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Walgreen Company (NYSE:WAG)

F3Q08 Earnings Call

June 23, 2008 8:30 pm ET

Executives

Rick Hans – Divisional Vice President Investor Relations and Finance

Jeff Rein – Chairman, Chief Executive Officer

Wade Miquelon – Senior Vice President, Chief Financial Officer

Bill Rudolphsen – Senior Vice President, Chief Risk Officer

Greg Wasson – President

Analysts

Meredith Adler – Lehman Brothers

Eric Bosshard – Cleveland Research

Mark Miller – William Blair

Analyst for Lisa Gill – J.P. Morgan

Ed Kelly – Credit Suisse

Debora Weinswig – Citi

John Heinbockel – Goldman Sachs

Neil Currie – UBS

Mark Wiltamuth – Morgan Stanley

David Magee – Suntrust Robinson Humphrey

Operator

Good day everyone and welcome to the Walgreen Company third quarter 2008 earnings conference call. (Operator instructions) And now I would like to turn the call over to Mr. Rick Hans, Divisional Vice President of Investor Relations and Finance. Please go ahead.

Rick Hans

Thank you Mickey and good morning everyone. Welcome to our third quarter conference call. We’ll start today’s call with Jeff Rein, our Chairman and CEO discussing the quarter’s results. We’ll then introduce Wade Miquelon, our Senior Vice President and Chief Financial Officer who just joined us last week.

Bill Rudolphsen, who has moved from the CFO to the new position of Senior Vice President and Chief Risk Officer will provide additional details on the third quarter financial results. And Greg Wasson, our President will give an overview of our growth strategies. Following that, Jeff will give a brief summary and then be ready to take your questions. Before the Q&A, we will also be joined by John Spina our Vice President and Treasurer.

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.

Before we get started I’ll 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 market, competitive and regulatory expectations that involve risk and uncertainty. Please see our form 10-K for the fiscal year ended August 31, 2007 for a discussion of factors as they relate to forward-looking statements. Now here’s Jeff Rein.

Jeff Rein

Thank you Rick and good morning everyone. Today we reported a solid third quarter performance. In a challenging economy, we continue to successfully execute our strategies for growth while effectively managing costs.

We reported record quarterly sales of $15 billion, an increase of 9.6% despite the impact of tight consumer spending. We had a touch comparison to a net earnings increase of nearly 20% in last year’s third quarter which was aided by blockbuster generic drug introductions.

This year’s net earnings grew 2% to $572 million. That amounts to $0.58 per share, up 3.6% from last year’s $0.56 per share. One of the sales components that stood out in the quarter was our strong front end comparable store sales which increased 4.6%. Competitors simply can’t match our convenient locations. They’re the best in the business with 144 million Americans living within 2 miles of a Walgreens.

Combined convenience with more promotional activity and we are positioned very well to win in today’s environment. Both the number of customers in our stores and the average dollars per transaction increased this quarter. On the pharmacy side, the number of prescriptions we filled in comparable stores in the quarter increased 1.1% over a year ago, compared to an industry-wide decrease, excluding Walgreens of 0.9%.

Industry-wide prescriptions continued to be impacted by a number of factors according to IMS Health, including the switch of Zyrtec from prescription to over-the-counter status, fewer new drug introductions, safety concerns over newer medications and the weaker economy.

Despite these near term challenges, nothing will slow the impact of nearly 80 million Baby Boomers moving into their peak prescription use years. This is a very good business to be in for the long term. That’s why our growth will increase approximately 9% this year.

And to attract more patients to our pharmacy services, we’re offering our prescription savings club to the public. The club goes well beyond generic discount programs by offering savings on more than 5,000 brand name and generic medications. Greg Wasson will talk about this a little bit later.

We opened 138 new drugstores in the third quarter, 17 more than the year ago period. So far in fiscal 2008, we’ve opened a record 420 drug stores compared to 339 a year ago. That resulted in a net gain of 370 drugstores after relocations and closings. Even with all those openings in the third quarter and investments in our Take Care health clinics, SG&A expense dollars increased only 10% over the year ago quarter.

To put that in perspective, it is only the second time since the fourth quarter of 1995 that SG&A expense dollars have been held to an increase of 10% or less. We decreased the rate of store selling and expense growth and lowered advertising expenses. At the same time, our pharmacy service remained high as store level pharmacy satisfaction levels improved each month during the quarter.

As a percent of sales, SG&A expenses at 22.1% were essentially the same as last year. Throughout this fiscal year, we’ve proven our ability to hold the line on expenses. SG&A expense dollars are up only 10.3% through the first nine months of fiscal 2008.

With that overview, I’d now like to welcome Wade Miquelon as our new CFO. Wade officially joined us a week ago and is quickly getting up to speed with our people and the business. Wade comes to us from Tyson Foods where he was Executive Vice President and CFO. His excellent financial, strategic and operational experience at companies like Procter & Gamble will be a great benefit to us.

As the financial community gets to know him, I’ll sure you’ll see why we’re so impressed with his strategic thinking and communication skills. In our press release announcing Wade’s hiring, you saw that Bill Rudolphsen is moving from CFO to lead our risk management area as our Chief Risk Officer. This new role is critical to Walgreens given our size, the growing complexity of our business and the highly regulated industry in which we operate.

Earlier this month we also announced the appointment of Sona Chawla to the new position of Senior Vice President of Ecommerce. Sona will join us on July 1 from Dell where she was Vice President of Global Online Business. Her hiring represents a significant commitment we’re making to take our online marketing and sales to a higher level.

Even with the hiring of Wade and Sona, we continue to be primarily a promote from within company. But as the industry and environment in which we compete change, we will look outside for unique abilities that compliment the expertise we develop in house. And now Wade would you like to say a few words please?

