The rising cost of healthcare is one of the most fundamental and daunting economic challenges that the United States is facing moving forward. Therefore, businesses that can lower these costs and improve patient outcomes are likely to thrive, while companies that have benefited from fat profit margins at the expense of patients and insurers are likely going to have to adjust their business models. It is in this context that Express Scripts (ESRX) appears poised to gain market share and increase profitability through lowering the costs of pharmaceuticals for health benefit providers. While the pricey $30 billion acquisition of Medco enhanced financial leverage and risk, the synergies and benefits of consolidation should be highly accretive for the company. At a recent price of $53.30, we at T&T Capital Management (TTCM) believe that Express Scripts is a very good business selling for a reasonable price, and should be accumulated on dips.
It is no secret that medical costs for employers continue to outpace the rate of overall inflation. While providing healthcare for all U.S. citizens is clearly an admirable objective, the program must be paid for and will most certainly enhance these already inflated costs. In response to these pressures, health benefit providers such as managed care organizations (MCOs), health insurers, employers and unions are increasingly benefiting from the scale and efficiencies that Express Scripts can bring its customers. The company has more than 100 million members and due to industry consolidation now controls roughly one-third of U.S. pharmaceutical spending. The company is able to lower costs through leveraging purchasing volume to deliver discounts to health benefit providers, and through promoting the use of generic and low-cost brands. In addition, Express Scripts provides health benefit providers with key administrative assistance in evaluating drugs for price and value to aid in its customers' ability to select cost-effective formulas. The company's number one competitor is CVS Caremark (CVS) and many of the other smaller competitors have been looking to exit the business, and are interested in obtaining the benefits that Express Scripts size can provide.
In late 2011 to early 2012, I was quite surprised by the disastrous consequences of Walgreen's (WAG) dispute with Express Scripts. Basically Walgreen fought for better pricing, but when Express Scripts didn't comply and instead directed its customers toward competitors such as CVS or mail delivered pharmaceuticals, Walgreen's business suffered materially. Even after eventually coming to an agreement with Express Scripts former Walgreen clients haven't returned nearly as quickly as they have left, yet Express Scripts faced a relatively low number of problems associated with the disagreement. This brief quarrel proved to me that Express Scripts had a stronger competitive advantage than I initially believed. In 2011 ESRX's top 5 clients, including Wellpoint (WLP) and the Department of Defense, collectively represented 56.7% of revenue. This concentration was a bit scary for me because often such a concentrated client base weakens the pricing strength of a company. The fact that Express Scripts was able to fight off Walgreen and emerge as a stronger company because of it highlights the value and attractiveness of the service it provides its clients, and the impressive competitive position of the company in the pharmacy benefit management (PBM) industry.
There is no question that the $30 billion price tag for Medco was not an easy pill to swallow. Express Scripts wisely used a combination of cash and stock for the purchase so that the combined company wouldn't be buried with an unsustainable debt load. The Medco acquisition took out a large competitor in addition to significantly enhancing the purchasing scale of Express Scripts, allowing the combined company to drive for bigger bargains from its suppliers. The company's combined expertise and customer base allow for the reduction of redundancies that should bring in excess of $1 billion in overall cost reductions. Many of these cost reductions will be achieved through streamlining claims processing and mail-order distribution, as opposed to having two unique systems to deal with. Express Scripts has historically done a wonderful job in keeping its customers in its network with a retention rate around 94%. Many of Medco and Express Scripts customers have long-term contracts so there isn't much risk of significant short-term network dropouts, but one key upcoming loss is UnitedHealth (UNH), which has actually decided to in-house its PBM requirements.
The company mentioned in the 3rd-quarter conference call that current analyst EPS estimates for 2013 of roughly $4.50 were likely a bit high causing the stock to sell-off materially. One factor hurting the company is that the uncertain economic and political environment has slowed down full-time employment, as much of the recent gains in employment data have been related to part-time employee additions. Often part-time employees don't get the same employee benefits as full-time workers, so even if Express Scripts doesn't lose its customers, the lack of underlying employment gains reduces the amount of scripts filled in the network. Prior to the Great Recession, pharmacy benefit managers benefited from both increases in employment and healthcare utilization. This led to very strong earnings growth but the economic slowdown has pressured the industry, and perhaps was a cause for some of the consolidation that has occurred. At some point hiring will pick up again and with the aging of our population there is no doubt that healthcare utilization must rise. There is a tremendous amount of excess healthcare costs associated with patient non-adherence to their prescribed drugs, and Express Scripts is doing extensive work on both educating and promoting the proper adherence. Drug delivery through mail is a growing distribution model and is actually more profitable for the company due to the elimination of the middle man between Express Scripts and the prescription holder.
I'm always reluctant to buy a stock that has performed as well over the last 5 years as Express Scripts has, because often the valuation becomes too dear as momentum investors' chase performance, but in assessing the future possibilities I believe the stock to offer a reasonable value at current prices. ESRX has consistently generated a return on equity in excess of 30% over the last 7 years, and returns on invested capital have been between 15%-28%. The company has deployed significant leverage on its large acquisitions, but because of the large free cash flows, paying off the debt hasn't proven to be too problematic and I don't expect it to be different this time. Operating margins have hovered around 5% but I believe with the synergies provided by the Medco acquisition it is possible that margins could potentially reach 7%-8%. It is the thin margins that make this business model sustainable in the long-term as the greatest value Express Scripts provides its customers is the reduction in pharmaceutical costs, so if margins were around 20% competition would obviously be able to encroach. Express Scripts will reap material benefits from being the lowest-cost provider in a thin margin industry, and in the 3rd quarter EBITDA per adjusted prescription improved 9% to $4.06, which leads the industry. I believe this number will continue to grow well in excess of its competition bolstering both margins and the moat of the company.
Express Scripts projects free cash flow to be roughly $4 billion in 2013 after backing out one-time costs associated with the Medco merger. The company's success in prior acquisitions leads me to be confident that these additional costs will indeed be one-time issues as opposed to some companies that seem to have recurring problems after saying the same thing. As of the end of the 3rd quarter, ESRX had 829.6MM shares outstanding, so at $53.30 the market cap is roughly $44 billion. In addition the company has $16.1463 billion in long-term debt versus cash and cash equivalents of $1.2484 billion; therefore the enterprise value is approximately $59 billion. I believe Express Scripts has an opportunity to grow free cash flow by 13%-15% over the next 5-7 years, so while the initial 6.8% free cash flow/enterprise value yield doesn't scream out as being a bargain, the power of compounding could make the current valuation seem quite cheap. The 3 pillars of earnings growth for the company over the long term will be increases in employment/enrollment, higher healthcare utilization, and cost-cutting from the integration and scale benefits of the company's recent acquisitions. I highly recommend dollar cost averaging into a position and potentially using puts to attempt to manufacture a cheaper entry point, but for the patient investor there is good value to go along with an extremely competitive business model.