Walgreens' CEO Discusses F3Q13 Results - Earnings Call Transcript

| About: Walgreens Boots (WBA)

Walgreen Co. (WAG) F3Q13 Earnings Call June 25, 2013 8:30 AM ET


Rick Hans – Divisional VP, Investor Relations

Greg Wasson – President and CEO

Wade Miquelon – CFO

Kermit Crawford - President, Pharmacy

Mark Wagner - President, Store Operations


Lisa Gill - JPMorgan

Tom Gallucci - Lazard Capital Markets

John Heinbockel - Guggenheim Securities

Ajay Jain - Cantor Fitzgerald

Matthew Fassler - Goldman Sachs

Ross Muken - ISI Group

Andrew Wolf - BB&T Capital Markets

Ricky Goldwasser - Morgan Stanley


Good day, ladies and gentlemen, and welcome to the Walgreen’s third quarter 2013 earnings conference call. [Operator instructions.] I will now turn the call over to your host, Rick Hans. Please begin.

Rick Hans

Thank you, operator. Good morning, everyone. Welcome to our third quarter conference call. Today, Greg Wasson, our president and CEO; and Wade Miquelon, executive vice president, CFO and president, international will discuss the quarter. Also joining us on the call are Kermit Crawford, president of pharmacy, and Mark Wagner, president of store operations.

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 statement 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 Wasson

Thank you, Rick. Good morning everyone, and thank you for joining us on our call. Today I’ll begin with the highlights of our results for the quarter. Second, I’ll update the steps we’re taking to improve our daily living business, expand our role in the changing healthcare system, and advance our long term strategic growth drivers. Then I’ll turn the call over to Wade for a more in-depth look at our results and key considerations for the remainder of the year.

We recognize our business has become more complex, with a number of moving parts, and we do want to help you get to the underlying performance of our business as we remain confident in our long term strategic direction. Starting with our financial results, we reported adjusted earnings per diluted share of $0.85 and GAAP diluted EPS of $0.65.

In the quarter, along with Alliance Boots, we announced a strategic long term relationship with AmerisourceBergen, one of the largest pharmaceutical supply chain companies in America. Through this relationship, we have formed a collaborative, integrated wholesale retail model here in the U.S., with a 10-year comprehensive primary distribution agreement for our branded and generic products.

Combined with our partnership with Alliance Boots, Europe’s leading fully integrated wholesale retail model, we are now best positioned to drive efficiency and innovation throughout the entire pharmaceutical supply chain, harnessing the benefits of global sourcing and making it easier for manufacturers to bring products to market and providing patients with better access to healthcare.

Cash flow from operations was $1.4 billion, with $1.1 billion in free cash flow, which is one of our strongest quarters for both. Earlier this month, we launched the Boots No 7 men’s product line in more than 5,000 stores across the country. We’ve already introduced with great success the No 7 women’s skincare line and other Boots products in four of our flagship locations, with more expansion planned.

And finally, our joint synergy program with Alliance Boots is meeting our expectations. We’re on track to deliver $125 million to $150 million in combined synergies, compared to our previous target of $100 million to $150 million.

Now let me walk through our quarterly results on a GAAP and non-GAAP adjusted basis. Sales came in at $18.3 billion, up 3.2%, from the same quarter a year ago. GAAP operating income for the quarter was $991 million, up 13.5% from $873 million for the same period last year.

Non-GAAP adjusted operating income for the quarter was $1.2 billion, up 22.9% from just over $1 billion in third quarter 2012. GAAP net earnings for the quarter were up 16.2%, from $537 million, or $0.62 per diluted share last year to $624 million, or $0.65 per diluted share.

The non-GAAP adjusted net earnings for this quarter were a record $812 million, or $0.85 per diluted share compared to adjusted net earnings of $628 million, or $0.72 per diluted share in the same quarter last year.

Turning to trends in gross profit dollars and SG&A dollars, in the third quarter, on a GAAP basis, our gross profit dollar growth increased 4.1%, or $208 million from a year ago. SG&A dollar growth increased 5.3%, or $221 million, compared to a year ago.

Now, on a non-GAAP basis, adjusted gross profit dollar growth increased $268 million, or 5.3% year over year. Non-GAAP adjusted SG&A dollar growth was up $182 million, or 4.5%. During the quarter, the rate of growth in adjusted FIFO gross profit dollars exceeded adjusted SG&A dollar growth by 80 basis points. You can see this was the first positive spread in six quarters, and we’re pleased that this is moving in the right direction.

Now let me update our progress on the three key strategic growth drivers we put in place last year to position our company for long term growth and value creation. First, on creating a well experience, while we’re seeing several positive indicators in our daily living business, such as increases in customer delight, basket size, and gross margins, our front-end sales and traffic are still not up to our expectations.

There are certainly factors that affected our results this quarter. As with other retailers, the weather had a negative impact on seasonal sales in the third quarter. We also continue to face a soft economy, especially in our lower income communities, where our stores, on a comp basis, are performing on average below our stores in middle or higher income neighborhoods.

That said, we’re taking steps to balance our investment in sales and margins. We’re focused on a clear three-point plan. First, we’re making further adjustments to our pricing and promotions, implementing a number of meaningful changes to our weekly ad. As you know, we began those changes in mid-May, and you’ll see more throughout the fourth quarter.

We’re applying what we’re learning from our Balanced Rewards program to ensure we have the items that are most relevant to our customers, in both assortment and price, to meet their daily living needs.

Second, we’re focused on maximizing the value of our Balanced Rewards program. With 75 million people signed up, we’re turning our focus from enrollment to redemption and rewards. For example, as shoppers earn points, we’re highlighting the dollar value of points earned in both our stores and in our circulars.

Third, we’re enhancing our store segmentation to better meet the local needs and preferences of our communities, whether they’re in the intercity, suburbs, or rural communities. We’re customizing our advertising circular according to individual community needs, especially in the hardest-hit communities where our customers are working hard to stretch their paychecks. We’re also working to ensure we have the right products and targeted promotions in our communities across the country.

