Walgreen ( WAG) investors have a bitter pill to swallow -- and they may not be the only ones. Shares of the drug store chain plunged 15% in furious trading Monday after the normally reliable company posted a steep earnings shortfall. And the source of Walgreen's pain -- the once-hot generic drug business -- may spell pain for rivals Medco ( MHS) and CVS ( CVS). "The year-over-year earnings decline is the first that we are aware of -- going back at least 10 years," Bear Stearns analyst Robert Summers wrote. "While it is easy to downplay this miss as one bad quarter for a normally very predictable company, we believe the industry as a whole is heading into a very difficult period as the generic margin benefit begins to roll off dramatically." Walgreen's "significant earnings miss
is indicative of tough roads ahead." Specifically, Walgreen reported that earnings dropped 3.8% to $397 million, or 40 cents a share, in the latest quarter. Analysts were expecting profits, which came in at 41 cents a year ago, to climb to 47 cents a share. Walgreen blamed lower payments for popular generic drugs, coupled with higher expenses, for the downturn. Last quarter, for example, Walgreen said that it filled nearly three times as many prescriptions for simvastatin -- the generic version of blockbuster cholesterol drug Zocor -- as it did a year ago. But with prices for simvastatin falling, Walgreen explained, the company's actual gross profits for that drug remained virtually unchanged.
Meanwhile, Walgreen added, costs at its stores continued to rise. "Our expenses weren't in line with the level of reimbursements we were receiving," Walgreen CEO Jeffrey Rein admitted on Monday. "Managing both expenses and lower reimbursements on some generic drugs is my top priority. "We're going to fix this and, at the same time, continue our aggressive growth plan." But investors choked on Walgreen's results in the meantime. They sent the company's shares down to lows unseen since late last year. Medco fell 4% and CVS 5%. Even cautious industry analysts had to feel stunned. For example, Summers warned of only "modest downside earnings risk" in a preview of Walgreen's results last week. Specifically, he said that he felt "comfortable" with his below-consensus earnings projection of 46 cents a share at the time. "While gross margin should continue to benefit from the historic shift towards generics -- which peaked in 3Q07 -- more optimistic consensus estimates of 48 cents may be underestimating the cost structure underlying its continued expansion," Summers explained on Wednesday. "WAG has easily exceeded earnings expectations in the last three quarters, likely creating complacency amongst investors. This represents the first quarter this year where we see some earnings risk to expectations." Of course, nobody -- not even Summers with his Street-low forecast -- could foresee such a major miss. Thus, Summers stuck with his peer-perform rating on Walgreen despite his slight uneasiness about the company's upcoming report. His firm has noninvestment banking ties to the company.
Meanwhile, JPMorgan analyst Lisa Gill may have saved her followers some money with a timely downgrade of Walgreen last week. When cutting the stock from overweight to neutral on Tuesday, Gill said that Walgreen's "lofty" valuation left "no room for error" at the company. She seemed to be nudging investors toward CVS instead. "In our view, Walgreen's healthcare strategy is behind that of CVS-Caremark," wrote Gill, whose firm has investment banking ties to the latter. "If Walgreen wants to compete more effectively, it may need to make additional acquisitions -- an area in which this management team is not very experienced, therefore raising integration risk potential" going forward. But Walgreen's bombshell hurt its competitor as well. Shares of CVS-Caremark fell too, even as the company reaffirmed its own earnings guidance. Summers, for one, sees more pain ahead. "This is not quarter-specific and is not company-specific, in our opinion," Summers stressed on Monday. "This has been our general cautious thesis on the sector" all along.