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Laboratory Corp: A Solid Margin of Safety

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·7 min read
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- By Robert Abbott

Like many other diagnostics and drug development companies, Laboratory Corp. of America Holdings (NYSE:LH) saw its base business decline as Covid-19 took hold. Fewer patients sought routine medical care and many clinical trials were suspended, leading to a decline in its two streams of revenue.

Yet, according to its 10-K for 2020, those declines were more than offset by the company's development of polymerase chain reaction testing for Covid-19.


The company, also known as Labcorp, launched the first commercial PCR test by an American company on March 5, 2020. Eleven days later, it received Emergency Use Authorization from the Food and Drug Administration.

New revenue from testing helped generate a 32% increase in 2020 revenue of the diagnostics segment, from $7.0 billion in 2019 to $9.25 billion. Operating income more than doubled from $1.08 billion in 2019 to $2.63 billion in 2020.

That was enough to get the share price back on track:

Laboratory Corp: A Solid Margin of Safety
Laboratory Corp: A Solid Margin of Safety

So what will happen in the next five to 10 years now that vaccinations are reducing the need for Covid-19 testing?

What is Labcorp?

Labcorp calls itself a leading global life sciences company in its 10-K; it provides essential information that helps doctors, hospitals, pharmaceutical companies, researchers and patients make "clear and confident decisions."

It does this through two segments, diagnostics and drug development. Its two reporting segments are Labcorp Diagnostics, Dx, and Labcorp Drug Development, DD. The PCR testing was developed by the Dx team.

In 2020, Dx contributed 65% of the revenue, while DD contributed 35%. Geographically, Dx generates the lion's share of revenue in the U.S., with modest amounts from Canada and an even smaller proportion from the rest of the world. DD's revenues are about evenly split between the U.S. and the rest of the world. In the future, it hopes to expand DD's opportunities abroad to further diversify its revenue.

Growth

Labcorp has a five-point "enterprise" strategy:

  • Leveraging the power of the company's combined capabilities.

  • Advancing the company's leadership position in oncology.

  • Integrating artificial intelligence, data, digitalization and analytics across the company's business.

  • Putting customers at the center of all the company does.

  • Evaluating and executing on high-growth opportunities.



On the latter point, the company pointed out it spent $267.6 million last year on strategic business acquisitions. Those purchases expanded its service offerings, grew its customer and revenue mix and broadened its geographic footprint.

Competition

Labcorp, with $15.316 billion in 2020 revenue, is bigger than its three closest competitors:

  • Quest Diagnostics Inc. (NYSE:DGX): $10.335 billion.

  • PerkinElmer Inc. (NYSE:PKI): $4.438 billion.

  • Mettler-Toledo International Inc. (NYSE:MTD): $3.240 billion.



Although Mettler-Toledo is significantly smaller than Labcorp and Quest, it has handily outperformed them:

Laboratory Corp: A Solid Margin of Safety
Laboratory Corp: A Solid Margin of Safety

And there may be a newcomer that could increase competition - Amazon.com Inc. (NASDAQ:AMZN). A May 17 article in Business Insider (a company in which Amazon founder Jeff Bezos has or had invested) reported that Amazon could begin selling testing kits for infections that lead to respiratory and sexually transmitted diseases. It could start selling a Covid-19 home testing kit as early as next month.

Risks

As well as the risk of new entrants into the diagnostics industry, Labcorp investors face numerous other risks, including:

  • Covid-19, which has "created significant volatility, uncertainty, and economic disruption that could have an adverse effect on the Company's financial position."

  • Regulatory and compliance matters include changes in regulations or policies made by insurance companies and other payers.

  • The company's business may be affected by general or macroeconomic factors, especially a major downturn in the broader economy.

  • Financial issues such as contracts that are underpriced, experience cost overruns, delayed or canceled could be problems. There is also risk from currency fluctuations.

  • Technology and cybersecurity are other potential concerns, with risks related to cyberattacks on the company, its customers and vendors. Failure to develop and implement updates to its software could disrupt relationships with customers and internal stakeholders.



Financial strength

Laboratory Corp: A Solid Margin of Safety
Laboratory Corp: A Solid Margin of Safety

Debt is a reason why Labcorp does not receive a higher rating for financial strength. Although it has an interest coverage ratio of 18.69, a graphic view comparing cash and debt might unsettle some potential investors:

Laboratory Corp: A Solid Margin of Safety
Laboratory Corp: A Solid Margin of Safety

The Piotroski F-Score is high, indicating the company is well managed, as is the Altman Z-Score, which suggests the company is financially stable.

