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Walgreen Company (NYSE:WAG)

F1Q08 Earnings Call

December 21, 2007 8:30 am ET

Executives

Rick Hans – Director, Finance

Jeffrey A. Rein – Chairman, CEO

Gregory D. Wasson – President, COO

William M. Rudolphsen – Sr. Vice President, CFO

John W. Spina – Vice President, Treasurer

Analysts

Edward Kelly – Credit Suisse

Patricia Baker – Merrill Lynch

Meredith Adler – Lehman Brothers

Andrew Wolf – BB&T Capital Markets

Mark Miller – William Blair & Company LLC

David Magee – Suntrust Robinson Humphrey

John Heinbockel – Goldman Sachs

Scott Mushkin – Banc of America Securities

Lisa Gill – J.P. Morgan

Mark Wiltamuth - Morgan Stanley

Robert Summers – Bear Stearns

Derek Leckow – Barrington Research

Operator

Welcome to Walgreens first quarter 2008 earnings conference call. (Operator Instructions) I would like to turn the call over to Mr. Rick Hans, Director of Finance, please go ahead sir.

Rick Hans

Thank you and good morning everyone. Thank you all for joining us today for our first quarter earnings conference call. With meare Jeff Rein, Walgreens’ Chairman and CEO, Greg Wasson, our President, Bill Rudolphsen, our EFO and John Spina, our Treasurer. During this call we’ll provide a brief overview of the first quarter and a review of the cost control measures we’ve implemented and the success we’ve seen from them. We’ll also highlight our efforts to leverage our stores to drive higher sales volume and our investments in new and expanding health care services. I should point out that today’s call is being simulcast on our Investor Relations’ website atwww.investor.walgreens.com. After the call, this presentation will be archived on our website for 90 days. Following our prepared remarks we’ll be happy to take any questions. Please limit yourself to one question and a follow-up so that we can give an opportunity to as many investors as possible during our limited time.

Before we get started I’d like to read our Safe Harbor language. Certain statements and projections of future results made in this presentation constitute forward-looking information that is based on current markets, competitive and regulatory expectations that involve risk and uncertainty. Please see our Form 10-K for the fiscal year ended August 31st, 2007 for a discussion of factors as they relate to forward-looking statements. Now I’d like to introduce our Chairman and CEO, Jeff Reins.

Jeffrey A. Rein

Thank you Rick, good morning and thank you for joining us. We appreciate your time particularly on the Friday before Christmas. Many of you may be aware that Walgreens has recently made a significant effort to broaden investor access to senior management. Today’s call is just one more example of this effort and consistent with our commitment to greater transparency, access to senior management and improved information flow to shareholders. Let’s begin with our quarter.

As you saw from our release we reported record sales and earnings despite facing a tougher comparison for 25% earnings increase in the year-ago quarter expense control is the top priority and our folks came through particularly in payroll. We also maximized our advertising dollars through greater efficiency while keeping up our promotions during the critical pre-holiday season. We are very pleased that we’re starting 2008 with a strong footing. Due to a number of factors, our sales growth in the period was slower than expected. Among these were late quarter weakness in seasonal categories, discounts on digital photo processing, a milder than normal flu season and the recall and cautions on children’s cough and cold products. We continue to execute on our organic growth strategy in the quarter opening a record number of new stores and continuing to invest in our future.

As of November 30th we had 6,139 stores nationwide. In addition we have about 1,800 new store leases in our active pipeline, of those 600 have already been signed. Taking a closer look at cost controls this quarter, we took a number of significant actions in response to the unacceptable growth and expenses in the fourth quarter. In particular, store and district managers redoubled efforts to more closely align store expenses with budgets and sales performance. We also were very careful to manage service levels and discretionary costs with a keen eye to avoid disrupting customer service or slowing sales momentum. At the corporate level we put certain non-critical projects on hold. I want to acknowledge and thank our teams in the stores and at corporate office for their hard work. You’ve done an extraordinary job. While I’m happy with our great products on the cost front, have no doubt we’ll continue to be vigilant.

Looking forward, we expect the first half of fiscal 2008 to remain challenging from a bottom line perspective as we cycle a very robust period for generic drug introduction last year. However, our long term outlook for margins and sales remain strong and should improve in the second half of fiscal 2008 and beyond. I would also like to point out the comparisons in the second quarter will be difficult versus last year when we recorded gross margin of 28.96%. Last year we benefited from new generic introductions, significant SG&A leverage and operating margin expansion. Now I’ll turn the call over to Bill Rudolphsen, our CFO, for more details on the numbers.

William M. Rudolphsen

Thanks Jeff and good morning to all of you. Let’s briefly discuss our first quarter financial performance. We reported revenue of $14 billion, a 10.4% increase. Comparable store sales were up 5.4%. Net income and earnings per share grew 5.5% and 7% respectively. Prescription sales rose 11.1% for the quarter and 5.9% on a same-store basis impacted by more sales of lower cost generic drugs and a milder flu season. The number of prescriptions filled in the first quarter increased 3.7% on a comparable store basis. Front-end store sales increased 4.6% on a comparable store basis. In terms of the current environment as we’ve indicated, our gross margin dollars and overall profits are being impacted near term by self-comparisons to what was a stellar year-ago period. In addition we saw a positive impact on volumes a year ago from the introduction of the Medicare Part D benefit. Total gross profit in the quarter was $3.9 billion, a $331 million year over year increase. Our LIFO rate this quarter was 1.5% compared to 1.75% in the year-ago quarter. That let to a LIFO provision of $26.9 million in the quarter, just $.50 million less than last year’s first quarter.

As Jeff indicated we made significant progress at slowing the rate of growth of advertising, payroll and direct store expense. SG&A expenses increased 9.5% in this year’s first quarter versus 18% in the year-ago quarter primarily due to lower growth in store salaries, legal expenses, insurance and store closing costs. Advertising expenditures grew more slowly than sales in the first quarter. Our advertising spend was up 8% in dollars year over year to drive traffic through circulars and other media. Even though payroll and direct store expense dollars grew faster than sales, we made good progress slowing the rate of growth compared to the fourth quarter. We believe we can hold the line on the cost control improvements we’ve already made while making additional progress in other areas.

