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Executives

Rick Hans – Divisional VP of IR and Finance

Greg Wasson – President and CEO

Wade Miquelon – SVP and CFO

Analysts

Andrew Wolf – BB&T Capital

Robert Willoughby – Banc of America

John Ransom – Raymond James

Neil Currie – UBS

Deborah Weinswig – Citi

John Heinbockel – Goldman Sachs

Ed Kelly – Credit Suisse

Lisa Gill – JP Morgan

Walgreen Company (WAG) F2Q09 (Qtr End 02/28/09) Earnings Call Transcript March 23, 2009 8:30 AM ET

Operator

Good day everyone and welcome to the Walgreen Company Second Quarter 2009 Earnings Conference Call. As a reminder, today’s call is being recorded. Now I’d like to turn the conference over to Mr. Rick Hans, Divisional Vice President of Inventor Relations and Finance. Please go ahead sir.

Rick Hans

Thank you Angel, and good morning everyone. Welcome to our Second Quarter Conference Call. Today Greg Wasson, our President and Chief Executive Officer, will discuss the quarter’s highlights and how we are reinforcing our key strategies through changes in our corporate structure; Wade Miquelon, Senior Vice President and Chief Financial Officer, will detail the second quarter financial results before we begin taking your calls. John Spina, our Vice President and Treasurer, also is joining us on the call today.

When we get to your questions, please limit yourself to one question and a follow up so that we can give an opportunity to as many investors as possible during our limited time. Today’s call is being simulcast on our Investor Relations website located at investor.walgreens.com. After this call, this presentation will be archived on our website for 12 months.

Certain statements and projections of future results made in this presentation constitute forward looking information that is based on current market, competitive and regulatory expectations that involve risk and uncertainty. Please see our latest Form 10-K for a discussion of factors as they relate to forward looking statements. Now I will turn the call over to Greg.

Greg Wasson

Thank you Rick, and thank you everyone for listening to our call. We appreciate your continued interest in Walgreens. It is my first call as CEO, which makes it very exciting for me personally, but it is also an exciting time for Walgreens. First, we are moving fast to execute our growth strategy and strengthen our position as America's most convenient provider of consumer goods and services, as well a pharmacy and health and wellness services.

Second, in an economy more challenging than most of us have experienced in our professional lives, Walgreens is well positioned to win. We are responding to the new consumer landscape with new merchandising experts focused on value. And third, we are aggressively reducing costs across the company, and have maintained a healthy balance sheet, which gives us significant flexibility at a time when cash is king.

Now let's review the quarter's financial highlights. Net sales for the quarter were a record $16.5 billion, up 7%. Comparable store sales, adjusted for calendar shifts and last year's leap day, rose 2.1% in the quarter, while front-end comparable sales decreased 0.2% on an adjusted basis.

We are continuing to see evidence of customers changing their buying habits. Front-end comps or discretionary items were down in the second quarter, but that was offset by positive comps for nondiscretionary and other items. Another good sign is that we are holding our own in terms of attracting customers into our stores.

Adjusted for last year's leap day, comparable store traffic was virtually flat in the quarter when compared with a year ago. That means we're keeping our doors swinging at a good pace even while the retail industry as a whole is seeing more doors permanently close.

Net earnings were $640 million or $0.65 per share diluted compared with $686 million or $0.69 per share diluted a year ago. Remember that last year's earnings benefited from an extra day due to leap year. Earnings per share this quarter were reduced by a net $0.04 after costs and benefits for our Rewiring for Growth initiative, which I will talk about more later.

As we noticed in recent quarters, consumer behavior has changed dramatically in recent months beyond just the kind of products they are purchasing. Job losses and other financial pressures have led to fewer doctor visits, which means fewer prescriptions made, written and filled. Despite that fact, we have filled 164 million prescriptions during the quarter, an increase of 4% over last year's second quarter. That compares favorably to the industry-wide decline of 1% has reported by IMS, excluding Walgreens.

The first half of fiscal 2009 saw us open or acquire 269 drugstores. Even though that is 13 fewer openings than a year ago, the significant impact from our slowdown in new store openings will hit later in fiscals 2010 and 2011. We also opened 117 Take Care clinics in the first half of the year, including 41 in the second quarter.

During my first 60 days as CEO, one of my key priorities has been to manage – has been to build our management team and its structure in a way that fully supports our three key strategies. Again those strategies are one, to leverage the best community store network in America, two, to enhance the customer experience inside our stores and three, to significantly reduce our costs and boost our productivity.

Now let me recap the moves we made to our senior management team in the second quarter to put the right people in charge of the right processes. First Randy Lewis, who is in charge of Logistics and Distribution, is now our Senior Vice President for Supply Chain Management, a pipeline with tremendous opportunity for inventory and cost reduction.

Now George Riedl is now leading the ongoing rollout of our new POWER pharmacy program, which I will talk about more a little later. George will also continue to manage pharmaceutical purchasing.

Bryan Pugh is now leading our merchandising divisions for all front-end categories in addition to developing new store formats. Finally, Tom Connolly takes over our facility division. Tom is replacing Bill Shiel, who retired after 38 years with us. Bill had the hard work of turning our division of 7000 community stores into reality, and we certainly thank him for that.

In addition to securing the best store sites in America, Tom will take more of a portfolio management approach towards our growing organic store growth rate. Historically that growth rate was in the 8% range and even reached 9% in fiscal 2008. Now that we're stepping down that rate to between 2.5% and 3% by 2011, it is absolutely the right thing to do for three reasons.

First, it provides flexibility to invest in our core strategies and improve shareholder value. Second, we will have more time to development management and focus on the shopper experience. And third, a prudent step in the context of today's economic conditions.

