Market Overreaction Makes Express Scripts Even More Attractive

The pure-play pharmacy benefit managers we cover have seen their stocks come under material pressure recently because of market fears regarding the growing importance of private health insurance exchanges. We believe that these fears are unfounded and that many market participants are fundamentally misreading these developments. We believe the pullback in  Express Scripts' share price offers a buying opportunity, given the significant discount to our $89 fair value estimate.

The delivery of pharmaceuticals to consumers encompasses many firms along the supply chain, and among those, Express Scripts stands out as an elite participant. The firm's strong competitive advantages have churned out excellent returns on invested capital and have resulted in a wide Morningstar Economic Moat Rating. We anticipate robust growth for the pharmaceutical industry over the long term, which should provide Express Scripts with a solid platform for continued success.

Express Scripts' core pharmacy benefit manager service assists pharmaceutical benefit payers with the fulfillment of member prescriptions. This entails processing prescription claims made by a client's members and ensuring the claims comply with benefit plan parameters. Additionally, the PBM is responsible for paying the retail pharmacy on behalf of the client. Originally, PBMs would charge a fee per claim processed; however, the revenue structure for the industry has morphed into spread retention.

Major PBMs have increased their claim volume to a point where they are able to directly negotiate discounted drug pricing with manufacturers, distributors, and retail chains, which allows their aggregate client bases to obtain products more cheaply. The PBM usually can negotiate large enough discounts where it can keep a portion of the discount and still provide its clients with highly advantageous drug pricing.

Claim Volume and Scale Result in Wide Moat
With more than 1.3 billion adjusted claims processed in 2012, Express Scripts is the largest PBM. This allows the firm to negotiate favorable supplier pricing and solid spread retention. The firm has the advantage of expanding its client base by providing low-cost products while preserving its gross margins. The power of the firm's negotiating position was demonstrated recently with its Walgreen (WAG) contract negotiations. Even though Walgreen is the largest retail pharmacy chain, it had to acquiesce to Express Scripts' pricing demands.

More critically, however, the colossal claim volume processed by Express Scripts allows the firm to scale its centralized costs and leverage its asset-light capital structure into solid economic profits: Each additional claim processed is more profitable than the previous. The firm has some of the lowest selling, general, and administrative costs and highest operating profit per claim. These metrics have translated into ROICs well above its weighted average cost of capital, and we believe this trend will remain over an extended period.

Competition and Regulation Are Risks
Although Express Scripts' competitive position has improved, aggressive pricing by rivals could still hurt profitability. For example, CVS Caremark (CVS) may have an incentive to underprice its PBM offering to drive more traffic to its retail stores. UnitedHealth (UNH) is expected to fully in-source its PBM business in 2013, which increases the competitive threat from this managed-care organization as well. While some health-care policy reforms could benefit Express Scripts, like generic biologics legislation and expansion of insurance coverage to 32 million of the nation's uninsured, other reforms could make it harder for Express Scripts to conduct business, such as PBM transparency requirements.