Walgreens Boots Alliance's (WBA) CEO Stefano Pessina on Q1 2017 Results - Earnings Call Transcript

| About: Walgreens Boots (WBA)

Walgreens Boots Alliance, Inc. (NASDAQ:WBA)

Q1 2017 Results Earnings Conference Call

January 05, 2017, 08:30 AM ET

Executives

Gerald Gradwell - Senior Vice President, Investor Relations and Special Projects

Stefano Pessina - Executive Vice Chairman and Chief Executive Officer

George Fairweather - Executive Vice President and Global Chief Financial Officer

Alex Gourlay - Co-Chief Operating Officer

Analysts

Ross Muken - Evercore ISI

Alvin Concepcion - Citi

George Hill - Deutsche Bank

Ricky Goldwasser - Morgan Stanley

Lisa Gill - JP Morgan

Robert Willoughby - Credit Suisse

David Larsen - Leerink

Eric Percher - Barclays

Steven Valiquette - Bank of America Merrill Lynch

Scott Mushkin - Wolfe Research

Operator

Good day ladies and gentlemen and welcome to the Walgreens Boots Alliance First Quarter 2017 Earning Conference Call. At this time, all participants are in a listen-only mode. Later, there will be a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded.

I would now like to turn the conference over to Gerald Gradwell, Senior Vice President, Investor Relations and Special Projects. Sir, you may begin.

Gerald Gradwell

Thank you. And can I first say that in keeping with our corporate staffs on cold and flu, a number of us have gone out and caught colds and flu’s, so please bare with us if we sound slightly bunged up this morning. Welcome to our first quarter earnings call. Stefano Pessina, our Executive Vice Chairman and Chief Executive Officer; and George Fairweather, Executive Vice President and Global Chief Financial Officer will take you through our results as usual. Alex Gourlay, Co-Chief Operating Officer of Walgreen Boots Alliance is also here and will join us for questions.

You will find a link to the webcast on our Investor Relations website at investor.walgreensbootalliance.com. After the call, this presentation and webcast will be archived on the website for 12 months. Certain statements and projections of future results made in this presentation constitute forward-looking statements that are based on our current market, competitive and regulatory expectations, and are subject to risks and uncertainties that could cause actual results to vary materially.

Except to the extent required by the law, we undertake no obligation to update publicly any forward-looking statements after this presentation, whether as a result of new information, future events, changes in assumptions or otherwise. Please see our latest Form 10-K for a discussion of risk factors as they relate to forward-looking statements.

As a reminder, today’s presentation includes certain non-GAAP financial measures. And we refer you to the Appendix in the presentation materials available on our Investor Relations website for reconciliations to the most directly comparable GAAP financial measures and related information.

I will now handover to George to take you through the numbers.

George Fairweather

Thank you, Gerald. Overall, we are pleased with the progress of this quarter with results in-line with our expectations. We continue to make good progress towards completing our Rite Aid transaction. And today, we have raised the lower end of our adjusted earnings per share guidance for fiscal year 2017.

So, turning now to the financial highlights for the quarter, as we expected currency had a negative impact on the year-over-year financial performance, the U.S. dollar being around 18% higher versus sterling. Sales for the quarter totaled $28.5 billion, down 1.8% versus the comparable quarter last year. On a constant currency basis, however, sales were up 1.1%.

GAAP operating income was $1.4 billion, a decrease of 1.4%. GAAP net earnings attributable to Walgreens Boots Alliance were $1.1 billion and diluted EPS was $0.97. Adjusted operating income was $1.7 billion, up 0.4% and in constant currency was up 2.8%. Adjusted net earnings attributable to Walgreens Boots Alliance were $1.2 billion, up 6.1% and in constant currency up 8.2%.

Adjusted diluted net earnings per share was $1.10, up 6.8% and in constant currency up 9.7%. The adjusted effective tax rate, which we calculate excluding the equity income from AmerisourceBergen, this was 25.5%. This was lower than the same quarter last year, primarily due to changes in our forecast geographic mix of pre-tax earnings and the U.S. taxation of our non-U.S. entities.

So now, let me now turn to the performance of our divisions in the quarter, beginning with Retail Pharmacy USA. Retail Pharmacy USA sales were $20.7 billion, up 1.4% over the year ago quarter, comparable store sales increasing by 1.1%. Adjusted gross profit was $5.5 billion, up 0.1% over the year ago quarter reflecting an increase in retail, which is partially offset by a decline in pharmacy.

Adjusted SG&A was 20.4% of sales, an improvement of 0.5 percentage points, compared to the year ago quarter. This reflects benefits from our cost transformation program. Adjusted operating margin was 6.2%, up 0.1 percentage points resulting in adjusted operating income of $1.3 billion, up 3.7%. So next, let’s look in more detail at pharmacy. U.S. pharmacy total sales were up 2.5% driven by increased script volumes and higher specialty sales.

We filled 237.6 million prescriptions on a 30-day adjusted basis, including immunizations, an increase of 3.0%. On a comparable basis for stores, which exclude central specialty, our pharmacy sales increased by 2.0% with scripts filled up 3.4%, primarily due to drop in Medicare Part D volumes.

Within sales, volume growth and brand inflation was partly offset by reimbursement pressure, which was in-line with what we anticipated and by the impact of generics. While branded drug price inflation continued, it was at a more moderate level than in prior quarters. Keep in mind that these factors impacted sales and gross profit.

