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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Ladies and gentlemen, thank you for standing by and welcome to the Walgreens Boots Alliance Fourth Quarter 2019 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] Please be advised that today's conference is being recorded. [Operator Instructions]
I would now like to hand the conference over to your speaker today, Gerald Gradwell. Please go ahead.
Good morning, ladies and gentlemen and welcome to our fourth quarter earnings call. I'm 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, 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 and 10-Q 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'll 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.
Thank you, Gerald, and hello, everyone. Today I am pleased to report that we delivered quarterly results broadly in line with our expectation. In doing so, we closed our financial year roughly flat year-on-year, which is again in line with the expectation we set in April. That said, it has not been an easy task for us to recover from a very difficult second quarter and there has been a lot of hard work done by our team to deliver these results over the past two quarters.
We have continued to make progress against our four strategic priorities: accelerating the digitalization of our company in terms of the way we use technology to help us run our businesses more efficiently and effectively and more importantly to announce and transform the products and services that we offer our patients and customers and in the way we deliver those services; transforming and restructuring our retail offering, making sure we provide our customers what they want in the way they want; and using the strength of our extraordinary local presence as an asset to support and reach a modern multichannel tailored and far more focused responsive and interactive retail experience; and creating within our store a network of health care destination, backed by our digital investments, providing both services and support.
This will announce our goal as a co-provider of healthcare to the communities we serve and a highly effective and efficient resource for patients and payers alike. And, of course, to support all of these and to deliver the changes we need to structure our company, in a market that constantly demands evermore responsiveness and efficiency we are delivering on our Transformational Cost Management Program.
It is important to make that point. This is about transformation for us, both driving out costs and reinvesting in the business, to help fund the investments that we need to make to deliver our strategic priorities. This program is truly about saving to invest for growth.
Our teams have worked hard on the development of this strategy and are working just as hard on their delivery. We have identified an excellent group of partners that bring our skills, experience and resources to deliver our goal better, more effectively and more efficiently then we could do alone.
We are transforming not just our businesses, but our business model to deliver future growth. We have been very clear in our current expectation for the financial year ahead. James will cover them in detail as part of this financial review.
Looking forward to 2020, we expect adjusted earning per share to be roughly flat on a constant-currency basis. Excluding the impact of the 2019 bonus headwind, we would expect mid-single-digit adjusted earning per share growth. And looking forward, we see a clear line to sustainable profitable growth, driven by the work we are doing and the investments we are making.
I will now hand over to James and Alex to take you through today's earnings and update and we'll come back to take your questions at the end. James?
Thank you, Stefano, and good morning, everyone. Today's results are broadly in line with our expectations. Adjusted EPS was $1.43 in the fourth quarter, 2.9% lower than the prior year on a constant-currency basis. Fiscal year adjusted EPS was $5.99, up 0.5% in constant currencies and in line with our guidance.
We are encouraged by improved U.S. comparable sales and adjusted gross profit margin performance in the second half of the year.
Retail Pharmacy International, continued to be impacted by a challenging U.K. market, whereas the Pharmaceutical Wholesale division, delivered another strong performance. Our Transformational Cost Management Program is very much on track. And with rising visibility on cost savings, we are raising our annual savings target to at least $1.8 billion by fiscal 2022.
Let's now look in more detail at the full year results. Full year sales increased 4.1% versus prior year. On a constant-currency basis, sales growth was 5.8%, reflecting good performance from both Retail Pharmacy USA and Pharmaceutical Wholesale. Adjusted operating income declined 9.6% or 8.6% on a constant-currency basis, mainly due to Retail Pharmacy USA and Boots U.K., partially offset by Pharmaceutical Wholesale.
Adjusted EPS was $5.99, up 0.5% on a constant-currency basis. Share repurchases contributed 4.9 percentage points, with tax adding 4.1 percentage points. These were partially offset by the 3.6 percentage points of adjusted EPS headwinds that are shown on the slide.
GAAP operating income declined 20.5%, including $477 million of expenses, relating to the implementation of our Transformational Cost Management Program and as we mentioned last quarter, $114 million relating to our share of AmerisourceBergen's impairment of pharMEDium. In total, these two adjustments account for almost 50% of the year-on-year decline.
In the fourth quarter, sales were up 2.6% on a constant-currency basis, reflecting solid growth in our Retail Pharmacy USA division and a strong performance in Pharmaceutical Wholesale. Adjusted operating income declined 11.9% or 11.1% on a constant-currency basis. Adjusted EPS was $1.43 and constant-currency decline of 2.9%. 5% of growth came from our share repurchase program and another 7% from tax.
However, these were entirely offset by over 12 percentage points of headwinds, as we increased investments and we lapped one-time benefits in the fourth quarter of 2018, including a postretirement curtailment gain and a previously disclosed adjustment to legal accruals and settlements. GAAP EPS declined 51.4% to $0.75 per share. Just over half of this decline was due to two factors, a prior-year gain on the sale of Premise Health and the implementation of our Transformational Cost Management Program.
Now, let's move to Retail Pharmacy USA. Sales increased 2.1% in the fourth quarter, reflecting 4.2% growth in pharmacy. Full year sales advanced 6.2%, reflecting the acquired Rite Aid stores and organic sales growth of 3%. Adjusted gross profit declined 1.1% in the quarter, with a decline in retail, partially offset by higher, pharmacy gross profit.
