Laboratory Corp. of America Holdings LH and Quest Diagnostics Inc DGX could benefit from a "significant wave" of consolidation in the lab testing and diagnostics sector, according to KeyBanc Capital Markets.
The Analyst
Analyst Donald Hooker upgraded Laboratory Corp. from Sector Weight to Overweight with a new $210 price target. The analyst maintains a Sector Weight rating on Quest Diagnostics with no assigned price target.
The Thesis
Consolidation within the lab testing space is likely to occur as a result of both UnitedHealth Group Inc UNH and Aetna Inc AET opening up their networks to include both Laboratory Corp. and Quest Diagnostics as in-network providers, Hooker said in a research report.
UnitedHealth previously contracted only with Laboratory Corp. and hundreds of smaller regional labs, while Aetna contracted only with Quest Diagnostics and hundreds of smaller regional labs.
Laboratory Corp. and Quest Diagnostics are "by far" the lowest-cost labs, with industry leading economies of scale, but only account for less than 30 percent of the total $50-billion non-inpatient lab spending market, Hooker said. The fact that Aetna and UnitedHealth will do business with both companies should lead to "significant consolidation" of independent lab providers, the analyst said.
Laboratory Corporation Upgraded
Laboratory Corp. will only see a "modest" net revenue attrition in reaction to UnitedHealth opening its network to include rival Quest Diagnostics, Hooker said. It is likely the company anticipated this event years ago, which implies less negative pressure on profitability than investors may assume, he said.
After at least 10 years of being the exclusive lab provider to UnitedHealth, most of Quest Diagnostics' gains will come at the expense of smaller labs, as there is a "good level of stickiness" with UnitedHealth's providers, the analyst said. In addition, Laboratory Corp. can win back around half of any lost revenue from UnitedHealth with its new exposure to Aetna's network, Hooker said.
Laboratory Corp. still owns one of the largest global contract research organizations via its 2015 acquisition of Covance and 2018 acquisition of Chiltern International, Hooker said. This business should account for around 38 percent of total consolidated revenue, with future growth coming from a planned global expansion in the coming quarters.
Base Case Improves For Quest Diagnostics
Quest Diagnostics' new exposure to UnitedHealth's network should at the very least generate $70 million in incremental revenue in 2019 and $150 million in incremental revenue the following year, as the company will allocate most of its $75 million of tax savings to gain market share, Hooker said. This should generate an incremental $28 million in EBITDA in 2019 and $59 million in 2020, he said.
Quest reiterated its 2020 revenue growth target of 3-5 percent and will continue paying investors a dividend and buying back its own stock, the analyst said. Yet the stock is already trading at a "full valuation" at an 11x 2019 adjusted EBITDA estimate of around $1.7 billion, he said.
On a next-12-months basis, the stock is trading at 12x EBITDA, which is already a premium to its three-year average multiple of 10x and at the high-end of its 8x to 12x range.
Price Action
Shares of both Laboratory Corp. were down 0.43 percent at the time of publication Thursday, while Quest Diagnostics was down 0.39 percent.
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