Musing About Medco (MHS)
January 27, 2011
Medco Health Solutions (MHS) manages the pharmacy benefits for over 65 million people in employee groups, government agencies, and unions as well as for participants in Medicare PartD, and is the nation’s largest Pharmacy Benefit Manager. Through its mail-order pharmacy and network of retail pharmacies, MHS filled some 900 million prescriptions in 2009.
MHS was the monthly Online Stock Study for January 2011 at the Better Investing website. It was led by Avi Horwitz, a director of the BI Volunteer Advisory Board and a Director of the BI New York Chapter. Avi’s handouts, Presentation Slides, Follow-up Q and As, the Consensus SSG, and the recording of the online session are all available to BI members.
Company Background:
- Medco Health Solutions (MHS) went public seven years ago as a spin-off from Merck and was recently featured as the Stock To Study in the November 2010 issue of Better Investing magazine. According to BI’s thorough article:
- Medco is organized into two reporting sections: Pharmacy Benefit Management (PBM), 84.1% of 2009 revenues, up 16.2% from 2008 and Specialty Pharmacy (SP), 15.9% of 2009 revenues, up 19.5%.
** PBM contracts with retail pharmacies to fill prescriptions at discounted prices to patients covered by drug plans that Medco administers. In 2009, MHS contracted with some 60,000 pharmacies.
** PBM also operates Medco Pharmacy, its mail-order division and the largest in the industry, which filled 103 M prescriptions in 2009.
** SP operated three mail-order and 78 specialty pharmacies in 2008 which provided higher margin drugs for patients with chronic or complex diseases.
** SP also provides services such as in-home nursing, special packaging, and benefits administration.
- Medco filled a total of 694 M prescriptions in 2009, up 18.5% from 2008. Mail-order products accounted for 37.4% and retail products 61.2% of MHS’s revenue.
- According to the Morningstar analyst report, MHS earns most of its margins on generic drugs and an unprecedented number of brand-name drugs are about to lose their patent protection.
** In 2012, generic Lipitor may add 8.00% to Medco’s EPS. Other blockbuster drugs losing patent protection around the same time as Lipitor are Plavix, Seroquel, Singulair, and Cymbalta.
- And, in the past 5 years, MHS has spent a whopping $10 B on share repurchases, some 40% of its current market cap.
** Shares outstanding have gone down 20% in the last five years, from 576.20 to 481.1 M in 2009.
** As shares go down, EPS goes up (but this is an artificial increase as it is not derived from operations).
Recent Acquisitions and Joint Ventures:
- Acquisitions have been a major part of Medco’s growth:
- In October 2007, Medco acquired PolyMedica, a diabetes care provider and its Liberty Medical Supply brand, for $1.3 B in cash;
- In November 2007, Accredo Health Group (Medco’s specialty pharmacy) acquired Critical Care, a large provider of specialty infusion services, for $220 M;
- In April 2008, Medco acquired a majority interest in Europa Apotheek, a mail order pharmacy serving Netherlands and Germany, for $126.8 M in cash and a $24.1 M purchase obligation;
- In 2009, Medco formed a joint venture with United Drug plc to provide home based pharmacy care to patients covered by the U.K.’s National Health Service;
- In January 2010, Medco bought DNA Direct, a small, privately held fiem that provides utilization review and counseling by telephone for genetic testing (terms were not released); and
- In September 2010, Medco acquired United BioSource, a company that evaluates newly approved drugs and medical devices, for $730 M.
- These acquisitions have meant a high debt burden for Medco: 46.5% Debt to Total Capital when I did my SSG with long-term debt increasing from $944 M to $4,000 M in the last five years, an increase of 320%.
- Debt to Equity has also increased, from 15.0% in 2005 to 61.8% in 2009.
