Quest Bites: Will Pay $2 Billion for AmeriPath

AmeriPath’s tires have been kicked by a host of buyers, so why Quest and why now?

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CEO SUMMARY: From its inception in the mid-1990s as a pathology physician practice management (PPM) company, AmeriPath was a business that its investors created specifically to be sold. Now Quest Diagnostics Incorporated is stepping up to pay a princely ransom of $2 billion to make AmeriPath’s ultimate destiny become a reality. However, after the marriage, it is likely that neither the bride nor the groom will live happily ever after.

IT’S THE LABORATORY INDUSTRY’S SINGLE BIGGEST ACQUISITION EVER—in terms of dollars—and it’s an acquisition that will bring the buyer several migraine headaches.

Last week, on Monday, April 16, Quest Diagnostics Incorporated announced that it had signed an agreement to acquire AmeriPath, Inc., of Palm Beach Gardens, Florida. Quest Diagnostics will pay $2 billion, consisting of $1.23 billion in cash and assumption of $770 million in debt.

This is a record-breaking deal in the laboratory industry. The previous high price paid for a laboratory company was Quest’s acquisition of SmithKline Beecham Clinical Laboratories (SBCL) in 1999. It paid $1.27 billion and gained annual revenues of approximately $1.05 billion. That deal also pushed Quest Diagnostic’s total revenues to more than $3 billion and cemented its dominance of the lab testing market—a dominance it has maintained over the past eight years. (See TDR, February 22, 1999.)

Now, for $2 billion, Quest Diagnostics will get AmeriPath’s “annualized revenues in excess of $800 million.” That is a premium price, at 2.5 times annual revenue. In contrast, it purchased the better quality assets and revenue stream of SBCL for just 1.3 times annual revenue.

But that was 1999 and the commercial lab sector was still recovering financially from its near-death experience. In 2007, genetic medicine is hot and prices for both in vitro diagnostics (IVD) companies and specialized lab testing firms have been bid to record levels.

Ironically, Quest Diagnostics could have had AmeriPath for a lot less money. Since 2000, both Quest and Laboratory Corporation of America have kicked AmeriPath’s tires and declined to do a deal, at valuations significantly less than the current transaction.

Much-Shopped Company

Since its founding in the mid-1990s, AmeriPath has been a much-shopped company. As one business-minded pathologist told THE DARK REPORT after learning the news about the acquisition, “AmeriPath is a dog that’s been kicked plenty of times,” he said, then adding, “If AmeriPath is a pathology company with such good prospects that Quest will pay $2 billion today, why didn’t Quest buy it for less in recent years?”

On Wall Street, the answer to that question is more pragmatic. In recent weeks, persistent rumors surfaced that private equity investors were preparing to make a run at Quest Diagnostics. The rumors were credible enough that Quest’s share price had been bid up by 5% in just a few days (representing a $500 million increase in market capitalization).

To avoid being purchased and taken private by these private equity companies, the executive team grabbed the deal with AmeriPath. The high price—$2 billion for only $800 million in annual revenues— was similar to a “poison pill” takeover defense. Investors, recognizing that the AmeriPath deal would discourage private equity takeover attempts of Quest Diagnostics, allowed the company’s share prices to decline by 5% almost immediately after news of the deal became public.

Takeover Rumors Now Moot

Whether rumors of a pending takeover offer by private equity investors were true or not is now moot. Following due diligence, Quest Diagnostics Incorporated is likely to own AmeriPath by June 30. When that happens, attention will shift to how this deal is likely to alter the national marketplace for both anatomic pathology services and hospital send-out testing.

That’s because AmeriPath is composed of three primary lines of business. Each of these three business segments presents Quest Diagnostics with a unique set of challenges and opportunities.

Probably the single most attractive asset AmeriPath holds is its dermatopathology division. As of the end of 2006, AmeriPath employed 84 dermatopathologists, most of whom are office-based and serving the outpatient and outreach market. Dermatopathology has produced sustained growth and ample profits for AmeriPath. It is likely that Quest Diagnostics will integrate this business division into its company with few major problems.

Hospital Send-Out Testing

The second recognizable division at Ameripath is Specialty Laboratories, which provides reference and esoteric testing to hospitals and similar clients. It paid approximately $334 million to acquire Specialty in January 2006. (See TDR, October 3, 2005.) Specialty had revenues of approximately $160 million during 2005.

Integrating Specialty Laboratories into the Quest Diagnostics network presents some interesting problems. For example, Specialty Labs could be left as is and run as an independent business unit. However, it is known that Specialty Laboratories has struggled financially, for at least two reasons. First, it has the overhead of the large laboratory facility it opened in Valencia, California, a few years ago.

Second, profit margins on hospital send-out testing have declined significantly in recent years. This is a result of intense sales competition by national lab companies. Meager profit margins on lab testing generated from new reference accounts has made it tough for Specialty Laboratories to cover its overhead and deliver ample profits to its owners.

As the new owner of Specialty Laboratories, Quest Diagnostics will have the same problem: how to generate adequate profit margins, given the revenue mix from customers and existing overhead

It has been suggested that Quest Diagnostics, with its national esoteric testing center at Quest Nichols Institute in San Juan Capistrano, California, has a ready-made opportunity to consolidate testing. However, the limitations will be capacity issues at both laboratory locations, transportation logistics (because these labs are about 100 miles apart), and the need to retain skilled technical staff to perform the complex menu of reference and esoteric tests.

