Quest Diagnostics Incorporated (DGX) Earnings Call Transcript & Summary

Hi, good afternoon, good morning, everybody. I'm Derik De Bruin, senior life sciences and diagnostic tools analyst for Bank of America. Welcome to our 2021 Virtual Viva Las Vegas Healthcare conference. Also with me from Bank of America is Ivy Ma who focuses on diagnostics companies also on the group. And so in diagnostics, we have Quest Diagnostics with us this morning for our next presenters. With us today is Mark Guinan, Executive Vice President and Chief Financial Officer; and Shawn Bevec, Head of IR. Gentlemen, welcome. Thanks for being here today.

Thanks, Derik.

Thanks, Derik.

So, Mark, I want to start off with a big picture question just because it's something that I think we're still trying to grasp. It's like what do you think has changed about the diagnostic industry in general, and Quest in particular, in the wake of COVID? I mean I think I get the sense that COVID dropped the entire industry in a giant blender, and now we're trying to figure out what the margarita looks like at the back end of it. So what do you think has changed? And what will stay?

Yes. Thanks, Derik. Looking at the big picture, I think first and foremost if you -- pandemic really shone a spotlight on our industry. People all over the world spend a lot of energy trying to get a diagnostic test. And so I think one of the biggest impacts that pandemic has had was to give more people a sense of the tremendous value diagnostic testing and the roll it plays in the health care system. I also think the initial days of the pandemic when we were all scaling up capacity and finding new ways to let people access testing, exposed that there have been underinvestment in the industry after years of reimbursement cuts. And this really underscores the need for critical testing infrastructure and readiness for potential future pandemics. Quest has invested quite a bit in molecular capacity, which is now distributed throughout our lab network versus being concentrated in our high-end esoteric sites. And that's really going to improve our turnaround times and service beyond the pandemic, so industry remains a scale game. So huge economies of scale, and we firmly believe that those with the size and scale are going to win over time.

Got it. You guys had a great first quarter. You've been very clear when you had your Analyst Day coming up, you've very clear talking about the future. But people are still worried about the COVID cliff and the OpEx difficult comps. I know it's difficult to see into the future, but I just wanted to see if you could provide some incremental color to help guide investors through uncertainty. Just your general thoughts on the future and duration of COVID would be great.

Yes, I appreciate the question. And of course, it's a little ironic. Because the COVID cliff is being caused really by a huge bolus of opportunity with revenue and earnings and cash. And then as we shared at the Investor Day, getting right back to where we thought we would have been in 2022 had COVID not happened. So we talked about a baseline in 2022 of $8.5 billion in revenues. And if you had taken our CAGR, we laid out in 2018, that would have implied $7.40 to $8 in earnings per share. And again, I want to remind you that that's at the current level of corporate tax rate, which is likely to change. And [ instead ] we'd be at the higher end of that range. So we're really trying to give people the confidence that this was an opportunity, not a negative. Obviously, we generated a lot of cash. We deployed in a way that was shareholder-friendly, and we're going to be right back to where we would have been. And if anything, maybe even the higher end of that range that we laid out in 2018 once we get through this pandemic.

Yes, I mean I thought that was really interesting as I have talked with investors over the last few months. I mean if you looked at like where consensus estimates were versus where you guided in 2018, basically, there was no COVID in 2022. It was nothing embedded in the number. I mean it was like a 3% revenue CAGR is what you were looking for, which you guided to like 3% to 5%. So it was sort of an interesting experience because also -- I mean it's unlikely that, that entire business goes to 0, and it's not going to completely disappear. So I guess along those lines, I mean the nature of testing is evolving. And how do you think about sort of like back to work, back to normal, school testing? Can you sort of talk about where you're sort of playing in this sort of like return to work and sort of testing shifts from this complete panic right now to a more normalized life?

