Rite Aid Corp (RAD) 2005 Q2 法說會逐字稿

Good morning. My name is Pashante 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 speakers' remarks there will be a question-and-answer period. If would you like to ask a question during this time, simply press star then the number one on your telephone keypad. If you would like to withdraw your question press the pound key. Thank you. Mr. Standley you may begin your conference.

Thank you.

Welcome to our second quarter conference call. On the call today with me are Mary Sammons, our Chief Executive Officer, and Kevin Twomey, our Chief Accounting Officer.

Before we begin today I would like to remind you that today's conference call includes forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. The factors that could cause actual results to differ are described in our fiscal 2004 annual report on Form 10-K, and our periodic reports on Form 10-Q and 8-K.

Consequently all the forward-looking statements made during this call are qualified by these and other factors, risks and uncertainties. Also, during today's call non-GAAP financial measures are mentioned. The definition and purpose for using the measures are described in the Form 8-K we furnished to the SEC this morning.

The Form 8-K can be accessed through our Web site under the "Our Company and Investor Info" tabs. You're also directed to consider other risks and uncertainties discussed in documents we file with the Securities and Exchange Commission.

Our agenda for today's call will be as follows: Mary Sammons will give an overview of second quarter operations, I'll review the second quarter financial results and comment on our fiscal 2005 guidance and then we'll take questions. Mary?

Thanks, John. And thank you everyone for joining us today as we discuss our second quarter results.

Both our operational and financial performance improved in line with our expectations, with a 12% increase in adjusted EBITDA year-over-year and net income of $9.8 million compared to a net loss of 10.6 million for the prior second quarter.

Same-store sales increased 2%, and our team did a good job of managing controllable expenses even with slower sales growth than we have experienced in the past. Pharmacy same-store sales increased 2.1% during the quarter with pharmacy gross margin up over last year due to higher sales of generics and reduced inventory costs resulting from purchasing improvement.

New generic prescriptions growth lowered comps by 145 basis points and the overall percentage of generic prescriptions in the product mix continued to increase. While margins on generics have tightened, generics remain more profitable than branded prescriptions as well as a better value for the customer.

Also depressing pharmacy comps were the continued slowdown and sales of HRT products and the decrease in prescriptions because of OTC switches. The overall move to reduce healthcare spending continued to have a negative effect, with our stores in the central division particularly impacted by the United Auto Workers move to mandatory mail.

As we said on our last analyst call, we expect the negative impact on our business caused by growing industry trends like mail order and lower third-party reimbursement to be greater in the second half of the year.

Pharmacy initiatives during the quarter included continued aggressive pursuit of prescription filed-by's, and the continued rollout of our new next-gen pharmacy dispensing system, with nearly 3,000 stores now on the new system. We will complete the rollout by the end of the third quarter adding to our ability to deliver better customer service.

Also on the technology front, nearly 100% of our stores are now equipped with e-prescribing capability to electronically connect the doctors' offices. We expect to see acceptance by doctors of this faster and more accurate to send prescriptions to the pharmacy to increase dramatically over the next several years.

In August we launched our "With us it's personal" TV campaign which will run throughout the rest of the year in 33 markets that account for 74% of our pharmacy sales with a Spanish version running in our key Hispanic markets. This is a key element of communicating our brand positioning as a drugstore to customers.

We continued our managed care negotiations to gain market share through limited networks.

And as we said previously, we also started to look at ways to better compete with mail order. Examining the potential development of a PBA or PBM to allow us the opportunity to offer managed care clients a 90-day at retail option as well as mail order, facilitating rebates from drug manufacturers to offset the lower reimbursement.

On the front end, same-store sales increased 1.8% with customer count, transaction size and gross profit dollars all up.

Core drugstore saw good gains in key OTC categories and consumables posted strong, profitable sales growth. Private brand sales were strong with penetration up to 11.6% as we launched 107 new SKUs in the quarter with more ready for launch later in the year.

Our GNC departments continue to give us a competitive edge in the vitamin and supplement category with sales increasing nicely. Currently we have more than 1,000 stores with GNC departments and are planning to add 300 more over the next two-and-a-half years.

Even with the softening of front end sales in August, which were negatively affected by the shift in the timing of Labor Day, our results reflect the success of strong assortment and promotion, new items, private brand growth and excellent execution.

We did continue to experience weak sales in the overall photo category, but we will complete the addition of digital capabilities to all of our one-hour photo stores by mid November and will begin to more aggressively market the value of digital development to our customers.

According to A. C. Nielsen data on Rite Aid markets, we increased share in the major categories of health, beauty, general merchandise, seasonal and consumables.

