Quest Diagnostics Incorporated (DGX) Earnings Call Transcript & Summary

Hi, everyone. Good afternoon. For those of you who don't know me, my name is Andrew Brackmann, and I cover diagnostics for William Blair. Thanks for coming to the 43rd Annual Growth Stock Conference. Today, this afternoon, we're pleased to have Quest Diagnostics join us. We have EVP and CFO, Sam Samad. And in the crowd here, we have from Investor Relations VP of IR, Shawn Bevec. Before we get into the formal presentation, I do need to tell you that for a full list of research disclosures and potential conflicts of interest, please see williamblair.com. And then finally, following this session, we'll be going through the second floor for the breakout session in the Maher room. So I'll turn it over to Sam.

All right. Thank you, Andrew. All right. Good afternoon, everybody. So I'll be going through some comments and general information session on Quest here and telling you about what we do or focus on growth and our business strategy. So first, I'll start with the safe harbor. I'll just let you digest this for a couple of seconds. I'm not going to read it. And really, our focus today is to tell you about the capabilities and relationships that we have, how we are poised for growth, how we have the right strategy to accelerate growth and also talk about some of our focus around advance diagnostics, consumer-initiated testing, the investments for growth that we've made there, how we continue to drive productivity improvements through our Invigorate actions that you might or might not have heard about, but I'll talk a little bit about those. And then our long-term outlook, which is to focus on mid-single-digit growth in terms of revenue, high single-digit growth in terms of EPS and our capital deployment philosophy as well. So I'll start with the market, I'll talk about strategy. I'll talk about our growth in advanced diagnostics and the actions that we've taken there. And I'll end with the financials in terms of the P&L and the capital deployment focus. So for those of you that don't know Quest, maybe let me give you a few factoids here about Quest and what we do and what we cover. Basically, we touch about 1/3 of the adult population in the U.S. in the course of a year and 50% of the adult population over 3 years. So significant touch points across the country. We serve 50% of U.S. hospitals and physicians. We have over 30,000, whether it's frontline workers, latex, logistics personnel that serve the U.S. population. So significant presence across the U.S. in terms of diagnostic testing and capabilities. When you look at our revenue base, which, including COVID for 2022, was $9.9 billion. Excluding COVID, so what we call our base business, was $8.4 billion. Here's how it breaks down, and I'll get into those markets in a second. But $8.4 billion, as I said, is our base business. The physician office revenues approximately $5.9 billion. So basically the testing that we do based on physician referrals for patients. And then the health systems business, which is really 2 parts: $1 billion of reference business and which is test that hospitals send out for non-routine tests that they send out to our Quest Labs and then $0.5 billion for what we call PLS business, which is professional lab services business, which is the outsourcing business that we have with hospitals. And then the remaining portion of our business, which is close to $1 billion that you see there is things like consumer-initiated testing that I'll talk a little bit about. It's pharma services, so solutions that we have for pharmaceutical companies, employer solutions and employer population health business. So services that we do for employers as well as other, what we call, services business like life insurance, risk assessment services and other businesses. So the wraparound Diagnostic Services businesses. So if you look at the market, this is the total U.S. lab market. Today, it's about an $85 billion market growing at about 1% to 3% on a compounded growth basis. 65% of that is in the physician lab services space, 35% of that in the hospital lab services. And then if you look at the physician lab services, so that's about a $55 billion market. Today, Quest has about an 11% market share in this space. As you can see, the other independent labs about 43%. Our main competitor, LabCorp has a portion of that. And then you have what we call this hospital outreach portion of the business, where basically physicians send their lab tests to hospitals to be performed on-site and hospitals. And I'll talk a little bit about our growth in that space as well, partly through acquisitions. And that portion of the business is growing at 2% to 4%, impacted over the course of the last 3 years by COVID and some of the utilization trends around patients hesitating to go to physician offices, so care interrupted to some extent, but not really seeing utilization pick back up. And then the third or the second portion or the third pie that you see there is the hospital lab services. So a $30 billion market, flattish to almost 2% in terms of compounded growth. So we have about 5% of that through reference base testing and also PLS. And then as you can see there, other independent labs and other hospitals. The Physician Lab Services business, one thing to point out, still a fairly fragmented business, as you can see there. There's been consolidation over time by us, by our main competitor as well. But still a fairly fragmented market and fairly, I would say, opportune for consolidation even still. So then ask Quest, how do we play and what's our strategy? Across these 3 areas and the 3 areas being