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Walgreens Boots Alliance Inc (NASDAQ:WBA)
Q3 2019 Earnings Call
Jun 27, 2019, 8:30 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good morning, my name is Jessa, and I will be your conference operator today. At this time, I would like to welcome everyone to the Walgreens Boots Alliance, Inc. Third Quarter 2019 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions) Thank you.

Mr Gerald Gradwell, you may begin your conference .

Gerald Gradwell -- Senior Vice President of Investor Relations

Good morning, ladies and gentlemen and welcome to our third quarter earnings call. I'm here today with Stefano Pessina, our Executive Vice Chairman and Chief Executive Officer of Walgreens Boots Alliance; James Kehoe, our Global Chief Financial Officer; and Alex Gourlay, Co-Chief Operating Officer of Walgreens Boots Alliance and President of Walgreens.

Before I hand you over to Stefano to make some opening comments, I'll, as usual, take you through the legal safe harbor and cautionary declarations. Certain statements and projections of future results made in this presentation constitute forward-looking statements that are based on our current market, competitive and regulatory expectations and are subject to risks and uncertainties that could cause actual results to vary materially. Except to the extent required by the law, we undertake no obligation to update publicly any forward-looking statements 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 for a discussion of risk factors as they relate to forward-looking statements.

In today's presentation, we will use certain non-GAAP financial measures. We refer you to the appendix in the presentation materials available on our Investor Relations website for reconciliations to the most directly comparable GAAP financial measures and related information. You will find a link to the webcast on our Investor Relations website at investor.walgreensbootsalliance.com. After the call, this presentation and webcast will be archived on the website for 12 months.

I'll now hand you over to Stefano.

Stefano Pessina -- Executive Vice Chairman & Chief Executive Officer

Thank you, Gerald, and hello, everyone. After what was a very disappointing second quarter for us, it is pleasing to be able to report that this quarter has been broadly in line with our expectation. That said, the pressures we have seen for some times continue to impact our businesses and we still have a lot to do to deliver the transformation that will allow us to get ahead of the market trends again, and return our Company to stronger and consistent growth.

We were clear that the action we were undertaking to address the market changes take time and the impact will, therefore, not fully be reflected in our financial performance until future financial year, but we have been working hard to accelerate our plans and programs. I have repeatedly said that, we have within our Company the skills and the assets that we need to address the challenges we face as our markets evolve and transform.

Last quarter, we told you that we would focus on accelerating the work we are doing to transform our Company. We are doing that. The Transformational Cost Management Program that we begun early this year is one of the underlying foundations of the changes that we need to make. Most importantly, this program will help drive a structural change in the Company, making us a more efficient, and more agile and more responsive organization.

It is expected to provide a significant portion of the funding required for our major technology upgrade, and development investments. And of course, an element of it will help to give us leverage in our financial performance as we restructure our businesses to better meet the needs of an ever more rapidly changing market. James and Alex, will address some of these points as they talk you through the quarter, which I will ask them to do now. James?

James Kehoe -- Executive Vice President & Global Chief Financial Officer

Thank you, Stefano, and good morning, everyone. Third quarter adjusted EPS was $1.47, a constant currency decline of 2.4% versus prior year. The results were slightly ahead of our expectations and included some timing benefits from the fourth quarter. Overall, we are tracking well against our strategic goals.

We are quite encouraged by US comp sales, which were exactly what we needed to deliver to stay on track to meet our full year expectations. And while it is still early days, our Transformational Cost Management Program is very much on track and accelerating. Based on our performance in the quarter, we are reaffirming our full year adjusted EPS guidance. We continue to expect the year to be roughly flat on a constant currency basis.

Let's now look in more detail at the numbers. In the third quarter, sales increased 0.7%. On a constant currency basis, sales were up 2.9% mainly due to growth in Retail Pharmacy USA and the strong performance from our Pharmaceutical Wholesale division. Adjusted operating income declined 11.7%, or 10.4% on a constant currency basis. This was mainly due to lower pharmacy margins and a decline in front of store sales in the US and lower results in Boots UK.

Adjusted EPS declined 4% to $1.47, a decrease of 2.4% on a constant currency basis. This includes a 5.8 percentage point contribution from our share repurchase program. GAAP operating income declined 24.7%, including $86 million of expenses relating to the implementation of our Transformational Cost Management Program, and $115 million relating to our share of AmerisourceBergen's impairment of PharMEDium. In total, these adjustments account for more than 50% of the year-on-year decline. EPS declined 16.5% to $1.13 per share.

Year-to-date sales increased 4.9%, including a currency headwind of 1.9%. On a constant currency basis, year-to-date sales were up 6.8%, reflecting 7.7% growth in Retail Pharmacy USA, and 8% growth in Pharmaceutical Wholesale. Adjusted operating income declined 8.9%, or 7.8% on a constant currency basis. This was more than offset by a 4.8 percentage point contribution from share repurchases and 3.2% from tax, contributing to an increase in adjusted EPS, which was up 1.6% on a constant currency basis.

Now, let's look at the performance of our divisions, starting with Retail Pharmacy USA. Sales increased 2.3% in the quarter, mainly due to pharmacy brand inflation and pharmacy script growth. Organic sales increased 2.9%, adjusted gross profit declined 3.9% and gross margin declined 140 basis points, mostly due to pharmacy.

