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Walgreen Company (WAG)

F2Q08 Earnings Call Transcript

March 24, 2008 8:30 am ET

Executives

Rick Hans – Director of Finance

Jeff Rein – Chairman, CEO

Bill Rudolphsen – CFO

Greg Wasson – President

Stan Blaylock – SVP, President Walgreen’s Health Services

John Spina – Treasurer

Analysts

Mark Wiltamuth – Morgan Stanley

Mark Miller – William Blair & Company

John Heinbockel – Goldman Sachs

Ed Kelly – Credit Suisse

Debora Weinswig – Citigroup

Scott Mushkin – Banc of America Securities

Eric Bosshard – Cleveland Research Company

David Magee – Suntrust Robinson Humphrey

John Ransom – Raymond James

Andrew Wolf – BB&T Capital Markets

Sean Roberts – Lehman Brothers

Neil Currie – UBS

Bob Summers – Bear Stearns

Operator

Good day everyone and welcome to the Walgreen Company’s second quarter 2008 earnings conference call. (Operator instructions). I now would like to turn the call over to Mr. Rick Hans Director of Finance, please go ahead sir.

Rick Hans

Thank you Mark and good morning everyone. Welcome to our second quarter conference call. Joining me today are Jeff Rein, Chairman and CEO, Greg Wasson our President, Bill Rudolphsen our Chief Financial Officer. Also in the room and available during the Q&A session is John Spina our Treasurer and Stanley Blaylock Senior Vice President and President of Walgreen’s Health Services. Jeff will begin with a review of our specialty pharmacy announcement this morning and key highlights of the second quarter. Then Bill will discuss the detailed financial results of the quarter followed by Greg who will cover Walgreen’s health and wellness strategy and how it complements our retail pharmacy growth model. 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 may give an opportunity to as many investors as possible during our limited time. I’d like to point out that today’s call is being simulcast on our investor relations website, located at investor.walgreens.com. After the call this presentation will be archived on our website for 12 months. Certain statements and projections of future results made in this presentation constitute forward looking information that is based on current market, competitive and regulatory expectations that involve risk and uncertainty. Please see our form 10K 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 Rein.

Jeff Rein

Thank you Rick and good morning everyone. Before we discuss the second quarter financial results I want to update you on a significant contract announcement we made this morning. Walgreens has signed an exclusive multiyear specialty pharmacy contract with Prime Therapeutics, a pharmacy benefit manager owned by ten Blue Cross Blue Shield plans. We are delighted to partner with Prime Therapeutics to provide the highest quality care and service for any of their 20 million members with specialty pharmacy needs. We’re excited about the potential this contract offers us. These are large clients and we’ll concentrate on a flawless startup. We will be phasing in the individual plans over time. We strongly believe that our independence from the major PBMs is a significant factor in winning this business and our independence will help us consistently win contracts over the long term. Customers are telling us they prefer to be aligned with a company that isn’t involved in services with which they may be competing in the future. Now let’s turn to the second quarter. We reported record quarterly sales of $15.4 billion, an increase of 10.5% driven by continued organic expansion and acquisitions. Despite comparisons to a 27% net earnings per share increase a year ago, we increased net earnings per share [overlay].2% this quarter to $0.69 compared with $0.65 a year ago. For the second consecutive quarter we benefited from disciplined cost control and solid execution. We controlled costs while facing tough comparisons with last year. We executed our growth strategy with the opening of 121 new stores, 41 more than during the year ago quarter and including our first store in Washington DC. And we grew our market share while improving our overall customer service witnessed by store level complaints trending down. Sales improved as the quarter progresses, while Christmas seasonal sales were weaker than expected, we rebounded with strong Valentine’s Day sales. We also showed that our core product categories, including our popular private brand business insulate us from the full impact of a slowing economy. Some of the sales challenges we faced in the quarter included the withdrawal from the market and cautions on the use of cough and cold products for children six and under and the late flu season which when it finally hit didn’t generate the level of related prescriptions seen in 2007. During the quarter we also aggressively priced digital photo prints. While that created margin pressure in the short term, it will drive more front end business over the long term. During this fiscal year we’ve executed the classic balancing act very well. We’re controlling costs in a challenging economic environment and delivering results in the short term, while making the needed strategic and capital investments to insure our success over the long term. Now I’d like to introduce our CFO, Bill Rudolphsen.

