments that came off the balance sheet that we talked about.

I think in the third quarter things are kind of slowing down a little bit and we think we are at a more normal run rate right now on the cost side and in the fourth quarter what we see is just because the January plan changes some additional reimbursement rate. Again, that’s really the broader trend that I think you got follow across the fiscal year.

John Ransom

Are you seeing any like flattening out or maybe even a relief on the generic inflation side? Do you think that’s that fever is peaked or do you think it’s just too early to tell?

John Standley

Well, I -- what I think if you look at our results for this quarter, what we’ve basically said is that, essentially our gross margins on a rate basis is pretty flat to prior year.

John Ransom

Yeah.

John Standley

If you kind of think about the fact that we have reimbursement rate pressure that inherently implies that we did a better job in the prior year on the purchasing side that’s kind of what you get to.

So when we talk about generic inflation, yeah, we have generic inflation on certain items. But we were able to offset that inflation with reduction on other items or by working on those specific items that had inflation in this particular quarter. But it's become a little bit of a day-to-day battle and a challenge that we work on all the time.

So that's kind of the dynamic that you have there. But, clearly, I think, you see a -- an environment change, where there are certain generic manufacturers that feel they have more pricing power in the marketplace and they are trying to exert it and that is not a trend that I expect to go away any time soon.

John Ransom

Okay. And just lastly, if we think about -- and I am going to make up a number, let’s say that you can steadily grow your scripts, say 3% a year, you are doing better that now? Given the mix shift, there is some mix shift from higher margin, so let’s say, some of that coming from Med D and Medicaid. So it’s not going to have the same GP? But in general if you are growing your scripts 3% a year, what kind of gross profit number should we think about? In other words, you have, let’s say that’s 10 million scripts a year that you're growing is that a $10 GP, a $12 GP? How do we think about that growth in terms of a good guy?

John Standley

I don’t know that we've given any GP prescript numbers out and probably, wouldn’t be a good idea for us from a competitive standpoint to do that. So, I mean, I think you can look at our overall margin rates and use those, try and estimate some impacts of topline growth that's and we’ll be….

John Ransom

Your peers have talked about a $65 ASP and a low 20s gross profit. I mean, so is that, I mean, I'm assuming you're not to far from some thing like that?

Darren Karst

Yeah. I don’t -- I am not sure about those numbers honestly. But what we will do is give guidance next quarter so.

John Ransom

Okay. All right. Thank you.

John Standley

You’re welcome. And, Angie, we have time for one more question, please.

Operator

Certainly. Your final question comes from the line of Meredith Adler of Barclays.

Meredith Adler

Hey, guys. Thank for squeezing me in. I have...

John Standley

I have one foot out the door but…

Meredith Adler

Well, thank you, John, I appreciate that. Two questions. There was a comment very early on, I think in your prepared remarks about working with payors to maybe to lessen the pressure on reimbursement rates. I wonder if there is any specific, I don’t know tools or things you have to be doing for patients that would give you better reimbursement rates. How do you negotiate that?

John Standley

Well. We want to be a great partner with payors. And I’m not sure I said, we have any particular secret sauce, I think, as a term was recently used at front. But obviously, we are very focused on taking care of patients. We‘re very focused on compliance and adherence, and have a number of tools that we use to drive that. And I do think that is becoming more important over time to payors, as they look at the impact of compliance on their business and their ability to manage costs and provide good service to their customers.

So what we do inside that store is very, very important, I think, to our success long-term and managing those relationships. Because at some point, it will not be just be about the lowest cost provider, it’s really going to be about the patient, get the therapy they needed. And we think, we’re doing a great job in our stores, delivering that and are going to continue to enhance the services that we provide.

Meredith Adler

And is there some relationship between reimbursement and your successive adherence?

John Standley

Not today. Not today. But I think, there will be over time.

Meredith Adler

And then my other question is you do have some interesting things going on, in terms of wellness, the wellness and that serves all the smoking cessations effort to help spot. Do you see those things has being important for making you more connected to healthcare and cause the RediClinics to over the long-term, do you see yourself moving beyond being a retailer and actual positioning yourself to be working closely with health systems and physician groups?

John Standley

The answer to that is clearly yes. And the best example, we have today is Rite Aid Health Alliance, which we didn’t spend a lot of time on this call. But we are now in seven pilot projects across the country with large health plans directly integrated into their healthcare model for chronic and poly-chronic patients. So that just shows you how connected we’re getting into healthcare delivery in our stores.

And I think, if you look at broader trends, we really believe that in the long-term, healthcare delivery is going to be a retail-driven model and it’s going to be driven by consumer choice. And we’re developing our brand and how consumers and patients think of us and connecting ourselves into the healthcare marketplace and delivering services in our stores. So that’s clearly a direction that we are headed in.

Meredith Adler

Great. Thank you.

John Standley

Very much. Thank you everyone for joining us this morning. We greatly appreciate it and we’ll talk to you soon. Happy Holidays.

Operator

Thank you for participating in today’s conference call. You may now disconnect your lines at this time.

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