Adjusted SG&A spend decreased 0.7% and adjusted, SG&A was 17.3% of sales, an improvement of 0.5 percentage points compared to the year ago quarter. Adjusted operating income declined 13.8% in the quarter, procurement savings, pharmacy script growth and continued SG&A savings were not enough to offset reimbursement pressure and the lower front of store sales. These results also included store and labor investments of $40 million in the quarter, equivalent to approximately 270 basis points of adjusted operating income.

Now, let's look in more detail at pharmacy. Total pharmacy sales increased 4.3%, reflecting higher brand inflation, prescription volume growth and a strong growth in central specialty, which grew 8.6% year-on-year. Comp pharmacy sales increased 6% and comp prescriptions grew 4.7% in the quarter, a strong improvement on the first half growth of 1.9%. Market share was 21.2% in the quarter, down 50 basis points versus prior year, due entirely to our store optimization program.

Pharmacy gross profit declined versus prior year, as script growth was more than offset by lower gross margin. Gross margin was around 150 basis points lower than last year, due to continued reimbursement pressure, adverse mix associated with brand inflation and a 50 basis point impact due to the faster growing specialty business. These impacts were partially offset by procurement savings. The key to offsetting long term reimbursement pressure is building scale, driving efficiency and creating a sizable healthcare services business.

Turning next to our US retail business, total retail sales decreased 2.9%, and were negatively impacted by our store optimization program. Comp retail sales declined 1.1%, an improvement on the first-half comp decline of 3.5%. Tobacco accounted for 150 basis points of the comp sales decline, but we did benefit from a 65 basis point tailwind as a result of the cough, cold, flu season. Retail gross profit declined, mostly due to lower sales, which, as I mentioned earlier, were negatively impacted by our store optimization program. Gross margin was down slightly by 20 basis points, an improving trend versus the second quarter as we rebalanced our promotional mix. We expect to see a continued improvement in gross margin trends in the fourth quarter.

Turning next to Retail Pharmacy International, as usual, I'll talk to constant currency numbers. Total sales declined 1.6%, mainly due to a 1% decline in Boots UK in a challenging market. Boots UK comp pharmacy sales increased 0.8%, reflecting prescription growth in the quarter, whereas comp retail sales declined 2.6% as we continued to gain share in a weak market. Our beauty reinvention is now in place in 26 stores and we remain on track to introduce 25 new brands in 2019.

Adjusted operating income was down 10.5% due to weak retail sales and lower pharmacy margins in the UK. Our UK pharmacy business was impacted by temporary industrywide NHS under funding and higher generic pricing. These impacts were only partially offset by prescription volume growth. We are taking actions to address our UK cost base and I will cover these a little later.

Turning now to the Pharmaceutical Wholesale division, which I'll also discuss in constant currency, the division delivered another strong quarter, with sales up 8.3% led by emerging markets. Our UK performance was aided in part by our customer contract change mentioned last quarter, which contributed 2.3% to revenue growth. Adjusted operating income increased 9.4%, reflecting strong gains in Turkey and solid results from our European business.

Turning next to cash flow, operating cash flow was $3.2 billion for the first nine months of the year. Free cash flow was $2 billion. Operating cash flow was impacted by headwinds of around $1.4 billion. We are lapping a one-time prior year working capital benefit of $502 million. Cash tax payments were $395 million higher, mainly as a result of US tax reform. This year includes legal settlements of $276 million and we have $200 million of cash costs relating to the ongoing Rite Aid store optimization and integration and the Rransformational Cost Management Program.

Underlying working capital increased approximately $500 million primarily due to higher sales. Cash capital investment was $1.2 billion for the first nine months, $264 million higher than the prior year. This was due mostly to the impact of the Rite Aid store conversions.

Turning now to our Transformational Cost Management Program, we remain on target to deliver $1.5 billion in annual cost savings by fiscal 2022. Our smart spending benchmarking is complete, targets and execution plans are set up and we're accelerating a wide-ranging program to reduce pharmacy cost to fill.

The 20% headcount reduction at our Boots UK headquarters and the reorganization of our US field supervision structure are now complete. On digitalization, the Microsoft Cloud migration is moving at pace. And we have now started working on optimizing our many IT vendors. Work has also begun on building out compelling consumer value propositions.

Given the difficult market conditions in the UK, we have completed the review of our store portfolio, and have started a store optimization program that will impact around 200 locations over the course of the next 18 months. Many of these 200 stores are loss-making and approximately two-thirds of them are within walking distance of another Boots store. While the stores, we plan to close represent around 8% of our store base, we expect the revenue impact will be around 1%. We do not expect a significant impact on colleagues, as we plan to redeploy to nearby stores.

We are also reviewing our real estate footprint in the US and accelerating the pace of change, especially in our US supply chain. More to follow in the coming months, as we work through these key opportunities.

Turning to guidance, as I mentioned earlier, the third quarter was slightly ahead of our expectations, aided by some timing benefits. As a result, we are reaffirming our full year guidance and we expect adjusted EPS to be roughly flat on a constant currency basis. As a reminder, last quarter, we told you to expect a range of plus or minus 2%. Given the normal level of volatility in a business of this size, we feel this range is still appropriate.

