Quest Diagnostics Incorporated (DGX) Earnings Call Transcript & Summary

Perfect. Good morning, everyone. This is Rachel Vatnsdal with the life science tools and diagnostics team here at JPMorgan. And today, I'm joined by Jim Davis and the rest of the Quest Diagnostics team. So similar to most of the other sessions that you've been attending, this will be a 40-minute session, the first half being a 20-minute presentation by management, followed by 20 minutes of Q&A. For those of you listening online, feel free to submit a question via the webcast function. Otherwise, for those of you in the room, if you have a question, please raise your hand and we have mic runners throughout the room. With that...

Thank you. So good morning, everyone, and thanks for getting up early to join us here. And as always, our safe harbor disclosure that I'm sure you've read 30 times through the conference today or yesterday. So we're here to talk about 4 things today. One, for those of you that don't know us well, just to describe our essential role as a leader in the diagnostic information services industry. Second, we're about growth, and we're going to talk about the levers of growth and what we're doing to drive growth in our business. Three is we'll talk about operational excellence. When you process 170 million requisitions a year, you have to be very efficient, you have to be very effective, and we'll talk about ways in which we continue to do that. And then we have been very disciplined about our capital deployment over the last 10 years, we'll show you some data on that, and we'll continue to do that as we go forward. So first, a little bit about our business for those of you that don't know us well. We serve over 50% of the U.S. hospitals and physicians in this country. Every year, we serve about 1/3 of the U.S. adult population. About 50% of all U.S. adults come to Quest Diagnostics over a period of 3 years. We have over 60 billion patient data points. We believe we are uniquely qualified to answer questions that federal agencies like the CDC, HHS ask on a routine basis given the depth and the geographic breadth that we have across the country. We have over 7,100 retail and patient access points, about 2,100 patient service centers, 4,500 IOPs. We're in Walmart stores. As you know, Walmart sees over 100 million customers a week, and we want to be where the people are. We have 24 (sic) [ 24,000 ] phlebotomists, paramedics and health and wellness professionals that are able to make mobile visits. They staff our PSCs, they staff wellness events, they do drug testing across the company. And on average, we process over 2 million tests a day in the company. Now I think as many of you know, there's been a transition in Quest Diagnostics. I came into the CEO role as of November 1. With all transitions, there's been some movement. I want to just point out a couple of people. We brought on Sam Samad. Sam was the former CFO of Illumina, joined us in July of this year. And with that, yes, we recruited someone from the genetics and life sciences industry because it's a focus point of Quest Diagnostics and it's a way that we're going to grow in the future. We've also recruited Mark Gardner, you may see on the page here. Mark spent most of his career with Invitrogen, then Life Tech, and then spent some time with Thermo Fisher before doing a couple of entrepreneurial things and then coming back to Quest Diagnostics to lead our cancer and genomics business. And then Richard Adams, who happens to be in the audience today. Richard leads our consumer-initiated testing business, that's our consumer direct business where we go direct to consumers without any intervention from physicians. Now this is a framework that Steve introduced about 10 years ago, our guiding principles for our employees and for the external market. We called it Our New Quest, but that was 10 years ago, and so we will evolve this. We'll tell you more about this at our Investor Day in March. But I can tell you a few things that won't change. What won't change is our overall purpose of this company. And our overall purpose of this company is to help create a healthier world, and that won't change. And what won't change is on the left. We're in the diagnostic laboratory industry. And we believe that when we provide these diagnostic insights, it can help people lead healthier lives. What will change is some of the things in the middle, the strategy. The strategy has to evolve as our market structure and the players in our industry continue to evolve. And I'll talk about that more in a few minutes on some of those structural changes that we are seeing in the industry. But first, just for a moment, about the overall lab industry, again, for those of you that are new to this. We participate overall in an $82 billion industry. Now about 36% of that $82 billion is work done in health systems for patients that are in beds. Now we can participate in that market. And we do today. We have just under a $600 million professional lab services business where we run hospital labs, Quest employees inside the hospital that are doing that testing. In addition, a portion of that 36% is referred out to laboratories like Quest Diagnostics. We think that's about a $4 billion chunk of that $36 billion. And we get over $1 billion of that, just under $1.1 billion today. So we participate in that light gray area. But Quest Diagnostics has largely been centered on the physician lab services business, which is about a $52 billion segment. And you can see that hospitals also participate in that outreach business. They want to get that work from their physicians that are stationed out in the world. But the independent labs gather about 53% of that. And you can see that 53%, about $28 billion, and we've got about 24% share. We are the largest market share provider in this industry today. Now as I mentioned, the health care landscape continues to change and evolve. We grew up in a very simple industry, where a patient went to a provider and a health plan largely paid that bill. It was