Walgreens’ momentum falters as earnings decline hits stock

DEERFIELD, Ill. —Higher-than-expected operating costs and shrinking reimbursements for generic drugs took some of the wind out of Walgreen Co.’s earnings momentum in its fiscal 2007 fourth quarter, and Wall Street took the company to the woodshed in response.

Although net earnings for the fiscal year ended Aug. 31 rose16.6 percent to $2.04 billion, profits actually declined in the fourth quarter by 3.8 percent, to $397 million.

That was 40 cents per share, versus 41 cents per share in the final period of fiscal 2006. Sales rose 10.3 percent to $13.4 billion in the fourth quarter and 13.4 percent to $53.8 billion for the year, with comp-store sales up 6.3 percent in the final period and 8.1 percent for the year.

In response, investors drove Walgreens’ stock price below $40 per share, a decline of roughly $7 over a one-week period.

Chairman and chief executive officer Jeff Rein blamed two factors for the downturn. “This quarter was negatively impacted by lower generic-drug reimbursements, combined with higher salary and store expenses, and higher advertising costs,” he said.

Rein didn’t mince words. “Our expenses weren’t in line with the level of reimbursements we were receiving. Managing both expenses and lower reimbursements on some generic drugs is my top priority. We’re going to fix this, and at the same time continue our aggressive growth plan.”

Such generics as simvastatin, generic Zocor, “saw a significant reduction in gross profit dollars during the fourth quarter,” Walgreens reported.

“In the case of some block-buster generic drugs, it’s difficult to grow profit dollars after their first few months of availability,” Walgreens president Greg Wasson noted. “As this quarter shows, pharmacy gross profit margins on some drugs can increase on a percentage basis even while the gross profit dollars they produce fall.”

The slowdown in earnings momentum took investment analysts by surprise. Goldman Sachs analyst John Heinbockel called Walgreens’ 40-cent-per-share fourth-quarter performance “surprisingly disappointing,” and “well below our $0.47 estimate.” Like many other firms, Goldman Sachs reduced its 2008 earnings estimate for the company and downgraded Walgreens’ stock to “neutral” investment status.

“Our expectation for a smooth cycling of last year’s generic boom appears overly optimistic,” Heinbockel noted in an Oct. 1 report. “However, we do not regard these issues as structural, believing that the long-term growth story at Walgreen is intact.”

Heinbockel predicted Walgreens would maintain long-term earnings growth of 13 percent to 15 percent, but he said earnings over the next two or three quarters were likely to be “solidly below-trend … as the company cycles very strong generic-driven results last year and only gradually reins in operating expenses.”

Also blindsided was Lehman Brothers retail analyst Meredith Adler. As recently as Sept. 26, Adler had reiterated her prediction that Walgreens would earn 46 cents per share, a penny below Wall Street’s consensus estimate but substantially above the number Walgreens actually achieved.

Noting Walgreens’ reliance on organic store growth, Adler said, “New stores … put great pressure on expenses, and without a benefit to gross profit dollars from new generics, the operating margin is pressured. Given [Lehman’s] outlook for new generic introductions, we do not see this problem abating any time soon. Consequently, we see limited upside potential to the stock in the near term.”

Citibank analyst Deborah Weinswig joined the chorus, lowering Walgreens’ earnings-per-share estimate for fiscal 2008 to $2.20 from $2.38. “We believe that the unexpected increase in SG&A expenses is likely to persist in the near-term as the company’s advertising spend is now reset higher to be aligned with that of its competitors,” she reported.

Speaking with analysts Oct. 1, Walgreens finance director Rick Hans cited “several factors that drove down our profits,” including lower generic returns, higher costs and an increase in the LIFO [last-in, first-out] inventory inflation index, which Hans said resulted in a higher $32 million charge in the fourth quarter.

Nevertheless, he cited “strong results” in same-store sales, including a 6.1 percent rise in same-store front-end sales and the 4 percent gain in prescriptions dispensed at stores open more than a year, despite “last year’s lift from Medicare Part D.”

In addition, said Hans, “The fourth quarter saw our expansion program continue unabated, with the opening of 269 new or acquired stores that lifted us to a record 621 new stores for the year,” including 120 acquired stores, 58 of which came through the company’s recent buyout of specialty pharmacy operator Option Care.

Nevertheless, the increasing reliance on generics, both at Walgreens and within the U.S. health system as a whole, is a drag on the top line and—despite the relatively higher profit margins generics have traditionally yielded—on Walgreens’ bottom line in the most recent reporting period. “As we dispense more generic drugs, they slow our pharmacy sales increases because of their lower price,” Hans explained. “That’s why we believe a better indicator of pharmacy performance is the number of prescriptions filled.”

In fiscal 2007, that number rose 10 percent to 583 million scripts, Hans said, “or nearly 17 percent of all retail prescriptions in the country.”