Looking at slide number six, you’ll see that normally changes in SG&A expenses closely track changes in gross profit dollars. That didn’t happen in the fourth quarter of fiscal 2007; we quickly got back on track in this first quarter with the growth rates of SG&A expenses and gross profit dollars moving in [lock step]. Our effective tax-rate was 37.5% compared to a rate of 36.8% in the year-ago period. We anticipate a tax-rate of about 37.2% for the fiscal year.

Looking through our cash flow and balance sheet, cash flow from operations totaled $390 million in the quarter. Our total short-term debt stood at $1.2 billion at the end of the first quarter. We will continue managing our balance sheet for maximum financial flexibility and to support our core growth strategy. I would like to spend a few minutes discussing our store expansion program.

Some in the financial community speculate that our new stores are less productive than in years past due to high real estate and labor costs. Let me put that myth to rest. Our productivity improvements at the store level continue to be very positive. If you’ll refer to slide seven, you’ll see we published for the first time our front-end sales per store for stores we opened each class year from 2002 through 2006. As an example, the front-end sales after year one for the 2006 class of stores is just over $2 million which exceeds the front-end sales for each prior class store shown. On slide eight we show prescriptions per store per day at the end of each year. Again, for stores we opened each class year from 2002 through 2006. Both sets of data demonstrate that our 2006 class of stores performed as well in the front-end and the pharmacy as the store classes each year between 2002 and 2005.

On slide nine, we also show our return on average invested capital for the last five years. Those returns have increased from 9.6% in 2003 to 10.5% in 2007. You can find the details of this calculation on our Investor Relations’ website. You can use these three pieces of data to come to the same conclusion that we have, namely that the productivity of new stores has not diminished over the last five years. Also keep in mind that Walgreens ROIC is greatly impacted by the 20% of our stores that are less than three years old. It takes about three years for an organically developed store to break even. We estimate that when you adjust for the net operating profit after tax and the invested capital for these new stores, the after-tax ROIC for our stores opened more than three years is in the mid teens. This results in a significant spread over our weighted average cost of capital which we calculate at about 8% using the market value of equity method.

Given these returns we’ll continue the growth of these highly productive stores. Finally from an investment standpoint, it’s important to know that we have a goal for our capital investments to reach an average ROIC of more than 15%. This goal includes strategic growth initiatives such as organic and acquired store growth, new alliances and other ventures and acquisitions we might consider. Let me know turn the call over to our President, Greg Wasson, who will update you on growth initiatives.

Gregory D. Wasson

Thank you Bill and good morning everyone. I’d like to briefly touch on recent progress in our overall strategy to leverage our store box to drive higher sales while investing in new and expanding health care services to grow earnings. Our pharmacy business is strong from every competitive vantage point. Just to remind you, we filled more than 580 million prescriptions in fiscal 2007. Today our share of the U.S. retail prescription market is more than 17%. Our drugstore sales on a square footage basis are $797 among the highest in the industry. As you know, fiscal 2008 will not be a year of major new generic drug launches. This is simply part of the ebb and flow of generic introductions. However, we expect to see a new wave of generics in 2009 through 2011 which will bolster and accelerate our profit in those years. For example, looking ahead to the next several years, drugs coming off brand include [Lipitor and Nectim] but keep in mind it is difficult to forecast with certainty the timing of generic launches.

As important as mainstream prescription drugs are to our business, we’re also positioned to take advantage of the fastest growing area of pharmacy, specialty pharmacy, which is rising at a rate of 20% a year. You will recall that our acquisition of Option Care last summer is a key part of our growth in specialty pharmacy. I am pleased to report that the integration of Option Care is progressing on plan. This success demonstrates our ability to affectively integrate sensible acquisitions into our broader platform. Consistent with our strategy of strengthening our healthcare relationships with consumers, we continue to roll out our Take Care Health Clinics during the quarter. Today we have about 120 clinics operating in 15 cities across 11 states. Again, the convenience of ordering combined with the cost affective access to basic healthcare services that Take Care Health Clinics offer represent a distinct advantage.

Take Care Health Clinics offer high quality primary health care services and our staff by nurse practitioners position assistance. We work in collaboration with primary care physicians. We have an excellent model to retrofit our existing stores and we anticipate having more than 400 clinics operational by the end of calendar 2008. Our early studies indicate that approximately 20% of Take Care Health patients choose to fill their prescriptions at Walgreens are not existing Walgreens pharmacy patients. Our financial assumptions for these clinics are based solely on healthcare reimbursement and cash fees for common medical procedures such as vaccinations, basic diagnostic testing and similar activities. Incremental pharmacy volumes and front-end sales are not considered in our financial [inaudible].

We continue to look at opportunities to expand access to Walgreens as a trusted source for basic healthcare services. An example of this is our move to operate pharmacies at non-traditional venues such as Children’s Hospital in L.A. and Northwestern Memorial Hospital here in Chicago. We also have pharmacies onsite at corporate campuses of large employers such as Toyota Motor Manufacturing. You may have seen that during the quarter we made the decision to withdraw as a pharmacy provider for four prescription plans managed by [CVS Caremark] due to their unacceptably low below market reimbursement rates. While we continue to seek a negotiated solution, this won’t have a material financial impact on our results.

Thank you for your attention let me turn the call back to Jeff to discuss our strategy.

Jeffrey A. Rein

Thanks Greg. I want to spend the last few minutes of our prepared remarks on our corporate strategy and outline how our superior competitive will lead us to future growth and deliver long-term [inaudible] value.

We are focused on going on market leadership for strength in our competitive position. We intend to actively and aggressively manage organic store expansion to capture the best retail corners nationwide. We continue to make sales focus and customer focus investments in our stores, supply chain marketing and infrastructure. We’re expanding into adjacent sectors of pharmacy and healthcare services through our acquisitions of Option Care, Medmark, [inaudible] and Senior Med. [inaudible] will allow our patients to continue using Walgreens’ services as they develop needs for infusion therapy or specialty pharmacy products, or moving into an assisted living setting. We will prudently evaluate acquisitions that enhance our core service offerings, expand our convenience and meet our [inaudible] goals.

