沃博聯公司 (WBA) 2008 Q1 法說會逐字稿

Good day, everyone, and welcome to the Walgreens Company first-quarter 2008 earnings conference call.

As a reminder, today's call is being recorded.

And now I'd like to turn the call over to Mr.

Rick Hans, Director of Finance.

Please go ahead, sir.

Thank you, Jennifer, and good morning, everyone.

Thank you all for joining us today for our first-quarter earnings conference call.

With me are Jeff Rein, Walgreens' Chairman and CEO; Greg Wasson, our President; Bill Rudolphsen, our CFO; and John Spina, our Treasurer.

During this call we'll provide a brief overview of the first quarter and a review of the cost control measures we've implemented and the success we've seen from them.

We'll also highlight our efforts to leverage our stores to drive higher sales volumes and our investments in new and expanding healthcare services.

I should point out that today's call is being simulcast on our Investor Relations website at Investor.Walgreens.com.

After the call this presentation will be archived on our website for 90 days.

Following our prepared remarks we'll be happy to take any questions.

Please limit yourself to one question and a follow-up so that we can give an opportunity to as many investors as possible during our limited time.

Before we get started I'd like to read our Safe Harbor language.

Certain statements and projections of future results made in this presentation constitute forward-looking information that is based on current market, competitive and regulatory expectations that involve risk and uncertainty.

Please see our Form 10-K for the fiscal year ended August 31, 2007, for a discussion of factors as they relate to forward-looking statements.

Now I'd like to introduce our Chairman and CEO, Jeff Rein.

Thank you, Rick.

Good morning and thank you for joining us.

We appreciate your time, particularly the Friday before Christmas.

Many of you may be aware that Walgreens has recently made a significant effort to broaden investor access to senior management.

Today's call is just one more example of this effort and is consistent with our commitment to greater transparency, access to senior management and improved information flow to shareholders.

Let's begin with the quarter.

As you saw from our release, we reported record sales and earnings despite facing a tougher comparison to a 25% earnings increase in the year ago quarter.

Expense control was a top priority and our folks came through, particularly in payroll.

We also maximized our advertising dollars through greater efficiencies while keeping up on our promotions during the critical pre-holiday season.

Very pleased that we're starting 2008 on strong footing.

Due to a number of factors our sales growth in the period was slower than expected.

Among these were late quarter weakness in seasonal categories, discounts on digital photo processing, a milder than normal flu season and the recall and cautions on children's cough and cold products.

We continued to execute on our organic growth strategy in the quarter, opening a record number of new stores and continuing to invest in our future.

As of November 30th we had 6,139 stores nationwide.

In addition, we have about 1,800 new store leases in our active pipeline; of those 600 have already been signed.

Taking a closer look at cost controls this quarter, we took a number of significant actions in response to the unacceptable growth in expenses in the fourth quarter.

In particular, store and district managers redoubled efforts to more closely align store expenses with budgets and sales performance.

We also were very careful to manage service levels and discretionary cost with a keen eye to avoid disrupting customer service or slowing sales momentum.

At the corporate level we put certain noncritical projects on hold.

I want to acknowledge and thank our teams in the stores and at the corporate office for their hard work -- you've done an extraordinary job.

While I'm happy with our great progress on the cost front, have no doubt, we'll continue to be vigilant.

Looking forward we expect the first half of fiscal 2008 to remain challenging from a bottom-line perspective as we cycle a very robust trade for generic drug introductions last year.

However, our long-term outlook for margins and sales remains strong and should improve in the second half of fiscal 2008 and beyond.

I would also like to point out that the comparisons in this second quarter will be difficult versus last year when we reported gross margin of 28.96%.

Last year we benefited from new generic introductions, significant SG&A leverage and operating margin expansion.

Now I'll turn the call over to Bill Rudolphsen, our CFO, for more details on the numbers.

Thanks, Jeff, and good morning to all of you.

Let's briefly discuss our first-quarter financial performance.

We reported revenue of $14 billion, a 10.4% increase; comparable store sales were up 5.4%; net income and earnings per share grew 5.5% and 7% respectively; prescription sales rose 11.1% for the quarter and 5.9% on a same-store basis impacted by more sales of lower cost generic drugs and a milder flu season.

The number of prescriptions filled in the first quarter increased 3.7% on a comparable or basis.

Front end store sales increased 4.6% on a comparable store basis.

In terms of the current environment, as we've indicated, our gross margin dollars and overall profits are being impacted near term by tough comparisons to what was a stellar year ago period.

In addition, we saw a positive impact on volumes a year ago from the introduction of the Medicare Part D benefit.

Total gross profit in the quarter was $3.9 billion, a $331 million year-over-year increase.

Our LIFO rate this quarter was 1.5% compared to 1.75% in the year ago quarter, that led to a LIFO provision of $26.9 million in the quarter, just $0.5 million less than last year's first quarter.

As Jeff indicated, we made significant progress in slowing the rate of growth of advertising, payroll and direct store expense.

SG&A expenses increased 9.5% in this year's first quarter versus 18% in the year ago quarter primarily due to lower growth and store salaries, legal expenses, insurance and store closing costs.

Advertising expenditures grew more slowly than sales in the first quarter; our advertising spend was up 8% in dollars year-over-year to drive traffic through circulars and other media.

Even though payroll and direct store expense dollars grew faster than sales, we made good progress slowing the rate of growth compared to the fourth quarter.

We believe we can hold the line on the cost control improvements we've already made while making additional progress in other areas.

Looking at slide number 6, you'll see that normally changes in SG&A expenses closely track changes in gross profit dollars.