I can assure you that improving our front end is a high priority, and I am confident that the team’s plans will strengthen performance and drive profitable growth over time. And in fact, we’re beginning to see just that. We reported a positive front-end comp this quarter, with progress over the previous quarter. We’re also beginning to see sequential improvements in market share over recent periods.

Finally, our flagship locations continue to give us a platform for innovation and to showcase the best of our brand. This quarter we opened flagships stores in the Empire State Building in New York City; Washington, DC; Boston; and San Francisco, bringing our total to 10 across the country.

Now, turning to our second strategic growth driver, transforming the role of community pharmacy, here we’re beginning to hit on all cylinders. Our script comp for the quarter was 7.1%, compared to 5.7% in the second quarter. We gained 80 basis points in market share, from 18.4% to 19.2%. 90-day prescriptions continue to grow, increasing 19% year over year, while IMS continue to report slowing growth of mail.

All this comes in an environment where physician visits are down 2.7% year over year in May, according to JPMorgan’s monthly tracker, and this follows year over year declines February through April.

With that said, we’re positioned extremely well to continue driving market share and profitable growth. First, we now have long term contracts with predictable rates in place with many of the major commercial payers in the market.

Second, we’re capitalizing on our preferred position in Med D plans. Our increase in Medicare Part D volume has exceeded the market every month since January. And with 10,000 people turning 65 every day, and signing up for coverage, we have tremendous opportunity to continue growing our volume over time.

Third, with healthcare reform moving forward, Walgreens, with our 8,000 locations and 70,000 healthcare professionals, is increasingly well-positioned to meet the growing demand for convenient, affordable, non-emergency care.

During this quarter, we announced that most of our more than 370 Take Care clinics now offer an expanded scope of healthcare services. These new services include diagnosis, treatment, and management for hypertension, diabetes, high cholesterol, and asthma, as well as additional preventative health services.

We’re also moving forward with expanded plans to play a central role in emerging care models such as Accountable Care organizations. With our leading role in 3 ACOs, and our strategy to service many others, patients, providers, and payers are recognizing the value of community pharmacy as part of the solution to meet the triple aim of improving the patient experience, driving better health outcomes, and lowering overall healthcare costs.

Regarding our third strategic growth driver, establishing an efficient global platform, we’re pleased with the progress we’re making with our strategic partnerships with Alliance Boots and AmerisourceBergen, which collectively are creating an unmatched global pharmacy supply chain.

First, on AmerisourceBergen, our teams are on track to ensure a smooth transition of our branded goods distribution on September 1, and the transition of generics over the next 12 months. With these relationships, we’re piloting new delivery models with our stores to optimize frequency and putting in place new inventory management processes and metrics to improve local assortments.

Second, as I mentioned, we’re meeting our expectations for Alliance Boots synergies. We’re on course to deliver $125 million to $150 million in combined first year synergies. Alliance Boots contributed $0.10 per diluted share to our adjusted results this quarter, and we expect the contribution to be $0.08 per diluted share to fourth quarter adjusted results.

Finally, we’re pleased with Alliance Boots’ performance in their fiscal 2013. As I am sure you saw, trading profit was up 7.4% in constant currency, underlying profit after tax was up 12.7%, cash generated from operations was UK1.6 billion, and they reduced their net borrowings by UK1.1 billion.

So summing up, we have worked hard over the past year to crystalize our strategies and ensure we have the growth drivers in place to support long term value creation for Walgreens and our shareholders. We’re now focused on the execution that will propel both day to day performance in the short term and the growth we expect over the next two to three years.

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

Wade Miquelon

Thank you, Greg, and good morning everyone. Thank you for joining us on the call. This morning I will take you through our quarterly results, as well as update you on our investment in Alliance Boots. As Greg noted earlier, for the quarter we reported a GAAP EPS of $0.65 per diluted share, based on 959 million shares.

This GAAP EPS bridge to the adjusted EPS of $0.85 for the quarter is illustrated by this chart, with a LIFO provision of $0.08 per share; acquisition-related items of $0.12 per share, consisting of $0.05 of acquisition-related amortization costs, $0.02 of acquisition-related cost, and $0.05 of Alliance Boots step one related tax deferral.

Special items netted to zero cents per share, with $0.05 related to the DEA settlement, offset by the $0.05 related to the warrants issued by AmerisourceBergen. As you can see, the settlement with the DEA we announced earlier this month is treated as a special item. This settlement reflects the final reserve accrual as well as some tax impacts related to the terms of the final settlement.

Looking back on the first two quarters of fiscal 2013, prior accruals related to this matter had an adverse impact of around $0.03 per share in Q2 and certain litigation matters, including an accrual related to the DEA matter, and had a positive net impact of around $0.02 per share in Q1. These items are reflected in both our reported GAAP and adjusted earnings in the first two quarters, and were not treated as special items.

Let me now provide more detail on our comparable store sales for the quarter. Comp prescription sales increased 2%. Comp front-end sales increased 0.4%. Total comp sales increased 1.4%, and comp prescriptions filled increased to 7.1%, versus a script comp of negative 9.1% in the year ago period.

With respect to our front end, in the third quarter the front end comp increased 0.4%, and traffic decreased by 3.9%, while basket size increased by 4.4%. We see stable front end margins in the challenging promotional environment. As Greg discussed prior, moving forward, we are increasing our ads and promotional focus concurrent with other initiatives intended to increase store traffic. Still, we will continue to work to strike the optimum balance between sales and profitable growth, as our underlying front end business continues to make progress.

Looking at comp store script numbers, our retail comp scripts were up 7.1%. This continues to reflect the fundamentals of our underlying business, our win back of express scripts customers, and our continued progress in winning new Medicare Part D customers.

Turning now to margin, our FIFO gross margin was 29.2% in the current quarter, compared to 28.6% last year, a 60 basis point improvement. Pharmacy margins increased as a result of the ongoing impact from generics, and the increase is partially offset by market reimbursement pressure and the continued growth of our 90-day retail program.

