Lab wars: Doctors caught in the middle

Quest Diagnostics and Laboratory Corp. of America are pulling out all stops to stay at the top of the independent clinical lab market. And if physicians get annoyed along the way -- well, business is business.

By — Posted June 11, 2007

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When Laboratory Corp. of America announced last fall that it had signed a 10-year deal to be the exclusive national clinical lab for UnitedHealth Group, it was the shot heard 'round the independent lab world.

Physicians not only heard the shot, but with United instituting the threat of fines for physicians who refer patients to LabCorp rival Quest Diagnostics, they also felt collateral damage.

Doctors might need to be ready for more shrapnel, because the battle between No. 1 Quest and No. 2 LabCorp -- which together dominate the independent lab business -- is just getting started.

Analysts expect more exclusive deals between the national labs and national health plans as the labs fight for more business and as the plans fight for lower costs. In fact, one deal -- between Quest and Aetna -- is set to get started July 1.

Analysts also expect Quest and LabCorp to continue acquiring other lab companies, particularly those engaged in the more profitable genomic and esoteric testing that is economically unfeasible for smaller hospital and office labs.

So perhaps the more accurate statement is that the Quest-LabCorp battle is getting re-started.

The two companies have fought to control the lion's share of the independent lab business for the last 10 years, ever since Lyndhurst, N.J.-based Quest was spun off from Corning Corp., and two smaller labs merged into Burlington, N.C.-based LabCorp. Getting exclusive deals with health plans is one key way for Quest and LabCorp to assert their power in the marketplace.

But in terms of revenue, those companies are dwarfed by health plans. The move toward exclusive deals might turn out to be health plans' asserting their contracting power over labs, as physicians say plans have done with them.

"The jury's out on whether [the United-LabCorp deal] was the smartest thing [LabCorp] has ever done, or the dumbest thing it's ever done," said Thomas Hirsch, founder of Portsmouth, N.H.-based Laboratory Billing Solutions, a consultant and billing manager for laboratories.

Either way, physicians increasingly are going to be forced to choose Quest or LabCorp -- or neither -- as a consequence of insurance contracts, rather than what they think is best for their patients, analysts say.

"What's terrible for doctors is that there's no choice anymore," said Hirsch, who sold his own hospital-based lab to LabCorp in 2003. "That's terrible for medicine."

Anatomy of a deal

Recently, lab companies have thought that exclusive deals were, for the most part, terrible.

In the 1990s, independent labs signed exclusive deals with health plans -- often called preferred provider deals -- as a way to consolidate their business. The deals were capitated, meaning plans paid a flat per-member per-month fee regardless of usage. Many physicians also signed capitated contracts during that time.

But by decade's end, labs began unwinding those contracts, for the same reasons physicians wanted out of them -- because they were losing money. Quest and LabCorp spent most of the last 10 years acquiring other lab companies, particularly those specializing in esoteric and genomic tests.

Regardless of the companies' size -- Quest pulled in $6.3 billion in revenue last year, while LabCorp collected $3.6 billion -- the lab business is still considered fragmented. By the companies' own accounting, hospital labs make up 60% of the business, with Quest and LabCorp fighting over the 33% held by independent labs. (The remaining 7% is held by physician offices.) The companies' yearlong revenues are equal to what most big health insurers collect in a quarter.

The lab companies moved further into nonroutine disease testing because it paid more and because they could get business from hospitals and physician offices that don't do enough of it to justify the equipment investment. Quest said $1 billion of its 2006 revenue was from genomic and esoteric testing, and that number is growing 10% a year -- its fastest-growing segment.

In fact, neither Quest nor LabCorp said it was in the market for exclusive deals from insurers again. "We [choose] to compete based on access, quality, service," said Quest spokeswoman Nancy FitzSimons. "We think it is positive for the entire health care industry. Physicians benefited from this competition."

LabCorp CEO David King said the idea of an exclusive contract came from United, which told each lab in late 2005 that it was seeking such a deal. "It was our view that they were looking for network efficiency. It was our view they could do that without exclusivity. But you can't tell the customer you can't do what they want done because you don't think that's the best thing."

United spokesman Tyler Mason said, "It's irrelevant who brought up" exclusivity. He said in any negotiation, United is committed to any strategy that "will evolve into" discussion about how to improve quality and lower cost to members.

Zacks Investment Research senior analyst Greg Aurand said LabCorp had a particular interest in signing a deal with United. LabCorp was weak in the Northeast, and the money from the company would allow LabCorp to build its network in corporate headquarters-heavy cities such as New York and Boston, thus making it a more viable player for national contracts.

"For a major corporation that has far-flung locations, you want to be able to have consistent capabilities offered," Aurand said. "That makes sense -- for a lot of large contracts, the question is who can offer that across-the-board, McDonald's-type service. One Big Mac is the same from one McDonald's across the country."

Aurand laughed, saying he knows physicians will find the comparison between health care and McDonald's insulting, but it is one being made in corporate boardrooms.

Quest, already strong in the Northeast, said it elected not to meet United's reimbursement levels (which were not disclosed), nor pay any price for "leakage" to out-of-network labs. LabCorp promised United a payment of up to $200 million to cover extra, out-of-network reimbursement to Quest.

