CEO SUMMARY: When an investment group bought Focus Diagnostics, Inc. in 2000, its business objective was to increase the value of the business and sell it between year five and ten of its ownership. Thus, the announcement last Friday that Focus Diagnostics would be acquired by Quest Diagnostics. Focus Diagnostics is a prime example that confirms the existence of the new lab business life cycle.
IN RECENT YEARS, THE DARK REPORT WAS FIRST TO IDENTIFY AND DESCRIBE the new business life cycle for independent laboratory companies.
Last Friday’s announcement that Quest Diagnostics Incorporated would acquire Focus Diagnostics, Inc. is the latest confirmation that this new business life cycle is active and dominant in the laboratory industry. Not only does this transaction further consolidate the laboratory industry in the United States, but it makes it easier to predict similar acquisitions in future months and years.
The consequences of this new business life cycle for laboratory companies touch every dimension of the laboratory industry. For this reason, laboratory managers and pathologists will want to understand the details of this new business life cycle. That’s because it will affect the strategic planning of their own laboratory organization.
In simplest terms, the new business life cycle for independent laboratory companies involves three phases. In phase one, professional investors find experienced laboratory executives, develop a business plan, then enter the business by either starting up a lab company or acquiring an existing laboratory. Phase two is operational execution. Using the ample capital placed at their disposal, the executive team builds the business. The objective is to develop a growing base of clients, generate a continually-growing flow of specimens, and produce net profits.
Eventual Need To Sell
In phase three, it is time for the professional investors to liquidate their investment in the laboratory company. They need the money in order to pay off the venture capital and investment funds they tapped in order to capitalize the new laboratory company. These investment funds usually have a term of five to 10 years from inception to closing.
Typically, there are three options for liquidating the investment in the laboratory company. First, some or all of the lab company can be sold to other investors. Second, the company can attempt to sell its stock to the public in an IPO (initial public offering). Third, the company can be sold to another laboratory company. In recent years, that buyer has often turned out to be Quest Diagnostics Incorporated or Laboratory Corporation of America.
The new business life cycle for independent laboratory companies is that simple. What sets this business cycle apart from that seen in the 1980s and early 1990s is that the majority of new laboratory companies are no longer founded by pathologists who are motivated by an interest in expanding the laboratory medicine services they provide to their physician-clients.
For the past 10 years, most new laboratory companies have been launched by investors, armed with ample cash, who bring aboard experienced lab industry executives and then acquire an existing lab or create a brand-new laboratory company. Their primary motive is to make a profit by offering laboratory medicine services. That subtle difference from the pathologist-founded and operated laboratory drives the different outcomes.
In the old business cycle, the founding pathologists ran their laboratories conservatively. They offered a dense network of patient service centers and rapid response labs to maintain a high quality of service. They expanded their business step-wise, generally using internally-generated profits to fund this expansion.
Pathologists With Passion
The pathologist-founded laboratory company reflected their professional interest: to offer physician-clients high-quality and personal laboratory testing services. These pathologists were not motivated to sell their lab companies five years after start-up, since their laboratory was the profession and passion of the founding pathologists. Not until decades later, as retirement approached, did most pathologist-owners seriously consider the sale of their laboratory as the most likely way to get their investment out of the lab company so it could fund their retirement.
In direct contrast, the new business cycle for independent laboratory companies has an “automatic” sell date, usually between five and 10 years from the launch of the laboratory company. That means, from day one, the new laboratory organization is focused on its ever-approaching sale date.
Intent To Divest
It also means that hospital outreach programs and the remaining independent laboratories owned and operated by pathologists face a new type of competitor in the marketplace. Instead of competing laboratories owned and run by pathologists who intend to be around for a decade or more, increasingly the competition is from a lab company funded by investors, generally managed by non-pathologists, and organized to maximize growth and profits in the quickest time possible—since the business must be able to do an IPO or sell most of its equity in as little as five years.
It cannot be said that the competitive laboratory marketplace has become “better” or “worse” because of this new business life cycle for laboratory companies. It is certainly true that compliance boundaries are pushed to dangerous extremes by the most aggressive lab operators. It is also true that loss-leader pricing and sales practices such as the TC/PC split in anatomic pathology originate primarily with these types of firms. What is true is that, until more pathologists decide to start their own labs, for all the classic reasons, the lab industry will be dominated by this new laboratory business archetype.
Laboratory Business Life Cycle Changed By Investors in the Last Half of 1990s
IN THE MIDST OF LAB BANKRUPTCIES and forced mergers among the best-known commercial lab companies during the second half of the 1990s, some perceptive investors aligned themselves with experienced laboratory executives and went buying—at what proved to be bargain basement prices.
In Chantilly, Virginia, the venerable American Medical Laboratories, Inc.(AML) was acquired in early 1997 by Timothy Brodnick, Jack Bergstrom, and Jerry Glick, using capital provided by Golder, Thoma, Cressey, Rouner, Inc. (See TDR, May 12, 1997.) It was just a year earlier, in 1997, that AmeriPath, Inc. of Riviera Beach, Florida began acquiring pathology groups, spending capital provided by Summit Partners and commercial bank financing. By October 1997, AmeriPath had successfully raised $89.6 million in an IPO (initial public offering) and intensified its acquisitions of pathology group practices. (See TDR, October 27, 1997.)
Another benchmark deal was the acquisition of Tarzana, California-based Unilab Corporation in 1999 by veteran laboratory executive Robert Whalen, using capital provided by Kelso & Company. (See TDR, June 7, 1999.) In a similar fashion, lab companies like Dynacare, Inc., several pathology physician practice management (PPM) companies, and others got significant equity investments from private sources during these years.
And don’t forget some private laboratories which obtained capital from private sources to finance growth and the retirement of pathologist-owners. Two examples of labs which went this route are Path Lab, Inc. of Portsmouth, New Hampshire and Clinical Pathology Laboratories, Inc. (CPL) of Austin, Texas.
All these companies are the first examples of firms organized under the new business life cycle for laboratory companies. The outcomes are instructive. Purchased for about $25 million and the assumption of some debt in 1997, AML was sold to Quest Diagnostics in 2002 for $500 million in January 2002, not quite five years later.
Unilab was next on the sales block. In April, 2002, Quest Diagnostics paid about $1 billion to acquire Unilab, a company that Kelso had bought less than three years earlier for more than $400 million.
There were similar outcomes for Path Labs, Inc. and CPL. LabCorp purchased Path Labs in 2001. For its annual revenues of $51.6 million, LabCorp paid $99.6 million. Last year, in August, CPL was acquired by Sonic Healthcare, Ltd. With annual revenues of $185 million, the purchase price for an 80% interest was $300 million. (See TDR, September 12, 2005.)
This list of “first generation” examples doesn’t include the successful sales of companies like DIANON Systems, Inc. (annual revenues of $190 million and price paid by LabCorp of $598.6 million in early 2003), AmeriPath (annual revenues of $478.8 million in 2002 and price paid by Welsh Carson, Anderson & Stowe of almost $800 million), and LabOne, Inc. (annual revenues of $500 million and price paid by Quest Diagnostics of $934 million in 2005. (See TDRs, November 18, 2002, March 3, 2003, August 22, 2005.)
These examples make a compelling argument that lots of money can be made from laboratory testing. Over the past five years, Wall Street has noticed and professional money managers now constantly comb the laboratory industry for investment opportunities. Any lab company with a good business plan can attract ample funding.