Walgreens Boots Alliance's (WBA) CEO Stefano Pessina on Q4 2016 Results - Earnings Call Transcript

| About: Walgreens Boots (WBA)

Walgreens Boots Alliance, Inc. (NASDAQ:WBA)

Q4 2016 Results Earnings Conference Call

October 20, 2016 08:30 AM ET

Executives

Gerald Gradwell - IR

Stefano Pessina - Executive Vice President and CEO

George Fairweather - EVP and Global CFO

Alex Gourlay - Co-Chief Operating Officer

Analysts

Robert Willoughby - Credit Suisse

Ross Muken - Evercore ISI

Brian Tanquilut - Jefferies

Lisa Gill - JP Morgan

Michael Cherny - UBS

Ricky Goldwasser - Morgan Stanley

Steven Valiquette - Bank of America Merrill Lynch

George Hill - Deutsche Bank

Robert Jones - Goldman Sachs

Eric Percher - Barclays

Eric Bosshard - Cleveland Research

Charles Rhyee - Cowen & Company

Operator

Good day ladies and gentlemen and Welcome to the Walgreens Boots Alliance, Inc., Fourth Quarter 2016 Earning Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, today’s conference is being recorded.

I would now like to hand today’s conference call to Mr. Gerald Gradwell. You may begin, sir.

Gerald Gradwell

Thank you. Hello, and welcome to our earnings call. As usual, Stefano Pessina, our Executive Vice President and Chief Executive Officer and George Fairweather, Executive Vice President and Global Chief Financial Officer will take you through our results today. Alex Gourlay, Co-Chief Operating Officer of Walgreen Boots Alliance is also here and will join us for questions.

You will find a link to the webcast on our Investor Relations website at investor.walgreensbootalliance.com. After the call, this presentation and webcast will be archived on the website for 12 months. Certain statements and projections of future results made in this presentation constitute forward-looking statements that are based on our current market, competitive and regulatory expectations, and are subject to risks and uncertainties that could cause actual results to vary materially. Except to the extent required by the law, we undertake no obligation to update publicly any forward-looking statements 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 subsequent filings for a discussion of risk factors as they relate to forward-looking statements.

As a reminder, today’s presentation includes certain non-GAAP financial measures. And we refer you to the Appendix in the presentation materials available on our Investor Relations website for reconciliation to the most directly comparable GAAP financial measures and related information.

I will now handover to George to take you through the numbers.

George Fairweather

Thank you, Gerald. I am pleased that we’ve delivered good results, which is a fitting close to what’s been an outstanding financial year for the Company exceeding the upper end of our guidance when we have again experienced strong currency headwinds and some challenging market conditions. As usual, this performance has been achieved through a combination of operational progress and corporate efficiencies. In particular, we’ve managed our costs well and generated a healthy cash flow. At the same time, we’ve announced a number of significant strategic partnerships in the U.S., which Stefano will talk about later. But first, I’ll take you through our fourth quarter results.

Let me start with the financial highlights. Sales totaled $28.6 billion, up 0.4% versus the comparable quarter last year. Our results were impacted by currency translation; on a constant currency basis, sales were up 2.5%. GAAP operating income was $1.1 billion, an increase of 36.4%. GAAP net earnings attributable to Walgreens Boots Alliance were $1.0 billion and diluted EPS was $0.95.

Adjusted operating income was $1.6 billion, up 7.2% and in constant currency was up 10.3%. Adjusted net earnings attributable to Walgreens Boots Alliance were $1.2 billion, up 20.3%. And adjusted diluted net earnings per share was $1.07 that was up 21.6%. And the adverse currency translation impact was around $0.03.

So, now, let me turn to the performance of our divisions in the quarter, beginning with Retail Pharmacy USA. Retail Pharmacy USA sales were $20.7 billion, up 4.0% over the year ago quarter, comparable store sales increasing by 3.2%. Adjusted gross profit was up 0.5% to $5.4 billion, adjusted gross margin being lower for both pharmacy and retail. Adjusted SG&A as a percentage of sales improved by 0.9 percentage points to 20.7%. Adjusted operating margin was stable at 5.3%, resulting in adjusted operating income of $1.1 billion, up 4.4%. This increase was primarily driven by increased pharmacy volume, procurement efficiencies and cost control, partially offset by lower reimbursement rates.

We continued to make strong progress on our previously announced cost savings program, the majority of which is in the U.S. Overall, we are well on track to deliver our $1.5 billion in savings by the end of fiscal 2017. We now expect total pre-tax charges associated with the program to be between $1.3 billion to $1.5 billion, which is $300 million lower than we previously estimated.

So, next, let’s look in more detail at pharmacy. U.S. pharmacy total sales were up 6.2%, driven by increased script volume and improved specialty sales. We filled 229.5 million prescriptions and that’s on a 30-day adjusted basis including immunizations, an increase of 3.7%. On a comparable basis, the stores which exclude central specialty, pharmacy sales increased by 5.0% with sales up 3.9%, mainly due to continued growth in Medicare Part D volume. Our reported market share of retail prescriptions on the usual 30-day adjusted basis was 19.3%, up approximately 40 basis points over the year ago quarter. As you may know, IMS restated its market share numbers for the comparable period, due to an enhancement to the IMS panel. In the appendix, we set out fully comparable historic market share statistics for the division.

As in the last quarter and as we expected, gross margins were lower, mainly due to reimbursement grades and changes in mix, which were partially offset by procurement efficiencies. Retail sales on a comparable basis were down 0.3% on the same quarter last year. Sales were impacted more significantly by declines in certain consumable categories and seasonal items such as back-to-school and commodity electronics where we took action to proactively clear out old and legacy stock as we move to the next phase of our retail transformation program.