SG&A increased as a percent of sales this quarter due to increased union benefit costs, increased labor and training costs from the rollout of our new pharmacy system, higher advertising expense, and the timing of holiday pay relating to the Memorial Day shift. Inventory was on plan at the end of the quarter.

Our new store development program is on track for more than 30 new stores this fiscal year with most of them relocations designed to protect and enhance share in our strongest markets. We will open two pilot stores with our new prototype design in October and November, and we have already approved many of the sites for our target of more than 100 stores for fiscal 2006.

Before discussing the future outlook, let me first make a comment about the impact of hurricane Ivan.

Our stores, including those in our hardest hit state, Alabama, sustained minimal damage with most of them open again within a day or two after the storm. Our store teams did an outstanding job of serving our customers as soon as possible, many of them reopening without power and a skeleton crew. Our sales were impacted but the impact is not meaningful.

As I said in our last analyst call, our team has implemented initiatives to increase sales near-term while we continue to focus on our long-term initiatives to successfully grow our business for the future.

On the pharmacy side, we have further accelerated our filed-by program focusing on multi-store buys as well as single-serve purchases, and expect to exceed our original goal for the year. We expect to see results from an aggressive pharmacy customer acquisition campaign in priority markets, capitalizing on the Eckerd transition as well as running prescription transfer incentives.

We are especially focused on stores in the central division with comprehensive plans for acquiring new customers that include strong marketing support, third-party opportunities, store improvements, and aggressive file-by goals.

We continue to reinforce our health and wellness positioning with flu clinics in our stores starting later this month, a promotion to celebrate American Pharmacist month in October, and diabetes screenings and awareness events in partnership with the American Diabetes Association during National Diabetes Month in November. We have also identified long-term care opportunities and reimbursable clinical services as additional areas for future growth.

On the front end we expect to see improved results from additional promotions we will run in key markets in mid-October, and will soon launch our customer appreciation program in Southern California as a thank-you for the business we gained and held on to from last year's grocery strike. And we are enthusiastic about our strong holiday assortments and promotions including our "Shrek the Halls" holiday theme.

Longer term we believe our continued focus on our four critical priorities of growing pharmacy sales, increasing front end sales, improving customer satisfaction and containing costs will position us well for future growth.

Even with the challenges currently facing our industry, positive trends such as an aging population, increased drug therapy, new drugs coming to market with blockbuster potential, more generics, and our focus on being an active player in healthcare will more than offset these challenges.

Now I'll turn it over to John.

Thanks, Mary.

Second quarter results were in line with our expectations after revising our guidance on September 7th.

Total revenues for the 13-week second quarter were 4.12 billion this year versus 4.05 billion last year. Revenues increased 71.8 million or 1.8% this year versus last year.

We operated 3,370 retail stores at quarter end, versus 3,386 stores at the end of last year's quarter, a net reduction of 16 stores or 47 basis points. Same-store sales for quarter were up 2%, with pharmacy comparable store sales up 2.1%, and front end comparable store sales up 1.8%.

Pharmacy comparable store sales were positively impacted by inflation which was mostly offset by a switch in the timing of Memorial Day, which is a low volume pharmacy day, from the first quarter last year to the second quarter this year. Increased generic sales as a percent of total sales, lower reimbursement rates versus the prior year, and a modest decline in scripts counts caused mostly by the loss of scripts to mail order for certain benefit plans.

Although increased generic mix reduced our comparable pharmacy sales by 1.45% versus the prior year, it increased our gross margin. Prescription sales accounted for 63.9% of total sales, and third-party prescriptions represented 93.3% of total pharmacy sales.

Front end comparable store sales were positively impact by improvements in most of our core categories, partially offset by continued declines in photo categories, and softer back-to-school sales. August sales were negatively impacted 160 basis points due to the later timing of Labor Day.

Gross margins, which are net of occupancy costs, were a billion dollars, or 24.9% of revenues for second quarter this year, versus 964 million or 23.8% of revenues last year. The current quarter included a non-cash LIFO charge of $800,000 versus $11.8 million in last year's second quarter.

Excluding LIFO charges, the second quarter gross margins were 24.9% of revenues, compared to 24.1% of revenues last year, an increase of 81 basis points. FIFO margin was positively impacted by increased pharmacy and front end margins and continued leveraging of the occupancy and depreciation and amortization expenses included in gross profit.

Pharmacy margins were positively impacted by reduced inventory costs resulting from purchasing improvements and more generic scripts as a percent of total scripts partially offset by lower reimbursement rates. Frond end margins were positively impacted by improving shrink trends and lower markdowns.

