Express Scripts Holding Company (ESRX) Long Express Scripts Holding Company (ESRX) Summary

February 22, 2014

Business overview: Express Scripts Holding Company (ESRX) is a $61 billion Pharmacy Benefit Manager (PBM): it controls substantially all of the prescription drug reimbursement operations of insurance companies and large employers with their own healthcare plans. As a PBM, ESRX negotiates lower drug costs from retail pharmacies and drug distributors on behalf of its clients, runs the background database where prescriptions are processed and also operates its own mail-order pharmacy. Investment thesis: ESRX is the largest player in a scale-driven business with multiple structural tailwinds, including (i) ongoing implementation of the Affordable Care Act (ACA), (ii) a continued shift from expensive brand-name drugs to cheaper generic drugs and (iii) a growing market for high-margin niche drugs called specialty pharmaceuticals. Investors are concerned about potential longterm threats to the PBM business model under the new healthcare system, but my research suggests that their worries are overblown and create an opportunity to buy ESRX at an attractive price. Valuation: Due to significant amortization expenses resulting from a $29 billion acquisition in 2012, trailing GAAP earnings are artificially low. I suggest valuing ESRX on free cash flow yield because of its own historically wide capital expenditures range, and CapEx variability between competitors due to different business models. ESRX currently trades at 7.0% trailing free cash flow, relative to a 7.2% six-year average. Potential Catalysts: There are no direct catalysts, but ongoing share buybacks will reduce share count by 7%-8% in 2014 and ESRX should continue to realize the full extent of synergies from its 2012 acquisition of competitor Medco, which doubled its size. Potential Upside: Based on what I believe to be conservative assumptions regarding normalized free cash flow levels, ESRX likely has 15% upside from current levels without any yield compression. If ESRX were to trade in-line with the six-year average yield of preacquisition Medco (its closest competitor before ESRX acquired it), there would be 20% upside. PBM Industry In the US healthcare system, drug distributors, drug sellers (pharmacies) and healthcare payers (insurance companies) operate as three distinct types of businesses. PBMs are the power players of the drug industry: they link these three groups, controlling the flow of money from insurance companies to wholesale distributors and pharmacies. PBMs started out by building client-side databases for insurance companies because pharmacies needed an efficient way to submit reimbursement claims. As drug costs rose and insurance companies looked for ways to cut costs, PBMs took on a new role, exerting the combined purchasing power of all of their insurance company clients as leverage for cheaper drugs from suppliers. Today, PBMs have evolved to control the prescription drug operations of health plan sponsors: they help decide which drugs receive insurance coverage, choose which pharmacies subscribers can go to and keep a portion of the cost savings they generate through their volume bargaining schemes. ESRX is the largest player (34% market share in 2013) and its largest scale gives it the strongest competitive advantage. The second-largest PBM is CVS Caremark (24% market share in 2013). Switching costs for clients are very high and the three largest public PBMs (ESRX, CVS and Catamaran) consistently achieve 95%+ customer retention rates. The industry has tried to vertically integrate in the past to remove the PBM middleman from the supply chain. Merck used to own Medco, the second-largest PBM, but spun it off (it was acquired by ESRX soon after). ESRX itself used to be owned by a health insurance company, and was carved out in a dedicated IPO. Initially, most PBMs were owned by drug manufacturers who would exploit their relationships with insurance companies to market their own drugs at higher prices. The government stepped in and forced the sale of manufacturer-owned PBMs. Of the large public PBMs today, Caremark is the only one that is not a standalone PBM (it is integrated with CVS pharmacy), and its operating metrics are worse than Express Scripts, potentially indicating that the standalone model is more efficient.

Source: CVS

Express Scripts Holding Company (ESRX)

February 22, 2014

A large tailwind for PBMs has been the onslaught of popular drugs coming off patent or going generic over the last decade. When drugs go generic, the inventor loses monopoly pricing power because more companies can sell the drug. The generic manufacturers sell undifferentiated products and will bid lower and lower to win PBM contracts. From 2008-2012, the generic dispensing ratio in the US increased from 69% to 78% as the patent cliff opened competition for Plavix and Lipitor, the top two selling prescriptions. To get a sense of the pricing differential, consider that in 2012, branded drugs represented only 16% of prescription drugs dispensed by volume in the US but accounted for 72% of total costs. ESRX does not break down exactly what margins they achieve on different types of drugs, but government studies of other PBMs indicate that gross margins are in the 2%-3% range for branded drugs and closer to 10% for generics. Generic introductions are at cyclical lows, with several major branded drugs set to go generic in 2014: Copaxone from Teva ($4B 2012 sales), Evista from Eli Lilly ($1B 2012 sales), Sandostatin and Exforge from Novartis ($2.9B combined 2012 sales), and Nexium from AstraZeneca ($3.9B 2012 sales) see chart on previous page. Moreover, drug utilization rates tend to rise over time, and this trend should continue as the baby boomer generation ages. ESRX is also positioned to benefit from 25 million newly insured ACA patients who will have some form of prescription drug coverage for the first time. Since the introduction of the Affordable Care Act, the PBM industry has also grown by adding healthcare reform-influenced ancillary services, such as programs to increase patient adherence to pill regimens, and helping to manage spending on drugs for chronic illnesses, called specialty pharmaceuticals. These drugs often require special handling, distribution and administration techniques, and can cost upwards of $250,000 per patient per year. ESRX reports that due to technological advancements and increased incentives from the FDA to develop drugs for rare chronic illnesses, specialty drug spending will grow 67% by 2015. PBM margins on specialty pharmaceuticals tend to be in the 5%-10% range, in addition to the dollar values per script being higher. The generic-level margins on branded specialty pharmaceuticals are due to industry inefficiencies: since most patients with chronic illnesses obtain the drugs from their hospitals (and very few hospitals carry the drugs to begin with), hospitals can get away with charging artificially high rates for these treatments.

