Description

Express Scripts

ESRX

$63.60

Investment Summary

Express Scripts is the leading Pharmaceutical Benefits Manager (PBM) in the U.S. after recently merging with one of its few major competitors, Medco. Express’ primary business is to negotiate with drug stores and pharmaceutical companies on behalf of its corporate or insurance clients in order to lower the cost of drugs and improve clinical outcomes. The company is run by a savvy management team led by CEO George Paz, who has been CEO since 2005. At 13x 2014E P/E, the stock is significantly undervalued given the quality of the business, likely strong EPS growth and excellent management team. We believe an investment in Express’ stock will generate compelling annual returns over a 5 year period with minimal risk of capital loss.

The Business

Express sells prescription drugs and management services to insurance companies and health plan sponsors (employers) through 3+ year contracts, leveraging scale to negotiate lower drug costs from retailers as well as branded and generic suppliers. Express and other PBMs take a cut of the cost savings – the spread between the price to health plans and the cost from the manufacturer or the reimbursement from retail pharmacies. There are essentially two routes for drugs to flow through the supply chain and arrive in patients’ hands: through a retail pharmacy or through a mail-order pharmacy run by a PBM. Admittedly over-simplified versions of the two routes are below:

Retail Channel: 

Drug Manufacturer --> Retail Pharmacy --> PBM --> Payer --> Patient

Mail Channel:

Drug Manufacturer --> PBM Mail Pharmacy --> Payer --> Patient

PBMs are also paid an administrative fee per script. Note that client RFP processes are typically consultant driven.  Importantly, while Express is more advanced in its service offerings than its competitors, the business is largely a commoditized one, and therefore Express’ economies of scale are an important differentiator.  That said, Express is keenly focused on “consumerology,” using behavioral analysis to determine how to best motivate patients to opt for the most cost effective form of drug delivery as well as improve adherence (i.e. taking their medications). 

A PBM helps solve the continual need for health plan clients: containing drug costs.  The main drivers of reducing drug costs for clients are buying power as well as shifting to generics.  Moving willing clients’ customers to receive prescription drugs through mail delivery also lowers costs by cutting out the retail pharmacy. Note that PBMs are on the right side of the health care issues in the country by helping contain runaway costs.  Since the private sector is largely left with the burden of controlling costs, we believe that there could be not only continued relevance of PBMs but also a greater role in other areas of healthcare.

Express is a great business that enjoys high returns on capital.  Before its merger with Medco, Express earned a 17% ROIC even after building up intangibles with multiple acquisitions over time, and a 40% ROE.  Client retention is ~95% annually. The company has multi-year, staggered contracts with its clients, retailers, and drug manufacturers.   

It is important to note that Express generates a significant portion of its gross margin and profits from generics (where it has more bargaining power with multiple suppliers than with branded drug makers) and through its mail business (where it can cut out the retailer). 

Competitive Position

Express is the clear leader in a virtual duopoly with CVS/Caremark.  Express currently owns 34% of the $280 billion U.S. PBM market.  Caremark has 26%.  Several smaller players have less market share:  Optum (a division of UnitedHealth) has 12% which is 80% or more United business, Catamaran has 5%, and Prime has 5%. Contrary to industry hearsay, we believe large players will continue to act rationally on price, as oligopolists should. 

Express’ most significant competitive advantage is scale. Negotiating leverage from scale over retailers and drug manufacturers drives sustainable cost advantages, and cost to the client is the most important factor in retaining and winning business. Importantly, Express has not yet fully leveraged its improved market power from merging with Medco, which we view as a good opportunity to drive higher gross margins over the coming years. Express’ scale also provides access to more data than any other PBM has, driving superior analytics that allows Express to best optimize drug selections as well as influence patient behavior.

It is worth noting that Express has specialized in the push to generics and emphasizing of behavioral outcomes while Medco has been more focused on the shift to mail and on therapeutic optimization. The merger was good in more ways than simply economies of scale as optimizing both mail and generic penetration for the combined company should drive higher earnings.

The recent Express/Walgreens dispute illustrated Express’ strong competitive position. In June 2011, Walgreens (the largest retail pharmacy in the U.S.) would not agree to the pricing demands Express required to keep processing prescriptions with them. In a high stakes game of chicken, Express did not back down and pulled their customers from being able to buy drugs at Walgreens stores. Shortly after the Express/Walgreens contract was terminated, Express made a bid for Medco (Walgreens only real PBM alternative to Express) as Medco’s stock price was particularly weak. Express then steered its scripts away from Walgreens for nine months, at which point Walgreens realized the game was up and was forced to crawl back to Express at less advantageous terms. This situation shows the dramatic power Express has in the industry and will likely deter other, smaller retailers from balking at Express’ pricing.

