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SGMT 6050 April 4 2012 John Gaganiaras 206 491 518 Paul Bilenki 208 414 096 Sean Moore 211 836 509 Jude Philipneri - 211248481
TABLE OF CONTENTS
Introduction and Strategic Overview ................................................................................................. 3 Industry ........................................................................................................................................ 3 Express Scripts and Medco Health Solutions................................................................................. 4 Strategic Rationale for the Deal..................................................................................................... 5 Regulatory Approval a Major Concern ......................................................................................... 6 Valuation ......................................................................................................................................... 6 Method 1: Comparable Companies ............................................................................................... 6 Method 2: Precedent Transactions ................................................................................................ 7 Method 3: Discounted Cash Flow Analysis (4-step process) .......................................................... 8 Negotiation Strategy ....................................................................................................................... 10 Goals.......................................................................................................................................... 10 Target Price, Walk-Away Price and Opening Offer ..................................................................... 11 Structure of the Deal ................................................................................................................... 12 Other Negotiation Considerations ............................................................................................... 12 Integration Plan Overview .............................................................................................................. 12 Conclusion & recommendations ..................................................................................................... 14 Appendix ....................................................................................................................................... 16 Appendix A BCG Growth Matrix......................................................................................... 16 Appendix B PEST ANALYSIS ............................................................................................. 16 Appendix C Valuation Using Comparable Companies ......................................................... 17 Appendix D Valuation Using Precedent Transactions .......................................................... 18 Appendix E Medco And Express Scripts Stock Performance ............................................... 18 Appendix F Valuation Using Discounted Cash Flow Analysis ............................................. 19 Appendix G Improvements, Synergies, and Future Strategic Options ................................ 220 Appendix H Negotiation ...................................................................................................... 220
lower prices from PBMs and greater transparency regarding managers activities. This may materially impact margins going forward. EXPRESS SCRIPTS AND MEDCO HEALTH SOLUTIONS Express Scripts is ranked third in Pharmacy Benefits Management (PBM) industry in terms of revenue, with sales of nearly $45 billion. The company is headquartered in St. Louis, Missouri and employed about 13,170 people, as of FY2010. Express Scripts enjoys various business advantages over its competitors. First, it serves a diversified range of customers including HMOs, health insurers, and union sponsored benefit plans. The company continually seeks opportunities to extend its customer contracts into large organizations. Second, Express Scripts has an extensive retail network, enabling the company to penetrate the market efficiently. Express Scripts dispenses its products and services primarily through contracting with retail pharmacies. Express Scripts network includes more than 60,000 retail pharmacies which represent more than 95% of all US pharmacies. Third, the company pioneered consumerology a new approach in pharmacy benefit management which aims to reduce waste and improve health outcomes by driving the best clinical behavior. This leads to better adherence to medication regimen, greater adoption of generic drugs and a greater use of home delivery. Consumerology leads to lower medical costs for the consumers and strengthens high-margin revenue streams for the PBM company. Finally, strong financials and solid experience in strategic acquisitions mean the company is well-positioned to continue the aggressive industry consolidation strategy it has pursued in the past decade. Indeed, between 2001 and 2010 Express Scripts revenue has grown from $8.6 billion to $45 billion, largely as a result of acquisitions. While Express Scripts strategy of industry consolidation has improved its market power, it has left the firm with a debt-to-equity ratio of 1.4, compared to an industry average of 0.4. Moreover, Express Scripts has failed to break its reliance on major retail pharmacy chains for the delivery of its customers prescriptions. Specifically, the top ten retail pharmacy chains represent approximately 50% of the total number of stores in Express Scripts retail network. This weakens Express Scripts strategic positioning as individual pharmacy chains have bargaining power regarding revenue sharing relating to filled prescriptions. Thus, Express Scripts must expand and diversify its delivery channel in order to ensure profitability and financial stability going forward. Medco Health Solutions employed about 23,425 people and recorded revenues of $66 billion as of FY2010, making it the largest PBM by revenue. One of the key competitive advantages of the company is its innovative and research capabilities to capture impactful industry trends such as generic drug and personalized medicines. Ever since 2006, Medco has had in place a Senior Vice President of Channel and Generic Strategy, a position assumed by Mr. Laizer Kornwasser, as well as Generics First, a low cost generic prescription drug program for small to mid-size businesses. In 2010, Medco acquired DNA Direct, a telemedicine provider of guidance and decision support for genomic medicine, a critical enabler of personalized medicine solutions. Furthermore, Medco leads the industry in market share in the growing mail-order and specialty pharmacy businesses. As an emerging business in PBM, specialty pharmacy is driven by the prevalence of chronic conditions2 and is associated with high cost and complex care issues (e.g. cancer, diabetes). The average treatment costs
Taken from "Defining Specialty pharmacy: services, market and players http://findarticles.com/p/articles/mi_m0NKV/is_7_3/ai_89237271/, web, accessed 2012/3/31