That didn't happen in the fourth quarter of fiscal 2007.

We quickly got back on track in this first quarter, with the growth rates of SG&A expenses and gross profit dollars moving in lockstep.

Our effective tax rate was 37.5% compared to a rate of 36.8% in the year ago period.

We anticipate a tax rate of about 37.2% for the fiscal year.

Looking through our cash flow and balance sheet, cash flow from operations totaled $390 million in the quarter.

Our total short-term debt stood at $1.2 billion at the end of the first quarter.

We will continue managing our balance sheet for maximum financial flexibility and to support our core growth strategy.

I would like to spend a few minutes discussing our store expansion program.

Some in the financial community speculate that our new stores are less productive than in years past due to high real estate and labor costs.

Let me put that myth to rest.

Our productivity improvements at the store level continue to be very positive.

If you'll refer to slide 7, you'll see we published for the first time our front-end sales per store or stores we opened each of the class year from 2002 through 2006.

As an example, the front-end sales after year one for the 2006 class of stores is just over $2 million, which exceeds the front-end sales for each prior class of stores shown.

On slide 8 we show prescriptions per store per day at the end of each year, again, for stores we opened each class year from 2002 through 2006.

Both sets of data demonstrate that our 2006 class of stores performs as well in the front end and the pharmacy as the store classes each year between 2002 and 2005.

On slide 9 we also show our return on average invested capital for the last five years.

Those returns have increased from 9.6% in 2003 to 10.5% in 2007.

You can find the details of the calculation on our Investor Relations website.

You can use these three pieces of data to come to the same conclusion that we have -- namely that the productivity of new stores has not diminished over the last five years.

Also keep in mind that Walgreens' ROIC is greatly impacted by the 20% of our stores that are less than three years old.

It takes about three years for an organically developed store to breakeven.

We estimate that when you adjust for the net operating profit after-tax and the invested capital for these new stores, the after-tax ROIC for our stores open more than three years is in the midteens.

This results in a significant spread over our weighted average cost of capital which we calculate at about 8% using the market value of equity method.

Given these returns we'll continue the growth of these highly productive stores.

Finally, from an investment standpoint it's important to know that we have a goal for our capital investments to reach an average ROIC of more than 15%.

This goal includes strategic growth initiatives such as organic and acquired store growth, new alliances and other ventures and acquisitions we might consider.

Let me now turn the call over to our President, Greg Wasson, who will update you on growth initiatives.

Thank you, Bill, and good morning, everyone.

I'd like to briefly touch on recent progress in our overall strategy to leverage our store box to drive higher sales while investing in new and expanding healthcare services to grow earnings.

Our pharmacy business is strong from every competitive vantage point.

Just to remind you, we filled more than 580 million prescriptions in fiscal 2007 and today our share of the U.S.

retail prescription market is more than 17%.

Our drug store sales on a square foot basis of $797, among the highest in the industry.

As you know, fiscal 2008 will not be a year of major new generic drug launches -- this is simply part of the ebb and flow of generic introductions.

However, we expect to see a new wave of generics from 2009 through 2011 which will bolster and accelerate our profit in those years.

For example, looking ahead to the next several years, drug's coming off brand include Lipitor and Nexium, but keep in mind, it is difficult to forecast with certainty the timing of generic launches.

As important as mainstream prescription drugs are to our business we're also positioned to take advantage of the fastest-growing area of pharmacy, Specialty Pharmacy, which is rising at a rate of 20% a year.

You'll recall that our acquisition of Option Care last summer is a key part of our growth in Specialty Pharmacy.

I'm pleased to report that the integration of Option Care is progressing on plan; this success demonstrates our ability to effectively integrate sensible acquisitions into our broader platform.

Consistent with our strategy of strengthening our healthcare relationships with consumers, we continued to rollout our Take Care Health Clinics during the quarter.

Today we have about 120 clinics operating in 15 cities across 11 states.

Again, the convenience of Walgreens combined with the cost-effective access to basic healthcare services that Take Care Health Clinics offer represent a distinct advantage.

Take Care Health Clinics offer high-quality primary healthcare services and are staffed by nurse practitioners and physician assistants who work in collaboration with primary care physicians.

We have an excellent model to retrofit our existing stores and we estimate having more than 400 clinics operational by the end of calendar 2008.

Our early studies indicate that approximately 20% of Take Care health patients who choose to fill their prescriptions at Walgreens are not existing Walgreens pharmacy patients.

Our financial assumptions for these clinics are based solely on healthcare reimbursement and cash fees for common medical procedures such as vaccinations, basic diagnostic testing and similar activities.

Incremental pharmacy volumes and front-end sales are not considered in our financial model.

We continue to look at opportunities to expand access to Walgreens as a trusted source for basic healthcare services.

An example of this is our move to operate pharmacies in nontraditional venues such as Children's Hospital in L.A.

and Northwestern Memorial Hospital here in Chicago.

We also have pharmacies on-site at corporate campuses of large employers such as Toyota Motor Manufacturing.

You may have seen that during the quarter we made the decision to withdraw as a pharmacy provider from four prescription plans managed by CVS CareMark due to their unacceptably low below market reimbursement rates.

While we continue to seek and negotiate a solution this won't have a material financial impact on our results.

Thank you for your attention.

Let me turn the call back to Jeff to discuss our strategy.

Thanks, Greg.

I want to spend the last few minutes of our prepared remarks on our corporate strategy and outline how our superior competitive position will lead us to future growth and deliver long-term shareholder value.

