|Shares Out. (in M):||56||P/E||29.9||26.2|
|Market Cap (in $M):||4,070||P/FCF||32||26.5|
|Net Debt (in $M):||-90||EBIT||196||223|
|Borrow Cost:||General Collateral|
Diasorin (DIA IM) is an old-line diagnostics business that manufacturers equipment and reusable consumables for the blood diagnostics industry. Historically, the company generated almost all of its earnings from a Vitamin D test. Its tests are more diversified today, but Vitamin D remains ~25% of revenues, with other simple and basic blood tests representing the balance of the revenues. The company generates ~30% of its revenues from North America but due to significant differences in geographic pricing, we believe as much as ~60% of operating profit is derived from North America. While we hate the term “under-followed” we believe that Diasorin truly is under-followed for a number of reasons a) tight float with insiders controlling ~50% of the float, b) light liquidity with average daily volume of under $10M ADV, and c) Italian domicile despite generating 50%+ of operating profit from North America. We think shorting shares of Diasorin is particularly attractive because this Italian-based stock is not discounting the very obvious looming regulatory threat that is making shockwaves across the US diagnostics space – PAMA. In fact, we think the opportunity in DIA IM exists primarily because the general passive inflows into the Italian stock market has resulted in Diasorin’s valuation disconnecting entirely from underlying fundamentals and regulatory developments (Italian ETF EWI is +30% YTD and thin-float DIA IM is +39% YTD).
Diasorin is a very basic diagnostics company. This is NOT an EXAS in that we do not believe Diasorin is involved in any sort of “cutting edge” testing. Diasorin’s reliance on fairly “basic” tests can be seen in its R&D spend which in 2016 was under 6% of revenues. Nonetheless, Diasorin enjoys exceptionally robust margins, with the company’s overall EBITDA margin in the 35% range. This is due to the “razor/razor-blade” model that it employs, in which it sells equipment at fairly low margins, but makes the bulk of its profits on very high margin reusable equipment. As previously mentioned, we believe US margins for Diasorin are actually far north of the 35% level (North America is ~30% of sales but as much as 50-60% of operating profit). If you look at their latest annual report, you will see that North America has 46% operating margins (revenue from customers / segment EBIT). You will also notice that Italy has operating margins of 53% despite Europe having operating margins of 10.5%. This is because the Italy segment is where they book their machine equipment profits and charge each individual region with those equipment sales. This inflates Italy operating profits and deflates each of the geographic regions. So while just dividing North America segment EBIT / total EBIT implies North America is 48%, we believe it is higher if you were to allocate equipment sales properly. Regardless of the exact mechanics, we believe North America is significant for DIA.
Vitamin D testing grew well over the last several years which resulted in strong top-line growth at Diasorin. However, Vitamin D testing growth has now slowed significantly (albeit is still growing), and Diasorin has turned to M&A to try and bolster its top-line growth and diversify its product-lines. There are also significant regulatory changes on the horizon in the United States that we believe will cause a significant dent in Diasorin’s earnings power over the next three years. We view Diasorin’s valuation as already exceptionally stretched (30x earnings for a low-technology diagnostics business that we believe is overearning in the United States) and view this looming regulatory threat as the catalyst that will cause both negative earnings revisions as well as a significant multiple re-rating for Diasorin.
The specific regulatory shift in question is PAMA. PAMA relates to recently released schedules from CMS that set a new price schedule for all diagnostic tests that are paid for by medicare. The cuts for these tests are significant, with a 25% average cut across all tests. This alone is bad for Diasorin. We further believe that the tests tied to Diasorin have been disproportionately targeted for price cuts because they have been egregiously overpriced for the last several years. We have spoken with numerous diagnostic industry experts and also with Labcorp and Quest. Within the diagnostics industry, it is no secret that Diasorin has massively overearned in the United States for several years. The technology behind tests such at Diasorin’s Vitamin D test is very basic, and it is well-known fact in the industry that Diasorin was eventually going to see its margins compress on the Vitamin D test and also on its other similar tests (i.e. Vitamin E). However, it has taken years for PAMA to come to fruition due to significant back and forth between industry and government. Now PAMA is finalized and our industry contacts believe that it is likely to go through in more or less the current form that is laid out on the CMS website. Our sources have told us that industry lobbyists for the big testing companies actually pushed for PAMA (will push industry consolidation) but have now been caught off-guard by the sheer magnitude of the cuts CMS has proposed. However, CMS apparently deliberated on this extensively and even included a phase-in feature in anticipation of industry pushback, making the odds of a wholesale revision to PAMA unlikely. If PAMA goes forward as we expect, this means a 35% cumulative cut to Vitamin D test prices and a 25% average cumulative price cut for medicare reimbursement for diagnostic testing. The cuts are phased in over the next 3 years on average with 10% max annual price hits to individual tests, but nonetheless the size of the cuts speaks to how serious CMS is about leveling the playing field and getting medicare reimbursements for diagnostic testing more in-line with the far lower commercial rates.
