Rite Aid Corp (RAD) 2010 Q2 法說會逐字稿

Good morning. I will be your conference operator today. At this time, I would like to welcome everyone to Rite Aid second quarter fiscal 2010 conference call. All lines have been placed on mute to prevent any background noise. After the speakers remarks there will be a question-and-answer session. (Operator Instructions) Thank you. Mr. Hall you may begin.

Thank you. Good morning everyone. We welcome you to our second quarter conference call. On the call with me are Mary Sammons our Chairman and CEO; John Standley, our President and Chief Operating Officer; and Frank Vitrano, our Chief Financial and Chief Administrative Officer. On today's call Mary will give an overview of our second quarter results and fiscal 2010 outlook, Frank will discuss the key financial highlights and John will discuss our business then we will take questions.

As we mentioned in our release we are providing slides related to the material we will be discussing on our website, www.RiteAid.com under investor relations information tab for conference calls. We will not be referring to them directly in our remarks but hope you will find them helpful as they summarize some of the key points made on the call. Before we start I'd like to remind you that today's conference call includes certain forward-looking statements. These forward-looking statements are made in the context of certain risks and uncertainties that can cause actual results to differ. Also we will be using a non-GAAP financial measure. The definition of a non-GAAP financial measure along with the reconciliations to the related GAAP measure are described in our press release. I would also encourage you to reference our SEC filings for more detail. With these remarks I would now like to turn it over to Mary.

Thanks, Chris. Thanks everyone for joining us today and for your interest in our Company. This morning Frank, John and I are going to review our second quarter results, update you on the progress of our segmentation strategy and give you more insight on why we changed our outlook for the remainder of fiscal 2010. You will also hear about our programs to boost sales in the third and fourth quarters as we continue to adjust our initiatives to the realities of this tough economy, a changing customer and a challenging pharmacy environment. We will discuss our focus on further improving operating efficiency to help maintain our strong liquidity position. First let's talk about the quarter.

As you can see from our results we again made significant progress on man of our key initiatives and finished the quarter with more than $800 million in availability on our credit and accounts receivable facilities. Our team did a great job of reducing SG&A and controlling inventory. Critical in a challenging environment like this one. As we said in the past maintaining strong liquidity is of priority for us. Our script growth initiatives again delivered results as we continued to fill more prescriptions.

In the second quarter we reached the highest generic dispense rate ever for our Company 70.4% and dramatically increased enrollment in our RX savings card making prescriptions more affordable for our patients. Our pharmacy teams did an outstanding job taking care of customers too, with our pharmacy customer satisfaction ratings at an all time high, especially in the areas of friendliness and courtesy of staff and timely filling of prescriptions. With three more days left to go in our September sales reporting period both pharmacy sales and prescription growth trends are positive. Despite all of these positive factors our pharmacy results were tempered by increased pressure on margins. Which continued to deteriorate throughout the quarter especially for generics. John will go into greater detail in a few minutes.

As for front end sales although we've seen improvement in September they continue to be negatively impacted by a value driven customer searching for discounts buying more items on sale than they have in the past. On the positive side this same customer looking for value helped push private brand penetration 90 basis points higher than last year and private brand will continue to be a focus growth area for us. As the move in to the second half of the year we expect the negative trends that impacted our second quarter to continue. As a result we've lowered our outlook for fiscal 2010, and also widened our guidance because of the uncertainty we see over the next six months about the timing of the economic recovery and the strength of the cough, cold and flu season.

Our pharmacy teams and stores are prepared for a very busy season but we have seen before that cold and flu can fail to materialize. As frank will discuss we've also included the impact of the upcoming AWP roll back on Medicaid brand reimbursement which hits this weekend. On the front end expect softer holiday sales than last year. To help combat these trends we have multiple initiatives to grow profitable sales in the third and fourth quarters. We are stepping up our successful compliance programs continuing targeted script growth programs for under performing stores, and increasing file buys. We've launched additional promotions in the front end to encourage return shopping trips. We will begin a test in a group of pilot stores of our new loyalty program which we believe will differentiate us because of its emphasis on pharmacy. While we don't expect it to impact sales this year we believe we have developed an exciting program that will drive sales when launched nationwide next year.

As we work on growing profitable sales we will not take our focus off taking expenses out of the business and improving both sales and reducing costs with our segmentation strategy. We believe it's the right strategy. While some of our tactics may need to be tweaked it's clear that we are on the right track as John will show you later in his comments. We expect with all these initiatives our liquidity will remain strong. Even with our revised guidance we are forecasting $200 million in free cash flow this year. Our priority remains starting to pay down debt at the end of this fiscal year. I will now turn it over to Frank to discuss financial details. Frank?

Thanks, Mary, good morning everyone. Although it was a challenging quarter for sales and margin we made solid progress on a number of fronts during the quarter. We are in better position for long-term growth with the September 10, refinancing substantially completed. Improved liquidity as a result of working capital initiatives and reduced capital expenditures, continued improvement in lowering our operating costs and finally beginning to implement some of the segmentation work that John will discuss in more detail. On the call this morning I plan to walk through our second quarter financial results, provide an update on capital expenditures programs, discuss our liquidity position, review our rent reduction program as well as talk about the accounts receivable securitization refinancing. Finally, I will discuss our updated fiscal ten guidance reflecting ongoing front end sales and pharmacy margin pressure.

This morning we reported revenues for the quarter of $6.3 billion compared to $6.5 billion for the second quarter last year. The decrease in total sales was primarily driven by reduction in total store count and front end sales. In the quarter we closed 16 stores and year to date we closed 102 stores. On a quarter over quarter basis we had 118 fewer stores. Same store sales declined 110 basis points reflecting soft front end sales but positive pharmacy script growth. Front end same store sales were down 490 basis points and pharmacy sales were higher by 80 basis points during the quarter. Pharmacy scripts increased 140 basis points.

Excluding the acquired Brooks Eckerd stores same store sales for the 13 weeks second quarter decreased 60 basis points over the prior year with front end decreasing 490 basis points and pharmacy growing 200 basis points. At Brooks Eckerds stores same store sales decreased 230 basis points during the quarter while front end decreased 470. Pharmacy decreased 140 basis points in the quarter.

