LabCorp - Steady As She Goes, Fairly Valued

| About: Laboratory Corporation (LH)

Summary

LabCorp continues to grow at a healthy pace and announces another bolt-on deal.

Organic growth and M&A has resulted in a great growth track record.

With valuation being full and the balance sheet still being leveraged, I see few triggers at the current all-time highs.

LabCorp (LH) has grown to become a huge healthcare diagnostics business in recent years, benefiting from organic growth and smart dealmaking.

While the company has traditionally resorted to bolt-on deals, it broke with this tradition when it announced the huge acquisition of Covance back in 2014. A solid integration of these assets, the evading threat posed by Theranos and investor's appetite for growth has pushed up the stock to fresh highs.

I belief that the stock has very desirable investment qualities thanks to solid margins, business stability and decent organic growth. That said, the valuation multiples have become too steep following a recent run higher, also taking into account the still leveraged balance sheet.

The Business

LabCorp is a large diagnostics business which operates in two major segments. Nearly three quarters of 2015's annual revenues of $8.5 billion are derived from the Clinical Laboratory segment. This segment is comprised out of nearly 40 laboratories, 1,700 patient centers, processing over half a million specimens on a daily basis. This routine tasks remain solidly profitable, with margins of 20%. Despite these solid margins, laboratory testing is still way cheaper compared to testing at the local hospital, in large part the result of scale advantages.

The other segment is the contract research organization in which LabCorp provides a full spectrum of services, ranging from early development of drugs to actual trials. This segment posts margins of 14%.

Roughly 80% of the sales are generated in North America, as the company has overseas activities as well, notably following the 2015 purchase of Covance. This deal as well as multiple other deals have been the key driver behind the phenomenal growth trajectory displayed over the past decade. Revenues have nearly tripled from $3.3 billion in 2005 to an anticipated $9.4 billion by 2016.

The Acquisition Spree

LabCorp has made multiple smaller deals over the past decade, aiding the company to achieve a revenue base which is roughly 3 times the size of 2005. In total the company spent roughly $8-9 billion on deals over this time period with the Covance deal being by far the largest transaction.

The good thing is that the company actually managed to reduce the share base by a quarter over this time period following large share buybacks in the period 2006-2010. It has to be said that gross margins have been trending lower over time, pressuring operating margins as well as increased scale could not completely offset this pressure. Operating margins now trend at 15% of sales while they used to come in at the high-teens in recent years.

The $5.7 billion purchase of Covance, announced by the end of 2014, marked a major step in the overall growth, creating a more diversified basis. The huge deal stood out in relation to the typical deal which involved a couple of hundred millions. The integration appears to have gone well as leverage ratios have quickly fallen by a turn towards 3 times EBITDA at the moment.

The gradual reduction in leverage gave the company new ammunition to acquire Sequenom (SQNM), a business involved with non-invasive prenatal testing. The $371 million deal will boost the capabilities of LabCorp in this specific area. The purchase will have a very limited impact on the business as trailing sales of Sequenom come in at just $118 million. Following large losses in recent years the business has been able to narrow these losses in recent times.

Marching Forwards

LabCorp reported healthy organic growth rates of 6.4% in the second quarter. Based on this growth and the purchase of Sequenom the business has grown to a $9.5 billion revenue base.

The company has managed to boost its margins slightly, but they still trail the long term potential at 15% of sales. LabCorp has slightly raised the full year guidance to $8.60-$8.95 per share, but note that these are adjusted metrics. As such they do not include charges which predominately exist out of restructuring and amortization charges. GAAP earnings come in at roughly 80% of the non-GAAP earnings guidance, as the vast majority of the discrepancy is explained by non-GAAP amortization charges.

That means that earnings numbers of around $7 per share are more reliable, although actual cash flow conversion is very good, typically exceeding earnings as a result of the non-cash impairment charges. That also means that at $140 per share, the valuation is full at 20 times earnings, certainly if we take into account a balance sheet with leverage of up to 3 times EBITDA.

That said, the balance sheet is capable to deleverage at a quick pace. Actual cash flow conversion is very good, as 6% organic growth allows LabCorp to grow out of its debt load as well.

A Good Play, Just Not At This Level

LabCorp operates in a growing market and has demonstrated solid organic growth accompanied by savvy deals. For years this has resulted in steady topline growth, but this strategy changed with the huge purchase of Covance. While leverage ratios have fallen from 4 to 3 times EBITDA, they continue to be higher than the long term average. That said, the company has excellent opportunities to deleverage, as it does not pay out dividends.

The leveraged balance sheet could provide a drag for investors for some time to come, although LabCorp just announced another bolt-on deal. The reality is that at 20 times GAAP earnings and given the leverage employed, 6% organic growth is not appealing enough for me to jump aboard. This is certainly the case after shares are up 10-15% so far in 2016 at $140, following a huge momentum run from the lows of $100 in February.

Based on the GAAP earnings of $7 per share and a modest 15 times multiple, a $105 entry point would seem attractive enough as deleveraging continues. At these levels the multiples, solid cash flow conversion and good pace of organic growth gain the upper hand. This makes LabCorp an interesting play in my eyes, just not at this level.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.