Shoppers Drug Mart Corporation F2Q08 (Qtr End 06/14/08) Earnings Call Transcript

Shoppers Drug Mart Corporation (SHDMF.PK)

F2Q08 Earnings Call

July 16, 2008 3:30 pm ET

Executives

John Caplice- Sr. Vice President

Jurgen Schreiber- President and CEO

George Halatsis- Exec. VP and CFO

Brad Lukow- Sr. VP of Finance

Analysts

Michael Van Aelst- TD Newcrest

Irene Netel- RBC Capital Markets

Mark- Morgan Stanley

Perry Caicco- CIBC World Markets

Ryan Balgopal- Scotia Capital

Winston Lee- Credit Suisse

Keith Howlett- Desjardins Securities

David Hartley- BMO Capital Markets

Presentation

Operator

Welcome to the Shoppers Drugs Mart second quarter 2008 results conference call. (Operator Instructions) I would now like to turn the meeting over to John Caplice, Senior Vice President, Treasurer, and Investor Relations and Corporate Affairs.

John Caplice

On behalf of Shoppers Drug Mart Corporation I would like to welcome all of you to our second quarter conference call. With me on the call today to answer your questions are Jurgen Schreiber, President and CEO of Shoppers Drugs Mart Corporation; George Halatsis, Executive VP and CFO; and Brad Lukow, Senior Vice President of Finance.

Before we begin I would like to remind everyone that participants in today’s discussion may be making certain statements containing forward-looking information with respect to the company’s operating and financial plans and performance. Any such forward-looking statements are based on management’s current assumptions, beliefs and expectations. Inherent in any forward-looking statements are known and unknowns risks, uncertainties, and other factors beyond the company’s ability to control or predict. We want to caution you that actual results or developments may differ materially from those contemplated by such forward-looking statements.

Certain of the material risk factors and material assumptions that could cause actual results or developments to differ from expectations are contained in our second quarter earnings release that was issued earlier today. Further information regarding these and other material risk factors and material assumptions is included in the company’s public filings with Provincial Securities Regulatory authorities including, without limitation, those described under the heading “Risks and Risk Management” in the companies MV&A for the year ending December 29^th, 2007 and under the heading “Risk Factors” in the company’s annual information form.

Any forward-looking information provided in the context of today’s discussion represents the company’s views only as of today’s date. While the company anticipates that subsequent events and developments may cause its views to change, the company does not undertake to update any forward-looking information except to the extent required by applicable securities laws.

Earlier today we issued a news release on our second quarter results which included our financial statements and MV&A. By now most of you have had an opportunity to review this information so I will just make a few brief comments on the quarter before we open up the call to questions from the analysts.

I will start by saying that once again we were pleased with our results. Second quarter net earnings increased 14.4% to $128 million, or $.59 per share compared to $112 million, or $.52 per share last year. Total sales increased 9.4% in the second quarter, to more than $2.1 Billion with the company continuing to experience strong sales growth in all regions of the country. On a same-store basis, excluding tobacco which is being phased out of remaining stores in western Canada that list these products, sales increased 4.6% during the quarter.

Prescription sales, which accounted for 47.9% of the sales mix in Q2 increased 11.6% and were up 6.4% on a same-store basis. In the front of the store second quarter sales increased 7.4% with sales growth coming form all categories except tobacco. On a same-store basis, excluding tobacco, front store sales increased 3%, a particularly strong result given the Easter calendar ship this year which benefitted comparable same-store sales growth in the first quarter of 2008 by approximately 200 basis points.

With respect to our store network growth and revitalization program the second quarter saw us open or acquire 22 new drugstores, nine of which were relocations. At quarter end there were 1,171 stores in the company’s retail network, comprised of 1,106 drug stores and 65 Shoppers Home Healthcare stores. Drug store selling space is now close to 10.1 million sq. feet an increase of 13.9% compared to a year ago.

So without further delay what I would like to do now is turn it back over to the Operator who will open it up for questions from the analysts.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Michael Van Aelst - TD Newcrest.

