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MHS AT A GLANCE

P/E ► 23.2 HIGH EV/EBITDA ► 11.4 AVG ROA ► 8.5% AVG ROE ► 20.1% AVG Debt to Equity ► 1.78 HIGH Current Ratio ► 1.28 LOW Interest Coverage Ratio ► 11.4 AVG

 

 

 

 

 

 

Medco Health Solutions is one of the nation's biggest pharmacy benefit managers (PBMs). Medco provides services through a network of retail pharmacies and its own mail-order pharmacy. Pharmacy benefit managers like Medco generate profits by consolidating buyers to obtain discounts with pharmaceutical manufacturers, distributors, and retail pharmacies, and work with clients to design customized pharmacy benefit plans. By acquiring Accredo in 2005, Medco became one of the largest providers of specialty pharmacy services in the United States as well.

Recently, a series of potential threats to Medco’s continued success have garnered attention from investors. The CVS/Caremark merger is challenging Medco for market share (although retail pharmacies threatened by the merger may now look to Medco for contracts). There is also some worry that the new Democratic legislature will implement changes to the Medicare system that could be a detriment to pharmacy benefit managers. However, these changes are unlikely to happen immediately, and regardless, the increasing costs of prescription medications for patient or payer makes the services of a PBM even more appealing. Medco's size and current position puts them in a spot take advantage over these changes in the sector.

History and Corporate Overview

Based in Franklin Lakes, New Jersey, MedcoHealth Solutions was formed in August 2003 as a spinoff from Merck & Co. While under Merck control, the company was known as Merck-Medco Managed Care. Previously it was known as Medco Containment Services, Inc. In 2005 Medco acquired Accredo Health, a large specialty pharmaceutical operation.

Medco is also one of the national Prescription Drug Plans (PDP) named by the Centers for Medicare and Medicaid Services to administer prescription drug plan benefits for the Medicare-eligible population at large.

Products and Services

Medco's revenue comes primarily from contracting with clients to provide prescription drugs to their members through mail order and Medco's retail network. The PBM client will pay for the drugs dispensed to their members at a discount to average wholesale price plus a dispensing fee. Some clients may also pay center administrative fees attached to services. Increasing these fees is part of the way Medco has been able to increase its rebates to customers.

Mail Order

In the first quarter of 2007, mail revenue increased 7.2% from the year before to reach $4.3 billion. Like the increase in retail, part of the added mail revenue was an effect of inflation. Mail claims volume also increased 7.0% to 23.4 million. This increase was a more substantial one, the result of the more than 9 million people enrolled in Medco's Retail Refill Allowance programs, which encourage purchase of generic alternatives to prescription drugs through mail order.

Retail Network

Retail revenue increased 4.5% from the same period last year to $6.7 billion. The growth reflects both an increase in number of claims ($119.5 million, a 1.3% increase from the previous year) as well as increased revenue per claim. The increase in revenue per claim was the result of inflation to the cost of branded drugs.

In their second quarter 07 earnings release, Medco posted a 4.1% increase in revenue over this quarter last year and a 20% increase in net income. Prescriptions saw an overall increasing of 3.2%. Mail order revenue was up 6.3 % and retail was up 1.9%

Other Services

The revenue Medco derives from services other than Pharmacy Management made up only 1% of their 2006 earnings. Most of the services function primarily as compliments to its primary service and include:

• Plan Design: The Medco team assists clients in developing and implementing a prescription plan. Designed plans take into account mail-order and generic utilization initiatives, as well as specialty pharmacy, drug coverage and exclusion, and cost-share options. Integrating Medicare Part D into plans is increasingly important to clients.
• Clinical Management: Medco's Pharmacy and Therapeutics Committee and Medical Advisory Board creates and administers new programs and services for plan sponsors. Another initiative is the drug utilization review to monitor over-, under-, or misuse of prescriptions. They also use this program to notify pharmacists and physicians of alternative therapies in case of conditions where drug treatments would be dangerous, as in pregnancy.
• Physicians Services: In order to make the most of their other initiatives, Medco along with other PBMs has begun working with physicians to motivate them to prescribe more cost-effective drugs. Medco is also working on recruiting doctors to use open-access systems to ensure the availability of standardized solutions.
• Web-based Services: Medco offers sites for clients and retail pharmacists which provide interactive tools aimed at improving compliance with designed plans, creating greater transparency, simplifying benefit administration, and providing medical information.

Business Drivers

Benefits from expiring patents

An estimated $69 billion's worth of branded drug sales will lose patent expiration over the next five years. This is in addition to the nearly $13.6 billion in branded drugs that lost patent protection in 2006, including Zocor (Merck (MRK)), Zoloft (Pfizer (PFE)) and Pravachol (Bristol-Myers Squibb Company (BMY)). Generic drug utilization is an important part of Medco's business because generic versions of medications have a cheaper base price to begin with; Medco also has more bargaining power with the drug manufacturers.

However, as much as Medco stands to profit from generic drug utilization, CVS/Caremark and other retail pharmacies are likely to see an even greater benefit, since they buy generic drugs directly from the manufacturers.

