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Walgreen Company (NYSE:WAG)

F4Q 2013 Earnings Conference Call

October 1, 2013 8:30 AM ET

Executives

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

Gregory D. Wasson – President and Chief Executive Officer

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

Kermit R. Crawford – President - Pharmacy, Health and Wellness

Analysts

Edward Kelly – Credit Suisse

Meredith Adler – Barclays Capital Inc.

Robert P. Jones – Goldman Sachs & Co.

Robert Willoughby – Bank of America Merrill Lynch

Ricky Goldwasser – Morgan Stanley

Steven Valiquette – UBS

Operator

Good day, ladies and gentlemen, and welcome to the Walgreen Company’s Fourth Quarter 2013 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we’ll conduct a question-and-answer session, and instructions will follow at that time. [Operator Instructions] As a reminder, today’s call is being recorded.

I’d now like to turn the conference over to your host Rick Hans. Sir, you may begin.

Rick J. Hans

Thank you, Shannon. Good morning, everyone. Welcome to our fourth quarter 2013 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 is Kermit Crawford, President of Pharmacy.

As a reminder, today’s presentation include 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 will 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.

Gregory D. Wasson

Thank you, Rick. Good morning, everyone, and thank you for joining us on our call. Today, I’ll begin with highlights of our fourth quarter and fiscal year, next I’ll discuss the substantial progress we made in advancing our three key strategic growth drivers, and finally, I’ll take a look ahead to fiscal 2014.

Now, I’ll turn the call over to Wade for a more detailed financial review of the quarter, our full-year performance and the coming year.

Wade D. Miquelon

We’re pleased with our solid performance as we posted record adjusted earnings per share for the quarter of $0.73 generated $1.1 billion in operating cash flow and a record $785 million in free cash flow. We paid off $1.3 billion of senior notes upon maturity consistent with our debt reduction plan.

In addition to our strong financial performance, we also made significant strategic gains in the quarter. We introduced Smart90 Walgreens, our 90-day prescription drug program with Express Scripts. The program gets customers the option to receive their maintenance medications through Walgreens retail pharmacy or Express Scripts home delivery. We also announced our agreement to acquire certain assets of Kerr Drug in early September including their 76 retail drug stores in specialty pharmacy business.

Kerr and its associates will be a great addition to our family of companies. Also in September, we launched another innovation in pharmacies healthcare as we announced our long-term partnership with Theranos to provide new less invasive lab testing services to customers of Walgreen’s. The service is currently available at our Palo Alto, California store and we have plans to expand later this year.

And finally, we successfully transitioned on September 1, the distribution of our branded pharmaceuticals to AmerisourceBergen executing seamlessly to begin our 10-year strategic relationship. Fiscal 2013 was a year of major strategic progress as we advanced the transformation of our company for long-term sustainable growth and value creation.

As you know, we worked hard throughout the year to improve our performance in our daily living business and we continue to see growth and strong results in pharmacy and health and wellness. That performance across our business resulted in a record annual sales of $72.2 billion and record annual adjusted earnings per share of $3.12.

We continue to make progress in our strategic partnership with Alliance Boots achieving $154 million in combined net synergies exceeding our previous estimates of the year of $125 million to $150 million.

We generated $4.3 billion in operating cash flow and a record $3.1 billion in free cash flow. We distributed more than $1 billion in dividends this year to our shareholders increasing the dividends for the 38th consecutive year. We filled a record 821 million prescriptions for fiscal 2013, representing a retail prescription market share of 19.1% for the year.

In addition, we made substantial progress on a number of our key initiatives. We launched our Balance Rewards program last September. The program has now become the fastest growing loyalty program in the world with more than 85 million people enrolled to date.

Alliance Boots has nearly 20 years experience running the leading UK loyalty program and our partnership with them gives us the benefit of their experience, which we will leverage as we continue to enhance our program.

And finally, with our strategic partnership with Alliance Boots and our long-term relationship with AmerisourceBergen, our three companies are best positioned to create a pharmaceutical supply chain unmatched in the world.

Now I’ll take you through the high level results for the quarter. As always we will be presenting numbers on both the GAAP and non-GAAP basis. As you saw on our release this morning, we reported fourth quarter sales of $17.9 billion, up 5.1% from $17.1 billion a year ago.

GAAP operating income for the quarter was $1 billion, up 75.3% from $586 million last year. Adjusted operating income for the quarter was $1.1 billion, up 31.6% from $838 million in the fourth quarter of 2012. GAAP earnings per diluted share were $0.69 in the fourth quarter, compared to $0.39 last year, up 75.9%. Fourth quarter adjusted earnings per diluted share were $0.73, up 15.9% from $0.63 in the same quarter last year. GAAP and adjusted earnings per diluted share both include a positive $0.03 per share net impact from certain litigation matters.

Turning to our performance for the fiscal year, sales were $72.2 billion compared to $71.6 billion last year, up 0.8%. GAAP operating income was $3.9 billion, up 13.7% from $3.5 billion in fiscal 2012. Adjusted operating income for the year was $4.7 billion compared to $4.1 billion in 2012, up 14.1%. Our full-year GAAP earnings per diluted share were $2.56, up 5.7% from $2.42 last year. And on an adjusted basis, earnings per diluted share were $3.12, up 6.5% compared to $2.93 last year.

Looking at our gross profit dollar growth and SG&A dollar growth on a GAAP basis, this quarter the spread was $319 million. On an adjusted basis, the spread was $156 million. Adjusted gross profit dollar growth increased in the quarter by $216 million or 4.3%, we also continued our strong focus on cost control as adjusted SG&A dollar growth rose $60 million or 1.5% in the quarter, which included a 1.1 percentage point net benefit from certain litigation matters.

Our continued focus on our strategic growth drivers through the quarter in the fiscal year generated results across our business. We continue to create a Well Experience, introducing new products and formats and making other investments in our daily living business. The ongoing innovation in pharmacy and health and wellness continue to change the relationship we have with customers, patients and payers and uplift our market share. And we strengthened ties with our partners Alliance Boots and AmerisourceBergen, bringing us closer to becoming the first global pharmacy led health and well-being enterprise.

