TOP CONTRIBUTORS

Ryan McCarthy

Sean Hinton

Quest (DGX) is currently the largest independent research and testing laboratory in the world, holding approximately 14% of the $40 billion laboratory services market. The company provides diagnostic testing, information, and services, for the health care industry, primarily in the United States. Despite having a large domestic presence, Quest also operates in Central and South America and Europe. The company offers routine tests, including blood cholesterol level, blood chemistries, and Pap tests, and esoteric testing services, which includes genetic and immunologic testing, among others. It also provides testing services for clinical trials and risk assessment services for the life insurance industry.

In addition to offering testing services, Quest also manufactures and markets diagnostic and testing equipment for sale to hospitals, other laboratories, physicians, and health insurance companies, to name a few. As of December 31, 2006, Quest operated a network of approximately 2,000 patient service centers and principal laboratories, as well as approximately 150 smaller laboratories.

Despite the recent loss of its United HealthCare contract to rival Laboratory Corporation of America Holdings (LH), Quest's performance hasn't suffered much at all. Profit margins are still high, and the company released over 80 new or improved tests in 2006 alone. With a strong series of innovative developments, Quest is in a good position to maintain its strong performance in the future. Possible threats to this include political pressure to lower health care costs, budget cuts to Medicare or Medicaid, and increasing competition in the industry.

History and Corporate Overview

Originally founded as MetPath in 1967, Quest Diagnostics has become the leading provider of medical diagnostic testing, information, and services, in the U.S. A number of strategic acquisitions has allowed Quest to expand into nearly every area of the medical imaging and diagnostic industry, cementing its position at the forefront of the U.S. laboratory services market. As a result of the 1999 acquisition of SmithKline Beecham Clinical Laboratories (SBCL), GlaxoSmithKline (GSK) holds a sizable amount of Quest's stock.

The majority of Quest's business focuses on laboratory testing; other services generated only 8% of 2006 sales. Additionally, the majority of Quest's sales come from within the U.S., with only 3% of 2006 sales coming from international sources.

The clinical laboratory services industry was estimated to be worth between $40-$50 billion in 2006, split between hospital-based labs (54%); independent, clinical labs (41%); and physicians' office labs (5%). Laboratory testing is generally classified as either clinical pathology (testing performed on body fluids) or anatomical pathology (testing on tissue samples); Quest Diagnostics participates in both of these markets.

Routine Testing

Routine testing is a relatively mature segment of the laboratory services market. In 2006, however, 76% of Quest's revenue came from routine testing, up from 65% of revenue last year. This type of laboratory work is done through Quest's network of major laboratories, rapid response laboratories, and patient service centers. Routine tests measure various important bodily health parameters such as the functions of the kidney, heart, liver, thyroid, and other organs. Common tests include:

• blood cholesterol level
• Pap tests
• pregnancy and other prenatal tests
• urinalyses, alcohol and other substance-abuse tests
• asthma and allergy tests

Esoteric Testing

"Esoteric" refers to tests that require more sophisticated technology, equipment, or materials, to perform than routine tests. This type of testing requires a specialist to conduct and are performed less frequently than routine tests. Because it is not generally cost-effective for most hospitals and clinical laboratories to perform low-volume esoteric testing in-house, they refer these tests to a laboratory that specializes in these types of tests, i.e. Quest. Esoteric and gene-based testing is the smaller of Quest's laboratory-based segment, though it is less mature than routine testing. This leaves room for substantial growth, as shown by the fact that esoteric testing accounted for 16% of total revenue in 2006, up from 12% the year before.

These esoteric tests are generally in the following fields:

• genetics
• hematology (the study of blood and bone marrow cells)
• immunogenetics and human leukocyte antigens (HLA) (solid organ and bone marrow transplantation), immunology
• oncology (the study of abnormal cell growth including benign tumors and cancer);
• toxicology

Other Services and Products

In 2006, clinical laboratory testing accounted for 92% of Quest's revenue, with various other products and services generating the other 8%. Quest's secondary areas of operation include anatomic pathology, risk assessment, clinical trial testing, and data management solutions.

• Anatomic pathology: Quest's anatomic pathology business includes cytology (Pap testing) and tissue pathology (the analysis of tissue samples).
• Risk assessment: Risk assessment services comprise underwriting support services to the life insurance industry. Examples of these services include specimen collection and paramedical examinations, laboratory testing, medical record retrieval, motor vehicle reports, telephone inspections, and credit checks. The laboratory tests performed and data gathered by Quest are specifically designed to assist an insurance company in objectively evaluating the risk level of potential clients.
• Clinical trial testing: Clinical testing is the segment of Quest's business with the largest international presence as of 2006, running tests in the United States, the United Kingdom, Australia, China, Singapore, and South Africa. Clinical research trials are required by the FDA and other international regulatory authorities to assess the safety and efficacy of new drugs and vaccines. Approximately half of Quest's net revenues from clinical trials testing in 2006 came from testing done on behalf of GlaxoSmithKline (GSK).
• Care360 and MedPlus: Care 360 is Quest's information technology business developed and maintained by subsidiary MedPlus. The Care360 Physician Portal lets physicians order diagnostic tests and review laboratory results from Quest Diagnostics online. In addition, the Care360 Physician Portal enables physicians to electronically prescribe medications and view clinical and administrative information from multiple sources.

