Are Two Blood Brothers Using Economic Clout?

Impact from acquiring four large competitors in 2003 shows up in second quarter earnings

CEO SUMMARY: Quest Diagnostics Incorporated and Laboratory Corporation of America now dominate the national marketplace for testing referred by physicians’ offices. Release of their second quarter earnings reports provides the first look at their performance following the acquisitions in 2002 which removed American Medical Laboratories, Dynacare, DIANON Systems, and Unilab from the marketplace.

WITH THE RELEASE OF SECOND QUARTER earnings by Quest Diagnostics Incorporated and Laboratory Corporation of America, the lab industry has its first opportunity to gauge the impact of last year’s four big lab acquisitions.

That acquisition wave created a significant restructuring of the competitive market for testing that originates in physicians’ offices. It removed American Medical Laboratories, Dynacare, Unilab, and DIANON Systems as competitors to the two blood brothers.

It also expanded the geographical reach of the two blood brothers, giving them additional cities where regional laboratories were operated by the lab firms they acquired. One important consequence of these acquisitions is that the market for lab testing services delivered to office-based physicians now has two unique, and strategically relevant characteristics. First, it is a national oligopoly. Second, in specific cities where either of the two blood brothers holds a dominant market share, there exists a regional monopoly.

Last year THE DARK REPORT laid out the reasons why this oligopoly and monopoly market situation exists, and why it affects the strategic planning of hospital lab outreach programs that must compete against Quest Diagnostics and LabCorp. (See TDR, May 13, 2002.)

Classic economic theory recognizes that markets dominated by oligopolies and monopolies have unique competitive attributes. Among other things, the economic power, dominant market share, and economies of scale allow oligopolistic and monopolistic companies to squeeze competitors in a variety of ways. Antitrust laws were developed in response to these patterns of behavior, seen in a variety of industries over many years.

…each wants to change the test mix in favor of “esoteric” and “genetic” testing, because of the higher reimbursement attached to those classes of lab tests.

Against this historical background, the emergence of Quest Diagnostics and LabCorp as overwhelmingly dominant companies needs to be recognized in the strategic planning of competing laboratories. Both Quest Diagnostics and LabCorp must generate increased specimen volume and higher earnings to meet the expectations of the investment community.

In that search for additional specimens and revenues, the two blood brothers want to expand their market share in other segments of the diagnostic testing marketplace. There are three obvious targets: 1) hospital testing; 2) anatomic pathology: and, 3) esoteric and genetic testing. Within the hospital testing segment, each company would like to capture inpatient specimens through contract management of hospital labs and/or as a reference testing resource.

Looking At The Numbers

Using this background as a starting point, the second quarter earnings announcements by Quest Diagnostics and LabCorp are noteworthy. Second quarter represents the first few months since they completed their acquisitions and began integrating the operations of their acquired prizes.

First, a look at LabCorp. The impact of the Dynacare and DIANON acquisitions is evident. LabCorp’s revenues increased 21.5% for the quarter, to $743.7 million. Specimen volume increased 16% and price per acquisition went up 5.5%, compared to second quarter 2002.

At Quest Diagnostics, revenues increased 14.1%, to $1.22 billion. Specimen volume, measured by requisitions, increased 10% while revenue per requisition increased 3.5%, compared to second quarter 2002. The Unilab acquisition, which closed on February 28, 2003, contributes to Quest Diagnostics’ second quarter numbers.

Days sales outstanding (DSO) is comparable, at 47 and 54, respectively, for Quest Diagnostics and LabCorp. However, LabCorp’s bad debt expense, at 7.5%, is almost 50% greater than the 4.8% reported by Quest. Reduction of bad debt expense and DSO is a primary goal at Quest Diagnostics. It states that almost 10% of its employees are involved in billing and collections.

Similar Business Goals

From a strategic perspective, both laboratories are effectively pursuing the same objectives to boost financial performance. Each wants to increase specimen volume through acquisitions and its sales force. Each wants to improve pricing. And each wants to change the test mix in favor of “esoteric” and “genetic” testing, because of the higher reimbursement attached to those classes of lab tests.

