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WAG > SEC Filings for WAG > Form 10-Q on 1-Jul-2014All Recent SEC Filings

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Form 10-Q for WALGREEN CO


1-Jul-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 and our Quarterly Report on Form 10-Q for the quarter ended May 31, 2014.

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 May 31, 2014, we operated 8,683 locations in 50 states, the District of Columbia, Puerto Rico, Guam, and the U.S. Virgin Islands. Total locations do not include 404 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                                    May 31, 2014        May 31, 2013
Drugstores                                              8,217               8,097
Worksite Health and Wellness Centers                      362                 369
Infusion and Respiratory Services Facilities               91                  81
Specialty Pharmacies                                       11                  11
Mail Service Facilities                                     2                   2
Total                                                   8,683               8,560

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 lower reimbursements and a significantly lower rate of new generic introductions in the first nine months of fiscal 2014, as compared to the same period last year. We anticipate the effect of new generics to become positive on a year over year basis 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 include 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, 2014 and 2013 (prepared in accordance with IFRS as issued by the IASB) are available on our Form 8-K filed on May 15, 2014.

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. The investment is recorded as equity investment in Alliance Boots in the Consolidated Condensed Balance Sheets. Our investment in Alliance Boots and the related call option were recorded as assets with an $8.0 billion aggregate value on our May 31, 2014 Consolidated Condensed Balance Sheet, which represented 31.3% 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. 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. 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.

Fiscal 2014 combined synergies across both companies are estimated to be between $400 million and $450 million. The three-month lag impacts the quarterly and fiscal year timing of when Alliance Boots results and synergies are 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 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.

The Company continues to evaluate the potential exercise of the option to acquire the 55% equity interest in Alliance Boots it does not currently own, including the potential timing and structure, the combined management team, additional synergy and cost reduction initiatives and potential changes to the Company's capital structure. This evaluation is ongoing and further information in this regard is expected to be announced in the fourth quarter of fiscal 2014. 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, our Quarterly Report on Form 10-Q filed on March 25, 2013 and our Schedule 13D filed on April 15, 2014 for more detailed information regarding these agreements and arrangements. See "Cautionary Note Regarding Forward-Looking Statements" below.

STORE CLOSURES

On March 24, 2014, our Board of Directors approved a plan to close 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. 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 and number of store 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.

We closed 25 stores and incurred pre-tax charges of $95 million ($47 million related to lease termination costs and $48 million in asset impairments) during the quarter ended May 31, 2014. We expect that substantially all of the remaining charges will be recognized during the fourth quarter of fiscal 2014.

OPERATING STATISTICS

                                                            Percentage Increases/(Decreases)
                                                   Three Months Ended               Nine Months Ended
                                                May 31,          May 31,        May 31,          May 31,
                                                  2014             2013           2014             2013
Net Sales                                             5.9              3.2            5.6             (0.5 )
Net Earnings Attributable to Walgreen Co.            15.7             16.2           21.1              1.1
Comparable Drugstore Sales                            4.8              1.4            4.8             (3.1 )
Prescription Sales                                    8.4              3.4            7.6             (1.4 )
Comparable Drugstore Prescription Sales               6.3              2.0            6.4             (4.2 )
Front-End Sales                                       2.3              2.7            2.5              0.9
Comparable Drugstore Front-End Sales                  2.2              0.4            2.2             (1.5 )
Gross Profit                                          4.2              4.1            2.0              2.7
Selling, General and Administrative Expenses          4.3              5.3            1.8              5.0

                                                                  Percent to Net Sales
                                                   Three Months Ended               Nine Months Ended
                                                May 31,          May 31,        May 31,          May 31,
                                                  2014             2013           2014             2013
Gross Margin                                         28.1             28.5           28.3             29.4
Selling, General and Administrative Expenses         23.5             23.8           23.5             24.3

                                                                Other Statistics
                                                Three Months Ended              Nine Months Ended
                                            May 31,           May 31,        May 31,        May 31,
                                              2014             2013            2014           2013
Prescription Sales as a % of Net Sales           64.4              63.1           63.7           62.6
Third Party Sales as a % of Total
Prescription Sales                               96.6              96.1           96.3           95.7
Number of Prescriptions (in millions)             178               173            528            516
Comparable Prescription %
Increase/(Decrease)                               2.1               5.2            1.6           (0.1 )
30 Day Equivalent Prescriptions (in
millions) *                                       218               209            645            618
Comparable 30 Day Equivalent
Prescription % Increase *                         4.1               7.1            3.9            2.0
Total Number of Locations                                                        8,683          8,560