We’re also seeing the impact of direct management action in tobacco where we’ve continued to reduce space and visibility as we focus on helping customers, the ones who stop smoking. Importantly, the health and wellness and beauty categories performed well. While gross margins in the quarter were slightly down, we don’t see this as a permanent weakness, but the recent declines have been mainly due to actions we have take to put in place foundations for long-term growth.

I am delighted to report that the first phase of our new beauty offering reached more than 1,600 stores across the U.S. by the end of the fiscal year. This has three core elements, products; store environment; and customer experience. First, the products, in this phase, we are highlighting two of our best known brands, No7 and Soap & Glory alongside existing national brands already well known to Walgreens customers. The second element is the store environment. Our stores beauty areas are being transformed to provide a welcoming and colorful environment with improved signage and lighting, and the product range chosen to suit all types of customers regardless of age or background. The third element of the new Walgreens beauty offer is the customer experience. This involves training and deploying specialist beauty consultants to offer high-quality advice to our customers. The program has drawn our experience internationally, most directly from Boots in the UK but has been tailored [ph] specifically for the U.S. market based on customer engagement and research. This is the first phase of a multi-phase multi-year strategy to differentiate Walgreens beauty offering.

So, now, let’s look at the results of the Retail Pharmacy International division. Sales of the division were $3.0 billion, up 1.4% in constant currency. On a same basis, comparable store sales declined by 0.6%, mainly due to Chile and the UK, which I’ll cover in a moment. Adjusted operating margin for the division was 8.1%, up 1.0 percentage points. This resulted in adjusted operating income of $247 million, an increase of 15.7% in constant currency. To improve comparability, you will see that we’ve made certain classification changes to prior period sales, cost of sales, and SG&A. These changes have had no impact on operating income. To help with modeling, in the appendix, we’ve provided revised numbers by quarter for fiscal 2015 and 2016.

Comparable pharmacy sales were flat on a constant currency basis, as the loss of institutional contracts in Chile offset growth in other markets. In Boots UK, comparable pharmacy sales were up 0.6%. And while we continued to experience reimbursement pressure, pharmacy services continued to perform well. Comparable retail sales for the division decreased 1.0% due to a weaker Boots performance in the UK where comparable retail sales were down 0.8%, impacted by a particularly volatile and poor June.

So, now, let’s look at our Pharmaceutical Wholesale division. Sales for the division were $5.4 billion, down 1.5% on a constant currency basis due to the disposal of Alliance Healthcare Russia in April. Comparable sales on a constant currency basis, which excludes acquisitions and dispositions, increased by 2.9%. This was marginally behind our estimated market growth weighted on the basis of our country wholesale sales due to competitive market conditions in Continental Europe. Adjusted operating margin for the division, which we define to exclude AmerisourceBergen, income was 2.9%. This was up 0.3 percentage points on a constant currency basis versus the comparable quarter last year.

Adjusted operating income for the division was $208 million, up 39.2% in constant currency. While the increase was mainly due to equity earnings from ABC, excluding this, adjusted operating income grew by 7.6% in constant currency. As you know, we report our share of ABC’s net earnings on a two-month lag. As a result, this was our first full quarter of recognizing approximately 16% of ABC’s net earnings. When modeling ABC, remember that equity income related to our increased ownership from the August warrant exercise will be reflected in only five weeks of the first quarter due to the two-month reporting lag.

So, now, let me turn to the full year numbers for fiscal 2016. As I said at the beginning, this has been an outstanding financial year, exceeding the upper-end of our guidance. These results are of course not directly comparable with the previous year due to the Alliance Boots transaction.

In summary, GAAP diluted net earnings per share of $3.82 was down 4.5%. This reflects a number of factors including the fluctuations in the ABC warrants and last year’s non-cash gain relating to Alliance Boots. On an adjusted basis, diluted earnings per share increased by 18.3% to $4.59. The adjusted effective tax rate which we calculate excluding the equity income from ABC, this was 25.4%. This was lower than we had anticipated when we spoke to you last quarter. Ignoring discreet tax items, our underlying adjusted effective tax rate would have been 26.3%. Discreet items of approximately 0.9 percentage points primarily included completion of certain U.S. tax audits and true-ups of prior year accruals. The tax rate also reflects changes in the geographical mix of our pre-tax earnings and the U.S. taxation of our non-U.S. entities.

Operating cash flow was $2.7 billion in the quarter and $7.8 billion in the full fiscal year. Over the course of the year, working capital reduced by $1.4 billion due to improved payables. Cash capital expenditure was $421 million in the quarter and $1.3 billion in the full fiscal year. During the year, we invested in key areas to develop our customer proposition including investment in stores and the U.S. beauty program as well as upgrades to our IT systems, which we began earlier in the year.

Store investment included over a 100 new openings in Mexico which continues to be a focus area for expansion. Overall, this resulted in free cash flow for the quarter of $2.2 billion and $6.5 billion in the full fiscal year, a year-on-year increase of $2.1 billion.

So, turning now to our pending acquisition of Rite Aid. As announced on September 8, we remain actively engaged with the FTC on its review. And today, we still expect that the most likely outcome will be that the parties will be acquired to divest between 500 and a 1,000 stores. We believe that we’ll be able to execute agreements to divest these stores to potential buyers, pending FTC approval, by the end of calendar year 2016, and now expect to close the acquisition in early calendar 2017.

Taking into account our current expectations of store divestures, we continue to expect that the acquisition will be accretive to adjusted diluted net earnings per share in the first full year after closing. We also continue to expect that we will realize synergies from the acquisition in excess of $1 billion to be fully realized within three to four years of closing. These synergies have been updated where practicable and as previously disclosed, are expected to come primarily from procurement, cost savings, and other operational matters.

So, turning now to guidance for fiscal 2017. We are expecting adjusted diluted net earnings per share to be in the range of $4.85 to $5.20. This assumes Rite Aid accretion of $0.05 to $0.12 based on the assumptions that I just mentioned, and on the continuation of our normal anti-dilutive buyback program, relating to equity incentives. And in addition, this guidance is based on currency exchange rates remaining constant for the rest of the fiscal year.

