Description

Poor investor reception of the pending all-stock “merger of equals” between Chronimed (CHMD) and MIM Corp (MIMS) has created an interesting investing opportunity. The merger was announced on August 9, 2004, but the shareholder vote to close the transaction has been delayed until March 9, 2005. This idea therefore is to establish a long position in one or both securities in order to own a position in the pro forma company. Note that the terms of the transaction call for each CHMD share to be converted into 1.12 MIMS shares. This write-up will speak in terms of MIMS shares, of which there will be approximately 38 million outstanding if the deal closes.

Note also that MIMS was written up on VIC in May 2003 from a different perspective.

CHMD and MIMS are both specialty pharmacy companies, and will on a combined basis be the 4th largest such company in the U.S. (note that MIMS also owns the 8th largest PBM in the US, but that this represents only 15% of MIMS operating profit, or about 6% of projected 2005 operating profit for the combined company).

The Specialty Pharmacy Industry

Specialty pharmaceuticals are the fastest growing area of new drugs. As opposed to traditional pharmaceuticals, which are chemically based and can be orally administered (the first such drug was aspirin), specialty pharmaceuticals are bioengineered molecules. These molecules began appearing in the early 1980s with the rise of Genentech and Amgen.

The pipeline of these drugs is growing, as the amazing (and amazingly expensive) US healthcare system reaps the genetic whirlwind. Large molecules are a major focus of major pharma companies like Pfizer, as well as numerous biotech companies. Industry reports (those from Atlantic Information Services and Windhover are good sources) suggest that some 300 bioengineered molecules are working towards FDA approval – about ½ the total drug pipeline.

(A good example is Tysabri, a new molecule in FDA clinical trials to treat multiple sclerosis. It is expected to be a $3 billion drug, but will have to be infused under supervision. See http://www.tysabri.com/downloads/product_information.pdf)

Specialty pharmaceuticals have the following characteristics, which drive the need for specialty pharmacies (called SPPs hereafter):
- Most complex molecules cannot be digested, require injection, and need careful delivery, including refrigeration
- Careful dosing and patient management – the HIV/AIDS treatments that are keeping 350,000 people alive often require 8-12 medications at carefully spaced intervals each day. Failure to comply can mean death and/or drug-resistance
- These diseases are chronic (cancer, HIV/AIDS, hemophilia, organ transplant, etc.) = repeat business
- For many patients, chronic treatment may exhaust traditional insurance plans. SPPs help patients maximize the availability of reimbursement (for example, special programs in nearly every state to pay for HIV medications)
- High cost of treatment ranges from $5K-300K per year – payors are focused on efficient delivery of such drugs (for example, organ transplant medication may cost $15K annually, but a third liver will cost $100K+)

Such drugs are not going to be found in your local Walgreens, or mailed to you by Medco’s high speed picking machines. So SPPs have emerged to distribute these drugs. They offer overnight mail order with special packaging, pharmacies with highly trained staff, infusion centers, a high level of service, and careful handling of complex drugs.

One other key difference from traditional pharmaceuticals is the treatment of off-patent status. Biotech patents began expiring in 2001, and 17 molecules with $10B in sales are going off-patent during 2002-2006. But the generic approval process is unclear for bioengineered drugs. The FDA standard for approving generic versions of chemical drugs is (i) chemical similarity and (ii) how well the chemical gets into the bloodstream – these are not relevant for injected bioengineered molecules. Bottom line, there is no current FDA mechanism for a “biogeneric”, other than spending years doing full phase 1,2 and 3 clinical trials. This is even though biogenerics are available in Asia, and will be available in Europe in 2005. This is an important point to watch, as generics have been more profitable than on-patent drugs for traditional pharmacies (more unit profit, as more manufacturers to buy from, and higher unit sales, due to lower wholesale prices).

All this has the makings of a great business – good sales growth, repeat business, and upside from generics. But there are problems.

The first is the high cost of treatment. While HIV/AIDS is a relative bargain at $15-20K per year, the treatment for some of these diseases can get up to $300K per year. It’s like one of those late night dorm room questions – what price is society willing to put on human life? The tangible impact of this question on CHMD and MIMS is strong pressure from payors to reduce reimbursement for these drugs. Gross margins are shrinking in both businesses.

