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We’re expecting a big win at CVS in coming years, and it may come at the expense of Express Scripts.
By Alexander J. Poulos
With the recent addition of CVS Health (CVS) to the newsletter portfolios, we believe the sell off in the Pharmaceutical Benefit Managers (PBM) industry is overdone. We are intrigued by the free cash flow generated from a highly-predictable business model, and that the PBM’s negotiate contracts in advance, locking in a customer for an extended period, only adds to the attractiveness of their operations. Another PBM, but a pure play, is Express Scripts (ESRX). Let’s discuss the unique characteristics of Express Scripts along with notable risks, which prevented us from adding the name to the newsletter portfolios. Though we like CVS instead, Express Scripts is certainly a company to keep an eye on.
Overview
Express Scripts is a pure play PBM providing contracted pharmaceutical benefits to a diverse roster of clients. Express Scripts operates a network that is utilized by pharmacies to process and receive payment for prescription drugs. Express Scripts is the largest PBM in the US, scale of which it uses to drive down the cost of medications via a restricted formulary. A formulary is a list of medications that are covered by Express Scripts; non-covered meds will often require the patient to shoulder the entire burden of the cost of the medication.
The formulary is one of the principal methods that Express Scripts employs to drive down the cost of medications, a key point used to validate Express Scripts’ services. Express Scripts will often limit formulary coverage of expensive medications, which directly leads to the pharmaceutical manufacturers to negotiate on price. The restrictive formulary combined with the extensive pharmacy network is the secret sauce that culminates in Express Scripts’ very attractive Economic Castle. We believe that Express Scripts will play an integral role in the new health care regime that is expected to be rolled out at some point during the Trump administration.
As with its primary rival CVS, Express Scripts runs an extensive network of mail order pharmacies that processes claims for the lives it covers in its network. The main point of differentiation is the vast network of retail and long-term care pharmacies that is under CVS control, unlike Express Scripts which does not have a retail store presence. In essence, CVS runs a hybrid model, versus a pure play operation that is Express Scripts. Express Scripts and CVS Health both share an essential characteristic that we highly prize at Valuentum, the ability to generate a copious amount of free cash flow. Similar to CVS, Express Scripts is now trading at a free cash flow yield of over 10%, an outstanding “value” in light of the lofty valuation the market currently trades at.
But not everything is moonlight and roses.
Challenges
The PBM’s have engendered significant controversy over the past few months. The initial furor began with the CEO of Mylan (MYL) trying to pass off the reason for the enormous price hikes on its key product, the epinephrine autoinjector Epipen, in part as a result of the markups the middlemen of the drug distribution extract. We do not share this view as evidenced by the net margins the drug distributors and the PBM’s operate at. We view the statement as a clever “ruse” designed to take the heat off what could be considered price gouging. The initial furor did not die down as a famed short seller took aim once again at the industry and Express Scripts in particular over the payment of Direct or Indirect Remuneration (DIR) fees.
The DIR fees are initially established by the US Government via the Centers for Medicare and Medicaid Services (CMS). The purpose the DIR is to track the rebates offered by the drug manufacturers as an enticement to utilize a particular product over competitors. Also, volume discounts are often generated which falls in the DIR fee category. In essence, with the US government, the largest single payer for healthcare services has a keen interest in capturing the bulk of these rebates, hence the creation of the DIR fee.
The PBM is contractually obligated to return a portion of the fees generated back to the payer. The amount of the DIR fee returned varies per contract; the short seller mentioned Express Scripts retains a larger portion of the DIR fees than the next closest competitor CVS Health. We do not have a problem with this structure as the full purview of the contract is confidential. We are comforted by the fact that the Tricare contract which tends to the healthcare needs of the military remains under Express Scripts’ control.
We suspect if Express Scripts was engaging in deceptive practices via the retention of DIR fees, a competitor would have exploited this during the competitive bidding process to gain control of the contract. A loss of the Tricare contract would be an enormous blow to Express Scripts as the contract covers over 10 million lives. Express Scripts was awarded a seven-year contract in 2014 which we view as a positive sign. Express Scripts has controlled the Tricare contract for over 12 years now; we feel the company has performed well for one of its largest clients.
Anthem Litigation
Express Scripts faces significant overhang from a lawsuit brought by Anthem (ANTM), one of its most important clients. To demonstrate the importance of Tricare and Anthem, the two contracts accounted for roughly 29% of Express Scripts revenue in 2016. Express Scripts acquired the Anthem business when it purchased Anthem’s PBM business in December 2009. As part of the deal, Anthem signed a ten-year contract with Express Scripts. Anthem alleges in its suit against Express Scripts that the PBM has charged above competitive pricing for pharmaceuticals which directly led to Anthem charging an inflated price. Anthem is seeking over $13 billion in damages, a number Express Scripts contends is highly inflated and plans on vigorously defending itself against.
From where we stand, Express Scripts has already lost the “battle,” and we fully expect another PBM to step in to fill the void when Anthem’s contract expires in 2019. We think the most likely PBM to gain the contract is CVS, as the third largest PBM is Optum Healthcare which is a division of United Healthcare (UNH), a rival of Anthem. CVS does not compete directly with Anthem in the healthcare insurance market, making them an ideal candidate to replace Express Scripts. We view the litigation with Anthem as the main overhang affecting Express Scripts’ equity performance.
Express Scripts: A Possible Value Trap?
Express Scripts’ financial metrics are very appealing. The equity is trading at ~10 times this year’s earnings, but the looming litigation really puts a damper on our enthusiasm for shares. For one, even if Express Scripts can amicably resolve the dispute with Anthem, a renewed contract would be struck at far less favorable terms. The loss of the Anthem deal would be a significant blow; Express Scripts would be hard pressed to replace such a contract in the rapidly consolidating healthcare field.
Furthermore, Express Scripts, unlike its main rival CVS Health, does not pay a dividend. Instead, it rewards shareholders via an aggressive share repurchase plan, which while potentially value-creative in light of its share price, limits its consideration within the dividend growth context. It’s hard for us to get excited about this particularly dynamic, making CVS the better idea between the two, in our view.
Conclusion
We highly prize companies that can generate an abundance of free cash flow well above the needs of the underlying business. We like the industry dynamics of the PBM’s, and we do not see a reasonable scenario where the PBM business will erode under the current administration. We view the PBM model as part of the solution to the excessive cost of pharmaceuticals, pushing down the cost of specialty meds, by far the main culprit of the rising trend in pharmaceutical products.
The coming wave of biosimilars is the single-greatest opportunity of the PBM industry, in our view. By rapidly mandating the switch to biosimilar equivalents at the expense of branded products, the PBM’s can bend the cost curve downward to the delight of its clients. We do expect the aggressive formulary tactics pioneered by Express Scripts to become the norm, a potential headwind for the pharmaceutical industry. This will place an additional burden on the industry to justify its pricing scheme; the single best method is through the head-to-head outcome studies, pitting a competing product against a new product.
For the newsletter portfolios, the choice was clear from the beginning. We felt the hybrid model employed by CVS offered the most compelling risk-reward relationship. CVS topped out at a Valuentum Buying Index of 9, one of the highest in our coverage universe. CVS does have its share of unique challenges in 2017, notably reducing costs after losing out on a few contracts, but the primary difference between the two PBM’s is that we think any losses can quickly be absorbed by CVS as its customer base is far more diverse.
CVS was caught a bit flat-footed by Walgreens Boots Alliance (WBA) aggressive contract ploys, a mistake we feel will be rectified during this year’s contract negotiations with employers and insurance providers.
Alexander J. Poulos is long CVS Health and Gilead Sciences.