Walgreen’s (WAG) CEO Greg Wasson discusses Q4 2014 results on a conference call held on September 30, 2014…
Walgreen Co. (NYSE:WAG)
Q4 2014 Earnings Conference Call
September 30, 2014 8:30 am ET
Rick Hans – DVP, IR, Finance
Greg Wasson – President, CEO
Tim McLevish – CFO, EVP
Alex Gourlay – President, Customer Experience & Daily Living
Jeff Berkowitz – Co-President, Walgreens Boots Alliance Development GmbH
Robert Jones – Goldman Sachs
Mark Miller – William Blair
Ricky Goldwasser – Morgan Stanley
Eric Percher – Barclays Capital
George Hill – Deutsche Bank
Scott Mushkin – Wolfe Research
Lisa Gill – JPMorgan
Good day, ladies and gentlemen and welcome to the Walgreen Co., Fourth Quarter 2014 Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. (Operator Instructions) As a reminder, this call is being recorded.
I’d now like to introduce your host for today’s conference Mr. Rick Hans. Sir, you may begin.
Rick Hans – DVP, IR, Finance
Thank you, Amanda, and good morning, everyone. Welcome to our fourth quarter conference call. Today, Greg Wasson, our President and CEO; and Tim McLevish, Executive Vice President and Chief Financial Officer will discuss the quarter and the fiscal year. Also joining us on the call, and available for questions are Alec Gourlay, President of Customer Experience and Daily Living; and Jeff Berkowitz, Co-President of Walgreen Boots Alliance Development.
As a reminder, today’s presentation includes certain non-GAAP financial measures, and I would direct you to our Web site at investor.walgreens.com for reconciliations to the most directly comparable GAAP measures and related information. You find a link to our webcast on our Investor Relations Web site. After the call, this presentation will be archived on our Web site for 12 months.
Certain statements and projections of future results made in this presentation constitute forward-looking statements that are based on current market, competitive and regulatory expectations that involve risk and uncertainty. Except to the extent required by law, we undertake no obligation to update publicly any forward-looking statement after this presentation, whether as a result of new information, future events, changes in assumptions or otherwise. Please see our latest Form 10-K filing and subsequent Exchange Act filings for a discussion of risk factors as they relate to forward-looking statements.
Now, I’ll turn the call over to Greg.
Greg Wasson – President, CEO
Thank you, Rick. Good morning everyone and thank you for joining us on our call. Today I will begin with a review of the highlights of the quarter and the fiscal year. Next, I will provide an update on our progress toward the launch of Walgreens Boost Alliance Inc. And finally, I will look ahead to fiscal 2015. And then I will turn the call over to Tim McLevish for a more detailed financial review.
In the quarter, we continue to see improvements in our top line with growth in our Daily Living business and prescription volume that resulted in our largest quarterly and fiscal year sales increases in three years. In addition, we continued to see margin improvement across the front end of our business.
As we move into fiscal 2015, we are very focused on our performance. We put into place a strong blended management team for the future of Walgreen Boots Alliance organization, which is bringing greater focus and clarity to the critical work at hand.
For the quarter, net sales were $19.1 billion up 6.2% from $17.9 billion in the fourth quarter last year. GAAP operating income for the quarter was $969 million down 5.8% from $1 billion last year. Adjusted operating income for the quarter was $1.14 billion up 3.5% from $1.1 billion in the fourth quarter 2013.
The GAAP loss per share in the fourth quarter equaled $0.25 compared to earnings per share of $0.69 last year. Fourth quarter adjusted earnings per diluted share were $0.74 up 1.4% from $0.73 in the same quarter last year. This quarter’s GAAP results were negatively impacted by $866 million or $0.90 per diluted share non-cash loss related to the amendment and exercise during the quarter of the company’s Alliance Boots call option.
I will turn into our fiscal year performance, sales were $76.4 billion compared to $72.2 billion last year up 5.8%. GAAP operating income was $4.2 billion up 6.4% from $3.9 billion in fiscal 2013. Adjusted operating income for the year was $4.9 billion compared to $4.7 billion in 2013 up 4.6%.
