CVS Health Corp (CVS) 2003 Q2 法說會逐字稿

Good day everyone. Welcome to Longs Drug Stores fiscal '04 second-quarter earnings results conference call. Today's call is being recorded. At this time, for opening remarks and introductions, I would like to turn the call over to Phyllis Proffer.

Thank you, Erica. Good afternoon and thank you for joining us today as we review Longs' results for the second quarter ended July 31, 2003. On the call with me today are Warren Bryant, Chairman, President and Chief Executive Officer, and Steve McCann, Senior Vice President and Chief Financial Officer. After our prepared remarks, we will be happy to take your questions. Before we start, let me advise you that we will be making forward-looking statements within the meaning of the federal securities laws during this call. We believe that our expectations are reasonable and are based on reasonable assumptions. However, certain risks and uncertainties relating to future events could cause actual results to differ materially from our expectations. For a full discussion of these risks and uncertainties, please refer to our recent SEC filings, including the discussion of forward-looking statements in our recently filed form 10-Q for the quarter ended May 1, 2003. Longs does not intend and assumes no obligation to update any forward-looking statements.

Now I will turn the call over to Warren, who will provide an overview of our operating performance for the second quarter and update you on the progress we are making in the transformation of Longs. He will be followed by Steve McCann, who will comment on our financial results and outlooks.

Thank you, Phyllis. And good afternoon to all of you. Today we reported net income of $5.3 million or 14 cents per diluted share, on total sales of $1.1 billion for the second quarter. Included in our net income this quarter are several charges that Steve will discuss in greater detail in his financial summary later in the call. We are generally pleased with our progress in the second quarter, despite the influence of an extremely weak economy in the western states, our results reflect our efforts toward improving our productivity, delivering higher value to our customers, and enhancing our future growth prospects. While there is still a lot to do, we believe we are moving in the right direction.

My remarks today are divided into three sections. I will start with our sales performance, because our experience didn't mirror the national retail trends and we want you to understand why. Next I will talk about our core operations and the progress we are making on the initiatives we have shared with you previously. Last, I will summarize the important organizational changes we have announced and the significance of their impact on our culture, as well as our structure.

First, sales. Our total sales of $1.1 billion for the second quarter represent a 0.7 percent increase from the second quarter last year. Same-store sales declined 1.9 percent. Our sales for the second quarter, both the pharmacy and the front-end, were heavily influenced by the weak economy in the western states. Despite early signs of improvement in the nation's economy, many of the markets that we serve are still very slow, especially in California. The California unemployment rate is 6.9 percent, above the national rate of 6.3 percent, and this is the second consecutive year that this state has outpaced the national unemployment rate. More recently, in the last two months the employment statistics in California are getting worse, while the U.S. numbers are getting better. Nevertheless, California is still one of the largest economies in the world and we are confident that the economy and consumer spending will improve here overtime, but we expect a recovery will be more gradual than other regions of the country.

Pharmacy same-store sales grew 2.8 percent year-over-year. Generic substitutions for brand-name drugs negatively impacted pharmacy same-store sales approximately 125 basis points. This was offset by a continued increase in average script prices. Our script counts declined in the quarter, consistent with the overall decline in script counts in California. This was driven by the loss in volume of the allergy drugs replaced by OTC Claritin, as well as the significantly reduced consumption of hormone replacement therapy drugs or HRT. We indexed very high in both last year and just to give you a perspective on their magnitude, our script counts for the quarter would have increased from last year if we removed these two drug classes from the comparison. Our core pharmacy business remains strong, despite the decline of allergy and HRT prescriptions filled and the pressure we are experiencing from a weak economy. Total pharmacy sales were 46.7 percent of our total drugstore sales for the second quarter, compared with 44.4 percent a year ago. Third party reimbursements accounted for 90 percent of total pharmacy sales, down from 91.1 a year ago. Front-end same-store sales declined 5.6 percent from a year ago. AC Nielsen data indicates that overall consumer spending in our markets on the front-end categories on which they report has declined. The data also shows that our sales performance in these reported categories was better than the total they reported in aggregate for all classes of trades in the markets we serve. This includes drugstore chains, grocery retailers, mass and food retailers. Based on the data, we are maintaining our share in total in the major front-end categories on which AC Nielsen reports.

The key factors influencing front-end same-tore sales during the quarter were first a weak economy in our markets that has created an aggressively competitive and highly promotional environments. In fact, our percent of add sales to total sales has risen significantly. Second, we experienced a significant decline in our photo category, which includes film, processing, and batteries. The decline is primarily attributable to the continued migration to digital as the preferred choice of an increasing number of customers. This national trend is gaining momentum and we are adjusting our offering accordingly.

