Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Walgreen (NYSE:WAG)

Q3 2011 Earnings Call

June 21, 2011 8:30 am ET

Executives

Kermit Crawford - President of Pharmacy Services

Wade Miquelon - Chief Financial Officer and Executive Vice President

Rick Hans - Divisional Vice President of Investor Relations & Finance and Assistant Treasurer

Gregory Wasson - Chief Executive Officer, President and Director

Analysts

Edward Kelly - Crédit Suisse AG

Mark Miller - William Blair & Company L.L.C.

David Magee - SunTrust Robinson Humphrey, Inc.

Jonathan Baucom - Goldman Sachs Group Inc.

Lisa Gill - JP Morgan Chase & Co

John Heinbockel - Guggenheim Securities, LLC

Meredith Adler - Barclays Capital

Eric Bosshard - Cleveland Research Company

Steven Valiquette - UBS Investment Bank

Robert Willoughby

Thomas Gallucci - Lazard Capital Markets LLC

Mark Wiltamuth - Morgan Stanley

Deborah Weinswig - Citigroup Inc

Andrew Wolf - BB&T Capital Markets

Operator

Good day, ladies and gentlemen. Welcome to this Walgreen Company Third Quarter 2011 Earnings Conference Call. Today's call is being recorded. At this time, I would like to turn things over to Mr. Rick Hans. Please go ahead.

Rick Hans

Thank you, and good morning, everyone. Welcome to our third quarter conference call. Today, Greg Wasson, our President and CEO, and Wade Miquelon, Executive Vice President and Chief Financial Officer, will discuss the quarter and the additional announcement this morning regarding Express Scripts. Also joining us on the call and available for questions is Kermit Crawford, our President of Pharmacy, Health & Wellness Services and Solutions; and Mark Wagner, President of Community Management. When we get to your questions, please limit yourself to one.

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. Also, I'm available throughout the day by phone to answer additional questions.

You can find a link to our webcast under Investor Relations website. After the call, the presentation and the podcast will be available in archives on our website for 12 months.

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

Now I'll turn the call over to Greg.

Gregory Wasson

Thank you, Rick, and good morning, everyone. And thank you for joining us on our call. I'll give you an abbreviated review of our strong third quarter financial results and then Wade will take you through the details of our performance. And finally, we'll spend more time on our announcement this morning regarding the PBM Express Scripts.

Starting with our results today, we had a very solid quarter, which demonstrates that our strategies are generating strong financial results. We reported record third quarter sales of $18.4 billion, up 6.8% from $17.2 billion a year ago. Net earnings for the quarter were up 30.3% to a record $603 million compared to $463 million a year ago. Third quarter earnings per diluted share were $0.65, an increase of 38.3% versus last year's $0.47 per diluted share, marking our fourth consecutive quarter of double-digit earnings per share growth.

Strong cash flow trends continued in the quarter with cash flow from operations of $1.2 billion and free cash flow of $1 billion. In the quarter, we grew our gross profit by 8.5% and our SG&A by 7.2%. Our performance this quarter was a result of our ability to grow gross profit dollars faster than SG&A dollars, allowing us to deliver on our goal of double-digit earnings per share growth.

This quarter, gross profit dollar growth was $122 million above SG&A dollar growth, yielding an EBIT growth of 14.8%. Driving our gross profit dollar growth, we saw solid performance across a number of categories including retail pharmacy, over-the-counter medications, beauty and personal care. While we continue to grow our business and invest in the future, our strategies are implemented against a backdrop of economic and regulatory uncertainties.

Persistent high unemployment, a weak housing market, high fuel prices and inflation all put pressure on consumers. In response, we believe our customers are managing their overall spending by buying more ad and private brand items, as well as continue to see mix shift to consumables and nondiscretionary items.

Regarding inflation, we constantly monitor the competition and believe we are achieving the right balance between margin and traffic in our front-end comp. In addition, we continue to experience both commercial and governmental reimbursement pressure. On the government side of the issue, it's too early to speculate on the eventual timing and impact of AMP.

And on the regulatory front, we are pleased that the Senate took action on debit card reform. While the substance of the Durbin Amendment to the Dodd-Frank financial reform bill is clear, both the timing and financial implications are still unknown, and it's premature to speculate on any impact to our business. As we respond to a changing business climate, we also focus on solid execution to generate results. Throughout this quarter, we continued with our Customer Centric Retailing conversions, and in early June, reached a milestone of 4,000 CCR stores. We're on track to achieve our goal of 5,500 stores transitioned to CCR by the end of October this calendar year.

Overall, we're very pleased with the pace and success of our CCR conversions. With Walgreen employees responsible for much of the work, we're completing stores 30% faster this year than last, with costs running at about $45,000 per store. Customer satisfaction is up in converted stores and we believe that the success of CCR is being reflected in our solid front-end comp store sales numbers.

In addition to our focus on our core business, we also recently made significant strategic advancements as we continue to align our assets with our strategies. In the quarter, we announced the sale of our PBM and the acquisition of drugstore.com. On June 3, we closed on our transaction with drugstore, and we're pleased to welcome our new team members to the Walgreens family.

With the acquisition, we strengthen our position as the most convenient, multichannel provider of health and daily living, giving our customers more ways to connect and buy our wide range of products and services. I also want to acknowledge and thank the employees of WHI. We closed that transaction with Catalyst Health Systems on June 13, and I want to wish the team all the best in their new positions with Catalyst.

The sale sharpened our focus on our strategy to leverage the best community store network in America. In addition, the strategic relationship gives us the opportunity to expand all pharmacy products and services, including retail pharmacy, both 30- and 90-day supplies, mail service and specialty and infusion pharmacy, while Catalyst grows its PBM.

