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By Mark Terry
Staff - Washington G2 Reports, author Lab Industry Strategic Outlook 2007
02/27/08
Stock analysts have shown increased interest in Quest Diagnostics (DGX) and Laboratory Corporation of America (LabCorp) (LH) recently because of their aggressive acquisition activity and managed care contracting efforts. To help put the various views into perspective, Washington G-2 Reports has analyzed and compared the recent stock buy/sell opinions and drivers behind each firm from the analysts at Cowen and Company, PiperJaffray & Co., Goldman Sachs, and StockScouter, part of Money Central/MSN.com, affiliated with Zachs Investment Research.
Overall, for Quest, three of the four analysts gave the stock either a neutral rating or indicated that Quest’s stock will perform at the expected market level. Goldman Sachs was slightly less optimistic with a sell rating.
Analysts for LabCorp, on the other hand, were more evenly split. Cowen and Company felt LabCorp stocks would outperform the market, and StockScouter suggested a moderate buy. PiperJaffray and Goldman Sachs were neutral, suggesting that LabCorp stocks would perform at the expected market level.
Analyst Quest Diagnostics LabCorp
Cowen and CompanyNeutral Outperform
PiperJaffrayNeutral Neutral
Goldman SachsSell Neutral
StockScouterHold Moderate buy
QUEST DIAGNOSTICS
Cowen and Company Evaluation
There are four overarching concerns facing Quest Diagnostics, according to Cowen and Company. As stated by Kemp Dolliver, CFA and David Larsen of Cowen and Company, they are:
- Cost-reduction program;
- Ameripath integration;
- Cross-selling; and
- 2008 guidance.
Cost-Reduction Program
Cowen and Company notes that Quest management has stated a goal of cutting $500 million in costs. Approximately a third of that goal is related to process changes and improvements. “Management is well aware that process changes carry higher risk than process improvements.”
AmeriPath Integration
In 2007, Quest acquired anatomic pathology leader AmeriPath. Kemp Dolliver notes that although the acquisition made a lot of strategic sense, it was probably overpriced. Cowen and Company indicates that the earnings per share (EPS) from the acquisition remains “a near-term risk.” There are cost issues for AmeriPath related to systems and billing conversion. “AmeriPath’s systems conversions were not adequately rigorous, and the systems have not lived up to expectations.” AmeriPath further notes that although Quest management intends to address those issues, it has not specified a dollar amount.
After Quest’s 2007 annual report and 2008 guidance, Cowen and Company notes that both the AmeriPath investment and its development of the India market will be a drag on the company’s 2008 guidance. “DGX does not expect a positive ROI in India for three to five years and thinks additional IT spend is possible in 2009.”
Cross-Selling
As mentioned above, Dolliver notes that the AmeriPath acquisition made strategic sense. The strategic goal of the acquisition was to accelerate the growth of the combined pathology business. Cowen and Company notes that selling AmeriPath’s dermatology services to Quest’s clients is the first opportunity to do this. The second opportunity is to do the reverse: sell Quest’s clinical testing services to AmeriPath’s clients. “Management still needs to establish the sales force’s structure to execute this strategy. Our consultants think this strategy is logical, which makes execution the main risk.”
2008 Guidance
Quest management released its 2008 earnings guidance in late February 2008. Cowen and Company notes that the outcome of this was strongly influenced by the United Healthcare (UNH) business, which currently accounts for approximately $125 million in Quest revenue. Cowen and Company says that because of LabCorp’s increased marketing efforts, it has not seen a decrease in Cigna test volumes and the UNH LabOne contract expiration in May 2008 is not significant. “While EBITDA margin has improved 480bps from Q1:07 (16.7%) to Q4:07 (21.5% versus 21.6% F2006), we remain cautious on India and AmeriPath investment spend.”
Cowen and Company reduced their 2008E earnings per share (EPS) from $3.40 to $3.10 and their 2008E EBITDA margins from 21.4% to 20.3% as a result of the higher costs related to IT and the India market development.
Cowen and Company’s evaluation: Neutral.“We maintain our neutral rating on the shares and think the stock will trade in line with the market over the next 12 months.”
