EX-13 4 exhibit_13.htm 2012 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
 
2012(1)
   
2011
   
2010(4)
   
2009
   
2008
 
Net sales
  $ 71,633     $ 72,184     $ 67,420     $ 63,335     $ 59,034  
Cost of sales (2)
    51,291       51,692       48,444       45,722       42,391  
Gross Profit
    20,342       20,492       18,976       17,613       16,643  
Selling, general and administrative expenses (1) (2) (6)
    16,878       16,561       15,518       14,366       13,202  
Gain on sale of business (3)
    -       434       -       -       -  
Operating Income
    3,464       4,365       3,458       3,247       3,441  
Interest expense, net (1)
    (88 )     (71 )     (85 )     (83 )     (11 )
Earnings Before Income Tax Provision
    3,376       4,294       3,373       3,164       3,430  
Income tax provision (5)
    1,249       1,580       1,282       1,158       1,273  
Net Earnings
  $ 2,127     $ 2,714     $ 2,091     $ 2,006     $ 2,157  
Per Common Share
                                       
Net earnings
                                       
Basic
  $ 2.43     $ 2.97     $ 2.13     $ 2.03     $ 2.18  
Diluted
    2.42       2.94       2.12       2.02       2.17  
Dividends declared
    .95       .75       .59       .48       .40  
Book value
    19.32       16.69       15.34       14.54       13.01  
Non-Current Liabilities
                                       
Long-term debt
  $ 4,073     $ 2,396     $ 2,389     $ 2,336     $ 1,337  
Deferred income taxes
    545       343       318       265       150  
Other non-current liabilities
    1,886       1,785       1,735       1,396       1,410  
Assets and Equity
                                       
Total Assets
  $ 33,462     $ 27,454     $ 26,275     $ 25,142     $ 22,410  
Shareholders' Equity
    18,236       14,847       14,400       14,376       12,869  
Return on average shareholders' equity
    12.9 %     18.6 %     14.5 %     14.7 %     18.0 %
Locations
                                       
Year-end (7)
    8,385       8,210       8,046       7,496       6,934  

(1)  
On August 2, 2012, the Company completed the acquisition of 45% of the issued and outstanding share capital of Alliance Boots GmbH in exchange for cash and Company shares.  The Company accounts for this investment using the equity method of accounting on a one-month lag basis.  Because the closing of this investment occurred within one month of the Company’s fiscal year-end, the results of operations of Alliance Boots GmbH are not reflected in the Company’s reported net earnings for fiscal 2012.  Transaction costs associated with the investment were $90 million pre-tax, $82 million or $.11 per diluted share, after tax and after including the earnings per share impact of issuing shares to finance the investment.  Costs included $69 million in selling, general and administrative expenses and $21 million of interest expense.
(2)  
Fiscal 2011, 2010 and 2009 included Rewiring for Growth restructuring and restructuring-related charges of $45 million pre-tax, $28 million after tax, $106 million pre-tax, $67 million after tax; and $252 million pre-tax, $160 million after tax, respectively.  Charges included in cost of sales for fiscal 2011, 2010 and 2009 were $3 million, $40 million and $95 million, respectively.  Selling, general and administrative expenses related to the initiative for fiscal 2011, 2010 and 2009 were $42 million, $66 million and $157 million, respectively.  Fiscal 2012, 2011, 2010 and 2009 included expenses related to Customer Centric Retailing store conversions of $15 million, $84 million, $45 million and $5 million, respectively, all of which were included in selling, general and administrative expenses.
(3)
In fiscal 2011, the Company sold its pharmacy benefit management business, Walgreens Health Initiatives, Inc., to Catalyst Health Solutions, Inc. and recorded a pre-tax gain of $434 million, $273 million or $.30 per diluted share, after tax.
(4)
Includes results of Duane Reade operations since the April 9, 2010 acquisition date.
(5)
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.
(6)
Fiscal 2008 included a positive adjustment of $79 million pre-tax, $50 million after tax, relating to an adjustment of the Company’s vacation liability.
(7)
Locations include drugstores, worksite health and wellness centers, infusion and respiratory services facilities, specialty pharmacies and mail service facilities.  The foregoing does not include locations of unconsolidated partially owned entities, such as Alliance Boots GmbH, of which the Company owns 45% of the outstanding share capital.

 

 

 
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.   References herein to “Walgreens,” the “Company,” “we,” “us” or “our” refer to Walgreen Co. and its subsidiaries included in the consolidated financial statements and does not include unconsolidated partially owned entities, such as Alliance Boots GmbH, of which we own 45% of the outstanding share capital, except as otherwise indicated or the context otherwise requires.

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 and fresh foods, personal care, beauty care, photofinishing and candy.  Customers can have prescriptions filled in retail pharmacies as well as through the mail, and customers may also place orders by telephone and online.  At August 31, 2012, we operated 8,385 locations in 50 states, the District of Columbia, Guam and Puerto Rico.  Total locations do not include 360 Take Care Clinics that are operated primarily within other Walgreens locations or locations of unconsolidated partially owned entities such as Alliance Boots GmbH.


   
Number of Locations
 
Location Type
 
2012
   
2011
   
2010
 
Drugstores
    7,930       7,761       7,562  
Worksite Health and Wellness Centers
    366       355       367  
Infusion and Respiratory Services Facilities
    76       83       101  
Specialty Pharmacies
    11       9       14  
Mail Service Facilities
    2       2       2  
Total
    8,385       8,210       8,046  

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, online pharmacies, warehouse clubs and dollar stores.

Our sales, gross profit margin and gross profit dollars are impacted by, among other things, both the percentage of prescriptions that we fill that are generic and the rate at which new generic drugs 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 profit dollars typically 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 major brand name 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 our 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 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 in 2010 (the ACA).  The ACA seeks to reduce federal spending by altering the Medicaid reimbursement formula (AMP) for multi-source drugs, and when implemented, is expected to reduce Medicaid reimbursements.  State Medicaid programs are also expected to continue to seek reductions in reimbursements independent of AMP.  In addition, we continuously face reimbursement pressure from pharmacy benefit management (PBM) companies, health maintenance organizations, managed care organizations and other commercial third party payers, and our agreements with these payers are regularly subject to expiration, termination or renegotiation.

Following our June 21, 2011 announcement that contract renewal negotiations with pharmacy benefit manager Express Scripts, Inc. (Express Scripts) had been unsuccessful, Walgreens exited the Express Scripts pharmacy provider network as of January 1, 2012.  On July 19, 2012, Walgreens and Express Scripts announced their entry into a new multiyear agreement pursuant to which Walgreens began participating in the broadest Express Scripts retail pharmacy provider network available to Express Scripts clients as of September 15, 2012.  From January 1, 2012, until September 14, 2012, however, Express Scripts’ network did not include Walgreens pharmacies.  Express Scripts, in its capacity as a pharmacy benefits manager, processed approximately 88 million prescriptions filled by Walgreens in fiscal 2011, representing approximately $5.3 billion of our fiscal 2011 net sales.  Compared to fiscal 2011, we estimate that the negative impact of not being part of the Express Scripts, Inc. pharmacy provider network, net of associated cost reductions, was $0.21 per diluted share.

We expect the positive impact of our new agreement with Express Scripts will be incremental over time, particularly over the first several quarters after September 15, 2012. While we cannot predict with certainty which Express Scripts clients will choose to include us in their pharmacy networks after September 15, 2012, we expect that our pharmacies will participate in the pharmacy networks of most clients for which Express Scripts serves as pharmacy benefit manager.  However, one substantial client of Express Scripts, the United States Department of Defense TRICARE program, has announced that Walgreens will continue to not be a part of its pharmacy network and will be designated as a non-network pharmacy provider for TRICARE beneficiaries.  Most of the patients we served in calendar 2011 who participated in a plan for which Express Scripts served as pharmacy benefit manager transitioned to another pharmacy after we exited the Express Scripts network on January 1, 2012. We expect to incur marketing and other costs in connection with efforts to regain former patients and attract new patients covered by plans for which we become a network pharmacy provider as a result of our agreement with Express Scripts.

Ultimately, the magnitude and timing of the impact on our financial results of rejoining the Express Scripts retail pharmacy provider network will depend on our ability to regain former patients and attract new patients covered by existing and new Express Scripts clients; however, we cannot predict with certainty what level of business we will achieve as a result of rejoining the Express Scripts retail pharmacy provider network in any particular future time period. We also intend to continue to pursue initiatives seeking to align our costs with anticipated business levels and requirements over time. Rejoining the Express Scripts retail pharmacy provider network is expected to positively affect our net sales, net earnings and cash flows over time relative to the levels we would otherwise achieve if we were not in the Express Scripts network and to mitigate the adverse effects related to our non-participation in the Express Scripts retail pharmacy provider network during the period from January 1, 2012 through September 14, 2012.  See “Cautionary Note Regarding Forward-Looking Statements.”

Total front-end sales have grown due to sales gains in existing stores, acquired stores and new store openings.  Front-end sales have increased in the non-prescription drugs, beer and wine, beauty, convenience and fresh foods and photofinishing categories.

