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WAG > SEC Filings for WAG > Form 10-Q on 25-Mar-2013All Recent SEC Filings

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Form 10-Q for WALGREEN CO


25-Mar-2013

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, 2012. 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, 2012.

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 customers may also place orders by telephone and online. At February 28, 2013, we operated 8,537 locations in 50 states, the District of Columbia, Guam and Puerto Rico. Total locations do not include 371 Take Care Clinics that are operated primarily within other Walgreens locations or locations of unconsolidated partially owned entities such as Alliance Boots GmbH.

                                                            Number of Locations
Location Type                                     February 28, 2013         February 29, 2012
Drugstores                                                    8,072                     7,841
Worksite Health and Wellness Centers                            371                       354
Infusion and Respiratory Services                                81                        82
Facilities
Specialty Pharmacies                                             11                        11
Mail Service Facilities                                           2                         2
Total                                                         8,537                     8,290

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, online pharmacies, warehouse clubs 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 typically 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 July 19, 2012, Walgreens and Express Scripts announced their entry into a new multi-year agreement pursuant to which Walgreens began participating in the broadest Express Scripts retail pharmacy provider network available to Express Scripts clients as of September 15, 2012. From January 1, 2012, until September 14, 2012, however, Express Scripts' network did not include Walgreens pharmacies. We expect the positive impact of this agreement will be incremental over time, particularly over the first several quarters after September 15, 2012. While we cannot predict with certainty which Express Scripts clients will choose to include us in their pharmacy networks in any particular future period, we expect that our pharmacies will participate in the pharmacy networks of most clients for which Express Scripts serves as pharmacy benefit manager. However, one substantial client of Express Scripts, the United States Department of Defense TRICARE program, has announced that Walgreens will continue to not be a part of its pharmacy network and will be designated as a non-network pharmacy provider for TRICARE beneficiaries. Most of the patients we served in calendar 2011 who participated in a plan for which Express Scripts served as pharmacy benefit manager transitioned to another pharmacy after we exited the Express Scripts network on January 1, 2012. We have incurred, and expect to continue to incur, marketing and other costs in connection with efforts to regain former patients and attract new patients covered by plans for which we become a network pharmacy provider as a result of our agreement with Express Scripts.

Ultimately, the magnitude and timing of the impact on our financial results of rejoining the Express Scripts retail pharmacy provider network will depend on our ability to regain former patients and attract new patients covered by existing and new Express Scripts clients; however, we cannot predict with certainty what level of business we will achieve as a result of rejoining the Express Scripts retail pharmacy provider network in any particular future time period. We also intend to continue to pursue initiatives seeking to align our costs with anticipated business levels over time. Rejoining the Express Scripts retail pharmacy provider network has positively affected our net sales, net earnings and cash flows over time relative to the levels we would have achieved if we were not in the Express Scripts network and partially mitigated the adverse effects related to our non-participation in the Express Scripts retail pharmacy provider network during the period from January 1, 2012 through September 14, 2012. See "Cautionary Note Regarding Forward-Looking Statements."

Periodically, we make strategic acquisitions and investments that fit our long-term growth objectives. Consideration is given to retail, health and well-being enterprises and other potential acquisitions and investments that provide unique opportunities and fit our business objectives such as the acquisition of USA Drug, completed in first quarter of fiscal 2013, and key fiscal 2012 acquisitions including certain assets of BioScrip Inc.'s (BioScrip) community specialty pharmacies, centralized specialty and mail services pharmacy business and Crescent Pharmacy Holdings, LLC (Crescent).

In August 2012, we acquired a 45% equity interest in Alliance Boots GmbH (Alliance Boots) and a call option that provides Walgreens the right, but not the obligation, to purchase the remaining 55% over a six month period beginning February 2, 2015. Additional information regarding our investment in Alliance Boots is available in our Current Reports on Form 8-K filed on June 19, 2012 and August 6, 2012 (as amended by the Form 8-K/A filed on September 10, 2012). The amendment to our August 6, 2012 Form 8-K filed on September 10, 2012, includes as exhibits thereto Alliance Boots audited consolidated financial statements for the years ended March 31, 2012, 2011 and 2010 (prepared in accordance with International Financial Reporting Standards as issued by the International Accounting Standards Board) and unaudited pro forma consolidated financial information related to our 45% investment in Alliance Boots. Walgreens initial investment and the call option excludes the Alliance Boots minority interest in Galenica Ltd. (Galenica). The Alliance Boots investment in Galenica continues to be legally owned by Alliance Boots for the benefit of Alliance Boots shareholders other than Walgreens. We account for our 45% investment in Alliance Boots using the equity method of accounting. Investments accounted for under the equity method are recorded initially at cost and subsequently adjusted for our share of the net income or loss and cash contributions and distributions to or from these entities. Net income reported by Alliance Boots is translated from British pounds Sterling at the average rate for the period.
See Note 5 to our unaudited consolidated financial statements for additional information regarding our equity method investments. We utilize a three-month lag in reporting equity income from our investment in Alliance Boots, reported as equity earnings in Alliance Boots on the Consolidated Condensed Statements of Comprehensive Income. The investment is recorded as Equity investment in Alliance Boots in the Consolidated Condensed Balance Sheet.