per patient stands between $6,000 to $100,000 and specialty drugs account for 22% and 28% of US drug expenditure in 2005 and 2010.3 Medco's growth prospects are limited by its heavy reliance on large, low-margin clients. For instance, revenues from UnitedHealth Group, Medcos largest client, amounted to approximately $11,000 million or 17% of net revenues in FY2010. Medcos reliance on clients like UnitedHealth is problematic for two reasons. First, clients like UnitedHealth have power over Medco, and are able to demand lower prices for Medcos services. Second, large institutional clients tend to not take advantage of Medcos mail-order prescription network, a higher-margin business than its retail network. Together, these two facts contribute to lower margins for large institutional clients like UnitedHealth. They also expose Medco to a high degree of significant customer risk. UnitedHealth, for instance, decided to move its PBM business in-house starting in 2013, and chose not to renew its contract with Medco. Along with the UnitedHealth contract, Medco also lost several other clients including CALPERS and the Federal Employee Program, which altogether put a significant downward pressure on the companys near-term outlook. All of these contract losses occurred in the first half of 2011 undoubtedly a factor in Medcos decision to merge. STRATEGIC RATIONALE FOR THE DEAL For both Express Scripts and Medco, the companies have a leading position in the PBM market and command a relatively high market share. Meanwhile, the traditional PBM market is at a mature stage with low overall growth. To put this in the BCG Matrix framework (see Appendix A), both companies operate for the most part a cash cow business. However, the dynamics in the health care industry as well as the socio-political environment suggest that both companies market share could be soon eroded, which would effectively push them into an undesirable dog position (see Appendix B for PEST Analysis). The reasons for this conjectured erosion mainly stem from the vertical integration by health insurers and pharmaceutical companies into the PBM businesses, and the lower costs, better care mantra of the ongoing health care reform. With prevailing industry dynamics in mind, it is clear that a merger of Express Scripts and Medco amounts to the best defensive strategy for both companies. The combination will result in a dominant market position leading to stronger bargaining power among pharmaceutical companies, likely resulting in higher gross margins. Additionally, the combined entity will have a highly diversified customer and delivery base, reducing their reliance on particular clients or delivery avenues. In particular, the merger would allow Medco to diversify away from low-margin, powerful clients like UnitedHealth, and at the same time relieve Express Scripts dependence on the retail network, given Medcos well-established mail-order network. The merger will also result in considerable costsavings, as the two businesses have overlapping managerial and sales divisions. These factors, combined, will help the merged entity effectively combat the industry pressures described above. The resultant business will be cost-effective, more stable, and have impressive market power. The two companies complementary capabilities, including Express Scripts consumer insights and Medcos innovative and research culture, will allow the merged entity to better tap into highgrowth nascent PBM business areas, such as generics and personalized medicine. We believe the generics play is immediately on the horizon while promoting personalized medicine solutions is more of a long-term goal. This means for business lines related to generics, they may move into the star
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David Calabrese, Pharmacy Benefits Management: Evolving strategies, emerging models. PDF on Web, accessed 2012/3
position directly and those business lines related to personalized medicine could become a question mark in the interim and eventually graduate to a star. All in all, we conclude that a merger transaction makes great strategic sense for both Express Scripts and Medco. REGULATORY APPROVAL A MAJOR CONCERN The proposed merger has been attacked by competitors, consumer groups and independent pharmacists. Their argument is that the merger would exacerbate the conflicts of interest and concentration of market power that already exist in the PBM industry and would further encourage PBMs to engage in self-dealing. The conflict of interest relates to PBMs special relationship with pharmaceutical companies. Essentially, certain individuals believe that PBMs direct consumers towards drugs that offer the greatest rebates, without passing those savings on to consumers.4 However, from the perspective of Express Scripts and Medco, the merger will save employers, the federal government, labor unions and consumers between $51 billion and $87 billion annually, increase the efficiency of prescription management and improve patients adherence to medications.
VALUATION
As with most mergers, a central issue is the cost for Express Scripts, and the financial benefit the merger provides for Medcos shareholders. In order to determine a fair transaction price, Medcos value must be determined. For the purposes of valuing Medco, three methods were used. Firstly, Medco was valued using multiples of comparable companies. A second valuation was then obtained using precedent transactions within the healthcare industry and the PBM segment of said industry. Finally, Medco was valued using a discounted cash flow analysis, taking into account operational improvements, synergies, and future strategic options. Although each of these valuation methods has inherent limitations, by using all three methods in tandem a more precise valuation estimate can be obtained that can then be used to determine a negotiation strategy. METHOD 1: COMPARABLE COMPANIES Valuing Medco using multiples of comparable companies requires a good deal of judgment due to the fact that the PBM segment contains very few companies. Consequently, for the purposes of obtaining a valuation using comparable companies, other companies within the U.S. healthcare industry were included, notable health insurers and pharmacy retail chains. While several of the firms included in the analysis are not direct competitors to Medco, they face many of the same industry risks, and therefore are reasonable to include in the analysis. Initially, a total of 16 companies were included in the comparables valuation. Additionally, six valuation metrics were used: Trailing-twelvemonths P/E, EV/EBITDA and EV/Sales, as well as 1-year forward-looking consensus P/E, EV/EBITDA, and EV/Sales. Please see Appendix C for the full comparables valuation Based on the six metrics and all 16 firms, an average value of $43.1 billion was obtained. However, this valuation is not as precise as one would like, due to several key reasons. Firstly, many of the comparable companies are significantly smaller than Medco. As a result of this variability in size, many of the companies included in the analysis may not be directly comparable even though they operate in the same industry as Medco. Furthermore, several of the companies included in the
Green, Kevin C. Regulation of Pharmacy Benefit Managers: An Economic Analysis of Regulation and Litigation as Agents of Health Care Change. Berkeley Electronic Press, January 2008.