The front end was positively impacted by candy, non-prescription drugs, and personal care categories, which is partially offset by costs associated with points earned from the Balanced Rewards program.

Taking a look at our longer term FIFO gross margin trends, this quarter’s 60 basis point improvement was up against a 30 basis point increase a year ago. The continuing generic wave, which temporarily peaked last quarter, was the primary driver of margin lift in this quarter.

Moving forward, we expect margins to be negatively impacted by a trough in the generic wave, expected to continue until the latter half of fiscal year 2014, when we expect to experience another peak in the wave, albeit smaller than the fiscal year ’13 peak. And again, as I mentioned, the front end was slightly positive for the quarter.

Margins may also be impacted as we become more directed with our new promotion and pricing initiatives to drive traffic and front end comps. As I will illustrate in a few minutes, and as we have stated on many occasions, we are more focused in driving gross profit dollar growth than margin growth.

This chart illustrates our two-year stacked SG&A dollar growth trends on a GAAP basis for the last nine quarters. Now let’s review the trends on an adjusted basis. Two-year stack adjusted SG&A trends improved versus a year ago, with 2.3% growth in the third quarter of 2013, down from 5.1% last year. This is certainly the lowest two-year stack we have had in recent history.

To get to adjusted SG&A dollar growth, you can see that our reported SG&A dollar growth was 5.3%, which included 60 basis points for the DEA legal settlement and 20 basis points of acquisition-related costs. Backing these out resulted in adjusted SG&A dollar growth of 4.5%.

Showed here are the SG&A dollar growth trends for the past seven quarters, on a GAAP basis, and the follow-on slide shows the trends on an adjusted basis. As I mentioned earlier, the adjusted SG&A dollar growth for the quarter was 4.5% year over year increase versus the 2.2% decrease in the third quarter of fiscal 2012.

Looking at adjusted SG&A dollar growth on a two-year stack basis, as you can see, there was a 560 basis point sequential step down from the second quarter of 2013. We are pleased with the SG&A dollar growth in the quarter, especially given the very tough compare in the year ago period, when we were not an express scripts pharmacy network.

Transitioning now to gross profit, this slide illustrates our quarterly gross profit dollar growth trends for the past seven quarters on a GAAP basis. Adjusted gross profit daily growth increase from positive 4% in the second quarter of 2013 to a positive 5.3% in the third quarter of 2013. The positive trend in domestic gross profit dollar growth is the result of the underlying strength of the business, combined with the generic drug benefit.

On a two-year stack basis, gross profit dollar growth stepped down sequentially as we lapped a 2.5% decrease from the prior year’s third quarter when we were out of the express scripts network. Also recall the second quarter benefited from stronger generic [wave] and an unusually strong flu season.

Looking more broadly at our income statement, this quarter included a LIFO provision of $120 million versus $50 million a year ago, driven primarily by significantly higher prescription drug inflation in the quarter. Our effective LIFO rate for the year was 3.5%, up from 2.5% a year ago.

Net interest expense was $50 million, up from $17 million a year ago, and the increase in interest expense is primarily attributable to the $4 billion note issued in association with the Alliance Boots transaction. But it also includes the $7 million noncash expense through a fair market value adjustment to the company’s outstanding interest rate swaps.

Our effective tax rate was 38.7%, versus 37.2% last year, primarily due to the nondeductible nature of the DEA settlement. Average diluted shares outstanding were 959 million shares, versus 865 million shares last year.

The change is due to a combination of the impact of the 83.4 million shares issued due to the Alliance Boots investment and the impact of a higher stock price in the money options counted in diluted shares. This options impact increased our diluted share count sequentially by 5.6 million shares in the third quarter.

In order to give some perspective on Q4, please note the following: We expect the LIFO provision in the fourth quarter to be approximately $85 million. We expect net interest expense to be $57 million to $60 million, including the negative impact of $16 million from a noncash fair market value adjustment to the company’s outstanding interest rate swap.

Based on the swap accounting treatment we put in place in 2009, when we first swapped our $1.3 billion in notes to floating, we are now reserving the positive accounting impact that has gradually offset interest expense over the past four years. We are very pleased with our hedging strategy, as the floating swaps on our $1.3 billion notes have generated over $100 million in pretax cash savings since 2009.

Going forward, our true cash interest expense will benefit from our plan repayment of $1.3 billion in notes in August. We expect the effective tax rate to be about 38%, and note our adjusted rate is anticipated to be better due to both the DEA impact as well as the adjustments for Alliance Boots benefit not captured by our effective GAAP rate.

And finally, we expect diluted shares outstanding to remain around 950 million shares, but as mentioned, it is subject to the impact of changes in our share price. And lastly, please keep in mind that we provide monthly sales on third business day of each month, so we kindly ask that you remember to update your models for actual sales at the end of each quarter.

Cash and cash equivalents were $3 billion in the third quarter, versus $2 billion a year ago. $1.3 billion of this cash is earmarked to retire outstanding debt due in August 2013. Net working capital decreased by 2% versus a year ago. Accounts receivable increased by 5.4%, while accounts payable increased 2.2%. And LIFO inventories were down 1.8% and FIFO inventories were up 2.9% year over year versus the sales growth of 3.2%.

During the third quarter, we generated $1.4 billion in cash from operations, versus $1.9 billion a year ago. Free cash flow in the quarter was $1.1 billion versus $1.5 billion a year ago, and roughly $300 million of this year over year difference was driven by the timing shift in our annual profit share plan payment. As a company, I think you can see we remain very focused on cash flow.

Let me transition now to our accretion to adjusted EPS for the quarter as a result of our partnership with Alliance Boots. The third quarter accretion was $0.10 per share, which fell $0.02 to $0.03 short of the $0.12 to $0.13 range we forecasted last quarter.

