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Weak economy, pharmacy margin woes dampen Walgreens’ sales, hit earnings

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DEERFIELD, Ill. Weak consumer spending, a squeeze in pharmacy margins and a drop-off in demand for products to treat influenza combined to hammer Walgreens in its fiscal 2010 third quarter. But company leaders maintained that Walgreens’ revitalization plan remains on track.

Net earnings for the period ended May 31 lagged prior-year levels by more than 11%, coming in at $463 million, or 47 cents per share, versus $522 million in the third quarter of last year. This year’s earnings were negatively impacted by several factors, including the elimination of the tax benefit for the Medicare Part D subsidy for retiree benefits resulting from the enactment of the Patient Protection and Affordable Care Act.

Also affecting this year’s results were costs associated with the Duane Reade acquisition and restructuring, as well as restructuring-related costs associated with the company’s Rewiring for Growth initiative. Together, those three factors drained seven cents per share from Walgreens’ bottom line, the company reported today.

Third-quarter sales increased 6.1% from the prior-year quarter to a record $17.2 billion, and increased 6.1% to $50.6 billion for the first nine months of fiscal 2010. But comp-store sales were flattened by weak consumer spending, increasing just 0.7%. Same-store results at the front end were even weaker, rising just 0.1% due to “continued weak demand for discretionary goods and by lower demand for flu-related products compared with the year-ago quarter,” Walgreens reported.

Prescription sales rose 5.7% overall and 1% on a comp-store basis, according to the company, and accounted for 65.4% of sales in the quarter.

Walgreens president and CEO Greg Wasson acknowledged the company’s current predicament. The pharmacy and health services giant, he said, is grappling with both economic headwinds and lackluster prescription drug development, along with the high costs of its own renewal efforts. “We anticipated this would be a challenging quarter for several reasons, including the sluggish economy [and] prescription reimbursement pressure compounded by a slowdown in the rate of introduction of new generics, [as well as] a lower incidence of flu compared with the beginning of the H1N1 pandemic a year ago,” Wasson said. “While we saw a number of positive signs in the quarter and reached several important milestones, we also realize there is more to be done.”

Nevertheless, added Walgreens’ top executive, the company sees positive signs. “During the quarter, we achieved record sales [and] a record number of prescriptions filled, continued growth in our retail pharmacy market share and continued generation of strong cash flow,” Wasson pointed out. “We also are seeing an improvement in our Customer Centric Retailing stores and an expansion of opportunities for our new Pharmacy, Health and Wellness Solutions. At the same time, we are directly addressing the reimbursement pressures we are seeing and following through on the cost-control initiatives associated with Rewiring for Growth. Looking ahead, we remain cautious on the economy and confident in our strategies.”

Wasson pointed to some recent milestones for the company. Among them the April purchase and ongoing integration of 258 Duane Reade stores across the New York metro area, which he predicted will yield $120-$130 million in synergies from the acquisition over the next three years; the rollout of the CCR initiative to more than 1,200 stores nationwide; and the progress of cost-reduction efforts through Walgreens’ Rewiring for Growth initiative. The company said it is “on target for net pre-tax savings of $500 million this fiscal year, and $1 billion in annual savings beginning in fiscal 2011.”

Walgreens also filled a record 198 million prescriptions in the third quarter. “With the passage of healthcare reform, we have the assets to provide holistic solutions to employers’ healthcare needs,” Wasson said. “For consumers, we are planning another comprehensive flu shot program this fall, as one example of our expanded vaccination and immunization program.”

Despite that upbeat outlook, Walgreens’ inability to maintain its earnings growth in recent months somewhat has shaken Wall Street’s faith in the short-term potential of the pharmacy and retail giant, whose stock was long considered a rock-solid and predictable source of investment gains as the company chalked up year after year of record sales and earnings. This morning, the company’s stock price dropped more than 6%, and financial analysts were mulling the numbers and issuing cautionary statements about Walgreens’ short-term investment potential.

Reuters, for instance, now rates the company as “underperform.” And in a report this morning, investment bank Morgan Stanley noted, “We expect weak sales to dominate the debate over WAG shares in the near-term.” However, noted the bank, “Longer-term, we are attracted to rising margin power from the ramp in generic drugs in 2012.” Standard & Poors also noted the “longer-term benefits from an acceleration in generic drug introductions in late [fiscal-year] 2011,” as well as “improving employment trends, acquisition synergies and remodeling benefits.” This morning, the ratings firm maintained its “buy” recommendation on Walgreens’ stock.

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