Intrinsic Value Assessment Of Express Scripts Co. (ESRX)

INTRODUCTION

Express Scripts Holding Co. is an American pharmacy benefit management (PBM) company whose principal business involves network-pharmacy claims processing, home delivery pharmacy services, and specialty pharmacy benefit management. Express Scripts Co. is currently a member of the Fortune 500 list with a market cap of $36.5 Billion. Its revenues and free cash flows for the previous financial year were around $100.3 Billion and $4.6 Billion respectively. The company’s common stock has fluctuated between a low of $56 and a high of $77 over the past 52 weeks and currently stands at around $65. Is Express Scripts Co. undervalued at the current price?

THE INTRINSIC VALUE OF EXPRESS SCRIPTS CO.

To determine the intrinsic value of Express Scripts Co., we’ll begin by looking at the company’s history of free cash flow. A company’s free cash flow is the true earnings which management can either reinvest for growth or distribute back to shareholders in the form of dividends and share buybacks. Below is a chart of Express Scripts Co.’s free cash flow for the past ten years.

As one can see, the company’s free cash flow has been on a strong upward trend, growing at an annual rate of over 22% for the past ten years. This growth has been driven by a consistent increase in demand for the company’s services. To determine Express Scripts Co.’s intrinsic value, an estimate must be made of its potential future free cash flows. To build this estimate, there is an array of potential outcomes for future free cash flows in the graph below.

When examining the array of lines moving into the future, each one represents a certain probability of occurrence. The upper-bound line represents a 6% growth rate. Since the 10-year historical rates of free cash flow and revenue were over 20%, the author has applied a 6% projected growth rate for the upper-bound line. This represents the projected growth rate of prescription medicine expenditures from 2015-2025, which functions as a reasonable proxy for a best-case growth scenario. This has been assigned an 8% probability to account for the fact that the PBM market is facing major disruption from the emergence of online competition such as Amazon, and for the fact that Express Scripts Co. will not be securing a renewal to the present contract it has with its largest client, Anthem Inc.

The middle growth line represents a 0% growth rate. This rate has been assigned a 46% probability of occurrence and assumes that the company can compensate for the loss in revenue from the Anthem Inc. contract by securing alternative revenue streams — either through a rumored partnership with Amazon or other new client contracts. The lower bound line represents a -10% growth rate in free cash flow growth and has been assigned a 46% probability of occurrence. This lower bound rate is based on the fact that Express Scripts Co. has lost its largest client contract with Anthem Inc. which accounted for 31% of FY2016 EBITDA. In dollar terms, this is a loss of $2.25 Billion. It also assumes that management is unable to compensate for this loss by securing the rumored partnership with Amazon or developing alternative revenue streams. Assuming these potential outcomes and corresponding cash flows are accurately represented, Express Scripts Co. might be priced at a 9.0% annualized return if the company can be purchased at today’s price. We’ll now look at some other valuation metrics to see if it corresponds with this estimate.

Based on Express Scripts Co.’s current earnings yield, which is the inverse of its EV/EBIT ratio, the company is projected to return around 11.30%. To account for the aforementioned contract loss, we’ll deduct 31% from the numerator. This gives us an earnings yield of around 7.9%. This is still above the firm’s 13-year historical median average of 6.40% and the Industry median of 6.07% suggesting that the company is marginally undervalued relative to the industry and its historical average. On a simple P/E basis, Express Scripts Co. currently trades at 10.68x. If we apply the 31% earnings discount, we get x15.48 versus a 13-year historical median average of 25.71 for the company and 19.90x median average for the Health Care Plans industry. Finally, we’ll look at Express Scripts Co.’s P/S ratio, a metric useful for estimating the fair value of a company relative to its revenue. In this instance, the Anthem Inc. contract accounted for 17% of FY2016 revenues, and so we’ll deduct this from the numerator to see what effect it has. This takes the current P/S ratio of 0.38 to 0.48, which suggests the company is still below a fair value of 1.

Taking all these points into consideration, it seems reasonable to assume that Express Scripts Co. appears to be trading at a discount to fair value even when factoring in the loss of the Anthem Inc. contract. Furthermore, the company may return around 8% at the current price if the estimated free cash flows are achieved. Now, let’s discuss how and why these free cash flows could be realized.

THE COMPETITIVE ADVANTAGE OF EXPRESS SCRIPTS CO.

Express Scripts Co. has various competitive advantages outlined below.

• Economies of Scale. Express Scripts Co. currently accounts for 30% of claims volume in the U.S. Its size creates scale advantages which enable it to outperform its peers on most of the key performance metrics. These are detailed in the chart below.

