'Merger of Equals' or Bargain Buyout?
In its lawsuit, the Iron Workers of Western Pennsylvania Pension Plan argued that the stated “merger of equals” was actually a buyout of Caremark by the pharmacy chain CVS—without a takeover premium being paid to Caremark stockholders.
Under the terms of the agreement, which is a stock for stock transaction, Caremark shareholders will receive 1.67 shares of CVS for each share of Caremark. The exchange ratio approximates the 90-day average ratio of the two companies’ closing stock prices (prior to November 1, 2006).
The new company will be called CVS/Caremark Corp. and will be headquartered in Woonsocket, Rhode Island. The pharmacy services business will remain based in Nashville.
The combined company’s ordinary shares will trade on the NYSE under the symbol “CVS”.
Caremark's stock closed Wednesday at $45.90 a share. CVS closed at $28.00. Based on that, its offer for Caremark would be worth about $46.76 a share, for a premium of 86 cents a share. On a pro forma basis, CVS stockholders will own 54.5% of the combined company and Caremark stockholders will own 45.5 percent.
The lawsuit also accused Caremark executives, including Chairman and CEO Edwin "Mac" Crawford, of "breaching their fiduciary duties" (given the negligible price premium involved in the merger).
The 10Q Detective will present a case that questions the critical suppositions underlying the Iron Workers’ accusations:
1. Did Caremark management fail to maximize shareholder value by negotiating a drug deal that included no premium for its stock price?
2. Was the deal a “merger of equals” or a “bargain buyout” of Caremark by CVS?
The Iron Workers were puzzled as to why management negotiated the deal when the price of its common stock was so low. Caremark was selling at $49.00 at the time of the announcement, more than 20% below where it was valued less than two months earlier.
Adding to the Iron Workers suspicions, too, was that during the third quarter ended September 30, 2006, management approved open market purchases of 1.85 million shares of its common stock (under a previously announced repurchase program begun back in 2002) at an average price of approximately $55.35 per share.
Caremark's Real Problem: The Changing Healthcare Landscape
Instead of griping about the dearth of a price premium in the $21.5 billion deal, the Iron Workers (and other dissatisfied investors) should question why the stock price was falling in the first place. [Ed. note. Before ridiculing the recent stock buybacks, investors should note that the average price paid for all repurchases made under the program from its inception through September 30, 2006, was $41.07 per share.]
In our view, investors were dumping Caremark stock because of recent events clouding future earnings’ visibility—including, but not limited to:
(i) the timing and launch of generic pharmaceutical products by Wal-Mart (WMT) into the marketplace, which will add incremental pressure to (already) weakening margins by decreasing the generic margin life cycle;
(ii) speculation that Democratic party gains in Congress will lead to an overhaul of the Medicare Part D prescription drug program, leading to lower average revenue per claim;
(iii) competition by other PBMs for managed-care providers’ prescription-drug plan contracts will continue to pressure margins.
Ergo, there was no price premium to the deal because Caremark’s current business model is dependent on the questionable ability of the Company to operate independently (and profitably) in a changing healthcare landscape.
In our view, the Iron Workers were correct in saying that deal was not “a merger of equals,” but the buyout of a PBM by a drugstore titan. Vertically integrating one of the biggest PBMs with the largest U.S. drugstore chain “as a deal of equals” in the best of times would be difficult. CVS’s $2.9 billion purchase of 700 standalone Sav-on and Osco drug stores (from Albertsons in January 2006), placating its own unhappy shareholders (given the recent drop in its own stock price), and executing on potential scale (and an expected $400 million in annual cost savings)—all these potential distractions will require dictatorial management—not management by consensus.
We predict that CVS will swallow the operations of Caremark into its own $3 billion wholly owned PBM (PharmaCare Management Services, the fourth-largest full-service PBM in the nation).
Both companies have said that
the board of directors of the new company will be split evenly between Caremark and CVS. Mac Crawford will become Chairman of CVS/Caremark and Tom Ryan will become President and Chief Executive Officer. CVS Chief Financial Officer David Rickard will be Chief Financial Officer of CVS/Caremark and Caremark Senior Executive Vice President and Chief Operating Officer Howard McLure will become President of Caremark pharmacy services business.
