Pathology Valuation

Valuation of Medical Laboratories

Amy Graham, MBA
Curtis Bernstein, CPA/ABV, ASA, CVA, MBA
Kyle Rudduck, CFA

Questions@BVResources.com
© 2012 Sinaiko Healthcare Consulting, Inc. Proprietary and Confidential 1

Presentation Outline

 What is Pathology?
 Revenue Cycle
 Expenses
 Valuation


What is Pathology

 Clinical pathology – diagnosis of disease through
the study of bodily fluids, such as blood, urine, or
tissue
– Drug or cholesterol testing

 Anatomic pathology – diagnosis of disease
through the gross, microscopic, chemical,
immunologic and molecular examination of
organs, tissues, and whole bodies
– Autopsy
– Analysis and diagnosis of tissue samples


REVENUE CYCLE


Medicare Payment Overview – Lab Services

Provider’s Charge

Payment is Payment
Fee Schedule
Lab Service Amount set by
carrier

the lesser of
National Limitation
Amount (NLA) (74%
of median fee
schedule amounts
set by carriers)

Note: The vast majority of claims are paid at the National Limitation Amount.


What is a CPT Code?

 Current Procedural Terminology

 Documents information about treatment and other medical
services

 Developed and maintained by the American Medical
Association

 Pathology is its own section of Category I CPT Codes


Understanding Medicare Billing Medicare Physician
Fee Schedule (“MPFS”)

•The Centers for Medicare and Medicaid Services uses the MPFS to reimburse
physician services. The MPFS became effective January 1, 1992 and replaced the old
“customary, prevailing, and reasonable” (CPR) charge system. The MPFS is funded by
Part B and is composed of resource costs associated with physician work, practice
expense and professional liability insurance.

•Under the MPFS, each of these three elements is assigned a Relative Value Unit
(RVU) for each Current Procedural Terminology (CPT®) code. These RVUs are then
adjusted based on the Geographical Practice Cost Index (GPCI) associated with
various geographic areas for different medical costs and wage differentials. The
conversion factor is the national dollar amount that is multiplied by the total
geographically adjusted RVU to determine the Medicare allowed payment amount for a
particular physician service.

•There exist a multitude of “Modifiers” that can be applied to certain CPT codes to
reflect variations of a certain procedure that was performed. Some of the most
common modifiers among them are: multiple procedure (51 or 59 modifier),
professional services only (26 modifier), or technical services only (TC modifier).


Billing for Lab Services

 Clinical labs - The patient and insurance company is billed
 According to MedPac, Medicare is the single largest
purchaser of clinical laboratory services
– Services are covered under Medicare Part B (does not cover routine tests
unless required by law)

 Medicare sets payment rates for more than 1,100 HCPCS
codes used to bill various laboratory services
– According to Medicare approximately 40% of all claims are not billed
correctly and a significant portion of denials are never refiled


Billing for Lab Services (cont’d)

 Many insurance companies use the Medicare rate as a
basis for developing their own reimbursement schedules.
– As goes Medicare, so goes the insurance companies.

 There is no beneficiary cost sharing for clinical lab
services (the fee schedule payment reflects the total
payment received for the service)
 Billing client vs. billing insurance


Understanding Medicare Billing
Professional vs. Technical Split
In the physician office setting, Medicare provides professional (physician
services) and technical (facility fees) reimbursement to the appropriate party,
according to the formula below:
Technical Professional Professional Conversion
Component Component Liability Factor

• Practice • Work RVUs x • Professional • Universal
Expense wRVU GPCI Liability amount for
RVUs x PE • Practice RVUs x PL all CPT
GPCI Expense GPCI codes.
RVUs x PE
GPCI

The formula is set such that the payments made to physicians (professional
reimbursement) plus the payments made to facilities (technical
reimbursement) equal “global reimbursement.” This means that the total
payment is the same regardless of whether separate payments are made to
the physician and the facility or, in the case of physician owned facilities, a
lump sum payment is made only to the facility.

