- By Grahamites
One of my favorite gurus is Dave Rolfe, who built Wedgewood Partners from a small shop to a multi-billion-dollar reputable fund. I think Wedgewood is unique in many ways such as being a truly focused high-quality money manager and being impressively adaptive with the investment in technology companies such as Alphabet (GOOG) and Priceline (PCLN) way ahead of other value investors. But the thing that I admire most about Dave is his humility and rationality.
All of us are subject to the commitment and consistency bias. This bias is especially strong if we shout it out in public. In the investment business, the commitment and consistency bias is exacerbated because of the quarterly or annually letters to investors that every investment manager has to write. Most investment managers would trumpet the winners and blame external factors for losers, which is understandable. Most investment managers would also stick with the losers when disconfirming evidence presents itself. Very few can act in a humble and rational way. After all, changing your mind after you have shouted it out publicly can be construed as being inconsistent by investors. That's one of the reasons Mohnish Pabrai (Trades, Portfolio) and Guy Spier don't talk about their current holdings.
Two great examples of staying humble and rational are Wedgewood's change of directions in two companies that had previously been great compounders - Stericycle (SRCL) and Express Scripts (ESRX). Wedgewood has held on to these two companies for many years and has written extensively about them. The pressure is there to avoid the "Oops, we are wrong" conversation with the clients. As recently as second quarter 2016, Wedgewood was a believer in Stericycle's business model in light of the deterioration in the core business and the Shred-It acquisition. But Wedgewood did the right thing. Over the next two quarters, they analyzed the situation rationally and decided to change their mind. Let's review what they wrote from second to fourth quarter 2016.
Second-quarter 2016 letter
Stericycle was also a top detractor during the second quarter. Stericycle's early year bounce reversed itself and then some time after, management lowered forward earnings expectations for the second time in three quarters. Management noted further weakness in their small (approximately 3% of revenues, we estimate), industrial hazardous waste business and pushed the timeline of about $20 million of expected synergies from their newly acquired document destruction business into next year. Taken alone, we think the stock's 21% drop reaction following the earnings release was an overreaction.
We think Stericycle's core business of regulated waste management continues to be very attractive, throwing off strong free cash flow, with historically steady results. The Company has consistently reinvested these cash flows into smaller, regulated waste management acquisitions, as well as entering new verticals. Secure document destruction is a relatively new vertical for the Company, but we think the demand characteristics (driven by regulatory requirements) and hub-and-spoke collection and disposal model should fit well over the long term. While management noted a longer than expected timeline for converting on-site processing into off-site processing (similar to the way that medical waste is handled), we expect the Company will be successful in this conversion. As for the Company's industrial hazardous waste business, it has proven to be highly cyclical. However, we expect the benefits of the Company's overall hazardous waste platform (acquired in 2014) to more than outweigh the risks, as we estimate that retail and medical hazardous waste have grown to over 5% of revenues, from close to zero in 2014 - more than offsetting industrial waste declines. So while we understand investors' concerns over the Company's near-term earnings disappointments, we continue to be patient because we think Stericycle's long-term opportunity for double-digit growth is intact as returns on reinvestment take hold.
Q3 2016 Letter:
Stericycle underperformed during the quarter as headwinds related to their core, regulated medical waste (RMW) segment began to emerge. Prior headwinds to the Company were limited to non-core businesses or are short-term issues that should be remedied over the next few quarters. While the stock has become cheap, historically and relatively, we did not add to positions during the quarter, as we continue to evaluate the extent of the pressure the Company is seeing in its RMW business.
Q4 2016 Letter:
We liquidated Stericycle from portfolios after we determined that the Company's competitive advantage in its core regulated medical waste (RMW) business was not as robust as we had seen during the past five years of our holding period. Prior to the erosion in the economics of their core RMW business, we remained optimistic about Stericycle's business. Despite recent stumbles in their non-core hazardous waste business and slower than expected integration of newly acquired Shred-it, the RMW business continued to serve as the engine to double-digit growth in free cash flow. We previously believed that Stericycle's unrivaled scale had served to insulate its RMW profitability from competitive pressures, including customer push-back associated with consolidating end-markets, as many of Stericycle's most profitable customers - particularly individual physician practices - have been consolidated by managed care organizations over the past several years. However, over the past few quarters, management began disclosing that the long-term contracts associated with these newly consolidated customers were coming up for renewal at significantly lower prices. It is not clear to us why the Company gave up this pricing, given that the market has few large-scale alternatives to Stericycle. Suffice it to say, these contracts are in place for several years (sometimes five years or more), and while the Company can spend this time recovering economics through more cross selling, this strategy is unproven and potentially dilutive. As such we lost conviction in Stericycle's ability to defend its excess profitability in RMW, and subsequently liquidated our positions.
In Express Scripts' case, Wedgewood did the same remarkable thing. Dave touted the company until Q2 2016 and then rightly changed his opinion based on "tacit evidence."
