Rite Aid Corp (RAD) 2003 Q2 法說會逐字稿

Good morning. My name is and I will be your conference facilitator today. At this time, I would like to welcome everyone to the Rite Aid second quarter results conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer period. If you would like to ask a question during this time, simply press star and the number 1 on your telephone keypad. If you would like to withdraw your question, press the pound key. Thank you.

Mr. John Standley, you may begin your conference.

Thank you, operator. Welcome to our second quarter conference call. On the call with me today are Bob Miller, our Chief Executive Officer, Mary Sammons, our President and Chief Operating Officer, and Chris Hall, our Chief Financial Officer. Our agenda for today's call will be as follows: Mary Sammons will give an overview of the second quarter, I will review second quarter results, Bob will give some comments on the quarter and talk about our guidance for the rest of the year, and then we will have a question and answer session.

Before we begin today, I would like to read the following regarding forward-looking statements. During today's call, forward-looking statements may be made. Such statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those expressed or implied in the forward-looking statements. Factors that could cause actual results to differ materially from those expressed or implied in such forward-looking statements include our high level of indebtedness, our ability to make interest and principal payments on our debt and to satisfy the other covenants contained in our credit facilities and other debt agreements, our ability to improve the operating performance of our existing stores and, in particular, our new and relocated stores in accordance with our long-term strategy, our ability to hire and retain pharmacists and other store personnel, the outcome of pending lawsuits and governmental investigations, both civil and criminal, involving our financial reporting and other matters, competitive pricing pressures, continued consolidation of the drugstore industry, the efforts of third party payers to reduce prescription drug costs, changes in state or federal legislation or regulations, the success of planned advertising and merchandising strategies, general economic conditions and inflation, interest rate movements, access to capital and the Company's relationships with its suppliers. Consequently, all of the forward-looking statements made during this call are qualified by these and other factors, risks and uncertainties. You are also directed to consider other risks and uncertainties discussed in documents we file with the Securities and Exchange Commission.

Mary Sammons will now comment on operations during the second quarter.

Thanks, John. We're very pleased with our second quarter results. EBITDA exceeded the high end of our guidance for the third quarter in a row, increasing 26.7 percent over the second quarter of last year. We achieved our same store sales target with a 7.1 percent increase over last year, even as consumer spending slowed and we faced the toughest prior year and comp comparison of any of our major drugstore competitors. Contributing to our success this quarter was continued improvement in pharmacy contribution, good overall expense control, and a focus by all of our departments on our EBITDA achievement program that I discussed on last quarter's call. Our pharmacy comp sales posted double-digit gains for the quarter, positively affected by a strong allergy season, as well as continued operational improvement in our pharmacies. Script count was up in all divisions. We also saw continued growth in generic dispensing. While this generic growth dampened comp sales by about 2.2 percent. It contributed to substantially higher gross profit.

Also positively impacting pharmacy margins was improved gross profit on both third party and cash prescriptions. Additional new pharmacy initiatives during the quarter included the launch of additional pharmacy marketing programs, finalization of our requirements for our next generation pharmacy system, which we expect to pilot in the third quarter and roll out in January, and a number of top to top strategy meetings with our major pharmaceutical suppliers and .

We also continue to strengthen our 'With us it's personal and ready when promised' customer service program. Many of you know we recently added Phil Keough to our pharmacy team as Senior Vice President of Pharmacy Operations. Phil brings a wealth of experience to pharmacy operations for even greater focus on improving our customers' experience in the pharmacy.

In the front end, consumables, general merchandise and four drugstore categories were our strongest contributors to sales. New , new item launches, strong promotions and great in-stocks were all key factors. Vitamin sales stayed strong thanks to our stores within a store and promotions that highlight our pharmacist vitamin training. Back to school sell through was good and we increased market share. We continue to improve our private brand penetration and have now launched over 200 items year to date.

Weak categories include a summer seasonal where strong sales through early in the season reduced product sold on clearance. Cigarettes and tobacco sales were negatively impacted by higher manufacturer prices and state and local regulatory initiatives that further raise retail prices and require tobacco placement behind the checkout. Film processing was weak. This is an industry-wide issue.

Cosmetic sales where we completed a total department reset by the start of the quarter was slower than expected, but out performed the channel according to data. While we experienced a softening of sales, as did other retailers in August, we are pleased with the sales momentum we are seeing so far in September.

During the quarter, our print advertising nears last year in page count. We do, however, successfully test larger format tabs in our key market and supplemented selected markets with television targeted to ethnic or price shoppers.

We also continued our strategy of smart promotions, growing sales profitably, not growing sales at any cost. I'll talk some more about promotion in just a minute as we discuss plans for the balance of the year.

As for SG&A, we continue to contain our operating costs with total store distribution and administrative expense down for the quarter. Effective labor scheduling and supply chain improvements have been significant contributors. We are beating plan on our strength objectives and have siphoned one year on the use of the shrink management tools developed as part of our supply chain initiative. We have now rolled this out to pharmacy.

Our inventory levels are in great shape, finishing below plan in both front-end and pharmacy but with service levels and in stocks better than ever. As we move into the back half of the year, we are keeping our focus on our EBITDA achievement program aimed at delivering at least a 20 percent increase in EBITDA for the year and over the next several years.

We have strong merchandising, marketing and promotional programs in place. We will continue these and make sure all of our communications to customers deliver our message. Right product at right prices. The product and value offer will vary depending the category, item, theme and timing. We will run more targeted promotions like our very successful 40th anniversary sale that is running right now.

