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Executives

Hélène Bisson - Director, Public Relations

François Coutu - President and CEO

André Belzile - SVP, Finance

Analysts

Derek Dley - Canaccord Genuity

Michael Van Aelst - TD Securities

David Hartley - Credit Suisse

Irene Nattel - RBC Capital Markets

Chris Lee - Bank of America Merrill Lynch

Keith Howlett - Desjardin Securities

Vishal Shreedhar - National Bank

The Jean Coutu Group PJC (OTCPK:JCOUF) Q1 2015 Earnings Conference Call July 8, 2014 8:30 AM ET

Operator

Good morning, ladies and gentlemen. Welcome to The Jean Coutu Group's First Quarter Fiscal 2015 Conference Call. Please be advised that this call is being recorded. I would now like to turn the meeting over to Ms. Hélène Bisson. Please go ahead, Ms. Bisson.

Hélène Bisson

Good morning, everyone. The Q1 earnings release was put on the wire earlier this morning and was posted on The Jean Coutu Group's corporate Web site. The quarterly press release is accompanied by additional financial information, and we will refer to the quarterly results slide presentation and MD&A during this call. The press release and MD&A are also available on SEDAR.

Here with me today are François Coutu, President and CEO; and Mr. André Belzile, Senior VP, Finance and Corporate Affairs. Mr. Coutu will discuss Company's results and key operating highlights and Mr. Belzile will then cover few financial results. This will be followed by a question-and-answer period for analysts only. I would ask you to limit yourselves to only one question at a time so as to allow us time to address as many different analyst questions as possible. The media are invited to contact me for comments or interview purposes. We would like to remind you that the Company's forward-looking statement disclaimer applies to all our communications.

Now, Mr. Coutu will begin our presentation.

François Coutu

Thank you, Hélène. Good morning everyone. Hope you are having a good start with the 2014 summer. So let’s look at our results. During the first quarter, network sales increased by 0.8% to $1.02 billion, while The Jean Coutu Group's consolidated sales were up by 0.9% at $619.6 million.

As shown on the first table, network pharmacy sales increased by 0.9%, while distribution center pharmacy sales were up by 0.8%. Obviously the introduction of new generic drugs reduced retail pharmacy sales growth by 1.1% in the last quarter and price reductions of generic drugs reduced by another 1.2%. Without these deflation factors, network pharmacy sales growth would have been 3.2% in the last quarter.

Furthermore the generic penetrations rate increased by 1.8% to reach 67.8% in the last quarter thus impacting pharmacy sales. This increase can be explained not only by the new generic drugs coming to market but also by increased dispensing in these pills which have higher generics content than a regular prescription and more mandatory generic formularies from both public and private payers. Note that the deflationary impact of new generic drugs and reduced prices is more important for the distribution center pharmacy sales as the dispensing fee earned by our pharmacist owners is a significant portion of the price of a prescription at retail. Network front-end sales showed an increase of 0.3% while distribution center front-end sales grew by 1.6%.

Turning to the next slide, we see that operating income before depreciation and amortization increased by 0.2% this quarter to $82 million, in spite of the deflationary impact on pharmacy sales of a strong penetration of generic drugs. Last quarter results were impacted by an increase of $1.4 million in the share-based instruments expense following the growth of the Corporation’s share market price.

Gross sales of ProDoc, net of intersegment eliminations amounted to $48.3 million in the quarter compared to $45.7 million for the same period last year. Net profit before gains related to the investment in Rite Aid amounted to $54.1 million or $0.29 per share during the quarter ended May 31, 2014 compared with $54.2 million or $0.26 per share last year.

The following slide shows the quarterly same-store sales growth for the PJC network. On a same-store basis network pharmacy sales increased by 0.3% during the first quarter of fiscal 2015 over the comparable quarter while prescriptions count grew by 3.7% year-over-year. Once again, keep in mind that combined with a 67.8 generics penetration rate, introduction of new generic drugs and price decreases reduce pharmacy’s retail sales growth. Also on a same-store basis front-end sales decreased by 0.5% year-over-year, and overall network sales increased by 0.1% during the past quarter on the same basis.

