Walgreen’s Focus On Lowering Internal Costs Will Help Improve Its Bottom Line

Walgreen (NYSE:WAG), the largest drugstore chain in the U.S. reported its biggest quarterly and fiscal year sales increases in three years on September 30th, driven by continuous growth in its daily living business and prescription volumes. While Walgreen’s top line continues to grow, it faces ongoing pressure on gross margins.

The company’s gross margins declined from 29.2% in fiscal 2013 to 28.2% in fiscal 2014. Walgreen’s adjusted gross margin declined to 27.9% in Q4 2014, as compared to 28.9% in Q4 2013. Though margins continue to grow at the front-end, the company’s pharmacy gross margin remains under pressure from: 1) higher third party reimbursement pressure; 2) increased Medicare Part D in the  business mix; 3) Walgreen’s strategy to continue driving 90-day prescriptions at retail; 4) pronounced generic drug inflation on a subset of generic drugs; and, 5)  the mix of specialty drugs.

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. In this article, we explain our rationale behind the same.

Our price estimate of $64 for Walgreens is slightly above the current price estimate.

View our analysis for Walgreens

Pronounced Generic Drug Inflation On A Subset Of Generic Drugs; Walgreen Is Working To Minimize The Impact Of Inflation

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. Generic drugs are comparatively lower priced but offer higher gross margins (approximately 50% higher) than branded drugs.

However, in the last 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. 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 (Average Wholesale Price), 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.

Declining Reimbursement Rates Can Put Pressure On Margins

The reimbursement rate by US Medicaid and Medicare Plan D, as well as health insurance providers, is expected to decline in line with the rising proportion of generic drugs. To address the mounting fiscal cliff, the U.S. government has been forced to lower medical reimbursement rates. In the budget sequester in April last year, it reduced the medicare payments to doctors, hospitals and other healthcare providers by 2%. Lower reimbursement rates impact the margins of pharmacy service providers and drug manufacturers.

Additionally, the ongoing consolidation in the Pharmacy Benefit Management (PBM) industry, like the merger of two of U.S.’s largest pharmacy benefit managers (Express Scripts and Medco Health Solutions), can increase reimbursement rate pressure over drug retailers.

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, in 2014 Walgreen completed the transition of its drug distribution into ABC and the company now supplies virtually all of Walgreen’s branded and generic medications. 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 $0.06 of adjusted EPS accretion in Q4’14. 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 $124 million and $491 for the fiscal year. For fiscal year 2015, the company’s combined synergy target stands at $650 million.

Walgreen claims that it is beginning to move beyond the cost only synergy phase from both of the partnerships, to one where it has started to share and exploit organizational capabilities to strengthen its core business.

Cost Discipline To Offset Negative Impact On Gross Margins

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 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.

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.

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