False positive.

LabCorp failed to diagnose the changes managed care would bring to its business. Now it's on the critical list.

On the wall of Jim Powell's office hangs a framed, handmade print of two Chinese characters. Together, they comprise the symbol for "crisis." And for "opportunity."

Powell,

the founder and, until January, CEO of Laboratory Corporation of America Holdings in Burlington, was given the print by one of his Midwest managers, a woman of Chinese descent. She mentioned the symbol in conversation, and Powell's delight led her to ask her husband, a calligrapher, to inscribe it in black ink on white paper.

The print has turned out to be more omen than office decoration. Since Powell hung it three years ago, the company he founded and built into the nation's largest provider of lab tests for hospitals and physicians' practices, a company that once seemed to have unlimited opportunities, has experienced little but crisis.

Powell, the 58-year-old scion of a prominent Alamance County entrepreneur and a small-town success story himself, has watched his company go from darling to dog. He has seen its earnings dry up and its stock price sag as it has been squeezed by the lower prices demanded by managed health care, overwhelmed by a merger that cost more than expected and hammered by a government investigation of its billing practices.

It has lost $166 million over the last two years, and its stock price, once as high as $14, was slumming at $2.63 in late June. "It's been rough," Powell says, "the most difficult time of my career."

LabCorp hit a low point last November when it pleaded guilty to a count of criminal fraud. That resolved an inquiry into the way it billed Medicare, Medicaid and other federal insurance programs. It agreed to reimburse the government $182 million and pay a $5 million fine. The feds say the companies that merged to form LabCorp in 1995 - Powell's Roche Biomedical Laboratories in Burlington and National Health Laboratories in La Jolla, Calif. - tricked doctors into ordering unnecessary tests. The investigation discovered that a lab acquired by NHL performed 22 unnecessary cholesterol tests on an AIDS patient in the year and a half before he died.

How did LabCorp fall so far so fast? In large part because Powell and his top lieutenants were caught off guard by the change wrought by managed care. They underestimated how quickly and completely it would take hold. In their scramble to keep up, they plunged into a massive merger without understanding the pitfalls. And they continued to push sales, ignoring signals the government was troubled by the way labs were billing.

True to his philosophy, Powell saw little but opportunity in changes pulsing through the industry. He figured managed-care companies' demands for ever-lower test prices would drive a lot of the small independent labs, such as those run by community hospitals, out of business. Then LabCorp would gobble up their contracts.

That still could happen. But first the company has to heal itself.

Powell started Biomedical Laboratories in 1969, shortly after graduating from Duke University's medical school. In 1927, his late father, Elon College biology professor Thomas Edward Powell Jr., founded Carolina Biological Supply, which grew into the biggest supplier of biological products for colleges, universities and high schools in the world. Jim Powell's brother Ed is now chairman of that company and, with his immediate family, controls the majority of the stock. In the 1980s, he paid more than $10 million to buy stock controlled by Powell and three other brothers out of fear they might sell to someone outside the company.

For 25 years, Jim Powell enjoyed the same sort of success his late father had. In 1979, he sold stock publicly for the first time, raising $7.2 million. Three years later, he sold out entirely to Nutley, N.J.,-based Hoffmann-La Roche Inc., a subsidiary of Swiss health-care giant Roche Ltd., for $164 million. Hoffmann-La Roche made his company a subsidiary, switching the name to Roche Biomedical. The deal made Powell, who stayed on as CEO, a multimillionaire.

He kept growing outside his stronghold in the Southeast by acquiring labs around the country. By the early '90s, the company had become Alamance County's largest employer and was buying up and renovating buildings in Burlington at a rapid pace. Today, much of downtown is a LabCorp campus. With about 1,700 employees there, the company occupies 405,000 square feet in 18 buildings. Its showpiece - as conspicuous in its small-town milieu as the Taj McColl is in Charlotte - is the old 9-story Atlantic Bank and Trust Building, which houses the executive offices.

