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Longs Drug Stores 10-Q 2007 Table of ContentsUNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549
FORM 10-Q
(Mark One)
For the quarterly period ended July 26, 2007
For the transition period from to Commission file number 1-8978
LONGS DRUG STORES CORPORATION (Exact name of registrant as specified in its charter)
(925) 937-1170 (Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act): Yes ¨ No x There were 37,759,570 shares of common stock, $.50 par value per share, outstanding as of July 26, 2007.
Table of ContentsCAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS This quarterly report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Such statements relate to, among other things, our strategic initiatives; supply chain changes; Medicare prescription drug benefits; development of our pharmacy benefit services segment; merchandise and marketing efforts; operational improvements; safety improvements and workers’ compensation claims and costs; the number of store openings, closures and remodels; revenues; pharmacy reimbursements; gross profits; operating and administrative expenses; depreciation and amortization; liquidity and cash requirements; level of capital expenditures; share repurchases; dividends; effective tax rates; contractual obligations; the effect of new accounting pronouncements; our goals for self-distribution of our front-end merchandise; and factors affecting front-end sales in fiscal 2008 and are indicated by words or phrases such as “continuing,” “expects,” “estimates,” “believes,” “plans,” “anticipates,” “will” and other similar words or phrases. These forward-looking statements are based on our current plans and expectations and involve risks and uncertainties that could cause actual events and results to vary materially from those included in or contemplated by forward-looking statements we make. These risks and uncertainties include, but are not limited to, those set forth below:
In addition, because we do not have a comprehensive perpetual inventory system, our ability to accurately forecast and track our retail drug store gross profit and inventory levels during periods between our quarterly physical inventories is limited. Therefore, our actual retail drug store gross profit and inventory levels may vary materially from those included in or contemplated by forward-looking statements we make. We assume no obligation to update our forward-looking statements to reflect subsequent events or circumstances.
Table of ContentsTABLE OF CONTENTS
Table of ContentsPART I—FINANCIAL INFORMATION
CONDENSED STATEMENTS OF CONSOLIDATED INCOME (unaudited)
See notes to condensed consolidated financial statements.
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Table of ContentsCONDENSED CONSOLIDATED BALANCE SHEETS (unaudited)
See notes to condensed consolidated financial statements.
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Table of ContentsCONDENSED STATEMENTS OF CONSOLIDATED CASH FLOWS (unaudited)
See notes to condensed consolidated financial statements.
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Table of ContentsCONDENSED STATEMENTS OF CONSOLIDATED STOCKHOLDERS’ EQUITY (unaudited) For the 52 weeks ended January 25, 2007 and the 26 weeks ended July 26, 2007
See notes to condensed consolidated financial statements.
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Table of ContentsNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. Basis of Presentation The accompanying interim condensed consolidated financial statements include the financial statements of Longs Drug Stores Corporation (“Longs” or the “Company”) and its wholly-owned subsidiaries. All significant inter-company accounts and transactions have been eliminated. The interim condensed consolidated financial statements have been prepared on a basis consistent in all material respects with the accounting policies described and applied in the Annual Report of the Company on Form 10-K for the fiscal year ended January 25, 2007, except for the accounting change discussed in Note 2, and reflect all adjustments that are, in management’s opinion, necessary for a fair presentation of the results for the periods presented. The condensed consolidated financial statements as of and for the periods ended July 26, 2007 and July 27, 2006 are unaudited. The condensed consolidated balance sheet as of January 25, 2007, and condensed consolidated statement of stockholders’ equity for the year then ended, presented herein, have been derived from the audited consolidated financial statements of the Company included in the Form 10-K for the fiscal year ended January 25, 2007. Reclassifications have been made to certain prior period amounts to conform to the fiscal 2008 presentation, including the combination of depreciation and amortization expenses with operating and administrative expenses on our condensed statements of consolidated income, and the separate presentation of various current liabilities on our condensed consolidated balance sheets. The condensed statement of consolidated income for the 13 and 26 weeks ended July 27, 2006, has been revised to present certain components as discontinued operations (see Note 3). Certain information and footnote disclosures normally included in the annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted. The interim condensed consolidated financial statements should be read together with the financial statements in the Company’s Annual Report on Form 10-K for the fiscal year ended January 25, 2007. 2. Accounting Change In the first quarter of fiscal 2008, the Company adopted FASB Interpretation No. (“FIN”) 48, Accounting for Uncertainty in Income Taxes, which clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 109, Accounting for Income Taxes. FIN 48 requires the recognition of tax positions when it is more likely than not that such positions will be sustained upon examination. Tax positions that meet this recognition threshold are to be measured at the largest amount of tax benefit that is cumulatively greater than 50% likely of being realized upon settlement with the taxing authority. The adoption of FIN 48 resulted in a $0.5 million decrease to retained earnings for the cumulative effect of the change in accounting principle as of January 26, 2007 (the first day of fiscal 2008). The Company’s total unrecognized tax benefits, including the portion that would affect the Company’s effective tax rate if recognized, are not material. The Company’s federal income tax returns for the years ended January 2004 and later are subject to examination by the Internal Revenue Service (“IRS”) under the federal statute of limitations. The Company’s California income tax returns for the years ended January 2003 and later are subject to examination by the California Franchise Tax Board under California’s statute of limitations. Income tax returns for the Company’s other major state jurisdictions are subject to examination by the respective state tax authorities for the years ended January 2004 and later. During fiscal 2008, the IRS commenced an examination of the Company’s federal income tax returns for the years ended January 29, 2004 and January 27, 2005. It is reasonably possible that the outcome of this examination could result in an adjustment to the Company’s unrecognized tax benefits in the next 12 months. However, the amount and timing of the adjustment, if any, cannot be estimated at this time. The Company includes interest and penalties related to income taxes in income tax expense on the statement of consolidated income and in taxes payable (the non-current portion of which is included in other long-term liabilities) on the consolidated balance sheet. Such amounts are not material to any period presented.