On the other hand, Quest Diagnostics has a large national network of laboratory facilities. That may allow it to redirect Specialty’s flow of specimens away from the lab in Valencia, to be tested in other Quest facilities. That would allow Quest Diagnostics to eliminate much of the overhead that now exists in Valencia.

Another challenge will come in retaining the hospital clients now using Specialty Laboratories. A substantial number of these hospital laboratories do not want to refer their send-out work to a national laboratory which is competing against them for routine specimens coming from physicians’ offices in their community.

Hanging On To Customers

Quest Diagnostics already has first-hand experience with this situation. In the years following its 1999 acquisition of Smith-Kline Beecham Clinical Laboratories, it lost as many as 400 of SBCL’s hospital send-out clients—many of whom had switched to American Medical Laboratories(AML). In 2002, after purchasing AML, Quest Diagnostics found itself working once again to retain many of these same customers.

AmeriPath’s third business segment involves inpatient, outpatient, and outreach anatomic pathology services. Since its inception, AmeriPath has purchased 67 laboratories and pathology practices. It now operates 40 outpatient laboratories in 19 states. It is “the exclusive provider of inpatient diagnostic anatomic pathology and medical director services for approximately 220 hospitals.” As of December 31,
2006, AmeriPath employed a total of 392 pathologists and scientists (including 84 dermatopathologists).

It is this business segment which presents the most intractable challenges to Quest following the acquisition. Simply put, AmeriPath has been the owner/operator of pathology group practices that serve community hospitals. AmeriPath has found it difficult to expand the specimen volume and revenue of these hospital-based pathology groups.

Another significant issue involves managing the productivity and morale of employee-pathologists working in these hospitals. AmeriPath says the turnover rate of its pathologist-employees has run just under 10% per year from 2004 through 2006. Quest Diagnostics will inherit this management challenge.

AmeriPath says the turnover rate of its pathologist-employees
has run just under 10% per year from 2004 through 2006.

Morale may be a big issue. Across the pathology profession, AmeriPath pathologists have told their peers that, at the annual AmeriPath pathologist meeting of two years ago, and then again this January, they were told, most emphatically, that AmeriPath would never be sold to either Quest Diagnostics or Laboratory Corporation of America. Those statements were reported to have been made by Paul Queally, an AmeriPath Director and a General Partner at Welsh, Carson, Anderson & Stowe, the majority owner of AmeriPath.

Assuming these anecdotes are true, it shows the tension that exists between AmeriPath and its employee-pathologists. In fact, there are reports that some of AmeriPath’s pathologists have contract clauses that reduce the non-compete periods from two years down to one year if AmeriPath is sold to either of the two blood brothers.

Unanswered Question

There’s another unanswered question that Quest Diagnostics faces once it becomes the owner of AmeriPath. Will any hospitals currently served by AmeriPath’s pathologists decide that, if Quest is the new owner, they want to redirect their pathology services to another source?

The change of ownership is most likely to concern hospitals that operate laboratory outreach programs and compete against Quest Diagnostics for test referrals from office-based physicians in their local communities.

It is common for contracts between a community hospital and its pathology group to have a 90-day cancellation clause. This gives the hospital some leverage in such situations where the hospital administration decides it doesn’t want a pathology group owned by Quest Diagnostics to be handling its anatomic pathology services and acting as medical director of its clinical laboratory.

Since it has evaluated AmeriPath more than once over the years, it is likely that Quest Diagnostics has identified the full spectrum of challenges facing it once the deal is closed. Thus, it should not be surprised at the variety of issues which surface. Because it has experience at integrating large laboratory operations, such as SBCL and Unilab Corporation (its acquisition in California in 2003), Quest may be confident that it can address these issues without much difficulty.

Raising The Stakes

What raises the stakes with this particular acquisition is the large premium Quest is willing to pay. That increases the difficulty of achieving an impressive return on investment. For example, rumors circulated that, once they got into the day-to-day operations after purchasing Specialty Labs (and paying $334 million for its $160 million or so in annual revenues), AmeriPath’s executives calculated that, at current operational performance, it would take the Specialty Labs division more than 20 years to generate a return on investment (ROI).

Now Quest Diagnostics has raised that bar even higher on themselves. It is paying a proportionally higher price for AmeriPath (and Specialty Labs). That means it must swiftly and effectively boost the performance of AmeriPath’s three business sectors. Further, since the core of AmeriPath’s business is its 400 employee-pathologists, keeping these individuals happy and productive is likely to be the first priority.

Up, Up, and Away! Lab Prices Are Soaring

DURING THE PAST YEAR, prices paid for clinical laboratory companies, in vitro diagnostics (IVD) manufacturers, and molecular pathology companies have set new benchmarks.

This is good news for owners of clinical laboratories and pathology laboratories. It is also a major validation of the economic future of laboratory medicine.

The $2 billion purchase price Quest Diagnostics Incorporated will pay to acquire AmeriPath is the most money ever paid for a company that provides diagnostic testing services to clinicians. AmeriPath’s revenues through December 31, 2006, were $752.3 million. Income from operations was $79.9 million. Based on these numbers, Quest is paying 2.5 times annual revenue and 25 times cash flow.

During 2006, AmeriPath reported that 70.7% of its revenues came from “outpatient and esoteric” sources. The balance, 29.3%, came from inpatient sources. This suggests inpatient pathology revenues from AmeriPath’s hospital-based group practices represented $220.4 million during the year.


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