沃博聯公司 (WBA) 2013 Q3 法說會逐字稿

Welcome to the Walgreen third quarter 2013 earnings conference call.

At this time, all participants are in a listen-only mode.

Later, we'll conduct a question-and-answer session and instructions will follow at that time.

(Operator Instructions)

As a reminder, this conference is being recorded.

I would now turn the call over to your host, Rick Hans.

Please begin.

Thank you, Stephanie.

Good morning, everyone.

Welcome to our third quarter conference call.

Today, Greg Wasson, our President and CEO and Wade Miquelon, Executive Vice President, CFO and President - International, will discuss the quarter.

Also joining us on the call are Kermit Crawford, President of Pharmacy and Mark Wagner, President of Store Operations.

As a reminder, today's presentation includes certain non-GAAP financial measures.

I would direct you to our website at investor.

Walgreens.com for reconciliations to the most directly comparable GAAP measures and related information.

You can find a link to our webcast on our Investor Relations website.

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

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

Except to the extent required by law, we undertake no obligation to update publicly any forward-looking statement after this presentation, whether as a result of new information, future events, changes in assumptions or otherwise.

Please see our latest Form 10-K and 10-Q and subsequent filings for a discussion of risk factors as they relate to forward-looking statements.

Now, I'll turn the call over to Greg.

Thank you, Rick.

Good morning, everyone.

Thank you for joining us on our call.

Today, I'll begin with the highlights of our results for the quarter.

Second, I'll update the steps we're taking to -- improve our daily living business; expand our role in the changing healthcare system; and advance our long-term strategic growth drivers.

Then I'll turn the call over to Wade for a more in-depth look at our results and key considerations for the remainder of the year.

We recognize our business has become more complex with a number of moving parts.

We do want to help you get to the underlying performance of our business as we remain confident in our long-term strategic direction.

Starting with our financial results, we reported adjusted earnings per diluted share of $0.85 and GAAP diluted EPS of $0.65.

In the quarter, along with Alliance Boots, we announced a strategic long-term relationship with AmerisourceBergen, one of the largest pharmaceutical supply chain companies in America.

Through this relationship, we have formed a collaborative, integrated, wholesale retail model here in the US with a 10-year comprehensive primary distribution agreement for branded and generic products.

Combined with our partnership with Alliance Boots, Europe's leading fully integrated, wholesale retail model, we are now best-positioned to drive efficiency and innovation throughout the entire pharmaceutical supply chain, harnessing the benefits of global sourcing and making it easier for manufacturers to bring products to market, providing patients with better access to healthcare.

Cash flow from operations was $1.4 billion, with $1.1 billion in free cash flow, which is one of our strongest quarters for both.

Earlier this month, we launched the Boots No7 men's product line in more than 5,000 stores across the country.

We've already introduced with great success the No7 women's skincare line and other Boots products in four of our flagship locations with more expansion planned.

Finally, our joint synergy program with Alliance Boots is meeting our expectations.

We're on track to deliver $125 million to $150 million in combined synergies, compared to our previous target of $100 million to $150 million.

Now, let me walk through our quarterly results on a GAAP and non-GAAP adjusted basis.

Sales came in at $18.3 billion, up 3.2% from the same quarter a year ago.

GAAP operating income for the quarter was $991 million, up 13.5% from $873 million for the same period last year.

Non-GAAP adjusted operating income for the quarter was $1.2 billion, up 22.9% from just over $1 billion in third quarter 2012.

GAAP net earnings for the quarter were up 16.2% from $537 million or $0.62 per diluted share last year, to $624 million or $0.65 per diluted share.

The non-GAAP adjusted net earnings for this quarter were a record $812 million or $0.85 per diluted share, compared to adjusted net earnings of $628 million or $0.72 per diluted share in the same quarter last year.

Turning to trends in gross profit dollars and SG&A dollars.

In the third quarter, on a GAAP basis, our gross profit dollar growth increased 4.1% or $208 million from a year ago.

SG&A dollar growth increased 5.3% or $221 million compared to a year ago.

Now, on a non-GAAP basis, adjusted gross profit dollar growth increased $268 million or 5.3% year over year.

Non-GAAP adjusted SG&A dollar growth was up $182 million or 4.5%.

During the quarter, the rate of growth in adjusted FIFO gross profit dollars exceeded adjusted SG&A dollar growth by 80 basis points.

You can see this was the first positive spread in six quarters.

We're pleased that this is moving in the right direction.

Now, let me update our progress on the three key strategic growth drivers we put in place last year to position our Company for long-term growth and value creation.

First, on creating a well experience, while we're seeing several positive indicators in our daily living business, such as increases in customer delight, basket size and gross margins, our front-end sales and traffic are still not up to our expectations.

Now, there are certainly factors that affected our results this quarter, as with other retailers, the weather had a negative impact on seasonal sales in the third quarter.

We also continue to face a soft economy, especially in our lower income communities, where our stores on a comp basis are performing on average, below our stores in middle or higher income neighborhoods.

That said, we're taking steps to balance our investment in sales and margin.

We're focused on a clear three point plan.

First, we're making further adjustments to our pricing and promotions, implementing a number of meaningful changes to our weekly ad.

As you know, we began those changes in mid-May, and you'll see more throughout the fourth quarter.

We're applying what we're learning from our Balance Rewards program to ensure we have the items that are most relevant to our customers in both assortment and price to meet their daily living needs.

Second, we're focused on maximizing the value of our Balance Rewards program.

With 75 million people signed up, we're turning our focus from enrollment to redemption and rewards.

For example, as shoppers earn points, we're highlighting the dollar value of points earned in both our stores and in our circulars.

Third, we're enhancing our store segmentation to better meet the local needs and preferences of our communities, whether they're in the inner city, suburbs or rural communities.

We're customizing our advertising circular according to individual community needs, especially in the hardest hit communities, where our customers are working hard to stretch their paychecks.

We're also working to ensure we have the right products and targeted promotions in our communities across the country.

