The approval of high-priced specialty medicine is expected to create a surge in healthcare spending over the coming three years. That surge will pressure insurers and other healthcare payers, such as employers who self-insure, to rein in costs.
One way these healthcare payers may attempt to do that is by contracting with pharmacy benefit managers, or PBMs, such as Express Scripts (NASDAQ:ESRX). That's because Express Scripts offers a slate of services designed to lower the cost of medicine for payers, including negotiating drug prices with drugmakers, improving patient adherence to medication, and boosting generic prescription fill rates.
On the surface, a rising tide of specialty drug spending would seem to suggest that Express Scripts' future is bright; however, the company may face hurdles along the way. As a result, let's look a bit closer at Express Scripts and see whether now might be a good time to buy shares.
Although PBMs such as Express Scripts operate on razor-thin operating margins, they do generate significant cash flow. That's because insurers including WellPoint pay Express Scripts a small slice of revenue to act as the middleman between payers and patients.
In the past year, those small slices totaled up to more than $100 billion in revenue for Express Scripts, but before investors cheer too loudly, remember that the company's 3.36% operating margin means that net income over that period totals just $1.77 billion after including interest and taxes.
That's still a healthy amount of profit, and the good news is that the company's net income has been climbing, especially following its acquisition of competitor Medco Health Solutions. The bad news is that integration struggles have reduced the company's client retention rate, weighing down results.
Still, since Express Scripts generates plenty of cash, those client losses haven't dented the company's ability to buy back shares. Those buybacks and the net income growth tied to the Medco deal have lifted the company's earnings per share from under $2.00 in 2012 to $2.23 in the past 12 months.
If the company's doubling down on customer service can stem client losses and allow new client wins to boost the top line, then Express Scripts earnings could head higher and potentially exceed its previous peak. That outcome seems to be what Wall Street analysts are expecting, given that analysts are projecting that Express Scripts' earnings per share will reach $4.88 this year and grow to $5.45 in 2015.
Analysts' earnings forecasts mean that Express Scripts shares are trading at 13.77 times forward EPS. That's not out-of-this-world expensive, considering that competitors CVS and Catamaran's forward P/E ratios are higher. But it's not that cheap, either, as the ratio was around 11 in 2013.
That could suggest that for investors to be rewarded for buying shares, Express Scripts will need to find ways to over-deliver on its bottom line. That may not be an easy thing to do, particularly since Express Scripts will need to hold the line on pricing and launch value-added products and services in a bid to shore up its customer base.
Looking at price to sales, which divides share price by revenue per share, Express Scripts valuation is smack dab in between CVS and Catamaran and is at its highest levels since 2012.
That could mean that investors are already pricing in some optimism now that the customer fallout following the Medco integration is over. Regardless, current levels suggest that there isn't much room for shares to head higher without having Express Scripts' over-deliver on top-line growth. That's because over the past few years, Express Scripts' P/S ratio has typically peaked near this level.
Fool-worthy final thoughts
High-cost drugs will put plenty of pressure on payers to embrace Express Scripts' services, and since people 65 and older tend to take twice as many prescriptions as those 54 and younger, there should be plenty of script volume growth as baby boomers age, too. However, despite those positive catalysts, investors may want to take a patient approach when it comes to Express Scripts, given that shares don't appear inexpensive right now relative to the company's peers.
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 Catamaran, CVS Health, and Express Scripts and owns shares of Catamaran and Express Scripts. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.