Description

From my experience, it is rare to find a long-short trade where both the long and short parts of the trade are very good, stand-alone investments, but at the same time the short component is an almost perfect hedge against the long investment. Since both the long and short has its own company specific thesis, I am submitting an individual write-up for both companies. Because both companies operate in the same core industry of institutional pharmacy, the long investment (Omnicare) will include all of the necessary industry information whereas the short (PharMerica) will mainly be company specific.

I think OCR is a very attractive risk-adjusted investment on an absolute basis, but especially hedging industry risk by being short PMC. Being able to buy an industry leader that operates in a growing industry at ~10x 2012E cash EPS of $3.25 (excluding amortization of intangibles) is a good value. Due to its Specialty Care growth, brand-generic conversions and increasing penetration of more efficient automated distribution over the next few years, OCR’s EPS should be able to increase at a high single digit CAGR. If management can improve account management/customer service and new sales such that it is able to achieve organic growth on a sustainable basis, then OCR should garner at least a couple points of P/E multiple expansion on a growing earnings stream.

I think OCR can earn ~$4.00+ in 2015E. Applying a 12-13x P/E plus some dividends would result in upside of ~$50 or a ~50% return over 2-3 years.

Investment Thesis

Aside from a rapidly growing (25%+) specialty pharmacy business, OCR primarily operates within the institutional pharmacy industry (80%+ of total revenue and profits) mainly delivering drugs to skilled nursing facilities (SNFs) and assisted living facilities (ALFs) in the US. The company has a few major, sustainable competitive advantages over the rest of the industry that are a result of its insurmountable scale of controlling 40%+ of the SNF market. OCR has 3x the scale of PMC, which is the #2 player in the industry.

The major competitive advantages OCR has in institutional pharmacy are:

1)      It is the only company in the industry that buys and self-distributes generic Rx directly from manufacturers. This allows it to capture the drug distributor’s margin. At the same time, since it is able to move market share (because there are typically several manufacturers selling a now commoditized drug) among manufacturers in a particular drug glass, it is able to garner much higher profit per Rx when a drug moves from brand to generic.

2)      Like a UPS or FDX in the U.S., OCR not only has the national scale, but also has much greater local scale in its markets compared to its competitors. As a result, OCR is the only company that has an efficient hub and spoke distribution model. At the hub, chronic or routine Rx (think Lipitor) is filled by specially designed automated equipment, which dramatically lowers the cost per fill compared to people filling these Rx. These Rx then get sent to the spokes or local pharmacies to be batched together with acute Rx (think pain medication for a broken hip) before being delivered to the SNF or ALF. Thus OCR has by far the lowest cost distribution expenses in the industry.

3)      It has the ability to negotiate better terms with Medicare Part D providers (47% of revenue) from which many seniors get their prescription drug coverage. As a result, OCR has pricing floors in most of its Part D contracts for generic drug reimbursement such that providers are unable to extract all of the cost savings (when drugs go from brand to generic) for themselves. This was one of the main reasons why OCR’s attempt at buying PMC was blocked by the FTC as the fear was it would raise drug prices for the institutional pharmacy industry (and indirectly the government).

4)      Since OCR is by far the most profitable player in the industry, both in terms of dollars and operating margins, it has the ability to reinvest in its business—both in customer facing technology as well as in increasing its distribution efficiency.

a) OCR’s unique customer facing technology platform, Omniview, saves its customers time and money. These are tools such as paperless Rx re-orders, pricing tools to determine how profitable a Part A patient is before accepting them and online order entry for doctors to prescribe narcotics. From doing channel checks with SNFs who use OCR, PMC and independents, we were able to determine that generally speaking independents do not have much, if any, technology offering, PMC’s technology is woefully behind OCR’s and as a result OCR can save a SNF up to 25% on their pharmacy spend (including direct and indirect costs) when using these tools. Given pharmacy spend is the second largest cost bucket behind labor, this is not inconsequential in the context of the low operating margins SNFs generally have.

b) OCR is able to continue to invest in its automated distribution platform. While OCR already has automation at the hub level, it is undergoing a prodigious effort to bring automation to its spokes. As a result, by 2015 OCR hopes to have a ~70% automation fill rate vs. just ~20% today (rest of the industry is at zero).

Institutional pharmacy is a recurring revenue business. These pharmacies are necessary for SNFs because the patient population does not have the ability to go to a drugstore to get their Rx. At the same time, since the average senior in a SNF takes 8+ different medications, it is more easily managed by having Rx put in punch/blister packs arranged by day as opposed to receiving several different bottles from a mail order pharmacy. Thus the nurse can more easily keep track of a patient’s medication regimen to help ensure his/her adherence.

