Quest Diagnostics Incorporated
Q3 2010 Earnings Call Transcript

Published: 21 Oct 2010

[Operator:]

Welcome to the Quest Diagnostics third quarter conference call. At the request of the company, this call is being recorded. The entire content of the call including the presentation and question-and-answer session that will follow are the copyrighted property of Quest Diagnostics with all rights reserved. Any redistribution, retransmissions or rebroadcast of this call in any form without the express written consent of Quest Diagnostics is strictly prohibited. Now I’d like to introduce Kathleen Valentine, Director of Investor Relations for Quest Diagnostics; go ahead please.

[Kathleen Valentine:]

Thank you and good morning. I’m here with Surya Mohapatra, our Chairman and Chief Executive Officer and Bob Hagemann, our Chief Financial Officer. Some of our commentary and answers to questions may contain forward-looking statements. You are cautioned not to place undue reliance on forward-looking statements, which speak only as of the days that they are made and which reflect management’s current estimates, projections, expectations or beliefs and which involve risks and uncertainties that could cause actual results and outcomes to be materially different. Risks and uncertainties that may affect the future results of the company include, but are not limited to adverse results from pending or future government investigations, lawsuits or private actions, the competitive environment, changes in government regulations, changing relationships with customers, payers, suppliers and strategic partners, and other factors described in the Quest Diagnostics 2009 form 10-K, quarterly report on form10-Q and current reports on form 8-K. A copy of our earnings press release is available and the text of our prepared remarks will be available later today in the quarterly update section of our website at www.questdiagnostics.com. A PowerPoint presentation and spreadsheet with our results and supplemental analyses are also available on the website. Now here is Surya Mohapatra.

[Surya Mohapatra:]

Thank you, Kathleen. We grew earnings in the third quarter despite continued softness in physician office visits. While revenue was down, we are confident in the future and are making progress executing our plans to accelerate profitable growth by promoting new gene-based and esoteric tests, enhancing sales effectiveness and improving our operational efficiency. During the quarter, earnings per share increased 11% to $1.13, revenue decreased to 1.7% to $1.9 billion and cash flow was $330 million. We are committed to using out substantial cash flow to generate value for our shareholders through both acquisitions and share repurchases. So far this year we have returned $750 million to our shareholders through share repurchases and now have flexibility to make $250 million of additional repurchases in the fourth quarter. We continue to focus on sales, service and science to drive organic growth and believe we are doing the right things to strengthen our foundation for revenue growth, increased profitability and enhanced shareholder value. We continue to promote new genetic and esoteric tests and healthcare IT services. We are upgrading our sales organization and enhancing their capabilities. We are working closely with health plans and employers to gain a larger share of their business by reducing their high-cost, out-of-network leakage. We are taking actions to make our business more efficient and we are putting our substantial cash flow to work to drive shareholder value. I will update you on our progress after Bob discusses the financial results. Bob?

[Bob Hagemann:]

Thanks, Surya. Revenues for the quarter were $1.9 billion, 1.7% below the prior year. Our clinical testing revenues, which account for over 90% of our total revenues, were also 1.7% below the prior year. Revenue per acquisition was 1.3% below the prior year and essentially unchanged from the second quarter level. While year-over-year revenue per acquisition continues to benefit from an increased mix of gene-based and esoteric testing and increases the number of tests ordered per acquisition, this benefit has been offset by some business and pair mix changes, the medicare fee decrease and pricing changes in connection with several large contract extensions executed last year and earlier this year. The business and pair mix changes, which continue to pressure revenue per acquisition, include a further rebound in drugs of abuse testing and weakness in our higher priced and atomic pathology testing. We expect changes in revenue per acquisition will continue to be modest through the first half of next year with the anniversary of the business mix, pair mix and contract changes, which are currently offsetting the benefits of the growth in gene-based and esoteric testing. Volume in the third quarter was 0.3% below the prior year and continues to be pressured by the general slowdown in physician office visits. However, the third quarter volume reflects some improvement from the first and second quarters of the year, which were below the prior year by 2.6% in Q1, 1.6% although adjusted for weather and 1.3% in Q2. Drugs of abuse testing has continued to rebound and grew 7.5% in the quarter and contributed modestly in crude volume trend. Revenue in our non-clinical testing businesses, which includes risk assessment, clinical trials testing, point of care testing and healthcare IT, was about 2% below the prior year level principally due to the performance in our risk assessment business. Operating income, as a percentage of revenues, was 18.1% compared to 18.4% in the prior year. We continue to make progress in managing our cost structure and driving quality improvements. We are currently evaluating a number of new opportunities to further improve our efficiency and service quality, which we believe will further streamline our cost structure. This will not only support margins during this period of market softness but also will allow us to disproportionately take advantage of the market rebound. We continue to see strong performance in our billing and collection metrics. Bad debt expense as a percentage of revenues was 4% in the quarter compared to 4.4% a year ago. BSOs at 43 days are unchanged from the beginning of the year. Earnings per share were $1.13 in the quarter, an 11% increase from the prior year. EPS benefitted by $0.08 in the quarter as a result of a reduced tax rate which was primarily due to the favorable resolution of certain tax contingencies. Cash from operations was $330 million and compares to $374 million in last year's third quarter, the difference primarily due to the commune of interest in tax payments. Capital expenditures were $47 million in the quarter compared to $41 million a year ago. During the quarter we repurchased 7 million shares at an average price of $46.64 for a total of $324 million. We have now fully utilized the $750 million share repurchase authorization granted in January of this year. Earlier today we announced that our board has authorized an additional $250 million of share repurchases to provide us with continued flexibility to deploy our cash through the fourth quarter. This incremental repurchase authorization is intended to bridge us until we complete our planning for 2011 and should not necessarily be viewed as the plan repurchase level for Q4. The level of share repurchases in any given quarter will continue to be a function of a number of factors, most notably expected acquisition activity. We plan to evaluate what level of authorization will be appropriate beyond the end of this year as part of our annual operating and capital plans and expect to share that with you in January as we have done historically. Our cash balance coupled with our unused credit lines provides us with significant liquidity and has positioned us extremely well to capitalize on growth opportunities and take other actions like share repurchases to drive shareholder value. Turning to full-year guidance, we now expect results from continuing operations before special items as follows. Revenue, to be approximately 1.5% below the prior year; operating income to be between 17.5% and 18% of revenues; cash from operations to approximately $1.1 billion; capital expenditures to approximately $200 million; and, lastly, diluted earnings per share to be between $3.95 and $4. As you will hear more about this area, we continue to focus our efforts on accelerating growth, including exploring both strategic and opportunistic acquisitions. In addition, as I mentioned earlier, we are continuing to drive efficiency in our operations, which together with improved top line performance we expect will accelerate earnings growth. Now I'll turn it back to Surya.

