Should You Buy Medco Health?

by Peter Cohan | July 22, 2011 4:00 am

Should You Buy Medco Health?

Medco Health Solutions (NYSE:MHS[1]) is poised to be bought for the second time. Merck (NYSE:MRK[2]) paid $6 billion for it in 1993, then took it public a decade later. Now Express Scripts (NYSE:ESRX[3]) has offered to buy it for $29 billion. But what if the deal falls through? Should you buy Medco stock?

Medco was founded as a mail-order drug distributor, and its change in ownership during almost the past two decades is a map of how the health care industry has changed. As I wrote in my first book, The Technology Leaders[4], Merck bought Medco because of a change in the way drugs were sold.

The old model was for big pharmaceutical companies to invest billions in R&D to develop patented drugs and hire thousands of salespeople who would give doctors trips to exotic locations to explain the benefits of prescribing the drugs. The doctors would dutifully prescribe the ones they thought would help their patients.

But in the 1980s, the decision-making power shifted from doctors to pharmacy benefit managers. PBMs acted on behalf of corporate health plans to make sure their members got the lowest-priced drugs that did the job. Thanks to the emergence of generic drug manufacturers who made lower priced versions of popular off-patent drugs, those cheaper substitutes were widely available.

Merck bought Medco, which is now the largest PBM, because its old model of selling to doctors was falling apart and it wanted to control its channel of distribution. Unfortunately, this did not work all that well because often a Merck product was not the PBM’s choice, so there was conflict between Merck’s interests and those of the PBM’s clients.

So Merck sold off Medco, and it operated independently for eight years. Now Express Scripts, a big PBM, is offering to pay $71.36 in cash and stock for each Medco share[5], a 28% premium. If the merger goes through, the combined company will control 1.7 billion prescriptions and about $110 billion in revenue. Moreover, they expect to cut $1 billion in costs through the combination.

Medco is selling out because it’s losing market share. The Associated Press reports[6] that Medco “has currently lost more business than it has booked for 2012.” For example, UnitedHealthcare will not renew its 2012 contract, and other clients – the Federal Employees Health Benefit Program, the California Public Employees’ Retirement System and a Universal American unit – already have announced that they will take their business elsewhere.

If this deal goes through, it won’t happen until sometime in 2012. So, should you buy Medco stock before the deal closes?

A couple positive points:

And two negatives for the stock:

This stock could do better if a hostile bidder enters the picture. And with acquires like CVS Caremark (NYSE:CVS[9]) likely to feel threatened by this deal, I would not be surprised to see a bidding war. Meanwhile, there’s no guarantee this deal will go through – after all, the Justice Department will need to decide whether the combination will have too much market power.

The best hope for Medco to rise further is a bidding war. Absent that, I would avoid the stock due to its disappointing earnings and loss of market share.

Peter Cohan has no financial interest in the aforementioned securities.

Endnotes:
  1. MHS: http://studio-5.financialcontent.com/investplace/quote?Symbol=MHS
  2. MRK: http://studio-5.financialcontent.com/investplace/quote?Symbol=MRK
  3. ESRX: http://studio-5.financialcontent.com/investplace/quote?Symbol=ESRX
  4. The Technology Leaders: http://www.amazon.com/Technology-Leaders-Profitable-Jossey-Bass-Management/dp/0787910724
  5. $71.36 in cash and stock for each Medco share: http://www.forbes.com/feeds/ap/2011/07/21/general-health-care-providers-us-medco-express-scripts_8576668.html
  6. The Associated Press reports: http://www.forbes.com/feeds/ap/2011/07/21/general-health-care-providers-us-medco-express-scripts_8576668.html
  7. 15.7% to $4.74 in 2012: http://moneycentral.msn.com/investor/invsub/analyst/earnest.asp?symbol=mhs
  8. EPS was 10% below analysts’ expectations: http://www.marketwatch.com/story/medco-health-posts-net-income-of-3428-million-2011-07-21?siteid=msn
  9. CVS: http://studio-5.financialcontent.com/investplace/quote?Symbol=CVS

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