Description

Catalyst Health Solutions presents an attractive event-driven opportunity.   Catalyst is buying the PBM business of Walgreens and the combined entity should generate at least $3.40 in EPS in 2012.  As PBM's have historically traded at PE's of over 20x, its reasonable to project that the stock will reach at least $70, ~30% higher than its current price.

COMPANY DESCRIPTION

• Catalyst Health Solutions, Inc. ("Catalyst") is a full-service pharmacy benefit management ("PBM") company. The Company operates primarily under the brand name Catalyst Rx. Clients include self-insured employers, state and local governments, managed care organizations ("MCOs"), unions, third-party administrators ("TPAs"), hospices, and individuals who contract with Catalyst to administer the prescription drug component of their overall health benefit programs. The Company provides clients access to a contracted, non-exclusive national network of approximately 63,000 pharmacies. Catalyst's primary business is to provide clients and their members with timely and accurate benefit adjudication, while controlling pharmacy spending trends through customized plan designs, clinical programs, physician orientation programs, and member education.

 INVESTMENT THESIS

• Transformational Acquisition of Walgreens Health Initiatives, Inc. ("WHI") - On March 9, 2010 Catalyst announced the signing of a definitive agreement to acquire WHI, the PBM subsidiary of Walgreen Company (WAG). This is a transformational acquisition for Catalyst as it (i) brings together two of the leading national PBM's and (ii) effectively doubles Catalyst's size, increasing the Company's PBM membership from 7 million to over 18 million individuals and its annual prescription volume from 80 million to over 165 million. The main aspects of the transaction are as follows:
• o Consideration - Catalyst is purchasing WHI for $525 million in an all-cash transaction. Catalyst is financing the transaction through $700 million in new credit facilities. Depending upon market conditions, Catalyst may choose to finance a portion of the purchase price through the issuance of new equity.
• o Transaction Rationale - The transaction has several strategic merits. First, it significantly increases Catalyst's size and scale. Second, the acquisition will enhance Catalyst's Medicare capabilities, increases its discount card programs, and expands its national employer account customer base. Third, the addition of WHI to Catalyst will provide the Company with key strategic assets including advanced informatics, reporting capabilities, and formulary management tools that will accelerate product development and minimize planned IT development costs.
• o Timing - The transaction is expected to close by June 30, 2011. Although management has stated that they do not expect the acquisition of WHI to be fully integrated into Catalyst until the end of 2012, Catalyst management is well known for "underpromising and overdelivering". During the Company's 4Q10 earnings conference call, management stated that Catalyst's integration of its acquisition of FutureScripts, LLC, completed on September 13, 2010, was well ahead of schedule and would be completed soon. This timeframe was significantly shorter than the "year period" of integration management originally projected.
• o Financial Impact - Management has provided very limited information on the financial impact of the transaction. Management did state the WHI generates ~$1.1 billion in annual revenues and is expected to contribute $75 million in annual EBITDA. This EBITDA contribution includes projected synergies expected to result from increased purchasing power (leveraging provider agreements, pharmacy network optimization, etc.) as well as increased operating leverage. The transaction should be significantly accretive to Catalyst's earnings in 2012. Further, Catalyst is utilizing a 338(h)(10) election to effectuate the transaction. As a result of the election, the Company will reap tax benefits, estimated to be worth $90-110 million to Catalyst. Management stated these tax benefits will result in about $12 million in annual tax savings over the course of 15 years.

