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Executives

Rick Hans - Divisional Vice President of Inventor Relations and Finance

Greg Wasson – President and CEO

Wade Miquelon - Executive Vice President and Chief Financial Officer

Analysts

Ed Kelly – Credit Suisse

Mark Wiltamuth – Morgan Stanley

Eric Bosshard – Cleveland Research Company

Ann Hynes – FTN Equity

David Magee – Suntrust Robinson Humphrey

Meredith Adler – Barclays Capital

Debra Weinswig – Citi

John Ransom – Raymond James

Andrew Wolf – BB&T Capital Markets

John Heinbockel – Goldman Sachs

Scott Mushkin – Jefferies

Walgreen Company (WAG) F1Q10 Earnings Call December 21, 2009 8:30 AM ET

Operator

(Operator Instructions) Welcome to the Walgreen Company First Quarter 2010 Earnings Conference Call. Now I’d like to turn the call over to Rick Hans, Divisional Vice President of Inventor Relations and Finance.

Rick Hans

Welcome to our First Quarter Conference Call. Today, Greg Wasson our President and CEO will discuss the quarter’s highlights, sales trends and the macro environment. Wade Miquelon, Executive Vice President and Chief Financial Officer will detail the first quarter financial results before we begin taking your calls.

When we get to your questions, please limit yourself to one question and a follow up so that we can give an opportunity to as many investors as possible during our limited time. You can find a like to our webcast under Investor Relations at Walgreens.com. After the call this presentation will be archived on our website for 12 months. We’re also making the call available as a podcast. You can download that too at our Investor Relations website.

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

Now I’ll turn the call over to Greg.

Greg Wasson

Today I’m going to review the highlights of this past quarter, update you on our sales trends, and provide the latest on the progress we’re making on our three strategic initiatives.

In the first quarter we reported record earnings and sales with solid double digit earnings growth, even in this difficult economic environment. We also continued to generate strong cash flow, a direct result of improved working capital, especially inventory, and drugstore performance. Net sales for the quarter were $16.4 billion up 9.5% over a year ago. Net earnings were up 19.6% to $489 million from $408 million a year ago. Earnings per diluted share were $0.49 a 19.5% increase from $0.41 per diluted share last year. This quarter includes the impact of $0.03 of restructuring and related costs.

Cash flow from operations in the quarter more than tripled to nearly $1.2 billion from $312 million a year ago. Meanwhile, free cash flow stood at $864 million compared with -$326 million a year ago. This strong cash flow gives us the financial strength and flexibility to continue investments in our three core strategies. In the quarter we also increased our dividend by 22% and bought back $150 million of company stock under the stock repurchase program we announced in October.

Looking at our sales in more detail, comparable store trends improved in the first quarter. An early flu season and a well executed flu shot campaign which started a month earlier then last year contributed substantially to the performance, especially in September and October. We saw some softening in November as this year’s flu season declined and we faced tougher comparisons with last year’s flu season.

The quarter saw some challenges including a slow start to the holiday shopping season over Thanksgiving weekend, which dampened November sales. It’s clear that consumer concerns about unemployment levels and the economic climate are weighing on spending. Consumers are focused on value and discretionary items are not high on their shopping lists. That led to the weak sales trends we saw in late November and that continued through mid-December.

We entered the holiday season with lower inventory levels and with a focus on basics as we anticipate a cautious consumer. While we don’t report December sales results until next month, we believe we will see good sell through on seasonal items. Like every Christmas season, our performance is driven by the final days, which makes this a big week. It could be more important this year as more consumers delayed their holiday shopping to last minute.

The calendar works in our favor this year with Christmas falling on a Friday. That means the convenience of our more than 7,100 drugstores with over half the US population living within two miles of them, will make them ideal destinations for last minute shopping needs and as always our stores will be open on Christmas day.

In addition to the final Christmas rush, we anticipate growing demand this week for H1N1 flu vaccine as additional supply is delivered. We’re working with government agencies to obtain more H1N1 vaccine and we intend to have it available at virtually all of our pharmacies as soon as possible. Mobilizing our pharmacy staff for flu shots is a great example of how we are advancing the profession of pharmacy as a valuable resource on the front line of healthcare. Our pharmacists are going beyond the dispensing of medication to providing preventative healthcare services.

Now I’d like to update you on our three key strategies which are:

Leveraging the best store network in America

Enhancing the customer experience

Achieving major cost reductions and productivity gains

We continue leveraging our existing store base and growing market share even as we slow our new store openings. Over the past seven years, as the prescription market has grown 16%, we’ve steadily grown our retail pharmacy market share from 13% in 2003 to 18.5% of all retail prescriptions today according to IMS Health Data. We see opportunities to continue that growth not only through organic store openings but also through comp store sales increases, prescription file purchases, and acquisitions that reinforce our core. An example of that is our recent transaction with Eaton Apothecary pharmacies in Boston which is expected to close in January.

As most of you know, one of our major initiatives is part of reinventing the customer experience is our customer centric retailing format, which is now in more than 400 stores in Texas. The stores have better sight lines, a new layout organized around customer solutions and an overall improved customer experience. We’re pushing the CCR rollout a few weeks to the beginning of March so that we can also include our new store decor package with the conversion work. The decor package is an important piece of the overall CCR customer experience which we want to include in this next wave on conversions. We expect to meet our goal of nearly 3,000 stores converted to CCR by the end of fall 2010.

