Medco Health: A Prescription for Growth

Mar.31.10 | About: Medco Health (MHS)

Medco Health Solutions, Inc. (NYSE:MHS), is the #1 pharmacy benefit manager in the country. Our previous article on July 5, 2009 showed Medco as a $22-plus billion market cap company, but today it has grown to around $30 billion. That being said, its debt as a percentage of capital has gone down from 40% to 38%. Most of Medco’s debt is attributed to a $2 billion one time dividend paid to Merck (NYSE:MRK), which was financed long term.

The healthcare reform bill signed into law on March 23, 2010 will have a definite impact on healthcare business operations in both the near and long term. With the new plan estimated to be over $900 billion, potentially adding over 30 million pharmaceutical customers to the mix, we believe the bill will have a net positive impact on Medco Health Solutions, Inc.


Using our EDMP, Inc. F.A.S.T. Graphs tool, we will look at the earnings history of Medco. At the time of our July article, Medco had a 7-year compounded earnings growth rate of 22.4%. Throughout its history, Medco has grown on average from 10% to over 25%, but it is averaging roughly the same today as it was 8 months ago at an annualized growth rate of 22.3%.

Take note, in Figure 1, of how closely the stock price followed its earnings line. The PE wavered between 20 and 30 over the period, with a Normal PE Ratio calculating at a 23.3 multiple.

Figure 1. MHS 8yr EPS Growth Correlated to Price (click to enlarge)
Figure 1. MHS 8yr EPS Growth Correlated to Price (click to enlarge)Click to enlarge
EDMP’s Valuation Principle

One principle we use at EDMP, Inc. is that a company’s True Worth value is when the PE multiple is equal to the earnings growth rate. If a company is trading at the growth rate multiple at the beginning of the graph and is trading at the same multiple at the end of the graph, the rate of return for investing in that company over the whole period will be exactly the same as the growth rate.

How to Look at Price Performance

With the principle above in mind, take note of the price line, the earnings growth rate line, and earnings growth rate figure, in Figure 1 above, compared to the price performance shown in Figure 2 below. Because Medco was trading below its growth rate at the beginning of the period and is slightly above its growth rate at the end of the period, we see that the price performance [27.1%] is greater than the earnings growth rate [22.3%]. Also note in Figure 2 that the price performance of Medco had nothing to do with the market returns of 2.3% over the same period.

Figure 2. MHS 8yr Price Performance (click to enlarge)
Figure 2. MHS 8yr Price Performance (click to enlarge)Click to enlarge

The Future

With past growth averages from Figure 1 in mind, we look at the earnings forecast and see that 27 analysts at FirstCall have a consensus estimate of 18.0% long-term growth. If Medco continues to grow at 18% as forecast and continues to trade at a 23.4 multiple, shown at the right of the Figure 3 graph, it would be about a $130 dollar stock by the end of 2013 (see red arrow in Figure 3). If it continues to grow at 18% and its multiple is reduced to 18 times earnings, it would be about a $100 stock by the end of 2013 (see green arrow in Figure 3). The key is “Will it continue to grow by at least 18% per year?”

Figure 3. MHS 3yr+ Earnings Forecast (click to enlarge)
Figure 3. MHS 3yr+ Earnings Forecast (click to enlarge)Click to enlarge

Taking into account the estimated earnings forecast for Medco, it can be considered a little pricey at 23.1 times earnings. But, as of today, it does have a calculated historical Normal PE ratio of 23.3, and we believe the 18% earnings estimate is possibly a conservative number, but at a minimum, a reasonable long-term expectation of the future.

Maintaining Growth

Medco continues to earn solid business and retains a majority of its prescription benefit plan clients. Medco is meeting anticipated retention rates for 2010 based on current renewals. So far in 2010, Medco has added more than $4 billion in new client contracts. However, over the next quarter, Medco expects its growth to be slow and is having some issues controlling costs, due to many new clients making use of retail pharmacies.

Medco is building upon its numerous channels for long-term growth. The company is maintaining its acquisition activity for new offerings and technologies and has attractive cost savings to retain clients. They are working on creative ways to develop the mail order business and are diligent in reducing costs and maintaining margins. We believe that the new healthcare bill will have a mostly long-term positive effect on the generic drug side of Medco’s business; especially since billions of dollars of branded drugs go off patent in the next few years. As a result, we think Medco will be able to gain market share in both Mail Order Prescriptions and Generic Drug Dispensing.

Over the next few years the healthcare marketplace will be very challenging and we believe Medco has shown they are prepared for the challenge.

Disclosure: Long MHS at the time of writing.

The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.