Bill Rudolphsen

Thank you Jeff and good morning everyone. Let’s briefly discuss our second quarter financial performance. Jeff already provided our total sales and earnings numbers, so I’ll move into more specifics. Total sales in comparable stores were up 4.7% in the quarter while front end comparable store sales increased 4%. Prescription sales rose 11.1% for the quarter and 5.2% on a comparable store basis. The number of prescriptions filled in the second quarter increased 3.6% on a comparable store basis. That compares to a 2.3% increase in total US retail prescription volume during the same period according to IMS Health. Gross margin dollars and overall profits are being impacted by tough comparisons to an unusually strong period a year ago which benefitted from the introductions of blockbuster generic versions of name brand drugs Zocor and Zoloft. Total gross profit in the quarter was $4.4 billion a 9.9% increase compared to a 16.7% increase in the prior year. Gross profit margins decreased 14 basis points versus the year ago quarter to 2882. In the front end we saw them decrease because of the sales mix shifting to lower margin items. In the pharmacy, margins increased with the growth in generic drug sales. But as pharmacy sales grow faster than front end sales, they reduce overall margins which are lower in the pharmacy than the rest of the store. The LIFO rate remained unchanged this quarter compared to the first quarter. But in last year’s second quarter we lowered the LIFO rate by 50 basis points resulting in a LIFO provision of $13.4 million in last year’s second quarter, less than half the $30.6 million recorded this year. As Jeff mentioned, this quarter we again demonstrated strong discipline in SG&A expenses which increased 11% over the year ago period, slower than the 14.3% increase in last year’s quarter. The improvement was primarily the result of a slower rate of store salary growth. We also saw contributions from lower legal and insurance expenses. Our entire organization continues to focus on taking a highly disciplined approach to managing our SG&A spending. As a percent of sales, SG&A expenses increased 11 basis points versus the year ago quarter to 21.75. The effective tax rate was 36.82% compared to a rate of 36.75% in the year ago period. We anticipate a tax rate of about 37% for the fiscal year. Cash flow from operations totaled $1.5 billion for the year to date. Total short term debt stood at $728 million at the end of the second quarter. We will continue managing our balance sheet for maximum financial flexibility and to support our core growth strategy. We expect to fund the acquisitions of I-trax and Whole Health Management with commercial paper and short term notes. Inventories in the second quarter climbed 12.2%, slightly ahead of our 10.5% sales gains. Inventory levels were affected by our non comparable Anderson South Carolina distribution center, additional pharmacy distribution capability at our Perrysburg Ohio facility and the launch of over the counter Zyrtec. I’d like to quickly note that our integration of Option Care, the specialty pharmacy and home care provider we acquired last August, is going well. We are on target to reach our $15 million synergies goal this fiscal year. I also want to note that we continue to target at least 15% ROIC on our acquisitions and organic growth initiatives. Store growth includes plans for total square footage increases of approximately 8% per year while our strong financial flexibility allows us to act on acquisitions opportunities as they come up. And now I’d like to turn over to our President Greg Wasson for an update on growth initiatives.

Greg Wasson

Thank you Bill and good morning. I’d like to briefly touch on recent progress in our strategy to, one, extend our pharmacy service offerings, two, expand our store base and three, add new store services that give our customers more reasons to shop with us. Through these initiatives we will grow earnings and add shareholder value. We see a tremendous opportunity in pharmacy and wellness care to connect the dots for patients and payers. That’s what our recent moves are doing. With the formation this month of our Walgreens Health and Wellness division plus the acquisitions of I-trax and Whole Health Management, we will make healthcare services more convenient and accessible. We’ll do that by tying these businesses with our other services that create almost 7,000 points of care. That includes retail pharmacies, in store take care health clinics, work site health centers and pharmacies and other outlets. Our platform will provide pharmacy services near the patient’s home or at work, specialty pharmacy products and patient management services needed for these complex and expensive medications, home care services including respiratory and home medical equipment programs and new services such as wellness programs, disease management and occupational health services. These services and the access points for reaching our patients that they provide allow us to become a close advisor to employers and health plans. We will help them reduce costs and improve the quality of health care for their employees, dependents and retirees. And our trusted brand will extend further into the health care sector. Meanwhile, our store expansion continues as we take advantage of current opportunities that will position us as the leading drug store retailer for years to come. We opened 290 stores in the first half of fiscal 2008, ahead of last year’s 223 first half openings. We’re on pace to open 550 new stores this year with a net gain of more than 475 stores after relocations and closings. We have the leading market share in 121 major markets, including Chicago, Dallas, Miami, Phoenix, St. Louis and San Francisco. We’re also growing through pharmacy file buyouts. We acquired pharmacy files from 43 pharmacies across the nation plus 27 Rite Aid stores in the Las Vegas area in the second quarter. These buyouts quickly build our pharmacy business and in many cases we add quality pharmacists and staff with strong ties to the community. We’ve had better than expected success in Las Vegas with the Rite Aid patient file acquisition. Vegas is a great success story for us where we’ve gone from no presence in 1996 to the market leader today. We will continue to track competitive developments in the individual markets and take advantage of acquisition opportunities as they come up. We also continue to improve customer traffic and add sales opportunities through front end store initiatives such as digital photo services, printer cartridge refills that will expand from 3,000 locations today to 4,500 locations by the end of the calendar year and DHL shipping services which will be virtually chain wide by December. All of these services add up to what the online world calls a sticky shopping experience. So now I’ll turn the call back to Jeff.

Jeff Rein

Thanks Greg. Before we move on to your questions, I’d like to thank our 230,000 employees who delivered the results we reported this quarter. Success always begins with serving our customers and patients and 5 million of them pass through our doors every day. And I’m looking forward to welcoming our new I-trax and Whole Health co-workers. You’ll be a great addition to helping us provide convenient and accessible care to our patients, including many who are new to Walgreens. We’ll also work hard to exceed the expectations of our specialty pharmacy patients, coming to us through our new contract with Prime Therapeutic with access to their 20 million members combined with our existing specialty pharmacy business we are a major player in this industry. All of this positions us well to create longterm shareholder value.

Rick Hans

Thank you. Folks that concludes our prepared remarks. We are now ready for your questions. Mark may we have our first question?

Question-and-Answer Session

Operator

(Operator instructions). Our first question today will come from Mark Wiltamuth with Morgan Stanley.

