Quest Diagnostics Incorporated — Q3 2010 Form 10-Q
Business and period: Quest Diagnostics provides diagnostic testing and related services; clinical testing generated more than 90% of revenue. This unaudited report covers the three and nine months ended September 30, 2010, compared with the same periods in 2009. Dollar amounts below are in millions unless stated otherwise.
Key financial results
| Metric | Q3 2010 | Q3 2009 | First nine months 2010 | First nine months 2009 |
|---|---|---|---|---|
| Revenue | $1,864.7 | $1,897.1 | $5,544.9 | $5,607.0 |
| Operating income | $336.9 | $348.3 | $1,001.3 | $1,028.7 |
| Operating margin | 18.1% | 18.4% | 18.1% | 18.3% |
| Income from continuing operations | $208.1 | $201.1 | $583.5 | $576.7 |
| Net income attributable to Quest | $198.1 | $192.2 | $555.1 | $547.5 |
| Diluted EPS | $1.13 | $1.02 | $3.09 | $2.90 |
| Operating cash flow | Not provided for quarter | Not provided for quarter | $778.5 | $637.1 |
Cost of services was 58.5% of revenue in Q3 and 58.4% year to date, versus 57.9% and 58.0%, respectively, in 2009. SG&A was 22.9% and 23.0%, respectively, versus 23.3% and 23.4%.
Balance sheet and liquidity
- At September 30, 2010, cash was $369.3, down from $534.3 at December 31, 2009. Current assets were $1,552.7 and current liabilities $1,148.3.
- Debt carrying value was $3,167.5, comprising $331.5 current and $2,835.9 long-term; cash less debt was approximately $2,798.2. Estimated debt fair value was approximately $3.4 billion, $203 million above carrying value.
- Operating cash flow of $778.5 funded $139.8 of investing outflows, chiefly $136.3 of capital expenditures, and $803.6 of financing outflows. Financing included $750.0 of share repurchases and $54.2 of dividends.
- The company reported $1.3 billion of available capacity under its revolving and secured receivables facilities, with no borrowings under either at quarter-end. The secured receivables facility was due to mature December 10, 2010.
Changes and management commentary
- Revenue declined 1.7% in Q3 and 1.1% year to date. Clinical testing revenue fell 1.7% in Q3; requisition volume fell 0.3%, while revenue per requisition declined 1.3%. Management cited slower physician office visits, payer and test mix, pricing on contract extensions, and Medicare fee reductions.
- Management said cost actions, lower performance-based compensation, improved professional-liability claims experience, and lower bad-debt expense partly offset weaker revenue. Bad debt expense was 4.0% of revenue in both 2010 periods, down from 4.4% in 2009.
- Operating income and margins declined year over year despite lower total operating expenses. Diluted EPS increased, helped by lower share counts from repurchases and a tax benefit of $0.08 per diluted share, primarily from favorable resolution of tax contingencies.
- Year-to-date 2010 results included $17.3 million of workforce-reduction charges and an estimated $14.3 million adverse operating-income impact from severe first-quarter weather. The 2009 comparison included a $15.5 million storm-insurance gain, as well as debt-extinguishment and investment-impairment charges.
- Operating cash flow increased against 2009, which included NID settlement payments. Management cautioned that, excluding those payments and related tax effects, underlying cash flow declined, primarily due to timing of variable compensation and accrued expenses.
Outlook, risks, and contingencies
- No specific earnings or revenue guidance was provided. Management estimated 2010 capital expenditures of approximately $200 million and said cash, operating cash flow, and credit capacity should fund expected needs and obligations.
- Management viewed healthcare reform as potentially beneficial over the long term through expanded coverage, but identified Medicare laboratory-fee reductions of 1.75% annually for five years starting in 2011 and other cost-control provisions as offsets. A potential 21.2% reduction to a separate Medicare physician/pathology fee schedule had been delayed through November 30, 2010.
- In California, the company agreed to temporarily suspend MediCal billing for up to six months while continuing services, pending resolution of a lawsuit and billing dispute. 2009 MediCal revenue was approximately $66 million; an adverse outcome could reduce reimbursement.
- The company faces federal and state investigations and lawsuits involving billing practices, alleged MediCal overcharges, and allegations concerning NID test kits. Management had recorded approximately $10 million in reserves for the discussed legal matters; some losses were considered reasonably possible but not probable or not reasonably estimable. Management said outcomes could materially affect results or cash flows in the period determined or paid.
- Healthcare reform, changing reimbursement and regulation, legal proceedings, and the ability to adapt to industry changes are identified risks. Management reported compliance with credit covenants and effective disclosure controls.
Important facts for investors to verify
- Whether clinical testing volumes, reimbursement, payer mix, and revenue per requisition stabilize or continue to pressure revenue and margins.
- Whether the secured receivables facility was renewed or replaced at its December 2010 maturity and how liquidity and debt obligations evolve.
- Developments in the California MediCal dispute and other government investigations and litigation, including potential liabilities beyond recorded reserves.
- The sustainability of cash flow after adjusting for the prior-year NID settlement comparison and working-capital timing.
- Implementation and financial effects of healthcare reform and Medicare reimbursement changes.
- Share-repurchase activity: the existing authorization was fully used by September 30; the board authorized a further $250 million on October 20, 2010.