I can assure you that improving our front-end is a high priority.

I am confident that the team's plans will strengthen performance and drive profitable growth over time.

In fact, we're beginning to see just that.

We reported a positive front-end comp this quarter with progress over the previous quarter.

We're also beginning to see sequential improvements in market share over recent periods.

Finally, our flagship locations continue to give us a platform for innovation and to showcase the best of our brand.

This quarter, we opened flagship stores in the Empire State Building in New York City, Washington, DC, Boston and San Francisco, bringing our total to 10 across the country.

Now, turning to our second strategic growth driver, transforming the role of community pharmacy.

Here, we're beginning to hit on all cylinders.

Our script comp for the quarter was 7.1%, compared to 5.7% in the second quarter.

We gained 80 basis points in market share from 18.4% to 19.2%.

90 day prescriptions continue to grow, increasing 19% year over year, while IMS continued to report slowing growth of mail.

All this comes in an environment where physician visits are down 2.7% year over year in May, according to JPMorgan's monthly tracker.

This follows year over year declines, February through April.

With that said, we're positioned extremely well to continue driving market share and profitable growth.

First, we now have long-term contracts with predictable rates in place with many of the major commercial payers in the market.

Second, we're capitalizing on our preferred position in Med D plans.

Our increase in Medicare Part D volume has exceeded the market every month since January.

With 10,000 people turning 65 every day and signing up for coverage, we have tremendous opportunity to continue growing our volume over time.

Third, with healthcare reform moving forward, Walgreen's with our 8,000 locations and 70,000 healthcare professionals is increasingly well-positioned to meet the growing demand for convenient, affordable, non-emergency care.

During this quarter, we announced that most of our more than 370 Take Care Clinics now offer an expanded scope of healthcare services.

These new services include diagnosis, treatment and management for hypertension, diabetes, high cholesterol and asthma, as well as additional preventative health services.

We're also moving forward with expanded plans to play a central role in emerging care models such as Accountable Care Organizations.

With our leading role in three ACOs and our strategy to service many others, patients, providers and payers are recognizing the value of community pharmacy as part of the solution to meet the triple aim of improving the patient experience, driving better health outcomes and lowering overall healthcare costs.

Regarding our third strategic growth driver, establishing an efficient global platform.

We're pleased with the progress we're making with our strategic partnerships with Alliance Boots and AmerisourceBergen, which collectively are creating an unmatched global pharmacy supply chain.

First, on AmerisourceBergen, our teams are on track to ensure a smooth transition of our branded goods distribution on September 1 and the transition of generics over the next 12 months.

With these relationships, we're piloting new delivery models with our stores to optimize frequency and putting in place new inventory management processes and metrics to improve local assortments.

Second, as I mentioned, we're meeting our expectations for Alliance Boots' synergies, we're on course to deliver $125 million to $150 million in combined first year synergies.

Alliance Boots contributed $0.10 per diluted share to our adjusted results this quarter.

We expect the contribution to be $0.08 per diluted share to fourth quarter adjusted results.

Finally, we're pleased with Alliance Boots' performance in their fiscal 2013.

As I am sure you saw, trading profit was up 7.4% in constant currency.

Underlying profit after tax was up 12.7%.

Cash generated from operations was GBP1.6 billion.

They reduced their net borrowings by GBP1.1 billion.

So summing up, we have worked hard over the past year to crystallize our strategies and ensure we have the growth drivers in place to support long-term value creation for Walgreen's and our shareholders.

We're now focused on the execution that will propel both day-to-day performance in the short-term and the growth we expect over the next two to three years.

Thank you.

Let me turn the call over to Wade.

Thank you, Greg.

Good morning, everyone.

Thank you for joining us on the call.

This morning, I will take you through our quarterly results as well as update you on our investment in Alliance Boots.

As Greg noted earlier, for the quarter, we reported a GAAP EPS of $0.65 per diluted share, based on 959 million shares.

This GAAP EPS bridged to the adjusted EPS of $0.85 for the quarter is illustrated by this chart with a LIFO provision of $0.08 per share, acquisition related items of $0.12 per share consisting of -- $0.05 of acquisition related amortization costs; $0.02 of acquisition related costs; and $0.05 from the Alliance Boots' step one related tax deferral.

Special items netted to $0.00 per share with $0.05 related to the DEA settlement, offset by the $0.05 related to the warrants issued by AmerisourceBergen.

As you can see, the settlement with the DEA we announced earlier this month is treated as a special item.

This settlement reflects the final reserve accrual as well as some tax impact related to the terms of the final settlement.

Looking back on the first two quarters of fiscal 2013, prior accruals related to this matter had an adverse impact of around $0.03 per share in Q2 and certain litigation matters, including an accrual related to the DEA matter and had a positive net impact of around $0.02 per share in Q1.

These items were reflected in both our reported GAAP and adjusted earnings in the first two quarters and were not treated as special items.

Let me now provide more detail on our comparable store sales for the quarter.

Comp prescription sales increased 2%, comp front-end sales increased 0.4%, total comp sales increased 1.4%, comp prescriptions filled increased 7.1% versus a script comp of negative 9.1% in the year-ago period.

With respect to our front-end, in the third quarter, the front-end comp increased 0.4%, traffic decreased by 3.9%, while basket size increased by 4.4%.

We achieved stable front-end margins in a challenging promotional environment.

As Greg discussed prior, moving forward, we are increasing our ads and promotional focus concurrent with other initiatives intended to increase store traffic.

Still, we will continue to work to strike the optimal balance between sales and profitable growth as our underlying front-end business continues to make progress.

Looking at comp store script numbers, our retail comp scripts were up 7.1%.

This continues to reflect the fundamentals of our underlying business, our win back of Express Scripts customers and our continued progress in winning new Medicare Part D customers.

Turning now to margin.

Our FIFO gross margin was 29.2% in the current quarter, compared to 28.6% last year, a 60 basis point improvement.

