There are a few things I've observed over a couple of decades of investing, and I think of my observations are particularly relevant when it comes to Express Scripts (NASDAQ:ESRX). The first observation is that the business cycle is alive and well. We can try to pretend that it doesn't exist, but sooner or later it will come roaring back. The second observation has seemed strangely controversial at times. It is that investors are compensated with net income. They aren't compensated by sales, neither are they compensated by sales growth, nor by EBITDA, and certainly they aren't compensated over the long term by some forecast that an analyst has come up with. It's for these reasons, among others, that I'm bullish on Express Scripts. I outline my reasoning below.
Express Scripts has had revenue that is at times choppy. For instance, revenue declined ~3% from 2013 to 2014, and it declined about 1.4% in 2016 relative to 2015. In spite of that, net income has risen fairly steadily. For example, it's up enormously in 2016 relative to 2015 (up about 37%). In fact, net income is up at a CAGR of ~13% from 2010 to now. This growth rate may slow at some point, but rising profits in the face of choppy revenue represents clear evidence that this is a company that can manage costs well.
The company is also quite shareholder friendly in that they have returned a little over $22.5 billion to shareholders in the form of stock buybacks since 2010. The thing about stock buybacks is that they boost earnings per share figures, but they can play havoc with the balance sheet (as treasury stock is a hit to owner's equity, thus making debt a much bigger part of the capital structure than it otherwise might be). In this case, though, the balance sheet remains in relatively good shape. The net owner's equity represents fully 31% of the capital structure, in spite of 35% of owner's equity being taken out by treasury stock. This is a "mostly" very healthy balance sheet.
I say "mostly" because I always find something to complain about, and in this case it is debt. Although the company has a demonstrated capacity to knock down debt aggressively (for instance, between 2012 and 2014, long term debt declined 27%), it has been rising steadily recently. More troubling to me is the fact that 27% of the long term debt is due this year (with ~35% due in 2020 or after). I don't consider this too troublesome, as the company has 15% of the debt due in cash, and has relatively ready access to sources of cash. That said, the debt here is the one thing I will be paying very close attention to in 2017.
The Stock and Politics
Another observation that I've made repeatedly over the years is the disconnect between the underlying business and the stock that supposedly represents the fortunes of that business. For instance, even a wonderful business can be a terrible investment if the stock is acquired at the "wrong" price. If a company is growing rapidly, but the shares are priced too aggressively, the marginal shareholder is likely to get burned. On the other hand, if an investor can see past some hype, they might pick up an excellent stock at a very decent price.
In my view, the current political maelstrom about pharma prices in the United States offers a golden opportunity here. Express Scripts shares are trading at a 38% discount to the overall market, obviously because of the political headwinds affecting the stock. President Trump has said that he does not like high drug prices and that he will bring them. I myself don't want to be the subject of any angry nocturnal rants on twitter, so I'll choose my next words very carefully. Reading political history gives one a sense that there's often a disconnect between what a politician says and (ahem) what are the actual facts of a situation. For instance, a politician might fire up their constituency by saying that they're going to go after a certain company that is generating vulgar profits. When the politician learns that the vulgar company is generating a margin in the low single digits, the storm blows over. This is why there's sometimes (often) a chasm between what a politician promises and what subsequently happens. Also, change of this type can take years, and in the meantime shareholders can profit. I hope these aren't controversial observations.
Regarding the specifics of this case, even if we assume that President Trump has both the motivation to expend political capital and the power to "cut drug prices", there are other companies in the pharma space that are making far more "vulgar" profits than this one. For example, Express Scripts' most recent net income margin is about 2.6%. This gives them a great deal of leverage in negotiating with a theoretically hostile administration.
As per our ChartMasterPro Daily Price Model the trend for ESRX turned Bullish on February 10 when the shares closed above the downtrend line that began on January 19. From here we see the shares rising to $73.50 over the next three months.
Today we will buy the ESRX 21APR17 67.50 Call Options which will provide us with approximately 10x leverage for our LONG trade. Our initial stop-loss exit signal will be a daily close below $68.00.
For investors in the shares we recommend you hold for three months or $73.50, whichever comes first.
In my view, the recent fuss about drug pricing is weighing on this stock and that presents investors with an excellent opportunity. The company has a demonstrated capacity to make rising net income in spite of the inevitable fluctuations in revenue. Most worrying to me is the debt level, and so I will be keeping an eye on it. What some politicians say in a sternly worded letter is probably the least of my concerns, but I will continue to monitor this also, as at the very least it makes interesting, if pointless, drama.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ESRX over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.