Quest Diagnostics Incorporated
Q2 2011 Earnings Call Transcript

Published: 20 Jul 2011

[Operator:]

Welcome to the Quest Diagnostics Second Quarter Conference Call. At the request of the company, this call is being recorded. The entire contents 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, retransmission 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 am here with Surya Mohapatra, our Chairman and Chief Executive Officer; and Bob Hagemann, our Chief Financial Officer. During this call, we may make forward-looking statements. Actual results may differ materially from those projected. Risks and uncertainties that may affect Quest Diagnostics' future results include, but are not limited to, those described in Quest Diagnostics' 2010 annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K. A copy of our earnings press release is available, and a text of our prepared remarks will be available later today in the Investor Relations' Quarterly Updates section of our website at www.questdiagnostics.com. A PowerPoint presentation and spreadsheet with our results and supplemental analysis are also available on the website. Now, here is Surya Mohapatra.

[Surya Mohapatra:]

Thank you, Kathleen. We grew revenues and adjusted earnings per share in the second quarter despite ongoing market softness. During the quarter, revenues grew 1.5% to $1.9 billion. Adjusted earnings per share increased 5% to $1.12. While clinical testing volumes decreased 0.9%, revenue per acquisition increased 1.6% compared to the prior year, and we generated strong underlying cash flow. Our growth strategy is to be the leading innovator and provider in the fast-growing esoteric and gene-based testing areas for cancer, cardiovascular disease, infectious disease and neurological disorders. This complements our large routine level through testing services, enabling diagnostics and monitoring of a wide range of chronic diseases. We continue to focus on growing our genetic, esoteric and anatomic pathology revenues. Demand for our esoteric and gene-based testing continued to grow faster than routine testing, driven significantly by Vitamin D testing, which saw double-digit volume growth in the quarter. However, the rate of growth in Vitamin D testing is moderating. Additionally, ImmunoCAP allergy testing continued to grow. In Anatomic Pathology, we continue to see pressure on volumes from physician insourcing, particularly in dermatology and hematology oncology. However, we have seen some moderation of this practice in other areas such as GI and GU. In cancer testing, we continue to promote our colorectal cancer blood test and OVA1 ovarian cancer test and Leumeta blood cancer test. These tests are proprietary to Quest Diagnostics and all showed strong growth. The acquisitions of Athena and Celera, which closed in the second quarter, will further accelerate our growth in gene-based and esoteric testing. I am pleased these integrations are on track. We are also taking additional actions to grow our business. We have strengthened our women's health test offering. We introduced SureSwab for gynecological infections and are launching Spinal Muscular Atrophy or SMA testing from Athena more broadly throughout our network. We are seeing early successes. We also introduced a new prescription drug monitoring service. We are seeing strong growth in this expanding market for pain management. We are helping citizens to ensure that prescribed pain medications are not being abused or diverted. Turning to sales effectiveness. In some areas, we are pleased with our performance, but we have more work to do. As we have said before, we have completed our sales force expansion, provided them with better tools and enabled them to spend more time with customers. We continue to work with health plans to move business to us from higher cost providers. Additionally, we have created a new Senior Vice President position to oversee all aspects of our core business with physicians, including sales, marketing, operations and quality. Cathy Doherty, who reports directly to me, has a proven track record over her 21 years of experience with Quest Diagnostics, including successfully leading our hospital services, as well as corporate strategy and business development. As regards to our costs, we have been looking closely at our cost structure. In the short term, we are aligning our costs with lower volume levels we have seen. Beyond that, we need to become more agile and efficient in our operation. Today, we're announcing a comprehensive initiative to improve profitability in this competitive marketplace, invest for growth and better prepare us for the substantial opportunity in the future. We expect this to reduce our cost structure by $500 million over the next 3 years and help us reach our goal of 20% operating income. I have asked Bob Hagemann to lead this initiative. Regarding capital deployment, our philosophy comprises the use of cash for growth and strategic advantage, the return of cash to shareholders through share buybacks and dividends. In addition to quarterly dividends, so far this year, we have returned $835 million in cash to shareholders through share buybacks, and we utilized about $1 billion for the acquisition of Athena and Celera. With regards to acquisitions, in the near-term, our interest is in smaller holding lab acquisitions, which will provide access to more customers and be immediately accretive to earnings. Now Bob will provide some analysis on our performance, and then we will take your questions. Bob?

[Robert Hagemann:]

