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Walgreens Boots Alliance Inc (NASDAQ: WBA) Q1 2020 Earnings Call Transcript

Final Transcript

Walgreens Boots Alliance Inc  (NASDAQ: WBA) Q1 2020 Earnings Conference Call

January 08, 2020

Corporate Participants:

Gerald Gradwell — Senior Vice President of Special Projects and Investor Relations

Stefano Pessina — Executive Vice Chairman and Chief Executive Officer

James Kehoe — Executive Vice President and Global Chief Financial Officer

Alex Gourlay — Co-Chief Operating Officer

Analysts:

Robert Jones — Goldman Sachs & Co. — Analyst

Eric Percher — Nephron Research LLC — Analyst

Elizabeth Anderson — Evercore ISI — Analyst

Lisa Gill — JP Morgan — Analyst

Soo Romanoff — Morningstar — Analyst

Eric Coldwell — Robert W. Baird & Co. — Analyst

Kevin Caliendo — UBS Investment Bank — Analyst

Michael Cherny — Bank of America Merrill Lynch — Analyst

Presentation:

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Walgreens Boots Alliance Inc. First Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions].

I would now like to hand the conference over to your speaker today Gerald Gradwell, Senior Vice President of Special Projects and Investor Relations. Please go ahead.

Gerald Gradwell — Senior Vice President of Special Projects and Investor Relations

Good morning, ladies and gentlemen and welcome to our first quarter earnings call. I am here today with Stefano Pessina, our Executive Vice Chairman and Chief Executive Officer of Walgreens Boots Alliance; James Kehoe, our Global Chief Financial Officer and Alex Gourlay, Co-Chief Operating Officer of Walgreens Boots Alliance and President of Walgreens.

Before I hand you over to Stefano to make some opening comments, I will, as usual, take you through the legal safe harbor and cautionary declarations. Certain statements and projections of future results made in this presentation constitute forward-looking statements that are based on our current market’s 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 the law, we undertake no obligation to update publicly any forward-looking statement after this presentation whether as a result of new information, future events, changes in assumptions or otherwise.

Please see our latest Form 10-K for a discussion of risk factors as they relate to forward-looking statements. In today’s presentation, we will use certain non-GAAP financial measures. We refer you to the appendix in the presentation materials available on our Investor Relations website for reconciliations to the most directly comparable GAAP financial measures and related information.

You will find a link to the webcast on our Investor Relations website at investor.walgreensbootsalliance.com. After the call, this presentation and webcast will be archived on the website for 12 months.

I will now hand you over to Stefano.

Stefano Pessina — Executive Vice Chairman and Chief Executive Officer

Thank you, Gerald and hello everyone. As you will see from our figures, it has been a slow start to the financial year with a competitive US pharmacy environment and soft trading conditions in the UK. That said, as you will hear, there are a number of items affecting the year-on-year comparisons and given the initiatives that we have underway, we are maintaining our full year guidance.

In the quarter, we continued to make progress against all four of our core strategic priorities. We are making progress in moving our data resources to a new and more flexible cloud-based infrastructure with a significant benefits that brings. We have also made a good progress with the development of new services to build on this new infrastructure to announce our customer experiences, make our teams more efficient and effective and open new opportunities for our businesses. Clearly, this work on the digitalization of our company must and are closely tie-in with our work to modernize our retail offering and the shape and structure of our retail footprint. At the same time, we are working with partners to redefine the delivery of healthcare in the community and the important role of pharmacy in the immediate and longer-term future. And all of these is of course supported and fueled by our Transformational Cost Management Program, which have made substantive progress during the quarter.

Finally, we have also continued to make progress on a number of significant partnerships, both established a new to enhance our offering and efficiency and towards the value growth in our businesses. In the quarter, we entered into a procurement joint venture with Kroger, building on the already strong relationship that has been formed between Kroger and Walgreens. And we announced a joint venture with McKesson to bring together our two businesses in Germany, improving our reach and scale with a focus on enhancing the efficiency and performance of whole [Phonetic] combined wholesale operation in the significant German pharmaceutical wholesale market.

I will come back to make a few comments on the future at the end of our presentation. But now, I will ask James and Alex to take us through the results in a little more detail. James?

James Kehoe — Executive Vice President and Global Chief Financial Officer

Thank you, Stefano and good morning. Adjusted EPS was $1.37, 5.7% lower than prior year on a constant currency basis. The year-on-year comparison was impacted by around 5 percentage points of adverse items including the year-on-year bonus impact. In Retail Pharmacy USA, strong cost management and improved retail comp sales were offset by lower gross margin. Retail Pharmacy International continued to be negatively impacted by a challenging UK market and we saw continued strong performance from Pharmaceutical Wholesale. Our Transformational Cost Management Program is very much on track and we expect to achieve annual cost savings in excess of $1.8 billion by 2022. Cash generation was very strong in the quarter with free cash flow of $674 million, $684 million better than prior year.

And finally, we are maintaining our guidance for fiscal year ’20 of flat adjusted earnings per share on a constant currency basis with a range of plus or minus 3%. Looking forward, we see improved core business trends with however some noise in the second quarter as we cycle through the timing of reimbursement payments and year-on-year bonus impacts. In total, these result in an expected EPS headwind of around 13%, but both of these items were budgeted in fiscal year ’20 and have no impact on full-year guidance.

Let’s now look in more detail on the results. First quarter sales were up 1.6% including a currency headwind of 0.7%. On a constant currency basis, sales were up 2.3%. Adjusted operating income declined 15.4% on a constant currency basis, reflecting lower gross margin in the US and a difficult UK market. Adjusted EPS was $1.37, a constant currency decline of 5.7%. Our share repurchase program contributed 4 percentage points of growth and an additional 5.7 percentage points came from a favorable tax rate as we benefited from a number of discrete items. The result included adverse items of over 5 percentage points, including the year-on-year bonus impact, mark-to-market adjustments and lapping prior year supplier funding. GAAP EPS declined 19.8% to $0.95 and also reflected costs relating to the Rite Aid transaction and the implementation of the Transformational Cost Management Program.