We've also learned from experience that while frequency, price impact and value are important to our core end consumable categories, being first and in-depth with what's new and different and creating in store merchandising excitement also get you sales.

Our third and fourth quarter print advertising page count will be very similar to last year. We will continue to run the larger format tabs in our top markets and support selective markets with targeted television campaigns. We're ready for the holidays with great themes for Halloween, Harvest and Christmas. Even more important, we've got strong seasonal selections from the exciting exclusive merchandise and new events to encourage customers to buy.

We will work on other key initiatives too. In pharmacy, closing the gap to increasing script counts continues to be our number one priority and starts with the execution of our and programs aimed at delivering more personalized service, along with faster prescription delivery.

Our pharmacy marketing campaign will continue too, directed at customers, doctors and managed care providers, selling our value proposition to each. A superior customer experience to our customers, a reliable source to doctors to recommend to patients, and a low-cost provider for managed care.

We'll continue to strengthen our healthcare image with another successful health and beauty expo this coming weekend in Detroit. And we'll host a series of health fairs, offering free screenings and educational programs in select stores in October.

Transitions in the optical category and in the pre-paid phone card program will be completed for most stores by mid October. A new photo department reset will be done during the same time period, with new programs, new prices, signs and graphics ready for the holidays business.

We won't forget about costs either. We'll continue to manage our labor effectively, utilize our new tools to keep bringing shrink down, and advance our supply chain initiatives. Part of these savings we'll bank and part of the savings we'll invest; in-store remodels and promotional offerings in customer service and associate incentive programs.

We have a solid business proposition, strong programs, exciting merchandising plans, and a team committed to delivering on our goals. Our second quarter results and our confidence in our ability to satisfy customers this upcoming season give us confidence that we'll continue having a successful year.

And now John Standley will fill you in on a few more details for the quarter.

Thanks, Mary.

Overall, we were very pleased with our second quarter results. Gross margins have improved and we are continuing to successfully contain our costs, which allows us to get the incremental earnings benefit of our strong sales growth.

Total sales for the 13-week second quarter were in line with our previous guidance, at $3.86 billion, versus sales of $3.69 billion for the prior year second quarter. Sales increased $165 million, or 4.5 percent this year versus last year. We operated 3,444 retail stores at quarter end, versus 3,594 stores at the end of last year's quarter; a net reduction of 150 stores, or 4.2 percent.

Same store sales for the quarter were up 7.1 percent, with pharmacy comparable store sales up 10.8 percent and front end comparable store sales up 1.3 percent. Pharmacy comparable store sales for the quarter were negatively impacted about two percent by an increase in generic sales mix. Although increases in generic sales negatively impact comp store sales, they increase gross margins.

Prescription sales accounted for 63.1 percent of total sales, and third-party prescriptions represented 92.6 percent of total pharmacy sales.

Gross margins, which include occupancy costs, were $883.1 million, or 22.9 percent of sales for the second quarter of this year, versus $834.3 million, or 22.6 percent of sales last year. Excluding non-cash LIFO charges of $17.3 million this year and $15 million last year, and adjusting the prior year's occupancy cost to include a comparable $4.8 million charge due to our June 2001 reclassification of capital leases, gross profits were $900.4 million, or 23.35 percent of sales this year, versus $844.5 million, or 22.88 percent, of sales last year, an increase of 47 basis points.

Occupancy related costs, including gross margin, were higher by 2.4 million due to the increase in occupancy costs resulting from the change in lease classification in June of last year and higher utility costs, partially offset by the rent reduction from closed stores. As a percent of sales, occupancy costs were lower by 12 basis points due to the better leveraging of fixed expenses. Front end gross margins were down slightly on total front end sales that were basically flat. Sales were flat because the impact of closures mostly offset the 1.3 percent comparable store sales gain. Pharmacy gross margins were higher as a percent of pharmacy sales by 65 basis points due to an increase in generic mix, higher gross profit on both third party and cash prescriptions, and soft pharmacy margin in the prior year second quarter.

Selling, general and administrative, expenses for the quarter decreased as a percent of sales by 78 basis points compared to the prior year after adjusting last year's SG&A for $17 million of non-recurring legal settlement income, which had net of $7.1 million charge for settlement of the Pharmacy Reimbursement Investigations last year. The lower operating expenses are due to the better leveraging of the fixed expenses as our volume-per-unit continues to increase and good control over operating expenses at our stores and in our corporate office, partially offset by increases in employee benefit costs.

Non-cash stock compensation resulted in income of 6.7 million this year versus income of .8 million in the prior year. The non-cash compensation relates to variable plan accounting on certain management stock options and current and prior year income results from a lower stock price at the end of the quarter versus the beginning.

Interest expense was $85 million for the second quarter versus 102.4 million in last year's second quarter. Interest is lower than in the prior year due to one, our June 2001 refinancing which lowered debt and reclassified $850 million of capital leases and two, lower interest rates this year versus last on rate debt. Interest was broken down as follows: cash interest on debt this year was 67.6 million versus 80.4 million last year, cash interest on capital leases was 4.2 million this year versus 9.6 million last year, cash interest on bank fees was 3.3 million this year versus 3.2 million last year, total cash interest this year was 75.1 million versus 93.2 million last year, non-cash interest was 9.9 million this year versus 9.1 million last year and, again, total interest was 85 million this year versus 102.4 million last year. Non-cash income and expense items can be summarized as follows: non-cash stock compensation, as I mentioned previously, was $6.7 million of income this year in the second quarter of '03 versus .8 last year, gains or losses on debt modifications were a gain this year of 1.4 million and a charge last year of 88.5 million, store closing and impairment charges were 58.2 million this year in the second quarter versus 22.1 million last year, closed store liquidation expense was .5 million this year versus 4.6 million last year, and last year we had equity loss on drugstore.com of 4.5 million in the second quarter and other non-cash charges of 3.6 million in the second quarter last year. Total non-cash expenses this year were $50.6 million versus 122.5 million last year.

