Quest Diagnostics Incorporated — Q2 2016 Form 10-Q
Business context and period: Quest provides diagnostic information services (DIS), which generated more than 90% of revenue, and Diagnostic Solutions (DS). This unaudited report covers the quarter and six months ended June 30, 2016, compared with the corresponding 2015 periods. Amounts are in millions except per-share data.
Financial performance
| Metric | Three months ended June 30, 2016 | Three months ended June 30, 2015 | Six months ended June 30, 2016 | Six months ended June 30, 2015 |
|---|---|---|---|---|
| Net revenue | $1,906 | $1,925 | $3,769 | $3,764 |
| Operating income | $422 | $301 | $679 | $529 |
| Operating margin | 22.1% | 15.6% | 18.0% | 14.1% |
| Net income attributable to Quest | $195 | $118 | $298 | $179 |
| Diluted EPS | $1.37 | $0.81 | $2.08 | $1.23 |
| Operating cash flow | Not separately reported for quarter | $464 | $337 |
Second-quarter DIS revenue rose 2.2% to $1,809; requisition volume grew 1.9% and revenue per requisition 0.2%. Six-month DIS revenue increased 2.9%. DS revenue declined 37.1% in Q2 and 32.1% for six months, primarily reflecting the clinical trials business contribution to Q² Solutions, the Focus Diagnostics sale, and the Celera products wind-down. Those changes reduced total revenue growth by 3.4 percentage points in Q2 and 3.1 points year to date.
Q2 reported operating margin includes the Focus sale gain. Cost of services decreased, while SG&A rose modestly in Q2 and 2.8% year to date. Management cited Invigorate savings and lower depreciation, partly offset by compensation, benefits, bad debt expense, and acquisition costs. The company changed estimated useful lives for certain assets; this increased operating income by $10 in Q2 and $20 year to date, and net income by $6 and $12, respectively.
Balance sheet, liquidity, and capital allocation
- At June 30, 2016, cash and cash equivalents were $283, versus $133 at year-end 2015; current assets were $1,510 and current liabilities $1,111.
- Debt was $3,842, including $7 current and $3,835 long-term, compared with $3,651 at December 31, 2015. The company issued $500 of 3.45% notes due 2026 and completed a $200 tender offer for older notes. No borrowings were outstanding under its $600 secured receivables facility or $750 revolving credit facility at quarter-end; reported available borrowing capacity was $1.3 billion.
- Six-month operating cash flow was $464; investing activities provided $27, including $275 of business-sale proceeds and $135 paid for the CLP acquisition. Financing activities used $341, including $390 of treasury-stock purchases and $111 of dividends paid.
- Capital expenditures were $104 for the first half. Management estimated 2016 capital expenditures of $250–$300. The quarterly dividend increased to $0.40 per share from $0.38; $582 remained available under repurchase authorizations at June 30. The May $250 accelerated repurchase had acquired $212 of shares by quarter-end, with the remaining settlement expected in Q3.
Material changes, outlook, and notable items
- Quest sold Focus Diagnostics on May 13 for $300 cash, or $293 net of transaction costs and working-capital adjustments, including $25 held in escrow. The sale generated a $118 pretax gain and $84 income-tax expense; the related tax rate was elevated because of the low tax basis, including goodwill.
- Quest acquired CLP’s outreach laboratory business for $135 cash in February. It also completed a $200 debt tender offer, recording a $48 pretax loss on retirement of debt.
- Reported earnings reflect unusual items: the Focus gain benefited Q2 diluted EPS by $0.24, while other listed Q2 items reduced it by $0.12, for a net benefit of $0.12. For the first half, the listed unusual items reduced diluted EPS by a net $0.20. Results also reflect the useful-life estimate change noted above.
- Management said it remained on track for its goal of $1.3 billion in cumulative Invigorate run-rate savings by the end of 2017. It estimated $80–$100 of 2016 charges for the program, including systems conversion and integration costs; $27 had been incurred through June 30.
- No specific full-year revenue or EPS guidance is provided in the supplied filing text. Management said the impact of Medicare laboratory reimbursement changes under PAMA, targeted for 2018, remained under evaluation and was expected to be manageable, while noting that final pricing data was not yet available.
Risks and contingencies
- Quest disclosed ongoing litigation and government inquiries involving billing and other business practices. A federal qui tam matter involving Berkeley HeartLab had reached an agreement in principle, subject to final terms and government approvals. The Florida Medicaid pricing lawsuit remained pending. Management said material losses were not considered probable at June 30, but potential losses on certain matters could not be estimated and could affect results or cash flows.
- Reserves for general and professional liability claims were $124. The company also disclosed $96 of liabilities for unrecognized tax benefits, a $74 redeemable noncontrolling interest, and $701 of operating lease commitments. It reported compliance with credit-agreement covenants.
- Key business risks cited include reimbursement and pricing pressure, competition, changing customer and payer relationships, regulation, and legal or governmental proceedings. DSO was 47 days, compared with 44 days a year earlier.
Most important facts for investors to verify
- How much of earnings growth came from the Focus sale gain, reduced prior-year debt-retirement charges, and the depreciation-life estimate change, versus underlying operating performance.
- Whether DIS volume growth and revenue per requisition can offset pricing pressure and the continuing drag from disposed or contributed businesses.
- Progress and cash costs against the Invigorate savings target and 2016 charge estimate.
- Final settlement terms and financial outcomes for the disclosed legal matters, and the eventual effect of PAMA reimbursement changes.
- Debt levels, cash generation, share repurchases, and dividend commitments relative to acquisition, capital expenditure, and contractual obligations.