· Creating Home Healthcare (“HH”) business of GTIV through arbitrage of ADCO’s purchase of GTIV’s Specialty Pharma business (“SPS”). ACDO is purchasing SPS for stock/cash which will be distributed by GTIV to GTIV shareholders shortly after deal closing. In addition to the cash/stock proceeds, GTIV shareholders will also be left with the largest, and only national provider, of home health services in the U.S. GTIV’s HH business includes professional and paraprofessional services, such as skilled nursing, rehabilitation and other therapies, to individuals with acute illnesses, long-term chronic health conditions, permanent disabilities, terminal illnesses and post-procedural needs. HH payor mix: 52% commercial pay (Cigna 35%), 26% Medicaid, 22% Medicare
· ACDO’s services include contract pharmacy services, clinical services, reimbursement services and delivery services. SPS business being acquired from GTIV includes distribution of drugs and other biological and pharmaceutical products and professional support services for individuals with chronic diseases, such as hemophilia, primary pulmonary hypertension, autoimmune deficiencies and growth disorders.
· Return Potential: Long GTIV @ $23.75, Short 0.1820 ACDO @ $52.50 (full hedge ratio). April close, May 30, 2002 distribution of consideration. Ignore transaction costs and short rebate. Base Case: 12.8% gross, 59% IRR (IRR drops to 31.0% if assume additional six months for full value on GTIV HH stub). Upside Case (ADCO drops to bottom of collar): 27.5% gross, 155% IRR (IRR drops to 80% if assume additional six months for full value on GTIV HH stub). Given the possibility that you will receive less cash given the value of the SPS transaction (see below) you cannot fully hedge your loss potential if ADCO share price increases: Downside Case I: (ACDO moves to Street target price of $62): gross return 10.3%, IRR 46% (IRR drops to 24% if assume additional six months for full value on GTIV HH stub). Downside II: You get decreasing returns as ACDO moves up with $100/ADCO share being break-even point. The downside scenarios can be mitigated by using less than 100% hedge ratio; however, it also lowers your Base Case and Upside Case returns. In event that you do not like to play the arbitrage you can wait until deal closes and hope you can still create GTIV HH at $7.15 (current implied valuation) versus estimated $10.25 in value.
· Deal Description:
o Consideration: GTIV will receive and distribute the following for the sale of SPS: (i) ACDO Shares: If ACDO > $41, 5,060,976 shares (0.1820/GTIV share), if ACDO < $31 6,693,548 shares (0.2408/GTIV share), if $31 < ACDO < $41, stock for $207.5mm in value ($7.45/GTIV share). ACDO price is determined over 20-day measurement period ending on 2nd trading day prior to close; (ii) Cash: $207.5mm ($7.46/GTIV share). However, according to GTIV management, if deal value for SPS is in excess of $440mm (NOL coverage limit available to GTIV) then 35% of value above $440mm will be held by GTIV to pay taxes, so potential for less cash as ADCO price rises above $46/share, (iii) remaining HH business which I value at $10.25, including $85mm in net cash. (Company anticipates $60-$80mm net cash remaining in HH post-distribution and net of HCFA advance due mid-2002). I have included another $15mm in option proceeds once all options vest at closing of transaction. Such options are included in the 27.8mm share count.)
o Timing: April close. 30 days to distribute consideration.
o Conditions: standard, the one performance test for SPS was met as of date of this write-up. Standard “material adverse change”.
o Financing: Cash portion to be financed under BofA commitment letter. Furthermore, no financing out for ACDO.
o Regulatory: HSR waiting period expired Feb 22, 2002.
o Rationale: (1) broadens ACDO’s product lines, (2) lowers ACDO’s dependence on Avonex (nearly 40% of FY01 sales to 20% for FY2003), (3) Lessens manufacturer dependence (increases manufacturers from 6 to 11), and (4) accretive.
· Play risk arb at attractive IRR on a base case, also get free put on ACDO below $41. Very high valuation on ACDO before you get start losing money on the arb.
· Creating HH cheaply.
· GTIV HH: GTIV has begun to see growth in the HH business (4%+ 4Q01/4Q00). I have modeled 3% top line growth. For GTIV HH management expects fully-loaded EBTIDA margins of 3.5-4% on a 2nd half 2002 run-rate. Prior to SPS sale management had mentioned a 10% contribution margin goal for GTIV HH over next couple of years. This would equate to a 6.5% fully-loaded EBITDA margin for GTIV HH. To date, margin improvements have come from investment in better billing systems, elimination in unfavorable agreements, adding better priced managed care contracts, and increased efficiencies resulting in improving margin on Medicare business under PPS. Future improvements should come from more of the same. I have modeled EBITDA margin improvements to 5.5% by 2004. Given $7mm in capex needs against $9mm in D&A annually and current W/C requirements (management believes they can improve W/C) I arrive at $10.25 value for the stub using a 11x terminal multiple on FCF to equity and a 12% discount rate.
· ACDO: Calendar 2002 EPS estimate $1.50 (36x). Price targets on street $62 (43x). Since Sept 1999 ACDO has traded between 40-60x trailing earnings. Trailing earnings are $1.00 p.f. for SPS (using analyst estimates of $0.30/share for SPS in FY02). So $40-$60 is not unreasonable trading level for stock in near term. According to analysts ACDO trades forward at 35x-40x on average - $51-$58/share.
DEAL RELATED RISKS
· Standard deal risk. (Minimum given standard conditions and termination provisions.). Only performance test was met as of end of 4Q01
· Only have NOL protection up to $440mm in value for SPS so if fully hedge-out ACDO there is chance that you generate less return up to $100/ACDO share at which point you are breaking even. Above $100 you begin to lose money. However, this is a high valuation for ACDO.
GENTIVA HH SPECIFIC RISK
· HH valuation is predicated on improvement of margins in a business that is just starting to see top line growth. However, management has delivered on its promises since ADO/OLS deal which created GTIV.
· Large contract with CIGNA (just signed through 2003). 35% of 2001 revenue.
· W/C management crucial to cash flow. Mitigated by fact that government business pays relatively quickly, if you file properly, but company is at mercy of large commercial payors such as Cigna.
· Medicare/Medicaid add level of filing complexity which can result in fraud charges and billing collection issues.
· Always risk of outright billing fraud. GTIV had this problem relating to an acquisition made under prior management.
· Medicare/Medicaid can always change pricing which decimated this industry before. However, company has been operating under PPS system since Oct. ‘01 and has improved margins as a result.
· GTIV is retaining liability for a variety of lawsuits and investigations against them. See the ADCO/GTIV proxy for a description. GTIV has lost an age discrimination case which has about $31mm in liability against GTIV (its on appeal). Other issues relate to false claim filings – always a part of doing business with government. Looks like government has decided not to intervene in these issues, but still very hard to assess ultimate liability if any.
· Closing of risk arb deal.
· Improvement in top line and margins for HH.