Quest Diagnostics Incorporated — FY 2016 Form 10-K
Reporting period: Fiscal year ended December 31, 2016. Although the request references 2016 Q4, this is an annual filing; quarterly figures below are included where disclosed. Amounts are in U.S. dollars.
Business context and reporting period
Quest provides clinical laboratory testing and related diagnostic information services, primarily in the United States. Diagnostic Information Services (DIS) generated 95% of 2016 revenue; Diagnostic Solutions generated the remaining 5%. The company reported processing approximately 160 million test requisitions during the year.
Financial performance and liquidity
| Metric | FY 2016 | FY 2015 | Change |
|---|---|---|---|
| Net revenue | $7.515 billion | $7.493 billion | +0.3% |
| Operating income | $1.277 billion | $1.399 billion | -8.7% |
| Operating margin | 17.0% | 18.7% | -1.7 percentage points |
| Net income attributable to Quest | $645 million | $709 million | -9.1% |
| Diluted EPS | $4.51 | $4.87 | -7.4% |
| Operating cash flow | $1.069 billion | $821 million | +$248 million |
| Capital expenditures | $293 million | $263 million | +$30 million |
Cost of services was $4.616 billion, or 61.4% of revenue, versus 62.1% in 2015. The reported gross profit was $2.899 billion (38.6% of revenue), compared with $2.836 billion (37.8%) in 2015. The company reported $359 million in cash and cash equivalents at year-end, versus $133 million a year earlier. Current assets were $1.531 billion and current liabilities were $981 million.
Year-end total debt was $3.734 billion, including $3.728 billion of long-term debt. The company had no borrowings outstanding under its $600 million receivables facility or $750 million revolving credit facility; stated available capacity was approximately $1.3 billion. It reported compliance with credit-agreement covenants. Operating cash flow less capital expenditures was approximately $776 million, a simple calculation from reported figures.
Q4 2016: Revenue was $1.861 billion, gross profit $701 million, net income attributable to Quest $155 million, and diluted EPS $1.09. In Q4 2015, the corresponding figures were $1.849 billion, $699 million, $188 million, and $1.29.
Material changes versus the prior comparable period
- DIS revenue increased 2.5% to $7.138 billion. Requisition volume rose 2.0%, while revenue per requisition increased 0.4%; favorable test mix was partly offset by approximately 0.7% pricing pressure.
- Diagnostic Solutions revenue declined 28.5% to $377 million, principally reflecting the 2015 contribution of clinical-trials testing to Q2 Solutions, the 2016 Focus Diagnostics product-business sale, and the Celera products wind-down. These portfolio changes reduced total revenue growth by 2.3 percentage points.
- Operating income and EPS fell despite modest revenue growth. The comparison is affected by the $334 million 2015 gain on the Q2 Solutions contribution, versus a $118 million 2016 gain on the Focus Diagnostics sale. The company attributed the lower 2016 net income primarily to the 2015 gain and a 2015 deferred tax benefit, partly offset by the 2016 Focus sale gain.
- Operating cash flow increased, helped by lower debt-retirement payments, receipt of $54 million from terminated interest-rate swaps, lower restructuring payments and improved performance; higher taxes paid, including $91 million related to the Focus sale, partly offset the increase.
Outlook, management commentary, risks and unusual items
- Management expected DIS reimbursement pressure of approximately 1% in 2017, broadly consistent with recent years. It stated that the impact of Medicare fee-schedule changes under PAMA, targeted for 2018, was not yet quantifiable but was expected to be manageable.
- The company’s strategy focused on accelerating growth and operational excellence. It targeted 1–2% annual revenue growth through strategic acquisitions and reported more than $1.1 billion of Invigorate run-rate savings exiting 2016, against a $1.3 billion target exiting 2017. It estimated 2017 program charges of $60–$80 million, all expected to be cash expenditures.
- Management estimated 2017 capital expenditures of $250–$300 million and said cash, operating cash flow and borrowing capacity should fund operating needs, debt service, dividends, repurchases and growth opportunities. No specific full-year 2017 revenue or EPS guidance is provided in the supplied filing text.
- Notable accounting and transaction items: the Focus sale generated a $118 million pre-tax gain and $84 million tax expense; the 2016 debt tender offer generated a $48 million pre-tax loss. A change in estimated useful lives of certain equipment and software reduced 2016 depreciation by $37 million and increased net income by $23 million, or $0.16 per share. These items affect comparisons and earnings quality.
- Key risks include reimbursement and pricing pressure, payer consolidation and network exclusions, patient bad debt, potential changes to the ACA, PAMA implementation, and possible expanded FDA oversight of laboratory-developed tests. The company also identified competitive pressure from hospital and point-of-care testing, regulatory and billing compliance, and execution risks in systems standardization and acquisitions.
- A December 2016 cyberattack resulted in theft of certain patient data. The company reported no indication of misuse and said the accessed data did not include Social Security numbers, payment-card information or insurance and other financial information; litigation or government investigation remained possible.
- Optum began providing billing and related operations for most company revenues in November 2016 under a 10-year agreement. The transition and billing accuracy are relevant execution and collection risks. The company also disclosed a qui tam matter with an agreement in principle, subject to final terms and government approval; other legal matters’ potential losses could not be estimated, and management did not consider material losses probable at year-end.
Most important facts for investors to verify
- Reconcile reported earnings with the Focus sale gain, debt-retirement loss, restructuring and integration charges, and the $0.16-per-share depreciation-estimate benefit.
- Review DIS volume, revenue per requisition, payer pricing and bad-debt trends, including the effects of patient cost-sharing and the Optum billing transition.
- Track Invigorate savings against the $1.3 billion target and assess the cash and earnings costs of the remaining program.
- Monitor debt maturities, interest-rate exposure, credit-facility availability and capital returns; the filing’s contractual-obligation schedule reports debt obligations on a different basis from the balance-sheet carrying amount.
- Assess developments in the patient-data breach, disclosed legal matters, ACA changes, PAMA reimbursement schedules and potential LDT regulation.