Reviewing Express Scripts Holding Company (ESRX)

Express Scripts Holding Company 
(ESRX)

ESRX is a very well covered stock so I will just comment on recent performance and then focus on valuation. I did find 2 buy side write-ups that are particularly insightful. The first can be found in SumZero (by Jason Spilkin) and the second one can be found on scribd.com (by Alex Bak) here. Seeking Alpha has a couple of nice ones also.

Thoughts on Recent Events
1Q14 results were disappointing as ESRX missed both top and bottom line. Growth came in below expectations even after taking the loss of UNH contract into account. This is in comparison with Catamaran having a strong quarter. Gains in EBITDA per claim were offset by volume shortfalls, for which management blamed “delayed client implementation” and of course, the weather, among other things. (By the way did anyone else notice management repeatedly pass the buck by saying “Dr. Miller is not here”?). It looks to me management is not telling the whole story and that ESRX is losing ground to competitors.

What is the market pricing in?

On 6/29/2014 ESRX traded at $69.6/share, which represents 14x 2014 earnings (consensus), 12.6x 2015 P/E, and ~11x LTM EBITDA. These are multiples that reflect pessimistic long term growth prospects. For the next few years though, consensus is expecting 5-6% CAGR in EBITDA.

Levers & Upside

Is that consensus realistic? I think so. EBITDA/Claim has been growing double digit rate the past 2 years (see below table for key drivers).

Business mix is one of the levers that management can pull. They have been focused on home delivery/specialty. (ESRX reports them together). These were only 12% of claims in 2013 but 36% of revenue and growing. As specialty drugs costs are inflating 15-20% per year, ESRX (and other PBMs with strong specialty offerings) will get a growing cut of that. Overall I don’t think EBITDA growth of 5% CAGR is that tough to beat. In fact If ESRX just stabilizes its volume we can look at some easy beats.

Financial flexibility is a big plus as ESRX can use its very strong FCF for buybacks, dividends, acquisitions…etc. They also have room to raise leverage further (currently ~2-2.5x EBITDA). If all else fails, ESRX can grow its earnings and free cash flows per share just from financial engineering.

Despite the weak 1Q14, ESRX just have too much scale, name recognition, and destructive power to not be able to overcome these short term pressures. I mean, this is the company that gave Walgreens a black eye for messing with them. Could Catamaran have done the same to Walgreens with their < 10% market share? I don’t think so.

Why is it cheap? Risks

1. Short term. Weak 1Q14 indicates that ESRX may be losing market share to competitors. ESRX also received 3 subpoenas over relationships with drug makers. Management did not offer details on these during the 1Q14 call.

2. Longer term, pressure from managed care clients. In my write up about PBMs, I mentioned pressure from managed care client as a big concern. Wellpoint (WLP) is the company’s largest client and contributed 12.2% of revenue in 2013. Its contract expires 2019 and WLP has been making noises about its PBM “optionality” lately. Specifically, Glenview Capital made the following point about Wellpoint at the Ira Sohn coference:

“. Improve terms of the current outsourcing arrangement with incumbent (ESRX) or another PBM, closer to comparable recent transactions. Achieving terms similar to AET/CVS (2010) or CI/CTRX (2013) would add ~$750M to WLP EBIT (+19%).
. Receive another up-front payment to renew the “long-term lease” on the outsourced PBM from the incumbent or another PBM. ESRX paid $4.7B for the contract in Dec 2009. A new deal could be worth >$5B in 2017 (+16% of WLP market cap after taxes)”

Large contracts typically have lower margin, so a loss of Wellpoint contract might lead to 10-12% decrease in EBITDA. While this is certainly material, it is not a devastating loss. Renegotiation will not occur until 2017, so ESRX has plenty of time to diversify its revenue base in the meantime. In my opinion managed care is also an attractive area, and investors can buy WLP as a hedge for ESRX.

Scenarios

Here are the scenario matrices with volume growth and EBITDA per claim at 12.5x and 14x 2016E earnings. These are conservative multiples, and I think ESRX can easily reach 15x P/E once growth stabilizes. The results show that ESRX just needs a 5% volume CAGR and 5% EBITDA /claim CAGR over the next 3 years for the stock to be a winner. I think that’s a pretty good bet. Keep in mind this is without factoring in share buybacks.

Using 14x P/E: