Specialty Progresses With CA Lab Regulators

Besieged laboratory company turns feisty in executing its turnaround strategies

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CEO SUMMARY: Earlier this month California laboratory regulators found Specialty Laboratories, Inc. to be “in substantial compliance with California clinical laboratory law.” This is an important milestone in restoring the lab company to full compliance with both state and federal laboratory regulations. Meanwhile, at the CLMA convention in New Orleans, Specialty Labs mounted a major educational effort.

IT WAS A BIG WIN for beleaguered Specialty Laboratories, Inc., which announced on July 3 that, following an inspection of the laboratory, California’s Department of Health Services (DHS) had “found Specialty to be in substantial compliance with California clinical laboratory law.”

This announcement indicates that Specialty Labs and lab regulators within DHS have agreed on a Plan of Correction (POC). Agreement with DHS is a significant milestone. Now that California lab regulators have deemed Specialty Labs to be again compliant, that would logically set up a similar review by federal lab regulators at the Centers for Medicare and Medicaid (CMS).

Review By Feds Is Next

That’s because CMS relied on much of the DHS’s findings of non-compliance in issuing its own set of sanctions, including revocation of Specialty Lab’s CLIA-88 license, subject to a legal appeal which was filed. Because of the turmoil caused by the April 15th disclosure of the federal sanctions, it can be assumed that both Specialty Labs and federal regulators have plenty of motivation to expeditiously resolve these sanctions.

“Specialty Comes Out”

The timing of the July 3 announcement just missed the Clinical Laboratory Management Association’s (CLMA) annual convention in New Orleans, which adjourned on June 29. But even without that important news, Specialty Laboratories served notice during the CLMA program that it will invest considerable resources to regain its standing as a major source of reference and esoteric testing.

Specialty Labs clearly came to CLMA with carefully-laid plans to address the issues and concerns of its clients. The public nature of the CLMA meeting put Specialty in full view of a wide cross-section of laboratory administrators.

The linchpin to Specialty Lab’s public strategy to rebuild confidence in the company is the prominent role it is giving Douglas S. Harrington, M.D., its new Chairman, CEO, and Medical Director. At an evening event held for clients and special guests of Specialty Labs, Dr. Harrington earned high marks for his comments and commitment to the company’s clients.

Evidence of Change

There is an interesting message in the fact that Specialty’s executive team was able to prepare and execute this type of performance at CLMA. At a time when the company must devote considerable resources towards multiple—and highly stressful—management challenges, its ability to impress its client base in New Orleans may be the first visible evidence that, indeed, a different type of corporate culture is evolving within the company.

The challenges facing Specialty Lab’s new executive team should not be underestimated. THE DARK REPORT has already observed that no public laboratory company has ever had to simultaneously: 1) work expeditiously to resolve a revocation of its CLIA-88 license and return to full compliance with both state and federal lab regulators; 2) deal with multiple shareholder class action lawsuits following the resulting decline in its stock price; 3) restructure lab operations due to ongoing revisions to the test menu, declining specimen volumes, and unexpected costs; and 4) operate under a suspension of Medicare and Medicaid payments even as new executives assume responsibilities during a time of high crisis. (See this article and also this commentary from TDR, June 24, 2002.)

New Corporate Culture

To communicate the extensive changes in the way Specialty Labs will conduct business, new management’s turnaround strategy is to use Dr. Harrington and his new executive team as the public face for this change. Under founder and former CEO James B. Peter, M.D., Ph.D., there was a distinct corporate culture. For all its good points, it was that corporate culture which led to the serious regulatory problems and the current difficulties at Specialty Laboratories. Thus, it is no surprise that Dr. Harrington is striving to establish a new corporate culture and a different public face for Specialty Laboratories.

Even as the lab company awaits resolution of its negotiations with federal laboratory regulators, it has another hurdle to cross. On July 23, it will release its second quarter earnings on a conference call with analysts and others.

Specialty Labs’ Problems Cause Lawyers To Pile On

WHEN NEWS OF SPECIALTY LABORATORY’S regulatory woes caused its stock price to plummet, more than a few lawyers took notice.

During the past three months, at least seven law firms advertised the commencement of class action lawsuits against Specialty Laboratories. Several of these were simply efforts to attract disgruntled shareholders.

However, Specialty Lab’s problems did attract the notice of one heavyweight law firm. Milberg Weiss Bershad Haynes & Lerach of San Diego, California filed their class action suit against the lab company on May 7, 2002.

Milberg Weiss has a well-deserved reputation for these types of class action lawsuits. Many corporations have paid it substantial amounts of money to settle allegations that they violated securities laws.

In fact, Milberg Weiss has already drawn blood from at least one laboratory company. When the stock price of Laboratory Corporation of America declined following its creation in 1995, Milberg Weiss filed a class action suit. As part of the settlement, LabCorp paid about $40 million.

Among the pending lawsuits, Specialty Laboratories’ toughest legal opponent will be Milberg Weiss. At the least, if Specialty prevails, it will have paid a significant amount of money in legal fees to defend itself, not to mention the distractions such lawsuits cause to the executive team.

Early Warning To Analysts

To prepare the financial community, Specialty recently disclosed it expects to report a “significant net loss”? for the quarter. It also plans to take a one-time charge of up to $3.8 million. It said revenue would be affected by a reduction in test volumes and because it was not billing for Medicare and Medicaid testing. Outsourcing certain tests was the source of additional costs during the quarter.

Any current concerns by the investment community would be reflected in Specialty Labs’ stock price. However, through most of June and July it traded in the $7 to $8 range. One reason for this share price stability is that investors recognize the balance sheet strength of Specialty, which includes more than $70 million of cash and investments. It thus has ample capital to absorb losses and fund ongoing operations.

Changes In Test Volume

When Specialty Labs reports its second quarter financials, one important item will be the change in test volume. In the past, Specialty has reported this number as a percentage change from earlier financial periods.

Test volume will be affected primarily by two factors. One is the fact that Specialty reduced its test menu and referred certain lines of tests to other laboratories. The other is the impact of clients who decided, in light of many uncertainties, to redirect specimens to other sources.

In the three months since Specialty’s regulatory sanctions were announced, there has been unease among many Specialty clients. Competing labs have used these events to aggressively court clients and it is known that plenty of new accounts have been opened.

But here is where the 80/20 rule may come into play. Once the state and federal sanctions were announced, Specialty Labs launched an intense effort to stay close to its largest clients and work with them through all the subsequent problems. Executives at the company represent that they have enjoyed great loyalty from these key accounts. Effectively, this could mean the 20% of their clients who generate 80% of the business have stayed loyal to Specialty.

If true, that means the many accounts opened by competing reference labs represent primarily the 80% of Specialty clients who generate just 20% of the business. It will take some months to better evaluate the economic value of those clients who did make a switch.

July May Be Pivotal

July may prove to be the pivotal month for Specialty Laboratories. It has the July 23 earnings release and another big lab convention when the AACC Annual Meeting convenes in Orlando on July 28 through August 1. Were it to have positive news about its federal sanctions by month’s end, that would restore a degree of competitive strength.

Lab administrators and pathologists interested in the reference testing marketplace should carefully follow events over the next eight weeks. After three months of dealing with the consequences of its regulatory sanctions, Specialty Labs has accomplished three important objectives. First, it survived. Second, it was not acquired. And, three, it cleared one of two big regulatory hurdles. Combined with its rather feisty attitude on display at CLMA, these are all signs that other chapters are yet to come in this saga.

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