We are focused on growing our market leadership to strengthen our competitive position and we intend to actively and aggressively manage organic store expansion to capture the best retail corners nationwide.

We continue to make sales focused and customer focused investments in our stores, supply chain, marketing and infrastructure.

We're expanding into adjacent sectors of pharmacy and healthcare services through our acquisitions of Option Care, Medmark, Schraft's and SeniorMed.

These businesses allow our patients to continue using Walgreens' services as they develop needs for infusion therapy or specialty pharmacy products or move into an existing assisted living setting.

We will prudently evaluate acquisitions that enhance our core service offerings, expand our convenience and meet our ROIC goals.

So how are we uniquely positioned to capitalize on this strategy to deliver that shareholder value?

First and foremost, with more than 6,000 locations, significant buying power and high service levels we have an exceptional retail platform that can be leveraged across both the front and back of the store.

As a pharmacy provider we believe our independence differentiates us and enables us to successfully compete for business as a provider of choice.

We believe any efforts to restrict us from provider networks with prove counterproductive with payers and will underscore the inherent conflict of interest of a vertically integrated business model.

Organic store growth remains a key part of our strategy.

This year we plan to open 550 stores for a net increase of 475 stores after relocations and closings.

In addition, we are targeting total square footage growth of approximately 8% per year.

Geographically we're aggressively expanding in the Northeast and California.

These areas have higher real estate costs and in some cases smaller properties with which to work.

So we're using a flexible and adaptable store model to customize product selections similar to our successful stores in densely populated urban markets such as San Francisco.

While the breakeven period is longer for these stores due to higher real estate development costs, our experience has shown that their sales growth tends to be sustained over a longer period than stores in less dense markets.

In other words, these stores continue to improve their performance for many more years after they breakeven.

Over the long-term we expect our productivity and sales per square foot to increase as we bring a higher mix of these stores into our system.

In short we are nowhere near the saturation point; there's plenty of room to grow and we have the right strategy to get there.

We're also growing market share through buyouts of independent pharmacies which face particularly tough economic times as pharmacy reimbursements fall in both the public and private sectors.

We completed a record number of 200 independent pharmacy buyouts in fiscal 2007 and expect this trend to continue.

Our strong balance sheet provides us with the ability to be opportunistic and flexible in pursuit of growth.

Our 50% debt to total cap ratio how positions us ideally in this regard.

So when you look at the different levers we have as an organization, we believe we are well positioned to deliver consistent growth.

That concludes our formal remarks and now we will turn to your questions.

Operator, may we take the first question, please?

(OPERATOR INSTRUCTIONS).

Ed Kelly, Credit Suisse.

Could you quantify the benefit from the lower legal, insurance and store closing costs in the quarter?

Was that all of the 19 basis point decline in the SG&A, is that how we should think about that?

This is Bill, Ed.

That's not -- I'd say the major reason for the increase or the change in the growth rate was store salaries.

We grew at 18% in the first quarter of last year, only 9.5% this year.

I'd say about a third of that improvement is related to store salaries.

Okay, but the year-over-year lower SG&A rate of 19 basis points, that's mostly the legal, insurance and the store closing costs, right?

Percentage of the sales basis, that is correct.

And then Jeff, I was hoping you could discuss comp trends a little bit.

Your comps have obviously decelerated somewhat and I understand that generics is playing a role in that.

But obviously from the information you provided your new store comps are still robust.

So can you help us dissect what you're older stores are comping at this standpoint if we call it stores older than five years?

And then what should we expect now going forward the rest of this year, particularly on the front end as it seems like things might be slowing down a little bit?

They still are doing very well.

We did see a traffic slowdown in mid-October and that's what we talked about in November.

So a traffic slowdown, you saw the customer buying down a little bit and the customer count once again when down a bit.

The comp stores are still doing very well, those stores open more than three years, is that what you're referring to?

Yes, I'm talking about your more mature stores.

Right, they're still doing very well in terms of comp sales.

But once again, overall we did see a decrease in customer count starting in about mid-October when the subprime crisis became big news, we saw people trading down a little bit.

That had slowed down the comp store sales a bit.

With regard to the rest of the year, it is a tough economic environment right now.

But of course we're not commenting particularly on sales for this month and also how it's going to be for the rest of the year.

But how do we just think about what your promotional strategy is going to be going forward on the front end?

Do we think about it as getting more aggressive because of this?

We will do what we need to do to either meet or beat competition.

If we need to get more aggressive we certainly can.

We do a good job day in, day out.

I have no problems with that, we've always been promotionally oriented not only in ads but in the way we merchandise our stores.

As you know, most of the products that we sell in our stores are low-end products and they lend themselves to promotional abilities.

People come into our stores based on convenience looking for 1.6 items, they leave with 3.3 items.

That has been very, very consistent whether the economy is great or the economy is poor.

so I think we'll do just fine, just fine in the months ahead.

Great.

Thank you.

Patricia Baker, Merrill Lynch.

Good morning, everyone.

I don't want to dwell well very much on the fourth quarter, but since we didn't have the benefit of this exact access with that quarter, can you just go back and explain to us why you think the fourth quarter did end up with much higher SG&A than was anticipated just so that we have a better understanding going forward?

Yes, Patricia.

In the fourth quarter of 2007 we did a very poor job of managing and focusing on expenses.

We are a $0.03 company -- that's our mantra right now, a $0.03 company.

We have got to remain focused.

During that time period our payroll was out of sight.

We also had direct order expenses and advertising that we had in the fourth quarter of last year that we did not have in the previous year.

So once again I would say to you it was a lack of focus.

As you can tell by this quarter, there's more focus on controlling discretionary costs.