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Table of ContentsLONGS DRUG STORES CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
3. Store Dispositions In February 2007, the Company’s board of directors approved a plan to dispose 31 stores during fiscal 2008, including all of the 23 stores located in Washington, Oregon and Colorado and eight stores in California. Most of the stores were located in markets the Company entered in the 1980’s and 1990’s that remained underdeveloped. Sufficiently developing the Company’s presence in these markets would have required significant investment that management believed would be better directed toward markets that offer greater opportunities for more satisfactory returns. As of July 26, 2007, the Company had closed 30 of these stores. Approximately two-thirds of the store locations have been sold or sub-leased and the remainder are being actively marketed. One California store remains open as the Company evaluates alternatives related to this store. Each of these 31 stores constitutes a “component” as defined in SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. The stores located in Washington, Oregon and Colorado are reported as discontinued operations effective in fiscal 2008 in accordance with SFAS No. 144, and as such both current and prior year results for these stores are classified within discontinued operations on the Company’s condensed statements of consolidated income. Net property – primarily land, buildings and leasehold improvements – of $4.2 million associated with these stores is classified in assets held for sale as of July 26, 2007. The eight stores located in California are reported within continuing operations. The Company records the net costs associated with the disposition of these 31 stores as the stores are sold or closed and the related assets are disposed of, in accordance with SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. For the eight stores located in California, such total net costs are estimated to be approximately $10.5 million to $13.0 million pre-tax (or $6.3 million to $7.8 million after tax), primarily for lease-related costs net of sublease income and severance. During the 26 weeks ended July 26, 2007, the Company incurred $9.6 million of such pre-tax net costs, which are included in the provision for store closures and asset impairments within continuing operations. The Company expects to incur pre-tax net losses of approximately zero to $2.3 million (zero to $1.4 million after tax) from discontinued operations related to the disposition of the 23 stores located in Washington, Oregon and Colorado, for the fiscal year ending January 31, 2008. During the 26 weeks ended July 26, 2007, the Company incurred a pre-tax net loss of $3.5 million ($2.1 million after tax) in discontinued operations for these 23 stores. This pre-tax net loss included costs of $10.7 million for lease-related costs net of estimated sublease rental income and $3.3 million for employee severance, and pre-tax operating losses of $7.3 million, offset by $17.8 million of pre-tax gains on the sale of store properties and related assets. Results from discontinued operations were as follows:
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Table of ContentsLONGS DRUG STORES CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
Following is a summary of the reserve for store closures, which is included in other long-term liabilities, for the first half of fiscal 2008 (in thousands):
4. Acquisitions In the first quarter of fiscal 2008, the Company purchased the assets of six retail pharmacies, including four from PharMerica, Inc., a subsidiary of AmerisourceBergen Corporation, for a total of $10.2 million. These acquisitions increased the Company’s portfolio of smaller retail pharmacies, many of which are close to the point of care, such as hospitals, clinics and medical office buildings. Three of the acquired stores are located in California, and three are in Hawaii. The Company allocated the $10.2 million total acquisition cost to pharmacy prescription files ($8.3 million), inventory ($1.8 million) and property and equipment ($0.1 million). The results of operations of the acquired locations are included in the Company’s consolidated financial statements within the retail drug store segment as of their various acquisition dates. The pro forma effects of these acquisitions on the Company’s consolidated financial statements for periods prior to the acquisitions are not significant, either individually or in the aggregate. During the second quarter of fiscal 2008, the Company acquired the assets of six stores in the Reno, Nevada area from Rite Aid Corporation (“Rite Aid”) and sold to Rite Aid assets of certain of the stores included in the Company’s disposition plans announced in February 2007 (see Note 3). This transaction increased the Company’s presence in the Reno area while accelerating the disposition of stores in Washington and Oregon. The Company accounted for this purchase and sale transaction based on the fair values of the net assets exchanged. The Company allocated the $4.2 million total fair value of net assets acquired to property and equipment ($4.4 million), inventory ($3.3 million) and pharmacy prescription files ($3.2 million), partially offset by under market lease obligations ($6.7 million). The results of operations of the acquired stores are included in the Company’s consolidated financial statements within the retail drug store segment as of their acquisition date. The pro forma effects of the acquisition of these six stores on the Company’s consolidated financial statements for periods prior to the acquisition are not significant, either individually or in the aggregate.
