Laboratory Corporation of America (LH) is a high-quality business with significant long-term growth potential and margin expansion opportunities trading at an attractive multiple.  LH is no stranger to VIC, but we think recent events have suppressed the company's valuation, making it an attractive long idea once again.  LH operates recurring revenue model with a strong market position that we believe will benefit as lab testing volumes shift out of high cost hospitals and sub-scale independent labs to the low-cost, national scale players, Quest (DGX) and Labcorp, further entrenching their competitive positions.  Automation investments will reduce costs and errors (which should also improve quality) by replacing high-touch labor with machines.  Our checks with industry participants also indicate that the market's current fear of heightened pricing pressure from managed care is misplaced.  Given the stability of demand and under-appreciated future growth prospects, we think a ~10% FCF yield with significant balance sheet flexibility in the hands of a shareholder-friendly management team is compelling. 

Company Summary

Labcorp is the second largest provider of lab testing services in the U.S.  It provides "routine" tests (64% of revs), genomic and other "esoteric" tests (30% of revs) and histology/anatomic pathology tests (6-7% of revs).  Labcorp has 28k employees and operates a network of thirty-eight primary laboratories which provide diagnostic testing services for specimens gathered at both physician offices (2/3^rd of business) and > 1,500 patient service centers (1/3^rd  of business) by its fleet of 2,600 couriers and eight aircraft.  Payers include managed care (44%), commercial (27%), Medicare/Medicaid (20%) and self-pay (8%).  Labcorp recently announced that it will acquire Genzyme Genetics.

Genzyme Genetics - Recent Transaction

On September 13, 2010, Labcorp announced that it would acquire Genzyme Genetics for $925 million ($795 million adjusted for acquisition-related expenses and expected income tax benefits).  Given the dilution in year one, some investors were initially bothered by the deal.  That reaction seems strange, as management had previously communicated its interest in the property to investors and the purchase price was actually lower than we (and probably others) thought it could be.  We believe the acquisition was strategic, reasonably priced and likely to prove quite accretive over a medium-term time frame.  We also think that projections at this point are likely conservative as management has little to gain from discussing cost savings and the attractiveness of the deal generally prior to closing.

Industry Summary

Lab testing is one of best price/value propositions in healthcare as it amounts to only 2-3% of healthcare spending yet influences >70% of physician decisions.  The >$55 billion industry is a structurally attractive duopoly with more logistics-like business model characteristics (i.e. hub and spoke model driven by scale/operating efficiencies) that drive significant industry BTE.  The industry's market share by revenue is as follows:

Quest                                   14%

Labcorp                                 9%

Independent Labs               19%

Doctors                                  4%

Hospital (outreach)             18%

Hospital (out-patient)         18%

Hospital (in-patient)            18%

   Total                                100%

Key Points

Logistics Business with Significant Scale Advantages. We think it is more appropriate to think about Labcorp as a logistics business rather than a health care company.  Together, Labcorp and Quest generate $12 billion in sales while the #3 competitor has just $500 million in revenue.  Massive scale allows LH and DGX to offer the industry's lowest prices as they benefit from advantages in supply/equipment purchases and operating/workflow efficiencies.  Further market share gains create a virtuous circle where the low-cost providers benefit over time, thus further entrenching their competitive positions.  In our opinion, LH has a more attractive free cash profile than the typical healthcare business due to its high recurring revenues and minimal R&D investment (it piggybacks on third-party spend). 

Revenue Growth Opportunities. While lab testing is not a high growth business in the U.S., we think Labcorp has the potential to be a consistent MSD organic grower as it benefits from both volume and pricing growth.  Labcorp is poised to grow volumes as it gains market share from higher cost competitors such as hospitals and independent labs.  Remarkably, hospital lab testing prices are at least 3-4x higher than Labcorp's, while independent labs are usually at least twice the price.  Given looming pressures on health care pricing, it seems highly unlikely that the industry's high cost providers will be able to maintain volumes.  Additionally, health care reform will add an additional 30+ million lives to the testing population and reduce bad debt expense, which currently accounts for ~5% of sales, as the customers most likely not to pay are covered by the government.  Volumes will also benefit from an aging population as tests per capita increase with age.  Finally, pricing should trend higher as the company's mix shifts to higher priced esoteric tests.

