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Edited Transcript of RADL3.SA earnings conference call or presentation 31-Jul-18 5:00pm GMT

Q2 2018 Raia Drogasil SA Earnings Call

Sao Paulo Aug 1, 2018 (Thomson StreetEvents) -- Edited Transcript of Raia Drogasil SA earnings conference call or presentation Tuesday, July 31, 2018 at 5:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Eugênio De Zagottis

Raia Drogasil S.A. - Corporate Planning & IR Officer and Member of Executive Board

* Marcílio D'Amigo Pousada

Raia Drogasil S.A. - CEO & Member of Board Executive Director

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Conference Call Participants

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* Joseph Giordano

JP Morgan Chase & Co, Research Division - Senior LatAm Healthcare Analyst

* Luciano T. Campos

Bradesco S.A. Corretora de Títulos e Valores Mobiliários, Research Division - Research Analyst

* Thiago Capucci Macruz

Itaú Corretora de Valores S.A., Research Division - Research Analyst

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Presentation

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Operator [1]

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Good morning, ladies and gentlemen. At this time, we would like to welcome everyone to RD Peoples Health and Well-Being Conference Call to discuss its second quarter of 2018 results. The audio for this conference is being broadcast simultaneously through the Internet on the website www.rd.com.br/ir. In the address, you can also find the slideshow presentation available for download. (Operator Instructions.]

Before proceeding, let me mention that forward-looking statements are being made under the safe harbor of Securities Litigation Reform Act from 1996. Forward-looking statements are based on beliefs and assumptions of RD management and on information currently available to the company. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions because they relate to future events and therefore depend on circumstances that may or may not occur in the future. Investors should understand that general economic conditions, industry conditions and other operating factors could also affect the future results of RD and could cause results to differ materially from those expressed in such forward-looking statements.

Today with us are Mr. Marcilio Pousada, CEO; Mr. Eugenio De Zagottis, Investor Relations and Corporate Planning Vice President; and Gabriel Rosenberg, IR and Corporate Planning Director. Now I will turn the conference over to Mr. Marcilio Pousada. Sir, you may begin your conference.

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Marcílio D'Amigo Pousada, Raia Drogasil S.A. - CEO & Member of Board Executive Director [2]

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Okay, thank you. Good afternoon, everyone. Welcome to the presentation of results for the second quarter 2018 year to date. As always, Eugenio will present the numbers and then we'll highlight some extras, okay? Eugenio?

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Eugênio De Zagottis, Raia Drogasil S.A. - Corporate Planning & IR Officer and Member of Executive Board [3]

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Hello everybody and welcome to the RD conference call. This was a challenging quarter for the company still, with disappointing revenue growth and the loss of operating leverage pressuring the metro stores. So this has had an effect in our margins.

As stable as we think this market has been, we believe that this environment is very important in driving consolidation for the market and making us stronger for the medium and long term. It's important to mention that when you compare us to competitors, and I think the numbers that should be reported by other drugstore chains and wholesalers on the next quarter, I think they will point that we're still very strong on a relative basis. So this environment will position us to keep consolidating the market and driving value creation.

So we ended the quarter here with more than 1,700 stores. We opened 62 new stores and closed 5 stores. Gross revenues reached BRL 3.8 billion, 11.6% of growth and a same-store sales growth of 2.5%. Gross margin amounted to 29.1% of gross revenues, a 30 bps pressure, mostly because of the lower inflationary gains.

Our EBITDA reached BRL 316.6 million. This will give us 8.4% of EBITDA margin and an increase of 5.2% in nominal terms. Net income reached BRL 142 million, a net margin of 3.7%, and an increase of nearly 3%. Cash flow amounted to BRL 68 million negative in the quarter, free cash flow, with a total cash flow of BRL 154 million negative.

And finally, we entered the state of Para in this quarter with 3 stores in Belem. We believe there's a huge opportunity there to fill the gap left by Big Ben, who disappeared from the market.

On page 4, we can provide more details in terms of store development. So we opened 62 stores in the quarter and closed 5 stores. We maintain a very robust performance for the new stores, which is absolutely in line with historical standards.

We are reiterating the guidance of 240 new stores both from this year and from next year. We believe that the challenges that we have, they are conjectural challenges. They are not structural challenges, and we're still very positive in terms of the expansion. The leading expansion will remain a major source of value creation for RD. We ended the quarter with 36.2% of stores still in the maturing stage.

On page 5, we can provide also details on our geographic footprint. As I was mentioning, one of the main highlights here is our entering into Para with 3 new stores. We have seen great initial results. So we are very optimistic about this market as Big Ben closed all stores, and Big Ben was the leader and best operated in the state. We believe there is a huge gap to be filled, and we think we have a great chance doing that. We have 20 other locations already signed, and we're still looking for more stores here.

