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RAD > SEC Filings for RAD > Form 10-K on 23-Apr-2013All Recent SEC Filings

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Form 10-K for RITE AID CORP


23-Apr-2013

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

Overview

Net income for fiscal 2013 was $118.1 million or $0.12 per basic and diluted share, compared to net loss for fiscal 2012 of $368.6 million or $0.43 per basic and diluted share and a net loss for fiscal 2011 of $555.4 million or $0.64 per basic and diluted share. The substantial improvement in our operating results is driven primarily by script count growth, the gross profit benefit from introductions of new generics and a current year LIFO credit of $147.9 million as compared to a charge last year, partially offset by higher selling, general and administrative expenses ("SG&A"). Our operating results are described in more detail in the "Results of Operations" section below. Some of the key factors that impacted our results in fiscal 2013, 2012 and 2011 are summarized as follows:

Sales Trends: Our revenue decline for fiscal 2013 was 2.8% compared to revenue growth of 3.6% for fiscal 2012 and a revenue decline of 1.8% for fiscal 2011. Fiscal 2013 revenues were negatively impacted by the extra week in fiscal 2012 and recent generic introductions, which have a substantially lower selling price than their brand counterparts, as well as continued reimbursement pressures. These decreases were partially offset by an increase of 3.4% in same store prescription count.

Gross Profit: Our gross profit was positively impacted by recent generic introductions, which have a higher gross profit than their brand counterparts, increased same store prescription count and a current year LIFO credit. We record the value of our inventory on the Last-In, First-Out (LIFO) method. We recorded a non-cash LIFO credit of $147.9 million, a non-cash LIFO charge of $188.7 million and a non-cash LIFO charge of $44.9 million in fiscal 2013, 2012 and 2011, respectively. The current year LIFO credit was due to significant generic drug deflation, partially offset by normal inflation on both brand drugs and front end products.

Selling, General and Administrative Expenses: Our selling, general and administrative expenses ("SG&A") increased in fiscal 2013 due primarily to the reversal of certain tax indemnification assets partially offset by lower operating costs associated with one less week this year. SG&A expenses as a percentage of revenue was 26.0% in fiscal 2013 compared to 25.0% in fiscal 2012. The increase in SG&A as a percentage of revenues relative to the prior year is due in part to the continued impact of recent generic introductions and reimbursement rate pressures which has resulted in a lower revenue base to measure our SG&A expenses against.

Lease Termination and Impairment Charges: We recorded lease terminations and impairment charges of $70.9 million in fiscal 2013 compared to $100.1 million and $210.9 million in fiscal 2012 and 2011, respectively. Our charges have been trending lower due to improved results of operations which reduces our impairment charges and closing fewer stores requiring lease termination charges.

Debt Refinancing: During fiscal 2013, we continued to take steps to extend the terms of our debt, reduce interest costs and to obtain more flexibility and we expect to engage in similar efforts in the future. During fiscal 2013, we completed two debt refinancings.

In February 2013, we increased our senior secured revolving credit facility to $1.795 billion, with an extended maturity of February 2018, and obtained new first and second priority secured term loans of $1.161 billion due 2020 and $470.0 million due 2020, respectively. The proceeds from these new borrowings, along with available cash, were used to refinance $1.370 billion of term loans and $1.060 billion aggregate principal of senior secured notes and debentures. This transaction resulted in a loss on debt retirement of $122.7 million which was recorded in the fourth quarter. This refinancing extends maturities and will reduce annual interest expense by $60.0 million.

In February 2012, we issued $481.0 million of our 9.25% senior notes due March 2020 and in May 2012, we issued an additional $421.0 million of our 9.25% senior notes due 2020. The proceeds of the notes, together with available cash were used to repurchase and repay the 8.625% senior notes due


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2015 and the 9.375% senior notes due 2015, respectively. This transaction resulted in a loss on debt retirement of $17.8 million.

These transactions are described in more detail in the "Liquidity and Capital Resources" section below.

Income Tax:

Net income for fiscal 2013 included income tax benefit of $110.6 million, compared to income tax benefit of $23.7 million for fiscal 2012 and income tax expense of $9.8 million for fiscal 2011. During fiscal 2013 we reached agreements with the Internal Revenue Service ("IRS") and Commonwealth of Massachusetts Appellate Divisions settling the examinations of the Brooks Eckerd fiscal years 2004 - 2007 and fiscal years 2005 - 2007, respectively. The settlements with the IRS and the Commonwealth of Massachusetts did not impact our net financial position, results of operations or cash flows.