Third, we permanently reduced prices on nearly 1000 SKUs in our best-selling categories, such as health and beauty care, over-the-counter medications, and convenience grocery. We are confident that improving the price value proposition we offer our customers will lead to increased sales longer-term.

Fourth, we established new parameters for local buys to improve the quality of their contributions, which is particularly important in this highly competitive environment. We are known for offering customers merchandise and assortments that reflect local tastes and preferences. We want store managers to preserve their local flavor purchase merchandise with more disciplined rigor and accountability. We believe reductions in local buys impacted sales in the quarters. Local buys will ramp up again, but with greater profit contribution than before as a result of the consistent adherence to the parameters we have established.

Now let's move on to a discussion of our operations beginning with gross margins. Our second-quarter gross margin of 26 percent is up over the 25.8 percent for the second quarter last year. We accomplished this despite reducing prices in our best-selling categories and generating more highly promotional ad sales. Our supply chain initiative is working and we are benefiting from the consolidation of our procurement, advertising, and promotional activities.

Operating and administrative expenses for the quarter were 22.7 percent of sales, compared with 22.1 percent for the second quarter last year. While we are making progress on reducing the trajectory of our expense rate, we did not achieve our previous expectation for flat or improved operating and administrative expenses as a percent to sales this quarter versus last year. We had some unusual items this quarter and Steve will detail our expenses in his remarks. We do anticipate flat or improved operating and administrative expenses as a percent of sales in the third and fourth quarters, compared with the same period's last year.

Now let's move on to the progress we are making on our previously announced initiatives. During the first quarter, we completed the realignment of our corporate offices and support areas and are on track to realize our estimated $7 million in annualized savings. One of our initiatives is to improve the performance of 25 underperforming stores. We have reduced the operating expense load in this group of stores significantly over the last two quarters and we are now focused on increasing sales and gross margins. There is still much to do here, but they are improving. We are making similar progress on our initiative to improve performance of stores opened in the last three years. We have reduced operating expenses and are now focused on sales and gross margins there. We are phasing out inefficient technology systems.

We are upgrading our pharmacy systems, and we have rolled out a new POS system to more than two-thirds of our stores this quarter. We expect to have the new POS system fully installed and operational in all stores by the end of the third quarter. This system speeds up customer checkout and gives us the ability to handle high-volume transactions. We will continue to pursue technological improvements that will increase our operational efficiencies and enhance our customers' shopping experience.

As for our work process improvement initiatives at the store level, we recently implemented consistent labor standards across all mainland stores and continue to refine them. We expect more improvement as the use of these standards becomes a routine part of our daily operations. We closed two facilities as part of our initiative to consolidate support facilities, and we will close the remaining two before year end. We are making progress on our initiative to centralize procurement of all office, store supplies, and equipment. Supply expenses have decreased and we are currently testing a procurement card which should improve should provide additional purchasing leverage.

We are making significant progress on our pharmacy profitability initiatives. We have installed robotic systems in 86 high-volume stores to improve efficiency and reduced costs per script. In addition, the mail-order center that we acquired last quarter is up and running and while small, it is contributing to our pharmacy profitability. As part of the front-end initiative to improve the contribution of service departments, we are making adjustments to our offering, our service level, and pricing. We are on track to remodel up to 20 stores this year. The remodels will focus on improvements in merchandising, store signage, lighting and displays, operational processes, labor efficiencies, working capital management, shrink control.

The first three store remodels will be completed by the end of the third quarter. Additionally, nine of our new stores will incorporate the visual elements and productivity improvements developed for the remodels. One of our process improvement initiatives has reduced by more than half the time and cost required to merchandise new stores and prepare them for opening. We made progress on reducing our working capital. We reduced working capital by $19 million on an equivalent store basis, and are on our way toward achieving our previously stated goal of a $50 million reduction by the end of the year.

In addition to the initiatives we have already discussed, we have adjusted our incentive compensation at all levels of the organization to align incentive pay with performance.

Now onto a review of the important organizational changes we've made at Longs. We are better aligning our organizational structure and our culture with the goals to enhance our customers' shopping experience, improve productivity, and strengthen our prospects for growth. I'll summarize our recent activity.

This quarter we completed the voluntary separation program for store managers. With all of the significant changes that we are making in store operation procedures and the resulting changes in the roles and responsibilities of our store managers, we believe that store managers who may have had difficulty in their new roles should have an attractive alternative. We realize that this is uncharacteristic for retailers, but we thought it was the right thing to do.

