INTRODUCTION

Walgreens is principally a retail drugstore chain that sells prescription and non-prescription drugs and general merchandise. General merchandise includes, among other things, beauty care, personal care, household items, candy, photofinishing, greeting cards, convenience foods and seasonal items. Customers can have prescriptions filled in retail pharmacies, as well as through the mail, by telephone and via the Internet. As of May 31, 2009, we operated 7,361 locations in 49 states, the District of Columbia, Guam and Puerto Rico. Total locations do not include 343 convenient care clinics operated by Take Care Health Systems, Inc.

                                 Number of Locations
Location Type               May 31, 2009        May 31, 2008
Drugstores                         6,857               6,252
Worksite Facilities                  373                 372
Home Care Facilities                 112                  89
Specialty Pharmacies                  17                  12
Mail Service Facilities                2                   2
Total                              7,361               6,727

The drugstore industry is highly competitive. In addition to other drugstore chains, independent drugstores and mail order prescription providers, we also compete with various other retailers including grocery stores, convenience stores, mass merchants and dollar stores.

The long-term outlook for prescription utilization is strong due in part to the aging population and the continued development of innovative drugs that improve quality of life and control health care costs. Certain provisions of the Deficit Reduction Act of 2005 seek to reduce federal spending by altering the Medicaid reimbursement formula for multi-source (i.e., generic) drugs. These changes are expected to result in reduced Medicaid reimbursement rates for prescription drugs. Also, in conjunction with a recently approved class action settlement, the methodology used to calculate the average wholesale price (AWP), a pricing reference widely used in the pharmacy industry, is expected to be reduced for many brand-name prescription drugs effective September 2009. The company expects to reach agreement on adjustments with its third party payors.

We believe deteriorating economic conditions and heightened turmoil in the financial markets have adversely impacted discretionary consumer spending, including spending at retail drugstores. It is unclear the extent to which these conditions will persist and what overall impact they will have on future consumer spending.

Front-end sales have continued to grow primarily due to the addition of new stores. Additionally, front-end sales grew due to strengthening core categories, such as over-the-counter non-prescription drugs, beauty care items, household products and consumables. Walgreens strong name recognition continues to drive private brand sales, which are included in these core categories.

We continue to expand into new markets and increase penetration in existing markets. To support our growth, we are investing in prime locations, technology and customer service initiatives. Retail organic growth continues to be our primary growth vehicle; however, consideration is given to retail and other acquisitions that provide a unique opportunity and strategic fit for our business.

RESTRUCTURING CHARGES

On October 30, 2008 we announced a series of strategic initiatives, approved by the Board of Directors, to enhance shareholder value. One of these initiatives was a program designed to reduce cost and improve productivity through strategic sourcing of indirect spend, reducing corporate overhead and work throughout our stores, rationalization of inventory categories, realignment of pharmacy operations and transforming the community pharmacy. In conjunction with these initiatives approximately $300 to $400 million of costs are anticipated over fiscal 2009 and 2010. We anticipate achieving approximately $1 billion in annual cost savings by fiscal 2011 related to these initiatives.

Additionally, in conjunction with our Customer Centric Retailing (CCR) initiative we are enhancing the store format to ensure we have the proper assortments, better category lay-outs and adjacencies, better shelf height and site lines and better assortment and brand layout, all of which are designed to positively enhance the shopper experience and increase customer frequency and purchase size. This format will be rolled out to approximately 5,000 to 5,500 stores beginning in the fall and continuing through calendar 2010. Although we will continue to refine our estimates as the roll-out progresses, based on our experience with the first thirty-five pilot stores, we expect the cost to be $30 thousand to $50 thousand per store.
As of May 31, 2009 we have recorded the following pre-tax charges associated with our restructuring initiatives within the Consolidated Statement of Earnings:

                                        Three Months Ended       Nine Months Ended
                                           May 31, 2009            May 31, 2009
Severance and other benefits            $                 6     $                65
Project cancellation settlements                          8                       8
Inventory charges                                        33                      44
   Restructuring expense                                 47                     117
Consulting and other                                     20                      57
   Restructuring and restructuring
related costs                           $                67     $               174

Cost of sales                           $                33     $                44
Selling, general and administrative
expense                                                  34                     130
                                        $                67     $               174

The $65 million of severance and other benefits includes the charges associated with 438 employees who participated in the voluntary separation program and 362 employees who were involuntarily separated from the company.