OCR’s payer mix is 47% from Medicare Part D & B, 41% from private pay/third-party and facilities (Medicare Part A), 9% from State Medicaid programs and 3% from other sources.

• Medicare Part D: these are seniors who live in a SNF as a full-time resident. They choose a Part D plan from one of the several eligible ones in their region. The institutional pharmacy has contracted rates with various Part D providers (such as UNH).
• Medicare Part A: these are seniors who have some sort of injury (think broken hip) and are sent from a hospital to a SNF to recover before being sent home. SNFs get paid a daily rate from the government for these patients. Their profits are this per diem revenue minus the costs to provide for this patient such as labor (nurses), medication, food, etc. Since pharmacy costs affect this revenue stream’s profitability, it is the driving force behind the SNF’s decision as to which institutional pharmacy it uses.
• State Medicaid: by far the least profitable revenue stream for institutional pharmacies. There are future potential actions regarding Rx reimbursement based on AMP or average manufacturer prices to further drive down lower Rx costs.

OCR buys its brand drugs from MCK where it has enough negotiating leverage given its respective market share to garner a slightly better price than independent pharmacies. It buys generic drugs directly from manufacturers because it has enough scale in its end markets to self-distribute and because its purchasing power allows it to negotiate directly with generic manufacturers to get the best price possible. In contrast, independent pharmacies and PMC don’t have that ability and thus buy their generic drugs from a distributor. Distributors claim that their average contribution margin per generic prescription is well over $3—a margin that only large pharmacies such as OCR are able to keep for themselves.

While ~80% of prescription unit volume is made up of generic drugs it represents ~90% of pharmacy profits, but less than half of prescription sales since the average generic drug price is about a quarter of the price of a branded equivalent. OCR make on average 2x the gross profit dollars per generic prescription compared to the average brand drug. This is because regarding brand drugs the pharmacy is generally a price taker since there is usually only one or two manufacturers. However, most generic drugs have multiple manufacturers, which allow a large pharmacy such as OCR that self-distributes generic drugs the ability to drive market share to a particular manufacturer.

The industry is made up of OCR (40%-45% market share of SNFs), PMC (10%-15% share) and independents (40%-50% share). Regarding ALFs, OCR is the only institutional pharmacy with any real share at 10%-20%.

Competitive Analysis

OCR has a sustainable and growing cost advantage due to its large scale/market share. PMC is a weaker competitor that lacks the national and local scale that OCR has. PMC continues to lose market share at a rapid pace—2x the rate of OCR. Independent pharmacies continually take share from OCR and PMC due to better customer service. However, most of these independents have a slim operating margin and really serve to help provide an owner/operator an income as typically the pharmacist is the owner/operator of the pharmacy.

Independent pharmacies must compete with better service because they cannot win on price. The large pharmacies have better negotiating leverage with the major drug distributors/manufacturers/Part D providers than small, independent pharmacies. Due to the tough reimbursement pressure from Part D providers on generic drugs, typically independent pharmacies will earn lower gross profit dollars on an Rx once it becomes generic (after the 180-day exclusivity period) compared to when it was a brand. As a result, the only way for independent pharmacies to remain as profitable as they were prior to the ongoing generic wave is to win new customers, which they have been very successful in doing.

Industry Outlook

Tailwinds: The significant number of brand drugs coming off patent through 2015 should help provide a boost to profitability for OCR since the avg. generic drug carries ~2x higher gross profit dollars per prescription vs. its branded counterpart. However, for the rest of the industry this is a neutral to negative factor.

By 2020 there should be almost 55 million people over the age of 65 in the U.S. compared to ~40 million today. The 3.1% CAGR of the 65+ U.S. population over the next 10 years should translate into a commensurate increase in Rx volume for OCR. It is worth noting that from 2000 to 2010 the 65+ year-old population increased from ~35 million to ~40 million or cumulative growth of just 15% vs. 36% expected growth for this decade.

Independent pharmacies will likely continue to take share from PMC and to a lesser extent from OCR. I believe PMC will continue to lose market share at a similar rate it has been over the past few years since it has all of the customer service disadvantages that OCR has vis-à-vis independents and none of the customer facing technology OCR possesses. However, unlike PMC, OCR has a very realistic opportunity to raise its customer retention rate and win an increasing amount of new business. I believe OCR can achieve organic growth by 2014/15. For OCR, it really comes down to management execution.

