EX-13 6 exhibit_13.htm 2010 ANNUAL REPORT exhibit_13.htm
 
Five-Year Summary of Selected Consolidated Financial Data
Walgreen Co. and Subsidiaries
(Dollars in Millions, except per share and location amounts)

Fiscal Year
 
2010(1)
   
2009
   
2008
   
2007
   
2006
 
Net Sales
  $ 67,420     $ 63,335     $ 59,034     $ 53,762     $ 47,409  
Cost of sales (2)
    48,444       45,722       42,391       38,518       34,240  
Gross profit
    18,976       17,613       16,643       15,244       13,169  
Selling, general and administrative (2) (3)
    15,518       14,366       13,202       12,093       10,467  
Operating income
    3,458       3,247       3,441       3,151       2,702  
Other income (expense)
    (85 )     (83 )     (11 )     38       52  
Earnings Before Income Tax Provision (4)
    3,373       3,164       3,430       3,189       2,754  
Income tax provision
    1,282       1,158       1,273       1,148       1,003  
Net Earnings
  $ 2,091     $ 2,006     $ 2,157     $ 2,041     $ 1,751  
Per Common Share
                                       
Net earnings
                                       
Basic
  $ 2.13     $ 2.03     $ 2.18     $ 2.04     $ 1.73  
Diluted
    2.12       2.02       2.17       2.03       1.72  
Dividends declared
    .59       .48       .40       .33       .27  
Book value
    15.34       14.54       13.01       11.20       10.04  
Non-Current Liabilities
                                       
Long-term debt
  $ 2,389     $ 2,336     $ 1,337     $ 22     $ 3  
Deferred income taxes
    318       265       150       158       141  
Other non-current liabilities
    1,735       1,396       1,410       1,285       1,116  
Assets and Equity
                                       
Total assets
  $ 26,275     $ 25,142     $ 22,410     $ 19,314     $ 17,131  
Shareholders' equity
    14,400       14,376       12,869       11,104       10,116  
Return on average shareholders' equity
    14.5 %     14.7 %     18.0 %     19.2 %     18.4 %
Locations
                                       
Year-end (5)
    8,046       7,496       6,934       5,997       5,461  


(1)
Includes results of Duane Reade operations since the April 9, 2010 acquisition date.
(2)
Fiscal 2010 and 2009 included Rewiring for Growth pre-tax restructuring and restructuring related charges of $106 million ($.07 per share, diluted) and $252 million ($.16 per share, diluted), respectively.  These charges, included in cost of sales and selling, general and administrative expenses for fiscal 2010 and 2009, were $40 million and $95 million, and $66 million and $157 million, respectively.  Fiscal 2010 and 2009 included pre-tax expenses related to Customer Centric Retailing store conversions of $45 million and $5 million, respectively, all of which was included in selling, general and administrative expenses.
(3)
Fiscal 2008 included a positive pre-tax adjustment of $79 million ($.05 per share, diluted), which corrected for historically over-accruing the Company’s vacation liability.
(4)
Fiscal 2010 included a deferred tax charge of $43 million related to the repeal of a tax benefit for the Medicare Part D subsidy for retiree benefits.
(5)
Locations include drugstores, worksite facilities, home care facilities, specialty pharmacies and mail service facilities.
 
 

 

 

MANAGEMENT'S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION

The following discussion and analysis of our financial condition and results of operations should be read together with the financial statements and the related notes included elsewhere herein. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from those discussed in forward-looking statements. Factors that might cause a difference include, but are not limited to, those discussed under “Cautionary Note Regarding Forward-Looking Statements” below and in Item 1A (Risk Factors) in our Annual Report on Form 10-K.

Introduction

Walgreens is principally a retail drugstore chain that sells prescription and non-prescription drugs and general merchandise.  General merchandise includes, among other things, household items, convenience foods, personal care, beauty care, candy, photofinishing and seasonal items.  Customers can have prescriptions filled in retail pharmacies as well as through the mail, and customers may also place orders by telephone and via the Internet.  At August 31, 2010, we operated 8,046 locations in 50 states, the District of Columbia, Guam and Puerto Rico.  Total locations do not include 352 convenient care clinics operated by Take Care Health Systems, Inc.

   
Number of Locations
 
Location Type
 
2010
   
2009
   
2008
 
Drugstores
    7,562       6,997       6,443  
Worksite Facilities
    367       377       364  
Home Care Facilities
    101       105       115  
Specialty Pharmacies
    14       15       10  
Mail Service Facilities
    2       2       2  
Total
    8,046       7,496       6,934  

The drugstore industry is highly competitive.  In addition to other drugstore chains, independent drugstores and mail order prescription providers, we compete with various other retailers including grocery stores, convenience stores, mass merchants and dollar stores.

The Company’s sales, gross profit margin and gross profit dollars are impacted by both the percentage of prescriptions that we fill that are generic and the rate at which new generic versions are introduced to the market.  In general, generic versions of drugs generate lower total sales dollars per prescription, but higher gross profit margins and gross profit dollars, as compared with patent-protected brand name drugs.  The positive impact on gross profit margins and gross margin dollars has been significant in the first several months after a generic version of a drug is first allowed to compete with the branded version, which is generally referred to as a "generic conversion."  In any given year, the number of blockbuster drugs that undergo a conversion from branded to generic status can increase or decrease, which can have a significant impact on our sales, gross profit margins and gross profit dollars.  And, because any number of factors outside of the Company’s control or ability to foresee can affect timing for a generic conversion, we face substantial uncertainty in predicting when such conversions will occur and what effect they will have on particular future periods.

The long-term outlook for prescription utilization is strong due in part to the aging population, the increasing utilization of multi-source (i.e., generic) drugs, the continued development of innovative drugs that improve quality of life and control health care costs, and the expansion of health care insurance coverage under the Patient Protection and Affordable Care Act signed into law on March 23, 2010 (the ACA).

Certain provisions of the Deficit Reduction Act of 2005 (the DRA) sought to reduce federal spending by altering the Medicaid reimbursement formula (AMP) for multi-source drugs.  Those reductions did not go into effect.  The ACA enacted a modified reimbursement formula for multi-source drugs, which, when implemented, is expected to reduce Medicaid reimbursements.  Also, in conjunction with a class action settlement with two entities that publish the average wholesale price (AWP) of pharmaceuticals, the methodology used to calculate the AWP, a pricing reference widely used in the pharmacy industry, was changed in a way that reduced the AWP for many brand-name prescription drugs effective September 26, 2009.  The Company has reached understandings with most of its third party payers to adjust reimbursements to correct for this change in methodology; however, most state Medicaid programs that utilize AWP as a pricing reference did not take action to make similar adjustments, resulting in reduced Medicaid reimbursement for drugs affected by the change.

Total front-end sales have continued to grow primarily due to new store openings.  Total front-end sales continue to be impacted by lower demand for discretionary goods such as household, seasonal and beauty products due to the overall economic conditions and high unemployment rates.

We continue to expand into new markets and increase penetration in existing markets. To support our growth, we are investing in prime locations, technology and customer service initiatives.  We continue to expand, focused on retail organic growth; however, consideration is given to retail and other acquisitions that provide unique opportunities and fit our business objectives, such as our recent acquisition of Duane Reade Holdings, Inc., and Duane Reade Shareholders, LLC (Duane Reade), which consisted of 258 Duane Reade stores located in the New York City metropolitan area, as well as the corporate office and two distribution centers.  This acquisition increased the Company’s presence in the New York metropolitan area.
 
 
Restructuring

On October 30, 2008, we announced a series of strategic initiatives, approved by the Board of Directors, to enhance shareholder value.  One of these initiatives was a program known as “Rewiring for Growth,” which was designed to reduce cost and improve productivity through strategic sourcing of indirect spend, reducing corporate overhead and work throughout our stores, rationalization of inventory categories, and transforming community pharmacy.  We expect to complete these initiatives in fiscal 2011.  

We have recorded the following pre-tax charges associated with our Rewiring for Growth program in the Consolidated Statements of Earnings (in millions):

   
Twelve Months Ended August 31,
 
   
2010
   
2009
 
Severance and other benefits
  $ 16     $ 74  
Project cancellation settlements
    -       7  
Inventory charges
    19       63  
     Restructuring expense
    35       144  
Consulting
    50       76  
     Restructuring and restructuring related costs
  $ 85     $ 220  
                 
Cost of sales
  $ 19     $ 63  
Selling, general and administrative expenses
    66       157  
    $ 85     $ 220  

Severance and other benefits include the charges associated with employees who were separated from the Company.  In the current fiscal year, 193 employees have been separated from the Company.  Since inception, a total of 890 employees have been separated from the Company as a result of these initiatives.

Inventory charges relate to on-hand inventory that has been reduced from cost to a selling price below cost.  In addition, as a part of our restructuring efforts we sold an incremental amount of inventory below traditional retail prices.  The dilutive effect of these sales on gross profit for the year ended August 31, 2010, was $21 million.  In the prior fiscal year we reported a dilutive effect on sales of $32 million.

We incurred pre-tax costs of $106 million ($85 million of restructuring and restructuring related costs, $21 million of gross profit dilution) in fiscal 2010.  Since inception, we have incurred $358 million ($305 million of restructuring and restructuring related expenses, and $53 million of gross profit dilution).  We anticipate approximately $50 million of pre-tax restructuring and restructuring related expenses and gross profit dilution in fiscal 2011.

We have recorded the following balances within the accrued expenses and other liabilities section of our Consolidated Balance Sheets (in millions):

   
Severance and Other Benefits
 
August 31, 2008 Reserve Balance
  $ -  
Charges
    82  
Cash Payments
    (78 )
August 31, 2009 Reserve Balance
  $ 4  
Charges
    19  
Cash Payments
    (23 )
August 31, 2010 Reserve Balance
  $ -  

In fiscal 2010, we realized incremental savings related to the Rewiring for Growth program of approximately $471 million as compared to fiscal 2009.  Selling general and administrative expenses realized incremental savings of $391 million, while cost of sales benefited by $80 million.  Since inception, we have realized total savings related to Rewiring for Growth of approximately $721 million.  Selling, general and administrative expenses realized total savings of $641 million, while cost of sales benefited by approximately $80 million.  The savings are primarily the result of expense reduction initiatives, reduced store labor and personnel reductions.

Additionally, as a part of our Customer Centric Retailing (CCR) initiative, we are enhancing the store format to ensure we have the proper assortments, better category layouts and adjacencies, better shelf height and sight lines, and better assortment and brand and private brand layout, all of which are designed to positively enhance the shopper experience and increase customer frequency and purchase size.  We expect this format will be rolled out to approximately 5,500 existing stores.   At August 31, 2010, in total, we have converted 1,469 stores and opened 345 new stores with the CCR format.  We expect to convert approximately 4,000 stores and open approximately 250 new stores with the CCR format in fiscal 2011.  Based on our experience with the first 1,469 stores, we expect the total cost, which includes both selling, general and administrative expenses and capital, to be approximately $50 thousand per store.  For the fiscal year ended August 31, 2010, we incurred $71 million in total program costs, of which $45 million was included in selling, general and administrative expenses and $26 million in capital costs.  In fiscal 2009, we incurred $5 million in program costs, all of which was included in selling, general and administrative expenses.

