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Medco Health Solutions
|Stock Price At Recommendation:||$47.96|
|Headquarters||Franklin Lanes, NJ|
|Market Cap||$22.7 billion|
Sources: Capital IQ (a division of Standard & Poor's), Yahoo! Finance, and Motley Fool CAPS.
This Week's Pitch:
I dug through the 10-K, looked at the numbers from the 10-Q, read the latest CC transcript, went through many articles, and read through all your fantastic posts to get a better understanding of the business and how their future should shape up. This is my analysis and thought process, and feel free to add any other information and correct me as necessary.
MHS provides pharmacy benefit management (PBM) services through a network of about 60,000 retail pharmacies and through their mail-order pharmacy. The job of the PBM is to negotiate discounts and rebates from manufacturers, get discounts with retail pharmacies, and then to educate clients on ways to lower costs through buying lower-priced generic drugs. The PBM is the main source of revenue, but MHS is also the largest specialty pharmacy through Accredo Health Group.
Although their PBM is their main revenue source, MHS has been acquiring several businesses in the past few years to expand their operations. Here is what they've acquired:
-In 2007 they acquired PolyMedica, which is the largest diabetes pharmacy care business based on the number of patients.
-In 2008 they acquired Europa Apotheek, which provides mail order pharmacy services in Germany.
-In 2009 MHS started a joint venture with United Drug plc to provide home based specialty pharmacy care services in the UK.
-Earlier this year they bought DNA Direct which is a leader in pharmacogenomic medicine
-On August 16, MHS stated they're acquiring United BioSource, which helps companies design drugs and does research on drugs and medical devices.
Some of these acquisitions are in growing sectors and someday should be much larger, so that is encouraging. They don't disclose everything relating specifically to these acquired businesses, but they tend to let shareholders know how they are doing in general.
To get a good idea of how much revenue comes from what (from latest 10-Q):
*I also want to note that about 62% of product sales are through retail and the rest is through the mail-order pharmacy.
In this business, gross margin is an important number to follow so I want to mention how different parts of the business add up from a gross profit standpoint. As different parts of the business grow faster than others, the gross margin tends to fluctuate. The product gross margin is 5.4% and the service gross margin is much higher at 74.9%, so as they start adding more services over time we should see the gross margin rise which also leads to greater earnings. Also, the PBM gross margin is 6.4% while the specialty pharmacy gross margin is slightly higher at 7.5%.
The next thing I wanted to check was to make sure the business is financially strong. Starting with the balance sheet, the debt/capital ratio is 3.25. Their debt is primarily comprised of a senior unsecured term loan facility, a senior unsecured revolving credit facility, and senior notes. The term loan facility is a $1 billion 5 year term loan and expires in April 2012 where they'll have to pay it all back. Their revolving credit facility is also 5 years in length and is up to $2 billion due April 2012. However, they have only used $1 billion of it, and correct me if I'm wrong, but then they would only have to pay up that extra $1 billion. They also have about $800 million in senior notes due in 2013, and the rest is due in 2018.
This is probably a little more debt than I would like to see relative to cash, but I'm not too worried since this past quarter they had an interest coverage ratio of 18.8 and generated almost $900 million in free-cash-flow (FCF) in the past 6 months. Even better, management expects in all of fiscal 2010 for cash flow from operations to be over $2.4 billion and for CapEx to end up around $245 million resulting in FCF for the year to be around $2.155 billion. In the face of their looming debt payments, they should easily cover it. Also, in the past 6 months FCF/Net Income was 1.3 showing that they are generating plenty of cash compared to earnings, and this number should grow as they stop significantly reducing inventory.
From a ROE standpoint:
See the trend? I sure like it a lot! Basically, this shows that MHS is making more earnings per year compared to shareholder's equity. It is always a good thing to see, and I bet in future years this trend will continue.
I also calculated ROIC:
ROIC has increased every year while WACC has slowly decreased, which is good. Bryan White (TMFCaccamise) helped me understand all this, so I would like to say thanks to him!
I also checked out the past growth rates to get an idea of how the company grows and what investor's are in for. In the past 5 years, revenue grew 11.1% annually, net income grew 21.6% annually, and EPS grew 24.4% annually. This shows that margins have expanded mainly due to a rising percentage of generic drugs being sold, and also since EPS is increasing faster than earnings it shows that management is using cash wisely to increase shareholder's investments through purchasing back shares.
