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Executives

Rick Hans - Divisional Vice President of Inventor Relations and Finance

Jeff Rein - Chairman and Chief Executive Officer

Wade Miquelon - Senior Vice President and Chief Financial Officer

Greg Wasson – President

John Spina - Vice President and Treasurer

Analysts

Andrew Wolf – BB&T Capital Markets

Robert Willoughby – Banc of America

John Heinbockel – Goldman Sachs

Debra Weinswig – Citigroup

Ed Kelly – Credit Suisse

Scott Mushkin – Jefferies

Meredith Adler – Barclays

David Magee – Suntrust Robinson Humphrey

Neil Currie – UBS

Mark Wiltamuth – Morgan Stanley

Walgreen Co. (WAG) F4Q08 Earnings Call September 29, 2008 8:30 AM ET

Operator

Welcome to the Walgreen Co. fourth quarter 2008 earnings conference call. (Operator Instructions) Now I’d like to turn the call over to Rick Hans, Divisional Vice President of Inventor Relations and Finance.

Rick Hans

We’ll start today’s call with Jeff Rein our Chairman and CEO discussing the quarter’s highlights. Wade Miquelon, Senior Vice President and Chief Financial Officer will provide details on the fourth quarter financial results. Greg Wasson our President will give an overview of progress on implementing our growth strategy. Following that Jeff will give a brief summary and then we’ll be ready to take your questions.

For the Q&A we’ll also be joined by John Spina our Vice President and Treasurer. Please limit yourself to one question and a follow up so that we can give an opportunity to as many investors as possible during our limited time. 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

Today we announced the fourth quarter in which we once again grew sales and earnings, controlled costs, gained market share and strengthened our management team. We also turned in our 34th consecutive year of record sales and earnings. That’s a track record matched by only one other Fortune 500 company. For the fiscal year sales increased 9.8% to a record $59 billion. Net earnings grew 5.7% to a record $2.2 billion or $2.17 per share diluted.

Fourth quarter sales were a record $14.6 billion that’s an increase of 8.8%. Net earnings rose 11.7% to $443 million, that’s $0.45 per share diluted up 12.5% from last year’s $0.40. The quarter included several unusual items both positive and negative that Wade will discuss in detail. Fourth quarter front end comp store sales grew 3.7% while total comps grew 2.6%. It’s obvious that customers are finding value in our products, services and convenient close to home locations especially as gas prices skyrocket.

On the Pharmacy side comparable prescription sales rose 2.8% in the quarter after adjustment for calendar shifts. The number of prescriptions filled in comp stores was 0.6% over a year ago. That compares favorably to an industry wide decrease of 1.9% excluding Walgreen’s. As you see we’re consistently beating the industry. As many of you know we’re facing a continuation of the slowest growing prescription drug market in 47 years according to IMS Health. Several things are driving this.

First is the switch of the allergy drug Zyrtec from prescription to over the counter status earlier this year. We’ve also seen fewer new drug interactions as well as some safety concerns over new medications. We believe the biggest impact has been the very tough economy. According to a July survey by the National Association of Insurance Commissioners 22% of Americans are reducing their doctor visits and 11% are scaling back on medication use. The good news is that we continue to gain prescription market share and now fill 17.6% of all retail prescriptions in the country. That’s up from 16.8% last fiscal year.

Before turning the call over to Wade for more details on our financials I’d like to give a quick recap of our competitive position. In fiscal 2008 we implemented our growth strategy through a number of short term and long term initiatives designed to deliver significant value to shareholders. First, we’re moderating Walgreen’s organic growth rate. This decision will give us greater operational and financial flexibility and it will also drive earnings growth in coming years.

Wade will offer more color in a few minutes but it’s important to note that even while organic expansion slows Walgreen’s will remain one of the fastest growing retailers in the country. Second, our worksite healthcare acquisitions in our Health and Wellness Division are integrating well. With them we’ve established the foundation to provide compelling future growth across all platforms. Third, we have a relentless focus on reducing costs through disciplined control today and over the long term. You can see the evidence of that throughout the past fiscal year and especially in the fourth quarter.

Fourth, we’ve expanded our leadership team to drive bold, creative and innovative responses to a rapidly changing retail and healthcare environment. This past summer we added Wade Miquelon as our CFO and Sona Chawla as our Senior VP of E-Commerce. Our latest addition is Kim Feil, the new Chief Marketing Officer we announced last week. Kim, previously CMO at Sara Lee will lead a new marketing organization to more effectively meet the needs of Walgreen’s customers and Pharmacy patients particularly for health and wellness.

Before moving on I’d like to note that we will not be discussing our previously announced proposal to acquire Longs Drug Stores. We remain committed to our proposal which we believe is a superior one but we won’t take any questions regarding it during the Q&A. With that overview I’ll turn the call over to our CFO.

Wade Miquelon

First I’d like to reiterate and thank our people for the strong sales and cost discipline that continued throughout our company in the fourth quarter. We continue to position ourselves as the leading retailer in a very tough economy. Recapping sales we were up 9.8% for the fiscal year and 8.8% for the fourth quarter. We posted a total comparable store sales increase of 2.6% for the fourth quarter and a front end comp store sales increase of 3.7%.

Prescription sales which represented 56% of total sales rose 7.9% for the quarter and 2% on a comparable store basis. Net earnings per diluted share grew 6.9% in fiscal 2008 to $2.17. For the fourth quarter net earnings per diluted share increased 12.5% to $0.45. In the fourth quarter we had a $79 million positive adjustment for employee vacation accrual.

During our year end controls processes we discovered we had been historically over accruing for vacation versus our long standing policies. As this was not material to the year nor to any one historical period prior it was appropriate for us to true it up this quarter. To the negative we had heavier promotional spending than originally planned, several smaller adjustments, a higher than year ago tax rate and a fairly significant LIFO provision.

