Catamaran Sails Through Another Solid Quarter

 Catamaran turned in another good quarter as it continues to robustly build its claims base and deliver strong revenue growth. Management also raised the lower end of its adjusted earnings per share outlook to $2.12-$2.22 from $2.10-$2.22. This strong growth is a positive for the pharmacy benefit manager and strengthens its ability to produce significant long-term economic profits. Accordingly, we are reiterating our $57 fair value estimate.

For the quarter, total revenue increased a healthy 57.6%, driven by a near 50% increase in claims volume. As a result of the large claims increase, Catamaran's core PBM operation produced revenue growth of 58.2%. Positively, Catamaran said most of this growth was organic and we believe reflects excellent client employee growth, cross-sales execution, and material new client growth. Additionally, Catamaran's recent Restat acquisition and Cigna contract integrations made a meaningful contribution to the top line. While the profitability of the Cigna contract is expected to remain muted over the course of the next several quarters, management did reiterate that it expects solid accretion from the contract starting in 2015 and beyond.

Catamaran's management team again raised the lower end of its outlook for the full year, and this development gives us increased confidence that the firm has a better handle on its infrastructure and cost needs moving forward. Management also said it will most likely execute a material acquisition by the end of the year, which we find largely positive. We believe management is now positioned favorably to continue its M&A rollup strategy and is signaling that the major activities related to the Restat acquisition and Cigna contract integration are solidly on track. Additionally, the continuation of the firm's long-term M&A roll-up strategy is highly positive from our perspective, as it allows Catamaran to build its claims base, cost and pricing advantages, and service capabilities. These variables should strengthen its narrow economic moat. Larger PBMs have a major advantage in the health-care services market from a cost and supplier pricing perspective; therefore, we believe the underlying bolt-on acquisition strategy being pursued by Catamaran is the correct path.

New Scale Brings Economic Profits
Catamaran is the third-largest pharmacy benefit manager, with more than 250 million adjusted claims processed in 2013. The firm was formed through the merger of PBM information technology provider SXC Health Solutions and pure-play PBM Catalyst Health Solutions. We believe the new entity is very beneficial to investors, as Catamaran's combined claim volume should produce solid economic profits over an extended period. As a result, we award the firm a narrow Morningstar Economic Moat Rating.

Catamaran's core PBM 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 expanded 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 at a cheaper cost. The PBM usually can negotiate large enough discounts to retain a portion of the discount and still provide its clients with highly advantageous drug pricing.

Even though Catamaran's claims volume pales in comparison with the billions processed by CVS Caremark (CVS) and Express Scripts , the company is still one of the largest players in the PBM industry. This dynamic positions Catamaran with decent supplier pricing negotiating leverage and, more critically, centralized cost scale advantages. Additionally, we believe the firm will be able to increase its claim volume as its clients expand their memberships and the overall demand for pharmaceutical management services increases.

Moat Comes From Claim Volume
Robust claim volume gives Catamaran the opportunity to take advantage of two key industry drivers: supplier pricing leverage and centralized cost scale. With total adjusted claims well above 250 million, the PBM is able to negotiate favorable pharmaceutical product pricing with suppliers. This factor gives it the advantage of expanding its client base and preserving its gross margins. Scale is also a source of competitive advantage as each additional claim processed is more profitable than the previous one. Centralized and technology system costs are able to be spread across the entire level of claims, which gives an advantage to larger PBMs. Because of these factors, Catamaran is able to produce gross and operating profits that translate into returns on invested capital well above its weighted average cost of capital. We believe this trend will remain over an extended period.

Acquisition Strategy Brings Risk as Well as Reward
The main risk facing Catamaran is its inability to effectively execute its M&A rollup strategy. The firm plans to build its scale advantages and claims volume through the acquisition of smaller PBMs. If management is unable to efficiently integrate these targets, its returns on invested capital could suffer. Additionally, the end of the generic wave will most likely happen over the medium term, and this dynamic could pressure profitability as a result. How Catamaran handles this trend will be key. Suppliers could also provide future headwinds as many major distributors and retail pharmacy chains have consolidated operations through partnerships. These partnerships could increase the supply of drugs each player distributes to a point where they could take some negotiating power away from Catamaran.