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WAG > SEC Filings for WAG > Form 10-Q on 29-Dec-2011All Recent SEC Filings

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Form 10-Q for WALGREEN CO


29-Dec-2011

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of our financial condition and results of operations should be read together with the financial statements and the related notes included elsewhere herein and our consolidated financial statements, accompanying notes and Management's Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the year ended August 31, 2011. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from those discussed in forward-looking statements. Factors that might cause a difference include, but are not limited to, those discussed under "Cautionary Note Regarding Forward-Looking Statements" below and in Item 1A (Risk Factors) in our Annual Report on Form 10-K for the year ended August 31, 2011.

INTRODUCTION

Walgreens is principally a retail drugstore chain that sells prescription and non-prescription drugs and general merchandise. General merchandise includes, among other things, household items, convenience and fresh foods, personal care, beauty care, photofinishing and candy. Customers can have prescriptions filled in retail pharmacies as well as through the mail, and may also place orders by telephone and online. At November 30, 2011, we operated 8,261 locations in 50 states, the District of Columbia, Guam and Puerto Rico. Total locations do not include 360 Take Care Clinics that are operated primarily within other Walgreens locations.

                                                            Number of Locations
Location Type                                     November 30, 2011         November 30, 2010
Drugstores                                                    7,812                     7,651
Worksite Health and Wellness Centers                            363                       370
Infusion and Respiratory Services Facilities                     74                       100
Specialty Pharmacies                                             10                        10
Mail Service Facilities                                           2                         2
Total                                                         8,261                     8,133

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

Our sales, gross profit margin and gross profit dollars are impacted by, among other things, both the percentage of prescriptions that we fill that are generic and the rate at which new generic drugs are introduced to the market. In general, generic versions of drugs generate lower total sales dollars per prescription, but higher gross profit margins and gross profit dollars, as compared with patent-protected brand name drugs. The positive impact on gross profit margins and gross profit dollars has been significant in the first several months after a generic version of a drug is first allowed to compete with the branded version, which is generally referred to as a "generic conversion." In any given year, the number of major brand name drugs that undergo a conversion from branded to generic status can increase or decrease, which can have a significant impact on our sales, gross profit margins and gross profit dollars. And, because any number of factors outside of our control or ability to foresee can affect timing for a generic conversion, we face substantial uncertainty in predicting when such conversions will occur and what effect they will have on particular future periods.

The long-term outlook for prescription utilization is strong due in part to the aging population, the increasing utilization of generic drugs, the continued development of innovative drugs that improve quality of life and control health care costs, and the expansion of health care insurance coverage under the Patient Protection and Affordable Care Act signed into law in 2010 (the ACA). The ACA seeks to reduce federal spending by altering the Medicaid reimbursement formula (AMP) for multi-source drugs, and when implemented, is expected to reduce Medicaid reimbursements. State Medicaid programs are also expected to continue to seek reductions in reimbursements independent of AMP. In addition, we continuously face reimbursement pressure from pharmacy benefit management (PBM) companies, health maintenance organizations, managed care organizations and other commercial third party payers, and our agreements with these payers are regularly subject to expiration, termination or renegotiation.