Pharmacy margins increased as a result of the ongoing impact from generics, the increase was partially offset by market reimbursement pressure and the continued growth of our 90 day retail program.

Our front-end was positively impacted by candy, non-prescription drugs and personal care categories, which was partially offset by costs associated with points earned from the Balance Rewards program.

Taking a look at our longer term FIFO gross margin trends, this quarter's 60 basis point improvement was up against a 30 basis point increase a year ago.

The continuing generic wave, which temporarily peaked last quarter, was the primarily driver of margin lift in this quarter.

Moving forward, we expect margins to be negatively impacted by a trough in the generic wave, expected to continue into the latter half of fiscal year 2014, when we expect to experience another peak in the wave; albeit, smaller than the fiscal year 2013 peak.

Again, as I mentioned, the front-end was slightly positive for the quarter.

Margins may also be impacted as we become more aggressive with our new promotion and pricing initiatives to drive traffic and front-end comps.

As I will illustrate in a few minutes and as we've stated on many occasions, we are more focused on driving gross profit dollar growth than margin growth.

This chart illustrates our two-year stacked SG&A dollar growth trends on a GAAP basis for the last nine quarters.

Now, let's review the trends on an adjusted basis.

Two-year stacked adjusted SG&A trends improved versus a year ago, with 2.3% growth in third quarter of 2013, down from 5.1% last year.

This is certainly the lowest two-year stack we have had in recent history.

To get to adjusted SG&A dollar growth, you can see that our reported SG&A dollar growth was 5.3%, which included 60 basis points for the DEA legal settlement and 20 basis points of acquisition related costs.

Backing these out resulted in adjusted SG&A dollar growth of 4.5%.

Shown here are the SG&A dollar growth trends for the past seven quarters on a GAAP basis.

A follow-on slide shows the trends on an adjusted basis.

As I mentioned earlier, the adjusted SG&A dollar growth for the quarter was 4.5% year over year increase versus the 2.2% decrease in the third quarter of fiscal 2012.

Looking at adjusted SG&A dollar growth on a two-year stacked basis, as you can see, there was a 560 basis point sequential step-down from second quarter of 2013.

We are pleased with the SG&A dollar growth in the quarter, especially given the very tough compare in the year-ago period when we were not Express Scripts pharmacy network.

Transitioning now to gross profit.

This slide illustrates our quarterly gross profit dollar growth trends for the past seven quarters on a GAAP basis.

Adjusted gross profit dollar growth increased from positive 4% in the second quarter of 2013 to a positive 5.3% in the third quarter of 2013.

The positive trend in adjusted gross profit dollar growth is a result of the underlying strength of the business combined with generic drug benefit.

On a two-year stacked basis, gross profit dollar growth stepped down sequentially as we lapped a 2.5% decrease in the prior year's third quarter when we were out of Express Scripts network.

Also recall, the second quarter benefited from stronger generic wave and an unusually strong flu season.

Now, looking more broadly at our income statement, this quarter included LIFO provision of $120 million versus $50 million a year ago, driven primarily by significantly higher prescription drug inflation in the quarter.

Our effective LIFO rate for the year was 3.5%, up from 2.5% a year ago.

Net interest expense was $50 million, up from $17 million a year ago.

The increase in interest expense was primarily attributable to the $4 billion note issued in association with the Alliance Boots transaction.

But it also includes a $7 million non-cash expense from a fair market value adjustment to the Company's outstanding interest rate swaps.

Our effective tax rate was 38.7% versus 37.2% last year, primarily due to the non-deductible nature of the DEA settlement.

Average diluted shares outstanding were 959 million shares, versus 865 million shares last year, the change is due to a combination of the impact of the 83.4 million shares issued due to the Alliance Boots investment and the impact of a higher stock price on the in the money options counted in diluted shares.

This option impact increased our diluted share count sequentially by 5.6 million shares in the third quarter.

In order to give some perspective on Q4, please note the following.

We expect the LIFO provision in the fourth quarter to be approximately $85 million.

We expect net interest expense to be $57 million to $60 million, including the negative impact of $16 million from a non-cash fair market value adjustment to the Company's outstanding interest rate swap.

Based on the swap accounting treatment we put in place in 2009, when we first swapped our $1.3 billion notes to floating, we are now reserving the positive accounting impact that had gradually offset interest expense over the past four years.

We are very pleased with our hedging strategy, as the fixed to floating swaps on our $1.3 billion notes have generated over $100 million in pretax cash savings since 2009.

Going forward, our true cash interest expense will benefit from our planned repayment of $1.3 billion in notes in August.

We expect the effective tax rate to be about 38%.

Note, our adjusted rate is anticipated to be better due to both the DEA impact as well as the adjustments for Alliance Boots benefit not captured by our affective GAAP rate.

Finally, we expect diluted shares outstanding to remain around 950 million shares.

But as mentioned, it is subject to the impact of changes in our share price.

Lastly, please keep in mind that we provide monthly sales on the third business day of each month.

So we kindly ask that you remember to update your models for actual sales at the end of each quarter.

Cash and cash equivalents were $3 billion in the third quarter versus $2 billion a year ago.

$1.3 billion of this cash is earmarked to retire outstanding debt due in August 2013.

Networking capital decreased by 2% versus a year ago.

Accounts receivable increased by 5.4%, while accounts payable increased 2.2%.

LIFO inventories were down 1.8%.

FIFO inventories were up 2.9% year over year versus a sales growth of 3.2%.

During the third quarter, we generated $1.4 billion in cash from operations versus $1.9 billion a year ago.

Free cash flow in the quarter was $1.1 billion versus $1.5 billion a year ago.

Roughly $300 million of this year-on-year difference was driven by the timing shift in our annual profit share planned payment.

As a Company, I think you can see, we remain very focused on cash flow.

Let me transition now to our accretion to adjusted EPS for the quarter as a result of our partnership with Alliance Boots.