[Surya Mohapatra:]

Thank you, Bob. Our updated guidance reflects the fact that while we are seeing progress some of the actions we have been taking to accelerate growth are taking longer to produce results than we had expected. None of us are satisfied, however, we are seeing encouraging signs and I want to provide you with an update on the progress we are making on some of the initiatives we shared with you earlier this year. We are investing in our sales organization. We are hiring and providing ongoing training to people who, over time, will serve as trusted consultants to doctors and other customers to meet their diagnostic testing needs. Over the past several quarters we have continued to add new talent to our sales force overall and in key specialty areas and geographies. So far this year we have upgraded the overall sales force and added about 100 new positions. To make them effective sooner we have enhanced our training programs in various subspecialty areas including oncology and genetic testing and we are giving them advanced tools to better target sales leads. As we shared with you last quarter, we have been working with health plans and have extended some of our health plan contracts to give us visibility and pricing stability. This has enabled us to turn our focus to working closely with health plans and their employer clients to reduce high costs and out-of-network lab spending, known as leakage. Health plans and large employers are considering changes in plan design that both drive business to us as a preferred provider and reduce lab costs for the health plans, employers and their employees. I am pleased that some health plans have also made reimbursement policy changes to address overutilization caused by in-sourcing of certain kinds of anatomic pathology. We continue to promote new esoteric and gene-based tests that help physicians personalize care. During the quarter, esoteric and gene-based testing grew about 4% driven largely by sales to hospitals and physician specialists. We continue to see strong double-digit revenue growth from Vitamin D testing which uses the tandem mass spectrometry platform, the gold standard in our industry. We have also driven double-digit revenue growth in ImmunoCAP allergy testing as well as testing for blood cancers, particularly our Leumeta family of blood tests and we are pleased by the increase we are seeing in the adoption of our OVA1 test for ovarian cancer. Service delivery is an important competitive differentiator and we have announced our service levels in several ways. We have added personnel such as phlebotomists and service reps and are opening new person service centers to offer convenience to patients and we are significantly reducing the time ti takes to connect new clients to our Care360 connectivity solutions. Healthcare IT is a strategic differentiator for us and care360 is the center piece. Care360 is not just a customer service. It's how we run our business. We depend on it every day so it has met the test of time. This month we passed a major milestone of 40 billion test results processed and transmitted via Care360 since it was launched six years ago. We are pleased that the American Medical Association selected our Care360 EHR as one of the few EHR solutions that can be accessed from their portal. We have partnered with Hewlett Packard to provide and integrated system to physician practices to accelerate their adoption of Care360 HER. Since we introduced the Care360 Electronic Health Record earlier this year more than 1000 doctors are using it. We generate strong cash flow. We are committed to deploying our cash to drive growth. Our preference is to invest in acquisitions primarily in genetics, esoteric testing and cancer diagnostics, including anatomic pathology. We are active in evaluating potential acquisitions that make economic and strategic sense. When acquisitions are not available on reasonable terms, we will return cash to shareholders through share repurchases and dividends. In closing, we are making tangible progress o a number of important initiatives. The long-term trends for our business continue to be positive and, as the industry leader, we are well positioned to take advantage of these trends. Thank you. We will now take your questions. Operator?

[Operator:]

Thank you. (Operator Instructions). Our first question comes from the line of Adam Feinstein - Barclays Capital.

[Bryan Sekino:]

I wanted to ask you if you could comment on the pricing growth in the quarter. I know you mentioned there were some contrasting things in the second quarter. The lower growth this quarter is it due to kind of a full quarter of that, the contracts in September quarter or is there something else that is going on there?

[Bob Hagemann:]

The contract changes were fully reflected in the second quarter and, yes, just continuing this quarter. Essentially, what you see is revenue per acquisition in Q3 essentially flat with where it was in Q2 and really what's driving the change in the year-over-year comparison is really the comps at this point. But we've got stability in revenue per acquisition and we're not expecting the absolute level of revenue per acquisition to change significantly from where it's at in the fourth quarter.

[Bryan Sekino:]

Where it's at in Q3? So you do expect the sequential flat number there in Q4.

[Bob Hagemann:]

Correct. We're not expecting it to change significantly.

[Bryan Sekino:]

Then a question on the physician in-sourcing; have you seen the dynamic there kind of pick up? I guess, is the upgrade in the sales force somewhat a response to some of those issues that are going on?

[Surya Mohapatra:]

Well, when we saw this year -- when we observed slowness in the marketplace and the less number of physician office visits, we said that we are going to enhance our sales people, hire some people where we didn't have [upgrade] people, train them in genetic and esoteric testing and cancer diagnostics and we're going to improve our service. Although the office visits are down by 4% but our revenue decline is 1.7% so we feel that we are seeing the revenue decline is moderating and now that we have surprising stability the sales force effectiveness is improving.

[Bob Hagemann:]

While we continue to see in-sourcing of both the technical and professional component, there are some signs that the rate of that is beginning to slow.

[Bryan Sekino:]

Is there a general sense that there are some legal issues with doing that? Is that potentially causing that rate to slow?

[Bob Hagemann:]

Well, I'm not sure exactly what's causing it at this point. But, yes, as we've indicated previously we do believe that this in-sourcing is essentially a form of self referral which it creates unnecessary utilization and we're working through that with our lobbying through [Acola] and others to try and alert legislators and policy makers to that effect.

[Surya Mohapatra:]

Some health plans have already taken into that consideration and they're restricting reimbursement in in-sourcing.

[Operator:]

Your next question comes from the line of Ralph Giacobbe - Credit Suisse.

[Ralph Giacobbe:]

So just want to go back to the sort of guidance. It looks like revenue and EBIT guidance seems to imply that 4Q is going to see a little bit of a drop off or worsen a little bit. Anything particular there going on that we should be aware of?

