PHARMERICA CORP PMC
January 31, 2011 - 5:20pm EST by
BJG
2011 2012
Price: 11.31 EPS $0.00 $0.00
Shares Out. (in M): 29 P/E 0.0x 0.0x
Market Cap (in $M): 331 P/FCF 4.0x 0.0x
Net Debt (in $M): 216 EBIT 69 72
TEV ($): 546 TEV/EBIT 7.9x 7.5x

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Description

"It is quite possible to decide by inspection that a woman is old enough to vote without knowing her age, or that a man is heavier than he should be without knowing his exact weight."   -Graham and Dodd, Security Analysis

 
I'm not sure exactly how much Pharmerica is worth as an enterprise, hence no specific price target on the equity shares.  However, I think it's very likely the equity shares are worth considerably more than where they trade today.
 
 
Summary Thesis

PharMerica ("PMC") is an institutional pharmacy (aka long-term care pharmacy) serving long-term care settings such as Nursing Homes (Skilled Nursing Facilities or "SNFs") and Assisted Living Facilities ("ALFs").  Daily consumption of pharmaceuticals by nursing home residents provides non-discretionary demand, which drives recurring revenues and cash flows.  However, supposed "irrational" competition from smaller local and regional players continue to drive material bed losses at PMC (and much larger rival OCR for that matter), partly leading to revenue and EBITDA erosion since 2007 when Pharmerica was created (see section titled "History of Pharmerica" for more details).  Pharmerica and LTC pharmacies in general deliver meds daily to long-term care facilities such as SNFs and ALFs.  Meds are prepackaged in blister packs for each patient, which minimizes dosing errors and so the nurse does not have to fiddle with several orange bottles every time s/he stops at a room.  Billing for drug reimbursements is also handled, and 24-hr emergency deliveries are provided for the occasional acute episode.

Although well off recent lows of $7/share, PMC is still absolutely cheap on an EV/EBITDA basis and based on its Free Cash Flow generation.  More notably, several catalysts exist which may bring higher margins, higher earnings (even if margins remain constant), and subsequently a higher valuation by the market.  Catalysts include material share repurchase (not the kind that just off-sets the effects of executive stock options) fueled by continued positive free cash flow, restructured supply contract (covers 95% of drug purchases) with what I anticipate will be more favorable terms, and the recent acquisition of Chem Rx via stalking horse bid which expands the business by approximately 20% as measured by beds serviced.

 

Pro Forma for Chem Rx transaction as of Sept 30, 2010 Cap Structure  

Cash...................................................24  

Debt (Term Loan due July 2012).........240  

Mkt Cap..............................................326  (as of Friday, 1/28/2010)

Enterprise Value.................................546  

 

LTM Equity Valuation Ratios (Pro Forma for Chem Rx

FCF 1 (CFO-CapEx) Yield on Mkt Cap  25%      (23% ex-Chem Rx)

FCF 2 (CFO-CapEx-Acquisitions*) on Mkt Cap  12%     (10% ex-Chem Rx)

*acquisitions are recurring and required to maintain beds, so should be considered a regular cash investment in business until (if) bed retention issues subside on an organic basis.

EV / EBITDA   5.6x   (6.3x ex-Chem Rx)

EV / EBITDA-CapEx  6.9x     (8.0x ex-Chem Rx)

 

LTM Leverage Ratios   

FCF 1 to Debt  34% (32% ex-Chem Rx)        

Debt / EBITDA  2.5x (2.8x ex-Chem Rx)        

Debt / EBITDA-CapEx   3.1x  (3.5x ex-Chem Rx)

 

3 things drive this Buy recommendation - summarized below but discussed in more detail subsequently

#1 - New purchasing contract will immediately alleviate some margin pressure

#2 - Recent acquisition, via stalking-horse bid, grows business by ~20% and could be highly accretive

#3 - Very undervalued equity, particularly if either of the above 2 items work out well, but not solely dependent upon those scenarios.

  

#1) Prime Vendor Contract with former-parent AmerisourceBergen has been restructured

 

As part of the spinoff and merger to create PharMerica, ABC stuck PMC with a 5-year prime vendor contract, requiring 95% of their purchases be directed through ABC, and expiring June 2012.  In hindsight, the contract was apparently disadvantageous if PMC's purchases from ABC fell below some level.  Industry-wide, participants have been squeezed so the prime vendor agreement is a factor but not the sole reason.

  • Announced on Jan 4 and effective Jan 1, 2011, the ABC Prime Vendor agreement was restated, with the new agreement running through Sept 2013, with automatic 1-year renewals thereafter.
  • PharMerica CEO has quoted on several occasions that any adjustment to the contract would favorably affect margins as a result of more favorable purchasing:

Q2 2010 earnings call (August 6th) dialogue excerpts pertaining to Prime Vendor agreement with AmerisourceBergen

Brendan Strong - Barclays:

Do you ultimately even have that leverage given that you have to buy almost all of your drugs through Amerisource, and is there anything you can do about the Amerisource contract here?

 

Greg Weishar, CEO - Pharmerica:

We are working with them [AmerisourceBergen], and I think they are starting to understand our issues and our needs, and we are confident that we will make progress there. So the market has changed a lot since that contract was written [in 2007], and so far we have seen cooperation on their part.

Q3 2010 earnings call (August 10th) dialogue excerpts pertaining to Prime Vendor agreement with AmerisourceBergen

 

Greg Weishar, CEO - Pharmerica:

Finally, I know you are all interested in progress with regards to the prime vendor agreement. I want to assure all of you that we are making good progress in our discussions with AmerisourceBergan. We anticipate we'll finish the fourth quarter and enter 2011 with a much improved contract for the purchase of drugs.

 

Steve Valiquette - UBS:

Curious though is it just simply a matter you will renew with them now it's a matter of trying finalize the terms or is there some possibility that ABC might not be your prime supplier going forward. I just want to get a sense of that as well.

 

Greg Weishar, CEO - Pharmerica:

I mean look we have an agreement that lasts for two more years. We originally had a five year agreement at the point of when we merged the two companies. So I think the idea here is that we will extend our agreement with AmerisourceBergen in exchange for better pricing.

 

Brendan Strong - Barclays:

...what type of flexibility do you think you will get out of the contract negotiations being able to be go out to generic manufacturers to buy directly, it is something else?

 

Greg Weishar, CEO - Pharmerica:

Clearly from a margin stand point it will be an improvement to our margins I think that's what we can confidently say.

 

Moreover, intuition alone would favor that the fact the contract was adjusted in the interim, well before expiry and in light of PharMerica's margin headwinds, might indicate the restructured contract can only have a favorable impact, or at the least, it can't be any worse than the pre-existing agreement. Plus, the 20% new beds from Chem Rx acquisition likely gave PMC a little more bargaining power at the table - it was noted in the press release that Chem Rx is included in the new purchasing agreement.