Despite the success, Powell was watching managed care erode his margins. Health-maintenance organizations were forcing prices down to break-even levels. "Every company has to make a profit, but the HMOs don't seem to care whether we make a profit or not," he says. But blame for LabCorp's downfall lies with his own panic and lack of preparation.

Fearful of losing thousands of doctors as customers, the company offered deep discounts to managed-care companies, says Tom Mac Mahon, whose LabCorp role expanded from chairman when he replaced Powell as president and CEO. "The managed-care companies would say, 'Remember those 100 doctors you used to deal with in New Mexico? We represent them now, and we're going to bid that contract.'"

Managed-care companies demanded a new pricing scheme - a set per-patient, per-month fee rather than by the test - and Roche Biomedical had little idea what to charge. Once the deals were signed, doctors started acting differently: They ordered more tests. While prices fell, volume rose. "We never anticipated the speed with which managed care would move ahead," Mac Mahon says. A decade ago, managed-care companies accounted for 3% to 5% of the company's billings. Today, it's 20%.

"If they'd been staying up on what was happening in the industry, they probably wouldn't have been caught like that," says Curtis McLaughlin, a business professor at UNC Chapel Hill who specializes in managed care. "But it's easy, if you're located in Burlington, to discount managed care. North Carolina has been very slow to have managed-care penetration."

In response to price pressures, Powell cast about for ways to lower costs. A merger made the most sense. Getting bigger would create economies of scale and better coverage in regions such as the West where Roche Biomedical had fewer labs. That, in turn, would let it offer one-stop shopping to managed-care companies. In theory, the HMO could sign a national deal rather than negotiate separate deals in each state or region it did business.

The urge to merge led Powell to National Health Laboratories, one of the first clinical labs snagged for fraudulent billing. In 1992, then-president Robert Draper pleaded guilty to two counts of criminal fraud and spent several months in prison. The company also pleaded guilty to fraud and paid $111 million.

Powell knew that when he entered merger talks in mid-1994. But he figured it made NHL an ideal partner. The government had already sifted through its activities up to 1992, and NHL's management would have learned its lesson. Powell was wrong. Federal prosecutors say NHL kept improperly billing the government.

Why didn't Roche Biomedical discover that during its due diligence? NHL was decentralized, operating like a group of affiliated labs, Powell says. That made it difficult to sort through its activities. "You do the best you can with a limited amount of time," he explains.

Meanwhile, the government's inquiry into clinical billing practices was spreading to other states and other companies. In 1993, it subpoenaed the nation's biggest labs, including Roche Biomedical. Brad Smith, then Roche Biomedical's general counsel and now LabCorp's, remembers the day an FBI agent delivered the papers. "It was Aug. 9, 1993, at about 2 o'clock."

Smith's initial concern was simply complying with the enormous scope of the government's request. "Our first reaction was, 'C'mon, please, do you really want all of this?' They said, 'We really do.'" The multipage subpoena asked for any document relating to about a dozen of the company's tests. "We reviewed a million or 2 million documents and produced several hundred thousand," Smith says. Powell wasn't worried. "I felt like we'd always run an ethical company," he says.

He had reason to be upbeat. For two decades, his company had been a Burlington belle, a success story spun in a capital of the state's slowly suffocating textile industry. Powell had been called a savior in Burlington for his commitment to redeveloping the dying downtown. But the government investigators weren't interested in the jobs Powell had brought to Alamance County or his restoration of Burlington. They just wanted to look at his files.

LabCorp didn't hear much more from the government for two years. NHL and Roche Biomedical completed their merger in April 1995, creating a company with 23,000 employees in 45 states and $1.6 billion a year in revenue. But the real work - the integration of the operations - was only just beginning.

Powell admits he underestimated how tough it would be. He misjudged the difficulty of combining the cultures. NHL focused on maximizing profits at the expense of R&D into new tests and technologies. Most of its executives came from sales, not science, and they concentrated on squeezing revenue out of basic tests, not devising new ones. At the time of the merger, NHL was the most profitable company in the industry, with operating margins more than twice that of Roche Biomedical.