Part of why Medco looks interesting to me too is that I heard that it would benefit from the new health care bill. I read a lot of articles and this is my takeaway: Basically the bill will extend benefits to 32 million Americans starting in 2014 and each is a potential new customer. There will probably be a larger focus on lowering costs, and since MHS keeps cost low through mail-orders and providing generic drugs they should gain business. PBMs will face disclosing more info about rebates for certain drugs but won't receive any new taxes, which is always good.
There are several other growth drivers for MHS that should help increase revenue, grow margins, and put the business into different and growing areas:
Generics provide lower revenue compared to brand-name drugs but have much higher margins, which means more earnings. This is the trend of their generic dispensing rate:
This trend is great, and this past quarter they reported that their overall generic dispensing rate increased to a record 70.6%. As long as brand-name drugs continue to go off patent and MHS starts selling the generic then we should easily see this tend continue. The good news is it should! Vic showed us in a past post the amount of revenue that is going potentially off patent through 2012:
2010 $11241 million
2011 $12171 million
2012 $32599 million
I bet if this continues then we should see the generic dispensing rate grow another 10%+ and hopefully the gross margin will increase as well. Out of all the growth drivers I think this is the largest one and should have the largest effect on the business.
This part of their business is still not that significant compared to the PBM, but should continue to grow as they expand by creating new services that reduce drug cost and are more convenient. As I mentioned earlier, specialty pharmacy margins are slightly higher than the PBM's margins, but these drugs tend to be much more expensive and require specific and more complicated care to keep the drug safe and usable for patients going through complex diseases and treatments.
For those of you who don't know, pharmacogenomics is basically the study of people's genes and how their bodies react to certain drugs so that pharmaceuticals will be able to make "personalized" drugs to tend to your body's specific needs. MHS entered this sector when they acquired DNA Direct in January. In the last earnings call, management said that client interest is strong and growing and that they are rapidly growing their client base (up about 14% in one quarter). This sector is still very small, but over the years I can easily see the idea of "personalized drugs" being the next big thing. This part of MHS should continue to grow and one day, hopefully be a large part of the business. To learn more about pharmacogenomics:
You all on the board have helped me realize how beneficial this service is for customers. It is cheaper to receive drugs through mail due to not having to pay for shelf space and you can get a 90 day supply, which is much more than what they provide at local pharmacies. It is convenient because you can order easily online through their website, and it is shipped right to your house. I bet over time as the baby boomers become older this service from MHS would seem extremely attractive, and we should see more customers come to MHS and growth in this area of the business on top of a continuous 99% retention rate.
We've seen this past quarter a mail penetration rate of 34.3%, which is about equivalent to last year. I doubt we'll see this rate rise quickly, but over time I bet we will see it slowly creep upward as convenience becomes a larger part of the decision in how to receive prescriptions.
I emailed Investor Relations about how mail-ordering is beneficial to the bottom line compared to retail, and this is what they replied back to me:
While we do not disclose the actual profitability of a mail script vs a retail script, mail prescriptions are more profitable to Medco than retail prescriptions. On the mail side, Medco actually is the distributor of the prescription; therefore Medco uses its scale to purchase drugs effectively and distribute the prescriptions to members in a highly automated process using six sigma quality dispensing. The mail channel provides our clients with the most clinically advanced method of pharmacy and the most cost effective solution for their chronic medications. In alignment with our clients best interests, mail prescriptions --specifically mail generic prescriptions, are the most profitable prescriptions for Medco.
They have already started acquiring and making alliances to help spread their presence in Europe. From the 10-K:
Making acquisitions, forming strategic alliances, and expanding into complementary adjacent markets. In March 2008, we launched a collaboration with Sweden's government-operated retail pharmacy authority, Apoteket, to develop and test the first automated electronic prescription review system to improve clinical and financial outcomes for Swedish patients and the country's health care system. In April 2008, we acquired a majority interest in Europa Apotheek, a privately held company based in the Netherlands, which primarily provides mail-order pharmacy services in Germany. In 2009, we formed a joint venture with United Drug plc, a pan-European health care leader, to provide home-based pharmacy care services in the United Kingdom for patients covered by the country's National Health Service.
This past quarter they also took a large step forward in growing internationally. They announced a 50-50 joint venture with Celesio, which is supposed to bring their technology-enabled advanced clinical solutions to up to 29 countries. To put this in perspective, these 29 countries' economies are larger than the US's economy. This is obviously a pretty big opportunity.
