Wednesday, Credit Suisse downgraded Quest Diagnostics Inc. (DGX) and Laboratory Corp. of America Holdings (LH) shares to Neutral from Outperform. The brokerage lowered its price target on DGX stock to $57 from $64, and on LH stock to $71 from $78. The brokerage reduced its 2010 EPS estimate for DGX to $4.23 from $4.29, and for LH to $5.27 from $5.37.
Analyst Giacobbe believes pricing headwinds, a slowing growth rate, and potential cuts from healthcare reform puts 2010 estimates at risk and constrains if not contracts valuation multiples. Labs are expected to see a 1.9% cut to Medicare payment rates in 2010 after a 4.5% increase in 2009.
More importantly perhaps is that the analyst expects managed care pricing to also face headwinds next year, an underappreciated risk in his opinion. The analyst estimates that combined Medicare and managed care pricing headwinds could pressure top-line growth by 150 bps. This would serve to limit any expected upside from a return to normalized volumes.
In the analyst's view, he is witnessing a maturation of the lab industry particularly as it relates to the large providers. The analyst sees slowing organic growth, lack of sizeable acquisition targets, and limited margin expansion opportunities. This all translates to a more measured rate of growth that carries with it a lower valuation multiple, in the analyst's opinion.
The analyst foresee a large international acquisition or large non-core deal from at least one provider if not both in the next 12-18 months to potentially help boost a slowing growth profile. The analyst noted that DGX and LH have discussed opportunities outside their U.S. domestic operations. A large deal outside of the existing core domestic business could be met with caution/skepticism given heightened risks/challenges of integrating a new business and/or new region.
The labs have largely stayed out of the fray of the HC reform debate. However, the analyst has recently seen headlines that suggest labs may not emerge unscathed. Despite the headlines of potential cuts, the analyst has been surprised at how well the group has held up. While cuts may be more measured than what the current headlines suggest, any payment reduction would create additional risk to current estimates, in the analyst's view.
The analyst continues to view labs as a core holding in HC services given solid business model, limited relative exposure to government reimbursement, strong free cash flow generation, and solid ROIC profile. Nevertheless, the analyst is concerned with expectations for 2010, and believes valuation will begin to reflect a slowing growth profile limiting upside over the next 12 months.
Currently, DGX is down $0.73 or 1.37% and trading at $52.51. LH is currently trading at $65.96, down $2.47 or 3.61%.
For comments and feedback: editorial@rttnews.com