Rite Aid Corp (RAD) 2003 Q3 法說會逐字稿

Good morning. I'm your conference facilitator today. I'd like to welcome everyone to the Rite Aid 3rd quarter 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 period. To ask a question during this time, simply press star, then the number 1 on your telephone keypad. To withdraw your question, press the pound key. Thank you.

Mr. John Standley, you may begin your conference.

Thank you. Welcome to our 3rd quarter conference call

On the call today with me 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 third quarter operations. I will review third quarter financial results. Bob will give some comments on third quarter and talk about our guidance for the fourth quarter and next year. Then we will have a question and answer session.

Before we begin today, I'd 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 outcomes 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, success of planned advertising and merchandising strategies, general economic conditions and inflation, interest rate movements, access to capital, and the company's relationship 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're 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 third quarter.

Thanks, John. Good morning.

We're extremely pleased with our third quarter results. Our EBITDA more than doubled compared to third quarter of last year and exceeded the high end of our guidance for the fourth quarter in a row. As a result of this strong EBITDA contribution to our year to date results, we have raised our full-year EBITDA guidance to 605 - $615 million.

While our same-store sales increase of 6.7% was slightly weaker than originally expected, gross profit improved year-over-year on the front end, as well as the pharmacy, as we continued to drive profitable sales. These growth profit gains, continued cost containment, and the focus by all of our departments on our EBITDA achievement program were the primary drivers behind our results.

Pharmacy same-store sales increased 9.6% with gains in all months of the quarter and script count up in all divisions. Comps were negatively impacted by several factors. A slow start to the cough, cold and flu season, weak sales of HRT estrogen products, and significantly reduced sales in the antibiotic Cipro, positively impacted last year by the anthrax scare. And the continued increase in generic dispensing dampened comps down by about 2% but it continued to contribute to substantially higher gross profits. Also positively impacting pharmacy was improved gross profit on both third party and cash prescriptions.

During the quarter, we continued our pharmacy marketing programs targeted to high-prescribing doctors in key markets and held events to strengthen our healthcare image and attract new customers. Nearly 80,000 people attended our two-day Detroit Health and Beauty Expo in September. We recognized National Diabetes Month in November with in-store Health Fairs in our stores.

We continued to purchase script files and have accelerated our acquisition program for the fourth quarter and into fiscal '04. Our pharmacy department, along with our legal, technology and training departments, stepped up the focus on HIPA-related initiatives as we get ready to implement these complex new privacy guidelines in April. We also, as discussed last quarter, piloted our next generation pharmacy system for rollout beginning in January.

On the front end, we led the chain drugstore channel with a 1.9% same-store sales increase and positive gains every month during the quarter. Consumables, general merchandise, liquors and core drugstore categories continued to perform well with OTC especially strong in November. With major transitions in cosmetics, optical and pre-paid phone cards completed, these categories posted substantial gains by quarter end.

Vitamins continued to produce several-digit increases as we added 42 new GNC departments during the quarter, bringing the total to 905 for the year, and keeping us on target achieve our goal of 1,000 GNC store-within-a-store shops by the end of this fiscal year.

Private brand penetration continued its gains over last year as we continued to add both new and improved products to our mix. We are also very pleased with the success of our online auctions with private brand products and have experienced double-digit savings. We have now extended the auction process to include nonretail items.

We experienced good sale through on Halloween seasonal products. The Christmas holiday seasonal was softer than expected due to the later Thanksgiving holiday.

Film processing continued to be weak for us, as well as the rest of the drugstore channel, and cigarette and tobacco sales remained depressed as a result of higher taxes and required placement behind the checkout counter.

Our promotional spend was similar to last year with our circular page counts the same as last year. Even without an increase in spend, our focus on key events, such as our Anniversary Sale, successful execution of channel-leading first-to-market strategies on new items, and overall strong product category and price offers, led to good results.

The West Coast dock strike had no impact on our business, thanks to the efforts of our category management team and distribution center associates.

As for SG&A, expenses were lower as a percent of sales by over 100 basis points compared to last year's third quarter. Benefiting from our labor scheduling tool, a reduction in our worker's compensation costs, and lower distribution expense.

Overall shrink expense continues to be on plan with pharmacy also benefiting from shrink management tools rolled out at the end of the second quarter. Inventory levels are down from last year but service level and in-stocks continue to be excellent.

As we approach the holidays, we face the challenges of a shorter holiday selling season, severe weather disruptions in various parts of the country, and increased competition. But a stronger cold and flu season now in full force will help script counts grow and OTC sales.