Yes, so that could be a big opportunity and it may not be as big. I think time will tell. The good news is that we are fully prepared. So we did the work that we needed to from an innovation perspective to get to this cooling concept that we call pods, where you basically pool a bunch of samples that are de-identified with the assumption that it will be negative. And if it's negative, you're good. And then if it's positive, you send an order back to the submitter, that being a school or employer and saying, hey, sample x was positive. They know who provided a specimen into that sample, and then you can test those individuals independently. And what this has enabled is to get to a price point that makes this affordable, because obviously frequency that people are talking about that and the number of people that are looking to screen would not have been affordable, like PCR reimbursement rates even if they were to come down somewhat, and even at rapid antigen. So you get the gold standard PCR-type testing at an affordable price, and we're ready to do that. We've also, as you've seen some recent press releases, have announced that we're partnering with some of folks that would be administrating these plans should they move forward. So we're ready, and we're set up both from a technology standpoint and from a logistical standpoint. The question is when will this start? And how much testing will be done? We had thought that we might kind of start this full year. Originally, our pre announcement was supposed to be made in [Technical Difficulty] April but now been delayed to late May. Our stance [Technical Difficulty] talking to various stakeholders, including some of the schools and so on, is that a lot of this is going to be delayed until the fall semester as opposed to starting year. So the question is over the summer as we continue to roll out vaccinations, maybe as infection rates drop, as people get more comfortable with the safety in the environment, with a lot of people vaccinated and lot of other people had it and probably have antibodies, which gives them protection, if not immunity. That what is the demand going to be for this testing? And what we've seen is that it's hard to predict. So Derik, if there is a significant volume, it will come for several months. And right now, it's kind of hard to predict. Kind of several weeks ago, or months ago, we thought it'd be pretty large. And there's still a lot of dialogue going on, but we don't know for sure.

Got it. That's really helpful color. So it's a sort of bigger question. I mean as testing sort of ramps down, you're talking about pooling. That seems a lot easier to do on an LDT platform versus in the IBDs. I guess as your testing has ramped down, are you shifting more volume to LDTs versus some of the IBDs, just because the margin is better on the LDTs given the current reimbursement? I mean you've got, what, 300,000 tests capacity. Is the bulk of that now on an LDT baker? Or is it still pretty fairly split?

Yes. So we can only do our LDTs at our esoteric sites. And as I said, we've rolled out testing to all of our major hubs. And actually, turnaround time has become the premium. So versus sending everything to our esoteric sites, which adds to the turnaround time logistics, we're actually trying to keep a lot of the testing local. So yes from a margin perspective, it'd be great to do more on the LDT. However, from a competitive standpoint and customer expectation, really keeping things local, and we can do pooling on the IBD platform [indiscernible] on the LDT.

Got it. So you mentioned this is like many diagnostic labs added significant molecular testing capacity during the pandemic. What's going to happen with all the capacity that you guys have added? I mean does it get mothballed and wait for the next pandemic? You sell it on the secondary market? Do you retire things? I'm just thinking about how you think about your vendors and your choices going forward? And sort of like what's your sort of like CapEx plans?

Yes, sure. Thanks, Derik. When you think about our capacity expansion, it came from a couple of different levers. We did buy more molecular equipment. Certainly, we talked about several tens of millions of dollars that we invested early in the pandemic. And really, what that enabled us to do was to replace some older, less efficient molecular equipment. And so that will enable us to not have to do that over the next couple of years because maybe we accelerated a little bit. But we'll also benefit from that operational efficiency as we do HCV testing, HIV testing, women's health, et cetera, and some COVID testing on that equipment. We did -- when we bought that equipment, we decided that the useful life would be shorter on some of that because we saw COVID as being temporary. So we did accelerate that depreciation. And so it will not be an overhang going forward from an expense standpoint. But really, the majority of our capacity came from really operating 3 shifts, operating 24/7. So historically, most of our testing is done in their labs really fired up third shift. And they sit somewhat idle first and second shift. So that capacity will remain. And should we have a time when we need it again, and some of that does get used when we do a PLS deal because that's what [Technical Difficulty] us through today. But that capacity will exist. It doesn't have a problem or overhang. And then the third lever was really pooling. And so that was the greatest lever to expand our capacity. And of course, that will still be there as needed. And one would assume as the positivity rate continues to drop, that more and more of our testing will be able to be pooled. It makes sense with certain thresholds of positivity. So really, that capacity is not a bunch of equipment that has to be mothballed or idled. It's really equipment that is now better and updated, combined with the ability to expand third shift and then pool.

Just sort of staying on the topic of equipment, some experts as well as a lot of new companies that have entered the market are arguing that the COVID pandemic has accelerated the trend towards decentralized lab testing. I mean that's been out there for a while. I mean what's your view on this? Does this ultimately represents a real threat to the central lab companies like yourself? That certainly is the narrative that's being put out there. I'd just sort of like your curiosity on how much of that is just [ book ] versus what's likely to happen.