During the first quarter we launched various dynamic promotions including two Passion for Beauty Magazines in March and May. We also launched, as you see on Slide 7 a new exclusive line of beauty products, Jouviance Makeup, with the popular TV Star Véronique Cloutier as the spokesperson. Other promotions like an interesting booklet of coupons were part of our marketing initiatives during the quarter. All these promotions were largely advertised on television, radio and our circular, and through social media.

We are also very pleased to report that The Jean Coutu Group was ranked as the second best brand in Canada according to the 2014 survey done by Canadian Business magazine and the Reputation Institute. This preferred position in the market is an improvement of three positions from our fifth rank last year. Moreover, Jean Coutu was ranked fifth favorite brand in the world by Canadians in the same survey as compared to 32nd last year.

On the real-estate front, we opened one store in Beauport near Quebec City and we relocated one store in Mont-Laurier. On Slide 8, you can see photos of the new drug stores. Six significant store expansion or renovation projects were completed during the quarter. There are another 36 projects underway.

During the first quarter we launched an important advertising campaign in New Brunswick to promote vaccination and medication review for those who take three medications or more. Also we were the official presenter of the popular Parents and Kids Fair held in Montreal and Quebec City in April and May promoting our various services and exclusive products. More than 50,000 persons visited the fair.

Thank you. Now let’s take a look at the financial review by André.

André Belzile

Thank you, François and good morning everyone. The table shown on Slide 12 reconciles operating income before depreciation and amortization to net profit. Income taxes amounted to $20.2 million in both the first quarter of fiscal 2015 and fiscal 2014. Earnings are subject to a 26.9% tax rate in the 2015 fiscal year again, and there was no significant item affecting the effective tax rate in the first quarter.

Depreciation and amortization charges amounted to $8 million during the first quarter of fiscal 2015 and the same amount was recorded last year. First quarter fiscal 2015 OIBA increased slightly to $82 million compared to $81.8 million in the comparable quarter of fiscal 2014. As mentioned earlier, last quarter results were impacted by an increase of $1.4 million in the share based instruments expense following the growth of the Corporation’s share market price. Also a publicity expense of $1 million for an annual event with our franchisees was incurred in last quarter while the same amount was recorded in the second quarter last year. Excluding these two items OIBA would have grown by 3.2% in the first quarter.

You also have a summary of our statements of financial position on the following slide. There was no bank debt used at quarter end and we have $116.4 million of cash on hand. The book value of total equity amounted to $968 million, compared to $932.1 million at the end of the previous fiscal year. The Company’s financial position is still excellent with no debt and strong and predictable cash flows.

On Slide 14, you can see that the cash flow related to operating activities amounted to $72.8 million during the first quarter of fiscal 2015. Cash flow used in investing activities was $12.3 million during the last quarter, including $8.7 million used for the construction and acquisition of store related capital assets and $1.2 million invested in intangible assets. Total selling square footage were 3,113,000 square feet at the end of the last quarter compared to 3,046,000 square feet at the end of the same quarter in the previous fiscal year. The Corporation did not purchase any Class A shares under its normal course issuer bid during the last quarter.

The last slide shows the contribution from our generic drugs manufacturing subsidiary and our consolidated results. Despite the deflationary impact on gross sales of the price reductions of generic drugs, volume increases allowed product to maintain strong results. Generic drugs penetration rate in the network was 67.8% of scripts dispensed in the last quarter compared to 66% for the same quarter of the previous fiscal year.

That concludes our presentation on the first quarter of fiscal 2015 results. I would now ask the operator to open the questions period.

Question-and-Answer Session

Operator

Thank you very much. (Operator Instructions) The first question is from Derek Dley from Canaccord Genuity. Please go ahead.

Derek Dley - Canaccord Genuity

Just wondering if you guys could give us an update on the smaller store initiative and how that’s been rolling out so far?

François Coutu

Yes. On the acquisition front we’re obviously very active. We have four projects that are being this time negotiated and two of each we have reached an agreement. And there are more than 12 projects that we are studying now. So it’s getting slowly but surely in the right direction.

Derek Dley - Canaccord Genuity

And can you describe the environment on the front-end and your same-store sales were a little bit soft. Was that a combination of both traffic and mix or how did that sort of shake out during the quarter?

