Description

On 9/10/12, when PMC was trading at $12.94, I posted PMC as “a short on a stand-alone basis, but also serves as an almost perfect hedge against an investment in OCR.” Since then OCR has appreciated 73% while PMC has increased by 9%, underperforming the market. While I no longer think the long side of this investment is particularly attractive, PMC is an even better short today given materially worse company specific fundamentals, a potential future catalyst coupled with a higher share price/valuation. So as to not be redundant from my prior write-ups on OCR and PMC, please review them for context and business/industry understanding. This write-up will focus on what has changed in the past year for Pharmerica and what makes it an even better short today.

To give a quick recap, the short thesis in a nutshell is that PMC has a competitive disadvantage on a few fronts. First, because it lacks scale and doesn't buy generic Rx directly, it's not a low cost distributor and thus cannot win on price. Second, it does not service customers as well as small, independent pharmacies and thus cannot win on service. Third, because it has underinvested in its billing/systems/customer facing technology, it is losing large chains (Kindred) to the likes of OCR or others are deciding to take the business in-house (Golden Living). Contrary to what some of the sell-side analysts will have you believe, Golden and Kindred left primarily for the same reasons—PMC’s service offering is very poor. The response to this was different with KND switching to OCR and Golden in-sourcing, but the reason was the same. As a result of these competitive disadvantages, PMC has not generated any free cash flow after maintenance acquisitions since it was spun out 6 years ago.

This is a network delivery business with large fixed cost leverage. It is very difficult to offset these kinds of impacts through cost cuts. It's basically in a downward spiral—a poor customer offering leads to customer losses, which further limits its ability to reinvest in the product/service offering, which increases its competitive disadvantage and leads to greater customer losses. Management had their chance to reinvest in the business over the past 5 years, but it has chosen time and again to paper over its issues with "maintenance" acquisitions instead of invest to improve its offering. As a result reported earnings don't accurately reflect the economic reality of the business, which is a big reason why the market has yet to accurately value the company. The sell-side focuses on adjusted EBITDA and EPS as well as “free cash flow” (OCF – capex). But these analysts never factor in these acquisitions as “maintenance” to keep the business from seriously declining nor do they factor in that its interest cost is artificially low as its entirely short-term (3 years) floating debt at L+275.

PMC is by far the best risk-adjusted short that I am aware of for the following reasons:

1) There are very few, if any, distribution businesses (which have fixed costs that need to be leveraged) that can ultimately survive in their current state if they lose (gross losses – new wins) 9%-10% of their customer bases each and every year. At some point they cannot cover their fixed costs. Witness what happened to DHL in the U.S. as an example—after 7 years of losses, exited stage right.

The first quarter (Q4’07) after PMC was spun-out, it filled 10.1M prescriptions. In Q2’13 it dispensed 9.4M Rx. Over the past 5.5 years, PMC has generated NEGATIVE $5M in FREE CASH FLOW. Of its $436M in operating cash flow, it spent $103M in capex, net and $338M on acquisitions. All of these acquisitions are entirely MAINTENANCE given the volume of business it does has DECLINED 7% over this time.

2) The equity has a very realistic chance of being worthless over time and therefore any short that can return 100% (even if it takes several years) is by definition a good one.

3) Private equity passed on buying the company and it has little strategic value given the FTC blocked its ability to merge with OCR in 2012. Since that point OCR has taken significant share from PMC so even if OCR could buy PMC, the price would likely be less than $15 it offered back then (vs. a ~$14 share price today).

4) There is a real catalyst that very well may speed up its demise come 2014/15—more on that later.

5) The CEO has proven to be a horrible manager of the business. He is the only person remaining in senior management since the company was spun out in mid-2007. The longer he remains in charge, the better the short is as the competitive gap between PMC and OCR/independents continues to widen.

6) The CFO quit in April and the new CFO was the old CFO at OCR who was part of a management team that did not know how to operate an institutional pharmacy well—would expect more of the same old behavior.

7) Management compensation metrics (mainly EBITDA based, but small EPS weighting and nothing for ROIC, customer retention, etc.) incentivize management to make short-term maneuvers to disguise the ugly reality of its business fundamentals that can be seen in its lack of true free cash flow (when factoring in its serial maintenance acquisitions). What management needs to do is reinvest in the business (billing, systems, customer facing technology, etc.) to make its customer proposition better, but this will likely never happen so long as the current management team is in place along with its heavy EBITDA based incentives.

8) Only 10% of shares outstanding are short, the stock is not hard to borrow and does not have a cost to borrow.

