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Morningstar | LH Updated Forecasts and Estimates from 11 Mar 2019

Following LabCorp’s fourth-quarter results that slightly exceeded our expectations on revenue growth, but met our estimates on the bottom line, we’re holding steady on our fair value estimate. Considering the various forces buffeting the diagnostic lab industry, we were generally pleased to see organic diagnostic volume rise 1.8% for the full year. The volume decline first seen in October, which led to management revising its outlook lower in November seems to have recovered in December, when hospitals and health systems increased the referral test volume to LabCorp. Having said that, the negative impact of PAMA remains an issue--slicing 100 basis points of revenue per requisition during the quarter. Despite the turbulent conditions, we remain confident that LabCorp’s narrow economic moat remains intact. We still think it will be extremely difficult for smaller independent labs and hospital-based labs to achieve the compelling cost structure based on volume that the largest diagnostic labs enjoy.

The star of fourth quarter was undoubtedly the Covance drug development segment, which saw organic top-line growth of 9.3%, and adjusted operating margin expansion of nearly 300 basis points compared with the prior-year period. Now that LabCorp has created the data management tools to address trial enrollment concerns while tapping into the diagnostic patient database, the firm has begun to see the fruits of this labor. The firm’s backlog has steadily grown over the last two years. We anticipate this segment should at least match market growth in 2019, as long as Covance has sufficient capacity.

We think it’s noteworthy that the Centers for Medicare and Medicaid Services has begun to back away from the severity of PAMA-induced reimbursement cuts that went into effect this year. As we enter the second cycle of market data collection by labs, CMS is now requiring a larger swath of hospital-based labs to report that data, which should moderate further cuts in 2021.

However, the key word is should. Based on our research, the majority of hospital-based labs remain woefully unprepared from an information technology standpoint to be able to collect private payer reimbursement information on a test by test basis for its hospital outreach patients. In the last round of data collection, approximately 5% of hospital-based labs required to provide this information to CMS ultimately did. Thus, even though the new CMS definition of “applicable lab” has expanded to include approximately 800 more labs reporting, we expect a fair proportion of this group will not be able to comply in the 2019 time frame.

Fortunately, the PAMA law did include a substantial financial penalty for noncompliance—up to $10,000 per day for each lab that fails to report, or each omission in reporting. Unfortunately, CMS failed to enforce this penalty in the last round of data collection. Since then, the Office of the Inspector General has encouraged CMS to enforce this penalty to gain more compliance. Nonetheless, we remain skeptical that this course of action will yield many results in the near term. Hospital administrators largely remain unaware and/or unconcerned about the impact of PAMA cuts, nor of the changing obligations of hospital-based labs to cough up granular private payer reimbursement information to CMS this year. Even if lab directors want to comply with the reporting requirements, a large proportion do not have the IT tools necessary to track and capture this information, and to obtain those tools, it may require further investment by the hospital and provider systems.