Walgreen (NYSE:WAG), the largest drugstore chain in the U.S., started its fiscal 2014 with a 68% year-over-year increase in its net income, as it benefited from its investments in not only the European health and beauty retailer Alliance Boots, but the U.S. pharmaceutical wholesaler AmerisourceBergen Corp (ABC) as well. Despite a soft macro environment, Walgreen reported $18.35 billion in sales for Q1 2014, a 6% increase compared to Q1 2013. Its comparable store sales climbed by 5.5% while the front-end comparable store sales grew by 2.2% annually. Prescriptions filled at comparable stores and comparable pharmacy sales increased by 5.6% and 7.5% year-over-year, respectively.
A slowdown in the introduction of higher-profit generic drugs, combined with an increase in promotional costs, lowered Walgreen’s gross margins by 1.3% in Q1 2014. The company expects the high promotional spending to negatively impact its margins in the current quarter as well, by a similar degree.
Nevertheless, Walgreen continues to believe that it is well positioned for future growth as it transitions from being a traditional pharmacy to a company participating more broadly in areas like specialty, home infusion, workplace health, vaccinations, diagnostic lab, hospital partnerships and primary care. As of November end, Walgreen operated 8,677 stores across 50 states in the U.S., the District of Columbia, Puerto Rico, Guam and the U.S. Virgin Islands. A large footprint places Walgreen in a strong position to benefit, both from an aging U.S. population and from the Affordable Care Act expansion of insurance to millions of Americans.
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Our price estimate of $50 for Walgreen is at an approximate 15% discount to the current market price of $59. We are in the process of updating our valuation.
Lower Generic Substitution & Higher Promotions Put Pressure On Margins
While Walgreen continued to face the pressure of declining reimbursement rates in Q1 2014, the slower rate of generic introductions in the quarter was the most significant factor affecting its pharmacy margin. Generic drugs are comparatively lower priced but offer higher gross margins (approximately 50% higher) than branded drugs, a trend that has benefited the bottom line of Walgreen (among other pharmacies) in the last several quarters.
The total generic dispensing rate, which factors the percentage of generic drugs in a consumer’s prescription, grew to 78.5% in 2012, from 74.1% and 71.5% in 2011 and 2010, respectively. Generic drugs increased Walgreen gross margins by about 1.3% in the first six months of fiscal 2013.
Generic drugs continued to replace branded drugs in 2013, albeit at a slower pace. The generic wave peaked in Q1 2013 and hit a trough in Q1 2014. Generic drug substitution has a 0.09% negative impact on comparable store sales in Q1 2014, compared to a 9% negative impact in Q1 2013. Walgreen anticipates a low rate of introduction of new generics in the first half of fiscal 2014 but expects the effect of the generic trough to moderate in the back half of the year.
Nevertheless, an estimated $15 billion worth of branded products will come off patent in the next three years, opening them to competition from generic drugs.  With the expansion of generic drug sales in the U.S., each script will bring an incremental $5-7 in profits, allowing up to 10% growth in EBIT margins.
Along with the pharmacy margins, Walgreen witnessed a decline in its front-end margins on account of its increased promotional investment. However, the higher promotional activity resulted in a sequential increase in traffic by 2.1%. Walgreen claims that its front-end margin will continue to be impacted by its promotional adjustments in the current quarter. However, the company is focusing on controlling its operating costs to keep margins under control.
Walgreen Regains Its Pharmacy Market Share
Walgreen filled a record 213 million prescription in Q1 2014 and increased its pharmacy market share by 0.5%, to 19.4%. It claims to have exceeded the industry prescription growth rate by 2.9% in the quarter. On account of its dispute with Express Scripts, Walgreen’s market share in total prescription filled in the U.S. declined from 19.6% in 2011 to 17.4% in 2012 (calendar year). However, the dispute resolution with Express Scripts in September 2012 and introduction of new programs helped Walgreen regain its lost market share in subsequent quarters.
Walgreen believes that the increasing market share reflects the fundamentals of its underlying business, the return of Express Scripts customers and its continued progress in winning new Medicare Part D customers. In 2013, Walgreen’s share in Medicare Part D outpaced the industry and the company believes that it is well-positioned to improve its performance this year.
The high demand for flu shots fueled Walgreen’s pharmacy and wellness business. The company administered 1.1 million more flu shots in Q1 2014 compared to last year, bringing the total for the season to-date to 6.4 million. Though the flu incidence this year is running 5% to 10% below last year, Walgreen is confident of leveraging its success with flu shots to drive its non-flu vaccine programs.
New Partnerships To Help Expand Global Operations
Aiming to become a leading global pharmacy Walgreen is pursuing new market opportunities, expanding its brand portfolio and optimizing its global supply chain.
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. It achieved $154 million in combined net synergies with Alliance Boots in fiscal 2013 and estimates combined synergies in the range of $300 – $400 million for fiscal 2014. In Q1 2014, the partnership with Alliance Boots contributed $0.14 per diluted share to Walgreen’s adjusted results, which included a $0.07 one-time tax benefit due to lowering of corporate taxes in the UK.
Walgreen has also entered into a 10-year agreement with AmerisourceBergen (ABC) to jointly source generic drugs and generate logistical efficiencies. ABC provides drug distribution and related services designed to reduce costs and improve patient outcomes. By combining its distribution in the United States and Europe with ABC, Walgreen will be able to negotiate better prices for generic as well as branded drugs. Walgreen expects to realize the full benefits of lower distribution costs by fiscal 2015.
This year Walgreen also launched a joint venture in Berne, Switzerland and achieved $154 million in combined net synergies for fiscal year 2013.
By 2016, Walgreen aims to achieve the following four goals – 1) sales of $130 billion including Alliance Boots share, associates and joint venture sales; 2) synergies of $1 billion; 3) operating cash flow of $8 billion and 4) net debt of $11 billion. As per its performance to-date, the company claims to be slightly ahead of its expectations.
Q2 2014 Outlook
– Interest expense of $40 million.
– Tax rate of 37.5%, excluding the various impacts associated with the Alliance Boots partnership.
– Adjusted EPS accretion from Alliance Boots to be $0.07 to $0.08 per share.
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