Updated from 7 a.m.

The big pharmacy benefit managers, especially industry leader

Medco Health Solutions

(MHS)

, have lost some adrenaline.

After racing ahead for months -- with its shares jumping more than 50% in a year -- Medco finally started to look a little winded when it reported first-quarter earnings on Tuesday. The company did post operating profits of 57 cents a share, up 19% from a year ago, that topped the consensus estimate by a penny. But it nevertheless weathered a downgrade from an analyst who believes the stock now has little room left to run. That action, in turn, helped drag the rest of the group lower.

"Our downgrade is based on valuation concerns," wrote Wachovia analyst Eric Veiel, who cut Medco from outperform to market perform on Tuesday. "Bottom line: While we applaud the company's improved positioning in the marketplace, we would look for more attractive entry points" for the stock.

It then became investors' turn to run. They raced out of the stock -- on triple the average volume -- and left the shares down 9.1% at $49 when trading drew to a close.

Express Scripts

(ESRX)

, which followed up with its own report later in the day, fell 2.8% to $85.02.

Caremark Rx

(CMX)

, the other big PBM, slid 2.6% to $38.71.

Second Wind

But Express Scripts, at least, may have caught its breath.

The company was off and racing again after reporting its own first-quarter results late Tuesday. While the company's revenue of $3.84 billion fell well shy of the $4.05 billion consensus estimate, its quarterly profit and full-year guidance exceeded expectations.

The company delivered operating profits of $1.11 a share, up 26% from a year ago, instead of the $1.07 Wall Street had anticipated. It also topped full-year earnings projections of $4.59 a share by issuing new guidance of $4.60 to $4.75 a share.

The company's stock jumped 1.3% in after-hours trading on the upbeat report.

Still, at least one analyst viewed Express Scripts as fully valued even before that jump. On Monday, Lehman Brothers analyst Lawrence Marsh dropped Express Scripts from overweight to equal-weight because he felt the stock already reflected strong first-quarter earnings and even a possible takeover. He noted that Express Scripts shares had jumped 45% over the past six months and had exceeded his price target in the process.

Even so, Marsh said he remained positive on the company's first-quarter results and its prospects overall. However, he did seem less confident in a company takeover than some.

"There has been some market discussion about the possibility of larger retail and managed-care companies broadening their footprint in the pharmacy benefit management space for various reasons," Marsh wrote. But "we do not look for any potential near-term combination."

Still, looking ahead, Marsh sees plenty of room for Express Scripts to grow its business on its own. He did, however, identify a few concerns. He noted that the company has recently lost two major contracts and could lose an even more important one down the road. He portrayed Express Scripts' contract in New York -- where Attorney General Eliot Spitzer has launched an investigation of the company -- as particularly vulnerable.

"The State of New York is ESRX's second-largest customer, whose $1 billion-plus contract is up for renewal at the end of 2005," he wrote. But "we have

already removed the State of New York from our 2006 revenue and EPS expectations" in anticipation of a contract loss.

Government Pain

By now, Medco has weathered an even bigger setback.

Last year, the company lost a huge contract with the federal government during a sweeping probe that continues even today. Since then, that loss has clearly cut into the company's results.

During the first quarter, Medco saw its revenue actually decline by 2% to $8.7 billion and miss the consensus estimate. It also weathered a drop in its lucrative mail-order business as a result of the lost account.

Meanwhile, Medco offered no update at all -- and never was asked by analysts -- about the pending investigation when discussing its quarterly results. Still, some legal experts have suggested that the company may soon have plenty to report.

"When a company is silent about something, it's often because very big things are in motion," says Patrick Burns, a spokesman for Taxpayers Against Fraud. "I would not be surprised if settlement discussions were under way."

Nor would he be surprised to see Medco saddled with a huge fine -- of around $1 billion -- in the end.

However, at least one analyst failed to even acknowledge that financial exposure when discussing the case. He simply mentioned old settlements - and litigation risks in general -- instead.

"While MHS has settled its most pressing litigation -- allegations into PBM business practices -- with the U.S. Justice Department and the attorneys general of 20 states a year ago, there remain other lawsuits outstanding," wrote A.G. Edwards analyst Andrew Speller.

When announcing that settlement, however, the feds made clear that they were still pursuing the company for monetary penalties under the False Claims Act. Thus, Burns found it "breathtaking" that analysts could overlook such a potentially big hit.

"The ignorance of analysts seems to be almost complete when it comes to litigation and the exposure that companies face with the False Claims Act," Burns said. "And ignorance by analysts can be extremely expensive for investors."

A.G. Edwards has since contacted

TheStreet.com

to say that Speller never meant that Medco had reached a monetary settlement with the feds even though he failed to mention that in his report.

Caremark's Case

Caremark could soon face a federal probe of its own. In recent court hearings, federal prosecutors have indicated that they plan to join a big Medicaid case -- also based upon the False Claims Act -- that's been pending against the company for years. The company already faces a separate whistleblower case in Florida.

But such regulatory risks haven't kept some analysts from embracing the stock. Lisa Gill of J.P. Morgan remains an especially big fan.

Clearly, Gill is expecting strong results from the company this quarter. She believes the company will grow revenue by 6.1% to $8.1 billion and, thus, come out slightly ahead of the consensus estimate. She also expects the company to post quarterly profits of 43 cents -- up from 27 cents a year ago -- that will match the high end of management guidance. Moreover, she predicts that pre-tax profit per adjusted claim -- one closely watched metric in the industry -- will jump a whopping 43% and represent the strongest growth in the group.

Meanwhile, she seems relatively unconcerned that her top stock pick has -- so far -- failed to live up to her own expectations.

"Despite the continued strong outlook,

Caremark shares have significantly underperformed the peer group over the past few months, which we believe is unwarranted," Gill wrote on Friday. But "we continue to recommend Caremark as the name to own in the group going into earnings" season.