The question then becomes how these lab price cuts will impact equipment suppliers like Diasorin. Quest stock price has been weak in response to PAMA and there have been a flurry of sell side notes on the impact of PAMA to both Quest and Labcorp. In the US, the negative drag potential of PAMA for the lab industry is no secret. We have spoken to industry experts in the diagnostics industry and have even spoken to Quest (who buys directly from Diasorin). Every single industry contact we have spoken to has told us that the cuts to lab pricing will flow through to more commoditized equipment suppliers such as Diasorin. One industry contact told us that “Labcorp and Quest have kept quiet about Diasorin’s high margins for several years because they themselves were making money hand over fist on tests like Vitamin D, but that will change now with PAMA so expect them to hammer Diasorin on price”. We spoke to Quest and found the call to be highly confirmatory of our thesis that suppliers like Diasorin are going to get squeezed in upcoming years to offset the lower Medicare rates.
We anticipate some pushback from readers who note that only a small portion of Quest’s business is medicare-linked (~12%). As a reminder, PAMA only impacts medicare reimbursement rates for lab tests. Quest told us that Medicare is far more profitable and that commercial profitability is low given previous price war between DGX and LH to gain market share with commercial payers (the dynamic is essentially the opposite dynamic to dialysis centers – read more about that with the Roddy Boyd story). However, a diagnostic industry player told us that commercial rates are effectively “tethered” to medicare rates – he expected that if medicare rates come down, commercial will bring their rates down for the industry as a whole (large lab testing companies like DGX and LH will likely be somewhat insulated from further rate cuts given their rates are already considerably lower than mom & pop and physician labs). So we believe that despite being a small proportion of lab company revenues, medicare reimbursement rates still drive the economic value chain and are the basis for capital budgeting.
Every single industry executive we spoke to suggested that the PAMA changes will absolutely flow-through and hit Diasorin. Diasorin earns massively outsized margins in the United States and largely does this because its tests have historically enjoyed exceptionally high medicare reimbursement rates that have resulted in the actual labs pushing back very little to the rich margins that Diasorin takes on consumables. Industry experts all expected this dynamic to change very shortly.
We actually think that these PAMA changes could be positive for both Quest + Labcorp because they have enough scale to withstand the price cuts. On the other hand, based on our conversations with industry experts, we expect many mom & pop diagnostic players to go out of business as a result of the PAMA changes. Despite Quest and Labcorp taking a negative public position towards PAMA, we have heard privately that they are cautiously optimistic about the opportunity to further consolidate the space. This lobbying dynamic should help keep PAMA intact and help it become the rule of law. This consolidation dynamic is yet another major headwind for Diasorin, as they will face continued consolidation of their customer base and even greater pricing pressure in the future. Given the scale of Quest and Labcorp, they have the most buying power against Diasorin. The smaller mom & pops could afford higher pricing for their Vitamin D testing that Diasorin sold given the overall pricing of Vitamin D tests, which is being corrected with PAMA. With PAMA, Diasorin is going to be losing their high margin customers.
So in summary, we believe Diasorin is a low-tech diagnostic equipment supplier trading at a massive growth multiple of 30x that is about to see its growth rate get whacked considerably. We expect the ~35% of revenues (as of 1H17) that come from North America are likely to see annual price cuts of ~8-10% for the next 3 years which will shave off as much as $75M of EBITDA over the next 3 years (DIA’s ~275M of US revenues getting hit by 10% per annum translates to ~82M of lost revenues which we believe will almost entirely fall to the bottom line). This translates to cumulative EBITDA losses of ~27% over the next 3 years relative to consensus estimates for EBITDA in CY2017. We believe Diasorin’s growth is likely to look more US+Europe “GDP-like” in such a scenario, and expect the stock to retrace its gains and trade at ~18x earnings to reflect its subdued growth outlook. Pro Forma for the coming changes from PAMA, we think that Diasorin’s earnings power will be about 2 Euro/share, and applying a 20x multiple to that gets us to a target price of 40EUR or ~45% downside. We see limited upside risk to the stock price at current levels barring: a) DIA getting taken out, which we view as low probability due to the valuation and due to the controlling majority stake held by insiders, or b) DIA using its unlevered balance sheet to do a transformative deal. We ascribe a low probability to scenario B as well as we have done checks on the management team and note that they are very conservative and view leverage with extreme caution.
Importantly, DIA IM released earnings yesterday and missed both topline and EBITDA. The company blamed one time items and the hurricane in the US for the miss. On the earnings call, there was not a single mention in the prepared remarks nor was there a question regarding PAMA. This to us was just further evidence that the European sellside coverage is completely missing this major headwind.
PAMA being finalized in the next several weeks
Sellside finally waking up to PAMA exposure