Our full year GAAP earnings per diluted share were $2 down 21.9% from $2.56 last year and on an adjusted basis, earnings per diluted share were $3.28 up 5.1% compared to $3.12 last year.
We closed fiscal 2014 entering the next important phase in our strategic partnership with Alliance Boots amending an exercise and the option to complete the second step. Through the transaction, the new Walgreens Boots Alliance will have unmatched global reach strength and leadership and a broad mix of retail health, well-being and beauty businesses and an international pharmacy wholesale network all dedicated to ensuring people across the world lead healthier and happier lives.
This fiscal year, we also completed the transition of our drug distribution into AmerisourceBergen. Their company now supplies virtually all of our brand and generic medications; the strategic relationship together with Alliance Boots is establishing the leading global pharmaceutical wholesale and distribution network.
Importantly, we achieved $491 million in synergies through our WBAD joint venture. Our retail pharmacy market share grew 30 basis points to 19% in fiscal 2014 and we filled a record 856 million prescriptions.
In our Daily Living business, it was a big year for beauty. We launched boots number 7 products in our Phoenix and New York markets and our flagship locations to a very positive customer reaction and improved performance. And finally, we increased our dividend for the 39th consecutive year.
Turning to trends in gross profit dollars and SG&A dollars, in the fourth quarter on a GAAP basis, our gross profit dollars increased 2.6% or $136 million from a year ago SG&A dollars increased 4.8% or $207 million compared to the same time last year.
Adjusted gross profit dollars increased 2.6% or $133 million compared to the same quarter last year. Gross profit dollars grew primarily as a result of the improvements in script comps and front-end comp sales.
Gross profit dollar growth also benefited from brand to generic conversions year-over-year, but were negatively impacted by lower third party reimbursement and generic drug price inflation.
Our adjusted SG&A dollars increased 2.1% or $86 million compared to the same quarter last year. These results reflect the impact of savings from enterprise optimization, our efforts underway to improve efficiency across the organization.
Looking ahead, we will continue our strong focus on cost reduction driving to achieve our $1 billion target over three years, which we announced in August. We have put headquarters and non-labor spending reductions into immediate effect and are continuing to work toward greater efficiencies in our processes through Walgreens lien Six Sigma.
Now, turning to our key performance drivers. In pharmacy, health and wellness, our script comp was up 3.9% in the quarter. We filled 211 million prescriptions in the quarter up 4.2% from the same period last year. To drive that performance, we continued our focus on winning with high value seniors through preferred relationships with Medicare Part D plans. Since 2013, our prescription share with Med Part D seniors has grown more than twice as fast as the overall retail prescription share. On average Med D seniors fill 3x as many prescriptions as our non-Part D – non-Med D customers.
We also are capturing share in the fast growing specialty market by improving and integrating care for patients with complex chronic disease states across our enterprise. By the end of the fiscal year, we now have access to more than 100 limited distribution drugs by manufacturers reflecting their growing desire to work with our unique specialty network of health system pharmacies, complex therapy pharmacies and fusion pharmacies and our specialty at retail offering.
In the fourth quarter, we continued to face headwinds to our pharmacy margin from ongoing pressure from reimbursement and generic drug inflation. To address the pressure on our pharmacy margin, we are focused on our contracting strategy to a lot of our payer contracts to the realities of an inflationary versus a deflationary market. We are also aggressively working to reduce total pharmacy costs by increasing efficiencies and providing high quality and cost effective pharmacy services.
Finally, Tim will discuss in greater detail the factors affecting generic inflation. We believe through our WBAD joint venture, we are well positioned to leverage our unique global retail wholesale relationships to create a long-term competitive advantage in the marketplace.
Turning to our front-end comp sales, which increased 1.3% in the fourth quarter, average basket size grew 3.5%, while traffic was down 2.2% as we cycled a more aggressive promotional environment from a year ago.
Key categories such as cough, cold and allergies drove comp sales and as I mentioned earlier, our front-end margin continued to improve in the fourth quarter compared to the same quarter last year with solid performance in health and beauty.
At the end of August, we had 82 million active balance rewards members giving us valuable insights that allow us to target our promotional investments even more efficiently. We are also offering store wide events designed to further build loyalty.
