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McKESSON CONSIDERING STOCK BUYBACK OR SALE OF PCS PRESCRIPTION CLAIMS PROCESSING UNIT; PCS NET INCOME PLUNGED 51% IN QUARTER ENDED JUNE 30

Executive Summary

McKesson is considering either increasing or selling its 86% interest in its prescription drug claims processing unit PCS, which was spun off by the drug wholesaler at the end of 1986, PCS announced July 31. "McKesson is reviewing its alternatives regarding its [86%] interest in PCS, including increasing or disposing of its interest," McKesson explained. The wholesaler said it has hired the investment banker Morgan Stanley to help handle any transaction. Goldman Sachs and Morgan Stanley jointly managed the original PCS spin-off. * The announcement comes as potential contractors, including PCS, are preparing bids to win one of three available contracts to process drug claims under the upcoming Medicare catastrophic care outpatient drug benefit, scheduled to go into full effect Jan. 1, 1991. A McKesson spokesperson declined to specify when a transaction might happen, but indicated any action would take place "expeditiously." If the decision is to divest PCS, industry observers say there are at least five or six firms that have expressed active interest in acquiring PCS. McKesson first acquired an equity position in PCS during the early 1970s. The announcement of a possible divestiture followed closely on the heels of the departure of PCS President and CEO Donald Dahlin. PCS said it has named John Pfeiffer to assume Dahlin's former responsibilities while it searches for a permanent replacement. Pfeiffer, 63, retired in 1988 as VP and general manager of McKesson's Data Systems and Services unit. Dahlin reportedly informed the McKesson board June 15 of his desire to leave PCS, and he and McKesson put together a severance package that will be charged against earnings for the second quarter (ending Sept. 30). Terms of that deal have not been released. Dahlin, 38, joined PCS in 1981 in the chief executive spot. McKesson has held approximately 12.5 mil. of the roughly 14.6 mil. PCS shares outstanding since 1986, when 2 mil. shares were sold to the public at $ 12 each. The price of PCS stock shot up quickly -- topping the $ 30 per share mark in 1987 -- as the "Street" saw the growth potential in third party claims processing in general and the upcoming Medicare drug benefit in particular. More recently, however, the price of PCS stock has retreated, closing at 14-1/4 on July 28, the last day of trading before McKesson made its announcement. Since the announcement, PCS stock jumped 2-1/2 points to close at 17 on Aug. 4. At that price, McKesson's 12.5 mil. share stake in PCS is worth about $ 212.5 mil. First quarter PCS financial results may have stimulated McKesson's interest in changing its relationship with the company. Net income for the three months ended June 30 plunged 51% to $ 1.6 mil., PCS reported July 31. First quarter revenues rose only 7.6% from last year, to $ 23.9 mil. The number of claims processed during the period was up slightly, to nearly 23 mil. "Health care insurers, PCS' major source of business, have been focusing their underwriting efforts on controlling spiraling health care costs," McKesson and PCS Chairman Thomas Field explained. "As a consequence, new cardholder growth has slowed in the last 12 months. The number of PCS cardholders at the end of the quarter was 8.1 mil. compared with 8.2 mil. at the end of March and 7.8 mil. a year ago." Approximately 80% of PCS revenues come from claims processing; the remainder is derived from the prescription audit and market research operation, Pharmaceutical Data Services. * Despite the sharp drop in PCS earnings, the prescription drug claims processing unit continues to provide McKesson Corp. with higher margins that the company's drug distribution business. McKesson Drug, by comparison, reported a first quarter sales increase of 10.9% to $ 1.5 bil. and a 10% increase in operating income to $ 34.2 mil. PCS operating profit declined in 1989 from $ 5.2 mil. in 1988 to $ 1.9 mil. PCS currently processes about 90 mil. prescription claims each year, about double the number processed in 1986 at the time of the McKesson spin-off. It is estimated that under the Medicare outpatient drug benefit, about 720 mil. claims will need to be processed annually -- split between the three claims processors on a geographical basis. The Health Care Financing Administration has scheduled an informational meeting with bidders Aug. 9 in Baltimore. Bids from potential Medicare drug benefit processors must be submitted to HCFA by Oct. 2. Over the last 18 months, PCS has been rapidly expanding its Recap electronic claims processing system network, which allows instant verification and eliminates paperwork, in order to prepare for the onset of catastrophic coverage. About one year ago, PCS reported to analysts that 10,000 of its 59,000 affiliated pharmacies in the U.S. and Canada were a part of the upgraded Recap-II system; 40,000 were targeted for the end of 1989. The firm estimates that when fully installed, Recap II will be able to handle 500 mil. on-line transactions a year. While McKesson has recently continued to talk up the importance of PCS to its future, the unit has also been the subject of conflict between McKesson and NARD. That conflict may have played a role in the company's reassessment of its relationship to PCS. McKesson and PCS have come under fire in recent months for a spring trade advertisement featuring an "open letter to retail pharmacists" from PCS Chairman Field. While reaffirming McKesson's close relationship to and support of pharmacists, Field noted that as a result of "pressures of the marketplace, PCS has offered plan sponsors a menu of cost-containment options." NARD Exec VP Charles West blasted the drug distributor in a March 27 letter for trying to "explain away the fact" that the marketing strategy of its PCS subsidiary "encourages a discount off the average wholesale price." West called the strategy "nothing more than a private sector version of HCFA's attempt to confiscate pharmacists' earned discounts. It's that simple." Field's open letter added fuel to a PCS brochure obtained by NARD in October 1988. The brochure includes a section on AWP in which PCS advises that "by applying a discount to AWP, usually 5% to 10%, a new upper limit of payment is established that more closely approximates [actual acquisition cost]. Our analysis indicates that significant savings are generated from this approach." In an April 7 response to West, then-PCS topsiders Dahlin and Field stressed the potential of Recap-II to create new alternatives to controlling drug cost plans "while providing fair and reasonable reimbursement" to pharmacists. PCS met with NARD, which subsequently issued a statement saying the company would be reviewing its discount policy on a case-by-case basis.
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