SSG Discussion:
- The following table compares the Consensus & Avi SSG with mine, Take Stock, and Avi’s 45-day earlier SSG. After the table, I discuss several key SSG issues and dig a little deeper into MHS’s Pretax-Profit Margin and Return on Equity, and its Financial Condition.
| Medco Health Solutions (MHS) | Consensus & AviH | Armin | Take Stock | AviH from BI’s First Cut |
| Date | 12-30-10 | 12-22 Data 12-30 Price | 12-30-10 | 11-12-10 |
| Data | Mstar via BI See fn [1] | Same | Mstar via SC See fn [1] | S&P via BI See fn [1] |
| Price | $61.80 | $61.89 | $61.67 | $59.00 |
| 52 week High & Low Price | $66.94 & $43.45 | $66.94 & $43.45 | Not Used | $66.94 & $43.45 |
| Last Quarter of Reported Data | Q3 ending 9-30-10 | Q3 ending 9-30-10 | Same | Same |
| Software Used | Online SSG See fn [2] | TK 6 | TS Online | Online SSG See fn [2] |
| Project Growth From End of | Last FY See fn [2] | Last Q | Last FY | Last FY See fn [2] |
| Sales Growth | 7.50% | 13.00% | 09.20% | 07.50% |
| EPS Growth | 16.80% | 13.00% | 20.00% init 06.85% final | 16.20% from Avi’s PP |
| High PE | 25.0 | 20.0 | 24.8 | 25.0 |
| High EPS | $5.67 | $5.51 | $3.63 | $5.44 |
| High Price | $141.75 42% > new VL | $110.20 10% >new VL | $90.03 | $136.00 43% > old VL |
|
Value Line Est High Price = 80-100 as of 12-24-10 and $75-95 as of 9-29-10 |
||||
| Low PE | 14.0 | 12.3 | 14.2 | 14.0 |
| Low EPS | $2.99 (ttm) | $2.93 (ttm) | Same | Same |
| Low Price | $41.86 (Low PE x Low EPS) | $36.80 (Same) | $42.46 | $41.02 (Same) |
| Upside/Down | 4.02 | 1.9 | 1.48 (imputed) | 4.29 |
| Total Return | 18.08% | 12.2% | 7.9% | 18.19% |
| SSG Buy Under | Not Used | $54.79 | $45.02 | Not Used |
| RV/PRV (outliers elim) | Not Used | Not Used | Not Used | Not Used |
| RV/PRV (no outliers) | Not Used | 90.8/80.3 | Not Used | Not Used |
| Quality | Not Available | S&P = Not Rated | TS = 6.3 (good) | Not Available |
| PTPM – 5 yr ave | 3.06% Trend NA | 03.10% Trend even | 3.10% Trend NA | 03.13% Trend NA |
| ROE – 5 yr ave Ending Yr Equity | 13.24% Trend NA | 13.20% Trend up | Not Used | 13.13% Trend NA |
| ROE – 5 yr ave Begin Yr Equity | Not Used | 13.8% Trend up | Same Trend NA | Not Used |
| Debt to Equity – 5 yr ave | Not Used | 38.6% Trend up | Same Trend NA | Not Used |
[1] On 12-22-10, Better Investing and StockCentral changed their SSG data provider to Morningstar and the new data also comes with a long-term EPS estimate from Zacks. Previously, BI got its SSG data and EPS estimate from S&P while SC (and Take Stock) got their SSG data from Morningstar-Hemscott.
[2] On 11-19-10, the BI Online SSG added the capability to project future growth from the end of the last Quarter, the last Fiscal Year, or the historical Trend line. Our TK 6 software always had those options. Previously, the Online SSG only projected from the end of the last FY and here Avi chose to project from the last FY on 12-30-10, but had no choice on 11-12-10.
Estimating Future Sales Growth for the Next 5 Years:
** “None of the above” is not a meaningful choice that I will not repeat.
** The consensus (40% of the votes) chose 7.0%, Mstar’s optimistic estimate, while the next highest vote-getter (31%) was Yahoo’s estimate of 5.0%.
** The future Sales growth decision is important only because Avi used the BI/NAIC Preferred Procedure to decide future EPS growth and the PP turns on this issue.
- Choices that Avi did not offer the participants were: 11.6%, historic sales growth last 5 years; 15.7%, last 3 years; 16.7% last 2 years; 11.53% Zacks.com sales growth estimate for the next 5 years; and, the most surprising omission, 6.2% Mstar’s conservative estimate.
Estimating Future EPS Growth for the Next 5 years – Part 1:
- Avi provided three (meaningful) choices: 23.0%, MHS’s historic EPS growth; 16.5%, Yahoo Finance’s estimate for the next 5 years; 7.0%, same as the group’s Sales growth choice.