Let me just give you a couple of assumptions. As you update your models, you should now be building in $0.06 of negative currency impacts. And this is $0.02 worse than our prior guidance. We continue to project full year share repurchases of $3.8 billion, contributing 4.8 percentage points to adjusted EPS growth. And we now project the full year adjusted effective tax rate of around 15.5% compared to our earlier guidance of 16% to 17%. The lower rate reflects non-recurring discrete benefits and changes to our geographic mix.

When we provided our original fiscal '19 guidance, we highlighted incremental store and labor investments of around $150 million. As we accelerate the pace of our digital investments, we now expect total incremental spend of approximately $175 million, with a significant portion of the additional spend coming in the fourth quarter.

Let me finish by highlighting the change in revenue trends coming from Rite Aid. We saw positive revenue contributions from the Rite Aid acquisition in the first two quarters of the year. From this quarter on, Rite Aid is actually a headwind to reported revenue due to the ongoing store optimization program.

I'll now hand you over to Alex, and he will update you on some of the business initiatives we have under way in the US.

Alexander W. Gourlay -- Co-Chief Operating Officer

Thank you, James, and hello, everyone. During the quarter, we continued to make progress on our four strategic priorities: accelerating digitalization; transforming and restructuring our retail offering; creating a neighborhood healthcare destination around a more modern pharmacy; and rolling a Transformational Cost Management Program.

We're also continuing to develop our omni-channel offering. Our Walgreens App has now been downloaded 57.3 million times, up 10.5% since last year. Around 26% of Walgreens' retail refill scripts were initiated through digital channels in the quarter, up 18.4% since last year. And also increased our active Balance Rewards members to 90.2 million.

In retail, a leading beauty brand No7 performed exceptionally well in the quarter, and Walgreens sales of No7 were up by over 50%, helped by the launch and advertising of the No7 Laboratories' Line Correcting Booster Serum and our other retail partners saw significant growth.

In addition to beauty, we are working on refreshing our own brand portfolio in Walgreens to drive sales and improve the customer value proposition. During the past two years, over 60% of the Walgreens own brand product portfolio has been relaunched or rebranded, enhancing the customer offer through better value and quality to deliver improvements in sales and margin. This work is ongoing.

Rite Aid is very much on track. Against a store optimization program, we've completed 631 of the planned 750 store closures, and we continue to see good customer retention. Of the remaining Walgreens owned Rite Aid stores, 394 have been successfully converted to Walgreens and we expect to complete the Rite Aid integration by the end of fiscal year 2020.

We've taken further steps to develop a neighborhood health destinations, working with our partners, including LabCorp and Humana, and as we announced during the quarter, VillageMD. With VillageMD, we will be opening five state-of-the-art primary-care clinics in the Houston area by the end of the year, branded Village Medical at Walgreens. We also remain on track to open 125 LabCorp outlets in Walgreens stores this year. And finally, on Kroger the teams are working well together, and so far, the initial customer response has been positive.

I'll now hand you back to Stefano.

Stefano Pessina -- Executive Vice Chairman & Chief Executive Officer

Thank you, Alex. So, as you have heard, we have broadly delivered what we expected, but we have a lot of work ahead to get the business growing again. We have been working hard to initiate or accelerate the changes we need to keep us in line with or leading the market. We are investing heavily in updating our systems and the infrastructure, creating efficiencies and capabilities, which will give us scope for development for many years to come.

We are developing new ways to engage with our customers, Introducing new services and products through new channels. We are working with partners who bring us skills, resources, scale and expertise that complement our own, to accelerate our development, give us access to new thinking (ph) market and allow us to create a significant new income stream. At the same time, we are continuing our focus on transforming our traditional areas of business to address the challenges of our core markets.

Economic and reimbursement pressures have long been and remain the fact of life for us. Over the years, we have developed various different levers to mitigate the impact of this pressure. In recent years, a major element of these mitigation has been improvement in generic procurement, made possible by changes in the global generic manufacturing sector, ongoing patent expiries and significant development in the actual procurement process, all of which have led to continued improvement in buying terms.

These buying benefits have enabled us to compensate for the significant demands made to us by payers. As we have made clear, the level to which we can mitigate current and future reimbursement pressure toward generic procurement has reduced, although it will continue to be an important lever for many years to come.

Recognizing this, we are accelerating other levers to mitigate the pressure. We have more to do through cost saving and efficiency and we expect consistent savings well into the future. There is no doubt that, over time, we also have to build a range of services and service levels that drive benefits for our payer partners.

We believe that the future of pharmacy is aligned to a wider range of healthcare service provided efficiently and conveniently in a community setting. This is why we are exploring partnerships with a wide range of innovative experts in various fields, allowing us to offer a better service more effectively and at a lower cost of sales than we would be able to do if we had set these services up on our own, or paid a significant premium for them.

Of course, many of these services are still being tested, or are still in development. Let's be clear, however, while a number of partnership we are piloting has the potential to have a meaningful impact on our business, mo single one of these will define or frame our future. And so, it will be a combination of products and services, working together in the convenience of a community pharmacy that will form (ph) the basis of our future customer proposition.

The mixture of products and services will inevitably bring together a range of complex and differentiated business models. Their economics will be, at least in part, based on changes to individual's health condition management and overall well-being over many years. The consequence of getting these services right has a huge potential benefit for us, for our partners and for our customers, but if we rush into them without truly understanding the operational or financial models, we have the risk is of wasting an extraordinary amount of time, resources and more. We must be sure of what we are doing before we enter into these businesses in scale.

