Walgreen's Gross-Margin Pressure Trumps Cash Flow

For Gilmartin's preview heading into the Walgreen conference call, please click here.

Walgreen (WAG - commentary - Trade Now) reported third-quarter 2009 EPS this morning that missed consensus estimates by 3 cents (53 cents actual vs. the 56 cents estimate) as revenue came in better than expected at $16.21 billion vs. the $16.154 billion estimate. Using reported results, revenue grew 8% year over year, while earnings fell 9% year over year. Excluding 6 cents per share in restructuring costs, Walgreen reported EPS of 59 cents.

In terms of comp performance, total comps improved slightly to 2.8%, while pharmacy comps increased 3.8%, as the segment's gross margin improved even though front-end comps remained relatively anemic at 0.9%. This was the best quarter of comp performance since August 2008, although the comp performance is tracking well below historical norms.

As we detailed in our preview, margins will be the key to the quarter, and for the third consecutive quarter, Walgreen's gross margin declined from the prior year, getting squeezed 72 basis points this quarter, vs. 55 basis points in the second quarter and 8 basis points in the first quarter. Both operating and net margins also saw pressure for the third consecutive quarter.

On the plus side, cash flow was strong at $1.5 billion for the third quarter of 2009, resulting in $1.0 billion in free cash flow as capex fell 4% year over year. Working capital management continues to be the big contributor to cash flow and free cash flow generation as the company's cash-conversion cycle fell to the low 30s, and even though sales grew 8% year over year, inventories fell 3%.

One of Walgreen's Achilles' heels through the 1990s and early 2000s was that management did not maximize working capital very well, given the new store growth and with new stores added every quarter. Now that capex and new store growth has been curtailed, however, management looks to be squeezing working capital for everything it can to the benefit of the shareholder via the cash flow.

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At the time of publication, Gilmartin was long Walgreen, although positions may change at any time.

Brian Gilmartin, CFA, founded Trinity Asset Management (TAM) in 1995, where he is currently a portfolio manager. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Gilmartin appreciates your feedback; click here to send him an email.