PharMerica's Structural Tailwinds And Margin Expansion Will Drive The Stock Higher

| About: PharMerica Corporation (PMC)
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Overview and Thesis

PharMerica Corporation (NYSE:PMC) is a pharmacy services company that operates in several segments in the US. The company offers services to healthcare facilities, pharmacy management services and specialty infusion to patients outside of hospitals. PMC's primary customers are assisted living centers, hospitals, and other long term care facilities. The company services just under 200 locations in 45 states in the US and produces about $1.7 billion in annual revenue. With shares near the bottom of their 52 week range following a nasty selloff, is there any value in PMC or is it a classic trap? I'll argue here that PMC's structural tailwinds for earnings including demographics and consumer preference shifts will increase PMC's ability to convert revenue into profit and drive the stock higher.

Earnings Model

Before we look at PMC's business I think it is instructive to understand what analysts think of the company's prospects. I'll use these and other inputs I my earnings model, which you can read about here in greater detail, in order to compute a fair value for shares. My inputs and sources are as follows: 1) reported earnings, 2) earnings growth rates, 3) current book value and 4) current dividend, all from Yahoo! Finance, 5) perpetual growth rate of 3% and 6) discount rate of 9%, both of which are my numbers.

 

2012

2013

2014

2015

2016

2017

2018

Earnings Forecast

             

Reported earnings per share

$1.27

 

$1.59

$1.36

$1.50

$1.64

$1.81

x(1+Forecasted earnings growth)

 

25.20%

-14.50%

10.00%

10.00%

10.00%

10.00%

=Forecasted earnings per share

 

$1.59

$1.36

$1.50

$1.64

$1.81

$1.99

               

Equity Book Value Forecasts

             

Equity book value at beginning of year

 

$15.63

$17.22

$18.58

$20.07

$21.72

$23.53

Earnings per share

 

$1.59

$1.36

$1.50

$1.64

$1.81

$1.99

-Dividends per share

 

$0.00

$0.00

$0.00

$0.00

$0.00

$0.00

=Equity book value at end of year

$15.63

$17.22

$18.58

$20.07

$21.72

$23.53

$25.52

               

Abnormal earnings

             

Equity book value at begin of year

 

$15.63

$17.22

$18.58

$20.07

$21.72

$23.53

x Equity cost of capital

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

=Normal earnings

 

$1.41

$1.55

$1.67

$1.81

$1.95

$2.12

               

Forecasted EPS

 

$1.59

$1.36

$1.50

$1.64

$1.81

$1.99

-Normal earnings

 

$1.41

$1.55

$1.67

$1.81

$1.95

$2.12

=Abnormal earnings

 

$0.18

-$0.19

-$0.18

-$0.16

-$0.15

-$0.13

               

Valuation

             

Future abnormal earnings

 

$0.18

-$0.19

-$0.18

-$0.16

-$0.15

-$0.13

x discount factor(0.09)

 

0.917

0.842

0.772

0.708

0.650

0.596

=Abnormal earnings disc to present

 

$0.17

-$0.16

-$0.14

-$0.11

-$0.09

-$0.08

               

Abnormal earnings in year +6

           

-$0.13

Assumed long-term growth rate

           

3.00%

Value of terminal year

           

-$2.12

               

Estimated share price

             

Sum of discounted AE over horizon

 

-$0.34

         

+PV of terminal year AE

 

-$1.26

         

=PV of all AE

 

-$1.60

         

+Current equity book value

 

$15.63

         

=Estimated current share price

 

$14.03

         

With the stock trading at about $12.50 as of this writing my model suggests there is moderate upside at present. With the stock trading at the $14 just weeks ago it seems a fair assessment of the company's potential fair value. However, I believe there is even greater potential upside to this fair value in the future based upon some structural tailwinds and PMC's ability to execute on those tailwinds effectively.

The Business

PharMerica's management has made it a general policy to be geographically diversified, as you can see below. Note: the following slides are from the recent investor presentation at the BAML Health Care Conference this past May.

While I like the idea of diversification for obvious reasons it also has some drawbacks. For instance, the supply chain is more stretched with such diversification and it may be more difficult for management to support each customer with them so far apart from each other. However, it seems to be working for PMC and there is no indication of it slowing down.

The way the company has grown its footprint, and geographic diversity, is seen below.

While I'm generally not a fan of the growth-by-acquisition strategy, PMC has made it work. The reasons I dislike this strategy are: it is expensive, it is difficult to integrate new companies into yours and it is usually the strategy of an otherwise stagnant business. As for the cost of acquiring to grow, the hundreds of millions of dollars of premiums PMC has paid to acquire its targets over their intrinsic values are still are on the balance sheet as intangible assets. This is why I'm generally not a big fan of acquisitions; the price that is necessary is often so high that it can take a decade or more for the acquirer to get a return on its investment. Of course this varies significantly by deal but the enormous amount of goodwill and intangible assets on PMC's balance sheet, good for 45% of total assets as of the end of June, would suggest that PMC is paying significant premiums for its targets.