Revenue Sources / Payor Mix

 Referring Physician / Client Office
– Dependent upon payor mix of physician office

 Hospital
– Dependent upon payor mix of hospital
– Medical Director fee (paid under Medicare Part A)


Physician Fee Schedule

 Medicare’s fee schedule for clinical lab services can be
found at:
– http://www.cms.gov/ClinicalLabFeeSched/

 Medicare’s fee schedule for physician services can be
found at:
– http://www.cms.gov/PhysicianFeeSched/


Market Forces – Revenue Considerations

Year Over Year Change in Medicare Spending
12.0%
11.2%
10.0%
9.7%
8.0%
6.0%
4.4%
4.0%
2.0% 2.4%
0.0% -0.5%
-2.0%
2000 - 2006* 2007 2008 2009 2010
Change in Medicare Spending

• 9.7% reflects the average change per year over this time period.
• Pathology labs represent 30% of all claims received by Medicare but only 2% of total
Medicare spending


Market Forces – Revenue Considerations –
Medicare Reimbursement

 Despite the variance in Medicare spending detailed in the
chart on the previous page, since 1997 payments for
procedures have increased only twice

– In 2003, there was an increase of 1.1% and in 2009 there was an
increase of 4.5%

– In 2011, there was a negative adjustment reflecting a 1.75% decrease
(see next slide)

– The Clinical Lab Fee Schedule (“CLFS”) has been frozen or reduced
in 9 out of the last 10 years (2003 – 2012)


Reimbursement – Medicare - Technical

Medicare National Average - Technical 2008 2009 2010 2011 2012 CAGR
88304Tissue Exam by Pathologist $51.04 $50.49 $50.88 $56.42 $55.78 2.2%
88305Tissue Exam by Pathologist 66.65 66.72 66.37 69.65 69.78 1.2%
88312Special Stains 65.89 71.41 73.38 87.97 74.00 2.9%
88313Special Stains 58.27 59.87 61.21 72.38 59.13 0.4%
88331Path Consult Intraop, 1 Bloc 28.95 29.21 29.13 31.94 33.70 3.9%

Source: Medicare Physician Fee Schedule

Interesting Note: CPT Code 88305 is one of the top five codes billed to Medicare


Reimbursement – Medicare - Professional

Medicare National Average - Professional 2008 2009 2010 2011 2012 CAGR
88304Tissue Exam by Pathologist $10.28 $10.82 $11.06 $10.87 $10.89 1.5%
88305Tissue Exam by Pathologist 36.18 37.15 37.24 36.35 36.08 -0.1%
88312Special Stains 25.90 26.33 26.55 26.16 25.87 0.0%
88313Special Stains 11.43 11.54 11.8 11.55 11.57 0.3%
88331 Path Consult Intraop, 1 Bloc 58.27 59.51 60.47 59.46 58.89 0.3%

Source: Medicare Physician Fee Schedule


Market Forces –
Revenue Considerations: Payor Mix

Managed Care Medicare & Medicaid Other

60.0%

51.3% 51.3%
49.6% 49.2% 48.9% 48.8%
50.0%

40.0%

32.8% 33.0% 33.4%
30.6%
28.9% 28.6%
30.0%

20.2% 19.8% 20.1%
18.1% 17.8%
20.0% 17.6%

10.0%

0.0%
12/31/11 12/31/10 12/31/09
LH DGX LH DGX LH DGX

Source: LabCorp and Quest Diagnostics


Market Forces –
Revenue Considerations – Health Reform

 Healthcare Reform Legislation impact on clinical laboratories

– Included as a component of the legislation, was a requirement that
Medicare reduce the CLFS by 1.75% for each of the next five years
(beginning in 2011).

– This reduction was accompanied by a productivity adjustment that
reduces the CPI market basket update beginning also in 2011


Analyte Codes
 The American Medical Association CPT® Editorial Panel is
continuing its process of establishing analyte specific billing codes
to replace codes that describe procedures used in performing
molecular tests. The 2012 CPT manual adopts approximately 100
of such codes and, it is anticipated that such codes will eventually
cover hundreds of molecular tests.
 While CMS has deferred adoption of the new molecular codes
until 2013, a handful of commercial health plans are implementing
them.
 The adoption of analyte specific codes will allow payors to better
determine tests being performed which could lead to limited
coverage decisions or payment denials.


