HealthExtras' Underappreciated, Unique Model: Feel the Difference

When investing in Healthcare, which I believe is one of the most attractive growth industries, I am always looking to find companies that take cost out of the system. I have long believed that Pharmacy Benefits Managers [PBMs] are one of the better ways to fulfill that goal. At my former employer, we were long Express Scripts (ESRX) from 2000 until late 2005. One of the things that always disturbed me was the black-box element: How EXACTLY did these PBMs make their money? Often, they were accused by their customers or state governments of misrepresentation and other crimes. Cutting through all of the politics involved, it is clear that there were (and still are) significant “gray areas”. I always appreciated Barrett Toan, the former CEO of ESRX, for his leadership in the industry. Under his watch, the company walked away from some business that was in conflict with the best interests of the company’s clients. While almost everyone is familiar with the “Big Three”, Medco Health Solutions (MHS), ESRX and CVS Caremark (CVS), I don’t think that investors appreciate the unique model of HealthExtras (HLEX) (30.50, $1.3 billion market capitalization, S&P 600 member).

I first came across HLEX in early 2006 when they won an absolutely stunning deal, taking away a client (Wellmark) from one of the Big Three. The stock ran up, as you can see in the chart below (to an unsustainable valuation), on that news and then consolidated for quite some time. The company has renewed two large contracts and won another competitive situation (Maryland) in that time. The stock has been in bull mode since Louisiana was re-awarded and Maryland’s implementation delay ended in Q1.

So, what makes HLEX different from other PBMs? First, their interests are more aligned with the customers. They don’t operate a mail-order facility for profit (though they do offer mail-order via CVS or Walgreen (WAG)). Their transparency is quite evident in other ways as well. Second, they tend to think locally, which is very different from the Big Three. They understand well that healthcare is a local service, and they customize their products in the geographies they serve. They tend to get very large concentrations in these localities, and they, unlike the other PBMs, are able to truly offer meaningful web interaction with the plan members. Their transparency and service levels get them very high ratings from their customers relative to their larger peers. The proof, though, is in their retention and competitive take-aways. The final difference is their size. I believe that due to the superiority of its model, increasing concerns about the lack of transparency at the Big Three and its relatively small size, this company could really grow.

Financially, HLEX has expanded very rapidly, sinking a lot of up-front cost into bring new clients on board (without any hitches, I might add). Their balance sheet remains much stronger than others in the industry (and requires less capital as the company doesn’t buy drug inventory for speculative purposes). Unlike their two pure-play peers, they have some tangible capital and no debt at all. Earnings estimates were dinged primarily by the Maryland delay, but they are increasing again. EPS growth in 2008 is expected to be 25% on top of 36% growth this year. EPS growth the past 3 years has been 36%. Future growth will come from further large contract wins, geographic expansion and their entry into a few new markets (Third-Party Administrators and Brokers, Worker’s Comp and Labor Unions).

I believe that HLEX could trade to 39 later this year based upon attaining a 30 PE (on the 2008 estimate). As you can see from the chart below, valuation is at median levels despite the many changes that have taken place. First of all, the company has successfully implemented some very large contracts. Second, consolidation should bode well for this company. Finally, the market cap is now at a level that the company should command the attention of small-cap investors. In my opinion, this company is the “safest” it has ever been, with large implementations behind them, big opportunities ahead and an environment that favors their business model of transparency. A final thought is that this company should command a premium for its lack of exposure to Medicare reimbursement.

Disclosure: Author and members of his family are long HLEX