Finally, there is clearly some more-than-linear downside when comparing the volume of drugs dispensed versus the gross profit per script. This is partly due to delivery scale (consider the profitability of a mail route in an urban area versus a rural route where the postal service worker only has one stop every mile or two). However, some of the apparent diseconomies of scale may have to due with purchasing via the legacy Prime Vendor agreement:

  • Excerpted from Prime Vendor Agreement as stated in 2007 10-K, "The Corporation has also agreed to a minimum purchase volume equal to $1 billion in the first year following the Closing Date. If the Corporation fails to reach this minimum purchase volume, in addition to remedies available at law, ABDC may adjust the price of goods the Corporation purchases from them to reflect the lower than expected purchase volume."
  • While ttm COGS stand at $1.5 billion, drug purchases may in fact be below the $1 billion hypothetical benchmark. (I stress 'hypothetical' because the Prime Vendor agreement only notes $1 billion for the first year following closing as a specific benchmark.) Note that COGS, as defined in PMC's Q's and K's, includes other costs in addition to drug purchases, such as delivery, rent, depreciation, direct labor, etc.

some profitability metrics for PMC since Q1 2009

_______________________________Q1 09     Q2 09     Q3 09     Q4 09    Q1 10     Q2 10    Q3 10                       Q1'09 to Q3'10delta

Scripts (000s)                                        9,919      9,815      9,713      9,590      9,664      9,316      8,949                      -10%  

Gross Profit/Script                               7.00        6.87        6.73        6.76         6.36        5.99        6.13                       -12%  

Gross Margin --- Inst'l Pharmacy        15.3%    15.1%    14.6%    14.8%    13.7%     12.8%    12.8%                   -2.5%

EBITDA Margin                                  5.4%       5.6%       5.8%       5.6%       5.0%       4.3%        4.1%                       -1.3%  

 

 

#2) Acquisition of Chem Rx adds 20% new beds to PMC's existing (although declining) beds serviced

Chem Rx, while in Chapter 11, was acquired by PMC with the transaction closing Nov 4, 2010:

  • Chem Rx, a northeast regional inst'l pharmacy primarily in New York, New Jersey and Pennsylvania (but with a pharmacy in Florida and a JV in Illinois), filed for Chapter 11 protection on May 11, 2010. Chem Rx's bank loans (CIBC) were in forebearance for about a year prior.
  • October 2010, it was announced that PMC earned the designation of stalking horse bidder with its bid for Chem Rx assets
  • November 4, 2010: PMC acquires Chem Rx for total consideration of $82 million, consisting of $70 million in cash and $12 million assumption of liabilities.
  • Mgmt has noted the acquisition would be accretive in 2011.
  • Acquisition brings $45 million in NOLs, some with expiries as far off as 2026, and Charitable Contribution carryforwards of $4 million (legacy PMC has $19 million in Federal NOLs as of Q3)

 

Chem Rx acquisition valuations, figures in $ millions

Total Consideration :  82                                                                                                                                   

                                                LTM as of 6/30/10                             Pro Forma 1*                                         Pro Forma 2**

Revenues                                              359                                         359                                                         359

EBITDA                                                11.4                                        14.4                                                        18.0

margin                                                   3.2%                                       4.0%                                                       5.0%

                                                                                               

xEBITDA                                              7.2x                                        5.7x                                                        4.6x

                                                                                               

*Pro Forma 1 assumption: assumes margin in line with legacy PMC's mrq

**Pro Forma 2 assumption: assumes new ABC vendor contract brings margins at Chem Rx to 5%, where they

 

 

#3) PMC shares are undervalued on both a cash flow basis and EBITDA basis, share buybacks at accretive prices is returning cash to shareholders

In the context of an adjusted (which I assume to mean 'improved') prime vendor contract for drug supply purchases and an acquisition that brings 20% new beds under the PMC umbrella, not much else has to go right for the equity shares to be considered very undervalued, in my opinion:

  • Scenario 1 - PMC pro forma for Chem Rx acquisition (LTM figures, no major assumptions)

 

______                                            Legacy PMC                         Chem Rx              _________   Pro Forma

Beds services (as of Q3 '10)               290,000                                   65,000                                     355,000

Revenues                                              1807                                        359                                          2166

EBITDA                                                  85.8                                         11.4                                         97.2

Margin                                                   4.7%                                       3.2%                                       4.5%

 

CFO                                                        94.2                                         7.3

Less: CapEx                                           -18.1                                        -0.7

FCF 1                                                      76.1                                         6.6                                           82.7                        

 

Less:  tuck-in Acquisitions                    -42.4

FCF 2                                                      33.7                                         6.6                                           40.3

 

xEBITDA                                                                                                                                               5.6x

Free Cash Flow 1  to Mkt Cap                                                                                                            25%

Free Cash Flow 2 to Mkt Cap                                                                                                             12.4%

EV/Beds Serviced                                                                                                                                $1,900

 

 

  • Scenario 2 - Chem Rx's margins, under PMC's purchasing power, increase to PMC's recent qtrly level of 4% and PMC's margin level remains steady at 4%.   Also, to be conservative, Legacy PMC figures are annualized based on mrq figures and margins - Q3 '10.

 

                                                                Legacy PMC                         Chem Rx     _____            Pro Forma

Revenues                                              1,772                                       359                                          2,131

EBITDA                                                  72.7                                         14.7                                         87.4

Margin                                                   4.1%                                       4.1%                                       4.1%

 

xEBITDA                                                                                                                                               6.2x

 

 

  • Scenario 3 - New Prime Vendor agreement leads to margin expansion, and EBITDA margins expand to 5% at legacy PMC and Chem Rx.  Note: as recently as Q1 2010 PMC's EBITDA margins were 5%.  Also, as before, Legacy PMC figures are annualized as using mrq.

 

                                                                Legacy PMC                         Chem Rx                _______ Pro Forma

Revenues                                              1,772                                       359                                          2,131

EBITDA                                                   88.6                                         18                                            106.6

Margin                                                   5%                                          5%                                          5%

 

xEBITDA                                                                                                                                             5.1x

 

 

  • Comp table vs Omnicare (OCR)

 

LTM Figures, in $ millions                  Pro Forma PMC                    Omnicare

Beds                                                       355,000                                   1,385,000

 

Revenues                                              2,166                                       6,127

EBITDA                                                   97.2                                         661

Margin                                                   4.5%                                       10.8%

 

Enterprise Value                                   542                                          $5,180

 

xEBITDA                                               5.6x                                         7.8x

EV/contracted Bed                               $1,900                                     $3,490


 

  • Share buybacks - very accretive so far
    • $25mm authorized by Board on Aug 2010,
    • $10.5mm spent during Q3 - represents 4% of shares outstanding repurchased in Q3 at avg price of $7.90/share (stock is around $11/share today), approx $15mm remains.

 

 

 3 Key Risks for PMC

#1 - Bed Losses, customer retention issues

#2 - unsaturated footprint - PMC spread too thin

#3 - customer concentration - 2 key customers account for ~17% of pro forma beds

 

#1) Bed Losses

Continued bed losses are eroding the core business and some scale opportunities.  Service issues have been cited, but also an aggressive posture by local/regional "mom and pop" pharmacies.  On the other side of the spectrum, 800-pound gorilla Omnicare is undergoing an operational turnaround and likely to become more aggressive and successful in their efforts to target new beds.  PharMerica is feeling this pressure and it shows in their bed retention rate figures:

Regarding "mom and pop" pharmacies: it's a misnomer.  Local/Regional pharmacies are highly competitive and barriers to entry minimal.  Local retail pharmacies already have contracts with insurance drug plans, and up front capital commitment to enter into the long-term care pharmacy space, inclusive of inventory, is estimated at no more than $1 million.

Operationally, drug wholesalers are willing to arm the local "mom and pop" shops to compete with the 2 national players - Pharmerica and Omnicare.  click here to view McKesson's web page pertaining to this.  AmerisourceBergen and Cardinal have similar offerings, and I'm sure I'm leaving out smaller firms with relevant offerings as well.

More notably, business is bid on the cheap as a loss leader strategy - Prescription drug reimbursements make up ~70% of Inst'l Pharmacy revenues, so they're willing to bid the remaining 30% at break-even or less because remaining 70% brings profits via commoditized drug reimbursements from 3rd Party payors.

The table below highlights retention issues at PMC and OCR.  The 3rd row adjusts for PMC's 2 key clients, former parent Kindred and Golden Living - which shows an even higher churn rate amongst more "arms length" clients.