So, how are we uniquely positioned to capitalize on this strategy and deliver that shareholder value? First and foremost with more than 6,000 locations, significant buying power and high service levels, we have an exceptional retail platform that can be leveraged across both the front and the back of the store. As a pharmacy provider we believe our independence differentiates us and enables us to successful compete for business as a provider of choice. We believe any efforts to restrict us [inaudible] provide our networks will prove counterproductive [inaudible] will underscore the inherent conflict of interest to vertically innovative business model. Organic store growth remains a key part of our strategy. This year we plan to open 550 stores for a net increase of 475 stores after relocations and closings. In addition, we are targeting total square footage growth of approximately 8% per year. Geographically we’re aggressively expanding in the northeast and California. These areas have higher real estate costs and in some cases, smaller properties with which to work. So we’re using a flexible and adaptable store model to customize product selection similar to our successful stores in densely populated urban markets, such as San Francisco.

While the break even period is longer for these stores due to higher real estate and development costs, experience has shown that their sales growth tends to be sustained over a longer period than stores in less dense markets. In other words, these stores continue to improve the performance for many more years after they break even. Over the long term, we expect our [inaudible] and sales per square foot to increase as we bring the higher mix of these stores into our system. In short, we are no where near the saturation point; there is plenty of room to grow. We have the right strategy to get there. We’re also growing market share through buy-outs of independent pharmacies which plays particularly tough economic times, pharmacy reimbursements fall in both the public and private sectors. We completed a record number of 200 independent pharmacy buy-outs in fiscal 2007 and we expect this trend to continue.

Our strong balance sheet provides us with the ability to be opportunistic and flexible in pursuit of growth. Our 50% debt to total cap ratio positioned us ideally in this regard. When you look at the different levers we have as an organization, we believe we are well positioned to deliver consistent growth.

That concludes our formal remarks and now we will turn to your questions.

Question-and-Answer Session

Operator

Our first question will come from Edward Kelly – Credit Suisse

Edward Kelly – Credit Suisse

Hi good morning. Could you quantify the benefit from the lower legal insurance and store closing costs in the quarter. Was that all of the 19 basis point decline in the SG&A? Is that how we should think about that?

William M. Rudolphsen

No Ed, that’s not, I’d say the major reason for the increase or the change in the growth rate was store salaries. We grew at 18% in the first quarter of last year, only 9.5% this year. I’d say about a third of that improvement is related to store salaries.

Edward Kelly – Credit Suisse

Okay but the year over year lower SG&A rate of 19 basis points, that’s mostly the legal, the insurance and the store closing costs right?

William M. Rudolphsen

[inaudible] sales basis, that is correct.

Edward Kelly – Credit Suisse

Okay. And then Jeff I was hoping you could discuss comp trends a little bit. Your comps have obviously decelerated somewhat and I understand that generics is playing a role in that, but obviously from the information you provided, your new store comps are still robust so can you help us dissect what your older stores are comping at this standpoint if we call it stores older than five years? And then what should we expect now going forward the rest of this year, particularly on the front-end as it seems like things might be slowing down a little bit?

Jeffrey A. Rein

They still are going very well. We did see a traffic slowdown in mid October and that’s what we talked about in November. So that traffic slowdown, you saw the customer buying down a little bit and the customer count once again went down a bit. The comp stores are still doing very well in those stores open more than three years. Is that what you’re referring to?

Edward Kelly – Credit Suisse

Yeah, I’m talking about your more mature stores.

Jeffrey A. Rein

Right, they’re still doing very well in terms of comp sales, but once again overall we did see a decrease in customer count starting in about mid October when the sub prime and crisis became big news. We saw people trading down a little bit and that slowed down the comp store sales a bit. With regard to the rest of the year, it is a top economic environment right now, but of course we’re not commenting particularly on sales for this month and also how it’s going to be for the rest of the year.

Edward Kelly – Credit Suisse

I want you to think about what your promotional strategy is going to be going forward on the front-end, do we think about it as getting more aggressive because of this?

Jeffrey A. Rein

We will do what we need to do to either meet or beat competition. If we need to get more aggressive, we certainly can. We do a good job day in, day out. I have no problems with that. We’ve always been promotionally oriented not only in our ads but in the way we merchandize our stores. As you know, most of the products that we sell in our stores are low end products and they lend themselves to promotional building. People come into our stores based on convenience looking for 1.6 items, they leave with 3.3 items. That has been very, very consistent whether the economy is great or the economy is poor. So I think we’ll do just fine, just fine in the months ahead.

Edward Kelly – Credit Suisse

Okay, thank you.

Operator

Our next question comes from Patricia Baker – Merrill Lynch

Patricia Baker – Merrill Lynch

Good morning everyone, I don’t want to dwell very much on the fourth quarter but since we didn’t have the benefit of this exact access with that quarter, can you just go back and explain to us why you think the fourth quarter did end up with much higher SG&A than was anticipated? Just so that we have a better understanding going forward.

Jeffrey A. Rein

Yes Patricia, in the fourth quarter of 2007 we did a very poor job of managing and focusing on expenses. We are a $0.03 company and that’s our mantra right now, a $0.03 company. We have got to remain focused. During that time period, our payroll was out of sight. We also had [inaudible] expenses and advertising that we had in the fourth quarter of last year that we did not have in the previous year. So once again, I would say it was a lack of focus. As you can tell by this quarter, there’s more focus on controlling discretionary costs; we are making sure that when we have the budgets and the sales those are being matched up. We’re taking [outliners] back to budget. Obviously if they get and do more sales then the budget is saying, then they get more hours. But if they do not, then we take hours out. The biggest leverage that the store manager can control in terms of expenses is that payroll salary line. Once again, by matching up the budgeted hours with the budget sales, we will do better.

Patricia Baker – Merrill Lynch

Okay thank you, that helps us understand it better.