Also, during the quarter, we developed collaborations with a number of hospitals and health systems designed to improve patient care, provide greater access to important pharmacy and healthcare services and lower costs. These collaborative relationships demonstrate how Walgreen pharmacists, nurse practitioners and other professionals are integrating our services and solutions into the healthcare systems within our communities for our patients' and customers' benefit.

In May, we announced a wide-ranging agreement with Johns Hopkins Medicine. The agreement promotes collaboration on population-based research. We'll also jointly review and develop protocols to improve outcomes for patients with chronic diseases. Continuing our focus on patient outcomes and chronic care, we launched a program with Northwestern Memorial Physicians Group of Chicago. Through the program, Walgreens and Northwestern Memorial employees will receive specialized care for chronic conditions. We will share important clinical information on the patient's care in progress with their primary care physicians to help enhance decision-making.

And finally, Take Care Health Systems, a wholly owned subsidiary of Walgreens, has developed relationships with Ochsner Health Systems in New Orleans and Memorial Health in Jacksonville, Florida. With these agreements in place, physicians will share information with their patients on Take Care Clinics and on other healthcare options when their practices are closed or they are unable to schedule an appointment within a patient's desired timeframe.

With that, I'll turn the call over to Wade for more detail on our results.

Wade Miquelon

Thank you, Greg, and good morning to everyone. Let me begin by saying we are pleased with our strong performance on our key financial metrics in what continues to be a challenging economic environment. As Greg mentioned, our net sales increased 6.8% to $18.4 billion. And our net earnings increased by 30.3% to $603 million, resulting in earnings per diluted share of $0.65, a 38.3% increase.

Our comparable sales trends have improved from a year ago with prescription sales up 4.1%, front-end sales up 3.9% and total sales up 4.1%. And our prescriptions filled were up 4.6% for the quarter. Looking at our comp trends more closely, our quarterly script trends, shown in the green bars, increased by 4.6% in the quarter, up from last year's 2.5%, continuing to outpace the industry growth rate of 1.1% excluding Walgreens.

On a 2-year stack basis, represented by the blue line, comparable prescription increases remain in the 6% to 8% range, with a spike in the first quarter of 2010 caused by the unusual timing and severity of the 2010 flu season. Retail prescription market share for the quarter was 20.1% compared to a 19.7% a year ago.

Our quarterly front-end sales comps increased to 3.9%, up from 0.1% a year ago. And we believe the CCR initiative, including expansion of and focus on core product categories and the rollout of beer and wine, continue to gain traction and drive our comps. The CCR initiative also helped drive the holiday sales comp this past Easter. And finally, the 2-year stack, shown by the blue line, continued to trend up after bottoming out in the second quarter of fiscal 2010.

Compared to the industry, our sales continued to perform well. When viewing a true to apples-to-apples time period that compares our front-end comps to our top 3 competitors based on their most recent reporting, we outperformed all by a wide margin as shown on this chart. We also continued to outperform on a 2-year stack basis as well.

Turning to margin, our gross margin as a percent of sales was 28.1% in the quarter compared to 27.6% last year. Overall margins in the quarter were positively impacted by higher retail pharmacy margins as the effect of generic drug sales more than offset market-driven reimbursements, and front-end margins were driven by OTC drugs, beauty and personal care and several private-label categories. And that was partially offset by a higher provision for LIFO. Taking a look at our longer-term gross margin trends, our front-end margins, while flat in the second quarter of 2011, increased in the other 5 quarters as shown.

Pharmacy gross margin in the quarter improved with the impact of generics. As we discussed in recent quarters, additional progress obviously becomes increasingly difficult to achieve on these strong numbers. And please keep in mind that we will continue to believe that gross profit dollar growth and increases in traffic and basket are the most relevant measures of our progress. Two-year stack SG&A trends continue to improve with 15.8% growth in the third quarter of 2011, down from 17.1% last year and 18.7% in 2009.

After adjusting for restructuring-related costs and cost associated with the Duane Reade acquisition, our 2-year stack SG&A trends also showed steady improvement to 12.4%, down from 13.4% last year and 17.6% in 2009.

Finally, walking through the progression of our reported SG&A dollar growth rate of 7.2% to our adjusted core SG&A rate of 6.4%, you can see the impact versus a year ago. Lower Duane Reade integration expenses offset SG&A dollar growth by 60 basis points. Higher Duane Reade operating expenses added about 150 basis points and lower net cost associated with our Rewiring for Growth initiative offset our SG&A growth by 10 basis points, all versus a year ago.

Taking you through our income statement, this quarter included a LIFO provision of $50 million versus $18 million a year ago. Our estimated annual inflation rate for the current year remained at 2.25% versus 1.25% a year ago. Restructuring costs were $11 million, down from $17 million last year. Net interest expense was $18 million, down from $24 million a year ago, primarily as a result of reduced interest rates associated with our interest rate swaps.

Our effective tax rate was 35.4% versus 42.5% last year and recall that last year's effective tax rate included a $43 million charge in deferred taxes related to the Medicare Part D subsidy for retiree medical benefits. This year's third quarter benefited from a favorable state tax settlement. For the fourth quarter and the year, we expect our effective income tax rate to be about 37%.

Average diluted shares outstanding were 922 million versus 982 million a year ago, due primarily to our share repurchase program. Cash and cash equivalents were $2.7 billion at May 31, up 14.7%. Overall working capital decreased by 2.3% versus a year ago while working capital as a percent of sales decreased by 8.5%.

Total FIFO inventory increased by 7.7% in the quarter and by 5% on a per-store basis. For the 9 months ended May 31, 2011, we generated $3.3 billion in cash from operations compared to $2.8 billion a year ago, primarily as a result of higher net earnings. Capital expenditures were $699 million, down from $786 million last year.

