Quest Diagnostics Incorporated (DGX) Earnings Call Transcript & Summary

Good morning, everybody. I'm Ricky Goldwasser, Morgan Stanley's Healthcare Services' analyst, and I'm pleased to welcome you all to Morgan Stanley Global Healthcare Conference. On with me this morning are Steve Rusckowski, Quest Diagnostics' CEO; Jim Davis, EVP of General Diagnostics; and Shawn Bevec, who is Head of IR. Steve, Jim and Shawn will join us today and share some of their insights. Before we get started, I would like to note that this webcast is for Morgan Stanley's clients and appropriate Morgan Stanley employees only. It's not for the members of the press. And if you are a member of the press, please disconnect and reach out separately. And for any important disclosures, please see the Morgan Stanley Research Disclosure website at www.morganstanley.com/researchdisclosures. And with that, thank you again for joining us. And Steve, you guys raised your guidance earlier this morning to reflect the accelerated demand for COVID testing. So I would like to turn it over to you for some -- just kind of like introductory remarks and color and help frame the conversation.

Yes. Thanks, Ricky, and good morning, everyone. So as Ricky said, we did just update our outlook for the second half of the year, and it's exclusively related to the increased demand that we're seeing for COVID testing. So as you recall, as we entered '21, we had high level of testing volumes for COVID at the beginning of the year. And what we said in our initial guidance for the year is that will come down through the first half, and it did. And as we entered the third quarter, we saw volumes significantly lower than what we're seeing right now. And so what we assumed in our initial guidance and outlook for the back half of the year on the low side is that we would average about 20,000 PCR tests per day in the back half of the year. What we have just said this morning is we're doubling that to 40,000 on average for the back half of the year. Albeit, again, what we are running at right now is higher than that number. We publish results on a regular basis, and we're running around 100,000 tests per day. However, what we're assuming with what we've just shared is like we've seen with other waves of the pandemic, we believe that, that number will come down throughout the second half of the year to give us on the low side, again, 40,000 tests per day. So what we have done, Ricky, is essentially increased our revenues, both to the low side and the high side by $300 million and added $1 a share in the back half of the year for both the low and the high end of our outlook. What I'd also like to share, what we have seen as well is a continuation in improvement in our base business. We have seen this in July. We did see some modest slowdown in August, and we're not quite sure if that's entirely related to maybe some concerns about the new Delta variant outbreak. We did see an increase in the number of vacations taken in the month of August because of anticipation of going back to school and anticipation of going back to the office. And also, we had a couple storms, as you know, which had an effect on our business as well. So we're watching it carefully, but no notable change in our base business. And so we're also assuming in the outlook is that improvement of our base business in the back half. And so what we again said going into the back half is that we would grow low single digits versus '19 in our base business, and we're continuing to stand behind that guidance going forward. So I'll turn it back to you.

Great. Thank you, Steve, for that update. I have some follow-up questions on that because clearly, core utilization and multi-core utilization are very topical in an area that we get a lot of questions on. So if we think about your new expectations around COVID, yes, you're doubling to 40,000, but still seems somewhat conservative as we think about the outlook for the rest of the year. So can you maybe share with us what you're seeing in terms of demand geographically sort of Northeast versus Southern starts? And maybe we'll start with that.

Yes, sure. And your question is specific to COVID?

Let's start with COVID, then we'll [ back on core ], yes.

Yes. So there is variation around demand depending upon where we see the outbreak. And we do track infection rates by geography. And so we have seen higher demand in some of those -- some operating states, Florida and Texas, 2 big states for us. Lesser demand in the Northeast. We haven't seen it yet. And to go back to your comment about 40,000 being conservative. Well, what we did, Ricky, is kind of look at what's happened with prior waves. And so if you remember going into '21, we were running north of 100,000. And by the time we got to June, it was down in the 30,000 to 40,000 per day. So a real drop. And so we're modeling it with similar decay, if you will, in the back half of the year. However, there's still a lot of unknowns and uncertainty around the Delta variant. And Jim's on the phone, Jim Davis is on the phone. And Jim and his team are tracking other countries and how they've dealt with and what they've seen around the Delta variant. And I think it would be helpful, pretty obvious to hear what we saw in Israel -- or seeing in Israel and also the U.K. Jim, could you speak to that?

