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SXCI: Hidden Gem of the PBM Ecosystem

SXCI Catches a Big Fish! Shares of pharmacy benefit manager SXC Health Solutions spiked 23% over the last two days after the company reported a very solid Q4:09 a well as signing a large PBM deal with Medicare-driven managed care company Healthspring to manage the prescription drug benefit for 500,000 HS lives with roughly $1B in annual drug spend. At a 2% pre-tax margin and 34% tax rate, the contract could be worth as much as +$0.42 to EPS (over the life of the contract); at a more conservative 1% pre- tax margin, it’s worth roughly +$0.22 bump to the bottom-line. Recall that managed care contracts are less profitable than employer wins for most PBMS. The HS contract begins 1/1/2011. Back of the enveloping it, I suspect the HS impact to 2011E EPS could be in the ballpark of +$0.08. Meanwhile, 2010 EPS will be dragged modestly by implementation costs going into the contract (this is typical of PBM contracts' year 1, wherein start up costs are the highest). Strikingly, the big 3 PBMs all bid for this contract (~15MM claims) and lost out to SXCI.

I believe that SXCI is an under the radar story not familiar to many investors. As a small cap stock ($1.5B market cap), many on the buy side focus more on PBM giants like ESRX and MHS, which also generated solid returns in 2009 (SXCI shares tripled) after severe scrip erosion trends that many assumed out of the recession did not materialize. Even after such a strong move this week, I feel SXCI has plenty of upside left and should handsomely reward investors with a 3-5 year outlook

Q409 Was a Blowout For Q409, SXCI reported adjusted EPS of $.052 (+85%) versus consensus of $0.44. Mail penetration increased + 150 bps y/y to 11%. Full-year operating cash flow increased +105% y/y and adjusted EBITDA/adjusted claim was $2.74. Adjusted claims were up +12% in Q409. 2009 EBITDA doubled y/y and EBITDA as a percentage of gross profit (48% Q409 versus 32% Q208) growing nicely, reflecting scalability across the model and hence strong operating leverage. Client retention is at 98%, in line with peers. Two uncertainties were cleaned up as well – SXCI renewed the state of Hawaii contract as well as its $150MM contract (worth I estimate ~$0.03 annually to EPS) with Boston Medical Center. Generic fill rate came in at an industry leading 72%. Notably, SXCI has a very active sales pipeline for 2010. I suspect there is as much as $3-5B in SXCI’s pipe. SXCI issued cash EPS guidance of $1.92 to $2.00 for 2010. Without the HS deal, that number would have been materially higher.

Investment Highlights

The PBM industry is morphing into a more integrated supply chain model than a pure “top-down buyer/sponsor decides” model. Technology is more important than ever, and using it to bend the health care cost curve is where I think the industry is ultimately headed. SXCI is a technology-driven PBM and I do believe there transparency and fee-based model is one reason they are winning a lot of new business. SXCI does a lot of state Medicaid FFS (fee for service) business, an area that has come under a lot of scrutiny given cost over-runs and squandered state budgets. States are trying to save money wherever possible, and SXCI is helping them do just that. Like most PBMs, the business is “cap ex lite,” so the opportunity to generate free cash is large. SXCI is running at a $2.5MM/qtr cap ex run-rate. Further, Health IT is roughly 7-8% of SXCI’s business. The cross-selling opportunity is large and SXCI is already transforming its 70 different technology clients to its PBM side (7-10 were converted in 2009), whose top-line grew +54% in 2009 versus the HCIT segment, whose revenues increased +17%.SXCI estimates that 1-in-4 PBM transactions in the US interface with its technology.

** Roughly $290B is spent on pharmacy benefits annually, comprising approximately 3.7 transactions a year. The major industry value drivers are well-known by now:

1. Mail delivery  - roughly 22% penetration in the industry while the Big 3 average penetration of ~30% -  SXCI is at 11%, so there is a long run way for them. Recall that PBMs make more money delivering scripts through mail and typically offer sponsors 500 bps more off a drugs wholesale price. Mail is essentially a win-win for both PBMs and customers since mail is cheaper for patients (lower copays) and yet more profitable for benefit managers. It is the fastest growing channel. PBMs will not be slow to point out that EBITDA/claim (profit metric the street focuses on) growth is correlated to mail penetration. 

2. Specialty pharmaceuticals are growing roughly ~15% versus low single digits for overall prescription drug spending in the US – specialty drugs are, as a reminder, exhorbitantly expensive, tough to handle, often injectable drugs. These drugs are patient-specific and PBMs have an opportunity to come in and handle these complex claims. I estimate the specialty drug mkt is worth about $80-$85B at year end 2009. I've seen numbers out there that think it could be as high as $100B by 2012. 

3. Generic drug penetration - roughly $80-$100B worth off brand drugs go off patent in the next five years – the US is at roughly 70% penetration and 2011-2012, “the Lipitor cliff years,” will be monster years for generics. Generics delivered through mail are wildly profitable, but I don't know how large the delta is here - Ive heard somewhere around 5-10x more profitable on an absolute dollar basis.

** The Baby Boomer bolus (# of people over the age of 65 is expected to double by 2040) we face longer-term also bodes well for prescription drug utilization. SXCI, like most PBMs, will leverage this opportunity. Lastly, the Part D business, although not sticky, is relatively profitable for PBMs, even though PBMs play a passive role in claim processing. The HS win is showing that SXCI can cut the mustard just as well if not better than the Big 3 pharmacy benefit managers who also bid. Whether MA-PD or standalone PDP plans [Part D
plans are approved and regulated by the Medicare program, but are actually designed and administered by health plans - Part D coverage is not standardized & plans choose which drugs they wish to cover, and at what tier they wish to cover them], seniors in Part D plans utilize an above average # of scripts annually so this is another leg of LT growth for the group.

Valuation Concerns SXCI fetches 32x 2010E street estimates of $2.01 (adjusted EPS). The Big 3 PBMs go for 18x, roughly, so investors are clearly paying up for growth and there is no room for error here. Accordingly, I would welcome a pullback and feel more comfortable grabbing shares at a 22-25x multiple. 22x is about where the other PBMs have traded on a peak basis recently. I do believe that if SXCI continues to win more high-level business at the clip that it is currently doing - and increases its mail penetration significantly - it may one day be acquired. After doing an oversubscribed secondary that raised $200MM in Q4, SXCI sits on $10/share in cash and no debt. Nearer-term however, I believe SXCI will be an acquisitor, not a seller. SXCI has a proprietary platform for claims adjudication and its hard for me to tell if it will integrate smoothly with another PBMs. As far as M&A, SXCI management has said repeatedly that they will only pursue EBITDA-positive targets and accretive deals. Assuming SXCI uses all of its cash on deal flow, it’d likely be taking out a smaller PBM with an annual $20-30MM EBITDA run-rate.

Risks Worth Thinking About A) irrational industry pricing - I do NOT think this is the case but CVS' blowup last year and bleeding book of business has some concerned B) pernicious health care reform, centered on PBM's opaque business model and Democrats fighting for more transparency on pricing & rebates (10-20% probability that something insidious passes, in my view - Id argue SXCI actually has an advantage here relative to other PBMs given its "see-through" model) C) the ABC wholesaler contract is up for renewal this year. Poor terms on that contract could pressure shares and D) there is a lack of clarity among some regarding what SXCIs gross margins will be in 2010. I believe a ~150 bps degradation is in order and is baked into expectations. Anything worse than that would raise questions and likely trigger PE compression.

Disclosure: No position in securities mentioned and author's firm does not cover SXCI. Authors views are STRICTLY his and do not reflect that of his employer.