We are seeing consolidation continue in the industry and our financial flexibility allows us to take advantage of these opportunities when they make sense. Last week, we agreed to acquire prescription files from 11 Drug Fair pharmacies in New Jersey, along with 32 other Drug Fair locations we would purchase and operate.

Also in February, we agreed to acquire 12 Rite Aid locations in San Francisco and eastern Idaho. The next piece of our strategy I want to update you on is financing our customer experience. One of the ways we are tackling this is through our customer centric retailing project. CCR is about streamlining assortments and reworking promotions. It is not simply about SKU reductions, but about prioritizing categories and items within categories.

As an example, we plan to get more space and add items to categories like skincare and cosmetics. These are signature categories that build brand and create loyal customers. We are rolling out 40 categories with optimized assortments to all of our stores by this fall.

These categories account for more than half of our front-end sales. We will do the rollout at the same time we normally do resets in order to avoid disruptions during peak sales periods.

New formats driven by CCR will be piloted in 35 stores by summer. These stores will represent various markets and demographics that we get a good read on results. Besides the new assortment of basic departments, these stores will include a lower store profile and new layouts designed around customer solutions.

After analyzing this initial effort and confirming its success, we plan to fully convert several hundred stores to CCR before Halloween. Then, after holding for the holiday sales period, and making any needed adjustments, we plan to roll out CCR formats at the beginning of calendar 2010.

Over the next 18 months, our goal is to touch every store in the chain. That is what I mean when I say we are going to juice our stores. Obviously, this will cost some money and we will pay for it by refocusing some dollars, previously earmarked for new stores to taking care of the older ones.

One part of CCR that has moved forward very quickly is our Affordable Essentials program, launched chain-wide in February. This program includes basic staples such as food, paper products, toiletries and other consumables marketed together to move customers up to Walgreens from traditional value retailers.

And the third piece of our strategy I want to highlight is cost reductions and productivity gains. Over the past four quarters, we have made dramatic improvement with selling, general and administrative costs, which has allowed us to better leverage gross profit dollars. That continued this quarter. SG&A costs increased only 8.1% in the second water over the year ago period. The increase was only 5.7% when factoring out our net restructuring costs.

Meanwhile the gross profit dollars increased 5.1% on an adjusted basis. We expect this moment to continue as our corporate restructuring program called Rewiring for Growth moves forward. We took our first steps under this plan in January, when about 400 corporate and field management employees took advantage of our voluntary separation program. Many of them spent 25 years or more with Walgreens, and are the ones who built the systems and executed the strategies that took this company to new levels of success. And we are certainly in their debt for all they accomplished, and now it is our job to build upon those accomplishments.

Earlier this month, nearly 200 additional jobs where eliminated from corporate and field management staff. These moves along with our voluntary separation program and other labor savings are streamlining our corporate structure. They also put us on target towards our goals of eliminating 1000 corporate and field positions by the end of August, which will contribute to $1 billion in annual cost savings in fiscal 2011.

One of the many structural changes we are making, one that really excites me is the decision to move our 29 store operations market Vice-Presidents out of the corporate office. Today they reside in the market for which they are responsible to support all of our businesses in that area and to drive growth and profitability.

This level of leadership on the ground and living in the market will move us from operating stores in communities to serving communities across America. We also expect to achieve cost savings, productivity gains, and improved pharmacy patient experience through the rollout of POWER pharmacy. POWER moves the administrative tasks involved in filling prescriptions to the central facilities, enables our store pharmacists to spend more time as the trusted clinician with our patients. It also means our pharmacists can provide additional healthcare services, such as wellness management and immunizations, and it makes us more competitive by improving the efficiency of our filling process.

POWER also ties in closely with our slowing of organic store growth. With POWER’s added capacity, we won't have to open new stores as quickly to relieve high pharmacy volumes at existing stores. POWER has already been implemented in nearly 400 of our approximately 780 Florida stores, with 19% of prescriptions being filled at our central facility.

In addition, more than 30 Arizona stores are using key components of POWER. George Riedl will manage the rollout for the remainder of our Florida stores by the end of August. Converting pharmacies to this system is as much about change management as it is about technology. And George, who is a pharmacist and lead the launch of our original online pharmacy in the late 90s, is the best person to help our pharmacists adapt to the changes that will transform how a community pharmacy is practiced.

Now, I would like to update you on our health and wellness division and what our folks there are doing to expand health services through our community store network. In January, we connected our prescription drug offering, retail clinics, and worksite health and wellness centers under one umbrella called complete care and well-being.

This program provides large employers with affordable, accessible, and high-quality care for their employees, dependents and retirees no matter where they work or live. On the retail clinic front, we opened 41 Take Care clinics during the quarter, and openings will continue this year.

Beyond just increasing the number of clinics, we are also working to expand our service offerings to patients. Some that we recently introduced or plan to in the future include health evaluations, an expanded vaccine suite, skin assessments and procedures, and disease management services for hypertension, diabetes, and cardiovascular disease that will be integrated with the medical community.

In addition, in two Florida markets we are piloting our Take Care clinics as administration sites for the injection and infusion of specialty drugs. These programs are preview of how we can integrate businesses like homecare and specialty pharmacy with worksite health centers, in-store clinics in our retail pharmacies. These services and others also will help reduce the seasonality inherent in the clinic business.

In addition to building strong relationship with employers, we're going direct to consumers with our Prescription Savings Club. On the club, the 1.7 million members, more than 30% of them are new to Walgreens. Plus, PSC members like the convenience of picking up a 90-day supply at the local pharmacy. As a result, they are bringing us their entire pharmacy business and increasing their compliance with their medication.

