Express Scripts (ESI) is the largest pharmacy benefit manager (PBM) in an industry where scale is a competitive advantage. It has been able to compound earnings, free cash flow, and free cash flow at very high rates (over 20%) over the past ten years. Fundamentally, I believe that Express Scripts’ returns are mostly driven by its CEO, George Paz, who has held the position since 2005. In the past, ESI never had the benefit of scale. Its success was driven by the quality of its management. In the future, ESI will begin to see advantages and disadvantages from its larger size.

On the other hand, the PBM industry has some dubious practices that creates regulatory risk. The PBMs are rarely transparent with their customers and have often taken kickbacks from drug manufacturers. There is a chance that future government intervention will target such practices.

Industry Overview

PBMs act as middlemen between their customers and suppliers.

The PBMs’ customers are:

Health insurance companies.

Employers with health plans.

The PBMs’ suppliers are:

Retail pharmacies. These are usually either independent “community pharmacies” or chain pharmacies such as Walgreens, CVS, etc.

Mail order pharmacies (“home delivery”). Instead of having bricks and mortar locations, drugs can instead be delivered through the mail. All of the major PBMs own their own mail order pharmacies.

Drug manufacturers. They supply the retail and mail order pharmacies.

The PBMs’ normal customers and suppliers have tried vertical integration with their own PBMs. The drug manufacturer Merck used to own Medco; Merck later spin Medco off. Express Scripts used to be part of a health insurance company and was later IPOed into an independent entity. CVS is a retail pharmacy that also has PBM operations. It seems to me that the advantages and disadvantages of vertical integration don’t matter too much. Express Scripts seems to have the best operating metrics in the business so perhaps being a standalone PBM is the best approach.

How PBMs are changing retail pharmacy

One of the major ongoing changes in the industry is the battle between PBMs and retail pharmacies. This is really more of a battle between mail order and bricks and mortar retail. Both modes of delivery have their advantages and disadvantages. The cost savings of mail order is very compelling and will likely push the industry towards mostly mail order. When consumers have higher co-payments for retail pharmacies, they increasingly opt for mail delivery. Health care plans are increasingly looking to save money and are working with PBMs to force health care users onto mail delivery for maintenance medications. The PBM industry will likely drag the American consumer kicking and screaming into the 21st century.

Another headwind for the retail pharmacy industry is the increased clout of PBMs. This is shown in the clash between Express Scripts and Walgreens, where the parties were unable to renew their contract. This meant that Walgreens was dropped from ESI’s pharmacy network for 8 months. It looks like ESI was the winner. Walgreens saw a significant drop in revenue while ESI was hardly affected. The Risk Factors section in Walgreen’s 10-K says it all:

We derive a significant portion of our sales from prescription drug sales reimbursed through prescription drug plans administered by pharmacy benefit management (PBM) companies. PBM companies typically administer multiple prescription drug plans that expire at various times and provide for varying reimbursement rates. There can be no assurance that we will continue to participate in any particular pharmacy benefit manager network in any particular future time period. If our participation in the prescription drug programs administered by one or more of the large PBM companies is restricted or terminated, we expect that our sales would be adversely affected, at least in the short term. If we are unable to replace any such lost sales, either through an increase in other sales or through a resumption of participation in those plans, our operating results may be materially adversely affected. For example, we were not part of the pharmacy provider network of Express Scripts, Inc., one of the largest PBMs, for more than eight months in 2012, which led most patients in plans administered by Express Scripts that we formerly served to transition to a new pharmacy and caused us to lose significant sales and adversely affected our operating results. While we reached an agreement with Express Scripts in July 2012 and became part of the broadest network of pharmacies available to Express Scripts clients as of September 15, 2012, we expect the impact of this new agreement with Express Scripts to be incremental over time. When we exit a pharmacy provider network and later resume network participation, there can be no assurance that we will achieve any particular level of business on any particular pace. In addition, in such circumstances we may incur increased marketing and other costs in connection with initiatives to regain former patients and attract new patients covered by in-network plans. When we exit a pharmacy provider network and later resume network participation, there also can be no assurance that all clients of the PBM sponsor of the network will choose to include us again in their pharmacy network initially or at all. For example, after we reached our agreement with Express Scripts, the United States Department of Defense TRICARE program, an Express Scripts client, announced that Walgreens would continue to be designated as a non-network pharmacy provider for TRICARE beneficiaries.

