Rite Aid Corp (RAD) 2015 Q2 法說會逐字稿

Good morning. My name is Jackie and I will be your conference operator today. At this time, I would like to welcome everyone to the Rite Aid second quarter fiscal 2015 conference call.

(Operator Instructions)

Thank you. I would now like to turn the call over to Matt Schroeder to begin.

Thank you, Jackie, and good morning everyone. We welcome you to our second quarter conference call. On the call with me are John Standley, our Chairman and Chief Executive Officer; Ken Martindale, our President and Chief Operating Officer; Darren Karst, our Chief Financial Officer; and Frank Vitrano, our Chief Administrative Officer.

On today's call, John will give an overview of our second quarter results and discuss our business. Ken will give an update on some of our key initiatives. Darren will discuss the financial highlights and fiscal 2015 outlook, and then we will take questions.

As we mentioned in our release, we are providing slides related to the material we will be discussing today. These slides include annual earnings and sales guidance. These slides are provided on our website, www.RiteAid.com, under the Investor Relations information tab for conference calls.

This guidance is a point in time estimate and the Company expressly disclaims any current intention to update it. This conference call and the related slides will be available on the Company's website until the next earnings call unless the Company withdraws them earlier and should not be relied upon thereafter. We will not be referring to the slides 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. These risks and uncertainties are described in our press release, in Item 1a of our most recent annual report on Form 10-K, and other documents we file or furnish to the Securities and Exchange Commission.

Also, we will be using a non-GAAP financial measure. The definition of the non-GAAP financial measure, along with the reconciliations to the related GAAP measure, are described in our press release. Also included in our slides are the non-GAAP financial measures of adjusted EBITDA gross profit and adjusted EBITDA SG&A and the reconciliations of these measures to their respective GAAP financial measure.

With these remarks, I'd now like to turn it over to John.

Thanks, Matt, and thank you all for joining us to review our results for the second quarter of fiscal 2015. We are pleased with our results for the second quarter which included our eighth consecutive quarter of profitability, growth in net income and adjusted EBITDA, and significant increases in same-store sales and prescription count. Our total comparable store sales increased by 4.1% in the quarter driven by a 3.7% increase in comparable scripts.

Higher utilization in Medicaid expansion states drove this increase as well as the results of our pharmacy initiatives. The increased sales helped us drive net income of $127.8 million and adjusted EBITDA of $364.2 million, both of which were increases over the prior year second quarter.

Our new Chief Financial Officer, Darren Karst, will provide additional details regarding our financial results for the quarter during his remarks. Darren is a proven leader with a track record of success throughout various financial disciplines, and we are very excited to have him as a member of our team.

One of the most significant initiatives we focused on during the second quarter was the continued implementation of our new drug purchasing and distribution process with McKesson, which provides our pharmacies with direct to store delivery five days a week. We have now completed the conversion of all stores and our four pharmacy distribution centers to this new distribution process. The Rite Aid and McKesson teams did a great job of executing this conversion.

We expect that this new process will provide the Company with working capital benefits and improved customer service through better in stock position. The agreement is also generating purchasing savings that are in line with our expectations. Pharmacy gross profit improved due to higher revenues, the benefits of our purchasing agreement with McKesson, and the impact on inventory valuation related to our transition to this new process.

The net effect on inventory valuation resulting from this transition is not expected to be material for our FY15 results but did increase gross profit, adjusted EBITDA, and pre-tax income by approximately $40 million in the second quarter. Pharmacy gross profit was negatively impacted by lower reimbursement rates. Our second quarter results certainly show that we've generated significant sales momentum in both front end and pharmacy.

While we believe that our key initiatives will continue to drive top line growth, we expect pharmacy gross margin in the second half of FY15 to be lower than previous estimates based upon current estimates for reimbursement rates and anticipated lower profitability due to a delay in the introduction of a generic equivalent to Nexium and due to higher costs for generic drugs that recently lost their exclusivity. Therefore, we have lowered our guidance for adjusted EBITDA, net income, and net income per diluted share.

In other developments, we made progress in our continued efforts to more aggressively pursue opportunities for long-term growth while transforming Rite Aid into a growing retail healthcare company. We continue to expand our pilot for Rite Aid Health Alliance, our innovative program that improves physicians -- that empowers physicians, in-store care coaches from health dialogue and Rite Aid pharmacists, to work together in providing a higher level of care to patients with one or more chronic conditions.

Early in the second quarter, we announced our largest Health Alliance partnership to date with Heritage Provider Network in Southern California. Most recently, we've partnered with a sixth medical practice, Physician Direct ACO in Detroit. We also plan to begin opening RediClinics in select Rite Aid stores during the back half of the fiscal year as we look to deliver yet another convenient layer of healthcare support to the communities we serve.

And as we continue to expand our healthcare offering, we're also making progress in building up our real estate pipeline to execute our relocation and new store program over the next several years. At this time, I'd like to turn it over to our President and Chief Operating Officer, Ken Martindale, who has additional information regarding our key initiatives. Ken?

