2 Large Blood Testing Companies Stand To Be Disrupted

| About: Quest Diagnostics (DGX)
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Summary

A new blood testing technology is going to bring pain for Quest Diagnostics and Laboratory Corporation of America.

Ordinarily, the chance of a new technology would just be enough to bring a risk to the companies exposed. Here, however, the level of certainty is higher.

The level of certainty regarding the disruption is higher, because there is enough proof that the technology works, is being deployed and is massively cheaper and better.

The idea for this article came from a Chris DeMuth Jr. stocktalk, where he linked to a New Yorker article titled "Blood, Simpler". This article is about Elizabeth Holmes, and how her company, Theranos, is seeking to revolutionize blood and fluid testing.

Quest Diagnostics (NYSE:DGX) and Laboratory Corporation of America (NYSE:LH) are the two largest players in the blood and fluid testing market in the U.S. market. These have market capitalizations of $9.2 billion and $8.6 billion, respectively. On the surface, these are not particularly expensive stocks, trading for TTM Price/Earnings of 18.2 and 17.1 - especially since both companies enjoy interesting ROEs and operating margins.

But, being very familiar with blood testing myself, by taking dozens of these tests per year, and based on what's in the New Yorker article, I can confidently say that these two companies will be disrupted. And either today's blood testing technology, provided to these companies by third parties like Roche, evolves rapidly to meet Theranos' challenge or these companies will over time have trouble keeping themselves alive.

Either way, technology or no technology, these companies will suffer mightily, because the prices Theranos is able to charge will always imply a significant deterioration in trade terms for the established players.

My reasons for saying this

Why do I say that this disruption is highly likely to take place? For many different reasons, actually:

  • There is a wide swath of the patient community that hates drawing blood and if given a choice like the one presented by Theranos - equivalent to a finger-prick similar to those the diabetics use to get their blood sugar levels - they will choose it massively. This includes not just adults but especially children, on which very few parents will probably be willing to use the old method if a much simpler and painless one is available;
  • You never get used to drawing blood. I speak from experience - it gets much easier over time and it doesn't bother you, but if you had an alternative such as the one presented, most would choose it over using a needle even if their discomfort is already low;
  • The analysis process, though not known outside the company, is already validated by work done for other pharmaceutical companies in clinical trials, as well as by sales to the military. These entities certainly correlated and validated Theranos' results before using them regularly;
  • Theranos charges prices much lower than the established companies. Indeed, it never charges above 50% of the Medicare reimbursement rates, and can go as low as 90% or more below those rates. It's likely that the average established laboratory is selling at, and above, those rates;

There are other details to the story, including trying to give the patient more control and access to its own health data, having patients initiate blood testing instead of doctors or having the tests be faster. But what will really disrupt this industry is the fact that the tests are much cheaper and much more comfortable for patients.

The tests being much more comfortable for patients will draw demand from patients as well as doctors which want their patients to be as comfortable and as compliant as possible.

The tests being much cheaper, will be something of interest to every payor, be it Medicare, the patients, or insurance companies - but with the tests being reliable, it's likely that there will be tremendous pressure from insurance companies to adopt them. And remember, we already have reason to believe the tests are reliable - from their usage by other pharmaceutical companies in clinical trials, as well as from the U.S. military using them.

The impact

This disruption is not just about a newer and better technology entering the market. It's also about the magnitude of the change that it implies for the established laboratories.

The pricing Theranos is putting of the table is 50% or more (up to 90% or so) below what Medicare lists in its reimbursement rates for blood and fluid tests. The established laboratories certainly charge those rates and higher, on average. And this means a large problem for them, since at the very least they're charging double to 10 times more than Theranos for the blood tests.

Even assuming double over the entire test suite, this must be terrifying, because the gross margin for Quest Diagnostics is just 37.8% over the last 9 months (Source: Latest 10-Q), and the gross margin for Laboratory Corporation of America is 36.8% over the same last 9 months (Source: Latest 10-Q). What this implies is that at the pricing Theranos is practicing, there won't be any gross margin at all for these two companies.

That's on top of it being more comfortable for the patients. In short, this type of testing will probably take off rapidly, with pressure from patients, insurance companies and at least some doctors.

While we are in some kind of IPO bubble, it's still noteworthy that Theranos already carries a $9 billion valuation. The private market clearly believes in this disruption, even if for now the stocks of the two most at-risk companies don't seem to reflect it.

Conclusion

Theranos is bringing a new technology to the blood and fluid testing which stands to disrupt the two largest blood testing laboratories in the market.

While usually the emergence of a possible new technology would not be enough to have any kind of certainty regarding such disruption, here there are ample reasons to believe otherwise, including:

  • The results from the new technology are already being used and validated by several institutions;
  • The advantages (especially cost and comfort) of the technology for patients and insurance companies are obvious;
  • and we know this works as advertised because even Walgreens (WAG) is already deploying these tests to the general public.

There's little reason to believe this won't have a significantly disruptive effect on the existing providers. As such, I believe that in spite of not having incredibly challenging valuations, both of these companies - Quest Diagnostics and Laboratory Corporation of America - are a clear avoid in the long term.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.