 

 _____________________   Q3 '08     Q4 '08     Q1 '09     Q2 '09     Q3 '09     Q4 '09     Q1 '10     Q2 '10     Q3 '10

Omnicare                               92.8%     94.3%     93.3%     96.4%     93.4%     92.3%     92.5%     88.4%     91.2%

PharMerica                            86.6%     89.5%     88.2%     86.1%     85.4%     83.0%     86.5%     85.0%     80.4%

PharMerica-Adjusted          83.3%     86.9%     85.2%     82.5%     81.5%     78.5%     82.9%     81.0%     74.8%

 

 

 

                                        Q1 '09                     Q2 '09                     Q3 '09                     Q4 '09                     Q1 '10                     Q2 '10                     Q3 '10

Pharmerica Beds

Beginning Beds               321,068                    318,761                    314,698                   314,324                  313,873                  307,874                 299,527

                                                                                                               

Adds                                 6,762                      6,473                       10,549                     12,137                     4,111                       2,586                       4,867

Losses                               (9,069)                    (10,536)                     (10,923)                  (12,588)                 (10,110)                 (10,933)                 (13,703)

Net Adds(Losses)            (2,307)                  (4,063)                           (374)                      (451)                      (5,999)                   (8,347)                    (8,836)

 

Ending Beds                      318,761                   314,698                      314,324                    313,873                  307,874                   299,527                 290,691

 

 

Omnicare Beds               1,425,000                1,427,000                1,389,000                1,377,000                1,370,000                1,353,000              1,385,000

(for comparison)


 

 

#2) Unsaturated footprint

PMC is sitting on plenty of idle capacity according to mgmt comments, which would be good thing is the business was growing, but the actual story is that service issues exist, which leads to more bed losses, which leads to retrenching in a given area and thus more service issues for the few surrounding areas where clients still remain.  The easiest way to think about this in my opinion is on a beds/pharmacy basis.  Note that PMC has about half the saturation that OCR boasts.  Also, Chem Rx will be operated as a segment and is new territory for PMC rather than a consolidating acquisition.  Nonetheless, Chem Rx actually has a strong footprint in its key areas.

 

_________________Legacy PMC                Chem Rx          Pro Forma PMC          Omnicare (peer)

Beds                            290,700                       65,000             355,700                       1,385,000

Pharmacies                   90                                5                      95                                215

States                           41                                5                      43                                47

 

Beds/Pharmacy            3,200                           13,000             3,700                           6,440

Beds/State                    7,100                           16,300             8,300                           29,500

 

 

#3) Customer Concentration - 2 key customers collectively account for ~18% of Pro Forma beds 

Former parent Kindred accounts for 10% of revenues, as disclosed in 2009 10-K.  Golden accounts for 9% according to company discussions.  Golden has more than 300 nursing facilities with, assuming 100 beds/facility, 30,000 beds.  Kindred has 28,000 nursing beds and 6,500 Long-term Acute Care hospital beds.  Given the Kindred IT agreement and its status as former parent (which results in PMC pharmacies being located in/around Kindred clusters), I view Kindred as unlikely to go elsewhere, although they of course exert significant buyer power against PMC and their contract expires June 2011.

 

Golden contract renewed through July 2013: http://www.bizjournals.com/louisville/stories/2010/06/28/daily39.html

Kindred contract renewed through June 2011: http://www.bizjournals.com/louisville/stories/2008/12/01/daily30.html

 

as of Q3 2010                          Nursing Beds                            LTACH Beds               % of Pro Forma PMC beds

Kindred Beds                           28,000                                     6,500                           9.7%

Golden (guestimated)                30,000                                                                         8.5%

Total for top 2 customers                                                                                              18.2%

 

 

History of PharMerica - a scale-driven merger thesis that never materialized 

PMC was created on July 31, 2007, with its equity shares being listed for public trading on August 1, 2007.  PMC is the result of the simultaneous spin-offs and merger of two separate business.  Kindred contributed its inst'l pharmacy, known as Kindred Pharmacy Services ("KPS"), which consisted of 46 pharmacies and 100,000 beds serviced (primarily but not solely Kindred facilities).  AmerisourceBergen contributed its inst'l pharmacy, known as Pharmerica  LTC, which consisted of 80 pharmacy locations and 240,000 beds serviced.  The new combined entity kept the Pharmerica name and the respective shareholders of Kindred and AmerisourceBergen each received fractional shares of the new entity, PMC. 

As part of the transaction, both former parents laid 5-year contracts on PMC.  Kindred retained all back-end accounting and IT systems on their premises at cost plus 10%, cited in PMC's 10-Ks at the "Kindred IT Services Agreement" effective through July 31, 2012.  Costs as reported by PMC vary but average $12M/yr.  AmerisourceBergen retained a 5-year Prime Vendor agreement which required PMC to purchase at least 95% of their drug purchases through ABC, effective through July 31, 2012.

Investor Presentations at the time showed very attractive slides, notably one slide forecasting 9% annualized growth for their market, and another slide showing pro forma PMC with 15% market share, Omnicare with 50% and "Ample opportunity for increased market share" to describe the remaining 35%.  Specifically for PMC, Revenue growth was targeted at 5-7% and EBITDA growth at 15-25% for the foreseeable future (2007 investor presentation link here).  Actual results to date have been far from what appeared to be reasonable expectations. 

Fast forward to today.  Pharmerica's revenues have fallen from $1.96 billion annually to $1.77 billion (will be $2.1b pro forma for Chem Rx).  EBITDA has been reduced from as much as $100 million annually to a $73 million run-rate if we annualize the mrq, and $86 million on an LTM basis.  EBITDA margins have been in the 5.5% range but have rapidly declined to 4.1% over the past 4 quarters.  The company has been forced to retrench to some degree as beds under contract have fallen from 330,000 to 290,000 (355,000 pro forma for Chem Rx), closing approx 36 of its original 126 pharmacies following the business combination.

Nonetheless, throughout the 2007-Q3 2010 period, Free Cash Flow generation has been consistently positive and PMC has not sought outside capital for support.  From calendar year 2007 (incl. 2007) through Q3 2010, FCF has totaled $187 million as measured by CFO less CapEx, and $97 million if we further net out acquisition investments.  Based on bed erosion, acquisitions look more like a recurring expenditure required to maintain the business and should be accounted for accordingly, unless you are one of the few believers that feels bed retention issues will subside sometime in the near future.

Smaller regional and local players, often referred to as "mom and pops", continue to nibble at PMC's and larger rival OCR's contracted beds quarter after quarter after quarter.  Meanwhile, drug reimbursement continues to get progressively less favorable, even on the generic side where gross profit dollars per script are typically higher (not a typo, generic dollar profits, not just margins, are higher across the supply chain).  Additionally, the effects of the demographic boom of the elderly has not materialized yet - SNF beds are nearly flat annually over the past few years as "less institutional" care settings continue to attract the marginal patient, such as Independent Living, Assisted Living, and Home Health.  Note that all else equal, an inst'l pharmacy such as PMC would prefer to service a SNF with 100 beds than an ALF with 100 beds for the following reason: an individual is admitted as a patient to a SNF while an individual is a resident of an ALF, and as a result, ALF residents can still opt to get their meds elsewhere in most cases, such as the local CVS or mail order via Medco.

Here's the link to the 8/13/07 report on PMC: http://www.valueinvestorsclub.com/value2/Idea/ViewIdea/2821

Please Note: I'm not criticizing or disagreeing with the referenced report, simply citing it as background reading for those interested.

 

 

Factors that affect the Institutional Pharmacy Industry as a whole

Below are some factors that continue to act as a headwind for Inst'l Pharmacies and/or are general characteristics of the industry as I see it.  Some of these issues are not unique to PharMerica so I will not dwell on them.  Moreover, I'm not smart enough to forecast industry changes, let alone within a highly regulated industry with a 3rd Party payor system, where the 3rd party is often the gov't (via Medicare Part D). 

