Quest Diagnostics Incorporated (DGX) Earnings Call Transcript & Summary

Okay. So hi, everyone. Thank you for joining us today. My name is Erin Wright. I am Morgan Stanley's Healthcare Services and Distribution analyst. I am pleased to have with us Quest's CEO, James Davis; as well as CFO, Sam Samad, here with us today. So thank you for joining us, a relatively kind of newer team at Quest. Before we get started, for important disclosures, please see Morgan Stanley research disclosure website at morganstanley.com. If you have any questions, please reach out to your Morgan Stanley sales representative.

And with that, I'll go ahead and get started with Q&A, if that works for you. And I want to give Sam some opportunity to speak here in terms of you're new to Quest. Let's talk about why Quest, why you came on board, some context around the transition and how it's going so far?

Yes. No, I'm super excited to be part of Quest. So a few things that really excited me about the role. First of all, where Quest sits in terms of the intersection of care and all the different constituents that we either support, serve or add value to. You've got health plans, health systems, obviously, patients, pharma. There's so many different intersecting parts of health care that we play a really, really key part in. And given my background, given the fact that I spent almost 10 years with Cardinal Health and a company that's really focused on operational excellence and disciplined execution, going to Illumina with my knowledge of genomics, advanced diagnostics, sequencing and the importance of NGS and some of these new therapies and new diseased and looking at really solving some of the problems in health care. I thought that I could add tremendous value to Quest. Then meeting the management team, looking at the opportunity to partner with Jim as the new CEO, myself as a new CFO. I think we can make a key difference here and a big difference. And then bigger than that, the management team as a whole, I think, was incredibly approachable. The culture is great, fits in with my values and really excited to be here.

Okay. Great. And then Jim, I want to give you an opportunity to talk about kind of your end goals at Quest here and where you do see kind of -- you're taking kind of yourself or yourself taking the company in years to come and how that strategic vision will or will not kind of change going forward?

Well, first, I've been part of the Quest management team working for Steve since 2013. So I joined roughly a year after he came into the company. So I've very much been part of the current strategy and don't expect to see any radical changes. The strategy that Steve and the management team have put in place, we believe is working, and we're going to continue to play that out. Now certainly, there'll be tweaks along the way as markets change, as industries change, as our competition changes, we'll react as well. But the 4 tenets of our growth strategy, we continue to make progress with our health plans. As you know, in 2019, we got back into network with UnitedHealthcare, with Horizon and with some of the Anthem plans. We still have some progress to make with Anthem, and we'll have opportunities here in 2023 to get back into network in Nevada and Colorado. But we continue to make progress. Our aspiration is to have our share of United, Horizon and Anthem similar to our share position of our other health plans, which is in the 20% to 25% range. So we continue that work and work in partnership with the health plans. As you know, we're part of the preferred lab network at UnitedHealthcare. Second is our progress with health systems. So we have about $1.5 billion of revenue today from health systems. About $1 billion of that comes from our reference testing where we do test that hospital laboratories choose not to do. And we have a very large and growing professional lab services, about $0.5 billion business where we are running health system laboratories with Quest employees, Quest equipment, doing that work on site. And then finally, with respect to health systems, we're opportunistic. When health systems decide they no longer want to participate in the outreach business, we'll monetize that book of business. And what I would tell you right now with health systems, given some of the financial pressures that they're under, our value proposition continues to play out. And I would -- I believe and we all believe that it's, in fact, giving us more opportunities. We have a good funnel of outreach opportunities and a lot of ongoing discussions regarding professional lab services. And you'll hear some announcements for us in the back half of this year. The third piece is our advanced diagnostics. We continue to invest in our genetics and cancer offering. We'll continue to do that. We seek partnerships. We're in deep discussions with Roche and Thermo Fisher on MRD assays and new therapy selection assays. We R&D some of that ourselves, and we're always looking for partnerships as well. And then finally, our commitment to our direct-to-consumer, you'll see a wholesale improvement in our platform, the experience that consumers go through when they purchase from Quest. Stay tuned in the next several weeks, you'll see a whole relaunch of that platform, which is going to significantly improve what we call the click-through rates. Once we get the eyeballs to the site, the objective is actually to get them to purchase. That business has a great value proposition. It played out during COVID, where you don't have to go to your doctor to order a lab test, especially for something like COVID. It has a great value proposition to people who value privacy, who don't want their doctors to know what they're getting tested for, and don't want their insurance company to know. And it has a great value proposition for people. We characterize them as watchful warriors. People with chronic diseases who want to get tested more frequently than their health plan, all will cover. So why not just come to Quest order directly rather than go to your doctor, pay for a bill for your doctor only to have them order a lab test that's going to get denied because you hit a frequency limit. So those 4 growth pillars remained, and we'll continue to tweak those along the way to make sure it generates the growth that we're looking for in the company.

