Walgreen’s Q4’14 Earnings Preview: Top Line To Grow But Gross Margin Remains Under Pressure

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The largest drugstore chain in the U.S., Walgreen (NYSE:WAG) is set to report its Q4 2014 earnings on September 30. Higher daily living sales, strong performance in prescriptions filled, and increasing pharmacy market share have all helped Walgreen post continuous improvement in its top line growth. The company reported a 6.2% annual increase in its Q4 2014 total sales ($19.06 billion) last month. Its comparable store sales and front-end comparable store sales grew 5.6% and 1.3%, respectively.

While Walgreen’s top line continues to grow, it faces ongoing pressure on gross margins. The company’s gross margin declined by 50 basis point (to 28.0%) in Q3 2014. It expets its Q4 2014 gross margins to decline by a similar percentage year to year as that witnessed in Q3 2014. 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 almost in line with the current market price. We will update our valuation after the Q4 2014 earnings release.

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View our analysis for Walgreens

Industry Trends Put Pressure On Gross Margins

In its latest earnings call (reported on September 18), Rite Aid (NYSE: RAD) lowered its fiscal 2015 guidance due to an anticipated decline in reimbursement rates and lower profitability from generic drugs in the second half of the fiscal year. Based on the current estimates for reimbursement rates, anticipated lower profitability due to a delay in the introduction of a generic equivalent to Nexium and higher costs for generic drugs that recently lost their exclusivity, Rite Aid expects the pharmacy gross margin in the second half of fiscal 2015 to decline compared to the same period last year. Since the above factors are industry specific, we expect the same to put pressure on Walgreen’s gross profit margin as well. (Read: Rite Aid Falls Despite A Strong Q2’15 As It Lowers Its 2015 Guidance)

In its Q3 2014 earning call, Walgreen admitted that it is seeing ongoing gross profit margin pressures, which are resulting from higher generic drug sales, reimbursement rate pressure and a shift in pharmacy mix toward 90-day prescription refills. 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 the increase has been significant.

In addition to the above factors, the absence of net gains from a certain litigation matter in Q4 2014 will also impact gross margin growth (annual) in the quarter.

Positive Synergies From New Partnerships Will Improve Bottom Line

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 in the industry, 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.

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.

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.

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