Inventory reserve charges consist of on-hand inventory that has been reduced from cost to current selling prices and the loss we incurred on the sale of inventory below cost. In addition, as a part of our restructuring efforts we sold an incremental amount of inventory below traditional retail prices. The dilutive effect of these sales on gross profit was $32 million in the current quarter and nine month period.

As of May 31, 2009 we have recorded the following balances within the accrued expenses and other liabilities section of our Consolidated Balance Sheets:

                             August 31, 2008                        May 31, 2009
                             Reserve Balance                           Reserve
                                             Charges  Cash Payments    Balance
Severance and other benefits      $  -         $ 72       $ 61          $ 11

We have realized savings related to these initiatives of approximately $87 million in the current quarter and $139 million for the first nine months. The savings, which are included in selling, general and administrative expense, are primarily the result of reduced store labor and headcount reductions.

OPERATING STATISTICS

                                                                          Percentage Changes
                                                   Three Months Ended May 31,              Nine Months Ended May 31,
                                                   2009                  2008              2009                 2008
Net Sales                                                8.0                   9.6               7.2                10.2
Net Earnings                                            (8.8 )                 2.0              (8.4 )               4.2
Comparable Drugstore Sales                               2.8                   3.4               1.9                 4.5
Prescription Sales                                       8.2                   8.9               7.4                10.3
Comparable Drugstore Prescription Sales                  3.8                   2.7               3.1                 4.5
Front-End Sales                                          7.4                  11.1               6.7                 9.9
Comparable Drugstore Front-End Sales                     0.9                   4.6              (0.2 )               4.4
Gross Profit                                             5.0                   9.5               5.2                 9.7
Selling, General and Administrative Expenses             8.4                  10.2               8.5                10.5




                                                                         Percent to Net Sales
                                                   Three Months Ended May 31,              Nine Months Ended May 31,
                                                   2009                  2008              2009                 2008
Gross Margin                                            27.5                  28.3              27.9                28.4
Selling, General and Administrative Expenses            22.3                  22.2              22.6                22.3




                                                                          Other Statistics
                                             Three Months Ended May
                                                       31,                            Nine Months Ended May 31,
                                               2009          2008                 2009                         2008
Prescription Sales as a % of Net Sales            65.6          65.5                   64.9                         64.7
Third Party Sales as a % of Total
Prescription Sales                                95.4          95.5                   95.4                         95.2
Total Number of Prescriptions (in
millions)                                          168           158                    488                          466
30 Day Equivalent Prescriptions (in
millions) *                                        187           173                    541                          510
Total Number of Locations                                                             7,361                        6,727

* Includes the adjustment to convert prescriptions greater than 84 days to the equivalent of three 30 day prescriptions. This adjustment reflects the fact these prescriptions include approximately three times the amount of product days supplied compared to a normal prescription.

RESULTS OF OPERATIONS

Net earnings for the third quarter ended May 31, 2009 were $522 million or $0.53 per share (diluted). This was an 8.8% decrease over the same quarter last year. Net earnings for the nine months decreased 8.4% to $1,570 million or $1.58 per share (diluted). The net earnings decrease in the quarter and nine months was attributed to a lower rate of sales growth, lower gross margins, higher selling, general and administrative expenses as a percentage of sales and higher interest costs. Additionally, in the current quarter we recorded $47 million in restructuring expenses, $20 million for consulting and other expenses and $32 million in margin dilution related to our restructuring activities. For the nine month period we have recorded $117 million in restructuring expenses, $57 million for consulting and other expenses and $32 million in margin dilution related to our restructuring activities.

