Rite Aid Corp (RAD) 2007 Q3 法說會逐字稿

Good morning. My name is Tina, and I will be your conference operator today. At this time I would like to welcome everyone to the Rite Aid third quarter results conference call.

[OPERATOR INSTRUCTIONS]. I would now like the turn the call over to Kevin Twomey, Chief Financial Officer for Rite Aid. Mr. two may, you may begin your conference.

Thank you, Tina. Season's greetings, everyone. We welcome to you our third quarter conference call. Mary Sammons, our President and CEO, and Jim Mastrian, our Chief Operating Officer, are also on the call with me.

Our agenda for today's call will be as follows: Mary will give an overview of our third quarter and a brief update on where we stand with the Brooks-Eckerds acquisition. I will then review the third quarter financial results and discuss guidance for fiscal 2007. Mary will then comment on several recent industry-related topics, and then we'll take questions.

Before we start, I would like to remind you today's conference call includes certain forward-looking statements. These forward-looking statements are made in the context of certain risks and uncertainties that could cause actual results to differ. Also, we will be using a non-GAAP financial measure. The risks, uncertainties, and definition of the non-GAAP financial measure, along with a reconciliation to the GAAP measure are described in more detail in our SEC filings.

Finally, I remind everyone we are soliciting proxies in connection with the acquisition of Brooks and Eckerd stores and we have filed a proxy statement with the SEC. You should reference the proxy for more information. With that in mind, let's get started. Mary?

Thanks, Kevin.

Good morning, everyone, and Thank you for joining us today to discuss our third quarter fiscal 2007. We're pleased with our results as our adjusted EBITDA improved nearly 14% year-over-year, and our strong pharmacy trends continued with solid gains in pharmacy same-store sales and prescription count growth. Our team also did a good job at controlling expenses. At the same time we continue to improve our existing business, we also made tremendous progress on our plans for the integration of the Brooks and Eckerd chain. We will continue to focus on building on our existing trends while at the same time effecting a smooth transition once the transaction closes. I will give you an update on the progress of the acquisition in a moment, but first let's talk about the quarter.

The positive trends in our pharmacy business continued with a 4.3% increase in same-store sales, and a 2.3% increase in the number of prescriptions filled in comparable stores even with the slower start to the cough, cold and flu season. Our emphasis on customer satisfaction and on our pharmacy initiatives, including tactical marketing programs against new competition, new and improved managed care relationships, and our focus on health and wellness continued to deliver results. So did our focus on senior customers, as our Medicare prescriptions rose to more than 14% of prescriptions filled, and the number of seniors in our Living More Senior Loyalty program climbed to more than 2.3 million.

Once again, our pharmacists were well prepared to give seniors and their caregivers assistance during the second round of Part D enrollment, which started November 15th, and we used our partnerships with planned sponsors United Healthcare, Aetna, HealthNet, and Silver Script to reach out to pharmacy patients 65 years and older. As you might expect our pharmacists reported significantly less confusion over the program this year than last.

The generic wave continued to have a positive impact on our business. Our generic dispense rate, which includes both old and new generic prescriptions, rose to nearly 63% this quarter compared to 61% in the second quarter, and 58% in last year's third quarter. The nationwide expansion of WalMart's $4 generics and similar programs launched by mass merchants during the quarter had limited impact on our business as customers chose location, convenience and services over the small price differential on nearly all of the Generics on the list. I continue to wonder how long these programs can last since the $4 cannot cover the full cost of dispensing, and you can only tell sell a product below cost for so long.

New generics negatively impacted comp sales by 269 basis points, up from 194 basis points in the second quarter. As we have said before, we expect this impact to be larger in the fourth quarter, and we remain confident we can hit our goal of 66% generic dispense rate by next June. The higher margins that come with this increase in generics helped offset a substantial portion of the lower reimbursement from Medicare Part D. We continue to believe that increased sales from Part D will eventually offset all of the negative impact, especially since we don't see Part D plans lowering reimbursement to reach out pharmacy into any material extent in calendar 2007. However, we can't give you a specific time frame.

As for the front end, same-store sales increased 1.9% in the quarter. Core drug store was strong, although a lack of cough, cold and flu negatively impacted OTC later in the period. Health and beauty was solid, and we saw good gains in consumables, private brand penetration that was well ahead of last year and our GNC vitamin departments posted sizable gains every month of the quarter. Also contributing to the increase was our additional marketing focus on diabetes in October and November. We saw our highest sales gains of the year in diabetes-related products. This comes on top of already significant increases in the category because of our ongoing commitment to helping patients manage the disease.