Selling, general, and administrative expenses for the quarter increased as a percent of revenues by 19 basis points compared to the prior year. The increase is the result of higher salaries and benefit expenses and higher advertising expenses partially offset by lower stock-based compensation expense and lower depreciation and amortization expense.

Factors impacting salaries and benefits include the shift of Memorial Day to second quarter this year versus first quarter last year, which increased our holiday pay by about $5.5 million in the quarter versus the prior year. Also, we invested some labor in the rollout of the new pharmacy system.

Employee benefit costs continue to increase year-over-year with some of the biggest increases in three specific union plans.

Non-cash stock-based compensation expense, which is now included in SG&A, was 5.1 million this year, versus 8.8 million in the prior year. We expensed the fair value of stock options granted. The decrease in expense from last year's second quarter is due to options granted in earlier years being fully amortized.

Store closing and impairment costs were 13.9 million this year versus a credit of 9 million in last year's second quarter. This charge reflects costs associated with closing of five stores, and an increase in our reserve caused by a decrease in interest rates since the first quarter.

Last year's credit is mostly the result of an increase in interest rates during the second quarter of last year.

Interest expense was 76.5 million for the second quarter, versus 79. [point] million in last year's second quarter. Cash interest expense was 71.6 million this year, versus 74.9 million last year, and non-cash interest was 4.9 million this year versus 4.6 million last year.

Adjusted EBITDA for the second quarter was 171.2 million, or 4.2% of revenues, an increase of 18.3 million over the prior year computed on a consistent basis. The schedule attached to our press release reconciles our net income to our adjusted EBITDA total.

Net income for the quarter was $9.8 million, or net income of about zero cents per diluted share, compared to net loss of 10.6 million, or a net loss per diluted share of 4 cents last year. The net income per share for the current second quarter includes $8.5 million of declared preferred stock dividends that are not included in net income, versus 7.9 million last year.

Liquidity remained strong during the quarter. Cash on the balance sheet at the end of the quarter was $407 million. Operations generated $232 million of cash year-to-date primarily due to a strong adjusted EBITDA, 31.8 million in first quarter tax refunds, a reduction in accounts receivable, and an increase in accounts payable partially offset by an increase in inventory.

Year-to-date expenditures for property plan and equipment were $75.8 million, and we acquired $12.7 million of script files for a total of 88.5 million of capital expenditures year-to-date. For the quarter, we spent $40.7 million for property plan and equipment, $6 million for script file purchases for a total of $46.7 million of CAPEX in the second quarter.

During the quarter we opened one new store, relocated two stores, acquired two stores, remodeled 57 stores, and closed 7 stores.

Based on second quarter results and current trends, we are confirming our adjusted EBITDA guidance range for fiscal 2005 of 770 to $800 million, and our net income guidance of between 122 million and $150 million. We're also confirming our range of sales estimates of 16.9 billion to $17 billion, and same-store sales growth estimates of 2.75 to 3.25%.

Attached to our press release is a table that reconciles our adjusted EBITDA guidance to our guidance for GAAP earnings.

Yesterday we completed our previously announced refinancing that includes a new $1.4 billion senior secured credit facility and a $400 million, three-year securitization facility. The new credit facility consists of a $450 million term loan and a $950 million revolving credit facility that will mature in September 2009. The new securitization facility will mature in September 2007.

This refinancing lowers overall borrowing costs by approximately $27 million annually, and along with the use of available cash on hand reduces debt by 634 million to approximately $3.2 billion. The refinancing will result in a pretax charge of approximately $16 million in the third quarter, consisting of $11.5 million prepayment penalty, and a non-cash charge of $4.5 million for the write-off of deferred debt issue costs.

Operator, we're now ready to take questions.

At this time I would like to remind everyone in order 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 Ron Fillas of Banc of America Securities.

Good morning.

Good morning.

One second. Our phone's a little out of whack here.

Good morning. Actually this is Reed on for Ron. We were just wondering if you could update us on what debt you might have bought back in the quarter, if any?

Sure. We bought about $65 million back. I've got a footnote here, if you give me a second, or maybe Kevin can find it.

We got the 7-5/8 due, that's 7-7/8 due 2005, and the 7.25 due 2007, and then the 6-7/8 due 2028. The net, the total for the year-to-date is 65.5 million. During the quarter it was, hang on a second.

I think that was all this quarter, wasn't it, Kevin?

No, that's year-to-date. But during the quarter, that is 26 million and 12 million.