As previously disclosed, we estimate combined synergies across both companies to be between $100 million and $150 million in the first year following completion of our 45% investment in Alliance Boots. The three-month lag impacts the quarterly and fiscal year timing of when Alliance Boots results and synergies will be reflected in the equity income in Alliance Boots included in our financial statements. Because of the three-month lag and the timing of the closing of this investment, our financial statements for the six months ended February 28, 2013 reflect six months of the dilutive effect of the incremental shares and interest expense associated with our Alliance Boots investment, but only four months (August 1, 2012 through November 30, 2012) of results of Alliance Boots are reflected in the equity earnings in Alliance Boots included in our Consolidated Condensed Statements of Comprehensive Income for the six month period. Similarly, our financial statements for the fiscal year ended August 31, 2013 will reflect 12 months of the dilutive effect of the incremental shares and interest expense associated with our Alliance Boots investment, but only 10 months (August 1, 2012 through May 31, 2013) of Alliance Boots results will be reflected in the equity earnings in Alliance Boots included in our fiscal 2013 financial statements. The Alliance Boots business is seasonal in nature, typically generating a higher proportion of revenue and earnings in the winter holiday and cold and flu season. Because of the adoption of a three-month lag in reporting equity income from our investment in Alliance Boots, the results of Alliance Boots for December, January and February will be reflected in the equity income included in our financial statements for the fiscal quarter ending May 31. See "Cautionary Note Regarding Forward-Looking Statements" below.

RECENT DEVELOPMENTS

On March 19, 2013, the Company, Alliance Boots GmbH and AmerisourceBergen Corporation ("AmerisourceBergen") announced various agreements and arrangements, including a ten-year pharmaceutical distribution agreement between the Company and AmerisourceBergen pursuant to which the Company will source branded and generic pharmaceutical products from AmerisourceBergen; an agreement which provides AmerisourceBergen the ability to access generics and related pharmaceutical products through Walgreens Boots Alliance Development GmbH, a global sourcing joint venture between the Company and Alliance Boots; and agreements and arrangements pursuant to which the Company and Alliance Boots together have the right, but not the obligation, to purchase a minority equity position in AmerisourceBergen and gain associated representation on AmerisourceBergen's board of directors in certain circumstances. The distribution agreement is expected to result in the distribution by AmerisourceBergen of branded pharmaceutical products that Walgreens historically has sourced from distributors and suppliers, effective September 1, 2013. Over time, beginning in calendar year 2014, distribution by AmerisourceBergen for the Company is expected to increasingly include generic pharmaceutical products that the Company currently self-distributes.

In connection with these arrangements, the Company, Alliance Boots and AmerisourceBergen entered into a Framework Agreement dated as of March 18, 2013 (the "Framework Agreement"), pursuant to which (1) Walgreens and Alliance Boots together were granted the right to purchase a minority equity position in AmerisourceBergen, beginning with the right, but not the obligation, to purchase up to 19,859,795 shares of AmerisourceBergen common stock (approximately 7 percent of the fully diluted equity of AmerisourceBergen, assuming the exercise in full of the warrants described below) in open market transactions, with the right to designate up to two members of the AmerisourceBergen board of directors upon achieving specified ownership levels; (2) Walgreens Pharmacy Strategies, LLC ("Walgreens PS"), a wholly-owned subsidiary of the Company, was issued (a) a warrant to purchase up to 11,348,456 shares of AmerisourceBergen common stock at an exercise price of $51.50 per share exercisable during a six-month period beginning in March 2016, and (b) a warrant to purchase up to 11,348,456 shares of AmerisourceBergen common stock at an exercise price of $52.50 per share exercisable during a six-month period beginning in March 2017; and Alliance Boots Luxembourg S. r.l. ("AB Luxembourg"), a wholly-owned subsidiary of Alliance Boots, was issued (a) a warrant to purchase up to 11,348,456 shares of AmerisourceBergen common stock at an exercise price of $51.50 per share exercisable during a six-month period beginning in March 2016 and (b) a warrant to purchase up to 11,348,456 shares of AmerisourceBergen common stock at an exercise price of $52.50 per share exercisable during a six-month period beginning in March 2017 (collectively, the "Warrants"). The Warrants collectively represent approximately 16% of the outstanding AmerisourceBergen common stock on a fully-diluted basis, assuming exercise in full of the Warrants. The number of shares which may be purchased in the open market is subject to increase in certain circumstances if the market price of AmerisourceBergen stock is less than the exercise price of the first tranche of warrants when those warrants are exercisable in 2016. The ability of the Company and Alliance Boots to invest in equity in AmerisourceBergen above certain thresholds is subject to the receipt of regulatory approvals. The parties and affiliated entities also entered into certain related agreements governing relations between and among the parties thereto, including the Shareholders Agreement, the Transaction Rights Agreement and the Limited Liability Company Agreement of WAB Holdings LLC, a newly-formed limited liability company jointly-owned by the Company and Alliance Boots for the purpose of acquiring and holding AmerisourceBergen common stock, described in our Current Report on Form 8-K filed on March 20, 2013.

