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Walgreen Company (NYSE:WAG)

F2Q13 Earnings Call

March 19, 2013 8:30 am ET

Executives

Rick J. Hans – Divisional Vice President-Investor Relations and Finance

Greg D. Wasson – President and Chief Executive Officer

Wade D. Miquelon – Executive Vice President and Chief Financial Officer

Analysts

Steven J. Valiquette – United Bank of Switzerland

John E. Heinbockel – Guggenheim Securities

Matthew J. Fassler – Goldman Sachs & Co.

Eric Bosshard – Cleveland Research Co.

Mark Wiltamuth – Morgan Stanley & Co. LLC

Meredith Adler – Barclays Capital, Inc.

Edward J. Kelly – Credit Suisse Securities LLC

Andrew P. Wolf – BB&T Capital Markets

Lisa C. Gill – JPMorgan Securities LLC

Operator

Good day, ladies and gentlemen, and welcome to the Walgreen’s Second Quarter 2013 Earnings Conference Call. At this time, all participants are in listen-only mode, and later, we will conduct a question-and-answer session and instructions will follow at that time. (Operator Instructions) And as a reminder, this conference is being recorded.

I would now like to introduce your host for today’s conference, Rick Hans, Divisional Vice President of Investor Relations. Please go ahead.

Rick J. Hans

Thank you, Bethanie, and good morning, everyone. Today, Greg Wasson, President and CEO; and Wade Miquelon, Executive Vice President, CFO and President International will discuss the quarter and this morning’s announcement about our strategic long-term relationship with AmerisourceBergen.

As a reminder, today’s presentation includes certain non-GAAP financial measures, and I would direct you to our website at investor.walgreens.com for reconciliations to the most directly comparable GAAP measures and related information. You can find a link to our webcast on our Investor Relations website. After the call, this presentation and a podcast will be archived on our website for 12 months.

Certain statements and projections of future results made in this presentation constitute forward-looking statements that are based on current market, competitive, and regulatory expectations that involve risk and uncertainty. Except to the extent required by law, we undertake no obligation to update publicly any forward-looking statements after this presentation, whether as a result of new information, future events, changes in assumptions or otherwise. Please see our latest Form 10-K and 10-Q and subsequent filings for a discussion of risk factors as they relate to forward-looking statements.

Now, I'll turn the call over to Greg.

Greg D. Wasson

Thank you, Rick. Good morning everyone, and thank you for joining us on our call. Today I'll begin with a review of the highlights of our results for the quarter, then I will touch on our announcement earlier today on the Walgreens and Alliance Boots strategic long-term relationship with AmerisourceBergen and how that carries forward one of our three key strategic growth drivers to create an unprecedented global platform through our Alliance Boots partnership. After that I will turn the call over to Wade for more information on our performance this quarter and details of the Walgreens, Alliance Boots, and AmerisourceBergen announcement.

Turning to our overall financial results, we’re pleased to report a solid quarter with adjusted earnings of $0.96 per diluted share and GAAP diluted EPS of $0.79. With that performance were a number of highlights; first, we had operating cash flow for the second quarter of $1.2 billion and free cash flow coming in at $953 million.

Second, our Balance Rewards program continues to show a strong response from our customers with more than 60 million customers enrolled. Third, the Alliance Boots business and synergies are on track with our expectations with accretion to our adjusted EPS of $0.05.

Finally, this morning’s announcement of our strategic long-term relationship with AmerisourceBergen demonstrates how we continue to move forward on our strategy to create a global network for pharmacy lead health and well-being with Alliance Boots.

With those highlight, let me recap our financial results this quarter, as we began doing in the fourth quarter of last year, we’ll present our results both in GAAP and a non-GAAP basis. We reported first quarter sales of $18.6 billion virtually identical to the same quarter a year ago, remember that this quarter includes one less day due to last years leap date, and sales also continue to be impacted by the growth in lower cost generic drugs which are for bottom line.

GAAP operating income or EBIT for the quarter was $1.2 billion, up 10% from $1.1 billion for the same period last year. Non-GAAP adjusted operating income or EBIT for the quarter was nearly $1.4 billion, up 12.9% from just over $1.2 billion in the second quarter 2012. GAAP net earnings for the quarter were up by 10.7% from $683 million or $0.78 per diluted share last year, the $756 million or $0.79 per diluted share this year.

The non-GAAP adjusted net earnings for this quarter were $915 million or $0.96 per diluted share compared to adjusted net earnings of $776 million or $0.88 per diluted share in the same quarter last year.

As I mentioned in January, we came into this year with a number of tailwinds and we capitalized on these positive trends in the second quarter. That's especially true in pharmacy which continues to be on the up swing, like Wade Miquelon will review some of these tailwinds.

For the multiyear contract with Express Scripts, we saw an increasing percentage of those patients returning to us this quarter. Walgreens is now a preferred drugstore for Medicare Part D plans giving these numbers a financial benefit when they chose Walgreens over our competitors. Our reinvigorated private brands led by nice, delish, and well at Walgreens are driving margin and receiving great feedback from our store managers, while they continue to build momentum with customers.

In this month we were cycling last year's change in our promotional strategy that moved us away from predominantly print promotions, instead we are leveraging digital media and our new Balance Rewards loyalty program launched last September.

From a global viewpoint, our Alliance Boots strategic partnership is now firmly in place and we’re already realizing benefits from our procurement joint venture. And now with this morning’s early announcement with Alliance Boots and AmerisourceBergen, we're taking another step forward in establishing an unprecedented and efficient global pharmacy led health and well-being network and achieving our vision of becoming the first choice in health and daily living for everyone in America and beyond.

Turning to trends in gross profit dollars and SG&A, in the second quarter on a GAAP basis, our gross profit dollar growth increased 4% or $218 million from a year ago. SG&A dollar growth increased $213 million or 5% compared to a year ago.