We completed our review of under-performing stores in the second quarter, resulting in the decision to close an additional 32 stores. We will review under-performing stores again in the first and second quarters of next year. Total store closing and impairment costs were 58.7 million, 58.3 million of expense on the face of the operating statement and a half a million dollars of expense in cost of goods sold representing inventory liquidation costs.

We have not yet incurred store liquidation costs on 48 stores we have identified for closure, but not yet closed. In addition, we perform our annual impairment test in the fourth quarter that could result in additional charges. Losses on asset sales were 1.5 million for the second quarter of this year versus gains of 1.6 million last year.

Net loss was 105.3 million or a loss of 21 cents per common share for the quarter compared to a loss of 245.9 million or a loss of 54 cents per common share for last year's quarter. On an adjusted basis, net loss for this year was 49.7 million or 10 cents per common share compared to 136.4 million or 31 cents per share last year. The adjustments for this year include the $50.6 million in non-cash expenses, $1.5 million of loss sales and $3.5 million of non-recurring legal and accounting costs.

Prior year second quarter adjustments include $122.5 million of non-cash expenses, $1.6 million of gains on asset sales, and non-recurring litigation income of $17 million and $5.6 million of non-recurring legal and accounting costs. We've included the schedule in our press release that reconciles our net loss to our adjusted loss.

EBITDA for the second quarter was 125.4 million or 3.3 percent of sales, exceeding the high end of our guidance range by 5.4 million and an increase of 26.5 million over the prior year computed on a consistent basis. We have also included a schedule in our press release that reconciles our net loss .

Some other second quarter information that you might interested in. First, liquidity. As expected, due to seasonality our liquidity declined during the quarter but remained strong overall with substantial amount of cash on the balance sheet and about $390 million of revolver availability after subtracting letters and credit. The major factors contributing to the decline in the quarter were the use of $62 million of cash for changes in net operating assets and liabilities and the use of $28.5 million of cash to reduce debt.

The change in operating assets and liabilities consist of a $26 million reduction in accrued interest due to timing of interest payments versus interest expense, $14 million of payments on close store releases and a $21 million increase in working capital. The debt reduction included the early redemption of $21 million of 2003 notes and $7.5 million of amortization.

Last week, during the third quarter, we paid off the remaining $150 million of outstanding five and a quarter percent convertible bonds and the remaining $20 million of 10 and a half percent senior secured notes on their scheduled maturing debts. One hundred and fifty million dollars of convertible notes were paid using cash from the balance sheet and the $20 million of 10 and a half percent notes were paid by drawing down on a portion of a term loan that was reserved for this payment. Neither payment was made with proceeds from revolver borrowings.

We expect our liquidity position to remain strong throughout the remainder of the fiscal year, but we may draw a revolver from time to time as we continue to build seasonal inventory.

During the quarter we remodeled 48 stores, relocated three stores and opened 47 departments within our stores and closed 10 stores. Cash capital expenditures for the quarter were 31.3 million including 3.5 million spent to acquire pharmacy prescription files. Bob Miller will now comment on second quarter results and our guidance for the second half. Bob.

Thanks, John. As Mary and John have both said, we're very pleased with our second quarter results. While the overall sales environment remains competitive, we're continuing to make good headway in creating a more efficient company. We expect a strong momentum of the second quarter to continue. As you can see from our news release, we've given guidance for the third quarter and raised our guidance for fiscal 2003.

Based on current trends, we expect same store sales for the third quarter to improve seven to eight percent over last year's third quarter. We expect EBITDA for the quarter to be to million, which compares to million for last year once you adjust last year to make it comparable.

With the momentum we're seeing, we are raising our full year EBITDA guidance to a range of million to million, from a range of million to million. Although we expect to incur a loss in the third quarter, we can see a profit in the fourth quarter if we make the high end of our full-year guidance.

Our balance sheet and liquidity position remain strong, and we continue to make good progress on improving our operating results. Our first-half results demonstrates that we are well on our way to achieving our goal of 20 percent annual growth in EBITDA. We will file our second quarter 10Q on or before October 15, which will include our certifications.

The operator will now open the call for questions.

At this time, I would like to remind everyone, if you would like to ask a question, please press star, then the number one, on your telephone keypad. We'll pause for just a moment to compile the Q&A roster.

Your first question comes from of Merrill Lynch.

I want to ask a question about that 20 percent EBITDA growth number. Do you have a medium term growth rate in mind? Is the 20 percent - or is it intended to cover next year as well? Is this just this year number?

No, we have really said that we expect to have 20 percent EBITDA growth for the next three years. That includes this year and the next two years. And we still have some work to do on the projections for the next two years, but that's our goal.

Mary, you might comment on that.

No, it is just based on our focus on increasing sales per store, getting the productivity up, growing our as well as front end. That is our goal.

