Walgreen To Start Fiscal 2014 On a Strong Note

Walgreen (NYSE:WAG), the largest drugstore chain in the U.S., will announce its Q1 2014 earnings on December 20. The company closed its fiscal 2013 with $72.2 billion in sales, a 0.8% annual increase, and witnessed a 13.7% rise in its operating income. (Fiscal years end with August.)  Its revenue base declined in fiscal 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, following the dispute resolution between the two companies in September 2012, Walgreen has seen its growth accelerate in subsequent months.

Earlier this month, Walgreen reported  $18.35 billion in sales for Q1 2014, 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.

The four key focus areas for Walgreen are: 1) improving customer value; 2) providing innovative products and services; 3) developing a systematic globalized offering; and, 4) designing the most relevant network and formats . As of November end, the company operated 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 Walgreen 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. We will update our valuation after the Q1 2014 earnings release.

View our analysis for Walgreen

Lower Generic Substitution To Ease 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)

Regaining Market Share In Prescriptions Filled

On account of its dispute with Express Scripts, Walgreen’s market share in total prescription filled in the U.S. declined from 19.6% in 2011 to 17.4% in 2012 (calendar year). However, the company claims that it filled a record 821 million retail prescriptions in fiscal 2013, which translates into a 19.1% market share. The dispute resolution with Express Scripts and introduction of new programs helped the company regain its lost market share in fiscal 2013.

Recently, Walgreen and Express Deals launched a new prescription drug program called Smart90 Walgreens. Smart90 Walgreens is a 90-day prescription drug program which offers plan members convenient access to in-person pharmacist consultations and a wide range of health and wellness services that can improve medication adherence and lower overall healthcare costs. It provides customers the option to receive their maintenance medications through Walgreen’s retail pharmacy or Express Scripts home delivery service.

In addition to the returning Express Scripts prescriptions, Walgreen believes that its preferred relationship with top Medicare Part D plans will help it improve market share with older Americans, a customer segment that is expected to rise in the future. The U.S. Census Bureau projects that within the next two decades, the proportion of total population over 65 years will increase from 13% to 19%, whereas those between 20 years and 65 years of age will decline from 60% to 55%. In its last earnings call, Walgreen declared that its Medicare Part D share grew by 1.2% in fiscal 2013. ^[1]

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1. Wagreen Company Q4 2013 Earnings Call Transcript, Morning Star, October 1, 2013 [↩]