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WAG > SEC Filings for WAG > Form 10-Q on 28-Jun-2013All Recent SEC Filings

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Form 10-Q for WALGREEN CO


28-Jun-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" below, , and in our Annual Report on Form 10-K for the year ended August 31, 2012 and our Quarterly Report on Form 10-Q for the quarter ended February 28, 2013.

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 May 31, 2013, we operated 8,560 locations in 50 states, the District of Columbia, Guam and Puerto Rico. Total locations do not include 374 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                                    May 31, 2013        May 31, 2012
Drugstores                                              8,097               7,890
Worksite Health and Wellness Centers                      369                 362
Infusion and Respiratory Services Facilities               81                  78
Specialty Pharmacies                                       11                  11
Mail Service Facilities                                     2                   2
Total                                                   8,560               8,343

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; 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. The positive impact of this agreement generally has been incremental over time, during the first three quarters since 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 otherwise 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."

On May 13, 2013, we announced a multi-year extension of our agreement to serve as a network pharmacy provider in the CVS Caremark pharmacy benefit management national retail network.

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. In addition, key fiscal 2012 acquisitions included 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. Alliance Boots fiscal 2013 results are available on our Form 8-K filed on May 15, 2013.
Walgreens equity earnings, initial investment and the call option excludes the Alliance Boots minority interest in Galenica Ltd. (Galenica). The Alliance Boots investment in Galenica was distributed to the Alliance Boots shareholders other than Walgreens during May 2013, which had no impact to the Company. 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 condensed 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 of the date of this filing, we estimate combined synergies across both companies to be between $125 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 nine months ended May 31, 2013 reflect nine months of the dilutive effect of the incremental shares and interest expense associated with our Alliance Boots investment, but only seven months (August 1, 2012 through February 28, 2013) 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 nine 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 cough/cold and flu season. Because of the three-month lag in reporting equity income from our investment in Alliance Boots, the results of Alliance Boots for December, January and February are 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.

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 addition to the information in this report, please refer to our Current Report on Form 8-K filed on March 20, 2013, our Quarterly Report on Form 10-Q filed on March 25, 2013 for more detailed information regarding these agreements and arrangements. See "Cautionary Note Regarding Forward-Looking Statements" and "Risk Factors" below.

OPERATING STATISTICS

                                                            Percentage Increases/(Decreases)
                                                   Three Months Ended               Nine Months Ended
                                                May 31,          May 31,        May 31,          May 31,
                                                  2013             2012           2013             2012
Net Sales                                             3.2             (3.4 )         (0.5 )            0.6
Net Earnings                                         16.2            (10.8 )          1.1             (7.7 )
Comparable Drugstore Sales                            1.4             (6.6 )         (3.1 )           (2.0 )
Prescription Sales                                    3.4             (6.6 )         (1.4 )           (1.5 )
Comparable Drugstore Prescription Sales               2.0             (9.9 )         (4.2 )           (3.8 )
Front-End Sales                                       2.7              2.8            0.9              4.4
Comparable Drugstore Front-End Sales                  0.4             (0.9 )         (1.5 )            1.2
Gross Profit                                          4.1             (2.7 )          2.7              0.5
Selling, General and Administrative Expenses          5.3             (1.6 )          5.0              2.5



                                                                   Percent to Net Sales
                                                    Three Months Ended               Nine Months Ended
                                                May 31,           May 31,        May 31,          May 31,
                                                  2013             2012            2013             2012
Gross Margin                                         28.5              28.2           29.4             28.4
Selling, General and Administrative Expenses         23.8              23.3           24.3             23.1




                                                               Other Statistics
                                               Three Months Ended              Nine Months Ended
                                            May 31,          May 31,        May 31,        May 31,
                                              2013             2012           2013           2012
Prescription Sales as a % of Net Sales           63.1             62.9           62.6           63.1
Third Party Sales as a % of Total                96.1             95.5           95.7           95.7
Prescription Sales
Number of Prescriptions (in millions)             173              162            516            508
Comparable Prescription %                         5.2            (12.3 )         (0.1 )         (7.7 )
Increase/(Decrease)
30 Day Equivalent Prescriptions (in               209              192            618            596
millions) *
Comparable 30 Day Equivalent
Prescription % Increase/(Decrease) *              7.1             (9.1 )          2.0           (4.1 )
Total Number of Locations                                                       8,560          8,343