Related to CCR our beer and wine rollout is now in nearly 1,600 stores. This category provides another reason for customers to shop in our stores. To sum up, CCR gives us a four way win. It helps us improve sales, it takes work out of stores, it reduces working capital deployed, and it provides a better customer experience with greater relevancy and efficiencies.

As we reinvent the customer experience we are also transforming community pharmacy. We intend to create a new service model which our pharmacists focus more on the patient then administrative tasks. Transforming community pharmacy will improve service, quality, and efficiencies so that we can offer patients valuable new healthcare services that generate incremental revenue.

As a first step, we implemented centralized pharmacy operations in Florida and Arizona and work to fully leverage our workload balancing system. These centralized operations made a significant impact during the fall flu season in Florida where our pharmacists provided more than 600,000 seasonal flu shots with virtually no additional payroll. Chain wide we provided more than 5 million seasonal flu shots this fall, up from 1.2 million for all of last year’s flu season.

As we expand from immunizations into other areas, we’re taking our suite of health and wellness services to the marketplace by going directly to employers, government entities, managed care companies, and pharmacy benefit managers.

Let me be clear, our center of gravity is our community drugstores and this slide shows the depth of our national footprint of pharmacy, health and wellness services which include more than 7,100 retail pharmacies and pipeline of more than 500 already approved new drugstore locations, over 350 take care clinics, more than 380 worksite health centers on the campuses of major employers, more than 110 pharmacies located in hospitals, clinics and medical centers, especially pharmacy distribution network with nine locations, 5 institutional pharmacies, and more than 100 home infusion respiratory service centers. Finally, two state of the art prescription mail service facilities.

This unique set of services allows us to tailor our offering to the needs of our clients. For example, we’ve recently expanded our relationship with Highmark Blue Cross Blue Shield for which we currently are provider, especially in home infusion services for their members. We now also offer Highmark employees access to worksite health centers and pharmacies at their Pittsburgh and Camp Hill, Pennsylvania office, creating a unique employer healthcare solution.

What makes this important is that we are bringing more services directly to not only employers but also to managed care companies and PBMs. Our bundled programs are an example of how the private sector is innovating to make healthcare more accessible and affordable.

Finally, we continue to make significant progress on our strategy to reduce costs and productivity. As you see from this chart, we achieved our goal this quarter of gross profit dollar growth exceeding our SG&A dollar growth. We remain on track to deliver $1 billion in annual savings in fiscal 2011.

Looking ahead, we plan to build on the progress we’ve made this quarter. We have the right strategy in place and remain very confident in our ability to execute it. At the same time, we are cautious in our view of the economy and will focus on consumers basic needs. In this environment we have an opportunity to drive our winning strategies while others may not have the resources to do the same. Our strong cash flow and balance sheet provides us with flexibility to invest in programs and opportunities for future growth.

Meanwhile, in Washington DC, talks continue on healthcare reform bill. It certainly remains difficult to say what a final bill may look like but in general we support the Obama administration’s guiding principles of improved access, greater affordability, and higher quality as part of any reform platform. The shift in focus to preventing and managing chronic disease by emphasizing health and wellness is something we intend to capitalize on. Our extensive network of community pharmacies and more than 70,000 health professionals position us on the front line of healthcare. Our pharmacists and nurse practitioners can have a positive impact on people’s behavior through direct face to face interaction.

Finally, I’d like to thank three Board members who announced last month that they will retire from our Board of Directors at January’s annual shareholder meeting. Cordell Reed and Marilou von Ferstel provided invaluable insight and contributed greatly to the Board over many years. Charles R. Walgreen III, grandson of our founder, is retiring after 46 years of Board service.

As we said in our annual report that many of you recently received, his legacy surrounds us. When he started with the company in 1952 we had 403 stores. By the time he retired as CEO in 1998 Cork expanded the company to nearly 3,000 stores. Along the way, he built a record of sustained success, provided huge career opportunities for thousands of people throughout the company, and established a culture of quiet determination.

In October I really enjoyed the chance to be with Cork at the grand opening of our 7,000th store. He’s provided amazing leadership and we’re really going to miss him. Cork, we wish you, Cordell and Marilou the best in retirement.

I want to thank all of our Walgreen team members for their contributions to these strong results as well. I also want to wish them and all of you a Happy Holiday Season!

Now Wade will give you an update on financial results for the quarter.

Wade Miquelon

Let me get into the details behind our financial results. In the quarter, net sales increased 9.5% while total comp sales rose 4.9%. Prescription sales rose 10% and represented 56% of sales for the quarter. Prescription sales in comp store rose a solid 6.1%. That was helped by a 1.1 percentage point from our flu shot program, a program which we led the drugstore industry.

We filled 194 million prescriptions during the quarter, an increase of 12% from a year ago. That includes the benefit of 0.7 percentage points from patients filling 90 day rather than 30 day scripts. On a comp store basis a number of prescriptions filled increased 9.2% and that includes a benefit of 1.2 percentage points from 90 day scripts.

We exceeded by 5.5 percentage points the industry wide pharmacy growth rate. Excluding Walgreen’s as reported by IMS and that is in line with a trend over the past six months. As Greg mentioned, and I’m pleased to report, earnings per diluted share were $0.49 in the quarter or $489 million including the impact of $0.03 in restructuring and related costs and $0.08 in savings associated with the company’s rewiring for growth initiative. This reflects a 19.5% increase from $0.41 per diluted share or $408 million in the same period a year ago. Excluding restructuring charges, earnings per share would have been $0.52.

