Description

While I'm generally lukewarm toward recycling ideas, the recent market correction provides the opportunity for me to re-recommend Labcorp (LH), which I pitched one year ago with the stock at $78. Over that period, much has gone well for the company.  Labcorp closed and began integrating Genzyme Genetics, a $935 million acquisition announced in September 2010, in addition to winning approval to close its acquisition of Westcliff Medical Laboratories, which the company purchased earlier in 2010.  Revenue, earnings and free cash flow have continued to grow (both organically and through acquisition) while the share count has declined.  Contracts with major customers have been extended and the gap between Labcorp's performance and that of its rival Quest Diagnostics (DGX) has widened.  And the reward for this progress?  LH now trades at $80.  This disappointing result stems from several factors that combined to take LH's stock down from >$100 in May 2011.  Most significantly, investors are concerned that "utilization trends", which is fancy talk for volumes, are weakening.  IMS data that tracks patient visits to physician offices has been weak all year, showing year over year declines that appeared to accelerate over the summer.   In addition, the specter of adverse regulatory change looms large.  While lab testing hardly has a target on its back like some health care businesses in terms of political vulnerability, investors are understandably nervous that the upcoming budget "super committee" or another entity could push cuts to lab testing reimbursement, obviously a negative.  Lastly, I believe that LH's recent extension of its exclusive contract with United Healthcare has, perhaps counter-intuitively, rekindled largely dormant concerns about market share fights between LH and DGX.  On top of this, of course, the market has been less than cooperative, particularly for health care companies, so here we are.  I believe that LH's recent correction is overdone and that we now have the opportunity to purchase an excellent company with a strong balance sheet and a management team competent in operational execution and capital deployment for a very attractive 10% current year free cash flow yield.  Importantly, without much in the way of underlying volume improvement this free cash flow yield increases to 11% in 2012 and over 12% in 2013, which I think is much too high for a business like Labcorp.  Rather than recounting the investment thesis I laid out a year ago, which to be frank is largely unchanged, I'd like to use this opportunity to argue why I believe the spectrum of current investor fears is manageable, if not somewhat misplaced, and to highlight thesis-affirming items of incremental interest.

First, let me rebut what I believe are the topical investor concerns.  In reverse order from above, lets start with wariness over a potential price war for HMO contracts.  The bottom line is that LH has very little exposure to upcoming contract renewals.  The current line-up is Horizon, which is pending, Humana at the end of 2012 and Wellpoint and Cigna, both mid-way through 2013.  These contracts are dwarfed by the United Healthcare contract, which represents 9% of Labcorp's business and was just renewed through 2018.  Very significantly, our understanding is that LH did not concede on price to extend this contract.  According to management, Labcorp's performance under the contract was very strong, resulting in LH achieving incentives for reduced leakage (i.e. out of network testing), for example.  Moreover, we have not heard that Quest has been incrementally aggressive in the marketplace.  It's possible that Labcorp loses its exclusive with Horizon, but the net impact of this would be marginal as LH's non-exclusive economics would improve.  Second, Labcorp is less vulnerable to adverse regulatory or reimbursement changes than most of its peers.  This is a function of the company's low price/low cost position in the industry, in addition to LH's relatively low exposure to government reimbursement revenues: <20% vs. 50%+ for the rest of the industry (excluding Quest).  This implies that should some of the issues currently being bandied about, such as co-pays for lab testing, are vastly more impactful to LH's peers who are highly exposed to Medicare and Medicaid and typically operate at 5-10% margin levels (vs. LH's >20% margin structure).  Should the government move forward with lab co-pays, for example, the headline would be negative and LH would likely encounter higher bad debt expense down the road, but the competitive landscape would irrevocably altered as many of the weak members of the lab testing herd would fall by the wayside, either disappearing entirely or selling out to LH at a discounted, "oops I'm in bankruptcy" price, like Westcliff was forced to do.  Finally, as it relates to volumes and "utilization", it's not appropriate to be flippant.  The current environment is soft, and I would expect LH's organic volume growth to decelerate in Q3-11.  Having said that, the IMS data that has spooked the sell side into shaving 2011 estimates down to the very bottom of management's guidance range is simply not a good proxy for LH's volumes.  Much better indicators are commercial covered lives (at HMOs) and general employment levels.  Everyone knows that the employment situation is grim, but the important detail as it relates to LH is that employment isn't falling apart.  In fact, it's flat to up, which is a good thing.  Another good thing is that many of Labcorp's HMO customers, such as United, are growing their commercial covered lives count.  Admittedly, some others are shrinking, like Aetna, which is one of Quest's challenges, but overall the likelihood of a major volume collapse is not particularly realistic unless the economy goes off a cliff.  I don't mean to be dismissive of these concerns, but I believe that the stock more than discounts them at the current price.

