California’s Rumor Mill Links LabCorp & Unilab

Speculation seems to fuel current rumors since neither lab seems under pressure

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CEO SUMMARY: Continued financial pressure on all laboratories operating in California leads some industry observers to believe that Laboratory Corporation of America and Unilab might be considering some kind of deal between the two companies. Senior executives at both laboratories say such talks are nonexistent.

FOR ALMOST TWO WEEKS there has been ongoing speculation that Laboratory Corporation of America and Unilab, Inc. of Tarzana are negotiating some type of deal.

Unilab Director and former Chief Financial Officer Rich Michaelson pointed out that “although acquisition rumors involving Unilab have circulated in this business for the last ten years, never should they be more ignored than now. As the scale player in California, our priority is to refine our internal operations and not be distracted by acquisition activity.”

LabCorp provided a similar statement. “As a matter of policy, we don’t comment on potential activities involving acquisition opportunities or similar transactions,” stated Brad Smith, Executive Vice President and General Counsel at Laboratory Corporation of America. “Any statements involving such activities would be released to the public as appropriate and in keeping with relevant securities law.”

Unilab’s financial progress during 1997 leads Michaelson to be optimistic and specific about the company’s business strategy, which does not call for doing any outside deals. “The opportunities for us to improve the margins at Unilab are huge. So not being distracted by some outside deal is a desirable goal for us,” explained Michaelson. “After emerging from this wrenching period where earnings hit bottom, the market is recognizing the progress made by Unilab during the last nine months.”

Rise In Share Price

Michaelson is referring to the recent rise in Unilab’s share price from 75¢ per share in June, to a current level above $2.00. “As we get our own operations in order, we don’t see acquisitions as being necessary or even desirable. We believe we are in the early stages of regaining profitability to our existing book of business.

“Fact number two is that we have a stable balance sheet today,” continued Michaelson. “Generally acquisitions tend to cost something. In light of our priority to focus internally, we would not want to weaken our balance sheet by acquiring business that is outside our own laboratory.”

Michaelson did note the obvious qualifier to that statement. Given the public knowledge of financial difficulties for laboratories in California, he realizes that Unilab would not categorically refuse to look at any deal offered to it. “Pick any company with laboratory operations,” he said. “Were they to come to us and say that they wanted to exit the business in California, would we take it off their hands? With the right terms, we would probably kick the tires and consider a deal. But that’s not likely to happen anytime soon.”

No Substance To Rumors

With senior executives at both Unilab and LabCorp telling THE DARK REPORT that current rumors have no substance, why would such rumors crop up? An analysis of both companies’ position in California indicates that there are two reasonable scenarios for a business deal between the two companies.

Scenario one says that LabCorp’s California operations lack the size and critical mass necessary to generate acceptable profit margins. This is why LabCorp would consider selling its California operations to Unilab.

Scenario two says that LabCorp wants to acquire Unilab. That single step would make it the largest laboratory in California, with important business consequences. The acquisition would also give LabCorp the unchallenged position as the largest clinical laboratory company in the world.

What Drives Deals

“There are several reasons why either scenario makes sense for LabCorp,” said one senior laboratory executive (not affiliated with Unilab or Labcorp) with experience in California. “However, it is important to understand what would drive any deal between laboratories in California, including LabCorp and Unilab. No public laboratory is ‘making money’ in California. The reimbursement picture in that state is so bad that it is outrageous. If you understand the difficulty of making money in California, then you understand why LabCorp might be motivated to restructure its California business. Since Unilab is dealing with the same marketplace economics, it would probably consider any option which might help the situation.”?

With senior executives at both Unilab and LabCorp telling THE DARK REPORT that current rumors have no substance, why would such rumors crop up?

In practical terms, Unilab, SmithKline Beecham Clinical Laboratories and LabCorp are the major commercial lab players in California. Quest Diagnostics Incorporated has a relatively small market share because MetPath made a strategic decision years ago to stay out of California.

“I estimate that LabCorp does about $65 million worth of testing in California,” said the lab executive, “Most of that goes through its San Diego lab. It is my opinion that anything less than $100 million in California lab business makes it difficult to survive the financial situation.

“LabCorp’s puzzle is: do they exit California to solve the problem, or is there a way to increase their business to give them the synergies they need?” he continued. “It is interesting that Unilab offers logical solutions to either approach. From Unilab’s perspective, they are making enough money to service their debt, but they still must improve earnings to an acceptable level. Were a buyer to offer the right combination of price and terms, it would not be unreasonable for Unilab’s existing shareholders to consider selling.”

This executive had some particularly insightful observations about the state of affairs in California, and why LabCorp and Unilab would be motivated to negotiate some kind of deal. “Reimbursement levels in California don’t support a financially-viable laboratory,” he said. “Medicare provides a perfect example of the economics of lab testing. At least 38% of California’s Medicare population is enrolled in managed care versus 5% on the East Coast. So California labs do not get the same proportion of Medicare fee-for-service reimbursement as labs in other areas of the country.

“Managed care capitation rates for seniors average approximately $1.00 per member per month (PMPM) in California. When you do the arithmetic, the financial gap becomes obvious. Assume a well-run laboratory averages $9.50 per accession in direct costs (without G&A and overhead). The encounter incidence of a Medicare population is three times that of the standard population. For every 100,000 Medicare HMO beneficiaries, each month, 30,000 will need lab tests. That is $285,000 per month in direct costs, against a capitation rate which generates less than $100,000 in revenue. The laboratory is losing money on that Medicare HMO business from day one.”

Similar Economics

“The economics are similar for the commercial managed care business,”? the lab executive continued. “After years of destructive pricing policies, the string has run out. The current reimbursement situation makes survival difficult for some laboratories, impossible for others,” he explained. “Boards of directors are finally beginning to understand this.”

However, some laboratories in California continue to pursue aggressive, below-cost pricing strategies. Even as Unilab learned this lesson and now strives to increase its contract pricing, there are reports that SmithKline Beecham Clinical Laboratories (SBCL) has chosen to aggressively offer discounted pricing. This is consistent with SBCL’s stated corporate strategy of increasing market share and building specimen volume.

Laboratory competitors note that SBCL recently bid cap rates of 35¢-40¢ PMPM for a contract in Northern California. Such low cap rates demonstrate how difficult it is for laboratories in California to restore financially sustainable price levels for laboratory testing.

With financial relief to clinical laboratories in that state unlikely, THE DARK REPORT predicts that a major realignment of commercial labs will take place in California sometime in the next 12 months. We believe that continuing financial struggles at Meris Laboratories and Physicians Clinical Laboratories will eventually be the catalyst for such marketplace changes.

Haywood Cochrane Now Unilab Director

AS UNILAB RESTRUCTURES ITSELF to meet the realities of the California market for laboratory services, one important move was to bring Haywood Cochrane onto Unilab’s Board of Directors.

Cochrane is familiar to most laboratory executives as the former CEO of Allied Clinical Laboratories, which was sold to National Health Laboratories (NHL) in 1994. Cochrane is a recognized deal-maker and served both NHL and LabCorp as an acquisitions specialist and the primary contact with the Wall Street financial community.

His involvement with Unilab’s Board of Directors is a sign that Unilab will be taking different directions in the future. Cochrane is active in several heatlhcare-related start-up companies. His entrepreneurial perspective will definitely cause Unilab to develop new management strategies to meet the changing marketplace for laboratory services in California.

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