DARK REPORT Picks 1998’s Ten Biggest Lab Stories

Annual year-end review provides revealing look at major influences affecting lab industry

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CEO SUMMARY: Our story picks for 1998 demonstrate a broad range of subjects. Each affects laboratories and pathology practices in significant ways and should be used to trigger appropriate management strategies. Two essential themes among this year’s ten biggest lab stories: continued downward squeeze on reimbursement and a flood of new technology is on the way.

Unlike 1997, there was no single compelling story during 1998 which would immediately impact every laboratory in every city.

The big story in 1997 was the requirement for laboratory compliance programs, introduced by federal regulators after their $325 million settlement with SmithKline Beecham PLC in February 1997.

During 1997 and 1998, every licensed laboratory in the United States found themselves immersed in laboratory compliance issues. So the fact that 1998 did not have a similar story should be considered a blessing. But the relative quiet of 1998 should not be misunderstood.

Although the year passed rather quietly, significant events were occurring behind the scenes. A careful analysis of 1998’s top stories indicates two consistent themes for the future.

First, all categories of healthcare providers have entered a business cycle where money management is critical to survival. The clinical laboratory industry was the first to show the effects of this trend in 1995. During 1998, the rest of healthcare began experiencing the same phenomenon.

Second, a wave of new technology is preparing to enter clinical usage. This new technology will force healthcare providers, including clinical laboratories and pathologists, to dramatically change the way their business is organized and the way it delivers clinical services.

That’s the bad news. The good news is that these two trends will not put laboratories and pathology practices under immediate pressure to change. Rather, the effects of these trends will be felt over time and each will interact to compound their cumulative effects upon laboratories and pathology practices.

But the cumulative and compounding effects of these two trends should not be underestimated. If one accepts the trend of increased negative financial pressure (from lower reimbursement, from changes in how HMOs and government health plans process claims, and similar factors), it becomes easy to see how that influences the impact of new technology.

Insufficient Capital

A laboratory must have money to acquire, install, and utilize new technology. If finances are deteriorating, then insufficient capital is available for the purchase of new technology.

This puts clinical labs and pathology practices in a double whammy. On one hand, reimbursement is insufficient to sustain existing operations. On the other hand, if new technology cannot be acquired, then the laboratory falls behind its competitors. That increases the financial pressure.

Since 1998 was not dominated by any single story, it signals that the clinical laboratory industry is in the midst of a transition.

Four stories on our Top Ten list reflect deteriorating financial prospects. They are: widespread HMO losses; crash of the PPM industry; decline in the value of clinical laboratories; and the stiff increase in health insurance premiums for 1999.

Three of our Top Ten stories reflect the trend of coming new technology. They are: automated Pap smear screening (page 4); the new human genome mapping partnership; and the advent of Luminex Corp.’s FlowMetrix™ system.

One Top Ten story illustrates an emerging market response to these twin trends. A new cycle of hospital chain-commercial laboratory ventures provides evidence that some organizations are attempting to forestall the effects of declining reimbursement by reorganizing themselves more efficiently.

Since 1998 was not dominated by any single story, it signals that the clinical laboratory industry is in the midst of a transition. Things are quiet because the healthcare industry is reacting to the effects of consolidation and the move toward integrated clinical services.

This is territory where no road map exists to guide physicians and administrators. In that sense, everyone is equal, because there is no “right” organizational model for the type of clinical laboratory required by clinical integration.

Reassess Strategic Position

THE DARK REPORT recommends that lab- oratory executives and pathologists use this quiet period to reassess their strategic position in their particular healthcare market. The relative lull provides a good opportunity to reposition the laboratory for the next cycle of market changes and declining reimbursement.

As 1999 progresses, expect the nation’s largest healthcare organizations to concentrate their market clout through further consolidation. The acquisition of Prudential Healthcare by Aetna U.S. Healthcare in December 1998 is an example.

Although size does not guarantee profitability and success, it certainly guarantees attention and a place at the table. Financially-weak providers will find themselves gobbled up by larger companies interested in growth by acquisition.