Wade Miquelon

Thanks Jeff and good morning everyone, it’s a pleasure to be able to join in on my first Walgreens call today. While I’ll only been on the job a few days and have an immense amount to learn, I can honestly say I’m very impressed with everyone I’ve met and I’m extremely excited about all the opportunities that lay ahead of our company.

Bill and his team are doing an excellent job of helping me to onboard and I look forward to meeting and spending time with our shareholders and the financial community in the future. [Now for the forward] to partnering with Bill and his team as he takes on the new and critically important role or Chief Risk Officer. And with that I’ll turn it over to Bill to review the financials in more detail.

Bill Rudolphsen

Thank you Wade. Looking closer at our sales, total sales in comparable stores were up 3.4% in the quarter. Prescription sales which represented 65.5% of total sales rose 8.9% for the quarter and 2.7% on a comparable store basis. Total gross profit in the quarter was $4.2 billion, a 9.3% increase compared to a 16% increase the prior year.

Gross profit margins in the quarter decreased one-tenth of one percentage point to 28.2%. The growth rates this quarter for gross margin dollars and overall profits were impacted by touch comparisons to an unusually strong period a year ago. That’s when we were aided by the introductions of blockbuster generic versions of name brand drugs Zocor and Zoloft.

Front end margins decreased because of more promotional activities, many in the digital photo category. We also saw the sales mix shift to lower margin items. We also lowered our LIFO rate this quarter by 25 basis points compared to a 50 basis point reduction in the year ago quarter. That resulted in a LIFO provision of $16.1 million in this year’s quarter versus a LIFO credit of $3.5 million last year.

In the pharmacy, margins increased with the growth in generic drug sales. The effective tax rate was 37.3% compared to a rate of 35.2% in the year ago period. Last year’s quarter included a $13.5 million credit from the resolution of a multi-year state tax matter. We anticipate a tax rate of 37.1% for the fiscal year.

Accounts receivable were up 19.5% in the quarter, driven primarily by the Option Care specialty pharmacy and home infusion business we acquired last August. The remainder of the increase resulted from the normal increase in third-party sales.

Inventories in the third quarter climbed 9.4%, less than our 9.6% sales gain. Total short term debt stood at $1.1 billion at the end of the third quarter. We will continue managing our balance sheet for maximum financial flexibility and to support our core growth strategy. Cash flow from operations totaled $2.5 billion for the year to date. And now I’d like to turn the call over to our President, Greg Wasson for an update on growth initiatives.

Greg Wasson

Thank you Bill and good morning everyone. First I’d like to congratulate our employees across the company for their sales efforts and expense management this quarter. We received suggestions from nearly every department in every location and we found opportunities to reduce costs throughout the company. In particular, our store operations folks proved why they are the best. They controlled costs and they took care of our customers. Thank you.

Over the last several months the competitive environment has clearly changed as the economy has slowed as the $4.00 gas impacts customers. At the same time, discount retailers and grocery chains are picking up their pace of promotional pricing, especially in the pharmacy, which they’re using to build traffic.

Our advantages are that in addition to being price competitive, we’re better positioned with more convenient locations and enjoy a powerful brand reputation. I like to put it this, while many of our competitors have a pharmacy department, Walgreen is a pharmacy.

Patients, employers and managed care groups look to us to be their low cost pharmacy provider. And we’re at the leading edge of healthcare cost management in retail pharmacy and beyond. Our specialty pharmacy and home care business, independent of a major PBM is attracting more and more interest throughout the industry.

We now have about 550 combined worksite health centers and retail clinics to provide accessible low cost healthcare. In this time of soaring medical costs, we’re helping Americans meet basic healthcare needs. We’re seeing strong momentum in the push toward electronic prescribing, which improves patient compliance and enhances safety.

We’ve been a strong advocate of this technology for more than 16 years and during this calendar year, we expect to fill 15 million electronic prescriptions, more than double 2007.

As Jeff mentioned earlier, we’re also expending our prescription savings club, a cost savings solution for many people who need help paying for prescriptions. The club provides discounts on not just a select list of generics but also an additional 5,000 brand and generic medications.

Plus members can get a 90 day supply of more than 400 generics for $12.99. And, they also get a 10% rebate on the purchase of Walgreen brand products. One of the most important aspects of our prescription savings club is that is encourages patients to have all of their prescriptions filled at Walgreens. Now only is that good for us but it allows our pharmacists to screen completely for dangerous drug interactions.

Many patients don’t realize that pharmacies can’t access their prescription records at a different retailer. They don’t know the danger in filling a generic at one retail pharmacy, an antibiotic at another and a brand name drug at a third. Our savings club is a great new product that’s being well received by many patients, saving them money and we’re very encouraged by patient reaction to it.

Meanwhile, our focus on expanding pharmacy services that are complementary to our retail pharmacies continues. This suite of services allows us to work with payers on a broad solution to lower costs. Our specialty pharmacy business, which is greatly expanded with last year’s acquisitions of Option Care is well positioned to deliver the growing number of specialty medications approved by the FDA and used by patients today.

And of the new products awaiting FDA approval in 2008, 80% are specialty drugs according to IMS Health. As you can see by this slide, the Prime Therapeutics contract for specialty drugs announced earlier this year has basically doubled our access to Blue Cross and Blue Shield plans nationwide.

We strongly believe that our independence from the major PBMs was a significant factor in winning this business. And our independence will help us to consistently win contracts over the long term. Clients 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.

Many specialty drugs are infused or injected rather than taken orally. That means more demand for home infusion services. We took another step toward growing that business this month when we announced our acquisition of CuraScript Infusion Pharmacy from Express Scripts. This transaction will further expand our national coverage in home infusion services and get us close to 100 home infusion locations in more than 30 states.