Operator

Our next question is from Meredith Adler – Lehman Brothers

Meredith Adler – Lehman Brothers

I’d like to talk a little bit more about first quarter expenses, the 18% SG&A growth you had in the first quarter last year, I believe some of that was related to Happy Harry. I don’t know how much of that was payroll but is it fair to say that some of the improvement in the payroll this year is of a function of fully integrating Happy Harry and that those were sort of one-time costs?

Jeffrey A. Rein

I wouldn’t say that completely Meredith. The reason being it’s an ongoing process with Harry’s. We’ve obviously put some payroll in but the stores were not necessarily all set completely. We’re still going through that right now with them, to make sure the [inaudible] are set to Walgreens’ system. So I would not classify that at all as the main reason. The main reason once again that we controlled expenses is that we had diligent efforts and we’re tracking it on a daily and weekly basis much better than we did in the past.

Meredith Adler – Lehman Brothers

Okay and then I’d like to just ask some questions about the slides you were kind enough to provide us about pharmacy productivity both front-end and one thing I noted is a footnote that you’ve excluded the 24-hour stores. Can you tell us how many of the stores you’ve been opening are 24-hours and then I have just a follow-up question related to that.

Jeffrey A. Rein

To answer the 24-hour question, when you say opening, do you mean opening per year? Right now we have approximately 27% of our company 24-hours, about 1,600 stores that are 24-hours. It’s hard to determine exactly to say how many we’re going to open per year because obviously it’s based on script numbers, the competition and so on, so that ebbs and flows. But right now, we’ve been around 27%, 28%; we’ll probably stay about that range for quite awhile. You have other questions regarding the charts?

Meredith Adler – Lehman Brothers

Yeah, well I mean you had excluded those 27% of the stores more or less from these charts, I just wanted to understand that, but also can you talk about over the same five year time frame where you’ve had very stable sales and script count, what’s happened to labor and real estate costs? Have they also been equally stable?

William M. Rudolphsen

Yes, they’ve been fairly stable. Certainly as we do expand into the northeast and California as Jeff mentioned, we would see slightly higher occupancy costs in those areas. But overall our costs have been fairly stable.

Meredith Adler – Lehman Brothers

And finally just the chart you do where you look at return on average invested capital, are you capitalizing leases in that calculation?

William M. Rudolphsen

Yes we are.

Meredith Adler – Lehman Brothers

Okay great, thank you.

Operator

Our next question comes from Andrew Wolf – BB&T Capital Markets

Andrew Wolf – BB&T Capital Markets

Good morning, I just wanted to ask you about the – from your commentary on the – it sounds like you’re making good progress on the payroll side of the business but actually there’s – it’s got to be carefully done, but it sounds like there’s more to come. Am I understanding that right and if so, what sort of, could you somehow give some quantification of how much more labor rates can be managed down?

Jeffrey A. Rein

Thanks for the question. I don’t want to give an exact figure on how much more can be managed down. It is a lot more focused than ever before. Once again, during the last summer we just did not do a good job of focusing on it, week to week to week. We are definitely doing it now. Focusing on [inaudible] from a corporate point of view and also engaged store level to make sure we look at that payroll. It’s more judicious use of payroll and once again we look at the out-liers. We have templates that the manager and district manager and store ops Vice President agree upon, that how many hours are allotted to every store including pharmacy and front-end. If the sales are there then we’re okay. If the sales get much better than anticipated, obviously we can put hours on. If they get much worse than anticipated we can take hours out. One thing we obviously don’t want to do is hurt service levels and as I’ve mentioned in the past, we’ve had a pretty track record now of having decreased service complaints in our stores. It’s a focused effort on taking care of the customer, taking care of the patient and once again we’re not going to be so silly as to cut payroll to the bone where we hurt ourselves. We don’t want to do that. We want to take care of our people and we want to take care of our customers and patients all the time.

Gregory D. Wasson

The other thing that we did do intelligently, back to the 24-hour, we did take a look at some of the 24-hour stores that we had and rolled back a few that maybe didn’t make sense and we may have been a little aggressive over the years in adding some of those 24-hour locations. We rolled a few back that helps us a little bit in that area. Again, as Jeff said, just an intelligent focus on labor costs. Our managers and our district managers in the field have done a great job responding.

Jeffrey A. Rein

That’s a good point by Greg. We’re reviewing the districts; we actually had some districts that were 50% 24-hour stores. We just didn’t need that for the coverage.

Andrew Wolf – BB&T Capital Markets

Okay so it sounds like you can at least maintain the current discipline and perhaps do some fine tuning to come.

Jeffrey A. Rein

I think that’s a good way to say it; a fine tuning is the best way to [steady] you’re right.

Andrew Wolf – BB&T Capital Markets

Okay and my follow-up if I might is just on the pharmacy side of the business, both at Walgreens and other public chains and the industry at large, this year has been a little slower than last year in the prescription business and as you all dissect it, there’s different reasons. One is obviously you’re lapping in the Part D infusion last year, Wal-Mart and others have made a competitive bid for business, the economy, add flu, how would you when you look at this year being a little slower than last year, how do you ascribe the slowing, slight slow down in the scripts?

Jeffrey A. Rein

I would agree with those reasons you listed and Medicare Part D, the flu obviously is playing a part of it. The economy as you mentioned. I think another thing coming into play is employers putting more cost on employees. As you see co-pays rising people unfortunately do not fill their medications as much as possible. But I think what you’re seeing is more and more people are getting access to care. I’m quite confident the numbers will go up as people get access to care. For example, through our Take Care Clinics and other clinics that are out there. I think people want to stay well, as insurance companies pay for visits to the Take Care Clinics for example. That encourages people to come into the system. Before, they might be putting it off, for example they didn’t want to go to a doctor, they know it’s very expensive. They just wait it out. There’s also been not a lot of negative publicity as you know regarding various cough syrups and other medications and people might be taking a little bit of a jaundiced view of it. Well let me just wait it out and see what happens. It’s our job though as a pharmacist and pharmacy profession, to encourage people to take their medication on a regular basis. I think that’s one of our biggest opportunities for us to grow numbers, is to get people to be compliant and adhere on their medications. You know if you miss your medication for a day on [Astatine] for example, or something for high blood pressure, you’re not going to feel any different. But if we can show people that you know what, you’re going to feel better, you’re going to be around to see your grandchildren in the years to come, then it will make a big difference and there’s our opportunity in this industry is to drive compliance and adherence.

