From the time the $29 billion merger was announced between Express Scripts (ESRX) and Medco, analysts, investors and commentators have been skeptical that the deal would be able to go through without substantial divestitures. That's because Medco and Express Scripts will have greater than $110 billion of sales leverage in the industry, catapulting them into leadership of a space that was already thought to be monopolized by a few large players.
Since the deal was announced in July of 2011, there have been multiple developments in the Pharmaceutical Benefit Manager ("PBM") space. First, Medco announced that it lost a large contract to service Unitedhealth Group (UNH). While some insurers have decided to sell their PBM businesses in recent years, others, including Unitedhealth, are bringing it back in house, assumedly because it is accretive to do so. Also, after years of missteps, the PBM arm of CVS (CVS) has started winning contracts again. Finally, relatively small competitors, including Catalyst Health (CHSI) and SXC Health (SXCI), have signed large contracts and experienced industry leading sales growth.
All of the above considered, it was management's presentation of the merger that likely influenced FTC votes. First and foremost, the company highlights that the deal will lower drug costs for millions of Americans. Better outcomes and greater therapy adherence, in addition to innovation, were listed as additional benefits. However, most of the discussion focused around greater efficiencies and lower waste. In an era when Congress and the executive branch are scouring to find cost savings in the health care continuum, the agency likely saw greater pricing power as an appealing option. As a result, the investigation into the deal was closed yesterday by a 3-1 vote at the FTC and the merger is complete. The question is, what sub sector of healthcare can investors expect this type of consolidation in next?
The pharmaceutical distribution space is dominated by McKesson (MCK), AmerisourceBergen (ABC) and Cardinal Health (CAH). The distributors serve as middlemen between the pharmaceutical companies and their customers, including hospitals and pharmacies. With the growing prominence of drug stores and other providers, there has been a school of thought that a company like CVS could take its drug purchases in house, if it was advantageous enough. This threat is enough to force distributors to offer favorable pricing at thin margins. While the distributors will note that the earnings contribution is often significantly less than the revenue contribution of these large contracts, any significant loss in business will affect their bargaining power with drug companies, as well as their logistical and infrastructure leverage. While previously it would have been difficult to conceive a merger between these companies, in the light of the ESRX merger, it is worth considering the possibility.
To start, if any of the large contracts are lost by the big three, including servicing Rite Aid (RAD), CVS and the department of Veterans Affairs, the companies would be able to argue that the market has become more scattered. Also of note, none of the companies are leveraged significantly beyond their cash position. This gives them the flexibility to make a large scale deal. In a low interest rate environment, these businesses would likely be able to acquire long term, low interest debt to get a deal done. Finally, the companies could argue that they all have different strengths, whether it is a presence in hospitals, a strong specialty base or a significant technology business that provides complementary strengths, instead of pushing a monopoly on its customers. Of note, while the distributors are sporting a Trailing Twelve Month (TTM) EV/EBITDA multiple of 7.0x-8.0x, ESRX is over 11.0x. If a merger would boost valuations by up to 50%, this could be too attractive of an opportunity to pass up.
While there's no telling if executives at these companies are considering a merger of this scale, the Express Scripts deal marks an important decision in the healthcare regulatory environment on trade. The approval of this merger sends a signal that lowering costs in the healthcare system is a top priority for a spectrum of government agencies.
Additional disclosure: Considering purchase of ABC in next 72 hours