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Walgreen Co. (NYSE:WAG)

F3Q10 (Qtr End 05/31/2010) Earnings Call

June 22, 2010 8:30 a.m. ET

Executives

Rick Hans - Divisional VP of IR and Finance

Greg Wasson, President and CEO

Wade Miquelon - EVP and CFO

Kermit Crawford - EVP of Pharmacy

Analysts

Ed Kelly - Credit Suisse

Mark Wiltamuth - Morgan Stanley

Derek Leckow - Barrington Research

Meredith Adler - Barclays Capital

David Magee - SunTrust Robinson Humphrey

Andrew Wolf - BB&T Capital Markets

Operator

Good day, ladies and gentlemen, and welcome to the Walgreen Company's third quarter 2010 earnings conference call. (Operator Instructions)

I would now like to turn things over to Mr. Rick Hans, Divisional Vice President of Investor Relations.

Rick Hans

Welcome to our third quarter fiscal 2010 conference call. Today, Greg Wasson, our President and CEO, will be discussing the quarter's highlights and our continued progress in executing our growth strategies. In addition, Wade Miquelon, Executive Vice President and Chief Financial Officer, would detail our third quarter financial results.

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. Also, joining us on the call or available for questions is Kermit Crawford, Executive Vice President of Pharmacy.

As a reminder, today's presentation includes certain non-GAAP financial measures, and I would direct you to our website at investor.walgreens.com for reconciliation. Also, I am available throughout the day by phone to answer any additional questions you may have.

You can find a link to our webcast under our Investor Relations website. After the call, the presentation will be archived on the website for 12 months. We're also making the call available as a podcast. You can download that too at our 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

Thank you, Rick, and thank you everyone for joining us on our call. Before I discuss third quarter earnings, I'd like to briefly acknowledge our Friday announcement where we reached a multiyear agreement with CVS Caremark. We won't be providing specific details regarding the economics of the deal, but I would say that we are very pleased with the outcome.

The agreement provides the framework we need to operate our business going forward, which is also good for patients or pharmacists and shareholders. We look forward to continuing to meet the needs of patients and payers across the country. We're also looking forward to building a mutually beneficial relationship with CVS Caremark and other PBMs.

Now let's move to the quarter. As you saw from our press release this morning, Walgreens reported record sales of $17.2 billion in the quarter, a 6.1% increase over the last year. Third quarter net earnings were $463 million compared with $522 million in the same quarter a year ago. And we generated strong cash flow from operations of $1 billion in the quarter and $2.8 billion fiscal year-to-date.

Our reported EPS of $0.47 included $0.04 in costs resulting from the Medicare Part D tax charge, $0.02 from the impact of our Duane Reade acquisition and $0.01 from our Rewiring for Growth initiative. Net sales for the nine-month period grew 6.1% to $50.6 billion, and net earnings were up 3.2%.

We anticipated that this would be a challenging quarter for several reasons. First, the weak economy continued to impact discretionary spending. Second, we faced prescription reimbursement pressure compounded by slower period in relative introduction of new generics. And third, we were cycling last year's high incidents of H1N1 flu, which impacted prescription comps by more than 1% in the quarter.

While we planned for these headwinds and saw a number of positive signs in the quarter, we also believe there is more we can do. Let me touch on some additional highlights of the quarter.

We filled a record 198 million prescriptions and increased our market share to nearly 20%. We made significant progress on our Customer-Centric Retailing initiative, opening or converting 500 stores. We closed on our acquisition of Duane Reade and began the integration to drive the expected benefits and synergies.

We continued on track with our cost control initiatives. We took steps to directly address some of the reimbursement pressure we're experiencing. And we restructured the healthcare division to bring new and unique pharmacy, health and wellness solutions to the market.

Now let's take a more detailed look at the quarter. This slide provides a good snapshot of the quarter's performance relative to recent trends. During the third quarter, gross profit dollars increased by $290 million or 6.5%. SG&A dollars increased $307 million or 8.6%. It's important to note, without Duane Reade, gross profit dollars grew 3.2% and SG&A dollars grew 6%. This rate of growth is near the low point of our SG&A dollar growth over the last six years.

And even at this low rate of SG&A dollar growth, we are investing in areas that would generate incremental sales. These include our e-commerce group, our sales and client services organization and our private brand business. At the same time, we continue our relentless focus on cost control.

Gross profit dollars were impacted by the weak sales and reimbursements I mentioned earlier. Our goal is to consistently drive gross profit dollar growth in excess of SG&A dollar growth.

Next I'll give an update on our Customer-Centric Retailing initiative. Here is a quick look at where we stood at the end of last quarter with total CCR stores. As you may recall, we expect CCR when fully implemented in Brussels reduced working capital and store labor and enhanced the overall shopping experience.

In order to achieve that, we are optimizing and enhancing our existing assortments. We're improving category and production adjacencies, improving site lines throughout the store and finally refreshing all our stores with a new in-store branding package.

Through the end of the third quarter, we've completed the opening or conversion of over 1,200 stores, 500 more than we reported to you last. We now expect to have over 2,000 CCR format stores by the end of the calendar year. While this is fewer than the 2,500 to 3,000 we had previously anticipated, the slowdown is critical to applying important lessons to future conversions.

Our latest CCR accomplishments include the following: The time needed to convert a store to CCR format is currently 20% less than the earlier conversions. We're adding key categories such as our successful beer and wine rollout which is now nearly 3,600 stores and on track to be in more than 5,000 stores by the end of the calendar year. And in the third quarter alone, this category added more than 50 basis points to front-end sales comps.

We added back several hundred products, primarily to the complement product class in categories such as automotive and hardware, and we initiated the introduction of new SKUs in existing categories such as our new branded electronic sets. All of this adds up to a refresh of our stores at a relatively low cost.