OCR’s Opportunity to Increase Customer Retention and New Account Wins

While OCR has the best customer facing technology, only its SNF chain customers utilize all of its available tools on a habitual basis. At these chains, the decision to implement Omniview and train nurses was a corporate level decision implemented at all of their SNFs. When speaking with top level executives at these chains, they appreciate how Omniview has made their business more efficient. We were told that they gave their nurses a set amount of time to learn the new system—it was either get on board or find a different place to work.

Unfortunately, only a quarter of OCR’s customer base is chains. Its largest customer base is made up of small, independent SNFs. Less than 50% of these customers use Omniview and of those that use it, less than half use the tools that they do use on a consistent basis. Part of the problem is that Omnicare needs to simplify the process of e-refills with fewer mouse clicks. Currently, the company is conducting a usability study for all of its Omniview tools. At the same time, it doesn’t even have an 800 number for help support—rather customers need to email regarding their questions and/or systems issues. Another example is the launch of Omniview Dr, which allows doctors to prescribe narcotics via an online system, but OCR hast yet to release an App so the utilization rate of the program is much lower than it should be.

The decision to implement new technology at these SNFs is often made by the director of nursing (not the President/CEO) who is typically not compensated on profits or efficiency. What complicates things even further is that approximately 35% of the industry is non-profit, so 1 out of 3 SNF Presidents are unlikely to be properly incentivized to run the most cost-effective operation. In those cases OCR must really highlight the qualitative benefits of Omniview.

Generally speaking, the nursing staff prefers to continue to do what it always has done and not learn how to use new technology. As a result, most prescription orders and re-orders are sent via fax. The reality is most independent SNF operators who use OCR either don’t know what technological tools are available and/or don’t care to learn how to use them—either because they aren’t properly incentivized or because the process to teach and service them is poor, which is something OCR is focused on improving. We spoke to many Presidents/CEOs of SNFs who are customers of OCR. They were consistently unaware that their facilities weren’t using all of the available technological tools. The reason why this is so important for OCR to improve is that once a customer is hooked on using its unique tools that save time and money, they’ll be stickier customers as they’ll be much less likely to go back to the old way of doing things. While it’s certainly possible that PMC and some independents could introduce technology that bridges the competitive gap with OCR, OCR will likely continue to innovate in this regard and maintain its technological advantage.

There are three key things OCR must do to increase customer retention and new wins:

1)      Properly educate its independent SNF customer base in terms of what Omniview can do for its operation and then provide their nurses with the proper training and ongoing support and account service.

2)      Not only must OCR have the right salespeople/account executives in place and the proper incentive structure to focus on greater customer adoption of Omniview, but it also must have the right sales approach for new customers that targets both the President and Director of Nursing. OCR recently promoted the head of its Specialty Care division, Nitin Sahney, to COO. Nitin’s background is in sales. He is in the midst of completely overhauling account service and new sales at OCR.

3)      One of the main reasons why independent pharmacies continuously take share from OCR and PMC is because they are within closer proximity to their SNF customers, which are often just a few accounts. As a result, they have the ability to deliver drugs in the wee hours of the morning whereas it is cost prohibitive for OCR and PMC to do so. Over the past 6 months, OCR has been trialing on-site dispensing machines for first dose and emergency fills. This is important because when Part A patients arrive at a SNF in the middle of the night or very early morning, they are often in pain and need medication. If the pharmacy is unable to deliver those meds until later in the day, the patient is unsatisfied, which is bad for the SNF’s reputation and thus business. If/when (likely within the next 12 months) OCR can offer on-site dispensing equipment at a reasonable cost to its customers, this will remove one of the key advantages independents have over OCR.

Management Overhaul

In July 2010, founder and then CEO Joel Gemunder abruptly “retired”. Just about the only thing Gemunder did right was roll-up a very fragmented industry to give OCR scale advantages. However, because OCR was made up of various acquisitions over the years that were never properly integrated, the company was an internal mess. There were multiple billing platforms, no standard pay grades for employees, a lack of discipline in its acquisitions and an overall lousy company culture that did not treat many of its employees well. As a result, many sales and account executives would leave the company in order to be paid market compensation. There are examples of OCR buying pharmacies where after the seller’s non-compete ended he would leave OCR, start up a new pharmacy, take his old customers back and then sell that pharmacy to OCR again. Nitin Sahney (now COO) sold his specialty pharmacy business to OCR in 2005 for $235mm, left OCR in 2007 and returned in late 2010 to take over the specialty division, just a few months after Gemunder left the company.

