Health care was one of the few bright spots in an otherwise dismal 2008, underscoring the sector’s reputation as a classic defensive play. This month we look at a pharmacy benefits management firm that’s well positioned to weather any economic headwinds and offers attractive growth potential.—The Editors

 

Prescription for Profits

 

The current economic environment is likely to weigh on corporate earnings for some time: Rising unemployment and diminishing consumer demand are part and parcel with the painful deleveraging process already underway.

 

Despite these formidable challenges, Medco Health Solutions (NYSE: MHS) recently confirmed that it expects earnings per share to increase 15 to 20 percent in 2009–and the low end of that forecast prices in a 10 percent unemployment rate.

 

The nation’s largest pharmacy benefits management (PBM) firm, Medco services one in five Americans and stands to profit from the recession as well as several interrelated trends. Not only does the company enjoy health care’s traditional countercyclical characteristics–patients view their medications as necessary rather than discretionary purchases–but the increasing cost-consciousness of health plan sponsors and members also presents ample opportunity.

 

Medco boasts an impressive track record of reigning in drug costs for its clients; in 2007, the company held drug trend inflation to around 2 percent as opposed to 4.5 percent at other PBMs and an 11.7 percent national average. This outperformance enabled the firm to retain 98 percent of its customers in 2008 and win market share from its competition. According to management, much of the $13 billion in new business over the past two years has been poached from rival CVS Caremark (NYSE: CVS) While the company’s massive scale enables it to negotiate attractive discounts and rebates from drug manufacturers and distributors, much of its success stems from two key trends: patent expirations on popular branded drugs and a customer-base that’s increasingly embracing the firm’s mail-order pharmacy.

 

For every $100 million of branded drugs that are replaced by a generic alternative, Medco’s clients save $45 million, and the company itself reaps an additional $9 million in profits. The cost savings and profit margins become even more compelling when members purchase these generics via mail-order.

 

In the third quarter of 2008, generic prescriptions comprised a record 64.4 percent of overall dispensations, and mail order volume increased 11 percent compared to the prior year. Net revenue reached $12.6 billion, a 15 percent increase from the year before, while gross margins improved from 5.6 percent to 6.5 percent. And these favorable trends should continue over the next several years. Between 2008 and 2015 patent protections on roughly $94 billion worth of branded drugs will expire, providing a huge boost to the generic market and, by extension, Medco. Meanwhile, analysts expect the company’s mail-order penetration to increase exponentially over the next several years as consumers opt for lower copayments and the convenience of purchasing drugs in 90-day supplies.

 

Although Medco has consistently positioned itself to exploit favorable market trends, government efforts to provide health benefits to even a fraction of the nation’s uninsured would be manna from heaven–an entirely untapped market. At the same time, the company has its eyes set on international markets, partnering with the Swedish government and acquiring a majority stake in Europa Apotheek Venlo, a mail-order pharmacy that serves Germany’s $35 billion market.—Peter Staas

 

WHY TO BUY

 

Medco Health Solutions (NYSE: MHS, $46.73)
*Recession makes health plan sponsors and members increasingly cost-conscious
*Patents on roughly $94 billion of branded drugs slated to expire in coming years
*Consumers embracing lower copayments and convenience of mail-order