March 15, 1999

Rite Aid Plunges 39% After Revealing A Substantial Shortfall in Earnings

By ROBERT BERNER and MARK MAREMONT Staff Reporters of THE WALL STREET JOURNAL

Rite Aid Corp. stock price plummeted 39% Friday after the drugstore chain warned that its fiscal fourth-quarter earnings would fall substantially below analysts' estimates.

The company disclosed that net income for the quarter ended Feb. 27 would range from 30 cents to 32 cents a share, or from $85 million to $91 million. Analysts had been estimating earnings of 52 cents a share, or $148 million, according to First Call. A year ago, Rite Aid had fourth-quarter earnings of 46 cents a share, or $120 million.

Rite Aid stock fell $14.4375 to $22.5625 in New York Stock Exchange composite trading Friday.

The news surprised analysts, many of whom had buy ratings on the stock. "I talked to the company just over a week ago, and they assured me the numbers were OK for the quarter," said Edward Comeau, an analyst at Donaldson, Lufkin & Jenrette Securities Corp.

The unexpected nature of the bad news and the wide range of problems blamed for it prompted some analysts to question management's control of the nation's third-largest drugstore chain. "Very possibly the operations have gotten out of control," Mr. Comeau said.

In telephone conference call with analysts and major investors, Rite Aid Chief Executive Martin Grass portrayed the shortfall as resulting from one-time problems tied to the company's rapid-fire growth. The chain opened 578 stores last year -- 78 more than planned -- and made the $1.5 billion acquisition of PCS Health Systems, which is the nation's largest manager of prescription benefits.

But analysts questioned whether the problems would be confined to one quarter. "Are the earnings power of this company compromised going forward or is this a one-time event?" asked Eric Bosshard, an analyst at Midwest Research.

Of the roughly 20-cent-a-share shortfall, Rite Aid, based in Camp Hill, Pa., attributed seven cents to the costs of opening or relocating 206 stores in the last 45 days, and an additional four cents to the loss on the liquidation of inventory from 208 stores closed during the fiscal third and fourth quarters.

Rite Aid said the start-up of a new distribution center cost it three cents a share. The earlier-than-expected closing of the PCS acquisition in January cost it two cents a share.

Rite Aid said another two cents in costs resulted from the markdown of inventory at southern and eastern stores, where the chain had attempted to carry a higher level of seasonal goods. Finally, "certain unanticipated costs and settlements were responsible for the balance of shortfall," Rite Aid said. In early March, Rite Aid disclosed it settled a nasty legal battle with a former executive.

A spokeswoman for Rite Aid said the 208-store closings belonged to the 379-store closings on which Rite Aid took a $173.8 million, after-tax charge during the second quarter of the just-ended fiscal year. That makes this the second earnings hit arising from those store closings.

The earnings shortfall also means that Rite Aid won't be able to go ahead with its plans to offer $1 billion in common stock and $500 million in preferred convertible stock to refinance its purchase of PCS, analysts said. The purchase was made on short-term debt. Rite Aid likely will face higher interest costs when it refinances, analysts say.

Rite Aid said it would release its earnings March 29.

   March 31, 1999

Rite Aid's Large Cash Deductions Irk Suppliers at Bill-Paying Time

By MARK MAREMONT and ROBERT BERNER
Staff Reporters of THE WALL STREET JOURNAL

The U.S. consumer unit of Bayer AG received an unusual notice from Rite Aid Corp. this month. The drugstore chain said it had deducted about $300,000 from money due Bayer for aspirin and other goods. The deduction was from a payment Rite Aid sent in February, just as its fiscal year was ending.

The notice gave only a sketchy indication of what the deduction was for, says a Bayer manager; it cited damaged and outdated merchandise removed from acquired and remodeled stores.

Bayer wasn't alone. Of two dozen Rite Aid suppliers that agreed to discuss the issue, about three-quarters say the drugstore chain cut their payments in the February pay period, by amounts ranging from under 1% to 16% of their annual sales to the chain. Bic Corp., Dial Corp. and the M&M/Mars unit of Mars Inc. say they were hit with deductions, ranging from $45,000 at Bic to $100,000 at Mars. Some suppliers say the notices, like the one Bayer got, included only a cryptic explanation.