Mark Wiltamuth – Morgan Stanley

Thank you. First on the SG&A improvements, could you let us know how much of that was from legal and insurance and then maybe give us an idea of how much more SG&A improvement you could have here, have you really reduced the 24 hour store counts and what are the other opportunities?

Jeff Rein

Yes, hi Mark this is Jeff here. Approximately 60% of our reduction was on the payroll side, about 40% was the legal and insurance experienced. Our goal as you know is that 11-12% increase in SG&A. There is more room, we have taken some actions on 24 hour stores where they haven’t made sense. We do look at the numbers of course, we look at the trade area and we want to make sure that we serve people properly. Where there’s an opportunity to save dollars and serve the folks just as well and of course we would reduce our 24 hour stores.

Mark Wiltamuth – Morgan Stanley

And if you could talk just a little bit about the mac-ing out trends, it seems like the worst of that should be over here in February and maybe a better half coming in the second half with generics, maybe you could talk about that a little bit.

Jeff Rein

Are you talking about the generic pipeline?

Mark Wiltamuth – Morgan Stanley

Yes.

Jeff Rein

As you know this was a weaker year than normal for brand going to generic and it’s still a little bit weak towards the end of the year, however in 2009 and 2010 in particular it picks up very, very nicely. We do try to take advantage of all brand to generic opportunities obviously but once again it’s just a little bit weaker this year as it has been in the past.

Bill Rudolphsen

Mark I would add to that in the third quarter of last year our gross profit increase was 16% so that still is a challenging comparison and it gets more favorable in the fourth quarter.

Mark Wiltamuth – Morgan Stanley

Okay, thank you.

Operator

And next we’ll hear from Mark Miller with William Blair.

Mark Miller – William Blair & Company

Hi, good morning. I was hoping you could share more on the Prime Therapeutics contract as it relates to the timing, you talked about phasing that in and also anything more you can share on how that’s going to impact you financially and will you need to build and invest ahead of the earnings growth as you do with stores or does the flow through improve relative to the retail model as you expand it?

Jeff Rein

Yes Mark that’s a good question, let me turn that over to Greg Wasson who’s been really involved in Prime Therapeutics now for quite a while.

Greg Wasson

Yeah, Mark, thanks, good morning. Just first first I definitely want to say that we’re excited to have been chosen by Prime Therapeutics for this exclusive opportunity, you know we’ve known Prime for quite some time, Tim Dickman and his management team have run a great shop, they’ve done a great job serving their affiliated Blues groups over time so we’re really looking forward to the opportunity. As far as the timing you know certainly it will be somewhat hard to predict because most of these plans will be phased down over time. You know we certainly think that over time that most if not many of the Blues will begin to use Prime Therapeutics product. [Larry] we’d say that you know with any large contract, obviously the first thing we’re going to want to do is to make sure that we execute the first plan or two that come on board flawlessly, we know that Prime and the Blues will certainly expect that. As far as the financial impact, it is tough to predict because the plans will roll out over time. You know we certainly think it’s a huge opportunity because of the significant specialty spend these Blues have, but certainly hard to expect or to predict. Capacity I may turn it over to Stan Blaylock who’s with us here. I think we have absolutely plenty of capacity and if you think back at some of our recent acquisitions a year and a half ago we acquired Medmark for just that reason, we acquired management expertise as well as capacity to scale. And certainly with Option Care you know last year with our national infusion capabilities we have plenty of capacity. So I think we’re in great shape looking forward to being a part of it. Stan anything you want to add?

Stan Blaylock

Yeah I would echo what Greg said, Mark, we clearly have capacity by virtue of our dedicated central fulfillment facilities in both Pittsburgh as well as the Ann Arbor operation which we have out of Option Care. We also now have a dedicated specialty pharmacy facility in Portland Oregon. So we have plenty of capacity to handle this and are looking forward as Greg said to working with the Prime folks who really I think chose us because we have a high quality independent service offering that meshes nicely with the high quality integrated medical and pharmacy services they’re trying to provide to their customer base.

Mark Miller

Okay, great, thanks. My other question is as we think about the easier comparisons coming up you know I know it’s a Walgreens contracting on a two year basis roughly a low 30% rate which averaging across the two years is about in line with your long term growth rate. Should we think about that continuing more or less into the back half of the year? I know you don’t want to have guidance but on the other hand I know you also have an interest in analysts being in the right ballpark.

Bill Rudolphsen

Mark I would say certainly our long term goal is to achieve the earnings growth that we have achieved in the past. I would again point to the third quarter as a little bit of a challenging comparison considering the significant gross profit improvement we experienced last year and again fourth quarter gets easier as our earnings actually fell last year in the fourth quarter.

Mark Miller

Okay thanks.

Operator

John Heinbockel with Goldman Sachs has our next question.

John Heinbockel – Goldman Sachs

Can you guys speak to performance of new stores you know specifically and maybe you look out over a couple year period here but sales, script count, EBIT margin, return on capital. You know how are new stores performing compared to two or three years ago or further back. Has there been any slippage there in the performance?

Jeff Rein

Yeah John that’s a good question I know people are concerned about our new stores. As we showed in the charts last time they are doing very well, based on trend, based on history. Bill I think you have some thoughts on that.

Bill Rudolphsen

Yeah John I would point you to the charts that we illustrated in the last quarter’s call. Our script count and our front end sales are still performing for our new store base as they had in the past so we feel very good about our performance in new stores.

John Heinbockel – Goldman Sachs

How about a return on capital?