To be clear, we are very pleased with both the operational performance of Alliance Boots and the combined synergies we are achieving. As noted, this shortfall is due to a number of non-fundamental factors, primarily the greater than expected impact of IFRS to GAAP conversions.

We now expect the accretion for the fourth quarter to be about $0.08 per share, which is less than our prior guidance of $0.09 to $0.10 per share, with the primary difference driven by the foreign currency translation impact of a slightly weakened pound relative to the dollar in our initial forecast. Consequently, we now estimate the adjusted EPS accretion for the year to be $0.16 rather than the previous estimate of $0.18 to $0.22, primarily for the reasons I just outlined.

Shifting to our quarterly Alliance Boots accretion [unintelligible], as shown, we realized $28 million before tax and synergies during the third quarter and $25 million after tax. Amortization adjustments amounted to $3 million for the deal amortization and $15 million for brand amortization. After tax, Alliance Boots equity earnings were $131 million for the third quarter on a GAAP basis.

On an adjusted basis, the income from the Alliance Boots investment was $147 million, as noted, and the incremental after tax interest expense to Walgreens was $13 million. After the impact of share dilution, the accretion equaled $0.10 in the third quarter.

I’d like to close by reviewing our fiscal [2016] goals: $130 billion of combined revenue, $8.5 billion to $9 billion of combined operating income, $9 billion to $9.5 billion of combined adjusted operating income, $8 billion of combined operating cash flow, a total synergy goal of $1 billion, and $11 billion of combined net debt, all by 2016.

When analyzing 2016 revenue, adjusted operating income, and cash flow goals, and netting the impact of our stated combined synergy goal of $1 billion, combined CAGRs from the base year of 2012 through our goal year of 2016 would need to be 5% for revenue, 9% for adjusted operating income, and 4% for cash flow in order to reach our goals.

To the extend we end up exceeding or falling short of our combined synergy goals, CAGR required to meet our 2016 goals will be impacted accordingly. With respect to synergies, we are off to a good start on our 2016 goals, and as we noted earlier, we are nearly in the range of combined synergies for the fiscal year 2013 to $125 million to $150 million, from the previous range of $100 million to $150 million.

Each of the six primary synergy work streams are producing results, and we are confident we are on the right track to now meet our fiscal year 2014 synergy objectives. Also recall that Alliance Boots retired $1.7 billion in debt in their fiscal year ended March 2013, exceeding their goal of $1 billion.

As I mentioned earlier, we are planning to retire $1.3 billion in Walgreens debt in August. As we progress, once a year, on a quarterly earnings call, we plan on going into a deeper dive on our 2016 goals, with respect to our progress, our risks, and the opportunities across each of these measures.

We remain confident with respect to our strategic long term relationship with AmerisourceBergen as well, and our core work streams are progressing and are on track. In addition to the planned domestic supply, sourcing, and international opportunities and benefits, we continue to identify areas where all three partners can work together to build on capabilities and competencies.

Now, in closing, let me share a few final thoughts. I realize that in the past few years, we’ve made several strategic and transformational moves that at times make our company more than challenging to model. Having said that, I’d like to talk a bit about how we think about our business.

At a strategic level, we have continued to refine our journey across three key planks and several related initiatives that we expect to greatly enhance our customer experience, allow us to participate profitably and more broadly in the challenging healthcare landscape, and let us fully leveraged efficiency and scale all the while.

The groundbreaking and transformational partnerships enhance these strategies, and we believe will enable us to unlock significant value and competitive advantage. Still, I believe we are just scratching the surface of what we can do working together longer term across both the supply chain as well as across geographies.

Now it all comes down to executing with excellence, as we effectively balance both the long and short term. I’m sure we’ll have some ups and downs along the way, but we remain very confident in our long term strategies and prospects.

I want to thank you again for your kind attention and support, and now I’d like to turn the call back over to Rick.

Rick Hans

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

Question-and-Answer Session


[Operator instructions.] Our first question comes from Lisa Gill with JPMorgan. Your line is open.

Lisa Gill - JPMorgan

I just had a couple of questions on the generic side. Wade, I heard you talk about the $125 million to $150 million of synergies. Can you talk about where you are in this new JV purchasing as far as contracting with the manufacturers and how much of the synergies are coming from that side?

And then secondly, I think Greg, you talked about market pressure and reimbursement, but on the other hand, you also talked about long term contracts. Where are you seeing the market pressure on reimbursement today? Is that coming from Medicaid? Is it coming from the commercial market? How should we think about that?

Wade Miquelon

I guess the JV first. The JV is up and fully running and operating. We have our two presidents, Jeff Berkowitz and John [Donovan] [ph], who are working one of the key workstreams that’s residing there, our generics. And we’re off to a very good start.

Without giving information that we consider too competitively sensitive, what I would say is that given the scope and breadth of what we’re doing together, I think we’re working with most of the key manufacturers already, in terms of understanding how we can bring volume benefit to better long term planning and create, I’d say, a real win-win.

I think that win-win comes, again, because of the size, the scale, and the breadth of the business that we can do with all the key partners that want to partner with us. But we’re off to a good start. It is a significant part of our early synergies, and as I said before, we expect it to be a significant part of the going ones as well. And Greg, I’ll let you comment on…

Greg Wasson

Yeah, on the market pressure on reimbursement. I guess I don’t think there’s any one segment. I think we’re seeing reasonable reimbursement pressure and focus from any payer, whether it’s government, commercial, on controlling costs. I think certainly as some states move from state Medicaid to managed Medicaid, you certainly see some movement there.

But when we look at those commercial arrangements, as we have in the past, we look at the individual plan, and we look at all the variables, whether it’s days of supply, generic utilization rate, and we make our decisions. But I don’t think there’s any one area that we would call out. I think we’re just seeing continues as expected focus on healthcare costs from all payers.

