Quest Diagnostics Incorporated (DGX) Earnings Call Transcript & Summary

Welcome to the Quest Diagnostics Fourth Quarter and Full Year 2022 Conference Call. At the request of the company, this call is being recorded. The entire contents of the call, including the presentation and question-and-answer session that will follow, are copyrighted property of Quest Diagnostics with all rights reserved. Any redistribution or retransmission of the rebroadcast of this call in any form without the written consent of Quest Diagnostics is strictly prohibited. Now I'd like to introduce Shawn Bevec, Vice President of Investor Relations for Quest Diagnostics. Please go ahead, please.

Thank you, and good morning. I'm joined by Jim Davis, our Chief Executive Officer and President; and Sam Samad, our Chief Financial Officer. During this call, we may make forward-looking statements and will discuss non-GAAP measures. We provide a reconciliation of non-GAAP measures to comparable GAAP measures in the tables to our earnings press release. Actual results may differ materially from those projected. Risks and uncertainties, including the impact of the COVID-19 pandemic, that may affect Quest Diagnostics' future results include, but are not limited to, those described in our most recent annual report on Form 10-K and subsequently filed quarterly reports on Form 10-Q and current reports on Form 8-K. For this call, references to reported EPS refer to reported diluted EPS, and references to adjusted EPS refer to adjusted diluted EPS. Any references to base business, testing, revenues or volumes refer to the performance of our business excluding COVID-19 testing. Growth rates associated with our long-term outlook projections, including total revenue growth, revenue growth from acquisitions, organic revenue growth and adjusted earnings growth, are compound annual growth rates. Finally, revenue growth rates from acquisitions will be measured against our base business. Now here is Jim Davis.

