Quest, LabCorp Slug It Out In Battle for Market Share

Executives from both companies discuss strategies and tactics for winning more business

CEO SUMMARY: In reporting second quarter earnings, both Laboratory Corporation of America and Quest Diagnostics Incorporated discussed market developments. There were no surprises in the comments made by executives of both companies. Quest Diagnostics emphasized that it is hanging on to a significant amount of the pull-through testing associated with UnitedHealth business. LabCorp acknowledged that each managed care contract creates its own opportunities and challenges.

IT’S BEEN A HIGH-PROFILE FIGHT for UnitedHealthcare patients between Quest Diagnostics Incorporated and Laboratory Corporation of America. Now the companies’ reports of second quarter earnings provide useful insights about the progress of this ongoing war for market share.

Quest Diagnostics Incorporated of Lyndhurst, New Jersey, said second quarter revenues were $1.6 billion, an increase of 3.7% compared with the prior-year level. Its second quarter income dropped 9%, to $142 million, compared with $156 million in the same quarter a year earlier. The second quarter this year includes the results of AmeriPath, Inc., which Quest Diagnostics acquired in May. The acquisition of AmeriPath increased consolidated revenues by 4.4%.

Quest Diagnostics reported that clinical testing revenues increased by 2.1%, and clinical testing volume, measured by the number of requisitions, decreased 6.0%. Revenue per requisition increased 8.6% for Q2-07, compared with to Q2-06. The acquisition of AmeriPath increased clinical testing volume by 1.8% and revenue per requisition by 3.1%. Quest Diagnostics dis- closed that the change in contract status with UnitedHealthcare reduced consolidated revenues by approximately 4.4% and testing volume by about 7%.

LabCorp Sales Up 15.4%

Laboratory Corporation of America, based in Burlington, North Carolina, said revenues for the quarter were $1,043.1 million, an increase of 15.4% compared with revenue for the same period in 2006. Net earnings increased 10.5% to $128.7 million, compared with $116.4 million in the year-earlier quarter. Excluding restructuring and other special charges recorded in 2007, net earnings increased 14.1% to $132.8 million. LabCorp further noted that testing volume, measured by accessions, increased 14.2%, and price increased 1.2% compared with those numbers from the second quarter of 2006.

Since Quest Diagnostics ceased to be a contract provider for UnitedHealth earlier this year, about 75% of the test volume related to that contract has been lost, according to company officials, who state that more of this business may switch over in the second half of the year. The UnitedHealth (UNH) contract had represented $400 million in revenue, said Robert A. Hagemann, Corporate Vice President and CFO for Quest Diagnostics.

Focus on Cutting Cost

“About 60% of our costs are variable and we have been adjusting those cost levels over the past six months,” he said in a conference call with financial analysts on July 24. “We have cut the number of full-time equivalent employees by 2,000 since the beginning of the year. Most of that has been through normal attrition. We have been deliberate in cost cutting so that we do not affect service levels. We have looked at every process across the company and the cuts have been reasonably proportionate—both in the labs, outside the labs, and in administrative functions.

“Also, in the first quarter, we incurred some extra costs in trying to retain business,” he said. “We avoided those costs in the second quarter and continued to make progress in pulling out variable costs.

“So far, we have taken out about $200 million in costs on an annualized basis,” Hagemann explained. “On top of that, we expect to reduce costs by about another $500 million on an annual basis by 2009.”

As a point of comparison, that $700 million in total cost cuts would equal about 11% of the $6.3 billion that Quest Diagnostics reported as revenue in 2006.

Target of 20% Margin

“This cost cutting is designed to get us to an operating margin of 20% of revenue—that is our aim,” declared Hagemann. “The structural cost cutting is designed to offset the loss of the UnitedHealth business. Some of it is designed to offset the pricing pressure, and some of it is designed to allow us to invest in growth and service differentiation as we continue to grow the business.”

Cost cuts and new managed care contracts helped the company deliver improved results, said Hagemann and Surya N. Mohapatra, Ph.D., Chairman and CEO. “Now that we have signed contracts with Cigna and Aetna, a number of uncertainties have been eliminated,” commented Mohapatra. “Plus, we feel that each managed care organization is different. They are not all adopting only one strategy for a long term [lab testing] contract with low transaction fees. We have signed a number of contracts and believe that what happened in October is not a trend.”

Quest Diagnostics believes it is succeeding in retaining pull-through specimens associated with its original UnitedHealth business. “In addition,” added Hagemann, “we have seen no additional loss of discretionary work, meaning that when physicians have a choice, they continue to choose Quest Diagnostics.”

More Tests Per Requisition

In answer to a question, Hagemann explained the company’s improved results were not driven by price. “It’s driven by a mix shift, meaning the mix of tests and the number of tests ordered per requisition,” he replied. “We don’t see any significant increases in price per test; rather, we see pricing pressure. And that’s not necessarily going away, but we feel good that we have signed a number of managed care contracts and the market recognizes that we provide a difference in terms of the level of service we offer.”

Despite improving results, Quest acknowledges it faces a number of challenges. “One thing that worries me a bit is whether the activities of last October [the UnitedHealth contract decision] have created a new water line for this industry,” explained Mohapatra. “So, we are reducing our dependency on routine, low margin testing, diversifying our billing, and emphasizing higher margin segments, such as esoteric testing and anatomic pathology.

“Second, we are opposed to competitive bidding, but the government is doing this [Medicare] demonstration project, and so that’s a concern of ours,” added Mohapatra. “A third issue is to have the right people doing the job for us. Execution in the marketplace is critical for us because we have been under price pressure and then the price pressure got worse.”

