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Walgreen Co. (WAG - Analyst Report) reported adjusted net earnings of 91 cents per share in the third quarter of fiscal 2014, up 7.1% from the year-ago adjusted number. However, adjusted earnings fell below the Zacks Consensus Estimate of 94 cents. On a reported basis, earnings came in at $722 million or 75 cents per share, up 15.7% or 15.4% year over year, respectively.

Walgreens’ sales came in at $19,401 million in the quarter, up 5.9% year over year and marginally ahead of the Zacks Consensus Estimate of $19,384 million.

Quarter in Detail

Front-end comparable store (those open for at least a year) sales and basket size grew 2.2% and 2.9%, respectively, in the quarter. On the other hand, customer traffic in comparable stores was down 0.7%. Overall, comparable store sales improved 4.8%.

Prescription sales (accounting for 64.4% of total sales in the quarter) climbed 8.4% over the prior-year quarter, while prescription sales in comparable stores increased 6.3%. Moreover, Walgreens filled 218 million prescriptions (up 4.5% year over year) during the reported quarter.

Prescriptions filled at comparable stores rose 4.1%. As reported by IMS Health, Walgreens’ market share in retail pharmacy improved 20 basis points (bps) to 19.0% at the end of May 2014.

In addition, prescriptions filled for Medicare Part D patients witnessed a solid growth of 11.6% in the reported quarter. Also, in May, Part D market share increased 60 bps from the year-ago period.

The company’s Balance Rewards loyalty program reached 81 million active members at the end of the third quarter.

Margins

Gross profit increased 4.2% year over year to $5.44 billion. However, gross margin contracted 48 bps to 28.0% as pharmacy gross profit were negatively impacted by lower third-party reimbursement, fewer brand-to-generic drug conversions and generic drug price inflation. However, as expected, both pharmacy and front-end margins were aided from purchasing synergies from the company’s joint venture with Alliance Boots. The LIFO provision was $41 million in this fiscal’s third quarter versus $120 million last year.

Selling, general and administrative (SG&A) expenses scaled up 4.3% to $4.6 billion. Operating margin contracted 11 bps to 4.6%.

The company opened/acquired 39 stores in the reported quarter in-line with the year-ago quarter numbers. As of May 31, 2014, the company operated in 8,683 locations in 50 states, the District of Columbia, Puerto Rico and Guam and the U.S. Virgin Islands, including 8,217 drugstores (120 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, e-commerce business and Take Care Health Systems.

Financial Condition

Walgreens exited the third quarter with cash and cash equivalents of $1.13 billion, significantly lower than $2.99 billion as of May 31, 2013. Long-term debt was $3.8 billion in the reported quarter, compared with $6.3 billion as of May 31, 2013.

Moreover, the company has generated year-to-date operating cash flow of $2.51 billion in the quarter compared with $3.18 billion in the same period last year.

AllianceBoot Deal Update

While moving into the second step of the Walgreens-Alliance Boots strategic transaction, Walgreens is currently suspending its fiscal 2016 goals that were announced in 2012. As a result of many step two considerations and current business performance, the company is planning to hold an investor call, which is expected to take place by late July or early August 2014 where it will provide a new set of targets for fiscal 2016.

So far, Walgreens’ partnership with Alliance Boots is yielding positive results, with combined year-to-date synergies of $367 million. The company expects second-year combined synergy program in the range of $400–$450 million, an increase from the previous second-year estimate of $375–$425 million.

In the third quarter, the Alliance Boots deal was accretive to adjusted earnings by 15 cents. The company estimates that accretion from Alliance Boots in the fourth quarter will be an adjusted 6 to 7 cents per share.

Our Take

Walgreens reported a mixed fiscal third quarter with a bottom line miss and a marginal beat on the top-line front. The generic wave in the pharmaceutical industry remains a threat to revenues. This is also reflected in the company's quarterly sales figure.

Nonetheless, Walgreens is poised to generate higher profits from escalating sales of higher-margin generic drugs. The company is also positioned on a healthy dividend growth track. Further, the customer loyalty program is gaining traction as reflected in increasing registrations. This should improve customer traffic for Walgreens going forward.

Moving into the second phase of the Walgreens-Alliance Boots strategic transaction, the company suspended its earlier provided fiscal 2016 guidance. We are waiting for the company’s updated guidance on the same, which is expected by late July or early August. Till then we prefer to remain on the sidelines.

Walgreens currently has a Zacks Rank #3 (Hold). While we choose to remain on the sidelines regarding WAG at present, stocks worth considering in the broader medical sector are Masimo Corporation (MASI - Analyst Report), ICU Medical, Inc. (ICUI - Snapshot Report) and Globus Medical, Inc. (GMED - Snapshot Report). All the three stocks hold a Zacks Rank #2 (Buy).

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