Beginning with our monthly September sales release, we will no longer breakout core Rite Aid and the acquired Brooks Eckerd store sales. We do not have internal initiatives that are acquired store specific. The business initiatives are centered around segmentation and other projects and not specific to the Brooks Eckerd stores. Adjusted EBITDA came in at $216.5 million or 3.4% of revenues for the second quarter. This compares to last year's second quarter of $219.9 million or 3.38%, or a 1.5% decrease. The results were driven by lower sales and lower FIFO gross margin dollars mostly offset by lower SG&A dollars. SG&A dollars adjusted for non-EBITDA expenses were $90.5 million lower and 75% as a percent to sales. This is an increase from the 30 basis points we achieved in the first quarter. We are very pleased with these results given $178 million or 2.74% decline in quarter over quarter revenues. This improvement reflects the various cost saving initiatives which John will talk about including store labor management, field controllable expenses and distribution center savings.

Net loss for the quarter was $116 million, or $0.14 per diluted share, compared to last year's second quarter net loss of $222 million or $0.27 per diluted share. The decrease in net loss was driven by no integration costs in this quarter compared to $32 million last year, a loss on debt modification last year of $36 million, lower store closing and impairment charge of $23 million, as well as a gain on sale of assets during the quarter.

The lease termination charge of $28.7 million relates to stores which were closed during the quarter. As I mentioned on the last call we expect to close 117 stores in fiscal '10. The LIFO charge of $14.8 million is consistent with the first quarter of fiscal '10. Interest and securitization expense was $142.3 million, which is $19.7 million increase over last year. The increase was a result of a refinancing completed in June as well as the increase in securitization expense from the second lean term facility renewed back in February. Later in my remarks I will discuss our plans to refinance the accounts receivable securitization which matures in September of '10. Net cash interest, primarily debt issuance cost amortization and workers compensation interest accretion was $10.1 million.

Gross margin dollars in the quarter was $89.9 million lower than last year 65 basis points. FIFO gross margin percent was also lower by 65 basis points which is worse than the gross margin trends we saw in the last two quarters. We saw a 53 basis point erosion in front end sales margins primarily caused by the sales shortfall and increase in the percent of item sold on promotion and an 88 basis point shortfall in pharmacy driven by lower Rx reimbursement rates but fewer new generics and higher generic product costs.

The margin dollar shortfall was partially offset by lower distribution center costs and lower front end and Rx shrink. Product handling and distribution expense as a percent to sales improved 25 basis points due to operational efficiency improvement and lower fuel cost. John will review the proactive measures implemented by the distribution center team in the quarter to drive these improvements. Selling, general and administrative expenses for the quarter were lower by $134.7 million or 135 basis points as a percent of sales as compared to last year. SG&A expense not reflected in adjusted EBITDA were lower by $44 million, primarily driven by no integration cost in the quarter as compared to $32 million last year.

Adjusted EBITDA SG&A dollars which includes -- which excludes specific items, the details of which are included in the second quarter fiscal '10 earnings supplement information which you can find on our website were lower by $90.5 million or 75 basis points as a percent of sales. This reduction in dollars reflects the aggressive cost saving initiatives that have been mentioned -- that have been implemented over the last 12 months.

The SG&A improvement was driven by better labor controls and lower field controllable costs including supplies, insurance costs as well as utilities. Corporate expenses were also lower.

On a sequential quarter over quarter basis, we reduced our adjusted EBITDA SG&A, from being 92 basis points unfavorable in the second quarter of fiscal '09, to 25 basis points unfavor until the third quarter to 8 basis points favorable leverage in the fourth quarter of fiscal '09, were 30 basis points of favorable sales leverage in fiscal '10 and now 75 basis points here in the second quarter. As previously mentioned our liquidity is strong as a result of the various working capital initiatives. As compared to the second quarter of fiscal '09 FIFO inventory is lower by $351 million of which 80% is due to our initiatives and the balance to store closings. FIFO inventory increased from the first quarter by $83.7 million, reflecting normal seasonal builds. Our cash flow statement for the quarter shows net cash provided by operating activity in the quarter, at the use of $146.9 million, as compared to a source of $96.1 million last year.

Repayment of the accounts receivable securitization of $125 million, normal seasonal inventory build and changes in other assets and liabilities were the driver. Changes in other assets and liabilities reflect store payment -- closed store payments and the timing of accrued interest payments, year to date net cash provided by operating activity was $210 million source of cash.

Accounts payable in the quarter was a small use of cash, $16 million, our days payable outstanding in the quarter was 24.2 days, this compares to 24.1 day in the fourth quarter and 28.3 in the second quarter of last year. A change from last year was driven by rent checks which were included in AP last year but not issued or included in AP this year because of our August 29, cutoff date. Net cash used in investing activities for the quarter was $27 million, versus $90 million last year. This reflects our proactive plan to trim capital expenditures. It also includes proceeds from script files and other asset sales. Year to date net cash used in investing activities was $42 million. During the quarter we opened three net new stores, relocated ten and closed 16. Our cash capital expenditures was $40.4 million. Now let's discuss liquidity.

At the end of the second quarter we had $822 million of availability under our credit facility and accounts receivable securitization programs and today we have $850 million of availability. We had no outstanding revolver borrowings under $1 billion senior secured credit facility, we did have $188 million of outstanding letters of credit and a $78 million borrowing base efficiency. I expect to periodically have borrowing based efficiencies during the year as we experience seasonal inventory swings as well as continue to adjust inventory levels for the various working capital initiatives.

We had $400 million drawn under our $570 million first and second lean accounts receivable securitization facilities with a borrowing base deficit of $92 million. Borrowing based deficiency excuse me, of $92 million. Total debt including AR securitization was lower by $250 million from year end. Lowering our overall leverage and improving our credit maturity profile is a top priority for the Company. The Company's overall debt leverage including off balance sheet accounts receivable securitization decreased from 6.6 times in the fourth quarter to 6.3 times at the end of the second quarter.

