Medco: Fresh Scrutiny on Old Deal - TheStreet

Medco: Fresh Scrutiny on Old Deal

Florida probes whether the company violated the terms of an 8-year-old government settlement.
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Medco

(MHS)

may have broken a promise to 17 state prosecutors.

Under fire in 1995, when it was still owned by

Merck

(MRK) - Get Report

, the pharmaceutical benefits manager signed a multistate agreement barring it from secretly favoring the drugs manufactured by its parent. But in September, just a month after beingspun off from Merck, Medco fielded a new complaint -- this one at the federal level -- raising familiar concerns.

The federal lawsuit, amended this month to add new details and charges, primarily accuses Medco of overstating efficiencies at its mail-order pharmaciesin order to dodge penalties and secure bonuses instead. But it also suggests that Medco has continued to favor expensive Merck drugs in what could be apossible violation of the company's 8-year-old settlement with state prosecutors.

For its part, Medco has denied any wrongdoing.

"No one is ever switched to a higher-cost medicine," David Machlowitz, Medco's general counsel, told analysts just after the federal lawsuit wasfiled. "The allegations ... in this complaint are either false, overblown or reflect an isolated incident here or there."

Medco CEO David Snow also downplayed the government's charges.

"I'd like to reassure you that, although we're dealing with this matter as an organization, we're certainly not obsessed with it," he stated.

But at least one Medco critic sees major risks ahead. He points out that Florida, one of the 17 states that settled with Medco, recently opened yetanother investigation of the company. And the Florida attorney general's office on Friday confirmed a link between the two probes.

"In 1995, one of the provisions

Medco agreed to was assurance of voluntary compliance," Bob Sparks, director of external affairs for Florida Attorney General Charlie Crist, told

TheStreet.com

. "That's basically what is being looked into -- whether they kept up with the provisions of that agreement."

The Medco critic suspects that Florida investigators will, in fact, uncover violations of the original settlement that have already been hinted at in the federal complaint. And if that happens, he says, thepunishment could be severe.

"When you violate an existing agreement," he said, "that's like the death penalty."

In essence, he said, the states that inked the deal could bar Medco from doing business there in the future. The Florida attorney general's office saidlast week that it could take some unspecified action if Medco has violated its settlement. But the company said on Friday that it has complied with the terms of the deal.

"We believe that we're living up to all of our obligations," Medco spokesman Jeff Simek said.

Medco shares tumbled 5% Monday to around $36 after Credit Suisse First Boston analyst Kevin Berg warned that PBMs in general had reached their "least promising risk/reward ratio" in more than a year. He was particularly cautious about Medco, which he cut from buy to neutral over valuation and other concerns. The company's stock started Monday's session just a quarter from their 52-week high of $38.

"We still contend MHS has greater legal risk than its competitors, even if the

federal charges ... so far lack the breadth we were fearful of only a few months ago," Berg wrote. "We think the market -- which originally overlooked many of MHS's specific strengths -- has now begun to overlook potential problems" instead.

Bad Rep

Still, even Berg raised no concerns about Medco's old settlement with the states. In general, Wall Street appears to have forgotten about it altogether.

In fact, analysts seem only mildly concerned -- at worst -- about the current probe of the company. Since the federal government filed its lawsuit, only Wachovia has downgraded the stock, while two other firms have actually raised their ratings. Nobody recommends selling the shares.

"We do not believe the ... allegations diminish the company's strong near-term earnings visibility," explained First Albany analyst Glenn Garmont, who hasa buy rating on the stock. "Regulatory and headline risk have long been factors in holding PBM stocks, but fundamentals remain strong."

Although formed to save customers money through the use of mail-order refills and cost-efficient drugs, PBMs, or pharmacy benefit managers, have been accused of actually driving up pharmacy costs instead. Medco, as a former subsidiary of drug giant Merck, has been particularly susceptible to criticism and charges of conflicts of interest.

"When health plan managers -- who are assumed to be promoting cost-containment -- can ... send prescription business to themselves, you've got thefox guarding the chicken coop," former Minnesota Attorney General Hubert Humphrey III said in 1995, when announcing the Medco settlement. "Patients need to understand that health conglomerates like Merck-Medco may be driven by the profit motive as much as by the cost-containment motive."

Back then, Medco agreed to pay a token $2 million -- essentially covering expenses for the multistate investigation -- and, more importantly, to abandonpractices that had benefited its parent instead of the customers it was supposed to serve. But eight years later, Medco's relationship with Merck remains under heavy attack.

"Medco Health made false statements to favor its parent company, Merck, and other manufacturers' products over less expensive, safer and/or moreeffective drugs," states the federal complaint, filed Sept. 29 in Philadelphia. "The primary reason Medco Health switches drugs is to enhance its revenue regardless of health plan costs or of any potential adverse or life-threatening clinical outcomes to patients."