As we create a Well Experience, we are transforming the customer experience across all of our touch points, channels and formats. So we discussed with you at our Analyst Day. We continue to focus in four areas, improving customer value, providing innovative products and services, developing a systematic globalized offering, and designing the most relevant network and formats. Today, I’ll discuss some of the progress we’ve made this year.

We finished the fiscal year with more than 500 Well Experience stores across the nation, breaking out the traditional drugstore format with cutting-edge design, new assortments and an integrated healthcare offering. We also now have 12 flagships, the ultimate Well Experience store.

We opened six new flags in fiscal 2017, including in Washington D.C., Boston and San Francisco. In duty, we launched the Boots No7 Women’s Skincare line at the grand opening over 8,000 stores at our Los Angeles flagship. No7 products and Boots Botanic skincare line are now available online and in select flagship locations. In addition, we are rolling out both lines to the Phoenix market by the end of the year.

We also introduced the Boots No7 men’s product line in stores across the country this summer, as well as two other high profile UK beauty lines, Indeed Laboratories skincare and Mark Hill Hair Care. Our private brands are also giving customers a reason to come to Walgreens. We invested significantly this year in our product lines like Walgreens, Delish, Nice! and Well Beginnings, introducing 400 new items in the fourth quarter and increasing our private brand penetration in our front-end sales by 90 basis points year-over-year to 22.3% this quarter.

In addition to these strategic initiatives last quarter, we implemented a three point plan to balance our investment in sales and margins in our daily living business to drive profitable growth.

First, we made adjustments through our promotional investments with particular focus on our weekly ad. Second, we worked to maximize the value of our Balance Rewards program highlighting redemption, rewards and dollar value of points earned in both our stores and our circular. And third, we began enhancing our store segmentation to ensure we meet the local needs and preferences of our communities.

The result of that plan was our front-end comp increased 1.6% in the fourth quarter compared to the same period last year, showing growth in every month beginning in May. Traffic also improved through the past two quarters compared to last year. And in addition, while final numbers for the month are not available, we have seen further improvement in our comp sales and traffic data in September. Final numbers for the month will be available in our normal monthly sales release on Thursday.

Turning to our strategy to transform the role of Community Pharmacy, we are making good progress across their business in core pharmacy, the enterprise, specialty pharmacy and health and wellness. We’re advancing our work across these three businesses by providing even more comprehensive care to our customers and patients, developing a differentiated experience that our competitors can easily match and we’re becoming a strategic partner of choice.

We’ve made significant progress in our pharmacy and health and wellness businesses here and I’ll take you through a few of the highlights. With the win back of Express Scripts patients beginning last September in the successful extension of other major pharmacy relationships, we now have greater predictability on rates in our commercial book of business meeting our principle for fair value for the services we provide.

Through our preferred relationship with top Medicare Part D plans, we improved our market share with an important customer segment Older Americans, our Medicare Part D share grew by 120 basis points this fiscal year outpacing the industry. As a result we’ve also increased overall retail pharmacy market share to 19.1% for the year, we rebranded our nearly 400 Take Care clinics as healthcare clinics at Walgreens and expanded the services we offer.

We added chronic care assessment treatment management to our preventative and acute offering. We also continue to build on our successful immunization program a foundation of our effort to transform community pharmacy. We administered more than 8.5 million total vaccines in fiscal 2013 compared to $6.7 million in the prior year. We remain the only chain pharmacy providing all 17 CDC recommended vaccines in every state where we can provide them and the largest retail provider of flu vaccines in the country. And to improve the experience we offer specialty customers, we launched an alliance this year with the Cystic Fibrosis Foundation to offer industry leading pharmacy services to patients through CF Services especially pharmacy that provides medication and treatment support to the cystic fibrosis community.

We’re also improving support to specialty patients by providing more access to limited distribution drugs for cancer, rheumatoid arthritis, and other conditions treated by specialty drugs. The specialty pipeline is robust and this year we gained access to 21 new limited distribution drugs, we’re making them available across our unique collection of enterprise specialty assets, which includes central, retail, health system and community pharmacies.

And finally our well transitioned program which provides Medication Therapy Management support to patients in the hospital and through their discharge was recently endorsed by the American Hospital Associations for improving medication inherence and reducing hospital readmissions.

Script comp for pharmacy shows the momentum in our performance throughout the year. In the fourth quarter prescriptions filled in comparable stores grew by 7.1% over the same period last year. Looking at the results over two years, which Wade will show you in his section, our script comp improved from the third to the fourth quarter.

We also saw solid progress this year on the work to establish a global platform. With this growth driver, we are focused on designing a winning global organization, optimize in the global supply chain, expanding our own brand portfolio, leveraging the best practices, capabilities, and the innovation in pursuing new market opportunities.

We launched our joint venture in Bern, Switzerland this year and thanks for the work of our joint teams achieved $154 million in combined net synergies for the fiscal year. Our strategic relationship with AmerisourceBergen is also making an impact. They began the daily deliveries of our branded drugs to our stores chain wide as of September 1.

In addition, we purchased $224 million of AmerisourceBergen stock as of August 31. Finally, we announced that Alex Gourlay, the Chief Executive of the Health & Beauty Division for Alliance Boots is joining our company. He will serve as Executive Vice President, the President of Customer Experience and Daily Living beginning today. It’s great to have Alex come to Walgreens, he brings tremendous depth and experience from Boots in the health and beauty business, and we are looking forward to his leadership of our Daily Living division.

Fiscal 2013 was a year of solid progress, looking ahead the fiscal 2014 we have real momentum, yet more work to do. While we’re still operating in a challenging environment, we will continue to focus on execution in our core daily living and pharmacy, and health and wellness businesses. We’re comfortable with the adjustments we’re making in our promotional investments in daily living, driving both sales and margins to advance profitable growth. With our momentum, we’re now turning our attention to flu season and the holidays our busiest season.

In pharmacy, health and wellness, we continue to be a preferred provider for Medicare Part D and we’re working closely with our key partners to ensure our customers can take advantage of lower co-pays and more access to services this season. With both our Smart90 Wallgreens offering and our Theranos launch of lab testing, we have new products in the marketplace that will help lower cost for our customers and improve their health outcomes supporting our purpose to help people get, stay and live well.

