College of American Pathologists
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  Parsing Sonic’s buy of U.S. laboratory





cap today



September 2006
Feature Story

Karen Lusky

Laboratories looking for a buyer often view themselves as having two major options: a national laboratory company or a national laboratory company.

But in the U.S. market where Laboratory Corporation of America and Quest Diagnostics reign as the main acquisitors, there is a potential new contender in play. Sydney, Australia-based Sonic Healthcare Ltd. last year purchased an initial 80 percent stake in Clinical Pathology Laboratories, or CPL, of Austin, Tex., which offers clinical and anatomic pathology services. In addition to the lab in Austin, CPL has regional labs in Toledo, Ohio, and Northern Virginia.

Since the CPL acquisition, Sonic has spurred growing speculation about what the company might be up to and how its presence might unfold in the lab market.

Sonic CEO Colin Goldschmidt, MD, answers the top question on people’s minds: “Yes, absolutely,” Sonic plans on purchasing additional laboratories in the U.S. “Now that CPL is firmly part of the Sonic group, we are keen to expand from this base…,” he told CAP TODAY. Sonic also owns radiology businesses in Australia, but Dr. Goldschmidt says the company isn’t planning to pursue “radiology opportunities” in the U.S. at this time.

Traded on the Australia Stock Exchange, Sonic has been a leader of laboratory consolidation in Australia, emerging as the No. 1 player, sizewise, in that country, Dr. Goldschmidt said in a presentation on Sonic at this year’s Executive War College sponsored by The Dark Report. Sonic is the third largest medical diagnostics company in the world, he added, with annual revenues of about $1.2 billion and market capitalization of about $3.4 billion in U.S. dollars.

After consolidation was complete in Australia near the end of the last decade, Sonic began purchasing labs in other countries, including New Zealand, Germany, England—and most recently, the U.S., says Dark Report editor Robert Michel. To grow, Sonic had to expand beyond Australia, which has a population of about 20 million. By purchasing CPL in Texas, a state with a population of almost 23 million, Michel says, “Sonic doubles the population base that it’s positioned to serve relative to the entire population of Australia.”

Health care investment banker Eric Coburn, a principal with Shattuck Hammond Partners LLC, New York City, predicts that “Sonic should be able to undertake additional acquisitions in the U.S. and compete effectively.”

Sonic’s approach to managing its acquired labs differs significantly from that of LabCorp or Quest, which some say may make it an attractive alternative for an independent or even not-for-profit hospital lab looking for a buyer that won’t dismantle or rebrand it. Says Michel: “Sonic is built around a business strategy of supporting the local laboratory that it acquires while maintaining that local lab’s unique identity.”

Sonic seeks to “retain all the value inherent in the existing business—the value of goodwill,” Dr. Goldschmidt says. To achieve that goal, Sonic not only retains an acquired lab’s original name, but also keeps “the local management and pathologists in their current positions,” he says. Sonic then serves as the “central hub to facilitate communication, synergy…and other benefits.”

Wachovia Securities analyst Bill Bonello doesn’t “believe there is a growing aversion to the idea of being acquired by one of the national lab companies.” But “there are many labs…built by physicians or physician entrepreneurs who feel a great sense of ownership and pride in what they have created,” he says. “And some of that pride comes from the fact that what they have is specialized and independent, and [it] provides, in their minds, a higher quality of testing than Quest or LabCorp. So there is always some natural resistance on the part of some of these physician owners to sell to a national company.”

Sonic uses a “medical leadership model,” which Dr. Goldschmidt defines as retaining “as much medical influence in the business of pathology as possible.” He is, in fact, a pathologist who had just started his career as a surgical pathologist at a practice in Australia shortly before Sonic bought the practice.

The medical model is something Dr. Goldschmidt has “been pretty passionate about,” as he puts it, since becoming CEO of Sonic in 1993. Integrally involving pathologists in the operations and in the management process results in positive “commercial outcomes” for the business, he insists.