Lisa Gill - JPMorgan

And Greg, just to follow up on that really quickly, on Medicaid, if we think about the initial impact of the Affordable Care Act, we would expect it’s primarily going to come from Medicaid expansion. Can you talk about, if that’s primarily where it comes from, do you have excess capacity in your stores today so that even if the reimbursement rate is a little bit lower with Medicaid, that you’re going to be able to lever that incremental volume and it should be still a positive as we move into calendar ’14 for Walgreens?

Greg Wasson

Well, I don’t know if I’d really take it down to the variable labor perspective, but I think with movement from growing Medicaid, whether it’s managed or state, again, I think we look at that as we have any commercial arrangement. In some of those, it depends on the market share and the state that we’re in.

It depends on, as I said earlier, a lot of these, with more and more folks coming into a Medicaid population that are conducive to, say, 90-day supplies of chronic medications, there’s opportunities for us to work with states in ways we haven’t in the past. There’s ways to work with them to drive adherence.

So I don’t think it’s really whether we have the capacity to make it work. I think it’s really focusing on the reimbursement, the value we bring, to begin with.

Wade Miquelon

Lisa, just one last thing I’d say is bundling the two together, apart from making sure we have the most effective cost buying structure, with respect to things that are happening that we’re doing, like driving 90-day, which I think you can see is really accelerating in terms of some of the automation that’s happening with respect to our stores, and streamlining of the process as well in things like e-prescribe. We’ll continue to find ways to be more efficient and effective on all aspects of cost, which will allow us to play more broadly in the expansion of healthcare and beyond.


Our next question comes from Tom Gallucci with Lazard Capital Markets. Your line is open.

Tom Gallucci - Lazard Capital Markets

First question was just sort of on the front end. You mentioned some of the pricing and promotional strategies that you’re sort of adjusting. Can you remind us what you’re doing there in terms of the impact we should see, that you had mentioned on the call, sort of gross profit dollars versus gross profit margins?

Greg Wasson

Certainly we’re focused, as we’ve said several times, on gross profit dollars versus margin. And I think what we’re beginning to do, and we talked a little bit probably on the last call, is trying to strike the right balance between price and promotion.

I think as we talked about, we made a strategic shift when we rolled out our Balanced Rewards program to shift some of our promotional effort and focus from our roto, primary our print circular, to more digital and balanced rewards. I think that absolutely was the right strategic move for us to make.

Along the way, I think we’ve probably got a little less promotional on that Sunday circular. So what we’re doing is we’re really focused, based on some of the data that we’re getting insights from our Balanced Rewards program, to make sure we’ve got the right items at the right price in that circular to drive comp and traffic.

This is something you want to tweak that dial ever so slightly, and we feel that we’re making the right adjustments, and we’re beginning to gain some momentum. We want to continue to do that in our Sunday circular and utilize our Balanced Rewards program to continue to move that in the right direction.

Tom Gallucci - Lazard Capital Markets

My other question was on the pharmacy side, with respect to specialty. Not so much in the quarter, but obviously all we hear from payers out there is troubles with the specialty trend that are only going to get worse over time. So can you just update us on your latest initiative on the specialty side? So your growth expectations and maybe some of the unique things that you think you’re doing in the marketplace in that area?

Greg Wasson

Great question. I think we have a great position to begin to provide more value to both patients, payers, and pharmaceutical companies as we go forward. We think our differentiating model allows us to focus on what we call specialty retail to make sure the patients are indeed eligible to pick up and receive specialty medications from the retail pharmacists that they’ve been using for years. AmerisourceBergen, the relationship we have with daily deliveries, will help us drive that even greater. We have a central facility that will allow us to either mail to stores or mail directly to the patient’s home based on where they’d like it. We’re really driving sophistication there.

And finally, our infusion business, we think, is truly a differentiator for us, because as more payers look for a single solution for the pipeline of drugs that are coming out that are either going to be injectable or infused, we think that looking for a one-stop solution that we can offer will help us win in the marketplace.

Last thing I’d say is Jeff Berkowitz and our team is focused on bringing solutions to the pharmaceutical partners we have, are really working with them in ways to help them launch and drive the value that they’re looking for with their specialty products.


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

John Heinbockel - Guggenheim Securities

Two things. Greg, when we think about getting the front end traffic back, digging into that a little deeper, how confident are you? Traffic is fairly negative, you obviously don’t want to do 12 packs of Coke for $2, because that really doesn’t accomplish that much. How confident are you that you can do that in a relatively - get back closer to flat in a relatively quick period of time without hurting gross unnecessarily? Do you think it’s kind of a trial here, maybe you go a little too far, hit gross a little bit, and then have to bring it back? Or do you think you can manage it in a more consistent way than that?

Greg Wasson

It’s a great question, and as I’ve said several times, it’s the balance of retail, right? I think our approach, as I said, is going to be a prudent approach to investing where it makes sense in order to get the results. We’re looking for traffic and comp, we’re focused on gross profit dollars, as I said. And I think the adjustments we begin to make, and with our circular in mid-May, as I said, we’re beginning to make progress. I want to continue to take the approach we’re talking about.

I’m extremely confident that we will continue to make progress and gain momentum in that trend for several reasons. I think our folks are doing the right things with the circular. They’re making the right adjustments.

As I said, we have a lot of insights now a year in, on the Balanced Rewards, which helps us do a better job of understanding what should we be putting on the front page, the back page, of that circular, at what price, to be able to drive profitable sales? And then also, with 75 million members now enrolled in Balanced Rewards, the insight we have, we’re able to now strategically drive promotions through Balanced Rewards to drive traffic and sales as well.

And then the third point is - and it’s interesting, I think we have, as you know, a lot of our stores are located in underserved or lower income communities. And one of the things that we have done extremely well in the past, and what we want to enhance, is making sure that we’re tailoring our merchandising mix or price or promotion to those stores.

All those are in motion. I think we’ve got a great plan, great team, and it’s all about executing. And I’m confident we can do that.

