Updated from 9 a.m.

Medco

(MHS)

plunged 14% early Tuesday after the big mail-order pharmacy warned that 2006 earnings might not please Wall Street.

The company posted a 33% earnings gain for its third quarter, as revenue hit $9.3 billion. Third-quarter profits of 62 cents a share came in 2 cents ahead of the consensus estimate.

But the company guided to 2006 earnings of between $2.52 and $2.64. Analysts were expecting Medco to report operating profits of $2.38 in 2005 and $2.79 in 2006. Medco dropped $7.50 to $49.

"Our performance in improving sales, achieving record levels of retention and expansion into Medicare and specialty pharmacy makes us confident that we will achieve our objective of recording double-digit earnings growth in 2005," CEO David Snow said, "and to achieve continued strong growth in 2006."

Early Calls

Several analysts recommended buying Medco ahead of the company's latest report. Still, one had backed away. Andrew Speller of A.G. Edwards cut the stock from buy to hold on Friday over valuation concerns.

Speller's downgrade came right after Medco jumped 4% in a single day -- leaving the stock up 33% for the year -- following a strong report from competitor

Express Scripts

(ESRX)

. But others continued to feel bullish on PBMs in general, even after the recent rally.

To be sure, Prudential analyst David Shove saw plenty to like about Express Scripts' latest performance. By filling prescriptions at fewer sites, he noted, the company had managed to save a lot of money on processing fees and related costs during the third period. The company also enjoyed big savings on generic drugs, he added, which could prove to be a positive sign for the industry as a whole.

"According to Express Scripts, generic pricing competition appears to be heating up," wrote Shove, who has a neutral rating on the company's stock. This development "is welcome news and hints at further cost trend moderation in 2006. Considering the new drug patent expirations on the horizon, the drug cost savings could be quite dramatic."

Going forward, Shove sees Express Scripts capitalizing on growing opportunities in the Medicare and specialty pharmacy businesses as well.

If anything, however, Shove feels that Medco is better positioned than most. The company won approval this fall to offer drug coverage in all 34 regions established under the new Medicare Part D program.

Gregg Haddad of First Analysis recently suggested during an interview with the

Wall Street Transcript

that PBMs in general should enjoy significant Medicare-related growth. Haddad expects some of those benefits to start showing up in PBM results next year, with a material boost coming the year after that.

Moreover, he indicated, that expansion will come at a particularly opportune time for the industry.

"The Medicare population essentially is the only insured population left that is not covered today by a pharmaceutical benefit management function," he explained to the

Wall Street Transcript

. "This is, from our perspective, the most significant remaining population for the PBMs and managed care companies to serve. The Medicare Modernization Act created a new opportunity, and we think that those companies will pursue it strongly and benefit from it."

In the meantime, he said, Medco has already made some important progress after losing its $1.5 billion contract with the federal government during an ongoing probe of the company. So far this year, he said, the company has enjoyed strong customer retention and solid contract wins.

Less than two weeks ago, in fact, Medco announced that it had regained the big account it lost two years ago serving the California Public Employees' Retirement System. Meanwhile, it has completed a $2.3 billion buyout of Accredo Health that significantly increases its presence in the attractive specialty pharmacy space.

Going forward, Haddad expects Medco's stock to keep rising in response.

"We believe Medco is at an inflection point," Haddad told the

Wall Street Transcript

. "Its valuation multiples are below those of the other two leading independent PBMs (

Caremark

(CMX)

and Express Scripts). However, we believe Medco's upside on earnings is as strong as the other two. From our perspective, Medco's stock should benefit by closing that valuation gap."