Quest Diagnostics Incorporated (DGX) Earnings Call Transcript

Good afternoon. My name is Lisa Gill, and I am Head of Health Care Services at JPMorgan. It is with great pleasure that I have with me Quest Diagnostics this afternoon. For those of you that have followed our research, you may know that I followed the lab industry from 2011 to 2021. And then in 2021, I gave it to our life sciences analyst. So when I had the opportunity a couple of months ago to take it back, it was a great opportunity. So one, I'm super happy to have you here. Second, this is my first time with this management team. So the management team changed over in that 2-year period of time. To my left is CEO, Jim Davis, and to his left is Sam Samad. And as just a funny background, Sam came from Cardinal Health, and we just reconnected in the fact that I think we met probably 15 years ago.

Yes, probably something like that.

So anyway. So with that, Jim is going to open it up and make some just opening remarks, and then the 3 of us are going to have a fireside chat. So with that, I'll turn it over to you.

Yes. So thanks, Lisa, and welcome back to our industry. As Lisa mentioned, I'm a year into the role, we started November 1, 2022. But I've been with Quest Diagnostics for 10-plus years. So I was leading all the operations of the company. And for those of you that may not know us well, we believe we're an integral part of the U.S. health care system. On an annual basis, we do over 200 million requisitions. On a daily basis that's 700,000 requisitions a day. Now being someone from the University of Michigan, I like to tell people that's filling up Michigan Stadium 7 times a day and drawing blood or collecting urine from every one of those people on a daily basis. So 200 million requisitions, it's about 110 million unique people. So we touch about 1/3 of the U.S. population every year. We touch about 50% of the U.S. population every 3 years. We'd like to think that we know more about the state of the U.S. health, not the U.S. health care system, more about the state of the U.S. health than any company in America. We can tell you more about BMI trends, LDL trends, HDL trends than anyone. Now 2023 was a bit of a year of transition, not just a transition for me as the CEO, but in 2022, our company did close to $1.5 billion in revenue. So I had the pleasure of guiding this ship from about $1.5 billion in COVID revenue down to, we guided this year, we're not going to announce our results today, we'll do that in a few weeks, but our COVID revenue, we guided to about $200 million. So the company dropped over $1.25 billion in COVID revenue. Now the good news is we replaced about half of that revenue with the strongest base volume-based revenue growth that we've seen since I've been in the company. So we guided to roughly $600 million of base business growth, which represents just under 7%. But with that, we had to do some hard work to align the cost structure of the company to the new revenue structure. And we guided to an EPS drop year-over-year of about $1.25. Had we done nothing, our EPS would have come down well north of $2 a share. So we aggressively took out costs, but more importantly, we drove the base -- we drove the operating margin of our base business up significantly higher from 2022 levels. Now as we think about 2024, I'll just make a few introductory comments, and I know you'll have a few questions. But we like to think there's some significant tailwinds as we enter the year. Number one, again, our base volume growth for this year was at record levels over the past decade. We think that base volume growth is going to continue, albeit perhaps not at the 6%, 6.5% level that we saw in 2023. But our long-term guidance around base revenue growth of 5%, we still feel very good about that. We feel very good about the strength of our M&A funnel and about the strength of our PLS funnel. So our M&A funnel, we just announced a small outreach acquisition yesterday, where we purchased certain assets of the Steward Health System. We were doing their outreach work in Massachusetts. Steward operates in many other states, and we purchased the outreach assets there. Our M&A funnel has never been stronger. It's primarily health system outreach opportunities. And our PLS business, which is Quest Diagnostics going inside of a hospital and running the laboratory for that hospital. We generally take on the people. We take on the assets of the institution, and we're able to generally bring them 15% to 20% cost savings when we do that. The reimbursement outlook continues to remain strong. This was a business from 2012 to 2019 that was generally seeing price declines of 1% to 100 to 150 basis points a year. Last year, our pricing was flat to slightly positive. We renegotiated a significant portion of our health plan contracts last year, and we're happy to report that we expect price to be flat to slightly positive again here in 2024. So all of those are very nice headwinds. In addition, as I mentioned, our Invigorate program delivered in 2023. The drop-down rate on that $600 million of base business growth was in the range of 40% to 50%, and we feel that will continue into 2024. Now there are some headwinds that sit in front of us. While our COVID revenue dropped to approximately $200 million in 2024, we expect it to just be a normal flu-like test in 2024 -- dropped approximately $200 million in 2023, I should say. So we expect it to drop about another $150 million as we enter here into 2024. Haystack, an acquisition we did in 2023, that gets us squarely into the MRD space. We still -- it was dilutive in 2023 to approximately $0.15 to $0.20. We owned it for a half a year, so we expect that to double in 2024. And then Sam will talk later about some debt refinancing that we did. Obviously, that came at a higher interest rate, and so that will pose about a 25% increment -- $0.25 incremental headwind as we enter 2024. So I think it's relatively balanced, but we're optimistic as we start the season there.