On a non-GAAP basis, gross profit dollar growth after adjusting for the LIFO provision, increased $218 million or 4% year-over-year, driven primarily by growth in generic prescriptions while front-end margins also increased slightly.

SG&A dollar growth was up $178 million or 4.2% after adjusting for the Alliance Boots transaction costs, other acquisition related amortization and the USA Drug acquisition related cost.

Through the quarter, we continued to make steady progress and executing on the three major strategic drivers we put in place in 2012 to position our Company for long-term growth and value creation. On creating a well experience, this week we’re opening our newest flagship store in Washington DC, followed by a flagship in the Empire State Building later this month and one in Boston next month. These locations are raising the Walgreen’s brand in important markets as we continue to drive innovation across our store network.

On transforming community pharmacy among other steps we recently formed accountable care organization, part of the national healthcare reform with three leading physician teams in Texas, Florida and New Jersey, and this morning’s announcement with Alliance Boots and AmerisourceBergen was a significant step forward and our third growth driver establishing an efficient global platform.

Our new strategic long-term relationship with AmerisourceBergen has three main components; a distribution agreement, strategic collaboration and equity alignment. Let me touch on each and then Wade will provide more details. First, our distribution agreement is a long-term tenure contract, it offers expanded service levels and more frequent deliveries and it offers improved economics through a number of operational efficiencies and better rates.

The second component, the strategic collaboration gives the supply chain and its procurement benefits, new opportunities for customer and so far our collaborations and for domestic and international growth.

Finally, the equity piece of the agreement is designed to align our common interest and allow us to participate in a joint value creation.

Let me sum up by saying, we are very pleased with the way customers, patients, and partners are responding to our efforts to help people get stay and live well. We see this in our response in the response to balance rewards, our vaccination and immunization program, our health and wellness initiatives, our innovations and partnerships, and the excitement we continue to generate in our well experienced format.

With our partnership with Alliance Boots performing well and producing the expected synergies and a new strategic long-term relationship with AmerisourceBergen we announced today, we believe Walgreens is truly on its way to be the first choice in health and daily living for everyone in America and beyond.

Thank you, and now let me turn the call over to Wade.

Wade D. Miquelon

Thank you, Greg. Good morning everyone and thank you for joining us on the call. This morning, I will take you through our quarterly results as well as build on Greg’s comments regarding today’s announced future relationship between Walgreens, Alliance Boots, AmerisourceBergen. I will also provide greater detail on the 10-year agreement as well as further perspective and why we are confident this relationship unlocks significant opportunities for our company and provide value to our shareholders.

Starting with the quarterly results; as Greg noted earlier, for the quarter, we reported a GAAP EPS of $0.79 per diluted share based on 953 million shares. This chart illustrates the walk from GAAP EPS to adjusted EPS for the quarter. The LIFO provision was $0.05 per share. The acquisition related amortization was $0.08 and the Alliance Boots adjusted earnings tax add back was $0.04 for total of $0.12 per share, and finally the special items column had a Net Zero impact on adjusted earnings per share because of the $0.01 of acquisition related costs, and they were offset by a $0.01 gain related to the client retention extra proceeds from the sale of our PBM in 2011, some of these yields and adjusted EPS $0.96 per diluted share for the quarter.

It’s also worth noting that the quarter this year had one less day than the quarter last year which included leap days February 29. Adjusting for leap day adjusted earnings per share increased over 10% in the quarter rather than the 9.1% that Greg noted.

Let me now provide more detail on our comparable store sales for the quarter. Keep in mind that our comp store reported on a 28 day basis. Comparable prescription sales decreased 1.2%, comparable front-end sales decreased 1.6%, total comp sales decreased 1.4%, and non-prescription sale increased 5.7% versus a negative 6.1% script comp a year ago. We also note that comparable prescription sales were negative versus the positive scrip comps primarily due to the increase introductions of new generics year-over-year.

This slide illustrates the trend of prescription comps for the last 14 quarters that clearly shows the impact on comp stores script numbers in the prior fourth quarters were not part of the Express Scripts networks. As you now Express Scripts customers started returning to our pharmacies in the first quarter.

The comp store scripts increased 5.7% in the second quarter, please note that the script comps also included a 1.9% positive impact from a higher incidence of flu this quarter versus a year ago.

Next slide shows the trend in Front-end comps for the last 14 quarters. The primary drivers behind the trend in the last four quarter were the impacted the move to rebalance our overall add and emotional spending strategy and the impact of Express Scripts. Our goal of (inaudible) balance between sales and profitable growth using our promotional strategy, as well as our unique Balance Rewards loyalty program. This gives us an additional lever to help find this balance between loyal customer sales and margins.

We are pleased to achieve stable margins in the front-end despite a very promotional environment. On a 28 day basis, traffic in the quarter decreased by 4.4%, basket size increased by 2.8%, and the front-end decreased by 1.6%. Keep in mind, we will have to change an overall promotional spend strategy this month, that should help improve the recent comp trend. March comps will also be positively impacted by the ships in Easter from April 8 last year to March 31 this year.

Turning to margin, our FIFO gross margin was 30.5% in the current quarter compared with 29.3% last year a 120 basis points improvement. The overall margin was primarily helped my pharmacy, but the front-end also contributed. Pharmacy margins were positively impacted by generics, front-end margins were positively impacted by OTC drugs, personal care and household products, but these benefits were partially offset by the increase in points accruing as we ramp up our loyalty program. Front-end margins were also negatively impacted by the e-commerce mix effects.

Taking a look at our longer-term gross margin trends, it is important to note this quarter's 120 basis point improvement builds on 20 basis point increase a year ago, and the improvement this quarter is similar to last year, both quarters a testament to the benefit of generics introductions this fiscal year. Front-end benefit to margin did move from neutral to positive sequentially, and also note the 4% improvement in FIFO gross profit dollar growth, which is much better than the 0.1% growth last quarter, and a 1.5% growth in the quarter a year ago.