As we announced in June we completed the refinancing of a portion of our senior secured credit facility, which was set to mature in September of '10, outcome extended to maturity 3 to 7 years, giving us sufficient run rate to execute our business plan. We have begun to examine several alternatives to refinance our accounts receivable securitization program which also expires in September '10. That program has a $345 million first lean revolver portion and a $225 million second lien term facility. The first lean initially expires in January of '10, and has a backstop feature which extends the maturity to September of '10. We are looking at both on balance sheet and off balance sheet alternatives including one refinancing as a new conduit securitization. This is probably the least likely execution as the receivable conduit capacity has decreased for issuers.

Second option is to refinance with a special purpose entity nonrecourse off balance sheet first loan, term loan or senior secured note, and the third will be to refinance with a combination of either first lean and second lean on balance sheet and do that on balance sheet. Our indentures restrict our first lean capacity to $3.7 billion of first lean debt, which would restrict our ability to refinance the entire $570 million of AR with first lean debt. If we were to bring the facility on balance sheet we would be limited to $320 million of first lean debt with the remainder of finance at second lean. Keeping the facility off balance sheet would maintain our first lean capacity, however presently we do not have sufficient borrowing base capacity on the credit facility for any incremental secured debt. First lean debt. There is a specific carve out for the accounts receivable facility which allows us to use up to $320 million for accounts receivable, given the quality of the collateral we are very confident that the accounts receivable facility will be refinanced.

I would like to discuss the landlord rent reduction initiative we discussed on the last call. We contracted with a nationwide real estate firm to assist us in working with 465 of our worst performing stores to seek rent concessions. These locations under review for possible -- these allocations we view under review for possible closure and ar seeking rent concessions from our landlords to improve the overall profitability and viability of the stores. Through both our internal resources which are working on an additional 230 locations as well as our outside real estate firm, we have achieved rent concessions in about 20% of the locations with the reduction fully achieved over a 5 to 6 year period of time. We continue to work with our landlord partners to arrive at a satisfactory outcome on the remaining locations.

Now let's turn to our fiscal '10 guidance update. We've revised our guidance to reflect a challenging front end sales and margin climate as well as growing -- as well as growing pharmacy margin pressures -- ongoing pharmacy margin pressures in the AWP roll back. Total sales are now projected in the range of $25.7 billion to $26.2 billion, which reflects a reduction in our same store sales guidance to a range of negative 100 basis points to up 100 basis points.

This reflects the expectation of a continuing difficult economic environment and a discount driven customer. We expect front end comps to be negative for the balance of the year despite easier comps in the back half of the year. A stronger flu season would push us to the higher end of the sales range. We revised our adjusted EBITDA guidance to be in the range of $900 million to $1 billion. This includes the sales impact as well as an estimated $21 million hit to our pharmacy margins as a result of the AWP roll back which will take effect on September 26. The annualized impact of the AWP roll back on our pharmacy -- on our Medicaid business is $52 million. Net loss is now expected to be in the range of $390 million to $615 million or $0.48 to $0.74 per share. We have not made any adjustments to capital expenditures or the other line items in our guidance. We now expect to generate $200 million in free cash flow for the year. The guidance does include a provision to close 117 stores in fiscal '10. This completes my portion of the presentation. Now I would like to turn it over to John.

Thank you, Frank. As both Frank and Mary mentioned even though it was a difficult quarter from a front end sales and pharmacy margin perspective we did a very good job managing our expenses and holding EBITDA very close to last year's number. I will just recap again one more time a few of the key accomplishments in the quarter.

Script count in comparable stores grew 1.4% for the quarter. The Rx savings card enrollment has now grown to over 3.5 million members. SG&A declined an impressive 135 basis points to 26% of sales compared to 27.4% last year. And 75 basis points of the 135 basis point decline were EBITDA expenses. Distribution costs were 1.55% of sales, our fourth consecutive quarter of improvement versus the prior year. FIFO inventory was $351 million lower than last year, and our availability under the revolving facility and the asset securitization facility was $822 million. As Frank mentioned total comps for the quarter were down 1.1%, second quarter front end same store sales decreased 4.9% over the prior year, front end sales were soft in most categories and were impacted by the weak economy and because we have held steady in our promotional spending versus last year compared to the rest of the market that has become much more aggressive.

As I mentioned last quarter front end sales may have also been somewhat impacted by the SG&A and working capital initiatives we've implemented over the last four quarters. In fact the 1800 biweekly delivery stores impacted our front end comp store sales about 1.4% in the quarter. The good news, however, is that the EBITDA excluding pharmacy margin in those stores increased $10 million over the prior year, a big step in the right direction, when we get the sales going in these stores we will get more of the savings from our changes the the operating model to the bottom line. To help with sales in these stores we've made some operational changes including an increase in safety stock to help improve shelf conditions. In addition we're working out some exciting merchandising changes for these years that will be rolling out next year. Script count grew 1.4% in comparable stores and pharmacy same store sales increased 80 basis points in the quarter. Similar to last quarter the low volume pharmacies with high volume front end continue to respond well to our targeted marketing efforts and the Rx savings card continues to provide significant script count growth and as Mary mentioned we continue to take good care of customers with strong customer service scores in the quarter.

In terms of recent trends, September sales have improved in both front end and pharmacy compared to August. Front end is declining at about half the rate we saw in August and script count is stronger than last quarter. Looking forward to the second half on sales we have some exciting plans in place to help us improve our front end sales including some of the operational changes I just mentioned, our continued focus on growing our opportunity in under performing stores and some initiatives designed to reward customer loyalty like our Wake Into Savings program we have going this fall. Speaking of customer loyalty our new comprehensive pharmacy loyalty program will be in test in a small group of stores in the next few weeks. Additionally, due to our strong liquidity position we are going to increase our file by spend for a second half which should help us late this year and early next year. Having said all that we are still expecting a pretty tough selling environment for front end sales in the second half of this year.

FIFO gross margin declined 65 basis points in the quarter driven by an 88 basis point decline in pharmacy margin and a 53 basis point reduction in front end margin that was partially offset by reduction distribution expenses. Front end margin declined in the quarter because one, promotional mark downs increased as percent of sales even though we were flat in dollars for the prior year, two, slightly lower vendor allowances due to our reduction in inventory purchases. Partially offsetting these negatives were continuing improvements in shrink expense and a 90 basis point increase in private brand penetration in the quarter, increase in private brand penetration to 15.2% of front end sales.