On our global platform, we expect to accelerate the contributions from our strategic partnerships with Alliance Boots and AmerisourceBergen through fiscal 2014. Wade will update you on the financial contributions we expect in both relationships.

In closing, we are confident we have the right strategic growth drivers in place to continue to transform today’s challenges and opportunities to deliver exceptional value and build toward our future as a global pharmacy led health and well-being enterprise.

In addition, to executing on our three key strategic growth drivers, we also remain steadfast in managing ongoing reimbursement pressure and are constantly looking for ways to streamline our cost structure to prepare our company for our global future. We’re setting our priorities against our strategies to ensure we can continue to grow in an increasingly competitive marketplace.

And finally, today I want to thank our 248,000 employees for their commitment and dedication. They are the driving force behind so much of what we talked about on these calls, the experience we offer our customers and the services we deliver, and they deserve much of the credit for our results.

Thank you. And with that, I’ll turn the call over to Wade.

Wade D. Miquelon

Thank you, Greg. Good morning, everyone and thank you joining us on the call. This morning I’ll take you through our quarterly results as well as update you on our investments and partnerships with Alliance Boots and AmerisourceBergen.

As Greg noted earlier, for the quarter, we reported a GAAP EPS of $0.69 per diluted share, based on 957 million shares. GAAP EPS translates to an adjusted EPS of $0.73 for the quarter as illustrated by this chart. In most quarters, we add back the LIFO charge, but in this quarter, the LIFO benefit of $0.01 per share is negative in the GAAP adjusted walk, which I’ll explain shortly.

Acquisition related items were $0.10 per share, consisting of $0.04 of acquisition related amortization costs, $0.01 of acquisition related costs, $0.04 from Alliance Boots related tax and $0.01 of Alliance Boots related amortization.

Finally, special items were a net reduction of $0.05 per share. As noted there was a $0.01 per share in costs associated with the Company’s charge in prescription drug wholesalers, which was more than offset by the positive impact of $0.06 related to warrants issued by AmerisourceBergen.

In the quarter, GAAP and adjusted EPS both included a positive $0.03 per share, net impact from certain litigation matters. Let me now provide more detail on our comparable store sales for the quarter. Comp prescription sales increased 6.4%. Comp front-end sales increased 1.6% and total comparable store sales increased 4.6%. Comp prescription still increased 7.1% versus script comp of a negative 8% in the year ago period. Recall, the year ago quarter was negatively impacted by our exit from the Express Scripts network.

In the fourth quarter, the front-end comp increased 1.6% and traffic decreased by 1.9%, while the basket size increased by a 3.6%. As Greg discussed, our front-end is now turned positive on both the one and two-year stack basis, primarily due to the momentum of our strategies and our new promotional decisions designed to balance traffic, basket and profitability.

Looking at comparable stores script numbers, our retail scripts were up 7.1%. This continues to reflect the fundamentals of our underlying business, return of Express Scripts customers have continued progress in winning new Medicare Part D customers.

With respect to margin, our FIFO gross margin was 28.9% in the current quarter, compared to 29.1% last year, a 20 basis point decline. Pharmacy margins increased as a result of the ongoing margin benefit from generics that was partially offset by market reimbursement pressure and continued growth of our 90-day, a retail program.

The front-end margin was negatively impacted by increased promotional investment, but we are pleased with the results we are seeing in improved traffic and front-end comp in a challenging consumer environment.

Taking a look at our longer-term FIFO gross margin trends, this quarter’s 20 basis point decline was up against a 60 basis point increase a year ago. The pharmacy margin was positive in the quarter, but was more than offset by the negative change in the front-end margin.

Moving forward, front-end margin will continue to be impacted by our new promotional adjustments until we cycle these changes in the latter half of fiscal 2014.

This next chart illustrates the impact that new generic drug introductions have on our monthly prescription sales comps. You can see that the generic impact on comp prescription sales was greatest in the first quarter of the fiscal year reaching a negative 9% versus the generic impact in the most recent quarter of approximately negative 2%. The highlighted quarter showed that the number of new generic drug introductions have slowed versus a year ago.

In our experience, the margin change resulting from generics is inversely correlated and slightly lagged to the impact of generic sales changes. That is the strongest positive effect on margin typically occurs shortly after generic impact on prescription sales and it’s most inflationary and conversely the weakest positive effect on margin typically occurs shortly after the generic impact on prescription sales is the least deflationary.

Transitioning now to gross profit, this slide illustrates our quarterly gross profit dollar growth trends for the past eight quarters on a GAAP basis. And next slide shows the trends on adjusted basis. Adjusted gross profit dollar growth slowed slightly from a positive 5.3% in the third quarter of 2013 to positive a 4.3% in the fourth quarter. Likewise on a two-year stacked basis, gross profit dollar growth stepped down sequentially, as we allowed the 3.2% decrease from the prior year’s fourth quarter, when we’re out of Express Scripts network.

Some of the slowing in the one and two-year gross profit dollar growth stacks can also be attributed to the slowing generic impact I just described as well as the continued strong adoption of our various 90 day retail programs.

As Greg said, we made solid SG&A progress in the quarter. To get to adjusted SG&A dollar growth, you can see that our GAAP SG&A dollar growth was 0.9% which included 0.1% for Walgreen’s acquisition related amortization and a 0.3 percentage point related to the company’s change in prescription drug wholesalers, as well as a benefit of 1 percentage point from below our SG&A expense for the acquisition related costs.

Netting these items resulted in an adjusted SG&A dollar growth of 1.5% in the quarter. GAAP and adjusted SG&A dollar growth both include a benefit of 1.1 percentage points from the net impact of certain litigation matters.

Showing here the SG&A dollar growth trends for the past eight quarters on a GAAP basis and the follow on slide shows a similar trend on adjusted basis. As I mentioned earlier, the adjusted SG&A dollar growth for the quarter was 1.5% year-over-year increase versus the 1% in the fourth quarter of fiscal year 2012.

