Medco Health Solutions: A Short-Term Arbitrage, Long-Term Opportunity

| About: Medco Health (MHS)

Medco Health Solutions (NYSE:MHS) was founded in 1983, and generated an impeccable record of earnings growth above 20% per annum until they were acquired by Merck & Co. (NYSE:MRK) in 1993. Pharmacy giant Merck & Co subsequently spun Medco off on August 12, 2003 and it became an independent company once again. After the spinoff, Medco continued its unblemished record of growing earnings In excess of 20% per annum.

Now once again, Medco Health Solutions is expected to be acquired by Express Scripts Inc. (NASDAQ:ESRX), only this time for approximately $29 billion. The deal will be comprised of cash and shares in the soon-to-be formed combined entity with an expected value of just over $71 per share. Consequently, we believe that Medco Health Solutions offers investors a short-term arbitrage between their current closing price and the $71 offer from Express Scripts. Longer-term, we believe that participation in the combined entity of Medco Health Solutions and Express Scripts offers a great long-term potential opportunity.

Growth stocks are defined as companies with high rates of change of earnings growth of 15% to 20% or better. Growth stocks offer the potential for share prices to rise in lockstep with their profit growth in the long run. Therefore, the PEG ratio formula (price equals growth rate) tends to be the most appropriate formula used to value growth stocks. However, due to the exponential nature of compounding large numbers, PEG ratio forecasts are capped at 40%.

Because of the higher valuation typically awarded to fast growth, growth stocks offer the potential for greater capital appreciation. On the other hand, they also offer higher risk. First of all, they tend to command much higher than average P/E ratios, and second, achieving very high levels of growth is very difficult to sustain. Consequently, forecasting future earnings growth is more important with high growth stocks than any other class of stock. Also, the average growth stock typically ploughs all of its profits back into the company to fund its future growth, instead of paying dividends.

Medco Health Solutions, Inc.: Large-cap Growth at a Reasonable Price

About Medco Health Solutions, Inc.: Directly from their website:

Medco Health Solutions, Inc. is pioneering The world's most advanced pharmacy® and its clinical research and innovations are part of Medco making medicine smarter™ for millions of Americans.

With more than 20,000 employees worldwide dedicated to improving patient health and reducing costs for a wide range of public and private sector clients, and 2010 revenues of $66 billion, Medco ranks 34th on the 2011 Fortune 500 list and is named among the world's most innovative, most admired and most trustworthy companies.

Earnings Determine Market Price: The following earnings and price correlated F.A.S.T. Graphs™ clearly illustrates the importance of earnings. The Earnings Growth Rate Line or True Worth™ Line (orange line with white triangles) is correlated with the historical stock price line. On graph after graph the lines will move in tandem. If the stock price strays away from the earnings line (over or under), inevitably it will come back to earnings.

Medco Health Solutions, Inc.: Historical Earnings, Price, Dividends and Normal P/E Since 2003.

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Performance Table Medco Health Solutions, Inc.

The Two Keys to Long-Term Performance

Years of research and experience have taught us that there are two critically important keys to achieving above-average, long-term shareholder returns at reasonably controlled levels of risk. The first key is earnings growth, or what we like to call the rate of change of earnings growth. The faster a company can grow its business (i.e. earnings), the larger the income stream it can produce with which to reward shareholders. This is because of the power of compounding, which Albert Einstein was alleged to have called "the most powerful force on earth." Ultimately, both capital appreciation and dividend income will be a function of a company's ability to grow its profits.

The second key is valuation. When a company can be purchased at its intrinsic value based on earnings and cash flow generation, the shareholders' rate of return or long-term capital appreciation will inevitably correlate to and/or equal its earnings growth rate. Overvaluation will lower that rate of return and conversely, undervaluation will increase it. Consequently, paying strict attention to the valuation you pay to buy a stock is a critical component of both greater return and taking lower risk to achieve it. Because, ironically, when you overpay for even the best business, you simultaneously lower your return potential while increasing your risk of achieving the lower return.