Although this may restrict provider access by hospital lab outreach programs and independent labs, THE DARK REPORT continues to believe that local testing, delivered with a high level of service, will continue to be a competitive advantage.

1. Hospital Chain-Commercial Lab Ventures Entering New Phase

DURING 1998, A NEW GENERATION of ventures between hospital chains and commercial laboratories emerged.

These new ventures represent an increasing awareness by hospital operators that the clinical laboratory can play a greater role in lowering costs and improving healthcare outcomes.

In January, Tenet Healthcare inked a contract with SmithKline Beecham Clinical Laboratories (SBCL) to reorganize Tenet’s 30 hospital laboratories in Southern California (See TDR, January 19, 1998.)

The next big announcement was a two-part strategic alliance between Premier, Inc. and Quest Diagnostics Incorporated. Made public in May, the alliance is designed to help hospital systems improve the productivity and clinical contribution of their laboratory organizations. (See TDR, May 26; June 15; and July 6, 1998.)

During the year, Dynacare and MDS’s AutoLab Systems continued to develop additional relationships with hospital operators. American Medical Laboratories, revitalized by its new owners, also began an intense campaign to develop strategic relationships with hospitals.

These developments promise to change the historical animosity between commercial laboratories and hospital-based labs. It will lead to the regional laboratory systems which economic forces dictate as an end game. But the transformation will not be immediate. Hospitals are slow to change their ways and these deals will be scratched out one at a time.

2. Automated Pap Smear Screens Enter Market With FDA Approval

PERSISTENCE CAN PAY OFF. The long and expensive effort to bring an automated cytology system to the marketplace was finally successful.

During 1998, the Food and Drug Administration (FDA) formally approved NeoPath, Inc.’s premarket approval supplement to use its AutoPap® system as a primary screener for Pap smears.

Once the FDA decision became official, the profession of cytology changed forever. Within months of the FDA’s action, two of the nation’s largest and most respected healthcare organizations made a major commitment to the AutoPap system.

Kaiser Permanente, with 1.4 million Pap smears per year, and SmithKline Beecham Clinical Laboratories, with 5.5 million Pap smears per year, each signed agreements with NeoPath. Both companies intend to move 100% of their Paps smears onto automated screening within two years.

These developments will revolutionize the cytology profession. THE DARK REPORT predicts that future generations of automated cytology technology will transform cytology practices in the same way that Coulter Counters transformed blood testing. As additional cytology companies enter the marketplace with new automated cytology products, laboratorians, physicians and patients will all reap the benefits.

3. Increasing Numbers of HMOs Disclose Significant Losses

MANAGED CARE’S GLORY DAYS may now be history. As 1997 ended and 1998 began, HMOs large and small in every corner of the country posted losses. It was a dramatic turnaround for an industry which was financially flush just 12 months earlier.

This is a big story for the laboratory industry. If HMOs find it impossible to operate with acceptable profit margins, it will be difficult for HMOs to increase reimbursement for laboratory testing.

Kaiser Permanente lost money in 1997 and projects losses for 1998. United Healthcare was ready to acquire Humana, but disclosure of a $900 million charge at United Healthcare during the second quarter derailed the merger. Oxford Health Plans lost $508 million during the second quarter as well.

Late in the year, Prudential sold its perennially money-losing healthcare division to Aetna U.S. Healthcare. The acquisition made Aetna the largest health insurer in the nation, with 22.4 million members. (See TDR, December 21, 1998.)

Laboratory executives should pay close attention to the financial condition of managed care companies. The profitability of the clinical laboratory industry is closely linked to that of the managed care industry. During the next 24 months, expect to see employers get hit with considerable premium increases as managed care firms attempt to regain financial stability.

4. Three Pathology PPMS Gear Up In Midst Of PPM Industry Crash

FOR PATHOLOGY PRACTICE MANAGEMENT (PPM) companies, timing could not be worse. 1998 was a disaster year for the PPM industry as a whole.