[Bob Hagemann:]

Yes, Ralph, the one thing that I would point out is -- I mean, you're right. Q4 implied guidance does indicate that we'll see a little further softening in revenue growth in Q4. One of the things that's important to keep in mind is that last year's fourth quarter benefitted from the flu season, the H1N1 scare. We are not expecting this year's flu season to be anything like that. In fact, we're expecting it to be a more normal flu season. But that's something that we've anticipated all along in our guidance. That's not what's driving the change in guidance. It's really what's driving how Q4 looks relative to the other quarters.

[Ralph Giacobbe:]

Then maybe, Bob, if you could talk about the sustainability of the bad debt improvement kind of going forward. Obviously it's helped the last couple, few quarters and it continues to trend down, just your thoughts there.

[Bob Hagemann:]

Well, it's an area that we continue to pay a lot of attention to and despite some of the challenges with the economy this year and the like, we've been able to continue to drive down bad debt. It's an area that we deploy a lot of sic sigma resources against. Our focus is really on continuous improvement there. While I think there are continued opportunities to further drive down bad debt, they're not as significant, obviously, as when our bad debt was in the high single digits. But, yes, I do think there continue to be opportunities. They'll be a function of decreased use of electronic ordering. Ultimately, as well, when we see more insured patients as a result of healthcare reform I think that's going to also serve to help reduce bad debt.

[Ralph Giacobbe:]

My last one going back to pricing, going forward, just to be clear, do you think this is sort of a level of kind of a base line that we should think about going forward?

[Bob Hagemann:]

Well, certainly, for the rest of this year we're not expecting significant changes in revenue per acquisition in absolute terms. Next year, as you know, we'll likely have a medicare fee decrease, which will put some downward pressure but we continue to expect that growth in g-based and esoteric testing and test mix is going to have a positive impact on revenue per acquisition. But as we said the last quarter and even prior to that, the big driver of our historic increases in revenue per acquisition has been test mix, business mix, number of tests ordered per acquisition. We expect that that will continue to have a positive influence. What we'll see, I think, going forward is as things like the importer solutions where the drugs of abuse testing business grows, that puts some downward pressure on it but that's, frankly, not a bad thing to have that business growing. It's just changing the mix a little bit.

[Ralph Giacobbe:]

My last one, are you done -- is it fair to say you're done proactively approaching managed care to extend out the contracts or is this something we should think about as ongoing?

[Surya Mohapatra:]

First of all, we work very closely with the health plans and all our large contracts are done and we have contracts beyond 2012 and now we actually turn our focus to work with them very closely to reduce their leakage.

[Bob Hagemann:]

What we have coming up over the course of the next several years is, in terms of renewals, is significantly less than we would have had in a typical year on average.

[Operator:]

Your next question comes from the line of Darren Lehrick - Deutsche Bank.

[Darren Lehrich:]

I wanted to just ask the question, Surya, you mentioned in your prepared remarks some of the work you're doing with managed care to prevent leakage. I guess, a few questions here; number one, have you incorporated any of those plan design changes into your contracts at this point or is this right now an ongoing conversation about how it would be structured?

[Surya Mohapatra:]

Well, Darren, the most important thing, I feel very, very encouraged with the work that's going on with the health plan organization and [our] organization. When you look at how much leakage the health plans have and how much extra money employees are paying now we are working now with the health plans and their employer clients and providing information to our sales people and to the health plan themselves to really reduce leakage. So I feel pretty good about the work that's going on there.

[Bob Hagemann:]

Darren, typically what you see in terms of contract language is that we'll work together and sometimes we outline how we might work together and the like but plan design changes are something that we can't contractually obligate the plan to do because that involves the employer as well. Yes, as you heard earlier, we are working jointly with health plans and employers to t4ry and get them to understand why those plan design changes are necessary and in some cases have been very successful in that regard. We're encouraged by what we see and think that we'll see more of it.

[Darren Lehrich:]

Just so I'm clear because my understanding is that this grandfathering issue may cause a lot of large employers to really prevent them from making substantive plan design changes. I’m just wondering if you're seeing that that's the case and, if so, can you just expand a little bit more on how you're working differently today with the contract structures that you have?

[Bob Hagemann:]

Well, the grandfathering question is a good question. I think, yes, based upon the data I've seen it's probably split 50, 50 as to whether or not companies are actually trying to keep their plans grandfathered. I mean, there's pluses and minuses, as you know, to that. But what we've seen and what we've been doing with the plans is in addition to plan design changes, making it more attractive for them to stay in network and the like we've been working with the health plans to educate the employers and their employees about the benefits of staying in network, even if there's not necessarily a plan design change, educating them about the benefits of lower cost, educating them about the convenience that we offer with our patient service centers and the like and it's resonated. We expect that we'll continue to do that.

[Darren Lehrich:]

Then if I could just switch gears a little bit, Bob, to the buyback. I think you've clearly stated a buyback would be the bigger focus when deals aren't readily available. I guess the question I have is are you sending a message here that you just aren't seeing any good deals over the near term? If that's the message, why do you think that is?

[Surya Mohapatra:]

First of all, we're not giving any message actually. In fact, the message we're giving that our preference will be to have acquisitions which will make, as I said, economic and strategic sense. But we're not going to really buy things for buying sake and that when those things are not available in reasonable terms we are saying that we're going to return money to shareholders.

[Bob Hagemann:]

Darren, what you see is us just following through on what we've told you in the past.

[Operator:]

Your next question comes from the line of Dawn Brock - Kaufman Brothers.

[Dawn Brock:]

Just maybe to follow up on the last question specifically for the fourth quarter, with an additional $250 million now authorized for specifically the fourth quarter is that -- I guess the question is, should we assume that maybe M&A activity would not pick up in the next two months and we could look for you to give us that additional guidance come January? Can we kind of confirm that?

[Bob Hagemann:]

Dawn, let me clarify. First of all, the additional share repurchase authorization is not limited to the fourth quarter. I want to clarify that. It's open-ended in terms of timeframe. The reason that it's a relatively small authorization compared to what you've historically seen is we're thinking of this as a bridge to what we might do in the first quarter because right now we're in our whole capital planning process. We'll think about the level of share repurchase authorization that we want for 2011 beyond and we'll inform you as to what we're doing there in January as we typically do when we provide full-year guidance. But we are not trying to send a signal that there is no deal activity that will in fact -- I think I did mention in the prepared remarks that the big variable in any quarter is the deal activity. So don’t necessarily assume that we're going to complete that $250 million in the fourth quarter. We've just now got that flexibility to do it.

