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Express Scripts Keeps Getting Better

Will it get involved in health care sector's deal mania?
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Express Scripts (ESRX) has done a remarkable job over the past decade morphing into the largest pharmacy benefit manager (PBM), with over $100 billion in annual sales. The progress has come from both organic growth and through acquisitions, including the 2012 Medco purchase.

Clients are increasingly relying on PBMs to make their patients healthier through increased drug compliance, while saving them money by buying in bulk, delivering via mail and utilizing lower-cost generic medicines. In particular, clients increasingly need help managing the rising costs of specialty biological drugs, which are growing at 15% to 25% per year. 

We expect Express Scripts to generate 11% annual earnings growth in the coming years.  Half of this growth will come from rising unit volumes and the benefits of scale efficiencies. Growth should start to ramp up again after client losses from the Medco deal. Industry analysts also expect ESRX to pick up incremental business from the recent UnitedHealth (UNH)/Catamaran (CTRX) deal.  

The other half of the earnings growth will come from aggressive share repurchase activity. ESRX returns all $4 billion per year in free cash flow to investors via stock buybacks. We expect this EPS accretive strategy to continue as the company has limited capital spending requirements of $300 million to $400 million per year, and a management team committed to generating shareholder value.

The shares are still reasonably priced at 16.5x 2015's EPS estimate of $5.44, and 14.9x 2016's estimate of $6.03. According to The Wall Street Journal, the health care sector as a whole trades at 17.5x earnings. ESRX's closest competitors, CVS Health (CVS) and Walgreens Boots Alliance (WBA), trade for over 20x earnings.

Express Scripts trades at a discount to these groups, therefore, good earnings momentum should close this gap over time.

In addition to the solid fundamentals and favorable valuation, there is also a good likelihood that Express Scripts becomes involved in the current health care deal mania. As the sector continues to consolidate to gain strategic and financial synergies from deals, we would expect ESRX to fully participate in this mega-trend.

It would make a lot of sense for Express Scripts to either form a joint venture or merge with Walgreens Boots Alliance. Both ESRX and WBA are falling behind CVS Health, which is larger, lower cost and offers clients both a PBM and a retail pharmacy network. Major clients have been increasingly shifting their business to CVS Health for more convenience and lower costs.

There is a good chance that both Express Scripts and Walgreens Boots realize the logic of a joint venture or merger to bring incremental value to both their clients and shareholders. Even a simple purchasing joint venture would save each company substantial amounts of money. A broader cross-alliance or merger would add convenience and lower costs to both firms' customers. Both management teams are pragmatic and shareholder friendly.

In any case, we still like Express Scripts on its own merits. The fundamentals are solid while the valuation remains reasonable. Over the next year, one could easily see a $100 to $110 stock price vs. the current $89 quote. Any deal activity would provide an additional upside kicker. 

At the time of publlication, Katz was long CVS, although positions may change at any time.