Quest Diagnostics Incorporated — Q3 2016 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2016. Amounts are in millions of dollars except per-share data. Quest’s Diagnostic Information Services (DIS)—clinical testing and related services—generated more than 90% of revenue.
Financial performance
| Metric | Q3 2016 | Q3 2015 | Nine months 2016 | Nine months 2015 |
|---|---|---|---|---|
| Net revenue | $1,885 | $1,880 | $5,654 | $5,644 |
| Operating income | $322 | $631 | $1,001 | $1,160 |
| Operating margin | 17.1% | 33.6% | 17.7% | 20.5% |
| Net income attributable to Quest | $192 | $342 | $490 | $521 |
| Diluted EPS | $1.34 | $2.35 | $3.42 | $3.58 |
| Operating cash flow | Not stated for quarter | Not stated for quarter | $765 | $549 |
- Q3 DIS revenue was $1.8 billion, up 2.1%; requisition volume rose 2.0% and revenue per requisition was flat. The Focus Diagnostics sale and wind-down of Celera Products reduced consolidated Q3 revenue growth by 1.8 percentage points. DS revenue fell 27.1% to $85 million.
- For the first nine months, DIS revenue grew 2.7%, while DS revenue declined 30.7%, mainly reflecting the Focus sale, Celera wind-down, and the 2015 clinical trials business contribution to Q2 Solutions.
- Cash and cash equivalents were $406 at September 30, versus $133 at year-end 2015. Long-term debt was $3,822, including a $7 current portion. Operating cash flow increased $216 year over year; investing cash use was $45 and financing cash use was $447.
- Available borrowing capacity was $1.3 billion, and there were no borrowings under the $600 secured receivables facility or $750 revolving facility at quarter-end. The company reported compliance with debt covenants.
- Capital expenditures were $165 for the nine-month period; management estimated approximately $250 for full-year 2016. Dividends were $0.40 per share per quarter. Share repurchases totaled $440 year to date, with $532 remaining authorized.
Changes versus comparable periods and unusual items
- Q3 operating income and EPS were sharply lower than Q3 2015, when results included a $334 pre-tax gain from contributing the clinical trials testing business to Q2 Solutions. Nine-month 2015 results also included that gain.
- 2016 nine-month results included a $118 pre-tax gain on the Focus Diagnostics sale. The sale generated $293 net proceeds, including $25 held in escrow, and $84 of related income tax expense. The sale-related effective tax rate was 71.4%, primarily due to the low tax basis of the assets sold.
- Other 2016 items included $48 of pre-tax debt-retirement losses and restructuring/integration charges. Management said identified items together reduced nine-month diluted EPS by $0.13; identified Q3 items together benefited diluted EPS by $0.07.
- DIS growth reflected organic activity and acquisitions, including the $135 acquisition of Clinical Laboratory Partners (CLP). Pricing pressure was partly offset by favorable test mix; Q3 unit pricing pressure was approximately 0.5%.
- A change in estimated useful lives of certain equipment and software reduced nine-month depreciation expense by $29 and increased net income by $18, or $0.12 per share. Management estimated a full-year 2016 EPS benefit of about $0.16.
Outlook, management commentary and risks
- Management said it remained on track to reach $1.3 billion in cumulative Invigorate run-rate savings versus 2011 by the end of 2017. For 2016, estimated program charges were revised to $50–$65, with $43 incurred through September; most estimated 2016 charges were expected to be cash expenditures.
- Quest said the impact of Medicare laboratory reimbursement changes under PAMA, targeted for 2018, remained uncertain pending final pricing data, but management believed it would be manageable.
- Management expected cash, operating cash flow, and available credit to fund working capital, capital spending, debt service, dividends, repurchases, and growth opportunities for the foreseeable future. This is commentary, not numerical earnings guidance.
- Risks include reimbursement and pricing pressure, competition, customer and payer relationships, regulatory changes, and legal or government proceedings. In the Berkeley HeartLab False Claims Act matter, the parties had an agreement in principle subject to further terms and governmental approvals. Other matters include a Florida Medicaid pricing and billing lawsuit and various investigations and claims. Management said material losses were not considered probable for the described legal matters, but potential losses could not be estimated; outcomes could affect results or cash flows.
- The company had $119 of reserves for general and professional liability claims and $3 for other legal matters. It also disclosed $95 of liabilities for unrecognized tax benefits, excluded from contractual-obligation totals.
- A ten-year billing and collection outsourcing agreement was signed in September 2016, with services commencing in Q4. Adoption of the new lease standard was expected to significantly increase balance-sheet lease assets and liabilities, but the amount had not been quantified.
Important facts for investors to verify
- How much reported earnings and cash flow depend on one-time gains, restructuring costs, debt-retirement charges, and the useful-life estimate change.
- Whether DIS volume and organic growth can offset reimbursement pressure and flat or declining revenue per requisition.
- The eventual PAMA reimbursement impact once final pricing data is available.
- Progress and cash costs under Invigorate, and whether the 2017 savings target remains achievable.
- Developments and potential financial exposure from the disclosed legal, government, and tax matters.
- Future debt, liquidity, and capital returns, including the effect of repurchases and dividends on leverage.