We ended the period here in Sao Paulo with a total of 926 stores. Here in the bottom of the page we highlight how our growth strategy, which was hugely concentrated in Sao Paulo until the end of 2015, started becoming more decentralized since 2016.

So in the second quarter '16, we had opened 125 stores in the state out of a total of 196 stores. So nearly two-thirds of the stores were in the state of Sao Paulo. So quarter by quarter, the number of new openings in Sao Paulo has fallen down and new opening in other states has been up. So this quarter, when you look on a last 12 month basis, only about a third of the stores were opened in the state. Two-thirds were opened in other markets. So this is a decentralization that comes as a result of the fact that we have a true national platform in which we make money on a very consistent basis in every market in the country.

We are the only chain in Brazil who can claim to have a national profitable presence. Nobody else; nobody else can say that. All the other chains, they make money in their native locations and native regions. But when you look at the expansion, they don't make money in virtually any region. For us, we have a full national platform, which we have been taking advantage for the last two years. This is not a quick fix as a response to increased competition in Sao Paulo, which is indeed happening. This is a strategy that has been unfolding for 2 years.

When you look at the market share, we gained 10 bps on a national basis and lost 80 bps in Sao Paulo. We believe one of the explanations for the share loss in Sao Paulo is exactly the grow decentralization. According to IMS, in the second quarter of '16 we are opening -- our expansion share was 10.9% in Sao Paulo, meaning of every stores open -- new stores opened, 11% of them belonged to us. Now this is only 5.7%, primarily because we have decelerated the growth in the state, but to some extent also because other players have accelerated growth here in Sao Paulo.

So there is indeed a share loss. I think to some extent it's a self-fulfilling prophecy since we have accelerated growth here. But what I'd like to point out is that the magnitude of the share loss has been amplified by the criteria adopted by IMS, which creates widening, and I'll show why on the next page.

If you look here on page 6, and I'll focus here on the bottom of the page on the real growth, this chart depicts the annual growth of each quarter of our Drogasil when compared to the other large chains who are part of Abrafarma and when compared to the total market. We can see that RD has been growing ahead of everybody, but Abrafarma, and through this quarter, was growing almost in tandem, slightly ahead of the average of the market.

This quarter something very different happened. We see that Abrafarma also decelerated on a real basis, but the average of the market went up. Abrafarma, including RD, accounts for nearly 50% of the Brazilian pharmaceutical market. I think 45% or 46% to be precise. So if the average has accelerated but the large chains are growing below, what this means is that the growth is coming from small chain and independents.

But the problem here is that, while large chains report real dividends for Abrafarma every month, the data that -- sorry, not Abrafarma, the IMS. The data that IMS captures for small chains and independents is sell-in data from wholesalers. In April, IMS reported an unprecedented market growth of 17%. So in our view, there is a big sell-in pitch here distorting the numbers. I think in the next quarters this should become clear, so we'll see how it happens.

But obviously, there is share loss in Sao Paulo, mostly from the decision to decelerate our growth here, but to some extent also because we see competitors opening stores here. We can ask if those openings are sustainable or not. We have our opinion on that. But growing less here is a decision that comes from opportunities in other states.

On page 7, we highlight the revenue growth here. So we grew 11.6% the top line in the quarter. The retail operation grew 10.6%, while 4Bio grew 36%. So 4Bio keeps growing at a very fast pace and also with much better results, as we have seen in this quarter. And I'll talk about them later.

When you look category by category, the main highlight has been OTC, which has grown the share in the mix by 140 basis points. It's important to highlight that the switch from branded -- from products that were previously branded RX and now have become OTC accounts for 40 bps out of the 140 bps. But still despite that, OTC is doing really well. When we look at branded, branded lost 70 bps, but 40 bps is due to the switches. So if you discount the switches, branded has been almost flat. It's only 30 bps pressure, and has been in line with the previous quarters.

Generics has grown only 3.4% in terms of revenues. But if you look at volume, the growth has been almost 14%, which we believe is a very -- it's a very good number. This reflects proactive investments by the company in terms of pricing and mix for generics to make us more competitive. This has been going on for a couple quarters.

And the best thing is that we are investing in prices, but our margins are still constant because we have been able to have other commercial gains. We have even been able to compensate some of those investments in regions and categories where we don't have pressure. So we are not in a contemplative mood in an environment like this. We are being very active in terms of managing the company and to respond to the environment that we have. So in a couple quarters, when the comp base fades out, this volume growth we see now in generics will translate in revenue growth as well. So this is a good thing for us.