The third quarter accretion was $0.10 per share, which fell $0.02 to $0.03 short of the $0.12 to $0.13 range we had forecast last quarter.

To be clear, we are very pleased with both the operational performance of Alliance Boots and the combined synergies we are achieving.

As noted, this shortfall is due to a number of non-fundamental factors, primarily the greater than expected impact of IFRS to GAAP conversions.

We now expect the accretion for the fourth quarter to be about $0.08 per share, which is less than our prior guidance of $0.09 to $0.10 per share, with the primary difference driven by the foreign currency translation impact of a slightly weakened pound relative to the dollar in our initial forecast.

Consequently, we now estimate the adjusted EPS accretion for the year to be $0.16 rather than the previous estimate of $0.18 to $0.22, primarily for the reasons I just outlined.

Shifting to our quarterly Alliance Boots accretion [walk], as shown, we realized $28 million before tax and synergies during the third quarter and $25 million after tax.

Amortization adjustments amounted to $3 million for the deal amortization and $13 million for brand amortization.

After-tax Alliance Boots' equity earnings were $131 million for the third quarter on a GAAP basis.

On an adjusted basis, the income from the Alliance Boots' investment was $147 million as noted.

The incremental after-tax interest expense to Walgreen's was $13 million.

After the impact of share dilution, the accretion equaled $0.10 in the third quarter.

I'd like to close by reviewing our fiscal 2016 goals; $130 billion of combined revenue; $8.5 billion to $9 billion of combined operating income; $9 billion to $9.5 billion of combined adjusted operating income; $8 billion of combined operating cash flow; a total synergy goal of $1 billion; and $11 billion of combined net debt, all by 2016.

When analyzing 2016 revenue, adjusted operating income and cash flow goals and netting the impact of our stated combined synergy goal of $1 billion, combined CAGRs from the base year of 2012 to our goal year of 2016 would need to be 5% for revenue, 9% for adjusted operating income and 4% for cash flow, in order to reach our goals.

To the extent we end up exceeded or falling short of our combined synergy goals, the CAGR required to meet our 2016 goals will be impacted accordingly.

With respect to synergies, we are off to a good start in our 2016 goals.

As we noted earlier, we are narrowing the range of combined synergies for the fiscal year 2013 to $125 million to $150 million from the previous range of $100 million to $150 million.

Each of the six primary synergy work streams are producing results, and we are confident we are on the right track to now meet our fiscal year 2014 synergy objectives.

Also recall that Alliance Boots retired $1.7 billion in debt in their fiscal year ended March 2013, exceeding their goal of $1 billion.

As I mentioned earlier, we are planning to retire $1.3 billion in Walgreen's debt in August.

As we progress, once a year on a quarterly earnings call, we plan on going into a deeper dive on our 2016 goals with respect to our progress, our risks and opportunities across each of these measures.

We remain confident with respect to our strategic long-term relationship with AmerisourceBergen as well, and our core work streams are progressing and are on track.

In addition to the planned domestic supply, sourcing and international opportunities and benefits, we continue to identify areas where all three partners can work together to build on capabilities and competencies.

Now, in closing, let me share a few final thoughts.

I realize that in the past few years we made several strategic and transformational moves that at times make this Company more than challenging to model.

Having said that, I'd like to talk a bit about how we think about our business.

At a strategic level, we have continued to refine our journey across three key planks and several related initiatives that we expect to -- greatly enhance our customer experience; allow us to participate profitably and more broadly in the challenging healthcare landscape; and let fully leverage efficiency and scale all the while.

Our ground breaking and transformational partnerships enhance these strategies and we believe will enable us to unlock significant value and competitive advantage.

Still, I believe, we are just scratching the surface of what we can do working together longer term across both the supply chain as well as across geographies.

Now, it all comes down to executing with excellence, as we effectively balance both the long and short term.

I'm sure we'll have some ups and downs along the way, but we remain very confident in our long-term strategies and prospects.

I want to thank you again for your kind attention and support.

Now, I'd like to turn the call back over to Rick.

Thank you, Wade.

That concludes our prepared remarks.

We are now ready to take questions.

(Operator Instructions)

Lisa Gill, JPMorgan.

I just had a couple of questions on the generic side.

So Wade, I heard you talk about the $125 million to $150 million of synergies.

Can you talk about where you are in this new JV purchasing as far as contracting with the manufacturers?

How much of the synergies are coming from that side, would be my first question?

Then secondly, I think, Greg, you talked about market pressure and reimbursement.

But on the other hand, you also talked about long-term contracts.

Where are you seeing that the market pressure on reimbursement today?

Is that coming from Medicaid?

Is it coming from the commercial market?

How should we think about that?

Okay.

So I guess, let me answer the JV first.

The JV is up and fully running and operating.

We have our two Presidents, Jeff Berkowitz and John Donovan, who are working.

One of the few work streams that's residing there is our generics.

We're off to a very good start.

Without giving information that we consider too competitively sensitive I guess, what I would say is given the scope and breadth of what we're doing together, I think we're working with most of the key manufacturers already in terms of understanding how we can bring volume benefit, through better long-term planning and create, I'd say, a real win-win.

I think that win-win comes just again, because of the size and scale and the breadth of the business that we can do with all the key partners that want to partner with us.

But we're off to a good start.

It is a significant part of our early synergies.

As I've said before, we expect it to be a significant part of the going ones as well.

Greg, I'll let you comment on reimbursement.

Yes.

Lisa, on the market pressure and reimbursement, I guess I don't think that there's any one segment that we're seeing.

I think we're seeing reasonable reimbursement pressure and focus from any payer, whether it's government, commercial, on controlling costs.

I think certainly as Medicaid -- as some states move from state Medicaid to managed Medicaid, you certainly see some movement there.

But when we look at those commercial arrangements, as we have in the past, we look at the individual plan and we look at all the variables, whether it's days of supply, generic utilization rate and make our decisions.

But I don't think that there's any one area that we would call out.

I think that we're just seeing continued as expected, focus on healthcare costs from all payers.