Our reported market share of retail prescriptions in the quarter, on the usual 30-day adjusted basis, was 19.5%, up approximately 40 basis points over the year ago quarter. Total retail sales were down 0.9% on the same quarter last year. This includes the impact of the previously announced closure in September of certain e-commerce operations.

Comparable retail sales were down 0.5% in the quarter due to declines in the consumables and general merchandise category and in the personal care category, partially offset by increases in health and wellness category and beauty category. Gross margin was higher than the same quarter last year, primarily driven by owned brand performance and procurement benefits.

Since the quarter end, while our December comparable sales were still negative, we saw stronger performances in our key health and wellness and beauty categories. We have now completed the first phase of the rollout of our new differentiated beauty offering, which is available in more than 1800 stores.

In addition, in October, we launched Beauty Enthusiast, a new loyalty offering which engages our most valuable beauty and personal care customers. Since the launch, with signups and incremental spend among Beauty Enthusiasts has been above plan. As we anticipated, we have increased beauty sales in these remodeled stores, particularly No7 and Soap & Glory.

During 2017, within these stores, we plan to introduce further new product lines, as well as expand the number of stores with beauty offerings. A significant element of the rollout is the recruitment and training of beauty consultants. In order to maintain high standards, we are doing this in a methodical manner, which is taking slightly longer than expected.

So now, let’s look at the results of the retail pharmacy international division. Sales for the division were $3.0 billion, up 0.5% in constant currency. On the same basis, comparable store sales decreased 0.1%. Comparable pharmacy sales were down 0.5% on a constant currency basis, due to a decline in the UK, which was partially offset by growth in other international markets.

Boots UK comparable pharmacy sales were down 0.8%, due to the expected reduction in pharmacy funding, partially offset by strong performance in pharmacy services. Comparable retail sales for the division increased 0.2%, due to growth in all countries other than Chile and Mexico. Within the UK, Boots performance was flat versus the year ago quarter, and we saw growth in our opticians business.

Adjusted gross profit for the division was down 2.7% in constant currency to $1.2 billion, mainly due to lower margins in the UK in what is really a new environment for retailers. Adjusted SG&A as a percentage of sales on a constant currency basis increased by 0.7 percentage points to 32.5%, mainly reflecting higher depreciation costs than the year ago quarter.

As you may recall, in January last year, I explained that fiscal 2016 first quarter results benefited from purchase price accounting refinements. In addition, the higher depreciation this quarter reflected our ongoing IT and store investment program. Adjusted operating margin was 7.2%, down 2.0 percentage points in constant currency. This resulted in adjusted operating income of $213 million, a decrease of 21.6% again in constant currency.

Since the quarter end, I’m pleased to report that December retail sales growth was notably stronger than in the first quarter. Boots December retail performance was solid, reflecting actions taken in the full to counter what are challenging market conditions. However, from December 1, as expected Boots was impacted by the government action to lower pharmacy practice payments.

So now, let’s look at our Pharmaceutical Wholesale division. Sales for the division were $5.4 billion, up 0.6% versus the same quarter last year on a constant currency basis. Comparable sales on a constant currency basis increased by 4.7%, this was slightly ahead of our estimated market growth weighted on the basis of our country wholesale sales, with the growth in the UK and emerging markets offsetting competitive market conditions in continental Europe.

Adjusted operating margin, which excludes ABC was 3.1%, up 0.3 percentage points on a constant currency basis. Adjusted operating income was $224 million, up 45.2% in constant currency. While the increase was mainly due to equity earnings from ABC, excluding this, adjusted operating income grew by 10.2% in constant currency, cost benefits, outweighing margin pressures.

Operating cash flow in the quarter was $525 million. During the quarter, our working capital outflow was $1.2 billion. This reflected our typical seasonal build in inventories and inventory build to a certain new initiatives, partially offset by improved payables days. Cash capital expenditures for the quarter was $378 million. We continued to invest in our core customer proposition, including our stores and U.S. beauty program, as well as the upgrades to our IT systems, which we have previously talked about. Overall, this resulted in free cash flow for the quarter of $147 million.

So turning now to our pending acquisition of Rite Aid, as you all have seen from today's earnings press release we are actively engaged in discussions with the FTC, and are still working towards the close of the acquisition in the early part of this calendar year, having announced the Fred's agreement on December 20, 2016.

So turning now to guidance for fiscal 2017, we have raised the lower end of guidance by $0.05 and now expect adjusted diluted net earnings per share to be in the range of $4.90 to $5.20. This assumes as before, Rite Aid accretion of $0.05 to $0.12 and current exchange rates remaining constant for the rest of the fiscal year. Now keep in mind, we still expect second half year growth to be stronger than in the first, as we get to benefit from the strategic partnerships announced last year.

During the quarter, we purchased 5.6 million shares at a cost of $457 million. This substantially completes our anti-dilutive share buyback program for fiscal 2017. At the quarter end, this resulted in just over 1.79 billion common shares outstanding.

So, I will now hand over to Stefano for his concluding comments.

Stefano Pessina

Thank you, George. As you have heard, the results for the quarter are good and very much in line with our expectations. As usual, they tell the story of a dynamic business with many moving parts. And we are aware of the complication these some things creates for people looking from outside the company when they try to measure our progress, especially on a quarter-by-quarter basis, when we are fulfilling strategies that are aimed at delivering value over the long-term.