Thanks, Surya. Revenues for the quarter were $1.9 billion, 1.5% above the prior year and adjusted earnings per share was $1.12 compared to $1.07 in the prior year. Adjusted earnings per share for the 2011 second quarter exclude $0.10 per share associated with deal-related and integration costs in connection with the acquisitions of Athena and Celera, which are further detailed in Footnote 2 to the earnings release. The acquisitions of Athena and Celera contributed about 2.5% to revenue growth in the quarter, and we're essentially neutral to adjusted EPS. Our clinical testing revenues, which account for over 90% of our total revenues, were about 1% above the prior year and about 1.5% below the prior year before the contributions from Athena and Celera. Volume in the quarter was 1% below the prior year and compares to the improvement of 1.3% in underlying volumes that we saw in the first quarter. We saw a further market softening in terms of physician office visits in the second quarter, which contributed to the volume slowdown. Our volume for the month of May was particularly weak, while the months of April and June were modestly positive versus the prior year. Drugs of Abuse Testing volumes have continued to rebound and grew about 6% in the quarter, although at a slower rate than the first quarter. Revenue per acquisition was 1.6% above the prior year, with the improvement due to the increased esoteric mix contributed by Athena and Celera. While our increased esoteric mix is benefiting revenue per acquisition, it continues to be pressured by business and payer mix changes, the Medicare fee decrease which went into effect January 1 and pricing changes in connection with several large contract extensions executed in the first half of last year. The business and payer mix changes, which continue to pressure revenue per acquisition, include a further rebound in lower-priced Drugs of Abuse Testing and continued weakness in our higher-priced Anatomic Pathology Testing. Revenue in our Nonclinical Testing businesses, which include Risk Assessment, Clinical Trials Testing, products and Healthcare IT, grew 10% for the quarter. Adjusted operating income as a percentage of revenues was 17.7% compared to 19.5% reported in the prior year. Recent investments we have made in sales and service are temporarily pressuring margins, but are expected to accelerate revenue growth and margin expansion over the longer term. Deal-related and integration costs associated with Athena and Celera, which are detailed in Footnote 2 to the earnings release, reduced reported operating income percentage by 1%. The adjusted operating income percentage in the quarter is generally in line with the percentage we built into our earlier full-year guidance, which contemplates improvement in the latter part of the year. We continued to see strong performance in our billing and collection metrics. Bad debt expense as a percentage of revenues was 3.6% in the quarter and reflected improvement from both the first quarter and comparable prior-year period. DSOs were 44 days, unchanged from the first quarter. Most of the MediCal billings, which had been on hold for the unsettlement discussions, have now been released and collections from MediCal have resumed. Capital expenditures were $40 million in the quarter compared to $49 million a year ago. Underlying cash from operations was strong. Before the effect of the MediCal settlement payment and acquisition and integration-related costs, cash from operations was $271 million compared to $209 million reported in last year's second quarter. Our strong cash flow provides us with significant flexibility to drive shareholder value. Through the first half of the year, we have deployed a significant amount of capital to enhance growth in revenues and EPS. We completed $835 million in share repurchases, which contribute about $0.15 per share EPS improvement. We completed the acquisitions of Athena and Celera, which bring us unique capabilities. While we are still in the early days of realizing the synergies associated with these important acquisitions, they are already neutral to adjusted EPS and accretive on a cash basis. With these acquisitions now completed, our focus is on small fold-in acquisitions, which will expand our customer base and further strengthen our distribution network. In addition, we will continue to ensure we balance our investments and growth with returning cash to shareholders in the form of share repurchases and dividends. Part of positioning us for the future is ensuring that we have a cost structure which enables us to continue growing cash flows and earnings, during not only what we expect to be a long-term period of market growth but periods like we are currently in, where the market may be going through some temporary slowdown due to economic or other factors. To that end, as Surya referenced, earlier this week we implemented a number of cost actions which we expect will enable us to meet earlier earnings commitments despite a reduced outlook for 2011 top line growth. These actions, which are broad in nature and affect most part of our business, will result in a charge estimated at approximately $20 million, which will be recorded in third quarter results. As you've also heard from Surya, beyond that, we have initiated a multiyear initiative designed to reduce our cost structure by $500 million over the next 3 years. This effort is intended to address continued reimbursement pressures and labor and benefit cost increases, free up additional resources to invest in science and innovation and help us achieve our goal of 20% operating income. This program, which I will directly oversee, will touch every aspect of our business and make us more efficient in both our operations and our general and administrative areas. It will include looking at how we operate our labs and other facilities, and redundant costs across our business and the speed and effectiveness of our decision-making. We've identified opportunities in the cost of testing, the cost of acquiring and transporting samples and in our general and administrative areas. We intend to provide you with more specifics and periodic updates as the program progresses. Now turning to guidance. We now estimate results from continuing operations before the anticipated third quarter charge and other potential special items as follows

[Surya Mohapatra:]

Thanks, Bob. That concludes our prepared remarks. We are ready to take your questions. Operator?

[Operator:]

[Operator Instructions] Our first question or comment comes from Tom Gallucci from Lazard Capital Markets.

[Thomas Gallucci:]

I guess I was curious if you could maybe give us a little more color on margins and costs. Three buckets, I guess. One, Bob, it seems like the margin guidance for this year has sort of trailed down a bit from around 18% to 17.5% to 18% to 17.5%. So what are sort of some of the pressures this year to the extent if maybe some of these investment sales and things? Can you size any of that so we can get an idea of sort of what goes away or how much better it gets as you get through that? And then you outlined I guess from a high-level some of your initiatives on the $500 million of savings. Is there any way to at least from a very high-level breakdown some of the buckets of expectations in terms of the areas that you're focused on?

[Robert Hagemann:]

Okay, Tom. There's a lot of questions there. Let me...

[Thomas Gallucci:]

Yes, sorry. I'll do them again if you need to. But it's also the margin and cost-related sort of short term and long term.

[Robert Hagemann:]

It's all connected. And what I'll try and do is bridge you back on operating income at least, the initial guidance that we put out for the year, which was approximately 18%. As we got through the first quarter, we adjusted that to 17.5% to 18%, essentially tightened that range a little bit, but still pretty close to where we had anticipated in the first part of the year. And at that point, we're still holding the revenue growth. What we saw in the second quarter, particularly in May, at least in our results, was a further softening in the marketplace. And as a result, we've adjusted our top line guidance now, essentially on the volume side. And as you know, with a business that's principally fixed-cost base, you've got to take a lot of cost out just to preserve margins if you're adjusting your top line. That's what we're doing. You've seen us announce now a charge in Q1. We've got another charge coming in Q3 in connection with the actions we've just taken. And then actually, we're looking longer term at what we can do with costs, and I'll come back to that in a minute. So at this point, we've adjusted operating income percentage down to 17.5%, essentially moved it to the lower end of the range that we had, reflecting the change in volume expectations. And some dilution, some minor dilution from Celera. As I told you, when we announced the Celera transaction, we expected it to be dilutive by an immaterial amount this year, and that's some of what you see in the operating income percentage there. With that said, as we look at where we're at versus the beginning of the year, despite the fact that we brought the top line guidance down, we stayed pretty close on the operating income percentage. And actually, from the beginning of the year, we've raised the EPS guidance at this point. The initial range that we had out there was $4.10 to $4.30 as a result of the share repurchases and the cost actions we've taken. We've been able to up that range to the $4.25 to $4.35 despite the expectations for lower volume. So hopefully that addresses your question on the current operating income percent. With respect to the cost reduction program, just like the last one that we announced several years ago, which that's also one that I oversaw, we provided more information as we went along. And we expect to do the same thing here. We'll give you some progress on how much we've achieved with those -- where those are coming from. But as you think about the areas that you typically think about, right, how we operate our labs and our other facilities, i.e., the cost of testing, we have a lot of costs outside the labs, though. Our network for obtaining and transporting samples is something that we're looking at as well. And additionally, we want to get at the SG&A area. So we're looking at all support functions, much of which sits in the G&A. And we believe that there's some redundancies in costs across our business, which we'll get at. At this point, we're not in a position to provide some more details. We want to socialize this and make sure our employees fully understand it and appreciate it before we start providing more details outside. But we expect to do that as we progress with the program.

