What About Shareholders?

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

A company that leads a growing industry should be at the top of most investors' buy lists. What better way to profit from the growth in prescription drug use than to buy the biggest pharmacy benefit manager?

When Express Scripts (NASDAQ: ESRX) merged with Medco last year, the combined company became the unquestioned leader in their field. Analysts generally expect good things from the company and are predicting over 17% EPS growth over the next few years. Since the merger, revenue and EBITDA have been up significantly, so what's the problem?

The problem is, Express Scripts generates huge free cash flow, and the company is neither buying back stock nor paying a dividend.

The pharmacy benefit business is booming, with both Express Scripts and CVS Caremark (NYSE: CVS) seeing their respective businesses expand. In fact, in CVS' recent quarter, their pharmacy benefit business saw growth of over 20% versus mid-single digit expansion at the CVS pharmacy chain.

Everyone knows by now what happened when Walgreen (NYSE: WAG) decided to exit the Express Scripts network, and their same-store sales went from positive to negative. Walgreen is still struggling to regain its same-store sales momentum.

The bottom line is, Express Scripts is the biggest dog in the industry, but it's hard to get excited about a company that isn't giving back to shareholders.

If there is any doubt that Express Scripts is showing good growth, a look at their last quarterly earnings, which shows what the company is capable of. Express Scripts saw EBITDA increase 136%, and this was on top of a 132% increase in the prior quarter. The company saw adjusted claims jump 116% to just under 400 million. This is mind blowing considering that CVS processed about half that amount.

However, net income increased a much less impressive 20.54% mainly due to integration and acquisition costs. As part of the Medco acquisition, the company had to issue millions of new shares, and their diluted share count is up over 69% versus last year. Primarily due to this huge increase in shares, diluted EPS was actually down 28.79%. Since Express Scripts EPS will be under pressure until the company either increases earnings further, or buys back shares, that leads me to my main point.

Express Scripts business operates with relatively thin margins, but the company's size allows them to generate significant free cash flow. In the most recent quarter, the company's gross margin was just 8.1%, but this was up from 7.5% last year. By comparison, CVS has the benefit of their higher margin pharmacy business and generated a gross margin of over 18%. Walgreen doesn't have the thin margin pharmacy benefits business to contend with, and their gross margin was over 29% because of this.

Though Express Scripts should be able to continue improving their gross margin through cost savings, the company is generating enough cash flow to address the EPS dilution or pay a dividend already.

When it comes to free cash flow, Express Scripts actually generates more per dollar of sales than their competition. In their current quarters, Express Scripts created about $0.07 of free cash flow per dollar of sales. CVS and Walgreen generated about $0.02 of free cash flow per dollar of sales by comparison.

The primary difference is that both CVS and Walgreen have pharmacy networks to maintain. Express Scripts does not. Given this higher level of free cash flow, what could Express Scripts do to improve investors' returns?

Peter Lynch used to say, it doesn't take much imagination to mail dividend checks compared to making a complicated acquisition, but it may be the right thing for the company to do. Both CVS and Walgreen have a history of not only paying but raising dividends.

CVS currently pays out just 21.72% of free cash flow, and Walgreen pays out about 66% of their free cash flow in dividends. Express Scripts pays no dividend, and you have to go back to December of 2011 to find the last time the company repurchased shares. Given the alternative investments available in CVS and Walgreen, I believe Express Scripts shareholders are being shortchanged by the lack of share buyback or dividend.

In the last nine months, Express Scripts generated nearly $2 billion in free cash flow. Using CVS and Walgreen as a proxy, the average payout ratio between the two is about 44%. Even if Express Scripts wanted to use a lower payout ratio, at 30% they could afford to use about $600 million for share repurchases or dividend payments.

With 829.6 million diluted shares outstanding, this $600 million would mean an annual dividend of $0.72. With the stock price at $54.90, this annualized payout would equate to a yield of 1.31%. If the company used the funds for share repurchases, at current prices this would retire nearly 11 million shares.

Either action would give Express Scripts shareholders proof that their company puts their interests first. In addition, this would make the stock more attractive.

Express Scripts currently sells for about 13.13 times earnings, and is expected to grow EPS by over 17% in the next few years. This gives the company a PEG of 0.76. By comparison, CVS has a PEG of 1.0, and Walgreen has a PEG of 0.92.

While it sounds like Express Scripts is already relatively cheaper, the difference is each company's dividend and share repurchase programs. CVS pays a yield of 1.73% and Walgreen pays 2.8%. Both companies also repurchase their shares on a regular basis. Investors are willing to pay more for their stocks because of the income and share repurchases.

If Express Scripts were to pay a dividend or institute a stock repurchase program, it's possible their PEG ratio would rise to closer to their competition. If the company's PEG rose to just 0.9 because of one of these actions, the stock would be worth about $66 a share. With shares at just less than $55, this would represent a 20% increase from current levels. Express Scripts has the size to dominate their industry, now it's time for management to reward shareholders.

MHenage has no position in any stocks mentioned. The Motley Fool recommends Express Scripts. The Motley Fool owns shares of Express Scripts. 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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