Strong Covid-19 testing demand is helping clinical laboratory fundamentals during the pandemic.Despite the widespread vaccine roll-out in the U.S., the delta variant is prolonging the pandemic.We forecast above-consensus revenue and EPS growth for clinical laboratories providers such as LH and DGX in 2021 and 2022.

Fundamental Context

Clinical laboratories have benefitted tremendously from the pandemic. The two largest independent U.S. clinical laboratories in the U.S., Labcorp and Quest, have seen fundamentals blossom from new Covid-19 testing required to manage the pandemic. A new series of tests (PCR and antibody) became in immediate demand, with an addressable market spanning the whole country. As seen in Figure 1, diluted EPS growth ballooned from a 10-year CAGR of 5% for both Labcorp and Quest, to 90% growth in 2020 for Labcorp and 71% for Quest.

A new product line emerged. On March 5, 2020, Labcorp became the first commercial laboratory in the U.S. to launch PCR testing for Covid-19, and the company received Emergency Use Authorization (EUA) from the U.S. Food and Drug Administration (FDA) on March 16, 2020. Labcorp steadily increased its Covid-19 test capacity, from several thousand PCR tests per day in early March to 275,000 per day by the end of 2020. LH performed over 31 million PCR tests and nearly 4 million antibody tests in 2020. By the end of 2020, LH won approximately 440 Covid-19 trial and study opportunities, from small nonclinical programs to late-stage clinical trials.

In 2020, Quest Diagnostics provided both molecular diagnostic and antibody serology tests to aid in the diagnosis of Covid-19 and the detection of immune response to the virus and performed over 30 million of these tests.

An increase in Covid-19 testing was initially met with a decline in base testing. As Americans put off routine doctor visits during the pandemic, routine testing volumes declined. Base testing includes blood chemistry analyses, urinalyses, blood cell counts, thyroid tests, PAP tests, prostate-specific antigen (PSA), tests for sexually transmitted diseases, vitamin D, alcohol, and other substance-abuse tests, as well as specialty testing services like gene-based tests. We focus on examples from Labcorp, though Quest’s business followed a similar trajectory. In the initial months of the Covid-19 pandemic, Labcorp experienced a significant drop in its non-Covid-19 business (Base Business) as patients postponed routine medical care and elective (non-emergency) procedures. For example, early in the pandemic during Q2 2020, organic revenue declined 21% year-over-year from LH’s Base Business, while Covid-19 testing increased 15%.

In addition, most global clinical trial activity was suspended, also resulting in a negative impact to LH’s Base Business in the latter part of the first quarter and the initial part of the second quarter of 2020. After the initial drop, LH experienced a steady recovery in its Base Business, which continued through the third quarter of 2020. During the fourth quarter, LH’s Base Business volume recovery flattened with volumes below prior year in the high single digits. Throughout 2020, the Company’s PCR and antibody Covid-19 testing (Covid-19 Testing) has helped to more than offset the pressure experienced in the Base Business.

Base testing revenues have staged a strong recovery in 2021. For Labcorp, revenue increased 43.1% during the first half of 2021 compared to the corresponding period in 2020. Of this 43.1%, organic revenue increased 40.3%, including a 23.8% increase in the company’s organic Base Business and a 16.6% contribution from Covid-19 Testing. The Labcorp Diagnostics (Dx) business segment experienced 50.9% revenue growth year-to-date in 2021 through June, with the largest contributors being a 27.3% increase in Covid-19 testing and a 21.9% increase in the Base Business testing. The Labcorp Drug Development (DD) business segment is also benefitting from a broad-based demand recovery, including Covid-19 vaccine and therapeutic work.

