Shares of Quest Diagnostics (NYSE:DGX) have held up well during recent market turbulence. With shares currently trading near their 52-week high, can we expect more of the same going forward for the lab-testing firm?
The second-quarter earnings Quest reported today were mostly in line with expectations, but somewhat difficult to discern, because of a charge for a discontinued operation, an investment write-down, and a recent large acquisition. Reported quarterly diluted earnings came in a bit below last year's results, but sales jumped 15%, of which 10% was attributed to the purchase of a formerly publicly traded lab firm, LabOne. Finally, management offered full-year, continuing operations guidance range of $2.95-$3.05 per share in diluted earnings, and revenue growth of 15%.
Quest and LabCorp (NYSE:LH), the largest diagnostic lab-testing firms, have both exhibited strong growth with the consistent ability to leverage roughly 10% top-line growth into 20%-30% average annual earnings growth over the past five years. Expansion has come from offering new testing services and consolidating what has been considered a fragmented industry. As such, the two firms are considered an effective duopoly, owning about half of the market
Quest and LabCorp are similar to other duopolies, such as Home Depot (NYSE:HD) and Lowe's (NYSE:LOW), in that they lead their respective industry. Like CVS (NYSE:CVS), which shares drugstore-chain dominance with Walgreen (NYSE:WAG), both the diagnostic testers rely on acquisitions to supplement their own internal growth. However, Quest's purchase of LabOne leaves few larger diagnostic test firms remaining, and investors have been concerned for some time that the law of large numbers may soon catch up to Quest and LabCorp in terms of snapping up competitors.
Overall, both Quest and LabCorp are worth tracking. They have similar P/E ratios, but Quest is the larger company, has grown earnings a bit faster over the past five years, and pays a modest dividend (yield of 0.7%). However, sales at LabCorp have been stronger, and it has higher margins. But both have strong operating cash flow generation capabilities, and both spend a portion of cash flow on making acquisitions and buying back stock. The best strategy may be to purchase some of each -- if and when the shares can be had at more compelling valuations.
Since Quest trades at a forward P/E of about 20, there may be current better bargains out there. The two lab-testing firms have continued expansion opportunities because of favorable demographics -- the United States' aging population will likely require higher levels of health care. But there are fewer rivals left to acquire these days. As such, I'm a bit concerned that Quest's valuations have become stretched. Relying solely on organic growth opportunities to bolster market share will lower the company's overall earnings leverage. In addition, the market's recent overall large-cap share weakness may provide investors opportunities to pick up other solid companies for even better valuations.
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Fool contributor Ryan Fuhrmann owns shares of Home Depot and Walgreen but has no financial interest in any other company mentioned. The Fool has an ironclad disclosure policy. Feel free to email Ryan with feedback or to discuss any companies mentioned further.
