September 10, 2012 - 9:35pm EST by
2012 2013
Price: 12.94 EPS $1.38 $0.00
Shares Out. (in M): 30 P/E 9.4x 0.0x
Market Cap (in $M): 385 P/FCF 0.0x 0.0x
Net Debt (in $M): 238 EBIT 77 0
TEV (in $M): 623 TEV/EBIT 8.1x 0.0x
Borrow Cost: NA

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  • Pharmacy
  • Customer Loss


Please see my other write-up on Omnicare (OCR) for the pertinent industry information relating to PharMerica (PMC). PMC is the 2ndlargest institutional pharmacy in the U.S. PMC is a short on a stand-alone basis, but also serves as an almost perfect hedge against an investment in OCR.

What would you pay for the equity of a company that has the following characteristics?

  • Structural competitive disadvantages both in terms of sales (poor service and customer facing technology) and costs (no self-distribution of generics and 100% manual distribution)
  • Has ~16% customer churn and annually loses ~8% of its customer base net of new wins
    • Its 2nd largest customer is taking its business in-house because PMC couldn’t give them what they wanted in terms of cost and service—the effect will begin to show up in its Q3’12 results
    • Has a large fixed cost pharmacy network and delivery infrastructure such that when it loses customers to this magnitude, it is unable to reduce costs at a commensurate level
    • Has little to no strategic value (FTC blocked its ability to merge with OCR earlier this year)
    • Has a management team more interested in keeping their jobs than maximizing shareholder value—witness how it handled putting itself up for sale and the OCR bid
    • Poor management incentives that focus on the wrong operating metrics, which results in poor capital allocation—namely making serial acquisitions to help plug the holes of continual customer losses at the expense of reinvesting in the business
    • Generates no free cash flow after capital expenditures and “maintenance” acquisitions
    • Has more aggressive accounting for bad debt expense vs. OCR
    • 3.1x Net Debt/EBITA leverage

My answer: not very much.

OCR and PMC trade at a similar EV/EBITA (LTM) valuation of ~8x, yet OCR has structural competitive advantages that should help its EPS grow at a high single CAGR over time whereas PMC is the exact opposite with a perpetually declining business. PMC’s LTM net organic customer loss rate is 2x that of OCR’s.

PMC came public in August 2007 via a spin-merger. ABC owned PharMerica and KND owned KPS pharmacy. They merged the two pharmacies together and spun-out their respective shares to shareholders.

A fair way to view PMC’s business is in the context of the past 3.5 years. Presumably this looks at the business after a ~1.5 year integration period of KPS and PharMerica such that most/all of the synergies from pharmacy consolidation, drug purchasing, etc. would have been realized by the end of 2008.

Over this 3.5 year time period cumulative operating cash flow was $261.8mm. Capital expenditures, net of some asset disposals were $53.6mm and acquisitions totaled $226.8mm. Combined, this is negative free cash flow of -$18.6mm. Despite more than 100% of free cash flow was spent on acquisitions of other institutional pharmacies, the number of beds served grew just 1.2% from 322,376 to 326,148. Adjusted EBITDA in Q2’09 was $25.8mm vs. $25.5mm in Q2’12. This is not a picture of a healthy company.                

Despite these horrendous results, the same management team from the spin-out five years ago is running the show. One might wonder why the company is run in a manner with such a strong bent on making acquisitions of other institutional pharmacies instead of focusing on fixing its own operations. The answer (at least partially) lies in how management is incentivized. Per the 4/30/12 proxy statement:

“Adjusted EBITDA was selected as the objective performance criterion because it is critical to focus our Named Executives on earnings and the achievement of cost savings. Annual bonuses are funded based on a combination of Company financial performance as measured by adjusted EBITDA, a non-GAAP measure, and individual performance relative to pre-established financial and non-financial objectives. Under the program, the bonus of the CEO and all Executive Vice Presidents is based 70% on Company performance and 30% on individual performance and the bonus of all the Senior Vice Presidents is based 50% on Company performance and 50% on individual performance.”

EBITDA is not a bad metric to have regarding incentive compensation. However by itself, with no other metrics in the mix such as return on capital and/or EPS, management is incentivized to make acquisitions at the expense of reinvesting in the business (given a delayed benefit), debt pay-down and/or share repurchases.

