沃博聯公司 (WBA) 2009 Q3 法說會逐字稿

Good day, everyone, and welcome to the Walgreen Company's third quarter 2009 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, Divisional Vice President of Investor Relations and Finance.

Please go ahead, sir.

Thank you, Cecilia, and good morning everyone.

Welcome to our third quarter conference call.

Today, Greg Wasson, our President and CEO, will discuss the quarter's highlights, including updates on our three key growth strategies.

Wade Miquelon, Senior Vice President and Chief Financial Officer, will detail the second quarter financial results before we begin taking your calls.

John Spina, our Vice President and Treasurer, also is joining us on the call today.

When we get to your 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.

Today's call is being simulcast on our Investor Relations web site, located at investor.Walgreens.com.

After the call, this presentation will be archived on our website for 12 months.

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 latest forms 10-K and 10-Q for a discussion of factors as they relate to forward-looking statements.

Now I'll turn the call over to Greg.

Thank you, Rick, and thank you everyone for listening to our call.

We certainly appreciate your continued interest in Walgreens.

Today I'm going to review the quarter, update you on our three strategies, and share some thoughts on today's consumer and healthcare reform.

In the third quarter, we posted solid results in a difficult economy, while recording significant restructuring costs.

Net sales for the quarter were a record $16.2 billion, up 8%.

We continue to see consumers save more, use less credit, and spend closer to payday.

This is challenging to all retailers, including us, but we are well positioned to continue to grow.

Net earnings were $522 million or $0.53 per share diluted, compared with $572 million or $0.58 per share diluted a year ago.

Earnings per share this quarter include $0.06 of Rewiring for Growth costs, and $0.06 in Rewire benefits.

I'm pleased with our ability to generate cash flow from operations of $1.5 billion in the third quarter, a 54% increase over a year ago.

For the nine months, our cash flow from operations was $3.3 billion, up 31% over a year ago.

Inventory control was one of the key drivers for our cash flow improvement.

Implementing our strategic initiatives is improving our cash flow, which in turn allows us to invest back into our key strategies and start the virtuous circle all over again.

We're often asked to clarify our cash priorities, so let me do that now.

Our first priority is to ensure a sound balance sheet and ample liquidity to weather any storm during these tough economic times.

Second, is to ensure that we continue to invest in our winning strategies for the future, such as CCR, and third, is to make sound decisions that reward shareholders.

As a reminder, our Board will review dividend and share repurchase options at its July meeting.

Most of you are familiar with our three strategies that are intended to help us return to double-digit earnings growth.

Those are leveraging the best store network in America, enhancing the customer experience, and implementing major cost reductions and productivity gains.

As part of our first strategy, late last year, we announced that we would slow our pace of store openings from the current 9% to 2.5 to 3% in fiscal 2011.

This slowing will have a positive impact on our operating profit and ROIC.

That's because we'll lessen the financial drag of a large number of new store openings each year.

As you see from this chart, new stores don't turn profitable until their second or third year.

And as those stores continue to mature, their profitability grows.

I think we just got the slide up.

With our past store growth, we've put down the tracks for significant ROIC improvement.

Now, our store growth hasn't slowed yet, but SG&A already has dropped significantly.

That reflects our Rewiring for Growth efforts, and the fact that we've done a good job managing the store operating expenses.

Beginning in the fourth quarter, we'll see a sequential decline in new store openings towards our 2.5 to 3% growth target.

As that slowing of new stores begins, it will contribute to SG&A control going forward.

I'll pause a few minutes so you can view the slide.

Looking at our second strategy, we hit new milestones in the third quarter with one of our key initiatives for enhancing the customer experience, Customer Centric Retailing.

CCR is redefining our customer offering through enhanced store formats, fine-tuning the role of various categories within the store, optimizing product assortment, pricing and promotions, and enhancing our vendor relationships.

The four big wins of CCR are improving the customer experience, thereby driving higher sales, lowering costs and reducing capital employed.

In the quarter, we rolled out the new CCR format to 35 pilot stores and here's a before and after look at one of those locations.

You see our CCR format on the lower right is more open, less cluttered and provides better sight lines to help locate products.

We also posted a short video on YouTube showing a store's CCR transformation.

You can find that video by clicking the link to it on the home page of our Investor Relations website after our presentation.

It's too early to extrapolate any results, but these 35 stores are performing ahead of plan on all metrics, so we're encouraged that achieving all four wins is possible.

Each of these 35 stores was converted in about a week, and with minimal disruption to sales.

Our plan is to roll CCR out to about 400 stores this fall.

And after a break for the holidays, we plan a nationwide roll-out through calendar 2010.

Besides the 35 store pilot program, we've completed optimized assortment resets for 36 of our first 40 product categories nationwide.

Through that optimization process, about 4500 SKUs were eliminated, or about 18% of our total.

That's one of the contributing factors to this quarter's tight inventory control.

Please note we're not reducing SKUs for reduction's sake.

We're developing a preferred assortment that our shoppers are telling us they want.

Meanwhile, gross profit dollars increased 6.6% on an adjusted basis.

We're encouraged that gross profit dollar growth has stabilized over the past two quarters.

We continue to focus on cost reductions and productivity gains around our business.