Recall, last quarter, that we showed you the performance of our pilot CCR stores. That time, front-end sales at those stores were outperforming the control stores by 1.9%.

I'm pleased to report today that for the 26-week period ending May 29, the same pilot stores are now outperforming the control stores by 2.6%. The Signature product class in which we want to win versus all retailers continues to outperform the control group by nearly 5%. Our Power product class, in which we want to be the best in the drugstore industry has experienced an increase in sales from 2.4% last period to 3.1% this period.

The Staples product class, which includes everyday needs, slipped slightly. We are sorting those reasons now and will continue to focus on improving it. And in the Complement product class, which are impulse buys or convenience items, we added back SKUs to all stores including the control group. And as you can see, the CCR stores improved versus the control group.

So the complement product class compromises 6% of front-end sales, and we are very pleased with the improved performance.

Although results are preliminary, our second wave of CCR store conversions is trending well against the rest of the chain, and in Dallas we're encouraged by the improvement in sales variance versus the rest of the chain as well. If you recall, Houston had a larger percentage of stores impacted by the reduction of SKUs in the complement product class that led to more pronounced sales impact in those select stores, which are now showing improvement with the reintroduction of key SKUs.

We're also making good progress integrating Duane Reade into our company. Duane Reade's new format is performing well, and I would encourage you to visit our recently relocated midtown Manhattan store, which is performing well above expectations. Duane

Reade contributed $272 million of sales in the quarter. We believe that this business represents an excellent strategic fit with Walgreens.

Since the acquisition, we are even more excited with their capabilities in urban retailing, loyalty private brands and beauty. We believe there is real opportunity to leverage these areas to the rest of our chain. And for example, an initial selection of Duane Reade's Delish private brand consumables will be offered across the chain in August.

As I mentioned earlier, this was a challenging quarter as we anticipated. Our strategy, which is built on the strength of our center of gravity, our 7500 community drug stores, gives me confidence we can win in any environment. We're located within five miles of nearly 75% of the U.S. population. Our plan with CCR is enhancing the customer experience and providing the low cost refresh of all stores.

We continue to transform community pharmacy to build on our nearly 20% market share and improve the patient experience. This includes expanding our scope of services by offering flu shots and other immunizations. We're bringing new and unique pharmacy and health and wellness solutions to employers and other payers from our worksite clinics to our hospital onsite pharmacies and from our specialty pharmacy to our market share leading home infusion capabilities. We offer a broad spectrum of healthcare solutions.

And we continue to have a relentless focus on cost control and productivity gains. So in spite of the environment, we hit many milestones in the quarter. We generated strong cash flow, and we continue to return that cash to shareholders through a combination of share repurchases and dividends. Walgreens has already returned over $1 billion to shareholders this fiscal year.

Looking ahead, I'm very optimistic about our company. We're focused on leveraging our 7500 convenient community drug stores, and I'm confident in our strategies and our goal to deliver double-digit earnings growth, increasing return on invested capital and top-tier shareholder return.

And finally, I want to say how proud I am of the way of the way our team members responded to a difficult environment, and their commitment to drive sales, reduce cost and improve customer service. I firmly believe their efforts will be reflected in our performance in future shareholder returns.

Now I'll turn the call over to Wade, who will update you on the financial results in the quarter. Wade.

Wade Miquelon

Thank you, Greg, and good morning, everyone. In the quarter, net sales increased 6.1%, net earnings declined 11.4% and earnings per diluted share were $0.47 or $453 million down from $0.53 per diluted share or $522 million in the same quarter a year ago.

Our reported EPS of $0.47 included $0.04 in costs resulting from the Medicare Part D tax charge, $0.02 from the impact of the Duane Reade acquisition and $0.01 from our Rewiring for Growth initiative. And that compares with $0.06 in rewire costs in the year ago period.

Prescription sales rose 5.7% and represented 65% of sales for the quarter. Prescriptions sales in comp stores rose 1%. As Greg noted, we built a record 198 million prescriptions during the quarter, an increase of 5.9% from the year ago. And that includes the benefit of one percentage point from patients filling 90 day rather than 30 day scripts.

On a comp store basis the number of prescriptions filled increased 2.5% and that includes the benefit of 1.3 percentage points from 90 day scripts.

Now, let me say a few words about our front-end comp store sales; these sales in the quarter were up 0.1% as we continue to face slower demand for discretionary goods. Also hampering the quarter were weak flu season compared with last year's unusual H1N1 flu and the recall of certain OTC products.

Despite this performance, we compare well to the industry. When viewing a true apples-to-apples time period, that compares our front-end comps with our top three competitors we are out performing for the same period they most recently reported as shown in this chart. And this is another why we feel good about CCR.

Turning to gross profit, the margin improved 10 basis points in the quarter; the primary driver was an increase in front-end margin, which more than offset the negative impact of lower margins in the pharmacy.

On a dollar basis, I'll start by pointing out that the front-end provided the majority of gross profit dollar growth in the quarter. As you may know, the rate of generic introductions and other factors is going to affect gross margins in ways we believe distort our underlying performance. And as a result, we focus on gross profit dollar growth as an important performance metric. And that grew by $290 million in the quarter.

Now, let's look at some of the drivers of that gross profit dollar growth. The pharmacy gross profit dollar growth was negatively impacted by two primary factors. First, we are in a period of slower rate of generic drug introductions. We expect less impact from this in fiscal 2011 and a significant benefit in fiscal 2012 due to large number of new generic introductions scheduled for that year.

