Generalist Vs. Specialist Approaches In The Competitive Pharmacy Space

Includes: APHYQ, ESRX
by: EnhydrisPECorp

Pharmacy stocks have been on an absolute tear over the past five years, due in large part to a growing elderly population in the U.S. and the loss of patent protection for several blockbuster drugs. For example, CVS Caremark (NYSE:CVS) is up nearly 43% and Express Scripts Holding Company (NASDAQ:ESRX) has nearly doubled in PPS (up 72%) in the past five years. Even so, these two market share leaders have cooled off somewhat in recent months due to the uncertainty brought on by the Affordable Care Act, which threatens to bring tighter regulations and, thus, lower margins to an already highly-regulated industry. Moreover, competition has become particularly intense within this industry due to national pharmacies such as Walgreen (WAG) and CVS expanding their prescription drug offerings. Supermarkets and discount stores have also gotten into the act by opening retail pharmacies onsite to accommodate consumers with all of their retail needs at a single location.

This competitive landscape has generated two vastly different business models within the pharmacy sector, i.e., a generalist versus specialist approach. Simply put, generalist pharmacies like Walgreen offer customers a one-stop shop for all their pharma needs, yet lack the ability to deal efficiently with highly regulated drugs such as Class II pain meds (also known as Schedule II drugs). Specialist pharmacies, by contrast, tend to offer a limited selection of drugs, but stellar customer service. Specifically, specialist pharmacies handle newer, higher cost drugs, biologics, and drugs that require special handling in terms of administration or reimbursement (e.g., Class II drugs). Thus they tend to be better prepared to handle the onerous regulations surrounding controlled substances, and focus on a smaller contingent of repeat customers. In this way, their customers can receive their medications in a quick and efficient manner, without the hassles typically associated with these medications.

Because generalist pharmacies focus on sheer volume and a wide variety of services, customers on Class II type drugs often have problems receiving their meds in a timely manner. I have personally experienced this issue when my father was dying of heart disease, and it took a stunning three months from the time his doctor ordered his pain meds until they showed up at the house. Unfortunately, there was no specialty pharmacy in the local area, and we had to go through a big chain pharmacy. That experience was a nightmare, and proved to me there is a need for specialty pharmacies. Nevertheless, there is something to be said about being able to bundle your pharmacy and general shopping needs, which is why the generalist approach has been so successful to date.

In this article, I give an overview of a generalist and a specialist pharmacy company, and outline their respective prospects for future growth. Overall, I believe this sector is rife with opportunities for both conservative and aggressive investors alike, making it a must-see for a diverse array of investors.

The Generalist Pharmacy

Express Scripts Holding Company is a full service pharmacy benefit management (PBM) company that literally does it all. After merging with Medco in 2011, ESRX is now the largest PBM in the world with a market cap of $49.9 B. The company offers a full range of services to clients such as managed care organizations, health insurers, third-party administrators, employers, union-sponsored benefit plans, workers' compensation plans, and government health programs. In fact, I recommend investors read the company's annual report here to gain at least a superficial understanding of the products and services offered by ESRX. After reading it, one will quickly understand why this company is considered to be a "generalist" of the pharmacy sector, i.e., it operates in every segment of the market from home delivery of drugs to clinical support operations. As such, it would take considerably more space than permitted here to cover the company's various business segments in any detail whatsoever.

Although ESRX operates primarily out of Canada and the U.S., its operation is global in scale, and employs over 40k people worldwide. Most impressively, 95% of all retail pharmacies in the United States are involved in at least one segment of the company's operations (see 10-K hyperlinked above), making ESRX the clear industry leader.

On the financial side of things, ESRX ended 2012 with cash and cash equivalents of $2.79 B, down significantly from $5.62 B in 2011. The decrease in cash was primarily due to the merger with Medco, which affected all aspects of ESRX's balance sheet. Even so, the company has more than sufficient working capital to continue to execute its business plan, and has a number of revolving credit lines with favorable terms. Most importantly, the projected 5-year EPS for ESRX sits at 18% due to the assets obtained by the merger in 2011. This favorable earnings projection has convinced institutional investors to take a major stake in ESRX, with 87% of the float owned by institutional investors. Despite the global economic weakness that may affect large corporations such as ESRX, I believe ESRX is a strong, long term buy. Namely, the company offers essential services to patients, hospitals, and insurers, which should provide investors with a nice defensive moat during economically turbulent times such as these.

The one negative with ESRX is that it is currently trading at a rather high multiple for the sector at 34.8, at the time of writing this article. Walgreen Company, by comparison, is trading at a multiple of only 21, and CVS Caremark trades at roughly an 18 multiple. Given that ESRX's Relative Strength Index is indicating slightly overbought conditions at 71, I believe a pullback to a more realistic EPS is likely in the near future. If and when that does happen, I would consider ESRX a strong buy at that point. Presently, I believe the company has great long term potential, but investors should wait for a pullback to initiate a position.

