"Newsmaker Interview:"

Bill Bonello Sees Opportunities In Diagnostic Services Companies

He explains why professional investors have increased interest in lab testing & anatomic pathology

CEO SUMMARY: With the clinical laboratory industry now enjoying growing interest by professional investors, THE DARK REPORT traveled to New York City to meet with financial analyst William B. Bonello, of U S Bancorp Piper Jaffray. Bonello co-authored a just-released overview of what he calls the “diagnostic services industry.” He is bullish on the future prospects for both clinical laboratories and anatomic pathology companies. In this interview, Bonello explains why fundamentals in the lab industry are providing new opportunities for lab companies to boost revenues and earnings.

“We believe the clinical laboratory industry has attractive prospects for steady earnings growth.”
—William B. Bonello

EDITOR: I would like to explore three facets of the lab industry with you. They are: 1) reasons for the rapid run-up, since January, in the share prices of selected lab companies; 2) what your crystal ball predicts for the future in diagnostic testing services; and 3) your assessment of the business strategies at several public lab companies. Let’s start with how you define the diagnostic services industry. Last week U S Bancorp Piper Jaffray released a report co-authored by you and Angela C. Samfilippo on this industry segment.

MR. BONELLO: I use the term “diagnostic services” to cover my assessment of companies that offer diagnostic testing services as providers.

EDITOR: So that excludes, for example, companies such as in vitro diagnostic (IVD) manufacturers?

MR. BONELLO: Yes. I focus on provider companies in diagnostic services because they share two elements. First, clinical advances have a direct impact on their business. Second, activities of both private payers and government health programs directly affect their ability to earn profits.

EDITOR: Let’s get right into it, then. Why do think the stock prices of companies like Quest Diagnostics Incorporated, Laboratory Corporation of America, DIANON Systems, and IMPATH increased substantially during the last 10 months?

MR. BONELLO: Three factors support higher share prices for these companies. The starting point is factor number one: these companies outperformed the expectations and predictions of financial analysts.

EDITOR: So their operating profits and earnings were measurably greater than predicted by Wall Street?

MR. BONELLO: Precisely. Stock is priced relative to the forecasted earnings of a company. If earnings are greater than expected, the stock price will go up.

EDITOR: So these companies are showing unexpectedly large increases in their profit flows.

MR. BONELLO: That’s correct. The reported earnings were higher than what either investors or analysts had projected. The second factor involves the perception by investors that buying these companies’ shares is a relatively low-risk way to play in the genomics and molecular diagnostic markets.

EDITOR: That’s interesting. Please explain.

MR. BONELLO: As you know, the human genome project is only the spearpoint for revolutionary changes in medicine, particularly in diagnostics and therapeutics. Investors believe that holding shares of a laboratory company is one way to bet on this entire “class” of technology. That’s because laboratories will sell the diagnostic tests produced by any IVD manufacturer.

EDITOR: That means, even if investors missed investing in, say, Roche as its PCR testing technology emerged from the research lab, by investing in Quest Diagnostics or LabCorp, that same investor can still profit from the increasing volume of PCR testing that takes place.

MR. BONELLO: True. It’s one way for investors to “cover their bets” in the area of diagnostics.

EDITOR: What’s your third factor?

MR. BONELLO: My third factor contributing to the run-up in lab stock prices has to do with the reality of their business environment. Investors can see that growth in the specimen volume at certain of these companies is accelerating. This is occurring in tandem with increased pricing for these tests. Since laboratories have a high-cost structure, investors know that increased volume, combined with increased prices, leads to very strong growth in operating profits and earnings.

EDITOR: Pricing is a topic of interest to most laboratories. Please explain why you believe that Quest Diagnostics and LabCorp will experience improved pricing over the next couple of years.

MR. BONELLO: I think the improvement in pricing for lab tests that was reported by these two companies recently is directly due to the removal of SmithKline Beecham Clinical Laboratories (SBCL) from the market. This was the aggressive pricer. Now that SBCL is gone, it is easier for Quest Diagnostics and LabCorp to negotiate improved prices for managed care contracts.

EDITOR: Then you believe the two blood brothers are repricing their existing lab business by negotiating higher prices whenever existing contracts come up for renewal?

MR. BONELLO: Yes. But other favorable trends will also contribute to higher pricing for lab tests. For example, managed care companies are getting higher premium increases. This gives them additional money to pass along to providers, like laboratories. Further, HMOs have customer problems. Restricting the ability of their doctors and patients to choose providers such as laboratories has proved to be unpopular with consumers. Thus, many HMOs are allowing more labs to be contract providers.

EDITOR: Is there less capitation for lab testing services?

MR. BONELLO: Definitely. Both Quest and Lab Corp report a decline in the percentage of revenue derived from capitated agreements.

EDITOR: That’s a major development for the lab industry.