Today, many people are looking at our Company, indeed at our sector, focused on the immediate risks they perceive us to face, and I understand this. We are far from complacent about the pressures that we face. However, we can see the inherent strength of our business. There is an ever-increasing demand for effective, efficient and convenient support for people to manage their health conditions while leaving productive and fulfilling life in their local communities.

The unique positioning of community pharmacy and our place in the sector gives us practical and financial scale, reach and strength. It gives us a robust platform on which to evolve and transform our Company to meet the ever-changing needs of the markets we serve. And it gives us a fantastic foundation from which to deliver innovation, growth and value for our customers and our shareholders for many years to come.

Thank you. Now, we will take your questions.

Questions and Answers:

Operator

Thank you. (Operator Instructions) Your first question comes from the line of Steven Valiquette from Barclays. Please go ahead.

Steven Valiquette -- Barclays Capital -- Analyst

Great. Thanks. Good morning, Stefano and James. Thanks for taking the question. So as the US Retail Pharmacy business remains difficult, really for all types of stores and operators across the entire industry, we are getting the sense that there could be an additional opportunity among the larger mass merchandisers in the US for a store within a store deal where a Walgreens or a CVS could take over the pharmacies within a specific large US mass merchandiser. So I'm just curious to hear about your current appetite for an opportunity like this right now in the US, given the simultaneous store rationalization program that you're going through right now and also your other initiatives in the US? Thanks.

Alexander W. Gourlay -- Co-Chief Operating Officer

Hi, Steve. It's Alex here. One of our strategy is -- clearly, that is to grow volume on to make our business bigger to get scale. And also partnership is really important to us, as we've said many, many times. So as the market changes and these changes are, really you can see the fact that the number of pharmacies in the US is in decline as measured -- for the first time for a long time. We are obviously open to partnership in this area. We bring scale, we bring expertise and we are investing, as Stefano said in his remarks and James said, in pharmacy and the pharmacy supply chain. So we're open and of course, we'll look for every opportunity available, providing it makes fiscal sense for us and our partners and improves the quality of our business.

Steven Valiquette -- Barclays Capital -- Analyst

Okay. Just one other quick one, as we think about the narrow network opportunities for calendar '20. Just curious if you see the potential for meaningful market share shifts for 2020 among the large retail pharmacies like yourselves given the level of RFP activity or do you think it's going to be a quieter year for calendar '20 just in terms of a narrow network opportunities and potential market share shifts within the marketplace?

Alexander W. Gourlay -- Co-Chief Operating Officer

Hi. This is Alex again. We think it's probably more normal. Again, we've laid out our plans in terms of item growth that we expect and we think it's a more normal year. Now, of course, within that there's always opportunities and there's always challenges, but we think it's probably a more normal year in 2020.

Steven Valiquette -- Barclays Capital -- Analyst

Okay. Got it. Okay. Thanks.

Operator

Your next question comes from the line of Robert Jones from Goldman Sachs. Please go ahead.

Robert Jones -- Goldman Sachs -- Analyst

Great. Thanks for the questions. James, you mentioned that the results included some timing benefits from the fourth quarter. I was just curious if you could share the source of those benefits and anything around the size of those benefits would be helpful?

James Kehoe -- Executive Vice President & Global Chief Financial Officer

Okay. Roughly we had two impacts in the quarter. One was timing, and I would say, that's around $0.03, or $35 million, is our best estimate. And the other one is, we also highlighted in the comments, we're ramping up the amount of spending in store labor and now digital and development expense. So, we've increased the spending on the full-year from $150 million to $175 million. There is about a $0.01 of that in the fourth quarter. So think about roughly around $50 million, around $0.04ish was it. And when you get to the two timing items, one was, $0.02 of the $0.03 was essentially the timing of payroll contracts when you do the compliance and true-up part you hit outcomes or whatever -- you hit volumes in certain tiers and that's the normal course of business, but we expected that in Q4. And then, a $0.01 is coming from expense timing. We accelerated some real estate savings from Q4 into Q3. So, it was actually one of the quieter quarters in terms of volatility and very few surprises.

What's interesting here, maybe I'll take the opportunity, as you start looking out into Q4, because this takes some income out of Q4, our Q4 target is actually quite -- when you start working through it, you start working out your estimates, bear in mind, we had two large one-time items last year and on an EPS basis, we're cycling through these. The first one is, you will recall there was a large true-up, a curtailment benefit relating to retiree medical, that was $110 million. And then, in the prior quarter of last year, we made an adjustment for legal cost, which was one time and that was approximately $60 million, so that's another $0.05. So if you think about it, we have a 10 percentage point headwind on EPS in Q4.

So, actually when you dissect Q4, we're looking forward to pretty good improving margin trends on the gross margin, and the headwind is all on the overheads and it's all due to one-time items in the prior year. So I think, as you shift through this, the volatility in Q3 was actually quite low. When you get into Q4. Think more that we have two large items last year. So, actually, when you analyze the results, the core performance actually is improving quite a bit. I hope that's a helpful?