The second is the entry of the PBMs. There was a flurry of acquisitions and joint ventures during 2004:
- Caremark (which had built the 2nd largest SPP organically) bought AdvancePCS, a PBM that had built the 5th largest SPP. This closed in March 2004, and created the #1 player
- Medco entered a joint marketing agreement with Accredo in February 2004
- Express Scripts bought CuraScript, the #8 player, in February 2004
- MIMS and CHMD each explored selling during spring and summer of 2004, as we will touch on later

Why are the PBMs entering?
- Specialty pharmaceutical patients are 1% of US drug-taking population but account for 25% of spending on drugs. This is too much money for the PBMs and their clients to ignore
- PBMs see this as an extension of their existing mail order operations
- PBMs see controlling patient, payor and manufacturer behaviors as a core competency
- Margins and growth are attractive: a Medco study in May 2003 saw specialty pharma revenue growth as 18% annually going forward, compared with slowing core growth (if you add up all of the claimed PBM lives, you get to more than the US population)

Industry Players

The total SPP market is estimated by Atlantic Information Services to be about $15-20 billion (sales in the table below are in millions, and data are for the SPP operations of the companies).

Player Sales GM (%) EBITDA (%)
Caremark 2,000E n/d n/d
Priority Health 1,677 11% 5%
Accredo 1,602 20 10
Chronimed 589 11 2
CVS Procare 450E n/d n/d
Exp Scripts/CuraScript 400E n/d n/d
MIM Corp 232 18 6

Priority Health and Caremark are the market leaders. Each is active in 8-12 disease categories, and is the leading provider in several of them (i.e., hemophilia for Caremark; oncology for Priority Health). These businesses deliver through the mail, either to infusion facilities or directly to patient homes. Priority Health is the SPP partner for Wal-Mart, and also has developed a joint venture with Aetna (taking CHMD’s place).

Accredo has a unique business model - it enters into a small number of exclusive contracts with drug manufacturers seeking to maximize profits for 7-10 years from a hot new drug. Thus, Accredo offers 21 drugs, whereas other players offer up to 500. Despite higher EBITDA margins, ROIC is lower than Priority Health’s because the exclusive contracts require high levels of inventory. Also, this model is not popular with payors or patients. Accredo has a joint venture with Medco, which seems to be experimenting with how to enter the SPP space.

MIMS and CHMD are similar to the payor- and patient-friendly Priority Health model, though their smaller scale means that their SG&A costs are higher, which was a primary reason for their merger. MIMS is particularly strong in the Northeast due to its 2001 acquisition of Vitality. Disease states served by MIMS include IVIG (19% of sales), oncology (18%), HIV/AIDS (14%), hepatitis C (13%), arthritis (9%), and multiple sclerosis (8%). MIMS’s PBM serves ~200 clients, and targets smaller companies.

Much of CHMD’s sales are through the mail, but about 60% are through its network of 28 StatScript pharmacies. These are pharmacies where patients can walk in and talk to pharmacists. These facilities grew out of CHMD’s dominance of the HIV/AIDS market – the patient population is urban, and CHMD’s walk-in facilities in cities have made it the #1 player. CHMD also serves organ transplant patients largely through these facilities, and is the #1 player in this category. HIV/AIDS is ~50% of sales, organ transplant is~ 20% of sales, and other categories include hepatitis C, arthritis, and multiple sclerosis.

(The U.S. demographics of HIV/AIDS are interesting. There are 350,000 patients taking drugs, but 950,000 people with the HIV virus, and 40,000 new cases each year. Lots of people don’t know they have the disease - this market looks under-penetrated).

CVS ProCare is the only other player with a network of walk-in pharmacies. It is the #2 player in HIV, and seems to focus on this segment. CVS is of course the second largest traditional pharmacy player in the US, and also owns a large PBM. Note that CVS added to both its retail and PBM operations through the 2004 acquisition of most of Eckerd.

