Application: Facilitating Strategy Formulation

STRATEGY CHALLENGE

Alan M. Zuckerman

What Would You Do?

should this successful integrated system divest one of its business units?

The Problem

Midwest Integrated Health is experiencing intensify-

ing competitive pressures and declining financial per-

formance in its regional pharmacy business. Midwest's

management team has solicited offers to purchase the

business from three vendors and believes a sale is in

the best interest of Midwest Integrated Health. The

board is reviewing management's report and recom-

mendations, including the bids ofthe three vendors.

What should the board do?

The Situation

Midwest Integrated Health is a highly successful, growing, not-for-profit integrated delivery system operating in a smaU urban area in mid-America. The system has had six straight years of outstand- ing performance, with revenues increasing from $?25 miUion to $375 miUion and total margins averaging 1? percent peryear. As a result, the sys- tem has an exceptional balance sheet, including $4,00 nullion in reserves and very little debt. Financial forecasts for the next five years, includ- ing ahility to fund capital needs, are exceUent.

In addition to its flagship hospital. Midwest has a foundation and four related business lines: > Midwest Begional Pharmacy (multi-outlet retail

pharmacy operation) > Midwest Medical Supply (provider of medical

equipment and supplies to the general public and hospital patients)

> Midwest Extended Care (operator of a ?3o-bed nursing home and 175-unit retirement center)

> Midwest Ventures (for-profit company that operates an ambulance service, a day care cen- ter, and two ambulatory surgery centers, and manages 3o physician practices)

The hospital represents about 35 percent of over- all assets and 75 percent of total revenues, but the

related business lines have been solid performers and nearly all members ofthe leadership team agree that good synergy exists among those lines.

Nonetheless, the management team has heen increasingly concerned about the future viability of its pharmacy unit. Historically this entity has been a stellar performer, but its performance is slipping, and growing competitive pressures are emerging. Growth in prescriptions filled was up 18 percent in ?ooi-o? but has decreased every year since, with 2005-06 growth only 1.5 percent. Market share in the region reached a high of 41 percent in 2005 and decreased for the first time in 2006. With significant expansion of national competitors locally in 2006-07, share is expected to drop dramatically in 2007. The unit is still profitable, but profitability is projected to decline beginning in 2007. Management has summarized the current situation as follows:

> Revenue growth is slowing dramatically. > Scripts wUl be flat for 2007 at best. > Some evidence of margin compression exists. > Walgreens has embarked on a rapid regional

expansion plan.

As a result of growing concerns about this busi- ness unit, management solicited proposals from companies interested in acquiring Midwest Regional Pharmacy. Three bidders responded to management's solicitation, and discussions and negotiations have been proceeding for months with two ofthe three bidders. Midwest's manage- ment team believes it has a fair offer from hoth bidders and that the $24.5 million offer and the terms and conditions agreed to with one ofthe companies is especially attractive.

Midwest's management team recommends sell- ing the pharmacy unit to the preferred bidder and

94 DECEMBER 2007 healthcare financial manalgement

The hospital represents ahout 35 percent of overall assets and 75 percent of total revenues, hut the related husiness lines have heen solid performers. has summarized its case in a report to the board. The highlights from the hold-versus-sell analy- sis, shown in the sidebar, were presented to the hoard.

Midwest's management team's conclusion is that the rationale to divest the pharmacy business is stronger today. The competitive environment is likely to intensify, and the downside scenario envisioned by Midwest could be significantly worse than anticipated. Given that the current bids fairly and fully valued the pharmacy unit, the management team wants to proceed to cash out while the unit was at near peak asset value. If you were in Midwest Integrated Health's posi- tion, what would you do?

The Decision

The board of Midwest Integrated Health agrees with

most ofthe managen)ent team's analysis. However, it

differs on the important issue ofthe value ofthe phar-

macy unit as a core holding of Midwest. The board's

discussion on this point highlights two issues: Midwest

Regional Pharmacy's synergy with other business

units, and its central role through many highly visible

distribution points throughout the area. The board's

conclusion is that the pharmacy unit is indeed a core

holding.

The board also has challenged management to come

up with an alternative use for the cash proceeds from a

sale that would be as beneficial to Midwest as the

investment in the pharmacy unit. Especially in light of

the magnitude of Midwest's current reserves, merely

liquidating what even management has conceded is

likely to continue to be a profitable business to add to

Midwest's bank account is not viewed as being in the

community's best interest.

Therefore, the board's decision is to reject the recom-

mendation to sell and charged management with

vigorously defending Midwest Regional Pharmacy's

position in the market, m

Alan M. Zuckerman, FACHE, FAAHC, is president. Health Strategies

& Solutions, Inc., Philadelphia ([email protected]).

HIGHLIGHTS: HOLD-VERSUS-SELL ANALYSIS OF MIDWEST REGIONAL PHARMACY

Reasons to Hold

> Midwest Regional Pharmacy is a significant contributor of operating profits to

Midwest Integrated Health. In FY06, the positive income statennent impact was

about $1.7 million and the pharmacy unit absorbed about $2 million in corpo-

rate overhead.

> Historical trends have been attractive, with a five-year (2001-06) compound annual growth rate of 15 percent. Midwest Regional Pharmacy commands a sizeable market share of about 4 0 percent.

> Midwest Regional Pharmacy extends the Midwest brand and reach in markets served by the organization.

Reasons to Sell

> Significant capital and management resources will be needed to remain com-

petitive and hold existing market share as Midwest's "natural" market matures.

Weakening economic conditions in the pharmacy business are predicted for

Midwest's service area, with payment pressures emerging as drugs become a

larger component of overall healthcare spending and increasing costs are

incurred due to the chronic pharmacist shortage.

> Financial performance is already showing some signs of weakness. Growth has

fallen dramatically, with trends suggesting further declines in FY07. Gross mar-

gins fell 0.5 percent in FY06 due to the impact of the Medicare drug benefit

shifting the mix from cash to Medicare. Further erosion of margins is expected

over the next few years, while operating costs and capital costs are increasing.

> An increasingly competitive landscape is emerging. The loss of dominant local

health plan exclusivity will invite aggressive competitors, while accelerating

encroachment of mail order and other competing distribution methods is

expected. Walgreens, with its extended channels of mail order and specialty

drug distribution, is opening three stores in the next 12 to 24 months in Mid-

west's service area. Market share erosion will occur. Each 1 percent in share for

the pharmacy unit is equal to roughly $1 million in annual revenues and

$ 2 0 0 , 0 0 0 in pretax profits.

> The pharmacy unit is not a core holding for Midwest Integrated Health and its

assets may be better deployed elsewhere. Financial markets are likely to sup-

port a sale. In addition, the timing for a sale is excellent. An active transaction

environment is in place and Midwest Regional Pharmacy has performed well

over the past several years.

M m DECEMBER 2007 9 5