Operating Statistics

   
Percentage Increases/(Decreases)
 
Fiscal Year
 
2010
   
2009
   
2008
 
Net Sales
    6.4       7.3       9.8  
Net Earnings
    4.2       (7.0 )     5.7  
Comparable Drugstore Sales
    1.6       2.0       4.0  
Prescription Sales
    6.3       7.8       9.7  
Comparable Drugstore Prescription Sales
    2.3       3.5       3.9  
Front-End Sales
    6.8       6.3       10.0  
Comparable Drugstore Front-End Sales
    0.5       (0.5 )     4.2  
Gross Profit
    7.7       5.8       9.2  
Selling, General and Administrative Expenses
    8.0       8.8       9.2  

   
Percent to Net Sales
 
Fiscal Year
 
2010
   
2009
   
2008
 
Gross Margin
    28.1       27.8       28.2  
Selling, General and Administrative Expenses
    23.0       22.7       22.4  

   
Other Statistics
 
Fiscal Year
 
2010
   
2009
   
2008
 
Prescription Sales as a % of Net Sales
    65.2       65.3       64.9  
Third Party Sales as a % of Total Prescription Sales
    95.3       95.4       95.3  
Total Number of Prescriptions (in millions)
    695       651       617  
30-Day Equivalent Prescriptions (in millions) *
    778       723       677  
Total Number of Locations
    8,046       7,496       6,934  

* Includes the adjustment to convert prescriptions greater than 84 days to the equivalent of three 30-day prescriptions. This adjustment reflects the fact that these prescriptions include approximately three times the amount of product days supplied compared to a normal prescription.

Results of Operations

Fiscal year 2010 net earnings increased 4.2% to $2,091 million, or $2.12 per share (diluted), versus last year's earnings of $2,006 million, or $2.02 per share (diluted).  The net earnings increase was primarily attributable to higher gross margins partially offset by higher selling, general and administrative expenses as a percentage of sales and higher income tax expense primarily related to the ACA.  In conjunction with the ACA, one provision of which repealed the tax benefit for the Medicare Part D subsidy for retiree benefits, we recorded a charge of $43 million, or $.04 per share (diluted), in fiscal 2010.  The dilutive effect of Duane Reade operations was approximately $.06 per share (diluted), primarily due to costs related to the acquisition.  In the fiscal year 2010 we recorded pre-tax Rewiring for Growth expenses of $85 million, or $.06 per share (diluted), and pre-tax margin dilution related to our Rewiring for Growth activities of $21 million, or $.01 per share (diluted).  This compares to pre-tax Rewiring for Growth expenses of $220 million, or $.14 per share (diluted), and pre-tax margin dilution $32 million, or $.02 per share (diluted), in fiscal 2009.  Expenses associated with converting stores to the CCR format were $45 million in the current fiscal year as compared to $5 million a year ago.

Net sales increased by 6.4% to $67,420 million in fiscal 2010 compared to increases of 7.3% in 2009 and 9.8% in 2008.  The impact of the Duane Reade acquisition increased total sales by 1.1% in the current fiscal year.  Drugstore sales increases resulted from sales gains in existing stores and added sales from new stores, each of which include an indeterminate amount of market-driven price changes.  Sales in comparable drugstores were up 1.6% in 2010, 2.0% in 2009 and 4.0% in 2008.  Comparable drugstores are defined as those that have been open for at least twelve consecutive months without closure for seven or more consecutive days and without a major remodel or a natural disaster in the past twelve months.  Remodels associated with our CCR initiative are not considered major and therefore do not affect comparable drugstore results.  Relocated and acquired stores (including Duane Reade) are not included as comparable stores for the first twelve months after the relocation or acquisition.  We operated 8,046 locations (7,562 drugstores) at August 31, 2010, compared to 7,496 (6,997 drugstores) at August 31, 2009, and 6,934 (6,443 drugstores) at August 31, 2008.

Prescription sales increased 6.3% in 2010, 7.8% in 2009 and 9.7% in 2008.  The impact of the Duane Reade acquisition increased prescription sales by 0.8% in the current fiscal year.  Comparable drugstore prescription sales were up 2.3% in 2010 compared to increases of 3.5% in 2009 and 3.9% in 2008.  Prescription sales as a percent of total net sales were 65.2% in 2010, 65.3% in 2009 and 64.9% in 2008.  The effect of generic drugs, which have a lower retail price, replacing brand name drugs reduced prescription sales by 2.2% for 2010, 3.0% for 2009 and 3.5% for 2008, while the effect on total sales was 1.3% for 2010, 1.9% for 2009 and 2.2% for 2008.  Third party sales, where reimbursement is received from managed care organizations, the government or private insurers, were 95.3% of prescription sales in 2010, 95.4% in 2009 and 95.3% in 2008.  The total number of prescriptions filled (including immunizations) was approximately 695 million in 2010, 651 million in 2009 and 617 million in 2008.  Prescriptions adjusted to 30-day equivalents were 778 million in 2010, 723 million in 2009 and 677 million in 2008.

Front-end sales increased 6.8% in 2010, 6.3% in 2009 and 10.0% in 2008.  The impact of the Duane Reade acquisition increased front-end sales by 1.9% in the current year.  Additionally, the increase over the prior year is due, in part, to new store openings and improved sales related to non-prescription drugs, personal care products and convenience foods.  Front-end sales were 34.8% of total sales in fiscal 2010, 34.7% in 2009 and 35.1% in 2008.  Comparable drugstore front-end sales increased 0.5% in 2010 compared to a decrease of 0.5% and increase of 4.2% in fiscal years 2009 and 2008, respectively.  The increase in fiscal 2010 comparable front-end sales was primarily due to non-prescription drugs and convenience foods which were partially offset by decreased sales in household products, seasonal items and photofinishing.

Gross margin as a percent of sales increased to 28.1% in 2010 from 27.8% in 2009.  Overall margins were positively impacted by higher front-end margins due to pricing, promotion and other improved efficiencies and lower Rewiring for Growth costs.  Retail pharmacy margins benefitted from the positive impact of generic drug introductions but were partially offset by market driven reimbursement rates.  Gross margin as a percent of sales was 27.8% in 2009 as compared to 28.2% in 2008.  Overall margins were negatively impacted by non-retail businesses, lower front-end margins due to product mix, a higher provision for LIFO and Rewiring for Growth costs.  This was partially offset by an improvement in retail pharmacy margins, which were positively influenced by generic drug sales, but to a lesser extent negatively influenced by the growth in third party pharmacy sales.

We use the last-in, first-out (LIFO) method of inventory valuation.  The LIFO provision is dependent upon inventory levels, inflation rates and merchandise mix.  The effective LIFO inflation rates were 1.70% in 2010, 2.00% in 2009 and 1.28% in 2008, which resulted in charges to cost of sales of $140 million in 2010, $172 million in 2009 and $99 million in 2008.  Inflation on prescription inventory was 4.72% in 2010, 2.40% in 2009 and 2.65% in 2008.  In fiscal 2010, we experienced deflation in most non-prescription inventories.  In fiscal years 2009 and 2008, we experienced deflation in some non-prescription inventories. The anticipated LIFO inflation rate for fiscal 2011 is 1.50%.

Selling, general and administrative expenses were 23.0% of sales in fiscal 2010, 22.7% in fiscal 2009 and 22.4% in fiscal 2008.  The increase in fiscal 2010 as compared to fiscal 2009 was attributed to higher occupancy expense, Duane Reade operational expenses and costs associated with the Duane Reade acquisition.  These expenses were partially offset by lower Rewiring for Growth costs and advertising expense.  Also positively impacting the current year’s selling, general and administrative expenses was incremental savings from our Rewiring for Growth activities, primarily from expense reduction initiatives and reduced store payroll.  The increase in fiscal 2009 as compared to fiscal 2008 was due to higher Rewiring for Growth expenses and occupancy.  Additionally, in fiscal 2008 we recorded a positive adjustment of $79 million, which corrected for historically over-accruing the Company’s vacation liability.  These items were partially offset by Rewiring for Growth savings, primarily in store payroll.

Selling, general and administrative expenses increased 8.0% in fiscal 2010, 8.8% in fiscal 2009 and 9.2% in fiscal 2008.  The combined effect of Duane Reade operations including acquisition costs and Rewiring for Growth costs on the current year is 1.5%.  The decrease in the fiscal 2010 rate of growth as compared to fiscal 2009 was attributed to incremental savings from our Rewiring for Growth activities primarily in expense reduction initiatives and lower store payroll, partially offset by new store openings.  The reduced rate of growth in fiscal 2009, as compared to fiscal 2008, was attributed to Rewiring for Growth savings, primarily in store payroll.  Store level salaries increased at a lower rate of growth than sales, contrary to the prior years where the rate of growth was higher than sales.  Partially offsetting the fiscal 2009 decrease was Rewiring for Growth expenses, which increased the rate of growth by 1.2 percentage points.  Additionally, fiscal 2008 results included a positive adjustment which corrected for historically over-accruing the Company’s vacation liability.

Interest was a net expense of $85 million in fiscal 2010, $83 million in fiscal 2009 and $11 million for fiscal 2008.  Interest expense for fiscal 2010, 2009 and 2008 is net of $12 million, $16 million and $19 million, respectively, that was capitalized to construction projects.  The increase in net interest expense from fiscal 2008 to fiscal 2009 was due to the issuance of long-term debt.

The effective income tax rate was 38.0% for fiscal 2010, 36.6% for 2009 and 37.1% for 2008.  In conjunction with the ACA, one provision of which repealed the tax benefit for the Medicare Part D subsidy for retiree benefits, we recorded a charge of $43 million to deferred taxes in the third quarter of fiscal 2010.  Excluding this adjustment, the effective rate for fiscal 2010 was 36.7%.  The decrease in the fiscal 2009 effective tax rate as compared to fiscal 2008 is attributed to an increase in federal permanent deductions as compared to the prior year.  We anticipate an effective tax rate of approximately 37.0% in fiscal 2011.

Critical Accounting Policies

The consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and include amounts based on management's prudent judgments and estimates.  Actual results may differ from these estimates.  Management believes that any reasonable deviation from those judgments and estimates would not have a material impact on our consolidated financial position or results of operations.  To the extent that the estimates used differ from actual results, however, adjustments to the statement of earnings and corresponding balance sheet accounts would be necessary.  These adjustments would be made in future statements.  Some of the more significant estimates include goodwill and other intangible asset impairment, allowance for doubtful accounts, vendor allowances, liability for closed locations, liability for insurance claims, cost of sales and income taxes.  We use the following methods to determine our estimates:

Goodwill and other intangible asset impairment – Goodwill and other indefinite-lived intangible assets are not amortized, but are evaluated for impairment annually during the fourth quarter, or more frequently if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value.  As part of our impairment analysis for each reporting unit, we engaged a third party appraisal firm to assist in the determination of estimated fair value for each unit.  This determination included estimating the fair value using both the income and market approaches.  The income approach requires management to estimate a number of factors for each reporting unit, including projected future operating results, economic projections, anticipated future cash flows and discount rates.  The market approach estimates fair value using comparable marketplace fair value data from within a comparable industry grouping.

