Dealtalk: If U.S. blocks Express-Medco, what's Plan B?

NEW YORK/PHILADELPHIA (Reuters) - As healthcare mergers go, this one is unique: Express Scripts Inc (ESRX.O) will not find a target in the pharmacy benefit industry anywhere near as large as Medco Health Solutions Inc MHS.N, while Medco realistically has little shot at wooing a suitor other than its chief rival.

So, if Express Scripts' $29 billion bid for Medco is blocked by U.S. antitrust regulators, Wall Street expects the pharmacy benefit management companies will avoid a second try at a massive deal.

"There's not a lot of other deals that significantly move the needle," said one healthcare banker who declined to be named because he was not authorized to talk to the media. "There's not a great second-choice solution that would fatten the PBM business enough."

Instead, bankers, analysts, portfolio managers and others interviewed by Reuters suggest the companies would stay solo, choosing to gobble up smaller rivals to get bigger while starting significant share buybacks to mollify shareholders. A dividend would also help, some say.

Express Scripts and Medco administer drug benefits for employers and health plans, and run large mail-order pharmacies.

They profit particularly from low-cost generic medicines, where they use their leverage to drive bargains. An Express-Medco merger would give them even more leverage at a time that a number of big-selling drugs are becoming available as generics, such as Pfizer Inc's (PFE.N) Lipitor cholesterol fighter.

"As you work through the generic wave, and the business becomes more commoditized, then I definitely think mergers that allow you to build scale and lower costs are very very important," RBC Capital Markets analyst Frank Morgan said.

When the deal was announced in July, investors continued to trade Medco shares with a substantial discount, factoring in the risk that the Federal Trade Commission might reject a deal between two of the industry's three top players.

That skepticism gradually waned after several Congressional hearings failed to raise significant new opposition.

New signs of merger scrutiny by the government, including AT&T Inc (T.N) abandoning its $39 billion bid for T-Mobile USA and a possible FTC block to Omnicare Inc's (OCR.N) $440 million bid for rival pharmacy services provider PharMerica Corp (PMC.N), have not deterred Medco and Express Scripts investors.

Analysts generally expect the deal to create the largest company managing Americans' prescription benefits will go through, with odds at 40 percent chance of approval on the low end and 80 percent on the high end.

Medco and Express Scripts spokesmen said they still expect the deal will close in the first half of the year, and would not speculate on what they might do if it does not.

Investment bankers following the deal say the AT&T setback should still give investors some pause.

"The Feds have shown with T-Mobile that they aren't afraid to use their teeth if necessary," said a second healthcare banker. "It doesn't bode well for another mega-consolidator deal."

COLLAPSE WOULD HURT STOCKS

Medco's shares trade at about a 13 percent discount to the cash-and-stock offer from Express Scripts. That spread is far below the 27 percent it reached last year but still indicates hesitancy over the deal closing, and gives Medco investors a chance to ring up a nice profit if the deal does close.

"Medco has more upside if the deal goes through, but more downside if it falls apart," Jefferies & Co analyst Arthur Henderson said.

Henderson reckons Medco stock could immediately fall to $50 a share or lower should the deal collapse, a nearly 20 percent drop from current levels. Express could decline 10 percent, though both companies would seek to mitigate any declines by immediately announcing large stock buybacks, he said.

Express Scripts Chief Financial Officer Jeff Hall told the JPMorgan Healthcare conference last week that if the deal does not close "then certainly buybacks would be possible, but in addition, looking at potential M&A and other tactics."

With a low debt profile if the deal fails, St. Louis-based Express Scripts could easily buy back $4 billion of its shares, Henderson said.

Should the deal collapse, Medco and Express are likely to consider buying smaller rivals, some of whom have capitalized on the uncertainty over the mega deal by taking away clients.

SXC Health Solutions Corp (SXC.TO) and Catalyst Health Solutions Inc (CHSI.O), with market values of about $4 billion and $2.8 billion respectively, along with privately held Prime Therapeutics are likely candidates, analysts say. Pharmacy benefit units run by health insurers, such as Cigna Corp (CI.N), also are potential targets.

"There are a number of mid-tier PBMs that will be probably be looked upon as potential acquisition targets," said Dea Belazi, a specialist on pharmacy benefit managers at information publisher Wolters Kluwer. "Large organizations like this are all about building up revenue."

Medco may be more pressured to strike deals. The Franklin Lakes, New Jersey-based company has lost contracts worth $10 billion in drug spending for this year, according to JMP Securities analyst Constantine Davides.

That does not include the 2013 expiration of Medco's agreement with insurer UnitedHealth Group Inc (UNH.N), which is investing in its own PBM and stands to be a major competitor.

"Medco is in a more precarious situation simply because they've lost a lot of business," Davides said. "I can't remember the last time they had a year when they were net losers in terms of net new business."

Another way to soothe investors could be to institute a significant dividend.

Chris Konstantinos, a portfolio manager with Riverfront Investment Group, sold its Express Scripts shares more than a year ago. Starting a dividend could lure him back.

"If these companies were suddenly to become significant dividend yielders and more importantly indicated they were going to aggressively grow those dividends, all of a sudden you start attracting an all-new investor base," Konstantinos said.

No one is suggesting that either company won't survive without the merger. But, Belazi says, clients are getting a little savvier and a little smarter "about where is the fat, how are the PBMs making money."

As a result, they can expect more pressure on their profits, driving the impulse for more efficiencies.

"The bigger question is not so much will we need PBMs, but what kind of margins can they expect to earn over the long run when we don't have this huge tailwind of generics," Morningstar analyst Matthew Coffina said. "That's very much up in the air."

(Editing by Michele Gershberg and Tim Dobbyn)