[Thomas Gallucci:]

Just one thing. On the SG&A, though, you've been investing, you're talking about in sales and service. Is there any way to sort of give an idea of either how much those investments have been or how much you sort of think they sort of come down over time as you're sort of expecting those better margins later?

[Robert Hagemann:]

Well, Tom, one thing I'll tell you is they are investments, so we're not expecting them to come down. We expect the impact that they're having on margins, though, to dissipate as they start to deliver top line growth for us, which we believe they will. But one way to think about it without completely sizing it for you is the increase that we're seeing in SG&A this quarter versus the prior year on an adjusted basis is principally due to the additions of Celera. As you know, Celera was basically operating at a loss before we acquired them. We're thinking about it as a turnaround. There's a lot of SG&A costs there which still needs to come out. We've got quite a bit of it in the first quarter of ownership, but there's more to go. But that's really the driver of the increase in SG&A versus the prior year at this point. We've seen improvements in Baghdad, which is helping that. And then the investments that we've made in sales and service are really offsetting those bad debt improvements.

[Surya Mohapatra:]

Tom, I just want to add one more thing that -- we have done this, and we are good at doing these things. And we will use Six Sigma and Lean Six Sigma principles, but we'll not sacrifice patient care or medical quality while we do cost reductions. As Bob said, we're going to look at SG&A, and we'll look at the way we organize and go after this.

[Operator:]

Our next question or comment comes from Adam Feinstein from Barclays Capital.

[Bryan Sekino:]

This is Bryan Sekino on behalf of Adam Feinstein here. Just a quick question on the top line growth of 1.5%. I guess the previous revenue guidance of 2% didn't include Celera. And I guess as now you're including it, is there some, I guess, further deterioration, I guess, in the macroeconomic environment that you're expecting to get to the 1.5% now?

[Robert Hagemann:]

Yes, that's exactly the case, Bryan. We had not included Celera in our previous guidance. That contributes about 1% to the total revenue growth. And what that means is our expectations for the base business now are down about 1.5% from where they were. That's principally all volume-related, and that's really as a result of what we've seen in the second quarter in terms of the further softening in physician office visits.

[Bryan Sekino:]

Okay. And as I think about the 20% margin goal, the 3 years, does that assume some kind of improvement in the volume environment? And I guess, is it a margin that you can reach through additional cost cutting if volumes don't improve?

[Robert Hagemann:]

Yes, you've heard us say this before. We need to have some top line growth in order to continue expanding margins. Certainly, this cost reduction program is going to be an important contributor to that, but we would expect to see some top line growth. And certainly, over the period we're talking about, we expect that to be the case. Our long-term outlook for the market is that it's going to continue to grow. Demographics, the pace with which new tests are introduced, the increased focus on early detection and prevention are all things that we believe bode well for this market over the long term. And we think we're very well positioned now with some of the acquisitions that we've done to take advantage of that future market growth, although we are seeing a temporary slowdown at the moment.

[Operator:]

Our next question or comment comes from Ricky Goldwasser from Morgan Stanley.

[Ricky Goldwasser:]

A few questions here. First on the top line. I know, Bob, in the past, you mentioned 2% top line growth that kind of threshold for operating margin expansion. Does this figure still hold or is the bar is higher now?

[Robert Hagemann:]

I wouldn't say the bar is any higher, Ricky. I think we do need a couple of points revenue growth to have sustained margin improvement. And as you've seen, we have not had that sort of revenue growth and that's one of the reasons that we're initiating the cost actions that we are.

[Ricky Goldwasser:]

Okay. And then on the pricing side, obviously you've reported an improved metric. What would pricing have been if you exclude the Athena and Celera acquisitions on same-store basis?

[Robert Hagemann:]

Yes, we're not disclosing that, Ricky, because we really don't want to put people in a position to back in to pricing of Celera and Athena because we think that, that is competitively sensitive information. But with that said, the underlying revenue per acquisition has been pretty stable and in line with our expectations. And as we told you, the year-over-year comparisons there start to improve as the year progresses, as we start to anniversary some of the things that occurred last year and the year before.

[Ricky Goldwasser:]

Okay. And then lastly on volume. I mean, obviously, your outlook for volume growth has come down. But in your prepared remarks you did mention that you saw weakness in May, where April and June were pretty positive. So what is it that you're seeing out there that makes you more cautious on the second half? Is it the macro environment? Are you seeing any increase in the competitive environment? Or are you just trying to be more conservative, given that visibility hasn't been that great over the last year or so?

[Surya Mohapatra:]

Ricky, first of all, May was not a good month, and we did confirm our guidance in May. But having 2 months of data, we realized that this temporary slowdown is probably going to continue for the rest of the year. So here is what we see. 85% of our business comes from patients visiting the doctor's office. In April to May quarterly data, we have 6% decrease in physician office visits, so that affects us a little bit. Regarding insourcing of Anatomic Pathology, that's 16% of our business. Obviously, that's affecting us a little bit. But then we have some of our health plans. They are changing their membership, and that's also affecting us. So when we look at all those things, just temporary things and we know that we are going to go through these things. But when I look at the long term and the medium term, I feel that we have all the efforts, and we are focused on our strategy of differentiation of making the company more esoteric and gene-based. So we reduced our guidance, the top line guidance, based on the office visits and what is going on in insourcing. And but on the other hand, the acquisitions like Celera and Athena is helping us to increase our presence in esoteric and gene-based testing, which is going faster than the routine testing.

[Operator:]

Our next question or comment comes from Dane Leone from Macquarie Capital.

