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Reaching for a Cool One

(Guest Commentary by Rick Konrad – July 16, 2009)

Dear Subscribers and Readers,

For those who had wanted to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have again brought in one of our regular guest commentators, Mr. Rick Konrad for a guest commentary.  Rick is a regular guest commentator and usually writes for us every third Wednesday of the month.  We highly appreciate your investment insights and general wisdom, Rick!

In this commentary, Rick will start off with a discussion on the schizophrenic nature of the financial markets – then moving on to the current “healthcare debate,” and finally to a discussion of the Clinical Laboratory Testing industry – an industry that Rick is still uncovering values.  Without further ado, following is a biography of Rick:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator of MarketThoughts (please see “Diving In” for his last guest commentary).  Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years.  You can view a more complete profile of Rick on his blog.  You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been involved with grading CFA examinations.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.


The schizophrenic nature of markets never fails to amaze me. A brief review of the year…prior to the stock market's turn in early March, the pundits fretted about the possibility of a re-enactment of the Great Depression. With a full-fledged rally (in which Henry stormed through with a 125% equity allocation) the catch-phrase of the year became the now, much over-used “green-shoots.” As employment figures cast doubt on the health of the consumer, those stocks rolled over as well as the reflation stocks. Suddenly, Goldman Sachs hits it out of the park followed by Intel, both handily beating expectations. As I write this on July 15th, the market is at session highs and the market internals are very strong with advances to declines at over 8 to 1. Equity markets have provided as much excitement as the Federer/Roddick marathon at Wimbledon.

First, a bit of a reality check. The Intel numbers certainly were well above expectations even with the legerdemain of pro-forma numbers. But how good are they? Analysts seemed quite surprised by the significant improvement in gross margins. But, given the lessons of history, this is hardly unprecedented for Intel. Check out this chart (courtesy of CashFlowAnalytics.com)

Intel Corp (INTC) - Gross Margin from Core Operations (Quarterly)

Gross profit margins did recover nicely to 50.83% versus 45.32% in the prior quarter. However, in 2007 the company experienced a similar recovery between the second and third quarters, going from 46.95% to 52.37%.

At about 19 times trailing earnings, INTC seems to be anticipating a fairly rapid return to profitability. Yet, when we again look at the actual ROE numbers, there is still little more anticipation than reality.

Intel Corp (INTC) - Return on Average Equity (Quarterly)

The ROE has more than doubled from the lows established in the prior quarter of 5.1% to the current 10.8%. However, a year ago ROE was 17.6% for the corresponding quarter. Looking at this metric on a trailing twelve-month basis also reflects just how much profitability in this industry has deteriorated:

Intel Corp (INTC) - Return on Average Equity (Four Quarters)

Though I do believe that INTC is a terrific franchise with commanding market share, my view of its value is in the $20-22 range. I am looking for an exit rather than establishing new positions at current levels for clients.

Where am I finding value? In the summer's heat, I like reaching for a cool one, whether a brew or a low-expectations stock. The beginning healthcare debate will likely produce many low expectations in some names relative to the most likely outcomes. The battle here is just beginning. This is an incredibly complex and controversial issue. The first cut at health-care legislation has just come out of the Senate. The Senate Health, Education, Labor and Pensions Committee bill would create a controversial government-run health insurance plan and require employers to provide health coverage for workers or face stiff financial penalties. The bill has received heavy criticism from business groups and Republicans, who say it would come at too high a cost to taxpayers and the private sector.

Fewer and fewer Americans have health insurance, and therefore cannot afford good medical care. Nearly 46 million Americans have no insurance, and 25 million more are underinsured. One major reason for this crisis is that many employers have stopped offering insurance to employees because of the high cost. In the United States, total health care spending was $2.4 trillion in 2007 -- or $7,900 per person -- according to an analysis published in the journal Health Affairs. The United States spends 52 percent more per person than the next most costly nation, Norway, according to the Kaiser Family Foundation.

There are often allegations concerning the wastefulness of government  healthcare spending. Clinical research presents health care providers with information on the natural history and clinical presentations of disease as well as diagnostic and treatment options. Consumers, patients, and caregivers also require this information to decide how to evaluate and treat their conditions. All too often, the information necessary to inform these medical decisions is incomplete or unavailable, resulting in more than half of the treatments delivered today lacking clear evidence of effectiveness.

