Medco's Merger Malaise

A strong quarter gets overlooked amid industry turmoil.
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Medco

(MHS)

didn't mess up.

It didn't fret over changes in drug prices. It didn't announce an unpopular merger. It just reported solid third-quarter results and promised better times ahead.

"While 3Q results and the initial 2007 outlook were largely in line, we believe favorable commentary on the conference call this morning should provide a positive catalyst following the dramatic selloff over the past six weeks," wrote JPMorgan analyst Lisa Gill, whose firm has an investment banking relationship with the company. "We reiterate our overweight rating on MHS and expect the stock to trade higher today."

It didn't, though. The stock sank 2.4% to $50.19 as investors continue to dwell on disappointing news from rival pharmacy-benefit managers

Express Scripts

(ESRX)

and

Caremark

(CMX)

.

Last week, Express Scripts expressed caution about proposed changes to the average wholesale pricing system for brand-name drugs. The company, like its competitors, can alter most of its contracts in an effort to keep its profit margins intact. But it could face resistance from clients who feel that drug costs -- and PBM profits -- look excessive already.

Then Caremark came along this week and rattled investors even more. The PBM suddenly decided to sell out to

CVS

(CVS) - Get Report

for less than the company itself has recently paid for its own shares. It failed to convince investors that its surprise merger is a great opportunity rather than a desperate reaction to the AWP changes and

Wal-Mart's

(WMT) - Get Report

new $4 generic-drug program.

So Medco was basically left to clean up the whole mess.

To its credit, the company tried. CEO David Snow portrayed Medco as "uniquely prepared" to handle the wholesale pricing changes -- saying that the company began bracing for them years ago -- and that they will have no material effect on the company's short-term or long-term profitability. He suggested that no client backlash should occur either.

"I have spoken personally with over 150 clients," he told investors during a conference call on Friday. "They understand."

Snow downplayed Wal-Mart's new generic-drug program as well. He said that the plan includes just 143 medications that are older and cheaper than most. And he suggested that only two major groups -- the uninsured and those caught in the so-called "doughnut hole" of Medicare Part D -- would be chasing after those bargains.

Indeed, Snow indicated that Wal-Mart had actually done the industry a favor by promoting generic-drug usage. PBMs enjoy higher margins when they sell generic, rather than brand-name, drugs.

"We applaud Wal-Mart's efforts," Snow said. And "we do not believe this move will hurt Medco."

Snow couldn't explain why Medco's biggest competitor had suddenly rushed into the arms of a retailer, however. For its part, Caremark has suggested that it was pushed there by the escalating consumer-driven healthcare movement. The combined company plans to become "agnostic" about the drug-delivery system, taking a neutral stand on whether prescriptions should be filled by retailers or mail-order pharmacies and letting customers decide for themselves.

In contrast, Medco continues to express strong faith in the current system. The company believes that mail-order service will remain attractive to the big employers and healthcare plans that -- unlike consumers -- pick up most of the prescription drug tab.

Indeed, Medco has suggested that Caremark could actually lose some of its own clients because of its new strategy.

"I'm hopeful that we will see opportunities that do arise because of this," Snow said on Friday. "We're excited about it, actually."

But Cowen analyst Kemp Dolliver foresees similar deals -- and a changing industry -- ahead.

Dolliver feels that Express Scripts, in particular, could now be in play. He points to health insurers

Aetna

(AET)

and

Cigna

(CI) - Get Report

, which operate internal PBMs already, as possible suitors for the company. He believes that big retailers, particularly

Walgreen

(WAG)

and Wal-Mart, could jump into the game as well.

"As pharmaceutical companies swallowed up the PBM industry in the mid-1990s, we expect a parallel situation now with drug retailers and possibly health plans as likely buyers," Dolliver wrote on Thursday. Now, "the merger's disappointing valuation of Caremark likely is the main concern for the group."

Dolliver isn't sure who would buy Medco, however.

On the surface, he notes,

UnitedHealth

(UNH) - Get Report

looks like the obvious choice. UnitedHealth is big enough to buy Medco, he says, and does plenty of business with the company already. However, he adds, UnitedHealth -- which boasts a big PBM of its own -- could simply bring more business in-house instead. Thus, he concludes, Medco could wind up with a cheap offer from a drug retailer as well.

Still, Medco feels no pressure to throw up the "for sale" sign just yet.

"I think there's some homework to do around that (Caremark) announcement," Snow admitted on Friday. But "it's not in our strategic plans today."