Some Interesting but Unknowable Things

First is the question of local versus national SPP services. MIMS and CHMD management have told the Street that a primary motivation for the merger is the local nature of medicine. Their example on conference calls and in person has been the experience of MIMS’s single pharmacy location in NY, which they claim does 3/4 of its business “out of the back door” – i.e., mail order business that results from having a local pharmacy. Under this model, the doctor and patient choose an SPP (even for mail order delivery) because of having a familiar local face. Also, payors in this model would choose a locally present SPP because of better patient outcomes using a blend of local and mail order services.

Therefore, taking the broader suite of MIMS and CHMD products across CHMD’s 28 local pharmacies would presumably drive revenue growth. They would be a unique player, given CVS’s lack of a broader suite of diseases, and Priority’s lack of local pharmacies. Do I think this is interesting? Yes. Is it knowable? No. There is a balance between cost, choice and efficacy that needs to play out.

Second is the question of margin compression. Margins have been shrinking across the industry as Medicare, Medicaid and private sector payors seek to lower drug costs. Gross margins are as low as 10-11%, and could go lower, putting even more pressure on CHMD/MIMS. Given the utility of the drugs, and the debate that society needs to have, is this knowable? No.

Some Other Interesting Things

The businesses are unlevered, and both generate positive free cash flow (numbers shown below are on a combined basis, with the caution that the historical years blend CHMD’s June year end with MIMS’s December year end):

2000 2001 2002 2003 LTM 2005E
Sales
CHMD 298 397 436 560 589
MIMS 370 457 577 589 600
Total 668 854 1013 1149 1189 1200

EBITDA
CHMD -2 5 11 12 13
MIMS 5 21 30 21 17
Total 3 26 41 33 30 35

Cap Ex
CHMD 3 1 1 3 3
MIMS 7 3 2 1 1
Total 10 4 3 4 4

The business does not appear to need much more cap ex. CHMD’s 10-K claims that its pharmacies and mail order centers are operating well under capacity, and a key merger synergy is the rationalization of mail order facilities to base primarily at MIMS’s facility in Minnesota.

The businesses’ top lines have been distorted by the loss of large customers. First, in mid-2003, TennCare (which is the wildly out of control Tennessee Medicaid program) announced that it was terminating its contract with MIMS PBM. This represented about 1/6 of MIMS total sales. MIMS claims that the next largest customers are each approximately 4% of sales.

Second, in June 2003 the largest customer of MIMS SPP, MedImmune, terminated its relationship selling a drug called Synagis. This accounted for about 3% of sales, and the next largest customer appears to be about 2% of sales.

Finally, in mid-2004, Aetna announced that it would terminate its relationship with CHMD by early 2005 in favor of a joint venture with Priority Health. This represents 25% of CHMD’s sales, and 13% of CHMD’s gross profit. This was by far CHMD’s biggest customer.

The bottom line has been to distort the top line performance of the business. If one strips out the TennCare, Synagis and Aetna businesses, the following year on year sales growth rates result (note that this calculation also makes an approximate attempt strip out the acquisition by MIMS of a $40m sales SPP company called Natural Living, which was bought for $15m in February 2004):

Q104 Q204 Q304
MIM SPP 22% 14% 25%
CHMD SPP 38% 12%
MIM PBM 23% 15% 13%

This compares with essentially flat growth on a reported basis. This underlying growth, as well as the reduced client concentration, may not be fully appreciated by the market.

Background to the Deal

The ‘background to transaction’ section of the proxy statement makes extremely interesting reading.

The increasing entry by PBMs seems to have spurred both of these companies to explore alternatives. CHMD held conversations with at least one large buyer during late 2003 and 2004, but was not able to come to an acceptable price.

MIMS conducted a broad ranging auction of itself in early 2004. In April 2004, MIMS received seven preliminary indications of interest – at least some for cash – in a range of $8.76 to $12. At least one PBM was one of the interested parties. In May 2004, five parties did due diligence. In June 2004, three parties were given contracts to mark-up, and final bids were submitted.

CHMD was selected as the final party, based on a $10-12 all-cash bid financed with the help of Warburg Pincus. But when CHMD found that it was necessary to use high coupon mezzanine debt to finance the transaction, they withdrew their offer. MIMS then contacted CHMD with the idea of an all-share merger of equals, and this transaction was announced in August.

