CEO SUMMARY: Executives at Regional Diagnostic Laboratories (RDX) made a splash last May when they announced the new company’s plans to acquire hospital laboratory outreach programs, backed by a capital commitment of $250 million. Now, in recognition of swift changes in the lab test marketplace, RDX has pulled back and will wait for a more auspicious time to acquire hospital lab organizations. RDX says six distinct factors have combined to push the lab industry into a time of transition.
ONE OF THE NATION’S NEWEST BUYERS of clinical laboratory organizations is suspending its originally stated acquisition activities. In recent weeks, Regional Diagnostic Laboratories, Inc. (RDX), of Brentwood, Tennessee, adopted a strategy of watchful waiting while quietly downsizing staff.
This decision was made after seven months of conversations with hospital and health system administrators about the possibility of selling their laboratory outreach programs to RDX. These developments mirror the larger trends which are eroding the financial stability of clinical laboratories large and small across the nation.
“The environment for the laboratory testing business is particularly challenging now, and it may last for a year or more,” stated Brian C. Carr, the CEO and Chairman of RDX. “A series of different headwinds are buffeting the lab industry and we believe that the industry at large is likely to undergo a significant transition.
“As an interested buyer of clinical laboratory organizations, RDX is moving to the sidelines in the near term,” he explained. “We want to let these issues play out and step back into the market when the environment becomes more stable.”
It was on May 1, 2012, when Carr announced the formation of Regional Diagnostic Laboratories. He had assembled a team of executives with decades of experience in the lab business and was armed with up to $250 million in capital from Warburg Pincus, a New York private equity firm.
As well, at that time RDX was close to completing negotiations with several major health systems to acquire their respective clinical laboratory outreach programs. RDX executives believed that at least two of these acquisition deals were likely to be consummated by summer’s end.
But, according to Carr, within weeks of the announcement of RDX’s formation, the clinical laboratory market began to turn. “In important respects, you can say that the laboratory testing industry has been hit by the ‘perfect storm’,” observed Carr. “We identified six distinct factors that caused us to change course at RDX while we let these events play out.” (See sidebar below.)
“Each factor alone would not be enough to stop RDX from pursuing the lab acquisition opportunities it saw in the marketplace,” explained Carr. “However, when these six factors act in concert, it creates a substantial headwind for lab testing companies like ours that want to build market share in a financially stable manner.
“One new factor, for example, is the actual emergence of accountable care organizations (ACO) and other new integrated healthcare delivery models,” noted Carr. “As of this date, no one we talked to has a clear picture of the role ACOs will play or how material they will be in healthcare delivery. Nor can they say with certainty how ACOs will reimburse clinical labs for testing services.
Possible Sale Of Labs
“We did meet with leading executives of health systems who were interested in selling their clinical lab organizations,” he said. “However, the asking prices were quite high. Therefore, at this moment in time, there is a gap between the price expectations of hospital lab sellers and the prices that lab buyers are willing to pay.
“Another area of great uncertainty involves how ACOs will reimburse clinical labs for diagnostic tests,” he observed. “Some administrators told us they thought fee-for-service would work for their ACOs. Other administrators thought there could be shared risk arrangements for lab providers. For us, that’s a complicating variable, since most industry veterans would agree that capitation has not been favorable for clinical lab companies.
“Remember, it was back in the 1990s, when some clinical lab firms eagerly took on full-risk capitated contracts,” recalled Carr. “These lab companies offered capitated rates that were below the fully-loaded cost of performing the lab tests.
“In the ensuing years, public lab companies lost millions and perhaps billions of dollars in market value,” he said. “It was the rejection of HMOs by consumers and providers that eased this situation for the lab testing industry.
“Thus, the idea that ACOs might want to return to capitation as a form of reimbursement for clinical laboratory testing services is enough to create questions for us as investors,” he said. “It motivates us to stand on the sidelines for a period of time and watch how this plays out with the ACO industry as it develops.