The fourth quarter had a LIFO provision of $24.9 million which compares to a provision of $32 million a year ago. The total LIFO provision in fiscal 2008 was roughly $98.5 million versus a provision of $69.3 million in the previous year. We expect the LIFO provision to become a much larger item in fiscal 2009 as inflation continues. We’ll work to offset that to the extent possible through our pricing strategy but we believe that LIFO could be as much as twice our current rate in the upcoming year.

One thing that we’re very proud of this quarter was our ability to control costs. SG&A expense dollars increased 5.5% benefiting from the vacation accrual credit. Net of this adjustment SG&A expense dollars increased only 8% which is less than our 8.8% sales gain in the quarter. SG&A benefited from excellent payroll control. Our store operations people from coast to coast did a terrific job of controlling expenses.

Looking at costs on a two year stack basis you will see that the fourth quarter SG&A dollar costs were 23.3% of sales or an improvement of more than four percentage points since the first quarter of fiscal ’08. That’s excluding the benefit from this quarter’s vacation accrual adjustment. Comparing our fourth quarter SG&A costs over the last three fiscal years you’ll see we’ve reduced the growth rate by five percentage points.

Turning to gross profit, total gross profit dollars in the quarter were just over $4 billion a 7.4% increase reflecting the slow growth rate in prescription sales and as mentioned the heavier promotional activity on the front end. Gross profit margins decreased 34 basis points to 27.64. Retail pharmacy margins increased due to a greater use of generics but total pharmacy margins were impacted negatively from the higher growth rate of specialty pharmacy which has a high dollar ring but a lower margin as a percent of sales.

Front end margins were essentially flat and helping the front end was a shift toward high margin items such as our private label brand products but hurting front end margins were heavier than normal promotions as I just mentioned.

Now let’s look at our tax rates, our working capital and our CapEx. The effective tax rate in the fourth quarter was 37% compared to a rate of 35% in the year ago period when we had some favorable adjustments. Accounts receivable were up 13% in the quarter driven primarily by third party sales and slower Medicaid payments by states such as California and Illinois. We showed continued progress and focus on inventories in the fourth quarter which were up only 6.8% or less than our 8.8% sales gain. Accounts payable increased 14.9% and this was primarily due to the timing a few major payments.

Our net debt at the end of the fiscal year was $977 million compared to a net debt of $651 million a year ago. Our net debt included $82.7 million of short term debt, $1.34 billion of long term debt and this was offset by cash and cash equivalences of $443 million at the end of the year. You’ll recall that in July we restructured our debt portfolio when we issued $1.3 billion in five year senior notes at 4.875%.

With our strong financial footing we have the flexibility to ensure that drive our core strategies and evaluate opportunities as they may arise. We will continue to be disciplined, however, with our capital allocations, our focus on working capital and our continued sharp cost control. Capital expenditures including new stores, distribution centers and IT development reached $2.2 billion in 2008. Since our last conference call we announced a slow down in our drug store organic growth rate. That will lead to lower capital expenditures going forward.

We expect to reduce organic net drug store growth rate from the current 9% growth to a long term rate of approximately 5%. Let me give you a year by year schedule for how we’ll take that down. We’ll open 495 net new stores in fiscal 2009, 425 in fiscal 2010 and 355 in 2011. As Jeff said, that still makes us one of the nation’s fastest growing retailers.

Many of you have asked why we decided to slow our growth rate at this time. I want to reiterate that our focused ROIC from new stores continues to be as robust as it was in the past but there are good reasons why we decided to moderate our growth. First and foremost it allows us more time to develop our management ranks and focus on improving the shopper experience. Improving the shopper experience to drive fierce loyalty with our shoppers and ultimately a larger basket size is one of the single biggest levers of value creation that we have and we are going to free up resources to do this.

Secondly, we want the flexibility to continue to invest across our core strategies and be opportunistic if appropriate especially in this time of a very uncertain and very challenging economy. Lastly, for the reasons I outlined above and as a result of the increased earnings power over time we believe it will also help us increase our shareholder value.

Now I would like to close my section with some thoughts related to the overall economic situation. It is our long standing policy not to give guidance but I do believe that it’s important that we continue to provide perspective to our stakeholders on the overall market dynamics and related factors that impact our business.

While we continue to grow our business and out comp the industry in both the pharmacy and the front end and while we firmly believe our strategies are absolutely the right ones to drive our business and shareholder value the market fundamentals pose significant challenges in these uncertain times. As we have talked before IMS status shows the slowest script growth rate in many decades and we continue to see our front end consumers under significant economic pressure from higher inflation and a growing unemployment trend.

While historically our business has been more recession resistant than most there is no question that at least as we move forward there will be some challenging times for retailers especially to the extent that the macro economic variables such as inflation and unemployment continue to move negatively. Having said that I am absolutely convinced that we have the right strategies which are the enablers to win in even the toughest markets which we have historically done.

We will look to turn market challenges into opportunities so we will come out of this difficult economy an even stronger company than when we went into it. We’ll talk more to you about all the things we’re doing in this regard at our analyst day conference next month. With that I’d like to turn the call over to our President, Greg Wasson for an update on implementing our strategies.

Greg Wasson

First I want to thank all of our employees across the company for their sales and cost control efforts this quarter. As Wade said, we are operating in a very tough economy but we’re taking care of our customers and doing everything we can to meet their needs. As I travel across the country I’m overwhelmed by the support of our people. I believe they are the best in the business. I also want to commend our employee efforts in the aftermath of Hurricane Ike; they were there to serve their communities and to help people when they needed us the most.