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Table of ContentsLONGS DRUG STORES CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
5. Earnings Per Share Basic earnings per share are computed by dividing income by the weighted average number of common shares outstanding during the period. Diluted earnings per share are computed by dividing income by the weighted average number of common shares and dilutive common equivalent shares (stock options and restricted stock awards) outstanding during the period. The following is a reconciliation of the number of shares used in the Company’s basic and diluted earnings per share computations:
The computation of diluted earnings per share excluded 0.1 million and 0.2 million stock option shares for the 13 weeks ended July 26, 2007, and July 27, 2006, respectively, and 0.2 million and 0.5 million for the 26 weeks ended July 26, 2007, and July 27, 2006, respectively, because their inclusion would have been anti-dilutive. 6. Merchandise Inventories Merchandise inventories are stated at the lower of cost or market value. Cost is determined using the last-in, first-out (LIFO) method. The excess of current cost over LIFO values was $200.9 million as of July 26, 2007, $188.4 million as of July 27, 2006, and $195.9 million as of January 25, 2007. LIFO costs for interim financial statements are estimated based on projected annual inflation rates, inventory levels, and merchandise mix. Actual LIFO costs are calculated during the fourth quarter of the fiscal year when final inflation rates, inventory levels and merchandise mix are determined.
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Table of ContentsLONGS DRUG STORES CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
7. Goodwill and Intangible Assets All of the Company’s goodwill and other intangible assets are included in the retail drug store segment. Goodwill and other intangible assets with indefinite useful lives are not amortized, but are subject to impairment testing annually or whenever events or changes in circumstances indicate that their carrying values may not be recoverable. The Company’s intangible assets other than goodwill include the following:
The increase in pharmacy prescription files was primarily due to the acquisition of 12 stores during the first half of fiscal 2008 (see Note 4). Amortization expense for intangible assets with finite useful lives was $1.9 million and $0.5 million for the 26-week periods ended July 26, 2007 and July 27, 2006, respectively. Estimated future annual amortization expense of these intangibles is as follows (in thousands):
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Table of ContentsLONGS DRUG STORES CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
8. Debt Debt at July 26, 2007 and January 25, 2007 consisted of the following:
The Company’s debt agreements contain customary restrictions, and the private placement notes also include various customary financial covenants. As of July 26, 2007, the Company was in compliance with the restrictions and limitations included in these provisions. 9. Commitments and Contingencies Rankin v. Longs Drug Stores California, Inc. was filed in the Superior Court of California, San Diego County, in October 2004, and was subsequently certified as a class action. The lawsuit alleges that the Company’s employment application violates California Labor Code Section 432.8 by inquiring about criminal convictions within the last seven years, without providing an exception for misdemeanor marijuana convictions more than two years old. The plaintiff seeks to recover statutory damages and attorneys’ fees for himself and all similarly situated individuals who applied for employment with the Company during the class period. The Company is vigorously defending this litigation. The trial commenced on August 20, 2007. The financial impact to the Company, if any, cannot be estimated at this time. During the third quarter of fiscal 2007, the Company completed a self-audit of certain of its California drug stores located in three counties that was initiated at the request of the State of California Department of Industrial Relations (“DIR”). The audit related to compliance with California law relating to meal period requirements. The Company made compensatory payments resulting from this audit, which were not material, during the fourth quarter of fiscal 2007. The DIR has also requested that the Company conduct an audit related to meal period compliance for all of its California drug stores. At this time the Company cannot reasonably estimate the amount of any possible payments that might be required as a result of an additional audit. In addition to the matters described above, the Company is subject to various lawsuits, claims and federal and state regulatory reviews and actions arising in the normal course of its businesses. The Company accrues amounts it believes are adequate to address the liabilities related to lawsuits and other proceedings that it believes will result in a probable loss if the loss can be reasonably estimated. However, the ultimate resolution of such matters is uncertain and outcomes are not predictable with assurance. It is possible that the matters described above or other proceedings brought against the Company could have a material adverse impact on its financial condition and results of operations. 10. Segment Information The Company operates in two business segments: retail drug stores and pharmacy benefit services. These segments were identified based on their separate and distinct products and services, technology, marketing strategies and management reporting. Management evaluates the segments’ operating performance separately and allocates resources based on the segment’s respective financial condition, results of operations and cash flows. Inter-segment transactions and balances are eliminated in consolidation. Pharmacy is the cornerstone of the retail drug store segment, complemented by such core front-end categories as cosmetics, over-the-counter medications, health and beauty products, photo and photo processing, and food and beverage items. As of July 26, 2007, the retail drug store segment operated 492 retail stores in the western United States, primarily under the names Longs, Longs Drugs, Longs Drug Stores and Longs Pharmacy. The retail drug store segment also operates a mail order pharmacy business.