Industry

PBMs play a key role in the prescription drug value chain. Effectively, a PBM consolidates millions of patients’ demand for scripts in order to drive a volume-based price discount when purchasing drugs. PBMs’ bargaining power varies greatly depending on whether the drug is branded (one supplier) or generic (multiple, commoditized suppliers). When 5 or more generic suppliers are competing for a large volume contract with a PBM, the PBM has enormous bargaining power. Even amongst generics, the gross margins on a particular drug can range from ~15% to over 50% depending on the number of manufacturers.

There are a number of tailwinds for the PBM industry.  Drug utilization rises over time, although it has been flat more recently because of the poor economy (fewer employed lives covered and less disposable income for drugs). Specialty drugs, i.e. large molecule biotech drugs, are expected to grow 10% over the next five years, and Express has a disproportionate 40% share of the non-medical specialty market. Also, branded drug price inflation of 5-8% over time is a positive factor.  The population is aging, and people tend to take more pills as they age. Lastly, there will be 30-40 million new insured people from Obamacare, although the profitability of these new covered lives is not yet clear.

Generic and mail penetration over time has significantly improved PBMs’ profitability. Generic penetration industry-wide has increased from 40% of scripts in 2002 to 77% in 2012. Given upcoming patent expirations, 2017 generic penetration is expected to be roughly 85%. 

Industry-wide mail penetration is 18% of scripts. (Express’ mail penetration is 28%.) There is room for increased penetration since 74-85% of scripts are chronic/maintenance. Movement to mail has been slow, partly as older people take a disproportionate amount of drugs and are slower to move to mail. Mail is superior to retail in driving down costs not only because it cuts out the physical retailer but also because it leads to better clinical outcomes through better adherence and compliance.  Mail is also safer since there are fewer fill errors than at retail pharmacies.

Management

The management team, led by CEO George Paz, is excellent with respect to operations, strategy and capital allocation. Paz joined the company as CFO in 1998, became President in 2003, and CEO in 2005.  Since joining, Paz and the management team have created tremendous value for shareholders: the stock price has risen 24% annualized since 1998 and 23% since 2003.  Paz owns ~$138 mm of stock. The company has a record of smart and successful acquisitions, Medco being the last.  Management believes that the pure PBM model is superior to that of a blend of both PBM and retail, such as CVS/Caremark, a view with which we agree. Paz has also proven very strategically savvy as the Walgreens dispute illustrates.

Management is focused on the right metrics: cash flow per share, ROIC, and growing EPS over the long-term.  Long-term compensation is based on total stock return, EPS growth, and ROIC.  The company has been a longtime user of both debt and share repurchases to enhance shareholder value.

Also, while the company has indicated that its Medco merger synergy goal is $1 billion, we believe the number could be substantially greater than this, especially when the market power of the combined company is exercised.

Price

Express currently trades at 13x 2014E P/E, which we believe is a significant discount to intrinsic value. (We believe 2014 is the best indicator of the price as 2013 has a number of one-off puts and takes in earnings, e.g. merging Medco and running-off the legacy Medco UnitedHealth contract.)

The current price does not reflect Express’ strong position in a near-duopoly with good growth prospects from increased generic penetration, drug price inflation, increased insureds from Obamacare, an aging population and higher mail penetration. Improvements in employment and expansion into adjacent areas of healthcare may also prove to be quite beneficial to Express’ earnings power over the next 5 years. Furthermore, the current valuation does not factor in the company’s high quality management team who will likely deploy capital in value-accretive ways over the next 5 years. Note that 13x P/E is near the lowest trading multiple Express has had over its long history and provides a great entry point for an excellent business. Over a 5 year time horizon, we believe Express’ stock represents an excellent risk/reward.

Because of near-term issues including contract renewal pricing, the economy’s impact on script volumes, the Medco merger, the loss of UnitedHealth and the impact from Obamacare, modeling Express’ EPS with great specificity over the next several quarters or the next year is quite difficult. This uncertainty around near-term EPS has led to the stock’s low multiple. While we agree that volumes may be weak due to high unemployment, there is also concern amongst analysts and investors that pricing in the industry is weakening, which we do not believe is correct. The near-term uncertainty is creating opportunity for attractive long-term returns.

Risks

U.S. shifts to single-payer healthcare system. This seems very unlikely given the recent huge battle just to get to Obamacare.  Similarly, if the federal government were to decree lower prices for drugs, this could reduce the PBM’s value in reducing drug costs.

Two large customer contracts that represent ~21% of revenues. The Wellpoint contract, which expires in 2019, was 25% of Express’ revenues before the Medco merger. (We estimate that percentage is now ~13% of the combined company.) The Department of Defense contract is ~10% of the combined company’s revenues and expires in October 2014. The next largest client is ~3% of total revenues.

Increased regulation and potential litigation surrounding pricing and rebates. Although nothing is currently on the horizon, there is potential for regulatory involvement in the practices of the industry (such as the relative opacity with which contracts allocate pricing and costs). 

Independent PBM model loses favor amongst clients. While there are advantages to being an independent PBM, we have to consider the possible complications of not being aligned with a retail chain (such as Caremark with CVS) or an insurer (such as Optum with UnitedHealth).

Catalyst