April 2014 LabCorp Price: $101 Research Report By Zachary Herbert, CFA, and Ryan Kinney Check Capital Management

Transcription

1 April 2014 LabCorp Price: $101 Research Report By Zachary Herbert, CFA, and Ryan Kinney Check Capital Management Laboratory Corporation of America Holdings ( LH or LabCorp ) can trace its origins back to 1905, when Hoffmann La Roche began operations in the United States. This Swiss-based company, originally known for producing vitamins, built a small U.S. diagnostics empire by acquiring and consolidating independent laboratories. LabCorp was eventually formed in 1995, with the merger of Roche Biomedical Laboratories and National Health Laboratories. Today, LabCorp (headquartered in Burlington, North Carolina) is the nation s second-largest independent laboratory, providing a variety of clinical tests for its 220,000 clients, including physicians, hospitals, managed-care groups, clinics and pharmaceutical companies. The Business LabCorp operates a network of 50 full-service labs and 1800 conveniently located patientservicing sites, providing over 4,000 clinical lab tests ranging from routine blood count tests to high-value esoteric testing (complex tests used to analyze molecules within organs or tissues). Given the firm s wide-reaching national infrastructure, LabCorp is able to achieve economies of scale which allow it to test 470,000 specimens per day at much lower cost than most hospitals and regional laboratories. Routine lab testing (63% of total revenue) is generally considered a commodity service. In fact, routine testing has been compared to electricity: it is indispensable but also plentiful and generally indistinguishable from competitors. Therefore, scale and efficiency which help lower costs is the key to success. And LabCorp is the low-cost provider, giving it a considerable competitive advantage. This is the primary reason why LabCorp is able to consistently win long-term contracts with some of the nation s largest healthcare companies. Financial Data Revenue $4,068 $4,505 $4,695 $5,004 $5,542 $5,671 $5,808 Earnings Per Share $3.93 $4.16 $4.98 $5.29 $5.11 $5.99 $6.25 Free Cashflow $566 $623 $748 $758 $710 $665 $617 Return on Equity 25.76% 27.21% 28.64% 24.42% 20.91% 22.34% 22.03% *Financial data presented in millions, except per-share figures For example, LabCorp is the exclusive national laboratory for UnitedHealth, the largest healthinsurance provider in the U.S. (The partnership began in 2007 and will continue through the end 1 Check Capital Management Inc. Costa Mesa, CA. (714) (800)

2 of 2018.) While details of the agreement were not disclosed, LabCorp mentioned that it is a tiered pricing structure. In other words, LabCorp takes a haircut on routine testing, but more complex esoteric tests are reimbursed at higher rates. This is noteworthy for two reasons: 1) LH can offer prices considerably lower than those of competitors, and 2) it is able to offset lowerpriced routine tests with an industry-leading portfolio of high-margin esoteric tests. Both of these advantages further strengthen LabCorp s competitive position. LH generates its revenue from a diversified mix of payors, with no customer accounting for more 2013 Payor Mix (% of Revenue) than 11% of total sales. LabCorp bills its thirdparty Patient 6.7% payors (managed care groups, Medicare Medicare and Medicaid 17.0% and Medicaid) in two ways: fee-for-service and capitated agreements. Payors under the fee-forservice Clinical Trials 3.0% agreement pay for services as rendered at Managed Care Capitated 3.4% an agreed-upon fee schedule. Conversely, Managed Care Fee-For-Service 42.3% capitated agreements are billed at pre-negotiated, Occupational Testing Services 6.3% bundled monthly rates, regardless of the actual cost of services performed. Because fee-forservice Hospitals and Physician Office 21.3% managed care agreements are more profitable, LabCorp has been aggressively shrinking its capitated business, which now accounts for just 3% of total revenues. In an attempt to further streamline operations, LabCorp launched a new online service called Beacon. This program makes it easier for physicians to manage, analyze and share lab-test results. In addition to lowering costs, this service improves customer intimacy and promotes practioner loyalty, which ultimately increases switching costs. Since its launch in 2012, Beacon has attracted more than 400,000 patients to its service. Esoteric testing Nearly two decades ago, LabCorp became the first commercial laboratory to fully embrace esoteric testing, like genomics and molecular pathology. LH recognized early on that this segment would provide a large platform for future profitable growth and strengthen the franchise. Because these tests are very labor-intensive and complex, most hospital laboratories (a major competitor) lack the ability to perform them internally. Accordingly, reimbursement rates for providing these tests are much more attractive, and increasing these capabilities has helped LH to differentiate its services from those of its peers. In light of these benefits, LH continues to aggressively expand its esoteric portfolio. In the past five years alone, the firm has spent over $2B to acquire several specialty laboratories, such as Genzyme Genetics, Orchid Cellmark and MEDTOX Scientific. And LabCorp has partnered 2 Check Capital Management Inc. Costa Mesa, CA. (714) (800)

