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Medco Soars on Upgrade

Cowen likes the stock's earnings power and takeout potential.

OKLAHOMA CITY -- Based on a recent checkup,

Medco

(MHS)

looks like the picture of health.

After a thorough evaluation focused heavily on high-margin generic drugs, Cowen analyst Kemp Dolliver upgraded Medco on Wednesday from neutral to outperform in anticipation of a muscular rally in the company's shares.

Looking ahead, Cowen feels that looming generic versions of popular drugs -- including Fosamax for osteoporosis and Nexium for heartburn -- will boost Medco's profits even more than some experts think. Thus Cowen's own forecasts now hover well above Wall Street targets, calling for Medco to outperform the broader market by some 15% over the course of the next year.

Specifically, Dolliver looks for Medco to grow profits by 36% this year -- and then another 28% next year -- as several brand-name drugs, costing billions of dollars annually, lose their patent protection and become available in cheap generic form. Following that revision, Dolliver's new forecasts sit a full 10% above consensus estimates.

Even so, Dolliver suggests that his newly raised projections could actually prove conservative in the end. After all, he reminds, Medco has managed to handily beat Wall Street's lofty expectations -- by a whopping 41% in the first quarter alone -- this year already.

"We think the significant difference between Q1:07's actual and forecast results reflects the accelerated dispensing of generic Plavix before it went off the market," Dolliver explains. "The relationship between generic and mail mixes -- particularly generic mix -- and profitability is little news to the market. But the degree of fit between these measures and

EBITDA/adjusted claim looks underappreciated."

Dolliver's recent analysis shows that each 1-point increase in generic mix boosts Medco's EBITDA by as much as $55 million or 3% -- up to three times the company's own guidance. With Dolliver looking for Medco's generic mix to expand by 4.5% by the end of next year, the impact could indeed be huge.

Meanwhile, Dolliver fully expects rival pharmacy benefit manager

TST Recommends

Express Scripts

(ESRX)

to capitalize on new generic opportunities as well. Specifically, he predicts that Express Scripts' generic dispensing rate -- already the highest in the industry -- will rise from 61% to 65.5% by the end of next year. He believes that Express Scripts could outperform even Medco as a result.

Ultimately, however, Dolliver likes both companies and feels that potential buyers -- including large drugstore chains -- could, too.

"The bidding war for Caremark Rx demonstrated the PBMs' significant intrinsic value," states Dolliver, whose firm makes a market in Express Scripts' securities. "

CVS'

(CVS) - Get Report

formation of an 'integrated PBM,' if successful, could force rival

Walgreen

(WAG)

to acquire either Medco or Express Scripts."

Certainly, he adds, "as we contemplate the evolving landscape, we cannot deny Medco's appeal to a third party."

Investors have sure chased the stock. The shares, while up just 42 cents to $85.81 on Wednesday's upgrade, have rocketed 80% since late 2006 and currently hover near the high end of their 52-week range.