Did Wrong Strategy Sink Westcliff Medical Labs?

California’s third-largest commercial lab firm took just 46 months to slide into bankruptcy court

CEO SUMMARY: All sorts of people will argue all sorts of opinions about the financial demise of BioLabs, Inc., and its subsidiary, Westcliff Medical Laboratories, Inc., and why it ended up in a California bankruptcy court. Documents filed in the case indicate that, from the birth of the new company in June, 2006, it never produced an annual profit. During the 46 months of BioLabs/Westcliff’s business life, its owners worked with two different management teams, each of which had a different strategy for growth.

FOR DECADES, Westcliff Medical Laboratories, Inc., operated profitably in California’s rough and tumble lab testing market. So why, just 46 months after it was acquired by new owners, did this commercial laboratory company end up in Chapter 11 bankruptcy court?

What may best illustrate Westcliff ’s remarkably rapid descent into bankruptcy court is the financial performance as disclosed in court papers. The company’s 2008 statement shows that Westcliff had revenue of $92.5 million—but incurred expenses and write downs of $179.5 million. That produced a total loss of $87 million. In 2009, Westcliff ’s revenue totaled $97.4 million and it says it incurred expenses and write downs of $110 million, thus producing a total loss of $12.6 million for the year.

The financial unraveling of the long-respected Westcliff Medical Laboratories, Inc., of Santa Ana, California—following its acquisition by private equity investors in 2006—has important lessons for the entire clinical laboratory industry. It is a story that also can be instructive to the professional investment community about the challenges of acquiring and operating commercial laboratory companies.

On the following pages, THE DARK REPORT attempts to provide a timeline of events that unfolded within Westcliff Medical Laboratories between 2006 and the present. Over the past four years, the origins and business life of BioLabs, Inc., and its Westcliff Medical Laboratory subsidiary have been the subject of hearsay and widespread misconceptions throughout the California laboratory community. It benefits the laboratory profession to have a more complete public record of what happened at Westcliff.

Timeline For Westcliff

The timeline which follows was assembled from a variety of resources. This includes conversations with a number of individuals who claimed knowledge of events at Westcliff, along with source documents that have become public. Calls by THE DARK REPORT to Westcliff Medical Laboratories had not been returned as of press time. That means the following timeline has no input from the current executive team and owners.

Readers should be aware that, among the sources consulted in the effort to create the following timeline about Westcliff Medical Laboratories from 2006 through 2010, there were differing opinions and perceptions. THE DARK REPORT recognizes these differences in opinion and is open to presenting those perspectives or correcting any factual inaccuracies when presented with appropriate and credible evidence.

For clarity, the timeline will be presented as chapters. The emphasis will be on known facts, often sourced from Westcliff ’s court filings.

Chapter One:
The Creation of BioLabs, Inc.

During 2006, BioLabs, Inc. was created as a partnership between Parthenon Capital Partners, Doug Harrington (as CEO), and Dan Angress (as COO). On June 30, 2006, BioLabs acquired Westcliff Medical Laboratories and Health Line Clinical Laboratories, Inc.

BioLabs paid approximately $79 million for Westcliff, which included about $6 million in transaction costs. Westcliff ’s former principle shareholder invested $10 million in convertible preferred stock in BioLabs. It is estimated that Westcliff ’s annual revenues were around $60 million.

BioLabs paid approximately $25 million for Health Line. The former principle shareholder of Health Line invested $4 million in convertible preferred stock in BioLabs. It is estimated that Health Line’s annual revenues were around $25 million. BioLabs/Westcliff started its corporate life with about $42.6 million in long-term debt.

Chapter Two:
2006-Mid 2007: Integrating Two Labs

Over the next 14 months, under the name Westcliff Medical Laboratories, BioLabs consolidated the testing operations of the two laboratories into a new, 80,000 square foot lab facility in Santa Ana.

In the summer of 2007, BioLabs acquired Clinical Pathology Laboratories, Inc., of Antelope Valley, California. The purchase price was about $2.0 million.

Based on Westcliff Medical Laborator ies’ financial statement for 2006 and 2007, it seems that the consolidation of the two acquired laboratories did not prove overly  problematic. Net revenues for the last six months of 2006 were $44.3 million, which projec ts an annualized run rate of about $88.6 million. By contrast, in 2007 WestCliff ’s full-year net revenue was $84.3 million.

This would suggest that Westcliff might have lost about $4.3 million in revenue during 2007. It is known that the new owners had anticipated some client turnover, particularly from the Health Line book of business.

