The Price is Right at Quest Diagnostics
Steve is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Quest Diagnostics Inc. (NYSE: DGX) and Laboratory Corporation of America (NYSE: LH) are two giants in the diagnostic testing business which is experiencing shifting domestic population demographics, changing laws and regulations, and changing customer preferences. Another player in the industry is the much smaller Bio-Reference Laboratories Inc. (NASDAQ: BRLI) which operates primarily in metro New York. Quest's position as the market leader should result in above market returns for the company's shares as it navigates the changing industry landscape.
The diagnostic testing business is an approximately $45 billion market in the United States that is dominated by Quest and LabCorp. With a market capitalization of about $10 billion and annual revenue of about $7.5 billion, Quest is slightly larger than LabCorp which has a market capitalization of about $8.7 billion and annual revenue of about $5.6 billion. Bio-Reference has a market cap of about $800 million and annual revenue of more than $600 million.
Between them, Quest and LabCorp operate most of the independent commercial labs that comprise about 33% of the diagnostic testing market. In-house hospital labs comprise about 60% of the market with small regional independents like Bio-Reference making up the remaining 7%. Vast networks of laboratories and patient testing centers have helped to establish barriers to entry for Quest and LabCorp. Market share gains have led to strong cash flow growth as this competitive advantage is exploited by them in the slow-growth domestic diagnostic testing business.
Quest is employing a strategy that should grow the business at a rate higher than the industry, thereby cementing its place atop the commercial diagnostics field. One component of this strategy involves overseas acquisitions to consolidate the highly fragmented international testing market, particularly in India. Another strategic area involves shifting product mix toward gene-based and "esoteric tests" that are higher margin due to the complexity and technical skills needed to administer the tests. Acquisitions led to growth in the esoteric testing segment of about 17% in 2011 while the combined revenue of gene-based and esoteric testing increased as a percentage of Quest's total sales from about 22% in 2010 to about 25% in 2011. As Quest increases its market share of esoteric and gene-based testing to a level closer to LabCorp, the leader in this niche market, the contribution to total sales will increase to more than 25%, thereby offsetting expected pricing pressure on routine testing.
The entire industry will also benefit in the years to come by a return to the normal rate of doctor visits by patients which declined as the economy weakened; a surge of newly insured customers in 2014 due to federal health care reform mandates; and an aging domestic populace that is expected to demand more esoteric testing that hospitals will need to outsource to independent laboratories like Quest and LabCorp. Quest is positioned to capitalize on these trends more than its competitors due to its low cost structure, scale, and focus on esoteric testing.
Quest was at a recent price around $62 per share so investors are paying a price to forward earnings multiple of about 12x based on analysts' estimates of 9.4% growth in earnings per share to $4.99 in 2013 from $4.56 per share in 2012. This indicates a reasonable price to earnings to growth (PEG) multiple of about 1.3x which compares favorably to the 1.6x PEG begin paid for LabCorp. but exceeds the 0.9x for Bio-Reference. Unlike the lofty 17% growth expected for Bio-Reference, the estimate of Quest's earnings growth of 9.4% over 2012 is reasonably achievable. Quest's future earnings growth rate is likely due to the anticipated improvement in the overall economy and doctor visit rates, growth in the number of patients in the U.S. market due to aging demographics and more demand for high margin esoteric tests, and consolidation by Quest of international markets, beginning with India.
As a long term investor I am willing to pay a reasonable amount for growth two and even three years out and Quest presents such an opportunity at $62 per share. Quest is also an appealing stock because it bumped up its quarterly dividend payout by a whopping 70% to $0.17 per share from $0.10 per share quarterly paid in 2010 and the first three quarters of 2011. Quest also announced in January 2012 an added $1 billion to its share buyback program which is more than 10% of current market capitalization. This new authorization brought the total to $1.1 billion at that time and as of June 30, 2012, the Company had $965 million remaining to repurchase. The dividend yield is currently about 1.1% which by itself is not a particularly compelling investment rationale but does provide a return to investors greater than can be found on savings accounts or treasuries, with the added kicker of potential capital gains from share price appreciation.
One new risk to this positive investment thesis is the possibility of a poor transition to new President and CEO Stephen Rusckowski, the former CEO of Philips Healthcare which is a unit of Royal Philips Electronics. Mr. Rusckowski joined Quest in May after the company announced the planned succession in October of 2011. Although Mr. Rusckowski’s tenure has the potential to be harmful to the company’s intrinsic value, I think that he will succeed at Quest given his experience in the same role in a similar business at Philips since 2006 and Quest’s deliberate succession planning.
Much is happening in the independent diagnostic testing business including shifting domestic population demographics, changing laws and regulations, and changing customer preferences. Because of its position as the biggest operator with the lowest cost structure in the industry, Quest is on track to increase its intrinsic value over the long term and is a good buy at current price levels.
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