Walgreens Q3 Earnings Call Transcript

123jump.com Staff
25 Jun, 2009
New York City

The online pharmacy and drugstore third quarter sales shot up 8% to a record $16.2 billion while net earnings dropped 8.7% to $572 million. Earnings per share were 53 cents as against 58 cents in the year ago quarter.

Walgreens Company ((WAG))
Q3 2009 Earnings Call Transcript
June 22, 2009 8:30 a.m. ET

Executives

Rick J. Hans - Divisional Vice President, Investor Relations and Finance
Gregory D. Wasson - President, Chief Executive Officer, Director
Wade D. Miquelon - Chief Financial Officer, Senior Vice President

Analysts

Mark Miller - William Blair & Co
Simeon Gutman - Canaccord Adams
Mark Wiltamuth - Morgan Stanley
Eric Bosshard - Cleveland Research
Scott Mushkin – Jefferies & Co
Meredith Adler - Barclays Capital
Lisa Gill - JP Morgan
Debra Weinswig - Citigroup
John Heinbockel - Goldman Sachs
Edward Kelly - Credit Suisse

Presentation

Operator

Good day, everyone and welcome to the Walgreens Company third quarter 2009 earnings conference call. As a reminder, today’s call is being recorded. And now I would like to turn the call over to Mr. Rick Hans, Divisional Vice President of Investor Relations and Finance. Please go ahead, sir.

Rick J. Hans – Divisional Vice President of Investor Relations

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 website 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 related to forward-looking statements.

Now I’ll turn the call over to Greg.

Gregory D. Wasson – Chief Executive Officer

Thank you, Rick and thank you, everyone for listening to our call. We certainly appreciate your continued interest in Walgreens. Today I am 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 consumes 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 am 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 are 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 store operating expenses. Beginning in the fourth quarter, we’ll see a sequential decline in new store openings toward 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, 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 homepage 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 are 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 rollout 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 4,500 SKUs were eliminated for about 18% of our total. That’s one of the contributing factors to this quarter’s tight inventory control. Please note we are not reducing SKUs for reduction’s sake. We are 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 are doing that is by transforming community pharmacy and our POWER project is an enabler of that. We’ve nearly completed rollout of POWER in Florida and rollout in Arizona is underway.

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 drugstores this quarter versus 45 in the second quarter and in last year’s third quarter, we opened 122 new drugstores. 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 convenient 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 are 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 II 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 change in consumer and the demands of healthcare today and will 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.

Wade D. Miquelon – Chief Financial officer

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 represent 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 for more patients filling 90-day scripts versus 30-day scripts. Now, 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 truly reflects better prescription usage. Despite rising unemployment, our prescription trend is stabilizing. We filled 187 million prescriptions during the quarter and our U.S. 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 stack basis, SG&A dollar growth for the third quarter declined from 24.9% to 17.6%, primarily due to store salary and expense control. And 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 costs and savings for restructuring related charges through to 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, and you’ll recall that last year’s LIFO provision was roughly 1.25%. Next are 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.

Now 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 percent to sales have 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. 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 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 and improve inventory and drive cost savings over the next few years. For the first three quarters of the 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 are making on cash flows are truly bearing fruit. Looking forward, I am 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 tailwinds and headwinds. Reimbursement pressure and economic uncertainty will undoubtedly provide challenges but winning companies can turn these challenges into 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 the 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.

So 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 have conveyed this message to you today.

And now I will turn the call back over to Rick.

Rick J. Hans

Cecilia, that concludes our prepared remarks. We are now ready to take questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) To ask a question at this time you may do so by pressing “*1” on your touchtone telephone and as a reminder if you are using a speaker phone please make sure that your mute function is disengaged to allow your signal to reach our equipment. Once again that is “*1” and we’ll go first today to Mark Miller of William Blair.

Mark Miller - William Blair & Co

All right, can you discuss what you think the impact to the P&L will be if the store remodels in 2010? So based on what you’ve learned so far from the up-front 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?