Last quarter, we told you that we expect that our result for fiscal 2017 would be weighted towards the second half of the year as our new agreement with key strategic partner that begin to believe that volume increase offset the commercial sizing that we have given. As this implies, we will continue to see this impact in the second quarter of the year, which is as we expected and previously segmented.

We continue to deliver major progress with cost reduction outsourcing both areas in which we have a lot more progress to make, which is allowing us to deliver these good financial results, while we implement initiatives to drive growth in our store. Further differentiate our retail offering and promote our own and exclusive brand across our businesses. We are still at an early stage of the deployment of new retail initiative in Walgreens and are refreshing the offering and in the processes to announce the customer experience.

Looking forward to recognize the natural work we're doing in the US. We are trying to bring on new way of thinking to our company, which if we're successful we will hopefully influence the sector alone. We're focused on working in partnership to provide a better, more efficient, and more effective approach within the U.S. customer. To make a better use of the infrastructure in place at the moment, rethink how we do along the other things that we do today.

There is no doubt that the healthcare system needs to change by improving the provision of health care, while at the same time acting to control the rapid growth in costs. We are working to play our part in the changes that need to happen to achieve this and as we deliver value in the system that we create we capture an element of that volume within our own business. Of course, we are a single part of the system, so can only do so much on our own, which is why we are succumbed to partnership and talk about it so much.

Working together with others to rethink the interaction and interfaces within the overall system allows us more impact within the system, a more leverage of a side and more ways and opportunities to create value, both in our business and in the system as a whole. Of course, the U.S. is only a part of our business albeit a very significant part.

Overall, across our company our business has changed and constantly reinvents themselves to remain relevant in the ever changing market. So, we continue to work to grow and develop the company as a whole. During the quarter, I have visited mainly of our operation outside the U.S. and they remain convinced that there are opportunities for us internationally. I said in the past that Asia and Latin America are areas of particular interest perhaps outside the U.S. And the more I see of the market the more convinced I am of these.

In terms of corporate development, you have seen the progress we announced at the end of December regarding the proposed transaction with Rite Aid, in having reached a conditional agreement with Fred’s. We still have to complete our work with FTC and as we have seen these things can take some time, as the FTC are scrupulous in ensuring that they consider everything properly and fully. As said, I remain as convinced as ever of the strategic benefit of the proposed Rite Aid transaction. I look forward to being able to provide you with another update as soon as we can.

We are clearly making progress and while I would always like to move faster and do more, we must be measured and ensured we work at the pace with which we are confident, we can deliver for our customers and our shareholder with all the plans and strategies we have discussed with you. How confident? It is only strengthened by our recent performance. Holiday shopping started later than usual, with the bulk of the sale occurring in the last days before Christmas. That said, we have once again seen what appears to be a solid holiday period in our main retail market.

As George had told you, we are raising the lower end of our adjusted earnings per share guidance for the year. As we see the business from in-line with our expectation. We continue to have mainly different ways to deliver the value and growth that we see possible in the business and as ever we will value each of these with prior guide depending on the market and the competitive changes that we see, but overall these continue to give us the tools we need to maintain the financial performance we have committed to further company as a whole.

Overall, we remain confident in the outlook for the company, optimistic that the strategies that we are pursuing will deliver future growth and convinced of the long-term opportunity to create the genuine value for this business, for many years to come. Thank you.

Now I will hand you back to Gerald.

Gerald Gradwell

Thank you, Stefano. We’re now ready to take your questions. Operator, can you open the lines.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] Our first question comes from Ross Muken with Evercore ISI. You may begin.

Ross Muken

Good morning gentlemen. So Stefano, you talked about the changing healthcare landscape, you’re obviously doing a lot of things to kind of revolutionize in some ways, how the supply chain functions, you know as you think about the competitive responses as you think about the partnerships that have happened, where do you feel like you’ve made the most progress and where do you see the sort of next leg of big opportunity, and obviously it’s going to depend somewhat on the Rite Aid transaction in terms of what you do next, but just on the core business, where do you feel like you have done the most and where do you feel like in the U.S. business you have probably the most to do.

Stefano Pessina

Well apart the Rite Aid transaction as you said, I believe that the big achievement of the last year has been for us to be able to create really a bridge with the main PBM and other big players in this industry, and now we have certain joint ventures, we have certain - let's say contracts that may be new patients as a consequence of what - of these or what we have done, but we have something which is much more important. We have established the trust.

The trust between us and a certain number of companies, not all of them, not everybody has been able to create these elements of trust, but for certain companies, the trust is there and on the trust we can build a lot of additional opportunities in future. And so, our relationship with Prime, our relationship with Express Scripts, our relationship even with Optum, even though there have been many discussions about Optum, but are creating a new basis of discussion and new basis of collaboration, which of course can go beyond a simple contract and can probably - at the end also take in consideration a wider scenario.

Ross Muken

That's helpful. And maybe just quickly on the international business, you know you highlighted obviously key emerging markets as a place for expansion, you know you entered a number of different countries with different mild acquisition, joint venture etcetera over time, I mean is this the kind of environment currently that is favorable toward accomplishing may be more of those goals and in terms of expanding your geographic reach and then to help us understand what are the key challenges, obviously we have seen folks enter Brazil and at times that’s been tough for Russia et cetera, what makes for a good emerging market in your view in terms of the ability to make money there and what not?

