Failure of AD Pathlabs: Structural Weakness?

Can any AP lab business model separate AP technical and professional and succeed?

CEO SUMMARY: AD PathLabs is the latest in a string of business disappointments. Over the past decade, a number of anatomic pathology companies have proven that they can grow rapidly—attracting substantial volumes of specimens. But these companies seem to hit a financial wall that leads their owners to sell the firms to more traditional laboratory companies. Is there a fatal flaw in these business models?

OVER THE PAST 10 YEARS, national anatomic pathology companies have shown they can attract significant case volume from referring physicians. What they have failed to demonstrate is the sustained economic viability of the underlying business model.

During the 1990s, IMPATH, Inc., UroCor, Inc., and DIANON Systems, Inc., caught the attention of Wall Street with their blistering rates of growth in specimen volume and revenue. Yet these three companies were unable to survive as independent and profitable enterprises. IMPATH entered bankruptcy and the owners of UroCor and DIANON decided to sell their lab company when profits turned meager or non-existent.

New Model Of Pathology

Since 2001, at least three anatomic pathology companies have bet on the severability of anatomic pathology technical component services to generate profits and grow revenues. They created a new business model for pathology services, based on performing technical AP services and giving referring pathologists the option of performing the professional service on the case themselves.

US LABS, Inc. launched this business model in 2000. It was a pathology physician management company (PPM), funded by venture capitalists, that was failing to grow. It decided to abandon the PPM business and compete against IMPATH, but with an essential difference. It would offer to do the technical component for referring pathologists and give them the option of performing the professional component.

This business model was made possible, in part, by a unique insight. US Labs could use the the ACIS® instrument system, manufactured by ChromaVision Medical Imaging Systems, Inc. (now Clarient, Inc.), to support splitting the case between its technical and professional components.

At that time, ACIS had recently been cleared by the FDA for sale and use in specific clinical applications. It was a digital imaging microscope, married to software designed to support “image analysis for quantitative IHC measurement.” US LABS recognized that, if the referring physician had a ChromaVision workstation, the company could use the ChromaVision imaging system to digitize the slide. It could then electronically transmit the digital file to the referring pathologist. That digital image would be used by the referring pathologist to diagnose the case.

This arrangement proved popular with certain elements of the pathology profession. Between 2001 and early 2005, when US LABS was acquired by Laboratory Corporation of America, the company’s revenues grew from about $6 million per year to an estimated $75 million in 2004.

Charles Madden, who had been employed by the PPM-precursor to US LABS, observed the rapid growth in specimens and revenues after US LABS adopted this business model. He decided to copy US LABS, but on a regional basis.

Contract For Technical Lab

Using contacts at Catholic Healthcare West (CHW), Madden negotiated a multi-year contract to provide pathology technical services to six CHW hospitals in the Los Angeles area. After obtaining venture capital funding, Madden launched AD PathLabs, Inc. in late 2001. It became the second company to organize itself around a business model of providing technical laboratory services to referring physicians and allowing them to perform the professional service component.

THE DARK REPORT visited the company’s pathology laboratory in El Monte, California in 2003. At that time, Madden explained the business plan and the operational arrangements. Immunohistochemistry was a mainstay of the lab’s test menu. AD PathLabs was using the ChromaVision system to image the IHC slides. Digital images were then sent electronically to the referring pathologists to be read in their hospitals or offices.

During the tour, Madden pointed out that this arrangement contributed to improved turnaround time. Each morning, AD PathLabs would process specimens picked up the previous day and transmit the digitized images by, say, 8 a.m. As pathologists read these cases during the morning, they could call or email requests for special stains. AD Path would retrieve the tissue, cut and stain the new slides, and deliver digitized images of those special slides, generally within two or three hours of the pathologists’ request.

High-Water Year

2003 was the high-water year in the business life of AD PathLabs. It attracted $8.9 million of additional venture capital funding in February 2003 and had about 30 hospital clients across Southern California, including its contract with Catholic Healthcare West.

Despite this optimistic start in the early years, AD PathLabs never achieved break-even on monthly operations. Throughout 2004 and 2005, its owners looked for interested buyers. Madden was ushered from the scene and investors brought in new management. But the company continued losing money. This led to its dissolution in late 2005, when Pathology, Inc. of Torrance, California purchased certain laboratory assets and the client list of AD PathLabs.

Technical AP Laboratory

The failure of AD PathLabs, and the sale of US LABS in early 2005 raises an interesting question: is the business model of a regional or national pathology technical laboratory company viable—both in the marketplace and financially? Keep in mind what differentiates these entities from pathology group practices. The pathology technical laboratory company is founded by individuals who intend to compete with local pathologists for case referrals. Thus, the company would lack the long-standing professional relation- ships that exist between local pathologists, their hospital administrators, and clinicians practicing in the region.

In the case of AD Pathlabs, it is known that low pricing for key clients played a role in the company’s financial struggles. (See sidebar at right.) The other major factor seems to be ineffective executive leadership during AD Paths’ formative period. For example, the sales team at AD PathLabs included a sales manager and up to seven sales reps operating in and around the Los Angeles area. Yet, for this considerable investment, the company never realized the volume of new accounts—at appropriate price levels—necessary to financially sustain AD PathLabs. Nor did Madden, as CEO, take effective action to correct this major failing.