On page 8, of the 11.6% consolidated revenue growth, 2.5% has come from the same-store sales growth. Mature stores fell by 1.4%. That is a positive calendar effect of 60 bps in the quarter, but there is also a negative 60 bps seasonal effect from the World Cup. So in the end, seasonality and calendar, they net off and the real impact is 1.4%.

On page 9, we see the gross margin has fallen down by 30 bps. Out of the 30 bps, 20 bps relates to lower inflationary gains on inventories because the price increase this year was somewhat lower than last year. So it's a 20 bps impact on the quarter, but this is almost nothing when you look for the total year. So on a structural basis, the margin fell down by only 10 bps.

There is also a 20 bps pressure from 4Bio. 4Bio has lower margins so when it outgrows retail, this will press gross margins down. But there is also 10 bps in other commercial gains that we have obtained. Finally, we see 1.7 days of cash cycle pressure, of which 1.4 days are coming from receivables. The fact that the month ended in June increases the balance of receivables, so this should normalize next quarter.

On page 10, we can see that we are having pressure at the expense level. And this pressure doesn't relate to expense inefficiency. This is really the reflection of a loss of operating leverage. If our mature stores are fading 1.4 -- are decreasing by 1.4%, there is less revenues to absorb the expenses. So the total expense pressure has been only 20 bps, but we can break this down. So labor represents 30 bps of pressure, rental 10 bps, logistics 10 bps, and new stores another 10 bps. So these pressures were mitigated by a G&A dilution of 20 bps and by a dilution arising from the 4Bio growth of 10 bps.

So all in all on page 11, we see that our EBITDA amounted to BRL 316.6 million in the quarter. This represents 5.2% nominal growth verse the same quarter last year, and this implies a margin loss of 50 bps. But it's important to mention that 20 bps relates to inflationary gain -- a lower inflationary gain on inventories.

So the structural margin loss, because of the revenue momentum, has been only 30 bps, which I don't think it's a bad number considering how weak the top line has been. We see that, if you consider only the 1,600 stores that we had in operation since 2Q '17, we would have seen here an EBITDA margin of 8.9%. So there is a pressure from new stores that shows in our numbers. The retail business did 8.6% of the EBITDA margin, and 4Bio did 3.1% of the EBITDA margin.

On page 12, net income amounted to BRL 141.8 million, 2.8% nominal growth and a net margin loss of 40 bps. This relates to the EBITDA margin pressure offset by taxes, but there is also a big -- a reported impact here from nonrecurring expenses. We had BRL 6 million in nonrecurring expenses. We had basically almost BRL 10 million of consulting expenses related to our strategic planning that takes place every five years. But there is also BRL 3 million in tax credits from previous year which is partially offsetting that nonrecurring expense.

On page 13, we see that the free cash flow has been very similar to the second quarter last year, BRL 68 million negative, with a total cash flow of BRL 154 million negative, also close to the BRL 134 million negative we saw in the second quarter last year. Any quarter when we see -- when we compare year-to-date generally shows a negative picture because the fourth quarter is the best quarter in terms of working capital. So generally Q1, 2, and 3, when you compare to Q4, there is a pressure. Q4 to Q4, then it's a more realistic figure. But we still believe there will some pressure in terms of free cash flow.

Finally on page 14, you see the performance of the stock. So our share has fallen 27% year-to-date versus a fall of 5% for the BOVESPA. Obviously, when you look since the IPO, the cumulative gains are really staggering.

I'll pass to Marcilio, and then I'll be back to provide some IR highlights and then for the Q&A. Thank you.

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Marcílio D'Amigo Pousada, Raia Drogasil S.A. - CEO & Member of Board Executive Director [4]

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Okay, Eugenio. Thank you. Just for the short terms achievements, I'm about to talk about the value and about the results. We know how difficult it is to make good results when you have this momentum in sales. And we believe that we have a cycle for this quarter; maybe next quarter also. And we did a very, very good job in the past to increase the productivity in the stores. Even when having this very good productivity in the stores, we achieved the best number, and our NPS number this quarter is very, very good for us.

Let's talk about these short term achievements. We entered in Para. Para is the first market in the north area (inaudible) share together, okay? Already this starts very, very good, and we believe we can do the same result that we did in (inaudible), when we entered (inaudible). We are -- have 20 stores to open in 2 days of this year, with all the achievement to there maybe we can do the second player in this market very, very quickly. We have a focus in A/B customer again, okay?

The other good thing, we changed our pricing strategy in generics. This is good. We saw very, very good elasticity in price and we preserved our gross margin. And we preserved also our total -- increased our average ticket also. This is good for us and can bring for us more customers in the future.