As one of our core capital allocation priorities, we continue to return surplus cash to shareholders, and in the third quarter, we returned $535 million, including $160 million in dividends and $375 million through share repurchases. As of May 31, 2011, we repurchased $825 million against our $1 billion authorization. And as you can see year-to-date, we have returned a total of nearly $1.7 billion to shareholders.

Now this slide shows our gross profit dollar growth trends for the past 7 quarters, with the blue line representing 2010 and the green line representing the first 3 quarters of 2011. The red line above shows the 2-year stack trend. Last year's fourth quarter benefited from the initial inclusion of Duane Reade, a higher level of organic store openings and the rollout of beer and wine to about 3,500 stores, all of which we'll be cycling in the upcoming quarter.

As you can see the fourth quarter, will have the most difficult gross profit dollar comparisons of the year. And we'll continue to see some volatility resulting from the timing of generic introductions. As an example, we received greater gross profit dollar help from new generics in the third quarter versus a year ago. In the fourth quarter, we expect the help from generics to be significantly less than it was last year.

We have a similar construct for SG&A dollar growth for the last 7 quarters, with the blue line representing 2010 and the green line representing the first 3 quarters of fiscal 2011 and the red line showing the 2-year stack trend. As you can see, we're cycling a high rate of SG&A dollar growth this year due to Duane Reade acquisition, so the compare there will be easier than the prior quarters in the year.

As Greg said, we closed both the WHI and drugstore.com transactions in June. We expect the sale of WHI to be accretive to earnings by about $0.30 in fiscal 2011, largely due to the onetime gain on the sale, and neutral in 2012, not including the reinvestment of the proceeds. As we indicated at the announcement, we anticipate the drugstore.com transaction will be dilutive to earnings per share in the fourth quarter of 2011 by about $0.03 to the transaction related and onetime cost.

Based on Walgreens' intention to reinvest in the business, the company further anticipates the transaction to be dilutive to earnings per share by about $0.03 to $0.04 in fiscal 2012 and about $0.01 to $0.02 in 2013.

Well, in closing, we are pleased with our quarterly results, which represented record third quarter sales, net income, earnings per diluted share and free cash flow, all notwithstanding an unforgiving economic environment. It is a validation that our strategies are translating into solid financial performance. And I want to acknowledge every one of our 244,000 employees who work hard every single day to help drive these results. And now I'll turn the call back to Greg for details regarding the developments with Express Scripts.

Gregory Wasson

Thanks, Wade. First, let me start by saying while not easy, this was a very clear decision for us. And one that we believe is in the best interest of our shareholders, our patients, our customers and our company.

Based on the terms and rates that Express Scripts has insisted on and after months of unsuccessful negotiations, we have reluctantly concluded it does not make sense for our business and the strategic direction of our company to continue our relationship with them. As a result, we're planning not to be a part of Express Scripts pharmacy provider network as of January 1, 2012.

This means that in January, Express Scripts provider network will no longer include our 7,700 Walgreen stores and Duane Reade pharmacies. Despite today's announcement, we remain committed to serving all of our patients' pharmacy and healthcare needs in the Express Scripts plan through end of this calendar year. To give you more context on our decision, as the largest provider in the Express Scripts network, we no longer felt like a valued partner for several reasons.

They were insistent on unacceptable reimbursement for the value we provide. In fact, their proposed reimbursement rates were below the published industry average cost to provide each prescription. Express Scripts attempted to define unilaterally what does and does not constitute a brand and generic drug despite existing industry standards, which when combined with the unacceptable rates further compounds the problem.

And third, they wanted the ability to move Walgreens into lower reimbursement networks and benefit designs without our approval and without fair compensation, reducing the predictability we need to forecast our business adequately. As I said as I began my comments, I want to emphasize this was not a decision we made lightly. We considered all our alternatives. But based on Express Scripts' position, it was very clear, principled decision for us.

We believe the long-term ramifications of accepting Express Scripts' position with below market rates and minimal predictability would have been much worse than any short-term impact to our earnings. Given that, accepting Express Scripts' position would not have been in the long-term interest of our company, our customers, our pharmacists and our shareholders.

Furthermore, in a world where cost effectiveness and access to healthcare is so important, any time an intermediary continues to disproportionally grow its profit per prescription at the expense of the provider delivering the service, the relationship's out of balance.

The fact is we fill one out of 5 retail prescriptions in America, patients and payers value the trust and relationship they have with their pharmacist. They value the high quality, cost effectiveness and convenience we provide, which is why we work with hundreds of PBM and health plan networks across the country.

To give you some of the history, we've been in negotiations with Express Scripts for many months. Our team worked hard in a concerted effort to come to an agreement on a contract renewal that makes sense for both parties. We came in to our discussions with Express Scripts with what we thought was a market-based reasonable approach to terms and rates. We proposed to lower rates on the behalf of the Department of Defense TRICARE program, the pharmacy benefit plan managed by Express Scripts that serves active and retired military personnel. We also offered to contract separately with Express Scripts for TRICARE beneficiaries in order to continue providing services for all active and retired military personnel.

Under our proposal, the reimbursement costs of the DOD [Department of Defense] would have been lower than under Walgreens' new proposed commercial rates. For all other plans managed by Express Scripts, we offered to hold rates for a new contract at the level that will be in effect with Express Scripts at year end, which will be lower than current rates.

