Pharmacy benefit management company, or PBM, Express Scripts (NASDAQ:ESRX) has done quite well for investors in the past, but Wall Street is less confident about the future. Analysts are skeptical that, with the large advances already made in the shift to generics, Express Scripts can leverage formulary design, producer discounts, mail delivery and other drivers to continue generating double-digit free cash flow growth.

That skepticism could work in investors' favor, though, as Express Scripts looks like one of the relatively few meaningfully undervalued large health care companies.

The biggest pure-play left
Having acquired Medco in 2012, Express Scripts is far and away the largest PBM, handling close to one-third of prescriptions. At that size, Express Scripts is about four times the size of the next-largest pure-play Catamaran (UNKNOWN:CTRX.DL), though retail-PBM hybrid CVS Caremark (NYSE:CVS) claims around 20% of scripts and is a very competitive player in the space. Express Scripts also competes with managed care companies that run their PBMs, most notably UnitedHealth Group's (NYSE:UNH) OptumRx, and newcomers like Costco which launched its own PBM in 2013.

Express Scripts manages pharmacy benefits for close to 100 million lives, it's reasonably well diversified across employers, and health plans (with WellPoint as its largest customer). Size is important, as Express Scripts' scale gives it important leverage when negotiating with drug manufacturers on price, as well as retail pharmacy chains.

Generics fading as a tailwind
The past decade was a big one for generic drug manufacturers like Teva and Mylan, as well as PBMs like Express Scripts, as billions of dollars of branded drugs went off patent. As Express Scripts, CVS Caremark, and Catamaran were able to shift more and more prescriptions to generics, they were able to continue to post solid profit growth despite ongoing pricing pressure from clients.

That generic substitution tailwind, which likely contributed at least half of Express Scripts' earnings growth over the past decade, is probably not going to be repeated over the next decade. There aren't nearly as many high-value branded drugs going off patent, generic substitution rates are already high, and new drugs like PCSK9 inhibitors for cholesterol are going to hit the market.

Specialty pharmacies and formularies will fill at least some of the gap
Express Scripts still has levers to pull to save money for employers and managed care plan operators on pharmaceuticals. Specialty pharmaceuticals, including biologicals for inflammatory conditions like rheumatoid arthritis, oncology drugs, and drugs for MS, make up only a single-digit percentage of script volume, but around one-third of spending.

With CVS Caremark, Express Scripts is one of the largest specialty pharmacy operators, with significant operations on both the pharmacy and fulfillment sides. Better managing these costs is a significant value-add opportunity and Express Scripts stands to become a major beneficiary if and when biosimilars (essentially generic versions of biological drugs like Humira or Lantus) reach the market in significant volumes.

Controlling the formulary is another way Express Scripts can cut costs. In essence, this is a process where Express Scripts chooses one version of a drug (or removes a particular version) and includes/excludes it from plan members. In practice, this means that Express Scripts can obtain very competitive bids for included drugs and/or exclude particularly expensive drugs. But it does run the risk of alienating and angering members (patients with chronic conditions don't like to change a medication that has been working, even if the replacement is supposed to be basically identical).

A relentless drive toward lower costs
I have no particular expectations for Express Scripts to earn significant revenue growth in the coming years. Smaller rivals are growing their capacity, while larger rivals like CVS Caremark are looking to integrate the drug supply chain. Rivals like UnitedHealth's OptumRx are going to push hard to grow (as scale brings savings) and large customers are more than willing to play PBMs off each other for better deals.

I do expect, though, that Express Scripts will find additional drivers for improved savings and margins. The company's scale in specialty drugs is significant and the potential price benefits from biosimilar substitution are large. Management also believes there is more to do with expense synergies from the Medco deal and conversion to a mail-order pharmacy. The penetration here is just under 30% and management believes it can hit 40% in the medium-term and perhaps as high as 70% down the line.

All told, I'm looking for revenue growth of around 3% from Express Scripts, with ongoing margin improvements leading to a free cash flow growth rate close to double that. Discounted back, I believe these shares are worth around $85 today.

Bottom line
CVS Caremark, UnitedHealth, and Catamaran are not trivial rivals, and Express Scripts no longer has the benefit of substantial conversions to generics to help grow its profits. Even so, the company's considerable scale and opportunity to leverage that scale with manufacturer discounts, formulary control, and savings in specialty pharmaceuticals should allow for additional margin leverage. On that basis, Express Scripts appears to offer meaningful value at these levels.