Tickers in this Article: MHS, UNH, WLP, ESRX, CVS, WMT, TEVA
Medco Health Solutions (NYSE:MHS) is part of the oddball contingent of the healthcare spectrum. While many investors reflexively think of healthcare as a sector with high margins and proprietary products, the pharmacy benefit management space is the opposite - a low-margin business that relies on contracts and scale rather than innovative new products. Nevertheless, Medco has carved out a sizable market presence and delivered solid returns on capital, even if some investors are still quite worried about upcoming contract expirations.

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The Quarter That Was
Medco delivered a solid end to the year. Revenue climbed more than 11% this quarter, surpassing even the high end of the analyst range of estimates. Revenue was boosted by 21% growth in the specialty pharmacy business and solid prescription volume growth of 7.4%.

Looking at some additional details, the company's mail-order value grew by 7.3%, with generic mail-orders up over 15%. With this quarter, generic penetration exceeded 72%, while mail penetration more or less stayed put around 34%.

Medco once again leveraged its scale and operational efficiency to good effect. Gross profits rose over 13% this quarter, EBITDA rose by a similar amount, and operating income was up over 14%. These operational improvements were a bit less than what the analyst community had assumed for the quarter. At the end of it all, the company reported adjusted earnings of $0.94 a share - in line with the average estimate and well below the top end of the range.

The Road Ahead
Medco's operational performance was once again solid, consistent and encouraging ... and arguably irrelevant to many investors. These investors are instead worried about what will become of the company's contracts to provide pharmacy benefits to the Federal Employee Plan (FEP) and UnitedHealth (NYSE:UNH). While the UNH contract offers lower margins than Medco's other business, it is nevertheless true that Medco gets almost one-fifth of its revenue from UnitedHealth and that cannot all disappear without making an impression.

It is hard to know for sure what UnitedHealth means to do. UnitedHealth has its own internal PBM operation and it would seem logical to just end the relationship with Medco and go all in-house. But not so fast - there are other factors to consider. UnitedHealth has to figure out how it will navigate the new rules and regulations concerning mandated medical loss ratios, as well as the return on capital involved in expanding their PBM business to absorb the business currently going to Medco. All in all, maybe the two companies continue to work together, maybe there's a potential sale (similar to the deal between Wellpoint (NYSE:WLP) and Express Scripts (Nasdaq:ESRX) a while back), or some other option altogether.

Apart from contract renewals, Medco's business seems to be in solid shape. The FDA has not cracked down on new generics like they have on branded drugs, so Medco is continuing to see a steady stream of new generic options. So, what's good for Teva (Nasdaq:TEVA) or Dr. Reddy's (NYSE:RDY) is largely good for them as well.

Likewise, Medco continues to operate in a PBM market where the three majors pursue different strategies. Medco has aggressively pushed the mail-order channel and has the highest penetration of all the majors. Express Scripts, though, focuses more on enhancing patient compliance and saving its clients money through better long-term outcomes. Then there's CVS Caremark (NYSE:CVS) and its ability to offer a captive in-store option. Of course, there is also the seemingly inexorable growth in competition from the likes of Wal-Mart (NYSE:WMT) and Target (NYSE:TGT) and their widely-advertised cut-rate prices on certain prescriptions.

The Bottom Line
Although Medco has a relatively high level of debt, the company is aggressively pursuing buybacks. In addition, the aforementioned worries about Medco's contract renewals have kept a lid on the stock. If investors believe that Medco can continue to deliver mid-single-digit revenue growth and tack on another 50 basis points of free cash flow margin, this is worthwhile stock to consider for more conservative portfolios. (For related reading, see Medco A Top Pharmacy Stock Pick.)

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