Walgreens Boots Alliance Inc (WBA) — Q2 2015 Earnings Call Transcript

Thank you, Nicole, and good morning, everyone. Welcome to our fiscal 2015 second quarter earnings conference call. Today, Stefano Pessina, our Executive Vice Chairman and Acting Chief Executive Officer; and George Fairweather, Executive Vice President and Global Chief Financial Officer, will take you through our second quarter results. Also joining us on the call and available for questions are Alec Gourlay, Executive Vice President and President of Walgreens; and Jeff Berkowitz, Executive Vice President and President of Pharma & Global Market Access. As a reminder, today's presentation includes certain non-GAAP financial measures, and I will direct you to our website at investor.walgreensbootsalliance.com for reconciliations of the most directly comparable GAAP measures and related information. You can find a link to our website on our Investor Relations website. After the call, this presentation and the webcast will be archived on our website for 12 months. And now to read out the Safe Harbor statement. Certain statements and projections of future results made in this presentation constitute forward-looking statements that are based on our current markets, 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 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 subsequent filings for a discussion of the risk factors as they relate to forward-looking statements. Today's presentation includes certain non-GAAP financial measures, and we refer you to the appendix, to the presentation materials available on our Investor Relations website for reconciliations to the most directly comparable GAAP financial measures and related information. With that, I'll hand you over to Stefano for his opening comments.

Thank you, Gerald. Good morning, everyone, and welcome to the first ever earnings conference call for Walgreens Boots Alliance. Let me begin by underscoring how pleased we were to finally bring the two companies together on December 31, 2014. This was a historic and pivotal milestone for two iconic companies, Walgreens and Alliance Boots, as we completed our merger to establish Walgreens Boots Alliance, forging the new company, the world's first global pharmacy-led health and well-being enterprise. We established a senior management team to bring together our businesses and lead them forward to the next phase of their evolution while making steady progress with the integration and the establishment of a single unified corporate identity and culture. Our team worked very hard to accelerate the closing of the deal two months ahead of the beginning of the completion window. We raised the funds to complete the transaction and refinance essentially all the Alliance Boots debt in an efficient manner while going through a complicated process of preparing our first full consolidated earnings under U.S. GAAP, including eliminating the three-month reporting lag. The complexity and effort these tasks have taken cannot be underestimated. I would ask you to remember that until completion, our businesses had to operate at arm's length as separate entities. We are today only 14 weeks, in fact 99 days, into the creation of this new global entity. It is still very early, but we have moved mountains in what we have done and are still in the first steps of our journey. We have achieved much in a short time and are moving quickly. We have expanded our restructuring program to create a more competitive cost structure, begun to access synergies created through the combination and sharpened our focus on our strategic priorities, including the sale of a majority interest in our infusion business subsequent to the quarter close. And today, I am pleased to announce a strong quarter, achieved along with all the other tasks that we have undertaken. We are looking forward to the future with enthusiasm. Our transaction has created a group which, I believe, has enormous potential to grow in ways that give us great excitement and optimism for the future. Let's start by looking at our business as we stand today. Based on an in-depth review of our Retail Pharmacy USA segment, I can say that Walgreens is on a sound structural footing. As you might expect, some parts are better than expected while others offer room for improvement. Our first priority is to understand the business fully, its interdependencies, and its differentiators. This exercise is underway, and we'll ensure we stay focused on what is truly important: delivering against the needs of our customers in a dependable yet innovative manner that provides us with sustainable and growing income across all parts of our business. This will be achieved through a combination of efficient practice, research and insight, investments in our core business and innovation in our business model. From what we have seen already, we believe there to be significant scope to enhance the performance of our pharmacies through refreshing and differentiating our stores, improving customer experience, delivering products and services to customers and patients, and introducing new offerings through innovative partnerships. We believe that through good business practice and the application of these and other initiatives, we can over time expand the retail margin, grow market share, and prepare ourselves to better address the competitive and market-driven headwinds we face in certain areas of our business. Let me be perfectly clear. Our aim is to help Walgreens further develop strategies that will continue to deliver growth for many years to come. It is vital that we make the best use of the assets that we have, core to which is our unrivaled portfolio of locations across the U.S. We must work tirelessly to drive the best possible return from these assets. And to that end, we have today announced an enlarged but necessary restructuring program to focus the Walgreens business back on its core assets. We believe we will come out of this stronger and better positioned to deliver enhanced performance that our premium locations should command. In Retail Pharmacy International in Boots, we are working hard to refine the new cycle of our business that will deliver growth in the coming year. We are continuing to develop our online offering and building on our recent successes. We are working to further integrate these with our physical stores and logistical network to enhance customer choice while making better use of our resources. The constant work to keep our offering fresh through innovation within store and within our own brand and exclusive product portfolio is continuing to differentiate us in the extremely competitive U.K. retail market. I'm confident that the work which Simon and his team are doing will set us on a path for further growth in the years ahead. As you're aware, our retail businesses are also continuing to perform well, and it has been a particular pleasure to welcome our new colleagues in Mexico and Chile to our company, making the expansion of our international retail presence in Latin America through their vision of two outstanding businesses with excellent prospects for growth. Our Pharmaceutical Wholesale division is continuing to develop the integrated business model that we introduced many years ago, operating an ever-growing suite of services to the manufacturers that tie up most growth than ever to them as partners. On the other side of the supply chain, we are expanding our offering to our pharmacy customers to both align them more globally with our wholesalers and let them improve the quality and economics of their businesses. While such initiatives enhance the vertical integration of our wholesale businesses and create strength and value, the ever-changing market that we are operating in and the continuous economic pressure that health care systems are under present us with several opportunities to expand our network. These present themselves in many ways. In one extreme, through consolidation within markets; and at the other extreme, through innovative partnerships and alliance systems, as you have seen us do with AmerisourceBergen. As wholesale is a business that is enhanced by volume and market presence, we will continue to explore opportunities to expand our network as they arise. Underpinning all of these, Walgreens Boots Alliance has embarked on the beginning of a new year, a new year that will bring a new attitude, a new culture aligned toward driving performance, serving our customers and creating long-term, sustainable shareholder value. Now I will ask George to take us through the quarterly results. George?