Thanks, John, and thanks, everybody for joining us on the call this morning. We continue to make excellent progress on our key initiatives as we build a unique and engaging brand centered around health and wellness, while actively working with our customers to keep them well. Our wellness store program is perhaps the most visible component of our ongoing transformation and these stores continue to deliver strong results in the second quarter, once again outperforming the rest of the chain in terms of same-store front end sales and script count.

Our teams are doing an excellent job of completing additional wellness remodels while minimizing the impact this process has on the customer experience during construction. Thanks to their efforts, we now have a grand total of 1,433 wellness stores, which represents about 31% of our entire chain. We remain highly focused on leveraging our wellness store program to launch innovative merchandising concepts that significantly enhance the shopping experience.

A great example is our new OTC presentation. This unique research based consumer solution was developed and tested in conjunction with several key suppliers during the past year. The new design makes shopping navigation much easier and incorporates consumer education and product cross-selling to deliver a much better customer experience. This concept has been very well received by shoppers and is now rolling out to most future genuine well-being stores.

In addition, Wellness stores will continue to play a key strategic role in launching initiatives that expand our healthcare offering. Initiatives such as the Rite Aid Health Alliance and RediClinics are taking our overall health and wellness experience to a new level.

Another critical component to our health and wellness strategy is our highly successful wellness+ customer loyalty program. During the quarter, we continued to further develop our customer relationship marketing program which is helping us to better understand the individual needs of our wellness+ members.

Our increasing number of targeted campaigns, we've been able to drive incremental growth not only in terms of basket size but also trip frequency. Our gold membership continues to increase, which is significant because these members represent our most valuable and loyal customers. This month, we launched a promotion that gives all wellness+ members the opportunity to earn triple points on qualifying front end purchases.

Known as Member September, this promotion is designed to further engage our plus and bronze level members to incent them to advance to the silver or gold tiers where they can experience the value of receiving a 10% or 20% discount the entire year. We now have more than 2.1 million senior members enrolled in the wellness65+ plus program.

A specific area of success has been our monthly wellness65+ Wednesday events which allow 65+ members to receive a 20% discount on most items in the store for the entire day. While they are in the store, these members can also participate in our monthly wellness focused events that are designed to help our senior customers experience all of the benefits wellness+ has to offer.

And finally, we've incorporated wellness+ into our new comprehensive Quit For You smoking cessation program. Launched in late August, this free program centers around the counseling skills of our nearly 11,000 Rite Aid pharmacists who have received special training to meet one-on-one with these patients who want to quit smoking. Our pharmacists actively work with these patients to develop a personalized quit plan based on a variety of effective smoking cessation methods.

We are also providing free in store and online educational resources as well as discounts and incentives through wellness+ to encourage them to follow through on their quit attempt. The Quit For You program is an excellent example of how we continue to look for ways to make wellness+ even stronger while positioning our Rite Aid pharmacist to play a more active role in helping patients achieve their wellness goals.

Our flu immunization program is now in full swing as our teams engage with customers about getting their annual flu shot from a Rite Aid pharmacist. Once again, we're supporting these efforts with a comprehensive marketing campaign, which includes radio spots as well as television commercials airing on national networks through November. Our chain-wide goal for the year is to administer three million flu shots.

We're also using the annual flu shot campaign as an opportunity to educate our customers about the additional vaccines we offer on a state-by-state basis to strengthen Rite Aid's position as an immunization destination. Customers continue to respond positively to our offering of Rite Aid brand products. During the quarter, private brand penetration increased more than 30 basis points over the prior year to 18.3%, and we remain highly focused on further developing our offering to create a world class private brand.

Our prescription file buy initiative continues to gain momentum as we completed $20.4 million in file buys during the second quarter. We expect to achieve our goal of $90 million for the fiscal year and as we more aggressively pursue opportunities for growth, we're prepared to increase our allocation for file buys if additional opportunities arise. To sum it up, we are pleased with the significant progress of our key initiatives as we focus on growing our business while delivering the ultimate health and wellness experience for our customers.

We're also very excited about the recent enhancements we've made to our KidCents program, which is administered through the Rite Aid Foundation. KidCents allows customers to round up their purchases to the nearest dollar and donate the change to support charities focused on the health and well being of children. We launched KidCents about a year ago and the program has been very well received.

Just this week, we announced that we're taking this charitable giving program to the next level by letting customers choose the charity that they want to support by directing their donation to one of our 204 KidCents charities. To celebrate the occasion, Rite Aid associates across the country are presenting $10,000 checks to each of these 204 inaugural charities totaling over $2 million in donation. One of our core values is being a caring neighbor in the communities that we serve and we are proud of the positive impact we're making in support of children's health and wellness through KidCents.

At this time, I'll turn it over to Darren who will provide additional details about our financial results. Darren?

Thanks, Ken. Good morning, everyone. Our second quarter results reflect strong script count and front end trends, good cost control, and continued progress on our business initiatives. Gross margin was slightly improved from last year's second quarter due to a lower LIFO charge and cost reductions from our purchasing arrangement with McKesson, but that was partially offset by continuing reimbursement rate pressure.

