Medco Health Solutions (MHS) 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, the company’s EPS came in at 94 cents, meeting the Zacks Consensus Estimate and 23.7% 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 20.1% higher than the previous year.

Medco, the largest pharmacy benefit manager (PBM), recorded an increase of 11.1% in revenues on a year over year basis to $16.9 billion, 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 lower-priced generic drugs. Revenues in 2010 increased 10.3% to $66 billion, in line with the Zacks Consensus Estimate.

Based on the acquisition of United BioSource, Medco recorded a 58.7% year over year growth in service revenues to $350 million. Revenues from Medco’s specialty pharmacy segment, Accredo Health Group, increased 21.3% to $3 billion primarily due to a significant addition of new clients and organic growth.

During the reported quarter, the generic dispensing rate increased 3.9 percentage points to 72.2% compared with the fourth quarter of 2009. Net revenues at Medco were lower by approximately $1.1 billion due to higher volumes of generics, which are cheap compared with branded drugs.

Both the mail-order and retail generic dispensing rates increased 4.6 percentage points to 62.9% and 3.8 percentage points to 73.8%, respectively.

For the reported quarter, out of $16.6 billion of net product revenues, retail products accounted for $10.3 billion, with mail-order products accounting for the rest. Both retail and mail-order products recorded an increase of 10.1% and 10.7%, respectively, compared with the same period last year.

Total prescription volume (244.3 million) recorded a 7.4% growth compared with the year-ago period, with mail-order volume increasing 7.3% to 27.9 million. Branded mail order prescription volume decreased 3.7% year over year to 10.4 million, while generic mail-order prescription volume increased 15.1% to 17.5 million.

Medco’s gross margin during the quarter increased 20 basis points to 6.9% due to strong generic mail-order prescription volume and growth in service margin. Selling, general and administrative expenses increased 14.1% during the quarter to $428.5 million reflecting higher expenses associated with the acquisition of United BioSource and other expenses associated with the company’s strategic initiatives.

Medco exited 2010 with $853.4 million in cash and cash equivalents, down from $2.5 billion at the end of December 2009. The company repurchased 15.8 million shares during the quarter for $963.3, thereby exhausting the $3 billion buyback program announced in May 2010.

In February 2011, the company announced a new $3 billion share repurchase program. The continuous share buyback program led to a 11.7% reduction in share count, which in turn improved the company’s bottom line.

Debt level at Medco increased 25% to $5 billion compared to December 2009, following the issuance of $1 billion of senior notes in September 2010 associated with the acquisition of United BioSource. Consequently, interest expense increased 21.6% during the quarter to $49.5 million.

Medco is witnessing an impressive selling season with high client retention rates. The company has recorded $1.7 billion in the form of 2011 annualized new-named sales and net-new sales of $1.5 billion (up from $1.4 billion disclosed during the third quarter) with a client retention rate of more than 99%.

Outlook

Medco reiterated its guidance for fiscal 2011. The company expects to record adjusted EPS of $3.80 to $3.93.  However, the company will be implementing certain changes in 2011 to exclude all intangible amortization. Consequently, the EPS is expected to be $3.99−$4.12.

Recommendation

An aging population coupled with the associated higher frequency of chronic diseases continues to drive demand and add to the escalating cost of new drug therapies. As a result, we expect the outlook for the PBM industry to remain positive.

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 with the presence of players such as CVS Caremark (CVS) and Express Scripts (ESRX), especially in the current backdrop of economic uncertainty, we are encouraged by the company’s client renewals for 2011.

We are currently ‘Neutral’ on Medco, which also corresponds to the Zacks #3 Rank (Hold).

 
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