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Table of ContentsLONGS DRUG STORES CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
The pharmacy benefit services segment, operated through the Company’s subsidiary, RxAmerica LLC, provides pharmacy benefit management services whereby RxAmerica contracts with third-party health plans, retail pharmacies and drug manufacturers to provide a range of services to third-party health plan members, including pharmacy benefit plan design and implementation, claims administration and formulary management. The pharmacy benefit services segment also operates prescription drug plans under Medicare Part D as established by the Medicare Prescription Drug, Improvement, and Modernization Act of 2003. The following tables summarize significant financial information by segment:
Consolidated total revenues include the following product and service types:
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Table of Contents
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read together with our consolidated financial statements and the related notes. This discussion contains forward-looking statements relating to, among other things, matters set forth under “Cautionary Statement Regarding Forward-Looking Statements.” Our actual results and the timing of events could differ materially from those anticipated in these forward-looking statements as a result of many factors, including, but not limited to, those set forth in the following discussion, under “Cautionary Statement Regarding Forward-Looking Statements” and under “Risk Factors” in our Annual Report on Form 10-K for fiscal year 2007 and elsewhere in this Form 10-Q. OVERVIEW Longs Drug Stores Corporation is one of the most recognized retail drug store chains on the West Coast and in Hawaii. With 492 stores as of July 26, 2007, we provide expert pharmacy services and a wide assortment of merchandise focusing on health, wellness, beauty and convenience. We also provide pharmacy benefit services, including pharmacy benefit management and Medicare beneficiary prescription drug plans, through our wholly-owned subsidiary, RxAmerica L.L.C. We participate in the Medicare drug benefit program through both our retail drug store pharmacies and our pharmacy benefit services subsidiary. RxAmerica has contracted with the federal Centers for Medicare and Medicaid Services (“CMS”) to be a prescription drug plan sponsor in all 50 states and the District of Columbia. Our financial results for the first half of fiscal 2008 reflect the progress we have made on our initiatives to make Longs a stronger competitor and more profitable company. We made significant progress on our initiatives to improve our profitability and the longer term growth prospects of our core retail business by realigning and upgrading our store base, increasing our self-distribution of front-end merchandise, installing supply chain system technology and improving our operations. Our consolidated results also reflect the continued profitable growth of our pharmacy benefit services segment. In February 2007, we announced a plan to dispose 31 stores during fiscal 2008, including all of our 23 stores located in Washington, Oregon and Colorado and eight stores in California. Most of the stores were located in markets we entered in the 1980’s and 1990’s that remained underdeveloped. Sufficiently developing our presence in these markets would have required significant investment that we believed would be better directed toward markets that offer greater opportunities for more satisfactory returns. We, therefore, decided to close the stores and market the assets. As of July 26, 2007, we have closed 30 of these stores. Approximately two-thirds of the store locations have been sold or sub-leased and the remainder are being actively marketed. One California store has remained open while we evaluate alternatives related to this store.
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Table of ContentsRESULTS OF OPERATIONS Revenues
Thirteen Weeks Ended July 26, 2007 versus Thirteen Weeks Ended July 27, 2006 Total revenues increased 3.0% in the second quarter of fiscal 2008 over the second quarter of fiscal 2007. Retail drug store sales were $1.20 billion, a 2.9% increase over the second quarter of fiscal 2007, with same-store sales increasing 1.0%. Growth in the number of stores and higher mail order sales also contributed to total retail drug store sales growth. Pharmacy benefit services revenues were $79.0 million in the second quarter of fiscal 2008, a 4.8% increase over the second quarter of fiscal 2007. Pharmacy benefit management revenues increased $6.7 million, or 102.0%, while prescription drug plan revenues decreased $3.1 million, or 4.5%. Retail Drug Store Sales Pharmacy sales increased 5.2% in the second quarter of fiscal 2008 over the second quarter of fiscal 2007, with same-store pharmacy sales increasing 1.8%. The increase in same-store pharmacy sales was primarily due to continued increases in average prescription prices. Average prescription prices increased due to pharmaceutical cost inflation and the continued introduction and utilization of newer and more expensive drugs. The increase in average prescription prices was mitigated in part by the increased utilization of lower-priced generic drugs. We estimate that generic utilization negatively impacted our same-store pharmacy sales by approximately 5.4 to 5.6 percentage points. We expect that average retail prices for prescription drugs will continue to rise due to pharmaceutical cost inflation and the continued introduction and utilization of newer and more expensive drugs, partially offset by continuing increases in utilization of generic drugs. Pharmacy sales were 51.3% of total drug store sales in the second quarter of fiscal 2008, compared with 50.2 % in the second quarter of fiscal 2007. We expect pharmacy sales to continue to increase as a percentage of total drug store sales as pharmacy sales continue to increase faster than front-end sales.
