Why Response Genetics Could Be the Business Cure for Quest Diagnostics

Source: Thinkstock

Source: Thinkstock

Quest Diagnostics Incorporated (NYSE:DGX) is one of my favorite companies. In this article, I will discuss why it desperately needs to do something to spark interest and growth back into the stock. I believe there is severely undervalued company that it could acquire to provide some much needed growth in diagnostics services.

For those unfamiliar with the company, it provides diagnostic testing information services in the United States and internationally. The company operates in two businesses: Diagnostic Information Services and Diagnostic Solutions. It offers clinical testing services, such as routine testing, gene-based and esoteric testing, anatomic pathology services, and drugs-of-abuse testing, as well as related services and insights. It also offers laboratory testing services for new drugs, vaccines, and medical devices; and risk assessment services for the life insurance industry. The company also develops, manufactures, and markets diagnostic products, including Simplexa molecular chemistries for testing infectious disease and hospital-acquired infections.

It has speciality products like the HerpeSelect HSV serology, DxSelect IFA, and ELISA products for testing infectious diseases. In addition, it provides molecular diagnostic products in various segments, such as HIV-1 drug resistance testing under the ViroSeq brand name and reproductive genetics and transplantation under the brand names of Atria and AlleleSeqr. Further, the company offers Care360 EHR, a solution that allows doctors to electronically create, manage, and distribute patient encounter notes, including vital signs and progress notes. The company offers its diagnostic information services to patients, physicians, hospitals, integrated delivery networks, health plans, employers, and others through a network of laboratories, patient service centers, and phlebotomists in physician offices.

In this sector, organic growth can be tough to come by. You often have to design, test, and then receive approval for new diagnostics, and this process can take many years. Further, selling your products requires contracts, and they can be tough to sign. Since I have long been a shareholder of this company and the stock has been flat in the last year, the company needs new sources of growth. There is one severely undervalued company that Quest could purchase for instant growth. This company is Response Genetics (NYSE:RGDX). The company is worth just $37 million. Assuming a premium purchase of $100 million, the entire company could be bought for about $2.50 per share, possibly even $2.00 a share. Quest could easily afford it.

For the first-quarter of 2014, adjusted operating income from continuing operations was $236 million, or 13.5 percent of revenues, compared to $272 million, or 15.2 percent of revenues, for 2013. For the first-quarter of 2014, reported operating income from continuing operations was $208 million, or 11.9 percent of revenues, compared to $227 million, or 12.7 percent of revenues, in 2013. Cash provided by operations during the first-quarter of 2014 was $84 million, compared to $47 million in the first-quarter of 2013. Thus, the company brought enough cash from operations in just a single quarter to fund this purchase. But why should Quest do this?

The answer is the company needs growth to resume its share price appreciation as well as to maintain and grow its dividend. Response Genetics is a cheap and reasonable acquisition for Quest for several reasons. Response Genetics is focused on the development and sale of molecular diagnostic tests that help guide cancer therapy selection, which is growth into a segment that Quest can always capitalize on. Response Genetics recently announced the availability of new testing capabilities to advance cancer immunotherapy clinical development. The Immuno-Oncology assay, which runs on HTG Molecular’s Edge System, is designed to measure the RNA expression of 26 commonly investigated immunotherapy related genes enabling screening for response to immunoregulatory pathways.

The Immuno-Oncology test will be made available to all of Response Genetics’ existing biopharmaceutical partners and new potential partners to aid in development of biomarker driven cancer immunotherapy clinical trials. As the field of cancer immunotherapy continues to expand with potential immunotherapeutic targets in a broad range of malignancies, this test will help grow sales at Response Genetics. Regulation of the immune system is the key to several therapeutic approaches for cancer treatment. A number of clinical development programs being pioneered by large pharma are focused on signaling pathways like PD-1, PD-L1, OX-40, LAG3 and CTLA4 with the goal of enabling the immune system to attack cancer cells. The new assay covers these pathways as well as numerous other targets.

This is just one area of the company’s developments that are relevant for Quest. The company is also expanding internationally. Response Genetics recently announced execution of a commercial agreement with DxMDiagnostico Molecular, a leading distributor for cancer testing in Mexico, to offer the ResponseDX testing services to patients throughout Mexico. The agreement covers the ResponseDX: Tissue of Origin test as well as the other targeted molecular tests in the Response Genetics portfolio. The ResponseDX: Tissue of Origin test is an FDA-cleared test that uses gene expression analysis to provide a definitive diagnosis for poorly differentiated or metastatic cancers without a clear primary origin. While Quest has a number of its own exams this acquisition makes sense for shareholders. Further, Response Genetics has recently signed a major deal with major provider networks.

Quest could capitalize on Response Genetics deal where it recently signed agreements with six additional health plans across 10 states bringing Response Genetics total national contracted membership to more than 174 million lives. The new agreements include additional Blue Cross Blue Shield contracts in Arizona, Iowa, South Dakota, Pennsylvania, Delaware, and West Virginia. The company also signed new agreements with an Independent Physician Association (covering two states) in the North West region and a Commercial Health Plan (covering two states) in the North East region of the United States. These partnerships mark a further step forward in Response Genetics’ growing managed care contracting program. With these agreements, Response Genetics is now in-network with a total of thirteen Blue Cross Blue Shield health plans, which brings the total number of “Blues” subscribers with direct access to Response Genetics to approximately 23 million. Among Response Genetics’ other Blue Cross Blue Shield contracts are Blue Cross and Blue Shield of Illinois, Blue Shield of California, and CareFirst BlueCross BlueShield.

Quest Diagnostics has been stuck for a year. While the company is cheap trading at only 10 times earnings as well as offering a 2.2 percent yield, it needs growth. In its last quarter, revenues from diagnostics dropped. Revenues from continuing operations were $1.75 billion in its most rcent quarter, 2.3 percent below the prior year. Diagnostic information services revenues decreased 2.1 percent. Volume, measured by the number of requisitions, increased 0.7 percent versus the prior year. In order to put some spark and some growth back into share prices, I think an acquisition of a small diagnostics company like Response Genetics is worth considering while its share price is severely undervalued.

Disclosure: Christopher F. Davisis long Quest Diagnositcs. He has a hold rating on the partnership and a $60 price target.

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