Specialty Labs diversifies base in bid to recover from losses.

SPECIALTY Laboratories Inc. is showing signs of life after its near-death experience.

Just a year ago, the Santa Monica clinical laboratory, which specializes in sophisticated medical tests, lost its single biggest customer when Unilab Corp. was bought by a competitor. Then, just weeks later, the federal government sought to revoke Specialty's license after regulators found quality control problems and unlicensed personnel performing lab tests.

Clients vanished, revenues fell 20 percent and the company lost $13.8 million in 2002 after years of solid earnings.

"They had the 100-year storm," said Thomas Gallucci, a Merrill Lynch analyst. "They had a lot of things happen to them at once."

But just 16 months after those April events, which saw its founder resign as chairman and chief executive, Specialty appears to be in recovery mode.

The company recently reported a second-quarter loss of $1.9 million, compared with a loss of $7.4 million for the like period a year ago, as newly won business replaced that lost from Unilab.

Specialty also announced a new contract with the University of Maryland Medical System, and an agreement with Consorta Inc., a group purchasing organization representing 400 hospitals.

That prompted UBS Warburg to upgrade the stock to neutral from "reduce" in anticipation of a growth in earnings and the company reaching profitability again early next year.

However, investors don't yet seem convinced, with shares trading around $10, far off their $25 range prior to the setbacks.

Science based

Much of the turnaround is being credited to the new chief executive, Dr. Douglas Harrington, a professor at USC's Keck School of Medicine who had served as president of another sophisticated testing lab.

Harrington, a Specialty board member prior to his appointment in May 2002, said he found a solid company in need of better management. "In that sort of environment what seems important are science and discovery, and the details of the operation don't have as high as a priority," he said.

Specialty Labs has the broadest menu of esoteric medical testing in the country, according to analysts. It performs some 2,400 assays, including those for SARS, cystic fibrosis and leukemia.

Harrington was also able to retain the company's federal and state licenses to provide testing for Medicare and Medicaid patients by hiring more licensed lab technicians and paying $600,000 in fines and other costs related to the investigations.

Specialty is still subject to unannounced lab inspections while under state probation over the next two years. And it's also battling several shareholder lawsuits accusing the company of failing to follow costly lab requirements to inflate its profits.

Also challenging has been recovering from the loss of the Unilab business, which accounted for 10 percent of revenues in 2001. Tarzana-based Unilab conducts pap smears and other routine tests and had been outsourcing more sophisticated work to Specialty.

Such work had been a core business of Specialty since its founding 28 years ago. But that changed in the late 1990s when the industry started to consolidate and large players like Quest Diagnostic Corp. bought up regional labs and competitors, becoming one-stop shops.

Recognizing the trend, the company sought more direct contracts with hospitals, a strategy that showed some results by 2002 when hospital work accounted for 65 percent of its business.

These days, no one client provides more than 2 percent of the business, and over the past year the lost Unilab business has been replaced with increased work from its existing hospital clients, as well as the addition of new ones, said Frank Spina, Specialty's chief financial officer.

The biggest win to date came was the University of Maryland contract, which is expected to bring as much as $1.5 million in annual revenues, while the Consorta agreement makes it easier to sell its services to hospitals in that network.

The company also has formed a scientific advisory board and hired a new chief scientific officer in an attempt to redouble its effort to develop new tests faster than the competition.

Gallucci said Specialty is making all the right moves, but a full recovery will be some time in coming. "You are not going to go from $29 million to $44 million (in quarterly revenue) overnight," said Gallucci, who still rates Specialty's stock just neutral.

Specialty Laboratories Inc.

Stock Prices

Aug. 6, 2002           $7.20
Aug. 6, 2003          $10.00

Note: Table made from bar graph.

YEAR (Dec. 31)                 2002     2001

Revenue (millions)           $140.2    $175.2
Total Expenses (millions)     162.9     156.7
Operating Income (millions)   (22.8)     18.5
Net Income (millions)         (13.4)     13.1
Earnings Per Share            ($0.61)    $0.59

SUMMARY

Business: Clinical reference laboratory
Headquarters: Santa Monica
CEO: Dr. Douglas S. Harrington
Market Cap: $219 million     Dividend Yield: N/A *
Total Liabilities: $21.1 million  P/E Ratio: N/A
Long-Term Debt: $0

* Specialty Laboratories does not pay a dividend.