Our seasonal sales, however, were off to a slower start than expected. This was partially due to one less holiday shopping day in the third quarter as compared to last year, the day having moved into this year's fourth quarter, and more aggressive promotion by mass retailers at the Thanksgiving holiday. We believe we'll make up for the slower start with a strong December Christmas marketing plan that includes larger weekly circulars, the addition of circulars mid-week, a holiday coupon book similar to last year, and special seasonal offers to our most loyal customers through our e-mail database.

Also planned to promote front end sales in the fourth quarter are our annual Rite Aid brand Super Value days in January and President's sale in February, both historically very successful events. To help our customers with their New Year's resolutions, in January we'll introduce the Rite Way challenge, a health and wellness marketing program focused on healthy weight loss. The program involves in-store educational material at our pharmacies, special offers on related products, and a nationwide challenge to lose weight. In February we'll continue our focus on health and wellness services with a program on heart health.

As I said at the start of the call, our team did a great job in the third quarter of controlling expenses. Our field management did an especially good job with managing labor costs Without sacrificing customer satisfaction which improved in both the front end and the pharmacy during the quarter. Our focus on Win Them Over Bring Them Back and Take 10, our new weekly training program that reinforces critical customer service behaviors by the store manager and the pharmacy manager have started to pay off in very short order.

As for our new store growth program, you saw from our release that we opened 23 new and relocated stores this quarter. This was short of our third quarter goal, and as a result we now expect to open 110 new and relocated stores this fiscal year versus our original projection of 125. Delays in the entitlement and permits process caused most of the short fall. We expect the stores that flipped to open early in our next fiscal year. We remain very committed to our new and relocated store program, based on our new customer role design, and it will be exciting to also bring these new stores to the new markets we will be entering after the acquisition closes.

Prescription filed by transaction slowed somewhat during the quarter, but we have forecasted a significant number for the fourth quarter. Our pipeline is full, and we expect to keep this initiative a high priority in growing scripts and getting new customers. As you know, another of our strategic initiatives to attract new pharmacy and front end business is the addition of in-store clinics in targeted markets. During the quarter, the first Lindora health clinic opened in Rite Aid in Southern California. This is the first in-store clinic anywhere to offer medically supervised weight management programs along with traditional clinic services.

We expected this to be a popular concept since Lindora already operates 35 well respected successful weight loss clinics in southern Cal. The first two months of operation have far exceeded our expectations. We look forward to expanding the program. An additional benefit is the high margin we get from the Lindora weight loss products we added to the front end. We're also excited about our Southern Health in-store clinics with the first just opened in northern California.

Now let's talk about the Brooks Eckerd acquisition. As you know, we took two significant steps towards completing the transaction during the third quarter. First, we set January 18th as the date for our special stockholder meeting to vote on the acquisition. Our proxy was mailed to stock holders at the end of November, and the votes are starting to come in. We expect the acquisition to be approved, because we believe stock holders understand that greater scale will make their company more competitive, better able to take advantage of the growth in the retail drug store industry, and better able to withstand both industry and competitive challenges to our business.

Rite Aid and the Jean Coutu group also filed with the SEC for our Hart Scott Rodino regulatory review and received, as expected, a request for additional information. Both companies have begun responding to what's commonly called a second request and should complete all submissions next month. So far this process has gone smoothly, and we expect it to continue that way. As I said in the beginning of my remarks, we are well into the planning for the integration including working through conversion plans and timetables and organizing our conversion team so we can begin immediately after the close.

Our plan is to begin by converting 23 pilot stores that represent a variety of Brooks and Eckerd store footprints within the first three months, which will give us the chance to test and perfect all phases of the conversion process. That includes training, systems, distribution, merchandising, and redecorating. Because we want to ensure that stores are converted with as little disruption as possible to both customers and associates, this pilot is a critical piece of our integration plan. We'll also begin integrating the Brooks and Eckerd distribution centers and expect to complete this in the first 90 days after close. This is primarily so the centers can support the planogram and merchandise mix changes for the acquired stores with all stores expected to be converted as we said, twelve months after the close. I will give you more specifics on how the conversion will roll out on our next analyst call in April.

We are also in the process of putting our field management structure in place for the additional stores. We will add two separate operating divisions, each headed by a Senior Vice President of Operations with seven new regions, each headed by a regional Vice President and a regional Vice President of Pharmacy just like the field organizational structure that exists at Rite Aid today. This will allow us to focus on the unique needs of the acquired stores while maintaining continuity and focus on our current business. When the integration is completed, we will realign geographies to ensure a total integrated field approach among all of our stores.

As members of our management team meet with more Brooks and Eckerd associates, they continue to be impressed with their talent, dedication and professionalism, and we look forward to having them join the Rite Aid team. Because communication is so important during a transition like this, we continue to update associates on the integration planning and career opportunities with Rite Aid and are getting a very enthusiastic response.