Within five days of the storm we had over 200 of our 235 stores open in Southeast Texas taking care of customers and pharmacy patients. We were also one of the first retailers to reopen in Galveston to help out residents who didn’t evacuate. Having spent the early part of my Walgreen career in Houston I’m not surprised by the response and efforts of our folks to overcome a disaster like this.

Now I’ll spend a few minutes talking about the progress we’ve made on each plank of our strategy to grow earnings and create shareholder value. Our first plank is broadening access to our products and services for organic expansion and acquisitions. We’re building an impressive network of healthcare access that combines our mail, retail pharmacies our in store health clinics, our worksite health centers with our specialty pharmacy facilities, our home care centers and our long term care facilities.

Let me be clear on this point we intend to be the most complete and convenient provider of pharmacy and healthcare services in the nation. Today we offer most or all these services in markets across the country. The next step is tying them together into a single unmatched offering to meet the needs of employer groups and managed care organizations. Payers are looking for accessible low cost convenient healthcare during times of soaring medical costs. Simply put, we’re helping Americans meet basic healthcare needs with an affordable solution.

Our second plank involves reinventing the customer and patient experience. We’re in the early stages of a process intended to create a very convenient shopping experience in our stores. With the customer centric mindset we’re working across the company to offer an efficient assortment of products, price points and promotions. We’re really looking forward to our new CMO, Kim Feil to help us identify and meet the needs of our shoppers.

One early example which is available in our stores today is the Walgreen Prescription Savings Club. This club is making medications more affordable for more than 45 million uninsured Americans. We’re proving the power of this program and our brand over the last two months as we kicked off an aggressive marketing campaign. As a result our membership has soared over the one million mark. In this economy people aren’t just looking for low cost alternatives, they’re searching for the best overall value. That’s where our brand reputation comes into play.

We’re offering patients a way to stretch their dollars without sacrificing safety, service, or convenience. Furthermore the Prescription Savings Club goes well beyond the discount generic programs at other retailers. We offer savings on more than 5,000 name brand and generic medications plus you can get any of more than 400 generic medications for less than a dollar a week. To top it off club members receive a 10% reward on all Walgreen’s branded products that can be used on future Walgreen purchases. We’re very excited about the early success of this program.

Our third strategic plank expands the pharmacy related healthcare services that we offer. One part of this effort is our new Health and Wellness Division announced last spring. Today we are the largest provider of worksite health centers in the country through our Take Care Employer Solutions Group. The division also includes the Take Care Consumer Solutions Group which manages convenient care clinics at our select Walgreen Drug Stores.

Between the two groups our Health and Wellness division manages nearly 600 health centers. Our goal is to have 800 retail clinics and Employer Wellness centers in operation by the end of fiscal ’09. Another area where acquisitions have helped us build out healthcare offering is Specialty Pharmacy. We’re experiencing strong growth in this business as we become the provider for more and more payers. Today we are the largest independent specialty provider in the country.

Earlier this month we were named one of two specialty providers for Premera a health plan serving more than 1.7 million members in four Western states. One of the big factors in winning this business was our ability to integrate specialty pharmacy services with our retail pharmacies and with our infusion services through our home care branches. Specialty pharmacy is increasingly important to us because it’s the fastest growing sector of pharmacy expanding at about 15% a year. The new products awaiting FDA approval in 2008, 80% are specialty drugs according to IMS Health.

Fourth, finally our fourth plan supports the three I just discussed by developing the systems and capabilities necessary to carry them out. We’re conducting an across the board review of our support and cost structure to place the right resources in the right spots. We want to ensure that our costs, culture, and capabilities support and enable our strategy. With that I’ll turn the call back to Jeff to wrap things up.

Jeff Rein

I’m proud of the progress we’re making. We’re becoming a sharper, faster moving company that’s more focused on customers. We’re put the people and strategy in place for future growth. We’re working hard to ensure we’re successful in a tough economy. Over the long term the impact of the baby boom generation on healthcare is too strong for prescription sales to continue their current trend. That means demand for our retail healthcare offering will be strong for years to come.

As an affordable and accessible provider of high quality healthcare we’re positioned very well to take advantage of this long term opportunity. As Wade briefly mentioned we’ll hold an analyst day conference on October 30th. That’s when we’ll provide financial analysts with details on our plans for Pharmacy operations, the front end customer experience and other new insights that we haven’t offered before.

While you can listen online to the webcast of the presentation analysts who attend in person also will have a chance to meet our management team including the new members we’ve added over the past year. As we close out another record year at Walgreen’s I’d like to thank all our supporters for backing us and we look forward to our prospects for successful fiscal 2009.

Rick Hans

That concludes our prepared remarks. We’re now ready for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Andrew Wolf – BB&T Capital Markets.

Andrew Wolf – BB&T Capital Markets

I want to ask about the promotional activity during the quarter which you called out more in your press release than your remarks. The press release essentially indicates you over invested, you did mention that but then it spoke to that you’re going to ratchet back investments. One way to look at it is what would the quarter have looked like if the promotional activity you’re going to ratchet back to had been in place during the entire quarter so that we can get a sense of how much over investment you think you might have put into the quarter.

Jeff Rein

What happened during the quarter is when I talk about over investment is we drove too many promotions to get folks into our stores. We want to be more targeted, we want to create value and we want to make sure from the customers point of view it’s a value. What I was talking about particularly in the press release and even at the conference before was we made this investment but people did not buy the impulse items that we thought they would in the past.

Typically when people come in they buy the coupon items, they buy the promotional items and then the market basket typically goes up in a good way, in terms of profitability because they’re buying extra items. That did not really happen this time.

Wade Miquelon

You’re probably looking in the range of $0.01 to $0.02 per share in terms of heavier promotional activity versus what would have seemed to get for it.