a very simple, nice business. We were called an independent lab, and we were an independent lab because we called on independent physicians. And there were a lot of independent physicians out there. But today, a lot of those independent physicians are now working for someone else. And as I walk around the circle, important to note that every one of these other participants in this industry is a customer of Quest Diagnostics today. So let's start with the patient. Patients are customers. They pay a portion of the bill. Sometimes they are consumers and they come directly to Quest Diagnostics without going through a doctor. We've committed to building a $250 million business by 2025. Health plans, which one thought of as largely contracting entity, is no longer. Health plans are customers of Quest Diagnostics. Health plans own providers. We're seeing that with UnitedHealth Group, Aetna, Humana, Cigna, all organizations that own providers. Employers. We call directly on employers today for prescription drug, for drug monitoring, drug testing of new employees, for wellness. But we also go into employees and get them to understand that if their employees use independent laboratories, it can save them a lot of money. Retailers. You've seen what CVS, Walmart, Walgreens and even Amazon are doing in a primary care space today. And life sciences. Life sciences is actually -- generates more than $100 million of revenue to Quest Diagnostics. We provide pharmaceutical industries and CROs with data to help them do clinical trials better, faster and more efficient. And then obviously, providers and health systems are a big portion of our business and will remain. Our commitment is to remain at the center of this ecosystem. We -- a $45 average requisition in Quest Diagnostics unlocks a lot of vital information for every member of this ecosystem that I show on this page. Now through the pandemic, we established many, many new relationships with hospital systems. Mercy, we recently purchased their outreach book of business and now serve all of the outreach physicians in Mercy across the Midwest. Hackensack Meridian Hospital, as I mentioned, our professional lab services business, we are inside the 4 walls of their hospitals. Northern Light up in Maine, Summa Health -- we did an outreach deal in Akron, Ohio. We work closely. We have our PSCs in Walmart. We enjoyed a wonderful relationship and still do with CVS from a COVID testing standpoint as well as Rite Aid. And then through our Quest for Health Equity, we're working with organizations such as Choose Healthy Life, STM (sic) [ SIM, ] Bread of Life to help provide lab testing to underprivileged people in parts of this country where lab testing just simply isn't accessible. And then through the pandemic, we developed deep relationships with the CDC, HHS and the FDA to again answer questions from a COVID standpoint that we were uniquely qualified to answer. So let me now come back to the 4 levers of growth that we've been driving through the company over the last 4 years: health plans; a focus on hospitals; a continued commitment to drive advanced diagnostics, in particular around genomics and cancer; and then our consumer-initiated testing business. So first with health plans. As I mentioned, health plans are no longer. We don't view them as contracting entities. They are real customers here in Quest Diagnostics. And we've established what we call value-based contracts, meaning we get paid a fee-for-service rate for most of our customers. But beyond that, what we're trying to do with these health plans is move requisitions from expensive hospital-based laboratories to independent labs like Quest Diagnostics. We're focused on quality. We're focused on an incredible patient experience. We're focused on an incredible physician experience. And when we do those things for these health plans, we can earn extra value. When we move reqs out of high-priced systems to our system, it's a way for us to generate incremental value beyond the fee-for-service rates that we get paid. We're enhancing these partnerships through value-based services, population health initiatives. And then as I mentioned, we are going directly to employers today. Employers today are still paying the preponderance of health care costs in this country. And when we can help employers educate their employees that when they come to independent labs like Quest Diagnostics, it can save them a lot of money. Our focus on health systems continues. I'm sure at this conference, you've heard about some of the turbulent times that health systems face today: margins pressures, labor cost pressures and a shift to home-based care. We can help with that. Our lab management offering, our mobile services, our population health analytics that can help these health systems target patients that are most critically ill and our ability to monetize their outreach book of business when they choose not to participate in that outreach business anymore. And then finally, our advanced diagnostics business. We brought in Mark Gardner to really help us focus on our genomics offering as well as our cancer offering. Now it's a bit of a secret in Quest Diagnostics and in the industry today, we have over $1 billion in cancer testing today. That's some routine testing like PSA and pap smears. And we have a very, very strong anatomical pathology business where we get tissue samples in our labs every single day. Now where we're not so strong but where we're building capability is everything post diagnosis. That includes prognostics, it includes therapy selection, and it includes minimally residual disease. And when you come back and join us at our Investor Day in March, we'll get very, very specific about what we're doing to develop tests, to partner with others in the industry so that we're participating in this high-growth market. We control the specimens today, so it's just a logical next step to be able to do that testing as these tests continue to emerge. And then finally, from a consumer-initiated testing perspective. We believe