We start to accelerate our digital strategy. We put all the stores on Click & Collect. The customer can buy by Internet perhaps or in the site, and can pick in a store. In one hour, the product is ready for the customer. This is doing very, very well. And this shows for us that the customer is ready for the digitalization, to start to make a relationship with us with using the app and the Internet also. And we started to offer same day delivery service in 15 capitals. And we believe this will be very, very important. For the future, we are planning to put it in even more major cities in Brazil.

Despite the results of this quarter, we are very, very optimistic. And we know our strategy is only long term and creates a valuable return, okay? If you look at our sales, if you look in -- we had for 2015 50% of our sales made in Sao Paulo. At the end of this year, there's less than 50% of sales are made in Sao Paulo area. This proves that we set a national chain. We are the only player in this market that had a national chain in health goods to fight against the competition like a share gain, okay, city by city, territory by territory.

Then our performance for the new stores is very, very strong. When we take the decision to open 11 stores in Sao Paulo, open more stores in the North and Northeast, this helped with the results of the company. And you can see the same quality in our stores. You didn't see the same quality in the competition. The competition is too happy with stop and go strategies, go open large stores and have product than try to do it right, okay? Then this is very, very important for us in the long term vision.

The other thing that can help us is the generics. We stood a lot the other countries. And generics pick up very, very good growth and they help the consolidation in the market. When it starts to decrease the price in generics, you should be very smart to do that. This can help us to bring some competition out of the market and help us to consolidate the market in the future also. Then in spite of the result in this quarter, we are very confident that you have a great value in the company in the future.

Right now Eugenio will talk about the IR activities, and then I will be here for the answers to the questions.

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Eugênio De Zagottis, Raia Drogasil S.A. - Corporate Planning & IR Officer and Member of Executive Board [5]

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So first thing is the date for the third quarter earnings release will be October 30th. And we have the RD Day for this year already scheduled. It will take place in Sao Paulo on October 11th in the same venue we did last year, Vila Bisutti, and it's to start at 8:00 a.m. So obviously we always have a huge local attendance, but everyone who can meet the commitment can come from the U.S. or Europe and be here. I think it will be worthwhile.

And we are in the middle of a strategic planning process, and our idea is to provide visibility on the strategies for the next four or five years during this event. So I would highly advise anyone who can make it here for attending.

And finally, we have 3 upcoming conferences in which we'll be presenting. So on August 22nd, we will be at Healthcare Check-Up by J.P. Morgan in Sao Paulo. And then we have two conferences, on in Europe, one in the U.S. So September 10th to 12th, we will be in the Morgan Stanley in London. It will be myself and Gabriel. And finally, November 13th, 14th, Marcilio and Gabriel will be presenting at the CEO Conference of Bradesco in New York.

So now we're ready for your questions. Thank you very much.

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Questions and Answers

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Operator [1]

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[Operator instructions.] Mr. Thiago Macruz from Ita would like to make a question.

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Thiago Capucci Macruz, Itaú Corretora de Valores S.A., Research Division - Research Analyst [2]

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You've mentioned that you don't envisage opening that many stores in Sao Paulo as you did in 2015 in the near term. Should I anticipate that that's something that you shouldn't do from now on? And if the answer to that question is yes, should I then think that you feel you're closer to your market share cap in the region of the state of Sao Paulo?

And a follow up to that question, guys, if you maintain your guidance for store opening this year and you're not depending so much on the region, on the Sao Paulo state, should I think that the vintage for this year should carry lower returns? Can you generate the same sort of return in other regions where Raia and Drogasil might not have their strongholds as you do in the region of the state of Sao Paulo?

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Eugênio De Zagottis, Raia Drogasil S.A. - Corporate Planning & IR Officer and Member of Executive Board [3]

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Macruz, thank you for your question. So the first thing is, as you can see from the numbers, quarterly numbers we provided, I mean, the things are, in terms of decentralizing our growth out of Sao Paulo and in toward the region, has been very natural and very progressive. I mean, there is no quick fix here. We didn't start today. We didn't stop a single day and say, hey, let's stop Sao Paulo and let's find some other place. It has been natural as our operation has been grown outside of Sao Paulo.

And the other element here is that we saw, I think over the last -- from five years ago to two years ago, a huge wind of opportunity to close -- to occupy some white spaces, especially in the city of Sao Paulo. So if you look at the number of stores we opened during this period in Moema, in Jardins, in all these regions where we already had a reasonable presence. It was very big. So there was a reasonable opportunity to take advantage of the market to advance execution, and we did this with tremendous quality. Obviously, cannibalization is higher in these markets, but the revenues were strong. We often there have more than justified the investment that we made.

