Quest Diagnostics Incorporated (DGX) Earnings Call Transcript & Summary

Hi. Good morning, everyone. Welcome to the Morgan Stanley Healthcare Conference. We're on our last day here. But I'm very happy to have with us today quest Diagnostics. I'm Erin Wright, I cover health care services at Morgan Stanley. With Quest today, we have Jim Davis, Chairman and CEO -- Chairman, President and CEO; as well as Shawn Bevec, who heads up and is the IR maven across health care services. So we're happy to have him as well on stage. For more important disclosures, I guess, please see the Morgan Stanley Research Disclosure website at morganstanley.com/researchdisclosures. If you do have any further questions, please reach out to your Morgan Stanley sales representative.

Okay. And with that, we'll get started with Q&A. So let's talk a little bit about kind of what's transpired in 2024 and in the most recent quarter as well and some of the moving pieces because it's been phenomenal volume growth kind of across this industry. But you did raise your guidance and there's so many different moving pieces in terms of the headwinds and tailwinds as well as kind of acquisitions that are embedded there. Can you break out for us a little bit of what you've seen so far year-to-date, kind of how you see that transpiring in the second half and maybe some of the more recent trends?

Yes. So let's go back to the Q2 guidance that we gave. We took it up, EPS, $0.05 to $8.90. I think we took revenue up $100 million, or $9.54-ish billion. And embedded in that guidance, we had just recently signed Allina up in Minneapolis, the outreach book of business, and OhioHealth in Columbus, Ohio and we had completed and closed the small pathology lab that was previously owned by PathAI. So that was all embedded in that guidance. Now in the back half of the year, the base revenue growth implied in the back half is roughly 5% organically. With those 2 acquisitions -- 3 acquisitions, it -- organically, it was 3.5% to 4%. So utilization -- health care utilization still remains strong, organic, some of the best organic growth we've seen pre-COVID, post-COVID. Now what was not embedded into that guidance was LifeLabs. We announced it, expected it to close late Q4 is what we said and it closed a lot earlier than we thought, which is actually good news. When you buy an asset company up in Canada, there's the, obviously, regulatory review but then there's a government review to make sure that the company coming into Canada meets their criteria. Is it good for Canada? And it moved through very quickly. We are very pleased with the cooperation of the Canadian government. And so that has closed. What we said in the first 12 months is LifeLabs will produce about $710 million of revenue and we said in the first 12 months $0.10 to $0.15 of EPS growth. And we'll come back on the Q3 earnings call and give a little more guidance for the fourth quarter and how that will play out in the fourth quarter.

Okay. And as it relates to LifeLabs, since we're talking about it now, I'll jump to that, in the $0.10 to $0.15, was that a ramp-up? So would it be accretive this year alone as well, or do we -- how do we run rate that?

Yes. So again, we'll give more detail in Q3. We're just working through the final accounting. The revenue is going to be more linear-ish than the EPS. So there's some work to do to obviously get the margin rate of LifeLabs to levels of Quest Diagnostics. But we really feel great about this Canadian asset. In Canada, roughly 41 million people, LifeLabs is the largest community-based lab in both British Columbia and Ontario. By the way, those 2 provinces make up about 50% of the Canadian population. The Canadian population growth, of all the G7 countries, is the highest. They have a average age -- their population is slightly older than the U.S. That's good for laboratory testing as elderly people get more testing than younger people. So we feel great about being up in Canada. Look, it's a market we knew. We have served LifeLabs as a reference partner. We serve other health systems in Canada as a reference partner. We had our ExamOne business that operated in Canada. We served Canada during the COVID. We served it post-COVID. So it's a market we knew, we understood. We like the pricing dynamics in Canada. Pricing is more well established, multiyear contracts in both provinces with price escalators. So we feel really good about the Canadian acquisition.

And in terms of the underlying growth across kind of the Canadian market, you like the pricing environment, the demographic factors as well. But what's the overall kind of lab market growing out in Canada now?