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Table of ContentsThird-party health plans covered 94.8% of our pharmacy sales in the second quarter of fiscal 2008, compared with 94.4% in the same quarter last year. We expect third-party sales to remain over 90% of our total pharmacy sales for the foreseeable future due to significant consumer participation in managed care and other third-party plans, including the new Medicare prescription drug plans. Front-end sales increased 0.6% in the second quarter of fiscal 2008 from the same quarter last year, with same-store front-end sales increasing 0.3%. The increase was primarily due to the performance in our core categories of health, wellness, beauty and convenience as a result of our on-going merchandise strategy. Pharmacy Benefit Services Revenues Pharmacy benefit management revenues were $13.3 million, compared with $6.6 million in the second quarter of fiscal 2007. Last year’s second quarter pharmacy benefit management revenues included a reduction of $3 million due to adjustments of certain rebate accruals recorded during that quarter. RxAmerica’s Medicare prescription drug plan revenues were $65.7 million compared with $68.8 million in the second quarter of last year. Prescription drug plan revenues include fixed monthly premiums paid by beneficiaries and CMS, as well as a CMS risk share component. The fixed monthly premiums are recognized on a straight-line basis over the coverage period. The risk share component is variable and can cause revenues to fluctuate from period to period. Twenty-Six Weeks Ended July 26, 2007 versus Twenty-Six Weeks Ended July 27, 2006 Total revenues increased 4.3% in the first half of fiscal 2008 over the first half of fiscal 2007. Retail drug store sales were $2.38 billion, a 3.6% increase over the first half of fiscal 2007, with same-store sales increasing 1.5%. Growth in the number of stores and higher mail order sales also contributed to total retail drug store sales growth. Pharmacy benefit services revenues were $191.0 million in the first half of fiscal 2008, a 13.2% increase over the first half of fiscal 2007. Pharmacy benefit management revenues increased $11.1 million, or 62.7%, while prescription drug plan revenues increased $11.1 million, or 7.4%. Retail Drug Store Sales Pharmacy sales increased 5.7% in the first half of fiscal 2008 over the first half of fiscal 2007, with same-store pharmacy sales increasing 2.4%. The increase in same-store pharmacy sales was primarily due to continued increases in average prescription prices. Average prescription prices increased due to pharmaceutical cost inflation and the continued introduction and utilization of newer and more expensive drugs. The increase in average prescription prices was mitigated in part by the increased utilization of lower-priced generic drugs. Pharmacy sales were 51.8% of total drug store sales in the first half of fiscal 2008, compared with 50.8 % in the first half of fiscal 2007. Third-party health plans covered 94.9% of our pharmacy sales in the first half of fiscal 2008, compared with 94.1% in the same period last year. Front-end sales increased 1.5% in the first half of fiscal 2008 from the same period last year, with same-store front-end sales increasing 0.7%. The increase was primarily due to continued improved performance in our core categories of health, wellness, beauty and convenience as a result of our on-going merchandise strategy to improve our profitability by focusing on these categories. Pharmacy Benefit Services Revenues The increase in pharmacy benefit services revenues in the first half of fiscal 2008 reflects the continued growth of RxAmerica, our pharmacy benefit services subsidiary. Pharmacy benefit management revenues were $28.7 million, an increase of 62.7% from $17.7 million in the first half of fiscal 2007. Last year’s pharmacy benefit management revenues included a reduction of $3 million due to adjustments of certain rebate accruals recorded during the second quarter. RxAmerica’s Medicare prescription drug plan revenues were $162.2 million, an increase of 7.4% from $151.1 million in the first half of fiscal 2007.
