There are approximately 8,000 medical and diagnostic laboratories generating $55 billion in annual revenues. The industry is highly fragmented and competitive with thousands of independent labs, physician office labs, and hospital based labs. The industry’s two largest companies are Quest Diagnostics (DGX) and Laboratory Corp. of America (LH). Other publicly traded, but significantly smaller, competitors include Bio-Reference Laboratories (BRLI), Genomic Heath (GHDX), MEDTOX Scientific (MTOX), and Psychmedics (PMD). Through significant consolidation over the past decade, the majority of publicly traded labs have been acquired, primarily by Lab Corp and Quest.
Demand is linked to the number of people receiving medical treatment. The profitability of individual companies depends on efficient operations and good marketing. There are large economies of scale in the operation of medical labs, which can receive samples from a wide geographical area. Small medical labs can compete effectively by providing specialized analyses, or by serving geographical regions with few medical facilities.
Across the United States, medical laboratory accreditation and Clinical Laboratory Improvement Act (CLIA) compliance is getting tougher. This is a trend which affects every clinical laboratory and anatomic pathology medical group that must comply with CLIA and meet the accreditation requirements of the Medicare program.
The long term trends are very favorable for the diagnostic laboratories. All laboratories will benefit from volume increases due to both population growth and the baby boomer budge in the aging population; an increase in the number of tests per requisition; and an increase in esoteric/genomic tests which we see as a result of technological developments and the nascent trend to customize treatments. Taken together, these trends will accelerate revenue growth beyond single digits. We think that the expansion of health insurance coverage to millions of currently uninsured consumers will out way reduced reimbursement rates. The main beneficiaries of the trends will be the most cost efficient service providers. We also believe that consolidation will also accelerate as the small service providers will be less like to successfully compete. Economies of scale will be the determining factor on which companies survive, let alone prosper. The largest companies in this sector have the best prospects.
Bio-Reference laboratories, Inc. Bio-Reference Laboratories, Inc. (Bio-Reference) is engaged in providing laboratory testing services, to customers in the greater New York metropolitan area, as well as to customers in other states. It offers a range of chemical diagnostic tests, including blood and urine analysis, blood chemistry, hematology services, serology, radio-immuno analysis, toxicology (drug screening), pap smears, tissue pathology (biopsies) and other tissue analysis. As of October 31, 2010, it operated two clinical laboratories, one in Elmwood Park, New Jersey and one in Valley Cottage, New York, and an andrology laboratory in New York City; a cytogenetics testing laboratory located in Milford; a pathology laboratory in Poughkeepsie; a pathology laboratory in Clarksburg, and a genetics laboratory in Gaithersburg. The laboratory testing business consists of routine testing and esoteric testing. On March 2, 2010, the company completed the acquisition of Lenetix Medical Screening Laboratory, Inc. (Lenetix).
Genomic Health, Inc. Genomic Health, Inc. (Genomic Health) is a molecular diagnostics company focused on the development and global commercialization of genomic-based clinical laboratory services, which analyzes the underlying biology of cancer, allowing physicians and patients to make individualized treatment decisions. The company’s Oncotype DX platform utilizes genomic analysis in standard tumor pathology specimens to provide tumor-specific information, or the oncotype of a tumor. It offers the Oncotype DX breast cancer test as a clinical service, where it analyzes the expression levels of 21 genes in tumor tissue samples and provides physicians with a gene expression profile expressed as a single quantitative score, which it calls a Recurrence Score. The test also provides measurements of quantitative gene expression for estrogen receptor (ER), progesterone receptor (PR), and human epidermal growth factor receptor 2 (HER2), genes, which are used in the calculation of the Recurrence Score result.