[Dane Leone:]

Actually, this kind of builds on a previous question, but I'm just curious. When we're thinking about this longer-term cost restructuring that I guess would be targeted around early 2014, you mentioned in the press release that it could kind of get you to that 20% operating margin goal. What type of fundamental revenue growth rate would we really have to see to get to that 20% operating margin goal?

[Robert Hagemann:]

We just addressed that a little bit with Ricky. Certainly, the cost reduction program is an important contributor to that -- achieving that goal, but we do need some top line growth. Yes, we need generally in the range of a couple of percent top line growth to have sustained margin expansion. And we haven't seen that and again that's why we're initiating this program.

[Dane Leone:]

And then just one on the sales force reorganization. Can you just remind us when -- from this reorganization when we should really see productivity ramp?

[Surya Mohapatra:]

Well, as I told you that our sales force expansion is completed, and we are organized with the customer phasing organization so that we can be closer to our customers, whether they are hospital, physicians or oncologists. In some areas, I'm pleased how these sales people have come up. In some other areas, we have much work to do. But I want to also make a comment on our operating income. We had a long-term goal of reaching 20% operating income, and we know that we're going through a temporary slowdown. However, as Bob said, the medium-term expectation of this industry is really great. It has tremendous potential for growth, and we are launching this multiyear initiative for cost reductions. So I am much more encouraged with some top line growth and some reduction in the expenses to reach operating income of 20%.

[Dane Leone:]

Great. I guess the underlying question really comes around to looking over the past couple of years where volume growth has been, I guess, somewhat lackluster. I'm trying to figure out what can kind of fundamentally turn that around going forward and I guess that from what...

[Surya Mohapatra:]

Let comment on that. Over the last 2 or 3 years, what we have been doing methodically is moving our business to more gene-based esoteric and anatomic pathology and getting focused on the diseases, which are very important, like cancer, infectious disease, cardiovascular disease and neuromuscular disorders. Those are the areas which are growing. Now because of recession and because of Health Care Reform for the time being, we have a lot of personal routine testing and some insourcing going on in anatomic pathology. But we are uniquely positioned to take advantage of the fast-growing markets in esoteric and gene-based, and nobody else has the products of the test and the network as we have. So I'm very excited that although the last 2 or 3 years have been lackluster -- but going forward, we are going to gain market share in the areas which are faster moving market.

[Operator:]

Our next question or comment comes from Ralph Giacobbe from Crédit Suisse.

[Ralph Giacobbe:]

Just going back to the cost savings number. I guess, first, is that a gross number or a net number?

[Robert Hagemann:]

Help me understand how you think about gross and net, Ralph.

[Ralph Giacobbe:]

Sure. Fair enough. Like if I were to just assume that you're able to hold your EBITDA flat for the next 3 years, can I just then add $500 million to that number?

[Robert Hagemann:]

No, that's not the way I would necessarily think about it. Yes we, like every business, have cost increases that we expect to see in salaries, wages and benefits. And this $500 million is a reduction in cost that we'd otherwise have, had we done nothing, essentially. So we'll still see some inflationary increases as we look ahead. But this is going to mitigate that and also provide us additional funds to invest in science and innovation and contribute to margin expansion.

[Ralph Giacobbe:]

Any sense -- so what's the timing around that? I mean, I know it's a 3-year plan. Is it starting today? Did it start this quarter? Is it starting next year? And is it front-end loaded, back-end loaded? Any guidance there?

[Surya Mohapatra:]

Let me just make a comment, Ralph. First of all, as you heard, we are adjusting our cost based on the lower volume. So we have taken some costs out, and we will take charge in the third quarter. And as Bob said, despite the lower volume, we are still meeting our full-year guidance. So that's short-term cost reduction we do as a part of the business. As far as the long-term cost reduction, we just started the program. And like the last time, we will give you the information as we go on. But like any other cost reduction and efficiency improvement program, some cost savings are going to go towards investment, and some cost savings are going to go towards the bottom line. But again, we have done this before. We can do it, and we will do it without sacrificing medical quality and patient care.

[Ralph Giacobbe:]

Okay. But just in terms of the timing and stuff, are numbers baked in? Like for the guidance, I'm assuming there's some of that already playing in. Is that fair?

[Robert Hagemann:]

You should assume that what's baked into the current year guidance is you're impacted by the short-term actions that we've taken.

[Ralph Giacobbe:]

And then maybe just remind us on the timing of when you comp those pricing pressures from a year ago. Did that play a role at all starting this quarter? Or should we look for the benefits of that starting in the second half or 3Q?

[Robert Hagemann:]

We started to see some benefits of that this quarter, Ralph. But remember, it's not just changes in contract pricing that drove this. A lot of it was mix and that mix shift continues, as we see continued growth in the Drugs of Abuse Testing business and as we see a continuation of the softness on the AP side. Those 2 factors are also contributing to the change in revenue direct year-over-year. But again, we've seen it stabilize, and we feel good about the underlying revenue direct at this point for the remainder of the year.

[Ralph Giacobbe:]

Okay. And then just my last one. I just want to put in the context of sort of your -- you talked about your quarterly progression on the volume side with May being sort of worse, and then I believe you said positive for the last 2 months. Is that right?

[Robert Hagemann:]

We saw positive year-over-year growth in the months of April and June.

[Ralph Giacobbe:]

Okay. And I just -- the context, we just got the physician office visit data this morning and in the context of -- the numbers seem pretty weak for June, down over 13%, probably one of the worst months we've seen. So I guess I'm just trying to understand sort of the context of seeing improvement versus those physician office visit numbers...

[Surya Mohapatra:]

Ralph, which data are you looking at today? Is it IMS data or JPMorgan?

[Ralph Giacobbe:]

The IMS data. IMS.

[Surya Mohapatra:]

IMS. Well, you heard from Bob...

[Robert Hagemann:]

Ralph, as you heard from Surya, 85% of our business comes from physician offices. As you start to look at the data, I think it's important to understand what's happening with primary care versus specialist and the like. I have not had a chance to analyze the June data at this point. And while there's a strong correlation overall with physician office visits, month-to-month is not necessarily the best way to look at it. And frankly, we even need to be careful as we look at volume trends within the quarter as well. There's certainly correlation.

