Rite Aid Corp (RAD) 2018 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to Rite Aid Second Quarter Fiscal Year 2018 Earnings Release Conference Call. (Operator Instructions)

It is now my pleasure to turn the call over to Matt Schroeder to begin. Please go ahead, sir.

Thank you, Marie, and good morning, everyone. We welcome you to our Second Quarter Fiscal 2018 Earnings Conference Call. On the call with me today is John Standley, our Chairman and Chief Executive Officer; and Darren Karst, our Chief Financial and Chief Administrative Officer. On today's call, John will provide an update on our business, Darren will provide a recap of the Walgreens' asset sale and our second quarter results, and then we will take questions.

As we mentioned in our release, we're providing slides related to the material we will be discussing today. These slides are provided on our website, www.riteaid.com, under the Investor Relations information tab. We will not be referring to them in our remarks, but hope you'll 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 presented 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 and Item 1A of our most recent annual report on Form 10-K and other documents that we file or furnish to the Securities and Exchange Commission.

Also, we will be using a non-GAAP measure in our release. The definition of the non-GAAP measure, along with the reconciliations to related GAAP measure, is 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 those measures to their respective GAAP measure.

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

Thanks, Matt, and thanks to everyone for joining us on the call this morning.

As you know, last week, we announced that our company took a critical step forward by securing regulatory clearance for the amended and restated asset purchase agreement with Walgreens Boots Alliance. Just to recap, through the amended agreement, Rite Aid is selling 1,932 stores, 3 distribution centers and related inventory to WBA for an all-cash purchase price of $4.4 billion on a cash-free, debt-free basis. Once the transaction's complete, Rite Aid will retain ownership of nearly 2,600 stores, along with 6 distribution centers, our pharmacy benefit manager, EnvisionRx, RediClinic and Health Dialog. While we still have some remaining conditions that are necessary to close the deal, securing this regulatory clearance gives us a clear path forward to complete the transaction and realize the benefits it has to offer.

So before I turn it over to Darren, who will provide some more specifics about the transaction and information about our second quarter results, I wanted to spend a few minutes discussing how we plan to work as a team to rebuild our momentum and grow our business. Our plan focuses on what we believe are 6 important areas of our business heading forward, and they are: to build our management team for the future; to redefine and enhance our customer and patient experience; to engage with our payer partners in creating a sustainable business model; to evaluate our pharmacy purchasing options to ensure we have a competitive drug cost; to streamline our operations; and to grow our pharmacy benefits manager, EnvisionRx.

This is an especially important time for Rite Aid as we move forward as a stand-alone company, and we fully understand the importance of having the right leaders in place. To that end, this morning, we announced that Kermit Crawford is joining our team as President and Chief Operating Officer of Rite Aid Corporation effective October 5. As many of you know, Kermit served as Walgreens' Executive Vice President and President of the Pharmacy, Health and Wellness division, where he was responsible for all aspects of strategic, operational and financial management for the division. Kermit is a licensed pharmacist and a proven leader with extensive retail pharmacy experience. We're extremely pleased to have such an innovative and well-respected senior executive joining our leadership team.

In addition, we recently announced the promotion of Bryan Everett to the newly created position of Chief Operating Officer of Rite Aid Stores. In this position, Bryan will be responsible for store operations, merchandising, distribution and logistics for our retail business. Since joining Rite Aid, Bryan has had a significant positive impact on our store operations and in other areas of our business as well. We believe he is the right person to lead these key areas of our organization as we look to drive improved business results, provide a great customer experience and deliver value for our stakeholders.

We're also pleased to have Jocelyn Konrad in place as our Executive Vice President of Pharmacy, which is certainly an important role for us. Jocelyn is a valued member of our team with more than 25 years' experience in retail pharmacy. She is a licensed pharmacist who is very passionate about the expanded role that pharmacists can play in delivering valuable health and wellness services to our patients. With her extensive knowledge and experience, especially in the areas of clinical pharmacy services, we believe that Jocelyn will help lead us in achieving our vision for providing a higher level of care at Rite Aid pharmacies. With these and other key leaders in place, we have further enhanced our leadership team and have a strong foundation for guiding our associates in making the most of the opportunities ahead of us.

Moving on to the second area of focus. We will build upon our strong health and wellness platform to redefine and enhance the customer and patient experience. It's important to note that our team has done a tremendous job in continuing to provide great service. In fact, our internal metrics for overall satisfaction are higher year-over-year in both the front end and the pharmacy. This gives us an important momentum as we look to further leverage the highly successful initiatives that are already providing a unique and engaging experience at Rite Aid.

As you know, our wellness store format has resonated with customers as these stores continue to outperform the rest of the chain in terms of same-store front-end sales and script count. Following the completion of the transaction with WBA, more than 70% of our chain will be comprised of wellness and customer world stores. These stores, along with the continued evolution of the wellness format, will continue to be an important part of our strategy in both the short term and the long term.

Our highly popular wellness+ customer loyalty program continues to be a key differentiator for Rite Aid. We've proven to be an innovator in the customer loyalty space, and we will continue to build upon our successful loyalty program by adding new features and benefits in the months to come.

