Express Scripts: A Defensive Health-Care Play

Express Scripts (ESRX) is one of the largest pharmacy benefit managers (also known as PBMs) in the U.S. We expect the demand for the services offered by PBMs to rise as governments, health plans, and employers seek help in reining in the rising cost of health care. In our view, the need to contain such costs has become even more critical in a weak economic environment and should outweigh the impact of slowing drug utilization. As such, we view Express Scripts as one of the more defensive plays in our coverage universe.

We expect the weak economy to have a modestly negative impact on the number of prescriptions sold in 2009. Indeed, Express Scripts' management forecasts flat utilization among existing customers and expects overall claims to decline by 2% to 3%, compared with the historical average annual growth rate of 3% to 5%. The drop in overall claims is mainly due to the loss of a large mail-only account. However, we do not believe that investors focus on trends in near-term script volumes and think they should view PBMs as a margin story during this weak economic period. Over the longer term, we expect volume trends to rise as the U.S. population ages.

The company, like other PBMs, has the margin leverage to outweigh the impact of softer volumes as more generic drugs are used, and, according to our analysis, should still be able to realize strong earnings growth in 2009. Although the year is expected to be relatively slow for patent expirations of branded drugs and subsequent conversions to generic drugs, we see demand for existing generics spurred not only by consumers' health plans and employers, but also by individuals' interest in cost savings.

We particularly like Express Scripts because its market-leading generic drug utilization rate suggests to us that it has been one of the more aggressive PBMs in encouraging the use of generics. For example, at the start of 2006, the company took an aggressive position in removing, for a time, the leading anti-cholesterol drug, Lipitor, from its formulary, encouraging members to switch to the No. 2 anti-cholesterol, Zocor, which was slated to lose patent protection in June that year. Currently, Express Scripts is piloting initiatives in consumer behavior messaging, which involve tailoring messages on its Web site to individual consumers that show how generic drugs and mail-order prescriptions can provide opportunities to save money. The initial response has been very positive, according to the company.

Express Scripts carries Standard & Poor's highest investment recommendation of 5 STARS (strong buy).


St. Louis-based Express Scripts is one of the largest PBMs in the U.S. Of the 60 pharmacy benefit managers surveyed by AIS Health, a publishing and information company serving the health-care industry, as of the second quarter of 2007 (the latest data available), Express Scripts was ranked No. 3, with a 9.0% market share by membership and a 14.5% share by prescription volume. It provides a wide spectrum of services to its broad range of clients, which include health plans, third-party administrators, self-insured employers, union-sponsored benefit plans, workers' compensation plans, and government health programs.

The company's PBM services include: retail network pharmacy management, retail drug card programs, home delivery pharmacy services, benefit design consultation, drug utilization review, specialty services, drug formulary management programs, and compliance and therapy management programs. In 2007, 80.2% of Express Scripts' revenues were derived from its PBM operations. The number of retail pharmacy network claims declined to 380 million in 2007 from 390 million in 2006, while the number of home delivery pharmacy claims dispensed declined to 40.8 million in 2007 from 41.2 million in 2006. The volume declines were primarily due to the loss of members resulting from attrition of several clients, including the shift to the government-funded benefit, Medicare Part D.

Express Scripts' Specialty & Ancillary Services (SAAS) segment is mainly responsible for providing treatments for diseases that rely on high-cost injectable, oral, and inhaled biopharmaceutical and other specialty drugs. These drugs are delivered to patients' homes, physicians' offices, and associated patient care services. During 2007, 19.8% of Express Scripts' revenues were derived from SAAS services. We note, though, that Express Scripts faced a number of issues involving SAAS in recent quarters, resulting in the sale of its underperforming home infusion and medical kit assembly businesses. Even so, third-quarter 2008 SAAS revenue rose 8.7% from the same quarter a year earlier and was 1.9% higher than in the second quarter, while prescriptions declined year-over-year, but were flat sequentially. This suggests to us a more favorable sales mix.

Revenues are generated primarily from the delivery of prescription drugs through Express Scripts' contracted network of more than 60,000 retail pharmacies, which represent more than 95% of all U.S. retail pharmacies, as well as from home delivery pharmacy services and SAAS services. Revenues from the delivery of prescription drugs to the company's clients accounted for 98.4% of revenues in 2007. Prescription drugs are dispensed through the PBM segment's three home-delivery fulfillment pharmacies and the SAAS segment's 25 specialty drug pharmacies operated as of Dec. 31, 2007. The PBM segment also operated three stand-alone front-end processing centers and nine patient contact centers at yearend 2007. Revenues from services accounted for the remainder of its revenues.

Express Scripts consistently eyes acquisition opportunities in order to gain and retain accounts in a highly competitive marketplace. In 2005 it acquired Priority Healthcare, a specialty drug pharmacy and distributor, using $167 million in internally generated cash and a $1.6 billion term loan through a new credit facility. In 2007 it purchased a leading provider of consumer directed health-care technology solutions for the employer, health plan, and financial-services markets. In 2008 it acquired a workers' compensation PBM business, expanding its existing workers' compensation PBM operations. Despite its high debt leverage, we believe the company's healthy operating cash flow gives it the financial wherewithal to pay down debt while making acquisitions.