[Surya Mohapatra:]

There's certainly correlation, but it's not one to one because obviously if they are down by 4% or 6%, we are not down by that much. And that also shows at least to me that some of the investment we have made in sales and sales force, we are staying close to our customers.

[Operator:]

Our next question or comment comes from Bill Bonello from RBC.

[Bill Bonello:]

So I guess I just wanted to go back to this cost savings a little bit more and maybe from a slightly different angle. I mean, going back to the concept that for the last 2.5 years, you've had positive volume growth in one quarter. It seems to me like the critical thing here is to jumpstart volume growth. And I guess, how do we get comfortable that you can take out $500 million of cost and sort of not just create an ongoing problem of weak volume?

[Surya Mohapatra:]

Well, let me answer that a little bit. First of all, $500 million sounds obviously large, but it is less than 10% over the next 3 years. You are absolutely right. The number one item for me is how to increase the volume, and that is one of the reasons why over the last 18 months, we have done a lot of work. For example, the organizer needs organized to be customer phasing because we know that we are going through some personal routine testing, but we also know that gene-based and esoteric testing are growing faster than the routine testing. So we are very pleased actually how we are growing in hospital services and how we are growing in esoteric and gene-based testing. But we also have to grow in the routine testing, and these costs take -- we're going to take out -- we're going to use this Six Sigma, Lean Six Sigma principle. And as Bob said, one of the major target that we see and I have is DNA. So we're not really going to take costs out from customer phasing or patient-phasing activities. And I think this is the appropriate target for us, and we will do it in a deliberate speed with growth as the number one goal. And that's why we are saying that a part of this cost savings would be invested in growth. And we are focused on actually growing the top line. If we cannot grow the top line, no cost reduction is going to help us.

[Robert Hagemann:]

Bill, I would also add, too, that it's important for us to make sure that we understand what's important to our customers, and that those aspects of the business are not impacted by what we do here. Certainly, the accuracy and reliability of our testing is paramount there and we expect to continue to be able to differentiate ourselves in that regard. Yes, having a broad testing menu is also very important, and you've seen that we continue to invest in that regard. And as Surya said, SG&A is an area that we're going to spend a lot of time looking at. And for the most part, that doesn't touch the customer.

[Bill Bonello:]

Okay. And just one, not follow-up, but one second question and I'll hang up. And I apologize if somebody asked this and I missed it. But Surya, did you -- have you renewed your contract yet? And can you give us any update on that front?

[Surya Mohapatra:]

I must tell you, the contract is fine and the way they work in contract, and neither party has given any notice of nonrenewal. The board and I are fully aligned, and I'm focused on growing the top line and the bottom line.

[Operator:]

Our next question or comment comes from Kevin Ellich from Piper Jaffray.

[Kevin Ellich:]

I'm just wondering if we could go back to the volume issues. You gave some good detail on the monthly trends and also, you continue to see some pressure on the AP insourcing. Is it all just insourcing to physician offices or are you seeing greater competition from other labs that are really focused on like the Dermpath business?

[Surya Mohapatra:]

Well, Anatomic Pathology is major activities going on in insourcing because this is the way for the practitioners to get revenues. We are working with our trade association to see if we can reduce some of the tests. We are working with some health plans who have not changed reimbursement. But most of the Anatomic Pathology reimbursement, especially now, what we see in derm is going towards dermatologists.

[Kevin Ellich:]

Got it. And then on the managed care side, have you seen any greater attrition out of some of the regional plans like Empire Blue Cross that opened up last August?

[Surya Mohapatra:]

Not really. We work with them and working very closely. As we said, there are no major managed care contracts for renewal. Our relations with managed care organizations are very good. We are working with them with the employers to change the benefit plan to have test coming from higher cost provider to us. We're also working with many managed care organizations on the disease program, and we're using our analytics and informatics skills to help them getting prepared for the future, which may be around [ph] care organizations.

[Kevin Ellich:]

Okay. And then just thinking about your comments about utilization trends and volumes. Yesterday, United made some comments saying they expect an increase in utilization, specifically physician office visits during the back half of the year. That's kind of goes contrary to what you guys are seeing. So just wondering if you could help connect the 2 data points?

[Surya Mohapatra:]

You're getting the same data, many more data than we are getting. We represent 15% of the market, so I consider our numbers are representing what is happening in the market. We really don't know actually, unless -- well, first of all, I cannot comment actually what they see, maybe different kind of membership. But we are assuming that at least to this year, the rest of the second half, we are going to see lower utilization. But if it goes up, everybody is happy.

[Kevin Ellich:]

Sure. It makes sense. And then just maybe switching over to the regulatory legislative environment. Obviously, there's a lot of discussion on potential Medicare lab co-pays, and then the Institute of Medicine came out with your recommendations for preventative screening, I think, yesterday. Just wondering if you had any -- have a chance to look at that, and it looks like it would be an incremental positive for you guys. Any comments?

[Surya Mohapatra:]

Well, at first, Institute of Medicine, I must be honest, I haven't looked at it. But we have looked at all the reports. As Bob mentioned, diagnostics is a very good area and has a tremendous potential for growth not only because of demographics, but also very different tests with a higher specificity and sensitivity. But also we will have 29 million people who will be in this plan. So in the long term and the medium term, diagnostics is the right area to be. And I think the short term, the temporary stuff which is going on is not going to last for long. So I'm very pleased. And Kathleen, do you want to make some comments about the FDA?

[Kathleen Valentine:]

On the Medicare co-pay. We're working with the trade association, educating the administration officials and members of congress on the negative impact, the Medicare co-pay and the considered forms would have on the seniors, as well as the lab industry. And we're looking importantly to remind the folks in Washington that diagnostic testing, laboratory represents a very small portion of total healthcare spending in the U.S., less than 3%. And we've already given up a lot. We're absorbing 1.75% reduction for 5 years. We've got a productivity adjustment that we've agreed to with the healthcare reform legislation over the past last year. So we feel like we've contributed significantly already. We're a small portion of the healthcare spend, and we want to make sure that that's appropriately and fairly considered in wherever they go with the co-pay idea.

