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WAG > SEC Filings for WAG > Form 10-Q on 27-Mar-2014All Recent SEC Filings

Show all filings for WALGREEN CO

Form 10-Q for WALGREEN CO


27-Mar-2014

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, 2013. 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, 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. We offer customers the choice to have prescriptions filled at our retail pharmacies as well as through the mail, telephone or online including through our mobile application. At February 28, 2014, we operated 8,681 locations in 50 states, the District of Columbia, Guam, Puerto Rico and the U.S. Virgin Islands. Total locations do not include 408 Healthcare Clinics that are operated primarily within other Walgreens locations or locations of unconsolidated partially owned entities such as Alliance Boots GmbH (Alliance Boots).

                                                   Number of Locations
Location Type                             February 28, 2014     February 28, 2013
Drugstores                                            8,210                 8,072
Worksite Health and Wellness Centers                    366                   371
Infusion and Respiratory Services                        93                    81
Facilities
Specialty Pharmacies                                     10                    11
Mail Service Facilities                                   2                     2
Total                                                 8,681                 8,537

The drugstore industry is highly competitive where we compete with other drugstore chains, independent drugstores and mail order prescription providers.
We also 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. 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 (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. 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. In addition, plan changes typically occur in January and in fiscal 2013, the high rate of introduction of new generic drugs moderated the impact of any associated rate adjustments. We experienced a significantly lower rate of new generic introductions in the first six months of fiscal 2014, as compared to the same period last year. We anticipate this effect to moderate in the third quarter and become positive in the fourth quarter of the current fiscal year.

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 since September 15, 2012.

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. In the first quarter of fiscal 2014, we acquired certain assets of Kerr Drug and its affiliates, which includes 76 retail drugstore locations, as well as a specialty pharmacy business and a distribution center, all based in North Carolina. In fiscal 2013, we acquired Stephen L. LaFrance Holdings, Inc. (USA Drug), which included 141 drugstore locations operating under the USA Drug, Super D Drug, May's Drug, Med-X and Drug Warehouse names. Additionally, we acquired an 80% interest in Cystic Fibrosis Foundation Pharmacy LLC. This investment provides joint ownership in a specialty pharmacy for cystic fibrosis patients and their families in addition to providing new product launch support and call center services for drug manufacturers.

In August 2012, we acquired a 45% equity interest in Alliance Boots GmbH 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 (IFRS) 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 audited consolidated financial statements for the years ended March 31, 2013 and 2012 (prepared in accordance with IFRS) are available on our Form 8-K filed on May 15, 2013. 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 Earnings. The investment is recorded as equity investment in Alliance Boots in the Consolidated Condensed Balance Sheets.

Fiscal 2014 combined synergies across both companies are estimated to be between $375 million and $425 million. The three-month lag impacts the quarterly and fiscal year timing of when Alliance Boots results and synergies will be reflected in the equity earnings in Alliance Boots included in our financial statements. See "Cautionary Note Regarding Forward-Looking Statements" below.

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 we utilize 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.

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 Walgreens and AmerisourceBergen pursuant to which we 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 Walgreens and Alliance Boots; and agreements and arrangements pursuant to which we 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. AmerisourceBergen began to distribute all branded pharmaceutical products that we historically sourced from distributors and suppliers, effective September 1, 2013. In the second quarter of fiscal year 2014, AmerisourceBergen began distributing generic pharmaceutical products that we previously self-distributed. We expect the levels of generic pharmaceuticals distributed by AmerisourceBergen to continue to increase throughout the fiscal year. In addition to the information in this report, please refer to our Current Report on Form 8-K filed on March 20, 2013 and 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" below.

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. Our investment in Alliance Boots and the related call option were recorded as assets with a $7.7 billion aggregate value on our February 28, 2014 Consolidated Condensed Balance Sheets, which represented 30.8% of our long-lived assets as of that date.
Because our investment in Alliance Boots is denominated in a foreign currency (British pounds Sterling), translation gains or losses impact the value of the investment. See Note 5 to our unaudited Consolidated Condensed Financial Statements for additional information.

RECENT DEVELOPMENT

On March 24, 2014, our Board of Directors approved a plan to close 76 underperforming stores in efforts to optimize and focus resources in a manner intended to increase shareholder value. We estimate that total pre-tax charges associated with the plan will be between $240 million and $280 million, largely attributable to lease termination costs. We expect that substantially all of these charges will be recognized during the third and fourth quarters of fiscal 2014. This store optimization plan is expected to result in an annual operating income benefit of $40 million to $50 million beginning in fiscal 2015. The amounts and timing of all estimates are subject to change. The actual amounts and timing may vary materially based on various factors, including the timing of closings; the timing and amount of sublease income and other lease expense; factors relating to real estate including sale proceeds; asset write-downs and other factors affecting inventory value; changes in management's assumptions; and other factors. See "Cautionary Note Regarding Forward-Looking Statements" below.