This quarter we also formed our Walgreens Health and Wellness Division to incorporate the acquisitions of I-Trax and Whole Health Management, operators of worksite health centers. We’re on track with a solid plan to aggressively integrate these businesses. I-Trax and Whole Health were the top providers in their industry and we’ve combined their best people to create a powerful management team.

Together with our Take Care health clinics, we can offer large company employees health plan members and their dependents access to health centers and pharmacies at their worksite and at our drug stores. We’re already hearing a great deal of interest from clients for these services.

We currently have about 550 retail clinics and worksite centers under our Health and Wellness Division, we’re ramping up that growth. We also have continued our expansion of pharmacies in hospitals and other medical centers to serve outpatient prescription needs. By extending our definition of Main and Main locations to prestigious health systems, we’re creating great value for the hospitals, patients and Walgreens.

In closing, in the past 18 months, we have acquired and assembled a terrific set of assets, including specialty pharmacies, home infusion and home care facilities, worksite health centers, retail health clinics and pharmacies on location at major medical campuses.

The real value will come as we connect the dots for a complete low cost pharmacy and healthcare solution for payers. This gives us a closer relationship with employers and health plans, making us a more valuable healthcare provider. Now I’ll turn the call back to Jeff.

Jeff Rein

Thanks Greg. Not only are the adjacent pharmacy and healthcare services Greg just outlined an important part of our future growth, it will also center around our retail drugstore business, which is proving its worth to American consumers during this tough economic period.

Above all, we’re a drugstore and we’re proud of the success we’re showing, especially in our front end business as consumers turn to us for value and shopping that’s close to home. Very few retailers can match our strong front end comparable store sales. At the same time, our comparable store prescriptions filled are outpacing the industry.

The opportunity for growing our business is as strong as ever, especially with the impact of the Baby Boom generation looming on the healthcare industry. Our growth strategy entails: first, broadening our customer access to an expanding store base; second, leveraging the best retail corners in America to improve their productivity; and third, expanding our platform of adjacent healthcare services to be the provider of choice.

To ensure the financial community has the complete picture of our value and growth strategies and how they enhance shareholder value, we intend to hold an investor’s day conference later this year. We’ll keep you up to date on the event as the details are arranged. I look forward to many of you joining us for the day when you’ll have a chance to get better acquainted with our senior management team. Thank you.

Rick Hans

Folks that concludes our prepared remarks, we’re now ready for your questions. Mickey, may I have our first question?

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from Meredith Adler – Lehman Brothers.

Meredith Adler – Lehman Brothers

I’d like to start by asking a question about the infusion business you’ve got. You obviously have the capability to do infusion either at locations or people’s homes. Does your infusion business also give you exclusive rights to distribute or infuse those particular drugs or will you work with the drugs that are controlled by anybody?

Greg Wasson

A little of both. Our goal is to be able to offer services that will work with, to support any pharma company’s drug, infused drug. So we’re looking, we have access to just about all infusion product. Looking to gain access to those that we don’t. But it’s not a restricted drug program if that’s what you’re asking.

Meredith Adler – Lehman Brothers

Just in terms of the exclusive control. My second question is about kind of the connection between the Take Care facility and I-Trax slash Whole Health, the worksite health facilities. Do you anticipate that you will be able to provide the same kinds of services and range of services at the Take Care facilities that you offer on the worksite facilities or will there be a difference in the offering?

Greg Wasson

Yes I think there will be a different portfolio of services. I think the worksite centers can provide everything from a range of physical therapy to acute care to primary care, worker’s comp programs and so forth. I think the real value is connecting the dots for the employer for the members and employees that are able to use those services at the worksite with our retail health clinics and retail pharmacies in the community which gives them a more complete network of care.

So the Take Care health care clinics within the retail stores will probably be more acute, more HR type wellness programs. We just recently launched [soft backs] through all of our Take Care clinics nationwide. So I think there will be probably a more intense and more disease management focus in the centers and then combined with acute care and wellness programs in the retail stores.

Jeff Rein

One more thing to keep in mind also between the onsite clinics and the Take Care clinics is that we’ll also be able to take care of retirees and dependents because when you’re dealing with the employer onsite, you only have the employee. This gets them very familiar with the Walgreen name, it gets them into our system and we’ll be able to serve their whole family, once again the dependents and the retirees.

We think the two will tie together very, very well. So wherever they need care, whether it’s at home or work, we will be there and that’s the main intent of trying to integrate all of these together.

Meredith Adler – Lehman Brothers

One follow up question with that is about technology. To really make this effective, do you think you need to make significant investments in technology? It’s clear that there’s probably a demand for on the part of employers to have a repository of all kinds of healthcare information about their employees, is that something that you anticipate being involved in?

Jeff Rein

Absolutely, we’re involved in that right now. We’re integrating all of them. As you know we’re working with outside companies, it could be Google for example, could be Microsoft. So there is a demand, it’s still an evolving business. There will be some money and resources that we will put into technology to make it happen.

But one of the most important points that we can do is to make sure that there is one face for Walgreens and that the patient is able to integrate it across all the different companies. So basically what they see is one company and we take care of them no matter where they are.

Greg Wasson

If I might add, that’s one of the reasons all three of these companies, Whole Health, I-Trax and Take Care really appealed to us as all three of them have state of the art systems, Take Care has a great EMR, Whole Health and I-Trax have great operating systems which will help us leverage that technology.

Operator

Your next question comes from Eric Bosshard – Cleveland Research.

Eric Bosshard – Cleveland Research

The progress on SG&A at the store level, it looks like SG&A per store is actually now running flat year over year and you commented the sort of historic low level of SG&A growth. Can you just talk a little more about specifically what’s going on there that’s different than what we’ve seen in prior years when that number was growing more like 15%?

