How High Will Medco Fly On Its Own?

One day not long from now, Merck (MRK )'s many shareholders will find they own stock in not one but two companies. The drug giant is set to hand out shares of Medco Health Solutions (MRK ) its pharmacy benefits management, or PBM, unit that by revenue is 50% bigger than its drug operation. Merck, with a stock that once enriched many investors but has taken a five-year trip to no- where, is clearly hoping the spin-off will refocus Wall Street on its underlying profitability. Yet Merck's shareholders may be left to wonder: What's this Medco thing?

Merck bought Medco in 1993. Since 1997, its revenues have tripled, to $33 billion. But because PBMs act as mere middlemen among patients, health insurers, and drugmakers, they see only a sliver of each sale. In this year's first quarter, for example, Merck's pharma biz captured 40 cents in pretax profit on each $1 in sales; Medco saw 2 cents. Troublesome, too, have been conflicts of interest between Merck, a seller of drugs, and Medco, a buyer on behalf of cost-conscious insurers. It's a strain of corporate schizophrenia that has brought legal headaches and for which there's no magic pill.

So Merck is aiming for a divorce by midyear. It has kept mum about exact terms, such as how many shares will be issued, but promises that the details are set to come soon via a sleeping aid, er, document the Securities & Exchange Commission calls Form 10. As it happens, though, Merck last year filed other papers in a thwarted effort to sell part of Medco in an initial public offering. Key elements of the coming spin-off of 100% of Medco may differ from the deals envisioned last summer. Just the same, they offer a starting point for estimating how the market may value Medco.

Two big variables will come into play. First, how much money will Merck take out of Medco by way of a dividend? Second, how will Medco finance the dividend? Had Merck gone ahead with a Medco IPO, it would have kept the estimated proceeds of $1 billion. In addition, after selling $1 billion in notes and borrowing $500 million more from banks, Medco would have paid to Merck a dividend of $1.5 billion. In all, Merck would have received about $2.5 billion in cash.

Now, with IPO proceeds the mere memory of a mirage, it's unknown if Merck will demand a bigger dividend. Let's assume it still wants to end up with $2.5 billion, but that to do so, Medco must borrow an extra billion. That, I estimate from Medco's IPO filing, would leave Medco with debt about half the size of its equity. With such a balance sheet, and with profits that it expects will grow this year in line with the industry, or 20% to 25%, what might Medco be worth?

Medco's three principal rivals are publicly held, so their valuations also offer some guidance (table). AdvancePCS (ADVP ) is the biggest but least profitable, with an earnings multiple of under 16. Caremark Rx (CMX ) and Express Scripts (ESRX ) have higher multiples -- almost 20 times estimates of this year's earnings -- because they enjoy wider profit margins. Given a debt load and profitability more akin to AdvancePCS's than the others, a multiple of 15 times 2003 earnings seems about right for Medco. That suggests a market value of $7.5 billion.

There's another, unrelated consideration about Medco. In March, it named David Snow Jr. as its new CEO. In January, Snow bolted the No. 2 job at WellChoice (WC ) operator of Blue Cross & Blue Shield insurance plans in New York. Just weeks before, WellChoice CEO Michael Stocker was diagnosed with prostate cancer. Snow's move left Stocker and others at WellChoice puzzled. Snow did not explain his move then and declined to explain it now. A Medco spokesman told me Snow left WellChoice when it became clear he was still some years away from realizing his ambition to be a CEO.

For Medco, Snow may turn out to be a sterling choice. Even so, if Medco's debt is as high as I expect, it will be a buy only at a market value well under $7.5 billion.

By Robert Barker

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