Bio-Reference Labs (Nasdaq:BRLI) is an odd diagnostics company. It combines a somewhat sleepy conventional diagnostics business centered on the Northeast (New York City, in particular) with a nationwide esoteric testing business. The company has had a less-than-spectacular record of cash flow generation and cash conversion, but it has improved significantly in recent times. While its smaller scale and fierce competition from Quest (NYSE:DGX) and LabCorp (NYSE:LH) are risk factors, growth in the esoteric testing business could make this a name worth following.

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Diagnostics a Good Place to Be
As a testing services provider, Bio-Reference Labs is in a pretty attractive business. Unlike much of the healthcare sector, these companies don't live in any particular fear of government reimbursement. While Medicare and Medicaid are major components of the overall U.S. healthcare industry, Medicare and Medicaid are only about 20% of the business for Quest, LabCorp, and Bio-Reference. While that does not mean they're immune to reimbursement pressures, it does give them a much lower exposure than companies like Lincare (Nasdaq:LNCR) or even a larger diversified drug and device company like Johnson & Johnson (NYSE:JNJ).

Another benefit to the diagnostics service industry is that it exploits the R&D competition of others. While there is an arms race to develop, posses, and market exclusive tests, this sector benefits from the competition between companies like Abbott (NYSE:ABT), Bio-Rad (NYSE:BIO), Becton Dickinson (NYSE:BDX) and Luminex (Nasdaq:LMNX). These companies are all competing to develop systems and tests that offer economic advantages to companies like Bio-References in terms of greater throughput, improved accuracy and less hands-on time.

SEE: Companies Playing Catch-Up With The Competition

Combining Regional and National
Bio-Reference has a somewhat different model. The company is relatively large in terms of regional routine test providers, and holds a strong share of the New York market. It's a smaller player on the national scope, though, but is seeing strong growth from its molecular diagnostics capabilities and units like GenPath and GeneDx. A fair bit of the 19% revenue growth seen in the last quarter, for instance, was due to the growth of this esoteric testing business.

The question is whether Bio-Reference can compete on a nationwide basis for the long-term. LabCorp and Quest have substantial resources, as to other companies like PerkinElmer (NYSE:PKI) and General Electric (NYSE:GE). While tie-ups with small companies such as InCellDx will help give it access to proprietary tests, this is a small company in an arms race where R&D and marketing dollars can make a real difference.

SEE: Crazy Research The U.S. Government Is Funding

Time to Think, and Act, Like a Bigger Company
In many respects, Bio-Reference still behaves like a smaller company and that's not necessarily to the advantage of shareholders. Management seems disinterested in the possibility that it could be an acquisition target, and the company's decision to stick with a smaller auditor has seemingly helped fuel accusations of weak financial controls. Likewise, the company has not historically been very efficient with cash collections and the company's days sales outstanding has been a lot higher than the industry norm in years past.

Some of this is already improving; the company's cash collection cycle has been getting quite a bit better lately. Moreover, I don't think changing auditors just to impress people with a better-known name makes much economic sense. Nevertheless, the company's past decisions and past volatility in financial results opens itself up to trouble and a failure to adopt "big company practices" may well interfere with future growth plans.

SEE: The Evolution Of Enterprise Risk Management

The Bottom Line
Buying Bio-Reference really comes down to an investor's confidence in the growth prospects for the national esoteric testing business. The opportunity is absolutely there; molecular diagnostics is both a double-digit growth market and one that can be measured in the multiple billions of dollars. Moreover, considering the opportunity in markets like cancer, immunology and endocrinology alone, there's plenty of runway here to support many years of double-digit growth at BRLI.

On the other hand, investors have to remember and realize that companies like LabCorp and Quest are already big players in the esoteric market, and that this is a market where strength frequently builds upon strength. This is also a stock already near its 52-week high.

All in all, then, this is a somewhat typical high-risk/high-reward opportunity. As part of a diversified portfolio, Bio-Reference could be a good addition, but I'd wait for a pullback before buying shares.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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