The Specialist Pharmacy

Assured Pharmacy Inc. (APHY.OB) is a specialty pharmacy chain that deals primarily with pain medications with a Class II designation. The company presently operates four stores in California, Kansas, Oregon, and Washington, and has announced plans to open an additional six stores in the coming months. According to the company's website, APHY's business model targets physicians specializing in pain management - orthopedics, neurology, oncology, psychiatry, physical rehabilitation, and industrial medicine. The goal is to treat patients with long-term, acute, chronic pain conditions, making them reliable, repeat customers. APHY currently has a small market cap (roughly $24 M fully diluted), but is entering a market expected to be valued at $60 B by 2015. As such, APHY represents a potentially grossly undervalued play in the pharmacy sector.

Assured's competitive advantage in its business model lies in the company's ability to maintain and handle a large inventory of Class II pain medications, much larger than typical retail pharmacies. Moreover, Assured has pharmacists specifically trained to remove the significant burden of the refill/authorization process on the physician's administrative staff, and the pharmacies are purpose built to handle the needs of chronic pain suffers. Patients can therefore rely on their prescriptions being filled accurately without long, needless delays or return visits. Having had to deal with these issues for my parents recently, I intimately understand the need for such a business. Retail pharmacies flat out failed to handle our needs in a time of suffering, and I only wish a specialty pharmacy like Assured had been an option.

My opinion of the company's business model is apparently shared by investors as well -- the PPS of APHY is up over 70% in the last 3 months alone. This dramatic increase in PPS is likely due to the company announcing that it will aggressively reduce operating costs and, hence, the profitability of its four stores currently in operation, as well as having designated locations for its six new stores. Finally, the CEO, Robert DelVecchio, stated in a recent letter to shareholders that he expects APHY to uplist to a major exchange, such as Nasdaq or AMEX, relatively soon. Taken together, APHY is clearly putting together an aggressive expansion plan designed to take advantage of a significant portion of the pharmacy market.

Although I do firmly believe in the company's stated business plans, its financial house is currently not as strong as it could be -- not unusual for a small and emerging entity. There exists some risk here with APHY, and it should be considered going forward. According to the company's 10-K, Assured needs to reach an agreement with its existing debt holders to extend the maturity date of debt securities that were due in 2012. As of December 31, 2012, Assured had $844,948 in debt securities that were due in the year 2012, which included $500,000 in principal amount of unsecured convertible debentures. The company is working diligently to extend the maturity date of all outstanding debt securities, but has yet to do so. One possibility is that the debt holders will convert their securities into equity, which is the option preferred by management.

Despite these financial problems, I believe Assured will survive and become a major player in the specialty pharmacy sector. My belief stems from two facts: 1) If the debt holders balk at working out a deal, they will potentially lose most or all of their initial investment. Assured's business is truly centered on highly trained pharmacists and associates that have experience in dealing with the vagaries of Class II medications -- not in tangible assets such as buildings, patents, etc. All four pharmacies combined come to a grand total of $1 M, and wouldn't likely fetch nearly that much in a fire sale. So if the debt holders force an outright default, they will only recover pennies on the dollar so to speak. That seems absurd when the company isn't far away from becoming cash flow positive. 2) Mosaic Capital LLC has taken a major position in the company (44%) of outstanding common shares, and as such, has too much invested in this business failing. I believe they will continue to invest until Assured finally turns the corner and becomes cash positive. Based on the company's revenues (see 10-K), this event is likely to be sooner than later. Overall, APHY represents a fairly new business that has certainly experienced its share of growing pains, but the demand for specialty pharmacies, in my opinion, will only get stronger in time. APHY's stated business plan thus puts it on the path to rapid growth in a vital industry. I look for APHY to continue increasing in PPS over the long term.


The pharmacy space has treated investors well over the past few years, and looks to be one of the few sectors with a positive outlook under the current economic conditions. I believe that the generalist companies have achieved essentially a plateau in their operations, and growth will most likely occur through mergers and acquisitions in the space. Indeed, this is exactly what ESRX did in 2011. As companies get too large, however, they always tend to have trouble with dealing with problematic regulations. One only needs to look at the multitude of failings with Bank of America (NYSE:BAC) to know the truth in this statement. As such, the time is ripe for smaller, more focused specialty pharmacies to take advantage of a major demand in the sector. Patients with chronic pain, for example, must have access to their medicine in a timely, humane fashion. I have personally found that generalist pharmacies simply cannot meet this demand, and so are vulnerable to losing market share to specialty pharmacies like APHY. In sum, I like ESRX because it offers investors a wide margin of safety by being the industry leader and an intriguing 5-year EPS. Yet, I also like the prospects of the specialty pharmacy APHY due to its focus on its customers and their needs. I plan on watching both of these stocks closely and may initiate a position in APHY in the near future. I will also likely initiate a position in ESRX if a pullback to the low to mid $50s occurs, giving it a more comparable multiple for the sector.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in ESRX, APHY.OB over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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