Andrew Wolf – BB&T Capital Markets

Alright, thank you.

Operator

Our next question comes from Mark Miller – William Blair & Company LLC

Mark Miller – William Blair & Company LLC

Good morning, first one to say thank you for posting this forum. I think it’s going to be helpful for the dialogue going forward. I want to follow-up on an earlier question about the rate of expense control we’ve seen so far and Bill you talked about you can improve additional things going forward. I hope you can elaborate on that and then Jeff you mentioned the non-critical projects on hold. How long can those stay on hold if the economy does tighten up, how much ability do you have to bring down the expense growth rate further?

Jeffrey A. Rein

We have a lot of ability to bring that down as needed without being silly or stupid about it. Obviously what ever we want to do is, in terms of payroll, is to make sure we don’t impact sales. On the expense and [inaudible] we want to make sure that we don’t impact shareholder value for the long term. As you know there’s always been this unique needs and want-to-do. Some of those want-to-dos are not necessary right now. There are some needs to obviously that we are moving ahead with, but once again, the wants-to-do we just can’t do that. And any list of projects we obviously have to prioritize what we want to do and what we need to make happen and position ourselves well for the future. In terms of the expenses, once again, about one-third of our savings this quarter was due to payroll, the other two-thirds was due to these higher legal, insurance and store closing costs. Those ebb and flow as you know. And so we can’t be exact about those, but the biggest SG&A expense line that we can control is payroll. Payroll represents about 50% of our SG&A and that’s where, if we have a concentrated effort to make a difference, we can do it.

Mark Miller – William Blair & Company LLC

In the stores where you’ve put in the discipline you talked about, have you seen a bigger change in their sales so as comped flowed in November, was that more so at those stores that had that greater expense discipline?

Jeffrey A. Rein

No Mark, absolutely not, no, no, no. As a matter of fact it’s kind of interesting. If you look at the stores on an individual basis, typically those folks that run the most disciplined payroll have the best stores in terms of being in stock, taking care of the employees, taking care of the customers; everything is great. It’s just like inventory for example. You go into some stores and if they’re a lot over in inventory, some folks think well there should be no out-of-stocks, but actually those are the worst stores in terms of being in stock.

Gregory D. Wasson

You know our operations folks have done a great job delivering this message to help us make this happen. They’ve been in the stores, working with the stores that might have some challenges making sure it’s done the right way and intelligently. And they’ve been extremely careful and cautious about doing anything that might hurt service levels. I just think it’s been one heck of an execution from our store ops folks.

Mark Miller – William Blair & Company LLC

Thanks, my other question on the slides, looking at the pharmacy productivity, it moved up in this past year, but it is down from where you’ve been a couple years prior despite overall growth in scripts in the market. I guess I was hoping you could address that and also explain whether that’s coming from more stores in these new markets so you talk about higher investment costs in the new markets on the coast, but do you also start with lower sales productivity and then as more of these stores are coming on is there some risk that return on capital would actually be weighed down for some period of time until enough of them are in the maturity phase of the curve?

Jeffrey A. Rein

Let me answer the first part of that. In terms of the slower growth, as we expand more into areas where we’re not as well known, the prescription growth is slower to begin with. But what we’ve found many, many times particularly in the northeast and California and so on, that after that four and a half to five year break point, our sales actually go up faster than the other stores in more mature markets. So I think we’ll be okay. Once again long term it shouldn’t be a problem in terms of growing the scripts. Bill, do you have anything to add?

William M. Rudolphsen

Yeah Mark, as I look at the numbers I really don’t see a material difference amongst the numbers throughout the years, that’s why we posted the chart and I would agree with Jeff’s comments that we do start out slower in the northeast but we ramp up over time as the public becomes more and more aware of Walgreens in the market.

Jeffrey A. Rein

Mark a good thing to always keep in mind is that the market share of penetration actually drives the ROIC. So once again, in more mature markets the stores come up to that break even point, break even and above, much quicker than they do in some of the areas where we have less than a two coverage. That’s stores per 100,000.

Mark Miller – William Blair & Company LLC

And on the ROIC part of the question, it’s intuitive to me that it would weigh in returns, is there some reason why that wouldn’t manifest itself in the results?

William M. Rudolphsen

Yeah Mark early on I would say as we start slower certainly that would weigh on the returns but long term we would get where we need to be which is a 15% return on invested capital which is our target.

Mark Miller – William Blair & Company LLC

Right, thanks, enjoy your holidays.

Operator

Our next question comes from David Magee – Suntrust Robinson Humphrey

David Magee – Suntrust Robinson Humphrey

Good morning, just a question about the generics and your expectations for the lesser introductions in 2008, would you expect that your generic percentage to still grow this year in the environment and how should we do that? Is it just less of a positive in this kind of a year or is it actually a negative and that you’ve got less to offset older generics that are being axed out, et cetera?

Jeffrey A. Rein

As you know David, the generic, the plan going to generic is actually a low point in 2008 then it picks up in 2009, 2010 significantly. I do believe that our generic penetration will continue to move up, maybe not quite as quickly of course on a percentage basis because you don’t have all the brands going to generics. But more and more people are familiar with generics, doctors believe in generics and the customers and patients know a generic now and are asking for it. Also it’s part of the design of the co-pays. Most folks, most employers obviously are keeping those generic co-pays down. As a matter of fact, some companies now are starting to waive co-pays on certain generics just so people will take their medication, and that’s where I come back to this compliance and adherence. I think there’s realization in the health industry in general, that if we can get people to take their meds then our total health care costs will go down over time.

David Magee – Suntrust Robinson Humphrey

Thank you Jeff, from 10,000 feet, do you think that the generic profitability would change that much over the next three or four years?

Jeffrey A. Rein

What do you mean change?

