Rite Aid Corp (RAD) 2006 Q3 法說會逐字稿

Good morning. My name is Lynne, and I will be your conference facilitator today. At this time I would like to welcome everyone to the Rite Aid third quarter conference call. [OPERATOR INSTRUCTIONS] I would now like to turn the conference over to Mr. Kevin Twomey, Chief Financial Officer for Rite Aid. Please go ahead, sir.

Thank you, Lynne, and good morning everyone. We welcome you to our third quarter conference call. Mary Sammons, our President and Chief Executive Officer, is also on the call with me. Our agenda for today's call will be as follows: Mary will first give an overview of our third quarter. I will follow with a review of the third quarter financial results and comment on our fiscal 2006 guidance. And then we'll take questions.

But before we begin, 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 2005 annual report on Form 10-K and our periodic reports on forms 10-Q and 8-K, if any. Consequently, all of the forward-looking statements made during this call are qualified by these and other factors, risks and uncertainties.

Also during today's call, a non-GAAP financial measure called adjusted EBITDA is mentioned. The definition and purpose for using this measure is described in the Form 8-K we furnished the SEC this morning. The Form 8-K can be accessed through our website under the tabs entitled "Our Company" and "Investor Info." You are also directed to consider other risks and uncertainties discussed in documents we file with the Securities and Exchange Commission. Now that we've covered the administrative aspects of the call, let's begin. Mary?

Thanks, Kevin. Good morning everyone, and thank you for joining us today for our third quarter conference call. Third quarter same-store sales increased by 1.7%. Pharmacy same-store sales rose 0.7% and we saw positive script count growth at the end of the quarter. This is good news and even better: both our front end and pharmacy sales improved each month of the quarter, with November posting the strongest performance in monthly comps in over a year. Even the central division, which has born the brunt of the negative impact of the United auto worker's shift in mandatory mail order for prescriptions started to see improvement over prior quarters. We are pleased with these positive sales trends, which have continued into December.

Today we reported a 5.2 million net loss and a decline in adjusted EBITDA compared to the third quarter of last year. An increase in SG&A, as a percent of sales, and higher occupancy costs resulting from more sale lease-back transactions year-over-year continued to negatively impact EBITDA comparisons as they did in the second quarter. The increase in SG&A reflects our commitment to the right staffing levels to improve customer satisfaction, as well as additional advertising spend for market-specific tactical marketing plans, and our Medicare part D marketing program. As you know, the benefit of sale lease-backs is the additional capital they provide to invest in our store base.

Hurricane Katrina had no significant impact on our operating results, as much of the pharmacy business from our four stores that were destroyed and our 13 stores that are still closed moved to other Rite Aid stores in neighboring areas. Our associates continue to work hard to serve the many Rite Aid patients who have been transplanted by the storms.

Let's talk about pharmacy results in the quarter. The improved sales were due to several key items. The cycling of major health plan changes, a slightly more positive cough, cold and flu season, improved customer satisfaction in the pharmacy, and the tactical marketing and operational plans in select markets that I talked about earlier. These tactical programs, coupled with extra focus by field management on customer service initiatives, delivered significant results. We will continue to invest in these initiatives.

New generic dispensing negatively impacted our comp sales by 164 basis points, but positively impacted margins, with generic dispensing up 336 basis points year-over-year. We continue to focus on the opportunity to take advantage of new generics and grow the overall contribution of generics to our mix. It improves our margin and delivers great value to both our patients and managed care. Front end sales were strong throughout the quarter, posting a 3.4% increase. Core drug store, health and beauty care and general merchandise all showed gains. Vitamin sales improved, and we opened 61 new GNC store-within-a-store vitamin departments, bringing the chain-wide total to 1166. Consumables continued to show very strong growth with double-digit increases. Private brand sales were also up over last year. So far this year, we have introduced 353 new private brand SKU's and are well on our way to our goal of 400 by the end of the fiscal year.

Digital photo sales once again performed better than the overall one-hour photo film and photo finishing category. We are seeing good response to the digital one-time use camera and video products we introduced in 800 of our stores in November and which we will roll out to an additional 700 stores this month. The new digital print-to-store online service, which is now available in 800 stores, and will be offered chain-wide by the end of the fiscal year, also strengthens our offerings in this important category.

During the quarter, we continued to make significant progress in our key strategic growth initiatives. Our store development program continues to be on track to meet our goal of 80 new and relocated stores this fiscal year, and we are well underway in planning for 125 to 150 new and relocated stores for fiscal '07. New store growth and strategic markets, whether it be organic or through acquisition, continues to be a top priority for us.