Stefano Pessina

You see, it’s always a tricky answer because things change so rapidly. For sure, I wouldn't be particularly excited to invest in Brazil unless we could find a very, very favorable situation, but Brazil is still a big country, sooner or later it would be interesting again. But you see countries like China, for instance are still enormously interested. I remember that in China we have a good presence in sales but not as a retailer and this is due to a historical reason that until three years ago the foreign people could have just 30 pharmacies. So, we had 30 pharmacies, we were 29 in Brazil. So, we were prevented by the pharmacies there.

So the only way to do so was to team up the minority with state-owned company. So, we have -- now this restriction has been a reality, I would say even withdrawn, there are still certain things, but substantially withdrawn and from - in the last two years, we have been very, very active in finding the right partner for us to have a big pharmacy chain. Sooner or later we will be able to it.

The problem is that you have to dedicate a lot of time to get a deal in China, and it’s true that we have a team in China, a permanent team in China of Chinese people, but it is also true that to do a big deal in China, you must have the agreement of the Chairman of the relevant company and the Chairman generally doesn't want to talk to the Chairman.

China is really, it’s a very high hierarchical society. And so, it's also true that in the last two years, I have not gone to China as frequently as I used to go. And so I was not able to keep the relationship as I should have done, but now I have gone to China, I have spent some time to China in the last months and now we are back and I believe, I strongly believe that sooner or later we will be able to do something. When? I don't know, but it is possible.

Ross Muken

Great, thank you so much.

Operator

Thank you. Our next question comes from Alvin Concepcion with Citi. You may begin.

Alvin Concepcion

Great. Thanks for taking my question. How would you characterize the competitive promotional environment in the U.S.? There has been some concerns that recent partnerships and your wins could result in things like a price war, so I'm just curious, your take on it?

Alex Gourlay

Hi. Good morning Alvin it is Alex here. Yes, we are - I think as we said quite a few times in the last 12 months, our partnership strategy is to really get deeply inside conversations with our partners to understand what they want from us, and it is not about price, only prices, it is also price and service on how we work together to really help them get their goals of creating better health outcomes. So we feel good about where we are now. We are in the very early stages of delivering these services to our pharmacies to TRICARE, and the first month is going well. And of course January 1st is a very important one for the extension of Med D and our new Prime networks, which again kick-in in Jan 1.

So there is no other place from our point of view. We got a very clear governance structure, we make sure that we stick to the pricing structure and with the market - is that not below the market, and that's very important to us. And we are working very hard to deliver existing customer care to the pharmacies to make sure we take care of the patients, our [indiscernible] given us had to take care of.

Alvin Concepcion

Thank you. I know this is a tough question, but in light of the new political climate in the U.S., what kind of changes for the operating environment you know things like the potential appeal of the Affordable Care Act, what are you planning for in your outlook, is there anything proposed out there that would change your way of thinking about the business?

Stefano Pessina

We really believe that we could start to work on hypotheses with information that we have. We have a lot of affirmation that will appeal the ObamaCare okay, but after they say yes, but maybe we have to give something similar. We have to create a transition. It’s very difficult to understand what worked practically, the new administration will decide to do because for sure will try to do something sensible and rationale and they will start something, which will not be to the detriment of the citizens.

So, it will take some time to start, probably the outcome will be quiet rationale and at that time we will be able to organize ourselves and prepare our business to respond to the new environment. We don't have to be taken by panic, just because the rules, mainly rules - the rules are changed. We have to wait for the changes and after rationally we will decide how to react without panicking.

Alvin Concepcion

Alright, thank you very much.

Operator

Thank you. Our next question is from George Hill with Deutsche Bank. You may begin.

George Hill

Yeah. Hi good morning and thanks for taking the question. I guess Alex I wanted to talk a little bit about the U.S. business and the price versus volume trends you are seeing there a little bit, where you guys continuing to see volume up pretty comfortably on the Scripts side with dollar sales coming in below that? However, from a lot of the data that we look at, it looks like net price mix is still trending positively, so I guess can you talk about what are the factors that are driving the discrepancy where dollar sales are coming below script volume growth?

Alex Gourlay

Yes sure George. I think that if you take it from our quarter-to-quarter, the differential for us is just under 3% as you really pointed. And we see really a couple of main factors George mentioned on the script. The first one is less inflation in branded drugs, that’s pretty clear and that’s our major chunk of it. The second one is volume. Volume in the market is down. So as you see we are doing pretty well in the market, 40 basis points open market share from what we measure, but overall the volume in the market is down in this quarter relative to the last quarter, and I think that's on top of that. And as you said, we have been pricing model competitively in some of our networks in preparation to drive volume as Stefano and George said in the second half of this year. And again that is the third element for us. So that really is the three elements that we see reimburse some pressure continuing, branded inflation de-accelerating a bit of volume decline in the market during this period.

George Hill

Okay that's helpful. And then maybe a quick follow-up. There’s been a little bit of chatter in the market recently about the launch of some of the biosimilars, particularly on the pharmacy benefit side with wholesalers trying to take different tax around whether or not they will supply or carry these drugs, I guess how are you guys thinking about primary and secondary wholesaler relationships in general and kind of secondary source contracts if your primary vendor doesn't want to carry certain products or wholesalers all the sudden want to be more selective about products they want to carefully depending upon the economics they can generate from manufacturers?