[Dawn Brock:]

I think really where I wanted to get a little bit more color is, Surya, in your prepared remarks you talked about new tests. We would love to hear, I think, about what you're working on there. Secondly, EHR connectivity solutions obviously Care360 is out there. It's got at least the initial final rule stage one certification. I know that you're going for the final certification now that the rules are out. Can you just give us an update on the enrollment and just the marketing around that and where you think that goes from here?

[Surya Mohapatra:]

Let me first talk about the tests. As you know, we are focused on three diseases. There's cancer, infections disease and cardiovascular disease. The current tests, which are really growing double-digit tests as I said about Vitamin D and ImmunoCAP for allergy testing, Leumeta for lymphoma and leukemia. But the tests which are in the pipeline and we are very excited about -- we just introduced OVA1 for ovarian cancer. We will promote Septin 9 ColoVantage for colorectal cancer, AccuType CP which is for the Plavix therapy and some of the personalized what you call the companion diagnostics like [EZ for pathways]. So there's a number of tests that's in the pipeline and I feel good about where our science and innovation is bringing new products. So that's about the tests. With regards to EHR and Care360, as I said, I was very excited that Care360 just passed 40 billion tests, so this is not like buying an EHR system from an IT company who is not really using it every day. So the advantage of our Care360 EHR is that it is a system which is fully tested. Since we introduced it almost 1000 doctors are using it and, as you know, we have partnered with Hewlett Packard to provide an integrated system with hardware and software and now it is being promoted by AMA, so we are very, very encouraged about the future of our EHR.

[Kathleen Valentine:]

Dawn, this is Kathleen. You did mention we did get preliminary [feature] certification. We are expecting final [feature] certification by the end of the year. As you heard in our prepared remarks, we're pleased to see that we've got over 1000 active physicians using EHR and we just launched it at the end of Q1 this year. So we're pleased with the uptick in what we're seeing in the EHR adoption.

[Dawn Brock:]

Kathleen, actually anybody, could you just give us an idea for the physicians that are enrolling and adopting EHR who had been on Care360 in the past, can you give us some sort of indication as to whether or not you actually see increased utilization of testing for those physicians, for those practices?

[Kathleen Valentine:]

We do look at that, Dawn, in terms of across all of the Care360 solutions from lab orders and results on through EHR and we do see an uptick in the business we get from those existing physician customers when we either install or upgrade their solution within the Care360 product offering. So it truly is a stickiness benefit for us and that's one of the reasons the physicians choose it. But it makes running their practice much easier.

[Bob Hagemann:]

Dawn, to reinforce what Kathleen just said, it's not necessarily increased utilization on the part of the physican but we're getting more of that physician's work because it's easier to deal with us, we're more embedded into the workflow, et cetera.

[Operator:]

Your next question comes from the line of Kevin Ellich - RBC Capital Markets.

[Kevin Ellich:]

Just a couple of questions; going back to comments on the M&A environment, Surya, I was wondering if you could tell us how you view the current environment and potential opportunities.

[Surya Mohapatra:]

We have a very active program on M&A and we constantly evaluate what is available. But we are primarily focused on the M&A which is going to help us, our genetic esoteric and with all the (inaudible) laboratories or the hospitals. So I think it boils down to what makes economic sense and what makes strategic sense and we are very encouraged at what is available now in cancer diagnostics and in the genetic field.

[Kevin Ellich:]

Then just going back to the managed care pricing, there was, in my opinion, a little confusion last quarter and now that we've had more time to think about this, in my view, I think things are stable now and maybe you could -- I was hoping maybe you could give us a little more color about what you were really talking about last quarter in the managed care pricing. Bob, you made the initial comments about several large contract extensions. I think this quarter you mentioned that they happened last year and also earlier this year. Could you quantify that context? Are we talking about -- has there really been any changes or switching of contracts?

[Bob Hagemann:]

I wouldn't say necessarily switching, Kevin. Yes, as we indicated last quarter and I reinforced this quarter, this has been something that we've been doing for probably the last 18 months or so. It's really designed for us to be able to change the dialogue with the health plans. Make sure, one, that we have visibility into reimbursement; make sure that we have access to the health plan members but now change the dialogue from one of regularly discussing contract terms and the like to one where we're working together to figure out how to capture that leakage. As Surya has said, yes, I think we're starting to see the benefits of that now. Our discussions with the health plans are much more focused now on what we can do to drive this work in network, which is beneficial, obviously, to us but also to the health plan, the employers and the members. So, to me, that's the other real benefit associated with this.

[Kevin Ellich:]

What types of things can you do to capture the leakage and drive more in network utilization?

[Surya Mohaptra:]

I think, first of all, the most important thing we can do is what I call the analytics and informatics. If we know how much the health plan is paying for an account -- there's all four expenses when people go out of network. So now they know what is going on and we can do the analytics because we are a very strong informatics group and we are looking at data with them and now we can go back and say, "Dr. X's facility is spending so much money," and it's actually one X if it comes to Quest and it's four X if it's going outside. So that realization of that opportunity is now driving the work both by the managed care organization and by us providers and also the employers. So that is the new thing which we are now getting because of our extended relationship and because of how we are providing them with the data.

[Bob Hagemann:]

Right and interesting enough, Kevin, sometimes in that regard you would think that the health plans have state of the art analytic capabilities. In some cases they don't have what you'd expect and we can provide some better insights than they can as to where the testing volume is going and the like and what type of testing, et cetera, based upon what type of physician, all those things. The other thing I would tell you is, without getting into too much detail here, we can work with the employer and the health plan to make using Quest Diagnostics even more convenient. That's some of what we're doing as well which is driving business to us.

[Kevin Ellich:]

I know it's kind of early since Empire Blue Cross opened up on August 1 but have you noticed any changes in volumes coming from that plan that you could talk about?

[Bob Hagemann:]

We have, Kevin. As you'd expect, any time you add providers to a contract you'd expect that they would pick up some business and that certainly has happened. Yes, I would characterize it as not material to our overall results and in line with our expectations and fully built into the guidance that we provided.

[Kevin Ellich:]

Last question, on the drugs of abuse, that grew, I think, 7.5% this quarter. Is that absolute growth or is that just due to an easy comp do you think?

[Bob Hagemann:]

Well, it is absolute growth. I would imagine that the comps will continue to get easier. But it truly is absolute growth year-over-year.

