National Labs Show Improved Finances For First Quarter, 1998

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FIRST QUARTER FINANCIAL performance of the three national laboratories indicates that they may finally be past the worst of the managed care storm.

On April 14, Quest Diagnostics Incorporated became the first of the three blood brothers to release earnings. First quarter revenues declined 5.2% from the previous year. But earnings per share increased from $0.14 last year to $0.21 and this is the number most closely watched by investors.

The revenue decline was expected. It resulted from Quest’s corporate strategy of repricing existing accounts to profitable levels. Otherwise Quest has stated that it would walk away from unprofitable business.

Money-Losing Accounts

Quest saw a decrease in test requisitions of 8.1%, but net revenue only declined by 5.2%. That is evidence that Quest correctly identified money-losing accounts while keeping the more profitable business. Further validation may be the fact that Quest’s average net revenue per requisition actually increased by 3.1% over last year. As it drops unprofitable clients, Quest improves the profitability of existing business.

Quest Diagnostics’ net revenues of $367.9 million for the quarter give it an annual run rate of $1.47 billon. This is a significant reduction from the $1.7 billion that Quest generated just a few years ago. But, despite a decline of $20.2 million in revenue from the same quarter last year, Quest was able to shave expenses by $24.8 million. Again, this disproportional gain in cost savings over revenue loss demonstrates that Quest is making progress in restoring financial balance to its business operations.

Growth At SmithKline

SmithKline Beecham (SB) reported earnings on April 21. Corporate revenues increased by 8%. For the first time in several years, revenue growth at SmithKline Beecham Clinical Laboratories (SBCL) was similar to other business groups within SB. Revenues at the laboratory division were up 7%, the same growth rate as the consumer healthcare division. Pharmaceuticals increased 10% over last year.

SBCL’s revenues for the quarter were $337 million, which is about 8% less than Quest’s $367.9 million. SBCL’s annual run rate is now $1.35 billion, compared to Quest’s run rate of $1.47 billion. SBCL reported operating profits of $22 million for the quarter. This is a healthy increase of 15% over first quarter 1997.

Different Pricing Strategy

SmithKline’s laboratory division is fol- lowing a different pricing strategy than Quest. Because of this, it shows a different revenue/profit performance than Quest. Like Quest, SBCL is purging or repricing unprofitable client accounts. But it is also willing to acquire incremental new business using marginal cost pricing. That is why SBCL showed a 7% gain in revenue over last year.

Operating profits increased by 15% during the same period, reflecting SBCL’s corporate strategy of acquiring new test volumes while squeezing the production side of the business. Anecdotal reports from different areas of the United States indicate that SBCL is still willing to be the “low price” leader to attract new business. That feeds additional specimen volume into its regional laboratories and helps it to lower its overall aver- age cost per test.

Marginal Cost Pricing

Laboratory executives in states such as California observe that SBCL’s strategy of bidding new work with marginal cost pricing has another effect in the marketplace: when competing laboratories match those prices to prevent their existing business from going to SBCL, it hinders them from negotiating higher reimbursement at contract renewal time. SBCL’s pricing strategy has the effect of denying additional revenues to competing laboratories.

THE DARK REPORT observed two years ago that excess laboratory capacity is what causes marginal cost-based pricing. Every laboratory with extra capacity has an incentive to use marginal cost-based pricing to attract additional volumes of specimens which can fill that excess capacity.

Management Experiment

With SmithKline Clinical Laboratories still willing to use marginal-cost pricing to capture new business, its corporate strategy provides an interesting management experiment when compared to Quest Diagnostics. Quest is unwilling to use marginal-cost pricing unless forced to defend existing business. Instead, Quest is attempting to realign the capacity of its network of regional laboratories to better match demand for the markets served by its system.

Readers of THE DARK REPORT will recall that Quest Diagnostics announced last December that it would close laboratories in Tampa and Atlanta, downsize the St. Louis operation, and restructure a number of satellite laboratories. (See TDR, December 8, 1997.) Quest stated that 6% of its work force, an estimated 1,000 employees, would be released as a consequence of this extensive downsizing project.

To accomplish this restructuring, Quest Diagnostics wrote down $70 million in the fourth quarter of 1997 and another $2.5 million in the first quarter of 1998. But Quest expects annual savings of $20 million per year will result from the restructuring project.

Here is a good opportunity to watch the outcomes for two competing strategies. SBCL’s strategic priority appears to emphasize increasing specimen volume relative to restructuring and downsizing. Quest Diagnostic’s stated strategy is to emphasize better alignment of laboratory testing capacity in each market while improving pricing margins for existing and new business.

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Number Of Laboratories

It should be pointed out, however, that SmithKline has progressively reduced the number of laboratories in its system over the previous five years. It also did not use acquisitions to fuel rapid growth, unlike MetPath (now Quest) and National Health Laboratories (now Laboratory Corporation of America). Thus, SBCL is neither burdened with a “crazy quilt” of laboratories operating with different systems nor excess capacity created by the multiple acquisitions of its laboratory competitors.

One conclusion to be made from these results is that the unbridled financial losses of 1996-97 are over. A level of stability is returning to these businesses, although their overall financial condition is still not strong.

Laboratory Corporation of America reported its first quarter earnings on April 30. Like Quest, there was a modest revenue decline accompanied by an improvement in operating profit. But LabCorp was the only one of the three blood brothers to report a net loss for the quarter, of $1.8 million. This is a slight decrease from the net profit of $2.5 million LabCorp reported after the first quarter of 1997.

LabCorp’s revenues declined 4.6%, to $373.0 million. This gives LabCorp an annual run rate of $1.49 billion. This is just slightly greater than Quest Diagnostics (at $1.47 billion). LabCorp’s earnings before interest, taxes, depreciation and amortization (EBITDA) for the quarter was $50.2 million. This compares favorably against Quest’s EBITDA, which was $40.1 mil- lion on almost the same revenue base.

LabCorp attributes the revenue decline to three reasons. First, LabCorp is concentrating on dropping money-losing accounts. Second, changes to government and private reimbursement policies are causing a decline in physician ordering patterns. Third, hospital laboratory outreach pro- grams are aggressively competing in the marketplace and winning business.

Cost-Cutting Benefits

First quarter financial performance of the three blood brothers indicates that each laboratory is reaping some benefit from cost-cutting efforts. Operating profits increased over the same production period in 1997.

Declines in revenue at Quest Diagnostics and LabCorp indicate that any sales growth is being neutralized by efforts to release unprofitable accounts, changes in physician ordering patterns, declines to reimbursement, and competitors who are stealing business.

One conclusion to be made from these results is that the unbridled financial losses of 1996-97 are over. A level of stability is returning to these businesses, although their overall financial condition is still not strong.

Regional laboratory competitors and hospital laboratory outreach programs which benefited from the service problems and internal operational focus of the three blood brothers should take note of these new developments. The days of easy pickin’s may be over.

As the three national laboratories improve their management execution and financial condition from quarter to quarter, they will intensify sales efforts to gain additional market share. Competition for new business may once again intensify.

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