We were wondering, if you could, this is Ron, we were wondering if you could outline for us what restrictions, if any, in the new credit agreement you have on the repurchasing of debt in the future?

We can repurchase the, any debt that basically matures after the senior secured credit facility.

We can repurchase any debt we want as long as we have more than $300 million available on the revolver, our new $950 million revolver, and we can purchase any debt we want that has, you know, maturities after the credit facility.

Prior.

I'm sorry, prior.

You misstated that.

We have a lot of flexibility to repurchase debt.

Okay. This is Reed again. Just on the competitive front, just had a question about, I know it's early, but whether, you had commented on your last call about some marketing initiatives with the recent change in ownership of the Eckerd chain. I was just wondering if you could give us the latest update? Thanks.

A lot of the results of the marketing efforts will show up over the next several months, because anytime you run transfer instead of coupons it takes several months for those to develop so we expect activity as we move through the third quarter into the fourth. And then we have additional other marketing support, particularly I mentioned in our central division that includes promotional efforts as well as efforts around store improvement.

Okay. And then last question on that front is just the, I know you don't usually like to specify where you're looking to possibly construct new stores, but we were wondering in your existing markets are there anywhere you feel like capacity is kind of an issue, either in the pharmacy side or just in terms of the overall retail environment? Any areas?

I'm sure that's the case but there are some markets, you know, we operate obviously in a substantial number of markets. I think the real point to you would be that, and if you look at the whole picture, there's endless opportunities for to us grow really in existing markets. So on a go-forward basis at least for the next few years the CAPEX is really focused on markets that we're in.

Okay. Thank you.

You're welcome.

Your next question comes from John Heinbockel of Goldman Sachs.

Hey, John. The gross margin looked relatively solid in the quarter given the comments you made three weeks ago. What did you see toward the end of the quarter? Did anything actually hit here in the second, or most of the things you saw are dated such that they hit in the second half? And then how much of the reimbursement issue really impacted this quarter?

Really, I think it was more towards very late in this quarter. The last few weeks we really started to see it develop, John. And again, as I think I've tried to explain previously, that issue also just relates to our thinking about the second half versus our prior guidance, not necessarily year-over-year.

We have seen strong pharmacy margin on a year-over-year basis, and even with our revised guidance we would still expect to see some increases in pharmacy margin for the second half.

And I think we mentioned, too, John that generics continue to grow for us, and even though they have some reimbursement pressures they are still much more profitable than brands and we continue to grow generics at a faster clip than brands.

I mean your second half sales guidance sort of suggests not a lot of improvement from the second quarter. Are there, I know you're making investments in the business for the long-term. Are there things that can be done or are being done to mitigate some of the cost pressure on the business because, you know, if you grow the top-line at 2% or a little bit better you're going to see some cost pressure in the back half? Can you mitigate that somehow, or that's going to be difficult to do?

From our standpoint we have to be very careful about what we do on the cost side. We need to continue to make the right investments in our business, in our store labor, and in things like the marketing programs to support our priority markets as well as our electronic campaign.

I think we've done a really fine job of managing expenses and we'll continue to look to contain them, but we're not going to look to just overall reduce expenses in the wrong way.

Then finally, in terms of mandatory mail, I think you guys have said the UAW is not getting worse month-to-month. Is that fair? And then secondly, do you see anything else out there on the horizon, say at CalPERS that may go in that direction?

I think, John, UAW, what we saw through the first and second quarter is that it did worsen month-to-month, and that's really what happened in the second quarter as it progressively worsened as more of the people came on the program. And so that will continue, at least the effect that we saw toward the end of the second quarter, we'd expect that to continue through the balance of the year.

I think what you said, John, is kind of right. We think that August, the month of August, represented a pretty good month of what the impact of that's going to be, and that level of impact is what we'd expect to continue for the rest of the year. I think that's what you might have said.

Right. And there's, I think you've also said that there's no other UAW out there. How would you dimensionalize CalPERS versus UAW? It's not as impactful, I imagine, but still significant if that were to go mandatory or no?

I remember in our analysis relative to UAW we had a significant number of stores affected because all throughout our central division we had, I think, between 1000 and 1100 stores that were affected by UAW. So there's no other, at least time that I can think of that would have that same kind of effect.

And a CalPERS, if something happened there it certainly could have an effect but it wouldn't be of the magnitude that we saw with UAW.

Okay. Thanks.

Thank you, John.

Your next question comes from Mark Wiltamuth of Morgan Stanley.