John Heinbockel - Guggenheim Securities

And then secondly, if you look at SG&A run rate, up 4.5% adjusted, you’ve got a lot of the ESRX business back. Are we sort of steady state now? Whatever you were going to add back is added back, and that’s sort of a steady state run rate going forward? Or is there more head to head back?

Wade Miquelon

No, I think I’d say that, because you’re cycling sort of an unusual base period, it looks choppy, but in terms of how we run our business, I’d say we’re pretty steady state. And we run algorithms every day to understand the incremental line scripts, etc., that we have, and how to tweak labor up or down accordingly. Also, in terms of cycle of express scripts, you know, we have things like a little beefier profit sharing and things like that that are in the underlying base, that are just structural, and the right thing to do. But that gets washed through.

But I think we’re seeing, in our two year stack right now, I would say really just a lot of great effort and focus on SG&A control. And that’s not going to change. I think moving forward, to be effective and hit our goals, and anyone to be successful, is going to have to have [unintelligible] focused on winning the customer, but also on the cost side.


Our next question comes from Ajay Jain with Cantor Fitzgerald. Your line is open.

Ajay Jain - Cantor Fitzgerald

I wanted to ask about your front end performance as well. I think there’s been some mention in the past that there was maybe a more margin driven promotional strategy from last year, which it looks like you’ve fully cycled at this point. So just based on the loyalty card and the high level of enrollment that you have now with the Balanced Rewards card, when do you expect to start getting the customer insights through the loyalty card that would have the effect of increasing customer traffic and higher average ticket?

Greg Wasson

As I said on the earlier question, I think the good thing is we’re getting those insights now. And that’s why we’re so excited about having 75 million people already enrolled, and the reason now we begin to not only drive enrollment, but focus on the effectiveness of that program. The insights that we’re getting are frankly just incredible, and will allow us to get more efficiency out of our marketing dollars and our promotional dollars.

So we’re getting those insights and the data now, to help us continue to drive traffic in a prudent and reasonable way.

[Mark Wagner]

Just a couple of factoids. Already about 60% and growing of our purchases made in store are now with the card. We’re seeing a significantly bigger basket of those that have a card versus all others. Now the [unintelligible] as we move forward, longitudinally, to make their baskets bigger than they were prior, and that’s the work to be done.

So I think as Greg said, in the end, the magic comes from redemption, and building critical mass, critical points, and being able to use that as a lever so people really understand the currency and the value of it is the next phase that we’re just now moving into.

Ajay Jain - Cantor Fitzgerald

And just as a related question, I’m assuming that there’s some derivative impact on front end due to the legacy issues with express scripts. So do you think it’s reasonable to expect that we’re going to see some improvement in front end when you anniversary the new express scripts agreement in a couple of months?

[Mark Wagner]

Yeah, I think as we’ve also said before, every day we’re kind of moving forward and getting more and more express scripts customers back. I think that trend is going to continue. And so I think those two [unintelligible] hand in hand as well.


Our next question comes from Matt Fassler with Goldman Sachs. Your line is open.

Matthew Fassler - Goldman Sachs

Just a little more detail if we could about the components of the change in the Alliance Boots accretion. I know you spoke about the IFRS and then FX. Any way to sort of desegregate those impacts and quantify them?

Greg Wasson

I’m sorry, could you clarify the question?

Matthew Fassler - Goldman Sachs

If you think about the reduction in the guidance for Alliance Boots, if you could quantify how much is attributed to each of the drivers that you identified?

Greg Wasson

It’s roughly $0.02 in this quarter, thereabouts, which is just IFRS to GAAP conversions. And again, a lot of, until you really get into it and understand things, like how the leases actually work, their retirement programs, etc., you just don’t know until you get into it. So that’s $0.02 in the quarter, and next quarter is roughly about $0.01 of currency. Again, I think it’s about a 152 versus a 158 in the pound. But I think you’ve seen from their annual results that they’ve had, all things considered, in a tough environment, a very successful year. And trading profit and underlying profit are really two measures that they’re focused on.

Matthew Fassler - Goldman Sachs

And just one other follow up, kind of a high-level strategic question. I know we’ve spoken about the Balanced Rewards program already. If you think about the net economic impacts since launch, and when you would expect the program to start to deliver earnings benefits in aggregate, is there any way to kind of identify the timing, if you could simplify it down to that level?

[Mark Wagner]

I guess I’d put it this way, because you never really know until you get there, but we were in pretty heavy investment phase last year, not only from the systems, but also in terms of just the employee finance, between 100 and 200 people per store per day, and the effort that takes. And all the while people start building points, but until they actually have enough to redeem, you can’t really use it as a lever. It’s more of just kind of an investment from that point of view.

We’ve now got critical mass of people enrolled, critical mass of points. We also have critical mass of what I would call data analytics and insights. So I think as we move forward here, we just get progressively better.

I’d also say that the way we executed it, which was, as I like to say, we put teeth into it by making sure to get our discounts or promotions you need to have the card. In effect, it’s sort of a two-tier pricing system which allows us to generate incremental funds to invest even more heavily in the people that are truly our most valuable and most loyal customers.

And so economically, I’d say from that point of view, it’s a positive, but I think really the real heart of it kind of starts about now.

Greg Wasson

I think there’s two ways to look at Balanced Rewards. The insights and the data that we are capturing now with the 75 million people is helping us make adjustments that drive even more relevancy with our circular, with the way we merchandise our stores, etc. We’re beginning to use that data now.

The second part would be as consumers begin to understand the value of the currency and the points, then we begin to get the traffic and the basket and the trips that we want to begin to see out of it. So we’re already beginning to use a lot of the data and the insights to drive decisions across the entire business.


Our next question comes from Ross Muken with ISI Group. Your line is open.

Ross Muken - ISI Group

I wondered if you guys could extrapolate maybe more on some of the comments you talked about relative to generics. I think in general there’s a belief that we’ve got a better uptick next year in terms of flow through. The comment that you made in terms of being back in ’14, I’m assuming that’s your fiscal year versus the calendar. So maybe talk a bit about how that differential works and sort of where you’re focused in terms of what’s going to be a bigger contributor from a category perspective or maybe from a specific launch perspective.

