Tuesday, January 29, 2013

Quest Diagnostics Investment Research and Analysis

Diagnostic testing company Quest Diagnostics (NYSE: DGX) caught my eye recently. It’s always nice to balance a portfolio by deliberately buying stocks whose prospects are not cyclically aligned, and Quest seems to fit the bill. In summary, the stock price driver is likely to be a combination of its internal reorganization plans plus the top line effect of reimbursement issues. It does have some cyclical upside from an improving economy leading to more doctor visits but the key drivers will be the first two points.

Quest Diagnostics

The investment thesis with Quest is that it operates in a marketplace that has historically grown at 4% and (it expects) will do so in the future. The problem with Quest is that hitherto it hasn't grown at these rates, and the opportunity exists for them to do so in the future through a mix of initiatives. As such, Quest offers the kind of growth via execution that I referred to earlier.
I’m going to list these initiatives in order to refer to them later in the year and comment on their progress and viability.
  • The first platform is the refocusing towards Diagnostic Information Services and an ongoing review of the existing businesses. Indeed investors immediately saw some evidence of this in the plan to sell HemoCue (point of care tests). This sort of thing is emblematic of the restructuring challenge ahead. HemoCue was bought as recently as 2007 for $420 million in cash, and from the conference call its clear that it doesn’t expect anything like that amount from the sale. Another area under review is the poorly performing pathology services unit. Anatomic pathology revenues have declined 13.8% since two years ago.
  • The second is described as ‘operational excellence,’ which just seems to be a nicer way of saying cost cuts plus some procurement efficiencies. The good news here is that it affirmed it was on track to hit run rate savings of $600 million by 2014. To put this in context, this year’s revenues were $7.4 billion and these savings are a large part of why it feels it can achieve double digit growth in 2014.
  • The third platform is a range of measures intended to restore growth. This includes internal measures like consolidating the sales force and investing in higher growth areas like esoteric testing. Longer term things like companion diagnostics and international expansion are on the table. With the new unified sales team in place, this will be the first year of this restructuring activity.
  • The fourth is an administrative measure that reduces management layers, which will simplify how the company is run.
  • The fifth measure relates to better capital deployment and a commitment to try to return the majority of free cash flow to shareholders. Debt is being reduced and given that Quest generates huge cash flows there is room for acquisitions. Indeed it forecast $750 million in free cash flow for 2013 (although high, this is lower than normal due to increased CapEx), which equates to around 6% of its current enterprise value. There is scope for greater shareholder return here.
Quest Downgrades Expectations

These plans are fine but Quest has to deal with ongoing challenges from pricing pressures emanating from reimbursement issues. Indeed full year revenue expectations were cut to 0-1% growth and EPS guidance came in at $4.35-4.55, way below analysts’ consensus of $4.81.

Reimbursement issues are expected to cause a 1-2% decline through to 2015 but with a 3% impact in 2013. The key word is ‘expect’ because ultimately political issues come with the usual caveats. In 2013 the biggest negative impact will come from Medicare and pathology.

Here are the last three years of revenues by payer:

It’s not hard to see that it is a difficult marketplace.
Interestingly the hospital and reference lab marketplace has been growing for Quest even though many see this as a challenged area. Going forward, I suspect Quest will try to leverage up its esoteric testing because this is where it can offer the greatest opportunity cost benefit to the hospital.

Where Next for the Market?

Together with Laboratory Corp. of America (NYSE: LH) Quest makes up less than half the market in the US so it is still a fragmented marketplace that could benefit from consolidation. A quick look comparison of LH’s vs. Quest revenues displays that the opportunity for Quest to play catch up is real.

DGX Revenue TTM data by YCharts

Both companies are hoping for growth in the future from the Affordable Care Act (ACA) on the basis that it will bring more people into the mix but the real question is whether the long term growth rate is still at 4% for the industry.

I think there is reason to doubt this because Quest described current market conditions as remaining sluggish, and if it is relying on the ACA to spur growth in 2014 to 4% then the underlying trend must be weaker. Throw in the reimbursement pressures and does 4% per annum really look achievable long term?

Where Next for Quest?

The stock is attractive and worth watching closely. From a value investor's perspective this sort of situation is attractive and Quest does have upside from successful execution. I like the idea here and will monitor with a view to seeing how the diagnostics market develops. If Quest can hit its targets and start returning cash to shareholders, it will surely be higher in a year’s time. However there is plenty of time for this to play out, and reimbursement issues are not going away anytime soon.
One for the monitor list.

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