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valuation have significantly different capital structures than Medco. The use of extensive amounts of debt can serve to increase the riskiness of a firms cash flows and, as a result, may lead one company to be inherently riskier than a competitor. Thus, although a firm may exhibit other characteristics that are quite comparable to Medco, if they have a significantly different capital structure or size, they may result in a skewed valuation of the target firm. After adjusting for both firm size and a firms use of leverage, the list of comparable companies was narrowed down to ten publicly traded firms. Based on the six metrics and the ten companies, an average value of $22.7 billion was obtained. This valuation should be a more precise estimate than the valuation obtained previously for the reasons stated above. A final step in valuation using comparable companies is to add a control premium to the valuation obtained. This premium adjusts for several factors including the fact that the incremental value of Medco for Express Scripts is greater than the market value of Medco, the fact that the incremental value of Medco with enhanced management is greater than the market value of Medco, and the fact that Express Scripts would be willing to pay higher than the market value of Medco due to the synergies that would result from the transactions. For the purpose of this valuation a control premium of 30% was used. This is the historical average premium for mergers and acquisitions5. Using this 30% premium, a final value using comparables of $29.5 billion was obtained. This equates to a value of $73.44 per fully diluted share. This value reflects a premium of 31.6% over the closing share price of $55.78 on July 20, 2011. Due to the fact that comparable companies still face significant idiosyncratic risks, valuation based on comparable companies should only be taken as a loose guideline for valuation. Regardless, it can be used along with valuations obtained from other methods to triangulate a fair acquisition price for the firm. METHOD 2: PRECEDENT TRANSACTIONS Valuing Medco using precedent transactions within the healthcare industry and pharmacy benefit management segment of the healthcare industry also requires a significant degree of judgment. The values that companies are willing to pay for acquisitions vary along with economic conditions and, resultantly, an appropriate time frame for transactions to include in the valuation must be determined. In total, 9 precedent transactions from the healthcare industry were initially selected ranging from April 2002 to March 2011. Over this 9-year timeframe there was significant variability in market conditions, so averaging the values based on these transactions should result in an approximate valuation during a stable economic state. Furthermore, the metric used to obtain the value using precedent transactions was enterprise value divided by twelve-month forward-looking consensus EBITDA. This was determined to be the most appropriate metric for valuation based on the fact that companies pay for a targets future prospects, not their past results, and for the fact that this metric takes into account a companys ability to control both revenues and expenses, rather than focusing on revenues in isolation. Additionally, it is important to note that Medcos consensus 12-month forward-looking EBITDA excludes the ten contracts, amounting to 13% of Medcos revenues, which the company was unable to renew for 2012. Based on all nine precedent transactions, a valuation of $27.4 billion was obtained. Please see Appendix D for the full precedent transactions valuation.
Unfortunately, this initial valuation lacks a degree of precision due to the fact that several of the transactions in the healthcare industry are unrelated to PBM and are therefore not very relevant for valuing a firm such as Medco that is highly concentrated in that segment. As a result, the list of 9 precedent transactions was narrowed down to those involving one or more firm from the PBM segment of the healthcare industry. Five of the nine transactions initially selected were found to be directly related to the Express Scripts and Medco deal. Using the five precedent transactions, a valuation of $25.9 billion was obtained. This equates to a value of $64.40 per fully diluted share, a premium of 15.4% over the closing share price of $55.78 on July 20, 2011. As with the valuation obtained using comparable companies, the valuation obtained using precedent transactions is not as precise as one would hope. Reasons for this include the variability of acquisition premiums over time and the limited number of directly related transactions. Of the 5 transactions that were found to be directly related to the Medco and Express Scripts deal, the most recent was in April 2009. Due to recent market conditions, the premiums on the transactions included may therefore be over- or under-inflated. Regardless, using this valuation along with the comparable company valuation and a DCF valuation can help to triangulate a more precise acquisition price. METHOD 3: DISCOUNTED CASH FLOW ANALYSIS (4-STEP PROCESS) Generally, valuation using a discounted cash flow analysis should provide a more precise estimated valuation than the methods previously discussed. This is due to the fact that cash flows have been modeled 6 years into the future and unique circumstances affecting Medco (such as the impact of an increasing number of generic drugs) can be included in the model. In performing the discounted cash flow analysis, the first step is to determine the as-is or base-case value. This is the value of the company prior to taking into account things such as operational improvements that could be implemented, synergies, and future strategic options. In calculating this base-case value, several key assumptions must be made. Please see Appendix F for the full As-is valuation including assumptions. Also, one must determine the key drivers in valuation. For Medco, these key drivers were found to be the firms bargaining power with manufacturers, its ability to control costs, and the innovation it illustrates operating in a service capacity. Each of these items will impact the value of Medco greatly and are points of focus in the discounted cash flow valuation. Additionally, once the model to value the firm has been built, it is important to determine what the key levers in the financial model are (i.e. which inputs have the greatest impact on determining firm value based on the model). The three most significant levers in the financial model were found to be product gross margins, SG&A expenses as a percent of revenue, and service revenue growth. Extra attention should be paid to each of the assumptions used to model these levers, since they significantly affect the valuation obtained. Within the model built, Medcos revenues were broken down into six unique, identifiable streams: mail-order prescriptions (brand and generics), retail prescriptions (brand and generics), and service revenues (client and manufacturer). Analysis was then performed on each of the segments growth characteristics to forecast future volume behaviour (an exponential decay model way used to forecast volume growth). Both mail-order and retail prescriptions were determined to have decelerating positive growth rates with mail-order prescriptions growing slightly faster due to the fact that the current economic environment favors less costly drug options. Brand prescriptions were established as having a decelerating negative growth rate due to the fact that they are a more costly 8