Andrew Wolf – BB&T Capital Markets

On the million members that you have in the Prescription Savings Club what kind of multiple of that are in your plans and if you look at those million members do you have a way of figuring out through your files which ones are net new pick ups or return customers who might have gone elsewhere and which ones are just customers who are joining the club to create savings for themselves?

Jeff Rein

It’s actually been a very popular card right now. Our goal is actually several million. We hadn’t given out a specific goal yet but I can assure it’s going to be several million. I know Greg has been intimately involved in that.

Greg Wasson

I do think there’s tremendous up side. There are 40 million uninsured Americans out there so we’ve got a long way to go now that we have a million. As far as new patients I think what we’re really excited about is we just kicked off that marketing campaign on August 1, which was targeted to bring in new patients. We’re seeing nearly 25% to 30% of the patients coming in since are new patients to Walgreen’s and we think that will continue to grow.

Andrew Wolf – BB&T Capital Markets

That’s of the one million its 25% to 30% to make sure I understand that?

Greg Wasson

Yes.

Andrew Wolf – BB&T Capital Markets

Of the rest that are just current customers does the economics of the plan including the membership fee and other things when you look at that, let’s say the lifetime over a years worth of business with that customer is that net neutral or dilutive or accretive for that customer in terms of earnings for the stores.

Greg Wasson

Certainly a net positive. What we’re seeing with even existing customers who choose to use our Prescription Savings cards one is obviously you’ve got to consider the retention factor and two there’s absolutely an increase in compliance with our prescription members. We think that’s a good thing for healthcare.

Operator

Your next question comes from Robert Willoughby – Banc of America.

Robert Willoughby – Banc of America

As it relates to the healthcare strategy that seems to be a bit more dependent on acquisitions are you finding there are enough attractively priced platforms big enough to make a difference in the consolidated company’s numbers or do you just still anticipate a lot of smaller deals over the next couple of years?

Jeff Rein

There are more opportunities. As you know healthcare is evolving very, very quickly right now. It is consolidating a bit so there are more opportunities. We typically don’t comment on current and future acquisitions but I can tell you by putting all of this together we are becoming the affordable low cost accessible provider whether it’s the Take Care Clinics, the On site clinics at employers, the hospital clinics, the Walgreen Stores themselves, all ties together once again to bring folks easy into the system and save them money.

There are more opportunities whether it’s big or small that’s debatable at this point of course but I can assure you it’s all coming together and has been well received not only by the public but the payers and also the employees.

Robert Willoughby – Banc of America

You were quite clear a couple years ago I think in the annual report where your areas of interest were, there’s not change to those listed areas?

Jeff Rein

Let put it to you this way, we are always looking at acquisitions. We are always looking at healthcare and we are always looking at our business model to make sure that we are going down the correct path. Something might have been going on two years ago. As you know the whole world has just changed in the last couple weeks. We are certainly open, we’re flexible, we’re adaptable and that’s one of the reasons actually we brought new people into the company like Wake, Sona, Kim, Stan Blaylock, Hal Rosenbluth just brings a different perspective and gives us different ideas. I would say that we’re still marching forward.

Wade Miquelon

I would just say there’s really no change in the standpoint that we continue to put it through the same filter which is number one we’re only looking at things that are on strategy and that means it really has to link to our assets and our capabilities it has to be strong for the core of that. It’s got to have a strong financial payout. Finally, we have to believe we’re highly capable of executing with excellence. We’ll continue to use that filter as we go forward.

Jeff Rein

You will definitely not see get us get off track in terms of acquisitions or how it relates to healthcare.

Operator

Your next question comes from John Heinbockel – Goldman Sachs.

John Heinbockel – Goldman Sachs

About a month ago you talked about the consumer and they’d really sort of gone into a shell mid July and beyond in terms of cherry picking. We have heard from other retailers things were a little bit tougher after Labor Day. What’s the update on where your consumer sits and are they still as cautious, did they get more cautious or what?

Jeff Rein

In terms of the consumer they are still being very cautious, they are very promotionally oriented, and they’re looking for value all the time. They’re still buying products obviously. It’s a good thing we are in a recession resistant type business. They still need their medication; they still need their toothpaste, toiletries and so on.

I think people are being cautious but actually for us that’s not so bad because the products we sell, once again, they need them on a daily basis or that the small things in life like $5 toys or $10 gifts that make people happy. It’s not all doom and gloom. For example, let’s say Christmas sales, we expect to have a decent Christmas. I don’t think it’s going to be spectacular but I think it’s going to be decent. People are not going to give us on Christmas; they’re not going to give up on Halloween. They still want to take care of themselves and their families, have some fun.

Usually what happens for Walgreen’s is a poor economy is actually better for us particularly around the seasonal events because people are trading down. Once again most of the products that we sell are not that expensive. It’s about the same as I mentioned a couple three weeks ago but still I think we’re in a very good position going forward.

Greg Wasson

We’re certainly seeing in this environment an up tick in private label sales which also helped us overcome some of the margin pressures and additional promotional pricing. So it’s definitely an economy that’s helping us with private label.

John Heinbockel – Goldman Sachs

Have you guys rethought or will you rethink with your new marketing person the idea of a loyalty card and whether that can direct promotional dollars better or not.

Jeff Rein

That is one of the things under consideration. As you know Kim has a lot of experience in that area in that share came from IRI so she’s not only a great marketing person but she’s very, very analytical. We believe over the years our best loyalty card has actually been our SITES. We have class A SITES, we’ve put a lot of money into being in the right location, the best location but a loyalty card may be in the cards. We’ll certainly look at that when Kim comes in.

John Heinbockel – Goldman Sachs

In the quarter retail gross margin was up, pharmacy was up, front end was flat, so gross margin was up what would the retail EBIT margin have done. I’m not sure what your retail SG&A dollars grew at. Would retail margin have been down for the quarter or not.