On the call this morning, I will walk through our second quarter financial results, discuss our liquidity, certain balance sheet items, our capital expenditure program, and finally, review our revised 2015 annual guidance. Revenue for the quarter was $6.5 billion, which was $244 million or 3.9% higher than last year's second quarter. The increase was primarily due to higher pharmacy sales. Overall same-store sales increased 4.1% in the quarter, reflecting a higher pharmacy script count and inflation rate.

Front end same-store sales increased by 1.1%. Pharmacy same-store sales were higher by 5.6%, which included an approximate 200 basis point negative impact from new generic drugs compared to 250 basis points in the prior year second quarter. Pharmacy same-store script count was up 3.7% reflecting higher utilization particularly in Medicaid expansion states.

Adjusted EBITDA in the quarter was $364.2 million or 5.6% of revenues, which was $22.6 million higher than last year's second quarter of $341.6 million or 5.4% of revenues. The current quarter's results were primarily driven by improved sales which drove an increase in gross profit, offset in part by higher SG&A which was also the result of higher sales.

Net income for the quarter was $127.8 million or $0.13 per diluted share compared to last year's second quarter net income of $32.8 million or $0.03 per diluted share. The increase was driven by the $22.6 million improvement in adjusted EBITDA, a lower LIFO provision, and a $62 million loss on debt retirement in the prior year all partially offset by higher income tax expense.

Income tax expense includes certain state income taxes and a provision to maintain a full tax valuation allowance for the Company's deferred tax assets. The increase year over year was related to the adjustment to maintain the full tax valuation allowance, which was driven by higher stock compensation expense for tax purposes. The valuation allowance increase is a non-cash item. The lower LIFO charge was primarily the result of a partial LIFO liquidation resulting from the decrease in pharmacy inventory levels which reduced the effect that inflation otherwise had on our LIFO charge.

Total gross profit dollars in the quarter were $78.2 million better than last year's second quarter and 12 basis points higher as a percent of revenues. Adjusted EBITDA gross profit, which excludes specific items, was favorable to the prior year second quarter by $55.2 million but lower by 25 basis points as a percent of revenues.

Pharmacy gross profit dollars were higher but margin rate was lower. Pharmacy gross profit was positively impacted by our increased prescription count and negatively impacted by continued reimbursement rate pressure which we were able to partially offset through purchasing efficiencies. Gross profit was also favorably impacted by the effect on our inventory valuation related to the transition to our new drug purchasing and delivery arrangement with McKesson.

The net effect on inventory valuation resulting from this transition to McKesson is not expected to be material to our full-year FY15 results but it did increase our gross profit by approximately $40 million in the second quarter. We expect to see continued margin pressure from reimbursement rate reductions throughout the remainder of the year. Front end gross profit dollars and margin rate were favorable to last year.

Selling, general and administrative expenses for the quarter were higher by $37.6 million but 38 basis points lower as a percent of revenues compared to last year. Adjusted EBITDA SG&A dollars, which exclude specific items, were higher by $32.6 million but 40 basis points lower as a percent of revenues compared to last year as we were able to leverage the increase in sales through our various expense control initiatives.

The increase in dollars was, in part, related to the incremental $19 million in operating costs related to the recent acquisitions of Health Dialog and RediClinic with payroll costs related to our higher sales volume driving the balance of a dollar increase. FIFO inventory was lower than the second quarter of last year by approximately $220 million driven by a reduction in pharmacy inventory resulting from our transition to direct store delivery from McKesson.

Our cash flow statement for the quarter shows a net source of cash from operating activities of $123 million as compared to a source of $80 million in last year's second quarter with working capital timing differences and higher adjusted EBITDA driving the variance. Net cash used in investing activities for the quarter was $120 million versus $111 million last year. During the second quarter, we remodeled 117 stores, expanded one store, opened one store, relocated five stores, and closed 10 stores.

At the end of the second quarter, we completed and grand reopened 1,433 wellness stores. For the second quarter front-end sales -- front end same-store sales in our wellness stores were approximately 250 basis points higher than our non-wellness stores and script growth was 85 basis points higher.

Now let's discuss liquidity. At the end of the second quarter, we had $1.37 billion of liquidity and that includes $1.32 billion of availability under our revolving credit facility and $50 million of invested cash. Our liquidity has increased by $340 million year over year. We had $405 million of borrowings outstanding under our $1.8 billion revolving credit facility and had $72 million of outstanding letters of credit.

Total debt net of invested cash was lower by $348 million from last year's second quarter. Our leverage ratio, defined as total debt less invested cash over LTM adjusted EBITDA, improved to 4.4 times from 4.6 times as compared to last year's second quarter.

Now let's turn to our current year guidance. Our guidance reflects greater reimbursement rate pressure than we previously anticipated. In addition, it reflects a delay in the introduction of the generic equivalent of Nexium and lower profitability due to manufacturing delays on new generic drugs that recently lost exclusivity.