Thank you, Stefano. Good morning, everyone, and good afternoon to those listening in Europe. Today, I would like to cover the following three topics: first, to provide detail on our fiscal 2015 second quarter performance; second, to provide you with an overview of our restructuring program; and finally, to articulate our views on FY '15 and FY '16 results. To summarize, the second quarter was a solid start for our new company. Key highlights include net sales of $26.6 billion, GAAP earnings per share of $1.93 while adjusted EPS was $1.18, cash flow from operations of $1.3 billion and free cash flow of $1 billion. The quarter's financial results are complicated as we began reporting as a consolidated entity partly through the quarter and the comparability to last year is a challenge and of limited use. Before we get into the details of our second quarter financial performance, I'd like to explain some elements of our new reporting structure. Historically, Walgreens has reported as one segment, which consisted of the results of Walgreens in the USA; its corporate costs; synergies from the Walgreens Boots Alliance Development joint venture, also known as WBAD; and equity earnings from Alliance Boots on a three-month lag. Our focus was to merge the businesses as soon as possible and eliminate the three-month reporting lag. This aligns the reported results of the global enterprise and will make our performance easier to understand going forward. As Walgreens Boots Alliance, we now report results in three segments: Retail Pharmacy USA, Retail Pharmacy International, and Pharmaceutical Wholesale. Segmental reporting includes the allocation of synergy benefits, including WBAD and combined corporate costs. Within our Retail Pharmacy USA segment, since the deal closed on December 31, we have reported one month of Alliance Boots equity income this quarter versus three months in the comparable quarter a year ago, recognizing the 45% stake that Walgreens had in Alliance Boots until end December. The months of January and February are fully consolidated. Year-over-year comparisons of results required consideration of the foregoing factors and are not directly comparable. So now let me take you through our financials in greater detail, beginning with the consolidated results. For the quarter, GAAP net earnings attributable to Walgreens Boots Alliance were just over $2 billion or $1.93 per diluted share, while adjusted earnings were $1.2 billion or $1.18 per diluted share. This compares to $0.74 of GAAP net earnings per share and $0.97 of adjusted earnings per share in the prior year quarter. Net sales in the second quarter were $26.6 billion, an increase of 35.5% versus the prior year. Operating income on a GAAP basis was $1.4 billion and on an adjusted basis was $1.8 billion. The increase in adjusted operating income was driven by growth in our Retail Pharmacy USA segment as well as the consolidation of Alliance Boots' results for January and February. We reported $144 million of net interest expense this quarter, which included interest expense associated with prefunding the transaction for the month of December. Consistent with last quarter, our adjusted EPS excludes this interest expense, which we'll not need to do going forward. The adjusted tax rate for this quarter was 27.7%. Now this has been impacted by a number of factors, including a change in the geographic mix of forecast profits now that Alliance Boots has been fully consolidated, includes net discrete tax benefits specific to the quarter and the presentation of Alliance Boots' taxes in the income statement. Prior to the full merger, Walgreens 45% share of Alliance Boots' adjusted results, net of Alliance Boots' tax, were presented in a single line within operating income. Now following the transaction, Alliance Boots' tax is reported within the income tax provision line in our income statement, impacting the calculation of the adjusted tax rate. Diluted shares outstanding at the end of the quarter were 1.1 billion and average diluted shares outstanding for the quarter were 1.05 billion resulting from the issuance of 144 million shares on December 31 as part of the consideration for Alliance Boots. So now let me walk you through the component pieces to explain the change from GAAP to adjusted EPS. The GAAP earnings per share for the quarter of $1.93 reconciles to an adjusted earnings per share of $1.18. The net adjustment of $0.75 per share, this reflects the removal of net gains on transaction-related items of $0.67 and gains on the warrants we hold over AmerisourceBergen shares of $0.35. This is partially offset by LIFO provision costs of $0.04; acquisition-related amortization expenses of $0.15, which includes $0.08 relating to an inventory step-up which will not reoccur in future quarters; and special items of $0.08 related to optimization costs and asset impairments. The components of the net gain on transaction-related items were a gain on Walgreens' previously held equity interest in Alliance Boots of $0.77; a foreign currency hedge loss of $0.07 related to the delivery of the British pound element of the Step 2 consideration; and a net $0.03 cost of transaction fees, tax adjustments, and interest costs from prefunding the cash consideration. So next, I'd like to provide insights into financial results at the segmental level, starting with Retail Pharmacy USA. Reported net sales were $21 billion, up 6.9% on a comparable store basis. In the pharmacy, comparable store scripts, which includes immunizations, increased 5% on a 30-day adjusted basis. The increase was driven by the positive impact of a strong cough, cold and flu season; continued growth in Medicare Part D scripts; and positive underlying share trends. For the quarter ending February 28, the division's 30-day adjusted retail prescription market share in the U.S. reached 19.3% as reported by IMS Health. This represents an increase of 20 basis points versus the same time last year. In retail products, comparable store sales increased by 2.5%. This was partially driven by strong December holiday sales, including seasonal sales of cough, cold, and flu products. GAAP operating income for the quarter was $1.3 billion while adjusted operating income was $1.6 billion, up 13.4% over the year-ago quarter. Strong expense control and efficiencies offset the expected pharmacy gross margin pressure from declines in reimbursement, generic drug inflation, as well as the Medicare Part D rate step-down that began on January 1 this year. Retail product margins increased this quarter, helped by seasonal and cough, cold, flu mix as well as our focus on reducing less profitable promotions. We remain very pleased with the progress on controlling and reducing SG&A expenses this quarter. Our GAAP SG&A expense declined 0.3% compared to the prior year quarter. So next, let's review the Retail Pharmacy International division, which is pharmacy-led health and beauty retail businesses in eight countries. The biggest contributor is Boots in the U.K. Total sales for the two months ended February were just over $2 billion. As the businesses included in our Retail Pharmacy International division were acquired as part of the merger with Alliance Boots, no comparable information is included in the WBA consolidated results. On a pro forma constant currency basis, comparable sales for January and February grew by 2.9%. Comparable sales of Boots U.K. were up 2.3% while sales in our businesses in Chile and Mexico, which we acquired by Alliance Boots back in August 2014, were up 2.9%. The acquisition brings us over 1,000 stores in Mexico and over 400 in Chile and provides strong growth opportunities in the Latin American market. The inclusion of these businesses in the division, combined with contract manufacturing, are reflected in the margins. Now turning to Pharmaceutical Wholesale, which mainly operates under the Alliance Healthcare brand in 12 countries. Results in any given quarter are influenced