No Buyer As “Going” Lab

A further sign that the business model of separating AP technical component from AP professional component is weak is the simple fact that AD PathLabs’ owners could find no buyer for the company as a going business. Instead, its owners were forced to essentially liquidate the assets in the face of their self-imposed deadline to close the money-losing lab company outright if no buyer was found.

Assuming that low pricing, poor executive leadership, and a lack of sales performance were major contributors to the failure of AD PathLabs, what were the factors that led US LABS to sell itself to LabCorp early in 2005? After all, the company had grown rapidly between 2000 and the end of 2004.

At the time the sale was announced, US LABS acknowledged that the decision to sell was, in part, a response to the impending draconian reduction in flow cytometry reimbursement that Medicare would implement on January 1, 2005.

Was Discounted Pricing Part of AD Path’s Woes?

LOW PRICES FOR ANATOMIC PATHOLOGY (AP)TECHNICAL SERVICES are believed to be a significant factor in AD PathLabs’ demise.

One major source of the company’s specimen volume and revenues was its contract with Catholic Healthcare West (CHW) to serve six of its hospitals. This contract had to be priced at a significant discount to provide the financial incentive necessary for CHW to justify outsourcing anatomic pathology services that its local AP groups were already providing.

AD Path’s business strategy was to use the CHW case volume as the critical mass needed to open the laboratory. But the company was unable to generate enough new clients, at adequate prices, to offset the inadequate profits resulting from the CHW work.

A second fact or in the market likely hindered ADPathLabs’ efforts to get higher pricing for AP technical services. In late 2001, as ADPathLabs launched business operations, IMPATH was operating a histology laboratory in Southern California that offered high-volume slide preparation at attractively low prices. IMPATH was pursuing a loss-leader strategy. Since it was cutting the slides and held the tissue specimens, it believed that it would be asked to do higher-priced, follow-on testing for clients.

Not only did IMPATH’s low-priced technical lab suppress pricing in the region for such services, but IMPATH was employing a large number of histotechnologists. This aggravated the existing labor shortage for histotechs, raising costs to competing laboratories, including AD PathLabs.

That reason is true, as far as it goes. However, US LABS had its own leadership issues in its executive suite. In May 2002, the company abruptly replaced Mike Danzi, who held the titles of Chairman, President, and CEO. It was Danzi who had originated the business concept of offering separate AP technical services to referring pathologists and other physicians.

Several factors contributed to Danzi’s departure. Key among them was the negative cash flow of the business. Intelligence at that time hinted that US LABS’ revenues were at the $20 million per year level, but its spending was at the $40 million per year level. Further, Danzi was just completing construction of a new laboratory that included the largest number of several instrument systems that vendors had placed in a single site anywhere in the world!

Operating Deficits

With US LABS outspending revenues by a factor of 100%, venture capital companies had a decision to make. Faced with this huge cash flow deficit, many of US LABS’ investors wanted to pull the plug on the company. However, the decision was made to continue with new leadership. To cover the negative cash flow from operations, additional funding was put into the company over the course of 2002.

US LABS continued to grow at spectacular rates during 2002, 2003, and into 2004. But, because of its cumulative operating losses, it was struggling to achieve the kind of high profits necessary to justify the investments made by the venture capital companies. When news surfaced that Medicare would slash flow cytometry reimbursement by 60% for 2005, investors on US LABS’ board made the decision to sell the business and redeploy their capital elsewhere.

Collectively, the experience of AD PathLabs and US LABS provides strong evidence that the business model both companies pursued—that of forming a company from scratch to offer AP technical services to a regional or national market—is not viable.

Viable Business Model?

It should be noted that there are a number of independent pathology laboratories around the country which operate successfully. What these companies have in common is that they were founded by pathologists who had strong clinical and professional relationships with hospitals and office-based physicians in the communities they serve. Both of these attributes were lacking in the case of AD PathLabs and US Labs.

And what of the third company founded on the business model of offering AP technical services? It is Clarient, Inc., the new name for ChromaVision Medical Imaging, Inc.

In the face of lackluster sales for its ACIS Imaging system, and having watched the spectacular specimen volume growth at US LABS (its single largest customer for ACIS), ChromaVision decided to enter the clinical laboratory testing business and use its ACIS instrument system in a similar fashion as US LABS.

To fund its expansion into clinical services, in the spring of 2004, ChromaVision raised $21 million from investors. In subsequent months, it hired a number of people who held key administrative and clinical positions at US LABS and IMPATH. Its laboratory facility was licensed in November 2004. Revenue from clinical services totaled $2.2 million that year.

In March 2005, ChromaVision changed its corporate name to Clarient, Inc. It reported revenues from clinical testing services of $1.9 million in Q1, $2.6 million in Q2 and $3.0 milion for Q3. Year-end earnings for 2005 have not been released.