François Coutu

Yes, that’s a good question. The first quarter is always based on three major things. First of all on the front side you have the seasonal aspect to it. And most of the time the first quarter you have Easter and then you have the summer items, who try to pick up. On the summer items, I don’t know if it was the same throughout Canada but here it was a miserable summer beginning and suntan lotion for example are down 11.8% in that first quarter but fortunately it looks like the summer is back and we’ll pick it up later on, early this month as well. And the Easter; Easter usually in April, early April and we had an exceptional Easter this year. So that tells you that for seasonal items and products like this, Jean Coutu is still a very good destination. So we are not losing any customers.

On the OTC front, so that’s the back of the store, first quarter is a negation whether allergy season will be good or not and this year we‘re 17% down just for the allergy. Good for the people. We love to see them and to hear from them that they are healthy and not suffering from the allergy. But for us on the traffic side, it definitely does not generate as much traffic when the allergy season is low, like it is this year. So that gives you a good indication where the first quarter is. It’s not excuses. I think it is just explanation of facts.

Operator

Thank you. The next question is from Michael Van Aelst from TD Securities. Please go ahead.

Michael Van Aelst - TD Securities

I’d like a little bit more color on ProDoc if you could. You have talked for a while about margins long-term being closer to 40% but going up in part because you pre-negotiated some new sourcing contracts. But at 47% margin now, how long can EBITDA dollars continue to increase at a much faster pace than revenues at ProDoc?

André Belzile

Yes, first of all margins in dollars grow not only because of the gross margin as a percentage but also because of volume increases. But on the margins themselves, keep in mind that we have on average about five months’ worth of inventory for the different molecules of product here at the warehouse. So before we benefited from the full impact of the gains we got from our sub-contractors in the cost of the drugs that are actually being sold, it took some time. And so we probably reached a peak at this point. You may see in the following quarters a slight decline in these margins depending again on the impact of the announced price decreases on additional three molecules by the coalition of Canadian provinces that you probably reflected in your own model. But again keep in mind that in terms of cost for us, before these costs reduction are reflected in our margins we have to first of all get rid of the five months of inventory we had at the whole cost first in.

Michael Van Aelst - TD Securities

It doesn’t seem like the price changes next for generics is going to be material enough to put a significant dent in that 47% margin. Is this pre-negotiation? Was that reflecting what you thought was going to happen over the next several years?

André Belzile

You mean for the price gains we negotiated last year?

Michael Van Aelst - TD Securities

Yes.

André Belzile

Yes, it was not only for the impact of the price reduction of this year but more for the next two, three years. So we’ll see if at the end, we underestimated the impact of those price reductions at retail then we may sit back with our suppliers. But currently this is not something we expect to add to do at this point.

Michael Van Aelst - TD Securities

And then on the operating expense front, it was up over 9% and if I back out that share expense that you talked about, it is still up over 7% despite your square footage growth being up just over 2%. So, what’s the main, you can see that all the categories, wages are up significantly, the operating leases are up and your other goods and services are also up meaningfully. So, can you talk about a bit of the drivers, why those numbers are growing as much as they are?

André Belzile

Yes, as you say the SG&A increased by $6.2 million in the quarter, $2.4 million we explained over this call. First $1.4 million increase in the share based expense -- share based instrument expense as mentioned earlier. Also the timing issue with the annual events with our franchise which normally is anchored in the second quarter, so we’ll gain back that in the following quarter. This was another 1 million.

On top of this, again as you mentioned yourself, rental expense did go up by about 1 million. But keep in mind that we have the same increase in other revenues for rental income. So SG&A looks like it’s increasing, but actually the related revenue is growing by the same degree. And then we had the normal growth in terms of salaries excluding again the share-based instruments, which are part of the salary expense and SG&A, normal salary increase as negotiated per hour labor agreement with the distribution center employees. And even though again prices go down and we don’t look at significant growth in terms of sales for prescriptions because of the pricing and type of the deflation impact, we are still handling more prescription, as you know, more drugs are being distributed, so more hours to handle them at the distribution center. So the increase in salary excluding the share-based instrument again has been a normal increase.

And on top of that lastly, there was a slight increase also in the support that we provide to our franchisees that are in a start-up situation with the new stores. As you know, it takes some years at the beginning when you open a Greenfield store before it reach to breakeven point.

