Quest Diagnostics Incorporated (DGX) Earnings Call Transcript & Summary

Awesome. Good afternoon, and thank you for joining us today, and welcome to the 2023 Jefferies Global Healthcare Conference. I'm Brian Tanquilut, health care services analyst here at Jefferies. And our next presenter here is Quest Diagnostic, one of the leading lab operators in the country. And with us this afternoon is company's CEO, Jim Davis; and head of IR, Shawn Bevec. Jim thanks for joining us. Nice to see you again. And maybe I'll throw it at you first. Kind of like, just a little bit of state of the union what's going on with Quest. I know you hosted your Investor Day recently, there's a lot of going on. So we'd love to hear.

Yes. So the year got off to a very good start, as you know. We've all been preparing for the inevitable COVID going away. And I think we transitioned nicely in the first quarter. We reported volume growth of 8% revenue growth of 10%. Our employee attrition is more stable than it was last year, still not back to 2019 pre-COVID levels. But by all means, the year got off to a great start. And then, of course, we announced the Haystack acquisition at the earnings call in early April.

So maybe let's go to that first since that's kind of interesting to a lot of folks, right? I mean what's the motivation behind Haystack or maybe even take a little bit of step back? Like what exactly does Haystack do? What made it attractive to you guys? And why now?

Yes. So let me talk about the motivation first, and then we'll get into the specifics of Haystack. So for Quest Diagnostics, we do $1 billion a year in cancer testing, and that includes routine screenings like PSA, Pap Smears, HPV, routine cancer markers, CA 190, CA 125. And then we have in that $1 billion, about $0.5 billion of anatomical pathology, right? Most of Quest Diagnostic is clinical pathology, but we have $0.5 billion of anatomical pathology. The majority of times, you cut something out of the human body, it's you're looking for cancer, whether it's skin, colon, breast, brain, prostate. Now that portfolio of $1 billion grows at about 2% per year, right? Routine screenings, PSAs, Pap Smears is not a high-growth business. It's everything post-diagnosis that is growing at 15% to 30% a year. And what occurs post-diagnosis. Well, once one has been diagnosed with cancer, there's obviously a surgical option or potentially even chemotherapy first to shrink the tumor. But at some point, when that tumor is considered gone, removed, whether it's by chemical means or by surgical means, the next question that the medical oncologist asks is always, is there any cancer left in this human body? Did the surgeon get it all? And the hope of these tests liquid biopsy test to detect minimally residual disease is to answer that question. So post-surgery, more often than not, the patient is going to get chemotherapy or radiation therapy. Why? Because you're uncertain as to whether the surgeon got it all or not. But 6 weeks post-surgery, before any chemotherapy is administered, you can run this blood test and see is there any minimally residual disease left in the human body. If there's not, there's no reason to get chemotherapy or subject that person to harmful radiation therapy. If there is, then let's start chemotherapy. Now post-chemotherapy, today, the standard of practice is, let's wait 6 months, and let's put a person in something we call a PET-CT, right? And you use a PET-CT to look for metastatic disease that results from residual tumor after chemotherapy that is now spread to another organ and rooted itself and then it becomes a whack-a-mole type of game for the medical oncologist. So the hope of these blood-based test is whether it's post-surgery or post-chemotherapy is to detect within 6 to 8 weeks, is there any remaining cancer left? Before it spreads, before it becomes metastatic in nature, meaning it's rooted itself in a lung, a liver, a brain, a bone. And so we call this treatment monitoring, okay? And it has both an economic value proposition, avoiding expensive and harmful radiation that you get through imaging studies. And it has a way of detecting minimally residual disease long before it will show up in an imaging device.

So as I think about this, Jim, a couple of questions pop in mind, right? So number one, is this a fee-for-service model going forward, do you think? Or is this one where there's a value-based aspect to it? Because obviously, like you said, you can save the system a lot of money by preventing unnecessary procedures.

Yes. So right now, the reimbursement that Medicare has approved for the 2 companies that are doing the testing, it's really a bit of a bundled payment that covers both the sequencing that is required in order to inform the blood-based assay and then a series of blood tests that cover a certain period of time. Now there is a value story to this, however, right? One is earlier detection leads to lower cost treatments. Earlier detection leads to, again, avoiding expensive PET-CT or whole-body MRI types of exams. So there is an economic value proposition. But obviously, the biggest value proposition is saving lives, right? Earlier detection, earlier treatment, better outcomes for the patient.

So maybe a different question because we've been asked by investors since you announced the deal. Why now? I think the company is in fairly early stages of development, not quite start-up mode, but why now and why that asset specifically?