* 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 third quarter ended May 31, 2014, were $722 million, or $0.75 per diluted share. This was a 15.7% increase in net earnings over the same quarter last year. The net earnings increase in the quarter was primarily attributable to higher net sales, a lower effective income tax rate, lower selling, general and administrative expenses as a percentage of sales and gains on fair market value adjustments related to the AmerisourceBergen warrants partially offset by lower gross margins. Included in the third quarter net earnings and net earnings per diluted share, respectively, was $68 million, or $0.07 per diluted share, of store closure and other optimization costs; income of $67 million, or $0.07 per diluted share, related to combined fair value adjustments and amortization related to both our and Alliance Boots warrants to purchase AmerisourceBergen common stock; $63 million, or $0.06 per diluted share, in acquisition-related amortization; $55 million, or $0.06 per diluted share, in Alliance Boots related tax; $28 million, or $0.03 per diluted share, from the quarter's LIFO provision; and $14 million, or $0.01 per diluted share, of other acquisition-related costs. Included in the third quarter ended May 31, 2013 net earnings and net earnings per diluted share, respectively, were the negative impacts of $76 million, or $0.08 per diluted share, from the quarter's LIFO provision; $52 million, or $0.05 per diluted share, in acquisition-related amortization; $47 million, or $0.05 per diluted share, related to a legal settlement with the Drug Enforcement Administration (DEA); $44 million, or $0.05 per diluted share, in Alliance Boots related tax; and $17 million, or $0.02 per diluted share, of acquisition-related costs. Net earnings in the quarter ended May 31, 2013 were positively impacted by $48 million, or $0.05 per diluted share, from combined fair value adjustments and amortization related to both our and Alliance Boots warrants to purchase AmerisourceBergen common stock.

For the nine month period ended May 31, 2014, net earnings increased 21.1% to $2,171 million or $2.25 per diluted share. The net earnings increase for the nine 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 nine month period net earnings and net earnings per diluted share, respectively, was $254 million of income, or $0.26 per diluted share, related to combined fair value adjustments and amortization related to both our and Alliance Boots warrants to purchase AmerisourceBergen common stock; $181 million, or $0.19 per diluted share, in acquisition-related amortization; $130 million, or $0.13 per diluted share, in Alliance Boots related tax; $98 million, or $0.10 per diluted share, from the nine months' LIFO provision; $84 million, or $0.09 per diluted share, of store closure and other optimization costs; and $41 million, or $0.04 per diluted share, of acquisition-related costs. Included in the nine month period ending May 31, 2013, net earnings and net earnings per diluted share, respectively, were the negative impacts of $182 million, or $0.19 per diluted share, in acquisition-related amortization; $156 million, or $0.16 per diluted share, from the LIFO provision; $86 million, or $0.09 per diluted share, in Alliance Boots related tax; $53 million, or $0.05 per diluted share, of acquisition related costs; $47 million, or $0.06 per diluted share, relating to certain litigation matters including the DEA settlement; and $24 million, or $0.03 per diluted share, in costs related to Hurricane Sandy. Net earnings in the nine month period were positively impacted by $48 million, or $0.05 per diluted share, from combined fair value adjustments and amortization related to both our and Alliance Boots warrants to purchase AmerisourceBergen common stock 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, 2014, increased by 5.9% to $19.4 billion. Sales increased from higher comparable store sales and new stores, each of which includes an indeterminate amount of market-driven price changes. Sales in comparable drugstores were up 4.8% in the quarter ended May 31, 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 8,683 locations (8,217 drugstores) as of May 31, 2014, compared to 8,560 locations (8,097 drugstores) a year earlier.

