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Walgreen Co. (NYSE:WAG)

Q3 2014 Earnings Conference Call

June 24, 2014 08:30 AM ET

Executives

Greg Wasson - President and CEO

Wade Miquelon - EVP, CFO and President, International

Kermit Crawford - President, Pharmacy

Mark Wagner - President, Operations & Community Management

Alex Gourlay - President, Customer Experience & Daily Living

Rick Hans - DVP, IR and Finance

Analysts

George Hill - Deutsche Bank

John Heinbockel - Guggenheim Securities

Meredith Adler - Barclays Capital

Ricky Goldwasser - Morgan Stanley

Steven Valiquette - UBS Securities LLC

David Larsen - Leerink Swann & Company

Robert Jones - Goldman Sachs

Lisa Gill - JPMorgan

Edward Kelly - Credit Suisse

Operator

Good day, ladies and gentlemen and welcome to the Walgreen Company Third Quarter 2014 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. (Operator Instructions) As a reminder, today’s conference is being recorded.

I’d now like to introduce your host for today's conference call Mr. Rick Hans, Divisional VP of IR. You may begin sir.

Rick Hans

Thank you, Kevin. Good morning, everyone. Welcome to our third quarter 2014 conference call. Today, Greg Wasson, President and CEO; and Wade Miquelon, Executive Vice President, CFO and President International, will discuss the results for the quarter. Also joining us on the call, and available for questions are Kermit Crawford, President of Pharmacy; and Mark Wagner, President of Store Operations; and Alex Gourlay, President of Customer Experience and Daily Living.

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

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

Now, I’ll turn the call over to Greg.

Greg Wasson

Thank you, Rick. Good morning, everyone and thank you for joining us on our call. Before we get to today’s financial results, I’d like to begin with a few comments on the proposed second step in our transaction with Alliance Boots.

Our Management Team and Board are making significant progress evaluating the proposed transaction determining the timing and structure, the combined management team, additional synergy and cost reduction initiatives and potential changes to our future capital structure. We will be in a position to hold an investor call once key decisions on these major issues have been made, which is expect to occur by late July or early August.

Now I’ll turn to our third quarter financial results. Today I’ll begin with a review of the quarter. Next I’ll discuss the key factors affecting our financial performance, and finally I’ll provide more detail on our strategies and overall progress and then I’ll turn the call over to Wade for a more detailed financial review.

In the quarter, we continue to see improving top line growth with increased daily living sales and strong performance in both prescriptions filled and our pharmacy market share. For the quarter, sales were $19.4 billion, up 5.9% from $18.3 billion a year-ago. GAAP operating income for the quarter was $1 billion, up 3.5% from $991 million last year.

Adjusted operating income for the quarter was $1.3 billion, up 4.5$% from $1.2 billion in third quarter of 2013. GAAP earnings per diluted share were $0.75 in the third quarter compared to $0.65 last year; up 15.4%.Third quarter adjusted earnings per diluted share were $0.91, up 7.1% from $0.85 in the same quarter last year.

Our results this quarter benefited from a lower GAAP effective income tax rate. The lower rate of 31.5% compared with 38.7% last year resulted from increased foreign income taxed at a lower rate, favorable audit settlements, certain nondeductible expenses last year and other discrete events.

Turning to trends in gross profit dollars and SG&A dollars in the third quarter. On a GAAP basis, our gross profit dollars increased 4.2% or $218 million from a year-ago. SG&A dollars increased 4.3% or $189 million compared to a year-ago. Adjusted gross profit dollars increased 2.6% or $139 million compared to a 5.3% increase in the same quarter last year. This difference primarily resulted from decline in pharmacy gross margin, which we will discuss in detail later in the call.

On adjusted SG&A dollars increased by 2.9% or $121 million compared to the same quarter last year. We remain focused on cost disciplined to offset a negative effect to our gross profit dollar growth. We will be accelerating our optimization efforts, taking additional steps to lower our expenses company wide.

I appointed a key member of my executive team to lead this effort. We’ve been making tremendous progress in identifying opportunities when combined with additional synergies and cost reduction initiatives that are part of step two and the completion of the strategic transaction with Alliance Boots, we expect to drive sustainable efficiencies and value for the combined enterprise.

In the quarter, we continue to focus on our three strategic growth drivers, create a well experience, advance the role of community pharmacy, and establish an efficient global platform. Today I will provide more detail on those strategies.

Performance and our well experienced growth driver has continued to improve, giving us even greater confidence in the significant potential of our daily living business. Our front-end comp increased 2.2% in the third quarter. And when you look at the two-year stack, our performance is the best it’s been in eight quarters. Average basket size grew 2.9% as customers consolidate -- continued to consolidate trips.

In addition, front-end margin improved in the third quarter compared to the same quarter last year. To drive margins, gains, we improved our product mix with a strategy to advance our health and beauty categories. We are also delivering great efficiencies in our promotional investment with our Balance Rewards program.

At the end of May, we had 81 million active Balance Rewards members, allowing us to reach more customers with our offers. We received solid response rates on our personalized point offers. We’ve integrated our award winning Paperless Coupons into our program and have nearly 1.5 million people enrolled in our Balance Rewards for healthy choices program.

Also in the quarter, while we continued our program to optimize our store footprint, we opened our converted 24 well experienced stores, reaching a total of 642 across the country. To further engage our beauty customers, we extended the reach of Boots brands. We launched Boots No7 and more than 300 stores across the chain primarily in our Phoenix and New York markets.

In New York, one of the countries most important beauty markets, we currently have Boots brands and more than 125 Walgreens and Duane Reade stores with a goal of 183. From New York, we will begin our launch across the United States. As we prepare for that expansion, results were coming in from Phoenix, our most mature market for Boots No7 and its clear our new beauty experience is elevating our performance. Boots No7 is the number one skin care brand sold in all of our Phoenix stores and baskets with boots items are bigger than the average beauty basket.

In addition, 80% of our beauty customers tell us their beauty experience is improving. We are not only seeing better performance in our stores No7, it’s also the number one beauty brand on walgreens.com.

Finally, our focus on extraordinary customer care is paying off. Our customer delight score increased 230 basis points this quarter and is at an all-time high for the Company. Pharmacy delight is also at its highest level ever, up 270 basis points this quarter over last year. This performance is a credit to our store leaders and our team members who are demonstrating their commitment to our customers with every transaction.

