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Stock Strategist

Taking the Investment Pulse of Diagnostic Laboratories

This low-key health care niche could offer therapy for some portfolios.

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Although processing blood tests isn't as splashy as the latest biotech therapeutic therapies, diagnostic reference labs remain one of our favorite health care businesses. The domestic clinical lab business racks up approximately $55 billion in revenue a year, and is split between hospital-based labs (more than half the market), physician office labs (at minority at 7% share), and independent laboratories (accounting for an estimated one-third of the total market). The independent lab segment has historically been a fragmented market, with only a handful of clinical labs that were able to build out national geographic coverage.

Thanks to consolidation in the independent lab space over the last 15 years, a duopoly consisting of  Quest Diagnostics (DGX) and  LabCorp (LH) has emerged to dominate the independent lab space. The two behemoths account for combined market share close to 22% of the entire diagnostic testing market. The expansive networks these competitors enjoy make them attractive vendors to managed care plans that like to offer convenient lab services to its insureds. The scale of Quest and LabCorp's businesses also translate into lower costs, as they can push more tests through their regional laboratories. It would be difficult for a third competitor to replicate the number of locations, convenience, and cost advantages that Quest and LabCorp offer.

Several Tailwinds Add up to Bright Prospects
There are several trends that make the industry particularly attractive, even as cost-cutting pressure bears down across the entire health care sector.

First, there is greater reliance on diagnostic tests by health care professionals in order to formulate treatment plans. The tests themselves are also growing more complex, especially as scientific progress has allowed for greater accuracy and precision in testing. As we learn more about genetic biomarkers, this has also racheted up the complexity of tests. Rather than just simple, lower-margin blood and urine tests, more higher-margin tests are being run on actual tissue samples and human cells.

Second, there is growing recognition of the significant role diagnostics can play in controlling health care costs, and we've already begun to see managed care companies using diagnostic tests to determine whether individual patients should be reimbursed for certain therapies. For example,  UnitedHealth (UNH) is requiring patients to take a diagnostic test to find out if they have the KRAS mutation that predicts a very poor response to Vectibix or Erbitux for colorectal cancer, before the firm will provide coverage for the therapy. A gastrointestinal oncology study presented in 2009 estimated $600 million in annual savings, if use of Erbitux were guided by diagnostic testing for the KRAS mutation. These numbers are nothing to sneeze at, and managed care firms have been very interested in using diagnostic tests to do a better job of matching the right therapies with the patients most likely to benefit.

The concept of better matching of therapies with patients gets us to a third trend that would help the diagnostic labs. As the march of scientific discovery continues, we are getting closer to realizing the promise of personalized medicine. In various clinical trials, pharmaceutical and biotech companies have begun to look at and use certain genetic markers to identify patient subgroups that may see greater efficacy from key drug therapies.  Elan (ELN) and Wyeth have partnered to develop bapineuzumab for Alzheimer's. Even though trial results among the total sample of patients was disappointing, the data suggest that significant improvement resulted among the patients who lacked the APO4 gene. If bapineuzumab is eventually approved for marketing, we strongly suspect managed care companies will require diagnostic testing for the APO4 gene in order to qualify for coverage, as a matter of standard operating procedure.

Unfortunately, most current Medicare practices do not require this type of diagnostic testing to match patients with therapies. However, with the creation of the Center for Medicare and Medicaid Innovation (CMMI) coming off the new health care reform law, we think this entity will likely tackle this issue of companion diagnostics under its larger mission of improving health outcomes at lower costs. By 2015, we expect CMMI to issue guidelines for the incorporation of companion diagnostics (though this may be wrapped into larger programs, such as reimbursement for accountable care organizations), just in time for bapineuzumab's expected approval.

More Bumpiness in the Near Term
While the trends we've laid out paint a favorable picture of the longer term outlook for the diagnostics market, we remain somewhat cautious about 2011 due to the general declines we've seen in office visits across many specialties. As tough economic conditions have hurt the normally recession-resistant health care sector over the last 18 months, we think patients have been delaying non-acute or non-symptomatic care. This has resulted in recent soft performance for Quest and LabCorp. The anemic volumes could linger, especially if unemployment remains at high levels. We do see one ray of light. In 2014, an additional 32 million patients will begin joining the ranks of the insured thanks to health care reform. Despite any turbulence the diagnostics firms could see in the next year, we remain enthusiastic about Quest and LabCorp over the long run.

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