Bill Rudolphsen

Same thing. We did illustrate some return on capital numbers in that slide last quarter and we do see it increasing over time.

John Heinbockel – Goldman Sachs

Now what do you think as you look forward here because you know a lot of retailers tend to slow expansion only after returns have fallen. I mean as you look forward what are the kinds of puts and takes you guys look at to, is what we’re seeing today likely, do you think it’s likely to continue or when you look at whether it be changes in reimbursement, you know maybe competition at the front end, you know do you think returns go down over time or what’s, as you look out a couple years, what’s your thought?

Jeff Rein

John this Jeff here there are fabulous opportunities to continue to expand. As you know the age rate, nothing is going to slow that down, people are going to continue to get older, they’re going to continue to take medications which we are a major provider, they’re going to continue to use pharmacy services whether that’s specialty, immunization, flu shots and they like the convenience of the smaller store. I think you’ll even see some of the competition now trying to experiment with smaller stores because as the population gets older they want accessible healthcare, they want accessible service and they want it to be convenient at the same time. So we are very, very well positioned. And stores we’re building, they’re in A locations, great demographics, great trade areas, there is no reason to think that we’re going to do any worse at all, in fact maybe we’ll even do better as other competition consolidates or goes out of business.

John Heinbockel – Goldman Sachs

Fair and finally what’s your capacity on stores, what’s the big limiting factor today, just people or locations?

Jeff Rein

Locations are not a problem. I would say it does come back to the people, we want to make sure that we have the proper trained personnel to staff the stores, not only in the front end but in the pharmacies, but it’s a real balance of course. We want to balance to make sure we get the best size, we don’t want to over reach and be pressured to make some number, we do want to make sure we get that return on investment that we’ve been targeting and we’ll keep going after the best of the best.

John Heinbockel – Goldman Sachs

Okay thanks.

Operator

Our next question will come from Ed Kelly with Credit Suisse.

Ed Kelly – Credit Suisse

Good morning. Your gross margin was down less than it was in the first quarter especially on a FIFO basis. Is this because the front end, or I should say is this because the pharmacy margin was up more year over year than it was in Q1 or is it because the front end margin declined less. And then how should we really think about the gross margin for the remainder of the year, does it continue to get better from here, get worse, should we just assume a similar trend?

Jeff Rein

Yeah, sure, let me turn that over to Bill for an answer please.

Bill Rudolphsen

Yes Ed we are seeing better margins in the pharmacy, I do believe that that will continue. As Jeff had mentioned, we’ll see probably a bigger increase in 09 and 10 as generics come out in the marketplace. And the front end, it was a challenge in the quarter, we did have a softer seasonal season in December, we did see sales of lower margin items as the economy tightens, I think we’ll continue to see some of that. In addition we were a little bit more promotional, especially in the digital photo area. I think that that’ll probably continue as the economy tightens here.

Ed Kelly – Credit Suisse

Okay great and then just a follow up here, your front end comps if you kind of look historically grew at an average rate of maybe about 3% or a little bit more prior to 2004. Now you know the growth over the last few years was obviously in the 5-6% range but it has decelerated recently. You know which of these two growth rates should we think about going forward over the next few years, are we seeing a reversion back to the mean? Maybe you could just kind of help us understand how you’re thinking about that.

Jeff Rein

I think a reversion to the mean does happen of course. I think one of the things to consider over the past couple of years is that people felt extremely wealthy you know with the stock market, their houses and all that sort of thing. So their discretionary spending was up. Right now they are being very careful on the type of products they buy, they are trading down a little bit, we’re seeing more ad sales versus the everyday basic sale. And you know I think once again people are looking for that value. We’ll continue to do well based on our convenience and access but people are really looking for that sharp price, that value price that makes the difference. However, there are a lot of things that we’re going to get into that Greg has talked about in the past where it will help increase sales. As you know the ink cartridges, the refills, we’ll have those in 4,500 stores, so that’s a way of driving business. We’ll have DHL in almost all of our stores. Once again it gets back to convenience and offering that consumer a value.

Ed Kelly – Credit Suisse

Great, thank you.

Operator

Debora Weinswig with Citi has a question.

Debora Weinswig – Citigroup

Hi, Jeff you talked about sales improving as the quarter progresses, is that a combination of traffic and ticket or can you dig a little deeper there for us?

Jeff Rein

I think what happened is in December people were really shocked almost, not only with the stock market but with the housing crisis and folks scared of losing their job and that sort of thing, so we did see a trend of down seasonal sales or slowing of seasonal sales. However, when you look at Valentine’s in particular in terms of seasons, it’s one of those things as who’s going to forget their sweetheart? So we had phenomenal, phenomenal Valentine’s sales, it worked out very well. And once again as people are looking for value and in terms of our advertising, it really helped drive those sales.

Debora Weinswig – Citigroup

And would you say during the quarter that traffic improved?

Jeff Rein

Traffic, it’s hard to say on that in terms of the quantifiable but it’s about 50/50 in terms of traffic and then ticket.

Debora Weinswig – Citigroup

Okay and then obviously on the SG&A side there it’s very impressive in terms of what’s happening at the store level, can you talk about how you are optimizing labor you know differently now than you have in the past.