Looking at adjusted SG&A dollar growth on a two-year stacked basis as you can see there was 180 basis point sequential steps down from the third quarter of 2013. We are very pleased with the SG&A dollar growth in the quarter and we continue to be very focused on continuing to drive efficiencies across all aspects of our business. 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 two-year stack trends on adjusted basis. Two-year stack adjusted SG&A trends improved versus a year ago with 0.5% growth in the fourth quarter of 2013, down from 3.4% last year. During the quarter, the rate of growth and adjusted FIFO gross profit dollars exceeded adjusted SG&A dollar growth by 280 basis points. As you can see this is second consecutive quarter with a positive spread and we are very pleased this is moving in the right direction. Excluding the impact of net litigations, our spread was 170 basis points, meaningfully above our ongoing fiscal year objective of 100 basis points.

Turning to other aspects of our income statement, this quarter included a LIFO benefit of $8 billion versus the provision charge of a $132 million a year ago. Significant change in LIFO was primarily driven by unusually high branded drug inflation in the year ago quarter and lower than anticipated prescription branded drug level inventory as we initiated our transition to AmerisourceBergen. Our LIFO rate for the year was 2.67% down from 3.3% a year ago.

Net interest expense for the quarter was $55 million, up $18 million from a year ago. The increase in interest expense was primarily attributable to the $4 billion note issuance associated with the Alliance Boots transaction and also includes a $16 million negative impact from a non-cash fair market value adjustment to our interest rates swaps associated with a $1.3 billion notes that were repaid in August.

Our effective tax rate was 35.4% versus 35.8% last year. Average diluted shares outstanding were 957 million shares versus 895 million shares last year. And as a reminder, the change is primarily due to the rolling impact of the 83.4 million shares issued for the Alliance Boots investment and to a lesser extent, the impact of a higher stock price in the money options, which accounted in diluted shares. In Q1 2014, you can expect a diluted share count of approximately 960 million shares from exchanges in the current share price. You can also expect interest expense of approximately $35 million.

On a go forward basis, Walgreen’s tax rate is expected to be about 37.5%, excluding the various impacts associated with Alliance Boots partnership. Cash and cash equivalents were $2.1 billion in the fourth quarter versus $1.3 billion a year ago. Accounts receivable increased by 21.5%, primarily due to the return of Express Scripts prescriptions, while accounts payable increased 5.7%. LIFO inventories were down 2.6%, and FIFO inventories were up 0.6% year-over-year versus the sales growth of 0.8%.

Overall, net working capital decreased by 0.6% versus a year ago and we are pleased given our strong focus in this area. During the fourth quarter, we generated $1.1 billion in cash from operations versus $768 million a year ago. And free cash flow in the quarter was a record $785 million versus $320 million a year ago. As a Company, we remain very focused on cash flow.

Returning cash to shareholders remains a key initiative for Walgreens as evidenced by the 20.2% year-over-year increase in dividend per share distribution to shareholders in fiscal year 2013. As previously announced, in fiscal 2014, shareholders will receive a 14.5% increase in their dividends per share. And our goal remains the dividend payout ratio in the range of 30% to 35%.

Our capital allocation policy has four primary components, beginning with continued investment in our key strategies. In addition to returning cash to shareholders via dividends, we are also focused on delivering our 2016 goals, which includes a combined net debt level of $11 billion grounded on the basis of a very solid cash flow generation.

During the past year, Walgreens repaid $1.3 billion of debt while Alliance Boots reduce their net borrowings by $1.8 billion. We also invested $224 million to purchase AmerisourceBergen stock in the quarter at an average of $56.55 per share. As a reminder, we are not currently repurchasing Walgreen shares.

As we have stated on previous occasions, we deal with the fair amount of quarterly variability in our business including seasonality, reimbursement rate changes, generic wave trends, food trends, and changes in macroeconomic conditions among others.

Looking forward let me give you some general thought on fiscal 2014 by quarter. We expect Q1 2014 will face the headwind of a relatively slowdown in the introduction new generic drugs, but will be helped by an easier compare to a year ago because Q1 2013 adjusted EPS was negatively impacted by the dilutive impact of issued shares and interest associated with the Alliance Boots transaction without any meaningful synergy or equity income benefits due to three months reporting lag.

Q2 2014 faces the challenging comparison as Q2 2013 benefited from one of the strongest flu seasons in the last 12 years and also benefited from our peak in the pharmacy margins during that recent generic wave. In addition, keep in mind that plan changes with rate adjustments typically occur in January and last year, the high rate of reduction of new generics moderated the impact of those adjustments. This year however, we anticipate a very low rate of introduction of new generics in the second quarter.

Generic rates together [ph] helped us in the later half of fiscal 2014 and our synergies should ramp throughout the year. Lastly, our strategic relationship with AmerisourceBergen is expected to be modestly accretive from a distribution perspective in fiscal 2014 as a four generic distribution cut over benefits are expected to be realized in the more meaningful way in fiscal year 2015.

Shifting to our quarterly Alliance Boots accretion walk as shown, we realized $56 million before tax and synergies during the fourth quarter and $33 million after-tax. Amortization adjustments amounted to $8 million for deal amortization and $11 million for brand amortization. After-tax Alliance Boots equity earnings were $90 million for the fourth quarter on adjusted basis.

The non-adjusted basis, the income from our Alliance Boots investment was $109 million. And the incremental after-tax interest expense to Walgreens was $14 million. After the impact of share dilution, the accretion equaled $0.08 in the fourth quarter.

Looking forward, we estimated the adjusted EPS accretion from Alliance Boots for the first quarter of the fiscal year 2014 to be approximately $0.05 based on our current estimates of IFRS to GAAP conversions and foreign exchange rates, and moving forward, we will provide our attrition estimates on the call for each quarter in advance.

We estimate the combined synergies for fiscal year 2014 to be in the $350 million to $400 million range. We are very pleased with both the operational performance of Alliance Boots and the combined synergies we are achieving and we feel we’re just scratching the surface of things that we can do together in the coming years.

I’d like to close now by reminding you of our fiscal 2016 goals. A $130 billion of combined revenue, $8.5 billion to $9 billion of combined operating income, $9 billion to $9.5 billion of combined adjusted LIFO operating income, $8 billion of combined operating cash flow, total synergy goal of $1 billion.

