Description

Recommendation: Long Catamaran (NASDAQ: CTRX) - $60 PT

Investment Thesis

A combination of undue pessimism about the PBM industry, the recent market sell-off of high growth stocks, and over-optimistic expectations for Catamaran have caused the stock’s valuation to become attractive. While all PBM’s should be poised to do well given several key secular tailwinds, Catamaran is in a position to not only benefit from those tailwinds, but to also gain market share from its competitors. Catamaran is a unique PBM with a high-caliber software offering that can provide customized solutions to its PBM clients. The recent sell-off has left Catamaran trading roughly in line with its peers (namely Express Scripts and CVS), despite offering much higher growth potential. At these levels, Catamaran is attractively valued and could be worth as much as $60 per share.

Company Overview

Catamaran is a leading PBM (pharmacy benefit manager) and Healthcare IT provider. The company began as a Healthcare IT provider but slowly transitioned into the PBM business through acquisitions and through leveraging its existing technology platform. Part of the strategy the company used to acquire PBM customers was to convince clients already using its software platform to also use its PBM services. Additionally, Catamaran has a long and successful track record of acquiring PBM businesses and thereby expanding its footprint in the industry. As one of the smaller players among the major PBM players, Catamaran prides itself on offering more flexible and customizable plans than some of its larger competitors. Additionally, Catamaran’s robust technological platform helps it provide solutions that are comparable to, if not better than, competitors’ offerings.

Catamaran has executed several large M&A deals in recent years that have helped it reach its current size: notably the Catalyst merger in 2012 and the Restat acquisition in 2013. Additionally, a large portion of Catamaran’s growth has been organic through winning new business and expanding its reach with its existing customers. Some summary historical financial data can be found in the table below.

Industry Overview

The PBM industry has undergone rapid growth recently due to the aging of the U.S. population and the rise in usage of prescription drugs generally. PBM’s are able to leverage their significant scale to drive advantageous pricing on prescription drugs for their customers. This is an industry where sufficient scale is required to be able to negotiate with drug manufacturers and retail outlets. It is estimated that Express Scripts controls ~37% of the market, CVS controls ~20% of the market, OptumRx controls ~10% of the market, and Catamaran controls ~9%. While Catamaran lacks the scale of Express Scripts and CVS, it is still large enough that it has sizable negotiating power with suppliers. As Catamaran continues to gain scale, its negotiating leverage will continue to improve and its margins could eventually match those of its larger competitors (i.e. GM projected at ~7% in 2014 as compared to ESRX’s recent historical GM of ~7.8%). Despite its smaller size, Catamaran has demonstrated that it can win large contracts even when competing with Express Scripts and CVS (i.e. recent Cigna deal and $1BN in additional contracts won recently).

Reason for Mispricing

The entire PBM industry has come under pressure due to concerns about private exchanges hampering the existing business model. Based on comments by Catamaran’s management team and other primary information, these concerns are likely overblown given not many people have been enrolled on the private exchanges. Additionally, there are a number of avenues for growth for the PBM industry that have opened up due to the ACA that should more than off-set any potential issues with private exchanges. In addition to the sell-off of PBM stocks, Catamaran’s stock has been put under additional downward pressure due to investor disappointment with 2014 guidance. Catamaran was viewed by many as a high-growth stock that will benefit from strong industry tailwinds throughout most of 2013. Enthusiasm for the stock and expectations for its growth were likely overdone and the combination of uncertainty over the Cigna deal and relatively low 2014 guidance likely caused a lot of growth investors to head for the exits.

Growth Opportunities

Since Catamaran only controls ~9% of the PBM market, it has ample runway to grow and capture a larger portion of the market. Additionally, the recent implementation of the ACA and the aging of the U.S. population are providing large secular tailwinds that should stimulate growth for the entire industry. As a relatively smaller player, Catamaran can be more accommodative of customer requests and can do a better job of customizing its offerings than its larger competitors. Additionally, Catamaran can continue to execute small M&A deals to supplement organic PBM growth (it is getting more difficult to find targets due to the large concentration of the industry, but there is likely still some room to go).

Moat

Catamaran’s moat is comprised of its top-flight technology platform and its ability to customize and tailor its services to individual customer needs. The paradox of the situation faced by Express Scripts and CVS is that they have the necessary scale to negotiate successfully with drug manufacturers and retail outlets, but they are such big players in the PBM market that they are no longer nimble enough to meet idiosyncratic customer needs (i.e. they are too large to be burdened by trying to adjust their offerings for a small to medium-sized customer). With the recent disruption in the healthcare market caused by the implementation of the ACA, Catamaran is positioned well to be able to offer tailored solutions for clients that allow those clients to adhere to new rules and regulations that are being put in place.

Valuation

The $60 price target was derived by valuing Catamaran using a ten year DCF. Using a 10% WACC and an 8.50x Terminal EBITDA multiple suggests Catamaran is worth ~$60 per share, or ~55% above the current price of the stock. The model and sensitivity table can be found below.

Risks

·   Integration of acquisitions – while Catamaran has historically been successful with this, it is possible that there could be integration issues in the future

·   Customer concentration – Cigna accounted for ~23% of revenue in 2013 – Cigna can thus exert a lot of pricing pressure on Catamaran – Catamaran just signed a 10 year deal with Cigna so this should not be an issue for the near-term

·   New regulations or legislation –any new regulations or legislation affecting PBM’s could pose a challenge – appears remote right now given more important issues being focused on in Washington

·   Uncertainty over ACA – any changes to the ACA or roll-back of the law would make planning for the future difficult for PBM’s

·   Operational issues – since Catamaran is expanding rapidly, it could potentially run into issues in managing a larger PBM client-base

Disclaimer:

This is not a recommendation to buy or sell shares.  Our views are subject to change without notice and we may trade in any manner, whether consistent or inconsistent with this recommendation.  The information below is from public sources.  We have not independently verified this information and we make no representations as to the accuracy or correctness of any such information.  We undertake no obligation to update any information below.

Catalyst

·   Accretive M&A deals – Catamaran just recently repaid its borrowings under its credit facility by issuing senior notes at a higher interest rate – while Catamaran listed the use of the additional proceeds as general corporate purposes, it seems likely they may use the cash for M&A

·   Large contract wins – any such wins against larger competitors prove that Catamaran is well-positioned to gain market share in the industry and has competitive offerings

·   Upcoming earnings announcement on May 1st – expectations for 2014 have come down dramatically since management released low 2014 guidance – any beat on earnings or raise of this year’s guidance would be a big boon for the stock

·   Implementation of ACA – the disruption in the market presented by the ACA is opening up numerous opportunities in the PBM space

·   Acquisition of Catamaran by ESRX or CVS – while this is not a high probability event given there would likely be anti-trust issues due to the existing market concentration, the fact that scale is so important in the PBM industry make this a possibility

·   Jay Carney follows up his short RSX recommendation with a long PBM stocks recommendation