Inside the Lab Industry: Two Models for the Hospital Outreach Business: Dive In or Stay on Sidelines

The two biggest deals Quest Diagnostics has consummated in recent months involved hospital outreach laboratories. In October, it announced that it was acquiring the outreach business of the UMass Memorial Medical Center in Worcester, Mass., and that the two entities would build a combined regional lab. Last month, Quest announced it was acquiring the outreach laboratory services of San Francisco-based Dignity Health, a large hospital system operating throughout much of California that was formerly known as Catholic Healthcare West. But those deals may be the exception to the rule. “Other than a few deals from Quest/LabCorp, the M&A market has basically been non-existent,” said Brian Carr, chief executive officer of Regional Diagnostic Laboratories, a Nashville-based firm founded a year ago to focus on making hospital lab acquisitions and backed by $250 million in capital by Warburg Pincus. “For the most part, there are no buyers in the market.” Carr, who was out of the country earlier this month and responded to questions by e-mail, noted a variety of factors that are creating uncertainty in the market. They include recent steep cuts in the technical component of CPT Code 88305 by the Centers for Medicare and Medicaid Services, the acquisition of physician practices by large hospital systems in some markets, and the uncertainty of how laboratories will be integrated into the ever-growing number of accountable care organizations. Deals Still Make Sense Nevertheless, industry observers believe acquiring hospital outreach businesses makes sense. As many as 30 million Americans are expected to gain insurance coverage over the remainder of the decade as large swaths of the Affordable Care Act (ACA) are enacted next year. Millions of baby boomers are also toddling toward Medicare eligibility and the consumption of even more medical services. Therefore, the overall market for basic lab testing is expected to grow, even though national labs such as Quest have struggled with flat revenues in recent years. “Hospital lab strategies seem to be the path independent labs are heading down,” said Piper Ellich analysts Kevin Ellich and Bradley D. Maiers said in a recent report. “While lab volumes have been weak for over 12 months, we believe the independent labs are focused on partnering and acquiring hospital labs and outreach programs.” But the strategy may be the best fit for national companies such as Quest and LabCorp, whose market power and cash hoards—nearly $1 billion combined—afford them a heap of patience. According to Piper Ellich, the bottom-line gains for the two Quest deals are relatively small: up to $80 million a year for the Dignity Health business and $30 million to $40 million for the UMass deal. That would represent a 1.7 percent bump in annual revenues based on Quest’s 2012 numbers. Moreover, Ellich and Maiers reported that volume at the UMass lab are down between 10 percent and 20 percent since the deal was announced—the kind of numbers Quest will be challenged to build back up over the coming years. Long Timelines Meantime, those looking for quicker gains may not find the market as attractive, observers say. “Quest is a global company. They plan on staying in the business for the long term, they have lots of money, and they are looking for hospital outreach to really grow their business and survive during health care reform,” said Susan Stegall, a laboratory consultant in Youngstown, Ohio. That may be why Quest—which did not respond to a request for an interview—has been diving into the hospital outreach market, while other seemingly big players for hospital outreach labs have been decidedly more hesitant to do so. “It’s a long-term strategy because there is still uncertainty in the larger market as to where this is going—there’s so much experimentation in new delivery models,” said Dennis Weissman, president of Dennis Weissman & Associates, a laboratory consulting firm in Washington, D.C., and founder of G2 Intelligence. “More providers are at risk, and there is a pretty strong sense that the industry is moving toward further realignment, and no [specific] sense in terms of where we’re going to end up.” However, that tends to play to the advantage of hospitals, according to Stegall. No matter how the ACA unfolds, they need capital to invest in health care information technology systems to deal with the influx of new patients and to meet many of the new quality care mandates. In California, systems such as Dignity Health have been spending billions of dollars to meet tough seismic standards that were introduced in the mid-1990s—in many cases, building replacement hospitals because it’s easier than retrofitting. “In this environment, with the reimbursements down, they can buy labs for cheap,” Stegall said. “A hospital CFO has to weigh the possible returns for the diagnostic area and where they can get more of a return,” Weissman said. “One of the options is to sell the lab if they can use the money for better returns.” Financial considerations or not, hospital labs tend to be toward the bottom of the hierarchy when considering strategic moves involving capital projects. Even for a relatively minor job such as redesigning the emergency room, it’s often recommended that hospitals scrap their existing lab space for the new project, according to Phillip Monteleoni, a veteran hospital architect who worked for decades in New York City before retiring several years ago. It is those factors, in part, that have been driving Regional Diagnostic Laboratories to take a decidedly different tack than Quest and LabCorp. On the Sidelines Carr admitted that his company “is on the sidelines” for now based on the current market conditions. The company Web site, which has been contracted to a single landing page, is being redesigned, he added. However, he dismissed whispers that the venture is being shut down. “It is our intention that this is temporary,” Carr said. “Warburg Pincus has a long time horizon and remains committed to me, RDX and the laboratory diagnostic space.” Carr told Laboratory Industry Report last fall that Regional had backed away from closing two deals, including one so close to completion that job postings for the lab were on the company’s old Web site. Regional has since backed away from additional opportunities, Carr noted, a decision he said was “wrenching” but would have led to the company owning assets that would now be worth substantially less than what they would have paid for them (due in part to the differences in payment for hospital laboratory services versus services provided by independent labs). “Our experience in the laboratory business over the last 25 years allowed us to see the early indications of a business downturn in the diagnostic laboratory industry,” Carr said. “We believed that laboratories would be challenged to navigate/counter the predicted trends we were foreseeing over the next 12 to 24 months.” Although Carr is optimistic that eventually the market will be primed for hospital outreach acquisitions, the time horizons envisioned by Regional, Carr, and Warburg Pincus may not be the same as Quest and LabCorp, according to Stegall. “(Carr) has a reputation of buying up labs and flipping them,” Stegall said. “His perspective and what he is trying to do is really different from what Quest is doing. He’s in it for the short term. He wants to get in there, fix up the asset, sell it off, and make money for his investors. I see it as two different strategies in this era of health care reform.”