Wade D. Miquelon

Yeah, Mark, good morning. Obviously we are finalizing the modeling for it. I’ll give you a rough range. The rough range, we’re probably talking in the order of $30,000 to $50,000 per store, doing the bulk of stores. Obviously the new stores coming out won’t need to be done. There are some inner city stores that won’t need to be done, so 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 as we continue to go forward, we’ll be getting benefit coming from rewire to help pay for that and from CCR.

Mark Miller - William Blair & Co

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 and the benefits, which come a little bit later?

Wade D. Miquelon

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

Mark Miller - William Blair & Co

Okay. My other question is the comment was made about rewired 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?

Wade D. Miquelon

We’re absolutely on track.

Mark Miller - William Blair & Co

For the $500 million next year?

Wade D. Miquelon

For this year next year, and the year after.

Mark Miller - William Blair & Co

Okay. Thanks a lot.

Operator

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

Simeon Gutman - Canaccord Adams

Hey guys on the path to achieving double-digit earnings growth, and 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 has 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 downwards or are there some spikes along the way?

Wade D. Miquelon

I think if I interpret the question, kind of try and understand where SG&A will go over time, you know obviously this quarter’s SG&A, I think we made very good progress when you look at the number of store openings, which is the major driver. I guess what I would say is over this quarter and last quarter, we’ve actually seen our established store base, our comp store base SG&A negative. So we are 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 that 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.

Gregory D. Wasson

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 are doing a very good job on just an everyday operating model, with an operating structure within the stores. Store operations groups are doing a very good job controlling expenses, and I think with the slowing of stores, as Wade said, we’ll begin to see a pretty good improvement there.

Simeon Gutman - Canaccord Adams

And with the slowing of stores, and I guess as you get closer to the end of CCR, and I know I might be stepping forward, mid-single-digit expense dollar growth is a good ballpark to think about. And then let me just 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 is being done in the warehouse as well?

Gregory D. Wasson

I’ll take the CCR markdown and let Wade come back to the SG&A but one of the things that we are 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 having to take more aggressive cut. 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 was what affected this month’s gross margin.

Wade D. Miquelon

On the SG&A, you kind of referenced over time can we see kind of a mid-single-digits, I would say that’s very reasonable and perhaps better.

Simeon Gutman - Canaccord Adams

Okay, thanks.

Operator

And we’ll go next to Mark Wiltamuth of Morgan Stanley.

Mark Wiltamuth - Morgan Stanley

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

Gregory D. Wasson

Mark, this is Greg. I think that as I say internally a lot is that certainly healthcare reform, there are certainly some threats and there are opportunities. I think as the administration tries to provide more coverage for the 47 million uninsured, there’s certainly going to be focus on costs and so we’ll be focused on margin pressure and reimbursement pressure. But 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, there will 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 I think we have a great opportunity to play a part, as I said earlier, with access and affordability. This weekend, you saw where-PhRMA made some concessions to help with the doughnut hole in Part D. I think that’s a positive. That will help seniors that have had been challenged during that, when they hit the doughnut hole.

Mark Wiltamuth - Morgan Stanley

Is there any pressure on retail to make any concessions?

Gregory D. Wasson

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 a couple of states as is out there, and you’ve probably heard with Medicare, but we think we have solutions and we think rather than rates, there’s ways to improve generic compliance for states and really, really help improve the quality of the benefit they offer.

Mark Wiltamuth - Morgan Stanley

Okay. Thank you.

Operator

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

Eric Bosshard - 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?

Wade D. Miquelon

I’d say probably roughly, you know -- I’m going to just guess the number, two-thirds. I’d say we are more than halfway for sure. As Greg said, we’ve been very aggressive early to clean up 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 and more quickly on the ultimate ending.

Eric Bosshard - Cleveland Research

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

Wade D. Miquelon

Two-thirds.

Eric Bosshard - Cleveland Research

Okay. 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 depreciation of the business I think is running around $1 billion. With store growth going towards 2%, do we ultimately get to where you are 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?

Wade D. Miquelon

We haven’t given obviously that kind of out guidance but I would say that’s probably kind of a bottom threshold. If you consider three-ish percent store growth, the basic maintenance infrastructure that we need and then the basic distribution of systems, that’s kind of a rough floor, I would say.