Gross profit in the first quarter was $4.5 billion a 9.3% increase versus the year ago quarter. Gross margin decreased 10 basis points compared with the year ago quarter to 27.7%. Negatively impacting margins were front end product mix, non-retail business and CCR markdowns. Helping overall margins was an increase in retail pharmacy margins due to the impact of generics and flu shots, although those gains were partially offset by third party reimbursement pressure including the impact of ADP changes on Medicaid prescriptions. Also helping margins was a lower LIFO provision compared with the year ago quarter.

The two year stacked SG&A dollar growth shows improvement compared with the year ago quarter, dropping from 18.6% to 16% and up from the fourth quarter two year growth rate of 14.1%. Clearly, as we cycle these comparisons it becomes more difficult to continue that pace of SG&A reduction. Given the inherent complexity of our business we want to provide you with a better understanding of the key drivers and building blocks of SG&A growth.

Let’s review those drivers in detail. First, store openings, which we anticipate at 4.5% to 5% this year, but on a four quarter moving average basis the store count will effectively grow 6% to 7%. This tempers the immediate benefit to SG&A of our slower store openings. Our four quarter moving average remains high and as you won’t see a significant dip in that average until the fourth quarter of this fiscal year, at that point we expect to see some SG&A leverage from our slowdown in store openings.

Second driver to keep in mind is inflation, which we expect to run about 2% to 3%. Third, acquisition and business mix SG&A is anticipated to increase about 1% to 2%. Fourth, CCR reset, as Greg mentioned, we plan to have nearly 3,000 stores converted by the end of fall 2010 and these are to cost of $30,000 to $50,000 per store. Then there’s always a few other puts and calls in any quarter that takes place.

Finally, while rewiring for growth is expected to provide a net benefit of $500 million the net benefit to SG&A is expected to be about $425 million in fiscal 2010. This chart summarizes the savings and costs for rewiring for growth restructuring charges since the initiative has started in last year’s first quarter. Total rewiring expenses this quarter were $42 million. We anticipate approximately $140 million in rewire expenses in fiscal 2010. We remain on target for a net pre-tax savings of about $500 million this fiscal year and a net pre-tax savings of $1 billion in fiscal 2011 both versus our base of 2008.

Now let’s review some additional income statement details. The LIFO provision was $34 million versus $43 million in the first quarter of 2009 and that represents anticipated LIFO provision of 1.75% for the year. Its also lower then the 2% we anticipated heading into the quarter and a 2% that we recorded in fiscal 2009.

Next, for the $42 million in restructuring costs in the quarter, including $28 million in sku discontinuation, $7 million in consulting and other costs, and $7 million associated with workforce reductions. Net interest expense was $21 million compared with $15 million last year due to the issuance of $1 billion in long term debt in January 2009. Net interest expense benefited from a fixed rate to floating rate swap executed in July 2009 on the $1.3 billion note issued a year prior. The effective tax rate was 37% compared with a rate of 37.6% in the year ago period. We expect a tax rate of approximately 37% for the fiscal year.

Accounts receivable, inventory, and accounts payable are all components of working capital that we can most directly impact. The net sum of these as a percent to sales has improved by 24% in the quarter, primarily due to inventory improvement. I should mention that accounts receivable benefited from timing issues this quarter. Even without that, receivables would have been virtually flat.

Total inventories were down $800 million or 9.9% against total sales growth of 9.5% and total drugstore growth of 7.8%. Among other interventions we were helped by our sku rationalization program which is now roughly 80% complete. FIFO total inventories on a per store basis fell 13.7% in the first quarter. Controlling inventory continues to be a top priority and as you can see, we have made great strides over the past four quarters.

Controlling inventory of course helps cash. Our net cash position at the end of the quarter was $773 million which compares favorably with net cash of $236 million at the end of the fourth quarter and a net debt of over $1.5 billion at the end of last year. Cash and cash equivalents and short term investments totaled $3.2 billion and long term debt totaled $2.4 billion. We were also able to pay out $136 million in dividends during the quarter and buy back $150 million in company stock. Our financial flexibility and liquidity are in very good shape.

Greg gave you the details on cash flow performance but this slide shows the comparisons and improvements in cash that we have generated from store operations and improved working capital. We plan to continue returning cash to our shareholders through a combination of dividends and buy backs and you will recall that our September dividend was 22.2% increase over the year ago quarter. In addition, we set a long term dividend payout target of between 30% and 35% of net earnings.

As I mentioned, we also announced a $2 billion stock repurchase program at the same time. By the end of the first quarter we had repurchased $150 million in company stock under the program. You’ll recall the plan was approved in mid-October has left us with a limited number of open trading days to make purchases.

In closing, I remain very optimistic about Walgreen’s future, with many opportunities as we focus on executing our core strategies. We will continue to drive growth both organically and through smart acquisitions including prescription file purchases. I emphasize smart growth because it’s all built around prudent risk taking and ROIC focus designed to deliver long term shareholder value.

To reiterate Greg’s point, we are confident in our strategy and cautious about the economy. As we move through this uncertain economy, we continue to be agile and do what’s right and drive smart decisions for both the short and the long term. Building on Greg’s earlier comments, I also want to thank everyone at Walgreen’s for all of the accomplishments this quarter. It would not have been possible without all of our team member’s efforts. We thank them for that and we wish them and you a Happy Holiday Season!

Now I’ll turn the call back over to Rick.

Rick Hans

That concludes our prepared remarks. We are now ready to take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Ed Kelly – Credit Suisse

Ed Kelly – Credit Suisse

You have the number of about $425 million in net benefits for rewire and previously you’d been saying $500 million isn’t that correct and is there something that’s changed there to bring that number down?