As I mentioned earlier, our customer satisfaction scores continue to improve again this quarter, both in pharmacy and also on the front end, with pharmacy scores for timely filling of prescriptions and courtesy and friendliness of staff increasing the most. As part of our initiative to gain new customers, Rite Aid Health Solutions, our new pharmacy benefit management company made significant progress in the quarter. We developed a comprehensive sales and marketing program and began using it with potential managed care clients. We hired a Vice President of Sales with extensive pharmacy benefit management and managed care experience that we will name later this month. As we have said before, our goal is to strategically target plans and employers to provide a low cost alternative to mail order, as well as develop clinical programs that can reduce healthcare costs. Our acquisition team continued to aggressively identify and pursue prescription file-by's, making its quarter goal and putting us on track to make our target for the year.

We made good progress in initiatives designed to bring more customers into our stores, focusing on our health and wellness positioning. Take care in-store medical clinics, staffed by nurse practitioners who provide diagnosis and treatment for common family illnesses, vaccinations and physical exams successfully opened in ten Rite Aid stores in the Portland, Oregon area. So far, the response from customers has been outstanding. More than 1000 customers visited the clinics in the first two weeks, taking part in the grand opening event, as well as receiving medical treatment, including immunizations. We drew many new customers to our stores and have seen positive impact to our business. We have plans in place to expand the in-store clinic concept to other markets.

In November, national diabetes month, we reemphasized our commitment to patients with diabetes, focusing on the disease as part of our quarterly health condition marketing program. Our diabetes specialists, our website that carries the most up-to-date information about the disease, and our partnership with the American diabetes association, continues to put us at the forefront of diabetes care. Perhaps our most significant initiative during the quarter is the extensive education and marketing program we launched around the new Medicare prescription drug benefit. To date, we and our partners, including United healthcare, Aetna and Coventry, have hosted thousands of in-store events, often attracting several hundred seniors in one day.

We are also getting good response to our in-store Medicare information centers, which explain the benefit and also carry a listing of plans available in each of our store's specific geographic area. And, our pharmacists, whom we have promoted as a key resource for understanding Medicare part D, are busy answering questions both from seniors, as well as their caregivers. Seniors tell us they to take advantage of this prescription assistance, but that they also want to take their time to make sure they enroll in the best plan for them. Our Living More Senior loyalty program has grown to nearly 2 million members during the quarter, as we enhanced its benefits to attract even more senior customers to Rite Aid. Through newsletter mailings, to Living More members, circular advertising in key senior markets and in-store promotion, we are positioning Rite Aid as the best choice for seniors covered by Medicare part D.

One other important initiative in the third quarter is the new corporate structure we announced in October. We have combined all functions that directly impact our stores under the strong leadership of our new Chief Operating Officer, Jim Mastrian, and on Jim's team, all the functions that impact marketing, merchandising and supply chain under Mark Panzer and all the functions that directly impact our pharmacy business under Mark de Bruin. This gives us a stronger, more cohesive and effective operation. Jim and his team are certainly in the process of further strengthening our field operation to make it even more pharmacy-focused. I will have more details on this on our next call.

I mentioned earlier that our positive sales trends have continued into December. Focus on our key strategic initiatives is delivering results. With this positive momentum going forward, we are definitely expecting to have a strong December and to finish this selling season, coupled with the extra week in -- in a 53-week year, to have a strong fourth quarter. Now I'll turn it over to Kevin.

Thanks, Mary. Let's begin with the operating statement. Total revenues for this quarter were 4.51 billion compared to 4.11 billion last year, or an increase of 38.3 million. We operated 3333 stores at quarter end, versus 3363 stores at end of last year's quarter, which is a net reduction of 30 stores. Hurricane Katrina caused the closure of 13 of those 30 stores. The revenue increase for the quarter of 38.3 million is primarily due to the 1.7% increase in same-store sales that Mary mentioned. That improvement is primarily due to this quarter's positive pharmacy sales of 0.7, which was up positive for the first time since the third quarter of last year, and also it's due to a front end same-store sales of 3.4%. Our programs for improving customer satisfaction, especially in the pharmacy, are gaining traction.

The impact of Hurricane Katrina was included in the third quarter as Mary mentioned. It initially impacted 109 of our stores, primarily due to loss of power. Currently we have 18 stores that are closed because of the hurricane, but five of those 18 are operating out of trailers, and we expect them to reopen soon. The 18 stores have been excluded from our same-store sales calculations since the beginning of September, but are not significant to our results of operations. We have adequate insurance for replacement value of the inventory, replacement value of the fixed assets, and for business interruption losses and expenses.

Let's continue down the operating statement, then, and cover gross profits. Gross profits, remember, are net of occupancy expenses, and they were 1.02 billion, or 24.55% of revenues for this quarter versus 1.01 billion, or 24.56% of revenues for last year. So the percents were relatively flat. The current quarter included a non-cash LIFO charge of 7.6 million versus a charge of 5.8 million in last year's quarter. The LIFO charge increase was simply due to the effect of higher estimated product inflation. Excluding LIFO, this quarter's gross margin was 24.74%, compared to 24.70% of revenues last year, or an increase of 4 basis points.