Now I will turn it over to Kevin for more details on the quarter.

Thanks, Mary.

Let's talk through the operating statement. Revenues for this quarter were $4.32 billion compared to $4.15 billion last year. That was an increase of $175 million, or 4.2%. The revenue increase was primarily due to the 3.4% increase in same-store sales. Pharmacy same-store sales increased 4.3%, which was driven primarily by a 2.3% increase in prescription.

In addition to the favorable demographic trends, our growth initiatives, such as our focus on customer satisfaction, prescription file buys, marketing to Medicare patients, our senior loyalty program, and the new and relocated store program produced results. We expect the prescription growth trend to continue. As Mary mentioned, our mix of generic prescriptions continues to increase. During the third quarter, all generic prescriptions were 62.7% of total prescriptions, which was 181 basis points higher than the current year's second quarter, and 440 basis points higher than last year's third quarter. We expect this trend to continue.

New generics had a negative 269 basis point impact on pharmacy sales during the quarter, which was higher than the second quarter's negative 194 basis points impact on pharmacy sales. Front end same-store sales increased 1.9%, our initiatives for improving customer satisfaction along with our consistent promotion program with a focus on core categories and an anchor in events produced results. However, the percent of sales coming from our promotion activities increased. Also, the photo category continued to be a negative contributor. As Mary said, we saw some weakness in the cough, cold and flu related categories and in our seasonal sales late in the quarter.

Gross profits were $1.15 billion or 26.71% of revenues for this quarter, versus $1.12 billion or 27.06% of revenues for last year. Gross profit increased due to the sales increase, but the gross margin rate decreased. The current quarter included a non-cash LIFO charge of $8.9 million versus $7.6 million in last year's quarter. The LIFO charge increase was primarily due to the effect of higher estimated product inflation. Excluding LIFO, this quarter's gross margin rate was 26.92% of revenue, compared to 27.25% of revenues last year or a decrease of 33 basis points.

The 33 basis points decrease in consolidated FIFO gross margin rate consisted primarily of two pieces. One component was a 44 basis point decrease in front end gross profit contribution to the consolidated gross margin rate. Although front end sales were higher than last year, which contributed to higher gross profit, the gross margin rate for front end was lower due primarily to three factors: A higher mix of promotional sales due to customer preferences, reduced vendor income primarily due to the expiration of exclusive contracts, and reduced gross profit contribution from the photo category.

The other component to the 33-basis point decrease in consolidated gross margin rate was an 11-basis point increase in contribution from distribution expenses. Similar to other areas of expense, we had good distribution expense control. The pharmacy gross profit was higher for the quarter due to higher sales, and the contribution to consolidated gross margin rate was 1 basis point more than last year's third quarter. Contribution to consolidated gross margin rate was a positive 12 basis points, due to the increase in generic prescriptions and reduced pharmacy shrink. However, the 12-basis points of contribution was mostly offset by product cost reductions that were reflected in the inventory valuation. We'll get the benefit of those lower costs when we sell the product.

Selling, general and administrative expenses for the quarter decreased as a percent of revenues by 58 basis points compared to the prior year. The 58 basis points of improvement was the result of good overall expense control, especially labor and benefits. Store closing and impairment charges were $2.5 million higher than last year's charge. The increase was due primarily to an increase in the store lease exit costs. We closed more stores in the current quarter compared to last year. This increase was partially offset by a lower impairment charge in the current quarter, fewer stores were included in the impairment calculation.

Interest expense was $68.2 million for the quarter versus $66.9 million in last year's quarter. The increase was due to the higher interest rate and slightly higher borrowings. Cash interest expense was $63.6 million for this quarter versus $61.8 million last year and non-cash interest expense was $4.5 million this year versus $5.1 million last year. Gain on asset sales was $48,000 in the current quarter versus a gain of $1.4 million in last year's quarter. Regarding income taxes, the income tax expense was $175,000 compared to last year's third quarter income tax benefit of $1.1 million. The effective income tax rate for the current quarter was about the same as last year. This year's quarter had pretax income, thus income tax expense. Last year's quarter had pretax loss, resulting in an income tax benefit. From a cash income tax perspective we are a state income tax payer. The cash outflow for state income taxes continues to be approximately 6% to 8% of pretax income.

Net income for the quarter was $1.1 million, compared to a net loss of $5.2 million last year. The improvement was primarily due to the $19.5 million increase in adjusted EBITDA which was a result of increased revenue and the resulting gross profit and improvement in the ratio of expenses to revenue. We did have an increase in depreciation and amortization expense. Net loss for diluted share was $0.01 for the quarter compared to a net loss of $0.02 for diluted loss per diluted share for last year's third quarter. Each quarter's diluted per share calculation included declared preferred stock dividends. You will remember that preferred stock dividends are not included in the net income or loss but they are considered in calculating per share amounts.

