Description

ESRX - $87

The temporary impairment in investor sentiment provides the opportunity to buy the PBM industry leader at an 8% 2014E FCF yield.  

The PBM industry has gone through a significant consolidation period leaving the industry much better positioned to generate long-term economic profits.  This structural change has created an oligopoly in which the largest PBM’s have the most bargaining power with suppliers as well as the most scale.  This provides the largest PBM’s, such as ESRX, with a durable competitive advantage that should lead to several years of margin expansion and growing ROIC.  In addition, growing generic volumes provide a tailwind to gross margins and an aging U.S. population as well as healthcare reform provides tailwinds for volumes.  Longer-term, 6% annual U.S. pharmaceutical spending growth should support continued growth for the PBM’s.      

The negative effect of patent cliff uncertainty and private exchanges has temporarily impaired investor sentiment, leading to a contraction in ESRX’s valuation.  Consensus is currently pricing in too negative of a scenario and as sentiment improves and investors recognize ESRX’s indispensable position in the U.S. healthcare system, ESRX’s multiples should continue to rerate.  In addition, growing generic volumes and Medco synergies should drive operating margin expansion and EPS growth over the next few years.  The company’s current valuation is particularly attractive with ESRX shares trading at a discount to peers, ~14x 2014E EPS and an over 8% free cash flow yield.  We believe the company can grow EPS by 10% to 20% annually over the next several years with aggressive share repurchases of $4+ billion over the next several years (7%+ of the current market cap).  Our base case $87 one-year price target is based on 15x (a discount to the 5 year historical average multiple and a discount to peers) our 2015 EPS estimate of $5.80.  An $83 valuation is supported by our DCF model. 

COMPANY OVERVIEW

Express Scripts (ESRX) provides pharmacy benefit management (PBM) services primarily in the U.S. and Canada.  PBM’s provide several services to customers including determining if a cheaper generic or discounted branded drug is available, creating a list of lowest cost branded and generic drugs, determining if a specific authorization for a specific drug is needed before the prescription is filled, implementing step therapies to eliminate dosage waste, developing deductible/copayment schemes to incentivize members to use the cheapest drug options, delivering prescriptions directly to patients and choosing the least costly retail pharmacy to fill the prescription.  The PBM either charges a fee or increases its spread retention per claim for providing these management services.  ESRX also provides home delivery services and has 6 mail order distribution centers.  ESRX provides its PBM services to managed care organizations, health insurers, third-party administrators, employers, union-sponsored benefit plans, workers’ compensation plans, and government health programs.  The company processed 1.4 billion claims in 2012 and has 34% market share.  Express Scripts was founded in 1986 and is headquartered in St. Louis, Missouri.  

KEY INVESTMENT POINTS

Porter’s 5 Forces suggest that this is an attractive industry with high barriers to entry.

Bargaining Power of Suppliers - Low

• More generics lessen Pharma company bargaining power as generics are standardized and interchangeable with nearly identical performance to branded drugs. 
• Pharma companies have more bargaining power with branded drugs for which there are few available substitutes. 

Bargaining Power of Buyers – Low to Moderate

• Buyers typically need the scale and negotiating power that PBM’s have.
• Buyers benefit from working with the PBM’s through lower costs for drugs.
• There are some switching costs that reduce the bargaining power of buyers. 
• Buyers often do not make up a large portion of a PBM’s volumes.
  • The U.S. government is prohibited from directly negotiating drug prices and therefore, it is required to use PBM’s.

Availability of Substitutes – Low

• Insurance companies and employer plans can manage their own pharmacy services however, they lack scale; the cost of drugs will likely be higher, even after paying a margin to a PBM. 

Threat of New Entrants – Low

• Scale is needed to be effective in this business and it would be very difficult for a new entrant to gain the necessary scale to effectively compete.
• Health insurance companies might try to enter this business but will likely lack the scale and negotiating power of the large PBM’s.