Greg, just to follow up on that really quickly, on Medicaid.

If we think about the initial impact of the Affordable Care Act, we would expect it's primarily going to come from Medicaid expansion.

Can you talk about -- if that's primarily where it comes from, do you have excess capacity in your stores today, so that even if the reimbursement rate is a little bit lower with Medicaid that you're going to be able to lever that incremental volume and it should be still a positive as we move into calendar 2014 for Walgreen's?

Well, Lisa, I don't know if I'd really take it down to a variable labor perspective.

But I think with movement from growing Medicaid, whether it's managed or state -- again, I think that we look at that as we have any commercial arrangement and some of those it depends on the market share and the state that we're in.

It depends on -- as I said earlier, a lot of these with more and more folks coming into a Medicaid population that are conducive to, say, 90 day supplies of chronic medications -- there's opportunities for us to work with states in ways we haven't in the past.

There's ways to work with them to drive adherence.

So, I don't think it's really whether we have the capacity to make it work, I think it's really focusing on the reimbursement -- the value we bring to begin with.

Lisa, one last thing I'd say is, just bundling the two together, apart from making sure that we have the most effective cost buying structure, with respect to things that are happening that we're doing like driving 90 day, which I think you can see is really accelerating, in terms of some of the automation that's happening with respect to our stores and streamlining of the process, as well as things like ePrescribe.

We'll continue to find ways to be more efficient and effective on all aspects of cost, which will allow us to be more placed, more broadly in expansion of healthcare and beyond.

Great.

Thank you.

Tom Gallucci, Lazard Capital Markets.

Thanks for all the color.

I guess that my first question was just sort of, on the front-end.

You mentioned some of the pricing and promotional strategies that you're sort of adjusting.

Can you remind us what you're doing there in terms of the impact that we should see?

You had mentioned on the call, instead of gross profit dollars versus gross profit margins?

Yes, Tom.

Greg.

Certainly, we're focused on, as we've said several times, on gross profit dollars versus margin.

I think what we're beginning to do and we talked a little bit probably on last call is trying to strike the right balance between price and promotion.

I think as we talked about, we made a strategic shift when we rolled out our Balance Rewards program, to shift some of our promotional effort and focus from our roto, primarily our print circular, to more digital and Balance Rewards.

I think that absolutely was the right strategic move for us to make.

Along the way, I think we probably got a little less promotional in that Sunday circular.

So, what we're doing is, we're really focused -- based on some of the data that we're getting insights from our Balance Rewards program, to make sure we've got the right items at the right price in that circular to drive comp and traffic.

This is something you just want to -- you want to tweak that dial ever so slightly.

We feel that we're making the right adjustments.

We're beginning to gain some momentum.

We want to continue to do that in our Sunday circular and utilize our Balance Rewards program to continue to move that in the right direction.

Okay.

My other question was on the pharmacy side.

With respect to specialty, not so much in the quarter, but obviously all we hear from payers out there is troubles with the specialty trend that are only going to get worse over time.

So, could you just update us on your latest initiative on the specialty side?

Your growth expectations?

Maybe some of the unique things that you think you're doing in the marketplace in that area?

Yes.

Great question.

I think that we have a great position to begin to provide more value to both patients, payers and pharmaceutical companies as we go forward.

We think that our differentiating model allows us to focus on what we would call specialty retail to make sure that patients are indeed eligible to pick up and receive specialty medications from their retail pharmacists that they've been using for years.

AmerisourceBergen -- the relationship we have with daily deliveries will help us drive that even greater.

We have a central facility that will allow us to either mail to stores or mail directly to the patient's home based on where they'd like it.

We're really driving sophistication there.

Finally, our infusion business, we think is truly a differentiator for us because as more payers look for a single solution for the pipeline of drugs that are coming out that are either going to be injectable or infused, we think that looking for a one stop solution that we can offer will help us win in the marketplace.

We're working with -- last thing I'd say is, Jeff Berkowitz and our team is focused on bringing solutions to the pharmaceutical partners that we have, are really working with them in ways to help them launch and drive the value that they're looking for with their specialty products.

John Heinbockel, Guggenheim Securities.

So two things.

So Greg, when we think about getting the front-end traffic back.

Digging into that a little deeper, how confident are you -- traffic is fairly negative.

You obviously don't want to do 12-packs of Coke for $2, because that really doesn't accomplish that much.

How confident are you that you can do that in a relatively -- get back closer to flat in a relatively quick period of time without hurting gross unnecessarily?

Do you think it's kind of a trial here?

Maybe you go a little too far, hit gross a little bit and then have to bring it back?

Or do you think you can manage it in a more consistent way than that?

Yes, John, it's a great question.

As I've said several times, that's the balance of retail; right?

I think our approach, as I said, is going to be a prudent approach to investing where it makes sense in order to get the results we're looking for in traffic and comp.

We're focused on gross profit dollars as I said.

I think the adjustments we begin to make with our circular in mid-May -- as I said, we're beginning to make progress.

I want to continue to take the approach we're talking about.

I'm extremely confident that we will continue to make progress and gain momentum in that trend for several reasons.

I think our folks are doing the right things with the circular.

They're making the right adjustments.

As I said, we have a lot of insights now at year end.

The Balance Rewards, which helps us do a better job of understanding what should we be putting in the front page, back page of that circular at what price to be able to drive profitable sales.

Then, also, with 75 million members now enrolled in Balance Rewards, the insight we have we're able to now strategically drive promotions through Balance Rewards to drive traffic and sales as well.

The third point is -- and it's interesting.

I think we have -- as you know, a lot of our stores are located in underserved or lower income communities.

One of the things that we have done extremely well in the past and we want to enhance is making sure that we're tailoring our merchandising mix, our price and promotion to those stores.

All those are in motion.

I think we've got a great plan, great team.

It's all about executing.

I'm confident we can do that.

Then, secondly, if you look at SG&A run rate, up 4.5% adjusted.

