Growing Generic Drug Sales Offers Hope of Higher Margins for Walgreen

Walgreen (NYSE:WAG), the largest drugstore chain in the U.S., reported its sales figure for the month of November and Q1 2014, ending November 30. The company’s revenue base had declined in fiscal 2012 as its dispute with the pharmacy benefits management company Express Scripts led to a significant loss in the number of Express Scripts’ prescriptions filled at Walgreen stores. However, following the dispute resolution between the two companies in September 2012, Walgreen has seen its growth accelerate in subsequent months. It closed its fiscal 2013 on August 31 with $72.2 billion in sales, a 0.8% annual increase, and the growth momentum continued in September, October and November.

Quick Snap Shot Of November’13 & Q1 2014 Sales

November – Walgreen reported a 4.1% annual growth in total sales ($6.07 billion) and a 3.2% increase in comparable store sales for the month of November. Pharmacy sales, which accounted for 63.5% of the total sales, climbed by 4.7% while prescriptions filled at comparable stores increased by 1.4% annually. Total front-end sales and comparable store front-end sales increased by 3.2% and 1.9%, respectively. A meaningful increase in Walgreen’s promotional investment in the last few months contributed to a 0.8% rise in customer traffic in comparable stores.

Q1 2014 – Walgreen ended Q1 2014 with $18.35 billion in sales, a 6% increase compared to Q1 2013. Its comparable store sales climbed by 5.5% while the front-end comparable store sales grew by 2.2% annually. Prescriptions filled at comparable stores and comparable pharmacy sales increased by 5.6% and 7.5%, respectively.

Year-to-date, Walgreen sales ($66.54 billion) are up 4.3% compared to the same period last year. As of November end, the company operates 8,677 stores across 50 states in the U.S., the District of Columbia, Puerto Rico, Guam and the U.S. Virgin Islands. A large footprint places the company in a strong position to benefit, both from an aging U.S. population and from the Affordable Care Act expanding insurance to millions of Americans.

Our price estimate of $50 for Walgreen is at a 10% discount to the current market price of $57.

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Lower Generic Substitution Eases Pressure Off Walgreen’s Top Line

Since generic drugs are comparatively lower priced than branded drugs, a rising generic dispensing rate puts pressure on Walgreen’s top line growth. The total generic dispensing rate, which factors the percentage of generic drugs in a consumer’s prescription, grew to 78.5% in 2012, from 74.1% and 71.5% in 2011 and 2010, respectively. Generic drugs continued to replace branded drugs in 2013, albeit at a slower pace.

Generic drug substitution in the last 12 months had a 0.6% negative impact on Walgreen’s comparable store sales, compared to a 2% and 9% negative impact on comparable prescription sales in Q4 2013 and Q1 2013 respectively. Walgreen anticipates a low rate of introduction of new generics in the first half of fiscal 2014, which should further lower the pressure of generic drugs on its top line.

Nevertheless, an estimated $15 billion worth of branded product will come off patent in the next three years, opening them to competition from generic drugs. Thus, we expect generics to continue to offset Walgreen’s top line growth in the future as well, albeit at a slower pace.

Generic drugs offer approximately 50% higher gross profit dollars compared to branded drugs. With the expansion of generic drug sales in the U.S. (even if the pace is expected to slow down), each script will bring an incremental $5-7 in profits, allowing up to 10% growth in EBIT margins. (Read: Walgreen’s Bottom Line Will Continue To Grow)

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