In the quarter, we converted or opened 88 well-experienced format stores giving us a total of 750 with plans for an additional 1000 in the coming year. These formats offer more integrated health and wellness products and solutions provide a private consultation room to receive health services and speak to your trusted pharmacists. And offer personal care and everyday items our customers’ value.
We are integrating these new store designs with digital and mobile technology to offer our customers ultimate convenience. And finally, with our newest flagship store in Wrigley building here in Chicago, we now have 14 flagships in 9 major markets. These flagships along with our well-experienced stores bring a real vibrancy to our markets and build awareness of our brand.
Our strategic partnership with Alliance Boots contributed $0.06 of adjusted EPS accretion in the fourth quarter, combined synergies reached $124 million in the quarter and $491 million for the fiscal year.
For fiscal 2015, we are introducing a full year combined synergy target of approximately $650 million. In addition, we are making good progress on the integration of our two companies. We recently held our first meeting in Bern, Switzerland with the future Walgreens Boots Alliance leadership team to ensure we are on track to close in the first quarter of calendar 2015. Meeting was extremely productive as we prepared to launch our new company and hit the ground running on day one.
As you know, we also filed our preliminary proxy on September 16th and are now working toward obtaining all regulatory approvals and the vote of our shareholders.
Finally, let me be clear. While the work underway to integrate our two organizations is an important strategic priority, the overwhelming majority of our team remained focused on serving our customers, improving our top line, expanding margins and bringing our costs down.
Now, looking ahead to 2015, we are well-positioned to capitalize on the industry tailwinds and aging population growth in chronic conditions, consumerization of healthcare, increase new generics and growing demand for a personalized experience.
With a suite of healthcare services and team of professional in our communities, with our approach to omni-channel access and the strength of our loyalty program and most important, the potential of our strategic partnership with Alliance Boots, we’re positioned well to serve the needs of a changing customer and industry.
We expect to continue to drive sales and margin growth in the front-end, offering ultimate convenience, the best in customer loyalty and extraordinary customer care with a focus on integrating health, beauty and convenience. We also expect to continue to increase pharmacy volume and share with high-value customers through growth in Med D, enterprise specialty and immunizations.
Building on our efforts to optimize our enterprise and control SG&A, our three-year cost reduction plan is already underway. Looking at savings at the corporate field and store levels, we expect to begin to realize incremental benefits in fiscal 2015 and we will expand on these efforts leveraging the expertise of both Walgreens and Alliance Boots moving forward.
We are realistic about the headwinds we face for the year, a cautious consumer, ongoing reimbursement pressure, generic drug inflation and significant step-downs from Med D reimbursement rates. The market reality certainly created challenge for us in fiscal 2015, but one that we understand except and are driven to meet.
With that, I’ll now turn the call over to Tim.
Tim McLevish – CFO, EVP
Thank you, Greg. Good morning, everyone, and thank you for joining us on the call. I will begin with the details regarding our fourth quarter performance then provide a few thoughts on capital structure, expectations for fiscal year 2015 and finish with some comments on our long-term goals.
As Greg noted earlier, for the quarter, we reported a GAAP loss of $0.25 per share, but this doesn’t tell the whole story. The GAAP loss of $0.25 per share walks to an adjusted earnings of positive $0.74 per share for the quarter and is illustrated by this chart. The GAAP number is first adjusted by $0.90 to reverse the accounting treatment of the call option to purchase the remaining 55% ownership interest in Alliance Boots.
Let me elaborate on this. GAAP accounting requires that upon amendment and exercise of the call option, the company needed to compare the fair value of the amended option with the book value of the original option and record a gain or loss to recognize the difference. Applying the standard, we determined that the fair value of the amended option once exercised was estimated to be zero. This valuation is as a financial instrument without regard to its strategic value.
This reduction in value was primarily due to the shorter duration of the amended option and the appreciation since the original valuation in the price of Walgreen stock. The resultant effect required us to record a non-cash loss on the exercise of the call of $866 million with no tax benefit – with no immediate tax benefit. I will also point out that for GAAP EPS purposes and due to the loss any outstanding stock options would be anti-dilutive and they are not included in the share count.