Quest Diagnostics Revenue Buildup ($MM)
2006 2007 2008E
Q3 Q4 Year Q1A Q2A Q3A Q4 Year Q1 Q2 Q3 Q4 Year
Total Revenue $1,583 $1,547 $6,268 $1,526 $1,641 $1,767 $1,770 $6,705 $1,779 $1,858 $1,848 $1,819 $7,305
% Increase +16% +9% +15% -2%$4% +12% +14% +7% +17% +13% +5% +3% +9%
Source: Cowen and Company and Quest Diagnostics quarterly reports
Quest Diagnostics Stock Price and Percent Change
Date Price % Change
8/18/06 $62.50 4%
10/20/06 51.44 -17
11/17/06 53.36 4
12/15/06 52.26 -2
2/23/07 52.37 3
4/20/07 49.97 2
5/18/07 48.53 -3
6/23/07 51.25 5
7/20/07 54.02 6
8/17/07 54.12 0
9/21/07 56.66 2
11/16/07 54.53 -2
12/17/07 53.00 -3
1/18/08 51.66 -3
2/20/08 52.16 1
Source: Washington G2 Reports Laboratory Industry Report
PiperJaffray Evaluation
In a February 21, 2008 evaluation of Quest Diagnostics, PiperJaffray broke its analysis of the company stocks into five points.
- PiperJaffray notes that Quest’s announced 2007 annual revenues were $1,770 million, above its own prediction of $1,739 million and Wall Street’s prediction of $1,849 million. Although Quest lost about 5.1% of its test volume due to the United Healthcare contract losses, management indicates it has retained more than 20% of its volumes, which are consistent with its 2007 Q3 levels. Overall, interest expenses were lower than predicted ($53.9 million versus an expected $59.9 million). “Slightly lower-than-expected gross margin was offset by better-than-expected interest expenses and SG&A leverage.” GAAP EPS was $0.04 higher ($0.79) than its original estimate of $0.75 and Wall Street’s $0.78.
- PiperJaffray noted that, excluding acquisitions, Quest’s revenue per requisition had increased by 5.1%, quite a bit higher than its 3.0% estimate. Quest revenue per requisition was 2% higher due to higher reimbursement on the United Healthcare business it retained, although its volumes have increased with Aetna in 4Q07, which partly offset the United Healthcare losses.
- Quest Diagnostics intends to open a lab in Delhi, India in 2008. Quest management has indicated to PiperJaffray that it is considering other foreign markets, including South America and Asia; it currently operates small labs in the United Kingdom and Mexico. “Quest is choosing to set up its own infrastructure versus creating an alliance in order to preserve its high-quality products/services. We view this as a longer-term positive.”
- PiperJaffray notes that Quest has been renewing its managed-care contracts with Humana and hopes to continue with Cigna. Quest does not expect significant volume changes with these contracts.
- PiperJaffray notes that Quest’s 2008 revenue guidance was $7.3 billion compared to its own $7.5 billion estimate and Wall Street’s $7.4 billion estimate. In addition, Quest’s EPS guidance was $3.00 to $3.20. PiperJaffray’s EPS estimates were for $3.40, and Wall Street’s was $3.36. Quest has announced it intends to invest approximately $0.20 per share in new IT systems and global expansion ($0.13 and $0.07, respectively). “We believe guidance is achievable and have modeled FY08 revenue and EPS of $7.3 billion an $3.13, respectively.”
Evaluation: Neutral—“Anticipate limited total return (general appreciation less than 10% or decline less than 5%) over the next 12 months.”
Goldman Sachs Evaluation
Goldman Sachs initiated analysis on Quest Diagnostics and LabCorp in November 2007. Its evaluation of Quest Diagnostics shows concern about the aggressive cost-cutting Quest has made in response to the loss of the United Healthcare business, as well as the AmeriPath acquisition. It notes that managed-care contracts have threatened to push prices down, an additional incentive for cost-cutting.
In an update on Feb. 21, 2008, after Quest’s 2007 earnings report, Goldman Sachs maintained its sell rating, while tweaking only slightly its evaluations. It notes as well that Quest’s guidance indicates IT system development will cost $0.13 per share and its India expansion will cost $0.07 per share. “However, here we find the long-term benefits more difficult to quantify: While potentially accretive to earnings over the long term, the India expansion initiative will be a net investment for several years and management is currently not providing any guidance on the expected long-term impact on margins.”
Valuations
Goldman Sachs notes that Quest generates about $600 million in annual free cash flow. It believes management’s estimates for debt reduction and modest share repurchasing will contribute about $0.03 per share in 2008 and 2009. “We view the company’s higher leverage as potentially limiting access to capital over the near term as the industry continues to consolidate; however, the company is in a position to focus on integrating recent acquisitions and improving margins.”
Rate Resetting
When United Healthcare and Quest cut back on business, UNH used that as an opportunity to reset pricing, which affected the entire industry. “Offsetting attractive growth trends, commercial insurer UnitedHealth triggered a resetting of pricing across the industry late in 2006 when it demanded 15% to 20% pricing concessions in exchange for an exclusive national contract.” Although this has been worked out to some extent, Goldman Sachs notes that “we believe Medicare rates are due for an adjustment.”
