Express Scripts (NASDAQ: ESRX ) appears to have bitten off a bit more than it could chew with its 2012 purchase of Medco Health Solutions. During its second-quarter earnings conference call, the pharmacy benefits management company reported that client retention is sagging due to integration struggles tied to the acquisition.
It's not surprising that Express Scripts had challenges combining these two big businesses. Investors would be wise to pay attention to comments from management, as they may offer clues on just how long it may take for the company to get its business back on track.
With that in mind, let's consider five points made by Express Scripts executives during the company's quarterly earnings call and what they may mean to investors.
1. Tripping over hurdles
"The integration activity specifically resulted in some isolated challenges with some of our clients revamped our leadership, strongly aligned our metrics to key service indicators, and redefined our commitment to service across the organization," said Express Scripts President Tim Wentworth.
Based on comments made by Wentworth and other executives during the call, the company seemingly had some turnover among account managers that made it easier for competitors like CVS Caremark to win away Express Scripts customers. Express Scripts specifically suggested that it had fallen short in key customer service metrics following the merger.
2. Getting back on its feet
Customer losses prompted Express Scripts to guide investors to expect client retention rates in the low 90% range, which is below the company's preferred levels.
However, efforts to refocus teams on customer retention might be curbing customer defections, and since retention levels reflect past losses, opportunity may exist for the company to improve the customer retention rate in the coming year or two.
"We have stabilized our teams, again, we -- the turnover that came was unfortunate and regrettable, but we do believe that [retention] is more than largely stabilized," said Wentworth.
3. Specialty drugs are the future
"Specialty is a primary driver of growth and it will continue to be so in the future," said CEO George Paz.
Demand for specialty medicine is climbing quickly as drugmakers launch next-generation personalized medications that are increasingly more expensive.
The approval of these high-priced medicines has Express Scripts expecting that spending on specialty drugs will climb 63% over the next three years.
That spending increase is likely to support demand for Express Scripts' pharmacy benefit services, which include negotiating lower drug prices with manufacturers, programs designed to increase the percentage of patients taking generic drugs, and programs that help patients take their medicine as prescribed, which is important to minimizing high-cost hospitalizations.
4. Generic biotech is untapped
Express Scripts believes that healthcare payer demands for pharmacy benefit services will grow once the FDA establishes a pathway to approval for biosimilars.
Despite biosimilars winning support in language contained within the Affordable Care Act, regulators have been slow to adopt rules that offer drugmakers clarity into how to win FDA approval for generic biologics.
Although ambiguity acts as a stumbling block, it's likely that obstacles to biosimilars will disappear over the coming few years given that these drugs are already being approved in Europe and other foreign markets, and that pressure from U.S. healthcare payers is likely to grow once blockbuster specialty drugs like Roche's Rituxan and AbbVie's Humira lose patent protection.
As a result, Express Scripts is focused on working with the FDA to create "better and easier pathways to bring biologic generics into the marketplace," according to Paz. "When that occurs, that [biosmilars offer] significant upside for us and significant upside for our clients, and this is going to improve adherence for our patients, less cost, less strain, less concern," he added..
5. Buybacks will continue
"[Express Scripts] generated $735.5 million of cash flow during the quarter, and repurchased 29.9 million shares for $2.2 billion," said CFO Cathy Smith.
Pharmacy benefit managers operate on thin margins because they take a small piece of the savings they generate for their clients; however, their businesses generate significant cash flow that can be used for shareholder friendly acquisitions and buybacks.
To put that in perspective, consider that Express Scripts' revenue in the first two quarters of 2014 totaled $48.8 billion, resulting in $857 million in net income. Those are pretty heady numbers for a company that is admittedly not firing on all cylinders.
Assuming that Express Scripts overcomes the headwinds holding back its performance, investors should expect the amount of money returned to shareholders to grow over the coming years. In the short term, Express Scripts estimates it will buy back 28 million more shares just in the second half of this year.
Fool-worthy final thoughts
Previously, I outlined three challenges facing Express Scripts, but that doesn't mean there aren't opportunities for the company's business to improve over time. Based on comments during the earnings conference call, management appears aware of the challenges it faces; recognizing those headwinds should serve as the first step in overcoming them. If that's the case, Express Scripts' hiccups may prove to be short term, which is something shareholders would applaud.
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