The determination of the fair value of the reporting units and the allocation of that value to individual assets and liabilities within those reporting units requires us to make significant estimates and assumptions.  These estimates and assumptions primarily include, but are not limited to: the selection of appropriate peer group companies; control premiums appropriate for acquisitions in the industries in which we compete; the discount rate; terminal growth rates; and forecasts of revenue, operating income, depreciation and amortization and capital expenditures.  The allocation requires several analyses to determine fair value of assets and liabilities including, among other things, purchased prescription files, customer relationships and trade names.  Although we believe our estimates of fair value are reasonable, actual financial results could differ from those estimates due to the inherent uncertainty involved in making such estimates.  Changes in assumptions concerning future financial results or other underlying assumptions could have a significant impact on either the fair value of the reporting units, the amount of the goodwill impairment charge, or both.

We also compared the sum of the estimated fair values of the reporting units to the Company’s total value as implied by the market value of the Company’s equity and debt securities. This comparison indicated that, in total, our assumptions and estimates were reasonable.  However, future declines in the overall market value of the Company’s equity and debt securities may indicate that the fair value of one or more reporting units has declined below its carrying value.
 
One measure of the sensitivity of the amount of goodwill impairment charges to key assumptions is the amount by which each reporting unit “passed” (fair value exceeds the carrying amount) or “failed” (the carrying amount exceeds fair value) the first step of the goodwill impairment test. For the reporting units that passed step one, fair value exceeded the carrying amount by 6% to more than 700%. The fair values for two reporting units each exceeded their carrying amounts by less than 10%. Goodwill allocated to these reporting units was $173 million, at May 31, 2010. For each of these reporting units, relatively small changes in the Company’s key assumptions may have resulted in the recognition of significant goodwill impairment charges. Our Long Term Care Pharmacy’s goodwill was impaired by $16 million as a result of the asset sale agreement with Omnicare which was signed on August 31, 2010.
 
Generally, changes in estimates of expected future cash flows would have a similar effect on the estimated fair value of the reporting unit. That is, a 1% change in estimated future cash flows would decrease the estimated fair value of the reporting unit by approximately 1%. The estimated long-term rate of net sales growth can have a significant impact on the estimated future cash flows, and therefore, the fair value of each reporting unit. For the two reporting units whose fair values exceeded carrying values by less than 10%, a 1% decrease in the long-term net sales growth rate would have resulted in the reporting units failing the first step of the goodwill impairment test. Of the other key assumptions that impact the estimated fair values, most reporting units have the greatest sensitivity to changes in the estimated discount rate.  A 1.0 percentage point increase in estimated discount rates for the two reporting units whose fair value exceeded carrying value by less than 10% would also have resulted in the reporting units failing step one. The Company believes that its estimates of future cash flows and discount rates are reasonable, but future changes in the underlying assumptions could differ due to the inherent uncertainty in making such estimates.
 

We have not made any material changes to the method of evaluating goodwill and intangible asset impairments during the last three years.  Based on current knowledge, we do not believe there is a reasonable likelihood that there will be a material change in the estimates or assumptions used to determine impairment.

Allowance for doubtful accounts – The provision for bad debt is based on both specific receivables and historic write-off percentages.  We have not made any material changes to the method of estimating our allowance for doubtful accounts during the last three years.  Based on current knowledge, we do not believe there is a reasonable likelihood that there will be a material change in the estimates or assumptions used to determine the allowance.

Vendor allowances – Vendor allowances are principally received as a result of purchases, sales or promotion of vendors' products.  Allowances are generally recorded as a reduction of inventory and are recognized as a reduction of cost of sales when the related merchandise is sold.  Those allowances received for promoting vendors' products are offset against advertising expense and result in a reduction of selling, general and administrative expenses to the extent of advertising incurred, with the excess treated as a reduction of inventory costs. We have not made any material changes to the method of estimating our vendor allowances during the last three years.  Based on current knowledge, we do not believe there is a reasonable likelihood that there will be a material change in the estimates or assumptions used to determine vendor allowances.

Liability for closed locations – The liability is based on the present value of future rent obligations and other related costs (net of estimated sublease rent) to the first lease option date.  We have not made any material changes to the method of estimating our liability for closed locations during the last three years.  Based on current knowledge, we do not believe there is a reasonable likelihood that there will be a material change in the estimates or assumptions used to determine the liability.

Liability for insurance claims – The liability for insurance claims is recorded based on estimates for claims incurred and is not discounted.  The provisions are estimated in part by considering historical claims experience, demographic factors and other actuarial assumptions.  We have not made any material changes to the method of estimating our liability for insurance claims during the last three years.  Based on current knowledge, we do not believe there is a reasonable likelihood that there will be a material change in the estimates or assumptions used to determine the liability.

Cost of sales – Drugstore cost of sales is derived based on point-of-sale scanning information with an estimate for shrinkage and adjusted based on periodic inventories. Inventories are valued at the lower of cost or market determined by the last-in, first-out (LIFO) method.  We have not made any material changes to the method of estimating cost of sales during the last three years.  Based on current knowledge, we do not believe there is a reasonable likelihood that there will be a material change in the estimates or assumptions used to determine cost of sales.

Income taxes – We are subject to routine income tax audits that occur periodically in the normal course of business.  U.S. federal, state and local and foreign tax authorities raise questions regarding our tax filing positions, including the timing and amount of deductions and the allocation of income among various tax jurisdictions. In evaluating the tax benefits associated with our various tax filing positions, we record a tax benefit for uncertain tax positions using the highest cumulative tax benefit that is more likely than not to be realized. Adjustments are made to our liability for unrecognized tax benefits in the period in which we determine the issue is effectively settled with the tax authorities, the statute of limitations expires for the return containing the tax position or when more information becomes available. Our liability for unrecognized tax benefits, including accrued penalties and interest, is included in other long-term liabilities on our consolidated balance sheets and in income tax expense in our consolidated statements of earnings.

In determining our provision for income taxes, we use an annual effective income tax rate based on full-year income, permanent differences between book and tax income, and statutory income tax rates. The effective income tax rate also reflects our assessment of the ultimate outcome of tax audits. Discrete events such as audit settlements or changes in tax laws are recognized in the period in which they occur.  Based on current knowledge, we do not believe there is a reasonable likelihood that there will be a material change in the estimates or assumptions used to determine the amounts recorded for income taxes.

Liquidity and Capital Resources

Cash and cash equivalents were $1,880 million at August 31, 2010, compared to $2,087 million at August 31, 2009.  Short-term investment objectives are to minimize risk, maintain liquidity and maximize after-tax yields.  To attain these objectives, investment limits are placed on the amount, type and issuer of securities.  Investments are principally in U.S. Treasury market funds and Treasury Bills.

Net cash provided by operating activities was $3,744 million at August 31, 2010, compared to $4,111 million a year ago.  The decrease from the prior year is primarily attributable to lower working capital improvements.  For the year, we generated $306 million in cash flow from working capital improvements, primarily through better accounts payable management.  Higher earnings also positively contributed to cash from operations.  Last year, cash flows from working capital improvements were $728 million.  Cash provided by operations is the principal source of funds for expansion, acquisitions, remodeling programs, dividends to shareholders and share repurchases.  In fiscal 2009, we supplemented cash provided by operations with long-term debt.

Net cash used for investing activities was $1,274 million versus $2,776 million last year.  In the current year we invested $3,000 million in short-term Treasury Bills, and redeemed $3,500 million.  Additions to property and equipment were $1,014 million compared to $1,927 million last year.  During the year, we added a total of 670 locations (550 net) compared to 691 last year (562 net).  There were 95 owned locations added during the year and 65 under construction at August 31, 2010, versus 183 owned locations added and 42 under construction as of August 31, 2009.

               
Home
   
Specialty
   
Mail
       
   
Drugstores
   
Worksites
   
Care
   
Pharmacy
   
Service
   
Total
 
August 31, 2008
    6,443       364       115       10       2       6,934  
   New/Relocated
    556       36       5       5       -       602  
   Acquired
    70       3       11       5       -       89  
   Closed/Replaced
    (72 )     (26 )     (26 )     (5 )     -       (129 )
August 31, 2009
    6,997       377       105       15       2       7,496  
   New/Relocated
    359       24       4       1       -       388  
   Acquired
    281       -       1       -       -       282  
   Closed/Replaced
    (75 )     (34 )     (9 )     (2 )     -       (120 )
August 31, 2010
    7,562       367       101       14       2       8,046  

Business acquisitions this year were $779 million versus $405 million in fiscal 2009.  Business acquisitions in the current year primarily include the purchase of all 258 Duane Reade stores located in the New York City metropolitan area, as well as the corporate office and two distribution centers for $558 million net of assumed cash of $6 million; and selected other assets (primarily prescription files).  Business acquisitions in 2009 included select locations of Drug Fair to our retail drugstore operations; McKesson Specialty and IVPCARE to our specialty pharmacy operations; and selected other assets (primarily prescription files).

Capital expenditures for fiscal 2011 are expected to be approximately $1.4 billion, excluding business acquisitions and prescription file purchases.  We expect new drugstore organic growth of between 2.5% and 3.0% in fiscal 2011.  During the current fiscal year we added a total of 670 locations, of which 359 were new or relocated drugstores.  We are continuing to relocate stores to more convenient and profitable freestanding locations.  In addition to new stores, expenditures are planned for distribution centers and technology.  The timing and size of any new business ventures or acquisitions that we complete may also impact our capital expenditures.

Net cash used by financing activities was $2,677 million in fiscal 2010.  In fiscal 2009, net cash from financing activities provided $309 million.  Upon the closing of the Duane Reade acquisition we assumed debt of $574 million. Subsequent to closing, we retired all Duane Reade debt for $576 million. In the prior year we had net proceeds from the issuance of long-term debt of $987 million and repayments of short-term borrowing of $70 million.

On October 14, 2009, our Board of Directors approved a long-term capital policy:  to maintain a strong balance sheet and financial flexibility; reinvest in our core strategies; invest in strategic opportunities that reinforce our core strategies and meet return requirements; and return surplus cash flow to shareholders in the form of dividends and share repurchases over the long term.  In connection with our capital policy, our Board of Directors authorized a share repurchase program (2009 repurchase program) and set a long-term dividend payout ratio target between 30 and 35 percent.  The 2009 repurchase program, which was completed in September 2010, allowed for the repurchase of up to $2,000 million of the Company’s common stock prior to its expiration on December 31, 2013.  Shares totaling $1,640 million were purchased in conjunction with the 2009 repurchase program during fiscal 2010.  On October 13, 2010, our Board of Directors authorized a new share repurchase program (2011 repurchase program) which allows for the repurchase of up to $1,000 million of the Company’s common stock prior to its expiration on December 31, 2012.  To support the needs of the employee stock plans, we purchased shares totaling $116 million in fiscal 2010, compared to $279 million in fiscal 2009.  We had proceeds related to employee stock plans of $233 million during the current fiscal year as compared to $138 million a year ago.  Cash dividends paid were $541 million during the current fiscal year versus $446 million a year ago.