Eric Bosshard - Cleveland Research

Okay, and then if I could sneak one last one in, in terms of the reset stores, the 35, you said that they are running ahead of plan. Can you just quantify what you are seeing out of those stores in regard to, I guess really how you are evaluating them, if it’s an expense, if it’s a gross margin, if it’s the sales, if it’s a mix, what you are seeing out of those stores?

Gregory D. Wasson

I think, Eric, you know, obviously it’s too early to extrapolate and give any numbers on that. I will say that the two areas that we’ve really been focused on in those 35 stores is the rollout period itself and what’s the disruption of sales look like. We feel good there that we are doing better than we expected, and as well as obviously the lift coming out of it. We feel good there, we are beating those metrics. But I do think the four wins that we talked about earlier, the improved sales, improved margin, the reduction in payroll and inventory is what we are absolutely focused on and we believe we are going to be able to achieve.

Wade D. Miquelon

In the shopper feedback right, the ultimately experience is coming back very positive as well.

Eric Bosshard - Cleveland Research

Great. Thank you.

Operator

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

Scott Mushkin – Jefferies & Co

Hey guys, thanks for taking my questions. First, the store you show us, the transformation, did that cost $50,000 or is that more?

Wade D. Miquelon

What you will see on YouTube, that’s kind of the general range.

Scott Mushkin – Jefferies & Co

Thirty to fifty-thousand, so you’re not, I mean, just to understand the process, because a lot of companies have done this and they have spent a lot more, it looks like a pretty radical change in the interior décor and what not. Is that not right?

Wade D. Miquelon

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 and the Gondola height. So it’s not, there’s a lot that happens in that shot but it’s really refresh. Obviously the other thing we’re looking for is as we roll through this, our costs 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.

Scott Mushkin – Jefferies & Co

So if you’re guys are going to keep going on the line, if we say $40,000, you expect us to be about a…and you are going to run none of it through CapEx, it’s all going to be an expense next year, about a $300 million expense?

Wade D. Miquelon

Well, a couple of things, number one is, I’d like to say it’s 90-ish percent expenses, not all expense, obviously counting…and separately we’re probably not talking 7,000 stores. We’re probably talking 5,000, 5,500, 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 had in urban areas, small format, whatever that don’t really lend itself towards this type of refresh.

Scott Mushkin – Jefferies & Co

So, okay, $200 million, $250 million, now is that net of the $500 million next year or is that, or is it $500 million on top like, this is, that expense is contemplated with the $500 million that we are supposed to get in savings?

Wade D. Miquelon

This is separate. The $500 million again is reflective of the rewire, so the SG&A reductions. The CCR program is separate but excluding the SKU reduction, which is also driving down labor, so you’ll see this as a separate bucket of costs but we’ll also have of course benefit associated with the CCR that we hope to outrun this by.

Scott Mushkin – Jefferies & Co

Okay, so you expect the $500 million, we shouldn’t have $200 million extra expenses here next year, just to clarify?

Wade D. Miquelon

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

Scott Mushkin – Jefferies & Co

Right.

Wade D. Miquelon

It’s effectively a separate program from this.

Scott Mushkin – Jefferies & Co

Okay, so if I was going to do like a little key account though, I’ve got $500 million there. I get $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 we didn’t think going more consumables would hurt gross margins at all but it seems to have this quarter and it wasn’t in that many stores. So how are we thinking of gross margins next year?

Wade D. Miquelon

I think we had a little compression this quarter obviously, but big the factor here was really markdowns and LIFO. I think as most retailers saw May was a bit 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 are taking lots of steps over time here, that despite perhaps changing mix, we’re going to continue to drive the private label. They can be more efficient in terms of how we price and promote and I think that we’ve got offsetting things that are going to help to stabilize and increase the gross margin over time.

Gregory D. Wasson

Scott, I think we have to keep in mind too that obviously the benefits of CCR should help cover a lot of these costs as we roll it out and also, one of the things that I think we are excited about, obviously private brands picking up quite a bit for us, as we talked about, but also with the work that Kim Feil done on our customer segmentation, I think we can become much more effective and efficient with our promotional strategy and drive more effective volume but at the same time, protect margins.