These acquisitions aren't just intangible asset events, of course, as acquirers generally require cash for payment. PMC's significant acquiring activity cannot be paid for from the operating cash of the business so it has done the logical thing and borrowed heavily to finance these transactions. The company now has $245 million of long term debt on its balance sheet, which represents roughly eleven years' worth of net income. This is an enormous amount of debt but PMC has shown consistently the ability to service it without significant adverse effects.

Earnings Growth Drivers

The most basic, and perhaps most powerful, reason I believe PMC is well-positioned for future earnings growth is the simple fact that its core customer, seniors, is going to see its demographics explode over the long term in the US.

As you can see, the population of 65+ Americans is set to double over the next 45 years. Now, while I don't expect PMC will even exist in its current form in 45 years, that doesn't mean it will take that long for benefits to accrue. Even looking out five to 10 years we can see that PMC's customer base is going to experience rapid growth of three to four percent per year. This means that even if PMC doesn't execute anything properly at all for the next few years, its revenue base should still continue to grow at 3%+ per year. Assuming that it can, that is simply additional leverage to the upside on any successes PMC experiences. This is a very simple, but very powerful, earnings growth driver over the medium and longer terms for PMC. Having built-in organic growth like this is something most businesses can't even imagine having and PMC doesn't have to do anything for it.

Next, PMC, along with other pharmacy businesses, has been distributing more and more generics in relation to branded pharmaceuticals in response to cost pressures and commensurate consumer preferences. While these generics offer PMC markedly lower revenue they also have much better margins. Thus, even though PMC's top line numbers are dropping I'd suggest that it should largely be taken with a grain of salt. Nobody likes declining revenue but if it comes with greater margins, investors should love it.

This chart depicts the meteoric rise in gross margins for the pharmacy business at PMC over five recent quarters. As you can see, in just five quarters, the pharmacy business increased its gross margins by 460 basis points. A major driver of this, as the orange line depicts, has been the increasing rate at which generics are being filled instead of branded drugs. This has allowed PMC to drastically increase its operating leverage and profit margins, as we will see later.

Since generics are a large driver of increased profitability, how likely is the trend to continue? If the slide below is to be believed, the trend is here to stay. If we look at the drugs that are coming off patent over the next five years, we see many blockbusters. Cymbalta, Celebrex, Nexium, Abilify, Crestor and others are all huge revenue drivers for their respective owners. However, as those come off of patent it will mean that, ostensibly, more people may use them due to lower cost, and when they do, PMC will be there to collect higher and higher margin rates on their generic forms.

I don't think the importance of this trend can be overstated in terms of its impact on PMC's business. This chart is certainly not all-inclusive so when you couple the blockbusters that are coming off patent along with all the other medications that aren't on the list PMC has built-in margin growth going forward. It's not specific to PMC's business but it is no less important or powerful as a result.

Finally, the dynamics we've touched on already, built-in revenue base growth and higher generic dispensing rates, are helping to increase operating leverage. For the most recent four quarters, PMC produced gross margins of 17.1%, 17.5%, 19.1% and 19.2%. As you can see, margins are increasing in a hurry and this is allowing PMC to pay down its substantial debt load along with increasing profitability in general. In addition, this extra margin allows additional operating leverage to enter the model as PMC isn't having to hire additional staff or build additional facilities for this margin; since the margin tailwinds are structural PMC is producing extra profits with little incremental effort. If that doesn't get shareholders excited about the prospects of this company I'm not sure what would.

The Bottom Line

PharMerica is in a tough business. It operates on thin margins, as is traditional in its line of work, and shares have been punished in the past for management's transgressions in the eyes of shareholders. However, I believe PMC has a business model that will allow it to capitalize on the trends we discussed above in a big way. Management has been working to take cost out of the model through improved purchasing practices and technology improvements. Demographic trends favor PMC in a big way over the medium and long terms through the general trend of the US population aging. Expensive or not, PMC will likely continue to make acquisitions and grow market share, achieving some scale in the process and building its brand for the future. All of these things will factor into PMC's earnings capability in a positive way.

In terms of a value for the shares, if we assume demographic trends contribute three to four percent growth each year, management can find 50 basis points of efficiencies each year and that gross margins continue to increase even 50 basis points per year (which is very conservative), PMC could be earning 3%+ on sales next year and perhaps closer to 4 percent in 2015 - 2017. With analysts expecting 2.7% return on sales that would equate to large earnings beats and would undoubtedly send the stock much higher. An earnings growth rate of 12% to 15%, under the scenario I've highlighted, would mean that PMC's shares are grossly underpriced at less than 10 times next year's earnings and if I'm right, the earnings multiple should expand to 12 or 13, offering additional upside to the $20+ area next year and beyond. I think analysts are underestimating PMC's ability to expand margins and I believe that is where the opportunity lies. If you want for them to catch up, however, you'll miss the move.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in PMC over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.