Description

Investment Thesis

LabCorp is a good business trading at a reasonable multiple. The company is one of two dominant independent players in the diagnostic testing industry. At current prices, LabCorp trades at under 11x FCF, despite returns on capital in excess of 30% and a healthy balance sheet. In fairness, this is not a rapidly growing business, but it is defensive and should see mid-single digit growth and substantial cash generation. Over the past five years, LabCorp has purchased over $2.5 BN worth of stock. Share appreciation should come from both multiple expansion and earnings growth.

The preoccupation with healthcare margin contraction should be discounted for LabCorp given its superior cost-benefit proposition. Diagnostic testing accounts for only 2-3% of healthcare spending but influences 70-80% of all physician healthcare decisions. The focus on preventive care to lower health care costs and expanded healthcare coverage should benefit screening companies like LabCorp.

As mentioned above, moderate growth is expected and should come from several sources:

1. Steady state "core" testing growth of ~2%.
2. Mix shift. Esoteric testing should grow 5-10% annually. This represents 35% of revenues and has gross margins 2x higher than the "core" business.
3. US population demographics. Lab testing increases with age.  
4. Expansion of managed care contracts and market share wins (from hospitals and physician offices). For example, >30% of the market for outpatient and outreach business is controlled by hospitals, which are often priced 3x or higher than national laboratories.
5. Industry consolidation (i.e. acquisitions - this is not factored into my numbers).  

On the pricing side, I would expect slight improvements (based on inflation) over time, although reimbursement cuts will always be a concern. Expense reduction through facility consolidation and greater automation is another area of potential upside.

Company Overview

LabCorp is the 2^nd largest independent clinical laboratory in the US. The company maintains 36 primary laboratories and over 1,600 patient service centers along with a network of branch and quick service labs. Other units include a contract research organization (Tandem), robotics (Protedyne) and outcome improvement program (Litholink).

LabCorp offers a range of routine testing, patient diagnosis and monitoring/treatment of disease for the medical profession. Additionally, the company has developed specialty tests for oncology, HIV, genetics and clinical trials. Clinical laboratory testing is separated into clinical pathology testing, which is performed on body fluids, anatomical pathology testing, which is performed on organs and tissues and genomic testing.

The users of these tests include physicians, hospitals, managed care organizations, governmental agencies, employers, pharmaceutical companies and other independent clinical labs. Most results are reported in 24 hours. Laboratory tests are used to assist in diagnosis, evaluation, detection, therapy selection, monitoring and treatment. The most frequently-requested tests include blood chemistry analyses, urinalyses, blood cell counts, thyroid tests, Pap tests, HIV tests, microbiology cultures and alcohol and other substance abuse tests. Specialty tests include allergy, clinical trials, diagnostic genetics, identity forensics, infectious disease, oncology and occupational testing.

LabCorp's revenues are as follows: Medicare/Medicaid (19%), managed care (44%), physicians, hospitals, other (28%) and patients (9%). On the cost side roughly 20% is variable meaning contribution margins approach 80%. The costs of a running a lab consists of the real estate, phlebotomists, sales force, couriers, supplies and other largely fixed overhead. Labor is the largest expense followed by testing supplies (75% of COGS). 

LabCorp's competitive advantages include its scale (national infrastructure), broad test offering (over 4,000 tests), long term managed care contracts and lower costs. For these reasons, LabCorp and Quest Diagnostics are the low cost players, although LabCorp's lower real estate and labor costs and centralized IT result in higher margins than for Quest. 

Industry Overview

There are three types of clinical laboratory providers comprising the $52 BN industry: 

    Hospitals (55% market share)

    Independent labs (34%) - LabCorp (9%), Quest Diagnostics (14%) and others (12%)

    Physician-offices (11%) 

Testing services are billed to private patients, Medicare, Medicaid, commercial clients, managed care organizations and other insurance companies.             

2008                                        Volume                   Revenue/Test                       

Private Patients                            2%                      $165.00                  

Medicare/Medicaid                      17%                      $42.01                    

Commercial Clients                    32%                      $33.65                    

Managed Care                           48%                      $35.80              

The market share for independent labs is expected to grow at the expense of hospitals and physician offices. Large-scale automated testing and larger service networks offer cost savings that hospitals and physician offices cannot match. With managed care and Medicare focused on removing costs from the system, I expect more volume to be sent to independent labs. However, partially offsetting this will always be pricing concerns given the "buyer power" of LabCorp's customers.

Capital Structure

Revolver                                $71 MM

Term Loan                             $463

5.5% Senior Notes                  $350       

5.625% Senior Notes              $250

Zero Coupon Bonds*              $287

Total Debt                             $1,420

Cash**                                 $84

Net Debt                               $1,337

Minority Interest                    $119

Equity Mkt Cap                      $6,644

Enterprise Value                    $8,100 MM

*Pro forma for redemption of $369 MM zero coupon notes.

**Substantial cash generation for remainder of 2009 should result over $4 per share of cash on hand by YE.   

Financials                              2006                        2007                        2008                        2009E - Consensus

Revenue                              $3,591                     $4,068                     $4,505                     $4,666

EBITDA                                $920                        $1,068                     $1,062*                   $1,133

EBIT                                    $765                        $906                        $882                        $949

EPS                                     $3.27                       $4.17                       $4.53                       $ 4.88

FCF                                     $3.44                       $4.38                       $5.26                       $5.92 (LH guidance)***

*Increased provision for doubtful accounts to $45.0 MM in 2Q 2008. Some analysts add this back as it relates to prior periods.