In our Pharmacy and Health and Wellness business, our script comp was up 4.1% in the quarter. Our retail pharmacy market share increased to 19% from the quarter, up 20 basis points year-over-year and we filled 218 million prescriptions, up 4.5% from the same period last year.

To drive our performance, we’ve been making deliberate strategic decisions to win with high value seniors through preferred relationships with Medicare part D plans by growing 90-day at retail and expanding vaccines and other preventative care services. These decisions continue to drive results in the quarter, contributing to strong top line growth. We saw solid growth in prescriptions filled for part D patients with an increase of 11.6% this quarter compared to the same quarter last year.

Part D market share increased 60 basis points this May compared to the same month last year and overall 90-day volume was up 15%. Our 90-day retail product is competing effectively with mail giving customers a choice to receive their chronic medications at their pharmacy.

As you know 90-day at retail is at a lower margin than comparable 30-day fills, but we believe this strategy will have a long-term positive impact on gross profit dollar and EBIT growth for our Pharmacy business as we grow our share of maintenance meds.

Turning to headwinds faced in the industry, we’ve seen an increase in reimbursement pressure as well as a shift from historical patterns of deflation in generic drug cost to inflation. Over the past year, we’ve seen cost increases on a subset of generic drugs and in some cases these increases have been significant. Both reimbursement pressure and generic inflation are having an adverse effect on margin.

In addition, this quarter on a year-over-year basis, there was a slow down in generic introductions, although the impact continues to moderate as we move through the second half of the calendar year. To address the pressure on our gross margin, we’re focused on our contracting strategy to account for increasing drug cost. We are aggressively working to increase efficiencies and providing high quality and cost effective pharmacy services that reduce total pharmacy costs.

With our global procurement organization in Bern, Switzerland, we also are well positioned to offset the impact. Along with Alliance Boots and AmerisourceBergen, our three companies are the largest purchaser of pharmaceuticals worldwide. Together we’re working closely and collaboratively with manufacturers to drive sustainable growth both here, in the U.S and in Europe.

Our strategic partnership with Alliance Boots contributed $0.15 per diluted share to Walgreens third quarter 2014 adjusted results. Combined synergies for the first nine months of fiscal 2014 were approximately $367 million. We now expect to exceed our second year combined synergy target and are now estimating $400 million to $450 million in the second year of combined synergies.

We estimate that accretion from Alliance Boots in the fourth quarter of fiscal 2014 will be an adjusted $0.06 to $0.07 per diluted share. As I said at the top of the call, there are a number of opportunities we continue to work on as we move toward consideration by the Board of Directors of the second step of our strategic transaction with Alliance Boots.

Stefano and I are pleased with our progress to realize our joint vision for exercising step two of our strategic transaction. We are working through complex issues and we’re taking the appropriate time to come to the right resolutions for the combined enterprise.

One final note, as a result of the many step two considerations and current business performance, the Company is withdrawing its fiscal year 2016 goals that were previously announced in 2012. The Company expects to provide a new set of goals and metrics for the proposed combined enterprise for fiscal 2016 and we will communicate those to you on our call, which we expect to hold in late July or early August.

Let me speak directly to two of the prior goals regarding our adjusted operating income goal of $9 billion to $9.5 billion. On previous calls we noted we were tracking below the CAGR required to meet the goal. We now no longer expect to reach that goal on our combined synergy goals I noted earlier. We are tracking ahead of that goal and we expect to exceed the $1 billion amount by the end of fiscal 2016.

As noted above, some of the opportunities we’re pursuing are below the operating line, the income line on the income statement and decisions about those will be reflected in our new goals and metrics. Two years ago, we announced our strategic partnership with Alliance Boots, an opportunity to bring together two companies with iconic brands.

We’ve made tremendous progress over the past two years, bringing to life our vision for a global pharmacy led health and well-being enterprise that can address the needs of a challenging healthcare market, improve service delivery and health outcomes. With the addition of our strategic relationship with AmerisourceBergen, we’re creating a truly powerful combination of retail and wholesale leaders that can better serve customers in the U.S and around the world.

Now we’re focused on making the decisions necessary for the combined enterprise in preparation for step two. We’ve work to do; we’re intent on getting that work done right for the benefit of our enterprise, our team members, customers and shareholders. We look forward to sharing our decisions with you later this summer.

And now I’ll turn the call over to Wade.

Wade Miquelon

Thank you, Greg. Good morning everyone and thank you for joining us on the call. This morning I will take you through our quarterly results as well as update you on our Alliance Boots strategic partnership and our AmerisourceBergen relationship.

As Greg noted earlier, for the quarter, we reported a GAAP EPS of $0.75 per diluted share based on nearly 968 million shares. GAAP EPS walks to an adjusted EPS of $0.91 for the quarter as illustrated by this chart. A LIFO provision of $0.03, acquisition related items were $0.13 per share consisting of $0.06 of acquisition related amortization costs, $0.01 of acquisition related cost and $0.06 from Alliance Boots related tax.

Finally, the special items had no net impact due to the positive $0.07 impact of the warrants issued by AmerisourceBergen to Walgreens and Alliance Boots with the Alliance Boots impact reported on a three month lag basis, offset by the negative $0.07 impact of store closures and other asset optimization costs.

Let me now review our comparable store sales for the quarter. Comp prescription sales increased 6.3%. Comp front-end sales increased 2.2% and total comp store sales increased 4.8%. Comp prescriptions filled increased 4.1% versus a script comp of 7.1% in the year-ago period.

The components of the 2.2% front-end comp traffic which decreased by 0.7% and basket size which increased by 2.9%. We are pleased with the trends in the one and two year stack comps over the past few quarters.

Moving to comp store script numbers, our retail scripts were up 4.1%. This performance reflects the fundamentals of our underlying business, the ongoing progress and winning new Medicare Part D customers and increase of 90-day at retail scripts and return of Express Scripts customers. The two-year stack on script comp has improved dramatically in the last two years.

