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Express Scripts: A Good Risk/Reward Tradeoff

Matthew Coffina, CFA
Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Pharmacy benefit manager Express Scripts has been locked in a battle with insurer Anthem. I'm joined by Matt Coffina, he is the editor of our StockInvestor newsletter, for what this could mean for Express Scripts.

Matt, thanks for joining me.

Matt Coffina: Thanks for having me.

Glaser: You've liked Express Scripts for some time now. Before we get into the Anthem dispute, can you just talk a little bit about why you think this is an attractive business?

Coffina: Sure. So, Express Scripts' most attractive quality is that it generates a tremendous amount of free cash flow. Free cash flow normally is at or above net income because they are receiving funds from customers before they are paying suppliers. When the stock is trading where it is today in a low-double digit multiple of earnings, they are able to repurchase maybe 8% to 10% of their float every single year, year-in and year-out, and that's what they do. They use all that cash flow for share repurchases.

In the meantime, it's a defensive business, obviously linked to overall pharmaceutical spending. Customer relationships tend to be fairly sticky. Normal customer retention is in the 95% to 97% range. So, people get concerned sometimes if they lose a couple of customers here or there. But at the end of the day, they are keeping their average customer more than 20 years and that's pretty good for a business like this. So, a defensive business, growing in line with the overall pharmaceutical market excluding client wins and losses, and generating a ton of free cash flow.

Glaser: Let's look at what our analyst has called a steadily escalating dispute with Anthem. Why are these two firms going to court right now?

Coffina: Sure. It's a very interesting situation. So, Anthem is Express Scripts' largest customer. They've been that since 2009. Express Scripts actually bought the business from Anthem. So, this is a very unusual relationship. They paid $4.7 billion upfront for the right to be Anthem's PBM. We've seen other long-term deals, for example, between CVS and Aetna where no money was exchanged upfront. It was just a normal contract, normal partnership.

And I think that's important to keep in mind, because in exchange for receiving a higher upfront payment Anthem agreed to pay higher-than-market-rates for its ongoing PBM benefits. And Anthem, of course, has new management since then. They don't really care about the fact that they were paid $4.7 billion for the business back in 2009. They just want market-based pricing. So, they have taken Express Scripts to court alleging that they are being overcharged by $3 billion per year.

Now, this is a number that we can't justify. It doesn't really make any sense based on the publicly available information. Anthem hired a consultant, a very small and not well-known consultant, that came up with this $3 billion figure and they haven't even released the underlying data or the facts that are supposed to support this number. And Express Scripts has pretty much said the same thing. The number just doesn't make any sense. They haven't seen any justification for it. So, no, Anthem, you are not entitled to $3 billion. So, Anthem has sued Express Scripts. Express Scripts has countersued them and that's just sort of where we are now. It's going to be up to the courts to decide unless they can reach some kind of settlement.

Glaser: So, what could this mean for Express Scripts? Is there now a tail risk that they can lose this Anthem business?

Coffina: Sure. So, Anthem is about 16% of revenue. The important point is that we don't know what contribution it has to earnings. Normally, a very large customer like this would have below-average margins. So, you'd expect the earnings contribution to be something below 16%. On the other hand, the fact that Anthem is so upset about this and that it wasn't a usual relationship as I described, it could possibly be more than 16% and I've seen some estimates as high as 30% of earnings. I don't personally think it's that high, but nobody really knows. I think it's probably closer to 16%, again in line with the revenue contribution.

Now, Anthem is technically under contract until the end of 2019, and based on what we know about the lawsuit, I don't think that Anthem's claim really has any merit. The contract language is very specific that Anthem is entitled to propose different pricing, it's entitled to look at the market, decide that it's not getting competitive pricing and propose different pricing. But Express Scripts' only obligation is to negotiate in good faith, that's all it says in the contract. Anthem isn't entitled to competitive benchmark pricing and Express Scripts isn't obliged to change their pricing at all unless they agree to it in writing.

So, I don't think Anthem's legal case really has any merit and I think Express Scripts feels similarly. It's probably going to drag through the courts for multiple years. I'd be surprised if it's resolved before 2019 when the contract was going to be up anyway. Maybe Express Scripts will lose the relationship at that point. But in any case, the stock, again trading for a very low-double digit, maybe 11 to 12 times earnings, even if they lose the business and say, it's 20% of earnings or 25% of earnings, the company is still going to be trading at maybe 15 times earnings, which is a below-average multiple relative to the market, relative to their peers like CVS. So, I think that Express Scripts stock at the current time is basically assuming that the Anthem contract will be lost tomorrow as if it was a definite thing, and the reality is that they are going to probably keep that contract at least three more years and who knows, maybe more than that.

Glaser: Sounds like it's creating an opportunity then?

Coffina: I think you always have to weigh the risks and rewards, and if the valuation is already incorporating a really negative scenario then the rewards can outweigh the risks.

Glaser: Matt, as always, thanks for your thoughts.

Coffina: Thank you.

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