Express Scripts Is One of the Most Powerful Players in Healthcare

The delivery of pharmaceuticals to consumers involves many firms along the supply chain, and  Express Scripts (ESRX) is a dominant participant. The critical role it plays has given the company significant competitive advantages. We believe Express Scripts’ positioning will remain steady for years to come as demand for its cost-saving services grows.

Express Scripts’ core pharmacy benefit manager service assists pharmaceutical benefit payers with the fulfillment of member prescriptions. This entails processing prescription claims made by a client’s members and ensuring the claims comply with benefit plan parameters. Additionally, the PBM is responsible for paying the retail pharmacy on behalf of the client. Originally, PBMs would charge a fee per claim processed; however, the revenue structure for the industry has morphed into spread retention.

Major PBMs have increased their claim volume to the point that they can directly negotiate discounted drug pricing with manufacturers, distributors, and retail chains, which allows their aggregate client bases to obtain products more cheaply. The PBM can usually negotiate sufficiently large discounts to keep a portion of the discount and still provide its clients with highly advantageous drug pricing.

With approximately 1.3 billion adjusted claims processed in 2015, Express Scripts is the largest PBM. This dynamic positions the firm positively, as it can negotiate favorable supplier pricing and solid spread retention. More critically, however, the colossal claim volume processed by Express Scripts allows the firm to scale its centralized costs and leverage its asset-light capital structure into solid economic profits. The firm has some of the lowest selling, general, and administrative costs and highest operating profit per claim. These metrics have translated into significant economic profits.

Pricing Leverage and Scale Result in Wide Moat
We believe Express Scripts possesses a wide economic moat. The firm’s substantial claim volume gives it the opportunity to take advantage of two key industry drivers: superior supplier pricing leverage and unmatched centralized cost scale. With total adjusted claims at approximately 1.3 billion, the PBM can negotiate favorable drug pricing with suppliers. This gives it the advantage of expanding its client base by providing low-cost products while preserving its gross margins. Scale is also a source of competitive advantage, as each additional claim processed is more profitable than the previous one. Centralized and technology system costs are able to be spread across the entire level of claims, which clearly gives an advantage to larger PBMs. As a result of these factors, Express Scripts can produce top-tier gross and operating profit per adjusted claim. The firm’s significant advantages have produced outsize economic profits, and we believe this trend will remain in place over an extended period.

Increased Uncertainty Regarding Regulation
Among the biggest risks to Express Scripts are increased competition and regulatory change. Although Express Scripts’ competitive position has improved, aggressive pricing by competitors could still hurt profitability. For example, CVS (CVS) could be encouraged to underprice its PBM offering to drive more traffic to its retail stores. UnitedHealth (UNH) has built its internal PBM into a major player through insourcing and acquisitions, increasing competition in the space. While some healthcare policy reforms could benefit Express Scripts, like generic biologics legislation and expansion of insurance coverage to 32 million of the nation’s uninsured, other reforms could make it harder for Express Scripts to conduct business, such as PBM transparency requirements. If the Affordable Care Act were repealed, drug supply chain firms would face headwinds due to the lost benefit of drug demands from the newly insured patients.

From our perspective, management’s capital-management strategy has been outstanding over the past few decades, having built the firm into a pharmaceutical industry powerhouse through a series of acquisitions. Additionally, management has shown a propensity to buy back shares at excellent prices, creating value for shareholders. However, we believe recent operational missteps (involving a less-than-efficient integration of the Medco assets and a major contract dispute with Anthem (ANTM)) have prevented Express Scripts’ share price from reaching what we believe the firm is intrinsically worth.