* 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 May 31, 2013 were $624 million or $.65 per diluted share. This was a 16.2% 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, were the negative impacts of $76 million, or $.08 per diluted share, from the quarter's LIFO provision; $52 million, or $.05 per diluted share, in acquisition-related amortization; $47 million, or $.05 per diluted share, related to a legal settlement with the Drug Enforcement Administration (DEA); $44 million, or $.05 per diluted share, in Alliance Boots related tax; and $17 million, or $.02 per diluted share, of acquisition related costs. Net earnings in the current quarter were positively impacted by $48 million, or $.05 per diluted share, from fair value adjustments of warrants acquired through the AmerisourceBergen long-term partnership and the amortization of the deferred credit associated with the initial value of the warrants.

For the nine month period ended May 31, 2013, net earnings increased 1.1% to $1,793 million or $1.88 per diluted share. The net earnings increase for the nine 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 nine month period net earnings and net earnings per diluted share, respectively, were the negative impacts of $182 million, or $.19 per diluted share, in acquisition-related amortization; $156 million, or $.16 per diluted share, from the LIFO provision; $86 million, or $.09 per diluted share, in Alliance Boots related tax; $53 million, or $.05 per diluted share, of acquisition related costs; $47 million, or $.06 per diluted share, relating to certain litigation matters including the DEA settlement; and $24 million, or $.03 per diluted share, in costs related to Hurricane Sandy. Net earnings in the nine month period was positively impacted by $48 million, or $.05 per diluted share, from fair value adjustments of warrants acquired through the AmerisourceBergen long-term partnership and the amortization of the deferred credit associated with the initial value of the warrants 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 May 31, 2013 increased 3.2% to $18.3 billion.
The acquisition of USA Drug and BioScrip assets increased total sales by 0.9% in the current quarter and 1.4% for the nine month period. Sales increased from new stores, each of which include an indeterminate amount of market-driven price changes, and higher comparable store sales. Comparable drugstore sales were up 1.4% in the quarter ended May 31, 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 8,560 locations (8,097 drugstores) as of May 31, 2013, compared to 8,343 locations (7,890 drugstores) a year earlier.

Prescription sales increased 3.4% in the current quarter and decreased 1.4% for the first nine months and represented 63.1% and 62.6% of total net sales, respectively. In the prior year, prescription sales decreased 6.6% in the quarter and 1.5% for the first nine months and represented 62.9% and 63.1% of total net sales. Comparable drugstore prescription sales increased 2.0% in the current quarter and decreased 4.2% for the nine month period. The effect of generic drugs, which have a lower retail price, replacing brand name drugs reduced prescription sales by 4.2% in the current quarter and 6.3% for the first nine months versus 3.2% and 2.4% in the same periods last year. The effect of generics on total net sales was a reduction of 2.4% in the current quarter and 3.5% year to date compared to a reduction of 1.7% and 1.3% in the quarter and nine 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 nine month periods which is expected to continue for the remainder of fiscal 2013 although at a reduced level relative to the contributions in the first three quarters of fiscal 2013.
Third party sales, where reimbursement is received from managed care organizations, the government, employers or private insurers, were 96.1% of prescription sales for the quarter and 95.7% for the nine month periods ended May 31, 2013 compared to 95.5% for the quarter and 95.7% for the nine 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 173 million compared to 162 million for the same period last year.
Prescriptions adjusted to 30 day equivalents were 209 million in the current quarter versus 192 million in last year's quarter.

