Quest Diagnostics Incorporated
Q3 2013 Earnings Call Transcript

Published: 17 Oct 2013

[Operator:]

Welcome to the Quest Diagnostics' Third Quarter 2013 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 expressed written consent of Quest Diagnostics is strictly prohibited. Now I'd like to turn the meeting over to Dan Haemmerle, Executive Director of Investor Relations for Quest Diagnostics. Please go ahead, sir.

[Dan Haemmerle:]

Thank you, and good morning. I'm here with Steve Rusckowski, our President and Chief Executive Officer; and our new Chief Financial Officer, Mark Guinan. In addition, our Senior Vice President and Chief Medical Officer, Dr. Jon Cohen will be joining us for Q&A. 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' 2012 annual report on Form 10-K and 2013 quarterly reports on Form 10-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 Investor Relations' Quarterly Update 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 Steve Rusckowski.

[Stephen H. Rusckowski:]

Thanks, Dan, and thanks, everyone, for joining us today. I'd like to start by taking us through the top line performance, share our thoughts on utilization and reimbursement trends as well as review progress against our 5-point strategy. Then Mark will provide detail on the results. Well, first, clearly, our third quarter performance was disappointing. We recognized that we have missed expectations this year and revised our guidance more than once. We understand it is extremely important to achieve expectations, and we are focused on improving our predictability. Our current view reflects 2 changes, the impact of a softer market than we originally expected and the fact that our strategy to reserve growth is taking longer to produce results. Before commenting further, I'd like to welcome Mark Guinan, our new CFO. Mark brings strong financial operations experience to Quest, providing us with a fresh perspective on how we can improve our performance and predictability. Mark and I are already deeply engaged in driving shareholder value by executing our 5-point strategy. Now let's turn to the market dynamics. All year, we have been saying that we anticipated continued revenue softness in the first half of this year, and that our efforts to restore growth would result in gradual improvement during the back half of this year. Although we have seen a gradual improvement in performance versus the prior year, our third quarter performance was less than we expected. As a result, we fell short of expectations for the period by approximately $50 million. As we all have seen from commentary from industry stakeholders including hospitals, physicians, payers, suppliers, competitors, the healthcare industry overall is facing utilization headwinds. At the start of this year, our expectation was that 2013 would have about the same level of utilization we saw in 2012. In the first half, we saw clear signs that health care utilization had declined versus last year and at this point it appears this trend continued. As we reported to you last week, despite seeing some hopeful signs early in the quarter, volume softened late in the quarter. Overall, despite the soft finish to the quarter, volumes remained in line with our previous run rate as organic volumes. Adjusted for our business days, they were lower by 2% versus the prior year. As I said earlier, in addition to the continued soft market, our initiatives to restore growth that we've been planning on to contribute in the quarter are taking longer to show results. Additionally, this industry also faces considerable and ongoing pressure on reimbursement. In 2013, reimbursement challenges have become much more pronounced. This includes the reductions in Medicare payments of approximately 5%; the cuts to pathology codes on Medicare physician fee schedule; the changes to Medicare fee schedules, including requirements from molecular diagnostics; and finally, the effects of renewed commercial payer contracts. These changes, just this year, contributed to the lowering of underlying revenue per requisition by 3.3% in the third quarter compared to 2012. We now expect underlying revenue per requisition before acquisitions to be down a similar percentage for the full year. On a full year basis, our price erosion will be greater than $200 million in 2013. Also, we're going to see traders [ph] association has been fighting additional cuts that have been proposed or discussed. This includes a measure to extend the fixed rate reduction of the clinical lab fee schedule through 2023, as mentioned in the President's budget proposal in April. And CMS has proposed significant changes to the physician fee schedule and a mechanism to adjust to clinical lab fee schedule in the future, as was reported in July. We are operating in a challenging environment, at the same time, we are making the changes to the way we operate. Together, these factors have affected our progress to restore growth. Now let me give you an update on our efforts and the progress we're making executing our 5-point business strategy. First, let me start by looking at how we are refocusing on Diagnostic Information Services. We have made significant progress on our portfolio review. Since last year, we sold our OralDNA dental diagnostics business, HemoCue diagnostic products business, ibrutinib royalty rights and, most recently, Enterix, all jittering gross proceeds of approximately $800 million, providing us flexibility to drive shareholder value. Our portfolio review is helping us deliver disciplined capital deployment. Our commitment is to return the majority of our free cash flow to our shareholders. During the quarter, we increased our share repurchase authorization by $1 billion and, in September, we entered into an accelerated share repurchase agreement to repurchase approximately $350 million of our shares and then, finally, year-to-date, we have deployed nearly $1 billion in share repurchases. In addition, our goal is to generate about 1% to 2% revenue growth per year through strategically aligned accretive acquisitions. So far, we have completed 4 acquisitions, including the lab outreach business of University of Massachusetts and Dignity Health as well as Concentra's toxicology business and, most recently, ConVerge. Our first 3 acquisitions are on track and contributed 2% to revenues in the third quarter. In October, we completed the acquisition of ConVerge, our second this year in the New England market. Next, we're making progress driving operational excellence. With Invigorate, we are on track to realize more than $200 million in savings this year and remain committed to our goal of $600 million in run rate savings next year on a path to $1 billion beyond 2014. This strategy, in addition to making us more efficient, will also allow us to improve our customer experience. Now most importantly, we are building the capabilities we need to restore growth. Our commercial reorganization is complete. As we have said, restoring growth is a gradual process and it takes time. We have made investments on our clinical franchises and the laboratory professional services business. These investments are critical to helping us restore growth. The clinical franchises are beginning to deliver new solutions to meet customer needs and will help us grow esoteric and advanced diagnostic solutions. To give you an example, we're very excited to introduce BRCAvantage, a new choice of BRCA testing, that's intended to significantly broaden patient and provider access to testing for BRCA gene mutations associated with increased risk of inherited breast and ovarian cancers. Quest BRCAvantage is based upon next gen sequencing technology, an expertise of cancer genetics and women's health matched by none and a rich service approach designed to better health care experience for the patient and the clinician. Our laboratory professional services team continues to expand its pipeline for hospitals of integrated delivery networks that are interested in working with us to improve outcomes and reduce costs. And then finally, we also continue to simplify the organization and build a culture so we can improve our operations and grow. We built an organizational structure to better service our customers by removing complexity, speeding decision-making and empowering employees. Along with this, we introduced new behaviors that will make us more agile, customer-focused, transparent, collaborative and performance-oriented. This week's launch of BRCAvantage demonstrates the power of our new organization and culture. Our key ancillary clinical franchise team work collaboratively with colleagues across our enterprise as well as externally with customers, suppliers and key opinion leaders to quickly develop and introduce this important solution. We're looking forward to launching many more successful solutions in the future. While we are in a difficult operating environment, we are taking the right actions to make our company a stronger and more effective competitor. We are making progress and recognize that there is much more to do. Now I'd like to turn it over to Mark for a detailed analysis of the numbers. Mark?