But when we look today, the capacity to grow in Sao Paulo, I don't think the best pace is the pace we were able to do during that window of opportunity. So I think the current pace is probably more representative of what we'll be able to do in Sao Paulo from now on.

In terms of share loss, it also depends on what the other competitors are doing. So yes, in the short term, it basically assumes that we show a lot more people opening stores. But in our view, the new entrants who are entering stores here, they are delivery stores who are not -- local stores who are not delivering, who will not be feasible. So I don't think this will continue over the longer term.

And within Sao Paolo, I think it is doing a good expansion here. They're taking advantage of the same window of opportunity we saw five years ago. And so I think it makes sense for them, but I don't think they'll be able to maintain this pace forever, as we were not able to maintain this pace. So, yes, in the short term this probably means we lose some share in Sao Paolo. But we're still opening a lot of stores here. I think potential openings will reduce over time. So we believe that progressively we can gain more in the state of Sao Paulo.

And finally, when we look at these entities' IRR, this is projecting around 20%. So this is very consistent with our long term track record. Last year it was ahead of the track record. I think we had the best year in 2017 in a five year period. This year is a normal opening. It's not as stellar as it was last year, but it's actually in line with what we have done historically. And we're still seeing 19% to 20% IRR when we project new stores for their full maturation.

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Thiago Capucci Macruz, Itaú Corretora de Valores S.A., Research Division - Research Analyst [4]

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And if I may, just one follow up question. Given this scenario that you just explained to us, does it make sense to think that maybe now it's time to pursue M&A, Eugenio? Do you think that certain specific regions were higher and Drogasil has not been successful thus far, it would make sense to go after a regional player? Do you think that this is something we could see in the near term?

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Eugênio De Zagottis, Raia Drogasil S.A. - Corporate Planning & IR Officer and Member of Executive Board [5]

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Macruz, just before answering this question, just a follow up on the previous question. You also asked if growing outside of Sao Paulo means lower IRR.

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Marcílio D'Amigo Pousada, Raia Drogasil S.A. - CEO & Member of Board Executive Director [6]

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No.

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Eugênio De Zagottis, Raia Drogasil S.A. - Corporate Planning & IR Officer and Member of Executive Board [7]

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And I think absolutely in an adamant way no. Today when -- especially when you factor out cannibalization, many of these markets outside of Sao Paolo, especially when we are thinking about the North, Northeast, and Midlands, they offer the even higher IRRs than in Sao Paulo, because Sao Paulo has cannibalization. In those markets, cannibalization is still much lower. And for the last year or two, we also defend cannibalization better. This is one of the elements that prompted us to reduce the openings in Sao Paulo. We have a better grasp for what cannibalization is.

And again, I mean, we are the only chain. There is not a single attraction here. There is not a single other chain who can say that. We are the only chain who has 20 plus base where we can grow with 20% IRR. Every other stake in the room, they make money in their core markets. They are able to grow profitably in their native markets. Maybe in one or two states they get it okay, but in the rest it challenges assets because of high entry barriers. Nobody can do what we do here without sacrificing IRR. So this is really the best, and it is a fact that we have a national footprint and a national presence.

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Marcílio D'Amigo Pousada, Raia Drogasil S.A. - CEO & Member of Board Executive Director [8]

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And Macruz, what people ought to know also, we are opening more than 200 stores every quarter, if you look at (inaudible) since second quarter 2016. This is very easy to do. I think the competition is doing more the stop and go strategy. They are doing the same strategy as in the past. They should replace the states that are put the stores like a champion matador. We are -- we have all the structure to do this well. Then open then in Sao Paulo, more in other states is only part of our strategy. It's not because their figures are competitive. We know where we've got a few more consolidation in this market.

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Eugênio De Zagottis, Raia Drogasil S.A. - Corporate Planning & IR Officer and Member of Executive Board [9]

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And in terms of then going to the second question, when you look at the ambition that we have in terms of consolidating the market, I am sure that at some point M&A will make sense for us. So we are not alerted to M&A, nothing like that. But the problem is that we have a huge quality bias. When you look around the market, there is a very small number of assets that have the underlying quality we'll be comfortable at.

I think those assets are not available today. I think those assets are very expensive so that they'll be available. We have to be very comfortable with the value creation ability. So yes, this will come to the picture eventually, but I don't think it's in the short term.

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Operator [10]

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Mr. Luciano Campos from Bradesco BBI would like to make a question.

