Walgreen's (NYSE:WAG) most recent earnings report shows a company that is still the envy of an industry from an operational standpoint, but suffering through a period of slow growth, uncertain prospects and tough comparisons.

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For its fiscal third quarter, the company posted $463 million in net income, or $0.47 per share, down 11% from a year ago. Total sales were up 6% year over year, to $17.2 billion, of which over 65% comes from prescription sales.

There were some charges pushing down on earnings in the third quarter, including four cents for the elimination of Medicare Part D subsidies and two cents for the acquisition of NY-based Duane Reade drug stores.

There was little to be excited about in the report, as evidenced by the 7% drop in Walgreen shares on Tuesday. To be fair, comparisons were tough versus one year ago, when H1N1 fears ruled the land and sent customers flocking to the drug store aisles. (For related reading, check out Measuring The Medicine Makers.)

Competition, Economy & Health Care Reform Loom
In the standalone field of retail drug stores, Walgreen still gets it done better than its peers. Gross margins were up year ago despite the weak economy, and stand at a healthy 27.6%, much better than rival CVS Caremark (NYSE:CVS) at 20%. Rite Aid (NYSE:RAD) looks like a similarly smooth operator with 26% gross margins, but the picture falls apart further down the income statement - Rite Aid has been posting net losses since way back when the economy was on solid footing.

The critical same-store sales measure is positive at Walgreen, but just barely. Pharmacy comps were up 0.7%, while "front-end" sales were up 0.1%. CVS grew pharmacy comps faster (3.7%) in their most recent quarter, but they have the benefit of the pharmacy benefits management (PBM) business to drive sales.

Meanwhile all the pharmacy companies - including burgeoning players like Wal-Mart (NYSE:WMT) and Costco (Nasdaq:COST) - complain of difficulties with pharmacy reimbursements, a trend that's certain to continue as healthcare reform shakes out in the coming quarters.

The Bottom Line
Walgreen shares have underperformed the S&P 500 by about 20% this year after closing out 2009 on a tear. While the drop is understandable given all the unknowns surrounding the industry -the stock market despises the unknown - Walgreen remains the top operator in the space. Their balance sheet is pristine, the stock sports a 2% yield, and prospects for the entire industry should perk up nicely in 2011 when a slew of new generics will hit the shelves.

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