Please remember, sterling today is around 15% lower versus the dollar than our weighted average operating income translation rate for fiscal 2016. This had an adverse impact on our guidance of around $0.13.

In terms of phasing, the timing and development of our recently announced new strategic pharmacy partnerships in the U.S. means that we expect Retail Pharmacy USA script growth to be stronger than usual in the second half of the fiscal year. The new rates come into effect on day one of the contracts mainly around the end of the calendar year, while we believe that enhanced volumes will take some time to build. Overall, we therefore expect Retail Pharmacy USA gross margins to continue to decline in the coming quarters, but expect to see sales and profit for the year as a whole to continue to grow as the expected volumes come through from our pharmacy contracts in the second half of the fiscal year.

So, I’ll now hand over to Stefano for his concluding comments.

Stefano Pessina

Thank you, George. As you have heard, this was a good quarter despite both currency and operational challenges. It is our fourth quarter and what I believe has been an extremely good year as whole for the Company. That said, the work that we have been doing to control cost, reduce waste and return our business to a path of growth has been showing marked effects for some time. For the past eight quarters however, we have grown our adjusted net earnings over the comparable prior period.

In fiscal 2014, if you make basic adjustment trading that 55% of Alliance Boots not reflected in the historical published results. We would have generated an estimated $3.9 billion of adjusted net earnings. As we reported $5 billion of adjusted net earnings in fiscal 2016, this could represent an increase of approximately 28% over the last two fiscal years on a reported currency basis. This is a compound annual growth rate of around 13% it also represents an annual increase of over 15% on a constant currency basis. In addition, we have delivered $10.9 billion of free cash flow over the same period.

While I believe that this is impressive by any measure, it is not solely due to the merger that created Walgreens Boots Alliance. We have continued to see aggressive operations growth across the Company, which has been a significant driver of our strong financial performance. This success has been achieved despite it having been a very busy time.

Let’s take a moment to remind ourselves of everything that we have achieved in the past year. In the U.S., we launched significant initiatives to advance our retail and pharmacy offering. These included investing in the customer acquisitions especially in beauty to differentiate Walgreens as a retailer. We also reset our relationship with healthcare payers and PBM and work to develop closer partnership as a platform for our future. Examples of these strategic partnerships include our new 90-day prescription agreement with OptumRx and EnvisionRx, our announced agreement with Express Scripts, and our innovative partnership with Prime Therapeutics. These close partnerships are central to our strategy of increasing volumes to our pharmacies and driving footfall to our stores.

We strengthened our relationship with AmerisourceBergen, exercising both tranches warrants, understanding our pharmacy sale distribution and sourcing agreement. This move further cements the strong and collaborative working relationship our companies have built together over the past three years. Our pending acquisition of Rite Aid continues to progress as George said.

Globally, we continue to expand our reach and presence. In Russia, we divested our retail [ph] business and as part of the deal retained a strategic stake in the country’s leading health and beauty retailer. And in South Korea, we signed an agreement to form a franchise relationship with one of the Company’s leading retailers.

At the Company level, we reached and surpassed our $1 billion synergies goal of ours from the WBA merger and further progressed cost saving goal of $1.5 billion by the end of fiscal year 2017. At the same time, we changed the role and responsibilities of our senior management team to structure our leadership more efficiently and move to operating a truly unified Company.

Looking forward to 2017, we expect to face the same headwinds we encountered this year but with some additional factors that are going to likely change the profile for the year. We are entering a period where we need to consolidate much of the recent activities in the Company. We must ensure we are properly positioned to get the full benefit of our work to-date as expected volume increases from our new commercial agreement begin to flow to our U.S. pharmacies and global procurement network.

Additional benefit will come as our retail transformation work accelerates and compounds the expected increase in traffic that flows through our stores with this agreement. We therefore expect a differentiating for the year-end with anticipated growth skewed significantly toward the second half of the year, but as you have heard from George, we are expecting the year as a whole to continue our record of healthy growth. We believe this saving is a temporary phenomenon as we see our work to transform the Company ahead and increase impact. Transformation and integration if done properly is never instant or easy, but we are progressing well. While we are delivering on the policies of the merger, we are also building strong foundation, based on establishing an outstanding team and structuring our Company for growth in core business especially Walgreens. We are doing this without losing sight of the global opportunities and are preparing the Company to play an even greater goal of healthcare awards in the U.S. and around the world.

Thank you. Now, I will hand you back to Gerald.

Gerald Gradwell

Thank you, Stefano. Kevin, can we open the line for questions, please?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Robert Willoughby with Credit Suisse.

Robert Willoughby

George, what clarity do you have now on the volumes slated to come in from Prime and Express and United? I think you’d have to have a healthy degree of conservatism in the guidance, not knowing exactly how their selling seasons are growing. Have you assumed any incremental volume coming through the Rite Aid stores from these relationships?

George Fairweather

We obviously don’t comment on individual contracts, but I think what we’ve tried to indicate, as I’ve said in my prepared comments is that we expect the volume to increase in the second half of the year as we look forward relative to the increase that we would anticipate in the first half, because it takes time for obviously contracts to come through. In terms of Rite Aid, obviously, we cannot make comments at this point, as I’m sure you’ll appreciate.

Alex Gourlay

Hi. Good morning, Bob. It’s Alex here. Obviously, we’re really pleased to have this volume coming through. The majority, as I think George has said is coming through early part of calendar year next year apart from Tricare which we expect to start to fall on November the 1st. The team has done a lot of planning here to make sure we take care of customers when they appear back in Walgreens. It’s something new to Walgreens. And obviously as the year progresses, we’ll be able to get a better feel on our ability to both get customers back into Walgreens and hold on to them. And remember, many of these new contracts are narrow [ph] but some are actually pretty broad, [ph] the Tricare contract for example, so has [ph] the vast majority of pharmacies in the U.S. in that contract. So, we’ve been -- what we think is a good estimate from what we know into the forecast and if things change, as George has said, we’ll update you.

