February 23, 2016 - 2:44am EST by
2016 2017
Price: 68.95 EPS 0 0
Shares Out. (in M): 668 P/E 11 0
Market Cap (in $M): 45,000 P/FCF 0 0
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT 0 0

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  • PBM


Express Scripts ESRX

This will be a pretty controversial idea.

Express Scripts has sold off 21% YTD because of a contract dispute with Anthem. The Street is freaked out because of the uncertainty, and because of the concern that renegotiating the Anthem contract will be a $1bn+ hit to ESRX EBITDA. For many investors, the ESRX story is now simply "too hard". While there are risks, I think the odds are in an investor's favor today.


PBMs Background

Since this is an event driven idea, I'll be brief. The PBMs are gate keepers through which most pharmaceutical sales must pass. It's a scale driven business -- operating mail order pharmacies, claims adjudication systems, negotiating against drug manufacturers, and negotiating against pharmacies all require scale. Therefore, the entire industry has now consolidated into three players -- UNH Optum, Express Scripts, and CVS Caremark. The fourth largest player has maybe only 6% share.

The PBM business is actually quite good:

  1. ·         Zero to negative working capital
  2. ·         Grows with drug spend (low-mid single digits)
  3. ·         97% retention ratios -- hard switching costs, and rather opaque contracts / information asymmetry. (There is a large consulting ecosystem to aid customers, but in practice the odds are still tilted in the PBM's favor, especially with smaller clients)
  4. ·         Low but fairly steady margins, and high FCF conversion

As a result, ESRX and CVS have created a lot of value in the past.

ESRX had actually struggled for several years post its Medco acquisition. They had transitioned the entire business into a new technology platform, and service issued had led to contract losses. In addition, several large clients defected for various reasons (UNH which brought its business in-house, Coventry got bought out, Medco clients that wanted to switch post merger, etc).

These service issues are finally at an end. Hopefully by 2017, ESRX will cease bleeding market share. (The Fall 2015 contract season was apparently quite strong, with a 97% retention ratio).


Anthem Background

Anthem is ESRX's largest client, with about 14% of revenues and ~20% of total scripts. Here is a timeline of the relationship:

·         In 2009, Anthem sells its PBM to ESRX for ~$4.8bn, with an initial 10 year contract. The contract contains periodic "market pricing checks", with the last one being 2012

·         Anthem gets a new CEO in 2013

·         All through the second half of 2015, Anthem's CEO goes on record for trying to extract $500-$700M of value from ESRX in renegotiations

·         In early 2016, the dispute goes public. Both sides exhaust the arbitration steps outlined in contract

·         Anthem goes on record that ESRX is "overcharging" them by $3bn


Losing Anthem would be a blow to ESRX. Not only would they lose the direct profits tied into the contract, but they'd also lose bargaining power, and thus the rest of their book would become less profitable in the long run.

Predictably, investors are freaked out.

My Thesis

The bear thesis out there is that ESRX will lose $1+bn EBITDA from the Anthem situation, maybe closer to $2bn. The Anthem exposure is much higher than what ESRX managed revealed before. Or, alternatively, they lose Anthem to a rival, now or in 2019, and the whole business would de-scale.

This is my prediction:

·         Anthem is not going to defect from ESRX, because ESRX is the best partner for it

·         The renegotiation will not lead to anywhere near $1bn in losses. In fact, I wouldn't be surprised if it's more like $500M, net / net. Anthem might give up some source of value in exchange for better monetary terms -- like a contract extension beyond 2019, promising to move Cigna over post acquisition, or give up formulary control.

·         Anthem's management is rational, and both sides are highly incentivized to come to terms

·         Likely the situation will be resolved in the next 3 months, almost certainly in 2016

Clearly, if I'm right, the stock is going MUCH higher.


