Express Scripts Parsimonious Forecasting

1. Express Scripts Parsimonious Forecasting Ian Johnston

2. Parsimonious Forecasting • Gather information useful in forming expectations of future payoffs • Examine RNEA • EPM (profitability measure) • EATO (efficiency measure) • Examine time series and compare to industry firms

3. RNEA • RNEA = EPAT/avg(NEA) • Use EPAT from sales • Takes out activities not relating to generation of sales (foreign currency translation, etc) • Use Average NEA for the year • Takes into account the average amount of resources employed during the year • Do not know the actual timing of investments • RNEA = EATO * EPM

4. Steps for Forecasting • Forecast revenues via forecasts of sales growth rates • Analyst calls and reports • Management discussion (be careful) • Past history • Forecast EPAT via forecasts of EPM • Forecast NEA via forecasts of EATO • Ignore firm’s financing activities: only value enterprise

5. ESRX Unique Issues • Announced acquisition of WellPoint’s NextRX subsidiaries in 2009 • No financial data for subsidiaries before merger • Impossible to combine ESRX and NextRX to obtain comparable 2009 data • Consequence: Only 3 years of ESRX financial data • Merged with Medco in 2012 • Massive amount of goodwill booked, leading to a large jump in NEA • Skewed EATO numbers in 2012

6. ESRX Unique Issues • Revenue irregularities • After acquisition of Medco, lost UnitedHealth Group as a client • Resulted in a 19% decrease in revenue in 2012 • One time event that makes it hard to project revenue growth • Shows volatility of PBM industry • 2013 data will be very helpful in establishing a trend • Will ESRX return to modest 4% growth or will it falter in the face of more lost clients?

7. Step 1: Forecast Revenue • 2010-2011: 4.73% increase • 2011-2012: 19.22% decrease • Loss of UnitedHealth contract hurt • Was a Medco client before merger • Assume 4% growth over next 5 years • Growth in number of insured due to Obamacare • Merger synergies will be realized • 2010-2011 will be status quo • Reevaluate estimation after 2013 financials are released

8. Forecasted Revenue

9. Differences from Industry • Most comparable firm is Caremark • Both Caremark and ESRX experienced volatility in revenue growth • Sales growth was not symmetrical (similar for the same year for both firms) • PBM industry is inherently volatile due to the gain and loss of large contracts with pharmacies • Drug Stores • CVS and Walmart experienced stable growth • Walgreens was much more volatile than its competitors • Overall: many differences within the industry

10. Step 2: Forecast EPAT using EPM • EPM 2010: 2.56% • EPM 2011: 2.62% • EPM 2012: 1.84% • Assume 2.50% for next 5 years • 2012 seems to be an anomaly due to loss of UnitedHealth • 2010 and 2011 appear to be status quo • Merger synergies = higher EPM (less admin costs) • Reassess after 2013 financials are released

11. EPM Data

12. Differences from Industry • Most comparable firm: Caremark • Caremark hovered between 2% and 3% EPM • ESRX was very similar, except in 2012 (below 2%) • Caremark also experienced lowest EPM in 2012 • Drug Stores • CVS led the way at around 5% • Walmart and Walgreens came in a little over 3% • Overall: similar EPM for the industry

13. Step 3: Forecast NEA via EATO • EATO 2010: 7.38 • EATO 2011: 7.47 • EATO 2012: 3.45 • Assume 3.5 going forward • Addition of $17 billion of Goodwill in 2012 • Addition of $12 billion of Intangible Assets in 2012 • Both additions are permanent and drastically changed EATO

14. EATO Data

15. Differences from Industry • Most comparable firm: Caremark • EATO climbing from 1.5 to 2.5 • ESRX post-acquisition EATO around 3.5 • ESRX before merger was much more efficient (7.5) • Firms going in opposite directions • Drug Stores • Walgreens was most efficient, but very similar to CVS and Walmart • Overall: EATO seems to be converging for the industry

16. Summary of Assumptions Sales Growth Rate: 4.0% EPM: 2.50% EATO: 3.5 Can project 2013-2016 sales, EPAT, and NEA

17. 4 Year Projection

18. Summary of Assumptions 2012 was an anomaly due to loss of UnitedHealth Merger synergies will begin to be realized Growth in contracts due to Obamacare Additions of Goodwill and Intangibles will define EATO going forward 2013 data needs to be added when available

19. Discounted Cash Flows • FCF = EPAT – Change(NEA) • Steps: • Calculate change in NEA • Calculate FCF based on equation above • Discount cash flows back to current period • Assume 10% discount rate for now • Calculate continuing value for period after 5 years • (FCF2016 x Growth Rate)/(Discount Rate – Growth Rate) • Discount back to current period • Sum four projected cash flows and continuing value to obtain enterprise value

20. Continuing Value Use 2016 FCF multiplied by 1.04 growth rate Divide by 10%-4% for perpetuity value Discount perpetuity value by dividing by the 2016 discount factor (1.46) (1,538,416 * 1.04)/(.1 - .04) = 26,665,884 26,665,884 / 1.46 = 18,213,158 = PV Con’t value

21. Enterprise Value PV continuing value + Sum(PV cash flows) 18,213,158 + 4,944,176 = 23,157,334 FCF projection of ESRX’s enterprise value

22. Calculations of FCF

23. Questions?