option and are less suitable for the current economic environment. However, an assumption was made that in several years once the economic environment is less recessionary that positive growth will resume for this segment at the rate of population growth. In addition, both generic prescriptions and service revenues were forecasted with high positive growth rates. Generic prescriptions were forecasted as such because they are a less costly alternative for consumers and are therefore more suitable for the current economic environment, as well as the fact that numerous significant drug licenses are expiring, leading to the emergence of new generic prescriptions that will be in high demand. Service revenues were forecasted with a high growth rate due to the fact that Medco has only recently begun providing research and consultancy services to customers and suppliers and that this segment is seen as having very high growth potential for the firm. Unit revenue growth was also determined to be segment specific and was modeled for each of the six segments individually. It was determined that unit revenue growth would be high due to historical brand drug price inflation of over 9% per annum. It was also established that mail order revenue growth would be slightly higher than retail growth since the penetration rates of generic drugs is lower in the mail-order segment of the industry. Furthermore, in modeling costs, both gross margins, as well as other operating costs were modeled separately. Product gross margins were forecast to grow at 8% per year for the six forecasted years due to the fact that mail-order and generic prescriptions continue to represent an increasing share of total prescription volume, and the fact that both of these segments are high-margin businesses. Service margins, on the other hand, were forecast to be very high in the initial years, while decreasing in later years. These were forecasted as such due to the historically falling service margins for Medco. All other costs were forecast using the simplifying assumption that they will remain as a constant share of revenue moving forward. Using the assumptions discussed (as well as those listed in the appendix), Medcos cash flows were modeled and discounted back to their present value, establishing an as-is value of the firm of $22.9 billion or $56.86 per share. As previously stated, this is the value prior to operational improvements, synergies, and future strategic options. A sensitivity analysis was then performed on the valuation to help obtain values for operational improvements and synergies. Operational improvements are improvements that could be implemented in Medco in a short time frame that serve to increase the firm value and that are not dependent on the acquirer. Numerous operational improvements were found stemming from inefficiencies currently in place at Medco. It was found that the firms supply chain management systems could be improved, that their mail-order services division could be streamlined, that distribution networks could be enhanced, and that fraud and abuse controls in place at Medco could be strengthened. In tandem, it was established that these improvements would lead to cost savings in the form of lower sales, general, and administrative (SG&A) expenses. We assumed that these improvements would be implemented gradually, and that SG&A expenses would fall by 2.5% annually over the forecasted period. In sum, these improvements would serve to increase Medcos value by approximately $1.33 billion or $3.30 per share. Synergies were modeled similarly to operational improvements. However, synergies are inherently different. Essentially, they are improvements that can only be implemented at Medco if they are acquired by Express Scripts. Medco would not be able to realize these synergies without the acquisition. As a result of this merger, two main synergies could be realized. Firstly, the merged entity would realize improved bargaining power due to the significant firm size and dominance over the 9
other firms within the industry. This is expected to lead to lower inventory costs and was modeled be increasing gross margins by 10%. Additionally, the merged entity would also have numerous redundancies initially. This is due to the fact that the two firms involved have similar operating structures and will therefore be able to realize other cost savings. For example, marketing costs will likely be reduced, as will other operating costs. It is anticipated that these savings will translate into lower SG&A by 2.5% per year as the redundancies are discovered over time. Together, these synergies have been valued at approximately $4.5 billion or $11.31 per share. The fourth and final step of a discounted cash flow analysis is to value future strategic options. It is much more difficult to model these future strategic options accurately since there is a significant degree of subjectivity involved in this portion of the analysis. There are numerous future strategic options available to a firm of the same size as the merged entity within the healthcare industry. However, as previously discussed, one of the main directions that many individuals see the industry moving towards is medicine specific to an individuals genetic make-up. A firm possessing the scale of a merged Medco/Express Scripts would certainly be at an advantage to capitalize on this trend once it develops. This is because a combined Medco-ExpressScripts would have the financial strength to aggressively pursue future opportunities in this high-growth segment. However, this trend is not expected to be realized in the short-term. Rather, it is a long-term direction that the company can take and is related primarily to Medcos service division. As a result, this future strategic option was valued by increasing the terminal growth rate of service revenues from 2% to 3%. This translates into an increase in firm value $0.7 billion or $1.74 per share. For additional information regarding improvements, synergies, and strategic options, please refer to Appendix G. Using all four steps of the discounted cash flow valuation results in an aggregate value of $30.1 billion or $74.95 per share. This is slightly higher than the valuations previously obtained (comparables analysis - $29.5 billion; precedent transactions - $25.9 billion). The average valuation of the three methods is $28.5 billion or $70.90 per share. Now that a valuation of Medco has been obtained, a negotiation plan can be developed to acquire the firm at a reasonable price.