Now let’s move to Retail Pharmacy USA. Sales increased 1.6% in the quarter with 2.9% growth in pharmacy, partially offset by lower retail sales. Note that the sales growth includes a negative impact of 50 basis points due to our store optimization programs. Adjusted gross profit declined 4.9% due to lower pharmacy and retail gross profit. Adjusted SG&A spend decreased 1.6% in the quarter and was 17.6% of sales, an improvement of 0.6 percentage points versus prior year. The decline in SG&A clearly shows our strong execution against our Transformational Cost Management Program with savings more than offsetting incremental investments, the impact of inflation and the year-on-year bonus impact. Adjusted operating income declined 16.2% as the SG&A savings were not enough to offset the decline in gross profit and the adverse items I mentioned earlier. In total, these adverse items accounted for over 6 percentage points of the decline in operating income.

Now let’s look in more detail at Pharmacy. Total Pharmacy sales increased 2.9% versus prior year, reflecting continued brand inflation and script volume growth. Central specialty sales continue to grow nicely, up 9.3% versus prior year. Comp pharmacy sales were up 2.5% and comp scripts grew 2.8%. While this was weaker than expected, we have seen improved growth in recent weeks. Market share for the quarter was 20.9%, down 55 basis points versus prior year including the impact from our store optimization program. Adjusted gross profit decreased mid single digit, as the impact of procurement savings and script growth was more than offset by reimbursement pressure.

Turning next to our US Retail business. Total Retail sales declined 2.2% in the quarter, impacted by store optimization. Comp retail sales declined 0.5% and continued to show an improving trend. Excluding tobacco and e-cigarettes, comp sales were up 0.8%. As you know, we are exiting the sale of e-cigarettes. While this did not have a significant impact on comps this quarter, it will have a bigger impact from the next quarter onwards and we continue to anticipate a full year EPS impact of around $0.06. We saw a solid comp growth in our core categories with health and wellness up 3.3% and beauty up 2.5%. We estimate a tailwind of around 80 basis points from cough, cold, flu. Retail adjusted gross profit declined low single digits due to lower sales including the impact of store optimization programs, higher shrink and the timing of prior year supplier funding. Adjusted gross margin declined slightly, however, excluding the higher shrink and supplier funding timing underlying category margins were in line with prior year.

Turning next to Retail Pharmacy International. And as usual, I will talk to constant currency numbers. Sales decreased 2.7%, mainly due to the UK and Chile. Boots UK comp pharmacy sales increased 0.9% in the quarter, reflecting relatively higher NHS reimbursement levels and increased sales from services, partly offset by lower script volume. Boots UK comp retail sales declined 2.9%, as the UK High Street continued to be very challenging. However, overall, we held market share. Adjusted operating income was down 39.1%, mainly due to lower UK retail sales volume and margin. The results include an adverse impact of 13 percentage points from the year-on-year bonus impact and higher technology investments.

Turning now to the Pharmaceutical Wholesale division, which I’ll also discuss in constant currency. The Pharmaceutical Wholesale division delivered another strong quarter with sales up 8.3%, led by emerging markets and the UK. The change in the customer contract, which I’ve mentioned before, helped our UK performance contributing 1.4% to the overall sales growth. We have now lapped the impact of this contract change. Adjusted operating income increased 4.9%, reflecting strong revenue performance and a higher contribution from AmerisourceBergen. This strategic joint venture with McKesson aims to drive sustainable profitable growth in the largest pharmaceutical drug market in Europe by leveraging scale and improving efficiency. Mid-term, we expect the JV to be EPS accretive and to accelerate our Pharmaceutical Wholesale profit growth.

Turning next to cash flow. Operating cash flow was $1.1 billion, up $601 million versus prior year. Free cash flow was strong at $674 million, up $684 million on prior year. Our key working capital initiatives are on track. We are removing excess inventory from the system and we have started to extend payment terms to industry leading levels and we have a strong pipeline of initiatives to fuel our cash flow generation over a multiyear period.

Let’s turn now to our Transformational Cost Management Program. In October, we raised our annual cost savings target to in excess of $1.8 billion by fiscal 2022. We now have a very robust pipeline and our savings initiatives are gaining momentum. This gives us a much higher level of confidence that we can exceed $1.8 billion target. Importantly, these savings will allow us to fund the investments needed to create new and innovative business models.

Let me now give you some detail on our activities in the quarter. On smart spend, we are accelerating our energy management efficiency program and we see opportunities to ramp-up our procurement activities in goods not for resale. The Energy Management Program is interesting. ULED lighting saves money, is environmentally friendly and improves the store experience for consumers. This is a perfect example of save to invest to grow. On smart organization, we’re undertaking an end-to-end process review in Boots UK, covering all major business processes with the aim of transforming how we operate, ultimately leading to a lean and effective operating model. We are now actively planning the implementation of global business services and we have implemented the second wave of headquarter cost reductions in Mexico, Chile, and Thailand.

On divisional optimization, we have completed 114 of the 200 Walgreens store closures and 28 of the 200 Boots UK closures. We continue to test new store formats in the US and we’re now operating 23 small stores with encouraging results. On IT, we have started implementation of a new operating model and our vendor optimization work is progressing well. For example, we recently selected Tata Consulting Services as our new partner to accelerate the work on our critical pharmacy operating system. On digitalization, we have prioritized investments in mass personalization and reinventing the pharmacy prescription journey.

Now, I’ll hand over to Alex.

Alex Gourlay — Co-Chief Operating Officer

Thank you, James. I’ll now update you in some of the actions we’ve taken in the US during the quarter, starting with a retail offering. Our strategic partnership with Kroger is progressing well. The initial Kroger Express pilot in Northern Kentucky has been running for just over one year and the pilot in Knoxville, Tennessee for five months. We’ve seen very positive results so far with a strong sales list [Phonetic]. Building on the success of these pilots, we formed the group procurement office, retail procurement alliance with Kroger in December to purchase both of our private label goods. We expect this joint venture to deliver cost savings, encourage sourcing innovation and generate efficiencies across the supply chain. Our strategy of focusing on the higher margin health and wellness and beauty categories is delivering benefits and both delivered solid performances in the quarter. Our flagship No7 beauty brand performed well with sales up in the mid teens, reflecting nationwide advertising campaign in our new e-commerce site and we have introduced an enhanced skincare offering in over 900 stores, which we expect to drive future performance.