In the pharmacy, immunizations will remain a significant opportunity, both from a business standpoint and also in showcasing how our pharmacists can provide valuable services beyond filling prescriptions. As an example, our flu immunization campaign is off to a strong start, and we've also increased non-flu immunizations by more than 20% year-to-date. We'll also look to engage additional patients and medication therapy management at our OneTripRefills program, which allows patients to fill all of their eligible maintenance medications in one convenient trip to the pharmacy each month. In addition, we plan to leverage the capabilities of RediClinic and Health Dialog to deliver a higher level of care in the communities we serve.

Now looking at our third area of focus, there's no doubt that reimbursement rate pressure has created challenges for our business. Now that our asset sale transaction has received regulatory clearance, we're in a better position to actively engage with our PBM and payer partners to address these reimbursement rate issues that have affected our business. Our goal will be to work with these partners to create a sustainable business model for Rite Aid. We believe these discussions will benefit from the fact that retail pharmacies and managed care partners share a common objective of taking care of patients by offering effective medication therapies and clinical services at a competitive value.

As we engage with our payer partners, we'll also be highly focused on completing a comprehensive evaluation of our pharmacy purchasing options, which is the fourth key component of our plan. As we announced last week, the amended agreement with WBA gives us the option to purchase generic drugs that are sourced through an affiliate of WBA at a cost substantially equivalent to Walgreens for a period of 10 years. This aspect of the agreement gives us an attractive option to consider as we explore other strategic alternatives for the future. Our objective is to evaluate how we can best meet the pharmacy need of our patients in a cost-effective manner.

Another important aspect of our plan is continuing our efforts to aggressively control costs, which, as Darren will address later, have already made positive contributions to our performance. At this time, we're also developing specific initiatives that will further streamline our operations in fiscal 2019. We expect these efforts to result in an expense reduction of about $50 million from our current run rate.

The final area of emphasis is to grow EnvisionRx, our PBM business. Now that we're beyond the regulatory review process, there's a significant opportunity to refocus and invest in the growth potential of this important business. Darren will provide additional information about EnvisionRx in a few moments.

We believe these 6 areas represent important opportunities for our business. Now that the amended agreement has received regulatory clearance, we can move forward with a clear sense of purpose. When you also factor in the key benefits of the transaction with WBA, such as a more profitable store footprint, enhanced pharmacy purchasing capabilities and a stronger balance sheet and improved financial flexibility, we're well positioned to implement our plan for delivering improved results.

At this time, I'll turn it over to Darren for some additional comments. Darren?

Thanks, John, and good morning, everyone. On the call this morning, I'll recap the financial impact of the revised asset sale and discuss the updated pro forma results that are included in our supplemental investor slides. I will also walk through our second quarter financial results, cash flow and liquidity.

As John said earlier, we have obtained regulatory clearance for the amended and restated asset purchase agreement with WBA, which clears the way for us to sell 1,932 stores, 3 distribution centers and related inventory to WBA for $4.375 billion. We expect to receive proceeds from the asset sale over a period of several months as WBA takes possession of the stores with receipt of proceeds beginning next month and ending sometime in the spring of 2018.

The proceeds will be used to pay off approximately $270 million of net liabilities related to the divested assets, which is predominantly trade payables and accrued liabilities, restructuring cost, transaction fees of approximately $100 million net of tax and income tax payments of approximately $85 million. Our proceeds, net of these amounts and including the merger termination fee that we've already received, are expected to be approximately $4.245 billion. Please keep in mind that some of these numbers are estimates and could move around a little, and you can see, we will have significant net proceeds to allow us to delever the balance sheet and give us the flexibility to strategically invest in our business.

Once the transition is complete, Rite Aid will retain ownership of nearly 2,600 stores and 6 distribution centers. We will have a more profitable store footprint in key states and markets that include California, Oregon and Washington on the West Coast and Pennsylvania, New York, Ohio and Michigan in the East. Over 70% of the stores we are retaining are wellness or customer-world locations, and per-store sales and adjusted EBITDA at these stores is higher than the current chain average.

In addition to the nearly 2,600 stores that we will operate going forward, we are also retaining our pharmacy benefits manager, EnvisionRx, as well as our RediClinic and Health Dialog businesses. This will give us a business model that is more diversified with less exposure to pharmacy reimbursement rates because a higher percentage of our adjusted EBITDA will come from our PBM business.

As you can see in the supplemental slides that we filed this morning, we've also updated our pro forma financial information for the revised asset sale and to reflect our results for the last 12 months ended September 2, 2017. Pro forma net income for this LTM period would have been $172 million, adjusted EBITDA would have been $674 million and our pro forma leverage ratio would have been 4.5x. Please be mindful that we are not providing guidance at this time, and so these pro forma numbers should not be construed as guidance.

I'll now turn to a review of our second quarter results. Revenue for the second quarter was $7.7 billion, which was a decrease of $351 million or 4.4% from the prior year second quarter. Net income was $170.7 million or $0.16 per diluted share versus net income of $14.8 million or $0.01 per diluted share in last year's second quarter. Note that our results benefited from a $325 million merger termination fee received from WBA during the quarter. Adjusted net loss in the current quarter was $15.6 million or $0.01 per diluted share versus adjusted net income of $36.4 million or $0.03 per diluted share in the prior year second quarter. Adjusted EBITDA was $213.3 million in the current quarter compared with $312.7 million in the prior year quarter. The decrease in adjusted net income and adjusted EBITDA is due to continuing pressures on Retail Pharmacy gross profit, which is consistent with the trends we have seen in the past several quarters.