At first, Powell tried to split the difference, maintaining dual headquarters in Burlington and La Jolla. LabCorp put its main human-resources office in California, which Powell admits made little sense because most employees were east of the Mississippi. "We should've done things the RBL way from the beginning. You need to immediately have one culture. It took us a year to get that resolved."

There were other glitches. LabCorp alienated some customers by billing them late. Some got a bill from one of the predecessor companies and a second one, for the same test, from LabCorp. And in the short term, costs ballooned. "We put two large labs together in New Jersey, and instead of getting efficiencies early in the game, it went the other way," Powell says.

He had guessed the merger would yield savings within a year. It took a year and a half. But he estimates LabCorp has shaved about $120 million off its predecessors' annual operating costs. In the third quarter of last year, its price per specimen, a key profitability measure, leveled off after falling for years. And in the fourth quarter, it began - and has continued - to rise.

The merger loaded LabCorp's books with more than $1 billion of debt. That's because NHL shareholders received not only half the stock in the new company but $5.60 for each of their shares. To comply with debt covenants, Powell had to cut bonuses and raises and slow his renovation of downtown buildings.

Amid this upheaval, the government came knocking again in late 1995. Investigators wanted more information, including computer records, and began interviewing current and former employees. They would talk to more than 150 people. The scope of the inquiry daunted the LabCorp brass. Among the government staffers reviewing their operations were lawyers affiliated with five arms of the Justice Department: U.S. attorney's offices in Greensboro, San Diego, Pennsylvania and New York City, as well as the main office in Washington, D.C.

Through nearly three years of poring over documents and grilling workers, investigators uncovered a pricing scheme that, they say, amounted to fraud. Here's how the government says it worked:

LabCorp would offer a package of tests to a doctor at a discounted rate. The package might include more tests than needed to diagnose a patient. LabCorp, for example, routinely added a syphilis test to one of its packages. But it was easier and cheaper for doctors to order them that way. Yet when Medicare or another government insurer was footing the bill, LabCorp would charge for the tests as if the doctor had ordered each separately. (The doctor, in effect, serves as the gatekeeper for Medicare.) A $15 package might cost Medicare $45. In essence, prosecutors say, LabCorp induced doctors to order more tests than they really needed by offering packages and letting the doctors believe Medicare would be billed at the same discounted rate.

Powell doesn't deny the particulars of the government's findings. But it wasn't fraud, he says. "We, as a company, had no policy to mislead the doctors. And we feel it's part of their responsibility to be informed about the costs of tests." If doctors hadn't wanted packages of tests, he says, they were free to order tests individually, and many of them did so. Seventy percent of the company's orders were custom ones.

LabCorp isn't the only company the government gigged. All six of the biggest - including SmithKline Beecham Clinical Laboratories Inc. and Corning Clinical Laboratories Inc. (now Quest Diagnostics) - entered into similar settlements, as have hundreds of smaller labs. In general, they have insisted part of the blame lies with the government for failing to provide adequate billing guidelines. LabCorp general counsel Smith says: "You have to ask, 'Were the members in the platoon uniformly out of step, or did the drill sergeant really not do his job of giving some much-needed guidance?'"

Still, Powell says he realized early on his company could not go to court, no matter what he thought of the government's conclusions. "The government is our biggest customer. They're 25% of our business. We can't operate without doing business with the government."

Serious settlement negotiations began in late spring 1996 when the government summoned LabCorp's lawyers to a series of meetings in Washington and Greensboro. Justice Department lawyers laid out the cases they had against Roche Biomedical, NHL and Allied Clinical Laboratories in Nashville, Tenn. Acquired by NHL in 1994, Allied had performed the 22 cholesterol tests on the dying AIDS patient.

After the initial meetings, negotiations shifted to Greensboro and the office of U.S. Attorney Walter Holton. While waiting for one meeting to begin, Smith sneaked behind Holton's desk to examine two certificates on the wall. They were documents that Presidents William McKinley and Teddy Roosevelt had signed to appoint, then reappoint, his grandfather - A.E. Holton - as U.S. attorney in Greensboro at the turn of the century. "I was standing about this close to it," Smith says, holding his fingers 6 inches apart, "when Walter walked in. I was sure he'd think I was going through his desk, but he didn't say anything."

