With the Federal Trade Commission's (FTC) investigation of the Express Scripts (ESRX)-Medco (MHS) merger closed, there is a new dominant PBM with a market cap over $50 billion. This leaves CVS Caremark (CVS), Catalyst Health Solutions (CHSI), and SXC Health Solutions (SXCI) as some of the remaining publicly traded PBMs. Several health insurance companies are also beginning to offer PBM services, United Healthcare (UNH), Humana (HUM), Aetna (AET), and Cigna (CI) to name a few.
In the various memos (pdf) the FTC put out to support its decision, it notes that Medco was the largest PBM, followed by CVS and then Express Scripts. It also noted that Medco and Express Scripts had been losing major accounts recently; Walgreen (WAG), the Blue Cross Blue Shield Federal Employee Health Benefit Plan, and the California Public Employees' Retirement System. Medco reportedly lost a third of its business last year. CVS won the latter two big accounts above and Catalyst won the Walgreen account. Walgreen said despite dropping Express Scripts, it will still honor the accounts with Medco. That makes me wonder if Walgreen will renegotiate with Express Scripts or drop Medco and move all its business to Catalyst.
The commission noted that the PBM market consists of at least 10 significant competitors. It also notes that during its eight month investigation, research showed that there was intense competition for accounts that is driving prices down and hurting PBM margins. It also acknowledges however, that the merged company will have just over 40% of the market share.
A Look at the Remaining Competition
SXC has a market cap of $4.6 billion, nearly $350 million in cash, negligible debt, and it generated almost $100 million in free cash flow over the trailing 12 months. SXC is not only a PBM but it also provides healthcare information technology services. It has been buying up smaller PBMs and independent pharmacy providers. Its revenue jumped $3 billion to $5 billion for 2011 as a result of acquisitions as well as its contract with HealthSpring (40% of revenue.) In its 2011 annual report SXC boasts a la carte options as one of its largest advantages over the bigger competitors. Unfortunately for SXC, Cigna just acquired HealthSpring in January, but the initial three-year term can't be broken except for a material breach. But with Cigna working on its own PBM services, SXC will have to fight hard to retain this contract or start finding other business so that it isn't so reliant on HealthSpring. SXC has been able to turn its IT customers into PBM customers; if it can keep leveraging combinations of these services it could be very profitable and help reduce dependence on HealthSpring. To survive SXC will have to be an aggressive competitor because it knows it likely only has three years of HealthSpring.
Catalyst is a little smaller with a market cap of $2.8 billion, only has about $50 million in cash, has $270 million in debt, but generated around $135 million in free cash flow over the trailing 12 months. Catalyst recently acquired Walgreen's Health Initiatives and signed a cooperative deal with RegencyRx. These deals are helping growth and to replace the State of Maryland account that was 7% of 2011 revenue. Like SXC, Catalyst has been buying up smaller companies to provide quicker growth than it could gain organically. The majority ($250 million) of Catalyst's debt comes due in 2015/2016, just before the Regency deal expires. It needs to look for more cooperative deals like the Regency one so that it can take advantage of the low cost of adding customers. This deal cost Catalyst pennies compared with the recent acquisitions that cost hundreds of millions each.
CVS's PBM segment had annual revenue in 2011 of $51 billion without retail co-payments. This is half of the expected $100 billion in annual revenue that is expected to be generated by the new Express Scripts with Medco. CVS also grosses over $100 billion in total revenue with another $60 billion coming from the retail pharmacy segment. Any products covered by the PBM segment bought at a retail location are attributed to the PBM segments numbers according to a note in the 2011 annual report (pdf).
United Healthcare is working on developing and expanding its PBM services after dropping Medco. The Optum Rx segment currently makes up 16% of revenue and 5% of operating profit based on 2011 figures. Along with the other health insurance companies listed above, it will be interesting to see if it can manage its own PBMs in a profitable way. If so, it could pave the way for all the large companies to handle it internally, which could have a severe negative impact on purely PBM companies.
I think the near future is growth for all the companies in the sector. Based on pending healthcare legislation and the aging population of the country and the number of those people living longer because of the medications provided, there is plenty of room for customer growth. For the PBMs, I see margins shrinking slightly because of intense competition for new accounts causing profits to be made on a volume basis. Keys to success will be signing big customers to long contracts to secure those large revenue streams for many years. For Express Scripts and CVS I see minor to moderate growth for the rest of 2012. Hold CVS for the dividend. For express Scripts, I think we could see a dividend coming once integration of Medco is complete. I think Catalyst and SXC are the strong growth plays here because they need to grow to survive amongst these two giants. They could end up being acquired by one of the health insurance companies as a way to start their own PBM segment as well.
Disclosure: I am long MHS.