Walgreens reported adjusted net earnings (excluding charges related to a legal settlement with DEA and other one-time expenses) of 85 cents per share in the third quarter of fiscal 2013, significantly higher than the year-ago adjusted net earnings of 72 cents.
Despite an 18.1% year-over-year improvement in earnings, the result missed the Zacks Consensus Estimate of 90 cents per share. While a possible explanation is that lower-than-expected front-end sales and unyielding macroeconomic conditions led to the miss, Walgreens also witnessed higher interest expense and tax rate in the quarter along with almost 11% higher share count.
On a reported basis, earnings came in at $624 million or 65 cents per share, better than the year-ago earnings of $537 million or 62 cents.
Walgreens’ sales came in at $18.31 billion, up 3.2% year over year. However, sales trailed the Zacks Consensus Estimate of $18.46 billion, missing the Zacks Consensus Estimate for revenues for the fifth time in a row.
Quarter in Detail
Front-end comparable store (those open for more than a year) sales clambered 0.4% in the third quarter. This is in stark contrast to the second-quarter result when front-end comparable store sales decreased 2.6%. On the other hand, a decline of 3.9% in customer traffic in comparable stores along with an increase of 4.4% in basket size resulted in 1.4% improvement in comparable store sales.
Prescription sales (accounting for 63.1% of sales in the quarter) inched up 3.4% compared with the prior-year quarter, while prescription sales in comparable stores increased 2%. Moreover, during the reported quarter, Walgreens filled 209 million prescriptions (up 8.7% year over year).
Prescriptions filled at comparable stores inched up 7.1% compared with an increase of 4.3% in the second quarter of fiscal 2013. Walgreens’ market share in retail pharmacy improved 80 basis points (bps) to 19.2% in the quarter.
The improvement can be attributed to the new multi-year pharmacy network agreement with Express Scripts Holding Company (ESRX - Analyst Report) under which Walgreens’ pharmacy network has started filling prescriptions from Express Scripts customers from Sep 15, 2012.
Gross profit increased 4.1% year over year to $5.2 billion. As a result, gross margin expanded 30 bps to 28.5% on the back of higher generic prescription drug sales and higher front-end sales. With selling, general and administrative (SG&A) expenses rising 5.3% year over year to $4.4 billion mainly due to the legal settlement with the DEA, adjusted operating margin (excluding equity earnings in Alliance Boots and gain on sale of business) during the quarter contracted 22 bps to 4.7%.
Exiting the third quarter, Walgreens’ cash and cash equivalents were almost $3 billion, up 50.1% from the year-ago quarter. Moreover, it generated operating cash flow of $1.4 billion and free cash flow of $1.1 million, reflecting sequential improvement from the second quarter.
Walgreens’ Balance Rewards loyalty program (launched in Sep 2012) has recorded more than 75 million registrations to date. The company opened/acquired 39 stores in the reported quarter compared with 52 stores in the year-ago quarter.
As of May 31, 2013, the company operated 8,560 locations in 50 states, the District of Columbia, Puerto Rico and Guam, including 8,097 drugstores (207 more compared with the year-ago period). The company also operates infusion and respiratory service facilities, specialty pharmacies and mail service facilities and e-commerce business.
Strides on Synergy Track
Walgreens’ partnership with Alliance Boots is yielding positive results. Further, Walgreens expects to attain synergies of $125–$150 million across joint operations in the first year compared with the earlier estimate of $100–$150 million.
The Alliance Boots deal was accretive to adjusted earnings by 10 cents in the reported quarter. Management envisages the deal to contribute 8 cents in the fourth quarter of fiscal 2013.
Walgreens reported a disappointing third quarter as it missed the Zacks Consensus Estimate on both lines. Sales lagged the Zacks Consensus Estimate despite the benefits of increasing return of Express Scripts customers.
While we believed that the persistent lower-than-expected sales will be remedied through the resolution of the impasse between Walgreens and Express Scripts, another quarter of sales miss remains a matter of concern. Nevertheless, we believe that Walgreens’ financial strength and sizeable market share in retail pharmacy should leverage the company’s sales growth.
Although the company gained from the Alliance Boots deal, Walgreens still missed the earnings mark. Nonetheless, we look forward to synergies from the deal. Moreover, the decade long deal (effective Sep 1, 2013) with AmerisourceBergen Corp. (ABC - Analyst Report) is another major upside.
Currently, Walgreens carries a Zacks Rank #3 (Hold). While we have a neutral disposition on this drug retailer, GNC Holdings Inc. (GNC - Snapshot Report), carrying a Zacks Rank #2 (Buy), is worth considering.