Yes. Sure, Steve. So if you look at the U.K., their Delta variant spike really started in late May, and it was a sharp spike up through the middle of July 20, and then they've had a big drop through, call it, middle of August. Now since the middle of August, they have had a steady rise, again as schools open, soccer matches occur and things like that. But precipitous rise up, precipitous rise down and then, again, a little bit of a steady rise up here in the last 3 weeks. Israel, which is behind the U.K., but in front of us, also saw a spike up in mid-June. They hit their peak in late August. And if you look at their number of new cases, it's down precipitously from that peak in late August, even in the last 2 weeks. So we're trying to use, as Steve said, the historical experience, the U.K. experience, the Israel experience to predict what's going to happen here. We also -- we look at our positivity rate across the country. It did peak for us and for the CDC. We think we're a pretty good microcosm of the country. it peaked about 2 weeks ago, and it's come down slightly over the last couple of weeks. So we are seeing a drop in the positivity rate, which is usually an indication that testing will moderate over the next, call it, 3 to 6 weeks. What happens after that? It's tough to predict as schools reopen and college football, pro football and big gatherings occur across the country.

So when I kind of think about what you're seeing to me, what really is kind of like striking, I think, more important is what we're seeing in the core volumes. And to your point, you're still sort of seeing that momentum that you saw at the end of the second quarter. I hear you, Steve, around some slowdown in August where there is usually vacation and the weather. But again, can you give us a little bit more color on what you're seeing in terms of core volumes by geography? And also, when I think about your partnerships with hospitals, it does give you some visibility into utilization trends that they're saying. So are you seeing any differences between what's happening on the hospital side versus what happens on the physician office side?

Yes. So I'll start with -- by channel, if you will, and hospital volumes have recovered. We said that going into the year. And we don't see a big change with hospital volumes so far as we look at August, there could be some disruption related to outpatient volumes as well as ED volumes, but those are not big drivers of what we do for hospital systems. We're primarily tied to patient days and those patient days have remained strong, so that is a fully recovered position versus 2019. Secondly is if you look at the recovery of our physician portion of our business and we broadly talk about that. There is variation by geography. And we shared when we came out of the second quarter that we fully recovered in most of the country, and the Northeast was the one portion of the country that was not fully recovered. And over the course of the last couple months, we did see recovery in New England, specifically Connecticut, Massachusetts, the Boston area had recovered in the summer months. And in New York, where we have a strong presence and New Jersey, New Jersey recovered, but New York was still not fully recovered to '19 levels. However, we did see some improvement throughout the summer, still down versus '19, still improvement. So what we still have in the third quarter is a situation in New York City, where we're still down versus '19. However, we're hopeful going forward in the back half of the year as we manage our way through this pandemic, more people that have been out of the health care delivery system will absolutely have to get back to the health care system for those things they've avoided or postponed over the last 18 months.

Do you think, Steve, as we talk through sort of these dynamics and the dynamics of the pandemic that the emergency period will be extended? I noted in your guidance, you're assuming through the end of the year. But what do you see the odds being now that it's going to be extended into 2022?

Hard to predict. We clearly have assumed in our guidance that it will continue through this year. And one of the pieces of that that's important to our assumptions is the price on PCR, given a higher price versus the NLA price that was initially provided to us when we started the pandemic, so that's a key assumption. But I'll say, Ricky, too, as we get into the fall and we start to see flu season, we see -- start to see people returning to life, we are going to see colds, we're going to see flu, and we will have to rule out COVID, okay, as we manage our way through this. And secondly is, we said at our Investor Day that this is not going away in 2022. I think we are now more strongly believing that we're going to have a more active role beyond '21 in helping this country manage the pandemic. And the management tools will continue to be vaccination, blood testing and behavior. And testing will continue to be an active role, and I think a more prominent role in getting more precision around immunity and precision around population management. And we have an active role to provide that insight.

[Operator Instructions] So Steve, you touched about sort of the importance of the emergency period on pricing, and pricing and price per requisition have shown signs of improvement. What's transitory and what's structural? And really, how should we think about pricing as we develop our 2022 models and pricing kind of like ex those kind of like COVID's dynamics?