Retail Pharmacy segment revenue for the quarter was $6.3 billion, which was $218 million or 3.4% lower than last year's second quarter. The decrease was due to lower pharmacy and front-end sales. Overall, same-store sales decreased 3.4% in the quarter. Front-end same-store sales decreased by 0.9% due to a highly competitive retail environment and soft results in summer seasonal and back-to-school categories.

Pharmacy same-store sales decreased by 4.6%, which included a negative impact of approximately 189 basis points from new generic drugs and was also negatively impacted by declining reimbursement rates. Pharmacy same-store script count was down 1.8% on a 30-day adjusted basis, which was caused in part by being excluded from certain pharmacy networks that we participated in last year.

Retail Pharmacy Segment adjusted EBITDA in the quarter was $164 million or 2.6% of revenues, which was $99 million lower than last year's second quarter adjusted EBITDA of $262.6 million. The reduction in Retail Pharmacy segment EBITDA was driven by reduced gross profit, partially offset by an improvement in SG&A expenses.

Total Retail Pharmacy segment gross profit dollars in the quarter were $136 million lower than last year's second quarter or 119 basis points lower as a percent of revenues. Adjusted EBITDA gross profit was unfavorable to last year's second quarter by $144 million or 131 basis points as a percent of revenues. Pharmacy gross profit dollars and rate were unfavorable to the prior year due to the impact of reimbursement rate declines that we were not able to fully offset with generic drug purchasing efficiencies as well as lower prescription counts. We completed our rebid of prescription drugs with McKesson, but the timing of that bid was delayed, and it fell short of our expectations. We expect to continue to see pressure on pharmacy margins for the remainder of the year. Front-end gross profit dollars were unfavorable to the prior year due primarily to the decline in front-end sales.

Retail Pharmacy segment SG&A expenses for the quarter were lower by $50 million compared to last year's second quarter. SG&A rate as a percent of sales increased by 12 basis points, but that was due to the deleveraging of our operating expenses as revenues have been declining. Adjusted EBITDA SG&A dollars were lower by $45 million but 12 basis points higher as a percent of revenues compared to last year's second quarter. We continued our first quarter trend of expense reduction as our operating teams have done a good job executing on various initiatives to get more efficient, which has helped us control payroll, benefits and store operating expenses. We expect to have similar reductions in SG&A expense in the back half of the fiscal year.

Moving on to the Pharmacy Services segment. Envision's adjusted EBITDA of $49.3 million was in line with the prior year second quarter as an improvement in customer mix drove a higher EBITDA margin, which largely offset a reduction in revenue. The Pharmacy Services segment had revenues of $1.5 billion, which is a decline of $142 million or 8.7% due to our strategic decision to not participate in certain Medicare Part D regions in 2017 and to focus on increasing our mix of chooser patients.

Our Med D business at Envision has historically been heavily weighted towards the low income subsidy member, and strategically, we are seeking to grow chooser membership, which we believe can be more profitable in the long term. While the results of our 2018 bid are not yet final, we believe that we will grow Med D membership in 2018 by approximately 100,000 members. We are pleased with the performance of the Pharmacy Services segment and believe the removal of the WBA transaction overhang and our improved leverage profile after we complete the asset sale will provide us with opportunities to invest in our PBM to grow lives.

Our cash flow statement for the quarter shows a net source of cash from operating activities of $205 million as compared to a $141 million use of cash in last year's second quarter. This improvement was driven by the WBA merger termination fee of $325 million in the current quarter. Our current year cash flow activity also reflects a normal seasonal inventory build.

Net cash used in investing activities for the quarter was $54 million versus $128 million last year. During the second quarter, we remodeled 54 stores, relocated one store, expanded one store and opened one store. At the end of the quarter, we had completed and grand reopened 2,532 wellness stores. For the second quarter, front-end same-store sales in our wellness stores that have been remodeled in the past 24 months were approximately 141 basis points higher than our non-wellness stores, and script growth in these stores was 130 basis points higher.

Now let's discuss liquidity. At the end of the second quarter, we had approximately $1.4 billion of liquidity. We had $2.2 billion in borrowings outstanding under our $3.7 billion revolving credit facility and $59 million of outstanding letters of credit. Total debt net of cash was $6.9 billion. As I said earlier, we expect our leverage to substantially improve upon completion of the asset sale. We are still working through our specific plans regarding our go-forward capital structure, but at a minimum, we do expect to refinance our revolving credit facility to both extend the maturity and to rightsize the facility, given our smaller store base.

We're not currently planning to provide guidance for the remainder of fiscal 2018 as we work through and get more clarity on the specific timing of the store divestitures as well as further refining the financial impacts of the business initiatives that John reviewed a few minutes ago. We expect to resume providing guidance for fiscal 2019 when we release our year-end fiscal 2018 results.

