Examining the Health of Express Scripts
Over the past few years, prescription drug pricing has been a frequent subject of news headlines. This isn’t surprising as new specialty drugs for conditions like cancer and hepatitis C are frequently priced in the tens, or even hundreds, of thousands of dollars per year. Going back to the mid-2000s, many branded products lost patent protection, leading to greater use of lower-cost generic drugs. This led to moderating growth in overall drug spending, but growth has again started to surge as the benefit from higher generic utilization wanes. Layer on the aforementioned specialty drug pricing trends, and we are again seeing double-digit growth in prescription drug spending, per IMS Health (see chart below). Against this backdrop, pharmacy benefit managers (PBMs) are playing an increasingly important role in the health care system. In this piece, we aim to explain the importance of PBMs and why we believe Express Scripts Holding Co. (ESRX) is a compelling investment opportunity.
Medicine Spending Growth 1995 – 2004
Source: IMS Health, National Sales Perspectives, Dec 2014; U.S. Census Bureau; U.S. Bureau of Economic Analysis
PBMs manage prescription drug benefits for a majority of Americans, typically on behalf of employers, health plans, or government entities. PBMs exist for one reason: to save these clients money by slowing the growth in drug spending, also known as “managing drug trend”. They do this in a variety of ways, one of which is by leveraging their scale. A PBM aggregates the bargaining power of its many clients to negotiate better prices with drug manufacturers and retail pharmacies. Much of the savings is passed on to clients while the PBM also keeps a portion. The interests of the PBM and client are directly aligned in this regard. PBMs also implement programs specifically designed to drive more cost-efficient drug utilization. These include increasing the use of generic drugs, filling prescriptions through mail order pharmacies when appropriate, and creating formularies for preferred drug options.
As implied above, scale is incredibly important for a PBM. Without enough bargaining power, it is hard for smaller players to match the prices of their larger competitors. This dynamic has helped drive the industry’s consolidation over the past few years. In April 2012, Express Scripts, the third-largest PBM at the time, acquired the industry’s largest player, Medco Health Solutions. Responsible for managing more than 1.3 billion adjusted prescription claims in 2014, Express Scripts is now the country’s largest PBM, followed by CVS Caremark at nearly 1.1 billion adjusted claims1. With nearly 600 million adjusted claims, it was becoming increasingly difficult for UnitedHealth Group’s PBM, OptumRx, to compete, so they acquired Catamaran in July 2015. The addition of Catamaran’s 400 million adjusted claims nearly levels the playing field among the top three players.
At Diamond Hill, we like companies that are attractively valued, run by competent management teams, and have the tailwind of attractive industry dynamics. We believe Express Scripts fits this bill. There are a number of characteristics we like in the company, including the importance of its role within the health care system. Managing the pharmacy benefits of approximately 85 million Americans, Express Scripts is the largest player in an oligopolistic market that collectively has a significant opportunity to reign in drug costs. The business is not capital intensive, which helps drive significant free cash flow. And just as important, management is smart about how they allocate that cash flow. Since 2009, management has repurchased a substantial number of shares at prices well below the recent stock price of approximately $842, as shown in the table below.
|Shares Repurchased (millions)||0||26.9||46.4||0||60.4||62.1||195.8|
|Amount Spent ($ millions)||$0||$1,276||$2,516||$0||$3,905||$4,643||$12,340|
|Average Price per Share||$0||$47||$54||$0||$67||$75||$63|
Source: Company filings
While share repurchases are management’s favored outlet for cash flow, every so often a unique opportunity to strengthen the business comes along. In 2009, Express Scripts acquired WellPoint’s PBM, NextRx, for $4.7 billion. In 2012, we saw the $29 billion acquisition of Medco. These two assets are a key reason Express Scripts has the scale it currently enjoys.
So why hasn’t the market fully recognized these favorable dynamics? We believe there are a few reasons. First, investors are overly-fixated on the contract expiration of its largest client, Anthem, in 2019. While Anthem is responsible for a large portion of Express Scripts’ earnings, we think the worst-case scenario of Anthem in-sourcing its PBM business is largely off the table given its pending acquisition of Cigna. Express Scripts will likely offer Anthem better pricing in exchange for renewing the contract, but we believe the impact will be manageable. Second, there is concern that the “generic wave” has come and gone, as there are fewer branded drugs coming off patent in the next few years than in the recent past. Brand-to-generic conversions have historically been a nice growth driver for Express Scripts since generic drugs are generally more profitable than brands. While it is true that there are fewer such opportunities, they certainly have not gone away, with IMS Health estimating $70 billion of branded drug spend coming off patent between 2016 and 2018. Finally, we believe investors are questioning Express Scripts’ ability to regain market share lost while integrating Medco. As Express Scripts worked to integrate the two businesses, poor service quality led to client attrition. Those issues have largely been addressed and the company’s January 2015 new client implementations were its best ever. We expect rectified service issues, a suite of effective programs to lower drug trend, and Express Scripts’ new status as the only scaled, independent PBM in the market to help drive net new business wins going forward. Collectively, these investor concerns give us the opportunity to own a quality business at a very reasonable price.
Going back to the 1990s, some have questioned the sustainability of PBM growth drivers, and even the need for PBMs within the health care system. While growth will likely be slower than in the past, we believe this is reflected in Express Scripts’ modest valuation, as are the previously-mentioned concerns. To the latter question, we simply think PBMs are more important than ever. Paired with an attractive valuation, Express Scripts’ scale and expertise in managing drug trend create a win-win opportunity for both clients and investors.
1 Adjusted prescription claims multiplies 90-day prescriptions by a factor of three to get to the equivalent number of normal, 30-day prescriptions.
2 $84.49 (closing price as of September 11, 2015).
Originally published on September 17, 2015
The views expressed are those of the research analyst as of September 2015, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.