We had no commercial paper outstanding at August 31, 2010.  In connection with our commercial paper program, we maintain two unsecured backup syndicated lines of credit that total $1,100 million.  The first $500 million facility expires on July 20, 2011, and allows for the issuance of up to $250 million in letters of credit, which reduce the amount available for borrowing.  The second $600 million facility expires on August 12, 2012.  Our ability to access these facilities is subject to our compliance with the terms and conditions of the credit facility, including financial covenants.  The covenants require us to maintain certain financial ratios related to minimum net worth and priority debt, along with limitations on the sale of assets and purchases of investments.  At August 31, 2010, we were in compliance with all such covenants.  The Company pays a facility fee to the financing banks to keep these lines of credit active.  At August 31, 2010, there were no letters of credit issued against these facilities and we do not anticipate any future letters of credit to be issued against these facilities.

Our current credit ratings are as follows:

Rating Agency
Long-Term Debt Rating
Commercial Paper Rating
Outlook
Moody's
A2
P-1
Stable
Standard & Poor's
A
A-1
Stable

In assessing our credit strength, both Moody's and Standard & Poor's consider our business model, capital structure, financial policies and financial statements.  Our credit ratings impact our borrowing costs, access to capital markets and operating lease costs.

Contractual Obligations and Commitments

The following table lists our contractual obligations and commitments at August 31, 2010 (in millions):

   
Payments Due by Period
 
   
Total
   
Less Than 1 Year
   
1-3 Years
   
3-5 Years
   
Over 5 Years
 
Operating leases (1)
  $ 36,369     $ 2,263     $ 4,562     $ 4,384     $ 25,160  
Purchase obligations (2):
                                       
Open inventory purchase orders
    1,802       1,802       -       -       -  
Real estate development
    370       184       168       18       -  
Other corporate obligations
    682       368       189       96       29  
Long-term debt*(3)
    2,352       7       1,304       9       1,032  
Interest payment on long-term debt
    636       113       232       105       186  
Insurance*
    558       233       169       77       79  
Retiree health*
    441       12       26       32       371  
Closed location obligations*
    151       32       36       23       60  
Capital lease obligations*(1)
    92       5       8       8       71  
Other long-term liabilities reflected on the balance sheet* (4)
    860       91       176       149       444  
Total
  $ 44,313     $ 5,110     $ 6,870     $ 4,901     $ 27,432  
*Recorded on balance sheet.

(1)
Amounts for operating leases and capital leases do not include certain operating expenses under these leases such as common area maintenance, insurance and real estate taxes.  These expenses for the fiscal year ended August 31, 2010, were $375 million.
(2)
Purchase obligations include agreements to purchase goods or services that are enforceable and legally binding and that specify all significant terms, including open purchase orders.
(3)
Total long-term debt on the Consolidated Balance Sheet includes a $51 million fair market value adjustment and $8 million of unamortized discount.
(4)
Includes $76 million ($31 million due in 1-3 years, $33 million due in 3-5 years and $12 million due over 5 years) of unrecognized tax benefits recorded under ASC Topic 740.

The expected timing of payments of the obligations above is estimated based on current information. Timing of payments and actual amounts paid may be different, depending on the time of receipt of goods or services, or changes to agreed-upon amounts for some obligations.

Off-Balance Sheet Arrangements

We do not have any unconsolidated special purpose entities and, except as described herein, we do not have significant exposure to any off-balance sheet arrangements. The term “off-balance sheet arrangement” generally means any transaction, agreement or other contractual arrangement to which an entity unconsolidated with us is a party, under which we have: (i) any obligation arising under a guarantee contract, derivative instrument or variable interest; or (ii) a retained or contingent interest in assets transferred to such entity or similar arrangement that serves as credit, liquidity or market risk support for such assets.

Letters of credit are issued to support purchase obligations and commitments (as reflected on the Contractual Obligations and Commitments table) as follows (in millions):

Insurance
  $ 233  
Inventory obligations
    185  
Real estate development
    19  
Total
  $ 437  

We have no off-balance sheet arrangements other than those disclosed on the Contractual Obligations and Commitments table and a credit agreement guaranty on behalf of SureScripts-RxHub, LLC.  This agreement is described more fully in Note 10 in the Notes to Consolidated Financial Statements.

Both on-balance sheet and off-balance sheet financing alternatives are considered when pursuing our capital structure and capital allocation objectives.

Recent Accounting Pronouncements
In June 2009, the Financial Accounting Standards Board (FASB) issued Accounting Standards Codification (ASC) Topic 810, Consolidation (formerly SFAS No. 167, Amendments to FASB Interpretation No. 46(R)), which amends the consolidation guidance applicable to variable interest entities. The amendments will significantly affect the overall consolidation analysis under ASC Topic 810. The application of the new provisions under this topic, which will be effective for the first quarter of fiscal 2011, is not expected to have a material impact on the Company’s Consolidated Balance Sheet or Consolidated Statement of Earnings.

Cautionary Note Regarding Forward-Looking Statements

This report and other documents that we file with the Securities and Exchange Commission contain forward-looking statements that are based on current expectations, estimates, forecasts and projections about our future performance, our business, our beliefs and our management’s assumptions.  Statements that are not historical facts are forward-looking statements, including forward-looking information concerning pharmacy sales trends, prescription margins, number and location of new store openings, outcomes of litigation, the level of capital expenditures, industry trends, demographic trends, growth strategies, financial results, cost reduction initiatives, acquisition synergies, regulatory approvals, and competitive strengths.  Words such as “expect,” “outlook,” “forecast,” “would,” “could,” “should,” “project,” “intend,” “plan,” “continue,” “believe,” “seek,” “estimate,” “anticipate,” “may,” “assume,” and variations of such words and similar expressions are often used to identify such forward-looking statements, which are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995.  These forward-looking statements are not guarantees of future performance and involve risks, assumptions and uncertainties, including, but not limited to, those described in Item 1A “Risk Factors” in our Form 10-K and in other reports that we file or furnish with the Securities and Exchange Commission.  Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those indicated or anticipated by such forward-looking statements.  Accordingly, you are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date they are made.  Except to the extent required by law, we undertake no obligation to update publicly any forward-looking statements after the date they are made, whether as a result of new information, future events, changes in assumptions or otherwise.

 

 

Consolidated Statements of Earnings
Walgreen Co. and Subsidiaries
For the years ended August 31, 2010, 2009 and 2008
(In millions, except per share amounts)

   
2010
   
2009
   
2008
 
Net sales
  $ 67,420     $ 63,335     $ 59,034  
Cost of sales
    48,444       45,722       42,391  
Gross Profit
    18,976       17,613       16,643  
Selling, general and administrative expenses
    15,518       14,366       13,202  
Operating Income
    3,458       3,247       3,441  
Interest expense, net
    (85 )     (83 )     (11 )
Earnings Before Income Tax Provision
    3,373       3,164       3,430  
Income tax provision
    1,282       1,158       1,273  
Net Earnings
  $ 2,091     $ 2,006     $ 2,157  
                         
Net earnings per common share - basic
  $ 2.13     $ 2.03     $ 2.18  
Net earnings per common share - diluted
    2.12       2.02       2.17  
                         
Average shares outstanding
    981.7       990.0       990.6  
Dilutive effect of stock options
    6.2       1.3       4.9  
Average shares outstanding assuming dilution
    987.9       991.3       995.5  

The accompanying Notes to Consolidated Financial Statements are integral parts of these statements.

 

 

Consolidated Statements of Shareholders' Equity
Walgreen Co. and Subsidiaries
For the years ended August 31, 2010, 2009 and 2008
(In millions, except shares and per share amounts)

Shareholders' Equity
 
Common Stock Shares
   
Common Stock Amount
   
Paid-In Capital
   
Employee Stock Loan Receivable
   
Retained Earnings
   
Accumulated Other Comprehensive Income(Loss)
   
Treasury Stock Amount
 
Balance, August 31, 2007
    991,141,357     $ 80     $ 559     $ (52 )   $ 12,027     $ (4 )   $ (1,506 )
Net earnings
    -       -       -       -       2,157       -       -  
Cash dividends declared ($.3975 per share)
    -       -       -       -       (394 )     -       -  
Treasury stock purchases
    (8,000,000 )     -       -       -       -       -       (294 )
Employee stock purchase and option plans
    6,034,861       -       (55 )     -       -       -       249  
Stock-based compensation
    -       -       71       -       -       -       -  
Employee stock loan receivable
    -       -       -       16       -       -       -  
ASC 740 adoption impact
    -       -       -       -       2       -       -  
Additional minimum postretirement liability, net of $2 tax benefit
    -       -       -       -       -       13       -  
Balance, August 31, 2008
    989,176,218       80       575       (36 )     13,792       9       (1,551 )
Net earnings
    -       -       -       -       2,006       -       -  
Cash dividends declared ($.4750 per share)
    -       -       -       -       (471 )     -       -  
Treasury stock purchases
    (10,270,000 )     -       -       -       -       -       (279 )
Employee stock purchase and option plans
    9,655,172       -       (48 )     -       -       -       297  
Stock-based compensation
    -       -       78       -       -       -       -  
Employee stock loan receivable
    -       -       -       (104 )     -       -       -  
Additional minimum postretirement liability, net of $29 tax benefit
    -       -       -       -       -       28       -  
Balance, August 31, 2009
    988,561,390       80       605       (140 )     15,327       37       (1,533 )
Net earnings
    -       -       -       -       2,091       -       -  
Cash dividends declared ($.5875 per share)
    -       -       -       -       (570 )     -       -  
Treasury stock purchases
    (55,716,733 )     -       -       -       -       -       (1,756 )
Employee stock purchase and option plans
    5,760,396       -       (5 )     -       -       -       188  
Stock-based compensation
    -       -       84       -       -       -       -  
Employee stock loan receivable
    -       -       -       53       -       -       -  
Additional minimum postretirement liability, net of $34 tax expense
    -       -       -       -       -       (61 )     -  
Balance, August 31, 2010
    938,605,053     $ 80     $ 684     $ (87 )   $ 16,848     $ (24 )   $ (3,101 )

The accompanying Notes to Consolidated Financial Statements are integral parts of these statements.