Operator

The next question comes from Ross Muken with Evercore ISI.

Ross Muken

Good morning, gentlemen. So, I guess just maybe not specifics on sort of how gross margins in the U.S. retail business are going to pace on a numerical basis, but more qualitatively. Obviously, you’re getting a volume pickup to get that and there is obviously reimbursement pressure in the market. So, could you just help us in the phasing of that relative to the procurement savings and then relative to the new beauty rollout to just show maybe qualitatively how we should think about the different elements as they roll in, whether it’s Tricare or it’s these new PBM relationships and then offset by the frontend? How we just should think about either the cadence or the other pushes and pulls outside of that?

Alex Gourlay

Yes, we have a lot of confidence in terms of our ability to deliver both these strategies. So, the first one is speaking about the new volume, where we are giving better value to volume. But we believe that we’ve seen already with the Med-D work in the past, this really is accretive to our model. And again, as I said, I think the previous question to Bob, most of these contracts start in January 1st. So, we see the majority of the volume, as George has said in the second half of our fiscal year, which I think starts in March of next year. So that will start to build out. And then we’ve built solid plans on what we know about the market and what our great partners help us to build this business have told us about their networks. And some of the selling season is happening right now; you’ll see some more which we announce particularly [ph] through days and the weeks ahead.

On the frontend strategy, this is a multi-year multi-phase approach. We’ve put 1,600 new beauty departments on the ground, not complete but new in terms of the brands that George mentioned, particularly No7 and Soap & Glory of this phase with new lighting, importantly upgraded training and development of our consultants to give the customers the information they need. And this is on the ground based on the trials we did before. Now, majority of this work will phase in over a two or three-year period in reality but you should expect the ongoing improvements to margin -- gross margin through 2017 and the years ahead.

Remember that we focus our business on the whole box; we focus our business on operating margin including costs and of course an adjusted net earnings. All of this work is designed to drive all elements of profitability within the box of Walgreens. And we are very confident with what we are doing and the pace is accelerating.

Ross Muken

Again to that point, what I am trying to get at is should we think about on gross profit, a more of a dollar growth basis versus a margin basis so long as it’s accretive over time to kind of returns in the operating margin because the market has been a little bit myopic on the margin percentage overall. But obviously not everything you can do to drive value will be necessarily gross margin accretive, correct?

George Fairweather

I think, remember, our big focus is on growing our operating income, our overall income and our cash flow. So, in terms of reimbursement pressures, it’s something that we’ve seen in the past; it will continue to happen. We’ve got to continue to drive efficiencies. It’s got to be a way of life. So, really this is what we’re focusing on and offering our customers a competitive offer and then being very financially disciplined in a way that we can drive our overall shareholder value. So in terms of thinking about -- and that’s how I would really encourage you to think. We are absolutely focused on operating profit. That’s what we are doing, in summary.

Operator

Our next question comes from Brian Tanquilut with Jefferies.

Brian Tanquilut

Just a question on your views on the supply chain. As we think about potential pricing pressure in the drug world, whether it’s government driven or just the pressure is on the drug manufacturers, how do you think that flows through to your business as we think about that flow through of the distributors and PBMs? I mean what’s your exposure in your minds to drug pricing pressure?

Alex Gourlay

Yes. I mean, I think we’ve spoken of this for since we’ve been here with some expansion in Europe where reimbursement pressure really does come through the supply chain. And in fact, you’ll probably see if you read the UK papers, this morning the government’s claimed [ph] a major announcement and confirmed what we expected was a supply chain pressure and reimbursement coming through in the UK business as we planned for and as we expected. So, we are quite used to this pressure. Again, if you think back to what Stefano and George said, we are working really close with AmerisourceBergen, they’re proving to be strong partners to help us to not just improve our availability to make sure we take care of customers, which is driving our volume but to make sure we do that in a really efficient and integrated and more innovative way going forward. So, we feel confident that we can use our scale, use our partnerships, use our knowledge and knowhow from Europe to be in a good position in what we expect to be continued supply chain pressure.

Operator

Our next question comes from Lisa Gill with JP Morgan.

Lisa Gill

I just want to take an opportunity to go back to the strategic partnerships that you talk about and just have a better understanding as to how it works contractually. If we think about the fact that you’ve had PBM relationships with all of these parties in the past, how do we think about those relationships compared to the new strategic relationships? And what I’m trying to get at is that my understanding is that come January 1st, the trade of the volume for the price has to do with specifics around products on the maintenance side where you’re getting people to a 90-day script. It’s not your overall PBM contract, but I just want clarification to better understand that.

Stefano Pessina

Lisa, this is really our strategy, it’s always been our strategy. We want to partner with as many people as possible. And when people understand this, they accept that we are on the market and we have to offer our best services to everybody within the market. If you don’t really accept, you as an operator of the market, if you don’t accept this concept of collaboration, sooner or later, you are isolated and you cannot really exploit your potential at best. When we have announced some of these deals, of course we have spoken to the other customers that we have, the other PBMs and we have explained [ph] which is our logic, and we have explained that we are willing to help collaborate with everybody. And you have seen that in few months, we have been able to announce agreement, special collaboration practically with most of the operators in the sector. This is a strategy, a strategy which has always worked for us in the past in other countries, and I believe will work also in the U.S. Of course, as George said, every time that we do something new, every time that we propose an agreement [ph] or take into consideration an agreement which is proposed by one of our customers, we are running the numbers in a very disciplined way considering of course everything, considering the volume, considering the discount, considering the work that we can extract more from our suppliers if anything, considering the increased efficiencies of the pharmacies. And then, at the end, we decide whether we can do this particular kind of the deal or not. And of course we are very conscious that when we come with an innovative deal or with a partnership on the market, we have to be prepared to offer similar things to other people. I believe that this is a beauty of being independent. We can work with everybody and we can offer our services to everybody. And we are not seen as particularly skewed toward this or that player in the market.