Please refer to our Current Report on Form 8-K filed on March 20, 2013 for more detailed information regarding these agreements and arrangements. We currently expect modest earnings accretion from the agreement for fiscal year 2014, excluding one-time transaction-related costs. See "Cautionary Note Regarding Forward-Looking Statements" and "Risk Factors" below.

OPERATING STATISTICS

                                                                   Percentage Increases/(Decreases)
                                                       Three Months Ended                      Six Months Ended
                                                February 28,         February 29,      February 28,        February 29,
                                                    2013                 2012              2013                2012
Net Sales                                                 0.0                  0.8              (2.3 )               2.7
Net Earnings                                             10.7                 (7.7 )            (5.5 )              (6.3 )
Comparable Drugstore Sales                               (2.6 )               (1.5 )            (5.3 )               0.4
Prescription Sales                                        0.0                 (1.7 )            (3.7 )               1.3
Comparable Drugstore Prescription Sales                  (2.7 )               (3.9 )            (7.1 )              (0.7 )
Front-End Sales                                          (0.1 )                5.0               0.0                 5.2
Comparable Drugstore Front-End Sales                     (2.6 )                2.1              (2.3 )               2.2
Gross Profit                                              4.0                  1.2               2.0                 2.2
Selling, General and Administrative Expenses              5.0                  4.0               4.8                 4.5



                                                                        Percent to Net Sales
                                                      Three Months Ended                     Six Months Ended
                                               February 28,        February 29,      February 28,        February 29,
                                                   2013                2012              2013                2012
Gross Margin                                            30.1                28.9              29.8                28.5
Selling, General and Administrative Expenses            24.1                23.0              24.7                23.1




                                                                     Other Statistics
                                                  Three Months Ended                    Six Months Ended
                                           February 28,        February 29,      February 28,      February 29,
                                               2013                2012              2013              2012
Prescription Sales as a % of Net Sales              61.1                61.0              62.4              63.2
Third Party Sales as a % of Total                   95.3                95.7              95.5              95.7
Prescription Sales
Number of Prescriptions (in millions)                174                 167               343               346
Comparable Prescription %                            2.5                (8.7 )            (2.6 )            (5.4 )
Increase/(Decrease)
30 Day Equivalent Prescriptions (in                  208                 196               409               404
millions) *
Comparable 30 Day Equivalent
Prescription % Increase/(Decrease) *                 4.3                (4.9 )            (0.4 )            (1.6 )
Total Number of Locations                                                                8,537             8,290

* 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 quarter ended February 28, 2013 were $756 million or $.79 per diluted share. This was a 10.7% increase in net earnings over the same quarter last year. The net earnings increase in the quarter was primarily attributable to improved gross margins and equity earnings in Alliance Boots, partially offset by higher selling, general and administrative expenses.
Included in the current quarter's net earnings and net earnings per diluted share, respectively, was $71 million, or $.08 per diluted share, in acquisition-related amortization; $46 million, or $.05 per diluted share, from the quarter's LIFO provision; $42 million, or $.04 per diluted share, from the incremental taxation on equity earnings in Alliance Boots; $13 million, or $.01 per diluted share, of acquisition related costs; and $13 million, or $.01 per diluted share, from an additional gain on the 2011 sale of the Walgreens Health Initiatives, Inc. business relating to a client retention escrow.

For the six month period ended February 28, 2013, net earnings decreased 5.5% to $1,169 million or $1.23 per diluted share. The net earnings decrease for the six month period was primarily attributable to lower sales and higher selling, general and administrative expenses as a percentage of sales, partially offset by improved margins and equity earnings in Alliance Boots. Included in the six month period net earnings and net earnings per diluted share, respectively, was $130 million, or $.14 per diluted share, in acquisition-related amortization; $80 million, or $.08 per diluted share, from the quarter's LIFO provision; $42 million, or $.04 per diluted share, from the incremental taxation on equity earnings in Alliance Boots; $36 million, or $.03 per diluted share, of acquisition related costs; $24 million, or $.03 per diluted share, in costs related to Hurricane Sandy; and $13 million, or $0.01 per diluted share, from an additional gain on the 2011 sale of the Walgreens Health Initiatives, Inc. business relating to a client retention escrow.