Margin Expansion
Goldman Sachs states, “Pricing pressure has forced the lab companies to take aggressive cost-cutting measures to stabilize or expand margins following managed care rate cuts in 2007.” It notes that the UNH contract drove Quest’s operating margin down to 14.0% (versus 2006 margins of 18.0%) and that Quest was continuing to work on trimming the annualized costs. “Our projections assume operating margins will be restored to pre-United contract loss levels by 2009 year-end, largely through reduced labor costs (through voluntary attrition) and improved operational efficiency with current capacity.”
Expansion Beyond Routine Testing
Goldman Sachs notes Quest’s strategy to continue expanding into higher-margin market segments such as esoteric testing, point-of-care testing, and international expansion.
Goldman Sachs Rating: Sell
StockScouter Rating
MSN StockScouter program rates stocks on a scale of 1 to 10 based on an evaluation of four characteristics:
- Fundamental;
- Ownership;
- Valuation; and
- Technical.
It further provides numerical values utilizing analyst recommendations (provided by Zacks Investment Research).
In the most recent evaluation of Quest Diagnostics, the overall rating was a 7, with 1 being the worst and 10 being the best. The summary evaluation was that Quest Diagnostics stock was expected to “outperform the market over the next six months with very low risk.”
The StockScouter notes that a positive factor was that Quest stocks were under heavy accumulation by financial institutions, which is considered a positive factor for companies its size. On the negative side, StockScouter indicated that Quest’s “measure of relative price change and consistency is very low.” This was evaluated as “very negative.” In addition, one or more analysts had “modestly decreased quarterly earnings estimates.” This was rated as “negative.”
Under Fundamental, Quest was given a C grade. StockScouter noted that Quest’s most recent quarterly earnings report was about equal to or even slightly higher than those of most analysts’ forecast. As a result, it cited this as “neutral.” It also notes under the same category that Quest’s 2007 earnings growth had “decelerated moderately compared to earnings growth in the past three years.” This was evaluated as “negative.”
Under Ownership, Quest was given a C grade. StockScouter again noted that Quest stocks were “under heavy accumulation by financial institutions,” which was evaluated as “positive.”
Under Valuation, Quest was given a D grade. StockScouter gave a “neutral” rating for the price-to-earnings multiple because it is close to the average for all other stocks evaluated by StockScouter. It also gave Quest a “neutral” rating for the price-to-sales multiple for the same reason. However, StockScouter gave Quest a “negative” for the ratio of price-to-earnings multiple because the five-year growth rate is above average for its evaluated stock universe.
Under Technical, Quest was given a D grade. “The StockScouter measure of relative price change and consistency is very low. Very negative.” It also noted that the previous day’s closing price for Quest stock was close to its 50-day moving average, which was a “neutral.”
Fundamental grade: C
Ownership grade: C
Valuation grade: D
Technical grade: D
As a result, the Zacks average brokerage recommendation was a hold.
Analyst Ratings
Recommendations Current 1 Month Ago 2 Months Ago 3 Months Ago
Strong buy 4 4 4 4
Moderate buy 0 0 0 0
Hold 6 5 7 7
Moderate sell 0 0 0 0
Strong sell 0 0 0 0
Mean rec. 2.20 2.11 2.27 2.27
Mean Recommendation Conversion Table
1.0 = Strong buy
1.1 thru 2.0 = Moderate buy
2.1 thru 3.0 = Hold
3.1 thru 4.0 = Moderate sell
4.1 thru 5.0 = Strong sell
Source: Money Central/MSN.com
LABORATORY CORPORATION OF AMERICA (LABCORP)
Cowen and Company Evaluation
Cowen and Company notes four areas that are significant factors on LabCorp’s stocks. They are:
- United Healthcare’s contract negotiations;
- New York City area service gains;
- Realistic expectations; and
- Stabilized pricing environment.
United Healthcare Contract Negotiations
Cowen and Company notes that United Healthcare is taking an aggressive approach in contract renewals with smaller laboratories and is expected to continue doing so in 2008. Although Cowen and Company notes it has no data to back this belief up, it believes LabCorp will ultimately benefit from that scenario.
New York City Area Service Gains
Cowen and Company conducted a survey of New York City-based physician practices. Part of its findings indicated there were fewer complaints about LabCorp’s service levels (22% versus 27% of respondents). “This modest progress is a positive indicator for near-term results.”
Realistic Expectations
Cowen and Company notes that LabCorp management set a very realistic range for its 2008 guidance. “ They raised their 2008 guidance to our estimates, so we still find it realistic.”