Now before turning the call over to Wade, I would like to comment briefly on the economy and health care reform. The new economy and its effect on consumers is dramatically changing the retail landscape. Many people have commented about once-in-a-generation shift in consumer attitude. We are adjusting immediately to this new consumer through programs like Affordable Essentials and stronger promotion of our private brands.

I would like to point out that we are being extremely prudent in our capital allocation and protecting our balance sheet. We believe our cash position and credit ratings are reassuring to investors during these turbulent times. And finally President Obama's plans for health care reform would certainly impact the retail pharmacy industry. His plans call for affordable and accessible health care, and he understands that medication can lower overall health costs.

We are well positioned to respond with our convenient pharmacy and health and wellness services. And that is one of the reasons I'm so optimistic about our future, even while we navigate some extremely difficult retail waters and align our company with the new realities. We also have the advantages of, one, selling basic necessities that people need, two, convenient locations in communities where people live and work, and a winning strategy and good progress on key initiatives to move us forward.

And finally a top management team that blends internal expertise, outside talent and new thinking. So now Wade will update you on the specific financial results for the quarter. Wade?

Wade Miquelon

Thank you Greg. I would like to reiterate Greg's confidence in our three key strategies and their ability to create shareholder value over the long term. Turning to the quarter, net sales increased 7%, while total comparable sales rose 1.3%. Total comp sales were negatively impacted by 0.8 percentage points with the calendar shift in last year’s leap day. This places us in good shape compared with other retailers, and we believe a (inaudible) given the amount of transformation that we are currently undertaking.

Prescription sales rose 7.8% and represent 63% of sales for the quarter. Prescription sales in comparable stores rose a solid 2.9%, and were negatively impacted by 0.7 percentage points by calendar shifts in last year's leap day. The number of prescriptions filled in comparable stores increased 0.3%. That was negatively impacted by 1.6 percentage points by more patients filling 90-day scripts versus 30-day scripts. Also calendar shifts in last year's leap day negatively impacted comparable scripts by 0.7 percentage points.

Net earnings for the second quarter were $640 million, a 6.7% decline from last year. This year's quarter included a $93 million impact or $0.06 per share from costs associated with Rewiring for Growth. We are now starting to see some Rewire benefits as well and this quarter had approximately $0.02 per share benefit from Rewire, giving as net costs from the program of approximately $0.04 per share. In addition, the quarter included impacts of a negative $0.01 per share for the LIFO reserve versus a year ago, a negative 1% per share for interest expense above the prior year.

Net these items had a total year-on-year quarterly cost of $0.08 per share or $0.06 per share after factoring in the Rewire benefits. Looking at our service performance in recent quarters, you will know the numbers have essentially stabilized in a very tough retail environment. With the progress we are making on programs such as CCR, and the Affordable Essentials roll-out, I believe we are poised to grow sales in the front-end despite the challenging economy.

Gross profit in the second quarter was $4.7 billion or a 4.8% increase versus the year ago quarter, reflecting the slowing economy.

Gross margin was down 60 basis points in the quarter compared with the prior year. Negatively impacting margins were lower front-end margins due to promotional pricing and product mix, non-retail businesses, and a higher LIFO provision. Helping the overall margins was an increase in pharmacy margins as a result of the impact of generic drug sales.

Before addressing SG&A expenses and the impact of a slowdown in store openings, I would like to revisit a couple of slides that we first introduced in the first quarter of 2008, and we're updating today. This slide shows the front-end performance by store class for each of the past seven years. You will see that despite a weak retail environment, our newest class of stores is performing close to the long-term average. Simply put, our store front-ends are as productive as always.

On the pharmacy side, our newest class of stores is a little below average, which can be attributed to several factors. First, we are opening more stores recently in markets that tend to build script counts at a slower initial rate. Second, we are operating fewer 24-hour pharmacies as a percentage of overall pharmacies. Third, the economy is affecting the number of scripts patients are filling, and finally we are seeing a market impact from 30-day scripts converting to 90-days.

Still our new store ramp up curve fairly robust, and although scripts have slowed slightly in the 2007 class, we expect them to return to their historical growth rate as the economy improves, and as initiatives such as Power and Prescription Savings Club continue to separate our pharmacies from the pack.

Cost control has been a central focus for the past 18 months. And our significant progress in cutting SG&A growth continued this quarter. Our increase in SG&A dollars in the second quarter was only 8.1%, and just 5.7% if you take out the costs for Rewiring for Growth.

On a two-year stacked basis, SG&A dollar growth in the second quarter has declined from 25.5% to 16.9%, primarily due to salary and store expense control. Going forward, slowing new store openings, opening fewer retail clinics, and realizing significant costs from Rewiring for Growth will all reduce growth in future SG&A.

Let me show you where we are in the cost reduction progress. Three primary areas of opportunity include strategic sourcing of indirect spend, corporate field and store overhead, and POWER.

This chart shows the schedule of cost in benefits associated with Rewire on an EPS basis. We recorded $93 million in restructuring costs in the second quarter. That included $59 million for voluntary and involuntary employee separations, $11 million for inventory write-downs associated with CCR, and $23 million for consulting and other costs. Overall, we're still on track for $300 million to $400 million in costs through fiscal 2010.

Now originally, we had thought the 2009 costs and benefits would offset each other in this fiscal year. Now we expect a few cents per share net negative impact as we have accelerated some of our Rewire cost efforts. But again, we are on track with respect to our total cost as well as on track to record more than $500 million in net benefits in fiscal 2010. We are also on target to achieve our long-term objective of $1 billion in annual cost reductions by fiscal 2011.