The four-basis point increase in a FIFO gross margin can be explained primarily in two pieces . The positive component is a 12-basis points increase contribution from pharmacy gross profit. We had an increase in generic prescriptions as a percent of total prescriptions and reduced inventory costs, resulting from purchasing improvements. Pharmacy gross profits strength continued, even with lower reimbursement rates. Partially offsetting the pharmacy gross profit contribution is an increase in rent expense, which reduced gross margin by 10 basis points. The increase in rent expense was caused by the new and relocated stores and the sale and lease-back of 64 stores since the third quarter of last year. As you recall, after stores are sold and leased back, we incur rent expense, whereas when the stores are owned, we incurred depreciation and interest expense.

Front end gross profit was flat. The contribution, that is. Although front end sales were higher than last year, the gross margin rate for front end was down slightly. Consequently, front end contribution to gross profit was flat. Although we did not change our promotion program, customers purchased more promotional product. Selling, general administrative expenses for the quarter increased as a percent of revenues by 93 basis points compared to the prior year. The current quarter included 0.7 million of litigation settlement income in SG&A, compared to the prior year's quarter litigation settlement income of 14.5 million. This 13.8 million decrease in income accounted for 33 basis points of the 93 basis point increase in SG&A. The remaining 60-basis point increase in G&A was primarily the result of higher salaries and wages and benefit expense, some higher advertising expense, and an increase in fees for our accounts receivable securitization facility, all of which support our strategic initiatives. The current quarter also was negatively impacted somewhat by higher energy expense.

Non-cash-based compensation and stock-based compensation expense is included in our SG&A. It was 6.1 million this quarter versus 5.4 million in the prior year. Remember, we expensed the fair value of stock options granted. Continuing down the operating statement, store closing and impairment charges were about the same as last year's charge. Interest expense was 66.9 million for the quarter versus 70.7 million in last year's quarter, due to lower costs to borrow. This reduction was primarily due to greater utilization of our accounts receivable securitization agreement and improvement in pricing in our senior secured credit facility, which was amended in September of 2005.

Cash interest expense was 61.8 million for this quarter versus 65.8 million last year, and non-cash interest expense was 5.1 million versus 4.9 million last year. Loss on debt retirements was zero in the current quarter, but 20.2 million in last year's third quarter. Remember, last year's third quarter included the expense related to amending and paying down senior secured credit facility.

Regarding income taxes, the current quarter, we had a 1.1 million income tax benefit and that's because we had a pretax loss for this quarter. Last year's quarter had a 5.4 million income tax expense, because the quarter had pre-tax income. However, note that the prior year quarter also included a catch-up adjustment related to a change in the estimated annual effective income tax rate; therefore, the prior year's quarter effective income tax rate is higher than the current year's quarter effective income tax rate. Net loss for the quarter, then, was 5.2 million compared to net income for last year's quarter at 0.3 million. The net loss per diluted share was $0.02 for both quarters. Each quarter's diluted per share calculation includes a -- the declared preferred stock dividends. Remember, preferred stock dividends are not included in the net loss or net income, but they are considered in calculating the earning or loss per share.

Let's move back to adjusted EBITDA, then, that Mary mentioned earlier. For the quarter, it was 141.3 million, or 3.4% of revenues. That's a decrease of 21.7 million from the prior year. The schedule attached to our press release reconciles our net loss, our net income, to our adjusted EBITDA total. Now, that decrease was primarily due to the 60 basis points that I mentioned increased in selling, general administrative expenses.

Let's turn to the cash flow statement. Net cash, provided by operations for the quarter, was 22.9 million this quarter versus 291.4 million last year's quarter. That 268.5 million decrease is primarily due to the 280 million decrease in the sale of accounts receivable under our securitization agreements. The impact on cash provided from --- by operations from the decrease in adjusted EBITDA was more than offset by a --- by less of a seasonal increase in inventory, net of payables. Net cash used in investing activities for this quarter was 76.1 million versus net cash provided by investing activities of 2.8 million for last year's quarter. The increase was primarily the result of capital expenditures for this year's quarter being higher than last year's, but proceeds from sale lease-back activity being lower this quarter than compared to last quarter.

For this quarter, we spent 97.4 million for property, plant and equipment and 11.3 million for prescription file purchases, for a total of 108.7 million of CapEx. During the quarter, we opened eight stores, relocated eight stores, acquired two stores, closed 22, which includes the 13 stores closed due to Hurricane Katrina that I mention mentioned earlier, and we remodeled 53 stores. Also, during the quarter we completed a sale and lease -back of nine stores for net proceeds of 24.6 million. Approximately 45 new or relocated stores will be opening in our fourth quarter. We are on target to achieve our goal for new and relocated stores and for prescription filed-by purchases for the year.

