"Dark Index"

Quest & LabCorp Encounter Different Business Hurdles

Nations’ top dogs in physician’s office testing struggle with unexpected developments

IT’S BEEN TOUGH SLEDDING in recent months for both Laboratory Corporation of America and Quest Diagnostics Incorporated.

THE DARK REPORT believes there may be significance in these developments. Both national labs find themselves confronted with unexpected obstacles. Though different, each case may be evidence of subtle changes in the competitive marketplace for physicians’ office testing.

In the case of Quest Diagnostics, its proposed acquisition of Unilab, Inc. has yet to clear antitrust review. Knowledgeable sources believe the Federal Trade Commission (FTC) has concerns about the acquisition. They also believe Quest Diagnostics is negotiating with the FTC to address those concerns and gain approval for the Unilab acquisition.

It’s a different situation at LabCorp. Last Thursday, the lab company issued an “earnings guidance” change. LabCorp disclosed that its second quarter revenues would fall short of Thompson Financial/First Call’s revenue estimate, probably by about 2%. LabCorp also disclosed that its earnings per share would be about 10% less than the First Call estimate of $0.49. The next day, LabCorp’s share price dropped about 35%, closing at $21.68 for the day.

The story behind LabCorp’s revenue shortfall will be of high interest to lab administrators and pathologists. LabCorp says revenues will be short of expectations in the third quarter because it accessioned fewer specimens than projected. LabCorp is telling Wall Street that the primary reason for this specimen shortfall is the success hospital laboratory outreach programs are having in capturing LabCorp clients. Further, LabCorp singled out Spectrum Laboratory Network of Greensboro, North Carolina as the hospital lab outreach competitor most responsible for its specimen shortfall during the third quarter.

Quality Of Service Slipped

In explaining why it lost specimens to Spectrum and other hospital lab outreach programs, LabCorp acknowledges a slippage in the quality of services it offers to physicians’ offices in North Carolina and admits that its management response to this situation didn’t fully address all the problems. However, that explanation may short-change Spectrum Lab Network as a competitor.

That’s because Spectrum’s success at bagging clients away from LabCorp might be equally credited to good execution by Spectrum’s executive team. Spectrum is aggressively marketing itself in North Carolina and surrounding states. Because it is located just 25 miles from LabCorp’s headquarters in Burlington, LabCorp executives must be particularly embarrassed at their inability to defend physician office-clients on their “home turf.”

Is Dynacare A Factor?

In attributing third quarter’s unexpected shortfall in specimen volume to the success of competing hospital laboratory outreach programs, LabCorp may not be totally forthcoming. THE DARK REPORT believes that LabCorp’s acquisition of Dynacare, Inc., consummated in July 2002, may also be a factor.

Prior to the announcement last May that LabCorp would acquire Dynacare, THE DARK REPORT was the first and only lab industry intelligence source to disclose that Dynacare had significant operational problems in several regions and that several of its hospital lab relationships were under strain. THE DARK REPORT believed the timing of its sale to LabCorp was fortuitous to Dynacare executives and shareholders. However, because of these unpublicized problems, LabCorp might find the Dynacare acquisition to be more troublesome than it expected.

Questions Will Be Answered

The upcoming year will demonstrate the accuracy of that observation, because, if these types of problems exist, they are likely to become public knowledge as LabCorp discloses them. If this occurs, then LabCorp’s executive team may face criticism from financial analysts for the price it paid to acquire Dynacare and its apparent lack of effective due diligence prior to the sale.

Hospital labs with outreach programs should closely follow this story about LabCorp and its ability to defend its existing physicians’ office business from hospital lab outreach competitors. For years, regional lab competitors have claimed that, on average, the level of services provided to physi- cians’ offices by the “Two Blood Brothers” are demonstrably inferior to those provided by strong regional competitors, whether independent commercial lab companies or hospital laboratory outreach programs. Apparently Spectrum Lab Network is demonstrating this may be true, at least in the North Carolina market.

Because LabCorp’s situation has captured the attention of Wall Street, executives at Quest Diagnostics find themselves out of the spotlight, at least temporarily. Until LabCorp’s public disclosure last week, most attention had been focused on Quest Diagnostics and whether it would be able to gain FTC approval to acquire Unilab.

Based on its recent actions, Quest Diagnostics seems determined to overcome all hurdles and acquire Unilab. In mid-September, negotiations between Quest and the FTC were reported to be at an impasse. Certain FTC-watchers believed the FTC’s investigative staff had recommended that the FTC commissioners vote to oppose Quest’s acquisition of Unilab.

Lab Monopoly in North. Calif.

These observers believe that one point of contention is an FTC concern about a monopoly situation in Northern California. In acquiring Unilab, Quest would hold a dominate share of physicians’ office testing in the Northern California market. Moreover, from the FTC’s perspective, there would be no viable lab competitor serving Northern California once Unilab merges with Quest. LabCorp has a small presence in Northern California. Moreover, only a handful of hospitals in that part of the state offer lab outreach programs that provide services much beyond their hospital campus.

In the face of this apparent opposition within the FTC, Quest and Unilab agreed to extend their merger contract for 60 more days, through November 30, 2002. That was followed, days later, by rumors that Quest Diagnostics intended to divest its Northern California laboratory as a way to meet the objections of the FTC.

Dublin Lab May Be For Sale

The Quest laboratory in question is located in Dublin. It was operated by SmithKline Beecham Clinical Laboratories before SBCL’s acquisition by Quest Diagnostics in 1999.

To divest its Dublin laboratory, Quest needs a buyer. Last week it distributed a sales prospectus to several commercial laboratory companies and hospitals/health systems. Since the prospective buyers are under non-disclosure agreements, none will publicly confirm the that sales negotiations may be taking place.

THE DARK REPORT’S sources indicate that LabCorp and Health Line Clinical Laboratories of Burbank, California got copies of the offering document. THE DARK REPORT also has reason to believe that at least one of the hospitals which received the sales prospectus is John Muir Mt. Diablo Health.

Located in Walnut Creek, a short distance from Dublin, Muir has a long-established lab testing outreach program. During the summer, Quest and Unilab offered John Muir as an example of a hospital lab outreach program that would compete against Quest after it buys Unilab.

Dwindling Path Influence

Regardless of the outcome in the proposed merger between Quest Diagnostics and LabCorp, THE DARK REPORT believes that the FTC’s heightened scrutiny of this acquisition signals a broader policy shift within the government. The FTC is pursuing other types of healthcare providers on antitrust grounds. Such a policy shift may make it tougher for bigger lab companies to acquire smaller lab companies, particularly in regions where the larger lab already holds a significant share of the market.

In the case of LabCorp, the swift decline in its share price demonstrates how quickly small declines in volume can translate into larger declines in net earnings. It may also be interpreted as a sign that professional investors are becoming more skeptical about the prospects for the national lab companies to sustain the same rate of earnings growth they demonstrated in recent years.

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