Michael Van Aelst- TD Newcrest

You had some pretty good gross margin expansion once again. Can you comment on your direct sourcing activity, and how much has it increased year-over-year and how high can this go?

Jurgen Schreiber

We don’t disclose the details on the margins. I think it is fair to say that when a margin clearly came out of both areas, out of the pharmacy side and based on generics, but also substantially out of the front store business and in particularly out of a change in category mix and out of a maturing of stores. So it is really fair to say that it comes out of absolutely both areas.

Michael Van Aelst- TD Newcrest

Direct Sourcing, is there still a lot more for you to do or are you starting to see the potential now?

Jurgen Schreiber

I think you will see on direct sourcing really in this quarter only a very minimum impact. The majority of the impact will come in the course of this year and in the course of next year.

Michael Van Aelst- TD Newcrest

I am sorry, which quarters?

Jurgen Schreiber

I think in the rest of this year because at the moment we have around 32 categories that we want to convert to direct sourcing. We have found a very small part, a significant part will come from the rest of the year, but also for next year additional categories will follow. So you can see more in quarters 3 and 4, but then continuously also in the entire next year.

Michael Van Aelst- TD Newcrest

And the switching over to the Nateeva or Ganex product line, can you give us an update as to the early performance of these products and what are your plans for the category?

Jurgen Schreiber

For us it was really the biggest success so far in any kind of privately label brand we have had. It has an incredibly strong performance. The nice thing behind this one was the entire store stock and the associates standing fully behind the product, so it works out for us incredibly well. We started out with a very strong promotion. We used the promotion like you should do. Actually 170 SKUs, we more than doubled out sales in this kind of category with the new products. It is very consistent now and we will launch a couple of more products in the rest of the year and then in next year. It was a great launch for us and it was absolutely fantastic what was reported from the stores.

Michael Van Aelst- TD Newcrest

And just one short question, generic inflation rate, what was it in the quarter?

Jurgen Schreiber

It was 350 basis points.

Operator

Your next question comes from Irene Netel - RBC Capital Markets.

Irene Netel- RBC Capital Markets

Obviously there has been a lot of chatter recently about the deteriorating consumer spending environment, and in the press release you say that you remain confident in your outlook for the year. Does this mean you are maintaining your front of store/same store sales guidance? Assuming that I am correct, what sort of key tools are you going to use to continue to drive this kind of performance?

Jurgen Schreiber

We will stick absolutely with the guidance on both sides, on front store and pharmacy for the rest of the year. There is no change on guidance from us. I think where we will continue is in our things which helped us in the first part of the year. I think we have very good position, that we have a couple of core categories in our business which are quite protected from economic changes. One of them is obviously are drugs, others are [inaudible]; OTCs and vitamins are quite protected. We see the cosmetic business actually very protected and doing incredibly well for us.

The second thing we see for us is significant market share increases in most of the categories. For some in the cosmetic business we had in the last twelve weeks 90 basis points of increase in share, and we had for example in OTC, baby, and seasonal 130 basis point increase in market share increase which shows us that a significant amount of our store has new capital clearly which came over the last year and these stores are now maturing.

That helps us in the runway, and the rest is permanent innovation bringing new products to the market; bringing products like Native in the market; and we have a couple of new private label launches also in quarter three and quarter four. We will not stop if Nateeva has new things really coming into play and really we have had a great program stepping up out promotions. You look at the Optima line and in Q1 for example we had 8.6 million cardholders, now we have close to 9 million cardholders. This program is running incredibly well for us. Based on all of that, we remain confident for the rest of the year.

Irene Netel- RBC Capital Markets

Are you seeing any meaningful changes in consumer spending patterns within front-of-store?

Jurgen Schreiber

From our side we don’t see [inaudible] but what we see of all of our categories are falling quite nicely and we really believe that on the positive side we gained share in pretty much every category at this point in time. We have a few new categories, things like food are new for us, and that obviously helps us in the sales. So far, no dramatic shifts in the categories, there is some shift in the core. We have more Prestige Cosmetics, which is a natural shift which are not proven out of the pattern from the customer, but out of the store opening program.