NEGOTIATION STRATEGY
Although Medco has greater market power than Express Scripts, the balance of power undoubtedly favours Express scripts. First, Medco has recently lost key contracts amounting, and expects to lose 13% and 17% of its revenue base in 2012 and 2013, respectively. Second, and relatedly, Medco was the one to approach Express Scripts after years of ignoring the companys advances, effectively signalling the firms current weak position. Finally, cost control and conducting M&A transactions are arguably some of Express Scripts core competencies. Particularly, George Paz, the companys CEO is known for his disciplined cost controls and his shrewd negotiation tactics6. As a result of Express Scripts' position of power, the proposed valuation and structure of the transaction will skew in its favour. GOALS It is important to understand what is important to each party in a negotiation. In addition to agreeing to an attractive price, Express Scripts has a number of other issues to consider in this
Matthews, Anna Wilde. Man Behind Mega-Merger: Penny Pincher George Paz. The Wall Street Journal. August 9 2011, accessed February 23 2012. <http://online.wsj.com/article/SB10001424053111904480904576494172504902438.html>
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negotiation. Express Scripts, as the buyer, would like to ensure that its current shareholders maintain majority of the equity holdings in the combined company and retain control of the board. It also needs to secure required financing without significantly increasing its debt and cost of borrowing. As such, it needs to balance how much cash it will pay versus how much stock of the new company it will transfer to the shareholders of Medco. Importantly, Express Scripts has an industry-high debt-toequity ratio of 1.4, and thus may not have the financial strength to assume much more debt. Thus, Express Scripts undoubtedly favours a stock-for-stock transaction. Finally, as both companies are direct competitors, any information sharing should be treated confidentially in case the merger is not successful. Medcos primary aim is to reach an attractive share price for its shareholders. The structure of the deal is also very important to its shareholders. The two most important considerations for Medcos shareholders regarding the transaction structure are liquidity and taxes. In a pure cash transaction, Medcos shareholders assume none of the risk of the merger, and are perfectly liquid after the transaction. In contrast, a stock-for-stock transaction pushes liquidity risks onto Medco shareholders. They also assume the risk of the mergers success. Moreover, a stock for stock transaction is a nontaxable transaction whereas a cash transaction subjects Medco shareholders to capital gains taxes. In the end, the liquidity preference is more important as a stock-for-stock transaction merely defers capital gains taxes. Although Medco is being bought, its management and board members would want to retain as many positions as possible in the newly merged entity. Smooth integration including minimal job losses for its employees would be desirable for Medco. Medco would also like to obtain the required regulatory approval quickly to minimize lawsuits from any disgruntled shareholders and employees. Any negative publicity may adversely impact regulatory approval. TARGET PRICE, WALK-AWAY PRICE AND OPENING OFFER Three valuation models were used to calculate the value as-is, resulting in a value of $59.25 per share ($23.8 billion). The opening offer should be lower than the target price, but at the same time provide a premium for Medco. The suggested offer is $61.31 per share ($24.6 billion). This is calculated based on the value after improvements. It has a premium of 9.9% over Medcos closing share price of $55.78 on July 20 2011. This value serves as an anchor for the negotiation and gives the negotiation team from Express Script some room to maneuver. Normally, the target price for the buyer includes significant portion of synergistic benefit7. However, Express Scripts goes into this negotiation with a position of strength for the reasons identified earlier. Therefore, the target price of $64.70 per share ($26.0 billion) only includes 30% of the synergies in addition to value after improvements less transaction and integration costs. A target price of $64.70 per share would result in a premium of 16% over Medcos closing share price of $55.78 on July 20 2011. This is below the historical average premium for M&A transactions due to the competitive industry conditions and the position of strength that Express Scripts is entering into this negotiation. Moreover due to the uncertainly of achieving all of the post-merger improvements, synergies and strategic options, the walk away price per share was set at $68.09 per share ($27.3 billion). This value includes value as is, improvements and 60% of synergies. Besides Express Scripts position of strength, a smaller portion of synergies are included in the target and walk-away prices than usual due
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to the riskiness of the merger. Specifically, mergers of equals are typically more difficult to implement than other mergers as redundancies are generally more numerous and a clear leader is not available. Moreover, large mergers like this are more risky than smaller ones Note that all of the above offer prices are after estimated transaction costs of $500 million. These costs relate to M&A advisory, due diligence, legal fees, and fees surrounding the regulatory approval of the merger. STRUCTURE OF THE DEAL Express Script needs to balance the need for current shareholders maintaining majority of the equity holdings in the combined company with minimizing the need for additional financing. As such, a combination of stock and cash should be used to structure the deal. A recommended mix would be two-thirds equity and one third cash transaction. This will ensure that Express Scripts shareholders retain control of the newly merged entity. The one third cash transaction will provide Medco shareholders with some liquidity, while ensuring that they assume some of the risk of the merger. The negotiations may also address how many of the key Medco employees will be retained in management positions in the merged company. OTHER NEGOTIATION CONSIDERATIONS Both companies must commit to working collaboratively to address anti-trust concerns and promptly comply with FTC's requests for information. In our opinion, any price higher than the walk away price of $68.09 per share has the potential to destroy value for Express Scripts. In the event that an agreement cannot be reached or regulatory approval is forthcoming, Express Scripts must be willing to walk away from the negotiations. If the merger is unsuccessful, Express Scripts may consider a joint venture with Medco since they have complementary services. If this is also not feasible, Express Scripts should develop competencies in-house or by acquisition of other smaller players in the industry.
achieve optimal cultural integration it is recommended that we amalgamate the two companies policies and practices. Express Scripts should make their intentions clear to the management of Medco and formulate an early comprise to avoid mistrust and difficulty in integrating these two cultures. In identifying and developing the most favourable corporate structure from operational and financial synergies, function and product lines must be consolidated and reduced to align with our key success driver of cost control. Management of the various combined business units should be identified and selection of key personnel is necessary to ensure the newly combined company is motivated and understand the mission that reaffirms who we are in the industry. Other cost reduction efforts should be the cutting of redundant departments that cannot be consolidated however new ones such as the R&D unit of Medco should be added. Other fundamental areas of the integration development include identifying methods to exploit synergies and implement immediate improvements. In reaffirming who we are Express Scripts should immediately enhance efficiency in supply chain management, mail-order services, distribution and fraud control which would result in automatic cost savings. The most suitable method to exploiting synergies for this merger is through increased diversification and expansion of its delivery channels which would eventually break its reliance on major retail pharmacy chains and low margin clients such as United Health. To quickly penetrate high growth areas and expand market share Express Scripts should embark on a retention plan for customers and suppliers. Relationship building of customers and suppliers go hand in hand to increase the profitability of the overall business and thus the objectives of both should be in equilibrium. By leveraging its bargaining power with suppliers Express Scripts should immediately begin renegotiating contracts to benefit from economies scale due to increased volume. In so much as to retain existing customers, attract new ones and rekindle lost relationships Express Scripts should communicate to customers and other major stakeholders the benefits of lower cost and better care for by their new size. Finally in the Pre- Combination phase is coordinating the integration of new business areas that increased innovation. In retooling its corporate structure Express Scripts should place Mr. Laizer Komwasser (Senior Vice President of Channel and Generic Strategy of Medco) in charge of the new business development areas in new generic drugs and personalized medicine solutions. He has been with Medco for the past six years and has grown this area of the business through innovation tactics and acquisitions of smaller generic firms. The combination phase is the second leg in this post-merger integration plan where we begin to implement the blueprint identified above. This execution phase is also the post-regulatory approval period within a 90-day window and would continuously measure against goals set in the plan developed in the Pre-Combination phase. The main focus for success at this stage is leveraging each others strengths and competencies, while continuously identifying areas of weakness, which can be attacked together as a team. Last but not least in this phase is the need for ongoing due diligence where the Express Scripts team will probe deeply and thoroughly working backwards to identify faulty assumptions that might hinder eventual success of this combination. The third and final step in the integration plan is the post-combination phase and attributes to continuous improvement and development of operational and financial efficiencies through monitoring. At this phase the combined entity (Express Scripts and Medco) and its people regroup from initial implementation and the new organization settles. In conclusion, it is evident that we distinguish the distinct phases that these two organizations would go through from being independent to integrated entities. The pre-combination phase is the planning aspect of the deal that is conceived and negotiated by executives and then legally approved 13
by shareholders and regulators. In the combination window, further integration planning ensues and implementation decisions are made. Finally post combination the Express Scripts and Medco regroup as an organization with one shared culture, mission and vision.
