Investors Coming Back To Clinical Lab Industry

Private LBO company pays $420 million in cash and debt to acquire Unilab Corp.

CEO SUMMARY: Wall Street money is beginning to flow back into the commercial laboratory industry. This time the beneficiary is Unilab Corporation of Tarzana, California. New York-based Kelso & Company signed an agreement to buy 93% of Unilab’s shares. The common perception among financial analysts and money managers is that commercial laboratories may again be a worthwhile investment.

COMMERCIAL LABORATORIES are again finding themselves attractive to investors. The latest deal is Kelso & Company’s acquisition of Unilab Corporation.

Kelso & Company is a private investment company involved in LBOs (leveraged buyouts). On May 25, it announced an agreement to purchase 93% of Unilab’s stock for $5.85 per share, paid in cash.

This was a 20% premium over Unilab’s market price on that date. As a result of this transaction, Unilab will be merged into UC Acquisition Sub, Inc., a wholly-owned subsidiary of Kelso & Company.

Unilab is the largest commercial laboratory in California, with revenues of $217 million in 1998. It does no testing outside that state. During the last six months, it acquired two major competitors, Meris Laboratories and Bio-Cypher Laboratories (formerly Physicians Clinical Laboratories).

THE DARK REPORT considers this transaction to be a significant event for the clinical laboratory industry. During the next two years, it will impact laboratory activities in four ways.

One, a new cycle of investment in commercial laboratories by outside investors is about to begin.

Two, in California, the competitive battle for market share of laboratory specimens will intensify.

Three, existing independent commercial laboratories can view both Unilab and yet-to-be identified new investors as serious and qualified buyers.

Four, there will be a heightened emphasis on sales and marketing by all public laboratories. However, this will not take place at the physicians’ office level, it will occur at the level of HMOs, IPA, and similar global contract sources.

Each of these four dynamics will affect the continuing evolution of the laboratory industry in fundamental ways. Here’s a closer look at how each dynamic can be expected to play out in the healthcare marketplace.

MARKET DYNAMIC ONE
New Cycle Of Investment

During 1999, nearly $2 billion will be spent on the acquisition of publicly-traded laboratories. Kelso & Company is paying $420 million for Unilab. Quest Diagnostics Incorporated will pay $1.27 billion to purchase SmithKline Beecham Clinical Laboratories.

Lenders and investors are willing to commit this money in 1999 because they have watched the success of Golder, Thoma, Cressey, Rauner Inc. (GTCR). During the last 30 months, GTCR made sizeable investments in both Dynacare, Inc. and American Medical Laboratories. (See TDR, May 12, 1997.)

Donald Edwards, a GTCR principal, told laboratory CEOs at last month’s Executive War College in New Orleans that GTCR was pleased with the performance of both Dynacare and American Medical Laboratories. GTCR is a 50% owner of Dynacare, which it helped convert from a publicly-traded company into a private firm.

Wall Street analysts share a view, rightly or wrongly, that the finances of the commercial laboratory indus- try have hit rock bottom. They can only improve. “This is a company [Unilab] that’s back from the dead in an industry that’s back from the dead. It’s a lower-risk strategy for management,” said Nancy Weaver, financial analyst with Stephens, Inc. about the Unilab deal.

Weaver’s opinion is shared by an increasing number of financial analysts and portfolio managers. They see the relatively depressed share prices of Unilab, Quest Diagnostics, and Laboratory Corporation of America as providing a good opportunity for market gains. They interpret the stabilizing finances of these companies as an early sign that the market for clinical laboratory services will improve during the next few years.

Given these facts, THE DARK REPORT predicts that other investments will be made in the commercial laboratory industry during the next 18 months. In cities where such investments occur, they will disturb the lab- oratory status quo.

MARKET DYNAMIC TWO
Increased Competition in California

As Unilab comes under control of new owners, it can be expected to develop a well-funded and focused sales and marketing program. Kelso wants Unilab to increase its profitability, which means Unilab must go out and build specimen volume.

Accordingly, competition for business in California can be expected to intensify. This will not be the financially-struggling, unfocused Unilab of 1996 and 1997. Competing labs can expect Unilab to show a new intensity in its pursuit for additional specimens and revenues.