Now, let us look at some of our other financial drivers in the quarter. The LIFO provision was $49 million versus $31 million in the second quarter of 2008, primarily reflecting higher than anticipated price increases for non-prescription drugs and other front-end merchandise. Next are the $93 million in restructuring costs that I have summarized previously.

Net interest expense was $20 million compared with $2 million last year due to the issuance of $2.3 billion in long-term debt. The effective tax rate was 36.7% compared with a rate of 36.8% in the year ago period. Accounts receivable were up 21.2% in the quarter, driven partly by growth in third-party retail prescription sales, and the impact of the quarter ending on a Saturday.

Thanks to excellent supply chain management by everyone, inventories grew only 3.5% despite a sales gain of 7%. Accounts payable increased 17.9%, again due primarily to a normal business growth and the quarter ending on a Saturday. As part of our focus on liquidity, we held a successful bond offering in the quarter of $1 billion in 5.25% 10-year treasury bonds. That was a spread of 2.875% to benchmark treasury notes, an exceptional result in these times by any standard.

Our net debt at the end of the quarter was $785 million compared with $1.5 billion at the end of the first quarter, and that reflects long term debt of $2.3 billion offset by cash and cash equivalents of $1.6 billion.

Next, we finished the quarter with more than $2.8 billion in cash and credit lines available, more than sufficient to operate in the toughest retail environments and to drive our winning strategies. Hence, we feel great about our financial strength and liquidity and our balance sheet should only strengthen as we slow store growth, improve inventory, drive cost savings, and work our way back to target double-digit earnings growth over the next few years.

Depreciation and amortization for the quarter was $242 million, up 19.3% over a year ago. The big driver was amortization for prescription file buys, which continued to be robust.

For the first half of the fiscal year, we invested $1.1 billion in additions to property, plant and equipment versus $1.0 billion last year, and mostly for the addition of 245 new stores versus 275 last year. We continue to estimate that capital spending for the full year will come in at around $1.8 billion or about $400 million less than fiscal 2008.

Free cash flow amounted to $647 million for the first half of the fiscal year, up 40% from year ago. Disciplined operations, inventory control and a slight slowdown in store openings were the driving factors here.

And many of you have asked about forecasting capital expenditures in future years, and in particular cost per store remodels and refreshes. Much of that will be expense dollars included in our Rewiring for Growth costs that we have outlined. If there are remodels that require capital expenditures, we will outline those for you in the future. As a general rule, we would expect our capital investment to continue to decline over time, but we're just not prepared yet to put a dollar amount on that.

So, wrapping things up, I believe we're off to a great start with our three key strategies, and they will take us to an entirely new level over time. The strategies are in motion and we're starting to see the fruits of that labor. And we remain committed to return to double-digit earnings growth as part of our overall shareholder plan to create long-term value for our shareholders.

And now I would like to turn the call back over to Rick.

Rick Hans

Thank you Wade. Angel that concludes our prepared remarks. We are now ready to take questions.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) And we will take our first caller Mr. Andrew Wolf of BB&T Capital.

Andrew Wolf – BB&T Capital

Ask you a few questions on the sales. You know on – I guess Greg, do you see a permanent shift towards staples from discretionary in Walgreen stores, you know, requiring fairly fundamental change in either in your mix, your merchandising, your pricing, and you know is just signaled by your hiring, you know, a new merchandiser from outside, not just outside Walgreens but from the discount store industry.

Greg Wasson

I don't see, you know, a permanent shift, Andy. I do think that the right balance between making sure we have good value items such as the Affordable Essentials that are stacked up in stores with prominence in our ads and our stores to swing doors is critical. You know, obviously the right balance to make sure we offset, you know, any margin pressure that we’d see from value pricing is got to be adjusted in the mix, and how we promote, and I think one of the things you will see us do is really aggressively promote our private brand to help offset that, but I do think you know, in going to Bryan Pugh that we now moved into merchandising area. I think Bryan is going to bring a lot of great experience. We are really, really looking to get to understand our customer, and know our customer more, we can file. And I think you’ll see a lot more target merchandising toward our customers.

Wade Miquelon

And I would just pile on there and say you know, I think part of this is also recognizing that we do have the best retail corners in America, and making sure that we have the right staple offerings there is just simply the right thing to do.

Andrew Wolf – BB&T Capital

In terms of driving traffic or just because, I guess back to the original point of the question, just because that is at least now and maybe into the future what a drugstore can expect to – its consumers to take away.

Greg Wasson

I think you know, as I said Andy I’m telling you, I hope I am getting to your question, I think you will see us, you know, continuing to make sure that we are swinging doors as I said. I mean we're going to have, going to have good value items on the front page of our rotas. We have good value items stacked up in stores, but at the same time you know, I think the merchandise selection, the promotional activity you will be seeing help will help offset that margin, and I think there is tremendous upside getting on private label.

Andrew Wolf – BB&T Capital

So you're going to remain committed to general merchandise and a pretty robust you know, gift and Christmas program.

Greg Wasson

Absolutely, you know one of the things we hear loud and clear is that our consumer likes our fun atmosphere. They like seasonal. They like the items, being able to find items quickly, the new items as they are launched. So we are not going to deviate from that part of our business. That is where we excel and have excelled for years.

Andrew Wolf – BB&T Capital

Thanks, and just one follow on, Wade on the Rewire initiatives. I've heard that you know, and I assume this would be the case anyway. So you're really managing down full-time equivalence with some top, you know, from top-down directives at the store level and also overtime pay, whether it is for assistance or what have you. Is that – how are you considering that. Is that part of your rewire savings, or is that part of the normal course of just running a tighter shift at Walgreens?