And second, we continue to be impacted by reimbursement pressure, which we have experienced for years. Looking at the bigger picture, our core pharmacy business is strong and expected to get stronger as indicated by our record scripts filled, market share increases, our expanded pharmacy health and wellness solutions. And that includes flu shots and other innovative programs such as optimal wellness in 90 day refills.

Moving to SG&A transit, two year stacked SG&A dollar growth shows some improvement compared with the year ago quarter, dropping from 17.6% to 16.5%. And when you adjust the two year stacked SG&A dollar growth to the acquisition Duane Reade, you will see a drop fro 17.6% last year to 13.4% this year. And this illustrates our continued focus on SG&A control.

Let me walk you through this SG&A adjustment. We reported SG&A growth of 8.6% in the quarter; first, we adjusted for the net impact of rewiring for growth, which had higher cost last year. And next, we accounted for the acquisition and operating expense associated with Duane Reade, which gives us the SG&A growth for the quarter, of 6%.

Some of our improvement can be traced to the benefits from Rewiring for Growth, and this chart summarizes the saving in cost for restructuring since inception. The net saving in the quarter, was $0.04 per share versus the year ago period. And please note we added two new lines to this chart to illustrate the cumulative savings by quarter and a total run-rate savings over the 2008 base year.

You can see that restructuring benefits are on track with cumulative savings by quarter at $0.11 per share and the run-rate over the 2008 base year at $0.37 per share. Total rewire expenses this quarter were $17 million and for the first nine months they totaled $87 million. We expect approximately $140 million in rewire expenses in fiscal 2010, although some of these costs may not be fully realized till early fiscal 2011.

We remain on target for net pre-tax savings of $500 million this fiscal year and net pre-tax savings of $1 billion in fiscal 2011 both versus our base year of 2008.

Now, let's review some additional income statement details. The LIFO provision was $18 million versus $32 million in the third quarter of 2009. That represents anticipated LIFO provision of 1.25% for the year; next of the $17 million in restructuring costs in the quarter. The effective tax rate was 42.5% compared with a tax rate of 36.4% in the year ago period. The higher rate was impacted by a non-cash charge due to the elimination of Medicare Part D subsidy. We expect the tax rate of approximately 37% in the fourth quarter.

Accounts receivable, inventory and accounts payable are the components of working capital that we can most directly impact. And the net sum of these as a percent to sales fell 4.1% in the quarter compared with the year ago. Total FIFO inventories rose 4.3% against total sales growth of 6.1% and total store growth of 9.7% including Duane Reade.

FIFO total inventories on a per store basis fell 4.9% in the third quarter. Controlling inventory continues to be a top priority. And as you can see, we have consistently made great strides over the past six quarters.

Cash flow from operations for the first nine months of the fiscal year was $2.8 billion. Free cash flow increased to $2 billion in the first nine months versus $1.7 billion in the same period last year. Cash and cash equivalents and short-term investments totaled $2.3 billion, and our long-term debt totaled $2.4 billion.

To update you on capital expenditures, last quarter we estimated $1.4 billion for the year. We now anticipate CapEx for the fiscal 2010 to be around $1.2 billion, as we make sure we're focusing on investing in the right projects at the right time.

Our strong cash flow and balance sheet allowed us to pay out $136 million in dividends during the quarter and buy back $254 million in company stock. In the first nine months of the fiscal year, we returned more than $1 billion in dividends and share repurchases.

We plan to continue returning cash to our shareholders through a combination of dividends and buybacks, which nearly tripled in the first nine months compared to the year-ago period. Our current dividend payout ratio was 25%, and you'll recall that we previously set a long-term dividend payout ratio of between 30% and 35% of net earnings. The next dividend announcement will be on July 14.

Like Greg, I am confident in our strategies. We are focused on driving smart growth, enhancing the customer experience and meeting our goals for cost reduction and productivity gains to create value for shareholders.

And now, I'll turn the call back over to Rick.

Rick Hans

Ladies and gentlemen, that concludes our prepared remarks. We are now ready to take your questions.

Operation-and-Answer Session

(Operator Instructions) And we will go first to Ann Hynes with Caris & Company.

Ann Hynes - Caris & Company

My questions have to do with CCR. When I look at your estimates on First Call, they're all over the place. And I think part of that is because people are modeling the CCR initiative differently. So end of 2010, 2,000 stores should be done, and you have 3,500 to 4,000 left. How should we break that out annually for fiscal 2011 and fiscal 2012? Would most of those be done in 2011?

And I guess the cost associated with it also, I think you had been saying that the cost per store would be $30,000 to $50,000. And in your last 10-Q, I believe it said it was up to 40,000 to 55,000 per store now. So can you just clarify how we should model that going forward, so maybe some of the estimates become more in line with each other? And also, does that include Duane Reade stores? And I guess that's it for now.

Greg Wasson

I'll start with the last and then back up. It does not include the Duane Reade stores as far as the total CCR. We are doing certainly remodelings within the Manhattan area to help them complete their journey of remodeling those stores.

As far as CCR, you're right. If we look, there is about, as we said, 5,500 total stores in the chain that would be conducive to the CCR fit. We will have 2,000 by the end of the calendar year. We expect to have the remainder of those done by the end of 2011 calendar year. So you can factor that in.

Ann Hynes - Caris & Company

Well, I guess the cost per store in your last 10-Q, it said 40,000 to 55,000. But I think in your previous presentations, you were saying 30,000 to 50,000. So I guess how should we model cost per store for fiscal 2011?

Greg Wasson

Yes, I'd use the latest, the 40,000 55,000. We're encouraged, Ann, and we may be able to pull that down. And if we are, we will give an update on that. But as I said, we're seeing from when we started about a 20% reduction in the cost to convert these stores. We're down to about four days. So I think we are optimistic we maybe able get it lower, but I think that's probably a good number to use.