As for the impact on our business from this decision, we estimate that Express Scripts will reimburse Walgreens approximately $5.3 billion in fiscal 2011. This figure represents about 7% of our total company sales. Those sales divide into 4 distinct categories. Managed care represents 45% of the business, 18% goes to the Department of Defense, 26% to employers and 11% is Medicare Part D. Express Scripts processes approximately 90 million prescriptions that are expected to be filled by Walgreens in fiscal 2011.

To mitigate that impact, we intend to work closely with our PBM and health plan partners. We've heard loud and clear over the past year from employers and payers that they value the choice, cost effectiveness, convenience and service of Walgreens. As a result, over time, we are optimistic employers and others are going to want Walgreens in their network.

Second, during the open enrollment period, we will reach out to the Medicare beneficiaries to make sure they know how to have access to Walgreens pharmacies they have known and trusted for years. We will assist them in finding Medicare Part D plans with access to Walgreens. And finally, we will work directly with employers and payers, who have the ability to work directly with Walgreens.

For all of these reasons, we are optimistic about our ability over time to regain these customers and grow our business. For now, however, we're not going to speculate publicly about the amount of business we can retain in fiscal year 2012 or the potential impact on our financial metrics and stated goals. In the long run, we believe employers will want plans with Walgreens in the network.

With that said, Walgreens is moving forward with our strategies, and I'm confident in our future. Never in my years with this company have I seen so much interest from key stakeholders within the industry for the services Walgreens can deliver. We're prepared to live without Express Scripts in our world and work together with companies that understand the course we, in the healthcare industry, are taking.

As we've demonstrated in this and recent quarters, we're focused on helping our patients live well and on our strategy to transform community pharmacy to improve the overall cost and quality of care. With that, I'll turn the call back to Rick.

Rick Hans

Thank you, Greg. Ladies and gentlemen, that concludes our prepared remarks. We're now ready to take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] We'll take our first question from Mark Wiltamuth with Morgan Stanley.

Mark Wiltamuth - Morgan Stanley

Can you give us a little more detail on how you'll go about with the mitigating strategies and how fast you can act on those conversions?

Gregory Wasson

Yes, Mark, this is Greg. Yes, as we said, I think, first, I'll start with the Medicare Part D beneficiaries. The pharmacist has a very trusted relationship, a close relationship with all seniors and all Medicare Part D beneficiaries. We intend, as I said, to work with them to make sure we help them find access to plans that have Walgreens in their network during open enrollment. Two, we do believe that in most cases, PBM contracts, health plan contracts typically are 3-year contracts, and typically most of those turn over about once -- 1/3 of them every year. So we intend to work with the hundreds of PBMs and health plans that we do business with, that we think value Walgreens in their network. We heard that loud and clear over the past year that they want Walgreens in their network. And third, we think that there's a fair number of employers and health plans who have the ability to work directly with us and we intend to work with them as well.

Mark Wiltamuth - Morgan Stanley

Contrast this with what happened with CVS last year. It seems like the CVS dispute was more over macking [ph] and maybe talk about this one versus that dispute.

Gregory Wasson

Yes, Mark, I think certainly this is about Express Scripts and the proposal we received from them. Frankly, as we said in the call, I think first and foremost, we weighed this and obviously didn't make the decision lightly. And we considered all the alternatives as I said. But really what we can agree with is someone having the ability to unilaterally decide what constitutes a generic drug or brand drug. We can't agree to someone putting us into a lower cost network or a network with a different benefit design, as I said, without our approval or without us getting compensated for the buying shift that, that creates. And third, we just can't accept rates that are less than industry average and does not value what we bring to the marketplace.

Wade Miquelon

I put it simply, I mean, while we're not here to talk about CVS Caremark, I guess, what I would say is that we are taking a principled stand that we deserve to be treated and compensated fairly for what we do. Nothing more, nothing less.

Operator

Our next question will come from Mark Miller of William Blair.

Mark Miller - William Blair & Company L.L.C.

It seems like a lot of the grievances you're citing here have existed for some time. And so it could be viewed as, I guess, constant. What specifically here has changed? And then I guess, what are the aspects of prior settlements that you want to see in parallel? I think predictability is one thing. But I guess, why is this happening now and why not prior years?

Gregory Wasson

Well, I think that, Mark, Greg, a good question. First of all, the proposed rates are well below the market rates that we have. And therefore -- and in fact, less than the industry average to fill us and provide us scripts as I said. Secondly, there are industry standards out there that define generic drugs today that the industry uses. And for someone to unilaterally decide to redefine a generic drug does not make sense to us and we can't accept.

Wade Miquelon

And I would say, Mark, I mean, obviously, negotiating with PBMs, managed care, whatever is a way of life, right. It's just part of the game, everybody wants to make sure that they do what's right for their company. So it happens all the time, it's just very seldom does it goes public. And honestly, we are so far apart from what we believe is principled and fair that it's not something that's going to be -- it's not going to be resolved honestly.

Gregory Wasson

And Mark, I would say, we were surprised by the proposal that we received from Express Scripts a couple of months ago. Surprised that the terms and conditions we received, the fact that they were looking for reimbursement rates far below the market rates that we have. And as Wade said, we work successfully with hundreds of networks across the country all the time.

Mark Miller - William Blair & Company L.L.C.

Can you just explain this last sentence in the third bullet, "for other plans managed by Express Scripts, Walgreens offered to hold rates at a new contract at a level that will be in effect at year-end, which will be lower than current rates?" I don't understand what that means.

Wade Miquelon

It means, we basically, as of December 31, offered to Evergreen that agreement, basically, right. But which we already feel quite frankly is not an acceptable agreement but that was -- in event, that's already below-market but that was what we felt was a very amicable proposal at the time.

Operator

Going next to Andrew Wolf of BB&T Capital Markets.

