Healthcare Valuations Are Out of Whack

Ted is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

There is so much uncertainty surrounding the health care reform law that many stocks in the sector are trading out of line with their intrinsic value. This creates a buying opportunity for discerning investors who are willing to buy and hold these undervalued companies for many years.

Although there is a high level of uncertainty in managed care providers and health insurers, there is less uncertainty as to the future prospects of diagnostic lab testing. As more people get added to the health care system -- supposedly everyone in America by 2014 -- the demand for diagnostic tests will skyrocket.

The two biggest companies in the diagnostic testing space are LabCorp (NYSE: LH) and Quest Diagnostics. However, recent price movements have rendered LabCorp the cheaper of the two.

Strong Market Position

LabCorp and Quest dominate the industry; they are the only two companies with a national reach. Both companies have built out regional economies of scale and have translated the advantage all across the U.S. Quest has entered into long-term contracts with its managed-care customers, which provides predictable income over the length of the contracts. LabCorp has pursued as similar strategy with its customers.

However, Alere (NYSE: ALR) is trying to disrupt the duopoly. The company has a good diagnostics segment, but it is also pouring money into a mediocre health management business. The combination of a diagnostic lab and a health management business is a unique one, but is so far unproven. While Quest and LabCorp have earned the consistent profits that are expected in a low-competition environment, Alere has struggled to maintain profitability.

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As a result, it is unlikely that Alere will disrupt the industry any time soon.

Only Upside Remains

After doing much better than just surviving the economic downturn, LabCorp has only good things on the horizon. For one, the aging U.S. population will be an enormous boon to the business because middle-aged and elderly patients require regular lab tests as a means of preventative care. Many of these tests are becoming increasingly complicated as new methods are devised to diagnose problems that leads to more expensive tests and thus higher margins for LabCorp.

In addition, LabCorp is increasing customer captivity by way of its software platform. The platform enables doctors to store medical records in the same program that LabCorp distributes its diagnostic testing data. As a result, it is somewhat of a pain to switch lab testing providers, which leads to a captive customer base for LabCorp.

Be Greedy When Others Are Fearful

To say that Mr. Market is completely ignoring LabCorp's value is a bit of an overstatement, but the stock sold off in 2011 when it became apparent that margins would be lower than normal.  The stock has yet to fully recover from the sell-off.

Until 2011, the company had a long history of posting a free cash flow margin of almost exactly 15%. However, that margin fell to just below 13% in 2011.

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It's typical of the market to overweight the last data point, which is why the stock is still cheap today. Nothing has occurred that could convince me that this will be a 'new normal' for LabCorp; there simply isn't any reason why the company should earn less than its historical average 15% free cash flow margin in the future.

If the company were to earn a 15% free cash margin on TTM sales of $5.632 billion, it would produce $845 million in free cash flow. At a 15x multiple (this is a duopoly, after all), the company should trade for $132 per share. At a recent price of $88.51 per share, LabCorp looks like a safe bet.

titans8904 has no position in any stocks mentioned. The Motley Fool recommends Laboratory of America and Quest Diagnostics. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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