Managed Care Contracts

Looking forward, Hagemann explained that Quest had been seeking to extend the length of contracts it holds with managed care companies. “There are a number of managed care contracts that we need to work on and generally our contracts are one to three years,” he said. “That means almost 50% come up [for renewal] in any single year. Right now, we have 60% signed up and the majority are signed up into 2010. So we have stretched out the cycle going forward. In addition, the Humana contract is still out.”

Both Quest Diagnostics and LabCorp discussed the Humana contract on their respective conference calls with analysts. LabCorp CEO David P. King stated on his call with analysts, “We believe Humana has just under eight million members; Cigna about 10 million; Aetna about 15 million; UnitedHealth about 28 million; and Wellpoint about 35 million,” he said. “Beyond that, we will not comment on the book of business we have, except that we expect an announcement from Humana soon. They issued an RFP (request for proposal), we responded, and we are in discussions.”

King also disclosed that LabCorp is interested in working more closely with Wellpoint, Inc. “Wellpoint has a new CEO and I thought it was important to meet her and introduce myself to other members of the executive team,” King said. “In a competitive situation and given a fair opportunity to compete, we believe we will be successful.”

Earlier this year, LabCorp lost out on a contract with Aetna, which Quest Diagnostics won on an exclusive national basis. “We lost some Aetna business in the run up to the announcement,” King explained. “Our competitor is very tough and they were out there pursuing the Aetna business. And we lost some business in the quarter and, as we got later into June, we tended to lose more, although not enough to move the needle much.”

UnitedHealth Achievements

On the subject of the UnitedHealth contract, there was cautious optimism. “UnitedHealth business came aboard faster than we expected. LabCorp is doing a higher volume of testing for UnitedHealth than we predicted at this point,” commented King. In discussing the transition payments that will be made to UnitedHealth based on controlling leakage, King noted, “we expect exposure to leakage will be 25% less than the contractual maximum defined in the contract.

“There is still an opportunity to increase the run rate we have with UnitedHealth and to increase the pull-through testing associated with the UnitedHealth contract,” he added. “Also, there is still leakage and that is an opportunity to gain more business.

“As it is with any contract, generating pull-through associated with the UnitedHealth business is more art than science,” observed King. “We’re pleased with our pull-through rate. There are more potential pull-through opportunities as doctors begin to understand how good we are.”

PSCs In Pharmacies

There is also satisfaction with the use of pharmacies as sites for patient service centers (PSCs). Responding to a question about LabCorp’s PSC build-out program, King stated, “I think the in-store PSC model is a great model. We are continuing to look at opportunities to create more in-store PSCs with Duane Reade and with other pharmacy companies.”

LabCorp continues to feel that the laboratory testing marketplace is dynamic and it is possible to build different segments of the business. For example, LabCorp Vice Chairman and Chief Legal Officer, Brad Smith, laid out some milestones recorded during the past quarter. “We’ve seen an increase in esoteric testing to 40% of our revenues,” he noted. “Image-guided Pap screening is increasing. During the quarter, 56% of liquid preparation Pap test orders included a request for image-guided Pap screening. Similarly, this quarter saw a 60% increase in the number of reflex or primary screening tests for HPV, relative to the same quarter last year.”

Higher Valuations For Labs

In a topic of interest to pathologists and lab directors, analysts asked about the higher prices paid for recent laboratory acquisitions and how that would affect LabCorp’s lab acquisition strategy. “The acquisition environment is competitive and pricing is higher than it was in the past,” responded King. “Sonic Healthcare has made four or five acquisitions and they have the appetite to continue to make acquisitions.

“So now there is a third competitor in the market that wasn’t there before,” he continued. “I view them as an aggressive competitor. We are aware that they will be interested in a number of the acquisitions that we also consider attractive.”

Apparently cost cuts are actively under way at LabCorp, although this subject was not discussed during the conference call. Information is circulating across the lab industry in recent days that LabCorp is in the midst of quietly cutting middle management positions in each region. It is said that the objective is to pare back as many as 70 employees per region, but no positions will be eliminated that deal directly with clients or patients.

Should this prove to be true, it is a sign that, all public optimism aside, like Quest Diagnostics, LabCorp faces similar pressure to maintain margins by reducing costs as a response to lower pricing.

LabCorp Discusses Unfolding Plan to Bring Regional Labs into “Managed Care Networks”

ONE OF THE THREE PRIMARY GOALS that Laboratory Corporation of America has for its exclusive national contract with UnitedHealth is to establish a series of regional “managed lab testing networks” in various communities. (See TDR, February 19, 2007.)

These would be organized in the same fashion as the Oxford Health Plans laboratory network, originally created by Quest Diagnostics Incorporated when Oxford was an independent health insurance firm. Oxford is currently owned by UnitedHealth and LabCorp has assumed management of the Oxford laboratory network arrangement under its exclusive national contract with UnitedHealth.

During the July 24 conference call, a research analyst asked LabCorp CEO David P. King if he expected further gains from LabCorp’s contract with UnitedHealth to come from smaller regional labs or from Quest Diagnostics in the coming months. “We are working with UnitedHealth on the [regional laboratory] network management issue,” responded King. “It will be 2008 when we get that off the ground. There are systems issues that make it a little less simple than it might seem. But we are committed to the network model and UnitedHealth is committed to the network model. We expect to see progress with the networks next year.”

It is important for regional laboratories to monitor these developments and prepare a strategy to respond to them. LabCorp and UnitedHealth believe that the creation of regional “managed lab networks,” based on the Oxford laboratory network model, will help them reduce UnitedHealth’s overall laboratory spend while bringing more regional laboratories under a contract with prices that are closer to what has been negotiated with UnitedHealth’s exclusive national contract laboratory. Another stated goal will be to standardize the flow of laboratory data provided to UnitedHealth.

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