Scott Mushkin – Jefferies & Co

One final one and thanks, and then I’ll give it up here. Are you guys using third-party liquidators? And then Wade, if you can go over 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, and I’m done.

Wade D. Miquelon

We’re not using third-party liquidation at this point. We’re really just trying to make sure that we market at an 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 rate for the year was 2.25 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 2.25 and we dropped it to 2.

Scott Mushkin – Jefferies & Co

Thanks. Thanks very much.

Operator

And we’ll go next to Meredith Adler of Barclays Capital.

Meredith Adler - 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 where are the cost-savings?

Wade D. Miquelon

You are getting cost-savings at several levels. You are getting it in the indirect spend bucket. You are getting it in headquarter, SG&A. You are getting in the field and you are getting it in the stores. What you have to remember again is that our new store openings, right, on an 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 relating costs, you would have seen that we were in general probably slightly negative.

Meredith Adler - Barclays Capital

Actually my question though was how are you recording the savings? Does it go into the SG&A line?

Wade D. Miquelon

Yeah, it’s folded into whatever item it’s in.

Meredith Adler - Barclays Capital

Then 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?

Wade D. Miquelon

Well, I think what we are trying to do by showing the savings and the benefit is we are basically, remember, 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 that the benefit we are starting to see. So you can track to that $300 million to $400 million over time and also track to the net flush 500 and $1 billion savings. So that’s the only reason we are giving that. Obviously we’re a company that’s still driving GAAP but we want you to have the perspective of how we are tracking along that and we are folding all those expenses and all those costs into the lines that they belong in. So we will cycle. I mean, think of it this way. The benefits that we are starting to see are going to keep recurring but we are 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 are on.

Meredith Adler - Barclays Capital

Okay, that’s good. That’s helpful. Now a question about inventory, at what point do you think you have gotten to the inventory that you want to? You are two-thirds of the way down in the SKU rationalization. Is there any other inventory activity that will go on, either the distribution centers or related to CCR? Or when you get done with this category rationalization, you’ll be done with reducing inventory?

Gregory D. Wasson

Meredith this is Greg. I think as Wade said, we’ve still got some opportunity to go through with CCR markdowns but we are also focused on older inventory that we have in the system. We are also focused on better seasonal buying but the big thing, and the thing I am really excited about, is our supply chain initiatives and as you know, or may not know, I moved supply chain under Randy Lewis from…. So he’s managing inventories from the vendor to the customer, all the way through and I think we are going to begin to see incredible opportunity there that I am really excited about. We moved our forecasting folks under Randy and so forth, so I think we will see a lot of opportunity going forward in the supply chain initiative improvement.

Wade D. Miquelon

Just to be totally clear, these costs that we are incurring 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.

Gregory D. Wasson

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.

Meredith Adler - Barclays Capital

That’s great. And 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?

Gregory D. Wasson

For the most part, we are seeing a transfer and a pick-up 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, so I think it’s designed, it’s doing exactly what we had hoped to do, which is a better customer experience and increased lift.

Meredith Adler - Barclays Capital

Okay and 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 happening at the stores and that there could be an impact on sales? Or is the assumption in the early reads in the 35 stores that this is just a net positive?

Gregory D. Wasson

Certainly we are surveying and getting feedback from consumers as well as the movement within the stores and Meredith, so far it’s been, we’ve got good feedback. I think one of the things that 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 has absolutely been received well. And I think we aren’t changing the stores so drastically that shoppers are confused as far as where items are and so forth. So far, we are positive with what we are seeing.

Wade D. Miquelon

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 just as shoppers get reoriented in the store and that comes back and increase over time but in fact, really not seeing much of that and we are seeing a very quick trajectory to increased sales. So apart from the anecdotals and the consumer and the survey data all being positive, we’re exceeding the plan significantly both on the dips and on the ongoing, and so that’s a very good sign.

Gregory D. Wasson

And that’s why we built in a couple months pause here to go back and learn and understand before we roll out the next wave of stores.

Meredith Adler - Barclays Capital

Great, thank you very much.