After stock analysts initially praised LabCorp's news, especially after Quest said United represented 7% of its total revenue, questions arose over whether the days of the money-losing contract were back. "That's a concern from an investment perspective as well as a shareholder perspective," Aurand said.

Still, in the short term, the deal looks good for LabCorp. As much as organized medicine fought United on the threatened fines -- and United has suspended the program in New Jersey while state regulators there look into the legality of the deal -- exclusivity is boosting LabCorp's bottom line.

The company reported faster-than-expected transition of physician referrals from Quest to LabCorp, with first-quarter 2007 earnings going up 20% over the first quarter of 2006, to $122.5 million. Zacks estimated that without earnings attributable to the United deal, LabCorp's earnings increase would have been 7%.

"I wouldn't draw a straight line" between the United-threatened fines and physician compliance, King said. The company ran local radio ads and visited doctors' offices to let them know about LabCorp and what it does, he said.

More deals to come?

Analysts say Quest signing an exclusive deal with Aetna a few months after the United-LabCorp deal was no coincidence. Quest had to make a dramatic response to give the stock market confidence in the company.

Quest's FitzSimons and Aetna spokeswoman Karin Rush-Monroe each said the deal just made sense for their companies. FitzSimons said 75% of physicians in Aetna's network already use Quest, so there was no need to put in penalties for out-of-network referrals or rapidly build up a network.

FitzSimons and King each said other major national health insurers are watching how the United-LabCorp and Aetna-Quest deals shake out.

"Our preferred way of doing business is through competition, open access," FitzSimons said. "But we will work with health plans. If the health plans feel they need an exclusive, we'll work with them on that."

"What we're dealing with is, it's going to be you or the other guy," King said. The question LabCorp asked itself in United's case was, "What would have been the consequences for our company and the industry? For us, it would have been a big revenue loss, and a dramatically negative impact on the people who work for us and our shareholders."

Soon enough, said Hirsch, the lab consultant, physicians are likely to send lab work to one of the two big players, depending on the insurer. "They're going to be sending half the work to LabCorp and half to Quest."

That will pose a hassle for physicians trying to keep track of which insurer has a deal with which lab and will also present a troubling long-term scenario for the lab companies, Hirsch said. "Neither ends up getting more business. The only benefit is to the health plan, because it gets lower prices."

Physicians still might have some choices. The exclusive deals are on a national basis, so doctors could still send work to a smaller independent lab or hospital lab that is part of a plan's network. Even esoteric or genomic testing not available locally can be done at larger facilities, such as the Mayo Clinic, Hirsch said.

Still, analysts say the revival of exclusive deals between labs and insurers signals a greater incursion of health plan influence onto physician decisions. "Quest and LabCorp don't make friends with the rest of the industry by signing these deals," Hirsch said.

King said doctors will have to get used to the new environment. "You always get from physicians, 'We don't like being told what to do.' But more and more, physicians are being told what to do. And we understand they don't like it."

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Tale of the tape

Quest Diagnostics Laboratory Corp. of America
Headquarters Lyndhurst, N.J. Burlington, N.C.
Founded 1967 1971
Sites 2,100 1,700
Employees 41,000 25,000
Annual revenue (2006) $6.3 billion $3.6 billion
Annual earnings (2006) $583 million $431 million
Earnings per share (2006) $2.94 $3.24
Annual revenue growth rate (2002-06) 8%-13% 5%-9%

Note: Both are predecessor companies. Quest was founded as MetPath and has been independent since its 1996 spinoff from Corning Inc. LabCorp was created by the 1995 merger of National Health Laboratories and Roche Biomedical.

Source: Company filings with the Securities and Exchange Commission

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Buying growth

Quest Diagnostics and Laboratory Corp. of America both have grown in size and scope through acquisitions. Among their notable recent deals:

Quest Diagnostics
Acquired company Year Price Reason
LabOne 2005 $947 million Does health screening and risk assessment for life insurance companies, employee drug testing, and clinical diagnostic testing services
Enterix 2006 $44 million Company focused on colorectal cancer screening
Focus Diagnostics 2006 $208 million Expansion into infectious and immunologic disease testing; company is awaiting FDA approval on in-office herpes simplex 2 antibodies assessment
POCT Holding/HemoCare 2007 $450 million Company produces handled, point-of-care testing for hemoglobin, glucose and microalbumin
AmeriPath 2007 $2 billion Allows big expansion into dermopathology, anatomic pathology and esoteric testing
Acquired Company Year Price Reason
Dynacare 2002 $685 million Expands LabCorp's geographic reach
Dianon 2003 $598 million Expands reach in anatomic pathology and oncology testing services
US Labs 2005 $155 million More reach in anatomic pathology and oncology testing
Esoterix 2005 $150 million Has asthma and allergy facility, genetics testing operation and coagulation lab

Source: Company filings with the Securities and Exchange Commission

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The lab market

Quest Diagnostics' breakdown of the $45 billion (in 2006) lab services industry shows that while it and LabCorp are big players in the field, that market is still fragmented:

60% Hospital-based labs

33% Commercial clinical labs (includes Quest and LabCorp)

7% Physician-owned labs

Source: Quest Diagnostics documents on file with the Securities and Exchange Commission

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