The Business

World’s leading provider of diagnostic testing

Revenue

o   54% routine lab testing

o   16% anatomic pathology

o   20% gene based and esoteric testing

o   2% drugs of abuse

o   8% risk assessment services, clinical trials business, health IT and diagnostic products

Offer > 3000 different tests

o   #1 provider of routine lab testing

o   #1 provider of cancer diagnostics

o   #1 provider of gene based and esoteric testing

o   #1 provider of risk assessment for insurance companies

o   #1 provider of employee drug screens

Provide testing to 50% of all doctors and hospitals in the US

Majority of sales in N. America but also has expanded into Ireland, India, Mexico, Puerto Rico and UK

Have also been expanding into POC testing: since 2006 have acquired three companies in POC. Results from these tests are fully compatible with DGX’s IT results system

Revenue Drivers

Medicare/Medicaid comprise 15-20% of volume and 15-20% of revenue

Physicians, Hospitals and Employers comprise 30-35% of volume and 20-25% of revenue

Health Insurance plans comprise 47-52% of volume and 47-52% of revenue

Private payers comprise 2-5% of volume and 5-10% of revenue

14% of revenue from two largest health plans, 9% of revenue from largest

Billing for clinical services done under two types of fee schedules

Client fees to physicians, hospitals and institutions which is wholesale and billed monthly

Patient fees to individual patients, third parties and Medicare/Medicaid

Medicare/Medicaid represented 18% total revenue in 2009 with a 1.9% cut in reimbursement on Jan 1, 2010.

Medicaid rates are state specific and are prohibited from paying more than Medicare

Medicare does not require copays for lab testing (except anatomic pathology testing)

Fixed prices that are nonnegotiable

Private health insurers represented 50% of revenue. These are based on negotiated rates or capitated payments

Capitated payment plans (flat fee for unlimited lab services) represented 14% of testing volume and 5% of revenue in 2009

Physicians, hospitals and self-pay comprise remainder of revenue (30%) 

The Moat

Economies of Scale:

o   Their large scale capacity affords them the ability to perform the same tests as smaller lab providers and hospitals but at much better margins. This is particularly valuable with their higher margin esoteric and genomic lab testing

Customer Captivity:

o   DGX maintains contracts with health insurance companies requiring their members use DGX for all lab testing. Additionally, many medical centers prefer the reliability of a company such as DGX for their lab testing over smaller local providers.

Technology:

o   Again, with regard to the high margin esoteric and genomic lab testing, DGX is one of two lab providers that has the volume required to make performing these tests economically sensible

Heavily Capitalized Business

o   DGX has its own distribution infrastructure including 3500 courier vehicles and 20 airplanes in addition to 8400 phlebotomists, 5600 paramedical examiners and 1000 MDs and PhDs. This valuable distribution network provides a significant barrier to new entrants.

Regulatory Barriers:

o   Lab testing requires FDA and CLIA approvals, which can be prohibitively costly to smaller lab centers

Balance Sheet and Economics

Largest asset is goodwill, $5.1B

Net debt position ($2.8B) is in line with historical averages and they have additional $1.3B borrowing capacity on their existing line of credit

Hedges FX exposure with fwd starting interest rate swaps and foreign currency fwd contracts (totaling $57M mostly in Swedish krona and British pounds)

Effective tax rate YTD is 36.4%

Avg ROIC w/out goodwill of 77.3%

Gross Margins 41.5%

Operating Margin 18.1%

Net Income Margin 9.8%

5 yr revenue CAGR 8.1%

5 yr operating income CAGR 7.2%

5 yr EPS CAGR 9.8%

5 yr FCF CAGR 12.5%

Ownership & Corporate Governance

17.2% owned by GSK as part of acquisition made by Quest of SmithKline Beecham Clinical Laboratories

1.0% owned by Surya Mohapatra, CEO since 2004

2.3% total director/executive ownership

Incentives to Management

o   Based on revenue and EPS

o   In 2009 Revenue target missed and payout to management was at 95% threshold

o   In 2009 EPS target exceeded and payout to management was 177% threshold

Weighted Avg Strike Price of all options outstanding at end of 2009 = $45.19 (-13% to current price)

Value Creation

DGX has been aggressive about share repurchases, totaling 30% of the total CSO ($2B) since 2003 with further buybacks planned.  Additionally, DGX recently declared a $0.10 dividend.

Share Repurchases

o   $750M in share repurchases in 2010 YTD

o   Additional $250M authorized in Oct 2010 for further repurchases 

Six Sigma strategy operational  improvements (streamlining admin roles, optimizing routes for drivers, improving IT system to have more accurate patient demographic info to reduce bad debt) which brought SG&A down 40bps in 2010. Additionally, management has generated over $500M of cost savings since implementing this program in 2007.