Irene Netel- RBC Capital Markets

In terms of Optima, it appears at least that you have you been using it quite effectively as a promotional tool. Are you still seeing, in terms of redemption, people really gravitating towards higher margin categories like Prestige Cosmetics?

Jurgen Schreiber

We still see the same pattern. It is very much on either high margin categories or high ticket items. We still see the same trend.

Irene Netel- RBC Capital Markets

What was the generic penetration in Q2?

Jurgen Schreiber

It was 51%.

Operator

Your next question comes from Mark [inaudible] - Morgan Stanley.

Mark- Morgan Stanley

In the U.S. market we are seeing kind of flat prescription volume trends for the industry. I wonder if you would give us an update on how Canada is doing and maybe if you feel like there is any economic damage to the prescription trend? I know you commented on the front end but I wanted to get the question out on the prescription side also.

Jurgen Schreiber

We saw a market increase around 6%. It is still the same on the script currents and on the sales. And we see for us in addition to that some major changes on that one really, and we see a share increase for us, 20.2% market share now, and we will see a share gain for us. It has been a combination of the two. Continuously good friends are market and slide market share gains.

Mark- Morgan Stanley

On the front end, what is your private label mix up to now, and what are some of those other things we can look forward to for the balance of the year?

Jurgen Schreiber

In quarter two we had a nice shift, we had 16.4 %. It is 2.7% points higher than in quarter 2 of 2007. That is a very significant shift if you compare it with quarter 1 we had 1.8 percentage points, now we have 2.7 percentage points increase, or actually we are speeding up the accruals of the penetration. I think what you see in the next quarter is that one side is a continuation of new things like Nateeva; you see a very new and spectacular thing on chocolates, a very interesting and exclusive program for us; and you see a new thing coming out of the heart of our business which is the skin business. We will launch two new product labels on the skincare side.

Mark- Morgan Stanley

Do you have any updates on your small format store, the experimental store that is just prescriptions and cosmetics?

Jurgen Schreiber

We have two things. We have the one thing that is just the small format store, a 1,000 sq. ft. store called Shoppers Simply Pharmacy, which is basically a script center in medical buildings which is doing really well for us. We started with that at the end of last year; we have fifteen stores at this point in time, and it is a very nice model for us which we will continue to grow. When you look at the new model which is a beauty store with pharmacy, that is something completely new and we will open that because we still are experimenting and we have really great new friends which join us in this store. Based on that, we made the decision to open it in November. This store will open in November in Ontario.

Operator

Your next question comes from Perry Caicco - CIBC World Markets.

Perry Caicco- CIBC World Markets

In the latest press release you make a reference to a new competitive bidding process being implemented by the internal ministry of health on certain drugs. Can you explain a little bit what that means, and how you expect that to play out in your role in this new process?

Jurgen Schreiber

At this point in time I think it is very preliminary, so it is very hard to say. What we know is that it is an execution of a policy which comes out of 06’. It is related to ODB only. It is related at this point in time to four relatively high-volume but small value trucks. And what we see in the government policy at this point in time, and it is very preliminary, is basically the most important thing for us in the pharmacy. There is no fundamental change in rules from ODB related to pharmacies because the pricing component is kept intact and for us the 20% professional allowance is kept intact.

Perry Caicco- CIBC World Markets

So you would have no role in this bidding process?

Jurgen Schreiber

No it is a question of the manufacturers and that always two per molecule and we obviously will carry these products in our stores. But for us the really fundamental part is that the role for us as a pharmacy has not been touched.

Perry Caicco- CIBC World Markets

So the next question is actually on your operating expenses. The store network expansion obviously drives the bulk of your rate increase in operating expenses, but outside of that how much cost pressure is there on the business right now and where is it coming from?

John Caplice

We really don’t have pressure coming outside anywhere right now aside from store expenses. That is the category that we see the increase, so it is basically in stores and tied to these store programs.