So it's consistent with our growth. We think it's going to grow in the 3% to 4% type of range, some of that coming from price, some of that coming from -- obviously, if you compare lab test per capita in the U.S. with any other market, any other market is going to be less. But it's 50% lower in Canada than it is here in the U.S. So we think there's tremendous opportunity for more advanced testing in Canada. We think there is a consumer market in Canada, even though it's largely a 1 payer system. When I say 1 payer, it's 1 payer in Ontario, 1 payer in British Columbia. So 2 different. But there is opportunity for consumer testing. Ironically, in Canada, different from the U.S., when the doctor orders labs, they give the patient the requisition. The patient largely chooses where they go for the lab work, right? In our market in the U.S., you go to a doctor, the doctor kind of writes the lab order for a specific lab. Now you can push back on the doctor and say, "I want to go to Quest and not this lab." But in Canada, the patients really have more choice. So it is actually more of a consumer market than the U.S. is.

Okay. And then let's take a step back and talk about kind of the underlying growth and organic growth that you're seeing so far in the U.S. market. What do you think is driving this? Is it the pent-up demand dynamics? Is it things that we're hearing from HCA and other kind of provider arms as well as the managed care companies? Or is it market share gains, for instance, that you're seeing? And this is more on an organic, I'm talking about this. And yes, what are you seeing now? What can continue a bit more?

Yes. So I think the pent-up -- if you go back to the second quarter, we had nice volume growth but we also had close to 200 basis points of growth from this side of the equation called revenue per req. And what's comprised in the rev per req, right? It's price per test, which we said has been relatively flat. So most of the growth in rev per req is coming from test per req, so we're seeing increased test density. The second and big driver is test mix, the kinds of tests we're doing. And what we're seeing is the investments that we've made in brain health, the investments we've made in advanced cardiovascular testing, things like Lp(a), ApoB, Omega test. And then a rise in autoimmune diseases, a rise in autoimmune testing. All of these things are providing higher revenue tests that are really mixing up the revenue per req. In addition, the payer mix has been favorable. And what I mean by payer mix is we've seen heavier Medicare and Medicare Advantage utilization. That's very good for Quest. But we've also seen a decline in Medicaid and a decline in managed Medicaid work. Now those lives didn't go away. Those lives shifted to commercial plans, mostly exchange-based types of plans. But an exchange plan is better than a managed Medicaid or a Medicaid plan. So that has helped as well. So the volume growth has been steady. Is it pent-up demand? At this point in the second, third quarter of 2024, 2 years post COVID, I'm not so sure there's -- it's pent-up demand. I think this increased volume that we're seeing, that the independent labs are seeing, I think, is a drawdown in requisitions out of hospital labs coming to the independent labs. And why is that occurring? The payers are making a concerted effort to educate patients, to educate providers, to educate employers that when a patient uses an independent lab, it's going to cost that patient 1/3 to 1/2 of if that same requisition goes into a hospital lab. And I think we're starting to see that volume movement from hospital labs into independent labs, which is good for the industry.

Can you -- we'll go there next in terms of those payer relationships. And how would you characterize them now than relative to, let's say, than 10 years ago in this space? It was vastly different. This is a really relatively under-managed area of health care. And we've seen that start to evolve truly here. And was it COVID that was the impetus of that? Or how are you -- how would you characterize, I guess, the payer relationships now?

I'd call them much more collaborative than they were when I first came into Quest 10 years ago where you had intense competitive price negotiations. You wrapped up the deal and then you went back and saw them 3 to 5 years later. I can tell you, we have a large commercial team that calls on our health plans. And it's not just we negotiate the price and we're done. As we've talked about, these are collaborative agreements. We work day in and day out with the health plans. They provide us lists of physicians that are using out-of-network labs. They provide us lists that are using health system labs and we work hand in hand. We go out, we educate employers. We try to educate the patients that they have choice and they can stand up and tell the doctor, "No, we want this requisition to go to Quest Diagnostics." So much more collaborative. I would also say, especially in Medicare Advantage plans where payers are now taking on more risk or large physician groups are taking on that risk, it's now more discussions around wellness. It's discussions on how data can help inform the best decisions. It's discussions on how early testing you can get in front of diabetes, you can get in front of other progressive diseases so that the long-term cost of care can be reduced by catching these things early. So much more collaborative, much more open, a spirit of working together to reduce costs, improve the patient experience and reduce costs for employers.