Health plans are more willing to drop Walgreens than ESI. It gets worse for Walgreens because ESI is now roughly twice as big. Walgreens’ 10-K also states:

Consolidation in the healthcare industry could adversely affect our business, financial condition and results of operations. Many organizations in the healthcare industry, including pharmacy benefit managers, have consolidated in recent years to create larger healthcare enterprises with greater bargaining power, which has resulted in greater pricing pressures. For example, in April 2012 two of the three largest pharmacy benefit managers, Medco Health Solutions, Inc. and Express Scripts, Inc., merged. The resulting entity is the largest pharmacy benefit manager in the United States. If this consolidation trend continues, it could give the resulting enterprises even greater bargaining power, which may lead to further pressure on the prices for our products and services. If these pressures result in reductions in our prices, our business will become less profitable unless we are able to achieve corresponding reductions in costs or develop profitable new revenue streams. We expect that market demand, government regulation, third-party reimbursement policies, government contracting requirements, and societal pressures will continue to cause the healthcare industry to evolve, potentially resulting in further business consolidations and alliances among the industry participants we engage with, which may adversely impact our business, financial condition and results of operations.

The situation is worse for independent pharmacies as they have even less negotiating power than chain pharmacies like Walgreens. The retail pharmacies have industry groups that are trying to lobby for government protection against the PBMs. I don’t think that they should succeed as the PBMs are genuinely driving down costs. However, there is a small chance that various levels of government may implement some protections for the retail pharmacy industry. However, I doubt it will happen since many Americans are sick and tired of their excessive healthcare costs.

PBMs are sometimes the frenemy

Weirdly enough, PBMs often cheat their customers. The drug industry in general has very little transparency mainly because the manufacturers want low transparency. The drug manufacturers often engage in various schemes to maximize their profits:

Drugs have higher prices in the US than poorer countries.

The manufacturers try to overcharge various US health programs (e.g. Medicare, Medicaid, etc.).

They provide rebates/kickbacks to PBMs so that the PBMs’ customers pay too much for drugs.

They spend huge sums of money marketing their drugs to doctors. They may provide doctors with free trips to conferences (which is like a free vacation), pay consulting fees to doctors, etc. etc. Because of these practices, doctors don’t always engage in the most cost-effective treatment options.

Sometimes the PBMs will respect their fiduciary duty to their customers and will fight the abuses and excesses of the system. PBMs will work with health care plans so that the patients have incentives to use the lowest-cost options. If a doctor prescribes an unnecessarily expensive treatment method, the PBMs’ pharmacist can take steps to try to change the prescription. Or the plan will only reimburse if the most cost-effective treatment option is tried first (“step therapy”).

However, this doesn’t always happen. Sometimes the PBMs are more sophisticated than their customers and will cheat them out of savings. The PBMs’ customers often discover that they have less savings than they were originally promised. There are various ways to achieve this:

Kickbacks / “rebates” from the drug manufacturer.

Selling generic drugs at brand-name prices. Many health plans allow their members the freedom to buy brand name drugs. If the PBM lumps generics into the brand name category but charges brand name pricing for the generics, they will be able to make an unusual profit.

“Spread pricing”. The PBM pays retail pharmacies one rate while it charges a higher rate to the health plan. The PBM pockets the difference.