Operator

We'll take our next question from Ed Kelly with Credit Suisse.

Ed Kelly - Credit Suisse

Greg, you mentioned that you slowed down the conversion to CCR to apply some credible lessons. Could you elaborate on what you have learned so far, and then the impact that those learnings are having on the newer conversions? And then also, could you maybe give us a bit more color on the performance of the conversions beyond the pilot stores?

Greg Wasson

I think the key learnings, and we kind of called that on our Q2 call, was the complement categories. And again, even though they're are only 6% of total sales, there are many stores that have a high percentage of sales coming from the complement categories.

And I think we took out some items that we probably didn't need or should have taken out. We've added about 200 items back into those stores and in particular those compliment categories, things like automotive hardware. In many stores, we may be more like the general store in a particular community. So I think we feel good with what we're putting back in. And I think you could see the improvement on the complement categories.

The other thing that we're exited about is the recent rollout of the actual refresh package, the décor and branding package that we're putting out there. I think as you recall, when we rolled out in Houston and Dallas, we didn't have it ready. We are rolling it now with the new conversions, and we are going back into Houston and Dallas I believe it's next week to put the new branding package in those two markets. So we're excited there.

And as I think you might have one more question as well, did I cover your points?

Ed Kelly - Credit Suisse

Well, the other question I actually have for you in relation to the reimbursement pressure that you've been talking about, is there a way to quantify the impact that that's had on the gross margin this quarter? And then, Greg, you mentioned that you are beginning to address some of the issues causing you reimbursement rate pressure. Is there more a work to do on that, meaning are there other PBMs that you need to go talk to as well?

Greg Wasson

Well, I'll take the first one and let Wade jump in on how to quantify. I think with the temporary slowdown in the generic pipeline that we've led to over the past year, I think that's probably heightened some of the reimbursement focus that payers have. And I think the good thing is that's a temporary period, and I think when we get into 2012, with the added generics, there'd be a little relief there.

But in this interim, I do think that we're focused on making sure that we get a fair value from payers for the services we provide. And I think we have 7,500 stores in all 50 states. We have 24-hour stores and communities across the country that many don't. So we're just focused on working with payers to make sure we get a fair value. And I think we're recognizing that people value Walgreens and their network.

Wade Miquelon

I'll just add some color. If you look at year-on-year generics, that's $0.02 to $0.03 down versus a year ago. As we talked about the impact of the lower flu incidents of about 100 basis points in totality is another $0.02 to $0.03.

And then building on Greg, we did see some reimbursement pressure. I would not say that it was unplanned reimbursement pressure. I think that's been for some time that while it's always cut by the layer that this is kind of an 18-month period that we see to be maybe a little bit more challenging that unusual. But again, I don't think there is anything we have unanticipated.

But I think moving forward, all three of these things have a potential to get stabilize and get stronger over time.

Ed Kelly - Credit Suisse

Does this contract with CVS Caremark change your view on growth at all going forward whether it be new store openings or acquisitions? Does it mean that you want to throw olds faster?

Greg Wasson

I'm not going to comment much on the CVS Caremark situation itself. But our plans haven't changed regarding our organic growth rate that we sit out there of 2.5% to 3% by the end of fiscal 2011. We still have a strong balance sheet. We're going to be looking for acquisitions that make sense strategically. And so our plans still remain as they have been over the past several months and a year.

Operator

We'll take our next question from Mark Wiltamuth with Morgan Stanley.

Mark Wiltamuth - Morgan Stanley

I wanted to get a feel for how much of a headwind we're going to be facing here from the swine flu in the fourth quarter, because swine flu obviously was building from basically this point all the way through December. And just want to get an idea how much of a drag we should expect on both the prescription copy and the front-end.

Greg Wasson

Last year, as we've said, we administered 5.5 million seasonal flu shots in addition to a couple of million H1N1. And most of that was in the first quarter. So we're going to get about 7.5 million total flu shots. We expect to play a big role in the seasonal flu program this fall.

Last year, I think we had 16,000 to 17,000 of our pharmacists certified. Today, Kermit Crawford is with me, tells me we have about 23,000 certified pharmacists. We're looking forward to adding the Duane Reade pharmacists of nearly 1,000 to participate. So we did a good job last year. We certainly expect to do a better job this year.

Kermit Crawford

We're certainly looking forward to another strong flu season. Like Greg said, 23,000 of our pharmacists are certified. Over 91% of our stores have two full-time certified pharmacists in it. So when we look at the pneumonia, Zostavax, tetanus, other immunizations, we look to have a very strong season this year.

Mark Wiltamuth - Morgan Stanley

I understand you'd like to get back to a normal flu season patter. But this fourth quarter that we're working on now has got a very big swine flu year-ago it's comparing against, I'm just curious if you could quantify how big that was.

Greg Wasson

Yes, I think, Mark, we actually experienced quite a bit at this third quarter and in fact probably a significant amount of third quarter that we're going against. And we absolutely anticipated in fourth quarter, I don't know if I've got the number that Wade can give, but it is a headwind. We anticipate aggressively going after more flu shots in the first quarter as well as the tail-end of the fourth quarter.

Wade Miquelon

I think you saw the impact more this last quarter, and then it remains to be seen in the first quarter. For the fourth quarter, I don't think there is going to be a huge impact either way. There is a big upside on the flu shot part of the season which should hopefully offset any reduction in the first quarter from the overall trend.

Mark Wiltamuth - Morgan Stanley

Okay. And then, Wade, on the SG&A cost savings, for a long time you were talking about 25% of that savings coming out of the Florida Central Fill. Have you really achieved much of that or is that really also to come in 2011? And what areas are you looking for in 2011 to get the additional $500 millions in savings?