Jeff Rein

Sure, about 60% of the relative savings this time was from the payroll at store level. There was some mixture in there of expenses and advertising control. What we’re really doing is making sure that we targeted our sales and targeted our budget on a weekly basis.

I think what happened before is that the payroll got away with us because we did not really follow our budgets. If you get budgeted sales and of course you get budgeted hours, if you’re above sales you get more hours and conversely if you’re down in sales then you get less hours.

So we’ve taken a more proactive approach. We’ve gotten more Operations Vice Presidents, District Manager and Store Mangers to pay attention to what is going on in their stores on a weekly basis. So once again it all comes down to discipline and focus. That’s a big difference from before.

Also as Greg mentioned, we’re getting more suggestions about how to really watch out for what we call duplication in terms of expenses. Are we doing things that we really need to do or just things that we want to do?

Big difference there, so we’re really focusing on what we need to do, we’re focusing on investing the business where it makes sense for the long term and being very, very careful on spending these expense dollars, keeping in mind we’re only a $0.03 company, $0.03 net to sales. We have to be very careful and very aware of that.

Eric Bosshard – Cleveland Research

On a go-forward basis, I think you previously talked about SG&A growing 11-12%, is that what you think is the number? Is it now 10%? So I guess what’s the number and how long is that sustainable?

Jeff Rein

We’ve put out there the 11-12%. Of course part of it is related to net store growth of course. This year we’re going to be up a little over 9%. And so holding down those expense dollars artificially, it would not be wise to do because we don’t want to hurt service levels.

We certainly don’t want to hurt going after new businesses. You know about all the acquisitions we’ve done, not only in the business itself but obviously expertise and different people. So our goal right now is still out there at 11-12%. We want to be smart about it but we are absolutely focused on making sure we manage it properly. And if we need to be under that level, 12%, we certainly will.

A lot of it is tied into the gross profit dollar increase. And you’ve seen that chart over time where it’s pretty well matched up. Where the gross profit dollars are decreasing, we will absolutely decrease those gross profit expenses.

Eric Bosshard – Cleveland Research

And I guess within this, do you feel like you’ve got visibility into the service levels at the store to know that you’re not cutting too much?

Jeff Rein

Absolutely, boy that is something we’re really focused on. We have what we call KPIs, key performance indicators. We have the mystery shop where we have an outside company shopping our company to give us feedback, they talk to the employees or they don’t even identify themselves and make notes of what’s going on.

Plus we use a receipt survey where after a customer purchases something, there is an inducement, if you’ve seen our receipt to actually have them call in or use the internet to give us feedback on how we’re doing. And we know exactly what store that that is being measured against.

So yes, we are extremely aware of what’s going on. Plus the other thing that we’ve done, really stepped up is in terms of night checks and making sure supervision is in the field. We absolutely have to do that.

Greg Wasson

Every morning at 6:00 am I can come in at my fingertips and read sales, ready payroll and read customer satisfaction. So we have visibility.

Eric Bosshard – Cleveland Research

And then secondly, the comment that was made about the front end promotional environment, could you just characterize it? I know the front end is always competitive but you mentioned grocery and mass, can you just talk a little more about how competitive that front end promotional environment is and is getting and sort of is this is as bad as it gets or does it get worse from here?

Jeff Rein

Well what we’re seeing is that people are absolutely shopping for a value. And with Walgreens convenience and our promotional pricing, they do get that value. We are seeing a trending up of ad sales. So items that we run on promotion or what we call mega-savers, that in store promotions, we are seeing an uptick in those particular sales. People are a little bit more price conscious, they definitely are trading down.

However, that does help us when they trade down for the private label products. As you know our private label products are just as good, if not better than the brand products. So we give people a value, they shop us, it’s working out very well. I can’t say if this absolutely the worst, I don’t know that, hard to predict. But I can tell you based on our convenience, being close to home, close to work and people only thinking of 1.6 items coming into Walgreens, they absolutely are using us more and more.

Operator

Your next question comes from Mark Miller – William Blair.

Mark Miller – William Blair

Can you talk about what has changed in the environment that has the company exceeding its goal for store openings this year? There’s some thought that slowing down perhaps you could get your real estate terms and how are you thinking about balancing this pursuit of long term growth with nearer term performance? And then final part of this question is how do you think about ROI on new stores versus buying back your own stock as an investment?

Jeff Rein

On the first part of your question, as you know Mark, many of these sites were approved 24-36 months ago. It typically takes anywhere from the time its approved in real estate to the time it opens is about 24-30 months, there are some outliers of course that can take longer.

So in terms of what’s going to open next year, the 9%, sometimes the authorities work with you, sometimes they work against you. In this particular case, many of the sites that we’re opening, we actually went through the entitlement process a little bit quicker than we anticipated.

Going forward, it’s interesting that we are seeing, we do see some weakening in terms of occupancy costs. So where there’s been a lot of emphasis on the home market, we are seeing some emphasis now on the commercial market where those prices are decreasing which is a really welcome sign.

In terms of construction, that has been going up for concrete and steel and so on, but we also have come up with different designs with our stores to take out costs out of the store which actually works real well.

The percentage increase this year will be over 9%, but that was really not by design once again. In future years you will see that percentage going down. We’ve always said organic growth would be around 8%. Sometimes it’s higher, sometimes it’s lower and you can track that over the years of course.

Going forward, I do see that percentage edging down though because this is about as many stores as we’re going to open this year and next, it will be about our maximum absolute number of stores in any one year.

