Quest Diagnostics Incorporated — Q2 2010 Form 10-Q
Business context and reporting period. Quest provides diagnostic testing and related services, primarily in the United States. Clinical testing generated more than 90% of continuing-operations revenue. This unaudited report covers the quarter and six months ended June 30, 2010; comparisons are with the same 2009 periods unless noted. Dollar amounts below are in millions except per-share data.
Financial performance
| Metric | Q2 2010 | Q2 2009 | First half 2010 | First half 2009 |
|---|---|---|---|---|
| Net revenue | $1,874.7 | $1,901.8 | $3,680.2 | $3,709.8 |
| Operating income | $365.9 | $359.4 | $664.5 | $680.4 |
| Operating margin | 19.5% | 18.9% | 18.1% | 18.3% |
| Income from continuing operations | $204.1 | $198.3 | $375.3 | $375.6 |
| Net income attributable to Quest | $194.6 | $188.2 | $357.1 | $355.3 |
| Diluted EPS | $1.07 | $1.00 | $1.96 | $1.88 |
- Revenue and volume: Revenue declined 1.4% in Q2 and 0.8% in the first half. Clinical testing revenue fell 1.6% and 1.0%, respectively. Requisition volume declined 1.3% in Q2 and 1.9% year to date; revenue per requisition fell 0.3% in Q2 but rose 1.0% for the first half.
- Costs and margins: Q2 operating expenses were 80.5% of revenue, down from 81.1%; first-half expenses were 81.9%, up from 81.7%. Cost of services was 57.6% of revenue in Q2 and 58.3% for the first half. SG&A was 22.4% and 23.1%, respectively. Bad debt expense improved to 3.8% of revenue in Q2 and 4.0% for the first half, from 4.4% and 4.5%.
- Cash flow: First-half operating cash flow was $448.4, investing cash outflow $92.0, and financing cash outflow $442.7. Capital expenditures were $88.8; operating cash flow less capital expenditures was approximately $359.5. Ending cash was $447.9, down from $534.3 at year-end 2009.
- Debt and liquidity: June 30 balance-sheet debt totaled approximately $3,145.0, comprising $171.1 current and $2,973.8 long-term. Current assets were $1,631.3 and current liabilities $995.5; working capital was approximately $635.8. The company reported $1.3 billion of available capacity across its revolving and receivables facilities, with no borrowings under those facilities; $742 million remained outstanding on the May 2012 term loan. It reported compliance with financial covenants.
- Capital returns: First-half repurchases were $425.8 for 7.7 million shares; $324 million of authorization remained at June 30. The quarterly dividend was $0.10 per share.
Material changes and drivers
- Q2 operating income and diluted EPS improved despite lower revenue, supported by cost actions, lower performance-based compensation, improved professional-liability claims experience, lower bad debt expense, and reduced share count from repurchases.
- First-half operating income was lower, reflecting reduced clinical testing volume, severe first-quarter weather, and $17.3 million of workforce-reduction charges. Management estimated weather reduced first-half operating income by $14.3 million, or $0.05 per diluted share.
- Revenue per requisition benefited from a higher mix of gene-based and esoteric tests and more tests per requisition. Offsetting factors included the January 2010 Medicare clinical laboratory fee reduction, payer and business mix, and pricing on large contract extensions.
- Comparisons with 2009 were affected by a $15.5 million insurance settlement gain, a $6.3 million early debt-extinguishment charge, and a $7.0 million investment impairment charge. The 2009 first-half cash-flow comparison also included $308 million of NID settlement payments.
Outlook, risks, and contingencies
- The filing provides no specific earnings or revenue guidance. Management estimated 2010 capital expenditures of approximately $200 million and said cash, operating cash flow, and available credit should fund operations, debt service, dividends, repurchases, and growth opportunities.
- Management expects healthcare reform to increase utilization over time through expanded coverage, but noted offsets including Medicare laboratory fee reductions of 1.75% annually for five years beginning in 2011, a productivity adjustment, and a medical-device excise tax beginning in 2013. About 12% of 2009 revenue was reimbursed under the Medicare clinical laboratory fee schedule. A potential 21.2% reduction in certain Medicare Part B physician-service fees was delayed until November 30, 2010; its final status was uncertain.
- Clinical testing volume was pressured by a general slowdown in physician office visits; management also identified severe weather as a first-quarter factor. Competition, regulation, customer and payer relationships, and the company’s ability to adapt to healthcare reform are risks.
- Government investigations and lawsuits include allegations concerning laboratory pricing, Medicaid billing, and former subsidiary NID test kits. The company had approximately $10 million in reserves for the specified legal matters. Management said losses were not currently probable or reasonably estimable in some investigations; outcomes could materially affect results or cash flows in the period determined or paid, though management did not expect a material adverse effect on financial condition.
- Unrecognized tax-benefit liabilities were approximately $142 million; the company said $27 million might decrease within 12 months, while timing for the remainder could not be reliably estimated. An $85 million letter-of-credit line matured November 19, 2010; $72 million of letters of credit were outstanding at June 30.
Important facts for investors to verify
- Whether clinical testing requisition trends and revenue per requisition improve, and how much Medicare cuts, payer mix, and contract pricing affect revenue.
- Whether cost reductions can offset lower volumes without impairing service levels, and whether the first-half workforce and weather impacts recur.
- Progress on government investigations, Medicaid and pricing litigation, NID-related claims, and adequacy of legal reserves.
- Implementation and financial effects of healthcare reform, including laboratory fee reductions and the uncertain Medicare physician-fee schedule outcome.
- Debt maturities, credit-facility availability, covenant compliance, and the cash-flow capacity to support planned repurchases, dividends, and capital spending.