Walgreen (NYSE:WAG), the largest drugstore chain in the U.S., will report its Q4 2013 and fiscal year 2013 results on October 1. The company’s revenue base declined in 2012 as its dispute with pharmacy benefits management company Express Scripts led to a significant loss in the number of Express Scripts’ prescriptions filled at Walgreen stores. However, post the dispute resolution between the two companies in September 2012, Walgreen has seen its growth accelerate in subsequent months.
Earlier this month Walgreen reported $17.95 billion in sales for Q4 2013, a 5.1% q-o-q growth. Comparable store sales for Q4 2013 climbed by 4.5% while front-end comparable store sales increased 1.7% sequentially. Walgreen witnessed a 6.8% and 6.2% growth in prescriptions filled at comparable stores and comparable pharmacy sales, respectively. Pharmacy sales for August 2013 were 6.4% higher compared to August 2012, and accounted for 64.3% of total Walgreen sales in the month.
With 8,585 stores operating across the U.S., the District of Columbia, Puerto Rico and Guam, we think that Walgreen is in a stronger position to gain from the Affordable Care Act expanding insurance to millions of Americans, as compared to its competitors.
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Growing Percentage Of Express Scripts Prescriptions
In 2012, a total of 3.76 billion prescriptions were filled in the U.S. and Walgreen accounted for 17.4% of the sales, a marginal decline from 2011 (19.6% market share) as the dispute with Express Scripts led to a loss of a major chunk of the corresponding 90 million prescriptions for the first nine months of 2012. As a result of the dispute between the two companies, many of Walgreen’s customers switched over to its competitors.
However, Walgreen and Express Scripts entered into a fresh agreement in September 2012, which allows Express customers to fill prescriptions at Walgreen stores. Walgreen claims that the proportion of Express Scripts prescriptions returning to its stores continued to rise in Q4 2013. Prescriptions filled at comparable stores increased by 5.6% y-o-y in August.
Total prescription revenue earned by U.S. drugstores are expected to reach $350 billion by the end of 2015, growing at 5.3% annually.  We believe Walgreen is in a strong position to leverage the above trend.
Lower Negative Impact By Generic Drugs Introduction
Generic drugs are comparatively lower priced than branded drugs. The total generic dispensing rate, which implies the percentage of generic drugs in a consumer’s prescriptions filled, grew to 78.5% in 2012, from 74.1% and 71.5% in 2011 and 2010, respectively. Generic drugs had a 7.3% negative impact on Walgreen’s comparable store revenues for the first six months of fiscal 2013. New generic drug introductions in the last 12 months negatively impacted the calendar day adjusted comparable store pharmacy sales and total comparable sales by 1.3% and 0.8% in August 2013, respectively
In its earnings call last week, Walgreen’s competitor Rite Aid (NYSE: RAD) mentioned that the pace of generic drugs substitution has slowed down. The introduction of new generic drugs had a 2.49% negative impact on Rite Aid’s top line growth in Q2 2014, as compared to a 7.5% negative impact in Q2 2013. Thus, we expect the negative impact of generic drugs on Walgreen’s top line to decline in Q4 2013. In addition, higher number of prescription filled can offset the negative impact from generic introductions in the future.
Generic Drugs Will Continue To Improve Margins
Gross profit dollars are approximately 50% higher on generic drugs compared to branded drugs. New generic drugs introduction helped increase Walgreen’s gross margins by about 1.3% in the first six months of fiscal 2013. Though the pace of generic drugs substitution is expected to slow down, an estimated $15 billion worth of branded product will come off patent in the next three years, opening them to competition from generic drugs. 
With the expansion of generic drug sales in the U.S., each script will bring an incremental $5-7 in profits, allowing up to 10% growth in EBIT margins. Thus, we expect Walgreen’s EBITDA margins to continue improving over our review period.Notes:
- New Study Predicts $350 Billion U.S. Pharmacy Industry by 2015, Identifies Risks to Profitability, Pembroke Consulting, July 30, 2013 [↩]
- CVS Caremark’s CEO Discusses Q2 2013 Results – Earnings Call Transcript, Seeking Alpha, August 6, 2013 [↩]