As I mentioned earlier, $11 billion of combined net debt again by the end of fiscal of 2016. Later this fiscal, we will review the components of the relevant measures with respect to our progress mix and opportunities across each of these measures.

And now in closing, let me just share a few final thoughts. This quarter reflects progress against many of our key focus metrics, such as accelerated top line growth, solid cost management and record free cash flow.

We also had many other meaningful proof points with respect to our long-term strategies such as strong Alliance Boots results and above goal synergy delivery, a successful start to our AmerisourceBergen partnership and a continued evolution of our healthcare strategy, which had its core leverages, our best-in-class nationwide retail footprint in more than 70,000 healthcare professionals.

I feel strongly that we are only at the very beginning at the next leg of our Company’s journey, a journey that started over 110 years ago, a journey that can put us at the epicenter of delivering better healthcare outcomes in the U.S. and abroad with everyday living a little bit better and change the paradigm of how we work with large global suppliers in ever and increasingly changing world to create value for them, for Walgreens and most importantly for the customers that we serve. I’m sure that there will always be challenges along the way and we’re very appreciative of the stakeholders who have taken a long view.

In that vein, I believe the mega trends we face, lend themselves to our unique assets and capabilities, related our strategies are differentiated and sound, and executed well to create significant value for shareholders; In short, its hours to win.

Thank you again for your kind attention and support and now I’ll turn the call back over to Rick.

Rick J. Hans

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

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is from Edward Kelly of Credit Suisse. You may begin.

Edward Kelly – Credit Suisse

Yeah. Good morning guys.

Gregory D. Wasson

Hi, Ed.

Edward Kelly – Credit Suisse

Could we start with the gross margin? I’m little bit confused on the FIFO gross margin down 20 basis points, pharmacy up, front-end down slightly. But I guess I don’t really understand how the front-end margin maybe as not down more or pharmacy not down given the total company down 20 basis points, because front-end just not it’s only 35% of sales or so, right? And it’s only down slightly. Now if you could maybe just help us reconcile exactly what’s going on there?

Gregory D. Wasson

Yeah, I’ll start and Wade can give some actual dollars. But as far as, as we said directionally pharmacy was up obviously with the help of the generics that we had for this past quarter offset obviously by ongoing reimbursement ratio, but also with our 90 day drive that we have.

One of the focuses as we have is to continue to give customers what they’re looking for and as our chronic medications in 90 day economies are retail. So that’s an impact is working the other direction certainly in pharmacy, but we think it’s a right thing to do long-term.

As far as a front-end, as we’ve said we think we are making good intelligent investments in price and promotion. I feel like we are getting steady momentum back into the front-end of the business and we’ll continue to make sure that we do that going forward. But as we said, we always plan to make some investments to the front-end, that’s exactly what we are doing.

Edward Kelly – Credit Suisse

Are you happy with the comparable gross profit dollar growth in the front-end, how does that look and how has that changed. Did you start investing in the promotions?

Gregory D. Wasson

Yeah, I think we had solid gross profit dollar increase and then when you compared to the SG&A dollar growth and we’ve said all along there goals to have a 100 basis points spread between the two over the long haul and I think with the performance that we’ve turned in this quarter, we’re pleased with the way both of those worked in Unison.

Wade D. Miquelon

Yeah, I just to kind of restart, I really think that we really look at it from a gross profit dollar basis as you know, and I think we are really finding a good balance with some good momentum we have in growth right now with also managing the margin wisely, so.

Edward Kelly – Credit Suisse

Okay. Wade, you gave some color on 2014, which is definitely helpful. I just had a couple of follow-ups on that. Given the fact that you have some tougher comparisons next year with the flu early on, less of a generic benefit, does gross profit dollar growth slow from here over the next few quarters?

Wade D. Miquelon

Well, we don’t give obviously, specifics on that kind of detail. But I think that fundamentally we feel very good about our business going forward. I think we just want to provide some color that quarter-to-quarter, there can be some lumps, some up, some down. But in aggregate, we feel good about our growth of our gross profit dollars and the managed SG&A as well.

Edward Kelly – Credit Suisse

Okay. And on the SG&A side, you’ve done a lot of good stuff from a cost control perspective. How much of that do you think, you can carry forward into 2014, is there still opportunity there?

Wade D. Miquelon

And I think we can always be better everyday forever and that’s one of the things we’re working hard at is to really put continuous improvement and continuous focus on driving efficiencies and effectiveness in every aspect of our business, so I’d say, yes.

Edward Kelly – Credit Suisse

Okay. And Alliance Boots equity income, first quarter you didn’t have it, seasonally how did that business look in the first quarter?

Wade D. Miquelon

The first quarter is by far the toughest quarter of the year seasonally. So that’s again we guided sort of roughly $0.05 accretion for the first quarter. It’s summer period, not holiday period, so both in the wholesale and the retail business, it’s a low seasonal point.

Edward Kelly – Credit Suisse

Okay. And then just one last question for you all, sort of modeling, but there has been a lot of talk sort of like, I think amongst investors about what the real tax rate is that we should be using on the synergies, any color there?

Wade D. Miquelon

I guess what I’d say is we’ll do some work to try to figure how we can provide more clarity and guidance as we go forward. I think obviously, the rate that I gave today looking forward was kind of the Walgreen standalone rate, Alliance Boots has different rates. So we have to use a blend for that and then of course, the work we’re doing together in synergy, and other things a bit more complex. But we’ll do some work to see how we can provide better understanding as we move ahead.

Edward Kelly – Credit Suisse

Okay. Thank you.

Kermit R. Crawford

Thanks, Ed.

Operator

Thank you. Our next question is from Meredith Adler of Barclays. You may begin.

Meredith Adler – Barclays Capital Inc.

Yeah. Thanks for taking my question. I was wondering as long as we were talking a little bit about the investments you’re making in the front-end comp, are you making the investments that you expected to make and are you getting more response that you expected to get.

And can you talk a little bit about how you think that plays out in full-year 2014? You only started this I think in May, this increased promotion. So do you think that last till May of 2014 or do you think that it’s something you’ll be doing for longer until the frequent shopper program really the huge traction?

