Medco's

(MHS)

immune system may not be as strong as some analysts think.

The giant pharmacy benefit manager, or PBM, has enjoyed two upgrades this month due to growing confidence in the company's health. Both Raymond James and Banc of America raised their ratings on the stock after seeing Medco win new business that will help offset the big federal contract it lost during an ongoing government probe of the company. But Banc of America went a step further by declaring that Medco has put its biggest regulatory headaches behind it.

"The company's highly publicized legal challenges have been dramatically reduced by high-profile settlements with a consortium of states attorneys general, as well as the non-monetary portion of the U.S. attorney's 'whistleblower' lawsuit," Banc of America analyst Robert Willoughby wrote when upgrading Medco to buy over the weekend. "With much of its regulatory difficulties resolved, our focus is on potential uses of more than $1 billion in cash reserves next year."

Medco listed just over $1 billion in cash on its most recent balance sheet. Willoughby believes the company may use some of that money to enhance shareholder value through stock buybacks and dividends.

But sources close to the Medco investigation suggest the company could soon need the cash for a government settlement that could reach as high as $1 billion or more instead.

Patrick Burns, a spokesman for Taxpayers Against Fraud, expressed little surprise at that figure. He, too, believes that Medco could end up spending far more than the $500 million mentioned as a maximum penalty by at least one analyst.

"I think $1 billion is certainly within the boundaries of what this case could, and probably should, settle for," he said.

Medco has denied any wrongdoing. But Jeff Simek, Medco's vice president of corporate communications, told

TheStreet.com

on Tuesday that the company "is always open to a negotiated settlement if it makes business sense." However, he added, the company has yet to be approached by the U.S. attorney's office with a potential deal.

Medco's stock slipped 16 cents to $39.11 Tuesday morning.

Misunderstood

By now, Simek says that Medco has already managed to settle "big pieces" of government probes into the company's business practices. And analysts clearly seem reassured.

But Burns, for one, insists that Wall Street has displayed a "breathtaking" lack of understanding about the federal case against Medco. His own group has repeatedly stressed that Medco failed to cure its biggest problem with a $29 million multistate settlement announced earlier this year.

"The 20-state settlement very explicitly does NOT settle either federal or state False Claims Act cases," the group said in a press release issued after the deal was announced. And "Medco's liabilities in those cases (are) likely to be astronomical if the charges are upheld."

The multistate settlement focused only on rebates from drug manufacturers "which were not quantified by the states or investigated by the states," one industry source said. In contrast, they source added, the federal government has laid out a solid case showing that Medco defrauded customers -- by delaying, shorting and even destroying their prescriptions -- and causing clear-cut damages in the process.

Simek labeled the final allegation, pertaining to destroyed prescriptions, especially "misleading and unfortunate." He also said that Medco remains "confident in the facts" supporting the company's defense.

Still, Burns claims that federal authorities tend to pursue only select cases they expect to win. The case against Medco has been building since 2000.

"And you won't find the government prosecuting a company for a single problem," Burns said. "It's 'business-plan fraud.' It's a very big deal."

Burns mentioned drug shorting as a simple example. He said the government has uncovered "pervasive" evidence showing that Medco has routinely supplied customers with fewer pills than it should. He said that even a member of the government's General Accounting Office found her family shorted by the company.

He went on to say that shorted customers often wind up paying for additional doctor visits and medications that health insurers feel they have already covered.

"Medco didn't do it once; it was a pattern and practice," Burns said. "This is not the kind of fraud you want to take before a jury."

Simek conceded that pill counting can be prone to errors. He also said that mistakes are "as likely to produce an overcount as an undercount." But he ultimately portrayed Medco's pill-counting technology as far more accurate than most.

The Summer Wind

Still, industry sources doubt that Medco will want to face a jury on emotionally powerful charges that are so simple to understand. As a result, they expect Medco to settle for "double damages" exceeding $1 billion. Otherwise, they say, the company faces a summer trial that could bring triple damages instead.

Meanwhile, Medco's two largest competitors --

Caremark

(CMX)

and

Express Scripts

(ESRX)

-- continue to fight legal battles as well. Caremark faces its own whistleblower lawsuit for allegedly defrauding, and even endangering, customers in Florida. And Express Scripts has been sued by New York Attorney General Eliot Spitzer for allegedly defrauding customers in that state. Investigators accuse the companies of saving their customers less than they should.

The PBMs deny any wrongdoing. But some PBM critics foresee major industry changes as a result of the current probes. For now, however, even Burns admits that the companies will probably continue to perform well on Wall Street.

"Their core business will continue to grow until people figure out whether they actually need PBMs or not," he said. "The real question is whether PBMs actually save money. ... I think the jury is still out on that."