Adjusted EBITDA for this quarter was $160.8 million, or 3.7% of revenues, an increase of the $19.5 million from the prior year that I mentioned. The schedule attached to our press release reconciles our net income or loss to our adjusted EBITDA. The increase was primarily due to the increase in revenue and the resulting gross profit and the improvement in the ratio of expenses to revenue. Now let's turn to the cash flow statement. Net cash provided by operations was $44.8 million this quarter versus $22.9 million in last year's quarter. The $21.9 million increase was primarily due to the increase in adjusted EBITDA, partially offset by a decrease in funds provided from the sale of accounts receivable.

I want to spotlight just a couple of items in this section of the cash flow statement for the current quarter. The increase in accounts receivable was due to increased sales and the difference in timing of cash remittances from third party payors. The increase in inventory was due primarily to normal inventory build for the season. The current quarter's decrease in accounts payable was related to the payment of invoices for pharmacy inventory forward buys that were made late in the second quarter. This decrease was partially offset by the increase in payables from the seasonal inventory build. Net cash used in investing activities for this quarter was $90.1 million versus $76.1 million for last year's quarter. The increase was primarily the result of capital expenditures being higher than last year and proceeds from sale and leasebacks being lower.

For the quarter, we spent $86.8 million for properties plant and equipment, and 6 million for prescription file purchases for a total of $92.8 million. During the quarter we opened ten stores, relocated 13, closed three and remodeled four. Net cash provided by financing activities for this quarter was $97.1 million, versus $68.2 million for last year's quarter. The increase was primarily due to draws on the revolver to fund seasonal inventory build and the payments of required maturities. We issued a new term loan for $145 million during the quarter that effectively refinanced the 12.5% note that matured in the quarter.

Liquidity continues to be strong. Our availability on the revolver is over $750 million. At the end of the quarter, we had $875 million outstanding under our $1.75 billion senior secured revolving credit facility. We used the revolver to fund the $250 million required maturity of the 4.75% convertible notes. We also had outstanding letters of credit of $117.1 million at the end of the quarter. Total debt since the beginning of the fiscal year has increased $96 million, and advances from the sale of accounts receivable had increased $40 million. The combined balances since the beginning of the fiscal year have increased a net $136 million. Most of this increase is due to the normal inventory build for the holidays. The $400 million accounts receivable securitization agreement continue to be a good source of liquidity. At the end of the quarter we had utilized the securitization agreements for $370 million. Regarding the remaining required maturities in fiscal 2007, we will use the revolver for the $184 million of 7.125% notes that mature in January 2007.

To wrap things up, then, let's discuss guidance. We are confirming our guidance previously given for fiscal 2007. For sales, same-store sales, adjusted EBITDA, net income or loss and capital expenditures. We're estimating fiscal 2007 sales to be in the range of $17.4 billion to $17.65 billion, sales guidance is based on same-store sales estimates of 2% to 4%. We're estimating that fiscal 2007 adjusted EBITDA to be in the range of $650 million to $725 million. Our guidance reflects the fact that fiscal 2007 is a 52-week year. We are estimating our net operating results to be in the range of net loss of $5 million and -- or net income of $40 million or a loss of $0.07 per diluted share to net income of $0.02 per diluted share. Attached to our press release is a table that reconciles our adjusted EBITDA guidance to our guidance for net income or loss.

Capital expenditures before sale and leaseback proceeds are estimated to be in the range of $450 million to $500 million for fiscal 2007. We estimate sale and leaseback proceeds to range from $50 million to $100 million. We expect to open approximately 110 new or relocated stores by year end, which is a little lower than the 125 we announced before, for various normal real estate development reasons several stores are going to slip into early fiscal 2008.

This concludes my prepared remarks. But before we go to questions, Mary has a few comments on recent industry developments. Mary?

Thanks, Kevin.

Before we take your questions, I would like to comment on several recent industry events. First, average wholesale price, or AWP. As you all likely know, the proposed settlement in the First Data Bank litigation changes the calculation method for reporting average wholesale price, basically seeking to lower it by 5 percentage points from a 25% markup to a 20% markup, and no longer -- and longer term eliminated altogether. Any changes to the reporting of AWP will be dependent upon the judge hearing the case and we don't know when that will happen. In the meantime, we have been talking to our third party payors, and have received favorable feedback regarding maintaining the existing economics of the program.