In terms of the ROI and looking at the stores, our mature stores do make over 15% and that’s what we’re looking for. It is true in the first few years that ROI is less, obviously because they’re new stores and they lose money. Over time, a mature store, we absolutely look for over 15%. Bill do you want to have a little comment please on buying back stock?

Bill Rudolphsen

I do want to comment on that, we have been able to generate a consistent return on investment over time, even growing our store base at 8% so it has definitely worked out for us. And just to echo Jeff’s comments, a mature store over three years old will generate a 15% return on investment.

So our best investment is continuing growing our company at an 8% clip in store growth. We are looking to maintain a debt to cap ratio in the 50% range and we want to maintain our credit rating. We’re still growing our store base rapidly. We are able to get 75 year flat term rents based on our credit rating and that’s how we’re going to continued.

Jeff Rein

Mark also in terms of new store growth, keep in mind that we’re in an industry that the pie is expanding, many industries are cutting back or shrinking, we are expanding, particularly with the Baby Boomers getting older. I think you’re going to see a great explosion of folks taking drugs, whether it’s Obama or McCain coming in, both of them have talked about increasing utilization of drugs, they want more access to drugs by people to help control total healthcare costs.

So there’s a lot of opportunity for us, most people choose a pharmacy based on location, whether it’s closest to home or closest to their office. So we want to make sure that we’re positioned very well in the future.

Mark Miller – William Blair

On the SG&A growth, could you help us disaggregate what is the change in the growth rate of comp store expenses you talk about lower rate, [inaudible] store salary and expense growth, how much would be coming from new stores? I recognize it’s not one for one, in other words these stores have a lower expense rate to begin with. And then how much would be if you could tell us the year on year change for the Take Care clinics.

Bill Rudolphsen

On a comp store basis, we’re looking at SG&A growth in the range of 4%.

Jeff Rein

And also Mark on the Take Care clinics, we have put out there $75 million as a drag on earnings. We’re still intending to hold it out right now. Obviously we’ll be able to measure more properly as we go along. But right now I would still have $75 million in your model.

Operator

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

Analyst for Lisa Gill – J.P. Morgan

Thanks it’s actually Mike [Mitchak] in for Lisa. First off, in terms of your healthcare offering and how you’re marketing the various pieces that you’ve assembled to the payer community, I was trying to understand whether you have separate sales teams that are in place for each of those various components or whether you’ve united them all under one common banner?

Rick Hans

We have what we call our managed care sales team which is more of a generalist organization where they’ve had the relationships over the years with the managed care and PBM payers, with the pharmacy directors and so forth. That group is leveraging those relationships to bring in the specialists that lie within the individual business groups.

For example, Mike Nameth who used to be with Wellpoint is running our PBM and specialty. You know he’s got a group of experts that’s helping sell our specialty business. Paul Mastrapa who now leads Option Care and our Home Care division has a great group of sales folks that understands that business. Take Care, Hal Rosenbluth and so forth. So we’ve kind of got a generalist team where we bring in the specialists as we get the opportunities.

Analyst for Lisa Gill – J.P. Morgan

Now that healthcare does make up a larger portion of your business following some of the recent acquisitions, do you have any plans or are there any requirements to increase the disclosure around that segment in particular?

Jeff Rein

We will do that as soon as it hits our 5% mark. Right now it’s all under our Walgreen Health Services.

Operator

Your next question comes from Ed Kelly – Credit Suisse.

Ed Kelly – Credit Suisse

On your digital photo promotional strategy. Can you maybe talk about how much of the overall front end gross margin pressure is from lower digital photo prices? And then are you pleased with the return you’re getting on this investment and how do you measure that?

Jeff Rein

On the photo we have lowered the prices as you remember we did that last October. It is definitely a drag right now because we wanted to make sure that we are competitive. We do see the photo volume moving up but once again on the margin itself as you know it’s extremely high margin business.

But it does hurt the margins. However, I can tell you that once again it does bring people in. Competition has lowered their prices so we obviously matched that. But we have one of the top rated photo websites around. Keep in mind that what really helps us in terms of convenience, once again, you can upload your scripts form anywhere in the company and pick it up at any other location in the company.

So if your daughter wants to upload scripts to you and pay for it which would be nice of her to do, you can actually pick it up at a pharmacy near you or a location near you. It’s still a very, very viable business. We obviously measure the ROI on each of the components. One of the things that in that department that we’re doing is expanding other services.

So if you look at the DHL services, if you look at printer cartage refills, those are all high volume high margin businesses. And Greg I know you’ve got some really good training programs going on to make sure we really increase those sales, do you want to mention that?

Greg Wasson

Yes I think I’d go back to the, when we talk about our strategy in the second bucket as leveraging the box, that’s exactly what this is doing. With our photo customers that we’re bringing in are attracted to a lot of the many additional services we’re looking to expand, the DHL and the inkjet and so forth.

We’re going to have a little over half of our employees trained this coming month on DHL as we roll DHL out to all stores by the end of the year. We’ve got some very good training programs now that drive incentives and opportunities for our photo folks to grow sales and earn commissions. So we’re really excited about this area.

Ed Kelly – Credit Suisse

At some point here and I guess it’s probably October, November, you’ll start to cycle this. So what I’m trying to figure out though is just how much pressure it’s creating on the gross margin now. I mean it sounds like it could be more than half of the decline in the gross margin. Is that fair?

Bill Rudolphsen

It’s less than that but there is an impact on the margin and it’s true that we would be cycling this in October. And we are definitely seeing some softness due to less travel out there and more promotional activity. But it is less than half of the impact on the front end margin I can say that.

Ed Kelly – Credit Suisse

And then one last question, I want to understand the questions and your answers earlier on the expense control. If we continue to see sales kind of at current levels and let’s fast forward to next year. It sounds like you have the ability to grow SG&A less than the 11-12% in that type of situation. Is that what you were trying to imply earlier?