Adjusted SG&A spend increased 2.1% in the quarter, entirely due to higher investments and the prior year one-time adjustment associated with previously disclosed legal accruals and settlements. Adjusted operating income declined 12.2% in the quarter and 9.6% full year. The quarter was held back by 9.4 percentage points of headwinds from higher investments and a one-time benefit in the prior year. Excluding these factors, the decline was low single digit.
Now let's look in more detail at pharmacy. Total pharmacy sales increased 4.2% in the quarter and 8.6% for the year. Growth in the quarter reflected higher brand inflation and prescription volume growth, along with growth in central specialty, which grew 7.8% in the quarter and over 20% for the year. Comp pharmacy sales increased 5.4% in the quarter and 4% for the year. Comp prescriptions grew 3.3% in the quarter and 3% for the year. The trend is improving, with comp scripts up 4% in the second half versus 1.9% in the first half.
As you will recall, we had some network headwinds in the first half, which we've now lapped. Market share was 21% in the quarter, down 55 basis points versus prior year, mainly due to the store optimization program. For the full year, market share increased 35 basis points to 21.3%.
Pharmacy-adjusted gross profit increased in the quarter, with script growth and procurement savings helping to mitigate reimbursement pressure. For the full year, pharmacy-adjusted gross profit was down slightly. Fourth quarter adjusted gross margin was 65 basis points lower than last year, including a 40 basis point mix impact from specialty.
Turning next to our U.S. Retail business. Total retail sales declined 3.9% in the quarter, impacted by store optimization. Comp retail sales declined 1.2% and excluding tobacco, comp sales were up 0.5%. Full year comp sales declined 2.4% with 1.6 percentage points due to tobacco.
Looking at the second half versus the first half. Second half comp sales were down 1.1% compared with a decline of 3.5% in the first half. Retail-adjusted gross profit declined in the quarter, mostly due to lower reported sales, which were negatively impacted by our store optimization program. We did say last quarter that we expected to see improved retail-adjusted gross margin in the fourth quarter, and I'm pleased to report that adjusted gross margin increased 35 basis points. Full year adjusted gross margin was down 20 basis points, as we adjusted promotional spend in the earlier part of the year.
Turning next to Retail Pharmacy International. And as usual, I'll talk to constant currency numbers. Boots U.K. comp pharmacy sales declined 2% in the quarter and 1.6% in the year, reflecting lower script volume and a lower NHS funding level, due to timing shift between years.
Boots U.K. comp retail sales declined 3.1% in the quarter and 2.6% in the year, as the U.K. market continued to be very challenging. However, we held share in a declining U.K. market with good share performance in beauty. Adjusted operating income was down 20.7% in the quarter and down 16.2% in the year, mainly due to weak retail sales and pressure on retail and pharmacy margins in the U.K.
Turning now to the Pharmaceutical Wholesale division, which I'll also discuss in constant currency. Our Pharmaceutical Wholesale division delivered another strong quarter with sales up 7.9% led by emerging markets and the U.K. In part, our U.K. performance was aided by a customer contract change which contributed 2.3% of revenue growth.
Fourth quarter adjusted operating income increased 6.9% reflecting strong revenue performance and higher earnings from AmerisourceBergen. Full year sales increased 8% and adjusted operating income increased 5.9% versus prior year.
Turning next to cash flow. Full year operating cash flow was $5.6 billion and free cash flow was $3.9 billion. Our free cash flow was impacted by some fairly large exceptional items and we have covered these on previous calls. Excluding these exceptional items our 2019 free cash flow was around $5.2 billion.
I'll now hand over to Alex.
Thank you, James. I'm going to update you on our initiatives in the U.K. and the U.S. starting with Boots U.K. Last quarter we talked about a number of initiatives to transform our retail offering, develop healthier services and accelerate digitalization in the U.K. We've introduced new beauty hauls in 26 key locations and we've opened up flagship stores in Covent Garden, London and more recently in Meadowhall, Sheffield.
We're also encouraged by our new brand introductions. 18 new beauty brands were introduced to key stores in the year and a further 17 in September. We're developing new initiatives in digital health care with plans for expanding pharmacy services to improve the customer journey and broaden access to health care.
We launched our online pharmacy in May 2019, which we've expanded to include repeat prescriptions. We've digitalized the Boots Advantage Card with an app now integrated across our all our main customer platforms. And importantly, boots.com performed well with sales up 14.4% in the year and 18.4% in the fourth quarter.
As James mentioned, we continue to take actions to address our U.K. cost base. In February, we announced our intention to reduce Boots' head office costs by 20%. This program has now been completed and the savings will come through in fiscal year 2020.
In June, we announced a store optimization program that will impact around 200 Boots locations, reduce the store count by 18 stores by the end of the fiscal year and they're on track to consolidate the remainder by the end of 2020. We have also generated cost reductions through simplification of our care home operations and the supply chain.
Turning now to our strategic initiatives in the U.S. We have made significant progress on our four strategic priorities during the year. Let me start with a retail offering, where we focus on delivering health, wellness, beauty and convenience both in-store and online. We remain very pleased about our strategic partnership with Kroger.
