January 12, 2012 - 1:03am EST by
2012 2013
Price: 35.00 EPS $2.10 $2.38
Shares Out. (in M): 116 P/E 16.6x 14.7x
Market Cap (in $M): 4,044 P/FCF 11.0x 10.5x
Net Debt (in $M): 2,052 EBIT 499 550
TEV ($): 5,856 TEV/EBIT 11.7x 10.6x
Borrow Cost: NA

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  • Specialty Pharma
  • Regulatory Headwinds
  • Pharmacy
  • Distributor
  • Regulatory Change



Investment Thesis:How would you like to short a leveraged company who is likely to see20-30% of its
customers go bankrupt or exit the industry in the next 12-24 months while the market is completely
oblivious to this fact? On July 29, 2011 the Center for Medicare & Medicaid Services (CMS) announced
an 11.1% cut to the skilled nursing facilities (SNF) reimbursement rates effective October 1, 2011. I
believe this cut will result in large number of skilled nursing facilities going bankrupt and will be very
disruptive to the entire supply chain.One such supplier is Omnicare. I am recommending a short
position in Omnicare (OCR) with price target of $15-$20/shr or 30-50% downside from current price.
Company Background:Omnicare provides pharmaceutical services to long-term-care (LTC) facilities.
Think Walgreens for skilled nursing facilities, assisted living facilities, hospice and other institutions. This
market is distinct from traditional pharmacies in that drugs are generally delivered at client site and in
single serve dosages at short notices. Thus the distribution and delivery network is different from retail
pharmacies like Walgreens or CVS and from mail-order pharmacies like Medco or Express Scripts.
Omnicare has circa 50% market share of the institutional pharmaceutical industry and typically contracts
with facilities to be their sole source provider for pharmaceutical products.I estimate that 2/3 of the
revenues are derived fromskilled nursing facilities and about 1/3 from assisted living facilities.The source
of payers is somewhat more diverse as shown in table below
Source         Estimate % of revenue
Medicaid                                        9%
Private insurance                          20%
LTC Facilities (Medicare part A)     22%
Medicare Part D                            44%
Source: Company filings; analyst reports. 5% of revenue derived from other businesses including CRO.
Skilled Nursing Background: Since Omnicare’s primary customers are skilled nursing facilities it is
worthwhile providing a little background about the industry. Skilled nursing facilities provide short-term
skilled nursing care and rehabilitation services to patients after they are discharged from hospitals. The
industry is highly fragmented with over 15,000 providers serving 1.6 million patients. For profit
institutions account for ~70% of providers.
Up until recently the skilled nursing facilities enjoyed some of the highest “Medicare margins” in the
facilities space. This naturally attracted the attention of the CMS, and through a series of changes in
reimbursement mechanisms, CMS has attempted to recapture those high margins. In what is a
significant blow to the industry, last month CMS announced a very large cut of 11.1% which I believe has
gone too deep and will result in large number of companies going bankrupt or exiting the business.
Impact of the cuts on SNFsin its annual report to Congress, The Medical Payment Advisory Council
(MedPAC), has published detailed review of the distribution of margins for the skilled nursing facilities
(see report Using data from this report, we
can approximate the impact of the recent 11.1% rate cuts on the industry as follows:
Skilled Nursing Facilities Pre-tax Margin Distribution
1stQuartile 2ndQuartile 3rdQuartile 4thQuartile
(a) 2009 “Total margins” (pre-tax) 0.1% 2.7% 4.5% 6.9%
(b) x Medicare share of revenues 16% 23% 25% 26%
(c) x % rate cut in FY ’12 (Oct ’11) (11.1%) (11.1%) (11.1%) (11.1%)
(d)= margins impact from cuts (1.8%) (2.5%) (2.8%) (2.9%)
(d) + (a) “Total margins” post cut (1.7%) 0.2% 1.8% 4.0%
As the calculation above shows, at least one quarter of the companies in the SNF space are likely to earn
negative pre-tax margins after the cuts. Furthermore, it is likely that a large chunk of the 2nd quartile
companies are also likely to earn negative margins. It is worth noting that I use 2009/2010 margins to
build to 2011/2012 margins. While I do not have the 2010/2011 margin distribution figures, looking at
some of the publicly traded companies reveals that 2010 margins were 0-70 bps higher than 2009
margins as result of new reimbursement guidelines (RUGIV) implementation. This does not change the
conclusions from the table above.
Will this cut really hold? Unfortunately (or fortunately) the answer to this question is yes. When
looking at the margin cut CMS points to the high “Medicare margins” for the industry as opposed to