One way we're doing that is by transforming community pharmacy and our Power project is an enabler of that.

We've nearly completed roll the-out of Power in Florida and roll-out in Arizona is under way.

SG&A expenditures in the third quarter were up only 7.4% excluding costs associated with our restructuring versus 10.2% a year ago.

SG&A is up slightly from the second quarter 2009 in part because we opened 162 new drug stores this quarter versus 45 in the second quarter, and in last year's third quarter we opened 122 new drug stores.

Looking ahead, I'd like to address two other topics.

Today's changing consumer behavior and healthcare reform.

Today's consumer is more value-driven than in the past, and this may be a permanent shift.

We're positioning ourselves to be more relevant to the customer through programs like our Affordable Essentials, CCR, our Prescription Savings Club, and our private brand strategies.

The latest AC Nielsen report for the 12 weeks ending in April shows our private brand dollar sales growing 12.8%.

That compares with an increase of 7.6% for all drugstores excluding Walgreens, and just a 1.2% increase for all other food, drugstore and mass merchandise retailers.

Our convenience store locations and iconic brand also give us a competitive advantage during times like these.

We are in communities where people live and work and entrusted by 5 million shoppers every day for their needs.

On the healthcare reform side, things are heating up in Washington.

If left unchecked, some estimate healthcare costs could increase from $2.5 trillion a year now to $4 trillion within a decade.

Walgreens and the retail pharmacy industry have a role in generating savings in healthcare.

Our pharmacists and clinicians at retail and employer clinics are accessible, affordable providers of quality care, and it makes good economic sense to include them as part of the solution.

As is widely proven, better prescription compliance is key to lowering healthcare costs.

Another example of the role our clinicians can serve, more than 16,000 of our pharmacists will be licensed by this fall to provide flu vaccinations and immunizations.

We also have nurse practitioners located about 350 in-store clinics to handle routine family illnesses at a much lower cost than an emergency room visit.

These services fit very well with the major themes of healthcare reform, access, affordability and disease prevention and wellness.

In addition, we're pioneering new approaches to achieve better healthcare outcomes.

In coming quarters, we'll pilot a chronic care management service in four markets, focused initially on Type 2 diabetes.

The service will integrate capabilities across all of our platforms, including pharmacies, retail clinics, call centers and mail service to enable patients to better control their condition.

Bottom line, Walgreens provides affordable, accessible and quality solutions to both the changing consumer and the demands of healthcare today.

And we'll continue to improve and invest in these areas.

We know we can do more.

So now, Wade will update you on the financial results for the quarter.

Wade?

Thank you, Greg.

We feel very good about our results in a very challenging environment.

In the quarter, net sales increased 8% while total comparable sales rose 2.8%.

Prescription sales rose 8.2%, and represented 65.6% of sales for the quarter.

Prescription sales in comparable stores rose a solid 3.8%.

The number of prescriptions filled in comparable stores increased 4.9%.

That includes a benefit of 1.6 percentage points from more patients filling 90 day scripts versus 30 day scripts.

Recall that when we reported May sales, we announced that we are now following a more typical industry convention by treating one 90 day prescription as three 30 day scripts for both comparable scripts and total scripts and this reflects better prescription usage.

Despite rising unemployment, our prescription trend is stabilizing.

We filled 187 million prescriptions during the quarter.

Our US retail scripts increased 8.3% over last year's third quarter.

That includes an impact of 1.4 percentage points from patients filling 90 day scripts rather than 30 day scripts.

We exceeded by 5.7 percentage points the industry-wide growth rate, excluding Walgreens, as reported by IMS.

Net earnings in the third quarter were $522 million, or a decline of 8.8% from last year's quarter.

However, this year included a $99 million pretax impact from costs associated with Rewiring for Growth or $0.06 per share diluted.

Offsetting that was about $0.06 per share diluted benefit from Rewire.

In addition, the quarter included negative impacts of negative $0.01 per share diluted for the LIFO reserve versus year ago, and a negative $0.02 per share diluted for interest expense above the prior year.

Gross profit in the third quarter was $4.5 million, a 5% increase versus the year ago quarter.

Gross margin was down 80 basis points in the quarter compared with prior year.

Negatively impacting margins were front end product mix, including LIFO, non-retail businesses, and CCR markdowns.

Partially offsetting the overall margin decline was an increase in pharmacy margins resulting from generic drug sales.

Our focus on cost control continued in the third quarter, as we recorded an increase in SG&A dollars of 8.4%.

And just 7.4% if you take out the cost for Rewiring for Growth.

On a two year stacked basis, SG&A dollar growth for the third quarter declined from 24.9% to 17.6%, primarily due to store salary and expense control.

As Greg showed you, slowing new store openings will reduce SG&A growth, as will the significant cost benefits resulting from Rewiring for Growth.

This chart summarizes the cost and savings for restructuring related charges through the first three quarters of 2009, with a net cost to date of about $0.04.

As we mentioned in our last call, because we accelerated some restructuring costs this year, we expect to be a few cents per share net negative.

Now, let's look at other highlights from our income statement.

The LIFO provision was $32 million versus $16 million in the third quarter of 2008.

We lowered our LIFO provision in the quarter from 2.25% to 2% due to lower than anticipated inflation.