Lisa Gill

Okay, great. And then, if I can just follow up, when I think about your strategy, specialty is clearly a big and growing area. And Stefano, do you feel like you need to make an acquisition in the area of specialty to continue to grow that business or do you feel that some of the partnerships that you have today, most recently Prime and talking about making some investments around specialty there that that will be enough?

Stefano Pessina

We believe that if we could improve our position in specialties through partnership, these would be much more efficient and much more profitable because if we have to buy something -- well, first of all, we would have to buy something in the market which has a potential for development. And now, in this market, we see that many people have an outlook which is not particularly positive in our judgment, first of all. And secondly, this would be extremely expensive. And so, again, we are very-disciplined. We will not buy something just because it’s nice to have. We want to be sure that if we use our money, our money will have an important return, a cash return, and we value all of what we do, not in terms of earnings per share, we value it in terms of EVA, [ph] in terms of cash. Maybe Alex, you want to add something about specialties?

Alex Gourlay

Yes, specifically on Prime, Lisa, I think this is a joint venture which we will get on in the first few months of next year. We have also good relationship with Prime and the team of Prime through Jim. And we’re getting closer, which is fantastic. But fundamentally, we’re combining our central specialty in a joint venture operation. So, we use the efficiencies that we can bring together to the market and we can buy there together in that area as well. So that’s what [ph] we’re doing here on the course by doing that through the PBM, which is owned by the Blue through Prime, we hope to be able to over time when we get that efficiency in it, attract more patients and more customers. This is a build out strategy, a classic example of this sort of partnership approach that Stefano described.

Operator

Our next question comes from Michael Cherny with UBS.

Michael Cherny

Just a quick question I guess on the frontend retail side. You talked about some of the investments you are making in improving the beauty side in particular. I don’t know if you touched too much on the digital initiatives that you guys are pursuing. Maybe talk about success you’ve had so far as you expand areas around the loyalty card and other digital marketing initiatives. And then if you can, any incremental plans you have in terms of targeting improved areas on a go forward basis?

Alex Gourlay

Sure, Michael. Yes. I think as I said before and I think as people know, we have quite a successful digital team and app [ph] for seven years I think as now annually quick fill continues, refilling prescriptions continues to be a breakthrough app that we continue to develop along with the mobile, which we continue to develop and we get absolutely fit for the modern customer and we continue to get score [ph] as a team frankly and it’s a great platform for us. We obviously transformed graphic [ph] business here in the U.S. and to that approach a couple of years ago when we transferred [indiscernible] as well. So to next question, I think as your question, well, we closed operations for Beauty and Drugstore.com and it’s been done successfully. The focus is really on the retail product business. We announced last Monday order online [ph] to store or Ship to Store in 7,600 clock stores including Duane Reade. And success we’ve built in again the Boots business, sharing of knowledge between frontend and the UK is really important part of our journey here. So, we continue to invest behind the digital team. We are a very strong team in my view, very impressive team. And we’re very confident with the platforms we have and knowhow we have and know we’re focusing back on volumes, health and beauty strategy, particularly in the frontend to become the entry gate omni-channel retailer where we have a lot of room to go. And while the rest of it is very clear, we understand the risk very well. We believe with [Indiscernible] corners across America and this capability, we are pretty well-positioned.

Operator

Our next question comes from Ricky Goldwasser with Morgan Stanley.

Ricky Goldwasser

First question is on Rite Aid, obviously divesting the Rite Aid storage has been taking longer than expected. You actually did include divided accretion [ph] in your guidance. So, what gives you confidence in an early 2017 close?

Stefano Pessina

I’d say that yes. I agree with you that it is taking more than we expected, but I have to tell you that as you have seen from our presentation and from the fact that we have included some part of Rite Aid potential profit in our guidance, from this you can really understand that we are confident, as confident as we were before about this deal. Nothing has changed. We have just a delay in the execution of the deal. This is our perception. We have always been optimistic because we have never seen an attitude from the FTC which was absolutely negative. Of course, they were requiring, they were asking a lot of questions, sometimes they were taking time to respond. But at the end of the day, I believe we have had a good collaboration; we are having a good collaboration. We try to respond to the all of their needs. This takes time. But at the end, we are still confident.

Of course I know that we read on the paper very different news. No idea about the sources of this news but for sure if we could talk and of course you know that we cannot, our view will be different. For what we see today, we see just a long administrative process but we don’t see substantial differences from what we were expecting. Yes, probably more stores, a little more stores here and there. But at the end of the day, as far as I can see today, as far as we can see today, we are absolutely confident that we can create, that we can do the deal and we can create the value. Just these values will be a little postponed on time because if and when we will do the deal, of course for the first month, we will not be able to start immediately the synergies; it will take some time. And we were hoping to do the deal at the beginning of this fiscal year for us. In this case, we would have had time to develop some of the synergies. Of course, if we could close the deal relatively late in our fiscal year, the synergies will be small but we will find all of them next year.

Ricky Goldwasser

And then my third question is about the PBM contracts that you signed. When we think about the partnerships, in aggregate, they manage more than 50% of the U.S. script market versus your share that is a little bit below 20%. When we think about the opportunity from a long-term perspective, how much incremental share do you think that you can gain through these relationships? I mean, when we look at CBS we estimate that their share with their maintenance choice account at retail is about 33% versus the 20% national share. So, is this a good goalpost for us to use when we think about this opportunity and the returns over the longer-term?

