Laboratory Corp: 15% Reward Asymmetry Under-Reflected, Seeking Exit At $280 Per Share
We are building a diversified portfolio of long-term cash compounders with headroom to withstand current macroeconomic headwinds. Laboratory Corporation of America Holdings (NYSE:LH) has flown onto our radar as one such name. On the current macroeconomic backdrop, LH is at a potential inflection point, offering attractive medium to long-term upside potential, by our estimation. Here, we cover all of the moving parts in the LH investment debate.
Exhibit 1. LH 12-month price return
The company’s efforts in diversifying its revenue stream have proven to be favourable, enabling it to capitalise on emerging trends. Nonetheless, COVID-19 tailwinds have been a net positive. Like many of its life sciences counterparts, LH was somewhat of a first mover in deriving revenue from the pandemic, however, it was also executing its strategy equally as well beforehand. The ability to withstand cost inflation and supply chain headwinds is increasingly attractive amongst large cap life sciences names at present. Examination of LH’s cash flow and balance sheet management yields respective results. Moreover, there appears to be several turning points still unrecognised by the market in our estimation, and this provides a solid underweight for our thesis to pull through. Here, we demonstrate the company’s uptrends in profitability and cash flow, measures that are set to drive equity returns into the coming years.
The question is whether LH can withstand the economic pressures and realities currently ensuing. Key undercurrents are climbing inflation and base rates. Sensitivity and duration to these measures has an impulse effect throughout equity markets. Those companies highly geared and with high rates exposure, likely won’t shine in the forward-looking climate. Consequently, rates sensitivity, balance sheet strength, profitability and earnings quality will move front and centre to the investment debate, by estimation. To that effect, LH has a total debt ratio of 31%, with debt to capital of 38.1% and a debt to equity over 61%, as of FY21. At the latest filing, results were largely unchanged. As a risk, short-term liabilities aren’t well covered from working capital at just 2x coverage, even less when stripping inventory out of the picture. Cash also does a poor job of covering short-term liabilities of just 0.4X coverage.
However, total liabilities are just 23% of CFO, whereas capital expenditures have plenty of headroom at just 3% of CFO in the previous quarter (down from 6.75% in FY21). The Altman’s Z score is 6.58 suggesting there is sufficient cash runway over the coming 2-year period. Accounts receivable turnover has trended down over the past few years on a quarterly basis, sliding from a high of 8.05x to 6.9x in the last filing. 3-year days sales outstanding also increased from 47 days to 52 days whereas inventory turnover reduced from 30.4X to 20.4X last period. Days inventory outstanding is also increased to ~15 days, whilst accounts payable turnover has also increased at around the same speed. The cash conversion cycle has increased by around 16 days to 46 days, whereas inventory to cash days has marginally increased to 67 days, each over a three-year period.
One other ingredient surfacing amongst investor circles right now is that of capital protection. There are numerous macro headwinds set to impact the life sciences and medical diagnostics sectors. Specifically, employment costs within the private industry continue tracing higher from a low point in 2021. Inflation has also been realised within medical care services in 2022, with a key index tracking prices in the sector now back at multi-year highs, ex-pandemic. The Producer Price index (“PPI”) also spiked up another 81 basis points month on month to March and is up 16% YoY. That’s also been recognised at the consumer level with the CPI hitting its highest level in years as well.
The question, therefore, becomes whether or not LH can absorb these cost pressures effectively from the top-down. First of all, diversification is a must in order to hedge against tail risk. In that regard, we estimate the company’s diversified revenue stream enables it to hedge the top line against large sigma events. Income is derived from an extensive assay menu and supplemented by revenue from end-to-end drug development, medical device development and diagnostic development. Moreover, with 27 suppliers and 8 customers reported in its supply chain per Bloomberg supply chain analysis data on LH, it has some degree of price elasticity on both ends of the demand/supply spectrum, giving it the headroom to withstand a small degree in cost inflation, by estimation. Thus, it becomes a question of margins, cash flow and free cash conversion as a litmus test to identify its capacity to do that.