[Mark J. Guinan:]

Thanks, Steve. As you and I have discussed, I have several priorities for the finance function. These include improving our predictability and supporting the business to achieve our 5-point strategy, starting with improving operations and restoring growth. I can assure the investment community that I recognize the importance of delivering on guidance, and we will instill the discipline to improve our predictability. I don't like surprises and recognize that investors like them even less than I do. Turning to revenues. Third quarter of consolidated revenues, $1.79 billion or 1.9% below the prior year. Diagnostic Information Services revenues, which account for over 90% of total revenues, were 2.4% below the prior year. Volume was better than the prior year by 2%. Our first 3 acquisitions completed this year

[Stephen H. Rusckowski:]

Thanks, Mark. Well, to summarize, 2013 is a building year for Quest. We are focusing on implementing our 5-point strategy in the challenging environment with a particular emphasis on our strategies to restore growth. This will require us to improve our execution. Our recent BRCAvantage launch demonstrates Quest's ability to empower better health with diagnostic insights. And this illustrates a great example of our innovation will help us restore growth. Despite the current tough environment, we believe we operate in a very attractive market, and our 5-point strategy positions Quest to deliver superior shareholder value. Now we'd be happy to take your questions. Operator?

[Operator:]

[Operator Instructions] Our first question comes from Kevin Ellich from Piper Jaffray.

[Kevin K. Ellich:]

Steve, I guess, starting off with -- one of the things that you guys called out in your press release last week was the 50 basis-point impact from increased denials on the molecular test. Will you be able to recoup the 50 basis points that was lost at some point or is that gone forever?

[Stephen H. Rusckowski:]

Yes, good question, Kevin. Let's give you a little more clarity on what we were talking about there. It has to do with really denials for our diagnostic-related charges that are in this molecular diagnostic category. And as you know, there's been quite some discussion in the past about this code stacking and then also the new proposals. And we've commented in the past, we think, on the price side, we were okay. And then, actually, we got into the quarter and we see some issues associated with getting paid. So I'm going to turn it to Dan to give us a little more color on the specifics of what we saw and how much of that could come back to us.

[Dan Haemmerle:]

Yes, sure thing. Thanks, Kevin, for the question. As we think about the molecular diagnostics issue and we think about pricing in general, first, let me say this. We said that reimbursement pressure would be about 3% in the year from government commercial payers, if it continues to be in that zone, so that we should be -- we're still in line with -- in terms of fee schedule erosion. We also share, when you think about revenue per requisition, that we see some favorable test mix and test per requisition, and that would be offset by some unfavorable business mix issues, okay, as our wellness and toxicology business has continued to grow. In this quarter, we saw a deterioration in the overall revenue per requisition, not necessarily fee schedule-related, but more due to test mix as well as the molecular diagnostics issues. And when we think about the molecular diagnostics issues, it has turned into -- resulted in a softer test mix benefit than originally anticipated. And as we look to those denials, some of the denials are related to some tests that we recently launched during the course of the year and have been growing, so we'll see some unfavorability there versus expectations. And then also, we do, as you know, perform reference testing for about half the hospitals around the country. We've had some clients that have started to see denials on their end a little bit later and, in an effort to maintain their profitability, have started to alter their ordering patterns, okay? And as they've altered some of those ordering patterns, we've seen changes, again, in our -- it would show up in our test mix. So denials, probably on their end, that resulted in softer test mix. So some of this -- is there an opportunity to continue to work this and get some improvement in the future? We will be working it and hope to get some improvements. But at this point, it's early to say, and we know the prudent thing to do would be to record our revenues right where they are.

[Kevin K. Ellich:]

Okay, that's helpful, Dan. But you mentioned you launched some new tests this year. I was just wondering if some of those tests have CPT codes assigned or are those tests -- I mean how big of an issue was that? And should we expect this kind of 50 basis-point headwind to continue?