With respect to margin, our adjusted gross margin reflecting FIFO inventory was 28.3% in the current quarter compared to 29.2% last year, a 90 basis point decline. The primary drivers of the pharmacy margin decrease were increasing third-party reimbursement pressure, particularly due to a few contract step downs, increases in Medicare Part D mix including the strategy to continue driving 90-day prescriptions at retail, fewer generic drug introductions versus the year-ago and pronounced generic drug inflation on a subset of generic drugs as well as the mix from specialty drugs.

Purchasing synergies in the pharmacy and front-end did partially offset this margin pressure. Front-end margin increased in the quarter, benefiting from mix and promotional adjustments, and we still expect the rate of generic drug introductions to increase in the fourth quarter to the point that it should not be a drag on margin year-over-year. On net, we expect the negative factors impacting pharmacy margin will more than offset generic introductions and front-end margin benefit next quarter on a year-over-year basis.

Taking a look at our adjusted gross margin trends, this quarter’s 90 basis point decrease versus a 50 basis point increase a year-ago. Based on our strategies and plans, we do expect the front-end margin to continue to improve over the long-term. As we demonstrated and discussed in the last few quarters, this graph illustrate the impact of new generic drug introductions had on our monthly prescription sales comps.

The highlighted quarters illustrate the number of new generic drug introductions remain slower than a year-ago. And you can see that the generic impact on a comp prescription sales was about a negative 4% in the third quarter of fiscal 2013 versus a generic impact of negative 1.4% in the most recent quarter.

In our experience, the margin change resulted from generics is inversely correlated and slightly lagged to the impact of generic sales changes. And that is the strongest positive effect on margin typically occurs shortly after the generic impact on prescription sales is the most deflationary.

The tough year-over-year generic impact margin comparison has continued to dissipate throughout fiscal year 2014 and expected to turn positive in the fourth quarter of 2014, given the increase in generic impact on pharmacy sales comps expected in that period. This trend however continues to be negatively impacted by the delay of a few large volume drugs like generic forms of Nexium and Diovan.

Transitioning now to gross profit, this slide illustrates our quarterly gross profit dollar growth trends for the past 11 quarters on a GAAP basis. And the next slide shows this trend on adjusted basis. Adjusted gross profit dollar growth increased to 2.6% versus 5.3% in the year-ago period. Gross profit dollar growth was positively impacted by the comps in both the pharmacy and the front-end and further helped by a margin expansion on the front-end.

On the pharmacy side, gross profit dollar growth was negatively impacted by the same issues impacting pharmacy margin, which I described a moment ago. But despite these headwinds and the benefit of synergies, adjusted gross profit dollars grew faster than the average 1% growth rate in the first half of the year.

For the quarter, GAAP SG&A dollar growth was 4.3%. We then deduct 2.3% per store closures and other optimization costs and 0.1% for Walgreens amortization cost, and add back 0.3 percentage point for the acquisition related cost and 0.7% for the DEA legal settlement. This walk yields an adjusted SG&A dollar growth of 2.9% for the quarter.

Shown here are the SG&A dollar growth trends for the past 11 quarters on a GAAP basis and the follow on slide shows a similar trend on an adjusted basis. The adjusted SG&A dollar growth for the quarter was 2.9% year-over-year increase versus the 4.5% increase in the third quarter of fiscal 2013.

Keep in mind that last year’s fourth quarter GAAP and adjusted net earnings include a $0.03 per diluted share in net gains from certain litigation matters. This net litigation gain reduced SG&A dollar growth by 0.9% last year and will be a factor in the SG&A dollar growth comparison year-over-year in the fourth quarter.

This next chart illustrates our two-year stacked SG&A dollar growth trends on a GAAP basis for the last nine quarters.

Now let’s review the two-year stacked trends on adjusted basis. Two-year stack adjusted SG&A trends increased versus a year-ago by 510 basis points. With a two-year stack of 7.4% growth in the third quarter of 2014, up from 2.3% last year. The two-year stack from a year-ago included a period when we were out of Express Scripts network in the third quarter of fiscal year 2012.

SG&A grew at a negative 2.2% in that period as we responded to the lower volumes in the pharmacy. Likewise a two-year stack SG&A dollar growth will be difficult to lap for the next two quarters is shown by the fourth quarter two-year stack of 0.5% and the first quarter two-year stack of 2.9%.

Turning to a few other components of our income statement, this quarter included LIFO provision of $41 million versus a provision or charge of $120 million a year-ago. Our effective LIFO rate for the quarter was 2.25%, down from 3.5% a year-ago. Net interest expense for the quarter was $35 million versus $50 million from a year-ago.

We expect interest expense of approximately $35 million in the fourth quarter. Average diluted shares outstanding were 968 million shares versus 959 million shares last year. And the change is primarily due to the impact of a higher stock price on a number of in the money options which are counted in diluted shares.

In the fourth quarter, we expect diluted share count of approximately 968 million shares subject to changes in the current share price. Our effective tax rate for the quarter was 31.5% versus 38.7% last year. And the difference is primarily attributable to additional foreign income tax taxed at a lower rate and net benefit per changes in uncertain tax provisions as well as a lower permanent difference between book and tax income.

For the fourth quarter, we estimate our GAAP tax rate to be approximately 36%, and we expect a similar increase in our adjusted tax rate in the fourth quarter compared to the third quarter.

Accounts receivable increased by 25.3% primarily due to higher vendor funding receivables from the Bern JV and AmerisourceBergen for brand and generic rebates along with the higher receivables generated by higher third-party pharmacy sales. Accounts payable decreased 6.5% and LIFO inventories decreased 6.4% in conjunction with our new agreement in terms of the AmerisourceBergen as more of the generic pharmacy distribution transitions to them. Overall, net working capital increased by 9.8% versus a year-ago.

During the second quarter we generated approximately $1.3 billion in cash from operations versus $1.4 billion in the year-ago period. And free cash flow in the quarter was $1 billion versus $1.1 billion a year-ago.

The next slide shows our correlated accretion from Alliance Boots which was $0.15 per share for the quarter versus our forecast of $0.13 to $0.14 per share with the out performance primarily related to incremental procurement synergies. You can find a more detailed walk included in the appendix to this presentation on our Investor Relations Web site.

Combined net synergies for the quarter totaled $131 million and for the first three quarters of the year totaled $367 million. And as Greg noted, because we’re running ahead of our previous estimate of $375 million to $425 million of combined synergies for the year, we’re raising the estimated to $400 million to $450 million.

