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Morningstar | Quest Diagnostics Posts Solid First Quarter; No Change to Our Fair Value Estimate

Quest Diagnostics posted first-quarter results that generally met our expectations, and we’re standing firm on our fair value estimate. Overall, Quest saw a mixed bag of factors that we have incorporated in our estimates for the full year. As expected, the PAMA-led reimbursement pressure continues to exert itself in 2019, and we do not expect this to let up until 2021 when the next three-year cycle of setting the Medicare clinical lab fee schedule begins to roll out. On the other hand, Quest’s organic volume growth of 2.4% in the first quarter was very respectable, from our perspective. And we believe volume should continue to grow over the longer term. We continue to think Quest and rival LabCorp, as the largest and lowest-cost producers, are best positioned to weather the Medicare cuts and gain scale as industry consolidation progresses. Ultimately, these trends should solidify Quest’s narrow economic moat.

As had been widely expected, UnitedHealth chose Quest as a non-exclusive preferred network lab provider, while at the same time, it ended contracts with other higher-cost labs. Quest also confirmed our suspicion that the firm avoided the significant price concessions we’ve seen in the past when UnitedHealth switched from Quest to LabCorp more than a decade ago. We see this as further evidence that payers are less interested in squeezing price from the lowest-cost producers by playing them off each other and are more interested in increasing access to Quest and LabCorp, which offer national scope, at the expense of the higher-cost hospital-based labs. Moreover, UnitedHealth aims to tap into the reams of diagnostic data that Quest and LabCorp have amassed as part of its larger effort to better manage patient outcomes, as value-based reimbursement takes hold. We think this trove of diagnostic data should be extremely compelling for UnitedHealth’s Optum unit, which already analyzes treatment and outcomes data to manage costs and heighten quality.

Thus, we’re not surprised that other payers have followed the path UnitedHealth has paved, including Aetna, Horizon Blue Cross Blue Shield of New Jersey, and Blue Cross Blue Shield of Georgia. We anticipate this trend toward non-exclusive contracts will benefit Quest and LabCorp, which offer both widespread access and lower costs.

We’re also intrigued by Trident's filing for Chapter 11 and view this as a canary in the coal mine when it comes to PAMA cuts. Trident is a major diagnostic lab that has a significant presence in the nursing home and long-term care sub-segment of the market. Independent labs serving those customers typically receive 50% to 80% of total revenue from Medicare, which is in stark contrast with Quest, which receives less than 13% of its revenue directly from Medicare. We wouldn’t be surprised to see more independent labs with substantial Medicare exposure to close in the next two years. While Quest and LabCorp are unlikely to pursue this new source of volume, the subsequent loss of access will only underscore second thoughts at CMS about this trade-off in its zeal to institute the PAMA-led cuts.