Tuesday, June 18, 2013

Quest Diagnostics is More Interesting Than it Looks

I'm more of a GARP orientated investor but I occasionally I dabble in some value stocks. I confess I get tempted by the sordid infidelity of it all.

A few years ago a well known UK fund manager outlined one approach to the art of value investing to me. In short it involved analyzing companies across a sector and finding one that was under-performing based on various key metrics, but whose management was committed to restructuring in order to get them back in line with the industry.

Such an approach fits well with the investment thesis for buying Quest Diagnostics (NYSE: DGX) and here is why the stock is worth a look.

Quest Diagnostics diagnostic quest

For the sake of brevity I’m going to refer to a previous article I wrote in January, which outlined a five point strategy aimed at returning the company to growth and improving efficiency.

In this article I want to try and assess the progress of the strategy. My reasoning is that if Quest can achieve the aims of this plan then there is no reason why it can’t get back to the kind of valuation that its rival Laboratory Corp of America (NYSE: LH) has.

I’ve broken out some metrics for potential investors to consider in this graph.




LH Price / Sales Ratio TTM data by YCharts

A few years ago Quest and Lab Corp generated comparable returns on invested capital and their price/sales ratios were similar. B ut over the years Lab Corp has executed better. Consequently the market is willing to pay a premium for Lab Corp in terms of price/sales.Quest’s challenge is to try and sweat its assets better while getting back to long term industry growth of around 4%.

How the five point strategy is faring

In summary Quest declared that its five point program was on track. Disappointingly it lowered its full year revenue guidance to flat from 0% to 1% but it maintained its earnings guidance of EPS between $4.35 and $4.55. Its confidence in hitting earnings numbers-despite lower revenue expectations- is a consequence of the management’s belief in the successful execution of its restructuring plans.

Turning to cash flow, it forecast operational cash flow of $1bn with capital expenditures targeted at $250 millin. In other words free cash flow is a targeted at around $750 million, which represents around 5.7% of its Enterprise Value (EV). Given that one of the five points is to return cash to shareholders –and Capital Expenditures (CapEx) are elevated this year thanks to restructuring -- this makes Quest a genuine value proposition. Indeed it bought back $63.5 million worth of stock in the first quarter (Q1) (at a price of $57.81) and plans to use the entire proceeds of the $300 million sale of HemoCue (a point of care diagnostics business that it bought for $420m a few years ago) in order to buy back stock in Q2.

Turning to the other initiatives, the HemoCue divestiture plus a couple of smaller acquisitions is evidence that the restructuring of the diagnostic information services segment continues apace. Its ‘Invigorate’ cost initiatives appear to be on track. Having left 2012 with a run rate of $200 million, Quest declared that it expected to reach two-thirds of the $600 million forecast for 2014 before the end of 2013. The long term aim is to hit $1 billion.

As for the administrative changes the sales force has been expanded and is now operating in a more methodical and targeted fashion while the new organizational structure has removed a few layers of management.

A mental check list of the five initiatives would likely see all of them ticked off in positive fashion. So while internal execution seems okay what of its end market environment and new developments?

What is happening in the industry?

As ever,  the specter of reimbursement cuts hangs over the industry and given the necessity to reduce public deficits it would not be surprising to see more pressure here, even as the Affordable Care Act adds more people into the system. Both Lab Corp and Quest see the latter as a positive but the uncertainty over reimbursement rates remains.

While Quest gave its Q1 results in Mid-April I decided to wait before discussing them because its large deal with Cigna Corp (NYSE: CI) was under renewal discussions. The good news is that Cigna renewed the deal with a multi-year extension. It's been a good year so far for the managed care insurers and I note that analysts have progressively raised their full year EPS estimates for Cigna this year from around $6.34 at the start of the year to $6.49. Cigna's upside potential lies in the hopes that the Affordable Care Act will increase the numbers of people able to acquire health insurance and it also has growth opportunities from its emerging market expansion.

Indeed it is a similar story for another client of Quest.The big story with Aetna relates to its purchase of Coventry Health Care and the possibility for Quest to gain some volume from the future integration. It is the early days (the deal was completed on May 7) but this holds out hope for some upside potential.

Another recent development is the extension of Quest ties with women’s health company Hologic (NASDAQ: HOLX). According to Hologic the deal is non-exclusive with an initial term of five years and is focused on its APTIMA product range (which it acquired with the purchase of Gen-Probe)  and marries Quest’s analytical abilities with Hologic’s product range. It makes sense because Hologic will benefit from increased distribution via Quest while giving it a broader product range in order to offer to its customers. Hologic needs this kind of initiative because 2013 is proving to be a difficult year for companies selling high ticket capital machinery to hospitals. For example Varian Medical reported a 9% decline in its North American oncology sales Hologic themselves reduced the mid-point of its full year revenue guidance from $2.63bn to $2.54bn recently.

Where next for Quest?

I note that Quest recently re-affirmed its full year guidance and Lab Corp also affirmed its full year guidance of full year revenue growth of 2-3% at the time of its results in April. In other words, conditions in the industry don’t appear to be getting worse.  Moreover the restructuring plans are on track for Quest and provided the second half growth kicks in as planned them

I think the stock is probably headed higher. The Hologic deal makes sense, the extension of the Cigna relationship helps to de-risk the stock and there may be some upside from Aetna. The big concern is future reimbursement issues and they effect that they might have on the industry. With that aside I think there is a good chance that Quest can play catch up with Lab Corp and it may well be a good proposition for value investors.