You'll recall that last year's LIFO provision was roughly 1.25%.

Next of the $99 million in restructuring related costs, highlighted by $65 million in SKU discontinuation, $28 million in consulting and other costs, and about $6 million in costs associated with workforce reductions.

Net interest expense was $25 million compared with $2 million last year, due to the issuance of $2.3 billion in long-term debt.

And the effective tax rate was 36.4%, compared with a rate of 37.3% in the year-ago period.

Here you can see the components of working capital that we can most directly impact.

Accounts receivable, inventory, and accounts payable.

Some of these as a percentage of sales has improved by nearly 11% in the quarter, primarily due to inventory improvement.

Total inventories were down $173 million or 2.4% against total sales growth of 8% and a total drugstore growth of 9.7%.

Over the last four quarters, FIFO total inventory growth has ranged from plus 10% to flat in the most recent quarter.

When adjusting for store growth, FIFO total inventories on a per store basis fell 9% in the most recent quarter.

As you can see, we have made significant progress but of course we can always do more.

Our net cash position at the end of the quarter was $52 million, with cash and cash equivalents of $2.4 billion, (Sic-See press release) and long-term debt of $2.35 billion.

This cash position compares favorably with a net debt of $785 million at the end of the second quarter, and a net debt of over $1.5 billion at the end of the first quarter.

Our financial strength and liquidity are in very good shape and our balance sheet should only strengthen as we continue to slow our store growth, improve inventory and drive cost savings over the next few years.

For the first three quarters of fiscal year, we invested $1.5 billion on additions to property, plant and equipment versus $1.7 billion last year.

Mostly for the addition of new stores.

We estimate capital spending for the full year to come in at about $1.8 billion, or slightly higher, about $400 million less than fiscal year 2008.

For fiscal year 2010, slowing store growth will result in lower CapEx for new stores, but we will increase our investments for systems and other improvements in existing stores.

In total, we anticipate next year's capital expenditure to be approximately $1.6 billion, and we will be vetting the final number in the coming months.

Let me say a little bit more about our cash flow performance.

These graphs demonstrate the improvements in the cash that we have generated from store operations and inventory control.

Our cash flow from operations in the quarter increased to $1.5 billion, from $985 million a year ago, a 54% increase.

Meanwhile, free cash flow for the quarter stood at almost $1.1 billion compared with $375 million a year ago, or nearly a three-fold increase.

So I hope you can see the efforts we're making on cash flows are truly bearing fruit.

Looking forward, I'm extremely optimistic about our future.

We have many opportunities, such as leveraging the best retail network in America, driving CCR is only the beginning of our journey towards customer centricity, and realizing the benefits of rewiring for growth.

Like any Company, we have tail winds and headwinds.

Reimbursement pressure and economic uncertainty will undoubtedly provide challenges, but winning companies can turn these challenges in to opportunities and we will.

For example, for healthcare payers, accessibility, cost efficiency and better outcomes are the order of the day and we are well positioned to step up and help.

On a consumer side, growing companies with winning strategies and strong balance sheets can gain loyal customers in unprecedented ways during down economies.

And we intend to be one of those companies.

I'll just close by saying, we are committed to returning to double-digit earnings growth and improving ROIC as part of our overall plan to create long-term shareholder value, and I hope that I've conveyed this message to you, today.

And now, I'll turn the call back over to Rick.

Cecilia, that concludes our prepared remarks.

We are now ready to take questions.

Thank you.

(Operator Instructions).

And we'll go first today to Mark Miller of William Blair.

Hi.

Can you discuss what you think the impact to the P&L will be of the store remodels in 2010?

So based on what you've learned so far from the upfront expense from converting the stores, compared to the benefits as they accrue, do you think it's reasonable to think that this will be a drag on EPS going forward?

I'll take that, Mark.

Good morning.

All right.

Obviously we're finalizing the modeling for it.

I'll give you a rough range.

The rough range is we're probably talking in the order of $30,000 to $50,000 per store, doing the bulk of stores many obviously the new stores coming out won't need to be done.

There's some inner city stores that won't need to be done.

It's not overall a tremendously significant number.

We are seeing lots of other benefits coming from CCR so while there will be some cost and investment here, mostly expense.

We also believe we're getting benefit coming from Rewire to help pay for that.

And from CCR.

Okay.

So net of it all, I mean, it sounds like there might be more expense as you go into this until you get more of a -- I guess accrual in the benefits which come a little bit later?

Yes, I mean, obviously the benefits from the store remodels come after we have remodeled but there's other benefits from CCR such as more efficient pricing promotion, supply chain work that we're already starting to see and will continue to see.

My other question is the comment was made about Rewire being on pace for the $1 billion in annual cost reductions by 2011.

There was no comment for 2010.

So can you give us some update?

Is that $500 million net savings number still a reasonable range or is that somewhat fluid?

Absolutely on track.

For the $500 million next year?

For this year, next year and the year after.

Okay.

Thanks a lot.

We'll go next to Simeon Gutman of Canaccord Adams.

Hey, guys.

On the path to achieving double-digit earnings growth, I don't know whether you think about it on just the one year or two year basis.