Yes, exactly. So if you look at the calculation we do, which is revenue per requisition, there's a lot of variables in there, and it's not all price. So if you look at pure price, we have continued to assume in '22 that we would have another round of reductions related to PAMA cuts in '22, okay? So we're assuming worse case than that. We're still pushing on PAMA relief, but we believe that it's prudent for us to assume that we'll have another round of cuts on PAMA. So that will have about 100 basis points worth of price reduction in '22. Second is we always have our natural competitive portion of price with hospital systems competing with some our competitors for volume. And so that has historically been about 100 basis points, and that's a safe assumption as well. So those are the 2 big price assumptions. The second piece of this, Ricky, has to do with what we're seeing in terms of test per requisition. We sometimes have referred to it as test density. And we have seen an increase in the number of tests per requisition. And to your point, we're watching to see if this is transitory or this is a new norm. We do believe as people reenter the system, start to see the doc that they haven't seen for 12 to 18 months, they might be tagging on additional tests to catch up, if you will. And that helps -- that's very helpful for us in terms of the test per requisition and also the revenue per requisition. And the third piece has to do with clinical mix. We have seen good recovery in many of our clinical franchise segments. But we're still seeing a slower recovery in categories like prescription drug monitoring and some of the more esoteric portion of our portfolio. So there is some mix change as well, which affects that calculation, again, of revenue per requisition. So as we go forward in '22 and what we laid out at Investor Day, assumes some reasonable assumptions around all 3 variables.

Wage inflation, is a hot topic in most industries outside of health care, with companies it's really quickly moving towards raising minimum wage and just overall wage inflation. It was really interesting at least in the second quarter call, not many health care companies talked about it. And our thesis was that some of it might be masked by sort of the COVID dynamics and demand. But are you seeing any signs of cost inflation?

Yes. Let me give you some dimensions to what impact this has on us. About half of our cost structure is our wage bill, so it's a big portion of our cost. We are a labor intense industry. Second is we employ about 50,000 people. Our average salary is about $45,000, okay, to give you an idea of impact. And so where we are seeing particularly wage pressure and labor shortage issues is in our frontline workforce and this varies geographically. And we have 2 specific jobs, which are characterized as frontline, and this is where we bring specimens into a laboratory, and we hire frontline people to sort out, if you will, those specimens to get them into our process to be able to result it by the morning. And then secondly is the picking up of those specimens with our couriers around the country. Those are 2 frontline positions. And so we have seen some pressure. And I'll turn it over to Jim because he manages this portion of our business. Jim, could you provide some color on what we've done and where there are some differences by geography?

Sure. And so we have an annual merit increase. And I would say, over the last 10 years, it's been always in the 2% to 3% range. Now in addition to that, yes, we are certainly seeing some inflationary pressures, in particular, on the coasts, on the West Coast and on the East Coast. And logistics, there's always competition from the big couriers, the Amazons, FedEx, UPSs of the world. Specimen processing, it's a difficult job because the shift starts at 10:00, 11:00 at night and runs through the middle of the night. Now a certain portion of those employees want to work that shift. So we're grateful for that. But there's other employees who for $0.50 more an hour to $1 an hour are going to jump ship. So we've seen -- we've had to make some equity adjustments along the way in logistics, phlebotomy, and as Steve said, in specimen processing. Our med tech staff is relatively stable at this point, and we see less wage inflationary pressures there.

And one, can you remind us, Steve, you mentioned $40,000 average salary. But Jim, you also mentioned Amazon as a competition for couriers, are -- is your workforce already on sort of a $15 minimum wage? That's first. And then second of all, in an inflationary environment, you still see the same runway and cadence for cost savings?

Yes, maybe I'll take that.

Let me start, Jim. So the average -- we published this data, the average or the median is about $45,000. That's 50,000 people, roughly 25,000 people make less than $45,000. And there's big chunks of individuals in that 25,000. One is our phlebotomists, the frontline phlebotomists. We employ about 12,000. So it's about half of the 25,000. And then the other 2 big pieces are what Jim referred to, specimen processing; and also our courier operations. There's different dynamics within that. So Jim, why don't you cover what we're doing in terms of hourly wage and the $15 minimum.

Sure, Steve. So there's very few jobs in Quest Diagnostics today that are under $15 an hour. We evaluated it and to get everybody up to that level, it's a rounding error in terms of our wage costs. Now in addition, Quest has what we call an annual incentive plan, which pays out bonuses tied to performance metrics for all of our frontline workers, which adds 2% to 3% on an annual basis to their pay. So with that, Ricky, we're probably -- every single job in the company is probably at $15 an hour when I add that in. So again, we're watching it. There's minimum wage laws in California, Washington, Oregon, other states that we have to come up to that does create some compression along the way. And so we make those adjustments and then work like crazy to offset it from a productivity standpoint.