Robert Jones -- Goldman Sachs -- Analyst

That's really helpful, James. Thank you. And I guess just one other follow-up. In the prepared remarks, you guys highlighted again that you're reviewing the real estate footprint in the US. I'm just wondering if you could elaborate a little bit just your thoughts around how we should be thinking about the store rationalization? Is this going to be a bigger focus or is this just ongoing course of business at this point?

Alexander W. Gourlay -- Co-Chief Operating Officer

Hi, Rob. It's Alex here. It is more ongoing course of business. This is regular. We have well over 9,000 drugstores in America. Therefore, things change, there are customer shifts, there are opportunities to move. We're also thinking about new formats, as we spoke before in answer to the previous questions, so this is just normal business.

James Kehoe -- Executive Vice President & Global Chief Financial Officer

And just to add though, the calculations are complex. We have to look at the lease portfolio, it's store-by-store assessment. And the teams are working through 9,500 stores, which is quite a heavy workload. We just recently confirmed the 200 stores in the UK and we will move ahead aggressively on that. And it's quite interesting as you go through it, about 60% of the stores in the UK that we're closing lose money. Not all of them, but some of the others are very like the Rite Aid optimization, where it is -- think of it as a (inaudible). So we closed two stores close to each other in the UK and sometimes they are at five-minute walking distance and we are transferring over to scripts, but you're taking out fixed cost structure.

So the calculations are quite complex. You have to assess are you living a trading area, which we generally don't like to do. We want to preserve our presence, both in the UK and in the US. And I would highlight that, in the UK, we highlighted in the comments, we're reducing the store count by 8%. The impact on revenue was around 1%. So I don't want to call it rounding, but it has no strategic impact on our ability to maintain strength of our position in the UK. I would actually argue, on the contrary, it makes us even stronger, because we're a profitable operator in the UK market.

Robert Jones -- Goldman Sachs -- Analyst

Great. Thanks for all that.

Operator

Your next question comes from the line of Justin Lake from Wolfe Research. Please go ahead.

Eugene Donathan -- Wolfe Research -- Analyst

Hi. This is Eugene Donathan (ph) for Justin. Quick question on the US Pharmacy gross margin, it declined 150 basis points year-over-year if we read it correctly, and it seems like Q3 was a clean quarter to compare year-over-year because FEP specialty contract lapped. How should we think about it going forward? Is it just a rate of decline in the near term that we should consider?

James Kehoe -- Executive Vice President & Global Chief Financial Officer

I'll take a shot and I'll ask Alex to weigh in afterwards. I think we cycled through the FEP contract, the specialty business growing at 8.6%. We would expect that always to grow faster than the core business. So it will always be somewhat dilutive to margins. One other thing, there is other dynamics in the quarter. So in the quarter, we sold more branded and the margin on branded is lower than it is on generic, and that creates a mix impact as well. And that's as significant as any other impact. And the problem is, we can't project with accuracy the individual mix in any single quarter.

But if you take out a lot of these mix items, the core reimbursement net of procurement and other mitigations, it was actually pretty solid quarter. We do expect some improvement in both retail and pharmacy gross margins in Q4. That's as far as we're willing to go. So this is, not something you should take and extrapolate out as 150 basis points on pharmacy. We do expect some improvements in the trend in Q4, but mix and everything else plays into it, it would be a very long discussion. Alex?

Alexander W. Gourlay -- Co-Chief Operating Officer

Yes. I think in terms of how we feel about margin going forward, well, we've always said that we recognize reimbursement pressure is there and will stay there and how do we compensate for it. And as James has just said, we are seeing the ability to compensate more in Q4 than Q3 as the trends come through. I think in particular a couple of areas which are just interesting going forward. First of all, we are getting paid more for, I would say, value-based contracts, particularly in Medicare D. So we're starting to hit some of the performance targets, which is encouraging. And I think, also, we continue to have the opportunity to work differently in some networks. For example, again, I would point to the Prime contract we did some time ago, where we have a different approach to marketplace, where we are really much more transparent. And again, that process we believe is going to become more, I would say, available to the market going forward than it has been in the past. So, reimbursement doesn't go away, the margin is under pressure as we've often said, but we continue to be innovative, we work creatively and we work hard on new levers, as well as the old levers that we've spoken about a lot.

James Kehoe -- Executive Vice President & Global Chief Financial Officer

The only comments we'll make on the Q4 margin is, these are obviously all factored into our full year guidance. We're just giving you the perspective that we had a tough Q2 on reimbursement, which was one of the highest numbers in history. Q3 was a tough quarter as well. As we said in the previous call, we will start to see an improving trend in Q4 on the gross margin side, but the caution is to call out those two large one-time items that are putting pressure on overheads. And the good news on that is, they don't repeat in the future, it's just impacting the Q4.

Eugene Donathan -- Wolfe Research -- Analyst

Got it. Thank you.

James Kehoe -- Executive Vice President & Global Chief Financial Officer

Okay.

Operator

Your next question comes from the line of Ricky Goldwasser from Morgan Stanley. Please go ahead.

Ricky Goldwasser -- Morgan Stanley -- Analyst

Yeah. Hi. Good morning. Last quarter, you directed as to fiscal year 2020 EBIT being moderating up year-over-year and flat EPS. With everything you're seeing in the marketplace, are you still expecting this?