  • 2011 and 2012 are key years for patent expiration, where several top geriatric drugs will convert to generic, driving higher gross profit dollars (2 to 3x by some estimates), particularly during the first few months of generic launch. More information on this can be found from investor presentations by any company that distributes meds (MHS, ESRX, PMC, OCR, CVS, WAG, etc)
  • Drug Pricing appears to continue to squeeze the middle-men
    • Federal Upper Limit pricing continues to shrink the abnormal profit window newly launched generics. Average period between generic launch and FUL pricing was as much as 21 months in 2006 and is now down to less than 6 months today. Generally, FUL is in effect when at least 3 therapeutically equivalent drugs are available, and pertains specifically to Medicaid but it affects pricing industry-wide nonetheless. Increased competition between generic makers will shorten the time it takes to reach FUL. see Slide #12 on this recent PMC Investor Presentation.
    • Medicare Part D, launched in 2006, accounts for 45% of PMC revenues.
  • Clients (SNFs and ALFs) are price inelastic to a certain extent. Only 30% of PMC revenues are sourced directly from the facility. Of that amount, an undisclosed proportion is simply pass-through via a patients Medicare Part A bill (which includes pharmaceutical charges). Only a small portion of an inst'l pharmacy's revenues, and somewhat inversely, a small portion of a SNFs costs, or directly born by the SNF for the inst'l pharmacy's service.
  • Postal delivery comparison - Inst'l pharmacy has a component that is similar to mail delivery by the postal service. Drugs are delivered daily to SNF and ALF clients. Naturally, the more saturated the footprint, the cheaper the delivery on a per unit basis, similar to urban vs rural U.S. mail.
  • Comparison to landscaping industry - The Institutional Pharmacy industry has some characteristics that remind me of the landscape industry... there are a very small handful of national players (we've all seen the tan and brown Brickman trucks tending to your local corporate office park) that handle national accounts; and the remainder of the market is very local and very relationship-driven (your local townhouse development homeowner's association probably hires one of the local landscape companies, and maybe you do the same for your home). Similarly, PMC and OCR will absolutely always service the national and multi-state living facilities, because those companies want to deal with just a single pharmacy contract. It's the smaller systems or stand-alone facilities where retention has suffered. No matter how attractive PMC's and OCR's respective presentation slide looks which shows their market share, and the approx 40% uncaptured market (at least by those 2), they'll never get there... that market is currently serviced already by much smaller pharmacies with deep local relationships. 

 

 

Exhibits

Comp footprint table in pdf format (shows an indication of operating scale as measured by beds/pharmacy for PMC, OCR, and Chem Rx)

https://docs.google.com/leaf?id=0BzYLZyqiGpVKZTY4ZmYzYTktMWI0OC00MTQxLWE3ZTItZjE2YmU5YjczYzA4&sort=name&layout=list&num=50 

 

Full dialogue for PharMerica pertaining to their Prime Vendor contract with Amerisource Bergen

 

Q2 2010 earnings call, August 6, Q & A dialogue

 Brendan Strong, Analyst - Barclays: And then just back to Frank's question about leverage that you have on generic manufacturers... ...Do you ultimately even have that leverage given that you have to buy almost all of your drugs through Amerisource, and is there anything you can do about the Amerisource contract here?

Greg Weishar, CEO - PharMerica: We are working with them [AmerisourceBergen], and I think they are starting to understand our issues and our needs, and we are confident that we will make progress there. So the market has changed a lot since that contract was written [in 2007], and so far we have seen cooperation on their part. Obviously when you come to them with a new model, which we have gone to them with, it's going to take them a bit of time to absorb it and understand it.

 

Q3 2010 earnings call, November 10, Prepared remarks

Greg Weisher, CEO - Pharmerica: Finally, I know you are all interested in progress with regards to the prime vendor agreement. I want to assure all of you that we are making good progress in our discussions with AmerisourceBergan. We anticipate we'll finish the fourth quarter and enter 2011 with a much improved contract for the purchase of drugs.

 

Q3 2010 earnings call, November 10, Q & A dialogue

Steve Valiquette, Analyst - UBS: Curious though is it just simply a matter you will renew with them now it's a matter of trying finalize the terms or is there some possibility that ABC might not be your prime supplier going forward. I just want to get a sense of that as well.

Greg Weishar, CEO - PharMerica: I mean look we have an agreement that lasts for two more years. We originally had a five year agreement at the point of when we merged the two companies. So I think the idea here is that we will extend our agreement with AmerisourceBergen in exchange for better pricing.

Brendan Strong, Analyst - Barclays:  Just to follow up on the ABC question, I mean on the last call you were hoping to make some progress there, this call you seem to be definitively saying you will have something announced by the end of the year, so just wanted to maybe ask as well, I guess in terms of specifically what type of flexibility do you think you will get out of the contract negotiations being able to be go out to generic manufacturers to buy directly, it is something else?

Greg Weishar, CEO - PharMerica:  Well, look Brendan, I hate to get in to the details. When we finalize the contract - you got to understand there is a lot of moving pieces to it - that we will provide this color to the extent we feel it's justified but I really, given that we don't have it done I really don't want to comment on what it may look like or what it may not look like. Clearly from a margin stand point it will be an improvement to our margins I think that's what we can confidently say.

 

Prime Vendor Agreement as stated in 2007 10-K:

On the Closing Date, the Corporation entered into a Prime Vendor Agreement (the "Prime Vendor Agreement"), with AmerisourceBergen Drug Corporation ("ABDC"), a wholly owned subsidiary of AmerisourceBergen, the Corporation's former 50% shareholder. Pursuant to this agreement, the Corporation has agreed to purchase at least 95% of the Corporation's prescription pharmaceutical drugs from ABDC and to participate in its generic formulary purchase program for a period of five years following the Closing Date. The Corporation has also agreed to a minimum purchase volume equal to $1 billion in the first year following the Closing Date. If the Corporation fails to reach this minimum purchase volume, in addition to remedies available at law, ABDC may adjust the price of goods the Corporation purchases from them to reflect the lower than expected purchase volume.

 

COGS from most recent 10-Q filing:

Cost of goods sold is comprised primarily of the cost of product and is principally attributable to the dispensing of prescription drugs. Our cost of product relating to drugs dispensed by our institutional pharmacies consists primarily of the cost of inventory dispensed and our costs incurred to process and dispense the prescriptions. Cost of goods also includes direct labor, delivery costs, rent, utilities, depreciation, travel costs, professional fees and other costs attributable to the dispensing of medications. In addition, cost of product includes a credit for rebates earned from brand-name pharmaceutical manufacturers whose drugs are included in our formularies.

Catalyst

1) Potential for higher earnings guidance on Year end call (Feb 25, 2011) as a result of the following 2 items

1a) AmerisourceBergen prime vendor contract restructured (we can assume for better, otherwise they wouldn't have done so - legacy contract wasn't set to expire until June 2012). Contract was restructured effective Jan 1, 2011 and runs through Sept 2013.

1b) Chem Rx acquisition (brings 20% new beds under PMC umbrella and, as noted by the prime vendor contract renegoation, Chem Rx purchasing also joins PMC which should bring buying power)

2) Cheap Valuation with share buyback program (in Q3, company repurchased approx 4% of shares at avg price of $7.90/share)
LBO possible given valuation and cash flow generation (whether general financial buyer or more focused such as Ross Crawford PE Fund: http://www.nashvillepost.com/news/2010/7/14/former_caremark_ceo_starts_new_health_care_turnaround_firm

3) If Pharmerica were to show any improvement in organic bed retention (via more additions, few losses, or the combo of both), the story as viewed by the market would materially improve, however, I don't anticipate this scenario - it's possible but not probable in my opinion.
    sort by    

    Description

    "It is quite possible to decide by inspection that a woman is old enough to vote without knowing her age, or that a man is heavier than he should be without knowing his exact weight."   -Graham and Dodd, Security Analysis

     
    I'm not sure exactly how much Pharmerica is worth as an enterprise, hence no specific price target on the equity shares.  However, I think it's very likely the equity shares are worth considerably more than where they trade today.
     