Biotechnology and specialty pharmacy growth

The Biotech/pharmaceutical industry is one of the fastest growing segments of the PBMs' potential business. These new drugs are more specialized to a patient's needs, but are also more expensive to make and administer because they require a specialist. By acquiring Accredo Health in 2005, Medco significantly expanded the offerings that were at the time wrapped up in the rest of its operations. Now, Accredo Health Group, as part of Medco, is responsible for processing specialty drug orders and dispensing them along with necessary supplies for administering the drugs to patients or the patients' physician.

With the largest specialty pharmacy segment by revenue versus other pharmacy benefits managers, Over the coming years, Medco stands to profit as higher-margin and difficult-to administer specialty drugs become increasingly popular versus traditional drugs.

Market Consolidation and Walmart's $4 Prescriptions

When Wal-Mart Stores (WMT) announced its $4 Prescription plan, there was worry about how this new competitor would affect the other companies in the prescription market, including pharmacy benefits managers. However, the long-term effect will probably be less than expected for a few reasons. First, most of Walmart's prescriptions come from drugs that have long been found in generic form, such as amoxicillin. Drugs that recently lost patent and those to do so soon are not included at this time. Second, Walmart doesn't have a specialty pharmacy segment. Finally, because the $4 mostly helps the uninsured, Pharmacy benefits managers are additionally protected: the plan doesn't decrease the cost of drugs to the insurer or plan provider.

However, Walmart's move does raise an important question for Medco about the role and viability of remaining a stand-alone PBM. Especially in consideration of the CVS/Caremark merger, Medco's strength and market position as strictly a PBM seems threatened by companies which are both PBM and drug retailer. Still, thus far, being a standalone has not hurt Medco's business--in fact, in the case of the Caremark merger, it may lead to a few more contracts as CVS' retail competition looks for an outlet.

Demand for greater transparency, more rebates

In an already super-competitive market, pharmacy benefits management companies like Medco Health Solutions are subject to additional pressure on two fronts. First, clients are demanding greater transparency from companies about business models and costs of drugs, as well as more rebates. Some of the mistrust comes from the assumption that if PBMs don't show clients information, then they must be short-changing them. Thus far, MedcoHealth has done a sufficient job of making disclosures without hurting their business model by offering plans that are more transparent and by passing more rebates to the client in exchange for higher administrative fees.

On a second front, several states have recently attempted to pass legislature to put further constraints on PBM practices. (Thus far, it has only passed in Maine and Washington D.C., but this is small consolation. In the future, the government, employers, and health plans are likely to continue pushing for better benefits and lower costs from PBMs.

The Democratic Congress and Medicare

With the recent victory of the Democrats in the House and Senate, there has been some fear of backlash for PBMs like MedcoHealth because of the Democrats' dislike of many aspects of the current health care system, including Medicare Plan D. However, since 2008 is an election year, it is unlikely that Democrats will push for short-term changes, especially considering the slim majorities that the Democrats hold in both houses.

Baby boomers, other trends outpace inflation

In the next few years, Medco stands to profit from several trends in the health care and prescription drug markets, especially as a result of the aging population in the U.S.

According to the Kaiser Family Foundation, there is a direct correlation between prescription drug utilization and spending, age, and the prevalence of chronic and other serious health problems. It is estimated that on average, older individuals tend to use three times more prescription drugs than do younger individuals. Thus, the high level of chronic illness among America's aging baby boomers should drive further expansion for mail-order dispensing and specialty pharmaceuticals, which should boost margins.

Medicare-eligible patients usually use more prescription drugs than non-Medicare populations do, and since the U.S. Census Bureau is forecasting that the U.S. population over the age of 65 is expected to increase approximately 3% per year for the next thirty years, prescription drug utilization is likely to increase. Medco is in a good position to capitalize on this, as it is one of the few companies contracted to offer plans for Medicare patients.

Health Care inflation, particularly as it relates to prescription drugs, continues to be a concern for payers, providers, and patients. The Centers for Medicare and Medicaid Services projects that prescription drugs costs will increase about 8.2% per year for the next eight years. Because PBMs have a history of reducing prescription drug costs by up to 25%, plan sponsors will likely continue to turn to PBM services designed to lessen drug expenses and improve patient outcomes.

Competition Metrics

Although Medco is one of a small number of PBMs that are publicly traded, there exist a large number of PBMs. In addition to several independent PBMs like Medco, a sizeable number of PBMs are owned by other types of businesses, including managed care organizations like WellPoint, Coventry Health Care (CVH), and UnitedHealth Group (UNH). Drug retailers like CVS are also in the PBM business, which already had a fairly sizable PBM prior to joining with Caremark.

Soon after CVS revealed its intention to bid for Caremark, Express Scripts also made a bid for it. Medco elected to watch the bids play out, as it stood to profit either way. Since CVS has become the apparent victor, its retail pharmacy competitors have agreed to give Medco better pricing in return for better volume from their customers. (This stems from non-CVS retail chains’ fears that the combination of CVS and Caremark would tilt the retail scales in favor of CVS stores.) Medco CEO Snow also said Medco believes they can take advantage of disruptions related to merger integration to pick up some incremental business.

CVS/Caremark's financial information is generated from the CVS annual report and includes non-pharmacy store sales.

References