Sure. So there's no doubt that the need for COVID testing has spurred innovation. You've seen FDA approve recently some point of care, not just COVID molecular, but molecular testing that's broader than COVID. So I would never want to ignore that. It certainly could be a factor. But I go back to what are the economics, and what is the need? And where we've been asked this question historically, we did get asked quite a bit. In the case whether there's a clinical need for point of care testing, glucose monitoring or diabetics being the classic case, absolutely that's where the testing goes. But when you don't have an absolute [Technical Difficulty] need then there's a consideration for the cost and the value, and even when you have something in 15 or 20 minutes, it's not the same thing as having it immediate like a glucose test strip. So how much value is there in shortening that cycle time and how much clinical difference does it make? And how much are the payers willing to pay for that? And what are the economic incentives for the prescribers. So throwing a lot at you, Derik, but it's hard to know until you see the answers to some of those. Obviously, you're not going to add a lot of cost to the system for point-of-care testing. That doesn't really adequately change the clinical approach. So it's got to be a similar cost or it's got to be almost a [Technical Difficulty] to really make a difference in the clinical approach. And then of course, how much of the payer is willing to pay in incentive for physicians to do that like flu testing. Vast majority has been done point of care. Part of it is because the economics for the physician are better if they do it themselves. And part of it is because they become comfortable taking that specimen. So when you think about going forward depending on how long COVID is around, as one presents themselves with symptoms, you don't know if it's COVID, you don't know it's flu. Will they be willing to take that specimen or they prepare that specimen that's taken elsewhere and that [Technical Difficulty] has come in the office? I don't know the answer to that. We'll see with time, and we'll see the economic value to them if they decided to take that specimen to do the test themselves rather.

That's actually a great segue to obviously you've also seen the emergence of the telehealth as an option, albeit more so for primary care and mental health, I would think, just based upon some of the panel discussions we've had recently from some of the other lab industry experts. I guess how do you sort of fit into the whole telehealth paradigm? And how do you make sure that if a patient is seeing somebody on telehealth that -- and they need a diagnostic test that, that script goes to Quest?

Sure. So we think there is a large role for national labs to integrate with telehealth. And certainly, we've done a lot of that as more primary care delivery shifts to this channel. Our national footprint makes us a logical partner with these telehealth providers because the [ point ] is telehealth. So either our at-home collection devices, which we work on for blood and obviously for nasal specimens as well or somewhere to go for those who don't want to take the specimen themselves. Obviously, with over 2,000 sites that people can go to get the work done, I think 95% of the population of the United States is within 20 miles of Quest patient service centers. So we've got the infrastructure. We've got the quality. We've got the brand reputation that we believe we are a logical partner. We're already doing some of that. But we also have our own Quest direct offering, which is our own telehealth backed up by a physician service. So we believe more and more people are going to want to take control or going to want to get their testing themselves without necessarily going to the doctor. And we believe the [Technical Difficulty] has really been enhanced as we have [ invested ] over the pandemic positions us well to grow our consumer business. If you recall at our Investor Day, we talked about growing this, we believe [Technical Difficulty] [ 0.25 billion ] by 2025 from relatively small pre-pandemic levels.

Got it. Let's shift over and talk about the base business. I mean I know that's maybe not as exciting to a lot of people, but let's talk about the base business. Still down 7% in the first quarter, March a little bit better. But I'd love some sort of like quarterly trends, if you continue to see things going on? And just when you look at the base business, how this is recovering? Where are we in terms of percentage of recovery versus pre-pandemic? And I guess are there still certain segments in your wellness routine testing business that are still lagging relative to what you would have expected?