Q1 2013 Letter:
Although we have been investors in Express Scripts Holding Company since 2007, it was not always a "holding company." Express Scripts is the largest pharmacy benefits manager (PBM) in the country, managing nearly one third of all prescriptions written in the U.S. The Company recently (second quarter of 2012) rose to this market position after successfully closing the acquisition of Medco Health Solutions (Medco), effectively doubling the volume of prescriptions previously handled. Express Scripts' primary value proposition is to drive lower absolute and relative drug spend by injecting itself into almost every step of a clients' drug prescription process from patient evaluation and distribution channels, to adherence. The Company's unparalleled scale and unique focus on the behavioral and clinical aspects of the drug prescription process enables them to effectively deliver an "open architecture" drug benefit which maximizes the opportunity for clients to eliminate spending waste. The Company's clients include managed care organizations, health insurers; mid-to-large employers and unions, all of whom are constantly bombarded by double-digit medical care cost inflation.
In our view, Express Scripts' unmatched scale and unique approach are what will continue to reinforce its competitive profile for years to come. For example, throughout 2011 and part of 2012, one of Express Scripts' pharmacy network members, Walgreens, purportedly tried to raise prices on prescriptions, without adding any incremental value - which would have mitigated savings from cheaper, generic drugs coming to market over the next few years. Express Scripts saw these terms as unacceptable, and boldly removed Walgreens from its pharmacy network, yet clients still had access to another 50,000, lower---priced pharmacy alternatives from CVS and Rite Aid, to thousands of independent pharmacies. So Express Scripts' clients were able to make a wholesale move to these new pharmacies, with minimal disruption. Needless to say, the effect on Walgreens was not as subtle, almost 10% of its fiscal 2012 earnings per share were quickly lost as millions of prescriptions were shifted to cheaper competing pharmacies. Ultimately, Express Scripts readmitted the retailer back into its network in mid- 2012, presumably with economics that were more beneficial to clients. While this "narrow network" approach is not a new concept, it had never been done to this scale, but Express Scripts was able to be effective while excluding the largest pharmacy chain in the U.S., a testament to the Company's scale and competitive leadership.
As Express Scripts reaches critical mass in terms of prescriptions, we believe there is still room for attractive growth in profitability through further waste reduction and optimization of client behavior. Express Scripts' research estimates show that there is over $400 billion in pharmacy-related waste every year. If the Company can continue to execute on its competitive advantage, we expect the Company to increasingly drive out more of this waste, and in turn, increase its profitability spread on each prescription (EBITDA/Rx).
In the interim, we expect Express Scripts will continue to be a prolific generator of free cash flow. Aside from information technology and a handful of automated drug distribution centers, there are few, large capital expenditure calls on the Company's operating cash flows. That said, in order to finance the Medco deal, Express Scripts issued debt with about $13 billion (net of cash) currently on the balance sheet. We expect that they will be able to generate between $4 billion to $5 billion in free cash flow over the next twelve months - and increasing each year for the next several years. With about $6 billion in debt due by the end of 2015, and $2.8 billion cash currently on the balance sheet, Express Scripts should have ample financial firepower to reinvest in the business, pay down debt and provide share buyback support over the next few years. The Company ended the quarter at a market cap below $50 billion, when squared against our free cash flow estimates, results in a yield of about 10% which, relative to competing investment opportunities and given Express Scripts' opportunity set, we earnestly believe represents an excellent investment opportunity.
Q2 2016 Letter:
Express Scripts was a top contributor during the quarter. The stock recovered some of the poor performance from the first quarter after Anthem management noted that, despite filing a lawsuit over Express Scripts' pricing, they believe any ruling on the lawsuit would take several years and were still open to negotiations. Express Scripts is the sole, independent pharmacy benefits manager (PBM), which we think is key for maintaining their alignment with customers. We continue to expect Express Scripts to drive mid-to-high single-digit EBTIDA growth using its scale to negotiate better pricing with drug manufacturers and service providers, while increasing patient adherence. We think earnings per share can continue to grow at a double-digit rate as shares are repurchased at what, in our view, are attractive valuations.
Q1 2017 letter:
Having reduced our weightings in Express Scripts over the past 12 months, we sold our remaining stake during the Quarter. In our view, the Company will be challenged to grow operating income beyond mid-to-low single digits, as the market has matured, mostly due to industry consolidation, over the past few years. The corollary is that Express Scripts' scale advantage isn't as potent as it once was. The most obvious example is Anthem's decision to replace Express Scripts with an alternative PBM (Pharmaceutical Benefits Manager) when their contract expires in 2019. That there are multiple service providers Anthem believes are capable of taking on, we estimate, 250 million or more claims per year, with minimal disruption, is tacit evidence that rivals and substitutes have gained enough traction and scale to compete away the Company's excess economics. That said, Express Scripts remains the last independent, large-scale PBM, which we think allows them to better align themselves with their customers when negotiating with the various players in the drug channel--and to differentiate their plan designs. But that novelty can be quickly copied by increasingly larger rivals. For example, we think the Company was the first, large PBM to offer a narrow pharmacy network that excluded a major pharmacy provider (Walgreens). While risky at the time, the narrow network shifted substantial value back to Express Script's customers (plan sponsors), which also benefitted shareholders. Today, narrow networks are table stakes, with CVS or Walgreens routinely excluded from benefit plans designed by rivals. With a slower rate of earnings growth than we are willing to accept, we decided to liquidate our remaining stake in Express Scripts.
For the past few articles, I have been critical to some money managers for finding excuses for their prolonged underperformance. Almost all of the letters I read are full of excuses. So it's very refreshing to read Wedgewood's letters, which I also think are good educational resources. I applaud Dave and his team for sticking to their approach and staying humble and rational throughout the years. They have truly been exemplary in the money management business.
This article first appeared on GuruFocus.
