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2001 BW 50


By David Shook

Positive Results for Quest Diagnostics
Its emphasis on more sophisticated -- and profitable -- lab-testing procedures has analysts predicting a healthy future

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Even without much recent growth, Quest Diagnostics (DGX ), the largest medical lab-testing company in the U.S., has enjoyed a huge run-up in its stock price and came in at No. 4 on the BusinessWeek list of the top companies in the S&P MidCap 400 index. Teterboro (N.J.)-based Quest saw testing volume increase less than 1% in 2001, yet the stock's value has soared about 500% over the past two years, to its recent $78 a share from $15 in April, 2000.

What gives? It seems Quest's growth potential doesn't lie in basic lab-testing services -- the more than 4,000 molecular screenings that determine anything from drug abuse by a job applicant to a person's white blood-cell count. Instead, it's placing greater emphasis on the more lucrative areas of specialized lab procedures that are an increasingly important part of health care.

Such sophisticated, or "esoteric," testing, as it's known in the industry, mainly involves diagnostics that hospitals don't have the resources to handle themselves or can't do on a large enough scale. These tests determine, for example, how well a cocktail of antiretroviral AIDS drugs is working on a patient. Or they can involve screening for certain forms of cancer or a rare genetic mutation that can influence the risk a child may have of developing a certain disease.

"DISTRIBUTION CHANNEL."  This emphasis should translate into strong gains for Quest in 2002, which helps explain the huge upside potential priced into the stock, say Credit Suisse First Boston analyst Robert Willoughby and other analysts. Salomon Smith Barney predicts that Quest will have average annual earnings growth of 25% for five years. That's far higher than what's expected for the rest of the health-care industry, save for a few biotech drug companies.

"Quest has become a distribution channel for all these new technologies coming onto the market," says Willoughby. As biotechnology and medicine becomes more targeted and predictive, "I think you'll see this company continue to embrace and benefit from all these new specialized forms of diagnostics," he says.

In 2002, analysts expect Quest's earnings per share to reach $2.87, a 50% jump from the $1.92 of a year ago. While sales are seen increasing only 8% to 10% this year, analysts expect the huge profit gains to result from Quest's focus on higher-margin clinical tests, an improving economy, and cost savings reaped from the company's $500 million merger this year with American Medical Laboratories.

GETTING SPECIFIC.  Also helping are the ongoing profit gains from Quest's $1.3 billion deal in 1999 for SmithKline Beecham Clinical Labs, which created the largest company in the lab-testing industry. "Quest has really grown through acquisitions, and the company has leverage with the big managed-care organizations, which pay for an increasing number of these sophisticated tests," says Theresa Womble, analyst at Morgan Keegan & Co.

The growth in specialized testing is part of the natural evolution of drug development toward targeting more specific subsets of patients. Around the world, the AIDS virus is mutating in ways that makes it increasingly resistant to many of the best drug cocktails on the market, which for the past 10 years have helped HIV patients live healthy lives.

So doctors are testing patients for resistant strains of the AIDS virus -- and also measuring the level of the virus in patients using standard therapies, to make sure the virus isn't gaining in its ability to resist current treatments. These are two of the types of HIV tests Quest now provides for immunologists.

PREDICTIVE GENETICS.  Quest also is expected to play an increasingly important role in oncology. Genentech's breast cancer drug Herceptin is genetically targeted toward a subset of breast cancer victims with a specific mutated gene. Quest offers a test to determine whether a woman with breast cancer has the specific mutation, revealing whether she'll be suitable for the drug.

And Quest may benefit from the burgeoning field of predictive genetics. The American College of Obstetricians & Gynecologists now recommends that couples planning to have a baby have their DNA screened for a mutation that can lead to cystic fibrosis in the child -- a test Quest offers.

"These kinds of tests require more skilled personnel and expensive technology that many hospitals simply can't afford. That's why this is a fast-growing area for the lab-testing industry," says Theresa Womble of Morgan Keegan.

EYE ON THE ECONOMY.  Quest didn't experience much growth in total test volume in 2001, but that's partially due to the recession. With fewer companies hiring and screening for substance abuse, many of the more basic, employment-related tests saw drops in volume, says William Bonello, analyst for U.S. Bancorp Piper Jaffray. Quest executives were unavailable to comment for this story.

According to Washington G-2 Reports, a trade news service, the entire U.S. clinical lab-testing industry grew by only 5.5% in 2001. This year, Quest could see its test volume increase at a substantially higher rate -- perhaps 10% or more, as the economy improves and insurance companies begin to place more emphasis on early detection and prevention of disease through sophisticated lab testing.

Even though Quest is the industry giant, it does have competition. LabCorp (LH ) in Burlington, N.C., is No. 2 and appears to be growing faster than Quest. In the fourth quarter, LabCorp's total test volumes grew 12% and total revenues 16%, while Quest in same period saw test volumes increase only 3.5% and sales 9%.

BIG BETS.  Moreover, smaller players such as DIANON Systems (DIAN ) are pecking at Quest's esoteric clinical-testing market. The Stratford (Conn.)-based company provides cancer and genomics diagnostics. In the fourth quarter, it had revenues of $41.2 million, a 61% increase over the year earlier. And while DIANON is a much smaller company, its stock has nonetheless soared in the last year to $60 a share from $25, suggesting that investors see tremendous potential in companies establishing themselves in specialized lab testing.

With investors having already made big bets on Quest and its rivals, "there's a valuation concern for these companies," says Womble. Quest is trading at 28 times 2002 earnings estimates and 23 times 2003 projections. Even given its competition, though, analysts say they believe Quest can deliver on the explosive earnings growth expected over the next five years.

If they're right, the stock may have less downside risk than it appears. Quest is poised to be the behind-the-scenes beneficiary of the advancements being made in predictive medicine and targeted drug development. As more of these treatments and diagnostics hit the market, Quest will be in the background -- cashing in.

MARCH 28, 2002

Shook covers biotechnology issues for BusinessWeek Online. Follow The Biotech Beat every week, only on BusinessWeek Online
Edited By Beth Belton

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