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Quest Shares Spiking on Buyout Talk, but Debt May Deter Deal

Recent spikes in Quest Diagnostics's stock price suggest the No. 1 medical testing company could be the latest buyout target in health care, but its valuation and debt load may keep private equity bidders at bay.

Driven by private equity, dealmaking among health care service companies has been healthy for the past year. The run began with the $22 billion leveraged buyout of No. 1 hospital chain HCA in July 2006. And just last week, Manor Care, the biggest U.S. nursing home chain, accepted a $4.9 billion takeover offer.

Companies in the $45 billion clinical lab testing market, which is dominated by Quest and Laboratory Corp of America, are natural targets because of their robust cash flows and steady earnings power, according to analysts.

Indeed, analysts said a report surfaced on July 5 in an online publication that Quest could receive a takeover bid of $70 per share.

But observers are lukewarm on the likelihood of a deal.

"We are suspicious of LBO speculation -- unsubstantiated and widely reported in the media -- at current valuations," Cowen and Co. analyst Kemp Dolliver said.

Quest's multiple and stock price, which now trades at about $55, "is high relative to the types of multiples than an LBO firm would pay," he said.

In addition, the company's debt doubled with the acquisition of specialty lab Ameripath earlier this year and now stands at about $3.9 billion.

Private equity firms typically buy companies to cut costs and sell them later, borrowing about two-thirds of the money needed to finance the deals.

Dolliver said his analysis of 11 prior acquisitions, mostly by LabCorp and Quest, showed a multiple of 11.9 times earnings power. But those were lab-to-lab mergers, where economies of scale make wringing costs out easier than for an LBO group.

Some have suggested the speculation could be linked to the fact that former Quest Chairman and Chief Executive Ken Freeman is now a special adviser at LBO shop Kohlberg Kravis and Roberts.

"I think people use that as basis for a rumor to drive up the stock," Dolliver said.

SPECIALTY APPEAL

Shares of Quest are up about 3% so far in 2007 after rising 45% over the three years ended last December 31.

LabCorp. is up about 10% year-to-date, but nearly doubled from 2004 through 2006.

Quest's recent $2 billion acquisition of Ameripath provides an opportunity for growth, according to Jefferies analyst Arthur Henderson.

Ameripath focuses on advanced tests such as those surveying a patient's genetic make-up to predict response to treatment.

These newer tests generate more lucrative margins than the more traditional kind, like for cholesterol.

"What is unique about the labs is the routine business is a total commodity, but the specialty side of it is really where the excitement is," Henderson said.

And compared with other health care companies, he said, reimbursement prospects for the lab sector are relatively stable. Quest and its rivals do not rely as heavily on the federal government for payment the way hospitals do.

But UBS debt analyst David Havens said that if the rumored deal occurred, Quest would be left with more debt than it could handle.

"We would envisage a company with $11.7 billion in debt," he said in a note earlier this week. "Our analysis suggests that a full blown LBO of Quest is unlikely."

Lehman Brothers analyst Adam Feinstein said a buyer might be willing to pay a double-digit premium to Quest's closing share price of $51.57 on July 3, before the latest round of speculation emerged.

Such a price would be in line with the multiple buyers have been willing to pay for health care facilities over the past three years, he said.

"We do believe the math could support a potential LBO, given the free cash flow characteristics," Feinstein said, "although the (rumored) $70-plus price per share appears high."

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