by performance in larger geographies, including the U.K., Germany, France, and Turkey and the division's contribution from WBAD. Total sales for the two months ending February were $3.9 billion. Similar to Retail Pharmacy International, our Pharmaceutical Wholesale division was acquired through the merger with Alliance Boots, and so no amounts are reported in the comparable period. However, on a pro forma constant currency basis, sales were relatively flat compared with the same period the prior year. Now let me spend a minute on our expectations for synergies and how they will be reported going forward. Prior to the merger, the majority of our synergies were flowing through WBAD, the former joint venture between Walgreens and Alliance Boots, which Walgreens fully consolidated and then removed Alliance Boots' portion via the noncontrolling interest line item. Following the combination, we're allocating all synergies, including those generated by WBAD, to the segments, and we're doing this according to the relative proportion of purchases driving the synergy benefits. With regard to performance in the quarter, combined net synergies were $170 million, bringing the fiscal year-to-date total to $310 million, driven primarily by our drug procurement efforts. We remain comfortable with our ability to achieve at least $650 million in combined synergies this fiscal year. For FY '16, we continue to expect at least $1 billion in combined quantifiable net synergies. Consistent with prior reporting, these synergies do not include any benefit from our AmerisourceBergen relationship. Now that we're a combined company, as expected, we are focusing on driving incremental synergies from sharing our best practices and working more closely together. However, not all of these can be easily quantified as some of them tend to blend into our normal business. So moving on to the cash flows. We generated approximately $1.3 billion in cash from operations during the quarter, and our free cash flow was $1.0 billion. We're pleased with the cash generation during the second quarter due in part to an improvement in our primary working capital within our Retail Pharmacy USA division, driven by a reduction in inventory levels. We will continue to focus on working capital and remain confident in future opportunities to increase efficiencies. Net debt as of the quarter end was $14.1 billion. With regard to uses of free cash flow beyond reinvestment back into the company, we completed $94 million of share repurchases in the quarter against our $3 billion authorization. We purchased additional shares post the end of the quarter under pre-established trading plans, bringing the total purchases to $330 million. I'd now like to make a few comments on our capital allocation policy. As we've consistently communicated, we remain committed to a solid investment-grade rating while looking for ways to enhance our cash generation. This includes driving working capital efficiencies, tightening capital expenditures, controlling costs and, of course, improving operations. Beyond maintaining a long-term 30% to 35% dividend payout target, our top priorities for free cash include M&A consistent with our strategy and share buybacks. All of these are with a view to optimizing long-term shareholder value. Following on this theme, and as Stefano mentioned, we are focused on becoming a more agile and more productive company. As you know, in August 2014, we announced a three-year $1 billion cost reduction initiative. After a rigorous analysis, we've identified additional opportunities for cost savings primarily in our Retail Pharmacy USA division. These additional cost opportunities will increase the total expected cost savings program by $500 million to a projected $1.5 billion by the end of fiscal 2017. So moving to areas of focus, they include plans to close approximately 200 stores across the U.S.A., to reorganize corporate and field operations, drive operating efficiencies, and streamline information technology and other functions. These actions are designed to restructure and invest in our company's future in a way that is better for customers, simpler for our employees, resulting in a faster and more agile organization. We estimate that total pretax charges associated with this program to our GAAP financial results will be in the range of $1.6 billion to $1.8 billion, of which the cash component is expected to be approximately 60%. The restructuring charges will be recognized over time as the program is implemented in accordance with GAAP. Looking ahead, we will continue to focus on other areas of cost reduction. So now let's talk about the rest of fiscal 2015. We understand and appreciate that there are lots of factors that will impact our results. So in order to help you, we are providing an adjusted EPS guidance range of $3.45 to $3.65 for fiscal year 2015. Now this range assumes quarterly interest expense of $140 million to $150 million. It assumes a full year adjusted tax rate of approximately 29% and a fiscal year diluted share count generally consistent with the current quarter. It assumes management's estimates for foreign exchange rates that reflect current market rates over the balance of the fiscal year. Now this guidance also includes recast fiscal Q1 results due to the elimination of the three-month lag. Finally, you will see an increase in the share count in Q3 and Q4 due to the full inclusion of the 144 million shares issued with Step 2 of the Alliance Boots transaction. This will result in approximately 1.1 billion diluted shares per quarter. Any additional share repurchases will impact, of course, the fiscal year diluted share count. So moving on to FY '16. Our previously published goals were based on a variety of assumptions to arrive at estimate ranges for both sales and adjusted EPS. These included operating assumptions for our businesses and certain below-the-line items, including interest, tax, and share count. When we set the goals in August, we made foreign currency assumptions based on exchange rates that were close to market rates at that time. Since then, we've seen significant global currency movements, especially the strengthening of the U.S. dollar. Because we report in U.S. dollars, we do have currency translational exposures primarily based on movements in the pound sterling versus the dollar. Simply put, a stronger dollar hurts our sales and earnings in dollars while a weaker dollar helps them. We estimate that a 1% move in the pound sterling versus the dollar from current levels would impact our adjusted EPS by approximately $0.01 per share. Despite the FX headwind, I'm confident that we have initiatives and resources in place to address the controllable elements that drive our adjusted EPS goal for FY '16. Our revenues have greater potential variability due to the varied mix of businesses, particularly in our Wholesale division, which accounts for a significant proportion of our overall revenue. In addition, the geographical spread of the Wholesale business increases its exposure to currency variations. This being the case, we view overall revenue as a less relevant measure of our business. So taking these two factors into account, we decided to no longer provide our published revenue goal. And please note that our forward-looking statements assume no significant changes to the current exchange rates. So I'd like to wrap up today by saying that our reporting structure has changed and comparability is limited, which I know makes it really difficult for you. Therefore, in an effort to be as informative as possible, we've provided adjusted EPS guidance for fiscal year 2015. And next week, we'll have a financial session to provide further insights. In addition, we plan to provide operational insights in each of our three segments as well as views on our key financial drivers and future strategy. We really look forward to seeing you then. So with that, I'll turn the call back to Stefano.

