Description

Excessive expectations and anticipated higher taxes wiped out 3/4 of MIMS’ stock price last year. But MIMS’ ‘hidden’ growth story, now cheap, will reward new investors on a good risk/reward basis. MIMS is a pharmacy benefit management company (PBM) developing a rapidly growing Specialty Pharmaceuticals (SP) segment. An investor has to dig this year to ‘see’ the growth from SP. But in 2004, it will become obvious to any casual screening.

A PBM works with your health insurer to administer the pharmacy benefit, and provide cost savings to your health plan. It is historically a high volume, low margin business. SP, a significantly higher margin business, deals with the pharmacological treatment of complex, chronic disease. It may involve infusion or injections. These are high cost patients suffering from cancer, diabetes, or genetic health problems. Based on new biotech products in the FDA pipeline, the growth outlook for the $27B SP industry is for a near doubling by the end of 2005. There are roughly 350 injectable products in this group, and that will expand to around 600 in the next several years.

*The attractiveness of the SP industry is that instead of battling for market share from competitors in a mature business like PBM, growth comes from opening up altogether new business. And the array of potential treatments will be rapidly growing for a lengthy period of time.*

Unlike PBMs which can demonstrate cost savings to customers in relatively short order, an SP company's 'value' to its client is more long term. Home based injection/infusion treatments are successful only if the patient is disciplined in following the regimen. MIMS’ clinical model for this business not only attempts to cost save on the medications, but provides case managment for the patient to insure a higher level of conformity with treatment regimens. There is demonstrable success in this active patient management role in achieving better compliance. The savings are less 'concrete' than merely lower pill costs, but are based on the idea that higher patient compliance reduces disease complications and setbacks, and costly hospitalizations or extended treatments. It is important to understand these patients are a much smaller population than health plan recipients overall, and that merely holding a contract to provide services to the Managed Care Organization or Health Plan doesn’t immediately translate to revenue building relationships with Doctors and Patients. Building relationships is key in this business, and a slower process than MIMS realized a year ago.

In early 2002, MIMS had very aggressive growth guidance for the year. The stock was trading north of $20. The expectations were based on rapid penetration into the SP business. Because of the lengthier time required to 'sell' these programs, it became clear by autumn those goals would not be reached, despite having ramped up an expensive sales force. So new business did not grow as expected, and old business couldn't support the new expenses without a hit to earnings at the margin.

It gets worse. In 2002, the tax rate used against pretax earnings was 20%, based on utilization of net operating loss (NOL) carry forwards. For 2003, the company is at a full 40% tax rate. Even with pretax earnings growth of 7-16% for 2003, year to year EPS comparisons will be negative through 2003 because of the tax effect.

*The failure to meet expectations, and the negative tax implications have left the current stock price at less than 30% of its peak. Current pricing reflects the market’s lack of faith in this company to execute and the negative comps in the quarters ahead.*

So what is the attraction? The stock price has already digested all of these negatives, and is positioned to reward new investors, based on the HIDDEN growth story. MIMS trades at $6.56. That is 8.7x trailing twelve month earnings, a trailing EV/EBITDA multiple of 4.9, and a 7.0 multiple of trailing free cash flow. Projected free cash flow/share for 2003 is $.81 for a multiple of 8.1 (higher because of the tax bite). It’s fairly cheap at present metrics, but it’s cheaper when you consider the potential for growth:

MIMS is responding to the lessons learned in 2002. A new CFO, who is oriented to operations, and a new COO, who is reorganizing the sales force, have taken over management reins. The CEO is much more realistic in projecting ahead than one year ago, and to his credit, did a pretty good mea culpa in last autumn’s CC. It is a team focused on a more disciplined growth plan.

The 2003 guidance calls for 7-16% pretax earnings growth. Management also provided a gross margin range of 11-12%, SGA/revenue ratios ranging from 7.5% to 8.0%, and PBM revenue growth of 6-8%, plus 30-35% SP revenue growth for a combined revenue growth of 13-16%.

*First quarter results released 4/29/03 show the company on plan.* Pretax earnings (adjusting for a one time reserving benefit last year) were up 1.4%. However, the SG&A expense at first quarter last year did not reflect the higher sales force now in place. Comparisons will improve later this year on that aspect. SG&A was at 7.5% of revenues for the quarter. Gross margin was 11.5%. PBM revenue declined by 9%; however the terms on several contracts were changed in the second quarter of last year requiring revenues to be stated at net rather than gross. This does not affect the gross profit number, but the accounting change does reduce stated revenue (and stated cost of revenue). So the YOY comparison is apples to oranges. On a proforma basis, PBM was up 14%. Specialty revenue increased 64%.

Fully taxed EPS were .15/share, providing a solid basis to see where MIMS is going for the year. Using the pretax earnings growth guidance of 7-16% on 2002 pretax income of $22.5MM, 2003 pretax earnings will range from $24.1MM to $26.1MM. After tax, this implies diluted 2003 EPS of 65 cents as the low end likely number. Alternatively, if one looks at this from guided revenue growth, 660MM is a middle figure. Using the existing 11.5% gross margin, gross profit will be 75.9MM. SG&A should stay fairly flat ahead, so 50MM(7.6%) can be expected for the year. With 1.8MM for amortization of intangibles, and .4MM for net interest expense, pretax income is 23.7MM. This yields a fully taxed 63.8 cents/share. Based on the present 15 cents/share, 64 cents seems like a very reasonable earnings expectation for 2003 considering the expected growth of revenues and gross profit over a flat SG&A picture in the 2nd to 4th quarters ahead. That is a 15.6% ROE based on the end of 2002 book value of $4.10/share.