Westcliff posted operating losses of $712,000 in 2006 (July-December), compared to a $1.4 million operating loss in 2007. To service its debt, the company paid interest expenses totaling $2.3 million in 2006 and $4.8 million in 2007.

Net loss was $3.0 million in 2006 and $6.2 million in 2007. During 2007, Parthenon contributed $6.4 million in capital to fund the acquisition and for operating expenses.

The noteworthy management event during 2007 was the departure of CEO Doug Harrington late in the year. CFO Brian Urban assumed responsibilities as acting CEO. In the following months, Kip Vernaglia came to Westcliff in the role of Senior Vice President of Sales and Marketing. Both Urban and Vernaglia had worked together at UniLab Corporation prior to its acquisition by Quest Diagnostics Incorporated in 2003.

Chapter Three:
Late 2007: Pump Up The Sales Program

During the last part of 2007, multiple sources indicate that the decision was made by Parthenon and its new executive team to adopt a strategy of growth in specimen volume and revenue as a way to return to profitability. Westcliff ’s court documents indicate that Bob Whelan assumed the position of Westcliff ’s Chairman before the end of 2007.

Several competitors selling against Westcliff have pointed out that—starting in the late months of 2007—the combination of Whalen, Urban, and Vernaglia adopted similar sales and marketing tactics at Westcliff to those they employed at Unilab in earlier years. At the core of this approach is the use of deeply-discounted prices and capitated rates to win managed care contracts and IPA (independent physician association) agreements.

Two assumptions underpin this sales strategy. First, that a low price for the managed care/IPA contract will win the business from competing labs. Second, that Westcliff ’s sales representatives can then use the network status of the managed care contract to persuade doctors to refer their Medicare and other fee-for- service specimens to Westcliff—these specimens representing the “pull-through” business. By blending the revenue from lower-priced managed care requisitions with the pull-through fee-for-service requisitions, there is then adequate cash to produce a profit.

Some outside observers claim to know of managed care contracts that Westcliff signed at rates as low as 45¢ per member per month (PMPM). They also state that Westcliff was often prepared to win new managed care and IPA contracts with prices at $1.00 PMPM or less.

The notable point here is that competitors recognized that, from this time forward, Westcliff adopted a sales policy that would have different financial ramifications compared to the sales strategy of the management team that ran Westcliff during 2006 and into 2007.

Chapter Four:
2008: Buying Labs, New MC Contracts

Sales activity accelerated at Westcliff throughout 2008, as the number of sales reps in the field increases in tandem with the effort to bid for a larger number of managed care and IPA contracts than in 2006-07.

In March, 2008, Westcliff acquired Southern California Reference Laboratory in Tustin, California. The purchase price was about $3.5 million. Then, a month later, Westcliff acquired Riverside, California-based NTI-Florida, Inc., (one of the business units of United West Laboratories, Inc.) for a price of approximately $2.0 million.

In October, 2008, Westcliff next acquired The Laboratory Choice, LLC, in Woodland Hills, California. The purchase price was about $2.0 million.

Notable dates in 2008 include August 14, 2008. That is the date Westcliff says it sent a notice of default to its long-term debt holders. Company financials indicate that about $5.3 million of its long-term debt was due that year. During 2008, Parthenon Capital Partners pumped in another $18.0 million in capital for the lab acquisitions and operating expenses.

Financial performance for 2008 indicates that neither the three small lab acquisitions nor the intensified sales campaign were relieving the financial pressure. Court documents include a 2008 financial statement.

Westcliff ’s total revenue was indeed higher, hitting $92.5 million in 2008, compared to $84.3 million in 2007. However, Westcliff ’s operating loss in 2008 was $10 million, an increase compared to the previous year’s operating loss of $1.4 million.

Assuming that the new sales strategy— along with the three lab acquisitions during 2008—was adding specimen volume and revenue, Westcliff saw a significant increase in expenses. For 2008, Westcliff ’s total operation costs and expenses were $102.4 million, in contrast to expenses of $85.6 million in 2007. This was a $16.5 million increase in costs during that 12 months.

So, against a growth in net revenue of $8.2 million during 2008, Westcliff ’s operating expenses and costs increased by $16.8 million. One way to look at this is to say that the company was spending $8.6 million more in operating expenses to support these additional sources of revenue that were brought in by the new lab acquisitions, the new managed care contracts, and the new clients. That is a simplistic analysis and does not reflect other undisclosed factors at Westcliff during 2008.

Another significant development at Westcliff during 2008 was the decision to write down its accounts for goodwill and intangibles. Collectively, the two accounts totaled $106.5 million in 2007. Apparently the owners and management team believed these assets were severely impaired. They decided to write them down to a combined total of just $29.4 million at the end of 2008.

