Seattle Hospital Lab JVs Involve Quest & LabCorp

One victory and one loss provide insight into blood brothers’ hospital lab strategies

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CEO SUMMARY: Joint ventures and collaborative business relationships between hospital laboratories and commercial laboratories continue to be a difficult business model. Recent events in Seattle demonstrate the challenges and frustrations of establishing such ventures, then making them successful. One footnote to the Seattle story is the success of a regional laboratory network at grabbing market share.

MAJOR CHANGES HAPPENED in recent months to hospital laboratory joint ventures (JV) operated by Quest Diagnostics Incorporated and Laboratory Corporation of America in Seattle, Washington.

It was a “renew one–lose one” scorecard. The big news was that LabCorp convinced 900-bed Swedish Medical Center to renew its long-standing laboratory operations agreement. Across town, Quest Diagnostics was unable to get Evergreen Hospital Medical Center to renew the agreement for the JV which started in 2001.

Dynacare’s Biggest Lab

The Swedish/LabCorp deal was closely-watched for an important reason. When LabCorp bought Dynacare, Inc. in 2002, the Northwest laboratory division was Dynacare’s crown jewel. With annual revenues in excess of $100 million, it contributed the lion’s share of Dynacare’s net income.

Wall Street is tough on labs which buy other labs, then lose the business they just bought. Along with other reasons, this is why LabCorp needed to retain this particular relationship.

With so much at stake in the Swedish/LabCorp relationship, a little history is useful to understand recent events. Until 1994, all inpatient and outpatient laboratory services at Swedish were provided by a pathologist-owned commercial laboratory called Laboratory of Pathology (LOP). LOP was one of the premier local laboratories in Greater Seattle and had an iron grip on the outreach market around Swedish Hospital.

LOP’s lucrative business was finally threatened in 1994. That was when Dynacare approached the CEO of Swedish and offered to perform the hospital’s laboratory testing for several millions of dollars per year less than Swedish was currently paying LOP. It was rumored that Dynacare offered Swedish inpatient testing prices that were one-third lower than what Swedish was then paying LOP.

Having received Dynacare’s offer, the Swedish CEO offered LOP’s pathologists the same deal. Dismayed at the revenue loss they faced, the pathologists opted to sell LOP to Dynacare, who followed through on the price reduction to Swedish and continued to do its testing.

In the years following that acquisition, Dynacare’s Seattle lab was one of its most successful regional operations. LabCorp became the joint venture partner with Swedish Medical Center when it acquired Dynacare in 2002.

Another Fascinating Twist

Along the way, another fascinating twist develops in the Swedish story. In 2002, Swedish purchased a nearby hospital from the Sisters of Providence. Known as Providence Seattle Medical Center, the laboratory of this 376-bed hospital was a member of PACLAB, a statewide regional laboratory network owned by nine hospitals and Pathology Associates Medical Laboratories (PAML) of Spokane, Washington.

There was an interesting consequence from this new arrangement. Even as LabCorp provided all laboratory testing for Swedish Medical Center, Swedish was receiving profit checks from PACLAB. These checks reflected Swedish Providence’s share of outreach testing activities conducted from its participation in PACLAB.

Opportunity To Learn

Administrators at Swedish had the opportunity to see the financial consequences of Providence Seattle’s participation in PACLAB. The lessons they learned triggered a different approach when it came time to consider renewing the joint venture with Dynacare/LabCorp.

Swedish Medical Center retained a laboratory consulting firm, the Nichols Management Group, to help it evaluate its options. “Since Swedish Providence Hospital was now part of our health system, our needs for laboratory testing services had expanded,” stated Brian Kuske, Vice President of Ambulatory and Ancillary Services at Swedish. “We decided to consider three business scenarios for our extended laboratory organization.

“First, should we rebuild and operate our own lab?” Kuske asked. “Second, would it make sense to have PACLAB as a partner? Third, how might Dynacare/LabCorp propose to change our existing relationship?”

Swedish Medical Center proved to be a tough negotiator. During 2003, both PACLAB and LabCorp aggressively developed multiple options to provide a competitive package. The bidding process was lengthy and intense. Last summer, LabCorp Chairman and CEO Thomas Mac Mahon flew to Seattle and met personally with Richard H. Peterson, President and CEO of Swedish. Some sources say that meeting “sealed the deal.” In any event, within a few months, Swedish decided to accept the LabCorp proposal.