YTD Performance and Price Dislocation

DGX has experienced a 1.5% drop in volume along with a 1.9% cut in Medicare pricing in 2010 leading to YTD revenue to be down 1.2% compared to this time in 2009. This was partially mitigated by an increase in pricing in their managed care contracts and continued growth of the higher margin esoteric and genomic testing business.

Despite this they have been successful in cutting SG&A by 40 bps and have grown operating cash flow to $778M YTD vs. $637M last year.

As a result of soft physician visits along with uncertainty over health reform, the stock is down 15.5%.

Valuation

DGX is on track for generating approximately $800M in FCF in 2010. Management has guided CAPEX for this year will be $200M and it appears they are on track for this as well. At current price, the FCF yield is 10%. Assuming forward growth rate of FCF to be in line with previous years, current IRR is between 17-20%.

Additionally, based on historical multiples DGX is trading at a 29% discount to its historical P/E, a 22% to its historical EV/EBITDA and a 35% discount to its historical EV/FCF multiple.

Relative to LH, DGX appears to be the cheaper of the two with slightly stronger economics:

                  P/E                  EV/EBITDA                  FCF Yield                  Assets/Equity                                    EBIT/EV

DGX                  12.6                  7.0                                    10.5%                                    2.2                                                      12.0%

LH                  15.4                  8.6                                    8.1%                                    2.2                                                      9.5%

Normalized earnings, EV/EBITDA and FCF multiples suggest the stock to have an intrinsic value of $68 - $73 per share, representing a 25-30% upside at current price.

Risks to Thesis

Loss of business to hospitals

o   A recent WSJ article cited the increasing number of physician practices that are being sold to hospitals. If these hospital acquirers have internal lab facilities, it is likely they will require physicians to send all lab testing to the hospital lab as opposed to DGX or LH. If this trend continues, it is feasible DGX and LH could lose business to hospitals for routine lab testing. Despite this, it is unlikely esoteric and genomic testing will be internalized in hospitals given their higher costs and need for specialized personnel/equipment. DGX has also protected its business with longstanding contracts with health insurance providers which require members to use their services.

Additionally, hospitals and hospital chains will have less purchasing power than LH and DGX for raw materials and reagants, so margins will likely be lower for them

Increased use of POC testing

o   POC (point-of-care) testing does not require CLIA certification. If doctors’ offices begin to use this more in the bedside setting it is feasible that DGX could lose business in routine lab testing. Despite this there are a few things that will hold back POC testing:

§  Accuracy- they are notorious for providing inaccurate results which could be a huge liability to a physician who sends a patient home with “normal” lab work

§  POC will only threaten the low margin routine lab testing such as blood counts, basic chemistries, urinalysis etc. The higher margin genomic and esoteric testing will continue be outsourced.

§  POC has been marketed as “at home tests” and as such have gotten by with FDA approval only. As POC testing becomes more widely adopted in the professional clinician setting, it is very likely CLIA will require that these tests obtain their approval as well.   CLIA approval is cost prohibitive barrier for smaller lab facilities so this would be strengthen the moat for DGX.

o   DGX has made headway in accessing the POC market since 2006 with three acquisitions of POC companies: HemoCue, Focus Diagnostics and Enterix.

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Consolidation of Health Insurance Providers

o   If health insurance companies roll up and consolidate, it is feasible they will have greater bargaining power with DGX and LH which will drive down pricing power for both companies

Increased use of capitated payment plans from insurance providers

o   Capitated payment plans entail a flat fee for unlimited lab services. They work well for chronically ill or those requiring frequent lab monitoring (heart failure, coumadin patients, endocrine patients, dialysis patients etc). This currently represents 5% of revenue for DGX and 3.6% of revenue for LH. An increase in capitated payment plans could depress margins as the population gets older and sicker and will require more lab testing going forward

Inflation

o   Lack of pricing power:

§  Approximately 50% of DGX’s COGS ($2.1B) is from capital equipment such as planes, delivery vehicles and laboratory facilities. If the cost of raw goods and materials (i.e. oil) rise it may be difficult to pass on these higher costs through higher pricing.

Obama Health Reform Impacts

o   The legislation provides for annual reductions in the Medicare clinical laboratory fee schedule of 1.75% for five years beginning in 2011 and includes a productivity adjustment which reduces the CPI market basket update beginning in 2011.

o   The legislation also imposes a 2.3% excise tax on the seller for the sale of certain medical devices in the United States, including those purchased and used by laboratories, beginning in 2013.

o   The legislation establishes the Independent Payment Advisory Board which will be responsible, beginning in 2014, to submit annual proposals aimed at reducing Medicare cost growth while preserving quality. It is feasible that this panel could recommend lower reimbursement rates for lab testing