Healthy Numbers at Medco

The big pharmacy benefit manager continues to roll up impressive quarterly profits.
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Medco

(MHS)

has delivered another healthy quarter.

The giant pharmacy benefit manager on Tuesday reported that revenue climbed 1.8% to $9 billion -- topping the $8.87 billion consensus estimate -- while net income jumped 7.9% to $137 million during the second quarter. Excluding special items, the company posted second-quarter profits of 58 cents a share that matched Wall Street expectations exactly.

Medco boasted on Tuesday that it has now produced "consistent financial results in the eight successive quarters" since the company's spinoff from drugmaker

Merck

(MRK) - Get Report

. For 2005, the company said that it won new business that's ultimately worth some $3.4 billion in annualized revenue. And for 2006, it said that it has already added another $600 million worth of new business to its books.

For the rest of this year, Medco says it will focus on two "top priority initiatives" that represent significant growth opportunities for the company. First, it will work to integrate

Accredo

(ACDO)

in an effort to create the largest specialty pharmacy in the nation. Second, it plans to take the steps necessary to help ensure the successful launch of its Medicare Part D offering when 2006 kicks off.

In the meantime, Medco has tightened its 2005 guidance to between $2.38 and $2.42 a share. Analysts were already expecting full-year profits to fall at the midpoint of that new range.

Medco inched up 17 cents to $48.39 on the quarterly update.

Strong Season

Leerink Swann analyst Ann Hynes this week predicted a strong earnings season for the PBM group as a whole. She singled out Medco as her top pick while recommending

Caremark

(CMX)

and

Express Scripts

(ESRX)

as well.

Hynes predicted that Medco would in fact match Wall Street expectations for the quarter and, more importantly, provide a reassuring outlook for the future. She pointed out that Medco has already kicked off its 2006 selling season with a bang, racking up "meaningful" state contract wins in Illinois and the Carolinas. In addition, she suggested that concerns about

UnitedHealth

(UNH) - Get Report

-- which ranks as the company's largest client -- seem to be overblown.

Earlier this month, Medco took a hit after UnitedHealth announced plans to acquire a major health plan --

PacifiCare

(PHS)

-- that operates a PBM of its own. But Hynes, for one, sees no real threat as a result of that deal.

"The scale of operations of PHS' PBM, combined with UNH's recent contract extension (through 2010) with MHS, provides us with confidence that MHS is well-positioned to retain this business," Hynes explained.

Moreover, Hynes has predicted that Medco's "new strategy of increased transparency" will bring the company even more business in the future.

Leerink Swann consultants "believe that the recent wins by Medco on the state level were directly influenced by the company's new approach to dealing with clients and increased transparency," Hynes wrote last week. Thus, the consultants feel that "the pendulum has swung in favor of Medco" this selling season.

Hynes views 2005 as a "recovery year" for the company. Going forward, however, she sees an "extremely compelling" earnings picture and ultimately a "banner year" in 2006.

By now, Hynes has pointed to several developments that could drive profits higher. For starters, she notes, Medco will be free to repurchase its stock after a restriction -- tied to its separation from Merck -- expires in August. In addition, she says, the company's pending acquisition of Accredo should further boost results. In the meantime, she looks for a number of favorable industry trends -- including growth in mail-order prescriptions, generic utilization and specialty pharmacy sales -- to keep helping out as well.

"As a result of these strong tailwinds in 2006," she says, "MHS is our top pick in the PBM sector."

Cautious Tone

Morgan Stanley analyst David Veal is decidedly more cautious. This month, in fact, Veal downgraded Medco from overweight to equal weight due to potential threats to the industry.

"We believe that, in the quarters ahead, gathering regulatory headwinds will offset much of the upside associated with powerful secular catalysts," Veal explained. "These countervailing trends, when combined with historically rich valuation, bring risk and reward into balance and make a more cautious rating appropriate."

Veal cut his rating on Medco after a recent court ruling went against the industry. PBM critics have been seeking enhanced transparency from the companies in an effort to bring spiraling drug costs under control. The companies have fought back by saying the added disclosures would hurt competition and simply make the situation worse. In the meantime, however, all three major PBMs already have attracted government probes into their business practices.

Veal, for one, sees tougher times ahead.

"We believe that the regulatory environment has reached a tipping point, after which it will begin to erode the economics of the business," he wrote in his downgrade of Medco this month. "We expect that the news flow to come on this topic will become increasingly negative, weighing on investor sentiment."

Indeed, Wall Street already expects regulatory challenges to cost Express Scripts one of its biggest clients. Many are assuming the company will soon lose its $1 billion contract in New York, where Attorney General Eliot Spitzer has been investigating the company for nearly a year. The company stands accused of pocketing excess profits and saving its customers less than it should. It has denied any wrongdoing.

Shares of Express Scripts climbed 58 cents to $49.10 on Tuesday.

Playing Favorites

Still, SIG Susquehanna analyst Michael Maguire likes the company's two larger competitors better.

For one thing, Maguire believes that Express Scripts will fall shy of expectations when it posts second-quarter results on Wednesday. For another, he says that the company continues to face renewal risks even after losing some major accounts. Finally, he raises doubts about the takeover possibilities that some investors seem to be banking on.

Thus, Maguire found himself recommending Medco and Caremark ahead of this earnings season instead. He is especially bullish on the latter name.

Maguire is looking for Caremark's acquisition of AdvancePCS to help boost second-quarter profits by some 51% to 45 cents a share on revenue of $8.1 billion. Those projections actually fall short of consensus estimates. However, Maguire portrays some of the company's most important metrics as the best in the group.

For example, he says, Caremark enjoys an especially strong earnings before interest, taxes, depreciation and amortization per adjusted prescription.

"Our 2Q EBITDA/adjusted script estimate of $2.18 is substantially higher than our estimate at ESRX ($1.08) and MHS ($1.92)," Maguire wrote earlier this month. "Caremark is currently the most profitable of the three PBMs" based upon this metric.

Ultimately, Maguire believes that Caremark's purchase of AdvancePCS has left the company better positioned than most.

"We believe the deal remains undervalued," Maguire wrote. "The company's increased market share and breadth of offering should allow Caremark to capture a disproportionate share of new business, in our view."

Caremark jumped 76 cents to $42.54 following news of Medco's results.