Recent Spinoff Pharmerica, an institutional pharmacy, has many of the characteristics that make for an attractive spinoff investment.
First, Pharmerica is a small cap ($462 million) formed by the merger of small parts of mid-cap ($783 million after the spin) Kindred Healthcare and large cap ($8.71 billion after the spin) AmerisourceBergen. If you were an AmerisourceBergen (ABC) shareholder, you received approximately 0.083 shares (a value of $1.25) of Pharmerica for each $45.56 share of ABC you were left with. Kindred Healthcare (KND) shareholders received about 0.366 shares (a value of $5.49) for each $19.35 (after the spinoff) Kindred share. The spin of a relatively small value of a small-cap stock to mid-cap and large cap shareholders is a nice recipe for indiscriminate selling. To date, the stock price has only fallen from a when-issued trading high of $23.20 to the current $15.
Highly incentivized management
The CEO, Gregory Weishar, joined the company in January from Pharmacare, the specialty pharmacy subsidiary of CVS Caremark Corporation that he founded in 1994 and grew to over $7 billion in sales. He’s been given a number of incentives. First, he will receive a $500K bonus for attaining merger-related cost -reductions of $30 million within 12 months of the spin. An additional $500K bonus will be paid for attaining cost-reductions of $45 million within 18 months. To compensate the CEO for lost pension benefits at CVS, a special grant of 300,000 stock options expiring in 7 years were priced at the 5th day trading price (around $16 and change). Finally, the stated policy of the company is to pay executive salaries that are relatively low (in the lower 25% to 50% of comparable companies). Incentive pay on the other hand, is to be paid at a rate 2 to 3 times that of comparable companies. The CEO will receive a salary of $700K and additional annual incentive compensation with a fair value of $3.6 million in restricted stock and options. The total pay seems like plenty, but the fact that the CEO who is knowledgeable in the drug business negotiated a pay agreement like this makes me suspect there is opportunity here.
Wall Street disinterest
To date the company has not made any investor presentations. The first one is scheduled for Wednesday, August 15th. The only analyst opinion is from Frank Morgan at Jefferies & Company. He put a hold on the stock stating “We continue to believe (the merger) makes strategic sense long-term, but we do not expect dramatic near-term improvements”.
Omnicare is the only publicly traded comparable with 98% of its revenue from its institutional pharmacy operations. Omnicare is larger than Pharmerica with revenues of $6.3 billion compared to $1.85 billion. The institutional pharmacy business benefits from scale so Pharmerica should trade at a lower fraction of sales than Omnicare but the difference in enterprise value/sales ratios is extreme.
Pharmerica: EV/sales = $722 million / $1853 million = 0.39
Omnicare: EV/sales = $6890 million / $6300 million = 1.09
Omnicare’s 2006 enterprise value/EBITDA numbers are only slightly higher than Pharmerica’s. If the $30 million merger-related cost savings is realized, however, then Omnicare’s ratio is 41% higher.
Pharmerica: EV/EBITDA = $722 million / $87.2 million = 8.27
Omnicare: EV/EBITDA = $6890 million / $795 million = 8.67
Pharmerica with $30 million cost reduction: EV/EBITDA = $722 million / $117.2 million = 6.16
What should Pharmerica trade at? The accountants had to estimate a fair value for the equity of the spinoff in order to assign goodwill in the merger. Their $650 million estimate in the Form 10 filing ($21.10 a share corresponding to an EV/sales = 0.49, EV/EBITDA assuming $30 million cost savings = 7.77) seems more reasonable than the current share price. Valuation of course depends on the longer term sales and earnings growth prospects to be discussed next.
Favorable industry dynamics and strategy
Institutional pharmacy companies benefit greatly from scale. The Medicare Part D prescription drug plan that began in January, 2006 has made this even truer. Pharmacies that used to bill state Medicaid programs are now instead paid by a myriad of different private insurance plans subsidized by the federal Medicare program. This is a significant change for institutional pharmacies. In the words of Pharmerica’s CEO, Gregory Weishar, (taken from the August 1st Louisville Courier Journal)
“Medicaid is very stodgy and slow to change their reimbursement rates … What you get today is what you’re going to get tomorrow. Now drug plan providers such as UnitedHealthCare and Humana periodically seek to negotiate lower prices. They are much more aggressive about setting rates than Medicaid has historically been. We have to be much more lean, much more aggressive, because we’re competing in a new environment”.
Mom and Pop pharmaceutical providers are also “competing in a new environment”. Coping with negotiating prices with and billing so many different prescription drug insurance plans is expensive for a small pharmaceutical provider. Larger pharmacies have more negotiating power and can spread the cost of billing systems and problem resolution over many more prescriptions. Consolidation of institutional pharmacies into a few larger players is natural in this type of environment.
Omnicare is the dominant institutional pharmacy provider. A glance at a long-term stock chart shows that they have been very successful. They have grown through acquisitions even before Medicare Part D created the current pressures on smaller pharmacies. The earnings power of their acquisitions have apparently benefitted sufficiently from Omnicare’s scale to provide a good return on investment. Omnicare has also benefitted from being the only company with national reach. This has made them more attractive to large nursing home chains.
The merger between Kindred and AmerisourceBergen’s operations gives Pharmerica national reach. It also gives Pharmerica important increased scale and a publicly traded currency for acquisitions. Gregory Weishar reveals the motivation for the spinoff and Pharmerica’s strategy going forward stating “Omnicare has kind of had a free rein in terms of acquisitions in the business. We’re going to be much more aggressive in that area”.
Smaller pharmacies feeling the pressure of “competing in a new environment” are likely willing to sell at a price where Pharmerica can use its scale to earn a good return on investment. Pharmerica, although much smaller than Omnicare, will be the number two player and one of only two institutional pharmacies with national reach. Pharmerica’s debt ratio is relatively small compared to Omnicare’s leaving them with the financial strength to acquire.
In summary, it appears there is a competitive advantage (scale) for Pharmerica. There is also an environment brought on by Medicare Part D legislation that is ripe for consolidation of institutional pharmacies. This acquisition environment should give Pharmerica an opportunity to earn a good return on invested capital.
In the words of CEO, Gregory Weishar, Pharmerica begins life at a time of “a lot of uncertainty in the business”. Will UnitedHealthCare and others squeeze reimbursement rates so much that there will be nothing left for the pharmacies? Who knows how congress might change the Medicare part D prescription drug program. No doubt they’ll want to squeeze costs any way they can. Pharmerica also has two companies to integrate together and they may not realize the anticipated $30 million in cost savings.
End of spinoff selling, investor presentation on Aug 15th