Intensity of Rivalry among Existing Competitors - Moderate

• The industry is a concentrated oligopoly.
• Competitors often compete on price but also compete on the value added services that they offer.
• Pricing has traditionally been rational.
• The industry continues to grow at a reasonable rate.  
• Customer retention has historically been in the mid 90’s%. 

This is a scale business and ESRX has the most of it; this provides the company with significant bargaining power and economies of scale.

The industry has transformed into an oligopoly through several acquisitions and the companies with higher volumes have been able to wield greater bargaining power with suppliers and lower average cost by spreading fixed SG&A costs over a larger sales base.  Express currently controls 34% of the $280 billion U.S. PBM market and Caremark has 26%. Several smaller players have less market share: Optum (a division of UnitedHealth) has 12% which is 80% or more United business, Catamaran has 5%, and Prime has 5%.  The April 2012 ESRX/Medco merger was transformational as it created the largest PBM with significant bargaining power. 

Processing the industry leading number of claims generates two key competitive advantages for ESRX:

1)     Pricing leverage with suppliers

1. ESRX’s scale and negotiating power leads to lower prices for ESRX’s customers than they would be able to obtain on their own.  ESRX generally has the most attractive pricing in the industry. 
2. ESRX can negotiate discounts of 30% or more and pass this savings along to customers/payers.  PBM’s are actually able to negotiate lower prices for customers than their customers would be able to on their own due to scale.  ESRX negotiates discounted drug pricing with manufacturers, distributors, and retail chains, which allows their aggregate client base to obtain products more cheaply.
3. Drug manufacturers want to be on ESRX’s formulary list and to do this they will offer discounts and rebates. 
4. ESRX can grow while expanding gross margins as it negotiates prices down with higher volumes.
5. ESRX does not possess the same level of pricing leverage with the pharmaceutical distributors and branded drug manufacturers as it does with the retail pharmacies and generic manufacturers because there are few substitutes for unique branded drugs.  However, more profitable generics are growing to be a larger portion of ESRX’s volumes. 

2)     Superior centralized cost scale advantage

1. By spreading fixed SG&A costs over a larger sales base, ESRX can earn a higher EBITDA margin than its peers.  CVS’s Caremark 2013E EBITDA Margin of 4.7% is below ESRX’s EBITDA margin of 6.5%. 
2. Scale is also a source of competitive advantage as each additional claim processed is more profitable than the previous.
3. ESRX leading market share and volume have enabled the company to generate the highest gross profit per adjusted claim and the lowest SG&A per claim. 

Pharmaceutical spending will grow robustly over the next several years given demographic shifts and the expansion of medical insurance coverage through the Affordable Care Act.

Driven by demographic shifts and the expansion of health insurance to the currently uninsured, pharmaceutical spending will grow at a healthy 6% CAGR over the 10-year period from 2012 to 2021 according to CMS.  This is a large opportunity for the PBM’s and ESRX to continue to grow volumes and leverage fixed expenses.  ESRX is well positioned to benefit from growing volumes under the ACA as over 90% of the newly insured should be in 40 states where ESRX has a key managed care relationship.  Seniors over 65 are expected to account for ~16% of the total population by 2017, up from closer to 14% today and this should help drive more demand for pharmaceutical drugs.  Lastly, the ACA seeks to curb the growth of costs and PBM’s play a key role in this process by negotiating down the cost of pharmaceutical drugs.

The percentage of generics as a percentage of total scripts is increasing over time and this is a tailwind for ESRX’s gross margins.

ESRX has been able to steadily increase its generic penetration and this is important because generics are more profitable than branded drugs for the company (and also the lowest cost for ESRX’s customers) due to increased bargaining power for ESRX due to multiple suppliers.  While the size of generic launches in 2013-2015 will decline to ~$56 billion, this is only moderately below the 2010-2012 launches of ~$63 billion.  This should provide a runway for ESRX to continue transitioning its volumes to higher margin generic business.   