Periodically, we make strategic acquisitions and investments that fit our long-term growth objectives.  Consideration is given to retail, health and well-being enterprises and other potential acquisitions and investments that provide unique opportunities and fit our business objectives.  On August 2, 2012, we completed the initial investment contemplated by the Purchase and Option Agreement dated June 18, 2012, by and among Walgreens, Alliance Boots GmbH and AB Acquisitions Holdings Limited (the “Purchase and Option Agreement”), which resulted in our acquisition of 45% of the issued and outstanding share capital of Alliance Boots GmbH, in exchange for $4.025 billion in cash and 83,392,670 shares of Walgreens common stock (first step transaction).  Alliance Boots is the largest retail pharmacy, health and daily living destination in Europe with over 3,330 retail locations. Its pharmaceutical wholesaling and distribution businesses, together with associates and joint ventures, operate over 370 distribution centers supplying more than 170,000 pharmacies, doctors, health centers and hospitals.  We account for our 45% investment in Alliance Boots using the equity method of accounting on a one-month lag basis.  Because the closing of this investment occurred within one month of the Company’s fiscal year-end, the results of operations of Alliance Boots GmbH are not reflected in the Company’s reported net earnings for the fiscal quarter or year ended August 31, 2012.  Our 45% proportionate interest in the profit of Alliance Boots GmbH for the three-month period ended October 31, 2012, will be reflected in the Company’s reported net earnings for the fiscal quarter ended November 30, 2012.  

The Purchase and Option Agreement also provides, among other things and subject to the satisfaction or waiver of specified conditions, that we will have the right, but not the obligation, to acquire the remaining 55% interest in Alliance Boots GmbH in exchange for £3.133 billion in cash, payable in British pounds sterling, and 144,333,468 shares of Walgreens common stock, subject to certain specified adjustments (second step transaction).  If Walgreens exercises the call option, in certain limited circumstances, Walgreens may be required to make the entire second step transaction payment in cash.  The call option is exercisable by us, in our sole discretion, at any time during the period beginning February 2, 2015 and ending August 2, 2015.  In addition, in certain specified cases, if Walgreens does not exercise the call option, or Walgreens has exercised the call option but the second step transaction does not close, Walgreens may be required to return to the sellers an approximately 3% interest in Alliance Boots GmbH in exchange for a nominal amount.  Walgreens initial investment and the call option excludes the Alliance Boots minority interest in Galenica Ltd. (Galenica).  The Alliance Boots investment in Galenica continues to be legally owned by Alliance Boots for the benefit of Alliance Boots shareholders other than Walgreeens.  Additional information regarding our investment in Alliance Boots GmbH is available in our Current Reports on Form 8-K filed on June 19, 2012 and August 6, 2012 (as amended by the Form 8-K/A filed on September 10, 2012).  The amendment to our August 6, 2012 Form 8-K filed on September 10, 2012, includes as exhibits thereto Alliance Boots audited consolidated financial statements for the years ended March 31, 2012, 2011 and 2010 (prepared in accordance with International Financial Reporting Standards as issued by the International Accounting Standards Board) and unaudited pro forma consolidated financial information related to our 45% investment in Alliance Boots GmbH.   

Other strategic acquisitions in fiscal 2012 included certain assets of BioScrip, Inc.’s (BioScrip) community specialty pharmacies, and centralized specialty and mail services pharmacy businesses, which advance community pharmacy and bring additional specialty pharmacy products and services closer to patients. The Company also grew its infusion business in select markets through the acquisition of Crescent Pharmacy Holdings, LLC (Crescent).  On September 17, 2012, the Company completed its acquisition of USA Drug, which includes 144 drugstore locations operating under the USA Drug, Super D Drug, May’s Drug, Med-X and Drug Warehouse names.  Significant acquisitions in prior years include the purchase of drugstore.com, inc. in fiscal 2011, which enhanced our online presence, and the acquisition of Duane Reade Holdings, Inc., and Duane Reade Shareholders, LLC (Duane Reade) in fiscal 2010, which included all of the Duane Reade stores in the New York City metropolitan area.

All Company sales during the last three fiscal years occurred within the United States, Puerto Rico and Guam.  There were no export sales.  Investments accounted for under the equity method are recorded initially at cost and subsequently adjusted for the Company’s share of the net income or loss and cash contributions and distributions to or from these entities.  The Company’s investment in Alliance Boots, which closed on August 2, 2012, and the related second step purchase option were recorded as assets with a $7.0 billion aggregate value on the Company’s August 31, 2012 Consolidated Balance Sheet, which represented 30.9% of the Company’s long-lived assets as of that date.  See Note 5 to Consolidated Financial Statements for additional information.

RESTRUCTURING CHARGES

In 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 realignment of pharmacy operations.  These initiatives were completed in the fourth quarter of fiscal 2011.

We recorded $42 million of pre-tax charges in selling, general and administrative expenses in fiscal 2011 associated with our Rewiring for Growth program and $66 million in fiscal 2010.  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 fiscal years 2011 and 2010 were $3 million and $21 million, respectively.

We realized total savings related to Rewiring for Growth of approximately $1.1 billion in fiscal 2011 compared to our base year of fiscal 2008.  Selling, general and administrative expenses realized total savings of $953 million, while cost of sales benefited by approximately $122 million.  The savings were primarily the result of reduced store labor and personnel and expense reductions.

Additionally, as a part of our Customer Centric Retailing (CCR) initiative, we have modified our store format to enhance category layouts and adjacencies, shelf heights and sight lines, and brand and private brand assortments, all of which were designed to positively impact the shopper experience.  This initiative was completed in the first quarter of fiscal 2012.  In total, we converted 5,843 stores and opened 559 new stores with the CCR format.  In the first quarter of fiscal 2012, we incurred $33 million in total program costs, of which $15 million was included in selling, general and administrative expenses and $18 million in capital costs.  In fiscal 2011, we incurred $144 million in total program costs, of which $84 million was included in selling, general and administrative expenses and $60 million in capital costs.  In fiscal 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.

OPERATING STATISTICS

   
Percentage Increases/ (Decreases)
 
Fiscal Year
 
2012
   
2011
   
2010
 
Net Sales
    (0.8 )     7.1       6.4  
Net Earnings
    (21.6 )     29.8       4.2  
Comparable Drugstore Sales
    (3.6 )     3.3       1.6  
Prescription Sales
    (3.1 )     6.3       6.3  
Comparable Drugstore Prescription Sales
    (6.1 )     3.3       2.3  
Front-End Sales
    3.6       8.5       6.8  
Comparable Drugstore Front-End Sales
    0.6       3.3       0.5  
Gross Profit
    (0.7 )     8.0       7.7  
Selling, General and Administrative Expenses
    1.9       6.7       8.0  

   
Percent to Net Sales
 
Fiscal Year
 
2012
   
2011
   
2010
 
Gross Margin
    28.4       28.4       28.1  
Selling, General and Administrative Expenses
    23.6       23.0       23.0  

   
Other Statistics
 
Fiscal Year
 
2012
   
2011
   
2010
 
Prescription Sales as a % of Net Sales
    63.2       64.7       65.2  
Third Party Sales as a % of Total Prescription Sales
    95.6       95.6       95.3  
Number of Prescriptions (in millions)
    664       718       695  
Comparable Prescription % Increase/(Decrease)
    (8.4 )     1.5       3.3  
30-Day Equivalent Prescriptions (in millions) *
    784       819       778  
Comparable 30-Day Equivalent Prescription % Increase/(Decrease) *
    (5.1 )     3.7       4.5  
Total Number of Locations
    8,385       8,210       8,046  

* 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 2012 net earnings decreased 21.6% to $2.1 billion, or $2.42 per diluted share, versus last year's earnings of $2.7 billion, or $2.94 per diluted share.   The decrease was primarily attributable to lower sales, the sale of our pharmacy benefit management business in fiscal 2011 and higher selling, general and administrative expenses as a percentage of sales.  Included in fiscal 2012 net earnings and net earnings per diluted share, respectively, was $195 million, or $.22 per diluted share, from the year’s LIFO provision and $161 million, or $.18 per diluted share, in acquisition-related amortization.  Fiscal 2012 net earnings and net earnings per diluted share, respectively, also included $82 million, or $.11 per diluted share, of transaction costs and interest, some of which are non-deductible for tax purposes, and share issuance impact (which affected net earnings per diluted share only) related to the Alliance Boots transaction.  Included in fiscal 2011 net earnings and net earnings per diluted share, respectively, were $273 million, or $.30 per diluted share, associated with the gain on the sale of Walgreens Health Initiatives, Inc., $138 million, or $.15 per diluted share, in acquisition-related amortization and $131 million, or $.14 per diluted share, from the year’s LIFO provision.

Net sales decreased by 0.8% to $71.6 billion in fiscal 2012 compared to increases of 7.1% in 2011 and 6.4% in 2010.  The acquisitions of BioScrip assets and drugstore.com increased total sales by 1.0% in fiscal 2012.  Net sales in fiscal 2012 were negatively impacted by our strategic decision to no longer be a part of the Express Scripts pharmacy provider network, partially offset by sales gains in existing stores and added sales from new stores, each of which included an indeterminate amount of market-driven price changes.  Sales in comparable drugstores were down 3.6% in 2012 and up 3.3% and 1.6% in fiscal years 2011 and 2010, respectively.  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 are not included as comparable stores for the first twelve months after the relocation or acquisition.  We operated 8,385 locations (7,930 drugstores) at August 31, 2012, compared to 8,210 locations (7,761 drugstores) at August 31, 2011, and 8,046 locations (7,562 drugstores) at August 31, 2010.

Prescription sales decreased 3.1% in 2012 compared to increases of 6.3% in 2011 and 6.3% in 2010.  Comparable drugstore prescription sales were down 6.1% in 2012 compared to increases of 3.3% in 2011 and 2.3% in 2010.  Prescription sales were negatively impacted by our strategic decision to no longer be part of the Express Scripts pharmacy provider network.  Prescription sales as a percent of total net sales were 63.2% in 2012, 64.7% in 2011 and 65.2% in 2010.  The effect of generic drugs, which have a lower retail price, replacing brand name drugs reduced prescription sales by 3.5% for 2012, 2.4% for 2011 and 2.2% for 2010, while the effect on total sales was 1.9% for 2012, 1.4% for 2011 and 1.3% for 2010.  Third party sales, where reimbursement is received from managed care organizations, the government, employers or private insurers, were 95.6% of prescription sales in 2012 and 2011 and 95.3% in 2010.  We receive market-driven reimbursements from third party payers, a number of which typically reset in January.  The total number of prescriptions filled (including immunizations) was approximately 664 million in 2012, 718 million in 2011 and 695 million in 2010.  Prescriptions adjusted to 30-day equivalents were 784 million in 2012, 819 million in 2011 and 778 million in 2010.