Yes. And then the last part of your question, Ricky, had to do with productivity gains. And so to remind everyone, we're really entirely focused on our 2 strategies, which is to accelerate growth and the second is to drive operational excellence. And on the second strategy, Jim and his team essentially are the owners across the company in that regard. And what we have indicated is we believe we have an opportunity to increase or improve our productivity by 3% per annum. We've been delivering on that promise, and we do see more opportunities going forward. We've made nice progress despite the pandemic in consolidating operations, building new laboratories. As a matter of fact, we have a brand-new laboratory that we built in the middle of the pandemic. It's in my mind, just unbelievably extraordinary that we've been able to pull this off. We built a over $300 million facility in Clifton, New Jersey, which is allowing us to consolidate the Northeast and apply contemporary practices in automation. So we still feel very bullish about the prospects of driving productivity improvement going forward. And when we talk about productivity, we've made sure it is quite clear we believe we need to do this in parallel with improving quality and also improving our overall customer satisfaction and service levels, and we've done both. And so we believe it's really important for us to drive that triple aim that we talk about in health care, great quality, great experience at more productive price or cost levels. And so we're doing that at Quest Diagnostics.

So wanted to address a couple of long-term sort of more thematic structural things that we're seeing in the marketplace. One is that acceleration in this change from -- move from the 4 walls of the hospital more towards outpatient. How does this -- do you see this is an opportunity? As I think about sort of the volumes that are done in hospitals versus the volume, the opportunity now for outpatient, where do you see you can benefit from that?

Yes, yes. So we have seen over the last decade, if you will, consolidated hospital systems and the acuity level of hospitals going up, and that drives what Jim referred to earlier as a reference testing or sophisticated test. So -- and that's tied entirely to inpatient patient days, right? So no bearing on outpatient volumes or physician activity. And so as hospitals get more centered on acute care and moved more of their activity to non-acute care, there is an opportunity for us to continue to serve those integrated delivery systems and particularly those physicians. And that's why, Ricky, we've been working hard on our hospital strategy, which allows a system, and we have many examples of this in our client base to rely on Quest to make them more efficient for acute care and we call this professional lab services. And then secondly, it's rely on us to consolidate their sophisticated testing and get better at it and smarter at it, and we have software tools and capabilities that help them get smarter at that inpatient testing. And the last piece is really, afford them an opportunity to monetize their outreach activities and rely on us. And so over the last year or so, we've done some nice transactions with some large systems throughout the United States. Memorial Hermann is a good example of all 3 of those opportunities for us. And then secondly, as Hackensack has -- Hackensack Medicals Center in New Jersey is a good example of us doing it with professional laboratory services, helping them become more efficient. So -- and there will be more going forward. So as they start to think about how they rationalize where care is provided, it provides us a bigger opportunity for us to serve that non-inpatient patient encounter in a better and more efficient way.

Yes. Steve, the one thing I might add is the outpatient procedures that are moving out of the acute care centers, namely orthopedic procedures, hip, knees, shoulders. Those don't generate a lot of lab volume to begin with, they never did even in an acute care setting. The one procedure that has largely moved out of the hospital, which we're all over is things like colonoscopies, right? Those are generally outpatient today. And we're certainly on top of every one of those outpatient centers because generally, they'll throw off a pathology specimen when needed.

So we are almost out of time, but I just wanted to touch on capital deployment. You just completed an ASR. But how should we think about buybacks in a more steady-state type environment?

Yes. So we're completing the ASR. We're not completely up but we should be there in the fall. Secondly, is we continue to execute our capital deployment strategy. To remind everyone, it's been consistent with us for now 10 years. We're -- give the majority of free cash flow to shareholders. We've increased our dividend 11 times in the last 10 years, and we continue to buy back shares. That leaves us enough capacity to do the acquisitions that's supportive of our growth ambition as well invest in the company. And I can't under underline the importance of investing in the company. For instance, the $300 million to talk about building the lab, we have the cash to do that. We just updated, Ricky, as well our cash expectation for the year. So we should be in the neighborhood of $2 billion in cash. And therefore, as we come out of '21, we'll review where we are with those 4 elements of our capital deployment and decide what's the best use of our cash going forward. But there will be more share buybacks going forward as we've done in the past.

Great. Well, Steve, Jim, Shawn, thank you very much for your time and the update.

Thank you, Ricky. Thanks. Bye.

Thank you, Ricky.

Thank you. Have a good day.