Thanks, Shawn, and good morning, everyone. Quest had a strong year in 2022 with base business revenues growing more than 6% in the fourth quarter and 5% for the full year. As we expected, COVID-19 testing revenues declined but still exceeded $1.4 billion in 2022. Our strong performance over the last several years would not have been possible without the commitment and compassion of our nearly 50,000 colleagues who rose to the challenge of COVID-19 while growing our base business. I am incredibly proud of how this team has worked together during an unprecedented period in the lab industry to deliver insights to help create a healthier world. This morning, I'll discuss our performance for the fourth quarter and full year 2022, then Sam will provide more detail on our financial results and discuss our 2023 guidance. In the fourth quarter, total revenues were $2.3 billion. Earnings per share were $0.87 on a reported basis and $1.98 on an adjusted basis. Cash from operations was $334 million. For the full year 2022, total revenues were $9.9 billion, including more than $8.4 billion in base business revenue. Earnings per share were $7.97 on a reported basis and $9.95 on an adjusted basis. Cash from operations was $1.7 billion. As you saw this morning, we increased our quarterly dividend approximately 8% to $0.71 per share and increased our share repurchase authorization by $1 billion. Before discussing additional highlights for 2022, I'd like to share some recent positive regulatory updates. First, Congress delayed Medicare reimbursement cuts under PAMA that were scheduled to take place in 2023, which would have impacted our revenue between approximately $80 million and $85 million. While we are pleased with the delay, we continue to work closely with our trade association to seek a permanent fix to PAMA. Second, CMS increased Medicare reimbursement for specimen collection fees for the first time in nearly 40 years. This could provide Quest with a benefit of approximately $35 million to $40 million this year. Regarding COVID-19 testing revenues. While we did see a steady ramp upward in COVID-19 volume throughout Q4, our volumes have steadily declined since late December. We expect our COVID-19 revenues to be significantly lower in 2023 compared to 2022. We have lowered our prior COVID-19 volume expectations in 2023 from 10,000 to 15,000 molecular tests per day to 5,000 to 10,000 tests per day. In addition, we continue to negotiate coverage and reimbursement policies with commercial payers following the end of the PHE in May. I will now share some recent highlights on how we are growing this business. In the fourth quarter, we completed our acquisition of the outreach laboratory services business of Summa Health, a large integrated health system serving communities in Northeastern Ohio. We also entered into an agreement to acquire select assets of Northern Light Health's outreach laboratory services business located in Maine. We will also provide professional laboratory management services for 9 of Northern Light's hospital laboratories, along with its cancer center lab. Our M&A pipeline is strong, including potential deals with health systems, small regional labs and other capability-building assets. In particular, the funnel of opportunities with health systems, which are facing major margin pressures due to labor challenges and mix shift from inpatient to outpatient care, is very active. Quest can help through lab management, population health analytics, mobile services and/or by monetizing their outreach business. In health plans, we continue to gain traction with value-based contracts, where we see meaningfully higher growth than with traditional contracts. Also, we've started to benefit from incentives related to these value-based contracts, which helps demonstrate the value of these strategic relationships. With CMS' recent increase in Medicare reimbursement for specimen collections, we've begun discussions with our health plan customers about getting paid appropriately for the phlebotomy services we provide to their members. Higher specimen collection fees enable us to make continuous investment in patient services so their members continue to have the broadest access to high-quality and low-cost lab testing. In advanced diagnostics, we generated strong double-digit growth in prenatal genetics and pharma services in 2022. In 2022, we also launched a solid tumor expanded panel as a laboratory-developed test. This 523-gene test relies upon the Illumina TruSight Oncology 500 Assay to help oncologists with therapy selection by providing comprehensive genomic profiling of a patient's tumor. This test extends our capabilities beyond tissue pathology to offer faster turnaround time from cancer diagnosis to therapy selection. Throughout 2022, we continue to make investments to strengthen our bioinformatics capabilities, which supports some of the faster-growing opportunities of our portfolio, like genomic sequencing services, prenatal and hereditary genetic testing and pharma services. We also invested in our women's health sales force, which will position us well for continued strong growth in prenatal genetics. We continue to make progress executing our consumer-initiated testing strategy. Last year, we recorded approximately $96 million of both base and COVID-19 consumer testing. In the fall of 2022, we launched our new digital platform, questhealth.com. Consumers have found this to be a simpler, more intuitive way to order lab tests. Following the launch of our new consumer site, we began ramping up marketing spend through the fourth quarter. We saw some of the strongest order volumes to date following some Cyber Monday promotional advertising, and we are encouraged by the acceleration of growth in base testing in December. Shifting to operational excellence. In 2022, we approached our goal of 3% productivity improvements and savings through our Invigorate program. Those savings and productivity improvements did not completely offset the inflationary pressures in our business as well as the impact of a modest unit price declines. Following the pandemic, we, like many companies, have faced significant inflation and wage pressures. We are increasing our efforts to drive productivity and expand margins in our base business. We continue to drive additional productivity improvements with lab platform consolidation and greater use of automation and artificial intelligence. Last year, we began a new automation conversion project in our Lenexa laboratory. This new project builds on what we've done in our Marlborough and Clifton labs. We've introduced a new microbiology platform that is highly automated and makes use of artificial intelligence to assist with sample analysis. Finally, we've begun to realize savings from the urinalysis platform conversion that we announced early last year. Billing and retaining our frontline physicians continues to be a key priority for us. Although we have experienced higher-than-average turnover in some of our job categories, we have taken actions to stabilize our workforce and improve frontline employee engagement and retention. We expect these actions to help enhance our productivity in 2023. We have also taken actions to reduce our SG&A by approximately $100 million in 2023, including workforce reductions of approximately 1.5%, primarily in corporate support functions. With that, I'll turn it over to Sam to provide more details on our performance and our 2023 guidance. Sam?

