The aging population in the US and the trend of making a pill for everything build a very compelling base for this growing pharmaceutical middle man notes, Matthew Coffina in Morningstar StockInvestor.
Following its merger with Medco, we view Express Scripts (ESRX) as the only wide-moat company among health plans and drug supply-chain middlemen. We expect Express Scripts, supported by a superb management team, to use its newfound scale to pressure suppliers and drive down administrative costs-creating value for both clients and shareholders.
Pharmacy benefit managers administer drug benefits on behalf of clients such as employers and managed-care organizations, with the principal goal of controlling costs. Express Scripts has two primary strategies for achieving this. First, it leverages its purchasing power to extract better prices from suppliers.
Second, it encourages its members to make cost-effective pharmaceutical consumption choices, such as switching to generic drugs and preferred brands, improving therapy adherence, or using lower-cost retail pharmacies or the company's own mail-order pharmacy.
Express Scripts earns mid-single-digit margins. At the same time, pharmaceutical spending accounts for only around 10% of overall health-care spending. This means that Express Scripts' operating income accounts for well less than 1% of its clients' overall health-care costs. If Express Scripts can lower its clients' health-care costs by even a percentage point more than the competition, it will justify its margins and facilitate market share gains.
We believe scale provides Express Scripts with significant competitive advantages. For example, scale allows Express Scripts to extract better rebates from brand-name drugmakers, better prices from generic drugmakers, and favorable reimbursement rates with retail pharmacies. Scale also allows Express Scripts to leverage fixed costs like claims-processing infrastructure and mail-order facilities.
Furthermore, we think these competitive advantages are getting stronger over time as the PBM industry consolidates. Even though Express Scripts earns a rich return on capital and has experienced 23% compound annual operating income growth during the past five years, smaller competitors like WellPoint (WLP) and Aetna (AET) have been looking to exit the pharmacy benefit management business in favor of partnering with the independent PBMs. In our view, the merger with Medco greatly enhances Express Scripts' scale advantages.
Express Scripts has a history of successfully integrating acquisitions, and we see no reason Medco will be any different, particularly since we already consider the company to be very well run. Express Scripts now has more than 100 million members and controls around a third of US pharmaceutical spending.
It dwarfs second-place CVS Caremark (CVS), which is likely to find it very difficult to catch up, given the lack of other possible acquisition targets of size. Suppliers-such as retail pharmacies, distributors, and drug manufacturers-risk seeing their own margins compress, to Express Scripts' benefit.
We estimate Express Scripts' fair value at $73 per share. As a result of the Medco purchase, we project revenue to approach $118 billion by 2016. Thanks to a combination of merger synergies, increased generics penetration, and other cost-saving initiatives, we project Express Scripts' operating margin to improve to 7.6% by 2016 from 5% last year.
Overall, we project 20% annual adjusted earnings per share growth over the next five years, starting from a 2011 base. We estimate Express Scripts' cost of equity at 10%. Using more aggressive assumptions, we might project Express Scripts' 2016 revenue to approach $127 billion and its operating margin to reach 8.7%. In this case, we think Express Scripts would be worth $90 per share.
Using more conservative assumptions, we could see 2016 revenue leveling off at $109 billion with a 6.4% operating margin. In this case, we think Express Scripts would be worth $57 per share.
Express Scripts took on significant new debt and issued stock to fund the NextRx purchase. However, it quickly repaid the debt and repurchased the stock. While the Medco purchase also resulted in a temporary increase in Express Scripts' financial leverage, we expect the firm to use its substantial cash flows to rebuild the balance sheet in fairly short order.
Express Scripts' financial health is boosted by its substantial free cash flows and the low capital intensity of its business. The company has negative net working capital, and at year-end 2011, it had only $416 million in net property and equipment. In fact, excluding intangibles related to past acquisitions, the company has essentially no invested capital and little need for future capital investments other than to fund acquisitions.
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