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Summary

  • If you’re Quest Diagnostics and Laboratory Corp. of America, a medical testing startup, Theranos, may pose a threat.
  • Theranos performs conventional blood tests with a fraction of the amount of blood used by Quest and LabCorp, it charges less and provides results faster, and there’s less pain involved.
  • The threat -- while not immediate to Quest and LabCorp – could be substantial.

By Jeff Bailey

What sounds more threatening: the combination of Obamacare and giant private insurers like UnitedHealth Group (NYSE:UNH) moving to reduce the cost and at times frequency of medical testing; or a 30-year old vegan and college dropout with some famous friends?

If you’re Quest Diagnostics (NYSE:DGX) and Laboratory Corp. of America (NYSE:LH), it may be the dropout, named Elizabeth Holmes, who left Stanford to launch a medical testing startup, Theranos, that has raised $400 million of investors’ money, valuing the company at $9 billion, and already operates testing sites at a handful of Walgreen (NYSE:WAG) stores, with the potential of thousands more to follow.

Theranos and Holmes a week ago were the subject of an admiring Fortune magazine article that had a former Stanford chemical engineering professor of Holmes – now her employee at Theranos – comparing her to Steve Jobs and Bill Gates. Make that super admiring.

The back issues of business magazines are full of the Next Big Things we’ve never heard from again, of course, and problems with regulation, technology, competition or management could upend this Cinderella story. Theranos (you really should read the Fortune article; it’s fascinating and well-reported, and asks all the right questions even if it can't get them all answered) performs conventional blood tests with a fraction of the amount of blood used by Quest and LabCorp and others, we’re told in the article; it charges less and provides results faster; there’s less pain involved (Holmes, we learn, is also needle-phobic). And it builds its own diagnostic equipment, while Quest and LabCorp buy theirs from the likes of Siemens (OTCPK:SIEGY), Olympus (OPCNY) and Beckman Coulter.

Credible people vouch for the science. Holmes says she’s determined to bring transparency to medicine, but of course keeps much of what’s going on at Thernanos secret, for competitive reasons we’re told. Fair enough. (Holmes’ board includes former Secretaries of State Henry Kissinger and George Shultz and former U.S. Senators Sam Nunn and Bill Frist. David Boies, the famous litigator, provides advice.)

If most of what’s reported by Fortune pans out, the threat -- while not immediate to Quest and LabCorp – would be substantial. The companies’ innovation has been to consolidate and standardize lab testing, rolling up hundreds of little competitors. That has made their dominance seem inevitable. Doing so, however, they’ve built large corporate establishments on the assumption that pricing will be stable.

DGX Total Employees (Annual) Chart

DGX Total Employees (Annual) data by YCharts

Some disappointing forward guidance sent the shares of Quest and LabCorp plunging last December, and we were moved to recite the many pluses of their businesses. Insurers -– the government and private companies –- have been lamentably poor at reducing healthcare costs for decades, so why would we bet they’d be any good at it now?

Their stocks have rallied since the December plunge and they now trade at a forward P/E ratio closer to 15, as opposed to the 12.5 or so when they scraped bottom. The current multiple is reasonable for a wide moat company -– one with significant barriers to entry that protect its business.

DGX PE Ratio (Forward) Chart

DGX P/E Ratio (Forward) data by YCharts

Barriers remain, and still must be torn down, even should Theranos (or some other smaller, cheaper, faster lab outfit) effectively scale its business. But one can at least envision a scenario over the next decade in which Quest and LabCorp are forced to cut price to hang onto business and forced to invest in expensive technology like that at Theranos. That could narrow profit margins further.

DGX Profit Margin (Quarterly) Chart

DGX Profit Margin (Quarterly) data by YCharts

And divert capital that has been going to aggressive stock buybacks in recent years, which has rewarded shareholders by substantially reducing shares outstanding.

DGX Shares Outstanding Chart

DGX Shares Outstanding data by YCharts

Disclosure: None

Source: Bloody Disruption: New Threat To Quest, LabCorp