OK. And is that possible with a one to two percent type of front end comparable store sale number? Because it seems that, you know, maybe half of your EBITDA comes from the front end. That level of growth would be difficult to sustain that kind of EBITDA number from.

Is there a front end target that accompanies that EBITDA growth?

Well we're not ready to give guidance for next year and the next year after that, . We have done models that shows us achieving the 20 percent growth target. But we're really not going to give guidance beyond this year.

OK. Then maybe you can just sort of split it down into recovering from historical lower levels of management attainment. And then, you know, future growth inside of this business.

I mean what is it? Are you still in recovery mode? Is this still getting to where you should be today or is this a whole of new stuff?

Well, Mary, why don't you comment on that. I think it's both, but, Mary, give him some color maybe.

Well we know that there's a gap between our company and our competitors. And we are working on closing that gap. And it starts with the prescriptions that we do per store per week. And we've got very solid plans in place by store, by market, by region, by division.

And the same thing with the front end. As we've continued to get the stores better stocked, at taking care of space issues on the front end, we're continuing to see our transaction size go up. And what we're doing with our promotional vehicles will continue to help us build customer traffic.

, I will tell you that our projections show same store growth in a range that we're comfortable with and that's without new store growth which really allows us to leverage the expense in our existing store base substantially. So most of the savings that we experience is really cost savings that will help us improve our EBITDA.

Great, thanks so much.

Your next question comes from of Research.

Hi, .

, your line is open.

Thank you. Can you give us a little bit of sense on pharmacy margin? Impressive to have growth of that magnitude. I understand the generic side of the equation, but outside of generics, can you give us little bit more color on what the comparison might have looked like and, going forward, should we expect this level of gross margin improvement in the pharmacy or what might it moderate to?

Mary, why don't you take that?

OK. , on the pharmacy side, remember last year we did our cash pricing reduction so we're also cycling against that. So we did have some softer margins in pharmacy that started last year in the second quarter and continued, in fact got pretty dramatic, in the third quarter. So we are cycling through those, we did a lot of fine-tuning on our pricing and that has helped us. We've continued to work very hard with our third party plans and done a lot in that arena, too, to improve our overall business. And with what we've done on generic, and we continue to work that initiative very hard, we expect to be able to sustain our pharmacy margins.

The biggest factor though, Mary, is the generic sales increase.

Absolutely. It's a big one, both what's come from new generics, as well as our proven track record in base line generics.

Any sense of a composition of that increase of 65, what was, you know, a function of the easy comparison and what was a function of generic contribution?

Mary?

Our generic contribution is still going to be the most significant contributor and, you know, you heard our 2.2 percent impact on the comps from what we've done with generics and that does add substantially to the margin line. But all the factors I mentioned have a role in that basis point change.

OK. And then secondly, to be clear on your outlook for the front end for the balance of the year, can you just clarify again what your expectation is in terms of front end comp, as well as what your year-over-year position is expected to be in terms of pricing and promotion?

Let me say this, Mary, first. , the only guidance we're giving is seven to eight comps going forward. We haven't broken that down front end pharmacy, we don't plan to. Mary, why don't you take the promotional part, though.

We feel very good about the promotional plans that we have in place. I think they strike the right kind of balance between what you need to do from a value offering, as well as add new merchandising events into the equation. And we're doing a really good job of playing up new items and scenes that we think will help get customers into our stores. We're doing sales events that we believe give us sustainable sales advantages for the future and we believe that will get us to the number we need to get to.

Is the gross margin experience of the second quarter what we're likely to see continue in the back-half?

Mary?

Well, we're going to continue to promote at about the same kind of level. I mentioned that our page counts are going to be very similar to last year. Customer's definitely responding to ads, but we've done a great job of working with our suppliers on putting together profitable promotions and, I think, do a really good job of balancing consumables with new items.

And , as you know, there's a bigger seasonal impact in the third and fourth quarter that has high margin but more mark-downs.

OK, great. Thank you.

Our next question comes from of Deutsche Bank.

Hi, good morning. Good quarter. I guess I'd like to just explore a little bit the comp guidance that was going into. It seems to me there is a lot of pressure on pharmacy comps. You've pretty much cycled the growth of third party. Obviously, the generic pressures you cited. And you do not have a lot of new stores moving into the comp base.

Can you just tell us, Mary, is this going to be a very -- I guess I'm just trying to figure, is the growth going to come from acceleration in front-end? Or am I wrong in assuming pharmacy comps have to slow?

Well, pharmacy comps are slowed by what generic -- due to your comp number. But in terms of real prescription growth, we have very specific goals to continue to raise that level by store. Remember, , I said that we are at a real disadvantage still to our competitors that we don't fill as many scripts as they do per store. And we've got very specific initiatives in place to raise that number across our chain.

Can you give us a metric there of what you're running now versus a year ago in terms of volume of scripts per store? I know you've -- kind of have a wide range, but is there an average or a high or low?

We don't put that number out, but we've made real, solid progress on our goals.

OK.

And again, we're not going to breakdown guidance on sales any more than the seven or eight comp sales for the third quarter.

OK.

And we're very comfortable with that number today.

Just looking at the store base, is there any reversal, you think, coming next year? And perhaps getting some new stores open? Do you see more stores, I mean, closing? What would you say for unit growth looking for next year?

Yes, I think we've done a lot of work this year to get through store closures. We still have some underperforming stores that we're working with and they had attributes that encourage us to believe that they may become profitable stores. So we're working through those. But those are stores we would come back and look at again in the first part of next year.