Wade Miquelon

Well, I think, you know, I guess what I would say is that, you know, we're looking everything off of the 2008 base. We are looking for as you know savings in three buckets. The middle bucket is really looking for savings and corporate overheads, field management and at the store level, but except that there is some tightening there, yes, that is factored into it.

Andrew Wolf – BB&T Capital

Okay, so on a pro forma or run rate basis have you given what you have done at the store level, and have you already reached the 1000 heads on a full-time equivalent basis?

Greg Wasson

That 1000 heads is in the store level number really. That 1000 heads is more of a corporate and field level. So that's a really separate initiative. So again, you know, for the 1000 number we've been targeting, it's really primarily corporate and field management separate from store labor.

Andrew Wolf – BB&T Capital

Okay, let me one follow-up, and then I will surrender. So, at the store level could you take – what is the full-time equivalent reduction that you think it is going to work out to?

Wade Miquelon

We haven't given any numbers or thoughts on that. Obviously, if we’re going to reduce labor there we are going to have to re-engineer processes. People work very hard at the store; they've got a lot to do. So making sure that we have simpler promotions, few allotments and all that is going to help, but we haven't given any specifics on that to date.

Andrew Wolf – BB&T Capital

Okay, thank you.

Operator

Next we will go to Robert Willoughby of Banc of America.

Greg Wasson

Good morning Robert.

Wade Miquelon

Good morning Robert.

Robert Willoughby – Banc of America

On the receivables build there, can you comment on how much may be attributable to the shift into healthcare franchises that you have, and then just a follow up. Have you really clearly laid out kind of plans for cash. How much kind of goes into retail, how much goes into healthcare over the next 12 months?

Greg Wasson

Yes, I would say that, you know, there is not really any market shift from the mix in healthcare there. The primary reason for this slight, you know, receivables change year-on-year, again I said is really the Saturday timing. So you’ll see that balance up over time. Also, as there has been in the public domain, little bit of timing on some of the Medicaid payments. But that should work its way out over time.

So I think essentially, which you just see here is anomaly, mostly of ending on a Saturday.

Robert Willoughby – Banc of America

Okay, and just how you split your CapEx going forward between healthcare and retail?

Greg Wasson

You know, the bulk of it is still going to be on the core, right. Everything we are doing is to reinforce the core. The bulk of our spending is you know, things like new store openings, remodel and refreshing on our stores, IT infrastructure and distribution infrastructure to support our stores. So, you know, the overwhelming majority will continue to be on the core.

Robert Willoughby – Banc of America

But I can’t get you to kind of commit to a healthcare acquisition spend by any means, could I?

Greg Wasson

No.

Robert Willoughby – Banc of America

Okay. All right, thank you.

Operator

And next, we'll go to John Ransom of Raymond James.

John Ransom – Raymond James

Hi good morning. Could you tell me your SKU rationalization, how much is that affecting your front-end sales, and when do you think you will be through that process?

Greg Wasson

John, it is Greg, you know, we are just beginning to, you know, as I said roll out some of the categories. We are not seeing any effect on front-end sales. Actually we are looking for an opportunity to grow sales, but keep in mind we've got – we are through about 50% to 60% of the categories of merchandise we have now.

John Ransom – Raymond James

Okay.

Greg Wasson

We are going to rule out 40 of those, as I said by fall. We are looking at the results as we rule them out, and it will begin to pile at full CCR formats in 35 stores in spring.

John Ransom – Raymond James

Just an idea, how many SKUs you are trying to take out, and what those – has that changed since you talked, started talking about it this fall. Has the type of stuff you are taking out changed as you learn more?

Greg Wasson

You know, I think – I think the one thing that we are doing is, you know we had maybe a year ago kind of had a benchmark goal out there of a percent reduction, but I think it's much more laser focused now by category, and you may see some categories where, you know, maybe a 20%, 30% reduction, maybe see some of our signature categories with maybe a single digit reduction.

So I think it's just really using shopper based principles to really determine what those merchandise categories should be and how to optimize them.

John Ransom – Raymond James

Yes, and what percentage of your front-end is Walgreens private label versus third-party, and where do you think that could get to in a couple of years?

Wade Miquelon

Well, about 20% of our business is private-label now, still growing fairly healthily. I mean I don't, you know I only have to surmise what it could be. Obviously, it is seen in countries overseas, you know, Germany, UK, Italy et cetera. Those at the very high-end can approach, you know, 40ish percent over time, but really I think it depends by category, and at the end of the day how do we make our brands, you know, play very well with our private label, kind of have an overall portfolio to give the customer the right choice.

John Ransom – Raymond James

Okay. That's helpful, and then the other thing I wanted to ask you was this 90 day going to or 30-day going to 90-day retail. I know one of your responses is to do more automated prescription fills to lower your cost. Is there any other strategic response that you might use with your mail-order or otherwise to get ahead of this.

Greg Wasson

I think one of the things we are most excited about is the POWER initiative that we talked about. And I think we have tremendous opportunity there to take costs out, we are central filling in Orlando now about 19% of chronic prescriptions. We think there is tremendous upside there yet.

John Ransom – Raymond James

Okay.

Greg Wasson

We are also moving, as you know, a lot of the work such as insurance verification and so forth out, which is reducing lot of the tasks within the stores.

Wade Miquelon

But I also think our PSC card, what we are really seeing is we are seeing about 20% of the prescriptions filled 90-day or being filled for 90 day supplies versus the typical prescription trend of about 4%. So we are encouraged that folks look for 90-day supply within drug channel in the convenience we offer.

