Buyout of AmeriPath Riles Some Shareholders

Dispute over proposed sale to Welsh Carson provides an inside peek into the deal structure

CEO SUMMARY: Owners of the few remaining independent private laboratory companies closely watch prices paid by lab buyers. In the pending sale of AmeriPath to private equity investor Welsh, Carson, Anderson, & Stowe, dissenting shareholders disclosed several aspects of the valuation process. This information provides useful insights into the process of valuing laboratory companies.

DISSENTING SHAREHOLDERS ARE unlikely to change the outcome of the announced acquisition of AmeriPath, Inc. by Welsh, Carson, Anderson, & Stowe, a private equity investment company based in New York City.

Announced on December 9, the transaction is moving forward. Welsh Carson offered $21.25 per share, which was a 30% premium over AmeriPath’s closing price of $16.45 on the previous business day.

At least one group of shareholders filed suit against AmeriPath seeking a court injunction to prevent the sale. Another dissident shareholder objecting to the sale was MMI Investments, which beneficially holds 4.5% of AmeriPath stock. MMI raised several objections to the sale, including poor timing, potential conflicts of interest by officer/directors, and a rather low sales price based on several different ways of valuing the company.

Because of its large size and activities in hospital-based pathology services, AmeriPath has become a bellwether company—one which is closely watched for clues as to how the anatomic pathology marketplace is evolving. THE DARK REPORT can identify three categories of pathologists directly affected by AmeriPath’s business activities.

First are the 400+ pathologists employed at AmeriPath. They not only rely on AmeriPath for income, but hold modest amounts of stock in the company.

Second are pathologist-partners in private group practices. Because AmeriPath is an active buyer of pathology group practices, pathologists interested in selling their group want a financially-flush AmeriPath capable of paying top dollar. But AmeriPath also represents a competitive threat to local pathologists. In certain cities where AmeriPath owns a group, it competes directly against other pathology groups in that region.

Guidance About Lab Values

The third group is laboratory owners. For them, how AmeriPath itself is valued by its current buyers provides guidance about what knowledgeable buyers are willing to pay to acquire laboratories.

In criticizing the proposed buyout of AmeriPath by Welsh Carson, dissident shareholders opened the door to aspects of laboratory acquisitions not normally made public. As professional investors with sizeable holdings of AmeriPath stock, they believe AmeriPath is selling at the wrong time, and for too cheap a price.

Their first criticism is that the timing of AmeriPath’s sale to Welsh Carson stinks. MMI stated “this is a management buyout that has been pre-arranged with extraordinary barriers to competitive bidding in order to ensure a low price from shareholders for management’s enrichment.”

12-Day Sale Window

First was the decision to limit offers from other buyers to a 12-day period. MMI noted that a 12-day window makes it extraordinarily difficult for other potential buyers to arrange financing and express interest.

Next, MMI pointed out that AmeriPath entered into this sales agreement at a time when both Quest Diagnostics Incorporated and Laboratory Corporation of America are preoccupied with significant acquisitions of their own (Unilab and DIANON Systems, respectively). Thus, neither national lab company would be expected to be an aggressive bidder, if at all.

This is highly relevant reason because everyone involved in this sale—both within AmeriPath and Welsh Carson—earnestly expect that one of the two blood brothers is likely to bid a hefty price for AmeriPath sometime in the next three to five years.

Another significant objection by dissenting shareholders involves the price at which AmeriPath’s board has agreed to sell. MMI argues two credible points. One, AmeriPath’s sales price is too low and comes at a time when AmeriPath’s share price is down for factors unrelated to its core business fundamentals. MMI believes waiting another 12 to 24 months for additional growth would support a higher price at that time.

Low Price For AmeriPath

Second, the sales price for AmeriPath is too low when compared to existing Wall Street numbers for public laboratory companies. Specifically, MMI observes that, “at 6.7 times and 11.7 times Street Consensus 2003 EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and EPS (Earnings per share), the valuation for this deal is a discount of 26% and 37% of EBITDA and P/E trading multiples of AmeriPath’s publicly-traded comparable. This deal is even a 20%+ discount to AmeriPath’s own trading multiples from just six months ago. The entire lab sector, but AmeriPath in particular, is experiencing a wholesale multiple compression— why sell now?”

In fact, MMI provides its own estimate of AmeriPath’s value should be within 18-24 months. “Using conservative assumptions, many from our discussions with [AmeriPath] management, our discounted cash flow models indicate an implied value of $31 to $46 [per share] using J.P. Morgan’s assumptions about the fairness opinion for DIANON Systems [in its sale to LabCorp].”

Of course, arguments about future value must be weighed against today’s reality. At the time AmeriPath entered this sales agreement, its stock was trading at $16.45 per share. Welsh Carson is paying a 30% premium over that market price.

…certain shareholder groups, after doing their own financial analysis, have reason to believe that AmeriPath is being sold too cheap.

However, it should also be noted that certain shareholder groups, after doing their own financial analysis, have reason to believe that AmeriPath is being sold too cheap at a poor time in the economic cycle. If one accepts that assumption, the next question is why?

