Walgreens (WAG: Charts, News, Offers), the largest drugstore chain in the United States, impressed investors when it announced a 30% increase in earnings this week. The Deerfield, Illinois-based company posted an EPS of 65 cents, or $603 million, up from the 47 cents per share, or $663 million, it posted the same period last year. Net income has now increased three quarters in a row. Revenue increased from $17.2 to $18.37 billion, continuing a streak of four consecutive quarters of rising sales. Analysts on average expected earnings of 62 cents per share on revenue of $18.33 billion. Gross margins increased 0.4 a percentage point to 28.1%, due to the revenue increase of 6.8% outweighing its 6.2% increase in costs. The company is also selling its prescription benefits management subsidiary, Walgreens Health Initiatives, for $525 million in cash to slim down on its brick and mortar expenses, while acquiring online prescription store Drugstore.com for $409 million to expand its e-commerce presence.
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All this good news, however, was overshadowed by the company ending its partnership with long-time partner Express Scripts (ESRX: Charts, News, Offers), valued at $5.3 billion in annual revenues. This massive blow to its revenue stream, which accounts for 7% of its revenue, sank the stock over 4% during Tuesday trading despite the company’s record earnings. The loss of Express Scripts is forecast to impact the Walgreens’ annual earnings by 50 cents.
St.Louis, Missouri-based Express Scripts is a pharmacy benefits manager (PBM), which pays Walgreens to fill prescriptions. Express Scripts is forecast to process 90 million prescriptions at Walgreens in fiscal 2011. Express Scripts has requested that Walgreens lower these required payments further, to a price which Walgreens claims is lower than the published cost of the provided prescriptions. Walgreens has stated that the proposed rates are “unacceptable” and would be ending its partnership effective January 1 next year.
Walgreens has also stated that Express Scripts was attempting to unilaterally define contract terms – which includes definitions of name-brand and generic drugs and the transfer of current prescription plans to other networks. These terms, Walgreens states, would have cut the company out of the decision-making loop and made its business “unpredictable.” This unpredictability, combined with the loss of revenue due to lower payment rates, caused the company to finally end negotiations.
In his company’s defense, Express Scripts CEO George Paz has stated that the costs of non-specialty branded medications are expected to rise 10% per year while branded specialty medications are expected to increase 14% per year over the next three years. In addition, his company believes that once major patented drugs from the large pharmaceutical companies lose patent protection over the next few years, there will be a huge market for affordable generic alternatives which Express can offer. Paz doesn’t believe Walgreens’ current payment rates fairly reflect these future drug prices.
When the partnership ends, Express Scripts will be placed at a significant competitive disadvantage against other PBMs without the support of the 8,000 Walgreens and its subsidiary Duane Reade pharmacy locations. “In these challenging economic times, it is critical that we all work together to keep medicines affordable and accessible,” Paz stated, “It is shocking to us that Walgreens would back away from the table with six months to go in the current agreement, especially considering that negotiations are part of the normal course of business.” The company, however, has stated that it is ready to continue without Walgreens, and is unwilling to continue paying at its current rates.
Credit Suisse is still bullish on Walgreens, advising investors to buy the dip as the stock could easily recover by the first quarter of 2012 if it hits its current projections. However, a 50 cent impact to annual earnings could just as easily sink the stock if the void in its PBM isn’t quickly filled by a comparable partner. Shares of Walgreens currently trade with a forward P/E of 14.18 and pay a quarterly dividend of 18 cents per share.
Other News About WAG
Walgreens’ earnings in review.
Walgreens Shocks Express Scripts
Walgreens and Express Scripts Part Ways.
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Leo Sun is long-time market follower and finance writer. He regularly contributes to the Stock of the Day analysis.