And even as our competitors' ads heat up with more pages, hotter prices, and more items on sale, we keep successfully working our programs. We have very strong promotional plans of our own, with new events complementing a strong product assortment. We've added a holiday coupon book in the West Coast and select Central and East Coast markets to our 20-page weekly circulars. Our 24 Days of Christmas holiday promotion, with a bonus card for specially marked items throughout the store, has been well-received. And we're running strong holiday TV advertising in select major markets.

I can't yet tell you what Christmas sales will be. Late and short holiday seasons have always been unpredictable. But I can tell you this: We expect to earn our fair share of the business out there. Post-Christmas events are also strong and include Rite Aid Brand Super Value Days in January and our Third Annual President's Day Sale in February.

Two noteworthy events during this month include the introductions of OTC Claritin, which we have on our shelves December 10th, the first day it was available, and generic Prilosec, one of the mostly widely prescribed brand drugs. In the first 11 days, our Claritin sales have been slightly above expectations and it remains to be seen what impact insurance companies dropping Claritin from coverage will have on overall pharmacy sales. As for generic Prilosec, we don't expect a huge benefit at this state because it is a single source generic with high acquisition costs and limited supply.

While we still find ourselves operating in a challenging environment, I feel very positive about the programs we have in place to maximize our opportunities in the fourth quarter and excited about the tremendous progress Rite Aid has made this year. And we are already hard at work on our EBITDA achievement program initiatives for fiscal '04, which will again involve cross-functional teams focusing on sales and margin growth, operational excellence, market optimization, continued supply chain improvement, and continued expense control.

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

Thanks, Mary.

Overall, we're very pleased with our 3rd quarter results. Gross margins remain strong and we did a good job containing our costs.

Total sales for the 13-week third quarter were 3.88 billion versus sales of 3.73 billion for the prior year third quarter. Sales increased $147 million or 4% this year versus last year.

We operated 3,411 retail stores at quarter end versus 3,583 stores at the end of last year's quarter, a net reduction of 172 stores or 4.8%.

Same-store sales for the quarter were up 6.7% with pharmacy comparable store sales up 9.6% and front end comparable store sales up 1.9%. Pharmacy comparable store sales for the quarter were negatively impacted about 2% by an increase in generic sales mix. Although increases in generic sales negatively impacted comp store sales, they increased gross margins.

Prescription sales accounted for 64.3% of total sales and third party prescriptions represented 92.9% of total pharmacy sales.

Gross margins, which include occupancy costs, were 902.5 million or 23.3% of sales for the third quarter this year, versus 816 million or 21.9% of sales last year. Excluding noncash LIFO charges of 17.3 million this year and 15 million last year, gross profits were 919.7 million and 23.7% of sales this year versus 831 million or 22.3% of sales last year, an increase of 144 basis points.

Occupancy related costs included in gross margin were flat as higher utility costs offset the rent reduction from closed stores. As a percent to sales, occupancy costs were lower by 15 basis points due to better leveraging and fixed expenses.

Front end gross margins were up 69 basis points on total front end sales that were down slightly. Front end sales were down slightly because the impact of closures more than offset the 1.9% comparable store sales gain.

Pharmacy gross margins were higher as a percent of sales by 187 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 third year quarter.

Selling, general, and administrative expenses for the quarter decreased as a percent to sales by 108 basis points compared to the prior year, after adjusting this year's SG&A for 6.6 million of net nonrecurring legal settlement income. The lower operating expenses are due to the better leveraging of our fixed expenses as our volume-free unit continues to increase, and good control over operating expenses at our stores and in our corporate office.

Noncash compensation was a charge of 2.6 million this year versus income of 39.4 million in the prior year. The noncash compensation relates to variable plan accounting on certain management stock options and the vesting of restricted stock brands. A large amount of income in the prior year is a result of the change in our stock price at the end of last year's third quarter compared to the price at the beginning of that quarter.

Interest expense was 80.9 million for the third quarter versus 82.5 million last year's third quarter. Interest is lower than in the prior year because we've reduced debt by $200 million since the end of last year and due to lower interest rates this year versus last on floating rate debt.

Interest was broken down as follows: Cash interest on debt this year was 64.6 million. Last year was 67.1 million. Cash interest on capital leases was 3.7 million this year versus 3.8 million last year. And cash interest bank fees were 3.2 million this year versus 3.2 million last year. Total cash interest expense was 71.5 million this year versus 74.1million last year. Noncash interest expense was 9.4 million this year versus 8.4 million last year. And again, total interest expense was 80.9 million versus 82.5 million last year. Last year's third quarter also included a $10.4 million charge for interest rate swaps. There were no interest rate swaps in effect during the third quarter of this year.

