PBM Stocks: Unsexy Sector Can Make You Rich

| About: Medco Health (MHS)
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By Brian Sozzi

From 2006 to 2009, drug distributor and PBM (pharmaceutical benefit managers) stocks were among the darlings of Wall Street. Profits were booming amidst increased generic drug utilization by those in the US, operating efficiencies, and price hikes on branded drugs.

On a CAGR, the main names in the group (Medco (NYSE:MHS), Cardinal Health (NYSE:CAH), Express Scripts (NASDAQ:ESRX), AmerisourceBergen (NYSE:ABC), and McKesson (NYSE:MCK)) notched average market cap growth of 16%. Since the start of 2009 to present day, the average share price gain for the companies mentioned has been a whopping 61%, more than double the advance in the S&P 500 Index.

However, much of the friendly share price performance for the group was derived in 2009 rather than in 2010. The stocks have either flat-lined or declined in 2010 as the market became jittery on profit growth potential due to heightened competitive pricing on contract renewals and a softer generic drug launch calendar relative to prior years.

Moreover, the companies began to spend the fruits of their labor by investing in assets to fund future growth ahead of new healthcare reform kicking into gear. With some 30 million new entrants arriving in the market long before not, the sector is licking its chops as each can be sold a script (hopefully a generic script through the mail).

As the earnings season for the sector winds down, a few thoughts have come to mind. The first, and perhaps most important, is that now is the time to invest in the sector as growth in calendar 2012 will ramp significantly as big name brand drugs roll off patent protection (Plavix, Lipitor, Lexipro). Second, the strong are becoming stronger through acquisitions. At the end of the September quarter, the sector was sitting on nearly $10 billion in cash and equivalents.

McKesson just plunked down $2.7 billion for privately held US Oncology on November 1. Express Scripts is about to experience strong earnings growth in 2011 fueled by its 2009 acquisition of NextRx. These companies are utilizing their balance sheets to grow, increase dividends, and repurchase shares at an eye opening rate. In addition, they are improving their capital structures by tapping debt markets for attractive financing.

Taken as a whole, there is much to like, so it pays to get in prior to the market sniffing out the future earnings potential. I am overweight the sector (in Wall Street parlance, this means I am positive on the stocks in the sector).

Sector Rundown

  • Name: Express Scripts
  • Rating: Buy
  • 12-Month Price Target: $63.00
  • Claims to Fame: Highest generic drug utilization rates in industry; NextRx purchase in 2009 will greatly ramp up the earnings growth in 2011; lost out to CVS (NYSE:CVS) to buy Caremark (in hindsight, lucky it did lose out).

The company generally had good things to say on its earnings call, such as an ahead of plan integration of NextRx, strong client retention, new client wins for 2011, and compelling long-term industry trends. Earnings power at Express Scripts is likely to be quite strong in coming years as NextRx clients are up-sold and healthcare reforms promote greater drug utilization (especially generics).

I remain impressed by the execution of the Express Scripts management team, and believe low balance sheet gearing hints at another PBM acquisition in the not too distant future. Moreover, it's my view that Express Scripts' initial FY11 EPS guidance, suggesting 30% y/y profit growth, puts to bed numerous concerns held by the market (pricing, integration risk).

  • Name: MedcoHealth Solutions
  • Rating: Buy
  • 12-Month Price Target: $70.00
  • Claims to Fame: Has an unworldly client retention rate of 99%, the highest in the sector; seems to win new business at an unstoppable pace quarter after quarter.

I was very pleased by Medco's 3Q10 report as it displayed healthy sequential growth in revenues, gross margin, and EBITDA per adjusted claim. Following concern among consensus analysts regarding Medco's client mix and how it would impact margins, the 3Q10 report calms the fire. Medco is driving strong generic drug utilization through its book of business and is increasingly shipping higher profit generics via its mail order pharmacies. Combined with an aggressive amount of share repurchases, the positive trends in the business are likely to cause consensus estimates to edge up for 4Q10 as well.

The major takeaway from Medco was the FY12 EPS earnings power amid big name generic drug introductions, such as the aforementioned Lipitor, Lexipro, and Plavix. In 4Q11 alone, with Lipitor available for one month, the contribution from generics is outlined to be $0.06 P/S, the most robust of FY11. The impact is quite obvious in FY12, which management stated will be the largest in terms of new generic launches up until 2020.

I think the stock will run into analyst day on November 19, where increased granularity on the FY12 generics contribution will be unveiled. Valued at a P/E multiple of 16.9x my new FY11 EPS estimate of $4.12 (top-end of management's guidance), forecasting at least y/y growth in non-GAAP EPS of 18%, Medco shares are compelling.

  • Name: AmerisourceBergen
  • Rating: Buy
  • 12-Month Price Target: $40.00
  • Claims to Fame: The most efficient pure drug distributor; strong management team; loves to buy back shares.

Though I acknowledge that AmerisourceBergen shares may have a neutral bias medium-term as the market balances a muted FY11 growth story with a stronger growth story in FY12, I believe the stock should ultimately begin to price in the ramp in the earnings trajectory beyond the current fiscal year. At current valuation, the stock has a favorable risk reward ratio in front of the ramp in earnings growth long-term.

  • Name: Cardinal Health
  • Rating: Buy
  • 12-Month Price Target: $44.00
  • Claims to Fame: New CEO continues to impress me on turning around the generics business and driving out wasteful spending in the organization; starting to reverse years of relative earnings underperformance.

Cardinal Health reported a strong 1Q11 on October 28, aided by continued momentum behind the Pharmaceutical segment. The Pharmaceutical segment notched 32 bps of operating margin YOY as execution on generics programs improved and sales mix (bulk versus non-bulk) was favorable. Cardinal Health noted margins in both bulk and non-bulk strengthen YOY as well.

I remain impressed by the work Cardinal Health has done at its largest segment of business in addition to working capital, and think there is an upward bias in profit margins in FY11. As for the Medical segment, it was a soft quarter on sales and margins compared to 1Q10, as guided to by management on the 4Q10 earnings call.

Cardinal Health shares are attractively valued in my opinion. The stock trades at 11.3x my new FY12 EPS forecast of $2.92, or 13.4x my estimate for FY10. In each case, the stock trades at a discount to the five-year P/E multiple of 15.0x. With profit margins trending up and cash deployment being robust, the stock sticks out in my drug distributor coverage universe as a best in breed play.

  • Name: McKesson
  • Rating: Buy
  • 12-Month Price Target: $44.00
  • Claims to Fame: Has a ton of idle cash even after recent acquisition; unlike others in the sector, has deeply penetrated the healthcare IT marketplace.

McKesson continues to represent one of the more underappreciated large-cap stocks in my coverage universe. The stock trades on a P/E multiple of 11.8x my revised FY12 EPS forecast of $5.50 (+$0.11), a discount of 15% to the five-year mean, and an even larger discount to the broad market. I view valuation as very attractive as McKesson begins to experience a ramp in earnings growth as early as the fourth quarter.

Support for that call include (1) indications of a top line turnaround at Technology Solutions on the back of an influx of government dollars and increased human capital; (2) strengthening mix of sales at Distribution Solutions; (3) increased penetration of customers with the OneStop generics program; and (4) utilization of the new $1.0 billion share repurchase plan. Risks to my analysis include (1) fundamental changes in the Canadian drug market; (2) longer than expected improved at Technology Solutions.

Disclosure: No positions