We are making sure that when we have the budgets and the sales those are being matched up.

We are taking outliers back to budget.

Obviously if you get and do more sales than the budget is saying then they get more hours.

But if they do not then we take hours out.

The biggest lever that the store manager can control in terms of expenses is that payroll salary line.

Once again, by matching up the budgeted hours with the budgeted sales we will do better.

Okay, thank you.

That helps us understand it better.

Meredith Adler, Lehman Brothers.

I'd like to talk a little bit more about first-quarter expenses.

The 18% SG&A growth you had in the first quarter last year, I believe some of that was related to Happy Harry's; I don't know how much of that was payroll.

But is it fair to say that some of the improvement in the payroll this year is a function of fully integrating Happy Harry's and that those were sort of one-time costs?

I wouldn't say that completely, Meredith.

The reason being, it's an ongoing process with Happy Harry's.

We obviously put some payroll in but the stores were not necessarily all set completely.

We're still going through that right now with them to make sure that the planograms are set to the Walgreens' system.

So I would not classify that at all as the main reason.

The main reason, once again, that we controlled expenses is that we had a diligent effort and we're tracking it on a daily and weekly basis much better than we did in the past.

Okay.

And then I'd like to just ask some questions about those slides you were kind enough to provide us about pharmacy productivity both front end and -- one thing I noted is a footnote that you've excluded the 24-hour stores.

Can you tell us how many of the stores you've been opening are 24 hours?

And then I have just sort of a follow-up question related to that.

I'll answer the 24-hour question in just a minute.

When you say opening you mean opening per year?

Right now we have approximately 27% of our company 24 hours; it's about 1,600 stores that are 24 hours.

It's hard to determine exactly to say how many we're going to open per year because obviously it's based on script numbers, the competition and so on.

So that ebbs and flows.

But right now, we've been around 27, 28% and we'll probably stay in about that range for quite a while.

Do you have other questions regarding the charts?

Because you had excluded those 27% of the stores more or less from these charts I just want to understand that.

But also, can you talk about over the same five-year time frame where you've had very stable sales and script count, what happened to labor and real estate costs?

Have they also been equally stable?

Meredith, this is Bill.

Yes, they've been fairly stable.

Certainly as we do expand into the Northeast and California, as Jeff mentioned, we would see slightly higher occupancy costs in those areas, but overall our costs have been fairly stable.

And finally, just the chart you do where you look at return on average invested capital, are you capitalizing leases in that calculation?

Yes, we are.

Okay, great.

Thank you.

Andrew Wolf, BB&T Capital Markets.

Good morning.

I just wanted to ask you about the -- from your commentary on -- it sounds like you're making good progress on the payroll side of the business, but actually it's got to be carefully done, but it sounds like there's more to come.

Am I understanding that right?

And if so, could you somehow give some quantification of how much more labor rates can be managed out?

Yes, Andy.

Thanks for the question.

I don't want to give an exact figure on how much more can be managed down.

It is a lot more focused than ever before.

Once again, during the last summer we just did not do a good job of focusing on it week to week to week.

We are definitely doing it now.

Folks are engaged from a corporate point of view and also engaged at the store level to make sure we look at that payroll.

It's more a judicious use of payroll and once again we look at the outliers.

We have templates that the manager and district manager and store ops vice president agree upon that how many hours are allotted to every store including pharmacy and front end.

And if the sales are there then we're okay.

If the sales get much better than anticipated, obviously we can put hours on; if they get much worse than anticipated we can take hours out.

One thing we obviously don't want to do is hurt service levels.

And as I've mentioned in the past, we've had a pretty good track record now of having decreased service complaints in our stores.

It's a focused effort on taking care of the customer, taking care of the patient and, once again, we're not going to be so silly as to cut payroll to the bone where we hurt ourselves.

We don't want to do that.

We want to take care of our people and want to take care of our customers and patients all the time.

Andy, this is Greg.

The other thing that we did do intelligently, back to the 24-hour, we did take a look at some of the 24-hour stores that we had and rolled back a few that maybe didn't make sense.

We may have been a little aggressive over the years in adding some of those 24-hour locations.

If we rolled a few back, that helped us a little bit in that area.

And again, as Jeff said, just an intelligent focus on labor costs.

Our managers and our district managers in the field have done a great job responding.

Andy, that's a great point by Greg.

When we were reviewing the districts we actually had some districts that were 50% 24-hour stores, we just didn't need that for the coverage.

So it sounds like you can at least maintain the current discipline and perhaps there's some fine-tuning to come.

I think that's a good way to say it, the fine-tuning is the best way to say it, you're right.

And my follow-up, if I might, is just on the pharmacy side of the business both at Walgreens and other public chains and the industry at large.

This year has been a little slower than last year in the prescription business and, as you all dissect it, there are different reasons.

One is obviously you're lapping -- you compare them to the Part D infusion last year, Wal-Mart and others have made a competitive bid for business, the economy, bad flu.

How would you -- when you look at this year being a little slower than last year how do you ascribe the slowing -- slight slowdown in the scripts?

I would agree with those reasons you listed -- Medicare Part D, the flu obviously is playing part of it, the economy as you mentioned.

I think another thing that's coming into play is employers putting more cost on employees.

As you see co-pays rising people unfortunately do not fill their medication as much as possible.

But I think what you're seeing is more and more people getting access to care.

I'm quite confident the numbers will go up as people get access to care, for example, through our Take Care Clinics and other clinics that are out there.

I think people want to stay well.

As insurance companies pay for visits to the Take Care Clinics for example, that encourages people to come into the system.