Pharmacy margin declined 88 basis points in the quarter, a further reduction from last quarter's pharmacy margin. Similar to last quarter, the decline was due to reductions in reimbursement rates that were at levels similar to last year, but we were unable to offset the impact of these reductions with generic product cost improvements and benefits from new generics. Generic penetration did increase 274 basis points to 70.4% in the quarter.

Looking forward on margins front end margin will continue to be pressured in the second half because the economic downturn will continue to impact customers making it more difficult to drive foot traffic into our stores. Medicaid pharmacy margin will be reduced an estimated $21 million from the AWP roll back that goes into effect this weekend. Although the roll back is significantly impacting our Medicaid business third party plans have provided us language that will hold us harmless from the roll back. LSO impacting pharmacy in the second half is the cycling of a number of significant new generics that were introduced during the first and second quarters last year. This will hurt our margins because they are becoming less profitable as they amature because they're getting matched, and because they are now in our run rate so they are not helping us offset current year rate reductions from third parties.

As I mentioned on the last call other significant factors that hurt pharmacy margin this year is the tightening of the generic supply market, it's more difficult to find cost savings today to offset reimbursement rate reductions and in fact, we have seen some cost increases. The positive trend in distribution expense has continued in the second quarter. The improvement is due to initiatives we started last year and continue to roll out this year including more efficient transportation, routing, biweekly deliveries and 1800 low volume stores, a reduction in administrative head count in our distribution facilities, lower fuel costs and lower product handling costs resulting from a significant reduction in inventory. Also the Bohemia, Long Island facility and the Atlanta facility are now closed.

As Frank mentioned FIFO inventory was $351 million lower than last year. Since we started the inventory reduction initiative last year we have reduced our SKU count by about 3700s SKU's or about 13%. I think we are through the steepest part of the inventory reduction. Ongoing initiatives include our back room inventory reduction program and our SKU optimization initiative. These two initiatives will provide some smaller more gradual inventory reduction over the remainder of the year and should help us put the disciplines in place to help keep our inventory under control going forward. With that in mind we are expecting inventory purchases to return to more normal levels over the next two quarters which should help us with vendor allowances.

SG&A declined an impressive 135 basis points from the prior year of which 75 basis points were EBITDA expenses with the remaining reduction coming mostly from the integration cost in the prior year. The reduction in SG&A expenses resulted from reductions in store labor, other store expenses including supplies, repairs and maintenance, utilities, advertising, insurance costs and lower corporate administrative expenses. The reduction in labor and other store expenses was driven by the initiatives we introduced over the last several quarters including the low volume store initiative, our best ball efforts, effective use of our new labor scheduling tool and improved labor standards for certain store initiatives.

Storing it all together our initiatives really helped us reduce SG&A and offset the impact of the difficult sales environment and the decline in our pharmacy margin in the second quarter. Unfortunately when we prepared our plan and ultimately our guidance for the year, it was our thinking that we would get more of these savings to the bottom line. Looking forward to the remainder of the year and based on second quarter results we believe that our initiatives will exceed our initial cost saving estimates by $50 million and pharmacy margin and front end sales will continue to be difficult and will more than offset these incremental savings.

In addition, we will begin to cycle changes we put in place in the third and fourth quarter last year, making it more difficult to achieve the kind of year-over-year SG&A improvement that we obtained in the second quarter and making it harder to offset the front end sales and pharmacy margin impact. The combination of all these factors is causing us to revise the guidance as Frank discussed. I remain convinced that the course of action we are taking is the right one and despite the difficult pharmacy margin if we can get our sales going we really have positioned ourselves from a cost structure perspective to make the most of it. Finally, as you may have seen in our press release yesterday, Robert Thompson, has been promoted to Executive Vice President Pharmacy and Bill Wolfe has been promoted to Senior Vice President Pharmacy, Managed Care and Government Affairs. I congratulate both of them on their promotions and I know they will make significant contributions as we go forward. Operator, we are now ready for questions.

(Operator Instructions) Your first question comes from Meredith Adler with Barclays Capital.

Good morning, can you hear me?

Yes.

Couple of questions. Could you talk a little bit more besides this change in AWP, which is impacting reimbursement rates could you talk a little bit about how we are seeing, what is going on that's making -- putting pressure on reimbursement rates and then also a little bit about why generic pricing or the availability of generic product is not as good as it was?

I'll jump in there. I guess a couple things. We have reimbursement rate pressure every year, Meredith, and there is pressure from the third party side because obviously the PBMs are all competing with each other to get clients, there's pressure from Medicaid given tight state budgets and so that pressure has been going for several years and continues this year. When I look at the level of reimbursement rate reduction, what we are seeing this year versus last year it's not dramatically worse, what's really hurting us this this year is one, the fact we are having a little bit tougher time on the generic purchasing side really due to market conditions, we've had some consolidation in the industry, we've had some issues from the FDA, where some source has been restricted so it's been a little bit tougher on the purchasing side and particularly relates to the second half of this year I think a slowdown from our perspective in terms of the benefit of new generics which are important to pharmacy margin. There those are the big factors rolling around in the margin today. In addition, I think there has been some ongoing impact from the Wal-Mart $4 generic situation, it just continues to evolve as it goes.

And as John mentioned in his comments too, we've really grown our Rx savings program which is a real benefit, gives a lot of value to our customers but really has had pretty dramatic growth in our mix and I think that's also a factor.

Great, then I have a question about the -- how much of the reduction in SG&A is coming from lower fuel and when do you think you will cycle that?

It's actually a small amount. It's actually a couple million dollars, half of the reduction overall fuel is due to the fact we reduced our routes. Number of miles we are driving is actually reduced. Impact of fuel on a dollar basis is actually not that significant.

Change in routing will last for a while?

That's correct.

That's all my questions for now. Thank you.

Your next question comes from Lisa Gill with JPMorgan.