In line with our expectations, 69 of our store managers opted to participate in the program. We know it was a difficult decision for many of them to make, and we thank them for their many contributions and their service to Longs. We wish them the best. At the same time, we are pleased that more than 80 percent of our store managers renewed their commitment to Longs and to our strategic initiatives. We are especially excited about the promotions of 140 experienced and highly-qualified store managers, assistant managers, and department managers who are now stepping up into new roles and responsibilities. I have spoken to many, and they are energized by this opportunity and their enthusiasm is contagious.

Also during the quarter we recruited a seasoned retail executive, Rick Dreiling, as Executive Vice President and Chief Operations Officer. He is responsible for all store operations, combining pharmacy and front-end, as well as construction and asset protection. Rick is already playing a critical leadership role in our initiatives to enhance our already strong customer service, and to improve our store standards, operational efficiencies, inventory management, and shrink control throughout the company. We also consolidated merchandising, marketing and distribution under Bruce Schwallie as Executive Vice President and Chief Merchandising Officer. Bruce, an experienced marketing executive, joined Longs in January too as Senior Vice President of pharmacy and business development, and will now lead the integration of pharmacy and front-end marketing and the continued execution of our centralized merchandising strategies and distribution logistics. With these changes, we believe we now have a full complement of talent and experience on our senior management team, as well as the commitment required in store operations to achieve our strategic initiatives.

In summary, we are concerned with the sales trends and believe we have identified the structural and operational reasons for their decline. We also have a number of sales initiatives which we did not enumerate that are designed to get the topline moving even in this difficult sales environment. We are pleased with the continued progress that we are making. We are improving our productivity and our efforts are beginning to show up in our gross margin, operating and administrative expenses, and working capital results. We are also pleased with the depth and breadth of our senior management team and the outcome of the voluntary separation program for store managers. We planned on continuing strengthening our operations and building a foundation for profitable growth that can only get better with improved consumer spending and a stronger economy.

Now I will turn it over to Steve for an analysis of our second-quarter financial results and our business outlook for the rest of this fiscal year.

Thanks, Warren. Net income for the second quarter ended July 31st was $5.3 million or 14 cents per diluted share on sales of $1.1 billion. Year-over-year this compared with net income of $10.9 million or 29 cents per diluted share. Included in our net income were charges we recorded totaling $6.8 million pretax or 11 cents per diluted share and are comprised of a number of charges offset by a gain that I will break down in detail for you. A pretax charge of $2.6 million or four cents per diluted share related to the accelerated depreciation for the abandonment of the PPS++ pharmacy system.

We recorded a pretax charge of 3.7 million or 6 cents per diluted share for the cost related to the voluntary separation program for our store managers. We announced this program on July 7 and its now complete. The remaining net charge of one cent per diluted share consisted of a pretax charge of $1.5 million for the write-off of information technology assets and a $1 million increase in the company's closed store reserves, which were partially offset by a $2 million pretax gain on the sale of property during the second quarter. Considering the additional charges against net income, we are pleased with our reported results.

Just to summarize, our reported net income of $5.3 million, or 14 cents per diluted share, included the impact of $6.8 million pretax in net charges for 11 cents per diluted share. Total sales for the second quarter of $1.1 billion represented a 0.7 percent increase over last year, and this was consistent with the guidance we gave at the beginning of the quarter. Our gross margin for the second quarter was 26 percent, up from 25.8 percent last year on a comparable basis. Both pharmacy and front-end gross margins benefited from our centralized procurement and promotion initiative, and while the pharmacy gross margin benefited from increased generic utilization, it was offset by continued pricing pressure from third party and government payers.

On the front-end, we reduced prices in approximately 1000 high-volume items in our best-selling categories. The LIFO provision for the quarter was $1 million, down $700,000 from the $1.7 million last year. Year-to-date we have recorded $3 million in LIFO provision compared with $3.4 million for the same period a year ago. Again, that was year-to-date.

As we noted on last quarter's call, we have begun classifying advertising expenses and cost of sales rather than operating and administrative expenses. For comparison purposes, we have reclassified last year's cost of sales and operating administrative expenses as well. The result is a decrease of $5.4 million in last year's reported gross profit and a comparable decrease in last year's reported operating and administrative expenses with no impact on reported net income.

