|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|
"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
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
Debt (Term Loan due July 2012).........240
Mkt Cap..............................................326 (as of Friday, 1/28/2010)
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.
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:
_______________________________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 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:
______ 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
Free Cash Flow 1 to Mkt Cap 25%
Free Cash Flow 2 to Mkt Cap 12.4%
EV/Beds Serviced $1,900
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%
Legacy PMC Chem Rx _______ Pro Forma
Revenues 1,772 359 2,131
EBITDA 88.6 18 106.6
Margin 5% 5% 5%
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
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
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
#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).
Comp footprint table in pdf format (shows an indication of operating scale as measured by beds/pharmacy for PMC, OCR, and Chem Rx)
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.