As a result, 956 million basic shares was used in the calculation for GAAP EPS. But since the adjusted EPS is positive, the effect of the diluted shares has been reflected. The remaining adjustments should be more familiar to you. A LIFO provision of a negative $0.01 per share, acquisition related items were $0.11 per share, consisting of $0.06 of acquisition-related amortization, $0.01 of acquisition-related costs and $0.04 from Alliance Boots related tax. And finally, the special items had a negative impact of $0.01 per share. This was comprised of a negative $0.10 impact of the warrants issued by AmerisourceBergen to Walgreens and Alliance Boots, Alliance Boots impact was reported on a three-month lag basis. Also, a gain on the sale of a business of $0.01 was partially offset by the positive $0.10 impact of store closures and other assets optimization cost.
Turning now to comparable store script numbers, on a one-year and two-year stack basis, in the quarter, comp scripts increased 3.9% on top of 7.1% in the prior year. The three year stack, therefore, on script comps has improved dramatically at or over 11% for both of the last two quarters. This performance reflects growth of our underlying business, the ongoing progress in winning new Medicare Part D customers, an increase of 90-day at retail scripts and the return of the Express Scripts patients.
According to IMS, we grew script 60 basis points faster than the retail industry in the quarter. Likewise, we look at front end comparable store sales fronts on both the one year and two year stack basis. In the quarter, we reported 1.3% front-end comp with the individual components of this being basket size, which increased by 3.5% and traffic which decreased by 2.2%. You can see that comps have been positive for the last six quarters and the two year stack comp trends have improved about 400 basis points since the second quarter of 2013.
Now on to margins, adjusted gross margin was 27.9% in the current quarter compared to 28.9% last year, 100 basis point decline. Margins were solid on the front end, but were weak in the pharmacy. Front-end margin benefited from our purchasing synergies and our strategy of winning in the most important categories particularly in health and wellness and beauty, which is also driving market share growth.
The primary drivers for the pharmacy margin decrease were increased third party reimbursement pressure partly due to contract step downs increased Medicare Part D business mix including our strategy to continue driving 90-day prescriptions at retail, pronounced generic drug inflation on a subset of generic drugs and the mix of specialty drugs partially offsetting these pharmacy margin decreases were the positive effect of the increased rate of introductions of new generic this quarter versus the year ago quarter and purchasing synergies in the pharmacy.
As we look into the future, for the next quarter we expect the negative factors impacting pharmacy margin to outweigh the expected benefit from new generic introductions and front-end margin improvement.
Let me say a few additional words about generic drug inflation. The dynamics under which generic drug and manufacturers can avail themselves of pricing actions has not changed. They are able to raise prices when demand outpaces supply. These drug supplies can be impacted by a number of mechanisms including regulatory actions by the FDA resulting the shutdowns of both API and finished dosage for manufacturing plants, generic drug manufacturer consolidation and portfolio harmonization, API manufacturer consolidation and FDA backlog on approvals as well as a shrinking pipeline of first to market generic blockbuster launches.
Our current environment is experiencing all of these mechanisms and as a result, the average inflation in our basket of generic drugs is mid-single digit as measured on a comparable drug priced basis.
This change is caused by very large price increases and a small percent of molecules because these supply constraints and other factors are continuing, we expect a generic drug inflation will be with us for a while. In the meantime, we are working diligently to minimize the impact of this inflation by tracking the movement of AWP. And working with market participants to help them understand the importance of appropriate AWP adjustments to represent changes in actual drug costs, evolving our payer contracts to reflect the realities of an inflationary versus a deflationary market and working through our joint venture to secure better costs by leveraging our unique global retail and wholesale value proposition to create a long-term competitive advantage in the marketplace.
Jeff Berkowitz is here with us today and available to answer any further questions about this subject. As you know, the mix of generic and specialty drugs can have a significant impact on gross profit margins, so we also focus on gross profit dollar growth in our business.
This next chart illustrates our one and two-year stack gross profit dollar growth trends on a GAAP basis for the last 16 quarters. The primary difference between GAAP and adjusted gross profit is LIFO provision. So let’s review the one and two-year stack trends on an adjusted basis.
Adjusted gross profit dollar growth increased 2.6% compared to a strong 4.3% growth in the year ago period. This growth was positively impacted by the comparable store script and sales trends in both the pharmacy and front-end respectively.