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Table of ContentsGross Profit
Thirteen Weeks Ended July 26, 2007 versus Thirteen Weeks Ended July 27, 2006 Retail Drug Stores Retail drug store gross profit was 26.3% of retail drug store sales in the second quarter of fiscal 2008, compared with 25.3% in the second quarter of fiscal 2007. The increase was primarily due to merchandise mix, improved inventory management, increased self-distribution of front-end merchandise and increased generic utilization. Our LIFO provision, which is included in the cost of retail drug store sales, was $2.0 million and $3.3 million in the second quarter of fiscal 2008 and fiscal 2007, respectively. The LIFO provision fluctuates with inflation rates, inventory levels and merchandise mix. We estimate LIFO costs for interim financial statements based on projected annual inflation rates, inventory levels and merchandise mix. We calculate actual LIFO costs during the fourth quarter of the fiscal year when we determine final inflation rates, inventory levels and merchandise mix. Prescription Drug Plans (Pharmacy Benefit Services Segment) Prescription drug plan benefit costs relate only to prescription drug plan revenues. Revenues generated from pharmacy benefit management services are reported net of reimbursements to participating pharmacies. Prescription drug plan gross profit was 17.5% of prescription drug plan revenues in the second quarter of fiscal 2008, compared with 14.6% in the same period last year. The increase was primarily due to increased generic utilization. Twenty-Six Weeks Ended July 26, 2007 versus Twenty-Six Weeks Ended July 27, 2006 Retail Drug Stores Retail drug store gross profit was 26.0% of retail drug store sales in the first half of fiscal 2008, compared with 25.1% in the same period last year. The increase was primarily due to improved inventory management, increased self-distribution of front-end, increased generic utilization and merchandise mix. The effects of these factors were partially offset by the negative impact of lower reimbursement levels on our pharmacy sales. Our LIFO provision, which is included in the cost of retail drug store sales, was $5.0 million and $5.3 million in the first half of fiscal 2008 and fiscal 2007, respectively. Prescription Drug Plans (Pharmacy Benefit Services Segment) Prescription drug plan gross profit was 9.6% of prescription drug plan revenues in the first half of fiscal 2008, compared with 10.0% in the same period last year. The decrease was primarily due to more competitive bidding by prescription drug plan sponsors in the second year of the Medicare prescription drug benefit resulting in lower premiums as we expanded our prescription drug plans to all 50 states. Operating and Administrative Expenses Operating and administrative expenses were $295.0 million, or 23.1% of revenues, and $581.3 million, or 22.6% of revenues, in the second quarter and first half of fiscal 2008, respectively, compared with $280.0 million, or 22.6% of revenues, and $552.0 million, or 22.4% of revenues, in the second quarter and first half of fiscal 2007, respectively. The increase in operating and administrative expenses is primarily due to store expansion.
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Table of ContentsProvision for Store Closures and Asset Impairments The provision for store closures and asset impairments of $0.4 million in the second quarter and $9.6 million in the first half of fiscal 2008 primarily includes lease-related costs, net of estimated sublease income, related to the planned disposition of eight stores in California as announced in February 2007. We closed or sold seven of the eight stores during the first half of fiscal 2008. We expect to incur total net pre-tax costs of approximately $10.5 million to $13.0 million in fiscal 2008 related to the disposition of these stores. Costs related to the planned disposition of 23 stores in Washington, Oregon and Colorado are included in discontinued operations. See Note 3 to our Condensed Consolidated Financial Statements and “Discontinued Operations” below for further information. Net Interest Expense Net interest expense was $1.5 million and $3.0 million in the second quarter and first half of fiscal 2008, respectively, compared with $0.8 million and $1.2 million in the second quarter and first half of fiscal 2007, respectively. The increase was a result of higher average borrowings and less invested cash. Income Taxes Our effective income tax rate was 39.9% and 39.7% in the second quarter and first half of fiscal 2008, respectively, compared with 34.8% and 36.7% in the second quarter and first half of 2007, respectively. The lower effective tax rates in fiscal 2007 reflect the resolution of certain tax matters in the second quarter last year. We expect that our effective income tax rate for the full 2008 fiscal year will be approximately 39%. Discontinued Operations In February 2007, we announced a plan to dispose 31 stores during fiscal 2008, including all of the 23 stores located in Washington, Oregon and Colorado and eight stores in California. Most of the stores were located in markets we entered in the 1980’s and 1990’s that remained underdeveloped. Sufficiently developing our presence in these markets would have required significant investment that we believed would be better directed toward markets that offer greater opportunities for more satisfactory returns. As of July 26, 2007, we had closed 30 of these stores. Approximately two-thirds of the store locations have been sold or sub-leased and the remainder are being actively marketed. One California store remains open as we evaluate alternatives related to this store. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the stores located in Washington, Oregon and Colorado are reported as discontinued operations effective in fiscal 2008, and as such both current and prior year results for these stores are classified within discontinued operations on our condensed statements of consolidated income. The eight stores located in California will continue to be reported within continuing operations. We record the net costs associated with the disposition of these 31 stores during fiscal 2008 as the stores are sold or closed and the related assets are disposed of, in accordance with SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. We expect to incur pre-tax net losses of approximately zero to $2.3 million (zero to $1.4 million after tax) from discontinued operations related to the disposition of the 23 stores located in Washington, Oregon and Colorado, for the fiscal year ending January 31, 2008. During the 26 weeks ended July 26, 2007, we incurred a pre-tax net loss of $3.5 million ($2.1 million after tax) in discontinued operations for these 23 stores. This pre-tax net loss included costs of $10.7 million for lease-related costs net of estimated sublease rental income and $3.3 million for employee severance, and pre-tax operating losses of $7.3 million, offset by $17.8 million of pre-tax gains on the sale of store properties and related assets.
