![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
&
Solution
s, 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](https://image.slidesharecdn.com/strategychallengealanm-221112071106-f5f6df11/85/STRATEGY-CHALLENGEAlan-M-ZuckermanWhat-Would-You-Do-docx-6-320.jpg)
STRATEGY CHALLENGEAlan M. ZuckermanWhat Would You Do.docx
- 1. 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,
- 2. 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.
- 3. 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.
- 4. 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
- 5. 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.
- 6. 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 & Solution s, 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
- 7. 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
- 8. 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.
- 9. > 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
- 10. 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 STRATEGY CHALLENGE Alan M. Zuckerman What Would You Do?
- 11. is this system's smaller hospital a keeper? The Problem Suburban System has two bospitals: a medium-sized, vibrant one in tbe western suburbs of a major metro area, and a smaller one about 20 miles further west in a semirural but rapidly growing area. The smaller hos- pital's capital needs have been deferred for many years andaré now great. However, the system does not have tbe capital capacity to keep the larger hospi- tal vibrant and make the required investments in the smaller hospital. What should the system do witb tbe smaller hospital? The Situation
- 12. Suiurban System is well-located on the western edge of a major metropolitan area. Suburban's flagship, the merger of two small hospitals 15 years ago, is a modern, thriving, community hospital situated in a growing, affluent market. The flag- ship is a ?oo-hed hospital that has generated consistently healthy operating margins of about 5 percent annually. Its volumes have grown with the community; Admissions are up ?? percent in the past five years, emergency department visits are up 27 percent, surgery volumes have risen ?5 percent, and nearly all other volume indicators are similarly positive. To continue to meet the needs ofthe community, the flagship is facing major capital expenditures over the next five to 10 years, estimated to be a minimum of $50 mil- lion and possibly as high as $80 million, apart from routine capital needs. While the flagship hospital has prospered, the smaller hospital has languished. The smaller hospital is located about ?o miles further west in a rural area, and there are no hospitals between it and Suburban's flagship facilities. The rural hos-
- 13. pital has 100 beds, runs an average census of 70, and has experienced minimal growth in the past five years, ranging from o percent to 5 percent in key areas. Operating margins have hovered between o percent and minus 2 percent for the past five years. The hospital's physical plant is functionally obsolete, it is located in a historic village on a very small site, and its technology is barely adequate. By any measure, a total renewal or replacement of this hospital will be required if it is to continue. The hospital has struggled in recent years operationally as well, facing difficulties attracting new physicians as older physicians are retiring; staffing has been an ongoing challenge. However, the area that the rural hospital serves is beginning to develop rapidly, partly due to con- tinued suburbanization as the metropolitan area pushes west, and because the local military base has been identified as a hub for the military under federal base consolidation plans. Competitors are undertaking initiatives to exploit this development. Another, larger rural hospital, about 15 miles further west, is in the midst of a
- 14. major facility expansion and upgrade, and all of Suburban's flagship's competitors have ambula- tory initiatives for the rapid growth area planned or under way. Because this is a certificate-of-need state, com- petitors' options are somewhat limited, and the franchise that Suburban has is of greater value than it would be in a deregulated environment. Capital needs for Suburban's rural hospital for the next five to 10 years range from $70 million to $100 million, depending on how Suhurban approaches this situation. While Suhurhan's financial performance has been good, its deht- to-capitalization ratio is already 68 percent and additional deht capacity is limited. Although 112 JUNE 2008 healthcare financial management STRATEGY CHALLENGE OPTIONS BEING CONSIDERED FOR SUBURBAN SYSTEM'S
- 15. RURAL HOSPITAL Option Divest - Close Divest - Sell Maintain Grow- Current Site Grow- Nev^ Site Pros Cons Pros Cons Pros
- 16. Cons Pros Cons Pros Cons Considerations > Close hospital services; maintain medical office space and basic services for local physicians. > Advantages include elimination of (historically) marginal business, ability to focus on flagship, and less strain on medical staff covering both sites. > Disadvantages include loss of market share, community backlash, likely financial losses as patients leave before hospital can close, increased costs to expand capacity at flagship for some redirected rural hospital volume, and smaller base to spread flagship's overhead costs. > In addition to those listed above, advantages include potential net gain in financial position v/ith sale, and
- 17. fewer expansion requirements at Suburban than with continued rural hospital operations. > In addition to those listed above, disadvantages include even greater loss of market share wiih new, active competitor nearby. > Continue to manage costs and selectively grow existing services, minimizing capital investments required. > Recruit physicians to replace existing ones as needed and to meet community need. > Advantages include least political risk and management attention. > Disadvantages include aging physical plant likely to result in continued erosion of competitive position and failure to attract new population to the area; moderate capital investment required; and small size, leaving rural hospital vulnerable to market and cost pressures. > More aggressively recruit physicians and selectively add programs/centers of excellence. > Develop interim investment strategy even if rural hospital is relocated eventually. > Advantages include stronger growth in market and financial
- 18. position. > Disadvantages include additional management effort and capital investment required; also, existing site may not support capacity or image required. > Aggressively recruit physicians and expand programs to become more full service longer term. > In addition to the above, advantages include new location, offering greater visibility and access. > Disadvantages include high level of capital investment required to replace hospital, longer timef rame to completion, greater management effort, and need to manage/reuse existing site. growth, philanthropy, and operational improve- ments can help raise capital capacity, it is impos- sible to see how both hospitals' capital needs can be met concurrently. Suburban's board is divided about how to pro- ceed, and discussions have been in gridlock for ?4 months. How can progress be made? Alternative Considerations
- 19. Staff were directed to thoroughly review all recent previous studies on this situation (of which there were eight, directly or indirectly related) and dis- till them into a series of options for leadership consideration. Carrying out the required capital investment at the flagship hospital was taken to be a given. Therefore, the focus was on the rural hospital. Staff identified three general options- divest, maintain, or grow—and then suboptions within two of the three general categories. A sum- maiy of staff's analysis appears in the table. Although staff's distillation and analysis were helpful, the board was still divided about how to proceed. Clearly, the desire to grow the rural hos- pital was strong, but the financial realities were equally stark. An ad hoc committee was appointed to develop a recommendation. What should that recommendation be? The Decision Tbe committee came to tbe conclusion early in its
- 20. deliberations tbat tbe maintenance strategy was not working now and was wbolly unsatisfactory going for- ward. Altbougb its preference is to grow tbe rural bos- pital, desirably on a new site close by a major interstate bigbway, tbis approacb is feasible only if "angels"can be found to support tbe large capital investment required. Tbe committee asked to be given six montbs to explore private and public options in tbis regard, up to and including obtaining a capital partner to assist in carrying out tbe necessary development. If, after six montbs, tbe committee is no furtber along or out of options to pursue, a sale is recommended as tbe
- 21. next best alternative, m Alan M. Zuckerman, FACHE, FAAHC, is president. Health Strate- gies &