Front-end sales increased 3.6% in 2012, 8.5% in 2011 and 6.8% in 2010.  The increase over the prior year was due, in part, to new store openings and improved sales related to non-prescription drugs, beer and wine, beauty, convenience and fresh foods and photofinishing products.  Front-end sales were 36.8% of total sales in fiscal 2012, 35.3% of total sales in fiscal 2011 and 34.8% of total sales in fiscal 2010. Comparable drugstore front-end sales increased 0.6% in 2012, 3.3% in 2011 and 0.5% in 2010.  The increase in fiscal 2012 comparable front-end sales was primarily due to the beer and wine, non-prescription drugs, beauty and photofinishing categories, which were partially offset by decreased sales in household products.

Gross margin as a percent of sales was 28.4% in fiscal 2012 and 2011.  Gross margin in fiscal 2012 was positively impacted by higher front-end margins in the household items, convenience and fresh foods and non-prescription drug categories but offset by lower retail pharmacy margins where lower market-driven reimbursements and a higher provision for LIFO more than offset the impact of new generics including the generic Lipitor.  Gross margin as a percent of sales was 28.4% in fiscal 2011 as compared to 28.1% in fiscal 2010.  Overall margins were positively impacted by higher front-end margins in the non-prescription drug, beauty, personal care and convenience and fresh food categories.  Retail pharmacy margins were also higher as the positive effect of generic drug sales more than offset market-driven reimbursements and the write-down of flu shot inventory.  These positive effects were partially offset by a higher provision for LIFO.

Gross profit dollars in fiscal 2012 decreased 0.7% over the prior year.  The decrease is primarily attributed to lower sales volumes and a higher provision for LIFO.  Gross profit dollars in fiscal 2011 increased 8.0% over fiscal 2010.  The increase is attributed to higher sales volumes and increased front-end and retail pharmacy margins.

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 3.30% in 2012, 2.39% in 2011, and 1.70% in 2010, which resulted in charges to cost of sales of $309 million in 2012, $208 million in 2011 and $140 million in 2010.  Inflation on prescription inventory was 10.04% in 2012, 4.64% in 2011 and 4.72% in 2010.  As a result of declining inventory levels, the fiscal 2012 LIFO provision was reduced by $268 million of LIFO liquidation.  In fiscal 2010, we experienced deflation in some non-prescription inventories.   The anticipated LIFO inflation rate for fiscal 2013 is 2.50%.

Selling, general and administrative expenses were 23.6% of sales in fiscal 2012 as compared to 23.0% in 2011.  The increase was primarily due to higher occupancy expense, drugstore.com expenses, including costs associated with the acquisition and integration, investments in strategic initiatives and capabilities, expenses associated with our investment in Alliance Boots GmbH and store direct expense, which were partially offset by lower expenses associated with our CCR remodeling program which was completed in the first quarter of fiscal 2012.  Selling, general and administrative expenses as a percentage of sales remained at 23.0% in 2011 as compared to fiscal 2010.  Increased corporate costs and Duane Reade operational expenses were offset by lower Rewiring for Growth costs and incremental savings from our Rewiring for Growth activities, primarily from expense reduction initiatives and reduced store payroll, as a percentage of sales.

Selling, general and administrative expense dollars increased $317 million, or 1.9% over fiscal 2011.  Operating and integration costs related to drugstore.com added 0.6% and costs associated with our investment in Alliance Boots GmbH added 0.4%.  The remaining increase was primarily attributed to new stores.  Selling, general and administrative expense dollars in fiscal 2011 increased 6.7% over fiscal 2010.  The increase was attributed to higher comparable store spending, new stores and the acquisition of Duane Reade.

Interest was a net expense of $88 million in fiscal 2012, $71 million in fiscal 2011 and $85 million in fiscal 2010.  Interest expense for fiscal 2012, 2011 and 2010 is net of $9 million, $10 million and $12 million, respectively, that was capitalized to construction projects.  In fiscal 2012, we incurred $21 million in interest expense on the bridge term loan facility in conjunction with our investment in Alliance Boots GmbH.  This was partially offset by lower interest expense as a result of the additional $500 million in fixed to variable interest rate swaps, $250 million of which was entered into in May 2012 and $250 million of which was entered into in March 2011.  The reduction in net interest expense from fiscal 2010 to fiscal 2011 was attributed to reduced interest rates associated with our $1.3 billion of fixed to variable interest rate swaps entered into in January 2010.

The effective income tax rate was 37.0% for fiscal 2012, 36.8% for 2011, and 38.0% for 2010.  The increase in the effective tax rate from fiscal 2011 was attributed to certain non-deductible transaction costs associated with the investment in Alliance Boots GmbH.  Fiscal 2010 included a $43 million charge to deferred taxes for the repeal of the tax benefit for the Medicare Part D subsidy for retiree benefits.  We anticipate an effective tax rate of approximately 37.0% in fiscal 2013 before incorporating the investment in Alliance Boots GmbH.

LIQUIDITY AND CAPITAL RESOURCES

Cash and cash equivalents were $1.3 billion at August 31, 2012, compared to $1.6 billion at August 31, 2011.  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.

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.  

Net cash provided by operating activities was $4.4 billion at August 31, 2012, compared to $3.6 billion a year ago.  The increase was primarily as a result of changes in working capital balances including reduced inventory levels.  Cash provided by operations is the principal source of funds for expansion, investments, acquisitions, remodeling programs, dividends to shareholders and stock repurchases.

Net cash used for investing activities was $5.9 billion versus $1.5 billion last year.  Additions to property and equipment were $1.6 billion compared to $1.2 billion last year.  In fiscal 2012, we added a total of 266 locations (175 net) compared to last year’s 297 locations (164 net).  There were 34 owned locations added during the year and 41 under construction at August 31, 2012, versus 62 owned locations added and 44 under construction as of August 31, 2011.

               
Infusion and
   
Specialty
   
Mail
       
   
Drugstores
   
Worksites
   
Respiratory Services
   
Pharmacy
   
Service
   
Total
 
August 31, 2010
    7,562       367       101       14       2       8,046  
   New/Relocated
    237       21       1       2       -       261  
   Acquired
    32       -       4       -       -       36  
   Closed/Replaced
    (70 )     (33 )     (23 )     (7 )     -       (133 )
August 31, 2011
    7,761       355       83       9       2       8,210  
   New/Relocated
    169       36       5       2       -       212  
   Acquired
    43       -       10       1       -       54  
   Closed/Replaced
    (43 )     (25 )     (22 )     (1 )     -       (91 )
August 31, 2012
    7,930       366       76       11       2       8,385  

Investing activities in 2012 include the August 2012 purchase of a 45% equity interest in Alliance Boots GmbH for $7.0 billion, of which $4.0 billion was cash.  This investment is accounted for as an equity method investment.  Business acquisitions this year were $490 million versus $630 million in fiscal 2011.  Business acquisitions in fiscal 2012 included certain assets from BioScrip’s community specialty pharmacies and centralized specialty and mail services pharmacy businesses for $144 million plus inventory; the purchase of Crescent Pharmacy Holdings, LLC, an infusion pharmacy business, for $73 million, net of assumed cash; and selected other assets (primarily prescription files).  Business acquisitions in 2011 included the purchase of drugstore.com, inc., for $398 million net of assumed cash, $29 million of infusion and respiratory services assets and selected other assets (primarily prescription files).  In fiscal  2011, we sold our pharmacy benefit management business, Walgreens Health Initiatives, Inc. (WHI), to Catalyst Health Solutions Inc. (Catalyst) and recorded net cash proceeds of $442 million.  In fiscal 2012, we paid $45 million to Catalyst which was the result of a working capital adjustment in accordance with the June 2011 sales agreement.  On July 5, 2012, we entered into an agreement to purchase a regional drugstore chain in the mid-South region of the United States from Stephen L. LaFrance Holdings, Inc. and members of the LaFrance family for $438 million, subject to adjustment in certain circumstances (the USA Drug transaction). The transaction included 144 stores operated under the USA Drug, Super D Drug, May’s, Med-X and Drug Warehouse names.  The transaction closed subsequent to our fiscal year end on September 17, 2012.
 
Capital expenditures for fiscal 2013 are expected to be between $1.6 billion and $1.8 billion, excluding business acquisitions, joint ventures and prescription file purchases, although the actual amount may vary depending upon a variety of factors, including, among other things, the timing of implementation of certain capital projects.  We expect new drugstore organic growth of approximately 1.5 to 2.5 percent in fiscal 2013.  During fiscal 2012, we added a total of 212 locations, of which 169 were new or relocated drugstores.  We are continuing to relocate stores to more convenient and profitable freestanding locations.

Net cash provided by financing activities was $1.2 billion compared to the prior year’s net cash use of $2.4 billion.  We borrowed $3.0 billion under a 364-day bridge term loan facility in connection with the Alliance Boots GmbH investment, which borrowings were repaid subsequent to year-end using net proceeds from the September 2012 public offering of unsecured notes described below.  We repurchased shares totaling $1.2 billion in fiscal 2012, $1.2 billion in conjunction with our share buyback programs and $40 million to support the needs of the employee stock plans.  In the prior year, we repurchased shares totaling $2.0 billion, $1.8 billion in conjunction with our share buyback programs and $244 million to support the needs of the employee stock plans. We had proceeds related to employee stock plans of $165 million compared to $235 million last year.  Cash dividends paid were $787 million versus $647 million a year ago.  On June 19, 2012, we announced an increase in the quarterly dividend to 27.5 cents per share from the previous rate of 22.5 cents per share.  The increase raises the annual dividend rate from 90 cents per share to $1.10 per share.