Noncash income and expenses can be summarized as follows: Noncash stock compensation this year was a charge of $2.6 million versus income last year of 39.4 million. Store closing and impairment charges were 2.9 million this year versus 18.7 million last year. Closed store liquidation expense was 7.5 million this year versus 6 million last year. And last year we had a charge of 1.7 million on our drugstore.com equity and other noncash charges of 1.9 million. Total noncash expenses for this year were $13 million and for last year we had income of 11.1 million.

Store closing and impairment costs totaled 10.4 million which includes the 2.6 million of expense on the face of the operating statement and 7.5 million in expense to cost of goods sold, representing inventory liquidation costs. We have not yet incurred store liquidation costs on 21 stores that we've identified for closure but not yet closed. In addition, we will perform our annual impairment test in the fourth quarter that could result in additional charges.

Gains on sales of assets were $800,000 for the third quarter this year versus losses of $700,000 last year. Our net loss was 16.4 million, or a loss of 5 cents per common share for the quarter compared to a loss of 112.8 million, or a loss of 23 cents per common share for last year's quarter.

On an adjusted basis, net loss for this year was 7.3 million, or 3 cents per common share compared to 117.7 million, or 24 cents per common share last year. The adjustments for this year include the $13 million of noncash expenses, the $800,000 of gains on asset sales, the net nonrecurring litigation settlement income of 6.6 million, and 3.3 million of nonrecurring legal and accounting costs.

Prior year third quarter adjustments include the 11.1 million of noncash income, $700,000 of losses on asset sales, and $5.5 million of nonrecurring legal and accounting costs. We included a schedule in our press release that reconciled our net loss to our adjusted loss.

EBITDA for the quarter was 161.1million or 4.2% of sales, exceeding the high end of guidance range by 31.1 million and an increase of 83.6 million over the prior year computed on a consistent basis. We've also included a schedule in the press release that reconciles our net loss to our EBITDA total.

Some other third quarter information you might be interested in. First of all, liquidity. Although we completed the seasonal build of inventory and repaid $161 million of debt, our liquidity remained strong during the quarter. Cash on the balance sheet at the end of the quarter was $237 million, and our revolver remains undrawn, except for outstanding letters of credit and reduced our availability on the revolver to 410 million.

Factors contributing to our liquidity include our strong EBITDA results, modest changes in operating assets and liabilities, and a $68.5 million of tax refunds we received during the quarter. The majority of the refunds are due to changes in the tax law that allowed us to carry our 2001 tax laws back to years in which we had taxable income. We continue to work on amending our tax returns to reflect the adjustments we made in the statement, which should result in additional tax refunds in the future.

The debt reduction was primarily due to the repayment of the $150 million 5.25% convertible notes due September 2002 on their scheduled maturity date.

During the quarter, we remodeled 45 stores, relocated 4 stores, opened one new store, added 42 GNC departments within our stores, and closed 34 stores.

Cash capital expenditures for the quarter were $27 million, including 2.3 million spent to acquire pharmacy prescription files.

Bob Miller will now comment on third quarter results and our guidance for the fourth quarter of next year.

Thanks, John.

As you can see, we had a very good quarter. In fact, this is the best quarter we've had since this management team came to Rite Aid three years ago. There is no question that this company is on solid ground and our business plan is working. As you can see from the press release, we've given guidance for the fourth quarter that includes a 6 to 7% increase in same store sales and an EBITDA range of 160 to 170 million.

Because of our strong EBITDA results to date, we've also raised our guidance for the full fiscal year. We expect EBITDA for fiscal 2003 to be between 605 to 615 million compared to the previous range of 565 to 600 million. Mary and her team have done an outstanding job improving our operating performance in a very tough environment.

In the press release, we've also given you a preliminary look for fiscal 2004, which begins March 2nd, 2003. Based on initial business plans, we expect sales of 16.6 billion to $16.8 billion, a same-store sales increase of 6 to 7%, an EBITDA of 675 to 725 million. We also expect to generate 200 to 250 million of free cash flow.

Our results this quarter and our projection for next year speak for themselves. Things are better at Rite Aid. In the past few months I've seen it first hand in our stores across the country. I see better run stores, satisfied customers, happier associates, and an enthusiasm for and a commitment to our company. This makes us well-positioned to continue to improve our performance and deliver shareholder value in the future.

Operator, we'll now open it up for questions.

At this time, I would like to remind everyone, in order to ask a question, please press star, then the number 1 on your telephone keypad. Please hold for just a moment while we compile the Q&A roster.

Your first question is from Mark Husson.

Good morning, guys. Amazing numbers. Just off the cuff, I mean, you obviously had an easy comparison in this quarter. As you were budgeting and getting your guidance, was it because you sort of misjudged the step-up you would achieve over the course of last year? Or were things sort of, you know, what happened? Basically?

