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Finding Moats in the Diagnostic Lab Industry

Diagnostic reference labs: Narrow moat firms have strong prospects.

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The $55 billion U.S. diagnostic testing market is broken down into three segments: hospital-based labs, independent commercial labs, and physician office-based labs. We estimate that hospital labs account for about 55% of the market, independent labs another 34%, and doctor offices about 11%. We estimate that the market has grown at a compound clip of 4% during the last decade.

These diagnostic services range from routine testing of bodily fluids (such as blood urine for blood chemistry, pregnancy, and thyroid function), to far more complex testing of specific tissue and genetic signatures for cystic fibrosis, oncology, and Down Syndrome. Though there are two major competitors,  Quest Diagnostics (DGX) and  LabCorp (LH), that dominate the independent lab segment, there are still an estimated 5,200 commercial labs scattered across the country. As of 2009, Quest and LabCorp accounted for roughly 22% of the total diagnostic lab market, and considering the firms' historical acquisition patterns, we expect these two rivals to continue to make strategic purchases of other labs, which will only reinforce their leadership positions.

The Nature of Diagnostic Lab Moats
We have awarded Quest and LabCorp narrow moats, thanks in part to their unmatched scale in the diagnostic service business against the backdrop of the largely fragmented commercial lab landscape. Both firms enjoy the benefits of a national footprint. This allows them to reap rewards in several ways. First, there are cost efficiencies as the large players can run more samples through their labs. Additionally, they have invested more heavily in automating their processes, especially for routine tests. By lowering the cost structure and increasing throughput, Quest and LabCorp can each spread the cost of their fixed asset base across a greater revenue base. Second, nationwide capabilities also give them a leg up in securing contracts with large managed-care organizations that would rather negotiate with a few (or even just one) diagnostic labs that offer coverage in multiple markets instead of many smaller, regional labs across all the geographic 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 became effective in 2007. While decade-long contracts are not the norm, it is not surprising for managed-care companies to lock into three- or four-year contracts for diagnostic testing.

Another aspect of the scale advantage is that it makes Quest and LabCorp attractive partners for the pharmaceutical companies that are working to develop companion diagnostics for certain therapeutic agents. Once a companion diagnostic test is developed, the most efficient way to put in reach of the greatest number of patients would be to leverage Quest and LabCorp's extensive network of patient centers and laboratories, along with the access to insured patients through their contracts with the large managed-care organizations.

We provide our thoughts on the entire diagnostics industry in our recent Healthcare Observer. For the complete analysis of the diagnostics environment, including key industry trends and potential risks, the impact of health-care reform, offshoots in animal diagnostics, and case studies in diagnostic medicine in oncology and infectious disease, click here: http://healthcare.morningstar.com/IssueArchive.aspx

 

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Debbie Wang does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.