The associated performance results with the earnings and price correlated graph, validates the above discussion regarding the two keys to long-term performance. Notice the impact that valuation (black line above or below orange earnings justified valuation line) had on the following performance results.

The following graph plots the historically normal P/E ratio (the dark blue line) correlated with 10-year Treasury note interest. Notice that the current price earnings ratio on this quality company is as low as it has been since 2003.

A further indication of valuation can be seen by examining a company's current price to sales ratio relative to its historical price to sales ratio. The current price to sales ratio for Medco Health Solutions, Inc. is .36 which is historically low.

Looking to the Future

Extensive research has provided a preponderance of conclusive evidence that future long-term returns are a function of two critical determinants:

1. The rate of change (growth rate) of the company's earnings

2. The price or valuation you pay to buy those earnings

Forecasting future earnings growth, bought at sound valuations, is the key to safe, sound, and profitable performance.

Therefore, it logically follows that measuring performance without simultaneously measuring valuation is a job half done. Medco Health Solutions, Inc. is clearly an industry leading superior business, which based on the consensus estimates from leading analysts, appears to be capable of growing earnings at an above-average rate for the foreseeable future.

At its current price, which is attractively aligned with its True Worth™ valuation, Medco Health Solutions, Inc. represents an opportunity for growth at a reasonable price. The important factor is that Medco Health Solutions, Inc., with its strong balance sheet and potential for future earnings growth, has real assets and cash flow underpinning its stock price. This solid economic foundation offers shareholders the potential for both a strong margin of safety and an opportunity for outsized future returns.

The Estimated Earnings and Return Calculator Tool is a simple yet powerful resource that empowers the user to calculate and run various investing scenarios that generate precise rate of return potentialities. Thinking the investment through to its logical conclusion is an important component towards making sound and prudent commonsense investing decisions.

The consensus of 27 leading analysts reporting to Capital IQ forecast Medco Health Solutions, Inc.'s long-term earnings growth at 15%. Medco Health Solutions, Inc. has medium long-term debt at 56% of capital. Medco Health Solutions, Inc. is currently trading at a P/E of 15.3, which is inside the value corridor (defined by the five orange lines) of a maximum P/E of 18. If the earnings materialize as forecast, Medco Health Solutions, Inc.'s True Worth™ valuation would be $135.92 at the end of 2017, which would be a 13.8% annual rate of return from the current price.

Earnings Yield Estimates

Discounted Future Cash Flows: All companies derive their value from the future cash flows (earnings) they are capable of generating for their stake holders over time. Therefore, because Earnings Determine Market Price in the long run, we expect the future earnings of a company to justify the price we pay.

Since all investments potentially compete with all other investments, it is useful to compare investing in any perspective company to that of a comparable investment in low risk Treasury bonds. Comparing an investment in Medco Health Solutions, Inc. to an equal investment in 10 year Treasury bonds, illustrates that Medco Health Solutions, Inc.'s expected earnings would be 6.4 times that of the 10 Year T-Bond Interest. (See EYE chart below). This is the essence of the importance of proper valuation as a critical investing component.

Summary & Conclusions

This report presented essential "fundamentals at a glance" illustrating the past and present valuation based on earnings achievements as reported. Future forecasts for earnings growth are based on the consensus of leading analysts. Although, with just a quick glance you can know a lot about the company, it's imperative that the reader conducts their own due diligence in order to validate whether the consensus estimates seem reasonable or not.

Medco Health Solutions is one of the nation's largest pharmacy benefit managers that covers approximately one in five Americans. Once combined with Express Scripts , the synergies between these two companies should provide a powerful combination. Over the short run, the value of Medco shares should rise to the $71 purchase price assuming the deal goes through.

On the other hand, if the deal does not go through, we believe that Medco Health Solutions represents a compelling growth opportunity in its own right. Consequently, we find it hard to see how investors seeking above-average long-term growth can go wrong. Both Medco Health Solutions and Express Scripts represent compelling opportunities to participate in the large economic opportunity of the graying of America.

Disclaimer: 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.

Disclosure: I am long ESRX, MHS.