regulatory approval of the merger. Suggested first steps would be to fund reports on the economic impact of PBMs, and to contact key legislators in Washington. Overall, it is recommended that both companies pursue the merger. It will provide Express Scripts with a larger platform on which it can push its cost control competencies. Moreover, Medcos shareholders will benefit greatly from a jump in the companys share price. Due to the contract losses alluded to throughout this report, Medcos share price returned only 5% in the year leading up to July 20 2011, while the S&P 500 returned 26% over the same period. Thus, this merger represents an opportunity for Medco shareholders to cash-out at a time when the companys stock is moving sideways (see Appendix E).
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APPENDIX
APPENDIX A: BCG GROWTH MATRIX
Technology:
The American pharmaceutical industry is due to encounter a patent cliff in 2012 At that time, the patents for drugs generating more than $30 billion annually are due to expire. Additionally, between 2011 and 2016, 116 drug patents are expected to expire. This unprecedented expiry of drug patents will be a boon to generic drug manufacturers, who will instantly have access to these drugs, boosting industry sales considerably. Development in the study of genomics and proteomics, and eventually pharmacogenomics It aims to develop rational means to optimize drug therapy, with respect to the patients' genotype, to ensure maximum efficacy with minimal adverse effects. Scientific breakthroughs in these fields will enable personalized medicine solutions that capitalize on the trends toward wellness, consumerism, and preventive care
Social
In 2050, United State's elderly population will double in size from that of 2005. This trend will likely cause an increase in the demand for PBM services.
Economics
Increasing overall healthcare costs become a major concern of the health care service and putting pressure on PBM industry. Government is finding ways to reduce costs. Generic drugs might be the solution.
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ITEMS OF NOTE: All data was obtained from Investext Unable to obtain several ratios for certain firms because of negative values (example: could not obtain EV/EBITDA ratio for SXCI because of negative forecasted EBITDA for 2012-04-02 TTM = trailing twelve months and FY1 = 1 year forward looking (consensus) A control premium of 30% was used to account for undervaluation, operating premiums, and synergy premiums (from Lecture 5, Slides 27 and 29) Firms that are not highlighted were excluded from final comparables valuation because of either firm size, vastly different use of leverage compared to Medco, or insufficient data
P/E (FY1) EV/EBITDA (TTM) 15.3 15.08 13.87 N/A 22.92 13.64 13.12 13.41 10.59 7.73 11.4 8.27 8.97 8.27 10.8 10 12.22466667 11.705 10.14 0.61 8.57 25.04 21.64 7.97 7.55 6.92 9.19 6.46 6.23 N/A 5.26 5.26 5.63 N/A 9.033571429 7.058888889 EV/EBITDA (FY1) 9.45 0.58 7.76 N/A 13.24 7.04 7.03 6.63 7.81 5.79 6.41 N/A 6.22 4.67 6.45 N/A 6.852307692 6.851111111 EV/Sales (TTM) 0.45 11 0.63 1.19 0.63 0.18 0.14 0.12 0.84 0.91 0.59 N/A 0.59 0.6 0.4 N/A 1.305 0.41111111 EV/Sales (FY1) 0.53 8.95 0.56 N/A 0.55 0.17 0.14 0.11 0.84 0.82 0.54 N/A 0.56 0.48 0.37 N/A 1.124615385 0.38444444 Enterprise Value 31531.06 28146.17 66907.45 4198.33 3387.89 21005.29 15007.19 9431.16 5258.79 5289.26 58511.63 29817.75 20017.5 13494.38 14569.7 4787.48 D/E 1.26 3.26 0.26 0 0.32 0.53 0.43 0.66 0.53 4.65 0.42 0.43 0.47 0.67 0.25 0.32
Company Medco (MHS) Express Scripts (ESRX) CVS Caremark (CVS) SXC Health Solutions (SXCI) Catalyst Health Solutions (CHSI) McKesson Corp. (MCK) Cardinal Health, Inc. (CAH) AmeriSourceBegen Corp. (ABC) Omnicare, Inc. (OCR) Health Management Associates, Inc. (HMA) UnitedHealth Group Inc. (UNH) WellPoint, Inc. (WLP) Aetna Inc. (AET) CIGNA Corp. (CI) Humana Inc. (HUM) Coventry Health Care, Inc. (CVH) AVERAGE MULTIPLE (ALL COMPANIES) AVERAGE MULTIPLE (HIGHLIGHTED)