Wade Miquelon

I don’t think we usually give that out. I think you can probably follow the math a bit across the lines but I think in general we don’t give that out.

John Heinbockel – Goldman Sachs

Going forward you think that it’s highly likely we will see overall margins up and front end up because of your pull back in promotional spend?

Jeff Rein

It depends on the buy; also as you know we’re being very careful on the inventory we’re putting into the stores. As you know we grew inventory less than sales this time so if the sell through is pretty good then our margins will come out pretty good too, so it’s a little bit of a wildcard. We’re trying to be very, very careful on our promotion; we want to make sure they make sense. Keep in mind that when you’re looking at our margins overall we are selling more specialty products and the margin was flat in the front end, it was up a little bit in the pharmacy, the retail stores.

The margin was squeezed by the specialty products that we are selling. As you know they do have a lower margin but high gross profit dollars.

Wade Miquelon

On the front end there is the balancing factor between promotional activity and in finding the sweet spot of good everyday pricing. In these challenging economic times we have to continue to make sure that we drive good loyal traffic through the front door. Again, I think we’re going to fine tune our approach to it in terms of using just promotions per se but there’s no question that we can’t be uncompetitive either.

John Heinbockel – Goldman Sachs

Is this a new level of SG&A growth if you back out the vacation accrual 8% give or take is that sustainable?

Jeff Rein

We are committed to the cost discipline plan that makes sense to growing our company. We are very, very strict on this. There are opportunities not only at the store level but there are more opportunities at the corporate level. Believe me, going forward we are going to be very, very strong on this, very disciplined and make sure we do the right thing to grow our business.

Wade Miquelon

We’re doing a lot of work to really understand a sustainable growth model both in best of times and more challenging and working backward from there to say how do we make all of our costs fit in that model, now do we stay agile and how do we make it something that’s accretive consistently over time.

Operator

Your next question comes from Debra Weinswig – Citigroup.

Debra Weinswig – Citigroup

As regards to the front end can you maybe discuss where you saw strength in various categories and also on the lines of private label can you update us in terms of your current penetration and what your goals are.

Jeff Rein

What was the first part of the question, I didn’t hear that.

Debra Weinswig – Citigroup

Where you see strength in the front end from a category perspective.

Jeff Rein

In the health and beauty aids very, very strong particularly in the allergy department and also in food just been phenomenal. People are looking for a bargain. As you know we carry a wide selection of food. People can use it obviously on the way home or anytime during the day. We carry a full line of milk, refrigerated groceries, and canned goods and so on. This has been phenomenal. Once again on the drug side we’re seeing a lot more people self medicate themselves. As you know doctor visits are down, they’re not generating the prescriptions as much as in the past.

However, people are still getting sick and they do go in and see the Take Care clinic nurse practitioner, they do come in and buy the drug wall themselves so we’re seeing our drug sales be very, very strong on that respect.

Wade Miquelon

The other changing pattern we’re seeing too is we’re seeing a heavier shift towards private label as consumers are seeing good value. We’re also seeing a shift in terms of overall traffic pattern we tend to see a bit of more frequent visits during the weekdays with slightly less on the weekends. I think this speaks to both consumers loading up on the weekend, maybe some of the larger stores but also seeing that we’re a good value on the weekdays with respect to the cost of gas and cost of time.

Greg Wasson

We’ve seen about 100 basis point improvement year after year in private label and expect to see that continue to grow.

Jeff Rein

Private label has been phenomenal.

Debra Weinswig – Citigroup

On the Specialty Pharmacy side you discussed there is a negative gross margin impact as a result can you talk about what percentage of your business Specialty Pharmacy represents right now? I don’t know if you can give any additional color in terms of gross margin impact.

Wade Miquelon

Specialty Pharmacy is in the 6% to 7% range of the total business. Again, it’s very high dollar range so it’s very high gross profit dollar per se but again those margin in that business are much smaller as a percent of sales. I don’t know if we’ve given specific mix factor but you could probably do some back of envelope math and get a feel for it. The growth rates are very high in this area. That’s providing the mix effect.

Greg Wasson

Keep in mind that specialty patients bring a lot of traditional prescriptions along with them. Definitely a good customer to have.

Operator

Your next question comes from Ed Kelly – Credit Suisse.

Ed Kelly – Credit Suisse

I’m sorry to harp on the gross margin question but I’m not sure I quite understand it yet. If I look at your gross margin in the year over year increase or decrease and if we ‘x’ out LIFO, if you look at last quarter your FIFO gross margin was up six basis points and the pharmacy was up and the front end was down. This quarter your FIFO gross margin is down about 40 basis points and the pharmacy is up and the front end is flat.

The Specialty Pharmacy issue I think from a mix standpoint would have been there last quarter I’m just not really sure what would have changed and does any of it have to do with the acquisition of CuraScript. I was hoping you would give us more color on that.

Wade Miquelon

If I fully understand your question, part of it on a year on year base is the acquisition of Option Care being folded in plus overall growth. That might be something that you’re not picking up there because that was the subsitive mix effect.

Ed Kelly – Credit Suisse

Option Care was there last quarter or no?

Wade Miquelon

It was there last quarter but not year ago. I’m not sure what you’re reconciling to. We had two weeks of Option Care in this quarter only versus 12 prior.

Ed Kelly – Credit Suisse

From an acquisition standpoint I think historically you’ve looked at organic growth as sort of a core competency and now it seems like acquisitions are becoming what you feel is more of your core competency in fact even bigger retail acquisitions. Can you help us understand what’s changed over this time period?