Front-end sales increased 2.7% for the current quarter and were 36.9% of total net sales. For the nine months ended May 31, 2013, front-end sales increased 0.9% and comprised 37.4% of total net sales. In comparison, prior year front end sales increased 2.8% and 4.4% for the quarter and nine month periods, respectively, and comprised 37.1% and 36.9% of total net sales. The increase in the current quarter's front-end sales is primarily due to new store openings. Comparable drugstore front-end sales increased 0.4% for the current quarter and decreased 1.5% year to date compared to the prior year which decreased 0.9% and increased 1.2% in the quarter and year to date periods, respectively. The increase in comparable front end sales in the current quarter was primarily attributed to an increase in basket size, which was partially offset by lower customer traffic. For the nine month period, comparable front-end sales were negatively impacted primarily from lower customer traffic, which was offset to a lesser extent through an increase in basket size.

Gross margin as a percent of sales was 28.5% in the current quarter and 29.4% for the first nine months compared to 28.2% and 28.4% last year. Gross margin in the current quarter and nine 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 increased in the current quarter driven by the candy, non-prescription drug and personal care categories. For the nine month period, improved margins were driven by the non-prescription drug, personal care and household products categories. Costs associated with the points earned from our Balance® Rewards loyalty program negatively impacted front-end margins, but were partially offset by purchasing synergies realized from the joint venture formed by Walgreens and Alliance Boots. Additionally, a higher provision for LIFO negatively impacted margins for the quarter and nine month periods. New generic introductions are expected to continue to positively contribute to pharmacy gross margins for the remainder of fiscal 2013 although at a reduced level relative to the contributions in the first three quarters of fiscal 2013.

Gross profit dollars increased 4.1% over the prior year's quarter and 2.7% over the prior year's nine 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 $120 million and $247 million for the quarter and nine month periods ended May 31, 2013 versus $60 million and $177 million a year ago. In the current quarter, our estimated annual inflation rate increased from 2.75% to 3.50% primarily due to higher than anticipated prescription drug inflation. The prior year's estimated annual inflation rate was 2.5% at May 31, 2012.

Selling, general and administrative expenses as a percentage of sales were 23.8% for the current year's third quarter and 24.3% for the first nine months compared to 23.3% and 23.1% a year ago. As a percentage of sales, expenses in the current quarter were higher primarily due to higher store salaries; legal provisions and fees associated with the DEA settlement; higher profit sharing provision; USA Drug expenses which include operating, acquisition and store closing costs; and investments in strategic initiatives and capabilities.
Expenses for the nine month period as a percentage of sales were higher due to store salaries, occupancy expense, legal provisions and fees associated with the DEA settlement, investments in strategic initiatives and capabilities, USA Drug expenses which include operating, acquisition and store closing costs and Hurricane Sandy expenses.

Selling, general and administrative expense dollars increased $221 million or 5.3% over the prior year's quarter and $628 million or 5.0% over the prior year's nine month period. The current quarter's growth includes 2.5% of new store expenses, 1.4% of comparable store and headquarters expenses, 0.6% from USA Drug operations, 0.2% from acquisition related costs and 0.6% in costs related to the DEA settlement. Growth for the nine month period ended May 31, 2013 includes 2.5% of new store expenses, 0.7% of comparable store and headquarter expenses, 0.6% from USA Drug operations, 0.5% from acquisition related costs, 0.3% from Hurricane Sandy, 0.2% in acquisition related amortization and 0.2% in costs related to the DEA settlement.

Earnings in the 45% Alliance Boots equity method investment for the three and nine month periods ended May 31, 2013 were $131 million and $220 million, respectively. Alliance Boots earnings are reported on a three-month lag. As a result, only August through February's results of operations of Alliance Boots are reflected in the equity earnings in Alliance Boots included in our reported net earnings for the nine month period ended May 31, 2013. Earnings included amortization expense resulting from the fair value of certain Alliance Boots assets of $3 million in the current quarter and $36 million for the nine month period, $18 million of which was related to inventory.

For the three and nine month periods ending May 31, 2013, other income was $77 million. The fair value of the Company's AmerisourceBergen warrants was $150 million at May 31, 2013, which resulted in recording other income of $73 million . . .

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