Thanks very much and good morning. My question has to do with today the initial job claims came out, you're talking about unemployment going forward in the future outlook that the consumer is still weak. In the last couple of weeks are you starting to see things improve at all number one? And then secondly, your private label grew 90 basis points, is that a pretty good percentage of your sales can you maybe just talk about the difference in profit there because I would expect that if you are seeing more private label it should actually drive more gross profit dollars.

It absolutely does. That's exactly right. Private label is much more profitable, almost 50% more profitable than branded products. We continue to drive a strong margin there. That's a real opportunity for us. In terms of recent trends I think I mentioned while we are still negative on front end comps the rate of decline is about half of what it was last month. We seen a little improvement here in, actually some big improvement here in September in terms of where front end same stores sales are right now.

Has it been easier, John? I mean, don't the comps get easier as we go through the next couple of months?

When we get in November. October was still reasonably stout. November it started to slow down. December, was a difficult holiday. January actually picked up again. It's up and down as we look across the rest of the year.

From the unemployment standpoint you still have an awful lot of states out there where you've got double digit unemployment. Even though the overall total may be hanging in there about the same level and until that unemployment picture lessens, as an issue I think you are going to have some pull back from the customer and they're buying lower priced items and going towards private brand, buying more on sale. We are anticipating that could impact holiday.

When we think about reduction in guidance, it sounds to me like primarily, talking about unemployment and issues on the front end it sounds as if primarily it's coming out on the pharmacy end that it's a double whammy, right. So you've got a reduction in reimbursement and on top of it you've got OpEx and others that are in the market so you can't source the product as well. Is that really where it's coming from it's not so much on the front end but on the back end. Is that how we should be thinking about it?

I think the double whammy comment is right. It's a combination of the two, if it was just one or the other I think we would be much closer to being in the range of our prior guidance but a combination of the two makes it difficult to get there. On the other thing I would mention on the pharmacy side, two other things, one is AWP roll back impact is not just the supply of the cost of generics and two, is just I think fewer new generics in the second half or this year versus last year that are going to put pressure on pharmacy margin in the back end here.

You can't under estimate when the new generics are cycled and they roll off and they're not in your numbers and from where you had the highest profitability and now begin to get back that has a definite impact on your business and we will move through that in the next number of quarters and by the time you get towards the end of next year they are going to see more newer generics come out and over the next few years there a lot of new generics and we've seen the generic ups and down as you move through the cycle. There is good news ahead we just got to get through the next few quarters.

Can you just remind me.As we move through the cycle is 180 days of exclusivity better for you or worse for you from a reimbursement profit perspective on generics?

I think it's much better for us.

Great.

Exclusive that's a good thing for us.

Looks like there is a number that the big ones will have exclusivity as we move through the next couple of years?

I think the new generic environment is actually pretty good. We're in a low point here I think right now, but like Mary said, next year and the few years after that are actually quite strong. So there's good news out there, we just got to get there.

Thank you.

Your next question comes from Walt Wiltamuth with Morgan Stanley.

I wanted to ask a little about what you are seeing on healthcare reform? Obviously there are still a lot of moving parts there. But at least one of the bills out there has got some redefinition of the AMP, and wanted to get your thoughts on that and anything else in the healthcare reform, which you think may impact you on the pharmacy side?

Well, as far as healthcare reform in the AMP, there is definitely a better definition of what it is in some of the proposed bills in that its really looking at retail pharmacy but what is still part of the big question mark is where it all settles out around the multiplier on that AMP.

Clearer definition.

The definition is better but the multiplier still kind of is at a level where you might not be very profitable. What level of multiplier do you think you need for the economics to work.

Right now the industry is still doing some independent work around that and should have some information to share with legislators over the next few weeks.

In addition to that we don't know what AMP is. This is a definition there but we have no way to compile that data or derive what that number is. So we don't honestly really quite yet understand what the implication of it is.

It works all the, at least in the new definition an average which again is a lot better than working off lowest price, which was where the deficit reduction act had it. So what's in the health care reform build is a little bit better. Again, until you really know what that multiplier is and what that average is likely to look like, we can't really say what the multiplier needs to be.

Do you feel like there is threat to the Medicare, Medicaid margins in general in all this reform or is this just a thing we need to watch, the AMP part?

That's definitely going to play a factor on margins. Wherever that settle out at. I think we do need to be real aware of what is going on there. The good news is that Medicaid will get expanded so there is potential to do definitely more scripts. But again at what cost will those scripts come to you and it's important that the industry stay on top of this and I think there has been a lot of lobbying work going on and a lot of visits to the hill even a lot of them this week to really get those points across with the legislators.

Okay. And any thoughts on what the the impact would be for insuring the uninsured? Obviously that number moves also but any rough estimate there?

I don't know an exact number. I think it varies from build to build but it's a sizeable number of people that would be getting covered under any of the bills it's going mean significantly more scripts. Like I said, that's good for all of us in this business. It's again comes down to what the reimbursement around it. And I guess the other factor that I think the industry is really working hard on has to do with this whole MTM part of these healthcare reform bills and how you make sure that the role of the pharmacist is better defined in any of the initiatives or processes that are put in to place around that. So that there is really a good place for retail pharmacy in delivering this kind of healthcare.

Okay. Just to switch topics, sounds like you are going to stop reporting Brooks Eckerd separately so this is probably one of our last shots to ask about it. Any reasons why it's not doing as well as the rest of the base right now and factors you are looking for to improve and close some of that gap?

In any opinion it's really, as Frank said, it's really more of a store by store thing at this point. There isn't anything particular about Brooks Eckerd that I could point you to that says it should be under performing at this point when we go through it. There are just isolated store by store instances that we got to deal with as part of our under performing store initiative. It's not germane to the whole group of stores. There are some under performers out there we got to get those stores going the right way and I think that's more of where it is at this point than any other issue.

Okay. Thank you very much.

You're welcome.

Your next question comes from Brian Hunt with Wells Fargo Securities.

Good morning. I was wondering if you could explore the Rx savings card a little bit further? It sounds like it created a little bit of margin degradation in the quarter. Could you talk about maybe one, the stickiness of that customer and two, whether you are seeing a different average basket with that customer than your core customer or your other customers that aren't Rx savings customers?