It also reflects our expected benefits from the McKesson purchasing agreement in the second half of the year. Our guidance continues to include anticipated benefits of our wellness remodel program, customer loyalty program, and other initiatives to grow sales and drive operational efficiencies. We expect the current competitive environment to remain promotional.

We continue to expect a working capital benefit of approximately $250 million as a result of the McKesson agreement. We also continue to expect script growth to benefit from the Affordable Care Act, favorable demographics, file buy acquisitions, growth in immunizations, and other initiatives. Total sales are expected to be between $26 billion and $26.3 billion and adjusted EBITDA to be between $1.2 billion and $1.275 billion for FY15.

Same-store sales are expected to be in a range from an increase of 3% to 4%, including the anticipated negative pharmacy sales impact of approximately 220 basis points from new generic introductions and continued reimbursement rate pressure. We expect a range of net income of $223 million to $333 million and earnings per diluted share to be in a range of $0.22 to $0.33. The range of guidance is primarily driven by our same-store sales range and pharmacy margin expectations.

Our FY15 capital expenditure plan is to spend $525 million with $225 million related to remodels and $90 million for file buys. We're planning to open two new stores, acquire seven stores, complete 16 relocations, and remodel 450 wellness stores in FY15. We expect free cash flow to be in a range of $325 million to $375 million for the year including the benefit of lower pharmacy inventory and the acquisition of RediClinic and Health Dialog.

We expect to close a total of 40 stores of which the guidance includes a store lease closing provision for 15 stores with the balance of the stores closing upon lease expiration. The guidance also reflects the call and prepayment of our 10.25% second lien notes due in 2019 when the call premium steps down in October. We will fund this prepayment with borrowings under our revolving credit facility.

This completes my portion of the presentation, and now I'd like to turn it back to John. John?

Thank you, Darren. Before we open the phone lines for questions, I would like to thank our Rite Aid associates for a great quarter and the tremendous work they are doing to execute our key initiatives and deliver a great experience to our customers. Looking ahead, we remain focused on executing our strategy to expand our healthcare offering and position Rite Aid as a convenient destination for affordable and effective healthcare solutions.

We believe that this approach will help us better meet the needs of the communities we serve while capitalizing on key opportunities to grow our business. That concludes our prepared remarks for this morning. I'm sure there aren't any questions but just in case, we'll open the phone lines and see. Operator?

(Operator Instructions)

Our first question comes from the line of John Heinbockel with Guggenheim Securities.

Hello, guys. A few things. You talked about the $40 million inventory valuation item as being not material for the year. Is that because there is an offset in other quarters or because $40 million on the base of $1.2 billion is not material?

Yes, there is offsets coming in the third and fourth quarter.

Totaling roughly $40 million or close to it?

Yes. Close to it.

And then those relate to what? The same valuation item or something else?

Yes, as we are making this transition, there is a inventory valuation is impacted from a number of different items so they all relate to inventory valuation but related to allowances and cost capitalization, all kinds of things, kind of moving through the numbers as we make this transition.

All right. And then secondly, is reimbursement -- when you think about it, it's not as -- it's worse than you thought it might be. Is that because -- I'm also thinking about generic inflation in here. Have those things gotten worse in the past two, three, four months or they haven't improved the way you thought they might in the back half?

So we'll break that into two pieces. The first animal is really reimbursement rates, and I would say the reimbursement rate environment seems a little tougher in the back half than we expected and I'm sure as you know, John, the reimbursement rate view evolves all the time.

We have plans under negotiation, we have migrations inside of plans, and a number of different things going on all the time related to reimbursement rates. So that's a view we're constantly updating and sort of looking at and based on what we can see at this time, the back half looks a little tougher than we initially expected or expected even as of June, so that's kind of where we sit.

On the generic inflation front, I think the good news is we're making some good progress in our purchasing arrangement with McKesson, and so I think on the margin side in terms of cost, we had a pretty darn good quarter here this quarter and we're expecting to continue to make good progress there across the back half.

Okay, and then lastly, when do you now think Nexium begins to positively impact you? Next fiscal year?

Yes, it's next fiscal year. It feels like in our fiscal year, it will probably be the first or second quarter based on what we know today.

Okay, thank you.

You're welcome.

Our next question comes from the line of Robert Jones with Goldman Sachs.

Thanks for the questions. The reimbursement issue is something we've been talking about now for several quarters and it sounds like it got even worse than what you guys thought it was just three months ago. I guess just maybe to level set everyone, how well of a handle do you feel like you have on this dynamic today?

And then maybe just to help us out, it doesn't necessarily sound like generic inflation itself is the issue, it's really the rate at which your reimbursement rate catches up. I guess how much exposure do you have to this today and are there tangible meaningful things you can do to kind of right this discrepancy in the way you're reimbursed?

Yes, so in terms of our view and our handle on it we do have good information for a piece of our business. We have a number of fixed rate contracts we've talked about in the past, but even inside of those plans, there are different levels of rates and we have migration around inside of those plans. We have migration amongst payers as well as constant contract negotiations going on all the time, so there are a number of dynamics we do have to estimate, so it is not a perfect science for sure.