 

 

Consolidated Balance Sheets
Walgreen Co. and Subsidiaries
At August 31, 2010 and 2009
(In millions, except shares and per share amounts)
   
Assets
 
2010
   
2009
 
Current Assets
           
Cash and cash equivalents
  $ 1,880     $ 2,087  
Short-term investments
    -       500  
Accounts receivable, net
    2,450       2,496  
Inventories
    7,378       6,789  
Other current assets
    214       177  
Total Current Assets
    11,922       12,049  
Non-Current Assets
               
Property and equipment, at cost, less accumulated depreciation and amortization
    11,184       10,802  
Goodwill
    1,887       1,461  
Other non-current assets
    1,282       830  
Total Non-Current Assets
    14,353       13,093  
Total Assets
  $ 26,275     $ 25,142  
                 
Liabilities and Shareholders' Equity
               
Current Liabilities
               
Short-term borrowings
  $ 12     $ 15  
Trade accounts payable
    4,585       4,308  
Accrued expenses and other liabilities
    2,763       2,406  
Income taxes
    73       40  
Total Current Liabilities
    7,433       6,769  
Non-Current Liabilities
               
Long-term debt
    2,389       2,336  
Deferred income taxes
    318       265  
Other non-current liabilities
    1,735       1,396  
Total Non-Current Liabilities
    4,442       3,997  
Commitments and Contingencies (see Note 10)
               
Shareholders' Equity
               
Preferred stock, $.0625 par value; authorized 32 million shares; none issued
    -       -  
Common stock, $.078125 par value; authorized 3.2 billion shares; issued 1,025,400,000 shares in 2010 and 2009
    80       80  
Paid-in capital
    684       605  
Employee stock loan receivable
    (87 )     (140 )
Retained earnings
    16,848       15,327  
Accumulated other comprehensive (loss) income
    (24 )     37  
Treasury stock at cost, 86,794,947 shares in 2010 and 36,838,610 shares in 2009
    (3,101 )     (1,533 )
Total Shareholders' Equity
    14,400       14,376  
Total Liabilities and Shareholders' Equity
  $ 26,275     $ 25,142  

The accompanying Notes to Consolidated Financial Statements are integral parts of these statements.

 

 

Consolidated Statements of Cash Flows
Walgreen Co. and Subsidiaries
For the years ended August 31, 2010, 2009 and 2008
(In millions)
   
   
2010   
   
2009   
   
2008   
 
Cash Flows from Operating Activities
                 
Net earnings
  $ 2,091     $ 2,006     $ 2,157  
Adjustments to reconcile net earnings to net cash provided by operating activities –
                       
Depreciation and amortization
    1,030       975       840  
Deferred income taxes
    63       260       (61 )
Stock compensation expense
    84       84       68  
Income tax savings from employee stock plans
    3       1       3  
Other
    57       12       11  
Changes in operating assets and liabilities -
                       
Accounts receivable, net
    124       6       (365 )
Inventories
    (307 )     533       (412 )
Other assets
    50       7       (24 )
Trade accounts payable
    167       11       550  
Accrued expenses and other liabilities
    262       66       84  
Income taxes
    10       105       80  
Other non-current liabilities
    110       45       108  
Net cash provided by operating activities
    3,744       4,111       3,039  
Cash Flows from Investing Activities
                       
Purchases of short-term investments – held to maturity
    (3,000 )     (2,600 )     -  
Proceeds from short-term investments – held to maturity
    3,500       2,100       -  
Additions to property and equipment
    (1,014 )     (1,927 )     (2,225 )
Proceeds from sale of assets
    51       51       17  
Business and intangible asset acquisitions, net of cash  received
    (779 )     (405 )     (620 )
Other
    (32 )     5       10  
Net cash used for investing activities
    (1,274 )     (2,776 )     (2,818 )
Cash Flows from Financing Activities
                       
Net payment from short-term borrowings
    -       (70 )     (802 )
Net proceeds from issuance of long-term debt
    -       987       1,286  
Payments of long-term debt
    (576 )     -       (28 )
Stock purchases
    (1,756 )     (279 )     (294 )
Proceeds related to employee stock plans
    233       138       210  
Cash dividends paid
    (541 )     (446 )     (376 )
Other
    (37 )     (21 )     (29 )
Net cash (used for) provided by financing activities
    (2,677 )     309       (33 )
Changes in Cash and Cash Equivalents
                       
Net (decrease) increase in cash and cash equivalents
    (207 )     1,644       188  
Cash and cash equivalents, September 1
    2,087       443       255  
Cash and cash equivalents, August 31
  $ 1,880     $ 2,087     $ 443  

The accompanying Notes to Consolidated Financial Statements are integral parts of these statements.

 

 

Notes to Consolidated Financial Statements

(1)      Summary of Major Accounting Policies

Description of Business
The Company is principally in the retail drugstore business and its operations are within one reportable segment.  At August 31, 2010, there were 8,046 drugstore and other locations in 50 states, the District of Columbia, Guam and Puerto Rico.  Prescription sales were 65.2% of total sales for fiscal 2010 compared to 65.3% in 2009 and 64.9% in 2008.

Basis of Presentation
The consolidated financial statements include the accounts of the Company and its subsidiaries.  All intercompany transactions have been eliminated.  The consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and include amounts based on management's prudent judgments and estimates. Actual results may differ from these estimates.

The Company follows the guidance of Accounting Standards Codification (ASC) Topic 855, Subsequent Events, which requires a review of subsequent events through the date the financial statements are issued.

Cash and Cash Equivalents
Cash and cash equivalents include cash on hand and all highly liquid investments with an original maturity of three months or less.  Credit and debit card receivables from banks, which generally settle within two business days, of $80 million and $70 million were included in cash and cash equivalents at August 31, 2010 and 2009, respectively.  Also included in cash and cash equivalents at August 31, 2010, was $600 million in U.S. Treasury Bills.

The Company's cash management policy provides for controlled disbursement.  As a result, the Company had outstanding checks in excess of funds on deposit at certain banks.  These amounts, which were $235 million at August 31, 2010, and $336 million at August 31, 2009, are included in trade accounts payable in the accompanying Consolidated Balance Sheets.

Financial Instruments
The Company had $185 million and $69 million of outstanding letters of credit at August 31, 2010 and 2009, respectively, which guarantee foreign trade purchases.  Additional outstanding letters of credit of $233 million and $265 million at August 31, 2010 and 2009, respectively, guarantee payments of insurance claims.  The insurance claim letters of credit are annually renewable and will remain in place until the insurance claims are paid in full.  Letters of credit of $19 million and $13 million were outstanding at August 31, 2010, and August 31, 2009, respectively, to guarantee performance of construction contracts.  The Company pays a facility fee to the financing bank to keep these letters of credit active.  The Company had real estate development purchase commitments of $370 million and $383 million at August 31, 2010 and 2009, respectively.

In January 2010, the Company terminated all of its existing one-month future LIBOR interest rate swaps.  Upon termination the Company received payment from its counterparty which consisted of accrued interest and an amount representing the fair value of its swaps.  The related fair value benefit attributed to the Company’s debt will be amortized over the life of the debt.  The Company then entered into six-month LIBOR in arrears swaps with two counterparties.  These swaps are accounted for according to ASC Topic 815, Derivatives and Hedging (formerly Statement of Financial Accounting Standard (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities and SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities).  The swaps are measured at fair value in accordance with ASC Topic 820, Fair Value Measurement and Disclosures (formerly SFAS No. 157, Fair Value Measurements).  See Notes 8 and 9 for additional disclosure regarding financial instruments.
 
Inventories
Inventories are valued on a lower of last-in, first-out (LIFO) cost or market basis.  At August 31, 2010 and 2009, inventories would have been greater by $1,379 million and $1,239 million, respectively, if they had been valued on a lower of first-in, first-out (FIFO) cost or market basis.  Inventory includes product costs, inbound freight, warehousing costs and vendor allowances.

Cost of Sales
Cost of sales is derived based upon point-of-sale scanning information with an estimate for shrinkage and is adjusted based on periodic inventories.  In addition to product costs, cost of sales includes warehousing costs, purchasing costs, freight costs, cash discounts and vendor allowances.

Selling, General and Administrative Expenses
Selling, general and administrative expenses mainly consist of store salaries, occupancy costs, and expenses directly related to stores.  Other administrative costs include headquarters’ expenses, advertising costs (net of advertising revenue) and insurance.

Vendor Allowances
Vendor allowances are principally received as a result of purchases, sales or promotion of vendors' products.  Allowances are generally recorded as a reduction of inventory and are recognized as a reduction of cost of sales when the related merchandise is sold.  Those allowances received for promoting vendors' products are offset against advertising expense and result in a reduction of selling, general and administrative expenses to the extent of advertising costs incurred, with the excess treated as a reduction of inventory costs.

Property and Equipment
Depreciation is provided on a straight-line basis over the estimated useful lives of owned assets.  Leasehold improvements and leased properties under capital leases are amortized over the estimated physical life of the property or over the term of the lease, whichever is shorter.  Estimated useful lives range from 10 to 39 years for land improvements, buildings and building improvements; and 3 to 12 1/2 years for equipment.  Major repairs, which extend the useful life of an asset, are capitalized; routine maintenance and repairs are charged against earnings.  The majority of the business uses the composite method of depreciation for equipment.  Therefore, gains and losses on retirement or other disposition of such assets are included in earnings only when an operating location is closed, completely remodeled or impaired. Fully depreciated property and equipment are removed from the cost and related accumulated depreciation and amortization accounts.  Property and equipment consists of (in millions):

   
2010
   
2009
 
Land and land improvements
           
Owned locations
  $ 3,135     $ 2,976  
Distribution centers
    103       106  
Other locations
    233       241  
Buildings and building improvements
               
Owned locations
    3,442       3,189  
Leased locations (leasehold improvements only)
    1,099       887  
Distribution centers
    592       619  
Other locations
    343       331  
Equipment
               
Locations
    4,126       4,177  
Distribution centers
    1,106       1,068  
Other locations
    410       355  
Capitalized system development costs
    333       295  
Capital lease properties
    97       46  
      15,019       14,290  
Less:  accumulated depreciation and amortization
    3,835       3,488  
    $ 11,184     $ 10,802  

Depreciation expense for property and equipment was $804 million in fiscal 2010, $787 million in fiscal 2009 and $697 million in fiscal 2008.

The Company capitalizes application stage development costs for significant internally developed software projects, including upgrades to merchandise ordering systems, a store point of sale system, a workload balancing system, and an advertising system.  These costs are amortized over a five-year period.  Amortization was $44 million in fiscal 2010, $40 million in fiscal 2009 and $36 million in fiscal 2008.  Unamortized costs at August 31, 2010 and 2009, were $244 million and $202 million, respectively.

Goodwill and Other Intangible Assets
Goodwill represents the excess of the purchase price over the fair value of assets acquired and liabilities assumed.  The Company accounts for goodwill and intangibles under ASC Topic 350, Intangibles – Goodwill and Other (formerly SFAS No. 142, Goodwill and Other Intangible Assets), which does not permit amortization, but requires the Company to test goodwill and other indefinite-lived assets for impairment annually or whenever events or circumstances indicate impairment may exist.

Revenue Recognition
The Company recognizes revenue at the time the customer takes possession of the merchandise.  Customer returns are immaterial.  Sales taxes are not included in revenue.

The services the Company provides to our pharmacy benefit management (PBM) clients include: plan set-up, claims adjudication with network pharmacies, formulary management, and reimbursement services.  Through its PBM, the Company acts as an agent in administering pharmacy reimbursement contracts and does not assume credit risk.  Therefore, revenue is recognized as only the differential between the amount receivable from the client and the amount owed to the network pharmacy.  We act as an agent to our clients with respect to administrative fees for claims adjudication.  Those service fees are recognized as revenue.

