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Morningstar | Quest Diagnostics Leans on Its Narrow Moat to Weather Medicare Reimbursement Pressure

Quest Diagnostics has positioned itself as the leading provider of independent diagnostic testing in the U.S. by building out a network of more than 2,000 patient service centers across the country. We think Quest's size and cost advantage will allow it to benefit from several secular trends, including the proliferation diagnostic tests and greater clinical reliance on personalized therapies. Additionally, we expect that over the longer term, reimbursement pressure will push hospital-based labs and small independents to outsource more volume at the largest, lowest-cost producers, including Quest.Quest and its primary national competitor, LabCorp, dominate the independent diagnostic testing landscape. Thanks to vast national networks of laboratories, the two firms have created barriers to entry and generated substantial cost advantages over regional and hospital labs. The industry has seen steady consolidation, as both companies have acquired smaller competitors. Most recently, Quest has focused on establishing a presence in hospital-based labs, either on an operational or consulting basis. This is in contrast with its historical pattern of expanding its portfolio of higher-margin esoteric tests with the acquisitions of AmeriPath, Athena, and Celera.Importantly, Quest has benefited from key trends including greater activism by managed care to steer insureds to the lower-cost labs, the penetration of high-deductible plans, and increased presence in retail.Despite Quest's formidable size and attractive cost structure, the firm has historically trailed peer LabCorp on operational efficiency in its diagnostics business. We think the firm's recent shift toward working with hospital-based labs could hamper efficiency even further due to the higher cost structure of the latter. Nonetheless, Quest still reliably generates economic profits, which underscores the strength of its moat. The current management team spent the four years focused on ongoing integration of its acquisitions, playing catch-up on the operations front, and streamlining the organization for greater efficiency. We have finally begun to see results from this turnaround effort on profitability growth.