This was originally sent to subscribers of TheStreet.com Stocks Under $10 on March 24 at 2:55 p.m. EST. For more information on this newsletter, click here.Many investors are scrambling to come up with good strategies to play the rising costs of prescription drugs and medical treatment in general. Unfortunately, most of these investors are focused only on mega-cap companies such as UnitedHealth Group ( UNH) and Pfizer ( PFE). This has created a compelling opportunity to invest in shares of BioScrip ( BIOS). The company, a small drug distributor and pharmacy benefits manager, should deliver strong earnings growth in 2006, thanks to a recent merger and growing end-market demand for specialty pharmaceutical products. Shares were recently trading at $6.63, and we believe the stock could trade into the double-digits in the coming 12 months. Even so, we aren't adding BioScrip to the model portfolio because we already have exposure to the health care sector with two other existing positions. Also, on March 16, the company announced it was delaying its 10-K filing because it needed more time to complete its internal accounting processes. BioScrip said there will be a few one-time charges in its fourth-quarter 2005 earnings report, which should be out by the end of the month. Headquartered in Elmsford, N.Y., BioScrip was formed through the $108 million merger of MIM Corp. and Chronimed, a deal that closed in March 2005. The combined company makes money through two businesses, a pharmaceutical benefits manager (PBM) and specialty management and distribution services. The market for BioScrip's specialty management and distribution services segment, which distributes medications to patients with chronic medical conditions such as AIDS, cancer and multiple sclerosis, is growing larger as the U.S. population ages. According to research firm Sterne, Agee & Leach, about 3 million Americans live with a condition treated by specialty drugs that can cost anywhere from $12,000 to $200,000 annually. The drug distribution market is highly competitive. Low-margin suppliers and tightening financial reimbursements from the government and insurers can squeeze returns of many of the distributors, which makes cost-savings, even small ones, the possible difference between a profit and a loss. This is what makes the merger of MIM and Chronimed so crucial to BioScrip's success. Founded in 1985, Chronimed was a drug distribution company that operated some 30 pharmacies under the name StatScript throughout the U.S. Its counterpart, MIM, also distributed pharmaceutical products such as drugs through its relationships with large health care providers and insurance companies.
The combination of MIM and Chronimed provides the purchasing power and cost-savings potential to drive market-share gains and margin expansion in the coming years. At the time of the merger, BioScrip said it expected $10 million in total cost synergies to materialize over time as a result of the merger. The combined company's larger orders of drugs that it will distribute should give it purchasing power with drug wholesalers, which would help BioScrip boost its gross margins in 2006. The company's gross margin was 10.7% over the past 12 months but has been as high as 12.2% in the past five years and could head back to this level in the second half of 2006 and into 2007 on cost savings and greater revenue from higher-margin generic products. Also, combining labor forces should lead to a reduction in operating expenses as a percentage of sales because of lower employee benefit and overhead costs. The company has already laid off 67 employees as a result of the merger. BioScrip's third-quarter earnings results showed signs of successful merger integration and served as evidence that the management team is executing well. The company said its top line grew to $293.9 million, from $161.5 million in the year-ago period, and gross margins were up 20 basis points to 10.8%. Management said on the earnings call that it plans to use the BioScrip name across all of its products and services going forward, including its 30 retail locations, which we believe will lead to greater consumer brand recognition and help boost sales. In addition, the company is expanding its drug offerings at its retail locations, which should be a positive catalyst for sales and margins in 2006. During the third quarter alone, BioScrip said it added new drug-therapy offerings in 10 retail locations with plans to continue this rollout in the fourth quarter.
We believe BioScrip would make an attractive acquisition target for a larger provider of specialty pharmaceutical products, given the benefits from economies of scale in the drug distribution business. Just last year, Express Scripts ( ESRX) acquired specialty pharmaceutical distribution company Priority Healthcare in a deal valued at 15 times trailing 12-month EBITDA (earnings before interest, taxes, depreciation and amortization). This same takeover multiple applied to BioScrip would yield as much as 50% upside potential in the stock. Even if a takeover doesn't materialize, BioScrip has solid financials to go it alone. The company ended the third quarter with working capital of $78.5 million, up from $14.4 million at the end of 2004. In addition, BioScrip has access to a $45 million line of credit, which can be used to finance its operations. There are risks to holding a position in BioScrip. The company's CEO, Henry F. Blissenbach, announced Feb. 27 that he will retire when his contract runs out at the end of June. Blissenbach will remain as a consultant with BioScrip and has a noncompete agreement to prevent him from seeking other work in the industry for six months. Even so, the departure of a top executive could slow down the company's recent success. However, as the fruits of the merger continue to play out and the company posts solid earnings reports, we believe BioScrip will pick up more Wall Street analyst coverage, which should more than mitigate any near-term headline risk from the CEO's departure. As it stands now, just two analysts actively follow BioScrip, despite its generating more than $1 billion in annual sales. However, accelerating top-line growth, coupled with increased profitability in 2006, will make it hard to ignore the stock trading at just 20 times 2006 analyst earnings-per-share (EPS) estimates.