This illustrates our two year stacked SG&A dollar growth trends on a GAAP basis for the last nine quarters. The next slide shows the trend on an adjusted basis. Three year stack adjusted SG&A trends improved versus a year ago to 7.9% growth in the second quarter of 2013, down from the 11.6% last year.

To get to adjusted SG&A dollar growth, we could see there are reported SG&A dollar growth and 5% included 30 basis points of Walgreens amortization and 50 basis points of acquisition related costs, which result in adjusted SG&A dollar growth of 4.2%. This illustrates our quarterly gross profit dollar growth trends for the past ten quarters on a GAAP basis.

And the next slide shows the trend on an adjusted basis. Adjusted gross profit dollar growth increased from a positive 0.1% in the first quarter to a positive 4% in the second quarter. The trend in adjusted gross profit dollar growth data shows a benefit from members of Express Scripts plans returning to our stores, combined with an increase in the mix of generic drugs.

While on the same construct this slide shows the SG&A dollar growth trends for the past 10 quarters on a GAAP basis. and the next slide shows them on an adjusted basis. As I discussed in the SG&A walk earlier, the adjusted SG&A dollar growth for the quarter was 4.2%, an increase from the 2.5% adjusted SG&A dollar growth reported in the first quarter.

Keep in mind that the adjusted SG&A dollar growth rate of 4.2% also includes a few other non-comparable expenses as the operating expense related to the USA Drug acquisition and further expenses to sign up Balance Rewards numbers among other items as well.

Focusing on our income statement for a moment, this quarter included a LIFO provision of $72 million, the same amount as the year ago. Our effective LIFO rate for the year was 2.75%, up from 2.5% a year ago. Net interest expense was $23 million, including the impact of the Alliance Boots acquisition and interest and income associated with delayed payments by a state Medicaid payer.

Our effective tax rate was 36.6% versus 37.3% last year. and average diluted shares outstanding were 953 million shares versus 875 million shares last year and again, this increases primarily due to shares issued for the Alliance Boots investments.

Cash and cash equivalents were $2.4 billion at February 28 versus $1.1 billion a year ago. Overall, working capital decreased by 5.4% versus a year ago; accounts receivable decreased by 1.1% while accounts payable increased by 4.4% and inventories decreased 1.3%. Total FIFO inventory increased by 2.5% in the quarter versus a negligible percent increase in total sales. FIFO inventories on a per store basis were flat.

During the second quarter, we generated $1.2 billion in cash from operations versus $1 billion a year ago. Cash flow in the quarter benefitted from the timing of $300 million employee profit share and contribution, which occurred in February last year that occurred in March this year. Free cash flow in the quarter was $953 million versus $753 million a year ago. And keep in mind; we also raised the dividend over 22% this year, $0.275 per share per quarter.

Let me now transition to our accretion for the quarter as a result of the partnership with Alliance Boots. Second quarter accretion was $0.05 per share in line with $0.04 to $0.06 range we forecasted last quarter. We are reconfirming our estimates throughout the $0.30 per share in the third quarter and now into $0.10 for the fourth quarter.

The next slide illustrates the synergy dollars, the amortization adjustments and the equity earnings that comprise $0.05 of accretion. As shown, we have realized $25 million before tax and synergies during the second quarter and $15 million after tax. We expect synergies to ramp during the second half of our fiscal year and we remain comfortable with our $100 million to $150 million combined synergy goal for fiscal ‘13.

Amortization adjustments amounted to $23 for the deal amortization and $12 million for the brand amortization. After tax Alliance Boots equity earnings were $85 million for the second quarter on a GAAP basis. Adjusted basis, the income from affiliate was $120 million as noted here and the incremental after-tax, interest expense to Walgreens was $13 million after the cost to share dilution; the accretion equaled $0.05 in the second quarter.

Now let me take a few minutes to speak about our announcements this morning regarding the strategic long-term relationship with AmerisourceBergen. I would like to fully express my enthusiasm for this agreement and what it means with respect to the various opportunities that it brings us.

As Greg outlined earlier, this relationship has three components; distribution agreement, strategic collaboration, and equity alignment. Let me first describe the detailed structure of the agreement. First and foremost, Walgreens is committing to a 10 year comprehensive pharmacy distribution agreement with AmerisourceBergen. The strategic collaboration with allow broad international reach and significant knowledge sharing opportunities to create efficiencies and design programs to improve access to pharmaceuticals or healthcare providers or life. So aligning interest in strengthening the long-term relationship was underlined, we together have been granted the right to purchase a minority equity position in AmerisourceBergen.

We are getting this right, but not the obligation to purchase up to 7% of this fully diluted equity of AmerisourceBergen in the open market. We have established a joint venture with Alliance Boots that we intend to fund over time, there will be an efficient vehicle to purchase and hold these shares.

In addition, AmerisourceBergen has granted to Walgreens and Alliance Boots equity warrants exercisable for 16% in the aggregate of the fully diluted equity of AmerisourceBergen.

First launch representing 8% of the fully diluted equity of AmerisourceBergen and strike price of $51.50; it will be exercisable for six months period beginning in March 2016. The second reward had a strike price of $53.50 it will be exercisable for six month period beginning in March 2017.

Walgreen’s and Alliance Boots had agreed not to acquire additional equity of AmerisourceBergen under the terms of the standstill agreement. But Walgreens executive will be appointed to AmerisourceBergen's board upon Walgreens and Alliance Boots together acquiring a 5% equity stake. But Alliance Boots executive will be appointed upon exercise in full of the first one. These new board fleets will add to AmerisourceBergen’s current nine member board.