The benefit recognized in fiscal 2013 was primarily comprised of recognition of previously unrecognized tax benefits resulting from the appellate settlements discussed above. This amount is offset by a reversal of the related tax indemnification asset which was recorded in selling, general and administrative expenses. The fiscal 2012 income tax benefit was primarily attributable to the unrecognized tax benefits due to the lapse of statute of limitations and the income tax expense for fiscal 2011 comprised of the accrual of state and local taxes and adjustments to unrecognized tax benefits.

We maintain a full valuation allowance against the net deferred tax assets. ASC 740, "Income Taxes" requires a company to evaluate its deferred tax assets on a regular basis to determine if a valuation allowance against the net deferred tax assets is required. A cumulative loss in recent years is significant negative evidence in considering whether deferred tax assets are realizable. Based on the negative evidence, ASC 740 precludes relying on projections of future taxable income to support the recognition of deferred tax assets.


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Results of Operations

     Revenue and Other Operating Data

                                                           Year Ended
                                            March 2,        March 3,     February 26,
                                              2013            2012           2011
                                           (52 Weeks)      (53 Weeks)     (52 Weeks)
                                                     (Dollars in thousands)
Revenues                                  $ 25,392,263    $ 26,121,222    $ 25,214,907
Revenue (decline) growth                          (2.8 )%          3.6 %          (1.8 )%
Same store sales (decline) growth                 (0.3 )%          2.0 %          (0.7 )%
Pharmacy sales (decline) growth                   (1.6 )%          1.9 %          (1.8 )%
Same store prescription count increase
(decrease)                                         3.4 %           0.9 %          (1.2 )%
Same store pharmacy sales (decline)
growth                                            (1.0 )%          2.4 %          (0.9 )%
Pharmacy sales as a % of total sales              67.6 %          68.1 %          67.8 %
Third party sales as a % of total
pharmacy sales                                    96.6 %          96.5 %          96.2 %
Front end sales growth (decline)                   0.8 %           0.7 %          (1.6 )%
Same store front end sales growth
(decline)                                          1.4 %           1.1 %          (0.3 )%
Front end sales as a % of total sales             32.4 %          31.9 %          32.2 %
Store data:
Total stores (beginning of period)               4,667           4,714           4,780
New stores                                           -               -               3
Closed stores                                      (44 )           (47 )           (69 )
Total stores (end of period)                     4,623           4,667           4,714
Remodeled stores                                   516             279              19
Relocated stores                                    13              15              28

Revenues

Fiscal 2013 compared to Fiscal 2012: The 2.8% decrease in revenue was due primarily to one less week in fiscal 2013 and a decrease in same store sales. The decrease in same stores sales was driven primarily by recent generic introductions and continued reimbursement rate pressures, partially offset by increased same store prescription count, the positive impact of our wellness + loyalty program, and other management initiatives to increase sales. The increase in same store prescription count was driven in part by the Walgreens / Express Scripts dispute which was settled in September 2012, our immunization program and our wellness + loyalty program. We expect lower reimbursement rates, our cycling of the Express Scripts business and the softening benefit of new generic introductions in fiscal 2014 to continue to have a negative impact on our revenues. Same store sales trends for fiscal 2013 and fiscal 2012 are described in the following paragraphs. We include in same store sales all stores that have been open at least one year. Stores in liquidation are considered closed. Relocation stores are not included in same store sales until one year has lapsed.

Pharmacy same store sales decreased 1.0%. Pharmacy same store sales were negatively impacted by recent generic drug introductions, which have a substantially lower selling price than their brand counterparts but higher gross profit. Also contributing to the decrease are continued reimbursement rate pressures. These decreases were partially offset by an increase of 3.4% in same store prescription count driven in part by incremental prescriptions gained from the Walgreens / Express Scripts dispute and by our immunization program and wellness + loyalty program.


