Pharmacy benefit management is a controversial industry. Yes, the industry saves health insurers on drug costs. But the giant pharmacy benefit managers, called PBMs, have also been the targets of multiple lawsuits claiming these middlemen earn outsize profits through opaque business practices.

That's why it's paid off for SXC Health Solutions (NasdaqGS:SXCI - News) of Lisle, Ill., to be relatively small and transparent.

PBMs aim to reduce costs for employers, health plans and governments that purchase huge volumes of drugs. Studies over the years have credited the PBMs with negotiating rebates that have helped contain the growth in the costs of drugs. But several large PBMs have also faced lawsuits by payers who say the PBMs conceal the true size of the rebates they negotiate, keeping more than their share for themselves.

SCX, along with other smaller PBMs, has challenged the traditional opaque pricing with transparent pricing. For SCX, transparent pricing has opened many customer doors. "They benefit because they circumvent issues relating to confidential agreements. Some payers prefer that transparency," said Scott Rattee, an analyst at Blackmont Capital.

Transparent Pricing

State fee-for-service Medicaid programs, for example, insist on collecting the full rebate from drug manufacturers. SXC, using transparent pricing, passes along that rebate and collects a negotiated administrative fee. The firm has won six state Medicaid contracts, in part because of its pricing model.

"Transparent pricing has been driving a number of the growth markets, particularly state governments," Rattee said.

Transparent pricing was one of the factors that helped SXC blow through consensus analyst estimates last quarter. Earnings of 43 cents per share nearly tripled the 15 cents of a year ago. And SXC raised estimates for all of 2009. It now forecasts revenue of at least $1.375 billion. Fully diluted GAAP earnings should come in at $1.57 to $1.62 per share. That's up from SXC's previous forecast of $1.42 to $1.50.

SXC targets five market sectors, CEO Mark Thierer told IBD. These include small employers and small to medium regional health plans. Also targeted are the long-term care market and the state fee-for-service Medicaid market, which insists on transparency.

"The traditional PBM model lacks transparency," Thierer said. "In the traditional model, PBMs keep a portion of the rebate." But the problem for payers is that "nobody knows" how much of that rebate the client is getting and how much is retained by the PBM.

"The industry has definitely had its fair share of lawsuits," Rattee said. In some cases, "payers have alleged that the PBM has disclosed some but not all of the rebates." Concern over the opaque pricing model of the larger PBMs has created an opportunity for smaller players like SXC.

The top three PBMs, CVS Caremark (NYSE:CVS - News), Medco (NYSE:MHS - News) and Express Scripts (NasdaqGS:ESRX - News), control 60% of the PBM market, Thierer says. Roughly 100 smaller companies compete for the remaining 40% of the PBM market.

Like many of the smaller rivals, SXC competes with transparent pricing. But with well over $1 billion in projected 2009 revenue, SXC is big enough to get meaningful discounts from drug manufacturers.

"SXC is one of the larger of the small companies pitching transparency," said analyst Dushan Batrovic of Canaccord Adams. "They can deliver transparency along with volume buying discounts."

SXC also has a leg up on its fifth targeted sector: its own legacy software customers. Before its 2008 acquisition of National Medical Health Card Systems, SXC simply sold transaction processing software for handling drug benefit claims.

But with the $143 million cash and stock buyout of NMHC, it became a full-service PBM, performing a broader range of functions. PBMs negotiate large volume discounts on drugs. They also manage existing formularies. And they may help clients design new formularies, choosing the drugs that will be stocked to treat specific conditions and diseases. Like other PBMs, SXC is a heavy user of generics, which help to cut payer costs.

CEO Thierer notes that SXC has 70 legacy software customers, many of whom are prospects for an "up-sell" to the full suite of PBM services. Last quarter, SXC managed to convert New Mexico-based Presbyterian Health Plan, a long-term software customer that spends $150 million a year on drugs, into a PBM customer. In all, Thierer says, SXC has thus far converted "less than five" of its software customers to full-service PBM management. But Thierer sees huge opportunity in converting many of the other IT clients. "That's going to be a big part of setting our model apart," he said.

SXC also stands to benefit from the $20 billion in stimulus funds that will go toward the broad electronic sharing of patient medical records. Thierer told analysts in October that SXC would directly benefit from "the money that's being thrown at technology and health care, this $20 billion stimulus."

"It's a big windfall," he told IBD.

Computer Records

The Obama administration, along with numerous health care lobbies, has promoted the thrust to computerize patient records. But countless examples of breached corporate, government and university databases have heightened anxiety over broadly exposing sensitive medical records.

Unlike many proponents and beneficiaries of electronically shared patient records, Thierer does express concern over privacy issues. "It's a real concern," he said. "The industry will have to address it before it's widely adopted."

The smoke has not yet cleared on health care reform. But Thierer figures SXC can only gain. Providing drug benefits for tens of millions of new health care enrollees can only pump up drug sales. And Thierer says he's reviewed both the passed House bill and proposed Senate legislation. "We don't see any line item in either the House or Senate proposals that is adverse," he said.

Analyst Batrovic also expects SXC to benefit from new legislation.

"The goal is to get more people covered," he said. "More utilization means more prescription drugs. Higher prescription drug volumes means higher revenues for companies like SXC."