I would like to reemphasize that this is a reclassification of costs among lines, that is lines in our P&L, and has no impact on reported net income. Operating and administrative expenses as a percent of sales for the second quarter this year was 22.7 percent compared with 22.1 percent for the second quarter last year on a comparable basis. Operating and administrative expenses of $251.6 million in the quarter ended January 31, 2003 included the net impact of $3.7 million pretax for the charge associated with our voluntary separation program, and was offset by a $2 million gain on the sale of property. This added 16 basis points net to operating and administrative expenses as a percent of sales in the quarter. In addition, increased workers' compensation and other insurance costs accounted for approximately 34 basis points of the increase in rate compared with last year.

The impact of generic substitutions on operating and administrative expenses accounted for approximately 14 basis points. As Warren mentioned, we have reduced the trajectory of operating and administrative expenses and although I'm pleased with the progress we are making, we still have a lot to do.

Moving down the income statement, second-quarter depreciation and amortization expense was $21.9 million. This included the previously mentioned pretax charge of $2.6 million for the accelerated depreciation of the abandonment of the PPS++ pharmacy system. Depreciation and amortization expense for the second quarter last year was $19.2 million. The provision for store closures and asset impairment of 2.5 million was comprised of $1.5 million pretax for a charge to write-off information technology assets, and a $1 million pretax charge to increase our store closure reserves related to the default of a tenant we were subleasing space to in a closed store.

Net interest expense was $3.6 million, compared with $3.1 million last year on increased borrowings. Our effective tax rate was 37.6 percent for the second quarter this year, compared with 38 percent for the second quarter a year ago. On the balance sheet, working capital was $228 million, down from $243 million at the end of last year. On a per store basis, working capital was $492,000, down almost 8 percent from the end of fiscal 2003, and down approximately 9 percent compared with the second quarter last year. We have reduced working capital by $19 million on an equivalent store basis since the end of fiscal 2003, and 23 million compared to the end of the second quarter last year.

Overall, we are very pleased with the progress we are making on our goal to reduce working capital by $50 million on an equivalent store basis by the end of the year.

Our next debt which, as a reminder, is short and long-term borrowings less cash on hand, at the end of the second quarter was $126 million, down from the $144 million reported at the end of fiscal 2003, and down from the $140 million we reported at the end of the second quarter last year. Our borrowing needs are less because we are generating more cash. Year-to-date, we have generated $98 million in cash from operating activities as a result of improved working capital management.

Total inventory is down despite adding 21 stores in the last 12 months, while accounts payable has increased, largely due to renegotiated payment terms. Total inventory on a LIFO basis was down $14 million or 3.3 percent against a 4.8 percent increase in store count. Average inventories per store decreased 5.9 percent on a FIFO basis. This decrease reflected a 7.5 percent reduction in our average in-store inventories, partially offset by a 12.5 percent increase in distribution center inventories, primarily in pharmacy. This is a reflection of the progress we're making toward centralized procurement and distribution and reducing in-store inventory levels.

As we mentioned earlier, we have already begun to see the benefits of this progress in our improved gross margins and our lower working capital per store. Net capital expenditures for the first six months of the fiscal year were $50 million. We opened 8 new stores in the first half of this fiscal year as part of our expansion plans to open a total of 19 new stores for the full year.

Our capital expenditure forecast for the year is expected to be between 110 and $120 million. For the first six months of fiscal 2004, we earned $11.1 million or 30 cents per diluted share on sales of $2.2 billion. We recorded net charges of 19 cents per diluted share in the first half of this year. Net income for the first six months of last year before the cumulative effect of an accounting change related to our adoption of SFAS 142 was $21.9 million or 57 cents per diluted share on sales of $2.2 billion.

Given the current sales trends, our outlook for 2004 remains conservative. Despite a soft sales environment, we plan to improve our operating margin for the full year by 10 to 20 basis points compared with last year, excluding charges we've recorded in the first half of the year. We expect operating and administrative expenses as a percent of sales to be flat to down in both the third and fourth quarters compared to the same periods last year, again, excluding charges. For the third quarter, we estimate that total sales will be flat to up 2 percent and same-store sales will be flat to down 2 percent from the third quarter of last year.

Given these sales assumptions and the continued progress we plan to achieve on our initiatives, our goal is to achieve net income in the range of 11 to 14 cents per diluted share for the third quarter. This compares with net income of 8 cents for the third quarter last year. For the fourth quarter, we estimate that total sales will be flat to up 3 percent, and same-store sales will be down 2 percent to up 1 percent from the fourth quarter of last year.

Given these sales assumptions and the continued progress we plan to achieve on our initiatives, our goal is to achieve net income in the range of 38 to 41 cents per diluted share in the fourth quarter. This compares with net income for the fourth quarter of last year of 17 cents per diluted share, including store closure and asset impairment charges of 17 cents per diluted share, offset by income tax credits of 7 cents per diluted share.

