By Alex Gavrish, Etalon Investment Research; author of “Wall Street Back To Basics

Recent price declines

Investors are always looking for cases of market overreaction and possibilities to profit. Intuitively we understand that there are good investment opportunities out there in periods of general market distress or declines in a specific industry sector. Shares of two leading companies – Quest Diagnostics Inc (NYSE:DGX) and Laboratory Corp. of America Holdings (NYSE:LH) – declined 17% and 16%, respectively, from their November 2013 highs – in a period of about two months. In December 2013, LabCorp issued its 2014 guidance which came below analyst’s expectations, causing shares of both companies to decline sharply. At the same time, both Quest Diagnostics and Laboratory Corp. of America recently appeared on a Goldman Sachs Group Inc (NYSE:GS) list of 40 stocks to own in 2014. Goldman Sachs analysts picked stocks that lagged their peers last year and had attractive valuations relative to their sectors. Perhaps declines in laboratory services stocks might offer an interesting investment opportunity.

Company overview

Quest Diagnostics Inc (NYSE:DGX) is the leading provider of diagnostic testing information services. It provides insights that enable patients, physicians, hospitals and others make better healthcare decisions. The uncertainty that surrounds the company is related mostly to increases in Americans with high deductible and co-insurance plans, which might make some customers pickier as to the testing needs due to higher out of pocket expenses. In addition, health insurers are trying to cut costs meaning there will be more pricing pressure on service providers such as Quest Diagnostics Inc (NYSE:DGX) and Laboratory Corp. of America Holdings (NYSE:LH). Over the long-term, some of these pressures should be mitigated due to implementation of the Affordable Care Act, which will increase the number of patients with medical insurance.

Current valuation

Based on a recent price of $52.72 per share, Quest Diagnostics Inc (NYSE:DGX) had a market capitalization of $7,667 million and an enterprise value of $10,876 million. The company is valued at an EV/EBITDA multiple of x7.6, based on 2012 financial results and at an EV/EBITDA ratio of x6 based on annualized 9 months 2013 financials.  It is worthwhile to note that Quest Diagnostics shows excellent ability to generate free cash flow: free cash flow averaged $866 during a five year period of 2008-2012. During this period the company repurchased, on average, $528 million worth of stock annually. Total shares outstanding decreased over this period by 19%. During first nine months of 2013, Quest Diagnostics spent $994 million on share buybacks, which represents a yield of 13% if calculated using current market capitalization and an additional decrease of 8% in the amount of shares outstanding. The company still has outstanding share buyback authorization in place in the amount of $871 million. Quest is also attractively valued compared to its main competitor Laboratory Corp. of America Holdings (NYSE:LH), which currently trades at an EV/EBITDA multiple of about x8.3 (based on annualized 9 months of 2013). Quest Diagnostics currently pays an annual dividend of $1.2 per share which equals to a 2.3% yield.

It is worth noting that company’s stock price had significantly underperformed the S&P 500 Index over the 5 year period: Quest Diagnostics’ share price returned only 10% while the S&P 500 rose 105% (without accounting for dividends). After the general stock market rally, it might be especially important to pick individual equities that are valued attractively on an absolute basis. If market overreaction proves incorrect in case of laboratory stocks, Quest Diagnostics can provide an excellent long-term potential.