[Kevin Ellich:]

Okay. And then 2 quick ones for Bob. Bad debt saw nice improvement of 3.6%. How much lower can that go? And then also, can you remind us if the guidance includes the $0.07 impact from weather in Q1?

[Robert Hagemann:]

Well, with respect to bad debt, I'd certainly love to see it go lower, although we're not prepared to put guidance out there. But if you think about one of the positive impacts of healthcare reform in addition to further volume, it should be to help reduce the bad debt over time because a significant portion of that has to do with uninsured patients. So I would be hopeful that over time, we could see that continue to come down as we see more and more insured patients. With the other part of your question, Kevin?

[Kevin Ellich:]

Oh, the EPS guidance, that includes the $0.07 impact from weather in Q1?

[Robert Hagemann:]

It's adjusted out. So if you look at the Footnotes in the earnings release, you'll see all the things that are adjusted out to arrive at the adjusted guidance.

[Operator:]

Our next question or comment comes from Robert Willoughby from Bank of America.

[Robert Willoughby:]

Bob or Surya, I guess if I were a critic, I'd look at another $500 million in cost cutting on the heels of some of the initiatives that you've completed to date. It kind of calls to like some tardiness maybe in getting at some of these inefficiencies. I guess I'm not clear what new opportunities are your really addressing, cutting SG&As. I mean, you just sound like that you should have maybe gotten your arms around years ago.

[Surya Mohapatra:]

Robert, this is Surya. First of all, you are right that some of the costs we could have taken out as we bought some other companies and integrated. But one of the things that we have been doing is actually going towards more esoteric and gene-based, and we have been investing some of these things. Now we have 4 or 5 esoteric laboratories. We also are looking at what is happening to the routine testing. And over the last 4 or 5 years, we have now learned more about how to run the laboratory more efficiently and more on the lower cost. We have used some automation as we have reduced to the cost before. So when we look at it again, this $500 million sounds really big. But to be perfectly honest, it's less than 10% over next 3 years. So we do cost reductions all the time, but again, we are going through another concerted effort to look at what is happening with the routine testing business. As Bob said, how much money we spend in logistics, how much money we spend in DSC and phlebotomy stand. We feel that $500 million is a good target for us, and this will give us some money for investment and will give us some money to meet our operating income goal. Bob?

[Robert Hagemann:]

Bob, as Surya indicated, look, we get smarter each year about our business and what we can and can't do. And certainly, I think that the customer constraints that we have in terms of what we can do with our cost structure we've learned more about over the last several years as we've taken costs out. And I think I have a better view as to some areas that we can go after now, which we previously thought may have been off limits.

[Robert Willoughby:]

Will there be any change in your international expansion strategy or current international focus?

[Surya Mohapatra:]

We will maintain our current international focus, and mainly it is actually in India because that's where we're investing. We have some business in Mexico and some business in -- a small business in U.K., and we're looking at that. But mainly it's the investment in India, which remains the same. And you say it's a medium-term investment, and it's moving. But it is a very slow progress. But that's all.

[Robert Hagemann:]

It's also still a pretty modest investment.

[Surya Mohapatra:]

Yes.

[Robert Willoughby:]

And just lastly, your dividend payouts are down year-over-year actually with some of the share buybacks. You anticipate moving that higher here to enhance the appeal?

[Robert Hagemann:]

Bob, that's something we look at periodically with our board. Over time, we would expect that the dividend payout would grow commensurate with earnings and cash flows. But it's something that we look at over a longer period. And again, we evaluate it with our board on a periodic basis.

[Operator:]

Our next question or comment comes from Gary Lieberman from Wells Fargo.

[Gary Lieberman:]

You said there will be a $20 million charge in the third quarter. Is that a severance charge or is that something separate?

[Robert Hagemann:]

That's principally associated with severance, Gary.

[Gary Lieberman:]

Okay. And then just to stay on the cost cutting, is there any way you could sort of compare and contrast maybe the new initiative to the previous $500 million initiative? Is it more focused on one area than another?

[Robert Hagemann:]

Yes. As I mentioned earlier, I think we're probably going to have more focus on SG&A this time around. Not that we didn't address SG&A as part of the last program, but I think we want to take a harder look at that. And additionally, as I said, I think we understand our customer constraints better, and that's going to free us up to do some other things.

[Gary Lieberman:]

Okay. Is there going to be a bigger IT component of the focus on the cost cutting or streamlining this time around?

[Robert Hagemann:]

IT certainly an element of it.

[Gary Lieberman:]

Okay. Will it be a greater element than previously or is just sort of in there with everything else?

[Robert Hagemann:]

I wouldn't say it's greater or less. It's an important piece of our spending. It's also important in terms of the way we deliver our service to our customers, and we want to make sure that it continues to be something that we do very effectively. But we do think that there's opportunities to further reduce cost there as well.

[Gary Lieberman:]

Okay. And then I think you've talked about it, but just to clarify on the revenue per requisition, the weakness. It sounds like it's primarily a mix issue. And is there anything like we saw last year in terms of pressure on the commercial pricing or extension in contract changes that's incremental this quarter or that you foresee throughout the rest of the year?

[Robert Hagemann:]

And just to clarify a little bit, Gary, as we think about mix broadly, it's the esoteric mix contributed by Athena and Celera that drove the improvement in revenue per rec this year. And the base business is where we've seen sort of the negative mix as we've got growth in the lower-priced Drugs of Abuse Testing business and the continued challenges on the AP side of the business, which is higher priced. With that said, the base business, the underlying revenue per rec continued to be pretty stable, and we don't foresee anything that would cause that to change dramatically this year.

[Operator:]

Our next question or comment comes from Darren Lehrich from Deutsche Bank.

