Blood Money: LabCorp and Quest Turn Medical Testing Into Cash

Roll-ups -- companies that consolidate fragmented service industries by acquiring hundreds of little operators -- have traditionally done wonderfully in early years and then come crashing down, the result of overpaying for acquisitions and often a failure to actually integrate all the little companies into one efficient operation. Trash haulers and funeral homes are exhibit Nos. 1 and 2 in this sorry history.

But the medical testing business has produced two powerhouse roll-ups, and they appear to have lots of growth potential remaining. Out of a $55 billion market, Laboratory Corp. of America (LH) and Quest Diagnostics (DGX) combined control about 21% of the industry. Hospitals hold a roughly 55% share, but many can’t match the low costs of the big commercial lab players. And there are some 5,000 little independent labs remaining that collectively control about 20%, each one a potential acquisition. Doctors’ offices doing their own labs account for the remaining 4%, also typically at higher cost that LabCorp and Quest.

Physicians order up an increasing number of blood and other lab tests. As recently as 1997, patients aged 65-to-74 averaged about six a year; now that age bracket gets close to a dozen annually. And test frequency has risen for all age groups.

LabCorp is No. 2 in the industry – with a 9% share vs. Quest’s 12% -- but in recent years it has been working harder and its shows. LabCorp recently pulled even with Quest in market capitalization.

LH Stock Chart by YCharts

This, despite Quest’s far larger revenue.

LH Stock Chart by YCharts

And a continuing, if less commanding, lead in profit.

LH Stock Chart by YCharts

Does LabCorp deserve its higher multiple? Or should investors bet on the laggard Quest, hoping it catches up?

LH Stock Chart by YCharts

Pricing is crucial in the industry because the labs have huge fixed costs. Quest, for instance, fields small army to perform lab tests and transport specimens: 3,200 courier vehicles and 25 aircraft; 8,900 phlebotomists; 900 MDs and Ph.D.s; more than 2,000 offices where Quest collects specimens from patients.

Last year, Quest suffered a 0.2% decline in revenue per requisition (a test or series of tests), on a 1.0% decrease in volume. LabCorp managed a 6.4% increase in price on a 0.1% increase in volume. Quest says the recession led to a 5% overall decline in visits to the doctor last year, but clearly LabCorp dealt with the tough environment more favorably.

YCharts Pro is neutral on both stocks, finding LabCorp slightly overvalued and Quest somewhat undervalued. Those valuation judgments, though, are based on historical comparisons for the companies, and don’t reflect what seems to be more effective management at LabCorp.

Quest pays a scrawny dividend, and LabCorp none at all.

DGX Stock Chart by YCharts

But both companies produce tons of cash and use it to fund sizable stock buybacks.

LH Stock Chart by YCharts

Health care reform should help both companies with more insured consumers, but for now LabCorp appears better able to take advantage.

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