Express Scripts Well Positioned for New Health-Care Order

With its wide Morningstar Economic Moat Rating, solid growth potential, and dominant market position,  Express Scripts is significantly undervalued, in our opinion. We strongly believe the firm's command of the pharmaceutical supply chain is unparalleled, given its 30% market share. The pharmacy benefit manager's recent exclusion of certain branded drugs from its national formulary and its Medicare Part D partnership with Walgreen highlight its advantages. Given these factors, we believe Express Scripts will produce robust economic profits over the long term.

Express Scripts reported third-quarter results that were largely in line with our expectations, and we are reiterating our $89 fair value estimate. The firm also narrowed its 2014 adjusted full-year earnings per share outlook to $4.86-$4.90 from $4.84-$4.92 (maintaining a midpoint estimate of $4.88). The shares remain materially undervalued and continue to be one of the better opportunities in the market, in our view. We believe the cost-containment services Express provides its clients will grow more critical as payers look for ways to materially curb the cost of pharmaceuticals. From our perspective, this dynamic will be a major driver of long-term outsize returns on capital for the pharmacy benefit manager.

Revenue decreased 4.8% year over year while operating margins increased a decent 44 basis points to 3.82%. These metrics include the runoff of the UnitedHealth Group contract and are not unexpected. Excluding the effect of the UnitedHealth claims volume, adjusted EBITDA increased 8.4% from year-ago levels.

The subpar integration of the Medco acquisition has been a major headwind throughout most of 2014; however, Express seems to be on track with correcting these issues. For the quarter, gross and operating margins increased materially, expanding 35 basis points to 8.04% and 44 basis points to 3.82%, respectively. This positive expansion in both profit lines is highly encouraging and we believe points to increasing pricing leverage with suppliers, excellent generic program execution, and better Medco integration.

However, the firm did make material infrastructure investments during the third quarter with adjusted selling, general, and administrative expense increasing 2%, factoring out UnitedHealth claims. Management will also make incremental client service infrastructure investments during the fourth quarter. We believe these investments are necessary and will correct for certain client servicing issues the firm is facing. As the firm moves past 2014 and into 2015, these investments should help drive long-term client retention and new client sales.

All metrics on a per-adjusted-claim basis also improved at a healthy clip during the quarter. This included gross profit rising a robust 13.4%, operating profit increasing a solid 22.6%, and adjusted EBITDA up a strong 14.5%. We believe the increase in both revenue and profitability per adjusted claim points to Express' ability to drive increased services and savings to clients. Ultimately, this dynamic will also lead to more value growth for investors. Express was able to increase its generic fill rate 240 basis points to 84%.

Express Is an Elite Player
The delivery of pharmaceuticals to consumers encompasses many firms along the supply chain, and among the numerous players Express Scripts stands out as an elite participant. The firm's strong competitive advantages have churned out excellent returns on invested capital and resulted in a wide economic moat. 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 are compliant 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.

With more than 1.3 billion adjusted claims processed in 2013, Express Scripts is the largest PBM. This dynamic positions the firm positively as it is able to negotiate favorable supplier pricing and solid spread retention. The power of the firm's negotiating position was demonstrated recently with its Walgreen contract negotiations. Even though Walgreen is the largest retail pharmacy chain, it had to relent to Express Scripts' pricing demands.

More critically, however, the colossal claim volume processed by Express Scripts allows it to scale its centralized costs and leverage its asset-light capital structure into solid economic profits. 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 the firm's weighted average cost of capital.

Claim Volume Brings Opportunity; Competition Brings Risk
We believe Express Scripts possess a wide economic moat. The firm's substantial claim volume gives it the opportunity to take advantage of two key industry drivers: supplier pricing leverage and centralized cost scale. With total adjusted claims well above 1.3 billion, the PBM is able to negotiate favorable drug pricing with suppliers. This factor gives it the advantage of expanding its client base by providing low-cost products while preserving its gross margins. Scale is also a source of competitive advantage as each additional claim processed is more profitable than the previous. Centralized and technology system costs are able to be spread across the entire level of claims, which clearly gives an advantage to larger PBMs. Because of these factors, Express Scripts is able to produce gross and operating profits per adjusted claim that are top-tier. The firm's significant advantages have historically produced ROICs well above its WACC, and we believe this trend will remain over an extended period.

Among the biggest risks to Express Scripts are competition and regulatory change. Although Express Scripts' competitive position has improved, aggressive pricing by competitors could still hurt profitability. For example, CVS Caremark may have an incentive to underprice its PBM offering to drive more traffic to its retail stores. 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, such as PBM transparency requirements, could make it harder for Express Scripts to conduct business.

Investors Benefit From Exemplary Management
Stewardship at Express Scripts has been exemplary, in our opinion, as operational execution and capital management have been beneficial to shareholders. This dynamic was highlighted over the past year with the acquisition of Medco and the Walgreen contract negotiation. With the acquisition of Medco, the firm's management was able to approximately double its claim volume. This gave the combined entity unparalleled negotiating power with suppliers and superior scale advantages. We believe this was an excellent use of capital. Additionally, management was able to muscle through its pricing demands with Walgreen due to the colossal level of claims it processes through retail pharmacies. We believe this episode demonstrates management took the correct strategic steps in order to enhance the firm's competitive position.