[Dan Haemmerle:]

I would expect some portion of it to continue to the end of the year.

[Kevin K. Ellich:]

Okay, that's helpful. And then, Steve, just going back to your prepared comments, you talked about weaker utilization this year. You saw it in the first half and in the latter part of the quarter impacting your volumes. I was just wondering, what makes you think this is an industry issue? Obviously, we thought -- I'm on the same page, I think, overall utilization is a little weaker. But do you think there's any company-specific issues here? I mean could you guys be losing share to some of the smaller labs or even the hospital-based labs?

[Stephen H. Rusckowski:]

Yes. Good question, Kevin. So we -- and, obviously, you're looking at what's happening in the marketplace and the results are starting to come in. So on the utilization front, as I said in my prepared remarks, and I've shared this with you before, we entered the year thinking that it will be about the same levels as we had last year and, in fact, it's been worse. We expected that Q3 would be similar to what we saw in the first 2 quarters. And actually, as we have seen regarding to the quarter, beginning of the quarter, we actually were encouraged. And then as we got through midpoint of the quarter, it started to slow down. And we actually have gone back and looked at kind of our underlying business. Operationally, I talked about our reorganization of our sales force, we're putting more focus on operational excellence. Yes, that's about efficiency but, as importantly, it's about enhancing our customer experience. And when we look at our underlying performance and if you look at the key measures and if you go back and look at -- we do look at this sort of top 1,000 accounts and say, "What is happening between Q2 and Q3? Is there anything exceptional in there?" What we see is less utilization. Also, when you go back and look at sort of where we might be picking up accounts or where we might be getting some defections related to hospital in-sourcing, it was about where we expected. So the big change, really, for the quarter is related to our belief that some of the programs we've put in place with our sales force, with our new products and with our professional services business would yield more than what we delivered, and that's the $50 million I commented to. But overall, if you look at the marketplace, and if you look at how we compete with regional labs, how we compete with some of the national -- large national labs, we look at our customer experience, we look at our product offering, we look at our access, there's no notable change in that. And actually, we are improving as our plan -- as it's improving throughout the year. So that's our take on the quarter. Obviously, we're still digging into exactly what's happening in each of the regions, what's happening by each of our payer types, what's happening by product category, and we'll have more knowledge about it as we go forward. But as we sit right now, that's our perspective on the quarter.

[Kevin K. Ellich:]

Understood. And then one last question here, Steve. So apparently, there has been some guideline changes for women's health on the paps. Just wondering if you guys have had a chance to assess how much of an impact do you think this will have on your women's health testing business?

[Stephen H. Rusckowski:]

Yes. The guideline changes for pap.

[Jon R. Cohen:]

Yes. The guideline changes...

[Stephen H. Rusckowski:]

This is Jon Cohen.

[Jon R. Cohen:]

Sorry, it's Jon. As you know, these guideline changes do change to more than -- to less frequently than 1 year. And I think, in general, everyone is going to see some decrease in pap testing as a result of that, as physicians, particularly OBs and primary care, begin to seriously engage with the new guidelines that we're offering.

[Operator:]

[Operator Instructions] And our next question comes from Tom Gallucci [ph], FBR.

[Unknown Analyst:]

I guess, just on the volumes, for my first question then I'll ask a follow-up. Curious about the trend that you're saying you saw there was a little stronger in the first part of the quarter and weaker in the second part. Just trying to understand the magnitude of the dropoff that you saw or exactly what you're relaying here in terms of the trend.

[Stephen H. Rusckowski:]

Yes. Well, we are starting to get some data back from some of the industry watchers. And it appears that things did drop off in terms of physician visits in September more than what we had seen at the beginning of the quarter, so that's tracking with what we experienced. And second is I just saw -- we just are digesting some hospital admission data and it looks like the same happened on the hospital side, too. So it was tracking, actually, in the first part of the quarter, Tom, better than what we had experienced in the first half, and then it went to a place that was lower than what we saw in the first half. So -- and on average, it's about what we saw in the first half. But we were hopeful in the early part of the quarter that things were actually improving somewhat versus what we had experienced in the past. So it's our best perspective on this, and we're trying to understand how much of this is the market, the environment, utilization, what could have been the causes for that and also what has -- Kevin asked earlier, what portion of it is us versus the competition versus what we expected versus our plans, so we're going through all that. But as we sit right now, the biggest shortfall in the quarter is related to not executing as well, is the programs that we put in place and that we had planned on in our guidance, and that's the $50 million. When we got through the quarter, you can say when the dust settles, it was a little better than the first part of the quarter, less in -- that part of the quarter overall utilization was about, for the quarter, what we have seen in the past 2 quarters. That's not it. But we actually had planned on getting more out of our restored growth initiatives. And as we said, they're still valid. We have the resources in place. It's just going to take more time for us to see the benefits of those.

[Mark J. Guinan:]

And I just want to add -- it's Mark -- a majority of the $50 million miss came in September, so -- and I do want to make that clear. And historically, September has been a strong month for us. So we were actually, based on where we were at early in the quarter, we were expecting some momentum in September and we saw the dropoff. Now back to Steve's point, when you look at the quarter in total, the overall health of the business, frankly, utilization was pretty consistent with the first 2 quarters of the year. So while September was disappointing, when you look at it in light of the whole quarter, it seemed like it just was a continuation of the year. But earlier in the quarter, we felt like things were turning.

