LabCorp's Challenges Ahead

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 LabCorp's Challenges Ahead 

The U.S. clinical testing industry is an important component of the healthcare system. It is the part of the system which helps confirm or make diagnosis, monitor disease states and provide treatment rationale data. It generally consists of two segments: hospital-based labs which makes up approximately 40% of testing volume and outpatient which comprises 60%. The outpatient segment has three main components: physician office laboratories, hospital outreach and independent clinical labs.
The total clinical lab testing industry in the U.S. generated approximately $60 billion in revenues in 2014, and of that commercial clinical laboratories accounted for approximately one-third of testing volume according to industry leaders Quest Diagnostics Inc.'s (DGX) and Laboratory Corp of America Holdings' (LH) most recent annual reports. Quest Diagnostics and LabCorp, the number one and two independent labs respectively, compete with the other hospital and non-hospital-based labs.

Business Model

LabCorp, based in Burlington, North Carolina, has two main lines of business that consist of clinical laboratory testing and contract research organization business. This $12.25 billion market capitalization company’s clinical laboratory testing business assists in detection, diagnosis, evaluation, monitoring and treatment of diseases and other medical conditions. The clinical laboratory business is intensely competitive. Despite being the second largest independent lab, many smaller labs compete with the larger players for patient volumes.
Like the clinical laboratory industry, the contract research organization industry has many competitors ranging from hundreds of small, limited‑service providers to a limited number of full‑service contract research organizations with global capabilities, according to LabCorp's 2014 annual report. The contract research organization (CRO) industry provides research services to the pharmaceutical or biotech industries to assist during clinical trials and other research.
LabCorp's CRO business was recently enhanced by the 2014 acquisition of Covance, and is now named Covance Drug Development. LabCorp states this “business primarily competes against in‑house departments of pharmaceutical companies, full-service and limited‑service contract research organizations and, to a lesser extent, selected universities and teaching hospitals.” (For related reading, see: The "Healthy" Play in Contract Research Organizations.)

Factors Affecting Profitability: Regulations and Seasonality

The Affordable Care Act of 2010 has increased the number of insured individuals in the U.S., creating an opportunity to serve more Americans and increase testing volume. At the same time, the primary insurers—Medicare (which principally serves patients 65 and older), Medicaid (which principally services low-income patients) and third party insurers—have put forth renewed “efforts to control the cost, utilization and delivery of health care services,” according to the LabCorp annual report. This has resulted in lower pricing and limited ability to set prices, at the same time pressuring individuals to decrease usage as their co-pays have also increased. (For more, see: Essential Health Benefits Under the Affordable Care Act.)
Lab testing tends to experience periods of time throughout the year when volumes decline, this trend is more broadly called seasonality. These declines usually happen during holiday periods and during the summer months when vacations are more prevalent. Utilization also declines during severe weather.

Investment Thesis and Valuation

The profitability of LabCorp is impacted by a few factors. Volume or the number of tests performed is a major contributor to profitability. But total volume alone does not explain changes in profitability. The level of volume for the different types of tests and the payer mix are highly correlated with a change in profitability.
There are many different varieties of clinical tests and LabCorp lumps them into two buckets called core testing and genomic and esoteric testing. Volume at LabCorp's Clinical Diagnostics Lab shows that core testing has almost three times more volume compared to genomic and esoteric testing, but genomic and esoteric testing provided more than one-and-a-half times more revenue per requisition (test) than core testing in 2014.
In terms of payer mix, in 2014, Medicare and Medicaid (government sponsored insurance) make up only 14% of LabCorp's patients but they are the most profitable. Commercial and managed care patients comprise 84% of the patients, but provide on average 15.6% less revenue per patient compared to Medicare/Medicaid.
Because the payer mix and volume type play a major role in determining profitability, any change in regulations or reimbursement cuts directly impact LabCorp's earnings. The risk of lower reimbursement tends to coincide with weak volumes, slowing clinical laboratory growth rates. Slower growth usually puts downward pressure on valuation metrics. Currently, LabCorp is trading at a forward price-to-earnings (P/E) ratio of 12.9 times and an enterprise value-to-earnings before interest taxes, depreciation and amortization (EV/EBITDA) ratio of 7.1 times. The forward P/E is slightly higher than its nearest competitor, Quest Diagnostics, but the EV/EBITDA is slightly lower than Quest Diagnostic’s 7.3 times, putting LabCorp around a similar valuation as Quest Diagnostics.

The Bottom Line

LabCorp is in a business that gets pressured at times based on regulatory changes and reimbursement cuts. But in the long run, this is a business that aids the healthcare industry in making good medical decisions. LabCorp is one of two national players that experiences strong competition from local labs and has a limited ability to set prices, except where new and innovative tests are developed and administered.
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