physician, hospital and consumer health. Physician Lab Services, as you can see there, through share gains, we expect to outgrow the market. And we have been outgrowing the market. So compared to a market growth of 2% to 4%, we expect to grow at 4% to 5%. And through 3 areas that we're focusing on: partnering with health plans; value-based contracting; working with health plans on redirection of volumes and getting them from high-cost providers like hospitals to lower-cost providers like Quest, we can grow our footprint in the Physician Lab Services space, value-based care, which is a trend that we think is going to be significant by 2030. I mean Medicare is basically deferring most lives to accountable care organizations and physicians to basically defer and care to them. And Quest being able to partner with providers and perform, again, more efficient, lower-cost testing as well as wraparound services, around gaps in care, around other patient counseling and mobile phlebotomy and other ways of partnering with providers, we can offer a lower cost and better experience and providers can benefit from that, retail expansion, which I'll talk a little bit about. On the hospital side, I talked about reference capabilities and the ability to do nonroutine testing in our labs, the ability to partner with hospitals and outsource their business to us as well as acquire some of the outreach hospital physician, affiliated physicians with hospitals. And then finally, consumer health. So all that underscored by the investments in our advanced diagnostics testing. Again, we expect that we can grow over the next 3 years in the mid-single digits in terms of revenue aided by acquisitions and high single-digit EPS. So how do we grow in the physician space. In terms of access, so our access with health plans today, we have, I would say, almost close to 100% access across the country, not quite 100%, but we're 90% access. We still have some areas, some states like Colorado, Nevada, Pennsylvania, where we still don't have as much access as we could have, and we're focusing on that. But really very broad access across all health plans. What we're focusing on is increasing our capture. So even though our access is really high, as you can see there, capture still can be improved, especially in areas and states in the Midwest, for example. And we do that, how do we improve our capture 3 ways that you can see there. Leakage programs are working with on physicians, working with employers, for instance, on redirecting patients, patients like yourselves to do your testing at Quest sites as opposed to hospital sites. Reimbursement for hospitals sometimes it's 3, 4x or price points are what they are for Quest. And so patients benefit, health plans benefit when we can redirect that work to lower-cost providers like ourselves. Outreach acquisitions. When you think about outreach acquisitions and the dynamics in the hospital market today, you have a certain group of physicians that are affiliated with a health care system. And these health systems are constrained by obviously challenges around workforce, higher turnover, labor shortages, higher cost. And so we're engaging a lot on these outreach acquisitions with health systems where we basically acquire the physician book of business for these hospitals. Through an acquisition, we'll acquire that business. They will refer the work to us, as opposed to refer their patients to do work in hospital labs. Again, we look at this as a win-win-win, a win for health plans because they're reimbursing at much lower rates; a win for patients because it's less out-of-pocket, less co-pay for them; and obviously, a win for us because we're integrating that business. We're benefiting. These acquisitions are accretive on day 1, and we're driving value in the health care system. And I think I've touched on that in terms of how we work to basically redirect by engaging with patients and physicians and employers. As we think about retail, I mean our first foray into retail was to really set up what we call physician or patient, I should say, service centers in retail sites, places like Safeway and others. And then through the pandemic, we partnered with CVS on testing for COVID and sending those tests to labs like Quest. And then the next step is going to be also partnering with these, what we call retail groups on potentially point-of-care testing, on wraparound services, on kits. So there's a lot of opportunities for us to partner with retail, and that's part of the strategy there. I talked a little bit about PLS and physician lab services and -- or Patient Lab Services. So the focus there is really acquiring or partnering with hospitals to really take on their lab services business, so outsourcing that to us. And that can take shape in 2 ways. One is we can run the lab for them by basically having their employees become our employees, running soup to nuts their lab operations or it can be a supply chain relationship. So there's been a key focus on that by Quest over the last, as you can see, 3 years, we've more than doubled that business. We expect to continue to grow it. And with this PLS 2.0 is really a focus on how do we drive value to hospitals by helping them meet their quality standards, helping them meet their workforce challenges, so continuing to find ways to outsource their lab business to us. We get a fee for it as we lower the cost of care, and we help hospitals meet their quality standards as well. Last piece in terms of the strategy consumer-initiated testing. So we focused a lot of our investments over the last 2 years on bringing up and improving this platform that's called questhealth.com, that