Net cash provided by financing activities for this quarter was 68.2 million versus net cash used by financing activities for 605.3 million for last year's quarter. During this year's quarter we paid off a term loan, as part of amending the senior secured credit facility, and borrowed [under] a revolver for seasonal inventory build and capital expenditures. During last year's quarter, we established the accounts receivable securitization agreements and with those proceeds and the use of excess cash, we paid down the term loan as part of the amendment to the senior secured credit agreement.

Liquidity continues to be strong. Our availability under the revolver at quarter end is over 1.1 billion. At the end of the quarter, we had 530 million outstanding under our senior secured credit facility, which now consists solely of a 1.75 billion revolver. We also had outstanding at the end of the quarter letters of credit of 110.7 million. At the end of the prior year quarter, we had 540 million outstanding under our old senior secured credit facility, but it consisted of two pieces: a 90-million drawdown on the old revolver and 450 million outstanding under the old term loan, which we paid off.

The 400 million accounts receivable securitization agreement continues to be an excellent source of liquidity. At the end of the quarter, we had utilized securitization agreement for 345 million.

To wrap things up, then, let's discuss guidance. We are confirming guidance for fiscal 2006, which will be a 53-week year. We are estimating fiscal 2006 revenues to be in the range of 17.1 billion to 17.4 billion. Revenue guidance is based on same-store sales estimates of 0.5% to 2.0%. Pharmacy same-store sales will be positive in the fourth quarter. We are estimating fiscal 2006 adjusted EBITDA to be in the range of 675 million to 725 million.

Now that we have three quarters of the year complete, you can see we are guiding you to a strong fourth quarter. Our guidance reflects the fact that the fourth quarter is one of our strongest quarters, because of the holidays, and the cough, cold and flu season, and this year includes an extra week. Our guidance also reflects our confidence in continued improvement in both front end and pharmacy same-store sales.

Finally, we've included in our guidance estimate of the negative impact from the new Medicare prescription drug [bampa] program as it relates to the due eligible participants, as well as the negative impact from increased occupancy and operating expenses of the new and relocated stores. We are estimating our net income to be between 31 million and 62 million, or a loss of $0.01 per diluted share, to net income of $0.04 per diluted share. Attached to our press release is a table that reconciles our adjusted EBITDA guidance to our guidance for net income.

CapEx is estimated to be in the range of 350 million to 400 million, for fiscal year 2006, including approximately 80 new and relocated stores.

Now, our guidance for net income and diluted loss -- diluted earnings per share does not include a possible positive adjustment to our income tax valuation allowances. Further, CapEx estimates do not reflect proceeds from possible sale and lease-back transactions.

This concludes our prepared remarks. Lynne, we are now ready to take questions.

[OPERATOR INSTRUCTIONS] Your first question comes from John Heinbockel of Goldman Sachs.

Good morning, guys this is Eric [Wisen] from Goldman.

Hi, Eric.

Hi. With respect to expenses, as you guys both mentioned in your remarks, it looks like the expansion program and your pharmacy investments are causing a fair bit of expense pressure,, at least they were during this quarter. Is it something that you guys are expecting to persist kind of until pharmacy comp momentum picks up a lot from where you are today? Secondly, is there anything you guys are doing proactively to mitigate the expense pressure in the interim?

Let me give you a brief response there. We've always been very focused on containing costs overall, and yet we still know it's important for us to spend dollars on the important initiatives. We have continued to emphasize overall what we call spend management initiatives in our Company. We really identified some new areas across the Company where we can look for expense savings as we move forward to help mitigate some of the expenses we know we're going to spend.

I would like to add, Eric, the sales lift that you get, like, say, in the fourth quarter, has a significant impact on the SG&A percentage. So we expect things to continue being added to SG&A in connection with support of our new and relocated store program, as well as continued use of the accounts receivable securitization facility, for example, and, you know, tactical, promotional activities. But nonetheless, with the sales lift, the rates overall will start to settle down.

Okay. Then secondly, I think this is a question for you, Kevin. Could you give us a sense for the amount of EBITDA dollars that you are attaching to the extra week during the quarter, and how much is embedded in the guidance that you give us for the year? Is it 2% number or kind of 12 to 15 million, is that about right?

I think we've talked about that in earlier calls and basically we have no better information to change at this point in time, and we'll update you when we complete our fourth quarter.

Okay. But I mean is that fair to assume kind of a 2% number, though, for the year, that that's what's embedded?

2% of what, Eric?

2% of the annual --- I mean is the extra week worth about 2% of the annual EBITDA?

Does that translate to the 12 to 15 million that you just said?

Yes.

Yes.

Okay. Okay. Then lastly, can you give us an update on what's happening with the federal Medicaid legislation in Washington, kind of what stage they are in in the process and how do you see this eventually playing out?

Well, there's a lot going on and I think this is probably one area where the industry is pretty united, too, in the message that we're giving to both house and senate, and to any of the legislators that can have an impact here, and it's still in heavy discussion. Where we are focusing the lobby effort along with any CVS is on the mandating of dispensing fee, on how pricing calculations are updated, timing in particular, and the whole issue of enforceable co-pay. And this effort's going to continue to go on and we know that there is going to be change, but the final answer isn't here yet.