David Magee – Suntrust Robinson Humphrey

Well in terms of just you’re net dollar per script reimbursement that you get for generics? Do you expect that to change much?

Jeffrey A. Rein

No. Not on a per script basis, no I don’t see that happening.

David Magee – Suntrust Robinson Humphrey

Great, thanks.

Operator

Our next question comes from John Heinbockel – Goldman Sachs

John Heinbockel – Goldman Sachs

Jeff do you think, are we headed toward a period of greater ongoing confrontation between PBMs and retailers over reimbursement, broadly not just [Care Mark], but Medco and Express as well? Are we headed in that direction and do you see opting out of other plans or no?

Jeffrey A. Rein

You know John, it’s always been a discussion with the PBMs over the years in terms of the reimbursement rate which we feel is needed and fair to us, and at the same time fair to them. I wouldn’t say it’s more conflict at all. These four plans with [CVS Care Mark] is just something that we haven’t been able to work out yet. I’m hoping that we do come to a resolution but we just have not yet. But in terms of the major PBMs and the conflicts, no I don’t see it intensifying at all. I really don’t. I think we’ll be just fine in the years to come. They have their point of view, we have our point of view, but once again with our coverage and the locations and market share we have, I don’t see it changing from what it was in the past.

John Heinbockel – Goldman Sachs

With regard to Care Mark, do you sense a different agenda than had been the case a year ago or this issue you had with these four plans, they would have cropped up whether CVS owned it or not?

Jeffrey A. Rein

Yeah, that’s the best way to put it. As you know we have been fighting, if you want to term it that way, with the PBMs for a long, long time. Most of these don’t get to be public knowledge. You would never hear about it. These four plans unfortunately couldn’t come to an agreement which was fair to both sides. Again, we’re still talking with them. We hope to have a resolution, but no I wouldn’t say things are going to get worse at all. And obviously we’ll continue our discussions.

John Heinbockel – Goldman Sachs

And then finally, how much of your front-end do you think is really economically sensitive, is discretionary and of that, of what is discretionary, how price-elastic do you think that is such that if you increase promotions you get a response?

Jeffrey A. Rein

John in my opinion, we are recession resistant, but we’re not recession proof. Once again, it depends on your level of income. What might be someone’s discretionary spend is someone’s needed spend somewhere else. But with promotional activity that ebbs and flows as you know, once again, most of our sales happen because folks are in the store. That’s why we want these prime locations on the best corners in America. Once they get them into the store, we are just fine in terms of selling and what we need. Now maybe we need to do some price points, lets say instead of $3.19 maybe it’s $2.99 or two for $5 or something of that nature, but our job in terms of the [rodo’s] and the circulars is to get people in the door. And we’ll do what we need to do depending on how competition responds and how the economy is and how things have been and are going.

John Heinbockel – Goldman Sachs

Does $3 gas help you in that traffic generation or no?

Jeffrey A. Rein

It is interesting. We are in a neighborhood; we’re close to home so in that sense when people have a need, once again, the only time we ask for 1.6 items so they’re top of mind. They’re out of milk, right. They’re out of bread. Who’s not going to have that for their children in the morning? They think of Walgreens right off the bat. They think about Walgreens’ milk, they come to our store to buy it and then they pick up something else. So I would say actually with gas prices increasing, people are coming to our stores.

John Heinbockel – Goldman Sachs

Okay thank you.

Operator

Our next question comes from Scott Mushkin – Banc of America Securities

Scott Mushkin – Banc of America Securities

Just a couple of questions, one just to clarify, I know we’ve drilled on this SG&A subject but what in basis points would it have been OpEx some of these one-time items, legal and insurance and store closings?

William M. Rudolphsen

We’re not going to release the exact amount but it’s not a tremendously significant amount. I would again point to as we look at the increase in SG&A last year in the first quarter of 18% versus 9.5% this quarter, the most significant amount of that reduction in the increase was store salaries and we would point to that being about a third of the change.

Scott Mushkin – Banc of America Securities

But the other two-thirds were pretty much one-time items, not as repeatable?

William M. Rudolphsen

More one-time items, plus other control of expenses in other areas.

Scott Mushkin – Banc of America Securities

And then moving to the gross margin which I don’t think we’ve hit on yet down 29 [biffs] it’s somewhat surprising, was that all front-end related as we look at that? How do we think about that going forward with sales slowing a bit in the front-end and then maybe just as a follow-up to that, consumer behavior seems pretty odd this time around. Usually you guys are the last to slow and supermarkets haven’t really slowed much at all, so maybe a comment on why you think all of a sudden with employment still very robust you’re actually seeing a pull-back, of why you think it’s not related to some of the actions you’re taking.

William M. Rudolphsen

On the margin side Scott, our pharmacy margins were up, driven by generics but our front-end margins were down as we moved to less profitable categories being sold. But the front-end was the major factor in the reduction of gross margins.

Jeffrey A. Rein

When you look at the sales once again going back to November where it started to tail-off, don’t forget that cough cold is a big, big part of our business and before the FDA said anything about children’s cough medications, we were up about 15%. The day after that immediately started to drop. We actually ended up zero for the time period. Just zero. We have never seen, I’d mentioned to several folks, I had never seen us up zero in cough cold. Seasonal-type products we saw starting to decline a bit in November. Once again, Halloween was pretty good but not quite as good as we would have liked and we have high expectations of course. Items like vaporizers in November just didn’t sell. They just aren’t going. People aren’t buying, they don’t need them, it’s too warm. Products like mittens and hats and clothing are down 20%. Those products we’re not selling. So once again in an environment it’s slowing, people do look at what they’re spending and what’s discretionary. They may or may not be buying some of the promotional items that we offer. I think a lot of it is dependent on not only what do they think of the future of course in terms of their mortgage, their job and so on, but also the weather does impact us. Particularly on the cough, cold and the flu index side.

John Spina

I just want to add that you know in a tough economic time, there’s so many moving parts to our sales, it’s tough to pin it on one thing. So we’re just going to make sure we take care of the customer, we have the right advertising, get them in the door, put that extra item in the basket and go forward. But to predict the future, we just never could do that. There’s too many moving parts.

