CEO SUMMARY: Along with a recovering economy, the possibility of an increase in the capital gains tax rate for 2011 may encourage owners of clinical labs and anatomic pathology companies to sell their businesses during 2010. That could make 2010 a busy year for laboratory mergers and acquisitions, particularly if valuations for laboratory companies hold or increase from current levels. A growing number of credible buyers is another reason why laboratory sellers are likely to make 2010 a busy year for laboratory M&A.
FOR OWNERS OF CLINICAL LABORATORIES AND PATHOLOGY PRACTICES, 2010 shapes up be a very good year for them to put their laboratory up for sale. That may be true for at least two reasons.
“First, there is pent-up demand after two years of relatively slow sales,” stated Christopher Jahnle, Managing Director of Haverford Healthcare Advisors, in Paoli, Pennsylvania. “As indicated by the number of lab acquisitions completed in recent months, there is an active group of qualified buyers looking for the opportunity to buy laboratories.
“Second, the capital gains tax rate may rise next year as the Bush-era tax cuts of 2001 expire at the end of 2010,” continued Jahnle. “This is important, because if Congress allows the capital gains rate to increase in 2011, that would motivate laboratory sellers to close the sale of their lab during 2010 so that they would avoid paying increased taxes.
“We could also say that a third reason exists that encourages a higher rate of laboratory acquisition activity during 2010,” he said. “It is an uncontested fact that today is a laboratory seller’s market. That is because we see numerous buyers pursue a steadily-dwindling supply of independent laboratory companies. Thus, anytime a quality laboratory comes to market, it is guaranteed that numerous credible buyers will be interested in making an offer to buy that laboratory company.
Heightened Investor Interest
“This has always been true for the clinical laboratory side of the business,” added Jahnle. “The new development we saw in the second half of 2009 is heightened investor interest in anatomic pathology laboratories.
“This bodes well for pathologists who are partners in anatomic pathology laboratories,” he noted. “With more potential buyers in the mix, it means now is an interesting time for owners to consider a possible sale. Many signs point to more acquisition activity during the next six months.
“I suspect that, along with a recovering economy and the recent increase in the number of announced laboratory acquisitions, laboratory owners will be motivated to shop their laboratories for sale due to the possible coming increase in tax rates.
“Let me explain,” Jahnle said. “Lab sellers should consider that capital gains tax rates are scheduled to increase as of January 1, 2011. Thus, if their laboratory sales transaction can be structured so that their gain is characterized as a capital gain, sellers would be wise to complete a transaction in 2010 rather than 2011 and beyond.
“What triggers this change is the expiration of the Bush-era tax cuts, which reduced the capital gains tax rate from 20% down to 15% in 2001,” he commented. “If Congress does nothing, then those tax cuts expire and, on January 1, 2011, the capital gains rate reverts back to 20%.
“…the high values of lab businesses seen in late 2007 and early 2008 were closely linked to the stock market valuations at the time.”
“A smart seller can do the math,” explained Jahnle. “A laboratory owner can look at that 5% tax increase and calculate how much he or she would need to grow the business to be at the same place as he or she would be if the sale went through this year as opposed to next year. The answer is that the growth would need to be substantial, and certainly greater than 5% to overcome an increase in taxes of 5%.”
Valuations of laboratory businesses will play a factor in the laboratory M&A market during 2010. It is known that a number of laboratory sellers pulled their businesses off the market during 2008 and 2009 as they saw the prices paid for labo- ratories trail downward.
“In general, we currently see valuations that are lower than they were in the latter part of 2007 and the beginning of 2008,” observed Jahnle. “However, the drop in prices was not much and I believe valuations have stabilized.
“Keep in mind that, even as some sellers took their lab businesses off the market because valuations were down, buyers for these same lab companies would have moved forward with a postponed transaction despite the slower acquisition market—if the seller would have taken a lower price. That is a reminder of the strong demand for laboratories.
