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ALCO's HOSPITAL DISTRIBUTION BUSINESS REACHED $ 650 MIL. IN FISCAL 1988 ON 25% GROWTH; LEVERAGED COMPANY FACES ANNUAL DEBT PAYMENTS OF ABOUT $ 60 MIL.

Executive Summary

Alco's distribution business to hospitals increased by more than 25% to over $ 650 mil. in sales during the most recent fiscal year. Growing by about $ 140 mil. in 1988, hospital sales increased sharply from the $ 510 mil. in the twelve months ended September 30, 1987. With the increases, Alco's hospital sales are continuing to develop into a larger share of the wholesaler's overall business. In fiscal 1987, Alco's customer mix was comprised of 50% of sales to independent pharmacies, 30% to hospitals and 20% to chains and mass merchandisers. A year later, Alco's hospital customers increased their share of the wholesaler's business by a percentage point at the expense of the independents: hospitals represented 31% of sales in fiscal 1988 while independents generated 49% (or $ 1.02 bil.) of sales. The higher proportion of hospital sales is having a predictable effect on Alco's profit margins. Its gross operating margin slipped to 7.7% in fiscal 1988 from 8.2% the year before. The company noted that this is an industry-wide trend in drug wholesaling. The firm also pointed out that the trend in gross margin erosion "has slowed" in recent years. More than half (53%) of Alco's overall sales growth in fiscal 1988 was due to unit gains. Total sales for fiscal 1988 reached $ 2.1 bil. Price increase pass throughs also played an important role, accounting for $ 120 mil. of Alco's sales growth in the most recent year. Alco's flexibility to pass along drug price increases reflects the advantageous effects of the current inflationary trends in the drug business for distributors. The continuing pace of the price increases, however, may be particularly important to Alco. Part of the rationale behind its ongoing leveraged buyout is predicated on the hidden effects of inflation on its profit and loss statement. As it switches from equity to borrowed debt, one of the key components of Alco Health Distribution's ability to handle the sharply increased debt load will be the hidden debt service in the non-cash charges to operating earnings represented by LIFO accounting provisions. Alco's 1988 figures include a LIFO charge of $ 15.5 mil.; the three months ended Dec. 31, 1988 had a $ 3.2 mil. LIFO charge. Including the non-cash LIFO charge, Alco would have had a shortfall of $ 24 mil. in 1988 if it had been funding the buyout debt that year. Alco estimates that without the non-cash charges (including amortization of goodwill, financing fees and depreciation, as well as LIFO), it would have cleared its debt requirements with $ 5 mil. to spare. According to a recent high-yield ("junk") bond filing by Alco with the Securities and Exchange Commission, the company's debt service would have shot up from $ 7 mil. in 1988 as a public company to almost $ 61 mil. under the management buyout. Alco registered to sell $ 175 mil. in high-yield securities through Drexel Burnham in an early April S-1 registration statement. The $ 175 mil. to be raised through the unsecured, ten-year notes will pay for about 32% of the $ 553 mil. buyout purchase conducted at the end of last year. The new debt will technically retire interim private notes to pay off the public shareholders. A bank group headed by Chemical Bank loaned $ 274 mil. for the purchase. Alco is going to contribute $ 32 mil. from its working capital to the deal, reducing cash on hand to $ 13 mil. (as of end of September levels). With the caveat of a leveraged junk bond buyout, the SEC filing points out that the new company will be "highly leveraged and its debt service requirements are substantial." The new company will have "substantially greater" debt than Alco did historically and the interest will bear a "higher average rate." The standard warnings are echoed by a reminder of the leverage risks in two references to Alco reserves for non-payment by Revco -- the drug chain that went from a leveraged buyout in 1987 to Chapter 11 in 1988. Alco established a reserve of $ 2.1 mil. for Revco debts to the supplier. In addition to the use of the non-cash charges, Alco plans to pay for the buyout by moving ahead with its consolidation of facilities from the acquisition growth of the past decade. Noting that the health distribution business was put together by Alco Standard with 18 acquisitions, the company says that "management believes Alco could achieve economies in warehousing, delivery and administrative charges." The wholesaler has 29 distribution facilities. It reports closing two distribution facilities since October of last year. Reportedly, the firm also considered moving its corporate headquarters from the Philadelphia suburbs to the Sunbelt, but decided against that relocation. "Management believes" Alco said, that "additional operating efficiencies may be realized through the improved management of inventory and accounts receivable." The company pointed out that control of slow moving items could provide savings. "Through centralization of these items at a single location within a given region, duplicate investment will be reduced," the offering prospectus notes. The pressures of the leveraged buyout should accelerate the consolidation of the various houses that were purchased to build the Alco health group. The company maintains a decentralized operating philosophy, noting that "each operating unit retains its individual identity in the local markets it serves and operates as a profit center with complete management, sales and operations staffs." Alco is emerging from a fast period of acquisition growth, however, and the leverage -- and some of the provisos of the financing -- should focus the company back onto consolidation savings. In fiscal 1986 and 1987, the company acquired six businesses for an aggregate of $ 62 mil.: $ 48 mil. in cash and $ 14 mil. in notes. Restrictions in the agreement limit the types of further acquisitions (to assure no further indebtedness) and divestitures. If Alco is forced to sell a segment of the business, it is covenanted that at least 75% of the purchase price is in cash. In the bidding between two management groups for Alco, the group headed by John MacNamara, who had Drexel's backing, was the winner. MacNamara is president and chief executive officer and heads the management group that has the chance to purchase a 20% equity stake (and 45% voting stake) in the firm. The registration statement gives a good look inside the incentive and retirement packages of a company caught in a buyout contest. MacNamara's five-year employment contract calls for a base salary of $ 300,000 plus annual Consumer Price Index increases and bonuses "in accordance with Alco's normal practices." He also received approximately $ 360,000 for his holdings in Alco at the time of going private. An initial buyout offer, preceding the Drexel/Citibank/MacNamara offer, was presented to Alco in March 1988 by a privately held company. A management group offered $ 330 mil. in June. MacNamara's predecessor as chief executive officer, John Kennedy, resigned in late July.
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