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

Thanks, Darren. Before we begin taking questions, I'd just like to take a moment to thank our entire Rite Aid team. We've been pursuing an important strategic transaction for quite some time. Throughout the process, the commitment that our associates displayed for taking great care of our customers has been nothing short of incredible. The fact that our customer service metrics had improved, as I said earlier, is a great example of how our associates have remained highly focused on delivering an outstanding experience. I'm proud of our entire Rite Aid team for displaying tremendous patience, professionalism and dedication throughout this entire process.

That concludes our prepared remarks for this morning. We'll now open up the phone lines for your questions.

(Operator Instructions) Our first question comes from the line of Charles Rhyee of Cowen and Company.

John, I just wanted to understand in terms of -- you made some comments about -- of delays in the generic purchasing contracting with McKesson that kind of caused pressure, and then you talked about pressure for the rest of the year. And should we think that, that pressure for the rest of the year is a little bit less as you gain the benefits of -- from better contracting with McKesson? And is that a result of the new ClarusONE organization?

So thanks for the question. Thanks for being with us here this morning. We appreciate it. So we completed the McKesson bid, as Darren mentioned in his comments, during the second quarter. I think Darren pointed out that the bid's probably -- was a little bit short of our expectations as they came through the process. That bid was completed as part of ClarusONE, that was a ClarusONE bid, and that, I think, was our first bid as ClarusONE come into market. So we got some of those benefits in the second quarter. We'll have those benefits as well in the third and fourth quarter. But as Darren also mentioned, we are still working our way through some reimbursement rate reductions for the remainder of the year that have also impacted the first and second quarter. So we're going to continue to see some pressure on pharmacy margin through the back half.

Can you expand a little bit? You kind of said that the bid was short of expectations. Can you clarify what you mean by that?

Sure. Well, as you, I think, are aware, we contract reimbursement rates into the future, and so we have to build in some estimates of what we believe generic cost reductions will be. So we know what rates that we can digest in third-party contracts. So in terms of what we planned for, the McKesson bid was short of what we built in.

Okay. I see. As we think about -- as we deliver the balance sheet with the cash and we divest the stores, are there any other dis-synergies we should be considering? Or is that all factored into sort of the numbers you've given us, beyond the sort of pro forma numbers you've given us?

Yes. I mean, I think on the pro forma information that we provided, we did not build in either synergies associated with direct purchasing or we didn't build in any dis-synergies. We did build in the payments that we would receive from WBA under the TSA agreement.

I think our goal was to try and adjust our cost structure. So that has been $6 million goes away as stores transfer off the TSA that we're bringing our cost structure in line.

Right.

So we're going to try and minimize any dis-synergy the best that we can.

Right.

Understanding. And does that include -- when we look at the pro forma store profile, I mean, you've still got a couple of states where you really only have a handful of stores. Should we assume...

I think we've dramatically -- one good thing that came out of this is we dramatically reduced the number of states where that was the case. So really, there's just a couple of instances of that, and I don't think those will be material to the overall operation of the business, the cost of those.

Great. And the last question would be Medicare Part D. We already sort of missed the bidding process for 2018. Is it right to think that next year is your first chance really to rebid back into the Part D networks as a new organization?

That's right. That's right. We're -- I think we're pretty far down the line on contracting for the Retail business for our fiscal '19. So there's -- we've got a couple of -- we have contracts that are open for next year. But as it relates to Med D, I'd say those rates are largely locked in at this point.

Our next question comes from Lisa Gill of JPMorgan.

I just wanted to follow up on your comments on the payer contracting. See, John, you said you're fairly far along on fiscal '19. Are you talking about on commercial rates with PBMs and health plans at this point? And how are they thinking about you now that I would call you more of like a super regional in different parts of the country?

Yes. I'm going to back wrap right there. What I meant to say was we're pretty far along on Med D for 2019. We have a lot of work to do on 2019 from a commercial perspective.

Is there any opportunities in calendar 2018 on the commercial side now that you've got the footprint of where your stores will be?

I think there is opportunity and exposure for 2018 from a contracting perspective. We still got some work to do there to figure out how calendar year 2018 is going to shape up.

And you talked a little bit -- I'm sorry, go ahead.

Which is one of the reasons why we're not out with guidance right now because we're...

Okay. When do you expect that we'll have some incremental color beyond the -- the pro forma number of 675 rates, when we think of this as the number to kind of start to think about? But when will you give us more clarity as we think about guidance going forward?

Yes. I think -- Lisa, our plan is to provide guidance for fiscal 2019 when we get to the fourth quarter. That's our current plan.

Okay. And then if I could just ask one other question around the PBM. You talked about Medicare Part D. But I'm just wondering how your selling season went on the commercial side of your book of business as we go into '18.

So I think -- we talked about Med D. We had -- I think we're in a pretty good position there. We don't have the landscape files yet. So we're kind of waiting to see officially where we landed here. But we feel pretty good about our first glance at this for next year. On the commercial side, we did lose one large client as we were kind of going through this protracted review process here to get this transaction cleared. So that set us back a little bit on our calendar year 2018 selling seasons for commercial. So we're going to be soft on that side of the business for '18.

Okay. And so is it a material client, John? I mean, just as we start to think about how we put this through our numbers, is it -- is there any way to size that?

Yes. We're going to be probably slightly down in lives for 2018 on the commercial side. So it offset the gains we made in the selling season. So we're going to be down a little bit in lives on the commercial.

Our next question comes from the line of Carla Casella of JPMorgan.