Moving on to healthcare. We have opened the second of five VillageMD primary care locations in Houston. Our wellness partnership with Jenny Craig is progressing well and we are on-track to open approximately 100 locations by the end of January. We’re also in the process of converting our optical pilots to the [Indecipherable] brand, which offers improved insurance coverage and stronger consumer brands.

In specialty, I’m delighted to see that all 300 community-based specialty pharmacies have received URAC accreditation and we continue to believe that our strong community-based presence alongside our central fill capability provides the best access for these important medications to our patients in the marketplace. In partnership with UnitedHealthcare, we continue to create new opportunities for growth in Medicare Advantage. We are very pleased with customer adoption of the new core branded Medicare Advantage product, we started selling from October 15th 2019. And finally, we are also opening 14 UnitedHealthcare patient resource centers, designed to help our customers navigate their insurance and healthcare needs within Walgreens stores.

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Turning next to digitalization. Our Find Care platform now has 32 healthcare service providers, spanning over 46 services. We continue to develop our patient medication adherence programs to deliver better clinical outcomes. Our Save A Trip Refills program now has 3 million patients signed up, an increase of over 25% since last quarter. Our consumers continue to demand the convenient omni-channel retail shopping experience. I’m pleased to say we had record breaking sales on walgreens.com on the Black Friday weekend, up over 45% versus the prior year and particularly strong performance in retail products [Indecipherable]. Overall, our omnichannel business continues to grow. Our Walgreens app has now been downloaded 60 million times, up 12% since last year. Around 33% of Walgreens retail refill scripts eligible for digital refill were entered via digital channels in the quarter, up almost 18% since last year. And we have increased our Balance Rewards members to 89.9 million. Finally, Walgreens digitally initiated sales reached over $3.7 billion in the quarter, up around 9% year-over-year.

Next I will update you on initiatives we’ve undertaken in Retail Pharmacy International, starting with the retail. In Boots UK, as you know, we’ve introduced our beauty reinvention program to 26 of our flagship beauty hauls in the second half of last year. I’m pleased to report that we’ve seen an improved performance in these stores in line with our expectations. Building on this, we rebalanced the retail space in 200 of our largest stores and have introduced 20 new beauty brands. Since the quarter-end, we have signed an exclusive UK franchise agreement with Mothercare, a British retailer and brand, specializing in products for mothers, babies, and children. We will be selling Mothercare branded goods across the UK and online.

Moving on to healthcare. Our purpose-built pharmacy operating system has been rolled out to over 1,400 Boots to UK stores, allowing our pharmacists to provide a greater level of customer service, even more efficiency and over-time a wider range of new pharmacy offerings. And we continue to develop new healthcare services with diagnostics where our pharmacists now have the ability to write prescriptions for certain conditions. I mentioned last quarter that we are developing new initiatives in digital healthcare with plans for expanding pharmacy services, to improve the customer journey and broaden access to healthcare. We launched our online pharmacy in May 2019, which has made solid progress in the markets. We have made further good progress on digitalization. Our online business, boots.com delivered strong growth with sales up 12% versus prior year in the quarter. We also saw a record-breaking Black Friday weekend with result in online sales, up around 25%. And finally, we have agreed an exclusive partnership to offer omnichannel photo and personalized gifting services in the UK and Ireland.

I’ll now hand you back to Stefano for his closing comments.

Stefano Pessina — Executive Vice Chairman and Chief Executive Officer

Thank you, Alex. As you have heard, this year has opened with a number of challenges. The main changes that are impacting the global healthcare sector are generating some difficult conditions for our businesses. As said, change always brings opportunity. We must act to meet the challenges and ensure we make the most of the opportunities we see. Seeing these opportunities and mindful of the challenges side, we are maintaining our full year guidance for the year. We continuously review our Group to ensure we have the right mix of businesses, to maximize our performance in a dynamic sector. Pursuing our strategic priorities is having a real impact in driving our businesses. The changes in our markets are obscuring some of the positive impacts we are having, but these will not be the case forever.

I have said before and I will say again. I strongly believe in an expanded role for pharmacy and in our company’s ability to play a significant part in shaping how healthcare is delivered in the community going forward. I believe these as much today as I ever have. I believe we have true financial strength as a business. As we have demonstrated this quarter, we have an extraordinary ability to generate strong and sustainable cash flow and we have many opportunities to deploy this cash flow to create real value. I remain convinced that we have in our company through our partnership an extraordinary foundation on which to build. The work that we are doing today is creating a strong and flexible engine of our growth in our businesses for many years to come.

Thank you. Now we will take your questions.

Questions and Answers:

Operator

[Operator Instructions] Your first question comes from the line of Robert Jones from Goldman Sachs. Your line is open.

Robert Jones — Goldman Sachs & Co. — Analyst

Great, thanks. Thanks for taking the question. I know there’s a lot of moving pieces and it’s only the first quarter, but if I just take a step back, clear EPS was down around 6% in the quarter, below the full fiscal year guidance, it sounds like, James, if I’m hearing you correctly next quarter given some of the moving pieces, it could see an even steeper decline in EPS. I guess if we think about the back half, could you maybe just give us the building blocks or the things that you guys have visibility into that gives you confidence that the back half can get you into that flat plus or minus 3% EPS for the year?

James Kehoe — Executive Vice President and Global Chief Financial Officer

Yeah. That’s an expected question, obviously. Let me just give you a little bit of context on the first quarter. However, first, I think the only real surprise we had in the first quarter was on the script volume, it did come in weaker than we expected. We were thinking of a number of around 4% and we come in at 2.8%, that’s the piece that — and I want to be clear. Our internal budget was $1.37 and we came in over budget. What we had was a favorability on tax, offsetting script growth in Q1. So that was the one thing we were disappointed on.