Comparative effectiveness research (CER) identifies what works best for which patients under what circumstances. Comparative effectiveness quite simply means comparing two or more treatments for a given condition. Studies may compare similar treatments, such as two drugs, or it may analyze very different approaches, such as surgery and drug therapy. Comparative effectiveness evaluations may focus only on the relative medical benefits and risks of each option, or they may also weigh both the costs and the benefits of those options. In some cases, a given treatment may prove to be more effective clinically or more cost-effective for a broad range of patients, but frequently a key issue is determining which specific types of patients would benefit most from it.

Congress, in the American Recovery and Reinvestment Act (ARRA) of 2009, tasked the Institute of Medicine (IOM) to recommend national priorities for research questions to be addressed by CER and supported by ARRA funds. To put things into perspective, the $1.1 billion appropriated for this CER research can be compared to the $894 million that Pfizer paid to settle claims for Bextra and Celebrex or the $4.9 Billion reserve that Merck put up to handle the Vioxx claims. In its 2009 report, Initial National Priorities for Comparative Effectiveness Research, the authoring committee establishes a working definition of CER, develops a priority list of research topics to be undertaken with ARRA funding using broad stakeholder input, and identifies the necessary requirements to support a robust and sustainable CER enterprise.

Here is a list of some of the initial research topics.

As this research develops, there will be clear beneficiaries and victims that will be distinguished and highlighted, a real division of haves and have nots. Barron's featured an article by Bill Alpert on July 6th which we have excerpted:

Issued Tuesday, the reports by the Institute of Medicine and the Federal Coordinating Council for Comparative Effectiveness Research suggest the priorities for spending $700M of the research program's funds under the American Recovery and Reinvestment Act of 2009. Neither report identifies particular products or companies for scrutiny, but many suggested studies clearly would zero in on money-makers from identifiable companies. At the top of the Institute of Medicine's list is the comparison of heart-arrhythmia drugs with device-based treatments marketed by Medtronic (MDT) and St. Jude Medical (STJ). Surprisingly high among research priorities is the need to examine "balance training" services that home-health-care outfits such as Amedisys (AMED) promote for the prevention of injurious falls by older adults. Such programs have been a fast-growing source of profits in the home-health business. Another top priority is examining the use of pricey biologics for fighting auto-immune diseases such as arthritis and ulcerative colitis. Those biotech treatments include Humira from Abbott Laboratories (ABT), Remicade from Johnson & Johnson (JNJ) and Orencia from Bristol-Myers Squibb (BMY). Also being spotted are the expensive tests for antibiotic-resistant staph germs, now sold by Cepheid (CPHD) and Becton, Dickinson (BDX). Many hospitals have said they can better contain resistant germs by paying careful attention to low-tech anti-infection practices. They are also urging a comparison of conventional prostate-cancer surgery with surgery that uses the $1.3M robot from Intuitive Surgical (ISRG) or treatment with radiation. Another suggested study would compare non-drug treatments for attention-deficit hyperactivity disorder with treatments using drugs such as the bestsellers marketed by Shire (SHPGY). Somewhat lower on the list of suggested studies were the comparison of exercise as an osteoporosis treatment versus bisphosphonate drugs such as Actonel from Procter & Gamble (PG) or Fosamax from Merck (MRK). Spinal fusion should be compared with artificial cervical disks, such as the Prestige device sold by Medtronic. Still lower on the recommendation list were studies of the expensive new drugs from Genentech (DNA) used to fight the progressive blindness known as macular degeneration; the suction treatment marketed for chronic skin sores by Kinetic Concepts (KCI); and doctors' off-label prescribing of antipsychotic drugs like Zyprexa from Eli Lilly (LLY), Seroquel from AstraZeneca (AZN) and Risperdal from J&J. Those three antipsychotics have numbered among Medicare's top 10 expenditures under the Part B program.

I think there are some sectors of healthcare which are less vulnerable to scrutiny by virtue of their efficiency, effectiveness, and their important role. As well, they appear to be interesting values.

Clinical laboratory testing seems to be one of the few bargains in healthcare. Such testing provides probably about 80% of the information that physicians might use in their decision-making yet account for less than 2% of overall healthcare spending. I suspect that under a doctrine of comparative effectiveness which should lead to better understanding of the value of various procedures, the data that will be culled to make the proper assessments will come from the clinical lab. Among the clinical labs, we favor Quest Diagnostics (DGX). The company generates more than 90% of its revenue through clinical testing, anatomic pathology, esoteric testing, and substance abuse testing at its national network of 2,100 patient service centers. Quest and its only national competitor, LabCorp (LH), dominate the independent diagnostic testing landscape and have scalable cost advantages over regional competitors.