• Sticky Client Base. It is very difficult for Express Scripts Co.’s clients to switch the benefit plans of their employees and plan members since this involves a lengthy and costly process of selecting new preferred drugs and pharmacy networks. This stickiness is reflected by a projected 2017 customer retention rate of between 95-98%.
• High Barriers to Entry. There are high barriers to entry in the healthcare industry due to substantial government regulatory costs. This limits the number of new entrants likely to enter the space, and recent history has shown a trend of consolidation taking place as the larger players cement their position.
• Oligopoly Status. The chart below shows the oligopoly status of Express Scripts Co. within the PBM market. At present, three firms account for 73% of market share and Express Scripts Co. leads the way with 28%. Not only is this greater than that of its closest two competitors, but it also eclipses the combined market share of the remaining players in the PBM market. Readers should note that Express Scripts Co.’s market share is likely to decline in the future if it is not able to compensate for the loss of the Anthem Inc. contract which expires at the end of 2019.

EXPRESS SCRIPTS CO.’S RISKS 

Now that Express Scripts Co.’s competitive advantages have been considered, let’s look at some of the risk factors which could impair my assumptions of investment return.

• While Express Scripts Co. possess multiple competitive advantages, there still exists a possibility that one of its rivals could mount a challenge to erode its competitive advantages and move on its market share. CVS Health Corp. is on the verge of acquiring health insurer Aetna Inc. which will strengthen its position and potentially weaken that of Express Scripts Co.
• Changes in or failure to comply with government regulation could materially impact Express Scripts Co.’s revenues and earnings. The healthcare industry is heavily regulated, and this can both be a blessing and a curse. The regulation creates high barriers to entry which limits competition, but it can also result in large financial penalties if companies fail to adhere to it.
• The emergence of a serious economic crisis similar to that witnessed in 2008 could materially impact the company’s revenues and profits leading to lower growth in the coming years. While Express Scripts Co. possesses numerous competitive advantages, a fall in consumer confidence and spending would be detrimental to the company’s economic performance.
• The PBM market is currently experiencing significant disruption as Amazon is making moves to enter the space. Should Amazon strike a partnership with one of Express Scripts Co.’s competitors or form its own PBM network, this would likely have a negative impact on the latter’s growth prospects.

OPPORTUNITY COSTS

Whenever an investment is considered, one must compare it to any alternatives to weigh up the opportunity cost. At present, 10-year treasuries are yielding 2.37%. If we take inflation into account, the real return is likely to be closer to 1%. The S&P 500 Index is currently trading at a Shiller P/E of x 31.4 and, at present, is likely to return around 2-3%. Express Scripts Co. appears to be trading below fair value at present and should offer a higher rate of return than both U.S. Treasuries and the S&P 500 Index. There are, however, other individual stocks to be found which may offer a more favorable return relative to the risk profile.

MACRO FACTORS

Investors must consider macroeconomic factors that may impact economic and market performance as this could influence investment returns. At present, the S&P is priced at a Shiller P/E of 31.4. This is around 87% higher than the historical average of 16.8, suggesting that markets are at elevated levels. U.S. unemployment figures are at a 30-year low suggesting that the current business cycle is nearing its peak. U.S. private debt/GDP currently stands at 199.6% and is at its highest point since 2009 when the last financial crisis prompted private sector deleveraging.

SUMMARY

The future for Express Scripts Co. looks uncertain at present. Consolidation within the PBM market will likely strengthen the position of the firm’s competitors, and the entry of Amazon into the space will cause major disruption. Express Scripts Co. CEO Tim Wentworth recently expressed interest in a partnership deal with Amazon or one of the major health insurers. But to assume this will occur is somewhat speculative at present. The company has recently completed a $3.6 Billion acquisition of medical benefits management firm Evicore Healthcare which management has described will make Express Scripts Co. “an even more powerful partner in managing costs for patients and payers” by “bringing us closer to our goal of becoming the nation’s leading patient benefit manager.”

Readers should note that Express Scripts Co.’s financial strength is weaker than its competitors. The firm currently has a D/E ratio of 0.9 versus an industry average of 0.7. The company’s liquidity position is also of concern as evidenced by the fact that its current and quick ratio presently stands at 0.73 and 0.59 respectively. Management has a reasonable track record of being shareholder-friendly, having returned around $4.7 Billion to shareholders in share buybacks in FY2016. Though it currently does not distribute any earnings as dividends. Furthermore, the company has managed to achieve an annualized growth rate in book value of over 38% during the last ten years. In that timeframe, the company also achieved an average ROIC of over 15%.

At present, Express Scripts Co. appears undervalued with an estimated return of around 9%. While the company’s stock price is currently trading at a discount to fair value, there are several areas of concern which investors must consider carefully before contemplating an investment.

To learn more about intrinsic value, check out our comprehensive guide to calculating the intrinsic value of stocks.