Total spending on health care in the United States is expected to climb from $3 trillion to over $4 trillion annually by the end of the decade, and while that may mean sales growth for a lot of health care industries, it doesn't mean every company will participate equally or climb in a straight line.
Since returns across the sector could prove choppy, investors need to not only understand why stocks like Express Scripts (NASDAQ:ESRX) may climb, but also why shares may falter. With that in mind, let's consider three hurdles that the company will need to overcome.
First, a bit of background
Express Scripts is a pharmacy benefit manager, or PBM, that manages drug programs for health care insurers and self-insured companies. A PBM's goal is to lower health care payers' expenses by negotiating lower drug prices from manufacturers, increase the use of low cost generics, and decrease expensive hospitalizations by improving patient's adherence to prescribed medications.
Since PBMs act as a go-between, their profit margin is typically low because they're pressured on one side by drugmakers eager to earn top dollar for their medicine and on the other side by payers laser-focused on boosting their own bottom line.
1. Consolidation risk
The PBM industry has seen a wave of consolidation over the past few years which has significantly disrupted industry market share as competitors vie to take advantage of merger integration struggles.
For example, pharmacy giant CVS (NYSE:CVS) expanded into the PBM market in 2007 with the acquisition of Caremark and although that deal created an industry giant that serves millions of people through retail stores and mail order, the complexity of integrating the two companies opened the door for competitors like Express Scripts.
Today, that competitive advantage has shifted back to CVS Caremark following Express Scripts' own merger with Medco Health Solutions in 2012. According to Express Scripts second quarter conference call, it's own integration challenges, including the shifting of customers to new systems, weighed down customer satisfaction rates last year.
Some integration struggles are to be expected given the size of these companies, but if those challenges resurface, or the company fails to deliver on the cost savings expected from the deal, then Express Scripts may find that its business suffers.
2. Risky business
In December 2009, Express Scripts acquired NextRx, the PBM subsidiary of WellPoint (NYSE: WLP), and inked a 10-year contract to provide WellPoint with PBM services. That deal made WellPoint Express Scripts biggest customer; accounting for roughly 12% of the company's sales. Given that so much of Express Scripts revenue comes from WellPoint, long term investors are right to be antsy over whether WellPoint will renew when its contract expires in five years.
But it's not just WellPoint that investors need to worry about. Express Scripts' top five customers, including the Department of Defense, made up 38% of its revenue in 2013.
If any of those clients move to a competitor or bring their PBM services in-house, Express Scripts could see its revenue drop significantly. That's exactly what happened last year when UnitedHealth Group, a former Medco client, decided to run its PBM business in-house through its OptumRx division.
UnitedHealth Group completed its transition away from Medco in 2013 and Express Scripts saw its network pharmacy revenue decline by 10% year-over-year in the second quarter, as organic growth was overwhelmed by the loss of $1.8 billion in revenue from UNH.
So far, those big accounts remain in place. However, Express Scripts reduced its customer retention rate guidance during its second quarter earnings conference call to between 92% and 93% for 2015. If management keeps bleeding clients, it could be a problem for Express Scripts in this highly competitive space.
3. Margin compression
Investors should also keep in mind how new, next-generation drugs are being priced and whether the use of tiered formularies to control access to expensive drugs will continue to be embraced by payers.
The approval of Gilead's Sovaldi, an $84,000 treatment for hepatitis C, has increased attention on the use of high-priced medicine. According to Express Scripts, the cost of specialty medicine is expected to grow by 18% in both 2015 and 2016 due in part to the launch of next generation treatments.
Those costs will have to be made up somewhere, and given the strain on payers it may have to come from PBM margin, either via price concessions to renew contracts or investments in new technology to add more value. And given that Express Scripts' operating margin has slipped from 6.25% in 2010 to 3.36%, there isn't but so much room for negotiation. If that trend continues, it will likely weigh on the bottom line.
Fool-worthy final thoughts
There's little question that healthcare spending is heading higher, or that those that are paying for healthcare are going to be looking for innovative solutions that can reduce their costs of care. PBMs like Express Scripts could find they have an increasingly important role in helping payers accomplish this, but only if they can demonstrate that they can do it more effectively than the payer can do on their own.
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Todd Campbell has no position in any stocks mentioned. Todd owns E.B. Capital Markets, LLC. E.B. Capital's clients may or may not have positions in the companies mentioned. Todd owns Gundalow Advisors, LLC. Gundalow's clients do not have positions in the companies mentioned. The Motley Fool recommends CVS Caremark, Express Scripts, and WellPoint. The Motley Fool owns shares of Express Scripts and WellPoint. 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.