"The Dark Index"

Improved 3rd Quarter Performance Posted By National Laboratories

Third quarter financial performance at all three national laboratories improved over the same period of 1997. It is an important sign that the three companies are stabilizing their finances.

All three national laboratories continue to emphasize cost-cutting as a major corporate priority. That is to be expected, since increased penetration of managed healthcare maintains a downward pressure on reimbursement for laboratory testing.

Laboratory Corporation of America posted net sales of $398.3 million for the quarter. This is a 5.8% increase from last year. Net income almost doubled, from $5.4 million in third quarter 1997 to $11.4 million this quarter.

First Gain In Three Years

The most notable fact about this accomplishment is that it is the first time in three years that LabCorp has seen a quarterly increase over the same quarter of the previous year. That is a significant fact, because it indicates that some level of financial stability is returning to the clinical laboratory marketplace.

LabCorp also indicated that the 5.8% gain in revenue was attributed to two facts. First, 4.4% of the increase was the result of higher test prices. Second, 1.4% of the increase was attributed to additional testing volume. LabCorp also reported that its revenue per accession jumped 2.6% over that of third quarter 1997.

LabCorp’s EBIDTA (earnings before interest, depreciation, taxes, and amortization) showed strong growth. It totaled $54.1 million for the quarter, up 14% over the same period in 1997. EBIDTA is an important measurement of the cash flow available to pay corporate expenses.

Two Acquisitions In 1998

During the first nine months of 1998, LabCorp’s revenue was helped by the company’s acquisition of two laboratories. In April it announced the purchase of MedLab, Inc., a $20 million laboratory in bankruptcy court in Delaware.

LabCorp followed that acquisition with another. In July, it purchased the laboratory testing business and related assets from Universal Standard Healthcare, Inc. of Southfield, Michigan. This chunk of business brought another $37 million per year of lab revenues to LabCorp. (See TDR, July 27, 1998.) The full impact of these acquisitions will show up in LabCorp’s earnings for 1999.

Experts familiar with LabCorp’s operational issues know that the company has struggled with its billing and collections. During 1996 and 1997 this area was the source of many problems. For third quarter 1998, LabCorp reported a DSO (days sales outstanding) of 84 days. That is an improvement over 1997, but still leaves room for further gains.

Next up for review is Quest Diagnostics Incorporated. Relative to its two national competitors, Quest has aggressively strived to identify and purge unprofitable accounts. So it is not surprising that Quest reports a modest decline in revenues. Third quarter 1998 revenues were $360.7 million, compared to $373.7 million for the same quarter of 1997. This is a 3.5% decline.

However, reflecting the improved profitability of the remaining accounts, Quest saw net income increase by 103%, from $3.0 million last year to $6.1 million this year. EBIDTA climbed modestly, increasing from $35.7 million for third quarter 1997 to $37.6 million this year.

Although Quest’s requisition count was down by 5.6%, its revenue per requisition went up 1.4% over the same period last year. DSO (days sales outstanding) stood at 61 days.

In contrast to LabCorp’s strategy of doing selected acquisitions, Quest is choosing to pursue strategic alliances. In October, a joint venture with UPMC Health System (formerly University of Pittsburgh Medical Center) was announced.

Whereas LabCorp’s acquisitions generate an immediate surge in requisitions, frequently a joint venture takes some time before there is a net increase of specimens to both partners. Quest also entered into a similar joint venture with Unity Health System of St. Louis this year.

Time-Consuming Initiatives

Along with Quest’s developing relationship with Premiere, Inc. these are all business initiatives which require time to bear fruit. Historically, such ventures are time consuming to negotiate, complicated to organize, and slow to generate profits.

On the other hand, Quest, as a joint venture partner, becomes embedded in the local healthcare community. It brings Quest inside the integrated healthcare system. If clinical and operational integration of healthcare is the wave of the future, then Quest should benefit from these efforts, even though the eventual pay-off is years away.