And you mentioned the payers taking on more risk. And can you talk a little bit about those value-based arrangements, what they look like for you from an economic standpoint for Quest relative to other types of relationships and contracts? And is this something that's broad-based in terms of others establishing these types of relationships? And do you see kind of, I guess, these outsized incentive payments being more regular or consistent in terms of the financial contributions for Quest?

Yes. We said over 50% of our contracts involve some type of value-based arrangement, meaning we agree on a price per test and then depending on how much share we can move out of hospital labs into our labs, or out-of-network labs into our labs, there could be payments tied to those incremental volume shifts. And so we like those kinds of incentives. In addition, when we do some of these outreach deals and the payer has been paying a health system 200% to 300% of Medicare, we're obviously getting paid something less than Medicare. We're not going to step down to our rates overnight. We're going to glide down over a 2- to 3-year process. And so that, in fact, provides incremental pricing over that 2- to 3-year period. So largely, those are the types of incentives that we like to build in with the plans. Now in addition to that, some of the plans, we have incentives around patient satisfaction indexes. And so to the extent the patients score us well, there could be incentives tied to those things as well.

And on a net basis and looking at the business as a whole, like I think you typically say it's about 1% in terms of price realization, do some of this, in terms of this sort of backdrop that we're in, does that inflect higher?

Well, what we said in total, so price this year is flat to slightly up. On the health plan side, which is largely our physician book of business, pricing has been slightly up coming out of COVID. So we've been able to get pricing up in that book of business. On the health systems side, which we drive roughly $1.7-ish billion out of that $9.5 billion this year, pricing in that segment has been more challenged. So we're not getting positive price there. Now that's an environment, as you know, health systems coming out of COVID have been challenged. And so while we're challenged, they're challenged and those have been more difficult price discussions.

Yes. And then as we, since we're talking about contracts, anything to call out in terms of contract renewals that we should be thinking about as we head into 2025?

Yes. So several hundred health plans that we negotiate with every year. They're all 3- to 5-year agreements. So on average, every year, 25% of our contracts are coming up for renewal. That 25% is true this year. I think we're through the majority of our negotiations. And so they're established. You still have a couple left in the fourth quarter of this year. But we still feel good about where we're going to land this year going into 2025.

Okay. Great. I want to talk a little bit about the regulatory landscape in terms of -- let's start with LDT regulation that obviously came in seemingly a little bit more favorable than some of the more onerous kind of outcomes that could have happened. But I guess how do you think about the near-term costs associated with that for Quest, the implementation of the LDT regulation and what actually is going to come to fruition? And then the offsets.

Yes. So if you're sitting in my chair, I'm not sure I would describe it as more favorable than what we thought. We still largely have to implement this thing called 21 CFR Part 820. There was a little bit of favorability on what some referred to is the grandfathering of old LDTs and it's -- the FDA decided to continue enforcement discretion on those LDTs, which one would call grandfathering. So when you think about this new regulation and I came out of the medical device world 10 years ago, there's really 3 parts. There's the upfront design controls, how you develop a test. There's the middle part, which says how you run these tests, how you run the laboratories. And the third part is what we call post market surveillance. Let's start with the middle part, largely CLIA, was a set of regulations on how we run our laboratories, the validation, verification studies we do before we implement an LDT. Nothing has really changed there. So we have a several hundred person organization today in charge of the quality assurance aspects of running our laboratories. Where we have to make investments, the first part is on the post-market surveillance, if there's complaints, if there's issues, trending those issues, which we do today but in fact, you may have to report if there's an adverse event, report that to the FDA. That piece of work has to be largely in place by May 6 of next year. So we're moving towards that, okay? So we have to make some investments on that end. And on the upfront end, what we call design controls, how you develop an LDT, design inputs, the processes for doing that. There's some people investments, there's some system investments, documentation, control systems, things like that, that we have to make. Now we've said whatever costs we've incurred this year is embedded in the current guidance. As we get into next year, we'll give an update, it probably won't be until Q1. But it's not significant that it's affecting our long-term outlook that we put in place during 2023. But there's investment required. There's people investments, some capital investments around systems and processes to be fully compliant. Now having said all that, as you know, our trade association filed a lawsuit in the federal courts of Texas. Just this week, AMP, the Association of Medical Pathologist (sic) [ Association for Molecular Pathology ] also filed a lawsuit against the FDA. So now we have 2 large institutions filing suit. I'm not going to handicap what happens here. The only thing I can do is talk to other cases recently. The Texas federal courts in Texas ruled, as you know, that the FTC could not end these employment noncompetes. I think the words were very strong in what the judge said in terms of Congress did not authorize the FTC to do this. Only Congress can set the boundaries of what these agencies can do. You're familiar with the Chevron cases. So there's some case law that's certainly on our side but the message for all of you is, we're compliant with the new law and we'll continue to be compliant as the phases roll in.

