Highlights From WAG's Q4 Conference Call: Substantial Progress on Our Transformation Strategy

Walgreen Company (NYSE: WAG) reported Q4 EPS of $0.57, $0.02 better than the analyst estimate of $0.55. Revenue for the quarter came in at $18 billion versus the consensus estimate of $17.88 billion. Shares are trading down 5.13% today.

Highlights From WAG's Q4 Conference Call:

• (Gregory D. Wasson) We had a solid quarter and a strong year as we made substantial progress on our transformation strategy.
  
• We reported record fourth quarter sales of $18 billion, up 6.5% from $16.9 billion a year ago.
  
• Excluding the after-tax gain from the sale of WHI, our Pharmacy Benefit Manager, which closed in June, fourth quarter EBIT increased to $832 million, fourth quarter net earnings were $519 million and fourth quarter earnings per diluted share increased to $0.57.
  
• To the gain from the sale of WHI, both our reported and our adjusted earnings per diluted share included $0.02 of dilution from our acquisition of Drugstore.com and $0.01 of restructuring and restructuring related costs associated with our Rewiring for Growth initiative.
  
• Now turning to our performance for the fiscal year, we posted record sales of $72.2 billion, up 7.1% from $67.4 billion last year. Excluding the after-tax gain from the sale of WHI our adjusted fiscal 2011 EBIT was $3.9 billion, up 13.7%; and our adjusted fiscal 2011 earnings per diluted share work $2.64, a 24.5% increase.
  
• On a GAAP basis, including the after-tax gain on the sale of WHI, fiscal 2011 EBIT was $4.4 billion, up 26.2%; net earnings for the year were $2.7 billion, up 29.8%; and fiscal year 2011 earnings per diluted share were $2.94, up 38.7%. And finally, operating cash flow for fiscal 2011 was $3.6 billion versus $3.7 billion in fiscal 2010.
  
• In the fourth quarter, we grew gross profit dollars at 5.8% or $277 million versus SG&A dollars at 4.8% or $191 million, yielded $86 million difference.
  
• For the full year, the spread between gross profit dollar growth and SG&A dollar growth was $473 million.
  
• On the Pharmacy and Healthcare side, Walgreens now fills one out of every five retail prescriptions in America with a record 819 prescriptions filled, an increase of 5.3% in fiscal 2011. We also administered 6.4 million flu shots during the last flu season as we continued to be the largest provider of flu shots in the country outside of the government.
  
• Walgreens now fills one out of every five retail prescriptions in America with a record 819 prescriptions filled, an increase of 5.3% in fiscal 2011.
  
• We also administered 6.4 million flu shots during the last flu season as we continued to be the largest provider of flu shots in the country outside of the government.
  
• To expand the role we play in healthcare we established important partnerships with top health systems, including Johns Hopkins Medicine, Posner Health Systems and Louisiana State University to name a few in order to enhance coordinated care to patients.
  
• Turning to the daily living side, we refreshed and revitalized our front-end completing our planned launch in 2009 to convert or open 5,500 stores through our Customer Centric Retailing format, which offers more target assortment, better sidelines and new decor packages. Our CCR stores are reporting higher customer satisfaction and improve sales.
  
• In addition, we opened or acquired 199 net new drug stores this past year including the 22,000 square-foot flagship Duane Reade store at 40 Wall Street with a pharmacy powered by Walgreens.
  
• In terms of our financial highlights, in addition to record sales and earnings per diluted share, we completed our three-year Rewiring for Growth cost-savings initiative and exceeded our $1 billion goal.
  
• And finally, we announced the largest dividend increase in the history of the company in July and including share repurchase, this year we returned a record $2.4 billion to shareholders.
  
• Looking ahead, let me touch on our status with Express Scripts (Nasdaq: ESRX) and the opportunities we see. As you know, our contract renewal negotiations have been unsuccessful and we're planning not to be part of the Express Scripts network as of the first of the year. At the time we made our announcement on the last earnings call, we emphasized that the terms Express Scripts offered us including rates that were below the industry average cost to provide a prescription were not in the best interest of our company, our customers, our employees or our shareholders and we still firmly believe that. We also said we intend to work closely with our partners who are focused on lowering overall healthcare costs and recognize the critical value that community pharmacy can provide.
  
• Finally, during the upcoming open enrollment period, Medicare beneficiaries will be able to choose a plan that best meets their healthcare needs. Many Medicare plans include Walgreens in their pharmacy-provider networks and we expect the beneficiaries will take that into account as they make these important plan decisions.
  
• We're also focused on expanding across new channels and markets to ensure our customers have access to what they want, when they want and where they want it. Fiscal 2011 was a pivotal year in our expansion of our multi-channel business as we welcome Drugstore.com into the Walgreens family of companies.
  
• (CFO) The fourth quarter comparable sales and prescription trends have each approved from a year ago, with prescription comp sales increasing 4.4%, front-end comp sales increasing 4.6%, total comp sales increasing 4.4% and comparable prescriptions filled increasing 3.4% for the quarter.
  
• For the year, our comparable sales trends have improved as well, with prescription sales comps up 3.3%, front-end sales comp up 3.3% and total sales comp up 3.3%.
  
• Finally, our Rx script comp for the year was up 3.7% versus up 4.5% in fiscal '10, reflecting the slowdown of prescription utilization in the industry year-over-year. For fiscal 2011, we achieved 20% retail pharmacy share, up 50 basis points from fiscal 2010.
  
• Looking at our quarterly trends over the past three years, our prescription comp, shown in the green bars, increased by 3.4% in the fourth quarter, up from last year's 3.3% despite the slowdown in the industry from 3.5% growth in the fourth quarter of 2010 to 1% in the fourth quarter of 2011.
  