Dr. Goldschmidt says the CPL model is based on a pathologist partnership working in the laboratory and in operations in general, and in interfacing with clinicians and providing personalized service on a regional basis. “Sonic in Australia does much the same thing,” he adds.

In fact, as Sonic has grown, it has “stuck to its guns” in terms of maintaining a medical leadership model, which he believes has contributed to the company’s commercial success, Dr. Goldschmidt said at the War College. From a “personal point of view, that’s gratifying,” he added, “because in the early days I had people tell me doctors couldn’t run anything.”

With a goal of helping its labs “rise to the highest common denominator” and pool resources, Sonic offers them a list of initiatives for which information is shared, Dr. Goldschmidt says. “We do benchmarking between all our businesses at many levels—not just financial benchmarking but at the operational level, going right down to the departmental level.”

This benchmarking provides, for example, a “like-for-like comparison of productivity between lab departments,” Dr. Goldschmidt says. It’s “always a surprise to discover significant productivity differences between lab departments doing exactly the same tests,” he adds. “And it is equally satisfying to uncover and then share the particular system advantages that the high productivity departments may be using.”

Robert Connor, MD, CPL chairman, CEO, and medical director, says CPL has “just scratched the surface” in using the benchmarking that Sonic makes available. The data include turnaround times, financials, and service indicators, such as stat courier retrieval times and how long patients wait to have their blood drawn.

Since the Sonic acquisition, CPL continues to grow at its historical double-digit annual rate, performing chiefly physician office testing, Dr. Connor reports. CPL hasn’t felt pressure from Sonic to produce immediate results, he says. “It seems Sonic people take a more European approach of ‘we are in this for the long term,’ looking farther into the future than just the next quarter.”

He says CPL’s transaction with Sonic benefited retired pathologists and private investors in the laboratory. “The only people who remain as investors from the old CPL are those of us who are actively involved in providing services or actively involved in management,” Dr. Connor says. More than 20 pathologists hold a 20 percent interest in CPL. Sonic’s 2005 annual report says it will transition to “100 percent ownership” of CPL between 2009 and 2012.

CPL had intentionally restructured the laboratory business in 1990 so that when pathologist owners retired from practice, they didn’t have to sell their stake in the lab, Dr. Connor says. But “eventually people want their money out.” The prospect of selling CPL first came up in 2000. And “through a series of good timing, good luck, and, in retrospect, some good decisions,” CPL didn’t sell to Quest or LabCorp, Dr. Connor says. “A lab like ours has a 95 percent chance that if it’s going to maximize its return, it would sell to one of those labs.”

Instead CPL teamed up with a private equity partner, Summit Partners, in Boston. That partnership paved the way for CPL to purchase the two additional labs in Ohio and Virginia in 2003, ultimately positioning it to sell to Sonic in 2005 for about $300 million. Dr. Connor says that working with the private equity investor also helped CPL prepare for the more intense financial and reporting responsibilities required of a publicly traded company.

“We don’t have a sense of loss about the sale. Things are no different in 2006 than they were in 2005. We still have our independence,” Dr. Connor says, noting there has “been no consolidation of people’s positions since the transaction.”

The Sonic approach of keeping an acquired laboratory doing business as usual locally or regionally offers a competitive edge in many respects. For example, Bud Thompson, CEO of Carilion Labs, a for-profit subsidiary of Carilion Health Systems (Roanoke, Va.) that has been acquiring labs, says their experience tells them that “with AP services, in particular, there is a desire for the service to remain local as opposed to large-scale consolidation.

“Pathologists in some of the markets have very strong relationships with referring physicians and can be very sensitive to and involved in the patient care process. The diagnostic process involves more than just reading slides in an office,” he says.

As a model, what are the downsides to Sonic’s approach of maintaining a lab’s local and regional presence? For one, says Wachovia’s Bonello, “maintaining a local lab can limit economies of scale.” Yes, you get the benefit of having the local physician practices and relationships that have been established and, it is hoped, will continue, but you don’t have the benefit of consolidating operations. Another potential drawback is that it could limit the ability to get managed care contracts, “although CPL has a regional presence, which would help with managed care contracts,” Bonello says.