The 10 year comprehensive distribution agreement will be positive to earnings and cash flow from operations. The agreement is market based and is expected to be modestly accretive in fiscal year ‘14 adjusted earnings. The working capital was negotiated to essentially have a neutral impact to both parties, specifically the reduction in inventory days at Walgreens, will largely be offset by the decrease in accounts payable days over time.

The operational benefits for Walgreens will include enhanced supply chain with daily delivery. Synergies will also contribute to earnings and cash flow from operations in fiscal ’14 and they are expected to build in subsequent years. Likewise the equity investment will drive dividend income in fiscal year ’14 and beyond.

To summarize, the financial benefits for both Walgreens and Alliance Boots to begin in the first year are improved commercial agreement rates, synergies and dividend income that arrives from the investment. Beginning in year three, the Walgreens and Alliance Boots JV also expect an incremental financial benefit from the equity income. As we stated in our announcement this transaction is structured to enable all three organizations, to work together on programs to improve service levels and efficiencies and benefit from available synergies.

To wrap up the day, I would like to revisit our fiscal year 2016 goals for the combined Walgreens, Alliance Boots equity. We are not changing our goals. We want to clarify that the agreement we announced today to provide operating income, synergies, and operating cash flow benefit is accretive to our prior plans. We continue to believe that this partnership will reward our stakeholders who will deliver significant synergies and have mutual capabilities and change strategic landscape in the U.S., Europe and other geographies around the world.

The business performance objectives are meeting our expectations and are on track to meet our first year synergy target. And now the new strategic relationship with AmerisourceBergen, we are well positioned as leaders in the rapidly changing global healthcare environment.

In that context, we had reaffirmed our combined stated goals for fiscal 2016 of $130 billion of revenue, $9.5 billion of adjusted operating income or $8.5 billion to $9 billion on a U.S. GAAP basis. The combined synergy goal of $1 billion with a $100 million to $150 million in fiscal year ‘13 combined synergy goals, $8 billion of operating cash flow and given the strong cash flow trends at both Walgreens and Alliance Boots, we believe that with a 7% investment in AmerisourceBergen, we still need to combine net debt goal of $11 billion or less.

In summary, we are on a journey, a journey to alter the global landscape in pharmacy led health and well-being and create significant shareholder value along the way. With our partners, Alliance Boots and AmerisourceBergen, the opportunity before us are limitless and combined capabilities are unmatched.

Thank you and we appreciate your interest in our company. And with that, I will turn the microphone back over to Rick.

Rick J. Hans

Thank you, Wade. That concludes our prepared remarks. We are now ready to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Steven Valiquette of United Bank of Switzerland. Your line is open.

Steven J. Valiquette – United Bank of Switzerland

All right, thanks, good morning. Hey, just a question on the gross margin, once again looks pretty strong in this quarter. And obviously there is some seasonalities that kind of jump from the holiday related quarters to the non-holidays. I’m just curious, I know you don’t like to give guidance, but to the extent, you’ve kind of shifted from LIFO to FIFO gross margins. Should we assume the same sort of seasonal progression of gross margins on a FIFO basis that we kind of saw previously on LIFO, just any sort of general color along those lines will kind of help? Thanks.

Greg D. Wasson

Yeah. I mean, we’ve got couple of things, one is, we are very focused on margin, I think in the front-end even though we’ve had combined profits. I think we’ve been able to do very good job of improving profitable mix. On pharmacy, you’re seeing some of the benefit of generics, but also I’d say a real focus I think at the end of the day, we will keep looking to improve margin opportunities, but really again I focus on our gross profit dollar growth versus our SG&A dollar growth and being able to continue to widen that spread. And I think you see now for the first time since the Express Script’s dispute. It was actually crossed back over into positive territory and I expect that momentum to build.

Steven J. Valiquette – United Bank of Switzerland

Okay, in that previous guidance you gave a line that is kind of unchanged on a FIFO basis versus what you gave on a LIFO basis previously. Is that just to confirm that, is that correct?

Greg D. Wasson

Yeah, so, I mean obviously LIFO to FIFO you never really know until you get the various price increases and things that flows through. I think LIFO was very indicative though over the way we do run our business.

Steven J. Valiquette – United Bank of Switzerland

Okay.

Greg D. Wasson

Again I think, with all the things I mentioned we should be able to have nice solid gross profit margin or SG&A dollar growth.

Steven J. Valiquette – United Bank of Switzerland

Okay, thanks. And congrats on the ABC deal as well. Thanks.

Greg D. Wasson

Thanks. We appreciate it.

Operator

Our next question comes from the line of John Heinbockel with Guggenheim Securities. Your line is open.

John E. Heinbockel – Guggenheim Securities

Just a couple of things on the Amerisource deal, your comment about working capital, is that neutral to the system or neutral to you?

Greg D. Wasson

It’s relatively neutral to the system and to us, but over time working together we should both be able to get additional efficiencies and drive additional days of inventory out of it. So, I think there is probably upside results as we work together. But it’s relatively neutral to the system and it’s been balanced, so it is relatively to both parties with some exceptions at the initial startup phase.

John E. Heinbockel – Guggenheim Securities

Okay. And then the idea is modestly accretive in ‘14, is that including some one-time cost and then how do you think that generally ramps up in 2015?

Greg D. Wasson

There should be very modest one-time costs, so by and largely accretive and modestly accretive including those. But the key thing here is, we’re going to have – today if I really have three distributors and when we think about it, we’ve had AmerisourceBergen, we take cardinal event ourselves. We’re streamlining all of that into one and generic volume is very, very significant and so that will be faced in overtime. And as we face that in and get that up to speed, that’s were there is additional opportunities, significant opportunities for both party.