     
    Summary Thesis

    PharMerica ("PMC") is an institutional pharmacy (aka long-term care pharmacy) serving long-term care settings such as Nursing Homes (Skilled Nursing Facilities or "SNFs") and Assisted Living Facilities ("ALFs").  Daily consumption of pharmaceuticals by nursing home residents provides non-discretionary demand, which drives recurring revenues and cash flows.  However, supposed "irrational" competition from smaller local and regional players continue to drive material bed losses at PMC (and much larger rival OCR for that matter), partly leading to revenue and EBITDA erosion since 2007 when Pharmerica was created (see section titled "History of Pharmerica" for more details).  Pharmerica and LTC pharmacies in general deliver meds daily to long-term care facilities such as SNFs and ALFs.  Meds are prepackaged in blister packs for each patient, which minimizes dosing errors and so the nurse does not have to fiddle with several orange bottles every time s/he stops at a room.  Billing for drug reimbursements is also handled, and 24-hr emergency deliveries are provided for the occasional acute episode.

    Although well off recent lows of $7/share, PMC is still absolutely cheap on an EV/EBITDA basis and based on its Free Cash Flow generation.  More notably, several catalysts exist which may bring higher margins, higher earnings (even if margins remain constant), and subsequently a higher valuation by the market.  Catalysts include material share repurchase (not the kind that just off-sets the effects of executive stock options) fueled by continued positive free cash flow, restructured supply contract (covers 95% of drug purchases) with what I anticipate will be more favorable terms, and the recent acquisition of Chem Rx via stalking horse bid which expands the business by approximately 20% as measured by beds serviced.

     

    Pro Forma for Chem Rx transaction as of Sept 30, 2010 Cap Structure  

    Cash...................................................24  

    Debt (Term Loan due July 2012).........240  

    Mkt Cap..............................................326  (as of Friday, 1/28/2010)

    Enterprise Value.................................546  

     

    LTM Equity Valuation Ratios (Pro Forma for Chem Rx

    FCF 1 (CFO-CapEx) Yield on Mkt Cap  25%      (23% ex-Chem Rx)

    FCF 2 (CFO-CapEx-Acquisitions*) on Mkt Cap  12%     (10% ex-Chem Rx)

    *acquisitions are recurring and required to maintain beds, so should be considered a regular cash investment in business until (if) bed retention issues subside on an organic basis.

    EV / EBITDA   5.6x   (6.3x ex-Chem Rx)

    EV / EBITDA-CapEx  6.9x     (8.0x ex-Chem Rx)

     

    LTM Leverage Ratios   

    FCF 1 to Debt  34% (32% ex-Chem Rx)        

    Debt / EBITDA  2.5x (2.8x ex-Chem Rx)        

    Debt / EBITDA-CapEx   3.1x  (3.5x ex-Chem Rx)

     

    3 things drive this Buy recommendation - summarized below but discussed in more detail subsequently

    #1 - New purchasing contract will immediately alleviate some margin pressure

    #2 - Recent acquisition, via stalking-horse bid, grows business by ~20% and could be highly accretive

    #3 - Very undervalued equity, particularly if either of the above 2 items work out well, but not solely dependent upon those scenarios.

      

    #1) Prime Vendor Contract with former-parent AmerisourceBergen has been restructured

     

    As part of the spinoff and merger to create PharMerica, ABC stuck PMC with a 5-year prime vendor contract, requiring 95% of their purchases be directed through ABC, and expiring June 2012.  In hindsight, the contract was apparently disadvantageous if PMC's purchases from ABC fell below some level.  Industry-wide, participants have been squeezed so the prime vendor agreement is a factor but not the sole reason.

    • Announced on Jan 4 and effective Jan 1, 2011, the ABC Prime Vendor agreement was restated, with the new agreement running through Sept 2013, with automatic 1-year renewals thereafter.
    • PharMerica CEO has quoted on several occasions that any adjustment to the contract would favorably affect margins as a result of more favorable purchasing:

    Q2 2010 earnings call (August 6th) dialogue excerpts pertaining to Prime Vendor agreement with AmerisourceBergen

    Brendan Strong - Barclays:

    Do you ultimately even have that leverage given that you have to buy almost all of your drugs through Amerisource, and is there anything you can do about the Amerisource contract here?

     

    Greg Weishar, CEO - Pharmerica:

    We are working with them [AmerisourceBergen], and I think they are starting to understand our issues and our needs, and we are confident that we will make progress there. So the market has changed a lot since that contract was written [in 2007], and so far we have seen cooperation on their part.

    Q3 2010 earnings call (August 10th) dialogue excerpts pertaining to Prime Vendor agreement with AmerisourceBergen

     

    Greg Weishar, CEO - Pharmerica:

    Finally, I know you are all interested in progress with regards to the prime vendor agreement. I want to assure all of you that we are making good progress in our discussions with AmerisourceBergan. We anticipate we'll finish the fourth quarter and enter 2011 with a much improved contract for the purchase of drugs.

     

    Steve Valiquette - UBS:

    Curious though is it just simply a matter you will renew with them now it's a matter of trying finalize the terms or is there some possibility that ABC might not be your prime supplier going forward. I just want to get a sense of that as well.

     

    Greg Weishar, CEO - Pharmerica:

    I mean look we have an agreement that lasts for two more years. We originally had a five year agreement at the point of when we merged the two companies. So I think the idea here is that we will extend our agreement with AmerisourceBergen in exchange for better pricing.

     

    Brendan Strong - Barclays:

    ...what type of flexibility do you think you will get out of the contract negotiations being able to be go out to generic manufacturers to buy directly, it is something else?

     

    Greg Weishar, CEO - Pharmerica:

    Clearly from a margin stand point it will be an improvement to our margins I think that's what we can confidently say.

     

    Moreover, intuition alone would favor that the fact the contract was adjusted in the interim, well before expiry and in light of PharMerica's margin headwinds, might indicate the restructured contract can only have a favorable impact, or at the least, it can't be any worse than the pre-existing agreement. Plus, the 20% new beds from Chem Rx acquisition likely gave PMC a little more bargaining power at the table - it was noted in the press release that Chem Rx is included in the new purchasing agreement.

    Finally, there is clearly some more-than-linear downside when comparing the volume of drugs dispensed versus the gross profit per script. This is partly due to delivery scale (consider the profitability of a mail route in an urban area versus a rural route where the postal service worker only has one stop every mile or two). However, some of the apparent diseconomies of scale may have to due with purchasing via the legacy Prime Vendor agreement:

    • Excerpted from Prime Vendor Agreement as stated in 2007 10-K, "The Corporation has also agreed to a minimum purchase volume equal to $1 billion in the first year following the Closing Date. If the Corporation fails to reach this minimum purchase volume, in addition to remedies available at law, ABDC may adjust the price of goods the Corporation purchases from them to reflect the lower than expected purchase volume."
    • While ttm COGS stand at $1.5 billion, drug purchases may in fact be below the $1 billion hypothetical benchmark. (I stress 'hypothetical' because the Prime Vendor agreement only notes $1 billion for the first year following closing as a specific benchmark.) Note that COGS, as defined in PMC's Q's and K's, includes other costs in addition to drug purchases, such as delivery, rent, depreciation, direct labor, etc.

    some profitability metrics for PMC since Q1 2009

    _______________________________Q1 09     Q2 09     Q3 09     Q4 09    Q1 10     Q2 10    Q3 10                       Q1'09 to Q3'10delta

