Quest Pays $1.1 Billion To Acquire Unilab Corp.

Its second lab purchase in 2002 positions Quest Diagnostics to dominate California

CEO SUMMARY: Quest Diagnostics Incorporated is showing its muscle. The dust had hardly settled on its $500 million acquisition of American Medical Laboratories when the lab industry’s behemoth announced that it would pay $1.1 billion to buy Unilab, by far the largest lab testing company in California. Integration of the two laboratory operations is planned to occur over the next two years.

YANKEE BASEBALL GREAT Yogi Berra’s classic malaprop “it’s deja vu all over again” aptly characterizes Quest Diagnostics Incorporated’s acquisition of Unilab Corporation, based in Tarzana, California.

After all, Unilab itself was once part of MetPath. It was created back in 1988 when MetPath spun-off several laboratories it owned in the Western United States into a company called MetWest (renamed Unilab in the 1990s).

MetPath was then owned by Corning Corporation and was itself spun-off by Corning in 1997 to become Quest Diagnostics. Viewed from this perspective, the merger of Quest Diagnostics and Unilab is a simply the reunion of two separated branches of the same family tree.

Merger Announcement

Quest Diagnostics and Unilab announced the merger on April 2. Quest Diagnostics will pay for Unilab shares using a combination of stock and cash. It will also assume $200 million of Unilab’s debt. The total value of the transaction will be about $1.1 billion.

Unilab generated revenues of $390 million during 2001. It operates three sizeable laboratories in Tarzana, San Jose, and Sacramento and has 39 rapid response laboratories and 396 patient service centers. It also holds managed care contracts with most of the state’s largest HMOs and IPAs (independent physician associations).

Quest’s California operations include the two laboratory facilities it picked up when it bought SmithKline Beecham Clinical Laboratories (SBCL) in 1999. These are located in Dublin and Van Nuys. It also performs reference and esoteric testing at the Nichols Institute laboratory, located in San Juan Capistrano.

Quest Diagnostics expects to eliminate as much as $30 million per year of costs following integration of Unilab with its California operations. Savings will come from moving Unilab’s reference test to Nichols In- stitute, consolidating laboratory operations, bringing Unilab’s bad debt ratio and DSO down to Quest Diagnostics’ current ratio, and eliminating redundant infrastructure, such as courier routes, patient service centers, and rapid response labs in the state.

Measured Pace of Integration

As it did with the SBCL acquisition, Quest Diagnostics will integrate and consolidate Unilab’s business with its own in a measured fashion. In an analyst call, Quest Diagnostics Chairman and CEO Ken Freeman stated “our strategy anticipates closing certain facilities to rationalize capacity in California. Some positions will be eliminated over time, which we expect to address primarily through normal, voluntary attrition, as we’ve done in past integrations.”

Unilab’s President and CEO, Bob Whalen, will remain with Quest Diagnostics after the acquisition is finalized. “Bob Whalen will lead the integration of our California operations,” noted Freeman. “He will be responsible for our local California business.”

Value of Clin Labs Rises With Quest’s Purchases

Not surprisingly, even as the number of independent commercial laboratory companies dwindles in the United States, their market value as an ongoing business is increasing.

In purchasing American Medical Laboratories and Unilab Corporation this year, Quest Diagnostics was willing to pay a multiple of up to 12.5 times EBIDTA (earnings before interest, depreciation, taxes, and amortization). Net earnings at both acquired labs were negligible because each had considerable levels of debt which had to be serviced from cash flow.

Quest Diagnostics was willing to pay a strong price for both labs because each had a strong cash flow and customer base. After retiring the debt from both companies, and following cost reduction measures, Quest Diagnostics believes it can squeeze an additional $45 million per year in cash flow from both acquired labs, whose combined revenues in 2001 totaled $690 million.

Supported By Lab Industry

One immediate consequence of the Unilab transaction is that Quest Diagnostics will become the dominant comercial laboratory competing for physicians’ office business in California.

In public filings, Unilab has acknowledged that “we believe that our revenues in 2000 represented approximately 25% of the California independent clinical laboratory testing market and approximately twice the annual sales of the next largest independent clinical laboratory in California.” The second largest lab in California has been Quest Diagnostics (estimated by Unilab to hold a 12.5% market share).

Based on Unilab’s estimates, post- acquisition, Quest Diagnostics will hold at least 37.5% of the lab testing referred by physician’s offices in the State. Its market share will be higher in Northern California, where, outside of Laboratory Corporation of America’s lab facility in Reno, there are no independent commercial labs doing $5 million or more per year in revenue.

In Southern California, excepting LabCorp, there are about six viable independent labs with revenues of at least $5 million per year. But none have annual sales exceeding more than about $30-35 million annually.

It is another characteristic of the California marketplace that hospital laboratory outreach testing programs are not a major factor in serving the testing needs of physicians’ offices. Observers attribute the relative lack of hospital lab outreach programs in California to poor hospital finances in the 1990s and exclusionary managed care contracts in favor of Unilab, Quest Diagnostics, and LabCorp. Such contracts meant hospital lab outreach programs could not get paid for lab testing referred to them by physicians’ offices.

From this perspective, the acquisition of Unilab by Quest Diagnostics represents a significant development for California. Most of the state’s testing referred by physicians’ offices will be performed by Quest Diagnostics. This situation can be expected to skew the competitive dynamics within the state.

Once again, California becomes a bellwether for the lab industry. Quest Diagnostics’ newly-enlarged market clout will surely impact managed care contracting patterns and access by smaller independent labs to patients in the physicians’ office testing segment.

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