In terms of the stickiness it's working pretty well, there is a good core customer, there is some one time use as well. But there is a pretty good core customer that's using this thing. In terms of its impact on the margin in the quarter, where you have some impact on margin is from cannibalization of your cash business which is at a higher rate. So you convert some cash customers. Honestly in the quarter in terms of gross profit dollars it drove growth. Even if you took our cash business and Rx savings card business and added them together and compared to the prior year, just to set a benchmark the gross profit dollars from those two categories are up quite a bit on a year-over-year basis. Not sure it's not deteriorating our gross profit, it is a rate difference between cash and the Rx savings card but the Rx savings card represents more scripts today than we had in cash in the prior years. I'm not sure I can quite get to where you want to go. But in terms of its overall rate it's a better rate than managed care, it's a better rate than Medicaid. It's a good business for us.

Great. Then second, just looking more in depth in the pharmacy, and this hit from AWP maybe just to give us an idea what type of elasticity you may need on same store sales to offset AWP hit, is there any way you can give us some metrics around that? Is there a good way to look at that? You are taking a $50 million hit. If you were to have a pick up in pharmacy, same store sales, whatever it's from--?

Here's the dilemma. That's a great way to think about it. If we can drive script count growth that's how we can pay for it. The problem is it's not changing access at all. It's taking existing scripts and just reducing the rate. So there is not a real price play if you will as it relates to that book of business. It would be -- it's reasonably good script count for us to cover that.

Mid single digit? Low single digit?

Yes, I think it would be single digit when you think about it across the total of all pharmacy business, but like John said, this is affecting your current business if Medicaid itself grows and you can get a bigger share of that Medicaid business it can help offset but it's a big hit.

I think it would take 2 or 3% roughly as I'm sitting here trying to come up with a number, somewhere in that range.

Thank you. I appreciate it.

Not a problem.

Your next question comes from Carla Casella with JPMorgan. One question on the refinancing you mentioned on the AR facility. You mentioned as one of your options potentially issuing a second lien debt to take out accounts receivable. Are you limited on your second lien debt to the extent you wouldn't be able to refinance the full facility using second lien?

In terms of our -- right now we would have on the first lien side to be able to do a combination of $320 million first lien and the balance would be second lien. The reason why we would do a combination is really par from a rate perspective. (Inaudible) the first lien.

I guess in terms of the bond market, if you weren't to link the lien directly to AR but to all of the assets do you have additional second lien capacity? Second lien bond on existing -- the same -- using the same assets that first lien and second lien bonds are linked to?

As of today we do not, what we do have is a carve out which will enable us to refile up to the $570 million that we currently have with the accounts receivable. That's the carve out that we have.

Great. Then, on the store closings, that are coming up, how many of those are in what you would consider noncore markets or markets where low density? Are you tackling noncore markets by closing stores or are those still potential opportunities to sell some noncore markets?

The stores are pretty well distributed. It's not been done on market by market basis.

Individual store performance is really what is driving it, Carla.

Do you have still some noncore markets where you are considering whether you would exit like you did last year when you sold stores to Walgreens?

When we exited Las Vegas it was a pretty definite noncore market for us. We had not invested any dollars in that market and really would have got out of it sooner. And I think we sold some last year around the San Francisco core area which again was a very limited number of stores and right now I would have to say we have no noncore identified.

Anything we did would be opportunistic at this point. Our real objective today is to take those kind of markets and those kind of stores and see what we can do with them. That's what a lot of the low volume store and low initiatives that we have going are really making the best of those assets today.

One on the other results, you mentioned that you are seeing cost increases in certain areas in SG&A, can you give specifics where you are seeing cost increases?

I mean generic drugs we talked about being a more difficult purchasing environment in terms of savings but I don't think we talked about cost increases in SG&.

That would not fall under SG&A.

(Inaudible - multiple speakers) The gross margin decline can you just talk a little bit about how much that is from end versus pharmacy? I may have missed it if you've already talked about that.

Front end is down 53 basis points and pharmacy was down 88, Carla.

Back half you are looking for the same type trends?

Yes. We are not expecting to see any huge change.

One last question on holiday. How much of your total front end merchandise is typically seasonal type? And are you going to have to same type balance of seasonal versus nonseasonal this year as you did last?

I don't know if I know a percent right off the top of my head. I would tell you as Mary mentioned, our expectation is towards probably a little bit of a tougher selling environment this year for the holiday. So we have bought less inventory for the holiday than we bought last year.

Generally when there is some uncertainty in the economy the kind of seasonal buys do get cut back a little bit by the customer they try to make due with some of their seasonal decor kinds of things a little bit longer.

Okay. Great, thank you.

Thank you very much.

Your next question comes from John Heinbockel with Goldman Sachs.

If you pick the one or two items that would have the greatest impact between being at the low end of your range and the high end of of EBITDA what would they be?

I think we mentioned in our comments the strength of the cough, cold and flu season is a definite. The stronger the season there, the closer to the high end we are going to be.

That's a big one. John, there were a couple of unanticipated new generics that popped onto the market which does happen from time to time. I think that would be helpful to us if we can make a little headway on the generic purchasing. In the second half that's going to help us a little bit too so there are some things that are involved between moving between the low end and the high end of guidance.

Sounds like there are more potentially positive surprises than negative surprises?

I think we made a lot of progress here. We got to keep focusing on the top line at this point. It's been a big SG&A push. We got to shift gears a little bit here and work on the top line.

I think the great thing is there is sustainable expense reductions because changes in how we operate. So any topline growth that we see above and beyond what we got in the forecast pushes all of that to the bottom line. And we are not done with the expense reductions either. There are more initiatives getting traction in the back half of the year.

Your thought on do you think holiday will be promotional, than it -- more promotional than the front end has been up to this point and more promotional than last year or what?

Seems to me like in terms of seasonal merchandise is getting much more promotional. The way people are using it and marketing it has gotten promotional I expect that that to continue right in to holidays.

So if you think about having a softer holiday it's not from a consumer standpoint but more -- because your comparison is fairly easy, it's more the level of promotional activity out there that will maybe--?

