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Morningstar | Quest Weathers Near-Term Price Pressure, but Long-Term Prospects Remain Positive

While the market drove shares lower, we’re holding steady on our fair value estimate as Quest Diagnostics posted second-quarter results that generally lined up with our expectations on the top and bottom lines. Acquisitions contributed 200 basis points to solid quarterly volume gains, but we were less impressed with the anemic organic volume and revenue-per requisition growth. The latter reflected major PAMA-related cuts to Medicare reimbursements, as well as a mix shift to accommodate lower-margin tests for inpatients. Despite the price pressure, Quest's narrow moat remains intact, and indeed could grow stronger over the long term as higher-cost labs outsource more volume to the largest independent labs.

We're still focused on the industry-led lawsuit that contests Medicare's data collection from applicable labs to set its Clinical Lab Fee Schedule. As the case winds its way through the legal system, we expect a ruling could come this fall. However, even if the judge rules in favor of the diagnostic industry, it will still take another estimated 12-18 months to reach new definitions of applicable labs and to collect price data in order to revise the current CLFS.  We anticipate the headwind from cuts to the Medicare CLFS are unlikely to ease until 2020, even if the ruling is favorable.

We remain intrigued with Quest's new nonexclusive contract with UnitedHealth, and the details that management has revealed about the potential for shared savings. Overall, UnitedHealth's (and now Aetna's) decision to contract with both Quest and LabCorp fits in neatly with our thesis that, as value-based reimbursement expands, payers and providers will gravitate toward the lowest-cost lab services. Considering the significant differential between the cost structures of the largest independent labs and hospital-based labs, the payers are clearly better off if they can shift more patient volume to Quest and LabCorp, even if they share some of those savings with the labs.