For the full year, we are looking for a total sales increase of flat to up 3 percent and same-store sales to be in the range of flat to down 3 percent, again, for the full year. Our earnings guidance for the second half of the year remains the same as we previously discussed last quarter. However, we are revising our full-year earnings guidance to incorporate the charges we have incurred in the second quarter. Our outlook for net income or for EPS is 79 to 85 cents per diluted share for the year, including the negative impact of 19 cents per diluted share net for the charges that we have previously discussed. And just to close the loop, we reported a net charge of 8 cents per diluted share in the first quarter related to the cost of our reduction in force, consolidation of facilities, and a portion of the accelerated depreciation of the PPS++ pharmacy system.

In addition, we reported a net charge of 11 cents per diluted share in the second quarter related primarily to the cost of the voluntary separation program for the store managers and the remainder of the accelerated depreciation charge for the abandonment of the PPS++ system.

Again, we are taking a conservative approach here as appropriate to the weak economy. We remain committed to improving our operational efficiency, executing our strategic initiatives, and driving our top line. We will keep you advised of our progress. Now, we will open up the call for questions. Operator.

Thank you. (OPERATOR INSTRUCTIONS) Meredith Adler with Lehman Brothers.

This is actually Scott Mushkin sitting in for Meredith. A few housekeeping items. You were saying the O&A, you said 34 basis points for workers' comp and then you said 14 basis points for something else. I didn't catch that.

It was for generic substitutions, Scott, the impact on O&A rate.

And RxAmerica revenue?

RxAmerica revenue, I believe, is $6.7 million.

Just to get a little bit more into that gross margin and some of the comments that were made about the sales, especially on the front end of the store. I think it was mentioned that the Nielsen data showed that you are at least holding share, maybe gaining. And I was wondering does that -- it seems like the economy must be very poor out there. Maybe you can just get into a little bit more detail about that?

The economy here is very soft. We track our front-end performance in several categories with Nielsen. They get market data in several categories that are important to us. We track ourselves with Nielsen in the various categories and in the aggregate, and as I said in the call, in the aggregate -- of course, the category shift from quarter to quarter, but in the aggregate we are holding our share.

Do you think the third-party dropping is an indication of the poor economy? Would you take it that way?

We would take, as people lose coverage, health-care coverage, they lose prescription coverage. As they lose prescription coverage, it causes them to have the cash (indiscernible) prescriptions, so the third-party decline we attribute mainly to the people's loss of plans in two to three years of high unemployment. And we have been fairly aggressive on cash pricing.

And I know it's really early, but do you have any sense of how August is breaking for you?

Too early.

Thanks.

Jack Murphy with CS First Boston.

A couple questions, following up on the front-end, could you took a little bit about the 1000 SKUs with the reduced prices, if you are seeing any difference there, and kind of remind us when you did that and that is progressing? And I just have a couple follow-ups after that.

We did that early in the quarter. It is progressing well. We, of course, as most retailers do track our competitiveness and movement of these items each week, and movement on these items are up. They are important items in each category, in each of our main categories, and we believe the move has been successful.

So they are tracking significantly better than the front end in total?

Sales on those items have improved.

So would you consider expanding that or maybe making even more aggressive cuts in those items in order to invest in gross margin to actually go to a share-taking position?

We would always consider reinvesting gross margin into becoming more competitive. And it is something we measure constantly and consistently, and I guess that's probably all I should say on that. Ad sales additionally are way up, which is another measure of the competitiveness of the environment out here.

Okay. Could you -- I'm not sure if you mentioned it. I might have missed it, but how your out-of-stock or in-stock position looks year-over-year and sequentially?

We believe that we have an in-stock/out-of-stock opportunity in this company, and we have aggressive plans around it, and the addition of Rick Dreiling as one of his major initiatives is to quantify/measure our in-stock/out-of-stock position, and he is putting several activities together to improve our position there.

Just to follow up on that as well, as I think you are aware, we don't have great visibility into what it was. So while we believe we have an opportunity, the year-over-year comparison, we really don't have visibility into that. So doing a comparison is difficult.

I guess what I am trying to connect the dots on a little bit is the reduction in store inventories coupled with poor front-end sales performance and to the extent that you are having a major -- the two things are moving together?

When you put an inventory focus and emphasis, as a retailer you always run the risk, of course, of stores reducing stock on the wrong items, and reducing stock on the items you need the most. Obviously, that has been and would be a continued concern for us. We believe our inventory reduction is a result of several things. First, we are moving more SKUs in our distribution center and so our distribution centers are actually up in inventory because we're not carrying safety stock in 460 stores; we're carrying safety stock in key distribution centers.

