Where’s The Write-down ? LabCorp Faces Key Decision

LabCorp still has not followed the example of competing labs in writing down goodwill

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CEO SUMMARY: Commercial laboratories are recognizing declines in the market value of their assets. LabCorp has yet to do the same. Taken cumulatively, these write-downs demonstrate the sizable revenue erosion that large commercial laboratories experienced during the past three years. Soon it will be LabCorp’s turn to address this issue.

MORE THAN $550 MILLION of clinical laboratory net worth disappeared from the balance sheets of public laboratories during the last twelve months.

This is a direct consequence of changes to the clinical laboratory marketplace during the previous three years. Further, this $550 million shrinkage of clinical laboratory net worth is directly linked to the reduced competitive ability of these laboratories to dominate the markets they serve.

Quest Diagnostics Incorporated (formerly Corning/MetPath), Physicians Clinical Laboratories (PCL) and Unilab already took major write-downs of intangible assets.

Laboratory Corporation of America has yet to formally address the issue of goodwill and intangible assets. If LabCorp were to take the same action as its competitors, it could decide to write- down intangible assets by as much as $355 million. (See table below.)

If that happened, it would represent a recognized loss of laboratory asset value approaching $1 billion in less than two years. The story behind this loss of shareholder value in commercial laboratories reflects several dynamics.

“Goodwill and intangibles are used to value those revenue streams of a laboratory which represent the service component,” said Richard Michealson, Chief Financial Officer at Unilab. “This distinguishes goodwill and intangibles from property, plant and equipment. These are physical assets subject to depreciation.”

If that happened, it would represent a recognized loss of laboratory asset value approaching $1 billion in less than two years.

“Laboratories are service companies,” he continued, “so traditionally they have a higher proportion of intangible assets as compared to a manufacturing company. Under current accounting rules, companies are required to revalue intangible assets and goodwill whenever there are significant changes to the market value of those assets.”

This is precisely the accounting requirement which caused Quest, Unilab and PCL to write down a substantial portion of their intangible assets during the last year. Three laboratory marketplace dynamics eroded these intangible assets.

The first dynamic involves goodwill. Whenever an acquiring laboratory paid too much to purchase a laboratory, it created an inflated value for goodwill. If the laboratory overpaid for the business it purchased, then excess goodwill needs to be adjusted downward at a future date.

Fundamental Changes

The second dynamic involves fundamental changes to the business itself. This reduces the value of intangible assets. For the laboratory industry, declining test utilization, reduced Medicare/Medicaid fee schedules and unprofitable managed care capitation rates dramatically cut the amount of revenue collected for medical tests. This directly reduced laboratory profits from the existing volume of tests.

The third dynamic can be categorized as mismanagement. Did the acquiring laboratory manage the newly purchased laboratories wisely? Were lost client revenues excessive during and after the transition to new owners? The negative revenue impact of mismanagement would require the value of intangible assets to be adjusted downward.

For LabCorp executives and its public auditors, the decision about when to properly write down goodwill and intangible assets, and by how much, represents an important decision for the future of the company. The potential size of the write-down in this area could approach $355 million. If so, then LabCorp would end up with a negative net worth.

It should be noted that such write-downs do not affect cash flow. But they do affect how the company’s business is valued. A lower valuation can reduce the amount of credit extended and increase the interest rate of that credit.

It can be speculated that both LabCorp executives and their audit firm understand the dilemma which faces them. Were they to now revalue intangibles downward, they could affect the success of the impending $500 million stock offering. Were they to wait, they could subject themselves to investor lawsuits for withholding material facts.

How could the laboratory industry bleed between $500 million and $1 billion of net worth in just a few years? The National Health Laboratories purchase of Eastside Medical Laboratories in Seattle, Washington in early 1994 provides a revealing example. National Health paid approximately $22 million for Eastside. Eastside had about $20 million in annual revenues, with physical and financial assets of, say, $10 million. For accounting purposes, the difference between the purchase price and physical assets would be $12 million.

National Health, now part of LabCorp, would categorize that $12 million on its balance sheet as “intangibles.” It would normally write down a small percentage of intangibles each year, similar to a depreciation account.

Disappearing Revenues

But what happens when revenues from the acquired laboratory shrink or disappear? In the case of Eastside, within 18 months of closing Eastside’s lab and consolidating testing at LabCorp’s Seattle division, it was reported that the facility was accessioning fewer specimens per day than before the Eastside acquisition.

If this is true, then it means that LabCorp paid $22 million for Eastside’s $20 million revenue stream, but less than two years later those revenues had disappeared. So what happens to the “intangible” value on LabCorp’s balance sheet?

As a public company, they should disclose the diminished asset value and write down an appropriate amount to reflect current market value. Competing laboratories have already done this.

In 1996, auditors for Physicians Clinical Laboratories (PCL) revalued its corporate assets at current market value. PCL wrote down $36.3 million. A significant part of this involves the difference between the $55 million paid in 1994 for Damon’s California laboratories and what those Damon revenues were worth to PCL in 1996.

When Corning Clinical Laboratories spun off from Corning Incorporated on January 1, 1997, Quest Diagnostics took a $445 million charge to bring corporate assets in line with current market value.

Industry observers agree that the company overpaid for Damon Clinical Laboratories and Nichols Institute, resulting in a large amount of overstated goodwill. Corning also did a poor job of integrating both companies into their laboratory system. Tens of millions of dollars of acquired revenue disappeared. The largest revenue losses probably came from Texas operations and Nichols labs in Kansas City and Sioux Falls.

Acquisition Strategy

California-based Unilab followed the same acquisition strategy as National Health Labs, Corning/MetPath and Physicians Clinical Laboratories. Unilab aggressively purchased laboratories dur- ing the first half of the 1990s. Unilab, with annual revenues of $200 million, was forced by its auditors to recognize a $70.2 million charge for year end 1996 to align corporate asset values with current market values.

As of December 31, 1996, LabCorp listed intangibles as $891.1 million. Were LabCorp to write down the same percentage of intangibles as Quest, it would use about 40%.

This would generate a write-down of $355 million. Offset against stockholder equity, currently at $258.1 million, LabCorp would end up with a negative net worth approaching $100 million. Obviously such a step would have far-reaching consequences for both LabCorp and the competitive laboratory marketplace throughout the United States.

Speculative Scenario

The scenario described above is speculation. But it is based on projecting the specific actions already taken by laboratory industry competitors and applying the same principles to LabCorp’s balance sheet.

Obviously there are a host of legal and financial issues involving this matter which observers outside LabCorp cannot fully understand. However, it is important to understand that this industry-wide trend of revaluing intangibles quantifies the financial devastation experienced by clinical laboratories during the last three years. It presages further restructuring of the commercial laboratory industry which will take place in 1997 and 1998.

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