We had a good quarter, Mark. I think one of the keys for us is we have worked hard to really control our operating costs and Mary and her team have done an outstanding job and certainly that helped us in the third quarter. But I think it's going to help us ongoing, too. Mary, you may have some comments?

Yes, I think what you're seeing is just a momentum continuing from what we got started on early in the year and all of our cross functional teams are doing a good job on keeping the parts moving forward that they are responsible for.

And just going forward, what are the things that you haven't got that the others have got? You've got amazing internal momentum, as you talked about, but there isn't an awful lot of top line. With an increase in free cash, you have an increase in profitability. Presumably a number of capital expenditure projects start to screen out positively for you that wouldn't have done before. Are there any plans to use the free cash to step up cap ex?

Mark? Two points. Number one, we think our best return is continue to increase our average volume in existing stores. I can tell you we have more remodels planned next year than we've had any time since we've been here.

We also are aggressively looking at a stepped up capital plan that would really be to build relocation stores in existing strong markets. At this time, we have not decided to do that. Our capital plans are still in the 150 range for next year, but we have the potential, with our strong cash position, our projected free cash flow, to certainly invest more money in this company next year if we decide to.

I did a very comprehensive, strategic review of our markets and identified the markets where we do need to do replacement stores going forward and are prepared to put those plans into effect over, you know, a shorter period of time if that becomes possible.

Great, thank you very much.

Thank you, Mark.

Your next question comes from Leah Hartman.

Good morning. I'm with CRT Capital. Congratulations on a fabulous quarter! A couple of questions, was there a term loan repayment during the quarter?

Yes. 7.5 million.

Okay. And I didn't hear on the cap ex the number spent on prescription files?

For the quarter?

Yeah.

Not very much.

2.3 million.

2.3?

Mary, you might comment. We are really trying to gear up our script purchases, though.

Yeah, we've added additional resources in the field to really step up the program and we will have stepped it up substantially for the fourth quarter and dramatically for next year.

And we have very strict requirements on payback, too. So we're not going to buy script files unless we get a very good payback.

And it's really focused on specific stores and areas where we need to get the script volume up.

I assume that was part of your strategic overview as you were focused on replacement stores, you're also focused on that?

Yes.

And could you tell us what percent or dollar amount of the 150 for next year is targeted toward prescription file purchases?

About 20 million.

Yeah, about 20 million, at this point.

But I will tell you, if we found more available that met our requirements, we would increase that if we can find the script files to buy.

Sounds good. And my last question is, with respect to open market purchases or privately-negotiated purchases of debt, which you've done very successfully in the past, are you now permitted, under the bank agreement, to purchase 2005 debt maturities?

The answer is no. But we are in discussions with our lenders to provide us more flexibility to purchase indebtedness. However, we have no definite plans to do it at this time.

And like I said, one of the challenges for us is we see big opportunity with an increased capital plan and we may think that's a better investment as we analyze that. So, like I said, we're in discussions, we may have the right to do that and we may do it, but we're going look for the best investment to get the best return for our shareholders.

Understood. Did you make any more purchases of the (indiscernible) during the quarter?

I think we bought nothing in this quarter. Nothing in this quarter.

Nothing in the third quarter?

Right.

Okay. Thank--

I think we bought three early. We might have bought 3 right in the very beginning of the quarter.

We might have bought 3 million in the start of the quarter.

But nothing since.

Nothing since.

Okay, that sounds great. Well, best wishes for the upcoming quarter.

Thank you.

Your next question comes from Jack Murphy.

Good morning.

Hey, Jack.

Wonder if you could talk a little bit more about the generics? And it sounds like most of the addition to the pharmacy gross margin was from that. Could you just kind of verify that and maybe give us a sense of where you think the benefit is going in the coming quarters? Do you expect the gross margin benefits to diminish at all? Or is it going to be on this order of magnitude?

Well, generics are definitely a positive contributor to what's happening with our pharmacy margin. I think all the different things that we've worked on this year have helped too, because we continued to aggressively work with our different third-party plans. We continue to fine tune our cash prescription pricing and staying competitive, but making some inroads there over what had been done last year. The generics, where we were already strong, we've continued to get stronger and we have specific goals to keep increasing that penetration.

In terms of the number of patented drugs or branded drugs coming off patent, are you -- do you expect any kind of decrease in the benefit, though, or...can you offset that with the internal push for higher utilization?

Yeah, well the utilization is a real key factor and that's what we will keep pushing on. I don't know of any significant change in what's going on right now there.

Okay. On the OTC, with Claritin OTC coming into stores, are you seeing, or do you expect to see, more of a push toward direct OTC and less toward generic with a prescription? Or do you think that this Claritin OTC is more of a one-off occurance?

I think it's maybe a one ocurrance right now. I haven't heard of any other large ones on the OTC switch. I think there will be discussion on that. I think there will be definitely a move to get generics to market faster, though, just based on the fact that they offer more value to everybody in the pharmacy supply chain.