Jeff Rein

Well in the past as we mentioned before, we didn’t really follow the budget as well as we should have. We do have the district managers and store op vice presidents sitting down with the store manager and decide on a budget, what is appropriate for the front end and what is appropriate for the pharmacy. And one of the things that got us in trouble last year is we did not follow those budgets as well as we should have. We do follow the budgets now and people track that. We look at it usually twice a week but no less than once a week and once again we make sure we follow the budget that is set up through the system and through people talking with each other. And it’s worked out very, very well for us.

Greg Wasson

And Debora, Greg, I think giving that as Jeff eluded to earlier to one of the callers was that we’re really looking at every store’s opening hours, looking at competition, looking at what makes sense for the store and really getting laser focused on when the store should be open and how long it should be open, et cetera.

Debora Weinswig – Citigroup

So are there any changes in processes or procedures or it’s mainly kind of being very budget focused and mindful kind of hours?

Jeff Rein

It’s attention to what the hours are needed to serve the folks, not only in the pharmacy but out front. As we mentioned complaints have continued to trend down and many, many years ago for example, we would just cut 20 hours per store across the chain. It didn’t make sense, so if a guy or a gal was doing very well, they still lost the 20 hours. What we’re doing now once again is we’re focusing on that budget and what is really needed to serve our customers well.

Debora Weinswig – Citigroup

Great, thanks so much.

Operator

Our next question will come from Scott Mushkin with Banc of America Securities.

Scott Mushkin – Banc of America Securities

Yeah I wanted to get back to the Prime Therapeutics, just to understand a little bit more about the opportunity. So what was the total specialty spend at these ten Blues were doing and how quickly will it ramp over to you guys? Do they all have to use Prime PBM service or no? I just guess a little bit more clarity there. And then the integration, I know you guys have been putting together pieces of the specialty business and you said there really isn’t much investment to be done. And maybe you could give us a little bit of color on how the integration of all the separate business is going you know in order to handle this type of contract, do we have to put a lot of systems in place to get it done?

Greg Wasson

Yeah, Scott, I’ll take a shot and then I’ll have Stan come on in on it. As far as go back to when will the Blues, the various groups come on board, again Prime Therapeutics realizes they wanted to really put together a good solution specialty solution, they had realized that they didn’t really want to outsource and chose us. I think for a lot of reasons, primarily because they valued our independence as a specialty pharmacy provider. I think they also realized that with Medmark we had a long standing relationship with very respected Blues in Western Pennsylvania Highmark. And so I think that’s what they’re looking for us to bring to them. As far as the Blues groups that they work with, they obviously are at will to make their own decision as to who they use and when. I think because that they are affiliated and or have ownership within Prime Therapeutics they certainly would be looking to utilize all the resources that Prime brings to them, that’s the reason that Prime put together this solution. So as I said earlier I think that many if not most will come to us and will use [Tryethen] over time. And our key will be to really start off strong with the first one or two that come on board. As far as the integration, maybe I’ll turn that to Stan, let Stan talk to you a little bit about the integration.

Stan Blaylock

And to continue on with what Greg said, to Scott when you sort of look at the overall spending amount you know there are 20 million sort of underlying medical lives when you look at the Blues plans that our investors in the Prime and Prime Therapeutics so the opportunity is both on the pharmacy benefits side and the medical benefits side so it is a tremendous amount of spending. We’re not commenting on the value of the contract as we indicated in the release. As it relates to our systems aspect, this will be run on our current platform, our script [ment] operating system so we have invested significantly in that system and have already rolled that out to our multiple facilities. So from a systems integration perspective we’re already there in terms of being able to handle it. Obviously we will be coordinating that tightly with Prime who’s going to be handling some of the front end functionality as it relates to things like eligibility and prior authorization and some of the clinical oversight. But we’re already there from a systems perspective as well.

Scott Mushkin – Banc of America Securities

Alright, perfect. And maybe just one follow up and this actually has to do with the front end, I know you guys signed that DHL contract. How does that work exactly? I mean is there a certain volume, I guess maybe a little insight into the profitability there, how I mean clearly you’re trying to get more people into your stores to use these services but is there any kind of volume break that you guys need to see to make it profitable or is it profitable from the beginning?

Jeff Rein

There is obviously a volume break in packages per store. We wouldn’t give out those figures at this point, but what of the things it does do is get folks into Walgreens on a timely basis when they need to mail their packages. And obviously they pick up other supplies, they do impulse purchasing and things of that nature. DHL is helping us spread the word that Walgreens Stores have this. We think its one more way to leverage the box and take advantage of what’s going on. It ties very, very well into our digital and certain home office services, it’s just a furthering of how we can serve our customers as we need to serve them.

Scott Mushkin – Banc of America Securities

But there’s a packages per store breakeven point, is that correct?

Jeff Rein

There is and we do have that.

Scott Mushkin – Banc of America Securities

Any insight into how that’s going so far?

Jeff Rein

It’s going actually very well in the areas that we piloted. It’s been extremely good. As you know there’s a lot of small business owners, a lot of entrepreneurs, a lot of people that don’t want to wait in lines at the post office or maybe the post office is too far from them. With over 6,200 stores across America we are very convenient for people to send their package whenever they want to.

Scott Mushkin – Banc of America Securities

Great, thanks, that’s it for me, thank you for answering my questions.

Operator

Our next question will come from Eric Bosshard with Cleveland Research.

Eric Bosshard – Cleveland Research Company

Good morning. Two things, first of all on the Prime, two follow ups. One is how did, did the Blues go their own independent ways previously to get their specialty needs dealt with?

