In a move that startled analysts and investors, Express Scripts (ESRX) announced this week that it is buying its larger rival (in terms of sales and net income), Medco Health (MHS). While there is some speculation that the FTC may be a roadblock to this deal, which is predicated on cost-savings, I think that it probably goes through, with a early to mid-2012 close. With that said, the reaction of the stocks is puzzling to me. The spread between the buy price and the current price of MHS is very wide, implying a 12% return to the close and suggesting the deal might not go through. Yet, ESRX rallied sharply on the promise of the accretion from the potential deal, rallying over 10%.
My take is that ESRX is a sell here. Before I elaborate on this thesis, let me explain where I was before this transaction. I have followed the industry very closely for a decade as a buy-side analyst, and have owned ESRX in the past. I was a huge fan of their former CEO, Barrett Toan. A year ago, I reviewed MHS closely and felt it was a much better value. I have loosely described the two companies as the one with the customer service (ESRX) and the one with the innovation (MHS), though these are obviously a bit too general. I have favored Catalyst Health (CHSI), which is smaller and used to be known as HealthExtras, because of its growth potential as well as its superior business model in my view (more transparent). Before I go on, look at how well the Express Scripts stock has done over the past decade:
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This is an easy stock to own for a big money manager. It's plenty liquid, with $26bln market cap, it's "high and to right" on price and earnings, and the valuation isn't too bad at 16PE. After all, it has traded at a median of almost 20 over the past decade. The stock has been a 10-bagger over the past decade, driven by earnings compound earnings growth of 59%. What's not to like?
Before the MHS deal, my antennae was already up. I felt as if the dispute with Walgreen's (WAG) was a signal that the future isn't so bright. For those not familiar with the PBM industry, it is about to have its best year ever in 2012 due to a massive wave of new generics, but growth beyond next year could be challenged. Already, the number of lives that these companies serve has stalled as have revenues. The key metric of EBITDA per prescription is facing challenges due to mail penetration and generic switching having slowed after years of great success. ESRX is attempting to squeeze WAG in my view in order to prop up this metric going forward. As an aside, with the FTC scrutiny ahead, I expect this dispute to be resolved favorably for WAG. This has been a core holding in my Conservative Growth/Balanced Model Porfolio, and I added to it Friday after having sold some near 45 before they reported earnings (due to the position having become larger than I wanted).
As further support of my contention that the best days for the industry, at least in the U.S., are behind, I look to none other than the CEO of MHS, Dave Snow, who I think is the sharpest guy in the industry. He essentially said so when he announced a large transaction almost a year ago that got the company into Europe (UCB). On the conference call, he talked about the limits of growth, a refreshingly honest admission. Unfortunately, Snow will not be involved with the combined entity in an executive role.
While I was concerned before, I have moved to negative now, especially given the favorable reaction of the stock. I take this bold move as a sign that the growth ahead wasn't going to be very strong beyond 2012, so swallowing a whale was essential. Before buying blindly into the "$1 billion" in synergy ahead, investors should consider:
- The deal might not go through (I think it will)
- Both companies could suffer client attrition
- ESRX is repurchasing clients that they specifically had shed (ironically!)
- Integration risks shouldn't be dismissed
- The forward earnings power doesn't justify the current price
The first four issues are pretty self-explanatory. The basic issue is that maybe things don't play out the way investors hope they do - this is always a risk. How many big mergers truly create value?
It's really the fifth point I want to argue. As a huge rather mature company that is growing mainly through cost-savings, I don't expect that the valuation will be a premium to the market. I have modeled my 2013 estimate of earnings to be between 4.80 and 5.60, but I consider these aggressive as they don't account for client attrition. The high end incorporates a lot of cost-savings, while the low-end assumes none. Using my high estimate and applying a 13 PE, I get a end-of-2012 price of 73. That implies an 18-month return of 27%, and I think that's a best-case scenario.
I actually prefer to use EV/EBITDA. I have run a pro forma balance sheet and income statement and estimate that the high-end of EBITDA will be $8.4 billion. Applying a multiple of 10, which is appropriate in my view, the valuation would be between 65 and 76 at the end of 2013. At the high-end, that's a 30 month return of less than 33%.
While these aggressive results could fuel positive returns on the stock, they don't justify the risks to me. At less aggressive assumptions, the stock is likely to underperform the market, perhaps even lose value if the attrition turns out to be significant. While I don't expect the FTC to kill the deal, that would likely push ESRX sharply lower.
So, in summary, I believe that ESRX has signaled that its future alone wasn't so great. With MHS, it may be better, but the current valuation, after the sharp rise this week, leaves the stock looking like it will lag the market over the next 18-24 months by my calculations, even under optimistic assumptions. If you disagree with me and think the deal is going to go through, you should prefer MHS at its big discount (it seems to me that 3-7% would be more appropriate). To me, there are many better opportunities in the Healthcare sector.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: Long WAG in a model at Invest By Model
