Walgreen (NYSE:WAG) is the largest drugstore chain in the United States and operates 8,516 stores. The sales from prescription drugs account for about two thirds of the company’s sales. Walgreen’s sales have been suffering from a decline this year as a result of the loss of Express Scripts prescriptions to competitors like CVS Caremark (NYSE:CVS) and Rite Aid (NYSE:RAD) among others and the introduction of generics.
With the company now part of Express Scripts pharmacy network and the partnership with Alliance Boots expected to bolster earnings over the coming quarters, the future looks promising for the company. Below, we take a look at the company’s performance in 2012 and its future plans.
Dispute With Express Scripts Resolved
Express Scripts is a pharmacy benefit manager and works as a middleman between drug makers and employers. Pharmacy benefit managers pay pharmacies to dispense the drugs. The dispute between Walgreen and Express Scripts began in mid-2011 over pricing terms. Express Scripts claims the company was demanding a 20% hike in its reimbursements while Walgreen says that the pharmacy benefits manager was offering “below-average” reimbursements.
Walgreen filled about 90 million Express Scripts prescriptions in 2011.  The disagreement on the pricing terms resulted in the two companies ending their arrangement at the beginning of 2012 and is estimated to have cost Walgreen a loss of $5.3 billion in annual sales. Customers were forced to switch to another pharmacy or pay more for drugs if they continued to use Walgreen. The dispute took a turn for the worse when Express Scripts acquired another pharmacy benefit manager Medco in April further costing Walgreen millions of prescriptions. 
In July, the two companies reached an agreement which allowed Express Scripts customers to return to Walgreen starting September 15. Walgreen followed up the new agreement with the launch of its loyalty program, Balance Rewards, which too came into effect on September 15. The new agreement resulted in a substantial improvement in the prescriptions filled by the company each month. The y-o-y drop in prescriptions filled improved from 10% in June to 3% in November.
The new agreement does not mean Walgreen will automatically recover all of its lost business as Express Scripts has relationships with other pharmacies. In addition to several customers who would stick to their new pharmacies, Walgreen will still lose approximately 18% of its original Express Scripts prescriptions as Tricare which is part of the Express Scripts universe decided to keep Walgreen out of its pharmacy network even after the dispute was resolved. 
With almost 8500 stores across the country, we expect the company to leverage its wide footprint to gain from the aging population and expansion of insurance cover under Obamacare and negate the loss of a section of Express Scripts customers.
Generics To Drive Margin Improvement
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 will be helped by the expansion of the company’s operations. It completed the acquisition of USA Drugs in 2012 and larger operations would provide it with more bargaining power with drug manufacturers which could result in further margin improvement.
Partnership With Alliance Boots
The company completed an initial 45% investment in Alliance Boots in August 2012 and is satisfied with the latter’s performance so far. The strategic partnership aims to create the a global pharmacy led health and well being enterprise that sells and distributes products and services. Walgreen closed a $4 billion public debt offering getting attractive rates across all of its maturities, and Alliance Boots completed a successful amend-and-extend transaction of its current debt portfolio which significantly increases financial flexibility of the partnership. Both the transactions will enable a closer tie-ups of operations between the two companies. The partners aim to capture the revenue and saving opportunities provided by the arrangement through procurement and merchandising and we expect the results of the initiative to show from the first quarter of 2013. 
Plans For 2013 And Beyond
The company is undertaking a strategic transformation from a traditional drug store to provider of innovative, high-quality, affordable health and wellness services. The transformation will happen across all of its channels and formats. It also aspires to be a global pharmacy led health and well being enterprise through the Alliance Boots partnership.
Its strategic shift has been received well with the Balance Rewards loyalty program now boasting of 45 million registered members from zero at the start of September. The program now accounts for ~60% of Daily Living sales and millions have already redeemed their reward points.  As part of the transformation the company has expanded its product offerings to include grocery items and fresh food selections. The stores also stock an array of niche and prestige brands not found in traditional drugstores, and new upscale-look boutiques are being rolled out in specific markets across the country. The private brands now enjoy a penetration of 22% and will support margin growth over the coming quarters.
Walgreen has over the past few years completed the acquisition of Duane Reade, drugstore.com, USA Drug and certain assets of BioScrip. During the Q1 2013 earnings call it announced that it is willing to participate in further industry consolidation and file buys. In Q1 2013, it purchased a significant ownership stake in the parent company of Cystic Fibrosis Services, a specialty pharmacy that provides medications and treatment support for the cystic fibrosis community.
We have a $38 Trefis price estimate for Walgreen which is at par with the market price.Notes:
- CVS gains new prescription customers as Walgreens agreement with Express Scripts expires, Mercury News, January 2012 [↩]
- Bigger means cheaper, The Economist, April 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 [↩]
- Current Report, Walgreen Investor Relations, December 2012 [↩]
- Walgreen Management Discusses Q1 2013 Results – Earnings Call Transcript, Seeking Alpha, December 2012 [↩]