(MHS) Medco Healh Analyst Reiterates Shares at Neutral

Recently, we reiterated our Neutral recommendation on Medco Health (MHS) with a target price of $74.00.

During the fourth quarter of fiscal 2011, Medco reported adjusted EPS of $1.25, beating the Zacks Consensus Estimate of $1.17 and 26.3% higher than the year-ago level. Increased sales combined with 8.3% reduction in number of shares outstanding contributed to the bottom-line improvement during the quarter.

Additionally, the introduction of generic Lipitor contributed $0.03 to the fourth quarter EPS. For the full year, adjusted EPS came in at $4.17, surpassing the Zacks Consensus Estimate of $4.10 and was up 17.5% year over year.

In fiscal 2011, Medco’s top ten clients (based on revenues) contributed approximately 46% to net revenues. Besides, the largest client, UnitedHealth accounted for 17% of net revenues.

However, in July 2011, Medco failed to renew its pharmacy benefit management (PBM) contract with UnitedHealth despite arduous negotiations. The existing agreement is set to expire in December 2012.

The company also witnessed several other contract losses that 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 California Public Employees’ Retirement System (CalPERS), all to CVS Caremark (CVS).

In August 2011, Medco also lost its PBM contract with Blue Cross and Blue Shield. Despite undertaking various efforts, Medco was not able to successfully overcome these hindrances.

In October, Medco again lost its pan-European joint venture with Germany-based Celesio AG and Dublin-based United Drug. We consider this to be a big setback for Medco in achieving its goal of gaining traction in the European market.

Amidst several contract losses, in July 2011, Medco announced that it would 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.

With the completion of the deal, Express Scripts Holding Company will be formed wherein 59% of the holding would lie with the shareholders of Express Scripts. On December 21, 2011, Medco shareholders voted in favor of this merger.

Medco’s proposed takeover by Express Scripts is the biggest in the health care industry. Although we expect the combined entity to pose a major challenge to its peers by becoming the largest PBM provider, we remain concerned about the uncertainty related to the successful completion of the deal based on the potential anti-trust challenges from the Federal Trade Commission (FTC).

Recently, FTC issued a ‘second request’ to both Medco and Express Scripts seeking additional information, also supported by the American Antitrust Institute (AAI). FTC along with AAI is of the view that the merger may create market concentration in the entire economy, leading to an anti-competitive landscape.

In March 2012, both the companies extended their merger closing date to early second quarter of 2012 from the original timeline of March 12, 2012. Although Medco strongly anticipates successful closing of the deal, the company will suffer a major blow if the situation turns around.

However, during the quarter, Medco witnessed higher service revenue growth fueled by United BioSource acquisition. In addition, under the Specialty segment, Accredo’s performance remains strong primarily attributable to significant client additions and organic growth across the business.

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