Medco Health Solutions MHS
September 23, 2003 - 12:03am EST by
2003 2004
Price: 24.02 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 6,485 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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  • PBM


Medco Health Solutions is the nation’s largest pharmacy benefits manager (“PBM”) . The Company processed approximately 548 million prescriptions (82 million of which were handled by its home delivery network) and generated $33 billion in revenues and $318.4 million in pro forma net income (1.0% of sales) in 2002.

On August 19th a total of 270 million shares of Medco were distributed via a tax free spin-off to shareholders of its then parent company, Merck. According to MSN/Money, a total of 90.7 million shares have changed hands to date within the range of $23.05-$27.70, though some data services recorded a trade as low as $20.20.

Trading at $24.02, there are 270 million fully diluted shares outstanding (before options grant) for an equity market capitalization of approximately $ 6,485.4 million. Net debt (pro forma the financing transactions described later) totaled $1,293 mm at 3/29/03. EBITDA for the twelve months ending 12/28/02 totaled $885.6 and earnings $1.34 per share.

The stock trades at an Enterprise Value/Trailing EBITDA multiple of 8.8x and a trailing P/E of 17.9. Five Wall Street analysts expect MHS to earn $1.51 for the year ending 12/03 for a forward P/E multiple of 15.9x.

On traditional valuation metrics, and considering the low margins earned on this business, one might rightly ask why this stock qualifies as a value to which I respond as follows: (1) this industry leader trades at a meaningful discount to its competitors (2) organic growth is expected to continue to be robust (>10%) in the coming years (3) margins are likely to expand (4) the working capital cycle will improve and CAPEX spending will decline, and (5) new service lines and acquisitions are probable.

The current trading discount and the virtuous possibilities presented above are nowhere reflected in the current value of the shares. Instead the market appears to either be ignoring these attributes, overly focused on industry and company specific legal issues, concerned about the Merck contract, or suffering from an imbalance of sellers over buyers at this infant stage of MHS’ public life.

Should the company trade in line with its peers this is a $35 stock, representing appreciation potential in excess of 40%.

PBM’s administer drug benefit programs for clients that include: managed care organizations, self insured employers, insurance companies, unions, federal and state employee health plans, and other plan sponsors.

At their core, PBM’s are sophisticated transaction processors and aggregators who have historically earned their keep by delivering volume based cost savings to plan sponsors. Those cost savings, earned in the form of discounts from drug companies and pharmacists, are shared between the plan sponsor and the PBM.

The following statistics illustrate the critical role PBM’s play in the drug delivery infrastructure (Source: AIS, A Guide to Drug Cost Management Strategies, 2002):

· Roughly 95% of all patients with drug coverage receive benefits through a PBM
· PBMs manage about 70 percent of the more than 3 billion prescriptions dispensed in the United States each year
· Pharmacy networks typically include over 90% of pharmacies in a given area
· 13-16% of prescription sales are through mail order pharmacies, a higher margin business
· PBMs paid approximately $121 billion for prescription drugs in 2001-02, or about 80% of total spending on prescription drugs for 2001-02
· PBMs manage pharmacy benefits for nearly 200 million Americans, including 65% of the country’s seniors

The industry is fairly concentrated, with four publicly traded competitors accounting 65% of industry drug expenditures in 2002.

Medco 24%
AdvancePCS 22%
Express Scripts 16%
Caremark 3%
Sub-Total 65%
Others 35%
Total Annual Drug Expenditures 100%

Huge upfront (and largely one time) computing infrastructure costs relative to the very low per transaction contribution, combined with the inherent benefits that accrue to large networks over small ones, creates a compelling economic urge to get big. In fact, there has been underway an unremitting industry consolidation wave culminating with the recent announcement (9/2/03, after the MHS spin-off) of the merger of Caremark and AdvancePCS.

Spending on patented and generic drugs drives the growth in the PBM industry. According to the 1999 ExpressScripts Drug Trend Report, drug spending is expected to increase on the order of 15% CARG through 2004.. What drives this trend is higher priced patented drugs and growth in the number of prescriptions filled. Additionally, there is the prospect for an increase in the number of covered lives as a result of public policy initiatives to provide a prescription drug benefit to Medicare recipients and offer some form of prescription drug benefit to the uninsured. A total of approximately 100 million Americans do not currently have a prescription drug benefit.

Other contributors to industry growth include mail order home delivery and specialty pharmacy services.

These positive industry trends need to be weighed against increasing price and margin pressures driven by the clients efforts to reduce prescription drug costs, and industry rivalry. Over time, however, I believe that industry rivalry will moderate somewhat as company shares stabilize and more differentiated competitive strategies emerge. This industry appears naturally given to an oligopolistic structure and reasonable economics, driven not by margins but by capital efficiency. There can not be just one or two dominant players as this outcome would limit a client’s ability to reduce the share of discounts earned by PBM’s by threatening switching. On the other hand, new entry at this stage (given the established networks and costs to build) would seem prohibitively difficult.