Can you talk about structurally where the expense dollar growth, you think it's got to go, and then related to where it was this quarter, I think on a two-year basis, 17%, does it continue on a straight path downward, or are there some spikes along the way?

I think if I interpret the question, trying to understand where SG&A will go over time, obviously this quarter's SG&A, I think we made very good progress when you look at the number of store openings which is a major driver.

Over this quarter and last quarter, we've actually seen our established store base, our comp store base SG&A negative.

So we're making tremendous progress and then over time we'll also overlay increased benefits that we get from the entire Rewire initiative.

So without giving a number, it should help you kind of factor into your model just how much of SG&A is driven not only by store growth but also as we see the benefits fully come through, what we could potentially overlay on that.

I think we feel good about where we are as far as Rewiring and restructuring costs that we talked about earlier.

But I also think we're doing a very good job on just an everyday operating model, with operating structure within the stores, stores operations groups are doing a very good job controlling expenses.

With the slowing of stores we'll begin to see a pretty good improvement there.

With the slowing of stores, and I guess as you get closer to the end of CCR, and stepping forward, mid single digit expense dollar growth a good ballpark to think about?

Let me throw out my follow-on.

Markdown risk with CCR and the magnitude of that impact to gross margin and then whether that's likely to accelerate as stores go by or is that something that's being done in the warehouse as well?

Maybe I'll take, Simeon, the CCR markdown, let Wade come back to the SG&A.

One of the things that we're doing and one of the reasons you saw a little bit of margin compression this quarter was a lot of that is coming from early markdowns from CCR products.

And what we did is we decided to move on some of those items early, to be able to sell them through at a higher margin than waiting late until we roll out the departments and then have to take more aggressive cuts.

So we've been actually moving through a lot of that inventory over the last two or three months and taking advantage of normal traffic to discount some of those products at a more profitable price.

So I think we've moved through a lot of that inventory.

We've got some more to go through.

But a big chunk of that is what affected this month's gross margin.

You kind of referenced over time could we see kind of the mid single digits.

I would say that's very reasonable and perhaps better.

Okay.

Thanks.

We'll go next to Mark Wiltamuth of Morgan Stanley.

Could you give us a little more detail on what we should be watching for on the healthcare reform in terms of generics, access for the public, margin compression that could come out of it?

Yes, I think that as I say internally a lot, certainly healthcare reform, there's certainly some threats and there's opportunities.

I think as the administration tries to provide more coverage for the 47 million uninsured, there's certainly going to be a focus on costs and so we'll be focused on margin pressure and reimbursement pressure.

That's something that we deal with and have dealt with over the years.

I do think the opportunities are great as well.

Certainly with coverage for more than 47 million Americans, be more prescription volume, just like we saw with part D.

I also think that the administration, one of the key principles is prevention and wellness and an understanding and, realization that prescription drugs are a big part of that.

So we have a great opportunity to play a part as I said earlier with access and affordability.

This weekend you saw where pharma made some concessions to help with the donut hole in part D.

I think that's a positive.

That will help seniors that have been challenged when they get to the donut hole.

Is there any pressure on retail to make any concessions?

I think that probably no more than what we've experienced.

Obviously, I think that holding down costs both on the medical side and prescription side will be a focus.

We've had some challenges in the couple states as is out there and you probably heard with Medicaid, but we think we have solutions and we think rather than rates, there's ways to improve generic compliance for states and really help improve the quality of the benefit they offer.

Okay.

Thank you.

And next we'll go to Eric Bosshard of Cleveland Research.

Good morning.

Two things.

First of all, on the SKU reduction, can you just quantify how far along you are in that process?

Yes.

I'd say probably roughly I'm going to just guess a number, two-thirds.

I'd say we're more than halfway for sure.

As Greg said, we've been very aggressive early to clean out the pipes, if you will, just because, A, it's obviously less expensive than waiting and B, I think it's enabling us to move faster, more quickly on the ultimate ending.

If you had to guess how far along you are in the markdowns necessary to accomplish that --

Two-thirds.

And then the second question is as you think about cash flow going forward and you frame this roughly $1.6 billion next year, the appreciation of the business is running around a billion.

With store growth going towards 2%, do we ultimately get to where you're running around $1 billion of CapEx after we get through the incremental investments that the business needs to accomplish Rewire, how do you think about how that behaves going forward?

We haven't given obviously kind of that out-guidance but I'd say that's probably kind of a bottom threshold.

If you consider 3-ish percent store growth, the basic maintenance infrastructure that we need, and the basic distribution systems.

That's kind of a rough floor I would say.

Okay.

If I could sneak one last one in, in terms of the reset stores, the 35, you said that they're running ahead of plan.

Could you just quantify what you're seeing out of those stores in regards to -- I guess really how you're evaluating them, if it's an expense, if it's a gross margin, if it's a sales, what you're seeing out of those stores.

I think that, Eric, obviously it's too early to extrapolate, give any numbers out there.

I will say the two areas we've really been focused on in those 35 stores is the roll-out period itself and what's the disruption of sales look like.

We feel good there that we're not -- that we're doing better than what we expected and as well as obviously the lift coming out of there, we feel good there, we're beating those metrics.

I do think the four wins we talked about earlier, the improved sales, improved margin, reduction in payroll and inventory is what we're absolutely focused on and we believe we're going to be able to achieve.

