Testing Investors

Is LabCorp Making a Smart Deal?

Investors applauded LabCorp’s $6.1 billion offer for Covance announced Nov. 3 by the lab-testing and diagnostics giant. Covance, a contract research firm, runs new drug trials for big pharmaceutical companies. Like LabCorp, its business is generally steady and stable.

While the market’s warm welcome incorporates the deal’s strong points, it seemingly fails to discount execution risk. The acquisition is many times larger than LabCorp’s typical $1 billion bolt-on transaction. It will also double the company’s debt and will raise leverage sharply. Given LabCorp’s relatively high valuation, even a minor execution miss could lead to a disproportionate share drop in 2015.

LabCorp is paying a rich 13.3 times Covance’s annual earnings before interest, taxes, depreciation, and amortization (Ebitda) and says the acquisition will be accretive to earnings per share (EPS) this year. LabCorp also hopes to achieve annual cost synergies “in excess of $100 million.”

Not every investor is enthusiastic. Darren Pollock, a money manager with Cheviot Value Management, says his firm sold its longstanding LabCorp stake following the announcement. Each company could add to the other’s business, Pollock concedes, but the deal may be less about synergies than about taking a step away from LabCorp’s slowing core business, he says.

The pricing pressure afflicting lab testing in the past two years hasn’t abated, he says. Demanding customers such as Medicare and Medicaid, which with managed-care customers provide two-thirds of LabCorp’s test volumes, look at lab testing as a place where costs can be cut, he says. The industry has endured 1% to 3% annual price erosion in the past couple of years.

The debt has gotten the attention of ratings agencies. Last Wednesday, Standard & Poor’s downgraded LabCorp’s credit rating to BBB- from BBB, reflecting higher leverage. Pro forma, the combined companies’ debt will be nearly $7 billion and debt-to-Ebitda leverage will jump to more than four times from 2.7 times, says S&P analyst Shannan Murphy. A Moody’s report last week said the higher leverage will leave LabCorp a “limited cushion” to absorb negative developments.

Carol Levenson, director of research at Gimme Credit, an independent bond-research boutique, notes that while benefits accrue from a more diversified customer mix, there is also the potential for greater cash-flow volatility from Covance’s reliance on big pharma research and development spending. Management’s resolve to reduce debt will be tested, she adds. LabCorp spent $1 billion in share repurchases in 2013, which made the difference between a 2% decline in EPS and a 2% rise, she adds.

Pollock says the acquisition changes the routine that LabCorp shareholders were accustomed to: a long history of strong free cash flow financing bolt-on acquisitions and share buybacks.

LabCorp’s EPS growth in recent years has slowed to single-digit percentage gains from a double-digit rate a few years ago. Costs have shot up. In the first nine months of 2014, sales rose 3% to $4.5 billion but the cost of sales rose 6%, due partly to government payment reductions, while selling, general, and administrative expenses increased 5%. Net income fell to $392 million, or $4.53 per share, from $448 million or $4.81.

The shares don’t look expensive on an absolute level, but at 16 times consensus analyst estimates of $7.37 this year, that’s near historical highs and above the median price/earnings ratio of 13.5. LabCorp didn’t respond to a request for comment.

When a business changes this dramatically, Pollock notes, there can be unforeseen execution risks and other surprises. That won’t be welcomed by investors.



The securities discussed in the posted article were held by Cheviot’s clients. The viewer should not assume that investments in the securities identified and discussed were or will be profitable and it should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. All information is provided for informational purposes only and should not be deemed as a recommendation to buy the securities mentioned. Cheviot closely monitors its positions and may make changes to the portfolio’s investment strategy when warranted by changing market conditions. If a security’s underlying fundamentals or valuation measures change, Cheviot will reevaluate its position and may sell part or all of its position or repurchase sold securities. There can be no assurance that Cheviot’s clients will continue to hold the same position in companies described herein, and their portfolio positions may change at any time. If you would like a complete list of securities purchased or sold during as a block group the past twelve months in client accounts, please contact Cheviot via our contact page or by phone. Thank you.

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