Last week, top U.S. drugstore operator Walgreen (NASDAQ:WBA) reported that its comparable-store sales had increased 3.2% in November. The company achieved solid gains in both front-end and prescription sales. To drive these gains, Walgreen boosted its promotional activity during the month.
In fact, Walgreen has been ramping up discounts for about six months now. These promotions may start to depress the company's gross margin. However, Walgreen's recent sales growth has not been so strong that it could offset significant margin pressure. This creates some risk that Walgreen will miss analysts' aggressive earnings growth targets when it reports its quarterly results next week.
Discounting for market share
Back in June, Walgreen executives told investors that they planned to increase the company's promotional activity in order to reverse a string of weak front-end sales results. This strategy bore fruit in the August quarter, as front-end comparable-store sales increased 1.6% year over year.
Most importantly, Walgreen's gross margin grew 60 basis points year over year during that quarter, despite the increased promotional activity. Sales growth also allowed Walgreen to leverage its operating expenses, driving additional margin expansion.
However, this margin growth trend may not be sustainable. Walgreen and other drugstore chains saw a big benefit earlier this year from a wave of generic drug introductions (generics carry higher profit margins for pharmacies than brand-name drugs). In the August quarter, the benefit from generic drug introductions more than offset the pressure on front-end gross margin from heavier discounting.
In recent months, the impact of new generic drugs has been much smaller. Rite Aid (NYSE:RAD) warned investors in September that margins would be squeezed going forward with fewer new generics coming to market. Walgreen has also seen a decreasing impact from new generic introductions as the year has progressed.
As pharmacy gross margin flattens out, Walgreen may have trouble absorbing a decline in its front-end gross margin. As a result, while deeper discounts helped Walgreen outgrow Rite Aid last month -- Rite Aid's front-end comparable-store sales increased just 0.4%, compared to Walgreen's 1.6% gain -- earnings may fall short of investors' expectations.
Since Walgreen returned to a higher level of promotional activity earlier this year, front-end sales growth has responded nicely. However, more discounting also carries the risk of margin deterioration. This is especially true for Walgreen today because the flow of new generic drug introductions has become less favorable in recent months.
The success of Walgreen's current strategy depends in large part on its ability to improve the efficiency of its promotions by driving more traffic for any given level of discounting. The new Balance Rewards loyalty program is providing Walgreen with a wealth of data on customer shopping habits. It hopes to use this data to better target promotions for maximum effect. The company's upcoming earnings announcement will offer some early insight into whether or not this effort is paying off.
Adam Levine-Weinberg has the following options: long January 2014 $4 puts on Rite Aid. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.