Jeff Rein

I really wouldn’t classify it as a change. Our whole strategy in terms of growth is to broaden access and connect all these points of care. We’re still growing very strongly in an organic way. However, the industry, in terms of retail in particular is consolidating bit time. To have these broadening the access and having the points of care we want to make sure that we participate in this consolidation similar to what we did with Happy Harry’s a couple years ago. If there’s an opportunity we’re open to it.

I think before we basically said we’re just going to do organic growth only and that was that. As you know over the last couple years we’ve said we’re more open to these acquisitions that make sense from a strategic point of view. We’re still going along the same path but once in a while there might be opportunities that it’s obviously very good for us and good for the shareholders.

Wade Miquelon

Remember as said before, that our potentially single biggest value creation lever is to make our good stores out there even better. Being able to have the energy to take our core and do more from our core is really a great place for value accretion too.

Jeff Rein

An example of that may be the file buys Wade was talking about in terms of our core stores. These file buys in terms of either a small chains or independents going out of business it’s a great, great opportunity for us. Once again, that’s part of an acquisition but at the same time you’re growing your core business.

Ed Kelly – Credit Suisse

The $76 million is that after tax or pre-tax?

Wade Miquelon

The $79 million is pre-tax.

Operator

Your next question comes from Scott Mushkin – Jefferies.

Scott Mushkin – Jefferies

I’m trying to understand ’09 I took it as being somewhat cautious in ’09. From a gross margin we had a pretty nice hurt from Specialty on gross margin is this something we should expect as we move forward into ’09. On SG&A we did have a lot of one time items that flowed through ’08 on a positive basis and when we look at ’09 what should our expectations be for SG&A. Is it possible to have flat earnings next year, what are you guys really saying about next year. It seemed like you were being cautious, I’m just trying to understand how cautious we should be as we look at this.

Wade Miquelon

On Specialty you’re certainly going to see a little bit of dilution over time because the Specialty business is growing faster than the core. Remember that things like the acquisitions we’ve done have made that disproportionate in the particular quarter. I think you’ll see a little bit of effect there but I think from a gross profit dollar basis it’s actually a very good thing and it’s a good ROIC business and it’s a good growth vehicle for us.

On SG&A in terms of SG&A the key thing is what I mentioned earlier is that we are really looking at what our sales will be over time and working backwards to say what’s the right SG&A structure. I think we’ve done a lot of good work in the last few quarter to get some low hanging fruit but we’ll continue to be very aggressive to make sure they’re weeding out all of the costs that don’t add value and having a model which is flexible and works in anything.

In terms of flat earnings I don’t want to go there. I think what I am foreshadowing is just that it’s a very challenging economic environment. I don’t think anybody here can predict with the events of the last few weeks where things like unemployment will go over the next quarter or two or three. I think we’ll just have to keep watching it. Right now we’ve done a very good job in this environment, we’re out comping the industry front end and back end. We do have a good cost control; we are effectively keeping our margins in general in tact.

I also think it’s important for all of us in retail and across all sectors to make sure we keep a watchful eye on the consumer. I think the consumer is under quite a bit of pressure right now.

Jeff Rein

I’m hoping you’ll be able to come to our analyst day conference at the end of October where we’re going to talk specifically about SG&A and programs and projects, initiatives that we have in place and going forward what we’re going to do about that.

Scott Mushkin – Jefferies

Getting back Bob Willoughby and Ed was also talking about your acquisition strategy, just to clarify a couple things, is the PBM still just off the table or is that something you now think fits a little better. I wasn’t clear with the answer there. As far as on the retail side Happy Harry’s and the one that we don’t want to talk about are very different as far as your market share in those areas are and is something changed in that aspect that you’re more open to things with a lot more overlap?

Jeff Rein

In terms of the PBM we haven’t changed our position on that. We think our transparent model has been well accepted in the marketplace and is the right path to go, the most profitable path to go. In terms of the retail acquisitions, if it makes strategic sense then we will go forward as long as it meets our hurdle rates and we’re getting value to shareholders then it is something we’ll go after.

Operator

Your next question comes from Meredith Adler – Barclays.

Meredith Adler – Barclays

Can we talk a little bit about you mentioned shelf pricing and that you think you need to make some adjustment. Have you done any consumer research that gives you some sense of what consumers reception is about your shelf pricing?

Jeff Rein

We have done that and we do watch that all the time. We do competitive shops obviously; we have a consumer research department where we do look at what folks think about our pricing. What I was talking about earlier was the amount of promotional spend that we had to get people into the store particularly when we look at what we call rotos or the circulars that come out every Sunday in the Sunday papers.

In some cases we gave away more than we had to. It’s always good of course to draw them into the store but then you have to be very careful of how you mark down products in the stores on a promotional basis. We just went a little bit overboard on that. Our shelf pricing, our everyday shelf pricing is good. We obviously look at the major competitors whether it’s Target, Wal-Mart, CVS, and Rite-Aid and so on to make sure that we were right for that particular market.

Greg Wasson

We certainly want to understand to the fullest and that’s why the values we’re really look for Kim Feil to help bring us to really get out there and understand the consumer more and more what they see is value and what they don’t. We certainly have a lot of focus in that area.

Meredith Adler – Barclays

I presume part of Kim’s tasks will be to figure out if you are less hot, less aggressive on your promotions, what that’s going to do with sales, is that part of her mission.

Jeff Rein

That is working all of us together whether its market planning and research, advertising, purchasing, it’s an effort that gets together for everybody. Yes, we want to be very correct in what we’re doing. One of the things that Kim will help us do also is to present one face of Walgreen’s to the consumer to the customer.

Right now when folks come in sometimes it’s difficult when you go online or you shop in the stores or you shop Walgreen Health Services we want to make sure that we are really working on that patient, that shopper experience that is very, very pleasing to them and as Wade mentioned earlier that creates that sense of fierce loyalty.