And I didn't want -- Shawn, I didn't introduce you previously, but he is a key voice and a key integral part to this whole strategy, too. So thank you for joining us today, Shawn as well. So I apologize I didn't introduce you before.

Thank you.

But now talking about sort of the long-term targets. Speaking to some of those pillars as well. I mean does that mean those seem to be relatively consistent, obviously, with the messaging from Quest more recently. But you previously disclosed 4% to 5% revenue CAGR through '24, implying 2% to 3% organic growth, and then also some incremental capital deployment growth drivers there as well. So is all of that still intact? And can you talk about sort of the pathway to get there?

Yes. Let's stay on the revenue side. The 4% to 5%, we stand behind that, absolutely. This year, we may come in slightly less on the acquisition side on the 2%, but that's chunky as you know. In 1 year, it could be 1.5%. Next year, it could be 3%. But what I would tell you is on the acquisition side, especially on hospital outreach, other independent laboratories, the funnel looks good from that perspective. And again, I think the economics of -- from a health system perspective, only make that value proposition even better. On the organic side, the investments we're making, again, from a consumer-initiated direct-to-consumer testing, the investments we're making in advanced diagnostics. We've disclosed that our total molecular -- portfolio molecular and genetics test growing in the 6% to 8% range. Feel great about that. And then again, we'll continue to grow share with the new plans that we have access to and feel very strong about that. So we still believe we have the right equation to get to the 4% to 5%, and we'll continue to look for new opportunities beyond that.

Okay. Great. So let's switch gears a little bit to core utilization trends. It's a key question. We're asking pretty much everyone at this conference. So where does the base business utilization stand now, especially relative to pre-COVID baseline and as we exit kind of this -- or as we're amid sort of the third quarter here? But where does -- I guess, where is the run rate now compared to when we kind of entered the quarter? Even some of the distributors today were talking about a weaker July period. Is that consistent with what you were seeing as well?

Yes. So let's kind of go back to the beginning of the year. We entered January. COVID was an all-time high. January was a weak month for us. And then as COVID started to decline in February and March, our base business picked up considerably. COVID bottomed out in the early March time period, our base business was strong at that point. And then it was a slow climb back up, cases started to surge again in the April time frame, April, May, June, July. And as it surged and as we said in Q2, our base business softened. We said it softened in June and on our second quarter call, which was the third week of July, we said it was softer in the beginning of July. That played out in July. In August, our base volumes recovered. It was stronger than July. So we've had lots of discussion today on the [ Zyfin ] data. Remember, [ Zyfin ] is a revenue cycle management tool used by small laboratories, some hospital systems doesn't necessarily represent all segments of the market that we participate in. But we certainly saw as COVID weakened in August, and we've talked about our volumes on COVID, 42,000 in July, 32,000 in August, as that continued down, our base business started to recover, and we felt good about that in August, and we feel good about the recovery here in the early part of September.

And so where does the current -- where are your thoughts on the current monthly COVID testing metrics now?

So again, we said we still continue to let you know on a monthly basis, 42,000 in July, 32,000 in August. Obviously, the trend continues to soften a bit. It doesn't change our guidance at all in the second half of the year. We still feel good about 15 to 25 per day for the back half, last 6 months of the year. And look, it's tough to predict where this thing is going. What I would tell you is the total amount of PCR testing in the country remains in the 500,000 per day kind of a range. Will it soften to 400,000? Hard to tell. But look, we continue to pay close attention to variants in other countries. Obviously, the administration's ending of free COVID testing is a plus for PCR testing. Kids going back to school, meetings like this, that could be a plus for COVID testing. So there's so many factors at play here that we can't pin a number as we enter the fourth quarter, but there are some factors that would suggest it will go higher. There are some factors that say it will stabilize. I think the important point is, is if it hangs in there at the 400,000 to 500,000 a day, even when price drops to $51, it's still a very, very good market. That's a $400 million market. And as that price drops to $51, we think some of the supply will come out of the market. There's a lot of suppliers that won't make money at $51. And so that will shake out some of the supply. And then our plan is to continue to grow our share. We said it's been as high as 8%, and our aspirations as we go forward will be higher than that.