Second, proposed guidelines were released late last week by CMS for calculating average manufacturers price, AMP, for Medicaid reimbursement. We're currently evaluating the guidelines, although we have not seen any actual AMP data, and from what we hear, CMS does not plan on posting any actual AMP data until late spring of next year. While it looks like AMP could negatively impact reimbursement on generics, it's important to remember that the retail pharmacy still has 60 days to comment on these proposed regulations, especially with regards to including PBM rebates and mail order pharmacy in the calculation of AMP.

On a positive note, the proposed regulation does instruct states to consider fair and reasonable dispensing fees. Several states are conducting costs of dispensing surveys, and we've had some positive conversations. The results of the national costs of dispensing survey by the Coalition For Community Pharmacy Action should be available in the next month or so to assist us in making a case for a higher dispensing fee, and will continue to lobby along with the rest of the industry for fair reimbursement.

Third, the CVS Caremark merger and the subsequent bid by Express Scripts to buy Caremark, how will this impact Rite Aid? The simple answer is we don't know yet. All of the networks in the PBM marketplace are based upon individual contracts with payors, and changes are unlikely to occur in the short-term since most are at least three-year agreements. CVS has indicated that if the merger with Caremark takes place, open pharmacy networks would still exist as they do with CVS's current PBM PharmaCare, with which we have a good relationship. We also have a good relationship with Express Scripts. We have no plans to acquire a large PBM. Our focus right now is on our core business, and the successful integration of the Brooks and Eckerd stores.

Operator, we'd now be happy to take questions.

Your first question comes from the line of Meredith Adler with Lehman Brothers.

Good morning and congratulations.

Thanks, Meredith.

I was wondering if we could talk a little about the gross margin. Did you get some benefit from generics and from shrink this quarter, but I am kind of wondering whether you're still seeing pressure from Part D. Is it more than you anticipated because the growth in Part D has been strong, and then maybe you could explain a little bit about why our lower costs in inventory would be helping or hurting your gross margin.

Okay. As far as the Medicare Part D, I think we said on earlier calls, too, that it is a larger percent of our scripts than we originally would have calculated, so just in terms of the impact on overall margins, it is going to have more of an effect, so obviously the key is to keep growing the scripts there so that you create more gross profit dollars and over time as the script base gets high enough, we should also see pressure taken off of the rate.

As far as the inventory cost reduction is concerned, Meredith, as a very illustrative kind of example, if you have 100 items and valued at $10 you receive 25 items and they're valued at at $9, the entire 125 on hand must be valued at at $9. When I sell those products, I am going to get that back assuming the retail price doesn't change. There is some timing impact when you have that kind of cost reduction. That's what occurred in our third quarter.

Then I also had a question in there about generics, and whether you are -- there are any surprises in terms of what you're seeing on the benefit to gross margin.

I would say we're real pleased with the contribution from generics on the margin. I think that's what really is helping substantially our pharmacy margin rate. Without that benefit it becomes very difficult on the reimbursement side because of the pressures of Medicare Part D.

Right. Then I had one other question about the front end. I think this is the second quarter in a row that you talked about customers buying more front end merchandise on ads, so that the margin would be lower. Do you think that's a function of the external environment, or is there potential for you guys to change your ad program to make them a little bit less hot, and would you lose a lot of traffic if you did that?

I think it is probably more a factor of what's going on externally because we really have not made any -- what I would call significant change in our promotional strategy, but when you have sort of a slow-off on say seasonal sales which tend to be higher margins, if cough and cold is a little bit slower, you might not have quite as much traffic, so maybe the traffic in the store is responding more to what you do have on sale, you end up with your mix being more driven by the ad. We spend a lot of time on advertising on the front end. It goes along with being in the front end business, and I think we have a good program, and I would expect our seasonal business to regain strength as we move forward.

Okay. Great. Thank you very much.

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

Good morning. Nice quarter.

Thanks, Ed.

Question for you on your full-year guidance which you left unchanged. The range at this point for adjusted EBITDA is pretty big. There is only one quarter left. Can you just speak to this a little bit?

Sure. We're expecting a good finish on the year, but we're comfortable with the guidance range, and so we really don't see any reason to go out and change it, but we're expecting a good finish to the year.

Okay. And then on your SG&A, up only about $18 million, you've got big leverage there. How should we think about this going forward, particularly on the fourth quarter? How sustainable is this?

One of our critical priorities over the last few years has been on containing costs, and we have put even more emphasis on it and in a very reasonable way. We aren't doing things that you shouldn't be doing, so I guess the only thing about the fourth quarter is you do open a number of new stores in the fourth quarter, so you'll have the impact of that on overall expenses, but in terms of any of our other expense lines and even in costs associated with new stores, we watch what we do.