I think that's me, Carla Casella. First question, just on the $673 million of pro forma EBITDA. I just want to confirm, that includes the $96 million of SG&A reduction that you expect over time as the TSA rolls off. Is that correct?

That's correct.

And so what's the timeframe on that? Is that over an 18-month period? Can you just remind us?

Well, it really is kind of built in as they take on stores. So yes, I mean, the TSA period is a 2-year TSA, and they have an option for 2 additional 6-month periods. So in theory, it could go 3 years, but probably less than that.

Okay, great. And then you said you'll refine your guidance once you've gotten most of timing of the store close. But should we, for now, just assume that the stores you're selling to Walgreens happen evenly over about the next 6 months period? Or is it more chunky than that?

I'd say it's (inaudible) waves. It's relatively -- I mean, if you -- it really is in waves, for purposes of kind of operationally taking these stores on. So there's a certain number of stores that can be cut over to them over, again, in weeks. So relatively speaking, that I guess it's probably fairly smooth.

I think very early on, it's a little slower just because there's a process where we cut some stores over, and there's an opportunity for everybody just to test and make sure that there's a process of closing this. We need to certify the IT system that the TSA stores are going to be using. There's a bit of a process to just kind of make sure that all works when we cut them over. So I would say in the first month or 2 is probably a little slower. Then after that, it starts to really ramp up -- from a cash flow standpoint.

Yes. I mean, I think in terms -- from a cash flow standpoint. In terms of trying to figure out the numbers, it's going to be disco ops. As we start the closing process on the first wave, we'll move to some disco ops accounting on the stores that are being sold.

Right.

Okay, great. But then the proceeds will come in kind of in line with the numbers. Is it like would you do it on a per-store basis as you go? Or would that be more chunky?

No, it's on a per-store basis.

Okay, great. And then as we look at the debt paydown, should we assume you go in order of kind of maturity or seniority that -- with the ABL being paid down with the first wave of stores and then the term loan with the second, how do we think about that? Because I know there's been a lot of focus in the debt markets on when there'll be an excess proceeds amount that'll be -- have applied to bonds on -- to buy back bonds at par and getting a sense -- trying to get a sense for, is that something that we could see this year? Is that something that is not until after you've paid down ABL and term loan?

I think what you said is correct. The first proceeds would go to the ABL and term loan, and then we would be in a position to make offers to the unsecured notes.

Our next question comes from the line of Karru Martinson of Jefferies.

Just to follow up on Carla's question. In terms of the excess proceeds offer, what's the mechanism? And how will that work? And kind of -- I mean, what happens to those proceeds if folks don't take the offer?

If they don't take the offer, then those proceeds are available for us to repay debt as we would see fit.

Other debt, yes.

Other debt.

Okay. So but it'll be a par offer pro rata for those 3 tranches of 20s, 21s and 23s?

Yes.

Okay. And this is an old question that I used to ask all the time. But in terms of the script files that remain, how should we be thinking about valuation? Historically, you guys talked about a $10 to $20 per script valuation. Is that still the case today in the industry?

That is probably a pretty good range of what we see as we go out and buy script files. How lenders view it may be different, but that's the way we view it when we buy -- when we're buying script files.

Okay. And then when we think forward here, recognize that this will be kind of a couple of messy quarters as you transition stores, but when should we be thinking about kind of the CapEx spend, the wellness remodel pickups, the script file buys? Does that kind of start day 1? Or is that something that you will gradually build as we go forward?

Well, I mean, frankly, on the file buy side, we have ramped that back up. We were a bit in limbo during the merger period of time, where we were rather limited in terms of what we could do on a file-buy -- buying perspective. So it takes a little time to get that engine kind of back up and running. But we're pretty active right now out there, and of course, we're obviously looking at just market areas where the remaining company will be. On the CapEx side, we're continuing to do remodels as well. So that will ramp up, probably a little bit slow during the merger period, but that's ramping back up as well.

That takes time. But we're -- I think for fiscal '19, we'd be back to a more normal cycle of...

Yes, for the size of the business we have.

Size of the business we had. So it takes a lot of time.

Our next question comes from the line of Bryan Hunt with Wells Fargo.

I was wondering, you talked about 100,000-person increase in your Medicare D. I was wondering if you can just give us an idea of what kind of increase that is on a percentage basis and in terms of your Medicare D lives on a PBM side?

Frank's with me here. Frank, it's...

Yes. It would be about a 20% increase in our overall lives.

Okay. I guess continuing on the balance sheet discussion. Pro forma, if you assume the paydown based on what's in the slide presentation, your 6.125% still account for more than half of your balance sheet debt. I was just wondering philosophically, does that make sense, though, to have over half of your debt in one tranche over the long term?

Yes. Bryan, I think that's -- we're continuing to kind of look at this. And I think what we'd like to see is see this progress a little bit further and to see where we end up in terms of the application of proceeds before we really conclude on that.

Okay. Is there any way you can give us an idea? I mean, it seems like 70% plus of your stores will be in updated formats. Can you give us an idea of maybe, one, what you think kind of pro forma CapEx may be? And two, where are you going to allocate dollars going forward will be, more towards file buys and trying to grow other businesses besides the Pharmacy business?

