The six-month dispute with Express Scripts (ESRX) took its toll on Walgreens' (WAG) recently released first quarter fiscal 2012 results. The company’s bottom-line was impacted by 2 cents per share from the loss of pharmacy sales and expenses associated with the dispute.
If a contract renewal is not finalized, effective January 1, 2012, Walgreens' 7,800 pharmacies will not be a part of Express Scripts’ pharmacy provider network. The contract accounted for $5.3 billion of sales in fiscal 2011 as Express Scripts processed 88 million prescriptions filled by Walgreens. In the recently concluded quarter the pharmacy benefit manager processed as much as 26 million prescriptions from Walgreens. The wrangle would undoubtedly have an adverse impact on Walgreens' sales, earnings and cash flow, going by the company’s recently filed 10Q.
However, the company is preparing for a life without the Express Scripts contract. To minimize the impact, Walgreens is working on retaining some of Express Scripts’ clients, expanding its business with other payers and customers and implementing cost control initiatives. The company is reassured by the fact that more than 100 of Express Scripts clients, encompassing health plans and employers, would continue with Walgreens pharmacies in 2012. This will enable the company to retain 10 million prescriptions annually and maintain 97-99% of 2011 prescription volumes at fiscal 2012 end. This guidance takes into account the loss of Express Scripts clients such as the Department of Defense Tricare plan and WellPoint (WLP).
Considering that almost 75% of the business from Express Scripts’ clients would be lost, Walgreens expects to offset 50% of gross profit reduction in fiscal 2012 through leveraging selling, general and administrative expenses and cost of goods sold. However, the majority of these cost cuts would only begin to take effect from the latter half of fiscal 2012. Additional reimbursement pressure may crop up for Walgreens if the proposed merger between Express Scripts and Medco Health Solutions (MHS) goes through.
In cut-throat competition, major retailers are leaving no stone unturned to lure away Express Scripts patients who would otherwise lose access to Walgreens pharmacies beginning 2012. Jewel-Osco, a Supervalu (SVU) company, has asked Walgreens customers to switch to its 173 stores and is also planning to hire additional manpower to cater to these new patients. CVS Caremark (CVS) with its 7,304 retail drugstores, is also in this race.
Walgreens is working toward establishing itself as a leading provider of pharmacy and health and wellness solutions. Despite its best efforts, the loss of the Express Scripts contract, which accounted for 7.3% of total sales in fiscal 2011, will dent the company’s financials. Although the company is expecting to retain 75% of its business, we await further clarity regarding this.
On a long-term horizon, we are nonetheless optimistic about Walgreens. The company expects gross margins to improve in the second half of fiscal 2012 based on new generic drug introduction. Moreover, a strong cash balance enables the company to reward its shareholders through share buybacks and incremental dividends. In the last eight years, the company’s dividend has grown at a compound annual growth rate (CAGR) of nearly 22%.
Currently we are Neutral on Walgreens, in line with the short-term Zacks No. 3 Rank (Hold).