Two Great Investors Square off on Express Scripts. And… sleepless nights ahead for CVS and Walgreens?

We have frequently reported on the turmoil at Express Scripts (ESRX) – several major missteps and then the announcement that they would likely lose their largest customer, Anthem. Should this come to pass, 31 percent of earnings will walk out the door – a sum larger than most of the pundits thought. The stock dropped from the mid to upper 80s down to below $57 per share before recovering to around $60 per share.

Since the announcement a few weeks ago, two famed hedge fund investors have weighed in on ESRX. First, famed short seller Jim Chanos decided to go short Express Scripts (a bet that ESRX shares will decline). Chanos sites a flawed business model as his reason for the short position. He contends that ESRX is supposed to help control drug prices for their clients—yet prices continue to escalate. Now this is debatable, as there has been pressure applied to several drugs, and some price increases have abated. However, others, like Mallinckrodt Pharmaceutical’s Lupus Drug continues to defy gravity and has increased from about $1,000 a vial to $50,000 per vial. (Chanos is also short Mallinckrodt and thinks it will have a severe decline.) Chanos has been wrong before, as we all have. We are not sure at what price his short position was initiated, so whether it’s a winning bet is anyone’s guess.

Enter Seth Klarman from Baupost Group, a $31 billion hedge fund with a superb track record. Klarman interned with Max Heine and Michael Price at Mutual Shares. Price and Heine were two of the best value investors in the business. And Klarman is beginning to assemble a reputation that rivals his mentors. Klarman recently purchased 1,288,000 shares of Express Scripts. Given ESRX’s 33% decline, Klarman believes ESRX’s major problems are factored into the price which he believes is good value. A $73 million position is certainly putting his money where his mouth is!

So, who will win this Bull vs. bear struggle? I am biased. I own ESRX. And, while the position is a loser, I have written options on it in the past so the losses have been mitigated. But I do worry about Chanos being right. Even being a little right in this instance will pressure the shares. Moreover, with its largest customer creating quite a stir, analysts are worried that other customers may leave ESRX in search of better deals for their customers. I love both of these investors. Should be a heck of a fight. But my wallet is hoping that Chanos is wrong. With all due respect to Jim, I would never want to take the other side of a Seth Klarman trade.

And while we’re on the topic on prescription drugs, we have to mention Big Box Pharmacies: With CVS and Walgreens in possession of about 16,000 big box pharmacies, senior management at both companies received a wake-up call last week. Amazon is making noise about getting into the pharmacy business. Given that Amazon has upended all retail models, if they were to make serious inroads into pharmaceutical delivery, then we may see the retail carnage spread to the pharmacy world too. It’s way too early in the game, and putting a few books or items in your cart at Amazon is vastly different than selling prescription drugs. There are FDA and other regulatory issues that will not be easily overcome. We will keep you posted. But as a painful reminder, go back to our January 2016 issue featuring CVS vs. Walgreens Boots Alliance. We highlighted a table that showed all the defunct pharmacies over the years. An Amazon entry into pharmacy will likely add to that list.

Stay tuned…..

David Lerman and Jodie Warner

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