Looking forward, we estimate the adjusted EPS accretion from Alliance Boots for the fourth quarter of fiscal year 2014 to be $0.67 per share based on our current estimate of IFRS to GAAP conversion and foreign exchange rates versus $0.08 in the year-ago quarter. The adjusted accretion is expected to be slightly lower than the year-ago period for Alliance Boots primarily driven by the timing of recognition of certain tax matters.

Additionally, we’re assessing whether the fair value of one of the Alliance Boots wholesale reporting units is below its current value for U.S GAAP purposes. Our share of the goodwill from this reporting unit is approximately $195 million. We plan to finalize this assessment prior to filing our Form 10-Q, any impact will be reflected in our fourth quarter financial statements and we’d expect to exclude any impact from adjusted earnings.

Since I usually end with commentary on the fiscal year 2016 goals, let me reiterate the comments made in the press release and by Greg regarding these goals. As a result of the many step two considerations in current business performance, we’re withdrawing the fiscal year 2016 goals that were previously announced in 2012.

As Greg mentioned, we’re evaluating the proposed transaction including the potential timing and structure and combine management team, continued synergy and cost reduction initiatives and potential changes to our future capital structure, all through the lens of what is in the best interest of our shareholders long-term.

Once key decisions have been made on the above matters, Walgreens anticipate to being in a position to hold an Investor Call, which is expected to occur by late July or early August. Many of the areas under consideration are interdependent and so we believe that the prudent course is to share the scope of our decisions and related financial objectives and metrics together all the time.

In summary, our strategies remain sound in the fundamentals of our business and particularly with respect to top line growth has continued to strengthen. While we have gross profit reimbursement pressure in the traditional pharmacy as mentioned, we also have significant opportunities to drive additional cost efficiency and also turn the front-end of our business into a very meaningful profit pillar.

Our Alliance Boots and AmerisourceBergen partnerships also continue to go well and we’re beginning to move beyond the cost only synergy phase to one where we’re starting to share and exploit organizational capabilities to strengthen our core business and find new labors to create value for shareholders.

With respect to our merger with Alliance Boots, we realize that our investors have been patiently awaiting additional information about step 2. I can assure you that we have been using the time to evaluate all aspects of the transaction with the best long-term interests of our company and shareholders in mind. And now with that, I’ll turn the call back over to, Rick.

Rick Hans

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

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from George Hill with Deutsche Bank.

George Hill - Deutsche Bank

I appreciate you taking the question. I guess maybe we will start first with the 2016 guidance. It seems like that you guys aren't going to come in in-line with the original expected range. But I don't think most investors had kind of expected you to hit the numbers given current business performance. Is there any color you can give us with respect to how far off that range you think you are?

Greg Wasson

George, Greg, so yes I think as we had said we’re in the last couple of quarters we weren’t tracking on the CAGR that we required to hit that adjusted 30’s number and certainly with our current performance in some of the lines we talked about on the call that’s impacting pharmacy, we didn’t think that it was achievable. Now that, that meeting was, we’re still not working on a whole host of things to try to continue to drive value. I think the main point, and I’ll let Wade kind of take it from there as a fact that, four to six weeks we do have a lot of moving parts. We are going to be looking at different goals of metrics both above that line and below the line and we want to really get focused on those. So, Wade you want to add a little color?

Wade Miquelon

Yes, I think that’s right. I think we’re still aggressively driving all the [ph] [above] opportunities, but as Greg said we have opportunities below the line as well in terms of how we think about structure or cap structure, refinancing in the like and so we’re making sure at this point in time that we look at every thing kind of interdependently as a web of choices and we maximize value as best we can.

George Hill - Deutsche Bank

Okay, that's helpful. And then Wade, maybe a quick follow-up. I recognize that you guys are planning to do a call I guess in a little over a month from this point now. Is there any more color you can give us on what the puts and takes the -- kind of the company is considering as it evaluates Step 2?

Wade Miquelon

Yes, I think both Greg and I kind of listed them, but I would say everything, anything that can create value so we’re looking at apart from again kind of the organizational operational structure, we’re looking at more to the ideal cost structure moving forward. We’re looking at what's the ideal way to structure the transaction from a legal point of view. We’re looking at what's the best balance of the cap structures we think about the amount of cash this company can generate in a combined form. We’re looking at again the best way to refinance the transaction as we move forward. So, I would say that everything or anything what related to the big measures and again I think we’re going to make sure that we land down in a place that’s in the best interest of our shareholders long-term.

Greg Wasson

And George I would add, and I think the main point is all those that Wade just rattled are interdependent, and therefore we want to make sure that we thought through them all and that’s the reason we thought kind of late July we’d just have a lot more visibility on how all those connect and drive value together.

George Hill - Deutsche Bank

That’s very helpful. And then I’ll ask one quickly and I’ll drop off. In the press release you highlighted a focused -- increased focus on internal cost and reducing internal costs. Is there anyway to ballpark that opportunity for us, I guess kind of as we think about the next 12 to 18 months?

Greg Wasson

Well we’re working on accelerating up the optimization efforts across the entire organization. George we’ve actually identified and actually realized a lot of opportunity. Current the challenges unfortunately some of the pressure we’ve seen on pharmacy margin has eaten some of that up, that’s the reason I have elected a key executive begin to look for and identify new opportunities. The good news is, is we’re finding opportunities. We’re now in the process of trying to figure out how to get at it. What are the plans, the processes, several or some of those maybe require some restructuring or not. So we’re in the process of doing that. The other thing is that, we’ve been four to six weeks away from the real work that Wade and team are doing around the combined merger. We definitely, we see to reduce cost as the entity comes together. So, again we want to kind of put all that together and come to you with as much as we possibly can in that call that’s coming up in four to six weeks.

George Hill - Deutsche Bank

Okay. We’ll wait for that. Thanks guys.

Greg Wasson

Thanks, George.

Operator

The next question comes from John Heinbockel of Guggenheim Securities.

Greg Wasson

Hi, John.