Alex Gourlay

To be honest we have a great relationship with AmerisourceBergen and we, as you know we are very strong partners of particularly having both the second warrants. So from my point of view, we have direct conversations of how do we continue to make the supply chain more efficient, and that is a small part of the conversation, there is many more opportunities that we're speaking about today for tomorrow. So, to be honest, it really is not an issue we see as a big opportunity right at this point.

George Hill

Okay. I appreciate the color. Thank you.

Operator

Thank you. Our next question is from Ricky Goldwasser with Morgan Stanley. You may begin.

Ricky Goldwasser

Yeah, hi good morning. So a couple of questions. So first of all, obviously retail and pharmacy comps, soft across the industry yet did you raise the bottom end of the guidance, so what has changed since you guided that gives you more confidence in the outlook for the remainder of the year?

George Fairweather

We're obviously very pleased to be able to raise the lower end of guidance by $0.05. This really reflects that we are now four months into the year that gives us a clearer view of our performance. You have seen that we have obviously delivered to expectations in the first quarter and we remain confident very much about our ability to deliver the numbers going forward, but I think when you actually look at the shape of the results you can see obviously, you know Alex has talked about the market, the volume issues and there has been questions about margins, but we delivered very strong cost controls, which is very much a key focus of us across all our divisions, and again you would have looked to the mix of the profits and the taxes has again helped us a little bit on the comparables.

Alex Gourlay

Hi Ricky is Alex here. So, there’s only two things. First one, I’ve spoken about already and we have seen in the first month of Tricare, and is on plan, and that gives us the confidence for the rest of the year, and we will see the first month of Prime that is already this month. Secondly, and I think equally important strategically we have seen all in going solid trends through our investments, particularly in beauty, wellness and health, capturing these on the front end, and you know we saw retail pharmacy operating margin, as you know step up as a result of our investments and our focus on environment service and differentiated products and differentiation is the key example we have.

Ricky Goldwasser

Okay and then when we talked in the past, you talked about the vision of Walgreen is being kind of like the new retailer with lot of different wraparound service that will attract patients and consumers into the stores. I think you recently opened or are piloting a vision offering in one of your flagship stores, can you talk a little bit about what type of assets you are looking to add to your current offering and how it fits in with the recent partnerships that you signed in 2016?

George Fairweather

Sure. I think we have, we have got solid businesses in Europe, particular in all of the UK if you want send both optical and hearing care. So we have great partnerships in these businesses and we have partnerships with manufacturers that help us, so we have tested as you said, a pilot really in our flagship store in Chicago and that is really is to try and understand the market and how customers will react to that and will take decisions based on how that comes through going forward. So, these are two vision and hearing care, which clearly we could transport from our experience in Europe.

I think also we've been very successful in the last 12 months been able to outsource our retail clinics and again as a partnership model that we will speak about a lot and we have continued to sign deals and outsource these successfully with many partners across the Medicare, and again that’s another way that we bring wraparound services and more patients into all regions by walking closely with local service providers, providing the services they want inside of a pharmacy across USA, that’s an example of how we're thinking, how we're walking.

Ricky Goldwasser

Okay, thank you.

Operator

Thank you. Our next question is from Lisa Gill with JP Morgan. You may begin.

Lisa Gill

Great. Thank you, good morning. George, I just want to start with a question for you, you talk about being back half driven and I think we heard you say that when you gave the initial guidance, but I’m just curious as to how to think about the cadence and how do we think about going from Q1 to Q2, should it be a little more back half weighted than what you are currently seeing in the street, is that the message that we should be taking today?

George Fairweather

I think the message today is no different to the message we were certainly trying to give in the full quarter, sorry, in the full year results. The partnerships that we have been talking about it will - it takes time for us to build the volume and so when you are actually looking at relative numbers, our expectation is that as always been the earlier part of the year, relatively would be the tougher part. Then it will take time for us to build the volume to see the gross profit therefore in dollars and dollars come through from these, the new partnerships that we are also excited about. You should think of that in shape and really be thinking about as that of being a build across the four quarters and take the first quarter results as an indication of that and then think in terms of building.

Lisa Gill

And then my second question, and maybe I have misunderstood this, but I never thought of drug price inflation as being very important to the drug retail model, am I misunderstanding that, is there more than just that interim opportunity of capturing some level of spread as the price went up before the reimbursement changed or are there other inventory opportunities or something else because I did hear you call it today, less or moderating drug price inflation as being a little bit of a headwind?

Alex Gourlay

Hi this is Alex. Sorry if I missed. The headwind to sales of either volume differential if you like. In terms of – it is a slight headwind to the retail business, but obviously it is a support to the wholesale business. So when it makes a big difference, but it doesn’t make a difference in sales which is the question I was answering I think from Alvin earlier on.

Lisa Gill

Okay. And I guess if I could just slip in just one last one, and that’s around utilization, you talked about increasing your level of market share, but yet you are seeing less utilization, do you have any thoughts around why that is and normally I know this is a quarter end in November, but we start to see pick up as people move towards the end of the deductible, are you seeing anything or have you seen anything in the December quarter that’s shifted from what you have seen historically?