Operator

And we’ll go next to Lisa Gill of JP Morgan.

Lisa Gill - JP Morgan

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 better prescription volume than IMS. Could 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 doughnut hole, that’s what some of the driver is? And then thirdly, which would be around reimbursement, I know there continues to be pressure on the Medicare side but are you feeling any pressure in the commercial market?

Gregory D. Wasson

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 are rounding some softer comps from last year, so I think we are seeing a little bit of that but I also think we are seeing what we call Medicare Part D maturity where, as more and more folks are becoming eligible for Part D, we are seeing more utilization from seniors. I also think that we are seeing, as I said, benefit design, more benefit designs that make generic drugs more affordable and therefore more people are staying compliant and using the prescription meds. As far as ourselves, I think we are 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 the Medicare Part D effect and we are gaining share in the senior market. I think we are also seeing a 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 are 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 are 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. So I think it’s really more spending time with plans with states to help them understand how they can deliver great savings through other means.

Lisa Gill - JP Morgan

And any thoughts around wanting to be bigger in your PBM, to help to try to drive some of those costs down through the programs that the PBM could offer?

Gregory D. Wasson

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 are seeing a strong interest in the employer solutions model that we have 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 their PBM. I think there are folks out there that are looking at doing different things and I think everything from maybe outsourcing to provider services to potentially the entire PBM and I think we could, we are going to be looking to see if there are opportunities there for us.

Lisa Gill - JP Morgan

So are you interested if one of the managed care companies look to do something like that, is that something --

Gregory D. Wasson

We want to be a provider and so what we are really interested in is being able to provide mail service, retail prescriptions, and specialty services to payers across the country. That’s what I’m really interested in, Lisa.

Lisa Gill - JP Morgan

Okay, great. Thank you.

Operator

And we’ll go next to Debra Weinswig of Citi.

Debra Weinswig – Citigroup

Good morning. Greg, could you go through some of the details in terms of what you are doing to be proactive in terms of shaping healthcare reform in Washington? And then also with regard to CCR, could you maybe share with us some of the qualitative feedback from your customers?

Gregory D. Wasson

Deborah, I’ve spent a lot of time obviously in D.C. 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 in some of the plans that are being made, and as you know it’s changing daily sometime. 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 because 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.

Debra Weinswig – Citigroup

And then the --

Gregory D. Wasson

As far as CCR and qualitative, I think again our customer feedback has been good. Certainly we are early on and we’ve got to do a lot more of that but again, I think based on the early metrics that we are seeing, we’re pleased with the lift that we are seeing so far, we’re pleased with the feedback we’re getting. Obviously we are going to be doing a deep dive over the next couple of months and understand that better but so far, we feel pretty good.

Debra Weinswig – Citigroup

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

Gregory D. Wasson

It’s been both.

Debra Weinswig – Citigroup

Great. Well, congratulations and best of luck.

Gregory D. Wasson

Thank you.

Operator

And our final question today comes from John Heinbockel of Goldman Sachs.

John Heinbockel - Goldman Sachs

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 will go with as you go through the significant rollout?

Gregory D. Wasson

Yeah John, good question. I don’t, other than, unless we hear and get some feedback in the next couple of months before we start the next wave, I don’t think you’ll see a lot of drastic change of any type. This is, again, I’d 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. You know, 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 are 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.

Wade D. Miquelon

Yeah, and I’ll 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 thought, whatever. There might be a few categories that need some adjustment but in aggregate in terms of the overall layout, shelf life, planogramming, et cetera, we feel we’re 90%-plus right on course.

John Heinbockel - Goldman Sachs

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

Gregory D. Wasson

Well, I think the store of the future, John, was a good test for us and there are 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, the cosmetic department, there are some good learnings there from that. But I think it’s far too soon to say that that is the store of the future for us. And your second point was, John?

John Heinbockel - Goldman Sachs

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

Gregory D. Wasson

I think with Café 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.

John Heinbockel - Goldman Sachs

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

Gregory D. Wasson

You’re talking about the store of the future or the --

John Heinbockel - Goldman Sachs

No, the 35 pilot stores.

