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Q2 Earnings Miss at Walgreens

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Walgreen Co. reported adjusted net earnings of 91 cents per share in the second quarter of fiscal 2014, down 5.2% from the year-ago adjusted net earnings. The adjusted earnings also remained below the Zacks Consensus Estimate of 93 cents. On a reported basis, earnings came in at $754 million or 78 cents per share, down 0.2% or down 1.2% year over year, respectively.

Walgreens’ sales came in at $19,605 million in the quarter, up 5.1% year over year and marginally ahead of the Zacks Consensus Estimate of $19,547 million.

Quarter in Detail

Front-end comparable store (those open for at least a year) sales and basket size grew 2.0% and 3.4%, respectively, in the quarter. On the other hand, customer traffic in comparable stores was down 1.4%. Overall, comparable store sales improved 4.3%.

Prescription sales (accounting for 62.2% of total sales in the quarter) climbed 7.0% over the prior-year quarter, while prescription sales in comparable stores increased 5.8%. Moreover, Walgreens filled 214 million prescriptions (up 2.8% year over year) during the reported quarter.

Prescriptions filled at comparable stores rose 2.2%. As reported by IMS Health, Walgreens’ market share in retail pharmacy improved 20 basis points (bps) to 19.0% at the end of Feb 2014.

The company’s Balance Rewards loyalty program reached a milestone with approximately 100 million enrollees and 80 million active members at the end of the second quarter.

Gross profit increased a mere 0.8% year over year to $5.65 billion. However, gross margin contracted 125 bps to 28.8% due to fewer new generic drugs introduction, a less severe flu season and soft margin in front-end sales as the company made meaningful promotional investments to drive store traffic. The LIFO provision was $51 million in this year’s second quarter versus $72 million last year.

Selling, general and administrative (SG&A) expenses scaled up 1.6% to $4.6 billion. Operating margin contracted 44 bps to 5.5%.

The company opened/acquired 28 stores in the reported quarter compared with 29 in the year-ago quarter. As of Feb 28, 2014, the company operated in 8,681 locations in 50 states, the District of Columbia, Puerto Rico and Guam and the U.S. Virgin Islands, including 8,210 drugstores (138 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 second quarter with cash and cash equivalents of $1.77 billion, significantly lower than $2.4 billion as of Feb 28, 2013. Long-term debt was higher at $4.49 billion in the reported quarter, compared with $5.1 billion as of Feb 28, 2013.

Moreover, the company has generated year-to-date operating cash flow of $1.47 billion in the quarter compared with $1.17 billion in the same period last year.

Striding Ahead on Synergy Track

Walgreens’ partnership with Alliance Boots is yielding positive results, with combined first half of fiscal 2014 synergies of $236 million. In the second quarter, the Alliance Boots deal was accretive to adjusted earnings by 8 cents. The company estimates that accretion from Alliance Boots in the third quarter will be an adjusted 13 to 14 cents per share. Moreover, the company expects second-year combined synergy programin the range of$375-$425 million, an increase from the previous second-year estimate of $350-$400 million.

Our Take

Walgreens reported a mixed fiscal second quarter with a bottom line miss and a marginal beat on the top-line front.The generic wave in the pharmaceutical industry is still 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 on, the deal with Amerisource Bergen Corp. (ABC - Free Report) – likely to create a leader in the generic and branded drug purchasing space– is another major upside.

Walgreens currently has a Zacks Rank #3 (Hold). While we choose to remain on the sidelines regarding WAG at present, drug retailers like Rite Aid Corp. (RAD - Free Report) and CVS Caremark Corp. (CVS - Free Report) carrying a Zacks Rank #2 (Buy) are worth considering.

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