Additionally, as I said, we curtailed a significant amount of local buying last quarter. Local buying was adding to inventory because I believe, though we don't have good measurement, the terms on this merchandise wasn't as good as the general merchandise we had in the stores. Additionally, the slowing down of that allowed us to clean up a lot of the old local-bought merchandise in our stores. Add to that, we had a significant amount of promotional and seasonal merchandise in our back rooms and we have been working through that these past several months. That has also helped in our inventory reduction efforts.

There's a number of activities surrounding inventory, none of which should be affecting the in-stock position of fast-moving items. Difficult for us to measure. We have put a lot of emphasis on this. My guess is that some stores have been over aggressive, but I don't believe that this is a theme you can generalize from. I believe it is -- actually, I think the reduction in inventory has been a lot of good attention to unproductive inventory in our stores.

Okay, and I guess just when you'll be able to kind of get a look at sequential and year-over-year in-stocks and out-stocks?

Well, as part of our supply chain initiative, we should have a view into that into another 18 months. I am afraid it will take us that long. In the meantime, we are having to physically count in stores the out-of-stocks. It's a very laborious process, but it's an important one because that allows us to have a baseline on what is our performance in-stock/out-of-stock and what is the capability of our processes to get to numbers we think are the right ones.

All right, thanks.

Lisa Cartwright with Smith Barney.

Good afternoon. A couple questions. Just to follow up on Jack's comments, can you just talk a little bit about what it is exactly that has to be done before you can have -- you said it will take 18 months in order for you to have a view of out-of-stocks and both on a sequential and year-over-year standpoint. Does that have to do with the POS system that you talked about earlier? What all does it entail within the supply chain?

We are putting in merchandising systems. buying, procurement, purchase order management, category management, SKU management. We are tying our merchandising systems to our POS, and these are -- our systems are very, very old, and we don't have a perpetual inventory. And these are large systems, the transition of which is fairly complex, and so each one takes some time to, first, develop the software, do the integration with our current systems, and then make the transfer.

Are you outsourcing that or developing it internally, and are you doing it a program at a time or a system at a time?

We are doing it a program at a time. We are doing it internally. It is a very large undertaking. But I would say we are on schedule and below budget and the system is recapped.

And just switching gears a little bit, can you talk about how much the decline in photo sales, how much of an impact that is having on your front-end and have you -- it sounds like your plate is pretty full, but have you had a chance to look at some solutions to the digital issue, or is that something you'll do later?

I won't quantify it because we believe it's useful information for our competition, but it is a significant category for Longs. We have a very good share in our markets in photofinishing, film, and battery. We're well aware of the national and regional trends in the area, and we have very appropriate digital plans, and no, we are not waiting.

Can you talk about the plans, or is that something from a competitive --

That's something we think might be useful to others, and so we would rather not talk about our plans.

Some of the other drug retailers have talked about just how many stores there are going to be becoming digital capable, capable of processing digitally, and are you willing to at least comment on the scale of your effort?

For us it's large. We are in a limited area, so any quantification of that would tell everybody exactly what we're doing. If we were multiregional, it would be easier to quantify for you, but we are aware. We have some.

Fair enough.

It's an important part of our business.

Thank you.

Gary Giblen with C.L. King & Associates.

Good afternoon. The July national statistics for pharmacy showed some clear deceleration, so is that something that you are seeing in your marketplace?

Yes, we are seeing in our marketplace a script count decline.

Okay, and do you think that will continue? What is your sense?

In the region of the country, it's difficult to project that, but in this region of the country with high unemployment, with the HRT issue, with the Claritin issue, we will start lapping some of those toward the end of this year. So that part of the same-store script count will improve on the other side of the economy, and there's still a great deal of uncertainty around the economy. So we have some things moving for us, some things moving against us in this trend.

Okay, and then this kind of ties into the previous questions, but you have had a lot of hue and cry in the last week about the mass retail group having turned the corner and more price increases being passed on and less Wal-Mart and alternative format pricing pressure and so forth. So your (indiscernible) marks don't seem to indicate any abatement of competition. What is the disconnect? Is it just California? The problem there is that some of the upgraded viewpoints have been on Safeway and Albertsons which are California centric. So there still seems to be a disconnect that I can't resolve. So can you help me?