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Front end same store sales increased 1.4%. The increase in front end same store sales reflects the positive impact of our wellness + loyalty program, incremental sales from our Wellness format stores, and other management initiatives to increase front end sales. Active wellness + members, defined as those who have used their cards at least twice during the last twenty-six weeks, was over 25 million as of March 2, 2013. We have completed 797 Wellness store remodels as of March 2, 2013.

Fiscal 2012 compared to Fiscal 2011: The 3.6% increase in revenue was primarily driven by an increase in same store sales and an additional week in fiscal 2012. The increase in same store sales was driven by the positive impact of our wellness + loyalty program, our flu immunization program and other management initiatives to increase sales and prescriptions. These increases were partially offset due to lower pharmacy reimbursement rates and by operating fewer stores than last year. Same store sales trends for fiscal 2012 and fiscal 2011 are described in the following paragraphs.

Pharmacy same store sales increased 2.4%. Pharmacy same store sales were positively impacted by an increase of 0.9% in same store prescriptions driven in part by our immunization program, our wellness + loyalty program and inflation on brand drugs. Same store sales were also positively impacted by incremental prescriptions from the Walgreens / Express Scripts dispute and other initiatives to increase prescription count, partially offset by an approximate 1.7% negative impact from new generic introductions and lower reimbursement rates from pharmacy benefit managers and government payors.

Front end same store sales increased 1.1% from the prior year reflecting the positive impact of our wellness + program and other management initiatives to increase sales in the front end.

Costs and Expenses

                                                       Year Ended
                                   March 2, 2013     March 3, 2012    February 26, 2011
                                    (52 Weeks)        (53 Weeks)         (52 Weeks)
                                                 (Dollars in thousands)
Costs of goods sold                $   18,073,987    $   19,327,887    $     18,522,403
Gross profit                            7,318,276         6,793,335           6,692,504
Gross margin                                 28.8 %            26.0 %              26.5 %
Selling, general and
administrative expenses            $    6,600,765    $    6,531,411    $      6,457,833
Selling, general and
administrative expenses as a
percentage of revenues                       26.0 %            25.0 %              25.6 %
Lease termination and
impairment charges                         70,859           100,053             210,893
Interest expense                          515,421           529,255             547,581
Loss on debt retirements, net             140,502            33,576              44,003
Gain on sale of assets, net               (16,776 )          (8,703 )           (22,224 )

Cost of Goods Sold

Gross profit increased by $524.9 million in fiscal 2013 compared to fiscal 2012. The overall increase in gross profit was due to a LIFO credit resulting from significant generic deflation this year, compared to a LIFO charge in the prior year and an overall increase in pharmacy gross profit, partially offset by a slightly lower front end gross profit. Overall gross margin was 28.8% for fiscal 2013 compared to 26.0% in fiscal 2012.

Pharmacy gross profit was higher due an increased number of prescriptions driven, in part, from the Walgreens / Express Scripts dispute, higher immunizations and our wellness + loyalty program.


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Additionally, pharmacy gross margin improved due to significant recent generic introductions, partially offset by continued reimbursement rate pressure.

Front end gross profit was slightly lower due to higher tier discounts from our wellness + customer loyalty program and other markdowns, partially offset by increased sales. Front end gross margin was flat to the prior year.

Gross profit increased by $100.8 million in fiscal 2012 compared to fiscal 2011 due to overall revenue growth. Pharmacy gross profit was higher due to increased prescription volume and the introduction of new generics including generic Lipitor, partially offset by continued pressure on pharmacy benefit manager and governmental reimbursement rates. Front-end gross profit was driven by higher sales reflecting the positive impact of our wellness + loyalty program and continued strong Rite Aid Brand private label penetration.

We use the last-in, first-out (LIFO) method of inventory valuation, which is determined annually when inflation rates and inventory levels are finalized. Therefore, LIFO costs for interim period financial statements are estimated. The LIFO credit for fiscal 2013 was $147.9 million compared to a LIFO charge of $188.7 million in fiscal 2012 and $44.9 million in fiscal 2011. The LIFO credit for fiscal 2013 was primarily the result of significant generic drug deflation partially offset by normal inflation on brand drugs and front end products. During fiscal 2013, we experienced significant price decreases on the recent high volume generic introductions. During the first few months after new generic drugs are introduced, supplier prices tend to decrease as multiple suppliers enter the market place. The resulting impact was an approximate 42% decline in our generic product price index this year compared to approximately 6% last year. This significant generic deflation was partially offset by our branded product inflation of approximately 12%, resulting in a net deflation rate of approximately 9% in our overall pharmacy product mix in fiscal 2013, resulting in the LIFO credit noted above.

