Medical Diagnostic Laboratories - Which is the Best Investment?
The Magic Formula (MFI) screens can often be used to find entire industries that are out-of-favor with investors, but have attractive business models from a return on capital standpoint. In many cases, several of the top players (and often smaller players) within the industry will all show up at once, presenting investors with a choice as to which horse to ride if he/she wants exposure. This is where a little due diligence can assist in making the decision, as buying more than one similar firm creates certain "macro-economic" risks in your portfolio, where events effecting all participants effects your portfolio disproportionately.
One such industry right now are the medical diagnostic laboratories. There are many recent MFI stocks that are in this industry, from tiny small-cap upstarts like Genoptix (GXDX) to mid-cap specialized testing firms like Myriad Genetics (MYGN) all the way to the "big 2". For the purposes of this article, it is the latter we are interested in. Both Quest Diagnostics (DGX) and LabCorp (LH) are Magic Formula stocks in the large cap screens, and they are the two we want to look at here.
Quest and LabCorp are by far the two largest firms in the $45 billion dollar medical testing market. The majority of this market is in-hospital testing, but outsourced testing commands about 33% of the market. Of that slice, over 80% of the business is done between Quest and LabCorp. It is effectively a duopoly market, which is favorable as it tends to limit price wars and irrational competitive activity.
First, we want to be sure that the diagnostic laboratories as an industry present an attractive investment case. There are several secular growth trends that favor the sector. One, of course, is the demographics in the aging U.S., where the population aged 65 or over is expected to increase by 14 million over the next 10 years, as baby boomers hit retirement age.
Combine this demographic advantage with the fact that diagnostic tests are becoming more and more prevalent as a way to guide more expensive treatment options. Retirement age patients usually receive double the number of medical tests a year as they did a decade ago. Many health insurers are requiring certain diagnostic tests before agreeing to pay for expensive therapies that may not be effective. All of these add up to increased volume for the lab operators.
The third positive factor is the recently passed health care reform bill. The legislation calls for the elimination of co-pays for preventative care at the end of 2010, a certain boon for Quest and LabCorp. Longer-term, an expansion in health care coverage over the next 5 years should lead to more patients able to afford medical care, including testing.
Finally, both Quest and LabCorp have expanded into "esoteric" testing, which require highly skilled technicians and expensive lab equipment, and involve much more complex genetic analysis, often for early detection of cancers. These tests are performed less frequently than the standard blood and urine tests, but provide significantly higher margins. They represent an important growth driver going forward.
The main risks seem short-term here. Over the past year or so, people have been visiting the doctor less often to save some money on co-pays (office visits have declined in the mid-single digit percentages). Additionally, high unemployment and hiring freezes have limited the demand for drug screening. These have led to lower volumes for testing firms across the board. Growth will likely be harder to come by, as both Quest and LabCorp have utilized acquisitions of smaller labs to grow, and much of the larger independent firms have already been consolidated. Lastly, both companies rely on Medicare for about a quarter of revenues, and the government has been steadfast in attempting to reduce costs, which could lead to lower reimbursement rates. This could be exacerbated by managed care companies that peg their reimbursement rates to Medicare.
In balance, however, both firms look attractive, trading at P/E multiples that are almost half of their historic levels, and below the market average. So, which one is the better choice? Let's take a look at a few metrics to help decide:
Quest Diagnostics (DGX)
Revenues: $7.43 billion (3-year CAGR: 5.9%)
Operating Margin: 18.3%
Cash / Debt / Current Ratio: $448mm / $3.2bb / 1.64
P/E: 11.50 (forward 10.47)
MFI-adjusted Earnings Yield: 12.4%
MFI-adjusted Return on Capital: 100.3%
Dividend: 0.40 (0.90%)
Lab Corp (LH)
Revenues: $4.78 billion (3-year CAGR: 9.3%)
Operating Margin: 20.4%
Cash / Debt / Current Ratio: $104mm / $1.3bb / 2.48
P/E: 14.23 (forward 12.20)
MFI-adjusted Earnings Yield: 10.7%
MFI-adjusted Return on Capital: 65.3%
The two companies are remarkably similar, and making a choice between them is difficult. One the one hand, Quest is notably cheaper, has a better quantitative return on capital, and even pays a small dividend. On the other hand, Lab Corp has a better record of revenue growth, better operating margins, and is widely considered a better operator. For example, in 2007, LH tore away the business of UnitedHealth (UNH) from Quest, which was close to 7% of sales for Quest at the time. LH's stock has also performed significantly better than DGX over the past 5 years, increasing nearly 60% vs. a 10% decline.
Forced to choose at this point, I'd go with Quest. The valuation difference is significant - a P/E ratio in parity with LabCorp would result in a 24% gain alone. Additionally, there is probably more operational improvements to be had at Quest. The dividend, though small, has the potential to be raised. And Quest has begun to expand internationally into Mexico, the U.K., and India, whereas LabCorp is still exclusively a U.S. company.
Whichever stock the MFI investor chooses, both look like solid investments, with fundamental growth dynamics, dominant market shares, limited competition at scale, and cheap stock prices.
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