The following illustrates my point with regard to the structure of capital returns in this industry:
Net % X Turnover X Leverage = ROE
MHS 0.97% 3.4 2.1 6.7%
ESRX 1.65% 4.3 3.1 22.0%
ADVP 1.19% 3.8 3.8 17.4%
CMX 2.94% 3.6 7.4 78.3%

CMX is clearly an outlier given its narrow equity base and should experience returns on the order of 17%-20% over time, particularly considering the depressing impact on margins of actual and threatened client switching.

MHS should also be able to achieve industry comparable economics for two reasons : 1) major pharmaceutical companies are likely to offer comparable discounts to all PBM’s to gain the broadest inclusion in PBM formularies possible 2) MHS margins are likely lower because of accelerated systems and other expenditures preparatory to the spin-off, and 3) company is relatively overcapitalized, a situation that might be remedied by aggressive investment (ie, acquisitions) or by returning capital through dividends and share buybacks.

MHS trades at a meaningful and unjustified discount to its peers. As management begins to reach out to the investment community its multiple should come in line or slightly exceed the industry.

Market Cap Net Debt EBITDA EV/EBITDA
MHS 6,485 1,293 886 8.8x
ESRX 4,781 375 464 11.1x
ADVP 4,047 337 372 11.8x
CMX 5,776 391 411 15.0x

Prior to the spin, MHS took on a total of approximately $1,500 million in indebtedness and immediately after the spin expects to have substantial credit availability. These proceeds will be used to, among other things, pay a $2,000 million dividend to Merck. MHS plans to retain all future earnings, a policy very different from it former parent.

Management appears to be treated quite reasonably in the spin. Options in Merck stock granted before 2/02 will remain options in Merck stock. Holders of these options may be treated like terminated employees and have to exercise within a relatively short period. Options granted after 2/02 will be converted into options of MHS stock.

Additionally, what appear to be 12,855,300 shares will be granted to employees exclusive of the CEO after the spin. These options and restricted stock grants will be priced at fair market value on the grant date and have customary terms. The CEO will receive grants in amounts determined to approximate (using Black Scholes) $5.0 million after the spin and $4.8 million in Q1 2004. He will also receive $800,000 in salary and an annual bonus of up to 100% of salary.

About 5% of the company is available to the non-CEO management and a pot of about $10 million is available to the CEO...this looks reasonable and motivational to me.

Finally, MHS has entered into numerous contracts with Merck, including a managed care agreement. This agreement calls for certain rebates to be earned by MHS to the extent that Merck products are included in formularies offered clients and that specific market share targets are met. To the extent that these market share targets are not met, liquidated damages are payable by the company.

Most arrangements with pharmaceutical companies include market share targets to which rebates are tied. I’m not certain as to whether similar penalties for not meeting share targets are industry standard as yet.

Please see pages 99-103 of the Form 10. I’ll address these further in the Q&A, but the point to keep in mind is that MHS is offering Merck indemnifications against many of the suits and this is a risk factor.

(Please see Form 10, dated August 7th 2003 for further detail)

MHS projects that its capital spending will decrease to about $150 million per year, to the benefit of free cash flow.

With regard to trade working capital, MHS either has some room for improvement or is reporting numbers that are distorted by management decisions at Merck. I believe it may be the later.

“An important element of our cash flow is the timing of billing cycles, which are two-week periods of accumulated prescription administration billings for home delivery and retail prescriptions. We bill the cycle activity to clients on this bi-weekly schedule and generally collect before we pay our obligations to the retail pharmacies for that same cycle. We pay for drug inventory in accordance with payment terms offered by our suppliers to take advantage of appropriate discounts. Effective home delivery inventory management further generates positive cash flows. “ (Form 10, pg 68)

I don’t know how you all will read the above, but to me it says that MHS should have negative working capital with its customers financing its operations. The numbers don’t bear this out though.

Industry performance is as implied by the quote with many of the competitors showing negative working capital. In a follow up I’ll present the industry statistics.

Working capital cycle performance is likely to improve going forward.

($ millions) 2000 2001 2002 2003 2004-2005
CAPEX $251 $322 $235 $150 $150
Working Capital $639 $853
Working Capital/Sales 2.2% 2.6%

I believe that MHS should trade at least as well as its peers, representing appreciation potential of at least 40% from current levels. Additional value will result from margin improvement, better working capital management, and lower capital expenditures in the years ahead. Furthermore, MHS operates in a oligopoly market expected to grow in the double digit range, and one in which market shares are likely to stabilize in the next few years. As a result, I expect value to grow sustainably.

1.) Competition becomes cut throat eroding margins for all industry players.
2.) Legal problems get resolved unfavorably.
3.) Merck market shares not achieved resulting in payments of damages.

1) Medicare prescription benefit program announced and PBM’s participate.
2) MHS identifies attractive and sizeable acquisition OR returns capital to shareholders.
3) MHS attracts new clients as a result of no longer being captive to a drug company.


Time, including further public guidance by management.
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