CEO SUMMARY: In December, American Medical Laboratories, Inc. (AML) was preparing a second attempt to raise capital through an initial public offering (IPO). But a tempting purchase offer by Quest Diagnostics Incorporated led to a decision by AML’s owners to sell the company. This transaction is reminiscent of Quest Diagnostics’ bold move to buy SmithKline Beecham Clinical Laboratories in 1999.
By PURCHASING American Medical Laboratories, Inc. (AML), Quest Diagnostics Incorporated continues the trend of commercial laboratory consolidation that started in the mid-1980s, but slowed in recent years.
The sale was officially announced on Thursday, February 7. Quest Diagnostics will pay $500 million for AML. The price includes assumption of about $160 million of AML debt. It is an all-cash transaction.
It was disclosed that American Medical Labs, based in Chantilly, Virginia, has annual sales of approximately $300 million and EBITDA (earnings before interest, taxes, depreciation, and amortization) of $40 million. That means Quest Diagnostics is paying a multiple that is slightly greater than 12 times cash flow.
One interesting aspect to this transaction is that Quest also gets LabPortal.com, the start-up company that was selling a system for Web-based lab test ordering and results reporting between labs and physicians’ offices. AML was the beta lab site for LabPortal’s product and had purchased LabPortal before announcing its own sale to Quest Diagnostics.
THE DARK REPORT believes that the AML acquisition is a significant event in the market for lab testing services. First, it demonstrates that the two blood brothers continue to be ready buyers of independent lab companies. Moreover, sales prices are not at the discounted levels seen in the late 1990s. During the past 18 months, both Quest Diagnostics and Laboratory Corporation of America have paid generous prices to acquire selected independent laboratories.
Second, the concentration of AML’s lab testing business into Quest Diagnostics eliminates one of the few remaining lab companies that was in a position to challenge the two blood brothers for routine testing in two regional markets—Las Vegas and Washington, DC—as well as in the national market for hospital send-out testing.
Tough Growth Challenges
Third, the decision by AML’s owners to accept Quest Diagnostics’ purchase offer must be seen as a sign of the difficulty of competing for market share in the lab testing community. After AML was acquired by the ownership team that included Tim Brodnik in May 1997, it put a high-powered sales and marketing team in the field and aggressively pursued new accounts from hospitals throughout the United States.
Effectively, after almost five years of professional effort and substantial revenue growth, AML’s primary owner, the private equity firm of Golder Thoma Cressy & Rauner (GTCR), decided that selling to Quest Diagnostics for $500 million was a better business proposition than remaining independent and selling shares to the public. This is market evidence that the challenges of building a clinical laboratory remain expensive and challenging.
Successful IPO Expected
However, there is another perspective on this argument. The financial community tells THE DARK REPORT that it is likely that AML would have successfully placed its IPO in December or January, making it a public laboratory company. It is reasonable to assume that Quest Diagnostics looked at two factors. First, Quest believed the laboratory assets of AML were a good match for its own growth strategy. Second, acquiring AML prior to its public offering would prevent a tough competitor from acquiring the growth capital it would need to compete even more aggressively in the lab testing marketplace.
Of these two assumptions, Quest Diagnostics has publicly discussed the first. It has told the investment community that it plans to operate AML as a separate business division. Quest Diagnostics has said it intends to keep open AML’s biggest lab facilities, in Las Vegas and Chantilly, Virginia.
There are specific plans for the Chantilly laboratory, which already does substantial volumes of reference and esoteric testing. Quest Diagnostics wants to develop it as the East coast “Nichols Institute.” It has said that it needs additional laboratory capacity for reference and esoteric testing and, because of the impact of September 11, it sees value in having such sophisticated testing capability in operation on both the east coast and the west coast of the United States.
Continue Hospital Marketing
Further, Quest Diagnostics has indicated that it wants AML to continue its sales and marketing activities to hospitals and other types of reference lab clients. If true, it is an indication that Quest Diagnostics wants to expand its efforts to capture a larger share of send-out tests from the hospital segment of the marketplace.
That may be why Quest Diagnostics, in January, terminated a sales program that focused on developing collaborative marketing programs with individual hospitals and health systems. It laid off a number of individuals responsible for this program. The timing of this move may indicate that Quest Diagnostics, once it knew it had a deal to buy AML, reassessed its strategy for selling to hospitals and considered this particular marketing program to be expendable.
Quest’s purchase of AML and its stated intention to build AML’s esoteric testing may have downstream consequences in group purchasing contracts. The crown jewel in AML’s contract portfolio is its preferred provider status with Health Trust Purchasing Group, which serves the hospitals of HCA, Inc. (formerly Columbia/ HCA). Meanwhile, the Premier, Inc. preferred provider contract held by Quest Diagnostics will come up for renewal. AML’s assets involving esoteric testing may help Quest Diagnostics in its efforts to retain that relationship.
