Changes Expected in Market For Hospital Reference Testing

Acquisitions and Regulators Disrupt Status Quo

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CEO SUMMARY: For the hospital send-out testing marketplace, 2002 has been an eventful year. First came the acquisition of American Medical Laboratories by Quest Diagnostics Incorporated. In April, Specialty Laboratories disclosed its problems with state and federal laboratory regulators. A few months later, Premier announced that Laboratory Corporation of America was now the third lab provider on its national reference testing contract. Collectively, these and other developments have stimulated many hospital lab clients to rethink their existing send-out arrangements. As a result, competition for reference and esoteric testing has already intensified.

HOSPITAL SEND-OUT TESTING has become the most hotly-contested segment of the laboratory industry in recent years.

At the end of 2001, there were six major lab companies recognized in the first rank of reference and esoteric testing sources for hospitals and other types of clients. Behind this first rank of competitors is a growing number of specialty laboratories also seeking their own pieces of the send-out testing pie.

Because reference and esoteric testing is so lucrative when compared to the profit margins from routine chemistry and hematology testing, the nation’s largest laboratory companies have made it a target. That means hospital administrators and pathologists will see intensified marketing efforts by Laboratory Corporation of America and Quest Diagnostics Incorporated. Both companies want to expand their share of hospital send-out testing.

Upset Competitive Status Quo

Since the beginning of 2002, several key events have upset the competitive status quo. On February 7, Quest Diagnostics announced it would acquire American Medical Laboratories, Inc. (AML). A few months later, on April 15, Specialty Laboratories, Inc. disclosed that lab regulators from California and the federal government had levied sanctions against it for non-compliance with CLIA-88 requirements. (See TDRs, February 18 and April 22, 2002.)

Late this summer came the next market-altering event. LabCorp was selected by Premier to join Quest Diagnostics and ARUP Laboratories as the third lab company on Premier’s national reference testing contract.

All three developments changed the competitive environment. Each is causing many hospital laboratories to reassess existing business relationships with reference and esoteric laboratories. The impact of these competitive changes will reverberate for several years to come.

The events affecting AML and Specialty Laboratories in 2002 did not
surprise long-time clients and readers of THE DARK REPORT. It was back in 1999 when we declared that competition in the hospital send-out market was about to intensify. In particular, THE DARK REPORT predicted that newer lab players would aggressively use discounted pricing to capture market share from the more established reference lab competitors.

In 1999, the two newest competitors were AML, which ramped up its market-ing to hospital labs following its acquisition by new owners in 1997, and Specialty Labs, which expanded its own marketing to hospital labs in the mid-1990s. Since 1999, both lab companies demonstrated a willingness to offer extremely low prices to win new hospital lab clients.

During the past three years, both labs used aggressive pricing to capture substantial numbers of new accounts. Measured by growth in specimen volumes, that business strategy was successful for AML and Specialty, at least in the short term.

Downside Of Low Prices

However, what befell both these labs during 2002 shows the downside to their “low price” growth strategy. First, a look at AML. It spent heavily on sales and marketing to acquire new hospital reference testing business at relatively low prices. As a result, AML could not generate enough operating profit to pay down maturing debt, handle interest payments, and sustain the company through its next growth phase.

In late 2000, AML was unable to raise capital from a public offering. In the fall of 2001, it attempted another IPO (initial public offering). Without more capital it faced a difficult future. In December 2002, Quest Diagnostics launched acquisition talks with AML’s biggest stockholder that led to its acquisition agreement in February.

Thus ended the relatively short business life of AML as an independent
national reference laboratory provider. Despite impressive gains in specimen volume and revenue, its low pricing on that new business was not adequate enough to sustain the debt-laden lab company.

Different Impact At Specialty

The low-price business strategy at Specialty Laboratories played out in a different way. Specialty Labs was profitable and, unlike AML, virtually debtfree. After its IPO in late 2000, Specialty had upwards of $70 million of cash to fund its business activities.

However, since Specialty Labs was bringing on new testing business at low prices, it needed to carefully keep costs in line with revenues. Informed speculation is that management, trying to control costs even as it needed to cope with growing volumes of tests, neglected to invest the time and money required to maintain the type of high-level compliance assumed to exist at most esoteric testing laboratories.