Because esoteric and genetic testing is a hot button among Wall Street analysts and the investment community, progress in those areas is constantly emphasized by executives at both the two blood brothers. LabCorp, which advertises itself as “the first national laboratory to fully embrace genomic testing,” releases detailed information about the mix of tests and the revenue they generate.

For the six months ending June 30, 2003, LabCorp disclosed that it generated $437.4 million in revenues from genetic and esoteric testing. This was a 13.4% increase over the same period in 2002. By comparison, what LabCorp defines as “core” testing grew 16.2% during the same time.

A more interesting fact is the revenue attached to each category of tests. LabCorp reports that revenue per accession for genomic/esoteric testing was $53.90 and $62.85 for the first six months of 2002 and 2003, respectively. Revenue per accession for core testing was $27.47 and $27.85 for that same time period.

Thus, revenue per accession for genomic/esoteric testing climbed 16.6% over the year, while revenue per accession for core testing only increased 1.4% during that same time. This demonstrates that the clinical value of genomic and esoteric testing encourages higher reimbursement from payers.

Quest Diagnostic states that gene-based testing grew 20% over the previous year, while esoteric testing grew at a rate of 10%. Because of a 10% decline in drugs of abuse testing volumes due to the weak economy, Quest stated its core test volume was essentially flat during the past year.

Blood Draw Trend

Another trend may be indicated by developments within Quest Diagnostics. The company indicates that about 30% of its specimens are drawn by its 1,700 patient services centers (PSC), and this percentage is increasing. This could be confirmation that many physicians are deciding that they no longer want to draw patients in their offices. Instead, they refer their patients to the lab’s PSC.

If true, this is a consequence of inadequate reimbursement for blood draws, changes in compliance regulations which affect supplies a lab provides to physician-clients, and even concerns about malpractice liability from in-office blood draws.

Such a trend probably has a negative impact on local laboratories. That’s because they must pick up the cost of phlebotomy on those specimens which were, at one time, handled by the physician’s office staff.

Liquid Prep Conversion

Another trend of interest is the conversion, by physicians, from conventional Pap smear tests to liquid preparation Pap tests. Quest states that currently 82% of its clients have converted to the liquid-prep Pap test. It doesn’t expect the percentage to increase much in future months.

At LabCorp, the conversion rate is 74%. LabCorp believes the upper end will be about 85%, which is in the same range as the predictions at Quest. LabCorp also says that about 50% of its liquid-prep Pap specimens come with a request to reflex with HPV testing if clinically indicated. LabCorp notes that this is one reason why revenues from HPV testing jumped 70% during the past 12 months.

Prospects For Passage

Proposed legislation to impose a 20% co-payment on Medicare Part B laboratory tests was discussed by executives at both companies during their second quarter earnings call. Neither company believes that the final bill which emerges from the Senate-House conference committee will include the 20% co-payment provision. However, both companies hedged that statement, acknowledging that there are many uncertainties in the political process.

Second quarter earnings reports represent only four months since the last of the four major lab acquisitions was completed (Quest closed the Unilab deal on February 28). However, in that short time, some of the strategies and objectives of the two blood brothers have become known.

During the next 12 months, the two blood brothers will launch intense marketing campaigns to promote their particular colorectal cancer screening test.

Both companies will continue to look for growth by acquisition. But THE DARK REPORT believes that the most visible effort will come from efforts by the two blood brothers to acquire new diagnostic technology which is then offered to physicians on an exclusive basis. Such technology can be purchased outright, licensed, or acquired through marketing and distribution agreements.

In fact, THE DARK REPORT will now make one of its famous predictions. During the next 12 months, the two blood brothers will launch intense marketing campaigns to promote their particular colorectal cancer screening test. As this unfolds, it will allow the lab industry to learn whether the exclusive distribution rights to a new test technology can generate worth- while revenue growth and profits.

As billion-dollar behemoths, both LabCorp and Quest have the economic resources to further expand their market dominance. But size does have its disadvantages. Regional labs, nimble and close to the customer, still hold their own in many cities. That’s because local services of the national labs often fall short
of physician expectations.

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