Wade Miquelon

No, obviously its $500 million net benefit year to year but we wanted to is point out that if you do the reconciliation of where one time costs have gone because some of those one time costs go in items like COGS but the SG&A impact if $425 million. The total impact in terms of P&L is $500 million. We can give you the detailed breakdown of again where the benefits are coming through and where the costs, then you can do the reconciliation from SG&A to COGS and other.

Ed Kelly – Credit Suisse

In your mind there’s zero change in the way that you’re looking at this or in your expectations?

Wade Miquelon

Yes, there’s zero change. As we give the detail on the P&L line items thought I don’t think we’ve ever done a clear reconciliation of exactly how the difference hits the various lines and that’s what we want to do here.

Ed Kelly – Credit Suisse

The cost savings in general, obviously you continue to progress towards realizing more cost savings on a quarterly basis. How should this flow for the year is this something that takes place sort of fairly even or it will continue to build each quarter?

Wade Miquelon

A little bit, but I’d say it’s always going to be a little bit lumpy because different initiatives are time for time. Things like inventories clean out when they clean out and the other ones depending on when they’re announced or when they’re planned they can have different impacts. Yes, it’s going to build but I wouldn’t say it was perfectly linear. We can’t always even predict it exactly because of the timing of certain events.

Ed Kelly – Credit Suisse

As we think about the gross margin, how should we be looking at this line item for the rest of the year? You got some benefit this quarter from the flu shot. Comparisons ease quite a bit over the next couple quarters, is it unreasonable to think that your gross margin should be up for the year?

Greg Wasson

Obviously we’re going to continue to see a cautious consumer that’s going to be looking for non-discretionary products and more value. We’re also going to be countering that reimbursement pressure on pharmacy. I do think obviously where we’re going to try to counter the margin pressure obviously will be to drive more private brand. I think there’s more opportunity in pharmacy to drive more services such as seasonal flu. We’re definitely going to continue to see a cautious consumer. I think that it’s tough to predict right now.

Ed Kelly – Credit Suisse

On the share repurchase side, I know you touched on it; I was a little disappointed I thought the number would be higher. What should we expect going forward do you think?

Wade Miquelon

As I alluded to, we actually didn’t have a lot of days from the time we announced the program to where we weren’t in blackout. I think given that, actually $150 million was pretty good. I don’t know exactly, I hesitate to through a number out there but I can say we certainly, $150 million doesn’t reflect that we weren’t confident in buying our stock back, it was really just a matter of number of trading days we had available.

We are, by the way setting up a 10B-5 so that we’ll be able to be able to purchase even when we are in blackout systemically through the rules of that program.

Operator

Your next question comes from Mark Wiltamuth – Morgan Stanley

Mark Wiltamuth – Morgan Stanley

If you could just talk a little bit about the discounting environment on the front end right now, it sounds like the sales are a little softer and I’m curious if that has spurred more discounting?

Greg Wasson

I think that certainly there a lot folks out there driving promotions and I think we’ve seen softer seasonal sales then we had last year. I think as far as the promotions we’ve been and will remain pretty surgical on where we’re going with markdowns and promotions. I think the good thing is that we anticipated a softer season, bought down in seasonal goods last year. I think we’re in better shape so we won’t need to be as aggressive in markdowns post-holiday.

Last year, quite the opposite happened we had to be aggressive; we had a lot left over. I think we’re going to be extremely surgical about where we go with markdowns, additional promotions and try to balance that with swinging doors.

Mark Wiltamuth – Morgan Stanley

All the commentary on the SG&A components, are you trying to tell us that investors have gotten a little ahead of you on expectations on the SG&A reduction, a little signal that 2010 is a little to high right now?

Wade Miquelon

We’re completely confident in the savings we’re going to deliver. If some of these components, I’m not sure that everyone has the same understanding and clarity of the different building blocks of how we get there. For example, when you think about the impact of SG&A on new stores it’s not the number you do for the year it’s the 12 year impact that you cycle and that’s considerably higher. You’ve got all the building blocks now to do the math but again making sure that people have the understanding and the clarity of what goes in there I think is important so that over time people can see the direct impact of the rewire initiative and how it flows through.

Greg Wasson

We feel pretty good about the job we’ve done in the past four quarters with store SG&A and our store folks have done a tremendous job. Certainly we’re going to be copying those tougher quarters going forward.

Mark Wiltamuth – Morgan Stanley

Is there any way you can quantify how big the AWP hit was on gross margin this quarter?

Wade Miquelon

It was about $25 million so that range.

Greg Wasson

It was pretty much in line with our forecast that we had given for the year. We’re watching it monthly but so far it’s pretty much what we predicted.

Operator

Your next question comes from Eric Bosshard – Cleveland Research Company

Eric Bosshard – Cleveland Research Company

Can you talk a little bit about how the reset store strategy is evolving, you talked today about the decor and pushing it into March, can you talk about how that whole thinking is progressing?

Greg Wasson

Certainly we started off with the 35 pilot stores, we’re able to compare performance of those versus the control stores that we had set up, and we’re still feeling good about how they’re performing versus control. The next phase was to go Houston and Dallas, roll out mass markets which we completed about mid-October. The learning’s there was one, how do we roll this out in a mass market versus individual stores around the country. I think a lot of good learning’s came out of that to help us improve that process and reduce the costs of the rollout itself.