Laboratory Corporation of America Laboratory Corporation of America Holdings is an independent clinical laboratory company in the United States. The company has a national network of 51 primary laboratories and over 1,700 patient service centers (PSCs) along with a network of branches and STAT laboratories, which are laboratories that have the ability to perform certain routine tests quickly and report the results to the physician immediately. Through its national network of laboratories, the company offers a range of clinical laboratory tests that are used by the medical profession in routine testing, patient diagnosis, and in the monitoring and treatment of disease. In addition, the company has developed specialty testing operations, such as oncology testing, human immunodeficiency virus (HIV) genotyping and phenotyping, diagnostic genetics and clinical trials.
MEDTOX Scientific Inc. MEDTOX Scientific, Inc. operates through its wholly owned subsidiaries, MEDTOX Laboratories, Inc. (MEDTOX Laboratories), MEDTOX Diagnostics, Inc. (MEDTOX Diagnostics) and New Brighton Business Center, LLC (NBBC). MEDTOX Laboratories, Inc. provides forensic and clinical laboratory services. MEDTOX Diagnostics, Inc. manufactures and distributes diagnostic devices and other similar products. NBBC conducts the company’s building rental activities. The company operates in two segments: Laboratory Services, which consists of the activities conducted by MEDTOX Laboratories, Inc. and New Brighton Business Center, LLC, and Product Sales, which consists of activities conducted by MEDTOX Diagnostics, Inc.
Psychmedics Corp. Psychemedics Corporation (Psychemedics) provides testing services for the detection of abused substances through the analysis of hair samples. The company’s testing methods utilize a technology to perform radioimmunoassays on the hair sampled, with confirmation testing by mass spectrometry. The company’s primary application of its technology is as a testing service that analyzes hair samples for the presence of certain drugs of abuse. The company’s tests provide quantitative information that can indicate the approximate amount of drug ingested, as well as historical data, which can show a pattern of individual drug use over a period of time. This information is used by employers for both applicant and employee testing, as well as to physicians, treatment professionals, law enforcement agencies, school administrators, parents concerned about their children’s drug use and other individuals or entities engaged in any business where drug use is an issue.
Quest Diagnostics Inc. Quest Diagnostics Incorporated is a provider of diagnostic testing, information and services. It offers diagnostic testing services and products to patients, physicians, payers, and others. It offers the United States patients and physicians the access to diagnostic testing services through its nationwide network of laboratories and company owned patient service centers. It is a provider of clinical testing, including gene-based and esoteric testing, anatomic pathology services and testing for drugs-of-abuse, and the provider of risk assessment services for the life insurance industry. It also is a provider of testing for clinical trials. Its diagnostics products business manufactures and markets diagnostic test kits and point-of-care testing. It provides testing services to a range of customers. In April 2011, it acquired Athena Diagnostics. In May 2011, it acquired Celera Corporation.
With a market cap of $8,808 million and sales of $7,455.2 million for the trailing twelve months, Quest is by far the largest of these companies. LH is the second largest with a market cap of $8,232.1 million and sales of $5,471.6 million. Of the remainder, Bio-Reference has sales of $533.9 million; Genomic Health $199.8 million, MEDTOX $106.2 million and tiny Psychmedic $22.5 million.
In terms of earnings, Laboratory Corp is the largest with net income of $516.1 million or $5.00/share. Full year EPS estimates for LH range from $6.22 to $6.40 with the mean being $6.30. Quest reported net income of $443.9 million or $2.72 diluted for the last twelve months. Estimates for Quest run from a low of $4.23 to $4.33 and average $4.28. Bio-Reference is followed by fewer analysts. They estimate full EPS in the range of $1.12 to $1.16 and average $1.14. BRLI reported net income of just $34.5 million.
For 3Q11, BRLI reported EPS of $0.36 on sales of $148.0 million. EPS increased 29% y-o-y and sales increased 22% y-o-y. Quest saw a y-o-y EPS decline to $1.08 from $1.13. At the same time, sales increased to $1,906.4 or 2.0% from $1,864.7 million. In the middle, LH also saw a decline in EPS. EPS decline to $1.31 or 2% from $1.34 whereas sales increased to $1,404.5 million, a 10% increase from the year ago quarter sales of $1,276.5 million.
