Merger Of Pharmacy Managers Might Yield More Savings

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Express Scripts ( ESRX ) has been working hard to expand its leading position in the pharmacy benefit management, or PBM, industry. And it's reaping rewards.

St. Louis-based Express Scripts is on track with the integration of its recent $29.1 billion acquisition of the top PBM firm, Medco. Analysts expect the company to realize even more synergies than the originally announced $1 billion.

"The outlook is very bright for them," said Jeff Jonas, an analyst at Gabelli & Co. "Particularly, it's because of the Medco merger, which appears to be going much better than first planned. I think that $1 billion-synergies target can actually prove low, and I think they are coming faster than expected as well."

Jonas believes they could achieve $100 million to $200 million in extra synergies. Once combined, Express Scripts will be the largest PBM in the market with 1.6 billion in total adjusted claims or prescriptions processed per year.

Prior to the merger, it handled about half that amount. Its closest competitor will beCVS/Caremark ( CVS ), with the number of yearly prescriptions less than 1 billion.

"It's really more of a merger of equals rather than a true acquisition," Jonas added.

Claim Processing

Express Scripts acts as a third-party administrator of pharmacy benefits. Its clients include employers, health insurers, managed care organizations, unions and government agencies. It processes claims of drug prescriptions and provides additional services such as retail network pharmacy management, mail order, counseling, therapy management and distribution of specialty medications.

The advantage of PBMs is that they aggregate the purchasing power of millions of members to negotiate advantageous pricing and discounts from drugmakers and pharmacies. Often, those savings are passed on to the members.

Several macro trends have been helping the PBM industry.

One has been a wave of drug patent expirations. This has led to strong growth in the generic-drug market. Patents on drugs such as Lipitor, Plavix, Lexapro, Cymbalta, Lunesta and Celebrex have either expired or will be expiring in the near future.

"As more manufacturers make a generic drug, companies like Express Scripts benefit since they're able to use their purchasing leverage to get deep discounts, which allows them not only to pass along savings to employers, but also to make more money as well," said Charles Rhyee, an analyst at Cowen & Co.

With a brand-name drug, the pharmaceutical company sets the price. Since the cost of the drug is already very high, the price is usually pretty high as well. By contrast, when a drug goes generic and several manufacturers make it, a PBM will only carry the lines of one or two manufacturers.

This gives the PBM strong bargaining power. Consequently, the price of the drug drops dramatically, the gross margin percentage increases and, as a result, the gross profit is higher as well, explains Rhyee.

Another up-and-coming area of additional revenue is the specialty market. This is a market comprising nontraditional drugs and treatments that come out of biotech firms.They are usually more complex and have a different delivery mechanism.

"Over the last five to 10 years, we've seen an increasing shift in drug development away from traditional medications and into these larger biotech drugs," said Rhyee. "Look at the pharm index, and look at the biotech index. That just tells you where money is going and where drug development is happening.

"It's probably less about getting the lowest price since it's still entirely a brand market, and instead it's really more about driving compliance and proper utilization, so that it keeps people out of the hospital. In that case, it's less about gross profit growth and more about top-line growth."

The regulatory environment and, more specifically, the health care reform also play a positive though still uncertain role. Additional health coverage may become available to more than 30 million uninsured Americans through ObamaCare.

Not all of this will go to the commercial market, as a portion will be covered by Medicaid. However, there will be some volume gain for the PBMs.

They would get all the extra volume that comes from covering the uninsured people, said Jonas. "And they (PBMs) don't have any taxes. They don't have any extra regulations. It's just pure volume benefit for them."

Industry Consolidation

The industry has been consolidating over the past few years. Since Express Scripts will have a large chunk of the PBM market, the company may be more inclined to pursue acquisitions in the specialty drug space.

"They've always taken a pretty balanced approach," said Jonas. "I think they would be interested in doing smaller deals, even now while they are still dealing with Medco. Maybe as we get into next year, they may think about doing bigger deals again. But if they can't find a deal, they always just buy back stock instead."

Express Scripts had $16 billion in long-term debt on its books at the end of last quarter. This is mostly stemming from the Medco acquisition, but has been dropping rapidly. The company generates significant amounts of cash flow, while the capital expenditures are minimal.

"I think these companies are cash-flow-generating machines," said Rhyee. "It's a very asset-light business. There's not a lot of infrastructure. You have several mail order facilities, the corporate offices, but the bulk of your business is administrating these benefits. So the power is the scale of your membership, not the assets that you have."

Express Scripts is scheduled to report its third-quarter earnings Nov. 5 after the market closes. Analysts tracked by Thomson Reuters expect earnings of 99 cents a share, an increase of 25% from the year-ago quarter.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Investing Ideas

Referenced Stocks: CVS , ESRX

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