Hi. Good morning. My first question is on the repurchase of debt. You mentioned you have flexibility to repurchase debt, but given this latest refinancing and your previous activities, it seems like most of your debt is now maturing beyond 2008 and has been replaced with a lower interest rate. Just how much more near-term debt reduction do you think is available?

Well, we have, next year we have about 100, what's left, Kevin, 178 or so, bonds?

Maturities for next year is like 214 million.

Two pieces of that, two bond tranches that we have coming up next year I think. So there's say 200 million there that we could look at if we wanted to do that. So, but we try and balance our investments in the business with debt reduction, it's not all about debt reduction, it's a balance of debt reduction and investing the right money back into the business.

And we are increasing our capital plans for not only this year but on a go-forward basis. So I think you'll see us be very focused on improving our store base and growing in existing markets in terms of use of capital.

Okay. And then I wanted to ask Mary if she could follow up a little bit more on the benefits that you think you can get from starting up a PBM or PBA? And maybe talk a little bit about what kind of restrictions there are in terms of operating an entity like that while you're operating the drug retail ops.

Well, if you think about it, our major competitors all have PBMs, so you can certainly manage to do both of those. We really believe that we're still early in the exploration of it to put out too much detail, but we think that some type of either PBM or PBA that would allow us to be able to do 90-day at retail as well as mail, would also open up the ability to negotiate for rebates to offset some of the costs involved in, just the lower cost involved in competing with mail order, and that we need to very seriously look at it, and we have someone in charge of the project right now and have really put together kind of some proposals to look at, and we'll be coming to some decisions on that over the next few months.

Okay. So the key focus here is really a leverage into 90-day at retail and maybe some cost reduction on sourcing pharmaceuticals?

Those would be key components of it, yes.

Okay. Thank you.

Your next question comes from John Ransom of Raymond James.

First question, do you know if your drug stores on a same-store basis actually had an increase in volumes quarter-over-quarter compared to last year, i.e. number of prescriptions processed?

Yeah, we had a slight decline.

Slight decline. Okay.

Yeah.

Secondly, do you know what your operating lease expense was this quarter?

You were asking about script count, right? Is that what you're asking?

Yeah, just did you process more or fewer?

Okay. [inaudible] question right now. Okay. So slight-- Operating lease number, [inaudible] big one and throw it out here in a minute.

We don't put the rent expense on a regular basis, so I don't want to start doing that now.

It is true, though, your rent expense is a little higher than your peers on a percent of revenue basis? I would think that might be a margin ceiling for you down the road.

I would tell you on a per square foot basis it's less. If you want to look at that it way. I mean obviously our objective is to grow our revenues and leverage those costs. Obviously our average volume unit is less than Walgreen's and a little less than CVS, but our rent per square foot is actually less also.

If you want a rent expense, John, in light of the little store activity that we have from new stores, if you just look at the annualized rent number in the 10-K.

Okay. And then finally what we're seeing I guess from some of the, excuse me, some of the mail order pharmacies is concern that some of the state Medicaid programs over time are going to move to ASP-based pricing and away from AWP-based pricing and some concern about commercial plans. Do you have any reimbursement now that's ASP or WAC-based, or is it all WAP-based? And do have any concern that over time the pricing for pharma is going to move from kind of a fictional AWP-based pricing to more of a real cost plus-type pricing? And do you have concerns about particularly your generic margins if that were to occur?

Well, on the whole ASP issue there's a lot of discussion going on it right now, and I think it is of probably some concern to just the retail part of the industry just because it's still not clear exactly how they will go about calculating the ASP to have it accurate. And I think there's still in the formative stage, so we'll no more about that I think over the next month or so.

I mean it's hard to know if something like that changes, you've got to work through it. But right now what AWP basically is, is an index, and the ASP will basically make the same kind of thing.

So you would hope that we would be able to negotiate our way through that with our contracts and other agreements. So you know, to hold the line as best we can on our margins to work through something like that. But, you know, that's one of the things we need to see if that's what develops and work through it as it comes.

Okay. Thanks a lot.

You're welcome.

Your next question comes from Meredith Alder of Lehman Brothers.

That's Adler. Hey, guys.

Hey, Meredith. How are you doing?

I wonder if you could talk just a little bit about technology. I think you said you had 3,000 stores on the new pharmacy system. Is this really the first major change you've made to your systems in awhile, and how is it going? And then could you talk about any other sort of major systems initiatives that you have planned?

Obviously it has an impact to the stores directly. This is the biggest since I've been here and Mary's been here [inaudible] last five years. It's definitely a very significant change for us at store level.