You've gotten a lot of the ESRX business back.

Are we sort of steady state now?

Where whatever you were going to add back, you've added back?

That's kind of a steady state run rate going forward?

Or is there more ahead to head back?

No.

I think I'd say that because you're cycling sort of an unusual base period, it looks choppy.

But in terms of how we run our business, I'd say we're pretty steady state.

We run algorithms every day to understand the incremental line, scripts, et cetera, that we have and how to tweak labor up or down accordingly.

Also, as we cycle Express Scripts, we have things like a little beefier profit sharing and things like that, that are in the underlying base that are just structural and the right thing to do, but that gets washed through.

But I think you're seeing -- in our 2-year stack right now, I would say really just a lot of great effort and focus on SG&A control.

That's not going to change.

I think moving forward to be effective and hit our goals in any one of these to be successful is going to have to have relentless focus not only on the customer but also on the cost side.

Okay.

Thanks.

Thanks, John.

Ajay Jain, Cantor Fitzgerald.

I wanted to ask about your front-end performance as well.

I think there's been some mention in the past that there was maybe a more margin-driven promotional strategy from last year, which you've -- looks like you've fully cycled at this point.

So just based on the loyalty card and the high level of enrollment that you have now with the Balance Reward card, when do you expect to start getting the customer insights through the loyalty card that would have the effect of increasing customer traffic and higher average ticket?

Yes, Ajay, as I said on the earlier question -- I think, the good thing is we're getting those insights now.

That's why we're so excited about having 75 million people already enrolled.

The reason -- now we can begin to not only drive enrollment but really focus on the effectiveness of that program.

The insights that we're getting are frankly just incredible and will allow us to get more efficiency out of our marketing dollars and our promotional dollars.

So we're getting those insights in the data now to help us continue to drive traffic in a prudent, reasonable way.

Just a couple of factoids.

Already about 60% and growing of our purchases made in store are now with the card.

We're seeing a significantly bigger basket of those that have a card versus all others.

Now the key will be as we move forward, call it longitudinally, to make their baskets bigger than they were prior.

That's the work to be done.

So I think as Greg said, in the end the magic comes from redemption and building critical mass at critical points and being able to use that as a lever so people can really understand the currents and the value of it is the next phase that we're just now moving into.

Just as a related question.

I'm assuming that there is some derivative impact on front-end due to legacy issues with Express Scripts.

So do you think it's reasonable to expect that we're going to see some improvement in front-end when you anniversary the new Express Scripts agreement in a couple of months?

Yes.

I think as we've also said before, every day we're kind of moving forward and getting more and more Express Scripts customers back.

I think that trend is going to continue.

So I think those two to some small degree go hand in hand as well.

Okay.

Thank you.

Thank you.

Matt Fassler, Goldman Sachs.

Just a little more detail, if we could, about the components of the change in the Alliance Boots accretion?

I know you spoke about the IFRS and then FX.

Any way to sort of disaggregate those impacts and quantify them?

Sorry, Matt, could you clarify again the question?

Sure.

Just if you could -- if you think about the reduction in the guidance for Alliance Boots?

If you could quantify how much is attributed to each of the drivers that you identified?

Yes.

It was roughly $0.02 in this quarter, thereabouts, which is just IFRS to GAAP conversion.

Again, a lot of it -- until you really get into it and understand things like how the leases actually work, their kind of retirement programs, et cetera, you just don't know until you get into it.

That's $0.02 in the quarter.

Next quarter is roughly about $0.01 of currency.

Again, I think it's going to be $1.52 versus the $1.58 on the pound.

But I think you've seen from their annual results that they've had -- all things considered in a tough environment, a very successful year and trading profit and underlying profit are really the two measures that they're focused on.

Got it.

Just one other follow-up, kind of high level strategic question.

I know we've spoken a bit about the Balance Rewards program already.

If you think about sort of its net economic impact since launch and when you would expect the program to start to deliver earnings benefits in aggregate, in your you view, is there any way to identify the timing if you could simplify it down to that level?

I mean, I guess I'd put it this way, because you never really know until you get there.

But we were in pretty heavy investment phase last year, not only from the systems but also in terms of just the employees signing up between 100 and 200 people per store per day and the effort that takes and all the while people start building points.

But until they actually have enough to redeem, you can't really use it as a lever.

It's more of just kind of an investment from that point of view.

We've now got critical mass of people enrolled, critical mass of points.

We also have critical mass of what I would call data, analytics and insight.

So, I think as we move forward here, we should just get progressively better.

I'd also say that the way we executed it, which was, I'd like to say, we put teeth into it, by making sure to get our discounts and promotions, you need to have the card.

In effect, it's sort of a two tier pricing system, which allows us to generate incremental funds to invest even more heavily in the people that are truly our most valuable and most loyal customers.

Economically, I'd say from that point of view it's a positive.

But I think really -- that the real heart of it kind of starts about now.

Matt, maybe I'll -- I think there's two ways to look at Balance Rewards.

The insights and the data that we are capturing now with the 75 million people is helping us make adjustments to new things, driving more relevancy with our circular, the way we merchandise our stores, et cetera.

We're beginning to use that data now.

The second part would be as consumers begin to understand the value of the currency and the points, then we begin to get the traffic and the basket and the trips that we want to begin to see out of it.

To your question, we're already beginning to use a lot of the data and the insights to drive decisions across the entire system.

Okay.

Thank you.

Ross Muken, ISI Group.

I wondered if you guys could extrapolate maybe more on some of the comments you talked about relative to sort of generics?

I think in general, there's a belief sort of we've got a better uptick next year in terms of sort of flow-through.

The comments that you made in terms of it being back of 2014, I'm assuming that's your fiscal year versus the calendar?

So, maybe talk a bit about how that differential works and where you're focused in terms of what's going to be a bigger contributor from a category perspective or maybe from a specific launch perspective?

Ross, this is Kermit.

Let me -- what I would tell you is that as we look at our physical year, our second quarter, our generics peaked in our physical year.

