Subsequent to the release of Medco Health’s (MHS) fourth quarter and fiscal 2010 results on February 22, 2011, estimate revisions by analysts have been mixed for the forthcoming period.
Previous quarter highlights
Medco reported an EPS of 88 cents during the fourth quarter of fiscal 2010, up 25.7% from the year-ago quarter’s 70 cents. After adjusting for amortization of intangible assets from the 2003 spin-off, the company’s EPS came in 94 cents, meeting the Zacks Consensus Estimate and higher than the year-ago quarter’s 76 cents. For the full year, the EPS was $3.40, in line with the Zacks Consensus Estimate and higher than the previous year’s $2.83.
Medco recorded an increase of 11.1% in revenues on a year-over-year basis to $16.9 billion in the quarter, surpassing the Zacks Consensus Estimate of $16.6 billion. The increase in revenues was primarily driven by contributions from significant client wins as well as price inflation on branded drugs, partially offset by a higher volume of low-priced generic drugs. Revenues in 2010 increased 10.3% to $66 billion, in line with the Zacks Consensus Estimate.
For a detailed review of the earnings, read: Medco High on Revs, EPS in Line
Estimate Revision Trends
The recent Zacks Consensus Estimate revision trends remain positive for the first quarter of fiscal 2011, with the situation changing drastically in the second quarter. Over the past 30 days, 8 of the 27 analysts covering the stock have raised their estimates for the first quarter while 5 analysts have moved in the opposite direction. However, for the second quarter, 14 analysts have lowered their estimates with only one positive revision.
We believe the absence of any near-term catalyst has forced the analysts to adopt a cautious stand. Moreover, the uncertainty regarding the extension of the contract with UnitedHealth (UNH) remains an overhang on the stock. Medco’s largest client, UnitedHealth accounted for 19% of net revenues in fiscal 2009. While the current contract will extend up to December 2012, the company expects to begin discussions regarding the renewal in summer. However, a decision is not expected prior to the fall. Although Medco is confident about the renewal, the company will suffer a major blow if the situation turns around. Medco is also currently in discussions regarding the renewal of Federal Employee Program (FEP), with a decision expected by next quarter.
Although generics will provide incremental benefits to Medco for the next decade, the first half of the current year will not be significant in terms of generic introductions. The company expects the incremental growth in generic introduction to impact 2011 EPS by 9 cents with contributions from the first, second, third and fourth quarter remaining at 0, 1 cent, 2 cents and 6 cents, respectively. The highest selling drug, Lipitor (with annual sales of approximately $12 billion) will go off-patent at the very end of 2011 (November). Consequently, its impact will be felt primarily in 2012.
These circumstances have forced the analysts to adopt a negative stand in 2011. While 6 have moved in the negative direction, 3 analysts have revised their estimates in the positive. For fiscal 2011, the analysts are bullish with positive revisions (9 analysts) outweighing downward revisions (2).
In the recent past, Medco has been taking several steps to boost its top line. This included focusing on higher margin service revenues and expansion into Europe. Witnessing the huge potential of the international market, especially Europe, Medco has formed a joint venture with Germany based pharmaceutical company, Celesio AG, targeted at 29 European countries. This represents huge potential for Medco as the combined economies of the 29 countries represent a slightly larger economy than that of US. Europe is facing similar healthcare challenges as the US, hence is looking for alternative options to reduce healthcare costs beyond drug price controls
Magnitude of Estimate Revisions
The magnitude of estimate revisions for the second quarter has been significant. In the past 30 days, estimates for the first and second quarter have declined by 1 cent to 88 cents and 6 cents to 91 cents, respectively. Retaining the same trend, estimates for fiscal 2011 has declined by a penny to $4.07 while estimate for 2012 remained unchanged at $4.98.
Recommendation
We believe both the segments of Medco Health Services−PBM and Specialty Pharmacy segment − have a positive outlook for the upcoming quarters. The company has a very strong balance sheet that augurs well for further acquisitions. The company has adopted several strategies in the recent past to increase its footprint in the European market, which holds immense potential. Moreover, increased opportunity for Medco lies in the form of introduction of generics over the next few years. Although the PBM industry remains highly competitive, we are encouraged by Medco’s client renewals. Its client retention rate is maintained at over 99%. We maintain our Neutral rating on the stock, which also corresponds to the Zacks #3 Rank (hold).
About Earnings Estimate Scorecard
Len Zacks, PhD in mathematics from MIT, proved over 30 years ago that earnings estimate revisions are the most powerful force impacting stock prices. He turned this ground breaking discovery into two of the most celebrating stock rating systems in use today. The Zacks Rank for stock trading in a 1 to 3 month time horizon and the Zacks Recommendation for long-term investing (6+ months). These “Earnings Estimate Scorecard” articles help analyze the important aspects of estimate revisions for each stock after their quarterly earnings announcements. Learn more about earnings estimates and our proven stock ratings at http://www.zacks.com/education/
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