Meredith Adler – Barclays

I’d like to go back to talk about expense growth. I understand that this is a moving process that you’re working very hard on it. Wade was kind enough to talk about the two year which is how I look at it and you had a very, very easy comparison this past year especially in the fourth quarter. The comparisons start to get easier and if you do a two year it looks like you’re running 11.5% dollar growth is that something that we should see as for the near term sustainable? Obviously you’ve got an opportunity to do things in the future but I think that’s a lot higher than the 8% that happened in the fourth quarter.

Wade Miquelon

The two year stack it’s a good longer term metric but I think the key thing is when it comes to SG&A sometimes you’re only as good as your last quarter because of all the things that go into it. I feel very good about the 8% number that we effectively hit. I think it’s that we are making real progress in the short term. I think that we’ve got other things that we’re working aggressively. I think the trend there is very good and we’ll continue to challenge all things and say do they add value or not. Are we best utilizing our resources?

We’ve got to start with what we think our overall sales and gross profit are going and make sure that we engineer backwards to be efficient and accretive over the long haul.

Jeff Rein

The last two years if you look at fourth quarter ’06 as shown on the slide we were at 28.3% growth for two years stacked now we’re down to 23.3% excluding that vacation accrual. We are making progress and yes there is more to go. We absolutely believe there is more to go not only in the stores but in corporate and the way we do things.

Meredith Adler – Barclays

I’ve got a question about the vacation accrual I’m surprised nobody asked this. The most conservative way to look at it is to say that all of it is one time. It’s wasn’t clear from your commentary what timeframe that was multi-year, was that just this year so if we wanted to add it back to come up with a run rate how much of it should we add back?

Wade Miquelon

I would say effectively as you know it’s a very large amount that why we called it out. It is a multi-year it goes over many, many years. It was not material in aggregate to this year nor any single year and that’s why it was appropriate as part of this close to put it in this quarter. I think you could pretty much call the vast majority of it was one time in that regard as year end you’re always going to have a lot of puts and calls so this was obviously a large unusual help item.

We had several smaller hurt items that added up to a fairly large number too but I think for sake of transparency for the vast majority of this is all one time.

Meredith Adler – Barclays

My final question is back to Ed Kelly’s question. If I understand what you’re saying Option Care was not in the third quarter numbers and was only partially in the fourth quarter numbers for last year.

Wade Miquelon

Two weeks of last year in the fourth quarter.

Meredith Adler – Barclays

I would have expected that Specialty would have had a similar impact on the two quarters because there really wasn’t that much difference and yet that isn’t what happened. Is it because there was very big growth in Specialty in between fourth and third quarters?

Jeff Rein

Yes, we’ve had very, very good success, once again being the largest independent provider and the services we provide, the quality we’ll provide led by [Paul Mestropha] and company, they’re doing a fabulous job and we are winning more business.

Meredith Adler – Barclays

I’m very excited about you having an analyst meeting but next year could you maybe not do it the same day that CVS and Medco report earnings?

Wade Miquelon

We are deeply apologetic for that. We will delay our day and start it a little bit later and we’re going to provide rooms, phones, lines for everyone so that they can dial in and do that early morning work as need be. We’ll make sure we try to as best accommodate everyone so that you can serve all ends.

Operator

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

David Magee – Suntrust Robinson Humphrey

On the Specialty side obviously the gross margins are less there. Is there still a positive contribution note on the EBIT lines from that business?

Wade Miquelon

Absolutely, from an ROIC point of view as well it’s also despite the margin percent compression it’s also one of the best businesses we can invest in.

David Magee – Suntrust Robinson Humphrey

In the fourth quarter and year to year basis that business helped the EBIT line, it was accretive to the EBIT line year to year?

Wade Miquelon

Yes, that’s right.

David Magee – Suntrust Robinson Humphrey

You talked about the reserve being twice in 2009 if I heard you correctly were you speaking in dollars or percent of sales and is that something that would also help your comps at the same time. I’m trying to get a sense for how much of a negative that might be inflation being higher in the coming year.

Wade Miquelon

Its dollars, it really depends in terms of your ability to get out front and price ahead of it. So it could be a hurt or it could be a help. If you think about it, it’s sort of an accounting term so we don’t necessarily want to be pricing to aggressively just to recoup that when maybe we should be looking at it from a FIFO basis. As a general rule of thumb I’d say we’ve historically been pretty good at offsetting it. Again, it’s really a timing issue of how fast you can price in front of it.

Operator

Your next question comes from Neil Currie – UBS.

Neil Currie – UBS

One question about the real estate market where some of the problems we’re seeing in the banks I know traditionally one of your biggest competitors for retail space has been the high street banks. Are you seeing any signs yet of that competition easing or maybe even some SITES being available.

Jeff Rein

That’s a very good question; we have seen easing of the competition for good SITES. The banks started pulling back probably around six months ago approximately. You’re right; they’re actually one of our top competitors and really drove the costs up. They are pulling back big time and freeing us some SITES that we may not have ordinarily been able to obtain.

Neil Currie – UBS

The impact of that is it just more SITES available to look at or will those SITES that you’re looking at become somewhat cheaper?

Jeff Rein

It is lower SITES; it’s also more negotiating power on our end.

Neil Currie – UBS

No chance to take advantage of that and maybe rescind some of the slower growth that you’re expecting?

Jeff Rein

We’re doing what we can; I’m not quite sure what you’re saying there.

Neil Currie – UBS

You talked about cutting back the store expansion program might there be some opportunities to accelerate it a little bit?

Jeff Rein

Not at this point. We’re pretty much committed for the next two years. We’ll be down the 5% range for 2011. It does allow us though to make sure that we go after the very best of the best SITES. Once again, sometimes these banks pull away from an excellent location that we couldn’t get otherwise and so obviously we’ll put our priorities toward those areas that free up.