Having said that, it's also important to keep in mind that we dispense at the AWP level about $40 billion worth of drugs a year, so even a modest few basis points in reimbursement rate change in our view can have an impact on earnings. So that's just the way it is.

And I think this year maybe compared to last year or the year before or the year before that, one significant difference is we do not have as much profitability from new generics that we've had in the past. So whereas we may have seen some volatility in reimbursement rate, we also had a lot of profitability on new generics and so maybe just wasn't as visible maybe versus where we are at right this moment.

A couple of things that are slipping here are in fact slipping. We talked about Nexium already. We also had some newer generics that lost exclusivity that didn't come to market as profitably as we thought. Honestly in part because there just weren't as many manufacturers as we expected, but we can see FDA applications coming in on a number of those items and so we think those are items that are really probably moving to next year.

So we'll probably maybe catch up a little bit as those items bring us some profitability into next year, so I think that's all good news. But I think we're going to continue to have to work through the reimbursement rate environment that we're in. We're going to have to be efficient. We're going to have to continue to work on the purchasing side as hard as we can and pick away at this thing.

That's fair and I guess that kind of leads into my next question in thinking about how unique this year is versus next year. Back half typically better than the front half. Obviously this year a lot of different dynamics at play. Probably that's not the case, but as we think about the back half as a jumping off point into next year, are you guys viewing even preliminarily that you'll be able to kind of return to EBITDA growth next year?

And I only ask just because from a high level this year given other than the reimbursement issues, you did have a positive script trend, the McKesson benefit should help you in the back half. Just trying to think about putting the back half in context of FY16.

Yes, it's certainly a fair question. We're going to probably be careful not to give guidance at this point based on where we are at today, but we do have some very positive tail winds to help us.

We do have strong momentum on the top line. We are working on a number of initiatives including the McKesson arrangement. Lots of exciting things going on in retail that Ken is really pushing through the business here so we remain optimistic about next year but probably we're not in a position to give you guidance today.

Okay. Thanks so much.

You're very welcome.

Our next question comes from the line of Steven Valiquette with UBS.

Hi. So just to clarify, the pharmacy reimbursement pressure, is that still related primarily to your Mac-based contracts instead of the AWP deals? And also is the pressure there related more potentially more to Medicare Part D or is it commercial or is it both? Just trying to get more color on the reimbursement. Thanks.

Sure, it is not solely related to Mac-based contracts. It also has to do with again, contracts that have been under negotiation, contracts that we know are coming up in our view and estimates of those impacts, migration amongst plans, migration inside of plans, all those things are starting to really blend the numbers that make up our estimates today and have in the past.

In terms of where it is, it is not isolated to Med D. It's really -- we're looking at our total book of business and we see impacts across that book of business.

Okay, and then just quickly on the McKesson deal, obviously it's been talked about a little bit already here. But I think -- for me, I think of this as something that would just sort of gain momentum and improve over time.

So I guess I'm still trying to better understand the mechanics on how this sort of hurt your fiscal 1Q, then it seems to have provided some pretty good upside obviously in the just reported fiscal 2Q but then based on the guidance, it seems like it's going to be kind of neutral to negative in the back half of the fiscal year. So I'm just trying to figure out just more color on what you said about some of those negative offsets and why it wouldn't just sort of improve as time goes on?

Well I think the first quarter was a difficult transition for us. We were working our way into the relationship and as I think as we talked about, we were pretty unsupported in the marketplace during that first quarter. We really had no levers to work with to help mitigate some of the generic cost inflation that we saw during the first quarter and the reimbursement rate pressure.

I think in the second quarter, we saw pretty much a good strong benefit from the purchasing arrangement with McKesson that really helped drive the second quarter results, and I think if reimbursement rates stay right where they are right this second, we think the third and fourth quarter would be good too. But we think the reimbursement rate pressure is going to be tougher in the third and fourth quarter and it's going to erode some of the savings that we're generating from the McKesson arrangement. I guess the best way I can describe it.

In your mind right now, final one here, with McKesson, do you think that once they add in the Celesio volume, will that lead to a lot of incremental savings from your perspective?

I hope so. (laughter)

But that's certainly a key part of what's happening here is the timing around that as well. Okay. Got it. Okay. Thanks.

Our next question comes from the line of Edward Kelly with Credit Suisse.

Good morning, guys, and welcome Darren, by the way.

Thanks, Ed.

Whatever this next question is, Darren's going to answer. (laughter)

Okay let's go. So John, my question is again on reimbursement rate pressure, so we'll continue to beat this horse. You know, it's always been there, right? You've talked about reimbursement rate pressure for as long as I can remember, but it hasn't historically been this type of forecasting problem.

So why is the pressure intensifying? Why is the outlook for the business changing so rapidly? What's different here today?

Well I think I touched on a couple of things. One is we have much lower profitability from new generics this year versus other years and so to some extent, we probably agreed to some rates based on some assumptions we had that haven't fully come to bear, so that's a piece of the puzzle right there.