Prescription sales increased by 8.4% in the current quarter and 7.6% for the first nine months, representing 64.4% and 63.7% of total net sales, respectively. In the prior year, prescription sales increased 3.4% in the quarter and decreased 1.4% year to date, representing 63.1% and 62.6% of total net sales, respectively. Comparable drugstore prescription sales were up 6.3% in the current quarter and 6.4% for the nine month period. The effect of generic drugs, which have a lower retail price, replacing brand name drugs reduced prescription sales by 1.4% in the current quarter and 1.2% for the first nine months versus reductions of 4.2% and 6.3% in the same periods last year. The effect of generics on total net sales was a reduction of 0.8% in the current quarter and 0.7% year to date compared to reductions of 2.4% for the quarter and 3.5% for the first nine months last year. Third party sales, where reimbursement is received from managed care organizations, the government, employers or private insurers, were 96.6% of prescription sales for the quarter and 96.3% for the nine month periods ended May 31, 2014 compared to 96.1% for the quarter and 95.7% for the nine month period last year. We receive market driven reimbursements from third party payers based on negotiated and contracted reimbursement rates, a number of which typically reset in January. The total number of prescriptions filled for the current quarter (including immunizations) was approximately 178 million compared to 173 million for the same period last year. Prescriptions adjusted to 30 day equivalents were 218 million in the current quarter versus 209 million in last year's quarter.

Front-end sales increased 2.3% for the current quarter and were 35.6% of total net sales. For the nine months ended May 31, 2014, front-end sales increased 2.5% and comprised 36.3% of total net sales. In comparison, prior year front end sales increased 2.7% for the quarter and increased 0.9% for the nine month period, and comprised 36.9% and 37.4% of total net sales. Comparable drugstore front-end sales increased 2.2% for the current quarter and 2.2% year to date compared to the prior year which increased 0.4% in the quarter and decreased 1.5% year to date. 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 28.1% in the current quarter and 28.3% for the first nine months compared to 28.5% and 29.4% last year. Retail pharmacy margins were negatively impacted in the quarter and year to date periods by lower third-party reimbursement; the increase in Medicare Part D mix including the strategy to continue driving 90-day prescriptions at retail; fewer brand-to-generic drug conversions compared with the prior year period; generic drug price inflation on a subset of generic drugs; and a mix of specialty drugs, which carry a lower margin percentage. Front-end margins were positively impacted in the current quarter primarily from the personal care, household items and convenience and fresh foods categories partially offset by the candy, non-prescription drug and beauty categories. Year to date front-end margins were negatively impacted in the convenience and fresh foods, non-prescription drug, photofinishing and candy categories. Retail pharmacy and front-end margins were positively impacted in the quarter and year to date periods by purchasing synergies realized from the joint venture formed by Walgreens and Alliance Boots. We expect the negative factors impacting pharmacy margin will more than offset the anticipated generic introduction in the fourth quarter on a year over year basis.

Gross profit dollars for the quarter and nine month periods ended May 31, 2014 increased $218 million, or 4.2%, and $314 million, or 2.0%, respectively, compared to the same periods last year. The increase is attributed to higher sales volumes partially offset by lower 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 $41 million and $150 million for the quarter and nine month periods ended May 31, 2014, respectively, versus $120 million and $247 million in the same periods a year ago. In the current quarter, our estimated annual inflation rate decreased from 2.50% to 2.25%, primarily due to lower forecasted prescription drug inventory levels. In the prior year's quarter, the estimated annual inflation rate increased from 2.75% to 3.50% primarily due to higher than anticipated prescription drug inflation.

Selling, general and administrative expenses as a percentage of sales were 23.5% for the current year's third quarter and first nine months compared to 23.8% and 24.3% 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, store occupancy costs, acquisition related costs and legal expenses, partially offset by store closure costs related to our store optimization plan and higher weather-related costs. Expenses for the nine month period as a percentage of sales were lower primarily due to lower store compensation costs, legal expenses and store occupancy costs, partially offset by higher store closure costs through our store optimization plan. Included in the prior year's nine month period were expenses related to Hurricane Sandy, the DEA settlement, and higher investments in strategic initiatives and capabilities.

Selling, general and administrative expense dollars increased $189 million or 4.3% over the prior year's quarter and $242 million or 1.8% over the prior year's nine month period. The current quarter's growth includes 2.3% of store closure and other optimization costs, 1.8% of headquarters expenses, 1.4% of new store expenses and 0.1% of acquisition related amortization which were partially offset by lower legal costs incurred as compared to last year related to the DEA settlement of 0.7%, lower comparable store expenses of 0.3% and acquisition related costs of 0.3%. Growth for the nine month period ended May 31, 2014 included 1.3% of new store expenses, 0.9% of store closure and other . . .

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