Gift Cards
The Company sells Walgreens gift cards to retail store customers and through its website.  The Company does not charge administrative fees on unused gift cards and most gift cards do not have an expiration date.  Income from gift cards is recognized when (1) the gift card is redeemed by the customer; or (2) the likelihood of the gift card being redeemed by the customer is remote ("gift card breakage") and there is no legal obligation to remit the value of unredeemed gift cards to the relevant jurisdictions.  The Company’s gift card breakage rate is determined based upon historical redemption patterns.  Gift card breakage income, which is included in selling, general and administrative expenses, was not significant in fiscal 2010, 2009 or 2008.
 
Impaired Assets and Liabilities for Store Closings
The Company tests long-lived assets for impairment whenever events or circumstances indicate that a certain asset may be impaired.  Store locations that have been open at least five years are reviewed for impairment indicators at least annually.  Once identified, the amount of the impairment is computed by comparing the carrying value of the assets to the fair value, which is based on the discounted estimated future cash flows.  Impairment charges included in selling, general and administrative expenses were $17 million in fiscal 2010, $10 million in fiscal 2009 and $12 million in fiscal 2008.

The Company also provides for future costs related to closed locations.  The liability is based on the present value of future rent obligations and other related costs (net of estimated sublease rent) to the first lease option date.  The reserve for store closings was $151 million, $99 million and $69 million in fiscal 2010, 2009 and 2008, respectively.  See Note 3 for additional disclosure regarding the Company’s reserve for future costs related to closed locations.

Insurance
The Company obtains insurance coverage for catastrophic exposures as well as those risks required by law to be insured.  It is the Company's policy to retain a significant portion of certain losses related to workers' compensation, property, comprehensive general, pharmacist and vehicle liability.  Liabilities for these losses are recorded based upon the Company's estimates for claims incurred and are not discounted.  The provisions are estimated in part by considering historical claims experience, demographic factors and other actuarial assumptions.

Pre-Opening Expenses
Non-capital expenditures incurred prior to the opening of a new or remodeled store are expensed as incurred.

Advertising Costs
Advertising costs, which are reduced by the portion funded by vendors, are expensed as incurred.  Net advertising expenses, which are included in selling, general and administrative expenses, were $271 million in fiscal 2010, $334 million in fiscal 2009 and $341 million in fiscal 2008.  Included in net advertising expenses were vendor advertising allowances of $197 million in fiscal 2010, $174 million in fiscal 2009 and $180 million in fiscal 2008.

Stock-Based Compensation Plans
In accordance with ASC Topic 718, Compensation – Stock Compensation (formerly SFAS No. 123(R), Share-Based Payment), the Company recognizes compensation expense on a straight-line basis over the employee's vesting period or to the employee's retirement eligible date, if earlier.

Total stock-based compensation expense for fiscal 2010, 2009 and 2008 was $84 million, $84 million and $68 million, respectively.  The recognized tax benefit was $29 million, $29 million and $23 million for fiscal 2010, 2009 and 2008, respectively.

Unrecognized compensation cost related to non-vested awards at August 31, 2010, was $89 million.  This cost is expected to be recognized over a weighted average of three years.

Income Taxes
The Company accounts for income taxes according to the asset and liability method. Under this method, deferred tax assets and liabilities are recognized based upon the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured pursuant to tax laws using rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.  The effect on deferred tax assets and liabilities of a change in tax rate is recognized in income in the period that includes the enactment date. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts more likely than not to be realized.

In determining the Company’s provision for income taxes, an annual effective income tax rate based on full-year income, permanent differences between book and tax income, and statutory income tax rates is used. The effective income tax rate also reflects the Company’s assessment of the ultimate outcome of tax audits. Discrete events such as audit settlements or changes in tax laws are recognized in the period in which they occur.

The Company is subject to routine income tax audits that occur periodically in the normal course of business.  U.S. federal, state and local and foreign tax authorities raise questions regarding the Company’s tax filing positions, including the timing and amount of deductions and the allocation of income among various tax jurisdictions. In evaluating the tax benefits associated with its various tax filing positions, the Company records a tax benefit for uncertain tax positions using the highest cumulative tax benefit that is more likely than not to be realized. Adjustments are made to its liability for unrecognized tax benefits in the period in which the Company determines the issue is effectively settled with the tax authorities, the statute of limitations expires for the return containing the tax position or when more information becomes available. The Company’s liability for unrecognized tax benefits, including accrued penalties and interest, is included in other long-term liabilities on the Consolidated Balance Sheets and in income tax expense in the Consolidated Statements of Earnings.

Earnings Per Share
The dilutive effect of outstanding stock options on earnings per share is calculated using the treasury stock method.  Stock options are anti-dilutive and excluded from the earnings per share calculation if the exercise price exceeds the market price of the common shares.  Outstanding options to purchase common shares of 30,661,551 in 2010, 44,877,558 in 2009 and 12,962,745 in 2008 were excluded from the earnings per share calculations.

Interest Expense
The Company capitalized $12 million, $16 million and $19 million of interest expense as part of significant construction projects during fiscal 2010, 2009 and 2008, respectively.  Interest paid, which is net of capitalized interest, was $89 million in fiscal 2010 and fiscal 2009 and $11 million in fiscal 2008.

Accumulated Other Comprehensive Income (Loss)
The Company follows ASC topic 715, Compensation – Retirement Benefits (Formerly SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans—an Amendment of FASB Statements No. 87, 88, 106 and 132(R)).  The amount included in accumulated other comprehensive income related to the Company's postretirement plan was a loss of $57 million pre-tax ($24 million after-tax) at August 31, 2010 compared to income of $37 million pre-tax ($37 million after-tax) at August 31, 2009.  The minimum postretirement liability totaled $441 million and $328 million at August 31, 2010 and 2009, respectively.

New Accounting Pronouncements
In June 2009, the Financial Accounting Standards Board (FASB) issued ASC Topic 810, Consolidation (formerly SFAS No. 167, Amendments to FASB Interpretation No. 46(R)), which amends the consolidation guidance applicable to variable interest entities. The amendments will significantly affect the overall consolidation analysis under ASC Topic 810. The application of the new provisions under this topic, which will be effective for the first quarter of fiscal 2011, is not expected to have a material impact on the Company’s Consolidated Balance Sheet or Consolidated Statement of Earnings.
 
(2)      Restructuring

On October 30, 2008, the Company announced a series of strategic initiatives, approved by the Board of Directors, to enhance shareholder value.  One of these initiatives was a program known as “Rewiring for Growth”, which was designed to reduce cost and improve productivity through strategic sourcing of indirect spend, reducing corporate overhead and work throughout the Company’s stores, rationalization of inventory categories, and transforming community pharmacy.  The Company expects to complete these initiatives in fiscal 2011.  

The following pre-tax charges associated with Rewiring for Growth have been recorded in the Consolidated Statements of Earnings (in millions):

   
Twelve Months Ended August 31,
 
   
2010
   
2009
 
Severance and other benefits
  $ 16     $ 74  
Project cancellation settlements
    -       7  
Inventory charges
    19       63  
     Restructuring expense
    35       144  
Consulting
    50       76  
     Restructuring and restructuring related costs
  $ 85     $ 220  
                 
Cost of sales
  $ 19     $ 63  
Selling, general and administrative expenses
    66       157  
    $ 85     $ 220  

Severance and other benefits include the charges associated with employees who were separated from the Company.  In the current fiscal year, 193 employees have been separated from the Company.  Since inception, a total of 890 employees have been separated from the Company as a result of these initiatives.

Inventory charges relate to on-hand inventory that has been reduced from cost to selling price below cost.

We have recorded the following balances in accrued expenses and other liabilities on our Consolidated Balance Sheets (in millions):

   
Severance and Other Benefits
 
August 31, 2008 Reserve Balance
  $ -  
Charges
    82  
Cash Payments
    (78 )
August 31, 2009 Reserve Balance
  $ 4  
Charges
    19  
Cash Payments
    (23 )
August 31, 2010 Reserve Balance
  $ -  

Additionally, as a part of the Company’s Customer Centric Retailing (CCR) initiative, it is enhancing the store format to ensure that it has the proper assortments, better category layouts and adjacencies, better shelf height and sight lines, and better assortment and brand and private brand layout, all of which are designed to positively enhance the shopper experience and increase customer frequency and purchase size.  The Company expects this format will be rolled out to approximately 5,500 existing stores.   At August 31, 2010, in total, the Company has converted 1,469 stores and opened 345 new stores with the CCR format.  The Company expects to convert approximately 4,000 stores and open approximately 250 new stores with the CCR format in fiscal 2011.  Based on its experience with the first 1,469 stores, the Company expects the total cost, which includes both selling, general and administrative expenses and capital, to be approximately $50 thousand per store.  For the fiscal year ended August 31, 2010, the Company incurred $71 million in total program costs, of which $45 million was included in selling, general and administrative expenses and $26 million in capital costs.  The Company incurred $5 million in program costs, all of which was included in selling, general and administrative expenses, in fiscal 2009.

(3)      Leases

The Company owns 20.2% of its operating locations; the remaining locations are leased premises.  Initial terms are typically 20 to 25 years, followed by additional terms containing cancellation options at five-year intervals, and may include rent escalation clauses.  The commencement date of all lease terms is the earlier of the date the Company becomes legally obligated to make rent payments or the date the Company has the right to control the property.  Additionally, the Company recognizes rent expense on a straight-line basis over the term of the lease.  In addition to minimum fixed rentals, most leases provide for contingent rentals based upon a portion of sales.

Minimum rental commitments at August 31, 2010, under all leases having an initial or remaining non-cancelable term of more than one year are shown below (in millions):

   
Capital Lease
   
Operating Lease
 
2011
  $ 8     $ 2,301  
2012
    7       2,329  
2013
    6       2,296  
2014
    7       2,248  
2015
    6       2,188  
Later
    89       25,428  
Total minimum lease payments
  $ 123     $ 36,790  

The capital lease amount includes $31 million of executory costs and imputed interest.  Total minimum lease payments have not been reduced by minimum sublease rentals of approximately $23 million on leases due in the future under non-cancelable subleases.

The Company provides for future costs related to closed locations.  The liability is based on the present value of future rent obligations and other related costs (net of estimated sublease rent) to the first lease option date.  In fiscal 2010 and 2009, the Company recorded charges of $90 million and $67 million, respectively, for facilities that were closed or relocated under long-term leases.  These charges are reported in selling, general and administrative expenses on the Consolidated Statements of Earnings.

The changes in reserve for facility closings and related lease termination charges include the following (in millions):

   
Twelve Months Ended August 31
 
   
2010
   
2009
 
Balance – beginning of period
  $ 99     $ 69  
Provision for present value of non-cancellable lease payments of closed facilities
    77       38  
Assumptions about future sublease income, terminations, and changes in interest rates
    (9 )     8  
Interest accretion
    22       21  
Cash payments, net of sublease income
    (45 )     (37 )
Reserve acquired through acquisition
    7       -  
Balance – end of period
  $ 151     $ 99  

The Company remains secondarily liable on 28 assigned leases.  The maximum potential undiscounted future payments are $33 million at August 31, 2010.  Lease option dates vary, with some extending to 2027.