Thanks, Jim. In the fourth quarter, consolidated revenues were $2.33 billion, down 15% versus the prior year. Base business revenues grew 6.3% to $2.15 billion, while COVID-19 testing revenues declined 75% to $184 million. Revenues for Diagnostic Information Services declined 15.3% compared to the prior year, reflecting lower revenue from COVID-19 testing services versus the fourth quarter of 2021, partially offset by strong growth in our base testing revenue. Total volume, measured by the number of requisitions, declined 11.2% versus the fourth quarter of 2021 with acquisitions contributing 20 basis points to total volume. For the quarter, total base testing volumes declined 0.6% versus the prior year. The year-over-year decline was primarily related to lower employer drug testing volume and adverse weather events during the quarter, which together represented a volume headwind of more than 1.5%. COVID-19 testing volumes contributed to decline during the fourth quarter. We req-ed approximately 1.9 million molecular tests in the quarter. This was down 1.2 million tests versus the third quarter and down approximately 5.4 million tests versus Q4 of 2021. After rising modestly throughout the fourth quarter, our COVID-19 molecular volumes declined to an average of roughly 17,000 tests per day in January and currently make up less than 3% of our daily volumes. In the fourth quarter, revenue per requisition declined 5.1% versus the prior year driven primarily by lower COVID-19 molecular volume. Base business revenue per req was up 6.8%. The strong increase in revenue per req was driven by a number of factors, including test and payer mix; the more favorable pricing environment with health plans, including incentives under our value-based contracts; and lower patient concessions. Unit price reimbursement pressure remained consistent with our expectations at approximately 50 basis points in the quarter. Reported operating income in the fourth quarter was $135 million or 5.8% of revenues compared to $536 million or 19.5% of revenues last year. On an adjusted basis, operating income was $330 million or 14.2% of revenues compared to $579 million or 21.1% of revenues last year. The year-over-year decline in adjusted operating income is related primarily to lower COVID-19 testing revenues and to a lesser extent a negative impact of adverse weather on our volume as well as higher investments to accelerate growth in our base business. Additionally, in the fourth quarter, we experienced a significant increase in employee health care costs. Reported EPS was $0.87 in the fourth quarter compared to $3.12 a year ago. Adjusted EPS was $1.98 compared to $3.33 last year. Cash from operations was $1.72 billion for full year 2022 versus $2.23 billion in the prior year period. Turning to our full year 2023 guidance. Revenues are expected to be between $8.83 billion and $9.03 billion. Base business revenues are expected to be between $8.65 billion and $8.75 billion. COVID-19 testing revenues are expected to be between $175 million and $275 million. Reported EPS expected to be in a range of $7.61 to $8.21 and adjusted EPS to be in a range of $8.40 to $9. Cash from operations is expected to be at least $1.3 billion, and capital expenditures are expected to be approximately $400 million. For our 2023 guidance, please consider the following. As Jim highlighted, we are now assuming COVID-19 molecular volumes to average roughly 5,000 to 10,000 tests per day for the full year. Expect volumes to continue to decline through the spring and summer, but could see a modest uptick during respiratory season in Q4. We assume average reimbursement for COVID-19 molecular testing to continue near recent levels through the end of the PHE. CMS has indicated that reimbursement will be $51 when the PHE expires in May. We continue to negotiate with health plans regarding coverage policies and reimbursement for COVID-19 testing post PHE. Note that our COVID-19 testing revenue guidance for 2023 is approximately $150 million lower than the expectations we had back in October. With COVID-19 testing becoming a significantly smaller portion of our overall business, we expect an earnings cadence that is more in line with pre-pandemic seasonality this year with Q1 typically being the lowest quarter of the year at roughly 22% to 23% of full year earnings. We have also taken actions to reduce our SG&A by approximately $100 million in 2023, including workforce reductions of approximately 1.5%, primarily in corporate support functions. The benefit of these actions will be modest in Q1 and will expand in the second quarter. With that, I will now turn it back to Jim.

Thanks, Sam. To summarize, we delivered strong growth of 5% in our base business in 2022. COVID testing revenues, as expected, declined last year and will represent a significantly smaller portion of our business going forward. We are increasing our efforts to drive productivity and expand margins in our base business. We look forward to sharing more of our strategy during our upcoming Investor Day on March 16 at the New York Stock Exchange. Look for an announcement soon with more details on this event. And now we'd be happy to take your questions. Operator?