Non-Governmental Payors

 Trend of consolidation among healthcare payors has resulted in
decreased number of payors with increased negotiating leverage

 Some healthcare plans have been willing to limit the PPO or POS
laboratory network to only a single national laboratory to obtain
improved fee-for-service pricing

 Some healthcare plans also are considering steps such as
requiring preauthorization of testing

 An increasing number of patients enrolling in consumer driven
products and high deductible plans that involve greater patient
cost-sharing.

Revenue Considerations – Quest Diagnostics
Lawsuit Settlement
 On May 19, 2011 Quest Diagnostics (NYSE: DGX) announced
the settlement of a lawsuit with the State of California in regards
to alleged violations of the state’s False Claims Act
– In a qui tam case filed by a competitor of Quest, the Government
alleged that Quest offered deeply discounted, private rates to
physicians for laboratory services in exchange for the physician’s
referral of Medi-Cal business to Quest.

– In many cases, the private rates charged by Quest to the
physicians were below the costs incurred by Quest in providing the
test.

– Competitors alleged that the deeply discounted pricing created
large barriers for new laboratories attempting to gain market share
and stifled competition.


Revenue Considerations – Quest Diagnostics
Lawsuit Settlement (cont’d)
 On May 19, 2011 Quest Diagnostics (NYSE: DGX) announced
the settlement of a lawsuit with the State of California in regards
to alleged violations of the state’s False Claims Act
– Quest then allegedly would offset the losses incurred on the private
business by overcharging Medi-Cal for services.

– This would have violated the law that requires Medi-Cal providers
to bill Medi-Cal at their lowest reimbursed rate received for
services.

– California’s penalty for violation of its False Claims Act is up to
$10,000 for each false claim.

– The case resulted in a settlement of $241 million paid by Quest to
the state of California.


Revenue Considerations – Anti-Markup Rule

 2009 Medicare Physician Fee Schedule final rule

 If the anti-markup payment limitations apply, the payment to
the billing physician for the technical or the professional
component of the diagnostic test may not exceed the lowest
of the following amounts:

– The performing physician’s “net charge” to the billing
physician

– The billing physician’s actual charge

– The fee schedule amount


Revenue Considerations –
Hospital Based Stipends

 Commonly paid when fees generated by services provided to
hospital by physician practice are not sufficient enough to
cover market salaries to physicians

– Must take into consideration any fees paid to physician for
services provided and reimbursed to hospital under Medicare
Part A (i.e., bundled payments)

 Based on hospital’s required staffing and overhead
expenses, and expected reimbursement to practice.


EXPENSES


Market Forces – Expense Considerations

 Healthcare Reform Legislation impact on clinical
laboratories

– Beginning in 2013, the legislation imposes an excise tax
on the seller for the sale of certain medical devices in the
U.S., including those purchased and used by laboratories


Market Forces – Expense Considerations

 New FDA Regulations

– In 2011, the FDA issued several draft guidance
statements including, among others, guidance documents
regarding software applications used for handheld
devices, companion diagnostics, products labeled RUO
and IUO and enhancements to the 510(k) process

– If enacted this could result in increase product costs
and/or delays in obtaining supplies


VALUATION


Valuation Multiples

 Labs generally trade on multiples of revenue and EBITDA
 In our experience, we generally observe ranges of 4.0x to
6.0x EBITDA for controlling interest purchases

– Most purchases are for a 100% controlling interest.


Publicly Traded Company Market Data

EV/Revenue EV/EBITDA P/E

25.0

21.2x

20.0 19.4x

17.1x
16.1x
14.7x
15.0 13.4x 13.6x
12.6x 12.4x
10.7x
9.3x
10.0 8.9x 7.9x 7.9x 7.8x
7.3x 7.2x
6.1x

5.0
2.1x 1.6x 1.9x 1.7x 1.9x 1.7x
1.4x 1.x .8x
0.0
12/31/10 Last 12 Months Next 12 Months
LH DGX BRLI LH DGX BRLI LH DGX BRLI