** The Consensus choice (46% of the votes) was 7.0%, same as its Sales growth estimate, and the next highest vote getter was 16.5%, Yahoo’s estimate.
Estimating Future EPS Growth for the Next 5 years – Part 2:
The Consensus/Avi SSG:
- Avi threw out the above two Consensus choices in order to use the NAIC/BI Preferred Procedure to estimate MHS’s future EPS growth
.
** The PP is like a simplified income statement and involves four estimates for the next 5 years: Sales Growth (less) Pre-Tax Profit Margin (less) Taxes (divided by) Shares Outstanding (equals) future EPS Growth.
** Avi began with 7.5% future Sales growth and did not explain why he disregarded the earlier 7.0% Consensus choice.
** He gave the participants 4 choices to decide the PTPM: 3.1%, MHS’s 5 year historical average; 3.5%, the most recent year PTPM; 4.4%, the most recent year & Mstar’s best case scenario; and 5.5%, the most recent year & Mstar’s optimistic case scenario.
### The consensus (69% of the votes) chose 4.4% PTPM.
** Avi used the default value for Taxes, the 5 year average of 39.2%, and did not offer any choices to the participants.
** Avi revised the default value for Shares Outstanding from 429.9 M to 405 M shares, and again did not offer any choices to the participants.
*** The mostly-Avi PP resulted in a 16.8% estimated EPS growth rate (compared to the initial 7.0% chosen by the Consensus) which he used for the Consensus/Avi SSG.
*** I no longer use the PP because it involves too many estimates and too much guesswork for me; if you want to learn more about the PP, see: Pondering The Preferred Procedure, click here.
Armin’s SSG:
- I ALWAYS check 7 long-term EPS estimates for every SSG I do and the average for MHS was 16.37% with 18.00% the highest (by CNNMoney via FactSet CallStreet) and 13.00% the lowest (by Value Line).
** As mentioned in footnote 1, Better Investing and Stock Central both changed their SSG data provider to Morningstar on 12-22-10. The Mstar data comes with a long-term EPS estimate from Zacks which, I discovered, is consistently different from the long-term estimate that’s available free from Zacks.com.
### I now check both Zacks estimates.
** I decided to use 13.00% which was the lowest estimate (from VL) and also the lowest estimate by one of the 15 analysts at Reuters.com (who ranged from 20.6%-13.0%).
** For how I estimate EPS for all my SSGs and the seven estimates I always check, see: Estimating EPS, click here.
Final Results:
- The Consensus/AVI SSG started with 16.80% projected EPS growth and a High PE of 25.0 that resulted in a Forecast High Price for the next 5 years of $141.75, a whopping 42% greater than the high end of VL’s current estimated $80-100 High Price.
- Avi’s SSG, some 50 days earlier, was very similar and started with 16.20% EPS growth and a High PE of 25.0 that resulted in a Forecast High Price of $136.00, and was still a whopping 43% greater than VL’s earlier estimated High Price of $75-95.
- I started with 13.00% projected EPS growth and a Forecast High PE of 20.0, both much lower than Avi, and got a Forecast High Price of $108.00, only 14% greater than VL’s current estimate.
** I never want to substantially exceed (or fall below) VL’s estimated High Price, at least not without some good reason, and this is one step I use to evaluate the reasonableness of SSG judgments; see: Determining What’s Reasonable and What’s Not: An Update, click here.
** The Avi/Consensus SSG got an 18% Total Return primarily because Avi’s Forecast High Price was 40% greater than VL’s estimate and was unreasonably high in my opinion. And, to ignore VL’s estimate seems irresponsible to me.
Projecting Future Growth:
- Avi made a big deal that it makes little or no difference whether future growth is projected from the last quarter or from the last fiscal year.
- He’s mistaken and that’s not good advice. Our judgment as to where project future growth can be the difference between a SSG Buy and a SSG Don’t-Buy. See:
** Counting on Coach (COH), August 1, 2010: AnnC projected future growth from the end of the last FY and got a SSG Don’t Buy while I used the same judgments and price as Ann, but projected from the last Q, and got a SSG Buy; for more, click here.
** Appraising Aeropostle (ARO), April 9, 2010: same with BudS; click here.
- These results don’t happen every time, but they can happen any time, especially when the last Q is the third quarter.
