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Executive Summary

The $3.8 bil. merger between Baxter Travenol and American Hospital Supply Corp. received the blessing of Hospital Corporation of America in the form of a volume purchase agreement worth over $1.5 bil. in the five-year period 1986-1990. Hospital Corporation of America (HCA) bowed out of its planned merger with American with the assurance of a long-term supply agreement and an upfront payment of $150 mil. to help the hospital chain continue its diversification efforts into HMOs and health insurance. HCA "has rescinded its notice of cancellation of its I.V. supply agreement with Baxter Travenol and has confirmed that both that agreement and its long-term supply agreement with American will remain in effect, with their terms extended by two years," Baxter and American declared in their July 15 announcement of a definitive merger plan. The two agreements with HCA "will provide over $1.2 bil. to Baxter Travenol during the next five years in sales of products and services to HCA (at least $1 bil. from the American supply agreement and $200 mil. from the Baxter Travenol I.V. solution agreement)." The $1.2 bil. figure for five years is a minimum figure. HCA is likely to buy at least $1.525 bil. from American and Baxter combined, based on an incentive bonus available to the hospital chain. if HCA buys $325 mil. in excess of the contract minimum with American, HCA can earn a $50 mil. bonus at the start of 1991. Baxter and American noted: "HCA will also receive $50 mil. in 1991 if its aggregate purchases under the five-year American supply agreement exceed $1.325 bil." Baxter/American Merger Already Intensifying Price competition; American Health Care Systems Resolicits Bids According to the three-year agreement between HCA and American signed prior to their merger accord, HCA was ready to do $325 mil. per year with American. HCA and American have amended that agreement cutting it back to a $200 mil. per year figure; but, based on the previous agreement, it is clear that HCA believes it can exceed $200 mil. a year with American comfortably. The agreement to buy HCA out of the deal was crucial to Baxter's success; it is also important as an indicator of potential price cutting which may develop in the hospital supply segment in the wake of the Baxter$/ American merger. In effect, what HCA is getting from Baxter/American is the continuation of its favorable long-term arrangements with the two suppliers plus a 4% rebate on the American purchases to be paid as a bonus in 1991. From HCA's point-of-view, the hospital chain may achieve some of the savings it sought from the vertical merger without any of the risks of ownership. HCA's deal is obviously a special case based on its tie-in to American. However, Baxter$/ American's ability to bid over a broad range of supplies for a long period of time is indicative of the new power of the combined firms and the downward pressure on prices that the dealing between big suppliers and consolidated hospital groups could have on the supply market. The reaction of one of the major not-for-profit networks, American Health Care Systems, reinforces the view of the Baxter/American merger as a watershed event presaging new price cuts. American Health Care was an interested observer in the merger machinations, but it feels it was one of the winners from the deal. The network, which encompasses 300 hospitals and represents another 650 hospitals in buying arrangements, asked for rebids on about $50 mil. in business with American Hospital Supply when the original HCA merger plan was announced. That rebidding process opened the door for bids by competitors to American Hospital Supply and almost certainly elicited lower prices for the network -- including a rebid by American. The non-profit network publicly expressed its support for Baxter's merger proposal as a way to keep a major suppply source in the industry independent and is likely to be more favorably inclined to the American bid now that HCA has backed out. Whether American gets the business back or not, a round of bidding has been initiated which can force prices down. The goodwill that Baxter created with competitors to Hospital Corporation of America by breaking up the HCA/American vertical integration could provide a good growing climate for Baxter/American. The new firm, however, will have to compete against a proliferation of other verticle tie-up arrangements. Humana, for example, announced two supply agreements during the week of July 15-19: one with the major drug wholesaler Bergen Brunswig and another with the device business of Squibb. The Bergen deal could expand to hospital supplies in the future through Bergen's Gentec subsidiary (see related item T&G-16). * Baxter goes into the new environment fully aware of the significance of its increased size and bidding power. In its public material explaining the upstream merger attempt, Baxter highlighted the deal as a way to contribute to overall cost containment efforts. Baxter President