Walgreen Company (WAG)

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Walgreens (NYSE:WAG) is a U.S. drug retailer that sells both prescription and non-prescription drugs as well as retail merchandise (cosmetics, convenience foods, photo processing services, seasonal merchandise, etc). In addition to its store offerings, Walgreens provides pharmacy services like prescription fulfillment. The company operates roughly 7,000 retail locations in the U.S.^[1]

Company Overview

The company is principally in the retail drugstore business and its operations are within one reportable business segment.

Product Classes^[3]

The company sells three types of products:

• Prescription Drugs - 65% of net sales
• Non-Prescription Drugs - 10% of net sales
• General Merchandise - 25% of net sales

Financial and Operating Metrics

FY2011 Q1 Earnings Summary

• WAG reported net income of $580 million, or $0.62 EPS, for the first reporting quarter of FY2011 compared to $489 million same quarter last period.^[4]
• Sales for the quarter also rose 6% to $17.3 billion, with same-store sales increasing 0.8%.^[5]

FY2011 Q2 Earnings Summary

• WAG posted earnings of $739 million or $0.80 EPS for the second reporting quarter of FY2011.
• Revenues also rose 8.9% to $18.5 billion, with WAG increasing the number of prescriptions filled by 6.9% during the quarter, raising the figure to 205 million.^[6]

Trends and Forces

Walgreens In-Store Brands will Help the Company Push for Higher Profit Margins

Walgreens recently launched a new campaign in 2011 to push for its own private-label brands, and decided to take the advertising across the country to promote its branded Health and wellness products. This is the first time Walgreens has gone beyond the Sunday paper to advertise their own brand, which emphasizes price and quality as the central themes.

Continued high unemployment has created a market for private-label products that are almost or exact same in quality but are different in price due to reduced marketing expense. These private-label products have especially caught on, as a recent study by Opinion Research Corporation stated that of 1,006 adults surveyed, 84% said they purchased store-brand OTC medications when they are available and 36% have increased these purchases of store-brand products last year.^[7] kljeadkfjaskdjfaskjdfaslidfjaifj;laisjdf;ailsjfa;sidjfol

Economic Slowdown Hurts Walgreens

Walgreen's revenues come mainly from pharmacy sales (65% in total) and partly from front store sales. Though medical costs such as prescriptions are not discretionary expenses and thus less vulnerable to an economic downturn, patients still migrate towards lower cost generic drugs instead of more expensive brand name drugs. Walgreens stands to benefit from this, as they receive higher levels of reimbursement from groups like Medicare for generic drugs. Additionally, CVS Chief Executive Tom Ryan says that very little of front store sales comes from "true discretionary sales," meaning that same store sales won't be affected by penny-pinching consumers. A weak economy also means higher costs. These costs have a large negative impact on the company's bottom line.

Medicare Part D and Medicaid

Government cuts in Medicaid and the introduction of Medicare Part D have affected pharmacies like Walgreens.

While Medicare Part D had over 29.3 million enrollees (many of whom who were previously uninsured)^[8], many of these used to be Medicaid patients. Medicaid reimburses more for drugs than Medicare, so cuts in the former and increases in the latter have resulted in two competing effects on pharmacies: more customers but lower margins.

At the same time, certain provisions of the Deficit Reduction Act seek to reduce federal spending by altering the Medicaid reimbursement formula for multi-source (i.e., generic) drugs. These changes are expected to result in reduced Medicaid reimbursement rates for prescription drugs. In addition, a class action settlement with two entities that publish the average wholesale prices (AWP) of drugs, AWPs have been reduced for many brand-name prescription drugs. While Walgreen’s has reached understandings with most of its third-party payors to adjust reimbursements to correct for this change in methodology, but state Medicaid programs that utilize AWP as a pricing reference have not taken action to make similar adjustments, resulting in reduced Medicaid reimbursement for drugs affected by the change.

Health Reform Legislation

The Patient Protection and Affordable Care Act, the much awaited and much debated health reform law signed into law on March 30, 2010 by President Obama, may indirectly help US pharmacies by encouraging increased drug utilization, which could boost pharmacy sales.

First, the law is projected to expand insurance to 32 million Americans previously without coverage. Presumably, newly uninsured patients will increase their utilization of drugs. Part of this expansion of coverage is done through an insurance mandate, while part is done by an expansion of Medicaid eligibility. Partially offsetting the benefit accrusing from those newly covered under Medicaid will be the lower reimbursement rates paid by the program to pharmacies relative to cash customers (who pay higher prices but generally buy fewer drugs).