Andrew Wolf - BB&T Capital Markets

Follow-up on some of the mitigations strategies. Could you just talk on the cost structure side, to what extent you could bring down pharmacy hours so that as work kind of get to -- capital contributions?

Gregory Wasson

Yes, Andy. Greg. Certainly, we've talked this through clearly. And we're prepared, and we have a plan. And certainly, we've looked at the areas where we're ready to adjust SG&A where we can, where we should. All of the above, as you just said, operating hours and others are in our plan. But we feel confident that we can adjust as needed and are prepared to do so.

Wade Miquelon

And this is a very important point. Even the worst-case scenario, if us moving forward, living in our world without Express Scripts in it is certainly better than what they were proposing. And we certainly have many things, levers we can pull, cost offsets, et cetera, that I guarantee you that our path forward for shareholders and for employers is better than the alternative, even in the worst-case scenario.

Andrew Wolf - BB&T Capital Markets

Okay, and I know you probably -- someone asked about you're pairing this to CVS, but it seems so similar. It is similar, but it sounds like in a way this was a little more shocking and more of a discontinuous kind of, "Hey, here's our new offer. " And it's as if wherein CVS, it seems like Caremark -- it seems like maybe the issues have been kind of culminating, maybe came to a head. Is that -- am I reading that right? Is this sort of like more of an out-of-the-blue really discontinuous change in the business relationship and therefore, the profitability in the new business?

Gregory Wasson

Mark, Greg, yes. As I've said, we were surprised by the initial proposal we received. We've been working for several months to try to come to a successful agreement with what we thought were fair and reasonable terms and conditions for the value we provide. We haven't been successful, and therefore, we felt that it was necessary to inform our shareholders on this earnings call that where we are and that we're prepared to go on. As Wade said and as I said earlier, that although we are in the business to fill prescriptions, we didn't take this lightly, as I'm sure you wouldn't -- would expect. When we look at the long-term ramifications to our business, it's far worse than the short-term impact would have been, having accepted below-market rates.

Operator

And our next question will come from Tom Gallucci of Lazard Capital Markets.

Thomas Gallucci - Lazard Capital Markets LLC

Clarify a few things, if I could. One, I think it was Wade before, did you sort of say that this is not going to be resolved? I just want to be clear are you guys still open to negotiations? Or...

Wade Miquelon

Well, I would say this -- I would say that we're not going to back off our principles and our stand that we deserve fair compensation, market-based compensation for what we do. If that day comes so be it. But if not, we're prepared to move forward.

Thomas Gallucci - Lazard Capital Markets LLC

Okay. So in theory, there could be a deal, it's just a matter of it's got to be closer to your terms.

Wade Miquelon

Of course.

Gregory Wasson

Tom, this is Greg. Let me add to that. Certainly, as I've said, we're in a business to fill prescriptions. And certainly, if we can reach an agreement some point in time, where our issues that we lay down are accepted, certainly. But I also want to be clear that we are prepared, as I said, to continue to live in a world without Express Scripts. We're prepared. We've got a plan in place to do that.

Thomas Gallucci - Lazard Capital Markets LLC

Okay. And then this generic versus brand definition, is there -- were they proposing a change versus what you've seen in the past? Or is there some new sensitivity on your part as to why this is an issue?

Gregory Wasson

Yes, the proposals, I said, is redefining what we understand the industry has used for years to define a generic drug. And I feel to unilaterally defined what constitutes a generic and brand-name drug is not acceptable.

Wade Miquelon

I mean, honestly any agreement where one party can define and change levers and things that they want any time they want basically means that they can do any thing they want.

Thomas Gallucci - Lazard Capital Markets LLC

That's different than the contract you've had in the past, that nuance? Is that nuance different than the contract you've had...

Gregory Wasson

We're just talking today, Tom, about the proposal going forward.

Wade Miquelon

[indiscernible] our current terms in contracts.

Thomas Gallucci - Lazard Capital Markets LLC

Okay. And the last thing, the $5.3 billion that you called out, to what extent would you estimate that there are front-end sales related to that foot traffic?

Wade Miquelon

Obviously, front-end sales are in a big correlation to prescriptions. As we've said many times, we're not going to speculate on any of the numbers per se, today.

Operator

The next question comes from UBS, Steven Valiquette.

Steven Valiquette - UBS Investment Bank

You guys mentioned that you were surprised by the terms offered by Express. I'm just curious just from your end. I mean, what you think is driving the more difficult terms that are being demanded by Express and maybe some of the other PBMs? And also, I mean, you went through with CVS last year, Express this year, is there any color on when your Medco contract might be up for renewal or has it been renewed recently? Those are my 2 questions.

Gregory Wasson

Well, I mean, we can't speculate on what's driving. And I would say obviously, if organic volume for them is roughly flat and their gross profit per dollars and EBITDA per script keeps going up, that probably suggests something. But with respect to Medco or others, we're not here to talk about any other party. We have good relationships with hundreds of other plans, and we're going to continue on that. And this is really about Express Scripts.

Operator

And we'll go next to Meredith Adler of Barclays Capital.

Meredith Adler - Barclays Capital

I have just a related question. What do you think the chances that Express Scripts does what Caremark did in terms of saying, "No, January 1, you really -- we're going to kick you out in the next 3 weeks"? Is that something they have the ability to do?

Gregory Wasson

Meredith, I'm not going to speculate on what Express Scripts might do. As I said, we've made this decision, and we thought it through, consider all options. And we are prepared to move forward in a world without Express Scripts. So I can't speculate on what they may do, but we're prepared to move forward.

Wade Miquelon

Our high road objective of January 1 is just to make sure that there's time for payers and patients to transition, if necessary, so that we don't disrupt them because at the end of the day, we should both take the high road around that.