I think it's going to be both.

And I think you might see customers again gravitating towards lower ticket kinds of items too and you may see that trend through the holiday

The $550 million of EBITDA improvement opportunity you highlighted, how much of that do you think you will actually see this year? I assume you can mature that pretty cleanly.

About $150 million. I'm getting a nod from Frank so I think I got it right.

So the end of the day -- so that actually is coming along as you thought it would?

Yes.

Or little bit better?

A little better.

You still think, I think in past you've talked about $100 million of EBITDA improvement per year. A lot of it coming from that segmentation, do you still think that's fair?

Obviously we are off the mark a little this year. I mean I think we are in a little bit of a weird spot here on the pharmacy margin and so I think over time if we can get that situation stabilized we will have a better opportunity to get those to the bottom line. I think there is is some important merchandising things that are coming next year, loyalty program, if we can get the top line percolating and I think we will over time it's not an over night kind of thing but if we can make steady improvement here I think we can get a lot of dollars to the bottom line just based on where we've got the cost structure today. I remain optimistic about where we are going.

Thanks.

Your next question comes from Ed Kelly with Credit Suisse.

It's Jay standing in for Ed. Just to talk about the flu season a little bit. I know you mentioned it could be a higher more strong flu -- within your guidance are you thinking about a more normalized flu season? Like you said we've seen periods where it just really hasn't kind of transpired in to anything in the pharmacy. Is there possibility that we could be thinking about an above average flu season where that could show up in your guidance? Is that what you're thinking about?

Right now looking at it we are assuming it is going to be what I would call a quote, unquote, normal flu season. To the extent that it gets ramped up a little bit as we mentioned before that's what would get us to the higher end of the sales range.

I think we all know any of us that have been in this business very long it's very unpredictable how that season eventually turns out. I'm not sure if there is what you call a real normal season any more. Look at all the grass from the last several years, and oftentimes if it starts good it finishes low and vice versa, it's difficult to call.

You mentioned the increasing file buys in the second half, is this just more of the activity that you really didn't do in the first half? Or is it more opportunity that you're seeing out there?

We are going to look to allocate some more dollars. We originally talked about allocating $10 million in file buys and we are going to up that in the second half of the year.

Just lastly, I know you guys aren't really exposed to a lot of the categories that grocers are, but is there any deflation in certain areas of categories that might be impacted in the front end and also I don't think you mentioned GNC or vitamins how was that category this quarter?

Vitamins were good. GNC continues to do well. I don't think we see material amount of deflation. In any categories.

All right. Thank you.

You're welcome.

Your next question comes from Emily Shanks with Barclays Capital.

I was curious around the inventory. I know you give a nice breakout of where gross margins went and why, I'm just curious -- inventories have come down very significantly on a year-over-year basis. Is anything that's going on in gross margin attributable to maybe, I don't want to use the word liquidation but maybe trying to move inventory faster than normal?

No. As I mentioned promotional markdowns and all markdowns really are fairly steady on a dollar basis year-over-year. Where I think we were a little impacted by the inventory reduction was on vendor allowances. We earned those allowances a lot of it, we with earn a lot of those dollars really based on purchases. As we brought our inventory down that's really reduced our vendor allowances a little bit. In terms of total markdowns we are pretty close to where we were last year in dollars.

Great. I don't know if you want to give this level of specificity, but, Frank, I was just curious around the free cash flow what amount of working capital source do you expect to see? I know a couple of calls ago you indicated you were looking for a $240 million reduction. Was just curious if you wanted to update us on that?

Right now, we are forecasting -- I think actually on the last call we talked about a $280 million benefit from kind of inventory. Obviously that gets offset by -- the way we look at (inaudible) from an EBITDA perspective and cash interest less the cash capital expenditures, and we factor in what the closed store payments are, we, as I mentioned on the last call, we expect to be able to get that $280 million out. Kind of the balance the math get to the $200 million we referenced before, other changes in working capital. Okay.

Can you just remind me what's the close store payments?

About $100 million.

Okay. Great. If I could, just one last one, given there has been a lot of speculation in the market, can you just refresh us on where you stand around your West Coast operations and (inaudible)?

I will jump all over that, we don't comment on rumors and speculation we just don't do it.

May I ask, I know in the past the statement around the West Coast operations has been that you guys, and correct me if I'm wrong, but that you are open to having discussions with people if the potential arose to sell the operations but it would have to make sense from an economic--?

What we said is we are going to always look at anything that comes up and make the right decisions for all of our stake holders. That's what we said. Not particularly any asset or any other thing. Again, we -- our plan right now is to operate the assets we have. That's where we are going. I think we said that. If something comes up we are going to take a look at it and do the right thing for all of our stake holders. But that's it.

West Coast is a very strong market for us, we've made significant investment in it over the last number of years and continued to invest in it.

Great. Thank you very much guys, good luck.

Thank you very much.

Your next question comes from Karru Martinson with Deutsche Bank.

Good morning. Just to clarify, I thought I heard you say inventory purchases were going forward would return to more normal level for the next two quarters so you can catch some of those vendor allowances. But then trying to reconcile that with lower seasonal orders for the holidays and expectation the holiday season would be weaker. Are we missing sales because we are under inventoried right now and we need to play some catch up? Or what is driving that?

What happens if you think about it, to get inventory down I sell it but I don't replace it. That's how inventory declines that's a math thing, so that means I don't have as much purchases. That's what brings inventory down. As inventory reaches the level we want to have it at, including seasonal merchandise then we now need to replenish at more normal level to hold it steady. That's all we're saying. Does that make sense?

That makes sense thank you. In terms of the closed store payments $100 million, what's the expectation of your ability to either bring that down or do you think with your rent reduction programs there is an ability to help offset that?

Karru, if we don't close more stores it will come off naturally in a ten year cycle. So as we implement various initiatives to bring it down it will come down a little faster than that.

Okay. I notice there was a modest amount of sale lease backs in the quarter, is there a change kind of in the market, are you seeing opportunities there?

These are one off deals that come up for very specific reasons. The market in general is still pretty tough.