An interesting aside about Quest. During the first nine months of 1998, the company was able to pay down $44.1 million of debt, of which $20 million was a prepayment. Quest also purchased $12.4 million of its shares. The fact that Quest is using cash flow for these activities indicates an easing of the financial pressure experienced in past years.

13% Growth At SBCL

At SmithKline Beecham Clinical Laboratories (SBCL), the most striking development during third quarter 1998 was growth. Compared to third quarter 1997, revenues were up 13% and specimen volume increased 10%. SBCL’s revenues for the quarter totaled $396 million.

The downside at SBCL was a decline in operating profit, which decreased 8% to $38 million. Because SBCL is a division of SmithKline Beecham, PLC and is based in London, the parent company does not disclose the level of financial detail required by U.S.-based companies like LabCorp and Quest.

What explains SBCL’s spurt in specimen volume and a decline in operating profit? Clients and readers of THE DARK REPORT know that SBCL has pursued a managed care strategy based on exclusive sole source contracts with national MCOs.

Quest And UPMC Decide To Dance

Once again Quest Diagnostics Incorporated is on the strategic alliance trail. This time the partner is UPMC Health Systems.

UPMC Health Systems (formerly University of Pittsburgh Medical Center) is the strongest integrated delivery system in the Pittsburgh metro. Quest operates a large regional laboratory in the town. This joint venture combines two strong players.

Each partner is contributing existing laboratory assets to the venture. Equity ownership is split, with 51% to Quest and 49% to UPMC. The management board will have equal representation and the joint medical leadership team will be chaired by a physician from the Pathology Department at the University of Pittsburgh Medical School.

What few laboratory executives realize is that UPMC has advanced technical expertise in laboratory and pathology information systems. This is an interesting side benefit to Quest, as they will have access to cutting-edge projects under way at UPMC and the medical school.

Specimen Volume Gains

In particular, during the last year it was implementing the Prudential Healthcare contract and building strong relationships with United Healthcare. Some unit volume gains at SBCL can be attributed to implementation of these types of contracts.

The specimen volume pickup from SBCL’s sole source contract with Aetna/U.S. Healthcare is too recent to impact its revenue and earnings. But during 1999, as the implementation of the contract proceeds, that source may fuel increased specimen volume for SBCL.

As to reduced profitability, the company cryptically reports that “the decline in operating profit is due to the continuing difficult pricing and reimbursement environment and start-up costs associated with the implementation of the Tenet Healthcare Corporation contract.”

SBCL’s Pricing Strategy

During 1997 and 1998, THE DARK REPORT received anecdotal reports on SBCL’s pricing strategy in various areas of the United States. The consistent theme of these reports is that SBCL was willing to bid for incremental new business using “marginal cost” pricing.

This stood in contrast to LabCorp and Quest, as those companies were attempting to live up to their public statements about renewing laboratory services contracts at price levels adequate enough to cover full costs.

Since both LabCorp and Quest are reporting increased revenues per accession for third quarter, it may be that one contributing factor to SBCL’s decline in operating profit is its own strategy of capturing incremental business using “marginal cost” pricing.

The Tenet contract involves SBCL’s involvement in helping Tenet consolidate laboratory operations at 30 Southern California hospitals. (See TDR, January 19, 1998.) SBCL’s role is as consultant and project manager.

The parent company’s comment about start-up costs involved in the Tenet contract is “corporatese.” It is specific enough to disclose a material fact to investors that things are not going as well as planned. But it is vague enough that it doesn’t have to provide details about the project’s difficulties.

Requisition Count Decline

Analysis of the third quarter financials of the three blood brothers does validate the conclusion that the marketplace for clinical laboratory services has ceased its downward free fall.

Further, the financial experience of each of the three national laboratories indicates that their individual business strategies and initiatives are leading each in a slightly different direction.

For those laboratories competing against the three blood brothers, the message should be clear: don’t delay in aggressively pursuing new business.

The reason why should be obvious. As the three blood brothers slowly regain their financial strength, they will spend increasing dollars to gain market share in all the regional markets they serve, making them even tougher competitors than they are today.

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