I had received some emails and phone calls from BioScrip ("BIOS" or the "Company") investors over the past few weeks asking what my investment status with the Company was and I wanted to provide a broader update. I actually sold my position in BIOS prior to Q3 and in fact have shorted BIOS off and on, generally trading the stock with a focus on what I think is growing downside for the Company. Aside from BIOS-specific issues, I have no long interest in the Company because with the market experiencing such a significant sell-off, relative value comes into play and BIOS, at nearly any price, offers little relative value to most companies these days. Notwithstanding the broader market issues, there are a number of items that made it clear that maintaining a long position in BIOS offered little upside and cutting my losses was far more sensible than digging my heels in.
When I first discussed BIOS, some investors reached out to me and were very helpful in terms of suggesting ways of changing the Board to ultimately remove CEO Richard Friedman and his cronies and (preferably) pushing the Company into the hands of an acquirer. It's important to note that many rumors have circulated with respect to BIOS being approached by a variety of strategic buyers as recently as this year, but Friedman, whose main incentive is his compensation rather than shareholder value, has never informed his investors. As a result, any attempt to generate value from BIOS would require the help of a large investor; I had hoped Heartland Funds ("Heartland") would be willing to take a more activist stance with the Company given its long history with BIOS as an investor and what I'd hope would be major disappointment in the Company's performance.
Unfortunately, Heartland had shown no inclination to do this and in my opinion BIOS only had value in the arms of a strategic buyer who could leverage the Company's revenues over a more efficient cost structure. Without the M&A option available, I felt I was stuck with a management team with a penchant to perpetually destroy value and little evidence to show any interest in changing that behavior. As Charts I and II illustrate (a favorite amongst BIOS followers), CEO Richard Friedman has been a boon for short sellers in 2008 and the Company, since going public, has been a complete failure, a statement which would be valid even prior to the market malaise of the last 16 months.
CHART I: BIOS 2008 YTD [click to enlarge]
CHART II: BIOS VS. PUBLIC PEERS [click to enlarge]
Given what Friedman has "achieved," I was concerned about the future potential role of his son, Executive VP Scott Friedman, and was worried he would be groomed to take over the Company. I had little interest to see where that would lead, at least from the perspective of a long investor, and the lack of an M&A avenue was what partially influenced my decision to cut my losses and try to earn some capital back via short-term, short sells on the Company.
Another factor that influenced my sell decision was my belief that the Company's operations were significantly declining and by plain luck I was able to take a loss before the awful Q3 results. The Company's Q3 results continue to reveal the impacts of management's poor tenure with BIOS. First, there was a $0.75MM settlement tied to an issue from the Office of the Inspector General from 2003-06. This, like the CAP issue and the loss of the United Health contract, is another example of poor top-level management abilities resulting in shareholders taking another one on the chin. Another area I had qualms with was the Company's Bad Debt Expense. On the Q2 08 conference call, I specifically asked BIOS management about the Company's credit exposure with respect to bad debt. The following was taken from Seeking Alpha's transcript of the call:
Amit Chokshi – Kinnaras Capital Management: On the balance sheet I see the accounts receivable at 146 versus $129 million but the doubtful account allowances are the same. Can you explain just why that's the case?
Richard Friedman: We review our accounts receivable bad debt reserve every quarter. We were in several different models. We continue to see tremendous success in collecting old and fully reserved or written off receivables in the past.
AC: Okay. And then what is the long term like revenue growth rate in terms of like your gross profit margins, it is tough to get a fix on what these really are going to be, do you guys have any – you know, expectation of what you're looking for in the next one to two to three years?
RF: I am sorry we were just talking, but the other part of your question is the growth in the receivables side and as Stan reported earlier we saw the decline in the DSOs but the increase in receivables is strictly as a result of the increase in the revenues.
AC: Okay, and you guys have looked through the credit aspect of that and you're comfortable with keeping the doubtful allowance generally the same despite the 14% bump during the mid year?
SR: We're very comfortable with our bad debt reserve because during every single quarter we have detailed reviews. We're very comfortable where we're right now.
So as of Q2 08 management was fairly confident about the credit and bad debt exposure, but interestingly enough in Q3 08, bad debt expense increased by 84% on a comparable basis from $0.76MM to $1.4MM. This may sound like a small number but BIOS recorded an operating profit of just $2.8MM in Q3 08 compared to $3.2MM in Q3 07, so the significant jump had a material impact on profits. The bad debt expense accounted for 0.4% of revenues in Q3 08 compared to 0.2% of revenues on a comparable basis, but the kicker was that Friedman expects bad debt expense as a percent of revenues to increase to 0.6% going forward. The reason for the lower bad debt expense in previous quarters was due to recoveries on written-off bad debt. These were anomalies that impacted a few quarters and overstated the Company's margins; going forward, one should not be surprised to see bad debt expense increase over the 0.6% target. This is, after all, the same management team that expected CAP to generate a significant profit only to find that it was losing money for the Company, after spending money marketing CAP to doctors.
Aetna (AET) also renegotiated a contract with BIOS and while terms were not released, it's likely worse than the original terms. With United Health (UNH) dropping BIOS, other companies can exert pressure on the Company and either pull their contracts or renegotiate on more favorable terms. Given the expected focus on cost containment for healthcare, companies like BIOS will be squeezed and lose out on contracts to larger competitors that possess scale.
