Quest Diagnostics Seems Primed For Purchase

| About: Quest Diagnostics (DGX)
This article is now exclusive for PRO subscribers.

Quest Diagnostics (NYSE:DGX) is the industry leader in clinical testing solutions. The company provides both clinical testing and anatomic pathology testing. Strong management performance, coupled with an attractive equity value, causes us to provide further research on Quest.

Investment Thesis:
Recent offers to buy Bausch and Lomb (BOL) by American Medical Optics, Inc. and Warburg Pincus suggest that Quest Diagnostics could be the next to be bought. Management performance is strong in terms of Returns on Assets and Equity; the fact that Quest is the industry leader further confirms our assessment of management.

Investors should pay close attention to the current valuation of Quest Diagnostics, Inc. A few days ago, we provided some links to the trading action in Quest shares. The heady action in July $55 and $60 calls suggests price movement to the upside. Current share prices are due to the loss of UnitedHealth Group, Inc. (NYSE:UNH) as a client, due to UNH’s demand for cheaper prices.

Based on the financial data at hand, it seems that DGX is undervalued and offers investors an opportunity to achieve a 30% return.

The thesis above argues that Quest Diagnostics is a takeout target based on other purchases currently pending. In order to fully understand the fair value of Quest shares, multiple comparisons are in order.

Table 1: Value of Quest Diagnostics, Inc. Shares in Comparison to the Industry

The table suggests that the industry leader is undervalued in terms of the entire Medical Labs and Research Industry. First, Price and EV to EBITDA values are the key component of our valuation analysis. These values provide us a preliminary valuation range for what a private equity investor or another firm might be willing to pay for Quest. The next three prices give the investor an idea of what Quest is worth on a relative basis in terms of the entire Medical Labs and Research Industry. Quest performs quite well, despite a lackluster showing on Price to Book Value. Lastly, our analysis considers Earnings Power Value and Reproduction Value in order to get a better sense of what Quest is truly worth. These last two values allow investors to obtain a price of Quest’s income stream, as well as what it would cost to reproduce the business or start over from scratch. Reproduction value helps understand what it might cost a competitor to recreate Quest’s business rather than making the outright acquisition.

Table 2: Comparison of Valuation Metrics for Quest Diagnostics, Inc., Laboratory Corporation of America Holdings (NYSE:LH), and the Medical Labs and Research Industry

Table number two compares the valuation metrics of Quest to its main competitor and the industry. Quest is mildly under value in terms of its main competitor Laboratory Corp of America. Each are similarly valued on a takeout basis, but the similarities end there. Quest appears undervalued on both a Price to Sales and Price to Earnings basis. A reason for this undervaluation can be attributed to the 7% loss of revenue due to losing UNH as a client (see 4/30/07 10-Q).

Table 3: Valuation of Quest Diagnostics in Terms of Laboratory Corp. of America Holdings and the Medical Labs and Research Industry

Table Three applies the values illustrated in Table Two in order to develop a valuation range for Quest Diagnostics, Inc. Our original range as described in a previous article was $75 to $85. The analysis in this article places that range a little lower at $68.07 to $77.82.

Despite any issues about revenue growth, Quest should be trading closer to the $68 to $71 range. Since Quest is the industry leader, an investor can reasonably expect DGX to trade a price near or above the same valuation of the main competition.

Table 4: Selected Financial Data

The key takeaways of Table Four are the slowing EPS growth as well as the impressive Altman Z Score. An assessment of the financials shows that the company is not likely to hit insolvency, has strong management, and despite a slowing growth rate, EPS is not declining.

Business Prospects/Model:
Quest Diagnostics, Inc. is the leading provider of diagnostic testing services, which include clinical testing and anatomical testing. Over 90% of revenues were generated by the clinical testing business through over 2000 testing centers. The clinical testing service offerings are as follows: blood cholesterol levels, blood chemistries, complete blood cell counts, Pap tests, urinalyses, pregnancy and other pre-natal tests, alcohol and other substance-abuse tests, and asthma and allergy tests. The services offered by the anatomical or esoteric testing segment are: endocrinology and metabolism, genetics, hematology, immunogenetics and human leukocyte antigens, immunology, microbiology and infectious diseases, oncology, serology, and toxicology.

The revenue can be broken into five major segments: patients; Medicare and Medicaid; physicians, hospitals, employers and other monthly-billed clients, Healthcare insurers-Fee-For-Service, and Healthcare Insurers-Capitated. Fee-For-Service makes up between 40 and 45% of annual revenues, with the Healthcare Insurers-Capitated being the most problematic and price sensitive. UNH’s policy changes, which demanded lower pricing and unattractive contracts for DGX, drove flat earnings in the 1st Quarter of 2007. Quest expects the loss of UNH as a customer to slow growth between 7 and 10%.

Disclosure: The author does not own any shares in Quest Diagnostics, Inc.