We’re still analyzing obviously numbers coming out of Dallas and Houston to look at maybe if there are opportunities to improve before we roll out in March. The real reason for delaying it the two weeks into March is we do want to add the decor package. It didn’t make sense for us to start a rollout before that new decor package was finalized. I actually saw it Saturday we got good results on it; I liked what I saw so by March 1 we’re rolling out both the conversion as well as the new decor package in parallel.

Eric Bosshard – Cleveland Research Company

The addition of the decor package changed the costs or the time to implement meaningfully?

Wade Miquelon

No, they’re always factored into the costs and it pretty much done in parallel. Again, making sure that we have it right is important to the overall proposition.

Greg Wasson

It was included in the $30,000 to $50,000 cost that we’ve been talking about.

Eric Bosshard – Cleveland Research Company

As the data has moved on with Houston and Dallas, what have you learned? I think you talked about maybe a comp improvement you needed of a point or two to make the math work. Can you talk about how that’s going?

Greg Wasson

We’re still analyzing data. The only thing that kind of threw a kink in it is we probably wouldn’t have picked Houston because comping on hurricane there so it’s been kind of difficult to get apple to apples numbers. I think the key learning’s that we’re really addressing, looking at is again we’re looking at sku by sku did we take out some skus that maybe we needed to add back. We feel good with the 3,500 items that we have reduced. I also think what we want to do is look at local unique stores.

For example, this has worked well in the majority of our stores that are pretty much according to prototype. When we began to look at maybe Hispanic stores, African American stores, maybe beach stores, and so forth, the uniqueness there is what want to now address. We’ll have more data and I think hopefully by our next quarter call we’ll be able to share more. I think we’ll have a good two month to drive through the data and analyze it and give you more color on the next call.

Eric Bosshard – Cleveland Research Company

On the beer and wine rollout can you give us any sense on is the comp benefit from that material and how’s the profitability of that influenced the overall store?

Greg Wasson

We’re in about 1,600 stores now. The comp benefit will be material. We think that not only will it drive sales but also it’s a nice basket item, it drives basket size as well. As far as the margin, we’re really working through the mix now as far as what we hope to obtain. We’ve got a private label wine that we just launched that has a little higher margin we feel good about. We’ll know more about that as well as we come through the season.

Operator

Your next question comes from Ann Hynes – FTN Equity

Ann Hynes – FTN Equity

Can you give us some more details around H1N1, what is your internal expectations, how many flu shots do you think you’ll receive, and I guess the economics? I’m assuming that you get the flu shots for free and you’re just charging an incremental charge to administer it. How should we look at that in the coming months?

Greg Wasson

It’s kind of hard to predict because we’re really working with obviously the government and the individual states. Most of the states at this time have worked through what they call the priority high risk population and how they’re opening distribution up to the pharmacies across the country. We have provider agreements in 49 states excluding North Dakota. We have product in about 3,000 stores in 36 states today. We’ve given about 350,000 H1N1 vaccinations to date.

We’re depending on how the states begin to open up and utilize pharmacists across the country. We think they will and we’re working with the states and the government to make sure that they understand how we can help.

Operator

Your next question comes from David Magee – Suntrust Robinson Humphrey

David Magee – Suntrust Robinson Humphrey

Not to be simplistic but on the SG&A side if I’m hearing you correctly we should be looking for the type of differential over the next couple of quarters. I know that year to year comparison is good, maybe a little bit tougher but on a two year basis it looks actually fairly flat. The improvement we saw this quarter is it fair we should assume that’s a good proxy for the next couple of quarters?

Wade Miquelon

You’ve got to run the model out quarter by quarter and put in the timing of how that store lag happens like I said, things like the CCR initiative is almost all SG&A contract labor resetting stores so when those stores hit and things like that. I’d say it’s a little more complicated then that but in general you’re probably not too far off.

David Magee – Suntrust Robinson Humphrey

On the pharmacy side you talked about the AWP hit. I’m assuming some of that concept better dispensing fee in certain states. Any other positive offset to that we can look forward to as the year goes on?

Greg Wasson

We are working state by state to try to get improved dispensing fees and that’s certainly something we’re focused on. I think the things like improving our generic penetration rate to help offset it. The services we’re talking about with flu shots and so forth that we’re going to rolling out will help offset some of that. We’re also looking at taking out supply chain costs as well and operating costs with our transforming community pharmacy initiative as well as our supply chain efforts to try to offset it.

David Magee – Suntrust Robinson Humphrey

Will generics be enough positive or negative this year, we have another kind of light year ahead of us here and I’m just wondering how the profitability levels will beef that product anyway?

Greg Wasson

Obviously we’re not going to see another big wave until the latter half of 2010-2011 on generics. At the same time, we work to improve our utilization or penetration of generics of the existing generics as much as we can.

Operator

Your next question comes from Meredith Adler – Barclays Capital

Meredith Adler – Barclays Capital

I’d like to just go back and talk a little bit more about Medicaid. The states all have pretty significant budget problems. Do you think that they’re looking at the AWP cut as maybe sufficient for them to cut their Medicaid reimbursement or are you expecting that there could be another round of cuts as they try to balance their budgets?

Greg Wasson

It’s hard to say, it varies state by state. I think some of them may see the reduction as sufficient. Some, depending on the state, may be looking for more. We’re going to have to certainly work with each state individually and try to bring them other solutions to help reduce costs. Believe me; we’ve got to focus on each individual state today.

Meredith Adler – Barclays Capital

The states generally don’t do much to incent patients to fill with generics. Is that changing, are they getting more understanding about the benefit of that?