During 1998, Pathology Consultants of America (PCA); Pathology Partners, Inc.; and PATHSource, Inc. obtained venture capital funding and entered the marketplace. Along with AmeriPath, Inc., each company had high hopes of offering pathologists another business model besides a group practice.

Through the course of 1998, the investor public was stunned by announcements that billion-dollar PPM giants such as MedPartners, Inc.; PhyMatrix Corp.; and others suffered significant losses or announced that they were quitting the physician management business.

Many Wall Street analysts now doubt the viability of the PPM concept. Pathologists seem to agree.

During 1998, the collective group of pathology PPMs struggled to do enough acquisitions to meet their original growth projections. Executives at these PPMs opted for a “go slow” strategy in buying pathology practices.

Because the PPM industry is undergoing a severe financial squeeze, it is unlikely that the PPM business model will become a significant factor in altering the practice of pathology. Going into 1998, few experts would have made such a prediction.

5. New Generation of Technology To Speed Human Genome Map

DURING THE NEXT TEN YEARS, probably no single story of 1998 promises to revolutionize the clinical laboratory industry more than that of the partnership between Perkin-Elmer Corp. and J. Craig Venter, Ph.D.

In May, the two parties announced a joint venture to map the human genome. Using a new generation of genetic analyzer developed at Perkin-Elmer, the partnership believes it can map the entire human genome in as little as three to four years, at a cost of less than $300 million.

Contrast this to the federally-funded Human Genome Project, launched in 1990. Budgeted at $3 billion and projected to take 15 years, the project is at the half-way point and is ahead of schedule, with about 3% of the genes completely mapped.

If the Perkin-Elmer/Venter partnership succeeds in its goals, there will be several consequences. First, it will unleash a cascade of new genetics knowledge that will spur a variety of healthcare discoveries in both diagnostics and therapeutics.

Second, these gene-based discoveries may end up as private patents. Thus, new diagnostic assays will enter the marketplace through untraditional delivery channels. General reference labs may not be able to license rights to many worthwhile new assays.

Keep an eye on this joint venture. If it succeeds, there will be a steady stream of changes to clinical lab practices during the next five to ten years.

6. First Major Laboratory Site Earns ISO-9000 Certification

IT WAS DURING THE 1990S THAT the healthcare industry finally became aware of management techniques common to successful Fortune 100 companies.

It was not until 1998 that the first major laboratory site achieved ISO-9000 certification. It was the Nichols Institute Division of Quest Diagnostics Incorporated which earned this honor. (See TDR, July 27, 1998.)

This story makes our Top Ten List for an important reason. The clinical laboratory industry, along with most healthcare providers, is finally awakening to the management philosophies and techniques used by America’s most successful companies.

The importance of ISO-9000 certification at Nichols Institute lies not in the fact that they were first. Rather, the importance is that Nichols Institute is now organized around a powerful new philosophy of management.

Simply put, if the executives at Nichols use these management tools effectively, Nichols Institute will increasingly be more competitive than other laboratories. It will force competitors to adopt the same management philosophies.

The management parameters embodied in ISO-9000 guidelines are what create the world-class companies which dominate their markets. Its arrival in the clinical lab market signals that an irrevocable change is now under way.

7. Managed Care Consolidation Changes Competitive Balance

CONSOLIDATION IS A BUSINESS THEME familiar to all readers of THE DARK REPORT. For better or worse, consolidation is transforming every sector of healthcare.

During 1998, the consolidation of managed care companies followed two trails. First, the industry giants continue efforts to grow through acquisition. Second, significant losses at many small and medium-sized health plans have made them acquisition targets.

Consolidation of managed care companies will not be a positive development for the clinical laboratory industry. The larger the managed care plan, the greater the tendency to sign exclusive provider arrangements with large laboratory companies.