All right. Just one last question for you, Mary. Eckerd's front end has been a pretty good-sized issue under Coutu, and it was already pretty bad when they acquired it, only 26% of the mix seems pretty low. Can you just walk us through maybe what some of the challenges have been, what your initiatives are to get front end productivity up, and how quickly do you think you can do that? It seems like a huge opportunity when you run the numbers on that.

Well, when we built our models, we did not factor in any huge increases, but we obviously looked at their mix of sales compared to ours on the front, and clearly there is a big gap. We are about 35% more productive on the front end on an average store in the same areas that a Brooks Eckerd store is, so we believe that by getting in our planogram mix, by getting in our assortment, the businesses that we're in, being faster in introducing new items, more current on planogram changes, our seasonal program, and our event marketing and merchandising, kind of getting away from sort of a cherry picker promotional strategy that we will grow their productivity on the front, but that kind of initiative takes a little bit of time. You don't get it overnight because you have to get your customer really seeing what you're doing and responding to it.

Is there any reason the stores couldn't get close to your 35%?

No. Over time they should be able to achieve that same level of front end sales per store.

Several of the things that Mary mentioned are dependent upon the system's conversion and just people changing their work habits and things of that nature.

Improving service levels, all that stuff?

Right. It is the combination of all of it. That's why you want to give it time to really take hold.

All right. Great. Thank you.

Thanks, Ed.

Your next question comes from the line of Mark Wiltamuth with Morgan Stanley.

Mary, on the CVS-Caremark deal contemplates breaking down the barriers between PBMs and retailers. I know you've said you're not pursuing an acquisition there but is there some way you can participate in that type of program through an alliance or joint venture or something of that nature?

I think we also said before, too, we feel we have good relationships with the large PBMs and probably a lot of that is because we don't have a PBM of our own. Our new one is very fledgling, and we've worked hard at relationship building with them, and I think we will always look at ways of making those partnerships stronger and getting more benefit for ourselves out of it as well as for them.

CVS also indicated they would allow 90-day retail products to be sold through other retailers, not just through CVS. Would that have margin implications for you?

On a 90-day script you're definitely going to have a lower margin, but if you get a script that you weren't going to get, you have to look at it on a case by case basis which is what we've done up to this point in time so we would look at that through whatever they would offer too.

Okay. Lastly on the AMP rules, I guess the CMS also had estimates on cost savings for the government and the states. If you could give us some thoughts on what you think your earnings impact could be in 2007 as we go to this new program?

I think again we're still developing what that impact will be. A lot of it depends on really what the absolutely final rules are and what happens with the dispense fees in the state. Again, retail pharmacy still has about 60 days to respond to what's been put out by CMS on the guidelines, and we fully intend to do that, and we've got in fact discussions in any CVS going on now on this issue, and the focus on what the state dispense fee will be will be another key piece of it.

Mark, just remember that the Medicaid business contract is a store by store business contract, and so consequently we also are going to be looking at things from an incremental perspective as well as I think that the various state programs have to provide the necessary access which gives us some opportunity to continue encouraging fair dispensing fees.

And I think I would also add, too, because of the patients that moved over already from Medicaid, it is not as big a percentage of our total pharmacy business, still significant because it is still 10% in sales and about 9% in scripts, but it isn't the big mountain that it would have been when it was 18% of our sales.

Right. And the states you indicated you had some positive conversations with the states on dispensing fees. If you can give us a little more color on that, that would be helpful. Thanks.

We have not had any state really come and say they're going to do this or do that. I mean, they'll discuss with our people and our lobbyists around the issue, but so far no state has agreed to raise dispense fees. That's why continuing this lobby effort is so important because obviously the cost to dispense does not cover the cost to dispense. I mean especially when you look at the reduced margins proposed by the AMP changes.

Thank you.

Your next question comes from the line of John Heinbockel with Goldman Sachs.

A couple of things. The gross margin on the new generics in the exclusivity period, was that basically in line with what you thought it would be, Zocor, Zoloft, et cetera?

I think we're getting about what we expected to out of those.

Remember, John, in our guidance we had several scene arrows out there and whether they're exclusive versus multi-source right away are a couple of the scenarios. It is hard to nail down specifically.

Do you think the accounting on the inventory side, is that essentially push out the generic benefit, meaning if you sort of followed the -- when these products came on the market, you would think you would get a lot of it in say this quarter, but because of that accounting you'll actually get more than you would have thought otherwise in subsequent quarters.

The inventory in pharmacy turns very, very fast, John, like 30 or 45 days, so it is not long of a delay.

Before you actually get it out there, and really negotiating for lower purchase price is absolutely what we need to be doing to keep improving the balance between our costs and what we are going to be able to get for it.

Do you think being in the non-exclusivity period now will -- how much of a difference will that make in terms of changing the gross around on some of these big drugs, big generics?

