Express Scripts has for the first time decided to exclude a few dozen drugs from its preferred formulary. The leading pharmacy benefits manager, or PBM, took the decision in a bid to counter steadily rising prices for brand-name medications, the increasing use of co-pay cards and continually narrowing formularies elsewhere.

Steve Miller, the chief medical officer at Express Scripts, has however, downplayed the exclusions, terming them as ''surgical'' and ''minimal.'' Miller said the company will continue to maintain its traditional three-tier benefits plan. The new plan will see Express Scripts exclude 48 drugs from its national preferred formulary, approximately 1% of its total drug portfolio. According to Miller's own calculations, the new move will impact about 780,000 people in total, approximately 2.6% of the 30 million people served by the PBM. Miller pointed out that the company arrived at the decision not out of purely economic reasons alone, but also in a bid to bring down net costs and maintain market share.

Private exchanges muddy waters for PBMs
The decision by Walgreen, IBM, and Time Warner to move their employees into private health exchanges seems to have muddied the waters considerably for pure-play PBMs such as Express Scripts (NASDAQ:ESRX), CVS Caremark (NYSE:CVS) and United Health (NYSE:UNH). Express Scripts' shares traded down by a considerable margin the minute the news hit Wall Street.

Source: YCharts.

But maybe investors overreacted to the implied threat by private health exchanges. Although there is some potential to shuffle the decks for the PBM industry, in reality, there will have to be massive adoption before private exchanges can begin to really threaten the dominance of large PBMs such as Express Scripts and CVS. A recent study by the National Business Group on Health found that only 1% of companies plan to shift their employees into private exchanges in 2014. The same report found that approximately 33% of large companies will consider joining private health exchanges in three to five years. Mark you, these companies said that they ''will consider'' joining the private health bandwagon, meaning they might not necessarily do so. So we are probably looking at 10%-15% market share for private health exchanges by the end of five years, possibly much lower.

Following the 2012 merger with Medco Health Solutions, Express Scripts commands a leading 40% markets share, with CVS Caremark coming second with 26% market share. The two PBMs account for a massive 60% of the projected 2013 revenues for PBMs. Although it's quite likely that private exchanges might grow their market share at the expense of these two behemoths, it's also quite possible that the attendant market share erosion will not be significant. The recent move by Express Scripts to exclude some drugs from its formulary is perhaps one of the many counter-measures that PBMs will undertake to limit margins compression in the face of growing competition from private exchanges.

Express Scripts' revenue favors spread retention structure
Large PBMs such as Express Scripts and CVS Caremark have increased their claim volume to a point where they now negotiate directly with various players such as drug manufacturers, distributors and retail chains. This helps them offer their customers more favorable prices. PBMs make money by retaining the spread between what they charge their customers, and what they pay to drug manufacturers. PBMs at first charged a fixed fee for processed claims. Their revenue structures have, however, morphed to such an extent that it actually favors spread retention while still managing to pass considerable benefits to their customers.

Express Scripts and CVS Caremark flourishing
Express Scripts managed to process a staggering 1.3 billion claims in 2012. During the first half of the current year, the company managed to handle 759.4 million claims, meaning its well on its way to surpassing last year's claim numbers. The enormous claims volume processed by Express Scripts places it in a unique position to leverage its asset-light capital structure, and, therefore, maximize its returns. Express Scripts as a result boasts some of the lowest sales, administrative, and general costs, as well as the highest profit per claim in the industry.

Although CVS Caremark continues to play second-fiddle to Express Scripts, it is currently undertaking rigorous cost-cutting measures including a greater focus on specialty drugs,maximum use of cost-effective generic drugs and reduced reliance on expensive drugs with no clinical benefits. This will help the company offer more favorable pricing to its customers.

Underlying risks
Express Scripts faces growing competition from CVS Caremark. The threat might increase considerably if CVS decides to become more aggressive in its pricing.

UnitedHealth is planning to fully in-source its PBM division in 2013, which might mean less business for Express Scripts and other PBMs. The company was recently ranked tops in terms of customer satisfaction in a recent J.D. Power study. More than 3,00 vision plans were involved in the study, that measured member satisfaction based on cost, coverage, communication, and customer care.

PBM investors are still wary of the planned implementation of the Affordable Care Act in January, as well as other developments such as the recent entry of private health exchanges, generic biologics legislation, and other industry reforms. Express Scripts continues to do well, and the planned expansion of insurance coverage in the country to include 32 million previously uninsured citizens is a huge plus for the company and other PBMs.

Fool contributor Anthony Maina has no position in any stocks mentioned. The Motley Fool recommends Express Scripts and UnitedHealth Group. The Motley Fool owns shares of 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.