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Walgreen Co. (WAG - Analyst Report) reported adjusted earnings of 63 cents per share in the fourth quarter of fiscal 2012, well ahead of the Zacks Consensus Estimate of 55 cents. However, earnings lagged the year-ago adjusted level of 66 cents per share.

The adjusted figure takes into account the negative impact of 9 cents per share related to the Alliance Boots transaction, 10 cents per share from LIFO provision and 5 cents per share from acquisition-related amortization costs.

For fiscal 2012, the company reported adjusted earnings of $2.93 per share, also surpassing the Zacks Consensus Estimate of $2.59 but unchanged from the previous year.

Since January 2012, Walgreen has not been a part of Express Scripts’ (ESRX - Analyst Report) pharmacy provider network, which has adversely affected its sales. This led to a negative impact of 6 cents per share (net off associated cost reduction) during the quarter and 21 cents per share during the fiscal year.

The company has already reported sales for the fourth quarter and fiscal 2012, which were at $17.1 billion, down 4.9% year over year and $71.64 billion, down 0.8%, respectively. With several branded drugs going generic, Walgreen’s sales were adversely affected by $664 million in the fourth quarter and by $1.4 billion in fiscal 2012.

Front-end comparable store sales (those open for more than a year) during the quarter dropped 1.3%. In addition, a 3.2% decline in customer traffic in comparable stores coupled with a 1.9% rise in basket size led to an 8.7% decline in total sales in comparable stores.

Prescription sales, accounting for 63.3% of sales in the quarter, declined 8.1%, while prescription sales in comparable stores were down 12.8%. Moreover, during the quarter, Walgreen filled 188 million prescriptions (down 6.9% year over year) while prescriptions filed at comparable stores dropped 8%.

Gross profit in the quarter dropped 4.6% year over year to $4.8 billion though gross margin expanded 10 basis points (bps) to 28.3%. Pharmacy margin benefited from generic drug sales, partially offset by market reimbursements, specialty pharmacy mix and LIFO. With selling, general and administrative (SG&A) expenses unchanged at $4.2 billion, operating margin during the quarter contracted 120 bps to 3.4%.

At the end of fiscal 2012, Walgreen had $1.3 billion in cash and cash equivalents, compared with $1.6 billion at the end of fiscal 2011. Moreover, during fiscal 2012, the company generated operating cash flow of $4.4 million, free cash flow of $2.9 billion and increased dividend rate in June, 2012 by 22.2% to 27.5 cents per share. During the fiscal year, the company returned $1.9 billion to shareholders through share repurchases and dividend payments.

Our Recommendation

Fiscal 2012 has been a challenging year for Walgreen as it experienced lower sales owing to the loss of contract with Express Scripts, high unemployment levels and lower discretionary spending. However, the company has undertaken several strategic initiatives. Significant among these being the 45% stake in Alliance Boots to become the world’s first pharmacy driven health and wellbeing retail.

Walgreen also acquired USA Drug, a mid-South’s regional drugstore chain. We expect these new ventures to boost growth going forward.

Moreover, with the resumption of the contract with Express Scripts sales are expected to improve, though winning back clients remains crucial. As a result, to stimulate customers’ demand amidst a challenging macroeconomic scenario, the company also launched a customer loyalty program.

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

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