On June 21, 2011, Walgreens announced that contract renewal negotiations with pharmacy benefit manager Express Scripts, Inc. (Express Scripts) had been unsuccessful, and as a result we do not expect to be part of the Express Scripts pharmacy provider network as of January 1, 2012. Express Scripts, in its capacity as a pharmacy benefits manager, processed approximately 88 million prescriptions filled by Walgreens in fiscal 2011, representing approximately $5.3 billion of our sales. In the first four months of fiscal 2012 ending December 31, 2011, we estimate that Express Scripts, in its capacity as a pharmacy benefits manager, will have processed approximately 26 million prescriptions filled by Walgreens. If a contract renewal is not reached, beginning January 1, 2012, Express Scripts' network would no longer include Walgreens more than 7,800 pharmacies nationwide. In addition to the approximately $.02 net earnings per diluted share adverse impact in the first quarter of fiscal 2012 resulting from a loss of pharmacy sales and expenses related to our dispute with Express Scripts, this development is expected to adversely affect our net sales, net earnings and cash flows during the remaining portion of fiscal 2012 beginning January 1, 2012 when we are no longer part of the Express Scripts pharmacy network. We intend to moderate the impact of this development on our consolidated financial results by seeking to retain business from Express Scripts' clients (consistent with their contractual obligations to Express Scripts), expand our business with other payers and customers, and implement cost saving initiatives. As of the date of this filing, over 100 health plans, employers and other Express Scripts clients have informed us that they have either changed pharmacy benefit managers or taken steps consistent with their contracts to maintain access to Walgreens pharmacies in 2012, which we estimate will result in our retention of approximately 10 million prescriptions beginning January 1, 2012 on an annualized basis of the 88 million prescriptions we filled and were processed by Express Scripts in fiscal 2011. We also expect to learn of additional retained prescriptions once information regarding Medicare Part D elections and small plan renewal decisions becomes available in 2012. See "Cautionary Note Regarding Forward-Looking Statements."

While we cannot predict what percentage of business we may retain or regain from these and other entities and groups that were Express Scripts' clients in fiscal 2011 in any particular future period, over time, we believe employers and others will want plans with Walgreens in the network. Based on our current estimates, and the current assumption that we will not be in Express Scripts' pharmacy networks beginning in calendar 2012 (including those of Express Scripts' clients such as the Department of Defense Tricare plan and WellPoint, Inc.), we expect to achieve 97 to 99 percent of our fiscal 2011 prescription volume in fiscal 2012. We have begun implementing plans designed to offset approximately 50 percent of any reduction in fiscal 2012 gross profit resulting from a loss of up to 75 percent of the business from Express Scripts' clients, primarily through reductions in selling, general and administrative expenses and cost of goods sold. We expect a substantial majority of these reductions to be realized in the second half of fiscal 2012. There can be no assurance, however, that for the portion of fiscal 2012 beginning January 1, 2012, we will retain any particular level of business from Express Scripts' clients, and if we were to lose more than 75 percent of such business it is uncertain whether we would be able to offset as much as 50 percent of the reduction in gross profit resulting from the marginal loss of such business above 75 percent. See "Cautionary Note Regarding Forward-Looking Statements." Additionally, in July 2011, Medco Health Solutions, Inc. (Medco), another large pharmacy benefit manager, and Express Scripts announced an agreement to merge, completion of which is subject to regulatory and other conditions. If the merger is successfully completed, we may face additional reimbursement pressure or potential loss of business. Because the Express Scripts/Medco merger remains under review, we have made no assumption regarding the consummation, timing or impact of the merger related to our business for fiscal 2012.

Total front-end sales have grown due to sales gains in existing stores, acquired stores and new store openings. Front-end sales have increased in the non-prescription drugs, personal care, convenience and fresh foods, beer and wine and beauty categories.

To support our growth, we are investing in prime locations, technology and customer service initiatives along with reinvesting into our existing stores. We are focused on retail organic growth; however, consideration is given to retail and other acquisitions that provide unique opportunities and fit our business objectives, such as our acquisition of drugstore.com, which enhanced our online presence.

RESTRUCTURING CHARGES

In 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 known as "Rewiring for Growth," which was 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, and transforming community pharmacy. These initiatives were completed in the fourth quarter of fiscal 2011.

We recorded $7 million of pre-tax charges in selling, general and administrative expenses in the first quarter of fiscal 2011 associated with our Rewiring for Growth program. 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 for the three month period ended November 30, 2010 was $1 million.

We realized total savings related to Rewiring for Growth of approximately $1.1 billion compared to our base year of fiscal 2008. Selling, general and administrative expenses realized total savings of $953 million, while cost of sales benefited by approximately $122 million. The savings were primarily the result of reduced store labor and personnel and expense reductions.