In August, we announced the expansion of our store pilot to new test locations in Knoxville, Tennessee. The Kroger Express concept will be available in 50 Walgreens stores and their own health and beauty brands will be available to customers in 17 Kroger stores.
We are extending our nationwide offering with FedEx. A new customer return system is being introduced to Walgreens stores before the holiday season giving customers an easier returning service for unwanted goods for Walgreens and other selected retailers. We continue to look for solutions for the last mile building on our presence in the community.
We have recently announced our first-of-a-kind partnership with Wing to test on-demand drawing delivery, joining up with our previously announced trial with FedEx for robot delivery. We continue to make progress in health and beauty. We have seen strong progress in the U.S. with No7 skincare and we're expanding the distribution of No7 skin care in Walgreens in the months ahead. And last month, we launched a stand-alone No7 website, No7beauty.com, alongside of national U.S. TV campaign.
Turning next to health care. We're strongly focused on creating neighborhood health destinations around a more modern pharmacy. We have made significant steps during the year to develop our primary care business. Our model is based on physicians and clinical pharmacists and we'll have primary care locations in four markets across the U.S., working in partnership with partners in primary care, VillageMD and Southwest Medical an Optum Company.
We also have plans to develop a new wellness partnership in our stores and I'm delighted to see that we've recently signed a new agreement with Jenny Craig, a health and weight loss management company to open centers in around 100 Walgreens locations by early 2020.
We have been interviewing our nurse practitioner clinic model. And we've taken a decision to exit our wholly-owned loss-making clinics, but we will continue to work with our local health system partners, who are running successful clinics in 217 Walgreens locations. We now have a network of 15 partners and we recently signed a new agreement with TriHealth to add further seven clinics.
Our collaboration with LabCorp is well on track. We're aiming to open at least 600 LabCorp patient centers across the U.S. providing diagnostic lab testing in the community. We opened 21 centers in the fourth quarter, taking the total to 58.
We've also expanded our reach in specialty, making an equity investment in specialty provider Shields Health Solutions. We are an important partner for peers anchored by a national network of local community pharmacies. And we continue to drive better clinical outcomes through patient medication adherence programs, such as Save a Trip Refills which already has over 2.7 million patients signed up as we aim to lower the cost of care.
As you've seen we've announced a strategic partnership with Centene, a leading Medicaid insurer and RxAdvance, a cloud-based pharmacy benefit manager. And we recently signed a multi-year Medicare agreement with UnitedHealthcare, including a new co-branded Medicare Advantage plan with Walgreens being the only preferred Retail Pharmacy.
Turning next to digitalization. Our partnership with Microsoft signed in January is essential to driving our technology strategy and a cloud migration program is on plan. We have expanded the Find Care platform available on walgreens.com to include new strategic partners and offerings and now has 30 healthcare providers and over 40 services. And we're making good progress in our existing omni-channel business.
Our Walgreens app has been downloaded 58.9 million times, up 11.8% since last year and around 26% of Walgreens retail refill scripts were initiated through digital channels in the quarter, up 14% since last year. And we also have increased our active Balance Rewards members to 89.7 million. Finally, we're also really pleased to report that Walgreens' digitally-initiated sales reached over $15 billion in the year, up around 25% on last year.
Now back to James.
Thank you, Alex. I'll now update you on our Transformational Cost Management Program. While we're making strong progress, in April, we announced we were targeting annual cost savings in excess of $1.5 billion by fiscal 2022. We now have a clearer line of sight to multiple cost saving initiatives over a multi-year period and this gives us the confidence to increase our target.
We are now raising the annual cost savings target to in excess of $1.8 billion by fiscal 2022. Additionally, we are rolling working capital programs into the cost management program governance and we see meaningful opportunity to reduce working capital investments over the coming years.
Regarding implementation costs, our estimates are unchanged versus the 8-K we filed on August 6. We continue to estimate that the program will result in cumulative GAAP pre-tax charges of approximately $1.9 billion to $2.4 billion. And we recently rebranded the cost management program internally.
It's now called Save to Invest to Grow. This emphasizes that we must not only reduce costs to become the leanest operator, but we must also save more to generate the investment dollars needed to fuel long-term capabilities and growth.
Let me give you a quick update on some of the actions taken in the quarter. On smart spend we've started making policy changes. For example, we are changing how we manage the external consultants, mandating competitive bidding, and making the contracts more outcome-based.
On smart organization, last week we made select reductions in the U.S. support office and additional restructuring is underway in our Retail Pharmacy International and Pharmaceutical Wholesale divisions. We are also working hard to define our new vision and road map for business services. We have completed the review of our real estate footprint and the actions are well underway in both the U.S. and the U.K. And dedicated teams are working hard against our biggest programs, particularly pharmacy costs to fill and shrink. We've reorganized our global digital and IT leadership under a new chief information officer to improve execution and focus. We've also defined a new operating model for our day-to-day IT operations and we've refocused our IT and digital spent to our growth priorities.
Now, let's turn to 2020. Let me start by providing some key assumptions for the upcoming year. We are projecting a full year adjusted effective tax rate of around 17% and this may vary depending on the level of discrete items in the year. This will reduce adjusted EPS growth by approximately two percentage points as we lap an exceptionally low tax rate in fiscal 2019. We anticipate full year share repurchases of $1.75 billion. While this is lower than the $3.8 billion of repurchases in fiscal 2019, it is entirely consistent with our prior indications.