Greg Wasson

We’re working with them to help them understand that for every x% in generic utilization there’s x% savings. I think us getting state Medicaid directors and helping educate them and look for alternative solutions is exactly where we’re going.

Meredith Adler – Barclays Capital

About AMP, can you give us an update about where that stands? Is that going to be put into place?

Greg Wasson

It’s awfully hard to predict what comes out of healthcare reform. Certainly with the Senate probably passing something its looks like they’re passing something before the holiday. There is AMP legislation and language in both bills. We feel good about the new definition of AMP how the benchmark is established and we’re obviously looking make sure we get enough of a multiplier on top of that AMP to make sure the pharmacists can afford to continue to serve Medicaid patients across the country.

Operator

Your next question comes from Debra Weinswig – Citi

Debra Weinswig – Citi

Obviously the flu shot program by any measure has been a huge success. What do you learn from this you can apply to potentially other initiatives internally? Have you done any analysis around the retention rate of the new customers?

Greg Wasson

The first thing tells me and tells us is that this is a great illustration that consumers across the country value the convenience and access that community pharmacists can bring in addition to prescription drugs. For us to administer better then 5% of the nation’s seasonal flu shots I think basically indicates that. As far as the learning’s I think certainly there are ways that now if we go into next season we’re going to be able to improve the process as far as some of the administration work and so forth at patients come in.

I think as far as new services, there’s plenty of opportunity to do more script like services in our community pharmacies such as flu shots. Retention rate, I think we saw that about 40% to 42% of the flu shot patients were new to Walgreen’s. We won’t know the retention probably for another 30-60-90 days certainly that’s something we’ll be analyzing to get a better understanding of that. Once we do know then next year we can certainly work to make sure that we have good programs out there to improve that retention rate.

Debra Weinswig – Citi

In terms of power, can you talk about the savings; obviously it’s just been a few markets that have been driven so far by the initiative. How should we think about a rollout plan?

Wade Miquelon

The big idea here we call it is transform community pharmacy of which power as you know is one initiative, there’s other things; dynamic work load balancing, some of the reengineering efforts we’re doing. So far so good in power. As you know, we’re strong in two states now and Florida is over 10% of our business. We’ve rolled out now in Arizona, Phoenix. So far, so good. We’re seeing, again good customer service levels now, we’re seeing more importantly a lot of time freed up for other things.

In Florida in flu shots we gave 15% or more of our total flu shots in Florida with out adding any overtime pay. Honestly that would not have been possible or even remotely possible without the power initiative to pull some of that transactional work out. We feel very good about it. Again, its taking a shorter time to fill pharmacy and wait times is one of the key elements of success so that’s helping as well. We feel good about it and we feel that both the front end and the central fill have broader applications across the country.

Greg Wasson

With transforming community pharmacy there’s really kind of three buckets there that we talk about. One is what we’re doing within Florida and Arizona with centralization of some of these tasks that Wade just mentioned. The other is we’re continuing to leverage the dynamic workload balancing technology and systems across the entire nation to leverage excess capacity at some stores to help others. Third, really we’re just going back into the existing pharmacies and looking at the complete work flow and the work process that takes place, continue to work to find ways to improve processes and take costs down.

Debra Weinswig – Citi

Can you talk about traffic and ticket in the quarter and were there any real differences by month?

Rick Hans

Could you repeat the question?

Debra Weinswig – Citi

Can you talk about traffic and ticket in the quarter and were there any real differences by month?

Greg Wasson

We’re seeing traffic hold pretty good. We’re up in traffic. We are down a little bit in ticket. Our units per customer are running a little bit down. Therefore, we feel good that we’re swinging doors, people are coming in. That goes to the promotional point that we don’t really need to over promote people to get inside. The real focus now is driving and working basket size and units per customers.

Wade Miquelon

Even though our traffic has been robust as Greg suggested over the quarter it was a bit heavier in September/October driven by the flu shot traffic. Still even as today we still feel pretty good about what we’re seeing in the numbers.

Operator

Your next question comes from John Ransom – Raymond James

John Ransom – Raymond James

You guys redid your distribution contract with Cardinal. How much did that help in the gross margin in the November quarter?

Greg Wasson

That’s been over a year ago I guess at this point in time. Certainly we worked with Cardinal, they’re our main supplier and obviously we feel like we’ve got good costs and a good rate with Cardinal but we don’t give that out.

John Ransom – Raymond James

When you talk about your gross profit savings as part of your $1 billion, is that the sku rationalization or how should we think about that?

Wade Miquelon

You mean the $1 billion CCR initiative?

John Ransom – Raymond James

You said you broke it out, its not all SG&A, part of it is gross profit, and could you talk a little more about the gross profit savings?

Wade Miquelon

The rewire for growth initiative which will have ultimately $1 billion benefit. In the short term some of the one time costs are in things like SG&A, consulting fees and reduction in force, etc. A lot of the one time costs are in cost of goods for inventory write downs due to sku elimination and the like. It’s the timing of the one times in cost of goods year on year that means that defacto all of this doesn’t flow net to SG&A. We can give a reconciliation table but you’ll see year by year benefit and year by year costs and some of those costs end up being in SG&A and some of those costs end up being COGS and some end up being in other. You have to reconcile each one of those to know where the net impact shakes out.

John Ransom – Raymond James

Once you work through this short term is there any cost savings in your gross profit line long term or is it all going to be in SG&A once you get through?

Wade Miquelon

It’s going to be in SG&A.

John Ransom – Raymond James

There was a pretty big cancer injectable drug that went off patent in August, Eloxatin. Just to clarify, through your specialty you’re not really participating in any of the oncology market. Is that a market that you’re looking at long term?