Taking Aim

Nearly five years have passed since Associate U.S. Attorney James Sheehan -- who's a critic of PBMs in general -- first zeroed in on Medco.

Based on evidence from three whistleblowers, followed by documents and interviews supplied by the company itself, Sheehan has filed more than a dozencharges against Medco for allegedly violating federal laws. For its part, the company has criticized both the whistleblowers and the merits of their lawsuits.

"One of the whistleblowers is someone who never worked for us, never dealt with us in any way that we're aware of and is someone who had been convictedof Medicaid fraud by the federal government, convicted of income tax evasion and had his medical license lifted," Machlowitz told analysts in September. "Theother two people involved in the other whistleblower suits both left our Las Vegas pharmacy five years ago to pursue other interests, and it is unclear to uswhat -- if anything -- they know about how our business has been conducted in the past five years."

Machlowitz went on to attribute some of the government's evidence to "disgruntled employees telling tales." He also claimed that the lawsuit is"all over the map" and lacks any suggested penalties or changes to the company's business.

Snow, too, views the lawsuit as weak.

"What surprised me, actually, was that there was so little specificity, that it was so vague," he told analysts. "And it indicates to me that the realfactual data behind these things is hard to come by."

To be fair, much of the government's case rests on testimony from whistleblowers who appear to be former victims of verbal abuse known as "Monday beatings" -- and even termination -- when they failed to meet company quotasfor delivering mail-order prescriptions. But the charges related to Merck, at least, seem to have additional support.

In its own registration statement, filed just ahead of last summer's spinoff, Medco revealed that it "may have to pay substantial liquidated damages if we fail to achieve specified market-share levels" for Merck drugs. The federal complaint indicates that Medco may have satisfied its obligations by improperly favoring Merck products.

"Medco Health represents to health plans that its 'Preferred Prescription Drug Formulary' list is reviewed by an independent ... committee and willachieve quality care and cost containment objectives for health plans," the lawsuit states. "However, this formulary favors many expensive Merck-brand drugs ... over other manufacturers' less expensive drugs."

Even in its September call with analysts, Medco acknowledged that it had shifted some patients to Merck brands with higher sticker prices -- but alsohigher rebates -- than other drugs. But it said it abandoned the practice early last year, despite alleged savings to customers, because "it wasn't worthhaving to answer ... questions." The company also said that it had previously executed similar switches to non-Merck drugs.

"So there wasn't an overabundance of Merck drugs that might have fallen in that category?" asked A.G. Edwards analyst Andy Speller.

But Machlowitz was somewhat vague.

"You know, I've never seen specific totals for how many of those interchanges were Merck or non-Merck," he replied. "But I do know it was not just Merck products."

Popular Target

By now, Medco has fielded multiple complaints about its lingering ties to Merck.

Last year, for example, West Virginia filed numerous charges against Medco for allegedly pushing state customers toward expensive Merck-brand drugs. Although a state judge this month dismissed most of those charges, a few of them -- including breach of contract and unjust enrichment -- stillstand.

Meanwhile, Medco has agreed to pay $42.5 million to settle a class-action lawsuit which accuses the company of favoring Merck drugs and then secretlypocketing rebates from its former parent. More recently, Medco has expressed a willingness to settle even the new federal case that it views as weak.

"If there's a reasonable accommodation that can be made, fine," Machlowitz said in September. "We'll get it behind us."

Analysts seem open to the possibility as well.

"Based on the language of the complaint -- and lack of specificity of the charges -- we would estimate the potential settlement at less than $100million, though this is certainly nonspecific conjecture on our part," noted Lehman Brothers analyst Lawrence Marsh, who has an equal-weight rating on thestock.

Still, some believe Medco could face tougher penalties at the state level. Eight years ago, the company pledged to at least reveal its ties to Merckwhen promoting its parent's drugs. But the federal government claims that Medco -- which allegedly pocketed $430 million for favoring Merck drugs in 2001alone -- has been far from open with its clients.

"Medco Health specifically represented to clients and the United States that it was independent of Merck in its services to its clients and in its advocacy of drug switches," the complaint states. But "due to the conditions of the relationship between Merck and Medco Health, Medco Health is unable to present objective information, advice or opinions to patients, plans,physicians or consultants."

Thus, the federal government is now questioning the same motives that landed Medco in trouble with state prosecutors eight years ago.

"Getting the proper medication in the hands of patients as quickly and efficiently as possible should be the mission of any pharmacy benefit manager,"Sheehan said, when expanding his case against Medco this month. "However, these allegations suggest that -- somewhere along the line -- the focus became theprofit instead of the patient."