The Company's insider actions were also telling. Insiders can sometimes provide insight into a company's operations and BIOS insiders are currently behaving pathetically. In the current environment, where executives of some companies are showing confidence in the long-term prospects of their companies by buying stock in the open market, BIOS insiders are actually dumping shares in the open market. Insiders including Barry Posner, CFO Stan Rosenbaum, Brian Reagan, and CEO Richard Friedman and his son Scott Friedman have all sold BIOS stock in the $3 price range in recent weeks. When those that are leading BIOS are selling their free, granted stock at multi-year lows, why would anyone want to invest in the Company?
This takes us to Friedman's latest move - the hiring of Richard Smith as Chief Operating Officer, who will be receiving a $475,000 base salary along with an incentive bonus plan. I would suspect if the incentive plan is anything like Friedman's, operating profits could be at historical lows and he would still qualify for millions in compensation borne by the shareholders of BIOS. However, what's really disturbing is that after losing the United Health contract, after the CAP blunder, renegotiating the Aetna contract at likely less favorable terms, after a $750,000 legal settlement, and most importantly, after a disastrous merger between Chronimed and MIM engineered by Richard Friedman, it's only now that a COO is hired? Based on the Company's history, it's likely that the COO position is just a gravy train position for anyone connected to Friedman to enjoy, irrespective of actual performance.
The large revenue base that BIOS generates has been an attractive aspect of investing in the Company. The general view is that if a competent management team was in place, the cost structure could be organized such that BIOS could generate considerable operating leverage, thus yielding a much higher share price. However, that investment thesis has been in place for years and was never realized, since Friedman was in charge which resulted in - at best - inconsistent results. One thing that has not changed during that time is the rampant increase in healthcare costs, and containing costs at the provider level is a growing focus. It is for this reason that the time for BIOS to right the ship may be running out.
Just less than a year ago BIOS was awarded a large contract with United Health to be its sole provider of HIV and transplant medications. This was considered a watershed contract that would result in $100+MM in revenues and be profitable. However, in September 2008, UNH terminated its contract with the Company, which will result in a loss of $100MM in revenues and $2MM in operating profits in 2009. The loss of this contract provides significant insight into the rest of the Company's revenues and can explain why BIOS can trade so low relative to its large revenue base.
First, large care providers are willing to bring competencies offered by BIOS in-house. This will put major pressure on inefficient operators like BIOS, where care providers either leave or renegotiate contracts that are far more favorable to the care provider. Second, the reason the market has placed little value on the Company's large revenue base could in part be because those revenues add no value to BIOS and in fact have negative value to the Company. Through 9M 08, BIOS had $1B in revenue and $6.4MM in operating profit. For FY 2008, perhaps BIOS generates about $10MM in EBIT. With the loss of UNH, BIOS is losing less than 8% of its 2009 revenues but likely 15-20% of its operating profit. Assuming no increase in profits, BIOS would have just $8MM in operating profit on a loss of just $100MM in revenues. This suggests a lot of those big revenues have low profits or rack up losses.
The operating segment data further validates this notion. According to the latest 10-Q, Specialty Services generated $307MM in revenue but had a segment loss of $0.4MM. In contrast, the slow growth PBM segment had revenue of $52MM but a profit of $3.2MM. Through 9M 08, the Specialty Services segment generated revenues of $883MM but a loss of $2.9MM while the PBM business had revenue of $153MM and a profit of $9.2MM. BIOS would be a far more profitable business without 85% of its revenue base. This could be why the market has never really assigned any value to the Company's large revenue base. Friedman and his friends are basically being paid millions to run a profitable, albeit slowly declining, $200MM revenue with 6% operating profit margins, and are subsidizing the Specialty Services business with these profits.
The only way the Specialty Services segment would realize any value would be if it was consistently profitable, which is highly unlikely given the ineptitude of current management, or if a strategic buyer bought BIOS. A strategic buyer would have a more efficient cost structure to leverage that revenue base into profits, something that BIOS does not. Second, a strategic buyer could rationalize some of the Company's distribution facilities and would also save real money by eliminating much of top management. However, this is unlikely because it has become increasingly clear that Friedman is more concerned with his and his friends' long-term prospects than shareholder value.
It's not a surprise that Friedman has no interest in letting shareholders know of proposed offers for their company because in an acquisition, Friedman and his cozy buddies would be out of a job. When one is making a salary of $850,000 and receiving considerable bonuses and benefits for just showing up to work, there's little reason to care about shareholder value. In addition, the large revenue base may somehow allow management to justify their ridiculous compensation (even aside from the fact that they still have jobs) as they can claim to run a large "billion dollar" corporation, even if they are running it into the ground. Unfortunately, I suspect Friedman and his accomplices will be happier with a BIOS stock price of $0.01 (as long as they have jobs and can line their pockets irrespective of abysmal performance), than with a $6+ price an acquirer could pay, if it meant management was shown the door. The flip side for nimble short sellers is that given the stock performance under current management tenure, that $0.01 price may be achievable.
DISCLOSURE: SHORT BIOS