Walgreen (NYSE:WAG), the largest drugstore chain in the U.S., reported another quarter of strong sales ($19.4 billion) with a 5.9% annual growth in earnings in Q3 2014. (Fiscal years end with August.) It started its fiscal 2014 on a strong note and has retained its growth momentum so far this year. Higher daily living sales, strong performance in prescriptions filled and increasing pharmacy market share have all helped the company see a continuous improvement in its top-line growth. The addition of new Medicare Part D customers, increasing 90-day retail scripts, and the return of Express Scripts customers, are all contributing to Walgreen’s strong business fundamentals.
Though Walgreen’s gross margin declined by 50 basis point (discussed in detail below), from 28.5% in Q3 2013 to 28% in Q3 2014, its net income expanded by 22.4% annually as it benefited from a lower effective tax rate, favorable audit settlements, certain nondeductible expenses last year and other discrete events. GAAP earnings per diluted share were $0.75 in Q3 2014 compared to $0.65 in Q3 2013.
Walgreen believes that a focus on its three strategic growth drivers — i.e., creating a Well Experience, advancing the role of the community pharmacy and establishing an efficient global platform — will help it become a leading global pharmacy. Its customer delight score increased 230 basis points in Q3 2014 and is at an all-time high for the company.
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A large footprint places the company in a strong position to benefit, both from an aging U.S. population and the Affordable Care Act’s expansion of insurance to millions of Americans. As of May 2014, it operated 8,683 locations across 50 states in the U.S., the District of Columbia, Puerto Rico, Guam and the U.S. Virgin Islands. Though recent trends have put pressure on margins, we believe that Walgreen’s constant focus on lowering its internal costs will help improve its bottom-line in the long-run.
Our price estimate of $64 for Walgreens is at an approximate 10% discount to the current market price. We are in the process of updating our valuation.
Higher Generic Substitution To Ease Pressure Off Margins
Walgreen’s front-end gross margin improved in Q3 2014 (annually), benefiting from an improved product mix and promotional adjustments. However, the company witnessed a decline in its pharmacy margin in the quarter mainly on account of increased third-party reimbursement pressure (particularly due to a few contract step downs), higher 90-day prescriptions at retail, fewer generic drug introductions and a larger than expected generic drug inflation. Of all the factors, the company believes that the generic drug inflation had the most adverse impact on pharmacy gross margin.
In the last few years, the U.S. market for medicines has shifted more towards generic drugs as a significant number of patents expired for major brand names. 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 drugs are comparatively lower priced but offer higher gross margins (approximately 50% higher) than branded drugs. Thus, though the higher generic substitution put pressure on Walgreen’s top-line growth, it benefited its bottom line. However, in the last one year, Walgreen claims that the market has shifted from historical patterns of deflation in generic drug costs into inflation, a trend that is negatively impacting margins. The company has witnessed higher costs for a subset of generic drugs and in some cases these increase have been significant.
Walgreen anticipates the rate of decline in new generics introductions to moderate going forward and turn positive towards the end of the year. An estimated $15 billion worth of branded products will come off patent in the next three years, opening them to competition from generic drugs.  The company expects the higher rate of generic drug introductions to improve margin in the latter part of the year. It also expects front-end margin to continue to improve over the long-term.
Walgreen is focused on driving cost discipline across the company to offset the negative impact on gross margin. Apart from its ongoing store optimization efforts (shutting down the unprofitable stores), it is identifying additional opportunities to lower its expenses. A key member of Walgreen’s executive team has been appointed to focus on increasing efficiencies and providing high quality and cost effective pharmacy services that reduce total pharmacy costs. Additionally, Walgreen’s expects the completion of the strategic transaction with Alliance Boots to drive sustainable efficiencies and value for the combined enterprise, offsetting the increase in drug pricing.
Positive Synergies From New Partnerships Will Improve 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 $0.15 per share to its Q3’14 earnings, above its forecast of $0.13 to $0.14 per share. Both pharmacy and front-end margins benefited from purchasing synergies from Walgreen’s joint venture with Alliance Boots. Combined net synergies for the quarter totaled $131 million and for the first three quarters of the year totaled $367 million. Walgreen has raised its estimate of combined synergies for the year to $400 million to $450 million, compared to its initial estimate of $375 million to $425 million.
Early last year, AmerisourceBergen (ABC) entered into a 10-year agreement with Walgreen and Alliance Boots, which allows Walgreen to jointly source generic drugs and generate logistical efficiencies. The distribution contract initially included branded pharmaceutical products that Walgreens historically sourced from distributors and suppliers. However, starting 2014, ABC was supposed to increasingly assume the distribution of the generic products that Walgreens has historically self-distributed. Post the ABC deal, the Walgreens-ABC combined generic purchasing power is estimated to be the highest, at around $12 billion. By combining its distribution in the United States and Europe with ABC, Walgreens will be able to negotiate better prices for generic as well as branded drugs.
Walgreen claims that it is beginning to move beyond the cost only synergy phase from both the partnerships, to one where it has started to share and exploit organizational capabilities to strengthen its core business.Notes:
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