Is Express Scripts’ Future Threatened by Private Health Exchanges?

Express Scripts' (NASDAQ: ESRX  ) investors reacted with alarm at the early September 2013 news that Walgreen (NYSE: WAG  ) , one of Express Scripts' biggest customers, had jumped ship and was planning to shift the management of the firm's health insurance benefits to Aon Hewitt Corporate Health Exchange. Aon is one of the new private health exchanges that have recently debuted in the rapidly evolving drug distribution landscape. Express Scripts is the largest pharmacy benefit manager (PBM) in the country, with a huge 37% chunk of the $287 billion in annual revenues PBM market. The firm's shares traded down a shocking 5% the day after news of the development hit Wall Street.

Catamaran Corporation (NASDAQ: CTRX  ) , another large PBM, was the hardest hit, and its shares fell a jaw-dropping 8.2%. Catamaran has been a health insurance provider for Walgreen since 2011, and it owns Walgreen Health Initiatives, Walgreen's PBM wing. The huge stock slump was a reflection of expectations by investors for the development to negatively impact its revenue.

CVS Caremark (NYSE: CVS  ) , the second largest PBM, was fortunately spared the drama and its shares held steady. The firm renewed its agreement with Walgreen in May 2013 to continue filling Walgreen's prescriptions for a few more years. This gives it good future revenue visibility.

CVS was also the biggest beneficiary of the standoff between Express Scripts and Walgreen in 2011, which developed into a long-drawn battle of wills that lasted a whole nine months before Walgreen finally raised a white flag and acquiesced to Express Script's terms. During the showdown, Walgreen customers gradually shifted to other drug stores (most notably CVS) and Walgreen's sales took a big hit.

Panic not warranted
Was the panic by investors really warranted? If the estimates for expected market share by private exchanges being spewed out by both Express Scripts and CVS are anything to go by, probably not. Express Scripts predicts that private health exchanges will constitute a minuscule 0.25% of total prescriptions in 2013, and a mere 2% by 2016. CVS' forecasts are not off Express Scripts' estimate by much, and the firm predicts that private exchanges will account for only 1% of covered lives in 2014.

Of course, these companies have vested interests in the matter and would probably downplay the numbers a bit to make them look better for investors. Because of this, it pays to hear the story from a more neutral standpoint. The National Business Group on Health conducted a study in September 2013 to look at employer reactions to private health exchanges. The study found that only 1% of employers planned to shift their employees into private exchanges in 2014, while a third ''might consider''doing so in the next three to five years.

Investors worried that employers with self-insured employees will rush to private exchanges can rest easy since a recent study by The Midwest Business Group on Health found that 90% of self-insured employers had no plans to move their employees into either public or private health exchanges come 2014.

There is no denying that private health exchanges do have the potential to shuffle the decks and could muddy the water a little for firms such as Express Scripts and CVS Caremark. The overall market share erosion for these businesses will probably not be large enough to unsettle them to any appreciable degree, however.

Heft pays in this business
Express Scripts clearly proved its mettle in 2012 when Walgreen balked and refused to renew its contract with the firm. Walgreen's sales plummeted 8.1% in the fourth-quarter of 2012 as its customers fled to Rite Aid and CVS Caremark. Since the firm's acquiescence to Express Script's terms, sales have steadily picked up. Express Scripts increased its share of the PBM market from 20% to 37% in 2012 after it merged with Medco Health.

CVS Caremark has not been resting on its laurels, either. It announced a deal in November 2013 that will see the firm partner with Cardinal Health to form the largest generic sourcing entity in the world. Size certainly pays in this business.

Other PBMs more of a threat
Investors should stop looking at private exchanges as a possible source of disruption, but instead should focus on the threat that other well-established PBMs pose to Express Scripts. Express Script's revenue fell 4% in the second quarter after UnitedHealth Group shifted its PBM business into OptumRX, the firm's in-house unit.

The greater adoption of generic drugs by consumers is also likely to slow down top-line growth. It is expected that around $15 billion worth of branded drugs will go off patent in the next three years, opening them up to generic competition. Although generic drugs carry 50% higher gross margins than their branded counterparts, their lower prices tend to have a negative impact on top-line growth.

Focus on specialty drugs to grow revenues
Despite the challenges confronting Express Scripts, the firm has managed to beat analysts' earnings estimate for four straight quarters. Earnings for the full year are expected to improve 13%-16% compared to 2012, to $4.26- $4.34.

Perhaps the biggest reason to get excited about Express Scripts is the huge 52% market share for specialty drugs that the firm currently commands. CVS Caremark released a report in September 2013 where it pointed out that it expects the global market for specialty drugs to grow at a blistering 22% annual clip from 2013-2020, eventually hitting $400 billion. This kind of growth is sweet music to the ears of Express Scripts investors. Although specialty drugs make up only 4% of total customer prescriptions, they account for 25% of overall health care costs since they are so pricey.

Bottom line
It is highly unlikely that Express Scripts or other large PBMs will experience a significant degree of market share erosion by private health exchanges when Obamacare goes into operation in 2014. Express Scripts' huge size is a big plus in this business, and will help it continue being a major force in the PBM landscape.

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