Despite rallying strongly in the past six months, Express Scripts (NASDAQ:ESRX) is trading at a 22% discount to our fair value estimate. We believe the current stock price fails to account for likely synergies from the merger with Medco (NYSE:MHS). Following the deal, we upgraded Express Scripts' economic moat rating to wide from narrow. Antitrust considerations will probably prevent Express Scripts from participating in any further consolidation, however, which means its moat is now about as wide as it will get, in our view.
Medco and Express Scripts have both done extraordinarily well over the past several years. This is partly attributable to the generics wave and growing concern about health-care costs. Medco took advantage of these tailwinds to boost its market share while passing most savings through to customers, as Express Scripts maintained flat market share but boosted profitability per prescription. Both companies took advantage of the low capital requirements inherent in the pharmacy benefit manager business model--Medco repurchasing 22% of its outstanding shares in three years, and Express Scripts acquiring volume. CVS Caremark's (NYSE:CVS) PBM has languished during this time as the company struggled to find its identity as a unique retail-PBM combination.
Express Scripts' results received a major boost during this time from the acquisition of WellPoint's NextRx PBM subsidiary. It is difficult to isolate the earnings contribution of this acquisition, but Express Scripts claims that it contributed around $1 billion of incremental earnings before interest, taxes, depreciation, and amortization (almost the entire increase in EBITDA since the deal closed in late 2009). That would imply that NextRx's EBITDA approximately doubled within two years under Express Scripts' management. Although we don't expect Express Scripts to repeat this feat with Medco's much larger and better-run book of business, it sets a favorable precedent that indicates synergies from the merger are likely to be realized.
PBM Economic Moats Are Founded on Scale
In our opinion, scale is the only source of a sustainable competitive advantage for pharmacy benefit managers. PBMs exist to control pharmaceutical spending, or ideally to lower overall health-care spending. This is accomplished in two primary ways: by leveraging purchasing power to extract better prices from suppliers, and by encouraging members to make cost-effective pharmaceutical consumption choices.
Large PBMs have several advantages over smaller competitors. Following the Medco merger, Express Scripts has the ability to influence the pharmaceutical spending of more than 100 million individuals. By excluding some pharmacies from its retail pharmacy network, the company can direct patients to low-cost dispensing outlets. In drug categories with multiple brand-name alternatives, Express Scripts can use its influence to extract favorable rebates from manufacturers. In categories with generic options, it can negotiate with manufacturers for large supplies of generic drugs to its mail-order facilities. The company should be able to operate these facilities at maximum efficiency, while leveraging other administrative costs such as claims processing systems. Express Scripts will also have greater resources to invest in innovative programs that encourage generic substitution and ensure that the right patients are taking the right drugs, in the right dosages, at the right time. The company already has industry-leading capabilities here, combining its own behavioral-sciences approach with Medco's Therapeutic Resource Centers and investments in pharmacogenomics.
Thanks to the merger, Express Scripts is much larger than any of its competitors. After accounting for a few major client losses by Medco, Express Scripts' run-rate market share will be around 41%. We expect Express Scripts' 1.5 billion adjusted prescriptions to make it 50% larger than CVS Caremark in 2013, 3 times the size of third-place UnitedHealth (NYSE:UNH), and around 8 times the size of fourth-place Catalyst Health Solutions (NASDAQ:CHSI).
Goodwill and other intangibles associated with the Medco merger will temporarily depress returns on invested capital. However, it is important to note that intangibles account for pretty much all of Express Scripts' invested capital. The company operated with negative net working capital and less than $500 million of net property, plant, and equipment before the merger. We expect the company to increase earnings substantially in the coming years without any incremental investment of capital.
Dispute With Walgreen Is Case Study in Relative Competitive Advantage
A month before the Medco merger was announced, Walgreen declared that it planned to exit Express Scripts' network because of inadequate reimbursement terms. We said from the beginning that Express Scripts had the upper hand in negotiations. Half of the company's legacy business was concentrated in two contracts with terms exceeding five years. Much of the remainder of the business was on a three-year contract cycle, leaving only a midteens percentage of the book up for renewal in any given year. Most important, the majority of clients seem to view pharmacy services as a commodity and prefer lower costs to broad access. Even without Walgreen, Express Scripts has more than 50,000 retail pharmacies in its network and was able to meet all contract provisions related to network adequacy.
Express Scripts is claiming 97% client retention for 2012, with 95% of clients moving forward without Walgreen in their networks. Walgreen is on the opposite side of that equation, with 85% of Express Scripts' members' prescription volume immediately lost in January. Competing pharmacies such as CVS Caremark, Wal-Mart, Rite Aid, and supermarket chains have welcomed Express Scripts' members with open arms. Now that those patients have already been transferred to other pharmacies, there is little incremental disruption to keeping Walgreen out of the network. With Medco's members, Express Scripts' bargaining position has only gotten stronger, allowing the company to dictate terms to suppliers and extract the greatest portion of value from the pharmaceutical supply chain. This supports our view that retail pharmacies and pharmaceutical distributors have declining moats.
Risks Remain, but Valuation Is Attractive
There are long-term risks to our thesis. CVS Caremark has been pricing its services aggressively to steal market share, which could pressure margins industrywide. Medco has mostly been on the losing end of CVS Caremark's share gains. Although we think Medco's recent contract losses are explained by some unique circumstances, it is possible that the company has some more fundamental shortcomings that will affect Express Scripts' long-run client retention. It is also possible that we are underestimating how much clients value access to Walgreen, which could result in market share losses as contracts come up for renewal. Finally, the generics wave has been a boon, but most large generic conversion opportunities will be used up by 2015. That could lead to intensified price competition and margin pressure.
Even so, we think Express Scripts is cheap. Relative to our stand-alone projections for Medco and Express Scripts, we project $1.6 billion in pretax synergies by 2016 as a result of the merger, which would require the company to add about 1.8% to total revenue and cut about 1.4% from total costs. While this hardly seems like a heroic assumption, considering Express Scripts' operating margin was 5% last year, even these modest synergies could provide a huge boost to earnings. We estimate that the operating margin could reach 7.7% by 2016, compared with the 6.9% we had projected without the merger. Despite our expectation for 20% annual earnings per share growth over the next five years, Express Scripts trades for about 19 times trailing earnings and 12.4 times our estimate for 2013 earnings. We don't think the current stock price properly accounts for the likely synergies of the merger.
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