Well, we continue to have a certain amount of unknowns in terms of how they're going to come out, and they do change rather dynamically, so we just continue to have different scenarios and take our best estimate. It is one of the reasons why we still have the range.

One of the things you also built in was the Medicaid cuts coming through in January/February. Based on what you know today, do you still think that's the case or that it seems like it might be pushed back?

Yes. From what I am reading on timing, you won't see an impact from that in January/February any more than we're seeing today, but like you open up the paper any day, and there is always new news out there to confront pharmacy.

Yeah. Obviously that's just a federal program. Everybody is focused on that, but remember the states are very much in the thick of this, and we're not quite sure how they're going to land on everything.

Is it possible if they put it into effect mid-year, do you think they then go back and there is a retroactive impact, in which case would you accrue the impact before it goes into effect or true it up when it actually passes?

We would accrue for things based upon what is most probable. There is a high standard there and a conservatism, John, so to the extent that there was for example in one case a -- they withheld some reimbursement rates, we would have to record things at that lower reimbursement rate and only after they said here is what the retroactive positive adjustment would be would we record that.

And right now from anything that I have heard up to this point, I haven't heard the intent to make it retroactive.

If it is a half year, it is a half year.

Right, it would go into effect.

However, the state programs have -- not a lot -- but have made unilateral deductions.

Finally, when you think about the remodel effort at the Eckerd stores, how is that going to play out in terms of prioritizing the actual remodels? Will there be more clustering of stores geographically or doing it by the performance level and how will that shake out?

We're discussing the Brooks Eckerd stores?

Yes.

We have built a pretty detailed plan already as to how we would bring groups of stores on. I mentioned the 23 pilot stores first so that we have first hand experience with each of the different kind of prototype versions of the store, and then we will begin working out around the DCs that have converted, so that will be sort of like the first condition is that the Brooks Eckerd DC that supports the group of stores will have to convert, and that's why getting all of the DCs converted in the first 90 days is important because then we can begin to spread the effort out around all the distribution centers and so that we can better balance the workload for our supervisors out in the field, and that's important, too, because you don't want to totally disrupt a whole district at one time either.

John, there is a difference between what we call the installing the decor package and making it look and feel like a Rite Aid versus a remodel. The remodeling is going to be spread out over several years, but the first twelve months after close we're going to put the decor package and the paint and powder and make it look and feel like a Rite Aid in all the stores.

Will the remodel, will you try to cluster into old Philadelphia stores or it will be spread out?

We have not built the plan for that beyond the first twelve months, John, but we will do that as we get through the process of understanding what consolidation we'll end up doing or what divestures will be there, and then we will also plot in our plans for relocations as well as new stores in an area and build our remodel program around that.

All right. Just finally, you would argue or it sounds like you think that no motor how Caremark plays out, the impact to you is not materially different whether it is CVS or Express scripts?

You mean whether it is Caremark and Express scripts versus Caremark CVS?

It doesn't sound like it is materially different as it impacts you?

We don't know until you actually see what would happen until you put a combination together like that. If it plays out the way that the relationship has been with CVS, PharmaCare, it should work out fine.

Thanks.

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

Thanks.

Hi, Steve.

Congratulations.

Thank you.

A couple of more housekeeping questions. Did you say, Kevin, what -- sometimes you say what the occupancy cost impact is, and I think that's in your SG&A now. Did you cite what the basis point drag was on the quarter.

I did not, Steve, but maybe just talking about rent if that helps, rent for the quarter was about $148 million, and year-to-date it is about $436 million. We're going to have these 50-some stores in the fourth quarter coming on. That's going to go up a little bit. If you have to do your rent annualized estimate for the year. I would use somewhere around a 585 to $595 million range.

Okay. And I guess I don't know if you remember quarter to quarter like last quarter you said there was a drag about 9 basis points and a quarter before that it was about 22 basis points. Are you getting away from giving those numbers out or do you have that handy by any chance?

I don't have it handy, and just in light of the 58 basis points improvement in SG&A, I mean we felt it wasn't all that relevant.

I think we could provide you with something even offline on that, too, Steve.

Yeah, that would be helpful. Then second thing, just with your CapEx guidance, I think you shifted some new stores falling into next year, but your CapEx guidance I think stays the same as -- are you going to still spend on the 450 to $500 million in anticipation of opening the stores up next year or is it just a timing thing?

It is, Steve, and also there is some CapEx in front of the acquisition in order for us to keep things going as smoothly as possible. We're going to be making some capital expenditures before closing.

Okay. All right. That makes sense. And then last if I could, the generic contribution in gross I think you said was 12 basis points to pharmacy margins this quarter?