Greg Wasson

To my recollection I believe that some of them used a previous provider from Prime and then others may have used their own specialty providers, gone their independent route. I think this is Prime’s intent to really put together Prime’s quality solution with Medmark to be able to go to the Blues and really offer them a complete package.

Eric Bosshard – Cleveland Research Company

Okay and I certainly understand the confidentiality of the size of the contract but can you just give us any guidance at all of what the total spend was you know that is potential or what was done within this group, now what the contract is for but just to give us an idea of how big the pie might be.

Jeff Rein

We just signed the contract with them. We obviously have to see the uptake in terms of specialty, it’ll be phased in over time. As we learn more we can tell you more about it but let’s get started with it and make sure we do it very well and then we’ll get into the numbers.

Eric Bosshard – Cleveland Research Company

And then secondly the gross margin performance in the quarter was quite strong and was different than 1Q in terms of the year over year comparison and I understand there’s lots of moving parts, the front end being one, but the pharmacy progress in the quarter which seemed immaterial versus the first quarter, is that sustainable. I’m just trying to figure out if the 1Q or the 2Q experiences are what we should be thinking about for the second half of the year.

Bill Rudolphsen

I think what you’re seeing there Eric is a lift in the pharmacy margin related to generics, again generics always drive the pharmacy margin. I certainly, this thing can certainly move around but I believe it will be sustainable for a while and again as new generics come out we would certainly see a lift.

Eric Bosshard – Cleveland Research Company

Okay, that’s helpful, thank you.

Operator

David Magee with Suntrust Robinson has a question.

David Magee – Suntrust Robinson Humphrey

Yeah, hi, good morning. A couple things, really more of a follow up. On the new store side are you actually seeing any benefit in this environment on the real estate cost side of the equation as far as opening up stores?

Jeff Rein

Okay are you talking about land costs or building costs?

David Magee – Suntrust Robinson Humphrey

Exactly.

Jeff Rein

Yes, there’s been some weakening in some areas but it’s not as pronounced as you’re seeing in the residential areas. We go after the prime corners, there’s still a lot of competition for those prime corners and whether it’s banks or our competition or Starbucks, whatever it may be, there is still competition for the very best corners, people want that easy in, easy out location. So we’re not really seeing much once again on the commercial side.

David Magee – Suntrust Robinson Humphrey

Does it make you change your decision whether to buy the property or just to lease?

Jeff Rein

It depends on what we can work out with the developer. We do like to buy as we can at times, but once again depending on the property, the situation, the risk involved, we may lease the property.

David Magee – Suntrust Robinson Humphrey

With regard to the specialty pharmacy business, can you remind us what your approximate market share might be at this point in time and any goals you might have in that regard?

Greg Wasson

Today we like to think that we’re the fourth largest specialty provider in the country but we also like to talk about we’re the number one independent specialty provider in the country and I think that’s where we’re looking to really grow our business with the Blues organizations, Prime Therapeutics and regional health plans. So we’ve made significant progress over the last several years with the Medmark acquisition, Option Care, with Option Care we’re actually one of the largest and leading infusion specialty providers as well. So I believe we’ve made good progress in market share.

David Magee – Suntrust Robinson Humphrey

Then lastly, when you mentioned the ROIC goal for acquisitions, can you tell us what timeframe that you would hope to achieve 15% and is that the first or second year or is that three of four years out?

Bill Rudolphsen

David it would be over a long period of time, certainly we’re not going to get there within the first several years. Very often on a new store we’re going to lose money as we’ve illustrated in the past.

David Magee – Suntrust Robinson Humphrey

Yeah, well I was thinking more on the acquisition side. I think your comments were related to…

Bill Rudolphsen

Yeah, it’s going to phase in over time, I would say it’s over the long term, it’s not going to be immediately within a two to three year timeframe. So I would be thinking you know six to eight years out, over time.

David Magee – Suntrust Robinson Humphrey

I see, thanks a lot.

Operator

John Ransom with Raymond James is next.

John Ransom – Raymond James

Hey, good morning. We heard some of the wholesalers grumble a little bit about Fosamax that is was because it wasn’t a 180 day exclusive that you had multiple manufacturers so the thought at least for the wholesalers was the product wasn’t as profitable at the launch as they were hoping. At the retail level given the multiple manufacturers, is that a plus or a minus for you in terms of kind of out of the box profitability?

Jeff Rein

I’m not quite sure what the wholesalers are saying here but in terms of exclusivity and everything, if there’s only one other manufacturer then they don’t drop the price as much obviously. If there’s multiple manufacturers it does help drop that price, there’s a lot of profit available.

John Ransom – Raymond James

But you had, all things being equal, I mean looking at a Zocor where you had the 180 day and an authorize and looking at Fosamax where it’s a free for all, would you prefer the Fosamax type situation over the Zocor type situation?

Jeff Rein

No, not necessarily, we would not.

John Ransom – Raymond James

But I mean, okay so I guess I’m confused, so did Fosamax meet your expectations?

Jeff Rein

Any time that we can save the patient’s money, we can save the payer’s money and we can make more money for Walgreens, we are satisfied.

John Ransom – Raymond James

Okay, thank you.

Operator

And next is Andrew Wolf with BB&T Capital Markets.

Andrew Wolf – BB&T Capital Markets

Hey good morning, Jeff, how would you characterize the competitive environment currently and particularly if you could in reference or in comparison to other periods of consumer slowing, is it typical or do you think there’s some major differences?