Second, the law partially fills in the Medicare Part D coverage gap, or "donut hole". This is a gap in Medicare prescription drug coverage that kicks in after a moderately high annual threshold of spending on prescription drugs is reached. Before then, Medicare generally covers about two-thirds of drug cost; after reaching the gap, the next $3,610 worth of drugs is fully paid for by the patient, after which Medicare covers 95% of all remaining costs. Beginning in 2011, they will also receive a 50% discount on branded drugs. Over the next nine years, a series of discounts and benefits will lead to elimination of the gap. This should make sicker patients with high drug spend less price-sensitive and thus also encourage drug utilization. ^[9]

Additional Influential Factors

Several external trends are currently increasing all pharmacies' revenues across the industry. In addition to increased sales of prescriptions, CVS will benefit as additional foot traffic for the pharmacy naturally leads to increased retail sales in the front end of the store.

• Baby boomers are only getting older, and will be more likely to need prescription medications in the coming years
• There has been an increase in prescription drug coverage over the last 10 years
• Over the next five years, around $50 billion in branded drug sales will lose patent protection, opening them to generics and driving profit margins

When Major Drug Manufacturers Suffer, Retail Pharmacy Generics Prosper

Major drug manufacturers carrying common household OTC medications such as Tylenol, Advil, and Motrin are six times more likely to be purchased by consumers than its same function generics.^[10] The main idea behind this thinking, even though most often than not the drug facts are the same, is consumers grew up with these brands and perceive them as safer or more effective than inferior goods.

However, when in the rare case that these trusted household brands are recalled, consumers are often thrown into confusion and will make the switch over to retail pharmacy generics, sometimes permanently. This presents a very valuable opportunity for retail pharmacies.

As a result, all major pharmacies such as CVS, Walgreens and Wal-Mart have revamped private label drug manufacturing by five times capacity versus 2009.^[11] As traditional JNJ loyalist consumers are forced to use generics, they may realize that they are just as effective as Tylenol and JNJ, except cheaper. As such, these loyal consumers may choose to permanently change over, which presents an extremely lucrative opportunity for retail pharmacies.

Competition

Drugstore competitors to Walgreens include:

• CVS/Caremark (CVS) - CVS is the second largest drugstore retailer and also has its own PBM business. CVS's sales and profits grew significantly when CVS completed its merger with Caremark, a leading PBM, as a part of its recent acceleration of its physical and geographical expansion. The company continued to aggressively expand with the acquisition of Longs Drug Stores (LDG).

• Rite Aid (RAD) - Rite Aid is the third-largest drugstore chain in the United States, with over 4,800 stores in 31 states. The company makes most of its money from the sale of prescription drugs, but it also sells non-medical items such as cosmetics and greeting cards.

• MedcoHealth Solutions (MHS)
• Express Scripts (ESRX)

In addition to other drugstore retailers, Walgreens also competes for market share with supermarkets, convenience stores, mass merchants, dollar stores, Internet drugstores, and PBMs. In particular, Wal-Mart (WMT) has grown its retail pharmacy business at its retail mega-stores. Wal-Mart is the third largest domestic retailer in terms of pharmacy sales, and it has continued to increase the number of total pharmacies in its installed store base. Wal-Mart also announced a strategy to aggressively undercut prices of generic drugs compared to traditional drugstores such as Walgreens and CVS.

'==References==

1. ↑ Walgreens 2009 10-K Section 1 - Properties. pg 4
2. ↑ Walgreen 2009 Form 10-K, Page 2
3. ↑ WAG 2009 10-K pg. 2
4. ↑ Walgreen profit exceeds estimates
5. ↑ Walgreen Profit Rises 19%, Exceeding Estimates, on Drug Sales; Shares Gain
6. ↑ Walgreens profits up 10 percent on prescription growth
7. ↑ Walgreens Launches Campaign to Push Store-Brand Products
8. ↑ HHS Monthly Summary on Medicare Part D Enrollment. June 2010.
9. ↑ Missoulian "Health care reform bill tries to fill part of 'doughnut hole'" 25 April 2010
10. ↑ Tylenol's side effect? A brand boycott
11. ↑ Johnson & Johnson Announces Another Recall of Children’s Tylenol