OPERATING STATISTICS

                                                                   Percentage Increases/(Decreases)
                                                       Three Months Ended                      Six Months Ended
                                                February 28,         February 28,      February 28,        February 28,
                                                    2014                 2013              2014                2013
Net Sales                                                 5.1                  0.0               5.5                (2.3 )
Net Earnings Attributable to Walgreen Co.                (0.3 )               10.7               3.9                (5.5 )
Comparable Drugstore Sales                                4.3                 (2.6 )             4.8                (5.3 )
Prescription Sales                                        7.0                  0.0               7.2                (3.7 )
Comparable Drugstore Prescription Sales                   5.8                 (2.7 )             6.5                (7.1 )
Front-End Sales                                           2.2                 (0.1 )             2.7                 0.0
Comparable Drugstore Front-End Sales                      2.0                 (2.6 )             2.2                (2.3 )
Gross Profit                                              0.8                  4.0               0.9                 2.0
Selling, General and Administrative Expenses              1.6                  5.0               0.6                 4.8

                                                                         Percent to Net Sales
                                                       Three Months Ended                      Six Months Ended
                                                February 28,         February 28,      February 28,        February 28,
                                                    2014                 2013              2014                2013
Gross Margin                                             28.8                 30.1              28.5                29.8
Selling, General and Administrative Expenses             23.3                 24.1              23.6                24.7

                                                                     Other Statistics
                                                  Three Months Ended                    Six Months Ended
                                           February 28,        February 28,      February 28,      February 28,
                                               2014                2013              2014              2013
Prescription Sales as a % of Net Sales              62.2                61.1              63.4              62.4
Third Party Sales as a % of Total                   96.2                95.3              96.2              95.5
Prescription Sales
Number of Prescriptions (in millions)                175                 174               350               343
Comparable Prescription %                           (0.4 )               2.5               1.4              (2.6 )
Increase/(Decrease)
30 Day Equivalent Prescriptions (in                  214                 208               427               409
millions) *
Comparable 30 Day Equivalent
Prescription % Increase/(Decrease) *                 2.2                 4.3               3.8              (0.4 )
Total Number of Locations                                                                8,681             8,537

* 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 attributable to Walgreen Co. for the second quarter ended February 28, 2014, were $754 million, or $.78 per diluted share. This was a 0.3% decrease in net earnings over the same quarter last year. The net earnings decrease in the quarter was primarily attributable to lower gross margins and a loss on fair market value adjustments related to the AmerisourceBergen warrants mostly offset by higher net sales, lower selling, general and administrative expenses as a percent of sales, higher equity earnings in Alliance Boots and a lower effective income tax rate. Included in the second quarter net earnings and net earnings per diluted share, respectively, was $60 million, or $.06 per diluted share, in acquisition-related amortization; $47 million, or $.05 per diluted share, in Alliance Boots related tax; $33 million, or $.04 per diluted share, from the quarter's LIFO provision; income of $26 million, or $.03 per diluted share, related to combined fair value adjustments and amortization related to both our and Alliance Boots warrants to purchase AmerisourceBergen common stock; $11 million, or $.01 per diluted share, of other acquisition-related costs and $1 million of organizational efficiency costs.
Included in the second quarter ended February 28, 2013 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, in Alliance Boots related tax; $13 million, or $.01 per diluted share, of acquisition-related costs; $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, 2014, net earnings increased 23.9% to $1,449 million or $1.51 per diluted share. The net earnings increase for the six month period was primarily attributable to higher net sales, lower selling, general and administrative expenses as a percentage of sales, higher equity earnings in Alliance Boots, fair market value gains related to the AmerisourceBergen warrants and a lower effective tax rate partially offset by lower gross margins. Included in the six month period net earnings and net earnings per diluted share, respectively, was $187 million, or $.20 per diluted share, related to combined fair value adjustments and amortization related to both our and Alliance Boots warrants to purchase AmerisourceBergen common stock; $118 million, or $.12 per diluted share, in acquisition-related amortization; $75 million, or $.08 per diluted share, in Alliance Boots related tax; $70 million, or $.07 per diluted share, from the six months' LIFO provision; $27 million, or $.03 per diluted share, of acquisition-related costs and $16 million, or $.02 per diluted share, of organizational efficiency costs.
Included in the six month period ending February, 28, 2013, 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, in Alliance Boots related tax; $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, 2014, increased by 5.1% to $19.6 billion. Sales increased from new stores, each of which includes an indeterminate amount of market-driven price changes, and higher comparable store sales. Sales in comparable drugstores were up 4.3% in the quarter ended February 28, 2014. 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 8,681 locations (8,210 drugstores) as of February 28, 2014, compared to 8,537 locations (8,072 drugstores) a year earlier.