[Operator Instructions] The first question in the queue is from Ann Hynes with Mizuho Securities.

Maybe can we talk about major assumptions in the low end of guidance versus what's embedded in the high end of guidance? And can you also discuss the incremental $115 million to $125 million that is now benefiting 2023 versus when you reiterated that mid-$8 range back in Q3 earnings? How much has fallen to the bottom line? And how much do you expect to be invested in the business?

Yes. Let me just speak first about the revenue guidance. As we indicated in the remarks, our COVID guidance, which had originally been 10,000 to 15,000 requisitions per day in '23, we revised that downward to 5,000 to 10,000 per day. And it's really just based on the trends we're seeing. It peaked in December. We averaged roughly 17,000 a day here in January, but that's had a downward slope. So we continue to expect COVID volumes to decline, and that's really had about $150 million change in revenue versus what we thought last fall. So again, the guidance, we've suggested a midpoint of about $225 million in COVID revenue for the year. On the base business, without acquisition help, we've assumed a 2.5% to 3% revenue growth on the total base business. So really, that's the explanation on the revenue side.

Yes. So maybe I'll add a couple of comments, Ann, and thank you for the question. This is Sam. So versus what we shared back when we talked about in Q3 of 2022 around the fact that we were somewhere in that $8.50 range. Obviously, some positives that you mentioned, which is, I think what you're referring to, is the $115 million to $125 million, which includes the PAMA delay, which includes also the reimbursement of the specimen collection fees which we now benefit from. But there are a couple of things also that have changed to the negative. Really, the key one being -- or just one thing really that's changed to the negative, I should say, which is COVID. The COVID assumptions that we had back then were, as Jim just said, 10,000 to 15,000 a day. Now we're seeing volumes, as we mentioned on the prepared remarks, 17,000 a day in January. And January is typically around the peak of the respiratory season, and then it starts to come down from there. So our expectations of 10,000 to 15,000 a day for the year are, I would say, realistic. And -- but in terms of the range itself and what differentiates the bottom versus the top, I think it's going to be really around the COVID assumptions. But again, keep in mind, we've taken COVID down by $150 million in terms of total revenues versus what we really shared back in October when we expected 10,000 to 15,000. We've also -- from the benefit itself, the $115 million to $125 million that you referenced, we've also carved out a small amount for investments in the business, strategic investments that as we said a couple of months ago, we said we will reserve some of that benefit to invest in the business for long-term growth.

Our next question is from Patrick Donnelly with Citi.

Sam, maybe one for you. Margins came in a little light of where we were expecting in 4Q. Can you just talk about the puts and takes there between DTC growth investments, inflation, pricing? And then going into '23, it seems like the base business margins need to step up. You called out the $100 million SG&A cut. Are you guys changing any plans for DTC investments? Just want to get comfortable with that margin bridge from the lower 4Q number and the moving pieces.

Sure, Patrick, yes. And thank you for the question. So let me talk a little bit about Q4 and the margin rate in Q4, the 14.2%. So here are some of the headwinds, some of which we were seeing throughout the year. But obviously, we also had a drop in COVID revenues in Q4, which was significant versus Q3, at least sequentially, which impacted the margin as well. But in terms of the margin rate itself, we had inflation I would say per expectations, but still elevated. We had growth investments of roughly about $40 million that impacted Q4, which were fairly in line with Q3, what we had in terms of investments, so not necessarily a sequential driver. One driver in Q4 that impacted our margin rate was higher employee health care costs. That was higher than our expectations, and some of it driven by higher utilization, especially towards the end of the year after employees had met their deductibles, but also higher cost of health care in general. And so that was about 80 basis points of impact on the quarter in terms of negative rate impact. So that was another thing. And I talked about, obviously, if you're looking at things sequentially, you have to factor in that COVID revenues were $184 million roughly versus approximately $313 million in Q3. So a big drop in COVID revenues. Now if you look prospectively in 2023, here are some of the things that obviously give us confidence that we can achieve the rate that we have in our projections and that's factored into the guidance that we gave. We have taken $100 million in SG&A reductions, and I would say 90% of those have already been implemented. Now you won't see the benefit starting in Q1. You'll probably see it in the latter part of Q1 and really taking effect in Q2 more fully. But that's $100 million in SG&A reductions that we expect to see over the course of this year. In terms of investments, you referenced that we expect investments to be less dilutive in 2023 versus 2022 because we start to see the benefit from some of these investments towards the growth of our business. And then finally, obviously, the margin rate is going to benefit from the specimen collection fee reimbursement that we have. And we have a volume growth assumption as well and a revenue growth assumption that, at the midpoint of the guidance range, is on the base business of approximately 3%. And so that's going to drive also additional margin improvement based on the drop down from those revenues.