John Heinbockel - Guggenheim Securities

Greg, I guess looking at the big picture, when you think about the US pharmacy or drug retail business, you and all your peers, do you think is that business not going to be as profitable going forward as maybe you thought because of reimbursement pressure, government involvement, etc.? Do you think it's a secular issue? And then if that's true or remotely true, the things you think about on the cost side, are they really more strategic i.e. supply chain, what do we need to do with that long term in how we staff our stores? Is it really very secular and strategic or you think, no, it's just a period we are going through and it requires more tactical stuff?

Greg Wasson

Yes, John on the first part, no, I don’t necessarily think that we should assume that the US business cannot continue to grow on profitability. I think the work that Alex and Mark and team are doing on the front end of the business, we think we have -- we think we actually have tremendous opportunity to grow EBIT and operating margin on the front end of the business. We are beginning to getting more confidence in just that, and I think that is obviously going to help us with the overall business. I think in the pharmacy business the good thing is, is that we’re growing top line for the first time consistently in a long time with some of those strategic decisions I’ve talked about. We’re absolutely winning in a Part D space. We’re growing 90 day customers and so forth. We do have obviously the pharmacy margin pressure that we talked about. But I think Kermit and team and he can maybe allude a little bit about how we think will go at that. We think we -- we think with our contracting strategy going forward, with the generic inflation that we’re seeing versus historical deflation we're going to start taking that in consideration in our contracting. He’s going at cost of fill reduction with a vengeance and I think with Bern, and Jeff Berkowitz and John out in Bern, we’re positioned better than anyone to be able to get at comp. As far as the cost opportunities, I think there’s a little of both. I think that there’s opportunity to get at cost to your point that’s more maybe cyclical, but I think structurally we’re going after -- we’re going after the business from a structural point of view, everything from supply chain, everything from how we supervise and manage stores, everything from looking at our store footprint as we never have in the past and as we indicated on the last call. So we’re really taking a step back and looking at the entire enterprise from a structural perspective.

John Heinbockel - Guggenheim Securities

And is there, what's going on in Bern, how much opportunity is there to accelerate those efforts to offset the margin pressure you’re seeing today? Is there enough flexibility to do that or not really to play around with that?

Greg Wasson

I think there’s opportunity. Yes, I think Jeff and team have their pedal on the metal and their foot on the accelerator as far as trying to find to deliver additional opportunities. And yes, I’m optimistic that there’s additional opportunity in Bern.

John Heinbockel - Guggenheim Securities

Okay. Thank you.

Greg Wasson

Thanks, John.

Operator

Our next question comes from Meredith Adler with Barclays.

Meredith Adler - Barclays Capital

Good morning, this is Meredith Adler and I’ve got questions from Eric Percher as well. I guess I would like to start by asking about talking with payers about the fact that you have generic inflation. How much work do you have to do to change the terms of the contracts? I mean if it was branded drugs, I think the inflation would be dealt with automatically but not so with generics. What kind of discussions are you having and how hard do you think it will be to get this adjusted?

Wade Miquelon

Well, I’d say that it's a fairly complex topic, but there’s lots of different levers. One is, I think that we’re going to be -- we’re not going to be very tolerant of long-term partnership with people that are opportunistic. I think number two is, we do have contracts which over time need to reflect the market, but then there’s also indexes that those contracts are based on and some of those are sometimes maybe late in reflecting the realities of the market place, but over time we believe that those will catch up as well and therefore that will flow through. So, there are many different levers to go at it and we’re working all of them. But I do think that it will roll through as we go through. So, I don’t know Kermit, if you want to comment on it.

Kermit Crawford

Yes, Meredith maybe I’d add to that, that sort of this past year we have seen a shift from historical patterns of deflation in the generic drug cost which we have planned for into one that is inflation and it is negatively impacting our margin. But I wouldn’t say it's all around the drug inflation. I mean we’ve certainly had some increase in our third party reimbursement pressures. We have had fewer brand-to-generic drug conversions compared to a year ago. And so as we think about our contracting strategy it certainly will account for these increases in the drug cost. But there are other things we’re doing as well. Greg had mentioned we’re aggressively looking at our cost of fill around improving efficiencies in our cost of fill sometimes like technology where our customers are refilling their prescriptions through digital and mobile technology, through automation that is making us more efficient in selling prescriptions, through centralization that is reducing labor in the stores but as the same time increasing our customer service level. And I also do believe that our joint venture with Alliance Boots, we’re well positioned to provide some offset to this increase in drug pricing. So, I think over time you’ll see the market adjust through market efficiencies, through supply and demand.

Meredith Adler - Barclays Capital

And then, I guess I have a question, I mean I would have said that some of these pressures have been there for a while. Was there’s something in particular that really made you feel that you needed to start addressing both aspects of cost structure, the way you fill scripts and becoming more efficient. Is there something particular that drove that now?

Greg Wasson

Yes, Meredith as I would say, I am three-bucket for a person. I would say that we have, bucket one, we have made strategic decisions that I believe are absolutely the right thing for the company to do long-term which is to grow our share of high value senior patients with preferred positions already planned, convert 30 day supply of the chronic medications to 90 days, those, that’s helping us win share, but it's also impacting margin as those preferred positions have a little more aggressive rates with them and obviously 90 day supplies a little more -- have little less margin of 30 day fill. So bucket two would be there are reimbursement pressures that are on going step down to some of the contracts year-over-year, but there’s also consolidation going on in the industry and there’s been some signification step downs in consolidation. And third would be in fact as Kermit alluded to, we are seeing inflation versus deflation in some of those contracts we’ll have to make up for. So I think with that all those together, as I said we’ve got to get at one trying to make sure that we account for that both in our purchasing of Bern, our contracting with payers, but the same time get after a cost structure to offset. But I do think the opportunity for us to continue to grow share and win in the senior market is encouraging because we’re starting to see real growth.

Meredith Adler - Barclays Capital

Okay. And then I guess just a final question on expenses. How, the -- some of what you sounded like you’re going to do is going to be taking cost out of the operations and how you run the stores, and I’d assume some of it is just more looking at the overhead structure. How much opportunity do you think there is in either place to lower -- generally lower cost?

Greg Wasson

Yes, I think we still have opportunity in both, and again I think it's looking at how we support stores, the businesses we have, the projects we have, the way we run projects, so forth in corporate. So all of the above we have opportunity. I don’t know Wade if you want to add anything?

