Problems keep sweeping through the pharmacy benefit management industry like a contagious disease.

In a disappointing earnings release on Wednesday, Express Scripts ( ESRX) revealed that it has become the latest target of state prosecutors investigating major players in the PBM sector. The company's two larger peers -- Medco ( MHS) and Caremark ( CMX) -- already have come under intense government scrutiny.

"While ESRX has been generally above the fray of the legal scrutiny faced by other PBMs, it is obviously no longer immune," wrote Thomas Weisel Partners analyst George Hill, who has a peer perform rating on the stock. "The regulatory scrutiny certainly damages ESRX's credibility in the near-term.

"Based on our experience, PBM stocks typically react violently on the downside after such legal issues are announced," Hill wrote.

Indeed, shares of Express tumbled 13% to $62.84 late Thursday morning. Medco and Caremark came under some selling pressure as well.

Express Scripts said it received a "notice of proposed litigation" from the New York attorney general on July 12. The AG has accused Express Scripts of violating civil laws and breaching its contract with the state.

The company also has fielded a "civil investigative demand" from the attorney general of Vermont and expects similar subpoenas from 18 other states. It is being asked for "documents regarding a wide range" of its business practices.

The company denies any wrongdoing but, nevertheless, plans to increase its legal reserves by as much as $20 million to pay for its defense.

"Obviously, the company will be forced to defend itself against all these allegations," noted Schwab Soundview Capital Markets analyst Glen Santangelo, who has an outperform rating on the stock. And "a legal staff is not cheap!"

Phil Blando, vice president of the PBM industry trade group Pharmaceutical Care Management Association, expressed surprise at news of yet another government probe in the sector. Blando is convinced that PBMs -- accused of defrauding customers -- are in fact responsible for saving huge sums of money every year.

The mounting investigations "fly in the face of independent data and other data showing the value that PBMs provide to the system," Blando said. "I'm fully confident that ... these investigations will have a similar outcome of what other data have shown."

Santangelo isn't terribly concerned, either.

"We have been down this road many times over the past couple of years and have always ended up at the same location," he wrote. "None of the regulatory investigative efforts have yielded any findings that have amounted to any significant fines/penalties or -- more importantly -- any meaningful changes to the existing PBM business model."

Medco already has settled a multistate probe of its own by paying a modest fine and agreeing to change certain business practices. The company remains the target of a federal investigation, however. Caremark also faces multiple state probes as well as a whistleblower lawsuit that accuses the company of selling drugs that were returned through the mail but never tested for possible damage.

Both companies also have been accused of defrauding customers by improperly changing or canceling their prescriptions. They have denied any wrongdoing.

Still, both stocks took a hit on news of the latest industry probe. Medco dropped 70 cents to $30.50, and Caremark fell 18 cents to $29.45.

Meanwhile, analysts actually seemed more concerned about Express Scripts' latest results than its new regulatory challenges. The company posted second-quarter operating profits of 93 cents a share that missed the consensus estimate by a penny. It also reported a decline in operating margins and lowered its full-year guidance to the bottom end of its previous range.

"After several quarters of questionable EPS quality in 2003 and 2004, this quarter can really only be viewed as a miss, in our opinion," wrote Wachovia analyst Eric Veiel, who has a market perform rating on Express Script shares.

Caremark fared better. The company reported "record" second-quarter profits of 30 cents a share -- up 15% from a year ago -- that matched the consensus estimate exactly. Santangelo applauded the results, and recommended the stock anew, on Thursday.

"These 2Q04 results reinforce our conviction that the fundamentals at the company remain strong," he wrote. "In our opinion, the recent weakness in the shares is unwarranted and has created an attractive entry point. We reiterate our outperform rating."

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