Quality does cost money. Every laboratory in the United States understands the costs involved in running additional controls and taking extra steps during the testing process to insure an accurate test result. Because quality is not equal from lab to lab, that is why every laboratorian has an opinion on which “high quality” labs would be allowed to do critical tests on his/her spouse and children and which would not.

Regional Lab Networks

The travails at AML and Specialty are certainly a predictable outcome from the strategy of using low prices to build specimen volume from hospital send-out testing. The consequences of those decisions made in 1999 are now visible in 2002. Going forward, AML is gone and Specialty Labs faces tough, skeptical scrutiny as it works to restore its reputation.

Quest Diagnostics and LabCorp have been quick to seize competitive
advantage from the problems at AML and Specialty. Both national lab behemoths are using these events to bolster their resources and ramp up sales and marketing to hospital labs.

The events of 2002 have also been good to ARUP Laboratories and Mayo Medical Laboratories. Both companies continue to enjoy a reputation for high quality service at a fair price—but not the lowest price. During 2002, ARUP and Mayo picked up considerable amounts of new business, as many hospital labs reassessed existing send-out relationships.

Competition To Intensify

But even as ARUP, Mayo, and Esoterix are benefiting from the changes taking place at AML and Specialty Labs, the two blood brothers are preparing to compete more intensely for hospital send-out testing.

Quest Diagnostics used the purchase of AML as the trigger for a major overhaul of their existing hospital reference testing program. (See sidebar on page 12.) It’s worked hard to retain the key individuals responsible for AML’s sales and marketing success in the hospital segment.

Quest Diagnostics is also converting AML’s Chantilly laboratory into an east coast esoteric testing facility comparable to its Nichols Institute facility on the west coast. In fact, the two laboratories will now be called “Quest Diagnostics Nichols Institute San Juan Capistrano” and “Quest Diagnostics Nichols Institute Chantilly.” Last week the AML signage at the Chantilly lab was removed and replaced by new signs that include the Nichols Institute Name.

Even as Quest Diagnostics was busy absorbing AML into its national lab system, LabCorp was engaged in discussions with Premier and emerged as the third lab provider on the national reference testing contract. That improves its ability to do business with the 1,700 hospital labs that are Premier members.

Taken collectively, changes triggered by the sale of AML and problems at Specialty Laboratories have scrambled the status quo among labs that compete for hospital send-out testing. In the short term, the beneficiaries have been ARUP, Mayo, and Esoterix. But the financial clout of Quest Diagnostics and LabCorp gives each sales advantages and economic strength which may make them even tougher competitors.

Specialty’s Intentions

Meanwhile, Specialty Laboratories has cash reserves of $70 million and has emphatically declared that it intends to remain a major competitor. It will still use aggressive pricing as a lever to gain new accounts and protect its existing business.

What will be the outcomes from these changes? Unlike THE DARK REPORT’S predictions in 1999 of competition based upon low prices by the newest lab competitors (at that time, AML and Specialty), the line-up in 2002 is different.

ARUP and Mayo will be the industry’s Energizer Bunnies. They will keep
on going and going and going… Esoterix is a wild card. After three years of restructuring and major capital investments, it’s ready to compete at a higher level. But since it starts with a limited market share, its impact will be modest. Which leaves LabCorp and Quest Diagnostics. Because of their large size and national reach, it may be their game to win or lose.

Inside Story Behind Quest Diagnostics’ Acquisition of American Medical Labs

NEWS THAT QUEST DIAGNOSTICS INCORPORATED would acquire American Medical Laboratories (AML) last January triggered a sequence of events which led to subsequent acquisition agreements between Quest Diagnostics and Unilab (in April) and between Laboratory Corporation of America and Dynacare (May).

In the months since the AML deal became public, THE DARK REPORT has gathered information from a host of sources about these three deals. The most interesting story involves both the motives and the timing behind Quest Diagnostics’ purchase of AML.