Alex Gourlay

No, the December quarter, I mean it is one so for, again this is a season, it is a season for, obviously for cough, cold and flu and illness, and as Gerald said, it is a bit around the table here this morning as well. So, I think we are seeing a more normal flu trend, which kicked in a bit later in the season than we had expected, but that’s the only thing that has changed in December, which is going to be obviously a slight headwind, sorry a slight tailwind for us in the second quarter, but that’s still early on and we will see what happens with the rest of the season.

Lisa Gill

Okay great. Thank you.

Operator

Thank you. Our next question comes from Robert Willoughby with Credit Suisse. You may begin.

Robert Willoughby

Alright, what’s a good assumption for what sale lease backs can contribute in cash over the remainder of the year? The first quarter was a bit higher than what we had thought and then secondarily any metrics on what the new store format is contributing for you?

George Fairweather

Okay if I take the sale and leaseback what I mean, we are continuing to look at sale and leaseback opportunities on a go forward basis. The timing of those is a little tricky to actually predict because we’re very disciplined on the returns that we are looking for on the various transactions, but you should take it that it’s something that we would continue to do going forward, but as I said those tend to be your individual transactions. It’s hard to predict quarter-by-quarter, exactly when they are going to occur.

Alex Gourlay

I will take the second one. With regards to the new store formats, I mean the investment in the moment is to upgrade the whole state. So we have been upgrading at the whole state with a particular focus on beauty in our top volume stores, top 1,800 so far with more to come next year as George had said. We have got some pilots and test both in urban and what we are calling the lower volume stores, we call these opportunities stores, under the very early stages of testing and trying these out. And again we will update you when we followed in line, but the investment of this is to upgrade the whole state to make sure that we are give a more consistent - all these brand and offer across those and plus stock stores in the USA.

Stefano Pessina

But I would like to assure you that the cash flow this year will be operating cash flow, would be very good, you expect a very good operating cash flow. Of course we have had the first quarter with a relatively low operating cash flow, but this is up against every quarter because of course we buy more stock for Christmas because we pay bond fees because we pay dividends that are mainly cash [indiscernible] in this period. And so in all of our stores, in the first quarter has been relatively modest in cash flow and free cash flow, but after it caught up during the year and we don't see any reason why this year should be so dramatically different from the previous year. Of course it depends on how we manage our investment, how we manage our leases, but substantially we don't have structural differences. So, it’s - as always it is very difficult to analyze things quarter-by-quarter and to draw a conclusion adjusted from the last number.

Robert Willoughby

That's great, thank you.

Operator

Thank you. Our next question comes from David Larsen with Leerink. You may begin.

David Larsen

Hi. Can you please talk a bit about the billion dollars in synergies that you expect to capture from the Rite Aid transaction by year three or four, like – I’m assuming that’s $1 billion a year and then what makes up those synergies? And then how do you think about RAT earnings themselves versus cost synergies, is that billion dollars inclusive of both and then how do I tide this billion dollars back to $0.05 to $0.12 of accretion in year one? The $0.05 to $0.12 sounds very modest to me, so that’s a lot, thanks very much. Appreciate it.

George Fairweather

Okay. So it is quite a few questions and hope I won't miss any. To start by saying that the first thing is that in terms of the accretion for this year, I think it’s important to remember where we are. We’re already four months into the year and when we complete transactions the first priority is always very much about focusing on the customers getting the key elements of everyone working together. And in terms of delivering synergies our approach to synergies as you saw the Walgreens Alliance Boots transaction is to have a very clear plan going and then build the synergies up over a ramp up, over a period of time, so we do things in a disciplined way that we can secure the synergies year-after-year.

So, we don't just go for quick wins and pay the price later. And we've got a good track record of doing that. Clearly, there are certain synergies that take time to access. So, on procurement for synergies for example it takes time to put in place new arrangements. We've got stock sitting on the balance sheet that needs to be sold through. So that is really reflective of the guidance that we have given for the balance of this year. In terms of the synergies themselves, key areas the billion will come from is starting with areas like procurement, where we’ve got our sourcing operation on generics that sources products today both for ourselves and for Amerisource, so as Bergen is going to be that in sort of overhead cost savings that we will be able to deliver over time, but what the billion doesn’t include, which is important to understand is that it doesn't include the opportunity that we would have two actually rationalize the portfolio where there is overlaps in existing large markets.

And that’s something that we would do separately and it’s equivalent to [indiscernible] and that is outside the synergy numbers. What’s also important in the number of the billion is that we are very disciplined in the way we measure and track synergies and the billion is the synergies that we are confident that we can are very clearly identifiable and quantifiable synergies that we can measure and track and report on because that delivery is very important. What one on always gets in transactions over above that is a lot of the less tangible measurable synergies, but these are the ones that over time really won’t help deliver real long-term sustained shareholder value. The billion I say has a run rate just to be absolutely clear. It’s what we expect to deliver pair item.

David Larsen

Okay. That's very helpful. Thank you. And then how is, when we think about like Prime and Tricare and Express Scripts for this most recent quarter where the new prices and also co-pay and deductible plan designs in place at the start of the quarter?

Alex Gourlay

It’s Alex here. No, remember the first one I started was DOD in Tricare, we started on December 1 and Prime starts 1, 1, 2017, started 1, 1, 2017.

David Larsen

Okay, that's great. So then all of the new prices and the co-pay and plan design start on those dates right?

