Medco Deal Fuels Health Care's Hot Streak

BOSTON (TheStreet) -- The offer by Express Scripts (ESRX) to acquire Medco (MHS) is drawing attention to health care as investors look for opportunities in 2011's hot sector.

Health care is the best-performing industry group of the 10 majors in the S&P 500 this year, with its 46 components delivering a median gain of 13%. Top performers include Biogen Idec ( BIIB), Intuitive Surgical ( ISRG) and Humana ( HUM).

Thursday's deal may make Express Scripts the largest pharmacy benefits manager in the U.S., controlling 30% of the market. CVS Caremark ( CVS) would be the odd man out, in second place for market share.

The $71.36 per-share offer, denominated in both cash and stock, represents a 28% premium to Medco's closing share price, as of yesterday. The premium is warranted, given that the new company would have tremendous synergies, from a cost and growth perspective. Therefore, it is likely to be scrutinized by regulators.The acquisition will help Express Scripts compete in the low-margin business of distributing drugs for insurance companies and employers. Express Scripts posted a first-quarter net margin of 2.9% and Medco achieved a spread of around 2%.

The catalyst for the deal: Medco has suffered major contract losses as of late, including a partnership with UnitedHealth ( UNH), accounting for as much as $11 billion of sales. The company also lost contracts in March, pressuring the management team to explore strategic options to unlock value for shareholders.

The deal announcement marks the second largest of the year, after AT&T ( T) declared its intention to buy T-Mobile USA for $39 billion. Analysts are offering positive reviews, so far, while stressing that anti-trust regulators will thoroughly weight the benefits and costs of the deal for consumers, the industry and shareholders. Health care has been hot in 2011.

Express Scripts shares have rallied 24% in the past 12 months and Medco's have appreciated 21%. Equity researcher Leerink Swann expects the deal to increase Express Scripts' earnings, citing $1 billion of synergies. Leerink Swann views the deal as "a significant positive for both companies." Bank of America went further than Leerink Swann by saying that "estimated synergies of $1 billion seem conservative." The pharmacy benefits business depends on scale and bargaining power, which will be vastly amplified by the deal.

There are still values to be found in the space. For example, several of the device manufacturers and diversified pharmaceutical companies are selling at historical discounts. Value-focused Morningstar awards its superlative five-star rating to Abbott Laboratories ( ABT), which sells drugs, diagnostic products, vascular products and nutritional supplements. Abbott's stock is up 10% in 2011, but remains a compelling value equity.

Morningstar also bestows its top ranking on Vanda Pharmaceuticals ( VNDA) and Medtronic ( MDT), though Abbott remains the top value, trading at a forward earnings multiple of less than 11, a sales multiple of 2.3 and a cash flow multiple of 8.9, 21%, 43% and 29% peer discounts. Its PEG ratio, which discounts projected long-earnings growth, at 0.3 signifies that the stock sells at a 70% discount to estimated fair value. Morningstar values Abbott's stock, using a discounted cash flow analysis, at $58, equivalent to 15-times 2011 earnings, a premium multiple. It expects Humira, Abbott's TNF inhibitor, which is used to treat arthritis, Crohn's disease and psoriasis, to power growth, going forward.

Xience, a series of drug-coated stents, are also growth catalysts, says Morningstar. While noting that Abbott's pipeline may be weaker than peers', Morningstar awards the company a "wide economic moat" for its consistency, diverse operations and management. The sell-side is similarly optimistic, awarding the equity 14 "buy" recommendations, nine "hold" calls and one "sell" rating. Abbott is a health care stock to consider now.

-- Written by Jake Lynch in Boston.

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