    Scripts (000s)                                        9,919      9,815      9,713      9,590      9,664      9,316      8,949                      -10%  

    Gross Profit/Script                               7.00        6.87        6.73        6.76         6.36        5.99        6.13                       -12%  

    Gross Margin --- Inst'l Pharmacy        15.3%    15.1%    14.6%    14.8%    13.7%     12.8%    12.8%                   -2.5%

    EBITDA Margin                                  5.4%       5.6%       5.8%       5.6%       5.0%       4.3%        4.1%                       -1.3%  

     

     

    #2) Acquisition of Chem Rx adds 20% new beds to PMC's existing (although declining) beds serviced

    Chem Rx, while in Chapter 11, was acquired by PMC with the transaction closing Nov 4, 2010:

    • Chem Rx, a northeast regional inst'l pharmacy primarily in New York, New Jersey and Pennsylvania (but with a pharmacy in Florida and a JV in Illinois), filed for Chapter 11 protection on May 11, 2010. Chem Rx's bank loans (CIBC) were in forebearance for about a year prior.
    • October 2010, it was announced that PMC earned the designation of stalking horse bidder with its bid for Chem Rx assets
    • November 4, 2010: PMC acquires Chem Rx for total consideration of $82 million, consisting of $70 million in cash and $12 million assumption of liabilities.
    • Mgmt has noted the acquisition would be accretive in 2011.
    • Acquisition brings $45 million in NOLs, some with expiries as far off as 2026, and Charitable Contribution carryforwards of $4 million (legacy PMC has $19 million in Federal NOLs as of Q3)

     

    Chem Rx acquisition valuations, figures in $ millions

    Total Consideration :  82                                                                                                                                   

                                                    LTM as of 6/30/10                             Pro Forma 1*                                         Pro Forma 2**

    Revenues                                              359                                         359                                                         359

    EBITDA                                                11.4                                        14.4                                                        18.0

    margin                                                   3.2%                                       4.0%                                                       5.0%

                                                                                                   

    xEBITDA                                              7.2x                                        5.7x                                                        4.6x

                                                                                                   

    *Pro Forma 1 assumption: assumes margin in line with legacy PMC's mrq

    **Pro Forma 2 assumption: assumes new ABC vendor contract brings margins at Chem Rx to 5%, where they

     

     

    #3) PMC shares are undervalued on both a cash flow basis and EBITDA basis, share buybacks at accretive prices is returning cash to shareholders

    In the context of an adjusted (which I assume to mean 'improved') prime vendor contract for drug supply purchases and an acquisition that brings 20% new beds under the PMC umbrella, not much else has to go right for the equity shares to be considered very undervalued, in my opinion:

    • Scenario 1 - PMC pro forma for Chem Rx acquisition (LTM figures, no major assumptions)

     

    ______                                            Legacy PMC                         Chem Rx              _________   Pro Forma

    Beds services (as of Q3 '10)               290,000                                   65,000                                     355,000

    Revenues                                              1807                                        359                                          2166

    EBITDA                                                  85.8                                         11.4                                         97.2

    Margin                                                   4.7%                                       3.2%                                       4.5%

     

    CFO                                                        94.2                                         7.3

    Less: CapEx                                           -18.1                                        -0.7

    FCF 1                                                      76.1                                         6.6                                           82.7                        

     

    Less:  tuck-in Acquisitions                    -42.4

    FCF 2                                                      33.7                                         6.6                                           40.3

     

    xEBITDA                                                                                                                                               5.6x

    Free Cash Flow 1  to Mkt Cap                                                                                                            25%

    Free Cash Flow 2 to Mkt Cap                                                                                                             12.4%

    EV/Beds Serviced                                                                                                                                $1,900

     

     

    • Scenario 2 - Chem Rx's margins, under PMC's purchasing power, increase to PMC's recent qtrly level of 4% and PMC's margin level remains steady at 4%.   Also, to be conservative, Legacy PMC figures are annualized based on mrq figures and margins - Q3 '10.

     

                                                                    Legacy PMC                         Chem Rx     _____            Pro Forma

    Revenues                                              1,772                                       359                                          2,131

    EBITDA                                                  72.7                                         14.7                                         87.4

    Margin                                                   4.1%                                       4.1%                                       4.1%

     

    xEBITDA                                                                                                                                               6.2x

     

     

    • Scenario 3 - New Prime Vendor agreement leads to margin expansion, and EBITDA margins expand to 5% at legacy PMC and Chem Rx.  Note: as recently as Q1 2010 PMC's EBITDA margins were 5%.  Also, as before, Legacy PMC figures are annualized as using mrq.

     

                                                                    Legacy PMC                         Chem Rx                _______ Pro Forma

    Revenues                                              1,772                                       359                                          2,131

    EBITDA                                                   88.6                                         18                                            106.6

    Margin                                                   5%                                          5%                                          5%

     

    xEBITDA                                                                                                                                             5.1x

     

     

    • Comp table vs Omnicare (OCR)

     

    LTM Figures, in $ millions                  Pro Forma PMC                    Omnicare

    Beds                                                       355,000                                   1,385,000

     

    Revenues                                              2,166                                       6,127

    EBITDA                                                   97.2                                         661

    Margin                                                   4.5%                                       10.8%

     

    Enterprise Value                                   542                                          $5,180

     

    xEBITDA                                               5.6x                                         7.8x

    EV/contracted Bed                               $1,900                                     $3,490


     

    • Share buybacks - very accretive so far
      • $25mm authorized by Board on Aug 2010,
      • $10.5mm spent during Q3 - represents 4% of shares outstanding repurchased in Q3 at avg price of $7.90/share (stock is around $11/share today), approx $15mm remains.

     

     

     3 Key Risks for PMC

    #1 - Bed Losses, customer retention issues

    #2 - unsaturated footprint - PMC spread too thin

    #3 - customer concentration - 2 key customers account for ~17% of pro forma beds

     

    #1) Bed Losses

    Continued bed losses are eroding the core business and some scale opportunities.  Service issues have been cited, but also an aggressive posture by local/regional "mom and pop" pharmacies.  On the other side of the spectrum, 800-pound gorilla Omnicare is undergoing an operational turnaround and likely to become more aggressive and successful in their efforts to target new beds.  PharMerica is feeling this pressure and it shows in their bed retention rate figures:

    Regarding "mom and pop" pharmacies: it's a misnomer.  Local/Regional pharmacies are highly competitive and barriers to entry minimal.  Local retail pharmacies already have contracts with insurance drug plans, and up front capital commitment to enter into the long-term care pharmacy space, inclusive of inventory, is estimated at no more than $1 million.

    Operationally, drug wholesalers are willing to arm the local "mom and pop" shops to compete with the 2 national players - Pharmerica and Omnicare.  click here to view McKesson's web page pertaining to this.  AmerisourceBergen and Cardinal have similar offerings, and I'm sure I'm leaving out smaller firms with relevant offerings as well.

    More notably, business is bid on the cheap as a loss leader strategy - Prescription drug reimbursements make up ~70% of Inst'l Pharmacy revenues, so they're willing to bid the remaining 30% at break-even or less because remaining 70% brings profits via commoditized drug reimbursements from 3rd Party payors.

    The table below highlights retention issues at PMC and OCR.  The 3rd row adjusts for PMC's 2 key clients, former parent Kindred and Golden Living - which shows an even higher churn rate amongst more "arms length" clients.