DGX has renegotiated most of its large managed-care contracts for multiyear periods and in fact, turned down non-economic pricing for some contracts that have been accepted by LH. These moves should lead to fairly stable pricing over the next few years. As the uninsured begin to fill the system, no doubt reimbursement will fall. Yet, it seems that the incremental cost of additional patient tests is relatively low. There is some economic sensitivity in DGX as employment drug-abuse testing wanes during a recession.

Here is a look at the fundamental valuations courtesy of Reuters.

Here is a look at the progression of its profitability courtesy of CashFlowAnalytics.

Quest Diagnostics Inc (DGX) - Return on Average Equity (Four Quarters)

Here is a look at the quarterly cash flow progression courtesy of CashFlowAnalytics.

In a similar space, as a supplier to this industry, is Beckman Coulter (BEC). Beckman is an industry-leading provider of both diagnostic instruments and consumables, focusing on the needs of medium-size to large hospital laboratories. Beckman has created value for its clients with its automated diagnostic systems that simplify laboratory processes by combining several testing systems into one platform and reduce the need for difficult to find skilled labor. Automated systems also reduce test errors, which, combined with streamlined testing processes, leads to more-efficient testing and lower costs for clinical labs. BEC has a large installed base (200,000 systems) which creates an important competitive advantage in that switching costs are high given the investment in equipment and training. Hence, BEC also has developed a significant recurring revenue stream of high-margin consumables.

In a recent Wall Street Transcript interview, Scott Garrett, the company's CEO described the cost to perform tests on an inflation-adjusted basis being less than half of what it cost in 1985. He highlighted the most recent quarter:

We had very good solid recurring revenue growth - we were up 5% in constant currency. We did, however, have weaker cash instrument sales, attributable to two factors: very challenging comparables from the year before and clearly the economy today is making capital expenditures a lot more difficult. All of our customers are being very careful with their capital, and therefore our cash instrument sales were down almost 20% on a constant currency basis. However, about 80% of our revenue comes from recurring sources, which are the reagents, other consumables, the lease payments, and the service that goes with our diagnostics equipment. Recurring revenue really signals the stability of our sector and drives gross profit growth. We are in a very fortunate position in this economic environment to have the recurring revenue stream that we do. In addition, in the first quarter, we benefited from some very effective cost-containment efforts. We got those started in the second half of 2008 and we were able to deliver a 5% decrease in overall operating expenses in the first quarter. Finally, the first quarter was a great quarter for expansion of earnings and cash flow, despite a very challenging economy and operating environment. Our earnings grew 9% on a fully diluted basis and earnings before interest taxes, depreciation, and amortization increased by 13%. Operating cash flow was up $44 million to a total of more than $100 million. We came through the first quarter with a sustainable business that is well positioned to weather this economic storm.

The firm's acquisition of Olympus Corporation's diagnostics unit expands Beckman's global reach and adds cross-selling opportunities with a fresh customer base. Half of which is in Europe.

Here is a look at the fundamental valuations courtesy of Reuters.

Here is a look at the progression of profitability courtesy of CashFlowAnalytics.

Beckman Coulter Inc (BEC) - Return on Average Equity (Four Quarters)

Finally, here is a look at the progression of quarterly cash flows as per CashFlowAnalytics.

I suspect that there is significant value to be had focusing on some of these healthcare names as well as others that I intend to review both here and in Value Discipline. Though healthcare costs have been much decried, Scott Garrett in his Wall Street Transcript interview points out some of the legitimate benefits of healthcare progress:

I would like to add that we believe diagnostic testing has really proved its effectiveness. When we think about healthcare costs today, we really need to compare the outcomes today with outcomes from previous years. For instance, in the last 25 years, the mortality from heart diseases has been cut in half, stroke deaths by one-third, breast cancer deaths by 20%, and overall disability among the elderly by 20%. While healthcare costs may be an issue, we need to recognize the benefits that we all get from our healthcare system and medical technology innovations. We really need to look at the overall value, not just the cost, as we consider the great healthcare debate that's being carried out right now.

Disclaimer: I, my family and clients may have a position in some of the securities that have been mentioned in this post.

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