The Long Case for Omnicare

| About: Omnicare Inc. (OCR)

Leon Cooperman Omega AdvisorsNewsletter Value Investor Insight carried an interview November 29th with Leon Cooperman, who runs Omega Advisors, along with Steven Einhorn, Mark Cooper, Michael Freedman and David Mandelbaum. Omega manages $5 billion, and its flagship fund has earned net returns of 16.3% per year, versus 10.6% for the S&P 500, according to Value Investor Insight. Here's the excerpt from the interview in which they discuss Omnicare (NYSE:OCR), which was trading at $39.11 at the time of the interview:

Tell us about one of your current healthcare bets, Omnicare (OCR).

David Mandelbaum: Omnicare is the nation’s leading provider of pharmacy services to the long-term-care industry, primarily nursing homes. They have centralized dispensing and packaging facilities and also provide a variety of services beyond just filling prescriptions – things like making sure people are taking their meds and aren’t having any adverse drug interactions. After buying NeighborCare last year, they have approximately 50% market share, far ahead of PharMerica and Kindred Pharmacy, which now themselves are merging into a new, independent company.

This is a business that is all about scale and market share. Ominicare has cost, price and distribution advantages from being #1, which gives them superior EBITDA margins in the 11-12% range. PharMerica’s are around half that.

The stock’s been a bit of a disaster this year, off more than 35% to a recent $39. What are the primary reasons?

DM: Several things have been weighing on the stock. First, the industry is undergoing a dramatic transition. Omnicare had previously been largely a Medicaid provider, but this year, with the new Medicare Part D program for prescription drugs, all seniors who qualify for both Medicaid and Medicare – much of the nursing-home population – are now covered under Part D. With that, instead of being price takers of state Medicaid agencies for drugs and dispensing, Omnicare now negotiates separately with all the private Part D plans, such as HMOs or pharmacy- benefits managers that are licensed under Part D. While change causes uncertainty, I generally look at this as a longterm positive. As the only truly national provider, Omnicare has been able to get better pricing from the large private plans relative to what it had under Medicaid.

Second, there’s been an overhang problem because of some investigations into Omnicare’s practices. The state of Michigan went after them over billing errors it discovered and the federal government and 42 states sued them over some irregularities in documenting the substitution of generics. Both of these have recently been settled, and while the market has tended to view these as potentially indicative of a larger problem, we generally consider these to be isolated situations that are inevitable when operating in such a complicated regulatory environment.

The third thing worrying the market is a pricing dispute with UnitedHealth. United covers about one-third of the dualeligibles now getting their prescriptions paid under Part D. Omnicare negotiated great rates with United, but then United acquired PacifiCare, with which Omnicare had a less attractive contract. United then started moving its dual-eligible members over to the PacifiCare contract, which, if it sticks, would result in a 40-cent hit to Omnicare’s annual earnings per share. Omnicare has sued them over that, and while I’m not counting on it as part of my investment thesis, I think it’s most likely there will be a positive resolution of this for Omnicare, which would be a great catalyst for the stock.

Fourth, the company has been hit with significant extra costs – which we clearly see as non-recurring – in the second half of this year, due to a fire that closed one of its two main repacking facilities. Last, but not least, Democrats taking over Congress has been a negative for healthcare stocks of all kinds.

What upside do you see for the shares?

DM: In investing in any business, but particularly relevant to healthcare, you make money when you can separate the noise from the fundamentals. When the fundamentals are strong and improving, as they are with Omnicare, the noise can create an exceptional opportunity.

Omnicare’s earnings power is very strong. They’re getting higher margins on generics, which are taking market share. Other than with UnitedHealth, better pricing is locked in for next year. We see substantial cost-saving opportunities from the NeighborCare acquisition and efficiency initiatives now underway. There are also hundreds of acquisition opportunities for them among smaller players who can’t compete in an increasingly scale-driven business, and such deals have generally been extremely accretive.

We estimate on the low end they’ll earn $3.20 per share next year, versus the Wall Street consensus of $2.90. They could do even better than our estimate if the United case gets settled in their favor.

So the shares are trading at just over 12x next year’s earnings, vs. an historical average of around 17x. Once the market sees through all the clouds and starts focusing on how well the company is positioned and the mid-teens annual growth in earnings it can produce, we see no reason this shouldn’t return to its historical multiple. At 17x, this is a $54 stock.

What are the biggest risks here?

DM: If we’re going to be wrong, it’s most likely to be from some market change, say Medicare cutting Part D rates or plan sponsors squeezing them on pricing. We don’t believe either is going to happen.