During fiscal 2012, we experienced significant brand price inflation of approximately 12%. Brand pharmacy prices increased by approximately 2% more than in fiscal 2011. We did not yet experience the significant generic deflation impact described above. As a result, inflation on our overall pharmacy product mix was 5% and we incurred the significant LIFO charge noted above. The charge in fiscal 2012 was higher than fiscal 2011 due to the 2% higher branded product inflation rates.

Selling, General and Administrative Expenses

SG&A expenses increased by $69.4 million in fiscal 2013 compared to fiscal 2012 due primarily to the reversal of $91.3 million of tax indemnification asset resulting from our settlement with the IRS and certain states associated with pre-acquisition Brooks Eckerd tax issues, which are offset by an income tax benefit as noted below (in "Income Taxes"), litigation charges relating to the settlement of certain labor related actions and increased associate bonus expense. These amounts are partially offset by lower operating costs associated with one less week this year, lower depreciation and amortization, lower self insurance expense due primarily to the impact of the discount rate change on the prior year expense and the favorable settlement related to payment card interchange fee litigation. SG&A expenses as a percentage of revenue was 26.0% in fiscal 2013 compared to 25.0% in fiscal 2012. The increase in SG&A as a percentage of revenues relative to the prior year is due in part to the continued impact of recent generic introductions and reimbursement rate pressures which has resulted in a lower revenue base to measure our SG&A expenses against.

SG&A expenses increased by $73.6 million in fiscal 2012 compared to fiscal 2011 due mostly to expenses associated with the fifty-third week in fiscal 2012. SG&A as a percentage of revenue improved over fiscal 2011 due to leveraging our fixed costs relative to revenue growth. SG&A for fiscal 2012 was 25.0% as a percentage of revenue, compared to 25.6% in fiscal 2011. The decrease in SG&A as a percentage of revenues is mostly due to a decrease in salaries and benefits resulting from continued labor control initiatives, lower occupancy and lower depreciation and amortization, and other cost


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containment initiatives. These favorable variances were partially offset by an increase in bonus expense relating to improved results and higher workers' compensation costs associated with unfavorable discount rate changes.

Lease Termination and Impairment Charges

Impairment Charges:

We evaluate long-lived assets for impairment whenever events or changes in circumstances indicate that an asset group has a carrying value that may not be recoverable. The individual operating store is the lowest level for which cash flows are identifiable. As such, we evaluate individual stores for recoverability of assets. To determine if a store needs to be tested for recoverability, we consider items such as decreases in market prices, changes in the manner in which the store is being used or physical condition, changes in legal factors or business climate, an accumulation of losses significantly in excess of budget, a current period operating or cash flow loss combined with a history of operating or cash flow losses or a projection of continuing losses, or an expectation that the store will be closed or sold.

We monitor new and recently relocated stores against operational projections and other strategic factors such as regional economics, new competitive entries and other local market considerations to determine if an impairment evaluation is required. For other stores, we perform a recoverability analysis if they have experienced current-period and historical cash flow losses.

In performing the recoverability test, we compare the expected future cash flows of a store to the carrying amount of its assets. Significant judgment is used to estimate future cash flows. Major assumptions that contribute to our future cash flow projections include expected sales, gross profit, and distribution expenses; expected costs such as payroll, occupancy costs and advertising expenses; and estimates for other significant selling, and general and administrative expenses. Many long-term macro-economic and industry factors are considered, both quantitatively and qualitatively, in our future cash flow assumptions. In addition to current and expected economic conditions such as inflation, interest and unemployment rates that affect customer shopping patterns, we consider that we operate in a highly competitive industry which includes the actions of other national and regional drugstore chains, independently owned drugstores, supermarkets, mass merchandisers, dollar stores and internet pharmacies. Many of our competitors are spending significant capital and promotional dollars in certain geographies to gain market share. We have assumed certain sales growth from our loyalty program and other initiatives to grow sales. Recent Pharmacy Benefit Management consolidation and efforts of third party public and private payors have reduced pharmacy reimbursement rates in recent years. We expect this rate compression, which currently affects over 96% of our pharmacy business, to continue to affect us in the foreseeable future. We operate in a highly regulated industry and must make assumptions related to Federal and State efforts and proposals to affect the pricing and regulations related to prescription drugs, as well as, expected revenues and costs related to the Patient Protection and Affordable Care Act (health care reform).

