The relatively cheaper generic drugs were a perfect match for the post-financial crisis period, when organizations were looking for ways to reduce their health care expenditure. As a result, generic drugs have taken over the American market and now account for nearly 80% of all subscriptions filled.
The industry has been shifting toward generics, but the pace of that shift has been slowing down. That being said, it should also be noted that around $15 billion in branded drugs will come off patent in the next couple of years. This means that despite the slow pace, generics could continue to slowly increase their share of the market with the addition of these new and previously unavailable generic drugs.
Although these drugs carry higher margins, they are considerably lower priced. As a result, the rise of generics has an adverse impact on the top-line growth of the big drugstore chains: Rite Aid, Walgreen (WAG) and CVS Caremark. The slowdown in the introduction of generics and increasing competition in this category could be a drag on the bottom line as well.
These were some of the reasons behind Rite Aid's reduction of its earnings forecast. The second biggest player in the industry, Walgreen, is facing similar problems. In its previous quarterly results, Walgreen reported an increase in earnings but its gross margin slipped 1.3 percentage points, to 28.1%.
Three Reasons For Optimism
Although Rite Aid could struggle with top-line growth, there is still a lot to look forward to.
Firstly, the business has been working on its cost-control measures to drive its earnings growth. Its selling, general and administrative expenses, as a percentage of sales, have fallen to 25.6% in the previous quarter from 26.1% in the prior year. Further improvements will lead to better profitability.
Secondly, Rite Aid has been remodeling its stores into the new Wellness format, with more pharmacy services and healthier products. A typical Wellness store has 3.2% better front-end same-store sales than a non-Wellness store. The business has so far converted a quarter of its 4,600 stores into Wellness stores. They will convert nearly 500 more stores to Wellness by next fiscal year. This will give a boost to Rite Aid's revenues and earnings in the coming years.
Thirdly, Rite Aid's poor financial health has been a cause for concern, but the business has been moving in the right direction. In the previous quarter, the company cut its total debt by $44.1 million. Its debt is a lofty 4.5 times its adjusted earnings ratio. But that has improved significantly, from 5.6 times in the same quarter of fiscal 2013. With its strong ability to generate free cash flow, Rite Aid could significantly reduce its debt in the next three to five years.
In short, I still like Rite Aid.
At the time of publication, the author held no positions in any of the stocks mentioned.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.