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Quest Diagnostics Tests Positive for Value, Negative for Growth

Quest Diagnostics (DGX) is the largest independent clinical testing laboratory firm in the U.S., operating 2,000 service locations nationwide. About 65% of sales are generated through routine testing such as blood cholesterol or disease markers. 25% of sales come from esoteric testing, very complex tests involving gene-based or molecular analysis. About 3% of sales comes from performing illegal drug testing for employers, and the remainder comes from the firm's healthcare IT division.

As a prospective investment, Quest has a few really good traits. First of all, this is a stable, relatively predictable business. Unlike putting off that new car purchase or cutting back on eating out, people don't frequently put off necessary medical testing during a recession. Also, Quest operates a duopoly with LabCorp (LH) in the independent lab market, giving it significant doctor recognition and pricing advantages over would-be smaller competitors. Quest's stability is demonstrated through its financials. Revenues barely budged during the 2008-09 recession, and operating margins have remained in the 16-17% range for over a decade!

With these stable cash flows, Quest has rewarded investors by returning cash to them. The company has reduced share count by an average of 4% per year since 2008, and last year raised its dividend by an impressive 76%. The stock now yields over 2%, and the payout of free cash flow with the new dividend will still only be about 20%, a very safe level.

Now let's talk about the less desirable traits. The most obvious one is right on the top line of the income statement - where is the growth here? The just completed 2012 fiscal year saw revenues a whole 2% higher... than 2008! And this includes the 2011 acquisition of Celera and the 2010 purchase of Athena Diagnostics, among others. The truth is that diagnostic testing is a mature and stagnant market in the U.S. Despite trying to break into higher-margin esoteric testing, Quest hasn't shown much success so far. And while "Obamacare" could lead to a greater number of newly-covered patients entering the market in the next few years, increasing consolidation and cost cutting in private health care insurance and Medicare will make it very difficult to increase - or perhaps even maintain - pricing. Revenue growth has been and will continue to be a challenge for Quest.

This becomes even more of a concern when we see how margins have slid over the past 4 years. For most of the last decade, Quest had comfortable operating margins around 18%. However, they have slid steadily over the past 4 years: 17.6%, 17.2%, 16.1%, and 15.7% last year. Most of this has been on the cost of services line, a tell-tale sign of weakening pricing power.

Finally, Quest has just an "okay" balance sheet. Debt, at $3.4 billion, is over 10 times cash on the balance sheet ($300 million). While operating earnings cover interest 7 times over (a safe ratio), Quest isn't really in a great position to pursue any business-altering acquisitions or transformations at present.

At the end of the day, Quest is the kind of equity people think about when they speak of "value stocks". Stable business, generates plenty of cash, pays a dividend, buys back stock, not a lot of growth. My problem is, these kind of stocks need to be really cheap before they are worth buying. Quest isn't there right now. My fair value is about $65, about 19% above current levels. I'd like to see the stock drop into the mid or low $40's before getting interested.

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