Interest is up in outreach labs

March 2006
Feature Story

Karen Lusky

Where there’s smoke in the form of growing investor interest in a health care sector, there’s usually a market that’s been heating up for a time. That appears to describe what’s going on with not-for-profit hospital outreach laboratories, which are attracting buyers and equity partners in a trend portending new opportunities and challenges for hospitals, labs, and pathologists.

"The growth is coming from demographics and an increasing demand for integrated lab services—and some of it is coming the old-fashioned way where you slug it out with your competitors," says Thomas Tiffany, PhD, DABCC, FACB. Dr. Tiffany is president of Pathology Associates Medical Laboratories, or PAML, in Spokane, Wash., a for-profit outreach lab owned by Sacred Heart Medical Center that provides outreach and reference lab services in several northwestern states.

About 81 percent of not-for-profit hospitals operate outreach labs, according to a September 2005 survey of hospital senior executives conducted by Health Care Development Services Inc. The survey had 181 validated responses mostly from mid-size and large hospitals, says Barry Portugal, president of the Northbrook, Ill.-based consulting firm. Portugal presented the survey findings last fall at the G2 Lab Institute session, "Are Hospital-Based Lab Outreach Programs for Sale? The State of the Industry." The survey showed that about 60 percent of the respondents were fairly new to the outreach business, having run their labs for one to five years.

Portugal tells CAP TODAY that as a backdrop for doing the survey, he knew that venture capitalists were "knocking on the door" of a number of his firm’s hospital clients that have large laboratory outreach programs. The survey showed that 28 percent of respondents had been approached to sell or merge their lab outreach, though only four percent of the 181 respondents were seriously considering a sale or merger of their programs. Of those approached, 75 to 80 percent were hospitals with more than 300 beds, Portugal told Lab Institute attendees. "Suitors included commercial labs, venture capitalists, and other health care systems," he said, though many of the inquiries were mass-market. He’s quick to stress, however, that the "vast majority of hospital executives polled weren’t even aware of hospital lab outreach sale or merger activities."

Still, recent sales of two not-for-profit hospital-owned outreach labs provided a fiscal wake-up call for many in the lab industry who realized for the first time that such initiatives, when developed strategically, can accrue in value. A lot of value, considering the $43 million that Health Alliance, a six-hospital system in Cincinnati, commanded two years ago from LabOne (now Quest Diagnostics) for its outreach lab, described as an "attractive franchise with a large local market share," by Ronald Long, chief financial officer for Health Alliance. Long presented at the Lab Institute with Portugal and Michael Hammond of New York City’s Shattuck Hammond Partners, which served as an investment and financial advisor to Health Alliance in its sale to LabOne.

The $43 million cash purchase price was 1.3 times the outreach lab’s annual revenue, Long reported. Health Alliance also gave LabOne an exclusive five-year reference contract with a fixed escalator, and a five-year hospital lab management contract with incentives to reduce costs, and performance metrics for turnaround time and test accuracy.

In January, the hospital owners of Spectrum Laboratory Network, Greensboro, NC, sold majority ownership in the regional outreach lab to private equity investor Apax Partners LP, New York City, for an undisclosed sum. One of three of Spectrum’s original hospital owners, Moses Cone Health System, still holds a significant equity position in the lab, which provides outreach services to physicians in North Carolina, South Carolina, Georgia, Tennessee, and Virginia.

Though the outreach businesses of Health Alliance and Spectrum were sold to free up cash that can be used to support the systems’ core acute-care missions, other health systems view outreach as a cash cow or potential revenue source to serve that same purpose.

For example, Carilion Health System, a not-for-profit hospital affiliation in western Virginia, last fall formed a separate for-profit entity, Carilion Consolidated Laboratories, to develop regional outreach labs throughout the Southeast and mid-Atlantic areas and into the Northeast. The business plan calls for expanding the lab to a $300 million per year business in six to seven years, says its CEO Bud Thompson.

As a prelude to spinning off the outreach lab as a standalone business, Carilion purchased Laboratory Services Group from Park City Solutions, Alpharetta, Ga., and rebranded it Chi Solutions. With Chi on board, Thompson says, Carilion "can offer a menu of services from A to Z to hospitals or health systems that want to grow their outreach business but need support to do that," Thompson says. "If the hospital decides to divest itself of that asset, our for-profit entity can go out and buy that hospital-based lab." Thompson says Carilion’s strategy is to leave a shared ownership with the selling health system.