[It is a given that administrative cuts will be made in order to realize the promulgated ‘cost-savings.’ The litmus test for this purported equal business combination will be twelve-to-eighteen months down the road—when investors see how many current Caremark executive and directors are still hanging around.]
Corporate Governance Issues
We would not go as far (as the Iron Workers) in saying that CareMark senior executives have “breached their fiduciary responsibilities”; still, a recent read of CareMark’s April 2006 Proxy Statement illustrates that top executives will profit handsomely ((once again) if this deal proves to be accretive to CVS’s profitability (and the price of CVS’s common stock retraces recent declines):
CEO & Chairman Edward M. Crawford beneficially owns 4.11 million shares of Caremark common stock, excluding an additional 5.76 million unexercised (in-the-money) stock options worth about $248.7 million (when the stock sold for $51.79 per share). Mr. Crawford is also entitled to certain “gross up” payments related to any excise tax that may be imposed when he elects to exercise the aforementioned shares.
Mr. Crawford earned a base salary of $1.6 million and a cash bonus of $3.2 million in 2005.
General counsel Edward L. Hardin has an employment agreement that states: “in no event will his annual base salary be reduced below $450,000 in any calendar year.” As an ‘inducement’ to sign the agreement, Mr. Hardin received an option to purchase 400,000 shares of common stock at an exercise price of $3.25 per share!
Mr. Hardin earned a base salary of $540,000 and a cash bonus of $1.35 million in 2005.
COO Howard A. McClure earned salary/cash bonus of $2.18 million in 2005, and is sitting on about 724,000 in unexercised options worth $14.88 million (at year-end 2005).
In late 2003, when Caremark relocated its corporate headquarters from Birmingham, Alabama to Nashville, Tennessee, certain executive officers—can you guess who—participated in the Company’s relocation services program, which included any net losses from resale of the houses, real estate commissions and other seller closing costs as a result of their transfers. To date, the Company (i.e. shareholders) has incurred aggregate costs of about $2.45 million. In addition, the Company currently has an aggregate outstanding equity advance totaling $2.90 million for Mr. Crawford, whose house has not yet been sold.
"Fear not, dear friend, but freely live your days…. Step, without trouble, down the sunlit ways" – Robert Louis Stevenson
If Caremark’s senior executives do not survive the impending management shakeout after the ‘Change in Control,’ each of them is entitled to lump sum payments (of salary/bonus).
Investment Risks and Considerations
In the last month, the stock price of CVS has dropped about 10 percent, as investors fear that retailer Wal-Mart’s $4.00 prescription drug plan—which has been expanded to include popular drugs, like the cholesterol drug Pravachol, which are exiting their 180 Day Generic Drug Exclusivity Period—will adversely impact the drugstores generic margins and decrease store traffic (and non-prescription sales).
Given that cash prescriptions account for a small percentage of CVS’s prescription volume/ profits, we view the sell-off as an irrational over-reaction.
Excluding the Caremark acquisition, CVS is selling for about 14.8 times FY 2007 consensus estimates of $1.89 per share. If CVS management can successfully execute on the opportunities of scale presented by the Caremark deal—in terms of EPS and incremental new customer traffic—the current price of its common stock could prove to be attractive to patient investors.
Risks to our assessment include potential dilution of additional CVS shares issued in the Caremark merger offsetting expected accretion to EPS from scale and administrative savings; government overhaul of existing reimbursement rates of the Medicare Part D prescription drug benefits program; higher than anticipated integration expenses from recent acquisitions; and, continued margin erosions in lower-priced generic drugs.
CVS vs. CMX 1-yr chart:
Editor David J. Phillips holds a financial interest in the common stock of the drug maker Bristol-Myers Squibb, the manufacturer of the brand-name Pravachol. He is considering the purchase, too, of shares in CVS Corp. The 10Q Detective has a Full Disclosure policy.