"New Competitors Vie for Business"

Analysis of Lab Testing Market Reveals Competitive Shifts

SPECIAL INTELLIGENCE BRIEFING

CEO SUMMARY: Even as public lab and anatomic pathology companies enjoy sustained growth in specimen volumes and revenues, fundamental shifts in the basic marketplace have changed the competitive environment. Surprisingly, the most open market segment is anatomic pathology specimens referred by physicians’ offices. Hospital inpatient and outpatient testing continues to be a limited growth opportunity for commercial labs, while com- petition for routine testing from docs’ offices is increasingly between hospital lab outreach programs and the two national laboratories.

DURING THE PAST SIX YEARS, fundamental shifts occurred in the marketplace for both clinical laboratory testing and anatomic pathology services.

These marketplace shifts evolved at a steady pace between 1995 and the present, often escaping the conscious notice of many lab executives and pathologists even as they intuitively repositioned their labs to respond to these changes.

There are new competitors, and new market dynamics, in both clinical lab testing and pathology services. These new forces are rooted in how and where test specimens originate. Before looking at the “new” market dynamics, it will be helpful to understand the basic size of the lab testing market and how it is calculated.

Attempting to estimate the size of the lab market places us on a murky road, however. It is one which is often marked by controversy and differences of opinion. The challenge is gathering accurate data on the volume of lab tests performed each year in the United States. As most lab executives and pathologists know, accurate and highly-reliable numbers do not exist. The range of payers, from private health insurers, Medicare, Medicaid, and patient self-pay, make it difficult to gather information and develop an aggregate number. Similarly, on the provider side, lab testing is done in tens of thousands of settings including stand-alone labs, hospitals, physicians’ offices, and in patients’ homes.

Varying Estimates

During the past decade, I have seen estimates for lab and pathology testing that range from about $30 billion per year to as much as $36 billion. Sources for these estimates include consultants, government health planners, Wall Street analysts, and public lab companies.

There are two safe conclusions to make from this situation. First, on a consensus basis, experts looking at the laboratory services market seem to agree on a figure in the low to mid-$30 billion range for the annual value of lab and pathology testing.

Second, it is common for someone to cobble together an estimate using an unknown methodology. This estimate then is picked up and quoted by any number of other sources. Thus, there is often a good amount of “honest-wrong” information floating around—believed to be right for sincere reasons, but developed from unverifiable numbers.

Against this background, I think it is reasonable to accept a number in the mid- $30 billion range for the total value of clinical laboratory testing and anatomic pathology services performed annually in the United States. To make the math simple, I will use $36 billion for the annual income associated with clinical lab testing and anatomic pathology services.

$6 Billion For Anatomic Path

Of this number, probably $6 billion can be attributed to anatomic pathology. Again, different experts offer different numbers. For example, it is known that the typical hospital-based pathologist will generate an average of about $500,000 per year in collected revenues. There are more than 13,000 board-certified pathologists in the United States. Deduct a number for retired, semi-retired, researchers, and newly-minted doctors working in residency and internship programs, and a reasonable estimate is 12,000 pathologists. If these 12,000 generated an average of $500,000 per year per pathologist, the aggregate total would be in the range of $6 billion.

These numbers help frame the following analysis of competitive dynamics in the four segments of the lab testing industry. It is important to remember that these are ballpark estimates. The fudge factor on specific numbers can be significant, but won’t affect the fundamental analysis which follows.

Chart 1 illustrates what we can call “Robert’s Rule of 50/50.” For all intents and purposes, about half of all testing originates in hospitals. The other half of testing originates in physicians’ offices. This 50/50 ratio is a ballpark generalization. Obviously, any number of estimates out there give hospitals a market share ranging from 45% to 55% of all testing. But the basic point is unchallenged. Give or take a few percentage points, hospitals originate about half of all lab specimens.

“Robert’s Rule of 50/50” defines four market segments which can be separately analyzed. They are: 1) hospital-originated clinical lab testing; 2) physicians’ office-originated clinical lab testing; 3) hospital-originated anatomic pathology testing; and 4) physicians’ office-originated anatomic pathology testing. Assessing each of these four testing segments helps reveal the different competitors and new market dynamics that emerged since 1995.

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1. Hospital-Originated Clinical Lab Testing

Chart 2 shows how hospital-originated clinical laboratory testing comprises the largest single chunk of the testing marketplace. It totals about $15 billion per year. This includes hospital inpatient and outpatient testing. It does not include physicians’ office-originated testing which might be done by a hospital laboratory.

A relatively small slice of this market is done by non-hospital labs. Generally called “send-out” testing, it consists of the reference and esoteric tests that a hospital needs but does not do in-house. Thus, these tests are referred (or “sent-out”) to a select number of reference labs.

Also, there are commercial lab/ hospital lab joint ventures which involve the routine testing normally done within a typical hospital setting. However, these are relatively few in number and so only affect a small percentage of this market segment.

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2. Physicians’ Office-Originated Clinical Lab Testing

As chart 3 reveals, this segment represents about $15 billion in annual testing revenues. However, it’s important to note that about half of this $15 billion is done by physicians’ office laboratories (POLs). These are test specimens which are done in-house.

That leaves $7.5 billion of testing that can be done by commercial laboratories. Here is the market where there is intense competition between three classes of laboratories: 1) the two national labs (Quest Diagnostics Incorporated and Laboratory Corporation of America); 2) independent commercial laboratories (usually local or regional); and 3) hospital laboratory testing outreach programs.

