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Walgreen Plans to Offset ESRX Loss

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Walgreen is commencing the New Year with efforts aimed at minimizing the impact of the non-renewal of the Express Scripts (ESRX - Free Report) contract, which has just lapsed. With the intention of retaining Express Scripts’ clients, Walgreen recently came up with its comprehensive Patient Transition Plan, which will help smoothen the transition of existing members of the Express Scripts pharmacy network to another community pharmacy. Under this plan, Walgreen is providing several discounts to the members of Walgreen Prescriptions Savings Club, which facilitates savings on over 8,000 brand names and all generic drugs.

The six-month dispute regarding the Express Scripts contract took its toll on Walgreen’s first quarter 2012 results. The company’s bottom-line was impacted by 2 cents per share from the loss of pharmacy sales and expenses associated with the dispute. With the termination of the Express Scripts contract, effective January 1, 2012, Walgreen’s 7,800 pharmacies are no longer a part of Express Scripts’ pharmacy provider network.

The contract accounted for $5.3 billion of sales in fiscal 2011 as Express Scripts processed 88 million prescriptions filled by Walgreen. In the recently concluded quarter, the pharmacy benefit manager processed as many as 26 million prescriptions from Walgreen.

However, Walgreen is expanding its business with other payers and customers and implementing cost-control initiatives. The company is reassured by the fact that more than 100 of Express Scripts clients, encompassing health plans and employers, would continue with Walgreen pharmacies in 2012. The company aims to retain 10 million prescriptions annually and maintain 97-99% of the 2011 prescription volumes at fiscal 2012 end. This guidance takes into account the loss of major Express Scripts clients such as the Department of Defense Tricare plan and WellPoint .

Considering that almost 75% of the business from Express Scripts’ clients would be lost, Walgreen expects to offset 50% of the gross profit reduction in fiscal 2012 by leveraging selling, general and administrative expenses and cost of goods sold. However, the majority of these cost cuts are expected to take effect from the latter half of fiscal 2012. Additional reimbursement pressure may crop up for Walgreen if the proposed merger between Express Scripts and Medco Health Solutions takes place.

Our Take

Amidst a fiercely competitive landscape, major retailers are also trying their best to lure Express Scripts patients who would otherwise lose access to Walgreen pharmacies beginning 2012. Jewel-Osco, a Supervalu company, is trying to get hold of Walgreen customers with their 173 operational stores and is also planning to hire additional manpower to cater to these new patients. Besides, CVS Caremark (CVS - Free Report) with its 7,304 retail drugstores is also in the race.

Despite the competitive scenario, we are optimistic about Walgreen’s long-term prospects. The introduction of new generic drugs 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. During the last reported quarter, the company enhanced shareholders’ value through dividend payments and share repurchases amounting to $803 million ($601 million in share repurchases and $202 million in dividends). In the last eight years, the company’s dividend has grown at a compound annual growth rate (“CAGR”) of nearly 22%.

Currently, we are Neutral on Walgreen, which corresponds to the Zacks #3 Rank (Short-term ‘Hold’ rating).

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