|Shares Out. (in M):||30||P/E||9.4x||0.0x|
|Market Cap (in $M):||385||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||238||EBIT||77||0|
What would you pay for the equity of a company that has the following characteristics?
My answer: not very much.
OCR and PMC trade at a similar EV/EBITA (LTM) valuation of ~8x, yet OCR has structural competitive advantages that should help its EPS grow at a high single CAGR over time whereas PMC is the exact opposite with a perpetually declining business. PMC’s LTM net organic customer loss rate is 2x that of OCR’s.
PMC came public in August 2007 via a spin-merger. ABC owned PharMerica and KND owned KPS pharmacy. They merged the two pharmacies together and spun-out their respective shares to shareholders.
A fair way to view PMC’s business is in the context of the past 3.5 years. Presumably this looks at the business after a ~1.5 year integration period of KPS and PharMerica such that most/all of the synergies from pharmacy consolidation, drug purchasing, etc. would have been realized by the end of 2008.
Over this 3.5 year time period cumulative operating cash flow was $261.8mm. Capital expenditures, net of some asset disposals were $53.6mm and acquisitions totaled $226.8mm. Combined, this is negative free cash flow of -$18.6mm. Despite more than 100% of free cash flow was spent on acquisitions of other institutional pharmacies, the number of beds served grew just 1.2% from 322,376 to 326,148. Adjusted EBITDA in Q2’09 was $25.8mm vs. $25.5mm in Q2’12. This is not a picture of a healthy company.
Despite these horrendous results, the same management team from the spin-out five years ago is running the show. One might wonder why the company is run in a manner with such a strong bent on making acquisitions of other institutional pharmacies instead of focusing on fixing its own operations. The answer (at least partially) lies in how management is incentivized. Per the 4/30/12 proxy statement:
“Adjusted EBITDA was selected as the objective performance criterion because it is critical to focus our Named Executives on earnings and the achievement of cost savings. Annual bonuses are funded based on a combination of Company financial performance as measured by adjusted EBITDA, a non-GAAP measure, and individual performance relative to pre-established financial and non-financial objectives. Under the program, the bonus of the CEO and all Executive Vice Presidents is based 70% on Company performance and 30% on individual performance and the bonus of all the Senior Vice Presidents is based 50% on Company performance and 50% on individual performance.”
EBITDA is not a bad metric to have regarding incentive compensation. However by itself, with no other metrics in the mix such as return on capital and/or EPS, management is incentivized to make acquisitions at the expense of reinvesting in the business (given a delayed benefit), debt pay-down and/or share repurchases.
So despite these perpetually terrible results, the CEO hit 173% out of a 200% max bonus target and took home ~$2.1mm in cash compensation plus another ~$1.9mm in stock-based compensation. The interesting thing is the CEO appears to believe he’s managing the company in the right manner. In fact, he has been a consistent buyer of its stock over the past 5 years, spending ~$1.9mm in cash to purchase 181,500 shares at an average price of $10.29. The CEO owns 601k shares or ~$7.8mm of stock and has some RSUs and options, a majority of which are underwater. He also has an $8.1mm change in control payment. Thus it’s not surprising he tried to sell the company to private equity, but supposedly there were no bidders aside from OCR, which wanted the company for its installed base of customers.
In speaking to one of PMC’s largest customers we were told that:
Comparative Metrics (OCR vs. PMC)
In terms of thinking about fixed cost deleverage, PMC makes ~$7.25-$7.50 of average gross profit per Rx. PMC dispenses ~40mm Rx annually. It loses ~3mm Rx each year or ~$22mm in gross profit before covering this up with acquisitions. There might be an ability to remove some fixed costs if PMC stopped making acquisitions to replace this lost business, but for simplicity purposes let’s say it’s a ~$20mm incremental loss in EBITA. With 2012E EBITA of $77mm, it would likely take no more than 4 years before PMC’s EBITA were to go to zero. PMC is leveraged over 3x EBITA. Thus at its current rate of net customer losses, there isn’t much value, if any, left over for the equity.
One risk in being short PMC is if it is able to strike a much more favorable agreement with ABC for its drug purchases. PMC claims there might be another $30-$40mm of gross profit it could garner when its contract comes up for renewal in September 2013. When PMC was spun from ABC it had a 5-year contract that expired in September 2012. But in Q1’11, PMC proactively renegotiated the contract to get some cost savings in return for extending the contract another year. Now PMC believes that if it goes through the RFP process it will be able to get even better terms. Thus if PMC touts major cost savings on a future executed contract, one should be prepared for the stock to rise substantially since $30-$40mm in savings would boost cash EPS by 40%-60%.
Even supposing PMC was to garner $40mm in additional drug purchasing savings, assuming its current rate of net customer losses continues, it would take no more than 6 years before its EBITA is gone absent acquisitions. Unless PMC fixes its customer retention problems, PMC’s equity would still be worth materially less than it is currently trading at.