On 6/21/13 it was disclosed that Kindred Healthcare, its largest customer, would not be renewing its contract for skilled nursing pharmacy services with Pharmerica when the contract expires on 12/31/13. This business represents 11.5% of its revenue. The contract is moving to OCR. At the same time, Kindred has a contract for its long-term acute care (LTAC) hospitals with PMC expiring at the end of 2014, which made up ~3.6% of Q2’13 revenues. This business is likely to leave PMC when the contract expires.

At the same time, its second largest customer, Golden Living, announced last year that it would be taking its pharmacy business in-house. As of Q2’13, Golden had only moved an estimated 20-25% of its business out of PMC and plans to move the rest of the business over the next 4-6 quarters. Golden Living represented ~9% of PMC’s revenue (prior to taking the business in-house). Thus based on the remaining amount of business Golden Living will in-source over the next 4-6 quarters combined with the Kindred business moving away in 2014, PMC will be exiting 2014 with AT LEAST a 20% ORGANIC LOSS of volume compared to what it dispensed in Q2’13 and LIKELY ~30% given these already known losses, the likely loss of KND’s LTAC business and its current 9%-10% annual loss experience.

The reason why I think the loss of its largest customer is significant is it further proves the business is in a downward spiral. It's one thing to lose a one off customer operating a few nursing homes, but it is much more difficult to win or lose large chains (there are only ~15). The choice of replacing systems for close to 300 homes using a new vendor is just about the last thing a large chain wants to do. PMC has now lost its top 3 customers in the last 2 years.

Here are my notes from a recent conversation with the head of pharmacy operations with one of PMC’s largest customers:

• PMC is now better at public relations. It is being more attentive to customer’s needs and having account people appear to be acting on your needs.
  • The problem is they don’t get anything done
  • Operations are still a mess—still have significant billing errors
  • New salespeople say “we were wrong” instead of fighting you on it
  • PMC will bill you for something it forgot to charge you for 2 years ago
  • OCR moved to Catamaran to do 3^rdparty adjudication instead of PMC doing it internally
    • This allows OCR’s claims to be verified independently
    • OCR’s Omniview allows you to view claims before they hit your bill so the customer can analyze them
    • Kindred had a decent (KPS) pharmacy system—but when KPS and Pharmerica merged, PMC decided to use PharMerica’s system instead, which was a bad decision
      • PMC’s system still manually prints out a spreadsheet of patients to see who has come and gone
        • This as opposed to having an electronic, automated system like OCR’s, which drops the SNF’s file into the system in order to update the patient list on a regular basis
          • This is one reason why PMC ends up having lots of billing errors
          • Once Kindred and Golden Living move all of their business away, PMC will close pharmacies and serve customers from further away
            • This will ultimately result in losing more of the remaining customers because service levels will drop—it’s a death spiral

Adjusted EBITDA (net of stock-based compensation): $128.0M

• Gross profit Impact from Kindred & Golden Living Losses: ($8 in gross profit per Rx) x (~7M Rx) = -$56.0M
  • Note that I use an 8.8% discount in gross profit per Rx for these customers given their relative size compared to its average gross profit per Rx of $8.77 (implies the non-Golden/KND gross profit per Rx is $8.95)

• Organic customer losses (in addition to the already known KND and Golden Living losses): ($8.95 in gross profit per Rx) x (~5.25M Rx) = -$46.9M
  • Despite PMC having net annualized Rx losses in Q2’13 at -12%, I’m being conservative and using the annualized organic loss rate it had over 3 quarters from Q2’12-Q4’12 of -7.2%.
  • Assume these offset each other:
    • There will be some brand to generic conversions over the coming 2 years, but it’s not a huge amount given the generic dispensing rate is at 83.3% and will ultimately top out in the high-80s towards the end of this decade
    • There might be some organic growth from its home infusion acquisition, Amerita
    • There could be some “same-store” sales growth through a combo of higher occupancy and/or increased Rx per person at the SNFs it serves
    • But KND’s LTAC business at ~3.6% of run-rate revenues is likely going away

- As a side note, the KeyBanc analyst recently published an initiation report on PMC with a Buy rating and $17 price target. On page 2 he goes through an EBITDA walk-forward from 2013E to 2016E. All of his assumptions for the impacts from losing the Kindred/Golden Living business, prime vendor contract savings and SG&A cuts are all within the same ballpark as my estimates. The key difference is that he has ORGANIC GROWTH of $16M cumulatively from 2014E-2016E, which the company has NEVER achieved let alone organic neutrality. Given customer losses (outside of the Golden impact) are actually increasing, this is a huge assumption that is very aggressive with nothing to support it aside from management saying this will happen—which has failed to deliver on almost everything it said it would accomplish from the spin out 6 years ago.