Before they might be putting off.

For example, they didn't want to go to a doctor, they know it's very expensive and they're going to just wait it out.

There's also been a lot of negative publicity, as you know, regarding various cost tariffs and other medications and people might be taking a little jaundiced view of it -- well, let me just wait it out and see what happens.

It's our job though as pharmacists and a pharmacy profession to encourage people to take their medication on a regular basis.

I think that's one of our biggest opportunities for us to grow numbers is to get people to be compliant and adhere on their medications.

If you miss your medication for a day on a statin for example or something for high blood pressure you're not going to feel any different.

But if we can show people that you're going to feel better, you're going to be around to see your grandchildren in the years to come, then it will make a big difference and there's our opportunity in this industry is to drive compliance and adherence.

all right.

Thank you.

Mark Miller, William Blair.

Good morning.

I first want to say thank you for hosting this forum, I think it's going to be helpful for the dialog going forward.

I want to follow-up on the earlier question about the rate of expense control we've seen so far.

Bill, you talked about you can improve additional things going forward.

I hope you can elaborate on that.

And then Jeff, you mentioned the noncritical projects on hold, how long can those stay on hold?

If the economy does tighten up how much ability do you have to bring down the expense growth rate further?

We do have a lot of ability to bring that down as needed without being silly or stupid about it.

Obviously whatever we want to do in terms of payroll is to make sure we don't impact sales.

On the expense and consultants we want to make sure that don't impact shareholder value for the long term.

As you know, there's always things you need to do and want to do.

Some of those want to do's are not necessary right now.

There are some needs to do obviously that we're moving ahead with.

But once you've got the wants to do, we can't do that.

In any list of projects we obviously have to prioritize what we want to do and what we need to make happen and position ourselves well for the future.

In terms of the expenses again, once again, about one-third of our savings this quarter was due to payroll, the other two-thirds was due to these higher legal, insurance and store closing costs.

Those ebb and flow as you know, so we can't be exact about those.

But the biggest SG&A expense line that we can control is payroll.

Payroll represents about 50% of our SG&A and that's where if we have a concentrated effort to make a difference we can do it.

In the stores where you've put in the discipline you talked about, have you seen a bigger change in their sales?

So as comps slowed in November was that more so at those stores that had that greater expense discipline?

No, Mark, absolutely not.

No, no, no.

As a matter-of-fact, it's kind of interesting.

If you look at the stores on an individual basis, typically those folks that run the most disciplined payroll have the best stores in terms of being in stock, taking care of the employees, taking care of the customers, everything is great.

It's like inventory for example, you go into some store and if they're a lot over in inventory some folks think there should be no out of stocks, but actually those are the worst stores in terms of being in stock.

Mark, this is Greg.

Our operations folks have done a great job in delivering this message and helping us make this happen.

They've been in the stores; working with the stores that might have some challenges, making sure it's done the right way and intelligently.

And they've been extremely careful and cautious about doing anything that might hurt us on the service level.

So I just think it's been one heck of an execution from our store ops folks.

Thanks.

My other question on the slides, looking at the pharmacy productivity, it moved up in this past year, but it is down from where you had been a couple years prior despite overall growth in scripts in the market.

So I guess I was hoping you could address that and also explain whether that's coming from more stores in these new markets.

So you talk about higher investment costs in the new markets on the coast, but do you also start with lower sales productivity?

And then as more of these stores are coming on is there some risk that return on capital would actually be weighed down for some period of time until enough of them are in the maturity phase of the curve?

Thanks.

Mark, let me answer to the first part of that.

In terms of the slower growth, as we expand more into areas where we're not as well-known, the prescription growth is slower to begin with.

But what we've found many, many times, particularly in the Northeast and California and so on, that after that four and a half to five-year break point our sales actually go up faster than the other stores in more mature markets.

So I think we'll be okay, once again, long-term.

It shouldn't be a problem in terms of growing the scripts.

Bill, did you have anything to add?

Mark, as I look at the numbers I really don't see a material difference amongst the numbers throughout the years, that's why we posted the chart.

And I would agree with Jeff's comments that we do start out slower in the Northeast, but we ramp up over time as the public becomes more and more aware of Walgreens in the market.

Mark, a good thing to always keep in mind is the market share penetration actually drives the ROIC.

So once again, in more mature markets the stores come up to that breakeven point, breakeven and above, much quicker than they do in some of the areas where we have less than a two coverage, that's stores per 100,000.

And on the ROIC part of the question, it's intuitive to me that it would weigh on returns.

Is there some reason why that wouldn't manifest itself in the results?

Mark, yes, early on I would say as we start slower certainly that would weigh on the returns.

But long-term we would get to where we need to be which is a 15% return on invested capital which is our target.

Right.

Thanks, enjoy your holidays.

David Magee, SunTrust Robinson Humphrey.

Good morning.

Just a question about the generics and your expectations for the lesser introductions 2008.

Would you expect your generic percentage to still grow this year in that environment and how should we view that?

Is it less of a positive in this kind of a year or is it actually a negative that you've got less to offset, you have older generics that are being backed out, etc.?

As you know, David, the generic -- we planned going to generics at actually a low point in 2008, then it picks up in 2009, 2010 significantly.

I do believe that our generic penetration will continue to move up, maybe not quite as quickly of course on a percentage basis because you don't have all the brands going to generics.

But more and more people are familiar with generics, doctors believe in generics and the customers and patients know a generic now and are asking for it.

Also as part of the design of the formulary, most folks, most employers obviously are keeping those generic co-pays down.