Thank you, George. Let me finish today by reminding you of our key priorities as we look forward. We are working to deliver the benefits of our transaction within our core businesses. These will involve executing our synergies and efficiency programs across the group, including the progressive development of our procurement initiatives. We must also properly manage the assets of the business to ensure we are suitably structured and prepared to address the pressures we face as the pharmacy markets evolve. These pressures may variously be from reimbursement cuts, competitive action, or simply changes in consumer behavior. Whatever form they take, if we are properly structured and prepared, operating an efficient, high-quality, patient-oriented pharmacy service, we will earn the right not just to participate but to be an architect of the changes in our market. We are already seeing the benefits that can be achieved in retail with the initiatives underway at Walgreens and ongoing at Boots. We must ensure that we get the best return for our investment and create the best environment for our employees and customers alike. This will require us to operate enhanced systems and controls so that we can monitor and manage our business properly. Now many of you have asked where we are on the CEO search. As you know, we formed a search committee of the board and they have been working with one of the top executive recruiting firms to help us find a new CEO. Currently, we are in the process of reviewing the candidates they have proposed. Finding candidates with the combination of attributes that we deem important for the role is naturally challenging as we expected it to be. But we remain confident that in due course, we will find the right person for the job. Lastly, as the new culture takes hold and finds roots in a company, you can see echoes of it in all parts of the business. I hope that in one particular area, you are seeing the new culture emerge very clearly in the different approach to our owners and the financial community in general. I have always viewed investors as my business partner, and I hope that they will view me in the same way. As an organization, we strongly believe it is our duty to care for our shareholders and to ensure that we are as accessible, responsive and transparent as we can be. We also believe in being proactive in reaching out to our investors to properly understand their requirements and to ensure that in our investor relations efforts, we are as mindful of our shareholders as we are of the patients in our pharmacies or our customers in wholesale. I think that Gerald and his team have done well to demonstrate this new approach, and it is a great pleasure to see, although there is still more to do. We are in the first steps of a long and exciting path, and I look forward to traveling it with you as fellow owners and partners. As I said earlier, I am optimistic about the long-term future of our company and have made a significant personal commitment to our future not only as the Executive Vice Chairman and Acting CEO but also as a significant shareholder. I am convinced that the formation of Walgreens Boots Alliance is a unique first, which will almost inevitably lead to many other new firsts in our industry. It may not yet be clear which steps these will be, but we are determined to continue to show the way and be at the forefront of innovating health care. Our ambition is to build a globally recognized company and a universal health care champion. We look forward to providing a more comprehensive outlook on our future strategy and value creation next week at our first Analyst Day. With that, we are now ready to take your questions.