Share repurchases should contribute around 3.5% to adjusted EPS growth. Within the guidance, we are investing heavily to transform WBA, including modernizing and upgrading our core foundational pharmacy systems and implementing SAP in the U.S. We are also investing in new digital capabilities and we have fully funded the multiple pilots that are ongoing across health care and retail.
In fiscal year 2020, we expect to invest $800 million to $850 million, an increase of $250 million to $300 million over the prior year.
In terms of operating expenses, we expect to invest $300 million to $350 million in 2020 a year-on-year increase of $100 million to $150 million. Looking specifically at capital expenditures, we anticipate investing around $500 million in fiscal 2020 and this comes on top of $350 million in fiscal 2019. In summary, we are investing strategically to modernize and transform our capabilities to drive future growth.
Finally, while we don't provide currency guidance, we have provided our internal currency rates in the appendix. As you will see these assumptions are quite dated and at the time suggest that we could face a negative year-on-year currency impact of around $0.05. The only thing we can be sure of is that, we can expect the situation in the U.K. to remain fluid. The pound/dollar rate has moved quite a bit and external estimates range from $1.14 to $1.35.
Turning now to adjusted EPS guidance for 2020, we are projecting constant-currency adjusted EPS growth to be flat. And for a business of our size, you should expect a range of plus or minus 3%. As you work through your models please note that year-on-year adjusted EPS growth is negatively impacted by a lower bonus payout in 2019 and this is a headwind of 6.5%.
As we look at adjusted EPS phasing for fiscal year 2020, we expect a balanced performance between the first half and the second half with potentially a slightly stronger second half.
Let me now summarize the projected key drivers of adjusted EPS. The lower 2019 fiscal bonus payout leads to a headwind of 6.5%. Obviously this year-on-year impact will negatively impact both SG&A expense and adjusted operating income. The higher tax rate has an impact of approximately 2%. On the other hand, our share repurchase program should generate a favorable tailwind of around 3.5%.
Excluding these headwinds and tailwinds, we would expect operational growth of around 5%; within this 5% number, we are funding the incremental investments I mentioned earlier of around 2% and an approximate 1 percentage point impact from removing e-cigarettes from our stores.
I will now hand you back to Stefano for his closing comments.
Thank you, James. Nobody should be surprised by what we have told you today. After our poor second quarter earnings, we told you what we would be doing here and we have delivered for two quarters. As you have heard, we anticipate a reasonable underlying operating performance for the coming year with solid underlying growth in most of our core businesses. This is very much in line with what we told you some months ago.
The action that we have taken to transform our businesses and the drive and focus with which our teams are pursuing our strategic priorities gives me confidence in our ability to deliver this growth.
I strongly believe in an expanded role of a pharmacy and in our company's ability to play a significant part in shaping how healthcare is delivered in the community going forward.
I remain convinced that we have in our company through our partnerships an extraordinary foundation on which to build. The work currently underway on innovation and transformation across all our businesses, we mean, we can and will continue to deliver real value for our customers and investors for many years to come.
Thank you. Now we will take your questions.
[Operator Instructions] Your first question comes from George Hill with Deutsche Bank.
Hey good morning guys. Thanks for taking the question. I guess so James, I think one of the things that investors are going to struggle with this morning is it looks like if you back out all the puts and takes, the company's guiding to a 4% to 5% core OP growth in fiscal 2020.
I guess can you walk through some of the components of that about maybe a little bit on how the company's thinking about volume growth. And I think particularly reimbursement is going to be a big question in 2020? So I guess from a fundamental perspective is, how are you seeing the business -- kind of what are the building blocks for growth for 2020?
Yes. So that's a good question. So the -- we did call out the operating performance once you take out the headwind coming from the prior year bonus of around 5%. And within that as well, we're also covering 2 percentage point of growth investments, so you're getting closer to a 7%. And then we've removed e-cigarettes, so you could -- actually if you strip out -- these are all the puts and takes, we've laid out on slide 19.
So the way I think you should think about this is, we expect relative stability in the wholesale business. So you've seen the very strong performance in the current year. And I'd be calling on a -- something mid-single-digit revenue growth. And then I think as you look at the RPI segment, you'd be looking at probably flat to declining revenue until we see flat line of sight to improve market circumstances in the U.K. And that's the only question mark we have on the segment.
And then in the U.S., I think this year the way you should rationalize the U.S. is, this year we had a contribution coming from Rite Aid. If you kind of remove the contribution, I think we're looking forward to pretty strong script growth is our outlook.
And then secondly, we see continued recovery in the retail business. So, we had a very strong exit on retail compared with the first half. The same in pharmacy, we saw a strong recovery on scripts second half, first half. We expect to see a continuation of the improved trend. So that would lead to a low single digit revenue in the U.S. business. So I think, if you look at the total company, I think we're looking at something in the low single digit revenue growth maybe 2%, maybe 3%. So take out Rite Aid, this year and you get pretty close to the same kind of number. The way, we thought about reimbursement is we've planned reimbursement slightly higher than the last three-year average, and we expect 2020 to be a continued tough year on reimbursement. And we've planned it relatively conservatively higher than the last three-year average and we're not giving anymore information on that.