Net sales for the quarter ended February 28, 2013 were $18.6 billion, flat as compared to the prior year. The acquisition of USA Drug and BioScrip assets increased total sales by 1.5% in the current quarter and six month period.
Sales were positively impacted by our participation in the Express Scripts retail pharmacy provider network as compared to the prior year's quarter where we were excluded from the network for the months of January and February. Sales gains from new stores, each of which include an indeterminate amount of market-driven price changes, were offset by lower comparable store sales.
Comparable drugstore sales were down 2.6% in the quarter ended February 28, 2013. 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 8,537 locations (8,072 drugstores) as of February 28, 2013, compared to 8,290 locations (7,841 drugstores) a year earlier.

Prescription sales were flat in the current quarter and decreased 3.7% for the first six months and represented 61.1% and 62.4% of total net sales, respectively. In the prior year, prescription sales decreased 1.7% in the quarter and increased by 1.3% year to date and represented 61.0% and 63.2% of total net sales. Comparable drugstore prescription sales decreased 2.7% in the current quarter and 7.1% for the six month period. The effect of generic drugs, which have a lower retail price, replacing brand name drugs reduced prescription sales by 5.9% in the current quarter and 7.3% for the first six months versus 2.1% and 2.0% in the same periods last year. The effect of generics on total net sales was a reduction of 3.2% in the current quarter and 4.0% year to date compared to 1.1% in the quarter and six month periods last year. Prescription sales were positively impacted by the effects of our participation in the Express Scripts retail pharmacy provider network. New generic drug introductions have led to an increased effect of generics on total net sales during the quarter and six month periods which is expected to continue for the remainder of fiscal 2013. Third party sales, where reimbursement is received from managed care organizations, the government, employers or private insurers, were 95.3% of prescription sales for the quarter and 95.5% for the six month periods ended February 28, 2013 compared to 95.7% for the quarter and the six month periods last 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 174 million compared to 167 million for the same period last year.
Prescriptions adjusted to 30 day equivalents were 208 million in the current quarter versus 196 million in last year's quarter.

Front-end sales decreased 0.1% for the current quarter and were 38.9% of total net sales. For the six months ended February 28, 2013 front-end sales were flat and comprised 37.6% of total net sales. In comparison, prior year front end sales increased 5.0% and 5.2% for the quarter and six month periods, respectively, and comprised 39.0% and 36.8% of total net sales. The decrease in the current quarter's front-end sales is due to negative comparable drugstore front end sales. Comparable drugstore front-end sales decreased 2.6% for the current quarter and 2.3% year to date compared to the prior year which increased 2.1% and 2.2% in the quarter and year to date periods, respectively. The decrease in comparable front end sales in the current quarter was primarily attributed to lower customer traffic partially offset by an increase in basket size.

Gross margin as a percent of sales was 30.1% in the current quarter and 29.8% for the first six months compared to 28.9% and 28.5% last year. Gross margin in the current quarter and six month period was positively impacted by higher retail pharmacy margins where the impact of new generics more than offset lower market driven reimbursements. Front-end gross margin percentages in the current quarter and six month period increased slightly driven by the non-prescription drug, personal care and household products categories in addition to purchasing synergies realized from the joint venture formed by Walgreens and Alliance Boots, which were partially offset by costs associated with points earned from our loyalty program as well as our e-commerce operations. Additionally, a higher provision for LIFO negatively impacted margins for the six month period.
New generic introductions are expected to continue to positively contribute to pharmacy gross margins for the remainder of fiscal 2013.

Gross profit dollars increased 4.0% over the prior year's quarter and 2.0% over the prior year's six month period. The increase is attributed to higher retail pharmacy margins.

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 $72 million and $127 million for the quarter and six month periods ended February 28, 2013 versus $72 million and $117 million a year ago. In the current quarter, our estimated annual inflation rate increased from 2.5% to 2.75% primarily due to higher than anticipated prescription drug inflation. At February 29, 2012, our estimated annual inflation rate for fiscal 2012 was 2.5%.

Selling, general and administrative expenses as a percentage of sales were 24.1% for the current year's second quarter and 24.7% for the first six months compared to 23.0% and 23.1% a year ago. As a percentage of sales, expenses in the current quarter were higher primarily due to investments in strategic initiatives and capabilities, store direct expenses, legal expenses, occupancy expense and USA Drug expenses which include operating, acquisition and store . . .

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