Meredith Adler - Barclays Capital

And then another question about -- they've been public about their view on limited network. Obviously, Walgreen in -- not in the network is a big deal. That isn't a simple limited network to put together. But in your conversations with them, when they were talking, was there posturing about own [ph] limited networks to the direction we think the industry should go in?

Gregory Wasson

Yes, Meredith. We've read that, and we've heard comments in the industry about restricted networks. First of all, as I said, we've heard loud and clear the past year that employers and health plans absolutely want Walgreens in their network. Frankly, the cost savings from restricting a pharmacy network is really is not substantial enough to reduce access, for most is what we're hearing loud and clear. And finally, health plans and health systems today are really looking beyond pharmacy. They're looking for community pharmacy to help them reduce their overall medical costs while improving access and the quality of care. And I'll tell you, frankly, I believe the days of isolating and focusing on drug spend separate from medical costs are coming to a close. So I think that folks today are looking for help from community pharmacy to attack their entire medical costs, improve access versus just focusing on their pharmacy spend.

Meredith Adler - Barclays Capital

Well, I hope Express Scripts is listening to what you're saying.

Operator

And we'll take our next question from Guggenheim Securities, John Heinbockel.

John Heinbockel - Guggenheim Securities, LLC

From a long-term perspective, one that just concerns me is that when the generic wave kind of runs its course, that the level of confrontation between you guys and the PBMs would ratchet up. It looks like it's happening to some degree. How do you think about that long-term? If down the road there's less profit coming from generic, will the level of confrontation increase? How do you guys deal with that longer term?

Gregory Wasson

Well, John, first of all, as we've said before, I think anyone in healthcare we're always going to be facing reimbursement pressure of some type. I will circle back to the answer and the comment I just made to Meredith earlier. I think the value of community pharmacy going forward, working with forward-looking health plans and health systems that are looking to control their total medical costs, improve access is where we're headed. One of our major initiatives and strategies, as you know, is to transform the role of community pharmacy place in healthcare by expanding our scope of services via pharmacists, nurse practitioners and so forth. And that's when I say I've never had in my time with this company so much interest in what community pharmacy and what we can offer to health plans and health systems across the country.

Wade Miquelon

I guess, I would say and I said many times publicly, it's probably broader, this discussion is. We believe, that in a world of all generics and beyond the wave that we have many, many, many ways that we can drive value for our company and value for the people and the patients and the payers that we serve. So I think that there will always be some tension, but I think we're confident that there's enough things that we can do and over time that we have a very strong model.

John Heinbockel - Guggenheim Securities, LLC

And second topic, just on SG&A dollars. Maybe describe where you think we are with that. It looks like you're going to come in toward the high end of your range for the year. Do you think we're still on target for 3.5% to 4.5% growth next year? And what's the operating cost environment look like right now in terms of pressure on labor utilities, et cetera?

Wade Miquelon

Just a couple of things, number one is we are on track for our target next year of 3.5% to 4.5%. So very confident about that. But the fourth quarter, as you know last year was basically, I'd say, it's an easy comp. To make sure that you kind of on all the numbers, you are running the 2-year specs to really get the 2-year trend. I'd say with respect to cost, I mean, there's some inflationary pressure. But there's also, there's also, I'd say, in other areas, deflationary pressure because of the high unemployment and the economy. So we believe we can definitely manage to our targets.

Operator

We'll take our next question from Eric Bosshard of Cleveland Research Company.

Eric Bosshard - Cleveland Research Company

As you look out to the generic payback and 2012 and Lipitor and what have you, can you give us any perspective of how you think the reimbursement rate environment is going to evolve in that regard, specifically how reimbursement rates would have then allow you to earn on the incremental generics in 2012?

Gregory Wasson

Yes, Greg here. I think that as you said, as we see the generic wave coming, I think, certainly generics are good for all. I think when -- I think, certainly, we're going to continue to see pressures, as I said, from being in the healthcare industry. But at the same time, when you think about a world where virtually every therapeutic category of drug has a generic, payers are going to see a dramatic reduction in costs just from that same wave. So will they be continue to be focused on cost? Yes. But are they going to see and experience big relief coming forward because every category will, in essence, have a generic? Yes, absolutely.

Eric Bosshard - Cleveland Research Company

I guess within that as we start to get closer and see the reimbursement rate picture become more clear for 2012 with all these generics, how much of that are the payers sort of requiring goes into their pocket versus how much is able to be left to the benefit of the supply chain? I guess, that's what I'm specifically trying to understand.

Gregory Wasson

Yes, fair question. I think as I said, payers who are holistically and I believe, trending to holistically looking at how to reduce their total costs are going to look at this in a more balanced and fair way. And frankly, that's what we're seeing. They're realizing that keeping folks adherent and compliant on drugs is much more beneficial than squeezing another few percent on the cost on the drug side itself.

Operator

Moving on to Lisa Gill of JPMorgan.

Lisa Gill - JP Morgan Chase & Co

Greg, I know that this would be about time when [ph] CVS was pretty short-lived. But I know at that point, you also talked about going out directly to managed care company as well as employers. Can you maybe just talk about any success you had and the early stages of funding agreements directly with any of those employers, #1? And then #2, yesterday, the state Senate here in New York passed an anti-mandatory mail potential law, which would now allow retailers that are willing to take mail order economics -- they would be allowed to fill that mail order prescriptions in their pharmacies. Can you maybe just give us your thoughts from a Walgreens perspective on that?