It was negatively impacted by the same factors that impacted pharmacy margin that I described earlier. Despite this impact two-year stack in adjusted gross profit dollar growth trended up for the fiscal year.
This chart illustrates our one and two-year stack SG&A dollar change trends on a GAAP basis for the last 16 quarters. Let me walk you through the adjustments to SG&A. For the quarter, GAAP SG&A dollar change was 4.8%, our adjustments included 3.2% for store closures and other optimization costs, 20 basis points for acquisition related costs and as shown our adjustment also included 20 basis points for a decrease in amortization costs, 30 basis points for distributor transition costs, and 20 basis points for other small items in the quarter. The walk yields and adjusted SG&A dollar change of 2.1% for the quarter.
Two-year stack adjusted SG&A dollar trends increased versus a year ago by 310 basis points with a two-year stack of 3.6% up from 50 basis points last year. The two year stack from the year ago included a period when we were out of the Express Scripts network in the fourth quarter of fiscal year 2012.
In general, two-year stack SG&A dollar change has trended down over the last 16 quarters. Our operating model required widening the gap between gross profit dollar growth and the SG&A dollar change.
Now, I would like to take – to provide a little bit more detail on a few components of the income statement. This quarter included a LIFO benefit of $18 million versus a benefit of $8 million a year ago. Net interest expense for the quarter was $43 million versus $55 million last year. Our GAAP effective tax rate for the quarter was 231.9% versus 35.4% last year. The loss on the Alliance Boots call option was non-deductible for tax purposes resulting in this dramatic increase in the effective tax rate.
This loss however, is available to be carried forward and offset against future capital gains through fiscal 2020. But, under GAAP rules, we are not able to reflect the benefit until we have identified specific gains against which we can offset the loss.
Average diluted shares outstanding were 968 million versus 957 million last year. The change is primarily due to options exercised and the impact of higher stock price in the money options.
And now, a few words on our AB partnership. The combined net synergies for the quarter totaled $124 million and for the fiscal year $491 million. Adjusted EPS accretion totaled $0.06 for the quarter and $0.43 for the fiscal year. For the first quarter of 2015, we expect accretion from Alliance Boots to total $0.10 to $0.11 versus $0.14 in the quarter and the first quarter of 2014.
Note the last year’s accretion received a $0.07 tax benefit from the U.K. tax law change and this year a $0.02 benefit from AB’s acquisition of its partner’s interest in the joint venture.
For fiscal 2015, we expect the combined synergies to be approximately $650 million. We are very pleased with both the progress and the benefits we are receiving from this partnership.
Now, couple of words on working capital. Accounts receivable increased 22.3%, let me explain the increase in accounts receivable is primarily due to higher vendor funding receivables to the joint venture AmerisourceBergen for rebates. This increase was partially offset by better third party receivables. LIFO inventories decreased 11.3% and accounts payables decreased 6.9%, both in conjunction with the terms of our new agreement with AmerisourceBergen as the remaining generic pharmacy distribution transitioned to them. Under the terms of the agreement, we expect both the inventories – we expected both the inventories and account payables to decline. Overall, net working capital increased by 2.7% versus a year ago an opportunity as we increase our focus on cash flow.
Speaking of which let’s look at how we did. For the year, we generated approximately $3.9 billion in cash from operations versus $4.3 billion in the year ago period. Free cash flow in the fiscal year was $2.8 billion versus $3.1 billion in the prior year. The lower cash flows in the year were primarily due to changes in working capital I just mentioned.
Our capital allocation policy is structured to ensure a balanced and disciplined approach to capital and includes investing across core businesses at suitable returns to drive organic growth, pursuing strategic opportunities, including M&A that meet our return requirements and drive long-term growth, maintaining a strong balance sheet and financial flexibility with a commitment to solid investment grade credit ratings and returning cash to shareholders by committing to 30% to 35% dividend payout target over the long-term and finally returning cash to shareholders in the form of share repurchases.
As you know, we’re currently executing against our $3 billion share repurchase authorization. Many investors have recently asked us about the potential for incremental share buybacks beyond that $3 billion. As you know, the level of share repurchases are function of many considerations, including the impact on the cost of debt, leveraged ratios, credit ratings, the relative return on the investment and alternative uses of free cash. We will continue to discuss our capital allocation policies with our Board and will make any future changes when appropriate to maximize shareholder value.