any of you can log into basically order a test. So we have a range of menu of tests on this website and then basically getting that test fulfilled at a Quest patient service center. So it offers you the flexibility to order whatever test you want online and be able to fulfill it in a very short time and get a result online as well. We're focusing on a number of metrics in terms of execution, metrics that we are outperforming on things like customer conversion rate, things like return on ad spend, things like customer acquisition costs and getting eyeballs to the site. We have a goal to get to $250 million in revenues. We're on our way to that. We're seeing great progress and really focusing on 3 key patient segments. So one that we call -- you might ask, who comes to this site, who orders tests online, what kind of patient profile are we focusing on? So you have, one, which is what we call the watchful warriors. So those are people with potentially either preexisting conditions or could be diabetic patients. Ones that want to order a test on a regular basis. They don't want to go to their physician. They just want to do it online. So think about it, if you want to get your A1c measurement 4x a year, while your plan is really going to pay for 1 A1c test a year. You don't need to go to a physician, potentially get a denial from a health plan and order another A1c that eventually you're going to have to pay for. You might as well just do it online. And there's a lot of people that are motivated by that. And that's just 1 example. It could be a number of tests that some of these watchful warriors want to have close management of in terms of their health, their overall health. The other category is privacy seekers, so STD testing or other types of infections. They want to order a test in privacy and the privacy of their own home. They don't want to go to their physician. They don't want to have it go through their health plan. They want to order out -- or pay out of pocket and get a result in quick time and turnaround time of 2 days. So we see a lot of patients that are motivated by that. And then we see a third category, which is the health care avoiders. And for a lot of the males here in the room, I think we fall into this category. We are less inclined to go to physicians. We want to get a quick answer in terms of some aspect of our health, and we're not always great about keeping up with our overall doctor visits and ongoing routine care. And so you see a lot of also patients that order these general, let's say, health and wellness kits. And just to basically understand certain parameters of our health -- or their health without going to a physician. So these are 3 categories we're focusing on in the consumer-initiated testing space. And as I said, seeing good progress in terms of uptake. Then you go into something which is completely different on the advance diagnostics, which is nonroutine tests. So these are more complex, what we call esoteric tests. It could be in areas like oncology, cardiovascular, neurology, again, we've made investments in this space. I'll talk to you more specifically about 1 investment, 1 acquisition that we've just recently announced. But this is really the more higher growth aspects of our portfolio of tests. And that's an area that we're definitely focusing on. One part of this is an area that I'm very close to, which is the genomic sequencing space. So as the cost of sequencing has come down, as we see now the cost of sequencing at least whole genome sequencing, we see a path to $100 genome soon. This is an area that Quest is focused on also very closely. So whether it's germline, which is inherited mutations and inherited genetic conditions, or somatic, which is oncology, which is cancer mutations. We see a market that basically is, by 2030, double the size of what we have today, with significant growth on a compounded basis. So that's an area that we've doubled down on. We've made significant investments over the last 2 years. And as I said, some organic and some nonorganic as well. On the nonorganic side, so the M&A side, one area that we're focusing on very closely in the MRD space and now we're entering is what we call the MRD space so -- which is minimal residual disease testing. So when you think about the oncology continuum for a patient, you have the first step is diagnosis. The second step is therapy selection, which is really understanding based on a certain tumor and a certain type of cancer, what therapy works best. And we have an assay in that space that we partner on with Illumina, which is TSO-500. And then the last piece, which is minimal residual disease testing is to really measure the cancer that you have in your blood and how it's basically -- whether it's developing, whether it's still managed and under control and whether you need adjuvant therapy or not. So this is an area, today, I think it's a market that we estimate is about $200 million, with really 1 key player in it, which is Natera and Guardant has an assay in the space as well. But we think in -- by 2028, could be a market of up to $1.9 billion, close to $2 billion with 3 key areas being lung, breast and colorectal cancer. And we think in 10 years, this is a market that could approach $6 billion, maybe even more. So a lot of potential in this space. To that end, we've made an acquisition called Haystack Oncology, which I'm very excited to talk a little bit about today, and we announced this on our Q1 call earlier in the year. And it's a $300 million acquisition with $150 million in milestones if they achieve certain milestones over the next 3 years. But essentially, we think this is