The independent diagnostic testing business in the United States is essentially a duopoly that is dominated by Quest Diagnostics (NYSE:DGX), with a market capitalization of about $9.2 billion and annual revenue of about $7.5 billion, and its chief rival Laboratory Corporation of America (NYSE:LH) with a market capitalization of about $8.8 billion and annual revenue of about $5.5 billion. Between them, Quest and LabCorp, as Laboratory Corporation is commonly known, operate most of the independent commercial labs that comprise about 33% of the approximately $45 billion market in the United States. In-house hospital labs comprise about 60% of the market with small regional independents making up the remaining 7%. Quest and LabCorp have established barriers to entry through their vast networks of laboratories and patient testing centers that I believe will be sustained over time. This competitive advantage has historically allowed both companies to capture market share and generate strong cash flow relative to smaller regional competitors even though the domestic testing business is mature and characterized by slow growth.
Quest is pursuing a strategy that should grow the business at a higher rate than the industry and cement its place atop the commercial diagnostics field. This strategy includes overseas acquisitions to consolidate the highly fragmented international testing market, particularly in India, and shifting its product mix to higher margin gene-based and "esoteric tests" which are complex and require skilled technicians to administer. Due to acquisitions, esoteric tests grew by about 17% in 2011 and gene-based and esoteric testing combined increased their contribution to Quest's total sales from about 22% in 2010 to about 25% in 2011. As Quest increases its market share of esoteric and gene-based testing to a level closer to LabCorp, the leader in this niche market, their contribution will grow to more than 25% of total sales, offsetting expected pricing pressure on routine testing.
The entire industry will also benefit in the years to come by a return to the normal rate of doctor visits by patients that declined as the economy weakened; a surge of newly insured customers in 2014 due to federal health care reform mandates; and an aging domestic populace that is expected to demand more esoteric testing that hospitals will outsource to independent laboratories like Quest and LabCorp. Quest is positioned to capitalize on these trends more than its competitors due to its low cost structure, scale, and focus on esoteric testing.
Quest was at a recent price of about $58 per share so investors are paying a price to forward earnings multiple of about 12.7x based on analysts' estimates of about 2.0% growth in earnings per share to $4.55 in 2012 from $4.46 per share, adjusted for non-recurring charges in 2011. This indicates a lofty price to earnings to growth multiple of about 6.4x. However, looking ahead another year, Quest's price to forward earnings multiple is 11.5x on earnings per share of $5.05 estimated for 2013. I firmly agree with this earnings estimate of about 11% growth over the $4.55 earnings per share estimated for 2012 due to the anticipated improvement in the overall economy and doctor visit rates, growth in the number of patients in the U.S. market due to aging demographics and more demand for high margin esoteric tests, and consolidation by Quest of international markets, beginning with India. The price to earnings to growth multiple being paid at the recent $58 share price is a much more appealing multiple of less than 1.1x for 2013. As a long term investor I am willing to pay a reasonable amount for growth two and even three years out and Quest presents such an opportunity at $58 per share. This is especially appealing because Quest has recently bumped up its dividend payout by a whopping 70% to $0.17 per share quarterly beginning in 2012 from $0.10 per share quarterly in 2011. Quest also announced an added $1 billion to its share buyback program which equals about 11% of current market capitalization. The dividend yield is currently about 1.1% which by itself is not a particularly compelling investment rationale but does provide a return to investors greater than can be found on savings accounts or treasuries, with the added kicker of probable capital gains from share price appreciation.
A discounted free cash flow analysis indicates that investors could realize a return before dividends of about 8.5% over the next three years if Quest is able to grow free cash flow at about the same 5% rate that it has managed since 2002. Free cash flow at the end of three years would be about $809 million which would result in a free cash flow yield of just under 9% at the current market capitalization of about $9.2 billion. Another way to look at Quest is that investors today would be paying about 11x conservatively expected free cash flow in 2014. This is a very reasonable price to pay for the leader in a duopolistic market that should have faster growth in the coming years than in the past two years which saw the industry challenged by a historic financial collapse and subsequent weak economy. Quest is poised to accelerate its growth and investors are very likely to realize outstanding total returns if they can remain patient.
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