How Impressive Is Rite Aid Corporation (RAD)’s Earnings Increase?

On Thursday morning, Rite Aid Corporation (NYSE:RAD) reported significant improvement in first-quarter earnings. The company reported its third consecutive profitable quarter, with EPS of $0.09, up from a loss of $0.03 per share in the same quarter last year. Results hit the high end of the company’s recently updated guidance for EPS of $0.08 to $0.09.

As I have discussed in a series of recent articles, Rite Aid Corporation (NYSE:RAD)’s revenue has recently been pressured by a resurgence at top competitor Walgreen Company (NYSE:WAG). Rite Aid Corporation (NYSE:RAD) has been able to deliver strong profit growth despite that headwind due to the margin benefit from new generic-drug introductions. However, this benefit will drop off sharply later this year. Investors should monitor the company’s results carefully over the next several quarters, to see if Rite Aid Corporation (NYSE:RAD) will be able to stay in the black after the tailwind from generics dissipates.

Rough seas ahead
Rite Aid Corporation (NYSE:RAD) has achieved a remarkable turnaround, considering that the business seemed to be on the verge of bankruptcy just a few years ago. However, the company clearly got an assist from last year’s dispute between Walgreen Company (NYSE:WAG) and Express Scripts Holding Company (NASDAQ:ESRX), as well as from the ongoing shift from brand-name drugs to generics. The growth in generic drugs hurts sales, but provides a significant margin benefit to drugstores, improving profitability.

Rite Aid Corporation (NYSE:RAD)’s management has issued a very cautious outlook, because the generic-drug benefit is starting to wind down. Furthermore, Rite Aid is experiencing significant “reimbursement rate pressure” as Medicare, Medicaid, and insurance companies try to save money on prescription drug costs. On multiple occasions during its recent earnings call, Rite Aid’s management highlighted these two factors, noting that they will have a significant (negative) impact on gross margin, particularly in the second half of the fiscal year.

In fact, the midpoint of Rite Aid’s guidance assumes that the company will break even over the remaining three quarters of the fiscal year. That implies that the recent trend of improving earnings will reverse soon. One cause is a $60 million charge the company has recently incurred in order to refinance approximately $1.3 billion of debt. While Rite Aid’s various refinancing transactions will dilute earnings this year, they will ultimately reduce annual interest expense by $85 million, boosting cash flow.