John E. Heinbockel – Guggenheim Securities

All right. And then lastly, when we look at the front-end and script count as well, if you look at – February was it look like it was somewhat impacted by macro both the pharmacy and front-end, maybe your take on that as we kind of got into this year with payroll tax and what have you and did you still think in terms of getting positive on traffic at the front-end that’s still likely to be laagered relative to average tick I assume. Do you think we will see positive traffic by the end of the fiscal year?

Greg D. Wasson

Yeah John, Greg. Yeah, I would I guess agree with your comments to begin with the stories of macro trends in February and certainly in March as we said, we got an early Easter, so we probably know more by the time we come through April, but as far as the front-end certainly as Wade said, we are focused on shifting that promotional strategy from (inaudible) to some of the new media opportunities. And I think we’re working to balance both traffic and basket size. I think certainly we want to have both – as I said we are lapping to change in that new strategy beginning actually last month, but we are focused now on really reinvesting some of that margins that we are picking up from a private brand from our Balance Rewards program to focus on traffic.

So we want a little more balance going forward and we think we should be able to achieve that. Whether that’s in the fiscal year or not, we don’t want to give guidance, but we think we can achieve that.

John E. Heinbockel – Guggenheim Securities

Okay, thank you.

Operator

Our next question comes from the line of Matthew Fassler with Goldman Sachs. Your line is open.

Matthew J. Fassler – Goldman Sachs & Co.

Thanks a lot and good morning. A couple of questions, first of all, if you think about the cadence of Express reclination, talk about all the progressing relative to your planning, given that you’re almost through the first 90 day cycle of the calendar year, what kind of build you think you might see beyond the calendar first quarter.

Greg D. Wasson

Yeah, Matt again we kind of focus on comps versus just the Express Scripts, but I think we’re good about our comps and the win back we’re seeing. I think that it certainly is to the earlier call, the macro environment February is tightened up a little bit post Boots events, but I think we feel very good with where we are, we’re on track, and we feel good about our pharmacy comps going forward.

Wade D. Miquelon

Apart from being able to, we continue to win back that business which we are, we also feel very good about the ability to keep growing this proportionally our share of Part D, we were – go ahead I’m sorry, Matt.

Matthew J. Fassler – Goldman Sachs & Co.

No you just go ahead Wade.

Wade D. Miquelon

I think we’re just seeing very nice gains, we are expecting those continue to grow throughout the year as people switch into a preferred plan with Walgreens.

Matthew J. Fassler – Goldman Sachs & Co.

Understood, just a quick follow-up question on the Amerisource deal, if you think about the investments you make down the road, what were the cash needs to be able to fund those, and what’s your expectation for how you pay for it.

Wade D. Miquelon

Well over the next immediate period we have the ability to purchase up to 7% and that will be at the market price, so that will be whatever it will be. As I said before though the fact that both Walgreens and Alliance Boots we have been exceeding our cash flow targets, and we believe that we will over that period be able to continue to exceed, and in fact still be on track with $11 billion net debt or better even with that investment the warrants will be a separate investment, when you got the strike prices, and you’ve got the time and again we have the right to purchase those, but not the obligation so if we go down the road here we can reassess what makes sense at that time.

Matthew J. Fassler – Goldman Sachs & Co.

So most likely, cash on hand and incremental free cash flow or would you see, it’s going back to the debt markets to the bank line to fund this at all?

Wade D. Miquelon

I think we can do it internally, at least for the first piece 7%?

Matthew J. Fassler – Goldman Sachs & Co.

Got it, that’s helpful. Thank you so much.

Operator

Our next question comes from the line of Eric Bosshard with Cleveland Research. Your line is open.

Eric Bosshard – Cleveland Research Co.

Good morning. Two questions for you, first of all, Greg you’ve commented a little bit, of the evolving front-end and certainly I understand what you’ve done over the last year, but curious how the front-end strategy is evolving with regards to promotions also curious in terms of the new store format, what the strategy is in terms of what we made out broadly, obviously we’ve had a change in merchandise leadership or going through that right now. But give us an update of how all of those debts are evolving?

Greg D. Wasson

Yeah, Eric. Maybe, I’ll start with your last one first. As far as the change in the leadership, certainly our strategy has not changed, will not change. We feel very good with our well experienced format as you referred to; we’re in over 400 stores. We’re certainly still in pilot learn and enhance, but we feel good with, how we’re going forward with that the customer response, which is kind of the leading indicator is very good, which tells us that we’re moving in the right direction.

There are a lot of things that we feel very good about, they’re working well. There are some things we want to continue to tweak, but I think you’ll see that continue to evolve and expand. as far as our front-end, I think we feel very good with the adjustments and the opportunities that we have, Eric, as I said before, a shift from primarily print, advertising and a lot of spend in that area to leverage and utilize more digital media in our Balance Rewards program, that’s a big strategic shift. We actually feel good as far as how we move. But there is opportunity to look at ways to reinvest on that margin that we have, to make sure that we continue to focus on driving traffic and that’s what we’re doing. I think the luxury we have is the fact that our private brand strategy is doing extremely well, which is obviously delivering margin that we generally invest.

Eric Bosshard – Cleveland Research Co.

And then secondly with the ABC deal this morning, obviously you’ve got a lot going on with Boots especially with on the purchasing side, and I am just curious how you’re going to balance the effort with ABC along with combining those two businesses. It seems you put a lot on your plate especially within purchasing before we think of these other things. Can you talk a little bit about the bandwidth to execute on what becomes sort of a growing list of things to get accomplished?

Greg D. Wasson

Yeah, I think it is a fair question. In fact that we believe that actually it will become easier for us as Wade said, we’re actually moving from three to (inaudible) down to one, but I think when we look at certainly our three key objectives, I think we have a real focus in the organization in driving those three key objectives. I think secondly with our partnership with Alliance Boots, and where we are and being on track with that, we feel good there.