Okay. And do you think that there's a longer-term fundamental change in utilization trends in a post-COVID environment?

I don't think so. I think there's still pent-up demand out there. We quizzed all the participants and discussions today who's had their wellness event, who's been to their OB-GYN. And more often their not, it's -- I haven't seen the doctor in 2 years or nope, missed that appointment. So we still think there's some pent-up demand out there. I think people will return back to care. And we continue to innovate. There's new tests that come to market. Our clinical mix is improving. So there's some good trends there.

Okay. And then on the retail partnerships, can you talk about sort of the relationships with Rite Aid and others in terms of COVID testing and volumes? And what that means in terms of what more you can do with the retail pharmacies? And also, a little bit about the profit profile of those businesses because that is a component embedded in your guidance?

Yes. So first, our relationship, which really got started with CVS is just terrific. We work really, really well with the CVS team. I love the team and we still do, as we said, 40% to 50% of our volume is coming from retailers. Recently expanded our relationship with Rite Aid, serving well over 1,000 Rite Aid stores today. So we've had discussions with CVS about expanding our partnership. I mean it could be simple things like putting our patient service centers, some PSCs in some CVS stores. So we're having discussions with CVS about expanded ways to grow our collective presence in health care. We'll continue those discussions with Rite Aid, with Walmart, where we have a relationship. You may recall, we've got 70- to 80-patient service centers in Walmart stores today. They've been a participant in the COVID testing as well. And we love these retail relationships, and we'll continue to grow them.

And then switching gears a little bit to pricing. I think you've mentioned previously the commercial payers were starting to accept some degree of inflation and price increases during kind of renegotiation processes. But do you expect this dynamic to hold as we kind of think about 2023 and beyond? And how are you thinking about pricing?

Yes. So what I'd say is first, our discussion with payers aren't just -- our costs are going up, so pay us more. It's really around the value we create in the industry, okay? And there is a lot of value we believe we create for payers, and we believe we're part of a very value proposition that is affordable and it starts with affordable care. So having said all that, prior to the pandemic, we were losing 100 basis points of price a year on average for many years and then PAMA was on top of that. What we said in the second quarter is that our price loss was in the 40 to 50 basis point range. And obviously, that the way we went from 100 -- down 100 to down 40 to 50 is we've gotten price upped in many of our health plans. So the last 12 discussions or last 12 renewals with health plans have resulted in positive price increase for the 12, okay, in collection. So we feel good about the progress we're making. We go into every discussion that talks about our value that we create for the industry and our desire to get rewarded for the value we provide. So the momentum is really good there. Now where there is some price pressure is obviously on the health systems, right? Again, $1.5 billion of our total portfolio is from health systems. And given the challenging environment that they face, there is a little more price pressure there.

Right. Right. And can you give us an update on SALSA and PAMA and how we should be thinking about this? And what's the latest there and implications for your future commercial negotiations as well?

Yes. So we're hopeful. So there is a third round of PAMA. We've talked about the impact of that, a roughly $80 million impact. We got a plan as if that's going to happen. So we'll build a business plan for '23 as if it's going to happen. SALSA was introduced. We believe it has strong bipartisan support. Our industry trade association, ACLA, has done a fabulous job at getting more support. Obviously, all the companies that are part of ACLA are doing their part. And Steve is still the CEO and Executive Chairman -- will be Executive Chairman. He's going to spend a lot of his time on that, okay? He's got great connections and he's done a great job with that, and will continue to support that. If SALSA is successful, what it calls for is node cuts in 2023. And then a series of 3 cuts in '24, '25 and '26, that basically add up to the 1 cut that was contemplated in PAMA in 2023. And then a new collection process, one that we believe is actually fair, will be implemented in 2026 that will then be used to set rates in '27. So we are hopeful, it has bipartisan support. We probably won't know until the end of the year. If it's a negative outcome, then we're going to push for a delay in panel like we were successfully able to do in '21 and '22. If it is successful, we're going to feel great about that and continue to work with legislators to establish a fair data collection process that establishes a fair price point in the industry.