3 with top research organizations and academic institutions to launch new tests organically. In 2013, the firm launched 152 new tests, most of which relate to genomics and oncology testing. For instance, LabCorp recently entered the sizeable bracket testing market (critical to the diagnosis and treatment of breast cancer), launching its new BRAC 1 and 2 complete sequencing tests. Not only do these gene-based tests provide better patient outcomes early detection of localized breast cancer has increased the five-year survival rate to nearly 100% but payors value these tests and promptly reimburse laboratories for providing them *CAGR Genomic and Esoteric Testing $1.48B $1.60B $1.73B $2.09B $2.09B $2.02B 6.4% Volume (millions) % Price per Requisition $62.49 $62.14 $63.48 $71.19 $69.94 $ % *Compound annual growth rate Attractive market The $60B lab testing market is an essential part of the healthcare system and a very valuable service. Lab testing and diagnostics represent less than 3% of total healthcare spending yet influence 70% to 80% of physician decisions allowing for early detection and monitoring which greatly reduce future healthcare costs and provide better patient outcomes. Moreover, lab testing is vital to the diagnosis and treatment of most major chronic diseases, including cancer, diabetes, cardiovascular disease and COPD (Chronic Obstructive Pulmonary Disease). Collectively, these conditions account for more than half of all global healthcare spending ($3.5T) and are growing at roughly 20% annually. While the U.S. lab-testing market is largely controlled by hospitals (55% marketshare), LabCorp and largest rival Quest Diagnostics have carved out 21% of the market (10% and 11%, respectively) creating a very attractive duopoly. The rest of the industry is highly fragmented, with 5,700 independent labs controlling the remaining 24%. Because these smaller labs do not have the scale advantages that LabCorp and Quest enjoy as national laboratories, they are less efficient and operate at much higher costs. This makes it harder for them to compete for major contracts. Consequently, LabCorp has a significant opportunity to grow marketshare, as it continues to acquire, or roll up, smaller regional players. Market tailwinds: Aging population Technological advances in genomics and oncology testing Increasing number of lab tests per patient Additionally, diagnostics and clinical lab testing is generally considered nondiscretionary, therefore, LH s revenue stream is quite stable. In fact, even during the depths of the financial crisis, it was able to grow revenues and earnings. 3 Check Capital Management Inc. Costa Mesa, CA. (714) (800)