Chi Solutions’ annual outreach surveys show "more and more hospital-based outreach ventures are becoming large or in excess of $25 to $50 million," says Chi president Kathleen Murphy, PhD. In her view, the surveys overall signal that "outreaching is becoming a mainstream strategy."

Robert Michel, editor of The Dark Report, which provides lab intelligence for hospital executives, says "simple economics is driving the phenomenon" toward not-for-profit hospitals developing their outreach, a trend he’s seen afoot for the past five to six years.

A hospital that boosts its overall test volume through an outreach program can lower the average cost per test for inpatient and outreach testing, he says.

Pathologist Edward Catalano, MD, agrees, and adds, "With additional samples coming in, the [hospital] lab can do daily runs as opposed to batching tests and running them three times a week or so." As a result, the lab can provide a faster turnaround, "which has the potential to decrease patients’ lengths of stays." Dr. Catalano is president of Professional Pathology Services, Columbia, SC, and chairman of the board of Pathology Services Associates LLC, which offers business solutions and tools to private pathology practices.

An outreach program can pave a hospital’s way into doing more esoteric testing, which Carilion plans to do as it expands. Chi’s Dr. Murphy says, "If you bring in additional volume with outreach testing, you may have the volumes and economies of scale required to do molecular testing economically."

Michel notes that most well-run hospital laboratory outreach programs can produce additional profits from physician office-based accounts. Case in point: Centrex Clinical Laboratories, Utica, NY, owned by Mohawk Valley Network, has a hybrid strategy of selling directly to physician offices for its outreach in addition to contracting to provide reference lab services to hospitals in New York state, says John Finn, CEO and president of the reference lab. And its team of three sales professionals and three sales support representatives have been producing $2 million to $3 million in new outreach sales each year for the past four years, Finn says.

Carilion’s Thompson says outreach ventures also help hospitals exceed the four percent to six percent "organic growth rate" that the marketplace just "gives you," thanks to a growing and aging population that consumes more lab services each year. And "to the extent that you can develop a business model to take market share from another lab, then you have...the chance to end up with growth rates in the double digits."

Or the hospital-based outreach model can help a hospital beat dismal growth projections in a particular geographical area, says PAML’s Dr. Tiffany. He recalls one hospital whose management looked at the hospital’s population growth, which was in the range of one percent, or half of what the hospital needed to stay profitable, and realized it needed to diversify into an ancillary area. They began to look at, among other things, imaging and lab services. "They decided to go with outreach lab testing and are doing a very good job of it," Dr. Tiffany says.

Yet developing a profitable outreach business isn’t for the "faint of heart," cautions Chi’s Dr. Murphy. "The profit margins for hospital lab-based outreach average about 20 percent," she says, and can reach 30 percent or higher. But achieving that level of profitability requires "a lot of investment in the support infrastructure that isn’t normally present in a hospital-based lab."

Carilion’s Thompson says some hospitals view the outreach testing they do as being "on the margin" where "the next lab test coming in the door" costs only pennies more to do. But to keep those tests coming in and getting paid for them requires billing, information technology, sales, marketing, patient service centers, and couriers, Thompson points out. "And you have to consider the logistics of the courier system." Thus, viewing the outreach testing on the margin works for the short-term but not over the long haul, which requires investment, he warns.

Developing and maintaining a reference lab also requires hospitals to navigate tricky compliance terrain. There are "very strict regulations for outreach so you don’t give physicians inducements for their business," Chi’s Dr. Murphy notes. Compliance is certainly an investment a hospital has to factor in when doing outreach, she adds.

Not-for-profit hospitals that want to do outreach in a serious fashion typically set up separate for-profit lab companies or entities. "A for-profit subsidiary in many instances provides maximum flexibility for structuring transactions and raising capital," and protects the hospital-owner’s tax-exempt status, says Hammond of Shattuck Hammond Partners.

Michel notes that "Spectrum Laboratory was operated as a standalone business that did not rely on the human resources, billing, IT, purchasing, and other departments of its parent hospital. The lab could organize its management to focus on serving the specific needs of its laboratory customers." As Spectrum took that tack, its revenues increased, as did its capital value, he says.