We had a lot of stuff we’re very happy about; so free cash flow was off the charts, we beat our internal budget by hundreds of millions, largely driven by programs we’re implementing in the US. As Stefano said in his comments, Transformational cost management program and that’s key to the answer to your question is, I will classify it right now is well ahead of track, particularly due to actions in the US and the U.K. Another items I’d highlight that shouldn’t be lost on you, we finally we have nailed one of the first steps in the Kroger relationship. We think it’s extremely positive that we have started up a GPO. And I think it will lead to many good things in the future. And then finally a strategic deal in a problematic German wholesale market, which we think will drive tremendous value longer term. So we think there was a lot of good things that happened and script growth was the one that was more challenging.

Let me give you a prospect of looking forward is — and actually we’re a little bit surprised as well. We’re seeing quite a strong momentum in the current month of December. So we believe when we call out 5 percentage points of items in the first quarter, we’re probably under-calling that, that were clear shifts between call at the Thanksgiving period, Christmas periods and I don’t want to give the precise number, but our script growth is in solid mid single-digit growth in the month of December. So we’re clearly feeling that we’re not really reading why the shifts are happening that well. We know cough, cold, flu is driving some of the buoyancy in December. So we are seeing signals, but we are counting on to hit our full year guidance. We do need or script growth to be in the 3.5% to 4% kind of, maybe 4.5% depending on the quarter. But right now in December, we’re seeing numbers in excess of that. So script growth is the key one. The other key one is that will drive increasing performance as we exit the year. Obviously, as you take out costs, the cost take-out is over the course of the year. So the savings roughly in the first quarter are around 15%. So of the total goal of — we haven’t given the numbers, a large number were less than 15% in Q1. As we exit the year, we will be up double the run rate of savings. So overheads will become a much more significant driver in the second half. And I do want to point out for that, for a company of our size with the amount of overheads we have, the total overheads were down 1.6% in the quarter. In the context — and I think it’s important to have the context, we did say that the combination of inflation and volume impacts is about $400 million, you have the bonus year-on-year that’s in the region of $350 million, $400 million and we have incremental investments of $100 million to $150 million. So it will give you some indication of the size of the cost management initiatives. And I think we’ll come back next quarter with probably more visibility on the potential further opportunity on the cost program, but I just finished answering your question, I think if you were to do your model again for the full year, we will probably have a slight favorability in taxes. So call it somewhat 0.6%, 0.7% on the full year and we will have more coming from overheads and probably slightly less coming from gross profit because we had a miss in the first quarter on scripts. So that’s why we feel it’s basically the overheads and some tax opportunity that we feel we can offset the call of the script under delivery in Q1.

Does that cover what you were looking for?

Robert Jones — Goldman Sachs & Co. — Analyst

That’s tremendously helpful. And I guess just one other probably anticipated question again. Just around the prime relationship in the wake of the Prime Express Cigna announcement. Just wanted to get any update on how you guys are viewing the Prime relationship, any impact of the Alliance or ex-JV just as we think about how that relationship played out for you this past year relative to your expectations or how it would contribute in 2020 would be helpful. Thank you.

Alex Gourlay — Co-Chief Operating Officer

Hi Bob, it’s Alex here. Yeah. We have re-contacted with Prime in a direct relationship. So Prime is now working with Express Scripts as a PBM working with us in a direct relationship, so we anticipate to hold our market share with Prime and potentially grow as a Prime model will be more competitive in a marketplace. So our relationship with Prime continues to be a very strong one and we continue to walk you very well with independent blues [Phonetic]. So we are happy with the situation. In terms of the impact, obviously we’ve readjusted the margin of debts, but it really was in forecast in budget. So we had expected this impact and had planned for it.

On AllianceRx side, AllianceRx actually is doing okay at the moment. But again, we have a great relationship with Prime. We are speaking to them, how do we adopt to an ever-changing specialty marketplace, which is becoming even more important for both of us. We expect to have conversations next year along these lines to improve that model further. So all is good from our point of view and we wish Prime success with their new model and in that work we feel very confident that we will benefit from that relationship in the future.

Robert Jones — Goldman Sachs & Co. — Analyst

Thank you.

Operator

Your next question comes from the line of Eric Percher from Nephron Research. Your line is open.

Eric Percher — Nephron Research LLC — Analyst

Thank you and thanks for the commentary on the cadence with respect to volume and cost. Maybe to hit on one other item, reimbursement and the impact on 1/1/20. I know you gave us a 13% number, I think was reimbursement and bonus, but can you provide a little bit more context on what the outlook is as we move from Q1 into Q2 on 1/1/20?

James Kehoe — Executive Vice President and Global Chief Financial Officer

Yeah. The 13% reference was to Q2 and we’re specifically highlighting two things in the quarter. And I would say it’s like 7% due to reimbursement timing and the other [Phonetic] is 6% is due to bonus year-on-year. And the reason we called out the Q2 reimbursement is, it really is a timing item, it’s a true-up of prior year contracts that occurs typically in the April, May, June timeline of the year. And as it happened in the prior year, there was no true-up. So it’s not really a reimbursement impact year-on-year in terms of increase in contract prices, it’s a contractual true-up of the contract for prior year and it’s quite a large number because it impacts 7 percentage points. We didn’t actually call out anything on Q1. What we said about Q1 is reimbursement was actually broadly in line with the plans we’ve put together, because if you recall when we gave guidance, we said at the time that — I think 58% or 60% of all of our contracts were already defined when we gave guidance, so we had fairly decent line of sight to the full year reimbursement. And we came within $20 million of the reimbursement estimate for the first quarter. So we were actually quite pleased with that because it’s quite difficult to forecast reimbursement. And you know we have looked back on some of our prior guidance on the quarters and the reason for giving something on Q2 just to highlight this exceptional reimbursement of timing true up. Right now as we sit, we have no reason to call any different outlook on reimbursement for the full year. We should presume that means plus or minus $50 million. So it’s — we were pleasantly surprised with the Q1 on that side. And I reiterate our issue on pharmacy in Q1, nothing to do with procurement, nothing to do with reimbursement, they were actually net, probably slightly positive, it was probably, it was all script volume. So it was just lighter than we would have planned it to be.

