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Monday, May 23, 2011

Bio-Reference Laboratories Rise in Clinical Testing

In a brick industrial park amid whizzing New Jersey freeways, Bio-Reference Laboratories screens millions of patients each year for heart disease, infection, cancer or inherited disorders. Founder Marc D. Grodman proudly notes that when he first rented a small space there 25 years ago, he had to post a big security deposit. "I didn't have a pot to piss in," says Grodman. "I never had the pedigree. I earned my way… We're an overnight success story that's been 25 years in the making."
Bio-Reference shares trade at an all-time high at a recent 25 bucks (ticker: BRLI), having risen more than 12-fold since the clinical lab's stock offering in the early '90s. Over that period, Grodman and his loyal corps of managers have driven sales and earnings growth at a 20% compounded annual rate. Spending heavily on sales and the development of new products—like prenatal DNA screens—the Elmwood Park, N.J.-based outfit has even taken market share from giant competitors Quest Diagnostics (DGX) and Laboratory Corp of America Holdings (LH). Bio-Reference's record in a tough field has gained its stock a premium valuation compared with those of rivals.
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Founder Marc Grodman says Bio-Reference "struggled up from being a penny stock and then earned our way up over the years."

Grodman likes to boast that Bio-Reference's long history is unique in the clinical-lab business. That's for sure. The 59-year-old chief executive, a doctor who's a part-time faculty member at Columbia University's medical school, had business relationships with a remarkable succession of financial bogeymen in his first 15 years or so of operation—when Grodman says he was naive and unable to get financing from Wall Street's mainstream. The rogues ranged from Paul T. Russo, a Genovese crime family-associated broker, to John T. Moran, the convicted stock swindler whose firm inspired the movie Boiler Room, and on to Steven Hoffenberg, whose Towers Financial proved one of the largest Ponzi schemes of the 1990s, among others. Marc Grodman says he never saw any wrongdoing in his business dealings with these gentlemen.
"I survived it," says Grodman, of his Wall Street adventures. "We struggled up from being a penny stock and then earned our way over the years."
Still and all, the earnings that Bio-Reference has reported from its growing sales haven't been of the highest quality. The lab's level of bad-debt reserves and receivables is about twice that of its big rivals, while operating profit margins are about half. As the chart on the next page shows, very little of the company's sales growth has dropped down to its cash flow, after accounting for capital expenditures and acquisitions, even though rival clinical-lab businesses throw off large streams of cash.
Bio-Reference's paltry free cash flow is the result of investing in innovative tests, such as array-based DNA assays that can help select cancer treatments, or molecular diagnostics that identify specific micro-organisms, according to the company's chief. These, too, have been a point of controversy, since the results of a private study Barron's has seen says that the company has been performing molecular probes much more frequently than rivals and at an added expense. Bio-Reference says the tests are useful and requested by doctors and make up a small part of its revenue.
But the testing debates, together with Bio-Reference's early financial relationships and questions about earnings quality, could give investors pause—especially because of the stock's 25% valuation premium to its peers.
GRODMAN SAYS HE WAS FORCED into business as a young doctor who otherwise might have remained in academia. In 1981, his father filed for bankruptcy after his Newark pharmacy fell on hard times. "My family was destitute," says Grodman. "I was thrown into this."
Bio Ref chart
He outfitted a couple of vans as mobile-examination rooms and won contracts with New York-area unions to provide physicals for firefighters and other workers. Med-Mobile went public in 1986 through a little firm called Kureen & Cooper. Med-Mobile's banker was Russo, who'd joined Kureen & Cooper after his previous firm collapsed. The banker was subsequently convicted for conspiracy and stock fraud in a scheme that also led to the successful bribery prosecution of New York Congressman Mario Biaggi and Brooklyn's Democratic party boss Meade Esposito. Wiretap evidence in the bribery case showed Russo helping a Kureen & Cooper corporate client try to extort city employees with the help of a notorious Genovese family capo named Federico "Fritzy" Giovanelli (see Barron's, "Scientists and Stock Pushers," March 21, 1988).
Grodman's next investment banker was John Moran. The doctor was named to J.T. Moran Financial's board of directors in 1988 and also became a director of another Moran client, Transpirator Technologies, which offered oxygen therapy for racehorses. After an equity financing for Med-Mobile, Moran in 1991 pled guilty to manipulating "house stocks," or those a broker dominates, including Med-Mobile, to defraud investors of $60 million.
"We were not aware that there was any issue with them whatsoever," says Grodman, of his financiers.
The med mobiles kept breaking down, so Grodman had sold them off in 1989 and got into the clinical-laboratory business—changing the name to Bio-Reference. The business got a line of credit from Towers Financial, at a 27% annualized rate, before the 1993 collapse of Towers and the guilty plea of its chairman, Steven Hoffenberg, to defrauding investors of a half-billion dollars. Grodman had personally guaranteed the debt to Towers, but Bio-Reference was able to pay off most of it with a 1993 securities offering underwritten by a new investment banking firm named A.S. Goldmen. This relationship proved short-lived, too, when Goldmen folded a few years later and its executives were successfully prosecuted for swindling investors of $100 million.
"I was a doctor," says Grodman, to explain his repeatedly bad hook-ups. "What world experience did I have?"
Things didn't start turning around until 2001, he says, when he recruited Mort Topfer as a director. Topfer had been a well-known manager at Motorola before joining personal-computer maker Michael Dell as an advisor and co-chief executive.