I want to start with your initial comment, and that was really around the base business and the organic growth rate that you're seeing. And you talked about 6.5% growth, but maybe moving back towards that kind of traditional 5% growth. Can you talk about, have there been areas of growth that have been stronger than other areas within the base business?

Yes. So let's segment the base business into 2 primary markets. There is a health system market where we do reference testing for health systems. So these are tests that hospitals choose not to do. And then there's a physician office book of business paid for by Medicare, Medicaid and the commercial payers. The health system book of business is really growing, let's just say, in the 2% to 3% range, which says that the physician office book of business is growing significantly faster than that. That's what we saw in 2023. Now the question is why? This is a business that normally grows at roughly 2% volume growth, right? What is it that drives new growth in lab testing? One is an increase in the population, doesn't grow that fast. Second is the aging of the population. Older people get more tests than younger people, it doesn't grow that fast. And then the third is the introduction of new tests, okay? So clearly, in 2023, there was some return to care phenomena. I can't yet split that out to say how much of our growth was just a surge in return to care versus us winning share or taking advantage or introducing new tests. Look, we did see some incremental growth coming from our Alzheimer's book of business. The new blood-based test for the detection of early-stage amyloid plaque has been a nice addition to the portfolio. That was a Quest-developed -- that's an LDT that we brought to market. In addition, we had a CSF-based test that looks not only at amyloid plaque but certain tau protein markers. That test also has continued to grow. So what we're seeing is clinicians are ordering more blood-based, CSF-based Alzheimer's diagnostics tests. Is that because there's a therapy out there? It certainly doesn't hurt. So feel good about the overall strength of the base business as we enter '24.

You also talked about managed care rates, and I do remember from 2011 to 2019 the declining rates. And when I think about routine versus esoteric testing, did you see improvement in rates in both areas? Or is one outperforming the other when we think about managed care rates?

Not really. I think when we negotiate the book of business with a payer, we generally don't -- there's 5,000 tests on the menu, so we don't go through each one. Now do we look for specific increases in certain tests like our Alzheimer's tests that we're bringing to market? Absolutely. Importantly, what we do focus on in those discussions, though, is coverage decisions. So importantly, I'll give you a test that we presented evidence to UnitedHealthcare. It's a molecular test for vaginosis. Heretofore, it was a microbiology test. None of the payers were covering that molecular test and we got a positive coverage decision from United, from Aetna and a few others. So we really focus on coverage decisions, right, because denials are still a certain portion of this business, and we attack every denial and try to make sure the coverage decisions are right for the patient.

When you generally get a large payer like whether it's United or Aetna to decide to cover the test, do you generally find that the other smaller managed care companies follow?

Generally, if you kind of -- first, we always go to Medicare, right, try to get Medicare to cover. Generally, that's a positive single -- signal to the commercial payers. Generally, if you can get 2 or 3 of the big 4 or 5 nationals, then the Blues will start to develop it. Now we go after the Blues just as hard. So we may start with them, and that sends a nice signal as well.

