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Warren Buffett Loves Just One Of These PBMs, Shouldn’t You?

BERKSHIRE HATHAWAYExpress Scripts Holding Company (ESRX) is the largest pharmacy benefit management (PBM) company since its acquisition of Medco Health Solutions this year. PBM companies manage prescription benefits for employers and the health plans, and they offer using their buying power and scalable administrative capacity to lower costs and reduce waste.

For several years, ESRX spent time and treasure convincing possible clients that it was the ideal choice over any rival, especially the larger Medco Health Solutions. After years of competition, ESRX announced it would buy Medco outright and did so for $29 billion. The ESRX management team believed combining the two companies would provide as much as $1 billion in cost savings and synergies. Currently, ESRX now administers nearly twice the number of prescriptions each year, almost 1.5 billion, than it did before the combination.

In late 2011, ESRX made news again when it failed to come to terms over reimbursement rates with Walgreen Co. (NYSE:WAG), the largest drug retailing chain in the U.S. The end of negotiations was announced in June of 2011 and Walgreen filled its last prescription for an ESRX customer at the end of last year. There was no doubt that Walgreen would lose customers, but analysts and management were not expecting such large losses. Revenues and profits declined dramatically for Walgreen. ESRX saw revenue lost, but fewer than expected customers left them to remain at Walgreen or another pharmacy.

In May, ESRX reported 1st quarter earnings that were 5% lower than what analysts expected. Increases in expenditures partially caused by high staffing levels during a transition and management bonuses that were not paid and not accrued in 2011 were partially responsible for the shortfall. Revenue growth was positive with a 9.4% increase on a year-over-year basis. Second quarter results are scheduled to be announced after the market closes on Tuesday, August 7, and management will discuss results the next morning on a conference call with analysts and investors. Shares of ESRX have risen 28% year-to-date and the stock is trading 16.25x consensus estimates for fiscal 2012 and 13.15x 2013 estimates. Shares are now significantly more expensive than its next largest competitor, CVS Caremark Corporation (NYSE:CVS).

Thanks to the Walgreen-ESRX battle, CVS has been able to gain market share at a rapid pace. New marketing and incentive campaigns increased in an attempt to capture as many customers as possible leaving or open to leaving Walgreen. Hoping to keep the new customers, the company has been using store brands as a way to build loyalty. Chief Executive Officer Larry Merlo recently stated that the response to the introduction of the firm’s brands was “very favorable.”

In early May, CVS announced 1st quarter earnings rose 8.8% to $0.59 per share, totaling $776 million. Revenues in the pharmacy-services business jumped 32% to $18.3 billion. Results also benefitted from the acquisition of Universal American Medicare’s Medicare Part D business the company bought for $125 million.

CVS Caremark introduced Maintenance Choice 2.0 in 2010. The program allows Caremark customers to pick up their 90-day prescriptions at a retail location instead of through mail order. Customers benefit with no increase in co-pay or full cash price. Customers will also be offered greater savings if they opt for a more restrictive plan.

The third largest pharmacy-based business, OptumRx of Unitedhealth Group, Inc. (NYSE:UNH), handles more Medicare Part D business than any other. The company recently extended its contract with Walgreen. While many took notice, Chief Executive Merlo told one analyst that the agreement between the two was not significant because they were expecting this along with the rest of the market.

CVS continues to gain market share with their pharmacy business, which in turn leads to growth in stores’ retail sales. CVS is still focused on streamlining operations to reduce cost of revenue, further improving the bottom line. Management was confident enough to raise guidance for the year, now seeing earnings between $3.23 and $3.33 per share. However, the company’s stock is trading at just 14.4x to 14.9x the estimate ranges making it undervalued compared to ESRX. With the stock gaining just 18% year-to-date and trading at a multiple 11% cheaper than ESRX, shares of CVS still have more room to rise just to catch up. Other notable investors have taken a liking to CVS. Billionaire Warren Buffett holds 7.1 million shares of CVS, valued at over $318 million (see Buffett’s new picks). He has reported no holdings of Express Scripts. Other fund managers such as Jim Simons and Ralph Whitworth each hold over $100 million in shares. Mr. Menlo and the other member of the CVS management team are confident they will deliver results again. Mr. Buffett and the others certainly believe so. While shares are undervalued compared to competitors, perhaps it’s a good time to join them.

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