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Analysis: Walgreens needs to invest in, enhance core retail offer

On the surface, Walgreens [Boots Alliance] has posted another good set of results with growth in both net sales and U.S. retail pharmacy revenue accelerating over the prior quarter. However, the headline numbers are mostly driven by a favorable foreign exchange movement and the acquisition of 1,932 Rite Aid stores. When these things are stripped out, performance is somewhat softer with comparable sales down 1.2% in the U.S. and 2.1% internationally.

On the bottom line, Walgreens also posted gains. Net income rose by a solid 15.8%, thanks in part to a lower tax provision. Operating income, which is not affected by tax code changes, also increased, albeit by a less impressive 5.5%. Looking ahead, we remain confident about the profit outlook as we believe the integration of Rite Aid will create opportunities for both synergistic cost savings and improved operating disciplines which will boost sales and margins. We expect these benefits to accrue between now and the end of 2020.

While the acquisition of Rite Aid stores is financially helpful, it only serves to mask some of the underlying and entrenched problems on the core retail side of the business. Within the U.S., core comparable retail sales, which exclude pharmacy, fell by 3.8% over the quarter. This is a deterioration over the prior quarter when sales dipped by 2.7%.

There are several reasons for the deterioration of front-of-store retail. These include Walgreens pulling back on a number of categories in a bid to improve profitability — something which we recognize as sensible and which has produced an uplift in gross margins. A decline in customer traffic in some locations where Walgreens are located has also been unhelpful. However, the main reason that sales declines haven't moderated is a lack of effort. We maintain our view that Walgreens could and should do much better in front of store retail.

In fairness, Walgreens has made some progress in beauty thanks to improved shop layouts, enhancements to ranges, and better in-store marketing. However, even here, there is something lackluster about the investments.

Indeed, the vast majority of Walgreens stores remain below par when compared to the beauty market as a whole. And despite the addition of some high-profile brands from the Boots side of the business, Walgreens consistently fails to match the retail growth of players like Ulta and Sephora.

Outside of beauty, the product mix and strategy is mediocre. Although there have been efforts to make a play for growth categories like food on the go, the impact here is piecemeal and inconsistent. In Walgreens' main store in Denver, a sushi bar and other enhancements create a compelling experience that draws shoppers in. However, this kind of development is rare and not reflected across most of the chain. In our view, until Walgreens significantly enhances and invests in its core retail offer, it is not going to drive its front-of-store business forward in any meaningful way.

The failure to develop the retail business has a long-term downside as anything that minimizes footfall could also ultimately impact pharmacy sales. This will become a much greater risk as mail order and online pharmacy fulfillment become more significant.

The lack of a compelling store offer could also be a disadvantage if and when CVS adds more health services to its own stores. In essence, Walgreens needs to move onto the front foot in terms of retail in order to defend and grow other parts of its business.
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