Yes. So we shared that as we exited March, we were down about 5%. And that again is adjusting for what we think is the best indicator of where our utilization is in the market. So we strip out our organic PLS because we consider that a little different market. And obviously, the size of our PLS wins recently make that more impactful. So we said when you look on kind of an apples-to-apples basis, we believe naturally it was about 5% down in March. And the trend is continuing to improve slowly but surely. The important thing is that, well, if you look at therapeutic area or franchise, it's fairly consistent. When we share that lagging is toxicology, drug monitoring. A lot of that is policy driven because the testing that was required pre-pandemic was suspended for safety reasons. It has not been fully implemented. We [ would stack ] because it is good clinical practice that those will be reinstated. And when I say it's stacked, we're not sitting on our hands. We're talking to those policymakers. We're lobbying, et cetera, talking about the right time to implement that. But that needs to take place for toxicology or drug monitor [Technical Difficulty] have a chance to fully recover. But generally, the rest of the test areas are pretty similar. So even routine general health testing has recovered as much as -- or in the conditions they might expect. The area of variability is really by geography. So we have some areas like Texas that are above 2019 levels. Even California dramatically in March, it's pretty close to 2019 levels. The laggards are New York. It's not just [Technical Difficulty] but upstate New York as well. Buffalo is well behind. I mean Manhattan and the boroughs is way, way behind still. And then New England, we believe that this has as much to do with restrictions, local restrictions, as it does to the infection rate. Because certainly, Texas didn't have a lower infection rate over the last several months. Really the difference there was that it opened up completely. So as we look at the announcements recently New York, New Jersey talked about and I believe Massachusetts as well will start withdrawing restrictions. We believe that, that will help the cover. And once we get the East Coast and the northeast, then we'll be well on our way to being fully recovered or even better. And we said we fully expect it by the end of this year, at a minimum, we'll be back to 2019 levels and grow from there.

So along those lines, how should we think about margin progression as the COVID wanes, you get the continued rebound in the base business. What are some of the dynamics versus the first half or the second half of the year on the margins? And where should we sort of think about as a base for '22, [ 2020 ]?

Sure. So on the positive side as the base business recovers, the margins expand. Because as we've talked about, we're fairly leveraged cost structure in the short term. And so while we talked about in the past for winning organic volume and how the drop-through is higher than our fully loaded margins, as the business recovers, just like it was more of a decrement as a decline, it falls through at a higher rate. Then you've got the other side, which is COVID testing, and there's 2 dynamics. One is obviously there's incremental revenue above and beyond our base business. The second thing is that it's at the price point, reimbursed. It has had a healthy margin. And you talked about the expectation that you've seen it happen over the last couple of months. But we expect it to continue in the back half to see demand decrease. So that will be less of a tailwind to our margin. And then the second piece is trying some reimbursement. And right now, the Federal Health Emergency is extended to the end of July. We don't know what's going to happen after that. We would expect pricing pressure. So as we do less volume, and potentially there's a lower price obviously, there's less benefit from COVID. The final piece I would add is that I want to remind you that PLS is a lower margin than our core business. So it's a good source of growth and has a nice return on invested capital because it's organic. We're not buying it. We do have to invest some capital. We've got a real nice ROIC. It is a lower margin. So as we get more growth from PLS, that's going to have some impact from a mix perspective on the margin going in back half.

Got it. And...

2022 real quick, Derik, you asked about '22. So once the volume fully recovers to '19, the margins should be similar. We've had some pricing pressure, largely panel. We've had some wage inflation even more acute during the pandemic. But we also have our efficiency program, which generally offsets that. So once we get back to those levels of [ utilization ] in 2019, the margin should be similar. And then obviously from 2022 and beyond, we said we can grow the bottom line, cash on the top line, which implies margin expansion '22.

Got it. That's really helpful. You mentioned this big influx of COVID cash. Can we talk a little bit about capital deployment? You recently did an ASR, or you're in the process of doing an ASR. I guess why that versus just a standard ongoing share buyback? And talk about a little bit about some of your acquisition activity? And has COVID sort of disrupted the M&A dynamics out there? Are labs more willing, less willing to sell, a lot more money. Will they take anything they can get? Just some general comments on your sort of thoughts on capital deployment.

