Two Key Executives Leave Walgreen Due To a $1 Billion Forecasting Error

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A $1 billion forecasting error in Walgreen’s (NYSE:WAG) Medicare-related business cost the company’s two top executives (the CFO and the president of its pharmacy, health and wellness division ) their jobs. Walgreen’s CFO estimated $8.5 billion in pharmacy unit earnings for the year ending 2016 at the board meeting in April this year. (Fiscal years end with August.)  However, the estimate was lowered by $1.1 billion last month as the company had not factored in an increase in the price of some generic drugs that it sells as part of its annual contracts under Medicare. The extent of price degradation built into contracts was not fully understood or factored into forecasts.  Walgreen gets 25% to 30% of its prescriptions from Medicare Part D plans, which subsidizes the cost of prescription drugs and prescription drug insurance premiums for Medicare benefits in the United States. The company has appointed Kraft Foods’ former CFO, Timothy McLevish, as its new CFO. ((Walgreen’s CFO’s departure due to $1 billion forecasting error: WSJ, Reuters, August 20, 2014))

In its Q3 2014 earnings, Walgreen highlighted that the the market has shifted from historical patterns of deflation in generic drug costs into inflation in the last one year, a trend that is 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 witnessed a decline in its pharmacy margin last 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.

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.

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Additionally, Walgreen expects the rate of decline in new generics introductions to moderate going forward and turn positive towards the end of the year. A higher rate of generic drug introductions can improve margin in the latter part of the year. (Read: Walgreen Sustains Its Top-Line Growth But Reports Lower Gross Margin)

View our analysis for Walgreens

Our price estimate of $64 for Walgreens is marginally higher than the current market price.

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