Rental expense was as follows (in millions):

   
2010
   
2009
   
2008
 
Minimum rentals
  $ 2,218     $ 1,973     $ 1,784  
Contingent rentals
    9       11       13  
Less:  Sublease rental income
    (9 )     (9 )     (10 )
    $ 2,218     $ 1,975     $ 1,787  

(4)      Acquisitions

On April 9, 2010, the Company completed the stock acquisition of Duane Reade Holdings, Inc., and Duane Reade Shareholders, LLC (Duane Reade), which consisted of 258 Duane Reade stores located in the New York City metropolitan area, as well as the corporate office and two distribution centers.  Total purchase price was $1,132 million, which included the assumption of debt.  Included in the purchase price is a fair market value adjustment to increase debt assumed by $81 million.  This acquisition increased the Company’s presence in the New York metropolitan area.

The preliminary allocation of the purchase price of Duane Reade was accounted for under the purchase method of accounting with the Company as the acquirer in accordance with ASC Topic 805, Business Combinations.  Goodwill, none of which is deductible for tax purposes, and other intangible assets recorded in connection with the acquisition totaled $418 million and $438 million, respectively.  Goodwill consists of expected purchasing synergies, consolidation of operations and reductions in selling, general and administrative expenses.  Intangible assets consist of $297 million of favorable lease interests (10-year weighted average useful life), $74 million in customer relationships (10-year useful life), $38 million in trade name (5-year useful life) and $29 million in other intangible assets (10-year useful life).

Assets acquired and liabilities assumed in the transaction were recorded at their acquisition date fair values while transaction costs associated with the acquisition were expensed as incurred.  The Company’s allocation was based on an evaluation of the appropriate fair values and represented management’s best estimate based on available data.  The final purchase accounting has not yet been completed.  Any adjustments to the preliminary purchase price allocation are not expected to be material.  The preliminary estimated fair values of assets acquired and liabilities assumed on April 9, 2010, are as follows (in millions):

Accounts receivable
  $ 52  
Inventory
    232  
Other current assets
    23  
Property and equipment
    219  
Other non-current assets
    4  
Intangible assets
    438  
Goodwill
    418  
Total assets acquired
    1,386  
Liabilities assumed
    254  
Debt assumed
    574  
Net cash paid
  $ 558  

We assumed federal net operating losses of $261 million and state net operating losses of $252 million, both which begin to expire in 2018, in conjunction with the Duane Reade acquisition.

The unaudited pro forma consolidated statements of earnings for fiscal 2010 and fiscal 2009 (assuming the acquisition of Duane Reade as of the beginning of each fiscal period) are as follows (in millions, except per share amounts):

   
Twelve Months Ended August 31,
 
   
2010
   
2009
 
Net sales
  $ 68,603     $ 65,161  
Net earnings
    2,084       1,997  
Net earnings per common share:
               
     Basic
    2.12       2.02  
     Diluted
    2.11       2.01  

These pro forma statements have been prepared for comparative purposes only and are not intended to be indicative of what the Company's results would have been had the acquisition occurred at the beginning of the periods presented or the results which may occur in the future.

The Company incurred $71 million in costs related to the acquisition, all of which was included in selling, general and administrative expenses.  Actual results from Duane Reade operations included in the Consolidated Statements of Earnings since the date of acquisition are as follows (in millions, except per share amounts):

   
Twelve Months Ended August, 31, 2010
 
Net sales
  $ 732  
Net loss
    (56 )
Net earnings per common share:
       
     Basic
    (0.06 )
     Diluted
    (0.06 )

The aggregate purchase price of all business and intangible asset acquisitions, excluding Duane Reade, was $221 million in fiscal 2010.  These acquisitions added $34 million to goodwill and $156 million to intangible assets, primarily prescription files.  The remaining fair value relates to immaterial amounts of tangible assets, less liabilities assumed.  Operating results of the businesses acquired have been included in the Consolidated Statements of Earnings from their respective acquisition dates forward.  Pro forma results of the Company, assuming all of the acquisitions had occurred at the beginning of each period presented, would not be materially different from the results reported.

 (5)      Goodwill and Other Intangible Assets

Goodwill and other indefinite-lived intangible assets are not amortized, but are evaluated for impairment annually during the fourth quarter, or more frequently if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value.  As part of the Company’s impairment analysis for each reporting unit, the Company engaged a third party appraisal firm to assist in the determination of estimated fair value for each unit.  This determination included estimating the fair value using both the income and market approaches.  The income approach requires management to estimate a number of factors for each reporting unit, including projected future operating results, economic projections, anticipated future cash flows and discount rates.  The market approach estimates fair value using comparable marketplace fair value data from within a comparable industry grouping.

The determination of the fair value of the reporting units and the allocation of that value to individual assets and liabilities within those reporting units requires the Company to make significant estimates and assumptions.  These estimates and assumptions primarily include, but are not limited to: the selection of appropriate peer group companies; control premiums appropriate for acquisitions in the industries in which the Company competes; the discount rate; terminal growth rates; and forecasts of revenue, operating income, depreciation and amortization and capital expenditures.  The allocation requires several analyses to determine fair value of assets and liabilities including, among other things, purchased prescription files, customer relationships and trade names.  Although the Company believes its estimates of fair value are reasonable, actual financial results could differ from those estimates due to the inherent uncertainty involved in making such estimates.  Changes in assumptions concerning future financial results or other underlying assumptions could have a significant impact on either the fair value of the reporting units, the amount of the goodwill impairment charge, or both.  The Company also compared the sum of the estimated fair values of its reporting units to the total value as implied by the market value of its equity and debt securities. This comparison indicated that, in total, its assumptions and estimates were reasonable.  However, future declines in the overall market value of the Company’s equity and debt securities may indicate that the fair value of one or more reporting units has declined below its carrying value.
 
One measure of the sensitivity of the amount of goodwill impairment charges to key assumptions is the amount by which each reporting unit “passed” (fair value exceeds the carrying amount) or “failed” (the carrying amount exceeds fair value) the first step of the goodwill impairment test. For the reporting units that passed step one, fair value exceeded the carrying amount by 6% to more than 700%. The fair values for two reporting units each exceeded their carrying amounts by less than 10%. Goodwill allocated to these reporting units was $173 million, at May 31, 2010. For each of these reporting units, relatively small changes in the Company’s key assumptions may have resulted in the recognition of significant goodwill impairment charges. The Company’s Long Term Care Pharmacy’s goodwill was impaired by $16 million as a result of the asset sale agreement with Omnicare which, was signed on August 31, 2010.
 
Generally, changes in estimates of expected future cash flows would have a similar effect on the estimated fair value of the reporting unit. That is, a 1% change in estimated future cash flows would decrease the estimated fair value of the reporting unit by approximately 1%. The estimated long-term rate of net sales growth can have a significant impact on the estimated future cash flows, and therefore, the fair value of each reporting unit. For the two reporting units whose fair values exceeded carrying values by less than 10%, a 1% decrease in the long-term net sales growth rate would have resulted in the reporting units failing the first step of the goodwill impairment test. Of the other key assumptions that impact the estimated fair values, most reporting units have the greatest sensitivity to changes in the estimated discount rate.  A 1.0 percentage point increase in estimated discount rates for the two reporting units whose fair value exceeded carrying value by less than 10% would also have resulted in the reporting units failing step one. The Company believes that its estimates of future cash flows and discount rates are reasonable, but future changes in the underlying assumptions could differ due to the inherent uncertainty in making such estimates.
 
Changes in the carrying amount of goodwill consist of the following activity (in millions):

   
2010
   
2009
 
Net book value – September 1
           
Goodwill
  $ 1,473     $ 1,450  
Accumulated impairment losses
    (12 )     (12 )
Total
    1,461       1,438  
Acquisitions
    442       23  
Impairment charges
    (16 )     -  
Net book value – August 31
  $ 1,887     $ 1,461  

The carrying amount and accumulated amortization of intangible assets consists of the following (in millions):

   
2010
   
2009
 
Gross Intangible Assets
           
     Purchased prescription files
  $ 749     $ 578  
     Tenancy rights
    377       69  
     Purchasing and payer contracts
    280       266  
     Trade name
    44       26  
     Other amortizable intangible assets
    103       62  
Total gross intangible assets
    1,553       1,001  
                 
Accumulated amortization
               
     Purchased prescription files
    (293 )     (206 )
     Tenancy rights
    (38 )     (19 )
     Purchasing and payer contracts
    (68 )     (46 )
     Trade name
    (3 )     (11 )
     Other amortizable intangibles
    (37 )     (22 )
Total accumulated amortization
    (439 )     (304 )
Total intangible assets, net
  $ 1,114     $ 697  

Amortization expense for intangible assets was $182 million in fiscal 2010, $148 million in fiscal 2009 and $107 million in fiscal 2008.  The weighted-average amortization period for purchased prescription files was six years for fiscal 2010 and fiscal 2009.  The weighted-average amortization period for purchasing and payer contracts was 13 years for fiscal 2010 and fiscal 2009.  The weighted-average amortization period for trade names was five years for fiscal 2010 and three years for fiscal 2009.   Trade names include $6 million of indefinite life assets.  The weighted-average amortization period for other intangible assets was 10 years for fiscal 2010 and 10 years for fiscal 2009.

Expected amortization expense for intangible assets recorded at August 31, 2010, is as follows (in millions):

2011
   
2012
   
2013
   
2014
   
2015
 
$ 204     $ 185     $ 159     $ 124     $ 64  

(6)      Income Taxes

The provision for income taxes consists of the following (in millions):

   
2010
   
2009
   
2008
 
Current provision -
                 
Federal
  $ 1,129     $ 807     $ 1,201  
State
    90       91       133  
      1,219       898       1,334  
Deferred provision -
                       
Federal
    62       243       (59 )
State
    1       17       (2 )
      63       260       (61 )
    $ 1,282     $ 1,158     $ 1,273  

The difference between the statutory federal income tax rate and the effective tax rate is as follows:

   
2010
   
2009
   
2008
 
Federal statutory rate
    35.0 %     35.0 %     35.0 %
State income taxes, net of federal benefit
    2.2       2.2       2.4  
Medicare Part D Subsidy
    1.3       0.0       0.0  
Other
    (0.5 )     (0.6 )     (0.3 )
Effective income tax rate
    38.0 %     36.6 %     37.1 %

The deferred tax assets and liabilities included in the Consolidated Balance Sheets consist of the following (in millions):

   
2010
   
2009
 
Deferred tax assets -
           
Postretirement benefits
  $ 179     $ 170  
Compensation and benefits
    228       170  
Insurance
    190       195  
Accrued rent
    176       147  
Tax benefits
    138       25  
Stock compensation
    133       110  
Inventory
    59       41  
Other
    123       90  
      1,226       948  
Deferred tax liabilities -
               
Accelerated depreciation
    1,050       913  
Inventory
    356       319  
Intangible assets
    117       32  
Other
    45       39  
      1,568       1,303  
Net deferred tax liabilities
  $ 342     $ 355  

Income taxes paid were $1,195 million, $768 million and $1,235 million during the fiscal years ended August 31, 2010, 2009 and 2008, respectively.

