Quest Diagnostics (NYSE:DGX), the medical testing leader, performed consistently over the last three years, with respective revenue and earnings growth of 12% and 27%. The company's supremacy within the clinical testing market (those needle-intensive labs where technicians draw your blood for testing) was aided by patients' requests for more numerous and expensive tests in Quest's clinics. Profitability improved faster than sales as Quest used technology and increasing scale to reduce costs.
Despite these positive trends, revenues slowed to a tepid 5% in the first quarter of 2005. Quest is hoping to counter this slowdown by focusing more resources on its genome testing segment, which enjoyed 15% growth over the same period. The biotech and drug industries are making great progress in studying human genes to diagnose and treat disease. This development offers an outstanding opportunity for Quest to develop its overall leadership position -- provided it's willing to spend enough to acquire competitors and upgrade technology.
Opportunities in gene-based testing
For gene-based treatments to be successful, companies like Human Genome Sciences (NASDAQ:HGSI) must link genes to disease. Thanks to tightened FDA regulations, this process now requires a huge number of costly tests.
Hospital laboratories dominate the clinical testing business, conducting 60% of all tests. That leaves 40% of the $41 billion annual market to commercial labs like Quest and LabCorp (NYSE:LH). While the hospital labs' dominance restricts the size of the market, it also offers players like Quest surprising opportunities.
Gene-based testing poses numerous difficulties for hospitals:
- It's costly to install and upgrade the necessary specialized equipment.
- The tests are difficult to administer.
- Most gene-based tests are patent-protected and require licensing or royalty fees.
- Genome testing is required in less than 7% of cases. It makes more sense to outsource these tests by referring patients to labs like Quest's.
Quest benefits from all these shortcomings, taking in as much gene testing as it can handle and charging well above routine test rates. Last year, Quest generated $600 million, 12% of its total revenues, from gene testing. Quest tops all competitors in this area, commanding roughly 24% of a $2.5 billion market.
Healthy distribution arteries
The gene-testing industry includes many profitable players: test creators such as BiositeInc (NASDAQ:BSTE) and Gen-Probe (NASDAQ:GPRO), test equipment makers like Beckman Coulter (NYSE:BEC), and testing labs like Quest. While the test creators, remedy providers, and big biotechs suffer through rollercoaster earnings and increased FDA scrutiny, less glamorous distributors like Quest will see far more consistency in their testing earnings. Since Quest and LabCorp have the widest reach, most new tests will have to be distributed through them. Just like the California gold rush, it's better to be a supplier of pickaxes and shovels than a prospector.
Quest's two major strengths are its reach, with 1,900 patient collection centers all over the U.S., and its technological focus. Using its website to collect and deliver orders helps Quest keep costs low. As of March 2005, 43% of its orders and 64% of its test results were transmitted via the Internet -- a huge increase from last year's respective 30% and 40%.
Bleeding capital
Being a far-reaching market leader creates its own set of problems, though. Quest is expected to provide the widest array of tests, which demand a lot of capital without necessarily providing the best returns for it. Management has also worked toward beefing up its services in several subsegments where Quest lacks significant market share, another costly attempt to remain competitive.
For all the cash Quest's operations generate, the company also spends a great deal on capital expenditures. Between 2002 and 2004, Quest generated an average of $579 million per year in operating cash and spent well over $200 million per year on average in acquisitions and equipment. Quest must spend 35% to 40% of operating cash flow every year to remain competitive. For 2005, management has budgeted $200 million to $250 million in capex.
Too rich for my blood
For the first quarter of 2005, Quest improved earnings by only 15%. The revenue-growth slowdown affected income as well. Analysts estimate Quest will earn around $5.52 per share for 2005, less than a 10% increase over 2004. However, I expect that increased efficiency will help the company beat those estimates handily.
That said, at 21 times trailing earnings, the stock is priced higher than I'd like to pay. Its inability to increase prices more than 2-3%, dependence on a single high-growth segment that contributes only 12% of revenues, and high capex requirements make this stock appear somewhat expensive. At 15-16 times earnings, it would be a great bargain.
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Fool contributor BobbyShethia doesn't own any shares of the companies mentioned in this article. He is scared to death of needles and wouldn't venture within five miles of a lab.The Motley Fool is investors writing for investors.
