Unveiling the Motley Fool’s “All American Drug Cartel” Picks

"307,000,000,000 Reasons to Ignore the ObamaCare Armageddon"

By Travis Johnson, Stock Gumshoe, June 21, 2012

It’s been a few days since we covered a nice, long hyped up teaser from the Motley Fool Stock Advisor — though that’s also probably the newsletter that we’ve covered more than any other, given their popularity and their heavy marketing. So what are they promising this time around?

“The talking heads on TV are telling us that the Supreme Court will decide the fate of the healthcare industry later this week…

“They’re wrong. Because the key decision already happened two months ago. In a different courtroom.

“Very few investors know about this landmark case. Even industry insiders are stunned, calling it “a game changer” and admitting that they “didn’t see this coming [before] 2013.” Our expose takes you inside the chambers, and directs you to the 3 stocks that are perfectly positioned to benefit from this decision — no matter WHAT happens with ObamaCare.

“One of these three companies has boosted its earnings per share by 29% since February. Another just threw itself a $34 billion birthday party (you’ll see why when you check your mailbox next year). And the third one has delivered its shareholders 10 times the return of the S&P 500 in 2012. Our stunning report gives you the lowdown on how — and when — to invest in them. Read about this $307 billion jackpot now!”

Sounds intriguing, no? So what are these three companies? Let’s dig into the ad a bit more …

We get a bit of a “gotcha” tease that plays into the Supreme Court stuff, which everyone is talking about as the Obama healthcare decision pends:

“In the heart of Washington, D.C., just behind the Capitol Building and the National Art Gallery, sits an imposing building with tall Roman columns.

“To say that the men and women who work in this building are extremely powerful would be the understatement of the century.

“Only 83 people have ever held this elite office. Drawing on decades of legal study and courtroom experience, they make decisions that impact the life of every American citizen.

“Even a rumor about what they might say about a controversial topic like healthcare can send Wall Street into a trading frenzy.”

Well, folks think about the Supreme Court as being “behind” the Capitol Building, but I don’t think there technically is a “behind” for the Capitol — both the East side, facing the Supreme Court, and the West side, facing the National Mall, are called “fronts” — the “East Front” and “West Front.” But the main entrance is on the East side, so I guess it’s technically OK to refer to something behind the National Gallery (which is on the Mall) as also being behind the Capitol. Sort of.

Anyway, what they’re teasing here is not the Supreme Court, but another venerable be-columned DC landmark building — the headquarters of the Federal Trade Commission (FTC), a relatively new federal agency (just about to hit its 100 year birthday) that deals principally with consumer protection and competition — so as an investor, you’re most likely to hear about the FTC because of their active review of mergers and acquisitions to curtail monopolistic behavior, or because a company gets in trouble for something like false advertising.

So what’s the decision from the FTC that has Tom and David Gardner seeing dollar signs? Here’s how it’s teased:

“These are direct quotes, in print, from two top hedge fund analysts who were recently interviewed by Bloomberg Finance…

‘Wow, I didn’t see this coming.’

‘People in their wildest speculation thought that, maybe in 2013 [this could happen], but frankly no one put a lot of stock in it.’

“I’m excited to tell you what’s leaving them so tongue-tied. And why it throws gasoline on the fire for these 3 stocks.”

They then go into detail about why some well-known sub-sectors in health care are risky bets right now, like health insurance companies …

“If the Supreme Court strikes down all of ObamaCare, or even just part of it, the insurance companies won’t be celebrating. That’s because the law’s most controversial element — the “individual mandate” — is their diamond engagement ring. In fact, it’s the only reason they ever said “I do” in the first place…

The individual mandate forces 32 million Americans to be their customers. Most of these people are young and healthy; that’s why they were avoiding health insurance in the first place. And young and healthy people happen to be the most profitable customers for the health insurance companies.

What does it all mean for investors? It means there’s a lot of uncertainty built into the price of health insurance stocks. And that uncertainty isn’t going away anytime soon….

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To make a long story short, playing health insurance stocks can be a good investment. But in the current political climate, it might be too risky.”

Or pharmaceutical companies …

“… when you consider that most healthcare spending goes to hospitals, and that the vast majority of hospitals are non-profits, pharmaceuticals are undoubtedly the fastest road to investment profits in the medical industry.

“But that road is a bumpy one. I mean really bumpy.

“Drug research and development is tremendously costly; most of the experiments that those guys in the white lab coats do produce no results at all. And even when they do find something that could be a useful medicine, it rarely makes business sense to develop it.

“Then there’s the testing and approval process. It takes up to 10 years for a new drug to get the green light from the FDA. And one clinical trial can cost up to $100 million.

“That’s why only 1 of every 10,000 compounds that the major drug companies research will ever be approved for sale. Each one of those “successful” drugs costs about 4 billion dollars to develop….”

So if we don’t want to buy these kinds of stocks, many of which are getting bounced around like crazy as folks try to position themselves for whatever they think the Supreme Court will say and what impact that might have on real life, what do we want to buy?

