Quest Diagnostics Incorporated — Q3 2018 Form 10-Q
Business and period: Quest provides diagnostic information services (DIS), which generated about 96% of revenue, and smaller Diagnostic Solutions (DS) businesses. This unaudited report covers the three and nine months ended September 30, 2018; comparisons are with 2017, with prior-year revenue figures restated for the new revenue-recognition standard.
Financial performance
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Net revenue | $1.889B | $1.856B | $5.692B | $5.537B |
| Operating income | $304M | $298M | $881M | $896M |
| Operating margin | 16.1% | 16.1% | 15.5% | 16.2% |
| Net income attributable to Quest | $213M | $161M | $609M | $518M |
| Diluted EPS | $1.53 | $1.15 | $4.37 | $3.68 |
| Operating cash flow | Not separately stated | Not separately stated | $905M | $852M |
- Q3 revenue rose 1.8%; DIS revenue increased 1.9%, while DS revenue was up 0.3%. DIS requisitions increased 2.0%, but revenue per requisition fell 0.8%. Acquisitions contributed about 2.5% to DIS revenue growth; organic DIS growth was down 0.6%.
- For the first nine months, revenue rose 2.8% and DIS revenue grew 3.1%; acquisitions contributed 3.1% to DIS growth while organic growth was flat. DIS volume rose 2.3% and revenue per requisition increased 0.3%.
- Q3 operating income increased 1.8%, with margin unchanged. Nine-month operating income declined 1.7% and margin contracted 0.7 percentage points. Management attributed pressure in part to acquired businesses’ initially lower margins and integration costs.
- Net income and EPS growth outpaced revenue growth, primarily reflecting lower taxes following the Tax Cuts and Jobs Act (TCJA), along with other tax benefits and unusual items. The effective tax rate was 18.1% in Q3 and 18.8% for the nine months, versus 35.7% and 33.2%, respectively, in 2017.
- Nine-month operating cash flow increased $53M, primarily due to lower tax payments, partly offset by working-capital timing. Capital expenditures were $232M, versus $170M; acquisitions, net of cash acquired, used $219M.
Liquidity, debt and capital allocation
- At September 30, cash and cash equivalents were $263M, compared with $137M at December 31, 2017. Current assets were $1.603B and current liabilities $1.389B.
- Balance-sheet debt totaled $3.698B ($304M current and $3.394B long-term), compared with $3.784B at year-end 2017. The company reported $1.3B of available borrowing capacity across its credit facilities and no borrowings outstanding under either facility at quarter-end. It reported compliance with debt covenants.
- Interest expense, net rose to $124M for the first nine months from $112M, primarily due to higher rates on variable-rate debt. Interest-rate swaps had a $131M liability fair value; their notional amount was $1.2B.
- Accounts receivable increased to $1.097B from $924M at year-end; days sales outstanding rose to 52 from 47 at year-end and 46 a year earlier.
- Nine-month dividends paid were $198M; the quarterly dividend was $0.50 per share, up from $0.45 in 2017. The company repurchased $150M of stock and had $767M remaining under its authorization.
Material changes, outlook and notable items
- Reimbursement outlook: Management estimated PAMA reduced Q3 DIS revenue growth by 0.5%. It expects PAMA to reduce revenue from tests covered by the Clinical Laboratory Fee Schedule by about 4% in 2018 and 10% in each of 2019 and 2020. Those revenues represented 12% of consolidated revenue in 2017. Further reductions after 2020 may result from future rate revisions.
- Cost and investment plans: Management forecast 2018 capital expenditures of $350M–$400M. It said TCJA tax savings would support cash flow and be partly reinvested in the business and employees. The Invigorate program had delivered more than $1.3B of run-rate savings versus 2011 by year-end 2017; 2018 year-to-date program charges were $67M, and further restructuring charges may occur.
- Partnership and acquisitions: Quest expects to become a nationwide participating laboratory provider for UnitedHealthcare plans effective January 1, 2019, subject to existing capitation arrangements. It completed acquisitions of MedXM, Cape Cod Healthcare’s outreach laboratory business and ReproSource. The planned acquisition of Oxford Immunotec’s U.S. laboratory services business was expected to close in Q4 2018, subject to customary conditions.
- Unusual items: Q3 results included a $13M gain from reducing MedXM contingent consideration to zero. Management said specified items reduced Q3 diluted EPS by a net $0.02 and nine-month diluted EPS by a net $0.17. Nine-month items included $75M of pre-tax charges associated primarily with restructuring, systems conversion and integration; tax benefits and other gains partly offset charges.
- Contingencies and risks: The company faces legal proceedings and government reviews, including matters involving billing practices. Management did not consider material legal losses probable at September 30, 2018, but stated outcomes could affect results or cash flows; legal reserves were $5M. Reserves for general and professional liability claims were $122M. The filing also identifies contingent lease obligations for which no liability was recorded, and $97M of unrecognized tax-benefit liabilities, largely excluded from the contractual obligations table.
- Management stated that cash, operating cash flow and available borrowing capacity should provide sufficient flexibility for foreseeable operating needs, debt service, capital spending, dividends, repurchases and growth opportunities. The filing provides no specific full-year revenue or EPS guidance.
Key investor verification points
- Track PAMA reimbursement reductions against management’s estimates, especially the expected 2019–2020 impact.
- Assess underlying DIS growth separately from acquisitions, including requisition volume, organic growth and revenue per requisition.
- Separate ongoing earnings and cash generation from lower TCJA-driven taxes, tax benefits, restructuring costs and the MedXM contingent-consideration gain.
- Monitor receivables and DSO, which increased, and confirm that operating cash flow remains adequate for planned capital spending and acquisition activity.
- Verify execution of the UnitedHealthcare arrangement and pending Oxford Immunotec transaction, and monitor legal, tax and other contingent exposures.