James Kehoe -- Executive Vice President & Global Chief Financial Officer

Ricky, we're going to just comment on current year 2019. We don't want to get into a practice of going back to discussing long-term models or 2020 guidance. What we will be doing is, in the next conference call, we will give comprehensive guidance on all of the assumptions around 2020. So, we're not going back to a discussion on the -- we just refer people back to the previous material that we placed out there in Q2.

Ricky Goldwasser -- Morgan Stanley -- Analyst

Okay. And then, just to follow-up, in the prepared remark, when you talked about the review of the portfolio, I think, you also said that you're like looking at the US supply chain for additional improvements. So, can you just give us a little bit more color on what the opportunity is there and what are you seeing in terms of generic deflation trends as a headwind?

Alexander W. Gourlay -- Co-Chief Operating Officer

Yeah. So, I maybe split the -- I think we answered portfolio question already, Ricky, so I'll move on to the second question, supply chain. Obviously, we're halfway into replacement of our core supply chain system for retail. In the USA, the SAP HANA S4 software is going into stores and into DCs. So it's very clear that we now have there opportunities with new tools capabilities and data, especially the speed of the data we didn't have before. So as that goes through, we will give more updates in terms of what that means in terms of projections, but we are encouraged by the progress there, but we're only halfway through it.

I think, secondly, we've just hired, as you saw quite recently, a very experienced global supply chain veteran, Colin Nelson. And again, we're working hard with the team to really understand how to be even more focused on the new capabilities we are building in the business going forward. I think in terms of generics, as Stefano said in his prepared remarks, we continue to be very, very pleased with the performance of the (inaudible) office. And again, we see the opportunity going forward to continue to drive value through that (inaudible) office into a global platform, but also into America. So I think that's how we see the supply chain piece.

What was the third part of the question?

James Kehoe -- Executive Vice President & Global Chief Financial Officer

The generic deflation.

Alexander W. Gourlay -- Co-Chief Operating Officer

The generic deflation. Yeah. I mean, we don't see any difference to what's been recorded in the marketplace to be honest. We see this, I would say, low single-digit deflation. As we have spoken about, we see generics coming off patent in a way that has been described by others, and of course, we pay a lot of attention to this because it has a material impact on our ability to reduce our cost of goods and we feel comfortable that all that's captured in the guidance that we gave last quarter.

James Kehoe -- Executive Vice President & Global Chief Financial Officer

Yeah. And Ricky, just to add in, the low-single digit Alex refers to includes new molecules. If you strip out new molecules, the most recent quarter had -- at least, these are our numbers, not market numbers. We saw deflation of around 9%, right. So it's still up at a healthy clip and that will support continued savings in generic procurement. And the prior quarter was 9.4%. So, it's still up there in a healthy high single digit. Then the market builds in new molecules. I'm very excited about the supply chain people in the US, because we now have teams set up looking at shrink, so stock losses, whether that's in store, or it's stock losses in warehouses and we're using teams from Microsoft. So this shows the benefit of the bigger Microsoft agreement. They have put data scientists on this who are helping us build data lakes to understand what is going on, the true causes of shrink and how to eliminate it, and these are $100 million, $200 million opportunities and that's without getting into the working capital side of it. So I don't want that to be lost.

Once we have SAP S4 HANA in place across the 9,500 stores, that's stock visibility that we don't have today and we expect significant reductions in the level of inventory required to be held at store level. So, but this is a (Technical Difficulty) will be huge. So you would expect that exiting 2020, we're starting to see material reductions in inventory levels.

Ricky Goldwasser -- Morgan Stanley -- Analyst

Thank you.

Alexander W. Gourlay -- Co-Chief Operating Officer

Thank you.

Operator

Your next question comes from the line of Eric Percher from Nephron Research. Please go ahead.

Eric Percher -- Nephron Research -- Analyst

Thank you. I'd like to dig in on the international performance. And I understand we have seen some of the generic pricing fluctuations. You also made a comment about weakness or temporary weakness and under funding. Could you expand on that and how incremental is it to the pressures that we've already spoken about the last 12 to 18 months?

Alexander W. Gourlay -- Co-Chief Operating Officer

Hi, Eric. It's Alex here I mean, let me start with the last question first, which is the under funding point. The UK government pay in a certain way, I don't want to done into detail of it, but fundamentally it's a market payment for all the pharmacies in the UK. And if you go into what's called the PSNC website, there's more details there about how that works. So we are pretty convinced there has been under-funding in the last period, and of course, working within the pharmacy contractors and the PSNC, we are now debating that with the government in a positive way as the new contract is put in place. So that's there what we refer to. And of course, we can't make any further comments until that negotiation is complete.

But I think in terms of the overall performance of the business, we are making good progress in terms of reinvigorating the Boots model in the UK in very difficult times. I don't have to tell you how difficult the marketplace is there. For example, this morning, we opened a fantastic new store, a new concept store in Covent Garden, there were SKUs (ph) around the corner. And this is a health, wellness and beauty concept store, which will not only feed the future of Boots, but could also of course give us some great ideas for US market as well.

On top of that, we've done a lot of digitalization. We've digitalized Advantage Card, which is still the most popular card in the UK by some way in terms of beauty and treat cards and a lot of customers use it. I think it's well into 17 million holders today. We've also created digital pharmacy. We have launched that for the first time in the UK in terms of managing prescriptions, copying some of the great ideas that we can pass across to Walgreens as part of the merger.