I know we'll get a little more detail next week at the Analyst Day, but I thought maybe I'd start on the incremental cost-cutting you introduced today. I believe the previous expectation was for the bulk of the cost-cutting to come in fiscal '16. Just curious if you can give an update on how we should think about the cost-cutting over the next three years. And then related to that, given that there's an additional $500 million in cost-cutting, obviously reiterating the fiscal '16 guidance, I'm wondering if there were any negative offsets that you've realized since giving that '16 guidance.

So George. And after, Alec can give you, I believe, a satisfactory answer.

Our top priority, considering we're newly merged, is to identify additional achievable savings. The $0.5 billion increase in savings will take some time to materialize, primarily extending into the upcoming year and into 2017. Therefore, I would consider this a focus over the next two years for driving performance. I want to emphasize that as we discuss our guidance, it's important to keep in mind the change in currency rates. Currently, the exchange rate is around $1.48 for the pound, compared to $1.68 in August. So, when setting and reaffirming our guidance, we must consider the adverse currency fluctuations affecting our plans in other areas.

That's fair. And then I guess just maybe more near term looking at the U.S. SG&A, quite a bit lower than what we were looking for and obviously quite a bit lower than it was a year ago this time. I'm just wondering if you could give a little bit more clarity on what went on within the U.S. SG&A line. Is that reduction that we saw there in any part a result of these cost initiatives? Or are there other things at play within the U.S. cost structure?

Alec?

It's Alec here. Yes, it's a combination of both. First of all, the additional $500 million is going to be almost all in '17. So this is a result of what we've been doing over really the last 9 months as we've really deeply understood the current operating model and really tried to lay out the grounds for the new operating model that we're going to do through the business. We've been really successful. The team has done a great job in Walgreens in terms of being able to find cost savings that do not affect the customer. The most pleasing thing about this beyond these cost savings is the fact that we're still growing volume ahead of the market, both in pharmacy and in retail products. And also, we're seeing internally our measure in cost of the delay improving. The whole idea of better for customers, simpler for our teams and a more agile organization is what's driving all of this, and we'll keep on going as we'll keep on working the old model and trading these processes, the IT structures for a new model. So yes, we're delighted with the SG&A savings in this quarter and they are materially better than the same period last year. And as part of the restructuring we started already is in there, but a lot of this also is just due to ongoing cost control and cost management.