ESRX expects generic penetration to reach 85% over the near-term and sees long-term potential for penetration in the high 80s.  Moreover, while ESRX’s Q3 generic penetration was 80.8%, over 40% of its book has a fill rate below 80%.  This provides a near-term opportunity for ESRX to help these clients improve their benefit design to optimize their generic fill rates.  Generics by mail are the most profitable type of script for ESRX.  This business has been growing rapidly and is well positioned for additional growth. 

Mail order is a significant opportunity for ESRX.

ESRX posted adjusted mail penetration of 28.7% in Q3, well above the high-teen US industry average.  Mail order is a higher margin business and Medco has significant expertise in this market that should benefit the combined company.  Management believes it can utilize Medco’s expertise to help drive mail penetration to 40% in the near term (60% long term) given that (i) 75% of its prescriptions adjudicated today are for maintenance medications which are ideal for 90-day delivery, (ii) health plans are increasingly looking for ways to lower premiums, and mail is a more cost effective channel, and (iii) as the economy improves and unemployment decreases, members will be more willing to switch back to 90-day prescriptions.

High retention rates indicate that customers are satisfied with ESRX and its product offering & pricing.

ESRX expects 2013 retention to be in the mid 90% range.  Excluding acquisitions, retention would be at approximately 97%.  ESRX has also been successful at winning new business and the company is flat to slightly positive on net new business.  The switching costs and ESRX’s industry leading pricing (due to unmatched scale) make customers reluctant to leave ESRX.

Synergies from the Medco merger continue to materialize.

ESRX was able to reduce its absolute SG&A expense in Q3 2013, demonstrating the synergies that the company has been able to achieve.  The company expects integration expenses to cease in 2H 2013.  ESRX expects ~$1 billion of synergies by year-end in addition to the significant increase in bargaining power that the company is able to generate through higher volumes.  The company has already transitioned 80% of Medco clients to the new operating platform and this transition has gone relatively smoothly.  The company expects to have all Medco clients integrated into the new operating platform by January 1, 2014 and this should drive SG&A expense savings as it is expensive to run two separate networks.  Additional cost savings opportunities include rationalizing the specialty pharmacy footprint, better leveraging the cost base, driving better purchasing due to increased scale, and the sharing of best practices. In addition, ESRX has expanded its service offering after the Medco acquisition that should enable it to gain incremental volumes from competitors.

ESRX’s CEO has significant share ownership and has consistently generated value for shareholders.

CEO George Paz has historically generated strong returns for shareholders.  Paz owns ~$157 million of ESRX shares with a significant portion of his personal wealth tied to the success of the company.  This aligns his interests with those of the shareholders.  He also recently signed an employment agreement through March 2017.     

The company also recently hired a new CFO, Cathy Smith, from Walmart where she was EVP of Strategy and CFO for Walmart International since 2010.  She brings diverse experience to the company and should be an asset.     

Express Scripts is a negative working capital business and generates a significant amount of free cash flow.

As ESRX’s net income grows, its free cash flow grows at a faster rate due to the negative working capital nature of the business.  The company converted 1.4x net income into operating cash flow in Q3.  The company holds only about 6 days of inventory as it only carries inventory for mail order volumes.  Accounts receivable are typically collected within 15 to 20 days.  However, ESRX’s bargaining power enables it to push out accounts payables to over 30 days leading to a cash conversion cycle of about negative 10 days.  Also, ESRX’s business model is not capital intensive with CAPEX of less than 1% of sales expected in 2013.

The company has a significant amount of debt but consistent FCF generation and limited debt maturities limit the risk.

ESRX has $14.1 billion of debt, a debt to total capital ratio of 37% and a debt to EBITDA ratio of 2.2x.  While the leverage is high, the company should generate ~$4.8 billion of FCF in 2014 (debt pay down in ~3 years), providing sufficient cash to reduce the debt burden as well as repurchase shares.  The company reduced the debt burden by $1.8 billion in the first nine months of 2013.  Additionally, ESRX has a $1.5 billion revolving credit facility that has not been utilized and $1.7 billion of cash and equivalents.