P/E (TTM) 18.88 21.12 17.65 48.54 44.66 16.87 15.49 14.57 43.95 9.53 11.63 8.83 8.81 9.25 10.2 8.89 19.304375 13.218
Total Value (without control premium) Using All 16 firms Using 10 Highlighted firms 43078.82727 22712.89683
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Items of Note: Information regarding the precedent transactions was obtained from the Merger Prospectus Valuation was performed using the metric of 1-year forward looking consensus EV/EBITDA at the time of deal announcement Information regarding Medcos consensus EBITDA can be found in the prior Appendix Initially, Medco was valued using all 9 precedent transactions listed above. This list was then narrowed down to the 5 most applicable transactions (highlighted) to revalue the firm No further premium was added because premiums would be included in the metric EV/EBITDA used to value the firm
70%
45%
20%
-5%
MHS
ESRX
S&P 500
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Brand mail-order Generic Dispensing Rate Generic retail Brand retail Generic Dispensing Rate
Mail-order
Retail
C osts Increment 0.0% 0.0% 0.0% 0.0% 0.0% Total SG&A Amortization Net Interest C apEx Tax Rate WAC C Term Growth Rate in FC F 2.53% 0.49% 0.30% 0.72% 39.0% 9.30% 1.3%
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REVENUE MODEL Actual 2006 Net Revenues Retail product Mail-order product Total Product Client & other service Manufacturer service Total Service Total Net Revenues Cost of Revenues Product Service Total cost of revenues Gross Margin Product Margin % Service Margin % Total Gross Margin Margin % Volume Information Generic mail-order prescriptions Brand mail-order prescriptions Total mail-order prescriptions Generic retail prescriptions Brand retail prescriptions Retail prescriptions Total Prescriptions Adjusted prescriptions Adjusted mail-order penetration Generic Dispensing Rate Retail generic dispensing rate Mail-order generic dispensing rate Overall dispensing rate 57.2% 44.8% 55.2% 61.7% 50.0% 59.7% 66.0% 55.0% 64.0% 69.2% 57.8% 67.5% 72.7% 61.6% 71.0% 75.3% 64.7% 73.7% 77.2% 67.4% 75.7% 78.5% 69.6% 77.2% 79.5% 71.4% 78.3% 80.2% 72.9% 79.1% 80.7% 74.1% 79.7% 81.0% 75.1% 80.1% 81.0% 75.1% 80.1% 39.9 49.1 89 265.6 198.8 464.4 553.4 731.4 36.5% 47.4 47.4 94.8 286.9 178.1 465.0 559.8 749.4 38.0% 58.2 47.6 105.8 316.9 163.3 480.2 586.0 797.6 39.8% 59.6 43.5 103.1 409.2 182.2 591.4 694.5 900.7 34.3% 67.6 42.2 109.8 458.2 172.1 630.3 740.1 959.7 34.3% 73.2 39.9 113.1 485.2 159.1 644.3 757.4 983.6 34.5% 67.6 33.8 101.4 440.7 133.3 573.9 675.35 878.2 34.6% 58.8 27.6 86.4 377.9 108.5 486.4 572.79 745.6 34.8% 60.8 27.5 88.3 387.2 107.5 494.7 583.00 759.5 34.9% 62.4 27.4 89.8 394.4 107.0 501.4 591.20 770.7 34.9% 63.6 27.7 91.3 399.9 108.2 508.1 599.41 782.0 35.0% 64.6 28.0 92.5 404.3 109.4 513.7 606.24 791.3 35.1% 65.3 28.3 93.6 408.8 110.6 519.3 612.91 800.0 35.1% 2,010.1 4.8% 395.3 75.9% 2,405.4 5.7% 2,559.3 5.8% 386.0 70.9% 2,945.3 6.6% 3,268.0 6.5% 460.4 67.5% 3,728.4 7.3% 3,438.3 5.8% 588.7 69.9% 4,027.0 6.7% 3,587.0 5.5% 748.1 69.3% 4,335.1 6.6% 3,644.3 5.3% 977.9 65.2% 4,622.2 6.6% 3,575.2 5.7% 1,012.2 63.2% 4,587.4 7.2% 3,335.4 6.2% 1,047.7 61.3% 4,383.1 7.9% 3,733.3 6.7% 1,084.6 59.5% 4,817.9 8.4% 4,162.4 7.2% 1,122.8 57.7% 5,285.2 8.9% 4,640.3 7.8% 1,162.5 56.0% 5,802.8 9.4% 5,159.1 8.4% 1,203.7 54.3% 6,362.9 10.0% 5,215.9 8.4% 1,239.8 54.3% 6,455.7 10.1% 40,012.5 125.8 40,138.3 41,402.6 158.3 41,560.9 47,308.2 221.4 47,529.6 55,523.1 254.1 55,777.2 61,302.4 330.8 61,633.2 64,919.0 522.1 65,441.1 58,970.5 557.1 59,527.6 50,939.4 594.5 51,533.8 52,793.5 634.4 53,428.0 54,501.0 677.1 55,178.1 56,258.0 722.8 56,980.8 57,915.0 771.5 58,686.6 58,552.1 794.7 59,346.8 25,880.1 16,142.5 42,022.6 344.1 177.0 521.1 42,543.7 26,424.1 17,537.8 43,961.9 391.0 153.3 544.3 44,506.2 28,613.5 21,962.7 50,576.2 502.2 179.6 681.8 51,258.0 36,596.4 22,365.0 58,961.4 685.0 157.8 842.8 59,804.2 40,209.3 24,680.1 64,889.4 823.3 255.6 1,078.9 65,968.3 41,907.3 26,656.0 68,563.3 972.2 527.8 1,500.0 70,063.3 37,890.3 24,390.6 62,280.9 1,030.5 570.0 1,600.6 63,881.4 32,591.1 21,207.8 53,798.9 1,092.4 615.6 1,708.0 55,506.9 33,647.1 22,110.0 55,757.2 1,157.9 664.9 1,822.8 57,579.9 34,613.4 22,947.1 57,560.5 1,227.4 718.1 1,945.4 59,505.9 35,599.7 23,816.4 59,416.1 1,301.0 775.5 2,076.5 61,492.6 36,530.5 24,635.7 61,166.2 1,379.1 837.6 2,216.6 63,382.8 36,932.3 24,906.7 61,839.0 1,420.5 862.7 2,283.1 64,122.1 2007 2008 2009 2010 2011 2012 2013 2014 Forecasted 2015 2016 2017 Terminal