And of course the cost program James already referred to in his remarks in terms of moving maybe money from that maybe the older model into investing in the future of the Boots business. So that's the story really where we are using the current market situation to make sure that we're investing in our future. And we're seeing some interesting lead indicators of performance. And of course, we will give you more updates as that develops.

Eric Percher -- Nephron Research -- Analyst

And is you peers and so you (ph) comment suggesting that your business is now adjusted for the changes that have been made to-date, and you have some hope that those there might be some improvement moving forward, but you're basing the business on where we sit today ?

Alexander W. Gourlay -- Co-Chief Operating Officer

Yeah. Absolutely, right. I would say, that's an accurate reflection of where we are.

James Kehoe -- Executive Vice President & Global Chief Financial Officer

Yeah. That's a fair point. I think I would emphasize the word temporary. So we expect an improvement in Q4 and back to normal levels of funding next year.

Alexander W. Gourlay -- Co-Chief Operating Officer

Yeah.

Eric Percher -- Nephron Research -- Analyst

That's helpful. And could you just -- on the potential store reduction, you mentioned that employees may move to other stores. Can you help us with the way that you run those stores, and may be employment where you could see -- I guess, the revenue impact, only 1%, but it is 8% of the store base, will you continue to carry of the employee cost?

Alexander W. Gourlay -- Co-Chief Operating Officer

Yeah. I mean it's really straightforward. These are relatively small pharmacy. As James said, two-thirds are within a walking distance of another Boots pharmacy. And the main cost here to be honest is the cost of the pharmacists. We have pharmacists turnover like any company would have, and we simply see that as way of being able to manage the cost. We are retaining quality people that we need to take care of customers in communities.

And remember we learned a very important lesson here in the USA that if you retain the familiar face of the pharmacists and healthcare assistants in a local pharmacy, then very often the customers will transfer the script to the people who they know and trust. So this is economically important to us as well.

James Kehoe -- Executive Vice President & Global Chief Financial Officer

And, it's 8% of the stores, it's 3%, I believe of the square footage, so that the employee impact is much lower than the percentage of stores. And then, the revenue impact is much lower because they are less efficient stores. So it's actually quite logical. And then there is a fair amount of turnover in general and in an employee base of 56,000 people in the UK, so there is a fair amount of turnover. And I think we've seen in the past you manage to place the majority of people.

Eric Percher -- Nephron Research -- Analyst

Thank you.

Operator

Your next question comes from the line of Ross Muken from Evercore. Please go ahead.

Elizabeth Anderson -- Evercore ISI -- Analyst

Hi. This is Elizabeth Anderson in for Ross. I was wondering if you could expand on some of the comments Stefano made about generic procurement, and in particular, areas of future savings that you see?

Alexander W. Gourlay -- Co-Chief Operating Officer

Hi.. It's Alex here. Yes, I think I've stated that already and Stefan said it very clearly, we still have a very efficient, effective and innovative model out of (inaudible). And we continue to walk in a dimension, which we think is slightly different. We prefer to have contracts with manufacturers to give them certainty of supply, so that we get certainty of supply back in the marketplace. That's really important to our customers and allows us to plan together in a different way and that's how we work.

Having said that, we all know that the level of opportunities, as Stefano said, is changing going forward. It's not -- we will make savings, it's changing. So we've set up some innovative partnerships already. You know the partnership we set up with Express Scripts for example is one, where we are combining the volume from a PBM with a volume from a retail pharmacy. And we continue to look at other ways of making sure that we've got the right scale and mix of partners going into (inaudible) going forward.

I think, secondly, the manufacturers are thinking differently as well. And again, we can't talk on their behalf, but you've probably heard some of the things they have been saying. And we think that our approach to buying in partnership with them and the way that we organize how we work with them will continue to give us advantage into future going forward. Of course, in the future, other markets may open up. We don't know that in reality, and we're not banking on that particularly in how we see the plan going forward. But clearly, things will change in one direction and could change again. And having a global perspective and global volumes we think will give us global opportunities in the future as well.

Elizabeth Anderson -- Evercore ISI -- Analyst

Okay. Thanks. That's very helpful.

Operator

Your next question comes from the line of Glen Santangelo from Guggenheim. Please go ahead.

Glen Santangelo -- Guggenheim -- Analyst

Hi. Yeah. Thanks for taking my question. I just wanted to follow up on this reimbursement issue one more time. If I heard you correctly one of the main keys you keep pointing to is that, in order to combat the reimbursement pressure, you'll need scale, but yourself and your closest competitor, you guys have more scale than anyone else in the marketplace and you seem to be having issues. And so I was wondering if you could comment more broadly on the 65,000 to 70,000 pharmacy counters out there, I mean they must be obviously feeling more pressure than you. And I was kind of curious, are you starting to see that total number come down? And I guess my question is, can the reimbursement pressures subside until some of the capacity comes out of the market?

Alexander W. Gourlay -- Co-Chief Operating Officer

Hi. It's Alex here. Again I think we've said already, the way that we manage the market, internally we are starting to see some pharmacies close. And I think these numbers are pretty open in the marketplace as well. So that is starting to happen and not reopen. So I think that is a fact that you can check obviously out there.