Jeff Rein

Yes, that is very true, yes it’s not just implication but it is something that we are focused on doing, absolutely. We really watched the gross profit, we are really focused on do we need the expense, do we have to have the expense, is it best to spend that money for the benefit of the company? So yes, the bottom line question and answer is yes.

Ed Kelly – Credit Suisse

And just with the inflationary environment we have today, just fuel obviously but you’ve got the issue of price inflation as well on your cost of goods, does it make it more difficult to do what you were just talking about?

Jeff Rein

Only in the sense that you’re looking at probably payroll, electricity and things of that nature. But in terms of cost of goods, as you know, we would pass that along just like other retailers are doing, we’re very, very competitive, we make sure we shop the competition. But if there’s price increases and inflation coming down the pike which I believe there will be, then we will pass those on to consumers.

Operator

Your next question comes from Debora Weinswig – Citi.

Debora Weinswig – Citi

In terms of the Take Care clinics, obviously there’s a lot of competition out there right now, can you remind us what the competitive edge really is for Walgreens and how you see that developing going forward as well?

Jeff Rein

The competitive advantage for Walgreens is we’re very focused on having a quality experience in our Take Care clinic. If you look at our clinics versus the others, we’ve been rated one of the top ranked ones around. That’s because we have two exam rooms, we have a table, we have hot water. We also have strict protocols for the nurse practitioner and they’re based back near the pharmacy.

So if you look at the environment and the feedback that we’ve had from physicians, customers, patients and nurse practitioners, we have one of the highest quality experiences in all of retail. Once again, based on our convenience and our attracting of quality people and being accessible to people, whether it’s at night, weekends, I believe it differentiates us from the competition.

If you look at the some of the competition, they’re actually going back and redesigning, reformatting their clinics to bring them up to the standards that we have. We also have certain clinics within the industry that are owned by other folks, not Take Care, but that are actually going out of business, they’re pulling up shop because they cannot match the expertise and the quality that we are offering our patients.

Debora Weinswig – Citi

And then can you also elaborate a little bit on the Walgreens prescription savings club. How are you making sure that your customers in store are aware of the club and also how are you reaching out to those customers who maybe aren’t yet in your stores?

Greg Wasson

I think as far as in store, that’s where we’re really excelling right now. We obviously have in store signage, our folks who know how to execute are talking to folks and explaining the value of the card. So I think we’ve done very well on the in store, with the in store segment. As far as the external, we’re launching a major campaign as we speak.

We absolutely do think we have a great product, we want to get it out there. We want the doctors to know about the card, we think there’s great value for them to be able to talk to patients who are struggling with prescription costs to let them know about it. So we’re really looking forward to ramping up our marketing effort externally.

Jeff Rein

On interesting fact is that only 7.5% of the people that come into Walgreens actually go back and get a prescription. So there’s a great opportunity to make sure people know about the prescription savings club card on the front end. People who never make it back to the pharmacy that didn’t even realize the savings that are involved.

And I’m telling you this 400 generics for $12.99 for a 90 day supply is a great value. It’s a little over $4.00 a month of course, and you talk about convenience, that really plays into convenience and access and savings very, very well.

Greg Wasson

And the potential as you know is huge, there’s 47 million uninsured out there, there’s many more millions that are under insured. We think we’ve got a great product to help them control their prescription costs.

Debora Weinswig – Citi

And it also seems just from looking on the website that there’s also coupons that you’ll be giving to customers just for them inquiring about the club. So there is a definite kind of aggressive marketing strategy behind this?

Jeff Rein

There is, we’re using the internet more and more. We did find out for example during Medicare part D that that was very, very effective for us to give people coupons just for coming back to the pharmacy and talking to our pharmacists and staff about the savings they can do and the services that we do have. So you’re right, the onsite works very, very well.

Operator

Your next question comes from John Heinbockel – Goldman Sachs.

John Heinbockel – Goldman Sachs

You mentioned the competitive environment but you would think in light of pharmacy sales and this lull in generic activity that there would be more competitive fallout, independents and smaller regional chains, maybe then some supermarkets that we’ve seen. Are we seeing that, are we going to see that, where’s the market share opportunity for you there?

Jeff Rein

You’re darn right on that, we’re seeing fallout left and right. It’s interesting when Medicare part D first started, a lot of the independents were on the fence so to speak, should they get out of the business or not. Now they are definitely getting out of the business.

I also see smaller regional chains for example that can’t have the resources or don’t have the resources to put into technology, updating their format, things of that nature. So there’s a great opportunity and that comes back a little bit to our store growth. That’s why it’s very, very dynamic here.

And as people fall down and fall apart and are no longer with us and I can assure you they will be, that’s where we will be to have a site in the trade area that will take care of people. So you’re exactly right, the opportunities for us in the next three to five years because of the fallout of people going out of business is just tremendous for Walgreens and we’re going to take advantage of it.

John Heinbockel – Goldman Sachs

Is there enough market share opportunity to get you back to your long term profit growth rate in the interim here or does that require a better economy and a better group of generic drugs coming on the market?

Jeff Rein

I think this is a lull right now in prescriptions in general. As you know, prescription usage is down for various reasons, part of it is the economy of course. Part of it in our numbers is Zyrtec by the way. That was a 70 basis point drag on the quarter. Part of it is the scare of what pharmaceuticals do, for example the Heparin, Vytorin, some safety issues, people are a little bit more scared.

But I do believe that IMS is saying that there’s going to be a 4-6% increase over the next three to five years. And I think you will see, once again our growth being spurred on by whichever administration is in power. Both Obama and McCain have come out very strongly in saying drugs do help control healthcare costs and we want better access for the American public to these prescriptions.