Gregory D. Wasson

Meredith, I feel good about the investments that we have made and are making. And as I said, that’s a balance between the right amount of investment and to drive the right amount of performance. But I think that we’ve done a very good job in being surgical, using the data that we’re getting from our Balance Rewards program that help us understand how to strengthen the Sunday circular, as well as begin to use individual programs, Balance Rewards to drive traffic and basket.

So I think I would say, yes that we are seeing the expectations that we had with the investment we made. Going forward, I think we will continue to try to drive the improved performance. And I think what we feel good about that we’re going to be able to have at our – to be able to use would be the increase in information we get balance reward and the data that we have from the program. Not only to make even better decisions on what we promote and what pricing, but also more and more individual marketing programs through the Balance Reward program itself.

As I said, the other thing that’s needed with ALEC, here now working with our team would be able to begin to bring some of the best practices from their program and to our Balance Rewards program. So I would, I think it’s going to be as I’ve said before like a locomotive, this isn’t a jet aircraft, we’re going to continue to just gain steam and try to continue to gain momentum and feel confident about it.

Meredith Adler – Barclays Capital Inc.

Okay. And then I have a much more technical question maybe for Wade. And maybe you’ve answered this in the slides although you went through the slides quickly. You have other income and is that the warrants with a fair market value of the warrants and there is a number in one of your schedules at the end of the press release that has $62 million as opposed to whatever $43 million, $44 million for the other income, I don’t understand what the difference is?

Gregory D. Wasson

That is the fair market value of the warrant.

Meredith Adler – Barclays Capital Inc.

And why is that a different number than what you had in that schedule?

Wade D. Miquelon

Yeah, that’s an AB share as well, that’s the difference. Recall the warrants are split. I mean effectively we Walgreens has 50% of those warrants and AB effectively has 50% of those warrants.

Meredith Adler – Barclays Capital Inc.

And could you just explain how that shows up in the numbers here. Is that because it goes into your share of AB?

Kermit R. Crawford

Yeah, we can work it off-line, but that’s effectively right. And so these have basically been for purpose of adjusted earnings, then we’ve acted out.

Meredith Adler – Barclays Capital Inc.

Okay. And then, I guess I just have one more question about the gross margin. Could you talk again, I know you, Greg you talked about, so the expectation for generics next year, but are we saying that most of the benefit of generics for next year comes really towards the tail end of fiscal 2014?

Gregory D. Wasson

That’s right.

Kermit R. Crawford

Yeah, it is Meredith, I think, and in fact, if you think – if you, the graph that we showed, it showed the volume certainly last year shows what we’re up against. But then as far as first and second quarter, they’re like worsen in the second half, we’ll see a lift again.

Wade D. Miquelon

But we’re also against an easier compared to back half, but we’re up against the tougher compared to first half.

Meredith Adler – Barclays Capital

Okay. And then I guess, one more question about SG&A. You have done a pretty good job of managing expenses. Could you just talk about whether there is any one initiative or a group of initiatives that you’d point to that had been helpful in slowing the growth of SG&A?

Gregory D. Wasson

I think our folks in the field, Mark Wagner and Kermit and team has done a tremendous job in really making sure that they are ensuring that our SG&A and our labor in the stores, and our expense match the volume as we bring it back. I think our store people have done a tremendous job of becoming more efficient. We’ll really focus Meredith, on trying to take more and more tasks out of the stores; sort of we can free our folks that are in the stores up more to spend time with customers.

So I would give probably 80%, 90% of the credit to our folks in the field. With that, for our folks in corporate, we have really this year, I think done a tremendous job in getting focus on the key projects and initiatives that will move the needle for us going forward in a big way and stop doing a lot of things that will not.

And then it combined those and I think we feel very good with the focus we have, any ongoing focus we will keep.

Meredith Adler – Barclays Capital

Great. Thank you very much.

Wade D. Miquelon

Thanks, Meredith.

Operator

Thank you. Our next question is from Robert Jones of Goldman Sachs. You may begin?

Robert P. Jones – Goldman Sachs & Co.

Thanks for the questions. I wanted to ask you about the ramp of synergies, they are going to see you’re calling for $350 million to $400 million in fiscal 2014. On the generic procurement side specifically, I was wondering if you guys could comment on whether or not the re-contracting with your generic manufacturers’ kind of where you are in that process, is that close to complete. And then as it relates to that, how should we be thinking about the ramp on the generic procurement side specifically?

Is that something you expect within the overall bucket of synergies to come in a little bit faster or is that kind of pacing along with the other synergy areas of synergies?

Gregory D. Wasson

Yeah, couple of things there is one obviously, since we exceeded our goal this year, it hit $154 million and we effectively started at zero. That means by the end of the year you have to be close to $300 million. And so we continue to ramp that, that’s why we get the objectives and the goals for next year that we have pretty good visibility on.

With respect to generics, our team who’s leading it, Jeff Berkowitz and John Donovan made a tremendous amount of progress. I think we’re not going to get too much detail on it, because I think it’s work that’s probably making this happening as we speak. But I would say that I think they are working with likely specifics to find really win-win relationships where we can bring a lot more business combined with the players and help them and they can help us. And so we are very confident that we are going to create lot of value there over time, but I’ll just leave it at that.

Robert P. Jones – Goldman Sachs & Co.

And then I guess just to clarify Wade, the 350 to 400 synergies that does not includes any additional generic procurement benefits from AmerisourceBergen’s purchasing or does it?

Wade D. Miquelon

This business is really, primarily, this is just us and Alliance Boots. And again there is six work streams that which generics we’ve always said it’s the biggest one, but all the work streams are now creating value.

Robert P. Jones – Goldman Sachs & Co.

Any sense you can give us just as far as timing, I know it’s still little bit earlier on in the process than where you are with AB. But any sense you can give us and when you might be in a position to share an additional synergy number related to AmerisourceBergen?

Wade D. Miquelon

Perhaps maybe in future calls I will talk a little bit more. Really right now that the core focus AmerisourceBergen as Greg has said, we’ve now basically moved all the branded drugs into the AmerisourceBergen distribution network and that’s going fantastic.