Alex Gourlay

Yes, correct.

David Larsen

Okay. Great, thanks very much.

Operator

Thank you. Our next question comes from Eric Percher with Barclays. You may begin.

Eric Percher

To start, Alex did you just mention rationalization of the Rite Aid post acquisition and is that a important part of the – or a part end opportunity strategically following completion and approval of the transaction?

Alex Gourlay

These guys add sense to the field, so I didn’t mention of it, George answered the question and I think we made no decision on this at all, let’s be very straight about this. And this is not included in the 1 billion synergies that we have enhanced, that’s what George said.

Eric Percher

So it will be looked at as a strategic effort.

Alex Gourlay

There is a possibility for sure, of course it is, but it is not in the 1 billion synergies and it is not currently in the plan, yeah.

Eric Percher

Okay.

Stefano Pessina

More generally, one we talk of – you know if we talk of mergers, we try to figure out, which is the potential level of synergies and we would wait with the elements that we have comparing say that there are stores in this case to us and thinking that at the end we would be able to unify the terms with the suppliers, you may as you need that we can reduce a certain function, a certain duplication and so reduce certain cost. So, we booked in place all the area, we know where we can reduce cost, but it’s an exercise which cannot be precise because we don’t know exactly the situation of the other company. We don’t know exactly how these companies by today.

We don’t know exactly which kind of contract they have with the PBM. When we will be in charge of the company we will analyze all these documents and of course we will be able to access a level of synergies which is much more precise. What does it mean? This means that the level of synergies that we are - have calculated in a relatively prudent way rationally prudent, I mean not rationally prudent way because of course we cannot run the risk, not to meet our target internally, so we take some contingency. And are not really, not all of them are really dependent on the number of off stores, I mean 500 stores move - 500 stores may have 10% more, 10% less. In reality, in the rounding, or which we have to calculate in synergies because we don’t have a very clear understanding of what our counter party is because we cannot – the law doesn’t allow us to share all the secrets of our due diligence is probably necessarily a superficial, relatively superficial due diligence.

So, in reality we will - one thing I can tell you that when we - whatever acquisition, whatever merger we find that the final synergies wider and substantially wider, substantially larger than the synergies that we have announced. And so today we shouldn’t talk too much about the synergies that we would be able to view a precise the target and timing that too maybe we will have acknowledged what there is really in the company. But as we have calculated the synergies in the rationale way we believe that the number probably will be higher and not lower.

Eric Percher

So, I will come back to the rationalization at a point where we can all talk about it. So, maybe my original question was actually going to be volume, we’ve talked a lot about this year’s volume. As we consider commercial versus Part D where a lot of the growth has been, do we expect that commercial may actually be a greater contributor to growth in the second half and does that then extend over the next year or two where commercial pricing could be stable and give you a bit of an offset to the reimbursement pressure with the annually and Part D?

Alex Gourlay

Hi, it is Alex here, so it is - the truth of it is that reimbursement pressure is consistent and while Med D for sure is an annual contract that you see more regularly coming through, the pressure and the commercial pick up business is also strong, you know one does to some extend for the other. So, the market is a market, we are very clear in how we govern within the business and how we structure our pricing within the business. We do that both at the Walgreens level to myself and our Alan Nielsen, our FD and also the group level through Stefano and George. But the reimbursement pressure is real and we manage within the market.

So, I don’t think you will see the upside to be really straight with you. In the future that you will see continuing reimbursement pressure and we are managing it through a combination of three, through more volume, through better partnerships, which we are very happy with the moment and are going well. Secondly, to increasing our retail gross margin and retail operating margin where we are seeing good GreenChill and have seen good growth in the last three years and that continues on good cost control.

Eric Percher

That’s a straight answer, thank you.

Alex Gourlay

Thank you.

Operator

Thank you. Our next question is from Steven Valiquette with Bank of America Merrill Lynch. You may begin.

Steven Valiquette

Alright thanks, good morning everybody. So, it’s interesting now that with some hindsight that Walgreens never ended up pulling the trigger around the international tax inversion phenomenon from a couple of years, even now you maybe in a position to benefit from a U.S. corporate tax reform, so just a couple of questions on taxes, I guess first over these past couple of quarters you seem to have enabled to get your tax rate down to levels that people are only dreaming about with this inversion created a few years ago, so kudos on that, but how should we think about your tax rate for the rest of fiscal 2017, and then second do you have any preliminary comments on the pros and cons of this potential U.S. corporate reform and what it might mean for Walgreens? Thanks.

Stefano Pessina

I can answer on the second part of the question whether we have some ideas on the coming tax reform, I can repeat the same thing I said before, now there is not a project of tax reform there are certain principle, people are discussing about certain principle, not everybody in the administration agrees on the same principle and even if they are on the same principle they don’t agree on the level on their quantity of the principles. So it’s a waste of time today to start to create a scenario, which very likely would be in reality substantially different. So, let’s see when we will have the frame of the tax and after we will start immediately to think how we can leave with these new environment.

In any case we will not have a new tax system tomorrow morning, it will take months and we will have time to see how this will shape over time and when we believe that we are close to a final shaper we will start to see how we can work, but even though having looked at the taxes - at the different principle that are now have been debated, yes, there are certain principle who could damage us, but there are other principle who could benefit us and it is clear that the principle who could damage us, who would damage all our peer and so the market will find another equilibrium and other assets.