John Ransom – Raymond James

Okay. And then finally, how is much Take Care costs for you this year. I know, CVS has talked about something like about a nickel dilution. What kind of – is Take Care going to be profitable? When do you think that might have profited, assuming it is not profitable now, and how much is that costing you?

Wade Miquelon

It is costing us almost $0.06 cents a share.

John Ransom – Raymond James

Okay.

Wade Miquelon

You know, we believe this year is probably the most dilutive year, in other words will start to creep moving forward, although we won't move in the black next year. There will be less losses. Of other models, just remember that this model to become profitable on a stand-alone basis without a script or a front-end sale, you know, our models typically runs 2 to 3 years. So those losses we are incurring is not you know, because our older stores or older clinics are, you know, accretive and productive. It is just because of the timing of putting so many clinics in the last year. So again it really will become profitable sort of a function on when that overall – you know, those overall majority of stores start to getting that 2 to 3-year aging cycle.

Greg Wasson

You know, I like to add that we’re seeing majority of stores are surpassing breakevens but you know, I would like to point out, I do not see this as a seasonal business. I think that strategically long-term these – providing access and affordable health care is a huge opportunity for us to leverage our community stores within – and that is the reason we are putting a lot of effort into additional services that can be offered to the clinics as well as leveraging Walgreens’ labor model to help improve the operating model within the clinics.

John Ransom – Raymond James

Okay. And are you guys still taking off the table, if a big health plan wants to sell their PBM. Is that still something strategically that you would say is off the table or is that something you might look at now?

Greg Wasson

We will certainly continue, our key strategy is to broaden and deepen our payor relationships with managed care organizations and PBMs at large. So, we don't certainly see, you know, deviations from that at this point in time, and I can’t comment on the specific opportunity.

John Ransom – Raymond James

Sure, all right, thank you.

Greg Wasson

Thank you.

Operator

And next, we'll go to Neil Currie of UBS.

Neil Currie – UBS

Hi. Thank you for taking my question. Just a quick one. Bryan Pugh’s appointment as Head of Merchandising at just the front-end. Also he has a role in format, could you, maybe give us a bit more detail as to what his role is here, and what format you maybe considering, and whether you might venture into any particularly new formats?

Greg Wasson

Yes, Neil. Bryan is going to – yes, I originally brought him into lead new formats, and then I’d recently given him front-end merchandising, but as far as new formats, I think initially to be making sure that we launched the CCR initiative that we have across the chain in a very prudent and efficient manner. We will be testing, as I said in 35 stores that new format which is lower profile, low profiles as well as optimized merchandising.

But also, we will begin to explore new formats, based on our customer research that we are getting from Kim Feil, our new CMO, and begin to pilot in select stores . I think there is tremendous opportunity now that we’ve brought all the resources together under Bryan to really begin to be more efficient, to learn and study what we pilot. We are looking at high-volume urban locations, and how we can leverage new formats to help accelerate our growth in urban areas and so forth. So I think Bryan is going to really help us there.

Neil Currie – UBS

Would you consider formats without a pharmacy?

Greg Wasson

I don't think anything is off the table, but certainly be in a pharmacy and that being our franchise, I think it really will be something that we have to consider. So I don't see that being studied right now.

Wade Miquelon

We do have a few stores today that are very successful without a pharmacy, but those are in very specialized locations, may be tourist areas or whatever, but you know, broad scale it really doesn't make any sense for us right.

Neil Currie – UBS

And I just wondered where you are at the moment in terms of SKU rationalization. Is there any figures you could give us around that?

Wade Miquelon

Well, I think as we outlined here in kind of the script, we are getting ready to move not only to those 30 or so you know, pilot stores, but also into you know, a reset of 40% of the categories through the fall here. You know, again as Greg said there is no one-size that fits all for categories. We will try looking in that 15% to 17% overall reduction range. Some categories may be being flat or slightly up with their signature and other ones being down more markedly, but if you want to re-emphasize that because of the SKUs we taking out are either very slow moving, have lots of better alternatives in the store, you know, are desired by our customer base, you know, et cetera, the category by category belief that it is an opportunity to actually build sales through better facings, through more relevancies for better preselection, and it is the risk of losing sales, and the real key will be executing it flawlessly.

Greg Wasson

Certainly, and our signature categories are referred to such as skin and over-the-counter cough and cold and so forth. You'll see less SKU reductions in some of our, you know, discretionary categories such as hardware or automotive and so forth.

Neil Currie – UBS

Okay, thank you.

Operator

Next we will go to Deborah Weinswig with Citi.

Deborah Weinswig – Citi

Good morning. So a few questions, previously, I think it was at the analyst meeting back in 2008, you had talked about a comprehensive loyalty program, which would include the Walgreens Prescription Savings Club, but also you know, potentially more of like a typical rewards card kind of like CVS has its Extra Care. Can you talk about your current thoughts there?

Greg Wasson

We brought Kim Feil in as our new Chief Marketing Officer, and as you know she's got a strong IRI background, customer insight and customer research. Certainly you know, we believe that to improve and accelerate customer loyalty within our franchise is an opportunity. Kim’s first objective was to study and learn who our customer is, and more about our customer and how to target those customers, but with that we certainly think our loyalty program is of value. And she is working through how we would consider going to market and the proper loyalty program for Walgreens. So a lot of effort being put there Deborah.

Deborah Weinswig – Citi

Okay, very helpful. And then on the real estate side, since you're one of the key retailers or so growing, can you talk what you're seeing with regards to construction cost, site availability, and also your ability to renegotiate leases?

