Quest Diagnostics Incorporated — Q2 2018 Form 10-Q
Reporting period: Three and six months ended June 30, 2018. Unaudited consolidated results; amounts are in millions except per-share data. Quest’s Diagnostic Information Services (DIS) business generated 95.6% of second-quarter revenue.
Financial performance
| Metric | Q2 2018 | Q2 2017 | First half 2018 | First half 2017 |
|---|---|---|---|---|
| Net revenue | $1,919 | $1,864 | $3,803 | $3,681 |
| Operating income | $305 | $319 | $577 | $598 |
| Operating margin | 15.9% | 17.1% | 15.2% | 16.2% |
| Net income attributable to Quest | $219 | $193 | $396 | $357 |
| Diluted EPS | $1.57 | $1.37 | $2.84 | $2.53 |
| Operating cash flow | Not presented quarterly | $503 | $490 |
- Revenue increased 3.0% in Q2 and 3.3% in the first half. DIS revenue rose 3.3% and 3.7%, respectively; Diagnostic Solutions revenue fell 4.1% and 4.7%, largely because a royalty agreement’s payments received in 2017 had expired.
- Q2 DIS requisition volume rose 2.5%; revenue per requisition rose 0.2%. Acquisitions contributed an estimated 3.3% to DIS revenue growth, while organic growth was flat. For the first half, DIS volume rose 2.4%, revenue per requisition rose 0.9%, and organic growth contributed about 0.3%.
- Operating income declined despite revenue growth. Cost of services increased 6.2% in Q2, faster than revenue, and operating margin contracted 1.2 percentage points. Management cited acquisition costs, legal-related costs, higher supplies and reinvestment spending; acquired businesses initially carry lower margins before synergies.
- Net income and EPS increased as lower income taxes more than offset weaker operating income and higher interest expense. Effective tax rates were 16.2% in Q2 and 19.1% in the first half, versus 32.1% and 32.0% in 2017.
- Cash from operations was $503; investing used $330, including $165 for acquisitions and $151 in capital expenditures. Financing used $178. Cash and cash equivalents were $132 at quarter-end, versus $137 at year-end 2017. Accounts receivable rose to $1,055 from $924; days sales outstanding increased to 50 from 47 at year-end 2017.
- At June 30, current assets were $1,415 and current liabilities $1,262. Current and long-term debt totaled $3,713 on the balance sheet. The company reported $1.3 billion of available borrowing capacity and said it was in compliance with credit covenants. The $750 million revolving facility had no outstanding borrowings.
Material changes and notable items
- Quest acquired MedXM in February for $142 net of cash acquired, including estimated contingent consideration, and acquired Cape Cod Healthcare’s outreach laboratory business in June for $35. Acquisitions contributed to revenue growth and increased goodwill and amortization expense.
- The company adopted the revenue-recognition standard retrospectively. Patient responsibility amounts previously recorded largely as bad-debt expense are now generally treated as price concessions reducing revenue. For 2017 comparatives, this reduced reported Q2 revenue and SG&A by $79 and first-half revenue and SG&A by $161, with no effect on reported net income.
- Q2 2018 results included identified items that, on net, reduced diluted EPS by $0.04; first-half items reduced it by $0.15. These included restructuring and integration charges, legal-related costs partly offset by an insurance recovery, a $15 tax benefit from a tax accounting method change, and excess stock-compensation tax benefits.
- Restructuring and related Invigorate program charges were $49 pre-tax for the first half, including $19 of restructuring charges; the balance was primarily systems conversion and integration costs. Management said further restructuring charges may occur.
- Quarterly dividends rose to $0.50 per share from $0.45. First-half share repurchases were $50, versus $300 in the prior-year period; $867 remained authorized.
Outlook, risks and contingencies
- No full-year revenue or earnings guidance is stated in the supplied filing text. Quest estimated PAMA-related reductions to Clinical Laboratory Fee Schedule revenue of about 4% in 2018 and about 10% in each of 2019 and 2020. PAMA reduced Q2 DIS revenue growth by an estimated 0.5%.
- Management estimated 2018 capital expenditures of $350–$400, including IT, laboratory equipment and facilities, a new laboratory construction project, growth initiatives and headquarters relocation costs. It expected TCJA tax savings to support cash flow and partly offset PAMA reductions, with some savings reinvested in the business and employees.
- Effective January 1, 2019, Quest expects to become a nationwide participating laboratory provider for UnitedHealthcare plans, excluding existing lab capitation arrangements.
- Risks include further reimbursement pressure, payer and pricing changes, acquisition integration and realizing synergies, collection timing, and government investigations or litigation. The company reported $5 in legal reserves and $123 in reserves for general and professional liability claims; it said material legal losses were not considered probable, but outcomes could affect results or cash flows.
- Quest is substantially self-insured for a significant portion of liability claims. It also disclosed $111 of liabilities for unrecognized tax benefits, possible contingent lease obligations without a recorded liability, and a $76 redeemable noncontrolling interest with a potential redemption right beginning in 2020.
Important facts for investors to verify
- Whether organic DIS volume and revenue growth can improve as acquisition contributions moderate, and whether acquisitions deliver expected cost synergies.
- The actual impact of PAMA reimbursement reductions, particularly the anticipated 2019–2020 declines, and the effect of the UnitedHealthcare agreement beginning in 2019.
- Margin trends, including acquisition integration costs, reinvestment spending, restructuring charges and the pace of Invigorate savings.
- Receivables and collection performance given the increase in accounts receivable and DSO to 50 days.
- Debt maturities, variable-rate exposure and liquidity needs alongside the planned capital spending, dividends, acquisitions and potential share repurchases.
- The resolution and financial impact of legal, government, tax and liability matters; the filing says outcomes may be material in the period determined or paid.