Following previous analysis of Laboratory Corporation of America Holdings (New York Stock Exchange:LH) [See: here, and here ] I advocate that the company’s most recent set of numbers further substantiate the buy thesis on this name. Investors are treated double-digit return on invested capital and capital in LH, while multiples now trade at respectable levels after downgrading again in FY22.
Investors can now buy the shares at 12-14x future earnings, below the 5-year forward average P/E of 26.3x. As investors move away from top-line growth stories and toward bottom-line fundamentals, the investment opportunity for LH is plentiful in my opinion as I see its strengths in P&L below from the top line. There is a risk that the market will exceed any penalty from LH’s Covid-19 revenue decline. However, at the moment this seems to be highly anticipated and therefore well valued in the stock. Looking ahead, we think LH should trade at $244 and see upside potential above $249 with the right momentum. Net-net, I rate LH as a buy, target price $244.
Annex 1. Evolution of the price of LH in 6 months
LH Q3 numbers illustrate frontline sensitivity to Covid-19
The company largely acknowledged the sensitivity of the LH topline to Covid-19 testing demand in the third quarter. In particular, quarterly revenue decreased 11.2% year over year to $3.6 billion (“Bn”). The main downside was the substantial year-over-year decline in Covid-19 testing volume. In total, in the third quarter of FY22, Covid-19 testing revenue for LH was down 70% compared to this time last year. The pullback highlights a headwind looking ahead, as a previous medium-term growth lever is now removed.
Since the distribution of income is heavily skewed towards HL diagnosis, the absence of Covid-related income was felt more in this segment. In fact, Diagnostics (“Dx”) segment revenue was down $2.2 billion. [$24.8/share] – a 15.7% YoY decrease – as total volume contracted 10.3% YoY, and price/mix benefit also decreased 540bps. Other than this, drug development revenues amounted to $1.4 billion. [$15.80/share]a drop of 370bps YoY [with ~340bps of forex headwind baked into this result], while the core lab division saw a 980 bps year-over-year decline due to the same challenges. In Ex-Covid tests, each of these segments saw much more respectable results.
The pullback in revenue from Covid also came through P&L vertically. As seen in Exhibit 2, the year-over-year decline in diagnostics resulted in a 47.5% net outflow of operating income. Therefore, Dx’s operating margin fell by around 10 percentage points to 19.9% of turnover. Total operating income decreased 38.7% year over year to $469.4mm [including $65mm of amortization charge].
Figure 2. LH top line sensitivity to Covid-19 test volume revealed in Q3 with significant pullback in billing linked to decreased test demand/volume.
Lowering profit and loss, capital expenditures (“CapEx”) reduced from $118mm to $104mm [$1.17/share], with management projecting a FY22 CapEx margin of 350bps. Net-net saw an inflow of $270mm [$3.04/share] of FCF for the quarter, leading to realized TTM FCF of $1.47Bn [$16.60/share]. Investors also got $65 million in total dividends for the period and the company repurchased $400 million or 1.5 billion of its own common shares. You still have ~$800mm in authorized capital under this repurchase agreement.
Profitability trends continued to return to the range in the third quarter of FY22 for LH following a period of outsized performance, as seen in Exhibit 3. Return on invested capital (“ROIC”) has been narrowly spread with the company’s market value since fiscal 2015, therefore a return to a longer-term range has added to a pullback in LH’s market capitalization. Looking ahead, this is a key number for investors to watch for LH in my estimation.
LH also delivered a return on equity (“ROE”) of 17% on FY22 Q3 earnings, above its 7-year quarterly average of 15.1%. LH is also priced at 2x book value, meaning the investor’s ROE is 7.55% if they pay this multiple. Breaking down ROE further, we see that their net margin has contracted back to pre-pandemic ranges of 9.8%. [from a high of 20.9% in Q4 FY20], while asset turnover has increased to 0.75x and leverage has remained stable. Therefore, the increase in ROE has been realized as a function of the return on existing capital for LH during this time, versus the increase in earnings.
Figure 3. Narrow dispersion and covariance between market capitalization and ROIC for LH
In my opinion, the importance of these profitability measures cannot be underestimated in the case of LH. Since a substantial portion of your last 3 years of income continues to decline, your top line currently remains uncovered against this downside risk. However, LH’s ability to capitalize capital at its [double-digit] The long-term rate of return suggests that you can overcome this hurdle by raising earnings to the NOPAT level, thus adding value in this regard. More weight is placed here given that the final return comfortably exceeds the LH WACC of 8.21%.
Technical factors also favor
Since there are a number of variables at play with LH’s earnings structure, the market has been quite active this year to date. Specifically, I wanted to gauge how the market has perceived the latest drop in revenue and what this means in terms of valuation/price distribution. Therefore, technical studies are essential to understand LH’s price visibility outside of fundamentals and the strength of the order book.
As seen in the chart below, the price action has been leaning higher since October and the stock is now trading above the EMA after crossing below this mark in August. Long-term trend indicators [on-balance volume, momentum] they also suggest a continuation of this trend with both measures simultaneously snuggling in unison with the price distribution.
Figure 4. Stocks Down from 52-Week Lows in October with a Trend Showing Strong Support from OBV and Momentum Studies
The question then turns to what price levels we can expect from this latest move higher. As seen on the chart below, tracing the Fibonacci levels down from the August high indicates that the stock has already retraced ~50% of the low and is currently testing this level once again. To really confirm the uptrend, we would need to see the daily bars break above the $231 level, where the next test would be $239, followed by a target of $249, or ~78.5% of the August high. Therefore, the technical price targets lie at $239 and $249. This is down from our previous price target of $279-$289.
Figure 5. Currently testing the 50% retracement level from the August high, where the bars need to break through to record the $239 price target.
Assessment and conclusion
The remaining LH investment discussion revolves around valuation and the marriage between the fundamental and technical factors of the stock. We project FY22 earnings per share to decline ~30% year over year to $19.86. As seen in Exhibit 6, this gives investors a ~6% equity risk premium on LH [LH earnings yield spread over real risk-free rate]. In perspective, this is in line with the performance of many high-quality corporate bond issues, raising questions about possible risk/reward symmetry.
Therefore, we believe the stock should trade at 12.3x forward earnings, slightly below the 14.1x forward P/E that the market has priced it at. Using our FY22 EPS forecasts and the model seen below, this suggests that LH is worth $244, which, coincidentally, is the arithmetic mean of the two technical targets identified above. While the value gap is relatively small in percentage terms, it aligns with the analysis outlined above, so we reiterate our buy recommendation on this name.
Exhibit 6. Fair value of $244, which is the arithmetic mean of the technical price targets identified above
Net-net, I reiterate that LH is a valuation buy, supported by fundamental momentum coupling and favorable chart studies. The shares appear to have a fair value of $244 each, which corroborates previous analyzes we have done on this name. Buy rate, target price of $244.