But our capital is really going to be focused on store renovation. We're going to do a very modest number of new stores and re-lo's next year, but we're going to do a substantial number of remodels.

OK. Thanks.

Our next question comes from of Credit Suisse First Boston.

Hi, guys. A couple of things. On the front-end, looking out over the, you know, I don't know, two months. For instance, Wal-Mart today had some weak sales. I wonder if there's, you know, something specific to what you're doing that you could kind of -- drugstore industry trends and sort of the broader retail trends or whether, you know, you're feeling that you can't really offset all of the economic pressure.

Well, one thing we have, , is easier comparables for the rest year than we had in the first part of the year. But Mary, you might comment about -- and we're not giving specifics, but we feel comfortable with that seven to eight range for the third quarter. And certainly there's front-end growth in there.

Right. And Bob's right. First thing to remember is that you are up against easier comparisons because of everything that happened there. And we do have very strong events and promotions planned around the holiday season. In fact, all the way through from here until then. And we're in good stock position in the stores. We really have no issues in that respect. We've done a really good job with our suppliers on our first to market strategies and that's going to help us through the rest of the year. And we believe that we'll make the numbers that we intend to make for front-end.

I'll tell you, the thing we can't measure but we know it helps is our associates' dedication and morale. And we continue to see improvement and we think that's a factor that will help us achieve not only with our sales growth, but our EBITDA growth.

And you know one other point, too, is that strengthening our pharmacy business also helps our overall store. Because as we get more pharmacy customers and grow real script growth we've got opportunities to sell to customers that weren't in our stores before.

So I guess in terms of company-specific versus the industry, do you think that it's much more the fact that you're on a recovery trend that you seem to be doing better than a lot of retail even at, you know, kind of September to date. It sounds like you're very comfortable with what you've done in September so far. Or, is the industry and business you're in helping at all?

Well certainly the industry. We continue to have - if you look at our pharmacy growth and the effect of generics, we have good pharmacy growth and we have good script count growth. And, as Mary says, that helps your front end.

So we think the drugstore sector is still the best growth sector in retail and we're glad we're in it. Certainly a little tougher than it was a couple of years ago.

And you know one other thing that, you know, that gap, the one positive about it is it does give us opportunity. And so we continue to work at that and find more ways to get sales from existing customers - especially existing customers, as well as new customers.

OK. Just one last question for John. When you look at the impairment charge this quarter, if you just looked out of the next several quarters in aggregate, and just took a worse case number of stores that may be impaired and a number to go along with that, could you give us a sense of that? I mean obviously not a precise number.

I can't. I mean you know, again, we've tried carefully to analyze, you know, these stores and understand, you know, what the impact of a closure is on our consolidated numbers and our liquidity. And so I think we've gone through a very rational process so far. But we really need to see how the remaining under-performing stores behave and where they go before we're going to know how many more of those could get closed. So it's hard for me to project that.

In terms of impairment, it's possible that, you know, we could make our guidance or even the high end of our guidance. But some stores could their plans or have negative cash flow and they could get impaired, even though we make our total number. So, again, those numbers are hard to project or forecast. That's why we haven't been giving guidance on those.

But, , I can tell you that we have done lots of work in the time we're here. And we think most of the closures are behind us. And that doesn't mean there won't be more.

Is that a true statement, John?

That's correct.

OK. Fair enough - thanks.

Your next question comes from of Goldman Sachs.

Shrink experience in the quarter, since most people are reporting increased shrink?

We're in good shape relative to that, . But we've been working on it for probably a little bit longer, because we started focusing on it well over a year ago. We put shrink management tools in place.

I mentioned we have rolled those out to our pharmacy now, and we've also put in some new exception reporting software relative to monitoring cashier activities. So we continue to work that initiative and it's going well.

Is it sort of fair to say that you're flat to down, where others are up? Or it's up for you as well?

No, we're in good shape here.

We're down from where we were, . And even though we're not - also, we've got to give credit to . We put a new executive in charge of shrink and security, what, a year and a half ago, Mary? Two years ago?

Yes, about that time period.

And he is doing a terrific job. He's been with Rite Aid for a number of years, and he's really getting control of this for us.

All right. Now, third party and cash margins were up. Is that just an issue of the easy comparison, or they're things you're doing internally, ex-generic to move those up?

I mentioned, , that we have cycled that cash prescription pricing reduction we did last year. So that's certainly helping us on the comparison. We started doing some fine tuning on that last year in the fourth quarter after our third quarter experience on pharmacy margins, so that's helping us this year. And we've been very focused on working with our third party people to develop some strategies to help both of our businesses.

You've seen the insurance companies and the guys you negotiate with pushing harder, yet you're seeing better experience with those contracts? How is that playing out?

You know, the I mentioned, we're doing those with PBMs as well as the pharmaceutical suppliers and those are helping us, I believe, begin some future collaboration efforts to improve both of our businesses.

Alright, but also you mentioned sales in September being a little bit better than August. Generally, just generally speaking, where have you seen that? Is it certain geographies, certain categories, and is it really more post-9/11 compared to pre-9/11?

I said, what I think I said is that we're pleased with September sales so far and, you know, we are up against easier comparisons obviously because of what happened. But we're also pleased with the response customers are giving us to the new promotional events that we've put in, like our anniversary sale running last week and the second week of it this year. So we're getting good response to categories, as well as value items.

Alright. And then finally, how many stores are left on the performance watch list?

John, I don't know ...