"I've never seen anything as blatantly large," says Debbie Clatterbuck, a Bayer sales manager who oversees the Rite Aid account. Bayer never authorized any of the deductions Rite Aid took, she says.

Rite Aid says that the deductions it took from suppliers' bills were only a little higher than usual. But some industry veterans describe them as an escalation of an increasing practice among drugstore chains and other big retailers: trying to improve their finances by pressuring suppliers for ever more concessions.

Taking deductions from bills due is "something we've seen from other retailers, but not on this scale," says Tom Corbett of Creditek, a firm that helps suppliers with their billings. A random check he did of 15 clients found that Rite Aid had recently claimed deductions from all, ranging from small amounts to nearly $200,000.

Many of Rite Aid's deductions were dated just before the Feb. 27 close of its 1999 fiscal year. "I believe they were doing everything they could to make their financials look better," Mr. Corbett says. After a quarter ends, he adds, retailers that have claimed big deductions from bills often back off, explaining that "it's an error, and we'll repay it."

Kenneth Green, president of Internal Audit Bureau Inc., a Creditek rival, says several of his clients also received notices of substantial unauthorized deductions from Rite Aid. In his opinion, these deductions function "in some ways as a profit center."

Rite Aid won't say how much it deducted from suppliers' bills in February, but it says such claims had only minimal impact on its financial statements. Company officials say the deductions have a lot to do with year-end housekeeping and the company's rapid pace of acquisitions and store openings, closings and remodelings. These result in many items being classed as outdated, damaged or otherwise unwanted, and suppliers are expected to take them back or give credit if the merchandise is destroyed or marked down.

"Any deductions we've taken we believe are legitimate," says Rite Aid's chief financial officer, Frank Bergonzi. He and other officials of Rite Aid say its behavior toward its 5,600 suppliers is in line with industry practice.

The deductions issue arises at a time when investors are giving close scrutiny to Rite Aid's financial performance. With more than 3,800 stores and revenue of nearly $13 billion, Rite Aid is the No. 3 drug chain in the U.S. -- and has been racing to catch Walgreen Co. and CVS Corp. In the past 2 1/2 years, Rite Aid has more than doubled its size by acquiring three smaller chains and the leading manager of prescription benefits, PCS Health Systems Inc. It also has been rapidly opening and remodeling stores.

Earlier this month, Rite Aid jolted investors by saying earnings for its fiscal fourth quarter would fall far below expectations, and they did: On Monday, the company reported net income for the February quarter 39% below a year earlier, citing operational problems related to its expansion.

Rite Aid also has drawn criticism for failing to disclose certain financial and real-estate dealings between the company and its chief executive, Martin L. Grass, and other Grass family members, some of which were described in The Wall Street Journal earlier this year. (see article).

In leaning on suppliers for savings, Rite Aid has plenty of company among retailers. Manufacturers complain that unilateral deductions from bills have grown in recent years, as the drugstore industry has consolidated into a few large chains with enormous buying clout.

Mostly, retailers' demands are up front. It is common for them to insist that suppliers foot part or all of various costs, such as advertising and the "reset" of store displays, and provide deep discounts and even batches of free merchandise at times. The demands have become particularly vociferous after acquisitions, when retailers face high conversion costs and expect suppliers to share the burden.

But increasingly, suppliers say, retailers use a tougher tactic: Instead of paying for merchandise at agreed-upon terms, they claim they are entitled to pay less, and take a deduction when they pay their bills.

In fact, a small industry of "deduction management" companies has sprung up. Working for retailers, these firms comb through records to find invoice discrepancies, unbilled claims for shared advertising costs and the like. One common tactic: After an acquisition, identifying suppliers that had granted more favorable terms to one of the retail chains being merged, then demanding that these terms be retroactively applied to the other chain's purchases from the suppliers, sometimes reaching back several years.

