WAG Disappoints, Forms Partnership

Walgreen Co. (WAG - Analyst Report) reported earnings of 62 cents per share in the third quarter of fiscal 2012, in line with the Zacks Consensus Estimate. However, reported earnings lagged the year-ago earnings by 3 cents. The company witnessed a negative impact of 6 cents related to the non-renewal of the Express Scripts (ESRX - Analyst Report) contract and 1 cent per share in charges associated with the company’s latest agreement with Alliance Boots GmbH, a global international pharmacy-led health and beauty group. The year-ago quarter result included a negative impact of a penny in restructuring and restructuring-related costs associated with the company’s Rewiring for Growth initiative.

Walgreen reported a 3.4% year over year decline in total sales of $17.8 billion in the reported quarter, missing the Zacks Consensus Estimate of $17.9 billion. Front-endcomparable store sales (those open for more than a year) during the quarter decreased 2.6%. Customer traffic in comparable stores declined 6.6% and basket size increased 1.7%.

Prescription sales, accounting for 62.9% of sales in the quarter, declined 6.6%, while prescription sales at comparable stores were down 9.9%. Moreover, during the quarter, Walgreens filed 192 million prescriptions (down 8.4% year over year) while prescriptions filled check spelling at comparable stores dropped 9.1%.

Partnership with Alliance Boots GmbH

Walgreen and Alliance Boots have decided to form a strategic partnership to become the world’s first pharmacy driven health and wellbeing retail with more than 11,000 stores in 12 countries.

Additionally, they will create a global major in pharmaceutical wholesale and distribution network with over 370 distribution centers catering to 170,000 pharmacies, doctors, health centers and hospitals across 21 countries. Furthermore, it will also be considered as the largest purchaser of prescription medicines and many of the health and wellbeing products.

Walgreen’s primary plan is to invest $6.7 billion in cash and stock ($4.0 billion in cash and 83.4 million shares) to acquire a 45% equity interest in Alliance Boot. However, the company holds the option to acquire the remaining stake over the next three years for approximate value of $9.5 billion in cash and stock. The valuation is based on the current share price of Walgreen, present exchange rate ($1.55=£1) and the then outstanding debt level of Alliance Boots. The company expects the initial investment to be completed by September 1, 2012.

Walgreen expects the first step of this transaction to be accretive to its EPS by 23−27 cents in the first year. The company also expects the synergies across joint operation to be between $100 million-$150 million in the first year and $1 billion by the end of 2016..

Margins

Gross profit in the quarter decreased 2.7% year over year to $140 million leading to a 15 basis points (bps) contraction in gross margin to 28.2%. The pharmacy profit margins were impacted by generic drug sales, partially offset by market reimbursements, specialty pharmacy mix and LIFO. Front-end margins, however, remained stable year over year on the back of positive impact from convenience and fresh foods, household items and inventory offset by E-commerce mix. During the quarter, there was higher LIFO provision ($60 million) compared to the year-ago level of $50 million.

Selling, general and administrative (SG&A) expenses decreased 1.6% year over year to $62 million, including a 0.6% downside in operating and integration costs in drugstore.com, which was acquired in June last year. Operating margin during the quarter contracted 27 bps to 4.9%.

Cash Position

At the end of the quarter, Walgreens had $1.99 billion in cash and cash equivalents, compared with $2.65 billion at the end of May 2011. Year-to-date, the company’s net cash provided by operating activities were $3.66 billion.The company also declared a 22.2% increase in its quarterly dividend to 27.5 cents per share, payable on September 12, 2012.

Our Recommendation

The termination of the Express Scripts contract continues to affectWalgreen’s performance. Also, the company has been adversely affected by high unemployment levels and lower discretionary spending over the past few quarters. However, Walgreen is currently working toward establishing itself as a leading provider of pharmacy, and health and wellness solutions. The company has been taking steps over the last few years to align its assets. We are encouraged by Walgreen’s recent strategic decisions, the latest being with Alliance Boots GmbH.

On a long-term horizon, we are optimistic about Walgreens. The introduction of new generics should help improve the company’s gross margins in the second half of fiscal 2012. Moreover, a strong cash balance enables the company to reward its shareholders.

Currently, Walgreen retains a Zacks #3 Rank (short-term Hold rating). We have a ‘Neutral’ recommendation on the stock over the long term.