Thursday, July 21, 2011

Should You Buy Medco Health?

Medco Health Solutions (NYSE: MHS) is poised to be bought for the second time. Merck (NYSE: MRK) paid $6 billion for it in 1993 and then took it public a decade later. Now Express Scripts (NYSE: ESRX) is reportedly about to offer to buy it for $29 billion. But what if the deal falls through? Should you buy Medco stock?

Medco was founded as a mail-order drug distributor and its change in ownership over the last nearly two decades is a map of how the health care industry has changed. As I wrote in my first book, The Technology Leaders, Merck bought Medco because of a change in the way drugs were sold.

The old model was for big pharmaceutical companies to invest billions in R&D to develop patented drugs and hire thousands of sales people who would give doctors trips to exotic locations to explain the benefits of prescribing the drugs. The doctors would dutifully prescribe the ones that they thought would help their patients.

But in the 1980s, the decision-making power shifted from doctors to pharmacy benefit managers (PBMs). PBMs acted on behalf of corporate health plans to make sure that their members got the lowest priced drugs that did the job. Thanks to the emergence of generic drug manufacturers who made lower priced versions of popular off-patent drugs, those cheaper substitutes were widely available.

Merck bought Medco, which is now the largest PBM, because its old model of selling to doctors was falling apart and it wanted to control its channel of distribution. Unfortunately, this did not work all that well because often a Merck product was not the PBM's choice so there was conflict between Merck's interests and those of the PBM's clients.

So Merck sold off Medco and it operated independently for eight years. Now Express Scripts, a big PBM is offering to pay $71.36 in cash and stock for each Medco share, a 28% premium. If the merger goes through, the combined company will control 1.7 billion prescriptions and about $110 billion in revenue. Moreover, they expect to cut $1 billion in costs through the combination.

Medco is selling out because it's losing market share. The Associated Press reports that Medco "has currently lost more business than it has booked for 2012." For example, UnitedHealthcare will not renew its 2012 contract and other clients -- the Federal Employees Health Benefit Program, the California Public Employees' Retirement System, and a Universal American unit have already announced that they will take their business elsewhere.

If this deal goes through, it won't happen until some time in 2012. So should you buy Medco stock before the deal closes?
  • Reasonably priced stock. Medco price to earnings to growth (PEG) ratio of 1.08 makes it not-overly expensive (a PEG of 1.0 is considered fairly priced). However, since it's up 24% in pre-market trading, it's price is getting into the expensive range. Medco's P/E is 17 and its earnings are expected to grow 15.7% to $4.74 in 2012.
  • Out-earned its capital cost. Medco is earning more than its cost of capital – but it’s not improving. How so? It produced no EVA Momentum, which measures the change in “economic value added” (essentially, profit after deducting capital costs) divided by sales. In the first half 2011, Medco’s EVA momentum was 0%, based on first six months' 2010 annualized revenue of $65.4 billion, and EVA that rose from $796 million annualizing the first six months of 2010 to $1 billion annualizing the first six months of 2011, using an 8% weighted average cost of capital.
Here are two negatives for the stock:
  • Disappointing second quarter earnings. Medco earnings for the second quarter were less than expected. Its reported $342.8 million in net income on revenues of $17.07 billion and EPS of 85 cents a share. Medco's net income was 4% below what it earned in 2010's second quarter, its EPS was 10% below analysts' expectations and its revenues were $40 million less than forecast. Medco's mail-order prescriptions rose 0.7%, and 6% "on a generic basis."
  • Rapid growth but deteriorating balance sheet. Medco has grown solidly. Its $66.7 billion in revenues have increased at an average rate of 11.7% over the last five years and its net income of $1.4 billion has risen at a 18.9% annual rate over that period. To finance acquisitions, its debt has skyrocketed while its cash has barely budged. Its debt skyrocketed at 55% annual rate from $866 million (2009) to $5 billion (2010) while its cash inched up at a 0.6% annual rate from $887 million to $910 million.
This stock could do better if a hostile bidder enters the picture. And with acquires like CVS Caremark (NYSE: CVS) likely to feel threatened by this deal, I would not be surprised to see a bidding war. Meanwhile, there's no guarantee that this deal will go through -- after all the Justice Department will need to decide whether the combination will have too much market power.

The best hope for Medco to rise further is a bidding war. Absent that, I would avoid the stock due to its disappointing earnings and loss of market share.


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