Walgreen (NYSE:WAG), the largest drugstore chain in the U.S., is set to announce its Q2 2014 earnings on March 25. The company witnessed a 5.2% annual growth in its Q2 2014 sales ($19.61 billion). Its comparable store sales, prescriptions filled at comparable stores and comparable pharmacy sales increased by 4.5%, 2.4% and 6.1% respectively. The front-end comparable store sales, which grew by 2% year over year, was negatively impacted by the severe winter weather by 0.8%.
Walgreen’s dispute with pharmacy benefits management company Express Scripts led to a significant loss in the number of Express Scripts’ prescriptions filled at Walgreen stores, impacting its revenue growth in the last two years. However, following the dispute resolution between the two companies in September 2012, Walgreen has seen its growth accelerate in subsequent months.
Despite a soft macro environment, Walgreen 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.
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As of February end, Walgreen operated 8,681 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 the company 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.
Our price estimate of $63 for Walgreen is at a slight discount to the current market price. We will update our valuation after the Q2 2014 earnings release.
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.
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.
Last 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.
High Promotional Spending & Lower Generic Substituion To Impact Margins
The slower rate of generic substitution and high promotional spending are two key factors impacting Walgreen’s margins. 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 percentage points in Q1 2014.
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. 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.
While the high promotional investment has resulted in a sequential increase in traffic, the same negatively impacts Walgreen’s front-end margin. The higher promotional activity resulted in a sequential increase in traffic by 2.1% but lowered its front-end margins in Q1 2014. Walgreen expects the high promotional spending to negatively impact its margins in Q2 2014 as well.