And the shopper feedback, which ultimately the experience is coming back very positive as well.

Great.

Thank you.

And we'll go next to Scott Mushkin of Jefferies.

Hey, guys.

Thanks for taking my questions.

First, the store you show us, the transformation, was that -- did that cost $30,000 to $50,000 or was that more?

What you'll see on YouTube, that's kind of the general range.

$30,000 to $50,000.

So just to understand the process, because a lot of companies have done this and they spent a lot more.

Looks like a pretty radical change in the interior decor and whatnot.

Is that not right?

No, I think the best way to look at this, Scott, this really is what we would call a refresh of the store.

It's obviously the improved assortment, the optimization of SKUs, lowering the profile of the store, the gondola height.

There's a lot that happens in that shot but it's really a refresh.

Obviously, the other thing we're looking for is as we roll through this, our cost may be a little higher as we go into the first 35 stores but as we become more efficient with the process and the conversion, we expect to see even more efficiencies and, therefore, reduced cost.

Thank you, keep going on the line, so if we say $40,000, you expect this to be about -- you're going to run none of it through CapEx, it's all going to be through expense next year, a $300 million expense?

I'd say it's 90ish percent expense, it's not all expense.

We're probably not talking 7,000 stores.

We're probably talking 5,000, 5500, again, because the new stores coming online are refreshed and are starting to reflect the new format.

As well as there are some very unique stores we have in urban areas, small format, whatever, that don't really lend itself towards this type of refresh.

So okay, 200, $250 million.

Is that net of the $500 million next year or is that -- is it $500 million on top, like that expense is contemplated with the $500 million that we're supposed to get in savings?

This is separate.

The $500 million is reflective of the Rewire so the SG&A reduction.

The CCR program is separate with excluding the SKU reduction which is also driving down labor.

So you'll see this as a separate bucket of cost but we'll also have of course benefit associated with the CCR that we hope to outrun this by.

Okay.

So you don't expect -- do you expect a $500 million that we shouldn't have $200 million extra expenses this year or next year, just to clarify?

The net $500 million is basically the net of the one-time costs associated with Rewire and the SG&A benefits of Rewire, right?

Right.

That's effectively a separate program from this.

Okay.

So if I was going to do a little T account, I've got $500 million there, I've got $200 million offsetting it, potentially, and then going to -- because you saw the mix, you guys cited mix as an issue with gross margin.

That probably doesn't go away.

So how are we thinking about gross margins as we go into fiscal year 2010?

I know, Wade, you had said before you didn't think going to the -- going more consumables would hurt gross margin at all but it seems to have this quarter and it was only in -- wasn't in that many stores so how are we thinking about gross margins next year.

I think we had a little compression this quarter but the big factor here was markdowns and LIFO.

I think as most retailers saw, May was a more challenging month than we had the few prior months so we are seeing a bit of a kind of call it a bit of a lagging market out there right now.

But I think we feel pretty good that we're taking longer steps over time here that despite perhaps changing mix we're going to continue to drive the private label.

We can be more efficient in terms of how we price and promote and I think we've got offsetting things that are going to help stabilize and increase the gross margin over time.

Obviously the benefits of CCR should help cover a lot of those costs as we roll it out.

Also, one of the things that I think we're excited about, obviously private brands are picking up quite a bit for us as we've talked about, but also with the work Kim File has done on our customer segmentation, I think we can become much more efficient and on our promotional strategy and drive more effective volume but at the same time protect margin.

One final one.

Thanks and then I'll give it up here.

Are you guys using third party liquidators and then Wade if you could go through that LIFO thing again because I think you said your LIFO rate was down but the money, the charge was up.

I didn't actually fully understand that.

So those two things, third party liquidators and LIFO.

We're not using third party liquidation at this point.

We're trying to make sure we mark to the appropriate price and move it out on our own.

So there might be some later but right at this point we're not.

In terms of LIFO, it was down -- it was basically down for the -- the rate for the year was 225 but we dropped it to 2 in this quarter but versus year-ago, it's up.

So my number being up, again, was referencing 2% for the year versus 1.25 a year ago but the being down was referencing the rate going into the quarter was 225 and we dropped it to 2.

Thanks.

Thanks very much.

We'll go next to Meredith Adler of Barclays Capital.

Thanks.

I would just like to start with trying to figure out where the $0.06 of cost savings showed up in the numbers.

Because you talked about an SG&A rate of 7.4% or 7.3%, but is that -- where are the cost savings?

You're getting cost savings at several levels.

You're getting it at the indirect spend bucket, you're getting it in headquarter, SG&A, you're getting it in field SG&A.

You're getting it in the stores.

What you have to remember, again, is that our new store openings, right, on a same -- on a established store basis, we were negative.

Our new store openings were significant for the quarter versus year ago.

You'll see that number start dropping starting next quarter.

But again, if you were to take out the new store opening related costs you would have seen that we were in general probably slightly negative.

Actually, my question though was how are you recording the savings?

Does it go into the SG&A line?

Yes, I mean, it's folded into whatever item it's in.

