CEO SUMMARY: More laboratory overcapacity may be removed from the California marketplace if Unilab purchases Meris Laboratories. Unilab’s offer to buy Meris must be cleared by the bankruptcy court and other bidders may surface during the coming weeks. These events are a reminder that financial pressure on the clinical laboratory industry continues to force change and that lab values are declining.
CALIFORNIA’S ROSTER of commercial laboratories is poised for radical change in the coming months. Catalyst for this change is Unilab Corporation’s bid to purchase Meris Laboratories Inc. from its Chapter 11 bankruptcy case.
Meris, based in San Jose, California, disclosed on September 18 that it had signed a definitive agreement for Unilab to purchase “substantially all the assets (including the customer list)” of Meris.
Purchase terms validate the decline in recent years in the market value of clinical laboratories. The agreement to purchase calls for Unilab to pay $16.52 million. Revenues at Meris are currently around $30 million per year.
Payment is to be in the form of a convertible subordinated note for $14 million. This note bears interest at 7.5% per annum, is due in eight years, and is convertible at $3.00 per share. Unilab will issue a $2.52 million note for the balance of the purchase price, payable in equal installments over 72 months.
“This is the first formal purchase offer for Meris and it has been submitted to the bankruptcy court,” said Philip Tremonti, President and CEO of Meris. “The bankruptcy court has now begun an open bidding process for Meris Laboratories.”
Tremonti expects that other bidders will turn up. “Unilab has established a fair bid from which others will have to base their bids,” he noted. “The court will allow the bid process to continue for about 21 days. Sometime in late October the court will weigh all bids and make a decision.”
Meris’ financial problems have been severe in recent years. For fiscal 1996, losses totaled almost $30 million dollars, an amount approximately equal to the laboratory’s annual sales.
Things did not improve. “1997 and 1998 were at least as bad, if not worse,” Tremonti said. “These losses reflect the severe declines for laboratory test reimbursement in California during the same period.”
Continuous losses during the last three years did not prevent Meris from continuing business operations. Regular infusions of cash came from Wall Street investors such as Cereberus Partners.
Cereberus likes to invest in distressed companies and wants to take an active role in making these companies profitable. Observers familiar with the situation believe Cereberus has learned some unforeseen lessons about the economics of the clinical laboratory industry.
No such misconceptions about the viability of the lab industry exist at Unilab. During the last several years Unilab was forced to take dramatic steps to staunch huge losses and restore financial stability to California’s largest clinical laboratory system.
“Two reasons led us to consider this acquisition,” stated Richard Michaelson, a Unilab Director and former CFO. “First, through 1997 and into 1998, Unilab’s margins have appreciably strengthened, giving us the confidence in the strength and stability of our core operations to responsibly target additional growth opportunities.
“Second, the seller’s perspective of a distressed laboratory sale has changed,” he continued. “That created the opportunity to negotiate a sale with price and terms that more closely reflect current market conditions. Unilab’s offer to buy Meris is based upon something greater than their going EBITDA rate (Earnings Before Interest, Taxes, Depreciation, and Amortization). It reflects a valuation that Unilab feels can accrue substantial value to its shareholders.”
Unilab’s interest in acquiring Meris stems from two facts. One, Unilab likes the market areas served by Meris and the loyalty of Meris’ clients. Two, Unilab’s northern California core laboratory is located less than two miles from the Meris central laboratory. That makes consolidation and integration of the two operations much easier.
Hamstrung By Problems
“Unilab has always viewed Meris as a quality laboratory operation hamstrung by problems within the corporate shell,” observed Michaelson. “Doctors served by Meris generally view the laboratory as a good operation. Meanwhile, the multi year battle between Meris executives Chris Reidel and Steve Kass consumed millions of dollars in settlements and legal fees, while distracting management’s attention away from the day-to-day business operations.”
Phil Tremonti offers a fact which seems to confirm the operational stability of Meris during the multi-year crises which landed the company into bankruptcy. “Our specimen volume count is currently within 10% of our 1995 level. Yet reimbursement has dropped significantly during the same time. This means we continue to perform almost the same number of laboratory tests, but get paid much less than was typical three years ago.”
