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Going Long Express Scripts (ESRX) And Short A Call Option

|Includes: Express Scripts, Inc. (ESRX)

02/03/14 Covered Call Pick: Express Scripts Hldg Co (NASDAQ:ESRX)

Express Scripts Hldg Co (ESRX) is a pharmacy benefit management company that provides services such as network-pharmacy claims processing, home delivery pharmacy services, specialty pharmacy benefit management, drug-utilization review, and a host of other medical and drug analysis services. A Fortune 100 company, Express Scripts is the largest company of its kind in the country over 30,000 employees and 2012 revenue in excess of $94 billion.

Express Scripts Hldg Co. has a market capitalization of $60.19 billion with 805.8 million outstanding shares.

Express Scripts currently pays no dividend.

With a beta of 0.66, ESRX currently trades with approximately 2/3rds the current volatility of the market.

The stock markets saw a rough start to the year, as the first month of 2014 saw all the major indices declining since the beginning of the year. The Dow Jones Industrial Average is down nearly 5% since the beginning of the year, the S&P 500 closed under its 50-day moving average for the sixth straight day in a row last week, and the Nasdaq slipped to an Investors Business Daily Accumulation/Distribution to E last Wednesday signaling a period of high volume selling. So when looking for a new stock for us to recommend during a period of weakness, we want to find a name that offers us some safety not only in the stock, but the business model. We'll show you what we mean with Express Scripts.

ESRX is the largest pharmacy benefit management company (NYSEMKT:PBM) in the United States. In 2012, the firm reported processing just over 1.3 billion adjusted claims. For PBMs, a scale of this size gives Express Scripts a few favorable factors, namely the power to negotiate pricing and spread retention. By being able to negotiate discounted drug pricing with manufactures, distributors, retail chains, etc. by aggregating client bases, ESRX can essentially make it devastating for companies to not do business with them, which is a powerful position to be in. This was demonstrated with their contracts with Walgreen, the largest retail pharmacy chain. Even Walgreen had to relent to ESRX's pricing demands because it just couldn't afford to not do business with the huge claim volume the firm has possession of. By throwing their weight around, Express Scripts has been able to have some of the lowest SG&A costs and highest operating profit per claim in the business, which has translated into amazing ROICs, and a ROE of 23%. The firm's size also gives it a wide moat, making it difficult for competitors to muscle them out of the top spot. Sometimes being large makes you slow and vulnerable, but other times it makes you the king. And it's good to be the king.

Express Scripts also has a relatively conservative beta of 0.66. As we mentioned above, Investors Business Daily has recorded the markets to be in a distribution phase, with large lots of stock hitting the markets for sale. When the market is increasing in volatility and decreasing in price, stocks with low betas (and thus less proportionate reaction as compared to the overall market) are good bets for investments as they will not have as strong a decline as the market, and thus are a good place for your money. In fact, while ESRX's market, the Nasdaq, was down over the past month, the PBM's stock has actually climbed over 6% in price. Strength during overall market weakness is a good sign of a solid investment.

ESRX also has the tailwind of demographic trending. Pharmaceutical spending will grow over the next several years as the demographic shifts, the baby boomers enter their elderly years, and the expansion of medical insurance coverage takes hold. Having a business model that is in line with demographic shifts and overall global trends is always a good thing, and a position you want some of the companies in your portfolio to be in.

In terms of valuation, ESRX has a P/E Ratio of 18, which is not cheap on an objective basis, but is in the lower half of their 5-year P/E Range. The stock also is trading at a discount of Morningstar's $89 Fair Value Estimate for the stock, and currently holds a Morningstar Rating of 4 out of 5 stars and a position in its Hare Portfolio, which aims to outperform the S&P 500 Index over time.

For a Covered Call Strategy on ESRX, we are going to look for an at-the-money Call in order to provide a healthy premium for downside protection. While Express Scripts has outperformed its competitors and its stock has outperformed the market in this time of weakness, the fact is the market is still in a distribution phase and may be entering a proper correction. The stock has also had a decent run from a recent technical buy point, so instead of trying to chase the stock up during a period of market weakness, we rather hedge our bets and grab a higher premium. If the stock gets called away we grab a nice bit of yield from the premium, and if we hold the stock at the end of the strategy, even better. That is why we are recommending buying ESRX and selling the May 2014 $75 Call.

Scenario:
 

  • Buy 100 shares of ESRX @ $74.46 = $7,446 + Commission ($12.95) = $7,458.95
  • Write 1 ESRX May 2014 $75 Call @ $350 - Commission ($8.70) = $341.30

Note: Prices may vary from the time of post. Actual commissions paid will vary returns.


Static Return (Not Called):
(Call + Dividend)/Stock Price X (Days/Year)/Days to Expiration

(3.41)/74.59 X (365)/102

= 16.36% Static Return


If-Called Return:
(Call + Dividend + Strike Price - Stock Price)/Stock Price X (Days/Year)/Days to Expiration

(3.41 + 75 - 74.59)/74.59 X (365)/102

= 18.33% If-Called Return

Disclosure: Clients and/or principles of OakTree Investment Advisors may or will have an investment in the above positions, but only on the same sides of the trades. The above numbers are analytic estimations based on information known at the time of this post. OakTree Investment Advisors does not guarantee the above, or any, result. All investment decisions should be made based upon individual's personal investment goals and risk tolerance.

Disclosure: I am long ESRX.

Additional disclosure: As active managers we may increase or decrease positions in stocks we recommend as market situations change.