In connection with our capital policy, our Board of Directors has authorized several share repurchase programs and set a long-term dividend payout ratio target between 30 and 35 percent of net earnings.  The 2009 and 2011 stock repurchase programs, which were both completed in fiscal 2011, allowed for the repurchase of up to $2.0 billion and $1.0 billion of the Company’s common stock, respectively.  Additionally, on July 13, 2011, our Board of Directors authorized the 2012 stock repurchase program, which allows for the repurchase of up to $2.0 billion of the Company’s common stock prior to its expiration on December 31, 2015.  Activity related to these programs was as follows (in millions):
 
   
Fiscal Year Ended
 
   
2012
   
2011
   
2010
 
2009 stock repurchase program
  $ -     $ 360     $ 1,640  
2011 stock repurchase program
    -       1,000       -  
2012 stock repurchase program
    1,151       424       -  
    $ 1,151     $ 1,784     $ 1,640  

We determine the timing and amount of repurchases from time to time based on our assessment of various factors including prevailing market conditions, alternate uses of capital, liquidity, the economic environment and other factors.  We anticipate that the pace of any future share repurchase activity may be significantly curtailed from the levels achieved in the preceding two years due to the debt levels incurred for the investment in Alliance Boots GmbH.  The timing and amount of these purchases may change at any time and from time to time.  The Company has repurchased and may from time to time in the future repurchase shares on the open market through Rule 10b5-1 plans, which enable a company to repurchase shares at times when it otherwise might be precluded from doing so under insider trading laws.

We had no commercial paper outstanding at August 31, 2012.  In connection with our commercial paper program, we maintain two unsecured backup syndicated lines of credit that total $1.35 billion.  The first $500 million facility expires on July 20, 2015, and allows for the issuance of up to $250 million in letters of credit.  The second $850 million facility expires on July 23, 2017, and allows for the issuance of up to $200 million in letters of credit.  The issuance of letters of credit under either of these facilities reduces available borrowings.  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, 2012, 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, 2012, 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.

As of October 19, 2012, our credit ratings were:

Rating Agency
Long-Term Debt Rating
Commercial Paper Rating
Outlook
Moody's
Baa1
P-2
Negative
Standard & Poor's
BBB
A-2
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.

On September 13, 2012, we completed the issuance and sale via an underwritten public offering of $4.0 billion aggregate principal amount of senior unsecured notes of varying maturities and interest rates, the majority of which are fixed rate.  See Note 16 of Notes to the Company’s Consolidated Financial Statements.  Approximately $3.0 billion of the net proceeds of the offering was used to refinance the 364-day bridge term loan described above and approximately $438 million was used to pay the purchase price upon the closing of the USA Drug transaction described above in September 2012.

Pursuant to our Purchase and Option Agreement with Alliance Boots GmbH, we have the right, but not the obligation, to purchase the remaining 55% interest in Alliance Boots during the period beginning February 2, 2015 and ending August 2, 2015.  If we exercise this call option, we would, subject to the terms and conditions of such agreement, be obligated to make a cash payment of £3.133 billion (equivalent to approximately $5.0 billion based on exchange rates as of August 31, 2012) and issue approximately 144.3 million shares of our common stock, with the amount and form of such consideration being subject to adjustment in certain circumstances including if the volume weighted average price of our common stock is below $31.18 per share during a period shortly before the closing of the second step transaction.  We also would assume the then-outstanding debt of Alliance Boots upon the closing of the second step transaction.

COMMITMENTS AND CONTINGENCIES

The information set forth in Note 11 to the Consolidated Financial Statements is incorporated herein by reference.

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 comprehensive income 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, asset impairments, 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 engage a third party appraisal firm to assist in the determination of estimated fair value for each unit.  This determination includes 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.  Our reporting units’ fair values exceeded their carrying amounts by less than 10% to more than 140%. The fair value of one reporting unit exceeded its carrying amount by less than 10%. Goodwill allocated to this reporting unit was $255 million at May 31, 2012. For this reporting unit, relatively modest changes in the Company’s key assumptions may have resulted in the recognition of a goodwill impairment charge. Our Long Term Care Pharmacy’s goodwill was impaired by $16 million in fiscal 2010 as a result of the asset sale agreement with Omnicare, Inc., 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 change 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 reporting unit whose fair value exceeded carrying value by less than 10%, a 1% decrease in the long-term net sales growth rate would have resulted in the reporting unit 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% increase in estimated discount rate for the reporting unit whose fair value exceeded carrying value by 10% or less would also have resulted in the reporting unit 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.

Asset impairments – The impairment of long-lived assets is assessed based upon both qualitative and quantitative factors, including years of operation and expected future cash flows, and tested for impairment annually or whenever events or circumstances indicate that a certain asset may be impaired.  If the future cash flows reveal that the carrying value of the asset group may not be recoverable, an impairment charge is immediately recorded.  We have not made any material changes to the method of estimating our 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 asset impairments.

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 inventory counts. 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.

Equity method investments - We use the equity method to account for investments in companies if the investment provides the ability to exercise significant influence, but not control, over operating and financial policies of the investee.  Our proportionate share of the net income or loss of these companies is included in consolidated net earnings.  Judgment regarding the level of influence over each equity method investment includes considering key factors such as our ownership interest, representation on the board of directors, participation in policy-making decisions and material intercompany transactions.

Income taxes – We are subject to routine income tax audits that occur periodically in the normal course of business.  U.S. federal, state, 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 comprehensive income.

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.


CONTRACTUAL OBLIGATIONS AND COMMITMENTS

The following table lists our contractual obligations and commitments at August 31, 2012 (in millions):

   
Payments Due by Period
 
   
Total
   
Less Than 1 Year
   
1-3 Years
   
3-5 Years
   
Over 5 Years
 
Operating leases (1)
  $ 35,356     $ 2,412     $ 4,758     $ 4,517     $ 23,669  
Purchase obligations (2):
                                       
Open inventory purchase orders
    1,679       1,679       -       -       -  
Real estate development
    227       146       24       57       -  
Other corporate obligations
    1,566       907       409       182       68  
Long-term debt*(3)
    5,388       1,315       10       7       4,056  
Interest payment on long-term debt
    407       116       105       105       81  
Insurance*
    635       240       178       88       129  
Retiree health*
    342       10       25       31       276  
Closed location obligations*
    116       25       31       20       40  
Capital lease obligations*(1)
    134       9       11       8       106  
Other long-term liabilities reflected on the balance sheet* (4)
    984       76       219       152       537  
Total
  $ 46,834     $ 6,935     $ 5,770     $ 5,167     $ 28,962  
*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 were $419 million for the fiscal year ended August 31, 2012.
(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 $34 million fair market value adjustment and $4 million of unamortized discount.
(4)
Includes $141 million ($86 million in 1-3 years, $43 million in 3-5 years and $12 million over 5 years) of unrecognized tax benefits recorded under Accounting Standards Codification Topic 740, Income Taxes.

The obligations and commitments included in the table above do not include unconsolidated partially owned entities, such as Alliance Boots GmbH, of which we own 45% of the outstanding share capital.  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.

In connection with the Alliance Boots Purchase and Option Agreement dated June 18, 2012, we have the right, but not the obligation, to purchase the remaining 55% interest in Alliance Boots GmbH  at any time during the period beginning February 2, 2015, and ending August 2, 2015.  If we exercise this call option, we would, subject to the terms and conditions of such agreement, be obligated to make a cash payment of £3.133 billion (equivalent to approximately $5.0 billion based on exchange rates as of August 31, 2012) and issue approximately 144.3 million shares of our common stock, with the amount and form of such consideration being subject to adjustment in certain circumstances including if the volume weighted average price of our common stock is below $31.18 per share during a period shortly before the closing of the second step transaction.  We also would assume the then-outstanding debt of Alliance Boots GmbH upon the closing of the second step transaction.  In the event that we do not exercise the option, under certain circumstances, our ownership of Alliance Boots GmbH will reduce from 45% to 42% in exchange for nominal consideration to Walgreens.

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):

   
August 31, 2012
 
Inventory purchase commitments
  $ 157  
Insurance
    38  
Real estate development
    229  
Total
  $ 424  

We have no off – balance sheet arrangements other than those disclosed on the Contractual Obligations and Commitments table.  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 August 2010, the Financial Accounting Standards Board (FASB) issued an exposure draft on lease accounting that would require entities to recognize assets and liabilities arising from lease contracts on the balance sheet.  The proposed exposure draft states that lessees and lessors should apply a “right-of-use model” in accounting for all leases.  Under the proposed model, lessees would recognize an asset for the right to use the leased asset, and a liability for the obligation to make rental payments over the lease term.  The lease term is defined as the longest possible term that is “more likely than not” to occur.  The accounting by a lessor would reflect its retained exposure to the risks or benefits of the underlying leased asset.  A lessor would recognize an asset representing its right to receive lease payments based on the expected term of the lease.  On the basis of feedback received from comment letters, roundtables, and outreach sessions, the FASB has made significant changes to the proposals in the exposure draft and therefore has decided to re-expose the revised exposure draft in the first quarter of calendar 2013.  The proposed standard, as currently drafted, will have a material impact on the Company’s reported results of operations and financial position.  The impact of this exposure draft is non-cash in nature and will not affect the Company’s cash position.