Eric Percher — Nephron Research LLC — Analyst

That’s really helpful. And reimbursement in the UK, it sounds like NHS funding did improve, but we didn’t see it in the revenue line. Was this simply the new contract or have you seen any makeover for the debt and the lack of payment last year?

Alex Gourlay — Co-Chief Operating Officer

So again there is really two stories here. Hi, it’s Alex here. One is, as you say there has been a stabilization of payment, which is in the marketplace can be seen on the NHS site. And secondly, we have taken some actions to reduce loss making services that we have in the UK and to make them more profitable. As a result of that we’ve lost some volume, not as much volume as we had expected to be honest, but some volume. And we’re quite pleased that with the retention of customers with these actions and that’s what’s caused a slight further decrease in terms of our revenue in the UK, it’s not reimbursement, it’s actions we’ve taken to reduce loss making services that we were offering.

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Eric Percher — Nephron Research LLC — Analyst

Thank you.

Operator

Your next question comes from the line of Elizabeth Anderson from Evercore. Your line is open.

Elizabeth Anderson — Evercore ISI — Analyst

Hi, good morning guys. A couple of times you mentioned or should have alluded to potentially a little bit of a change in competitive environment in the US Pharmacy or perhaps some pressure on or versus your expectations in the quarter in terms of script growth. Could you comment more broadly on sort of what you’re seeing there and sort of your thoughts on how that’s progressing?

Alex Gourlay — Co-Chief Operating Officer

Hi Elizabeth, it’s Alex here. I think as the consolidation in the market has really accelerated both vertically and horizontally, and as for example, the Prime Express deal is a good example of this. The PBMs are working more closely together. That’s clearly putting more pressure on the marketplace for better pricing and that’s really what we are alluding to. So we are working hard as James has said, as we always have done to mitigate that pressure through cost programs and through driving volume. As James is going to say very clearly, we were disappointed with the volume growth in Q1. Part of that was timing as James has said and part of that is because the fact that we lost some access to some particular, some Medicaid networks during the summer, that is rolling into this year. And, as we spoke to — I think it was the last quarter, we’re working — investigating obviously with Advanced Rx [Indecipherable] the opportunity for us to to become more efficient together and offer a new model in the Medicaid business. We recognize that we are under share there and we have to operate differently in that marketplace.

In Medicare, we continue to do very well with UnitedHealthcare. We’re really pleased with the relationship and the new MA plan as we’ve spoke to in the prepared comments has done well and we expect that will come through in the changes in January 1. Obviously, we are doing less, well, with the other a strong performer, which is Aetna Insurance. We have done really well and we are doing less, well, with them for maybe obvious reasons. But in the whole, we feel we are going to be there or thereabouts in Medicare.

Then in commercial, already said and replied previously, they will be very pleased to have renewed the contract with Prime, which again is a very important book of business for us in the commercial network. So I think that’s the picture from my point of view. And I don’t know if [Indecipherable] question Elizabeth that’s how we see it and all underpins the 3.5% to 4% volume growth that we expect to see in the full year.

Elizabeth Anderson — Evercore ISI — Analyst

Okay, perfect. That’s very helpful. Thank you.

Operator

Your next question comes from the line of Lisa Gill from JPMorgan. Your line is open.

Lisa Gill — JP Morgan — Analyst

Thanks very much. Good morning. I wanted to start with just some thoughts around branded inflation as well as generic procurement in the current market. As we think about the gross margins and how this will impact it, I’m just wondering, James, first, can you just talk about what’s in your current expectation and guidance?

James Kehoe — Executive Vice President and Global Chief Financial Officer

What we saw in — I’ll tell you what we’ve seen in Q1. We saw branded inflation of around 4% and we — most of the market read seem to be the inflation and this is on a constant mix basis, so like-for-like SKUs, deflation of around 4%. We would say that internally — on generics, sorry. And maybe I’ll ask Alex to weigh-in. And then two is we would be outperforming versus that 4% will probably be in mid-to-high single digit and we generally are projecting that kind of number going forward, somewhere in the mid-to-high single digit deflation mix adjustment, which is — it’s probably quarters will change versus market, but generally that’s what we’re seeing in the market and we’re delivering slightly better in terms of cost reduction in the P&L.

I don’t know Alex, if you want to add.

Alex Gourlay — Co-Chief Operating Officer

Yeah. I think the [Indecipherable] and we continue to feel very good about our global operation and we via attack [Phonetic] delivering just slightly beyond [Indecipherable] reductions in COGS, cost of goods. So that’s exactly what we are seeing.

James Kehoe — Executive Vice President and Global Chief Financial Officer

Yeah.

Alex Gourlay — Co-Chief Operating Officer

Yeah.

Lisa Gill — JP Morgan — Analyst

And then Alex, you talked about a number of healthcare initiatives and updates, a few of that you didn’t touched on today would be LabCorp, and Humana. One, on the LabCorp side, can you just talk about where you are today, are you on track? On the Humana side, any plans to expand? Can you talk about United on the Medicare Advantage side. I’m curious what you’re doing with Humana. And then just more broadly speaking, the strategic priority for expanding the role of pharmacy, as you know I’m a big believer in that as well. But with the reimbursement pressure, do you ever see that subsiding in any way where you can actually get ahead of that where you can start to change the paradigm and I know I’ve asked this for multiple years, but do you finally think that you can start to see that on the horizon as you start to have bigger and bigger relationships like north of 100 million lives now in the combination of Prime and Express, you think about large relationships like United?

