Rising Star Buy: Medco Health

About $14 billion in annual sales of brand name drugs have come off patent annually since 2008, but that was just the beginning. Starting in December of this year through the end of 2012, approximately $35 billion worth of sales more will lose patent exclusivity, including Lipitor, Plavix, and Singulair. One industry positioned to profit from the wave of new generic launches is the pharmacy benefits managers or PBMs.

Born in the 1980s, PBMs work for health-care payors such as insurance companies, employers, and government agencies which outsource prescription drug plan management and claims processing. PBMs are responsible for developing and maintaining the formulary, contracting with pharmacies, and negotiating discounts and rebates with drug manufacturers on behalf of their clients, the health-care payors.

Essentially a PBM is a middleman with a stated goal of lowering prescription drug costs. They accomplish this by encouraging members to switch to lower-cost generics, preferred brands, lower-cost retail outlets, and the company's mail-order pharmacy. Dispensing generic alternatives -- especially through its mail-order channels -- is the most profitable part of a PBM's business.

Medco's edge
Medco Health (NYSE: MHS) is the largest PBM in the industry, administering 957 million adjusted prescriptions last year for about one-fifth of the U.S. population. Mail-order prescription counts are adjusted because of their 90-day supply, compared to a typical 30-day supply for a prescription at the retail pharmacy.

Medco's scale and successful track record influencing member behavior allow it to negotiate favorable pricing with drugmakers looking for formulary placement within Medco's vast network. While Medco is the largest player in the industry, its closest competitors -- Express Scripts (Nasdaq: ESRX) and CVS' (NYSE: CVS) Caremark -- are not far behind. That said, Medco's service is the most differentiated, allowing it to compete effectively beyond price thanks to its Therapeutic Resource Centers.

Pricing is typically the greatest selling point for potential clients, but health-care payors also look for a PBM that offers additional services such as comparative clinical, cost effectiveness, and access to specialist pharmacists. From this perspective Medco is the clear leader as it has had the most success differentiating itself from its competitors.

Why buy?

1. Generics: Medco's overall generic dispensing rate (GDR), currently at 71%, is set to expand as a record number of new generic drugs launch through 2012. The GDR measures the percentage of total generic prescriptions administered.
2. Mail-order pharmacy: Not only do PBMs make more cash administering generic alternatives, but they earn even higher margins when they are dispensed through their own mail-order pharmacies. Medco's mail-order penetration rate is only at 34%, providing a solid long-term opportunity to expand margins and fuel earnings growth.
3. Higher utilization: An aging population and the expansion of health coverage to an additional 32 million people will drive utilization. An aging population also lends itself to growth in drugs for chronic conditions which should help grow Medco's mail-order business.
4. Specialty pharma: There are 611 specialty drugs -- typically high-maintenance injectable drugs -- in phase II or phase III studies (124 in phase III for oncology alone). Accredo, Medco's specialty pharmacy, currently contributes about 17% of operating income, but will play a larger role in keeping specialty drug spend in check in the years to come.

What could go wrong?
The biggest concern in the market right now is whether Medco's largest client, UnitedHealth (NYSE: UNH), will pull its contract, set to end in 2012. UnitedHealth is expected to announce in the second half of this year that it will be bringing that business in-house. This contract represents nearly 20% of Medco's annual revenue, but is less profitable than Medco's core book of business. While it's unclear the exact proportion of profits, it is safe to say it was likely 10% or less of total profits in 2010. The loss of this contract is priced into the shares at this point, but headlines could certainly send the stock down in the near term.

Pricing will always be a concern in the industry as smaller rivals look to grab market share before the onslaught of profitable generics hit the market. Vertically integrated PBMs like Caremark are known for undercutting on price to drive share gains and traffic to CVS' retail stores. I expect Medco's 99% retention rate to hold firm while its Therapeutic Resource Centers and specialty pharmacy continue to attract new clients.

Medco also faces constant regulatory and litigation risk such as the latest accusation that it paid a "consultant" for the CalPERS contract several years ago. Despite these concerns I expect the PBM industry and Medco will remain on the right side of the law due to their role in lowering overall drug spend.

Valuation
I think headline risk concerning the expected announcement that UnitedHealth will be pulling its contract in-house has opened up a nice opportunity to buy Medco shares. I peg the company's intrinsic value between $65 and $70 a share. As you can see in the chart below, Medco is currently trading at a significant discount to its closest peer, Express Scripts. It's pretty clear that investors do not want to get out in front of UnitedHealth's decision to either stick with Medco or bring the business in-house.

The key driver of earnings growth in the next few years will certainly be the incremental earnings from brand-name drugs going off patent. Below you can take a look at Medco's estimates of incremental earnings per share expected from generic launches.

Over the long run Medco will need to continue to make progress switching members and plans from retail pharmacies to their own mail-order pharmacies. This is where Medco can obtain the greatest margin expansion and really become the cash cow that I expect it to become. Below you can see mail-order uptake has been less than inspiring, but notice the growth in mail-order generic dispensing. I expect this measure to improve closer to 65% in the near-term with the generic alternative to Lipitor, Plavix, Singulair, and Diovan leading the way. Each of these drugs currently has 45% to 60% mail-order penetration rates. Remember generic mail-order dispensing is Medco's bread-and-butter.

*The percentage of total prescriptions dispensed through the mail-order channel.
**The overall percentage of generic prescriptions dispensed through mail-order channel.

Foolish bottom line
Medco has a much brighter future than its current stock price implies. With a catalyst in plain sight it is a little surprising the stock trades at such a discount to its lesser-than peer. It appears the market is taking the view of selling the independent PBMs to then buy 'em back later, closer to the generic launches in 2012. I'll leave the timing to the timers and stick to investing with full intention to buy more if the stock falls after the UnitedHealth announcement.