• Our quarterly front-end comp sales were up a robust 4.6% versus an increase of about 1.2% a year ago. The biggest driver continues to be CCR, with over 5,500 stores either converted or opened in the new format to date, which was designed to positively impact the shopper experience and increase traffic and basket.
  
• We continue to achieve a good mix between traffic and basket, with traffic up 1.6% and basket up 3%. Within that basket we are seeing some inflation and believe our convenience model affords us the ability to pass the majority of it through.
  
• The two-year stacks shown by the blue line continued to trend up, reaching 5.8% in the quarter after bottoming out in the second quarter of fiscal 2010.
  
• Turning to margin, our gross margin as a percent of sales was up 28.2% in the current quarter compared to 28.4% last year. The front and margin was lower primarily as we were up against a strong prior-year quarter.
  
• Two-year stack SG&A trends improved versus a year ago with 15.8% growth in the fourth quarter of 2011, down from 20.6% last year. Recall in the fourth quarter of 2010 SG&A growth included 550 basis points impact from the acquisition of Duane Reade, which was a major driver of this year's lower SG&A dollar growth.
  
• With respect to our CCR, our SG&A included $84 million of CCR conversion costs in fiscal 2011, up from $45 million in fiscal 2010.
  
• Currently the incidence of flu is running 15% below a year ago. Second, we are cycling two years of strong gross profit dollar growth. And third, on a quarterly basis we will continue to experience volatility resulting from the timing of generic introductions which we believe will impact us more significantly as the year progresses.
  
• For the year, we invested $1.2 billion in capital expenditures including approximately $300 million in our new stores and $500 million in existing stores including remodels and store IT. In addition, we invested $100 million in our distribution centers at $300 million in corporate technology and other investments.
  
• For the year ended August 31, 2011, we generated $3.6 billion in cash from operations compared to $3.7 billion a year ago, continuing our strong cash flow generation driven by our strong earnings.
  
• Now let me share our plan to move forward without being in Express Scripts pharmacy networks. As Greg noted, we're working on a number of Express Scripts customers - with a number of Express Scripts customers, consistent with the contractual obligations, to help them evaluate all of their options to ensure that their members and our patients have continued access to Walgreens in their pharmacy networks. While we cannot comment on any plans or contracts specifically, we're very pleased with the response that we're receiving and we expect these plans will make announcements when they are ready.
  
• While it's still too early to quantify how much of this business we will ultimately retain, I can share with you how we think about the various levers, including retention of total sales and cost savings opportunities, and the potential resulting impact on our fiscal 2012 earnings. Because we're not going to speculate on the ultimate retention, we're going to illustrate three different retention scenarios among the many possible scenarios to illustrate how we frame the potential financial impacts.
  
• Regarding cost savings, we believe that within a range of 25% to 75% retention for the cost savings plans we have in place, we can offset the anticipated gross profit impact by approximately 50% including both COGS and SG&A interventions. Applying this framework under Scenario A, which depicts 25% retention, the total revenue retained would be approximately $1.3 billion. To frame our cost savings under the 25% retention scenario, consider that our COGS pull is nearly $52 billion, so improvement in the supply chain of one-third of 1% can generate over $170 million and savings and our SG&A pull is over $16.5 billion, so additional measures here could yield up to $250 million, equal to 1.5% of our total SG&A. So again, using this framework under the 25% retention scenario, we estimate the impact to financial earnings will be approximately negative $0.21 per diluted share. Using the same framework, we estimate that the impact of 50% retention could be approximately negative $0.14 per share and the impact at 75% retention will be approximately negative $0.07 per share. As I said before, we're not going to speculate at this time on the amount of business we'll ultimately retain, and it may be less than 25% or may be greater than 75%, but I hope this slide helps you dimensionalize the EPS impact that we may be looking at under different scenarios. And of course on a longer-term basis, we believe additional business will move to networks that have Walgreens in the network.
  
• The upcoming generic wave will benefit many including payers, PBMs, providers and patients. The generic wave will also help to control drug trend increases, projected to be in the low single digits compared to overall healthcare spending, projected to grow in high single digits. In Walgreens' proposal to Express Scripts, we offered to hold annual average reimbursement cost increases to within an estimated 2% annually over the next three years, which compares to a 3.2% annual drug trend increase that Express Scripts reflects in their 2010 drug trend report.
  
• (Q&A) There was a lot discussed there. Wade, in your prepared remarks, you went through kind of quickly the company's objectives to offset the lower gross profits proceeding without Express Scripts. Could you go over that in a little more detail and elaborate? Basically, where would you find the additional savings on the cost of goods and also on SG&A I guess given the company's been running leaner the last couple of years with prior objectives? Thanks. (A) Well, I guess the first thing I'd say is that we absolutely have plans in place to deliver against the framework that I gave you both in respect to SG&A and COGS. And as you've seen from the data, we have substantive pools: about $50 million of COGS and over $16 billion of SG&A. With respect to any specific detailed plans, the levers we'll pull are going to be dependent upon how much business we retain or don't. So I don't want to go into significant detail right now on what those are. But I guess I would just say that rest assured that the plans are in place.
  
• Can I just ask one follow-up then? I know one of the things you're working on is doing more direct imports. Is that a significant part of it? Or I mean can you comment at all on what the bigger buckets would be? It's just not obvious what it would be. (A) Yeah, I mean there's no question that expanding our base for suppliers including overseas being more rigorous about RFP processes are all part of that. Also just we're looking how we run the fundamental supply chain and how we can use different types of partners to help make us more effective is another piece. But again, when you look at the grand scheme of overall cost we're talking about a very small percent to get back to what we need to offset half of those retention rates.

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