[Operator:]

Your next question come from the line of Bill Quirk - Piper Jaffray.

[Bill Quirk:]

I just wanted to ask you a little bit about the, I guess, technically the pending change coming out of Palmetto as it relates to code stacking and genetics and arrays coming up here later towards the end of the year. I just want to ask how does this, if at all, affect logistics for some of your esoteric tests? How do you think about this in conjunction with some of the pipeline tests, et cetera?

[Kathleen Valentine:]

Bill, are you referring to what AMA is looking at and making changes to reimbursement for molecular tests?

[Bill Quirk:]

There certainly is that as well but I guess I'm specifically referring to Palmetto, a notification that went out in I believe it was late August talking about additional paperwork and clinical data, et cetera, in order to get reimbursed for some of these tests.

[Kathleen Valentine:]

Yes, I mean, we'll certainly comply with what Palmetto has put out there in terms of submitting our claims in a way that we'll get paid. I think Palmetto is maybe kind of getting out ahead and leading the pack in terms of what AMA is now looking at. From that perspective we certainly support the goal of -- is looking at reimbursement that's based on an ANA like specific reimbursement, which is consistent with other sections of the CPT manual and anything that gives more clarity in terms of what the payer's specifically paying for we think is a good thing but we want to make sure that we get appropriately paid for any test that we perform.

[Bob Hagemann:]

One of the things I'd reinforce as well is any of the panels that we've got out there we believe are driven by what's medically necessary and clinically relevant. So in terms of code stacking and piling things on I feel as though we're in a very good position and supported by medical necessity.

[Bill Quirk:]

Certainly taking a look at the overall business I'd argue that you guys are very well positioned compared to a lot of labs out there. I guess if I could push on this a little bit how do we think about this relative to saying over one or Septin 9 where there's limited clinical evidence out there, Bob, do you see that being a barrier at all or do you think that from a back office and payer standpoint you're in pretty good shape?

[Bob Hagemann:]

On an individual test like that I think it continues to be education, education of the physicians, education of the health plans, the utility that these tests have and that's what going to drive the utilization of them. I don't necessarily think that what Palmetto is doing is going to dramatically affect the uptick of those type tests.

[Operator:]

Your next question comes from the line of Tom Gallucci - Lazard Capital Markets.

[Tom Gallucci:]

I just had a couple of follow-up questions. I guess first, Bob, on the revenue growth guidance that's a little bit lower than what you had expected before, I'm assuming that's because you were saying that some of the actions you've taken are taking a little longer to gain traction. Is that sort of the key behind the change?

[Bob Hagemann:]

Absolutely, Tom. That's what Surya referred to in his comments. But, yes, I would tell you that we're increasingly confident that these are the right things to do. We're seeing some signs of progress and we're encouraged by that. But we would obviously like it to be benefitting us quicker. As I said, we're seeing some positive signs at this point and believe we're on the right track.

[Tom Gallucci:]

Just maybe to get an understanding of what's going on there, I think you mentioned maybe hiring 100 sales positions or something. Is the timing of let's say hiring people like that or is the ramp that you're seeing? Can you give us maybe a little more color on what's been different so that we can have the confidence that it is sort of headed in the right direction?

[Surya Mohapatra:]

Sure, Tom. As we move our company to more and more esoteric and gene-based testing -- at the moment we are -- 35% to 36% of our revenue is gene-based and esoteric testing. We are moving more and more towards disease-based solutions like cancer, infectious disease and cardiovascular disease. So the first thing we have to do is upgrade our sales force. So we have been doing this over the last 12 months and then as we saw the market softening and this less number of physician office visits we decided to put new people in new areas, especially in cancer diagnostics and allergy pathology and gene-based testing. We have added 100 new people and they will be selling in areas where we never sold before. So although it is taking some time -- but I have seen the sales people and I feel pretty confident that what we are doing is building up a very good sales organization which is focused on customer segment and subspecialty segments which is going to pay off in the long term.

[Tom Gallucci:]

Then maybe one or two other things here; on the pathology side I think you said that you sort of maybe saw some signs that the in-sourcing was slowing a bit. So directionally is your volume deterioration, is it getting better? Is that the implication there?

[Surya Mohapatra:]

Well, first of all, (inaudible), anatomic pathology is going through a tremendous challenge. However, what we are seeing is some leveling off in the in-sourcing. I think people are realizing that when you have in-sourcing you have overutilization and we are working with our (inaudible) system and CAP to really provide the data and also some health plans have now figured out actually that they are paying more. Now, having said that, it is a business challenge but the future is very bright because we have got (inaudible) in allergy pathology and cancer diagnostics and we're going to build on that.

[Tom Gallucci:]

On bad debt it's obviously getting better in a difficult environment. What are some of the particular areas that you're seeing that improvement, Bob? Is it certain pieces of the business? Is it maybe progress from some prior acquisitions? Or is there anything specific that you can point to there?

[Bob Hagemann:]

Well, Tom, we are certainly continuing to make progress with the AmeriPath bad debt, so when you think about prior acquisitions and drivers of -- that's certainly part of it. It's not all of it though. This is -- it's an area where it's a business of details. As I told you, we're a sic sigma organization. We apply those principals to everything that we do and there's hundreds of millions of transactions that go through billing every day. To the degree that we can touch them just a few less times we can save ourselves not only bad debt but we can also reduce the cost of the billing operation. That's the way we're going to continue to approach it. It's going to be incremental for the most part but I would say that there's no one big area. One area that we are getting some benefit from though is a little bit of mix patient billing, which is one of the biggest sources of bad debt, is down year-over-year and that's contributed a little bit to the improvement that we've seen as well.

[Tom Gallucci:]

Last one, just curious, you mentioned cancer testing a few different times. Any thoughts on the Epigenomics colorectal blood cancer test that starting development out there?

[Surya Mohapatra:]

Septin 9 ColoVantage, we are pretty excited about it and we are doing a soft launch and it's going to be promo-ed very soon.

[Operator:]

Your next question comes from the line of Gary Lieberman - Wells Fargo.

[Gary Lieberman:]

I want to discuss the contract extensions and the in-sourcing. I guess, can you maybe talk in a little more detail what is it about the contract extensions that allows the managed share companies and yourselves to focus more on reducing some of the leakage.