 

Perry Caicco- CIBC World Markets

So labor has been holding relatively steady for you?

John Caplice

Yes.

Perry Caicco- CIBC World Markets

And then on product costs, which is a totally different topic, what pressures have you been feeling, if any, on that front?

John Caplice

On the product costs as you saw on the announcement we did we reduced our costs we have sold as a percentage of sales. So I think we have been continuing on both side of the store. And within the front store, within categories, and we continue to see a better margin mix. We are in fact seeing improvement in our cost of goods again.

Operator

Your next question comes from Ryan Balgopal- Scotia Capital.

Ryan Balgopal- Scotia Capital

What are your competitor’s thoughts about product deflation again in their quarter? I wonder if you are seeing that from the consumer packaged goods companies.

Jurgen Schreiber

Honestly, at this point in time we would not really see that in our business, Ryan Balgopal- Scotia Capital.

Ryan Balgopal- Scotia Capital

Is that something you expect might happen because of the strength of the Canadian dollar?

Jurgen Schreiber

I think that we have a very different category mix really and I think we are still really clearly in the process of optimizing buying and optimizing our entire programs and promotions and the loyalty card. The entire mix, this is what makes for us the difference.

George Halatsis

The increase for us in our corporate brand penetration of course is going to have a bit of a deflationary impact.

Ryan Balgopal- Scotia Capital

Same-store sales a total in front including tobacco?

George Halatsis

It would be about a forty-fifty basis points impact.

Ryan Balgopal- Scotia Capital

On the front?

George Halatsis

Correct. And again we basically took it out, but we are trying to give investors and people on the call a sense for how the store is in fact operating for those categories that we continue to want to put into our stores.

Ryan Balgopal- Scotia Capital

Does that have any impact on profitability, or is it a pretty low- margin business for you?

George Halatsis

It is a fairly low-margin business.

Operator

Your next question comes from Winston Lee - Credit Suisse.

 

Winston Lee- Credit Suisse

I wondered about the stores you have in Quebec. You have increased them quite nicely and do you find that as you gain more mass over there that the ramp-up time for a store is changing?

Jurgen Schreiber

What we have now is a really nice presence in the most important parts in Quebec, so there is an incredible print recognition, and Quebec is for us one of the major driving factors. It is over-proportioned on the comp side and definitely more than over-proportioned on the total comp increase. We clearly see that based on this better print recognition we see slight improvement on the ramp-up time. You can see that going into the areas where we already had stores, it is helping us tremendously.

Winston Lee- Credit Suisse

Is there something about non-consumer [inaudible] that is different or unique, say compared to Ontario, or is it relatively similar and so your promotions would be similar?

Jurgen Schreiber

It is a different market, and we operate slightly different in the market from the branding to some of the marketing polices, and we have a very special team in Quebec and we have an office in Montreal. We have a small marketing team there, and specialists there. Most of the people come out of Quebec and they localize and specialize that they have some flexibility in sourcing prints which we is more appreciated from the customer, but it is really about the customer in the first place. So if you have to do adjustments in provinces, and in particular in Quebec, we do them.

For me it is all really about the decision of the customer. The format as such clearly is not different but some categories have a slightly different [inaudible]. We have Maxwell House products for example is much more important in Quebec so we have more products like that there. All of that gives us quite a unique mix and we believe that it is so important to have a local team there and then having really the associates who all come out of the area and live in that area and serve the customers to give the special touch to their stores is very important. And that is not only in Quebec so it is everywhere in the company like that. Particularly in Quebec it is very important.

Winston Lee- Credit Suisse

And on the Optima progress in Quebec, is that ramping-up nicely as well? I was quite pleased to hear that you were up to a tremendous increase sequentially.

Jurgen Schreiber

Optimum is ramping-up very nicely in Quebec. We are seeing similar developments.

Winston Lee- Credit Suisse

The last question is Beauty Boutique sales. What is the count?

Jurgen Schreiber

151 at this point in time.

Operator

Your next question comes from Keith Howlett- Desjardins Securities.