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Luciano T. Campos, Bradesco S.A. Corretora de Títulos e Valores Mobiliários, Research Division - Research Analyst [11]

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My first question is actually about this market share trend in the state of Sao Paulo in one of the aspects that you also commented in the press release, about the impact of pricing decisions that you have made that also influenced your market share in the region. I think Marcilio was also explaining that this pricing change probably was more concentrated in the generics segment, if I understood it correctly. Could you please elaborate a little bit more about what was the strategy change in terms of prices that you did, if it is just Sao Paulo or if it's generalized, and a little bit more color when it started?

And the second part of this question is, for instance, if you already had time to observe what is the impact of that. Normally, if you are more competitive in prices, you could see your market share reacting relatively fast. I would like to know if that was the case, if you can observe your market share kind of recovering in a store by store basis, or any basis that you can see that you can help us to understand what is the impact of this strategy in the market share.

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Eugênio De Zagottis, Raia Drogasil S.A. - Corporate Planning & IR Officer and Member of Executive Board [12]

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Luciano, thanks for the question. The first message is I don't think this is a quarter that, when we look at our math, we should spend a lot of time talking about share because there's a lot of noise in this quarter. For example, I mentioned for 17% revenue growth in April. I mean, there is no chance the market grew 17%, the fact that the large chains are maintaining the same pace they were having or the same trend they were seeing in previous quarters.

But the overall market acceleration really shows that acceleration is still taking place in the edge of the market. It's small guys, small chains, independents who report sell-in data and not sell-out data. So this is a very noisy quarter. I think we'll have to wait for probably one or two more quarters. Probably next quarter we can already have a more realistic picture of where the share is.

But I would assume there is a share loss in Sao Paulo. The fact that we are growing less than -- the fact that our expansion share is much lower than it used to be, this was first and foremost because we decided to decentralize over time, and second because there's also more activity. It will probably mean a share loss in the short term but not at this magnitude.

I think that what we did in terms of pricing, generics has been a key focus, but it's not the only focus. We have also invested prices in branded, for example. When you look at constant gross margin on a consolidated basis, it doesn't mean this is flat everywhere. At any given point in time, we optimize our prices. We are seeing the markets where we have to invest more, and we see the markets -- and we also look at the market where we can harvest some margin to fund that. So this is a very dynamic scene.

Obviously with new entrants in Sao Paulo, we have reinvested over the last two years in Sao Paulo. We are increasing entry barriers. We are defending our market share here. It's very difficult to predict where this will go and how fast the share can go up. But the fact that we saw a 13% volume growth in generics in such a sudden way, I think it's a very good indicator of the elasticity that Marcilio was mentioning.

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Luciano T. Campos, Bradesco S.A. Corretora de Títulos e Valores Mobiliários, Research Division - Research Analyst [13]

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Just to confirm, so it's too early to observe like May, June, and July. You don't see any particular trend already associated with your -- in terms of market share change relative to this price strategy. It's too early. Is that what you are saying?

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Eugênio De Zagottis, Raia Drogasil S.A. - Corporate Planning & IR Officer and Member of Executive Board [14]

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It's too early, and there's too much noise in the data.

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Marcílio D'Amigo Pousada, Raia Drogasil S.A. - CEO & Member of Board Executive Director [15]

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Yes.

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Eugênio De Zagottis, Raia Drogasil S.A. - Corporate Planning & IR Officer and Member of Executive Board [16]

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So it's both. It's both. And look, I'm not here to also criticize IMS. It's important that this is their own -- their methodology, the only possible methodology. There is no way that they can talk to 80,000 pharmacies and that they will provide them the market demand. So what they do is the large chains inform them. The small chains they capture through wholesalers. So the thing is there is noise in the base.

It's very difficult to look at IMS quarter-over-quarter. But generally when you look year-over-year, they show a reasonable picture. This time the sales of this huge selling peak in April I think isn't the real reading. It's compromise. But it's an intrinsic limitation to the only way, and I think that's the data. I think -- in the next quarters, I think we will get to normal visibility again.

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Operator [17]

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Mr. Joseph Giordano from J.P. Morgan Bank would like to pose a question.

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Joseph Giordano, JP Morgan Chase & Co, Research Division - Senior LatAm Healthcare Analyst [18]

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Eugenio, I have like a couple questions here. So the first one is still like on the generics' pricing. I'd like to understand here like how have you been changing your suppliers base in order to maintain your margins relatively flat, is there -- if this comes from basically better procurement terms.

And then looking at the cost cut initiatives, last year we had like several things, so like changes in carrier plan, renegotiation of salaries, some strategic layoffs. So here I would like to understand if we have like any initiative here that is worth highlighting to kind of cushion potential operating deleverage pressures into the second half of the year. As per my understanding, it seems that growth remains a little bit challenging in the more mature markets given competition.

