A Big Question Looms for Walgreen

Even though Walgreen (NYSE: WAG) posted record top- and bottom-line numbers for its third fiscal quarter, shares fell by more than 5% as it indicated plans to sever ties with Express Scripts (Nasdaq: ESRX). Up to this point, the pharmacy-benefits manager has contributed about $5.3 billion in annual sales, and investors wondered how Walgreen would buffer the revenue loss.

Express stop
This split-up is reminiscent of Walgreen's contentious fallout with fellow drug retailer CVS Caremark (NYSE: CVS) last year, which cost Walgreen nearly $4.5 billion in annual revenue. If the current deal with Express Scripts isn't renewed, it would cut Walgreen's annual revenues by more than 7%. Walgreen now fills more than 20% of U.S. prescriptions, but without the services of Express Scripts, that number is sure to decrease. 

According to Express Scripts, the sticking point is that non-specialty branded medication prices are expected to increase by over 30% and specialty branded medication prices by 50% over the next three years. Express Scripts' planned repayment rate cuts were unacceptable to Walgreen, which said that the rates were below the industry standard.

A look at the quarter
Regardless of this brouhaha, the company has been performing well. Profit jumped by more than 30% on a year-on-year basis, and the company said it's on track to meet its full-year guidance. Revenues for the quarter increased to $18.37 billion, up 6.8% from a year ago, and same-store sales increased 4.1%. Much of this growth was aided by a 6.4% increase in prescription sales, which accounted for more than 65% of total sales. The quarter also brought an increase in customer traffic and average sales, as demand for cough/cold, pain, sleep, and private-brand drugs went up.

Walgreen also opened or acquired 41 new stores during the quarter and expects to close the year with store growth of 2.5%-3%. It recently acquired drugstore.com, which will bring with it more than 3 million customers and 60,000 online-ready products.

Fundamentals
The gross margin rose by 0.5 percentage points, aided by higher generic-drug sales and higher front-end sales growth (except prescription drugs). Net income rose 30.2% year over year, to $603 million.

The Foolish bottom line
Walgreen performed well this quarter and should continue growing into its next and final quarter of the year. The effect of its split with Express Scripts, if that indeed happens, may not be felt this fiscal year. How it will react to the split is yet to be seen, but with a number of tie-ups and mergers this year, it may be able to cope with any adversities.