Scott Mushkin – Banc of America Securities

Do you at least anticipate all equal in the economy it just kind of keeps chugging along the way it is, which is just so-so, that this gross margin pressure will continue through the year?

Jeffrey A. Rein

We’ll see how it goes. We don’t comment on which way it’s going one way or the other. It’s a tough economic environment as we said before, we all read the same papers and see the headlines and so on, but we will have to see how that goes.

Scott Mushkin – Banc of America Securities

Thanks guys and thanks again for doing this, I know someone else said that but it’s really appreciated.

Operator

Our next question comes from Lisa Gill – J.P. Morgan

Lisa Gill – J.P. Morgan

Thank you and good morning. Jeff I think you talked a little bit about expansion of your healthcare strategy and I’m just wondering if you can maybe talk about areas that you’re looking at. I also think that someone made the comment that especially pharmacy is fully integrated or unplanned, can you talk about how your integrating specialty pharmacy into your front-end pharmacy and again just coming back to how you view the overall strategy for healthcare offering.

Jeffrey A. Rein

Lisa, just to let you know, we don’t comment on any acquisitions that may or may not be happening. We’ve never done that in the past and obviously we’re not going to comment right now. What we are trying to do with our strategy is make sure that we can take care of folk’s pharmaceutical needs. In the past we’ve been able to serve folks, in many cases, from the time they were born until maybe 65 to 70 and then we’re out of the picture. It just doesn’t make a lot of sense to us so we with the acquisitions that we’ve done, whether it’s Option Care, Med Mark, [inaudible] and Senior Meds, it allows us to take care of that patient from cradle to grave. And everything we’re doing and seeing is that more and more of the pharmaceutical needs of people can be met by the infusion or specialty side. And by the way, these folks who obviously have to be infused or take specialty meds also take other medications. So if we get the specialty person, you also get whatever else they’re taking that they can take orally. Greg I think you had some comments also on this specialty.

Gregory D. Wasson

Yes, I believe obviously a big area of focus for us is the specialty and fusion area. Obviously with it growing at 15%, 20%, $60 billion today, that could double in the next five years, maybe even triple. So it’s a huge area of focus for us. As we know, pharmacy, the science of pharmacy is moving more and more toward biologicals; we want to be there. So we invested a year ago in [Met Mart] and bought a lot of expertise and manufacturer relations. With Option Care we bought what we feel is one of the best national platforms and home infusion. We’re working at integrating the specialty side of that with the fusion side as we speak. That’s going well. As far as the retail opportunities, we do think that there’s going to be opportunity to leverage the retail pharmacy as well as to take care of healthcare clinics.

Lisa Gill – J.P. Morgan

And on the retail pharmacy side, are you using your pharmacist in a consultative way to talk about specialty pharmacy so if someone walks in to pick up a specialty prescription they don’t have a specialty pharmacy company today, are you using that opportunity to try to cross-sell some of the new services that Walgreens has?

Gregory D. Wasson

We’re heading towards that. We’re not as far along as we expect to be in the near future. We absolutely want to determine what it is that a store level pharmacist should and could add to that specialty patient to provide value. Certainly the combination between the centralized model, the pharmacist and nurses that we have to assist to pharmacist at the store level combined with the action that can be delivered at the point of care, is going to be, we believe extremely differentiating for us.

Jeffrey A. Rein

Just to remind you that infusion doesn’t necessarily have to be done in a facility although we do offer that. It can be done in the home. It can be done in our stores. One of the things that manufacturers and insurers get very worried about of course is, is their medication being used and is it being used properly. When they are able to get to someone like Walgreens that’s easily accessible, we can make sure that they take their medication. The payor is assured that the medication was used. The manufacturer doesn’t have to worry about returns. So it’s very important that we service these people correctly and that’s why infusion is so difficult, but we think we’re positioned quite correctly because it does take a lot of time, a lot of effort. Also when you Take Care Clinics, you’re probably familiar with this but that’s another way to get people into the Walgreens’ system and get those folks healthcare and that’s why the insurance companies are now paying for that healthcare. Because if they can get folks into the system earlier, they can get taken care of at the need medication, they get that. It avoids the hospital visit or an emergency room visit and helps to keep the total healthcare costs down.

Lisa Gill – J.P. Morgan

Jeff are you working with the plan sponsors, to advertise for example Take Care Clinics to a certain health plans members so they know and understand that the service offering you have?

Gregory D. Wasson

Certainly we’re working with the [inaudible] plans as we sign up and enter into contracts with them and certainly encourage them to help us promote our clinics. It certainly makes sense for them as well to lower their overall healthcare costs.

Lisa Gill – J.P. Morgan

And then just one last follow-up, obviously AMP has been brushed off by the current court ruling, we’ll probably find out at some point in January as to where it will move, aside from Medicaid, can you talk at all about any of your other business that will be impacted by changes in reimbursement around the Federal upper limit or around AMP?

Jeffrey A. Rein

Lisa, it’s very hard to comment on that right now. We don’t know the details. We have no idea of the metrics they’re using and how they’re going to figure AMP. We just don’t know so it’s very tough to comment on that now. When we have more information, obviously we’ll be glad to talk about it. We just don’t know how it’s going to end up.

Lisa Gill – J.P. Morgan

Okay great. Thanks very much.

Operator

Our next question comes from Mark Wiltamuth – Morgan Stanley

Mark Wiltamuth – Morgan Stanley

Hi, congratulations on your cost control. Looking at your chart there for the last five years you’re SG&A growth has ranged between 11% and 18%, I hear you did a 9.5% growth number, do you think you can stay down at that 10% range for the balance of the year?

Jeffrey A. Rein

That’s a good question. That’s going to be difficult to do. What we’re really shooting for obviously, just as I said before, is around 11% to 12% overall. In trying to get down to that 9% year after year, I think that would be tough particularly to opening new stores. If we weren’t opening all of these new stores, 550 of them next year, then I believe we could control expenses even better. But when you’re opening all of these new stores, you have to hire folks ahead of time. We’re going into smaller towns so it requires a little bit more help to get those stores open because you don’t have folks to draw from in a mature market. So once again I don’t want to commit to a 9% or 10% with opening all these new stores.