Okay. And, Mary, you mentioned a few things on -- that were depressing comps in the quarter. Is there anything beyond that? It looks like there was some erosion in the pharmacy comps, not just really with Rite Aid, but across the industry in the last two, three, maybe four months. Is there any kind of, you know, temporary trend or anything else you might point to and maybe give us a sense of how you're looking in December?

Well, we're pleased with where the pharmacy comps are in December. And some of the things, like the Cipro issue, gets behind you pretty fast. It was really a third-quarter issue. So, that's behind you. You will have continued issues with estrogen therapies because of all the bad press that it got, but we're pleased with where we are right now.

Okay. Thanks.

Thank you.

Your next question comes from Eric Bosard with Midwest Research.

Good morning.

Hi, Eric.

Hey, the first question today was about the internal momentum you have. I'd like to hear further from you on comps have slowed kind of throughout the year and are lower now than they were in the third quarter. The comps were lower than your guidance in the fourth quarter. Comp guidance is lower than it was in the third quarter. I understand the Cipro and some of these other things, but can you just talk about pharmacy and front end, why the internal momentum or comparable momentum is actually slowing?

Well, you've got different factors on different pieces. I think in terms of front end, we've performed well compared to our competition, when you look at our third quarter results and sales volume per average store has gone up pretty dramatically going back over the last couple of years. So we're making good steady progress on our initiatives to grow that sales per store.

There are, you know, obviously economic and weather factors that affect business. The later Thanksgiving was a factor on front end sales. And I think we discussed the pharmacy issues and pharmacy comps with a pickup on cold and flu have definitely improved.

And, Eric, you have to look at us a little different than our major competitors. We have not been opening new stores the last few years. And as you know, when you open a lot of new stores, you get the big sales increase in the second and third year, which affects the comps. We really don't have that in our numbers. Ours is a true comp number. It is different than our major competitors.

If you look into next year, and you've talked about guidance for next year, is the comp expectation now the sort of 6 to 7 we will see in the fourth quarter? Is that the kind of comp pace we will see maintained in the business heading into next year, or is this a fourth quarter specific slowdown?

That was our guidance for next year and our business plans are very early. But that's our number today. We will certainly update that every quarter if we see a trend that improves.

We definitely believe that sales are important to our future success, but we also know that the other components are important, also. And if there are factors that depress sales, you have to also be managing all those other components and that's what we're doing. And then you don't plan expenses too high against sales numbers. So, it's important to look at all the factors.

Again, if we decided to wrap up our relocation store plans, it would be a late year occurance, but that would affect us. And we have over 200 remodels scheduled next year?

Yeah, about 250 remodels that we've already put into the program for next year. It will affect a lot of stores, even a lot of the smaller stores that need some good clean-up on the East Coast and in Central.

I'm not sure that's a big, positive sales increase when the stores are torn up for a period of time. After the fact they are but if they get done late in the year it will probably be a little bit of a negative. That's our plan and we think that 6 to 7 is the number we see today. It may change when we talk to you after the fourth quarter.

And the mix of that 6 to 7 next year, is that similar numbers to where we are today? Or do you expect the front end to grow, perhaps a little bit faster within that?

I think it's pretty similar to what we're seeing today.

Okay. And then second question. On the promotional front it sounds like you're perhaps doing a little bit more here in February. You commented about sort of profitable sales. Can you just give us a sense in terms of what the promotional strategy is 4Q and then what's considered in the early planning for next year, really on a year-over-year basis, what you expect to be doing?

Eric, I think we have very strong promotional programs and I've always felt that. If you look at the kinds of events that we're running for fourth quarter, our preholiday events are strong and they're interesting. They're not just price promotions. If you look at what we're doing post Christmas, when the customer definitely more in a value, how much can my money buy mood, we do things like our Rite Aid Brand Stockup Sale and our President's Day Sale, which we have suppliers clamoring to get into because it is such a successful two-week event. So, I think we've got, you know, good promotional plans and that customers will respond to those.

And, Eric, we have not been in the giveaway the big commodity game just to drive traffic. We really want to improve drugstore sales on drugstore items and I think our people have done an excellent job of that.

One of the areas where we get a lot of applause from the suppliers happens to be on how we're getting new items introduced into the marketplace. And in almost every instance of a new item to market this year, we've led the channel because we've put together a plan that gets it out there as quickly as it can get out there. Stores get behind it. It gets in front of the customer. That's something you don't have to run a giveaway ad price on if you've got something the customer wants to buy. It is a combination of things to keep sales momentum positive.

Great. Thank you.

Thanks.

Your next question comes from Steven Chic with J.P. Morgan.

