A Rare, Wide-Moat Find in a Market With Few Values

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. In a market with few bargains, Morningstar StockInvestor editor Matt Coffina sees Express Scripts as a rare value. He's here today to talk to me about his outlook for the firm. Matt, thanks for joining me.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: Let's start by just looking at Express Scripts. Can you briefly tell us about what this company is and what they do?

Coffina: So, Express Scripts is a pharmacy-benefit manager. Basically, they manage pharmacy benefits on behalf of employers or health-insurance companies, managed-care organizations. Either the employers or the managed-care organization would be taking on the actual risk of providing pharmacy benefits--they are the ones who are actually paying the bills--but Express Scripts would help them with, for example, mail-order fulfillment, constructing formularies with preferred drugs and nonpreferred drugs, dealing with patients and doctors and getting them to switch to lower-cost drug options, negotiating with retail pharmacies, and so on. So, they are sort of the backend to the pharmacy benefit that you might get through your employer or through a government program like Medicare or Medicaid.

Glaser: Express Scripts did recently report quarterly results. What did that show? How is the business doing right now?

Coffina: Express Scripts has struggled over the last couple of years with client attrition related to their large Medco purchase. So, there were basically three large PBMs--Medco, Express Scripts, and CVS Caremark. Express Scripts bought Medco back in 2012. It was a very, very large merger--a lot of complication involved with integrating these businesses. And, since then, their client attrition has been running relatively high. There were actually even some Medco clients who had been former Express Scripts clients who had left the company at one point and went to Medco.

So, I think it's understandable that you would lose some clients as you are turning over a lot of the account management teams, integrating your backend systems, and doing all of this other integration work that maybe caused clients' services to suffer in the short run. And that's really weighed on their overall prescription volumes, their revenue, and investor sentiment.

That actually continued in the most recent quarter. A lot of the business renews on January 1 of every year, so we already had a pretty good sense of what their client numbers were going to look like for this year. But in the second quarter results, they gave some guidance for 2015, and it looks like client retention is, once again, going to be below average--about 92% to 93% client retention. In other words, 7% to 8% of the client base was lost for next year. And that is a little concerning, given that pharmacy-benefit managers more commonly retain more than 95% of their clients in any given year.

So, basically, the Medco integration headwinds have persisted for now three years. The good news is that their overall prescription volumes are expected to be down only slightly next year, and that’s because it seems like they are having some success with new business wins. They are also seeing growth of existing clients, so more prescriptions are being sold through existing clients. So, both of those things are helping offset the volumes that they are going to lose because of clients that have left them.

Glaser: Can they turn around the situation, though? What's your outlook for growth for the company?

Coffina: Well, the good news is that most clients for a pharmacy-benefit manager are on a three-year contract cycle. So, again, the Medco deal closed in 2012, and all of those clients should have been cycled at this point. All of them will either have been renewed or lost by this point at least once. So, my hope would be that there won't be these ongoing integration issues in 2016 and beyond. And now--Express Scripts having put that integration behind them--all of the backend systems are on one platform, all the account-management teams are in place, and so on. The company can now really focus on retaining and winning new business going forward.

In 2016 and beyond, my hope at least would be that the company can return to more industry-level growth, if not even return to get market-share gains, as the company still has more scale than any of its competitors. And scale is really the most important thing in this business and the source of economic moats since it gives bargaining leverage to pharmacy-benefit managers in their negotiations with drug manufacturers or retailers or distributors.

Glaser: Let's talk about that competitive landscape then for a minute. With the Affordable Care Act and some other pressures to keep prices down, are other firms potentially going to enter in here and compete against Express Scripts?

Coffina: I don't think you'll see a lot of new entrants in this business because of, again, the importance of scale. If you don't have a very large base of patients, you're not going to have bargaining power over drug manufacturers or retailers. So, it's going to be very hard to start this business from scratch. That said, we do see fairly robust competition between the top four pharmacy-benefit managers. [Those four] would be Express Scripts, CVS Caremark--who is the only company that's really on the same level as Express Scripts in terms of overall prescription volumes--and then further down below them would be UnitedHealth--which has an in-house pharmacy-benefit management business--and Catamaran, which has been gaining a lot of size through acquisitions and also through some organic client wins. Between those four companies, I think you will see this ongoing competitive pressure, and client losses happen from time-to-time.

Sometimes, in the past, Express Scripts has gained market share from its competitors; a really notable time would be when CVS acquired Caremark several years back. Both Medco and Express Scripts really took advantage of that--of the disruption that was created by that integration--and were able to steal some clients at CVS' expense. Now, we're sort of on the opposite side where Express Scripts and Medco have experienced these integration headwinds, and CVS has been able to gain back some clients.

I think you will see this back-and-forth over time. But in the long run, I continue to believe that Express Scripts and CVS Caremark are very well positioned to at least grow in line with the market as well as expanding their operating margins over time as they continue to save clients' money, again by directing patients to lower-cost drug alternatives.

Glaser: How about valuation levels--why do you think Express Scripts is cheap right now?

Coffina: Express Scripts is trading at a low- to mid-teens multiple of current-year earnings. They generate a tremendous amount of free cash flow. So, the free cash flow yield is up in the neighborhood of 8%. And so, with an 8% free cash flow yield and the company using almost all of that for share repurchases, you really need very little operating-income growth to achieve an attractive total return.

If you can get 2% operating-income growth--which, again, in the long run they should have a tailwind from growing prescription-drug spending--I would say that's probably in the mid-single digits. Particularly, as you see the aging population and you see expansions of insurance coverage under the Affordable Care Act, [Express Scripts] have this mid-single digit tailwind on the topline. So, it's not hard to see how they can grow operating income at least 2% per year, which is all they need on top of that 8% free cash flow yield to generate a double-digit total return for investors.

So, even if the stock keeps its low- to mid-teens multiple, you repurchase 8% of the flow every year, and then get a couple of percentage points from operating-income growth and right there, you have a 10% plus total return. So, the reason why I continue to like Express Scripts more than its peers is that the valuation really does look the most attractive.

That said, they can't afford to lose clients like they have been losing them. And definitely, in 2016, we're going to need to see those client losses return to more normal levels--call it 95% plus client retention--while also winning new business either at the expense of competitors or just growing in line with the market, such that prescription volumes grow over time. So far, their earnings have continued to grow quite nicely as they've realized synergies from the merger and cut costs and continued to repurchase shares.

But in the long run, some level of prescription-volume growth is important to maintain a healthy, balanced growth outlook. So, the really important factor to consider here is the valuation. And again, with that 8% free cash flow yield, you don't need a lot of growth to achieve an attractive total return.

Glaser: Matt, I certainly appreciate your thoughts on Express Scripts today.

Coffina: Thanks for having me, Jeremy.

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