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Walgreen Co. (WAG - Analyst Report) reported adjusted net earnings of 72 cents per share in the first quarter of fiscal 2014, a 24.1% improvement from the year-ago adjusted net earnings. However, earnings were in line with the Zacks Consensus Estimate.

The adjustments include negative impacts of acquisition-related amortization and other costs, the quarter’s LIFO provision and Alliance Boots-related tax, and positive impacts of fair value adjustments and amortization related to Walgreens’ warrants to purchase AmerisourceBergen Corp’s (ABC - Analyst Report) common stock. Morever, implementation of new initiatives in the fiscal 2014 first quarter resulted in an adverse impact of 2 cents per share.

On a reported basis, earnings came in at $695 million or 72 cents per share, up 68.3% or 66.1% year over year respectively. Both reported and adjusted net income in the quarter include the positive impact of 7 cents per share of a deferred tax adjustment resulting from a reduction to the U.K. corporate tax rate applicable to Alliance Boots (enacted in July 2013).

Walgreens’ sales came in at $18,321 million in the quarter, up 5.9% year over year and marginally ahead of the Zacks Consensus Estimate of $18,309 million.

Quarter in Detail

Front-end comparable store (those open for at least a year) sales and basket size grew 2.4% and 2.2%, respectively, in the quarter. On the other hand, customer traffic in comparable stores inched up 0.2%. Overall, comparable store sales improved 5.4%.

Prescription sales (accounting for 64.7% of sales in the quarter) climbed 7.3% from the prior-year quarter, while prescription sales in comparable stores increased 7.2%. Moreover, Walgreens filled 213 million prescriptions (up 5.8% year over year) during the reported quarter.

As reported by IMS Health, prescription growth rate of Walgreens’ exceeded that of the rest of the industry by 2.9%. Prescriptions filled at comparable stores grew 5.5%. Walgreens’ market share in retail pharmacy improved 50 basis points (bps) to 19.4% in the quarter.

Gross profit increased 1.04% year over year to $5.15 billion. However, gross margin contracted 134 bps to 28.1% on the back of fewer new generic drugs introduction, soft margin in front-end sales as the company made meaningful promotional investments to drive store traffic. The LIFO provision was $58 million in this year’s first quarter versus $55 million last year.

Selling, general and administrative (SG&A) expenses declined 0.4% to $4.4 billion. Operating margin expanded 97 bps to 5.04%.

The company opened/acquired 84 stores in the reported quarter compared with 128 stores in the year-ago quarter. As of Nov 30, 2013, the company operated in 8,681 locations in 50 states, the District of Columbia, Puerto Rico and Guam, including 8,200 drugstores (142 more compared with the year-ago period). The company also operates worksite health and wellness centers, infusion and respiratory service facilities, specialty pharmacies, mail service facilities, and e-commerce business.

Financial Condition

Walgreen exited the first quarter with cash and cash equivalents of $969 million, significantly lower than $1.8 billion as of Nov 30, 2012. Long-term debt was higher at $4.5 billion in the reported quarter, compared with $5.0 billion as of Nov 30, 2012.

Moreover, the company has generated operating cash flow of $133 million in the quarter compared with $601 million in the same period last year.

Second Quarter Stance

In the second quarter, Walgreens plans to balance its front-end sales and margin. The company foresees the impact of generic wave on pharmacy margin similar to what it has been in the first quarter of the fiscal. However, the company expects this effect to keep on moderating through the rest of the fiscal. Additionally, the company plans to focus on expense management to tackle the challenging environment.

Strides on Synergy Track

Walgreens’ partnership with Alliance Boots is yielding positive results, with combined first-quarter 2014 synergies of $107 million. The Alliance Boots deal was accretive to adjusted earnings by 14 cents including 7 cents attributable to the deferred tax adjustment. The company estimates that accretion from Alliance Boots in the second quarter will be an adjusted 7 to 8 cents per share.

Walgreens and Alliance Boots’ strategic long-term relationship with AmerisourceBergenis also moving ahead, with Walgreens and AmerisourceBergen implementing their 10-year agreement for pharmaceutical distribution last quarter. Moreover, several of Boots’ product brands were launched across Walgreens stores in the Phoenix market.

In the fourth quarter of fiscal 2013, Walgreens and Theranos, Inc. had entered into a long-term partnership, whereby the new lab testing service of the latter will be available throughout the wide network of Walgreens’ pharmacies. In the reported quarter, Walgreens initiated the national rollout of Theranos Wellness Centers by opening two new centers at Walgreens stores in the Phoenix area.

Walgreens currently has a Zacks Rank #3 (Hold). While we choose to remain on the sidelines regarding WAG, drug retailers like Herbalife Ltd. (HLF) and CVS Caremark Corp. (CVS - Analyst Report) carrying a Zacks Rank #2 (Buy), are worth considering.

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