Over five months, Smith attended dozens of meetings with a varying cast of the 15 government lawyers principally assigned to the case. Often, he would meet with one group while others were patched in by phone. Both sides soon realized they would have to agree to disagree about the allegation that LabCorp committed fraud. Government lawyers insisted the pricing scheme was fraudulent. LabCorp's lawyers insisted it wasn't. "They'd say, 'You did this,' and we'd say, 'That's not exactly right,' and go dig out a bunch of documents to prove our point," Smith recalls. "Then they'd say, 'No, that's wrong,' and go and dig out a bunch of documents."

The prosecutors pressed for a criminal count and demanded the resignation of David Weavil, LabCorp's chief operating officer and a former Roche executive. (Neither the government lawyers nor LabCorp's executives will say why Weavil was singled out.)

LabCorp knew it would wind up having to pay a lot of money, but it was determined that any settlement put all the government billing issues behind it. It wanted, in Smith's words, a deal that was "global and final."

By late October, they had agreed on the outlines of the settlement. But, lawyers being lawyers, they dickered over it another month. "We finally said, 'Look, either you take this or we're going to court,'" says Rick Glaser, head of the criminal division in the U.S. attorney's office in Greensboro and, with Holton, the other key government negotiator in North Carolina.

On Nov. 14, LabCorp announced it would take a onetime charge against earnings of $185 million. That extinguished earnings for 1996 and, combined with leftover merger expenses, resulted in a loss of $153.5 million - $1.25 a share.

On Nov. 21, LabCorp and the government announced their deal. The prosecutors crowed about their victory. In one newspaper account, Holton said, "This is a signal that we will pursue these cases aggressively, and we will get back every dollar." And LabCorp, as expected, admitted no wrongdoing beyond the guilty plea on behalf of Allied. Only Allied was prohibited from doing business with the government. LabCorp's stock, already battered, closed unchanged at $3 a share.

Within two months, Powell stepped down as head of the company he started 27 years earlier in a laboratory of the old Alamance General Hospital. He remains on the board and insists he left voluntarily, as does LabCorp's management. Government lawyers won't say whether they asked for his resignation. Powell says he had grown weary of the grind of running a company as large as LabCorp and had lost touch with what had drawn him to the clinical-lab business - science and entrepreneurship.

While the merger and settlement bled management's time, attention and energy, managed care continued to buffet the core business.

New CEO Mac Mahon, 50, who had been a senior vice president at Hoffmann-La Roche, has begun renegotiating contracts with managed-care companies. His pitch: LabCorp can provide a broader range of tests and services at more locations than competitors. But to do so, it needs higher prices. "Some agree and some don't," he says. "We're not, by any means, 100% successful."

He's also concentrating on getting hospitals to hire LabCorp to run their labs. As hospitals look for ways to cut costs, they'll be under pressure to farm out these sorts of services, says Justin Tang, an analyst with Gargiulo Group in New York. "That's a very big growth opportunity. In five or 10 years, a big chunk of the $18 billion [in testing business] that hospitals now command should switch into the independent labs."

To reduce its massive debt, LabCorp in June completed a public offering of convertible preferred stock, raising $500 million. Hoffmann-La Roche, which owns about half the company's shares, took half of the new securities. LabCorp also announced that month that it would cut 161 Winston-Salem jobs.

Since its troubles began, several stock analysts who used to follow the company have dropped it. But two who still do - Tang and Brad Lips at Smith Barney in New York - rate its chances of recovery as good.

As in many industries, small, inefficient players are either being swallowed by large ones or simply shutting down. A huge, independent clinical lab - even one with LabCorp's problems - should capture more of the market. "In the clinical-lab business, bigger is better," Tang says. "It's that simple. There's going to be tremendous consolidation in the next few years."