Stabilized Pricing Environment
Cowen and Company suggests that price escalators on 2007 price renewals should gradually offset price concessions on the company’s 2008 renewals. “Our 2008E EPS of $4.85 is above the average of $4.69. Share repurchases account for one-half of the difference. The balance reflects above-consensus revenue and operating margin estimates.”
Cowen and Company’s evaluation: Outperform. “We think the stock can outperform the market by 15% to 20% over the next year.”
LabCorp Revenue Buildup ($MM)
2006 2007 2008E
Q4 Year Q1A Q2A Q3A Q4 Year Q1 Q2 Q3 Q4 Year
Total Revenue $899 $3,591 $999 $1,043 $1,021 $1,006 $4,068 $1,070 $1,120 $1,099 $1,079 $4,368
% Increase +9.3% +7.9% +13.7% +15.4% +12.2% +11.9% +13.3% +7.2% +7.3% +7.7% +7.3% +7.4%
Source: Cowen and Company and LabCorp company reports
LabCorp Stock Price and Percent Change
Date Price % Change (From Five Weeks Earlier)
8/18/06 $68.06 10%
10/20/06 68.10 2
11/17/06 69.60 2
12/15/06 71.89 3
2/23/07 80.38 10
4/20/07 74.07 3
5/18/07 78.43 6
6/23/07 78.70 0
7/20/07 79.81 1
8/17/07 75.25 -6
9/21/07 77.61 2
11/16/07 69.72 -9
12/17/07 74.64 7
1/16/08 76.31 2
2/20/08 80.27 5
Source: Washington G2 Reports Laboratory Industry Report
PiperJaffray Evaluation
PiperJaffray evaluated LabCorp in light of its unexpected positive 2007 annual reports. It focused on six areas:
- LabCorp’s 2007 revenue and EPS were above both PiperJaffray and Wall Street’s expectations.
- LabCorp reported an 11.9% top-line growth, 5% of which came from new contracts with United Healthcare. PiperJaffray predicted revenues at $993.8 million, Wall Street at $992.6 million, but LabCorp reported $1,005.8 million. Price and volume increased by 0.9% and 11.0%, respectively, above PiperJaffray’s estimates of -0.2% and 10.9%, respectively.
- PiperJaffray notes that LabCorp’s adjusted EPS was $1.04, which was $0.03 above its $1.01 estimate. “We note a favorable share count and tax rate added $0.03 and $0.03, respectively.”
- LabCorp is expected to close on the acquisition of Tandem Labs in 1Q08, which should complement LabCorp’s clinical trials business. Although PiperJaffray notes this will probably have a neutral impact on FY08 EPS, LabCorp also acquired partnership units in the Ontario-based Gamma-Dynacare JV, which management expects will add 6.0% to 6.3% to its revenue growth.
- PiperJaffray notes that LabCorp management expects the industry pricing trends will stabilize and even turn positive in 2007; PiperJaffray, however, predicts that reimbursement cuts to the Medicare lab fee schedule may very well have a negative impact on pricing.
- LabCorp management issued FY08 guidance for 2008 revenue of $4.353 billion to $4.394 billion, slightly higher than PiperJaffray’s ($4.350 billion) and Wall Street’s ($3.334 billion) expectations. “We believe guidance is achievable due to ongoing cost-cutting initiatives and have modeled FY08 revenues and EPS of $4.6 billion and $4.74, respectively. However, we believe there is risk to Medicare growth in ’09.”
Evaluation: Neutral—“Anticipate limited total return (general appreciation less than 10% or decline less than 5%) over the next 12 months.”
Goldman Sachs Evaluation
Goldman Sachs initiated analysis on Quest Diagnostics and LabCorp in November 2007. It notes that LabCorp’s low leverage position will allow further consolidation. However, it also notes that LabCorp initiated an expanded share repurchase authorization in November 2007, which indicates mergers and acquisitions (M&A) may not be attractive to the company.
Valuations
Goldman Sachs notes that LabCorp generates about $500 million in annual free cash flow. “Our estimates reflect about $250 million share repurchase in 2008 ($0.12 per share) and $200 million in 2009 ($0.10 per share), indicating potential upward earnings revisions if management favors accelerated share repurchase.” That statement was made prior to LabCorp’s revision of its 2008 guidance and announcement of its 2007 annual report. In light of LabCorp’s unexpectedly improved earnings, Goldman Sachs revised some of its valuations, although its overall evaluation did not change. It made four points:
- It was raising LabCorp’s 2007 EPS to $4.18 in keeping with actual results.
