We just published a new IOI ChartBook on pharmacy benefits manager giant Express Scripts (ESRX) to our members. Here are the three most important points discussed in our report.

  • Express Scripts succeeded in building the strongest business for the last decade – it may not be the right business for the next decade.

The firm spent years making a series of acquisitions that transformed it from a middling drugstore chain to a powerhouse in prescription management. However, the Prescription Benefits Management (PBM) business is shifting, thanks to changes in Big Pharma related to drug development and pricing, changes in insurance related to the introduction of the ACA, and a general trend to re-integrate the prescription management function into insurance firms or firms with a retail presence. Express Scripts worked very hard to build the strongest business among its contemporaries in the aughts, but did not or could not anticipate the changes that look to be making its stand-alone PBM model less relevant in the future.

Because its standalone business is strong, competitive and has such scale, it is possible that Express Scripts will be an acquisition target. We think the most likely buyer is the Walgreens Boots Alliance (WBA), but realize that Walgreens is more likely to spend some time digesting Boots before making another large acquisition. Time may be on Walgreens’ side.

  • The Anthem suit probably has longer-term implications and signals fundamental changes in the PBM business.

Anthem (ANTM) is Express Scripts’ largest client, making up around 16% of 2015 revenues. It has filed suit against Express Scripts alleging that the PBM has nefariously cheated it by not passing along kickbacks from Big Pharma firms that are a feature of Americas messed up medical system. We think that Anthem will cease to be an Express Scripts client at or before 2019, but that the suit creates two problems that are more serious. First, the suit has raised doubt in other clients’ minds that Express Scripts may not be a fair dealer. Second, the suit suggests that the PBM industry is changing and re-integrating with other insurance or drug providers. If customers start to defect and see an integrated model as being more beneficial to their own interests, Express Scripts’ valuation is in danger.

  • The stock is fairly valued now, but the potential for both a downward and upward step-change in fair value is very real.

Our fair valuation range is almost perfectly reflected in the stock price range implied by the option market. That said, if customers begin to defect en masse, we would have to downwardly reassess the forecasts for our preferred profitability measure – Owners Cash Profits (OCP) –  for Express Scripts. Doing so creates a fair value range whose average is 30% lower than today’s price. On the other hand, the fact that Express Scripts’ business may be attractive to a large acquirer (ESRX market cap is $48 billion, so would be a big bite to swallow), suggests that there is upside risk to a bearish investor. We are steering clear of this company as a single-name investment due to this uncertainty, which we believe is too hard to accurately handicap.