We still feel that this economy here is very soft. Unemployment is very high. It appears to be going in opposite directions of the national trends. There is still an unresolved -- enormous in California where we're very, very strong, a very great unresolved state budget deficit, a lack of clarity on how the state is going to handle it. We know that they are talking about reducing state employment. We know they are talking about increased taxes. Neither of which, by the way, are going to be good for the economy here. So our view is, and of course we are West Coast. By the way, Oregon and Washington are similar. There's all kinds of election turmoil, so our view is that the West Coast in general and California in particular is counter to the rest of the national trends.

And our concentration, Gary, is clearly a lot more heavy in California than Albertsons or Safeway is.

That could explain some of it. Then finally, it's early days Rick Dreiling's time at Longs, but I guess other than the shrink aspects or the in-stock aspect that you mentioned, Warren, are there other areas that you think Rick can really add value in a dramatic way?

He is already adding value. He is adding value in his approach to front-end service, the measurement and quantification of the important service attributes there. He's adding value, as I said, in-stock. He is adding value in the area of shrink control and shrink management. He is adding value in store conditions, store standards, store execution. We're just delighted to have him with us.

Okay, great. Good luck.

Bob Summers with Banc of America.

Real quick, your expectations for OTC Prilosec and maybe why or why it is not going to be a problem? And then if could you update us on -- you mentioned the state budget. I know that part of that involves changes to Medicaid. If you could maybe give us a hint of what is going on there, and then I have one more.

Let me try the Medicaid. It's still uncertain as to how those Medicaid cuts will play out. We're not exactly sure whether they're going to reduce reimbursement rates, whether they're going to reduce co-pay. We have a senior discount program and we're not sure that the Medicaid proposal will be any better or worse than our our own senior discount program. So we have not been able to get any clarity on what the state intends to do in this area. And we are waiting so that we can quantify its impact on us. It's just not clear enough for us yet. It is a concern. I didn't quite get your question on Prilosec.

Prilosec in, I think it's, what, September or October here, the over-the-counter version is going to be launched. And I know that there's a lot of to do going on on the generic side, but just trying to weigh what the impact is going to be in terms or either comps or operating profit or both?

I would tell you that we will have aggressive plans on the front end for the launch of the OTC version. We haven't quantified yet the impact in pharmacy on this. I guess -- do we do that? Will we do that publicly?

No.

And then the last question, and I think you were forced to go through this on the last conference call, but the Nielsen data, the Nielsen data that you look at, does it include Wal-Mart? The stuff that I see doesn't or doesn't include a proxy for it. So I am curious as to how that changes -- how you might view your positioning in the market?

The Nielsen data, as you probably know, does not include a Wal-Mart, but they adjust for that by using panel data. They believe their adjustment is as accurate or quantifies the Wal-Mart accurately, and so the data we look at includes their panel-derived estimates for Wal-Mart, yes.

Okay, thanks.

Glenn Creblin (ph) with Glenhill Capital.

I have a series of questions. First, could you quantify in any way the voluntary retirement and what that could mean for costs going forward or cost savings? Secondly, can you just comment -- it looks like you did not repurchase any shares in the quarter despite some pretty good cash flow that you mentioned. Third, Warren, can you quantify in any way what kind of sales impact you might have from the reduction of these locally merchandised products that you are removing from the store? I am going to stop there or else you probably won't remember them, and I'll come back.

First of all, the voluntary separation program for store managers, we did not do that as a cost-saving initiative. We rather did that as an organizational change initiative, trying to get our culture and our organization aligned. However, saying that, we would not have done it unless the investment in it did not produce a positive return above our cost to capital to our shareholders. So this was an investment, but it wasn't done for cost savings reasons.

Second question was repurchase. No, we didn't repurchase any shares. Third question was to quantify the sales impact on local buyers. Glenn, we wish we could. We don't have a look into what those items were. In our statements, they're called unclassified items or non-taxable taxable items, and so we couldn't quantify exactly the sales impact. Not only that, we couldn't quantify the residual inventory we had in those unclassified items.

Okay, and then two other questions, Warren. One, has your thought process changed in regards to what either a remodeled or new store will look like going forward based upon the more time that you've spent at the company? And then lastly, your description or your comments regarding the stores on the watchlist, if I recall originally you spoke about those being much more of a expense issue, and on the call today you referenced some gross margin and sales issues, and I was just a little bit confused there.

That's a great callout. On the unproductive stores, it was primarily an expense issue. And I think you will recall I said in the call, generally those stores were meeting their sales objectives. But in any store, you have to have a certain sales amount for it to be profitable at any expense rate. You can't save your way into success in many of these cases. So while we think we've got the expense part of the equation fairly well in line, now we have to work on the top-line and the gross margin lines in order to make these things at least cash flow.