Net sales for the third quarter increased by 8.0% to $16,210 million and rose by 7.2% to $47,632 million for the first nine months. Drugstore sales increases resulted from sales gains in existing stores and added sales from new stores, each of which include an indeterminate amount of market-driven price changes. Sales in comparable drugstores were up 2.8% for the quarter and 1.9% for the nine month period. Comparable drugstores are defined as those that have been open for at least twelve consecutive months without closure for seven or more consecutive days and without a major remodel or a natural disaster in the past twelve months. Relocated and acquired stores are not included as comparable stores for the first twelve months after the relocation or acquisition. We operated 7,361 locations as of May 31, 2009, compared to 6,727 a year earlier.

Prescription sales increased by 8.2% for the third quarter and 7.4% for the first nine months and represented 65.6% and 64.9% of total sales, respectively. In the prior year, prescription sales increased 8.9% for the quarter and 10.3% year to date and represented 65.5% and 64.7% of total sales. Comparable drugstore prescription sales were up 3.8% in the current quarter and 3.1% in the nine month period. The effect of generic drugs, which have a lower retail price, replacing brand name drugs reduced prescription sales by 3.8% in the current quarter and 2.8% for the first nine months versus 3.4% in the previous quarter and 4.0% in the previous nine month period. The effect of generics on total sales was a reduction of 2.1% in the current quarter and 1.5% year to date compared to 1.9% in the prior year's quarter and 2.2% year to date. Third party sales, where reimbursement is received from managed care organizations as well as government and private insurance, were 95.4% of prescription sales for the quarter and the first nine months this year compared to 95.5% and 95.2% in the prior year. The total number of prescriptions filled for the third quarter was approximately 168 million compared to 158 million for the same period last year. Prescriptions adjusted to 30 day equivalents were 187 million in the third quarter verses 173 last year.

Front-end sales increased 7.4% for the current quarter and 6.7% for the first nine months and were 34.4% and 35.1% of total sales, respectively. In comparison, prior year front end sales increased 11.1% and 9.9% and comprised 34.5% and 35.3% of total sales. The overall increase is due to the addition of new stores and an increase in sales dollars related to consumables and household items. Offsetting the increase were decreases in sales dollars from seasonal items, photo and personal care. These factors contributed to comparable front-end sales increasing 0.9% in the current quarter and decreasing 0.2% year to date compared to increases of 4.6% and 4.4% last year.

Gross margin as a percent of sales was 27.5% in the current quarter and 27.9% for the first nine months compared to 28.3% and 28.4% last year. Overall margins were negatively impacted by lower front-end margins due to product mix, non-retail businesses, which have lower margins and are becoming a greater part of the total business, restructuring and restructuring related costs and a higher provision for LIFO. These items were partially offset by an improvement in retail pharmacy margins, which were positively influenced by generic drug sales, but to a lesser extent negatively influenced by the growth in third party pharmacy sales and lower market driven reimbursements.

We use the LIFO method of inventory valuation, which can only be determined annually when inflation rates and inventory levels are finalized; therefore, LIFO inventory costs for the interim financial statements are estimated. Cost of sales included a LIFO provision of $32 million and $124 million for the quarter and nine month period ended May 31, 2009 versus $16 million and $74 million a year ago. This quarter our estimated annual inflation rate was reduced to 2.0% from our estimate of 2.25% at February 28, 2009, primarily due to lower than projected prescription drug inflation. Last year, during the third quarter the estimated annual inflation rate was reduced to 1.25% from 1.5%, due to lower than projected non-prescription drug inflation.

Gross profit increased 5.0% in the quarter and 5.2% year to date versus 9.5% and 9.7% increases in the same periods last year. The change from the prior year is primarily due to lower sales growth and lower gross margins.

Selling, general and administrative expenses as a percentage of sales were 22.3% for the current quarter and 22.6% for the first nine months compared to 22.2% and 22.3% a year ago. As a percentage of sales, the current quarter and nine month period increases were due to higher restructuring and restructuring related expenses and occupancy, partially offset by lower store level salaries and savings related to our restructuring activities.

Selling, general and administrative expenses increased 8.4% in the third quarter and 8.5% for the nine month period ended May 31, 2009 compared to 10.2% and 10.5% a year ago. Restructuring and restructuring related expenses accounted for 1.0% of the increase in the current quarter and 1.3% of the increase for the nine month period. Partially offsetting restructuring and restructuring related expenses was a reduction in store level salaries for the current quarter and year to date. Store level salaries increased at a lower rate of growth than sales, contrary to the prior year where the rate of growth was higher than sales.