Greg Wasson

Yes, we are in the oncology space and we anticipate playing a bigger role in oncology going forward. Frankly our infusion platform that we have built over the last couple years with Option Care positions us extremely well to play in oncology going forward because a lot of those drugs are not only injected but infused drugs. We definitely think we can put together a unique service model to work with both payers and pharmaceutical companies that are in the oncology space.

John Ransom – Raymond James

Sequentially in the February quarter as the flu shots slow down just isolating the flu shot in your gross margin in the November quarter going into the February quarter how should we be thinking about pulling that out in the February quarter?

Wade Miquelon

There are a lot of different puts and calls. Obviously we had the basic flu in this quarter and then next quarter we’ll have some H1N1, how much remains to be seen. Those are effectively helps because of margin and how that flows through. We also have some other things like reimbursement pressure which might have slight different timing quarter to quarter. Again, it’s probably a little bit too early to say how all those will flow through exactly especially because H1N1 remains a little bit of an unknown for now.

Operator

Your next question comes from Andrew Wolf – BB&T Capital Markets

Andrew Wolf – BB&T Capital Markets

Did I hear you say you expect good sell through for Christmas? If I heard you right, is that more driven by the lean inventories or the day fall or do you have some history that says when there’s a big snowfall with this kind of timing its going to force people to stores as well.

Greg Wasson

This is the time of year when a retailer becomes a weatherman. I do think that based on our position going in that depending on how this last week certainly comes together I feel pretty good as far as where we’ll be on the amount of seasonal left over that we have to reduce. Last year, as I said, I think it’s an opportunity for us, last year all retailers out there certainly were in a position with some pretty large carry over quantities. I guess a combination of where I believe we are this year depending on how this last week comes through and as compared to last year I think there’s opportunity there for us.

Andrew Wolf – BB&T Capital Markets

Can you remind me, did you make a concerted effort last year to reduce the pack away? Really take some margin hits.

Greg Wasson

I don’t think you’d say out philosophy had changed much. We had always had a pretty aggressive markdown where we’d go 50% maybe throughout the season and then depending on the quantity of the item we have a pretty sophisticated system that it will help us determine what that markdown needs to be is it 50%, do we need to go to 75%. Based on last year’s inventory level we were in many cases on the more aggressive end of that markdown program. Nothing’s really changed as far as our carry over, our pack away program.

I think this year, as I said; we’re in a better position so I’m not as concerned about the aggressive markdowns that we took last year.

Andrew Wolf – BB&T Capital Markets

Could you update us more on the direct to payer initiatives that you started and I think you just briefly mentioned it? Maybe could you quantify maybe the number of folks you’re talking to or proposals on the table, what kind of expectations you might expect to see for closed deals similar to the ones you had with Caterpillar in maybe the next year or so?

Greg Wasson

I want to clarify, when we talk about going direct to employers, managed care organizations PBMs we’re talking about going direct with all of our services. I think if you go back in time five or 10 years ago when the industry was a little more fragmented it was a little more difficult for a drugstore chain to go direct to an employer, direct to a managed care organizations organization. Today with our suite of services we have everything that an employer or managed care organizations organization would like to take to their clients.

We’re talking about going direct, especially going direct with retail pharmacy programs. Our worksites are now what I would say becoming more of an employer healthcare solution to take to employers as well as managed care organizations. We’ve got a robust pipeline. If you look at the employer healthcare solution model there are a lot employers that are interested in trying to figure out how to control their healthcare costs while improving the quality of health for employees there’s a lot of interest in that product.

Andrew Wolf – BB&T Capital Markets

The Texas stores the cost to do that is that in part of the $42 million the restructuring or is that in addition to or was the captured in previous quarters?

Wade Miquelon

The cost of all the CCR refurbs is not included in the one time costs so it’s a separate initiative. This $30,000 to $50,000 per store is mostly SG&A. For the Texas area we don’t have the refurb package in yet and that will be coming, the refresh package will be coming on the next wave of all stores.

Andrew Wolf – BB&T Capital Markets

Was most of the work completed the quarter you just reported or split with the prior quarter?

Wade Miquelon

A little bit split.

Operator

Your next question comes from John Heinbockel – Goldman Sachs

John Heinbockel – Goldman Sachs

If you look at what you’re seeing from the consumer do you think they have slowed down their spending here in the last month and a half or do you think you guys as a channel are getting crowded out by mall based retailers as people go back and spend on those types of products such that post-Christmas you don’t get credit out as much?

Greg Wasson

I do think that it’s the macro consumer in general. I think they are indeed spending less on discretionary and I think that includes seasonal this year. I don’t believe we’ve being crowded out, I think what we are seeing for the past several seasons whether its Halloween, Back-To-School, or Christmas we are seeing shoppers that are becoming more and more last minute. That’s the reason we said this week obviously is important week for us because I think we’re well positioned to take advantage of those last minute shoppers.

John Heinbockel – Goldman Sachs

When you think about the consumer, if that’s the case then January is not going to be a lot different then December, when you think about the consumer getting healthier do you think your comps outside of CCR and beer and wine your comps will basically keep pace with the labor market and unemployment and that’ll be the tell tale sign for an improvement in comps?

Greg Wasson

I do think that post the Christmas holiday season there are a lot of non-discretionary purchases with seasonal goods. I think once we get through the holiday we should see less of an effect on pure seasonal merchandising and the effect it has on our comp.