a best-in-class minimal residual disease test. It will complete that portfolio of testing that we have. We currently operate. We have $1 billion cancer portfolio, more in the mature screening space, things like HPV and Pap and prostate testing. And we have also presence in the pathology diagnosis side as well. So that's our $1 billion portfolio today. And this now takes us -- as I said, we have a therapy selection assay. This takes into the MRD space. And MRD with a tumor-informed assay, that's important. There are 2 types of MRD assays, for those of you that maybe are not as familiar with the space, tumor-informed and tumor agnostic or tumor naive. And we think tumor-informed is the superior type of assay here. You're basically using your NGS testing to really look at identifying patient-specific mutations and then developing a customized or bespoke blood test that monitors these mutations. So think about it this way. A patient presents with cancer, they get a diagnosis. They are -- you get a tissue sample. And then based on that tissue sample, you develop a customized assay and a customized approach that then you can do repeated blood testing on to determine whether cancer is recurring or not. If it is, you can then intervene and that intervention can take the form of radiation, chemotherapy. If not, you don't have to intervene. Think about that compared to today. Today, you have a diagnosis. You have an intervention, which is surgery potentially. And then most of the time, you're basically hit with chemotherapy radiation regardless because a physician and oncologist wants to make sure that, that cancer doesn't recur. But this really helps you monitor that. And based on a very specific, as I said, tumor-informed approach, develop the right approach in terms of how you manage that cancer. To that end, there are 3 really patient journeys that we call our 3 main patient journeys here. One is the very operative monitoring. So in that 1-year period post intervention and post diagnosis, it's how that cancer is developing, how that cancer is mutating. And then following resection, understanding whether that cancer is recurring or not. The next phase is the surveillance phase is whether that patient is where the cancer is managed or not. And then the third one is based on an advanced MRD or immunotherapy, how are you -- is the patient responding to that therapy or not? So I know there's a lot of nuance to this, but this is really an area that we're very excited about, that in the oncology space has tremendous potential for growth. In terms of what's next for this assay, we expect to -- I mean, first, we have to close the transaction, then we have to launch this assay in 2024 for colorectal cancer. We expect to get CMS coverage for it. We expect to launch in breast following that at some point over the next 2 years and then lung after that. So we think, again, a lot of potential for growth. Finally, before I talk about the financials, I do want to talk about Invigorate where every year, we have a target to essentially improve our productivity and reduce cost by 3% on an annual basis. And we do that through 4 areas: leveraging automation and AI, AI through many aspects of our workflow, whether it's pathology, whether it's sequencing, whether it's through our workflows in the lab. We focus on reducing denials, so health or private payer denials and write-offs and patient concessions. Enhancing our digital experience and also importantly, and something that's been really impactful in a negative way over the pandemic is selecting and retaining talent. It's been a very challenging frontline labor environment. So let me turn to the financials. I'll start with our guidance for this year, which we modified. On the Q1 call, we actually raised guidance. So today, our guidance is on the base business, $8.78 billion to $8.8 billion for the year, which is a 4.2% to 5.4% year-over-year growth. For COVID, which for us last year was $1.5 billion business, we expected this year to be $150 million to $200 million in terms of annual revenues for COVID. So definitely a big steep drop off, as you would expect, as you probably heard from a lot of companies that are in -- that were playing in the COVID space in one way or another. EPS, so non-GAAP adjusted EPS, $8.45 to $8.95 or $8.70 at the midpoint. We do expect base business margin expansion year-over-year. Our pricing environment is the most favorable it's been through some of the work that we've done with payers on redirection efforts that I talked about earlier, what we call value-based contracts. And we have put in place $100 million in terms of reduction of SG&A expenses to help drive the base business margin growth. To that end, the base business margins over the next 3 years, we expect this year to be at approximately 17%. But over the next few years and by 2026, we expect 75 to 150 basis points of margin growth on our operating margins. We're going to do that through some of the things that I talked about earlier. SG&A reductions for this year, Invigorate actions, those 4 areas that I talked about earlier, price improvement. So all of those are going to drive -- and obviously, volume growth are going to drive improvements in our margins. And you might ask why is there the -- why we think there's a spread of 75 basis points between low end and high end. And some of that is contingent on the pricing environment in terms of government actions. So there is this thing called PAMA in our world, which is pricing reductions that the government has put in place that have been on hold for the last 3 years. And depending on whether those get restored or not, if they do get