looking at the “Total margins.” The table below highlights, the big discrepancy between the two sets of
margins as Medicare has for the longest time subsidized the lower reimbursement rates provided by
Medicaid.MedPAC has recommended that CMS stop this indirect subsidy to States and as a result there
has been a growing pressure to reign in the “Medicare margins” regardless of impact at the bottom line.
Skilled Nursing Facilities Pre-tax Margin Distribution
1stQuartile 2nd Quartile 3rdQuartile 4th Quartile
2009 “Medicare margins” (pre-tax) (0.7%) 14.5% 22.6% 32.6%
2009 “Total margins” (pre-tax) 0.1% 2.7% 4.5% 6.9%
De Ja Vu? History is actually a pretty good guide here. In 1997 congress passed the Balanced Budget Act
(BBA) which resulted in significant changes in reimbursements to skilled nursing facilities effective July
1998. According to the Muse study, reimbursements were effectively cut by 14.6% between Q1’98 and
Q1’99 resulting in ~20% of the facilities going bankrupt or exiting the businessbetween 1998-2001
(Source: MedPAC). It is worth noting that in 1998 companies had a lot more flexibility in reducing costs
as pre-1998 they were reimbursed on a cost + profit model so there was a lot of “excess fat” that
companies were able to trim. The cut this time around is likely to be much worse for the industry given
thelimited ability to reduce costs.
Getting back to the thesis stock, Omnicare was in business back when the BBA was passed. From the
period starting July ’98 – July ‘00the share price for Omnicaredeclined by 75% as compared to the S&P
500 index rising by 13%. During this period Omnicare’s gross margins declined from 30.2% to 26.7%
while Net Income margins dropped by over 50% from 5.3% to 2.5%. What is particularly interesting is
that market had plenty of time to react to the news after the new reimbursement system went into
effect in July 1998 but the stock didn’t really start falling until few quarters later when the actual
financials were reported. Many of the reasons cited back then on why Omnicare will not be affected by
the changes in reimbursement for skilled nursing facilities are being cited today by the analysts covering
the stock. I recommend the reader go back and look at some of the analyst reports from that period as
it relates to OCR.
Valuation and Price Target currently trades at consensus CY 2012E P/E of 12.3x EV/EBITDA of 7.5x and
11% fcf yield.I believe those multiples are very rich for a company who is likely going to see a material
decline in earnings over the next 12-24 months. However, even if I were to apply those multiples to my
earnings estimate range of $1.08 - $1.77/shr I get a stock price that is 30-50% below current levels.I
have a wide range as forecasting earnings is somewhat trickyand is a function of two key variables:
1) Volume declinefrom the analysis highlighted before we can estimate that ~20-30% of
Omnicare served facilities will be forced to exit the business however the actual patient count
decline is likely to be less as surviving entities will take on some of the lost patients hence my
range of volume decline estimate is anywhere from 5% to 15%.
2) Gross margins declineSNF are likely going to ask all their suppliers to share in the pain and
will be looking hard at re-negotiations pricing of drugs. I estimate that each 10% reduction
innegotiated pricing translates to 1.5% points decline in gross margins for OCR. In period from
1998-2001 we saw gross margins decline by 3.5% points as result of these re-negotiations.
Estimated EPS for 2012
Volume decline
$ 1.39 -5.0% -7.5% -10.0% -12.5% -15.0%
-0.5% $ 1.77 $ 1.72 $ 1.66 $ 1.60 $ 1.55
-1.0% $ 1.60 $ 1.55 $ 1.49 $ 1.44 $ 1.39
-1.5% $ 1.42 $ 1.38 $ 1.33 $ 1.28 $ 1.23
-2.0% $ 1.25 $ 1.21 $ 1.17 $ 1.12 $ 1.08
Note: consensus earnings estimate is $2.4/shr
Some Risks Factors:
1) Government Intervention: The skilled nursing facilities are likely to lobby hard for congress
or the courts to reverse the cuts proposed by CMS. The chances of anything emerging from
this in the immediate term are very limited as the cuts go into effect starting Oct 1, 2011.
Furthermore, the lobbying power of the SNFs is fairly limited and wasn’t successful in
fighting the law last time around in the late 1990s. Finally congress is currently looking at
ways of cutting costs and there has been talk of targeting the SNF sector even more
2) M&A: The industry has been actively consolidating however this risk is small for OCR as
they are consolidator with 50% market share (next largest player has 15% market share).
Retail pharmacies are unlikely buyers as they spun-off most of their institutional pharmacy
segments over the last decade due to lack of synergies. PBMs don’t have the necessary
infrastructure and PE is unlikely to buy with uncertainty around reimbursements


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