Operator

Thank you. The next question is from David Hartley from Credit Suisse. Please go ahead.

David Hartley - Credit Suisse

Just curious again about the balance sheet, some cash on there, no debt on there. Any thoughts on plans to use the balance sheet for any purpose?

André Belzile

As mentioned in the past, we would rather reinvest that money in the business to grow. But we have currently, as you know, a large project which is the construction of a new distribution center and headquarter what will eat up a portion of these liquidities. But otherwise at some point as we’ve mentioned in the past, the Board of Directors of the Company will have to sit down and assess what they want to do with these liquidities. But currently there is no more discussion on this.

David Hartley - Credit Suisse

And I don’t believe you bought back any shares in the quarter, any reason?

André Belzile

Yeah, we didn’t. As you know, the share price went up quite substantially from around $18 back in January or February to as high as to $24. So we wanted to let the dust settle a bit to see where it would land. Not being too much active to let the market assess where it should be before being more aggressive. So we’ll see currently trading more around slightly over $22, where we’ll see what we’ll do. But the goal is still to buyback the full program over the next 12 months. But obviously, we want to be prudent when there is high volatility in the stock price.

David Hartley - Credit Suisse

Just on the CapEx for the year, what is your planned spend?

André Belzile

We published that in the previous quarter. I don’t have the numbers in front of me, I can forward that to you Jim again but that has been published actually in the previous press release on the fourth quarter results announcement.

Operator

Thank you. The next question is from Irene Nattel from RBC Capital Markets. Please go ahead.

Irene Nattel - RBC Capital Markets

I was just thinking about the competitive environment. We typically tend to focus on shoppers or on the grocery stores the mass. But we’re starting to see some of the smaller players; Proxim seems to be extending its reach, some new stores opening from the Uniprix, Familiprix, Essaim Group. I am just wondering what you are seeing in terms of perhaps a little bit of incremental competition coming from those guys?

François Coutu

Yes, Irene. I think you are right. You cannot pin point what competition is against Jean Coutu. I think it’s a wide array of situations, it could be in smaller communities like you say, it could be a Familiprix or Proxim or Uniprix opening up and it has an impact on our sales or so but slightly. But I think overall, I think with the fact that everyone, all the competitors all included, decided that they want to give more value to the customers, to their customers and we are seeing obviously more aggressive promotions out there from everyone. So that also has an impact overall. But imagine if they are aggressive, we are also at Jean Coutu and we’re holding very nicely, if not better.

Irene Nattel - RBC Capital Markets

And then just on seasonal. With [indiscernible] come and with the allergy season and presumably sales of things certain things like suntan lotions. So, just wondering how much of that Q1 shortfall you’re seeing coming back into the fall in really Q2?

François Coutu

Yes. That is something that it won’t recoup, because of say allergy season. At times, June is usually it’s not as strong as in May for example. But you’re right, we had a much better June and early July so obviously it’s back.

Operator

Thank you. The next question is from Chris Lee from Bank of America Merrill Lynch. Please go ahead.

Chris Lee - Bank of America Merrill Lynch

Just wondering if you can please comment on the gap between the front store retail sales growth of 0.3% versus your distribution front store end sales was up 1.6%. And I think that type of gap was also present in sort of last couple of quarters. Is that just merely a function of what you mentioned earlier about the weaker seasonal product sales or do we expect that gap to narrow in the future quarters?

François Coutu

We’ve introduced a lot of new products here at The Jean Coutu Distribution Center, especially in the private label brand. And this is to compete with some of the Dollar Stores and some of them we’ve given to the consumers a better selection, imports and so on. And that’s why we’ve increased our sales at distribution center a little bit more than the sales that were done in our stores. But it should stabilize over the next quarter.

Chris Lee - Bank of America Merrill Lynch

And you mentioned about private label, what is your current penetration on private label on the front-end?

François Coutu

It grew up to 12.5% now.

Chris Lee - Bank of America Merrill Lynch

Okay.

François Coutu

We will confirm that right away.

Chris Lee - Bank of America Merrill Lynch

And do you do a lot of sourcing from China?

François Coutu

We do, actually especially in the seasonal category where you don’t find anything like this here in Canada. We do have a direct relationship with suppliers and manufacturers in China.