Yes. I think we're probably looking at, for the remaining company CapEx, somewhere in the neighborhood of $250 million on a go-forward basis. In terms of how that's allocated, I think it's -- it will continue to be allocated to the stores. You're correct, 70% is pretty -- we are in pretty good shape. But we'll still continue to remodel stores and add stores, and we'll also continue to buy script files. The other area is in -- we think there's some opportunities on the Envision front, to be able to invest there as well.

Right. I mean, I think we're going to be in a pretty good shape on the stores. There are opportunities to, I think, go back and touch some stores we've done previously with some concepts that have evolved over time. But we're excited about the store base that we have. We think there's opportunities to invest in the markets that we're going to be in. Our local strategy is going to be really focused on being very competitive and advance in the markets that we have left after the transaction. We're putting good money into technology. There's some things we can do to really operate our stores more efficiently with technology. And so we've got some things working right now that'll hopefully come to bear in 2019 that'll drive even more synergy and improve the quality, the experience for our associates as we put those things in place. And then maybe most importantly is really the opportunity to work with Envision to grow their business. I think we have some technology opportunities over at Envision and some things to invest in there, and that's really, we think, a real strong potential growth area for us as we look forward. So we've got some exciting things to do with capital that we have.

Great. And 2 more quick ones. If I look at your pro forma EBITDA and kind of flesh out what interest expense and CapEx, and I imagine you have no tax liability going forward, it looks like you'll generate $300 million of free cash flow, in round figures, $250 million to $300 million. Kind of where do you foresee putting that to use? Is it acquisitions of additional businesses? Or are you solely focused on delevering the balance sheet?

I'll tell you what, isn't that a great thing to be asking? I mean, that -- there's a conversation we haven't had for a very long time.

It's been a while.

That is what is so exciting about where we are is that all kinds of doors start to open for us, and the honest answer is we've got a lot of work to do here to figure some of those things out. There's just a lot of different things, opportunities that we're now looking at that we just really couldn't even consider before. So we're just real excited to get this transaction done, get ourselves repositioned here in the market, get a chance to refocus on the things we've talked about and generate that free cash flow so we can pursue some exciting opportunities. But there -- again, there's opportunities to put some money back into the business. There's some things to look at for Envision. There's just a lot of different directions we could go here. But the primary focus right now is getting the core business, some momentum back in that business, getting some of these things that got a little bit stagnant while we were suffering through the review process back on track, like remodels and script file buys, private labels and other opportunities that I think slowed down a little bit while we were winding our way through this thing, that we're really working to kind of get jump-started. And I think for Envision, getting the noise of this whole thing behind us, I think, will really help them when they come up to their next selling cycle here. I think just the overhang in this transaction got them a little muddied up as well. And so getting that noise cleared away really, I think, opens up things for them as well. So we're all pretty energized here with what we've got, and we're excited to get to that free cash flow number, whatever it is. I don't want to give guidance, but we're pretty excited about what we got here.

All right. And the last question, I'm sorry about lingering. If we look at your peers' results in Pharmacy gross margin, you definitely underperformed based on the overhang associated with the WBA transaction. When we look at your peers and how they performed on a relative basis in this pressured environment, what do we think the opportunity might be for your Pharmacy profits as you work with your partners and your payers to align prices with cost better?

Yes. That -- I think that's -- it's a great question. And so we've obviously been doing a lot of work here to -- on Pharmacy margins to figure out how we can be competitive in that marketplace but also have what I would call a sustainable business model. That's really, I think, the question of the day. And we do a lot of work to benchmark our cost versus competitors, what are the costs to fill a script, are we competitive on generic purchasing, those kinds of things, and we've obviously had the opportunity to gather a lot of market intelligence. And I think if you look at our gross margin over the last couple of years, its behavior is not dramatically different than what you've seen at Walgreens and CVS. I think the difference is they've gained access to some lives with those investments where we haven't. I think we lost them right here where there was no benefit of lives, where when I look at Walgreens and their similar rate decline, they gained access to, I think, a lot of lives through Med D and through some narrow networks in the commercial space where we really haven't had those opportunities. I think now that it's clear that we're an ongoing business and what we are, it should allow us to, I hope, have open dialogues about our opportunities to participate in those kinds of things. But I also think it's important that we also figure out how that model is one that works for both us, in terms of being an ongoing and profitable business that makes a respectable return for its shareholders, but also a great partner for payers, that we deliver great service and that we're competitive in the marketplace. So that's kind of the balancing act that we're always working on, but I think it got a little out of whack as we went through the merger process because people didn't view us as a long-term partner. They really probably viewed us more as a place to go to, to find value. And now I'm hoping that the conversations will represent both sides of the equation and not just one.

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

This is Nathan Rich on for Bob. Can you -- could you talk about the process of evaluating whether or not to move your generic purchasing to Walgreens from McKesson and kind of how you'll go about making that decision? And then also just around timing. Given your current contract with McKesson, when you think you could move to WBAD if that's the decision you ultimately make?