MR. BONELLO: I believe it’s hugely significant. HMOs are moving away from capitation and this will definitely benefit clinical laboratories. When you add up the changing dynamics among managed care companies, there is a subtle shift in the balance of power which favors laboratories over payers.

EDITOR: Do you believe the two blood brothers will enjoy a boost in earnings directly linked to how they shift their internal mix of payers and contract types?

MR. BONELLO: Definitely. I also think the major lab companies are working to shift their internal mix of tests. As they add more reference and esoteric tests to their test mix, the higher reimbursement from such tests will increase operating margins and earnings.

EDITOR: So far, you’ve described three factors which you believe will continue contributing to higher earnings for the national labs. What types of trends in diagnostic testing do you predict will also improve the financial performance of clinical laboratories?

MR. BONELLO: When you look at the overall market for diagnostic testing, I see a number of positive developments. For example, we believe that the absolute number of diagnostic laboratory tests will increase by anywhere from 3% to 5% during the next few years.

EDITOR: That’s certainly a modest growth rate. How does it support strong earnings predictions for the two blood brothers?

MR. BONELLO: That’s easy. It doesn’t take huge increases in specimen volumes to generate respectable increases in lab earnings. As a business with high fixed costs, specimen volume gains that exceed the break-even point for the labs will generate proportionally higher profits.

EDITOR: I agree. That’s a basic fundamental in laboratory economics.

MR. BONELLO: What will reinforce the year-to-year increases in the volume of lab tests performed are the population demographics. As increasing numbers of Americans reach their 50’s, and beyond, there is a steady increase in the number of lab tests utilized in their healthcare.

EDITOR: Is there anything else that reinforces these “aging” trends?

MR. BONELLO: If anything, it will be increased involvement of consumers. Greater numbers of people are taking control of their healthcare. As I mentioned earlier, HMOs are having to improve the way they service their patient-customers. Integrated health systems and hospitals are beginning to respond to this consumer movement.

EDITOR: You also have some specific data on laboratory reimbursement trends.

MR. BONELLO: That’s true. I see evidence that the overall reimbursement cycle is swinging in favor of laboratory providers. Right now, HMOs are getting premium increases of 6% to 12%. This makes it easier to pass some of this along to providers like labs. Eventually there will be an employer backlash against rapidly-rising healthcare prices. This starts the cycle of price-squeezing. But, it is likely that employers may, over the next few years, require increased health benefit contributions from employees as one way to counter increased premiums.

EDITOR: That’s an interesting way to look at the problem. It makes sense.

MR. BONELLO: Moreover, since this entire cycle takes a number of years, labs should see a favorable reimbursement environment in the foreseeable future.

EDITOR: To this point, you’ve shared your thoughts on the reasons behind the big run-up in the share prices of the two blood brothers. You’ve also discussed why you believe their financial performance will continue to support further share price gains. Could you tell us what you think are differences between the two leading lab companies–Quest Diagnostics and LabCorp?

MR. BONELLO: That’s an interesting question! To start with, both companies have lots of similarities. In fundamental ways, they run parallel operations. So it is important to recognize that the differences which exist today do not make them radically different from each other.

EDITOR: So the starting point is to understand that both companies are very similar in operational structure, specimen mix, and payer relationships.

MR. BONELLO: That’s probably a good way to characterize their similarities. What I consider, at this time, to be the main difference between the two is that Quest Diagnostics is unquestionably the market leader, due to its $3.5 billion in revenue. But, Quest Diagnostics is also the leader in most sub-markets served by both companies. Being the market leader bears fruit in a number of ways. It makes it easier for Quest Diagnostics to negotiate favorable contracts with the largest private payers. It makes Quest Diagnostics the partner of first choice for strategic joint ventures, such as those involving drug companies and research consortiums.

EDITOR: Yes, go on…

MR. BONELLO: In contrast, LabCorp seems to be the first mover in esoteric testing. With its national infrastructure, it is moving to position itself as a major source of esoteric testing. It wants to play a significant role in bringing new diagnostic technology into the healthcare marketplace. Meanwhile, Quest Diagnostics looks at its national infrastructure and seeks to leverage this asset into a major provider of laboratory information. Quest Diagnostics is also striving to convert itself into a respected “brand,” known by payers, physicians, and consumers.

EDITOR: What you describe are two companies which are fundamentally similar, other than revenue size, but will evolve differently in the future because of these differing business strategies.

MR. BONELLO: Correct. I expect that the two companies will start to look different as they restructure them- selves to achieve their distinctly different strategic goals.

EDITOR: One subject that I wanted to explore with you is anatomic pathology.

MR. BONELLO: I see anatomic pathology as a diagnostic service which is worth tracking. In fact, I believe molecular and genetics technology now moving through research labs may cause anatomic pathology and clinical lab testing to become increasingly interconnected.

EDITOR: Of the existing anatomic pathology companies, you cover AmeriPath, Inc. and monitor DIANON Systems, Inc., IMPATH, Inc. and UroCor, Inc. Will that change?