Chris Lee - Bank of America Merrill Lynch

Okay. And then as you know like with the new import duties happening next year, would that be a material impact on your business?

François Coutu

You know what, we’ve done our negotiation. I think we’re still being able to buy at a very competitive price. And they include a little bit of inflation there obviously, but still overall the quality and the value that we give the consumers with some of the imports are just tremendous. And we will keep forward the dynamic in that field.

Chris Lee - Bank of America Merrill Lynch

Sorry my last question is; are you hearing any sort of new developments on the drug reforms firm with the new government in Quebec. Has there been any communication from the ministry in terms of what they are thinking about sort of the future is in the pharmacy industry?

François Coutu

You’re right; we just have a new government, still young. They haven’t had any indications as to whether they will either go ahead with the 41 Act there that gives additional responsibilities to pharmacists and we’re still waiting on this. And for the rest it’s quite calm.

Operator

Thank you. The next question is from Keith Howlett from Desjardin Securities. Please go ahead.

Keith Howlett - Desjardin Securities

Yes. I was wondering on your new distribution and head office in Varennes. If you could just outline when it’s completed, sort of what capacity you’ll have there or what additional advantages you’ll have over the existing facility?

François Coutu

Obviously we did the first ground breaking there a couple of weeks ago and obviously it’s up and running very dynamically in Varennes. So we should be able to head office to go into our new premises in late 2015, next year, year and a half from now. And as far as distribution center will be early to mid-2016 as we are adding a lot of new automation and a very effective distribution center, especially because we want to be focusing on some of the unit picking activities that we are more and more demanded by our franchisees. And we’ll be up and extremely efficient in that field and that’s why we believe we will increase some of the volume that we’re not generating at this time.

Keith Howlett - Desjardin Securities

And would that new facility be capable of serving a substantially greater number of stores? Like could it service 600 stores or where does the capacity lie?

François Coutu

We’ve looked at the capacity for another 25 years.

André Belzile

Yes. And keep in mind that new distribution center will be built on a very large land of 3.4 million square feet. And there will be some place for expansion left on that land. So if needed, we will be ready to expand it so we can add even more volume and see foreseeable growth until 2025, for the next 20, 25 years as François mentioned.

Keith Howlett - Desjardin Securities

And are you anticipating a substantial improvement in sort of cases picked per hour or whatever measure you use on your warehouse labor productivity?

François Coutu

Definitely we’ll have an improvement on this and we’ll have a lot of training done to our existing employees and they look forward to. We’ve had several meetings with the employees and they look forward to because, let’s put it this way, it’s a new page of the history of Jean Coutu, we’re moving out to a one distribution center, very effective in Varennes and obviously everybody will put their [Foreign Language] I should say and make it successful.

Keith Howlett - Desjardin Securities

And just in terms of the pharmacy business, I presume specialty pharmaceutical products are mostly branded but maybe there are some that are private label, is there any opportunity there for ProDoc, I guess it would have to be older specialty pharmaceuticals.

François Coutu

Yes, that is something we’ve looked at, at this time it doesn’t make sense. It’s too difficult to make and too expensive to make and not only us ProDoc but most generics don’t really get involved at this time. We’ll see, but definitely there is a market for this eventually.

Keith Howlett - Desjardin Securities

And then just one on the front of the store, you mentioned that you were bringing in some new private labels to compete with the Dollar Stores, I’m not sure where that would be, would that be in sort of wrapping and gift cards or can you?

François Coutu

Health and beauty, lot of new products that we launched last six months, and very successful. We’ve sold over 2 million items of these. So obviously we want to give the choice to consumers, they’re planning on buying say shampoo, Pantene shampoo which could be run as high as $5, but at times they would rather go for a $2 shampoo and we now have the selection, we have the offering. And that’s what’s great about this; we will maintain our clientele because we could offer selection. And we didn’t to lose that market share that we have here in this deal and that’s why we are beginning to propose to our clientele a choice.

Keith Howlett - Desjardin Securities

And in terms of finally on categories, are there any categories you can see expanding into significant categories.