Sure. Let me start with capital deployment. So we're sticking with our strategy. Obviously, we had a lot more cash last year. [Technical Difficulty] share repurchases and did enough M&A to make up for it. We need a lot more cash to meet our commitment of 50% of our free cash flow. So we have a little catching up to [Technical Difficulty] 2021 to meet that commitment and the good news is we generated a lot more cash than we normally would. The ASR versus open market really was triggered by the sale of our stake in the JV with IQVIA. We immediately incurred the loss of those equity earnings, didn't want to create dilution. So we needed to deploy that cash right away. And then the fact that we have already committed the $900 million in the first half of open market that [Technical Difficulty] less than half that in first quarter. [Technical Difficulty] said, we may as well add that on to the ASR because we can't do open market and ASR at the same time. So that would have pushed that off, and [Technical Difficulty] first half. So we added those 2 together and then a little more based on our cash performance in the first quarter. That's where the ASR came from. In terms of M&A, yes, I don't know that it really slowed things down. We did a couple of deals last year, Memorial Hermann and [Technical Difficulty] called MACL, which is the JV in Indiana. We did delay the timing of that MACL acquisition so that it didn't happen right in the middle of pandemic for operational considerations, but also because we didn't want to buy a business when it was down 50% et cetera. But that's turned out to be a great deal because by the time we did it, volume had largely recovered and we got the COVID revenue on top of it. And then we announced the Mercy Health Systems outreach acquisition this year that [Technical Difficulty] implemented about the middle of the year. So we're still moving the needle. We're still on track to deliver that 2% that we talked about on a CAGR growth in revenue from deals. So in the pipeline, it's been very deep. I can assure you that contrary to what people might assume, we're not finding potential sellers. People thinking they're going to get the COVID value in the sale. They know that it's short term, and so that's not become an impediment. And actually, the one factor I'd say that's being most helpful is you talked about PAMA cuts having an impact, but it's really more of the commercial payers who are starting to put pressure on those rates. So if your Medicare book of business drops by 30-plus percent over 3 years, that's not good if [Technical Difficulty] a hospital system on your outreach. But if your pressure rate moves from 500% to 100% of Medicare, that's a much bigger impact. And you've seen some of the payers, most notably United, Anthem has done some of it and Horizon has done some of it, recontracting outreach rates to independent lab rates. And that has certainly added to the momentum. So deep pipeline. We shared at Investor Day, we expect to do that 2% at least for the next several years. So really not a tremendously disruptive impact from the pandemic.

And are there more of those preferred lab network deals out there? I mean are more of the payers sort of joining as blues, for example, or things like that? I guess anyone who's there has a chance to sort of do more of that bundling?

Yes. So it may be not in that exact format in terms of designating a preferred lab network that have this membership criteria based on -- we talked about several dozen quality and capability metrics and [indiscernible] to get in there, and the benefit of the zero out of pocket. And we also talked about outside the preferred lab network that in the value-based contracting, we've done with United things like when we do M&A, instead of the rate stepping down immediately, it steps down over time. So we need to share more in that savings, instead of it all going to the payer. Which is a win-win for both of us because it enables us to do more of those deals. And they love when we do those deals because it saves them a lot of money. So some of those elements, without calling them a preferred lab network and designating as such, are absolutely in the contracts with other payers. We certainly had those with Aetna for years, with Cigna as well. Cigna places a lot of value, it does a lot of membership outreach to talk about why pay more and so on, so things are already done. And then with Anthem, it's not as much a network as it is a contract we signed with them. So we are partnering with Anthem in much better ways and much different than we have historically. They are very focused on helping us to help them get better value by giving us physicians who are prescribing out of network, by talking to us about large employers who have a very expensive [ blood ] spend that we can approach with their support, and even going in to the [ quarter] with them, talk about client benefit design and other ways to save the value on labs. So it's not a preferred lab network, but it has a lot of the same elements that a preferred lab network has. And it's a sign of a much stronger partnership with the stakeholders [Technical Difficulty]

Got it. We're coming up on to the top of the hour, so I'll ask you my standard closing question, which is what do you think is underappreciated about Quest?

Yes. So I think that we're much more than a lab. We try to socialize that, but we talk about us being the business of diagnostic information services. We are a service business. And so one of the differentiators is not necessarily the IBD equipment. None of us do the same laboratory work, but it's really everything else from -- we get great Net Promoter Scores in our patient service centers. Our MyQuest app, which people really love the functionality, our cost estimator tool where you present your insurance card and actually know, before even blood is drawn, what your responsibility is and whether it's covered. For the payers, the fact that we feed them the data, we give it to them cleanly in a world where that's very valuable. So don't think of us just as a laboratory, but as a service provider. And that's really where we've increased our value proposition and why the payers have wanted to work more with us. Because they see we're not a commoditized provider of laboratory results. We're actually a service organization that their members are delighted with -- when they go to us for the laboratory one.

Great. With that, Mark, Shawn, Ivy, thank you. Thanks for being here. And thanks to the investors for listening. And have a great day, everybody. Appreciate it.

Thanks, Derik.

Thanks, Derik.