The new pharmacy system offers a lot more functionality to a pharmacist. It's a Windows-based system, it's very intuitive to use. If you use the Internet at all, as an example, something you can pick up and kind of figure out fairly quickly.

As Mary mentioned we're in 3,000 stores. It does require some change in the work flow though as part of the change of the system, not just the technology, we're also asking our pharmacists to handle the business inside the pharmacy in a little bit different way.

I would tell you, like any systems conversion or rollout, I'm sure there's some impact out in the store from this thing, but once people get up to speed on it they seem very excited about it. They seem very positive. Once you're trained and you've used it a little bit, it seems like the majority of pharmacists really embrace it. So I think it's going okay as we work our way through it.

In terms of where we're going with other systems we're looking at our front-end systems. I think you'll see us make some investment in our store registers over the next couple of years. We'll gradually roll out some more modern technology there.

And where we put a lot of money is back stage on our marketing and merchandising systems. We've made a lot of investments over those systems the last couple of years and we're also investing right now pretty heavily in our back side pharmacy systems both in the third-party management area as well as on the business side of pharmacy back stage. So we're pretty active right now on the technology side in our business.

And of the capital spending that you need to do in the next couple of years, or want to do, kind of what percentage of it does it, goes to technology?

Probably 10 to 15%.

And that will vary by year depending on what we're investing in. I know last year we spent considerably more than that as went through the development of our next-gen system.

I think the dollars as a percentage were larger last year. We had lower CAPEX base but we spent about $40 million on this new system. We would be spending in that range on a go-forward basis with some of these things but our total CAPEX is probably quite a bit bigger as we go forward so that's why kind of the 10 to 15% range.

Also understand that there are other costs associated with technology including things that are expensed. And we do a fair amount of development internally which keeps those costs down.

Okay. And then I guess I just have one other question. It went out of my head, so never mind.

Okay. Thank you.

Thanks, Meredith.

Sure.

Your next question comes from Edward Aubin of Deutsche Bank.

Good morning. Just a question regarding labor costs. How would you describe the current contracts you have renegotiated over the past 12 months with the unions? Were you able to extract some concessions with joint bargaining? I think you mentioned also three specific plans, and if you could describe which plans are they?

I'm not going to describe specifically which plans they are but generally we are seeing, the big issue is that the cost generally in these negotiations, and those three particular plans, there are increases in the benefit costs that were impactful for the last, you know, at least the last two quarters on SG&A, and will be for the rest of the year. In terms of extracting big savings, I don't think we're doing that.

Right. And more specifically, regarding your biggest market, California, how do your labor costs compare to that of the grocers, second tier? I don't know if you had time to look at that. Has the gap narrowed in favor of the grocers, yes or no?

I don't know if I know the answer to that specifically off the top. And you think we're competitive in terms of our wage rates. We have different kind of contract wage scales than the grocers do so it's kind of apples and oranges. I'm not sure I could tell you that.

Right. And just finally, you talked about systems. In terms of logistics you have not opened a new distribution center in several years, if I am correct. In the meantime some of your largest competitors are opening up state of the art facilities. To what extent are you falling behind, or are you just modernizing your existing facilities?

We're based around two really, I would say, state-of-the-art facilities, one in Lancaster, California, one in [inaudible] Maryland. Those are pretty modern, newer facilities. They're both a million square feet. And then, you know, those are surrounded by other facilities that we use, some of which are older facilities.

Having said that, we haven't grown our store base at the same rate as our competitors have. And I think to support their store unit growth they've built some new facilities in their network which would be appropriate for them.

For us, you know, what it's about for us is leveraging our existing cost structure. We've made continuing investments in those facilities, new and old to try and keep them up to date and current if we can. And we think we have some capacity out there right now which is part of our opportunity to grow our store base.

For instance, our facility in Lancaster can certainly support more stores than we have on the West coast in California.

Great. Thanks.

You're welcome.

Your next question comes from Monica Aggarwal of Merrill Lynch.

Good morning. Given that your store base has shrunk by 12 to 13% in the last four years and you've invested heavily in remodelings, can you give us an update on where your marking positioning is today on an absolute basis and relative to your competitors?

Well, if you look at market share positioning, say from the Metro Market survey which I think is the one that most of our competitors use too, we hold strong market position and really most of our key markets having either a 1, 2, or 3 position in those markets. And considering we haven't opened a lot of new stores, we've maintained share I think very well.

Just, in fact, if you look from 2000 to 2004 and just benchmarked over that period of time where we've closed a substantial number of stores, in most of our markets we've either held or built a little bit share. So forget what the competitors are doing, that's just us.

Okay. And then where do you need to direct spending to continue to improve it?

