Markets & Finance

Quest Can Keep Climbing


By Phillip Seligman Medical lab-testing company Quest Diagnostics (DGX) has been catching the eye of many investors these days. So far this year, this mid-cap stock has jumped nearly 22%, to a recent price of about $87, far outpacing many market indexes. Despite this strength, Standard & Poor's figures the stock, which is ranked 5 STARS (buy), can move significantly higher over the next 6 to 12 months.

The main reason: Quest should reach its long-term financial goal of 30%-plus annual EPS growth over the next three to five years as it continues to gain market share through acquisitions and organic growth. An improving revenue mix and a major cost-control initiative will also help (see BW Online, 3/28/02, "Positive Results for Quest Diagnostics").

Quest Diagnostics was formed from the spin-off of Corning's MetPath blood-testing unit in December 1996. In March, Quest closed its merger with American Medical Laboratories (which had 2001 revenues of $300 million, rising 10% annually). AML has strong diagnostic-testing market share in Nevada and Virginia, and a large East Coast "esoteric testing" lab with 500 hospitals as clients. (Esoteric tests are those used to diagnose specific infectious diseases and are more complex than routine blood tests.) The lab geographically complements Nichols Institute, Quest's large esoteric-testing facility in California.

ACQUISITION SPREE? Quest also recently agreed to acquire Unilab Corp. (ULAB), with 2001 sales of $390 million, operating margins of approximately 21%, and net income of about $22 million. ULAB is the market leader in diagnostic testing in California, the largest and one of the industry's fastest growing markets in the U.S. The two recent acquisitions should contribute $0.02 to $0.03 each in EPS in 2002, and that contribution should increase as the operations are melded.

S&P expects Quest to continue to acquire smaller, local "mom and pop" labs since so few large diagnostic-testing labs are available to buy. In 2001, Quest had a 10% share of the U.S. diagnostic-testing market, while No. 2 LabCorp (LH) had a 6% share. The market remains highly fragmented, with hospitals holding a 39% share; independents, including Quest, LabCorp, and thousands of small labs, 39%; and doctors' offices, 12%.

This suggests that Quest still has a lot of room for acquisition-related growth. It may also gain market share as increasingly cost-conscious hospitals outsource more esoteric and genomics tests, and eventually routine blood tests.

HIGH-GROWTH TESTING. Meanwhile, the revenues of the relatively small, but highly profitable, esoteric and genomics testing services area are currently growing at approximately 25% annually, vs. 5% or so annual growth in routine blood tests. Driving such impressive growth are an increasing number of new blood tests that screen for infectious and noninfectious (such as cancer) diseases.

S&P sees a rapid increase in diagnostic testing to determine patient-specific drug therapy (including dosage), as well as an individual's genetic tendency to acquire a particular disease. Even though genetic testing raises privacy issues -- which are solvable -- S&P believes it will be used to develop preventative therapies, ranging from drug treatments to dietary regimens.

We expect Quest's earnings before interest, taxes, depreciation, and amortization (EBITDA) margin, which was 15.3% in 2001, to increase rapidly over the next few years, thanks to an improving revenue mix and cost savings. The company recently started a "Six Sigma" quality-improvement program, which Quest figues will save $150 million annually by 2004.

S&P sees EPS increasing 54%, to $2.90 in 2002 (or 33%, excluding a $0.35 benefit from the elimination of goodwill amortization this fiscal year) from $1.92 in 2001. In 2003, EPS should rise by an additional 33%, to $3.85.

DESERVED PREMIUM. Quest's stock was recently trading at 30 times our fiscal 2002 estimate, a significant premium to the p-e multiple of the S&P 500-stock index, as well as that of the health-care-services industry.

However, S&P believes that Quest deserves its premium because of its sustainable, long-term EPS growth that appears more reliable than for most companies in the S&P 500 and health-care-services industry. This is attributable to bright prospects for the diagnostic-testing industry as well as to good management.

S&P thinks the shares will rise even higher over the next 6 to 12 months. A three-year EPS growth target of 30% gives the shares a p-e-to-growth (PEG) ratio of 1.0 based on our 2002 estimate, which is par with the health-care-services industry average for 2002. Even so, given the S&P MidCap 400 index PEG of 1.3 and our confidence that Quest's EPS is more sustainable than most in its industry -- and that the company has the ability to exceed that growth target -- the shares have ample room for appreciation.

And this is also borne out by Quest's strong free cash-flow generation. Indeed, S&P's discounted cash-flow analysis -- which assumes 20% initial growth, modest deceleration thereafter, and a weighted average cost of capital of approximately 10% -- implies an intrinsic value estimate of approximately $115 a share, a 29% premium to the stock's recent price. Analyst Seligman follows managed health care and health-care facilities, services, and distribution stocks for Standard & Poor's


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