Alex Gourlay — Co-Chief Operating Officer

So I think maybe start with the Humana questions. So we’ve opened-up preferred partners in primary care. It looks very good and is operating really well and the relationship between the pharmacist and doctors is really close. So we continue to feel really good about that, very small, but important test joint venture and of course, we’ve opened up two also with the clinical VillageMD which I’m sure you know, down in Houston will be five in total by the end of February. And again, we are very, very pleased with how that’s operating already. We’ve taken a small stake in that company, VillageMD as well, which we’re pleased to do and we see that partnership of the doctor and the pharmacist been fundamental to the future of community healthcare delivery going forward in core to our model on the lending lots about how we can do two things; take cost out the system together and get customers to understand and do the medications better and change the lifestyles. And so it’s really interesting walk and it points to maybe your last question. So that’s on the Humana.

On LabCorp, we’re bang on track in terms of number of service centers opened. I think we’ll have well over 100 in the ground by the end of this quarter. I think that’s really bang on track and they are performing well. We are seeing NPS scores and the usage of the centers all in or above our expectations, so we are very pleased with our program and we expect 600 and maybe more, we don’t know yet in the ground within the four years as we promised. And role of pharmacist, we are working really hard to get our new system in. As James spoke to in prepared remarks, we’re going to be accelerating that system from the current pace. That will be fundamental to be in the cloud, the date will be in the cloud, it will be fundamental to taking the work code out and freeing up our pharmacists to really drive that in future.

We’re seeing increased payments from certain insurers and PBMs, particularly in Medicare D. We really like working with United because they are stretching to this in terms of getting the payment, but the very clear on the goalposts that we have to hit to get the payment and we’ve been successful in achieving that. I do believe other insurance companies will follow their leads and the government eventually will also make sure that we have clear KPIs going forward as well. So, yeah, it’s a longer play for sure, but we are really committed to and we’re making more progress and appears right now than our numbers on and we continue to keep on pushing this to fundamental to pharmacy and fundamental we believe to a more efficient healthcare system in the US.

Lisa Gill — JP Morgan — Analyst

And then just for understanding that none of that is in your expectation for 2020. So I heard you say longer term a couple of times in this conversation, so should we anticipate that this could potentially impact fiscal 2021 or 2022. How do we just think about it from a timing perspective?

Alex Gourlay — Co-Chief Operating Officer

Yeah. We are already earning some money back, as you know the famous [Indecipherable] well. So we are earning more money back than we did previously and the amount of money available to us is growing and our ability to get that money grows as we get our systems in and of course, we’re also deploying pharmacy specific of pharmacists. I think we have about 150 Internet work who are specifically working to achieve these performance outcomes. So I think this will start to affect ’21 and ’22. It’s already given us some relief in ’20 as well. There is improved money in our forecast for performance networks.

Lisa Gill — JP Morgan — Analyst

Okay, great. Thank you for the comments.

Operator

Your next question comes from the line of Soo Romanoff from Morningstar. Your line is open.

Soo Romanoff — Morningstar — Analyst

Thank you for taking the question. The background you’ve given on a lot of initiatives have been great, perhaps maybe specialties become such a big component of your business. I mean is that, is that mix also impacting the margins as well?

James Kehoe — Executive Vice President and Global Chief Financial Officer

Yeah. We called that out in the quarter. It impact by about 50 basis points because it’s growing at high single-digit versus the pharmacy scripts of 2.8%, so it’s driving adverse mix of 50 basis points.

Soo Romanoff — Morningstar — Analyst

And I guess that makes sense. I mean, do the initiatives that you’re kind of putting in place help expand those margins or also provide kind of that long-term wellness and part of the healthcare transformation.

Alex Gourlay — Co-Chief Operating Officer

Yeah. Absolutely, Soo. I mean, we strongly believe in having a community presence and as you know, we have two models. We have one, which of course to the doctors who are practicing and specialty for example in oncology and then we have pharmacies inside of their hospitals and sort of healthcare systems. We have 300 plus of these and we’ve now got URAC accreditation for them all. So every single pharmacy that we run in the community, which is very unusual I believe will be fast to achieve this has got that accreditation. That means more attractive to the manufacturers, because they know that we will take full care of the patient and more and more patients are living longer with diseases in communities. So we believe the local model that will become important to the future of healthcare delivery and always be a central fill model, I’m sure, but we believe the local model will become more and more important.

Also, we announced our relationship with Shields. Shields as a variance, I think platform that’s working with healthcare systems and we have a lot of relationships with healthcare systems as you know to make sure as patients leave hospitals, they maintain themselves on the drugs, being dispensed primarily by the hospital pharmacy. So again, we are investing both in technology with Shields and also [Indecipherable] as well in terms of data and tracking customers and low community pharmacies to make sure pharmacist can actually take care of these customers as it lifts and more often a home and we’re also of course working closely with Prime as we said already to make sure that we have a really efficient and effective central model.

And most importantly of all we have, outstanding relationships with the manufacturers, it’s really driven, both through our relationship with AmerisourceBergen and also the Ornella with her team at global level to make sure that we have the very best relationships. So while these manufacturers are bringing these new and unique products to the markets and we feel as a global partner we can apply our capabilities for them in the US market through our relationship.

Operator

Your next question comes from the line of Eric Coldwell from Baird. Your line is open.

Eric Coldwell — Robert W. Baird & Co. — Analyst

Thank you very much. I know it’s difficult to parse this out with the store closings in the UK as well as the shift to more services from volume perhaps, but could you give us a clear sense on the impact of the NHS reimbursement scheme change either quarter-over-quarter or year-over-year. And then how did that really stack up compared to your expectations. It sounds okay, but I’d like to get a little more detail on that in terms of not only the quarter-over-quarter, but also how that progresses through the next few quarters. Thank you.

