Walgreen Reports Strong Topline Growth But Pharmacy Margin Pressure Remains

The largest drugstore chain in the U.S., Walgreen (NYSE:WAG) reported its Q4 2014 earnings on September 30. With net sales of $19.1 billion in Q4 2014 (a 6.2% annual increase), Walgreen continued to see growth in its daily living business and prescription volumes, which resulted in the largest quarterly and fiscal year sales increases in three years.

As pointed out by us in our pre-earnings article, the gross margin remained under pressure, due to an anticipated decline in reimbursement rates and lower profitability from generic drugs. Though Walgreen reported a net loss 0f $0.25 per share, its adjusted earnings per diluted share ($0.74) came in 1.4% higher compared to Q4 2013. GAAP results were negatively impacted by $0.90 per diluted share non-cash loss related to the amendment and exercise of Walgreen’s Alliance Boots call option, which had no immediate tax benefit. Overall, the earnings were in-line with market expectations, while revenue slightly beat the market consensus.   For the 39th consecutive year, Walgreen increased its dividend, this time by 7.1% to $0.3375 per share.

While Walgreen remains confident of seeing a continuing growth in its top line, it believes that the margin pressure will persist in the short-term. A cautious consumer, ongoing reimbursement pressure, generic drug inflation and significant step-downs from Med D reimbursement rates, are some of the factors that will act as headwinds in fiscal 2015. Nevertheless, Walgreen believes that it is well-positioned to capitalize on the industry tailwinds, which include an aging population,  growth in chronic conditions, the consumerization of healthcare, continuing increases new generics and growing demand for a personalized experience.

Our price estimate of $64 for Walgreens is slightly above the current price estimate. We are in the process of updating our earnings for the recent earnings release.

View our analysis for Walgreens

Walgreen Gains Share In The Retail Pharmacy Market

Walgreen revealed in its Q4 2014 earning call that its retail pharmacy market share grew 30 basis points (to 19%) in fiscal 2014, as it filled a record 856 million prescriptions. It filled 211 million prescriptions in Q4 2014, 4.2% higher compared to the same period last year. According to IMS, Walgreen grew script 60 basis points faster than the retail industry in Q4 2014. ^[1] It expects to continue to increase its pharmacy volume and share with high-value customers through growth in Med D, its enterprise specialty business and immunizations.

Since 2013, Walgreen claims that its prescription share with Med Part D seniors has grown more than twice as fast as the overall retail prescription share. On an average, Med D seniors fill three time more prescriptions compared to the company’s non-Med D customers. Walgreen is confident of increasing its share further in subsequent quarters, driven by a continued focus on winning high value seniors through preferred relationships with Medicare Part D plans.

Walgreen also intends to increase it share in the  specialty market by improving and integrating care for patients with complex chronic disease states. As of August 2014 end, it had access to over 100 limited distribution drugs by manufacturers, which the company believes symbolizes the manufacturers desire to work with Walgreen’s unique specialty network of health system pharmacies, its complex therapy pharmacies and fusion pharmacies and its specialty  retail offering.

A new report released by CVS Health (NYSE:CVS) in November 2013 projects that specialty drug spending will more than quadruple by 2020, crossing $400 billion a year. Expanding its presence in the specialty sector will help increase Walgreen’s share in the overall pharmacy market, in our view.

Unfavorable Industry Trends Continue To Put Pressure On Pharmacy Gross Margins

Walgreen’s adjusted gross margin declined to 27.9% in Q4 2014, as compared to 28.9% in Q4 2013. While margins continued to grow at the front-end, its pharmacy gross margins were pressured by: 1) higher third party reimbursement pressure; 2) increased Medicare Part D in the  business mix (including Walgreen’s strategy to continue driving 90-day prescriptions at retail); 3) pronounced generic drug inflation on a subset of generic drugs; and, 4)  the mix of specialty drugs. The increased rate of introductions of new generics in Q4 2014 and purchasing synergies in the pharmacy did offset the decline in pharmacy gross margin to some extent.

Walgreen claims that, in the last year, 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. The average inflation in its basket of generic drugs is mid-single digit as measured on a comparable drug priced basis. Walgreen believes that generic drugs inflation will continue to negatively impact gross margins in the near term.

Walgreen is working to minimize the impact of inflation by tracking the movement of AWP, working with market participants to help them understand the importance of appropriate AWP adjustments to represent changes in actual drug costs, evolving its payer contracts to reflect the realities of an inflationary versus a deflationary market, and working through its joint venture with AmerisourceBergen (ABC) to secure better costs.

Walgreen expects to achieve $1 billion in cost reductions over three years by incorporating savings at the corporate field and store levels. It has put headquarters and non-labor spending reductions into immediate effect and continues to work toward greater efficiencies in its processes through Walgreens lien Six Sigma. It expects to begin realizing incremental cost benefits in fiscal 2015.

Fiscal 2015 Outlook

– Capex of $1.7 billion.

– Adjusted tax rate between 29% to 30%.

– Share count of approximately $1.1 billion.

View Interactive Institutional Research (Powered by Trefis):
Global Large Cap | U.S. Mid & Small Cap | European Large & Mid Cap
More Trefis Research

1. Walgreen’s (WAG) CEO Greg Wasson on Q4 2014 Results – Earnings Call Transcript, Seeking Alpha, September 30, 2014 [↩]