And now over the next 9 to 12 months, we’ll be moving on to generics and it will be comp further out, but perhaps we’ll get in that later?

Gregory D. Wasson

Bob, I will say that I happen to be in Bern last week or two weeks ago with Stephanie Hattenschweiler and Steve Collis and the team, and I’d tell you there is a lot of confidence and a lot of energy with that team. So we feel good going forward with what that team is going to be able to deliver.

Robert P. Jones – Goldman Sachs & Co.

Got it. That’s great. And if I could just sneak one more in on the front-end, obviously promotional activity seem to be a big focus. Currently, I know you talked about the more targeted promotional programs and it sounds like you obviously have had a negative impact in this quarter and you are expecting that to continue in the front half of fiscal 2014 if I heard you correctly. I was just wondering if you could give us any order of magnitude as we think about the cadence into 1Q and 2Q, is it more or less negative than what we saw on the gross profit margin in this quarter. Anything directionally there will be really helpful? Thanks.

Wade D. Miquelon

I don’t know if we give actual numbers Bob, but I will say, I think the investment the team is making in over the past several months that’s beginning to drive the momentum. I would say that, we’re pretty much right on as far as the order of magnitude that we need to continue to invest to drive that steady momentum. So I wouldn’t see any probably more aggressive investment. I think we’ll just continue to take it quarter-by-quarter and make the right investments. But I feel good with the level of investment we are make on, I think that could continue to drive the momentum we’re looking forward in front-end of the business.

How could they get other balancing the promotional strategy is just one small component what the teams are doing driving the Well Experience, improving our own brand portfolio more relevant localized tailored format. There is a lot of great work going on that’s very structural and long term in nature, our customer satisfaction keeps growing. So I think this is the bigger store story of why we feel confident as we move forward here.

Robert P. Jones – Goldman Sachs & Co.

It makes sense. Thanks so much.

Gregory D. Wasson

Thanks, Bob.

Operator

Thank you. Our next question is from Robert Willoughby of Bank of America Merrill Lynch. You may begin.

Robert Willoughby – Bank of America Merrill Lynch

Wade, what is the after – what’s the inventory run rate we could expect with ABC now controlling more of the flow here. Should it drop meaningfully?

Wade D. Miquelon

The run rate of what, I’m sorry Bob?

Robert Willoughby – Bank of America Merrill Lynch

Your inventory?

Wade D. Miquelon

Well with our inventory I mean effectively we produced substantial inventory all of our branded effectively in the cutover, but it’s part of the agreement we’ve also increased our days payable. So the working capital balances out to fair degree, it just ends up on different lines.

Robert Willoughby – Bank of America Merrill Lynch

Okay. And that kind of continue current run rate spend overall for working capital?

Wade D. Miquelon

Yes, I would say that’s a pretty good assumption.

Robert Willoughby – Bank of America Merrill Lynch

And just another question in terms of the real estate that you own for your stores that metric was always kind of 19%, 20%, where does that stand now?

Gregory D. Wasson

It’s still about that, historically that was both for how we want to balance our balance sheet as well as there are just some areas where it’s more advantageous to own than it is to do a structured lease agreement. But I think we’ll probably be about that zone moving forward.

Robert Willoughby – Bank of America Merrill Lynch

That’s great. Thank you.

Gregory D. Wasson

Thanks, Bob.

Wade D. Miquelon

Thanks, Bob.

Operator

Thank you. Our next question is from Ricky Goldwasser of Morgan Stanley. You may begin.

Ricky Goldwasser – Morgan Stanley

Yeah. Hi, good morning.

Gregory D. Wasson

Good morning.

Ricky Goldwasser – Morgan Stanley

You mentioned that you heard about $300 million of run rate at the end of fiscal year 2013. So when you think about your synergy guidance for 2014 of $350 million to $400 million, what is the exit run rate that you’re expecting to achieve?

Gregory D. Wasson

The exit run rate is that?

Ricky Goldwasser – Morgan Stanley

Yes, the exit run rate for 2014?

Gregory D. Wasson

I mean it will be obviously higher than the higher end of that limit, but we haven’t give an exact guidance because we are going to give rise to the following here, so it will be higher than $400 million.

Ricky Goldwasser – Morgan Stanley

Right, but should we think about it as $500 million to $600 million range? I guess it all depends on the magnitude of the ramp up.

Gregory D. Wasson

Yes, I mean there is moving parts right so if I gave you exact number it would probably be plus or minus wrong, but I think we feel confident that year by year by year we can keep delivering incremental synergies on these extremes and we are also increasingly finding new areas that we can focus on, now we drive cost efficiencies but just take capabilities and drive top line benefit as well.

Ricky Goldwasser – Morgan Stanley

Okay. And can you share with us, when you think about Alliance Boots for fiscal year 2014, any color on what’s the top line and EBIT growth that we should expect from AB? And understanding that there is some seasonality as we’ve seen in fiscal year 2013, but just like overall for the year?

Gregory D. Wasson

I guess we’re not going to comment on their business anymore than we feel that they are obviously performing very strong in a challenging environment. I think you saw this is the last year, delivered strong numbers I think that they feel, the wholesale business continued to do well in challenging environment as well as their retail business and being able to drive profitable meaningful growth.

Ricky Goldwasser – Morgan Stanley

Okay. And then just a follow-up on the SG&A, I mean obviously I think in response to an earlier question, you said – that you think that you continue to improve SG&A spend going forward, but growth initiative on SG&A on an adjusted basis were about 2.6%, so really significantly below can affect your long-term steady state guidance of 3.5% to 4.5%. So as we think about our model for fiscal year 2014, should we stick with the 3.5% to 4.5% or are you now at a new base line of growth?

Wade D. Miquelon

I guess it’s right to say is that I just kind, I’d revert back to that objective we have that 100 basis point or more spread over time on SG&A gross profit dollar growth. There are also an SG&A, there is lots of lumps that happen quarter-to-quarter and even fiscal-to-fiscal, I guess the key takeaway is we are very focused, as Greg said on really prioritizing the organization around the things that really matter. We’re really looking at everything to see does it create value, things like indirect spend, things that we buy that we don’t re-sell do we need it., we does it cost optimizer, is it efficient.