I don't really understand why you gave us the actual number and the adjusted number if the adjusted number includes $0.06 of one-time costs and $0.06 of one-time savings, doesn't that mean the reported number is the growth rate for SG&A dollars?

I think what we're trying to do is we're basically -- recall we said at the beginning of Rewire, we would each quarter report what were the restructuring and one-time costs, things like reduction in forces, and we would also likewise report the benefit we're starting to see so you can track to that $300 million to $400 million over time and also track to the net $500 million to $1 billion savings.

That's the only reason we're giving that.

Obviously we're a Company that's still driving GAAP but we want you to have the perspective of how we're tracking along that and we're folding all those expenses and all those costs into the lines that they belong in.

So we will cycle.

Think of it this way.

The benefits that we're starting to see are going to keep recurring.

But we're going to cycle these one-time costs.

So if you want to know what's more of a sustainable level, you could effectively take the costs out and see the trajectory that we're on.

Okay.

That's good.

That's helpful.

Now, a question about inventory.

How -- at what point do you think you have gotten to the inventory that you want to?

You're two-thirds of the way done in the SKU rationalization.

Is there any other inventory activity that will go on, either at the distribution centers or related to CCR or when you get done with this category rationalization, you'll be done with reducing inventory?

Meredith, Greg.

I think that as Wade said, we're still got some opportunities to go through CCR markdowns.

But we're also focused on older inventory that we have in the system.

We're also focused on better seasonal buying.

The big thing and the thing I'm really excited about is our supply chain initiatives.

As you know, or may not know, I moved supply chain under Randy Lewis, so he's managing inventories from the vendor to the customer, all the way through, and I think we're going to begin to see incredible opportunity there that I'm very excited about.

We moved our forecasting folks under Randy and so forth.

I think we'll see a lot of opportunity going forward in supply chain initiative improvements.

Just to be totally clear, the costs that are occurring now, associated with Rewire, are really only those SKUs that are being discontinued permanently.

But there's, as Greg alluded to, there's lots of opportunity for us to keep improving overall inventory as a separate ongoing structural initiative.

We're working with our vendor partners in ways that we haven't in the past to provide a more seamless exchange from them to us.

That's great.

When you look at the categories that you have already rationalized, did you get a complete transfer of sales to other items in the category or was there any net loss of sales in those categories?

For the most part, we're seeing a transfer and a pickup in sales.

We do have about 30 some of the first 40 categories rolled out.

We're beginning to see some nice lift in several of those categories.

I think it's doing exactly what we hoped it would do, which is a better customer experience and increased lift.

I just have one final question.

When you think about all the opportunities, have you made any assumptions that the customer will be a little bit disquieted by the changes at the stores and there could be an impact on the sales?

Or is the assumption and the early read from the 35 stores is that this is just a net positive?

We're getting feedback from consumers as well as movement within the stores and Meredith, so far we've gotten good feedback.

One of the things we've heard over the years is that we needed to lower the profile in our stores.

And I think this accomplishes that, and I think that is absolutely being received well.

I think we aren't changing the stores so drastically that shoppers are confused as far as where items are and so forth.

So, so far, we're positive with what we're seeing.

As Greg said, even though it's too early to call it a victory, certainly when we initially modeled this we expected to see some substantial early dip as shoppers get reoriented to the store and then come back and increase over time but in fact we're really not seeing much of that and we're seeing a very quick trajectory to increased sales.

Apart from the anecdotals and the consumer and the survey data all being positive, we're exceeding the plan significantly, both on the dip and on the ongoing so that's a very good sign.

That's why we built in a couple month pause here to go back and learn and understand before we roll out the next wave of stores.

Great.

Thank you very much.

We'll go next to Lisa Gill of JPMorgan.

Thanks very much and good morning.

I just had a couple of questions on the prescription side of your business.

Greg, I think you made a comment that you were seeing a better prescription volume than IMS.

Can you maybe talk about where you think that's coming from?

Are you taking market share from others?

And then secondly, when you made the comments around generics being better, is there a particular drug, or do you think as the seniors are starting to fall into the donut hole, that's what some of the driver is?

Thirdly would just be around reimbursement.

I know there continues to be pressure on the Medicaid side, but are you feeling any pressure in the commercial market?

Maybe I'll start with the macro level a little bit.

I think that was your second question, Lisa.

I think as an industry, certainly we're rounding some softer comps from last year.

So I think we're seeing a little bit of that.

But I also think we're seeing what we call Medicare part D maturity.

As more and more folks are becoming eligible for part D, we're seeing more utilization from seniors.

I also think that we're seeing, as I said, more benefit designs that make generic drugs more affordable, and therefore, more people are staying compliant and using prescription meds.

As far as ourselves, I think we're seeing two or three things.

Again, we're rounding those softer comps as well so that's some of it, but we're also benefiting from that Medicare part D affect.

We're gaining share in the senior market.

I think we're also seeing the benefit from some of the weaker competition in the marketplace.

Obviously there's several struggling.

And I also think our PSC card is attracting new patients and we're pretty pleased with it.

As far as pressure on margins, as I said, I think we'll continue to see as we have in the past, and have to manage that, I think what we need to do and will be doing is to help work with states and plans for ways to save costs, that's just not rate related.

I think there's opportunity to still increase generic utilization.