In the past, the various major PBMs had to pay various settlements over these shenanigans. One major risk to the PBM industry is that the government intervention may try to eliminate these practices. It would theoretically make sense for the US government to intervene as it would help lower the US’ excessive healthcare costs. In the future, I think that there will probably be more regulation (not less). It’s also possible that the politicians leave the PBM industry alone because it’s complicated and hard to figure out. The party could continue for a while.

Specialty Pharmacy

There are a few diseases where the drugs are extremely expensive due to low volume of patients and the high impact of the disease (e.g. multiple sclerosis). Many patients obtain these drugs through the hospital that treats them. Unfortunately, a reality of the American hospital system is that competition is low. Specialist doctors band together into practicing groups and cause many markets to effectively operate as monopolies or oligopolies. Similarly, many hospitals merge into hospital networks so that competition between hospitals is low. (Personally, I think that a major reason why the American healthcare system is inefficient is because there is an artificial shortage of doctors.) This allows hospitals to apply extreme markups on specialty drugs. It is not unusual for private insurers to pay 2-3X what Medicare would pay (this is the norm in the dialysis industry). PBMs can legitimately help health plans save money by buying the drugs themselves and avoiding the hospital’s markups.

The future of the PBM industry

I’m not really sure.

In the past, the PBM industry was dominated by drug manufacturers that owned PBMs. Not surprisingly, there were conflicts of interest. The manufacturers would use their PBMs to push their own drugs at inflated prices. Eventually government regulators intervened and many of these PBMs were sold for a loss. There were times when various companies lost billions of dollars buying a PBM and selling it later at a loss. It seems to me that the PBM industry’s profitability is not the best in the world and not the worst.

However, I think that Express Scripts will do well despite the industry’s tricky economics because it is the best operated PBM among the publicly traded PBMs. I will use EBITDA per adjusted claim as the metric for comparison purposes. Mail order scripts are counted three times since mail order often delivers 90 days of drugs while retail pharmacies dispense 30 days at most. Here are the figures for 2011 EBITDA per adjusted claim (I use 2011 because there were more public PBMs back then):

ESI: $3.54

Medco: $3.15

Catamaran: $1.82

Catalyst: $1.12 (this is EBITDA per unadjusted claim; if the adjusted figure were provided, EBITDA/adj. claim would be lower)

I will point out that Medco had higher EBITDA per adjusted claim than ESI in 2008. Both companies increased EBITDA/adj. claim at a very high rate until ESI overtook Medco in 2009. Both ESI and Medco are very well operated. In the future, I think that ESI will continue to consolidate the industry and will be able to enjoy greater economies of scale. Here is ESI’s trend in EBITDA/adj. claim over the years:

2012: $3.87

2011: $3.54

2010: $3.19

2009: $3.19

2008: $2.70

2007: $2.28* (my calculation)

2006: $1.78* (my calculation)

2005: $1.28* (my calculation)

To some degree, ESI’s dramatic increases in EBITDA per prescription may not be sustainable. Many of their customers are sophisticated and will eventually realize that the middleman is making too much money. If PBMs become too profitable, other companies will likely enter the field. For example, United Health (UNH) has started its own PBM and is transitioning away from Medco. Ultimately, PBMs can only exist if their clients are saving money.

Going forward, I think that George Paz will find ways to create value and generate high returns on capital. As long as there are massive inefficiencies in the US healthcare system, ESI will be able to make high returns on capital from legitimately saving its customers money.

Is Express Scripts ethical?

I’m pretty jaded and cynical about the US healthcare industry, especially after researching DaVita. The PBM industry has its share of value creation and abuses. I think that ESI leans mostly towards the value creation side.

In terms of legal settlements, it has paid out very little money. In 2008 it paid $9.3M to 29 states and patients over drug rebates and certain business practices. In 2007 it paid $10.5M because one of its subsidiaries illegally distributed human growth hormone to well-known entertainers and athletes. Compare this to other PBMs and their settlements:

Medco (now part of Express Scripts): $184.1M in 2006

AdvancePCS (now part of CVS/Caremark): $137.5M in 2002

Caremark: $41M in 2008

ESI has paid out significantly less money than its PBM peers and companies owned by Berkshire Hathaway (DaVita, Goldman Sachs, Walmart, etc.). To be fair, one could argue that this isn’t the best metric. I would consider Microsoft to be one of the most ethical companies around, yet it has been hit with fines and settlements from billions of dollars to several hundred million.

