Rare is it for a company to push around the likes of Walgreen Company (NYSE:WAG) and CVS Caremark Corporation (NYSE:CVS), but that is just what Express Scripts Holding Company (NASDAQ:ESRX) is managing to do.
The massive pharmacy benefit manager ended a year-long standoff with Express Scripts Holding Company (NASDAQ:ESRX) coming out ahead while Walgreen Company (NYSE:WAG) suffered irreversible damage. Meanwhile, CVS Caremark Corporation (NYSE:CVS) is quaking in its boots as it is now the last remaining giant for Express Scripts to topple. Investors who buy now may do very well for themselves as Express Scripts continues to widen its moat.
Enemy under siege
Express Scripts Holding Company (NASDAQ:ESRX) held off renewing its contract with Walgreen for nearly a year over a pricing disagreement. The result? Walgreen lost billions in revenue, not to mention the permanent loss of thousands of customers that now get their prescriptions filled at other pharmacies, while Express Scripts hardly suffered a scratch. This is evidence of significant bargaining power that is likely to persist over the coming decades.
Walgreen is no pushover; as the nation’s largest drugstore chain, it expected to have significant bargaining power in its negotiations with Express Scripts Holding Company (NASDAQ:ESRX). However, it turns out that Express Scripts can easily switch its customers to other pharmacies, a miscalculation that revealed a gaping hole in Walgreen’s moat. It is now clear that drug stores have little in the way of bargaining power when it comes to negotiations with Express Scripts.
CVS’ last stand
After the departure of less-committed pharmacy benefit managers, CVS is the last remaining major company with a significant presence in the market, save for Express Scripts Holding Company (NASDAQ:ESRX). CVS’s strategy is unique in that it seeks to leverage an integrated offering — clinical services, retail pharmacy, and pharmacy benefit management — that Express Scripts cannot match.
The idea of building an integrated system that captures 100% of a pharmacy customer’s business is alluring, but it has not worked so well for CVS. The expected synergies between the three components have yet to develop, which has caused the pharmacy benefit management segment’s margins to plummet. If CVS is unable to make its integrated offering successful, it too will fall prey to Express Scripts’ superior bargaining power.
Digging a wider moat
Even as it has its way with drugstore giants, Express Scripts is not done expanding its moat. Its 2012 acquisition of Medco enabled the company to top the 100 million member mark — members that account for about one-third of pharmaceutical spending in the United States. With these numbers in mind, it is hard to see how any pharmacy could deny concessions to Express Scripts without suffering mightily for it.
Investment case
At first glance, Express Scripts’ 36 earnings multiple is too expensive even for a wide-moat company that controls a greater percentage of pharmaceutical spending each year. However, due to GAAP accounting rules, Express Scripts’ net income figure understates the company’s true earnings. Instead, free cash flow — which routinely comes in much higher than net income — is a better gauge of the company’s true earning power.
Over the last four quarters, the company has generated about $6 per share in free cash flow. The stock currently trades for just over 10 times that figure. Investors who buy the stock today are getting a wide-moat company with brightening prospects for a 10% initial earnings yield. Investors will not find a deal like this anywhere else in the market today.
Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends Express Scripts. The Motley Fool owns shares of Express Scripts.
The article This Company’s Widening Moat Swallows Competitors originally appeared on Fool.com and is written by Ted Cooper.
Ted is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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