On January 1, 2018, a new law goes into effect that has the potential to wipe out a large portion of the 6,000 medical testing labs in the United States. And as smaller labs give up the ghost, large, publicly traded lab-testing companies will take much of the business of those smaller labs.

That’s because changes to Section 216 of the Protecting Access to Medicare Act of 2014 (PAMA) will result in the single most disruptive event to hit the clinical laboratory industry in the past quarter-century.

Medicare currently pays roughly $7 billion a year to laboratories performing more than 1,300 different lab tests. And the majority of those tests haven’t seen updated fee schedules since the last major change in 1984. 

#-ad_banner-#But that’s about to change. 

The PAMA update will cut the testing fees payable under Medicare’s Clinical Laboratory Fee Schedule (CLFS) by more than $5.4 billion over the next decade. This will significantly reduce the revenues of most of the small independent labs. 

And since 40%-60% of lab-testing volumes at small labs are exclusively Medicare patients, these labs will struggle to stay in business with the lower fee schedules. That’s because they have fewer customers and relatively high fixed costs.

Even worse, most economists expect private insurers will match the Medicare cuts, leaving only the most financially stable labs standing. Of course, this means the bigger labs will greatly benefit from the updated fee schedule, giving prudent investors an opportunity to grow their portfolios.

Who Benefits the Most?
One company will weather the lower Medicare pricing better than all other companies in the industry.

Quest Diagnostics (NYSE: DGX) is the largest provider of diagnostic lab testing services in the world. It has a $14.7 billion market capitalization and does $7.5 billion a year in sales. The company employs more than 43,000 people.

Quest serves one-third of all adult Americans needing testing and more than 300,000 doctors. Quest dominates the lab-testing market in the United States by a large margin and owns the world’s largest database of clinical lab results.

Amazingly, this is only going to improve once the smaller, less financially solvent firms begin to fold under the weight of the changes taking place New Year’s Day 2018.

Wide MOAT
Quest owns more than 700 patents, with another 570 pending. 

One of its subsidiaries, ExamOne, is the largest risk-assessment provider to the life-insurance industry in North America. The company also owns 3,700 courier vehicles and 23 aircraft for transportation of test specimens. 

The overall U.S. market for lab services is roughly $80 billion annually. About 60% of the market is served by hospitals, with the remaining 40% (about $32 billion per year) split between doctor’s offices and independent labs. 

Quest controls about 24% of this $32 billion market, and will certainly grab a bigger portion after January 1, 2018. And the total U.S. lab market continues to grow at about 2%-3% a year.

Putting it all together, Quest has created a wide moat that insulates the company from virtually all other competitors. 

Strong Free Cash Flow
Free cash flow (FCF) is the mother of intrinsic value. Free cash flow is a company’s cash flow less its capital expenditures. FCF represents the amount of cash a company generates after spending to maintain or expand its business. 

Here, Quest has a stellar record…

FCF peaked in 2012 at roughly $1 billion. Reductions in Medicare spending in 2013 reduced the company’s FCF to just $421 million. But it has reversed course since then.

The company generated $776 million in FCF last year, while it expects 2017 FCF to come in at about $825 million. Now, the reduced fees associated with Medicare lab testing could influence future revenues, but it’s unlikely. Here’s why…

The company is already the low-cost leader in Medicare lab services, and management expects to see no more than a 1% impact on its revenues. Of course, that’s only happens if Quest doesn’t take a single dollar of revenue from smaller providers who go out of business as a result of the Medicare changes, which is a huge stretch.

What Is Quest Worth?
At the end of the day, valuation is the most important factor in successful investing. A 1-year chart shows that DGX has had a remarkable run, with gains of 41.5%. But don’t let that fool you into thinking the company is fairly priced now. 

Quest currently trades at 17 times FCF — 13.7% lower than the average S&P 500 stock. Let’s put this in perspective. Most companies dominating their industry trade at FCF multiples of 25% or more. Given this, Quest should be priced between $145 and $155, or roughly 25% higher than today’s price.

Even looking at it from a conservative viewpoint indicates that Wall Street undervalues the stock. Quest upgraded its long-term forecast for revenue growth from 2%-5% per year to an average of 3%-5% per year. If so, shares should be trading closer to $130 — a 21.4% premium to today’s price.

Quest Is A Safe Investment
At a time when it’s difficult to find undervalued stocks, investors need to make sure that potential investments have room to run while maintaining a level of safety.

That describes Quest in a nutshell. It’s a dominant player in a long-term uptrend. Better yet, Quest dominates in a steady industry with sticky customer relationships and demand that keeps growing as the population grows. 

Risks To Consider: Social Security and Medicare are facing huge financing problems. As such, there is some risk that the U.S. government will be forced to make further cuts in welfare spending — directly affecting Quest’s revenue and earnings projections. 

Action to Take: Buy shares of Quest up to $110. Mitigate risk by using no more than 2% of your portfolio to shares of DGX. Hold the position until shares reach full value above $140 per share. Use a hard stop of $95 to protect the downside. 

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