Okay, and I guess just as a follow-up, assuming it does pass, because it seems like something, in some, way, shape or form will -- to what degree do you think it will be a negative for Rite Aid and is there anything you guys can do to kind of mitigate the hit, as you mentioned through increased dispensing fees or reducing expenses in stores with heavy Medicaid mix?

Well, obviously we'll have to look at stores that have extraordinarily high percentages of Medicaid fill because it, depending on the degree of change, reimbursement change, some of those stores may not be able to fill scripts. I mean, that is something we have to look at, and in -- no matter what passes, it will have a negative effect, not just on Rite Aid, but on the industry in general and that's an issue that the overall industry has to take up.

So, it will come down to continuing to build incremental volume across pharmacy customer base and to continue to work on other initiative areas that can help offset some of the margin impact, for instance, the focus on growing generics. That's a key initiative for us. We're highly successful with it and we intend to be even more successful in future years.

Okay. Thank you.

Your next question comes from Meredith Adler of Lehman Brothers.

Hey, guys. Couple of questions. You talked about continuing to meet your goals on pharmacy file-by's. Do you anticipate that the advent of part D is going to provide more opportunity for you guys to buy files?

Yes, I expect there is going to be significant pressure on independents, as well as some small regionals and that there will be opportunities for us to increase our level of purchase activity here.

And what's been happening with the pricing of those files? Is there a lot of competition for the sales, or is that lessened at all?

No, there's definitely competition for them, and I would say over the last several years, the cost has gone up, but we still do an ROI on every single file, and it has to meet our hurdle rates. It still is most effective way to grow script base in a store and it returns its purchase price very quickly.

I was also wondering if you could talk a little bit about your PBM. How quickly do you anticipate that the PBM will actually be able to be functioning in covering lives and is there still a chance for you to get involved in some of what's going on with part D, maybe not for this year, but would it be your intention to try to bid to be the PBM compartment plan for '07?

Yes, Meredith, I don't see that happening for '07. You know, we're still in very early stages, but we are actually in contract stages now with at least one new client and in contract discussions with more. So we will begin to strategically cover lives and we are being very focused on how we go about this effort and I mentioned in my comments that we just recently hired a VP of sales in addition to our General Manager, that our marketing program put together and -- so we should begin to make some pretty serious progress over the next three to six months.

I just had one final question about pharmacy. There has been some noise coming out of the large PBM's about creating limited networks or limiting the number of pharmacies that are in their networks. I'm wondering whether you guys are seeing any of that. I know way back when, I guess it was General Motors kicked Walgreen out of their network, and you guys and CVS stayed in it. I'm wondering if you're seeing more of that. Is that becoming more of an issue?

I don't know that I've seen more of it. I think there's been some amount of it over the past number of years. I think that we had some active participation in some more limited and preferred networks and I would expect that to still happen. I haven't really seen that we've been eliminated from any network that I am aware of.

Okay, great. Thank you.

Your next question comes from John Ransom of Raymond James and Associates.

Hi, good morning. A couple of questions. It looks like, according to the data we have, that mail order has really slowed quite a bit, and I know that a year ago or so, you guys were citing the UAW contract as a reason for your pharmacy slowdown. Now that that's played out and mail order has abated, do you think there's another structural reason why your pharmacy volume numbers appear to be lagging in the industry a little bit as the mail order threat seems to be at least for the moment receding?

John, I would say probably the single biggest factor is that we have not grown our store base over the last five years. You know, we just started back up our growth program this last year and expect to open about 80 stores between relocations and net new, and then I mentioned 125 to 150 next year. And our competitors have been growing pretty rapidly. And if you factor into account the impact of new store growth on comps, it's pretty significant because I see what it's going to do for us over the next five years.

Right.

So I think that's the single biggest issue.

Okay, and then secondly, obviously your Medicaid exposure is about 700 basis points higher than your peer's, and you operate in some states with some presumably pretty high Medicaid reimbursement levels, the AWP mountain states with no [mac], like Pennsylvania and New Jersey and New York. Are you seeing anything coming out of these PDP's for the dual eligibles that would be kind of a meaningful delta from -- for your generic pricing in those states yet?

I haven't really seen anything at this point. You are correct in that we have a higher percent of Medicaid business.

Right.

[overlapping speakers] that is where we're located.

Right. It just looks to us, and you know more than we do, but some of the states with no [mac] and no cost-plus pricing --- the Medicaid prices are significantly higher. So I guess we assume as we transfer these dual eligibles into the PDP's that the pricing will come back in a little closer to market, but I just didn't know if you had seen anything specific on any of the price schedules yet.

No. We have - we have factored what had we expect to be the impact from the dual eligibles, moving over into our January/February forecast.

Okay.