     

     _____________________   Q3 '08     Q4 '08     Q1 '09     Q2 '09     Q3 '09     Q4 '09     Q1 '10     Q2 '10     Q3 '10

    Omnicare                               92.8%     94.3%     93.3%     96.4%     93.4%     92.3%     92.5%     88.4%     91.2%

    PharMerica                            86.6%     89.5%     88.2%     86.1%     85.4%     83.0%     86.5%     85.0%     80.4%

    PharMerica-Adjusted          83.3%     86.9%     85.2%     82.5%     81.5%     78.5%     82.9%     81.0%     74.8%

     

     

     

                                            Q1 '09                     Q2 '09                     Q3 '09                     Q4 '09                     Q1 '10                     Q2 '10                     Q3 '10

    Pharmerica Beds

    Beginning Beds               321,068                    318,761                    314,698                   314,324                  313,873                  307,874                 299,527

                                                                                                                   

    Adds                                 6,762                      6,473                       10,549                     12,137                     4,111                       2,586                       4,867

    Losses                               (9,069)                    (10,536)                     (10,923)                  (12,588)                 (10,110)                 (10,933)                 (13,703)

    Net Adds(Losses)            (2,307)                  (4,063)                           (374)                      (451)                      (5,999)                   (8,347)                    (8,836)

     

    Ending Beds                      318,761                   314,698                      314,324                    313,873                  307,874                   299,527                 290,691

     

     

    Omnicare Beds               1,425,000                1,427,000                1,389,000                1,377,000                1,370,000                1,353,000              1,385,000

    (for comparison)


     

     

    #2) Unsaturated footprint

    PMC is sitting on plenty of idle capacity according to mgmt comments, which would be good thing is the business was growing, but the actual story is that service issues exist, which leads to more bed losses, which leads to retrenching in a given area and thus more service issues for the few surrounding areas where clients still remain.  The easiest way to think about this in my opinion is on a beds/pharmacy basis.  Note that PMC has about half the saturation that OCR boasts.  Also, Chem Rx will be operated as a segment and is new territory for PMC rather than a consolidating acquisition.  Nonetheless, Chem Rx actually has a strong footprint in its key areas.

     

    _________________Legacy PMC                Chem Rx          Pro Forma PMC          Omnicare (peer)

    Beds                            290,700                       65,000             355,700                       1,385,000

    Pharmacies                   90                                5                      95                                215

    States                           41                                5                      43                                47

     

    Beds/Pharmacy            3,200                           13,000             3,700                           6,440

    Beds/State                    7,100                           16,300             8,300                           29,500

     

     

    #3) Customer Concentration - 2 key customers collectively account for ~18% of Pro Forma beds 

    Former parent Kindred accounts for 10% of revenues, as disclosed in 2009 10-K.  Golden accounts for 9% according to company discussions.  Golden has more than 300 nursing facilities with, assuming 100 beds/facility, 30,000 beds.  Kindred has 28,000 nursing beds and 6,500 Long-term Acute Care hospital beds.  Given the Kindred IT agreement and its status as former parent (which results in PMC pharmacies being located in/around Kindred clusters), I view Kindred as unlikely to go elsewhere, although they of course exert significant buyer power against PMC and their contract expires June 2011.

     

    Golden contract renewed through July 2013: http://www.bizjournals.com/louisville/stories/2010/06/28/daily39.html

    Kindred contract renewed through June 2011: http://www.bizjournals.com/louisville/stories/2008/12/01/daily30.html

     

    as of Q3 2010                          Nursing Beds                            LTACH Beds               % of Pro Forma PMC beds

    Kindred Beds                           28,000                                     6,500                           9.7%

    Golden (guestimated)                30,000                                                                         8.5%

    Total for top 2 customers                                                                                              18.2%

     

     

    History of PharMerica - a scale-driven merger thesis that never materialized 

    PMC was created on July 31, 2007, with its equity shares being listed for public trading on August 1, 2007.  PMC is the result of the simultaneous spin-offs and merger of two separate business.  Kindred contributed its inst'l pharmacy, known as Kindred Pharmacy Services ("KPS"), which consisted of 46 pharmacies and 100,000 beds serviced (primarily but not solely Kindred facilities).  AmerisourceBergen contributed its inst'l pharmacy, known as Pharmerica  LTC, which consisted of 80 pharmacy locations and 240,000 beds serviced.  The new combined entity kept the Pharmerica name and the respective shareholders of Kindred and AmerisourceBergen each received fractional shares of the new entity, PMC. 

    As part of the transaction, both former parents laid 5-year contracts on PMC.  Kindred retained all back-end accounting and IT systems on their premises at cost plus 10%, cited in PMC's 10-Ks at the "Kindred IT Services Agreement" effective through July 31, 2012.  Costs as reported by PMC vary but average $12M/yr.  AmerisourceBergen retained a 5-year Prime Vendor agreement which required PMC to purchase at least 95% of their drug purchases through ABC, effective through July 31, 2012.

    Investor Presentations at the time showed very attractive slides, notably one slide forecasting 9% annualized growth for their market, and another slide showing pro forma PMC with 15% market share, Omnicare with 50% and "Ample opportunity for increased market share" to describe the remaining 35%.  Specifically for PMC, Revenue growth was targeted at 5-7% and EBITDA growth at 15-25% for the foreseeable future (2007 investor presentation link here).  Actual results to date have been far from what appeared to be reasonable expectations. 

    Fast forward to today.  Pharmerica's revenues have fallen from $1.96 billion annually to $1.77 billion (will be $2.1b pro forma for Chem Rx).  EBITDA has been reduced from as much as $100 million annually to a $73 million run-rate if we annualize the mrq, and $86 million on an LTM basis.  EBITDA margins have been in the 5.5% range but have rapidly declined to 4.1% over the past 4 quarters.  The company has been forced to retrench to some degree as beds under contract have fallen from 330,000 to 290,000 (355,000 pro forma for Chem Rx), closing approx 36 of its original 126 pharmacies following the business combination.

    Nonetheless, throughout the 2007-Q3 2010 period, Free Cash Flow generation has been consistently positive and PMC has not sought outside capital for support.  From calendar year 2007 (incl. 2007) through Q3 2010, FCF has totaled $187 million as measured by CFO less CapEx, and $97 million if we further net out acquisition investments.  Based on bed erosion, acquisitions look more like a recurring expenditure required to maintain the business and should be accounted for accordingly, unless you are one of the few believers that feels bed retention issues will subside sometime in the near future.

    Smaller regional and local players, often referred to as "mom and pops", continue to nibble at PMC's and larger rival OCR's contracted beds quarter after quarter after quarter.  Meanwhile, drug reimbursement continues to get progressively less favorable, even on the generic side where gross profit dollars per script are typically higher (not a typo, generic dollar profits, not just margins, are higher across the supply chain).  Additionally, the effects of the demographic boom of the elderly has not materialized yet - SNF beds are nearly flat annually over the past few years as "less institutional" care settings continue to attract the marginal patient, such as Independent Living, Assisted Living, and Home Health.  Note that all else equal, an inst'l pharmacy such as PMC would prefer to service a SNF with 100 beds than an ALF with 100 beds for the following reason: an individual is admitted as a patient to a SNF while an individual is a resident of an ALF, and as a result, ALF residents can still opt to get their meds elsewhere in most cases, such as the local CVS or mail order via Medco.

    Here's the link to the 8/13/07 report on PMC: http://www.valueinvestorsclub.com/value2/Idea/ViewIdea/2821

    Please Note: I'm not criticizing or disagreeing with the referenced report, simply citing it as background reading for those interested.

     

     

    Factors that affect the Institutional Pharmacy Industry as a whole

    Below are some factors that continue to act as a headwind for Inst'l Pharmacies and/or are general characteristics of the industry as I see it.  Some of these issues are not unique to PharMerica so I will not dwell on them.  Moreover, I'm not smart enough to forecast industry changes, let alone within a highly regulated industry with a 3rd Party payor system, where the 3rd party is often the gov't (via Medicare Part D). 