John Carroll, a principal in Summit Partners, which worked with CPL, agrees with the benefits of doing high-volume testing. “But the reality is, the larger the lab, the more it loses that local feel and touch. That is a threat that locally focused labs [like CPL] pose to national lab companies. That is how CPL built its business to almost $200 million” a year in revenues, he says.

Also, bigger isn’t always necessarily better in dealing with managed care, which has its own competitive agenda. Bonello observes that “managed care payers like to keep a balance of power or alternatives to Quest or LabCorp in most markets… Each time a smaller player is swallowed up by one of the national labs, the managed care contracting opens up to another small player.”

What might the future hold for Sonic, and what might it be with Sonic in the picture? For one, Sonic’s arrival “isn’t the first edge of a tsunami of foreign acquisition of U.S. labs,” says The Dark Report’s Michel.

And its success as a foreign laboratory in unfamiliar territory isn’t a slam-dunk. The two largest Canadian labs—MDS and Dynacare—tried to do business in the U.S., with mixed results. “MDS struggled,” says Bonello, “but Dynacare did OK. It came out as a publicly traded company and exceeded expectations for [its] operating results. LabCorp swallowed them up, so it’s hard to know at the end of the day how well they were doing or would have done. The rumor was that some of the Dynacare joint ventures [with hospitals] were struggling, but we don’t know how to confirm if that’s true.”

Dynacare’s strategy differed from that of other large labs, however. It was “much more focused on servicing hospital-based labs, either through joint ventures or management contracts,” Bonello says.

One challenge for Sonic, Dr. Goldschmidt says, “has been making the transition into the U.S. market” and learning the market’s specifics—a feat “made a whole lot easier” by “our friends at CPL.”

“Clearly, there is much competition in the U.S. lab market, and consolidation has gone a long way. We thus see these as the two biggest challenges—competition and the degree of consolidation.” Yet Dr. Goldschmidt says he’s “optimistic that the offering of a new model will present Sonic with new opportunities.”

Michel says it’s well known that the owners of some remaining independent lab companies have been in contact with Sonic. “Some of those conversations [between Sonic and the labs] were taking place at the Executive War College in Miami,” he adds.

Sonic suffered a setback this summer, however, when its New Zealand lab, Diagnostic Medlab, lost a major contract to a competitor. But it doesn’t change Sonic’s acquisition plans in the U.S., Dr. Goldschmidt says.

Speculation about Sonic’s plans and fate include predictions it could potentially end up trading on Wall Street. To do so, says Shattuck Hammond’s Coburn, “Sonic would have to meet certain listing and regulatory oversight requirements, some of which [it] may not want to do. However, the CPL transaction significantly enhances the U.S. profile of a company that was virtually unknown in this country, especially on Wall Street.” As a result, Coburn says, “in addition to growth and increasing shareholder value, part of Sonic’s rationale for acquiring CPL may be to create a foundation for listing its shares in the U.S.”

Coburn says the U.S. market is much larger and more liquid than the Australian stock market, offering “many more institutional and individual investors.” Thus, for Sonic to list its shares in the U.S. would enhance its “ability to raise capital,” he says. Second, “if Sonic is interested in undertaking additional U.S. acquisitions and using its stock as consideration, a U.S. listed stock would be of more interest to a potential U.S. acquisition target than Australian stock,” he says.

But Dr. Goldschmidt says that taking Sonic to Wall Street isn’t in the company’s plans— “not at this stage, although it has been something we have spoken about.” But it wasn’t part of the company’s strategic plan for coming to the U.S., he adds.

There’s another possibility: Sonic could become an acquisition target for LabCorp and Quest, analysts suggest. But CPL’s Dr. Connor doesn’t believe that’s what Sonic has in mind. “These guys, who are pathologists essentially, love the lab business…it’s been their whole career.”

Karen Lusky is a writer in Brentwood, Tenn.