Long-Term Margin Expansion Opportunity. Management believes they're in the first inning of automating the business as currently less than 10% of test volumes are automated.  Automation actions reduce the cost of labor, minimize reagent costs and eliminate errors.  The company recently disclosed the savings it achieved by automating its HPV testing operation (50% labor savings, 60% increase in throughput), suggesting significant margin expansion potential.  In 2011, the company expects to automate the sorting function in its major labs.  We think this will allow headcount reductions that could result in a ~3% overall workforce reduction.  We expect further automation to support margins and strengthen the company's low-cost position over time.

Shareholder-Friendly Management Team. Labcorp's management has an excellent long-term record for both execution and capital allocation.  Operationally, the company has grown revenues and profitability significantly over the last decade.  EPS grew from about $0.30 in 1999 to over $5.00 in 2009.  In addition to the contribution to EPS growth from improved operational performance, management has also been an active acquirer of LH stock.  Over the last five years, Labcorp has spent around $2.5 billion to retire nearly a third of the company's shares (at prices well below current levels).  For comparison, this amount is roughly twice Quest's level of repurchases despite Labcorp's smaller size.

Attractive Valuation with Relatively Undemanding Expectations. We think Labcorp is attractively valued at a ~10% FCF yield.  The company's modest financial leverage provides management significant flexibility for future acquisitions (e.g. Genzyme) or further stock buybacks.  Given recent financing deals, we also think that Labcorp could utilize low-cost financing to buy back its high yielding stock.  A nice additional kicker is that the Street's expectations for revenue and EPS growth look relatively undemanding.

Key Financials

One of the key differences between our assumptions and the Street's is capital allocation.  Oddly, the Street seems to give little credit to management's history of aggressive (though well priced) capital deployment in the form of stock buybacks.  Given the stock's current ~10% free cash flow yield (which management has indicated it views as attractive for repurchase, both through words and action), these buybacks are very accretive.  Instead, most analysts seem preoccupied with current cyclical weakness in lab testing volumes.  We'd agree that volume growth is relatively anemic at the moment, but it's unlikely this weakness persists for an extended period (to say nothing of the factors outlined above which should support growth over a longer time frame).

                            2009       2010       2011       2012

Revenue              4,695      4,900      5,518      5,826

EBITDA                1,152      1,219      1,333      1,451

% Margin              24.5%    24.9%    24.2%    24.9%

EPS                       $5.10      $5.60      $6.29      $7.51

FCF/Share             $6.75      $7.01      $7.70      $9.02

Risks

• Pricing Pressure: DGX Q2-10 conference call commentary stoked fears of fresh rounds of HMO price cuts. Our research, which involved calls with numerous competitors and customers, disputes this interpretation. LH's position as the low cost (and low price) provider, coupled with low competitor margins, further mitigates this risk. In addition, high priced hospital lab spending looks like low hanging fruit for insurers looking to cut prices compared to LH.

• Hospital Competition: Some hospitals are ramping up "outreach" programs and/or acquiring physician groups to drive more volume through their lab testing departments. Despite such efforts, they seem unlikely to gain much traction given much higher prices at hospitals. This risk has been commonly mentioned in the past, but the reality is that hospitals have lost share over time, which seems like the logical outcome.

Disclaimer: We and our affiliates are long LH.  We may buy or sell our shares without notification.  This is not a recommendation to buy or sell shares.

LH continues to repurchase shares and make tuck-in acquisitions.  Revenue growth exceeds Street expectations as various secular trends complement a modest cyclical volume recovery.  Benign contract extensions with managed care organizations calm investor nerves.  Eventually the Street recognizes the company's attractive FCF per share growth and values it appropriately (i.e. at least a market multiple).