CHSI Catalyst Health Solutions, (MM)

Walgreen (WAG) reported adjusted earnings of 57 cents per share in the fourth quarter of fiscal 2011, beating the Zacks Consensus Estimate of 55 cents and were 38.3% higher than the year-ago quarter.

Results for the quarter excluded an after-tax gain of 30 cents per share associated with the company’s sale of pharmacy benefits management (PBM) business, Walgreens Health Initiatives, to Catalyst Health Solutions (CHSI). The result includes negative impact of 2 cents per share from Walgreen’s acquisition of drugstore.com and restructuring and restructuring-related costs of a penny per share associated with the company’s Rewiring for Growth initiative.

The year-ago quarter included negative impact of 4 cents per share from costs associated with the Duane Reade acquisition and 1 cent towards costs associated with Rewiring for Growth.

For fiscal 2011, the adjusted earnings came in $2.64 per share, beating the Zacks Consensus Estimate by 2 cents and prior-year adjusted earnings of $2.12 per share. The full year result excluded the after-tax gain on the sale of Walgreens Health Initiatives, included the effect of 3 cents per share in costs associated with Rewiring for Growth, 2 cents per share from the drugstore.com acquisition and 1 cent per share in Duane Reade related costs.

The company reported total sales of $18.0 billion for the fourth quarter, beating the Zacks Consensus Estimate of $17.8 billion. Total sales increased 6.5% from $16.9 billion reported in the year-ago period.  Comparable store sales (those open for more than a year) during the quarter increased 4.4% while front-end comparable drugstore sales were up 4.6%. For fiscal year 2011, total sales were up 7.1% year over year to $72.2 billion, surpassing the Zacks Consensus Estimate of $72.1 billion.

Prescription sales, accounting for 65.4% of sales in the quarter, leaped 5.7%, while prescription sales in comparable stores expanded 4.4%. Moreover, during the quarter, Walgreen filled 202 million prescriptions (up 4.0% year over year) and prescriptions filled in comparable stores jumped 3.4%. The company also increased its retail pharmacy market share to 20.0%.

The gross profit increased 5.8% year over year to $5.1 billion. However, during the quarter, lower front-end margins, combined with the flat retail pharmacy margins resulted in 20 basis points (bps) drag in the overall gross margin to 28.2%.

Selling, general and administrative (SG&A) expenses surged 4.8% year over year to $4.2 billion due to new store openings (contributing 2.0%) and drugstore.com acquisition (1%) related costs. Other expenses, including comparable store and headquarter expense, accounted for 1.8% of the increase. However, operating margin during the quarter expanded 262 bps to 7.04%.

At the end of the quarter, Walgreen had $1.5 billion in cash and cash equivalents, compared to $1.9 billion at the end of fiscal 2010. The company generated $3.6 billion in cash flow from operations during fiscal 2011. Moreover, during the year, the company returned $2.4 billion to shareholders through share repurchases and dividends. Additionally, in July, the company announced a new $2 billion share repurchase program and increased its quarterly dividend rate by 28.6%.

In addition, Walgreens opened/acquired 59 new in the fourth quarter compared with 65 in the year-ago quarter. For the full year, the company added 199 new drugstores including 32 acquisitions, based on the target of organic store growth in the range of 2.5%-3% during 2011.

Our Recommendation

We are encouraged by Walgreen’s strategic decisions to align its assets with core strategies. These encompass several recent acquisitions including the takeover of drugstore.com. and selling of its PBM business. Moreover, the company has made satisfactory progress with respect to meeting the targeted savings under the rewiring initiative. The benefits from these initiatives will be experienced over a period of time. Walgreen is also aggressively tackling this year’s flu season with its new flu shot program.

However, we are concerned based on the impact of the current high unemployment levels and lower discretionary spending. Moreover, the company faces intense competition from major players like CVS Caremark (CVS) and Rite Aid Corporation (RAD).

In addition, Walgreen decided not to renew its agreement with Express Scripts (ESRX) citing certain disagreements. With this move, effective January 1, 2012, Walgreen’s 7,700 pharmacies will not be a part of Express Scripts’ pharmacy provider network. Walgreen estimates that Express Scripts, as a pharmacy benefits manager, processes 90 million prescriptions that are not expected to be filled by Walgreen in fiscal 2012, representing approximately $5.3 billion in annual sales. Thus, we believe the decision not to renew the contract will affect the company’s future growth.

Walgreen currently retains a Zacks #4 Rank (short-term Sell rating). However, we are encouraged by the company’s hard work toward establishing itself as a leading provider of pharmacy, health and wellness solutions and thus are confident about the longer term potentiality of the company. Presently, we remain Neutral on the stock.

 
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