Carilion developed its outreach as a standalone entity over many years. To reduce costs, the multi-hospital health system consolidated its routine clinical testing, anatomic pathology, and cytology into a core lab in the mid-1990s, Thompson says. But the consolidation also provided a platform on which the health system was able to build its outreach services.

In the early 2000s, Carilion began to give the reference business more structure and invest in its infrastructure, including management, technology, sales and marketing, and courier services. "Then three years ago, even though the reference lab was technically still a department of Carilion’s flagship hospital, we began to really manage it as a discrete business line with its own profit and loss statement," Thompson says. Only last fall did Carilion convert the lab to a separate legal for-profit entity. "Since then we have added a lot of management capacity—people who are experts in their disciplines to help us to continue to grow the lab," he adds.

Being able to realize outreach profits also makes it easier for laboratory managers to negotiate a fair share of capital from a hospital system "that seems more willing to buy new technology in radiology where the profitability is assumed to be higher," says Centrex’s Finn. In his view, hospital lab managers and pathologists need to spend more time with chief financial officers to help them understand what it takes to compete with commercial laboratories.

"For example, if a physician office buys a full-featured practice-management IT solution, they will be looking for a laboratory that can very quickly provide a lab interface to avoid handling paper reports," Finn says.

Setting up outreach as a separate entity with its own profit and loss statement also makes it possible for a hospital to keep tabs on the lab’s bottom line. Knowing what the outreach business is worth is especially important should the hospital consider selling the business—unless it wants the potential buyers to do the valuation, Portugal says facetiously. "That isn’t a good business strategy," he adds.

Hospitals have a continuum of options and relationships to consider for their lab outreach business, Hammond says. "If a hospital thinks the value is high for its reference lab, then the hospital’s inclination may be to sell it," he says. But if the hospital sees "a lot of growth opportunity for its reference lab but needs capital for other things, then it might want a partner that has capital, such as one of the national lab companies or a regional company such as Carilion Labs."

Carilion’s chief strategy is to work with health systems and partner with them to acquire their labs but leave a retained ownership interest with the selling health system, Thompson says. Using that strategy, Carilion can keep the work closer to its site of origin, unlike national commercial labs that often send specimens to labs that can be several states away. "We plan to maintain the relationship with local pathologists who can, in turn, maintain their relationships with surgeons and other clinicians...."

Thompson says Carilion is willing and can afford to sacrifice some of its profit margin to avoid having to centralize as much work as the publicly traded commercial labs do to sustain the kind of financial performance they need to have.

A few hospitals develop profitable outreach through joint ventures with a commercial lab or sometimes a pathology group. "It can be a challenge, however, to fully meet each partner’s needs in a joint venture, as pathology groups, hospitals, and national commercial labs have different perspectives, objectives, and goals," says Ed Dou cette, general manager of CompuNet Clinical Laboratories in western Ohio. CompuNet is a joint venture with three equal owners: Valley Pathologists, Miami Valley Hospital, and Quest Diagnostics. "Miami Valley Hospital outsourced its laboratory to CompuNet, and the joint venture built a separate, freestanding reference lab to go after outreach testing," which is now the bulk of the joint venture, he says.

CompuNet’s outreach testing has been growing steadily at about five percent to 10 percent a year, says Doucette, who is a Quest employee provided to the joint venture.

Portugal says there is a "laundry list" of reasons a hospital system might choose to sell its outreach business. But the upshot, he says, is this: "If a group of executives feels that the managed care market is going to eat them alive and they will lose market share if they don’t have the right technology and people," the hospital system may think about selling its outreach business.

Centrex could have found itself on the selling block several years ago if it hadn’t been able to provide a $6 million dividend to its owner to help finance a capital expansion project. "The needs of the [hospital] network at the time created a situation where we might have been sold had we not been in such good financial shape," Finn says. "The dividend and a minor restructuring in our contract was actually worth more over the next 10 years than a one-time buyout could produce."

Health Alliance’s decision to divest itself of its outreach program reflects the intersecting factors that drive a health system to take that route. For one, the outreach lab had an attractive and salable franchise at the time. But it faced the prospect of deteriorating revenues because of changes in the local managed care climate, CFO Long said in his Lab Institute presentation. The health system was facing significant short-term financial pressures requiring an influx of cash. And Health Alliance "wasn’t very comfortable" with the lab outreach business, Long said.