ASC Topic 740 provides guidance regarding the recognition, measurement, presentation and disclosure in the financial statements of tax positions taken or expected to be taken on a tax return, including the decision whether to file or not to file in a particular jurisdiction.  All unrecognized benefits at August 31, 2010, and August 31, 2009, were classified as long-term liabilities on our consolidated balance sheet.

The following table provides a reconciliation of the total amounts of unrecognized tax benefits for fiscal 2010 (in millions):

   
2010
   
2009
   
2008
 
Balance at beginning of year
  $ 128     $ 64     $ 55  
Gross increases related to tax positions in a prior period
    12       38       7  
Gross decreases related to tax positions in a prior period
    (57 )     (5 )     (21 )
Gross increases related to tax positions in the current period
    37       38       28  
Settlements with taxing authorities
    (21 )     (1 )     (3 )
Lapse of statute of limitations
    (6 )     (6 )     (2 )
Balance at end of year
  $ 93     $ 128     $ 64  

At August 31, 2010, and August 31, 2009, $57 million and $43 million, respectively, of unrecognized tax benefits would favorably impact the effective tax rate if recognized. 

The Company recognizes interest and penalties in income tax provision in its Consolidated Statements of Earnings.  At August 31, 2010, and August 31, 2009, the Company had accrued interest and penalties of $20 million and $18 million, respectively.

The Company files a consolidated U.S. federal income tax return, as well as income tax returns in various states.   It is no longer subject to U.S. federal income tax examinations for years before fiscal 2008, except for one issue related to fiscal 2006 and 2007 currently in appeals. With few exceptions, it is no longer subject to state and local income tax examinations by tax authorities for years before fiscal 2005.  The Company anticipates that the Internal Revenue Service (IRS) will complete its audit of fiscal years 2008 and 2009 in fiscal 2012.

It is reasonably possible that the amount of the unrecognized tax benefit with respect to certain unrecognized tax positions will increase or decrease during the next 12 months; however, the Company does not expect the change to have a material effect on its results of operations or our financial position.

(7)      Short-Term Borrowings and Long-Term Debt

Short-term borrowings and long-term debt consists of the following at August 31 (in millions):

   
2010
   
2009
 
Short-Term Borrowings -
           
Commercial paper
  $ -     $ -  
Current maturities of loans assumed through the purchase of land and buildings; various interest rates from 5.00% to 8.75%; various maturities from 2011 to 2035
    7       10  
Other
    5       5  
Total short-term borrowings
  $ 12     $ 15  
                 
Long-Term Debt -
               
4.875% unsecured notes due 2013 net of unamortized discount and interest rate swap fair market value adjustment (see Note 8)
  $ 1,348     $ 1,294  
5.250% unsecured notes due 2019 net of unamortized discount
    995       995  
Loans assumed through the purchase of land and buildings; various interest rates from 5.00% to 8.75%; various maturities from 2011 to 2035
    53       57  
      2,396       2,346  
Less current maturities
    (7 )     (10 )
Total-long term debt
  $ 2,389     $ 2,336  

The Company had no commercial paper issued through fiscal 2010.  In fiscal 2009, the Company issued commercial paper to support working capital needs. Short-term borrowings under the commercial paper program had the following characteristics (in millions):

   
2010
   
2009
 
Balance outstanding at fiscal year-end
  $ -     $ -  
Maximum outstanding at any month-end
    -       1,068  
Average daily short-term borrowings
    -       272  
Weighted-average interest rate
    -       1.51 %

In connection with its commercial paper program the Company maintains two unsecured backup syndicated lines of credit that total $1,100 million.  The first $500 million facility expires on July 20, 2011, and allows for the issuance of up to $250 million in letters of credit, which reduces the amount available for borrowing.  The second $600 million facility expires on August 12, 2012.  The Company’s ability to access these facilities is subject to our compliance with the terms and conditions of the credit facilities, including financial covenants.  The covenants require the Company to maintain certain financial ratios related to its minimum net worth and priority debt, along with limitations on the sale of assets and purchases of investments.  At August 31, 2010, the Company was in compliance with all such covenants.  The Company pays a facility fee to the financing banks to keep these lines of credit active.  At August 31, 2010, there were no letters of credit issued against these credit facilities and the Company does not anticipate any future letters of credit to be issued against these facilities.  

On July 17, 2008, the Company issued notes totaling $1,300 million bearing an interest rate of 4.875% paid semiannually in arrears on February 1 and August 1 of each year. The notes will mature on August 1, 2013. The Company may redeem the notes, at any time in whole or from time to time in part, at its option at a redemption price equal to the greater of: (1) 100% of the principal amount of the notes to be redeemed; or (2) the sum of the present values of the remaining scheduled payments of principal and interest thereon (not including any portion of such payments of interest accrued as of the date of redemption), discounted to the date of redemption on a semiannual basis (assuming a 360-day year consisting of twelve 30-day months) at the Treasury Rate, plus 30 basis points, plus accrued interest on the notes to be redeemed to, but excluding, the date of redemption.  If a change of control triggering event occurs, unless the Company has exercised its option to redeem the notes, it will be required to offer to repurchase the notes at a purchase price equal to 101% of the principal amount of the notes plus accrued and unpaid interest to the date of redemption.  The notes are unsecured senior debt obligations and rank equally with all other unsecured senior indebtedness. The notes are not convertible or exchangeable.  Total issuance costs relating to this offering were $9 million, which included $8 million in underwriting fees.  The fair value of the notes as of August 31, 2010, was $1,446 million.  Fair value for these notes was determined based upon quoted market prices.

On January 13, 2009, the Company issued notes totaling $1,000 million bearing an interest rate of 5.25% paid semiannually in arrears on January 15 and July 15 of each year, beginning on July 15, 2009. The notes will mature on January 15, 2019. The Company may redeem the notes, at any time in whole or from time to time in part, at its option at a redemption price equal to the greater of: (1) 100% of the principal amount of the notes to be redeemed; or (2) the sum of the present values of the remaining scheduled payments of principal and interest thereon (not including any portion of such payments of interest accrued as of the date of redemption), discounted to the date of redemption on a semiannual basis (assuming a 360-day year consisting of twelve 30-day months) at the Treasury Rate, plus 45 basis points, plus accrued interest on the notes to be redeemed to, but excluding, the date of redemption.  If a change of control triggering event occurs, unless the Company has exercised its option to redeem the notes, it will be required to offer to repurchase the notes at a purchase price equal to 101% of the principal amount of the notes plus accrued and unpaid interest to the date of redemption.  The notes are unsecured senior debt obligations and rank equally with all other unsecured senior indebtedness of the Company.  The notes are not convertible or exchangeable.  Total issuance costs relating to this offering were $8 million, which included $7 million in underwriting fees.  The fair value of the notes as of August 31, 2010, was $1,167 million.  Fair value for these notes was determined based upon quoted market prices.

(8)      Financial Instruments

The Company uses a derivative instrument to manage its interest rate exposure associated with some of its fixed-rate borrowings.  The Company does not use derivative instruments for trading or speculative purposes.  All derivative instruments are recognized in the Consolidated Balance Sheets at fair value.  The Company designates interest rate swaps as fair value hedges of fixed-rate borrowings.  For derivatives designated as fair value hedges, the change in the fair value of both the derivative instrument and the hedged item are recognized in earnings in the current period.  At the inception of a hedge transaction, the Company formally documents the hedge relationship and the risk management objective for undertaking the hedge.  In addition, it assesses both at inception of the hedge and on an ongoing basis whether the derivative in the hedging transaction has been highly effective in offsetting changes in fair value of the hedged item and whether the derivative is expected to continue to be highly effective.  The impact of any ineffectiveness is recognized currently in earnings.

Counterparties to derivative financial instruments expose the Company to credit-related losses in the event of nonperformance, but the Company currently does not expect any counterparties to fail to meet their obligations, given their high credit ratings.

Fair Value Hedges

For derivative instruments that are designated and qualify as fair value hedges, the gain or loss on the derivative, as well as the offsetting gain or loss on the hedged item attributable to the hedged risk, are recognized in current earnings.

On January 27, 2010, the Company terminated all of its existing one-month future LIBOR swaps.  Upon termination, the Company received payment from its counterparty that consisted of accrued interest and an amount representing the fair value of our swaps.  The related fair value benefit attributed to the Company’s debt will be amortized over the life of the debt.  Then, the Company entered into six-month LIBOR in arrears swaps with two counterparties.

The notional amounts of derivative instruments outstanding at August 31, 2010 and 2009, were as follows (in millions):

   
2010
   
2009
 
Derivatives designated as hedges:
           
     Interest rate swaps
  $ 1,300     $ 1,300  

The changes in fair value of the notes attributable to the hedged risk are included in long-term debt on the Consolidated Balance Sheets (see Note 7) and amortized through maturity.  At August 31, 2010 and 2009, the Company had net unamortized fair value changes of $51 million and $2 million, respectively.

The fair value and balance sheet presentation of derivative instruments at August 31, 2010, were as follows (in millions):

 
Location in Consolidated Balance Sheet
 
2010
   
2009
 
Liability derivatives designated as hedges:
             
     Interest rate swaps
Accrued expenses and other liabilities
  $ -     $ 2  
Asset derivatives designated as hedges:
                 
     Interest rate swaps
Other non-current assets
  $ 44     $ -  

Gains and losses relating to the ineffectiveness of the Company’s derivative instruments are recorded in interest expense on the Consolidated Statement of Earnings.  The amount recorded for the year ended August 31, 2010, was a $1 million gain.  In the prior fiscal year, the ineffective component was not material.

(9)      Fair Value Measurements

ASC Topic 820, Fair Value Measurements and Disclosures (formerly SFAS No. 157, Fair Value Measurements), defines fair value as the price that would be received for an asset or paid to transfer a liability in an orderly transaction between market participants on the measurement date.  In addition it establishes a fair value hierarchy that prioritizes observable and unobservable inputs used to measure fair value into three broad levels:

Level 1 -
 
Quoted prices in active markets that are accessible at the measurement date for identical assets and liabilities. The fair value hierarchy gives the highest priority to Level 1 inputs.
Level 2 -
 
Observable inputs other than quoted prices in active markets.
Level 3 -
 
Unobservable inputs for which there is little or no market data available. The fair value hierarchy gives the lowest priority to Level 3 inputs.

Assets and liabilities measured at fair value on a recurring basis were as follows (in millions):

   
August 31, 2010
   
Level 1
   
Level 2
   
Level 3
 
Assets:
                       
     Interest rate swaps
  $ 44       -     $ 44       -  

   
August 31, 2009
   
Level 1
   
Level 2
   
Level 3
 
Liabilities:
                       
     Interest rate swaps
  $ 2       -     $