Quest to Pay $1.27 Billion To Buy SB’s Lab Division

Quest’s acquisition of SBCL will make it the largest laboratory firm in the world

CEO SUMMARY: Consolidation is the story of the clinical laboratory industry during the 1990s. The decade will close out with the granddaddy laboratory consolidation of them all! When Quest Diagnostics Incorporated completes its acquisition of SmithKline Beecham Clinical Laboratories later this year, it will become a $3 billion laboratory testing behemoth. Expect the merger to also trigger profound change.

ONCE AGAIN, IT’S A CASE OF THE big getting bigger. Quest Diagnostics Incorporated will acquire SmithKline Beecham Clinical Laboratories (SBCL) in a deal worth $1.27 billion.

The merger, announced February 9, promises to transform Quest Diagnostics into the largest clinical laboratory company in the world, with revenues of $3 billion. The merger will also trigger profound changes to the clinical laboratory industry as we know it today.

“We expect the merger to actually occur sometime in the early summer,” said Kenneth W. Freeman, Chairman and CEO at Quest Diagnostics. “Two things must happen first. Regulators need to review the proposed transaction. Also, the transaction will be presented to our shareholders. They must vote to approve the purchase. If everything proceeds as expected, the merger could take place as early as June or July.”

Quest Diagnostics will pay $1.025 billion in cash for SBCL. At closing, it will also issue 12.6 million shares in favor of SmithKline Beecham, PLC. Valued at $245 million on the day of the announcement, it will give SmithKline a 29.5% stake in Quest Diagnostics. “This makes SmithKline a passive investor in our company,” explained Freeman. “They will get two people on our board of directors.”

Several aspects of this transaction are noteworthy and should not be overlooked by laboratory executives and pathologists seeking to interpret the market signals represented by this transaction.

First, Quest Diagnostics gets a ten-year agreement to provide testing for all of SmithKline’s clinical trials. This is a significant plum. Because of the potential of pharmacogenomics to transform diagnostics, the arrangement allows Quest Diagnostics to stay updated about new genetic technologies. (See TDR, September 8, 1998.)

Access To Laboratory Data

Second, SmithKline Beecham contin- ues to have access to laboratory data, which is valuable in its pharmaceutical research and development. SmithKline’s CEO, Jan Leschly emphasized this point to analysts during the press conference dealing with the SBCL divestiture.

“We retain access to lab data from an enlarged patient data base,” he said. “We also retain access to patient data and enhanced formulary opportunities in our sale of Diversified Pharmaceutical Services to Express Scripts.” Leshly’s emphasis on these points indicates that SmithKline considers access to data an essential component of its business strategy.

THE DARK REPORT believes these aspects of the transaction validate the importance of laboratory data as the “added-value” linchpin for laboratory services in the future. Both buyer and seller in this transaction want to maintain strong links in each other’s information-gathering activities.

Market Forces Drive Deal

Market forces in healthcare are directly behind the decision of SmithKline to divest its laboratory division. (See sidebar on next page.) Competition among the three national laboratories and their local competitors has been brutal in recent years.

Quest Diagnostics sees this acquisition as an opportunity to solidify its place as a national provider of laboratory services. “We believe this transaction will make Quest Diagnostics a more successful company,” explained Freeman. “Pooling the resources of both laboratory organizations will allow us to enhance services to all levels of customers.

“Patients will see improved access,” he noted. “Clinicians will benefit from a fuller menu of lab tests. Clinicians, hospital clients, and man- aged care companies will have an expanded set of laboratory data with which to work. These are tangible improvements that will result from combining our two companies.”

Freeman is correct on these points. Compared to other laboratory organizations in the United States, the post-merger Quest Diagnostics will have a comprehensive network of patient service centers, rapid response labs, courier routes, and regional testing centers. It’s national infrastructure will be unmatched by any competing laboratory.

Technology Exchange

In his interview with THE DARK REPORT, Freeman also emphasized the opportunities expected to flow from the ongoing information exchange between buyer and seller. “The world is on the edge of a fundamental change in medical technology,” he stated. “Research in a variety of areas moves with ever-increasing speed. All of this will open up new opportunities in diagnostic testing.

“Quest Diagnostics has a right of first refusal with SmithKline for technology which emerges from diaDexus, LLC, their research joint venture with Incyte Pharmaceuticals, Inc.,” explained Freeman. “We hope such access helps us to be first at introducing new diagnostic assays into clinical use.

“If you look broadly across the healthcare marketplace,” observed Freeman, “there continues to be consolidation of hospitals, physician groups, and managed care plans. An underlying theme driving these transactions is the need to lower costs while offering an increased level of service.

“We recognize that Quest Diagnostics must do the same thing,” he said. “Our interest in SBCL stems from the recognition that every laboratory must master the art of continually shaving costs while simultaneously increasing the value of services it provides. A successful combination of the two laboratory organizations can help us achieve this goal.”

Freeman is on target with his succinct description of the healthcare marketplace. It is certainly true that combining the test volumes of Quest Diagnostics and SBCL will provide new opportunities for economies of scale.

But before Quest Diagnostics can harvest those benefits, it must deal with the challenges of pooling two different company cultures, at a time when the healthcare marketplace is undergoing dynamic changes. Other stories in this issue of THE DARK REPORT explore these issues. Quest Diagnostics’ acquisition of SBCL will have long-lasting impact on the entire clinical laboratory industry.

SmithKline Finally Follows Roche & Corning

By capturing SBCL, Quest Diagnostics becomes the beneficiary of forces long at work inside SmithKline Beecham, PLC. Clients and readers of THE DARK REPORT know we predicted, several years ago, that SmithKline would find itself forced to divest the laboratory division. The reason is simple.

SmithKline Beecham is the eighth-largest pharmaceutical company in the world. During the past four years, its pharmaceutical division and its consumer products division posted revenue and profit gains of 15% to 25% per year.

As a division within SmithKline, SBCL was in a no-win position. Compared to other SmithKline business units, its profit margins were unsatisfactory. Further, because the clinical lab industry is undergoing shrinking utilization and reimbursement, future growth prospects were poor.

Thus, SmithKline Beecham, PLC finally made the decision its two corporate competitors made several years ago: sell the laboratory business.

In 1995, Roche spun off Roche Biomedical Laboratories when it acquired National Health Laboratories and created Laboratory Corporation of America. By retaining only 49% of the stock, Roche effectively uncoupled itself from LabCorp’s performance. Corning Incorporated followed Roche’s example. Horrendous financial problems with MetPath/Corning Clinical Laboratories (CCL) in 1995 and 1996 forced Corning’s hand. They announced in late 1996 that CCL would be spun off to existing shareholders on January 1, 1997. The new company was called Quest Diagnostics Incorporated.

Thus, SmithKline Beecham’s decision to divest its laboratory division comes a full two years after those of Roche and Corning. Why it took so long for SmithKline executives to recognize the situation and redeploy those assets is a question that will probably go unanswered.

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