I’m a big fan of stocks that offer support services to large industries.
Healthcare is a massive component of our economy, so I normally like the prospects of businesses that the industry relies on — like diagnostic services.
Two of the biggest players in that field are Quest Diagnostics (NYSE:DGX) and Laboratory Corporation of America (NYSE:LH). Combined, they generate $13 billion in revenue annually.
But the big question on the horizon is how these companies will be affected by Obamacare.
My guess is they’ll do just as well, if not better, than they did before the changes. I expect the government and insurance companies will require people to get all sorts of tests to absolutely, positively make certain that any procedure is really necessary, which would increase revenues for diagnostic labs.
On the other hand, companies like these are capital-intensive, labor-intensive and require massive infrastructure. And as Medicare cuts its reimbursement rates, diagnostic services companies will suffer along with the rest of the industry.
So what’s the diagnosis for these two laboratories? Both companies reported earnings last week, and as you’ll see, each of them faces challenges.
Quest’s adjusted EPS fell almost 17% on a 7.7% decrease in revenue, and missed estimates by 14 cents (reporting 89 cents per share). The company has instituted cost-cutting measures — good for earnings, but also a sign of a company in distress. Quest also shed two divisions so it could concentrate on “core diagnostic information services,” which probably isn’t a good sign.
Requisition volume was down 3.4% year over year, possibly related to the transition going on in insurance ahead of Obamacare. Doctor’s office visits have declined, pricing has flattened and organic revenue has lowered as well. The company’s cash reserves are down to $134 million, compared to $295 million in the previous quarter. Even worse, operating cash flow was only $47 million, compared to $161 million a year ago.
On the other hand, the company did chop its debt down by $207 million.
But a company trading at 13x earnings on flat growth this year, and 10% long-term growth, isn’t a business I’d be happy owning right now.
Laboratory Corporation of America
Laboratory Corporation isn’t faring much better. Revenue was only up 1.2%, leading to adjusted EPS of $1.74 — flat over last year but missing estimates of $1.77. Testing volume was up a mere 1.1% and revenue per requisition inched up only 0.2%.
Gross margins deflated by 80 basis points to 39.7%, partly due to a 4.4% increase in SGA. (At least Quest managed to cut SGA by 7%.) LH sits on $185 million in cash, way down from $467 million at the end of 2012, while operation cash flow was up a fraction of one percent to $198 million.
The company trades at almost 16x earnings, and a PEG ratio of 1.3. Given the company’s struggles and questionable industry trends, LH doesn’t look much better than its competitor.
Based on disappointing earnings reports and broader industry uncertainty, I think investors would be wise to remove these stocks from their portfolios.
As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities, and hopes Quest employees do not take this article personally next time they stick a needle in him.