Hi.

Hi, Steve.

I guess a couple of questions. The first one: For your fourth quarter guidance -- EBITDA guidance, is, you know, it looks like, given the results that -- and given the results you just reported, which were very good, it seems like you could be, you know, possibly maybe airing on the conservative side for Q4. Or it seems like what you raise for the full year was largely kind of what you have to date. Is there -- are you thinking a little more conservatively for the fourth quarter in terms of any of the, you know, sales or margins and so forth? And is there a potential upside to that number?

There is potential upside and there's potential downside, Steve. So, the guidance is the guidance. We're really not going to comment on guidance except to say, based what we see today we're comfortable with the guidance we're giving for the fourth quarter and next year.

Okay, and what you're seeing, maybe it is too early to tell, but I don't know if you said, what you're seeing with December sales trends right now, are they, have you seen overall an uptick from what you saw in November?

We still have six big days to go until Christmas. And when you've got a shorter and more compressed season like this, you have to get those six days in. And I think I mentioned earlier that we're pleased with where pharmacy sales have gone with the improved cold/flu season.

But with the jury still out on the front end.

Okay. Gotcha. A separate question. What rate of -- what percentage of your total prescriptions are you filling now, approximately what is that, that are generics? Do you have the number handy?

We don't generally provide that number, but we would be right up there with the very best generic providers and it works in our favor with the third party plans.

Okay, gotcha. And one last thing, John, you mentioned a tax refund you received during the quarter. What was it? 68 million, did you say?

There was a total of $68 million in tax refunds in the quarter.

That doesn't affect the P&L?

It doesn't. We took a benefit in the first quarter, I don't know, of 48 million or so. This refund relates to that benefit.

Gotcha. Okay, thank you.

Uh-huh. Thank you, Steve.

Your next question comes from Karen Miller from Bear Stearns.

Yes, good morning. Hi.

Hi.

In terms of the growth margin improvement, how much of that is attributable to profitability? In other words, could you increase these refills on a weekly basis?

I'm sorry, could you repeat your question?

Okay, sure. We can't hardly hear you, Karen Is this better now? Yes, that's better. Okay. Great. In terms of the prescriptions filled on a weekly basis, the gross margin improvement, does some of that stem from better productivity and have you increased your script count on a monthly basis and if you have that figure?

Yes, script count is in all divisions, I think I mentioned that in my comments and really it is the mix of what we're selling.

Do you have a number for the script count, exactly what it is?

No, we don't give that number out.

Okay. And in terms of your front end sales, about how much now do you have in terms of private label penetration?

It is about 11% and we're tracking pretty close to our plans. We believe we still have room to continue to grow that and we've got good plans in place already for next year.

Okay. Great. Thanks a lot. Thank you.

Your next question comes from John Heinblocker from Goldman Sachs.

Two things. What is the update on state Medicaid? And in particular, are there more -- a lot more Delawares out there -- hello?

Hi, John. Can you hear us?

Are there a lot more Delawares out there, or, you know, do you think that's kind of, you know, a unique situation for this year?

Well, with Delaware we've made our position pretty clear with state and that we've met with them in their offices and gone through some ways that they can actually save more dollars by doing some other strategies in their program. And we've told them that the rate that they are proposing is not acceptable to us and we're waiting for some answers back from them.

As far as other states, it is too early to really tell on the other states. There are a lot of states out there that have budget problems and there are going to be a lot of issues come up on Medicaid and we are working very actively, both ourselves, and along with NACDF, to educate legislators on ways to get those savings within their programs without taking it out of the hides of the pharmacies.

And I will tell you,John, where we've had the ability to sit down with state officials and go through our program and talk about potential savings that we can help them achieve, we've had good luck in offsetting some of these proposed, I'll call them decreases and reimbursements.

You don't make much money on Medicaid prescriptions to begin with, is that fair?

Average, I would say.

Average, yeah.

Is there -- is -- I guess the goal here is to maintain what you make, there's not -- is there any prospect to, you know, move that profitability up a little bit or not really?

No, that wouldn't be realistic.

If we can maintain, we'd be lucky. I think there's probably a bias it will go down slightly over the next year.

But that's why it is important to work with them on figuring out how to do other things because rate cuts don't really do them any good over the long-term. Because the next year they have the same problem if drug prices go up. They have to do another rate cut. They need to get smarter on what they're doing.

The second thing is, you've done a good job here. The sales have been light, but the EBITDA has been better than expected. Where is -- where are the -- the big variances? Have you looked at where you thought EBITDA might be, where it's coming in? Where are the variances to the upside, either in gross or SG&A? What's sort of driving that? What are you tweaking to, you know, to drive that higher number?