Wade Miquelon

I think construction costs have been basically flat, maybe slightly better. I think availability, you are probably going to see, you know, more availability than you've seen in the past, and again we only go for the best corners, but historically you know, we tend to maybe be looking at those corners versus retail banks and others. So that will probably open up over time. But on renegotiation I would say, you know, no. I mean in general I think we structure these deals, you know, these long-term deals in a way that we believe is beneficial for both parties. And I think that even if we are able to renegotiate or restructure some, you know, it wouldn't be a marked amount of money.

Deborah Weinswig – Citi

Okay, and then last question on the POWER initiative in Florida, how are the stores benefiting and have you seen an impact on the consumer as a result of increased attention by the pharmacist, and maybe how are you measuring that?

Greg Wasson

And that's exactly one of the main benefits from POWER is to improve service levels and free the pharmacists up, and certainly we are measuring, and we see you know, we see a pretty kind of neutral effect right now, and I think that's probably good Deborah, because there is – with any system rollout, you know there is a lot of technology, a lot of change in management that were thrown into the market. I think we are certainly pleased with what we are seeing. I think the potential to improve service levels and really allow that pharmacist to spend more time with patients is going to be incredible, and that's the reason we continue to roll it out.

Deborah Weinswig – Citi

Thanks so much and best of luck.

Greg Wasson

Thank you.

Operator

And next will go to John Heinbockel with Goldman Sachs.

John Heinbockel – Goldman Sachs

A couple of things. How would you guys look at the front end margin reduction, and how would you generally break that out discretionary clearance markdowns around Christmas versus you know, normal promotional activity, you know, that you will have pretty much every quarter?

Wade Miquelon

I give it to you a few different ways. You now our – we have a little bit of drag from the businesses like specialty, which have a lower margin but you know, very small. You know, our assessment part of gain was from the Rx retail margin, and in the front-end, you know, margin was now maybe 70% of that, but at the end of the day almost the entire reduction could be attributed to seasonal closeout and clearance, and I think we did pretty well this seasonal period, you know all things considered especially since our buying happened, you know far before we saw the total impact of the recession, and I think as we move forward, we’ve made the right adjustments for that, but I guess the other way I’m saying is you could slice it is that almost all that is essentially, you know, some types of seasonal or write-down mix.

Greg Wasson

I think we did a pretty good job in pulling down our seasonal buyer for the Christmas and holiday, but at the same time obviously there are lots of folks down there that were early with markdowns and we had to react to, but I think even more so is we did decide to take some markdowns because we want to turn that inventory into cash this year. And I think that was a prudent thing to do. Certainly we've reacted to the upcoming seasons as Wade said to make sure that we’ve adjusted to the new economy.

John Heinbockel – Goldman Sachs

And then you – and Easter is fundamentally different than Christmas in terms of discretionary importance, so you would not expect the same type of – or anything close to it for Easter.

Greg Wasson

We feel pretty good with Easter right now. Again we were able to make the adjustment with our buy. We've got a longer selling season this year, two extra weeks in April. So, you know, we certainly don't expect and hope to have the same type of markdown challenge that we had with Christmas holiday, but you know, we feel pretty good.

John Heinbockel – Goldman Sachs

Is there a plan to sort of manage non-discretionary front-end growth to a certain level may be flat and you know, keep investing in value alongside, whatever cost reduction you're getting or do you actually thinking you can see some improvement there?

Greg Wasson

You know, I think we are seeing a lift in non-discretionary categories and other items now offsetting the drop and the duration, we have seen more discretionary categories. So I think that balance will be critical, and that's the reason again, I think there is opportunity for us to continue to grow our private-label sales, which will help offset their margins.

Wade Miquelon

I wouldn't see any reason why we couldn't strive to make improvements in margin in all of our categories, you know whether we are being more targeted in discretionary, whether we are pulling our staples through more effectively or whether we are you know, driving you know, more business to private-label, et cetera.

John Heinbockel – Goldman Sachs

All right, and finally what do we see right now with regard to reimbursement pressure, but I know it is always there, has it picked up given the macro, will it pick up? And it doesn't look like we're seeing a lot of issue – a lot of big cuts on the Medicaid front statewide but is that coming?

Wade Miquelon

Well, I think as you have said we have experienced reimbursement pressures and constantly managed that. Hey John, I think with, you know, healthcare reforms there is going to be opportunities for us to provide access solutions, but at the same time there is going to continued reimbursement pressure. And I think we've got to continue to do what we've done over the years and manage that aggressively, build the resources, Stan Blaylock [ph] over water and health services has the horsepower to continue to manage and get the best reimbursement force, but I think we will continue to see it. I don't see it accelerating any more aggressive than they have in the past but certainly we are prepared for it.

John Heinbockel – Goldman Sachs

Okay, thanks.

Operator

(Operator instructions) We will take our next one from Ed Kelly of Credit Suisse.

Ed Kelly – Credit Suisse

Hi Good morning guys.

Greg Wasson

Hi Ed.

Wade Miquelon

Hi Ed.

Ed Kelly – Credit Suisse

Greg, how do you manage the risk of hurting sales by pulling products out that may be your more loyal customers are looking for in terms of the SKU rationalization, and does not having a loyalty card program raise that level of execution risk?

Greg Wasson

Yes, good question Ed. I think as far as how we manage the risk, you know as I said, we are really using what we call a shopper-based principles to look at these departments, and we are truly looking item by item, and what the true profitability of an item is, but we're also looking at the regional and the geographic value of each item as well. So, we are really being careful not to select and not to cut out. What has really made us unique, and that is the fact that we typically do have the item to fit certain geographies.