No. What we said was we had pharmacy had a 12-basis points improvement. That's a net number. That's the generic offset by the other reimbursement rate pressures. We still have an anniversaried Medicare Part D. That's a net number.

So pharmacy margins improved by 12 basis points?

Right minus the 11-basis points of almost 11 basis points from the inventory cost reduction, so net pharmacy contribution to the consolidated gross margin rate was 1 basis point.

Great. Thank you.

Your next question comes from the line of Karen Miller with Bear Stearns.

Good morning.

Good morning.

Happy holidays to you.

Thanks.

Kevin, maybe you could tell me this. Jean Coutu has requested a definitive resolution regarding the transfer of the 8.5 subordinated notes. Would this impede closing the transaction if the courts don't decide and you guys are ready to close and you receive all the other green lights from your shareholders as well as any antitrust issues?

No, we're not going to let anything get in the way of closing the transaction as soon as we can.

Okay. So you plan to proceed even if there hasn't been a judgment yet --

We're requesting the expeditious treatment of this thing, and we're approaching it in a way so that there is all uncertainty removed before we close, Karen.

We anticipate the suit and any appeal being resolved prior to closing.

Okay. Great. Thanks. That's helpful. Just could you tell us the amount of the sale and leaseback proceeds you received this quarter?

It is on the cash flow statement, Karen. It shows for the quarter -- I apologize to get it in front of me here, the charts that are attached.

I missed that, then. I missed the charts. Sorry.

It is only -- we had very little, only $200,000 this quarter.

Okay. Thanks. That's helpful. Also, Kevin, usually you give us an update. How much are you carrying now in terms of leases for dead stores?

Well, the -- you're saying carry, you mean the cash outflow.

Right.

It is running around annualized basis around $32 million.

Really hasn't changed much?

No. It's continued to work its way down.

Okay. That's it for me. Thanks. That was helpful.

Thanks, Karen. Operator, we'll take two more questions.

Thank you. Your next question comes from the line of Carla Casella with J.P. Morgan.

Hi. I had a couple more questions regarding gross margin. Kevin, when you talked about the LIFO charge, you mentioned that there was a higher estimate product inflation.

Right.

Whether you talked about the front end you talked about deflation. Can you talk about the differences there?

We did not talk about deflation in the in the front end. We did talk about the pharmacy area. The LIFO charge is both front end and pharmacy.

The higher estimated inflation means you're expecting the pharmacy --

No. What you got is you're talking about a FIFO charge and then which is based upon the here and now purchases that are probably a lot of them will be sold in the fourth quarter. My LIFO charge is an annual estimate, so we still expect a fair amount of pharmacy inflation in our fourth quarter.

Okay. So the higher estimated product inflation is coming more from pharmacy, actually asking which areas that's mostly related to?

Right.

Okay. Then you talked about on the front end discussion the expiration of exclusive -- which areas are those?

We don't comment specific. This is a similar phenomena we described in our second quarter announcement. It is just a continuation of that.

Okay. How long would you expect that to continue? Will it be another two more quarters until we annualize it?

Yes.

Okay. Can you update on the total number of owned stores, land or other significant property ownership?

We have about 230 owned stores and 7 out of 8 distribution centers and corporate headquarters, I guess, too.

Thanks.

One last question, operator.

Your final question comes from the line of Reid Kim with Merrill Lynch.

Thanks. Just on the timing of the transaction, once you assuming you get shareholder approval, will you go out to approach with your financing proposal pretty soon there after?

Yeah. We will go to -- once we know the closing, about three weeks before the closing we'll be asking for credit ratings, and then probably as soon as they get out there, we'll hit the road which will be probably two weeks or so before the closing, and be raising the money.

If for any reason the court took its time to get back to Jean Coutu about the determination on the 8.5, would you put things off a little bit to wait for that or would you just go ahead?

We don't want to speculate about the court going to do this or do that, it is just going to proceed as it does.

We still anticipate that it is going to get resolved prior to closing.

Last question, just on the business. Thanks for the disclosure on the unit growth in the quarter for pharmacy. How much of that do you think was related to Part D?

It was certainly a significant part. I think in prior quarters I've seen since it has been about half of our prescription count growth, and I think it was at least that in the third quarter.

And in relative to in your markets maintaining a pharmacy market share that's stable, what kind of growth should we see in that measure?

Well, for us, we're very focused on growing our script base. It has been our critical priority for the last several years, and so we would like to see that number continue to go up, and I don't know that I am ready to set a number out there ahead of everybody, but we certainly want to see it keep growing from where it is at today.

Okay. Thanks a lot. Bye-bye.

Happy holidays, everybody. Thanks for the interest.

Thank you very much.

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