MR. BONELLO: Obviously I cannot comment on whether or not we will cover other companies. We have covered AmeriPath since its IPO, which is what caused me to begin looking at the whole class of companies in diagnostic services.

EDITOR: Do you see the anatomic pathology (AP) companies as different from clinical laboratory companies?

MR. BONELLO: No. I believe the business and healthcare fundamentals influencing AP companies and clinical laboratories to be similar.

EDITOR: What is your assessment of AmeriPath?

MR. BONELLO: First, AmeriPath’s stock trades at a steep discount to the rest of the companies in diagnostic services.

EDITOR: Does that mean, relative to its level of operating profit and earnings, AmeriPath’s stock price is valued less that the stock of, for example, the two blood brothers?

MR. BONELLO: Yes. For investors, that is one reason to consider that AmeriPath’s share price is undervalued.

EDITOR: What other business factors make you optimistic about AmeriPath’s future?

MR. BONELLO: From the perspective of a stock investor, I like the fact that AmeriPath is shifting its emphasis away from growth by acquisition. Instead, it wants to grow by increasing specimen volumes and revenues of its existing pathology operations.

EDITOR: Do you believe this is something it can accomplish?

MR. BONELLO: Yes. AmeriPath has a local presence in several regional markets. In these areas, its pathologists have strong relationships with both doctors and hospitals. I think this positions them to generate additional revenues from tissue banking activities and increased case referrals from local doctors in their service area.

EDITOR: What would make it difficult for AmeriPath to achieve these goals?

MR. BONELLO: There are two basic challenges. First, AmeriPath owns and manages doctors’ practices. There is a lot of recent business history that says it is difficult to manage doctors. Second, because AmeriPath is the sum total of the individual pathology practices that it owns, it is more difficult for AmeriPath to generate economies of scale compared to some of the national AP companies.

“…point-of-care testing is a longer-term risk
to the laboratory industry as we know it today.”

EDITOR: You are saying that a company like DIANON Systems, with its centralized laboratory and pathology centers, may be generating cost savings that AmeriPath cannot match?

MR. BONELLO: Basically, yes. But on the other hand, AmeriPath is in a good position to capitalize on its local presence with such fast-evolving diagnostic services as molecular pathology and tissue banking.

EDITOR: Could we also talk about your views on such lab technologies as point-of-care (POC) testing and its potential to shift routine testing out of the core laboratories operated by hospitals and commercial labs?

MR. BONELLO: My best answer is that POC is a longer term risk to the laboratory industry as it is organized today. At this point, it is not clear that the economic model for several POC options indicates that it is not supportable. In the near term, we may see POC technology creating a modest shift of testing within an integrated healthcare network. But there are lots of uncertainties about POC testing. During the next year or two, there may be some very effective POC technology hit the market.

EDITOR: What about the future of hospital laboratory outreach programs. Do you see such outreach programs making inroads against commercial labs like the two blood brothers?

MR. BONELLO: That’s the $20 billion question. When I attended your Executive War College in New Orleans last May, I gained a greater appreciation for the potential of a professionally-marketed hospital lab outreach program to capture substantial market share in their community. But I am also aware that many hospitals don’t have detailed and accurate knowledge about their outreach laboratory costs. From that perspective, the jury is out as to whether a hospital lab outreach program is a strategic asset for a hospital and is, in and of itself, a profitable investment.

EDITOR: What do you believe will be the role for hospital labs as new diagnostic technology is cleared for clinical use?

MR. BONELLO: That’s an interesting question. If you look at the trend for increased outpatient procedures, a shortening length of stay for inpatients, and the complexity of advanced esoteric assays, you could make an argument that lots of lab testing may shift away from the hospital. But does that mean such tests are performed by national esoteric laboratories? Or would hospital lab specimens end up in regional esoteric testing labs, established in common by the leading hospital systems in the area?

EDITOR: That may be simplifying the impact of complex esoteric assays, which have yet to leave the research lab and enter the clinical market. Healthcare will remain a local business. Hospital labs and community hospital-based pathologists have tight relationships with local physicians and patients that cannot be easily replicated by national lab and AP companies.

Bill, do you believe investor interest in the laboratory industry will remain strong?

MR. BONELLO: Definitely. As you know, our diagnostic services industry meeting was in New York last week. Institutional investors want to learn more about lab testing as a business. I’ve explained my reasons about why the lab industry should see improved financial performance in the coming years.

EDITOR: Do you think at least some of these investors are seeking private laboratory or anatomic pathology com- panies for possible investment?

MR. BONELLO: Definitely. Investors attended this conference on diagnostic services specifically because they wanted to learn more the lab industry as well as identify likely investment prospects.

EDITOR: If true, there’s certainly some interesting changes yet to come. Bill, thank you for sharing your analysis about diagnostic services.

MR. BONELLO: You’re welcome. I hope THE DARK REPORT’S readers find this information to be useful.

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