Wade Miquelon

No, I think that the way we’re going at it is to really look closely across the major processes that drive cost versus in silos or in small buckets and I think that I guess one of the examples currently it's just the entire cost of fill process and how we think about in 90 day and how we think about ePrescribe and how we think about working with payers differently to drive really radical improvements in those processes and therefore cost. So I think there’s a lot of opportunity in both, but I think that it's looking at it more systemically going after the big prices, the way we’re going to get the bit cost out, Kermit.

Kermit Crawford

Mark, Alex anybody want to add. Mark.

Mark Wagner

Yes, Meredith this is Mark. I think we -- part of like looking at the cost structure was what I talked about on the last quarter call was the store optimization and shutting down some of the unprofitable stores or stores that weren’t really strategically positioned. But there’s a lot of opportunity dealing with any operation of the store in terms of one, making the right investments in the stores in terms of labor, but then pulling out where it doesn’t make sense. I think there’s other ways to manage the cost that’s on a property side that the team is taking a look at and have really engineered through the stuff, through the last six months into the stores. I think that there is always opportunity to reexamine the cost structure and to pull out what's not necessary or to reestablish what really adds value and not.

Meredith Adler - Barclays Capital

Okay, that’s all very helpful. Thank you. I wish you guys luck.

Greg Wasson

Thanks, Meredith.

Operator

The next question comes from Ricky Goldwasser with Morgan Stanley.

Ricky Goldwasser - Morgan Stanley

Yes, hi good morning and thank you for taking my question. Greg, there's a lot of discussion around inversions especially in the healthcare world. In couple of times on this call both you and Wade highlighted the below-the-line benefits, so can you just give us a sense of what kind of like is your most updated perspective on the prospect of inversion?

Greg Wasson

Yes, Ricky I think as I said we’re certainly analyzing all the moving parts that will lead us to certainly our decision on the timing the structure of step 2 and so it's difficult to kind of break those apart and talk more of a piecemeal. I'll say as we had said that we’re looking at all and everything. We’re looking at everything from what the timing, best timing would be, what the capital structure should be, what our tax structure or what the structure could do to as far as our effective tax rate. So, and that’s complex stuff I guess is what I would say Ricky as we work through this. We are working around the clock to try to understand all the above so that we’re able to make the right decision for the company. And again that’s why we need a little more time to be able to bring all this together. But I would say that we’re looking at everything. It is complex and it's all interdependent and that’s why we want to come forth with a call where we can give as much as we possibly can at late July early August.

Ricky Goldwasser - Morgan Stanley

Okay. And then I mean obviously the -- on the expense side and kind of like the margins, trends have been sluggish for some time now. I guess the question is, have you kind of like not been as, I would say proactive about kind of like, and I know you have done some but maybe you have not been as proactive as you could about managing the margin, because you are kind of like looking now at the combination and looking at things and doing holistic, it's kind of like trying to understand what could have been done already versus kind of like the opportunity going forward.

Greg Wasson

Yes, Ricky I’ll start off maybe my peers can weigh in. I would say that historically we’ve done I think an admirable job on controlling on SG&A into your stack. Now with that said, we need to do more. And I also think that frankly we have cut a lot in the last six months to a year unfortunately some of that’s got absorbed in the increased pharmacy margin pressure that we’ve seen. With that said, we’re continuing to identify additional opportunity. So, I wouldn’t want you to read into the fact that we have not been getting after it. Now with that said, we also think that as we look at the current Walgreen business and opportunities in addition with the merger of the two that there are going to be even greater opportunities in different ways of looking at that. So, we’re absolutely focused on the core business. We have made significant reductions, some of that’s been absorbed as I said because the pressure of the margin we’re identifying additional opportunities and we’re going to combine those with every other opportunities we have at Step 2.

Ricky Goldwasser - Morgan Stanley

Okay. And one final one because you did mention the re-pricing and then to Meredith -- just to follow-up on Meredith's question, can you remind us when is your contract with Express Scripts is up for renewal?

Greg Wasson

We don’t give that out. They were both to multi-year contract Ricky, but we don’t -- and the reason is, for competitive reasons we don’t -- obviously we don’t want to be disadvantaged.

Ricky Goldwasser - Morgan Stanley

Okay. Understood. Thank you.

Greg Wasson

Thanks, Ricky.

Operator

Our next question comes from Steven Valiquette with UBS.

Steven Valiquette - UBS Securities LLC

Yes, that color on the complex issue, I think it’s definitely helpful for people. So, I will just leave that alone. But I guess, Greg, since you mentioned you are a three-bucket guy, I guess just a quick three-bucket question for you on the gross margins. Since you did mention the pharmacy reimbursement pressure, the generic price inflation and fewer launches, just curious which of those buckets had the biggest impact in the quarter? And then also just to be clear, did the generic price inflation in particular did that definitely increase in the May quarter specifically versus the trends you saw back in the February quarter? So, I definitely want to hone in on that generic price inflation specifically.

Greg Wasson

Yes. Thanks Steve for putting in three buckets for me. Yes, I think and I’ll let Kermit maybe weigh in. I think certainly generic inflation kind of runs through a lot of this, and meaning that it shows up in the contracts obviously we’re -- certainly we were thinking about the deflation and now seeing some inflation. We’re also just -- obviously just playing cogs. We’re certainly doing everything we can do at Bern to offset that. But I think in the order of magnitude I think probably generic inflation is specifically more -- probably more important because it was -- we didn’t quite anticipate it. A lot of the other strategic decisions we certainly anticipated. We know exactly what our contract arrangements with some of the commercial plans are. We know what our Part D preferred positions cost this as far as gross margin. This was really kind of snuck up I think on the industry and us, and now I do think as I said I don’t -- I can’t think of anyone that’s better positioned than us to offset this because of what we’re doing at Bern. But I would say inflation. Kermit, you want to add.

Kermit Crawford

Steve, I would add that generic inflation was higher than we expected compared to the normal deflation that we planned for and we saw the full impact of that in the third quarter versus the second quarter. But I’d also add our growing 90 day share and our market share of Medicare Part D. I mean both of those as Greg mentioned earlier we are growing market share. Both of those margins have been hurt in the near term. Because of that and the expectation in both 90 day and in our mix of the Medicare Part D is greater than we had anticipated this quarter. So, I think when you look at a combination of the impact of our reimbursement pressure we’ve not been able to fully offset that due to a lack of new generics as well as the generic inflation versus deflation.