I think, secondly, you have to look at the comments from other competitors in the marketplace to see the pressure that we are all feeling in the marketplace. The other side of the coin is that we continue to believe strongly that the community care in the pharmacy, the physical location in the community with the pharmacist available and accessible, is a really great opportunity for not just pharmacy, but for healthcare, all connected through data, all connected with other healthcare professionals, all connected to bringing forward new solutions going forward.

That's why we are so excited about the work we're doing, not just with Microsoft, but as Stefano said, other relevant partners. For example, Verily, we've announced as well, and LabCorp. And I can assure you the list could go on in terms of the people who are talking to us and we are talking to them. So we are really confident about the future of pharmacy. We are really confident that the model that we see today will change, driven by new technologies. And the same need that customers and patients have always had, we still have a conversation with their local pharmacist in their local community.

Glen Santangelo -- Guggenheim -- Analyst

Hey, Alex, maybe if I can just follow up on the one comment you were talking about with respect to some of the partnerships. I mean over the last year and a half we've talked a lot about the JV strategies and trying to crack the code of generating additional foot traffic. And it seems like there has been mixed results on that front. And maybe I'm wondering if you could just reiterate exactly where the strategy stands today and maybe what has worked better than what you might have thought and what maybe hasn't worked as well as what you thought and I'll stop there? Thanks.

Alexander W. Gourlay -- Co-Chief Operating Officer

Thank you. Thanks. I'll give an example of where we are very comfortable, which is our FedEx partnership. Again, we are seeing the footfall that we expected. We are seeing the halo from that foot fall that we expected, i.e., new customers to Walgreens and we also see the opportunities. We work closely with the FedEx team strategically to develop new customer propositions in the corner drugstore. So that would be one example that we are very comfortable with.

And of course, going forward, there will be other partnerships which are really interesting. We mentioned already that Kroger partnership is going well and the customer reaction has been positive. So, again, that's another example where we believe that Kroger are really experts in food and they can help to really improve our customer proposition, and our value over time. But time will tell if we can find the right model that works for both companies and also for customers.

Glen Santangelo -- Guggenheim -- Analyst

Okay. Thanks.

Operator

Your next question comes from the line of Michael Cherny from Bank of America . Please go ahead.

Michael Cherny -- Bank of America -- Analyst

Good morning. And thanks for all the color so far. Just thinking about 4Q. I know you had talked about a number of the moving pieces and some of the reimbursement true-ups that you have seen so far year-to-date. With regards to the removal of pressure on retail pharmacy gross margins or at least less pressure, I guess what gives you the confidence, why do you think it should get better? Is there something in mix, is there something in timing, is it just the annualization or I guess within your annualization of those pressures that you've talked about relative to last quarter and this quarter? I guess just want to know a little bit more about the why relative to the sequential gross margin improvement?

James Kehoe -- Executive Vice President & Global Chief Financial Officer

Yeah. I think it's a little bit of everything you said actually, because you have to go back on our journey. Q2 was reimbursement pressure, which we said I think was, exceeded 30% of the full year reimbursement pressure. So we would have set an unprecedented level. We saw it go back to more of normalized level in Q3, but we saw some slowness on the procurement savings in Q3. We're going to see those both of the variables equalize in Q4. So it gets back to, you can't really look at it as reimbursement. It's reimbursement, net of the mitigation. The biggest two: one is, procurement savings and there has been some timing between Q3 and Q4 there. When you get to volume, I want to highlight. We had a great quarter in Q3. We set some fairly challenging goals internally. Bear in mind, we had script volume for the first half on a comp basis below 2%. So to come in in the high 4s was something we needed to do it and we need those kind of numbers. That's number one.

We were also very pleased with the way retail came in. If you strip it back a little bit, it's a down 1.1%, we were tracking in the first half a pretty disappointing 3.5% comp store decline. So the change on changes is quite impressive. We won't deliver exactly the same numbers, but we will continue to hold on to some of these trend improvements. I think what will happen in Q4 is, you will see a little bit of stabilization of the top line outlook together with some improvement in both businesses on the margin side. So it's a confluence of trends. And then, I'll highlight again, then you've got these two big one-time items in overheads. So it's too early to call victory in Q4, obviously, but that's why our current expectation is improved gross margins and continued stabilization of scripts and same-store sales. I hope that helps you as you think through it.

Gerald Gradwell -- Senior Vice President of Investor Relations

Thank you. I'm afraid, but that's probably all we have time for. I know we haven't got to all of your questions, but as ever, the IR team are around to answer them all. And I'm sorry for those of you who didn't get to ask your questions today. We will be back again next quarter. Thank you very much indeed.

Operator

This concludes today's conference call. You may now disconnect.

Duration: 60 minutes

Call participants:

Gerald Gradwell -- Senior Vice President of Investor Relations

Stefano Pessina -- Executive Vice Chairman & Chief Executive Officer

James Kehoe -- Executive Vice President & Global Chief Financial Officer

Alexander W. Gourlay -- Co-Chief Operating Officer

Steven Valiquette -- Barclays Capital -- Analyst

Robert Jones -- Goldman Sachs -- Analyst

Eugene Donathan -- Wolfe Research -- Analyst

Ricky Goldwasser -- Morgan Stanley -- Analyst

Eric Percher -- Nephron Research -- Analyst

Elizabeth Anderson -- Evercore ISI -- Analyst

Glen Santangelo -- Guggenheim -- Analyst

Michael Cherny -- Bank of America -- Analyst

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