Quest Announces Major Restructuring for 1998

Changes will include staffing reductions, downsizing of several regional laboratories

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CEO SUMMARY: Recognizing the reality of laboratory over-capacity in the marketplace, Quest Diagnostics Incorporated intends to align its laboratory capacity with existing specimen volumes. In so doing, it’s taking a progressive step and moving more aggressively than its two national competitors to resolve an issue which impacts the entire industry.

WHEN IT WAS ANNOUNCED last week that Quest Diagnostics Incorporated would downsize several regional testing centers, the prime motivation was to reduce laboratory overcapacity and improve corporate cash flow.

In a press release dated December 2, Quest Diagnostics noted that laboratories in Atlanta and Tampa were scheduled to be converted into “Local Customer Centers with rapid-turnaround (STAT) laboratories for time-sensitive testing.” Quest also declared that the St. Louis regional laboratory would be reduced in size, along with several smaller branch laboratories in various regions of the country.

Quest Diagnostics estimated that its work force will shrink by approximately 1,000. This is a 6% reduction in the company’s overall employment. The restructuring will take place during the course of 1998.

In taking these actions, Quest Diagnostics is once again demonstrating initiative relative to its national competitors. There is excess laboratory capacity in most cities. Laboratories which figure out a strategy to downsize capacity while improving profit margins should gain a competitive edge over other laboratories in that specific market.

But Quest’s actions also provide insight into the difficulties of sustaining a geographically diverse system of laboratories. Both SmithKline Beecham Clinical Laboratories and Laboratory Corp. of America face the same pressure. Announcements about restructuring and re-engineering of their national laboratory systems should be expected during the next 24 months.

“Given the overcapacity that characterizes our industry, reducing the size of these facilities was a difficult but necessary decision.”
—Kenneth W. Freeman
Chairman & CEO, Quest Diagnostics

For Quest, these changes will result in a pre-tax charge to earnings, estimated between $60 and $70 million. The company intends to take the charge during the fourth quarter of 1997. In writing off these expenses during fiscal 1997, Quest Diagnostics hopes the earnings improvement resulting from the laboratory restructuring program will improve operating profits and earnings starting in 1998. In fact, Quest Diagnostics estimates that it will take all of 1998 to restructure the laboratories as planned. When completed, the announced changes are projected to generate annual benefits of $20 million.

If true, then Quest Diagnostics is taking an immediate financial charge of up to $70 million, to obtain a projected gain of $20 million per year from the restructuring. With shareholder equity of $566 million and debt of $600 million, Quest has the capability to sustain the write-down.

Quest’s Rating Affirmed

Standard & Poor’s (S&P) agrees. It affirmed its current rating for Quest Diagnostics, noting a negligible after-tax impact of the charge and a modest increase in financial leverage, from 55% to 58%. But Standard & Poor’s also noted the difficult environment for Quest. In giving Quest a “stable” outlook, S&P stated, “In an era of tight-fisted payers, the company [Quest] is unlikely to improve profit margins and credit measures beyond that anticipated by the rating.”

S&P recognizes the financial challenges facing all clinical laboratories. Taken in this context, Quest’s actions reveal some interesting aspects to the competitive marketplace. Since Quest was able to recast its balance sheet during the spin-off from Corning Incorporated last January, it has flexibility to restructure operations.

Obviously, it is not cheap to shut down laboratories, provide severance packages to laid-off employees, and liquidate instruments, equipment and other assets. Quest estimates a $70 million charge, related primarily to three laboratory sites. But the numbers involved in Quest’s restructuring illustrate why the national laboratories are not more aggressive at shutting down redundant laboratories in their systems. Note that a $70 million charge generates annual benefits of $20 million. Quest will not recoup this money until mid-year, 2002.

Write-Down Size

The size of the write-down and lengthy repayment period illustrate two points overlooked by most laboratory executives. First, it is very expensive to close a laboratory operation and remove those operational assets from the books.

Second, corporate officers at these laboratories face the constraints of debt- to-equity covenants, along with the need to maintain good relations with lenders, investors and the corporate parent. Even if the right thing to do was to close down underutilized and marginally profitable laboratories, the size of the charge against earnings would trigger a variety of potentially unpleasant events. Not the least of which could be the replacement of existing corporate officers with new Presidents, COOs, CFOs, etc.

However, by allowing marginal laboratories to continue operating, the status quo can be maintained and future developments might improve the situation, offering new options for resolving these problems. This is a strategy of “sit and wait; we’ll see what happens.”

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Commendable Qualities

Seen from this perspective, Quest Diagnostics demonstrates two commendable qualities. First, it is restructuring its laboratory system while it still has the financial capability to accomplish the task. This improves its long-term prospects, particularly if profitability in the clinical laboratory marketplace continues to decline.

Second, its executives were courageous enough to “bite the bullet” and restructure laboratories before market pressures forced them to do so. By taking the initiative, they are actually improving the financial stability of the company for stockholders and the remaining employees.

How will this imminent restructuring at Quest Diagnostics reshape the laboratory marketplace? In any city where Quest ceases local testing and sends the work to a regional laboratory outside the area, there will be an increase in lost clients. It is a given in the laboratory industry that physician office clients do not like change. When a laboratory alters any aspect of service, some clients will switch to competing laboratories.

Thus, in the affected cities, both hospital laboratory outreach programs and commercial laboratory competitors can be expected to intensify their marketing efforts to Quest clients.

Among the three blood brothers, Quest’s actions probably give it a long-term competitive edge. Improvement in cash flow helps strengthen the company’s ability to compete for new business. By restructuring its own laboratory system, Quest creates pressure on the other two national laboratories to do the same.

This is probably most true of LabCorp. Observers still recognize that redundancies remain from the merger of the two laboratory systems operated by Roche and National Health Laboratories almost three years ago.

But if Quest Diagnostics must charge off $70 million to restructure three laboratory sites, how large a write-down would LabCorp incur if it closed and wrote off unnecessary or marginally profitable laboratories in its system? Also, would LabCorp’s existing balance sheet and debt covenants even permit it to take such a step?

As a market thermometer, the restructuring soon to take place at Quest Diagnostics provides useful intelligence. It is a reminder that all three of the national laboratories continue to deal from a position of relative weakness. They no longer dominate their local markets as they once did in the first half of the 1990s.

Evidence Of Pressure

It is also fresh evidence that intense management pressures continue within the three national laboratory systems. This pressure has been literally non-stop during the past three years. It would be reasonable to expect the burn-out factor to kick-in and show itself within all three companies, particularly with middle managers and sales representatives at the regional laboratories.

Laboratory competitors should also recognize another obvious conclusion. As the three national laboratories focus internally to regain financial stability, there exists an exceptional market opportunity. Hospital-based laboratories which professionally market a competitive laboratory outreach program have an open door to build their client base at the expense of the three blood brothers.

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