Lots Of Folks Know A Little

Few details of the final package were disclosed in public statements about the new agreement. However, after polling a number of individuals familiar with different aspects of the transaction, THE DARK REPORT has determined that Swedish Hospital obtained significant benefits from the new pact with LabCorp.

Collectively, the opinions of lab industry veterans in Puget Sound support several broad assumptions about the recast agreement. One, the initial term is probably five years, or slightly longer. However, with options, this agreement can extend as far out as 2015.

Two, estimates are that Swedish was paying about $20 million per year to LabCorp for lab testing. Kuske acknowledges total annual savings for the recast lab testing package (with outreach) in the range of 20%, with much of the savings coming from lowered costs in the Providence Hospital lab. However, THE DARK REPORT constantly heard the number of $6 million per year as the savings negotiated. If true, that would generate razor-thin profits for LabCorp, since hospital inpatient testing in these types of arrangements is typically already priced close to marginal cost.

Consolidating Lab Sites

Three, LabCorp has committed to lease as much as 75,000 square feet in a medical office building next to Swedish Providence Hospital. Although it has not announced that it would close its existing lab in Kent, Washington, informed sources bet that LabCorp intends to do just that and consolidate all its Seattle-area testing into this new laboratory facility.

Four, Kuske told THE DARK REPORT last week that Swedish intends to enter the outreach business sometime in the next 18 months. Its agreement with LabCorp includes a joint venture arrangement that allows it to share in the outreach business.

Smaller Profit Pie

If these four assumptions come reasonably close to the actual situation, they indicate that LabCorp’s profit contribution from the Swedish lab testing business will be significantly less than under the original joint venture. That also may be true of the outreach business around the Swedish Medical Center campus, because, for the first time in decades, Swedish will finally participate in the profits from outreach testing around its own campus. But that reduces the revenue yield for LabCorp.

In addition to the above, LabCorp must incur the cost of building a new laboratory, as well as the cost of closing two existing laboratories (the ones operated by LabCorp and Dynacare, respectively, prior to the acquisition). It must also deal with union contracts covering employees connected with the Dynacare and Swedish laboratories.

Thus, to keep the Swedish relationship intact, LabCorp will have to accommodate lower pricing and higher costs. At the same time, its existing business around the Swedish medical campus will be at increased risk. That’s because a new lab competitor recently moved into the neighborhood: PACLAB.

“I’m proud to say that PACLAB’s newest laboratory is now open and conducting business. In a ‘can do’ spirit, it took just six weeks from signing the lease to a fully-licensed, operational laboratory,” said Adelman.

“PACLAB aggressively made its case to Swedish Medical Center,” stated Stewart Adelman, COO and General Manager of PACLAB. “We were disappointed when Swedish Medical Center decided not to become a member and withdrew the Swedish Providence Hospital laboratory from PACLAB.

“As part of this change, Swedish retained the right to provide laboratory services to those Providence physicians owned by the Swedish health system,” noted Adelman. “That was about 50% of the existing outreach business around that hospital. To service the remaining 50% of those clients, PACLAB decided to build a laboratory in that neighborhood.

“I’m proud to say that PACLAB’s newest laboratory is now open and conducting business. In a ‘can do’ spirit, it took just six weeks from signing the lease to a fully-licensed, operational laboratory,” noted Adelman. “Staffing the new laboratory was not difficult. As the Swedish Providence hospital laboratory was consolidated into the LabCorp/Swedish joint venture, 160 laboratory employees were laid off. That put a large number of highly-skilled med techs into the job market—just as we were hiring!

“We expect the competition for business in this sub-market to be intense. For the immediate future, non- compete agreements govern marketing to specific clients of LabCorp/Swedish and PACLAB. However, that still leaves a substantial number of business prospects that PACLAB can pursue from its new laboratory location.”

Changes At Evergreen

Across Lake Washington from downtown Seattle, the joint venture contract between Quest Diagnostics and Evergreen Hospital Medical Center was approaching renewal time last year. Evergreen Hospital is located in Kirkland, Washington. The arrangement, which became effective in 2002, was designed to fully integrate inpatient, outpatient, and outreach laboratory testing activities at Evergreen with those of Quest Diagnostics.

Evergreen ended its laboratory joint venture with Quest Diagnostics on January 5, 2004. On that same day, it launched a business relationship with PACLAB.

Hoped-For Benefits

Evergreen Hospital Medical Center is a 240-bed public hospital. In doing a joint venture with Quest Diagnostics, it expected to see a reduction in the overall cost of inpatient testing and better laboratory testing services because of an expanded test menu done locally, supported by Quest’s national esoteric testing capabilities.