*We now have a baseline to project growth in 2004.*

Looking backwards, adjusting for 40% taxation in 2002, had it occurred, the comparable earnings number would have been 59 cents/share, and so we see about a ‘comparable’ 8.5% growth rate in place.

For 2003, to reach the pretax EPS growth guidance, it is clear that favorable values for the other guidance elements are incorporated. It is also evident that the gross margin percentage is the MOST critical element.

In 2002, for every $1 of PBM revenue there was just under $.42 of SP revenue. PBM gross margins ran about 7.9%, while SP gross margins were 22.7%. The combined gross margin was 12.2%. SP gross margins are sensitive to the mix of infusion versus lower margin injection products. Injectables are becoming a larger part of the mix going forward, so its gross margin will decline. In the first quarter, of ‘03, the SP gross margin was 18.8%.

By the end of 2003, due to the much higher anticipated SP growth, the ratio of PBM to SP revenue will have shifted: now for every $1 of PBM revenue there will be nearly $.51 of SP revenue on 660MM total revenue (224MM for SP and 436MM for PBM). Still the softening of the SP gross margin reduces the expected overall gross margin to something around 11-12%.

By extrapolating similar dollar, rather than percentage growth rates for both segment revenue streams, 2004 total revenues will grow from $660MM to 740MM, and the mix will be 278MM (SP) and 462MM (PBM), or about 60 cents SP revenue for every dollar of PBM revenue. As a result, depending on the stabilized gross margin for SP, the overall gross margin should level off well above the PBM gross margin, and even begin to INCREASE.

For 2003, we know the low end guidance for overall gross margin is 11%, and we can project the revenue mix of SP to PBM at about 51 cents on the dollar. We know the stable PBM gross margin is 7.9%. So we can solve for the low end SP margin which works out to 17.1%. Given the SP revenue growth, it’s fair to assume we’re converging to a ‘stable’ baseline SP margin.

Now let’s project this onto the 2004 revenue mix listed above. We get an overall gross margin of 11.4% (SP at 17.1% and PBM at 7.9%). We’re increasing from the ‘low end’ guidance figure of 11% in 2003. From this, we get a gross profit of 84MM. Based on present infrastructure, expenses will not grow as rapidly as revenues, so providing SG&A at 55MM (up 10%), and holding amortization at it’s present 1.8MM, and no interest expense with no debt, we have a pre tax profit of 27.2MM, and an after tax profit of 16.32MM, or 73 cents per diluted share.

*This assumes the low end of stabilized SP profit margin, yet still projects EPS growth of at least 9 cents (14%) from the 2003 figure of around .64 to the 2004 figure of .73. What’s a fair price on a 14% growth rate?*

MIMS peers (OPTN, NMHC, ADVP, ESRX, CMX) generally command PE multiples in the mid double digits. A 14x PE on .73 translates to a potential target price of $10.22 in around 18 months. From the present price of $6.56, that is a 56% potential gain. If the market begins to anticipate the growth, the returns could be greater, or come sooner.

Other Positives: MIMS is in the midst of a $10MM share buyback program. Half the capacity was used in the first quarter buying in 800K shares at an average price of $6.34/share. That should put a floor under the stock price. Senior management has made open market purchases of the stock in recent months. MIMS also is looking for acquisitions. MIMS is willing to pay 4-7x EBITDA. (MIMS present pricing of 5.2x EBITDA gives an indication of its present low price.) MIMS paid cash and stock for an accretive aquisition last year at 5x EBITDA, and has fully paid off the $35MM debt incurred for the purchase. In addition, there are $21.5MM in NOLs available related to stock based compensation. They will not directly reduce the 40% tax liability on the income statement; rather, as they can be realized, they will be reflected in stockholders’ equity and positively affect cash flow.

Risks: The primary risk is a failure to execute for growth. The company is painfully aware of the consequences for failing to meet excessive expectations and I suspect is being quite conservative in its guidance for 2003. Safety lies in the fact the existing business is recession resistant. That said, one should note MIMS has a major stake in providing PBM services to TennCare (Tennessee medicare/medicaid). While the percentage of revenues derived from this line is declining as SP ramps up, it represented 30% of revenues in 2002. Like most state programs, cost controls and reforms are being sought. MIMS does not expect a disruption in this business, but one should be aware of the potential risk that exists. Overall, the margin of safety is the low pricing relative to peers, negligible debt, and existing free cash flows.

I have been fairly conservative on my assumptions. You’ll find higher ‘04 earnings estimates in other research reports on the company. But like MIMS, I’d rather exceed than miss my expectations. I’ll adjust my assumptions as the company actually demonstrates performance. Accumulate on weakness near term. Price should rise as market confidence in the company’s execution increases and anticipated ‘03-’04 comps overshadow ‘02-’03 comps.

Catalyst

1) MIMS better understands its new SP business, has strengthened management to execute, and should do an excellent job of meeting more realistic 2003 expectations.

2) This is a disguised growth story. Valuations will increase as the business growth, hidden by the tax driven negative comps, becomes more apparent through 2004.