Focus Diagnostics, Inc. To Be Acquired by Quest

Sale’s timing is no surprise, but what’s unexpected is the price paid—three times annual revenues!

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CEO SUMMARY: Another national laboratory company loses its independence and consolidation of the lab industry continues. Last Friday it was announced that Quest Diagnostics Incorporated would acquire the laboratory testing and diagnostic manufacturing divisions of Focus Diagnostics, Inc. of Herndon, Virginia. Quest Diagnostics will pay $185 million for about $65 million in annual revenues.

ONCE AGAIN, ONE OF THE TWO BLOOD BROTHERS has scooped up a fast-growing specialty test provider. This time the target is Focus Diagnostics, Inc. of Herndon, Virginia. The acquirer is Quest Diagnostics Incorporated.

In a deal announced just last Friday, May 19, Quest Diagnostics will pay $185 million to acquire the laboratory testing business of Focus Diagnostics, which generates annual revenues of about $65 million per year. Excluded from the sale is a pharmaceutical testing division, called Focus Bio-Inova. The acquisition is expected to close during third quarter 2006 and is subject to the usual regulatory review and due diligence.

It’s no surprise that Focus Diagnostics is being sold at this time. Having owned the company for more than five years, the equity investors in Focus Diagnostics needed to liquidate their ownership and pay back their own investors. The surprise came from the willingness of Quest Diagnostics to pay $185 million for just $65 million in annual revenues. That’s almost three times net revenue.

“In general, sales of laboratories are based on more than just the historic financial results,” stated Chris Jahnle, Managing Director of Haverford Healthcare Advisors in Paoli, Pennsylvania. “Value can be based on more than just the two dimensions of revenue and operating profits. A higher valuation multiple can be supported by factors such as sustained and rapid growth of the acquired company in recent years or synergies that have value to the acquiring company.”

Based on Jahnle’s remarks, THE DARK REPORT believes that Quest Diagnostics is willing to pay a premium price for Focus Diagnostics because of several ways it can benefit from the acquisition. First, it is believed that Quest Diagnostics is a big, if not the biggest, customer of Focus Diagnostics. From this perspective, it knows which are the fastest growing lines of tests it sends to Focus Technologies and, going forward, it wants to capture the additional profit margin that will come from doing these tests in-house.

Second, the client list of Focus Diagnostics includes a substantial number of hospital laboratories. Quest Diagnostics may assume that it can use these existing relationships with Focus Diagnostics to cross sell and encourage client hospitals to refer more reference and esoteric tests to its Quest Nichols Institute division.

Consolidate Testing

Third, Quest Diagnostics sees the opportunity to consolidate the testing Focus Diagnostics currently does in its Cypress, California laboratory and move those tests to other sites in its national lab network. Not only does that eliminate redundant overhead, but with its substantial economies of scale, Quest Diagnostics is likely to generate greater profit margins on the same volume of tests.

Fourth, Quest Diagnostics may have a keen interest in several proprietary tests and services developed by Focus Diagnostics that can be considered “added value” and capable of generating additional revenue when sold by Quest’s hundreds of sales reps. For example, Focus has a product called GenomEx™ that is designed to give referring physicians a more detailed interpretation of genetic tests. The report is built upon data that includes personal history, family history, ethnicity, and other elements. The first offering on the menu addresses Cystic Fibrosis carrier analysis and is designed to allow referring laboratories to report this enriched information to their client physicians.

Vaccine Response Testing

Another service Focus Diagostics is developing involves vaccine response testing. This technology is designed to assess how the patient’s immune system is responding to vaccines. The company offers these assessments for six viruses, including influenza, Japanese encephalitis, Streptococcus pneumoniae, and West Nile. Both GenomeEx and vaccine response testing are examples of value added assays and services that could be leveraged on a larger scale by Quest Diagnostics.

Fifth, the reality is that, for this slice of the lab testing menu, Quest Diagnostics will be removing an effective competitor from the national marketplace. Because of anti-trust and related regulatory issues, neither the buyer nor the seller involved in this acquisition will comment on this aspect. However, the fact remains that, over time, financial gains can accrue to companies serving a market with fewer competitors.