Steven Valiquette - UBS Securities LLC

Okay, got it. Okay. Thanks.

Operator

Our next question comes from David Larsen with Leerink.

David Larsen - Leerink Swann & Company

Hi. With respect to the reimbursement pressure, aren't the generic rates typically set at a max price, and aren't those fixed so that the pressure is really the cost of the generic at the higher inflated rate and the difference between that and the fixed mac price or do those prices actually shift around or are they fixed? Thanks.

Greg Wasson

So, every contract is different. But you’re right, it's kind of a general abstraction that’s more or less true, but the thing is that I guess the key thing I alluded to earlier is that the indexes that those are based on don’t always immediately reflect the changes in that inflation, and so that’s the disconnect. But again I think we’re working this from many different angles.

David Larsen - Leerink Swann & Company

Okay, great. And then, how were volumes relative to your own expectations? Did you see any flow from newly enrolled members through the public exchanges?

Greg Wasson

David, it's still very early to tail around ACA. I mean obviously publicly they have announced 8 million people have joined the ACA. We certainly feel like we’re getting our share of that 8 million people, but certainly some of those folks were former cash paying customers that are now in the exchange. They were former customers at other forms of coverage that are now in the exchange. So, I think it's still early on around ACA where we’re seeing growth in our core business. I mean Wade talked about gaining back customers from our ESI customers. But primarily when we look at this business our core business Med D 90-day return of ESI, low ACA is all growing our underlying business.

Wade Miquelon

Yes, I guess I just would say across the board both in the front end and the pharmacy I think we’ve got real growth momentum. And I think what's also encouraging is that our customer satisfaction metrics continue to strengthen. That’s very fundamental and important for the long-term.

David Larsen - Leerink Swann & Company

Great. And then just one more quick one; any thoughts around specialty, is that a positive driver or longer term and any impact from Hep-C? Thanks.

Greg Wasson

Yes, it's certainly a positive driver long-term. David, as you know it does impact the margin. Wade mentioned earlier in our speech and, but we’re seeing positive growth in our specialty business.

Wade Miquelon

I think one of the things David that we’re excited about and again I think it's the work that Jeff Berkowitz and team in Bern are doing combined with Mike Ellis and Kermit’s group that’s running our specialty group there with a central and retail model. We’re gaining access to limited distribution drugs. In fact, I think we’ve gained access to every one of the last 14 or 15 launches of limited distribution drugs. I think that’s reflective of the fact the good work that Jeff and team are doing with our pharma partners who are looking for special services as well as what Kermit and team are doing with the services we provide both centrally and at retail. So to me that’s a solid proof of point that we are making progress and winning in specialty space.

David Larsen - Leerink Swann & Company

Thanks very much.

Wade Miquelon

Yes.

Operator

Our next question comes from Robert Jones with Goldman Sachs.

Robert Jones - Goldman Sachs

Not to keep going back to this topic, but just on the gross profit margin in the quarter, I guess what the concern is in the last couple of quarters is you guys are pacing very nicely on the procurement synergies. If I look at this quarter it looks like $89 million to Walgreen’s. But if I back that out assuming most of that is clearly from purchasing the gross margin rate looked like it was somewhere in the 27% to 28% range, clearly below where I think the company has been historically. Could you maybe just give us a little bit of context relative to history of where these pressures are and is it something that is more transient in such that as we move past them we will start to really realize the benefit of the procurement synergies?

Wade Miquelon

Yes, I’ll just take it. I mean look, there are some conscious choices we made as Greg said. So for example, driving 90 day and also being aggressive about Part D, and I think those are the kind of opportunities though based upon how they are set up structurally and the volume over time that we can cost optimize on the other side to make sure that it's beneficial and accretive. But that’s a conscious choice. I think there’s things that we will cycle. So for example as I talked about just the pace of new generics and the timing of that and we’ve been very explicit with that, but I do think there’s just and there are some new things. And we also have contractual step downs but of course there’s things like brand inflation and generics and whatever that compensate. I think the real thing that’s probably different is what we’ve seen in the inflation generics and how we handle that. But at the end of the day I guess what I would say and as an aggregate we’re focused on gross dollar -- gross profit dollar growth. And again both those choices are what we can control, and then what in the short-term we can’t. But over the long-term we have to address. That’s really I think the focus and in terms of how we drive the business.

Robert Jones - Goldman Sachs

So I guess just to be clear, that you wouldn't characterize any of these pressures as some kind of structural change in the business that you didn't contemplate say a year and a half, two years ago when you embarked on the AB transaction?

Wade Miquelon

I think the thing that -- I think Greg said that the thing that probably wasn’t fully anticipated probably was just what we’ve seen in some inflation on drugs, and it's a fairly narrow subset but some pretty hefty increases. And those contracts historically have been under the assumption that there is net deflation. But like I said I think there’s many ways that we can attack this, and I can assure you that we’re going after it from all angles. And I do think though that again I think that if we can drive market share growth, if we can drive better customer satisfaction, if we can optimize our cost accordingly, and if we can tack this issue on all fronts I think we’re as well positioned as anybody to be successful.

Robert Jones - Goldman Sachs

Got it. And I guess just my follow-up changing subjects a bit, just around ABC obviously now being part of the purchasing platform, it sounds like you’re getting the incremental benefit from their volume. Are you looking at opportunities of bringing any of other companies into the joint venture to further enhance that scale? Are there ongoing conversations that you could highlight in the marketplace?

Wade Miquelon

Yes, I think certainly right now we’re focused on maximize and optimize, I mean the synergies that we can achieve through the three of us with AB and ABC, and I think there’s tremendous opportunity there to continue to realize before we’d begin to really discuss maybe other partners.

Robert Jones - Goldman Sachs

Got it. All right. Thanks.

Wade Miquelon

Yes. Thank you.

Operator

Our next question comes from Lisa Gill with JPMorgan.

Lisa Gill - JPMorgan

Thanks very much and good morning. Greg, I heard you made a comment around regaining or Wade made the comment around regaining some scripts for Express Scripts. And you talked about 90 day as well on the growth of that. Are you seeing the scripts that you are regaining are through the Smart90 Program? Can you maybe just update us on how that program has gone thus far with Express Scripts?