Yes. So as you mentioned, our contract with McKesson goes through the end of March 2019. I think we have until May 2019 to exercise the WBAD options. So I kind of think just sort of outside dates, that's probably the outside of when it plays out. We're in -- obviously, as you would expect, we're in conversations with McKesson about how the relationship will work going forward. There's a point in time at which we trigger the WBAD option under the WBAD agreement and the merger for the asset sale agreement. And so what will happen here is as time kind of marches on here a little bit, we'll get to a point where we have access to the WBAD purchasing option. We'll obviously be in ongoing discussions with McKesson. We have the opportunity to do a cost analysis to kind of compare the 2 opportunities. And from that, we would make a decision. And I think the outside date that we could implement that decision is really April 2019. If we can work through our -- some opportunities that we have in our contracts with McKesson, it could possibly be sooner, but I view that as kind of the outside date.

Okay, that's helpful. And then just as a follow-up. I wanted to go back to your comments on SG&A and just make sure that I understood it correctly. So you talked about $50 million of opportunity, potentially, in fiscal '19. Also, in the pro forma estimates that you had given, I think that also included $96 million of corporate cost savings. So I just wanted to make sure that the $50 million was in addition to that $96 million that I think is assumed in the pro forma. And then maybe just more broadly, can you kind of talk about the areas of opportunity to lower cost? And as you take a closer look at the business on a go-forward basis, are there other areas that you think could yield potential savings or efficiencies?

So the $50 million is incremental to the $96 million. They're a different set of initiatives. We're really -- I think we're -- we are focused on trying to make sure that we -- that our stores are as easy to operate for our associates as possible. So are we giving them the right resources and tools to be successful in what we're asking them to do? So a lot of our energy and effort is really around how we -- we use the term streamline, to really make those processes more efficient and easier for our associates to use and, thereby, gain some cost advantage for doing that. We also have been looking at the way corporate administration's organized and some of the things that we do here corporately. We've been very focused on our advertising cost and how we go to market there as well. And so I think those are kind of the general areas. Distribution, we found a lot of cost savings and synergy in the distribution side of our business. So those are all parts and pieces of how the thing, I think, kind of comes together.

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

So John, curious, when you -- again, when you think about your procurement options, right, so timing is important and lack of disruption is important. So do you have to get -- when you think about maybe you get more with WBAD, do you have to get 100% of the way there with McKesson to -- you avoid disruption and maybe you do it quicker. So maybe talk about that trade-off. And then sort of along the lines of that, if you think about the Walgreen relationship, how much does Kermit help in understanding that and managing that? And what do you think, most importantly, he brings to the table from a Pharmacy standpoint?

Yes. So there's about 5 questions in there. So let me go back, start at the beginning. So on the purchasing options that we have, just for background information, for whatever it's worth, we are actually building a whole process here to transition stores from McKesson to AmerisourceBergen as part of the whole Walgreens TSA process. So we will have built a pathway where, if we choose to move, we think we can move with a minimal amount of disruption, if that's what we choose to do. So I do believe that if we're going to go with McKesson, we have to be extremely confident that, over the long term, they're going to deliver the value we need to be competitive in the marketplace. So they got -- yes, they have to be 100% of the way there. So that's the answer to that one. In terms of timing, again, I think I kind of touched on it a little bit earlier, and it's really driven around the McKesson contracts and our ability to work through that with McKesson is really going to dictate the timing of how this thing, I think, plays out. In terms of Kermit, we're really excited to have Kermit join the team. I've known Kermit through NACDS and other industry function and really through competing against him for a very long time. I have great respect for Kermit. I've gotten to know him a little bit over the years. He brings very deep pharmacy experience here. He had experience in a number of different areas in pharmacy, not just pharmacy operations. But he did play a key role in the Pharmacy Benefit Management business for a number of years during a period of time that it grew very rapidly. So he understands the third-party side of this thing. He was responsible for Walgreens third-party contracting for many years, and so he has deep experience there. But he was also an innovator at Walgreens. He played a key role in a number of interesting things that Walgreens did over the year. I mean, they're really the leader on flu shots, and Kermit had a very key role in helping them bring the whole flu shot concept to market. And he drove a lot of their health care innovations. So I don't really see Kermit spending really very much, if any, of his time as it relates to the TSA or the transition with Walgreens. He's really going to be more involved in helping us forge the strategy for the future in pharmacy and how working with Jocelyn and Bryan really determining how we can bring better care to patients, bring health care to local markets and really differentiate ourselves in the marketplace. That's really where I see Kermit having an impact on this thing.

And then second topic. One of the things -- obviously, retailers have been ceding margin, right, at the -- probably the power of the PBMs. What -- do you think -- and when do you think, maybe there's a philosophical shift among the PBMs, that there's just not much more margin to be had, right, at retail and the focus has to go elsewhere? Are we going to -- we need to see that. Are we going to see that anytime soon?

Well, I think the challenge for me answering that question is it is a competitive marketplace, and so there certainly are situation. I think others are in different situations and maybe have different philosophies about how they're pricing for the marketplace. But from our perspective, generic cost is really the smallest piece of the drug spend, if you look at specialty, you look at brands, you look at generics. I mean, just in our book of business, specialty or brand is really probably 70-plus percent of the spend and generic is less than 30%. And when you look at what our relationship is with PBMs, what we control, we really control generic cost. We buy brand at a fairly standard cost, just like all of our competitors, and that brand cost is determined by rebates that the PBMs receive. That's their job. Our job is to be efficient on the generic side. And based on the work we've done, we're very efficient on the generic side. So like you say, I think there's a growing understanding that generics are getting to be a fairly mature book of business. They've been rebid over and over and over again for many years here, and that generic costs -- while there's still some grounds to be made here, we're going to find some more value in generics over time, relative to the whole drug spend is really a very small piece of the puzzle. And I think that's a growing understanding in the marketplace. Isn't going to happen overnight, John, but it's -- people are starting to get that. And we're working honestly in the marketplace with payers and consultants and others to help them understand those dynamics.