It is likely that Clarient will report revenues from its clinical testing operation of around $11 million for 2005. That is impressive growth for an a national anatomic pathology laboratory that has only been operational for less than 18 months.

In fact, Clarient’s growth trajectory is comparable to that of US LABS’ growth in the 2001-2003 period. On the surface, this is an auspicious start for Clarient. At the same time, when viewed against the experience of US LABS, and to a lesser degree, AD PathLabs, several questions must be asked.

Local Path Groups Have Local Market Advantage, But Fail to Use Effective Sales & Marketing

SINCE 1995,THERE HAVE BEEN AT LEAST 10 venture capital-funded companies that operated in the lab services marketplace and were organized primarily to provide anatomic pathology (AP) services.

Of that number, only two have not changed ownership. One is Pathology Partners, Inc. of Dallas, Texas, formed in 1998. The other is CBL Path,Inc., which is still a young firm, having launched in 2003.

The fact that the original owners of 80% of these enterprises were not able to sustain the business as independent, ongoing companies raises an interesting question. Why would 80% of these enterprises, funded by sophisticated investors and managed by veteran executives, be unable to continue as independent businesses?

Threat To Local Path Groups

The answer to this question is highly important to the long-term financial viability of the private pathology group practice, typically affiliated with a community hospital. That’s because there is one thing that these 10 or more anatomic pathology-focused businesses have proved they can do well. They can send sales people into physicians’ offices and convince a high number of physicians to refer their anatomic pathology cases to a regional or national AP laboratory company.

Through the late 1990s and into the first years of this decade, THE DARK REPORT regularly called attention to the rather amazing rates of growth enjoyed by these companies. For example, in 1997, DIANON Systems, IMPATH, and AmeriPath had only about $125 million in AP revenues among them. Remarkably, at the end of 2002, the combined revenues of these three firms totaled $954 million. In five years, this threesome had captured nearly $1 billion of revenues from local pathology groups across the nation!

I believe the business histories of the 10 or so companies that entered the AP marketplace have two lessons to teach. First, if you spend enough money, your sales force can convince doctors to steer their specimens away from local, hospital- based pathology groups and, instead, send them to a regional or national laboratory located many miles away.

Second, the combined costs of running a huge sales and marketing campaign, along with the normal costs of operating a regional or national AP company, makes it difficult for these companies to earn the profit margins needed by their venture capitalists. As they deliver unimpressive profit margins despite amazing growth rates in specimens and total revenues, investors decide to close out their AP investment and redeploy the money into more profitable opportunities.

Pathologists in private group practices should heed the knowledge provided by these two lessons. To protect their business relationships with local physicians, they need to have some type of sales and customer service program. It is essential that they contact their clients regularly and “resell” the reasons why their local group is the best option. That will protect their client base as each generation of new AP companies sends a fresh crop of sales reps into the community. —By Robert L. Michel

Life Span Of Five Years

First, neither US LABS nor AD PathLabs survived past year five with their business strategy of offering primarily AP technical services. Is Clarient doing something different in its execution of this business model that may give it a different—and more positive—outcome?

Second, the market experience of AD PathLabs and US LABS must be considered evidence that the cost of operating a company that provides primarily AP technical services may not be totally recovered by the income earned from such services. Has Clarient improved productivity or removed costs sufficiently to earn adequate profit margins from existing reimbursement for AP technical services?

Third, both US LABS and AD PathLabs financed expensive sales and marketing programs to attract new clients. The average cost-to-acquire a new account can be quite expensive. Is Clarient’s sales and marketing program gaining new client accounts without overspending? If too much money is spent to acquire individual accounts, those accounts may never generate sufficient profit margins to recoup their original acquisition cost.

Fourth, many of the same people who worked in important management and clinical positions at IMPATH (filed for bankruptcy in September 2004) and US LABS (sold to LabCorp in February 2005) are now working at Clarient. Will Clarient benefit from their experience, and thus not make key strategic mistakes which led both the aforementioned companies to a loss of corporate independence?

Based on the life spans of AD PathLabs and US LABS, it may take five years or longer for the laboratory industry to learn the answers to these questions. For the pathology profession, this is a subject of keen interest, for a very important reason.

The consistent inability of AP companies, some of which managed to sell their stock to the public, to remain independent over the long run indicates some type of financial weakness in the business model. These companies do share some interesting characteristics: 1) they are AP companies formed by non-pathologists; 2) they are amply funded by professional investors; and, 3) they are organized specifically to win the specimens currently going to local, pathologist-owned laboratories and group practices.

Where’s the Pathologist?

THE DARK REPORT observes that all of these attributes may be a cause for failure for one reason: they have not been founded by pathologists—who understand the diagnostic needs of clinicians, who want to practice a higher level of medicine (a larger laboratory operation can fund a deeper test menu and acquire esoteric testing technology), and who intend for their business to support their medical career.

This conclusion can be supported by the host of small (under $5 million) specialty pathology laboratories that operate around the country. Owned and run by subspecialist pathologists, some have been around for almost two decades and are financially robust, even if they are not large by Wall Street standards. Might it be that an AP company—to be truly successful—really needs to be led by an anatomic pathologist?


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