I think when we began to explore our strategic opportunities for our US supply chain with our exploration of our contract we looked at a lot of different options. And frankly this was the most compelling strategic and financial option that we had. And with AmerisourceBergen’s expertise, Alliance Boots’ expertise, we actually think it can enhance our supply chains and frankly simplify and ease some of the work that we’ve been doing in the past with self distributing.

And so we have also established our JVs and our collaborative efforts in bringing them into the fold as a partner that is really, I would argue was not more work, it’s just going to complement and augment what we are already doing.

Eric Bosshard – Cleveland Research Co.

Thank you.

Greg D. Wasson

Thanks, Eric.

Operator

Our next question comes from the line of Mark Wiltamuth with Morgan Stanley. Your line is open.

Mark Wiltamuth – Morgan Stanley & Co. LLC

Hi good morning. Could you maybe go through the global nature?

Greg D. Wasson

Good morning, Mark.

Mark Wiltamuth – Morgan Stanley & Co. LLC

Of the transaction with AmerisourceBergen and how this works for the Boots side of things, and then if you are shifting to more generic sourcing, doesn’t this kind of get entangled with that synergy target that you have laid out? And it sounds like your goals here are not incremental to or they are incremental to the synergy targets you have given us, maybe explain how that interaction works for the generics?

Greg D. Wasson

They are incremental and with respect to the international collaboration, efficiency work for example, our JV and our employees there will be working with AmerisourceBergen people, and again we expect incremental benefits for both us and for them and our benefits will be spilt with our partners; Alliance Boots and separately on the other global work. the Alliance Boots folks are working with them to identify various opportunities, whether it would be expansion of specialty overseas, [3PO], free wholesaling and others and we fee there is a lot of opportunities overtime, and as those get more firmed up, I am sure we will share more details.

Mark Wiltamuth – Morgan Stanley & Co. LLC

Okay. And just on a separate topic, how do you expect the script gains from the preferred Part D networks to really start to build as the year progresses, and how much were they on the quarter for script volume?

Greg D. Wasson

We haven’t dissected the quarter, but we did see nice gains in January as people switched into plans where Wallgreens isn’t preferred, and what we usually see, we saw the year prior is that throughout the year as Part D people are made aware the benefits they can get by going to a preferred pharmacy within that network. We tend to see gains all year long as well. I have to mention the 12,000 people a day which are entering into Part D and getting into a plan, and hopefully disproportionately into a plan that has Wallgreens and/or is preferred by us.

Mark Wiltamuth – Morgan Stanley & Co. LLC

Okay, thank you.

Greg D. Wasson

Thanks, Mark.

Operator

Our next question comes from the line of Meredith Adler with Barclays. Your line is open.

Meredith Adler – Barclays Capital, Inc.

Thanks for taking my question. I was wondering, I’m trying to understand sort of the mechanics of the relationship with AmerisourceBergen, are they going to take over operating your distribution centers, will those distribution centers ever support their independent or other customers I mean, are you really merging the two supply chain networks or is it not going to be like that?

Wade D. Miquelon

Reflectively they may be like some of our generic distribution assets, but they will get the large benefits by integrating broadly into their supply chain, a lot of our distribution centers have a generic distribution upon in our front-end components, so we’ve got actually lots of volumes still there, and a lot of opportunities to reallocate resources, but broadly they will be taking this volume into their system to get the full scale and efficiencies, and be able to deliver three lines of business task versus just one prior or three lines from three different distributors to include ourselves as one.

Meredith Adler – Barclays Capital, Inc.

It sounds like they were very anxious to do this business, obviously there were many, many layers and pieces to the benefits of this, it’s all very interesting, and just talking about the most supply chain contract, it seems like because you have been shipping generic drugs on your own trucks for your shipping front-end products, isn’t it just less efficient for them to be the one that ships that product.

Greg D. Wasson

Well Meredith it’s Greg, keep in mind that they deliver daily, which is obviously it improves the service level that we have in our sources we go direct in most cases once a week, I think that the opportunity, think about it this way, Alliance Boots and AmerisourceBergen are experts in pharmaceutical supply chain distribution. We’re very good at it, but the combination of what they both do to improve our supply chain, take that off of our hand and improve our service levels is really the opportunity that we’re excited about.

Wade D. Miquelon

And it’s they can probably do – rather than do brand deliveries and separate from our generic deliveries, they can tolerate brand generic and on specialty into one shipment, which has lots of positive implications for us and lot of efficiencies and aggregate for every one.

Meredith Adler – Barclays Capital, Inc.

All right. Well, congratulations, it’s very, very interesting transactions and…

Greg D. Wasson

Thanks, Meredith.

Meredith Adler – Barclays Capital, Inc.

I will turn it over to somebody else.

Greg D. Wasson

Thanks Meredith.

Operator

(Operator Instructions) Our next question comes from the line of Edward Kelly with Credit Suisse. Your line is open.

Edward J. Kelly – Credit Suisse Securities LLC

All right, good morning guys. Congratulations on new deal.

Greg D. Wasson

Thanks Ed.

Edward J. Kelly – Credit Suisse Securities LLC

I have a question for you related to this along with the original synergy target with Alliance Boots; I think it was kind of ask maybe, kind of different way still kind of unclear to me, practically how does this impact the cap share of the generic procurement synergy that you actually talked about. I’ve asked that question because you had control, I guess in the past right over your own generic purchasing, you’re going to combine that with Alliance Boots, and it’s clear as to how you benefit from that scale. But I think you’re transferring that control to a more synergy’s program, it’s just unclear to me, how all this is going to work and how it flows through into the income statement of the companies.