Next question is from Jack Meehan with Nephron Research.

I had a few questions on Quest Health. So first, of the $96 million you talked about on sales, is there a rough breakdown you can share of COVID versus base? Then second, on the base sales, how did that ramp after the fall push? And then finally, just what are your expectations for consumer-initiated testing revenue and investment for 2023?

Yes. So Jack, let me start. So on CIT, our consumer-initiated testing business, the total $96 million, more of it was COVID than our base business. However, our base business, once we launched the new platform, once we launched the marketing spend, actually performed as expected in November and December. We got significant growth year-over-year, over 50% growth in the month of December based on the initiatives we put in place. So as we've said, this year, we expect that business to be less dilutive versus more -- versus 2022. In terms of the total revenue projection for CIT, we'll give you something at Investor Day. Obviously, the COVID will significantly ramp down, but we expect our base to significantly ramp up. And we'll give you a better view of that at Investor Day.

Great. And then one follow-up on COVID. If we do a look-back on 2022, is it possible to call out how much of the sales came from serology, your CDC contract or anything kind of outside of the core molecular? And just what you're assuming there for 2023?

So here's what I say. As we indicated, the volume is coming down, right? We said 10,000 to 15, 000 last fall. We now expect 5,000 to 10,000 for the year. The one thing I'll say on serology, we had a significant contract with the CDC. It was simply a test add-on seroprevalence study. That contract, as expected, ended in December. The CDC just doesn't need that information anymore. What does remain, in addition to the PCR volume, is we've got a roughly $25 million contract with the CDC to do continuous sequencing work of the positive cases to help inform the CDC and others about the spread or the development of new variants that continue to pop up.

Next question is from A.J. Rice with Credit Suisse.

Yes. Obviously, it continues to be a steady pipeline of hospital-related deals. Can you tell us whether -- and I know your closest peers announcing transactions, too. Do you see any change in the competitive landscape for those deals on the terms on which those deals are being done? And then you also mentioned seeing some more activity in small regional labs. What do you attribute that to? As the COVID testing is running off, are you seeing some of the regional labs express more interest in potentially aligning with you?

Yes. A.J., thanks for the question. So I would tell you, no, there's no real change in the competitive dynamic in terms of pursuit of these hospital outreach deals or professional lab services types of engagements. What I would tell you is the funnel is as big as it's ever been. We expect to close several deals here in the first half of the year. So still feel very good about that. In terms of small regional labs that are out there, first, I'd say there's not that many left out there that are of significant size. Certainly, those that participated in COVID testing and now that, that volume is declining, yes, we are seeing a few raise their hands and put up the retirement flag and potentially sell out. So we look at each and every one of them. If we think it adds to our competitive position in a certain geographic marketplace, we'll look at it. If we don't think we need it from a competitive standpoint, then we take a bye on those.

Next question is from Pito Chickering with Deutsche Bank.

Quest has a very long track record of finding cost efficiencies through Invigorate. So I'm curious how the SG&A cost cutting of $100 million compares to what Invigorate usually finds in SG&A. Or are most cost savings via like Invigorate are usually done in cost of services and fixed cost leverage on volume?