    • 2011 and 2012 are key years for patent expiration, where several top geriatric drugs will convert to generic, driving higher gross profit dollars (2 to 3x by some estimates), particularly during the first few months of generic launch. More information on this can be found from investor presentations by any company that distributes meds (MHS, ESRX, PMC, OCR, CVS, WAG, etc)
    • Drug Pricing appears to continue to squeeze the middle-men
      • Federal Upper Limit pricing continues to shrink the abnormal profit window newly launched generics. Average period between generic launch and FUL pricing was as much as 21 months in 2006 and is now down to less than 6 months today. Generally, FUL is in effect when at least 3 therapeutically equivalent drugs are available, and pertains specifically to Medicaid but it affects pricing industry-wide nonetheless. Increased competition between generic makers will shorten the time it takes to reach FUL. see Slide #12 on this recent PMC Investor Presentation.
      • Medicare Part D, launched in 2006, accounts for 45% of PMC revenues.
    • Clients (SNFs and ALFs) are price inelastic to a certain extent. Only 30% of PMC revenues are sourced directly from the facility. Of that amount, an undisclosed proportion is simply pass-through via a patients Medicare Part A bill (which includes pharmaceutical charges). Only a small portion of an inst'l pharmacy's revenues, and somewhat inversely, a small portion of a SNFs costs, or directly born by the SNF for the inst'l pharmacy's service.
    • Postal delivery comparison - Inst'l pharmacy has a component that is similar to mail delivery by the postal service. Drugs are delivered daily to SNF and ALF clients. Naturally, the more saturated the footprint, the cheaper the delivery on a per unit basis, similar to urban vs rural U.S. mail.
    • Comparison to landscaping industry - The Institutional Pharmacy industry has some characteristics that remind me of the landscape industry... there are a very small handful of national players (we've all seen the tan and brown Brickman trucks tending to your local corporate office park) that handle national accounts; and the remainder of the market is very local and very relationship-driven (your local townhouse development homeowner's association probably hires one of the local landscape companies, and maybe you do the same for your home). Similarly, PMC and OCR will absolutely always service the national and multi-state living facilities, because those companies want to deal with just a single pharmacy contract. It's the smaller systems or stand-alone facilities where retention has suffered. No matter how attractive PMC's and OCR's respective presentation slide looks which shows their market share, and the approx 40% uncaptured market (at least by those 2), they'll never get there... that market is currently serviced already by much smaller pharmacies with deep local relationships. 

     

     

    Exhibits

    Comp footprint table in pdf format (shows an indication of operating scale as measured by beds/pharmacy for PMC, OCR, and Chem Rx)

    https://docs.google.com/leaf?id=0BzYLZyqiGpVKZTY4ZmYzYTktMWI0OC00MTQxLWE3ZTItZjE2YmU5YjczYzA4&sort=name&layout=list&num=50 

     

    Full dialogue for PharMerica pertaining to their Prime Vendor contract with Amerisource Bergen

     

    Q2 2010 earnings call, August 6, Q & A dialogue

     Brendan Strong, Analyst - Barclays: And then just back to Frank's question about leverage that you have on generic manufacturers... ...Do you ultimately even have that leverage given that you have to buy almost all of your drugs through Amerisource, and is there anything you can do about the Amerisource contract here?

    Greg Weishar, CEO - PharMerica: We are working with them [AmerisourceBergen], and I think they are starting to understand our issues and our needs, and we are confident that we will make progress there. So the market has changed a lot since that contract was written [in 2007], and so far we have seen cooperation on their part. Obviously when you come to them with a new model, which we have gone to them with, it's going to take them a bit of time to absorb it and understand it.

     

    Q3 2010 earnings call, November 10, Prepared remarks

    Greg Weisher, CEO - Pharmerica: Finally, I know you are all interested in progress with regards to the prime vendor agreement. I want to assure all of you that we are making good progress in our discussions with AmerisourceBergan. We anticipate we'll finish the fourth quarter and enter 2011 with a much improved contract for the purchase of drugs.

     

    Q3 2010 earnings call, November 10, Q & A dialogue

    Steve Valiquette, Analyst - UBS: Curious though is it just simply a matter you will renew with them now it's a matter of trying finalize the terms or is there some possibility that ABC might not be your prime supplier going forward. I just want to get a sense of that as well.

    Greg Weishar, CEO - PharMerica: I mean look we have an agreement that lasts for two more years. We originally had a five year agreement at the point of when we merged the two companies. So I think the idea here is that we will extend our agreement with AmerisourceBergen in exchange for better pricing.

    Brendan Strong, Analyst - Barclays:  Just to follow up on the ABC question, I mean on the last call you were hoping to make some progress there, this call you seem to be definitively saying you will have something announced by the end of the year, so just wanted to maybe ask as well, I guess in terms of specifically what type of flexibility do you think you will get out of the contract negotiations being able to be go out to generic manufacturers to buy directly, it is something else?

    Greg Weishar, CEO - PharMerica:  Well, look Brendan, I hate to get in to the details. When we finalize the contract - you got to understand there is a lot of moving pieces to it - that we will provide this color to the extent we feel it's justified but I really, given that we don't have it done I really don't want to comment on what it may look like or what it may not look like. Clearly from a margin stand point it will be an improvement to our margins I think that's what we can confidently say.

     

    Prime Vendor Agreement as stated in 2007 10-K:

    On the Closing Date, the Corporation entered into a Prime Vendor Agreement (the "Prime Vendor Agreement"), with AmerisourceBergen Drug Corporation ("ABDC"), a wholly owned subsidiary of AmerisourceBergen, the Corporation's former 50% shareholder. Pursuant to this agreement, the Corporation has agreed to purchase at least 95% of the Corporation's prescription pharmaceutical drugs from ABDC and to participate in its generic formulary purchase program for a period of five years following the Closing Date. The Corporation has also agreed to a minimum purchase volume equal to $1 billion in the first year following the Closing Date. If the Corporation fails to reach this minimum purchase volume, in addition to remedies available at law, ABDC may adjust the price of goods the Corporation purchases from them to reflect the lower than expected purchase volume.

     

    COGS from most recent 10-Q filing:

    Cost of goods sold is comprised primarily of the cost of product and is principally attributable to the dispensing of prescription drugs. Our cost of product relating to drugs dispensed by our institutional pharmacies consists primarily of the cost of inventory dispensed and our costs incurred to process and dispense the prescriptions. Cost of goods also includes direct labor, delivery costs, rent, utilities, depreciation, travel costs, professional fees and other costs attributable to the dispensing of medications. In addition, cost of product includes a credit for rebates earned from brand-name pharmaceutical manufacturers whose drugs are included in our formularies.

    Catalyst

    1) Potential for higher earnings guidance on Year end call (Feb 25, 2011) as a result of the following 2 items

    1a) AmerisourceBergen prime vendor contract restructured (we can assume for better, otherwise they wouldn't have done so - legacy contract wasn't set to expire until June 2012). Contract was restructured effective Jan 1, 2011 and runs through Sept 2013.

    1b) Chem Rx acquisition (brings 20% new beds under PMC umbrella and, as noted by the prime vendor contract renegoation, Chem Rx purchasing also joins PMC which should bring buying power)

    2) Cheap Valuation with share buyback program (in Q3, company repurchased approx 4% of shares at avg price of $7.90/share)
    LBO possible given valuation and cash flow generation (whether general financial buyer or more focused such as Ross Crawford PE Fund: http://www.nashvillepost.com/news/2010/7/14/former_caremark_ceo_starts_new_health_care_turnaround_firm

    3) If Pharmerica were to show any improvement in organic bed retention (via more additions, few losses, or the combo of both), the story as viewed by the market would materially improve, however, I don't anticipate this scenario - it's possible but not probable in my opinion.
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