Description

LabCorp (NYSE: LH)
Lots to write, but I’ll try to keep it limited. If you have specific questions, I'll try to help. Have to move quickly.

Conclusion
When I look at the level of interest rates, level of the stock market, the economy (combined with my lack of faith in any real improvement for some time to come), and other places for my capital, the potential returns (cash on cash yield for starters) at LH look like an attractive opportunity to me. Given the combination of attractive price compared to cash flow, strong cash generating business model (vol and price increases spread over high fixed cost structure), growing industry (volume and price), society’s reliance on the products, demand not sensitive to economy, the buyback, Republican victory, favorable demographics, industry capacity reduction through consolidation, solid barriers to entry, and rational behavior by industry players, the downside looks protected by a nice margin of safety between price and value. Worse case, I think capital will be preserved. Looked interesting to me. Good luck.

LabCorp is a leading clinical laboratory services company, trailing only Quest Diagnostics (DGX) in size. Offers more than 4000 clinical tests, and more advanced esoteric tests. Clinical Laboratory (testing on blood, urine, and other bodily fluids) and Anatomic Pathology (testing on tissues and organs). Also does some drug abuse testing and some clinical trials testing. Only area materially impacted by economy is drug testing, new employees, etc. If words like “human genome” and “gene-based” scare you as an investor, me too. But I think you will find comfort here, this is applied science, this company is not finding a cure to cancer, etc. We take blood, urine, cell, and tissue samples, which are picked up or shipped to the labs, and test them and then get the results back to Dr. ASAP. Some tests LH devs internally (apparently it is fairly simple to reverse engineer a standard test in the market), and some are licensed from others. LH becoming leader in partnering with smaller companies with great products, leverage a good new test with LH’s infrastructure/sales force. See deals and talk with Myriad, Exact, etc. Latest news shows the strength of LH and DGX, preferred partner of smaller players. Correlogic Systems, Inc., (ovarian cancer protein pattern blood test) (DGX and LH got exclusive on this one)

Price of $23.98, Market cap of $3,544M. Net debt of $536M (leverage goes up to debt to cap of 42% if DIAN acquisition happens, still comfortable level).
Company guiding to $1.83 in EPS this year, and then 20% growth to $2.20 next year off 13-14% sales incease. LH sells at 03 PE of 10.9X.
Free Cash Flow is even better. Company pegs 2002 FCF (after capex and WC) at $350M. LH selling at roughly 10X this year’s FCF, with strong growth in 2003 likely, aided by continued improvement in bad debt expenses and reduction in DSO’s. Look at Q3 8K to see DSO improvement which has been impressive.
Bad debt level is very high (seems ridiculous), in the 8’s (DGX is better), but with obvious room for improvement, which they are achieving. Problem is not really the customers, but rather the company figuring out who to bill and when, really needs to improve.

DGX is a good comp, sells a materially higher multiple. Both companies and managements are well aware of the destructive price wars of the mid 90's and have been rational for several years on the pricing front. This industry was a complte mess in the mid 90's as their were 6-7 national players, (combined with many government investigations). Big event was when DGX bought SmithKline Beecham, who had been most irrational player. Now there are 2 national players left, both aware of the past. Another trend favoring the industry, both Government and HMO's are increasingly seeing that it's a lot less expensive for them when patiets get diagnosed early as hospital stays are very costly. As a result, we are seeing reimbursement rates for some tests (pap smear being a good example) going up, and a medicare increasing for clinical tests will likely happen this year for the first time in many years. Company likes to point out that testing is only about 3-4% of healthcare spending in US, yet it influences/directs 80% of healthcare spending. Estimate it is a $34-36B industry. (Note, if you start following this company, they put out an earnings press release over the wires, but also file an 8K at the same time. The 8K is where they will sometimes put their earnings guidance and more detailed info on the results.)

LH stacks up well against DGX, and sells at a much lower multiple as DGX sells at 18.8X this year's consensus EPS and 14.9X 2003 numbers. EBITDA margin for LH this year should be in 22% range. EBITDA for DGX this year is maybe in the 17% range. But in bad debt, DGX is several hundred bps below LH. Again, LH has a lot of improvement to make in that area.

LH Changing from simple routine testing (price and volume story) and moving towards more gene based testing, more complex esoteric testing, where prices are higher and volumes are lower. Wants to be leader in Cancer testing. Gene based testing to reach about $320-330M this year (% of the total) versus $8M in 1990.

Company 2003 guidance would appear conservative. Company has seen what happens when miss by just a little bit. 2003 guidance does not include buyback, does not include Medicare reimbursement increase which is likely given congress would need to act to stop increase that is already in place (probably add a penny or two). Company assuming bad debt for 2003 at 8.4%, so no improvement over first 9 mos of this year, seems conservative given how they have been improving. 03 Excludes any contribution from Exact Sciences which will offer new colon cancer test through LH, could be quite large. Exact is talking about some very big numbers, LH CEO told me he thinks they are being too optimistic. But this new test could be very nice new business.

Stock was recently hammered when company disclosed a competitor in NC/SC area was taking business. Very important market for LH, and very profitable, caused miss in quarter. Company now working to correct this issue. The big worry is that other hospital JV’s will become more competitive and take share from LH around the country. I think this fear misses the reality of the situation. LH took their eye of the ball in their own backyard, and allowed a very shrewd operator (formerly employed by independent lab) to take share. The competitor did not take share on price, took it on better customer service. Fact is that hospitals share of testing market has been flat for a long time and the independent labs have several competitive advantages which should allow them to maintain their position. Each time a hospital wins some share, another hospital somewhere else outsources more. Hospitals in general are not economically rational entities, are not focused on the lab market any more than they have been in the past, lack the volumes, infrastructure, and expertise for many tests, and have to favor in house patient’s test over outside ones, causing customer service issues. My sense is that they can eventually win back what they lost in NC/SC market. DGX sees no change in competitive environment with hospital JV’s Business is competitive on regional basis, as it has been. When you look at the loss of market value versus how much they missed on top line, looks extreme.

Proposed DIAN acquisition - leading provider of anatomic pathology and oncology testing services in the U.S., on strategy in that LH wants to be leader in cancer testing. Also gets them a presence in Northeast. Paying 11.5X 2003 EBITDA w/o synergies, 6.6X with peak synergies. Fast growing, $60M cash an no debt. Synergies not based on facility closing. Would take debt to cap up to 42%. Add 5 cents to EPS in 2003. Regulatory issues should not be a problem. DGX and Unilab are having some issues, but they are unique.

Attitude on the Street seems to be, ‘good business, lots of cash flow, cheap price, downside is limited, but we want to make sure the situation in the Carolina’s is under control and that it doesn’t happen elsewhere before we get bullish’. Also note there is some concern over slowing volume trends towards the mean, as LH has been growing above industry for a while. They will likely slow down to industry vol growth rate over time, which is fine given price, which seems to assume no growth. (one reason is that they have finished seeing benefit of low hanging fruit that came when DGX bought SmithKline Beecham)

Risks
Integration of both Dynacare and DIAN at same time, good thing is DIAN is not a big facility closure play, which lessens integration risks.
How long it takes to get Carolina issue under control, how much it costs.
Have they taken their eye off the ball in other markets? Management says that if the problems in Carolina had existed anywhere else, they would never have had to disclose it as there is no other market where business is as profitable, and market share as high, and where one competitor could have such an impact like the Carolinas.
Pricing and medicare always need to be watched.
Government investigations are always a concern when a company bills for Medicare. Apparently LH has a good system now in place, Attorney General has cited it as the model for good internal control process.

Catalyst