Because that's part of our fourth quarter, and we have good data around our dual eligible population by state, et cetera, and so we can make some prereasoned judgment on what that's going to do.

What sort of impact do you think it has? Is it noticeable, or is it -- I mean you're talking about a strong fourth quarter and yet you're having to absorb this margin hit. Obviously, is it less noticeable than the --- people might think?

Well, the dual eligible population is not as large a percentage of the total Medicare population as I think maybe some people have said, at least not for us.

Okay.

And so we believe it is going to be impactful, but that we have taken it into consideration. I'll just go back again and say that overall changes that are happening with Medicare necessitate getting incremental volumes to offset the hits to margin because there is no doubt about it, there's going to be a hit to margin on just converting your own customers. So all of our marketing plans have been really built around getting new customers into our stores and another reason we've launched the loyalty program for seniors, our reason for our partnership with Aetna, Coventry, United healthcare, Humana and that we put marketing spend behind that so that we can get more seniors into our stores.

Just so everybody has the same data, too, our Medicaid percentage of our pharmacy business is about 18%, and the dual eligibles, if had you to break that 18% down, you would say it's 14% non-dual eligibles and then 4% dual eligibles. That, I think people have got us higher mix of dual eligibles than that.

But that's patients, correct? That's not sales.

That's sales.

That is sales, okay. So 4% of your total pharmacy sales come from the duals, in other words?

Right.

Okay. That's helpful. And just finally, we are hearing stories about some fairly low dispensing fees coming out of the, some of the PDP contracts. Can you comment on that, that the generic spreads look like they are okay, but the dispensing fees look fairly skinny. What are you seeing out of that?

I haven't really seen anything that I could confirm that.

Okay. All right. Thanks a lot.

Yes.

Your next question comes from Ed Kelly of Credit Suisse First Boston.

Good morning.

Hi, Ed.

Could you discuss in more detail your initiatives to gain new pharmacy customers? How much of this is done through file-by's versus internal initiatives, and could you talk just in more in depth in terms of what these internal initiatives are?

Well, file-by's is --- is an important piece of our overall gaining new customers, but a whole lot of it is really centered around first, improving the pharmacy experience in our stores so we gain a better representation and can get better word of mouth out there. It's what we've also done with our tactical marketing initiatives in particularly priority and strategic markets to get new customers to either transfer a script to us or bring us a new script and give them incentives to do it. It's a -- the cross-marketing effort against the -- our front end customers to become pharmacy customers. It's doctors detailing initiatives that we also have in place out there. It's a combination of, I would say, initiatives that are all squarely on this.

Even what we've done with our organization structure to really put more focus on pharmacy so that we give more support to our stores in terms of that pharmacy experience has been key. We invested significant dollars in new technology. In the past year we rolled out the new pharmacy dispensing and management system. That's been a real plus in attracting new pharmacists to our Company. It's a state of the art system, and that also helps us in terms of just overall staffing initiatives, and -- but everything around customer satisfaction, as well as very specific targeted marketing efforts are part of getting new pharmacy customers.

And then our PBM down the road should help us, too, in terms of being able to work directly with specific plans or employers in bringing new customers to our stores. I mention that also -- that take care initiative with nurse practitioners clinics: small, in that it's just a pilot, but it certainly shows you can get new customers into your store.

Okay, and is there an opportunity to accelerate file-by's as you ramp up new store growth to help these stores ramp up to profitability more quickly?

We have accelerated them, and we would be willing to accelerate them even further as more opportunities present themselves.

Yes, we're taking advantage of what is economically available and makes sense already, Ed.

Okay. Great, thank you.

Your next question comes from Elly Radenski of Citigroup.

Yes, hi. Can you talk about your acquisition strategy, especially along the PBM line? Would you be interested in looking at other PBM's in order to accelerate your development there? And also, I know that you purchased a few --- acquired a few drug stores. Please talk about your appetite for acquisitions.

We, we really are focused on our strategic markets in terms of ways to grow, and that includes new stores and relocations, but if something else made sense and it was a good value to our shareholders, we would look at that. As far as the PBM goes, we believe that the strategy we've embarked on is the best one for us. Whether other opportunities present themselves down the road, we would look at those as they came up.

How much investment did you have in PBM's which may have impacted your SG&A in this quarter?

It --- is significant.

Okay. Thank you very much.

Your next question comes from Mark Wiltamuth of Morgan Stanley.

Hi. Mark Wiltamuth with Morgan Stanley. Could you just give us a little outlook on how you think the first half of the calendar year will progress versus the second half? Obviously, we have some transitional issues with Medicare part D, and in general, do you think Medicare part D will end up being a net positive for you or more like a neutral impact on earnings?

Well, obviously, I think all of us realize that sign ups will probably come slower than was originally forecasted for Medicare part D. So, that would say that you'll see more of the positive impact from incremental customers in the back half of the year, although our year starts in March, so our first half will end in August. But you will see more in back half. Plus a lot of the generics start coming onboard in the back half of the year, too.