For example, Aetna U.S. Healthcare’s purchase of Prudential Healthcare in December now gives it 22.4 million members and provider contracts with 400,000 of the nation’s 600,000 physicians. (See TDR, December 21, 1998.) This is market clout. SmithKline Beecham Clinical Laboratories was the sole source laboratory provider to Prudential and is Aetna’s sole source provider in nine states.

At the other end of the scale, a number of smaller health plans, after posting significant losses, find themselves acquired by stronger insurers. This also tends to concentrate market buying power to the detriment of hospital labs and independent commercial labs. The result is that more laboratories are finding themselves denied status as a laboratory services provider.

8. Sales of Clinical Laboratories Reveal Ongoing Financial Woes

ONLY A LIMITED NUMBER of commercial laboratories were sold during 1998. Those that did come to market were generally in poor financial condition.

Bankruptcy was frequently the reason a laboratory had to be sold. That was certainly the case for $28 million Meris Laboratories (bought for $16.5 million by Unilab, Inc.) and $20 million Medilab, Inc. (bought for $11 million by Laboratory Corporation of America).

These sales were consummated for about 50¢ per $1.00 of annual revenue. This is a dramatic reduction from the heady acquisition frenzy of 1990-1994, when the large laboratories were commonly willing to pay sales prices of $1.00 per $1.00 of annual revenue.

These forced sales are evidence that many independent commercial laboratories continue to operate under severe financial stress. The impact of lower reimbursement and burdensome compliance requirements is preventing them from achieving financial stability.

Laboratory sales during the year revealed another interesting development. Some of the three blood brothers are showing interest in selective acquisitions. LabCorp purchased significant laboratory business on at least two occasions. Quest Diagnostics Incorporated did one acquisition in December.As independent labs are forced to sell, the big labs are again potential buyers.

9. Healthcare Premiums Jump, Providers Fight Medicare Cuts

THERE IS AN INTERESTING contradiction in the marketplace. Widespread losses caused HMOs to push stiff premium increases onto employers for 1999. This, despite the fact that prices charged by hospitals and physicians only climbed by about 2% during the year.

Meanwhile, healthcare providers are reacting to the Medicare cuts enacted by Congress in recent years. As the impact of these cuts, particularly in home health services, hit providers, they responded immediately by lobbying Congress for relief.

Large employers are seeing premium increases in the range of 6% to 12%. It is small andmedium-sizedemployerswhoare getting slammed. Companies in this size range are seeing increases of 30% to 50%.

This means that both private employers and government healthplans will soon react to the actions of HMOs and providers. There is not enough money to go around.

After several years of moderate premium increases to private industry, the staggering financial losses of the HMO industry are causing them to raise premium prices as aggressively as possible.

Laboratory executives and pathologists should monitor this trend. If premium hikes at the end of 1999 follow a similar pattern, there will be a response by private employers. Larger employers may turn to direct contracting as a way to control healthcare costs. If so, that could be to the benefit of clinical laboratories.

10. Luminex Brings “Disruptive Technology” To Diagnostics

IN THE DARK REPORT’S final issue for 1998, the cover story was about Luminex Corp. and its remarkable multiplex bioassay system.

It is THE DARK REPORT’s prediction that Luminex has developed a bioassay technology that will eventually transform how clinical laboratories are organized and how they deliver testing services.

Called FlowMetrix™, it is a technology which can perform up to 64 individual assays simultaneously on one specimen, at a cost of literally pennies per assay. (See TDR, December 21, 1998.)

Although Luminex recognizes that the pharmaceutical market represents the greatest potential, it is already attracting the attention of large clinical laboratories in the United States. The reason is simple. Clinical laboratories are under great pressure to cut costs, without cutting service and quality.

Luminex’s FlowMetrix has the capability to greatly reduce the costs of individual tests while maintaining or improving specificity and sensitivity.

However, it is in the long run that FlowMetrix will have its greatest impact on laboratory services. Here is a technology platform that can perform 64 discrete assays at the same time on one sample. We predict that labs will develop a wide range of value-added test panels which only this technology can make possible.

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