And we'll stick with this theme with PAMA and SALSA since we're there. And also just an update there but also political kind of implications just in the election cycle that we're in. Anything else that you're paying attention to from a regulatory...

Yes. So on the PAMA, SALSA front, the good news is each year the Congressional Budget Office scores what happens if PAMA is delayed. Last year they said if PAMA is delayed, it actually saves the -- so don't do the final round of cutting and it will save the government $700 million over a 10-year period. They went through that same math again this year and they said, if we don't cut -- take this final round of cuts, it's going to save the government $3.3 billion over a 10-year period. Now why would it save the money by deferring the cuts? Because when you defer -- if you don't defer the cuts, if they do -- if they cut us one more time, it will lead to a new data collection process. And that data collection process, when done fairly, meaning they'll sample hospital labs and independent labs, not just independent labs, they'll sample both, they're going to arrive at a price per test that is more than what they're paying us today. Plus they build in, the last data collection process was 2017. And when you look at what's happened to health plan pricing 2017 to today, you may find that, in fact, prices are higher. So we think the likelihood of another delay is high. We think getting a long-term final resolution to this problem is relatively low given what's on the mind of legislatures and you're in the midst of an election season. So we think another delay is probably the most likely outcome.

And in terms of a delay, does, whatever, perceived savings of the $80 million, $90 million drop through, or do you reinvest? Or how do you think about investments, I guess?

Well, again, it's not a savings. It's a hit that would occur.

Lack of it.

It's a lack of -- right. So if the pricing stays stable, Medicare pricing stays stable going into 2025, that's already in our run rate. If we get -- if there is a cut, it's a $90 million revenue -- $90 million win here.

And then let's switch gears a little bit to advanced diagnostics. Just give us an update, your current exposure to growth, margin profile but I also want to touch on kind of Haystack and what's going on and the latest there.

Yes. So just to put a little clarity on what we call advanced diagnostics. First of all, on routine testing in our business, testing that can be done overnight in our regional laboratories, about 60% of what we do. About 40% of what we do is we refer to it as esoteric testing. And this is testing done in very specialized labs, 3 or 4 across Quest Diagnostics. A lot of that comes from health systems. They do their own routine testing, send us the more advanced work. Now advanced testing comprises a lot of things and let me touch on 3 or 4 categories. #1, the brain health work that we're doing, Alzheimer's, dementia related. We've launched the AB 4240 test. We've launched both of the pTau markers. And the growth we're getting from that has been very good. We've launched some advanced cardiovascular testing, well beyond the LDLs and HDLs of the world, Lp(a), ApoB, Omega-type -- Omega testing. And these testing have grown very well. Autoimmune disorders and some new test launches we've done in the autoimmune space has been very, very -- the uptake has been good. And then on the genetics side, our prenatal screening growing at double digits, our hereditary carrier screening growing at double digits has also been a tremendous lift. All of that is what's lifting our rev per req, we said about 200 basis points in the second quarter. So that test mix, the average revenue per test has been quite good. We expect that to continue on. As we bring Haystack to market, that will help us in that area. So these are all investments that we've made over the last 4 or 5 years and these investments are starting to help.

Okay. And then so Haystack, I guess where do you stand in terms of the early experience programs? Like when does that start really becoming a driver for you from a revenue perspective? And one of the biggest swing factors, I think, in my bridge for 2025 is, how much less dilution there will be relative to 2024. >So how do we think about that?