Gregory D. Wasson

I think it will be both. Certainly if we attract new patients, new customers, we’ll see lift.

John Heinbockel - Goldman Sachs

Okay, and then finally, what’s the prognosis? I know you mentioned state Medicare a bit earlier. Washington went well for you, sort of well for you, compared to where it was. Are we going to have this 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?

Gregory D. Wasson

John, that’s certainly hard to predict. I do think that we cannot fill prescriptions below our cost and we’d much rather be filling prescriptions for Medicare 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 a better overall healthcare for their beneficiaries as well as reduce cost.

John Heinbockel - Goldman Sachs

Okay, thank you.

Gregory D. Wasson

Hey, Cecilia?

Operator

Yes, sir?

Gregory D. Wasson

This is Greg. We’re not tired yet. We’ll take another question.

Operator

Okay, no problem. We’ll go next to Ed Kelly of Credit Suisse.

Edward Kelly - Credit Suisse

Good morning. Thanks for taking another question.

Gregory D. Wasson

Good morning, Ed.

Edward Kelly - Credit Suisse

I look at your gross margin this quarter and from a headline perspective, it doesn’t look very good because of the costs for rationalizing SKUs. But underneath of 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 are able to at least get this line kind of flattish as we look to next year?

Wade D. Miquelon

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 are seeing a bit of a transition phase. We’ve got a lot of things going on. We’re kind of, I call it changing the tires while the car is moving but still, we’ve got traffic, even in this kind of tough economic year we’ve got traffic increasing, which is very good. Again, we’re making lots of changes to clear out the old stock, to refurbish stores. So 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. So, I don’t want to predict exactly what it will be but certainly we are working on improving this over time and I think right now we’re just in a bit of a kind of a transition and mostly I feel very good that we are still again swinging the doors and driving sales in a pretty tough economic environment as well.

Edward Kelly - Credit Suisse

Great and then Wade, on the inventory side, I know that you’ve publicly said that you’ve got a $500 million goal in terms of reducing inventory. It sounds to me like the body language is that maybe the potential is more. Is that fair?

Wade D. Miquelon

Well, 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 are 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.

Gregory D. Wasson

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

Edward Kelly - Credit Suisse

And then a question for you, I’ve heard that you are thinking about adding liquor to the stores. Where do you stand right now in terms of assessing whether you are going to do that? How many stores do you sell it in today? How big could it be?

Gregory D. Wasson

We are looking at beer and wine, Ed, versus spirits. You know, we do have several markets now, the Southeast and the 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. I don’t know really the total number of stores yet. We’re kind of in the early stages of it.

Edward Kelly - Credit Suisse

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

Gregory D. Wasson

It’s single, small single digits.

Edward Kelly - Credit Suisse

Small single digits?

Gregory D. Wasson

Yeah.

Edward Kelly - Credit Suisse

Okay. And then Greg, last question for you, I was just kind of hoping that maybe you could go back to that question on the PBN business and maybe just help us understand strategically how you are 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.

Gregory D. Wasson

No, Ed, I’m glad you came back to that. No, 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 PBNs and/or managed care. And as we link our provider services together, I think that’s where the real value is and I talk about that we are growing, we’re building our specialty platform. Now we’ve got the number one infusion platform across the country. We’re growing our clinics, as you know. We’re growing our employer on-sights 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 PBN to be able to do that. I’d much rather would want to work with all payers to be able to bring those services to them versus link up with one or two in particular.

Wade D. Miquelon

And one thing we like to say is, as you know, we had a PBN and whatever you call it, it’s the capabilities that underlie it that we have and we continue to want to be very good at. So whether it’ll be formularies, whether it is to claim support, it’s really the capabilities that we are trying to drive versus the spread game or something else. That’s where we are really focused.

Gregory D. Wasson

And 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 PBN to be able to do that and I think, as I said, 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.

Edward Kelly - Credit Suisse

Okay. Thank you.

Gregory D. Wasson

Thank you.

Rick J. Hans

Hey 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 who 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.

Operator

And that does conclude today’s conference, ladies and gentlemen. We appreciate everyone’s participation today.