Exhibit 2. Income & Cashflow trends normalising
Where the investment case weakens for LH is in efficiency at the margin level. It has a 3-year normalised gross margin of 32.82%, slightly behind its GICS industry peer median gross margin of 33.85%. It also reported a compressed gross margin of 31.62% in its latest filing, potentially hurting bottom line fundamentals. This is a key risk investors must realise. Leverage from cash flow and earnings is, therefore, essential. Calculating the company’s 3-year normalised FCF margin of 12.67%, it clearly outweighs the peer median of 7.83%. It also reported an above-average 16.43% FCF margin in its latest results. This is important as LH carries a high degree of earnings below the bottom line. These numbers are supported by a robust growth schedule in earnings. EPS has averaged growth of 40.95% since FY 2018, and has jumped from $8.93 to ’20 to $25.36 in FY21 – printing $5.46 in EPS in the last quarter alone. Below the bottom line, the company has generated $2.65 million in FCF from FY21, a substantial CAGR of 31% from FY 2018. These results have delivered an average 7.71% in average FCF yield over the last 4 years, serving investors an average $19 in FCF per share over the same time period, well ahead of the peer median’s $0.90.
LH also grew return on assets (“ROA”) at a normalised rate of 25.78% over the past 5 years to date, with similar 20.42% and 22.2% normalised growth in return on capital and return on invested capital (“ROIC”), respectively. The company also averaged 10.71% growth in operating margin from FY17 through to FY21. However, each of those margins has contracted in recent periods. Since Q3 FY21 gross margin has contracted by more than 110bps from 32.93% to 31.62% after tightening sequentially over the last 3 periods. Moreover, operating margin contracted by around 70bps in the last 3 quarters from 18.33% to 17.64%. As a result, the last quarter saw a down step in ROIC and ROA. However, this isn’t in line with the longer term quarterly and/or annual trends. A quarterly basis, ROA has averaged a growth of 144.7% since Q42019 and ROIC has averaged a growth of 106.4% per quarter in the same time.
Life Beyond Covid revenue
Turning to the latest quarter, FY2022, results were mixed with the company printing revenue of $3.9 billion, a ~6.3% decrease YoY. Results at the top were below the consensus of $4.01 billion, whilst the company reported EPS at $6.11, ahead of the street’s $6.04. Stripping COVID-19 income out of the mix, we estimate the organic-based business contracted by ~630bps YoY. This comprised a ~980bps YoY contraction in COVID-19 testing which was anticipated. Segmentally, diagnostics contributed around $2.45 billion, an 11.5% decrease YoY. Looking at the core business, we saw growth of ~560bps YoY, and this appears to have translated to a CAGR of 3.7% annualised from FY2019. Drug development revenues were just shy of $1.5 billion, a 4.3% YoY expansion when stripping COVID-19 out of the mix. Checking the order book and order log, trailing 12-month net orders were ~$7 billion. A key near-term catalyst for LH lies in the T12M order backlog of $15.2 billion – with ~$5 million of that to be recognised still in 2022.
Still, we need to analyse LH’s base business as this is a key component in its growth narrative. When stripping Covid-19 out, organic revenue growth for the diagnostics unit has largely normalised towards long-term averages. Moreover, as FCFs have bloated for the company, it now has propensity to take a serious look at its capital budgeting plans for the coming years. This is of benefit to investors. LH can put its balance sheet to work again by targeting high margin and/or complementary acquisitions to its product mix. We estimate acquisitions are an effective hedging tool that is equally accretive to decompress margins now more than ever in life sciences. There’s good reason to project that this type of strategy could increase for LH at one point over the next few periods as well. LH resumed the acquisition quest following the landmark deal by purchasing Sequenom Pathology Associates Medical Laboratories and then Chiltern. It also just completed the acquisition of Diagnostic Clinical Laboratory Service/AtlantiCare Healthcare System Inc in May, although final terms of the transaction are undisclosed. We’ll be examining the performance of these measures via the revenue per acquisition as time goes on.
LH has also employed a capital budgeting program that’s allocated more than $16 billion in capital over the past decade. Around 30% of that was used in finance for the Covance transaction, and management has flagged another $3 billion to complete out or build out its acquisition strategy. It also is set to acquire select assets of Prisma Health’s outreach laboratory business in H2 FY22. During the last quarter, the company invested $455.1 million on acquisitions. In December 2021, an internal strategic review advocated for two incentives to create value for shareholders. This included a $2.5 billion share buyback, with around $1 billion authorised under an accelerated version of that buyback program. As part of the company’s accelerated stock repurchase program initiated in December 2021, 0.6 million shares were retired during the quarter. Bloomberg consensus data has LH to pay a 72 cents per share in Q2FY22, 36 cents in Q3 and then another 36 cents in Q4, already paying 72 cents/share already in Q1FY22.