What becomes obvious when looking at this $7.5 billion slice is that Quest Diagnostics and LabCorp already hold $4.37 billion of this market, or 58.3%. (This factors out an estimated portion of the two lab companies’ revenues attributable to hospital send-out testing and anatomic pathology.)

For the remaining $3.1 billion, the change since 1995 is that most of this business is being done by hospital lab outreach programs. There are only a handful of independent commercial labs remaining in the United States, due to mergers, acquisitions, and bankruptcies throughout the 1990s.

Hospital lab outreach programs are a consequence of the growth in multi-hospital health systems since the mid-1990s. These lab outreach programs were created to serve the local medical office campuses surrounding the health system’s hospitals. They fill the vacuum left after most local independent labs were acquired by larger lab companies.

3. Hospital-Originated Anatomic Pathology

Hospitals originate at least half of all the anatomic pathology specimens, which, given my assumptions, totals about $3 billion per year. This is illustrated in Chart 4.

Typically, this work is done by local pathology group practices. Because of consolidation, a growing proportion of these local pathology groups are serving more than one hospital in their local market.

These specimens originate from hospital inpatients and outpatients, so only a small portion of this work is referred (sent-out”) to other pathology labs. To participate in this market segment, a company would have to own the local pathology group which holds the anatomic pathology (AP) services contract with the local hospital.

Currently, only one public company fits this description. It is Ameri-Path, Inc., which owns both office-based dermatopathology practices and local hospital-based pathology groups. AmeriPath does an estimated $200 million per year of hospital-originated anatomic pathology work.

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4. Physicians’ Office-Originated Anatomic Pathology

Chart 5 shows this testing segment. Currently there is lots of competitive action in this $3 billion segment. Historically, the primary providers to this market segment have been local pathology group practices.

However, during the past four or five years, companies like AmeriPath,
DIANON Systems, IMPATH, UroCor, and others have launched extensive sales and marketing programs into the physicians’ office environment. These marketing efforts have fueled significant and sustained growth in specimen volumes and revenues.

Quest Diagnostics and LabCorp also do considerable business in this segment. Estimates are that this totals about $10% of their annual revenues, or $350 million and $200 million, respectively.

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Conclusions & Observations

Breaking down the market for clinical lab testing and anatomic pathology in this manner allows us to isolate and identify the significant changes which occurred during the past ten years. It leads to some interesting conclusions and observations.

The physicians’ office clin lab testing segment has probably seen the most significant changes. First, Quest Diagnostics and LabCorp now control almost 60% of the national market. Second, competition for these specimens increasingly comes from hospital lab outreach programs, not from regional independent commercial labs. Collectively, these two factors have changed the competitive dynamics in physicians’ office testing.

It might also be argued, with justification, that the two blood brothers will have a difficult time increasing their share of this market segment. On one hand, much of the business they don’t have may be in regions where they have minimal or no support infrastructure. On the other hand, in regions where they are strong, professionally-managed hospital lab outreach pro- grams are successfully positioning themselves to be a high-service Avis (“We try harder”) to the blood brother’s Hertz (“We’re number one”).

Also undergoing significant change is the competitive market for anatomic pathology specimens generated by physicians’ offices. Whereas this market was overwhelmingly served by local pathology groups as recently as 1997, during the past four years a handful of national pathology companies have made major gains in market share, revenues, and profits. Having captured as much as 26% of this market, it appears these companies have plenty of room for continued growth in specimen volume and revenues.

Competing For Specimens

That means a mixed bag in competing for physicians’ office business. For clinical laboratory specimens, competition will increasingly be between the two national labs and local hospital/hospital system lab outreach programs.

Moreover, in coming years the arrival of viable point-of-care testing instruments that allow the physicians to do more tests in-office and get paid for them will certainly change this market segment. It may reduce the flow of specimens (and associated revenues) sent to commercial labs and outreach test programs. On the other hand, a growing menu of POL tests may create an opportunity for labs to earn revenue by managing POLs for physician group practices.

Competition for anatomic pathology specimens originated by office-based physicians is thriving in the current market environment. There seems to be ample growth opportunities for national anatomic pathology providers. However, THE DARK REPORT predicts that, in many cities, local pathologists will consolidate into regional super-groups. This will give them both the capital base and specialized pathology expertise needed to successfully compete against the national AP companies.

Things are equally interesting on the hospital side. There seems to be little evidence to date that commercial labs have strong prospects for capturing sizeable shares of the market for hospital inpatient and outpatient lab testing. Since the mid-1980s, almost every publicly-traded laboratory company has told Wall Street that it sees hospital lab testing as a fertile, untapped market. Yet, after 20 years of sustained marketing to hospitals, the current crop of public lab companies has just a limited number of situations where it participates in the routine testing of hospital inpatient/outpatient lab specimens.

THE DARK REPORT’S prediction is for little change in this situation. Similarly, unless a well-financed company proves willing to buy local pathology practices, the majority of hospital-based anatomic pathology will continue to be done by local pathology groups. However, because of changing technology, these same local pathologists may be referring ever-increasing numbers of cases to national AP companies to do more sophisticated diagnoses.

Broad Estimates

Finally, a caveat and a disclaimer: As noted earlier, the numbers included in this assessment of laboratory market changes are broad estimates. In many cases, public companies do not break out and disclose revenues for certain lines of business, which makes it impossible to verify precise numbers.

Notwithstanding these facts, this intelligence briefing does provide a “big picture” view of the macro changes which have altered competitive dynamics within the clinical lab testing and anatomic pathology segments of the lab marketplace. These are the forces impelling changes in how clinical labs and pathology group practices organize and deliver lab testing services.

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