William Rudolphsen

We have done a very good job in the past of matching our SG&A growth to our gross profits. That’s our intent for the future. We fell off the wagon a little bit inthe fourth quarter. We’re coming back and that’s the plan going forward.

Mark Wiltamuth - Morgan Stanley

Can you give us an indication, I know labor reductions are one of the major goals here. How have you done on scaling back some of those 24-hour stores and what does that look like to the customer as you’ve been doing that?

Jeff Rein

We’ve taken approximately 60 down year over year. But once again, it’s all based on what the needs are of that particular store. At least some folks got a little too aggressive and opened a 24-hour store just to try and capture more volume. That’s not a smart way to run the business, to have all of that open, for the store to be open when you don’t need to cover those expenses like that.

I just want to remind you though that year over year we still have more 24-hour stores than we did last year at this time. Once again, we’re trying to rationalize the use of these 24-hour stores and make sure we are smart business people and match up the sales with what’s actually needed.

Mark Wiltamuth - Morgan Stanley

In your November press release you talked a little bit about discounting inthe market place. Was that more on the front end or was it discounting to capture prescriptions? If you could just characterize what’s going on out there.

Jeff Rein

That was in reference to the front end. It was more in the front end.

Mark Wiltamuth - Morgan Stanley

On the Take Care clinics, how much of an earnings drag are you suffering right now as those stores get started? What year do you think you’ll shift to profitability?

Jeff Rein

Bill, could you answer that please?

William Rudolphsen

Yes Mark, the earnings drag is going to be about $75 million for the year; $0.05 earnings per share. The breakeven point, it probably is going to take about a year to two years for units to gain share and become profitable. So it’s all going to hinge on how fast we roll them out. Certainly we are rolling a lot of these out in calendar 2008. We’re going to have about 400 of them by then end of next calendar year, so it’s difficult to project beyond that.

Gregory Wasson

This is Greg. I’d like to add that the encouraging part of what we’re seeing is some of our more mature markets, mature clinics those that are over a year, in many cases we’re already exceeding [inaudible].

Operator

Your next question comes from Bob Summers - Bear Stearns.

Bob Summers - Bear Stearns

Not to beat a dead horse here, but just trying to understand the direct store expenses and I want to make sure that I heard you correctly when you said that direct store expense dollars grew faster than sales, if you could maybe frame that a little bit for us?

Tying that into the cash flow statement, I am just trying to understand why cash flow from ops, you had a deterioration versus last year and it looks like there were some significant changes, particularly on the accrued expense line. If you could maybe walk us through that? Thanks.

William Rudolphsen

Cash flow from operations, we did have an impact versus last year. Last year we had the Ovations contract through our PBM. That really gave a lift to our cash flow, probably inthe $300 million range. We don’t have that contract this year. So as we turn the calendar year, we will be more comparable on cash flow and I would expect accruals.

On the direct store expense line, that again grew faster than sales, but it didn’t grow as fast as it had in prior periods, just like store salaries.

Operator

Our final question will come from Derek Leckow - Barrington Research.

Derek Leckow - Barrington Research

It looks like you were able to take advantage of the weakness in the stock recently to buy back some stock. Could you give us an update on your buyback program?

William Rudolphsen

We have not been buying back stock, Derek. At this point we are investing in the company. We certainly do consider it, but at this point we don’t have excess cash to return to shareholders. We do have about $1.2 billion inCT at this point in time.

Derek Leckow - Barrington Research

So we should probably anticipate that to be fairly flattish going forward?

William Rudolphsen

I do want to make sure that you know that we do buy back stock for our employee program and that’s probably what you’re seeing inthe cash flow.

Derek Leckow - Barrington Research

A final question on the Take Care clinics, you said that you’re seeing a positive lift in some mature markets but I just wondered if you could talk on a store level basis, what happens to store profitability when you initially open one of these clinics?

Jeff Rein

We haven’t really seen anything. It’s been very, I would say it’s de minimus when you talk about something like that. Once again, you’re getting people into the Walgreen’s system. We really haven’t measured that in terms of what you’re asking. What we want to do is get people into the Walgreen’s system, approximately 20% of folks coming inare new to Walgreen’s. It helps them get into our system and get familiar with our stores. They get their pharmacy needs at our stores, they get exposed to photo, cosmetics and so on. And, they are being serviced properly in terms of healthcare needs. So I wouldn’t quantify itat this point.

Derek Leckow - Barrington Research

But longer term, isn’t it true that you’re expecting to see some incremental lift in some of these other categories when you open up these clinics? Or are you not anticipating that?

Jeff Rein

Yes, that is true. When we did the pro forma for them, we didn’t add anything in but yes, you do see cross shopping. Obviously if people don’t need a prescription, sometimes they need an OTC so they will buy it there. There is the opportunity to sell other products; that is true.

Derek Leckow - Barrington Research

Okay, thank you very much.

Rick J. Hans

Well, that’s it folks. That’s our final question. Thank you for joining us today. We sincerely hope you found this call useful and have a clear understanding of our financial results and outlook.

We’re committed to maintaining an open dialogue with you and look forward to speaking with you again and answering your questions inthe future. Our next scheduled financial announcement will be January 3 when we release our December monthly sales results.

We also invite our shareholders to our annual meeting on January 9 at Navy Pier in Chicago. For those of you unable to attend, you can listen via the simulcast available on our Investor Relations website. Until then, we wish you alla happy holiday and a healthy New Year.

I’d also like to take a moment to wish my daughter a Happy Birthday, she’s six today. By the fact that she’s a Winter Solstice baby, she sure can throw a lot of light into the room. So Happy Birthday, Catherine.

Thanks again for listening. Remember, you’re always welcome at Walgreen’s.

Operator

That does conclude our call for today. Thank you all for your participation.

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Source: Walgreen Company F1Q08 (Qtr End 11/30/07) Earnings Call Transcript
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