Additionally, as a part of our Customer Centric Retailing (CCR) initiative, we have modified the store format to enhance category layouts and adjacencies, shelf heights and sight lines, and brand and private brand assortments, all of which are designed to positively impact the shopper experience and increase customer frequency and purchase size. In total, we converted 5,843 stores and opened 559 new stores with the CCR format. For the three months ended November 30, 2011, we incurred $33 million in total program costs, of which $15 million was included in selling, general and administrative expenses and $18 million in capital costs. In the prior year's quarter, we incurred $10 million in total program costs, of which $6 million was included in selling, general and administrative expenses and $4 million in capital costs. This initiative was completed during the first quarter of fiscal 2012.

OPERATING STATISTICS

                                                               Percentage Increases/(Decreases)
                                                                      Three Months Ended
                                                                         November 30,
                                                                 2011                    2010
Net Sales                                                               4.7                     6.0
Net Earnings                                                           (4.5 )                  18.8
Comparable Drugstore Sales                                              2.5                     0.8
Prescription Sales                                                      4.2                     5.3
Comparable Drugstore Prescription Sales                                 2.6                     0.9
Front-End Sales                                                         5.6                     7.3
Comparable Drugstore Front-End Sales                                    2.4                     0.4
Gross Profit                                                            3.2                     9.0
Selling, General and Administrative Expenses                            5.0                     7.0




                                                  Percent to Net Sales
                                                   Three Months Ended
                                                      November 30,
                                                  2011             2010
Gross Margin                                         28.1             28.5
Selling, General and Administrative Expenses         23.1             23.1




                                                            Other Statistics
                                                           Three Months Ended
                                                              November 30,
                                                            2011          2010
Prescription Sales as a % of Net Sales                          65.5        65.8
Third Party Sales as a % of Total Prescription Sales            95.8        95.3
Number of Prescriptions (in millions)                            179         181
Comparable Prescription % Increase/(Decrease)                   (1.9 )       0.8
30 Day Equivalent Prescriptions (in millions) *                  208         202
Comparable 30 Day Equivalent Prescription % Increase *           1.8         2.0
Total Number of Locations                                      8,261       8,133

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

RESULTS OF OPERATIONS

Net earnings for the first quarter ended November 30, 2011 were $554 million or $.63 per diluted share. This was a 4.5% decrease in net earnings over the same quarter last year. The net earnings decrease in the quarter was primarily attributable to lower gross margins. Operations at drugstore.com, including costs associated with the acquisition and integration, reported a pre-tax loss of $12 million, $7 million after tax, or $.01 per diluted share. Prior year earnings included pre-tax Rewiring for Growth expenses of $8 million, $5 million after tax, or $.01 per diluted share ($7 million of restructuring and restructuring related expenses and $1 million in margin dilution).

Net sales for the quarter ended November 30, 2011 increased by 4.7% to $18,157 million. The acquisition of drugstore.com increased total sales by 0.7% in the current quarter. 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 2.5% in the quarter ended November 30, 2011. 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 8,261 locations (7,812 drugstores) as of November 30, 2011, compared to 8,133 locations (7,651 drugstores) a year earlier.

Prescription sales increased by 4.2% and represented 65.5% of total net sales for the quarter ended November 30, 2011. In the prior year's quarter, prescription sales increased 5.3% and represented 65.8% of total net sales. Comparable drugstore prescription sales were up 2.6% for the quarter ended November 30, 2011. The effect of generic drugs, which have a lower retail price, replacing brand name drugs reduced prescription sales by 1.9% in the current quarter versus 3.0% in the prior year's quarter. The effect of generics on total net sales was a reduction of 1.1% in the current quarter compared to 1.8% in the prior year's quarter. Prescription sales also were negatively impacted by our strategic decision to no longer be a part of the Express Scripts pharmacy provider network. With new generic drug introductions, including generic Lipitor, we expect to see an increased effect of generics on total net sales in the second half of fiscal 2012. Third party sales, where reimbursement is received from managed care organizations, the government, employers or private insurers, were 95.8% of prescription sales for the quarter ended November 30, 2011, compared to 95.3% in the prior year. We receive market driven reimbursements from third party payers, a number of which typically reset in January. The total number of prescriptions filled for the current quarter (including immunizations) was approximately 179 million compared to 181 million for the same period last year. Prescriptions adjusted to 30 day equivalents were 208 million in the current quarter versus 202 million in last year's quarter.