When we think about the space, the consolidation obviously continues. We just heard the news last week on kind of like how United is thinking about the supply chain in the payer world. Do you think that you now have all the relevant pieces that you need in the U.S. market? Or are there still areas that you think that you might be missing or below scale at?

Well, what we think is not really important. The reality is that, as I have said many times and I have realized immediately after being for two weeks in the job, is that this market, the American market, is ready for another round of consolidation because the margins are squeezed everywhere. The government is more and more in charge for the cost of the health care business. And so for sure, they will exercise their power to squeeze the costs as much as possible, as we have seen in Europe for decades. And so the complex structure of delivering the medicines to the patients will have to be rationalized. And as a consequence, it's easy to believe that we will have additional synergies coming from M&A activities. These could be, of course, at the level of horizontal consolidation. But in many layers of the chain, the consolidation is still up and is still quite advanced. So it's very likely that we'll see also vertical consolidation. And the opportunities are there for everybody, and we will see what happens. But as I have said before, we want to be, as we have been in the past, at the forefront of changes. And so if there is a need for a consolidation, we will be ready to be part of it.

Okay. And then just as we think about the trends on the front end, can you talk a little bit about promotional activities in the quarter and just how you think about promotional activities for the rest of the year and also about private label penetration?

Alec?

It's Alec here. Yes, the team has built a new tool and some good data. And so this has been driven really from the implementation of Balance Rewards, the insights we're getting. And they're driving that through better tools to the merchants. So the merchant teams have done a really great job in terms of understanding more precisely where customers truly value promotions and where actually they don't. And you can see the growth in the front-end margin. You can also see the growth in product sales at the same time. So we've really been able to pull these two things off together. And we feel confident with the new tools we've got and the key tools we're developing going forward. Also a great hire. Linda, Linda Filler, has come into us. And again, Linda, we believe, will accelerate our journey given her tremendous experience in Walmart and Sam's Club in particular. So that feels pretty good. In terms of own brand penetration, we've created a new division within our organization, within Walgreens Boots Alliance, led by Ken Murphy. And again, we're able to think about how do we understand local insights in America and also global insights, and Ken will speak more about this next week, and how therefore do we get the right products and the right brands into the American consumers' hands in the drug store channel. Having said that, we've done a couple of things recently. We've issued two new masstige cosmetic brands, CIRCA and Colour Prevails. That's happened in the last two or three weeks. So we're not waiting for that to happen. We continue to work on the basis of growing own brand penetration. So I think on both fronts, we made good, solid progress and there's more to come.

George, as I look at the first half versus the second half, it looks like there was a deceleration in earnings. Can you talk about what the primary contributors are there? I'm just curious if the Medicare Part D, while you talked about the trends being positive from a script perspective, we know that there's been pressure there on the reimbursement front.

Yes. I mean...

George?

Yes. I mean, there are a number of factors. And I know what makes it really complicated looking at half year on half year, and of course, it includes the deal and removes the three-month lag, et cetera. I mean, in terms of Medicare Part D step-down, obviously, firstly, we've got two months' results in Q2 given this kicks in at the beginning of the year but will impact us for the full quarters in each of Q3 and Q4. The second half of the fiscal year is seasonally weaker than the first half normally. And of course, I know we haven't got all the comparables to sort of give you the overall seasonality, which makes it tough to model. And then, of course, we've got the exchange rate issues as well coming in because of where the exchange has moved over the last six months. And of course, we are still bringing in the 45% of Alliance Boots at that point in time.

Alec, if you can add something.

Yes, absolutely. We also got some cost savings timing. So for example, we've got much closer to the plan of how we're going to actually drive the cost savings. And therefore, we've been able to take a few more of the cost savings in the first half relative to the first half of last year. And then the remainder of the year, we have still cost savings coming through. So we actually had quite a lot of cost savings in Q4 of last year to go against.

And then my second question would just be around generics. If we think back to last summer, a lot of talk about drug price inflation on generics being a headwind. As I think about the generics pipeline for the back half of your year, it looks to be improving. Can you maybe talk about what you're seeing, one, on drug price inflation and the impact that it's having? Are you able to offset that with your procurement entity? And then secondly, kind of your outlook for incremental generics that are going to come as we go through the next couple of quarters.

Jeff, can you answer this question?