Wade D. Miquelon

We are not transferring control is back to – our JV which is set up and working and will continue to work, and it will work on behalf of our partner effectively as well. And we do see that these benefits are going to be incremental the components for us, but also incremental to them. And so again, we will maintain control on this, a lot of those benefits on our side will flow through our JV structure, which then gets split, and then cycles a little bit because of the 45% ownership that we have in Alliance Boots, but at the end of the day, we will see that this will bring incremental value for us and clearly incremental value to AmerisourceBergen as well.

Greg D. Wasson

Ed in essence we are bringing new board of buying volumes from AmerisourceBergen into the Alliance Boots to Wallgreens, venture that we have said we have established.

Edward J. Kelly – Credit Suisse Securities LLC

Is there upside to that initial synergy target or is that upside captured and the better pricing is this deal?

Wade D. Miquelon

Well, there is upside to the synergy target. Commercial agreement is very separate. The commercial agreement stands on its own.

Edward J. Kelly – Credit Suisse Securities LLC

Okay.

Wade D. Miquelon

Compared to a distribution agreement and we feel that it’s a good agreement and better than we have today for a lots of reasons not only costs but will be service level, the deliveries it’s also a market fair and good deal for AmerisourceBergen. And again by having going from effectively three distributes to one, it provides opportunities for both parties to gain. But this agreement is really separate from that.

Edward J. Kelly – Credit Suisse Securities LLC

Okay. And then just one other question for you; on SG&A, this quarter a little bit higher than we thought it was going to be. If we and you have been talking in the past, Wade about looking at your stacks, so if we think about to your stack today and we carried out forward to the second half. It looks like you could see SG&A dollars up like 9% plus. So I guess the first question is that, right, the right way to think about it. And then secondly, if that is right, can you still grow gross profit dollars faster than that in the back half?

Wade D. Miquelon

Yeah. A couple of things; one is our SG&A this quarter had some, outside of what we can call adjusted have some anomalies. We had some further investments in loyalty, we had some from M&A which adds SG&A on top of that from a growth point of view, but sheer gross profit as well and then there was actually some other one-time items there we didn’t call out, so we actually felt pretty good about our SG&A this quarter. I think the thing to look at is, the SG&A versus gross profit dollar growth, which both, gross profit dollar becomes easier in the back-end too. So it’s that spread separately, our sustainable model has always been to have kind of organic SG&A growth of 3.5% to 4.5% on any period, 1.5% to 2% that’s driven by new stores. And I think on a two-year stack basis over time, that models will still be as relevant as the one before.

Edward J. Kelly – Credit Suisse Securities LLC

Okay, thank you.

Greg D. Wasson

Thanks, Ed.

Operator

Our next question comes from the line of Andrew Wolf with BB&T Capital Markets. Your line is open.

Andrew P. Wolf – BB&T Capital Markets

Thanks and good morning.

Greg D. Wasson

Good morning, Andy.

Andrew P. Wolf – BB&T Capital Markets

Good morning too. Kind of piggyback on Meredith’s question, just logistically, over time with the AmerisourceBergen contract, is there still going to be some cross-docking of branded drugs or are they going to basically over time be going to Walgreen stores directly on a daily basis?

Greg D. Wasson

Yeah. Andy, let me go on to the stores on a daily basis, that’s a big part of the opportunity as the improved service levels frankly and over time, I think also as Wade mentioned, certainly if there’s opportunity to leverage some of the space that we have in the DC, that’s committed to pharmacy warehousing. It also frees up capacity with our existing distribution centers for our front-end products as well. But yeah, we’ll be leveraging their ability to come to the stores on a daily basis.

Andrew P. Wolf – BB&T Capital Markets

Okay. And the second part of that question is, daily delivery really from my view, can really increase your in-stack rates particularly around specialty drugs. So can you discuss what the long-term, as more of the pharmaceutical market and the value of the pharmaceutical market moves to specialty drugs? Is that sort of the underlying or part of the underlying reason for this agreement long-term strategically?

Greg D. Wasson

Loved that question, Andy, yes. I think that the opportunity to leverage that daily delivery for all medications, but even in particular high cost specialty medications. So that patient’s can access their trusted community pharmacists as they have known for years to pick up a special message, a huge opportunity. One of the things that really excites me, intrigues me is obviously of the wholesalers in the U.S., AmerisourceBergen absolutely elites in specialty sector. So we think there’s a lot of opportunity to work together to provide new and innovative solutions for specialty. The other thing that’s intriguing with AmerisourceBergen is their focus on health systems and in patient’s meds in fact, as you know, we’re working a lot of major health systems without patient pharmacy as well. So there’s a lot of opportunities along those lines, Andy.

Andrew P. Wolf – BB&T Capital Markets

Okay. And just lastly, shifting to the kind of the Balance Rewards program and the membership strong numbers, what can you talk about usage rates and other trending versus expectations and just a color around that, it’s a very ambitious program, not just for Walgreens but I think what we’ve seen in the country?

Greg D. Wasson

Yeah. I mean I think we’ve been, I guess it’s really been a heavy ramp up base with more than 60 million members in very large, let’s say majority of our sales now on the card, it’s really that investment phases, as they are long, the magic now comes with redemption. And that we have a critical math that people signed up or a critical math of purchases, people are getting significant number of points that they can use. It becomes about redemption turning now to delay. And that’s what I think, Greg, we’re running the online promotion. But to some extent to we’re also exiting the build phase on loyalty. And that’s why we see that as a win going forward.

Wade D. Miquelon

Yeah, Andy, Wade in here, I think of this as obviously a new currency that it takes a while for people to understand the value of that and as they build points and then begin to redeem them, they begin to understand the value of that currency especially in the economic climate like we have today. And that’s where we are beginning to see gaining momentum and we feel will really help us with the traffic in the front-end as we go forward.