[Unknown Analyst:]

Okay. Is that new guidance just to clarify, is more of a run rate that you saw in September or is it really the average for the quarter?

[Stephen H. Rusckowski:]

Mark?

[Mark J. Guinan:]

It's really looking at the quarter. We're not building off September and assuming that's indicative of what the balance of the year will be.

[Unknown Analyst:]

Okay. My bigger picture sort of follow-up was just on use of cash. Obviously, you guys are describing a difficult environment. You bought back a lot of stock, you've done some acquisitions. In the environment that we're in, how do you sort of think about the visibility you have on acquisitions performing or on your own business performing and the stock being a good use of cash versus doing dividends or acquisitions in different lines of businesses? I'm just wondering how you're thinking about the use of cash in this difficult environment.

[Mark J. Guinan:]

Yes. We're committed to our 5-point strategy. And as we look at the acquisitions, as we mentioned in our prepared remarks, they're on track, so the 3 that we actually integrated at this point. So we continue to feel that's a good use of cash. And in terms of other use of cash, whether it's dividend or share buybacks, we've said we're going to return the majority of our free cash flow to our shareholders and we're going to continue along that strategy.

[Operator:]

Our next question is from Ricky Goldwasser from Morgan Stanley.

[Ricky Goldwasser:]

I have a couple of questions. The first one is on the Invigorate cost savings. So I think that the implied guidance assumes about $160 million to $170 million of incremental savings in the second half of the year. And when we kind of like think about the business, the acquisitions, doing back of the envelope analysis, we get to Invigorate incremental savings of around $60 million to $65 million in the quarter. So I just wanted to confirm that. And should we -- is it reasonable to think that you're going to see another kind of like 40% of sequential uptick in the savings that you're seeing coming through in the fourth quarter?

[Stephen H. Rusckowski:]

Yes. So let me go through what we said before and my perspective, and I'll turn it to Mark to round it off. Well, first of all, what we have shared is that we have a goal of $600 million run rate savings by the end of 2014, so we're standing behind that as I said in my prepared remarks. We actually are encouraged by the rate of change we're making with Invigorate, and we need it to offset the headwinds we have in this industry. And as we said before, we have our foot on the accelerator to get as much out of it as possible, so that continues. What we also have shared is that last year, in 2012, we were exiting about $200 million run rate and we've never provided a run rate for 2014 -- 2013, but what we have said is that we would save -- deliver savings $250 million this year. We are well on our way to save that this year, that's $250 million. We also said, as you recall, about twice as much in the back half than the front half. So if you go through the math, as you have done, Ricky, that would save -- that would be somewhere in that range that you discussed. But also it says, given the rapid pace of improvement that we're making on our cost structure, there is a ramp, and that ramp means that we'll have a ramp going into the fourth quarter versus the third quarter. So with that as just refreshing our guidance on this, I'll turn it to Mark to round it off.

[Mark J. Guinan:]

Yes, sure. Ricky, as I mentioned again in my prepared remarks, some of the Invigorate savings is volume-dependent. And we were tracking actually ahead of our plan in the first half of the year, and we're expecting to deliver something north of the $250 million that we communicated externally. As volumes have softened, we're expecting to still meet our commitment of over $250 million, but not quite reach the levels that we had thought and had projected and built into our expectations for the full year. So therefore, the ratio of first half to second half has been impacted by 2 things

[Ricky Goldwasser:]

Okay, that is helpful. And then, just as a follow-up, regarding the code stacking kind of like reimbursement delays, does this relate only to Medicare or are you also seeing some of that's playing over to the commercial side?

[Stephen H. Rusckowski:]

Dan, why don't you take that?

[Dan Haemmerle:]

Yes. We have seen it with other payers in -- on the commercial side, Medicaid side. And keep in mind, as you go through this with different payers in different states, even on the Medicaid side, different payers are implementing on different timelines and they're taking different approaches to this. But we still have some payers in different states that were actually billing with the old coding system, okay? And so we expected that some of these will continue to move but, at this point, we are seeing it across multiple payers.

[Operator:]

Our next question comes from Bill Bonello, Craig-Hallum.

[William B. Bonello:]

A question and a follow-up. I want to revisit something you kind of touched on earlier, but maybe push you a bit more on it. I guess I'm kind of flummoxed by the degree of attention that you are placing on sort of the challenging macro environment. I mean, if I look at your performance compared to the only other national lab, it's been incredibly divergent over the last 3 quarters, with you guys obviously performing significantly more poorly. And I guess, what I want to understand is how we can get comfortable that you're accurately assessing what problems really might be performance-based rather than macro-driven and what you might be doing to address those. And then I do have a follow-up.