Well, I mean, we're very focused. There's some very strategic markets for us in New York.

Philadelphia.

Philadelphia. So there's some very key markets for us. That's where we're going to focus our capital.

And we went through a pretty extensive process of prioritizing what we call our strategic market and the investment opportunities for us, and that's how we are putting together our real estate plans over the next several years, and those are well underway.

Great. Thank you.

Your next question comes from Sri Nadesan of Wachovia Securities.

Good morning. My question relates to your balance sheet. You said in your press release that you've reduced debt by 634 million. Can you give a breakdown of that?

Sure. Two major components.

One is cash from the balance sheet that we used in the, you know, we've been sitting on a fair amount of cash, and it's more productive to use it to pay down debt, and you know, given where the bonds have traded and what not reducing the size of the bank facility we thought made some sense. So we used about $330 million of cash off the balance sheet to pay down debt with the closing of this financing yesterday.

In addition, part of this financing was a securitization facility where we sold receivables and used the proceeds from the sale of those receivables, $305 million to pay down debt. The revolving facility where over the next three years we'll continue to sell receivables to the securitization participants through a conduit program and generate cash that way.

So the ABS facilities off balance sheet?

The AR facility is off balance sheet, yes.

Okay. And the debt reduction specific components is in addition to the debt specific issue that you talked about?

Yeah.

The rest is bank debt reduction?

We bought some bonds, is the other piece.

So the bond covert is bank debt, right?

What's that?

The bulk of it is bank debt that went down?

Yes.

The bulk of the redemption is the term loan.

Yes.

Okay. And lastly, what is the current pro forma balance sheet for the debt pay down, I'm sorry, the cash balance on balance sheet?

Well, we basically used invested cash that we had, $330 million. So pro forma, there'd be 75 to 100 million of cash on the balance sheet at any given time.

Great. Thank you very much.

You're welcome.

Your next question comes from Leah Hartman of CRT Capital.

Good morning. I did have a couple of questions following up on the go-forward cash balance. As it did a number for store cash or just required for operations that 75 to $100 million number?

That's basically right, yes.

On a comp store sales side, as you do remodels, can you give an idea of how the comp store sales performance is occurring and if you can, can you break it out between are you seeing a script count pickup versus a front end improvement?

Couple of things. We do different kinds of remodels. A full remodel that includes pharmacy and front end would generally help your comps a little bit over time. Realistically doing 157 or 200 stores a year out of 3,400 stores, it does not material impact total comp store sales.

I was looking on a per-store basis.

I couldn't give you an exact percent but it's worth at least a few percentage points in both sides of the store.

If you do remodel a pharmacy and front end, what's the average cost running on a per-store?

Depends where the store is. They vary anywhere from 300,000 in the East and central to 500 to 600,000 in the West.

On average.

On average.

Okay. And then I guess I'm not clear what's left outstanding under the 7-5/8's of '05, Kevin.

Why don't you call me later, Leah? I don't have it in front of me right now.

It was 198 at the end of the first quarter.

Right. 170.5.

That was a little confusing, but it's 170.5.

Okay. And then the term loan, the old term loan, had been amortizing.

Small amount. It was down 3 million bucks or something.

2.8 million.

Right. That was during the quarter so---

It was just subsequent to the quarter.

Okay.

So it was 1144 about.

Okay. Yep, that ties to my number. Thank you very much. Good luck this quarter.

Okay, thank you.

Your next question comes from April Prisosomus of Morgan Stanley.

Hi. Essentially most of my questions were answered regarding mail order program but I just have one small question. Just on when you have, say in the case of UAW contract just in general, I mean do new prescriptions need to be filled at the drugstore before they are transitioned to a mail order program for refilling or whatever?

Yes, they do.

Okay. All right, thank you.

Your next question comes from David George of Deutsche Bank.

Hi. I had just a quick question. On the benefit you're seeing on your pharmacy gross margin, would you say that the rate of generics that you're dispensing and the purchasing improvements that you had, are those equal weighted, or is the generic higher weighted, or how would you break those out?

Well, the purchasing is pretty significant. That we've actually made some pretty good headway there, so that's a fairly sizable number. I don't know if I could break it out between the two.

Just qualitatively.

I would say it's probably pretty equal between the two.

And the purchasing, could you just explain, is that from dispensing a higher amount of generics so you've gotten volume discounts or what's going on there?

Part of it is working with McKesson. You know we've made some headway on our branded drug costs you know on a year-over-year basis. We entered into a new contract with them and we saw some benefits from that renegotiation, and on generics side we've done a very good job on the purchasing there.