Now, let me comment about fiscal year 2015. While we have set a new goal for fiscal 2016, the trajectory to get there is not linear. The tailwinds we expect through fiscal 2016 will be largely offset in the short-term. Of note, our reimbursement rate pressure, including specifically lower Medicare Part B reimbursements coming in January of 2015 and the continued impact of generic drug inflation. Also affecting the EPS growth rate in 2015 is the timing of the close of step two with Alliance Boots.
Our adjusted tax rate is expected to be between 29% and 30%. Our share count at fiscal 2015 year-end is expected to be approximately 1.1 billion shares, the average shares outstanding for the year will be subject to the timing of the close and the pace of our share repurchase. We will continue to focus on utilizing available cash to offset dilution; that is, the impact of dilution due to option exercised and the dilutive impact of in the money on exercised options.
In fiscal 2014, CapEx was $1.1 billion. This was below our original plan of 1.4 billion as we slowed some investing in well experienced stores until we further optimized the investments and rollout plan. In fiscal 2015, we now plan to convert or open an additional 1000 stores to the well experienced format. The step up and expected CapEx to $1.7 billion reflects this new expansion plan.
We also like to provide some further clarification on interest expense for 2015. Due to market sensitivity around our financing plans, we cannot provide any specific estimates at this time. We will be in a better position to provide this on our next earnings call.
But to give you some perspective, I would offer the following. We have an obligation to deliver $3.1 billion in Sterling at close that equates to approximately $5 billion at today’s exchange rates. We’re factoring that obviously into our financing plans. We also intend to refinance substantially all of the Alliance Boots debt at closing to optimize our capital structure and take advantage of lower rates afforded by our combined credit profile. You can look to AB’s last reported gross debt balance for reference a point, but please understand that this does not reflect the debt issued and assumed with the recent acquisition of FASA.
Finally, you can assume our current reported interest expense is a reasonable run rate for 2015 for Legacy Walgreens interest expense. In order to accomplish our step two objectives, we would look to secure the necessary capital in advance of our expected closing, which we are targeting for the first quarter of calendar 2015. In our first quarter of fiscal 2015, we expect our interest expense to be comparable to the fourth quarter at $43 million the tax rate to be approximately 30% and the average share count to be about 957 million shares.
Before closing, I want to take the opportunity to make sure that everyone understands the major elements and the reconciliation of the original fiscal year 2016 adjusted EBIT goal that the company first presented in the summer of 2012 to the new adjusted EPS goal announced this past August.
This slide identifies the relative sizes of the four major elements involved in the walk from the old goal to the new goal namely Walgreens front-end, Alliance Boots, Walgreens Pharmacy and finally the Walgreens incremental cost savings. Even though we’re not quantifying the side of each element in this reconciliation, we wanted to give you a sense of the relative magnitude as well as some of the individual factors for each element contributing to the shortfall.
With that, I’ll turn it back to Greg for a few final remarks.
Greg Wasson – President, CEO
Thanks Tim. Let me close by saying that overall the quarter met our expectations and closed on a challenging important and historic year for Walgreens. We recognize we have more to do and as fiscal 2015 is another milestone year for our company. We have two very important opportunities ahead of us. The first, drive performance and execution for Walgreen Co. and the second, established Walgreen Boots Alliance as the first global pharmacy led health and well-being company.
A few weeks into fiscal 2015 I am confident in the combined leadership team we have put in place. We’re already working well together to develop and implement plans to improve performance across the business. We have the discipline and focus we need to deliver the performance you expect. Finally, as we close the book on fiscal 2014, I want to thank our customers, the Walgreens and Alliance Boots teams and our shareholders for their commitment to our company and confidence in our future. We are equally committed to meeting your expectations as we bring two great companies together to create something even greater for all of us.
Thank you and I will now turn the call back to Rick.
Rick Hans – DVP, IR, Finance
Thank you, Greg and Tim. That concludes our prepared remarks. We’re now ready to take your questions. Please limit yourself to one question. Amanda?
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