Certainly we are going to see a trough in the third and fourth quarter as Greg said, but we anticipate it coming back up in Q4.

We did -- we have said in the past that 2013 would be better than 2012.

We consistently are seeing 2013 better than 2012 and somewhat a little bit better than 2014.

Maybe just on the traffic piece again, I don't mean to beat a dead horse, but if you sort of look at the components of it in terms of the declines, if you look at it in terms of what you've strategically done to sort of improve margins, what percentage impact you think that's had versus just sort of kind of the impact of maybe the Express lag or anything else going on in the business?

Is there any way even qualitatively, you can kind of compartmentalize how you would think about that metric, just so we could kind of assume as we start lapping at what traffic could look like on the up-swing?

Yes.

I'll give you kind of a rough feel.

This will be probably close but not perfect.

It's hard to understand exactly what's happening.

If you think about kind of that 400 basis point traffic kind of step-down we've had over the past year, which is now starting to improve -- I'd say that a couple things have happened.

Number one is with Express Scripts, probably between 50 and 100 basis points of traffic.

Because, it's not one for one, they're separate trips.

But that's kind of the range that we have seen.

So as the customers come back, we see some benefit but it's in proportion to that.

The second thing is the promotional shift we had, which I think was for the right reasons, to keep moving money into more strategic marketing mix like loyalty, equity building, campaigns, probably was around 200 to 250 points.

Again, from a prophet point of view, I think the team did a great job of holding margin.

But it wasn't as many hot items at cost or below.

But we did see that shift.

Then the last piece is roughly almost 100 basis points of traffic from cigarettes.

I'd say the primary driver there was we saw $15,000 to $20,000 stores introduce cigarettes.

We haven't seen, outside of cigarette category, much hit if any at all versus other competitors in the other categories but I would say from a traffic driver we did see something there.

So that's kind of how I'd break it down.

The only other bucket I'd probably add, and I hate to, because I'm a three bucket guy, but the fourth would be weather-related economic.

Certainly we're coming around that.

I think Wade did a great job breaking it down.

Maybe just one last one.

You guys have obviously done a lot of interesting strategic things in the space the last 12, 24 months.

Now with the relationship with Alliance Boots and Amerisource, seems like the synergy flow-through, you guys are executing well there.

How do you figure out where the synergies get allocated in terms of -- is this an Alliance Boots synergy?

Is this something that Amerisource gets to keep?

Is it sort of a corporate WAG synergy?

How do you sort of figure out what goes into what bucket, just big picture?

Yes.

I'd say -- well, first, if we take them separately.

With respects to Alliance Boots, we both have our baseline projections of what we think we do otherwise independently.

As we work together and drive synergies, effectively, we for the most part, split them.

Because we have a 45% ownership stake in them, it means that we get our half plus their 45%, which is 72.5%.

It's probably not perfect plus or minus where it goes.

But in the end because we're ultimately planning on becoming one Company, it's not worth arguing about as much as making sure we maximize them.

Because in the end it will all go to the same place.

I think it's a little more complex with AmerisourceBergen because there, we are a small investor.

We plan to just be a partner versus anything grander.

So we really have to make sure that we have mechanisms to understand each year not only what is the synergy but we also have mechanisms in terms of how we equitably share those based upon agreements that we have.

We haven't talked any more about that.

But I would say they're a little bit different in the two constructs.

But I think that we have pretty good models, understanding what we would do on our own if not in partner with someone else.

That for all cases is usually the baseline.

Thanks, guys.

Andrew Wolf, BB&T Capital Markets.

I have a few follow-ups.

First, around the sustainability of this improvement in the SG&A stack.

You cycled the Balance Rewards investments -- start-up costs.

Was that something that was meaningful to helping the SG&A improvement?

So that would obviously carry forward; right?

We haven't called out what we did in terms of investing in systems for Balance Rewards and also for people.

I wouldn't say it wasn't not meaningful but it wasn't hugely meaningful either.

I think the key thing is just if you think back to last September, and all that was going on -- not only were we trying to sign up 100, 200 people a day in loyalty, we were welcoming Express Scripts customers back.

We had all our competitors that were launching promotional campaigns to try to keep them.

This was all in the context of probably lower overall investment in promotion activity.

So I think that's probably more the -- the more thing to watch for is now, as Greg said, as we sharpen our focus, make incremental investments where it makes sense to do so, seeing how we round the horn and what that looks like.

Yes.

By using the word investment I meant hard costs going through SG&A, let's say programming costs that you couldn't capitalize.

I think you have at least qualitatively said that was --

There was some of that.

But I think the bigger thing as we alluded to a few quarters ago, is we had some SG&A that was attributed to loyalty sign-ups attributed to, again, Express welcome backs because there was a lot -- and also to Med D sign-ups.

There was a lot going on at the same time.

That really was important but in some ways a distraction from taking care of the core customer every day.

Okay.

The other part on the SG&A, was there anything unusual in some of the major line items that can kind of swing quarter to quarter?

Sometimes you hear healthcare costs were -- or workers' comp was particularly good or bad.

Was there anything like that this quarter?

There's tons of moving parts under the hood in the way that they get treated for.

But I would say there was no anomalies in this quarter really.

I think what you pretty much see is our performance exactly kind of as it was.

As I said before, it's kind of more normalized out now the way we run our business even if the base period and then two periods ago have anomalies in it.

Okay.

So moving on to gross margin, at least versus my expectations, that's where things came up light.

Then sequentially, just looking at your FIFO gross margin, the expansion was about half of last quarter's.

I'll give you three buckets, Greg.

Generics, was the sequential contribution less so in generics?

Was it you started ramping up promotions?

This is my hearing and it may be something else.

Or was it also just the flu was so profitable?

How would you think about sequentially having less gross margin expansion?

There's probably a little bit of generics.

I think you're right, the flu was a big boost the prior quarter.

There was also a lot of other things going on under the hood that you won't see at the surface.