That is going to happen, it’s absolutely going to happen. So once again this is a lull, I do see us getting back to our normal growth rates and we’re going to be well positioned to take advantage of it.

John Heinbockel – Goldman Sachs

What’s going on with discussions with other PBMS with regard to, I don’t know if it would be a joint venture, working together to bring new programs to the market. Is that fertile at this point or not really going anywhere?

Jeff Rein

We are definitely talking to the other PBMs. As you know CVS Caremark manages about 15% of the prescriptions at Walgreens, that leaves 85% of the prescriptions that are managed by somebody else and we are definitely talking with those folks.

Greg Wasson

I’d echo just that, I think that we have several of the payers, the PBMs out there that do not own mail or specialty that we work with very closely. We’re expanding those relationships. We’re also working with the managed care plans that are out there as Jeff said. Prime for example is a great example of the [inaudible] in our specialty relationship, we’re looking to work even closer with them.

Certainly the remaining large PBMs have been more interested in talking to us as we’ve talked about in the past since the merger. So we’re really working closely. We’re really targeted on the Blues as you know.

And as Jeff said, the premise to our strategy is that we absolutely believe that our large vertical integration between a PBM and a retailer creates competitive conflict between the rest of the payer community. And there are 85% of the lives out there being managed by many payers that we want to work with more closely.

Operator

Your next question comes from Neil Currie – UBS.

Neil Currie – UBS

I just wanted to dig down a little bit more on new store productivity. You talked about the 15% ROI on maturity but at any one time you have a lot of your stores which are less than three years old. And just looking at your pharmacy volumes in same stores, a lot of the stores that contribute to same store volumes are the ones between two, three, four years old.

And it does seem that the gap between yourselves and the rest of the market seems to have narrowed. I mean you’re opening 8-9% square foot a year, your pharmacy volumes are just about positive, obviously the rest of the industry is slightly negative, but the gap, historically has been somewhat higher.

So I’m wondering whether a couple of things are happening here, whether Wal-Mart is having more of an impact than we think on overall volumes hence the introduction of the savings club or whether recent new stores that are in that sort of two, three year age, whether they are continuing to drive the sort of comp growth that they have traditionally. Can you just comment on that?

Jeff Rein

The first five years, under five years, the new stores are definitely a drag on earnings. On average it takes stores three years to become, to hit that breakeven point and then they start growing from there. I think one interesting thing that you might want to consider in terms of narrowing of the spread and it has narrowed a little tiny bit is our competitors number one are consolidating.

So they’re doing two for one locations, they’re putting two stores into one store. And also we’re going into markets that are more difficult for us, they take a little bit longer to grow and we’ve talked about that in the past, that’s California, particularly Southern California and the Northeast. Those stores once again take a little bit longer to hit their breakeven point.

And since we’re not as well known, it takes longer to build up the pharmacy business. It is interesting though that in looking at numbers from IMS is that we are still having a significant spread between us and the competition and of course you can look at those numbers and see that our spread is still very significant on a month to month basis.

So there has been a little bit of narrowing over the last I would say three to four years. Part of that is the competition is stronger and getting stronger. But once again our spread is still very significant compared to the industry.

Neil Currie – UBS

And just on the Wal-Mart $4.00 generics and $10.00 90 days, it’s not just Wal-Mart anymore, it’s a whole host of discounters and it seems that supermarkets are gradually starting to move towards that pricing. Is this becoming more of an impact on the cash business hence as I say the introduction of your savings club card?

Jeff Rein

That’s one of the reasons that we came out with the prescription savings club card. Keep in mind that the cash business at Walgreens, depending on the month is in that 5-6% range. So even though it’s not part of our total business in terms of how big the impact is, it is still part of our business.

But this prescription savings club card as Greg mentioned has been very, very well received by our patients and customers. And we’ll make more inroads in the future. We’re having approximately thousands and thousands of signups a week that are absolutely taking advantage of this and will be good for us in the future.

So once again, people are getting more aware of the cost of medications. But when you come back to our convenience and the stores that we have opened and the hours that we have open, we will definitely win out.

Greg Wasson

Keep in mind that the majority of our business is indeed contracted with third-party payers where members have co-pays and many generics at $5.00 or less in some cases. So as far as the third-party business, we absolutely believe our convenience is a major factor. And we think that the PSC will help us gain share in that cash customer.

Operator

Your next question comes from Mark Wiltamuth – Morgan Stanley.

Mark Wiltamuth – Morgan Stanley

I wanted to hone in a little more on your comments that some of this IMS data may be weak because of the economy. Are you seeing different compliance trends in different parts of the market and have we seen any drop off in prescriptions more in the California or Florida region or anything along those lines?

Jeff Rein

Yes, a couple things that are happening that we’ve heard and seen. Number one, people are actually splitting their medications to make sure they go further. They are skipping doses, in other words they’re taking their dose every other day. And certain medications you wouldn’t be able to tell the different short term, for example on high blood pressure medication, if you skip a dose or skip a day, you probably won’t feel a difference. Same thing with statins.

California and Florida have been difficult. As you know they’ve been hurt terribly by the economy. And we are seeing impact there. But overall we are continuing to pick up market share across the nation. Even with the introduction of the Wal-Mart $4.00 program, we have increased our market share since that time. So even though there’s a lull in prescriptions right now, I do believe it will come back and many of these factors in my mind are temporary.

Mark Wiltamuth – Morgan Stanley

Maybe you could just talk a little bit about how generics were for you in the quarter. Was it helpful or how did it compare versus last year’s?

Jeff Rein

The big difference this quarter in terms of the profitability is we lost Oxycontin. If you remember Oxycontin was a pain medication that went from generic to brand. That was a significant hit in terms of earnings. Otherwise everything else was pretty much normal.