• Positive Outlook for PBM Industry - Several key themes in the PBM industry portend a favorable environment for it at least over the next 12-24 months:
• o Increased Pharmaceutical Expenditures - According to the journal Health Affairs, overall pharmaceutical expenditures in the United States are expected to be ~$274.7 billion in 2011, a 5.6% increase over 2010. Further, average annual increases in expenditures of 6.3% are expected through 2019. Price growth is projected to contribute to more than 50% of the total of those spending increases with the remainder resulting primarily from volume and utilization. Several factors are increasing pharmaceutical expenditures including (i) greater reliance on drug therapy by the physician community, (ii) increased "preventative prescribing" including the management of high cholesterol levels and digestive disorders, (iii) efforts by drug manufacturers to increase market share and extend single-source brand use, (iv) increased patient demand and education as a result of direct-to-consumer advertising and other pharmaceutical marketing efforts, (v) an aging workforce, and (vi) increased obesity among all age groups.
• o Generic Utilization - PBMs are responsible for implementing and administering benefit plans that are care-effective and also seek to lower overall prescription spending by encouraging greater generic utilization, increasing the proportion of brand drugs dispensed from preferred categories and encouraging, where appropriate, non-prescription therapy and treatment alternatives. These objectives are accomplished through a combination of clinical, administrative, educational and technological initiatives directed towards pharmacies, physicians and members. For Catalyst specifically, the Company receives performance-related fees as generic use increases within a contract, raising its overall margins and profitability. As generic versions of branded drugs become more prevalent due to patent expiry, the profitability of PBM's should steadily increase. Of note, Catalyst's generic utilization rate has been steadily increasing from ~62% in 1Q08 to 73% in 4Q10.
• Strong Business Stability and Visibility - Catalyst contracts with clients are typically at least 3 years in length with some being 7 years. Nine of Catalyst's top 10 accounts are contracted through at least 2012, giving Catalyst's business both strong stability as well as visibility into its future revenues and cash flows. This business stability was demonstrated by the Company's performance during the economic downturn of 2008 and 2009. Despite the downturn, Catalysts steadily grew its revenues and EBITDA each year during the 2006-2010 timeframe.

KEY RISKS

• New Equity Issuance - Although Catalyst has obtained full financing for the acquisition of WHI through new credit facilities, management stated that depending upon market conditions, they may choose to issue equity to partially finance the transaction. The prospect of this issuance may create a negative overhand on the price of Catalyst's stock until the offering, if executed, is completed.
• Potential Loss of Maryland Contract Renewal - There is a high likelihood that Catalyst will loose its PBM contract renewal with the State of Maryland. While the contract is sizeable, estimated to represent ~9% of the Company's 2011E revenues, it is relatively low margin and likely represents only 5% of profits. Catalyst management stated on the Company's 4Q10 earnings call that should the Company loose the contract, management would not need to adjust 2011E EPS guidance, indicative that the earnings from the contract are minimal. Further, the loss of the contract already appears "priced into" Catalysts' stock. In January 2011 Catalyst's stock declined by ~10% over a three day period on rumors that the Company was going to loose the contract. Later, the Maryland Board of Public Works posted an agenda for its March 9, 2011 meeting that indicated that the state proposed to award the PBM contract to Express Scripts, Inc. (ESRX). The Board disclosed that a contract with Express Scripts would save the state $100 million over five years, a considerable figure given the state's budget challenges. However, Catalyst is protesting the award of the contract. Given Catalyst is headquartered in Maryland and jobs are potentially at stake, the situation has become a political tug-of-war. Resolution is not expected quickly as the protest process can drag out over a year with the incumbent, Catalyst, continuing to serve as PBM throughout it.
• Health Care Reform Uncertainty - As health care remains a primary focus of both federal and state legislatures, the potential for passage of significant reform measures that might adversely impact the PBM industry will persist. Specifically, in 2010 the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010 were signed into law. These statutes require significant changes in the manner in which health insurance coverage is administered and made available in the United States, including applicable pharmacy benefits. The laws contain PBM transparency provisions that will require PBMs to report a variety of financial information to the federal government, including pricing, rebate, and discount information, which will be made publicly available by the federal government. It is unclear whether the public availability of commercial financial information from all PBMs will adversely alter the discounts, rebates, and fees that PBMs can negotiate in the commercial marketplace.

SUMMARY FINANCIALS

Catalyst