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Published: June 14, 2010
In a bid to keep a lid on runaway
prescription drug prices, many companies have turned to Pharmacy
Benefit Managers (PBMs). These firms act as a middleman,
handling all prescription-related paperwork and gently nudging
consumers toward lower-priced generic drugs and an increased use
of low-cost mail-order services. Over time, the PBMs have proved
they can save clients lots of money, and as they grow
ever-larger, scale economies kick in, making their compelling
business models look even better.
PBMs have been in the news this week, as CVS Caremark (NYSE:
CVS) and Walgreen (NYSE: WAG) embarked on a very
public spat. Walgreen and CVS had a contract to provide mail
order delivery for Walgreen’s customers. (Customers also have an
option to simply pick up drugs at a Walgreen store). But CVS
began to push Walgreen’s customers toward CVS’ “Maintenance
Choice” program that allows for retail refills good for 90 days.
The catch: drugs needed to be picked up at CVS stores, even
though they were Walgreen customers.
Walgreen saw where that was going, and told CVS that it would no
longer send new customers to CVS’ PBM. CVS responded by telling
Walgreen to take its existing customers somewhere else as well.
That public fight has left both companies bruised. CVS stands to
lose that Walgreen business, and Walgreen risks its customer ire
as they have to scramble to quickly sign up with another PBM.
The two sides may still amicably resolve this dispute, but one
thing is clear: CVS’ hopes of being both a retail pharmacy chain
and a PBM (though a 2007 acquisition of Caremark) was a bad
move. Trying to compete with rival drug store chains while also
supplying them with PBM services has created a clear conflict of
interest, one that CVS foolishly exploited through its
Maintenance Choice customer switching initiative.
As a result, CVS has started to lose PBM customers, and the
trend is likely to continue. The clear beneficiaries:
MedcoHealth (NYSE: MHS) and Express Scripts (Nasdaq: ESRX).
And though both stocks are similarly valued, Medco, the biggest
player, looks like the best investable play here.
In addition to any business it can pick up from defecting CVS
customers, Medco should also uses its size and favorable
demographic trends to keep pounding out impressive growth. As
has been widely chronicled, the number of senior citizens is
rapidly rising, and they are the biggest consumers of
prescription drugs. That’s why analysts think prescription drug
volumes will keep rising at a +5% to +7% clip each year for the
foreseeable future.
But rising volumes doesn’t mean rising spending. Cost pressures
are leading many organizations to emphasize generic drugs. And
that trend should only accelerate. Branded drugs that generated
roughly $100 billion in annual sales in 2008 are expected to
lose patent protection during the next five years. Medco and the
other PBMs actually make greater profits on cheaper generic
drugs. That’s counter-intuitive, but the result of much better
leverage in negotiations, as there are usually multiple
providers of a generic drug.
Another plus: a
number of managed
care firms and large
employers have begun
to realize that PBMs
can operate a lot
more efficiently
than they can. So
the PBMs have been
picking up about $5
billion in new
business each year
as PBM contracts get
outsourced. There’s
ample room for that
trend to continue:
at recent
conferences,
executives at Medco
and Express Scripts
have noted that they
are signing new
contracts at a
robust pace for next
year’s selling
season. That’s why
analysts think both
hose firms can boost
sales at least +5%
next year, although
a +10% growth rate
could be the actual
result.
And as they gain
scale, these firms
are able to show
substantial profit
gains. During the
past decade, Medco’s
earnings before
interest, tax,
depreciation and
amortization
(EBITDA) margins
steadily grew from
3% to 4%, enabling
profits to rise even
faster than sales.
The company is
eyeing further
savings to push
EBITDA margins
closer to the 5%
mark.
Medco’s per-share
profits have grown
at least +20% in
each of the past
three years, and are
expected to rise at
least that much in
2010 and 2011 as
well. Per-share
profits have also
been boosted by a
massive $3 billion
share buyback, which
has taken the share
count from 600
million in 2006 to a
recent 475 million.
Analysts suspect a
similar fresh
buyback will be put
in place later this
year, as long as
shares don’t quickly
move to new highs.
Action to Take
-->
Even after a recent
spike, shares of
Medco still hold
great appeal.
Assuming the forward
price-to-earnings
ratio (P/E)
rises back to its
historical norm of
20, shares will rise
to $80, representing
+30% upside form
current levels.
-- David Sterman
Staff Writer
StreetAuthority |