Andrew P. Wolf – BB&T Capital Markets

Okay. I mean because a lot of the behavior you’re trying to get is lot towards like accumulate the points as to get, people to buy a certain product, and that is a different kind of modality I think than a typical loyalty card. And so that’s what I was asking, is that on trend or the CPG partners getting what they want out of that, whether it’s trail of a new product, or that’s what I was asking may be, shed some light.

Wade D. Miquelon

Again like anything obviously there is some learning and start-ups that what I would say is that the loyalty card holders are – the feedback is very, very positive in terms of the program and increasing the ability to understand it. So I think we feel that we’re in a very good spot there. As we continue to tweak and refine in terms of what will motivate people, how do we make the CPG dollars, and others, and money go as far as possible. In fact there are some refining and tweaks but I think directionally we are on a good track and we know where we’re going to take this over time.

Greg D. Wasson

And specifically to your question, Andy, we’re encouraged by the basket size unless that we’re seeing with lot of the floating numbers.

Andrew P. Wolf – BB&T Capital Markets

Thank you.

Greg D. Wasson

Okay.

Operator

Our last question comes from the line of Lisa Gill with JPMorgan. Your line is open.

Lisa C. Gill – JPMorgan Securities LLC

Hi, thanks very much. And good morning.

Greg D. Wasson

Good morning.

Lisa C. Gill – JPMorgan Securities LLC

I just had two quick questions. First, just wondering Wade, was there any benefit in the quarter to gross margin from your purchasing synergies now that you have the purchasing alliance with Alliance Boots?

Wade D. Miquelon

Well, there is about $25 million of total combined synergies of which the purchasing piece was a big piece right, and of course without all the nuance detail on the form because of our JV and because of our present ownership whatever, it’s a little complex in terms of how it flows right back to the company. So yes, there was, again, we have $100 million to $150 million run rate this quarter. Again, I guess that was sort of $25 million, that’s building very quickly. So we expect a very nice pickup here in the back half. In part, because there is the P&L timing, when we get the cash benefit, it’s different from some of those that actually flows through our inventory and through our accounting.

Lisa C. Gill – JPMorgan Securities LLC

Great. And then my second question has to do with ACA, as we start thinking about exchanges and calendar 2014 and we think about relationships with exchanges. Can you talk about how you anticipate those will be set up to you? Will the rates be the same as we see in commercial markets? So therefore, if you have a relationship with a large managed care entity it will just get the increase in that volume. It would be my first question. And then secondly, what are your thoughts and anticipation around Medicaid, whether it’s fee-for-service Medicaid or direct Medicaid increases and what that will do for reinvestment as we start thinking about 2014?

Greg D. Wasson

Lisa, I think a lot of that certainly is unknown at this time, although we’re beginning to see things take shape. I believe that the first half it’s really community pharmacy has and we’re certainly looking forward to do as to help people understand, educate and navigate to help the government locate folks who are eligible. I think secondly as far as participation in networks, I think you’ll see all the above. I think you’ll see some preferred networks like you are with Medicaid Part D. Then certainly we want to leverage our existing relationships with to participate. Medicaid, I think with the expansion in Medicaid, we’re interesting to see how states respond. I think in fact see maybe – potentially you may see more move into managed plans. But there again, I think we intend to work with them in whatever way or former fashion they’re looking to go forward with its preferred opportunity or not, at least one (inaudible) at the ACA it’s even though a lot of it’s unknown, it’s kind of unfolding before eyes. I think there’s really two positive dynamics embedded in it for us as a community pharmacy.

Number one is the fact that similar to Medicare Part D, individuals want to go where they want to go, and so when there is a dynamics that allows people to choose what they want, we typically more times in that are able to be a provider to people that want to go to Walgreen.

Lisa C. Gill – JPMorgan Securities LLC

Okay.

Greg D. Wasson

That’s a good dynamic. I think the second thing is by the nature of this overtime, we’ll be looking to reduce the overall cost of healthcare for the patients and community pharmacy, being more generic utilization, be it for preventing things that we can do on the front line, screenings, compensations, a variety of things, we will deliver for that. So we can – we will expect to be fairly compensated for what we do because the levers that we can pull to reduce the overall cost of that are significant well beyond just the cost of the drug.

Lisa C. Gill – JPMorgan Securities LLC

Secondly….

Wade D. Miquelon

Kelly, I think both the plans and the government understands that finding, educating this population to help them find plans that work for them is going to be even more difficult than the seniors.

Lisa C. Gill – JPMorgan Securities LLC

And in…

Wade D. Miquelon

Okay, go ahead.

Lisa C. Gill – JPMorgan Securities LLC

Am I also correct though Wade and Greg in thinking about this that you have leverageable fixed cost today that you probably have excess capacity in most of your stores, but this should be all of this increase in volumes, there shouldn’t be a lot of incremental cost on your side to bring these on, and therefore if the pharmacy of choices is Walgreens that you’re going to see this increase in volumes without a lot of increase in cost of finding the patients and ringing them on the doors, is that the right way to think about it?

Greg D. Wasson

I think to some degree that’s true, I thought you’re going to say, are we looking into variable pricing, and the answer is no but yeah, for sure, some will be incremental, but also there will also be some shipments of those from mid and small employers maybe others that chose to go in different way and push people to exchanges and from that managed points by zero some gains.

Lisa C. Gill – JPMorgan Securities LLC

Okay, great. I appreciate the comments.

Greg D. Wasson

Thanks Lisa.

Operator

That does conclude the question-and-answer portion of today’s call, I’d like to turn it back to Rick Hans for any closing statements.

Rick J. Hans

Ladies and gentlemen, that was the final question. Thank you for joining us today. As a reminder the company will report March sales on Wednesday, April 03. We will report our third quarter 2013 results on June 25. Again thank you for your time today and please feel free to follow-up if you have any further questions. Good bye for now.

Operator

Ladies and gentlemen, this does conclude your conference. You all may disconnect and have a good day.

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