Gregory Wasson

Yes, I'll take the first. On going to direct employers, certainly, we have had success there. And we lead with the employers. We lead with our employer solutions product. We also have direct relationships with health plans and employers across the country, and we continue to see more of that. On the state of New York, we applaud that. We absolutely think that payers and employers benefit from having a 90-day retail benefit added to an existing mail benefit. And I think that through proper benefit design and structures, that does make sense for retail to participate.

Lisa Gill - JP Morgan Chase & Co

Can maybe Wade comment on the economics of that? So if you look today the average mail order contract is AWP minus 23 or 24. If you have to take the exact same economics, such as the way that the bill is written, is that a profitable script to you on a 90-day basis?

Wade Miquelon

Look, I would say that there is no one contract. There is no one rate for mail. And when you factor it all together, it can be all over the map. But the truth is there's a lot of mail most of it is kind of shadow priced-off retail. Being able to do -- we can do a 90-day very cost effectively versus mail providing a discount for the payer, but also providing good economics for us given the benefit of being able to fill it once. So we'll have to look at that. I don't want to give an absolute but I think absolutely, we can be competitive, and we'll just have to see what the actual details are.

Operator

Our next question will come from John Baucom of Goldman Sachs.

Jonathan Baucom - Goldman Sachs Group Inc.

It's John Baucom for Matt Fassler, from Goldman. I know you guys touched on this a little bit, but would you mind just kind of going through the drivers of the underlying or adjusted 6.4% expense growth?

Wade Miquelon

Well, we can talk a little bit. One thing I do want to clarify, too, is -- I think, it's John's question earlier -- the 3.5% to 4.5% target is kind of our, call it, our cost base. Obviously, we said today with the Express Scripts, we don't know exactly where this will end, what our sales will be. So we're not going to clarify goals, but we're on track for that. I mean, the key drivers is obviously the same key drivers we've had before. We have a little bit less, to a degree [ph], because of partial quarter in there. We have our new store openings. We have some one-time costs associated with some of the deals that we've announced. But effectively, there's nothing out of the ordinary versus the normal trend.

Jonathan Baucom - Goldman Sachs Group Inc.

Got it. So there was no impact from the .com acquisition this quarter? And I know there's a 3% -- $0.03 impact next quarter, would you just remind us how the different line items flow through the P&L on that impact?

Wade Miquelon

With respect to the deals?

Jonathan Baucom - Goldman Sachs Group Inc.

The .com, the drugstore.com acquisition.

Wade Miquelon

Well, I mean it's going to come across a couple of different lines, both in terms of what their actual earnings accretion is et cetera, plus we have some one-time and some expense costs that we're doing to beef up the proposition plus we have some [ph] related cost. So it cuts across all the various lines. It really just flows through it. But you have closing cost transaction fees, and like I said, you have the base P&L of the business.

Jonathan Baucom - Goldman Sachs Group Inc.

Okay. And then on the gross margin side, you talked about the big drivers there. Could you kind of quantify maybe the impact of input cost this quarter?

Wade Miquelon

Well, we've seen obviously some inflation coming through, though not huge amounts but some inflation. We feel we've been very effective at pricing with it and in front of it. That's our plan to keep pricing. So again, input costs are coming through a little bit. I think that while we do see higher fuel, et cetera, on our transportation we also get some benefit offset because we're very convenient, and so we get it through sales. I think you see it through our traffic as well. But really I think, thus far inflation is coming some but it's been manageable. And for the most part we plan on offsetting it through pricing. We'll stay competitive on that since we have to. But we'll also be smart how we play our whole portfolio and drive things like private label even harder.

Operator

We'll take our next question from Deborah Weinswig with Citi.

Deborah Weinswig - Citigroup Inc

One topic we haven't really touched on is what you're seeing with regards with clinics. Can you just talk about what you're seeing with regards to profitability and also just traffic?

Gregory Wasson

Yes, Deborah. We're feeling good with the retail clinics. As you know and I think I talked last couple of calls, we've got over 300 out there. We've got scale. We now have really been able to look at the model and make some adjustments to the model, which are positive. So I think that such as expanding our scope of services beyond acute care into more screenings, chronic care management and primary care like we've -- we're seeing a different approaches. We're finding different approaches to market and build customer awareness. At the same time, we are hearing more and more, as I said, from health plans and hospital systems as we announced. Health systems are looking to leverage our retail clinics for access and affordable care. So we feel good there. Our employer business, our employer worksite health has the same thing there. We're seeing increased awareness and demand. We just signed the relationship with Ochsner Health, as we talked about. So we are feeling pretty good there, as well as our pharmacy on campus hospital system model. We're seeing a lot of interest from health systems who are looking for us to help them with their discharge process to prevent readmission.

Deborah Weinswig - Citigroup Inc

My thoughts have always been that as you continue to build out your relationships with the employers, that it might actually enable you to go directly to them and dis-intermediate, if you will, the PBMs. You're obviously in an interesting situation right now with Express Scripts, and Wal-Mart has been successful on going directly to employers. Can you maybe talk about how the relationships that you're building with employers because it looks that healthcare clinics might allow you to do this?

Gregory Wasson

Yes. And first and foremost, let me say that we work with all stakeholders in the industry. So we have valued relationships with PBMs that help take our product and services to the marketplace, health plans that take our products or services, health systems, et cetera. But at the same time, you're right. We do have what we believe is a unique and value-added solution for employers to build or provide worksite health on their campuses. With that, we are indeed able to build -- create or build relationships because we create real value, and we believe are influential in a positive way as to how they design their benefits for the best of their employees.

Operator

We'll take our next question from Robert Willoughby of Bank of America Merrill Lynch.

Robert Willoughby

Greg and Wade, I guess your principles in holding the hard line with Express Scripts should be much more comforting if some of the other major retailers also banded together to reject some of these new terms. I mean I would assume Express is playing hardball with everybody. So how is this anything but Express leveraging what they perceive is overcapacity in the industry?