John Heinbockel – Goldman Sachs

As part of the CCR retool with the decor package are you making any other changes to departments whether it be cosmetics or it’s basically just the decor?

Greg Wasson

With CCR, one is basically the refresh that we’re talking about in Houston and in Dallas and the addition of decor package, that’s pretty much as is. We are looking at certainly the modifications, maybe the changes that we learn regarding skus and so forth as I mentioned earlier. We are indeed looking at additional opportunities to improve the format whether its in beauty, whether it’s in expanded food and beginning to look at pilots and a better understanding of how we can improve the experience and become more relevant to the future shopper.

John Heinbockel – Goldman Sachs

That could be part of CCR 2011?

Greg Wasson

I don’t know if I’d call it part of CCR. I think CCR you’ll see CCR-2 which will be just continued modification improvement of the refresh that we have out there now. I think some of these others I’m talking about would be bigger format changes as we understand how we can leverage that footprint that we have now in areas like beauty, food, and so forth.

John Heinbockel – Goldman Sachs

The CCR cost, how much of that is incremental as opposed to what you normally would have spent? Secondly, you guys now have $3 billion plus of gross cash, how do you think about doing something with that, obviously you’re not earning much in the bank?

Wade Miquelon

The CCR costs, effectively almost all of it is incremental. Its really because of the nature of how we’re executing it, we’re doing it very quick, we’re using onsite crews and things to make sure we have minimal disruption in our stores. Again, we’re hoping the benefits of CCR help close to pay for this thing on the run. That’s how we’ve positioned and talked about that. Again, I think in terms of the size of the investment its actually pretty miniscule investment relative to the impact that we get from the stores and expect to get.

On cash, we’ve laid out our cash priorities. Obviously it’s not great having money in the bank earning almost no interest but we also want to be very smart and very ROIC driven. Just because we’re generating cash doesn’t mean that we’re going to feel compelled to doing something that doesn’t earn a good robust return for the company and for the shareholder.

Operator

Your last question comes from Scott Mushkin – Jefferies

Scott Mushkin – Jefferies

I wanted to go back to the CCR in Houston. Is that helping or hurting sales? I know we didn’t answer what its moving comps up by but do you guys view it as helping sales at this stage or hurting?

Greg Wasson

As I said earlier, it’s a little too early to tell. With some of the variables that we’ve got thrown at us right now as far as the season and the hurricane comping in Houston. Believe me, we’ll have better insight by the next call and be able to feel a little bit better about where we are what kind of numbers we are seeing.

Wade Miquelon

Note that all these stores always had a planned dip just from the initial, not shut down, the work going on. We’ve modeled what that planned dip is. In most cases we’re doing better then the planned dip. Still there is a structural bend as you get into this initially.

Scott Mushkin – Jefferies

I also had a question on the decor package. My impression being down in Houston was you actually did switch the decor package and so as to say another switch of decor or just a clarification there?

Greg Wasson

When we went it we gave a refresh to the existing decor package which was minimal in cost. What we’re looking at rolling out in March is a complete new decor package with different graphics and so forth.

Scott Mushkin – Jefferies

Talking about the dip, as we do 3,000 stores, any magnitude there of what kind, is it mostly front end or how do we look at the dip?

Wade Miquelon

Mostly front end. We haven’t given a number but its something two or three weeks come out of it then go positive. I don’t think its going to be that material that I would worry too much about it.

Scott Mushkin – Jefferies

One final thing on SG&A, is your thought process here, I think you said that 7% to 8% growth range that would seem to be a little bit above where the street was and could take your earnings down below the 240 level, the street I guess is down there. Is that how I should be looking at this?

Wade Miquelon

The reason we give clarity on SG&A first and foremost was just because we wanted to make sure that we maintain transparency and credibility with you and all of our stakeholders in terms of these rewire for growth benefits so that people can see that they actually are being delivered. Again, because there’s lot of moving parts in that SG&A and in some cases lack of clarity of how new stores, the rolling average how that impacts whatever there is a wide range out there in terms of how SG&A is modeled.

That I think is really the key thing that we wanted to focus on with this is to make sure people understood how they should look at SG&A, how can they have confidence over time that in fact these rewire savings are being delivered as committed.

Scott Mushkin – Jefferies

Consulting fees in the quarter, what were they?

Wade Miquelon

I think it was about $7 million

Scott Mushkin – Jefferies

That’s coming down nicely

Wade Miquelon

Clearly over time I think we feel we did the right thing by getting lots of outside help. In fact, a lot of what we’ve been doing is changing the tire while the car is moving and our people are working very hard in their day jobs. The additional capability has been helpful so that we can keep running the business. Clearly over time we’ve got a lot of great people and we’d like to be much less reliant upon that and much more dependent upon our great people.

Operator

We have no further questions at this time. I’d like to turn it back to our presenters for any additional or closing remarks.

Rick Hans

That was our final question. Thank you for joining us today. We’ll announce December sales on January 6th. Please note that reflects our new schedule of announcing monthly sales on the third business day of the month rather than the second business day. The following week we will hold our annual shareholders meeting on January 13th at Navy Pier in Chicago starting at 2pm Central Time. Afterward we will host a Q&A session for analysts who are attending; we hope to see you there.

Our next quarterly financial announcement will be Tuesday, March 23rd, that’s when we will announce fiscal 2010 second quarter results. Until then, thank you for listening and have a Happy Holiday and a great New Year.

Operator

That does conclude today’s call. Thank you for your participation.

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Source: Walgreen Company F1Q10 (Qtr End 11/30/09) Earnings Call Transcript
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