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PBMs: Health Care's Hidden Gems

Matthew Coffina, CFA

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Matt Coffina--he is the editor of Morningstar StockInvestor newsletter--to see what impact the UnitedHealth-Catamaran merger will have on the pharmacy-benefit-manager space.

Matt, thanks for joining me.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: So, can you give us a little bit of background on what these PBMs are and why they are so important to the health-care system?

Coffina: Pharmacy benefit managers maybe are not household names, but they're very important within the health-care system and their role is really to manage pharmacy benefits on behalf of employers and managed-care organizations. So, when you go to the drugstore, you present your insurance card and what's happening on the back-end of that is that the pharmacy benefit manager is negotiating rebates with branded drugmakers. They are negotiating for discounts with generic drugmakers through their mail-order pharmacies. They are negotiating prices with the retail pharmacy, and then they are taking the funds from the client and passing them through to the retail pharmacy collecting the rebates from the drugmaker and so on.

So, they're really processing claims behind the scenes, operating mail-order pharmacies for consumers who want to get their drugs directly from the PBM through the mail, and then negotiating the best deals that they can with suppliers, which would include generic and branded drugmakers, distributors, and retail pharmacies.

Glaser: How is landscape going to change with this merger?

Coffina: The PBM space is already fairly consolidated. We've seen a lot of mergers over the years. It's been a very active space over the past five years. For example, we saw CVS (CVS), which is a major retail pharmacy, acquire Caremark, which is a major PBM. We saw Express Scripts (ESRX) acquire Medco. Those were two of the top three PBMs before the merger, and now Express Scripts is the largest PBM. Most recently, as you mentioned, UnitedHealth (UNH) acquiring Catamaran (CTRX)--those were the number-three and number-four players coming together to form an even stronger number-three player.

What we are left with is the top three players controlling about 75% of drug spending in the United States, and I think this really points to the importance of scale within this business. So, the larger you are as a pharmacy benefit manager, the more you are able to direct patients to one drug choice over another or one retail pharmacy over another. That really gives the PBMs bargaining power over their suppliers. So, the larger you are, the more bargaining power you have and the better terms you are able to negotiate with those suppliers. And you're able to pass through most of those cost savings to customers--which, again, are the employers or the insurance companies, the managed-care companies.

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Glaser: Looking more specifically at this new deal with Catamaran, does it really change your thinking about UnitedHealth as a company? If you are interested in the PBM space, would that be the place to look right now?

Coffina: UnitedHealth is a very large, very diversified company. I wouldn't say this deal is really enough to move the needle for UnitedHealth; it's still a fairly small portion of their business--the PBM. I think the business does get incrementally stronger, and we think that UnitedHealth paid an appropriate price. They actually paid a modest discount to our standalone fair value estimate for Catamaran, even before accounting for synergies. But again, the deal is not really big enough to move the needle for UnitedHealth.

If I were trying to get exposure to the pharmacy-benefit-manager industry--and I am because it's actually our largest holding in the Hare portfolio--I would mostly be looking to Express Scripts, which is, again, the largest company in the industry. It should have some direct benefits from this UnitedHealth-Catamaran merger. For example, Express Scripts has lost clients over the past several years during its integration of Medco; there were some disruptions to customer service, and that caused them to lose some customers--including to Catamaran.

Now, the tables have really turned. UnitedHealth is going to be integrating Catamaran, and that could create some disruption on their side, which could enable Express Scripts to come in and regain some market share that it lost over the last few years. As I said, I think the acquisition really points to the importance of scale within this industry, and nobody has more scale than Express Scripts. They control about 29% of the market today--number one, ahead of UnitedHealth and also CVS/Caremark.

And then there's another aspect of this deal that could be positive for Express Scripts. I always hesitate to speculate on mergers and acquisitions, but it is possible that Express Scripts could be involved in further M&A activity--possibly as a target. Express Scripts is often rumored as a potential target for Walgreens Boots Alliance (WBA). That company has gotten much larger, especially on the distribution side, but some people think that they're lacking a PBM capability to really keep up with CVS, [which is now called] CVS Health. Walgreen is probably the only company that's actually large enough to buy Express Scripts. It's a $60-billion-plus market-cap company, so there aren't a whole lot of suitors out there. But then, even barring a major M&A transaction like that, there are a few smaller PBMs still out there--that other 25% of the market--and they may find it increasingly important that they achieve scale. And Express Scripts would seem to be a very attractive partner for those smaller PBM's, particularly if they don't want to work with UnitedHealth, which is a competitor to managed-care organizations.

For example, Humana (HUM) is another managed-care organization that owns a PBM business. They might not want to outsource that to a competitor in UnitedHealth. And CVS also comes with its own issues because of the potential conflicts with the retail business. So, Express Scripts is really the only pure-play large-scale independent PBM left, which could make it an attractive partner and possibly lead to value-creating deals with these smaller PBMs that make up the [remaining] 25% of the market that isn't controlled by the big three.

Glaser: So, having a stronger number three in place actually improves your confidence in the outlook for Express Scripts?

Coffina: I think so. On one hand, you could say UnitedHealth will be a somewhat stronger competitor, but I think it's actually more important that the pricing environment within the industry could become a bit more rational. Again, with Express Scripts having some near-term opportunities potentially to steal some market share from UnitedHealth and with the benefits of scale still accruing, I don't see it as a reason to be negative on Express Scripts. If anything, I'd see it as an incremental positive for that company.

Glaser: Matt, thanks for your take on this space today.

Coffina: Thanks for having me, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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