[Surya Mohapatra:]

Well, first of all, it's not only the contract extensions. I think if you just think about how much time we spend trying to see every two or three years [renewing] the contract and this uncertainty about what is exclusive and non-exclusive and the fact that we have now worked with them -- and remember we're working with them and they [opinion is that] if we have a longer period we can invest together in certain activities like analytics, like informatics, like working with them. That has really changed the focus just like negotiating to reduce unit cost. Now we are talking about to really reduce leakage. So it's a culture change when you have a longer period. That's the most important thing I find and I see. I am very encouraged.

[Bob Hagemann:]

To Surya's point, he characterized it as an investment which it absolutely is, Gary. As you think about this the health plans are introducing us more and more to the employers and if they're going to introduce us to employers, have us much more ingrained in that employer, they want to know that there's a long-term relationship there. These longer contracts are an enabler to that.

[Gary Lieberman:]

I guess the question that I have and that it raises is that under the prior contracts that they would not have been incented enough to want to reduce the leakage. That, I guess, is the piece that I want to come back to.

[Surya Mohapatra:]

No, I think that's not the case, actually. We've been working with them also. I think what you are saying is maybe everything is coming together in the healthcare reform, uncertainty is actually what is happening in the health care costs, so all these things have come together. I think looking back some of the things we have done along with the investment we are making in the company is we're in a better place to work with the health plans and the employers, so it's not a question that they were not working and these contracts are going to give us opportunities, just give us a longer period to invest and work rather than every two years we spend time negotiating and reducing unit cost.

[Gary Lieberman:]

Just in the third quarter, did you extend additional contracts or are you just sort of continuing to see the impact from the changes that had been made prior to the third quarter?

[Bob Hagemann:]

There was nothing significant in the third quarter. Basically, what you're seeing is just a carry over of what we've done last year and earlier this year.

[Gary Lieberman:]

Then just sort of final follow-up; you gave some good commentary about pricing overall. On the rest of the book of business just in terms of thinking about the commercial book of business will on an apples-to-apples basis pricing be up similarly on the commercial book of business or will it be up to a lesser extent from what it has in the past?

[Bob Hagemann:]

We're expecting revenue per acquisition to be relatively unchanged over the course of the remainder of the year.

[Gary Lieberman:]

Just on the commercial book of business or on the entire book of business?

[Bob Hagemann:]

On the entire book of business.

[Gary Lieberman:]

How about going into 2011?

[Bob Hagemann:]

Well, we'll give you more insight into 2011 in January.

[Operator:]

Your next question comes from the line of Ricky Goldwasser - Morgan Stanley.

[Ricky Goldwasser:]

I have a couple of questions. The first one, Bob, just to clarify, guidance does not include the additional buyback of $250 million in the fourth quarter, correct?

[Bob Hagemann:]

What guidance always includes is us deploying our cash, whether it be into acquisitions or share repurchases. We typically, Ricky, don't give specific guidance as to how much we'll be doing in terms of share repurchases. But generally the guidance assumes that we're putting the cash flow to work.

[Ricky Goldwasser:]

Then the second clarification is on the top line growth metric for the fourth quarter. The guidance implies negative 2.7% of growth year-over-year. I understand the sales force initiative that's taking time to materialize. But is there something that you're seeing in the fourth quarter to date that makes you think that sequentially, both year-over-year but also sequentially -- again, year-over-year I understand the flu differential -- sequentially things are going to deteriorate beyond the normal seasonality? It just seems that you're factoring in greater decline than we've seen in the past between third quarter to fourth quarter and if you can just give us some more color on that. Is it the Empire (inaudible) that you're factoring in would be very helpful?

[Bob Hagemann:]

Yes, Ricky, there's nothing specific relative to Empire that we're factoring in that would cause Q4 growth to look different than Q3 growth. The principal driver of the differences I said earlier is our view of the flu season, the fact that we're not going to have the H1N1 scare that we had last year. But, yes, I think in terms of sequential progress, we feel good about the progress that we're making there. It doesn't have -- you don't see the results necessarily within one quarter. It takes time for these to show up in the results but we do feel as though we're continuing to make progress there.

[Ricky Goldwasser:]

But, again, to the point -- I guess I’m trying to understand whether kind of the change in the fourth quarter guidance is just you being conservative or do you think, again, ex-flu season because that was factored into your original guidance. You just think that the overall environment is going to potentially somewhat slow down versus third quarter.

[Bob Hagemann:]

I wouldn't say that we're expecting the overall environment to slow down. We're expecting physician office visits to be comparable and not change significantly. The one thing that I would say is we do expect a little bit of softness in our non-clinical testing business in the fourth quarter. The risk assessment business continues to be soft. The clinical trials business, we probably have good visibility , at least a quarter out into that business. We expect that to be a little softer in Q4 as well.

[Ricky Goldwasser:]

Then lastly, Surya, on the acquisition strategy, can you prioritize for us just in terms of kind of how you think about acquisitions both based on what's out there as kind of number one four (inaudible) acquisitions [for] the international and then acquisitions outside kind of the core testing business? If you can walk us through that it would be great.

[Surya Mohapatra:]

Sure. I think you started with, number one, with the easy one, with the four (inaudible), the regional labs and some hospital laboratories. So those things are what I call that we do it in due course of business, so there's number one. Number two is anything that is going to help us in cardiovascular disease, cancer diagnostics and infections disease, so that one's genetic and esoteric testing and cancer diagnostics including allergy pathology because those three diseases we are focused. As you know, I have always said that our future is in science and innovation, so the second tier, which is the most of our [war] going on, is do we have acquisitions available to help us in cancer diagnostics in genetic and esoteric? Then the third one, once those are done, then we look at actually the point of care (inaudible) testing. We have invested in India and it's a long-term investment and we are not looking at any major international acquisitions in the short term. So those are the strategies.

[Operator:]

Your next question comes from the line of Steven Valiquette - UBS.

[Steven Valiquette:]

A couple of questions here, first, you have 100 new sales reps that you're adding. Based on my math I would add maybe about $20 million in annualized costs. I'm just curious, did that start in the fourth quarter or was some of that run rate already absorbed in 3Q, just trying to get a sense of that for modeling purposes?

[Bob Hagemann:]

Steven, some of that -- obviously a big piece of that is already absorbed and reflected in Q3. The interesting thing is while you get the cost up front you don't get the full benefit of the sales force until they're trained, they're up and running and they're out in the field. We're starting to see the productivity starting to ramp up at this point. So we're expecting going forward we're going to see a nice return on that investment.

