Long's Drugs Stores Corporation Shareholder Meeting, May 29, 2008

The Longs Drugs Stores shareholder meeting (LDG, 2008) took place at the Shadelands Arts Center in Walnut Creek, CA. Walnut Creek is a storybook kind of city, with trees, churches, and friendly people seemingly on every corner. The Shadelands Center in Walnut Creek is a room that is part of an overall community center. There were about 160 chairs in the room. Food was practically non-existent. Pepperidge Farm's basic "Milano" cookies were served with some coffee and water. (Of all the Pepperidge Farm products to bring, why, oh why, did it have to be the basic Milano?) Needless to say, I was not impressed with the food offerings, and with the meeting being held in a community center, and no company products being given away, I was ready to call "cheapo" on Longs. I was pleasantly surprised, however, by the quality of the presentation. Longs is an old-school company, but if you're dealing with drugs, maybe old-school is just fine.

First, some definitions: PDP = prescription drug plan; PBM = pharmacy benefit management services; and front-end sales...we'll get to that later.

Longs Drugs first began by introducing its Board. The actual presentation was done by slides. Longs' CEO, Warren Bryant, talked about "superior customer service" being an "important differentiator." He seemed bullish on Hawaii. Longs opened six new stores there, while shutting down stores in other states. A slide indicated that Longs opened its first store in Hawaii in 1954.

Rx America, LLC (http://www.rxamerica.com/) is Longs' real jewel. Longs doubled its Medicare beneficiaries from the previous year.

Longs touted its share buybacks and community service (local charities and Governor's Council on Fitness and Sports).

The Q&A session had exactly one person who asked questions, and yes, it was yours truly. I asked what "front end sales" and "front end merchandise" meant. (See 21-23 of 10K, etc.) The CFO said it basically meant "everything other than prescription sales." This is an important term and should be defined more clearly in the 10K--other drug stores (e.g., Rite Aid) have been hit with accounting scandals, so drug companies need to be as clear as possible in their accounting terminology.

I asked the CEO about Longs' reliance on AmerisourceBergen (Symbol: ABC), which supplies them with most of their drugs (http://www.amerisourcebergen.com/cp/1/). (ABC's numbers are difficult to decipher because of the acquisition of Bellco in October 2007 as well as its share buybacks.) I asked why Longs didn't take a minority stake in such an important partner, and only did a 50% joint venture with them. CEO Bryant said that ABC was a publicly traded company and that Longs had no investment stake in it. He deferred the joint venture question to the CFO, who said that about eight years ago, ABC and Longs started a joint venture to open a "central fill operation" in Sacramento, CA, which was completed about three(?) years ago.

I asked whether Longs had a "poison pill" provision to prevent a takeover from CVS or Walgreen's. The CEO made some comments but basically said that it was a matter for the Board of Directors. The general counsel chimed in and said that after a stockholder's rights plan amendment a few years ago, there was no "poison pill" as the term is generally understood. I am betting CVS eventually makes a bid for Longs.

Before I get to the annual report, one interesting tidbit--I heard some directors talk about Dubai. One said, "I was just in Dubai--fabulous." Dubai is getting a good reputation among businesspeople.

Here are the highlights from the 10K:

Pages 14-38 are about compensation. (The first part of the 10K pamphlet is a compensation audit.)

The actual 10K report begins on a separate page 1 after the compensation audit. Longs was founded in Oakland, CA in 1938 (page 1).

Pages 39-40 would be fun to read for employment lawyers. Longs talks about what a "for cause" departure is for severance package purposes.

Longs has 510 stores, mainly on the West Coast and Hawaii (447 stores in CA: see pages 6, 13).

Here's an interesting part: RxAmerica, Longs prescription benefit subsidiary, is buying an insurance company (which it openly refers to as a "shell" company). Longs has to buy such a company because the new Medicare rules require all prescription plan providers to do so--although I can't figure out why, other than the reference to plan providers shouldering some of the risk and the expiration of Medicare and Medicaid waivers. The company is Accendo (page 2), which used to be Nutmeg Life Insurance (page 5). Now, here's the issue--presumably, these insurance companies have issued policies to customers. What happened to all those policies, especially the life insurance ones? I should have asked this question at the meeting, but I really didn't have much information about the insurance company transaction, so I refrained.

