There’s a lot to be said for going with the category killer in an investment. I’ve been watching Express Scripts (NASDAQ:ESRX) for many years, waiting to see if it would become king of the hill. After many years and many acquisitions, that certainly appears to be the case. The company’s most recent merger was with Medco Health Solutions (NYSE:MHS). Together, these two behemoths will become a $50 billion market cap mega-prescription monster. In fact, it’s so big that the FTC is taking a long, hard look at the marriage.
So it might surprise you to discover that despite Express Scripts’ dominant market position, the stock is the ninth-most shorted stock in the S&P 500. To that, I can only say cover now before it’s too late.
ESRX is projected to grow 16% annually going forward and only trades at 15 times earnings. It generated $2.2 billion in free cash flow last year, and even repurchased $2 billion of its own stock. Maybe the shorts don’t like the company’s debt position? Yes, it carries $7.08 billion in debt — but also $5.64 billion in cash, and cash flow is almost seven times what’s needed to pay the interest. I have no idea why this stock is shorted so much, but all that means is there’s more upside when the inevitable short squeeze occurs.
Things look good for Medco as well, and therefore the merger should mean great things for the combined entity. The company also trades at 15 times this year’s estimates, with 13% annualized growth going forward. The balance sheet isn’t quite as pretty, but is hardly problematic. Here we have $3 billion in debt offset by $230 million in cash, but again, free cash flow eliminates any debt service concern. Free cash flow was $950 million last year, while debt service was $209 million.
All this comes at a time when both companies are severing relationships with big drugstores. Medco will be losing its contract with CVS Caremark (NYSE:CVS). Express is moving away from Walgreen (NYSE:WAG). That’s a bummer to be sure, but I don’t sweat it because contracts come and go. Medco didn’t get this big because of any one contract.
There’s another great lesson in here for investors. Net margins at Medco are only a hair above 2%, and 3% at Express Scripts. In other words, the bottom line profit at the companies are 2 cents and 3 cents per dollar, respectively. Under normal circumstances, that doesn’t leave much margin for error. However, because these companies are so huge and have such a large market share, the volume of business they generate makes those thin margins turn into big dollars. So don’t scoff at thin margins.
Going forward, I’d be thrilled to get a 15% annual return on the biggest prescription play in the stock market. If the merger should fail, then I’d prescribe Express Scripts as the stronger play of the two.
As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities. He is president of PDL Capital, Inc., which brokers secure high-yield investments to the general public and private equity. You can read his stock market commentary at SeekingAlpha.com. He also has written two books and blogs about public policy, journalistic integrity, popular culture and world affairs.