Galeanu Mihai
Pick and shovel plays exist in every sector, as they provide the necessary products to keep their respective industries going. For example, Applied Materials (AMAT) is one such company that supports the semiconductor industry.
When one thinks about these types of companies in the healthcare industry, drug distributors such as Cardinal Health (CAH) and McKesson (MCK) may first come to mind. However, lab-testing companies are just as essential to the healthcare industry and may get ignored.
This brings me to Laboratory Corporation of America (NYSE:LH), more commonly referred to as Labcorp. Labcorp has benefitted from strong tailwinds over the past couple of years, and in this article, I highlight why it’s emerged stronger than before and is set up for potentially strong long-term returns, so let’s get started.
Why Labcorp?
Labcorp is an S&P 500 company and a leading global life sciences solutions provider that guides patient care through its comprehensive clinical laboratory and end-to-end drug development services. It has a presence in over 100 countries, and its clients include hospitals and healthcare systems, pharmaceutical companies, research institutions, physicians, and patients.
Labcorp’s business is well-diversified between its diagnostics and drug development business, in which LH assists pharmaceutical companies with clinical trials on new drugs in their pipelines. As one of the two largest players in its market, with Quest Diagnostics (DGX) being the other one, Labcorp controls roughly 20% of the independent lab market, serving patients through its 2,000 service centers and offering a broad range of 5,000 clinical lab tests.
Labcorp’s relatively low market share despite being one the two largest players means that it has a long runway for growth. It also benefits from synergies, as its large patient database can aid its pharmaceutical clients in their drug development. These strengths are highlighted by Morningstar in its recent analyst report:
Even though hospitals still dominate the $72 billion diagnostic market, LabCorp has carved out a significant slice of the pie through serial acquisitions. The firm then added Covance’s drug-development expertise, which also offers LabCorp an avenue to monetize its large patient database. Just as importantly, LabCorp has single-mindedly pursued greater efficiency, which translates to an ability to reduce costs more quickly than reimbursement cuts coming down the pike.
The firm has invested in greater automation and systems that can decrease the number of employees involved in sorting and running the tests. LabCorp has also put significant resources behind beefing up its information technology capabilities.
As a result, physicians can more easily access test information in a timely manner, and patients can schedule blood draws with increased convenience. We admire how the management team has consistently focused on these strategies over the long term, and we expect LabCorp’s investments today will reap rewards in future years.
Meanwhile, Labcorp continues to impress with strong results, generating adjusted EPS of $4.96 during the second quarter, beating analyst estimates by $0.28. This is less than the $6.13 EPS generated in the prior year period, but this was largely expected by investors, as Labcorp largely benefitted from mass COVID testing last year. This has been a windfall for Labcorp over the past couple of years, as its cash balance soared from $338 million at the end of 2019 to over $1 billion sustained since 2020.
Management is putting the cash to work by repurchasing shares, reducing the overall float by 3.2% over the past year. They are also positioning the company for growth by investing in new innovative diagnostics and expanding its drug development capabilities to serve customers in the Middle East, Africa, and Japan.
It’s also expanding into the largely untapped at-home test market with first-of-kind blood collection devices for diabetes screening as well as an FDA-approved rapid test for men’s fertility and tests for Alzheimer’s and Parkinson’s disease. These, combined with secular trends in the diagnostics market bode well for Labcorp, as highlighted by Morningstar below:
LabCorp should take advantage of the long-term secular trends that bode well for the diagnostics industry, as the proliferation of new tests grows and new disease markers and genetic mutations with pharmacogenomic implications are discovered. New reimbursement models inspired by healthcare reform should lead more doctors and hospitals to send tests to lower-cost producers like LabCorp.
Meanwhile, Labcorp maintains a solid BBB rated balance sheet, and recently initiated a dividend this year. While the forward yield of 1.1% is low, it’s very well covered by a 14.5% payout ratio (based on the aforementioned Q2 adjusted EPS), giving it plenty of headroom for raises down the road.
Moreover, at the current price of $259, Labcorp currently trades at a forward PE of 12.9, sitting below its long-term normal PE of 15.0x. While analysts expect LH’s earnings to decline through the end of next year due to less demand for COVID testing, earnings are expected to pick up pace in 2024. Sell side analysts have a consensus Buy rating on LH with an average price target of $300, translating to a potential one-year 16% total return including dividends.
Investor Takeaway
Labcorp is a well-run company that should benefit from long-term secular trends in the healthcare industry. It benefits from its large patient database, which aids its drug development services business for large pharmaceutical companies, and its low-cost services are a compelling choice for healthcare providers. As such, I believe LabCorp is a prudent choice for potentially strong long-term growth.
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