Quest Diagnostics: A Bullish Prognosis for Investors

Includes: CRA, DGX, TMO
by: Todd Campbell

The biggest drag on healthcare profits over the past year has been lower utilization tied to job loss. As neighbors lost their healthcare insurance – and savings dwindled – fewer people opted for elective procedures and more people skimped on preventive care. That was bad news for diagnostic demand. But, with the jobs picture improving its time to reconsider lab plays, including Quest Diagnostics (NYSE:DGX).

Temporary staffing has long been associated as a leading indicator of full time job growth. Why? Because companies tip toe back into the hiring market exiting recession, unsure if returning demand is sticky enough to justify bringing on full time employees. But, as demand has persisted, job postings are rising. and commercial healthcare insurance enrollment is increasing alongside it.

In March, the ASA weekly staffing index – which measures temporary staffing demand – was 9% above March 2010. This is especially interesting given Q1 is typically the weakest quarter of the year for temporary staffing demand. and the Monster Employment Index, which measures full time job growth by tracking advertisers, ran at a 9% annual growth rate in March; a 14th consecutive month of year-over-year growth. Despite employment overhangs tied to government job cuts, private employment is healing. and that is good news for Quest.

Outside of private sector job growth, another important driver of future diagnostic demand remains legislatively mandated insurance coverage and an aging population. As more uninsured Americans gain access to care and get older, demand for testing will increase.

DGX generates a lot of cash, nearly $1.1 billion from operations this year, and it's spending it ahead of the upcoming demand. It has just completed its $740 million acquisition of Thermo Electron's (NYSE:TMO) Athena Diagnostics and has offered to acquire Celera (NASDAQ:CRA) in a $671 million deal announced in March.

The Athena deal, which brings along $110 million in annualized sales, boosts DGX's market share in neurological testing, including for Alzheimer's. The Celera deal gives DGX greater exposure to cancer and heart disease genetic testing, which unfortunately remain growth markets. Overall demand for gene-based and esoteric testing has grown to 22% of DGX's overall sales from a mere 9% back in 2000.

The deal also gives DGX Celera's 7% stake in stage 3 drug Odanacatib, being developed by Merck. That osteoporosis drug is estimated generating as much as $550 million in annual sales by 2015. Further, $327 million in cash on CRA's balance sheet goes a long way to easing DGX's risks.

DGX is also shareholder friendly. Last year, DGX bought back $750 million in shares and in January the company had $1 billion remaining on its buyback authorization. In January, DGX also announced it will buy back half of Glaxo Smithkline's stake in the company for $54.30, some 15.4 million shares, helping DGX boost EPS expectations to $4.25-$4.45 this year from $4.1-$4.3 (the rest of GSK's ownership is being sold in a public offering). The company has beaten Street estimates in 3 of the past 4 quarters and analysts are playing catch up. 2012 earnings estimates have increased to $4.93 per share from $4.82 30 days ago.

The company continues to invest in new products, including its ColoVantage colorectal cancer blood test and OVA1, an ovarian cancer test. The company is also advancing its healthcare IT solution, used by some 1800 physicians. As healthcare demand rises, newly acquired and organically grown products offer considerable revenue opportunity, suggesting investors buying today will see gains over the coming year.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in DGX, LH over the next 72 hours.