Pharmacy Benefit Management: Your Prescription for More Profits

We continue our series on checklists by taking a look at the Pharmacy Benefit Management industry.

Apr 1, 2014 at 6:30PM

If you're interested in investing in Pharmacy Benefit Management (PBM) companies, you'll want to know the right way to measure their merits. At The Motley Fool, we're big fans of using investment checklists to help us make smarter decisions about stocks. Here's a checklist covering five key areas that can help you find better stocks in the PBM industry.

1. Member base
Scale matters. Building out a PBM platform to handle the prescription drug claims for tens of millions of Americans takes a lot of work and significant fixed costs. Companies should have a huge user base to help them spread out their fixed costs.

As an example, Express Scripts (NASDAQ:ESRX) is far and away the industry's top dog. It booked over $104 billion of revenue last year, which accounted for over 40% of the total PBM market share. It now serves 90 million members -- which is roughly 28% of the population of the entire United States.

As you're thinking about a PBM's member base, consider the following four questions:

  • How many prescription claims does the PBM process annually, and is this number increasing?
  • Does the PBM have greater than 20% market share of total industry revenue?
  • Has the PBM signed any long-term contracts (worth more than $1 billion per year of revenue) with large insurance networks?
  • Is the PBM's customer retention rate greater than 90%?

2. Operational efficiency
As a PBM increases its user base, it should also increase its profitability. Setting up new customers creates a lot of upfront work for a PBM -- they need to develop prescription drug plans and get all members migrated onto the platform. But with time, doing business becomes more routine, which costs the PBM less money to maintain. Each revenue dollar it receives drops more quickly to the bottom line.  

As an example, Catamaran's (NASDAQ:CTRX) gross margins have increased from 6% to nearly 8% during the past two years. The company has acquired smaller PBMs (and their corresponding customer bases) and brought them onto the Catamaran platform -- which gives them more options for their plans and at a lower cost. As the relationships mature, costs will continue to decrease, and margins will rise -- commonly referred to in the PBM-world as "operational efficiencies."

As you're thinking about a PBM's operational efficiency, consider the following three questions: 

  • Are the PBM's adjusted earnings growing faster than revenue?
  • Is the company's gross margin increasing?
  • Is the company making more profit on each claim? To check this, we can take its adjusted earnings or EBITDA (reported in each of its quarterly conference calls) and divide them by the total number of claims it processed during the period.

3. Business strategy
PBMs don't all look the same. Differences in business model or how integrated the company is can affect its profitability and valuation.   

CVS Caremark (NYSE:CVS) is the industry's second-largest PBM, though it also operates 7,600 retail locations to distribute its prescriptions. United Healthcare (NYSE:UNH) is America's largest insurance network, but it also handles its nearly $30 billion of PBM operations in-house.

Business strategy is one of the hardest parts of the PBM industry to analyze, since the companies all look different from one another. But, consider the following four points:

  • Does the company charge a fixed-price per transaction? Or does it profit from the "spread" -- which is the difference in the price between what it pays for the drugs and what it charges the insurance networks for them? Catamaran and Express Scripts are both pure-play PBMs (meaning they don't also have their own insurance network or pharmacies), but have very different business strategies. Catamaran charges a fixed price-per-claim, while Express Scripts profits from the spread.
  • Is the company making acquisitions? Is it funding these by taking out more debt or by issuing new shares?
  • Does the company own its own pharmacies? If not, does it have partnerships for national-level distribution?
  • Another option that has been popular in the industry lately is mail-order distribution, where the PBM bypasses retail pharmacies altogether and just ships prescriptions directly to its members. This allows it to avoid having to pay dispensing fees, which are charged by the pharmacies that fill the prescriptions. Does the PBM offer mail-order distribution, and if so -- are its volumes increasing? 

4. Book of business 
PBM customer demographics matter. Cost-controls, rising drug costs, and federal regulations are increasing competitive pressure, so the composition of the existing business is important.

Shortly after the public health care exchanges went live, McKinsey reported that Medicaid plans were the most common type of plan offered by new entrants. Many Medicaid plans are lower-cost, which potentially bodes well for Catamaran's fixed-price business model.

As you're thinking about a PBM's book of business, consider the following three questions: 

  • What plan types make up the majority of the PBM's business?
  • Are Federal regulations and initiatives from Obamacare (for example, the public health exchanges) favorable for the PBM's book of business?
  • Are more than 80% of the total drugs the PBM dispenses the cheaper, more profitable generic kind? This percentage is known in the industry as the "generic dispense rate." How does this compare to competitors?

5. Valuation
Lastly, relative valuation can help compare PBMs to one another. As an example, we can compare Express Scripts and Catamaran's market cap, member base, and number of claims processed:

 Metric Express Scripts Catamaran
Market Cap ($ billion) $58.4 $10.2
Member Base ($ million) 90 25
Claims Processed Annually ($ million) 1,478 296
Market Cap per Member ($) $649 $408
Market Cap per Claim ($) $39.5 $34.5

Note that Express Scripts is much larger than Catamaran, but the market is also awarding it a higher multiple with respect to Market Cap per member and per claim.

As you're thinking about a PBM's valuation, consider the following two questions: 

  • What is the company's market capitalization per member and per claim? Is this decreasing, which would make it a more attractive value?
  • After subtracting the cost of acquisitions and capital expenditures from operating cash flow, what is the company's resulting free cash flow yield? We like to see this number increasing -- which means more cash is available at the end of each year for shareholders.

Foolish bottom line
Pharmacy Benefit Management is a niche industry that isn't followed by too many investors. However, the importance of PBMs can't be overstated. An aging American population, rising drug costs, and the need to keep insurance premiums under control all indicate that there will be plenty of business for PBMs for years to come. Evaluating these companies with a checklist could help to improve the health of your portfolio.

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Simon Erickson owns shares of Catamaran. Simon Erickson has the following options: short April 2014 $42.5 puts on Catamaran. The Motley Fool recommends Catamaran, CVS Caremark, Express Scripts, and UnitedHealth Group. The Motley Fool owns shares of Catamaran and Express Scripts. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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