Prescription sales increased by 7.0% in the current quarter and 7.2% for the first six months, representing 62.2% and 63.4% of total net sales, respectively.
In the prior year, prescription sales were flat in the quarter and decreased 3.7% year to date, representing 61.1% and 62.4% of total net sales, respectively. Comparable drugstore prescription sales were up 5.8% in the current quarter and 6.5% for the six month period. The effect of generic drugs, which have a lower retail price, replacing brand name drugs reduced prescription sales by 1.3% in the current quarter and 1.1% for the first six months versus reductions of 5.9% and 7.3% in the same periods last year. The effect of generics on total net sales was a reduction of 0.7% in the current quarter and 0.6% year to date compared to reductions of 3.2% for the quarter and 4.0% for the first six months last year. Third party sales, where reimbursement is received from managed care organizations, the government, employers or private insurers, were 96.2% of prescription sales for both the quarter and for the six month periods ended February 28, 2014 compared to 95.3% for the quarter and 95.5% for the six month period 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 175 million compared to 174 million for the same period last year. Prescriptions adjusted to 30 day equivalents were 214 million in the current quarter versus 208 million in last year's quarter.

Front-end sales increased 2.2% for the current quarter and were 37.8% of total net sales. For the six months ended February 28, 2014, front-end sales increased 2.7% and comprised 36.6% of total net sales. In comparison, prior year front end sales decreased 0.1% for the quarter and were flat for the six month period, and comprised 38.9% and 37.6% of total net sales. Comparable drugstore front-end sales increased 2.0% for the current quarter and 2.2% year to date compared to the prior year which decreased 2.6% and 2.3% 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 partially offset by lower customer traffic.

Gross margin as a percent of sales was 28.8% in the current quarter and 28.5% for the first six months compared to 30.1% and 29.8% last year. Retail pharmacy margins were negatively impacted by a significant reduction in the number of brand to generic drug conversions and lower market driven reimbursements.
Front-end margins were negatively impacted in the convenience and fresh foods, non-prescription drug, photofinishing and household item categories. Retail pharmacy and front-end margins were positively impacted by purchasing synergies realized from the joint venture formed by Walgreens and Alliance Boots.

Gross profit dollars for the quarter and six month periods ended February 28, 2014 increased $43 million, or 0.8%, and $96 million, or 0.9%, respectively, compared to the same periods last year. The increase is attributed to higher sales volumes partially offset by lower retail pharmacy and front-end 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 $51 million and $109 million for the quarter and six month periods ended February 28, 2014, respectively, versus $72 million and $127 million in the same periods a year ago. In the current quarter, our estimated annual inflation rate decreased from 2.75% to 2.50%, primarily due to lower forecasted prescription drug inventory levels. In the prior year's quarter, the estimated annual inflation rate increased from 2.50% to 2.75% primarily due to higher than anticipated prescription drug inflation.

Selling, general and administrative expenses as a percentage of sales were 23.3% for the current year's second quarter and 23.6% for the first six months compared to 24.1% and 24.7% in the same periods a year ago. As a percentage of sales, expenses in the current quarter were lower primarily due to lower store compensation costs, legal expenses and promotional costs associated with the Company's loyalty program partially offset by higher weather-related costs.
Expenses for the six month period as a percentage of sales were lower primarily due to lower store compensation costs and loyalty expenses, partially offset by higher weather-related costs. Included in the prior year's six month period were expenses related to Hurricane Sandy and higher investments in strategic initiatives and capabilities.

Selling, general and administrative expense dollars increased $72 million or 1.6% over the prior year's quarter and $53 million or 0.6% over the prior year's six month period. The current quarter's growth includes 1.3% of new store expenses and 0.4% of comparable store and headquarters expenses which were partially offset by lower acquisition related costs of 0.1%. Growth for the six month period ended February 28, 2014 included 1.3% of new store expenses and 0.2% of organizational efficiency costs. These were partially offset by lower comparable store and headquarters expenses of 0.2% and acquisition related costs of 0.3%. In addition, Hurricane Sandy costs in the prior year were 0.4%.

Equity earnings in the 45% Alliance Boots equity method investment for the three month period ended February 28, 2014 was $194 million compared to $85 million last year. The current quarter included $99 million in fair value adjustments and amortization related to Alliance Boots warrants to purchase AmerisourceBergen common stock. Earnings also reflect $10 million, $8 million net of tax, of incremental acquisition-related amortization in the current quarter compared to amortization of $28 million in the prior year's quarter, $23 million net of tax, of which $13 million related to inventory.

Equity earnings in the 45% Alliance Boots equity method investment for the six month period ended February 28, 2014 was $345 million as compared to $89 million last year. Alliance Boots earnings are reported on a three-month lag. As a result, the six month period ended February 28, 2013 only included August through November's results of operations of Alliance Boots reflected in the equity earnings in Alliance Boots due to the timing of this investment. Earnings in the first six months of the current year included $118 million in fair value adjustments and amortization related to Alliance Boots warrants to purchase AmerisourceBergen common stock and $71 million from remeasuring deferred tax balances related to UK tax law changes enacted in July 2013. Earnings also reflect $20 million, $16 million net of tax, of incremental acquisition-related amortization in the current six month period compared to amortization of $40 million in the prior year period, $33 million net of tax, $19 million of which was related to inventory.

Other income/(expense) for the three and six month periods ended February 28, . . .

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