These days, Powell is devoting his energies to a LabCorp spinoff called AutoCyte. He rounded up several venture-capital firms and committed a chunk of his own money to start the company. It's built around a new and, Powell says, better technology for analyzing Pap smears, which test for cancer of the cervix.

Credit Powell with staying true to the philosophy espoused by the calligraphy on his office wall. Where some folks in his position might mope, ashamed of what has happened to LabCorp, he sees only opportunity ahead. "The Pap smear is the most successful test in the history of medicine," he says. "It's saved millions of lives, but we're going to improve it."

RELATED ARTICLE: The vital ingredient: volume

Taking reservations and making beds might seem to have little in common with testing blood and urine. But as a business, clinical laboratories work a lot like hotels.

Both have high fixed costs. Clinical labs must invest in inexpensive equipment to perform tests and pay an army of technicians to run them. The break-even point is high, so they need a lot of business - tubes of blood rather than the heads in beds hotels have to have. "Some of your big instruments cost $300,000 or $400,000," says Jim Powell, founder and former CEO of LabCorp, "so you want to run those machines as intensively as possible."

As in many industries, improvements in technology have fostered big national players like LabCorp. Powell was able to open his lab in 1969 thanks partly to the development a few years earlier of a machine that "could take one sample and do 12 tests in one minute," he says. These days, a big instrument can do 35 tests in less than a minute.

It used to be, once a lab broke even, it could add volume without increasing cost. What's more, the labs' primary customers - doctors - didn't shop prices because they weren't paying the bill, which was passed on to patients or third-party insurers. A clinical lab could charge 40 or $50 for a test that cost it $27 or $28, says Justin Tang, an analyst with Gargiulo Group in New York. Labs competed on service, variety of tests and turnaround speed, rather than price.

Managed care changed that. HMOs and others have the clout to force prices down. It's not uncommon for an HMO to pay $5 for a test that costs the lab $20, Tang says. The labs are stuck because they don't want to lose the patients managed-care companies control.

With managed care growing, margins are shrinking. Things are in such flux, Tang says, that analysts can no longer reliably estimate costs and charges. The $36 billion-a-year industry is consolidating as small, inefficient labs close or are swallowed by big ones like LabCorp, which are seeking greater volume and economies of scale.

In the long run, the big players should recover from their managed-care malaise, says George Shipp, a Norfolk-based analyst for Scott & Stringfellow Inc. in Richmond. "Diagnostic testing should be one of the biggest growth industries, but right now nobody wants to pay for it."

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LabCorp's management blames a lot of its troubles on managed-care price pressures. That's one reason, but not the only, that its stock has sagged in the two years since the company was formed by the merger of Roche Biomedical Laboratories and National Health Laboratories.

So how have other North Carolina health-care stocks fared in that time? "It's been a mixed bag," says Bill Michalak, an analyst with Charlotte-based Interstate/Johnson Lane.

The seven companies that have been public throughout that period saw their share prices rise an average 23%, way behind the Dow Jones Industrial [TABULAR DATA OMITTED] Average's 78%. Quintiles Transnational led the way, more than tripling. The Durham-based contract-research company has benefitted greatly from managed care as drug companies outsource more and more work. But some stocks you would have expected industry changes to help haven't performed well.

Durham-based Coastal Physician Group's niche, providing contract health-care workers to hospitals, seemed a natural under managed care, but its price has plummeted even more than LabCorp's. The reason? It tried to expand too quickly and made a disastrous entry into clinic management, then got caught up in a nasty proxy fight.

As a high-tech company tied to health care, Medic Computer Systems stock oscillates wildly. The Raleigh-based company, which makes software for physician practices, saw its shares peak at more than $48 in May 1996, only to tumble from $41 to $13 in March alone. MedCath, the Charlotte-based heart-hospital operator, has had a similar wild ride. Its stock hit a high of $42.25 in May 1996 before crashing to below $8 that May.

MedCath sums it up for North Carolina health-care stocks when it quotes from Charles Dickens in its 1996 annual report. "It was the best of times; it was the worst of times ..."

- Alex Frew McMillan