Well, look, as you know, Quest Diagnostics, if we're going to put something on our test menu, it's going to be orderable by hundreds of thousands of physicians, okay? So we think through these things very cautiously. So the first thing we ask is, is there reimbursement for the test that's established. And in this case, Medicare is covering the test. Therefore, Medicare Advantage has to cover the test and there's limited Blues plans covered it. So there is a basis for reimbursement today. Second, in general, when we think about adding things to our test menu, we first turn to our more established suppliers like Thermo Fisher, Siemens, Hologic, Roche. We didn't see this test in their pipeline, right? They share their pipelines with us 2 to 3 years out. We didn't see the development of this test, okay? It's not an easy test to develop. We then look towards partnerships, or we look towards acquisitions. But there's 2 established players in the industry. They're getting reimbursement. One of those players did $57 million in revenue for this specific type of MRD test. So look, we have a strong cancer business. We have a strong anatomical pathology business, more often than not, when we own this specimen and we declare it cancer, we're then being asked to send that specimen somewhere else to do this follow-on testing. So we think it's the perfect time to be into the market.

And then I know on the earnings call, Jim, you called out how the specificity rate for their test is strong, is superior to a lot of the other things you've looked at. So maybe if you can just talk a little bit about that, the technology itself?

Yes. So we talk about the limits of detection. And what you're looking for when you're looking for a minimally residual disease, you're not really looking for live cancer cells. You're looking for remnants of DNA that come from cancer cells that die. So if a patient has cancer, their cancer cells are dying, of course, but if you have cancer, more cancer cells are living than dying, right? They're growing at a faster rate. But the ones they die, they shed the DNA, the DNA ends up in serum. So it's a blood test, you separate the red blood cells from the serum. And within your serum, there's lots of different types of DNA in that. If you take 1 million types of DNA in your serum, this test can find 1 out of 1 million strands of DNA that come from cancer, okay? So the name Haystack, it's the idea that you're looking for a needle in a Haystack. We talk about this as a tumor-informed test, meaning if you're going to go looking for a needle in a Haystack, you want to know what that needle looks like, which is why you're using the sequencing information from the tumor to know exactly what types of DNA strands that you're looking for, so that when you go search for that DNA, you're looking for known DNA strands from the gene mutations.

Jim, that sounds like a really good compelling asset. So as I think about where you stand today, what kind of milestones are you looking for the next 12 to 18 months? And then maybe how are you thinking about accretion to earnings or dilution to earnings and then contribution to growth longer term?

Yes. So the goal -- Haystack is a small company, a 50-person company, most of the people in Baltimore, Maryland. I think, as you know, the roots of this technology came out of John Hopkins. There is a group of engineers also that work in Germany. But the small-scale lab that they built to do the clinical trials to establish the performance of the assay sits in Baltimore. We're going to take that and now industrialize that scale this in a very, very big way in one of our esoteric labs located in Dallas. And that's the next step is we're most likely weeks away from closing. We'll scale this thing. We'll get it up and running in our Dallas facility. The first indication that we're going to go after is colorectal cancer. We believe we have enough clinical evidence to put in front of CMS to establish reimbursement. Our goal is to begin generating revenue in the early 2024, Q1, Q2 type of time frame. We'll then go after other indications, breast, lung, potentially skin. As we move through '24 and '25, we said it will be mildly dilutive in '24. It will be, and we expect accretion to begin in earnest in the latter part of 2025.

Yes, that makes a lot of sense. So maybe shifting gears because one of the things that we saw in Q1 was the strength of your business. It will more than offset the dilution from this deal, right? So what are you seeing in the market? Why do you think volumes have been as strong as they are?

Yes. So volume growth in Q1 in the base business, everything ex-COVID was around 8% revenue growth of 10%. Now obviously, the compare with Q1 of last year was a bit easier. Omicron surged in January, but then quickly fell off February, March. But maybe half of that benefit came from an easier compare. So let's just say the underlying growth rate was 4% to 5%. That's relatively strong in this industry. And I think there's many reasons. One is best we can tell, there's still pent-up demand for routine laboratory testing. When we look at what generated the growth in Q1, a lot of it was routine chemistry panels, lipid panels, cardiometabolic testing. Now why do we suggest there's evidence of pent-up demand because we sample our physician office physicians, right? And we're still hearing that there's 6 to 8 weeks of delays in terms of getting an appointment for routine physicals, routine gynecological care. And so that, I think, provides some evidence that not everybody was getting their physicals in routine care during COVID and that there's strong demand. There's only so many physicians out there, the physician base and grow from 2019 to 2022, 2023. Physicians really aren't working weekends and things like that. So I think the demand will still stay strong here.

So given that, Jim, like that there's a 6- to 8-week lag before you can get to a doctor, does your direct-to-consumer strategy benefit from that in terms of people going -- skipping the doctor, so to speak?