How Much is the Anthem's Contract Really Worth

This is a major bone of contention today. The bears think the $3bn number bandied about by Anthem has merit. I personally think the number is much smaller, maybe closer to $1.2-$1.5bn. (Total EBITDA of ESRX is $7bn)

First, normally a large "anchor" health plan contract like Anthem's would be drastically less profitable than the rest of the PBM's book:

·         High bargaining power by the HMO

·         Low mail penetration

·         Some key profit drivers -- e.g. formulary control -- are missing. (Anthem controls its own formulary)

The key difference with the Anthem contract is that when they did the 2009 deal, Anthem management and ESRX management had a sort of "handshake" agreement that in exchange for cash upfront, the contract would slightly favor ESRX over its term, such that much of the cash would be recouped over the 10 year period.

Therefore, there is something like $500-$600M of extra EBIT per year embedded into the contract

If this was a "normal" contract, I would probably expect it to earn no more than a 3-4% operating margin. (To compare, CVS is on record saying its landmark AET contract has a 2% margin). Even with the additional profits from the unusual structure, I do not believe this contract is earning more than $1.5bn for ESRX, and in fact could materially be less.

I read the situation thus: after Anthem's prior CEO left, the current CEO wants to break the "handshake agreement" made in 2009. It wants to claim back the additional "padded profits" in the contract, which lines up with the ~$600M figure they were citing in 2015. It saw weakness in ESRX -- with its share losses since Medco -- and knew that its bargaining position was very strong. ESRX, understandably, views this as unfair, because they "paid for" these profits in 2009. As such, the parties are at a standoff.

Other Triangulation

1) Is Anthem stupid?

One of the corollaries of the bear thesis (that ESRX is making obscene profits from Anthem) is that Anthem is stupid. How else can you explain them leaving hundreds of millions of dollars, if not billions on the table, particularly after the contract was re-negotiated in 2012?

I don't believe this was true. In my DD, Anthem is actually a pretty sophisticated operator. They kept in close touch with the drug makers and the PBM consultants, and knew what "fair" rebate levels were. After all, they used to own one of the largest PBMs in the country!

Also, look at Anthem's EBITDA. Is it reasonable to believe that they had been leaving a huge piece of their overall profitability to ESRX for 7 years, and knew nothing about it until some revelation in 2016?

2) Is the rest of ESRX's book of business crap?

Another corollary of the "supra normal Anthem profits" thesis is that the non-Anthem book must be pretty unattractive. While ESRX does service Tricare, which is a low margin business, I find it hard to believe that their commercial book (which is normally the most profitable business a PBM can have) is actually anemic.

I also gut checked like this:

In 2012, pro-forma for the Medco acquisition, ESRX had $6.3bn of “baseline” EBITDA and 1.59bn scripts. This is pre-synergies and pre-contract losses

·         In 2015, ESRX will have about $7bn of EBITDA and 1.3bn scripts.

·         In 2012, adjusted EBITDA / script was $4.10. Therefore, they lost $1.2bn of EBITDA through the ~290M of lost scripts

·         2012 – 2015, they extracted a bit over $1bn of synergies from Medco, thru cost reductions and bargaining w/ channel partners. This roughly offset the losses from the script losses.


So, if there was indeed a substantial “kink” in Anthem’s contract profitability post 2012 to the degree that bears say, it would imply that the rest of ESRX’s business made little to no improvements at all.


3) What could have happened between late 2015 and early 2016?

In H2 2015, Anthem's goals were to extract $500-$700M from ESRX. Then apparently after some earth shattering revelation, their target goes to $3bn. In my DD, it's impossible for pricing to move that quickly. In fact, it's more normal for pricing to move maybe 1-3% year to year. Unless Anthem was really stupid (leaving huge dollars on the table before), I don't see how this is possible. Occam's razor says that ANTM is being very clever in putting pressure on ESRX. So far, judging by market reaction, it's working.


Anthem's Choices

Anthem has the following strategic options:

·         Come to terms in 2016, stay with ESRX

·         Patch things up with ESRX for now, but defect after 2019. (Well, actually since there is usually a 18-24 months transition period, even if the relationship blew up now, they'd really only escape ESRX in 2018-2019). Before 2019, I wonder if ESRX will litigate.