• Benefit from Renegotiation of Prime Vendor Contract with ABC: +$21.6M
  • After ABC successfully renegotiated its contract earlier this year, on the Q1’13 call it stated that, “In order to achieve that $30 million to $40 million range [of savings], we're going to have to put the direct purchasing in, and we still believe that those numbers are achievable.” The CEO’s comments from the Q2’13 call were: “Recall when we renegotiated the Prime Vendor Agreement, we estimated that roughly half of the margin improvement would come from direct purchasing. We expect to begin direct purchasing operations in the fourth quarter.”
  • Using the mid-point of $30M-$40M in savings, it appears that ~$17.5M would come directly from better terms with ABC and the other ~$17.5M would come from setting up the infrastructure for direct purchasing of generics, which it believes will come beginning in Q4’13.
  • I estimate that by Q2’13 (compared to Q2’12, prior to the renegotiation of its contract), given the large bump up in gross profit per Rx from $7.68 to $8.77 despite a nearly identical generic dispensing rate coupled with dispensing 4.6% fewer Rx in the quarter, I estimate that PMC realized ~$13.6M out of the ~$17.5M in savings coming from better pricing with ABC. One can triangulate this estimate based on the changes in its business over the past year from the benefit it received from its Amerita acquisition, filling fewer Rx due to customer losses, boost from lowering its provision for doubtful accounts and estimated SG&A cost cuts.
  • I think I’m being very generous in believing that PMC will realize the mid-point of its guidance for better Rx purchasing for 2 reasons:
    • Generally, there are minimum volume thresholds that need to be delivered to the distributor (ABC) in order to get certain levels of discounts. Given we know at least 20% and likely ~30% of its Rx volume is going to go away over the next 1-2 years, there is certainly risk to the level of savings it can achieve.
    • Aside from the above mentioned point, only half of that savings is a slam dunk from better pricing. The other half of the savings requires PMC to set up the necessary infrastructure to be able to purchase directly and then self-distribute certain generic Rx. This part of the savings has execution risk.
    • SG&A Cost Cuts: +$22M
      • Given a ~30% loss in Rx volume, I assume it can/will cut ~10% of SG&A ($222M)

EBITDA (in 2-years) assuming no acquisitions: $68.7M

EBITA: $49.5M

Net Debt/EBITA: 5.2x

EBIT: $33.9M

Pre-tax income: $22.3M

Net income (40% tax rate): $13.4M

EPS: $0.45

Applying a 10x P/E would result in a $4.50 stock. A 10x P/E multiple is generous for a business that continues to decline at such a rapid pace coupled with high leverage. Based on this price target, it would result in a ~65% total return or an IRR of 28.5%. However, over 3-5 years, PMC’s equity could ultimately be worthless.

Regarding its term loan, which makes up 100% of its debt, there are two large maturities. It has $112.5M due in 2015 and $178.0M due in 2016. Its business will be severely impacted entering 2016. In looking at the covenants, leverage cannot exceed 4.0x and interest coverage has to be at least 3.0x on an LTM basis. A majority of its debt comes due in 2015 and 2016. While PMC might not trip any covenants in 2015 or 2016, as its metrics deteriorate and it looks to sign a new deal, the terms could very likely be worse going forward. I think where things will get very dicey for PMC in 2016 when it has $178.0M of debt come due ($106.3M in term debt and $71.7M in revolving credit). This is about the time I think you could start to see things unravel for the company.

Management is going to have a couple major decisions to make on business strategy over the next year. As it loses 20%+ of its unit volume, it has to make a decision just how much SG&A it wants to cut. Particularly, it needs to decide how many pharmacies/pharmacy labor it wants to remove from its network to soften the gross profit impact from this volume reduction. If it doesn’t cut enough to maintain service levels, profits will suffer. If it cuts too much, customer service could suffer.

Guess which way management will go? It’s more likely they’ll cut too much than not enough given their heavy EBITDA based incentives. But this is a great thing for the short thesis because by cutting too much, it will actually speed up its demise. The worse its customer service gets the more customers will leave the company and its downward spiral into a bankruptcy filing will ultimately happen. This is my prediction.

I have high conviction that it will happen so long as the current management team and/or incentive structure is in place. But I’m much less certain of the timing. My best guess is that it’s a ~2017 event. PMC will generate free cash flow (before acquisitions) to the tune of ~$100M over the next 2 years that it can use to either pay down debt and/or make acquisitions, which can help delay the inevitable. Were it to go bankrupt in 2017 or take 4 years, it would be an IRR of 18.9%. If it took 5 years, it would be an IRR of 15%.

Catalyst