07/19/2012 08:17 EDT | Updated 09/18/2012 05:12 EDT

Shoppers Drug Mart says generic drug rules will weigh on last half of year

TORONTO - Shoppers Drug Mart Corp. turned in better-than-expected second-quarter results Thursday but warned that further generic drug reforms in several provinces are expected to pull down its pharmacy profits during the final half of this year.

Canada's largest drug store chain emphasized the potential downside to investors on an earnings call to discuss second-quarter earnings Thursday, noting that the impact won't be fully apparent until next quarter.

"I want to reinforce that we've seen ... many additional provinces launching reforms that did not impact us in the first half of the year (but) will impact us in the back half," said chief financial officer Bradley Lukow.

"(It's) going to reduce the gross profit per (prescription), so that's going to be a drag in the back half incrementally."

The retailer has faced an onslaught of changes brought in last year in Ontario, Quebec and British Columbia that cut generic drug prices to 25 per cent of the price of patented drugs — down from 50 per cent. The company has said those reforms affect revenue by an estimated $750-million a year.

But more recent changes in Ontario have further cut the costs for the Top 10 generic drugs to 20 per cent of the price of the branded equivalent, which will hit the company even harder.

Shoppers (TSX:SC) has been working to mitigate the changes by driving sales at the front of the store, areas of its operations that are separate from its pharmacies, like food and cosmetics.

"We will continue to push hard on the front of the store for market share gains," Lukow said.

"Let's not forget it is a very competitive environment and we still have a sensitive consumer out there that is chasing promotions, so we're trying to do our best in terms of optimizing that activity."

Shoppers reported that profit slipped in the second quarter due to costs related to the closure of two stores that were specifically angled to selling cosmetics.

Net income fell to $145.7 million, or 70 cents per share, for the period ended June 16. That compared to $147.9 million, or 68 cents per share in the same period ended June 18, 2011.

When filtering out the $5-million pre-tax charge from store closures, profits were higher at $149 million or 71 cents per share — up 4.4 per cent from the same time last year and a penny ahead of estimates.

Sales increased 2.6 per cent to nearly $2.5 billion, rising in line with expectations.

The Toronto-based company said stores open at least a year saw their sales rise by 2.2 per cent on average, while pharmacy sales in those stores were up 0.8 per cent.

"This performance speaks to the strength of our value proposition in what remains a challenging economic environment," said Domenic Pilla, president and CEO.

In May, Shoppers announced a $75-million agreement to purchase 19 retail pharmacies and three central fill pharmacies in Western Canada from with Paragon Pharmacies Ltd.

Pilla suggested that several similar deals will be revealed in the coming months.

"There are a number of other decent-sized acquisition deals that are in the pipeline," he told investors, noting that $34 million of deposits on the company's financial sheet are from deals that will close in the third quarter.

The company is also looking to improve its supply chain, as well as the productivity at its pharmacy operations, an initiative it expects will provide "significant gains" over the next year-and-a-half.

While investors must take into account that regulatory reform will continue impact the pharmacy industry, Shoppers should be able to weather the storm better than most as the leading network in Canada, said RBC Capital Markets analyst Irene Nattel.

"Shoppers Drug Mart is well positioned to partner with government to help improve efficiency of spend," she wrote in a research note.

"Shoppers' underlying business should continue to deliver industry-leading top line and profitability, which management will augment by consistent share repurchase."

Nattel reiterated her "outperform" rating with a price target of $47, about nine per cent above the current market value. The stock was up 41 cents to close at $43.07 Thursday on the Toronto Stock Exchange.