LabCorp Battling Flat Free Cash Flows

LabCorp (NYSE:LH) bills itself as the largest independent clinical lab tester in the U.S. Hospitals dominate most of the market, but LabCorp and its archrival have succeeded by growing internally and pursuing a healthy acquisition program. These dynamics played out during LabCorp's second quarter, and though its valuation is quite reasonable, cash flow growth remains an issue. TUTORIAL: Top Stock-Picking Strategies

Second Quarter Recap
Revenues advanced 13.3% to $1.4 billion. Organic volume grew 2% while total growth consisted of a 4.8% boost in testing volumes and high single-digit pricing growth. The acquisition of Genzyme Genetics was also a significant contributor to the top line and contributed 7.6 percentage points of the quarterly revenue growth.

Management also cited improvements in shifting testing to higher-margin sources, such as esoteric testing that consists of genetic testing and is an area that rivals including national provider Quest Diagnostics (NYSE:DGX) and Bio-Reference Labs (Nasdaq:BRLI) on the East Coast are also after. During the quarter, LabCorp stated that this type of testing grew to account for 40% of total revenue. It has a long-term goal to boost this to 45% of the top line.

Reported operating income fell 16.6% to $225.7 million, though management detailed that recurring operating income was closer to $280 million when adding back restructuring and special charges related to acquisitions of Genzyme Genetics, Westcliff and a legal settlement in California over allegations LabCorp overcharged the state's Medicaid program. Reported net income was $122.9 million, or $1.20 diluted share, but on this adjusted basis earnings increased a modest 5.1% to $1.64 per diluted share. This came in ahead of analyst projections.

Outlook
For the full year, management projects sales growth between 9.5 and 11.5% from the $5 billion it reported in 2010. Its adjusted earnings guidance is currently in a range of $6.17 and $6.32 per share, or year-over-year growth as high as 16.6%.

The Bottom Line
Management expects solid sales and earnings growth for 2011, but its free cash flow guidance of $750 million, or $7.30 per diluted share, suggests cash flow production will be flat for the third straight year. The forward free cash flow multiple is still pretty reasonable at below 13, but shareholders will eventually need to see higher levels of cash flow generation going forward.

LabCorp and archrival Quest have relied on acquisitions for a major part of their growth strategies given hospitals and other lab providers own about 75% of the $55 billion domestic lab testing market. LabCorp recently acquired Clearstone Central Labs to add exposure to late-stage clinical trials services to suggest it is having to move beyond its more traditional clinical lab testing business. Moving to contract research outsourcing services puts LabCorp in competition with firms including Icon plc (Nasdaq:ICLR) and Covance (NYSE:CVD) and adds a new list of potential buyout candidates. (For additional reading, be sure to check out A Checklist For Successful Medical Technology Investment.)

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