Yes. So we launched what we call this early experience program in the second quarter of the year. We targeted 20 customers but within those 20 customers, we've had over 100 distinct physicians order the test. And what we're trying to work out is the entire workflow, order to reporting. We had -- we moved the test from a small lab in Baltimore where Haystack was based, to our larger cancer Center of Excellence in Texas and that required a lot of work, lot of effort. And so we wanted to test that end-to-end, from block retrieval all the way to reporting. Happy to report that it's been going very well. We've obviously identified problems. You work out those problems. And we will be launching on a national basis in the fourth quarter of this year. What we said is that we expect Haystack to be less dilutive and it's still going to lose money in 2025 versus 2024. Still feel good about that. Obviously, we're going to ramp testing up. We will work through the reimbursement process with one of the MACs in -- that covers the Dallas, where our lab is. And we continue to build the body of evidence. We continue to build the clinical dossier. What we believe is this test has the lowest limits of detection. In cancer patients, this is important. Truth matters in cancer patients. This isn't the type of test where you want to tell somebody that we don't detect cancer and then 3 months later, you come back and say, well, we actually have found it again. That's not what you want to do. You want to detect this cancer at the lowest levels that exist. And we believe we have those lowest limits of detection, which is going to provide clinicians with the tools they need to make the appropriate decision, is chemotherapy needed, is chemotherapy not needed.

Okay. In terms of the quarterly progression of margins then as we think about the back half of this year but even kind of going and kind of the run rate going into 2025, there are some factors like, for instance, in the fourth quarter, there were some outsized costs, I guess, last year that you will lap. But how do we think about some of the quarterly cadence dynamics there?

Yes, always in this business, right, Q1 margins less, Q2 always the best, Q3 generally consistent with Q2, or maybe a little less in Q3 and then Q4, with all the holidays and volume dropping off in the Christmas, New Year time frame, better than Q1 but worse than Q2. I don't think that progression is going to change. Now we got a lot of moving parts right now, right? We have LifeLabs coming in 1 month in the third quarter. We've got the entire fourth quarter. We've said that, again, that EPS profile $0.10 to $0.15, it's not -- it's probably more back half weighted than early weighted. But we're still working through that. And again, we'll provide more direct guidance on that as we enter -- as we do the Q3 earnings in October. The hospital outreach deals are generally more -- we understand how those play out. There's some upfront costs when you do these outreach deals, some heavy IT integration works, some heavy training of phlebotomists. So you got some early upfront costs but generally by month 3, month 4, those tend to -- the revenue tends to drop down at a 40% kind of contribution margin. So those are some of the things that -- the puts and takes. Again, we'll provide some more clarity in Q3 and obviously give 2025 guidance in...

Thinking about some of those upfront costs, like the University Hospitals deal, for instance, like that would contribute to that, right? Is that fully closed too?

No. So let's go through the hospital outreach deals. So Allina, in Minneapolis, we expect to close in the month of September, so before the start of Q4. We expect OhioHealth to close in the month of October. And we expect University Hospitals in Cleveland to close at some point in Q4, November-ish time frame. Now let me just chat about those 3 deals for a minute. First of all, when we think about these hospital outreach deals, what we're trying to target, is we're trying to target markets where the independent labs have very little share. Why would the independent labs have very little share in Minneapolis, Columbus, Ohio and University in Cleveland, Ohio? It's because the health systems in those markets own probably 85% to 90% of the physician base. There's very few independent physicians, which is why the independent labs don't operate in those markets. So this gives us a nice foothold in Minneapolis, Columbus, Ohio and Cleveland, Ohio. There's a lot to like about those markets. Minneapolis is actually a really good health care market, good patient dynamics. Columbus, Ohio is a really good market. You've got some major employers that have recently moved in there, including Intel building a big chip factory. And Cleveland, Ohio is actually a very stable and still growing market. It gives us a foothold in each of these markets upon which to grow and to gather additional work. So really feel good about those markets that we've been able to penetrate.

Okay. And then just thinking about some of those key events, swing factors, as we're kind of working through our model, there was like weather and cyber and then there's LifeLabs and then we have Haystack, less dilution kind of into next year as well that we have to think about. But anything near term that we should be kind of aware of, weather incremental, weather headwinds, or otherwise?