Don’t worry, that’s the point of the Fool’s pitch here, so we get to some details now:

“What if I told you there’s a simple (but powerful) investment strategy that puts money in your pocket whenever a giant health insurance company like Aetna writes a check to a giant pharmaceutical company like Pfizer?

“What if I told you that it carries none of the political risk of investing in those health insurance companies. Because it doesn’t have to pass through two houses of Congress, be signed by the President, and get approved by the Supreme Court.

“What if I told you that it has none of the research, development, and regulatory risks of investing in those pharmaceutical companies? Because it doesn’t have to be tested by scientists, approved by the FDA, and picked over by an army of lawyers. It even makes more money when drugs go generic.

“And what if I told you that most investors don’t know about it? Even though it’s hidden in plain sight…”

What they’re talking about (and they do eventually reveal as much later in the ad) is pharmacy benefit managers and drug distribution — as is typical of Motley Fool ads, they give away one name and leave us dangling about the other two until you pony up your subscription money.

The one name they do give is industry stalwart McKesson (MCK), which is incredibly acquisitive and has built a huge wholesale drug business that touches most of us, and is part of what is essentially an oligolopy in the national drug wholesaling/distribution business along with the slightly smaller Cardinal Health (CAH) and Amerisource Bergen (ABC). The three together control probably at least 90% of the wholesale drug market, and some articles from a few years ago suggested that even with consolidation among drugstore chains the wholesalers still supply probably touch 80% of prescription drugs on the path from manufacturer to consumer.

But it’s not this oligopoly specifically that the Fools are teasing — they do think you should buy MCK, which seems reasonably priced for a dominant company (forward PE around 11). There may be some worry among investors about legislative or regulatory pressure to curtail the crazy high prices of drugs, particularly for Medicare and Medicaid, but that seems like it would have a relatively low impact on distributors — McKesson has a profit margin of only a bit over 1%, as is typical of wholesalers, and depends on a very small bite of each sale that goes through, they’re not the main culprits when it comes to pharmaceutical inflation. This falls into the category of “extremely strong company, fair price, probably going to have a rising dividend” but it’s not currently an income stock — the dividend is below 1%, so if you like the oligopoly but need a dividend the other two companies are valued almost identically and have slightly higher yields (though they also wring a slightly lower profit margin out of their sales, an indication that MCK’s acquisitions and larger scale might be helping them a little bit).

That’s the one they give away for free, though — what are the “secret” picks? Well unlike McKesson, which is more of a wholesale distributor, they’re actually pharmacey benefit management companies … and the point of the whole FTC pitch was to point out how crazy it was that a major merger recently went through that further concentrated this segment of the industry. That’s where they get the “Drug cartel” bit from, including this little snippet:

“CNBC commentator Herb Greenberg has even joked that … pharmacy distributors like McKesson and the other two companies I’ll tell you about in a minute are…

… ‘One step removed from a legal drug cartel'”

So who are they? Clues, please:

“One company was already a power before completing that history-making merger with its major rival…. Now it’s a superpower even more dominant than McKesson.

“It controls a 41% market share. That’s 1.5 billion prescriptions a year for 115 million Americans, making this company the largest drug distributor in the world.

“With popular drugs like Lipitor and Plavix going generic, you might think that the party’s over for everyone who markets them. But exactly the opposite is true for this company. Because its profit margins on generic drugs are actually MUCH HIGHER!!! ….

“The merger will also help this company open new markets outside of the United States, where it has even fewer direct competitors.

“And how’s this for superpower… This company just told the entire Walgreens pharmacy chain to take a hike unless it was prepared to offer a sweeter deal, leading Forbes to recommend that Walgreens had better ‘mend ties’ if it wants to survive. This sets up an even bigger, winner-take-all battle with CVS. And I wouldn’t put my money on CVS… because this company has one more game-changer up its sleeve. Just like Netflix and Amazon.com, it’s beginning to undercut its competitors by converting more and more of its business to mail order.”

So that one is clearly Express Scripts (ESRX), which recently got approval for its huge merger with Medco Health Solutions that turned them into a $40 billion company. And yes, if you live near a Walgreens or a CVS you’ve probably seen lawn signs out in front of their buildings jockeying for position with Express Scripts customers — Walgreens played hardball with Express Scripts last year, and now there’s some worry that with the merger, there might be concerns about Walgreen’s business with Medco, too. You can see that Forbes article referencing the deal here if you like, though it’s actually a Trefis analysis that was posted at Forbes.com.

Oh, and if you want that article from Herb Greenberg, about how crazy it would be if the FTC allowed the big Medco/Express Scripts merger (which, of course, they did), you can find it here.

And yes, this is a mega-company with a huge business — and they’ve also got pretty remarkable growth. So you end up with a firm that has a forward PE ratio of about 12 but a forecasted growth rate of almost 25% this year and close to 20% for many years into the future. Forecasters can be wrong, of course, and Express Scripts has posted minor disappointments for the last two quarters, but in general that kind of valuation and growth rate is very hard not to like — especially when it’s from a company that’s growing more dominant and was already quite profitable (their profit margin is also not huge, though at better than 2.5% it’s about twice as high as McKesson’s). I’m not all that delighted about a company having this much leverage over drug stores and pharmaceutical companies and therefore arguably over my health care needs, but that kind of profile for an investment certainly looks lovely. Hard not to like them as a potential investment unless your big picture vision for the future of health care includes the PBMs getting really squeezed by regulatory changes.