Looking at the seller side of this transaction, AML’s owners are very happy. In 1997, the group which included GTCR, Brodnik, Jerrold Glick, and Jack Bergstrom, paid $23 million to buy AML. GTCR invested less than $10 million in cash because it financed most of the purchase price. For that reason, the sale of AML to Quest Diagnostics for $500 million represents a substantial profit.
The inclusion of LabPortal.com in the sale of American Medical Labs was probably an exit strategy for GTCR, which had financed its launch. Sales of LabPortal.com’s product to support Web-based lab test ordering and results reporting have been disappointing. So it is not surprising that the equity investment firm wanted to terminate its involvement and concentrate on other investment opportunities.
Of greater interest will be how Quest Diagnostics changes its business strategy for expanding its share of the market for hospital send-out testing. To fully capitalize on the new resources it has bought from AML, it will need to integrate its existing sales and marketing team with that of AML.
AML Used Expanded Sales Campaign and Lab Acquisitions to Fuel Steady Revenue Growth
WHEN THE NEW OWNERS purchased American Medical Laboratories, Inc. in May 1997, it was a regional independent laboratory which had posted revenues of $78.0 million for 1996 and offered reference testing to a select number of hospitals along the East Coast.
Under new ownership, the strategy was to convert AML into a national reference and esoteric laboratory, competing against such established players as ARUP Laboratories, Mayo Medical Laboratories, and Specialty Laboratories. (See TDR, May 12, 1997.) To achieve this, AML expanded its sales force. It currently supports 25 sales reps who sell reference and esoteric testing and 18 sales reps who market routine testing to physicians’ offices in Las Vegas and Washington, DC.
For 1998 and 1999, AML’s annual revenue climbed to $102.7 million and $143.4 million, respectively. In late 1999, AML paid $107.2 million to purchase Associated Pathologists Laboratories (APL) of Las Vegas, Nevada. At that time, APL had revenues of approximately $90 million. (See TDR, September 20, 1999.)
After consolidating APL’s business, for 2000 AML reported total revenues of $260 million. For 2001, AML is posting revenues of about $295 million. This business is split as follows: esoteric testing (57%), about $168 million; routine testing (36%), about $106 million; toxicology testing (7%), about $21 million. Since the arrival of AML’s new owners in 1997, the company has increased its revenues by almost 380%.
Watching The Price Strategy
The prices offered to hospital lab customers by the resulting Quest/AML sales program will be closely watched. Quest Diagnostics’ CEO, Kenneth Freeman, has repeatedly told Wall Street that his company does not want to make highly-discounted prices the primary method for acquiring new business. Yet discounted pricing has played a key role in AML’s sales strategy in the hospital send-out market.
Over the past four years, AML has earned a reputation for offering uncomfortably low prices to gain new hospital lab clients. More than one competing esoteric lab has told THE DARK REPORT that AML offered individual test prices to hospital clients at a cost that was less than the kit price other esoteric labs paid in order to perform those same tests.
Certainly the acquisition of AML is a sign that Quest Diagnostics intends to compete more aggressively for hospital send-out testing. If it does, then competition in this business segment will intensify, since competing laboratories like ARUP, Mayo, Specialty, and LabCorp will respond to protect their own business interests.
In the meantime, lab executives and pathologists should not be surprised that Quest Diagnostics not only wanted to buy AML, put was willing to pay a strong price to seal the deal. This is consistent with Freeman’s bold purchase of SmithKline Beecham Clinical Laboratories (SBCL) in 1999. At the time, SmithKline Beecham Clinical Labs had revenues of about $1.3 billion. Freeman paid a total of $1.27 billion, of which $1.025 billion was cash, to purchase SBCL. (See TDR, February 22, 1999.) In the past 30 months, Quest Diagnostics has profited handsomely from that acquisition. From this perspective, the AML deal fits a formula already used by Freeman.
Further, there is an interesting wild card in this deal. AML CEO Tim Brodnik will become part of Freeman’s executive team. Brodnik’s ability to deliver sizeable increases in lab testing revenues have been demonstrated several times during the past two decades.
A Fit Within Quest?
However, will Brodnik’s temperament and philosophy fit within Quests’ existing corporate culture? If it does, possibly the entire Quest sales and marketing program might be infused with new energy. If it doesn’t, then no one would be surprised if Brodnik departed Quest Diagnostics, waited out his non-compete, and surfaced again in another laboratory venture.
Certainly this is all speculation. But it is an educated guess about at least two scenarios which could result from the integration of AML into Quest Diagnostics.
Finally, there are at least two important insights for the handful of clinical laboratory owners that remain in the United States. One, profitable labs can attract a handsome sales price, based on the recent acquisitions of PathLabs in New Hampshire and American Medical Labs in Virginia. Two, there is still opportunity to make money in the lab testing market. But pathologists will need to invest more in their own businesses if they want their share of these profits.