Okay. Thank you very much.

You're welcome thank you.

Your next question comes from Mary Gilbert with Imperial Capital.

I wondered if we could talk about the opportunities going back to the $550 million EBITDA opportunity, you realized $150 million factored into the guidance for this year the $900 million to $1 billion. If we look out to 2010 and we assume that the consumer is roughly the same next year as this year, but we are getting the benefit of the change in the generic reimbursement, meaning with new generics coming on the market will have some positive affect there, I was trying to weigh in the potential opportunity looking out to next year and how we should look at free cash flow, particularly for CapEx and plans for CapEx next year?

I don't think we are guiding quite that far out. I would keep a little more general than that say again I think from an SG&A perspective we made a ton of progress here. And if I think if we can make some progress on the sales side of this thing, even if margin rate stays where out is today on the pharmacy we have the opportunity to still have a very good year next year. And so we have to see how it plays out from here. I'm not sure I can do a lot more for you than that at this point.

What about plans for CapEx, because it seems that at the $250 million level it's below what would be normal maintenance; is that fair to say? How are you viewing CapEx and plans for CapEx over the next few years?

I think it's mostly focused on maintenance is where we are at. It's not that we are not doing maintenance CapEx at this point. I think we're Those levels with the few nickels to spend on some other things. I think what we said before is that we expect as our results improve to gradually increase the level of CapEx over time. We won't turn on the spigot and be back to levels that we were last year or the year before, but we would gradually work our CapEx up as our numbers improve, while we are a little bit off our EBITDA guidance we made huge progress with working capital. Liquidity position is very strong. If that continues in to next year, Frank is going to give a few more dollars to spend.

We did increase what we were allocating to file by which also falls into our CapEx spend because it's a strong return for us and we really still need to get the investment in the dollars we spent over the last few years as we did the conversions and integration.

The file buys are not incremental CapEx. That's within the existing budget.

Right. What's that increased to, it's going from $10 million to how much?

I mean, unidentified right now is really what the opportunities that we think we can get this year.

And what are the transactions taking place at? Is it like $10 per script? I know it varies by the purchase. But can you give us an idea of where the values are or what you are able to buy?

Mary, as we talked about before it really varies, based upon the location, whether the pharmacist is coming, gross margin in terms of scripts that we are acquiring. Range is pretty broad. It can be $10 or $20 a script. It's pretty broad.

So it could be in the range of $10 to $20 per script. Nothing below $10, right?

Who knows. I'm giving generic range. Chris does a great job, we'll see what he can come up with.

Can you also talk about any variation in terms of generic, I mean geographic performance that you are seeing?

We really don't break it out by geography Mary.

Okay. Great, thank you very much.

Operator we will take one more call -- or one more question.

Your last question comes from the line of Neil Currie with UBS.

Good morning, thanks for taking my question. I just wanted to ask a bit more detail on the SG&A reduction, particularly on the labor side. You already have very low SG&A per square foot, probably lowest in the industry. I'm wondering, first of all, how you continue to get the savings? Secondly, is there a point at which you would save any more money it starts to be at the detriment of customer service, maybe this question applies to inventory as well.

Sure, that's a risk, and I think as we talked about little bit of the sales situation that we find ourselves in today is probably just from those kinds of factors. So probably in some areas of the business we touched at those levels. The enablers of really moving the SG&A downward have been driven by a number of initiatives that now we've put in place, the store segmentation strategy was certainly a big part of that, but just good labor control from the operations guys. Use of the labor scheduling tool we talked about. There's a number of different initiatives that we put in to place over the last several quarters that are really taking hold as we look at SG&A expense in this quarter. That's where we are striving at. Are there more things that we can do? We continue to work our initiatives very hard and I think that's really where most of our value will come for the remainder of this year, and we are cognizant of the sales impact. As Mary mentioned in her talk and I think I mentioned a little bit too, we are making some changes to some of the initiatives to try and mitigate some sales impact. We think that happened for some of the things that we did. But that's a risk.

From a customer service standpoint we've seen our customer satisfaction improve. We measure it. We measure it by pharmacy, we measure it by front end, we measure it by every store. We have been doing that now for I think it's our fourth year. We, only time we ever had a dip in it was during a conversion integration time period and we've made steady improvement since then. If that were at our all time highs in terms of pharmacy and really holding in there at front end. I think our associates are doing a great job of taking care of customers so we are not going to let what we are doing from an SG&A standpoint get in the way of customer service.

Does that apply to instock levels as well?

Theoretically it does. Again, we took a lot of skews out of this thing and we changed some delivery models and those kinds of things. Certainly it's not our intention again, to make customer service worse. We tried to kind of carefully monitor what is happening and make adjustments as we needed to. But again, we may have had some impact in our sales here over the last couple of months.

John, you mentioned that we raised safety stock where we needed to in some of these lower volume stores, ones that are on biweekly delivery and we're constantly doing tweaking on that because we don't want to be out of stock on the shelf.

We have good measures in place to watch it and see what's happening. So it allows us to make adjustments as we go. We look at service levels pretty carefully.

Seems like you did a good job there. I guess the final one was, you talked a bit about the holiday season expecting to it be tough and partly because of promotions, are there any other behavioral changes you are seeing in shoppers at the moment that cause you to give those comments?

They seem real value driven there is no question about that. That's probably the single biggest change I can point to in terms of what is going on. Mary mentioned some trading down in size. Potentially or cost that's driving the private label sales. They go for the lower price point. I think those are the kinds of trends that we see. Don't know if there's anything else.

Those are the best. You might see, I think we mentioned this before, a little bit of impact on end of the month traffic.

That's a good point. Definitely been a shift there.

I always noticed it as a factor but it's more noticeable in this kind of economy that payday matters a lot more mid month and end of month.

Would you say these factors are stable or accelerating?

That's a good question. I think what we talked about is September has gotten a little better than August was. Maybe stable is the right word but not improving.

Thanks very much.

Thank you.

Thank you.

Thank you all for being on the call, thank you for your interests and we will talk to you again in a few months

This concludes today's Rite Aid second quarter fiscal 2010 conference call. You may now disconnect.