A Favorable Diagnosis for LabCorp

The laboratory's loss of a contract with Aetna gives it a chance to rethink fundamentals, while investors could grab an attractive value

We believe the recent decline in the share price of Laboratory Corp. of America (LH; recent price, $72) due to the loss of a big contract with health insurer Aetna (AET), effective July 1, 2007, creates an enhanced buying opportunity. We believe investors should look beyond LabCorp's recent loss of the Aetna contract and focus on the company's fundamentals.

Although we project that the loss of the Aetna contract will adversely affect 2007 sales by an estimated $75 million to $125 million and earnings per share (EPS) by 4 to 12 cents, we view the stock's decline as disproportionate to the loss of the contract. LabCorp shares have dropped about 10%, or $1.0 billion in market capitalization, as of Mar. 23, 2007, since the announcement about the contract.

We expect LabCorp's share-price volatility to subside as investors look past the contract loss and focus on the company's fundamentals, growth prospects, and what we see as its strong cash flow generation and EPS growth potential from solid profitability and stock buybacks. The stock carries Standard & Poor's highest investment recommendation of 5 STARS (strong buy).

Steady Industry Growth

LabCorp is the second largest independent clinical laboratory in the U.S. based on net revenues. It operates a national network of 36 primary laboratories and more than 1,700 service sites consisting of branches, patient service centers, and STAT labs (labs that have the ability to perform certain routine tests quickly). Lab tests are used by physicians and other health-care providers for the detection, diagnosis, and evaluation of diseases and other medical conditions and to assist in therapy selection, monitoring, and treatment of diseases and other medical conditions.

The clinical lab industry consists primarily of three types of providers: hospital-based labs, physician's office labs, and independent labs, and is estimated to generate annual revenues of about $40 billion. The industry has been growing at a compounded annual rate of about 5% for the past several years, and we expect similar growth for the next several years.

Hospital-based labs account for about 50% to 55% of clinical lab revenues, while independent labs such as LabCorp and Quest Diagnostics (DGX) account for about 40% to 45%. Physician-office labs account for the remainder. The Centers for Medicare and Medicaid Services (CMS) estimates that there are about 5,000 independent labs in the U.S., but LabCorp and Quest are significantly larger than the other independent labs.

Antitrust Not an Issue

Although we see potential short-term margin pressure as a result of recent exclusive managed-care contracts, we believe a pricing war between LabCorp and Quest is unlikely. We also expect managed-care providers to continue to press for price reductions with exclusivity as an incentive. However, the management teams at both LabCorp and Quest have years of industry experience, and we believe they will be prudent and will moderate their aggressive pricing in order to maintain margins.

Historically, both companies have been granted "preferred clinical lab provider" status for the major managed-care companies, a model that we believe remains beneficial. We do not think antitrust issues are a factor as, by our analysis, LabCorp's and Quest's pricing is equal to, or lower than, the majority of the 5,000 independent clinical labs in this highly fragmented industry.

Exclusive contracts and associated volume gains can be enticing for the labs, but we do not believe exclusive nationwide contracts are healthy for the clinical lab industry and for physicians and managed-care members. The only beneficiary, in our view, is the managed-care company.

Preferred Status

Although there are some exclusive regional relationships, the combined large nationwide networks operated by LabCorp and Quest provide their physician-members and patient-members with quality service and the most convenience, in our opinion.

In October, 2006, UnitedHealthcare (UNH) awarded LabCorp a 10-year exclusive national contract, effective Jan. 1, 2007. This was an unprecedented contract in terms of nationwide exclusivity and the length of the contract. Historically, both LabCorp and Quest had preferred clinical lab status, as large national managed-care companies believed the companies' combined national coverage provided the most convenience for their physician-members and patient-members and was cost-effective.

LabCorp is expected to realize in excess of $3 billion in incremental revenue over the term of the contract. However, we believe the company made significant concessions to win the contract and will not realize material margin benefits in the near term. LabCorp is required to build out an extensive infrastructure in several major locations, including the New York metropolitan region, to service the expected volume increase. However, we think it will take up to 12 months to fully establish the infrastructure and associated network. In the interim, the company agreed to reimburse UnitedHealthcare up to $200 million for transition costs.

Easy Transition

We estimate that revenue generated from UnitedHealthcare represented about 7%, or about $400 million, of Quest's annual revenue in full-year 2006. As a result, Quest reduced staff and had other cost cutbacks. Because of this, we believe it was very important for Quest to increase volume and aggressively pursue (at the expense of margins, in our view) an exclusive arrangement with Aetna.

LabCorp's sales, aided by acquisitions, have increased at a compounded annual growth rate (CAGR) of 6.9% over the past three years to $3.59 billion in 2006, slightly ahead of the industry's growth rate of about 5% over the same period. However, we see LabCorp's growth accelerating to 11% in 2007 with sales reaching $3.98 billion.