See also pages 11-12: For 2009 and forward, "in accordance with the federal statutory mandate [Medicare Prescription Drug, Improvement, and Modernization Act of 2003], the insurance company [Accendo] will provide the Medicare prescription drug plans." Apparently, Accendo has to make a bid to CMS (Center for Medicare) for 2009. Seriously, could Longs be more vague?

Longs completed a distribution center in Patterson, CA (I've never heard of that city before).

Longs has 21,900 employees, with 55% being part time, and non-union (page 5).

Medicare and Medicaid = 24% of pharmacy sales (page 6).

Longs 4Q sales increase not only generally because of the holidays, but because of the cold and flu season--when people need drugs and flu shots (see page 6). I had forgotten that Longs and other drug makers love it when we get the flu. What's also interesting is that the report implies that the fourth quarter seems to be when Longs does much of its non-pharmacy business, but that reading could be a mistake on my part. I need to see the quarterly reports to confirm this overall 4Q-concentration, because it seems counterintuitive.

As indicated previously, AmerisourceBergen (ABC) is Longs major supplier of drugs (page 6). A joint venture is mentioned on page 28.

Page 7 indicates that Longs fears competition from mail order services. (Really? I wouldn't want to get my drugs by mail from an unknown company. Perhaps Canada is operating reputable mail order facilities?)

Page 5--no international sales.

Page 8--Longs plans on closing 31 stores in 2008.

For all you job-seekers and college hopefuls--on page 9, Longs says there is a "shortage of licensed pharmacists."

Page 14: this is why people hate lawyers. See Rankin v. Longs Drugs Stores California, Inc. (legal name). Basically, the lawsuit alleged that Longs employment application violated Labor Code 432.8 by inquiring about criminal convictions over the last seven years, without carving out an exception for marijuana use more than 2 years old.

LC 432.7, which is where 432.8 derives from:

(a) No employer, whether a public agency or private individual
or corporation, shall ask an applicant for employment to
disclose, through any written form or verbally, information
concerning an arrest or detention that did not result in
conviction...

So the lawsuit alleged that job applications must specify that a company is asking for non-Mary -Jane-related convictions. Can you say, "technicality"? Unfortunately, that's how many (most?) lawyers make money in state court--by doing what they were taught in law school, which is to parse everything and abuse technicalities. (State court is far more nurturing of the technical than federal court, which tends to look at the substance of a complaint.) Go legislators! Don't stop until you've made it impossible for any small business to survive in California without having an army of lawyers. (If this were a Tom Toles cartoon, the bottom right hand side of this piece would say, "You're almost there...")

But enough against lawyers--how else would a bloke like me make money?

Longs has properties located in CA, UT (pharmacy benefits), and NV (call center).

Page 19--Longs expanded in Reno by buying out some other company's stores. Nice move--with all the hangovers from gamblers and revelers, Longs should do good business there.

Page 24--more generics lead to better profit margins for Longs. Retail drug store gross profit was 26% of retail drug store sales in 2008.

See page 24-25: as a result of the way Medicare Part D works, Medicare doesn't actually provide any fees to the drug company until after a Medicare recipient spends more than $2,510 on prescriptions. Then, from $2510 to $5726, the recipient covers all costs. Then, from $5726 onward, the drug provider is responsible for 15% of the drug costs. So basically, until grandma spends $5726, Medicare isn't very profitable for a drug provider, and it takes several months to get there--another reason why Longs makes much of its money in Q4.

So there you have it--Longs is going to be a good company and attractive takeover target, assuming its insurance company purchase works out. It's too difficult for new entrants to get into the pharmacy business, so there seems to be a wide moat here. Also, no one (except maybe Walgreen's) has the stores in California that Long's has, so CVS is going to be knocking one of these days. As long as anti-trust issues don't harm any possible deal, Longs should be a decent long term investment. I will look to add shares if Longs falls to the low 40's and will also be looking at AmerisourceBergen (ABC).