So despite these perpetually terrible results, the CEO hit 173% out of a 200% max bonus target and took home ~$2.1mm in cash compensation plus another ~$1.9mm in stock-based compensation. The interesting thing is the CEO appears to believe he’s managing the company in the right manner. In fact, he has been a consistent buyer of its stock over the past 5 years, spending ~$1.9mm in cash to purchase 181,500 shares at an average price of $10.29. The CEO owns 601k shares or ~$7.8mm of stock and has some RSUs and options, a majority of which are underwater. He also has an $8.1mm change in control payment. Thus it’s not surprising he tried to sell the company to private equity, but supposedly there were no bidders aside from OCR, which wanted the company for its installed base of customers.

In speaking to one of PMC’s largest customers we were told that:

  • They had to develop an in-house pharmacy management system because PMC’s was so poor
    • This ultimately gave it a greater incentive and made it easier to take pharmacy operations in-house
  • CEO Greg Weishar came to PMC from not knowing the institutional pharmacy business (was running CVS’ PBM before)
    • Leadership that surrounds the CEO doesn’t understand the business well
    • CEO doesn’t understand the business well enough to get why certain concepts are incorrect
      • Independents understand the business better—they’re not winning on price contrary to what Weishar says
  • Bill Monast, PMC’s executive VP of operations
    • Not as good at the business side as OCR’s people—gave them terms that were too good
      • Able to keep existing pricing on remaining facilities that it doesn’t take in-house despite the fact that it would cost PMC more to service the remaining facilities due to the fixed cost deleverage

Comparative Metrics (OCR vs. PMC)

  •  Net debt/EBITA: 3.1x vs. 3.1x
    • Avg. interest rate: 4.4% vs. 3.9%
        • % of debt floating: 17.6% vs. 100.0% 
        • Avg. maturity (years): 9 vs. 3
    • Net Losses (LTM): -3.8% vs. -7.6%
      • Customer Churn (LTM): 8.1% vs. 15.7%
      • Organic Adds (LTM): 4.3% vs. 8.1%
  • Bad debt exp. % of revenue (LTM): 1.6% vs. 1.3%
So what’s PMC worth? Given that it has a perpetually declining business with nothing on the horizon that indicates otherwise, it’s almost impossible to put a multiple on its earnings when it has ~8% net customer losses annually. Thus a DCF would make the most sense to try to value PMC, but aside from the various assumptions that need to be made, this exercise becomes particularly difficult to execute because PMC continually makes acquisitions to offset customer losses. As a result, PMC avoids the fixed cost deleverage that would ensue by spending its entire free cash flow and then some to avoid this fate.

In terms of thinking about fixed cost deleverage, PMC makes ~$7.25-$7.50 of average gross profit per Rx. PMC dispenses ~40mm Rx annually. It loses ~3mm Rx each year or ~$22mm in gross profit before covering this up with acquisitions. There might be an ability to remove some fixed costs if PMC stopped making acquisitions to replace this lost business, but for simplicity purposes let’s say it’s a ~$20mm incremental loss in EBITA. With 2012E EBITA of $77mm, it would likely take no more than 4 years before PMC’s EBITA were to go to zero. PMC is leveraged over 3x EBITA. Thus at its current rate of net customer losses, there isn’t much value, if any, left over for the equity.

One risk in being short PMC is if it is able to strike a much more favorable agreement with ABC for its drug purchases. PMC claims there might be another $30-$40mm of gross profit it could garner when its contract comes up for renewal in September 2013. When PMC was spun from ABC it had a 5-year contract that expired in September 2012. But in Q1’11, PMC proactively renegotiated the contract to get some cost savings in return for extending the contract another year. Now PMC believes that if it goes through the RFP process it will be able to get even better terms. Thus if PMC touts major cost savings on a future executed contract, one should be prepared for the stock to rise substantially since $30-$40mm in savings would boost cash EPS by 40%-60%.

Even supposing PMC was to garner $40mm in additional drug purchasing savings, assuming its current rate of net customer losses continues, it would take no more than 6 years before its EBITA is gone absent acquisitions. Unless PMC fixes its customer retention problems, PMC’s equity would still be worth materially less than it is currently trading at.

While it is possible for better terms due to an RFP process, my guess is OCR would not be too pleased if MCK gave PMC a great offer. Were PMC to leave ABC for MCK I wouldn’t be surprised to see OCR take its book of business away from MCK and give it to CAH. So realistically there is just CAH competing for the business, which happened to recently lose its ESRX contract to ABC.
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.


More of the same with continued levels of customer churn and net losses led by the exit of its second largest customer beginning in Q3'12.
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