"Dark Index"

Unfolding Events at Unilab, Specialty Labs and Dynacare

Each laboratory company is dealing with changes in its business operations

RECENT WEEKS BROUGHT important developments to several public lab companies. Each development changes and alters the competitive marketplace for laboratory testing services.

It was big news at Specialty Laboratories, Inc. when the troubled lab company signed a Plan of Correction (POC) with the Centers for Medicare and Medicaid Services (CMS), thus lifting sanctions that affected Specialty Laboratories’ CLIA-88 license.

Also big news was the continued silence over how the Federal Trade Commission (FTC) is going to rule on the proposed acquisition of Unilab Inc. by Quest Diagnostics Incorporated. Many Wall Street analysts speculate that the FTC may have reservations about allowing the deal to close as currently structured.

Debt-For-Equity Swap

Notwithstanding its reservations about the Unilab/Quest Diagnostics deal, the FTC took no objection to the acquisition of Dynacare Inc. by Laboratory Corporation of America. That deal closed on July 25, thereby ending Dynacare’s short life as a United States-based public laboratory company.

In the case of Specialty Laboratories, agreement with federal lab regulators was announced on July 18. With this agreement, Specialty Labs is now in full regulatory compliance with both state and federal lab regulators. Under the POCs signed with each agency, Specialty Labs will be subject to certain conditions for the next couple of years.

Specialty Reports Earnings

On July 23, Specialty Laboratories also disclosed its second quarter earnings. Net revenue declined to $34.1 million, compared to $45.2 million for the same quarter 2001. This was a decline of 24%. Specialty Labs had an operating loss of $12.8 million for the quarter.

Accessions declined by 6% com- pared to second quarter 2001 and by 11% when compared to first quarter 2002. Company executives attribute these declines to a reduction in Specialty’s extensive test menu and clients redirecting specimens to competing laboratory companies.

The other development at Specialty Laboratories was the hiring of a new Vice President, Sales. Mark R. Willig was recruited from Myriad Genetics, where he had been Vice President of Sales since 1997. Willig also has experience with Orca Medical Systems and Abbott Diagnostics.

Even as Specialty Labs got good news from federal regulators, Unilab and Quest Diagnostics continued to await the FTC’s decision on their proposed merger. The acquisition, announced April 2, has been in suspense while the FTC conducts an antitrust review.

In the months since the acquisition was announced, the FTC has actively made calls to organizations in California involved in laboratory testing. It is known that the FTC placed calls to: 1) independent commercial laboratory companies in California that compete against Unilab and Quest Diagnostics; 2) independent physicians associations which contract for lab testing services; and 3) hospitals. The FTC is evaluating the impact this proposed merger might have on competition in the nation’s largest market for laboratory testing.

One issue of concern is the amount of market share that Quest Diagnostics would control following its acquisition of Unilab. In conversations with Wall Street analysts, Quest Diagnostics and Unilab estimate California’s total market for laboratory testing is about $4 billion per year.

Estimate Of Market Share

Assume that 50% of that number is hospital inpatient/outpatient testing. The remainder, about $2 billion, represents tests that originate in physicians’ offices. Of that $2 billion, about half, or $1 billion, is done by physician office laboratories (POL). That leaves about $1 billion in testing which physicians’ offices refer to commercial laboratories.

Unilab does about $390 million per year of lab testing in California, virtually all of which are tests referred from physicians’ offices. In the same market segment, Quest Diagnostics has told Wall Street that it does about $90 million per year in California.

Combine those two businesses, and post-merger Quest Diagnostics would control at least 48% of the market for physicians’ office referral testing in the Golden State. On one hand, that is certainly a concentration of market share that would trigger antitrust concerns. On the other hand, the FTC has no track record of opposing the acquisition of one clinical laboratory by another clinical lab company. That is why there is much speculation in the investment community about why the FTC is taking so long to make a determination about this proposed merger.

LabCorp Buys Dynacare

Even as the proposed deal between Unilab and Quest Diagnostics awaits the FTC’s decision, LabCorp’s purchase of Dyncare is already done. Following the FTC’s announcement that it held no objection to the merger, Dynacare obtained shareholder approval and, within days of that action, LabCorp acquired Dynacare.

In acquiring Dynacare, LabCorp gets sizeable laboratory operations in Ontario and Alberta. This adds a new dimension to the management challenges of integrating Dynacare into the LabCorp family. Canada’s single-payer health system has significant differences from the United States healthcare model.

As it integrates Dynacare into its existing laboratory infrastructure, LabCorp expects to harvest as much as $45 million in savings during the next 30 months. Since Dynacare’s annual revenues are about $300 million, that means LabCorp believes it can squeeze out about 15% of Dynacare’s cost structure.

Economies Of Scale

The savings will accrue from two sources. First, considerable savings will come from consolidation and integration of laboratory sites throughout the United States. Second, LabCorp’s estimate reflects the lower purchasing costs for reagents and other items that come from LabCorp’s buying power with vendors.

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