Follows Stock Market Trends
“Laboratory valuations track the general economy and how the stock market values public laboratory companies,” he stated. “For example, the high values of lab businesses seen in late 2007 and early 2008 were closely linked to the stock market valuations at the time.
“Typically, the prices at which shares of public lab companies like Quest Diagnostics Incorporated and Laboratory Corporation of America trade tend to be what influences the valuation of privately-owned clinical laboratories and anatomic pathology companies,” noted Jahnle.
“To illustrate, take the price-to- revenue multiples paid for completed laboratory acquisitions,” he explained. “Compare these to the revenue multiples at which the stock of public lab companies trades. There is a very close correlation. The ups and downs in the stock market are mirrored in the valuations paid to laboratories acquired in the same time period.
Tracking Valuation Trends
“For laboratory owners, a good valuation bellwether is the collective prices for stocks of publicly-traded lab companies,” added Jahnle. “In a sense, you could say that ‘as goes the share prices of Quest Diagnostics and LabCorp, so goes the broader trend line for the valuations of labs acquired during that time.’
“This valuation relationship for clinical labs and anatomic pathology companies has been true over the past two decades,” he said. “It continues to be true today.
Valuation Follows Market
“A recent example demonstrates this principle,” continued Jahnle. “Earlier this month, Sonic Healthcare, Ltd., of Sydney, Australia, said it would acquire 100% of Medhold NV, a clinical pathology laboratory in Antwerp, Belgium, for $316 million. Sonic said that the price paid represented a multiple of 8.4 times earnings before interest, taxes, and depreciation (EBITDA).
“For Medhold, a valuation of 8.4 times earnings is just about the same multiple that the current share price for Quest Diagnostics represents,” he observed. “Thus, the stock market’s valuation multiple for Quest’s EBITDA is within the same range as the price paid for Medhold NV. Therefore, the price paid by Sonic Healthcare is consistent with this trend.”
Although cautious about predicting what lies ahead for laboratory mergers and acquisitions during 2010, Jahnle was willing to share some insights. He emphasized that there are at least four buyers with the financial capability to do almost any size deal.
“On the anatomic pathology side, there are a number
of acquirers that were active in the final months of 2010…”
“Of course, LabCorp continues to be bid strongly for laboratory acquisitions as they come to market,” offered Jahnle. “Similarly, Quest Diagnostics continues to seriously evaluate the laboratory companies which come to market.
“Sonic Healthcare has been one of the more regular acquirers in recent years,” he noted. “I expect Sonic will continue to use lab acquisitions to expand its presence in the United States.
“The surprise player for 2010 is the return of Welsh, Carson, Anderson, and Stowe to the laboratory business,” explained Jahnle. “In just a few weeks, Welsh Carson snapped up Spectrum Laboratory Network and then merged it with Carilion Labs. By combining these two laboratory companies, Welsh Carson now owns one of the nation’s largest clinical laboratory businesses. Plus, it has the financial resources to pursue other large laboratory acquisitions.
Anatomic Pathology Labs
“On the anatomic pathology side, there are a number of acquirers that were active in the final months of 2010,” he stated. “Two large pathology groups did deals with private equity investors. American Pathology Partners and Aurora Diagnostics, Inc., continue to actively pursue acquisitions of anatomic pathology laboratories.”
THE DARK REPORT observes that another factor likely to fuel an active year for laboratory mergers and acquisitions is the looming retirement of pathologists of the baby boomer generation. Anatomic pathology group practices will need a source of capital to cash out retiring partners. During 2010, the oldest baby boomer pathologists turn 64 years old. This demographic trend is likely to play a significant role in anatomic pathology mergers and acquisitions going forward.
In turn, a growing number of private pathology groups that accept investment capital from professional investors will become a new force for changing the competitive dynamics in the anatomic pathology marketplace. For these reasons, 2010 may turn out to be a year of significant change for the anatomic pathology profession.