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Morningstar | Medicare Cuts Press on LabCorp's First Quarter; No Change to Our Fair Value Estimate

LabCorp posted solid first-quarter performance that held few surprises as Medicare reimbursement pressure continues to bear down on the reference lab industry. We’re leaving our fair value estimate unchanged. The quarter included a number of offsetting factors in the diagnostics division, including a divestiture and foreign exchange headwinds, but we were pleased to see 0.4% organic revenue growth. Management remained closed-mouthed about the M&A pipeline and any indications that more robust group of labs are receptive to consolidation. However, with the reorganization of the largest lab handling the nursing home market, we suspect Medicare (along with the entire lab industry) must be wrestling with how to readjust PAMA cuts such that there aren’t widespread cuts to access for patients. We remain confident that LabCorp’s narrow economic moat, stemming from its compelling cost structure, puts the firm in a strong position to weather these near-term cuts that will flow through 2020.

Although LabCorp’s quarterly organic test volume growth of 0.8% was overshadowed by rival Quest’s 2.4% increase, we were pleased to see LabCorp’s revenue per requisition only declined 0.4%, which is considerably better than the 300-basis-point decrease Quest saw. We were also pleasantly surprised to see that the loss of exclusivity in LabCorp’s contracts with UnitedHealth and Horizon Blue Cross Blue Shield didn’t seem to take much of a bite out of LabCorp’s diagnostics business. This suggests that payers, employers, and patients themselves (via high-deductible plans) have aligned their interest in choosing low-cost producers such as LabCorp over the more expensive hospital-based and smaller independent labs. This underscores our confidence in LabCorp’s moat and the prospects for succeeding in the value-based environment.

The second three-year cycle of rolling out an updated Medicare clinical lab fee schedule is set to begin in 2021 and offers the potential for reimbursement pressure to ease. We think CMS’ new definition of applicable lab that encompasses most higher-cost hospital-based labs is a highly favorable development for LabCorp and Quest. However, the likelihood that hospital-based labs will (or can) comply with the reporting requirement remains an open question in our minds. For Medicare’s clinical lab fee schedule to increase, some critical mass of hospitals will need to collect and report the prices from private payers to CMS. At this point, we’re skeptical that many hospital-based labs are equipped with the appropriate information technology tools to be able to track test volumes and payments by payer and by plan. Collection of the data was to have started on Jan. 1 and should wrap up on June 30. The labs then have until the end of this year to submit all that data to CMS.

As LabCorp and Quest management have indicated, the entire lab testing industry to working with CMS to delay the collection and reporting time frame, in order to buy the higher-cost labs time to comply. We think it would be in CMS’ interest to lengthen the reporting period to maximize hospital-based lab participation. As PAMA is written, the reimbursement cuts were capped at 10% per year for the first round of resetting the clinical lab fee schedule from 2018 through 2020. For the second round of rate resetting, the maximum cuts are capped at 15% per year. Considering the significant effect Medicare cuts have had on the labs last year and the prospect of substantially reduced patient access, we speculate CMS will be keen to avoid the full impact of an incremental 15% cut in 2021, which would most likely hurt access further.