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Will a Medco/Express Scripts Merger Pass Regulatory Muster?

Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

Express Scripts and Medco have agreed to merge in a $29 billion deal. I'm here today with Matthew Coffina--he is an equity analyst at Morningstar--to take a closer look and see what the impact could be for investors and on the health-care industry?

Matt, thanks joining me today.

Matthew Coffina: Thanks for having me, Jeremy.

Glaser: So, can you give us a little bit of background on this deal? What do these companies do and why did they think it was a good idea to come together and try to build scale?

Coffina: So, Medco and Express Scripts are pharmacy benefit managers. That means they manage your drug benefits, which you might get through your health plan, through your employer. They pay the claims on your behalf. You go fill your prescription at Walgreens, they are the ones that pay Walgreens the bulk of money, not just the co-pay that you're giving to the company.

They negotiate rebates with pharmaceutical manufacturers. They operate mail-order facilities. So they are really the people behind the scenes of your drug benefit.

Glaser: So what was the rationale for these two companies to come together?

Coffina: Well, scale is really important in the pharmacy benefit management business. Scale gives you bargaining power of your suppliers, like drugstores over pharmaceutical manufacturers, again, and it allows you do the things you need to do more efficiently--processing claims, operating mail-order facilities. For all those reasons, it made sense for these companies to come together.

Glaser: When you look at valuation, do you think this deal looks kind of rich? Do you think that the existing [Express Scripts] shareholders are going to be better off, or are they paying too much for this scale?

Coffina: Well it's hard to say because really it's going to depend on what the combined company is worth when all is said and done. Medco shareholders are going to receive about $28 in cash but also 0.8 shares of Express Script for every share of Medco. So the value of the deals for both parties is really going to depend on what the end company is going to be worth.

Now, we think that it's going to be worth quite a bit. We think a lot of value is going to be created in this deal, assuming that the deal goes through, just because of the enhanced purchasing scale, bargaining leverage over suppliers, and efficiencies.

Glaser: You mentioned that if it goes through--one of the holdups could be regulators. Do you think the federal government is going to allow this to come through?

Coffina: So that's really the big unknown. This deal really took everybody by surprise. Nobody was expecting this because of the regulatory issues--including us. We didn't think that there was any way a deal like this could get done in the current regulatory climate.

The Obama administration has been very vocal that they want increased competition among health-care payers, and they think that that's the main way to keep health-care costs down. So, I think that there is probably less than a 50% chance the regulators actually will go along with this deal, but if they do, it would be great for these two companies.

Glaser: Now, if it did go through, who do you think would be some of the winners and losers? Is there going to be some squeezing of the margins at the drugstores? Are the drug companies going to be hurt?

Coffina: So I think Medco and Express Scripts are the clear winners, and you could see it in the stock price reactions today. Express Scripts was up maybe 6%, Medco was up 14%- 15% last time I saw it. The losers are pretty much everybody else in the drug supply chain. So, that would be pharmaceutical manufacturers, companies like Lilly, Pfizer, Bristol; drugstore chains like Walgreen, CVS; competitive PBMs like CVS Caremark, United Health Group; and distributors. So, for example, AmerisourceBergen was down 6% or 7% today. Medco is their largest client, so there is a risk that either that business would be taken to a competitive distributor or at least that this new company with much greater bargaining leverage is going to be able to wield that to reduce the margins of the distributors.

Glaser: So, it seems that right now we all really need to keep our eye on the regulator to see how this deal is really going to play out.

Coffina: That will be the thing to watch, certainly.

Glaser: Matt, thanks so much for your thoughts today.

Coffina: Thank you.

Glaser: For Morningstar, I am Jeremy Glaser.