[Stephen H. Rusckowski:]

All right, Bill. Thanks for the question. First of all, we only have access to our data, and we see what you see in terms of our competitors and what competitor you're referring to. As you see and what we have said is that our underlying volumes, when you do all the adjustments and just look at the organic volume for Q3, it was down by about 2%, that's adjusting for days and adjusting for -- everything we adjust for with our acquisitions. And that's about at the same levels we have seen for the last 2 prior quarters. With that said, you then look at what we had expected from each of the different categories of our operation. We have different mixes of business and different areas of focus than some of our competitors. And I would say that in 2 dimensions, one from a product perspective or a service-line perspective and the second is from a geographic perspective. And so when you look through our business and you look at our pathology business, and there was earlier questions about pap smears, and there's a dynamic going on with that business, which we understand and we're trying to track. Second is, if you look at our overall business versus others in primary care versus specialty care, we're actually looking at a routine business versus our esoteric and advanced business. If we look at our payer mix, we're also quite interested, as you would expect, at what's happening with our prayer partners and how they're growing or not growing, and that could affect our performance as well. So you go through the whole calculus and all we can do is control what we do control. And so what we're focused on in our strategy to restore growth is number one, a better commercial organization or sales organization that does a better job calling on our customers to make sure that we have the best superior experience that we can for our customers that we can. This includes on how we sell to them, how do we service them and, in any length, some portion of this marketplace that is growing. And so that's why we put that in place. Second is we created an organization around clinical franchises. This clinical franchise organization is putting more emphasis of getting more solutions to the marketplace that is much more aligned with what you see from another portion of the marketplace that is growing, which is sometimes referred to as the boutique or specialized laboratories. Our BRCAvantage introduction this week is a great example of the new organization that we put in place. From the Supreme Court ruling in June to today, we sped up. Quickly, we get to this -- to the marketplace. We're quite excited about that as an introduction and we're encouraged by that. So again, we're controlling our own destiny. We're introducing more to the market at a faster pace than ever before. And then, finally, is we're building a professional services business. And I'll share with you, this is gathering traction. It's gathering traction because many hospitals and integrated delivery networks are quite interested on what their strategy is going forward and how we can help them with that. Some of that took the form of 2 acquisitions this year with hospital outreach, but you'll be hearing about more laboratory management and professional service relationships with a number of systems as we go forward because our funnel is building. So we're encouraged by that. So you look at, fundamentally, how does business go from one of our competitors to the other and vis-a-vis how we compete versus those competitors, we think we're focused on all the right things. We're focused on the things that are going to drive volumes. We also understand, and you understand, that we've had a significant reimbursement change this year. Our guidance this year is about 3% change in price. We have our fair share of the cuts in Medicare, which are outlined in my remarks, but also, we had a number of commercial contracts that anniversaried and we renegotiated those terms, and that's in the 3%. So if you look at the top line and you look at price erosion for us versus some others, we had a year where we paid out, if you will, in price concessions about $200 million, and we're offsetting that as well. So we believe that we're working on the right things. We're disappointed by Q3. We do believe it's a difficult market with a lot of headwinds. However, we need to work on the things we do control. We believe our 5-point strategy. If you look through the 5-point strategy as the right strategy, if you look at the results, 4 of those points are tracking very well. The one we're disappointed in is our strategy to restore growth. We think those initiatives that are outlined are the right initiatives. Where you look at the marketplace and look at where people are growing, what I just outlined there is what is going to make a difference for us so that we do restore growth. So that's my best summary of what we've done vis-a-vis the market and vis-a-vis the competition.

[William B. Bonello:]

Okay, great. And then just a follow-up related to that. You've been here a couple of years now. In light of what you believe to be an extremely difficult macro environment and in light of the challenges that you still have in front of you, trying to cut costs and make some pretty significant operational changes while also trying to restore volume growth, I mean have you given any thought to -- that maybe these are things that would better be achieved as a private company? And are you exploring strategic alternatives at all? Any openness on the Board to a sale where there hasn't been in the past?

[Stephen H. Rusckowski:]

Okay, Bill. So first of all, I started here in May 2012. So time does go by fast, but not that fast, so not quite 2 years. But in relation to your question, this is a tough environment. However, we do believe we operate in a very attractive market and we do believe that our 5-point strategy positions Quest very well to deliver superior shareholder value. And with that said, we do believe we're operating in the right way. We believe we are making the proper investments. We do believe that our plan is the best value-creation plan irregardless of our ownership, so that's our focus, is our 5-point strategy in building shareholder value.

[Operator:]

Our next question is from Gary Lieberman, Wells Fargo.

[Gary Lieberman:]

Mark, just wanted to go back to one of the things that you had said, maybe just to get some clarification. You had mentioned that the Invigorate savings were, at least, in part, volume-dependent. And so some of those soft volumes had been slowing that down. Can you just talk a little bit more about what the exact relationship is there?

[Mark J. Guinan:]

Sure. Within our cost structure, obviously, there's fixed costs and variable costs, Gary, and we're not just saving on fixed costs, we're also saving on the rate on our variable costs. So therefore, the dollar figure that we've been quoting was based on a certain level of volume revenue. And as we have less volume, obviously, the dollar, not the proportional savings, on our variable cost is going to be lower.

[Gary Lieberman:]

Okay. That's -- that make sense, that's helpful. And then Steve, you had mentioned, I don't know if you'd threw or put this number out there before, sort of the $200 million in price concessions this year, can you characterize those to some extent or is there anything that you could have done differently? Maybe you did not have to have -- have had those, and sort of where are we in terms of those anniversarying so that maybe the impact isn't quite as much on a year-over-year basis?

