Walgreen's Dose of Bad News

Shares dropped Monday as the drug retailer announced a drop in quarterly profit

Some folks suffer side effects from certain drugs, but now drug store chain Walgreen (WAG) is feeling some pain from generics coupled with a bad dose of higher expenses, causing its profits to unexpectedly drop in its most recent quarter. The stock tumbled on the news.

On Oct. 1, Walgreen reported its profit in the fourth quarter fell 3.8% to $397 million, or 40 cents a share -- below analysts' EPS forecast of 47 cents and the year-ago level of 41 cents. Sales rose 10.3% to $13.4 billion in the fourth quarter, and same-store sales were up 6.3%.

Walgreen blamed lower payments for popular generic drugs, along with higher operating expenses, for the downturn. Specifically, it said it had "a significant reduction" in gross profit dollars in the fourth quarter from the generic version of Zocor (simvastatin), which was introduced in June 2006. Retail pharmacies typically see the highest gross profit dollars in the first few months after a generic prescription drug becomes available, the Deerfield (Ill.) company explained.

"This quarter was negatively impacted by lower generic drug reimbursements, combined with higher salary and store expenses, and higher advertising costs," said Walgreen's Chairman Jeffrey A. Rein in a release. "Our expenses weren't in line with the level of reimbursements we were receiving."

Rein tried to reassure investors. "Managing both expenses and lower reimbursements on some generic drugs is my top priority. We're going to fix this, and at the same time continue our aggressive growth plan."

The stock tumbled 14% to $40.51, and was just pennies shy of its 52-week low of $39.91 during trading on Oct. 1. In the last year, Walgreen shares have risen 2.9%, underperforming the S&P 500 by 4.7%, noted Goldman Sachs in a note.

A few analysts were surprised by Walgreen's fourth quarter shortfall. "The year over year earnings decline is the first that we are aware of -- going back at least ten years," wrote Bear Stearns analyst Robert Summers in a report on Oct. 1.

"While it is easy to downplay this miss as one bad quarter for a normally very predictable company, we believe the industry as a whole is heading into a very difficult period as the generic margin benefit begins to roll off dramatically," wrote Summers, who has a market weight opinion on the stock. He added that this is not "quarter specific" or "company specific," and that this has been his cautious thesis for the sector.

Most generic drugs have a "lifecycle," Summers explained. After being on the market for six months, the drugs shift from a "sweet spot" to maximum allowable cost (MAC) pricing where the payer begins to set an upper limit on the reimbursement, which essentially closes up the excess margin, he said.

What's more, drug chains will not have as much opportunity to boost margins from new generics because the number of branded drugs going off patent is poised to slow down over the next several years. "Even if the drug chains do not suffer any reimbursement compression for generics – which we believe is occurring – the decelerating generic introductions should lessen the margin benefit going forward," Summers said.

Goldman Sachs analyst John Heinbockel downgraded Walgreen shares to neutral from buy, even though he normally dislikes reacting to a company event with a ratings change, he said. "However, we do believe that EPS is likely to be solidly below-trend over the next two to three quarters as the company cycles very strong generic-driven results last year and only gradually reins in operating expenses," he wrote in a note. He sees EPS rising just 2.6% in the first half of 2008 before rebounding to 16.6% in the second half of the year.

"We see the shares now treading water over the next six to nine months and believe investors seeking "defensive growth" would be better served by CVS Caremark (CVS)(trades at a 16 p-e), which we continue to rate a buy," he said. Heinbockel cut his price target for Walgreen shares to $46 from $55.32.

Standard & Poor's equity analyst Joseph Agnese also cut his recommendation on Walgreen shares to hold from strong buy. He noted that "non-pharmacy growth appears healthy to us, with margins benefitting from a favorable shift in mix." But given the lower margin contribution he expects from new generic drug sales, he reduced his earnings forecasts and his target price by $11 to $45.

Shortly after Walgreen's disappointing news, CVS reaffirmed its third quarter and 2007 earnings guidance of 42-44 cents and $1.86-$1.91, respectively. CVS shares fell about 5% to $37.58 on Oct. 1.

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