So, at the end of today, the conclusion is that for the time being we have to continue to work with the rules that are in place today and probably one year or two year or three year, we will have to change if something, but now it’s too early to distract how people - to do things, which should probably will never happen before the end, the mixture will be completely different.

Steven Valiquette

Okay.

Stefano Pessina

The second part of your…

Alex Gourlay

Yeah, but just commenting on the rates, as Stefano said, at the year-end we indicated our effective tax rate last year, I think it was around 26.3%, excluding the discrete tax items and we look at the calc excluding ABC equity income on an adjusted basis because it is the only easy way to do the math. This quarter, we’ve come in around the 25.5%, so a little bit better. It is a function really of two things, the geographic mix which of course varies quarter-by-quarter and then the certain discrete items in an individual quarter, if your results, you know historic tax issues or other sort of discrete items that can have a little impact on the quarters-by-quarter’s results. That mix really reflects the composition of profits across Walgreens with the lines recognizing, we’ve obviously got profits from our international operations and we try and obviously organize our inter-group funding structure in efficient way from – from a taxation perspective and we obviously have sources, say profit outside the U.S. that benefit our rate, beyond that really not lot to comment on and Stefano has already covered the view of what may or may not happen in the future. But we seek - we are very focused on EPS and whether it is tax or whether it is up-funding cost, they get a lot of focus in our organization as well as adjusted operating income, along with cash flow, which Stefano also talked about to drive shareholder value.

Steven Valiquette

Okay, that’s helpful, thanks.

Operator

Thank you. Our last question is from Scott Mushkin with Wolfe Research. You may begin.

Scott Mushkin

Hey guys, thanks for taking me in. So just wanted to talk about strategy, and I know Stefano you talked about acquisitions overseas, when we think about Rite Aid, what’s the kind of Plan B if it doesn’t get approved as we kind of get down to the end here, kind of in the U.S. business and does that speed up some of your thoughts oversees?

Stefano Pessina

We're working hard to have the deal approved and for the time being we don't want even to think of the fact that the deal could not be approved after so many months when we have given a lot of information and we have had a very good relationship with the people of the FTC and they have continued to ask information and we have continued to gain information and in reality we believe that if they have spent so much time asking self, and analyzing so many documents is because they want to understand the transaction, which is fine. So we are not thinking of a Plan B today. We don't have to distract people today, I can assure you that if I, let’s say we had the big surprise that this wouldn't happen after we would have to sit down and decide what to do because there are many, many possible reaction to this, as you can imagine.

We would have to see what our counter party Rite Aid wants to do and see whether there are solutions or not, what are the other alternatives. In reality we would have money and we would use the money in the best interest of shareholders. We will continue to act rationally, we will not spend money in irrational way just as a matter of principle. We will analyze all the opportunities very quickly because I and more team of the people here are thinking in different ways of different scenario and analyzing many other things.

Then if we decide what to do we will communicate to the shareholder for what to do, but I can assure you that we will not have a, how could I say an historic reaction and we will not feel forced to do something at any cost, just to show that we are doing something. We will take stock of the money that we have and we will analyze very, very irrationally which is the best use of these money at that time for our shareholders.

Scott Mushkin

This does seem like you potentially could litigate depending on what happens, is that correct interpretation of what you said?

Stefano Pessina

Potentially, sorry, [indiscernible].

Scott Mushkin

Potentially litigate

Stefano Pessina

I can give you an answer like that. We don't - for the time being everything looks fine. So we don't go so far.

Scott Mushkin

Perfect. I wanted to move on to one last question and I appreciate the time. So Boots in the UK, the retail side of the business it sounds like it was slightly positive, but I think there were comments that maybe December got a little bit better, you know we were over in the UK it seems like it’s discounting, was pretty significant in the front end of the Boots operations, so I was wondering if we could get a little bit more color on the retail side of Boots and what is going on there, thank you.

Alex Gourlay

Hi Scott it is Alex here. I think that as George said really clearly in the script two things, first of all environment in the UK has changed and summer is a big change to the retail environment in particular, which we are working within, so we've repositioned into our business and focused on rebasing our cost again and also focused on customer care. So, the good news is these plans are walking on as George said, we’ve had a notable improvement in sales performance in through December as he said in his script. And again we are very much focusing back on our core business in a very clear way, the real challenges going forward, at the same for the retailers, which we are taking care of, we were very effective online on the channel model, which is working well, we have to obviously operate a cost level because obviously that does affect the margin slightly. And of course as George said in his script from December 1, you know the government is taking additional action and new action in fact on practice payments, which means more call back in terms of pharmacy which we are aware of and we've planned for, really planned against. So, we are feeling we are in a good position with a very strong business in a difficult environment and we're pleased with the progress.

Scott Mushkin

Alright thanks guys. Appreciate it, good luck.

Operator

Thank you. I would now like to turn the call back over to Gerald Gradwell for closing remarks.

Gerald Gradwell

Thank you very much indeed everyone. That concludes our call today. Obviously as ever, if you have further questions please feel free to reach out to any member of the IR team, myself Ashish, Deborah, Jonathan or Patrick and we will look forward to seeing some of you during the quarter and if not talking to you all in the next quarter. Thank you very much indeed.

Operator

Ladies and gentlemen, this concludes today’s conference. Thanks for your participation. Have a wonderful day.

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