+100% Upside Within a Few Years for This Market Leader

Recent healthcare reforms will add an estimated 30 million new patients into the system within the next few years. That means more office visits, medical procedures — and lab tests.

Lab tests impact a very high proportion of healthcare decisions and will also become increasingly important as medical advancements will make the course of treatment even more important. Personalized medicine over one-size-fits-all drugs and treatments is another major secular trend working in favor of the lab testing business.

There are only two dominant players in the lab testing industry: Quest Diagnostics (NYSE: DGX) and LabCorp (NYSE: LH). Both look interesting given the favorable industry tailwinds, but Quest stands out because it is the larger firm and also has a low valuation and potential for improving profits closer to the levels of its archrival.

Quest Diagnostics reported sales +55% higher than rival LabCorp, and controls about 15% of the diagnostic testing market. This may not sound like a dominant industry position, but it is when considering that other independent labs hold a combined 20% of the market, and that much of that share belongs to the smaller LabCorp. In other words, Quest is a giant among independent labs, and this brings pricing power and other negotiating clout. Hospitals control 60% of the market, with physician office labs holding the remaining 5%. Despite the size of hospital share, they obviously aren’t focused primarily on lab testing, so they represent a fragmented and disjointed group.

Quest has grown to one of the dominant players in the industry through organic means and a steady stream of acquiring smaller rivals. This has led to impressive trends in the past decade, where sales have improved +13% each year. Earnings growth has averaged +22% annually in this timeframe, as management has been able to cut costs and create other synergies from acquisitions. A close focus on cost controls and negotiating power has also allowed it to achieve sales leverage (growing profits faster than sales).

Quest likes to point out that lab testing influences more than 70% of healthcare decisions, as it helps diagnose potential illnesses and can lead to a course of action, such as surgery, treatment by drugs or further testing. A number of favorable industry trends will continue to boost its operations, including older populations that will require more testing and treatments, scientific innovations, a move to more personalized medicine, and information enhancements that can improve decision making in the industry.

Quest benefits from personalized medicine through its gene-based and esoteric testing services. Gene-based tests help doctors determine which types of treatments are likely to be most effective for individual patients. Esoteric testing refers to more complicated tests, such as determining a patient’s metabolism or investigating abnormal cell growth. As you might guess, these categories carry a much higher margin, and Quest has managed to double revenue in these areas in the past decade to comprise 20% of sales.

Since Quest is now one of the two largest players in the industry, growth by acquisition is harder to achieve. However, international expansion will take its place. Management has a goal of having 10% of total sales come from abroad over the long haul. It will also keep moving into higher-margin tests and cutting costs to boost operating margins to 20%. As a comparison, last year LabCorp logged a 20.4% operating margin, so we know higher profitability is achievable.

Action to Take —> In the nearer term, Quest expects up to $4 in earnings per share for this year and roughly flat sales. Free cash flow should reach close to $1 billion, or about $5.32 per diluted share. At the current share price, this gives the stock a forward free cash flow multiple below 10. At this low valuation, the market is basically saying that Quest will not grow in the next decade. I think this is overly pessimistic for a market that is about to have 30 million new patients in the system in the next few years.

Based on my discounted cash flow analysis, if the company can manage to grow cash flow at +5% annually for the next five years, then the shares are undervalued by -40%. And if it can manage +10% growth in this period, then the stock can easily double from current levels. I think this is very achievable and closer to more historical growth rates, which means that more of the same going forward is all Quest has to do to make shareholders significantly wealthier. Compared with to LabCorp, both are appealing, but Quest is the better buy right now.