[Stephen H. Rusckowski:]

Yes. So let me open it up and turn it to Dan to round it off. First of all, we have said from the beginning of this year that our price erosion will be 3%. So then you go through the 3%, 3% on our business is greater than $200 million, so it's consistent. We haven't shared the exact $200 million, but it is a big number for us and that's what we planned on. As you know, we have a pretty -- we have a very good line of sight on our pricing. It's a good part about this business. Why do we have a good line of sight? We knew what was going to happen with Medicare. We actually planned in that guidance for sequestration. It wasn't certain, but we wanted to make sure we plan for the worst and hope for the better. So -- and we have shared in our remarks that Medicare was about $50 million of that $200 million, roughly. Now that excludes, and on top of, you need to include the pathology cuts, okay? And the pathology cuts were up sort of substantial, that's 52% of the technical fee and that was a considerable portion of the $200 million this year. And the remainder is related to our price concessions with the commercial payers. Some of that had started in 2012 and carried over into 2013. We had a few renegotiations this year. We actually had shared in our second quarter call that we renegotiated, and we're very happy with our renewed contract with CIGNA going forward, and that's in the 3% or the $200 million for this year. And -- but what we also said, when we were in Investor Day last November, is that we expect, over a 3-year period, that price erosion would be about 1% to 2% over that 3-year period. And what we have also shared is that there is going to be more in 2013 than there will be in 2014 and 2015 as a percentage. However, we still have headwinds associated with all the discussion we're having in Washington around further Medicare cuts as I outlined in my remarks. That's how it all fits together. You asked, "Is there anything you would have done better?" Well, we're going to push -- as a trade association, I would say that the effort we're mounting in Washington to offset any actions to get further cuts beyond what we baked in is happening, so we're aggressively working on that. I sit on the board of ACLA. Dave King is the Chair, I'm the Vice Chair, we're actively working on this with members of the industry to make sure our voice is heard. We think that this industry is, I repeat, substantial yet. We are an industry that represents about 70% of health care decision-making. For Medicare, we represent about 2% of costs. In a world that you're worried about better patient outcomes and getting more data, we're part of the solution to how you make that happen. And if you look at these cuts that are being proposed going forward, not just for us and for our nearest competitor, but if you look at this marketplace with a lot of small regional players, it will be substantial for those regional players since they have a higher percentage of Medicare. So we think we have a strong argument. Our voice is being heard, and we're working on that. On the commercial side, we're working actively with our commercial insurance partners. As I said when I started in this job, I'm actively engaged with many of them. That's a key part of our business. I see health care insurance as part of a -- the transformational link effort in this country. We're making progress with them on how we bring more value to their membership, how we work with them to narrow their networks, to save them money and get us more revenues, which is an opportunity that we both enjoy, so we're working that. So overall, it's about what we expected for the year. The only change is, again, related to the earlier comments about what happened with molecular diagnostics and the coding, which is on top of, if you will, the 3% price concession guidance that we've given for the year. So Dan, would you like to round up my comments?

[Dan Haemmerle:]

Yes. I think you've touched on most of it. The only other question I think I heard in there was around contracts anniversarying. And so we do have contracts that our anniversarying in the back half of the year, both third and fourth quarter. So some of it happened in third quarter, we'll see a little more in the fourth quarter.

[Gary Lieberman:]

Okay. And maybe could you just throw -- you'd also mentioned that you thought it was going to take more time for the growth initiatives to kick in. How does that sort of fit into the comments that you made?

[Stephen H. Rusckowski:]

Well, it's what was the big difference between the third quarter expectations that we've set and what we delivered. And we have the 3 initiatives that we have outlined, those are our priorities for this year

[Operator:]

Our next question is from Glen Santangelo of Crédit Suisse.

[Glen J. Santangelo:]

I just have a couple of questions. First is around the implied guidance for the fourth quarter. It looks like you're using the midpoint of your range and looking for $0.93 in the fourth quarter, which is down almost 10% from what you reported this quarter. And given the benefits you have from accruing from share repurchase, from some of the recent acquisitions and some of the Invigorate savings, what are you implying, I guess, with respect to organic trends? I mean, where are we going to see incremental deterioration in 4Q versus 3Q levels?

[Stephen H. Rusckowski:]

Mark? Thanks, Glen.

[Mark J. Guinan:]

Yes. Glen, I'll try to answer that for you, thanks for the question. Historically, as you look at Q4, it does tend to be a softer quarter than Q3 given the seasonality. I mean, you've got the holidays. As you look at overall billing days, et cetera, there's definitely a reason to suggest a softer revenue quarter even without any trend break in terms of reqs per day and revenue per req and all that. So it's really just taking into account the days that fall within Q4. No significant change in business momentum other than a little bit more lift we're building in for some of the initiatives that Steve talked about. So we're not abandoning our belief that those investments are going to turn the tide. We just are getting a little more conservative, less aggressive in how quickly that will happen. And we're basing that on what we saw in the third quarter.

[Glen J. Santangelo:]

Okay, that's fair. And then maybe if I could just look forward to 2014. I can imagine you don't want to comment on 2014 at this point, but maybe could you at least address that Affordable Care Act? Have you done any sort of internal analysis in terms of what you think that could ultimately mean, how much you think it could help volumes? Any sort of high-level commentary you can give it at this point?