In July 2012, FASB issued Accounting Standards Update (ASU) 2012-02, which permits an entity to make a qualitative assessment to determine whether it is more likely than not that an indefinite-lived intangible asset, other than goodwill, is impaired.  If an entity concludes, based on an evaluation of all relevant qualitative factors, that it is not more likely than not that the fair value of an indefinite-lived intangible asset is less than its carrying amount, it will not be required to perform the quantitative impairment for that asset.  The ASU is effective for impairment tests performed for fiscal years beginning after September 15, 2012 (fiscal 2014), with early adoption permitted.  The ASU will not have a material impact on the Company’s reported results of operations and financial position.  The impact is non-cash in nature and will not affect the Company’s cash position.

FINANCING AND MARKET RISK

We are exposed to interest rate volatility with regard to future issuances of fixed-rate debt, and existing and future issuances of floating-rate debt.  Primary exposures include U.S. Treasury rates, LIBOR, and commercial paper rates.  From time to time, we use interest rate swaps and forward-starting interest rate swaps to hedge our exposure to interest rate changes, to reduce the volatility of our financing costs, and to achieve a desired proportion of fixed versus floating-rate debt, based on current and projected market conditions.  Generally under these swaps, we agree with a counterparty to exchange the difference between fixed-rate and floating-rate interest rate amounts based on an agreed upon notional principal amount.

Information regarding our interest rate swap transactions is set forth in Note 9 to the Consolidated Financial Statements.  These financial instruments are sensitive to changes in interest rates.  On August 31, 2012, we had $4.8 billion in long-term debt obligations that had floating interest rates.  A one percentage point increase or decrease in interest rates would increase or decrease the annual interest expenses we recognize and the cash we pay for interest expense by approximately $48 million.  In conjunction with the September 2012 notes issuance we refinanced $3.0 billion of the $4.8 billion outstanding floating rate long-term debt at August 31, 2012.  This refinancing included $550 million of floating rate notes which accrue interest at the rate equal to the three-month U.S. dollar LIBOR as determined at the beginning of each quarterly period, plus 0.500%.  The remaining notes that were part of the refinancing were at fixed rates.  A one percentage point increase or decrease in the three-month U.S. dollar LIBOR would increase or decrease the annual interest expense we recognize and the cash we pay for interest expense on these floating rate notes by approximately $6 million.

In connection with our Purchase and Option Agreement with Alliance Boots and the transactions contemplated thereby, our exposure to foreign currency risks, primarily with respect to the British pound sterling, and to a lesser extent the Euro and certain other foreign currencies, is expected to increase.  We are exposed to the translation of foreign currency earnings to the U.S. dollar as a result of our 45% interest in Alliance Boots GmbH, which we account for using the equity method of accounting on a one month lag.  Foreign currency forward contracts and other derivative instruments may be used from time to time in some instances to hedge in full or in part certain risks relating to foreign currency denominated ass4ets and liabilities, intercompany transactions, and in connection with acquisitions, joint venture or investments outside the United States.  As of August 31, 2012 and August 31, 2011, we did not have any outstanding foreign exchange derivative instruments.

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This report and other documents that we file or furnish 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. In addition, we, or others on our behalf, may make forward-looking statements in press releases or written statements, on the Company’s website or in our communications and discussions with investors and analysts in the normal course of business through meetings, webcasts, phone calls, conference calls and other communications.  Statements that are not historical facts are forward-looking statements, including forward-looking information concerning our investment in Alliance Boots GmbH and the other transactions contemplated by the Purchase and Option Agreement with Alliance Boots and their possible effects, levels of business with Express Scripts customers, estimates of the impact of developments on our earnings and earnings per share,  network participation, cough/cold and flu season, prescription volume, pharmacy sales trends, prescription margins, number and location of new store openings, vendor, payer and customer relationships and terms, possible new contracts or contract extensions, competition, economic and business conditions, outcomes of litigation and regulatory matters, the level of capital expenditures, industry trends, demographic trends, growth strategies, financial results, cost reduction initiatives, acquisition and joint venture synergies, competitive strengths and changes in legislation or regulations. Words such as “expect,” “likely,” “outlook,” “forecast,” “would,” “could,” “should,” “can,” “will,” “project,” “intend,” “plan,” “goal,” “continue,” “sustain,” “synergy,” “on track,” “believe,” “seek,” “estimate,” “anticipate,” “may,” “possible,” “assume,” variations of such words and similar expressions are intended 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 are subject to risks, uncertainties and assumptions that could cause actual results to vary materially from those indicated, including:  risks that the proposed transactions disrupt plans and operations of either us or Alliance Boots GmbH, the ability to realize anticipated synergies and achieve anticipated financial results, the amount of costs, fees, expenses and charges incurred by Walgreens or Alliance Boots related to the transactions, the risks associated with international business operations, the risks associated with governance and control matters with respect to Alliance Boots GmbH,  whether the option to acquire the remainder of the Alliance Boots equity interest will be exercised, changes in vendor, payer and customer relationships and terms, changes in network participation, competition, changes in economic and business conditions generally or in the markets we or Alliance Boots participate, risks associated with new business initiatives and activities, the failure to obtain new contracts or extensions of existing contracts, the availability and cost of real estate and construction, risks associated with acquisitions, joint ventures, strategic investments  and divestitures, the ability to realize anticipated results from capital expenditures and cost reduction initiatives, outcomes of legal and regulatory matters, changes in legislation or regulations or interpretations thereof, and those described in Item 1A “Risk Factors”  in our Form 10-K for the fiscal year ended August 31, 2012, 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 initially made. Except to the extent required by law, we do not undertake, and expressly disclaim, any duty or obligation to update publicly any forward-looking statement after the date the statement is made, whether as a result of new information, future events, changes in assumptions or otherwise.



 
 
Consolidated Statements of Comprehensive Income

 
Walgreen Co. and Subsidiaries
For the years ended August 31, 2012, 2011 and 2010
(In millions, except per share amounts)

   
2012
   
2011
   
2010
 
Net sales
  $ 71,633     $ 72,184     $ 67,420  
Cost of sales
    51,291       51,692       48,444  
Gross Profit
    20,342       20,492       18,976  
Selling, general and administrative expenses
    16,878       16,561       15,518  
Gain on sale of business
    -       434       -  
Operating Income
    3,464       4,365       3,458  
Interest expense, net
    (88 )     (71 )     (85 )
Earnings Before Income Tax Provision
    3,376       4,294       3,373  
Income tax provision
    1,249       1,580       1,282  
Net Earnings
  $ 2,127     $ 2,714     $ 2,091  
                         
Other comprehensive income (loss), net of tax:
                       
Reduction (addition) of postretirement liability
    52       40       (61 )
Comprehensive Income
  $ 2,179     $ 2,754     $ 2,030  
                         
Net earnings per common share – basic
  $ 2.43     $ 2.97     $ 2.13  
Net earnings per common share – diluted
    2.42       2.94       2.12  
                         
Average shares outstanding
    874.7       915.1       981.7  
Dilutive effect of stock options
    5.4       9.4       6.2  
Average diluted shares
    880.1       924.5       987.9  

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, 2012, 2011 and 2010
(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, 2009
    988,561,390     $ 80     $ 605     $ (140 )   $ 15,327     $ 37     $ (1,533 )
Net earnings
    -       -       -       -       2,091       -       -  
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 postretirement liability, net of $34 tax benefit
    -       -       -       -       -       (61 )     -  
Balance, August 31, 2010
    938,605,053     $ 80     $ 684     $ (87 )   $ 16,848     $ (24 )   $ (3,101 )
Net earnings
    -       -       -       -       2,714       -       -  
Dividends declared ($.7500 per share)
    -       -       -       -       (685 )     -       -  
Treasury stock purchases
    (54,739,474 )     -       -       -       -       -       (2,028 )
Employee stock purchase and option plans
    5,428,551       -       (12 )     -       -       -       203  
Other
    -       -       27       -       -       -       -  
Stock-based compensation
                    135       -       -       -       -  
Employee stock loan receivable
    -       -       -       53       -       -       -  
Reduction of postretirement liability, net of $22 tax expense
    -       -       -       -       -       40       -  
Balance, August 31, 2011
    889,294,130     $ 80     $ 834     $ (34 )   $ 18,877     $ 16     $ (4,926 )
Net earnings
    -       -       -       -       2,127       -       -  
Dividends declared ($.9500 per share)
    -       -       -       -       (848 )     -       -  
Treasury stock purchases
    (34,720,215 )     -       -       -       -       -       (1,191 )
Employee stock purchase and option plans
    6,088,749       -       (75 )     -       -       -       229  
Stock-based compensation
    -       -       99       -       -       -       -  
Employee stock loan receivable
    -       -               15       -       -       -  
Shares issued for investment in Alliance Boots
    83,392,670       0       78       -       -       -       2,903  
Reduction of postretirement liability, net of $32 tax expense
    -       -       -       -       -       52       -  
Balance, August 31, 2012
    944,055,334     $ 80     $ 936     $ (19 )   $ 20,156     $ 68     $ (2,985 )

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

 
 

 

Consolidated Balance Sheets
Walgreen Co. and Subsidiaries
At August 31, 2012 and 2011
(In millions, except shares and per share amounts)

Assets
 
2012
   
2011
 
Current Assets
           
Cash and cash equivalents
  $ 1,297     $ 1,556  
Accounts receivable, net
    2,167       2,497  
Inventories
    7,036       8,044  
Other current assets
    260       225  
Total Current Assets
    10,760       12,322  
Non-Current Assets
               
Property and equipment, at cost, less accumulated depreciation and amortization
    12,038       11,526  
Equity investment in Alliance Boots
    6,140       -  
Alliance Boots call option
    866       -  
Goodwill
    2,161       2,017  
Other non-current assets
    1,497       1,589  
Total Non-Current Assets
    22,702       15,132  
Total Assets
  $ 33,462     $ 27,454  
                 
