Quest Diagnostics Incorporated — 2012 Form 10-K
Reporting period: Fiscal year ended December 31, 2012. The filing is an annual report, not a standalone fourth-quarter filing; quarterly figures below are unaudited. Quest is a U.S.-focused diagnostic testing and information services provider. It processed approximately 147 million test requisitions in 2012. Diagnostic Information Services (DIS) generated more than 90% of continuing-operations revenue.
Financial performance and liquidity
| Metric | 2012 | 2011 |
|---|---|---|
| Net revenue | $7.383 billion | $7.392 billion |
| Operating income | $1.201 billion | $987 million |
| Operating margin | 16.3% | 13.4% |
| Income from continuing operations attributable to Quest shareholders | $630 million | $459 million |
| Diluted EPS from continuing operations | $3.92 | $2.85 |
| Net income attributable to Quest shareholders, including discontinued operations | $556 million | $471 million |
| Cash provided by operating activities | $1.187 billion | $895 million |
| Capital expenditures | $182 million | $162 million |
| Cash and cash equivalents at year-end | $296 million | $165 million |
| Total debt at year-end | $3.364 billion | $4.025 billion |
Cost of services was 59.1% of revenue; gross profit was $3.018 billion. Interest expense, net, was $165 million. Quest reported $1.3 billion of available capacity across its secured receivables and revolving credit facilities, with no year-end borrowings on either facility. Days sales outstanding increased to 47 days from 45.
Fourth-quarter 2012 revenue was $1.774 billion and income from continuing operations was $150 million. A $84 million after-tax loss from discontinued operations reduced fourth-quarter net income to $66 million.
Material changes versus the prior comparable period
- Revenue was essentially flat year over year. DIS revenue rose 0.1%; requisition volume increased 0.2%, while revenue per requisition was essentially unchanged. Acquisitions contributed approximately 1.0% to DIS revenue growth.
- Operating income and continuing-operations EPS increased substantially, but the comparison was significantly affected by the $236 million Medi-Cal lawsuit charge recorded in 2011. 2012 also benefited from Invigorate savings; it included $106 million of restructuring and integration charges and $10.1 million of CEO-succession-related charges.
- Operating cash flow increased, with approximately $70 million of income tax payments deferred to early 2013 and $72 million received upon termination of interest-rate swaps contributing to 2012 cash flow.
- Debt declined by approximately $661 million, mainly reflecting repayments; the $560 million term loan matured and was repaid in 2012.
- Quest recorded an $86 million combined impairment and sale loss in discontinued operations, principally related to HemoCue and OralDNA. Full-year discontinued-operations loss was $74 million after tax, versus $12 million of income in 2011.
- DIS represented approximately 92% of 2012 continuing-operations revenue. Diagnostic Solutions revenue declined approximately 3%, mainly due to lower clinical-trials testing revenue.
Strategy, outlook, risks and unusual items
- Cost and growth plans: Invigorate targets $600 million of annual run-rate savings versus the 2011 baseline by the end of 2014; approximately $200 million had been achieved exiting 2012. Management said it was pursuing potential savings of up to $1 billion beyond 2014. Estimated pre-tax program charges through 2014 are $170 million to $250 million, of which $160 million to $230 million are expected to be cash expenditures. Project Restore is intended to support profitable revenue growth.
- Restructuring: Management expected to eliminate three management layers and approximately 400–600 management positions by the end of 2013. Management identified no specific revenue or EPS guidance in the supplied filing text.
- Portfolio and capital returns: Quest agreed in February 2013 to sell HemoCue for approximately $300 million, plus estimated cash at closing and customary working-capital adjustments; it intended to use approximately $300 million of proceeds for share repurchases. OralDNA was sold in December 2012. The quarterly dividend was raised from $0.17 to $0.30 per share, payable beginning January 2013. Management expects to return a majority of free cash flow through dividends and repurchases after reaching its targeted leverage range of 2–2.25 times debt/EBITDA.
- Investment and liquidity: Management estimated 2013 capital expenditures of approximately $250 million and said cash, operating cash flow and available credit were expected to fund operating needs, debt service, dividends, repurchases and growth investments.
- Reimbursement and competition: Medicare’s 2013 Clinical Laboratory Fee Schedule was reduced 2.95% before sequestration; a further 2% reduction was scheduled to take effect April 1, 2013. Management cited payer consolidation, pricing pressure, restricted provider networks, utilization controls, hospital competition and possible internalization of testing as risks.
- Regulatory and legal risks: Potential FDA regulation of laboratory-developed tests could increase costs or delay test launches. The company disclosed government inquiries and multiple pending legal matters, including billing-related claims and subpoenas; it said losses on the described other legal matters were not considered probable but potential losses could not be estimated. The company had a five-year Corporate Integrity Agreement entered in 2009.
- Other exposures: Significant risks include execution of the restructuring and growth strategy, IT-system conversion or security failures, billing and collection issues, quality or professional-liability claims, and substantial debt obligations. The company reported approximately $110 million in reserves for general and professional liability claims and noted it is self-insured for a significant portion of such claims.
Important facts for investors to verify
- How much of the reported operating-income and EPS improvement reflects the nonrecurrence of the 2011 Medi-Cal charge versus sustainable operating improvement and Invigorate savings.
- Whether volume, revenue per requisition and payer mix improve, especially given flat 2012 revenue and lower clinical-trials testing revenue.
- Progress toward Invigorate’s $600 million savings target, realized cash costs, and the implementation and commercial results of Project Restore.
- Completion terms and proceeds of the HemoCue sale, the intended buyback, and the impact of divestitures on continuing earnings and cash flows.
- Debt repayment, leverage, liquidity and dividend coverage, including the effect of the scheduled 2013 credit-facility backup maturities and reimbursement changes.
- Developments in the disclosed government inquiries, pending litigation, Corporate Integrity Agreement, and regulatory proposals for laboratory-developed tests.