ESRX resumed its share repurchases in 2013 and it has repurchases $1.6 billion in the first nine months of 2013 and announced a $1.5 billion accelerated share repurchase in December 2013.  As of September 30, 2013, there were 51.3 million shares remaining under the 2013 Share Repurchase Program.  ESRX expects to maintain its debt/EBITDA at 2x and return the majority of its FCF to shareholders.  This could drive 8%+ annual EPS growth just from buybacks with the company generating $4+ billion of annual free cash flow over the next several years.  A dividend could also be initiated in the near future and could act as a catalyst for shares.    

VALUATION

Concerns regarding private exchanges have driven down ESRX’s valuation to very attractive levels.  ESRX shares are trading at a discount to historical averages on a forward P/E basis (14x vs. 16x), peers and the S&P 500.  The 2014 free cash flow yield on equity is attractive at over 8%.  Even though ESRX’s industry leading market position renders it best positioned to negotiate with supplies are derive scale advantages, ESRX shares are trading at a meaningful discount to peers.  As the market recognizes that the threat from private exchanges has been overstated and the attractiveness of ESRX’s positioning, ESRX’s valuation will likely continue to rerate.  The company expects long-term EPS growth of 10% to 20% and we believe that this is achievable.  The company also has the ability to reduce the share count by a mid to high single digit amount on an annual basis over the next several years (with $4+ billion of annual free cash flow generation over the next several years) and this could drive mid to high single digit EPS growth just from capital allocation.      

Our base case $87 price target is based on 15x (a discount to the 5 year historical average multiple) our 2015 EPS estimate of $5.80.  Our $5.80 estimate is based on continued growth in generic, slightly positive script growth and 60 basis points of EBITDA margin expansion from 2013 to 2015.  Our DCF valuation suggests a price target of $83 based on an 8% WACC and an 8x EBITDA multiple in 2018.   

RISKS

The growth of private exchanges could continue to cause uncertainty.

WAG recently announced plans to move its employees to a private exchange, the most significant announcement to date.  This followed IBM and Time Warner announcing plans to move Medicare eligible retirees into private exchanges next year.  The emerging consensus view is that PBMs will face a loss of revenue as some employers increasingly turn to private exchanges for employee health coverage.  However, private exchange health insurance providers will still need the negotiating leverage, the supplier pricing discounts, drug cost-containment expertise, and streamlined administrative functions of the PBMs.  In fact, the firms that will provide plans through both public and private exchanges are customers of major PBMs.  PBM’s will still be relevant in the private exchange market.  Currently, private exchanges represent less than a quarter of one percent of prescriptions in 2013 and are projected to reach just ~2% by 2016.

ESRX’s management team estimates that profitability on private exchanges is roughly equivalent to the profitability of health plan clients and large employer plans.  In fact, the private and public exchanges could be more profitable due to tighter pharmacy management tools under the exchanges such as narrower networks and fewer options, potentially driving more volume to higher margin mail order.  As long as the company is able to maintain market share, there shouldn’t be a drop in profitability if there is some volume migration to private exchanges. 

Several factors point against widespread dumping by employers onto private exchanges, including: 1) the perceived value of healthcare coverage to employees; and 2) the view that employer-sponsored coverage is an effective tool to improve overall employee health and productivity.  Dumping might work for WAG, but won’t be as attractive for an employer who is using their benefits program to attract employees to the firm. 

ESRX has some customer concentration risk, but it should not impact the business. 

14% of the company’s 2012 revenue was generated from Wellpoint and 11% was generated from the U.S. Department of Defense.  ESRX acquired WLP’s PBM, NextRx, outright in 2009 and signed a 10-year PBM relationship with WLP so there is no risk to losing this business.  The Department of Defense contract expires in October 2014 and we expect ESRX to renew this contract given 1) ESRX generally has very competitive pricing and government agencies have to choose the company with the best price and 2) the Federal government can’t directly negotiate drug pricing and has to use the services of the PBM’s. 

Competition could intensify.

While the industry is an oligopoly, there is the threat of competition intensifying.  However, pricing has been rational and retention rates have historically been ~95% for ESRX.

Catalyst