Alex Gourlay — Co-Chief Operating Officer

Sure. Yeah, I know. It’s Alex here. No, it was exactly as we expected. So the quarter for pharmacy both in volume as I said already were slightly below or on the market in terms of underlying business, but we gave up some scripts because of some unprofitable services. In terms of margin, exactly as we had expected. This tracking too as we expected. So it’s relatively easy to track this because the government resigned the five year contract with the industry through what’s called the PSNC, which represents all pharmacies in the UK as a one contract. So we can track this quite carefully. It does vary sometimes from from quarter-to-quarter, but it’s trued up in a way which is transparent. So we feel very confident that we’ve got a good line of sight to this. We feel very confident that we are working operationally very well in the UK and we have additional piece of work there, which is called pharmacy of the future, an idea really is to transform the operating model for pharmacy in the UK. This will take some time of course. We’ve already marked that investment, we are investing strongly in a new farm system, we’ve rolled out 1,400 which is well over half of the [Indecipherable] state and it’s now present all the home countries including Scotland most recently. So again we are feeling pretty good about the visibility. We’re not feeling as good about the profitability of pharmacy. We believe that that needs to improved further, so that we can reinvest back in community pharmacy properly in the years ahead. But we are very committed to getting that operating model understood and changed over-time.

Also Read:  Kroger Co. (KR) Q2 2020 Earnings Call Transcript

James Kehoe — Executive Vice President and Global Chief Financial Officer

Yeah. If you want to characterize the euro of prior year, it was a tough year for pharmacy where there were a lot of untime impacts coming from NHS funding, and there will be a general euro recovery from that. It was surprising. We were within $500,000 of the gross profit targets for pharmacy in the UK, it was bang on target. We are looking at a fairly sizable improvement in gross profit in the business this year. So as Alex mentioned earlier in his comments, we have some marginal profitability businesses on the sidelines and we’re aggressively driving the improvement of those. So don’t be surprised if you see script volumes and market share going down slightly. We’re addressing the profitability of sub categories that we don’t think are strategic to the company and we definitely don’t want to be in marginal profitability positions. So a bit of a shift in the orientation in the business, slightly more to profitability. So as your modeling is out, don’t get fixated by script declines because the core business is actually quite solid and solid in the quarter.

Eric Coldwell — Robert W. Baird & Co. — Analyst

Yeah. Got it. Thank you very much.

James Kehoe — Executive Vice President and Global Chief Financial Officer

And just one point on the UK though as we go through it. We did have a rough quarter in retail and it really does come down to the market and our share of the — whole share overall quite interestingly though we’ve seen in the last couple of weeks and it’s maybe a little bit important as you think through your modeling. We had a rough quarter, not 40% decline, now there was a lot of one-time items in there, probably half of that was one-time adverse items just generally, but as you think through this, we saw a very, very strong Christmas period. There are huge phasing on, mainly of our primary markets. The whole December month started out extremely slow. The second last week of the month was extremely strong with high-single digit revenue growth. And in the last week of the year, we again have mid to high single-digit growth across our key categories and we’re still getting in on bisecting just what happened, but December performance is quite a bit more positive than the quarter we just came out of. And the double surprise was it was achieved with higher margins than the prior year. So we’re rebalancing the commercial approach in the UK and we’re not chasing volume at any cost and surprisingly we’re seeing better volumes and we’re seeing better margins. Now it’s only two weeks, so it’s too early to churn success, but we’ve seen a better performance across December across the entire the main two markets, actually both businesses have done quite well in the Christmas period, very well actually.

Operator

Your next question comes from the line of Kevin Caliendo from UBS. Your line is open.

Kevin Caliendo — UBS Investment Bank — Analyst

Hi, thanks for taking my call. You mentioned you had 60% of your PBM contract set when you gave guidance and now you’ve renewed Prime. What remains outstanding and how much variance is there really at this point? Could there be an reimbursements as we look out over the rest of the year?

Alex Gourlay — Co-Chief Operating Officer

Hi Kevin, it’s Alex here. Firstly, I mean there’ll be some small net works which can change mid year for sure, but the vast majority now is contracted, the vast majority. I can’t give a precise number, but I will always give you an estimate, it will over 90, because the consolidation market is very clear. And yeah, so that’s where we are. But so we feel we have good line of state in this fiscal year and again we will start negotiating the majority of the Med D contracts as we move through the summer months, but that will be before starting January 1st 2021.

Kevin Caliendo — UBS Investment Bank — Analyst

And the renewal Prime that takes you through, is it more than a one-year contract, meaning like the Express relationship won’t have any impact on that at all going forward?

Alex Gourlay — Co-Chief Operating Officer

That’s right. I mean, we don’t disclose the length of the contracts, but this is a multi-year deal, typical of a longish commercial contract.

Kevin Caliendo — UBS Investment Bank — Analyst

Got it. And one last one. Have you guys looked at the OECD proposals around multinational corporation tax rules. They are obviously still just proposals, but wondering if they were implemented, but will it any way impact Walgreens or WBAD or anything like that?

Stefano Pessina — Executive Vice Chairman and Chief Executive Officer

We have I would say quite expert tax group and they are extremely active, they are all over this.think you have to wait till dust settles on these things, but we would obviously realign the corporate structure according to new legislation as it comes along. We think that we — that’s in a — it’s in the right location. It delivers attractive tax positions, but it’s all vetted and approved by all jurisdictions globally and it’s in line with current policy. As policies change globally, we will adapt to the policies, but we have an attractive tax rate compared to our peer set by quite a number of percentage points and we’ll try and maintain that as much as possible, but you can be sure the team is all over this and we don’t see any short-term risks.

Kevin Caliendo — UBS Investment Bank — Analyst

Great. Thanks so much. That’s really helpful.

Operator

Our last question comes from Michael Cherny from Bank of America. Your line is open.

Michael Cherny — Bank of America Merrill Lynch — Analyst

Thanks for squeezing me in here. So I want to tie back I guess a big picture question. At the beginning you talked about the broader strategy you’re taking, I know you mentioned the role of pharmacy going forward, you’ve highlighted a number of the various different partnerships. I guess as you think about the next call or rest of this fiscal year two, three years, what are some of the checkpoints you’re looking for relative to the partnership model, relative to the strategy, relative to the EBIT contribution from all of these to essentially declare success or if some of them are going to kind of cut bait. And how does that play into the broader on thought process around the organization and the role and where you sit in the market on a go-forward basis given as well but you’re also going through a pretty broad restructuring about the cost base and the store footprint.

