Walgreens Earnings Loom: Cost-cutting Measures and Favorable Sales Mix Likely Improved Margins
Walgreens (NASDAQ:WBA) is scheduled to report its Q3 2015 results on Thursday, July 9th. In the previous quarter, a strong flu season and continued growth in Medicare Part D scripts helped the company achieve healthy top line growth [1]. On the other hand, margins continued to remain subdued due to pressures seen across the industry such as low reimbursement rates and drug price inflation.
This quarter, we expect the numbers to be a bit out of the ordinary, given the slew of initiatives the company announced during its analyst meeting, shortly after the Q2 earnings release. Out of the many initiatives, we will focus in this article on the ones that we believe will impact the company’s financials immediately. We expect to see improvements in Walgreens’ operating margin, primarily due to cost reductions as well as favorable shifts in the sales mix (i.e. towards higher margin products). However, the benefits that will be realized can only be quantified based on what the management discloses about the progress made on these initiatives during the earnings release this week. Below, we discuss some of these initiatives in more detail and how they will translate into the above mentioned benefits.
Our current price estimate for Walgreens stands at $70, which is at a discount of about 20% to the market price.
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View our analysis for Walgreens
Store Closures And Other Optimizations Will Help Reduce SG&A Expenditure
Walgreens plans to close approximately 200 stores across the US to reorganize corporate and field operations, so as to drive operating efficiencies. It also expects to generate some savings by streamlining information technology and other functions. While store closure could potentially result in loss of sales generated from those stores, a recent study by the company indicated that it will be able to retain a sizeable share of customers, and therefore will not have any significant impact on the top line. This comes at a time when its competitor, CVS Health (NYSE:CVS) expanded its store count by more than 1,600 stores to become the largest drugstore chain in the US.
These opportunities for cost savings, primarily in the company’s Retail Pharmacy USA division, are expected to amount to about $500 million, which will be realized by the year 2017. This will take the company’s total cost-savings to a projected $1.5 billion by the end of fiscal 2017 (Walgreens, earlier in 2014, announced a three-year $1 billion cost-reduction initiative).
Focus on Beauty Products Will Improve Margins
In fiscal 2014, Walgreens earned about two-thirds of its US revenue from pharmacy sales and the remaining third from retail sales, which includes health and beauty products. The mix is quite the opposite when it comes to Walgreens’ international sales (i.e. Alliance Boots). In the first two months of 2015, only 38% of the company’s international sales were from pharmacy, with the remaining 68% from retail.
During the recent analyst meeting, the company indicated that it aims to transform Walgreens into a beauty destination and not just be a chain drugstore (which means a shift towards the latter mix). This doesn’t come as a surprise, as margins on pharmacy sales have been under pressure for years now and will continue to be so, given the government’s efforts to reduce healthcare expenditure. Under these circumstances, focus on retail sales would be a welcome move as it will help improve the overall margins.
As a part of this initiative, the company is experimenting with store formats and various forms of space utilization to see if they can organize stores more efficiently to improve the customer experience. In a recent trial, Walgreens organized some of its stores to give more space to core health and beauty categories, which saw positive results. The company is also trying new promotional strategies in some of the strongest categories: beauty, personal care, gifting, and health and wellness, and they’ve seen good results so far in the trials in Phoenix and the Philadelphia markets.
While these are some of the steps that Walgreens has taken to improve retail product margin, it will continue to test new ideas and subsequently implement proven changes across the chain.
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