quest diagnostics inc dgx

Quest Diagnostics, Inc. (DGX)

By: Steve Rubis

Leading Clinical Testing Company Seems Primed For Purchase

Recommendation: UNDERVALUED, possibly in play.

Quest Diagnostics 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

Return's 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. (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.

Valuation:

The thesis above argues that Quest Diagnostics is a take out 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 American Holdings, 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 take out 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 no 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%.

*Note: the author does not own any shares in Quest Diagnostics, Inc.

**The Author cannot be held responsible for any gains or losses

achieved through trades based upon information presented herein.

***The majority of data comes from Yahoo!Finance, Google Finance, and

the 10-K and 10-Q reports.

****The author current holds the following on the long side: Agilent