The Pharma Fallout Continues

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Express Scripts (NASDAQ: ESRX), the largest pharmacy benefit manager in the U.S., has tumbled over 17% since November 5th on reduced guidance for 2013. In its latest quarterly financials, earnings and revenue came in on track, but investors' real fear is the fact that Express believes the 2013 outlook by analysts is overly aggressive. Although things were patched up between Express and Walgreen months ago, we are just now beginning to see the "fallout" and its residual impact. Here are some of the hedge funds playing this situation.

Express and Walgreen's inability to come to terms on a new contract left many customers underserved, leaving the door open for CVS Caremark (NYSE: CVS), who capitalized. CVS's recent earnings announcement showed evidence of the pharmacy company's ability to capture and retain Walgreen customers. 3Q earnings beat estimates, up 16% from a year earlier, and CVS also raised earnings for the full year. Management believes that the Walgreen-Express debacle added $0.04 to its 3Q EPS.

Walgreen (NYSE: WAG) on the other hand, had a less than stellar earnings release, with EPS down from $0.57 a year earlier to $0.53, and same-store sales falling 5.9% in October alone. Walgreen and Express renewed their contract in September that will once again allow Express customers to fill their prescriptions at Walgreen stores, but the damage may already be done, as CVS's management expects it to keep upwards of 60% of the former Walgreen customers. Walgreen's sees limited ability to fully anticipate how its top line will be impacted due to the loss of around $4 billion in sales on the Express contract.

Earlier this year, Express bought Medco Health Solutions (MHS), and with the increased scalability is expected to break $100 billion in revenue for 2013. Prior to the company's recent earnings announcement, three investment firms all reiterated their outperform ratings on Express and had over $70 price targets - compared to Express's current stock price around $51 - due to the behemoth that Express had become with the Medco acquisition.

Medco previously did business with UnitedHealth Group (NYSE: UNH), making up around 15% of Medco's revenues, but this contract is set to expire next year. UnitedHealth is bringing its pharmacy benefit manager services in-house and should do well without Medco. It is expected to grow revenue 8% in 2012 and 9.2% in 2013. Key drivers for UnitedHealth include aggressive acquisition of Medicare and Medicaid customers; check out our analysis of UnitedHealth's recent earnings.

In addition to the Medco acquisition, Express's top line will be driven by increased demand for generics and a rise in higher-margin mail order scripts. The recent Express weakness could be a buying opportunity, and could also represent that CVS may perform better than expected over the interim.

At the end of September, Express saw Lone Pine Capital as the top fund owner at 4.3 million shares; meanwhile, other smaller funds concentrated their portfolio in Express, with around ten firms having near 5% of their 3Q 13Fs invested in the pharmacy benefits manager.

The positive for Walgreens is its 3.2% dividend yield, but the possible continued fallout from the botched Express renewal may hamper growth. Even though Walgreens might be neck-and-neck with its competitors in terms of profit margins and valuation, we believe the outlook for CVS is much more positive. CVS is expected to boost full 2012 sales 15% from 2011 on the back of new pharmacy benefit management clients and same store sales growth of 5%. CVS called billionaire investor Cliff Asness (here’s his full 13F portfolio) as one of its top fund owners, and saw nine funds with over 1.5% of their 3Q 13Fs invested in the pharmacy company.

Based on recent EPS, Express now trades above the industry average earnings multiple at 35x, where UnitedHealth and AmerisourceBergen trade at 11x and 15x, respectively. Express does trade at a much more acceptable forward P/E of 12x. We believe that the Medco addition is a long-term positive and will help mitigate the loss of Walgreen customers.


This article is written by Marshall Hargrave and edited by Jake Mann. They don't own shares in any of the stocks mentioned in this article. The Motley Fool owns shares of Express Scripts. Motley Fool newsletter services recommend Express Scripts and UnitedHealth Group. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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