Vernon Loucks explained the basic synergy from a merged Baxter and American business in a June 28 shareholder letter. "American is respected for its strong relationships with hospitals and for its outstanding distribution system. Baxter Travenol is recognized as a highly efficient manufacturer of quality health care products throughout the world, as well as for its technological innovation. " Baxter/American Merger Creates $5 Bil. Firm In 1984 Pro FormaSales Employing 62,000 Loucks will oversee the integration of the two major firms as chief exec-designate of the combined companies. Loucks earned the top spot for orchestrating the upstream merger, but the arrangement also fits the management plan that American had worked out with HCA. The HCA top executive, Thomas Frist, was set to take the top operating spot in that merger, and American's Chairman Karl Bays was headed for the chairmanship of the merged HCA/American business. While there has been no public statement on Bays' role following the Baxter merger, he is a substantial figure in the hospital field and could play a key role for the new company in relations with customer groups and other outside parties. American moved to clarify its executive positions prior to the merger, announcing on July 18 the promotion of Frank Ehmann, hospital group president, to president and chief operating officer of the overall American business. Hal Bernthal, the current president, is moving to a vice-chairman position. Based on 1984 results, the two firms would have generated over $5 bil. in sales and $525 mil. in operating profits. Combined employment would have been over 62,000. Predicting the eventual size of the merged firms is more difficult because of the probable divestitures. A major challenge for Baxter and American will be the assimilation of two distinct corporate cultures. Baxter's sharp pencil, MBA approach to the health care business differs in style from American's service orientation. The Baxter approach to business was clearly well-suited for the merger move. American, however, has been more successful in the past in assimilating acquisitions on a smooth schedule. American has purchased at least a dozen firms in the past five years. Baxter's final offer was improved by $1 per share (to $51 per share) and specifies the three types of stock to be offered for the share exchange part of the deal. Baxter will buy up to 53% of American's 73.6 mil. shares with cash, indicating a total cash outlay of about $1.9 bil. The remainder of the American stock will be purchased with Baxter shares. The exchange formula is (1) $25 in market value of Baxter common, (2) $16 in market value of Baxter convertible preferred (convertible at a 20% premium to the closing average), and (3) $10 in Baxter adjustable rate preferred. American had lined up sufficient credit to challenge the Baxter purchase offer, but the board apparently acceded to the Baxter bid as the most prudent way to end the betwixt-and-between status in which the company has been operating. If American had tried to buy back its own stock, it would have accumulated debt without an increase in the size or orientation of the business. A counter offer for Baxter would merely have forced up the price of the merger for virtually the same outcome. Opening up the bidding to a fourth party as a white knight would have prolonged the confusion and might not have brought in as logical a partner as Baxter. An irony of the deal from American's perspective is that the company has been looking at case studies of what could happen for several years but apparently missed the upstream merger scenario. American top management has been telling hospitals for several years to watch the consolidation in the airline and trucking industries as examples of what happens to a regulated industry as competition is increased. The Baxter move against American in some respects mirrors similar deals, such as Texas Air bidding for the larger TWA, now underway in the airline business. Baxter apparently will have to fund about $250-$300 mil. in annual debt to pay for the borrowed cash and stock dividends for the merger. That figure could change significantly based on the divestitures that accompany the deal. The Street is not looking for a sharp upswing in earnings potential from the two merged companies and that could lead to one potential hurdle that the deal still has to overcome. With Baxter hovering at about $15 per share, it is not out of range of nuisance offers. The Baxter/American deal has lock up provisions. American has granted Baxter an option to purchase 18.5% of its common stock at $51 per share. However, the lock up provisions between HCA and American did not prevent Baxter's move into that deal. A prospectus on the Baxter/American merger will probably be ready by October. In combination with the HCA/American prospectus, the two documents will provide an unusual view of the health care industry from both a vertical and a horizontal perspective. Chart omitted.

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