(MHS) Express Scripts to Buy Medco Health Solutions

Following the release of its second quarter of fiscal 2011 earnings, Medco Health Solutions (MHS) announced that it will be acquired by Express Scripts (ESRX) for $29.1 billion in cash and stock.

As per the terms of the agreement, each shareholder of Medco will receive $28.80 in cash and 0.81 shares of Express Scripts, representing a total value of $71.36 per Medco share. This represents a premium of 28% over Medco’s closing share price on July 20, 2011. Following completion of the deal (expected in first half of 2012), Express Scripts Holding Company will be formed wherein 59% of the holding would lie with the shareholders of Express Scripts.

In continuation of its series of contract losses over the last few months, Medco’s long-time negotiation with its biggest client UnitedHealth (UNH) was in vain.  The company suffered a major blow as its largest PBM contract was not renewed. Under the existing agreement with UnitedHealth, Medco is going to provide PBM services to the company till December 2012.

The recent contract losses include the Federal Employee Program (FEP) contract in May 2011, the Medicare Part D business of Universal American as well as the biggest US public pension fund Calpers, all to CVS Caremark (CVS) The FEP contract generated nearly $3 billion in annual revenues (including approximately 9.8 million mail order prescriptions) or about 4.5% of the company’s total sales in 2010.

Furthermore, contribution of the contract to the company’s 2011 earnings guidance was around 10%. The combined entity will be better placed to compete with CVS Caremark, which has gradually developed a strong PBM segment after winning several contracts in the recent past.

Second quarter update

During the second quarter of fiscal 2011, Medco reported adjusted EPS of 96 cents, beating the Zacks Consensus Estimate of 94 cents and also 10.3% higher than the year-ago quarter’s 87 cents. Revenues increased 4.1% year over year to $17.1 billion, in line with the Zacks Consensus Estimate. The increase in revenues was primarily driven by contributions from significant client-wins as well as higher prices charged on branded drugs, partially offset by higher volumes of lower-priced generic drugs.

During the reported quarter, Medco witnessed a 43.3% growth in service revenue to $349.9 million based on the acquisition of United BioSource and expansion in its client service offerings. Revenues from Medco’s specialty pharmacy segment, Accredo Health Group, increased 13.2% to $3.2 billion, primarily due to significant growth in prescription volumes, increase in manufacturer brand pricing, utilization of specialty products and the impact of recently introduced drugs.

Total prescription volume (239.7 million) recorded a 0.5% growth with mail-order volume increasing 0.7% to 27.7 million. Generic mail-order prescription volumes increased 6.0% to 17.8 million where as branded mail order prescription volume decreased 7.5% year over year to 9.9 million. Retail prescription volumes increased 0.4% year over year to 157.4 million. However, the adjusted mail-order penetration rate of 34.3% was unchanged with the second quarter of 2010.

Medco exited the quarter with $92.4 million in cash and cash equivalents, down from $853.4 million at the end of December 2010. The company repurchased 9.6 million shares during the quarter for $600 million. In July 2011, Medco repurchased another 6.3 million shares for $350 million.

Outlook

Medco reaffirmed its guidance for fiscal 2011. The company expects to record EPS of $4.02-$4.12 (previous range of $3.80-$3.93) representing a growth of 13%-16%.

Recommendation

The loss of the UnitedHealth contract was a major setback for Medco. The company has already suffered several contract losses in the recent past. Despite efforts, Medco was not able to successfully emerge from these hindrances. Medco’s takeover by Express Scripts is the biggest in the health care industry. The combined entity will pose a major challenge to players like CVS Caremark, among others.

We are currently Neutral on Medco. However, the upside potential of the stock is limited.

CVS CAREMARK CP (CVS): Free Stock Analysis Report

MEDCO HLTH SOL (MHS): Free Stock Analysis Report

UNITEDHEALTH GP (UNH): Free Stock Analysis Report

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