As a matter of fact, some companies now are starting to waive co-pays on certain generics just so people will take their medication and that's why I come back to this compliance adherence.

I think there's the realization in the healthcare industry in general that if we can get people to take their meds then our total healthcare cost will go down over time.

Thanks, Jeff.

From 10,000 feet do you think that the generic profitability would change that much over the next three, four years?

What do you mean change?

Just in terms of your net dollar per script reimbursement that you get for generics, do you expect that to change much?

No, not on a per script basis.

No, I don't see that happening.

Great.

Thanks.

John Heinbockel, Goldman Sachs.

Jeff, do you think -- are we headed toward a period of greater ongoing confrontation between PBMs and retailers over reimbursement, broadly -- not just CareMark but Medco an Express as well?

Are we headed in that direction and do you see opting out of other plans or no?

It's always been a discussion with the PBMs over the years in terms of the reimbursement rate which we feel is needed and fair to us, at the same time fair to them.

I wouldn't say it's more conflict at all.

These floor plans with CVS CareMark is just something that we haven't been able to work out yet.

I'm hoping that we do come to a resolution but we just have not yet.

But in terms of the major PBMs and the conflict -- no, I don't see it intensifying at all.

I really don't.

I think we'll be just fine in the years to come.

They have their point of view, we have our point of view, but once again, with our coverage and the locations and market share we have I don't see it changing from what it was in the past.

With regard to CareMark, do you sense a different agenda than had been the case a year ago?

Or this issue you had with these four plans, they would have cropped up whether CVS owned it or not?

That's the best way to put it.

As you know, we have been fighting -- if you want to term it that way -- with the PBMs for a long, long time.

Most of these don't get to be public knowledge.

You would never hear about it.

It's just these four plans unfortunately couldn't come to an agreement which was fair to both sides.

Once again, we're still talking with them and hope to have a resolution, but no, I wouldn't say things are going to get worse at all and obviously we'll continue our discussions.

All right.

And then finally, how much of your front end do you think is really economically sensitive, is discretionary?

And of what is discretionary, how price elastic do you think that is such that if you increase promotions you'd get a response?

John, in my opinion we are recession resistant but we're not recession proof.

And once again, it depends on your level of income.

What might be someone's discretionary spend is someone's needed spend somewhere else.

But with promotional activity that ebbs and flows.

As you know, once again, most of our sales happen because folks are in the store, that's why we want these prime locations on the best corners in America.

Once we get them in the store are we are fine in terms of selling them what we need.

Now maybe we need to do some price points.

Let's say instead of $3.19 maybe it's $2.99 or two for $5 or something of that nature.

But our job in terms of the rodos and the circulars is to get people in the door and we'll do what we need to do depending on how competition responds and how the economy is and how things have been and are going.

Does $3 gas help you in that traffic generation or no?

It is interesting.

We are in the neighborhood, we're close to home, so in that sense when people have a need -- once again, they're only coming after 1.6 items so their top of mind -- they're out of milk, right -- they're out of bread -- who's not going to have that for their children in the morning?

They think of Walgreens right off the bat.

They think about Walgreens' milk, they come to our store to buy it and then they pick up something else.

So I would say actually with gas prices increasing people are coming to our stores.

Okay, thank you.

Scott Mushkin, Banc of America Securities.

Just a couple questions.

One just to clarify -- I know we drill on this SG&A subject, but what in basis points would it have been up ex some of these onetime items -- legal, insurance and store closings?

This is Bill.

We're not going to release the exact amount, but it's not a tremendously significant amount.

I would again point to, as we look at the increase in SG&A last year in the first quarter of 18% versus 9.5% this quarter, the most significant amount of that reduction in the increase was store salaries and we would point to that being about a third of the change.

But the other two-thirds were pretty much onetime items, not as repeatable?

More onetime items plus other control of expenses in other areas.

Okay.

And then moving to the gross margin which I don't think we've hit on yet, down 29 bips, it's somewhat surprising.

Was that all front-end related as we look at that?

And how do we think about that going forward with sales looking like they're slowing a little bit in the front-end?

And then maybe just as a follow-up to that, consumer behavior seems pretty odd this time around.

Usually you guys are the last to slow and supermarkets haven't really slowed much at all.

So maybe a comment on why you think all of a sudden employment is still very robust you're actually seeing a pullback and why you think it's not related to some of the actions you're taking?

On the margin side, Scott, our pharmacy margins were up driven by generics, but our front-end margins were down as we moved to less profitable categories being sold.

So the front end was the major factor in the reduction of gross margins.

When you look at the sales once again going back to November where it started to tail off, don't forget that cough/cold is a big, big part of our business.

And before the FDA said anything about children's cough medications we were up about 15%.

The day after that immediately started to drop and we actually ended up zero for the time period, just zero and we have never seen -- I've mentioned to several folks, I have never seen us up zero in cough/cold.

Seasonal type products we saw started to decline a bit in November.

Once again, Halloween was pretty good, but not quite as good as we would have liked and we have high expectations of course.

Items like vaporizers in November just didn't sell, they just aren't going, people aren't buying, they don't need them, it's too warm.

Products like mittens and hats and clothing down 20%.

Those products were not selling.

So once again, in an environment where it's slowing, people do look at what they're spending and what's discretionary.

They may or may not be buying some of the promotional items that we offer.

I think a lot of it is dependent on not only what do they think of the future, of course, in terms of their mortgage, their job and so on, but also the weather does impact us, particularly on the cough/cold and the flu index side.

This is john Spina.

I want to add that in tough economic times there are so many moving parts to our sales it's tough to pin it on one thing.