Greg Wasson

We were also cycling the effect of Zocor and Zoloft going generic last year. So just to repeat, we had phenomenal increases in gross margins last year and they were a little bit soft compared to last year’s introduction of those two blockbuster drugs.

Mark Wiltamuth – Morgan Stanley

Just a general comment, I just get the impression that of all your adjacency acquisitions, you’re not really getting much credit form the investor community on those and a lot of them have been smaller individual deals. But in total there are several of them and I’m just curious if you could characterize what kind of accretion the group would have in terms of EPS impact over maybe a three to five year period.

Jeff Rein

Thanks very much for recognizing that, we appreciate that comment because that’s exactly what’s happening. Even though they look small, in total they are big. And keep in mind the expertise that we’re getting with this. Healthcare in America is changing and it’s evolving.

People are looking for a reason and a value to pay for services and they want to make sure that we can influence outcomes. We are absolutely doing that. Greg has been absolutely intimately involved working with WHS in really leading up these efforts in terms of the integration of our health and wellness area.

Greg Wasson

Thanks for the suggestion, I don’t think that we’re getting the credit and recognition we should. I think over the past 12-18 months we’ve assembled a national infusion platform that’s second to none I believe out there with a big pipeline of infusion specialty drugs coming at us. The MedMark acquisition with the expertise we got there from Stan Blaylock and his group has really provided us a scalable platform that we’re linking to the infusion platform as we speak.

I think we picked up the best in store retail clinic provider in Take Care that was out there. I think Hal Rosenbluth and his group is bringing us a ton of experience. A couple of the top providers in the wellness space, I-Trax and Whole Health and that has come together, we’ve assembled a strong management team there and we’ve got a heck of a platform.

The real value now comes between connecting the dots between the two as I talked about. I think all of these what they’ll do is the way we look at these is not only do we see these businesses and these adjacencies providing huge growth opportunity as we go forward but they also accelerate the drug store business for us as well. So we’re really bullish on this and thank you for the question.

Jeff Rein

One more thing to reiterate, all the time that we’ve been doing this, particularly over the last three quarters, we have managed to keep our expenses in check. We’re very, very focused on growing businesses that make sense and obviously cutting back on items that do not make sense.

Mark Wiltamuth – Morgan Stanley

Do you have any way of quantifying the total accretion we could be thinking about a couple years out?

Bill Rudolphsen

We haven’t laid out a lot of details there but we have talked about some of the larger acquisitions and we would place accretion anywhere from $0.05 to $0.10 per share over the next three years.

Operator

Your final question comes from David Magee – Suntrust Robinson Humphrey.

David Magee – Suntrust Robinson Humphrey

You mentioned the fact that new stores in the aggregate will be plateauing here over the next couple of years. Is there any difference in terms of just the profile of new versus existing markets that you’re going into and owning versus leasing?

And then the second part is that thinking longer term, many years down the road and knowing maybe that you guys would go international, are there any international markets that to you seem most similar to the US in terms of how it’s constructed that would look most interesting to you?

Jeff Rein

On your first question in terms of profiling, what the stores look like, we look at a trade area. We look at the demographics and other things in that trade area, we have many different metrics we look at. But in terms of profile of the store, I wouldn’t say there’s anything necessarily different about them except the selection of merchandise inside.

Sometimes there’s a little difference in the way the stores look, but that’s based on community approvals. But we do have many projects going on and one of them is facing department management, one is optimization of the SKUs in that store. So you always want to have that local flavor that matches the demographics and matches the wants and needs of that particular clientele.

But once again there’s opportunities across America in all the different trade areas. It could be in markets that we’re not heavily in right now or it could be in markets like Chicago, Memphis, St. Louis and so on to some that we’re already in that we’re doing very well that we want to dense up even more.

Bill Rudolphsen

Right now our target roughly is 20% owned, 80% leased. And that will probably continue on for a while but we’ll have to evaluate that if we do plateau or growth in the future. We’ll have to continually evaluate our capital structure. But that’s where we’re settling in right now to protect our credit rating.

David Magee – Suntrust Robinson Humphrey

And on the market, so you would expect the ratio between new and existing markets to be about the same as it is?

Jeff Rein

No, we’ve actually hit almost all of the new markets that are, as you know we’re going into Washington DC, we’ve got over 200 approvals in the Northeast right now. We’re all over the country, in fact we recently announced Alaska right so that will give us 50 states. So we’re okay there. But where we have an opportunity is to dense up in many markets. When you dense up you take advantage of costs, supervision costs, advertising costs, distribution costs, you can spread those costs out of a wider base.

And in any one market there’s always a tipping point where you build you build you build and you hit that tipping point and then your profitability explodes. And there’s many markets that are in that camp. So once again in terms of beach heads, we really are across all of the United States.

Getting back to your question also in terms of international, as Greg was talking about earlier on healthcare services, there are so many opportunities here for us in the US that between the US and Puerto Rico, there really isn’t any need to go international at this point. People are looking for value, they’re looking for health and how do they control their healthcare costs and how do they stay healthier.

And Walgreens with Take Care clinics, with Option Care, Schrafts, our infusion business, our pharmacies, 6,300 distribution points across America, we are extremely well positioned for the future. So once again, international we’ve look at it but our opportunities in the US here are just fantastic.

Rick Hans

Folks that was our final question. Thank you for joining us today. We’ll announced June sales on July 2. Our next quarterly financial announcement will be September 29 when we announce fourth quarter fiscal 2008 yearend results. Until then, have a great day and remember, you’re always welcome at Walgreens.

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Source: Walgreen Company F3Q08 (Qtr End 05/31/08) Earnings Call Transcript
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