- It raised the 2008 EPS to $4.96 (from $4.76), which reflected a $0.08 share repurchase versus the $0.12 per share. This is the only significant change cited.
- It raised the 2009 EPS to $5.34 (from $5.22), which remains the same as its prior analysis of $0.10 per share.
- Goldman Sachs introduced a 2010 EPS estimates of $5.74, reflecting $0.11 share repurchase.
It also expects LabCorp cost-cutting measures to expand operating margins from 19.8% in 2006, 20.6% in 2007, 21.0% in 2008, and 21.1% by 2009.
Rate Resetting
When United Healthcare and Quest cut back on business, UNH used that as an opportunity to reset pricing, which affected the entire industry. “Offsetting attractive growth trends, commercial insurer UnitedHealth triggered a resetting of pricing across the industry late in 2006 when it demanded 15% to 20% pricing concessions in exchange for an exclusive national contract.” Although this has been worked out to some extent, Goldman Sachs notes that “we believe Medicare rates are due for an adjustment.”
Margin Expansion
Goldman Sachs indicates that LabCorp management plans to cut $60 million run-rate operating costs in 2008. In 2007, LabCorp downsized or eliminated “redundant or underutilized facilities and implemented workforce reductions.” As a results, Goldman Sachs predicts LabCorp’s operating margin will improve from 20.6% at 3Q2007 to 21.0% by 2008 year-end and 21.1% by 2009 year-end. “The potential for needed capacity expansion to accommodate growth presents a risk to our view.”
Expansion Beyond Routine Testing
LabCorp guidance indicates it expects to “grow esoteric business from current mix of 34% of revenues to 40% over the long term.”
Goldman Sachs Rating: Neutral
StockScouter Rating
MSN StockScouter program rates stocks on a scale of 1 to 10 based on an evaluation of four characteristics:
- Fundamental;
- Ownership;
- Valuation; and
- Technical.
It further provides numerical values utilizing analyst recommendations (provided by Zacks Investment Research).
In the most recent evaluation of LabCorp, the overall rating was a 9, with 1 being the worst and 10 being the best. The summary evaluation was that LabCorp stock was expected to “significantly outperform the market over the next six months with less than average risk.”
The StockScouter notes that positive factors for LabCorp were that its earnings growth was about equal to or higher than analysts’ expectations, but not to such an extent that it was “predictive of future returns.” This was rated as “neutral.” LabCorp’s relative price change and consistency is very high, which it ranked as “very positive.” LabCorp’s earnings growth in the past year (2007) was holding steady compared to the previous three years, which it ranked “neutral.” On the negative side, StockScouter noted that LabCorp’s price-to-earnings multiple was similar to the average for all stocks it analyzes, which earned LabCorp a “neutral.”
Under Fundamental, LabCorp was given a C grade. StockScouter noted that LabCorp’s most recent quarterly earnings report was equal to, or a little higher than, what analysts expected, but not so much that it would predict future returns. This earned a “neutral.” It also noted LabCorp’s 2007 earnings growth was holding steady compared to the previous three years, also earning a “neutral.”
Under Ownership, LabCorp was given a C grade. StockScouter was “positive” that shares were being acquired by financial institutions.
Under Valuation, LabCorp received an A grade. StockScouter was “neutral” on LabCorp’s price-to-earnings multiple, which was close to the average of all stocks StockScouter analyzes. LabCorp’s price-to-sales multiple was slightly higher than those in the StockScouter universe, receiving a “positive/neutral” rating for companies of LabCorp’s size. StockScouter gave LabCorp a “positive” for the ratio of price-to-earnings multiple to its five-year growth rate, which is about the same or slightly higher than the average of all stocks it analyzes.
Under Technical, LabCorp received an A grade. StockScouter indicated that LabCorp’s “measure of relative price change consistency is very high. Very positive.” It also ranked LabCorp as “positive” because the previous day’s closing price was slightly higher than its 50-day moving average.
Fundamental grade: C
Ownership grade: C
Valuation grade: A
Technical grade: A
As a result, the Zacks average brokerage recommendation was a moderate buy.
Analyst Ratings
Recommendations Current 1 Month Ago 2 Months Ago 3 Months Ago
Strong buy 8 8 8 6
Moderate buy 1 1 1 1
Hold 4 3 3 5
Moderate sell 0 0 0 0
Strong sell 0 0 0 0
Mean rec. 1.69 1.58 1.58 1.92
Mean Recommendation Conversion Table
1.0 = Strong buy
1.1 thru 2.0 = Moderate buy
2.1 thru 3.0 = Hold
3.1 thru 4.0 = Moderate sell
4.1 thru 5.0 = Strong sell
Source: Money Central/MSN.com
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