Longtime subscribers to Motley Fool Stock Advisor will appreciate the irony of Tuesday's surprise announcement that megasized health-insurer UnitedHealthGroup (NYSE: UNH) has canceled its laboratory-testing contract with Quest Diagnostics (NYSE: DGX) and named Laboratory Corp. (NYSE: LH) as its new service provider.
Ordinarily, it's David Gardner, the gentleman recommending the stocks in the left column of our market-beating portfolio, who advocates a policy of keiretsu -- buying companies that work with each other to form a virtuous circle of profit for all (with "all" including us, the shareholders.) In contrast, it's rare that the right column of the portfolio (the stocks picked by David's brother, Tom) gets any keiretsu action going. But that's exactly what happened here -- because both LabCorp and United Health number among Tom's stock picks.
On Tuesday, in twin announcements, Quest admitted that it had lost, and LabCorp exulted that it had gained, the coveted 10-year exclusive diagnostic testing contract with UnitedHealth. For Quest, it was a bittersweet moment. On the one hand, the contract with UnitedHealth accounted for 7% of Quest's revenues; effective Jan. 1, 2007, Quest will lose an annual revenue stream worth about $385 million. On the other hand, Quest argued that UnitedHealth had set terms for contract renewal so onerous that it would have been "irresponsible" for Quest to agree to them.
Whatever the terms were (CEO Surya Mohapatra only said that they would have let UnitedHealth "unilaterally dictate certain key terms over a period of up to eight years"), they apparently weren't too harsh for LabCorp to accept. Nor did the market appear to consider LabCorp's signing on the dotted line an "irresponsible" act, as investors bid its shares up 2% (and counting).
In contrast, investors dropped Quest's shares 18% on the deal's announcement. That sets up an interesting situation for us at Stock Advisor. We recommended LabCorp because we like the economics of this de facto duopoly business. Both Quest and LabCorp sport profit margins hovering around 10%, and each claims a return on equity close to 20%. An aging population is only going to increase the demand for the sort of medical services LabCorp and Quest provide, meaning that analysts' projected low double-digit growth rates analysts seem sound.
So here we sit, staring at a Quest that just got 18% cheaper due to a 7% loss of revenues. We have to wonder whether it's time to give this keiretsu thing another try on the right-hand column of our portfolio, and add Quest to our stable of market-beating (64%, vs. 24% for the S&P 500) companies.
What do you think: Has Quest become a bargain? Drop by our Motley Fool's SA Stocks That Interest You board and give us an earful. If you're not a member of Stock Advisor, never fear. Take a free 30-day trial, and you'll be able to access the boards to discuss -- and there's no obligation to continue the trial if you don't like it. (That's what "free" means.)
Fool contributor
Rich Smith
does not own shares of any company named above.
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