it's a $2 billion market. We believe there's consumers out there that want to come to Quest Diagnostics and other labs but they do not want to go through a physician. These are people that are seeking privacy. These are people that are worried well. These are people that may be chronic diabetics, but a payer may only pay for 2 A1c tests a year, so why go to a doctor, spend $100 just to get a lab order written, only to get denied by the payer. It just is much easier to come directly to Quest Diagnostics. We launched a new platform over the summer. If you haven't seen that platform, take a look online. It provides an easier, simpler, more intuitive purchasing experience. And based on the analytics that we've seen thus far, we're off to a great start. As I mentioned, we've committed to building a $250 million business by 2025. And then finally, our productivity program. In the past, you've heard a lot about Invigorate. Now we certainly didn't pause Invigorate during the pandemic, but I can tell you, any available resource in Quest Diagnostics from 2020 through the better half of 2021 was highly focused on helping us respond to the pandemic. We're now taking those resources in what I call reinvigorating our Invigorate program. Our commitment has always been to try to use our Invigorate program to offset the impact of prices and the impact of wage inflation. And while the impact of price is less on our business, we talked about -- ex PAMA, about a 50 basis point reduction in price last year, the impact of inflation has grown as it has hit everyone here in this audience and as it's hit businesses across the U.S. So we are reinvigorating our Invigorate engine. And the piece I'd like to talk about in a little detail is what we're doing around automation and artificial intelligence. Many of you may have seen our laboratory in Marlborough, Massachusetts, in Clifton, New Jersey, and we've made a strong, strong commitment to automating many of the manual processes that exist in the laboratory today. From an artificial intelligence standpoint, we've partnered with companies like Copan in the microbiology area. When I walk around a laboratory, if I see somebody looking into a microscope, it represents to me an opportunity to digitize a slide and let something else read that slide. It's not just about productivity, it's also about quality improvement. And our early-stage development with some partners around digital pathology, especially of prostate images, has really started to prove out that the quality of the reads is actually better with the use of artificial intelligence. As I mentioned, from a capital deployment perspective, when Steve came into the company, he made it his mission to be much more efficient with the capital that we deploy in this company. We're proud to say over the last 10 years that we've returned over 60% of our cash to shareholders in the form of share repurchases and dividends. We've spent about $3.4 billion of capital to upgrade our patient services centers, modernize our fleet of logistics and the analytics we use to guide that fleet, to modernize our laboratories and to modernize and to continue to digitize all processes within Quest Diagnostics. In addition, we've used about $3 billion for accretive growth-oriented mergers and acquisition, and we will continue to be opportunistic about that M&A going forward. So just the key takeaways that I'd like to leave you with. I think we're well positioned for growth in this industry. We've committed to 4% to 5% revenue growth on a long-term basis. We'll continue to invest in the growth drivers that I spoke to. And we are reinvigorating our Invigorate program to really make a bigger chunk into the inflationary impact that we're seeing on our business. And we will generate strong cash flows and continue to return the majority of our free cash flow to our shareholders. Now I'd like to end with 2 important dates. First, we are going to report our Q4 earnings and our total earnings on February 2 of this year. We'll also provide full 2023 guidance to you at that point. And then on March 16, we're doing an Investor Day where we're going to go much deeper into our strategic priorities. And you'll hear from me, you'll hear from Sam, you'll hear from other members of our management team. But since that time -- since our Q3 earnings, there's been a couple of significant changes in this industry. First, as you know, Congress delayed the Medicare reimbursement cuts called PAMA. We were not successful in getting SALSA over the goal line. We'll continue to try to do that. But the impact from that delayed cut should have somewhere between an $80 million and $85 million positive impact on this business. Second, as many of you know, CMS increased the Medicare reimbursement for draw fees for the first time in nearly 40 years. That fee is going to go from roughly $3 all the way up to well north of $8. We feel good about that. That will add another $40 million of incremental revenue and margin to this business next year. And so while our expectations for 2023 have improved, we don't expect all of that upside from these new tailwinds to hit straight to the bottom line. We continue to face a challenging yet improving inflationary environment. Labor inflation is still high. It is going to be in the 3% to 4%. And while our turnover has lessened, it's still not back to the turnover rates that we had in 2019. There continues to be a lot of uncertainty around both the COVID demand as well as the COVID pricing. We know that when the PHE ends, the COVID pricing that CMS is committed to will be $51. What we don't know is what the commercial payers will pay us. We're going to argue strong for $51, but we may not get that rate. And there'll be uncertainty around what are the coverage policies regarding COVID testing going forward. So with that, we will give you full year guidance on the impact of that roughly $120 million improvement, and we'll be delighted to discuss that with you on our February 2 call. So with that, we will now take -- we're ready for some Q&A.