And number three?

“The other company is about to step onto the prime time stage for the first time. But it’s ready; Businessweek calls it ‘the next big player in the PBM space.’ And we already know that the FTC will approve its merger with another key mid-size firm, because the deal is only 1/8 the size of the other one we’ve been discussing — barely registering on the monopoly index.

“Even before it proposed the merger, Fortune named this firm number 1 on its list of fastest-growing companies. Beating out Apple, Chipotle, and Priceline.com. Hoover’s says that it ‘puts the sexy in prescription drug benefits.’

“Its share of the total market is only 8%. But this number is deceptive, because the company specializes in distributing medicines with much higher profit margins. In other words, exotic drugs created by 21st century biotechnology that cost hundreds of dollars for a single dose. And industry analysts say these specialty prescriptions will double within five years.

“When the patents on those biotech medicines run out, this company benefits in the same way that the previous one does from traditional generics. Biotech generics are called “biosimilars,” and the U.S. Food and Drug Administration has recently smoothed the path for their approval.

“This company started in Canada and only moved to the U.S. after its IPO a few years ago. So it’s finally mastering the nuances of the American healthcare system.

“This company started as a technology firm before it became a pharmacy benefit manager. So it’s taking a leading role in the healthcare industry’s conversion to computerized medical records — five bucks says that Obama and Romney both tout this record system throughout the 2012 election campaign as a miracle solution everyone can agree on. And they might even be right!”

This one, according to the Thinkolator, is SXC Health Solutions (SXCI), which is indeed an up-and-coming player in the pharmacy benefit management space — and, like all the other players in the business, it has been built up with a pretty aggressive series of acquisitions over many years, including the recent acquisition of Catalyst back in April. You can see that Businessweek article about the deal here, it basically says that SXCI has a nice niche because they specialize in higher-end drugs (like specialized biotech stuff), and that they’re also building appreciable scale because of this last acquisition, putting them close to the same neighborhood as the “top three” of Express Scripts, CVS Caremark (CVS — itself the widely debated merger of CVS with the huge Caremark PBM a few years ago) and UnitedHealth (UNH — which is an integrated health insurance/managed care company), though they’re definitely still the small fry in that group.

SXCI is definitely the one that’s priced as a small growth stock, with a forward PE of 30 or so, and they seem to have a somewhat different approach philosophically, sort of as a service provider rather than a gatekeeper — including PBM services and pricing that seem to be more flexible and that allow them to target smaller, more difficult or less homogenous clients, and a big healthcare technology segment that includes prescription processing software that’s used by a lot of smaller players.

I have no idea how it will work out, but they are getting similar margins to the other companies and posting much more rapid earnings growth — it might be that there are challenges in integrating this large (for them) acquisition, and it’s always possible that they overpaid, but analysts do still see them growing at nearly 30% a year and it will arguably be easier for them to grow than it will be for the larger players — and perhaps easier for them to pick up business if CVS Caremark and Express Scripts get so busy fighting each other that some clients get turned off.

I can’t say that I know the business well, but I’ll go along with the basic premise that pharmaceutical benefit management and drug distribution are definitely easier to understand businesses than drug development or hospital management or health insurance — and probably less likely to be changed dramatically by new regulations, since they’re essentially “middlemen” who take a small slice of the pie along the way but don’t really decide who gets pie or how long it needs to bake. These companies are all admirably profitable for high-margin distribution firms, and priced at the highs, but they’re carrying relatively high prices because they’re strong and growing — so it seems unlikely that we’ll see a double out of any of these picks this year, but there’s nothing wrong with a strong and growing business that compounds earnings … and if the business they’re in is an oligopoly that’s generally low-margin already, the chances of the firms competing away all the profits seem pretty low.

So I’m not an expert on any of these, and I don’t own any of these companies, but I don’t know of any reasons — other than big picture regulatory concerns — to stay away from oligopolies who operate in growing markets. And yes, given our demographics and extended lifespans, health care is definitely going to be a growing market over the next 20 years, no matter what the regulators do. After that, we might be so dead broke that medical investment withers on the vine, but I think one thing we cannot avoid is the fact that our largest generation is going to spend money on health care at unprecedented levels, period. Which means the companies who shave off 1-2% of that spending along the way to make sure folks get the drugs and medical supplies they need at the time they need them, should do just fine.

But that’s just my opinion, and the distillation of some recommendations from the Motley Fool that we’ve uncovered — I don’t know what their price targets might be or anything like that, of course, but they do seem quite enamored of all three companies. Still, if we’re talking about your investment dollars it’s your opinion that should really matter. So whaddya think? Ready to jump into bed with the oligopolists for a sure and steady rise, or do you think the health care debate will wobble the foundations of these companies, too? Let us know with a comment below.



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June 21, 2012 1:14 pm