Quest Diagnostics Fundamental Analysis

Quest Diagnostics’ narrow moat rating does not mean that the company does not excel well in creating an economic moat. Rather, the company has a well-balanced source of moat, but none stands out except for its cost advantages.

Quest Diagnostics and its primary national competitor, LabCorp, dominate independent diagnostic testing in the U.S. by building a vast network of laboratories and patient service centres across the country. The industry has also witnessed steady consolidation as both companies have acquired smaller competitors. This inevitability created barriers to entry and generated significant cost advantages over regional and hospital labs.

With an extensive network of laboratories and patient service centres, it presents a challenge for new entrants to replicate from scratch. In addition, Quest Diagnostics’ robust and well-established processes lower the risk of quality and reliability issues. New entrants without a track record may find it difficult to compete in terms of quality and reliability.

Besides barriers of entry that the company has created, Quest Diagnostics generates significant cost advantages due to its scale and volume. The company’s cost structure and national coverage also attract payers that structure reimbursement and policies to funnel patients to the large independent labs that offer lower prices. This is one key trend that the clinical testing industry is observing in the U.S. healthcare system.

Independent Delivery Networks (IDN) including hospitals and hospital health systems, which provide outreach testing and may encourage clinicians to send their outreach testing volume to the IDN's laboratory, historically were able to negotiate higher reimbursement rates with health plans than commercial clinical laboratories for comparable services. In addition, health plans generally reimburse non-participating laboratory testing providers at higher out-of-network rates. Quest Diagnostics is finding increased interest among health plans in driving better value in spending for laboratory testing. Health plans increasingly are taking steps to encourage the movement of testing volume to high-value, lower-cost providers like Quest Diagnostics, including by identifying preferred provider partners, plan design changes (e.g., zero-dollar out-of-pocket costs for members using preferred providers) and better aligning reimbursement rates for IDN-based providers and independent commercial laboratories. The UnitedHealthcare Preferred Lab Network, which chose Quest Diagnostics to participate, is a recent example of a health plan taking these steps.

With cost advantages being the only exceptional source of moat for Quest Diagnostics, I will assign the company a narrow economic moat rating.

Quest Diagnostics’ performance is satisfactory. The company’s revenue, earnings and operating cash flow are increasing year on year for the past 5 years. It also maintains a positive cash flow. However, Quest Diagnostics’ gross margin varies from year to year, and it is below its industry average.

Quest Diagnostics meets my requirements for ROE but not ROIC. The company achieves more than 12% ROE consistently over the past 5 years and is above its industry average. However, its ROIC has been hovering around 9% - 10% over the past 5 years. Despite a low percentage point, Quest Diagnostics ROIC is still two times more than its WACC.

Quest Diagnostics meets all my requirements for a good balance sheet. Its current ratio and debt-to-EBITA are satisfactory but still perform below its industry averages. Although Quest Diagnostics’ debt-to-equity ratio has reduced over the past 5 years, it is still considered high.

With a narrow economic moat, decent performance, and financial health, I will assign a 40% margin of safety. So, with an estimated intrinsic value of $181.25, I will only purchase the stock if the price is trading around the $110 range.