Family Feud: The Anthem / Express Scripts Tiff

One of the most frustrating things as an investor is to watch gains evaporate before your eyes. Even more troubling is when those gains evaporate rapidly — as in overnight — and become losses. This was the case recently with Express Scripts (ESRX), one of my personal holdings (although some covered call writing helped stem some of the losses). While publications and Wall Street research types love to brag about their winners, they are loath to discuss when things go wrong. As editor of In Sickness and Wealth, I like to discuss winners and losers. I have found that you’ll learn far more about the investing process when things go wrong. When things go well, you take your eye off the ball and smile smugly thinking you are a great investor. When they head south, you tend to dig a bit deeper and are awakened to all sorts of things you didn’t previously uncover in your due diligence.

Back in December of 2009, Express Scripts shelled out $4.7 billion for NextRx. NextRx was the Pharmacy Benefit Management system for WellPoint Inc. WellPoint was one of the largest health benefit plans and counted 34 million Americans as customers; and it was a key licensee for Blue Cross/Blue Shield. The transaction also provided a 10-year agreement whereby Express Scripts would provide PBM services to WellPoint and its affiliated members. Everyone seemed cheerful about the deal and the usual press releases went out with quotes from Express Scripts’ and WellPoint’s respective CEOs.

Two Industry leaders have aligned in an unprecedented way to promote better health and value for millions,” said George Paz, chairman and CEO of Express Scripts. 

Angela Braly, then president of WellPoint stated, “the alliance brings new strength to Express Scripts’ and WellPoint’s essential roles in addressing today’s critical health care issues.”

WellPoint, as some of you know, changed its name to Anthem. And this past January, Anthem’s CEO, Joseph Swedish, fired a shot heard round Wall Street by claiming (at the JPMorgan Healthcare conference, no less — one of the most respected conferences in healthcare) that Express Scripts was overcharging Anthem for its PBM services to the tune of $3 billion. When I checked my portfolio that morning all I saw was ESRX down about six percent, about an hour into trading. A stock that approached 100 a few months ago was now in danger of slicing through 70. OUCH!

Of course, ESRX denied the allegations and things died down a bit as the world was convinced that Anthem and ESRX would kiss and make up. Well, perhaps not, as this week the tiff escalated when Anthem filed a lawsuit in a federal court in New York City for $15 billion. It appears the lovers quarrel might actually turn into a full blown divorce, of headline proportions. ESRX says the suit is without merit.

So, how does the rational, cool and calm investor react? Panic? Walk it off? Wait? How about all of the above. Let’s consider a few things and some likely and unlikely outcomes:

  1. Express Scripts and Anthem finally stop airing their dirty laundry in the press and sit down and hammer out a mutually acceptable settlement. Anthem has to give a little. ESRX has to give a little. Very few corporations in history would be willing to risk a protracted court battle. Both have a lot to lose and battling would go on for years. Anthem is contractually bound to a 10-year agreement that has a few years left. But Anthem is also ESRX’s biggest customer, providing 15% of ESRX’s revenues. The hit to earnings would be substantial although not crippling. This is the mostly likely scenario given that both have a lot to lose in a breakup.
  2. For Anthem to break the agreement and go elsewhere would be an operational nightmare. There would also be significant costs to making such a large-scale switch. As the second largest health benefit provider, there are few places they could go that can handle that sort of volume. Moreover, should Anthem go forward with its Cigna acquisition, it would have a major task in integrating that acquisition at essentially the same time. Do they really want TWO major integration headaches? Good luck with that. In addition, what other PBM would negotiate and accept the prices that Anthem is trying to extract from ESRX? Nonetheless, it’s hard to predict the actions of some corporations. Sometimes irrational behavior rules the day.
  3. If ESRX loses Anthem it would be a nasty hit to Earnings Per Share, as we mentioned. But ESRX has been in this situation before when they bought Medco, had major issues integrating it, and lost a ton of customers as a result. JPMorgan analysts estimate $7.3 billion in earnings before interest, taxes and depreciation. Without Anthem, EBITDA would fall to $6.4 — a major hit. It would be next to impossible to make up that shortfall by acquiring new customers anytime soon.
  4. The stock seems to be discounting the worst case scenario, and ESRX’s Price to Earnings ratio is running quite low, even after adjusting for a potential hit to earnings.

Taking all this into account, I am going to hold ESRX in my personal account. This opinion may change pending the outcome of this tiff and future developments. My losses have been somewhat negated by call options I have written on the position from time to time. Other considerations, however, were to avoid exposure to additional risk by selling my position; hedging with the purchase of put options (which generally would go up in value should the stock sink dramatically lower); or hedging, to some extent, by selling call options against my position, as noted above.

Stay tuned. This should be quite a fight.

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