I think it's a competitive marketplace out there. I think there's some probably dynamics at work in the PBM marketplace as well as in federal and state governments that are also playing into some of the activity that we see from a reimbursement rate perspective. Those are probably the broader trends I can point at.

Now rates are not set sort of beginning of the year, but I guess what you're saying is that they can continue to move around throughout the year?

So a couple things there to think about. One, as you'd expect, there is probably some variation in rates amongst our book of business, so there is migration that occurs throughout the year amongst payers. There is also various rates inside of an individual payer and we do have movement inside of those plans within a year and then we have contracts that come up throughout the year.

All right, and this is probably a hard question to answer because things continue to move around here, but what do you think the outlook is for reimbursement rates on sort of an ongoing basis? The calendar sort of picks up next year but if we think about the underlying business, do we just assume this level of intensity each year as we think about your business?

We do. We think the reimbursement rate environment remains competitive for some of the reasons that we just talked about but we also believe that the strategic arrangement with McKesson will help us continue to be an efficient provider in the marketplace. We think we will continue to have opportunities to drive our top line growth through the various initiatives that we're working on that seem to be getting some traction.

So reimbursement rates just always going to be there. I think that this is a bit of a unique year with some different dynamics that we have going on inside our own Company, as well as some dynamics in the marketplace, but overall we remain optimistic about the future of our business and our Company.

John, just bigger picture question. And I know you can work on the cost side, right, but is there an answer strategically for reimbursements? We think about these models, right.

Obviously, Walgreen's has had some problems as well but CVS doesn't seem to be having as many problems. Is there the opportunity for a better mouse trap? Just how do we think about the business in that light?

I'll tell you this, I do think that at the end of the day, we do bring value to the equation in terms of what we do, and I think we're increasing that value every day with the various initiatives that we're working on in terms of things we're doing for chronic care and poly-chronic care, the counseling services that we continue to expand at the pharmacy, and so I think the strategic answer to this thing down the road is while today, we have a kind of a gross margin -- honestly a gross margin model, it's a buy low, sell high kind of negotiation that we have with these PBMs.

Ultimately the marketplace will recognize us for the value that we bring in patient care, and I don't think that -- that's not something that's going to happen overnight but in terms from a strategic perspective over time, that's where the real value in this relationship is created.

Just one final question for you. Just so we don't run the risk of blowing things out of proportion here, but as we think about your guidance where we started off the year, we were 9%, 10% lower on EBITDA. How much of that do you think is McKesson ramped up maybe slower than what you initially thought? Nexium gets delayed versus structural things like rate pressure?

Probably half to two-thirds of it.

Half to two-thirds is --?

Is McKesson and Nexium and all that stuff.

The rest is the rate pressure?

The rest is the rate pressure. And first quarter really suffered from the transition and that's going to be a chunk of our decline year over year.

Okay, thank you.

Our next question comes from the line of George Hill with Deutsche Bank.

Hi, good morning, guys, and thanks for taking the question. Maybe you can probably guess I'm going to drill in on kind of reimbursement a little bit more. I guess can you talk about maybe the earnings cadence of the year and how should we think about the changes in reimbursement?

I think a lot of us think of these reimbursement changes as kicking up in the beginning of the year as that indicated, so like is there, is Q4 going to be meaningfully weaker than Q3? And I guess any color you could give us on earnings cadence and how we should think about the timing there is helpful.

We don't normally kind of give you quarterly guidance but it is a factual statement that we do have plan changes go in on January 1, so that is one of several timing factors that impact reimbursement rates.

Okay so I guess the answer to that might be yes, we should probably think of Q4 as weaker than Q3.

I'm not going to take the bait. (laughter)

Okay, well I'll keep fishing then. (laughter) And then--.

Try some different bait.

And then let's talk about like you talk about the mix a little bit, and how much of the change in the reimbursement should we think of as the change, what I'll just call pressure from payers in aggregate versus movement of the plan members in mix between different benefit products. Like is more of the pressure being caused by --?

They're both kind of the same thing to some degree because we're filling that same script at a lower rate, whether they migrated to a narrow network plan or some other product or they migrated between payers or a payer just flat out lowered their rate. It is all those things combined together.

Okay and then this last one kind of also asked another way. I think you just answered this with the last question, I just want to hit it one more time. I'm trying to understand the amplitude of the impacts.

So it sounded like you said in the previous question that if we look at the step down in the guidance on the year, reimbursement is about half and McKesson is about half. I'm trying to get the sense for if we look at the $125 million EBITDA reduction for the year, it sounds like half of that is the delay in McKesson coming on and half of that is the delay of or changes in reimbursement and given it's like, it's kind of a half year impact of McKesson, McKesson could potentially be double that on an annualized basis and we should expect --.

I'm not following any of that math. I think in terms of McKesson, what happened with McKesson was really a timing issue in terms of when we got the bid to market, when we were able to purchase the products at the new cost, those kinds of things. That really occurred during the first quarter.

