Wedgewood Partners Comments on Express Scripts - Apr 10, 2013

Although we have been investors in Express Scripts Holding Company (Express Scripts) (ESRX) since 2007, it was not always a "holding company." Express Scripts is the largest pharmacy benefits manager (PBM) in the country, managing nearly one third of all prescriptions written in the U.S. The Company recently (second quarter of 2012) rose to this market position after successfully closing the acquisition of Medco Health Solutions (Medco), effectively doubling the volume of prescriptions previously handled. Express Scripts' primary value proposition is to drive lower absolute and relative drug spend by injecting itself into almost every step of a clients' drug prescription process -­‐ from patient evaluation and distribution channels, to adherence. The Company's unparalleled scale and unique focus on the behavioral and clinical aspects of the drug prescription process enables them to effectively deliver an "open architecture" drug benefit which maximizes the opportunity for clients to eliminate spending waste. The Company's clients include managed care organizations, health insurers; mid-­‐to-­‐large employers and unions, all of whom are constantly bombarded by double-­‐digit medical care cost inflation.

In our view, Express Scripts' unmatched scale and unique approach are what will continue to reinforce its competitive profile for years to come. For example, throughout 2011 and part of 2012, one of Express Scripts' pharmacy network members, Walgreens, purportedly tried to raise prices on prescriptions, without adding any incremental value -­‐ which would have mitigated savings from cheaper, generic drugs coming to market over the next few years. Express Scripts saw these terms as unacceptable, and boldly removed Walgreens from its pharmacy network, yet clients still had access to another 50,000, lower-­‐priced pharmacy alternatives -­‐ from CVS and Rite Aide, to thousands of independent pharmacies. So Express Scripts' clients were able to make a wholesale move to these new pharmacies, with minimal disruption. Needless to say, the effect on Walgreens was not as subtle, almost 10% of its fiscal 2012 earnings per share were quickly lost as millions of prescriptions were shifted to cheaper competing pharmacies. Ultimately, Express Scripts re-­‐admitted the retailer back into its network in mid-­‐2012, presumably with economics that were more beneficial to clients. While this "narrow network" approach is not a new concept, it had never been done to this scale, but Express Scripts was able to be effective while excluding the largest pharmacy chain in the U.S., a testament to the Company's scale and competitive leadership.

As Express Scripts reaches critical mass in terms of prescriptions, we believe there is still room for attractive growth in profitability through further waste reduction and optimization of client behavior. Express Scripts' research estimates show that there is over $400 billion in pharmacy-­‐related waste every year. If the Company can continue to execute on its competitive advantage, we expect the Company to increasingly drive out more of this waste, and in turn, increase its profitability spread on each prescription (EBITDA/Rx).

In the interim, we expect Express Scripts will continue to be a prolific generator of free cash flow. Aside from information technology and a handful of automated drug distribution centers, there are few, large capital expenditure calls on the Company's operating cash flows. That said, in order to finance the Medco deal, Express Scripts issued debt -­‐ with about $13 billion (net of cash) currently on the balance sheet. We expect that they will be able to generate between $4 billion to $5 billion in free cash flow over the next twelve months – and increasing each year for the next several years. With about $6 billion in debt due by the end of 2015, and $2.8 billion cash currently on the balance sheet, Express Scripts should have ample financial firepower to reinvest in the business, pay down debt and provide share buy-­‐back support over the next few years. The Company ended the quarter at a market cap below $50 billion, when squared against our free cash flow estimates, results in a yield of about 10% which, relative to competing investment opportunities and given Express Scripts' opportunity set, we earnestly believe represents an excellent investment opportunity.

From Wedgewood Partners’ first quarter 2013 investor letter.


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