To hear suppliers tell it, retailers sometimes know deductions are unwarranted but hope to use their bargaining power to force the manufacturer to swallow them. And some weaker suppliers invariably acquiesce, after calculating how much business they stand to lose if they don't. If the supplier strongly objects, the retailer can always pay the disputed amount later, and at worst has had interest-free use of the money.

"We've seen a general increase in deductions, and not only from Rite Aid," says John Cafiero, manager of credit at Bic, which supplies razors, pens and lighters. He says both CVS and the Eckerd drugstore unit of J.C. Penney Co. also have hit Bic with large deduction notices in recent months related to their acquisitions, and the CVS deduction was larger than Rite Aid's. Mr. Cafiero says Eckerd "is far worse than Rite Aid" on certain types of claims.

An Eckerd spokeswoman says the chain works closely with suppliers and "resolves any issues that come up in the normal course of doing business." A CVS spokesman says, "We're not going to comment on our relations with vendors."

The consequences of such tactics can sometimes stretch beyond tense supplier-retailer relations. Jay Scansaroli, who heads the retailing-industry practice at Arthur Andersen LLP in New York, says that claiming deductions from suppliers "is an easy way for retailers to help their bottom line" by reducing their reported costs. If the supplier accepts the claims, the company can legitimately book higher income.

It's more troublesome if a supplier balks and the retailer later has to pay part or all of the disputed funds, Mr. Scansaroli says. That could mean the retailer had overstated earnings, and it would face added costs in the subsequent period when it repaid the claims.

Speaking in general and not about any particular situation, Mr. Scansaroli says that a retailer that books a large number of deductions without a clear understanding with its suppliers is being "extremely aggressive" in its accounting.

In Rite Aid's case, Mr. Bergonzi says some of the fourth-quarter deductions had the effect of lowering costs, but he says most related to obtaining credit for damaged or otherwise unusable goods, which reduces inventory and has no earnings impact. He stresses that the company "did not inflate earnings in the fourth quarter with these return allowances and things like that." As for taking deductions that suppliers won't accept, Mr. Bergonzi says that though "we have disputed claims as a regular course of business ... when push comes to shove, very few of these things ever get paid back" to the manufacturer.

Some suppliers who got deduction notices say Rite Aid provided no documentation for its claims of unsalable goods. Christine Colley, a deductions manager for Dial in Scottsdale, Ariz., says Rite Aid's $50,000 February deduction not only was the biggest it has ever taken from Dial, but also "was very unusual because Rite Aid usually documents" its deductions.

Rite Aid says it typically supplies documentation on returns, but in February, it didn't do so on goods from Thrifty PayLess, the biggest of its recent acquisitions, because they couldn't be scanned into its computer system. Handwritten documentation is available for any supplier that requests it, the company says.

At Bayer, Ms. Clatterbuck says her company generally will give credit for damaged or outdated goods. But she says Rite Aid's claimed damages are running at 6% of Bayer's total annual shipments, two to three times the level of other customers. Bayer doesn't ask to have the goods literally returned; like most manufacturers, it doesn't want useless merchandise around. But Ms. Clatterbuck says the situation has become so serious that Bayer managers are planning a visit to Rite Aid in coming weeks, intending to deliver the message that "either we get the merchandise back or we can't authorize this" any longer.

At Parfums de Coeur Ltd., a Darien, Conn., maker of perfume and cosmetics, Rite Aid's damaged-goods claims equaled 4.5% of its purchases last year, compared with about a 1% level from most other retailers, says Cindy Nikbin, manager of credit collection. "We don't ship damaged goods," she says. "They concoct things knowing that the suppliers don't have the resources to look into it. It's getting impossible to do business with them." Big retailers in general, she contends, try "any way they can to rip off their suppliers and make their profits better."