Liabilities and Shareholders' Equity
               
Current Liabilities
               
Short-term borrowings
  $ 1,319     $ 13  
Trade accounts payable
    4,384       4,810  
Accrued expenses and other liabilities
    3,019       3,075  
Income taxes
    -       185  
Total Current Liabilities
    8,722       8,083  
Non-Current Liabilities
               
Long-term debt
    4,073       2,396  
Deferred income taxes
    545       343  
Other non-current liabilities
    1,886       1,785  
Total Non-Current Liabilities
    6,504       4,524  
Commitments and Contingencies (see Note 11)
               
Shareholders' Equity
               
Preferred stock, $.0625 par value; authorized 32 million shares; none issued
    -       -  
Common stock, $.078125 par value; authorized 3.2 billion shares; issued 1,028,180,150 shares in 2012 and 1,025,400,000 shares in 2011
    80       80  
Paid-in capital
    936       834  
Employee stock loan receivable
    (19 )     (34 )
Retained earnings
    20,156       18,877  
Accumulated other comprehensive income
    68       16  
Treasury stock at cost, 84,124,816 shares in 2012 and 136,105,870 shares in 2011
    (2,985 )     (4,926 )
Total Shareholders' Equity
    18,236       14,847  
Total Liabilities and Shareholders' Equity
  $ 33,462     $ 27,454  

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, 2012, 2011 and 2010
(In millions)

   
2012
   
2011
   
2010
 
Cash Flows from Operating Activities
                 
Net earnings
  $ 2,127     $ 2,714     $ 2,091  
Adjustments to reconcile net earnings to net cash provided by operating activities –
                       
Depreciation and amortization
    1,166       1,086       1,030  
Gain on sale of business
    -       (434 )     -  
Deferred income taxes
    265       132       63  
Stock compensation expense
    99       135       84  
Other
    43       53       60  
Changes in operating assets and liabilities -
                       
Accounts receivable, net
    394       (243 )     124  
Inventories
    1,083       (592 )     (307 )
Other current assets
    (4 )     (24 )     50  
Trade accounts payable
    (439 )     384       167  
Accrued expenses and other liabilities
    (184 )     218       262  
Income taxes
    (228 )     102       10  
Other non-current assets and liabilities
    109       112       110  
Net cash provided by operating activities
    4,431       3,643       3,744  
Cash Flows from Investing Activities
                       
Additions to property and equipment
    (1,550 )     (1,213 )     (1,014 )
Purchases of short-term investments – held to maturity
    -       -       (3,000 )
Proceeds from short-term investments – held to maturity
    -       -       3,500  
Return of (investment in) restricted cash
    191       (191 )     -  
Proceeds from sale of assets
    123       79       51  
Business and intangible asset acquisitions, net of cash received
    (491 )     (630 )     (779 )
   (Payments) proceeds from sale of business
    (45 )     442       -  
Investment in Alliance Boots
    (4,025 )     -       -  
Other
    (63 )     (12 )     (32 )
Net cash used for investing activities
    (5,860 )     (1,525 )     (1,274 )
Cash Flows from Financing Activities
                       
Payments of long-term debt
    -       (17 )     (576 )
Issuance of long-term debt
    3,000       -       -  
Stock purchases
    (1,191 )     (2,028 )     (1,756 )
Proceeds related to employee stock plans
    165       235       233  
Cash dividends paid
    (787 )     (647 )     (541 )
Other
    (17 )     15       (37 )
Net cash provided by (used for) financing activities
    1,170       (2,442 )     (2,677 )
Changes in Cash and Cash Equivalents
                       
Net decrease in cash and cash equivalents
    (259 )     (324 )     (207 )
Cash and cash equivalents at beginning of year
    1,556       1,880       2,087  
Cash and cash equivalents at end of year
  $ 1,297     $ 1,556     $ 1,880  

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, 2012, there were 8,385 drugstore and other locations in all 50 states, the District of Columbia, Guam and Puerto Rico.  Prescription sales were 63.2% of total sales for fiscal 2012 compared to 64.7% in 2011 and 65.2% in 2010.

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.

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 $88 million and $83 million were included in cash and cash equivalents at August 31, 2012 and 2011, respectively.  At August 31, 2012 and 2011, the Company had $820 million and $1,239 million, respectively, in money market funds, all of which was included in cash and cash equivalents.

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 $256 million at August 31, 2012, and $229 million at August 31, 2011, are included in trade accounts payable in the accompanying Consolidated Balance Sheets.

In fiscal 2011, the Company held $191 million in restricted cash to support certain insurance obligations.  In fiscal 2012, the restricted cash was released and the obligations were supported by issued letters of credit.

Inventories
Inventories are valued on a lower of last-in, first-out (LIFO) cost or market basis.  At August 31, 2012 and 2011, inventories would have been greater by $1,897 million and $1,587 million, respectively, if they had been valued on a lower of first-in, first-out (FIFO) cost or market basis.  As a result of declining inventory levels, the fiscal 2012 LIFO provision was reduced by $268 million of LIFO liquidation.  Inventory includes product costs, inbound freight, warehousing costs and vendor allowances not classified as a reduction of advertising expense.

Equity Method Investments
The Company uses the equity method to account for investments in companies if the investment provides the ability to exercise significant influence, but not control, over operating and financial policies of the investee.  The Company’s proportionate share of the net income or loss of these companies is included in consolidated net earnings.  Judgment regarding the level of influence over each equity method investment includes considering key factors such as the Company’s ownership interest, representation on the board of directors, participation in policy-making decisions and material intercompany transactions.

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 useful 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 2 to 13 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):

   
2012
   
2011
 
Land and land improvements
           
Owned locations
  $ 3,189     $ 3,209  
Distribution centers
    96       96  
Other locations
    232       240  
Buildings and building improvements
               
Owned locations
    3,684       3,651  
Leased locations (leasehold improvements only)
    1,518       1,235  
Distribution centers
    608       596  
Other locations
    525       372  
Equipment
               
Locations
    4,995       4,468  
Distribution centers
    1,158       1,098  
Other locations
    586       423  
Capitalized system development costs
    420       328  
Capital lease properties
    149       118  
      17,160       15,834  
Less:  accumulated depreciation and amortization
    5,122       4,308  
    $ 12,038     $ 11,526  

Depreciation expense for property and equipment was $841 million in fiscal 2012, $809 million in fiscal 2011 and $804 million in fiscal 2010.
 
The Company capitalizes application stage development costs for significant internally developed software projects, such as upgrades to the store point-of-sale system.  These costs are amortized over a five-year period.  Amortization expense was $70 million in fiscal 2012, $58 million in fiscal 2011 and $44 million in fiscal 2010.  Unamortized costs at August 31, 2012 and 2011, were $292 million and $230 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, 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.

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 $27 million in fiscal 2012, $44 million in fiscal 2011 and $17 million in fiscal 2010.

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 $117 million, $145 million and $151 million in fiscal 2012, 2011 and 2010, respectively.  See Note 3 for additional disclosure regarding the Company’s reserve for future costs related to closed locations.

Financial Instruments
The Company had $157 million and $143 million of outstanding letters of credit at August 31, 2012 and 2011, respectively, which guarantee the purchase of foreign goods, and additional outstanding letters of credit of $38 million and $40 million at August 31, 2012 and 2011, respectively, which 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 $229 million and $13 million were outstanding at August 31, 2012, and August 31, 2011, 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 $206 million and $240 million at August 31, 2012 and 2011, respectively.

The Company uses interest rate swaps to manage its interest rate exposure associated with some of its fixed-rate borrowings.  At August 31, 2012, $1.8 billion of fixed rate debt was converted to variable rate.  These swaps are accounted for according to ASC Topic 815, Derivatives and Hedging.  The swaps are measured at fair value in accordance with ASC Topic 820, Fair Value Measurement and Disclosures.  Additionally, in fiscal 2012, the Company entered into three forward starting interest rate swap transactions locking in fixed rates on $1.0 billion of its anticipated debt financing in connection with the Alliance Boots transaction, which debt was subsequently issued in fiscal 2013.  These swaps are designated as cash flow hedges and are measured at fair value.  See Notes 9 and 10 for additional disclosure regarding financial instruments.

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.

Revenue from the pharmacy benefit management (PBM) business was included in the Company’s Consolidated Statement of Comprehensive Income prior to being sold in fiscal 2011.  The services the Company provided to its PBM clients included: plan setup, claims adjudication with network pharmacies, formulary management, and reimbursement services.  Through its PBM, the Company acted as an agent in administering pharmacy reimbursement contracts and did not assume credit risk.  Therefore, revenue was recognized as only the differential between the amount receivable from the client and the amount owed to the network pharmacy.  The Company acted as an agent to its clients with respect to administrative fees for claims adjudication.  Those service fees were 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 2012, 2011 or 2010.
 
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.

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.

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.

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 $291 million in fiscal 2012, $271 million in fiscal 2011 and $271 million in fiscal 2010.  Included in net advertising expenses were vendor advertising allowances of $239 million in fiscal 2012, $218 million in fiscal 2011 and $197 million in fiscal 2010.

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.

Stock-Based Compensation Plans
In accordance with ASC Topic 718, Compensation – Stock Compensation, 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 2012, 2011 and 2010 was $99 million, $135 million and $84 million, respectively.  The recognized tax benefit was $9 million, $49 million and $29 million for fiscal 2012, 2011 and 2010, respectively.

Unrecognized compensation cost related to non-vested awards at August 31, 2012, was $115 million.  This cost is expected to be recognized over a weighted average of three years.