* LTM and NTM Data as of 2/15/2012


Publicly Available Market Transaction Data

Implied Enterprise Value/ Ta

Total
Enterprise
Transaction Buyer Target Close Date Value Revenue EBITDA EBIT

1 Sonic Healthcare Ltd. CBLPath, Inc. 12/2/2010 123.5 1.5x n/a n/a
2 Physician's Automated Laboratory, Inc. Central Coast Pathology Consultants, Inc. 2/7/2011 28.0 1.4x n/a n/a
3 Aurora Diagnostics, LLC Biopsy Diagnostics, LLC 10/8/2010 23.2 n/a n/a n/a
4 Ventana Medical Systems, Inc. BioImagene, Inc. 8/31/2010 100.0 n/a n/a n/a
5 Laboratory Corp. of America Holdings Esoterix Genetic Laboratories, LLC 11/30/2010 925.2 2.5x n/a n/a
6 Novartis Finance Corporation Genoptix, Inc. 3/4/2011 310.9 1.6x 6.6x 7.3x
7 Laboratory Corp. of America Holdings Labwest, Inc. 6/16/2010 57.5 0.6x n/a n/a
8 Quest Diagnostics Inc. Celera Corporation 5/10/2011 330.4 2.6x n/m n/m

High 925.2 2.6x 6.6x 7.3x
Median 111.8 1.6x 6.6x 7.3x
Low 23.2 0.6x 6.6x 7.3x
Average 237.3 1.7x 6.6x 7.3x

Source: Capital IQ Transaction database


M&A Observations

 The median and average EV / Revenue multiples over the past three
years have been 1.6x and 1.7x respectively.

 While there is insufficient data available to determine the correlation of
value with EBITDA and EBIT multiples, the correlation between revenue
and enterprise value is 94.8%. This equates to an R^2 of 89.8% which
tells us that, based on market data, revenue is a relatively good
predictor of enterprise value.


Additional Acquisitions – Lab Corp

While financial data related to all transactions is not necessarily available, in the
past six years LabCorp has made the following acquisitions (12 Total):

 Orchid Cellmark, Inc. (2011)
 Clearstone Holdings Ltd. (2011)
 Esoterix Genetic Laboratories, LLC (2010)
 DCL Medical Laboratories (2010)
 Labwest, Inc. (2010)
 Monogram Biosciences, Inc. (2009)
 PathNet Esoteric Laboratory Institute, Inc. (2008)
 NWT Inc. (2008)
 PA Labs, Inc. (2007)
 DSI Laboratories (2007)
 Protedyne Corporation (2007)
 Litholink Corporation (2006)
Source: Capital IQ Transaction Database


Additional Acquisitions – Quest Diagnostics

While financial data related to all transactions is not necessarily available, in the past
six years Quest Diagnostics has made the following acquisitions (10 Total):

 AHS S.E.D. Medical Laboratories, Inc. (2011)
 Celera Corporation (2011)
 Athena Diagnostics, Inc. (2011)
 Genomic Vision, S.A. (2010)
 Caritas Medical Laboratories, LLC (2009)
 OralDNA Labs, Inc. (2009)
 Pathway Diagnostics Corporation (2008)
 AmeriPath, Inc. (2007)
 HemoCue AB (2007)
 Enterix, Inc. (2006)

Source: Capital IQ Transaction Database


Accounts Receivable Data

Average Days in Accounts Receivable 2008- 2011
44.6
2011 42.6

44.9
2010 41.4

46.9
2009 40.6

51.0
2008 43.3

- 10.0 20.0 30.0 40.0 50.0 60.0
Lab Corp Quest Diagnostics
Source: Lab Corp and Quest Diagnostics via Capital IQ


Bad Debt Data

Quest Diagnostics Bad Debt as a % of Revenue
5.0%

4.5%
4.0% 4.3%
4.0%
3.7%
3.0%

2.0%

1.0%

0.0%
12/31/2008 12/31/2009 12/31/2010 12/31/2011
Source: Quest Diagnostics via Capital IQ. Lab Corp data was not available.


Contact
Curtis H. Bernstein
CPA/ABV, ASA, CVA, MBA
Sinaiko Healthcare Consulting
Curtis.bernstein@altegrahealth.com
www.altegrahealth.com

Amy Graham
MBA
ymalib@hotmail.com

Kyle W. Rudduck
CFA
Sinaiko Healthcare Consulting
Kyle.rudduck@sinaiko.com
www.altegrahealth.com


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