Jeff Rein

The difference this time versus the last time when it slowed is we have phenomenal competitors. I’d like to point out that CVS and Rite Aid have really stepped up their game. Wal-Mart is doing very well, Target as well merchandised, they do a very nice job. We have longs out there making progress, we have a lot of folks out there that are doing a great job today. And you have the internet. In the past we didn’t have as much in terms of competition being at the top of their game as they are right now. So I would say it’s a little bit tougher now than it was in the past and once again with all this consolidation, the strong get stronger. People are definitely looking for a value now, they’re definitely shopping Walgreens, so we’re going to be able to compete very, very well, not only in the stores, not only in specialty but at our site, we have one of the top rated websites right now that folks utilize. So I’m very confident that we’ll be able to fight against competition but once again they are very good.

Andrew Wolf – BB&T Capital Markets

Okay and just following up, how about in the area more specifically like in circulars with other drugstores, is that, is it hotter or about the same as you’ve seen sort of in terms of trying to promote folks into the store, again versus let’s say the last downturn.

Jeff Rein

I would say based on what I’ve seen with the different sectors with our drugstore competitors and the mass merchants is that it’s similar is that when we went into a lower spending environment that the ads heated up a bit as they did want to get folks into the store. We do see our competitors getting aggressive particularly on the front page and the back page where people pay the most attention to. So that is definitely heating up. I have not seen any huge, huge giveaways though that people are destroying profitability but there are instances where folks are obviously getting more aggressive than they might have a year ago.

Andrew Wolf – BB&T Capital Markets

Thank you and then I wanted to just follow up on John Heinbockel’s question on the new store performance but, get to the other end of the spectrum which is the mature store performance. I think I remember Dan [Jaunt] used to say you know drugstores are unique and that they have a 20 year tale on same store sales, it’s an annuity that keeps on giving. And you know obviously with all the upfront losses for three years, you kind of need that for the, to get to the ROIs you guys are talking about, so could you speak to really mature store performance, are the older stores still comping fairly decently as the way I understand the model to work.

Jeff Rein

Yeah, mature stores are still doing well. What’s nice is we’ve been able to fill in in more areas than ever before across the country. This does hurt obviously the mature store on a dilutive basis, maybe for a year to 18 months. But overall once again as people get older they take more medications so we can still serve them better and they’re shopping our stores more based on convenience and accessibility. So they’re still doing extremely well and the model still works.

Greg Wasson

Andy, once those stores hit the three year mark, after that you’re seeing mid teens ROIC and I think we’ve disclosed that in the past. Now that three to six year mark is really where stores take off and then I think beyond six years is where you’re seeing more of an inflationary increase.

Andrew Wolf – BB&T Capital Markets

Okay thank you very much, that’s helpful, thank you.

Operator

Our next question will ceom from Sean Roberts with Lehman Brothers.

Sean Roberts – Lehman Brothers

Hi, Sean Roberts sitting in for Meredith. On the script growth I think there’s been some questions on the front end but looking at script growth trends I realize that flu is part of the slowdown in the current quarter but as we start to move out of the flu season here, would you expect us to get back to that 5-6% script growth trend any time soon?

Jeff Rein

That’s a very good question, it really depends on what people’s actions are. I do believe one of the challenges of course is that people ramped up in 2006 on the Medicare part D, so we’re not seeing those huge increases that we did before. With Zyrtek going over the counter right now, that affects us by about 50 basis points. I think the other thing that’s happening too is that we’re seeing more folks really worried about their spending so we have had some reports of people breaking pills in half for example, either take it every

day like that or take their medication every other day, things of that nature. We still think the script growth is going to continue to do very well, it has trended down in the United States though as you know over the last couple years. So it’s definitely a challenge for us but once again we’re up to it. I believe as more drugs come online, particularly the generic drugs, that does help drive the business as people can afford those medications better than the brand side. So once again I’m quite confident of the future, I don’t know the exact numbers though.

Sean Roberts – Lehman Brothers

Second question would be on I-trax, I see that they’re headquartered in Pennsylvania. To the extent that you guys can say whether the clinics are actually geographically concentrated and if it is kind of in that mid-Atlantic Northeast region as you add pharmacies to these work site locations, do you think that will cannibalize your existing store base at all or will that be kind of a key part of growing into the new geographies where Walgreens isn’t as heavily concentrated today?

Jeff Rein

That’s a good question and will definitely, definitely play into our game plan. Greg I think you have some comments on that.

Greg Wasson

Yeah Sean I think definitely the latter I think that as we go into some of the newer areas such as the Northeast Mid-Atlantic that is absolutely will help us grow our brand, grow our recognition and help us grow in those areas. Concentration, both companies are pretty much nationwide, however there is a large concentration in the Northeast and Mid-Atlantics and that’s one of the things that was certainly appealing to us.

John Spina

Sean, this is John Spina, I want to add on to Greg’s comment that these aren’t cannibalized in our existing stores, they are new main and main, it’s not an either or, it’s another access point for these patients to get into our system. So it’s really, it doesn’t cannibalize, it really just, it’s in 40 states and if we have a store down the street it’s just another access point. We have a similar experience with our hospital clinics where you know these folks see us for the first time and they enter our network of pharmacies and stay with us.