Alex Gourlay — Co-Chief Operating Officer

Thanks, Michael. Yeah. It’s Alex here. So I think if we start with our key [Phonetic] priorities and they know that they start with managing of the drug store and new retail offerings. But probably more advanced with the Kroger relationship and the reason why that’s quite important is because it allows us to do two things, allows us to walk with them on the convenience model, which is really important to drive footfall into our physical stores and also really important from a consumer point of view, the definition of convenience is such a big change in the marketplace. So we are feeling really good about that. I said in my prepared remarks, we are seeing substantial sales growth both in the box itself and also in the categories that we are supporting. We’ve also launched our own products. I think we’ve got — we’re going to have them in the [Indecipherable] just over 15, 16, 17 Kroger stores so that for this gives us an opportunity to put our health and beauty composition and private label on brands into their customers views as well.

And then lastly, when you put together the two customer sets, we serve together around about 20 million customers a day between us. So we have a strong, strong presence in American households and our ability therefore to work with them being the the genuine [Indecipherable] part of America and those being very, very competent, we believe in pharmacy health and to some extent beauty category as it relates to healthcare and wellness. We believe that’s going to be a strong opportunity. The procurement structure allows us to earn money in the short to medium term. And of course we will be working together on other issues in the supply chain and also in other issues on procurement we believe as well in the future. So that’s one area where I think we have made good progress both tactically and strategically.

With healthcare, we are well into testing quality brands and quality offers in partnership with others, sort of the acceleration of our lessons learned and optical is one example of it. We are working with GrandVision who are renowned as a quality optical retailer with access to insurance and the very best brands. We really are delighted to get more opportunities to be doctors into our stores alongside pharmacists and we believe that, well, that will be a longer-term model. We know from experience in Europe that that model can be really effective in delivering end-to-end primary care in communities.

And last but not least into the Find Care platform that we have built very quietly with an internal team has really grown and we believe that will be a digital marketplace that will become very important to us into the market in the future, but will take time to grow. So that’s really where we are in terms of that measure. So we expect some contribution over-time in the retail side faster than the contribution maybe in the healthcare side but the healthcare side will come through the hill [Phonetic] of scripts over-time and the access to more.

James Kehoe — Executive Vice President and Global Chief Financial Officer

And maybe one we didn’t get this question, but progress on digitalization in the quarter. We’ve just launched two major initiatives launched and funded. I want to kind of go back to the previous guidance we gave. We’ve got $500 million of capital expenditures behind digital and development plus about $100 million to $150 million of expense this year and we launched two big initiatives in the last account. One is on mass personalization. And that’s how do you use your marketing dollars more effectively to target a better connection with the consumer. We believe we will significantly underpin particularly the retail revenue profile for a multi-year period. And these are not small investments, they are in the $50 million to $100 million range. And the second one is the, the prescription journey and I use that one very generically, but again it’s a similar size of investment and it’s on a two-speed, we’re not waiting for the core systems to be upgraded, it’s on a parallel process and this is a 2-ish journey and what’s it going to do what’s going to connect the consumer much more closely with the prescription, how they want to deliver, how they want to pay for it, the transparency of the cost of it and the options we give consumers and getting closer to consumers. And the second thing it will do it will take friction out of the system, which means it will reduce the cost to fill a prescription. So we’re working on initiatives that don’t just boost — take out costs, but they actually boost revenue and the connectivity to patients and consumers longer term and some of that will be lost, these investments are large and they’re multi-year and they will also drive long-term revenue and sustainable growth.

Michael Cherny — Bank of America Merrill Lynch — Analyst

And I guess just quickly, how do you balance all of those investments in long-term initiatives against some of the quarterly volatility and reimbursement risks and the moving pieces on the transformational cost program that you see?

Stefano Pessina — Executive Vice Chairman and Chief Executive Officer

It’s tough.

Alex Gourlay — Co-Chief Operating Officer

It’s not easy. But we have our program management approach. We have got a lot of cable people but it’s not easy in every — but we are paying a lot of attention to the future and to today as you can tell by the comments that James have made.

James Kehoe — Executive Vice President and Global Chief Financial Officer

A lot of these funds go through the Transformational Cost Management Program and Alex, myself and Ornella and Head of HR sit on it. We are the four people on it. So it’s a small team, takes decisions quickly and frankly some of these are tough trade-offs and in some quarters you theoretically can’t afford it, but you have to do it or otherwise you’re going to damage the long-term future of the company.

Stefano Pessina — Executive Vice Chairman and Chief Executive Officer

And this is the problem. It’s Stefano. Yes. Every strategy — our strategy is as it has always been a medium long-term strategy. And we believe in the pharmacy. We believe in the hold that the pharmacies will have in future. Of course, the pharmacy will have to be able to satisfy the needs of the patients and the needs of the customers and we are working in that direction. Not all the pharmacies will provide in future, not all the pharmacies will be important in the local economy of the city or the villages. We try to be in pharmacy that can have a whole and of course we have to invest. We had to invest now for the future. If we work just for the next quarter maybe we will have a little better results, but at the end, we will probably create a problem over the long survival of our stores of our pharmacies. And now you have to take a decision. Either you believe in the strategy, which is focused on the long term or you just try to look at the next quarters and maybe you try to do deals just to let’s say make easier over less evidence the problems that you have. We have decided to work for the long term. And I hope that at the end, we would be right.

Operator

There are no further questions at this time. I turn the call back over to the presenters.

Gerald Gradwell — Senior Vice President of Special Projects and Investor Relations

Thank you very much indeed. Thank you. I know that Not everyone that want to ask question got to ask the question but as ever the IR team are here and we’ll take your calls during the course tomorrow and the rest of the week and we look forward to speaking to you all again next quarter. Thank you very much indeed.

Operator

[Operator Closing Remarks]

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