Alex Gourlay

We don’t really think about [indiscernible] what we’re focused on is two elements of growing our business. One which we’ve seen in the last period which is a combination of access [indiscernible] growing channel but really through delivering for customers. Customer experiences [ph] for us in our pharmacies have moved and a big credit to Richard Ashworth and all of the teams involved and Brad, [ph] because that really has been a big shift in how we’ve been able to take care of customers in our pharmacies. That really has been a driver of the recent share you’ve seen in the past and we will be completely focused on continuing to do that. And secondly, it’s definitely still [indiscernible] We want to make sure that the people who are paying for these prescriptions with customers and payers, we just make sure we get the right understanding of what we want for the networks that we’re in and that’s what we’re trying to do in different ways and we have all sorts of different ways as we’re demonstrating of getting that done.

So, we do really, customer-by-customer and peer-by-peer and also network-by-network to make sure that we can grow our business. We’re early in this strategy, to be honest. We’re early in this strategy and we are still learning how to really drive it and make it work. And we remain confident that we’ll learn a lot this year with the ambitions we have and analyze [ph] to have access back into Walgreens that didn’t have access before and again we’ll continue to evaluate [ph] goals going forward.

Ricky Goldwasser

And lastly, the new terms of Express had any impact on the margins in the fourth quarter or it’s all in fiscal year 2017?

Stefano Pessina

Could you repeat? Sorry.

Alex Gourlay

So, the Tricare contract as you know is one as we declared [indiscernible] 2017. Yes.

Ricky Goldwasser

But for the rest of the Express book assuming that that has been re-priced as well. So, did you see any impact of that in your fourth quarter results or is this all going to be in fiscal year 2017, outside Tricare?

Alex Gourlay

Ricky, as you know, we agree what we disclosed with the partners that [Indiscernible] we haven’t disclosed anything outside of Tricare. So, we can’t disclose anything else this morning.

Operator

Our next question comes from Steven Valiquette with Bank of America Merrill Lynch.

Steven Valiquette

So, just a question or two on the Medicare margins. It seems like with Medicare becoming a bigger part of your mix -- I mean, I guess there was some noise in the channel about maybe some Medicare gross margins compressing as calendar 2016 was progressing for the industry, and we’re kind of seeing that in your U.S. gross margin as well, so kind of look at the progression year-over-year. So, I guess I’m wondering, first, are you seeing any fall off in Medicare gross margins as calendar 2016 is progressing or have they remained fairly stable? And then also just -- or is it more maybe just a mix issue where if Medicare is a bigger part of your mix, we’re just seeing our Medicare gross margins maybe lower than commercial gross margins? So, I just wanted to sort of tackle those two ankles on the U.S. gross margins? Thanks.

Alex Gourlay

Yes. See, margin is expected -- clearly there is pressure in the margin and Med-D because the volume’s growing stable and as we expected. And the mix as you can see in our book-of-business is shifting. So, therefore that’s what’s driving further pressure on the margin.

Steven Valiquette

Okay. So, some companies, we’re seeing that pressure maybe as the year’s progressing; you’re saying that you’re not seeing any material fall-off in your Medicare margin as the year is progressing?

Alex Gourlay

That’s correct. I mean there is the trend only [ph] year-after-year on these annual contracts but the trend is not any clear than it was in the past as we expected.

Operator

Our next question comes from George Hill with Deutsche Bank.

George Hill

I’m going to pull a little bit further on Steve’s thread here. Alex, if we think about the business and you guys talk about the EBIT margin and the kind of continued pressure there. I guess, can you separate the payer pressure and kind of the underlying pressure on the business versus the impact of mix, they move to 90-day, the new relationships with PBMs to take share? I guess, what I’m trying to get is a better understanding of what is actual pressure on the business and what is the margin change as a reflection of mix? And even digging into that further, how much of that is by the company’s design versus how much of it is the design of payers pushing down on you guys?

Alex Gourlay

I would say that as a company we now actively manage both these elements. I think as George described well in script on the frontend, we are actively managing the seasonal capacities, some historic stock and also we’re managing out of some product lines, particularly again in the consumables and seasonal items, which as we manage more into getting more space as appropriate over trying to help, and really the biggest example being clearly space for in 1,600 stores for extended beauty ranges. [Ph]

So, we are actively managing that. We are managing, again as we said, operating margin level, maybe through a box in terms of the question on reimbursement pressure. Again, we are actively managing it. We’ve spoken very clearly that we recognize and predict the trend. We saw conversations much earlier and much more strategically with peers if they call it to broaden the team from [indiscernible] strategy. We do this very actively now to understand how we can help them grow and help ourselves grow. And we are very confident that we can grow, particularly when you look at adjusted operating profit within the box, ticking both these parts. So, I don’t think we can see any more than that to be honest, because obviously we keep these things tight within the business for obvious reasons but we are actively managing it. That’s what we do, that’s what we’re paid, to be honest.

George Hill

Okay. And then maybe a quick follow-up is one large payer care market is noticeably absent from the deals that you guys have signed recently. I guess, can you talk to us about when the current contract with them runs through and I guess how we should think about how you will pursue kind of the next renewal of the Caremark pay arrangement?

Alex Gourlay

Yes. We can’t speak about the contracts of any of big peers; we can’t talk about obviously for obvious reasons. They will pursue it exactly the same way that Stefano described. We want to operate with everyone in the marketplace in a way that works for them and works for us.

Operator

Our next question comes from Robert Jones with Goldman Sachs.

Robert Jones

On the cost savings program, George, last year, you shared where you ended the year on the SG&A savings, which I believe was $775 million. I know you said you’re well on track to achieve the 1.5 by the end of 2017. But, can you maybe just share with us where you actually ended the year on that program in 2016? And then, I guess along those lines, beyond the 1.5, are there any other major areas of further cost savings that you guys have been able to identify?