Quest Diagnostics actually bought AML as a way to solve several business problems. First, on the physicians’ office side of the ledger, Quest Diagnostics had lost a major managed care contract in Baltimore during the summer of 2001. When the MAMSI contract converted to LabCorp in August 2001, the resulting decline in specimen volume in Quest’s Baltimore lab facility that fall forced Quest Diagnostics to radically downsize the Baltimore facility and lay off many employees at that site.

Replacing Lost Specimens

Because AML had considerable specimen volume from docs’ offices in its Washington, DC and Las Vegas lab divisions, Quest could replace the volume lost from Baltimore. Of equal importance, by closing the AML deal early enough in 2002, it could minimize the visible impact that the lost Baltimore specimens would have on its public financial statements.

On the hospital send-out testing side of the ledger, Quest Diagnostics had some equally serious problems that the AML acquisition could help solve. Following its purchase of SmithKline Beecham Clinical Laboratories (SBCL) in 1999, Quest Diagnostics did an admirable job of integrating the two companies and retaining the business it had purchased. However, the one area where client retention efforts proved disappointing was in hospital send-out testing. Multiple sources tell THE DARK REPORT that, in the years following the SBCL acquisition, Quest Diagnostics lost as many as 600 hospital reference accounts.

Successful Competitor

Moreover, evidence indicates that AML was extraordinarily successful at stealing business from Quest Diagnostics. As many as 400 of these lost Quest accounts may have ended up as AML clients. This sets the stage for the next revealing fact.

Until this summer, ARUP Laboratories and Quest Diagnostics were the only two lab companies on Premier, Inc.’s national reference test contract. Multiple sources tell THE DARK REPORT that, on Premier’s customer satisfaction surveys, ARUP consistently scores in the high 80s. In contrast, Quest Diagnostics has scored consistently in the low 40s—a customer satisfaction score less than half of ARUP’s!

Premier had made its dissatisfaction with this performance known to Quest Diagnostics. To reinforce this point, last February, Premier was ready to publicly announce it had inked an agreement with a third laboratory company for its national reference testing contract. The new laboratory provider was to be American Medical Laboratories. Several sources tell THE DARK REPORT that this contract was expected to feature measurably lower prices for lab testing, as well as some unprecedented performance clauses (with financial penalties) for such measurable service elements as turnaround time.

But that was not to be. The day before Premier was scheduled to finalize its agreement and announce the addition of AML to its national reference testing contract, Quest Diagnostics announced it had signed an acquisition agreement with AML.

This timing was not accidental. Sources tell THE DARK REPORT that Quest Diagnostics had grave concerns about the addition of AML to the Premier national reference testing contract. Having lost significant send-out business to AML already, Quest Diagnostics was worried that, once AML was an approved Premier provider, it would continue raiding Quest’s portfolio of hospital clients. Moreover, AML would offer more attractive pricing to hospital labs than what Quest offered under its Premier contract.

Buy The Tough Lab Competitor

But Quest could solve all these problems with a simple act: purchase AML and remove it as a competitor. Unintentionally, AML helped in the timing of its acquisition by Quest Diagnostics. As long-time readers of THE DARK REPORT know, AML carried lots of debt. (See TDR, October 23, 2000.) It needed considerable cash to pay off a current portion of its debt, as well as to make interest payments.

In the fall of 2001, it was testing the market for another try at a public stock offering. Thus, just at the moment when Quest Diagnostics wanted to purchase AML, it was “on the market.” Many were surprised that Quest Diagnostics paid almost $500 million to get AML and its revenues of $300 million. But that price was a bargain for Quest Diagnostics when one understands how the AML acquisition could solve serious business problems plaguing Quest with both the physicians’ office segment and the hospital send out segment.

Adding A Third Contract Lab

The next chapter in this story was written by Premier. By acquiring AML and refusing to honor AML’s commitment to Premier, Quest Diagnostics had removed it as the third provider on Premier’s national reference contract. Premier was now denied the opportunity to offer its member hospitals a new, lower priced lab option. Not surprisingly, an even unhappier Premier began negotiations with LabCorp. It announced that LabCorp would be its third national reference testing lab on July 15, 2002.

For lab administrators and pathologists seeking to understand the changes in the hospital send-out marketplace, this information provides a clearer insight into some of 2002’s major events.

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