Overall, ESI seems fine on the integrity front. It is certainly more ethical than DaVita as it does not endanger lives or actively defraud Medicare. It screws its customers far less than Goldman Sachs.

Insider compensation seems fine for a multi-billion dollar company. Insiders regularly sell stock though George Paz’s stock holdings have grown slightly over the years. This is a situation where you shouldn’t read too much into insider trading. With the benefit of 20/20 hindsight, we can see that insiders should not have sold their stock since it went up so much after they sold.

Accounting Issues

ESI has amortization charges related to its mergers and acquisitions that distort ESI’s true earnings. From the 10-K:

The aggregate amount of amortization expense of other intangible assets for our continuing operations was $1,632.0 million, $236.0 million and $159.8 million for the years ended December 31, 2012, 2011 and 2010, respectively.

These amortization charges should be added back into ESI’s GAAP earnings to get a better picture of what the business actually earns. (For a long explanation, see the appendix to Warren Buffet’s 1983 letter which touches upon similar issues.)

GAAP profits for 2012: $1,330.1M

Amortization expenses related to acquisitions: $1,632.0M

Adjusted earnings: $1,330.1 + $1,632.0 = $2,962.1M

At a market cap of $52.87B, the adjusted P/E would be 17.8. According to management, there are a number of one-time charges related to the Medco merger (e.g. consolidating clients onto one system). If you take them out, ESI’s profits would be even higher. I will err on the cautious side and leave them in. Here are the calculations for the trailing twelve months of reported earnings:

GAAP profits: $1,820M

Amortization: $2,072M

Adjusted earnings: $3,892M

Adjusted TTM P/E: 13.6

Capital Allocation

Capital allocation is excellent as Express Scripts continually buys back its shares or acquires other companies. Most of its debt is on reasonable terms. However, the overall level of debt is a little high for my tastes. Debt to EBITDA is roughly 2.32. But because the call options on ESRX are so cheap, I’m not too worried about the level of debt.

Putting it together

By far the biggest factor behind Express Scripts’ success is George Paz. His leadership since 2005 has allowed Express Scripts to overtake Medco in operating performance. If he were to die or leave the company, I would probably sell my shares to be safe. Of lesser importance is Express Scripts’ scale, which is a nice bonus.

Valuation-wise, the stock is reasonable. My adjusted TTM P/E is 13.6. The $14-15B in debt does inflate the P/E slightly but it’s not by much since it’s $14-15B in debt compared to a market cap of $53B for the stock. The debt and equity combined will still have a good earnings yield.

*Disclosure: No position, but I will likely be buying the call options.

**EDIT: As of August 2, I am long ESRX call options.



Links

Examining the Value of Pharmacy Benefit Management Companies – A great backgrounder on the industry. You may need to access the article via Google’s cached version of it.

VIC writeup on ESRX

PBM Issues – This website is by an advocacy group for pharmacists. It provides an overview of issues with the PBM industry.

PBM Watch “Problems in the market” – I believe this is a website put up by lawyers who want to sue PBMs. (Obviously the website is biased.)

Yelp reviews of Express Scripts – For what it’s worth, all the Yelp reviews are negative. (To be fair, there could be some adverse selection going on. People with problems tend to be more visible and vocal.)

Captive PBMs Humana, OptumRx Play Up Integrated Specialty Solutions for 2014 – Article that relates to the benefits of an insurance company with its own in-house PBM.

A penny to fill your prescriptions? and PBM Hubris – A pharmacist blogs about the impact of PBMs on community pharmacies.

Consumer Reports rates drugstores