Yes. So first, the $100 million cost takeout is incremental to our Invigorate plan for 2023. With our Invigorate plan, we target roughly 3% of our entire cost base for the company. So call that $6.4-ish billion, 3%, call it, $180 million, $190 million a year. We actually got very close to that target in 2022. As we said in the prepared remarks, it did not completely offset wage inflation and the slight price headwind that we did see along with just other nonlabor inflationary pressures. Now as we go into 2023, we've got a full funnel of productivity ideas, productivity initiatives that we're driving through the company. And I would say the other thing that we think will really help us in 2023 is simply the stabilization of our workforce. Attrition has really a major impact on your productivity when you're constantly churning phlebotomists, logistics and specimen processing. So that has stabilized. It's coming down. We feel good about it. And we feel good about the overall productivity plan in terms of offsetting inflation, which we expect to be slightly softer, easier in 2023. And we expect price, all in across Quest Diagnostics, to actually be a positive for 2023.

So just at the risk of being redundant here, I'm still going to repeat something from what Jim said at the beginning because it's really important for your -- all your assumptions, is the productivity improvements and the Invigorate actions, which is the 3% that we expect to get. That's in addition on top of the $100 million of SG&A reductions that we've already taken, for the most part.

Got it. And sort of 2 quick follow-ups. You talked about the phlebotomists. I was just curious where the phlebotomist hourly wage is today and kind of do you think that is sort of the right level to compete against retail channels? And second one is the public lab supply companies have talked about pricing for a while. Just curious, as one of the large labs in the U.S., what do you assume for supply inflation for '23? Or can you offset that inflation simply by changing vendors and/or leveraging your scale?

Yes. So our phlebotomy rates vary by region of the country. What I would tell you is our increase in wages for phlebotomy were certainly in line with the 3% to 4% wage impact that we saw last year. It's what we're planning for 2023. And as I indicated, our retention has improved, our attrition has certainly stabilized and declined. So we feel good about that.

Then on the supply inflation? Just curious.

Yes. I'm sorry, the supply inflation. So again, 70% of what we purchase each year is under contract. When those contracts come up, they generally represent an opportunity for deflation, meaning we're going to run a competition between the vendors. And we look for improvements from a cost, quality and turnaround time perspective. So where the inflation hit us in 2022 is really on some of the nonsupplies, the reagents and things like that. Some of that could have been pre-analytical supplies, masks, gowns, things like that; as well as just the normal inflation that you all see in your businesses, which could be hotels, air travel and things like that. Now again, we think that's softening here as we get into 2023, and we certainly put guardrails on travel and living-in expenses and things like that.

Next question is from Brian Tanquilut with Jefferies.

Jim, just a quick question on rates from payers. I think in the past, you've expressed some optimism in seeing a little bit of rate improvement on the commercial side. But I think in your prepared remarks, you called out a little bit of reimbursement pressure at 60 basis points or so. So just curious, how do you reconcile that? And maybe just broadly speaking, what you're seeing in terms of payer receptivity to increasing rates on the reimbursement front.

Yes. I think we said in the prepared remarks that our pricing was down about 50 basis points, which actually represents the best that I've seen in my time with Quest Diagnostics. So we feel good about that. We've also said that, as we renegotiate new contracts, and every one of these contracts is 4 to 5 years in length. So you can expect that 20% to 25% will renew this year, which they will. And the preponderance of those contracts, we've seen rate increases, at a minimum rate, holding rate flat to prior contracts. So we view that as a very positive. What we've also said is, look, we got a 40 -- $35 million to $40 million rate increase through Medicare draw fees increases. And today, we get reimbursed on roughly 25% of the commercial draws that we do. We're going to push hard not only to expand that 25%, but those that do reimburse us to take those rates up as well. So we are pushing hard at every turn to increase prices across this business. The last thing I'd say is, look, there's a portfolio of $700 million, $800 million of other businesses in Quest Diagnostics. That can be our ExamOne business, our employer solutions business, our employee population health business. And we pushed for 2% to 3% price increases on that portfolio of business, and we've largely gotten those in place for 2023. So again, this is the most optimistic price outlook that we've put forward since I joined Quest in 2013.