Testing Times for Quest and Lab Corp.

Some analysts are concerned about the near-term growth prospects for the two largest players in the diagnostic-lab business

By Amy Tsao

Over the past five years, growth at Quest Diagnostics and Laboratory Corp. soared. After the medical labs' whirlwind acquisitions of regional and specialty players, they became their industry's twin leaders. Quest's (DGX ) net income in 2002 was $322 million on revenues of $4.1 billion, up from $1.5 billion in 1998. In 2002, Lab Corp. (LH ) reported net profits of $254 million on revenues of $2.5 billion, up from $1.6 billion in 1998.

Looking ahead, though, the potential for continued growth appears to be eroding, given some analysts' diagnosis that large acquisition candidates are all but gone. Medicare reform may also crimp growth. And then there's the sluggish economy, which has resulted in millions of unemployed and uninsured workers. That, too, may interfere with the ability to increase sales.

Simply put, since patients are visiting their doctors less frequently, fewer diagnostic tests need to be performed. In the past year, both labs have seen retreating volume in the tests they perform, with Quest's organic growth turning negative. And, Burlington (N.C.)-based Lab Corp. is working through postmerger integration issues and market-share losses, experts say.


  True, the stock prices of Quest and Lab Corp. have risen with the broader market's gains. But volatility has increased. That leaves investors to ponder if the economy is the main reason for the growth slowdown, or if something more troubling is at work.

BB&T Asset Management analyst Brandon Carl says both companies are solidly run, but that didn't stop his firm from selling the stocks recently due to concerns about volume-growth deceleration. "Taking a more long-term view, we think they should perform," Carl says. "But...we really want to see volume begin to stabilize."

While Quest and Lab Corp. are adept at squeezing profits from an intrinsically low-margin business, any pullback on volume is a worry. In the quarter ended June 30, organic volume at Teterboro (N.J.)-based Quest fell 2.3%. In the same period, Lab Corp.'s rose 3% to 4%. It could take a couple more years before volume materially strengthens, says Weidong Huang, vice-president of TimesSquare Asset Management. (He also sold the stocks this past spring on volume concerns.)


  Though the shares -- selling at around 15 times forward price-earnings ratios -- are historically cheap, Huang is in no rush to get back in. "These companies had a great run, and not just because of volume trends," he says. But now that "the [acquisitions] binge is over...there are almost no companies left to acquire."

Lab Corp. appears to have stabilized market-share losses in North Carolina, which is one of its most profitable regions. But competition is cropping up for a recently acquired unit, Dianon, which performs highly profitable cancer testing, and where some doctors jumped ship when the division was purchased and went into business for themselves. "That was a shocker to Wall Street," Huang says. A Lab Corp. spokesperson says it's suing the former employees but declined to comment further.

Quest, on the other hand, recently lowered volume-growth guidance for 2003 to between 10% and 11%, from 12% to 13%. Robert Hagemann, chief financial officer, insists the lab is healthy, saying investors should focus on organic revenue growth, which is up about 3% year-over-year. "I don't believe that our volume is significantly impacted by actions of competitors," he says, adding: "We're not losing significant share."


  And despite analysts' concerns that few large takeover targets remain, Hagemann points to "thousands of small commercial labs" that could be snapped up to supplement growth. With Quest accounting for just 12% of the overall lab-testing market, he sees the smaller fry as being able to add incremental revenues and income as Quest processes those tests in its existing facilities. Says Hagemann: "Revenue growth won't be as great as in the past. But there's no shortage of acquisition opportunities."

On the issue of Medicare, reform proposals in the Senate call for a 20% co-pay for lab tests. Yet while sales of prescription drugs are surging at double-digit rates, diagnostic tests are rising more slowly. So lawmakers may feel free to kill that co-pay hike. Analysts also point out that revenues from Medicare coverage are a relatively small source of total revenues at both Quest and Lab Corp.

Some analysts remain quite bullish about both companies' prospects. Neither stock is economically sensitive "in any real, material way," notes Andrew Wellington, portfolio manager of Neuberger Berman's midcap value Regency Fund (NBRVX ). Diagnostic tests are a basic and relatively inexpensive tool in the health-care process and will become more important as baby boomers age, says Wellington, who adds: "People are trying to extrapolate disaster from normal volume activity."


  What does worry him is the risk that these stocks might be sold in favor of cyclical companies more likely to benefit more from an improving economy. "That's more the issue," Wellington says.

Still, he's upbeat about the outlook for the companies' shares, especially based on valuation measures. At around 15 times next year's earnings, says Wellington, they're cheap compared to the benchmark Standard & Poor's 500-stock index p-e of 17. "You're getting a 25% discount to the market," notes Wellington, who figures Quest and Lab Corp. deserve to trade 40% higher. As of the closing bell on Aug. 8, Lab Corp was trading at around $31, while Quest commanded $58.

They may be cheap, as Wellington asserts, but concerns remain about where growth is going to come from over the next year or so. A combination of low to no volume growth in a recovering economy and fewer big acquisition targets pose some tough challenges for Quest and Lab Corp. -- challenges investors might want to heed as they make their prognoses.

Tsao covers financial markets for BusinessWeek Online in New York

Edited by Beth Belton

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