Well John, I think the key for us is increased average sales per store. Leveraging that increased volume by managing our cost. We still see lots of potential to do that going forward. That's the key.

If you look at our sales growth, you know, we're up, I think, 4% in the quarter and that's with 170 less stores than a year ago or something in that ballpark. So, you know, we're really driving volume per unit and plan to continue that and leverage that cost site. We don't see a lot of room for margin improvement from where we're at today. Gross margin improvement.

So, yeah, so, is it -- would it be fair to say that if -- well, let's say difficult environment persists and, you know, you end up a comp, you know, closer to 6 for next year. Is there enough operating flexibility in the business, things you can tweak where you don't necessarily have to end up at the low end of your range? You can do better than that, even if the sales are a little light?

Yes.

Yeah, maybe -- Mary said yes. But I was going to say, "the range is the range and we're not going to comment on it." But she already got "yes" out before I could say that.

But he was still within the range.

Okay. Thanks.

Your next question comes from Mark Wilmuth from Morgan Stanley.

Hi, good morning.

Hi!

With your promotional activity kind of flat versus last year, that 1.9% comp on the front end sounds like it was driven by in-store execution. Mary, you gave a few comments on what you're doing there with vitamins and photo. Any other details you can give us that's really driving that?

First, I think we had very good promotional plans and events that were running out there, which stores got behind very well. But our operations group has done a really fine job of getting the stores more operationally sound and a better job of scheduling, having our people there when our customers are there. We've reviewed hours in all of our stores to be sure they're competitive.

Our inventories are in good shape. And when your inventories are in good shape and you're not dealing with a lot of old, distressed goods, it is a lot easier and better motivating for store people to work with that inventory. So, I think it's a lot of those things and we are executing better. And it's like Bob said in his comments, stores are feeling good about their results and good about the customers in the stores.

How about some of the in-store merchandising efforts? You mentioned the photos and vitamins improving, what else is going on there?

We are very current on all of our (indiscernible). Remember I mentioned that we completed some product transitions where we had taken certain categories and either changed suppliers and/or did a total rebound of the department, cosmetics was earlier this year. We did the whole optical, the reading glasses, sunglasses, pre-paid phone cards. And all of those are now behind us and so those are showing some nice double digit gains.

And probably most encouraging is our results in our core drugstore classifications, OTC, where, I believe, is a sign that we're getting a better image with our customers again and that goes along with what's important for our drugstore future success.

Also, we'll tell you, based on what I see compared to our competitors, our seasonal assortments are outstanding. I think that's helping us.

And can you comment just a little on what kind of promotional activity you're seeing out there from others? Any changes in the last quarter?

Definitely our competitors increased their page count and overall tended to put more items on the pages and run more frequently. But we are much better to continue to work our program and make our events and promotions more interesting, exciting to customers. It's not always page counts that get you the sales.

Just lastly, your debt load is still a huge burden. You're talking about 200 to 250 million of free cash flow next year. Would you anticipate that most of that will go to debt pay down?

Like we said, we're reviewing our options, whether we want to increase our capital substantially or pay down more debt. We're very comfortable with our cash flow, our cash position, and the debt level we have. Certainly over the long-term, we want to reduce it, though.

Okay. Thank you.

Your next question comes from Robert Thatch from Miller, (indiscernible),and Roberts.

Hi. Good morning. Just a few questions, please? Could you comment at all, quantify the -- the shrink change, either both sequentially and year-over-year for the third quarter?

Shrinkage, very manageable within our organization. We've had a shrink management program in place for over a year now and it's not any impactful factor on our margin results.

Okay, could you comment at all on sales both front end and pharmacy? On East Coast versus West Coast, just relative?

We really don't break it out geographically.

Okay. And finally, could you just comment on what the -- what your cash out is expected on closed stores, on an annual number?

About $50 million.

Right.

I'm sorry?

About $50 million. Annually.

Thank you.

Maybe explain what that is, John.

That's the lease carry.

Lease carry on leased income.

Is that -- is that number included in your free cash flow projections going forward?

Yes, it is.

It is. Okay, thank you very much.

Uh-huh.

Your next question is from Dan Kurt with DK Equities.

Good morning. Thank you. Let me take one more stab, if I might, at something a previous caller addressed. Specifically, could you please review the principle drivers, say order of magnitude, the top three/four, concerning how you're achieving the positive operating leverage, that is strong EBITDA growth, despite relatively weak same store sales growth. I mean, leveraging things such as rent, depreciation, salaries, those are fairly baked in. I don't think you're getting leverage from that.

You are. You're precisely wrong about that.

At 6.7% comp store growth, it is pretty damn good when you consider that we have 170 less stores than we had a year ago. So, and our average volume per store is up substantially. So, we really are leveraging our costs.