[Steven Valiquette:]

Then on the anatomical pathology, or AP, I know you don't break down these number quarterly. You only give them annually. But I’m just trying to get a sense for the range of where that trend is right now. I know your AP revs were down 0.5% for the fully year in '09. Maybe they were a little worse at the end of the year. So for the first half of '10 I'm sure it was worse than that trend line as well. But should we think of this as right now AP volumes may be down 5% to 10%, I mean, range ballpark and then pricing flattish? I mean, is that the way to kind of think of it right now?

[Bob Hagemann:]

Steven, as Surya indicated earlier, that business is under significant pressure. We aren't breaking it out at this point and we'll consider providing some more information at the end of the year.

[Steven Valiquette:]

Last just quick question on that, as far as the physician in-sourcing overall, was there any evidence either earlier this year or even now that this was ever expanding beyond AP or was that really the main area we're seeing it? There were some other companies that were kind of alluding to. They were seeing the same issue outside of AP like in oncology and some other areas. I'm just curious how you see that from categorization.

[Surya Mohapatra:]

Well, I think the main in-sourcing we have see, actually, [other than] oncology is allergy pathology actually and GI and GU. Did you mean that were they going to do any clinical testing? Physicians still have their fees in office labs. So it refers to only AP.

[Steven Valiquette:]

So you're not seeing it move down the acuity scale, basically what it sounds like.

[Operator:]

Your next question comes from the line of Amanda Murphy - William Blair.

[Amanda Murphy:]

Just a few questions, actually, one, the first one is a clarity on previous questions. In terms of the revenue guidance change, so am I understanding it correctly that that is primarily due to changes in the non-clinical testing business? Is that fair?

[Bob Hagemann:]

No, Amanda, that's a component of it but the principal reason for the change in the revenue guidance is that some of these things that we're working on that we put in place are just delivering results a little further out than we had anticipated.

[Amanda Murphy:]

So that's more on the volume side of the world then, right, than pricing it sounds like.

[Bob Hagemann:]

Correct. Right, so you should think about the adjustment in guidance as being principally due to volume.

[Amanda Murphy:]

Then it sounds like given the (inaudible) shift your focus on then that it's maybe on the esoteric side of the world versus the clinical routine. Is that fair?

[Bob Hagemann:]

No. I think the esoteric business we feel good about that it's continuing to grow. As we indicated, it grew 4% in the quarter. But just the overall business I wouldn't differentiate between the routine and the esoteric at this point in terms of what caused us to adjust the guidance.

[Amanda Murphy:]

Then just on the revenue per acquisition commentary, I’m not sure if I’m thinking about this correctly but so if it's flat on a dollar basis and the managed care pricing environment is relatively stable then it sounds like you got a benefit from mix. I would have thought that it would have been sequentially up. Is that -- am I thinking about that wrong or not?

[Bob Hagemann:]

Sequential -- well, the mix, we've seen that switch throughout the year. We haven't necessarily gotten a benefit in mix in this quarter. In fact, as the drugs of abuse testing business grows that puts pressure on the mix because that's lower price business.

[Amanda Murphy:]

Then just last one, I don't know if you're willing to make any comments here but one of your competitors made a pretty sizeable announcement related to a transaction. Do you have any comments there? Then just also another question on M&A in terms of focus; is it fair to say that you're maybe more focused on the services side versus product?

[Surya Mohapatra:]

Well, first of all, we're not going to make any announcement about what we're looking at. But all I can tell you is that we're very active in looking at assets which is going to help our company. As I told you, we're going to focus on cancer, cardiovascular studies and infectious disease. We have our strategies and services and laboratory and licensing and getting tests but if we get appropriate assets on point of care (inaudible) that's also not off the radar.

[Operator:]

Your next question comes from the line of Anthony Vendetti - Maxim Group.

[Anthony Vendetti:]

Just on the genomic and esoteric testing I know that was 35%, 36% of revenues. It's been, I think, pretty much that number for most of this year. How much do you think that that's going to increase as we move through 2011 as a percent of revenues? Is that 40% kind of goal? Is that a one to two-year goal or is that more like a three to five-year goal? Then if you could just talk about an update on the international revenues and how the expansion is going internationally.

[Bob Hagemann:]

Anthony, yes, here's the way that we should think about the percentage of gene-based, esoteric and [endotopic] pathology of the total business. If generally a test starts out as esoteric, if we're lucky it actually becomes routine over time and the vo0lumes ramp up significantly because it's becoming much more widely utilized. So you think about the life cycle of a test, it starts out as esoteric, over time moves to routine. So that sort of puts a natural governor on how big a percentage esoteric business can become of your total book of business. But, yes, I would expect though that it would continue to grow over time but we don't have a specific target there.

[Anthony Vendetti:]

Then internationally could you just give us an update on how that's going?

[Surya Mohapatra:]

Well, internationally we have the clinical trials business and the product business. (Inaudible) doing well and they're on their plan but when you think about the laboratory services our major investment in India and we're now focused on a growth plan. It is a long-term investment but I think although it would take some time but that's the right thing to do because there's a lot of opportunity in India with the 300 million middle class. But it is very small and very (inaudible).

[Anthony Vendetti:]

Then lastly just on physician volume, I mean, the physician office visits obviously have been weak the last couple quarters. Are you seeing that stabilizing or do you expect that to be weak through the remainder of this year ad into 2011 until the economy recovers or employment picks up?

[Bob Hagemann:]

Anthony, yes, as we indicated earlier, the physician office visits, at least for the first two months of the third quarter, were pretty much in line with what we saw in the second quarter and that's down between 4% and 5%. We're not expecting that to change dramatically over the course of this year. As we think about 2011, again, we'll give you some better insights into 2011 in January. But at this point our guidance for the rest of this year does not anticipate any significant swing one way or the other in how physician office visits behave.

[Operator:]

Your next question comes from the line of Kemp Dolliver - Avondale Partners.

[Kemp Dolliver:]

How much leakage is out there? I'm sure it would vary by plan but we've been hearing about reducing leakage for a long time and yet there's not a lot of data out there to work with.

[Bob Hagemann:]

Kemp, that's an interesting question and it's a significant number. I would tell you in some cases when you look at what's either off contract or going to the higher cost providers on contract it could be multiples of what the large commercial labs are actually realizing at this point. So it's a big opportunity. Obviously a lot of it's in with the hospitals and it doesn't necessarily all need to be moving off contract spend. In a lot of cases you can shift contracted spend to lower cost providers and that's part of what we're looking to do as well.

