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Summary

  • 96.8% probability of making a 20% return or higher on a Long position.
  • Company generates excess returns for shareholders with robust Economic Value performance and solid competitive position.
  • Short Squeeze candidate with a short interest of 27% of shares outstanding and significant capacity to increase leverage, buyback shares and/or payout dividends.

Bio-Reference Laboratories Inc. (NASDAQ:BRLI) provides clinical laboratory testing services for the detection, diagnosis, evaluation, monitoring, and treatment of diseases in New Jersey, New York, Maryland, Massachusetts, Texas, and Ohio (Source: S&P Capital IQ).

Based on our Economic Value model and Monte Carlo simulation, our probability distribution of "fair value" for BRLI affirms that the intraday share price of $27.15 is undervalued (as of 3/18/2014). The expected value of the share price based on the mean and median is estimated to be $40.35 to $39.79, respectively (Table 1).

Table 1: Monte Carlo Simulation - Statistics

(Figure 1) GAAP EPS has increased (red line) along with the share price (green line), and Economic Value (also known as Economic Profit, Economic Value Added, or EVA) per share (blue line).

Figure 1: Price, EPS, Economic Value Per Share

Although Economic Value has recently declined, we anticipate that the market has overreacted with an opportunity to buy at a significant discount (Figure 2).

Figure 2: Historical Share Price and Forecast

Hence, the probabilities of realizing a 20% return from either a long or short position is as follows (Table 2):

  1. Long: approximately 97% chance of 20% Return or Higher. 0% chance of a loss.
  2. Short: approximately 0% chance of 20% Return or Higher. 100% chance of a loss.

Table 2: Monte Carlo Simulation Probabilities

MARKET EXPECTATIONS VERSUS ECONOMIC REALITY

To further validate and provide context to the reasonableness of our analysis, we compare market expectations versus actual operating performance of the company relative to a peer set.

The peer set selected is from a universe of companies based on S&P Capital IQ's Health Services industry classification. Where possible we include up to 30 peers in order to get a better statistical sample. For this analysis our peer set includes: Addus HomeCare Corporation (NASDAQ:ADUS), Air Methods Corp. (NASDAQ:AIRM), Alliance Healthcare Services, Inc. (NASDAQ:AIQ), Almost Family Inc. (NASDAQ:AFAM), Amedisys Inc. (NASDAQ:AMED), AMN Healthcare Services Inc. (NYSE:AHS), Bio-Reference Laboratories Inc. , BioScrip Inc. (NASDAQ:BIOS), Catamaran Corporation (NASDAQ:CTRX), Chemed Corp. (NYSE:CHE), CorVel Corporation (NASDAQ:CRVL), Cross Country Healthcare, Inc. (NASDAQ:CCRN), DaVita HealthCare Partners Inc. (NYSE:DVA), Envision Healthcare Holdings, Inc. (NYSE:EVHC), ExamWorks Group, Inc. (NYSE:EXAM), Express Scripts Holding Company (NASDAQ:ESRX), Gentiva Health Services Inc. (NASDAQ:GTIV), Healthways Inc. (NASDAQ:HWAY), IPC The Hospitalist Company, Inc. (NASDAQ:IPCM), Accretive Health (NYSE:AH), Laboratory Corp. of America Holdings (NYSE:LH), Landauer Inc. (NYSE:LDR), LHC Group, Inc. (NASDAQ:LHCG), MEDNAX, Inc. (NYSE:MD), National Research Corp. (NASDAQ:NRCIB), Omnicare Inc. (NYSE:OCR), Providence Service Corp. (NASDAQ:PRSC), Quest Diagnostics Inc. (NYSE:DGX), and Team Health Holdings, Inc. (NYSE:TMH).

Market expectation can be observed through Market Value Added (MVA), which is the Market Value (Debt plus Market Value of Equity) less the Capital invested, and represents shareholders' expectations of the future stream of Economic Value or Discounted Cash Flow (DCF) that the business will generate. Mathematically the Net Present Value of a DCF is always equal to the Present Value of Economic Value. Consequently, we can calculate the Implied Economic Value Growth in MVA (Table 3) imbedded in the current share price. BRLI's Implied Growth in MVA is approximately 5.7%, which is at the low end relative to peers.

Table 3: MVA and Economic Value Ranking

Conversely, adjusting Economic Value for both size in Capital (6.4%) and Revenue (2.4%), BRLI's operating performance is at the high end (Table 4).

