Walgreens Q3 Earnings Preview: Cost Reductions And Acquisition Synergies Likely Boosted Margins

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Walgreen

Walgreens (NASDAQ:WBA), the second largest pharmacy chain in the U.S., is expected to release its earnings for the final quarter and fiscal year ending August on October 28th. This will be the company’s first full-year earnings release after the completion of its acquisition of Alliance Boots, a European health and beauty retailer.

Post the Alliance Boots acquisition, the pharmacy giant has shifted gears from an M&A driven expansion mode to an optimization mode, where the focus is on increasing operating efficiencies and cost-cutting. The company is looking to generate cost savings in multiple ways including better inventory management, store closures and IT optimization. While some margin improvement was already seen in the previous quarter (ending May), we believe the savings generated during the August-ending quarter were much larger. This likely resulted in an expansion in the company’s EBITDA margins and hence a higher earnings per share in Q3.

Below, we discuss a few company-specific factors as well as industry trends that form the basis of our positive expectations for Walgreens’ earnings.

View our analysis for Walgreens

Lower Drug Acquisition Costs After Alliance Boots Acquisition

Lower drug acquisition costs is one of the primary benefits arising from the Alliance Boots acquisition for Walgreens. With the acquisition, the number of drugstores owned by the company went up from about 8,000 drugstores in the U.S. to more than 13,000 stores across 11 countries. This gave Walgreens immense bargaining power with drug manufacturers, which in turn led to lower drug acquisition costs (on a per unit basis) and higher gross margins.

In the first three quarters this fiscal, net synergies realized amounted to about $500 million, most of them coming from drug procurement activities [1]. While the company is on track to achieving the target of at least $650 million in net synergies this fiscal, it expects another $1 billion in quantifiable synergies in fiscal 2016.

Slowing Generic Inflation

Meanwhile, price inflation of generic drugs, which has been a major headwind for pharmacy chains, seems to have slowed in the last few quarters. According to a study conducted by The Drug Channels Institute [2], more than 70% drugs in their sample had increases of less than 10% in Q2 of this year (calendar), compared to fewer than 50% drugs in Q2 2014. While half of the sampled generic drugs increased in cost, the average increase was a mere 2.6% this year (Q2 2015) versus 25.7% in the same period a year ago. The slower price inflation is likely to have provided some relief on the gross margin front for Walgreens and pharmacy retailers in general.

EBITDA Margin Expansion Due To Lower Operating Costs

In August 2014, Walgreens announced a three-year $1 billion cost-reduction initiative which included a plan to close about 200 stores across the U.S. A large share of the planned store closures, between 70 and 80 stores, was scheduled for the August-ending quarter resulting in significant reductions in operating costs. On the other hand, the company’s investments in setting up retail clinics within its existing stores likely offset the cost reduction to some extent. Nevertheless, we believe the cost reductions were far higher than the increases and led to net expansion in EBITDA margins.

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Notes:
  1. Seeking Alpha Earnings Transcript, Walgreens Q3 2015 Results []
  2. Drug Channels Institute []