Yes. And we did see evidence of that in the Q1. We did some survey in which I'll talk about, look, but most of our consumer-initiated testing is, first, the biggest segment tends to be STDs, people who value privacy. They don't want their payer to know. They don't want, especially if you're 18- to 25-year-old, you're still on your parent's policy. You don't want your parents to know you're getting tested for that. So generally, that segment pays out of pocket. It's not just that segment that pays out of pocket either. But that's a big segment. Then there's people with chronic conditions, diabetes, hepatitis C, HIV, that they know their payers will only pay for so many A1C tests, so many viral load tests a year. And they know that. And so they say to themselves, why go to a doctor spend $150 just to get a lab order that's going to get denied by a payer. So they come to us directly. They learn that over time. It's cheaper to pay out of pocket than go to a physician and get an order. But then there is a fair amount of what we call general health and wellness testing, $149 panel. And when we surveyed consumers in the first quarter as to why they were coming to us, first of all, we asked, did you have insurance? The answer was yes. If they said yes to that question, we asked why did you come to us? And the #1 answer was because I still couldn't get in to see my doctor, but I just wanted to understand is everything okay in my body. So we think that is an element of driving consumer growth as well.

Now that makes a lot of sense. Maybe shifting gears a little bit to pricing. You've made comments recently about how we're seeing a better pricing environment today versus, say, the last 10 to 15 years even, right? So what are you expecting in terms of commercial reimbursement? And then maybe adding the layer of these narrower network strategies that some of the payers are rolling out.

Yes. So in the first quarter, we used the words, we had slightly positive price, which is not something we've said in the 10 years that I've been in the company. So call that a moral victory, but pricing was positive. Now that came as a result of negotiations last year with commercial payers that came from a $40 million increase in fees associated with draw fees for Medicare patients. Remember, in our roughly $9 billion ex-COVID based business, there's about $800 million to $900 million worth of clinical work we do that is for employers, drug testing for employers when people come in for new jobs, we do employee health clinics at employers. We do health risk assessments for life insurance companies. And so all of that together is $600 million, $700 million of business where we've put in place really nice price increases there, okay? Easier to get price increases on that than it is with commercial payers. But we have had success with some of the commercial payers. And we don't go in leading with, hey, there's higher inflation, therefore, pay us more. It's still our value story, right? You want us to network, you want us to expand our network. You want us to provide great service because we can help you get requisitions out of high price, out-of-network labs, high-priced health systems into laboratories that are better value for the patient, better value for the person who's paying for that health care, which is generally the employer. So it's a win-win-win, okay? So we lead with that. And then we also try to structure incentives with these payers that if we move x number of reps per month per year into our network out of these health systems, there could be some value-based payments associated with that. The final thing is, as you know, we like these hospital outreach types of transactions. So NewYork-Presby was the most recent one where we bought their outreach book of business. So these are all the physicians that are part of Cornell, part of Colombia that sit outside the hospital, primary care, OB-GYN specialists. All of that work was going into the Presbyterian lab is now coming to Quest Diagnostics. And as you can imagine, the Presbyterian lab was getting paid higher prices than we were. But we work with the payers and say, if we're getting paid x percent of Medicare and they were getting paid 1.x percent of Medicare, maybe there's a 3-year transition down to x. It's still really good for the payer. It's good for us. It's good for the patient. It's good for employers. So those are the types of programs we like to try to structure.

And then maybe what about Preferred Lab Network, not just with United, but the other payer, key national payers?

Yes. So the key nationals all have some flavor of a Preferred Lab Network. Some call it out specifically some tailor programs around, if you are a preferred partner, we'll do less preauthorization work on certain tests, just things that if they have trust in us, if they think we're making the appropriate decisions, they'll give us a little more room to flow. So every payer has some sort of Preferred Lab Network that they work with.

That makes sense. So sticking with the topic of inflation, obviously, labor and just cost inflation has been high or higher than average over the past couple of years. How should investors be thinking about your ability to offset inflation when -- even though you're getting positive rates, like you said, it's slightly positive.

So look, it's real. We can't hide it. From 2012 to 2019, our average wage inflation across the company was about 2%. In 2021, '22, this year, we're probably running 4-ish percent, the high 3s to 4%. Now remember, during that whole period from 2013 to 2019, we are also losing well more than 100 basis points of price in the years that we had the PAMA cuts, it could have been closer to 150, 160 basis points. So price is positive, but wage inflation has been significantly higher than it was. We do the same things to try to offset it that we did in any environment, whether it's higher labor inflation or higher or more price loss. Look, we're working automation and the use of artificial intelligence. It's the #1 operational initiative in the company and it's proving to be successful. We continue to work things like denials. We continue to work standard work across all of our laboratories. We're able to leverage new technology. When we make new platform selections, those new platforms are going to come in at lower variable costs, it's going to require less people. So you work those programs as hard as you possibly can. But remember, there's a trade-off here. We have to be mindful of the attrition or the retention rates in the company. And we can hold wages to, let's say, 3%, but we let attrition go up. That's a bad equation as well because with attrition, it hurts your productivity levels. So we're trying to find that sweet spot where it's the right amount of attrition, but the right wage increase, and it's a delicate balance that we play each and every day.