Vaccine emergency use authorizations began in December 2020. The U.S. Food and Drug Administration issued the first emergency use authorization (EUA) for a vaccine for the prevention of coronavirus disease 2019 in individuals 16 years of age and older on December 11, 2020. President Biden announced that U.S. would produce enough vaccines for every adult in the U.S. by the end of May 2021, with all U.S. adults eligible by April 19, 2021. Even with vaccines available to all Americans, Figure 2 below demonstrates the change in tests per day hit another inflection point in July as the delta variant began spreading and herd immunity was not reached. We anticipate testing will remain for longer than the market expects, given the ability for the virus to continue mutating and spreading before eventually becoming endemic

Consensus estimates for revenue and EPS growth moderate over the next 18 months. Figures 3 and 4 show the S&P Capital IQ consensus estimates for revenue growth and normalized EPS growth for the remainder of 2021 and for 2022. We note that forecasts point to a lower revenue growth rate for both LH and DGX in 2021, followed by a decline in 2022. Consensus estimates for normalized EPS, on the other hand, average to flat growth in 2021, followed by a sizable decline in 2022.

Our revenue and EPS forecasts for 2022 are above consensus. We have a more optimistic view of revenue and EPS growth than the market. Seeing recent trends related to testing (Figure 2), we anticipate Covid-19 testing will remain a key theme and performance driver over the next 18 months given new variants such as delta. We also believe Covid-19 testing will remain a requirement in many circumstances over the next 18 months, for example, prior to surgeries, travel, in schools, and in workplaces.

We also see the potential for PAMA, The Protecting Access to Medicare Act, to continue to be suspended in 2022, which would protect LH and DGX from scheduled reimbursement rate reductions. As a result of provisions included within the CARES Act, passed by Congress in 2020, PAMA rate reductions for 2021 are suspended. Without suspension, PAMA would allow for test prices to be reduced by up to 15.0% per year between 2022 and 2024. We also anticipate the possible continuation of the Medicare Sequestration suspension, currently scheduled to go until year-end 2021, which results in higher reimbursement rates for diagnostic testing services performed on behalf of Medicare beneficiaries. For more information on Medicare, please refer to the Appendix at the end of this report.

Risk Factors

There are several risks to our opinion, including a rapid end to the pandemic. These risk factors could result in consensus estimates being fairly stated, or overstated, contrary to our thesis. These risks include – a rapid global vaccination effort that ends the pandemic sooner than expected, the end of the Medicare sequestration suspension or the Protecting Access to Medicare Act suspension beginning in 2022, and/or a strong reversal of recent positive trends for LH’s and DGX’s base business recoveries.

Company Implications

Laboratory Corporation of America Holdings (LH 307 *****) is one of the largest independent U.S. clinical laboratories. Clinical laboratory tests are used by medical professionals in routine testing, patient diagnosis, and in the monitoring and treatment of disease. Labcorp became the first commercial laboratory in the U.S. to launch PCR testing for Covid-19. We anticipate LH’s fundamentals are likely to outperform market expectations. LH stands to benefit to from its rapidly growing Covid-19 testing capacity and longer-term, its base testing business, which conducts 530 million tests a year. We anticipate small labs could succumb to financial pressure in the current environment and become attractive acquisition targets, boosting growth inorganically. We forecast EPS will fall 19% in 2022 to $19.30; our 12-month target price of $352 reflects an 18.2x multiple of our 2022 EPS estimate, a premium to LH’s historical forward average.
Quest Diagnostics Incorporated (DGX 158 ****) is a leading independent U.S. clinical lab operator. DGX offers a broad range of clinical laboratory testing services used by physicians to detect, diagnose, and treat diseases. We think DGX’s shares are undervalued. DGX runs an essential business during Covid-19 and is likely to benefit from elevated demand from coronavirus testing and receive ongoing government support during the pandemic. Goodwill built during the pandemic may help in future reimbursement rate discussions with Medicare, given DGX processes an estimated 25% of U.S. Covid-19 testing volumes. DGX has maintained a strategy since November 2018 to grow revenue each year by more than 2% compound annual growth rate through accretive, strategic acquisitions. Although the merger and acquisition environment significantly slowed in 2020 due to the Covid-19 pandemic, we anticipate the rate of acquisitions may gain speed in 2022. We forecast EPS will fall 11% in 2022 to $10.20; our 12-month target price of $162 reflects a 15.8x multiple of our 2022 EPS estimate, a premium to DGX’s historical forward average.