The LabOne offer wasn’t the only one on the table in the Health Alliance deal. In fact, a fledgling private investment firm valuated the reference lab higher than "many of the larger potential acquirers," says Hammond, whose firm advised Health Alliance in its sale. But more was at stake than just price. "Due to the complexity of the transaction and concerns over access to resources to support the lab in the future, we had to get buy-in from a variety of constituencies, including the medical school," he says. "And it’s hard to make a compelling case for going through the ups and downs of a startup company."

How pathologists fare with regard to hospital lab outreach development depends in part on the type of model the hospital uses. In some cases, pathologists see positive developments when the health system for which they do work joint ventures with a commercial lab, Portugal says. "The commercial lab partner generates substantial increases in outreach surgical pathologist business that goes to the pathologists in the hospital system," he says.

But deals where hospitals sell their outreach business outright to national commercial labs can place pathology groups in "immediate jeopardy" of losing their anatomic pathology work, Dr. Catalano cautions. Thus, a model that keeps anatomic and clinical work in the local market is becoming more popular, he says.

Dr. Catalano explains: A hospital’s development of outreach testing helps pathologists with independent practices expand their own outreach testing efforts "because the pathologists then have someone to partner with that has the necessary infrastructure." As a result, the pathology group can offer "one-stop shops" with clinical and anatomic pathology services to physicians in community practices, Dr. Catalano says. (By partner, he means relationships where the pathologist group and hospital support each other’s interests in a "win win" fashion, he says, rather than one that necessarily involves a written contract.)

For example, Professional Pathology Services PC, which has its own anatomic pathology lab, provides AP services to Palmetto Health Richland Hospital, Columbia, SC. "Our pathology group acts in partnership with the hospital, although we had an outreach initiative before the hospital ever did," Dr. Catalano says. "We were instrumental in helping the hospital develop its outreach initiative, and the hospital has tried to be a good partner to us."

Dr. Catalano’s pathology group is able to bring clinical pathology work into Palmetto. "When we pick up a hematology/oncology office, not only do we bring in bone marrows, which we read, but we bring in flow studies to the hospital laboratory." If the group picks up an OB-GYN office’s cervical biopsies and cytologies, the hospital does the office’s testing for gonorrhea, chlamydia, and HPV. "The hospital really supports our outreach initiative because we bring work to them," Dr. Catalano says.

Professional Pathology Services maintains control over AP, and the hospital maintains control over clinical pathology. "That way we have some control over our destiny and the hospital has some control over its destiny," he says.

As a pathology group, you want to be "a partner with your hospital lab outreach in developing, managing, and maintaining control over the AP work," he advises. "If you abdicate it to the hospital, the hospital is in control of making decisions down the line, such as selling to a commercial lab, that can be detrimental to the hospital’s pathology group’s best interests.

"What pathology groups really don’t want to do is become completely dependent on any other separate entity for their work," Dr. Catalano adds. They need to "develop [their] own infrastructure or partner with the hospital to develop it: IT, billing, marketing, etc." Of course, pathology groups have to invest resources to do so, which is why Dr. Catalano foresees more small pathology groups merging into larger groups so they can afford the infrastructure.

Can hospital-based outreach, if it continues to gain ground, take significant market share from commercial labs? In that regard, Michael Hitchcock, MBChB, a pathologist in Winston-Salem, NC, recounts an "intriguing" comment that a commercial lab executive made to him recently. The executive told Dr. Hitchcock that his "greatest competitive threat is from the hospital-based clinical lab outreach program—similar to Spectrum’s original form."

And Dr. Hitchcock can see his point: When hospitals "commit core resources ... suited to physician office work, they can be very successful. Apart from building on existing relationships between hospitals and community physicians, the hospital already has contracts with the main local payers—and useful patient information such as old biopsy results and inpatient encounters" that can help the community physicians care for their patients.

On the other hand, commercial labs are strong and moving into more complex, esoteric testing, says Carilion’s Thompson. "They are in the market acquiring small niche lab companies that have testing that’s protected proprietary intellectual property," he says. "And the big lab companies have the capital to make those acquisitions, whereas that would be a struggle for a lab like us." Opportunities for reference lab companies to be successful in the marketplace are plentiful, he says. "We’ll just do it in different ways."