A potential answer can be found by identifying which parties stand to benefit financially by putting AmeriPath up for sale at this time. It is recognized that AmeriPath’s senior executive team will get financial incentives linked to the change of ownership, including the acceleration of certain stock options.

For example, James C. New, AmeriPath’s Chairman of the Board and CEO, will receive two times the sum of his annual base salary and bonus. Under his current employment agreement, New’s current annual base salary is $475,000, and he is eligible to receive an annual bonus potentially equal to 50% of his base salary. When the sale closes, New may be paid as much as $1.5 million.

He currently holds 126,418 shares of AmeriPath stock, only .44% of AmeriPath’s 29 million outstanding shares. But after Welsh Carson buys the company, New will be granted options equal to 5% of the new company’s stock. Dissident shareholders say that stake could be worth as much as $50 million to New should the company be sold in the next five years.

In fact, post-acquisition, the existing AmeriPath executive team and Welsh Carson will have stock options equal to as much as 12% of the company’s total shares. By comparison, currently the executives and directors, as a group, only hold 1.3% of AmeriPath’s stock.

For Welsh Carson, if it is buying AmeriPath at a low price, it stands to make significant profits. MMI calculates that “if the AmeriPath transaction is consummated at $21.25, Welsh Carson would be able to flip AmeriPath within three years at a multiple between their purchase price and that of comparable [lab company] transactions— potentially generating an internal rate of return (IRR) of 70%.”

Value is the key issue raised by all dissenting shareholder groups. The AmeriPath board commissioned Salomon Smith Barney (SSB) to study the marketplace and provide an opinion of fairness. SSB looked at market values using six different comparative methods.

Fairness Opinion On Value

Salomon Smith Barney concluded that, in each method, the low-end “implied per share equity reference range for AmeriPath” was in the range of $18 and $21. On the high end, it was $28 to $33. Dissident shareholders point out that Welsh Carson is paying only $21.25 per share, a low price relative to the fairness opinion of SSB.

All of this information and criticism supports several conclusions. First, Welsh Carson is acquiring Ameripath with the intent to operate it as a short-term owner. It plans to exit this investment in one of two options. One option is to sell it outright. As noted earlier, two likely buyers are considered to be Quest Diagnostics and LabCorp. The second option is to sell stock to the public, thus providing the liquid market necessary for Welsh Carson to sell its shares at a profit.

Maximize Value

Second, as a “short-term owner,” Welsh Carson will be operating the business in ways that maximize its value to some future buyer. In particular, it will probably invest additional money to acquire more pathology group practices.

Third, the need to show steady growth in revenues and net profits means that AmeriPath will probably intensify its sales and marketing efforts against local pathology group practices. A professionally-managed sales and marketing program can generate solid gains in specimen volumes and revenues. That will help Welsh Carson dress up AmeriPath for its eventual sale.

Lots of Speculation

Within the anatomic pathology community, there has always been speculation about AmeriPath. Will it succeed? Will pathologists want to sell their practices? Will they be content to practice pathology as employees of AmeriPath and not as partners in their own group? Is AmeriPath going to compete for hospital contracts in cities where it owns a pathology group?

Since it became a public company in 1997, AmeriPath has demonstrated staying power. It outlasted all other companies that attempted to build a pathology PPM. Six years later, it now does business in at least 20 states and generates almost one half billion dollars per year in revenues. By those measures, it is successful, even if it hasn’t revolutionized the business of anatomic pathology…yet!

Understanding Why Quest and LabCorp Can Pay Big Bucks

IN RECENT YEARS, both Quest Diagnostics Incorporated and Laboratory Corporation of America paid strong prices to acquire laboratory companies.

Some lab directors and pathologists have wondered how the acquirers could afford to pay so much money for existing laboratory companies—which may not have been overly profitable at the time of acquisition. The AmeriPath deal provides an opportunity to look at deal-making math.

In criticizing the proposed Welsh Carson purchase of AmeriPath, dissenting shareholder MMI Investments provided its own analysis of various valuation approaches. MMI states “using the same assumptions as research analyst Bill Bonello of Wachovia Securities, (an all-cash transaction with interest at 5.0% and tax at 4.0%), we find that a transaction expected to be breakeven to Quest and LabCorp in 2003 would command a deal price [for AmeriPath] above $56 per share and be accretive to Quest’s projected 2004 EPS by 4.2% and LabCorp’s by 5.5%.

“If the [AmeriPath] deal were struck at $30 per share by these two strategic buyers in order to outbid financial sponsors, we would expect it to be 6.5% and 9.4% accretive to Quest in 2003 and 2004, and 8.2% and 12.3% accretive to LabCorp in 2003 and 2004—all without revenue or cost synergies!” concluded MMI.

It is MMI’s assessment that Quest and LabCorp could pay between $30 and $56 per share for AmeriPath as it exists today, and generate ample returns from that investment. This illustrates why the two blood brothers are considered potential buyers of Ameripath at some time in the next few years.

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