Calling around suggests that it was common knowledge in the industry and among analysts that MIMS was for sale (their bankers had broadly distributed their sale book). It seems likely that arbs owned much of MIMS, and that the announcement of an all-share, no premium transaction disappointed them. MIMS stock fell from almost $10 in June to under $6 after the August announcement. As the exchange ratio was fixed by the deal (bad advice from CHMD’s bankers), so fell CHMD’s share price.

Management did a poor job on the August conference call explaining the transaction. Guidance was given for 2005 EBITDA of $35 million on sales of $1.2 billion, and synergies of $10 million. But management was unable to explain where the day-to-day headquarters of the company would be, who would run the company under the level of CEO, and whether the $35 million included the $10 million in synergies. One analyst seemed to sum up the general mood of the call: “it’s something I’ve never heard in my career, which is not terribly long”.

Valuation

There seem to be three potential outcomes.

First, the combined business does well, and the stock trades up from its current level. On a relative basis the company looks cheap. $6.30 per share is a multiple of 9.7x 2005E owner earnings if one assumes $45m of EBITDA (defining owner earnings as management’s forecast of $35m in EBITDA plus $10m of synergies less $4m of cap ex and tax-effected at 40% - this would be a 3.8% EBITDA margin on $1.2 billion in sales). This compares with Priority Health and Accredo, which trade at 17-19x 2005E net income.

Owner earnings and reported free cash flow have tracked pretty closely over the past four years. Looking at the last twelve months for the combined companies, $6.30 per share is a 5% FCF yield and 15x owner earnings. These are somewhat distorted by Aetna earnings being in the LTM number, but do not include synergies.

A DCF valuation results in intrinsic values of $7-13 using the following assumptions:
- Sales of $1.2 billion and EBITDA of $35 million in 2005 – a margin of 2.9%
- Sales growth of 12-20% annually through 2009, and 7% through 2014
- EBITDA margin of 2.5-3.5%
- Cap ex equal to 0.4% of sales
- 10% discount rate, and 10% terminal free cash flow yield

Second, the business does OK, and is sold to a competitor. There were those indications of interest for MIMS in mid-2004 at $8.76 and up – the low end represented a multiple of 12.9x trailing EBITDA less cap ex. Express Scripts paid $300 million for CuraScript in February 2004, which depending on whom you ask was a multiple of 12-15x trailing EBITDA. When you consider the fact that CHMD is arguably a higher quality business due to its HIV franchise, there seems to be some support for a good private market outcome. Using a broad range of 9-14x on $35 million of forecasted 2005 EBITDA less $5 million of cap ex would result in $7-11 per share.

Note that MIMS’s CEO and ex-CFO feel that selling to a PBM is the most likely outcome, and openly describe the choice to merge with CHMD as maximizing the ultimate price in a sale because of the ability to deliver a national SPP platform.

Third, the business implodes due to margin compression or some other reason, and is sold at a low multiple of depressed earnings.

How likely are these outcomes? Hard to say, but the third seems somewhat unlikely. MIMS CEO will own 3% of the company outright, and a further 1.2% in options. CHMD CEO (and the ongoing CEO) will own 0.6% outright, and a further 2.4% in options. The pro forma company will have net cash of $10+ million, and will be free cash flow positive.

To me, the most likely outcome is the second. If well integrated, the combined companies would be an excellent way for a buyer – Medco or Express Scripts are the most likely, as CVS might have antitrust problems – to get a national SPP footprint in one step. Ultimately, this idea can be boiled down to betting based on the judgment of management rather than the judgment of the arbitrage community.

Risks
- Reimbursement pressure is intense
- Is management truly prepared to sell the business if necessary?
- Management are not ideal – they are not great communicators, and have granted themselves options of about 4-5% annually over the past couple of years
- The merger does not go through – seems unlikely, as HSR clearance has been received and there does not appear to be a shareholder movement against the deal. But if it fails, we can expect to see both companies under pressure to sell out in a hurry

Catalyst

- Deal closes in March 2005
- Synergies and execution
- A buyer