Fighting to regain lost Express Scripts customers from competitors, Walgreen (NYSE:WAG) announced an unexpected drop in quarterly profit on Friday. Net earnings declined 26% to $413 million from $554 million a year earlier. Sales during the quarter decreased by 4.6% to $17 billion. The company estimates the brand-to-generic prescription drug conversions to have negatively impacted sales by $883 million.
Prescription sales, which historically account for ~65% of sales, were down 7% compared to a year ago. The decline was a combined result of the loss of prescriptions to competitors like CVS Caremark (NYSE:CVS) and Rite Aid (NYSE:RAD) among others and introduction of generics. The company filled 201 million prescriptions during the quarter, a decrease of 3% over same period last year but an improvement upon the 188 million prescriptions it filled in the previous quarter. The improvement was a result of the company’s return to the Express Scripts pharmacy network, and we expect it to continue going forward. The recently launched Balance Rewards program now has 45 million registered members and should help the company attract back lost Express Scripts customers.  We expect it to be instrumental in the company’s turnaround plans.
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Prescription Count To Determine Future Trend
Walgreen’s future earnings will depend on it regaining Express Scripts patients and the rate of their return. It has been promoting its services through a loyalty program which has seen membership shoot-up from zero to 45 million within a quarter. Its efforts will be bolstered by an expected strong flu season which will bring shoppers in for flu shots and medications. 
The company will face tough competition for Express Scripts customers. Primary competitor CVS expects to retain about 60% of the ex-Walgreen patrons who switched over to its chain while Rite Aid reported on Thursday that it expects to retain most of the customers gained during the dispute.   The longer these customers stay away from Walgreen, the tougher it would be to gain them back. The next quarter marks the anniversary of the Express Scripts dispute and any improvements would become apparent in the second quarter earnings.
Besides customers lost to competitors, the dispute cost the company approximately 18% of its original Express Scripts prescriptions. Tricare which is part of the Express Scripts universe decided to keep Walgreen out of its pharmacy network even after the dispute between the latter and the company was resolved. 
Profits To Improve
The introduction of generic drugs which resulted in loss of revenues also resulted in gross profit margins increasing by ~1.5 percentage points to 29.5%. With several more branded drugs scheduled to go off patent over the next three years, we expect the gross margins to cross the 30% threshold. 
The margin improvement would be aided by the costs tied to the stake purchase in Alliance Boots and USA Drugs business acquisition being one time. Hurricane Sandy, which swept up the East Coast in late October and caused extensive destruction along the New Jersey and New York coasts also cost the company $24 million in the quarter as it was forced to close hundreds of stores temporarily. We expect the company’s net margins to return to historical levels over the next couple of quarters.
We are revising our $38 Trefis price estimate for Walgreen.Notes:
- Walgreen Co. Reports Fiscal 2013 First Quarter Results, Walgreen, December 2012 [↩]
- Walgreen profit falls; flu season may help this quarter, Reuters, December 2012 [↩]
- Rite Aid Management Discusses Q3 2013 Results – Earnings Call Transcript, Seeking Alpha, December 2012 [↩]
- CVS Caremark sees Obamacare as expansion opportunity, Reuters, December 2012 [↩]
- Walgreen loses key Express customer; August sales drop, Reuters, September 2012 [↩]
- Big Pharma struggles to protect its blockbusters as they lose patent protection, The Economist, December 2011 [↩]