Laboratory Service Providers Should Profit From This New Revenue Source

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Medical testing leaders such as Laboratory Corporation of America (NYSE: LH  ) and Quest Diagnostics (NYSE: DGX  ) have disappointed investors with little to no sales and profit growth over the past couple years. Sluggish demand and collapsing prices have smothered results. But better times may be coming. These lab giants might soon take advantage of a new revenue source, an opportunity that could boost both profits and shareholder returns. Here's how.

Growth is stifled
LabCorp is one of the largest and best-run medical diagnostic companies in the country, but it has found growth hard to come by. Revenue increased a scant 2.4% in 2013 from the prior year. Worse, adjusted operating income fell a disappointing 4.8% as weak sales gains could not offset higher costs. Expectations for this year are just as dismal. Revenue is anticipated to rise only 2%, with adjusted earnings per share excluding amortization dropping slightly.

Quest Diagnostics, the world's leading provider of diagnostic information services, has encountered even tougher times, with 2013 sales falling 3.3% year-over-year. While current-year expectations are better, they are still not very inspiring. Sales are envisioned flat to down 2%, with earnings per share also down.

Pricing pressures have constrained growth for these lab giants. In LabCorp's case, a 1.6% drop in the average selling price per procedure overwhelmed a respectable 4% increase in testing demand. Government payment cutbacks, mainly Medicare and Medicaid, were the culprit -- they reduced revenue per test by about 2%.

Quest saw even greater pricing pressures. Year-over-year revenue per test fell 3.6% due to Medicare and commercial insurer fee reductions. Further cuts appear likely.

There is a bright spot, however. Quest believes that payers will embrace a new generation of tests (once they're developed) that demonstrate improved diagnostic capabilities. The new procedures should be more generously priced given their greater effectiveness in assessing and managing patient health.

Genetic testing is a growth market
Myriad Genetics
(NASDAQ: MYGN  ) , a leader in gene profile testing, could offer confirmation of Quest's optimism. Thanks to its delivery of cutting-edge diagnostics, Myriad's results have boomed. Recent quarterly revenue climbed an impressive 37% year over year, with earnings per share jumping an astounding 57%. The gains were helped by the company's lead product, the BRACAnalysis test.

BRACAnalysis looks for mutations in the BRCA1 or BRCA2 gene, which are associated with an increased risk of inherited breast or ovarian cancer. Growing acceptance by doctors and patients boosted BRACAnalysis sales 28% year over year in the latest quarter.

Myriad is still vulnerable to industry pricing pressures, however. Medicare and Medicaid payments for BRACAnalysis will likely drop this year, with commercial insurer cuts to follow. That is a critical point since about 85% of the company's molecular diagnostics revenue comes from a third-party payer. A greater threat to procedure pricing could be mounting competition, as loss of Myriad's monopoly on BRCA testing could be quite damaging. Rivals offering a similar service at a lower cost is probable. 

Old labs getting into new diagnostics
It didn't take long for "old school" labs such as LabCorp and Quest Diagnostics to push into Myriad's market. Quest launched its own BRCA test, called BRCAvantage, in late 2013, hoping to secure significant volumes with an entrenched lab footprint. The company notes that its 2,100 patient service centers located across the U.S. offer a geographic convenience unmatched by any other BRCA test provider. Not to be left behind, LabCorp began offering its own suite of BRCA tests, called BRCAssure, around the same time.

These medical lab giants are also developing their own novel genetic tests. Quest recently unveiled a molecular diagnostic procedure that helps identify the risk of Lynch syndrome, an inherited genetic disorder that significantly increases the risk of colorectal and other cancers. One of LabCorp's latest offerings is the chromosome SNP microarray, a procedure that helps detect genetic changes that may be present in newborns or children with developmental delay, autism, or congenital anomalies.

Quest and LabCorp see the potential in genetic testing as acceptance by the medical community grows. The Society of Gynecologic Oncology last month issued new clinical practice statements that support hereditary testing for patients with ovarian and endometrial cancer. They echo recently revised National Comprehensive Cancer Network guidelines that also endorsed broader access to genetic testing.

Better times could provide higher valuations
Traditional medical testing companies should benefit greatly from an increased market presence in the burgeoning molecular diagnostics field. Additional and more lucrative volumes could provide the top- and bottom-line gains investors have been looking for. If a reduction in traditional lab procedure pricing pressure could be added, gains in LabCorp or Quest Diagnostics profitability could be substantial. 

A recent share-price spike, however, has lessened my belief in these giants' near-term investing appeal. LabCorp's 15.4 times and Quest's 15.1 times expected earnings valuations also appear a bit too enthusiastic compared to recent norms.

For noticeable long-term gains, purchasing on a stock price pullback may be preferable. But if companies such as LabCorp or Quest can produce significant revenue and profit growth, a valuation closer to Myriad Genetics' pricing of about 17 times anticipated earnings certainly seems possible.

Weak growth may continue to haunt Quest Diagnostics or LabCorp over the short term, but gains in the thriving genetic testing market could provide a better and more profitable future. Investors may want to consider being part of the potentially better times on any meaningful share price retreat.

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Bob Chandler

A dedicated Graham-style value man, Bob bought his first stock in 1986 and though he’s a miserable market timer, longer-term calls let him earn a meager living from his investments. With an MBA and MS in Accounting, Bob relies more on Hetty Green's advice for successful investing: "Buy cheap and sell dear. Act with thrift and shrewdness and be persistent."

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