4 Opportunity for international expansion Foreign lab-testing accounts for roughly 10% of LabCorp s total sales, with the majority of that coming from Canada (6%). While LH s international exposure produces relatively meager revenues, management said off the record that it expects foreign sales to account for 20% of total revenues in the next five years. Given that global healthcare spending (excluding the U.S.) exceeds $4T annually and approximately $160B is spent on diagnostics, this represents a tremendous growth opportunity. Moreover, expanding its international business will enable LabCorp to diversify its revenue base and reduce the percentage of sales that it collects for the U.S. government. (Medicare and Medicaid account for 17% of sales.) Being selective, LabCorp only enters foreign markets with the following characteristics: large self-pay segments, more than 20% of the population is upper to middle class, lab testing must account for at least 4% of total healthcare spending, and the physician community that is educated in complex diagnostics. After an appropriate country has been identified, LabCorp s expansion strategy uses a capital light model. LH is not interested in physically building out expensive new infrastructure. Instead, LabCorp will focus on joint ventures and partnerships with local firms. This is consistent with LH s entry into the Canadian market, which proved quite successful. Reimbursement Issues Undoubtedly, LabCorp s greatest threat stems from government reimbursement cuts. In April 2013, for example, Medicare spending was cut 2% due to Congressional sequestration legislation. Consequently, LH s 2013 revenues from Medicare and Medicaid decreased $55M 1% of total firm revenues. Two other reimbursement threats loom: 1) The Center for Medicare and Medicaid Services (CMS) reimburses laboratories according to the Clinical Lab Fee Schedule (CLFS). While reimbursement rates are generally fixed (except for minor annual inflation adjustments), CMS has the authority to alter rates based on technological advances, an authority it has never used until now. Last July, an Inspector General study was released that claimed CMS paid 18% to 30% more than private payors for clinical lab tests. Accordingly, it recommended that CMS reduce lab spending by adjusting rates for technological advances that have made it cheaper for labs to perform tests. CMS took this advice and shortly thereafter released plans to reevaluate all 1,250 CLFS tests over the next five years, with initial rate reductions starting in ) Medicare Sustainable Growth Rates (SGR) used by CMS to control spending on physician services are scheduled to drop 25%. In fact, this reduction was supposed to take effect January 1 of this year, but the U.S. Senate passed a last-minute budget agreement delaying these cuts for three months. In an attempt to prevent these price reductions, LH has been working closely with Congress and CMS. On a recent conference call, LH management said: We've been working with Congress on a proposal to make this a fair process, to limit the number of codes that could be reduced in a given year, to make sure that there are transparent 4 Check Capital Management Inc. Costa Mesa, CA. (714) (800)

5 inputs and outputs from the process, and to limit the percentage reductions to a particular CPT code [in] a given year The industry has done a terrific job of coming together to put a constructive and responsible proposal in front of Congress. These efforts have not been in vain. On April 1 (the day before the SGR deadline), Congress passed bill HR 4302, which suspends the SGR cuts one year and revokes CMS authority to adjust CLFS reimbursement rates based on technological advances. Instead, under the new system, every three years laboratories will submit pricing and volume data (on tests billed to private payors) to the Department of Health and Human Services, which will use this information to set a weighted median price that CMS will pay for a particular test. Although Congress passed bill HR 4302, it is not yet a law. The legislation still needs President Obama s signature, but industry experts believe it is a foregone conclusion that the bill will be signed. This is a move in the right direction. The looming reimbursement threats which have hung over the stock have been greatly reduced. (The stock reacted quite favorably to this news, increasing nearly 5% the day the bill passed.) LabCorp is cognizant that Medicare needs to get spending under control. However, targeting providers and arbitrarily cutting their reimbursement rates is not a practical solution. In real dollars, LH gets paid roughly $6 today for the same testing it received $10 for in the 1990s. Not only are rates dropping, but costs (labor, supplies, transportation, etc.) have risen. Consequently, labs are unable to perform the high-quality work they did in the past and patients are at risk. Based on Congress s recent actions, it seems this fact is finally becoming evident. [Note: A recent study commissioned by the American Clinical Laboratory Association (ACLA) and conducted by private data firm Avalere Health found that Medicare actually pays lower rates for high-volume testing than private payors. This is a stark contrast to the Inspector General s claim that Medicare pays 18% to 30% more than private payors. Avalere s research was quite extensive, with data collected on 56 million patients from both hospital-based labs and independent labs. In presenting the results, ACLA President Alan Mertz boldly declared: "All too often, judgments are made from anecdotal reports or incomplete, thumbnail sketches that cherry pick some commercial rates. No previous study on lab payments has had the depth and scope of Avalere's work. Avalere's analysis shows unequivocally that Medicare pays lower than average commercial rates. The argument that labs may be overpaid by Medicare is simply unfounded. Select results of Avalere s research appears in the table below. (For the full study, see the ACLA website.)] Medicare Vs. Commercial Payors (Lower-Priced Tests) Code Description Medicare Nat l Limit Avg. Commercial Price Routine venipuncture $3.00 $ Prothrombin time $5.56 $ Assay of urine creatinine $7.33 $ Complete blood count w/ white blood cell $11.02 $ Urine culture/colony count $11.43 $ Check Capital Management Inc. Costa Mesa, CA. (714) (800)