Yes. I think we said it on the Q3 earnings call, obviously, CrowdStrike and which cost us a full day of revenue plus [ barrel ]. I think we sized it roughly $0.06. It was in the guidance or it was in the guidance update. Haven't seen any hurricanes since that time but it certainly doesn't mean we're out of the hurricane season yet. And again, LifeLabs has come in earlier than expected. So we'll see the revenue and will likely be dilutive to our traditional margin rate in the fourth quarter.

And now since you've completed LifeLabs and M&A is a component of the growth strategy here and you think about the balance between opportunities like Haystack versus opportunities and whether it's hospital outreach or otherwise, how do you see the pipeline, I guess, from here? And where are your priorities?

Yes. So if we go back to the '23 long-term guidance, we said M&A would be 100 to 200 basis points of growth. We were light on that in '23, maybe 100-ish a, little more than 100 -- and, well, it would be more than 100 now in '24. But over the 3-year period, we're going to achieve that 100 to 200 basis points. We'll actually achieve more than that. Our bias is still the hospital outreach market, again, in markets where we don't have a strong foothold. That's what we look for every day. I can tell you, there's still opportunities out there. The funnel remains strong even though we've completed those 3. Capability building, look, our philosophy, if we're missing a capability in Quest Diagnostics today, we go through this pecking order. We first turn to our suppliers, the Roches, Siemens, Hologics, Thermo Fishers of the world. We always try to source our tests from them, leverage the R&D capabilities that they have and try to source. If the test -- if what we're trying to do doesn't exist in that supply base, then we turn to our own R&D team, which is why we do LDTs. We develop laboratory-based tests because there's tests that we cannot get from our supply base. That's why we go down the LDT path today. And that's still -- so we turn to our suppliers first. If we can't get it there, we turn to our own R&D team. And then if we don't think it's something we can complete in a time frame or an investment that makes sense, then we'll look at acquisition to build that capability. But we always go through that pecking order. And again, first start with the outreach deals because they're accretive, they're quick, they're easy and they generally don't involve us taking on large assets.

Okay. Great. And then you always have some sort of efficiency initiatives, whether it's in the various savings programs or otherwise. But where do you see kind of the bigger opportunity to drive further productivity gains across your business, whether it's automation or AI? Can you speak to some of those dynamics and where your initiatives lie and maybe touch on wages, too, since we're talking about growth?

Yes. So look, we're still in a game of we've got to generate several hundred million dollars of productivity a year, right? Our wage inflation, we've said, has been in the 3% to 4% range, that's, call it, $120 million to $140 million of pressure every year. And then you have other inflation that hits our business. Even though we try to keep supplies costs flat to going down, you still have pressure, lease costs for our patient service centers, things like that. So the productivity engine is -- we focus a lot on it. Where are there opportunities in the supply chain? Look, there's still opportunities in our patient service centers. Still way too many paper reqs that are coming in there. There's lots of opportunities in the laboratory. We've talked about the deployment of artificial intelligence in the areas of microbiology. We don't have human eyes looking at plates anymore. This can be done through digital images, software packages that are, analytics that are reading these digital images. The world of pathology is barely digital. Less than 5% of all pathology slides are digitized today and there's very few algorithms that are looking at these slides. So lots of opportunities left in our laboratory. In terms of turnover rates, it has moderated. So post -- during COVID, turnover rates in the industry and for us were upwards of 23%, 24%. For the frontline positions, lobotomy, logistics, our lab workers, last year, we got it down into the low 20s. First half of this year, we were down in the 18% to 19% range. But our goal is to still get it back to pre-COVID levels, in the 14% to 15% range. And we're on that trajectory and doing everything we can to get it there as quick as possible. So look, the productivity game never stops in this industry. We do things that cost $40 a req, every time we save $0.01 in this business, at 200 million reqs, there's $2 million of savings. So we focus a lot on the pennies in this business and look for continuous improvement, doing something better today than we did yesterday is the part of life at Quest Diagnostics.

Sounds like we need another 45 minutes.

We could use it.

Yes. Thank you so much. I appreciate the time.

Thank you.