Profit Squeeze Pressures Specialty Laboratories

Growth in revenue & specimen volumes still not enough to generate net profits

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CEO SUMMARY: Despite much success and milestones at Specialty Laboratories during the past 36 months, it has yet to achieve the most important goal of all: net profits. One reason is familiar to all laboratory administrators and pathologists: with its existing fixed overhead and cost structure, Specialty Labs’ key goal is to increase specimen volume and revenues past its break-even level.

DESPITE STRONG GROWTH in revenues and specimen volumes during the past two years, Specialty Laboratories, Inc. finds itself struggling to generate net profits.

It is a “good news/bad news” story. The good news is that the company successfully moved past its regulatory crisis of 2002. It has also built a state-of-the-art laboratory facility in Valencia, California and completed a problem-free relocation there in December 2004.

The bad news is that Specialty Laboratories accepted the resignation of both its Chairman and its CEO in recent weeks. On February 10, Specialty’s Chairman Richard E. Belluzo resigned “to focus on other professional obligations.”

Belluzo’s resignation was followed four days later by the resignation of Douglas S. Harrington, M.D., Specialty Lab’s CEO. He will work through March 29, 2005 and will assist in a search for his replacement. Specialty’s new Chairman is Richard K. Whitney, a director who was recently the CFO of DaVita, Inc., a dialysis company. Specialty’s Executive Vice President and CFO, Kevin R. Sayer, will serve as acting CEO after Harrington departs.

Several factors contributed to this major change in senior leadership—the second in the 36 months since federal and state lab regulators pulled the lab’s license for a variety of violations. (See TDRs, April 1 and May 13, 2002.)

Revenues Up, As Are Losses

For the year ending December 31, 2004, Specialty Laboratories reported revenues of $134. 8 million. This is an increase of 12.7% from revenues of $119.6 million in 2003. However, profitability continues to elude the company. Its net loss for 2004 was $13.0 million, compared to a net loss of $6.4 million in 2003.

Specimen volume in 2004 increased by 20.8%, rising to 3.0 million specimens from the 2.5 million it reported in 2003. This substantial growth in specimen volume illustrates the paradox facing Specialty Laboratories’ executive team.

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In the marketplace, its sales and marketing efforts are generating new client accounts. That is a strong sign that Specialty Labs has credibility in the marketplace. But to acquire and service these accounts, Specialty is outspending revenues. Among other factors, it increased its costs with the construction of its new laboratory.

Growth Strategy

Specialty Labs’ strategy to resolve this negative cash flow is to grow the business. That will allow it to realize economies of scale while accessing a higher level of revenues. On the business development side, Specialty Laboratories is hiring new sales representatives. On the operational side, it has a brand-new laboratory facility. It plans to increase automation and the new laboratory has plenty of capacity to handle increased volume of specimens.

As the two financial charts at left illustrate, Specialty Laboratories is showing sustained growth in revenues. At the same time, because of a variety of factors, some dating back to 2002 and some related to the construction of the new lab facility in 2004, Specialty Labs has yet to report net profits.

Because Specialty Laboratories has a strong balance sheet (cash and assets of about $40 million as of December 31, 2004), it has the financial strength to sustain it while it executes its growth strategy in the marketplace. In fact, the company is telling Wall Street that it expects to post revenue growth of between 10% and 14% during 2005. At the same time, it also predicts that it will not report net profits for the first two quarters of 2005.

Seen in that context, the departure of Specialty Laboratories’ Chairman and CEO within days of each other last month can be interpreted as a sign that there is significant pressure on the executive team to perform. Another sign of this pressure is the fact that, within a week of Harrington’s resignation, at least seven senior executives at Specialty Labs were offered “retention bonuses.”

These retention packages have one thing in common: each promises the executive a bonus of between $20,000 to $100,000 if that individual is still employed by Specialty Laboratories as of February 20, 2006. A resignation or termination for cause prior to that date means the employee forfeits the bonus.

Still A Tough Competitor

Assessing all of these factors, it seems reasonable to expect that Specialty Laboratories will continue to be a tough competitor in the marketplace. It has some $40 million of capital in its war chest and is expanding its sales force to pursue more new business. Also, as of October 2004, Specialty Labs has a contract with Premier, Inc., the nation’s largest GPO (group purchasing organization). This gives it better access to hospital laboratories which are members of Premier.

Because Specialty Laboratories has demonstrated strong growth in revenues and specimen volumes, the most appropriate question to ask is “when will Specialty Labs again be profitable?” This is a company which has ample assets, is considered credible in the lab testing marketplace, and has demonstrated that it can bring in new business.

It will not be an easy road. The management changes documented in this intelligence briefing provide evidence of that. One financial analyst tells THE DARK REPORT that until Specialty Laboratories can raise its annual volume to around $155 million, it is unlikely to show profits. To achieve that, Specialty’s management team will need to increase its annual revenues by 14.9% in 2005.

Major Shareholder May Have Played a Role

THERE MAY BE ADDITIONAL INFLUENCES behind the abrupt decisions of Specialty Laboratories’ Chairman and CEO to both resign just four days apart. It might be described as the “Jim Peter, M.D. Factor.” James B. Peter, M.D., Ph.D., is the founder of Specialty Laboratories and the company’s longtime leader. He currently serves as a Director and holds a significant amount of Specialty’s outstanding stock.

Under the scenario painted by those familiar with some of the dynamics affecting Specialties’ Board, there has been a fundamental difference of opinion on which strategies should be used to again make Specialty Laboratories a profitable company. When it became clear that a board consensus was not to happen, the Chairman and CEO opted to pursue other interests.

Peter, known to have fixed convictions and an energetic defense of these convictions, was said to favor different business strategies than the prior Chairman and CEO. Their departure was recognition of this difference.

Following the unexpected and rather swift departure of these two individuals—both liked and respected by employees of Specialty—there was a need to stabilize the remaining executive team. This was particularly important, since Specialty Labs is at a delicate point in its turnaround. The decision was made to offer “retention bonuses” of between $20,000 and $100,000 per person to seven key executives, payable if they are still employed as of February 20, 2006.

“Irreconcilable differences” within Specialties’ Board of Directors are requiring an expensive resolution. During the next 12 months, the company will spend “$1.1 million associated with the recently-announced departure” of its CEO, along with $390,000 in retention bonuses.

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