 

Keith Howlett- Desjardins Securities

I have a question on the front-end sales by region. You have indicated that Quebec is out-performing the national average. Are there any other noticeable differences across the rest of the country or not really?

Jurgen Schreiber

I think the rest is quite similar. It is really only Quebec that is truly significantly more than the others. But the rest is quite consistent.

Keith Howlett- Desjardins Securities

And just on the GOSH brand; what is the progress there and are there any other brands that you can mention at this point in time?

Jurgen Schreiber

GOSH is doing really well for us in the stores that we had it in the beginning. It is already our number three [inaudible]. It is very fast for a brand that had no recognition whatsoever so that is doing really well for us, and based on that program and on the success we will ramp it up faster, which means we will add in more stores than we originally planned so we just got the addition of another 100 stores and we will go to 500 stores and we will try to get it into more stores. It is doing incredibly well for us.

On the cosmetics side there are more [inaudible] which we got exclusive. Unfortunately I cannot disclose the names, but they will come in quarter three and quarter four.

Keith Howlett- Desjardins Securities

I think you were going to launch a VIP Optimum. Is that still scheduled for a date in the third quarter?

Jurgen Schreiber

Yes, it is still scheduled for the next quarter. Absolutely still in-line with plans, so we will launch the program.

Keith Howlett- Desjardins Securities

Finally, on the off-shore procurement on the Q1 call you said there were 22 categories, and if I heard correctly today you said 72 categories?

Jurgen Schreiber

No, that is 32 categories. Next year we will start with all the categories. We did some classes, but we do really category by category.

Operator

Your next question comes from David Hartley - BMO Capital Markets.

David Hartley- BMO Capital Markets

Could you talk a bit about retail price inflation/deflation outside of the categories of drug and cosmetics?

Jurgen Schreiber

What you find in us we have our policy that we have a certain kind of price index on an everyday low price for the key PIs. And then for us the fundamental difference is that we work very much on promotional scheduling and we work our prices very much with the loyalty card program, and while we added a much stronger price component versus the past is obviously the increase in private label and not particularly we launched the [inaudible] Everyday market which is a very high quality but value determined brand. So far in the moment you feel pressure in the market, especially in the food areas, but we have to optimize our prices so we are still in the process of adding some pressure to the prices from the supplies, but on the other side optimizing our value structure and our way of buying and increasing our volumes to overcome some of the pressure you would have on a potential price increase.

David Hartley- BMO Capital Markets

I am just trying to get a sense on your front-store growth how much of that growth is represented by price increases, not mix increases, but price increases?

Jurgen Schreiber

We have hardly any other deflationary or inflationary impact.

David Hartley- BMO Capital Markets

You talked a bit about direct store procurement. I just want to be clear; is there any DSD procurement taking place here, or are we talking more about private label and seasonal type product procurement?

Jurgen Schreiber

It is the latter. We have private label on one side and seasonal, and it is a couple of ongoing range items like sunglasses, like accessories that you have in an entire year in a store. This has a range that would traditionally come out of Far East, and we now buy them direct from the Far East.

George Halatsis

Rather than going through an intermediary, sourcing directly from abroad.

David Hartley- BMO Capital Markets

So it is 100% more or less that kind of procurement that we are talking about?

Jurgen Schreiber

And if it comes to private labeling for example, it would come from food private label or private label on the health and beauty side, they are really sourced locally or they are sourced out of Europe. But we took this strategic decision that these categories should be out-sourced out of the Far East.

David Hartley- BMO Capital Markets

Just two more questions, if I may. On the promotional side, it appears that the promotional environment has picked up and we are noticing in your flyers, could you talk a little bit about that and how it has affected the way you thought about different categories and how you have gone to market?

