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Scrushy Is Part of Caremark's Story

The fallen HealthSouth CEO helped build the company that eventually became Caremark.

Richard Scrushy refused to answer a federal judge's questions earlier this week. Still, investors are learning what happened on his watch at

HealthSouth

(HLSH)

: About $12 billion of market capitalization disappeared amid a

Securities and Exchange Commission

suit over an alleged $2.5 billion fraud.

Less well-known is Scrushy's seminal role years ago in founding and building another health-care company:

Caremark Rx

(CMX)

. Shares of Caremark, a company focused on pharmacy-benefits management, have been a strong performer this year, up 8.6% to $17.65. Several analysts have issued bullish calls on the company, including Banc of America, which Wednesday put out a buy rating and a $26 price target on the stock. Late last month, Zacks added the stock to its All-Star Analysts Portfolio.

In an interview Wednesday, Caremark Chairman and CEO Edwin M. "Mac" Crawford said there is "absolutely no current relationship" between his company and HealthSouth. Crawford, who was a HealthSouth board member in 1998 and 1999, also said Caremark bears little resemblance to the one that Scrushy helped create 10 years ago.

Still, HealthSouth and Caremark share some similarities and many executive-suite connections, though there is no evidence of any improper activity at Caremark.

Scrushy was chief executive of now collapsed HealthSouth. The SEC alleges in a civil suit filed March 19 against Scrushy and HealthSouth that he was involved in a scheme to inflate the company's earnings by $2.5 billion.

Citing his Fifth Amendment right against self-incrimination, Scrushy declined to answer a federal judge's questions about his assets in court. He hasn't been charged with a crime, though eight former HealthSouth employees have pleaded guilty to accounting fraud. A ninth, former Chief Financial Officer Michael Martin, agreed to plead guilty to conspiracy to commit fraud.

Scrushy helped found Caremark Rx in 1993, when it was known as MedPartners, and was closely associated with the company through most of its history. At Caremark, Scrushy handpicked a management team and board members from the executive ranks of HealthSouth, served as a board member himself from 1993 to 2001 and chairman from 1998 to 1999, and acted as CEO for two months in 1998,

Familiar Faces

Scrushy is not the only individual who has served in executive or director's roles at both HealthSouth and Caremark.

Larry House was CEO of Caremark from 1993 until 1998; before that he worked as an executive reporting to Scrushy at HealthSouth. Larry D. Striplin Jr., a member of the HealthSouth board's compensation and audit committees, was a compensation committee member at Caremark.

Malcolm McVay was senior vice president of investor relations at Caremark before joining HealthSouth in September 1999. At HealthSouth, he was named senior vice president and treasurer in February 2000 and executive vice president and treasurer in August 2001. Charles W. Newhall III was a director of HealthSouth and a director and compensation committee member at Caremark.

Michael Martin, the former HealthSouth chief financial officer who has agreed to plead guilty to conspiracy charges, was also a director of Caremark.

Crawford says there are no current executives or directors at Caremark who are still involved with HealthSouth.

All of these above mentioned directors left or were removed from the board of Caremark. The company has been distancing itself from HealthSouth in recent years, partially because management at Caremark wanted the two companies separate, as Caremark sold some assets to HealthSouth a few years ago, Crawford said.

Scrushy resigned from Caremark's board in 2001 and appears to have sold a stake that once amounted to 4 million shares in the company, though he didn't file required disclosure forms in a timely manner, according to a Caremark filing with the SEC.

Two Companies, One Founder

While HealthSouth and Caremark are engaged in different parts of the health care industry, both have their roots in Richard Scrushy. The flamboyant executive has been heralded as a tech-savvy visionary who was revolutionizing the stodgy health care arena. He was working on an all-digital hospital and made speeches side by side with

Oracle

Chief Executive Larry Ellison. Scrushy was a hero in Birmingham, Ala., where numerous buildings, charities, events, and roads bear his name. It is also the place where both HealthSouth and Caremark were founded.

HealthSouth owned and operated physical therapy hospitals and outpatient surgical centers. The company was recently delisted from the

NYSE

.

TST Recommends

In 1993, nine years after he founded what was to become HealthSouth, Scrushy started a company called MedPartners, a company that would evolve into Caremark Rx, a middleman between drugmakers and pharmacies. He directed HeathSouth to provide the first $1 million in seed money for MedPartners, according to several published reports. Scrushy installed Larry House, a HealthSouth executive, as chief executive.