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Eugênio De Zagottis, Raia Drogasil S.A. - Corporate Planning & IR Officer and Member of Executive Board [19]

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Joseph, thanks for the question. I mean, in terms of generics, we have here a combination of things. One thing that I didn't mention that also affects generics' pricing is that there have been price cuts in Farmacia Popular programs that happened in the quarter.

And Farmacia Popular is very focused on generics. So, this is not like one-off price cuts. And we also -- because of that price cut, we also redid an auction with our supplier. So there is some movement in the supply grade. There are some suppliers selling more to us than before. There are other suppliers selling less to us than they were selling before.

There is also the fact that in more popular areas we are also adopting cheaper generics than before. In regions where we have new entities, we have also increased the discounts in terms of not allowing someone to be a price cut versus us.

So there's a lot of movement going on. It didn't start this quarter. It started before. It's also not all applied to generics. As I mentioned before, we have invested in branded discounts in Sao Paulo. But the great thing is that, either because of better generic purchasing terms as a result of the auction or because we can harvest margins in market where we probably were more aggressive than necessary, we have been able to do all the required investment to defend our position without sacrificing the gross margin.

In terms of these expenses, I mean, obviously last year we did a lot of things. Those initiatives were very important. We are always looking for an opportunity, so there are minor things here and there. But we don't have any opportunities like we had last year. We are very decent in the Gen A side. We're very careful about that. But the message is we think long term.

We are not here to optimize the next quarter or to optimize '18. We're here to make what makes sense and what creates value on the longer term. So we are not taking people out of the stores just because we have to make the quarterly data. That's not how we work. We reduce people at the stores when we had productivity gains that allowed this to be so. If we don't have a another -- we're always seeking for monetary gains. But if we don't have a productivity gain, we can't force the headcount number down because if we did we'd be very happy the next quarter, but I would start selling my shares because it's not sustainable. There is a limit to that.

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Marcílio D'Amigo Pousada, Raia Drogasil S.A. - CEO & Member of Board Executive Director [20]

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Yes. Every process changes to an expense looking for invest, okay? We are here for the customer, to serve the customer well. If you compare our numbers, the people in the store -- that work in the store with our competition, we are much more full to the competition. We've stayed to work on this trait for the future. But it's impossible to really change these numbers as we saw in 2016 and '17.

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Eugênio De Zagottis, Raia Drogasil S.A. - Corporate Planning & IR Officer and Member of Executive Board [21]

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Yes. And, I mean, the thing is any consolidation process involves pain. I mean, if you look today less over the '90s, I mean, when we went through this one we had huge margin pressure from [Pilars]. When you look 20 years later, I mean, they own the market. They boosted their revenues. They boosted their market cap.

So life is not a straight line. I always talk about that. The only place a straight line exists is in financial models. And consolidation involves pain, this kind of market scenario in which we have players -- a lot of players doing unsustainable growth. We have a lot of leveraged players in the market. We have more competition and we have a market acceleration. I mean, it's a perfect market to start cleaning it up. Whatever can stretch us will keep a lot of players before. So I think this should be a very difficult environment for the other players.

Last quarter I told you guys to expect a bloodshed when our competitors started reporting. Here is the same thing. I mean, we have some margin loss. I think it's minor. But when you look at the numbers that our competitors will report, I expect a very bad scenario.

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Joseph Giordano, JP Morgan Chase & Co, Research Division - Senior LatAm Healthcare Analyst [22]

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One follow up question here, if I may, on the productivity side. I remember there were several efforts here with the data, like related to this year in data, so basically improved pricing, right, so interior. Like in the past, this was an expectation for a major gross margin driver. Here in this context, what I would like to understand here is if this new pricing algorithm and system is already in place and that's actually what's bringing like an edge in terms of competitive positioning to maintain like minimal share loss that's in the more mature markets here, right? So basically preserve returns.

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Eugênio De Zagottis, Raia Drogasil S.A. - Corporate Planning & IR Officer and Member of Executive Board [23]

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I would say that to some extent this is already happening. I mean, we rolled out pricing for HBC -- a pricing platform for HBC and OTC. We have much bigger segmentation across northern regions than before. We do way more detailed price surveys of competitors. So obviously there we have been adjusting the prices based on that.

But the fact that we have a platform already rolled out doesn't mean that we are using every resource the platform offers to the fullest extent. I think there's too a learning curve on that. We're now a strategic project now with them. One of the things we're analyzing is how to use machine learning, for example, to do pricing.

So I think this is a journey. I think, yes, it helps us invest in more perfected prices in some places, especially in Sao Paulo. And as long as it's dependable, we'll grow smarter. So this is a direct reflection of the pricing platform and also of our buying power. But this is not a -- this is a journey. This will keep happening more and more and more.