restored, that's a negative impact for next year, which would then drive us more towards the low end of the range. We think there's a good likelihood that, that PAMA action might be delayed. And if that's the case, and if it does get delayed, then we would be looking at something closer to the top end. Or if another legislation got enacted, which is the Saving Access to Laboratory Services Act or SALSA as the acronym says. It's an easy acronym to remember. Capital deployment. Our tenants are reinvesting the business. Execute on M&A strategy to drive 1% to 2% in terms of inorganic growth. Execute share repurchases and consistently raise the dividend over time. So basically, the philosophy is we're going to return the majority of our free cash flow to shareholders. And if you look at what we've done over the last better part of 10 years, actually since 2012 till 2022, we have basically generated $16.4 billion. And if you look at what we've invested $6.6 billion in the form of capital expenditures and M&A. And if you look at what we've returned to shareholders, that's another, again, $10.5 billion. So we've basically returned $16.5 billion of the cash that we've generated either to shareholders or invested in the business. So again, the majority of free cash flow being returned to shareholders is our philosophy, is our principle. I know I've got a couple of minutes here, and I'm about to wrap up. So the last piece is around M&A. What are our principles, what are our focus areas around M&A. So 3 key areas with the one in the middle there, really, being the key focus is around hospital outreach. So I referenced this earlier, which is buying the physician book of business that some health systems have where physicians refer their patients to do work in hospital settings. So a good example of that is NewYork-Presbyterian, which we acquired the hospital -- the physician outreach business earlier this year, where they have a group of physicians that work with them. As we acquire this business, now these physicians will refer their patients to basically do their testing with Quest Diagnostics as opposed to do their testing with NewYork-Presbyterian in their labs. Again, this benefits us. Obviously, we get those revenues from day 1, it's accretive from day 1, gives us more scale than what we have. We've already got fixed cost covered. So every dollar contribution is additional margin for us. It benefits the hospitals because they get much needed capital to reinvest in their business and some of the more strategic areas for them like operations, inpatient care, inpatient procedures. And it benefits the health plans as well. And we can actually use some of this as leverage with the health plans to drive price increases as we renew our contracts with them because instead of now reimbursing at hospital rates, they're reimbursing at Quest rates, which can be much lower. So I referenced this earlier, I wanted to come back to it just to give you that example. So we have, I would say, a healthy pipeline of deals in that space that we are focused on. And as I said, require capital deployment, but easy to integrate, accretive from day 1, high return on invested capital. The other area is regional independent labs, and those are now fewer and further between as there's been more consolidation. But if you go back to the chart that I showed right at the beginning, it's still a fairly fragmented market. That 55-or-so-billion physician lab market, there's still a lot of fragmentation and we can acquire more regional independent labs, again, highly accretive from day 1 because we take on those volumes and we bring them over to the Quest infrastructure. And then finally, what we call capability building assets, Haystack is one of those. And I've talked at length about it. But it could be other ways of expanding our menu, esoteric tests, non-routine tests or it could be things like Pack Health that we acquired about 1.5 years ago, which is patient coaching, helping patients manage their commodities. So different aspects of our business that provides more wraparound services to patients and to pharma as well as they manage patients. As I said, our hospital outreach is the key focus for us because it's accretive, high return on invested capital, highly profitable from day 1. But with capability-building assets, I think with Haystack now we're focused on the integration and the launch of that asset. So that takes us more to focus on hospital outreach and regional independent labs going forward, at least for the next few years. So finally, as I bring this all together, what's the financial outlook? And I think I've referenced this a couple of times now. But really, when you think about revenues organically for the next 3 years, to grow approximately 3%; acquisition contribution, 1% to 2% of that growth, so for mid-single-digit compounded growth. EPS to grow in the high single digits. When you think about our adjusted EPS as well as our dividend yield, is to provide something in the high single-digit, low double-digit return back to shareholders through a dividend yield of close to 2% or approximately 2% and a high single-digit EPS growth. And then continue to drive a generation of free cash flow commensurate with our earnings growth. So as I said, I think we have the right strategy to accelerate growth. I think we've done the right investments, whether organically or inorganically. We're focused on productivity improvement through our Invigorate program of 3% productivity improvement every year. And we think this will drive these financial returns that I showed you here. So thank you for your time today. I think we've got a breakout after this.