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Morningstar | Quest Diagnostics Faces Increasing Price Pressure; No Change to Our FVE

Quest Diagnostics reported third-quarter results that fell slightly short of our expectations, but our adjustments through 2019 weren’t enough to move the needle on our fair value estimate, which remains at $105 per share. We’re pleased to see quarterly volume up 2% (0.7% organically). However, we’re now beginning to see the extent to which the PAMA-led Medicare clinical lab fee schedule cuts are hitting Quest’s business, as price per requisition fell 0.8% year over year. We think 2019 will be a pivotal year for diagnostic labs as we expect unit price pressure to increase. Consistent with our long-term view of industry consolidation, we anticipate significant pressure on the smaller hospital-based and independent labs could lead to an uptick in those competitors exiting the field over the next several years. Nonetheless, this sets the stage for a tough year in 2019, as immediate pricing pressure may not be completely offset by additional volume from exiting rivals. We’ve long held that Quest and its narrow economic moat (rooted in cost advantage and economies of scale) would come out of this industry consolidation intact and would likely enjoy a stronger competitive position within a smaller field of rivals. We’ve seen little this quarter to change our thinking on that.

On a disappointing note, the trade industry-led lawsuit challenging the process by which the new Medicare clinical lab fee schedule was determined hit a speed bump as a District Court judge dismissed the case, citing lack of jurisdiction over this subject matter. Although the judge recognized the merit of the diagnostic industry’s concerns about how certain labs were included (and others excluded) from the pool used to determine market prices, this leaves the industry with dimmer prospects for any judicial relief. Instead, the industry is pursuing a parallel path to fix the legislation. Considering how slow that process could be, we’re not holding our breath for any changes in 2019.