Gregory Wasson

Well, Bob, obviously I can't go there but this is certainly about Walgreens and the proposal that we received, and were surprised by from Express Scripts and the actions we are taking. We do believe that community pharmacy does provide value. We believe we certainly do. We think that payers are beginning to look for community pharmacy to provide services far beyond what others may be. So as I said, this is about us and Express Scripts.

Wade Miquelon

And it's also our principle stand is also being fair to the other payers that we work with and the other PBMs and managed care. It's not -- it wouldn't be right to give some super discount below market rate for only one at the expense of the others. We need to be fair to all of them.

Kermit Crawford

Bob, this is Kermit. I just like to add, really no other PBM has taken this position to this point.

Robert Willoughby

It's interesting. I would view you guys as having a cost advantage in participating in this business. It seems to me other retailers must be agreeing to some similar hard-line types of deals. It just strikes me unusual that they pick out one provider in their entire networks.

Wade Miquelon

We can't speak to them. We're very cost effective and very reasonable and very market-based.

Gregory Wasson

And Bob, again, let me go back to again this is between us and them. But at the same time, I will say that we have decided to take a leadership position in this industry to transform the role of community pharmacy. And to play a greater role in healthcare. And I think, there is a tremendous opportunity for us to do that. We have tremendous interest from key stakeholders in the healthcare industry for us to play that role. And that's where we're headed. We moving forward into that new world. And as I said, we're prepared and ready to live in a world without Express Scripts.

Operator

The next question will come from David Magee of SunTrust Robinson Humphrey.

David Magee - SunTrust Robinson Humphrey, Inc.

Two questions, one is when you sort of outline the mix of business that Express had earlier on the call, how would you characterize the profitability of that overall contract relative to other third-party contracts in 2011?

Wade Miquelon

I think we said that we believe there are already unacceptable rates, and the proposal is even more unacceptable. So I'll just leave it at that.

David Magee - SunTrust Robinson Humphrey, Inc.

Okay, so sort of below average right now. And then when you make your assumptions regarding the retention of business after this, are you sort of basing that on sort of hard evidence in the past where you've had contract withdrawals from maybe smaller companies?

Gregory Wasson

Yes, David, Greg. As I've said in the last year, year and a half, we've heard loud and clear from employers and health plans that they want Walgreens in their network for all the reasons that we stated: the convenience we bring; the 24 hour locations we bring, the services we are offering, the; cost effectiveness that we do bring; when you look at our generic utilization performance, the adherence and compliance; the rate terms and conditions we give. They're looking for is to be in the network.

Operator

And we'll take our final question from Edward Kelly of Credit Suisse.

Edward Kelly - Crédit Suisse AG

Three questions for you, on the gross margin, you had a nice bounce back quarter in the gross margin after last quarter. You obviously said front-end and pharmacy were booked up. Can you talk about the sustainability of that over the next couple of quarters? It looks like the comparisons are obviously pretty tough in both of those quarters. Generics like you said, certainly are not going to help. Can you drive a positive gross margin over the next couple of quarters?

Wade Miquelon

I'm not really going to comment on the quarter. I would agree that there are tougher compares for various reasons that we outlined. I guess what I would say is we're a bit focused on not building a sandcastle but building a real castle, so over time how do we keep strengthening the foundation in the financials, the gross margin, the SG&A, making that model work, the 100 basis point model and over time, over a period. So I won't speculate on the quarter but I think that we feel that moving ahead, we have a very solid framework, and of course, we're moving into a good generic period, coming 2013, et cetera. So, I'll just leave it at that.

Edward Kelly - Crédit Suisse AG

Wade, could you maybe talk about of the drivers of the front-end gross margin. This quarter -- I think, last quarter you had mentioned that it was more flattish. Obviously, it's positive. And then is there -- are there legs to that in and of those benefits as well?

Wade Miquelon

Yes, obviously, right now we're in the midst of kind of finishing out CCR so that brings a fair amount of, cost et cetera. But then over time, we believe, what we're seeing is we're going to have stronger margins and stronger lift resulting from it. We're also doing a better and better job of driving a very healthy mix for us, more beauty products, more OTC products, things like that. Private label, we've done a great job. But we still have a lot of upside, and we're putting a lot of effort in that. So there are definitely drivers over time that we can, I think, keep improving the margin. But again, I think, it's really have to look over the longer haul and keep focusing on 2-year specs.

Edward Kelly - Crédit Suisse AG

Okay. And just last question for you. I mean, there's been obviously a lot of questions today about Express Scripts. And clearly, it's very -- at least, it seems very similar to what we saw last year with CVS. Can you just remind us how that negotiation progressed last year? And then last year, you started to see some real benefits in the gross margin when that resolution took place. So I know back then, you weren't really willing to talk about it. But is it something -- is there something that could provide similar benefits if it gets resolved in your favor?

Gregory Wasson

Ed, Greg. Certainly, I'm not going to comment much on the CVS Caremark other than to say, as we said in our release we were very pleased with the outcome of that issue. And we're working very closely with CVS Caremark today as a result. Again, this is about our relationship with Express Scripts and our desire to reach agreement on terms and conditions that are acceptable for the value we provide.

Rick Hans

Folks, that was our final question. As a reminder, the company will report June sales on July 6, and we will report the fourth quarter year-end results on September 27. Until then, thank you for listening, and we look forward to talking with you soon.

Operator

Ladies and gentlemen, that concludes our conference today. Thank you all for your participation.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Walgreen's CEO Discusses Q3 2011 Results - Earnings Call Transcript
This Transcript
All Transcripts