George Fairweather

On the program, overall, as I’ve said, we’re very much on track overall. The big change really from where we were a year ago, has really been that we were able to deliver this for $300 million less than we previously anticipated of which -- quite a portion of that will be true cash savings. So, we’re very pleased that we’ve been able do this. And we’re very much track to complete the program next year. It’s very much a defined program with the start and the finish. But of course, there are always ways to drive efficiencies. It’s just a way of life for us. We’re looking at it every day across all aspects of our business and we’ll continue to drive to do that. And clearly some of the investment that you’re seeing in capital in some of the areas like IT will take us a little bit of time to get some f the new systems in place that will further enable us to both drive efficiencies and drive -- and to manage the business in an increasingly more-tighter way.

Stefano Pessina

And next year, of course, we will have the big task of extracting value from Rite Aid. This would be another huge opportunity for saving costs.

Robert Jones

That’s very helpful. So, I guess, just one other one around SG&A. You guys talked about the initiative. Can you maybe just help us frame the investment needed to achieve that rollout? Just trying to think about on the model SG&A within the Retail USA segment as a percent of sales in 2017, maybe relative -- the core business relative to what we saw into 2016? That would be helpful. Thanks.

Alex Gourlay

I can’t give you specifics. But what I can say is that taking workload, particularly at out of our 8,200 drugstores is a big part of the cost program. And we are very pleased with the progress we made on our internal measure, independent internal measure to be honest on customer care, as we really move forward, despite the fact that we’ve held costs in the drugstores more or less flat this year. So, we are very confident that we can move that cost to give better advice [ph] and care, as George described, in the beauty model. And that would drive incremental sales and of course better margins for us as we’ve seen in the trials. So, we are very focused, as George said on costs, but we’re also very focused on reinvesting our cost back where customers appreciate it.

George Fairweather

Just to remind Bob, and as I said in the presentation there, SG&A in the USA as a percentage of sales fell 0.9 percentage points. And I think that’s the best evidence really of what we’re delivering. And just to add to the question on capital, I haven’t obviously given any specific guidance on capital for fiscal 2017. But in terms of thinking, I would expect it to be a little bit higher than we’ve seen in fiscal 2016, which is really reflecting some of the initiatives that we’ve got to develop the offer that we talked about as well as the investment in the new IT that we’re working on.

Operator

And our next question comes from the Eric Percher with Barclays.

Eric Percher

So, on the Rite Aid accretion number, I understand that you’re not including a lot of synergy here and that will come over time, and it looks like this is going represent about seven months of the fiscal year. It still looks quite low relative to the run rate of Rite Aid and what we might have thought accretion would run. So, can you speak to -- is this a fairly conservative number? I know there is a wide range of potential stores, I get that the indication of confident is really step one here, but any comments on that number itself?

George Fairweather

This is our view of it, which is why we’ve included on -- our accretion is built on our economics, which is the way we’ve built the model up. And really to emphasize a little bit of what Alex just said on the synergy -- Stefano was saying, synergies will take some time to come through as ever when we approach a merger like this, our focus is always on the customer first to make sure that we deliver for the customer through this period. And we’ve got a very detailed plan to deliver the synergies. But as we said, this will take three to four years. The important thing is to go in a straight line, but it does very much reflect our view on the timing and the time it will take to start to deliver the synergies.

Eric Percher

If I can give you any indication -- it’s Stefano. Normally, I don’t speak about these specifically but normally when we have done big merger, we have started to deliver the synergies after five, six months something because of the first months. Of course, you can do something but the first months are really needed to prepare the plan. And we cannot accelerate the plan; we cannot do the plan now. We are working on integration but we cannot do the plan about the synergies now because we don’t know the numbers of Rite Aid. As you know, we are not allowed to see their numbers. And so, in reality, we cannot put together the plan. As soon as we will know their numbers that we will have done the deal, we will start to put in place a plan which will take a few months and after we will execute the plan. This is why it is still skewed at the end of the first year, the first year of the merger, of any merger, not just this one.

Eric Percher

Okay. So, we have your best estimate there. And then for the fiscal year, I know Alex, you mentioned earlier some of the cuts that we’ve seen potentially in the UK. I know that it was a 6% cut that was delayed earlier. Was your comment around that cut actually being put into place and maybe equally important, George is that in the expectation for fiscal year 2017?

Alex Gourlay

Yes. That was my comment and I think it has been -- announced this morning, we had this morning from the UK. And George will -- I think also it’s in the guidance.

George Fairweather

Absolutely, it’s in our guidance. David made the announcement just a few hours ago, just orally, but it was very consistent with what we’ve been anticipating, so, no surprises there.

Operator

Our next question comes from Eric Bosshard with Cleveland Research.

Eric Bosshard

Curious, if -- George, if you could outline at all some cornerstones of how we should think about how the U.S. retail profit path should work going forward. Obviously you’ve got these new partnerships and you’ve outlined how that might influence gross margin and volume in 2017. But looking over the next handful of years, it would be just helpful to understand the walk of what the expectation might be in terms of either sales growth or profit growth just to have some metrics to think about in regards to that outside of acquisitions but just within the core business what you’re envisioning and how you’re -- and what goals you’re running the business to achieve?

George Fairweather

Well, I think the overall goal obviously as we’ve said is to focus on our operating income and cash flow. In terms of thinking as we’ve tried to sort of shape, you should think as we develop the new partnerships that we are able to build our pharmacy, our pharmacy volume, and as we said that we expect that to be -- the group to be faster in the second half of the year and you can think then about taking that beyond, as we said a lot of the new partnerships coming around the end of this calendar, beginning of the next calendar. There is obviously then the function of your views on inflation and then on mix, and of course with very different profile in somewhere like our central specialty versus our core pharmacy, there is an element of mix comes through there and that will obviously change over time. And then -- but we will continue to see the reimbursement pressures that are just very much a way of life.