And then you've seen with the call-up of the cost management program that should give you the confidence that we will have a significant leverage on the cost side to – so a combination of the solid revenue growth, plus generic procurement savings continuing at a similar level plus a cost program that is really ramping up and gaining pace gives us the comfort that we get to this mid-single-digit kind of range, before the bonus impact. And know, I'm love to give you a lot of insights here into how we talk through this. So reimbursement a little bit higher than in the past, but a much stronger cost program to give us the confidence to deliver this base case.
James, that's super helpful. And then I guess my quick follow-up would be it sounds like this cost program we should expect to see a lot of it flow through to the bottom line as opposed to reinvestment, I guess that's the right way to think about that?
Yeah. It's an interesting question and that's why we won't be providing growth savings on the call, because I have a philosophy on this, which is the only thing that matters is what hits the bottom line. And you know, the circumstances of the company and it's – if you think about – if you save on a gross basis you're going to offset your inflation. And for a company this size, you can work it out. It's probably $250 million. And then, if you're growing your scripts at 3%, 4%, 5% that's another $100 million of incremental costs, because you have an incremental cost impact every time you fill in new scripts.
So you can be quite easily – before you start the year, you're facing a $400 million headwind. So that's the first part. How do you offset inflation? And how do you offset the impact of volume growth? The second one as you've seen, we've taken a very strong stance on the investments. And I don't want that message to be lost. We're hitting the previously indicated guidance range with substantially higher investments. And that's what the cost program is helping us deliver. So, we quite hopefully put in the magnitude of the investments, we're actually spending this year. And it somewhat gets back to the age of some of the systems we have in the company, where 40% of that investment we have year-on-year is going on new pharmacy systems in the U.S. and U.K. and the implementation of SAP in the U.S. We will be able to take out an enormous amount of inventory over the next three years, as we implement these systems, enormous. So these systems will pay for themselves.
The second – the next call it third is on new digital capabilities. And then, the final piece is every time we do a pilot – and the pilots are starting to scale up. We have 60, plus 70 – 67 just on Kroger. It costs quite a bit of money to reorganize the stores and try these pilots. These are all fully funded. So that's – long answer to your short question was the overhead is to pay for inflation. It's the dramatic step-change in the investment profile of the company to drive sustainable long-term growth. That's the business we're in. We have to drive growth longer term, and then finally as part of the business model, where reimbursement is offset by [generic] [ph] procurement, savings, volume and SG&A and cost discipline.
That's very helpful. Thanks, James.
Next question comes from Lisa Gill with JPMorgan.
Thank you very much. Good morning. James, I just want to go back to your comment around the strong Rx growth expectation going into 2020. You did talk about the relationship on the preferred side for Medicare with United, but is there anything else that's specifically driving that would be my first question? And then secondly, you talked a little bit about the incremental costs around some of these pilot programs et cetera, but are you starting to see any benefit from some of these pilots and initiatives in the 2020 guidance that you're giving?
Yeah. Let me give you – I'll give you a quick answer and let Alex then take the more detailed one. Our point on the scripts is, if you take the second half versus first half the scripts are now running at second half 4%. And we had as you know a very weak first half. We were up 1.9%. And that's because we were lapping these call it network changes, where we lost two points in the previous 12 months.
And then as you look at the investment profile, I guess that's the upside scenario. We are quite conservative. We build in the cost of executing the initiatives. We do have working capital benefits built in our internal plans. They're quite sizable, so we do expect returns this current year on cash flow.
On the pilots themselves, we're not counting on significant flows of income in 2020. These will be building over the next three years and it depends on the success. Any one of them can become significant upside. We just have to see how the pilots play out in the next 12 months.
Thanks, James. Hi, Lisa. Morning.
Good morning.
Morning. Yeah, I think with regarding prescription growth we see a return to normal market in Med D driven by the fact that we got preferred relationships with some of the bigger plans. And we may have lost some of the small preferred access, but they are very small numbers otherwise. So, overall, we feel pretty good about that. You saw an announcement with Centene, where we intend to be more proactive in the Medicaid space going forward as well. There's still areas that we're working on. First of all, we are able to retain more customers. For example, I mentioned Save a Trip Refill in our prepared remarks. That's driving better retention adherence.
And last not least, of course, we are able to consolidate pharmacies, not just Rite Aid but the marketplace is changing. We're seeing more pharmacies than normal on the marketplace. And we have a good pipeline of pharmacies that we'll be able to secure in the future and consolidate as the number of pharmacies in the U.S. for the first time for a long time seem to be in decline. So, we're pretty confident that we'll be at the mark -- or maybe somewhat ahead of the market overall with all of these initiatives in terms of pharmacy growth.
Okay, great. And just as a follow-up I just want to make sure I understand this. So, we think about its operational growth of roughly 5%, James you talked about topline of 2% to 3%. So, we're talking about cost-cutting and leverage of this business including I think -- I just want to make I heard this correctly that reimbursement is higher. And when you think about it the reimbursement cuts are higher than what you saw in the last three years. So, you're conservative on reimbursement. It sounds like Alex that you have a line of sight to where the scripts are coming from, from that perspective 2% to 3% on the topline. Cost-cutting is going to get you to that five percentage range. Do I have that all correct?