“When it comes to clinical lab testing, ACOs create uncertainty for other reasons,” he added. “We know that, in preparation for the ACO model, health systems are acquiring physician practices at a much faster pace than anyone expected. Further, it is common for hospitals and health systems to want all lab testing from owned providers to stay within the new corporate entity. As this happens, it reduces the volume of lab specimens that would otherwise be available to regional independent labs and the large national labs.
“This is why, in the coming years, health systems (and ACO contracts) are likely to reconsolidate lab test volume back to labs owned by hospitals and health systems,” predicted Carr. “This is the opposite of what has happened in recent decades.
“During that time, in many communities, lab test specimens flowed out of local hospital labs and into the lower cost setting of independent regional and national lab companies,” he said. “That pendulum now swings in the opposite direction and favors hospital and health system labs.
Hospital Lab Outreach
“A key part of the business model for Regional Diagnostic Laboratories involves working to acquire those types of hospital lab outreach programs—we are just a bit early,” said Carr. “Once these circumstances change, we firmly believe plenty of those lab organizations will once again be good acquisition targets. It’s the nature of business cycles.”
Carr also pointed out that managed care companies are taking active steps to reduce the number of labs they allow in their provider networks. “This is another factor that hurts local and regional labs,” he noted. “Payers are under pressure to reduce what they spend on lab testing services, in many cases due to the high growth rate they are experiencing from molecular testing.
“One high-profile example of this is how Aetna is reducing the number of labs in its networks across the nation,” stated Carr. “Similarly, earlier this year, we understand Tennessee’s Medicaid program did an exclusive statewide contract with Quest Diagnostics Incorporated that excluded many regional and local labs. We see aggressive Medicaid activism as a material risk factor in the near term as states move aggressively to reduce healthcare outlays.
Deep Cuts To Lab Fees
“Along with these factors are the ongoing and substantial cuts to the Medicare Part B Clinical Laboratory Fee Schedule (CLFS) and the Medicare Physician Fee Schedule (MPFS),” he added. “The recent decision by the Medicare program to drastically change reimbursement for 88305-TC is a prime example.
“The announcement about the draconian cuts to 88305-TC is unprecedented,” commented Carr. “In my view, that one cut is likely to have significant impact on the anatomic pathology marketplace. Even if this decision is revised or partially reversed, it is still big, material, and unusual. It is a sign of what yet may come.
“To all of this, I would add one more factor and that is we observed what other lab industry investors were doing, particularly the ones that have already made substantial investments” concluded Carr. “It looks like they are similarly watching the lab marketplace and waiting until a more favorable environment evolves. That being said, Warburg Pincus has a long view and the ability to look across the entire diagnostic spectrum. As a result, RDX will continue to seek out quality investment opportunities during this time period.”
Lab administrators and pathologists should consider the shift in strategy at Regional Diagnostic Laboratories as a significant event. It is known that RDX was very close to signing contracts to acquire at least two different hospital lab outreach organizations. That these deals fell through at this time indicates much uncertainty exists about the financial prospects of the lab testing industry.
Six Factors in Lab Marketplace Played Role In RDX’s Decision
HAVING HELD LAB ACQUISITION discussions and negotiations with a number of hospitals and health systems over the summer, Regional Diagnostic Laboratories (RDX) decided to alter its course and adopt a “wait and see attitude” going forward. Brian Carr, CEO of RDX, identified six discrete factors that contributed to this decision. They are:
1) Actions by payers such as Aetna and other large national health plans to narrow their networks of labs.
2) Uncertainty over how healthcare delivery would change under the Affordable Care Act.
3) The development of accountable care organizations (ACOs) and a lack of certainty as to how ACOs would pay labs for testing services.
4) More aggressive moves by state Medicaid programs to contract with fewer labs and reduce what they pay for laboratory services.
5) The dislocation of testing volume resulting from health system acquisitions of large physician practices.
6) Drastic cuts in lab test reimbursement from the federal Centers for Medicare & Medicaid Service(CMS).