Front-end sales increased 5.6% and were 34.5% of total net sales for the current quarter ended November 30, 2011. In comparison, prior year front end sales increased 7.3% for the quarter, and comprised 34.2% of total net sales. The increase in the current quarter's front-end sales is due in part to new store openings and improved sales dollars related to the non-prescription drugs, personal care, convenience and fresh foods, beer and wine and beauty categories. Comparable drugstore front-end sales increased 2.4% for the current quarter compared to the prior year which increased 0.4%. The increase in comparable front end sales in the quarter was primarily attributed to the personal care, beer and wine, non-prescription drugs, convenience and fresh foods and beauty categories.

Gross margin as a percent of sales was 28.1% in the current quarter compared to 28.5% last year. Overall margins in the quarter were negatively impacted by lower retail pharmacy margins, where lower market driven reimbursements more than offset the positive effect of generic drug sales. New generic introductions, including generic Lipitor, are expected to positively contribute to pharmacy gross margins in the second half of fiscal 2012. Front-end margins were flat compared to the prior year.

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 $45 million for the quarter ended November 30, 2011 versus $42 million a year ago. Our estimated annual inflation rate at November 30, 2011 and 2010 was 2.0%.

Selling, general and administrative expenses as a percentage of sales were 23.1% for the first quarter of fiscal 2012 and 2011. As a percentage of sales, expenses in the current quarter were higher primarily due to drugstore.com expenses including costs associated with the acquisition and integration, investments in strategic initiatives and capabilities as well as costs associated with our plan to no longer be part of the Express Scripts pharmacy provider network. These were offset by reduced store labor expense as a percentage of sales.

Interest was a net expense of $17 million and $20 million for the periods ending November 30, 2011 and 2010, respectively. The decrease in interest expense for the three month period is primarily attributed to the additional $250 million in interest rate swaps that were entered into in May 2011 and reduced interest rates associated with our fixed to variable interest rate swaps. Interest expense for the periods ending November 30, 2011 and 2010 is net of $3 million that was capitalized to construction projects.

The effective tax rate was 37.2% compared to 37.0% in the prior year's quarter. The increase in the current year's effective tax rate, as compared to last year's rate is primarily attributed to an increase in state tax rates.

LIQUIDITY AND CAPITAL RESOURCES

Cash and cash equivalents were $1,094 million at November 30, 2011, compared to $2,062 million at November 30, 2010. 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.

On October 14, 2009, our Board of Directors approved a long-term capital policy:
to maintain a strong balance sheet and financial flexibility; reinvest in our core strategies; invest in strategic opportunities that reinforce our core strategies and meet return requirements; and return surplus cash flow to shareholders in the form of dividends and share repurchases over the long term.

Net cash provided by operating activities for the three months ended November 30, 2011 was $809 million compared to $1,165 million a year ago. When compared to the prior year, cash from operating activities decreased primarily as a result of changes in working capital balances. For the three months ended November 30, 2011, working capital was a use of cash of $133 million as compared to the prior year where working capital improvements generated $234 million of cash. Cash provided by operations is the principal source of funds for expansion, acquisitions, remodeling programs, dividends to shareholders and stock repurchases.

Net cash used for investing activities was $497 million for the three months ended November 30, 2011 compared to $334 million a year ago. Additions to property and equipment were $419 million compared to $273 million last year. During the first three months, we added a total of 86 locations (51 net) compared to 131 last year (87 net). There were 14 owned locations added during the first three months and 47 under construction at November 30, 2011 versus 29 owned locations added and 57 under construction last year.