Early indications show that the UnitedHealthcare-related physician transition to LabCorp is progressing well, and we believe that the company may also benefit from physicians consolidating their laboratories. We are also encouraged by the rapid build-out of the company's Northeast infrastructure—we think the company has added more than 400 patient access locations from October, 2006, to February, 2007. However, in our view, it will take about 12 months for LabCorp to fully establish the network.

More Expensive Testing

Once the build-out is completed, the company must increase the volume in these facilities in order to achieve greater economies of scale. We believe winning the Horizon Blue Cross of New Jersey PPO contract reflects early success and the benefits of having an expanded presence in the important Northeast market. In our view, the expanded infrastructure will enable LabCorp to aggressively pursue more deals in this region.

Aside from the recent focus on contract wins and losses, we see solid organic growth driven by volume increases resulting from more esoteric testing (more sophisticated tests that generally involve a higher level of complexity), inroads into the hospital outpatient market, and price increases. In 2006, approximately 35% of LabCorp's revenue was derived from genomic and other esoteric testing, which carry a significantly higher price.

The average price per accession (i.e., what the company receives for each individual test it conducts) for esoteric tests in 2006 was $66.14 compared to the $37.59 average PPA for routine tests, a 76% differential. The company has successfully increased the mix of esoteric testing from 31% of sales in 2004 to 35% in 2006. During this period, the average PPA for esoteric tests rose from $61.18 in 2004 to $66.14 in 2006, indicating a CAGR of 4.0%. The average PPA for routine tests increased from $33.86 in 2004 to $37.59 in 2006, a CAGR of 5.4%.

We see these trends continuing over the next several years.

Slight Decline Expected

LabCorp generated industry-leading EBITDA (earnings before interest, taxes, depreciation, and amortization) margins of 26.0% in 2006, reflecting the benefits of operating leverage, better cost containment, advancement in information technology, and improvement in bad debt expense. For comparison purposes, Quest's EBITDA margin was 20.4% in 2006, and we are forecasting a decline of 50 basis points to 19.9% in 2007.

However, due to increased operating costs related to growing its network and related personnel, we see a slight decline of about 20 basis points in LabCorp's EBITDA margins to 25.8% in 2007 with expected improvement in the second half of the year. In 2008, we anticipate that LabCorp will begin to realize further benefits from the UnitedHealthcare contract, which should help drive EBITDA margins to 27.1%. We forecast free cash flows improving 12.6% to $581 million in 2007, indicating a free cash flow yield of 6.4%.

LabCorp's operating EPS has improved from $2.45 in 2004 to $3.30 in 2006, representing a CAGR of 16.1%. We expect EPS to improve 18.2% in 2007 to $3.90, aided by LabCorp's extensive stock repurchase program, which we view positively.

Both Sides of Governance

We believe the shares are attractively valued, currently trading at about 18.4 times our 2007 operating EPS forecast of $3.90, inclusive of stock option expense. Although we anticipate some margin pressure from recent and future contract negotiations, we believe at current levels, LabCorp is undervalued given our view of the company's superior revenue growth, industry leading margins, robust cash flow generation, and attractive earnings growth potential.

Our 12-month target price of $90 is based on our discounted cash flow (DCF) and p-e–to–growth analyses. Based on a blend of these two valuation methods, we derive our 12-month target price of $90, representing appreciation potential of about 25% from recent levels.

We have a neutral view of LabCorp's corporate governance practices. We view positively that the full board of directors is elected annually, both the nominating and compensation committees are comprised solely of independent outside directors and that there were no "related party" transactions involving officers and directors other than the CEO. Issues that we view negatively include the board being authorized to increase or decrease its size without shareholder approval, and that the company has a poison pill in place that has a trigger of less than 20%, which was not approved by shareholders.

Current Build-Out Is Key

There are several risks to our recommendation and target price, in our opinion. The primary risk would be Quest successfully signing additional exclusive national clinical lab contracts with other large managed-care companies such as Cigna (CI), WellPoint (WLP), and Humana (HUM). Under this scenario, we think LabCorp would lose significant volume and face substantial margin and pricing pressure.

Another risk, in our view: The inability to build out successfully the required infrastructure and network to fulfill its requirement under the UnitedHealthcare contract. LabCorp agreed to reimburse UnitedHealthcare up to $200 million in transition costs. The inability to build out an appropriate network would most likely result in the company reimbursing UnitedHealthcare at the high end of the agreed-upon amount. Also, if the company builds out an extensive infrastructure, but is unable to generate significant volume in these facilities, we see the incremental costs adversely affecting margins.

Other potential risks, in our opinions: In recent years, LabCorp has been able to increase prices, the number of tests performed per accession, and the amount of higher-priced esoteric tests performed. If these trends reverse, we believe sales and margins would be adversely affected. Also, approximately 21% of the company's sales are generated from Medicare and Medicaid reimbursement. A five-year freeze on reimbursement rates was implemented in 2004.