Description

***I realize this was written up by Nails early in the year, but my other top long holdings have been written up as well.  This idea is timely as the election and 12/14 earnings guidance call are + catalysts***

I am long Express Scripts (ESRX) and believe the likely transition to growth in 2017 sets the stock up for a significant re-rating.  If I am wrong about a re-rating, the fact that it’s a 10x10x10 stock (e.g. ~10% growth, ~10x FCF, ~10% equity shrink) will mathematically take care of its self with time.  ESRX checks the boxes: a quality business, run by competent management, trading at an attractive price. 

Quality business:  ESRX is the #1 player in a scale-driven business.  They earn recurring revenue from the delivery of prescription pharmaceuticals either indirectly through a network of third party pharmacies or directly through owned mail order or specialty pharmacies.  The PBM’s job is to deliver lower net costs to payers – health plans, government agencies, corporations, benefit plans – than would be attainable on their own.  They achieve lower net costs as a by virtue of supply chain scale, achieving discounts in return for access to their patient network, pushing fulfillment to low cost channels, etc.  The business is not particularly cyclical, though employment levels will dictate covered lives in commercial plans.  Industry unit volumes are stable/growing due to a growing population, an aging population and new therapies.  The industry is a rational oligopoly.  ESRX produces strong returns and excellent conversion of earnings into free cash flow as the business does not require capital to grow.

Competent management:  Management has performed well lately in a few areas.  They have fixed post-integration service quality emanating from the Medco deal.  They’ve invested to improve mail order technology and the customer experience.  They’ve reduced operating expenses.  They’ve ceased reporting integration and restructuring expenses.  Most important, they have allocated capital well.  CVS made several poor deals (e.g. Omnicare) as ESRX has surveyed the landscape and instead focused on share repurchases during a bull market in healthcare valuations.  The best example, other than passing on Omnicare, is that if you carefully review management commentary they’ve discussed acquiring into the management of workers comp for several years, with no tangible results.  I view this positively.  It’s very difficult to instill capital discipline in a management team and they’ve got it here.  ESRX’s equity shrink is impressive; fully diluted shares are down 25% over the last 3 years.

Compelling valuation:  ESRX trades for about 10.9X FY16 EPS and a 10.5% FCF yield.  Based on the body language on the past few conference calls, I expect FY17 EBITDA growth to exceed the +1.8% forecasted by the Bloomberg estimates.  Bloomberg EPS estimates of $6.92 for FY17 is an 8.5% increase over FY16.  If earnings are flat and you roll forward the share count to 610mm (where I expect them to end the year) you get about $6.62 so the incremental 4.5% growth needed to hit FY17 numbers can come from share repurchases alone.  I think forward estimates are probably low.

A few other notes:  ESRX is cheap for a number of reasons.  Fundamentals at ESRX have disappointed for the past couple of years.  After completing the acquisition of Medco, service quality suffered, leading to market share losses to CVS in particular.  ESRX seems to have finally turned the page with a strong recent selling season and excellent client retention rates.  I expect them to announce positive metrics around organic growth on the upcoming 12/14/16 guidance call.

Many criticize PBM’s as being ineffective rent seekers in the pharma supply chain.  I think that is a lazy thesis.  Is the rebate system fundamentally different than charging a 20% performance fee for a hedge fund?  No.  All that matters is net pricing.  It’s very easy to find places where PBM’s have effectively brought down pharmaceutical prices.  Gilead’s Hep C drugs are one example.  Amgen’s recent earnings disappointment with Enbrel is another.  PCSK9 cholesterol drugs are another.  CVS today reported a poor 2017 earnings outlook as PBM’s re-directed retail scripts to a lower priced provider.  Further, PBM’s customers are very sophisticated.  If PBMs did not add value, customers would not use them.  Anthem to me is a one off case.  The company is suing Express Scripts, but also the Federal Government and their merger partner Cigna; they’re a litigious group.  In recent conference calls, ANTM’s commentary toward ESRX has calmed down.

Fraudy or quasi-fruady behavior has been the best economic model in health care for a few years.  Notice some of the best stocks like VRX and ADPT exhibited these traits and were well loved by Wall Street.  Price deflation is the enemy of the healthcare sector.  A PBM is the primary mechanism for generating price deflation; it should surprise no one that the groups who seek to create price inflation (pharmaceutical companies, hospitals, doctors, pharmacy chains, etc.) don’t like PBM’s and will rally support against them. 

Back to the Anthem contract, my view is that this might end up being a $1b headwind to EBITDA in 2020 and that will essentially be offset by a combination of organic growth and share repurchases.  You can run your own sensitivity given we know ANTM generated 175mm scripts in 2015 and EBITDA/Rx was $6.24 in Q3.  Remember that ANTM under-indexes to certain high EBITDA/Rx products like mail, restricted formularies, etc.  If you just strip $1b of EBITDA out of the numbers today and use end of year shares of 610mm that’s $1.07 of EPS and the multiple remains reasonable.

<A - Ian C. Read>: On PBMs, I mean, we work with PBMs. They have played up to date a role in improving access and reducing cost to patients. I think the issue of the size of the rebates and the net pricing and the general focus on getting pricing transparency could have a marked change, but it would require legislative change. I don't think accident ledgers have changed. I think the market will be stable around the PBMs. It just depends what happens when the new administration and Congress is in and how much they want to get rid of this issue of having high gross prices and low net prices, which I think today we would say is a disservice to patients, especially those that are not insured or poorly insured. Mikael? 

Catalyst

12/14 earnings guidance

Share cannibalization 

Anthem contract 

Health care sector re-rating post-election