Pre-Tax Profit Margin (PTPM) and Return on Equity (ROE):
- Is MHS outperforming or underperforming its industry averages for PTPM and ROE? Even though these trends are not going down, which is usually a troubling sign, I still want to know if Medco is better or worse than other companies in its industry. In other words, is MHS a leader or a laggard?
- In terms of PTPM, MHS is well below its industry average with Morningstar data (3.1% vs 5.6%, Health Care Plans industry) and ranks 16th out of 19 companies with 8.8% high and 2.3% low.
** Express Scripts (ESRX), the only direct competitor in this industry, was 9th with a 4.8% PTPM.
- In terms of ROE, MHS is slightly below its industry average (13.2% vs 14.8%) and ranks 10th out of 19 companies with 48.9% high and 7.4% low
** However, if I eliminate the 48.9% as an outlier, MHS is slightly better than its adjusted industry average (13.2% vs 12.7%) and ranked 9th out of 18.
** ESRX was the #1 company with a 48.9% ROE.
Financial Condition:
- Value Line gave MHS an A+ for Financial Strength and found its Balance Sheet in “decent shape” as of 12-24-10 with cash declining some 63% to $945M due to share repurchases and weaker cash flow.
** Debt also increased by 25% to $45B in order to purchase United Bio Source Corp (UBC) for $730M.
- Morningstar found MHS to be in “good financial health” with more than $1 billion in cash and enough operating income to cover interest expense many times over [AF: unnecessarily vague].
** Mstar also observed that Medco spent $10 B in the last 5 years, 50% of its market cap, to repurchase its stock at an average price of $42 per share.
- The one-click Bob Adams’ Analyzing the Annual Report spreadsheet gave MHS’s 2009 A.R. a 54 out of 100 with 9 Bullish results (good things) and 9 Bearish (not-so-goods):
** The Bullish-goods included: debt, inventories, and shares outstanding decreased; ROE at 20% in 2009 got a green flag and was very good; interest coverage at 13.2x also was very good and also got a green flag;
** The Bearish not-so-goods included: Debt to Equity at 62.6% for 2009 got a red flag warning sign and may be excessive; gross profit margin was not growing and got a yellow caution flag; cost of sales was up 17% and was growing faster than sales.
### You can get this free, easy to use spreadsheet and a description of its many features by going to my Favorite Links page, click here.
Armin
** Your fedback is important to me so please leave a comment below and let me know what you think and/or rate this post by mousing-over and clicking one of stars also below.
** I’m concerned that this post might be too long: if you think so, please let me know which section(s) I might eliminate.
The “total Return” entry in your first column,”Consensus & AviH” is not correct.Given the other entries in that column it should be appx. 18%
Comparing MHS to other most companies in the Health Care Plans industry is misleading because their business models are so different.ESRX and CHSI are the only good comparisons that I know of.
Thanks Steve:
(1) You are right (and I was wrong) about the Total Return of the Consensus/Avi SSG. I made the correction in my table: that TR is now 18.08%.
I am tempted to add a sentence that an 18% TR is possible only because Avi used an outrageously high Forecast High Price, some 40% greater than VL’s estimate.
- What do you think?
(2) I was comparing MHS to its industry average, not to its competitors. I was also uncomfortable with Mstar’s industry classification, but did you know there is little agreement about who are MHS’s competitors other than ESRX:
Mstar includes CVS as a close competitor, Hoovers.com also adds Aetna as a top competitor, and YahooFinance has no data on competitors. Your suggestion about CHST was not mentioned.
I tried to compare MHS to its industry AND to ESRX. I’d eliminate the entire section if a few people thought that was better than leaving it in.
- Again, what do you think?
Armin
I agree that Avi’s estimates are on the very aggressive side.
I find that industry classifications are frequently bad and find valid comparisons sometimes takes a lot of research. Pure PBMs seem to be a rare breed and although CHSI is a PBM they have been placed into different industry groups than MHS and ESRX by most of the services we use.I assume that is related to the fact that they’re a small company.
I think that comparison of a company to competitors is very important but must be done carefully.
I love your posts. I get so much from them, both in trying to analyze your charts but also in reading your comments. (Maybe, especially the comments section.)
Thanks Roy, I appreciate your kind words.
Be sure to check out the Table of Contents (my Home Page) to see if anything else interests you.
And, come back often…
Armin