So, beyond a rebuttal of what's scaring people, what is there to like?  In addition to the core investment thesis that I've discussed previously, I think there a handful of interesting things to consider:

• Recent acquisition activity is compelling in several ways. Most notably, the Genzyme acquisition is ramping up nicely. Management reports that revenue retention is ahead of schedule (recall that LH expected to lose some revenue given that, among other things, its prices were lower than Genzyme's), and that the facility rationalization is on track. Genzyme won't be at a steady state profit level until the end of 2012 / early 2013, but the incremental profitability will be considerable. Longer-term, I think Genzyme could contribute $1.00 or more of EPS. Meanwhile, management finally prevailed in its struggle with the FTC over Westcliff, a battle that needn't be recounted here. The significant thing is that management is now free to consolidate Westcliff's operations, which it previously was prevented from doing. Happily, Westcliff is an easy, tuck-in style acquisition that should produce earnings of perhaps $0.25 per share. Labcorp has also recently acquired two smaller businesses, Orchid Cellmark and Clearstone. While not terribly impactful economically, these acquisitions enhance LH's geographic footprint by giving the company its first labs in China and Singapore, while strengthening the company's clinical research franchise. The international expansion in particular is much more of a toe-in-the-water kind of move, which seems like the responsible way to expand.

• Though organic revenue growth will most likely be soft (low-to-mid single digits) over the next couple of years, profit and free cash flow growth will be much more significant. Obviously much of this improvement relates to the profit ramp at Genzyme and Westcliff which is discussed above. According to my numbers, which are shown below, FCF per share will grow from roughly $7.30 in 2011 to nearly $10.00 in 2013. About half of that gain is from Genzyme and Westcliff, while the remainder is attributable to modest organic growth, slight margin expansion and the deployment of about two-thirds of FCF into share repurchases. In this scenario, net debt ends 2013 under 1.0x EBITDA, which seems quite low. Note that my FCF figure includes stock-based comp, but I also assume share dilution, so the net effect is about neutral. Overall, I expect mid-teens FCF per share growth over the next few years, which is attractive given modest top-line assumptions. An improvement in the economy and employment, which would be quite nice for Labcorp's high incremental margin drugs-of-abuse business, would be gravy.

• Labcorp's competitive position is strengthening. Size and scale is the company's primary advantage; it is basically impossible for a new entrant to replicate LH's business at this point given the massive scale of the operation. LH is also making strides in efficiency, automation and IT to further entrench its cost advantage. Measured by margins, LH is already several hundred basis points ahead of Quest despite having significantly lower revenues. By management's own account, the company is 40% more efficient in testing activities that have been automated than it was three years ago (measured by specimens per employee). They don't believe anyone else is close. Quest, which by virtue of its greater size should benefit from scale benefits superior to LH, continues to stumble. The company's pricey Ameripath acquisition has killed them, as anatomical pathology has faced severe pressure as physician groups insource that business. Quest is also apparently not on a common IT system, unlike Labcorp, while the company's unfocused strategy, including endeavors into at-home testing and labs in India, drain its resources. It also is hard to believe that Quest can casually strip another $500 million from its cost structure without adverse effect as it intends to do. The bottom line is that lab testing is a scale and cost business, and Labcorp's position continues to improve. It's not a coincidence that the country's largest HMO was just willing to extend its exclusive contract with LH until 2018. (Note that if we opted to look at Quest's situation differently, it highlights how resilient the lab testing business can be despite weak macro environment and a host of unforced errors.)

• In the wake of the proposed Express Scripts-Medco merger, there has been chatter that Labcorp could potentially merge with Quest. I will be the first to acknowledge that the probability of such combination being allowed by regulators seems very, very low, but it is quite tempting to contemplate. Obviously a massive amount of cost could be stripped out of the combined entity as duplicative back office functions disappear and the number of lab facilities drops by a third (half?). From the perspective of the HMOs, such a merger might not be all bad. A single, national scale provider of services would be easy to use and, critically, able to offer much lower prices than anyone else in the industry. From a regulatory perspective, lower prices to HMOs and Medicare/Medicaid might make something that looks rather like a monopoly much more palatable. And who knows, perhaps the folks at the Justice Department decide that the correct market to measure includes the two-thirds of the industry controlled by hospitals, rather than the smaller portion operated by LH, DGX and the other independent labs. So yes, this is a low probability scenario, but management's unwillingness to quash the idea in public is somewhat intriguing, at a minimum.

To conclude, I think that in a time of genuine economic, political and social uncertainty, it's sensible to own predictable businesses (LH management knows ~90% of the year's revenues January 1) managed by individuals with a track record of solid operational execution and sound capital deployment.  Moreover, you want a business that provides a necessary product (lab testing used in >70% of all medical diagnoses) with a strong value proposition (lab testing represents 2-3% of total health care expenditures vs. 7-8% for administrative costs), and does so as the low price/low cost player.  Optionality related to accretive tuck-in acquisitions (or even something bigger...) and leverage to an up-cycle in employment doesn't hurt either.  It's not that hard to see the return of some enthusiasm pushing the multiple back up.  14x my 2012 FCF per share estimate produces a stock price of nearly $125.  Up 50%+ isn't bad for a business of this quality and lower risk profile.

Financials

                                2010       2011       2012       2013

Revenue              5,004     5,608     5,866     6,103

EBITDA                 1,220     1,315     1,446     1,548

Adj'd EPS             5.99        6.53        7.88        8.97

WASO                   105         102         97           92

FCF/Share           7.07        7.28        8.75        9.95

Net Debt             1,958     1,745     1,546     1,246

Catalyst

• Additional tuck-in acquisitions.
• Management steps up the stock buyback program with a more serious tender offer.
• Upcoming HMO contract renewals pass without incident (like United just did).
• The big enchilada: LH merges with Quest. As they say, drinks on me in that scenario.