Like HealthSouth, MedPartners grew through mergers and acquisitions. In 1996, MedPartners merged with Caremark, itself a spin-off from health care company

Baxter

(BAX) - Get Report

. MedPartners was almost acquired for $8 billion by PhyCor. The deal fell apart; PhyCor is defunct, and Larry House lost his job. MedPartners, facing problems from past mergers, fell from $20 a share to less than $2 a share in 1998.

Scrushy, a director of MedPartners since 1993 while he ran HealthSouth, stepped in briefly as acting CEO and chairman of MedPartners in January 1998 following the ouster of House. He heralded the recruitment of Crawford as permanent CEO two months later.

"I am extremely pleased that Mac is joining MedPartners," Scrushy said in a March 1998 press release. "Mac is one of the best operators and most experienced executives in the healthcare industry and we are fortunate to have recruited an individual of his caliber."

Crawford was formerly chairman, president and CEO of Magellan Health Services, which filed for bankruptcy in March.

MedPartners stock rose the day the company announced Scrushy as acting CEO, and hovered around $10 a share for his near two-month tenure. The stock fell more than 80% in the next few months after he stepped down. Scrushy stayed on as chairman through October 1998, eventually becoming a director again.

MedPartners' stock eventually bounced back to its merger highs. In September 1999, the company changed its name to Caremark Rx as part of a major operational revamping by Crawford. Under Crawford, the company discontinued MedPartners' physician-practice management business to focus on buying drugs directly from their makers and distributing them through pharmacies. In February 2001, Scrushy resigned as a Caremark director to pursue other ventures, according to Caremark.

Scrushy didn't file required insider trading forms on time with the SEC in August through December 2000 after selling Caremark stock in several accounts he beneficially owns or controls, according to a company's proxy statement in 2001. (The appropriate forms were subsequently filed, according to Caremark.) In 1997, Scrushy owned or controlled through HealthSouth roughly 4 million Caremark shares, or 2% of the company at the time.

Cracking the Books

Caremark Rx has employed a legal but thorny bookkeeping practice known as off balance sheet accounting, which was obscure until it surfaced at

Enron

. Caremark Rx's off balance sheet activities include entities such as "MP Receivables" to lower debt on the books and facilitate raising money, according to the company's annual statements.

Crawford said the practice at Caremark is known as "receivable financing" and is used by thousands of companies. Basically, the company moves receivables, an asset, to a separate entity within the company and uses them to get lower-rate interest loans than would be raised by the larger company. The process removes assets in the form of receivables, and debt in the form of borrowing against those receivables, from Caremark's balance sheet. The company still maintains the entity MP Receivables, but isn't currently using it as it has sufficient cash flow to manage the business, according to Crawford.

Caremark Rx recognizes hundreds of millions of dollars a year in revenue from patients' co-payments to druggists, while increasing liabilities for little net effect but to boost revenue. Again, Crawford notes that the practice is common, and that the revenue-recognition policy conforms to generally accepted accounting principles and is what regulators like to see.

Merck

(MRK) - Get Report

is another health care company that has employed off balance sheet accounting in similar ways with its Medco unit, but some investors frown on the behavior. Competitors like

AdvancePCS

(ADVP)

and

Express Scripts

(ESRX)

do not recognize co-payment proceeds as revenue.

Caremark's recent earnings were fueled by recognizing a deferred tax asset; the company has a long history of losing money, largely in connection with merger write-offs, and recorded losses of $1.75 billion to date. (The first year it had taxable income was 2001.) According to Crawford and Chief Financial Officer Howard A. McLure, the recognition practice is completely normal and simply reflects the fact that it is recognizing a tax-loss carry-forward as an asset on the books, because it will reduce future tax liabilities.

In 2002, Caremark posted earnings from continuing operations of $1.17 a share. In the company's earnings conference call in February, Crawford noted that those earnings were based on the company's 7.5% tax rate. At the current 40% tax rate, earnings would have been 76 cents a share. Crawford said that for 2003, the company expects to post earnings from continuing operations of $1.02 to $1.04 a share, a year-over-year increase of 34%-37% based on the same tax rate.

Crawford said he has no idea how Caremark was originally financed, how much -- if any -- Caremark stock that HealthSouth received, how much money, if any, it invested in launching Caremark, and how much if any it currently owns. However, he is crystal clear on one point: "There is no relationship, other than a Birmingham address, that links the two companies," Crawford said. The company Scrushy started, MedPartners, does not exist anymore; management runs Caremark, the company spun off from Baxter years ago.

Jonas Max Ferris is a founder of MAXfunds.com, a fund research and analysis company, and partner in an investment advisor. He does not have any positions in HealthSouth or Caremark Rx in personal accounts or in accounts that he manages. He welcomes comments at jferris@maxfunds.com.