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medical-device industry. The clinical labs were eventually spared, but the message sent was clear: There will be no free lunch. Managers from several of the diagnostic firms we cover, including Beckman Coulter BEC and Hologic HOLX, have acknowledged to us that there is growing pressure to increase reimbursement levels for their products as part of cost-control efforts. We expect to see this pressure increase over the next few years, because health-care costs post-reform are likely to continue to rise. Reform created some strong tailwinds for diagnostic companies, but they will face difficulties if the sector becomes the poster boy for health-care inflation. Therefore, for investors who like the potential of diagnostics, we think it will be smart to stick with companies that have the power to control costs. Two fit the bill: Quest Diagnostics DGX and LabCorp LH.
The Nature of Diagnostic Lab Moats

Our Top Picks in Diagnostics
Morningstar Rating for Stocks Fair Value Estimate Economic Moat Fair Value Uncertainty Price/Fair Value

LabCorp LH Quest Diagnostics DGX

QQQ QQQQ

$87.00 $65.00

Narrow Narrow

Medium Medium

0.85 0.77

Fair Value Uncertainty rates how much confidence our analysts have in their Fair Value Estimate for a company. The greater level of uncertainty, the greater the discount to fair value required before a stock can earn 5 stars. Price/Fair Value divides the stock price by our Fair Value Estimate. Companies with a ratio less than 1 are undervalued. Data as of July 9, 2010

The market is composed of three segments: hospital-based labs, independent commercial labs, and physician office-based labs. We estimate that hospital labs account for 55% of the market, independent labs 34%, and doctors’ offices about 11%. The market has grown at a compound rate of 4% annually during the past decade. Although competitors Quest and LabCorp dominate the independent lab segment, there are an estimated 5,200 commercial labs across the country. As of 2009, Quest and LabCorp accounted for about 22% of the total diagnostic lab market, and, considering the firms’ historical acquisition pattern, we expect these two rivals to continue strategically purchasing other labs to reinforce their leadership positions. We have awarded Quest and LabCorp narrow moat ratings, thanks in part to their unmatched scale in the diagnostic-service business amid a largely fragmented commercial-lab landscape. Both firms enjoy the benefits of a national footprint, allowing them to reap rewards.

For one, there are cost efficiencies. The two large players have invested heavily in automating their lab processes, especially for the routine tests, and they can run a large number of samples through their labs. By lowering the cost structure and increasing the amount of samples they process, Quest and LabCorp can spread the cost of their fixed asset base over a greater revenue base. Second, their nationwide capabilities give them an advantage in securing contracts with large managed-care organizations. These groups would rather negotiate with a few (or even just one) diagnostic labs that offer coverage in several markets than deal with a larger number of smaller, regional labs across the markets they serve. The multiyear contracts that are typical for Quest and LabCorp are another element of their moats. In an extreme example, managed-care giant UnitedHealth UNH signed a 10-year exclusive contract with LabCorp that began in 2007. While decade-long contracts are not the norm, it is not surprising for managed-care companies to lock in to three- or four-year contracts for diagnostic testing. Another aspect of the scale advantage is that Quest and LabCorp become attractive partners with the pharmaceutical companies that are working to develop diagnostics for certain therapeutic agents. Once a companion diagnostic test is developed, the most efficient way to make it available to the greatest number of patients is to leverage Quest’s and LabCorp’s extensive network

of patient centers and laboratories, along with the access to insured patients through the diagnostic firms’ contracts with the large managed-care organizations.
More Trends Look Positive

In addition to the huge group of newly insured patients who will enter the marketplace, we think that there are three other key dynamics that paint a bright picture for Quest and LabCorp. First, the march toward personalized medicine has gained momentum. Most pharmaceutical and biotech companies have embraced the idea of selectively matching patients with therapies. Drug companies are motivated to demonstrate superior efficacy in a select patient group—it can translate into a higher probability of regulatory approval and pricing power in the market. As drug firms move down this path, Quest and LabCorp can follow along by providing the testing services. Second, we expect Quest and LabCorp to continue their shift toward more esoteric and gene-based testing and away from lower-margin routine tests. There will always be demand for the routine clinical tests, but ongoing scientific discovery and knowledge in genomics will spur the invention of more-sophisticated, esoteric tests related to endocrinology, oncology, and immunology. Third, managed-care companies looking to cut costs will more frequently mandate

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Morningstar Advisor - August/September 2010

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