Interest was a net expense of $25 million in the quarter and $60 million year to date, compared to $2 million and $4 million in the prior quarter and year to date, respectively. The increase in interest expense is primarily attributed to the issuance of long-term debt. The current year's interest expense is net of $3 million in the quarter and $12 million year to date, which was capitalized to construction projects versus $4 million in the quarter and $16 million year to date capitalized last year.

The effective tax rate was 36.4% for the quarter and 36.8% for the first nine months compared to 37.3% and 37.1% a year ago. The decrease in rate is attributed to additional permanent tax benefits in the current year.

CRITICAL ACCOUNTING POLICIES

The consolidated condensed financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and include amounts based on management's prudent judgments and estimates. Actual results may differ from these estimates. Management believes that any reasonable deviation from those judgments and estimates would not have a material impact on our consolidated financial position or results of operations. To the extent that the estimates used differ from actual results, however, adjustments to the statement of earnings and corresponding balance sheet accounts would be necessary. These adjustments would be made in future statements. For a complete discussion of all our significant accounting policies please see our 2008 annual report on Form 10-K. Some of the more significant estimates include goodwill and other intangible asset impairment, allowance for doubtful accounts, vendor allowances, liability for closed locations, liability for insurance claims, cost of sales, and income taxes. We use the following methods to determine our estimates:

Goodwill and other intangible asset impairment - Goodwill and other indefinite-lived intangible assets are not amortized, but are evaluated for impairment annually or whenever events or changes in circumstances indicate that the value of a certain asset may be impaired. The process of evaluating goodwill for impairment involves the determination of fair value. Inherent in such fair value determinations are certain judgments and estimates, including the interpretation of economic indicators and market valuations and assumptions about our business plans. We have not made any material changes to the method of evaluating goodwill and intangible asset impairments during the last three years. Based on current knowledge, we do not believe there is a reasonable likelihood that there will be a material change in the estimate or assumptions used to determine impairment. Allowance for doubtful accounts -
The provision for bad debt is based on both specific receivables and historic write-off percentages. We have not made any material changes to the method of estimating our allowance for doubtful accounts during the last three years. Based on current knowledge, we do not believe there is a reasonable likelihood that there will be a material change in the estimate or assumptions used to determine the allowance. Vendor allowances -
Vendor allowances are principally received as a result of purchase levels, sales or promotion of vendors' products. Allowances are generally recorded as a reduction of inventory and are recognized as a reduction of cost of sales when the related merchandise is sold. Those allowances received for promoting vendors' products are offset against advertising expense and result in a reduction of selling, general and administrative expenses to the extent of advertising incurred, with the excess treated as a reduction of inventory costs. We have not made any material changes to the method of estimating our vendor allowances during the last three years. Based on current knowledge, we do not believe there is a reasonable likelihood that there will be a material change in the estimate or assumptions used to determine vendor allowances. Liability for closed locations -
The liability is based on the present value of future rent obligations and other related costs (net of estimated sublease rent) to the first lease option date. We have not made any material changes to the method of estimating our liability for closed locations during the last three years. Based on current knowledge, we do not believe there is a reasonable likelihood that there will be a material change in the estimate or assumptions used to determine the liability. Liability for insurance claims -
The liability for insurance claims is recorded to an actuarially determined estimate for claims incurred and is not discounted. The provisions are estimated in part by considering historical claims experience, demographic factors and other actuarial assumptions. We have not made any material changes to the method of estimating our liability for insurance claims during the last three years. Based on current knowledge, we do not believe there is a reasonable likelihood that there will be a material change in the estimate or assumptions used to determine the liability.
Cost of sales -
Drugstore cost of sales is derived based on point-of-sale scanning information with an estimate for shrinkage and adjusted based on periodic inventories. Inventories are valued at the lower of cost or market determined by the LIFO method. We have not made any material changes to the method of estimating cost of sales during the last three years. Based on current knowledge, we do not believe there is a reasonable likelihood that there will be a material change in the estimate or assumptions used to determine cost of sales. Cost of sales will continue to be impacted by our restructuring initiatives which include inventory rationalization and the subsequent write-down of inventory to the lower of cost or market. Income Taxes -
We are subject to routine income tax audits that occur periodically in the normal course of business. U.S. federal, state and local and foreign tax authorities raise questions regarding our tax filing positions, including the timing and amount of deductions and the allocation of income among various tax jurisdictions. In evaluating the tax benefits associated with our various tax filing positions, we record a tax benefit for uncertain tax positions using the highest cumulative tax benefit that is more likely than not to be realized. Adjustments are made to our liability for unrecognized tax benefits in the period in which we determine the issue is effectively settled with the tax authorities, the statute of limitations expires for the return containing the tax position or when more information becomes available. Our liability for unrecognized tax benefits, including accrued penalties and interest, is included in other long-term liabilities on our consolidated balance sheets and in income tax expense in our consolidated statements of earnings.