Kermit Crawford

What I would tell you is that as we look at our fiscal year, our second quarter, our generics peaked in our fiscal year. Certainly we are going to see a trough in the third and fourth quarter as Greg said. But we anticipate a comeback in Q4. We have said in the past that ’13 would be better than ’12. We consistently are saying ’13 better than ’12, and somewhat a little bit better than ’14.

Ross Muken - ISI Group

Maybe just on the traffic piece again, I don’t mean to beat a dead horse, but if you look at the components of it in terms of the declines, if you look at it in terms of what you’ve strategic done to improve margins, and what percentage impact you think that’s had versus just kind of the impact of the express lag or anything else going on in the business, is there any way even qualitatively you can kind of compartmentalize how you would think about that metric just so we can kind of assume, as we start lapping it, what traffic could look like on the upswing?

Wade Miquelon

I’ll give you kind of a rough feel. This will be probably close, but not perfect. It’s hard to understand exactly what’s happening, but if you think about that 400 basis point traffic step down we’ve had over the past year, which is now starting to improve, I’d say that a couple of things happened.

Number one, the express scripts, approximately between 50 and 100 basis points of traffic. As you know, it’s not one for one, they’re separate trips. But that’s kind of the range that we have seen. And so as the customers come back, we see some benefit, but it’s in proportion to that.

The second thing is the promotional shift we had, which I think was for the right reasons, to keep moving money into more strategic marketing mix, like loyalty, equity building campaigns, probably was around 200-250 points. And again, from a profit point of view, I think the team did a great job of holding margin, but it wasn’t as many hot items at cost or below, but we did see that shift.

And the last piece is roughly 100 basis points of traffic from cigarettes. And I’d say the primary driver there was we saw $15,000 to $20,000 stores introduce cigarettes. We haven’t seen outside the cigarette category much hit if any at all versus any of our competitors, in the other categories, but I would say that from a traffic driver, we did see something there. So that’s kind of how I’d break it down.

Greg Wasson

And the fourth would be weather related economic, and certainly around that. But I think Wade did a great job of breaking it down.

Ross Muken - ISI Group

And maybe just one last one. You guys have obviously done a lot of interesting strategic things in this phase, for the last 12 to 24 months. Now, with the relationship with Alliance Boots and Amerisource, it seems like the synergy flows through, you guys are actually executing well there. How do you figure out where the synergies get allocated in terms of is this an Alliance Boots synergy? Is this something that Amerisource gets to keep? Is it a corporate lag synergy? How do you sort of figure out what goes into what bucket, just big picture?

Wade Miquelon

With respect to Alliance Boots, we both have our baseline projections of what we think we do otherwise independently. As we work together and drive synergies, effectively we, for the most part, split them.

And because we have a 45% ownership stake in them, it means that we get our half less their 45, which is 72.5. It’s probably not perfect plus or minus where it goes, but in the end, because we’re ultimately planning on becoming one company, it’s not worth arguing about as much as making sure we maximize them, because in the end it will all go into the same place.

I think it’s a little more complex with AmerisourceBergen, because we are a small investor, and we plan to just be a partner versus anything grander. So we really have to make sure that we have mechanisms to understand each year not only what is the synergy, but we also have mechanisms in terms of how we equitably share those based upon agreements that we have.

So we haven’t talked any more about that, but I’d say that they’re a little bit different in the two constructs. But I think that we have pretty good models for understanding what we would do on our own, if not in partner with someone else. And that, for all cases, is using the baseline.


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

Andrew Wolf - BB&T Capital Markets

First, around the sustainability of this improvement in the SG&A stack, you’ve cycled the Balanced Rewards investments [unintelligible]. Was that something that was as meaningful to helping the SG&A improvement? So that would obviously carry forward, right?

Wade Miquelon

We haven’t called out what we did in terms of investing in systems for Balanced Rewards and also for people. I would say it wasn’t not meaningful, but it wasn’t unusually meaningful either. I think the key thing is just if you think back to last September, and all that was going on, not only were we trying to sign up 100 to 200 people a day in loyalty, we were welcoming express scripts customers back. We had all of our competitors that were launching promotional campaigns to try to keep them. This was all in the context of lower overall investment in promotion activity.

So I think the thing to watch for is, as Greg said, as we sharpen our focus, make incremental investments, where it makes sense to do so, seeing how we round the horn and what that looks like.

Andrew Wolf - BB&T Capital Markets

By using the word investment, I meant hard costs going through SG&A. Let’s say programming costs that you couldn’t capitalize. I think you have, at least qualitatively, said that that was…

Wade Miquelon

There was some of that, but I think the bigger thing, as we alluded to a few quarters ago, is we had some SG&A that was attributed to loyalty sign ups, attributed to express welcome backs, and also to Med D signups. There was still a lot going on at the same time, and that really was important, but in some ways a distraction from taking care of the core customer every day.

Andrew Wolf - BB&T Capital Markets

The other part on the SG&A, was there anything unusual in some of the major line items that can kind of swing quarter to quarter? You know, sometimes you hear the healthcare costs or worker’s comp was particularly good or bad. Was there anything like that this quarter?

Wade Miquelon

You know, there’s tons of moving parts under the hood in the way they get treated, but I would say there were no anomalies in this quarter really. I think what you pretty much see is our performance exactly kind of as it was. And as I said before, it’s kind of more normalized out now the way we run our business, even in the phase period, and then two periods ago, have anomalies in them.

Andrew Wolf - BB&T Capital Markets

Okay, so moving on to gross margin, at least versus my expectations, that’s where things came up wide. And then sequentially, just looking at your FIFO gross margin, the expansion was about half of last quarter’s. And I’ll give you three buckets: Generics, was the sequential contribution less so in generics? Was it you started ramping up promotions? Or was it also just the flu was so profitable? How would you think about sequentially having less gross margin expansion?

