Description

Quest provides diagnostic testing and information services, operating a national network of full-service labs, rapid response labs, and patient service centers.  DGX offers esoteric, routine medical, drugs of abuse, and non-hospital-based testing services.  The U.S. lab market is about $82B with about a third of the market from hospitals and the rest from physician lab services. Independent labs make up about half the Physician Lab Services segment and DGX has about 24% of the Independent lab market. Note that DGX also manages some hospital lab outreach programs (whereby hosptials service surrounding physicians with lab servicces performed at the hospital).

PAMA: The lab market is going through significant disruption due to the passage of the Protecting Access to Medicare Act (PAMA) which will lower lab prices pertaining to Medicare by ~10% per year for three years from 2018-2020. The driver of PAMA was CMS's desire to bring Medicare lab diagnostic costs in line with commercial payors. CMS collected data from labs to determine the spread between Medicare costs and commercial payors and found lab costs were anywhere from 10%-50% higher for Medicare. Interestingly, a majority of the data collected by CMS was from DGX and LH who are the low cost providers and charge commercial rates significantly LOWER than hospital labs. This means that the spread between commercial and Medicare fees are widest with DGX and LH who accounted for the bulk of the data. More on this later.

For DGX, Medicare is about 12% of their business and so PAMA will negatively impact DGX topline by roughly 120 bps per year with a more severe impact on EBIT given it's all pricing at high incrementals. So that's the bad news....and the bad news is now well known. The good news for DGX is that it is the low cost provider given its scale and has less Medicare exposure than the rest of the industry. Most other independent labs have 30% or so exposure to Medicare and operate with higher cost structures. THIS MEANS THAT MANY INDEPENDENT LABS CANNOT SURVIVE THROUGH THE PAMA FEE CUT IMPLEMENTATION AND WILL LIKELY GO OUT OF BUSINESS OR GET SOLD AT POTENTIALLY DISTRESSED PRICES. I have spoken with several regional lab operators who have told me they expect operating margins to go zero or even negative by next year due to PAMA. This is clearly unsustainable and I expect meaningful market share shifts from the hospitals and  to DGXindependents and LH. These big guys can weather the storm and gain share out the other side of this mess. The third largest U.S. lab company is public (ticker OPK) and is operating at negative EBIT margins today. What does that say for the rest of the players in this highly fragmented industry? Bankruptcies are startign and will likely continue...





DGX estimates that perhaps 80% of industry profits (ex-LH and DGX) can get wiped out as a result of PAMA.

Greater Access to Large Insurers: UNH used to be exclusive with LH but in the beginning of 2019, UNH ended its exclusivity with LH whereby creating an opportunity for DGX to gain share. Additionally, Horizon BCBS of NJ and Anthem of Georgia opened up to DGX.  This represents 43M lives that DGX now has access to who were previously out of network. This equates to a $4B opportunity and even if DGX gets 20% of that over time that would be 10% accretive to the  over some numebrtop-line of years.Furthermore, UNH recently established a preferred lab network of 7 lab companies if which DGX is one (actually 2 including a subsidiary that is on the list). So greater TAM for DGX and less so for independents who are already struggling. Not surprisingly, last quarter DGX saw some of the best volume growth they've seen in a long time and I think the best is yet to come.

So when you think about PAMA, preferred lab networks and DGX scale it isn't surprising that the independents are terrified.

We are also seeing Anthem institute 'rate alignment' changes aimed at hospitals that charge 2x or more than that of DGX. Anthem BCBS Plans are dramatically slashing hospital reimbursement rates which will further pressure hospital lab margins which are already getting decimated by PAMA. This should open up more opportunities for DGX in the form of hospital lab management services or outright hospital lab acquisitions.

A risk to consider is the fact that PAMA will again get re-calculated for 2021 and beyond...theoretically pricing could deteriorate if the Medicare vs commercial payor gap exists. I believe, however, that more hospital labs will submit data as they are highly motivated to...after all they charge higher commercial rates than DGX and LH so they want to show the true industry spread is narrower than previously thought using the DGX and LH data. Could the price reduction even....gasp...reverse?! It's possible.

DGX trades for 14x our '20 EPS estimate, a slight premium to the insurance/hospital sectors, and well below devices/tools at ~20x.  Sluggish near term EPS growth explains valuation, but when the PAMA headwind dissipates and/or the lab market structure changes, DGX should accelerate EPS and will be  deserving of a multiple in the mid/high teens, back in line with its historical range and closer to health care sectors with better fundamentals.  17x (median multiple) the '20 estimate of $7.32 = $124 or ~25% upside.  Looking past the PAMA headwind to accelerating revenues/profits, a Bull case scenario is 19x (prior peak) on an ~$8 EPS estimate for a possible target of ~$150-160 (50% upside).  The U.S. diagnostic lab business is non-cyclical/stable from a volume standpoint, and with the pricing risk mostly behind them, downside risk to estimates is low.  If '19 comes in below expectations, downside is likely ~15% (13.5x X $6.30 = $85) using the low multiple of the last few years on flat EPS growth. 

Catalyst

PAMA is being challenged on multiple fronts and there is the potential for the price reductions to get mitigated or reversed which would lead to a massive re-rating of these stocks. Low proobability event but possible.