However, the European health care industry is much different than over here in America. In Europe the price of most everything is controlled, so over there they won't need MHS's PBM to get them better deals on drugs. Instead, they want to use MHS's technology services which have higher margins and would fall under the service part of revenue. Each country will be a little different to deal with, but this joint venture will enable them to meet the unique needs of each nation. The CEO said that this joint venture won't become meaningful to EPS until 2015, so we have a while to wait and see what kind of returns we can make from this vast opportunity.
MHS has been making acquisitions these past few years, and I wouldn't be surprised to see them continue to do so. I don't have a clue what they want to acquire, but I sure hope that they continue to reach out into new pharmacy related sectors, strengthen their position in markets they are already in, and grow into new countries.
One other thing I like that caught my eye is what management is doing to increase shareholder value. This past quarter they finished repurchasing shares through a prior $3 billion buy-back program, and in May they announced a new $3 billion buy-back program. Management has bought back more shares than they anticipated recently due to a low share price, and I bet that they have continued buying more shares as the price has dipped even more in the past couple months. Of course though, we need to make sure that the diluted share count is really decreasing:
As you can tell, the share count has decreased since fiscal 2006, and since then 113.3 million shares have been bought back. And even better, at the end of this last quarter management announced they expect the 2010 diluted average share count to be approximately 460 million, which a 6.1% share count decrease from last year and a 23.8% share count decrease since 2006. If they continue purchasing back shares in the years ahead than shareholders should continue to see a boosted EPS as long as earnings rise too.
Alright, so everything looks good, huh? To me it pretty much does! However there are still some risks involved:
As in most any industry competition is fierce, and the PBM industry is no exception. Their competition (as they put in the 10-K) includes Aetna, CIGNA, CVS, Express Scripts, Humana, UnitedHealth Group
Also, MHS's top ten clients represent about 49% of their net revenue, and UNH itself represents 19% of net revenue. If any of the clients stopped using MHS then it could have a big impact on results. MHS provides PBM services to UNH through the end of 2012, and if they don't renew then we could see revenue drop about 20%. I doubt this will happen, but if employers drop health care coverage for employees for economic reasons or rising costs then we could see a big drop in sales, earnings, and most likely the stock price.
Another risk is that the government could be more controlling of the health care industry and pass proposals that could be harmful to the PBM industry. If the US health care industry starts changing to be more like Europe where almost all prices are controlled, then the demand for PBMs would massively decrease and that would have a huge effect on MHS. No one can accurately know what will happen in the future and when it will happen, so MHS could have a very hard time adapting if anything major happens.
Maintaining and growing gross margins is a main key to increasing earnings and cash flow, and discounts and service fees from manufacturers is a big part of that too. If MHS can't continue to keep these discounts and service fees then gross margins will most likely fall, and the bottom line would be affected.
Lastly, I don't think this risk has much of a chance of happening, but if MHS doesn't follow regulations and the law they could suffer major penalties such as losing their licenses to operate their mail-order pharmacies. There are laws in every country they have operations in and changes could have a big effect on the business.
Some of these risks stick out more than others due to having a larger impact if the "unwanted" came true, but truthfully I'm not that worried. MHS provides services that are cheaper and more convenient than other businesses, and by growing into new, expanding areas and also into different countries, they are decreasing their risks by diversifying in a way that turns them into a better company. The risks are all legit, but I would be surprised if any of them came true anytime soon.
Another aspect in analysis that all investors need to be aware of is the people running the business. Due to acquisitions and expanding into new areas of business, MHS has 15 executive officers that run different parts of the business. I don't want to bore anyone that I haven't already, so I'll only go through some stuff about the man at the helm, David Snow.
Snow has been working in leadership positions in health care businesses for years. He joined MHS in 2003 and became CEO, chairman of the board, and president within that year. Prior to working at MHS he worked with WellChoice, Oxford Health Plans, American International Health care, US Health care, and co-founded managed Health care Systems which was later renamed AmeriChoice. As of the last proxy statement, Snow owns right around 300,000 shares in which 102,000 are restricted stock units (he has to own 5 times his base salary, which was $1.3 million) and 198,000 shares he owns independently in a trust. Including his near 2 million options he owns about 0.5% of the entire company. Although the amount of options is pretty ridiculous, he owns about $9 million worth of shares independently and I'll look up positively toward that. He hasn't bought or sold anything recently, but by the fact the MHS is buying aggressively under the share buy-back program, apparently management thinks it is a good time to buy.
