Medco Health Solutions: Potential Catalysts And Risks

| About: Medco Health (MHS)
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Healthcare is one of the fastest growing sectors in the economy. Healthcare reform will show its true effect starting in 2014 and the number of uninsured people will decline significantly. This is especially good news for pharmacy benefits managers like Medco Health Solutions (NYSE:MHS) which is the largest pharmacy benefits manager in the United States. Medco Health Solutions is involved in a potential merger with Express Scripts (NASDAQ:ESRX). We will compare MHS with its peers and decide whether it makes sense to invest in it at this moment.

In late December, Medco Health Solutions Inc.'s shareholders approved the company's $29 billion acquisition by Express Scripts . The merger arbitrage spread in this deal is about 13% while other mergers carry traditional merger arbitrage spreads of 1% to 4%. However, the National Community Pharmacists Association said that the deal would not be good for the company's consumers and employees. So, it's still uncertain whether the deal will take place.

MHS has a market cap of $24 billion. It's currently trading with a forward PE of 14, and an expected EPS growth rate of 13%. It has a beta of 0.81. Overall, analysts give it a score of 2.3 on a scale in which 1.0 indicates "Strong Buy" and 5.0 means "Sell." Specifically, S&P recommends a "Hold." Thomson Reuters rated it a positive score of 9 on a 1-10 scale, while Market Edge suggests a "Hold" based on technical indicators.

Peers Comparison

Express Scripts, Inc. is a major rival and potential acquirer of Medco Health Solutions Inc. The company has a market cap of $25 billion. It trades with a forward PE of 14.4 and an expected EPS growth rate of 16%. ESRX has a beta of 1.1 and lost 17% in 2011. On average, analysts give it a recommendation of 1.8 on a 1-5 scale. Thomson Reuters rates it 7 on a 1-10 scale and Market Edge gives a "Hold."

UnitedHealth Group Inc. (NYSE:UNH) is a diversified healthcare company which provides health services to its members in the United States. The company has a market cap of $54 billion, a beta of 0.79, a forward PE of 10.53, and an expected EPS growth rate of 12%. Additionally, it also offers a small dividend yield of 1.3%. UNH carries a mean analysts' score of 1.8 on a 1-5 scale. S&P suggests a "Buy." Thomson Reuters scores it 7 on a 1-10 scale, while Market Edge suggests a "Hold."

Hedge Fund Position

Hedge funds went crazy over MHS during the third quarter last year. The number of hedge funds invested in the company doubled during the quarter, moving from 27 at the end of June to 54 at the end of September. Meanwhile, the total volume of hedge fund investment nearly doubled, from $959 million to more than $1.8 billion. D. E. Shaw had the largest chunk among the hedge funds we track, with $545 million shares of MHS at the end of the third quarter. Thomas Steyer, Cliff Asness, Steven Cohen and Bruce Kovner largely boosted their positions, while Eric Mindich, Matthew Halbower, Jim Simons and John Paulson initiated new positions in the stock, according to their respective Q3 filings.

There were 49 hedge funds with a total $2.55 billion invested in ESRX at the end of September, up from 41 hedge funds with $1.99 billion invested in the company at the end of Q2. For UNH, there were 43 hedge funds invested in UNH at the end of Q3, declining from 52 at the end of Q2. Total hedge fund investment in UNH also dropped from $2.76 billion to $2.20 billion.


Based on the three companies' financial statistics, UNH has the smallest beta and offers a small dividend yield, so it tends to be more defensive than MHS and ESRX. The three stocks share similar forward PE and expected EPS growth rates, while analysts seem to be more conservative about MHS. On the hedge fund side, hedge fund managers were quite bullish about MHS probably because of the merger arbitrage opportunity. Hedge funds either boosted their existing positions of MHS, or initiated new positions in the stock. However, hedge funds also boosted their bets on ESRX which is a good sign.

Overall, we are bullish about both MHS and ESRX. Health insurance coverage expansion will benefit both stocks over the long term. We think the negative effects of government involvement have been overblown and healthcare stocks as a group will outperform over the next three years. We also suggest investors to look at other large-cap healthcare stocks, such as Pfizer Inc. (NYSE:PFE) and Johnson & Johnson (NYSE:JNJ). These are better options for conservative income investors. These stocks offer higher dividend yields in addition to their huge upside potential, and, as such, are good alternatives to the Fed's near-zero interest rate policy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.