That in my mind is a bit of a one-time issue and I think our second quarter results are kind of the proof in the pudding on that as the McKesson arrangement is now producing some savings in the current quarter that you're looking at right now, which is part of the reason why it came out as nicely as it did. So and then we sort of look at impacts and the currents of kind of have the $60 million from the first quarter which is really a bit of a timing play I think with McKesson.

We look at the current guidance change. I think we talked about three things there. We talked about Nexium, really that we thought we would get some benefit from in the fourth quarter that's slipping into next year. We talked about a number of newer generics that lost exclusivity that will get more manufacturers as time goes on, which will drive some cost out which we thought we would get this year which probably falls into next year.

And then we talked about reimbursement rate pressure here in the back half. So again, I think you got to stir all those things together in your thinking.

Okay, and just last tack on might be. As I understand the McKesson contract, you guys have a good level of price visibility and price certainty on the generic side that you see with them. Can you talk about how long that price visibility or price certainty extends? Is that just for this fiscal year or does that extend beyond this year?

Well prices in the marketplace change all the time, I mean, so there's no guarantees in life as it relates to any price on any one product. Our relationships with vendors apply us, allow us things like price protection and things like that that can help us have more certainty about prices over a short period of time, but over a longer period of time it's going to be a constant purchasing effort, no different than it has been in the past.

We work very closely with McKesson in that process. We have visibility to drug cost every day in terms of what's in the market place and what we're purchasing at.

Okay. That's helpful. Thanks, John.

Okay. You're welcome.

Our next question comes from the line of Lisa Gill with JP Morgan.

Hi. Good morning, thanks. John, I first had kind of a bigger strategic question and that's really around your comment around valuing patient care. How do you think you get paid for that over time?

We talked a lot today about reimbursement pressure. Do you think that it's via narrow networks and you get more volume? Is it do you in some way get a better reimbursement or you actually get paid for the cognitive services that you're providing to the patient?

How do we think about that going forward and then just going back to something Ed said earlier, do you think you need to have a closer relationship with someone like a PBM where you're their preferred pharmacy or something along those lines, a JV type of relationship in order for this to really help to alleviate some of the reimbursement issues?

So I think the concept that I think we have to understand a little bit is that the value that we create through what we do today is not by having the absolute lowest cost on the pill that we purchased. Honestly, average generic drug cost that we sell is maybe $25, $27, something like that. And so how much money are we going to save on a $25 or $30 prescription?

That's not really the question at the end of the day. The question is, is the patient compliant? Are they getting the counseling they need? Do they understand what they need to do to improve their health and stay out of emergency rooms and doctor's offices, so again, we're talking philosophically here.

I do not have the specific answer of how this migration is going to occur but I think over time, there's only so many dollars we're going to be able to squeeze out of the drug spend particularly on the generic side, and so it's really going to come down to then what differentiates you in the marketplace is not that you can fill that script for $24 versus $25. It's what did you do to help the patient.

So at some point I think the model migrates to something more where maybe there's a reimbursement for the service that you're providing to the patient versus trying to make gross margin on the script. Is that going to happen tomorrow? It's not. But I think if we look over the longer term, that's really probably the model that our industry needs to begin a migration to over some period of time.

Do you think you need to have a closer relationship? Clearly the numbers have spoken that CVS has performed better than the peers and they have Caremark. Do you think you need a closer relationship with a PBM entity to be able to capture some of these things that you're talking about?

I don't think necessarily that's the case. Again here I don't want to get into an argument whether the Caremark model is the right model or the wrong model. It's certainly been an effective model in the marketplace and I think you can see it certainly provides certain advantages relative to where we sit today on a standalone basis, I guess I wouldn't argue with that.

But if I look down the road again and think about drug spend and kind of where it's going, I think the real question is can we bring value at retail? We touch patients more than anybody else in the whole equation here.

So as I kind of come back to it at the end of the day, I think what we have to sort of work towards is it's just it isn't so much about again, putting the cheapest pill in the bottle, it's really about what kind of value can we bring to the patient relationship. Do we need a PBM necessarily to do that? Not necessarily.

Quite honestly, the direct relationships that we're building with providers gives us a lot of information and capabilities to directly interact with that patient in a way that we would never be able to get that information from a PBM. They don't have that information either. The provider does and by working directly with the provider, we're gaining access to a view of the patient that we just never had before and now have the capabilities to help that patient in ways we never had before and somehow that's got to stir into the long term, I think, strategic landing for where we're going.

Okay, and then I know that you talked about the $115 million and $125 million of EBITDA and you talked about two-thirds -- one-half to two-thirds being McKesson, Nexium, and generics and so therefore, the other half or one-third is reimbursement. I just want to make sure we have this correct.

So as we think about going forward, maybe not necessarily towards the back half of this year, but as we go into next year, is it correct to think that McKesson's going to reverse itself? We're ultimately going to get Nexium as we move into next year and as you talked about a number of these generic drugs that have an application will come to market, so that aspect should somewhat reverse itself and the reimbursement is just going to continue to be reimbursement pressure?