Ed Kaminski, Parfums de Coeur's chief financial officer, also says that "we're experiencing a problem" with Rite Aid in fees and return-related charges, but he adds that "usually if you yell and scream, they'll repay it eventually." He says "there could be a legitimate reason for" the level of Rite Aid's damaged-goods claims, which he says "isn't that bad" compared with some other retailers.

Asked about the charge of "concocting things" to support damaged-goods claims, Rite Aid's Mr. Bergonzi says, "We believe we can support any deductions we took." Except for the Thrifty PayLess goods, all claims are based on computer scanner data, the company says.

Jim Mastrian, Rite Aid's purchasing chief, says suppliers generally tell him that his chain's damaged-goods claims are indeed high compared with mass merchants' and Walgreen's, but are on a par with claims from CVS and Eckerd, which also have been involved in major acquisitions. "Nobody is satisfied with a high returns factor," Mr. Mastrian says. But he says vendors win at the end of the day when they have top-quality merchandise on the shelves.

Rite Aid began notifying manufacturers of the latest round of deductions early this month. Notices to Bayer and some others consisted of a one-page sheet, listing a sum deducted from the February payments and this explanation: "Damaged / Outdated Summary for Reset Merchandise Removed from TPI, Harco and KB acquisition stores and Rite Aid remodeled stores during the period 10/1/98 to 01/31/99."

Suppliers say this is unclear. Some manufacturers allow Rite Aid credit for damaged or outdated merchandise, but say they haven't agreed to "reset" charges for redesigned store displays.

The phrase "TPI, Harco and KB" refers to chains Rite Aid has acquired: Thrifty PayLess, Harco and K&B. But the Thrifty PayLess deal closed in late 1996 and the other two in 1997. Some manufacturers wonder how Rite Aid could expect them to swallow such old deals as a reason for another charge. Bayer's Ms. Clatterbuck says, "I thought I had taken back all I could" on the Thrifty PayLess merger. "This is over two years old."

Rite Aid President Timothy Noonan says that Thrifty PayLess turned out to be not very standardized, and time was needed to install new computer systems, inventory controls and such. It took until early 1998, he says, for the process of converting store displays to begin in earnest. That process generates claims as retailers ask suppliers to take back goods and share various costs.

As for Ms. Clatterbuck's remarks, Rite Aid's Mr. Bergonzi says such large charges to Bayer are normal, noting that Rite Aid does more than $35 million annually in business with it. Rite Aid's agreements with vendors, he says, are handled at senior levels, and lower-level employees "may not understand what they see."

The deductions can hit suppliers hard. At Qualis Inc., a Des Moines, Iowa, maker of private-label over-the-counter products, the deduction Rite Aid took from its February payment of invoices totaled about 5% of Qualis's annual sales to Rite Aid, says Mary Aagesen, Qualis's national sales manager. "I was shocked," she says. "Any time there is an unexpected deduction, it has a significant impact on profits."

Rite Aid's Mr. Mastrian says Qualis has a good relationship with the drugstore chain and supports what it's doing. "They love us," he says.

Some suppliers say they have a tough time getting explanations from Rite Aid. "They don't return phone calls or respond to faxes," says Manny Lubet, vice president and controller at Genal Strap Inc., a watch-strap maker in New York City's Queens borough. Genal was hit with a $21,550 deduction in February, the equivalent of 4% of its annual shipments to the drug chain, on top of $16,000 in charges over the prior 12 months, including abnormally high damage claims, Mr. Lubet says. "Vendor abuse," he calls it.

After checking, Rite Aid says that part of the Genal damage claim was in error and should have been charged to another vendor.

Tuesday afternoon, a Rite Aid public-relations firm provided a letter from a vice president of the watch-strap maker, Ira Gurvitch, to Rite Aid's Mr. Mastrian. "Rite Aid is a highly respected customer of ours whose purchasing and accounting methods are in good order and are the same as every other retailer that we deal with," the letter says. It adds that "anyone who would categorize our relationship in any other light would be jeopardizing the successful supplier-customer partnership that we have earnestly established together."

Mr. Mastrian says he has obtained letters of support from all of the suppliers about which he was asked.