And I do want to open it up to, to questions in the audience. If you do have one, feel free to raise your hand, and we'll get a mic over to you. And I'll try to see if there's anyone. And then in terms of efficiency initiatives, what are some of the latest productivity initiatives that you'd like to spotlight here? What's the bigger opportunity kind of going forward for further productivity gains, whether it's in automation or innovation and otherwise, but can you speak to kind of some of those dynamics and updates there?

Yes. So our goal with our Invigorate program, just to back up a bit is, our goal is always to offset wage inflation, offset price loss. And the mix, again, we had higher price loss in previous years. Our price loss is quite manageable at this point. But obviously, our wage inflation is a little bit higher, and we have other inflation running through the business. But the goal remains the same, generate variable cost productivity that offsets all of that so you continue to grow margins, or it continued to drop that next requisition at a very high contribution margin. There's still lots of opportunity throughout the system. It's a never-ending game. Innovation continues on. And some of those things that we've talked about in the past, in our patient service centers, right, continuing to drive work out of our patient service centers. So our phlebotomists are still doing way too much paperwork. And how do we do that? So we're asking patients to make appointments. And when you make appointment, we're asking you for your insurance information, we're asking you for your credit card. We're trying to ensure that the requisition that the patient has is there when the patient shows up by making sure the doctor has sent it to us. So all of these things that take time. The actual blood draw urine collection is a 5-minute procedure, but the typical patient time is a 12-minute experience. So we're doing everything we can to shorten that so that we can continue to do more draws with our existing staff. We deploy all sorts of tools and technology from a logistics standpoint. So most of our routes are predetermined. We know exactly where we're going to stop, but 20% to 30% of our pickups every day are random pickups, meaning we have an office that doesn't have specimens every day so they call us. And we're able to surgically insert those stops from an IT standpoint. We know where every driver is. We know who's closest to that office that just called us the needs of pick up. And so we're a lot more efficient there. Specimen processing, really trying to reduce those paper requisitions that still come into our laboratory, systems that automatically read bar codes on the tubes. The tubes that we give to physician offices that do their own draws. We're experimenting with having labels on those tubes already as opposed to off-putting labels on those tubes when they arrive in the laboratory. So when that tube arrives in the laboratory, I scan the tube, I already know who the patient is because the doctor has already entered the information. So all sorts of opportunities for us to continue to digitize this business and drive productivity. And then finally, we rely on the innovation of our suppliers from Roche, Siemens, Hologic, Thermo Fisher. And every time our platforms get to the end of life every 7 years. There's new innovative platforms that they're bringing to market that lower our labor cost, lower our reagent utilization, have automated artificial intelligence features that allow us to read things like microbiology plates that automatically read these things and sort negatives and positives and then make our reads more productive. Hologic working on some really interesting things from a digital cytology platform. Obviously, you're probably aware of all the digital pathology tools that are starting to come to market. And these aren't just about productivity, this is also about quality, right? Some initial studies on these digital pathology tools have shown that the quality of the read is better when these digitally assisted tools are given to clinicians. So it's about quality first, but they obviously enhance our productivity, enabling us to move a pathology slide, by the way, anywhere in the network. So you digitize that slide here in Clifton, New Jersey, and if I've got capacity in California, I can send that slide out to a pathologist in California. So still early stages, but a lot of opportunity left for us to drive quality improvements and productivity.

Okay. That's helpful. And then as we think about -- and maybe I should start with this first because those are the good syndicating factors. So can you speak to or give us an update on inflation, labor, supply chain? Just any sort of update there that you could give people some level of comfort around visibility on that front.