So we're just going to make sure we take care of the customer, we have the right advertising, get them in the door, put that extra item in the basket and go forward.

But to predict the future, we just never could do that with just too many moving parts.

So we anticipate all equal in the economy, it just kind of keeps chugging along the way it is which is just so-so, that this gross margin pressure will continue through the year?

We will see how it goes, we don't comment on which way it's going one way or the other.

It is a tough economic environment, as we've said before.

We all read the same papers and see the headlines and so on, but we will have to see how that goes.

All right.

Thanks, guys.

And thanks again for doing this.

I know someone else said that, but it's really appreciated.

Thank you for telling us.

Lisa Gill, JPMorgan.

Good morning.

Jeff, I think you talked a little bit about expansion of your healthcare strategy.

And I'm just wondering if you can maybe talk about areas that you're looking at.

I also think that -- someone made the comment that Specialty Pharmacy is fully integrated or on plan.

Can you talk about how you're integrating Specialty Pharmacy into your front-end pharmacy and, again, just coming back to how you view the overall strategy for a healthcare offering?

Lisa, just to let you know, we don't comment on any acquisitions that may or may not be happening.

We've never done that in the past and obviously we're not going to comment right now.

What we are trying to do with our strategy is make sure that we can take care of folks' pharmaceutical needs.

In the past we've been able to serve folks in many cases from the time they were born to maybe 65 to 70 and then we are out of the picture.

It just didn't make a lot of sense to us.

So with the acquisitions that we've done, whether it's Option Care, Medmark, Schraft's and SeniorMed, it allows us to take care of that patient from cradle to grave.

Everything we're doing and seeing is that more and more of the pharmaceutical needs of people is going to be met by the infusion or specialty side.

And by the way, these folks who obviously have to be infused or take specialty meds also take other medications.

So if we get the specialty person you also get whatever else they're taking that they can take orally.

Greg, I think you had some comments also on the specialty side.

Yes.

Lisa, obviously a big area of focus for us is the specialty infusion area, obviously with it growing at 15, 20%, $60 million a day, that could double in the next five years, maybe even triple.

So it's a huge area of focus for us.

As we know, the science of pharmacy is moving more and more toward biologicals, we want to be their.

So we invested a year ago in Medmark, bought a lot of expertise and manufacturer relations.

With Option Care we bought what we feel is one of the best national platforms in home infusion.

We're working at integrating the specialty side of that with the infusion side as we speak.

That's going well.

As far as the retail opportunities, we do think that there's going to be an opportunity to leverage the retail pharmacy as well as the Take Care Health Clinics.

And on the retail pharmacy side, are you using your pharmacist in a consultative way to talk about Specialty Pharmacy?

So if someone walks in to pick up a specialty prescription, they don't have a Specialty Pharmacy company today, are you using that opportunity to try to cross sell some of the new services that Walgreens has?

We're headed toward that.

We're not as far along as we expect to be in the near future.

We absolutely want to determine what it is that a store level pharmacist should and could add to that specialty patient to provide value.

Certainly the combination between the centralized model, the pharmacists and nurses that we have to assist the pharmacist at the store level combined with the action that could be delivered at the point of care is going to be we believe extremely differentiating for us.

Lisa, this is Jeff again.

Just to remind you that infusion doesn't necessarily have to be done in a facility, although we do offer that.

It can be done in the home, it can be done in our stores.

One of the things that manufacturers and insurers get very worried about of course is the medication being used and is it being used properly.

When they are able to get to someone like Walgreens that's easily accessible we can make sure that they take their medication, the payor is assured that the medication was used, the manufacturer doesn't have to worry about returns.

So it's very important that we service these people correctly and that's why infusion is so difficult.

But we think we're positioned quite correctly because it does take a lot of time and a lot of effort.

Also with these Take Care Clinics -- you're probably familiar with this, but that's another way to get people into the Walgreens system and get those folks healthcare and that's why the insurance companies are now paying for that healthcare.

Because if they can get folks into the system earlier they can get taken care of and if they need medication they get that, that avoids a hospital visit or an emergency room visit and helps keep the total healthcare cost down.

Jeff, are you working with the plan sponsors to advertise, for example, Take Care Clinics to a certain health plan's members so they know and understand the service offering that you have?

Lisa, this is Greg.

Certainly we're working with the managed care plans as we sign up and enter into contracts with them and certainly encourage them to help us promote our clinics.

It certainly makes sense for them as well to lower their overall healthcare cost.

And then just one last follow up.

Obviously AMP has been pushed off by the current court ruling, we'll probably find out some point in January as to where it will move.

Aside from Medicaid can you talk at all about any of your other business that will be impacted by changes in reimbursement around the federal upper limit or around AMP?

Lisa, it's very hard to comment on that right now, we don't know the details, we have no idea of the metrics they're using and how they're going to figure AMP.

We just don't know so it's very tough to comment on that now.

When we have more information obviously we'll be glad to talk about it.

Okay, great.

Just don't know how it's going to end up.

Okay, thanks very much.

Mark Wiltamuth, Morgan Stanley.

Congratulations on your cost control.

Looking at your chart there for the last five years your SG&A growth has ranged between 11 and 18%.

Here you did a 9.5% growth number.

Do you think you can stay down at that 10% range for the balance of the year?

That's a good question and that's going to be difficult to do.

what we're really shooting for obviously, as I said before, is around 11 to 12% overall.

It's hard to get down to that 9 year after year, I think that would be tough particularly with opening new stores.

If we weren't opening all these new stores, 550 of them next year, then I believe we could control expenses even better.

