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Tickers in this Article: ESRX, MHS, ABC, CAH, TEVA, UNH, WAG, CVS
When Express Scripts (Nasdaq:ESRX) announced its intention to acquire Medco Health Solutions (NYSE:MHS) last week, it lit the fuse on what is likely to become one of the most far-reaching (if not most interesting) developments in health care in some time. At a bare minimum, this deal is going to force the current U.S. administration to make some very interesting choices when it comes to market competition and health care costs.

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The Deal
To offer a quick review, Express Scripts is proposing to acquire its larger rival (in terms of prescription share) for total consideration of $71.36 at the time of the announcement. This consideration will be broken up between $28.80 in cash and 0.81 shares of Express Scripts. Assuming the deal goes through, it will deliver Medco shareholders a 28% premium to its pre-deal price and Medco shareholders will hold about 41% of the new company.

At more than $29 billion, this is clearly a large deal and the corporate bond markets seem to support the idea that Express Scripts will have to lever up (take on debt) to do the deal, but will work it down rather quickly. At full deal price (and Medco presently trades about 10% below the initial $71.36 bogey), the deal would value Medco at a little over 11 times trailing EBITDA - not an unreasonable price for either party, but incrementally more favorable for Express Scripts shareholders.

A Powerful Deal
All told, a combination of these two companies would control more than 32% of drug prescriptions in the U.S.. Moreover, deals in this space have almost always been highly synergistic, and Express Scripts will likely see very strong operating efficiencies when it comes to back-office and claims-paying functions.

Even more significant, the new Express Scripts would become much stronger when it comes to negotiating with drug suppliers. That would be seriously troubling news for companies like AmerisourceBergen (NYSEABC) and Cardinal Health (NYSE:CAH), which live in that treacherous area between the pharmacy benefit managers and drug companies, as well as drug companies like Teva Pharmaceuticals (Nasdaq:TEVA), Mylan (NYSE:MYL) and Pfizer (NYSE:PFE).

Why Now?
So why would Express Scripts do this deal? For starters, there is the previously mentioned scale that comes with deals. Express Scripts largely built itself with deals and solid internal execution and this would simply be the capper to that growth story. What's more, the synergies and buying power could create that rare two-for-one where Express Scripts could be both a low-price leader (and gain share) and preserve or improve margins - making it a rare true "wide moat" company in health care services.

There are other aspects to this deal that should not be underestimated. First, the torrent of top-selling branded drugs going generic that fueled the growth of the PBM space is slowing to a trickle (and represents an underappreciated risk factor for the likes of Teva). While biosimilars may refresh this thesis a bit, there simply aren't enough branded-to-generic switches coming up to really save PBMs much money.

Also, there are about to be millions more Americans on the membership roles of health insurance and PBM companies from the U.S. health care legislation based a while ago. When that larger stream of claims hits, there will be an even greater advantage to holding claims-processing scale.

Yes or No?
So, will this deal make it through? On the surface, it seems unlikely - this is the number three company buying the number one company and they will hold about twice the share of number two (CVS Caremark (NYSE:CVS). Moreover, it seems safe to assume that the pharmaceutical and generic industries will howl in protest, as well, pharmacies like Walgreens (NYSE:WAG) and perhaps other managed care providers like UnitedHealth (NYSE:UNH), which is set to become the fifth-largest (and the last PBM with 10% or more share) after taking its business back from Medco.

Oh, and don't forget that the current U.S. administration believes competition drives down cost (though there's no particular evidence of that in the PBM space).

On the other hand, the Department of Justice uses a metric called the Herfindahl Index to evaluate deals and this transaction would leave the PBM space as "moderately concentrated" - which it already is. What's more, if this administration wants to deliver the cost savings it promised with health care reform, this is one of the best chances of that happening.

The Bottom Line
All in all, this deal looks like a 50/50 shot today. If it goes through, expect more consolidation in the drug and generic industries, as well perhaps a major deal in the distribution space (the aforementioned Cardinal, AmeriSource, etc.). Also consider the possibility of further consolidation in PBMs, assuming the government would allow it.

For Express Scripts shareholders: hope this deal goes through - it's a bold move at an appealing price and it will position the company for some great results. For Medco shareholders: fret a bit about a price that discounts fair value, but take some solace in that share equity component and the prospect of owning a potential powerhouse health care company. (For related reading, also see Investing In The Healthcare Sector.)

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