Sure. Thanks, Lisa. The generic manufacturers are continuing to react to the supply issues and approval delays in ways that we've come to expect, which is what has been driving the inflationary environment. But we do continue to see a similar range of inflation as we've seen in the past 12 months or so. The teams at WBAD, Walgreens, ABC, and Alliance Healthcare all continue to work extremely effectively together to assure that as the biggest buyer of generics in the world, we are properly managing the industry dynamic. The teams in particular have gotten very sharp and have a number of effective mechanisms in place and are working very collaboratively with the generic drug manufacturers to really manage through this dynamic. They've gotten very flexible and nimble in understanding the marketplace where there might be issues and really managing them proactively. In terms of the generic pipeline, we've recently seen in February the entry of NEXIUM, but we haven't seen it go multi-source and we're looking forward to that. We are seeing the list of generics that are coming out. We're looking forward to maximizing those opportunities as they come.

And I'll echo the congratulations on getting the transaction closed. You highlighted in the press release a target of closing about 200 stores. I guess the first thing I'm wondering is, is that a kind of a complete evaluation? And could there be upside to this figure? And how should we think about the earnings profile of these stores? We would assume that they're less profitable than the composite of the business. But is there any chance that they're losing money and there's going to be a positive margin lift from this?

Alec?

It's Alec here. We have conducted a comprehensive review, and we've been doing this for some time. We also assessed the performance of the stores we closed last year, and the positive outcome was that we experienced greater customer retention and were able to retain many of our team members, which is essential for us. We are confident in the figure we provided, which is approximately 200 closures. We will inform our employees first about the upcoming closures. Additionally, we plan to open around 200 stores during the same timeframe. This process is about ensuring we have the right stores in the right locations, while also considering cash management and returns on a per-store basis. Each closure is based on individual store evaluations. We have thoroughly analyzed the current markets and customer traffic in these stores, observing that some locations have seen a decline in population and future potential.

That's helpful. I'd like to follow up on your mention of synergy targets excluding the ABC relationship. Where do we currently stand in the life cycle of that relationship? How much additional cost can still be eliminated? From an inventory standpoint, what more can be removed? It seems there is still a significant amount of store inventory that can be addressed and better managed through the DSD delivery from ABC.

Alec?

It's Alec again. Yes, we've made really good progress in terms of inventory reduction. And myself and Jeff are working really closely on this together. It's really an end-to-end view from the pharma manufacturers all the way through ABC into the work that Rachel Ashworth is doing in the stores. We're also seeing importantly our service levels improve as well. So again, we've seen this nice thing. When you get less stock out of the system, you improve costs and then you improve working capital. And importantly, you improve service levels. So again, we'll continue to work at this. There are more opportunities and we'll do it in a really balanced way to make sure that we care for customers first, get it right going forward and we take working capital out. And I'm confident that the working relationship with ABC will continue to improve. And of course, working in Europe, as I did before with Ronald and the team in Alliance Healthcare, we really worked as well for a number of years and saw more and more opportunities which comes through very clearly in the U.K. business performance for both the Wholesale and the Boots division.

So I guess for me just a clarification question on the gross margin for the quarter. I think the LIFO adjustment is pretty straightforward, but I think I heard you mention there may have been an inventory step-up charge as well. So I apologize if I missed this, but I guess did you provide the fully adjusted gross margin for the quarter just to make it a little bit easier for us? And also, part two is then that just curious, all the talk about the U.S. Medicare Part D rate reductions that went into effect on 1/1/15, is there any way just to get a rough sense for how much that impacted the gross margin in the quarter? Was it perhaps 100 basis points year-over-year or maybe something greater than that? I'm just trying to get a sense for that.

Right.

So George can answer the first part of that.

Sure, I can address the inventory step-up. There was an inventory step-up charge of $0.08 due to provisional purchase accounting allocation, which we have a year to finalize. We need to revalue the inventory at a selling price minus a small margin instead of at cost. This adjustment effectively lowers the U.S. GAAP profit in those two divisions. That's why we excluded it to clarify the operating results. It has no effect on the comparables since it doesn’t influence the Retail Pharmacy USA segment. I apologize for the numerous adjustments. Next week, I’ll provide more detail, as it does complicate presenting the story clearly, which I know we all want.

Jeff, can you answer the second question?

Yes, that was about the impact on Medicare Part D. Within the quarter, how much did that affect the overall gross margin? That was the second question.

Yes. Medicare Part D is an important part of our business. We are not specifically commenting on the gross margin impacts. As we mentioned, it will account for about one-third of our business moving forward. Currently, we are in the midst of negotiations for the 2016 year. These negotiations are very productive at this stage, but it is still early to assess their long-term impact.

We are happy with the volume, and the margins have come in as we anticipated. Overall, this has been a strong selling season, and we are optimistic about the results.

So thinking about the opportunities with both horizontal and vertical consolidation, that obviously goes in many different dimensions. But when you think about the opportunities, is it more about getting leverage with suppliers or more about getting leverage with payers in pharmacy? And then I guess sub-point to that is getting more scale within the retail operations. Or is it more about strategic moves that allow you to drive more share across your own network and then specifically thinking about better managing the payer relationships and potentially having a pharmacy benefit management relationship?