Table 4: Economic Value Ranking

The divergence between the company's ability to create value and the market's outlook for economic growth is one indicator that expectations may be too low.

ECONOMIC VALUE DRIVERS AND PERFORMANCE

To determine whether the company's recent performance will be a good indicator of future performance, we take a deeper look into the drivers of Economic Value. (Table 5) Impressively, the company has grown profitably with respectable Revenue Growth (15.5%) and a high Return on Capital (15.8%).

Table 5: Drivers of Economic Value

(Figure 3) Although difficult to see in the graph below, BRLI has consistently generated Revenue Growth (solid black line) near the 75th percentile of its peer set.

Figure 3: Revenue Growth Benchmarked Against Peer Set

However, (Figure 4) BRLI's profitability or Spread (solid black line), which is the Return on Capital less the Cost of Capital, has increased from the interquartile range toward the top of the 90% confidence interval relative to its peer set. Effectively, while the industry has declined, BRLI has declined less than its peers.

Figure 4: Spread Benchmarked Against Peer Set

The company's relative Spread performance can be largely attributed to a healthy Return on Capital. Return on Capital is driven by both NOPAT Margin and Capital Turns. (Figure 5) BRLI's NOPAT Margin (solid black line) has stayed consistent and remained within the interquartile range of its peers.

Figure 5: NOPAT Margin Benchmarked Against Peer Set

Comparatively, (Figure 6) BRLI's Capital Turns (solid black line) has continually performed in the top quartile relative to its peers.

Figure 6: Capital Turns Benchmarked Against Peer Set

The company's consistent NOPAT Margin and Capital Turns have both contributed to a strong Return on Capital (Figure 7).

Figure 7: Return on Capital Drivers - NOPAT Margin and Capital Turns

In particular, the company's Quality of Growth, which is the product of Economic Value Margin and Revenue Growth, has been 'Good Growth' (Figure 8).

Figure 8: Quality of Growth

VALUATION ASSUMPTIONS

Although past performance is not always indicative of future performance, historical data can provide a good estimate of the range of possibilities. The ranges we use for our key drivers of Revenue Growth, Spread, NOPAT Margin and Capital Turns represents our 90% confidence interval. For each scenario of our valuation, a random value is generated for the drivers of our discounted Economic Value model (Figure 9).

Figure 9: Overview of Economic Value and Monte Carlo Simulation

(click to enlarge)

These random values are based on reasonable ranges derived from Trailing Twelve Month (TTM) 10-year historical distributions of company and peer data. While point estimates are often "precisely wrong," range estimates provide a more realistic view of market variability and have a greater chance of the actual outcome falling within the estimated range. Additionally, we scrutinize the inputs of our Monte Carlo simulation through our Economic Value calculation, where adjustments are made to accounting statements to more accurately reflect the economics of each driver.

In some cases where our initial assumptions generate a valuation substantially different from the current trading price, we attempt to be overly conservative and create additional margin of safety by taking a very optimistic outlook for a short position or a conservative outlook for a long position. In the case of BRLI, despite our conservative projections for the key drivers, the company remains a clear Long (Figure 10).

Figure 10: Monte Carlo Simulation - Fair Value Distribution

Revenue Growth

Our range assumption of 14 to 18% for Revenue Growth is consistent with the current trend (Table 6).

Table 6: Revenue Growth - Range Assumptions

(Figure 11) BRLI's TTM quarterly Revenue Growth has bounced between the 90% confidence interval of 13 to 29%.

Figure 11: Revenue Growth Benchmarked Against Company's Own Historical Performance

(Figure 12) However, we conservatively projected that Revenue Growth would remain between the lower bound of the 90% confidence interval and the 25th percentile of past performance, ranging from 14 to 18%.

Figure 12: Revenue Growth - Historical and Projections

The distribution of Revenue Growth in our Monte Carlo simulation (black solid line) overlaid against the distribution of the peer set (dark blue dotted line), DGX (light blue dotted line), and the company's historical performance (orange dotted line), shows how our overall Revenue Growth estimates compare to different benchmarks (Figure 13). The Monte Carlo distribution falls in line with the peer set and is conservatively below its historical performance.

Figure 13: Revenue Growth - Forecast Monte Carlo Distribution versus Historical

Spread

Again, our estimates of Spread exhibit a fairly subdued view, when compared to historical performance (Table 7).

Table 7: Spread - Range Assumptions

(Figure 14) With the exception of the most recent period, BRLI's TTM quarterly Spread has increased towards the upper bound of the 90% confidence interval.