                                        Worksite       Infusion and
                                       Health and       Respiratory
                                        Wellness         Services           Specialty            Mail Service
                       Drugstores        Centers        Facilities          Pharmacies            Facilities           Total
August 31, 2011              7,761             355                83                    9                      2          8,210
  New/Relocated                 65              13                 1                    1                      -             80
  Acquired                       6               -                 -                    -                      -              6
  Closed/Replaced              (20 )            (5 )             (10 )                  -                      -            (35 )
November 30, 2011            7,812             363                74                   10                      2          8,261

Business acquisitions this year were $70 million versus $63 million in the prior year. Business acquisitions in the current year primarily include the purchase of prescription files. The prior year acquisitions included the purchase of $29 million of home care assets with the remaining balances relating primarily to the purchase of prescription files. Additionally, in the current year we paid $29 million to Catalyst Health Solutions, Inc. which was the result of a working capital adjustment in accordance with the June 2011 sales agreement of our pharmacy benefit management business, Walgreens Health Initiatives, Inc.

Capital expenditures for fiscal 2012 are expected to be approximately $1.6 billion, excluding business acquisitions and prescription file purchases. We expect new drugstore organic growth of approximately 2.5 to 3.0 percent in fiscal 2012. In the first quarter, we added a total of 86 locations, of which 71 were new or relocated drugstores. We are continuing to relocate stores to more convenient and profitable freestanding locations.

Net cash used for financing activities was $774 million compared to the prior year's net cash use of $649 million. We repurchased shares totaling $608 million in the current year, $601 million in conjunction with our share buyback programs and $7 million to support the needs of the employee stock plans. In the prior year, we repurchased shares totaling $510 million, all of which was in conjunction with our share buyback programs. We had proceeds related to employee stock plans of $42 million during the first three months versus $29 million for the same period last year. Cash dividends paid were $202 million during the first three months of fiscal 2012, versus $166 million for the same period a year ago.

In connection with our capital policy, our Board of Directors authorized a share repurchase program and set a long-term dividend payout ratio target between 30 and 35 percent of net earnings. The 2009 repurchase program, which was completed in September 2010, allowed for the repurchase of up to $2.0 billion of the Company's common stock. For the three months ended November 30, 2010, shares totaling $360 million were purchased in conjunction with the 2009 repurchase program. On October 13, 2010, our Board of Directors authorized the 2011 repurchase program, which was completed in fiscal 2011 and allowed for the repurchase of up to $1.0 billion of the Company's common stock. For the three months ended November 30, 2010, shares totaling $150 million were purchased in conjunction with the 2011 repurchase program. On July 13, 2011, our Board of Directors authorized the 2012 repurchase program, which allows for the repurchase of up to $2.0 billion of the Company's common stock prior to its expiration on December 31, 2015. Shares totaling $601 million were purchased in the first quarter related to the 2012 program. We determine the timing and amount of repurchases from time to time based on our assessment of various factors including prevailing market conditions, alternate uses of capital, liquidity, the economic environment and other factors. The timing and amount of these purchases may change at any time and from time to time. The Company has, and may from time to time in the future, repurchase shares on the open market through Rule 10b5-1 plans which enable a company to repurchase shares at times when it otherwise might be precluded from doing so under insider trading laws.

We had no commercial paper outstanding at November 30, 2011. In connection with our commercial paper program, we maintain two unsecured backup syndicated lines of credit that total $1.1 billion. The first $500 million facility expires on July 20, 2015, and allows for the issuance of up to $250 million in letters of credit, which reduce the amount available for borrowing. The second $600 million facility expires on August 12, 2012. Our ability to access these facilities is subject to our compliance with the terms and conditions of the credit facility, including financial covenants. The covenants require us to maintain certain financial ratios related to minimum net worth and priority debt, along with limitations on the sale of assets and purchases of investments. At November 30, 2011, we were in compliance with all such covenants. The Company pays a facility fee to the financing banks to keep these lines of credit active. At November 30, 2011, there were no letters of credit issued against these facilities and we do not anticipate any future letters of credit to be issued against these facilities.

Our current credit ratings are as follows: . . .

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