Expect this intensified sales and marketing effort to concentrate on global contracts for laboratory testing. This emphasizes building contracting relationships at the level of the HMO or IPA, rather than selling directly to physicians’ offices.

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MARKET DYNAMIC THREE
More Lab Acquisitions

If one accepts the assumption that new investors want to enter the commercial laboratory marketplace, then it becomes obvious that the pace of laboratory acquisitions will increase during the next few years.

THE DARK REPORT sees this occurring in two ways. First, public laboratories, including Unilab, Quest Diagnostics, and LabCorp, will selectively target and buy independent laboratories which offer them strategic benefits. Unlike the bidding frenzy of the early 1990s, these deals will be soberly negotiated, and based on their appropriateness to the acquiring laboratory.

Second, outside investors will use acquisitions as a way to buy into the commercial laboratory industry. This is what occurred to American Medical Laboratories of Chantilly, Virginia. Independent labs with size and regional market clout will be the most attractive candidates for investors.

Expect owners of these laboratories, many who regret not having sold their laboratory in the pre-1994 acquisition frenzy, to be willing sellers to this new class of buyers. As they sell, their laboratories will come under more aggressive management.

MARKET DYNAMIC FOUR
Intensified Sales & Marketing

One major consequence of this new investment money flowing into commercial laboratories will be increased intensity in sales and marketing for additional specimens.

This will be particularly devastating to any remaining smaller independent laboratories as well as hospital lab outreach programs that are run in a half- hearted manner. The reason is simple.

New owners of these acquired and “revamped” clinical laboratories will operate them under the principles of modern corporate management. Many of their competitors are laboratory managers still rooted in the old management models of the fee-for-service 1980s and early 1990s.

This management transition has parallels in other industries. When Japanese auto manufacturers entered the U.S. market in the 1970s, they used a different management philosophy to organize their companies. They designed, built, and sold cars under a different set of management precepts.

Management Philosophies

Not until the Big Three Detroit auto makers incorporated Japanese management philosophies into their business did they stabilize their market share. During the late 1970s and early 1980s, a similar process happened to manufacturers of business copiers and semiconductors.

THE DARK REPORT considers it important that both commercial laboratory executives and hospital-based laboratory administrators understand this point about new management principals. This transformation is already under way. American Medical Labs and Quest Diagnostics represent this new approach to management, marketing, sales, and service.

Managers Who Don’t Deliver

New investors have influence in these companies. Managers who don’t deliver will be replaced by those who can. This new class of managers will have an additional talent over today’s crop of lab administrators. They will be capable of initiating and managing proactive change in the lab while simultaneously improving the science of laboratory testing.

This duality of management thinking has been slow to take root in the clinical laboratory industry, particularly among hospital lab administrators. THE DARK REPORT believes that new investors now arriving in the lab industry will be a catalyst. They will accelerate this evolution toward a new management philosophy.

Clients and regular readers of THE DARK REPORT should evaluate how these four market dynamics will alter competition in the regional markets served by their laboratories. The healthcare marketplace is evolving at a rapid pace. What was a good management strategy last year may be a ticket to bankruptcy next year.

For that reason, laboratory executives should keep closely attuned to developments at both the regional and national level. In coming months, THE DARK REPORT will write more about the impact of Quest Diagnostics’ acquisition of SmithKline Beecham Clinical Laboratories. Like the Kelso purchase of Unilab, the Quest-SBCL merger will stimulate a number of far-reaching changes to the laboratory industry.

Hospital Labs Not Immune

As discussed earlier in this story, hospital laboratories should not consider themselves immune to the acquisition activity unfolding among commercial laboratories. Many independent laboratories believe that they can grow by capturing either hospital specimens, or gaining contracts to manage hospital labs. New investors, who don’t understand the differences between hospital labs and commercial labs, will tend to direct their sales force to generate business from hospital sources.

Will the arrival of large amounts of new investment capital be good for the clinical laboratory industry? Only time will reveal the answer. In the meantime, one thing is certain…more change is ahead for both commercial labs and hospital laboratories.

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