[Darren Lehrich:]

I just want to go back to the volume guidance. It's actually worse than the back half of the year versus what we've obviously seen the last couple of quarters, and this is coming at a time when I guess, theoretically, sales productivity should be ramping up from some of the initiatives you made in sales force. So I guess I just want to go back to your comments to just understand what's really changed in your mindset. You've said that there's some Managed Care membership churn. You cited the AP weakness and the continued trends in the physician visit, and I guess the new comment will just be around the health plan membership churning because the other 2 issues have been with us. So what's really changed, I guess? Is there something very different that you're seeing in the utilization environment? Can you just help us think about that in the context of your sales force that should be ramping and more productive in the second half of the year?

[Robert Hagemann:]

Darren, this is Bob. Let me answer part of it, and I know Surya is going to want to comment on the sales force aspect of it. With respect to the change in guidance, while we don't provide guidance for revenue per rec and volume, I would tell you that our expectations for full-year volume have been reduced principally as a result of what we've seen. That doesn't necessarily mean that the volume that we expect in the second half we expect to be worse than the volume that we've experienced in the first half. The point was our expectations for the full year have changed principally because the market is softer than we expected when we first put volume guidance out there.

[Surya Mohapatra:]

And as regards to the sales, as I mentioned, that in some areas, we added 100 people in different areas

[Darren Lehrich:]

And just as it relates to AP, I mean, is there any updated comment you could provide around trends? I think there was a period beginning mid last year where the message was that you saw a little bit of a moderation in the insourcing trend. Is that still the case? Or I see what you said in your prepared remarks, but has there been a negative shift there?

[Surya Mohapatra:]

Well, first of all, I think Anatomic Pathology is a very important aspect of cancer diagnostics, and that's not -- the demand for Anatomic Pathology is not going to go away. What is changing now that we saw in the beginning, as I mentioned, that there is more insourcing with GI and GU and that is moderated. And now it's going through a little bit of dermatologist and hemato-oncologists. I think all I can tell you is that the rate of internalization may have decreased a little bit, but we're still expecting this year we're going to be challenged. But again, this is a temporary challenge when you consider cancer is an unfortunate disease which is growing, and there's a lot more diagnostics required with the therapy. So we feel that we are positioned appropriately, and this is going to flatten out. But we are expecting the rest of the year that we will still be challenged in AP as far as the insourcing. It may not be as bad as last year, but still it is challenged.

[Darren Lehrich:]

So Bob, it was down 10% last year roughly. Is it tracking kind of in the upper single digits decline? Is that the way to think about it?

[Robert Hagemann:]

Darren, we haven't disclosed that, and we try not to provide too much guidance on the components of the business, again, obviously for competitive reasons. But we have been making it pretty clear that, that business continues to be soft.

[Darren Lehrich:]

Okay. And then my last question here is just back to the $500 million initiative. I'm curious just to know how involved the board was in developing that, and what the range of options were that you had on the table in the board discussion around a cost initiative. Maybe just enlighten us a little bit about how that process developed, if you could.

[Surya Mohapatra:]

Well, first of all, this is a very interesting question because I don't comment on the board discussion. But obviously, if the board and the management are aligned, all of us will now be doing these things. The ultimate goal and the one which I am focused on and also Bob and my management team is to grow the top line and the bottom line and we have to do what we have to do to run the business.

[Operator:]

Our next question or comment comes from Amanda Murphy from William Blair.

[Amanda Murphy:]

Just to follow up on Darren's outsourcing question. Can you talk about dermatology, rather? Is there another or other areas going forward that you could see outsourcing take off? And we've heard some noise about it in [indiscernible] commentary for example, that could maybe drive the next wave. Or is it pretty much the last feasible area? And then I guess another question there is on the regulatory side, any updates on just the model in and of itself and the sustainability?

[Surya Mohapatra:]

As regards to the flow, any molecular diagnostics and any flows under there are very complicated tests, and I think that will be less insourced than just the histology. That's what we see. And the advantage for a company like us is to combine clinical pathology, anatomic pathology and molecular diagnostics and that's how we still do the business with us. So I think the main insourcing is going on with the specialties for histology rather than molecular diagnostics, because it's a pretty complex thing to run and maintain.

[Kathleen Valentine:]

And the effort legislatively, Amanda, we continue to work hard to educate the folks in Washington on the issue. It's active, it's very active, but it continues. There's nothing of significant note yet, but we continue to work very hard with our trade association.

[Amanda Murphy:]

Okay. And then in terms of Celera and Athena, it seems like those 2 transactions or deals sort of are in line with your expectations in terms of the revenue that was added. I'm curious and it may be too early at this point, but now that they're kind of internalized, do you have any updated perspective on the opportunities for top line synergies? And then how much of that piece is contemplated in your guidance?

[Robert Hagemann:]

Well, certainly, as we told you when we acquired each of those businesses, we think that there's significant opportunity to accelerate their growth as part of being Quest Diagnostics, in terms of making our infrastructure and network available to them or connectivity or patient service centers or sales force, just access to the physician and hospital customers that we serve. And we feel very good about that opportunity, and we're executing against that now. Surya mentioned SMA, we're feeling very good about how that's progressing at this point, and our excitement about both of those deals continues to be very high.

[Surya Mohapatra:]

It's going to give us a pipeline of products. We didn't have SMA and with Athena, it's going to grow across the network. And same thing will happen with Celera and BHL, we'll provide our physicians some of the unit product BHL provides and some of the IVD products Celera provides. So we are pretty excited about our recent acquisitions.

[Amanda Murphy:]

Okay. I guess just last one, and I think people have asked this different ways. But just some of your comments on the sales force side, you mentioned that it's going through well, but there's work to do. Could you speak to some -- is that specific area where there is work or that's just a commentary on the macro environment?

[Surya Mohapatra:]

Well, first of all, when you are bringing in some new people that you are adding to the industry, people are different. It takes time for them to learn the business, learn the industry and at the same time we have some macro environment. So that's one thing. The second thing is we -- in some areas, people have come up to speed, and they are really meeting their quota. In some areas, we have to fully train them all, and we have to refine. But this is a process in which the sales force have pretty much improved. However, having said that, I'm glad that we have done these things because we are getting prepared for whenever there's an opportunity, we will be there before anybody else.