6 Medicare Vs. Commercial Payors (Higher-Priced Tests) Code Description Medicare Nat l Limit Avg. Commercial Price Hiv-1 quant & reverse transcription $ $ Tissue culture lymphocyte $ $ Chromosome analysis $ $ Chromosome analysis $ $ Tissue culture bone marrow $ $ *Source: Avalere Health (analysis of 2012 Medicare National Clinical Lab Fee Schedule and 2012 Lab Procedure Amount Paid Analysis from Marketscan Commercial Database. Average weighted by commercial volume.) Molecular pathology Besides government rate concerns, LabCorp has reimbursement issues with several payors regarding molecular pathology (testing for genetic disorders, such as cystic fibrosis and hemochromatosis). For years, LH performed these tests and was promptly reimbursed. However, as of January 2013, without notice to healthcare providers or beneficiaries, payors such as Medicare, Medicaid, Tricare (a healthcare program serving uniformed service members, retirees, and their families) and several commercial carriers stopped paying for over 100 molecular pathology tests. Consequently, LH has completed over $40M+ of testing for which it never received payment. Tricare said it will no longer pay for testing that is not a medical necessity or does not assist in medical management of the patient, and it will not cover any lab-developed tests that are not approved by the FDA. As judicious as that sounds, Tricare s statement seems to be at odds with its own policy. Indeed, it still pays for several lab-developed tests not approved by the FDA, like pap smears (a routine test for cervical cancer). LabCorp Chief Executive David King discussed Tricare s reimbursement inconsistencies on a recent conference call, saying: There's no transparency. It's a completely opaque decision-making process. There's no rationality to it and that's not good for everybody. This situation is damaging to labs, which should not be expected to provide critical services without being compensated. It is also harmful to patients, who do not receiving a proper standard of care, and physicians, who are exposed to malpractice liabilities. Company executives hope to eventually receive proper payment for tests that LabCorp has already provided and collect on future molecular pathology tests. If an agreement is not reached, LH has made its position very clear: We either get paid or we stop doing the testing. Certainly, doctors will not stop ordering their patients to receive gene-based clinical tests, but laboratories (such as LabCorp) will not provide them for free. Management David King has been the Chairman of LabCorp since 2009 and CEO since He joined the company in 2001 and thereafter held a variety of different positions. Perhaps the most valuable, 6 Check Capital Management Inc. Costa Mesa, CA. (714) (800)

