Kindred Kindles Hope

An Amerisource link could pressure Omnicare.
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AmerisourceBergen

(ABC) - Get Report

and

Kindred Healthcare

(KND)

plan to combine their institutional pharmacy units into a new, publicly traded competitor in that sharp-elbowed business.

The transaction would create the second-largest institutional pharmacy in the nation, with $1.9 billion in annual revenue and an estimated $1.2 billion in market value. Shareholders of AmerisourceBergen and Kindred would split the new company equally in a spin-off set for the first quarter of 2007.

AmerisourceBergen, which currently operates the larger of the two institutional pharmacies, rose 1.1% to $43.19, while Kindred jumped 6.9% to $31.

Institutional pharmacies cater to nursing home residents, a growing market that poses long-term opportunities -- as well as significant risks -- under the revamped Medicare system. News of the deal came less than two weeks after

Omnicare

(OCR)

, the country's largest institutional pharmacy, reported major setbacks in the wake of sweeping Medicare changes.

"This transaction is a huge win for patients, customers, associates, suppliers and shareholders," insisted AmerisourceBergen CEO David Yost. "It will build on the best of both organizations, as the new company becomes a national force in a growing market."

Admittedly, it will allow AmerisourceBergen and Kindred to focus on other prospects as well. AmerisourceBergen is primarily known as a pharmacy distributor that acts as a middleman between drugmakers and drug sellers. The company recently reported strong results from its core distribution business while hinting at ongoing challenges in its institutional pharmacy division.

Kindred runs hospitals, nursing centers and rehabilitation facilities. Without its institutional pharmacy, Kindred can spend more time on company-owned hospitals, which now face lower Medicare payments for short-term patients.

Stifel Nicolaus analyst Jerry Doctrow applauded the deal on Monday. Kindred is a client of his firm.

"We view this transaction as positive for Kindred shareholders, as it unlocks the value of the undervalued pharmacy division," wrote Doctrow, who has a hold recommendation on Kindred's stock. Meanwhile, "we see the transaction as incrementally negative for Omnicare, as the spun-off company will be a more significant national competitor. ... However, investors should keep in mind the new company will be only about 30% Omnicare's size in terms of pharmacy revenue -- and the strategy for the new pharmacy seems to endorse many of the advantages that Omnicare already has or is pursuing."

Omnicare slipped less than 1% to $46.18 on the development.

To be sure, Omnicare's strategies have not fully paid off yet.

Rather, Omnicare last month announced disappointing results while rolling out a major restructuring plan. The company blamed the new Medicare Part D program, including poor reimbursement from a major Part D player, for the shortfall.

Omnicare claims that

UnitedHealth

(UNH) - Get Report

promised higher payments for Medicare Part D services than it ultimately delivered. Specifically, Omnicare says that UnitedHealth switched its own customers to less favorable contracts that had been negotiated by its newly acquired PacifiCare division. Omnicare has sued UnitedHealth for alleged fraud and violations of antitrust laws as a result.

UnitedHealth has denied any wrongdoing.

In the meantime, however, Omnicare has suffered dearly. The company's big second-quarter miss, along with its reduced full-year guidance, came as a direct result of the lower UnitedHealth payments.

The shortfall took some, like JMP Securities analyst Alexander Draper, by surprise. Draper had assumed that the UnitedHealth cuts would reduce Omnicare's earnings by just 1 cent a share in the second quarter and 8 cents in the second half of the year. Instead, he notes, those cuts cost Omnicare a full 9 cents in the second quarter -- and will likely whack another 21 cents from the company's bottom line over the course of the next two quarters.

Draper downgraded Omnicare's stock following last month's disappointing update. He no longer has a strong buy recommendation on the stock, but still believes the shares will outperform the market due to the apparent soundness of the company's business.

For its part, Omnicare has already promised to do better. Notably, the company announced a major restructuring plan that's intended to slash costs by $120 million going forward.

"Omnicare -- and our whole industry -- must continue to meet the demands of the nation's health care system for cost containment and enhanced patient care," Omnicare CEO Joel Gemunder stated last month. "The 'Omnicare Full Potential' Plan will allow Omnicare to take advantage of economies of scale, standardization and automation to increase efficiency across our enterprise. ... Bottom line, we see this program as leveraging the benefits and strengths of our business platform and growth strategy."

Omnicare must now test that plan against a new competitor that intends to adopt a similar strategy of its own.