Of equal importance, it was expected that Quest Diagnostics would be more effective at sales and marketing. This would expand the outreach market and Evergreen would benefit from more specimens flowing into its core laboratory, along with a share of profits from expanding outreach revenues.

Similar benefits were expected at Quest Diagnostics. It was rumored that Evergreen was the single largest client for Quest’s Northwest laboratory region.

During the course of the joint venture contract, Evergreen became disappointed. The collaboration proved unsatisfactory in a variety of performance areas. “In simplest terms, this joint venture failed to meet the expectations of our mutual customers,” stated Ron Brown, Director of Laboratories at Evergreen. “The voice of the customer was one of frustration.

“Why didn’t this JV succeed? Without becoming a Monday-morning quarterback, it was probably two main reasons. First, Quest Diagnostics seemed to be organized to meet business objectives originating from the East Coast. That meant local needs and customers were often not well-served in this business model.

Right Incentive Needed

“Second, the joint venture itself was flawed in its original design,” he continued. “Financially, it was a cost-plus contract. Our hospital ended up with a relatively high average cost-per-test and there was no incentive for our partner to reduce costs and share those savings with Evergreen.

“This arrangement taught us lots of lessons about the do’s and don’ts of a laboratory joint venture,” added Brown. “It’s been Evergreen’s strategy to venture with a commercial laboratory partner to achieve a number of goals. Based on our experience, we established new parameters for our venture. Following a review process, Evergreen selected PACLAB to be our venture partner. This relationship started on January 5.”

The laboratory joint ventures at Swedish Medical Center and Evergreen Hospital Medical Center demonstrate some useful insights about this business model. First, hospital administrators remain intensely focused on the goal of cost reduction. Both hospitals wanted their joint venture structured so as to deliver a sustained annual reduction in the average cost-per-test.

High-Quality Lab Services

Second, the joint venture must deliver a high level of service and quality to the hospital and physicians. Hospitals are cautious about ceding control of inpatient laboratory testing. Because of that, a laboratory joint venture must demonstrate that the managing partner can provide better quality inpatient testing services than a standard, in-house hospital laboratory.

Third, hospital administrators remain skeptical about the joint venture throughout its life. Thus, a commercial lab-hospital lab joint venture must deliver services which go above and beyond. Even then, the two examples in Seattle demonstrate that there doesn’t seem to be much loyalty when the time comes to renew the operating agreement.

JVs in Today’s Marketplace

These two joint venture stories in Seattle show how today’s marketplace is handling the commercial lab-hospital lab joint venture concept. It is still a complicated process and no single business model seems to provide all the right answers. It will be interesting to see, in coming years, if continued cost pressures combine with expensive new molecular diagnostics technology, to make these types of joint ventures more attractive to a greater number of hospitals.

PACLAB Plays Spoiler In Seattle Lab Market

REGIONAL LABORATORY NETWORKS ARE even more difficult to organize and operate than a laboratory joint venture involving a commercial lab and a hospital lab.

Yet, as recent events in Seattle demonstrate, a professionally-managed regional laboratory network brings substantial benefit to member hospitals. It also represents a viable competitive force to counter the sales and marketing strategies of national laboratories competing in that regional market.

PACLAB was a credible participant in both laboratory joint venture situations which recently came up for renewal in Seattle. In the case of Swedish Medical Center, PACLAB’s proposal was not accepted. But the fact that PACLAB provided a credible option probably aided Swedish Medical Center in negotiating better terms from its commercial lab partner than might otherwise have been true. For Evergreen Hospital, which had rejected PACLAB’s proposal in 2001 when it first entered into a laboratory joint venture, PACLAB was a welcome option in 2004.

Since its founding in 1997, PACLAB has steadily increased its outreach revenues, improved its management capabilities, and built credibility with payers. Its track record means that this regional laboratory network can grow in any number of strategic directions. For member hospital laboratories, it provides the enhanced services and region wide visibility needed to sustain a competitive outreach program.

PACLAB in Seattle and Joint Venture Hospital Laboratories (JVHL) in Detroit show that the regional lab network business model can be viable over the long haul. Each often plays the role of spoiler in its market—for the right reasons. What may be an important next step for these two networks is to develop a much closer relationship with anatomic pathology (AP) groups. To date, pathologists in each city have resisted the idea of creating a parallel AP network. But that may change in the next couple of years.

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