·         Take some / all functions in house

·         Move to CVS

·         Move to UNH

·         Do some deal with Prime Therapeutics (6% PBM share, a co-op of Blues plans)


Let's take the "negative outcomes" one by one:

·         Move to UNH -- very hard, since they are enemies

·         Move to CVS -- also hard, because CVS is strategically aligned with Aetna.

·         Move to Prime (or another tier 2 PBM with tiny share) -- possible, but the deal could be complicated and it would be difficult for even the combined entity to have ESRX's scale.

·         Move in house -- also a huge hassle, and possibly not attractive. Anthem has no adjudication platform, and its standalone scale is much less than ESRX. You may argue that their local market shares are strong, which affords them bargaining power, but I can't see them coming out materially ahead.

In sum, I don't think any of these choices are particularly appetizing. That leaves the most obvious choice -- come to terms with ESRX, and soon.

·         ESRX is incentivized to offer attractive terms. There is enough value here that ESRX can make a deal that benefits both parties, and beats any other deal that Anthem can realistically do outside of the relationship.

·         Anthem is very strongly incentivized to realize cash benefits RIGHT AWAY. If they do not come to terms, they are not going to benefit until 2018-2019. Anthem's CEO basically already promised investors benefits soon (2016). Do they really want to wait another 2-3 years? Especially with the Cigna deal pending, do they want this hanging over their heads?

·         A move away from ESRX, although possible, will require a lot of management attention and there are execution risks. The path of least resistance, by far, is to stay put, at least if the dollars make sense.

I've spent some time figuring out the Anthem management team. My conclusion is that there isn't really "bad blood" between the two sides, aside from dollars and cents. I think they are opportunistic, but ultimately they are business people.



I think it's more likely than not that the situation will be resolved soon. I would handicap something happening in 2016 at 90%, but something in the next 3 months at 60%.

The reason is that there is such a long lag between decisions and implementation in the industry, that if they drag their feet past the early summer, they risk being stuck with ESRX for an additional year (since changes like this always go live Jan 1). In contrast, if they come to term soon, ESRX will likely make contract changes retroactive to Jan 1 2016, and pay Anthem a sweetener rebate for the 2016 plan year.

There is a lot of uncertainty of course... Anthem is incentivized to solicit RFQs from the rest of the industry, if only to beat ESRX over the head with. A lot also depends on how hardball ESRX wants to play... but I think the odds are pretty decent that this resolves sooner rather than later.


Possible Solutions


Obviously, both sides want to look like they "won". This fight has gotten too contentious and high profile and no one wants to be humiliated. Also, ESRX definitely does not want this negotiation to set a negative benchmark for all of its future negotiations.

Luckily, there are a few chips for both sides to play:

·         Obviously, ESRX can put plenty of dollars on the table

·         ANTM can: (1) let ESRX control its formulary, which would increase rebate volumes (2) try to push mail penetration (3) promise Cigna volumes to ESRX (4) extend the contract past 2019

Any of these outcomes by Anthem could justify ESRX giving them more money, without appearing that ESRX just totally caved. ESRX then can chalk this up to a "special situation" and avoid getting hammered in future negotiations.


What is ESRX Worth Past Anthem?

Assuming Anthem is resolved with mutual satisfaction, and that overhang disappears, ESRX is a good business that deserves a healthy multiple:

·         They are finally past their retention issues. Their scripts should begin growing again in 2017

·         There are earnings tailwinds:

·                         Tailwinds in Specialty drugs (rapid growth, moving to control medical spend, strength in their specialty pharmacy)

·                         Return of generic deflation (which is great for them)

·                         More biologics coming to market (which they will play off each other)

·                         Biosimilars (longer term)

·         Huge cash flows, and huge buybacks. This year, buybacks at low valuations.

·         In the longer term, it makes a ton of sense for ESRX to merge with WBA...


You can do your own math, depending on what you put for Script growth, evolution of EBITDA/Script, value given up to Anthem, and share buybacks.

To me, it's not unreasonable to see a $100++ stock in 2 years. For our purposes here though, I think it's safe to say that if Anthem is resolved in a non-disaster fashion, the stock is going up.




I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.


Announcement of Anthem resolution

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