Well, Stefano. We are indeed looking at the market. I have mentioned that we have been here for a little over three months, and I believe we are beginning to understand the market quite well and identify many opportunities. When discussing opportunities, we don't rule out typical M&A possibilities. However, there are numerous opportunities unrelated to acquisitions or mergers, such as potential joint ventures and commercial partnerships, similar to what we did initially with WBAD. When we approached Walgreens and began our discussions, our first decision was to create joint ventures to collaborate on purchases, which would have existed even without a merger. There are various ways to achieve synergies, and we are open to any organization that could enhance our company's value, analyzing many different alternatives. Ultimately, it also depends on the maturity of potential partners and their willingness to engage with us. What I was conveying is that the market is progressing in a clear direction, and these developments are likely to occur sooner or later.

And I assume, if we're speaking about this real-time, that you believe the organization is ready to move when the opportunities develop, I mean, given everything that's going on with the consolidation of Walgreens Alliance Boots?

We have consistently approached opportunities with determination, recognizing that establishing a solid platform at Walgreens Boots Alliance will require time due to the integration of the two companies. I am pleased to report that the integration is exceeding my expectations, though we still have much work ahead. Just because we haven't completed this process doesn't mean we can't pursue other initiatives in the interim. If any opportunities arise, we will seize them. Significant opportunities, whether they involve mergers and acquisitions or joint ventures, take time to materialize. We will continue our integration while exploring other possibilities, and we will be prepared to act when opportunities present themselves.

I mean, we've obviously got our $3 billion program authorized, so I think that should give you an indication of our thinking in that respect. We've obviously not been specific on this, but we wouldn't put a program in place if we hadn't felt that we have the ability to generate the necessary cash to complete that program whilst maintaining solid investment grade.

I just have a question on your guidance particularly as it relates to getting to 2016. Could you just give us a little bit of color on what your expectations are for the underlying growth of the business, maybe profit dollar growth by division that you've sort of contemplated here?

In terms of our overall guidance, I'm reaffirming what was shared last summer, keeping in mind the impact of currency fluctuations. We haven't completed our in-depth budgeting as a unified group yet, and we're working to align everything on a comparable basis following U.S. GAAP. We're undergoing significant changes in this process. Next week, during our meeting, we'll aim to provide more insights into the drivers for each division. Additionally, we'll dedicate time on Thursday for financial modeling to offer further clarity. The situation is quite complex due to the comparability challenges, particularly as we have established segments that focus on where synergies exist and where actual economic activity is taking place.

And so you don't have to be too impatient. At the end of the day, you have to leave us with something to tell you next week.

All right, that makes sense. And then just one quick follow-up for you on real estate. Obviously, getting smaller is not necessarily something that you want to do in the U.S. pharmacy. But do you still have other stores that you would consider underperforming or lower-margin stores? And I guess the question would be, what's the real answer to improving those stores if it's not necessarily closing?

Yes, I mean, obviously, we have a range of stores. I've said before that I'm really going to look at this and this is about 2% of our estate we've talked about this morning. And so therefore, 98% of the estate is in either good or satisfactory order. And I think also, we've done a lot of work on the front end. We are becoming more confident about our ability to not just improve the front end through margin expansion but to develop potential new formats, integrate digital assets to become a new channel. Some of the work Simon and the team have done in Boots has been great in that respect in the last couple of years. So we have different strategies that we will apply over the months and years ahead to make the very most of what is a great set of assets. Stefano said this in the introduction. We have got the best corners in America, and we have looked at them and we still think we have a really important asset that features the Walgreens company.

But also, we are discussing a few hundred stores that we have already closed. This represents a small percentage of the total number of stores we operate. In general, all retailers should maintain a program for their stores. Given the vast territory and the high number of locations, it's inevitable that some stores, which may have been profitable in the past, are no longer performing well today. Additionally, we will need to open stores in areas that didn't exist previously. Although a few hundred closures out of 8,300 stores is not a large figure, there is a noticeable concentration due to the lack of a structured program in the past. Moving forward, once we establish a new baseline, we should review all stores annually. If closures are necessary—whether it's 10, 5, or 15 stores—it's important to manage this process gradually over time. This approach will become part of our regular operations and will go largely unnoticed, even within the company.

Thank you. Ladies and gentlemen, I know there have been plenty of other questions we haven't had time for today. We are looking forward to seeing as many of you as possible next week at our analyst event on the 15th and 16th in New York. That will also be webcast live and will be archived on our Investor Relations site. So I hope as many of you as possible can participate in that. We'll address as many of your additional questions as we can then. And thank you very much indeed, everyone, for participating today.