2013 PBM Market Share

Source: CVS

Company Detail ESRX is the largest and (as far as my research suggests) the best-run PBM. Their current CEO has held the position since 2005, owns $70m of stock and has grown earnings and free cash flow 20% annually since then. ESRX has expanded through large acquisitions, including its $4.7B purchase of WellPoint Insurance Co.s PBM unit in 2007 and a behemoth $29.1B acquisition of Medco Health Solutions in 2012, which made it the largest PBM. ESRX tried to acquire Caremark in 2007 but lost the takeout battle to CVS, demonstrating pricing discipline. In total, ESRX has made seven major competitor acquisitions during the last 16 years. For those who tend to be skeptical of highly acquisitive companies (myself included),

Express Scripts Holding Company (ESRX)

February 22, 2014

management is rewarded on ROIC, not just earnings growth. This program can entice management to look past EPS accretion (a shorter-term measure) to long-term value generation when they consider acquisitions. ESRX last significant write-off occurred in 2000, when the previous management team invested in a tech bubble startup company. ESRX is a very capital-light businesses (CapEx historically 8% of EBIT), relying mostly on client relationships and industry dynamics to maintain its competitive advantage. It is also a negative working capital business, which has served the company well during the decade-long industry environment of rapid consolidation and growth. Moreover, management have leveraged the businesss increased scale to demand quicker payment from customers but extend the businesss own Days A/P, providing an additional cash flow boost each year as working capital expands. Pricing Power The single most important decision in evaluating a business is pricing power. If youve got the power to raise prices without losing business to a competitor, youve got a very good business. Warren Buffett In 2011, ESRX was involved in a competitive tug-of-war with Walgreens, the largest retail pharmacy chain in the US. Walgreens did not agree with the aggressive drug pricing that ESRX was trying to negotiate on behalf of its clients, so ESRX redirected patients to other pharmacies instead. During this period, Walgreens competitors advertised that they accepted ESRX-partnered insurance plans, and customers left Walgreens en-masse. After a half-year battle, Walgreens had no choice but to concede to ESRX pricing. Analysts estimated that Walgreens lost out on $4 billion in prescription revenues during that period. To me, this illustrates a diligent management team that understands how to play the pricing game and knows when not to fold. It should also be noted that ESRX clients (the insurance companies) did not seem to object to this strategy at all subscribers will not go through the hassle of changing their insurance plans just so they can keep going to Walgreens. Competitor Comparison There are several metrics that can be used to compare ESRX with competitors. I believe the most appropriate to use is EBITDA per adjusted claim because it adds back ~$2 billion/yr. of amortization expenses related to the Medco acquisition and is a cap structure-neutral measure. ESRX has the leading EBITDA per adjusted claim of the three largest public PBMs and has grown the metric at 9.6% annually over the last four years. This period includes two major acquisitions, one of which (the Medco acquisition) effectively doubled the size of the company. CVS, the runner up, has experienced annual declines in EBITDA per adjusted claim of 8.5% annually over the same period. According to the 2013 Proxy Statement, ESRX has led its peer group with in EPS growth and ROIC over the past three years. Acquisitions can weigh on ESRX gross margins because they can change the drug mix to a smaller relative proportion of generics (higher margin than branded drugs), but I think it is worth noting that ESRX average gross margin is still the highest among public comps. The companys 4Q13 gross margin was actually 8.5%, relative to 8.0% for FY 2013. ESRX recently migrated all of its clients onto the same software platform (a Q114 event), and combined with the oncoming wave of generic/specialty drugs, I believe it is fair to assume an 8.25% GM for FY 2014. Threat of a price war Is it possible that CVS decline in gross margin after 2010 reflects a move to undercut competitors pricing? An excerpt from CVS 2011 10-K provides more insight (emphasis added): The decrease in gross profit dollars in the year ended December 31, 2011 was primarily driven by pricing compression relating to contract renewals and in particular the renewal of a large government client contract that took effect during the third quarter of 2010 partially offset by activity associated with our April 2011 acquisition of the UAM Medicare Part D Business. During the year ended December 31, 2011, the decrease in gross profit as a percentage of net revenues was also driven by the previously mentioned client pricing compression, as well as the profitability associated with our previously announced long-term contract with Aetna,

