A 2015 Preview for the Laboratory Sector

The year 2014 was a challenging one for laboratories. They continued to confront cuts in reimbursement even as the Affordable Care Act brought millions of more Americans into the insurance fold for laboratory testing. The second half of the year also signaled a turnaround - or turning point - for the two biggest labs. Quest Diagnostics finally was able to successfully combat shrinking revenues, while LabCorp's bold acquisition of Covance for $5.6 billion may signal its transition from the Avis of the sector to the largest player overall by a significant margin, and with the diversification to maintain and grow a commanding lead over Quest. But with the lab sector entering 2015, questions remain about developing trends, reimbursements and companies. Where will the new year head? Regulation of LDTs The U.S. Food and Drug Administration began taking the first major steps in 2014 toward the regulation of laboratory-developed tests as medical devices. Not surprisingly, the laboratory sector immediately pushed back, with the American Clinical Laboratory Association retaining two of Washington's most prominent attorneys, Lawrence Tribe and Paul Clement, to represent its interests. "It's quite serious," said Lale White, chief executive officer of XIFIN, a San Diego-based laboratory software and consulting firm that works extensively in the regulatory realm. Although White believes the ACLA and other lab interests may sue the FDA if it does not back down on its current proposed regulatory plan, she also believes a compromise could be reached. "There's a danger of slowing down innovation in the sector, and the FDA does not want to be responsible for that," she said, adding that the regulations could also create a two-tiered pricing scheme for tests that have and do not have FDA approval. As for compromise, White believes it will come in the form of strengthening the Clinical Laboratory Improvement Amendments, or CLIA - a path that is being suggested by the ACLA and other laboratory lobbies. Bundled Pathology Payments The practice of pathology has been hit hard in recent years, most notably by the Centers for Medicare & Medicaid Services' decision in late 2013 to cut payments for the technical component of CPT code 88305 by 52 percent. It was an act that devastated many smaller pathology practices, forcing some to close and others to seek buyers at prices at a fraction of what they were just a few years prior. Now, independent pathology practices are facing another potential change in their reimbursement through the bundling of payments to those that provide services to hospitals. "There is no doubt payments are going to go down," White said. But Barry Portugal, chief executive officer of Florida-based Health Care Development Services, believes it will not impact too many labs, mostly the independent ones that provide services to hospitals. "The real question is if you're a hospital and you don't have a histology lab at all - and typically those are really small hospitals - then it becomes a contractual issue you have to resolve," he said. That means both pathology practices and hospitals will have to do their own cost calculations in order to determine how to eke out the appropriate margins in a bundling scenario. LabCorp vs. Quest Diagnostics With annual revenue of about $6 billion, North Carolina-based LabCorp has always been the smaller of the two national laboratories, about three-quarters the size of New Jersey-based Quest Diagnostics. It was also the favored lab on Wall Street, exhibiting organic growth at a time Quest's revenues were stalled for nearly two years. But with LabCorp's recently announced acquisition of drug testing firm Covance, whose annual revenues approach $3 billion, LabCorp is poised to overtake Quest in terms of size. "(LabCorp CEO) Dave King has called this a transformational transaction. It makes them bigger than Quest in most categories, and it puts LabCorp very strongly into the clinical trials business," observed Dennis Weissman, former executive editor of G2 Intelligence and the company's founder. But Weissman cautioned that LabCorp had to borrow fairly heavily to pull off the $5.6 billion deal, and that it would be under pressure from shareholders to perform moving forward. Deutsche Bank moved to a buy from hold action on LabCorp stock not long after the deal was announced. "Although we do believe LabCorp is buying a top-tier pharma services company in Covance, based on our significant interactions with investors of all stripes, we conclude the deal lowers LabCorp's appeal to most traditional health care services investors," analyst Darren Lehrich wrote in a mid-November report. He added that LabCorp may have also created a Quest-like problem of stagnant growth as a result of the deal, as its leadership had yet to make a compelling argument for revenue synergies from the transaction moving forward. Conversely, Lehrich also upgraded his hold recommendation for Quest Diagnostics to a buy rating. "In an environment where pricing looks more stable, volumes are improving and cost savings remain visible due to Quest's "Invigorate" initiative, we believe its ability to generate operating income and (earnings) growth above consensus makes it a more compelling idea right now," he observed. In other words, swapping places at the top of the heap leads to problems of their own. Will Theranos Pop? No doubt the single most intriguing company in the lab sector in 2015 is Palo Alto, Calif.-based Theranos. Its 30-year-old founder and chief executive officer Elizabeth Holmes was not only anointed Silicon Valley's latest world conqueror by dint of a recent $9 billion valuation of the company (Holmes owns half of Theranos' stock), but was also the subject of a recent lengthy profile by well-known author Ken Auletta in the New Yorker magazine. Holmes, who has raised some $400 million from investors after dropping out of Stanford University a decade ago, was portrayed as a soft-spoken visionary who has dismissed any thoughts of a personal life in order to grow her company. All the while, she deflected Auletta's questions about the technology Theranos has developed to conduct patient draws without the use of needles and perform assays with just a few drops of blood. In keeping with the company's tendency toward secretiveness, a spokesperson did not respond to a request seeking comment. There was one salient fact about Theranos in the New Yorker: Despite an unfolding partnership with pharmacy chain Walgreens, Holmes projects a mere 1 million tests will be performed by the company in 2015. That would place Theranos in the realm of a regional lab as opposed to the Fortune 500. "She's done an unbelievable job in terms of getting the Theranos name out there, and the way they do things could be a game-changer," Weissman said, noting that its business model fits well with the major pharmacy chains vying to provide primary care services. "But they have to prove it first." And aside from carefully curated locations inside a convenience retailer, Theranos has not divulged how it intends to wrestle business away from the draw stations already firmly ensconced in the doctors' offices, hospitals and medical groups where Americans routinely receive their health care services. That may be something that will be revealed in 2016 and beyond. Takeaway: 2015 could be a year of big changes - and big questions - for the laboratory sector.