Losing Its Independence

In acquiring Focus Diagnostics, Quest Diagnostics removes a respected specialty testing company from the national marketplace as an independent provider. Founded in the 1978 as Microbiology Reference Laboratories, it provided a full menu of reference and esoteric tests centered around microbiology. During the 1990s, it changed its name to MRL Reference Laboratory.

In 2000, the company sold a sizeable interest to two private investment companies. One is DLJ Merchant Banking Partners (Avista Capital Partners) and the other is Sprout Group (New Leaf Venture Partners). As part of this sale, MRL’s name was changed to Focus Technologies, Inc. (and later to Focus Diagnostics, Inc.).

Since 2000, Focus Diagnostics has broadened its test menu, with proprietary tests in autoimmune and genetics. It has also tried to be first to market with assays incorporating new diagnostic technologies. Examples have been SARS, West Nile Virus, and Lyme Disease. Current revenue from reference testing is estimated to be about $49 million per year.

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Focus Diagnostics also has a business unit that sells diagnostic products. Included in the product line-up are 18 FDA-cleared diagnostic kits, 14 kits for research use only (RUO), and 28 products with the CE mark (“Conformité Européen,” a French term which indicates the product can be used throughout member countries of the European Union). Revenue from this business unit is estimated to be $16 million per year.

It will be interesting to watch what Quest Diagnostics does with the diagnostic manufacturing business of Focus Diagnostics, given the product quality problems in the manufacturing line at its Nichols Institute Diagnostics business. (See sidebar above.) Another interesting question will be how Quest Diagnostics uses the Focus Diagnostics name and goodwill. Increasingly, the national labs are willing to continue using the business name of the acquired lab company.

What Is Unfolding At Nichols Institute Diagnostics?

SINCE IT IS SOON TO ACQUIRE another diagnostics manufacturing business, also located in Southern California, there will be greater interest in how Quest Diagnostics Incorporated decides to resolve the problems with its existing diagnostics manufacturing division, Nichols Institute Diagnostics (NID), located in San Juan Capistrano, California.

In the winter and spring of 2005, the FDA published multiple recalls for NID products. Then, on June 16, 2005, NID issued “Customer Bulletin CR-0520,” titled “Product Inventory Hold.” Sent to NID laboratory customers, it basically said that production and shipment of its diagnostics products had ceased until further notice. (See TDR, July 11, 2005.) Since that date, no product has been shipped.

In January 2006, John Hurrell, Ph.D., assumed duties as the Vice President and General Manager of NID. Hurrell has IVD manufacturing experience, having served in past years as Senior Vice President, Research and Development Operations at Boehringer Mannheim Corporation. Along with several new executives in Quality and Regulatory Affairs, the team has yet to announce a date when products will again be shipped to NID customers.

In public filings, Quest Diagnostics has disclosed that “During the fourth quarter of 2004, Quest Diagnostics Incorporated and Nichols Institute Diagnostics (NID), our test kit manufacturing subsidiary, each received a subpoena from the United States Attorney’s office for the Eastern District of New York. Quest Diagnostics and NID have been cooperating with the United States Attorney’s Office.

“In connection with such cooperation, we have been providing information and producing various business records of NID and Quest Diagnostics, including documents related to testing and test kits manufactured by NID. This investigation by the United States Attorney’s Office could lead to civil and criminal damages, fines and penalties and additional liabilities from third-party claims.”

Preceding this disclosure in Quest’s public filings is a paragraph which discusses pending known and unknown qui tam claims and other types of “whistle blower” action. The paragraph ends by stating that “In addition, we are involved in various legal proceedings arising in the ordinary course of business. Some of the proceedings against us involve claims that are substantial in amount.”

This statement is followed by the disclosure of the fourth quarter 2004 subpoena involving Quest Diagnostics and NID. The sequence of disclosures might indicate that it was whistleblowers with knowledge of problems at NID that caught the attention of federal regulators, including a U.S. Attorney and the Food & Drug Administration (FDA).

These facts are likely to fuel much speculation. What remains undisputed is that, one year after the FDA recall notices, NID has yet to resolve its problems and resume production of its diagnostic products.

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