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Rite Aid: Turning around?

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FILE PHOTO

Even the head of Rite Aid Corp. admits the company has challenges.

"We're on a journey here. We're not there yet," said John Standley, Rite Aid's president, CEO and — since the June 21 annual meeting — its chairman of the board.

Shareholder Steve Krol takes a far dimmer view of the East Pennsboro Township-based company, accusing it of faults including board cronyism, sweetheart deals for top executives and chronically poor customer service.

"This board must be changed," he told shareholders attending the annual meeting. Without reform, the company risks becoming worthless, he said, adding: "My crystal ball has been pretty accurate."

Rite Aid is the nation's third-largest drugstore chain, behind Walgreens and CVS — it ranks fourth if Walmart is included, said Michael Johnsen, a senior editor at trade publication Drug Store News. It operates more than 4,600 stores.

It remains a highly leveraged company, a legacy of its purchase of the Brooks and Eckerd drugstore chains in 2007, a move now panned by most analysts. And last week it reported its 20th consecutive quarterly loss.

"The fact is Rite Aid is a very challenged operator in a very challenged industry," Johnsen said.

Yet Rite Aid has made some innovative moves to adapt in a highly competitive and rapidly changing market, Johnsen said. He praised the wellness+ rewards program and other efforts designed to increase consumer loyalty.

Can Rite Aid return to prosperity? Here are the cases for and against:

FOR

The competitive landscape

Rite Aid is one of several drugstores experiencing a windfall of customers thanks to a dispute between Walgreens and Express Scripts, a company that handles prescriptions for many insurance plans. Express Scripts customers can no longer use Walgreens to fill their prescriptions, forcing them to seek alternatives.

The situation appears to account for most of Rite Aid's 2.5 percent first-quarter gain in same-store sales, analyst Kimberly Noland wrote in a research note for Gimme Credit, a New York firm that follows the corporate bond market.

The impasse will probably benefit Rite Aid through the end of the year, according to another research note written by Joseph Stauff, an analyst for New York-based Susquehanna Financial Group.

Also, it appears Rite Aid is no longer a takeover target. Earlier this year, some analysts speculated Walgreens might try to buy it. Instead, Walgreens announced this month it would acquire a $6.7 billion stake in European drugstore chain Alliance Boots, a deal that dramatically increases the Chicago company's debt load.

"This risky move likely rules out purchase of even part of the Rite Aid chain," Noland wrote.

Customer loyalty initiatives

Rite Aid introduced its wellness+ customer rewards program in 2010. Today it has 25 million active members, defined as those who shop at least twice in six months. Wellness+ members, Rite Aid said, account for 69 percent of "back-end" prescription sales and 75 percent of "front-end" sales, which are the consumer products in aisles.

Wellness+ is helping Rite Aid woo former Walgreens customers, executives told analysts last week in Rite Aid's quarterly earnings conference call.

In addition, Rite Aid said, it is seeing high revenues from stores using the "wellness" format, which features a more prominent pharmacy, expanded health product and health food selections and a "wellness ambassador" to help customers.

The company has built or remodeled 423 sites using the format and plans to reach 780 stores, about 15 percent of the total, Standley said.

Rite Aid has a major opportunity not only to retain customers migrating from Walgreens but to drive more front-end sales through wellness+, Stauff said. At present, Rite Aid generates just 43 percent of its profit from front-end sales, compared with Walgreens' 60 percent.

Innovation for a changing marketplace

Filling prescriptions is no longer the major moneymaker it once was, Johnsen said.

Reimbursement rates are being cut, he said. New branded drugs are few and far between; meanwhile, a wave of generics is flooding the industry. Margins on generics are wider, but they're so much cheaper than brand names that top-line revenues end up dropping.

To compensate, pharmacies are positioning themselves as health care centers, offering immunizations, medication management and other value-added services. Rite Aid is "at the forefront" of the transition to this new business model, he said.

At least one Rite Aid service, online pharmacist consultations, appears to be unique in the industry, he said.

"There really aren't any other retailers that are doing that," he said, adding: "The hope is that value-added (service) translates into loyalty."

AGAINST

Financials

Rite Aid's fiscal 2013 began March 3. The company lost $555.4 million in fiscal 2011, $368.6 million in fiscal 2012, and $28 million in the quarter that just ended. It projects losses for fiscal 2013 of $103 million to $248 million. Its stock price closed Monday at $1.32.

Some of Rite Aid's numbers have improved: The company highlights its six straight quarters of same-store sales growth and adjusted EBITDA. However, the numbers investors care about — notably, earnings per share — have not, said Anthony Liuzzo, director of the MBA program at the Sidhu School of Business and Leadership at Wilkes University.

An especially significant number is Rite Aid's debt, which stands at $6.3 billion, according to a research note by analyst Joseph Stauff of New York-based Susquehanna Financial Group. The company has been able to roll over its bonds on favorable terms, but Rite Aid still shoulders "outsized credit risk," Stauff wrote.

The company needs to make significant turnaround progress before its next tranche of debt comes due in June 2014, he said.

Board and management shortcomings

Rite Aid's board remains rife with insider relationships and ties to management, Krol alleges.

The board fails to hold management accountable, he said. Former CEO Mary Sammons, who engineered the now widely panned Brooks-Eckerd deal, received $1.5 million upon completing it, according to U.S. Securities and Exchange Commission filings, and she sits on the board today.

Standley's pay rose from $2.8 million to $11 million this year due to incentives for hitting an EBITDA target.

Krol proposed two shareholder resolutions, one that would have strengthened the definition of board member independence and one that would change how bonuses are awarded and provided for "clawbacks." However, both were defeated at last week's annual meeting, as were two proposed by a coalition of labor union investment funds.

Institutional investors are reluctant to interfere with boards and management, and usually have other means to assert their interests, said Michael Hussey, a professor at the Widener University School of Law.

Boards and management have closer ties than they used to, and overlapping relationships alone don't constitute cronyism, he said. Nor is it illegal to make poor decisions.

If shareholders don't think a board is representing their interests, they have to unite to vote them out, he said.

"The fact that institutional shareholders haven't done that means they don't think these folks are that incompetent, they're willing to wait or they don't think (decision-making) was that bad," he said.

Labor relations and customer service

Labor unions have tussled with Rite Aid in court for years regarding various claims, including alleged firings of older workers without cause. Rite Aid this month agreed to pay $20.9 million to settle allegations it counted assistant managers as exempt employees to avoid paying them overtime.

Rite Aid mistreats workers, lowering morale, and it short-staffs stores, leading to poor customer service, Krol and labor activists said. If the company monitored social media better, it would see patterns of negative comments that accurately reflect in-store experiences, Krol said.

The company does monitor social media sites, and actively addresses criticisms, Chief Operating Officer Ken Martindale said. In a statement, Rite Aid said it strives "to create an environment where every associate is valued individually and as a team member (and) treated with respect."

THE BOTTOM LINE

Given the tepid economy, Rite Aid still faces challenges, Liuzzo said. And the company is still paying for the error of buying the Brooks-Eckerd chain.

Nevertheless, "It's not a fatal error. I think the most recent numbers are demonstrating that," he said.

For Krol, much more needs to change at the top.

"This shareholder is tired of being the cop on the street when it should be the board," he said.

Standley has engineered two major company turnarounds, Johnsen said: One as part of the team that brought back Rite Aid a decade ago after a huge accounting scandal nearly sank the company, and again as CEO of supermarket chain Pathmark between 2005 and 2008. He and Rite Aid could succeed again, Johnsen said.

"I'm certainly rooting for them," he said.

Write to the Editorial Department at editorial@cpbj.com

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