So being real careful there. As far as royalty – not having loyalty program, does it add additional risk? You know, I don't believe so, I think I see us – I see tremendous opportunity as we go forward, as we know more who our customer is, and how to market drug directly to customers. So I think we are managing that risk prudently and appropriately.

Wade Miquelon

And I will just build on Greg's comments here, on the SKU reduction, we are being extraordinarily thoughtful, and apart from the profitability analysis, also we're doing a detailed shopper basket, which is by category to make sure that the end proposition is even better, the vetting process for testing or the wave of rollouts is going to give us lots of opportunities to make sure that our read is what we believe. So we should be good there. As Greg said I think the loyalty – building more loyalty is a great opportunity for us, and invested heavily in loyalty in the past, in things like the best corners in America, but to the extent those other things we can do that make sense, we will certainly consider.

Ed Kelly – Credit Suisse

Okay, great. And then you know, you have been more aggressive on the new store acquisition front recently. How important will this be going forward? How do you evaluate these opportunities, and just how do you balance doing this is with focusing just on improving your core store base?

Greg Wasson

I think that as we always do, we will certainly look at every opportunity to make sure it fits strategically Ed, as well as gives the right ROIC that we need going forward. I think we are continuing to see pressure and industry consolidation that we will have to look at and analyze, and do it appropriately. That is kind of what I meant my Tom Connolly changing our real estate strategy to more of a portfolio strategy going forward, to make sure if there is an opportunity that makes sense in a certain geography, we will consider it, but we will certainly manage that mix between organic and potential opportunities in a prudent way.

Ed Kelly – Credit Suisse

Greg, I mean, the company on the past made a bid for – or at least attempted to look at Longs Drug Stores. Now that you are CEO, I mean, are you open to doing something like a large deal or do you think you are just more value and focusing on your core store base right now?

Greg Wasson

I think that right now we are absolutely focused on our three-part strategy Ed which is, you know, taking and leveraging those 65,000 stores we have, and improving the front-end. I think there is tremendous value there. I do think that we will absolutely consider every opportunity, and if it makes sense strategically, and it makes sense financially we are certain to consider it going forward.

Ed Kelly – Credit Suisse

Okay, thank you.

Operator

And we will take a last question from Lisa Gill of JP Morgan.

Lisa Gill – JP Morgan

Thanks very much and good morning. Greg in the past you have talked about utilization trends, and I think you made the comment that there are less doctor visits et cetera, but yet it looks like your numbers are pretty strong on the pharmacy side, and then additionally, it looks like RX retail on the gross profit side are coming from generic utilization. So maybe can you talk a little bit about those two things, one, are you just taking market share is that why your numbers still look positive on the pharmacy side, and then secondly, can you talk about what you are seeing for generic utilizations trends, are you seeing a conversion within your book, and as you take that opportunity to now do some central fill, and have more time with the member. Is this giving you an opportunity to convert people from one therapeutic class – I am sorry, from one therapeutic prescription to another, for example, within the statin class and moving a member to a generic.

Greg Wasson

Yes, good questions Lisa. I will try to get to all of them. We do continue to take and grow our market share within pharmacy, and I think that we do have the luxury as we stated I think in a call that we're going to get some softening trends this time last year, but we are also continuing to outpace IMS. You know, I think that there are several things going on. I think that we are doing very well with our PSC card in response to the class of $4 generics from a year ago. We are actually seeing an increase in that category going forward. So, I think that shows that our convenience and our strategy worked there. I think we are continuing to see some struggles within the industry in this economic environment within independents and regional chains and potential (inaudible) there, and I think we are really, really promoting service as we going forward.

As far as generic utilization in our book, I think we are and will continue to see increased utilization over the next several years. I wouldn't say that where we want to be yet on therapeutic generic opportunities. I do think that the opportunity exists with our pharmacists having more time in being freed up by POWER to do more therapeutic switches, but I wouldn't say that we have seen a huge opportunity there yet. But I do think that other opportunities that we are seeing, immunizations and vaccinations are tremendous opportunities with Zostavax being a vaccine for 55-year-olds and older seniors across the country. So hopes that gets to your questions Lisa.

Lisa Gill – JP Morgan

And then just as a follow-up, when you think about central fill, and obviously you are doing it in the Florida market. But is there an opportunity to roll this out nationwide, and if so what percentage of your prescriptions do you think you could see going through central fill.

Greg Wasson

Maybe I will take the second question first. You know I think there is potential to do maybe 30%, 35% of our prescriptions to go through central fill that is kind of backing in from the percentage of chronic prescriptions that we get still ahead of time. The second will be really more dependent on how successful we are with, you now with State regulation and legislation that allow us to fill across states and between states. We're certainly are leveraging Orlando mail service – mail service facility in Florida. We intend to leverage our Tempe mail service facility in Arizona, to begin to central fill and aggressively work to show the value that we are seeing in Florida, as we work with other states to improve the legislation process – legislative process. That is it Lisa.

Operator

And that does conclude the question and answer session for today. At this time, Mr. Hans, I would like to turn the conference back over to you for any additional or closing remarks.

Rick Hans

Folks that was our final question. Thank you for joining us today. We will announce March sales on April 2. Please keep in mind that each default in April this year compared to last year's march Easter, which was the earliest since 1913. This will of course have a big impact on our March front-end sales comps. We will need to look at combined March-April sales to get a true picture of performance for those months.

Our next quarterly financial announcement will be Monday, June 22, when we announce fiscal 2009 third-quarter results. Until then thank you for listening.

Operator

We thank you for your participation. That concludes today's conference. You may now disconnect. Have a great day.

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Source: Walgreen Company F2Q09 (Qtr End 02/28/09) Earnings Call Transcript
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