In 2009 we expect revenues, which now include retail co-payments to be consistent with industry practice, to increase 1.3%, to about $22.4 billion, from the $22.1 billion we forecast for 2008. We see growth for 2008 of about 1.2% from $21.8 billion in 2007. A retention rate in excess of 95% and 226 new accounts garnered in 2008, covering more than 1.4 million consumers, should help drive growth in 2009. However, Express Scripts expects low utilization, due to tough economic times, and the recent loss of a mail-only client to lead to a 2% to 3% reduction in total adjusted prescriptions, or scripts, in 2009 (one mail script counts as three retail scripts). Meanwhile, the company expects adjusted scripts to be flat for 2008.

We look for EBITDA (earnings before interest, taxes, depreciation, and amortization) per adjusted claim, the standard way of measuring a PBM's profitability, to continue to rise in 2009 on generic drug penetration, mail penetration, and lower drug purchasing costs. Regarding the first factor, the company's third-quarter 2008 generic drug dispensing rate widened 400 basis points from a year earlier, to a record 66.2%.

Our 2008 and 2009 operating earnings per share estimates are $3.10 and $3.68, respectively, vs. 2007's $2.38, bolstered by share buybacks.


PBMs administer prescription drug programs for governments, health plans, and self-insured employers and unions seeking to rein in their rising health-care costs. They combine retail pharmacy claims processing, formulary development and maintenance, and home delivery pharmacy services into integrated product offerings to manage the prescription drug benefit for their clients. Due to their larger purchasing pool for prescription drugs, PBMs can negotiate rebates and discounts with drug manufacturers on behalf of their clients.

In our view, demand for PBM services appears likely to increase in the years ahead as drug utilization rises. The Centers for Medicare & Medicaid Services (CMS) estimates that spending for prescription drugs grew 6.7% in 2007 from $257.3 billion in 2006, and projects spending to reach $515.7 billion in 2017. This makes it one of the fastest-growing components of health-care spending, which CMS projects will have a compound annual growth rate of 6.7% from 2007 to 2017. By comparison, the U.S. gross domestic product is estimated to grow at a compound annual rate of 4.9% from 2007 to 2017. While the U.S. pharmaceutical market has slowed substantially because of its already large size, patent expirations, and increasing generic drug utilization, we expect more and more high-cost specialty and biotech drugs to enter the market.

Other factors we see contributing to the likely acceleration of drug spending include the aging of the U.S. population. The U.S. Census Bureau predicts that given longer lives and aging baby boomers, the number of older Americans will reach 71 million, or roughly 20% of the U.S. population, in 2030, compared with 35.9 million, or 12%, in 2003. What's more, as people age they require an increasing number of medications. A 2002 Georgetown University study showed that the average number of prescriptions filled each year for people aged 18-34 years was 3, vs. 22 for those aged 80 and older.

Meanwhile, we believe PBMs should benefit under President Obama's administration. We think plans to expand health coverage for the estimated 46 million uninsured will add more consumers to PBM rolls. We also expect generic drug utilization to be promoted as a way to save on health-care costs, and for a path to be created for the regulatory approval of bio-similars, generic versions of costly biotech drugs.


Express Scripts' stock recently traded at 53. Our 12-month target price of 77 assumes the shares will trade at about 21 times our 2009 operating EPS estimate of 3.68, below Express Scripts' five-year historical average price-earnings multiple of 25.7. The p-e translates into a forward p-e-to-growth (PEG) ratio of 1.1, close to that of PBM and health-care distribution stocks, using our estimated three-year EPS growth rate of 19%. Our target price represents a premium to the S&P 500, which we believe is warranted by our view of the company's relatively high level of earnings visibility amid the current U.S. economic slowdown.


We have an overall favorable view of Express Scripts' corporate governance practices. We view positively that the board of directors is comprised of a supermajority (more than 75%) of independent outsiders; the compensation committee is composed solely of independent outside directors; corporate governance guidelines are publicly disclosed; there are between nine and 12 directors serving on the board; and there were no related-party transactions between the company and the CEO or between the company and any other officers and directors of the company.

We view as negative that the chairman is an insider; the board is authorized to increase or decrease the size of the board and may amend the bylaws without shareholder approval; shareholders may not call special meetings or act by written consent; and the company has a poison pill in place.


Risks to our recommendation and target price include a further deepening and lengthening of the economic slowdown resulting in lower drug utilization. Other risks include pending or future litigation that subjects the company to significant monetary damages and/or changes its business practices; unfavorable regulatory changes; the loss or unfavorable modifications of key pharmaceutical manufacturer relationships, retail pharmacy relationships, and/or client accounts; unfavorable changes in industry pricing benchmarks; and intensified competition.

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