François Coutu

Well, we still have a store that is close to 10,000, 11,000 square feet. We got to be careful; we want to keep being the leader in the segments that we are very strong and traditionally strong as a destination. So we don’t want to lose track and say we’ll try to get to anything in the store to make a sale, to make a buck, no. We’re trying to work harder on the existing situation that we could develop even more, whether it’s cosmetics, its confectionary and all this. But for example a photo department, it’s not what it used to be. So we’re trying to replace it with more electronics where it’s a very hot item. So that’s why its questions that we’re asking ourselves continuously and we’re making readjustments at time. But when you look at say Coutu should be selling more food or should be selling clothing and we’re not at this at this time.

Operator

Thank you. (Operator Instructions). The next question from Vishal Shreedhar, from National Bank. Please go ahead.

Vishal Shreedhar - National Bank

Given all the competitive pressure and the Rx reimbursements reductions over time, assistance to franchisees et cetera. Are you seeing similar return on capital levels when you put in your CapEx, let’s say for the future stores that you’re putting in and for the stores that you’ve opened over the last couple of years.

François Coutu

I’ll let André answer, but the only thing I look forward to it’s the sheer number, the volume, the number of scripts should up in the future because again I’ve been tabbing on this for a long time, but the aging of the population should be, means additional prescriptions filled in our drug stores, like a brand. We’ll probably have a little squeeze on the profitability but it would be compensated by volume.

André Belzile

But Vishal are you referring to franchise from a franchisee point of view or for The Jean Coutu Group?

Vishal Shreedhar - National Bank

No. Well, I’m referring to the PJC Group in particular.

André Belzile

Valuation of scripts is adjusted accordingly based on the expected profitability. As you know, we are gaining even more than we were used in the past. If we could achieve a good purchasing from that new franchisee in the form of generics from products. And for the rest royalties declined a bit over the years, but that’s been more than compensative by again that additional source of revenue from the generic drug subsidiary. And for the rest, the wholesaler margin is the same. So, yes, the return on capital for us is roughly about the same.

Vishal Shreedhar - National Bank

And in terms of the DC and the new projects there, is that going to hit a similar return on capital level versus your stores let’s say?

François Coutu

It’s completely different thing, as you know when we announced the project, we explained that that we looked at the marginal investment as compared to expanding in the existing premises, as we have to do something. We are currently in a need for additional space. This is an issue we have to take care of while doing that, doing the investment in the new facility will allow us to be even more efficient. So for that marginal investment or additional investment of doing it in a new facility in Varennes as compared to expanding year, yes the return will be similar. But overall, there’s a portion of the investment that is part of cost of doing business.

Vishal Shreedhar - National Bank

I understood, in terms of your hurdle rate, when you open new stores are you able to share that with us?

François Coutu

Again it’s in the high teen but when we open a new store it will be completely different, if we could buy scripts from an independent that are been transferred in that store or if we really are doing a Greenfield opening then it obviously takes longer to build up the idea. The traffic in the store and the returns are lower, but for the long-term it’s still very good for Jean Coutu as it grows.

Vishal Shreedhar - National Bank

And in terms of the SG&A last quarter, I think there was a reimbursement, correct me if I am wrong but that reimbursement was supposed to continue over several quarters. Was that an impact in this quarter? It was a retroactive reimbursement.

François Coutu

What was that, sorry about that.

Vishal Shreedhar - National Bank

Maybe I can…

François Coutu

Just a second.

François Coutu

Yes. There was a one-time saving from the renegotiation of certain publicity costs in that quarter. But we also refer to a run rate saving going forward based on the new pricing being renegotiated. So we have also for the right portion of that. I think from the top of my mind it was something like 600,000 annual, so it’s about $150,000 on a quarterly basis.

Operator

Thank you. There are no further questions registered at this time. I would now like to turn the meeting back to Ms. Bisson

Hélène Bisson

Thank you very much for your interest in Jean Coutu Group and your participation in today’s conference call. If you have any further questions please feel free to contact us, our contact information is contained in the Company’s communications. Our AGM will be held in a few minutes and webcasted. So we invite you to listen in. We also look forward to report on our second quarter results of fiscal 2015 on October 8, 2014. We wish you a very nice summer. Thank you very much.

Operator

Thank you. The conference has now ended. Please disconnect your lines at this time. And we thank you for your participation.

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