Bio-Reference saw a small expansion in operating margins. Margins for BRLI are 10.4%, slightly ahead of its three year average of 10.2% and the five year average of 10.0%. On the other hand, both LH and Quest experienced margin contraction. LH reported an operating margin of 17.2%, down from its three year average of 19.4% and its five year average of 19.3%. We see a similar pattern for Quest. The three year average operating margin is 17.4% and the five year average is 17.3%, well above the current operating margin of 12.9%.
With the exception of Psychmedics, the other companies report razor thin operating margins. GHDX reports a margin of 3.4% versus negative three- and five-year averages. MEDTOX shows small improvement with an increase in operating margins to 6.3% from a three year average of 6.1% but down from its five year average of 8.5%. Psychmedics reports both strong and consistent operating margins over each period. The current operating margin is 23.6% as compared to the three year average of 19.2% and the five year average of 23.8%.
The growth picture for BRLI is fairly robust with consistent growth in sales and earnings in both the short and long term. The big negative for BRLI is that it is not generating much free cash flow. The smaller companies GHDX, MTOX and PMD show good recent sales growth and explosive, unsustainable growth in net income. Each of these companies is hindered by low or non-existent free cash. Quest has low growth in sales and faces challenges in growing its net income. However, it reports strong free cash at $4.50/share plus pays a dividend of $0.40/share yielding 1.2%. Quest has a history of growing the dividend at the hefty rate of 25.8% per year.
Sales growth by itself does not create a profitable company. These profitability ratios give us a good idea how well each company turns sales into profits. We can see here that size often does matter. Both LH and DGX have long term average operating margins significantly better than the smaller companies. PMD’s high margins probably reflect the specialized nature of its product offering. Two metrics we think very important are ROIC and CFROI. PMD gives a strong performance as measured by these metrics and GHDX does very poorly. The bigger companies, LH and DGX do well when compared to their direct competitors and to the industry medians. BRLI will be a contender when it can grow its free cash.
If we were either price momentum or earnings momentum investors, price would not be a critical factor in our analysis. If we were, perhaps GHDX would be of interest to us. Since we look for value, or at least a reasonable price, the purchase price becomes important. One metric that might be used to determine reasonableness of price is to look at PE to Dividend Adjusted EPS estimated Growth. On this basis, BRLI looks cheap at 0.7X; GHDX expensive at 2.4X; LH fairly valued at 1.4X; MEDTOX fairly valued at 1.5X; we have no long term EPS estimate for PMD; and, DGX slightly high at 1.6X.
Looking beyond the PE ratio, we can estimate an appropriate price-book ratio for each of the companies. The estimated price-book ratio is based on EPS growth, the payout ratio, beta and return on equity. BRLI has a current PB of 2.51X and an estimated PB of 3.91X; GHDX has a PB of 7.35X and an estimated PB of 4.47X; LH 3.24X vs. 3.4X; MTOX 2.2X vs. 4.37X; PMD 4.57X vs. none estimated; and DGX 2.5X vs. 2.56X. Some analysts like the price-sales ratio. Again, we can estimate an appropriate PSR based on EPS growth, free cash flow, EPS, beta and net margin.
The PSR for BRLI is 0.84X vs. an estimate of 2.46X; GHDX 3.92X vs. 3.67X; LH 1.5X vs. 2.2X; MTOX 1.17X vs. 2.42X; PMD 2.14X vs. none estimated; and DGX 1.18X vs. 1.71X. Using EV to EBITDA, BRLI and PMD look undervalued.
Of the six companies described here, we think that Bio-Reference Laboratories offers the best risk/reward scenario. The company has $19.2 million in cash and ST investments and just $10.9 million in long term debt. It consistently grown sales and net income and maintains a stable operating margin. Valuation, as measured by PE, PB and PS are all below the company’s long term valuation levels.