LabCorp's Sweet Spot: Aging America
By Phil Seligman
A growing -- and graying -- U.S. population will mean a dramatic rise in health-care spending in coming years. Standard & Poor's believes that Laboratory Corporation of America Holdings (LH ), the second-largest independent provider of blood tests, is poised to benefit from that demographic trend, and we give it our highest investment recommendation of 5 STARS, or strong buy.
LabCorp estimates that by 2006, 67 million Americans will be over 55 years old. As patients age, their medical outlays escalate dramatically, with seniors spending more than three times for health care than those who are under 45. The Centers for Medicare & Medicaid Services projects health-care spending will rise at an average annual rate of 7.3%, to $3.1 trillion in 2012. Although lab testing now represents only 4% of that total, industry experts note that the resulting information influences as much as 80% of all subsequent health-care decisions.
Indeed, over the next three to five years, we see LabCorp benefiting from the rising demand for esoteric, particularly gene-based, tests, as well as anatomic pathology. With the January acquisition of DIANON, which had revenues of $141 million and earnings before interest, taxes, depreciation, and amortization (EBITDA) of $32 million in the first nine months of 2002, LabCorp became a leading provider of anatomical and gene-based cancer testing, and that should provide a sustainable growth opportunity. LabCorp expects the acquisition to contribute $210 million to its 2003 revenue. Integrating DIANON should also result in cost savings of $7.5 million in 2003, $25 million in 2004, and $35 million in 2005.
We see gene-based tests for noncancerous conditions also rapidly growing in volume and importance. More gene-based tests are being used for particular diseases and conditions, including cystic fibrosis, hepatitis C, and HIV. LabCorp uses internal research and development, and it partners with biotech companies to develop blood tests that screen for an increasing number of infectious and noninfectious diseases.
Revenues for relatively small, but highly profitable, esoteric and gene-based testing services are growing at approximately 25% annually, vs. 5% or so for routine blood tests. Looking ahead, S&P sees rapidly increasing use of diagnostic testing to determine patient-specific drug therapy (including dosage), as well as an individual's predisposition (or genetic propensity) to acquire a particular disease. Although privacy issues (which are solvable) loom in testing for predisposition, we believe that such tests will be used to help develop preventative therapies, ranging from drug treatments to dietary measures.
Growth in routine blood testing (which includes tests for iron content and cholesterol) has slowed significantly, partly due to the current weak economy. The unemployed are less willing to go to doctors, particularly if they've lost their medical benefits. Moreover, drug-test volumes are down, due to layoffs and very little hiring. S&P believes that routine blood testing, including for drugs, will revitalize once the economy recovers. Even so, this category -- which carry lower prices than esoteric, gene-based, and anatomical pathology testing -- is becoming less critical to LabCorp's revenue and earnings growth prospects.
LabCorp should also continue to make progress on integrating Dynacare, a Canadian provider of clinical lab-testing services in 21 states and two Canadian provinces that was acquired in July, 2002. Dynacare had 2001 revenues of $238 million based on U.S. generally accepted accounting principles. It has expanded LabCorp's national testing network, given it a presence in Canada, and significantly increased its foothold in the hospital blood-test market. LabCorp achieved $4 million in synergy savings by yearend 2002 and is on track for savings of $36 million in 2003 and $45 million in 2004.
In March, 2003, LabCorp agreed to pay $4.5 million to purchase certain assets in Northern California, including 46 patient-service sites, from rival blood-test giant Quest Diagnostics (DGX ). With this purchase, LabCorp gains a competitive presence in the attractive Northern California market for the first time. By Phil Seligman
LOTS OF PLAYERS.
Few large diagnostic test labs are now left to acquire, so we don't expect LabCorp to make any purchases in this segment for about 18 months, when the DIANON and Dynacare integrations should be mostly completed. However, we expect LabCorp to continue buying smaller, local labs.
In 2002, LabCorp estimates it had a 7% share of the U.S. clinical lab market, while Quest had 11%. That market remains highly fragmented, with hospitals garnering a 49% share, independents such as LabCorp, Quest, and thousands of small labs, 39%, and doctors' offices, 12%. This suggests that LabCorp still has room for acquisition-related growth.
Some future market-share gains may also come from hospitals outsourcing to LabCorp an increasing number of esoteric, gene-based, and anatomical pathological tests and, possibly even routine blood tests, as hospitals become more cost-conscious.
LabCorp beat our first-quarter EPS estimate by 2 cents, posting 51 cents, vs. 46 cents a year ago, on 20.7% higher revenues. The EBITDA margin was flat, year-over-year, at 23.3%, despite recent acquisitions of lower-margin companies. Although volumes were hurt by harsh winter weather, we were encouraged by LabCorp's ability to increase organic volumes by 2.5% to 3%, particularly in light of the volume decline reported by Quest. We have become more bullish on the stock for a number of reasons, including the positive volumes, recent acquisitions, an improving revenue mix, and our projection of growing free cash flow.
S&P believes LabCorp is capable of generating 2003 operating revenues of at least $3 billion and EPS of $2.27, about 2 cents above company guidance. S&P believes that LabCorp's EBITDA margin, which was 22.5% excluding nonrecurring charges in 2002, will widen rapidly over the next few years, driven partly by an improving revenue mix and continuing leverage in selling expenses. For 2004, we see revenues of at least $3.3 billion. That would represent a slower rate of growth than in 2002 and 2003, each of which included a significant acquisition. We peg 2004 EPS at $2.70 to $2.80, based on our projection of 20% EPS growth.
LabCorp sees $380 million to $400 million in free cash flow in 2003, vs. $371 million in 2002 and $228 million in 2001. This gives it wide financial flexibility and reduces its need to enter the credit markets to support small acquisitions while continuing to repurchasing shares. We expect the number of shares outstanding to keep growing, albeit modestly, as stock-option exercises appear likely to keep outweighing the buybacks.
In valuing LabCorp shares, we have used our proprietary discounted cash-flow model and made some conservative assumptions. Among other things, we raised the stock's beta, which raises our estimated weighted average cost of capital. Our assumptions also project a rapid slowdown of free cash-flow growth to a level below our expectations of long-term GDP growth. Therefore, we have calculated an intrinsic value for LabCorp shares of $35 to $40. At that level, which is our 12-month price target, the stock would trade at 16 times our 2003 EPS estimate of $2.27. This multiple looks reasonable, given the three-year, 20% EPS growth rate we project.
A few risks could prevent LabCorp from achieving our earnings and price target. They include legislation or regulations affecting operations, increased pricing pressure from managed care, unforeseen difficulties in integrating acquisitions, broad weakness in the diagnostic-test sector, and unfavorable conditions within the U.S. equity markets.
S&P believes LabCorp has exceptionally high earnings quality. Based on our proprietary Standard & Poor's Core Earnings methodology, we see 2003 EPS of $2.06, about 9.4% less than our GAAP EPS estimate. The S&P Core EPS estimate assumes stock-option expense, under SFAS 123, of 17 cents, a 3-cent post-retirement benefit charge, and a 1-cent defined-benefit pension plan charge.
Analyst Seligman follows medical services stocks for Standard & Poor's