I'll invite the rest of the management team up as well. Great. Thank you. And as a reminder, if you have a question, please raise your hand. We'll have mic runners pass you a microphone. So kind of to kick it off here. On the base business volumes, you grew that 1.5 -- just over 1.5% during 3Q. So can you just walk us through some of the drivers there of really what was driving some of that growth and if that's continued into 4Q? And then are we at prepandemic levels? Or what should we expect from that volume going forward?

Yes. So we're better than prepandemic levels overall. And the drivers of that volume growth, number one, is share gain, working with these health plans. We're motivated to move the work. The health plans are motivated to move the work. And employers are motivated to move the work. And I can tell you, as we enter into a more inflationary environment, from a health care cost standpoint, it's hitting employers' bottom line. And they're very motivated to work with us directly to help educate employees that using labs like Quest Diagnostics, it's good for them, it's good for the patient, it's good for the payer, and it's good for Quest Diagnostics. And so we'll continue to do that. So a combination of share gains, moving high-cost reqs from health systems and other out-of-network plans. And then our focus on health systems. We got -- we have very nice growth in health systems this year, both on the POS and our reference book of business.

Perfect. That's helpful. Also just kind of following up on the mix side of things. So you mentioned during 3Q that better fee-for-service performance was one of the drivers of some of that mix. So can you kind of dig into that? What -- how are you being able to compete in that fee-for-service performance? And then how sustainable is some of that?

Yes. So there's a lot of things in this thing called mix. And let me just walk through a couple. First, test per requisition, test density. We've continued to see slight increases in test density, test per req. Some of that could have been because of delayed care, people coming back to the physician office, physician hasn't seen you in 2 years and maybe he's going to order more tests than he would have if he'd seen you once a year. That's part of it. Clinical mix. Our focus on our advanced diagnostics, molecular testing, genetic testing, some of the things I talked about in cancer, that mixes up the book of business. And then it's always -- there's always a mix of fee-for-service and capitated work, and we just saw in the quarter more fee-for-service work and less capitated work. So that can fluctuate from quarter-to-quarter. But all of those things drove improved revenue per recognition. And obviously, less price headwinds also helps us, right? As the price per test declined, the rate of decline year-over-year was an improvement.

Great. And then maybe following up on that, but just keeping on the mix topic, can you talk about how mix has shifted within that clinical piece? You've talked about doing more on the molecular side of things and genetic testing. So how do you think about that shift moving forward, especially as we have respiratory season being outpaced here in the recent weeks as well?

Yes. Well, obviously, we're seeing a massive increase, set aside COVID, in RSV cases and in flu cases. And that has an impact on our business. There's rapid test for flu. Sometimes those rapid tests could be negative, but the patient has symptoms, so the physician reflects to a molecular test, and we do that work. Now obviously, when a patient presents today with flu-like systems -- symptoms, the doctor may order 3 tests. The doctor may order a COVID test, a flu test or an RSV test. Some physicians order a COVID test. If it's negative, then they reflect to a RSV or a flu test. So that has been a very positive impact on mix for us. Flu testing, the molecular test, the combined panel is $142, but the reimbursement just on straight flu or straight RSV is very, very good.

Maybe just as a follow-up to that on the respiratory testing. How should we think about Quest competing with some of these at-home tests, especially once COVID has become more pronounced and everyone is getting used to some of these at-home testing modalities? How does that play into your share shift when it comes to COVID?