Right, and is there any way you can give us an overall picture of Medicare in total once all the ramp-ups in volumes have occurred?

Well, I think Medicare itself, unless-- as I said earlier, without incremental customer gaining is a negative.

Right.

So it means that you have to have strong marketing programs and also be driving growth of generics to really offset the margin hit you get from it.

And the margin hit for the dual eligibles hits immediately and the volume growth takes a longer period of time. So the answer to your question, Mark, in some regards is depending upon the timeframe that you're setting.

Okay, and there any way you can bracket the gross margin impact either on a prescription, per prescription basis or basis point impact, anything like that on how much impact you could get from the dual eligibles switching over?

We're, really what you're asking is a good question, but it's requiring us to sort of like comment on customer profitability, and we're just not going to do that.

Okay. Thank you.

Thank you.

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

Hi, thanks.

Hi, Steve.

Hi. I have a few questions. I guess first, for Kevin, related to your gross profit margin comments, I think you said pharmacy margins contributed 12 basis points and that's lower than what it's been in the past two quarters, I think. I think that's sequentially decelerated a little bit, but yet your total gross profit relative to Q2 improved. Can you speak a little more to that? What was the sequential improvement in gross, if you can identify that?

It's a little less negative impact from the occupancy, but a lot less negative impact, in fact none, for front end.

Okay. So that, that 10-basis point impact for occupancy was, that was a little bit--

A little bit less than it was in the second quarter.

Okay. Yes, because I don't know if you have given that before actually. Do you have those numbers handy?

Why don't you call me and I can go over some of that with you. I don't have it handy right now.

Okay. That's fair. I guess more importantly, that 10 basis points, your store development accelerates in fourth quarter an then as you said into next year. What's that 10-basis point impact you saw in Q3, what's that start to look like as you look forward a little bit?

Well, like -- in the fourth quarter there is 45 stores that are going to be coming out of the ground and a lot of it's in the very end of the fourth quarter, and so it's going to continue to be more significant, especially for new stores, which are starting out with a very, very slow sales --- very low sales base.

But we still are definitely committed to our new store growth program, whether it's relocations or net new because it's critical to our strategy of densing up strategic markets.

Okay, but I guess for us to -- that basis point impact I guess is tough to say what that might be on your gross in Q4?

In Q4, the gross margin rate should be a combination of -- should be lower because of, A, those 45 stores coming out of the ground and the occupancy expanse and also just because of the dual eligibles that we talked about. That's a negative. Then last, but not least, some of just the sales mix, but your gross margin -- our gross margin rate for the fourth quarter will be lower, generally speaking, because of those factors, but with a higher sales base, much, much higher sales base in the fourth quarter. We're still showing an increase in EBITDA.

Okay. All right. Second thing, you know, just maybe a little bit of clarity on your same-store sales guidance. Mary, did you say that your, at the end of November, your script comps had turned positive in units? Did I hear that right?

Yes, yes.

So that pharmacy comp that was up I guess, the 1.4%, are you talking about the end of November or the November comp?

I'm talking about November. There's not a lot of inflation in pharmacy at this point in time because I mentioned that we're very successful with generics and generics, especially, compared to brands, have very nominal inflation.

Okay, and what is-- your guidance for the year, you know, 0.5 to 2% sales is a pretty, still a pretty wide range. Should we look at November and what you did in that month and extrapolate that to what we should think about for December, January, February? That -- should that be a low point? How do you think about it?

Well, we expect the fourth quarter sales to strengthen.

Yes, relative to what we saw in November?

Yes.

Okay, that's good. Okay. And I guess two last things. Did -- what's your CapEx? I think you said new stores or relos would be 125 to 150 for FY '07. Do you have a sense of what your CapEx spending will --- will look like?

In the fourth quarter? Are you talking about next year?

Next year, next year.

We will not give out that guidance until I think probably our next call.

Okay, but you said no openings would accelerate to--

Yes.

That's with relos? Okay.

The mix of the stores, depends on whether they are turnkeys or whether we build them and then later on [inaudible] still very much being developed, Steve.

So I guess it's too early to say if CapEx will go up next year.

It will be about the same.

Okay. That's helpful. And the last thing, I know you'll eventually give us forward EBITDA guidance for FY '07, but at this point, given your fourth quarter guidance and the improvement you're going to see even without the extra week there, I mean is it safe to say that at this early stage that next year will be an up year in EBITDA?

We aren't commenting on '07 guidance at this point.

Okay, thanks.

Your next question comes from Karen Miller of Bear Stearns.

Hi, good morning.

Good morning.

I wonder if you could just tell me in view of the 22 closed stores, what's the runrate of your dead lease or closed store expense?

It's roughly -- the annual spend net of sublease income for closed stores is about 35 million.

And do you expect that to be about the same next year in view of the impact of Katrina?

You know, there's rate abatements. We just have to wait and see where we end up with -- in our dealings with the landlords. I just can't answer that yet.