Valuation And Price Objectives
Shares are trading at around 13X FCF, below the 4-year normalised FCF multiple of ~14X. Shares are also trading at a ~13X P/E, again slightly lower than the normalised 4-year 14.5X P/E and the peer’s 21x P/E. There is incremental value in LH trading at a discount to peers across key multiples, as seen in exhibit 5. Question is, how can we arrive at a justifiable price objective. We’re going to head about this in a couple of ways. Firstly, seeing as we’re building a diversified portfolio of companies that (by our assessment) have the characteristics as medium-long-term cash compounders, we’re obliged to use LH’s normalised cash flow multiples in forward estimates. We forecast LH to convert $1.75 billion of FCF in FY22 and ~$1.7 billion in FY23. Whilst these are substantial down-steps from FY21, we feel this is already well priced into the stock. Assigning a 4-year normalised 14x FCF to FY22 FCF estimates of $1.75 billion yields a price target of $260 per share.
Exhibit 5. Multiples & Comps analysis
To strengthen our understanding of just where the share price will head next, we need some insight behind the market’s psychology about the stock. In order to do that, technical studies can obtain an unambiguous viewpoint of where realistic price targets sit for LH. Confluence with other valuation factors mathematically estimates where this stock should trade.
We can achieve this using point and figure charts (“P&F”). These charts track price reversals and filter out noise by looking at price action alone, excluding time. Here, we can see multiple upside price objectives of $288 on calculations from the charting analysis. It has confirmed this level once before, adding weight to the second $288 target. The stock is in an upward trend, but currently testing the support level. However, it has not broken the lower trend line. There’s been numerous upward price swings since September 2020 as indicated on the chart, and it’s now in a consolidation at its current levels. There is strong bullish support towards these bullish objectives by our estimation. Noted are downside targets of the $170-$174 and this is where we’ve placed our stops. LH had topped at ~$318 per share earlier in the year, and has since undergone a small retracement to a key support level. Based on these several factors, we feel there is good reason for pricing a move towards the $288 pressure mark.
Exhibit 6. Bullish price targets at $288/share
Corroborating this with forward earnings estimates cements the mathematics of our estimates further. As earnings growth normalises at around 41.5% on a 4-year average P/E of 14.5X, we are comfortable in applying that multiple to our FY22 P/E estimates of 20X. Doing so returns a price target of $290 per share. So, here, we have a valuation range of $260–$288–$290 per share, which normalises to $279.30, lending 14.6% upside potential or around $37 per share.
Further Technicals For Sentiment
The stock is also trading below cloud support, however, is heading back north towards its long-term support level. On a longer-term time frame, it still has buyers at its current levels. However, looking at the shorter-term time chart, there appears to be a battle between the bears and the bulls in order to recapture momentum either way. On balance volume (“OBV”) has also begun to transit down in recent periods, showing a reversal in April off the longer-term uptrend. RSI has begun to creep up since May, however, has failed to breach the 70 level for some time.
Exhibit 7. Trading below, but heading towards cloud support
The stock also appears to have retracted back to its 50% mark on the Fibonacci retracement when drawing from the previous double low to the last peak. This appears to be the level of support and there’s good confluence from other indicators. Nonetheless, we believe this price action is supportive of an extended move to the upside, and have confidence in our price objective of $279 per share, where we would seek to re-evaluate the position at that point.
Exhibit 8. Retracement to 50% Fib from previous high
In short, LH appears to have a more diversified revenue mix versus its peers and also presents with robust bottom-line fundamentals to support share price appreciation in the current climate. We’ve noted the company’s healthy growth at the FCF and earnings level, and despite a planned wind-back in COVID-19 revenues, we back management in delivering on its strategies for long-term value. This includes further acquisitions of high-margin companies and share buybacks as a part of its capital management strategy, now that COVID-19 revenues look to have been fully realised.
We’ve set price objectives at $279–$280 per share where we’d seek an exit or re-evaluation of the position at that point. This seems a firm target, given our chosen methodologies to value LH and analysis of the crowd behaviour behind the stock. On this basis, we are looking to collect around 15% upside or roughly $37 per share on a small position around 0.1% of NAV or less. Others might weight the stock based on the expected return divided by the number of holdings in the portfolio. We look forward to revisiting this stock along its journey hopefully to this level.