We've tried hard not to give out, you know, numbers of under-performing stores. But it's down substantially, obviously as our results have come up, we have more and more stores that have turned profitable.

And remember, we are like 400 stores less that we got here, right John?

Right.

I mean really, John, we have closed what we think is the majority of the stores that don't have potential. There's not very many left in the category that don't have potential.

So the ones that are left are ones that have potential but aren't meeting that and they may, they may not, and if they don't, you'll close those in the future?

That's correct.

That should be a relatively modest number compared to what you've done already.

That's right.

That's correct.

OK, thanks.

Your next question comes from Miller of Bear Stearns.

Good morning. I wondered if you could just explain--it seems on a sequential basis, your EBITDA margin has declined from the first quarter this year. How much of that is seasonal and how much of that is just, you know, say lower margin in the front end or on prescriptions?

I think it's all seasonal. John and Mary, you want to take a crack at that?

Yes, I think that's the exact--our case is very much seasonal. I mean I think the first quarter and the fourth quarter are going to be our stronger quarters that we said previously and that has to do with more sales and better leveraging and fixed expenses than the second and third quarters and that's the trend we're seeing.

And some seasonal events, Mary, in the first quarter like Valentine's Day and ...

Well, you've got March, April, May mix-up our first quarter so you've got the strength of your spring plus you've got Mother's Day in there, Easter, so you've got a lot of strong events going on where in the summer you pretty much have summer and you've already done a lot of early selling on even some of that summer product.

In the first quarter.

In the first quarter.

So Mary, would you say it's really all seasonal driven, that margin reduction?

Yes.

OK, great. Thanks.

Your next question comes from Dan of DK Equity.

Good morning, thanks for the good quarter. Could you tell us what cash flow from operations was for the first half of the year using a FASB 95 definition?

John?

Yes, it's going to be--hang on one second, I don't have a cash flow right--I think we used $5 million of cash.

A $5 million use?

Yes.

Do you know offhand how that compared to last year?

I don't, right off the top of my head. Actually, give me a second, though. We're scrambling around, then. Last year we used 48 million.

Thank you. And can I move onto the next item? You've mentioned a few times in the recent past, free cash flow projections. I don't believe you've mentioned them so far on the call. Could you perhaps address those? What you see for the balance of the year relative to your earlier forecasts?

The only thing we've ever given -- Chris, I'll let you take this -- is an annual kind of target. And you want to try to give him that, Chris?

Yes, the guidance we've given was in the range of 100 to 150 and we're pretty comfortable with that.

And that's for this fiscal year.

That's for the full fiscal year.

OK. So, you'd say unchanged projections there?

Yes.

OK. And an earlier question had to do with script count growth in this quarter and the first half of the year. I believe you said you don't have a comfort level of giving actual script count numbers, right?

That's correct.

OK. Can I move onto something else, then? The improved pharmacy store profitability. One of the legs you stand on is third party contracts. And last year I remember you going after volume to close the gap in script counts, also with third party. And I guess we had some -- the first shade of margin pressure related to that effort.

Yet, this year we're doing better in that arena. And I just wondered, is that basically a function of leveraging the expense structure that you have combined with generics? Are those the key drivers allowing for better third party contact margins?

Well, that's the two drivers of better pharmacy total margins. I'll tell you that. Leveraging the fixed cost is a big part of that because most of the cost -- even the cost -- in pharmacies are fixed. You have so many hours you have to be open. So, as we increase sales we leverage those costs substantially.

Mary, I think that we have continued to grow our third party business, but we haven't had any margins reductions on that part of the business versus last year to speak of. Is that a true statement?

No, overall margins are stronger and you know, that can be the mix of everything that's being sold. It's also what we've done with generics throughout, you know, our whole pharmacy business.

Then I guess as third party is 93 percent of pharmacy sales, that pretty well speaks for the whole ...

Yes, and when you get to that level, you know, the growth has to flow some. There is some cash business out there.

And one last thing, if I may. Could you mention -- are there any material, regional discrepancies in terms of same store sales growth or where it came from? What section of the store as you go across the country?

You know, we don't share that. But I don't think there's big discrepancies, is there Mary?

It can vary from time period to time period. So it depends what you're going up against.

But we don't break it down by region.

The reason I asked that is I believe you, Mary, at the Conference talked -- I believe I heard it correctly -- market share gains that you had at least at one level of the store relative to the overall competition.

Yes. That came out of the metro market studies. And we look at that each year to see how we're doing because that tells us whether our initiatives are working. And in all -- most all of our major markets we had market share growth this last year.

Thank you very much.

Your next question is a followup question from of Merrill Lynch.

Yes. I just wanted to followup on private brands. And can you just sort of give us an indication of what private brand penetration is right now? And where the products are being launched that you've launched and what you've got in store for the rest of the year? Does that have a depressing effect on sales? And is it a meaningful improvement in gross margin?

Well it definitely is a meaningful improvement in gross margin, so I'll start there. And we've also done some things with private brand to improve the margins, because we've been participating in some of the on line auctions on key categories and got some additional savings in almost all of the ones that we've done via the auctions.

We've introduced a couple hundred new items so far this year, and we have at least another 100 that we'll be introducing before the end of the year. And they're in all sorts of different categories. You know certainly a lot of them in our core businesses of . And we'll continue to do that area too.

But some in cleaning category and chemical category. So we look at all of the areas where we think we have opportunity.

Our penetration is slightly up over last year. And we expect it to continue to be up and to finish the year ahead of last year.