So again I think it’s really more of that ratio that’s important, because even that number that you alluded to, the 2.6% also include things like USA drug. So it’s not really even a true organic number, which has been better than that and these things can change that metric over time as well.

Ricky Goldwasser – Morgan Stanley

Okay. So we should obviously include Kerr as we think about your SG&A growth for next year?

Gregory D. Wasson

Yes, right for sure. Yes.

Ricky Goldwasser – Morgan Stanley

Yes, okay. And can you give us a ballpark of what that dollar number would be?

Gregory D. Wasson

In terms of year-on-year growth or…?

Ricky Goldwasser – Morgan Stanley

Yes.

Gregory D. Wasson

Again, I guess I’d just say that that objective for us is to make that spread or beat it consistently most of the time…

Ricky Goldwasser – Morgan Stanley

Okay.

Gregory D. Wasson

And Kerr has 76 stores, so that alone isn’t going really I guess change materially our base SG&A.

Ricky Goldwasser – Morgan Stanley

Okay. And lastly on the third party network, it contributes to your growth last year. Are you looking to add new partnership, new network partnership on Part D this coming year?

Gregory D. Wasson

Yes, Kermit you want to address that?

Kermit R. Crawford

Ricky in this year as we were last year in January, we started to have relationship that are preferred with our Medicare Part D providers. We are excited about the opportunity that we saw our market share grow in this, as Greg said this is very valuable Older American. So next year you’ll see us with the same partnership that we’ve looked at in the past.

It’s a part of our and if you think about our overall strategy is being a better strategic partner. There is a number of examples out there, where we’re beginning to see this not only with the Medicare Part D plan, but also with our SmartD 90 plan with Express Scripts, where we see that customer will have a choice to get their 90 day at retail at a Walgreen or through Express Scripts home delivery. So this strategic partnership is the part of our overall corporate initiative to continue to work with partners.

Ricky Goldwasser – Morgan Stanley

Okay. And then finally in October 1, open enrollment is starting today. Can you just share with us your thoughts as to how you’re seeing ACA is going to impact your business over the next 12 months?

Kermit R. Crawford

Yes. Well, go ahead Greg.

Wade D. Miquelon

Well the enrollment period starts today we certainly have our pharmacist and all of our people prepared to ask questions as members or those who are affected or impacted coming to our stores. From an ACA perspective, we certainly know there is going to be an increase in a number of people that get insurance.

We’re not speculating on what that number is but overall we would anticipate benefiting from that in a number of ways not only from our script volume, but when you think about healthcare clinics. We have over 300 healthcare clinics that will provide not only preventative, but minor acute as well as chronic care.

We’ve also been involved in partnerships around the ACOs, where people are looking to have manage the entire benefit and under this exchange benefit design it’s a benefit design of both medical and drug. So we think we are going to play a key role in that as people take advantage of the pharmacy benefit and drive their overall lower medical cost.

Gregory D. Wasson

Yes, Ricky it’s Greg. I would just say I think we’re looking at it certainly for all those reasons it is more of a long-term benefit for us. For all the reasons have been expressed it’s a tougher audience diverse audience to bring into the program and make aware of.

But so next year is going to be hard to tell but certainly from a long-term we think it will be a benefit for us for all the reasons Kermit explained.

Ricky Goldwasser – Morgan Stanley

Okay. Thank you very much.

Gregory D. Wasson

Thank you.

Operator

Thank you. Our next question is from Steven Valiquette of UBS. You may begin.

Steven Valiquette – UBS

Hi, thanks. Good morning Greg and Wade. So I guess first is in relation to all that discussion on the adjusted gross profit dollar growth, is there any preliminary view on the change in LIFO provision and what that might be for FY 2014?

Gregory D. Wasson

Yes, I mean in terms of the rate or?

Steven Valiquette – UBS

Yes. But just kind of thinking about I mean if you’re going to have fewer generic launches and brand inflation remaining strong I would think you could have a fairly good size LIFO charge overall in FY 2014. So I just want to make sure I am sort thinking about that right way? And also does the ABC shifting change the way that you are LIFO inventory might flow.

Gregory D. Wasson

The ABC thing absolutely does change obviously, because it’s a different arrangement now and they are managing the bulk of the inventory. I would say I don’t think we see the rate being materially different than it has been over the past couple of years on average, but there are a lot of moving parts with that especially when you move from such dollar branded to having generics and then as we transition generics over time that will change yet again. So I think maybe as we go forward into the next quarter we can provide some clarity, but I don’t think it’s going to be anything material versus history.

Steven Valiquette – UBS

Okay. And then also we’ve been getting a lot of questions recently on what your tax rate may go down to once you get into your FY 2016, you also have a lot of guidance for that year but tax rate not being one of them but if we do assume that steps with Alliance Boots is completed. I guess the question is could there be a material step down in the tax rate on your income statement once we get into FY 2016 versus where the tax rate is currently?

Wade D. Miquelon

Very simplistically the kind of blend our rates and their rates on the relative businesses although there are things like sub Part S and other things which can move it off of that number depending upon how is the structure, but I think that if we want to model it simply you could probably use the blended rates and be close.

Steven Valiquette – UBS

Okay. Well, I think there has been some discussion at even some of your U.S. operations if it gets off-short in some way that even your overall tax rates it could go down even lower than what that blended rate would be. So we can just discuss that more off-line if you want, but that’s something coming up a lot recently just…?

Wade D. Miquelon

We have no plans for that, I mean really it’s managing our businesses as effectively we can the way they are.

Steven Valiquette – UBS

Yes.

Wade D. Miquelon

Fairly with some changes.

Gregory D. Wasson

Yes, Steve none at all.

Steven Valiquette – UBS

Okay, all right. Great, thanks.

Wade D. Miquelon

Thank you.

Operator

Thank you. We will now like to turn the call back over to Mr. Rick Hans for closing remarks.

Rick J. Hans

Ladies and gentlemen, that was our final question. Thank you for joining us today. As a reminder, we will report September sales this Thursday and until then, thank you for listening. Bye-bye.

Operator

Ladies and gentlemen, this concludes today’s conference. Thank you for your participation and have a wonderful day.

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