7 though, is his two-year tenure as Executive VP of Strategic Planning and Corporate Development. LabCorp s strategy of acquiring smaller regional laboratories to scale operations makes King s thorough understanding of both acquiring and integrating new companies a valuable asset. Under his stewardship, the company has performed admirably despite a challenging lab-testing environment. Last year, government reimbursement cuts and unexpected molecular-pathology payment issues cost LabCorp nearly $100M. Nonetheless, the firm s performance has been solid. In 2013, it increased revenues 2.4% to $5.8B, earnings-per-share rose 4.3% to $6.25, and testing volume grew a respectable 4%. Meanwhile, its main competitor, Quest Diagnostics, has struggled. Last year Quest reported a 3.2% decline in revenues, and it has posted six consecutive quarters of decreasing volume. LabCorp s outperformance can be directly attributed to a carefully calculated shift to highermargin testing, as well as shrewd executives delivering on their objective of being the low-cost diagnostics provider. Capital allocation LabCorp does not pay a dividend. Instead, half of its free cashflow is returned to owners via share repurchases and half is earmarked for acquisitions. During the last decade, LH repurchased $5.4B of its own stock at an average price of $71 per share decreasing the share count by approximately 40% from 150.7M to 88.3M. And, capitalizing on its languishing stock price over the past year, LH has increased its share buyback activity. In 2013, the company spent more than 100% of its free cashflow to repurchase ~$1B worth of stock, and it announced plans to buy back a similar amount of stock this year. LabCorp is prepared to take on additional leverage to accelerate its capital deployment initiatives. Management recently stated: In the absence of a large acquisition over the next year, we would anticipate using additional leverage to repurchase shares. The company s target debt ratio is 2.5x EBITDA (earnings before interest, taxes, depreciation and amortization). With net long-term debt of $2.6B, the debt ratio is currently around 2x EBITDA (2013 EBITDA of ~$1.25B). Therefore, LH can comfortably borrow an additional $550M. It already secured a $1B revolving line of credit none of which has been deployed that it can use to fund share repurchases or acquisitions. This borrowing capacity, combined with LH s strong cashgenerating abilities, gives it great flexibility to take advantage of opportunities that arise. 7 Check Capital Management Inc. Costa Mesa, CA. (714) (800)

8 Valuation LabCorp s shares currently trade at $101, resulting in a market capitalization of $8.6B. The firm is guiding ( projecting ) EPS of approximately $6.50 for 2014, and is therefore selling at a forward price-to-earnings ratio (P/E) of Yet management s EPS figure seems overly conservative: LH s guidance assumes that it will not recoup any of the $40M+ it is owed for molecular pathology testing already completed. Guidance also implies that LH will not receive payments on future molecular pathology testing. Management is not assuming an improved product mix, even though it is releasing several new high margin tests, like the aforementioned BRAC 1 and 2. Guidance includes no future acquisitions, which have historically been accretive to earnings shortly after close. Last, guidance ignores the effects of share buybacks. This is significant, since LabCorp will spend roughly $1B buying back stock over the next year. If its stock price stays at current levels, LH will repurchase nearly 12% of its outstanding shares. Factoring this alone into guidance would increase 2014 EPS to $7.35. Of course, it is possible that performance could surprise to the downside, with the greatest threat being more government-reimbursement rate cuts. Frankly, this seems less likely after Congress recently halted further reductions. If LH is able to produce EPS of $7.35 in 2014, still a conservative estimate, it will be selling at a P/E of 13.7, with an earnings yield of 7.3%. [See Executive Summary and footnotes on next page] 8 Check Capital Management Inc. Costa Mesa, CA. (714) (800)

9 Executive Summary: LH POSITIVES NEGATIVES Benefits of a stable duopoly Low-cost operator Industry-leading portfolio of highmargin esoteric tests Highly durable, non-cyclical business model Further reductions in government reimbursement rates Difficulty collecting payments on molecular pathology testing Threat of hospitals providing more in-house lab tests Aggressive share repurchase program (will retire ~12% of outstanding shares in 2014) CCM Research Reports are for informational purposes only and are not an offer to sell or a solicitation to buy. They are not personal recommendations for any particular investor and do not take into account the financial circumstances of any individual investor. Check Capital, or one of its officers, may have a position in the securities discussed and may purchase or sell such securities from time to time. CCM Research Reports are created using third-party data. While Check Capital believes such third-party information is reliable, we do not guarantee its accuracy, timeliness or completeness 9 Check Capital Management Inc. Costa Mesa, CA. (714) (800)