Is that around about 12 percent of front end? Is that what ?

No, it's actually closer to 11 percent.

OK. And just another product question. We're seeing quite a lot of comment in the press recently about, you know, a bunch of the vitamins and St. John's Wart and things like that not actually doing anything for you.

Mary, I think you said the vitamin category was quite strong because of the GNCs you've been putting in. But can you sort of talk about the underlying trend in this whole supplement area?

Well, I think what you're referring to with the St. John's Wart is more the herbal kinds of things that got a lot of negative press over the last few years. And so where we're really strong is in our core vitamin offerings, whether it's the , where we do a number of promotions every month; it's the GNC vitamin offerings. It's everything that makes up the GNC department.

And I think because we have a stronger emphasis on the whole vitamin category, it also helps the sale of our Rite Aid private brand vitamins too. So our vitamins overall, when you add those together, have been positive really for the last year and a half, two years.

And, , as you know, that category nationally has been down. So we give GNC a lot of credit; that GNC store within a store concept for that.

OK, great. Thank you.

Your next question comes from of .

Good morning.

Hi.

Would you be so kind as to repeat the figure that you released earlier about the amount of money spent on prescription files?

Yeah. It's...

3.5...

$3.5 million.

$3.5 million. Out of total cap ex it's ?

Yes.

Yes.

Great. And with respect to the issue of total script count, can you at least assure us that you - you know your script count, I guess on a comparable store basis, is growing faster than the market as a whole?

Mary? I don't even know if I know that.

Well I - yeah. I don't talk about what other people's script count growth is, they talk about it. We really focus in on ours, and we're really hitting on the numbers that we set as our goals.

Yeah, we're hitting - we had a script count growth target and we are hitting that target for the first half.

OK. But in other words, you couldn't then make a statement whether you are - you believe that on a per store basis you're gaining share or holding share or possibly not quite holding share?

I don't think we can.

OK, thanks.

Your next question comes from of .

Congratulations on the quarter.

Thank you.

A couple of questions on the balance sheet side. Could you give us the pro forma term loan balance for the repayment of the ? Are we up to ?

Chris, do you have that?

Yeah, we basically be fully drawn at this point.

OK. Even in light of the amortization that you're making on the term loan?

No. No. Hang on a second, Chris will give you the exact number.

We had a little, 7 or 8 million we paid down.

Right, and you're doing that quarterly, right, the 7.5 million, now? And I was just curious whether or not you had repurchased any of the sixes of '03 during the quarter?

We repurchased $21 million of those.

At the end of the quarter, the term loan was 1.366, the 20 million that we drew on was after the quarter. So that'll go up by 20 million in the third quarter.

OK, and I'm sorry, you repurchased -- of the sixes, you repurchased 20 million?

Twenty-one.

Twenty-one?

Yes.

OK, and do you have plans, if you're willing to comment, on asking the banks for permission to do open market repurchases of the '05 debt now that the converts have been repaid?

We wouldn't want to comment on that today.

OK. And I got the private label penetration is somewhere between 10.5 and 11 percent, is that correct?

That's correct.

And did you affirm the cap ex budget for the year of roughly 120 to 130?

Yes.

OK, thanks very much, good luck.

Thank you.

Your next question comes from of Credit Suisse First Boston.

Yes, good morning everyone. My first question, I just wanted to talk about the expense for closed stores. Just what should we be using as an annualized lease expense in light of the impairment -- stores closing and impairment charge that you've taken.

John, Chris?

Cash use for, you know, for store liabilities is ranging between 50 and 55 million right now. What happens is it goes up slightly as we close stores, and then we digest those with subleases and terminations. So.

It's been pretty constant around 50 for a number of quarters now, right John?

Right. I think it's actually at 54 right this second, but it will work its way back down.

OK, great. And also just -- I didn't hear the number of stores that were in the store closure program for the charge that was taken.

There were 32 stores.

So 32 stores will subsequently be closed, then?

That's correct.

Is there a target then in terms of number of stores by the end of the year?

We have identified foreclosure all the stores we're going to close. We've taken the store lease exit charges for those stores through the first two quarters

OK.

But there are stores we've taken the charge for, including the 32 that we just talked about, that are not yet closed. And that number is 48 stores. Does that make any sense?

So there's 48 that have been designated but not closed as of the current point in time?

Right, and then all those charges for those four that accept inventory liquidation has been taken, right?

That's correct.

OK, that's helpful. And also on the revolver, you said you had $390 million of availability. Is the balance just letters of credit, you have the $500 million full availability?

That's correct.

And finally, could you give us a sense of peak borrowing, just as you get into the holiday period, what we should anticipate from a peak borrowing standpoint?

John?

It's not going to be that significant. We haven't touched the revolver in 10 months now, so...

We did say earlier we may use the revolver at peak times, but there's a good chance we will not even use the revolver. Is that ...

No, I think -- kind of a Friday--Monday thing. I think it's how our revolver use will kind of shake out, and I don't know if that's 50 or 100, but it's something like that, it's peak.

For a very short period.

Right.

Great, thanks very much.

question comes from of Thomas Weisel Partners.

Hello?

Hi.

Hi.

Hi, I have two questions on the pharmacy side. My first question is about generics. I'm wondering if you get your generics primarily from the manufacturer or from your distributor?

Mary?

We buy our generics ourselves.

Direct.

Direct, OK.

We warehouse them.