I wish I could insert the pie-chart into my post, but to get an idea of where his pay comes from, 10% is the base salary, 15% is from his bonus, and 75% is based on long-term incentives. Their bonuses are based on whether they meet goals annually on adjusted cash earnings per share, net-new sales, mail prescription volume, and ROIC (Snow made $3 million in cash bonus). Their long-term incentives are all different for each executive and depend on factors specifically related to what they do, and Snow's was based on how he increased EPS, net revenue, the generic dispensing rate, how he showed leadership in shaping the national health care debate, and how he helped contribute to the MHS brand and reputation on top of the factors that were looked at for the bonus. 80% of what he gets paid is in options and the rest is in restricted shares of stock. They do this to align his interests with shareholders in the way that his options will be worth something when the share price increases.
All together, I think MHS has a pretty good CEO. He has years of industry experience, is involved in helping make the health care industry in favor of MHS, and even though he gets paid millions, he has his interest aligned with shareholders through his large share in the business.
Without looking at the price and valuation metrics, I would say MHS is definitely worth looking into. In simplest terms, it is financially sound, has growth drivers that should expand them into new areas while increasing earnings and FCF, is being positively affected by the new health care bill, has a CEO with interests aligned with shareholders, and even though it has some risks to keep an eye on, the potential reward outweighs the risk IMHO.
Now on to some valuation metrics! Since MHS is focused on growing revenue, EPS, and cash flow I think it would be good to see where we stand today compared to past P/S, P/E, and FCF yields.
Based on Morningstar, the current P/S ratio is 0.4 and the past 5 year average is 0.5. Even though it is below average, P/S in itself doesn't tell you much of anything at all, especially when margins always fluctuate.
Also based on Morningstar, the current P/E is 18.6 and the 5 year average is 25.6. The current ratio is below average and is trading close to the low end of the past few years. Also, the forward P/E is 13.4, which shows that analysts are expecting growth. And to make it look even better, the forward P/E on the S&P 500 is 14.1, so MHS is trading lower based on estimated earnings than the market as a whole even though I bet in the long-term they will have market-beating earnings growth.
|FCF Yield||June 05||June 06||June 07||June 08||June 09||June 10|
As of now, I calculate the FCF yield to be about 8.2% when using the diluted share count from the last quarter (462 million) to calculate market cap. This is the highest it has been in a while due to a lower share price (even though it has shot up some recently). Based on this, if FCF rises as expected and the yield stays the same or lowers, we could see the stock rise even more.
Using these three metrics with a historical perspective, I would say that MHS is undervalued even with the latest run-up. When adding in the fact that we should see plenty of top-line growth as they expand and even more bottom line growth as mail-ordering becomes more popular and the generic dispensing rate increases, I would say MHS still has a long ways to run over the next few years.
Consider this: Let's say MHS grows their revenue 10% annually over the next 5 years to $101.1 billion. The current profit margin is 2.2%, but as services and more profitable products are sold, it would be easy to see the profit margin rise to 4% by then. This would make net income 5 years off be $4 billion. Some analysts may think that this is pushing it, but I think this is possible when looking at their catalysts and how they affect their earnings. Also, over the past 3 years the number of shares outstanding has decreased annually by 6.7%. Management is continuing to buy back large amounts of shares (another $3 billion buy-back plan was put in place this past quarter), and even if they slow purchases down to a decrease of 5% a year, using the $4 billion in earnings that would make the EPS be $10.55. Using a P/E ratio of 20 that places the share price at $211.
Now I've seen plenty of analysts be wrong in their estimates, and this easily could be too. This is just an example of what could happen if everything goes right. I bet some catalysts won't turn out to be all that we thought it could be, but even so, overall the returns should be awesome. Even though revenue growth is important, what will make this stock perform extraordinarily well is through margin expansion and good use of shareholder money. If management can't grow their profit margin when gross margin should easily rise and if they stop using FCF wisely, then I will have a much different opinion on MHS.
In summary, MHS is financially solid and if they maximize their catalysts and use their cash wisely to grow into new innovative sectors and increase shareholder value then MHS should succeed. The CEO has a lot of experience in the industry, and even though there are plenty of risks, they should be able to make it through successfully while beating the market. The $211 mark may or may not be met in 5 years, but I still see the potential for the price to double or triple even if everything doesn't go as perfectly as planned. I recently purchased shares at around $45, so I'm looking forward to watching MHS perform in the years ahead.
If you have anything to add, feel free to do so!