I think that's right. I'll just clarify a couple things. And the thing with McKesson was really a timing issue in terms of just getting the thing implemented, and it's important to understand that it was a massive transition for our Company. We put in a huge amount of effort and so did McKesson to get this thing done in the time frame that we did.

Really believe strategically we're heading in the right direction here. I think our combined purchasing power is going to help us get the lowest cost over time, so we're really excited about where we came out here on this thing. And I got to tell you, our stores love the service that they are getting.

This five deliveries a week is such a big change from once a week for the vast majority of our stores where we were before. It's really helping from a customer service perspective. So that piece right there I think was just a timing transition thing that we had to work through.

The Nexium, we've talked about. On the loss of exclusivity, I'll just clean that up a little bit. Those are drugs that are already generics. The generic manufacturer that got it had an exclusivity period, that exclusivity period expired and either no one else has come to make that drug or those that have come are not as many as we expected.

The more manufacturers we get for that drug, the lower the cost. What we can see is that for some of those drugs, there will be more manufacturers next year so we do think there's some benefit there for us next year instead of this year. Same thing with Nexium. That's going to move into next year.

So to your point, as we sort of stand back and look at it, we know reimbursement rate will continue to be a challenge next year. As we get closer to guiding for next year, we'll have more view towards what that pressure is going to be and how all these other things will stir together to help us navigate through that.

Very helpful, thank you.

You are welcome.

Our next question comes from the line of Mark Wiltamuth from Jefferies.

Hi. It's Mark Wiltamuth from Jefferies. Well amidst all this concern over the margin rates, you did show some solid expansion in from the Medicaid states. If you could maybe quantify how much that helped the comp and if you think there's more expansion to go there on the comp front?

It is a very significant part of the comp, having a big impact I think on the pharmacy margin. I think that's going to continue to grow over time as patients utilize the benefits that they've received there.

On a much, much, much smaller basis, there is starting to be a developing trend. As we talked about before, there are some plans, Mark, where they are fairly specific to exchange based healthcare.

It doesn't cover all of the exchanges, but there's a few that are pretty focused on the exchanges and even those are starting -- they are not material yet to the total number but those are actually growing pretty rapidly right now, too. So we're hopeful that as more and more patients gain access here to healthcare, we're going to continue to see opportunities to grow our script count.

Okay, and as you head down the strategic path to provide more value at retail, obviously the RediClinics factor into that. How aggressive are you going to be on adding those this year and next year?

We're going to -- I think we're pretty much in line with our original expectations there. Ken, I don't know if you have any other?

Yes, I think we're tracking right on target and we're going to start opening them in several months. So you're going to see them aggressively rolling out and we're very excited about the opportunity that lies ahead of us here.

Is there a sizeable CapEx investment to do that remodel or does it just get folded into the broader remodel plans you have?

It's in our numbers. Our guidance numbers.

It's in our guidance. But it's some of both. There will be stores we put them in that have either already been remodeled and then they are going to be ones we put them in as we remodel? Is that right?

Yes, it's a combination. Some of them are going into existing Wellness stores. When we're putting these things up, we're trying to make sure that if the store hasn't been modified we're going in and trying to update it and do a wellness remodel, but again, that would be tracking with our original plan. So there's not a lot of CapEx above and beyond what we already talked about.

Do you have any thoughts on if you get any incrementality on scripts coming out of those clinics?

We would certainly hope we're going to get some incremental scripts and probably some incremental front end business will come along with it as well.

Okay, thank you very much.

Thanks, Mark.

Our final question comes from the line of Karru Martinson with Deutsche Bank.

Good morning. When we look at the take out of the 10.25% notes with the revolver, is the expectation that we would use the free cash flow just to kind of pay that off as it comes in?

Yes, that is the expectation.

Okay, and then with your competitor CVS exiting the tobacco market, what have you seen in terms of traffic in that category for sales for you guys?

Whatever is happening out there, it's not much. I think really what's happening in our stores, and it's been a little quiet because of all of the noise that they've made, but we rolled out a fairly extensive smoking cessation program about three or four weeks ago, and we're pretty excited. We're getting some early take away and the patients seem to be reacting well to it and so we're really focused on smoking cessation more than we are in retail sales of tobacco at this point.

Okay, and just lastly, kind of really don't want to ask another question on reimbursement.

Oh, go ahead. Come on.

Just so I'm clear, in terms of that period of exclusivity, and you just mentioned you thought there would be more production and hopefully there's more production on the horizon for some of these drugs that have lost exclusivity. Is my kind of take away here that the reimbursement rates kind of on those drugs have already come down but the cost just hasn't until that manufacturing picks up? Is that the disconnect that you guys are seeing right now in the market?

Well also, I just -- I hate to even bring it up but remember that for many of our contracts the reimbursement rate is fixed so had the cost been lower on those drugs, we would have made more profitability.

Okay. Thank you very much guys.

You are welcome, and I think that wraps up today's call. Thank you very much for joining us.

Yes, thank you everybody.

Thank you. This concludes today's conference call. You may now disconnect.