Another good sign comes from the fact that ROIC is more than double the WACC. Its return on invested capital is 17.38%, while its weighted average cost of capital is 6.54%.

Profitability

Laboratory Corp: A Solid Margin of Safety
Laboratory Corp: A Solid Margin of Safety

Labcorp's score for profitability has been bolstered by recent improvements in both the operating margin and the net margin:

Laboratory Corp: A Solid Margin of Safety
Laboratory Corp: A Solid Margin of Safety

Revenue growth over the past decade has averaged more than 11% per year:

Laboratory Corp: A Solid Margin of Safety
Laboratory Corp: A Solid Margin of Safety

Ebitda growth has not been as vigorous:

Laboratory Corp: A Solid Margin of Safety
Laboratory Corp: A Solid Margin of Safety

Earnings per share (diluted) has been bumpy, but the average growth rate is satisfactory:

Laboratory Corp: A Solid Margin of Safety
Laboratory Corp: A Solid Margin of Safety

Free cash flow also has seen turbulence, but the trend is going in the right direction:

Laboratory Corp: A Solid Margin of Safety
Laboratory Corp: A Solid Margin of Safety

Performance

Annualized returns have been stronger in recent years:

  • Year to date: 31.19%

  • One-year: 59.89%

  • Three years: 14.86%

  • Five years: 16.19%

  • 10 years: 10.24%



Total returns:

  • 2021 year to date: 32.45%

  • 2020: 20.32%

  • 2019: 33.88%

  • 2018: -20.78%

  • 2017: 24.25%



Dividends and share buybacks

Labcorp does not pay a dividend, but it has been buying back its own shares. Or, more accurately, it has begun repurchasing shares again after big issuances in 2015 and 2016:

Laboratory Corp: A Solid Margin of Safety
Laboratory Corp: A Solid Margin of Safety

Valuation

Laboratory Corp: A Solid Margin of Safety
Laboratory Corp: A Solid Margin of Safety

Seeing that the price has risen above the trendline so dramatically, we would expect this stock to be significantly overvalued. And that's the verdict of the GF Value chart, based on historical returns and analyst estimates of future earnings:

Laboratory Corp: A Solid Margin of Safety
Laboratory Corp: A Solid Margin of Safety

But thanks to an Ebitda growth rate that has averaged 13.20% per year, the PEG ratio, at 0.77, indicates Labcorp is undervalued.

Backing that up is the discounted cash flow calculator, which finds a significant margin of safety:

Laboratory Corp: A Solid Margin of Safety
Laboratory Corp: A Solid Margin of Safety

Gurus

Interest among the gurus has picked up since the third quarter of 2020:

Laboratory Corp: A Solid Margin of Safety
Laboratory Corp: A Solid Margin of Safety

Altogether, 22 gurus have positions in Labcorp, which is a relatively high number. The three largest positions at the end of the first quarter of 2020 were those of:

  • Vanguard Health Care Fund (Trades, Portfolio) with 1,387,554 shares, representing 1.42% of Labcorp's shares outstanding and 0.76% of the fund's assets under management. It did not buy or sell any shares in the first quarter.

  • Jana Partners (Trades, Portfolio) owned 1,139,588 shares, after increasing its stake by 40.4%.

  • Andreas Halvorsen (Trades, Portfolio) of Viking Global Investors held 1,081,219 shares, an increase of 1,044.15% in the quarter.



Conclusion

There's no doubt its Covid-19 PCR test gave LabCorp a boost in 2020, but the company is much more than just a pandemic resource. Looking at its fundamentals over the past decade shows the company enjoyed robust growth before the pandemic arrived, and so we can have at least some confidence that it will deliver more of the same over the next five to 10 years.

It has more debt than cash, yet it still can be considered financially strong. Profitability is very high, backing up the claim that the company should do well in the coming years. The biggest question for investors will be about valuation, whether to go with the chart and the GF Value Chart or to follow the PEG ratio and DCF calculation.

Value investors prepared to tolerate debt and put faith in the DCF calculator may find Labcorp an interesting prospect. Growth investors who expect the company's prosperous times to continue might want to look more closely. And with no dividend, income investors will need to look at other stocks.

Disclaimer: I do not own shares in any of the companies named in this article and do not expect to buy any in the next 72 hours.

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This article first appeared on GuruFocus.