The Bottom Line

Bio-Reference stock looks overvalued, given its 25% premium to its peers, its financing history and the questions about its earnings quality and new products.
In June 2002, federal prosecutors unsealed a racketeering case against New York and New Jersey Mafiosi that charged the mobsters with using their control of the International Longshoremen's Association to force dock workers to use the pharmacy-benefits company GPP/VIP, a joint venture between Gambino family associate Vincent Nasso and Grodman's brother Joel's company, GPP. Nasso pled guilty in 2003 to the GPP/VIP fraud charges. Joel Grodman cooperated with the feds and wasn't charged. Nasso had been a Bio-Reference salesman with a very small equity stake since 1989, when Marc Grodman's company acquired Nasso's lab. In 1999, Bio-Reference had also launched a venture with Joel Grodman's GPP pharmacy-benefits company. None of the charges against Nasso pertained to his work at Bio-Reference, and Marc Grodman says he fired him after his conviction. He's also no longer in business with his brother Joel.
Going head-to-head in the Northeast against big rivals like Quest, Bio-Reference has maintained a good piece of the region's blood-screen business, in which a lab performs routine tests on blood samples. Revenues grew more than 25% in the fiscal year ended October 2010, to $460 million, while earnings rose about 20% to $26 million, or 94 cents a share.
Examined more closely, however, Bio-Reference's financial results appear less impressive. While Quest and LabCorp enjoy operating margins near 20%, Bio-Reference's are 10%. Despite reporting over $1 billion in cumulative revenues over the last 10 quarters, Grodman's lab has produced less than $13 million in free cash flow (after capital investment). Its collections also badly lag rivals, with 92 days' sales worth of receivables in the last-reported quarter, compared to less than 50 at the larger labs. Bio-Reference's margins reflect its deliberate spending on sales and marketing, says Grodman, while receivables reflect its "retail" lab business. Meager free-cash flow results from investing in novel specialty tests. "If we have a chance to feed the growth, we'll feed it," he says.

Flat-lining Cash Flow

On $1 billion in cumulative revenue, Bio-Reference had just $13 million in free cash flow.
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Grodman plans to build a new genetics lab that could run prenatal samples through DNA arrays and screen for hundreds of inherited conditions in a single step. Innovations like this help Bio-Reference salespeople compete, but they can also generate controversy. One of the new offerings is GenPap, which uses molecular probes to check pap smears for infectious organisms whose mere presence doesn't necessarily cause health problems. Doctors use such probes to check for the human papillomavirus and other sexually transmitted infections. But since introducing GenPap in 2008, Bio-Reference is billing for molecular probes with pap smears for non-STI organisms at a rate double or triple that of other labs, according to a recently commissioned unpublished study of insurance claims seen by Barron's. That lifted the average lab payment for the Bio-Reference tests in the insurance sample to about $230, compared to less than $150 for other labs.
Leading gynecologists worry that such molecular tests can lead to inappropriate treatment with antibiotics that could aggravate problems like vaginitis and contribute to infertility. Bio-Reference isn't the only lab offering such tests.
Working last year with CareCore National, a benefits consultant company, University of Washington OB-GYN associate professor Linda O. Eckert studied over 200,000 commercial-insurance claims for molecular tests performed in 2008 by several hundred labs on behalf of women with vaginal complaints. Eckert told a medical meeting last year that over 20% of the molecular tests were for micro-organisms for which the American College of Obstetrics and Gynecology doesn't recommend such tests. Many of these organisms are normally present, says Eckert, and the highly sensitive probes will detect them, but not tell a doctor if the amount is out of balance or even related to the patient's symptoms.
Grodman says his lab personnel guard vigilantly against unneeded testing. "We will never succeed because a physician orders more tests," he says. "We'll succeed because more physicians choose to use us."



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