Neil Currie – UBS

I don’t know if you saw the press release from Caterpillar to their employees where they are allowing employees to go to Wal-Mart to get tier one generics at zero co-pay whereas they have to pay $5 to go other drug stores. Do you have any comments on that and would you consider pulling out from that network?

Jeff Rein

Yes, we did actually see that press release. What it really gets into is what I talked about earlier in terms of transparency and the way our model is in evolving even more in the future. I know Greg has been involved in that…

Greg Wasson

Obviously a pilot sounds like Wal-Mart but I think what it really shows I think Wal-Mart obviously is trying to go directly to employers and I think offer a solution for the employer. I think they’re really going to cut out the middle man in the process. I believe they believe that the middle man traps costs as we do. As you know, we’ve made two acquisitions in the employer wellness space. We’re looking to get on campus with large employers, small employers across the country to do much the same thing to really provide value and help them lower their other healthcare costs correctly.

I really think that it’s really focused on the intermediary within the healthcare and pharmacy benefit management systems.

Jeff Rein

These trap costs as you know there’s profit pulls, whenever there’s a middle man there’s a lot of profit. Wal-Mart is attacking that and rightly so and that’s our philosophy also. We’re aligned with them on this particular issue.

Neil Currie – UBS

We see the fact that you spent a bit more than you wanted to on promotional expense and people are cherry picking the promotions and maybe not spending on other things in the store. Would having a loyalty card help some of these issues because clearly you get information what the customer is spending and you can target that spending somewhat more effectively. In retrospect do you think this is something you should have considered before now?

Wade Miquelon

I think we have lots of vehicles for loyalty. Loyalty is a multi-dimensional thing. As Jeff alluded to great real estate and great service and a great environment is kind of job number one. Prescription Savings Club is another vehicle we have other ones as well. I’m not saying a loyalty card is good or not good but I think for it to work there’s really two key criteria and number one is how to you differentiate it so it’s meaningful to people and provides real loyalty on things that they want versus just say price alone.

Number two is you alluded to over time how do you really make sure that you mind the data in a way that is relevant to them. As Kim Feil comes in we’ll continue to look at it say here are all the things we’re doing whether it’s Mega-Savers, our real estate platform, our PCS card are all those things right for loyalty or is there some other proposition? It’s got to really go through that filter being differentiated, being meaningful and being able to be leveraged beyond the discount to make sense.

Neil Currie – UBS

I was thinking more from a practical point of view how can you get the data without having a loyalty card and analyze the effectiveness of your promotions and enable yourself to be less wasteful.

Wade Miquelon

I think the promotional effectiveness can be done. There are lots of tools to do that. I think it’s the segmenting that we obviously have a lot of data on. A lot of our shoppers not as broad as maybe a broader loyalty card but I think the benefit there lie in being able to do better segmentation.

Jeff Rein

There are a lot of point of sale tools that are out there that we utilize in terms of market basket and things of that nature. Also in terms of this spend what I’d like to mention is we did spend, in terms of marking down products that we didn’t have to. As you know, the average customer comes into our store for 1.6 items, they usually leave with 3.2. Where we went a little too far in the fourth quarter is we marked down items in the store that we didn’t necessarily have to once we already got them in. I think that’s a differential there.

Operator

Your next question comes from Mark Wiltamuth – Morgan Stanley.

Mark Wiltamuth – Morgan Stanley

I wanted to get Wade’s views on share buy back and dividends. As you look at other companies have kind of slowed their unit growth model, McDonald’s and others we have seen them increase share buy backs and increase dividends to focus more on return on invested capital. If you just talk about your approach on buy back and dividends. Also, the single A credit rating is kind of sack re-sack for some time for you and as you’re continuing to put acquisitions out there I’m wondering if you’re willing to let the single A credit rating go and does that change your approach to the sale lease back markets?

Wade Miquelon

We still remain committed as ever to keeping a very strong rating, really that’s very important to us for lots of reasons, least not the credibility it gives us and the flexibility in the real estate market, the people that we work with. We’re committed to that. In terms of share buy back we have done some in the past we’ve frozen that program for a while. I’m not saying that we would never re-look at it but I think we need to look at all of our different choices in terms of organic growth, some of the opportunistic stuff and I think we also want to monitor this economy as we go forward.

I think that there are some good scenarios and some tough scenarios out there and I think we want to make sure that we have enough flexibility, enough liquidity and a rating that is very, very strong which serves the end. We’ll put it through the filter then.

Mark Wiltamuth – Morgan Stanley

It sounds like at this point acquisitions are still winning out over buy back and dividends is that fair to say?

Wade Miquelon

Only if they make good financial sense, good strategic sense and they’re within our capabilities.

Mark Wiltamuth – Morgan Stanley

On the credit rating I guess the reason I’m asking that is I know you don’t want to talk about the Longs transaction but that one seems to put you in a position where maybe the credit rating would come to question, any comment there?

Wade Miquelon

The agencies have obviously written that an acquisition would certainly put some downward pressure on their point of view. We would still be very highly rated I suppose at the end of the day. I don’t know what more I can say versus that. Over the long term here we are very committed to keeping very strong credit ratings.

Operator

That does conclude today’s question and answer session.

Rick Hans

That’s our final question. Thanks for joining us today. Remember we’ll announce September sales this Thursday, October 2nd and we’ll also be delighted to host you at our analyst day on October 30th. Our next quarterly financial announcement will be December 22, when we announce fiscal 2009 first quarter results. Until then have a great day and thank you for joining us.

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Source: Walgreen Co. F4Q08 (Qtr End 08/31/08) Earnings Call Transcript
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