Thursday, May 19, 2005

Omnicare: Suffering from the Common Cold or a Terminal Illness?

Omnicare (OCR) is not a household name. However, this company is the nation’s largest provider of pharmaceuticals and pharmacy related services to long term care institutions such as skilled nursing facilities, assisted living facilities, retirement centers, hospitals and other institutional health care facilities. The company’s long term care pharmaceutical distribution business services over a million residents, controlling 37% of the US market and operating in 47 states.

The company’s main business consists of buying massive quantities of drugs in bulk and repackaging them into single doses and distributing them to long term care residents. OCR maintains a detailed data base on each patient allowing for cross checking on drug compatibility and provides suggestions for improved drug usage based on established guidelines. It also includes cost information allowing physicians to choose among the most cost effective drugs and provides suggestions for improved drug usage.

Omnicare had enjoyed rapid growth and improved profitability through the past decade. The company was #94 on Forbes list of the 100 fastest growing companies in America. Wall Street was enamored with the stock as it rose from $20 a share in 2003 to nearly $47 in early 2004. However, the good news did not last. The company saw its share price plummet 34% when it released its 2Q04 results.

Omnicare was suffering from intense competition and an unfavorable customer mix shift. Competition from small local pharmacies had intensified, cutting in to Omnicare’s profitability. The company was also seeing an increase of low margin Medicaid patients in its customer mix. These factors, in addition to uncertainty of future government drug reimbursement plans, marred the company’s future growth and profitability prospects. The average Wall Street analyst rating was “Under Perform”. It was questioned whether this business model was still viable given the new Medicaid Prescription Drug Plan, expected to become effective in the first quarter of 2006, which could remove the floor on drug reimbursements. Some value investors were touting OCR as an excellent buy citing a focus on short term issues and strength in the business model driven by the aging of America.

Omnicare’s strategy had been to acquire smaller companies and consolidate the highly fragmented institutional pharmacy segment. In an attempt to offset industry trends, Omnicare took its acquisition strategy to the next level when it announced its hostile take over of large competitor NeighborCare (NCRX), which would give it nearly 50% of the market. NeighborCare’s management quickly rejected the bid. OCR management made it very clear that they intended to proceed without the approval of NeighborCare’s management. Omnicare also announced cost cutting restructuring plans that would help to offset the gross margin pressure.

Many analysts were less than positive on the acquisition for a number of reasons and gave it only a 60% chance of consummating. NeighborCare is by far the largest target that Omnicare has tried to consume and may prove to be too much to handle. Also, the NCRX acquisition would double the company’s debt load while only increasing revenues 25%, potentially straining the company’s cash flows. More importantly, the effect on profitability was questionable given NCRX’s 2.5% operating margin compared to OCR’s 13% margin. There is also the issue of FTC approval given the combined company’s market dominance.

There also appears to be a number of powerful synergies resulting from this acquisition. OCR has an excellent track record of integrating companies and bringing their margins up to the corporate average. While NCRX’s margin is far lower than OCR’s, it is possible that Omnicare can not only bring them up to OCR’s average but also increase the overall company’s profitability. In this business, size and scale matter. Each acquisition allows Omnicare to spread its fixed costs over a larger client base and purchase a larger volume of drugs at better pricing points, further improving its pricing power. The size of this proposed acquisition would significantly strengthen the company’s bargaining power.

Omnicare is also removing a major competitor from the market and increasing its size to 4x that of its nearest competitor, further establishing market dominance. This alone should alleviate some of the competitive pricing pressures in the market. In addition NCRX’s network will fill in the few geographic holes that remain in OCR’s nationwide distribution network. The overlapping geographies fit perfectly into OCR’s restructuring strategy. The company closing down redundant, overlapping pharmacies and changing its distribution network to a hub and spoke configuration to increase efficiency and lower cost. The acquisition also serves to increase Omnicare’s data base of patient information which is difficult to quickly replace and gives the company some stickiness with long term care facilities.

A year after the takeover was announced, it still had not gone through. OCR extended the tender offer yet again on April 19. Management reiterated its intention to close the deal in a recent conference call. NCRX stock was recently trading at over the tender offer of $30 making it unlikely that additional shares would be tendered. Some analysts feel that OCR may have to increase the price of its offer to obtain the 80% necessary to gain control. The FTC is taking an unusually long time to give approval for this acquisition and OCR has agreed to not close the deal until June 16. Analysts feel that OCR may have to divest some of its assets in order to get approval.

Analyst sentiment seemed to become more positive when OCR announced its 4Q04 results. While the gross margin pressures continued, the company’s cost saving initiatives stabilized its operating margins. Though some analysts felt that pricing pressure couldn’t get much worse and with the cost saving initiatives taking full effect in 1Q05, there may be upside potential to estimates. One analyst turned bullish on the stock before the 1Q05 release based on both the positives of the potential NCRX acquisition and overblown concerns of the government’s new drug reimbursement plans. Omnicare’s 1Q05 results showed the first improvement in its operating margins in over a year, driven largely by its cost cutting initiatives and continued acquisition strategy. However, profitability fell versus the year ago period.

The institutional pharmacy market continues to experience continued gross margin pressure, both from government cost cuts and increasing competition. However, it appears that OCR has made the correct strategic moves to maintain its profitability and drive growth going forward. The potential acquisition of NeighborCare meshes well with the OCR’s existing strategy and the current market conditions. If the company can finally close this deal it should serve to strengthen the company’s future prospects.

Barfoot, Boles, Davey.


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