Jeff Rein

Sean, Jeff here you might consider an analogy could be Take Care clinics where 20% of the folks using the Take Care clinics are new to Walgreens so we believe the employer onsite pharmacies will be very, very similar, a lot of folks that may be are not shopping us right now will get introduced to the Walgreen brand, the Walgreen name and the Walgreen services. It will definitely get them into the Walgreens system, we’ll be able to serve them and their dependents very well.

Sean Roberts – Lehman Brothers

Great, thank you.

Operator

Neil Currie with UBS has our next question.

Neil Currie – UBS

Good morning, thanks for taking the question. I just wanted to ask another question about new stores and strategy going forward. I think there have been some people suggesting that you may decide to pull back on new stores if you saw the returns declining. As I see it thought the strategy has always been a long term one whereby you haven’t been acquiring stores and you’ve been looking at all the best drugstore markets in order to get access to the fastest growing markets which has meant that you’ve historically not had the store density that maybe your competitors have had in many markets or that you would actually require. So the question is, is actually pulling back on new store opening an option or is it absolutely vital to continue opening new stores in order to leverage your infrastructure in these still limit share markets?

Jeff Rein

Neil we obviously believe in long term growth so organic growth and acquisitions are major plans for us in the future. As you know we do buy other drugstores where they make sense. For example, El Amal in Puerto Rico, been very well to us, we bought those stores. We are continuing to look for other acquisitions. At the same time we want to continue our organic growth because you have the store as you want it, you have the people, the systems, everything is much easier and quicker and faster. Plus as the trading areas get denser and denser we find that many times you can build another store to service those folks that may have been serviced by a Walgreens store two miles away. Now it’s maybe a half a mile or a mile to their house. So a lot of it depends on the density. But definitely we want to continue our organic growth and acquisitions.

Neil Currie – UBS

Right and I wondered if I could also ask about seasonal sales. Obviously December is a very important month for seasonal sales, it tends to index higher than most months and is characterized by you know a lot of gift items that are maybe more discretionary. How should we think about other seasonal events in terms of their discretionary nature? Clearly Valentine’s is about cards and candy, maybe Easter similar, but summer seasonal, is that something that we should be a little bit more cautious of because of the nature of the items you’re selling there and how about other seasonal events?

Jeff Rein

No I wouldn’t characterize it necessarily as being more cautious there. One thing to keep in mind about seasonal products and the isle that we do have is seasonal products create hope, they create memories and folks are very, very reluctant to give that up. We don’t sell things that are very expensive. I like to tell the story that maybe about three or four years ago we learned our lesson when we went after Christmas toys that were very expensive, $50, $80, $100, we didn’t do very well and we wrote off about $10 million. Most of the items in our stores are $20-$25 and less. So for people to buy a cologne or chocolate or a small toy for their child, I do not see that slowing down. Where it’s incumbent upon us to increase the profitability is to make sure we buy correctly. Sometimes we can get very, very enthusiastic as we all are in retail sales but if we control our inventory, control the buy, the seasonal sales will still continue to do well. One thing to keep in mind is that seasonal sales is like gravy. It’s not there necessarily to provide all year profits, we get that from our basic everyday sales, whether it’s drug, health products, beauty products, food products, but once again the seasonal is like icing on the cake and if we can control the buy folks will always be coming in to create those memories.

Neil Currie – UBS

Thanks Jeff.

Operator

We have time for one final question and that question will come from Bob Summers with Bear Stearns.

Bob Summers – Bear Stearns

Can you take me through the gross margin line a little bit more, if pharmacy margins improve sequentially, what’s the right way to think about front end margins and was there an acceleration in margin erosion and could you also give us some texture about how front end margins, current front end margins compare to levels that you had in 2001?

Bill Rudolphsen

Bob, front end margins certainly were impacted again by the soft seasonal season and more promotions. I believe that that trend will continue in this softening economy. We’re going to have to be promotional to drive traffic. I think that that trend will continue. They are down versus the prior year. And I think that it’s probably to prior recessionary periods that you’re going to see softening margins on the front end. And we’re certainly thankful for the pharmacy margins to offset much of that.

Bob Summers – Bear Stearns

And then what’s the right way to think about the benefit from the extra day?

Jeff Rein

In terms of a number?

Bob Summers – Bear Stearns

Yes.

Bill Rudolphsen

About 1% on that Bob.

Bob Summers – Bear Stearns

Okay and then finally I don’t think that we’ve had this open forum since Trent Taylor last if you could maybe give us the circumstances surrounding that?

Jeff Rein

I’m sorry, Trent did leave the company as you know, it was mentioned in our 8K but we have no comment on that.

Bob Summers – Bear Stearns

Okay, thank you.

Operator

At this time I will turn the conference over to our host.

Rick Hans

Alright that was our final question. Thank you for joining us today. We’ll announce March sales on April 2nd. As a reminder with Easter this year falling on the earliest date since 1913, you’ll need to look at combined March-April sales to get a true picture of the performance for those months. Our next quarterly financial announcement will be June 23rd when we announce third quarter results. Before that Bill Rudolphsen will present at the Lehman Brother’s 11th annual retail and restaurant conference in New York City on April 30th. Then on May 28th Jeff Rein will speak at the Sanford C. Bernstein & Co. 24th annual strategic decisions conference in New York. Until then, we wish you a great day and remember, you’re always welcome at Walgreens.

Operator

And that does conclude our conference call, thank you for joining us today.

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Source: Walgreen Company F2Q08 (Qtr End 02/29/08) Earnings Call Transcript
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