We are encouraged. We actually see for most of them that there's a light at the end of the tunnel. We're not finished yet, but our work -- as I was intending to say, our work on the expense side has been progressing well, but now we've got to move sales and we've got to move grosses. We're pleased. So I didn't intend to say that we had a sales problem now versus prior, but rather we've got to focus on sales; got to focus on all three parts of it.

Just your thoughts on what remodels or new stores might look like from different new departments or just your thoughts; has it evolved at all?

Of course, it always evolves. Retailing is always an evolutionary kind of thing. Has it changed much? We -- no, our concept is health and wellness, beauty, it's convenience grocery. It was pretty much the same as it was when we first started designing our what we call total visual appeal. We will know how it physically looks. Of course, we've seen plans and remodels and drawings. My guess is that when we see the physical store itself, we will continue to make adjustments, get it right, but it has not changed much. It has taken us a little longer than we had hoped to get these out. The quarter will have three and we will have a number of new stores with these elements. Maybe in November, you can come out and see them.

And just if you could elaborate for me, I'm a little surprised you didn't buy back stock, given you increased the authorization and you generated some good cash flow, etc. Can you just maybe elaborate a little bit on lack of repurchase in the quarter?

Glenn, this is Steve. We review this routinely internally, and we match our expectations in terms of where our cash is going to be versus what we think it is, where we think we ought to put the money. We are entering into seasonal inventory buildup, and so we decided to hang onto our cash and we'll continue to make evaluations of whether or not we buy back stock on an ongoing basis as we go forward.

Thanks. See you in November.

Josh Fisher with Pequot Capital.

Thanks, I missed your accounts payable number.

I don't think we actually split it out separately. It was part of the current liabilities number.

Okay, can you give that to me or should I just wait?

Wait for the 10-Q.

And then for volume I missed -- what was your volume in the quarter on the drug side for prescriptions?

You are talking about sales?

No, just your prescription volume. You said it was down. Did you guys --

We didn't quantify our script volume.

Okay. And then again just on trying to understand why that was down, have you guys had any changes to managed care or PBM contracts, or lost any of those contracts the last year or so?

Our script count decline mirrors the script count decline in the regions in which we do business. So total script counts again where we do business is down, and of course there is HRT, the Claritin shift.

Okay, I mean also in a lot of your markets in the last year or two, you've got Walgreens or whoever right next door to some of your places. Do you feel that they have not affected your drug business at all over the last year or so?

Whenever a retailer has new square footage open against them, whatever it is, whether it is highly consumable or prescriptions, you always feel new competitors. You always feel when new competitors open, but retail markets are dynamic. We compete with many classes of trade, many different kinds of retailers, many different kinds of pharmacy. We always measure ourselves against each one of the individual competitors, classes of trade, and it is dynamic. So we can have a new competitor open and feel it, and another competitor can close and neutralize that effect. We open our own stores and we feel our own stores when we open within our trade areas. So sure, we feel all new square footage opening, but at the same time square footage closes.

Okay, and then last again on the managed care PBM contracts; any changes in the last year?

I wouldn't -- I don't think there is any significant changes.

Okay, thanks.

Operator, we can take one more question.

Dan LaScano (ph) with (indiscernible) and Associates.

I had a couple questions on the gross margin in the pharmacy and the front-end, you quantified they were both up in the second quarter. What do you see in the back half of the year? Do you see them both up still?

We've been encouraged by the increase in margins that we've had, but we still remain relatively conservative in our outlook, and the reason primarily is because we continue to look on the pharmacy side pricing pressure from third-party plans, and on the front-end side, we continue to look at our pricing in the markets that we're in. So we are trying to drive operational improvement, primarily on the O&A line. We're trying to take a conservative view of gross margin rates.

So in your guidance, you're assuming they are closer to flattish for both of those?

Those are your words, not mine.

Can you tell us what generic -- what was the quantification for generic in the quarter? Obviously, you quantified what it did on the O&A, but obviously -- you didn't say publicly what it did on the gross margins, but you must have a number like that.

I don't think we've ever actually published that number.

Could you tell us, did it more than offset the decline in O&A, or was it less?

We've never published that number, Dan. I'm sorry.

Okay, thanks.

We would like to thank all of you for participating in today's call and your interest in Longs, and we look forward to speaking with you again and reporting on the continued progress we've made in our initiatives during our third-quarter conference call in November. Thanks again and good afternoon everyone.

That does conclude today's conference. Thank you for your participation and have a great day.