And we are definitely using our promotional dollars wisely, our advertising spend. We've got a very good supply chain initiative in place. And that's helped reduce the expense of getting goods to stores and that's a positive any way you look at. Our distribution center expenses are well in line. The different initiatives that are part of our EBITDA achievement program have really focused on the cost side of the business as well as margin and sales opportunities.

And our plan all along has been to leverage the sales growth in existing stores to reduce the expenses as a percent of business. And we're doing that.

Okay. Thank you. Let me shift to something else.

Sure.

Would you be able to share with us what cash flow from operations was for the first nine months?

I think we can.

We will file a full-blown cash flow statement for the Q here in a couple of weeks. But the free cash, cash (indiscernible) operations are going to be in the range of 160 million.

$160 million?

Yes.

It's interesting. I think we bought 150 million worth of bonds in the third quarter and our ending cash flow is very similar to what we had last quarter. So, that really just says the same thing Chris just said.

And might you give us a number at the free cash flow level so far this year for the first nine months?

It is right around 70 million. And that will increase by the end of the year to 115 to 165, in that range somewhere.

For this year.

This year.

And lastly, you mentioned earlier, I think in this fiscal year, about breaking into the black on an EPS basis. Do you still see this happening in the near future? I would think that would be the case. And might it occur as early as the fourth quarter of this year, namely the current quarter we're in?

I'd just say based on present trends, we certainly have the potential to be positive on a GAAP basis for the fourth quarter of this year. Some of the things that are in our earnings, though, as far as one-time charges, some of those will continue into next year. I'm not ready to predict next year, but for the fourth quarter, based on present trends, that's certainly a possibility.

And lastly, Mary mentioned I think last quarter in terms of how you're faring versus the competition, in terms of getting your share of the business, both in the front end and the back end, could you, specifically, on the pharmacy side of the house talk about how are we doing in terms of maintaining share in key markets?

Well, our scripts growth is positive in all the divisions, as I mentioned earlier. And we've got goals by area to do that. We're not opening a lot of new stores, so, if it's in a marketplace where our competitors are opening a lot of new stores, the total market share might shift to them. But we look at it on a store by store neighborhood basis. Last year's metro study that came out we also showed that we had made market share gains in a number of significant areas for us.

Thank you.

Your next question comes from Michael Malarki with Markston.

Yes, very good quarter. I wondered if you'd be willing to comment on possible further consolidation in the drugstore business, whether or not the Canadians are likely to expand in the U.S.? And any thoughts that you could give us on the Eckerd, Penny chain?

We don't really comment other companies' plans. We don't know about them, anyway.

And the Canadian thing? I don't think it's a factor --

Some of them have indicated they may actually be talking to you.

Who's that?

First of all, we don't comment about rumors. We just don't comment about rumors.

Yeah.

Thank you.

Oh, thank you.

Your next question comes from Christina Bonet with CSFB.

Yes, good morning, everyone. Congratulations on the quarter.

Good, Christina, they're going to make this the last question so make it a good one, will you?

Okay. Well, most of my questions have been answered. I guess the one question I had was just on the SG&A front. You talked a little bit about labor scheduling, getting some improvement there. Can you maybe give a little more detail as to where you see further improvement and maybe the key areas that that would be seen in?

Well, we will continue to refine our use of the labor scheduling tools. We use them for both front end and pharmacy, and three years ago we were a long ways away from where we wanted to be and what we've done is work with individual stores and markets and regions so that they are using it to schedule help when help needs to be there. And that's probably the most important benefit out of using the tools.

It's not just cutting labor or controlling the expense. It's having your people there when customers are there or work needs to be done and the tool is very detailed and takes jobs and takes activity that's being planned and builds a schedule for our people.

Does that answer your question?

I just wanted to know if there were any other key areas or if you think this is the baseline SG&A levels for the company?

There's always opportunity.

Lots of expensiaries that we're digging in all the time. We continue to find lots of good things. Another area that was strong the last quarter was repairs and maintenance, for example. So, there are lots of areas we continue to work on where we think we can get future benefit in the area.

In technology, using technology to lower expense, too.

Okay. And just one last, final question on working capital. Can you give a sense in terms of inventory levels and just to the extent of your comp store sales growth next year, if there is more further inventory productivity or do you see inventories growing from here going forward?

We still believe we have room for improvement on inventory. We've gotten a lot better at managing that inventory and keeping the service level up at the same time and we're in great shape on service level and yet lower inventories than last year and we see more opportunities.

Great.

Okay. Thank you very much.

Thank you.

Thank you, everyone. Have a good holiday season and don't forget to do that last-minute shopping.

At Rite Aid!

At Rite Aid! Thank you.

This concludes today's teleconference. You may now disconnect.