Buy This Wide-Moat Company

Ted is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Companies that provide diagnostic lab testing for hospitals and managed care providers have been hit hard by the economic downturn, as many patients are visiting the doctor less often than they used to. However, this trend will likely reverse itself as the United States economy recovers and Obamacare is fully implemented.

In the United States, diagnostic lab testing is dominated by two companies: Quest Diagnostic (NYSE: DGX) and LabCorp (NYSE: LH). Both companies are positioned to benefit from an aging population, the increasing complexity of diagnostic tests, and additional volume due to the customers added by Obamacare. As a result of these promising trends, both Quest and LabCorp look cheap at today's prices. However, Quest looks like the safer bet due to its slightly better position in the industry.

Strong Tailwinds

Perhaps the best reason to believe that Quest's profitability will improve is the additional regulation mandated by Obamacare, which essentially requires all Americans to purchase health insurance. The law is set to take full effect in 2014, at which point diagnostic testing volumes should have significantly increased since the passage of the law.

In addition to a substantial increase in volume brought on by Obamacare, the increasing complexity of diagnostic tests should help boost Quest's margins. Not only are hospitals unable to perform many of these complex tests in-house, but there are also few third-party alternatives to Quest and LabCorp.

Alere (NYSE: ALR) has a diagnostic testing segment, but it does not have the same scale or scope as Quest and LabCorp. Thus, it is unable to provide the same range of tests at competitive prices as its more established counterparts. Both Quest and LabCorp have built extensive networks across the country that create high barriers to entry for newcomers looking to compete nationally. The only alternative for competitors is to try competing regionally. This gives Quest and LabCorp a fair degree of pricing power.

Finally, Quest has established long-term contracts with most of its managed care services, which should provide predictable cash flow over the coming years. Taken together, all of these things point to higher profits for Quest in the future.

Cheap Stock Price

Since 2002, Quest has averaged an 11.27% free cash flow margin with extremely low volatility. This means that the company turns a consistent amount of sales into free cash flow -- a testament to its position as one of two companies that dominate the industry. As a result, we can have high conviction that the company will continue earning at least the same amount of free cash flow per dollar of sales in the future as it has in the past (though the tailwinds mentioned above are likely to increase the margin).

Since we can be pretty sure that the company will turn $1 of sales into at least $0.11 in free cash flow, the important number to project is sales. If the company earns the same amount of sales in each of the next ten years as it has in the last four quarters, the company will generate $853 million in free cash flow per year. At a multiple of 15, the stock is worth over $80 per share.

However, the implementation of Obamacare will likely boost revenue, so either a higher multiple or higher terminal revenue figure is required. At $9 billion in revenues and a 15 multiple on FCF, the company is worth nearly $96 per share. Applying a 20 multiple to the previously-calculated $853 million in free cash flow gives a value of over $107 per share. In any case, Quest looks cheap at its recent price of $58 per share.

titans8904 has no position in any stocks mentioned. The Motley Fool recommends Laboratory Corporation of America and Quest Diagnostics, Inc.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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