This produced a net loss at Westcliff of $87.0 million for 2008, compared to a net loss of $6.2 million in 2007.

Chapter Five:
2009: Looking For A Solution

With the advent of 2009, owners and the executive team at Westcliff were looking for ways to resolve the issues facing Westcliff Medical Laboratories.

During the year, it is known that the debtors sent a Chief Restructuring Officer (CRO) to Westcliff to represent their interest. The consortium of lenders also provided additional working capital to sustain the business until the business could be sold or put into bankruptcy. In July, 2009, court papers indicate that Bob Whalen became CEO in addition to his role as Chairman.

After shopping Westcliff to prospective buyers, Laboratory Corporation of America surfaced as an interested buyer. Those negotiations eventually led to the purchase agreement disclosed in the Chapter 11 bankruptcy action initiated on May 19, 2010.

For 2009, Westcliff ’s revenue increased to $97.4 million, compared to $92.5 million in 2008. One positive sign was that operating expenses and costs declined from the $102.4 million level in 2008 to $96.3 million in 2009. That produced positive cash flow of $1 million.

However, because of the sizable debt and other non-recurring expenses, Westcliff ’s total loss for 2009 was $13.2 million. One interesting observation is that non-recur- ring legal expense reached $1.7 million during the year—a sign that Westcliff ’s lawyers were very busy during the year.

Chapter Six:
2010 YTD: Chapter 11 Bankruptcy

Having negotiated an agreement to be acquired by LabCorp, Westcliff Medical Laboratories needed to resolve the qui tam lawsuit alleging that it had defrauded Medi-Cal, the California Medicaid program, for lab claims submitted in earlier years.

That resolution was achieved with an agreement signed on May 13 with the State of California. Removal of that hurdle enabled BioLabs/Westcliff to file its bankruptcy petition just six days later, on May 19, 2010.

For the first four months of 2010, documents circulating to potential bidders disclose that Westcliff’s net revenue totaled $33.7 million, against operating expenses of $32.9 million. This produced a positive cash flow from operations of $876,000 for 2010’s first four months. However, this positive cash flow was too little and too late to affect the owners’ decision to file bankruptcy and sell BioLabs/Westcliff.

The Tale In The Financials

There are several obvious facts that emerge from a study of Westcliff ’s financial documents. One, starting in the first six months after the change of ownership in 2006, the new owners found it difficult to balance revenue against operating expenses to produce cash flow—the EBITDA (earnings before interest, taxes, depreciation, and amortization required to be a financially self-sustaining business.

Two, the level of long term debt the owners used to buy Westcliff and Health Line placed a heavy strain on the new company. That is most visible in 2006 and 2007, when operating losses of $700,000 and $1.4 million grew to net losses of $2.3 million and $4.8 million in 2006 and 2007, respectively. The need to service this debt was a challenge to both management teams backed by the owners during the 2006-2010 period.

Sales Strategy At Westcliff

As to the success of the sales and growth strategies adopted by the executives who arrived at Westcliff late in 2007, there are already vigorous defenders and vociferous critics. They are likely to argue far into the future as to how well the managed care contract acquisition/pull-through campaign played out at Westcliff.

However, the basic financial information for Westcliff ’s financial performance for the years 2006 through 2010 that is presented on these pages should prove helpful to those pathologists and laboratory executives who want to use BioLabs/Westcliff as a lab management case study. That would be consistent with the advice of English Prime Minister Edmund Burke (1729-1797) who said “Those who don’t know history are destined to repeat it.”

Westcliff Medical Laboratories’ Performance Shows How Debt Can Affect Profit Margins

IN DOCUMENTS FILED WITH THE BANKRUPTCY COURT, BioLabs, Inc., and its Westcliff Medical Laboratories, Inc., subsidiary disclosed its financial performance from the date of the business launch on June 30, 2006 through the end of 2009. These financial results are summarized below in a simple format.

During the first three years, Westcliff’s operating expenses and costs exceeded revenue. Only in 2009 did the company’s revenue exceed its operating expenses. The summary table also shows how the need to pay interest on the debt used by the new owners to acquire Westcliff and Health Line was a significant drain on cash flow.

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BioLab’s Acquisition History

BIOLABS, INC. WAS CREATED IN 2006 and immediately acquired Westcliff Medical Laboratories, Inc., and Health Line Clinical Laboratories, Inc., as the first step to implement its business plan. During the next 30 months, BioLabs was an opportunistic acquirer of smaller lab companies in Southern California. The information below was taken from company documents.

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