**Company 2009 guidance is $4.75-$4.95.

***Does not capture UNH payments, but does include $58 MM of pension contributions. 

Over the past five years, the company has grown revenue and EBITDA in the 8-9% area. This includes the benefits of acquisitions, the new UNH contract and the consolidation of the Canadian operations. Stripping out the acquisitions and Canadian consolidation, I calculate mid-single digit plus revenue and EBITDA growth. Over the same time period, EPS has grown at 15% rate aided by $2.5 BN of stock repurchases. 

Projections

Going forward, the "core" standard testing business is expected to grow 2% annually. The aging of the US population should add to this rate. Furthermore, over the last decade the number of tests per capita across all age groups increased - a testament to the value of LabCorp's services. Mix shift (i.e. growth in the esoteric business) should see mid-single to high-single digit expansion. Finally, advancements in personalized medicine, or treatment customized to an individual's genetic characteristics is another long term driver, albeit a small one for right now.

*Tests by age (<18 years = <2), (18-44 years = ~3), (45-54 years = ~5), (55-64 years = ~7.5), (65-74 years = ~11.5) and (>75 years = ~13).

On the margin side, the higher profitability of esoteric tests and the leveraging of the fixed cost infrastructure should result in upward trending margins. Additionally, LabCorp has a reputation for keeping a tight lid on costs. On the cost cutting front, the company expects cuts of $100 MM via greater automation (increased use of robotics* to automate front-end solutions), facility rationalization, lease renegotiation and improved bad debt performance. The numbers should start to incorporate these savings in 2H 2009 - picking up in 4Q. Adding all this up, I expect mid-single digit top line growth with slightly higher EBIT growth and even higher EPS gains considering share buybacks.

*LabCorp's Protedyne subsidiary (acquired May-07) brings laboratory automation to LabCorp's diagnostic testing facilities nationwide, specifically the pre-analytical stage. Protedyne's automation systems combine laboratory robotic hardware with a software infrastructure that ensures complete data management and process tracking.

Guidance

For 2009, revenue growth is expected to be 2-4% with diluted EPS and FCF of $4.75-$4.95 and $670 MM, respectively ($800 MM operating cash flow less $130 MM of capital expenditures).

Valuation

LabCorp has traded at average earnings and FCF multiples of 17x and 16x over the past five years. Due to the economic backdrop and concerns over reimbursement cuts, I haircut the appropriate multiple to 13x FCF (excluding stock compensation) to be conservative. This implies a high $70s price. Using a 15x FCF multiple, I get a high $80s share price. Cash generation during the remainder of the year further increases these price targets. As a reference, Quest Diagnostics trades at 14x EPS and 12x FCF.

On a private market value basis, I calculate a higher value. Historically, acquisitions have been done around 2x revenue and 11x EBITDA. For example, in May 2007, Quest acquired AmeriPath, a leader in anatomic pathology testing from Welsh Carson for ~$2.0 BN. The purchase price implies a 16-17x EBITDA. Quest likely overpaid for AmeriPath and the business merits a premium multiple to LabCorp's given its better mix, but a 10x EBITDA multiple for LabCorp is not unreasonable. This implies a low $90s price.

Conclusion

Laboratory testing should continue to see steady demand as it is an early diagnostic tool, and if the correct treatment path is followed, a tremendous cost savings opportunity for the healthcare system. Reimbursement reductions will always be a concern, but I take comfort in the value-add of this business and its reasonable valuation. The company should continue to expand at a measured pace and throw off substantial cash flow. At sub-11x, an investor should see the dual benefit of margin expansion coupled with continued growth in intrinsic value.

Risks

1. Buyer power. Managed care pricing pressure. This will always be a concern, but my view is that any pricing decreases will be more than offset by volume wins.
   1. Increase in (less profitable) capitated contracts, which shifts the risk of additional testing to the independent labs. The percentage of these contracts (4%) has been stable recently.
   2. Cigna contract up for renewal in mid-2010.
2. Healthcare reform. Medicare reimbursement pressure. Competitive bidding.
   1. Price increase (4.5%) in 2009 - first increase in five years and only second in the past 11 years.
   2. Any substantial cuts would impair smaller labs and hospitals.
3. Commoditization of lab services. 
   1. Irrational pricing among competitors was an issue in the 1990s.
4. Government investigations. This is a concern for anyone receiving Medicare funds.
5. Overpaying for an acquisition.
6. Rising unemployment and sustained economic weakness.
   1. Increase in bad debt expense. Relates to only uninsured patients which represent 8-9% of revenue. Including co-pays less than 20% is collected directly from the customer.
   2. Membership losses at managed care.
   3. Lag effect on volumes. Layoffs from late 2008 and early 2009 could have a more pronounced impact on volume and collections as these patients transition from employer-provided healthcare coverage to a government benefit, COBRA or uninsured status
   4. Substantial decline in drug abuse volumes (related to employment).
7. Cost inflation (personnel, supplies, transportation charges).
8. Point of care technological improvements resulting in migration away from independent labs.
   1. Currently lacks scale and efficiency.
9. Top management presents at most of the sellside healthcare conferences. I always thought IR should present most of the time and management should focus on running the company. 

Catalyst

Share buybacks.

Continued execution and numbers approaching guidance.

LBO? This business can support a lot of debt. Quest Diagnostics had been rumored to be an LBO candidate