Quest Diagnostics Gets Much Cheaper - But is It Now Cheap?

I have to admit, sometimes I can be a bit of an ambulance chaser. One of the guiltier pleasures I indulge in my search for stocks is a periodic check of top percentage losers -- stocks owned by legions of hopeful investors who were wrong. Very wrong. In a single day, 10, 20, 30, even 50 percent of their investment- wiped out. Humbling as this is, I’m not here to dwell on the vanity of man. I’m here to find the glimmers of hope that remain in the ashes, dust them off, and if they appear to have value, place them in my own pocket.

Quest Diagnostics (DGX) dropped 17.90% Tuesday (10/3) to $50.00 after announcing that it had lost a long term contract with UnitedHealth Group (UNH). UnitedHealth opted to give the 10 year, $3 Billion deal to a smaller rival, Laboratory Corporation of America (LH). Quest revealed that United Health had accounted for 7% of its buisness, and was its largest customer.
Though Quest did not address Q3 performance which it will be releasing on 10/19, the current contract runs through the end of the year, so impact on 2006 numbers should be minimal.

Quest did not release any information on what impact this will have on 2007. Though Quest will continue to be under contract to UnitedHealth in 2 small markets, and will continue to compete for non-contract work, it is probably reasonable to assume a worst case in which 7% of Quest’s revenue disappears.

Though Quest gave no guidance on earnings impact, they did reveal that margins on UnitedHealth business were not significantly different than the rest of the business. Without knowing what percentage of costs are fixed, it’s difficult to estimate what the earnings impact might be. It’s almost definitely greater than 7%. Jeffrey Loo at S&P lowered his 2007 EPS estimate $0.05 to $3.38, but I haven’t seen the report and it’s difficult for me to see why he sees the impact as so minimal, unless he believes that Quest will initially retain more of this business on a non-contract basis. Quest is set to earn (according to their guidance of 9/6) between $2.95 and $3.05. With next year’s estimates previously showing 10-15% earnings growth, and assuming a drop of 7-10% in earnings from the loss of UnitedHealth business, it’s hard to see how Quest can grow earnings by more than a few percent.

Quest has been making small, focused acquisitions of companies that manufacture propietary tests. In July, it purchased Focus Diagnostics, a maker of tests for diseases such as Lyme Disease, SARS, West Nile Virus and Herpes Simplex Virus, for $185 million in cash. Last month, it purchased Enterix, which produces a test for colorectal cancer, for $43 million in cash.

Quest’s liberal use of cash may be some cause for concern. In addition to acquisitions, the company has spent significantly to buy back shares. In the first 6 months of 2006, the company bought 4.6 million shares for $254 million. During the same time period, the company reissued 3.2 million shares for employee benefit plans, so despite the big outlay, the share count is not getting much smaller. The company also pays a $.10 quarterly dividend at a cost of nearly $20 million per quarter. At the same time, the company’s long term debt continues to hover above $1.2 billion.

Quest trades at 16.7 times 2006 earnings, and the company seems on track to earn at least as much next year, for a forward P/E of under 16.7. Obviously, there’s risk here as the numbers are unclear.

Quest isn’t an expensive stock, but at this point, for me at least, the potential reward doesn’t support the risk. While the stock is likely to move higher, the uncertain earnings impact of the Quest deal, questions surrounding the company’s ability to continue to grow earnings at a 10-15% rate, and questions surrounding balance sheet and share dilution are keeping me away.

Disclosure: I own none of the companies mentioned (DGX, LH, UNH)