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Operator [24]

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[Operator instructions.] It appears to be no further questions. Now I will turn the conference back to the company for the final remarks.

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Eugênio De Zagottis, Raia Drogasil S.A. - Corporate Planning & IR Officer and Member of Executive Board [25]

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Okay. So first of all, I'd like to thank you all for attending this call, thank our long term shareholders for their ongoing interest and support. I'd like also to stress some of the messages that we discussed today.

So the first thing is that this was indeed a disappointing quarter for us. We are in a difficult growth scenario because of the market deceleration, and I think this will last for several more quarters. We believe the third quarter will be another difficult quarter because last year was a very good quarter in terms of expense dilution, so probably we have the toughest comp base in a very long time in terms of expansion. And I don't think that the sales momentum will be any different from what we have seen this year.

But as we approach the fourth quarter, then we'll start becoming more hopeful because I think we have a manageable expense comp date. We have also outlined the easier revenue comp base. And we believe that some of the actions that we are taking should make -- maybe already are showing some results. So I don't know if we'll be able to stabilize margins the third quarter, but at the very least we would like to close the gap in the fourth quarter and position us for a better 2019.

As I mentioned in the call, just because consolidation will be good in the longer term and consolidation is painful and the market is decelerating, this doesn't mean we are in a contemplative mood. We are not at all in a contemplative mood. We are making, and it hasn't today, very meaningful investments in prices and looking state by state, city by city, neighborhood by neighborhood, category by category, project by project. And these investments have been -- they are very important. They are funded by all the gains in pricing in buying terms, for example. So, the 14% volume growth of generics is a great indicator of the success of this strategy. And after a couple quarters, I think the volume growth is what's making the revenue growth. So I think we are on right track here.

And another thing is that we have, as I mentioned, decentralized the retail expansion. Only one-third happened in Sao Paulo and it didn't happen this quarter. There has been an evolving process for the last two years as naturally it happened. This is not a quick fix. And we're the only chain in the Brazil today to be decentralize the growth and still maintain great and consistent returns because we have a very profitable national presence. Whatever we build, we build -- we make money.

And when we look at some of the market share we're growing, like (inaudible) now in the lane, in the new glass, even newer, we're growing very, very consistent returns when we compare to Sao Paulo. So decentralizing doesn't mean sacrificing with that. It's probably the opposite, because growth in Sao Paulo now involves a lot of cannibalization, and we always have to manage that. Growth in these markets has a much bigger greenfield component versus when we did Sao Paulo.

I'd also like to stress the huge progress we have achieved in omni-channel. So today is the new day in which 100% of our store base is part of our Click & Collect network. So no other retailer in Brazil has 1,700 stores with Click & Collect available. And I am not referring to my sector. I'm referring to any retail sector. We are the largest Click & Collect chain in retail in Brazil today, and we see very positive trends behind that. We believe the future will involve this reorganization. The store will still remain very important. And I think Click & Collect is the best example of that, because a customer could take advantage of technology to take some of the pain points away from his purchase experience, but he's still relying on the convenience of the store. So this is a great thing.

We have a myriad of markets in which we also have local delivery. And this is a year in which our omni-channel strategy that has been in the works for at least three to five years is starting to surface. And so today, and I mean this very day, is the day that the last stores are joining the Click & Collect method. So this is positioning us very well to take advantage of that.

And this is a journey. There's a lot more to do in terms of leveraging technology to improve customer experience, to improve our profitability, and a lot of that. And I think, again, our expansion is delivering. We see a huge opportunity, and the next quarters will show where our market share really is, because this quarter the IMS data is very noisy. So, we remain highly optimistic about the opportunities we have and about our future.

As I said before, this environment, it amounts to a bitter medicine. It's not nice to swallow but it's good for you, because I think the context in the competitive landscape in two years will be completely different than what it is today. I don't think every competitor will be around two years from today. I think several competitors will still be around but a bit weakened. We'll see player reduce expansion very sharply. We can see players who are in (inaudible) and maybe they won't be part of our industry in two years. So, I mean, obviously I could be wrong, but you can write down that.

I believe that two years will see a completely different market scenario. Expansion is cyclical, so a lot of the improvements that we are seeing from other players, they are not sustainable. And because they're not sustainable, they can't be -- they won't be happening forever. I mean, even if there is more capitalizing, at the end of the day they're irrational in the long term return for the investment they do.

So I'd like to thank you again for joining this call and for your -- for our long term shareholders for your ongoing support. And we remain available to you here through conference calls or by meeting at the investor conference and so forth. Thank you very much.

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Operator [26]

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Closing and disconnection.