In terms of retail, a lot of our focus has been on developing the offer, as Alex has said, both in terms of the actual offer in store, our own brands; leading U.S. brand or we’re doing on omni-channel. And so, a lot of our focus is being on working our way through getting ready for that. You should start to see the benefits of that coming through over time, focusing on the offer over time, then we believe we will be able to grow. But we are looking to grow in the right categories, which is very important and so mix is very important. And we know mix is important way of managing the margin, the gross margin in the retail products, part of the U.S. business. And so we’d expect to see the benefits of that coming through over time. And then on cost, as we say, as we drive efficiency, then we’re certainly very focused on continuing to improve our cost ratios. Our SG&A as a percentage of sales is a key area of focus. Again, we would be seeking to see that progressing. So, these really are the core drivers of what should drive the profit. I’m particularly talking obviously Retail Pharmacy USA.

Eric Bosshard

And so, within that and I appreciate all of those core drivers and how dynamic it is, but what we’d be curious to know is in terms of what you’re shooting for this to achieve in terms of operating profit growth from this business? And again, I understand there is a lot of moving parts, but is the goal of this -- this is a mid single-digit operating profit growth or an upper single-digit operating profit growth over the next three to five years, not necessarily the second half of 2017.

George Fairweather

Our overall growth is really as we target really is in terms of generating profit. It’s the goal we really talked about just over this time a year ago from our underlying activities to seek to drive profit around the double-digit level and assuming there are no extraneous factors. So, I mean currency would be a good example of an extraneous factor, where there is not a lot we can do on currency translation, it can go one way one year, another way another year. But fundamentally, that’s what we’re focused on is driving profit, and then from core activities, and then obviously shareholder enhancing transactions like the Rite Aid deal. And also at the same time, we are very focused -- and I know it’s a little old fashioned, but we’re very focused on cash flow, because cash flow is an engine for growth in the long-term. You see we’ve made good progress on working capital this year. And this really lets us invest, it lets us over time in M&A, and enables us to continue to drive shareholder value.

Stefano Pessina

As we have said in our presentation, in constant currency, in the last two years, we have delivered a compound growth of more than 15% in earnings on a comparable basis. So, this is independent on the acquisition of AB because we have restated pro forma. This is independent on the number of shares. Practically we have not had any acquisition in the meantime, excluding AB, acquisition contributed much in the last two years. We have also divested something. So, the real growth, the underlying growth of our Company in the last two years has been 13% if we consider the effect of the devaluation of the pound sterling, more than 15% in constant currency. And we have always said that we can deliver underlying double-digit growth, low double-digit growth, and this is what we are doing. And this is what are focused on.

Operator

Our next question comes from Charles Rhyee with Cowen & Company.

Charles Rhyee

Just a couple of questions to clarify, in the guidance for fiscal 2017, can you give us a sense of where we should think about a tax rate for the year, particularly as we think about the Rite Aid business coming on? Should we expect that as a U.S. business to bring the tax rate up slightly? Also Alex, you talked about minimizing or someone talked about minimizing the tobacco footprint in the stores. How much of a headwind may have that caused in foreign sales and should we think about that type of headwind that could cause as you continue to minimize that going forward?

George Fairweather

Okay. I’ll take the tax one first and then let Alex take the second one. In terms of tax, we’ve obviously not given specific guidance for fiscal 2017 on tax. But in terms of thinking about it, if you strip out the discrete items, as I talked about last year, then our real underlying tax pre-Rite Aid last year was -- our underlying tax last year was 26.3% on an adjusted basis. That’s obviously excluding the ABC income because of course that gets reported on a post-tax basis. So, it’s quite -- in terms of modeling, we always model and think about it the way I’ve just described excluding ABC.

If you think of that 26.3%, then excluding Rite Aid, that’s a fairly good proxy for what it should be going forward because pre-Rite Aid, the mix will be broadly the same. In terms of Rite Aid, you’re absolutely right. With Rite Aid, as the proportion of profit increases from the Rite Aid deal once we’re able to complete it, then we will see a higher portion of profit here in the USA and of course here the tax rates are higher than in most parts of Europe where the rest of the business operates. But of course this year, given the accretion that we’ve indicated that will be a relatively modest impact.

Alex Gourlay

On the tobacco, the tobacco comments that George made in his script, we’ll continue to obviously minimize and reduce visibility to tobacco in our drug stores but more importantly we’ll continue to help customers to stop smoking through the various platforms, smoke efficient platforms and pharmacies online and with the key suppliers put in place, for example Balance Rewards for healthy choices as one example. But you should expect that we’ll continue to see reducing sales in tobacco category in Walgreens going forward.

Charles Rhyee

Have you -- are you going to be able to quantify sort of what that headwind is as we think about that or can you talk about how much category and sales has been for you historically? I know CBS put out a number of -- couple billion a few years back.

Alex Gourlay

I am sorry. Beyond the market data that’s available, we can’t give that number. And as I said before, it’s an effect of the market as well as the effect of what we’re doing. So, we are just -- it’s just getting what we’re doing. And as said also, we’ll give you more updates.

Charles Rhyee

And if I could just add one follow up on Rite Aid again. In terms of the divestiture package, obviously a lot of noise, people making comments here and there. How flexible is this package as you think about stores that you’re looking to or willing to divest? Is this one where flexibility in terms of shaping the portfolio to be able to satisfy, not only you have to see it but potential buyers?

Stefano Pessina

Well, we are not able to give the details. First of all, I’ll repeat again, we don’t know in detail all data of Rite Aid. And it’s early time for us to take these decisions and that of course even if we them, we could not disclose them. So, it’s too early. In a few months, probably we will be able to discuss about this.

Operator

Thank you. Ladies and gentlemen, this does conclude the Q&A portion of today’s conference. I’d like to turn the call back over to our host.

Gerald Gradwell

Thank you. And thank you, everyone for joining us today and for your questions. That was our final question. If anybody does have any further questions, the IR team here and myself, Ashish, Deborah, Jay and Patrick are around for the next couple of days and of course always around and available at the end of phone or email.

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