Wade Miquelon

What we've actually said is that the 25% of our $250 million is actually a broader umbrella of transforming community pharmacy, which Florida POWER plays one part, but it's much broader than that.

So if you look at our aggregate across the country, the work to be done, and Kermit, maybe you can comment, we're confident that we'll be able to deliver that.

Beyond that, we've got indirect spend, opportunities as well as corporate field and other SG&A opportunities. So all three buckets would step up next year. And there is a big step up in the TCRx what we call the transform community pharmacy overall umbrella.

Kermit Crawford

Yes, Mark, we're very confident that we're going to beat our cost savings goal for 2011 under TCRx. But in addition to that, we've talked about enhancing our customer experience and our customer service. And we've put some automation and enhanced some of our technology to improve customer service by using up some of the additional capacity we have in the system.

For example, if a patient were to touch on a prescription in tomorrow in one of our 25-hour stores, our scheduling system now schedules that prescription to be filled on the overnight where we have capacity, therefore freeing up the pharmacists during the day. So we're filling the same number of prescriptions, but we're creating more free time during the day.

And as well, the third part of that was the (inaudible) services, which we talked about the flu and other immunizations. So all three of those parts of TCRx we think are on track.

Mark Wiltamuth - Morgan Stanley

Okay. And, Kermit, while we've got you, obviously during the dispute with CVS, there was some disclosure that Maintenance Choice was pressuring you. Is there anything you can do to counter that as they continue to build that out?

Kermit Crawford

Mark, as we talked about, we're very pleased with our agreement that we have with CVS. We would not go into any of the specific details around that agreement.

Operator

Our next question comes from Derek Leckow with Barrington Research

Derek Leckow - Barrington Research

Just a question on the SG&A growth, 6% SG&A dollar growth, and that's adjusted obviously. But, Wade, can you help me understand what the SG&A dollar growth is doing at store level, and is there a bigger component coming out of some of the corporate activities herein in the fourth quarter?

Wade Miquelon

We try to get the bridge before. It's a fairly complex bridge. But at the store level, yes, we have some base level store salary inflation, maybe 18 bps as a percent of sales. We also might have been a bit of occupancy. Our occupancy is up about 20 bps as a percent of sales. And that's really driven by the fact that we've skewed over the last three years more store openings to really the A+ sites on the East Coast and West Coast.

Other than that, we've given a little bit of a walk here in the presentation. I know Rick can share with you the details. But in aggregate, I'd also say, for the number of stores that we opened over the period, 6%, when taking out Duane Reade, it's about as good as we've done in many years. It's trending in the right direction.

Again, what primarily drives SG&A right now is new store openings. And like I said, some folks might have missed a bit of just the baseline inflation in store salaries as well as the occupancy.

Derek Leckow - Barrington Research

I'm sorry, I don't have the presentation right in front of me here, Wade, but the 6%, is that roughly what's going on at store level as well?

Wade Miquelon

No, the store level would be much less on a same-store basis, anywhere from 1% to 2% (short), which is really primarily driven by store salary inflation. And like I said, there is about 20 bps as a percent of sales from increased occupancy. And again, that's because of the decision to open more stores in A+ site on the East Coast and West Coast.

Derek Leckow - Barrington Research

And just one question on your working capital here. It sounds like inventory is up a little bit, and I wondered if store level inventory is down. But where the rest of the inventory? Is that something we should be thinking about coming out of the system in the fourth quarter?

Wade Miquelon

The same store inventory is actually down, right? And I think we made good progress there. That down across the board in stores as well as our distribution chain. I think we had opportunity to continue to improve that both in pharmacy as well as the front-end, and we'll do so.

But again, on a same store basis, we've made progress. Again, albeit not as much as we made in prior periods, but I don't think that we've run the gamut on that yet.

Derek Leckow - Barrington Research

Can you quantify how much opportunity there is in terms of inventory reduction?

Wade Miquelon

I'd hate to do it here on this call. I mean obviously we haven't announced anything publicly, but I think we've obviously got a lot of low-hanging fruit opportunity already from some of the store network, streamlining that. But now, we're looking more holistically at our supply chain opportunities there to operate a bit different; change how we think about some of the buffer stocks, replenishment etcetera.

And so I think that that's kind of the next generation if you will, of improvement.

Operator

And we'll take our next question from Meredith Adler with Barclays Capital.

Meredith Adler - Barclays Capital

I was hoping we could talk a little bit more detail, first about reimbursement rate. Is it fair to say that when you talk about fewer generics, you've got older generics macking, and newer generics, there aren't as many of them coming in at a more profitable stage. Or are we seeing lower reimbursement per script for the drugs that are macked?

What I'm saying is, is it a mix of age or the level of reimbursement?

Greg Wasson

Meredith, it's a little of both. To your point, I think some of the older macks are coming down a little bit, as well as the newer are coming down a little more quickly. But at the same time, I do think that the bottom-line is that generic utilization is a win, win, win for everyone. And our focus is to continue to drive a higher percentage of generic utilization.

And I think when we see more and more come out the latter half of 2011-2012 for our fiscal year, certainly we'd see the benefit there. We're watching Mack's diligently with all payers.

Wade Miquelon

I think Greg said it, but we are at a temporary period of fewer new generics. At the back end of calendar 2011, that starts to change dramatically. So that is what it is.

Meredith Adler - Barclays Capital

And then you've talked about 90-day at retail has been boosting comps. Could you talk about whether you see that concept, that kind of program expanding? Are you working on joint ventures with PBMs? And then I also have a question about limited networks.