Financially Troubling Trend
“Another financially troubling trend is the cost of billing for laboratory services,” he continued. “A multitude of managed care plans, increased claims rejection by payers, andmedical necessity requirements all add cost to the billing process. Our average billing cost now approaches $5.00 per accession.”
What makes the Meris case worth watching is that Unilab’s offer may precipitate a realignment of commercial laboratory competitors in California. Only a few laboratories remain in the state.
Unilab, currently at $214 million per year in sales, is the 800-pound gorilla in California. SmithKline BeechamClinical Laboratories (SBCL) and Laboratory Corporation ofAmerica have significant presence, although each does much less testing in the state than Unilab.
Emerged From Bankruptcy
Bio-Cypher Laboratories of Sacramento (formerly Physicians Clinical Laboratories) emerged from Chapter 11 bankruptcy in 1997 with new owners and about $65 million per year in sales (down from a peak of $110 million in 1995).
Rounding out California’s major laboratory players is Quest Diagnostics Incorporated, with a clinical laboratory operation in San Diego that does around $15 million per year in testing. Quest also operates its Nichols Institute division in San Juan Capistrano, but most testing at that location is reference and esoteric work.
The court will not disclose all additional bidders for Meris until 72 hours before the bidding window closes in late October. Any of the laboratories mentioned above could enter a bid. Another potential bidder is Oak Tree Capital Management, an investment company whichs hold sizeable portions of debt and equity in Bio-Cypher.
The court’s open bid process will reveal how much change has taken place in the business philosophy of commercial laboratory executives. If Unilab has accurately assessed Meris’ true market value and entered an appropriate bid, then any effort by a competing laboratory to outbid Unilab with a significantly higher price would be evidence that some lab executives are still willing to incur losses to grab market share.
If the Unilab bid stands unchallenged, that may be a sign that lab competitors in California have finally become unwilling to make unprofitable investments simply to become larger.
No matter who ends up buying Meris, the sale ofMeris validates a dominant market trend identified by THE DARK REPORT. That trend is the reduction of laboratory overcapacity. Any buyer of Meris can only do one rational thing with the company: close down its laboratory and consolidate the Meris clients and operations into the buyer’s existing laboratory infrastructure.
Lab executives should follow the aftermath of the Meris sale. California has already seen a huge reduction in laboratory overcapacity. Bankruptcies and downsizing at all the major labs are bringing capacity in line with demand. At some point equilibrium will be reached. When that occurs, the prices paid for laboratory testing should firm up and possibly begin to increase.
Further, these transactions give existing commercial laboratory owners a good indication of current market values for their laboratories.
Is Bio-Cypher Labs Next On The Chopping Block?
CALIFORNIA’S OTHER TROUBLED lab company is Bio-Cypher Laboratories, Inc., headquartered in Sacramento.
Formerly known as Physicians Clinical Laboratories (PCL), Bio-Cypher was acquired by J. Marvin Feigenbaum after PCL filed Chapter 11 bankruptcy in late 1996. From PCL’s peak revenues of $110 million in 1995, Bio-Cypher has dwindled to around $65 million in annual sales. Reports are that management turnover within Bio-Cypher has been extensive at all levels within the lab.
Cash flow problems within the reorganized laboratory continued the drawdown of operating capital after the bankruptcy was discharged. Bio-Cypher used its billings receivables to secure a $10 million receivables facility from Daiwa Securities America, Inc. in late 1997 as one method to maintain working capital.
Apparently more capital was needed. In June 1998 Bio-Cypher borrowed $4 million from one of its creditors, Oak Tree Capital Management.
Should Bio-Cypher’s negative cash flow continue, observers believe that Bio-Cypher will become the next laboratory organization in California to come into play, probably through sale or bankruptcy. If that occurs, it will have a greater impact on California’s commercial lab marketplace than the sale of Meris.