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Table of ContentsLIQUIDITY AND CAPITAL RESOURCES General Our primary sources of liquidity are operating cash flows and availability on our line of credit. We use cash to provide working capital for our operations, finance capital expenditures and acquisitions, repay debt, repurchase shares of our common stock and pay dividends. We have a secured $325 million revolving line of credit with a syndication of banks, which expires in January 2012 and accrues interest at LIBOR-based rates. The agreement includes an option to further increase the credit facility’s borrowing and letter-of-credit capacity from $325 million to $400 million, subject to certain conditions. Borrowings on this line of credit are secured by inventory, accounts receivable and certain intangible assets. As of July 26, 2007, borrowings of $73 million with a weighted average interest rate of 6.44% were outstanding on the secured line of credit. The secured revolving line of credit agreement contains customary restrictions but no financial covenants and no limitations on capital expenditures or share repurchases if availability of credit remains above a minimum level. Borrowings on the line of credit do not require repayment until the expiration date but may be prepaid without penalty. We pay a commitment fee of 0.25% per annum on the unused portion of the line of credit. Additionally, as of July 26, 2007, we had $57.1 million in outstanding privately placed promissory notes. These notes, which mature at various dates through 2014, bear interest at fixed rates ranging from 6.19% to 6.71%, and are secured on the same basis as the secured revolving line of credit. The notes include penalties for repayment prior to their scheduled maturities. Current maturities of $6.7 million as of July 26, 2007 constitute regularly scheduled principal payments due in the next twelve months, the majority of which will be paid in the fourth quarter of fiscal 2008. The privately placed promissory notes contain various customary financial covenants and restrictions. Failure to comply with these covenants and restrictions, or with the restrictions included in our secured revolving line of credit, could result in higher interest costs and potentially accelerated repayment requirements, and could affect our liquidity. As of July 26, 2007, we were in compliance with the restrictions and limitations included in these provisions. We believe that cash on hand, together with cash provided by operating activities and borrowings on our line of credit, will be sufficient to meet our working capital, capital expenditure and debt service requirements beyond the next 12 months. Operating Cash Flows Net cash provided by operating activities was $77.8 million in the first half of fiscal 2008, compared with $93.8 million in the first half of fiscal 2007. The decrease in our operating cash flows in fiscal 2008 from fiscal 2007 was primarily due to reduced cash flows in our pharmacy benefit services segment due to the timing of benefit payments to pharmacies relative to our fiscal calendar. This timing difference will negatively impact the comparison of fiscal 2008 operating cash flows versus fiscal 2007. These factors were partially offset by increased net income after adjustments for non-cash items, including the provision for store closures and asset impairments and stock based compensation expense. Operating cash flows associated with the planned disposition of 31 stores included severance and lease-related payments, and were not material to our operating cash flows during the first half of fiscal 2008. Investing Cash Flows Net cash used in investing activities was $59.2 million in the first half of fiscal 2008, compared with $86.7 million in the same period last year. The first half of fiscal 2008 includes $19.8 million in proceeds from the sale of property, primarily prescription files and real estate associated with the planned disposition of 31 stores. We expect capital expenditures in fiscal 2008 to be between $150 million and $200 million, primarily for new store investments, remodels and improvements to existing stores, technology and supply chain improvements. During the first half of fiscal 2008 we opened or acquired 15 stores, relocated one store, closed 32 stores and remodeled 14 stores. For the full fiscal year, we plan to open or relocate 30 to 35 stores and remodel up to 46 stores. In addition, in the ordinary course of business we may acquire additional stores, store-related assets including pharmacy customer lists, or other complementary businesses. Financing Cash Flows Net cash used in financing activities was $21.7 million in the first half of fiscal 2008, compared with $60.5 million in the first half of fiscal 2007. Our financing activities primarily consist of long-term borrowings and repayments, repurchases of common stock, dividend payments, proceeds from the exercise of stock options, and Medicare Part D subsidy receipts and disbursements.