But when you're opening all these new stores you have to hire folks ahead of time, with going into smaller towns it requires a little bit more help to get those stores open because you don't have folks to draw from in mature markets.

So once again, I don't want to commit to a 9 or 10% with opening all these new stores.

Mark, this is Bill.

I would jump in on that.

We have done a very good job in the past of managing our SG&A growth through our gross profit.

And that's our intent for the future.

We fell off of the wagon a little bit in the fourth quarter.

We're coming back and that's the plan going forward.

Okay.

And could you give us an indication -- I know labor reductions are one of the major goals here and how have you done on scaling back some of those 24-hour stores and what does that look like to the customer as you've been doing that?

We've taken approximately 60 down year-over-year.

But once again, it's all based on what the needs are of that particular store.

I believe some folks got a little too aggressive and opened a 24-hour store just to try to capture more volume.

That's not a smart way to run the business, just to open hours and have all that open -- for the store to be open when you don't need to cover those expenses like that.

I just want to remind you though that year-over-year we still have more 24-hour stores than we did last year at this time.

Once again, we're trying to rationalize the use of these 24-hour stores and make sure we are smart businesspeople and match up the sales with what's actually needed.

Okay.

And in your November press release you talked a little bit about discounting in the marketplace.

Was that more on the front end or was it discounting to capture prescriptions?

If you could just characterize what's going on out there.

That was in reference to the front end, that was more in the front end.

Okay.

And just to switch topics, on the Take Care Clinics, how much of an earnings drag are you suffering right now as those stores get started and what year do you think you'll shift to profitability?

Bill, could you answer that, please?

Mark, the earnings drag is going to be about $75 million for the year, $0.05 earnings per share.

And the breakeven point or -- it probably is going to take about a year to two years for units to gain share and become profitable, so it's all going to hinge on how fast we roll them out.

Certainly we are rolling a lot of these out in calendar 2008.

We're going to have about 400 of them by the end of next calendar year.

So it's difficult to project beyond that.

And this is Greg.

I'd like to add the encouraging part, what we're seeing are some of our more mature markets, mature clinics, those that are over a year, in many cases we're already exceeding breakeven.

Okay, thank you.

Bob Summers, Bear Stearns.

Good morning, guys.

Not to beat a dead horse here, but just trying to understand the direct store expenses and I want to make sure that I heard you correctly and you said that direct store expense dollars grew faster than sales.

If you could maybe frame that a little bit for us.

And then sort of tying that into the cash-flow statement, just trying to understand why cash flow from ops -- you had a deterioration versus last year and it looks like there were some significant changes particularly on the accrued expense line, if you could maybe walk us through that.

Cash flow from operations, we did have an impact versus last year.

Last year we had the Ovations contract through our PBM and that really gave a lift to our cash flow, probably in the $300 million range, and we don't have that contract this year.

So as we turn the calendar year we will be more comparable on cash flow and I would expect improvement.

On the direct store expense line, that again grew faster than sales, but it didn't grow as fast as it had in prior periods, just like store salaries.

Okay, thank you.

Derek Leckow, Barrington Research.

Thank you very much.

Looks like you were able to take advantage of the weakness in the stock recently to buy back some stock.

Could you give us an update on your buyback program?

We have not been buying back stock, Derek.

At this point we are investing in the Company.

We certainly do consider it, but at this point we don't have excess cash to return to shareholders, we do have about $1.2 billion in CP at this point in time.

So we should probably anticipate that to be fairly flattish going forward?

I do want to make sure that you know that do buy back stock for our employee programs and that's probably what you're seeing in the cash-flow.

Okay.

Then just a final question on the Take Care Clinics.

You said that you're seeing a positive lift in some mature markets, but I just wondered if you could talk on a store level basis what happens to store profitability when you initially open one of these clinics?

We haven't really seen anything, it's been very, very -- I would say it's de minimus when you talk about something like that.

Once again, you're getting people into the Walgreens system.

We really haven't measured that in terms of what you're asking.

What we want to do is get people into the Walgreens system, approximately 20% of the folks coming in are new to Walgreens, it helps them get into our system, they get familiar with our stores, they get their pharmacy needs at our stores, they get exposed to photo, cosmetics and so on.

And they are being serviced properly in terms of healthcare needs.

So I wouldn't quantify at this point.

But longer-term isn't it true that you're expecting to see some incremental lift in some of these other categories when you open up these clinics or are you not anticipating that?

Yes, that is true.

We did the pro forma for them we didn't add anything in, but yet you do see cross shopping.

Obviously if people don't need a prescription sometimes they need an OTC so they will buy it there.

There it is the opportunity to sell other products, that is true.

Okay, thank you very much.

Well, that's it, folks.

That's our final question.

Thank you for joining us today.

We sincerely hope you found this call useful and have a clear understanding of our financial results and outlook.

We're committed to maintaining an open dialogue with you and look forward to speaking again and answering your questions in the future.

Our next scheduled financial announcement will be January 3rd when we release our December monthly sales results.

We also invite our shareholders to our annual meeting on January 9th at Navy Pier in Chicago.

For those of you unable to attend you can listen via the simulcast available on our Investor Relations website.

Until then we wish you all a Happy Holiday and Happy, Healthy New Year.

I'd also like to take a moment to wish my daughter a happy birthday, she's six today.

And in spite of the fact that she's a winter solstice baby, she sure can throw a lot of light into the room.

So happy birthday, Katherine.

And thanks again for listening.

Remember, you're always welcome at Walgreens.

And that does conclude our call for today.

Thank you all for your participation and have a great day.