Wade Miquelon

You know, there’s probably a little bit of generics. I think you’re right. The flu was a big boost in the prior quarter. But there’s also a lot of other things going on under the hood that you won’t see at the surface. For example, the extent that our pharmacy business outpaced our front end. Our front end has a higher gross margin on average. You get mix effects in that regard. You also have other mix effects from business like specialty that have very little margin, but have had a lot of inflation and therefore to some extent growth.

So I think the key thing is the way we really run our business. The business model is to try to maximize gross profit dollars. And in the end, even with generics ever increasing, our margins probably over time look good, but if we can’t keep the gross profit dollar engine going, that’s not going to help us. So again, I think there’s just a lot of static. I think you probably hit on some of them, but there are mix effects and other things that can make a difference quarter to quarter too.

Andrew Wolf - BB&T Capital Markets

And just on the promotional posture of how the company’s going to market, clearly the press release stated that that’s going to increase. Was part of that increase during the quarter? Or is that all post quarter? The increase in promotionality.

Wade Miquelon

[crosstalk] back half of May, we started to make some of the tweaks and modifications. Those will continue. Again, we’re going to be smart about what we do. And we’re a lot smarter now that we have a lot of loyalty data we didn’t have prior.

Greg Wasson

With the lead time in circulars, it’s mid-May by the time [unintelligible] adjustments.

Andrew Wolf - BB&T Capital Markets

And just lastly, on this Alliance Boots trend, on expectations, so it’s $0.03 of currency. How much is the [unintelligible] in the IFRS to GAAP?

Wade Miquelon

This quarter we were about $0.02 versus the bottom of our range, and that was really IFRS to GAAP adjustments. So it was really no change in how they view their performance, only a change in terms of, as we get into the methodology and the differences in IFRS and GAAP, knowing those. And the $0.01 of currency we’re predicting for the next quarter. And because there’s a three-month lag, we know a lot about next quarter already. There’s still [unintelligible], and so there can be some final adjustments in IFRS and GAAP. But for the most part, things like currency are baked in, so we know that. So that’s why we’re calling that out.

Andrew Wolf - BB&T Capital Markets

So in the current quarter, was there any operational [miss] from Alliance Boots?

Wade Miquelon

No, the current quarter they were pretty much right on path. And I think if you look at their equity income reported, it’s probably pretty close to what we’ve seen on aggregate with what most of the people here on the phone have modeled.

Andrew Wolf - BB&T Capital Markets

But it looks like, given the range for your fiscal year, why is there $0.04? If you had explained $0.03, and you had given a $0.02 to $0.06 range for the year, it sounds like you think Boots could either be a penny above plan, or $0.02 below?

Wade Miquelon

No, we’re predicting, I think, $0.08 for the next quarter, and we just said that prior we had thought it would be a little higher than that. And the primary driver of difference is foreign exchange. If you look at this quarter, a couple of things. We don’t obviously manage to consensus. We manage to our internal target.

And I would say if we look there, probably the front end was the key thing that we were working against from our original projections. But if I look kind of externally, I think a couple of things are happening. One is our tax rate is a bit different than was assumed by many, and there’s a lot of complexity in that tax rate this quarter.

Second thing is share count. Again, I think there was probably 7 or 8 million shares, or 6 million shares, associated with options. Which sounds like a small number, but it actually does move the needle on an EPS basis.

Andrew Wolf - BB&T Capital Markets

So there’s going to be a $0.02 currency hit, based on current currency rates, to your prior expect for the current quarter? Is that right?

Wade Miquelon

In the current quarter we just put out, there’s $0.02 difference, and that was primarily almost all IFRS to GAAP adjustments. For the next quarter, Q4, it would be about a penny, which is all currency. And because we have a three month lag, we effectively already know what the currency will be in three months.

Andrew Wolf - BB&T Capital Markets

So for the quarter we’re in, and I guess Boots is reporting on a lag, so you already know how that ended, how was that quarter operationally? Was there a miss? According to this report, the quarter that you’ll be reporting, the Q4 quarter that you’re reporting, I think Boots already concluded, because they’re reporting with a lag, did that meet expectations?

Wade Miquelon

We know a lot, but if we told you, we’d have to kill you. Until we get to next quarter, we can’t divulge that. I think what you did see is as you saw the last fiscal year, for Alliance Boots. So hopefully you have confidence that they’ve run their business very effectively in a very challenging time. I don’t expect that that would change any time soon.


Our final question comes from Ricky Goldwasser with Morgan Stanley. Your line is open.

Zach [unintelligible] - Morgan Stanley

Hi, this is Zach [unintelligible] for Ricky Goldwasser. I want to ask first real quick about your gross margin progression going forward. I know you’ve talked in quite a bit of detail about some of the headwinds being generics and 90 days at retail and Balanced Rewards. Can you talk about any of the tailwinds that we might be seeing, or that you can talk about at a high level, other than synergies from the Alliance Boots deal?

Greg Wasson

Yeah, I think the tailwinds that we have frankly are the price and promotion, and the adjustments we’re putting into the front end. I think we’ll continue to see more and more people coming in from Medicare Part D plans that we’ve put in place.

I think with healthcare reform, as we talked about, and millions of people coming in gaining insurance coverage, we’ll begin as a company to benefit from that. I think certainly as we continue to gain strength, certainly with the consumer, I think we’ll see lift in our discretionary categories, which is where we’d see probably the biggest impact.

So thanks for the question. We do think we have ample tailwinds. We’re really focused on what’s currently in front of us, but we think longer term, and even short term, there’s a lot of opportunity behind us.

Zach [unintelligible] - Morgan Stanley

And then within the quarter you received regulatory approval to start buying shares of ABC. Can you comment on if you’ve started on that, or what your thoughts on that are?

Greg Wasson

We are in the market. We are buying, and beyond that, I can’t say much more.

Rick Hans

Ladies and gentlemen, that was our final question. Thank you for joining us.

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