Interest Expense
The Company capitalized $9 million, $10 million and $12 million of interest expense as part of significant construction projects during fiscal 2012, 2011 and 2010, respectively.  Interest paid, which is net of capitalized interest, was $108 million in fiscal 2012 and $89 million in fiscal years 2011 and 2010.

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 are 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 the 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 Comprehensive Income.

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 average market price of the common shares.  Outstanding options to purchase common shares that were anti-dilutive and excluded from earnings per share totaled 32,593,870, 16,869,061 and 30,661,551 in fiscal 2012, 2011 and 2010, respectively.

New Accounting Pronouncements
In August 2010, the Financial Accounting Standards Board (FASB) issued an exposure draft on lease accounting that would require entities to recognize assets and liabilities arising from lease contracts on the balance sheet.  The proposed exposure draft states that lessees and lessors should apply a “right-of-use model” in accounting for all leases.  Under the proposed model, lessees would recognize an asset for the right to use the leased asset, and a liability for the obligation to make rental payments over the lease term.  The lease term is defined as the longest possible term that is “more likely than not” to occur.  The accounting by a lessor would reflect its retained exposure to the risks or benefits of the underlying leased asset.  A lessor would recognize an asset representing its right to receive lease payments based on the expected term of the lease.  On the basis of feedback received from comment letters, roundtables and outreach sessions, the FASB has made significant changes to the proposals in the exposure draft and therefore has decided to re-expose the revised exposure draft in the first quarter of calendar 2013.  The proposed standard, as currently drafted, will have a material impact on the Company’s reported results of operations and financial position.  The impact of this exposure draft is non-cash in nature and will not affect the Company’s cash position.

In July 2012, FASB issued Accounting Standards Update (ASU) 2012-02, which permits an entity to make a qualitative assessment to determine whether it is more likely than not that an indefinite-lived intangible asset, other than goodwill, is impaired.  If an entity concludes, based on an evaluation of all relevant qualitative factors, that it is not more likely than not that the fair value of an indefinite-lived intangible asset is less than its carrying amount, it will not be required to perform the quantitative impairment for that asset.  The ASU is effective for impairment tests performed for fiscal years beginning after September 15, 2012 (fiscal year 2014), with early adoption permitted.  The ASU will not have a material impact on the Company’s reported results of operations and financial position.  The impact is non-cash in nature and will not affect the Company’s cash position.

(2)           Restructuring

In 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 realignment of pharmacy operations.  These initiatives were completed in fiscal 2011.  The Company recorded $42 million of pre-tax charges in selling, general and administrative expenses in fiscal 2011 associated with the Rewiring for Growth program and $66 million in fiscal 2010.

Additionally, as a part of the Company’s Customer Centric Retailing (CCR) initiative, it has modified the store format to enhance category layouts and adjacencies, shelf heights and sight lines, and brand and private brand assortments, all of which were designed to positively impact the shopper experience.  This initiative was completed in the first quarter of fiscal 2012.  In total, the Company converted 5,843 stores and opened 559 new stores with the CCR format.  In fiscal 2012, the Company incurred $33 million in total program costs, of which $15 million was included in selling, general and administrative expenses and $18 million in capital costs.  In fiscal 2011, the Company incurred $144 million in total program costs, of which $84 million was included in selling, general and administrative expenses and $60 million in capital costs.  In fiscal 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.

 (3)           Leases

The Company owns approximately 20% of its operating locations; the remaining locations are leased premises.  Initial terms are typically 20 to 25 years, followed by additional terms containing renewal 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.  The Company recognizes rent expense on a straight-line basis over the term of the lease.  In addition to minimum fixed rentals, some leases provide for contingent rentals based upon a portion of sales.

Minimum rental commitments at August 31, 2012, 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
 
2013
  $ 16     $ 2,447  
2014
    12       2,437  
2015
    11       2,385  
2016
    11       2,325  
2017
    9       2,250  
Later
    158       23,996  
Total minimum lease payments
  $ 217     $ 35,840  

The capital lease amount includes $122 million of executory costs and imputed interest.  Total minimum lease payments have not been reduced by minimum sublease rentals of approximately $29 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 2012, 2011 and 2010, the Company recorded charges of $20 million, $54 million and $90 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 Comprehensive Income.

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

   
Twelve Months Ended
August 31
 
   
2012
   
2011
 
Balance – beginning of period
  $ 145     $ 151  
Provision for present value of non-cancellable lease
     payments of closed facilities
    6       49  
Assumptions about future sublease income, terminations and changes in interest rates
    (11 )     (19 )
Interest accretion
    25       24  
Cash payments, net of sublease income
    (48 )     (60 )
Balance – end of period
  $ 117     $ 145  

The Company remains secondarily liable on 24 assigned leases.  The maximum potential undiscounted future payments are $15 million at August 31, 2012.  Lease option dates vary, with some extending to 2041.

Rental expense, which includes common area maintenance, insurance and taxes, was as follows (in millions):

   
2012
   
2011
   
2010
 
Minimum rentals
  $ 2,585     $ 2,506     $ 2,218  
Contingent rentals
    6       9       9  
Less:  Sublease rental income
    (20 )     (15 )     (9 )
    $ 2,571     $ 2,500     $ 2,218  

(4)      Acquisitions and Divestitures

In May 2012, the Company completed its acquisition of certain assets of BioScrip, Inc.’s (BioScrip) community specialty pharmacies and centralized specialty and mail services pharmacy business for $144 million plus inventory.  Based on preliminary purchase accounting, the acquisition added $92 million to goodwill and $50 million to other intangible assets.  The addition of BioScrip's community specialty pharmacies and centralized specialty and mail services pharmacy businesses advances community pharmacy and brings additional specialty pharmacy products and services closer to patients.

In February 2012, the Company purchased Crescent Pharmacy Holdings, LLC (Crescent), an infusion pharmacy business, for $73 million, net of assumed cash.  The Crescent acquisition added $28 million to goodwill and $26 million to intangible assets, primarily payer contracts.  The acquisition is a strategic investment to expand the Company’s infusion services in select California markets.

The aggregate purchase price of all business and intangible asset acquisitions, excluding BioScrip and Crescent, was $259 million in fiscal 2012.  These acquisitions added $220 million to intangible assets, primarily prescription files.  The remaining fair value relates to immaterial amounts of tangible assets, less liabilities assumed.  Operating results of businesses acquired have been included in the Consolidated Statements of Comprehensive Income from their respective acquisition dates forward and were not material.

In fiscal 2011, the Company acquired drugstore.com, inc. (drugstore.com) for cash proceeds of $398 million including the assumption of $17 million of debt.  The acquisition added $156 million to goodwill and $160 million related to intangible assets.   The addition of drugstore.com's online business across its health, personal care, beauty and vision categories better positions the Company as the most convenient multichannel retailer of health and daily living needs in America.

Also in fiscal 2011, the Company completed the sale of its pharmacy benefit management business, Walgreens Health Initiatives, Inc. (WHI), to Catalyst Health Solutions, Inc. (Catalyst) in a cash transaction for $525 million, $40 million of which was withheld in escrow.  Net cash proceeds related to the transaction were $442 million.  The Company recorded a pre-tax gain in the fourth quarter of fiscal 2011 of $434 million on the transaction.  In fiscal 2012, the Company made a payment of $45 million to Catalyst reflecting a net working capital adjustment to the sales price.

(5)  Equity Method Investments

Equity method investments as of August 31, 2012 and 2011, were as follows (in millions, except percentages):

   
2012
   
2011
 
   
Carrying
Value
   
Ownership
Percentage
   
Carrying
Value
   
Ownership
Percentage
 
Alliance Boots
  $ 6,140       45%     $ -       -  
Other equity method investments
    7       30% - 50%       7       30% - 50%  
Total equity method investments
  $ 6,147             $ 7          


Alliance Boots

On August 2, 2012, the Company acquired 45% of the issued and outstanding share capital of Alliance Boots in exchange for $4.025 billion in cash and approximately 83.4 million shares of Company common stock.  The agreement also provides a call option that allows the Company to acquire the remaining 55% of Alliance Boots in exchange for an additional £3.1 billion in cash (approximately $5.0 billion using August 31, 2012 exchange rates) as well as an additional 144.3 million Company shares, subject to certain adjustments.  The call option can be exercised beginning six months prior to the third anniversary of the first step transaction (February 2, 2015) and ending on the third anniversary (August 2, 2015).  In the event that the Company does not exercise the option, under certain circumstances, Walgreens ownership of Alliance Boots will reduce from 45% to 42% in exchange for nominal consideration.

The call option was valued using a Monte Carlo simulation using assumptions surrounding Walgreens equity value as well as the potential impacts of certain provisions of the Purchase and Option Agreement dated June 18, 2012, by and among the Company, Alliance Boots and AB Acquisitions Holdings Limited that are described in the Form 8-K filed by the Company on June 19, 2012. The preliminary allocation resulted in $6.1 billion of the total consideration being allocated to the investment and $866 million being allocated to the call option based on their relative fair values.

The Company accounts for its 45% investment in Alliance Boots using the equity method of accounting.   Investments accounted for under the equity method are recorded initially at cost and subsequently adjusted for the Company’s share of the net income or loss and cash contributions and distributions to or from these entities.  Because the underlying net assets in Alliance Boots are denominated in a foreign currency, translation gains or losses will impact the recorded value of the Company’s investment.  The Company adopted a one-month lag in reporting equity income in Alliance Boots and as a result, no earnings or translation adjustments were recorded in fiscal 2012.  The Company’s investment is recorded as “Equity investment in Alliance Boots” in the Consolidated Balance Sheet.

