Image Source: Mike Mozart
The first-quarter earnings performance across the pharmacy services industry has been a proverbial mixed bag with uncertainty continuing to weigh on performance. We continue to be interested in the industry for its defensive and strong free cash flow characteristics that bode well for dividend hikes and share repurchases going forward. We like CVS the most.
By Alexander J. Poulos
Walgreens Boots Alliance Remains Mired in Holding Pattern
Shares of Walgreens Boots Alliance (WBA) reported a relatively in-line first quarter, its fiscal second quarter, on April 5, and all eyes continue to be focused on the pending Rite Aid (RAD) acquisition. We have been fans of the moves taken by Walgreens post the Alliance deal that saw visionary CEO Stefano Pessina taking control of the combined entity. We view Pessina as a best-in-class leader, well suited to shake up a struggling entity. Pessina is operating out of the same playbook used with a large degree of success in Europe–consolidating the field with a razor sharp focus on cost containment. The most audacious part is for the consummated acquisition of Rite Aid.
Rite Aid is the third-largest pure-play pharmacy chain in the US with a large footprint in the Northeastern part of the US–a notable area that’s under-penetrated by Walgreens. The optics of the deal are very compelling for Walgreens; by acquiring Rite Aid, it will significantly enhance market share in the Northeast while eliminating a poorly-run competitor. Also, economies of scale should kick in as Walgreens would hold even greater sway with payers as it would become increasingly difficult to exclude Walgreens from its network. Pessina would use the depth of Walgreen’s system of pharmacies to push for a more generous reimbursement rate as well, boosting margins.
Though we applaud the audacious acquisition, significant doubt exists to the ultimate viability of the deal. The merger date has been pushed back multiple times as the FTC continues to be concerned over the anti-competitive nature of the deal. Walgreens has found a willing partner to offload stores in Fred’s (FRED), but the deal is still up for review. At this time, we feel that until the final verdict of the deal is made by the FTC, Walgreens’ shares may be range-bound. In any case, the acquisition continues to overshadow decent earnings by Walgreens as the company affirmed 2017 guidance range of $4.90-$5.08 in (non-GAAP) diluted net earnings per share. We’ll continue to monitor the developing story and post a timely update when necessary.
Express Scripts Shocking Earnings Report
Shares of Express Scripts (ESRX) came under intense selling pressure upon the release of its first-quarter earnings report, issued April 24. Express dropped a bombshell stating it doesn’t expect to retain its key contract at Anthem, which remains one if its largest customers. We continue to be skeptical of the validity of the bullish case on Express Scripts as detailed in a recent post, “PBMs: Express Scripts and CVS’ Looming Victory? (February 2017)”
We feel Anthem (ANTM) holds all the cards in the dispute as it continues to pressure Express for $3 billion in cost savings. Express presented the case that it believes it is impossible to offer concessions of this magnitude and instead is trying to ameliorate the hostile negotiating stance taken by Anthem by providing $1 billion in immediate relief from now until the contract lapses in 2020. Still, the Anthem contract looms large as it encompasses approximately one third of Express’ EBITDA. It’s worth noting that Express recently lost the Catamaran contract when it was acquired by United Healthcare’s (UHN) PBM division Optum.
We continue to view Express Scripts’ independent business model as challenged. For starters, Express is being squeezed by the growth of Optum, which continues to consolidate the field. Express may be the second-largest PBM, but that doesn’t matter; it is feeling the pressure from Optum, which sits at number three and from the hybrid model (retail network combined with a PBM) operated by industry leader CVS Health (CVS). We view CVS as the most likely victor of the Anthem deal as Anthem will be loath to turn over its data to one of its largest rivals.
The challenging operating environment for Express continues to weigh on the share price with the equity trading at the same level last seen in 2013. Value investors continue to point out the high free cash flow generated by Express, but as illustrated by the management team, with Anthem accounting for a large part of its EBITDA, sustaining existing levels of free cash flow may be out of reach. We think it is prudent to value Express while considering the loss of the Anthem contract. Though Express Scripts may look cheap on the basis of our DCF process, we point to the low end of our fair value range as a reasonable estimate in light of contract uncertainty–we’d need quite the turn of events to ever consider it in either newsletter portfolio.
CVS Health Continues to Feel the Impact of Contract Losses
CVS Health, one of the newest members of the Best Ideas Newsletter portfolio, has faced some selling pressure of late as it continues to reel from the loss of a few key contracts. On May 2, CVS posted adjusted first-quarter earnings of $1.17, slightly ahead of analyst expectations. The “earnings beat” was partially fueled by an aggressive capital allocation plan, which includes an accelerated share repurchase progra