In determining our provision for income taxes, we use an annual effective income tax rate based on full year income, permanent differences between book and tax income, and statutory income tax rates. The effective income tax rate also reflects our assessment of the ultimate outcome of tax audits. Discrete events such as audit settlements or changes in tax laws are recognized in the period in which they occur. Based on current knowledge, we do not believe there is a reasonable likelihood that there will be a material change in the estimate or assumptions used to determine income taxes.

LIQUIDITY AND CAPITAL RESOURCES

Cash and cash equivalents were $2,300 million at May 31, 2009, compared to $472 million at May 31, 2008. Short-term investment objectives are to minimize risk, maintain liquidity and maximize after-tax yields. To attain these objectives, investment limits are placed on the amount, type and issuer of securities. Investments are principally in U.S. Treasury market funds and Treasury Bills.

Net cash provided by operating activities for the nine months ending May 31, 2009 improved $768 million to $3,259 million compared to $2,491 million a year ago. The increase is primarily attributable to working capital improvements. For the nine months ended May 31, 2009 we generated $602 million in cash flow from working capital improvements, primarily through better inventory management. Working capital improvements were partially offset by lower net earnings. Last year, working capital improvements generated $114 million in cash flow. Cash provided by operations is the principal source of funds for expansion, acquisitions, remodeling programs, dividends to shareholders and stock repurchases. In fiscal 2009, we supplemented cash provided by operations with long-term debt.

Net cash used for investing activities was $1,936 million versus $2,154 million last year. Using the proceeds from our issuance of long-term debt we invested $650 million in short-term Treasury Bills of which $550 million was redeemed in the third quarter. Additions to property and equipment were $1,534 million compared to $1,653 million last year. During the first nine months we added a total of 525 locations (427 net) compared to 797 last year (730 net). There were 140 owned locations added during the first nine months and 53 under construction at May 31, 2009 versus 166 owned locations added and 67 under construction last year.

                          Drugstores       Worksites       Home Care      Specialty Pharmacy       Mail Service         Total
August 31, 2008                6,443             364             115                      10                  2         6,934
  New/Relocated                  407              28               4                       4                  -           443
  Acquired                        64               2              11                       5                  -            82
  Closed/Replaced                (57 )           (21 )           (18 )                    (2 )                -           (98 )
May 31, 2009                   6,857             373             112                      17                  2         7,361

Business acquisitions this year were $348 million versus $527 million in the prior year. Business acquisitions in the current year include the acquisition of 34 Drug Fair locations, McKesson Corporation's specialty pharmacy, a business within McKesson's Specialty division and IVPCARE, a specialty pharmacy focused on reproductive health and selected other assets (primarily prescription files).

Capital expenditures throughout fiscal 2009 are expected to be $1.9 billion, excluding business acquisitions. We expect to open approximately 540 new drugstores in fiscal 2009, with a net increase of approximately 475 drugstores and anticipate having a total of more than 7,000 drugstores in 2010. We intend to achieve new drugstore organic growth between 4.0 percent and 4.5 percent in fiscal 2010 and between 2.5 percent and 3.0 percent in 2011. In the first nine months, we added a total of 525 locations, of which 407 were new or relocated drugstores, with a net gain of 414 drugstores after relocations and closings. We are continuing to relocate stores to more convenient freestanding locations. In . . .