I remember the first time I think you had a chat about wages, like there was a concern that wage growth was going to be tough to pull back and attrition was one of the things that you mentioned as a lever that you'll put to manage costs, right?

Yes. You bring on a new phlebotomist in the company and experience phlebotomist can draw 25 to 30 patients a day, a brand new one can draw 15 a day. And it's not the art of drawing the blood, it's learning all of the systems in Quest Diagnostics. There's 5,000 tests on our menu. It's been -- it's understanding what tests require, what type of draw or how much CRM, how much plasma. And these are things that you have to learn over time. So attrition can really hurt the productivity of our company.

Well, we're in the topic of pricing, how should investors be thinking about progress with SALSA and PAMA cuts and how you're thinking about Medicare rates as a whole?

Yes. So there's 2 or 3 possible outcomes here, right? One is the worst possible outcome is that next round of PAMA cuts that are still out there. And we sized that and said it could be a $80 million to $90 million impact. It's been delayed 3 times now. Now -- and then there's -- so we'll push for a delay again or we'll push for the implementation of SALSA, which is still the preferred approach. Now why did -- why does PAMA keep getting delayed? The answer is pretty simple because it's going to save the government money. Remember, it's been ruled from a judicial standpoint that CMS is now required to collect data in a fair way, which means they have to sample from independent labs, physician office labs, hospital labs. They have to weigh the volume that goes into each one of those and arrive at a new market-based price for every test. Everyone knows that if you do it the right way, it will lead to higher prices. Medicare will pay higher prices when you statistically sample pricing in each of those segments. That's why the CBO scored a delay in PAMA cuts will save the government money. Because once that final round of PAMA cuts goes into place, it triggers a new data collection process. We already know what the new data collection process is going to show. Therefore, CMS will pay higher rates. So that's why they delayed it. Now the same is true with SALSA. Once SALSA is implemented, it's going to result in a new data collection process, but that data collection process is actually pushed out further versus the next round of PAMA cuts. So we prefer the salsa approach, even though there'll be a modest rate cut, not in '24, but in '25. But we don't want this hanging over our head every September, October. We go through our budget planning and you've got to try to figure out what is this $80 million thing going to hit me or not, and it makes life complicated.

That makes sense. Maybe this next question is for Shawn. Obviously, you hosted your Investor Day, a lot of cool initiatives, whether it's like trying to bring down the cost of BRCA tests. I mean, obviously, Haystack now in the mix. We've had some investors say, there are so many balls up in the air right now for Quest, and it's a little confusing. So maybe how do we put together the growth and margin outlook of the business given all the different initiatives that are in place right now?

Well, I think a lot of the -- what we're focused on is what we've been focused on for a number of years now. If you go back and listen to what Jim presented at the Investor Day, we're very focused on the physician customer of our business, which makes up approximately 70% of our revenues. Still a lot of focus around the hospital business. It's $1.6 billion of our company revenue. A lot of that's that reference work, where we work with half the hospitals in the U.S., a lot of the faster-growing opportunities within hospitals continues to be the PLS or Professional Lab Services. And there's a lot of opportunities on that front. And then there's a lot of still headway in terms of M&A on the outreach side. We came out and said, as a long-term outlook using 2023 as a baseline that we thought we could grow the top line in the mid-single-digit range and that earnings would grow high single digits. And within that mid-single digit, we said organic somewhere in the neighborhood of 3% with contribution from 1% to 2% from M&A.

That makes a lot of sense. Jim, we've got a minute here. Maybe just some closing remarks on how investors should be thinking about Quest going forward? I know you've been here as CEO coming up on a year. So just any thoughts that you want to share with the audience?

Yes. Look, the goal has been to continue to position the company into higher growth segments of the Diagnostic lab testing business. We've made a statement with Haystack, we're going to continue to invest in therapy monitoring, in therapy selection. By the way, we brought up a therapy selection assay, the TSO-500. We've continued to invest in genetic testing. The company has over $500 million worth of genetic testing today, and it actually makes money. It's profitable. We continue to streamline that business and add lots of AI-based tools to make it even more profitable. Finally, you're going to see this company become more of an automative -- automation, artificial intelligence, which we're driving through microbiology and all sorts of different test areas. And so it's not the old laboratory company that you think about. It's a highly automated digital company that will continue to thrive in the future.

Awesome. Thank you, guys. Really appreciate it.