And then just lastly, file buy target, is $50 million to $75 million annual -- obviously, it's going to be lower than what it used to be. But is that a fair target for what you think you can do in a year?

Yes, John. I think that's a fair number.

Our final question will come from the line of John Ransom of Raymond James.

I love being last. It's challenging to come up and be clever.

Don't. Don't be clever.

So probably -- we've been talking to a bunch of investors lately about your group, and I would say top of mind question, of course, is Amazon and potential disruption. So when you lay there at night at 2 in the morning worrying about Amazon, what sort of things do you think you need to do, particularly on the front end, which we haven't talked about much today, to Amazon-proof your business? And what weaknesses in your -- in the business model do you think are vulnerable to exploitation?

Yes. Well, obviously, that's a very -- that's a topic I do lay awake at night and worry about, and it's a serious topic. And I think a key part of what we have are we have relationships with our customers. They are visiting our pharmacy. Many of our front-end patients that we developed, hopefully, a good relationship there. We have a strong loyalty program, which makes us very competitive from a value perspective and works as a retention tool and really allows us to understand the behavior of our customers and patients so that we can deliver to them the best value and support that we can. That's also, I think, what Amazon is extremely good at. I mean, they've used a lot of data to analyze and understand their customers. They run a very efficient business model. They have a broad selection of products. So it's a real challenge for us. And in terms of things that I think we can do better, it's really -- I think we're very focused on improving the digital experience for our customers, so that it's not just what we're doing in the store, but it's how we're interacting with them day to day through other digital vehicles. That's extremely important, I think, to building that relationship, and that's something that they're extremely good at. That's probably, historically, not our strength that we're very focused on improving. So if I point to one thing, that's probably top of mind right there. But there's a lot to do.

Do you think you might test -- I mean, I know mail order is not new through a PBM, but frankly, the interface is pretty clunky. Are you going to test home delivery from the stores, same day home delivery? Because you got to think Amazon would come in and -- for a Prime membership, they'd give you discount on [certain] fees and do same-day home delivery, the electronic interface would be more seamless, you could yell at Alexa and have her have your pills at your front door in 14 minutes. I mean, are you thinking about any of that kind of stuff?

Absolutely. And we do home delivery today. It's probably not quite as seamless as you just described it, but we do home delivery today. And I think it's -- again, those are the kinds of things that, you're exactly right, we've got to focus on, remove the friction in the relationship, make it easy for patients. And I know behind the scenes somewhere, maybe deep in the bowels of Amazon, somebody's very focused on figuring that out as well. And so it's top of mind.

Okay. And my other question is, how much rebuilding do you have to do with the middle manager, right? I got to think you lost -- you've had some attrition during this process. So how much rehiring? And how will that -- are you below the top C-Suite positions?

We've actually done okay, better than you might expect in terms of holding this team together. I think we had a couple of high-profile losses, obviously, as we came through the end here. But overall, I'd have to say I'm very pleased with the way this whole team has hung in there through this whole process. So we're in pretty good shape from a management perspective at this point. I've got a couple of holes to fill, but overall, I think we're in pretty good shape. With Bryan and Jocelyn and Kermit in place, I think we really have the foundation on the Rite Aid side to build from, and so I feel very good about where we are there. We've done, I think, pretty good on the PBM side as well. We've got Frank and Dawn and their team hanging with us here as we've kind of gone through this. I kind of think they're pretty excited to get back into the market without having to answer 30 million questions about what's going on with Rite Aid and (inaudible). So I think we're pretty good.

Okay. And then my other one is -- I don't remember, personally, a tougher environment than where we are now with generic inflation, flat scripts, Part D reimbursement pressure, more competition on the front end. I mean, you could do what you could do. But if the environment doesn't get better, how are we just not looking at declining EBITDA every year? I just can't see how you grow with these hurricane-size headwinds.

Yes. I think at some point, the Pharmacy margin has to stabilize is my belief. I'm not saying it's tomorrow or next week or next quarter necessarily, but I think over the long term. Listen, everybody, Walgreens, CVS, we're all, by and large, consortiums today. My volume with McKesson is not that different than the way WBA buys through WBAD or CVS buys through Red Oak. And there's only so far these generic manufacturers are going to go on cost, and that starts to back up the supply chain right back to us. There's only so much we can do in terms of cost and what it cost to dispense a drug. There's a lot of regulation, there's a lot of focus on opioid abuse and other things that we all need to work on. At retail, we've got to take great care of patients. So there's somewhere down the line here where, just by virtue of the economics involved, this thing's got to settle down a little bit.

Thank you, everyone, for joining us this morning. We really appreciate it, and we'll talk to you soon.

Absolutely.

Thank you.

Thank you, ladies and gentlemen. This does conclude today's conference call. You may now disconnect.