[Amanda Murphy:]

So you're not seeing, other than outsourcing, a change in the competitive environment in one particular area?

[Surya Mohapatra:]

No. Well, first of all, this is still a very competitive marketplace. Many of our customers and even our competitors, whether they're hospitals or whether they're commercial labs and other stuff, we win in some areas and we have lost in some areas. As I mentioned, that we introduced SureSwab. Women's health is a large business for us, and we had weakness in that product offering. And now we plug that weakness by introducing SureSwab and SMA. So we take competition seriously. And in some areas, we have lost some accounts to competition, and we are going after those accounts.

[Operator:]

Our next question or comment comes from Steve Valiquette from UBS.

[Steven Valiquette:]

I'm just trying to piece everything together on the volumes, a lot of commentary, obviously. Can you just comment on how you see your overall organic volume trends in 2011 year-to-date versus the overall independent lab market volume trends?

[Robert Hagemann:]

Yes, as we look at our organic volume growth year-to-date, it's relatively flat. Again, we can point to physician office visits as an indication. The other thing I would point to is as we look at the volumes that come in to our esoteric testing facilities from reference labs, i.e., they're customers but they're also competitors, we see those down as well. I think that there's clearly a softening in the market, which is impacting volumes. And that, we believe, is the principal contributor to what we've seen in terms of the softness here.

[Steven Valiquette:]

Right. When you say flat, you mean flat with the market. So you think your volume trend is in line with the overall independent lab markets. Is that what you're trying to say?

[Robert Hagemann:]

Again, it's hard to say. There's not good data available on the market. We look at the data points that I just referenced here. And relative to those, our volumes seem like they're performing as you would expect overall. Well, we still think that we have opportunity to improve our performance. It seems as though it's relatively consistent with some of the broader market indicators that we see out there.

[Operator:]

Our next question or comment comes from Anthony Vendetti from Maxim Group.

[Anthony Vendetti:]

There was a comment in your prepared remarks about gene test growth moderating. Can you talk about it?

[Surya Mohapatra:]

Yes. I think that's actually -- I made a comment about Vitamin D, although it grew double-digit, but the rate of growth is moderating. So Vitamin D testing.

[Anthony Vendetti:]

Can you give us a percentage overall either on Vitamin D or just overall genomic and esoteric testing, what the growth was this quarter year-over-year? And what your -- if the moderating of any of that growth is a longer-term trend, does that push off your goal of getting up to a certain percentage of your overall clinical testing as a percentage?

[Surya Mohapatra:]

Well, first of all, we really don't give any particular test or a particular component. And the reason why I made that comment is because obviously everybody knows that Vitamin D has tremendous growth over the last 2 or 3 years, and it is appropriate for us to really tell you that although it is growing, it is not growing at the same rate as before. As far as our goal of being the leader and provider in gene-based and esoteric testing, that does not change because one goes down, one may come up. And as I mentioned that we introduced a number of other tests which are going from a small base whether it is colorectal, whether it's OVA1, whether it is SMA. So the pipeline is good. We have a good number of tests in gene-based and esoteric testing, and I feel pretty encouraged that, that market is growing faster than the routine. And we have been investing, and we'll continue investing that area to take advantage of the fast-growing market there.

[Anthony Vendetti:]

So do you expect that to be about 40% of overall testing at a certain point?

[Surya Mohapatra:]

At the moment, it's 36%. And again, we have not given any set goal. And as you know that what is esoteric today, may be routine in 3 or 4 years.

[Anthony Vendetti:]

Right, right. Lastly, are there any big Managed Care contracts that are coming up for renewal either in 2011 or beginning of 2012 that we should be aware of?

[Robert Hagemann:]

Anthony, some of our largest, many of our largest contracts go past 2013. There's always contracts coming up every year, but some of our largest ones are now locked in for long periods of time.

[Anthony Vendetti:]

Okay. So anything that's over like 5% of sales is not until 2013?

[Robert Hagemann:]

As I said, some of our biggest contracts are locked in. I don't want to get into specifics.

[Operator:]

Our next question or comment comes from Kemp Dolliver from Avondale Partners.

[B. Kemp Dolliver:]

Great. Just a follow-up on the Vitamin D commentary. Do you think that the slowdown in Vitamin D testing is a function of some of the recommendations or at least media attention in the last few months, noting that there's probably not the need to test as many patients or to test them as frequently?

[Surya Mohapatra:]

Well, I think -- well, first of all, the rate of growth in Vitamin D has been tremendous. So you cannot really continue with that rate of growth. So that's number one. Number two, I think there will be continued positive and negative, but I think what you are seeing is actually just the rate of growth. And the early adopters are slowing down.

[B. Kemp Dolliver:]

Okay, super. Second subject is looking into next year. I know you're not giving guidance, but it looks like based on the June CPI that Medicare under the clinical lab fee schedule could be slightly up next year versus the reduction you took this year. Does that look about right, right now?

[Surya Mohapatra:]

Well, that would be good, wouldn't it?

[Robert Hagemann:]

That is correct. The CPI which is used as the basis for the adjustment next year, I believe, was 3.6%. That will be reduced by a productivity adjustment and then the 1.75% that was a give back as part of healthcare reform. That productivity adjustment still has to be finalized. There are some estimates out there that it'll be about 1.2% or so. When you do the math, that gets you down to about 2/3 of 1% increase potentially in the Medicare fee schedule. And that's going to be relatively immaterial amount to us, although certainly better than a reduction.

[Surya Mohapatra:]

Well, if there are no more questions, I would like to say in closing, in the quarter we grew revenues and adjusted EPS and started the integrations of Athena and Celera. We announced short-term cost actions and are embarking on a multiyear initiative to improve our profitability. Diagnostic testing continues to have tremendous potential for growth. We are the clear leader with unique assets and value, and we are building on our strength and focused on execution. Thank you all for joining us on our call this morning. Operator?

[Operator:]

Thank you for participating in the Quest Diagnostics Second 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 [phone] for domestic callers or [phone] for international callers. No access code is required. Telephone replays will be available 24 hours a day until midnight, Eastern Time, on August 20, 2011. Goodbye.