Greg Wasson

I absolutely think that a retail 90 benefit and offering is going to become a greater and greater part of the pharmacy industry. I think as more and more generics come out, we see a greater percentage of chronic prescription drugs. And 90-day retail benefit just makes sense.

I think the good thing is that employers who have had only a 90-day mail benefit for years, by adding a retail 90 in a broad network of retailers, it gives them the opportunity to one, give their employees a benefit that had they had not wanted to use mail, lower cost by increasing the penetration of total 90-day prescriptions. And a broader network can be put together to give choice as well.

Wade Miquelon

I think the evidence is coming out that one of the best ways to reduce overall healthcare costs is through better adherence. And 90-day is clearly a tool to drive better adherence and compliance. So I think that that trend is also favorable and we'll see that play out over time.

Greg Wasson

So Meredith, to your point, we're working with all payers; all PBMs, managed care organizations to provide them a 90-day retail solution.

Meredith Adler - Barclays Capital

But is 90-day at retail profitable if everybody is able to do it, if you're not getting any of the benefits of sort of a limited network for 90 days?

Wade Miquelon

Of course, just like 30-day is profitable with the same open network, so is 90-day. And I mean it could be structured in a win, win for both the payer, but also for us. And like I said, drives adherence and compliance, and provides an innate list from that over time as well.

Greg Wasson

Yes, with what we're able to bring to all payers in a situation where they are able to put a broad network together, you figure Meredith, you take to cost to fill this out, you have a reimbursement that makes sense. It's a win-win for everyone.

Meredith Adler - Barclays Capital

And limited networks, where do you think that goes, and are you concerned that that leads to significant more competition on reimbursement cost?

Greg Wasson

Yes, I think limited networks in some form or fashion have been around for years. You go all the way back to the 80s where (inaudible) most restricted networks. We know that patients do want choice, and there are ways to provide value and lower cost, and provide choice at the same time.

So I think there would be limited networks around, and there always have been. I do think that folks can balance both choice and value and cost with a broader network. And I think that's what we're seeing more of.

Wade Miquelon

We haven't seen an uptake in that. I mean, at the end of the day, if that's where it wants to go, having a 20% share and being within 5 miles or 75% of the population, I think that we're positioned extremely well in that case.

Greg Wasson

And Meredith, I think you may begin to see preferred networks based on performance, which we would welcome.

Meredith Adler - Barclays Capital

And you don't think that leads to more competition between retailers on reimbursement rate?

Greg Wasson

No I think where healthcare is going is, the provider that can really show value with clinical outcomes, reduced cost, provide choice, to lower the entire medical spend versus just the pharmacy spend is where we are headed as a country as well as us as a company.

Operator

Moving on to David Magee, SunTrust Robinson Humphrey.

David Magee - SunTrust Robinson Humphrey

Couple of questions, one, the question about the flu season that's this fall, last year there was a lot of attention being paid to H1N1 and obviously a lot of vaccines being given. I understand that you're better positioned this year than last year, in which you had a good performance. Do you think that the public will be as aware of it this year, and will be as motivated as last fall, and if you had a shot last fall, do you have to go back at all?

Greg Wasson

Latter question, yes. The CDC recommends a seasonal annual flu shot. And there was probably some heightened concern last year due to the H1N1 pandemic. I think the fact of the matter is that there is more and more folks getting seasonal flu shots year-over-year because of the effectiveness.

We do know that there were around a 150 million or so doses produced last year. Looks like the latest info we're getting is that there are going to be more produced this year. So we feel good with how we're positioned.

And well, David, it's interesting combining the seasonal flu shot with H1N1 in the same dose. So I think people will probably tend to be more interested because they can get both in one dose.

David Magee - SunTrust Robinson Humphrey

The second question has to do with the performance on the CCR pilot stores. You've had an acceleration here of late. Does that have upward potential to it? And I think somebody earlier asked about the non-pilot stores, how they were doing. I didn't hear the answer on that one.

Greg Wasson

We're feeling good about the trend we're seeing in CCR. As I said, we were 1.9% in the pilot stores that are reported on Q2, 2.6% in those pilot stores overall this year. I feel good that we're making real progress in the complement category. That's where we sell the significant (mess) on some of the SKUs.

And at the same time, what we're beginning to see, David, is that last year when we began closing out the 4,000 SKUs, that was companywide. And what we're beginning to see now is as the new planograms come in nationwide, we're adding items. We're beyond kind of the optimizing the SKU level. We're actually enhancing the categories and the departments that we're putting on chain-wide.

So we're not only seeing improvement in the CCR stores, but we're beginning to see improvement based on enhanced categories chain-wide.

Wade Miquelon

And, Dave, let me just maybe address part of the underpinning of your question. But we have been very diligent about looking market-by-market of control and pilot stores and our market share in those markets as well the overall share in comps.

And as we illustrated here, we feel pretty good that our aggregate comps on apple-to-apples basis outperformed our top three competitors, which basically means that the control is strong too.

Greg Wasson

So obviously it's a tough environment out there, but we have to make sure that we're not only looking at whatever the comp is, but making sure that from a market share point of view on a competitive basis that we're actually outperforming others.

David Magee - SunTrust Robinson Humphrey

So do you think that 2.6 is an appropriate proxy to the more recent Convergent?

Wade Miquelon

Absolutely. And I think you can extrapolate again our aggregate versus other comps and add the 2.6 as a hopefully baseline or better move forward.

Operator

And next from (Susquehanna) we'll go to Bob Summers.

Unidentified Analyst

Just wanted to dig a little bit more into the SG&A line and better understand about the change in the net cost savings. And I can't access the presentation right now. What the four quarter trailing average store growth is? And understand maybe why we're not doing a little better job on that line at this point.

