CEO SUMMARY: Is the New Year’s spate of deals involving the sales of hospital lab outreach programs and a new joint venture the first tremors of an impending earthquake of similar transactions? In the first 10 weeks of 2017, Laboratory Corporation of America, Quest Diagnostics, and Sonic Healthcare announced significant agreements to purchase sizeable hospital lab outreach businesses and establish a laboratory joint venture. This is an unusual number of deals in such a short time.
IN THE FIRST 10 WEEKS OF 2017, hospitals and health systems have announced a surprising number of deals to sell off all or part of their clinical lab operations to the nation’s largest commercial laboratory companies. These laboratory acquisitions involve several of the nation’s biggest and most respected hospital-based clinical laboratory outreach programs.
The parade of transactions started Jan. 10, when Laboratory Corporation of America announced an agreement with Mount Sinai Health System in New York to acquire the assets of Mount Sinai’s Clinical Outreach Laboratories.
One month later, LabCorp worked out a deal with Providence Health and Services in Renton, Wash., and Catholic Health Initiatives in Englewood, Colo., to acquire Pathology Associates Medical Laboratories, and PAML’s interests in joint venture partnerships with Colorado Laboratory Services, Kentucky Laboratory Services, MountainStar Clinical Laboratories, PACLAB Network Laboratories, and Tri-Cities Laboratory. (See pages 6-7 for details.)
In February, Quest Diagnostics Incorporated agreed to acquire the outreach laboratory operations of PeaceHealth Laboratories in Vancouver, Wash., and manage 11 medical center labs that PeaceHealth will continue to own in Alaska, Oregon, and Washington.
Also in February, Sonic Healthcare USA formed a joint-venture partnership with Western Connecticut Health Network in Danbury. Under the name Constitution Diagnostics Network, the partners will manage clinical and anatomic pathology testing in WCHN’s three community hospitals (Danbury Hospital, Norwalk Hospital, and New Milford Hospital). Sonic will use its Sunrise Medical Laboratories in Hicksville, N.Y. for some reference testing.
Another acquisition that happened since the new year was Sonic’s purchase of West Pacific Medical Laboratories in Irvine, Calif. This deal was not disclosed publicly. In a separate agreement, Sonic said it will run the microbiology lab at Baptist Memorial Health Care, in Memphis.
THE DARK REPORT believes there is no precedent for four agreements involving the sale of three lab outreach businesses and the formation of a new lab joint venture among hospitals and health systems and three large national lab companies within just eight weeks.
keen Interest In These Deals
Pathologists and lab administrators who operate hospital lab outreach programs are watching these developments with interest to understand if this number of agreements represents the first wave of a new trend, or whether these four major deals are a coincidence.
One argument in favor of the “coincidence” interpretation is that these announcements came shortly after the start of 2017. It is common for buyers and sellers to want to enter into sales agreements before year-end because of the tax benefits and other advantages. Thus, one school of thought is that the agreements were signed in January and February because the parties could not complete their negotiations in December.
There could be another motive that triggered these sales. Over the past 25 years, the most common reason for a hospital or health system to sell its lab outreach business to a commercial lab company was to convert the value of that asset into cash. In a substantial number of these transactions, the hospital or health system needed to bolster a deteriorating balance sheet, due to either outright losses or erosion in operating margins. The recent financial statements for each of the hospitals or health systems involved in these four transactions shows some evidence of financial pressure.
Weakening finances could be a factor in the Mount Sinai transaction, for example. The health system saw its cash and cash equivalents on hand shrink from $289 million at the end of 2014 to $194 million at the end of 2015, a decline of $85 million in just 12 months.
hospitals’ Money Problems?
At PeaceHealth, financial performance has been stable. One big expenditure has been $352 million to implement an EHR in both the ambulatory and inpatient settings in recent years. The need to beef up capital could be one factor in the timing of PeaceHealth’s decision to sell its outreach business.
Providence Health and Services is feeling financial pressure and announced in November 2016 that it planned an undisclosed number of layoffs. At that time, officials said this action was a response to reductions in payment and increased costs.
Catholic Health Initiatives is experiencing similar declining reimbursement and higher costs. For its year ending June 30, 2016, CHI reported a loss in net income of $699 million.
Razor-Thin Profit Margins
Also, times are tough for WCHN. This three-hospital system reported a $12.8 million operating margin, or about 1%, for 2015. Last year, Modern Healthcare reported, “For the current year , the WCHN board approved a budget that envisions no margin whatsoever, but [CFO] Steven Rosenberg said even that might be optimistic. ‘We’re not at a breakeven pace this year, and we’re really struggling with what to do,’ he said.”
Among hospital administrators, interest in discussing the options for their clinical laboratories has never been higher, according to LabCorp and Quest Diagnostics. During presentations at investment conferences, lab executives from these two companies express great optimism about their respective prospects to do more clinical lab deals with health systems this year.
These dynamics leave unanswered a critical question: Is the lab industry at the beginning of a new trend in which significant numbers of hospitals and health systems are considering selling their lab outreach businesses and allowing commercial lab companies to manage their inpatient labs?
One factor forcing this question into the open is that hospitals and labs will continue to endure drops in reimbursement. This trend will work against most hospital and health system laboratories. For hospitals, less reimbursement for patient care will necessitate increasingly radical steps to bring costs in line with falling revenue. That would be one reason why selling an outreach lab business and outsourcing management of inpatient labs might appeal to hospital administrators.
Financial Analyst Comments on Strategies Quest Diagnostics Is Pursuing to Fuel Growth
IN A NOTE TO CLIENTS, AMANDA MURPHY, a stock analyst with William Blair & Company, explained the latest growth strategies Quest Diagnostics is pursuing.
One avenue is to work with hospitals to run clinical labs in those facilities. Quest describes this strategy as professional lab services (PLS) agreements. When seeking a PLS arrangement, Quest Diagnostics targets the inpatient and outpatient lab testing markets, she wrote.
“This setting is reimbursed under bundled payments beneath the DRG, and thus these labs serve as cost centers for the hospital, potentially tying up capital the hospital would prefer to use elsewhere,” she explained. “When labs are viewed as cost centers and revenue is declining, hospitals are likely to want to jettison those assets.
“PLS arrangements could save 10% to 20% for a given hospital,” she wrote. One disadvantage to PLS arrangements is that they take time to put in place. Yet, she added, “Lab management arrangements, particularly focused on inpatient/outpatient testing, have typically not been a focus for independent laboratory companies and thus, while lower margin, represent a greenfield opportunity.”
Quest also is pursuing opportunities to sell medical lab data to pharmaceutical makers and other companies, she added. “Given Quest’s national footprint and swath of testing data, the company is able to identify the locations with high disease-specific patient concentrations (thus providing a benefit for those interested in site selection/clinical trial enrollment),” she wrote.
Double-Whammy Hits Profits
At the same time, falling reimbursement for lab tests will erode the profitability and return on investment that lab outreach programs have produced. Reduced profitability will make it even easier for hospital administrators to consider selling their laboratory outreach operations and/or outsource inpatient lab testing.
Recognizing the importance of these developments, this year’s Executive War College on May 2-3 will include sessions from lab administrators and executives involved in these lab sale deals.