Unilab Files Registration For IPO of $115 Million

California’s lab giant hopes to become laboratory industry’s next public company

CEO SUMMARY: During the 1990s, Unilab used the twin strategies of lab acquisitions and aggressive sales and marketing to fuel rapid growth in specimen volumes and net revenues. However, California’s ultra-competitive managed care market and severe financial problems during the latter half of the decade almost sunk the laboratory. Today’s Unilab is a more experienced and cautious company.

CALIFORNIA’S LARGEST lab company wants to offer its stock to the public. On May 3, 2001, Unilab Corporation filed a registration statement with the Securities and Exchange Commission (SEC).

Unilab hopes to raise $115 million from this initial public offering (IPO). If it succeeds, it will be the third laboratory in the past year to complete an IPO. Last November, Specialty Laboratories, Inc. and Dynacare Inc. raised $92 million and $50 million from their respective IPOs. (See TDR, December 4, 2000.)

SEC “Quiet Period” Rules

Because of SEC “quiet period” rules, Unilab executives are not available to comment on the company and the IPO. However, Unilab’s registration statement provides current details on how the laboratory company coped with California’s managed care marketplace in recent years.

Unilab’s revenues in 2000 totaled $337.5 million and operating income was $41.6 million. Unilab claims to have “25% of the California independent clinical laboratory testing market.” It holds 150 managed care contracts, covering about 4.8 million beneficiaries.

To demonstrate the rock-bottom pricing for capitated lab contracts in California, Unilab says that “in Southern California, capitated reimbursement rates, according to a 1999 survey, averaged approximately 65¢ to 85¢ per member per month [PMPM]. In the same survey, areas in the north- eastern United States reported rates as high as $1.50 per member per month.”

Unilab’s dilemma is obvious. It reports that up to 40% of its testing volume is reimbursed under capitated agreements, yet these capitated contracts account for only 15% of its revenue in 2000. So the largest portion of Unilab’s test volume yields minimal revenue.

Unilab must also service a sizeable debt. Against annual revenues of $337.5 million, it has debt of $310.4 million. This debt was incurred in 1999 when Kelso & Company, Inc., a New York-based investment firm, acquired Unilab and took it private.

This sizeable debt impacts both Unilab’s profit & loss statement and balance sheet. Interest payments during 2000 totaled $37.7 million, thus reducing Unilab’s net income.

Negative Shareholder Equity

The large debt burden also has a substantial impact on the balance sheet. Unilab’s liabilities exceed its assets by a significant amount. At the end of 2000, Unilab’s shareholder equity was a negative $112.4 million.

Unilab would like to reduce this sizeable debt. That is a major reason why the company wants to raise $115 million through the proposed IPO. Most of the proceeds are ear-marked to retire debt, some portions of which carry an annual interest rate as high as 12.75%.

The other reason Unilab would like to again become a public company is that its owner, Kelso & Company, is ready to begin realizing profits from its investment. Kelso owns 82.7% of Unilab’s stock.

However, Kelso also paid a premium price of 12 times EBITDA to acquire Unilab in 1999. When Unilab’s annual revenues were $217 million, Kelso paid approximately $420 million to purchase Unilab.

Premium Price For Unilab

The Kelso dilemma can be aptly described by the old real estate adage that “you make your profit when you buy.” In other words, paying too much for a property makes it difficult to later sell that same property at a profit.

Kelso paid a hefty premium in 1999 to acquire Unilab, a company already the dominant lab in California. Knowledgeable observers always wondered where Unilab would find the increased specimens and higher prices necessary to increase the value of the company to the point where Kelso & Associates could sell its investment at a handsome profit.

In 1999, it was believed that two business strategies would feed increased revenues and net profits into Unilab. One strategy involved lab acquisitions. The second strategy involved repricing existing managed care contracts.

Between November 1998 and August 2000, Unilab acquired four lab companies. They were Meris Laboratories, Inc. (November 1998), Bio-Cypher Laboratories, Inc. (May 1999), Southern California Clinical Laboratories, LLC (March 2000), and Pathology Associates Laboratories (August 2000).

Limited Growth Potential

Combined, these four labs added about $91.6 million in net revenues to Unilab. The combined purchase price was approximately $75.3 million. However, few independent labs of size remain in California and Laboratory Corporation of America also wants to acquire labs in the state. Thus, it would seem that Unilab’s ability to generate significant growth from acquisitions would be limited.

The other strategy has been to reprice existing managed care contracts. As most lab executives and pathologists know, one of the amazing stories of California between 1990 and 1996 was Unilab’s willingness to ink capitated managed care contracts for rates as low as 25¢ PMPM.

As a growth strategy, it certainly contributed to Unilab becoming California’s largest lab company. But as a profit strategy, it proved disastrous. At its lowest financial point, in 1996, Unilab’s share prices fell below a dollar and bond holders sold out for discounts of as much as 50%. The company posted a loss of $93 million on revenues of $205.2 million that year.

During the past three years, Unilab has worked to reprice its capitated managed care contracts. But because many of these contracts started with a low capitated PMPM price, even a doubling of the capitation rate at each contract renewal still places Unilab a long way from profitability on specimens covered by these contracts.

Considering the facts of Unilab’s situation, it certainly faces one of the more interesting business challenges of any laboratory in the United States. With Unilab’s existing dominant position in California, it would seem that future growth would have to come from expansion outside the state. The impending IPO will certainly demonstrate whether investors are receptive to Unilab’s current business strategies.

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