"The Dark Index"

Quest Diagnostics and LabCorp Face an Evolving Marketplace

Companies emphasizing different strategies to rebuild financial stability, generate profits

TWO OF THE THREE BLOOD BROTHERS reported continued improvement in their financial condition as second quarter earnings reports were made public.

This news, however, was overshadowed by speculation about the failure of Quest Diagnostics Incorporated to consummate its purchase of SmithKline Beecham Clinical Laboratories (SBCL) during the month of July.

Quest Diagnostics and Laboratory Corporation of America both released second quarter earnings. SmithKline Beecham, PLC did not disclose the performance of its laboratory unit for second quarter 1999, noting that its sale (to Quest) was imminent.

At LabCorp, there was an increase in both specimen volume and revenue per accession. Quarterly revenues were $429.5 million, with operating income of $42.1 million. Compared to second quarter 1998, this was an increase of 6.7% and 5.7%, respectively.

Sales Efforts Having Impact

LabCorp reported that prices increased 2.3% and specimen volume grew by 4.4% for the quarter. These numbers demonstrate that the company’s sales efforts are having some impact in the marketplace.

According to LabCorp President and CEO Thomas P. Mac Mahon, growth in specialty testing was a major factor in the sales and revenue performance of LabCorp.

In contrast to LabCorp’s 4.4% growth in specimen volume for the quarter, Quest Diagnostics saw specimen volume decline by 3.9%, while average revenue per requisition jumped a hefty 7.6% over second quarter 1998.

Using The 80/20 Rule

As noted earlier in THE DARK REPORT, Quest Diagnostics has aggressively used the 80/20 Rule to purge money-losing accounts in recent years. (See TDR, June 2, 1997.) Consequently, it is making more money while testing fewer specimens.

Quest Diagnostics reported sales of $394.0 million and operating income of $24.5 million. It is consolidating the revenues and expenses of its QuestNet lab network management service into total corporate results. Thus, third party test costs are included in this number.

QuestNet’s primary contract is with Oxford Health Plans, Inc., a major managed care player in the Northeast. (See TDR, January 11, 1999.) Quest Diagnostics has a strong market pres- ence in the states served by Oxford.

With every quarter, effects from the distinct business strategies followed by Quest Diagnostics and LabCorp become more apparent. Each company has a different management challenge driving its particular market strategy.

LabCorp’s most pressing need is to generate cash flow to service its sizeable debt burden and make dividend payments to preferred stockholders. For that reason, it is assertively pursuing new sales volume. At the same time, LabCorp wants to move test prices upwards as much as possible. Both strategies work to increase cash flow and operating profits for the company.

Seeks Profitable Business

In contrast to LabCorp, Quest Diagnostics has a relatively clean balance sheet, with modest debt. Quest Diagnostics seeks to increase operating profits and net earnings. Thus, it is focusing on “profitable” business.

That means Quest Diagnostics evaluates each new account based on whether or not it meets specific profit targets. The company is not interested in new accounts where the cost to service that account does not leave a sufficient profit margin for Quest.

Like LabCorp, Quest Diagnostics is also pushing for higher prices. This difference in corporate business strategies explains why revenues are up at both companies, but LabCorp’s specimen volume is growing while Quest’s specimen volume is shrinking.

Hospital laboratory administrators and competing laboratories see the impact of these different corporate strategies in their regional markets. On one hand, the three national laboratories have achieved a financial stability unseen during the last five years. The extreme “crises management” mind set of earlier years has faded into the background, replaced by a focus on positive, growth-oriented business planning.

However, this increased stability does not mean that national laboratories will become the competitive steamrollers they were during the first half of the 1990s. None of the three national laboratories has the capability, nor the clout, to enter a regional market and push out competing laboratories they way they did for many years.

For example, as mentioned earlier, LabCorp is burdened with debt and preferred stock. Interest payments and preferred dividends siphon off considerable cash each quarter. It also doesn’t have much net worth or cash.

Quest Diagnostics Announces That SBCL Acquisition To Close Within Next Two Weeks

As this issue of THE DARK REPORT went to press today, Quest Diagnostics Incorporated announced that it had come to terms with SmithKline Beecham, PLC (SB) on its pending acquisition of SmithKline Beecham Clinical Laboratories (SBCL).

In a press released dated August 9, Quest Diagnostics’ Chairman and CEO Kenneth W. Freeman declared “now that all contracts have been finalized, we are planning an orderly closing.”

Quest Diagnostics believes the transaction will occur within two weeks. This would mean a closing between now and August 23.

It was disagreement over terms of access by SB to Quest’s laboratory data which kept both companies from finalizing the acquisition on July 2, as originally scheduled. That negotiating point was resolved by the a new side agreement between both companies.

SmithKline Beecham, PLC has been granted “certain non-exclusive rights” to use Quest’s proprietary laboratory information database. SB will also form a company to sell healthcare information products through channels such as the Internet. Quest Diagnostics will hold a minority interest in this company.

With this announcement, it appears that Quest Diagnostics will finally claim its prize. Once it takes title to SBCL, it faces a daunting task to integrate the two laboratory companies into a common management culture without negative impact on clients of the two companies.

Prevent Consolidation

These facts prevent LabCorp’s management from consolidating redundant laboratory facilities. It continues to operate a national system of laboratories made up of individual sites from the pre-merger National Health Laboratories and Roche Biomedical Laboratories.

Billing and collections continues to be a major management priority at LabCorp. The separate billing systems have never been fully integrated and standardized. Since 1995, this situation has created a number of problems. Among them, LabCorp is hindered from offering a more sophisticated data management package to managed care companies.

These and other reasons have caused LabCorp to focus its growth strategy on better sales and marketing of clinical testing, hospital alliances, and development of specialty testing. Specialty assays, such as viral load testing, seem to be the fastest-growing and most profitable result of this strategy to date.

Specific Market Segments

At Quest Diagnostics, the possible acquisition of SBCL has dominated management’s attention since early in the year. But ongoing business development priorities continue. In contrast to LabCorp’s emphasis on boosting both specimen volume and pricing, Quest Diagnostics has targeted specific market segments for growth.

Clients and readers of THE DARK REPORT are familiar with the Quest/Premier alliance. (See TDR, May 26 and June 15, 1998.) This is a long-term initiative that will take several years to produce significant revenues and profits. But it is consistent with Quest’s stated intention to develop close partnerships with hospital systems.

Quest Diagnostics’ relationship with University of Pittsburgh Medical Center and John Hopkins University Medical Center are other examples of this alliance strategy. Because each is a center of influence, Quest hopes these partnerships lead to a worthwhile market position over time.

Meanwhile, even as LabCorp, Quest Diagnostics, and SBCL work to increase their market share, hospital laboratory outreach programs and regional commercial laboratory competitors are steadily capturing profitable chunks of local markets.

Lab Outreach Successes

Few hospital laboratory administrators comprehend the widespread successes that hospital lab outreach programs are achieving. The experience of West Hills Hospital and Medical Center (See pages 2-7) in California is a prime example. Hospital laboratories which launch a professionally designed and managed outreach program are enjoying much success in cities around the United States.

This growing movement towards hospital laboratory outreach programs is a competitive dynamic that national laboratories find unfamiliar—and unpleasant to compete against.

Whether or not the merger occurs between Quest Diagnostics and SBCL, the national labs are finding tougher competition in city after city now, as both hospital labs and independent labs learn more effective ways to sell their services to office-based physicians.

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