Excellent. And my second question is regarding the Bush administration's drug discount card proposal. I'm wondering if you think that will actually go through or if you think it'll get held up in court as did the last proposal.

Mary? You can speculate on that one, Mary.

Yes, we don't know the answer to that one, yet. I mean, obviously it still doesn't answer the real needs that are out there and so we're working along with the rest of our industry to help do additional education there.

OK, but are you planning to take it to court -- is the lobbying organization planning to take it to court again?

I don't know the answer to that question.

OK, thank you.

Your next question comes from of Investment.

I wonder whether you can comment on external conditions that might get in the way or even facilitate your recovery. I'm thinking about competitive pressures, third-party payment pressures, a particular competitor, a particular region where you have problems. Anything that's sort of a big potential air pocket here over the next several years?

Competitive situation has been there all along. I think this whole last year has been a challenging environment for most people, most retailers, so we learned to get customers into our stores regardless of that.

I think you just repeated the risk factors we read at the beginning of the call.

I mean, you know, we can't speculate on what's going to happen in the future on things we don't know about. We still feel good about our trends today and the second half of this year.

But there's no, you know, proverbial Wal-Mart out there, one company that's particularly challenging?

Well, there's no one, there's hundreds of them that we compete with. You know, everybody sells the same thing we do in a lot of categories, and we just have to run good stores and take good care of our customers.

And your store prototype, what you have actually in place now is a competitive one in your view?

Mary?

Yes.

Thank you.

Your next question comes from of Investment.

Good morning.

Hi.

On the front end, is it fair to say that excluding the stores that you closed during the quarter that the front-end margins would have been up?

I think they're pretty flat. Mary?

Yes, they're pretty flat.

OK. And then on the pharmacy margins, specifically talking about the generic penetration. How do you expect it to continue to impact pharmacy margins throughout the rest of the year, given events that might have, you know, occurred last year?

Mary?

It continues to be very positive. There have been a lot of generic introductions, a lot of little ones, as well as some of the larger ones and it's also something that's getting focused through the states and the different agencies to promote the use of generics because it saves everybody money.

Certainly. What are you learning from the loyalty card? I know you haven't rolled it out in any more markets, it's a limited test that you have. What are you learning, what do you think about further using that?

A card doesn't get you loyalty. I mean, if you look at the food stores, you can see that most of them haven't been able to sustain sales momentum, so I think the jury's still out on what those cards do. We are continuing our tests in certain markets, but we're not prepared to roll it out at this point. We will continue to offer good values to customers and run our promotional events to get them in the store and take good care of them when they're there.

And finally, if you could just touch on your pharmacist position currently and how you're dealing with the -- do you have a shortage at this point in time?

The industry has a shortage. And so we all have strategies in place to deal with that. We've been very aggressive on the recruitment side. We've got very strong intern programs and we're in good shape. We've got hard to fill markets, but we continue to focus in on those.

Thank you.

And you know we would say certainly one of the strengths of not opening up a lot of new stores and closing some stores has been our ability to transfer those pharmacists to other stores. So I think that's helped our situation, compared to other competitors.

Hey, Bob, do you think one or two more questions?

Sure, two more.

Your next question comes from of J.P. Morgan.

Hi, .

Hey.

I guess a quick question. For the generic dampening effect on your pharmacy comps, I guess you didn't change your comp items for the third quarter. So is that - as you look out I guess for the third quarter and even the fourth, kind of thinking ahead with, you know, . Is it 220 basis points about the - where do you expect that could go, I guess, for the second half here?

Mary, you still see some growth there, I think.

Yeah. Or certainly around the same area that it is now. I don't think we still really know what's going to happen for sure with .

Yeah, that may be over the counter.

I still don't know on the date...

Right.

... what's going to happen for sure there.

And you're going to cycle some generics last year.

Right.

I think one or two - right, one or two ones .

OK. And in terms of, you know, kind of the scenarios with and, you know, if it's over the counter, is that the economic still - have you run the scenarios? Is it still pretty favorable in some of the - I guess in some of the analysis you've done?

The overall will be, yes.

OK. All right. And then one other thing, just to clarify.

With the improvement in your pharmacy margins, the 65 basis points - and I think you said a fair amount of that was from generics - was there - did you have a sequential improvement in your generic margins relative to what you did last quarter?

Mary?

I think it's modest. But I think our projection, our guidance really assumes that the level is going to kind of hold up for the rest of the year.

OK, thanks.

Your final question comes from of .

Hi. inventory ratio. It's been down - it was down in the second quarter by about 500 basis points. It's down in this - I'm sorry. It's down in the first quarter, down in the second quarter by 400 basis points. Can you say how that's benefiting your gross margins?

John or Chris?

A lot of that is just timing. Payables, you know, fluctuate some. It's just the nature of the beast. I don't think I can directly correlate that to any change in gross margin.

I mean if you're talking about cash discounts, I don't think cash discounts were up substantially.

Right. And your inventory is down 12 percent, while your sales are up five percent. Can you comment about inventory levels into next year?

Part of that, obviously, is higher productivity per store. We have reduced our store count but grown our sales. That's obviously getting us better turns.

That's certainly a factor there. And then we've been focused on working capital improvement, Mary.

Right. We have , and that significantly reduced any carryover inventories. We're very judicious about what happens there. So we're in clean shape out in the stores.

Thank you.

Great. Operator, that will do it. Thanks everyone and goodbye.

Thank you for participating in today's Rite Aid second quarter results conference call. You may now all disconnect.