[Stephen H. Rusckowski:]

Sure, Glen. Well, last quarter, as you know, we talked a fair amount about Affordable Care Act. And what we shared is it's taking more time to develop than we originally had expected. We still believe that is -- that the Affordable Care Act is net positive. Net positive for this industry and net positive for us. And the simple underlying principle why that is, is because there's going to be more lives with insurance. And when more people have insurance, they're going to need what we do. Now as you know, with all the change that has happened, this has been muted. Only half of the states have expanded their Medicaid program, which was an entry point for the lives. We all know that the exchanges have been more problematic, but I will also share that we're negotiating with many of the commercial payers on their exchanges. We actually feel good about that. But as you hear and will hear from health care insurance companies, they're being cautious about their ramp into the exchange world. And also you know about all the issues associated with the government exchanges. And then third is with the employer mandate being pushed out. And again, this is another piece of where the growth would come from that is taking this out by a year or so. We had all expected, as we entered 2013, that 2014 would be a year where we'd see some of the benefits, that is, more lives into the system, and more lives in the system, we would benefit from that, and that's, clearly, been pushed out. However, we still believe that the train has left the station. We still believe that more lives will be insured with a variety of products. And we still believe that, in the end, when people have insurance and have access to the health care system, it'll be net positive for this industry and net positive for us. So Dan, anything you like to do to round that off?

[Dan Haemmerle:]

No. I think you touched on most of it again. I think the exchange piece, as we said, we've been negotiating with a number of commercial payers. We're pleased with how those progressed so far, and we have a number of contracts that we've signed. A lot of this will depend on which -- who the big winners and losers are in exchanges in different markets and how many lives are signing up in terms of how it impacts the business. But overall, the rates we're seeing are generally in line with some of the commercial rates that we've seen in our existing contracts to this point.

[Operator:]

Our next question comes from A.J. Rice with UBS.

[Albert J. Rice:]

Maybe just following up and talking about fourth quarter expectations. I appreciate that on the -- income statement-wise, it looks pretty -- or even maybe a little conservative, but your cash flow assumption, you're going to need a pretty big pickup in cash flow in the fourth quarter to hit your target for the year. And I just wondered, is there some items that are going to swing in the fourth quarter that are going to drive -- I think you need more than $400 million to hit your target. And I just -- what's the thinking there, and any impact on capital deployment decisions given a little lower cash flow expectation?

[Stephen H. Rusckowski:]

Yes. A.J., let's turn that to Mark.

[Mark J. Guinan:]

We haven't changed any of our capital deployment plans. And in terms of what's going to give us some uplift in Q4, it's really the -- it's -- the DSOs to a certain extent are a contributor. We had a delay in getting our Medicare provider number and -- for some of our acquisitions. And so we're highly confident that that's going to take place and we're going to get paid. But at this point, that's really been the driver and the spike in our DSOs in Q3 -- in Q2 and Q3, and we expect that to be resolved in Q4.

[Albert J. Rice:]

Okay. On the commentary about expecting sort of pricing pressure, 1% to 2% annually for the next few years, maybe just to put it in perspective, to sort of maintain margin or even start to talk about expanding margin, what kind of -- give us a sense of what kind of volume growth you need in light of that pricing environment to sort of hold margin constant or even begin to expand at all?

[Stephen H. Rusckowski:]

I appreciate that, A.J. Well, when you go through the facts that we had in 2013, which was a substantially larger year than what we anticipate in 2014 and 2015, so we'll have less headwinds from pricing in 2014 than we clearly saw in 2013, that's number one. Number two, is we continue to talk about the acceleration and improvements that we're making on our cost structure with Invigorate. It continues to build, it hasn't stopped. We exited 2012, that $200 million we talked about. $600 million in 2014 is the exit, and we're tracking to exiting at our rate in 2012 and we're going to be on a path to get to the 2014 number that we have committed to. So that's tracking nicely. Third is we have a little bit of headwind, as you would expect, on our wage bill. We have to be competitive with our workforce and so we have to dial that into our expectations. And we continue to build our 1% to 2% top line of opportunities with acquisitions, which is part of our disciplined capital deployment. As you see in the back half of this year, A.J., we actually are now, in the third quarter, at 2% of our top line. So we are getting to the higher end of the range. And as you know, we do these acquisitions, with a large part of those acquisitions based upon cost synergies. As we work through their integration plans -- and some of those integration plans are short, short as 6 months, and some others as large as 2 years, when it's more complicated -- it builds our profitability from those acquisitions, so we have that flowing through in 2014. So I can't give you the specific color of 2014, and we won't do it at this call, but we're still tracking of where we think our 5-point strategy will allow us to build shareholder value. And we do believe it's still compelling as we keep on working through this. As you know, it's always more difficult to get the results with the headwinds and the challenging environment that we see. And if that improves, we're not planning on the significantly sunnier day, if you will, in the short-term. But the challenging environment is making it more difficult, and that challenging environment will improve. And then with the Affordable Care Act, with more lives in the system, because we do believe there will be more lives in the system, and that this marketplace is growing, we do believe we're in an attractive marketplace and we do believe that our 5-point strategy will give us lift as we go forward in 2014 and 2015 with our earnings and also with the opportunity to build shareholder value. So we will keep you posted on when we'll provide insight into 2014, but that is as much color as we can provide at this time.

[Operator:]

Our last question comes from Amanda Murphy, William Blair.

[Amanda Murphy:]

I have a couple of follow-up questions on the volume. Just a couple of questions on the volume side. I know we've talked a lot about it but, obviously, you've mentioned some of the underlying utilization trends. But one question I had was, you've made changes on the management side as well. I'm curious, did that have any effect on the business in terms of volume trends?