Greg Wasson

Yes, maybe I’ll start and let Kermit jump in. When I’m talking about the growth in 90 day, Lisa it's 90 day in general across the entire market place which excites me because I think as I said we launched it, we realized it was going to impact margin because of the fills, but at the same time we have seen male level off, we have seen customers who want to get 90 day supplies. There are few many pharmacists that continue to grow, so therefore I think it was absolutely the right thing for us to do for the consumer. Smart90 is a subset of that, and I do think we have been working with Express Scripts customer-by-customer somewhat unique. Those that are looking for a Smart90 solution is, the good thing is Express Scripts has an opportunity to present that. And Kermit, I think we’ve been pretty pleased with that.

Kermit Crawford

When you compare to that, that Smart90 is just hitting the market now and right now it wouldn’t be a significant contributor to our overall 90 day retail. I mean, a lot of the 90 day retail has been driven by the increase in market share of our preferred networks under Medicare Part D.

Lisa Gill - JPMorgan

Okay, great. And I know you have already talked a lot about the reimbursement buckets, etc. and around generics, but the one thing that I am still a little bit confused about is just you should be one of the largest global generic purchasers. Is it that the timing of Bern hasn't kicked in yet? Because I am just, if we go back and we look at Rite Aid last week, they talked about the fact that their relationship with Tussin hasn't kicked in yet and therefore that's why they’re feeling this pressure. Given the fact that you’re already starting to see some of the synergies I’m just trying to understand what’s happening around procurement and the timing aspect of how you are buying from Bern?

Greg Wasson

Yes. Lisa, I wouldn’t say that it’s been delayed. I think Bern, we’re pleased with and we’re out of the gates pretty quickly and on track. I think it’s a subset of molecules that have kind of popped up in this inflationary environment that we’re -- that caught I think the entire industry a little off guar. I’d say ourselves as well. We’re now all over with the combined Walgreen team with Bern team focused on those molecules. I do think that and there is a lot of moving parts there as Wade alluded to earlier, that the cost increase, the -- the corresponding AWP is not keeping up with the cost increases. There is a whole lot of things that we’re looking at. But I will say back to kind of the structural issue, I think the good thing is we’re aware of it, we’re on it. We know how to go at it and we -- and I think we’re well positioned as anyone to get after. But it did -- it was something that we didn’t expect. We are working through it and I think we’re well positioned to cover it and correct for it.

Lisa Gill - JPMorgan

And as we talked about gross margins, it sounds like most of this was on the healthcare pharmacy side in the quarter, but I was just wondering if Mark or Alex had any comments around promotional activity and what you’re seeing on that side of your retail business?

Alex Gourlay

Yes. Hi, its Alec here Lisa. We are feeling pretty good about progress in the front-end margin. We increased it quarter-on-quarter through more promotional efficiencies, really making sure that we reward our best customers are using the data from the Loyalty Card. So some of that is promotional market that would be more efficient and more targeted and we’re feeling pretty confident we can keep that going into the long-term.

Lisa Gill - JPMorgan

Okay, great. Thank you.

Operator

Our last question comes from Edward Kelly with Credit Suisse.

Edward Kelly - Credit Suisse

Hi. I wanted to start off with Alliance Boots. We did get results out of Alliance Boots more recently and I was hoping, could you just provide a little bit color on their performance, how they’re faring versus relative to what you thought and how much of the shortfall to EBIT in ’16 is the Walgreens business versus the Alliance Boots business, any color there I think would be helpful?

Greg Wasson

Maybe I’ll start Ed, and let Wade fill in. I think obviously still a challenging environment in some of the countries throughout Europe. I think as I’ve said, Stefano and his team pretty solid team, they’re managing through that. I think -- but they’re indeed had some challenges in some areas of the business. I do think when you look at their business compared to the markets whether it’s the retail business, boots business or the wholesale business and compare them to the market, to their competitors. They’re actually winning against the rest of the market and therefore that’s encouraging, they’re growing share. But as we’ve had some softness in parts of our business that we’re correcting for, they’ve had softness in parts of their business that they’re working to correct for.

Wade Miquelon

I think -- I guess I would just augment it and say I think they’ve also done some great work below the line, so both in terms of some of the tax efficiency work they’ve done in terms of driving very aggressive cash flow which has helped them to lever and as you know they refinanced a while back. Also we have a strong pound situation, which is also very favorable too, so I think on that we feel very good about their business and again they’ve a couple of challenging markets they’re in, but they’re positioned well for the long-term and I think on a cash flow base and after tax basis, the business had made up a lot of ground there. So we feel good.

Greg Wasson

And then I do think as we’ve said, certainly we weren’t on hitting the CAGR, to hit our adjusted earnings we had and their CAGR -- their EBIT CAGR has not been -- is below their original plan, but they’re doing a lot of things to try to offset that and correct for it.

Edward Kelly - Credit Suisse

And just one follow-up on your 2016 commentary. Are you optimistic that the below-the-line considerations may potentially offset the shortfall on the EBIT or even more than offset the shortfall on the EBIT as you sort of think about 2016?

Greg Wasson

Hey Ed, I will jump and let Wade -- I would be -- I’m hesitant to go there. I think as I said, we just had too many moving parts right now that we’re working through. There is potential obviously and that’s what we’re looking through from all of those how they come together. But I think give us the four to six weeks and we will be able to give -- we have a lot more clarity on how this is coming together and be able to give you a lot more information at that time.

Wade Miquelon

And there is lot opportunity, but I think the key is making the right choice, so they all interplay with each other for the best long-term value creation for shareholders and we’re looking at everything.

Edward Kelly - Credit Suisse

Okay, great. Thank you.

Greg Wasson

Thanks, Ed.

Rick Hans

Ladies and gentlemen that was our final question. Thank you for joining us today. As a reminder, the Company will report June sales on July 3rd. Have a Happy 4th of July. Until then, thank you for listening.

Operator

Ladies and gentlemen, this does conclude today’s presentation. You may now disconnect and have a wonderful day.

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Source: Walgreen's (WAG) CEO Greg Wasson on Q3 2014 Results - Earnings Call Transcript
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