Greg Wasson

Well, Bob, I'll jump in and then have Wade give more details. I agree with his comment earlier. I think we removed Duane Reade in light of the 5.9% new store growth. Our SG&A trend is pretty consistent with where we have been over the last two or three years. We certainly didn't fall out of bed. We certainly know that there's opportunity, we are going to keep pushing.

The goal I have, that I have given this team is to make sure that that two-year stack year-over-year continuously go down. I am sorry you can't open the presentation, but when you look at the bar graph, the two-years stack with Duane Reade out, we have continued to improve year-over-year on a two-year stack.

Unidentified Analyst

And then, sort of secondly with respect to the overall sales environment, two questions. First, are you starting to see any impact from people rolling off of discounted Cobra? And then, second, with respect to the front-end, where's the incremental pressure coming from?

Are you seeing share loss to discounters or dollar stores, and are you concerned that some of this given the overall employment market is a little but structural longer term?

Greg Wasson

I can't say that we've seen anything on people rolling off Cobra, and maybe it's something we should dig into. Well, I can't say we are seeing that. Bob, as far as the front-end I think we are still seeing some continued pressure on the discretionary categories, although we're feeling better with what we are seeing currently.

As I said, we are beginning to roll out some new and enhanced planograms and categories chain-wide. In addition to CCR, we're beginning to roll back some of the private brand as I said from Duane Reade. But as far as the pressure, it's mainly still in the discretionary categories, because customers are still holding on to their cash a little bit.

Wade Miquelon

And Bob, I would add that, further in this sluggish economy, finances are an important cause of low adherence to prescription medication therapies. So between the economy and a tough H1N1 comparison of last spring, I think that is more what's happening in this quarter on the pharmacy side of the business.

Unidentified Analyst

And then lastly, you talked about a 50 basis point lift from the alcohol rollout. Where do you see that trending, or what's your own bogey of where it can go?

Wade Miquelon

Well, I think there's no reason that shouldn't be able to be in 2% to 3% of the front-end over time. But of course, its how many you roll out and when you cycle, whatever, but I would say that's kind of I think what it should comprise. So what it is in terms of actual lift would depend upon the timing of when they're rolled out and how you cycle that.

Greg Wasson

I feel we had to watch, Bob, the basket that comes with that which we're encouraged by.

Operator

Our next question comes from the Debra Weinswig with Citi.

Debra Weinswig – Citi

I know it's early, but any unexpected benefits so far from the Duane Reade acquisition?

Greg Wasson

I think certainly, as I said we are really encouraged and excited. But with there private brand, frankly expertise in what they've done with private brand in that market, and that's the reason we're pulling back some of that in August as we said to begin to see what kind of lift we can get throughout the chain.

So, I think there is huge opportunity there. Their loyalty card, they just re-launched it a couple of months ago. They're seeing pretty good results from it. I think we can certainly learn from some of the things they are doing as we pilot our loyalty card.

Cosmetics & Beauty, we're excited there, I think their fresh food, urban retailing. So, the more excited we are and the more we think that we can pull out their expertise back through the chain.

Debra Weinswig – Citi

As you roll out some of their private label into your traditional Walgreen stores, what will that replace, if you will, in your existing stores?

Greg Wasson

It's interesting, we do a terrific job as you might expect in, kind of, the health and beauty private brand products, you know, the (inaudible) and so forth that we are known for. Where we under-penetrate and have over the years is in consumables, and that's where they over-excel, and in their delicious snacks, their cookies, their food, their consumable items.

So, we are going to continue to drive and enhance our OTC offering, which we've done well for years. But we think they can really help us in the consumable space.

Wade Miquelon

Yes, and in another way I think we've done a great job at kind of the me-too at a better value for consumers. But I think that, in terms of really differentiated propositions, in particular in food, they are really best-in-class doing a great job.

Debra Weinswig – Citi

And then also, Wade, as you look at it from today, because obviously you've had a lot of excess in traction with regards to expense reduction, what would you look at, say, as the biggest expense reduction opportunities going forward?

Wade Miquelon

Well, I think the key thing is to deliver on; job number one, is to deliver on our Rewire commitment. We've got that planned; now we have to just run that play. So, I say that's good news.

Beyond that we're actually doing a lot of work, what I would call in two different streams. One is kind of the day to day, how do we think about making increments in everything we do everyday. We have a group now dedicated to that, and separately also what are the next big breakthroughs, what are the big structural areas we should be looking out to transform. And we've got some ideas there as well.

But I think I guess just to wrap it up I think that the first job number one is to deliver on the rewire commitment and put that to bed, while we also figure out as a company how to be more systemic and not make these cost reductions a once-every-five-year event - really build it into our day-to-day.

So we're challenging everything all the time, how can we do it better, more efficiently, faster, and we've put significant resources and a new structure around that for the company. So I feel pretty good that on a going basis that we'll be more on a continual process there.

Debra Weinswig – Citi

And the last question, I agreed with your comments with regards to front-end comps, and when you look at your front-end comps versus the peers, it doesn't look like you're losing share to anyone else in the drug store channel. It doesn't necessarily look like there's anyone out there in the competitive landscape of all retail that's doing particularly well, maybe the club channel. Where do you think consumers are going to buy those items?

Greg Wasson

Overall, I think consumers are just pulling back their spending in total Debra. But I do think that we are encouraged, when we look at apples-to-apples that we are winning against our major competitors, and we are digging share across many markets. So I think it's some that's cut back on discretionary spend in total.

Wade Miquelon

If you look at the internals, our food traffic remains strong, which is people are coming, the items remains fairly strong. It's really the dollar'ing per item, where people had to trade down or make sacrifices. You see it in the other trends too in terms of people spending more after paycheck and less at the end of it, people who move more away from credit to cash etcetera.