Jurgen Schreiber

What you have is as you have seen the fundamental on the [inaudible] we still increase on the margin. We are in an environment based on optimal sourcing and other things we do have an increase in margin and very tactically immersed, strategically quarter-by-quarter, month-by-month, how much of that we put back into the market. And there is really no fundamental change in our policy on this one, we just use the Optimum card better than I think we have in the past and having a significant increase in card holders helps us. From quarter 1 to quarter 2 from 8.6 to close to 9 million cardholders is a fundamental method shift in new card members. And all of that really helps us. But the underlying quality for us is the flyers; it really did not change. We got more intelligent about it; we promote our private label better than we did, and all of this we do, but underlining it is same quality.

David Hartley- BMO Capital Markets

When you say that the competition for key categories for HBA and others are not experiencing hyper-competition of any sort in any category?

Jurgen Schreiber

We have to take the store as a totality. I think first of all you have 48% at this point in time which is pharmacy. Then you have things like cosmetics and so on which is quite unique and there is normally not a lot of price competition. And yet OTC and you have vitamins where have to have special things, and then you have food which you have quite frankly as something new for us, and you have private label on that side more and more. And then you have the middle part of the store, and I am not saying it is not an important part of the store, but again it is a part of the store, and in that important part of the store there again there is for example [inaudible] you have price competition. And you have promotional things like hair coloring and those kinds of things which you always see in an environment like that, and our obligation then is optimizing our sourcing optimizing our pricing, optimizing our mix and therefore [inaudible] in some parts, very tactically but not excessively going to a little stronger promotional pattern. This is not a significant part of the store.

David Hartley- BMO Capital Markets

Going back to the Ministry of Health and long-term care issue: it seems that volume rebates is something that would go to the Ministry. I am assuming that is as opposed to the drugstore retailer. Yet you can’t predict what kind of impact that may have. Could you maybe give us a little more color on how that is going to work? Is it just that the rebate that you used to receive or would have received in the future for these products is simply not going to be awarded to you, it’s going to the Ministry? And is there some kind of timeline where the Ministry or the government has talked a bit about how many drugs will eventually shift onto this kind of program?

Jurgen Schreiber

You absolutely misunderstand the policy. What it is at this point in time is as we have said before it is at a very preliminary stage at this point in time, as before, we talked with the government in Ontario, and it’s about ODP. An important part for us as a pharmacy is that the price, which is the index on generics, is 50 which have not been changed. And the allowance we have as pharmacies is 20% and has not been changed. The government has not at this stage and as far as we understand the policy is not touching that part. The government has sought to optimize the sourcing and try to optimize the sourcing by going back to the supplier to optimize potentially special rebates, but this has nothing to do with the pharmacy. So prices for us and the rebates are not touched.

Operator

Your next question comes from Michael Van Aelst - TD Newcrest.

Michael Van Aelst- TD Newcrest

Given that you are cycling through the interchangeability from Bill 102 about a year ago, where do you see generic deflation being by year-end?

Jurgen Schreiber

It used to be quarter-by-quarter now it is running fully under 50 to 400, and I think it will remain similar for the next two quarters. Let’s say around quarter 1 around 400 basis points, quarter 2 around 350, and we will see it pretty much the same for quarter 3 and quarter 4.

 

Operator

Your next question is a follow-up from Keith Howlett- Desjardins Securities.

 

Keith Howlett- Desjardins Securities

I just had a question on the cosmetics business. On the last call you indicated that in slow time’s lipstick sales spike, skincare stay about the same wasn’t affected too much, but fragrance might show some economic sensitivity. I am wondering if you have seen anything like that on the fragrances side to date.

Jurgen Schreiber

What we have seen at this point in time is changes in the category. This is more related to changes in the promotions. What we did is have special packs, which are sampling packs, and all of these kinds of things were in a gift voucher of $70. This promotional offer has been so successful that our fragrance business is increasing very nicely. I am not relating that truly to the category, I relate it more to the quality and the promotions we put in place.

Operator

This concludes today’s question and answer session.

John Caplice

As there are no more questions, this concludes our call for today. Once again thank you for joining us, and we look forward to our next earnings call. This call is tentatively scheduled for the 6th of November to review our results for the third quarter of fiscal 2008. Specific information with respect to this call will be forthcoming. Thank you.

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