Yes. Just be careful. The revenue doesn't track the scripts. So, for example, and I won't say much more than this, if you assume higher generic penetration which typically improves and has been improving over a fairly long period of time and will still improve not by major amounts that will have a deflationary amount on your -- deflationary impact on your revenue.
So, we would believe that the scripts would be higher than 2% to 3%. So, there'll be much more leverage in the income statement. So, the 2% call it 3% of revenue that includes a deflation assumption for a higher utilization of generics.
Okay, that's helpful. Thank you.
Next question comes from A.J. Rice with Credit Suisse.
Hi everybody. First, I know there's a reference in your U.S. Retail Pharmacy comment to improve a higher brand inflation. I wonder if we can get you to comment on what you saw -- what you're referring to there and where did you end up for the year and maybe any comment on what's embedded in your outlook for 2020.
Yes. We are -- on brand AWP. We think the average on a mix constant basis that we saw over the entire year was about 5%, but it was trending up in the second half of the year. So, the actual assumption on brand AWP doesn't have a massive impact on the income statement.
Honestly, the generic consumptions are much more important, but we're planning roughly the same kind of number. We're planning at the average level of the year. So, more like a 5%. We're not planning on -- in the 8% sort or 9%s where it has been touching in some recent months with a lot of--
Yes, that's right A.J. I think -- and obviously you look at the innovation in the marketplace and see what we're getting as well and in this particular year be more or less marked. So, I agree with James. A general increase has been happening this year, but we're not banking on it continuing and we see a trend a bit the same going to next year.
Yes.
Okay. And then maybe just follow-up -- or second one. On the pilots, I know it's a little unclear when they're going to swing positive, but I just want to make sure I understand. Is the main concept of the contribution from those the LabCorp, the VillageMD, the stuff with Optum and Humana, is that foot traffic? Is it your percentage of the earnings of those entities themselves? How's the company going to benefit from those ventures?
It is a mix. Yes, it's a mix. Each one will be slightly different, but you could envisage that a fairly standard one would be -- there'll be a rental contribution because we're giving up space in the store. There's probably some element of a share of the total business that the supplier does in that case the partner does in that case.
And then arguably the most important one is the foot traffic benefit where we have quite sophisticated models in the case of existing types of businesses. So, we know if there's a primary care. That's why we're testing these pilots. We're trying to see the uplifts on both retail and on scripts. So, you've got three sources of income in most cases.
And when we say there isn't a contribution the FedEx agreement delivers favorable contribution already and we're already at full capacity basically. Already LabCorp on an income basis is positive. What's negative is we're investing capital every time we touch the store. So, it's more a cash flow negative. Some of these are neutral to positive already, but as we roll out the 600 LabCorp stores, there's capital being expanded to reset each of the stores.
A.J. I think just one additional thing. The here was quite important particularly in pharmacy. So, we are really looking to see -- convinced that having a general practitioner in a pharmacy alongside a pharmacist working together not only drives additional prescriptions and a wee which is completely legal, but also provides better patient care. And that combination will lead to new platforms in the future we've spoken about as we look to not just provide a digital care, but also digital care in the community.
So, again, its early days, but we are very excited about this idea of doctor-led and pharmacist-enabled including that partnership going forward in that model, yes.
Okay. Thanks. That's great.
Next question comes from Peter Costa with Wells Fargo Securities.
Thank you. Can you talk a little bit more about your AllianceRx Walgreens Prime specialty solutions business versus the Shields Health Solutions business? And what is your strategy going forward for bringing in the specialty revenues to the company?
Sure. Hi Peter, it's Alex here. Yes, I think that they are set at the moment. So, let me deal with our investment in Shields to start with that. They really walk with health systems to enable the health system to take better care of the patients as they go back into community.
We have a number of local assets both in hospital systems and also specialty pharmacies where we want to make sure that working with the local health system, we can help them to service and take care of that patient more directly. So it's early days, but that's the model there. Really it's a community model.
Our work with AllianceRX is really about the central model in the mean, and of course, working very closely with the owners of Prime which are the Blues and particularly the financial contracts. Obviously, we've put together our business with their business just over two years ago. And the business is now performing from an operational point of view very well, but clearly the market is changing and we're looking forward to how we can of course accelerate growth and work even closer with the Blues in that model going forward.
So if you think of them as two separate areas at this stage, and of course, we recognize the incredible importance of specialty and the new drugs in the marketplace in the years ahead, I think 50% of the value of medication will be in specialty within three years. So of course, we're working very hard on both the individual piece, I've mentioned, but also how we combine the Walgreens brand and all of our assets over time to create a more powerful specialty model with our -- partners.
Can you help us understand more how the revenue stream is going to flow from these various products in terms of -- and concepts that you have in specialty because of more of a clearer strategy from you in terms of what your goal is to deliver?
Well, I think -- I'd go back to the central model, which is the predominant one at the moment in terms of the model there. You can see that our growth has been pretty reasonable this year in 20%. And that will continue as a market growth. We want to grow with Prime and grow it with that model.
The other -- and of course, 340B, again, is another area where we're growing as well. So that's pretty clear.
