Caremark Leads Rally in Its Sector

Strong earnings boost Express Scripts and Medco as well.
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Embattled pharmacy benefit managers continue to soothe Wall Street with super-strength earnings.

Caremark

(CMX)

issued particularly healthy results, posting record third-quarter profits and offering new guidance that topped consensus estimates. Smaller

Express Scripts

(ESRX)

delivered an upside surprise of its own, although a larger-than-expected charge for legal expenses -- associated with a new probe by New York Attorney General Eliot Spitzer -- reminded investors that the PBM industry remains under fire.

For now, however, Wall Street continues to focus on soaring PBM profits and considers legal challenges a mere footnote in the industry story.

J.P. Morgan analyst Lisa Gill was quick to gush about Caremark's "great" results in particular. The company posted third-quarter profits of 38 cents a share that came in 41% higher than a year ago and beat the consensus estimate by 3 cents. Revenue more than tripled to $7.5 billion following the company's big acquisition of Advance PCS.

Looking ahead, Caremark now expects to deliver fourth-quarter profits of 43 cents to 44 cents a share instead of the 42 cents analysts were anticipating. In addition, the company issued new 2005 guidance of $1.88 to $1.92 a share that's well ahead of the current $1.83 consensus estimate.

Following the report, Gill reiterated her view of Caremark as the best investment in the highly profitable PBM sector.

"The fundamentals of the PBM industry are strong," Gill wrote. And "we believe the strong quarterly results and forward outlook provided this morning additionally serve to reinforce our thesis that Caremark is the name to own within the PBM group."

Shares of Caremark rocketed 6.1% to $33.17 on the upbeat news.

Express Scripts posted smaller gains, climbing 1% to $68.59, after legal matters caused profits to drop from a year ago and delayed the company's 2005 guidance. The company generated third-quarter net income of 80 cents a share that was a penny lower than last year. Excluding special items, however, it posted earnings of $1.00 a share that beat the consensus estimate by 2 cents. Revenue jumped by 16% to $3.8 billion due in part to drug price inflation.

Industry critics blame PBMs for at least some of the rapid rise in prescription drug costs in recent years. They claim that PBMs rake in huge sums on generic drugs in particular. They also question whether PBM mail-order pharmacies -- an especially profitable line of business -- save customers money like they should.

But PBMs like Express Scripts insist they save their clients plenty.

"We are very proud of the work we have done in developing strategies that help clients manage their prescription drug trend," Express Scripts CEO Barrett Toan said on Thursday. "By increasing savings for our clients through higher generic drug use and more mail pharmacy services, including specialty drugs, Express Scripts' profitability has improved, demonstrating that our interests our aligned with our clients and their members."

Still, Spitzer has claimed otherwise. He has accused the company of overcharging New York state customers in a new probe that led to a $25 million hit to earnings in the latest quarter. The company had previously expected to reserve between $15 million and $20 million for the new legal expenses instead.

Analysts did express some concern about that change.

"This ... may reflect an increasingly unfavorable legal landscape," wrote First Albany analyst Glenn Garmont, who nevertheless maintained his "strong buy" recommendation on the company's shares.

In addition to Spitzer, more than 20 state attorneys general are now investigating Express Scripts' business practices. They have launched a similar probe of Caremark as well. And many of them have already secured settlements from

Medco

(MHS)

. The PBMs have denied any wrongdoing.

Medco remains under investigation by the federal government, however. Some industry critics believe analysts should take that particular probe more seriously and warn of a huge fine that could far exceed Wall Street's highest estimates.

In the meantime, Medco has already lost huge chunks of business -- including a big contract with the federal government -- since the investigation started. But at least one analyst, who upgraded the stock on Wednesday, believes Medco has undergone some changes and shows signs that it's on the mend.

"Based on our conversations with industry consultants,

Medco's push towards transparency appears to have yielded benefits in the second half of the selling season," wrote Raymond James analyst Michael Baker. "We believe the initiatives to draw strong ties with clients ... will help to improve retention going forward as well."

Medco climbed with the group on Thursday, jumping 2.6% to $36.94 a share.