As of August 31, 2012, the Company’s investment in Alliance Boots of $6.1 billion exceeded its proportionate share of the net assets of Alliance Boots by $2.4 billion based on preliminary estimates. This premium of $2.4 billion is recognized as part of the carrying value in the Company’s equity investment in Alliance Boots.  The difference is primarily related to the fair value of Alliance Boots indefinite-lived intangible assets and goodwill.  The Company’s equity method income from the investment in Alliance Boots will be adjusted in future periods to reflect the amortization of fair value adjustments in certain definite-lived assets of Alliance Boots.  Based on its preliminary estimates, the Company expects the incremental amortization expense associated with the Alliance Boots investment to be approximately $75 million during fiscal 2013, with a larger amount recognized in the first quarter representing the inventory step-up, which is amortized over the first inventory turn.

Other Equity Method Investments

Other equity method investments relate to joint ventures associated with the purchase of Option Care, Inc. in fiscal 2007.  These investments are included within other non-current assets on the Consolidated Balance Sheet.  The Company’s share of equity income is reported within selling, general and administrative expenses in the Consolidated Statements of Comprehensive Income.

Summarized Financial Information
 
Summarized financial information for the Company’s equity method investees is as follows:
 
Balance Sheet (in millions)
 
   
At August 31,
 
   
2012
   
2011
 
Current assets
  $ 9,193     $ 12  
Noncurrent assets
    20,085       6  
Current liabilities
    7,254       2  
Noncurrent liabilities
    13,269       3  
Equity (1)
    8,755       13  
 
Income Statement (in millions)
 
   
Year Ended August 31,
 
   
2012(2)
   
2011
   
2010
 
Net revenue
  $ 37     $ 37     $ 31  
Gross Profit
    17       19       11  
Net income
    2       5       2  
Share of pre-tax income from investments accounted for using the equity method(2)
    1       2       1  

(1) Equity includes $380 million related to non-controlling interests.
(2) The Company adopted a one-month lag in reporting its share of equity income in Alliance Boots and as a result, no earnings were recorded in fiscal 2012.

(6)      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.  The Company adopted in fiscal 2012 ASU 2011-08, Testing Goodwill for Impairment, which permits a qualitative assessment to determine whether it is more likely than not (a more than 50 percent likelihood) that the fair value of a reporting unit is less than its carrying amount, which would then require performing step one of impairment testing.  Otherwise, no further evaluation would be necessary.  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 Company’s 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. The Company’s reporting units’ fair values exceeded their carrying amounts by less than 10% to more than 140%. The fair value of one reporting unit exceeded its carrying amount by less than 10%. Goodwill allocated to this reporting unit was $255 million at May 31, 2012. For this reporting unit, relatively modest changes in the Company’s key assumptions may have resulted in the recognition of a goodwill impairment charge. The Company’s Long Term Care Pharmacy’s goodwill was impaired by $16 million in fiscal 2010 as a result of the asset sale agreement with Omnicare, Inc., 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 change 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 reporting unit whose fair value exceeded carrying value by less than 10%, a 1% decrease in the long-term net sales growth rate would have resulted in the reporting unit 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% increase in estimated discount rate for the reporting unit whose fair value exceeded carrying value by less than 10% would also have resulted in the reporting unit 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):

   
2012
   
2011
 
Net book value – September 1
           
Goodwill
  $ 2,045     $ 1,915  
Accumulated impairment losses
    (28 )     (28 )
Total
    2,017       1,887  
Acquisitions
    120       158  
Other
    24       (28 )
Net book value – August 31
  $ 2,161     $ 2,017  

“Other” primarily represents immaterial purchase accounting adjustments for the Company’s acquisitions.

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

   
2012
   
2011
 
Gross Intangible Assets
           
     Purchased prescription files
  $ 984     $ 913  
     Favorable lease interests
    388       385  
     Purchasing and payer contracts
    334       308  
     Non-compete agreements
    120       95  
     Trade name
    189       71  
     Other amortizable intangible assets
    4       4  
Total gross intangible assets
    2,019       1,776  
                 
Accumulated amortization
               
     Purchased prescription files
    (417 )     (338 )
     Favorable lease interests
    (109 )     (76 )
     Purchasing and payer contracts
    (119 )     (94 )
     Non-compete agreements
    (53 )     (43 )
     Trade name
    (32 )     (11 )
     Other amortizable intangible assets
    (3 )     (2 )
Total accumulated amortization
    (733 )     (564 )
Total intangible assets, net
  $ 1,286     $ 1,212  

Amortization expense for intangible assets was $255 million in fiscal 2012, $219 million in fiscal 2011 and $182 million in fiscal 2010.  The weighted-average amortization period for purchased prescription files was seven years for fiscal 2012 and 2011.  The weighted-average amortization period for favorable lease interests was 11 years for fiscal 2012 and 2011.  The weighted-average amortization period for purchasing and payer contracts was 13 years for fiscal 2012 and 2011.  The weighted-average amortization period for non-compete agreements was six years for fiscal 2012 and five years for fiscal 2011.  The weighted-average amortization period for trade names was 13 years for fiscal 2012 and nine years for fiscal 2011.  The weighted-average amortization period for other amortizable intangible assets was 10 years for fiscal 2012 and 2011.

Expected amortization expense for intangible assets recorded at August 31, 2012, not including amounts related to Alliance Boots that will be amortized through equity method investment income, is as follows (in millions):

2013
   
2014
   
2015
   
2016
   
2017
 
$ 252     $ 217     $ 182     $ 144     $ 99  

(7)      Income Taxes

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

   
2012
   
2011
   
2010
 
Current provision -
                 
Federal
  $ 890     $ 1,301     $ 1,129  
State
    120       147       90  
      1,010       1,448       1,219  
Deferred provision -
                       
Federal
    251       113       62  
State
    (12 )     19       1  
      239       132       63  
Income tax provision
  $ 1,249     $ 1,580     $ 1,282  

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

   
2012
   
2011
   
2010
 
Federal statutory rate
    35.0 %     35.0 %     35.0 %
State income taxes, net of federal benefit
    2.1       2.6       2.2  
Medicare Part D Subsidy
    -       -       1.3  
Other
    (0.1 )     (0.8 )     (0.5 )
Effective income tax rate
    37.0 %     36.8 %     38.0 %

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

   
2012
   
2011
 
Deferred tax assets -
           
Postretirement benefits
  $ 217     $ 214  
Compensation and benefits
    182       165  
Insurance
    157       226  
Accrued rent
    142       112  
Tax benefits
    214       327  
Stock compensation
    189       179  
Inventory
    96       143  
Other
    92       78  
Subtotal
    1,289       1,444  
Less: Valuation allowance
    19       91  
Total deferred tax assets
    1,270       1,353  
Deferred tax liabilities -
               
Accelerated depreciation
    1,332       1,176  
Inventory
    534       476  
Intangible assets
    28       49  
Other
    80       31  
Subtotal
    1,974       1,732  
Net deferred tax liabilities
  $ 704     $ 379  

At August 31, 2012, the Company has recorded deferred tax assets of $171 million reflecting the benefit of $328 million in federal and $1,248 million in state loss carryforwards.  These deferred tax assets will expire at various dates from 2013 through 2031.

The Company believes it is more likely than not that the benefit from certain net operating loss carryforwards will not be realized.  In recognition of this risk, the Company has recorded a valuation allowance of $19 million on certain deferred tax assets relating to these net operating losses as of August 31, 2012.

Income taxes paid were $1,203 million, $1,320 million and $1,195 million during the fiscal years ended August 31, 2012, 2011 and 2010, respectively.

ASC Topic 740, Income Taxes, 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 in a particular jurisdiction.  All unrecognized benefits at August 31, 2012, and August 31, 2011, were classified as long-term liabilities on the Consolidated Balance Sheets.

The following table provides a reconciliation of the total amounts of unrecognized tax benefits for fiscal 2012 (in millions):

   
2012
   
2011
   
2010
 
Balance at beginning of year
  $ 94     $ 93     $ 128  
Gross increases related to tax positions in a prior period
    100       25       12  
Gross decreases related to tax positions in a prior period
    (49 )     (68 )     (57 )
Gross increases related to tax positions in the current period
    53       54       37  
Settlements with taxing authorities
    (1 )     (8 )     (21 )
Lapse of statute of limitations
    -       (2 )     (6 )
Balance at end of year
  $ 197     $ 94     $ 93  

At August 31, 2012, 2011 and 2010, $118 million, $81 million and $57 million, respectively, of unrecognized tax benefits would favorably impact the effective tax rate if recognized. 

The Company recognizes interest and penalties in the income tax provision in its Consolidated Statements of Comprehensive Income.  At August 31, 2012, and August 31, 2011, the Company had accrued interest and penalties of $23 million and $24 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 under audit examination for U.S. federal income tax purposes for any years prior to fiscal 2010.  One issue related to fiscal 2008 and 2009 remains unresolved and is currently in appeals.  The Company anticipates that this issue will be resolved in fiscal 2013. With few exceptions, it is no longer subject to state and local income tax examinations by tax authorities for years before fiscal 2006.

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 its financial position.

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

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

   
2012
   
2011
 
Short-Term Borrowings -
           
Current maturities of loans assumed through the purchase of land and buildings; various interest rates from 5.00% to 8.75%; various maturities from 2013 to 2035
  $ 9     $ 8  
4.875% unsecured notes due 2013 net of unamortized discount and interest rate swap fair market value adjustment (see Note 9)
    1,305       -  
Other
    5       5  
Total short-term borrowings
  $ 1,319     $ 13  
                 
Long-Term Debt -
               
4.875% unsecured notes due 2013 net of unamortized discount and interest rate swap fair market value adjustment (see Note 9)
  $ -     $ 1,339  
5.250% unsecured notes due 2019 net of unamortized discount and interest rate swap fair market value adjustment (see Note 9)