The management overhaul began with ValueAct taking an active role at the company by placing Jeff Ubben on the board. Once Ubben saw how bad things were, he set to overhaul the board. This ultimately led to Denny Shelton (former CEO of Traid Hospitals) becoming non-executive Chairman. The fist major upgrade of management talent came when then CFO Dave Froesel retired in 2009, which led to the hire of John Workman to replace him. Workman was formerly the CFO of HealthSouth who came into help successfully turn around the company after the Richard Scrushy scandal. Once Gemunder left OCR they instituted a search for a new CEO, which included the consideration of Workman for the job.

At the end of 2010, OCR hired John Figueroa, then President of MCK’s $100 billion U.S. Pharmaceutical division, to become its CEO. At the time of the CEO search, after just one year at the company, the board felt Workman didn’t have enough experience in the pharmacy world and thought Figueroa was better suited for the role. Figueroa helped change the company into an operationally focused one. He also helped change the company culture to one that made employees more accountable for their performance, but at the same time paid them market compensation. Figueroa also helped OCR improve its buying on certain generic Rx given his knowledge of what MCK was paying for its drugs.

Overall Figueroa did a good job in his short tenure. When PMC put themselves up for sale in 2011, Figueroa tried to buy the company, but the FTC sued to block OCR’s bid. Figueroa abruptly resigned in June 2012. While not much has been said publicly, our sense of the situation was that he wanted to have total control of Omnicare whereas Shelton and the board had final say on matters such as capital allocation. Upon the failure of the PMC acquisition, word was Figueroa wanted to partially grow the company through pricey acquisitions in specialty and other non-core areas whereas the board wanted to see the focus on improving institutional pharmacy sales and account management—which had improved, but had not yet reached its potential.

Upon Figueroa resigning, CFO Workman became interim CEO and Nitin Sahney, President of its Specialty Care division, added the role of COO. In August Sahney promoted an executive from Specialty to become the new head of sales for institutional pharmacy. Together they are overhauling sales and account service—including compensation structure and incentives, coordination among sales, account reps and customer service as well as the sales approach for new accounts. Odds are the board will make Workman the CEO upon concluding their official search. We think Workman is a very capable manager, who can help OCR reach its potential.

Insider Buying

Upon Gemunder leaving OCR, both Workman and Shelton bought $200k of stock at $20 in August 2010. At the same time, four other directors bought stock as well. In November 2011, Shelton bought $1mm of stock at ~$30. At the end of July/early August 2012, Workman bought $156k at $31 and Sahney bought $320k at $32. By no means are these large purchases, but based on these actions it appears that the top 3 executives are cautiously optimistic about the future prospects for OCR. Generally when you see insiders buy stock into price strength, it’s a good sign.

Specialty Care

Market cap: $3,771mm (at $33.23)

Cash: ($565mm)

Debt: $2,481mm

PV of Goodwill Tax Shield: (~$550mm)—has a 9-10 year useful life of goodwill amortization (from its many acquisitions) for cash taxes; while its reported tax rate is 38%-39%, its cash tax rate will be ~10% over the next 9-10 years.

Enterprise Value: $5,140mm

2012E: $6,150mm sales, $670mm EBITDA, $625mm EBITA, $3.25 cash EPS

Multiples (2012E): 7.6x EBITDA, 8.2x EBITA, 10.2x cash EPS

Bridge to 2015E (base case)—assumes industry growth from aging population plus customer wins is offset by customer losses (net could be better or worse):

2012E: $670mm EBITDA +

• Generic drug conversion benefit: 7% x 115mm Rx x ~$6 in gross profit/Rx = ~$48mm
• Automation conversion benefit: 50% x 115mm Rx x ~$1 in gross profit/Rx = ~$58mm
  • Savings per Rx could easily be north of $1 per Rx as company has never given any guidance in terms of magnitude other than saying it is “large”
  • Specialty Care growth: 15% CAGR = ~$70mm
    • Compares to growth of 25% in the LTM and 35% in 1H’12

2015E: ~$845mm EBITDA, ~$800mm EBITA, ~$4.05 cash EPS

Multiples (2015E): 6.1x EBITDA, 6.4x EBITA, 8.2x cash EPS

Disclaimer: This report is neither a recommendation to purchase or sell any securities mentioned. The author and/or his/her employer may or may not have a position in any security discussed in this report. Further, the author and/or employer may buy or sell shares in any company mentioned, at any time, without notice. The information contained herein is believed to be correct as of the posting date. Readers should conduct their own verification of any information or analyses contained in this report. The author undertakes no obligation to update this report based on any future events or information.

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