Now again, we're not the biggest, but we're a lot bigger than we were two years ago and growing faster than we were two years ago. With the Shields one, it's an early stage investment. We're a minority shareholder and we're developing the local community model and specialty. We believe that more and more patients will want to be taken care of closer to their home and closer to the community. And as drugs develop, there will be new payment models. So we believe this model will be more suited too.
Thank you. That's helpful. And then just separately I just want to clarify something. The tobacco pressure from e-cigarettes of 1% next year, is that the only tobacco pressure? Or is there further of the tobacco de-emphasis in next year's numbers?
We see continuing – obviously, we will cycle for example New York City on January 1st when we -- when that was confirmed by the status coming out of tobacco for all pharmacies and other states may well take action in a similar vein, we don't know yet. So we expect the pressure on tobacco sales to continue into next year, but not that at the same extent as we had in the last 12 months.
Okay. So that will be on top of that 1%?
Yes, but not as much as we've seen this year. This year we've seen about 1% due to normal tobacco, and we think that will be less next year as we cycle particularly New York.
Thank you.
Yes. Just to confirm the 1% only covers the exit of e-cigarettes, 1% of EPS actually.
Yeah.
And you would have a further pressure in the retail segment in the U.S. more on the revenue line as a result of the continued decline of tobacco.
Yeah. Yeah. More than ready, yeah, yeah.
Thank you very much.
Next question comes from Kevin Caliendo with UBS.
Good morning everyone. I'm a little confused in one of the comments you made earlier and that you expected reimbursement to be a little bit better than it had been over the last three years. Did I hear that correctly? And I just wanted to make sure that was -- we did hear that correctly. And if you're referring to pharmacy reimbursement, as I thought there were some PBM renewals that were coming up, and I was wondering what the impact of those might be in terms of your guidance?
I'll correct that. No, no. We actually said it will be worse than the average of the last three years. And you're exactly right. The main reasons why 2020 would be worse than the last three-year average would be, there's probably I would say higher percentage of PBM renewals in 2020 than there is over the following two years.
Yeah. Yeah.
So that's the reason why we've planned that way. But you're exactly right, it's worse than the average over the last few years. Yes.
Okay. It's perfect. And what's happening with the commercial and the Medicaid plans? They're moving from three-year renewals to more like two-year renewals on average. And the bigger -- you know that there's been more consolidation that's happened. So that's actually the reason for James' comments.
One quick follow-up. I think you're no longer a preferred pharmacy in SilverScript. Is that correct? And if so can you just talk about what that might have done to the comps going forward?
Our position in SilverScript's hasn't changed. We've been generally either in the open or non-preferred really for quite a while. So that piece has not changed.
Okay. Thank you.
Next question comes from Ricky Goldwasser with Morgan Stanley.
Yeah. Hi. Good morning. I'd start it with the direct savings. I think in the past you said that the long-term plan is to save 50% to 60% of reimbursement pressure or to be offset by generic savings. So when you think about that long-term goal where are you at now into 2020?
We're probably in the range of 40% to 50%. As I said, we change the planning assumptions quite frequently based on the latest visibility. We saw generic deflation in 2019 of around 8%. That's mix-constant. So it would actually be lower than that if you include all the changes and new molecules that comes in.
And we've planned relatively consistent with that, but I think realistically I think generic deflation over the next three years is probably a single digit kind of number with some years going up a high single digit. I don't think we'll turn back to double-digit kind of numbers.
So we've adjusted. We're probably in the range of 40% to 50%, as we look forward in terms of how much of the reimbursement we expect to offset through procurement initiatives.
And I would answer – sorry, Ricky you go.
No, no, go ahead.
I would just say that we've got good line of sight into these savings as well. We've been working on this pretty hard to make sure we protect our customers and we drive efficiency. And again the volume increase that we spoke to earlier in the call, which will improve as the year develops is another important component of driving a more efficient pharmacy.
So just to confirm when we think about this updated number of 40% to 50% is that 40% to 50% that you're going to achieve in 2020? Or is that 40% to 50% that's in the long-term plan?
Yeah that's too specific a goal to be setting ourselves right now. I think our -- we've already given enough thoughts I think. But you can plot out -- I think if you can, kind of, triangulate this if you assume by single digit deflation on generics you can get close to the number.
Okay. And then when we think about the modern multi-channel strategy, you've announced a few months ago that you were going to close 200 stores in the U.S. Really when you think about the strategy that it's shaping out, when we think longer term over time, what is the type of the infrastructure? What's the size of the store infrastructure you think needed in the U.S. compared to existing?
It's Alex here Ricky. We don't see a lot of change. I've always been of the view that we can have roundabout 10,000 pharmacies probably more than we have today, although at different formats. So the format that we have today is really you see that a suburban drug store or the urban store that we have in the big cities, we're developing a small store pharmacy. We got about I think 30 or 40 now actively in the ground. And we're pleased with the results, lower cost more focus on pharmacy and OTC health care and obviously pick up as well. So we're developing that format. So we still got opportunities to fill in some networks.
And going forward -- and I think also remember there are 65,000 pharmacies, thereabouts, in the U.S. today and they're coming down in number. So we believe that our efficient supply chain, the strength of our brand and the quality of our pharmacists and the support they're getting through the new IT infrastructures and digital capabilities we're investing in that we will be able to improve not just the efficiency of the pharmacy, but the quality of the care that we provide to patients and payers going forward and have more percent of the pharmacies in the U.S. over time.