Well, first, antigen testing is an at-home test that has had an impact on the PCR industry. I mean the positivity rate in this country right now is running at 25%. When it was 25% a year ago, the industry was doing 3 million -- 2 million -- 2.5 million tests a day, substantially down. So antigen tests clearly have an impact. But we send kits to people's homes today. You can order a kit from Quest Diagnostics for COVID and you swab yourself, you send it back to us. So I think going forward, what we are going to see is an increase in home-based test, where the patient swabs themselves. If you can swab your nose, you can imagine swabbing other parts of your body, STD-related, and we'll participate in that market. We will have kits going forward that allow patients to swab themselves, do it in the privacy of their own home and return those tests to Quest Diagnostics.

Helpful. While we're talking about COVID, maybe just talking about the pricing of COVID right now. So the $100 COVID PCR reimbursement, can you talk about what's the latest on that? It sounds like the public health emergency may be getting extended again here today. So how should we think about that, especially as you shift more towards some of these combo tests in light of the triple-demic and flu and RSV being there as well at that higher price point?

Yes. So we're optimistic that the PHE will be extended. The White House and CMS have committed to always giving us 60 days' notice prior to it ending. So feel good that it will at least go to, let's say, April 1 of this year. As you know, the reimbursement through CMS is $100, that's what we're charging most of our commercial payers given the readiness response that we've been asked to carry as an industry. Post PHE, CMS has indicated that they will drop the rate to $51. What remains unclear is what we will get paid through some of the commercial plans. We're obviously going to negotiate $51. But as you know, some of the plans may have ideas about paying us a percentage of that $51. I think the other issue that we've got to get our arms around is what will be the coverage policies of the commercial plans with respect to COVID. And today, basically 100% of all COVID tests are covered, not 100% sure that, that will be the policy going forward. We'll argue, obviously, from a national health perspective that, that should be the policy.

Helpful. Maybe just going back to your comments on share gains there. So obviously, throughout the pandemic, you've had some of these smaller hospital labs and regional labs have really struggled. So that could be a source of share for you guys. But also on the other side of the coin, you've had some of these other labs invest pretty heavily in some of their capacity. So there's still some debate going on, on how that share shift is going to happen going forward. Are some of these labs are going to continue to run on the instruments that they invested in over the course of the pandemic or will they shift back to send out? So can you just kind of walk us through your perspective and how you're thinking about those dynamics and how it will shake out for '23.

Yes. So first, it's not clear that everyone in this industry can make money at $51 or a percentage of that, depending on what the commercial payers do. So number one. Second, there's been this concern that there's a lot more equipment out there, a lot of Hologic Panthers, a lot of Roche equipment that can do this molecular testing, in particular, going after STDs and STIs, which is one of the big things that is done on a Hologic Panther. But remember, having the presence of equipment does not guarantee commercial success. What's required to compete in that STD/STI market is, first, you need relationships with ob-gyns. You need a sales team to call on them. Second, we've got connectivity with hundreds of thousands of physicians today. You need electronic connectivity with them. And then the third and most important thing you need is you need to be in network with the payers. And I don't think all the payers are just going to instantly put in network these commercial laboratories just because they have equipment. If it was that attractive of a market to them, they could have gone out and bought that equipment long before the pandemic. So not actually worried about that equipment and the excess capacity that will exist.

Got it. Helpful. And then maybe just shifting over to PAMA. So you mentioned obviously some of the PAMA and SALSA updates here. How are you thinking about your conversations with the government around SALSA heading into next year?

Well, it's -- our trade association gathered on January 3. We celebrated for about 2 minutes the fact that there was a PAMA delay. We fought hard for that in 2022, and a real big callout to our trade association, ACLA, for getting that done. After that 2-minute celebration, we started talking about SALSA and what it's going to take to get a permanent fix in this industry. We still support SALSA. We know there's members on the Hill that still support it. There's some changing of the guard, as you know, some retirements, some new people coming in, committees changing. So I can tell you that there'll be maniacal focus on getting a permanent fix in this industry and we'll push hard for SALSA in 2023.

Helpful. Consumer-initiated testing is another area that you've spoken about a fair amount recently. So can you walk us through what's the CAGR that you guys are assuming to be able to reach that $250 million in revenue by 2025 on the consumer-initiated testing? And then how much higher is the rev req -- rev per req for CIT as well versus your standard base business?