There's states out there that are not driving generic utilization to the rate that they can, and there's huge savings there as we work with them.

I think it's really more spending time with plans with states to help them understand how they can deliver greater savings through other means.

Any thoughts around wanting to be bigger and your PBM to help to try to drive some of those costs down through the programs that the PBM can offer?

I think that as you've heard us say, we want to be a greater and greater provider of services and provide greater value to all plans out there, all payers.

I think that we're seeing strong interest in the employer solutions model that we are -- that we've talked about, where large employers are looking for solutions to land health and wellness and pharmacies on their locations.

I think that we are also seeing an opportunity for us to potentially be the back of the house, so-to-speak, for some of the plans that are out there.

As you know, one of the large managed care organizations recently divested of their PBM.

I think there are folks out there that are looking at doing different things, everything from outsourcing provider services to potentially the entire PBM, and I think we're going to look to see if there's opportunities there for us.

So are you interested if one of the managed care companies looked to do something like that?

Is that something -- ?

We want to be a provider.

What we're really interested it in being able to provide mail service, retail prescriptions, and specialty services to payers across the country.

That's really what I'm interested in, Lisa.

Okay.

Great.

Thank you.

We'll go next to Deborah Weinswig of Citi.

Good morning.

Greg, can you go through some of the details in terms of what you're doing to be proactive in terms of shaping health care reform in Washington, and then also with regard to CCR, can you maybe share with us some of the qualitative feedback from your customers?

Yes, Deborah, I've spent a lot of time obviously in DC over the last several weeks and when I go out, what I intend to do is really three things.

One, I want to get a better understanding of what the latest thinking is and some of the plans that are being made, and as you know, it's changing daily, sometimes.

So but secondly, I want to position ourselves as an employer, as well.

And be able to talk about the fact that I want to continue to provide benefit, medical benefit to my employees.

I think that's where real innovation happens, is in the private sector.

And then I also talk a lot about what I believe we can do to help as a provider, and certainly, I think that is along the lines of prescription drugs.

I think that we have community pharmacists that can be utilized in greater ways and there's a lot of interest in how community pharmacists can be used going forward.

And I talk a lot about our retail clinics, as you might expect, and there's a lot of interest in that model, being able to provide access and lower cost acute care.

And I'm encouraged, Deborah, by the opportunity that we can play, and there's a lot of interest from the administration along those lines.

And then the second --

As far as CCR and qualitative, I think, again, our customer feedback has been good.

Certainly we're early on.

We've got to do a lot more of that.

But again, I think based on the early metrics that we're seeing, we're pleased with the lift that we're seeing so far.

We're pleased with the feedback we're getting.

Obviously, we're going to be doing a deep dive over the next couple months to understand that better but so far we feel pretty good.

And then CCR stores has it been traffic or ticket or both that's been giving you the lift?

It's been both.

Congratulations and best of luck.

Thank you.

Our final question today comes from John Heinbockel of Goldman Sachs.

Hey, Greg.

As you evolve CCR, the remodel here, do you think it will get tweaked or what's out there today is pretty much what you think you'll go with, as you go through the significant roll-out?

John, good question.

I don't -- unless we hear and get some feedback in the next couple months before we start the next wave, I don't think you'll see a lot of -- a drastic change of any type.

Again, I would look at this as, CCR is an opportunity to refresh our stores across our network, and then I think obviously, we'll begin to look at new concepts and new formats and different ways to improve upon that.

I've been pretty public.

I think there's an opportunity for us in select stores to create a new and unique beauty experience.

I think there's opportunities to do some improvements upon that CCR refresh as we go forward.

But CCR in itself, I don't see a dramatic change in the plan that we have today.

I would just say, where the tweaking might occur is really as we go category by category, by category.

Every single category, are we seeing the lift we saw, whatever.

There might be a few categories that need adjustment.

In aggregate in terms of the overall layout, shelf, planogram, et cetera, we feel we're 90 plus percent right on course.

Was the store of the future model too radical a departure and in particular, I would have thought the Cafe W, would have a lot of promise, did that just not have a good return profile as you go forward?

Well, I think the store of the future, John, was a good test for us, and there's some good learnings there and I think there are parts of that store of the future that we may be able to pull forward as we go forward.

As you noted, in the cosmetic department, there was some good learnings there from that but I think it's far too soon so say that that is the store of the future for us.

And your second point was, John --

Cafe W, looked like that would have promise to do more soda fountain, coffee program but is the return there?

Is that the issue?

I think with Cafe W it's really -- it's based on the store.

We're doing well with it in select stores, and I think there's an opportunity for us to have it in our future and again, I think it will be based on store location and demographics.

Do you think that prototype store will lift pharmacy sales as well as the front end, or it's mostly front end-driven.

You're talking about the store of the future or the CCR?

No, the 35 pilot stores.

I think it will be both.

Certainly if we attract new patients, new customers, we'll see lift.

Okay.

Then finally, what's the prognosis, I know you mentioned state Medicaid a bit earlier, Washington went well for you, sort of well for you compared to where it was.

Are we going to have sort of that -- is this going to be a recurrence where the states put out these very aggressive reimbursement targets and through litigation or whatever, we get dialed back to something more reasonable or are we going to sit at a reasonable level at the beginning?