Thank you.
Next question comes from Brian Tanquilut with Jefferies.
Good morning guys. Just a follow-up to that question from Ricky. So as we think about where the store base is going, going forward where you're adding a lot of services Kroger, LabCorp, FedEx, how should we be thinking about the gross profit dollars per store? I get the gross margin commentary of how you guys are obviously doing a lot of things there, but how should we be thinking about the gross margin profile -- or the gross profit dollars given that it becomes more like rent revenue rather than true gross profit margins?
Yeah. It's Alex here. Again we do have a successful front-end-business. And I know we've not spoken about that very much today, and that's improved materially from a profitability point of view over the last period. So I think that -- I think you should think about costs coming down from a rental point of view for sure both in terms of as we rent space but also as we take advantage of the fact that we're over-rented today and a lot of these leases are coming towards us in the years ahead. In terms of cost profit dollars, our intention is to drive sales and drive profitable growth going forward.
I don't know James you want to speak about the rental opportunity?
I think if you think about it though the first place you go to is the storage in the stores. So these stories were built in a time when a lot of inventory was in the physical location. If you plot out three years from now there'll be no inventory in the stores in the back-office. So that freed up a couple 1,000, 2,000 square feet per stores. So if you think about it the first piece of the development was free because we've downsized the back-office and the storage space. So the impact on our revenue throughput was minimal.
And as we go through each of the partnerships because we're getting an uplift there's a lot of science that goes into this. So we'll be losing -- if you shrink the size of your retail footprint how much you are losing versus you're going to get some uplift from the increased traffic, I don't think you're going to see a massive reduction in the space -- sorry in the revenue as a result of this, quite the contrary.
So what you end up with is a more efficient box where you're probably dedicating less space to some categories where you weren't making very much money. You've gotten rid of your storage. You got rid of your back-office. And then you've got value-added services who are attracting different customers in there. And ideally your foot traffic has gone up as a result of that and a more efficient sales per square foot.
So I don't think you'll see the revenue. I think Alex is right. I think you'll see the revenue find consistent with what we have potentially improving. And then you see a big change in the rent. And bear in mind that we're quite over rented, so it's a long-term opportunity for the company versus our competitors, we probably years ago entered into lease contracts that were in the best locations, the nicest places and probably overpaid a bit.
So as you look forward over a multiyear horizon, we would expect consistent quite material reductions in the cost of rent. And then at the same time, we make each store more efficient in what's in each of the stores. I hope that gives you enough insights on it.
No that's great. Just my follow-up. As we think about 2020, are there any network changes you want to -- you need to call out just so that we're aware of? Or is it clear?
It's pretty clear. I mean, I think there's been – obviouslym there's been the conversation high over the weekend, which we were aware of a few weeks ago. Disappointed that CareSource have taken this decision but recognize that's their decision to take. But we are -- have got other games to make that up in other networks. So we think it's pretty balanced over the year and we're very confident in our ability to grow the market in 2020.
We have time for just one more question I am afraid.
We have a question from Steve Valiquette with Barclays.
Great, thanks. Good morning. So with Walmart announcing a big push in the primary care clinical services and a perception among some investors that Walmart may be offering these services at lower prices than the competition, I guess I'm just curious to hear your high-level thoughts on whether this may influence your pricing or marketing strategy and/or the timing of rollout of your own clinical services strategy at Walgreens over the next couple of years.
And then on the plus side of this, could the -- just the notion of greater visibility overall on primary care offerings in the traditional retail setting maybe be a net positive for Walgreens and really all the players at this early stage? Thanks.
Thanks, Steve. Yes. No, we think that it's a good move for retail to be involved in health care as that happens in a place like Walmart in 206 huge successful company and they do it well then we think that'll help us because, we've got a great brand. We think, we've got strong, better community locations. And we've got more focus on pharmacy there and more focus on health care relationships. So, overall, we think that's going to be an advantage to us. And we'll continue with our own strategy, developing and investing in the way that James and I have described this morning.
Okay. Great. Thanks.
You see, we have declared that we have been very open sometimes ago that we wanted to change our model that we wanted to really create not just a physical transformation of our pharmacies offering more and more services to our customers, but we wanted to change the model. Having a complete different relationship with our customers and this is what we are doing and you can see small things here and there that are already public that give -- can give you this feeling.
Now, everybody is coming to this concept, but I can assure you that we are quite advanced, more advanced than you can see outside the company. And we have done a lot of tests because when you change something in the company and you roll over your new ideas to the stores, you have to invest a huge amount of capital. And so you have to be sure, that you are doing the right things. And this is why, we are doing so many tests and this is why, we are working behind the scenes to prepare our future in something that could give us the right return in a reliable way.
So, we are not worried to see that everybody's going into this direction because this is what we saw two years ago, maybe more, three years ago. And we are working on that. And we believe that at the end we are more advanced than other people even though this is not clearly understandable outside the company.
Thank you. I appreciate the extra color. Thanks.
Thank you, Stefano. And we haven't, I know answered all your questions, but that's all we do have time for on the call. As ever Jay and the IR team are here to take any further questions you have off call, but thank you all for joining us today.
Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.