Yes. So our labor cost this year, we said are going to be up 3% to 4%. And what we'd say is going into next year, I think that's a good planning assumption for our frontline teams, okay? It doesn't necessarily mean everybody in Quest will get 3% to 4%. But certainly, for our frontline teams, it could be in that range. Our turnover levels have stabilized, but they've stabilized at a rate that's still too high, and higher -- much higher than it was pre-pandemic. So we have to get that down because these turnover rates actually impact your productivity, right? When you're turning phlebotomists, logistics, specimen processing, people come into the company, it takes time to ramp up to the same productivity levels. So important that we reduce that turnover so we drive our productivity back up. And it may take a percent more, it may take in that 3% to 4% range to do that. On the materials and supply side of our business, right, we spend about $2.5 billion on all things related to running laboratory tests. Those are pre-analytical supplies, gloves, gowns, masks, face shields, it involves needles, tubes, all the pre-analytical stuff as well as the analytical supplies, reagents, chemicals and things needed to run the actual test. And what we've said is about 80% of that spend is under contract, okay? And so we don't have many contracts that have price increases, all right? And so we feel good about that. 20% is floating, and we've had some inflation. But obviously, beyond that $2.5 billion, we have a significant chunk of spend that's related to fuel costs, utilities, temporary labor, temporary logistics, hotel bills, food bills for when people travel. And we've obviously seen inflation into that bucket of spend as well as the 20% that isn't under contract. So we've said it's probably somewhere costing us between $0.05 to $0.08 a quarter, right, this moment, but it was in our guidance this year and is still within the guidance.

And then broadly speaking, on -- and switching gears a little bit on the payer side. The payer relationships have evolved meaningfully even in recent years and using the PLN as an example with United. Where are we at in terms of the inning you're in? Or how you're thinking about the ability for that to truly steer volume?

Yes. So I feel great about the relationship with UnitedHealthcare, Aetna, Anthem, and the value-based contracting arrangements we have with them. But more importantly, we feel really good about the partnerships and how the joint teams in each of those companies are working with us. And much of this is around identification of physicians that are using out-of-network laboratories, between their messaging, our messaging, our visits to those, we certainly try to redirect that work. A lot of effort going into redirecting work that is in health systems that goes into expensive health system labs. And obviously, that's challenging, especially with physicians that are owned by health systems and under pressure to send that work into health system labs. But we come at it from multiple angles. We'll go into a local marketplace and work with employers, educate employers on why their employees should use independent laboratories as opposed to the health system laboratories. Most of these employees have a choice. And it's up to the employee. It's up to the patient to request that the doctor use 1 of these laboratories. And then finally, the payers are doing some innovative things around what we would call employee benefit design. So if you use 1 of the independent preferred laboratories, there's 0 out of pocket of expense. If you use 1 of the health system laboratories, there is going to be an out-of-pocket expense. And that will save the payer money -- I mean, think about this. If we have a requisition that's $60, and the payer gives us $40 and you give me $20 if you use an in-network lab. If you don't use it in-network lab, that bill could be $120, you're going to pay $40 and the payer is going to pay us $80 million. So the payer is very willing to go to the patient and say, "You know what, we'll pay the whole $60 because it will save us $20 if you use an in-network lab." So the patient saves money, the payer saves money and the employer saves money. So it's a win-win-win. So those kinds of innovative benefit designs can really help steer business to Quest Diagnostics.

Okay. And I want to make sure that we get the capital deployment too, because it's a big part of the story as well. How are you thinking about the deal pipeline, tuck-in deals versus opportunities to buy even innovation? And I know, Sam, you have a broad history there, too. But as we think about -- yes, the pipeline here from an M&A versus buyback standpoint, how should we be thinking about that?

Okay. So let me talk about the sort of deal funnel and I'll let Sam talk about the capital deployment strategy in general, okay? The funnel looks good. And again, we've said in the back half of this year, we should be announcing several acquisitions, okay, that get us closer to the 2% goal that we're striving for. It's a mix of hospital outreach deals, could be some specialty capability building things out there. But we continue to build the funnel. The discussions are good. As people are coming out of COVID, they have more time to really think about these things, and we'll continue to do that. So look, in general, our capital deployment strategy has been return of free cash flow to shareholders, okay, whether that's dividend increases or share repurchases. But our first bias is to put the capital, put the cash flow to work to generate future growth. And we're going to do that by continuing to invest in the things that I've talked about and by looking for acquisitions and free cash flow after that, we're going to return to our shareholders.

Yes. I think you captured most of it. The only thing I would add is we will return most of it to shareholders. That's -- we've been consistent on that. We'll remain consistent on that. We'll be disciplined in M&A. We'll look for things that definitely are accretive. And in cases where we don't find those M&A opportunities, we're going to return the rest back to shareholders as we have done over the last few years. So I think that's a very, very disciplined focus for us.

Okay. Great. Thank you so much for the time. I appreciate it, and hope you have a great conference.

Thank you, Erin.

Thank you. Thank you.