John, that's certainly hard to predict.

I do think that we cannot fill prescriptions below our cost, and we would much rather be filling prescriptions for Medicaid patients across the country and I think we will have to approach and take state by state, based on how they go forward.

I do think that there's huge opportunity like there was in the State of Washington and like we are doing with the State of Delaware for us to help states save cost in other ways.

Generic utilization, as I said.

And I think we'll be proactive, much more proactive going forward with states to help them design better benefits that help, one, provide better overall healthcare for their beneficiaries, as well as reduce cost.

Okay.

Thank you.

Cecilia?

Yes, sir.

This is Rick, we're not tired yet.

We'll take another question.

No problem.

We'll go next to Ed Kelly of Credit Suisse.

Good morning.

Thanks for taking another question.

Good morning, Ed.

I look at your gross margin this quarter and from a headline perspective it doesn't look very good because of the cost for rationalizing SKUs, but underneath that, the trend of it is actually better than what it was last quarter.

I mean, it's down about 23 basis points on a FIFO basis.

It was down 38, ex the noise last quarter.

So as we think about the gross margin going into next year, clearly you start running up against some easier comparisons.

What's the probability that we're able to at least get this line kind of flattish as we look to next year?

Well, I think everything you said is pretty astute.

I mean, obviously, we're focused on improving this over time.

I would just say I think right now you're seeing a bit of a transition phase.

We've got a lot of things going on.

We're kind of changing the tires as the car is moving.

We've got traffic even in this tough kind of economic period, we've got traffic increasing, which is very good.

We're making lots of changes to clear out the old stock to refurb the stores.

I think obviously our goal is to increase this over time.

We will be cycling an easier base period and I think that's important to note as well.

I don't want to predict exactly what it will be but certainly we're working on improving this over time and I think right now we're in a bit of a transition and mostly I feel very good that we're again, swinging the doors and driving sales in a pretty tough economic environment as well.

All right.

Great.

Wade, on the inventory side I know you said you have a $500 million goal in terms of reducing inventory.

It sounds to me like the bottom line is that maybe the potential is more.

Is that fair?

We had originally said 500 associated with the SKU assortment work.

Kind of call it the CCR Rewire combined.

But I think as Greg alluded to, that's really just one phase of what we're doing.

It's really I think the supply chain initiatives, changing how we work, the broader systemic things that will provide additional benefit.

We just haven't put a number out there yet.

I will say, I've never seen Randy Lewis so excited.

And then a question for you.

I've heard that you're thinking about adding liquor to the stores.

Where do you stand right now in terms of assessing whether you're going to do that?

How many stores do you sell it in today?

How big could it be?

Yes, we're looking at beer and wine, Ed, versus spirits.

We do have several markets now, Southeast and Southwest, where we still have full liquor.

We're looking at beer and wine.

We think there's an opportunity obviously to add that to our convenience goods.

Don't know really the total number of stores yet.

We're kind of in the early stages of it.

And the stores where you do sell beer and wine, what percentage of the front end sales does it typically account for?

It's single, small single digits.

Small single digits?

Yes.

Okay.

Greg, kind of last question for you.

I was just kind of hoping that maybe you could go back to that question on the PBM business and maybe just help us understand strategically how you're thinking about that business longer term.

Do you need it to connect the dots between specialty, the stores, the clinics.

It sounds like you want to grow that business.

Is that right?

And it sounds like whether it's via acquisition or organically, you may consider that and that to me seems like a bit of a change in rhetoric.

No, Ed.

I'm glad you came back to that.

I don't have a change in philosophy there at all.

We want to be a convenient provider of all pharmacy and health wellness services to all payers, and I think there's an opportunity to work even closer with the payer community, whether it's PBMs and/or managed care, and as we link our provider services together, I think that's where the real value is, and I talked about that we're growing -- we're building our specialty platform.

We've now got the number one infusion platform across the country.

We're growing our clinics, as you know.

We're growing our employer on-sites across the country.

As we link those provider services, there's where I think we can provide huge value to a payer and I don't believe we necessarily need to have a PBM to be able to do that.

I much rather would want to work with all payers, and be able to bring those services to them versus link up with one or two in particular.

And one thing we like to say, as you know, we have a PBM and whatever you call it, it's the capability that underlie it that we have and continue to want to be very good at.

The ability to do formularies, the ability to do claim support, it's really the capabilities that we're trying to drive versus a spread game or something else.

That's where we're really focused.

Ed, we're a major specialty provider for several managed care organizations across the country today.

We provide mail service for several organizations across the country.

You don't necessarily need to have that PBM to be able to do that.

I think the value that we think we can provide to help control medical costs is to integrate and link our provider services, so we really provide value.

Okay.

Thank you.

Thank you.

Folks, that was our final question.

Thank you for joining us today.

Remember, we'll announce June sales on July 2nd.

Also, because Yom Kippur falls on Monday, September 28th, we're accommodating those that are observing the holiday by moving our next quarterly financial announcement to Tuesday, September 29th.

That's when we'll announce fiscal 2009 fourth quarter and year end results.

Until then, thank you for listening.

That does conclude today's conference, ladies and gentlemen.

We appreciate everyone's participation today.