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February 22, 2014

which became effective on January 1, 2011. Additionally, gross profit as a percentage of net revenue continues to be positively impacted by the above mentioned increases in our generic dispensing rates as compared to the prior year. CVS 2011 10-K. Though CVS may have enticed Aetna to sign by pricing with a lower margin, this contract would not be sufficiently large to cause such a large drop in overall gross profit margin. Catamaran gives an equally vague explanation for their drop in gross margin during the same year. It may be due to the companies unique drug mixes being affected by market forces that weighed less on ESRX. Management Incentives and Capital Allocation ESRX also appears to be run by a competent management team. The CEO, George Paz, has led the company for nearly a decade, after serving as the CFO prior. Paz doubled the size of the company, owns $70M of stock (as of a Form 4 filing 11/25/13, adjusted for the current stock price) and just signed on to hold the position for another three years minimum. His 2012 compensation consisted of a $1.2M base salary, $4.8M in stock awards, $3.2M in option awards and a $3.4M non-equity bonus. This appears to be a compelling compensation program. Non-cash compensation was unusually high due to one-time special equity awards associated with ESRX acquisition of Medco. 73% of the CEOs total compensation was part of a long-term incentive plan consisting of: 40% - 50% stock options with three-year vesting periods, 25% restricted stock units with three-year vesting periods, and 25% - 35% performance shares, which are tied to ESRX relative peer performance in three equally weighted categories: total shareholder return, CAGR in EPS (adjusted for extraordinary items), and three-year average ROIC. These ratios are reflective of the compensation structure for all of Express Scripts executives. There is an undisclosed adjusted EPS hurdle that must be met, otherwise the annual bonus plan is not funded at all. Historically, management has either been (a) acquiring companies, (b) buying back shares in bulk, or both. The company has never paid a dividend. ESRX repurchased 60.4M shares for $3.9B during 2013. ESRX is in the process of acquiring an additional $1.5B of its own stock by the end of Q214, so far repurchasing 20.1M shares at an average price of $67.16. ESRX previous accelerated share repurchase program was entered into during May 2011, for $1B. Valuation I first set out to quantify the amount that P/E is being overstated due to the Medco acquisition (results: P/E screens as 33.4x but should really be interpreted as 26.3x after adding back integration expenses). As discussed earlier, I believe that free cash flow yield is the best measure by which to value ESRX due to comparability. As a benchmark, I found the FCF yield of the entire healthcare sector to be approximately 6% (range of 5% - 8% after introduction of the ACA). ESRX two closest current competitors are CVS Caremark (CVS) with 24% of the market and Catamaran Corp. (CTRX) with 5% of the market. CVS Caremark is a vertically integrated PBM, whereas Catamaran Corp is horizontally integrated/pure play like ESRX. Also included in the comparison is Medco, which was the second-largest public PBM when ESRX acquired it in 2012.

Express Scripts Holding Company (ESRX) I next consider a potential end-2014 valuation scenario, once again using FCF yield:

February 22, 2014

The purpose of conducting a potential 2014 FCF profile is to get a sense of the margin of safety on an investment in ESRX By assuming that revenues remain constant, margins/CapEx trend towards average levels as the Medco acquisition is integrated and management repurchases the guided number of shares in 2014, there appears to be 15% upside potential at the current yield of 7.0%. Why the Opportunity Exists This section may as well be titled risks. When PBMs negotiate lower costs for their clients, they do so in private discussions with all parties. Private insurance companies and employers may not know what other clients are paying for the same medications. The opacity with which contracts are negotiated (across the healthcare industry, not just drugs) is sometimes cited as cause of cost overruns. Any regulatory movements towards standardizing reimbursement rates or otherwise making the rate-setting process more transparent could essentially make PBMs redundant. The most likely way that this could happen is if the government decides to implement a single-payer healthcare system. Under this system, since there would only be one healthcare payer, the PBMs would lose all of their scale advantages. I believe that the threat of a single payer system is what makes the opportunity available, and that the threat of a single payer system is overblown. It would likely increase near-term drug expenses significantly and would upset the insurance companies, drug manufacturers and drug distributors who lobby for contracts from the PBMs and are perceived to be lowering costs. From a pharmaceutical market perspective, the only group that would be happy about this would be independent and family-owned pharmacies, which are increasingly losing their ability to compete since they lack the scale of larger pharmacies when it comes to fighting the demands of PBMs. However, if the ACA begins to threaten the solvency of insurance companies, a single-payer system might become the lesserof-all-evils option. Until then, PBMs are reducing health costs (despite taking a cut), and more importantly, they are perceived to be reducing health costs. They are, thus, on the right side of healthcare reform.