Unit Revenues Revenue/Mail-order prescription Revenue/Retail prescription Revenue/Prescription 60.5 55.7 57.5 61.7 56.8 58.7 69.2 59.6 63.4 72.3 61.9 65.5 74.9 63.8 67.6 78.6 65.0 69.7 80.2 66.0 70.9 81.8 67.0 72.1 83.5 68.0 73.3 85.2 69.0 74.5 87.0 70.1 75.8 88.7 71.1 77.1 88.7 71.1 77.1
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FORECASTING FREE CASH FLOW Actual Total SG&A EBITDA Amortization EBIT Net Interest EBT Taxes Net Income Shares Outstanding* EPS Change in NWC CapEx Free Cash Flow 2006 1,109.20 1,296.20 218.5 1,077.70 65.9 1,011.80 381.6 630.2 603.3 $1.04 2007 1,114.10 1,831.20 228.1 1,603.10 99.8 1,503.30 591.3 912 560.9 $1.63 2008 1,425.00 2,303.40 285.1 2,018.30 227.5 1,790.80 687.9 1,102.90 518.6 $2.13 2009 1,455.50 2,571.50 305.6 2,265.90 162.6 2,103.30 823 1,280.30 490 $2.61 2010 1,550.40 2,784.70 287.4 2,497.30 163.1 2,334.20 906.9 1,427.30 451.8 $3.16 2011 1,744.70 2,877.50 291.9 2,585.60 209.8 2,375.80 920.1 1,455.70 402.3 $3.62 361.3 458.6379 1,190.02 328.5 398.5126 1,287.44 -6.1 413.3963 1,840.43 -34.2 427.2238 2,110.08 0 441.4876 2,346.73 0 455.058 2,645.64 0 460.2069 2,678.74 2012 1,614.57 2,972.79 2972.788 504 2,468.79 189.9377 2,278.85 888.7516 1,390.10 1390.099 2013 1,402.91 2,980.15 2980.146 504 2,476.15 165.0377 2,311.11 901.3321 1,409.78 1409.776 2014 1,455.30 3,362.57 3362.569 504 2,858.57 171.2016 2,687.37 1,048.07 1,639.29 1639.294 Forecasted 2015 1,503.98 3,781.22 3781.219 504 3,277.22 176.928 3,100.29 1,209.11 1,891.18 1891.177 2016 1,554.19 4,248.62 4248.621 504 3,744.62 182.8351 3,561.79 1,389.10 2,172.69 2172.69 2017 1,601.97 4,760.89 4760.888 504 4,256.89 188.4551 4,068.43 1,586.69 2,481.74 2481.744 Terminal 1,620.09 4,823.59 4823.587 504 4,319.59 190.5874 4,129.00 1,610.31 2,518.69 2518.69
151 738.746
177.7 1,022.95
286.9 1,241.21
238.8 1,446.08
250.1 1,564.33
324.6 1,551.55
Present Value of Free Cash Flow 2012 FCF Discount Factor PV(FCF) 1,190 91.49% 1,089 2013 1,287 83.71% 1,078 2014 1,840 76.58% 1,409 2015 2,110 70.07% 1,478 2016 2,347 64.11% 1,504 2017 2,646 58.65% 1,552 8,111 Total
Terminal Value FCF PV in 2017 Discount Factor PV Terminal 2,679 33,281 58.65% 19,520
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Post-Merger Synergies Improved Bargaining Power with Suppliers Effect: Increase Gross Margins by 10% Eliminate Redudancies Effect: Lower SG&A by 2.5% Annually Total $1.33 billion $4.5 billion $3.30 $11.31 $3.17 billion $8.01
Future Strategic Options Genetically Specialized Medication Effect: Increase Service Revenue Terminal Value Growth by 1% $0.7 billion $1.74
Items of Note: Changes in value calculated using a sensitivity analysis on the DCF model used All of the above are estimates and may not be very precise
APPENDIX H NEGOTIATION
Price Elements9 Using Comparables Using Precedent Transactions Using DCF Average Value as is Improvements Synergies Strategic Options Full Value Transaction Cost Opening Offer Target Price Reservation Price / Walk Away Price
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Billion $ $22.7 $25.9 $22.9 $23.8 $1.3 $4.5 $0.7 $30.3 -$0.5 $24.6 $26.0 $27.3
Per Share $56.49 $64.40 $56.86 $59.25 $3.30 $11.31 $1.74 $75.60 -$1.24 $61.31 $64.70 $68.09
Comments
Value As Is + Improvements less Transaction and Integration Costs. Value As Is + Improvements + 30% of Synergies less Transaction and Integration Costs. Value As Is + Improvements + 60% of Synergies less Transaction and Integration Costs.
PLEASE NOTE: ADDITIONAL CONSIDERATION WAS GIVEN TO ECONOMIC CONDITIONS, LACK OF OTHER INTEREST, AND OTHER FACTORS BUT THESE WERE DEEMED TO HAVE A MINIMAL IMPACT AND WERE THEREFORE NOT INCLUDED IN THE NEGOTIATED PRICES
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