Recently, we reiterated our Neutral recommendation on Medco Health (MHS) with a target price of $67.00.

Medco reported an adjusted EPS of 91 cents in the first quarter of fiscal 2011, beating both the Zacks Consensus Estimate of 88 cents and the year-ago EPS of 76 cents.

Revenues increased 4.3% year over year to $17.0 billion in the quarter primarily driven by contributions from significant client wins as well as higher prices charged on branded drugs, partially offset by higher volumes of lower-priced generic drugs. However, revenues marginally missed the Zacks Consensus Estimate of $17.1 billion.

The United BioSource (UBC) acquisition in September 2010 combined with the expansion of client base at Medicare Part D services resulted in a stupendous 57.5% increase in Medco’s service revenues. In the reported quarter, Medicare Part D revenues increased by over 16% year over year.

Contributions from Accredo Health Group also helped boost the company’s Specialty business segment’s sales. During the first quarter of fiscal 2011 Accredo reported revenues of $3.1 billion, up 14.9% year over year.

Although gross margin in this segment witnessed a contraction of 50 basis points (bps) compared to the year-ago quarter, we are optimistic about the meaningful growth across a wide range of Accredo’s products based on improved product and channel mix along with new client wins in the coming quarters.

Moreover, increased opportunity for Medco lies in the form of introduction of generics over the next few years. The company is confident of achieving operating profit growth in 2012. Although the PBM industry remains highly competitive, we are encouraged by Medco’s client renewals. The company’s 2011 client retention rate was 99%.

In addition, Medco is opting for several strategic acquisitions which are encouraging. Viewing higher demand for genomic services Medco had acquired DNA Direct, which provides guidance and decision support to payors, physicians and patients on several issues related to genomic medicine. Medco has also launched four new clinical programs for neurology and cancer in the pharmacogenomics segment.

We believe both the segments of Medco Health Services — PBM and Specialty Pharmacy segment — have a positive outlook for the upcoming quarters. Medco has also launched four new clinical programs for neurology and cancer in the pharmacogenomics segment.

However we are concerned about the uncertainty regarding the extension of Medco’s contract with UnitedHealth (UNH) Medco’s largest client. UnitedHealth accounted for 17% of net revenues in fiscal 2010. The current contract will extend up to December 2012. Although Medco is confident about the renewal, the company will suffer a major blow if tthat does not happen.

Moreover, following CVS Caremark’s (CVS) acquisition of Medicare Part D business of Universal American (UAM), the latter’s contract with Medco was terminated (effective 2012).

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UNITEDHEALTH GP (UNH): Free Stock Analysis Report
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