So for example, the extent that our pharmacy business out-paced our front-end, but our front-end has a higher gross margin on average, you get mix effects in that regard.

You also have other mix effects from business like specialty that have a very low margin but have had a lot of inflation and therefore, to some extent growth.

So, I think the key thing, I know we say all the time -- but I think the key thing is the way we really run our business as a business model is to try to maximize gross profit dollars.

In the end even with generics ever-increasing, our margins probably over time look good.

But if we can't keep the gross profit dollar engine going, that's not going to help us.

So again, I think there's just a lot of static.

I think you probably hit on some of them, but there are mix effects in other things that can make a difference quarter to quarter too.

Okay.

Just on the promotional posture of how the Company's going to market.

Clearly the press release stated that's going to increase.

Was that part of that increase during the quarter or is that all post quarter?

Which part of the --

The increase in promotionality.

I'm trying to understand what --

I think Greg said in the back half of May, we started to make some of the tweaks and modifications.

Those will continue.

Again, we're going to be smart about what we do.

We're a lot smarter now that we have a lot of the loyalty data we didn't have prior.

Yes.

With the lead time in circulars, it was mid-May by the time we truly made some adjustments.

Got it.

I was late on the call.

I didn't hear that comment.

Okay.

Just lastly, on this Alliance Boots trim on expectations.

So, it's $0.03 of currency.

How much is the miscalc in the IFRS to GAAP convert?

For this quarter, we were about $0.02 versus the bottom of our range and that was really IFRS to GAAP adjustments.

Okay.

So it was really no change in how they view their performance, only a change in terms of -- as we get into the methodology and the differences in IFRS and GAAP -- knowing those.

The $0.01 is currency, we're predicting for the next quarter.

Because there's a three month lag, we know a lot about next quarter already.

There's still auto processes that needs to happen, so there can be some final adjustment in IFRS and GAAP.

But I think that for the most part, things like currency are baked and so we know that.

That's why we're calling that out.

So, in the current quarter, was there any operational miss from Alliance Boots?

No, the current quarter they're pretty much right on path.

I think you -- if you look at their equity income reported, it's probably pretty close to what we've seen on aggregate -- most people here on the phone have modeled.

Sure.

Okay.

Just double checking that.

But it looks like given the range for your fiscal year, that you're not so sure about this quarter?

Or why is there $0.04?

If you have explained $0.03 and you've given a $0.02 to $0.06 range for the year, it sounds like you think Boots could either add $0.01, be $0.01 above plan or $0.02 below.

No, we're predicting $0.08 for the next quarter.

We just said that prior, we had thought it would be a little higher than that.

The primary driver of difference is foreign exchange.

Okay.

If you look at this quarter, a couple things that's just -- again, we don't obviously manage to consensus.

We manage to our internal target.

I would say there, if we look there probably the front-end was the key thing that we were working against from our original projections.

But if I look at it externally, I think a couple things happening.

One is our tax rate is a bit different than was assumed by many and there was a lot of complexity in that tax rate this quarter.

Second thing is share count.

Again, I think there was probably 7 million or 8 million shares or 6 million shares associated with options, which sounds like a small number but it actually does move the needle on an EPS basis.

So, there's going to be a $0.02 currency hit based on current currency rates to your prior expectation for the current quarter.

Is that right?

In the current quarter, we just put out there was $0.02 difference.

That was primarily almost all IFRS to GAAP adjustments.

For the next quarter, Q4, it's about $0.01, which all currency.

Okay.

Because we have a three month lag, we effectively already know what the currency will be in three months.

Okay.

So for the quarter we're in and the quarter -- I guess Boots is reporting on a lag, so you already know how that ended.

That's right.

How was that quarter operationally?

Was there a miss in the -- not the quarter you just reported, but the quarter that you'll be reporting?

The Q4 quarter you're reporting that I think Boots already concluded because they're reporting with a lag, did that meet expectations?

We know a lot.

But if we told, we'd have to kill you, Andy.

(laughter) Until we get to next quarter, we can't divulge that.

I think what you did see is you saw the last fiscal year for Alliance Boots.

So hopefully you have confidence that they've run their business very effectively in very challenging times.

I don't expect that will change any time soon.

Andy, it's Rick.

We'll have to move on.

That's fine.

Thank you.

Ricky Goldwasser, Morgan Stanley.

This is Zack Sopcak for Ricky Goldwasser.

Thanks for the question.

I want to ask first, real quick, about your gross margin progression going forward.

I know you talked in quite a bit of detail about some of the headwinds being generics and 90 days at retail and Balance Rewards.

Can you talk about any of the tailwinds that we might be seeing?

Or that you can talk at a high level other than synergies from the Alliance Boots deal?

Yes.

I think the tailwinds that we have frankly are the price and promotion and the adjustments we're putting into the front-end.

I think we'll continue to see more and more people coming in for Medicare Part D plans that we put in place.

I think with healthcare reform as we talked about and millions of people coming in, gaining insurance coverage, we'll begin as a Company to benefit from that.

I think certainly as we continue to gain strength, certainly with the consumer, I think that we'll see lift in our discretionary categories, which we've seen probably the biggest impact.

Thanks for that question, Zack.

We do think we have ample tailwinds.

We're really focused on what's currently in front of us.

But we think longer term and even short-term there's a lot of opportunity behind us.

Okay.

Then a separate question.

Within the quarter, you received regulatory approval to start buying shares of ABC.

Can you comment on, if you started on that at all?

Or what your thoughts on that are?

We are in the market.

We are buying.

Beyond that, I can't say much more.

Okay.

Great.

Thanks for the questions.

Thanks, Zack.

Ladies and gentlemen, that was our final question.

Thank you for joining us today.

As a reminder, the Company will report June sales on July 3. Until then, thank you for listening.

Have a happy Fourth of July.

Thank you, ladies and gentlemen.

That does conclude today's conference.

You may all disconnect.

Have a wonderful day.