Additionally, we take into consideration that certain operating stores are executing specific improvement plans which are monitored quarterly to recoup recent capital investments, such as an acquisition of an independent pharmacy, which we have made to respond to specific competitive or local market conditions, or have specific programs tailored towards a specific geography or market.

We recorded impairment charges of $24.9 million in fiscal 2013, $52.0 million in fiscal 2012 and $115.1 million in fiscal 2011. Our methodology for recording impairment charges has not changed materially, and has been consistently applied in the periods presented.

At March 2, 2013, approximately $1.9 billion of our long-lived assets, including intangible assets, were associated with 4,623 active operating stores.


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If an operating store's estimated future undiscounted cash flows are not sufficient to cover its carrying value, its carrying value is reduced to fair value which is its estimated future discounted cash flows. The discount rate is commensurate with the risks associated with the recovery of a similar asset.

An impairment charge is recorded in the period that the store does not meet its original return on investment and/or has an operating loss for the last two years and its projected cash flows do not exceed its current asset carrying value. The amount of the impairment charge is the entire difference between the current carrying asset value and the estimated fair value of the assets using discounted future cash flows. Most stores are fully impaired in the period that the impairment charge is originally recorded.

We recorded impairment charges for active stores of $24.0 million in fiscal 2013, $43.4 million in fiscal 2012 and $109.0 million in fiscal 2011.

We review key performance results for active stores on a quarterly basis and approve certain stores for closure. Impairment for closed stores, if any (many stores are closed on lease expiration), are recorded in the quarter the closure decision is made and approved. Closure decisions are made on an individual store or regional basis considering all of the macro-economic, industry and other factors discussed above, in addition to, the operating store's individual operating results. We currently have no plans to close a significant number of active stores in future periods. In the next fiscal year, we currently expect to close fewer than 50 stores, primarily as a result of lease expirations. We recorded impairment charges for closed facilities of $0.9 million in fiscal 2013, $8.6 million in fiscal 2012 and $6.1 million in fiscal 2011.

Included in the impairment charges noted above were charges of $0.6 million in fiscal 2013, $5.9 million in fiscal 2012 and $2.4 million in fiscal 2011 for existing owned surplus property. Assets to be disposed of are evaluated quarterly to determine if an additional impairment charge is required. Fair value estimates are provided by independent brokers who operate in the local markets where the assets are located.


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The following table summarizes the impairment charges and number of locations, segregated by closed facilities and active stores that have been recorded in fiscal 2013, 2012 and 2011:

                                                            Year Ended
                                    March 2, 2013        March 3, 2012        February 26, 2011
                                  Number     Charge    Number     Charge     Number      Charge
Closed facilities:
Actual and approved store
closings                               29   $    325        55   $  2,283          51   $   3,278
Actual and approved relocations         -          -         2        499           1         317
Distribution center closings            -          -         -          -           1          94
Existing surplus properties             5        594        12      5,863          17       2,433

Total impairment charges-closed
facilities                             34        919        69      8,645          70       6,122
Active stores:
Additional current period
charges for stores previously
impaired in prior periods(1)          469      5,835       591      9,822         584      17,825
Charges for new and relocated
stores that did not meet their
asset recoverability test in
the current period(2)                  14      9,190        19     18,926          44      36,015
Charges for the remaining
stores that did not meet their
asset recoverability test in
the current period(3)                  47      8,948        53     14,605         167      55,159

Total impairment charges-active
stores                                530     23,973       663     43,353         795     108,999
Total impairment charges-all
locations                             564   $ 24,892       732   $ 51,998         865   $ 115,121

Total number of active stores       4,623                4,667                  4,714
Stores impaired in prior
periods with no current charge        588                  428                    263
Stores with a current period
charge                                530                  663                    795

Total cumulative active stores
with impairment charges             1,118                1,091                  1,058


(1)
These charges are related to stores that were impaired for the first time in prior periods. Most active stores, requiring an impairment charge, are . . .
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