Negotiation where especially where you've got multiple sources for generics and our purchasing department has done a terrific job of working on those costs to bring them down.

Right. Okay, great. And on the SG&A side is the, would it be fair to say that the employee benefits, the increase there, was that the highest component of the ones you outlined?

I'd say there's a couple things in there. One is the holiday pay timing.

Right. But in terms of the---

Is significant so I think wage dollars are, you know, at least a pretty good chunk of the increase, just pure wages. Part of that's the holiday pay, but just in general, wages, and then benefits.

Okay. And then finally, just two last quick questions, has the retention rate in terms of scripts in California been what you expected earlier in the year?

Yes. We've had, I think, extraordinary good success in holding onto business that we picked up during the grocery strike and feel very positive about our opportunities in California.

Great. And then last question just on working capital, How much, like what sort of use do you expect to have this year?

You mean like on a revolver?

No, just in terms of your working capital usage.

Use of cash. I mean the peak to valley on inventory is about $150 million with some offset by payables.

But for the year, if you had to, working capital is going to go up somewhat no matter what our initiatives are and the traction we get just simply because some of the inflation, so you're looking at somewhere around maybe $50 million increase in working capital by the end of the year.

50 million?

Yeah.

Great. Okay. Thanks very much.

Your next question comes from Luka Imaleho of Chesapeake Partners.

Thanks. Most of my questions were answered. One quick clarification. I kind of lost you on the restrictions from the new credit agreement. And by maturity and by amount left in the revolver. Can you go through that again?

Sure. I think we gave a confusing answer so I'm not surprised you're confused. But where the new facility basically the way it works is it has a screening covenants so as long as we have availability of at least $300 million we really don't have a lot of restrictions on repurchasing debt or doing other kinds of things. So we have a lot of flexibility there.

In terms of, you know, the old revolver was retired, we have a new revolving facility and basically the concept here was rather than have a lot of cash sitting on our balance sheet making 1% but paying 3% interest, we decided to kind of clear out all of our cash. So we really expect to be a net borrower instead of a net investor on a go-forward basis. It's just a more efficient structure from us, it keeps our debt balances down which is important and uses our money more efficiently, so at the closing we borrowed about $60 million to, Kevin to close the --

Yes.

To close the refinancing.

On the revolver.

On the revolver.

Okay. And then if you're north of 300 million then you can only --

If we're North we would North if we had borrowed more than $650 million, and we probably would not be purchasing any inside debt at that time. Or, I'm sorry, any outside debt.

Gotcha. Thank you.

You're welcome.

Your next question comes from Ron Fillas of Banc of America Securities.

Hi, guys. As we look at your company we see the old company before all of you sort of showed up and now we see a very different company, and then we have this sort of capital structure and its legacy. As you progress there have been some changes here and there and there was a pretty big change recently. Is there anything next in terms of capital structure changes that would be logical and beneficial that you can discuss with us today?

I think we're very comfortable with the capital structure today, this level of debt that we have, you know, relative to our cash flow from operations and EBITDA and that kind of stuff puts us in a position where we have a lot of free cash flow to invest in our business which we think is important on a go-forward basis.

So from a capital structure perspective, you know, we feel pretty good about where we are right now. We're always looking at it, we're always, there's opportunistic things that can be done to improve [inaudible], we're going to do that. But we're in a good position today.

Finally, could you tell us where your cash is today?

Well, we used our cash, you know, our invested cash to close the deal yesterday.

Okay. Thanks.

You're very welcome.

Once again, if you would like to ask a question, please press star then the number one on your telephone keypad.

We'll take one more question if there is one.

Your final question comes from John Ransom of Raymond James.

Another quick follow-up on your generic business. What is your approximate generic mix today versus what it would have been about a year ago? And how much did that, I assume that mix went up. How did that change in mix contribute to your rise in EBITDA margin, your commendable increase in EBITDA margin?

I did mention that our new generics affected comps by about 1.45%. And if I look at our overall mix of generics to brands, generics have improved over three percentage points as component of the mix.

And what would that be as a total percentage?

We're not, we've not been doing that because we don't give out specifically pharmacy margins and that kind of stuff, but it is impactful, it's helpful.

Is it over 50%?

Is it over 50%?

Is generic greater than 50% of your volume?

Yes. You're talking about scripts, right, not dollars? Talking about script count, it's more than 50%.

Okay. Thank you.

You're very welcome. Thank you very much everybody for joining us. We appreciate your interest in our company. Take care.

This concludes today's Rite Aid second quarter results conference call. You may now disconnect.