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Table of ContentsOur borrowing levels on our revolving line of credit fluctuate based largely on the levels of our cash flows from operations, capital expenditures, Medicare Part D subsidy receipts and disbursements, and stock repurchases. There were net borrowings of $8.0 million on our revolving line of credit during the first half of fiscal 2008, compared with net borrowings of $16.0 million in the same period last year. We also made regularly scheduled principal payments of $2.7 million on our private placement notes in the first half of fiscal 2008, compared with payments of $4.9 million in the first half of fiscal 2007. We are scheduled to make additional principal payments of $6.7 million on our private placement notes in the next 12 months. We repurchased 555,000 shares of our outstanding common stock in the first half of fiscal 2008 at a total cost of $30.0 million. In the first half of fiscal 2007, we repurchased 684,000 shares at a total cost of $30.5 million. We repurchased these shares under a program authorized by our board of directors in May 2005. Under this share repurchase program, as of July 26, 2007, we are authorized to repurchase additional shares of our outstanding common stock for a maximum additional expenditure of $46.0 million. Any future repurchase of our common stock will depend on existing market conditions, our financial position, and other capital requirements. Our board of directors makes decisions about the declaration of quarterly dividends based on, among other things, our results of operations and financial position. We paid regular quarterly dividends totaling $10.6 million in the first half of both fiscal 2008 and 2007. Financing cash flows include prescription drug plan disbursements covered by CMS, including reinsurance payments and low-income cost subsidies, net of amounts received from CMS for these payments. Differences between receipts and payments for these amounts depend on the timing and extent of the related claims from beneficiaries. In the first half of fiscal 2008, our payments for these claims exceeded reimbursements from CMS by $5.9 million, compared with $40.7 million in the first half of fiscal 2007. Final settlement of the outstanding balance with CMS is made subsequent to the end of the plan year. Accounting Change See Note 2, “Accounting Change,” in the accompanying notes to our condensed consolidated financial statements.
Our major market risk exposure is changing interest rates. We use debt financing in combination with operating cash flows to support capital expenditures, acquisitions, working capital needs, dividend payments, share repurchases and other general corporate purposes. Our revolving line of credit, on which $73 million in borrowings were outstanding as of July 26, 2007, bears interest at LIBOR-based rates, and therefore, an increase in interest rates could increase our interest expense. A 10% change in interest rates (64 basis points on our floating-rate debt as of July 26, 2007) would have an immaterial effect on our earnings and cash flows and on the fair value of our fixed rate debt. We do not currently undertake any specific actions to cover our exposure to interest rate risk, and we are not currently a party to any interest rate risk management transactions. We have not purchased and do not currently hold any derivative financial instruments. Depending on the interest rate environment and subject to approval by our board of directors, we may make use of derivative financial instruments or other interest rate management vehicles in the future.
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. As of July 26, 2007, the end of the period covered by this quarterly report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective and adequate to provide reasonable assurance that material information relating to the company would be made known to them on a timely basis. There have been no changes in our internal control over financial reporting that occurred during the quarter covered by this quarterly report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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Table of ContentsPART II—OTHER INFORMATION
Rankin v. Longs Drug Stores California, Inc. was filed in the Superior Court of California, San Diego County, in October 2004, and was subsequently certified as a class action. The lawsuit alleges that our employment application violates California Labor Code Section 432.8 by inquiring about criminal convictions within the last seven years, without providing an exception for misdemeanor marijuana convictions more than two years old. The plaintiff seeks to recover statutory damages and attorneys’ fees for himself and all similarly situated individuals who applied for employment with us during the class period. We are vigorously defending this litigation. The trial commenced on August 20, 2007. The financial impact to us, if any, cannot be estimated at this time. During the third quarter of fiscal 2007, we completed a self-audit of certain of our California drug stores located in three counties that was initiated at the request of the State of California Department of Industrial Relations (“DIR”). The audit related to compliance with California law relating to meal period requirements. We made compensatory payments resulting from this audit, which were not material to us, during the fourth quarter of fiscal 2007. The DIR has also requested that we conduct an audit related to meal period compliance for all of our California drug stores. At this time we cannot reasonably estimate the amount of any possible payments that might be required as a result of an additional audit. In addition to the matters described above, we are subject to various lawsuits, claims and federal and state regulatory reviews and actions arising in the normal course of our businesses. We accrue amounts we believe are adequate to address the liabilities related to lawsuits and other proceedings that we believe will result in a probable loss if the loss can be reasonably estimated. However, the ultimate resolution of such matters is uncertain and outcomes are not predictable with assurance. It is possible that the matters described above or other proceedings brought against us could have a material adverse impact on our financial condition and results of operations.
There have been no material changes from risk factors previously disclosed in the Company’s Annual Report on Form 10-K for the year ended January 25, 2007.
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We made the following repurchases of our common stock during the quarter ended July 26, 2007:
Our Annual Meeting of Stockholders was held on May 22, 2007. At the meeting, stockholders voted upon the following actions:
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Table of ContentsSIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
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