Okay, and then of the 13 stores closed in New Orleans, is that going to be permanent, or do you have plans to open those?

I think you look at each one will be a store-by-store decision and it is really going to depend on how the area is redeveloping.

Okay, and then, in view of the increase sale lease-backs, two questions. Could you tell us the nine stores that were sold on lease-back in 3Q, are those leases reflected on the balance sheet? And secondly, what can we expect for rent expense going forward next year? Runrate?

The nine stores were, they are operating leases.

Okay.

They were previously owned and we sold them, leased them back under operating leases. As far as rent expense for next year, we're just not prepared to give that to you. We're not done with our planning.

How about for this year? Could you give us a run rate?

It's about the same as what you've got for the rent in the 10-K. And remember, almost the vast majority of our new and relocated stores are coming out of the ground and the --- 45 of them are coming out of the ground in the fourth quarter.

Okay. Also, one last question, in terms of your new stores planned for 4Q and then next year, can you tell us what the mix is in terms of new and relocated?

For next year? It's probably still about half and half of relocations and net new. A lot of it's timing on the project coming to our real estate committee.

And is that pretty much what the trend's been this year?

Yes, maybe a little bit more on relos.

Okay. Thanks.

[OPERATOR INSTRUCTIONS] Your next question comes from Jeff Kobylarz of Citigroup.

Hi, good morning.

Hi.

Can you tell me about --- you mentioned that pharmacy, customer and pharmacy satisfaction was up. Can you elaborate about that?

I think we've talked about on our calls that we have had a real focus on improving customer satisfaction over, I would say, the last 18 months. We have a --- what is called a customer phone-in survey based on their experience in the store, both pharmacy and front end, separate transactions. But we have really worked to improve those results over this past year by really focusing on the experience itself. And we have still not hit our goal. We're very aggressive on our goal because we believe this could be a differentiator in the future, but we've made good steady progress upward, and I think it's beginning to show in our results.

Is the satisfaction measurement, is it up versus the second quarter? Is it still just up versus last year?

No, it's up quarter over quarter.

Sequentially.

And we have expected to be up even further in the fourth quarter, and we use this in, along with our benchmark survey that we do every year in terms of how we are viewed versus our competitors to really zero in on stores in areas that we need to help more on improving satisfaction. And we focus a lot on timely delivery of scripts, as well as the overall experience.

Okay. Can you comment about your -- the new stores you've opened so far, just general comments about how they are trending as far as ramping up sales and when will they -- what are -- when are they in general profitable?

Well, they have been extraordinarily well received by the customers. Very customer friendly layout, easy to get around the store, really features the pharmacy, and when you're talking about the, at least 50% plus being relocations, you're generally moving from the strip center to a corner with a drive-through, and so you get a nice bump on the pharmacy as well as just a really nice bump on the front end. So, very strong sales results, very strong customer reception and we expect that to continue.

And those sales are meeting the expectations that we set when we made the decisions to invest in them.

And chance to get into profitability, what are the rules of thumb you're using?

Well, a relocation will generally get profitable even within just a little over a year of getting it on its corner. A new store can take three to four years and I think that would be pretty typical of the industry. It depends on the site and how all the expense factors roll in.

All right, thank you.

Your next question comes from Keith Howlett Desjardins Securities.

Yes, I was wondering if you could comment on the impact on the Medicare eligible seniors who are currently cash customers who will be moving perhaps to an insurance program.

That's going to be another component of what happens with the Medicare program, and it will also have a negative impact on margin, so it also says, again, that's why it's important to grow the senior base, and we have taken that into account in our planning as we move forward.

If I could ask one last question on the customer service in the pharmacy department, is that primarily a labor scheduling or a software scheduling, or what are the key component there to improve the pharmacy customer satisfaction?

It's a combination. It's the overall experience, but it starts with timely delivery of the script, so did the customer get the script, when they expected it? Was it ready when promised? So that's probably a key component of it. Then the rest is just the accessibility of the pharmacist, the ability to talk with the pharmacist, the overall experience and what customers do through our telephone-in survey about their experience is to rate us on each component of the experience and then also give us an overall customer satisfaction rating.

And the only ratings that we look at in developing scores for our stores is what you call a top box rating. So the customer has to be highly satisfied for the score to earn a mark that's counted in rolling up their customer satisfaction score. And we have run incentive programs through almost all quarters of this year that really reward each and every associate in the store for achieving certain customer satisfaction goals and we'll continue to do that, too.

And the corporate associates, a portion of their incentive compensation is dependent upon improving customer scores, customer satisfaction scores also.

Thank you.

Operator, we have time for one more call.

At this time, there are no further questions.

Okay.

Mr. Twomey, are there any closing remarks?

Nothing other than happy holidays everybody, and thanks for joining us.

Thank you. This concludes your Rite Aid third quarter conference call. You may now disconnect.