Business Drivers

Acquisitions growth

Quest has augmented its organic growth with several recent acquisitions, adding testing facilities, obtaining rights to proprietary tests, and strengthening its position in certain geographies. Two of Quest's most recent acquisitions, Enterix and HemoCue, have helped to greatly expand its international presence. These acquisitions have also helped to balance Quest's loss of the United HealthCare contract to LabCorp. UnitedHealth Group is a managed health care group, a branch of United Healthcare, one of the largest domestic health insurers.

Some of Quest's most notable recent acquisitions include:

• Focus Diagnostics: In July 2006, Quest acquired Focus Diagnostics for $208 million. Focus Diagnostics is a leading provider of infectious and immunologic disease testing and has introduced new tests to the market, including diagnostic tests for Lyme disease, West Nile virus, and SARS.
• Enterix: In September 2006, Quest acquired Enterix, an Australian-based company, for $44 million. Before the acquisition, Quest had been the only laboratory offering Enterix's immunology tests.
• HemoCue: In January 2007, Quest acquired Sweden-based HemoCue for $420 million. HemoCue is a leading producer of near-patient or point-of-care hemoglobin tests.
• AmeriPath: In May 2007, Quest acquired AmeriPath, a national diagnostic test company specializing in anatomic pathology, for $2 billion.

Early in July, 2007, Quest announced that it does not expect to make any large acquisitions for the next twelve months, but the company has continued to sign multi-year contracts with companies such as Digene (DIGE) (for HPV tests) and Bio-Rad Laboratories (BIO).

Product Development/Organic Growth

The big news around Quest normally involves new tests or other breakthroughs that the company develops. Most recently, Quest announced that it had developed a new test to help doctors diagnose metabolic disorders in July, 2007, and released Focus Diagnostics' HerpesSelect tests in March of the same year.

In 2006, Quest developed and released 80 new or improved tests across the spectrum of their testing procedures. The segments with the most new developments are:

• Ten new tests were developed for blood chemistries relating to oncology.
• Fourteen tests were added to Quest's offerings of infectious disease testing for pre- and post-operation patients.
• Eleven tests complete Quest's typing capability for bone marrow transplantation, tumor vaccination, and immunotherapy.
• Quest added nine tests to the FDA-registered laboratory for Human Cell, Tissues' and Cellular and Tissue-Based Products Donor Testing, where tissue donors can get tested for communicable diseases.

Quest has also received positive attention for successfully cutting costs to balance the loss of the UnitedHealth Group contract.

Baby Boomers opportunities

As America's baby boomers get older, they're likely to require more medical care. Quest stands to benefit from this, as the demand for clinical tests and laboratory services is likely to increase as well. Due to an increased focus on preventive care, tests are often run to identify and begin treating conditions before they become more severe and, subsequently, costly. Since Quest is the leading U.S. provider of such clinical testing services, any increase in demand for these types of procedures would benefit the company significantly.

Political policy risks

Though Quest does have some international presence, the fact remains that it operates primarily in the United States, with domestic sales accounting for 97% of total revenue in 2006. As such, changes in the policies governing the U.S. medical industry can have a significant impact, whereas the company is much less leveraged to conditions abroad. Quest could benefit from increased concern for health and wellness, especially if government programs help increase the availability of health care for U.S. citizens. On the other hand, there have been moves by some politicians to lower the prices throughout the medical industry, which would undoubtedly have a negative impact on Quest's profit margins. Depending on how these, and various other, trends progress, Quest's performance could be altered substantially.

Sensitivity to health care coverage

According to U.S. law, an adjustment to the Medicare national fee schedule for clinical laboratory services based on the consumer price index cannot occur before January 1, 2009. Nonetheless, efforts by Congress to reconcile the national budget could result in further reductions in Medicare and/or Medicaid expenditures for laboratory services before this date. Any reduction in the amount these programs will cover for clinical testing procedures would certainly cut into Quest's sales, as many Americans rely on federal assistance to pay for their medical care.

Public/private research and funding

Government funding for scientific research is another factor that could impact Quest either positively or negatively. On one hand, there has been an increasing demand for the development of genetic tests, which has led to a correlated increase in federal funding for research in the area. On the other, potential budget cuts and political disagreement regarding ethical issues, such as stem cell research, could put a serious damper on Quest's federally funded innovations.

This idea connects also to the FDA's role in Quest's development process. Unlike in some international markets, Quest's products and services have to meet strict standards to obtain regulatory approval. For example, the HerpesSelect testing procedure has been available in interntional markets for a while but was only recently approved for use in the United States. The FDA has regulatory responsibility over instruments, test kits, reagents, and other devices used to perform diagnostic testing, giving it the power to approve or disapprove essentially all of Quest's sources of revenue. Failure on Quest's part to meet or quickly respond to changes in FDA regulations could harm efficiency and even result in more severe ramifications such as litigation.

Competition Metrics

Quest's major competitor is Laboratory Corporation of America Holdings (LH). The two often actively compete for both market share and contracts, as recently happened in the case of United HealthCare. Another player in the laboratory market is Bio-Reference Laboratories (BRLI), though it is much smaller than the either of the other two main competitors.

Though testing for private patients is the smallest revenue source, it provides higher margins than other revenue sources. Limits placed on the amount covered by Medicare and Medicaid, as well as government negotiations for lower prices, makes this segment relatively less profitable, though it makes up a larger percentage of total sales.

Since Bio-Reference, being the smallest of the three companies, has the lowest cost of services, it's also been growing the fastest. LabCorp and Quest, on the other, have shown very similar costs of services over the past year, further spurring competition between the two.

References