Labs Benefit From Cost Controls On Healthcare

By Kristina Zucchi, CFA | October 06, 2010 AAA

Healthcare is continuing along the trend of higher consumer participation, as more and more dollars are spent by both the employer and the member. Over the past several years, as healthcare consumed an increasing amount of the GDP in the U.S., the delivery of healthcare as been focused on wellcare.

This wellcare paradigm includes preventative care, which keeps members healthy by receiving treatment before they experience symptoms of disease. Included in these wellcare visits are an increasing number of diagnostic tests used to detect diseases at their earliest existence. Thus, the diagnostic testing or lab companies should be the beneficiaries of this continuing trend. However, these companies are not immune to recessionary pressures, as healthcare does have price elasticity of demand. Additionally, they face competitive pressures as many of the non-specialized tests are commodities and unable to get premium pricing, so market share and volume are key to revenue gains. Specialty tests have the highest margins, and are the areas in which these companies tend to focus R&D and M&A dollars.

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The Big Two
There are two large lab companies that tend to be associated with most insurance plans: Laboratory Corporation of America (NYSE:LH) and Quest Diagnostics (NYSE:DGX). These companies offer all the standard tests as well as many specialized tests. The focus on increasing margins and differentiation from the other has led these companies to concentrate on specialty or esoteric tests. An example of this was when Quest helped with the testing and development of the HPV vaccine. A more recent example was when LabCorp announced the purchase of the genetic testing unit from Genzyme (Nasdaq:GENZ). Genzyme's genetic testing division is a leader in providing reproductive and oncology testing in the United States, specializing in esoteric testing. It also has a nationwide network of genetic counselors.

While many tests are commodities, the ability to garner shares in the standard tests while developing or being the sole provider of specialty tests should result in stronger margins and growth profile, as seen with LabCorp's trailing 12-month operating margins of 20.4% vs. Quest's trailing 12-month operating margins of 18.3%, and the projected next 12-month growth of almost 11% and 9% respectively. (For more, see Analyzing Operating Margins.)

Specialty Labs
Genoptix, Inc. (Nasdaq:GXDX) provides specialized laboratory service in the United States, focusing on hematology and oncology. This business garners higher margins at times when new innovative tests are developed, but also shows greater volatility in earnings and growth. GXDX has a trailing 12-month operating margin of 25%, but is expected to show negative growth next year. Although the specialty lab business generally receives higher margins, like the standard testing, it can be affected by the economy and competition. In a recent investor presentation, GXDX lowered quarterly expectations because the weak economy is impacting physician and patient behavior. In addition, the company said it is facing an increase in competition. These two forces can significantly impact the growth of the company, especially if new tests are not expected to stave off competition. (For more, see Lab Corp And Genzyme Find Some Common Ground.)

The Bottom Line
It has been shown that laboratory tests reduce the overall spend on healthcare through early detection of diseases. As long as wellness care is a focus of consumers, the usage of lab tests should continue to increase, providing these companies with a strong long-term growth trend. (For related reading, see Potential Takeout Targets.)

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