Figure 14: Spread Benchmarked Against Company's Own Historical Performance

(Figure 15) Despite a robust historical performance, we conservatively forecasted that the Spread would trend to a range of 2 to 5% into perpetuity.

Figure 15: Spread - Historical and Projections

The distribution of Spread in our Monte Carlo simulation (black solid line) overlaid against the distribution of the peer set (dark blue dotted line), DGX (light blue dotted line), and the company's historical performance (orange dotted line), shows how our overall Spread estimates compare to different benchmarks (Figure 16). The Monte Carlo distribution conservatively leans towards the lower end of the company's historical performance.

Figure 16: Spread - Forecast Monte Carlo Distribution versus Historical

NOPAT Margin

Our range assumption for NOPAT Margin is also cautious (Table 8).

Table 8: NOPAT Margin - Range Assumptions

(Figure 17) With the exception of the most recent period, BRLI's TTM quarterly NOPAT Margin has bounced between the 25th percentile (6%) and upper bound of the 90% confidence interval of its historical performance (7%).

Figure 17: NOPAT Margin Benchmarked Against Company's Own Historical Performance

(Figure 18) We conservatively forecasted that the NOPAT Margin range would decline to towards the lower bound of the 90% confidence interval after the 5th year.

Figure 18: NOPAT Margin - Historical and Projections

(Figure 19) The NOPAT Margin distribution in our Monte Carlo simulation (black solid line) overlaid against the distribution of the peer set (dark blue dotted line), DGX (light blue dotted line), and the company's historical performance (orange dotted line), shows how our overall NOPAT Margin estimates compare to different benchmarks. The Monte Carlo distribution is slightly lower than the company's historical performance and in line with its peer set.

Figure 19: NOPAT Margin - Forecast Monte Carlo Distribution versus Historical

Capital Turns

Our range assumption for Capital Turns is consistent with historical performance (Table 9).

Table 9: Capital Turns - Range Assumptions

(Figure 20) BRLI's TTM quarterly Capital Turns has for the most part fluctuated within its historical interquartile performance of 2.51 to 2.72x.

Figure 20: Capital Turns Benchmarked Against Company's Own Historical Performance

(Figure 21) We forecasted that Capital Turns would stay near the same historical range after the first year, rounding our estimate to 2.55 to 2.70x.

Figure 21: Capital Turns - Historical and Projections

(Figure 22) The Capital Turns distribution in our Monte Carlo simulation (black solid line) overlaid against the distribution of the peer set (dark blue dotted line), DGX (light blue dotted line), and the company's historical performance (orange dotted line), shows how our overall Capital Turns estimates compare to different benchmarks. The Monte Carlo distribution is on par with the company's historical performance, but also highlights the company's ability to effectively manage capital compared to its peers.

Figure 22: Capital Turns - Forecast Monte Carlo Distribution versus Historical

Conclusion

BRLI remains a Long despite a conservative outlook. Further support for our Long position can be observed through two key strategic forces, namely the industry's market economics (average Industry Spreads) and the company's competitive position (Company Spread minus Market Economics). The analysis concludes the following (Figure 23):

  1. Although recent performance has been adversely affected by the market economics of the industry, the company continues to maintain a dominant competitive position.
  2. DGX's competitive position is weaker despite its size.

Figure 23: Market Economics versus Competitive Position

Lastly, BRLI exhibits many of the same Short Squeeze qualities we outlined in our analysis of Questor Pharmaceuticals (NASDAQ:QCOR), Short Squeeze Draws Closer For Questcor. Short Interest as a percentage of shares outstanding is fairly high and currently runs at approximately 27% (as of 03/18/2014, Source: S&P Capital IQ). The company could set the stage for a Short Squeeze and follow QCOR's example of buying back shares and issuing a dividend. With such a high Interest Coverage Ratio, the company can afford to do the same, and place additional pressure on the Short sellers.

Figure 24: Interest Coverage Benchmarked Against Company's Own Historical Performance

In addition, the company has significant financial flexibility, with the ability to minimize the Cost of Capital with an optimal capital structure of 39% (Debt to Market value).

Figure 25: Optimal Capital Structure

This would decrease the company's Cost of Capital from 9.4% to 8.5%. As a result, the value of the company would increase from our initial mean estimate of $40.35 to $46.67, and increase our initial mean expected return from 48.6% to 71.9%.

Source: Bio-Reference Laboratories: High Probability Of Making A 20% Return Or Higher

Additional disclosure: I am short EXAM and HWAY.