[Stephen H. Rusckowski:]

Yes, it's a good question and, obviously, we're going through territory by territory, understanding where we see effects, can we explain it. We've taken out a sizable portion of management throughout the entire company. As I shared with you, we had to do it. One is we had a very complicated organizational structure. It was not aligned with our 2 highest priorities, which are operational excellence as well as restoring growth. We now have an organizational structure that is leaner and is much more focused on those 2 priorities. And in doing that, we've taken out 3 management layers. And actually, we did this because we spent a lot of time inside talking to ourselves, and one of our behavior changes that we are driving is to get more external. And so if you take out 3 management layers, which we have done, we're spending less time talking to ourselves and more time talking to customers. And it starts with me and my entire management team and throughout the organization. So when you refer to management, I actually think our management changes has actually improved our ability to get outside, and our management today is much more externally focused than before, number one. Number two, though, is you go through a reorganization of the sales force, and these are at the sales rep level. We had to change our sales force organization to put an organizational structure that are more aligned with the way our customers are organizing. As you know, Amanda, customers are organized around integrated delivery networks, they include hospitals, they include physicians, they include ancillary services. And so, we now have a geographic organization. We've made those changes. We did have some account assignments in the first quarter that we had to change to get a more effective organization, and we feel good about that. We did incent our sales force to make sure any changes between the accounts, between sales reps would be handled properly. We don't see a substantial defections or losses in accounts because of that. We do track our customer experience, and we think we're actually improving how we experience -- or our customers experience us. So when we go through all the data, we think we have made all the right changes. We believe that, when you get down to the granular level, they're actually moving in the right directions. But we haven't seen many things come out of some of the positive sides of these. We do expect more productivity from our sales reps, we expect our sales reps to be able to sell more, we expect them to be able to get more from our new products. And that's what we planned for in the $50 million expectation that we've set, so that's the disappointing side of Q3. This is a lot of change. We believe we are making the right changes and we are doing the right things, but it will take longer. So that's my best perspective I can give you on what we've done and how it's affected our business.

[Amanda Murphy:]

Okay, got it. And just a broader question, obviously, the days has been, in just health care in general, has been challenged by lower utilization rates for quite a while now. So I mean, at what point do you say maybe this is a new normal and, if that's true, then I guess, that longer term, and you talk to M&A helping you supplement that growth, but how long is that runway?

[Stephen H. Rusckowski:]

Well, as you know, first of all, we're not planning on the environment changing abruptly or getting better quickly. You see that in our guidance for Q4, and that's what we should plan for. We believe that's being prudent. Second is, if we're seeing pressure, this whole industry is feeling pressure. If you look at the most broadly defined market, our sales and our nearest competitor represent about 20% of the market, 20% of that overall market, then has hospital outreach included in that. The reason why we're encouraged by the professional services business, many of the hospital clients we are now selling into are thinking about their lab strategy, which includes potentially selling their outreach business, the list continues to grow. They're also looking at us at helping them manage some of their inpatient laboratories or helping them with their outreach activities as well, and we are encouraged by that. And then finally, is if we look at the smaller players, the regional players in this marketplace, they have a much higher percentage of the business for Medicare, so with these cuts that we've seen this year and the potential cuts going forward, we think there is an opportunity for the strongest player, the leader, in this industry to continue to consolidate and gain share. And our plan, our 5-point strategy, addresses that. So we're moving forward on this strategy that we have to use some portion of our capital to get 1% to 2% top line for acquisitions. As I mentioned, we actually moved to the 2 side of that range in the third quarter. We are encouraged by that in the third quarter for the fourth quarter, and we continue to build our funnel. And there's a growing level of interest of parties that might consider selling. And also, we want to make sure that these are strategically aligned and accretive acquisitions as we go forward that helps build shareholder value. So that's my perspective. Mark, would you like to round that off?

[Mark J. Guinan:]

Yes. Just one thing I'll -- I'd add. I mean, as -- I think we are seeing a rebasing, driven by a lot of changes that we're all familiar with. One could argue maybe there's overconsumption of health care and we're rebasing it. But at some point, you're rebased, and then we should be growing along demographic lines. When that point is? I'm not sure. I mean -- in addition to that, when you think about the desire to move from treatment to early detection or prevention, so it's our belief that diagnostics is a great part of that solution. So that's -- as Steve said in the end of his remarks, we believe this is a great space. Those are really the drivers. While we certainly have had a couple of tough years here, that's not looking like it's going to be over in the immediate term, we do think that, long term, this is a good space to be in and also, as Steve said, one that's likely to migrate to the highest quality, low-cost providers and we certainly expect ourselves to be there within this marketplace.

[Stephen H. Rusckowski:]

Yes. So this is a tough environment, we all know that. But we also, to our Mark Guinan's belief, this is very attractive market. There is the routine work that we do. But most importantly, we're investing in advanced and esoteric work. And I think our example this week of our launch of BRCAvantage is a great example where we'll be entering a market that is growing. It enters in a market where clearly more information and more insight is helpful to helping health care overall. And that's one of the areas of focus for us, is to make sure we introduce more innovative solutions to the market. And as we've talked, it's not just the diagnostic, it's the information, it's the services. And that's what will fuel new growth as we go forward. And when you look at those prospects, we believe this is a very attractive market despite the difficult environment we're operating in today.

[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 will be accessed online at www.questdiagnostics.com/investor, or by phone at [phone] for domestic callers or [phone] for international callers. Telephone replays will be available from 10