[Kemp Dolliver:]

But in terms of just say a percentage of spend or the like there's no number ballpark to think about.

[Bob Hagemann:]

Well, when you just think about the total market, hospitals account for 60% of the total market and add on top of that the fact that there are other providers that are not contracted, so it gives you some sense as to the total size of the opportunity.

[Kemp Dolliver:]

Secondly, with regard to anatomic pathology and the plans, can you give us some color with regard to whether any of these plans are the national plans and if these payment restrictions how hard they are, is it a preauthorization or is it an absolute ban on payments to these arrangements?

[Bob Hagemann:]

It depends because each plan is approaching it differently. It varies by national plan as well as some of the regional plans. But in some cases they're outright denying reimbursement and they're indicating two physicians they will not reimburse for certain testing performed in the office.

[Kemp Dolliver:]

The last question relates to the sales force renewal. I think earlier on this year at least offline discussions were we are adding to the sales force but don't necessarily assume that say 100 is a net number. Is 100 a net addition number now?

[Surya Mohapatra:]

Well, 100 is a number -- new positions and new territories.

[Kemp Dolliver:]

But the size of your total sales force is increasing about 10% or is it -- ?

[Surya Mohapatra:]

Yes.

[Operator:]

Your next question comes from the line of Gary Taylor - Citigroup.

[Gary Taylor:]

A couple questions, I just wanted to make sure on the earnings guidance of the year, the $3.95 to $4, that's using the $3.09 year-to-date. Is that correct?

[Bob Hagemann:]

Correct. It has the year-to-date number in it.

[Gary Taylor:]

Can you help us think about gross margin a little bit? I guess historically gross margin's typically higher in the third and a little lower in the fourth. This time around it was lower in the third and I think the guidance, which has probably the gross margin [was] lower in the fourth quarter as well. I know pricing was stable sequentially. So can you talk about that 90-basis point drop in gross margin sequentially?

[Bob Hagemann:]

Yes, Gary, as we said in the past we look principally at the operating income number as opposed to the split between cost of sales and SG&A although we do manage both of those lines. But as you heard Surya indicate in his prepared remarks, we made some investments in phlebotomists, whether they be in physician's office, whether they be in our patient service centers. We've opened up new PSCs. Those costs all go into cost of sales. So that's where you're seeing some investment dollars right now. Additionally, we indicated that we're accelerating the pace with which we've been converting physicians onto our Care360 and the cost of those conversions, the training, the installation and the like also goes into cost of sales. So as we work down that backlog of physicians waiting to get on and we accelerate the work we've done with that backlog, that adds to some costs in the near term.

[Gary Taylor:]

I guess, if these investments are being made, when do we anniversary kind of the [kick-outs]? I mean, is that second half of next year when we'd expect to see that?

[Bob Hagemann:]

Most likely second half of next year is when you'd start to see that anniversary.

[Gary Taylor:]

The news sales people are in the G&A line?

[Bob Hagemann:]

Yes.

[Gary Taylor:]

My next question is just on the Care360, which you guys have talked a lot about and I understand potentially there's some benefits in terms of market share referring to Quest out of that. Can you talk about -- and you touched on it a little bit -- but can you talk about is there any other P&L impacts? Obviously you've just said there's some conversion costs that show up and costs of goods. Presumably the revenue impact is hopefully market share gains on lab testing. Are there other items, subscription fees or licensing or anything that have any material impact on the P&L?

[Bob Hagemann:]

Gary, I will tell you that in terms of revenue for subscription fees and the like we're not expecting that to be material because that's the EHR piece of it. But certainly as people go on to our latest Care360 product we do continue to see benefits on the building side. We get better billing information and the like and that has historically been one of the things that's helped us reduce and manage our bad debt levels. So that's an area as we see more and more electronic connectivity we'll continue to benefit.

[Gary Taylor:]

The revenue impact will be market share gains.

[Bob Hagemann:]

Correct.

[Gary Taylor:]

Hopefully you'll capture more market share from those docs that do the adoption, right?

[Bob Hagemann:]

Precisely.

[Operator:]

Our final question today is from Robert Willoughby - Bank of America Merrill Lynch.

[Robert Willoughby:]

Just listening to some other questions, I mean, don't you guys do a profound disservice to yourselves breaking out the aggregate price volume metrics? I mean, wouldn't disclosure along the lines of what your competitor reports on a quarterly basis help you better tell your story?

[Bob Hagemann:]

Bob, look, we continue to take a look at what we think is appropriate and at this point we believe that what we're providing is appropriate to help you understand the business, the absolute revenue per acquisition and absolute pricing we think is something that is valuable information that we keep confidential at this point because it is competitive information. We'll continue to try and provide you the information that you need to understand how the business is performing without providing what we believe is sensitive competitive information.

[Robert Willoughby:]

But do you see what one of your competitors is doing as somewhat sensitive information? Are you gleaming much from their disclosure that is helping you and your business? I'm not sure I understand the sensitivity to the breakouts.

[Bob Hagemann:]

We do try to understand it and use whatever public information is available to help us.

[Robert Willoughby:]

A different area, do you envision that some point -- we've asked for them in the past as the Care360 initiatives really gain more traction, I mean, will there ultimately be some sort of quantitative data you can speak to of 160,000 users, X amount are e-prescribers, X amount are EHR users?

[Surya Mohapatra:]

Yes, we will do that and I think as we gain ground and we're getting established and I think we provide some data as far as how many people are using e-prescription and how many users -- but, Bob, we will look at those things (inaudible).

[Bob Hagemann:]

Bob, as Surya indicated earlier in his prepared remarks, we have over 1000 users on the EHR at this point.

[Robert Willoughby:]

Right but sequential builds and anything like that to really help us understand the traction that you have there would be most helpful.

[Bob Hagemann:]

We can do that. As it certainly becomes more meaningful that's something that we would plan to do.

[Operator:]

Thank you for participating in the Quest Diagnostics third quarter conference call. A transcript of prepared remarks on this call will be posted later today on Quest Diagnostics' website at www.questdiagnostics.com. A replay of the call may be accessed online at www.questdiagnostics.com/investor or by phone at 866-350-3614 for domestic callers or 203-369-0039 for international callers. No access code will be required. Telephone replays will be available 24 hours a day beginning at 10