Q2 Earnings Highlight the Roadblock in Rite Aid’s Turnaround

The second-quarter earnings report from Rite Aid (NYSE:RAD) looks solid. Yet, RAD stock reacted poorly, dropping 29% in the ensuing five sessions.

Wooden sign with Rite Aid logo and the word 'pharmacy' on it
Source: Andriy Blokhin / Shutterstock.com

On its face, the decline may seem somewhat surprising. Q2 numbers nicely beat Wall Street expectations. The report also follows a fiscal Q1 release that even I thought was impressive — and I’m a long-time skeptic when it comes to Rite Aid.

The cause of the recent plunge, however, isn’t in the numbers for Q2 — it’s in the outlook for the next half of 2021. The market is a forward-looking mechanism, after all. According to even Rite Aid itself, trouble is on the way.

The issue isn’t just that guidance for the second half is disappointing. It’s why the guidance is disappointing. RAD stock has a big problem that it hasn’t fixed yet, and may not be able to.

Before the Post-Q2 Plunge

It bears repeating: Rite Aid’s second-quarter numbers look strong. Revenue increased more than 11% year-over-year. Same-store sales in the retail business rose 3.5%, including 6.1% growth in front-end (i.e., non-pharmacy) sales excluding tobacco. The company also noted in the Q2 release that it took a solid amount of market share during the quarter.

Meanwhile, RAD stock — which has long struggled with profitability — also posted adjusted earnings per share of 25 cents. Adjusted EBITDA (earnings before interest, taxes, depreciation and amortization) rose 13% year-over-year.

Q2 follows a first quarter in which same-store front-end sales increased almost 17% YOY. Obviously, the novel coronavirus pandemic boosted that performance (and to some extent, Q2 as well). Rite Aid’s store base is mostly on both coasts, and that left the company situated in several coronavirus hotspots. This drove sales of cleaning supplies and over-the-counter medicines, among other products.

Even in that context, the numbers in Q1 and Q2 both look good. The Elixir PBM (pharmacy benefits manager) business has done well, too, although upfront investments certainly pressured profits in the quarter.

So the first-half numbers seem to support, rather than undercut, the case for Rite Aid. Yet that same stock trades over 20% lower than it closed on June 24, the day before the Q1 release. What gives?

Guidance Crushes RAD Stock

The problem is the guidance for the second half of the year. It’s bad news, both short-term and long-term.

The short-term problem is that Rite Aid itself expects its performance to worsen over the next two quarters. We can calculate “implied” guidance for the second half by subtracting actual first-half numbers from the full-year outlook. And the implied guidance isn’t good.

Rite Aid expects same-store sales to slow noticeably. The full-year figure should come in between 3% and 4%. According to the company’s Form 10-Q filing with the U.S. Securities and Exchange Commission, same-store sales rose 5.1% in the first half.

In turn, that suggests same-store sales growth could dip below 1% in the second half. At the high end of the range, growth may reach 3%. And in brick-and-mortar retail, even 3% growth isn’t good enough.

But the bigger problem here is profits. Adjusted EPS will probably turn to a full-year loss, with the current range between a profit of 9 cents and a loss of 67 cents. This is opposed to the company’s gain of 21 cents in the first half.

And this guidance is coming from Rite Aid itself. The company expects second-half revenue growth to decelerate sharp enough that the business will post a net loss, even on an adjusted basis. No wonder investors are spooked.

Margins and Reimbursement Rates

Those broad numbers, however, don’t even get to the core of the problem: margins. In the second half of the year, Adjusted EBITDA should decline 18% year-over-year, even with higher expected sales. That means Rite Aid’s revised guidance for the year is actually lower than it was after the Q4 release in April.

Why are profit margins plunging? Rite Aid said on the second quarter conference call that the primary cause was continued pressure on reimbursement rates. Those rates are set by insurance companies to cover prescription costs — and they continue to decline.

That isn’t just a Rite Aid problem. Larger peers are struggling with the same headwind. But that makes it an even bigger issue.

Because Rite Aid can’t fix the problem itself. It can’t just execute better. In the past, pharmacies have offset lower reimbursement rates by pushing customers to lower-cost generic options. But that shift isn’t working well enough, as Rite Aid management has said for years now.

Due to that trend, RAD stock profits are headed in the wrong direction. In fiscal 2016, Adjusted EBITDA was $849 million (excluding the performance of stores sold in 2018). That figure was 2.6% of revenue.

In fiscal 2021, at the midpoint of guidance, Adjusted EBITDA for essentially the same store base will be just $500 million. That’s just 2.1% of expected revenue.

Bottom Line

This is a brick-and-mortar retailer whose profits are falling drastically. It still has significant debt, and high-tech competition is on the way.

That’s not a business to own. It’s a business to avoid. RAD stock is a no-go until something changes. And the reason it sold off after Q2 is that investors are rightfully worried nothing will.

On the date of publication, neither Matt McCall nor the InvestorPlace Research Staff member primarily responsible for this article held (either directly or indirectly) any positions in the securities mentioned in the article.

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