Walgreen’s (NYSE:WAG) dispute with pharmacy benefits management company Express Scripts led to a significant loss in the number of Express Scripts’ prescriptions filled at Walgreen stores, impacting its revenue growth in the last two years. However, Walgreen has seen its growth accelerate since the dispute resolution between the two companies in September 2012. Despite continued headwinds from slower generic introduction and severe weather conditions, Walgreen reported a 5.1% year-over-year growth in its Q2 2014 earnings, primarily driven by a 4.3% increase in comparable store sales. Its comparable prescription sales and comparable front-end sales grew by 5.8% and 2% year over year, respectively.
Walgreen’s strong performance in Q2 2014, despite the tough cough cold flu compare, can be attributed to its strong fundamentals, the return of Express Scripts customers and the company’s ongoing progress in winning new Medicare Part D customers. The company believes that focus on its three strategic growth drivers — i.e., creating a Well Experience, advancing the role of community pharmacy and establishing an efficient global platform — helps it become a leading global pharmacy.
As of February end, Walgreen operated 8,681 stores across 50 states in the U.S., the District of Columbia, Puerto Rico, Guam and the U.S. Virgin Islands. It plans to open around 55 to 75 stores in fiscal 2014. 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 expansion of insurance to millions of Americans.
Our price estimate of $63 for Walgreen is at a slight discount to the current market price. We are in the process of updating our valuation.
Wellness Format Stores Spurs Growth
In 2011, Walgreen introduced its Well Experience store format, which offers an enhanced layout, new products selection, a completely revamped pharmacy and health care experience. Through the active interaction of team members and a new Health Guide role, Walgreen aims to enhance the overall customer experience at its stores.
Walgreen claims to have made significant progress on this initiative and operated the new format at a total of 628 Wellness stores by the end of February 2014. The company continues to refine its store format to integrate healthcare, provide an elevated beauty experience and deliver seasonal and consumable convenience to meet customers’ needs.
Walgreen filled a total of 214 million prescriptions (2.8% year over year growth) and its retail pharmacy market share increased by 20 basis points (to 19%) in Q2 2014.  Its Balance reward program hit a milestone, reaching 100 million enrolls in Q2 2014. With approximately 80 million active members, Walgreen has the largest retail loyalty program in the industry. The company plans to leverage the customer insights from its reward program to further evolve its value preposition and enhance customer experience.
Positive Synergies From New Partnerships Improves Bottom Line
In August 2012, Walgreen completed an initial 45% investment in Alliance Boots, the largest European pharmacy-led drug retailer, with an aim to create a global pharmacy by expanding its operation in new markets including Europe, China, Latin America, etc. Walgreen’s partnership with Alliance Boots contributed $0.08 per diluted share to its adjusted Q2’14 earnings. Walgreen achieved $236 million in combined net synergies with Alliance Boots in the first half of fiscal 2014, as compared to $154 million in fiscal 2013.
With a purchase of 10.5 million shares of AmerisourceBergen (ABC) in February 2014, Walgreen now holds a 4.5% stake in the company. Walgreen has entered into a 10-year agreement with AmerisourceBergen (ABC) to jointly source generic drugs and generate logistical efficiencies. ABC provides drug distribution and related services designed to reduce costs and improve patient outcomes. By combining its distribution in the United States and Europe with ABC, Walgreen will be able to negotiate better prices for generic as well as branded drugs. Having successfully transitioned its branded drugs to ABC last fall, Walgreen started its generic transition in January this year. Walgreen expects to realize the full benefits of lower distribution costs by fiscal 2015.
Walgreen claims to be slightly ahead of its 2016 goals. These are: 1) sales of $130 billion including Alliance Boots share, associates and joint venture sales; 2) synergies of $1 billion; 3) operating cash flow of $8 billion and 4) net debt of $11 billion.
Generic Substitution To Increase Towards The End Of 2014, Improving Margins
Walgreen’s gross profits declined to 28.8% in Q2 2014, compared to 30.1% in Q2 2013. While Walgreen continued to face the pressure of declining reimbursement rates in the quarter, the slower rate of generic introductions and increased promotional investment were the key factors impacting margins in Q2 2014.
Generic drugs are comparatively lower priced but offer higher gross margins (approximately 50% higher) than branded drugs, a trend that has benefited the bottom line of Walgreen (among other pharmacies) in the last several quarters.
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. The generic wave peaked in Q1 2013 and hit a trough in Q1 2014. Generic drug substitution has a 1.3% negative impact on comparable prescription sales in Q2 2014, compared to a 6% negative impact in Q2 2013.
Walgreen anticipates the rate of decline in new generics introduction to moderate in the current quarter and turn positive towards the end of the year. Despite the slow substitution, an estimated $15 billion worth of branded products will come off patent in the next three years, opening them to competition from generic drugs. 
While the high promotional investment has resulted in a sequential increase in traffic and consequently Walgreen’s front-end sales, the same negatively impacts its margin. Walgreen expects the high promotional spending to negatively impact margins in the current quarter as well. However, the company believes that its on-going cost discipline will help balance out the pressure on its gross profit dollar growth. Despite the strong top-line growth in Q2 2014, Walgreen’s SG&A dollars increased by only 1.7% compared to the same period last year.
- Walgreen’s CEO Discusses Q2 2014 Results – Earnings Call Transcript, Seeking Alpha, March 25, 2014 [↩]
- CVS Caremark’s CEO Discusses Q2 2013 Results – Earnings Call Transcript, Seeking Alpha, August 6, 2013 [↩]