So I think it really is aggregate right now; is the bit of a suppressed consumer, which I think is good for us as this comes back. But I think the key thing we're doing is, through CCR and the other efforts to make our stores much more relevant.

First, I think its big opportunity to make those assets more accretive over time. And so the items we're launching in the new environment is going to help with that.

Debra Weinswig – Citi

And also, as you are building out your loyalty card and as you are building out your private label, it seems that you have a real opportunity in this environment to capture if you will this "new consumer" as well.

Greg Wasson

Yes, we definitely would agree with that. I think there is tremendous opportunity to grow our private brand offering. And that creates loyalty in itself as you know.

Wade Miquelon

And as Rick said before, if you look at beer and wine for example, beer and wine is not just what we're going to get for the list over time. We're finding when you do the basket diagnostics, that actually we're picking up more of that flow item or less consumer, who might not come by Walgreens because there was one or two items they couldn't get through that Mini shop. And that gives us a lot of encouragement.

Operator

Our final question will come from Andrew Wolf with BB&T Capital Markets.

Andrew Wolf - BB&T Capital Markets

Wade, on the generic impact, I think you said it was $0.02 to $0.03 in the quarter versus last year. Can you at all tell us when do you think that bottom, I mean you are kind of hinting at it, that it's sometime between now and sort of next few quarters and are you implying that even though fiscal '11 through August 11 is not going to be when the big waves kicks in that you are still going to have, that swing will turn positive in fiscal '11 on generic?

Wade Miquelon

Yes, we have a step down this whole year; so, we've seen it throughout the year. We're going to have another bit of a step down next year and then really at the en of calendar '11 is where we get a really nice step up and then the following year an even nicer step up. So, I hesitate to quantify the exact numbers in part, because actually no one can predict exactly when these things hit. But that's the basic pattern.

Andrew Wolf - BB&T Capital Markets

So is it fair to say that $0.02 to $0.03 is kind of the worst type of impact you would expect in realizing it's more like horse shoes than precise, but at least in terms of magnitude that's about as big you would expect in any one quarter?

Wade Miquelon

Yes, I say next year you could see another one to two on top of it, but we've got a lot of good stuff going as well. So, I mean, in aggregates there's lots of big moving parts, but we do see a bit of a step down next year, not to the degree we've seen this year and then I guess that we started to see a sequential year step up.

Andrew Wolf - BB&T Capital Markets

And then on the house keeping side, I think you talked about the AWP lawsuit settlement, that's still running at about $25 million a quarter?

Greg Wasson

Yes, about the same flow-through.

Wade Miquelon

We'll start to cycle that next fall.

Andrew Wolf - BB&T Capital Markets

I think in the past you've called out the dilutive expense from clinics. Is that neutral this year or is that still a dilutive churn?

Wade Miquelon

That's now moving to slightly accretive. So on a relative basis, it's not accretive. It's still a loss, but it's less loss than the year ago. And I would expect that that's going to keep becoming relatively accretive moving forward. And we are still very much big believers in this. Not only from an amazing experience what it does to our halo effect, but also our stores are now moving into three and four years.

Many of those are moving into the black and that's now the kind of torture test of fully loaded economics with no benefits in the front-end or the script basis. So again on a relative basis, it's year-over-year accretive, but where also the older ones are ramping nicely as planned. So, it gives us a lot of confidence that this is the way to go.

Andrew Wolf - BB&T Capital Markets

In terms of Bob's question with some of the extended (covers) falling off, it might be interesting to see since there are cheaper ways to get healthcare if you're not insured how that goes?

Greg Wasson

We definitely think we're going to be able to play a big role in the access challenges with healthcare reform, Andy, as you might expect. That's the reason we're so bullish on these clinics.

Andrew Wolf - BB&T Capital Markets

And on the front-end, you said the markdowns were lower, is that due to the competitive environment in anyway or is it just due to the amount of markdowns you took last year with the rewire?

Greg Wasson

The amount of markdowns we took last year due to rewire.

Andrew Wolf - BB&T Capital Markets

And are you saying that the competitive environment is about the same? I mean, I'm seeing some signs of rationality versus some of the competitors like the supermarkets where some milk prices are moving up and I think in prior quarters they were using them as loss leaders? So well, how would you characterize incrementally the competitive environment overall in retail?

Greg Wasson

I'd say it's pretty much what we've seen in the past six months to 12, I think there are folks that are out there still trying to go after the discretionary spend with consumers. I do think and as I said we're encouraged with what we're seeing currently. We'll see, I think people are still watching their, Andy.

Andrew Wolf - BB&T Capital Markets

My last question is on your direct-to-employer offering. Is there a way or is that an offering that can be run by an HR department in parallel with a PBM that has a mandatory element to it where the maintenance drugs could still be done in that type of a situation?

Greg Wasson

Yes, Andy, we have several relationships where we have direct arrangements with a payer over the years. The real opportunity we have, as you know, is we lead with the worksite health center solution that we have. And once we get in and really begin to provide real value and build the relationship with employers, there is other services that we can offer that we're able to deliver. If that indeed includes prescription drugs, then we can do that as well. But what we really want to do is get in and provide real value to an employers medical spend in total.

Rick Hans

Folks, that was our final question. Thank you for joining us today. We'll announce June monthly sales on July 6. The next quarterly financial announcement will be September 28. That's when we'll announce fiscal 2010 fourth quarter and yearend results. Until then, thank you for listening, and we look forward to talking to you soon.

Operator

And once again, ladies and gentlemen, that concludes our conference today. Thank you all for your participation.

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Source: Walgreen Co. F3Q10 (Qtr End 05/31/2010) Earnings Call Transcript
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