Laboratory Corporation Stock: Difficult To Eye Long-Term Compounding Ability (NYSE:LH)

Investment update

Following my previous publication on Laboratory Corporation of America Holdings (NYSE:LH) in June this year, reiterating it a hold, the stock is +10% and cycled back to long-term range.

The article’s summary points outlined the following (taken directly from):

• Labcorp’s recent acquisition of assets from Invitae could add ~$275-300mm in annualized specialty testing revenue.

• Q1 FY 2024 showed revenue growth despite a decline in COVID testing revenue, with adjusted EPS increasing by 7%.

• Despite this, the reinvestment opportunities to redeploy capital at an advantage appear limited, and valuations rest on multiple expansions at this point.

Looking to the present day, as much is true, particularly point (3) on that list. Investors have increased the multiple on invested capital for LH from 1.6x in Q1 23 to 2.1x at the time of writing. This is despite the fact that operating earnings continue to contract, and the business has fireless operating capital at work earning less than 10% on these assets.

Whilst post-tax margins have stabilized at 7.5% and the business is turning over capital at ~1x, the opportunities for LH to redeploy surplus cash flows into its underlying business, or make strategic acquisitions don’t appear to be abundant at this point.

Management has paid down ~$2.2Bn of debt over the past three years. It has also increased dividends on aggregate and continues to purchase high amounts of stock. These are shareholder-friendly moves and should be viewed favourably in the investment debate, in my opinion. But outside of this, the scope for LH to compound its intrinsic worth at rates above what we could expect to achieve elsewhere is narrow. Net-net, reiterate hold.

Figure 1.

Q2 FY’24 earnings insights

The big takeout of the quarter in my opinion was that LH completed the acquisition of the Invitae assets it had outlined in the previous quarter. This is its push into genetics and oncology. Management expects ~$300mm of revenue within the first year of the transaction closing. It will incur roughly 300bps of earnings dilution in the first year but expects, it to become accretive next year.

LH did $3.2Bn of business during the quarter, (+6.2% YoY) underscored by a 690bps growth in the base business with 4.5% organic growth. It pulled this to an operating margin of 9.2%, totalling $295mm. Excluding one of items and non-cash charges against earnings for the quarter, the company booked $480mm in, operating income, up 15% on last year.

Management now expects $120mm in Invitae sales this year, along with 6.4% to 7.5% growth in enterprise revenue, up 135bps from prior guidance. It expects 8% growth in diagnostic revenues at the upper end of the range and looks to ~5% upside in the BioPharma business.

Figure 2.

Management also said it is on track to deliver roughly one hundredmm dollars to one hundred and twenty fivemm dollars of cost savings this year and this could be a tailwind to operating earnings moving forward in my opinion.

As to the divisional performance, my takeouts were the following:

• Revenue in its diagnostics laboratories segment grew 8% YoY to $2.5Bn. This was underlined by 320bps of acquisition growth and 470bps of organic upside. Management said that volumes were up 6.3% compared to last year, with the split 3.5%/2.9% organic and acquisitions respectively. It also realise a 2.1% price tailwind.

• The biopharma laboratory services division did $707mm of business (+110 base points YoY) underscored by 9% growth in Central Labs revenues. Management said that early development revenues were down 15% given “higher than normal cancellations and lower orders in prior periods”.

Add to this, it threw off $430mm in freely available cash, after $34mm in acquisition-related activity, and returned $160mm to shareholders by way of dividends and buybacks. These are highly attractive moves and should be given high marks in my opinion. However, they are not enough to move the needle on the corporate valuation front. For that, I would need to see LH recycling tremendously high amounts of capital back into its business, either on the organic or acquisition front. Given it trades at ~2.1x EV/IC, for it to compound meaningfully, this is the only way it can do so. My opinion is that it needs to reinvest at least $.25 on every dollar to expand earning power beyond what we could reasonably achieve elsewhere.

As such, my view of the quarter was that it largely falls in line of where LH currently sits within the cycle. There are no abundant opportunities for the business to redeploy capital at an advantage. This supports a reiterated hold rating.

Valuation insights

Recent market gains have been the result of multiples expansion, as seen in the figure below. I commented on this in the June publication on LH, noting that, in my view, any market value gains were going to be the result of this is a great investment strategy – buying high-quality businesses at depressed valuation multiples relative to history.

Figure 3.

• But the fact of the matter is not necessarily a 3.0–4.0x invested capital business. Each dollar that is at work in operations is valued at ~$2 in market (i.e. 2x EV/IC), but the value of incremental funds recycled back into the business is valued at less than $2. In fact, since 2021, LH has shed more than $5Bn of capital from its base, resulting in a $9.5Bn decrease in enterprise value (~1.85x multiple).
• As such, carrying the 2.1x multiple forward on my FY’24–‘26E assumptions (see: Appendix 1) a valuation of $257-$260 per share. On the upside, this is not a high ask – get here through unemployed 6% reinvestment of cash earnings at a 17% marginal return on capital. These are entirely achievable for this business. The implied valuations indicated a potential 15% upside, but the margin of safety is not at this level. Furthermore, this is more an example of a mispricing or valuation asymmetry, rather than a dislocation in the market value to the intrinsic worth of the business. In my opinion, without that 2.1x multiple, it is difficult to see LH carrying higher prices from here. Again, this supports a neutral view.

Figure 4.

Risks to thesis

Downside risks include 1) further sales growth compression below 2% annualised, 2) compression in valuation multiples below 2.0x invested capital, and 3) the broadside of macroeconomic risks that should be faced into all equity evaluations at this point in time, particularly the inflation/rates access and gap political risks that could spill over and hurt equity valuations.

On the upside, LH could surprise in earnings and sales, which could result in a further multiples expansion. Embedded expectations are currently low, providing scope for this to occur. However, my view is that the “quality” factor does not suggest there is value on offer at these discounted multiples on earnings.

Investors must recognize these risks in full before proceeding any further.

In short

After extensive review of the latest developments in the LH investment debate, my view is the company remains a hold at this point in the cycle. Whilst it is highly cash productive and is returning cash to shareholders, plus servicing debt – both sensible uses of surplus cash flow – the propensity of LH to compound its corporate valuation rates above what investors could reasonably achieve elsewhere is limited in my view. The picture lies in multiples expansion rather than the fundamental economics of the business, namely invested capital turnover, growth and post tax margins. Net-net, reiterate hold.

Appendix 1.