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* Sales up 8.9 pct at $18.5 bln
* Q4 EPS $0.80 vs $0.80 Street View
* Q4 same-store sales up 4.1 pct
* Walgreen shares down 7 pct; CVS down 0.7 pct (Adds analyst comment, updates share prices)
By Phil Wahba
NEW YORK, March 22 (Reuters) - Walgreen Co WAG.N said its profits are under pressure as government agencies cut back on prescription drug payments to cope with huge U.S. state budget gaps.
Shares of the largest U.S. drugstore chain fell 7 percent to their lowest level in three months as lower reimbursements threatened to cut into margins well into next year and disappointed investors who had been excited by previously reported strong sales growth.
"As states wrestle with budget difficulties and the need to reduce overall spending, we do expect pressure to continue on Medicaid reimbursement," Chief Executive Greg Wasson said on a conference call on Tuesday.
Under the Medicaid program, U.S. states and the federal government pay for a large portion of medical care, including medication, for lower income Americans. But lately, those agencies have been reducing how much they pay as they try to balance budgets.
For articles on U.S. fiscal woes, see: [ID:nN14158511]
Walgreen got 62.6 percent of its sales from prescriptions last quarter, making it particularly vulnerable to any entitlement program pullback.
Rival CVS Caremark Corp (CVS.N) operates a pharmacy benefits management unit that accounts for half of its sales.
Gross margin, which measures the profitability of its products, held steady in the fiscal second quarter ended Feb. 28 compared with a year ago despite strong sales gains.
Analysts peppered Wasson and other Walgreen executives on the call with questions about the current lull in introductions of generic drugs, which cost less than name-brand medication but offer drugstores far higher margins.
A wave of new generic drugs will hit the market in 2012, executives said, suggesting Walgreen's margins are likely to stay under pressure at least until then.
The company is also trying to raise prices to cover higher costs for snacks and other foods without driving away consumers.
Walgreen warned investors that shoppers are still grappling with high unemployment and rising gas prices, meaning it may have to offer more promotions.
Andrew Wolf, analyst at BB&T Capital markets, said Walgreen's margins fell short largely because of general merchandise sold at the "front end" of the stores.
"What was not anticipated was the front end margin would be flat year over year," he said.
As reported earlier in March, quarterly sales rose 8.9 percent to $18.5 billion during its second fiscal quarter, as sales of general merchandise rose during the holidays and Valentine's Day and the drugstores filled more prescriptions.
Walgreen shares fell $2.95 to $39.02, while CVS shares were down 23 cents, or 0.7 percent, at $33.52, both on the New York Stock Exchange at mid-afternoon.
The company, which earlier this month sold its pharmacy benefits management unit to focus solely on its retail business, said it reached its largest ever share of the in-store prescription market, filling 20.1 percent of U.S. prescriptions during the quarter.
Bill Smead, a portfolio manager with Smead Value Fund which owns Walgreen shares, said that concentrating on its stores would pay off in the long run as the economy improves and more customers come in to have prescriptions filled while picking up household items.
"Those are the kinds of things that warm your heart if you're a long-term investor," Smead said.
Walgreen has nearly 7,700 drugstores, while CVS operates more than 7,100 drugstores.
Sales at Walgreen's stores open at least a year grew 4.1 percent during the quarter. Same-store sales of general merchandise rose 4.3 percent.
Prescriptions, which account for nearly two-thirds of sales, were up 3.9 percent at drugstores open at least a year. The company filled 205 million prescriptions, up 6.9 percent over last year's second quarter.
Walgreen's profit rose 10.4 percent to $739 million, or 80 cents per share, in its fiscal second quarter from $669 million, or 68 cents per share, a year earlier.
That was in line with Wall Street forecasts, according to Thomson Reuters I/B/E/S. Walgreen had handily beaten profit forecasts in the last two quarters. (Reporting by Phil Wahba, additional reporting by Brad Dorfman; Editing by Derek Caney, Dave Zimmerman and Richard Chang)