And then lastly, as I think about this test volume, is there anything to call out geographically? Are you seeing anything different in certain geographies versus another, especially as you talked about the return to the physician office? Is it the same from a national perspective? Or are there pockets of growth in one area?

I would say if we looked at the average growth rate, the volume we said, 6.5%-ish, the variation across the country, across regions may be as high as 1.5% one way or the other. What I will tell you in certain regions, we are seeing more health systems that are willing to relinquish the outreach work. We saw NewYork-Presby, right, which is the parent company over Cornell and Columbia hospitals. And I think when you see an institution like NewYork-Presby decide to get out of the outreach business, I think it makes a statement to the rest of the business -- to the rest of the industry. And certainly, NewYork-Presby did not exit the business because they were losing money on their outreach business. They were certainly making money from a laboratory standpoint. But if you were to talk to Dr. Corwin, I think what he would tell you is that when he's faced with investment priorities from neurosurgery, from cancer, from women's health care, from cardiovascular work, in an era when the cost of capital is significantly higher than it was 5 years ago, he'd rather pour his money into things that really drive market share away from the institutions he's competing with. And I think if you were to ask him, people don't choose to go to Cornell for neurosurgery because of the lab.

They don't? Really?

They don't. And so it's not that they weren't making money. It's just they decided that their capital dollars could be invested more wisely in other parts of their institution.

And you talked about this large pipeline. I want to still continue to talk about volumes, et cetera, for a second. But when you talk about that large pipeline, is that part of the decision-making process today around outreach that they say, look, we can do this, we make money on it, but there's a lot better ways for us to be able to spend those dollars so we can really truly compete?

I think it's absolutely that. I think, again, rising interest rates, your cost of is going up. So on a marginal basis, if there's something that they can invest in that has a better ROI, they'll do it. And in some institutions like in New York, you may be space limited, your ability to expand may be limited from simply a footprint standpoint.

When I think about volumes, and historically, we've talked about at this conference any incremental updates or color that you can provide on fourth quarter when you think about volume or mix. Is there anything that you could share at this point?

We're going to announce on February 1. What we did say in our October earnings announcement is we had Q3 base revenue growth of roughly 4.6% or volume growth higher than that. And we said in October that our October volumes and revenue growth were consistent with that. So we thought that the fourth quarter -- now you can do the math what we guided to for the total year. You can back into that fourth quarter growth, but it implied total base revenue growth for the year on the order of just under 7%.

On the -- when we think about the fourth quarter margin ramp, you highlighted what's driving the improvement. And historically, you've kind of given us some of the road signs to think about, if that's the right way to think about it. Is there any kind of update that you can give us today as we think about that road to improving margins?

Yes. So I'm going to let Sam talk to that.

Yes. So -- and thanks, Lisa. So we'll be talking more about Q4 margins on the earnings call, obviously. But let's talk a little bit about some of the drivers that we saw this year. So -- because it's important to reset for the audience here in terms of what we saw in terms of margin improvement this year. We had $1.5 billion roughly of COVID revenues last year -- or sorry, in 2022, as Jim said. And in '23, we have guided to approximately $200 million. So that has a significant margin impact attached to it. That's a lot of volume that basically is dropping at our contribution margin. So we took on a lot of actions to improve margins in 2023, including starting in Q2 to the tune of roughly $100 million of SG&A reduction. We have looked at productivity improvements through our Invigorate actions that basically net 3% of productivity and cost reductions every year. And we have executed on that successfully in 2023. Now we still have -- and we have had volume growth that's obviously helped us from a margin perspective as well. Now we are still facing a tough labor environment, labor inflation environment. Traditionally, we've seen labor inflation in the roughly 2%. And during COVID and as recently as last year, we've seen it in the 3% to 4% that is at the high end of that range. So we're still fighting a tough labor inflation environment. So when I think about margins, we had guided to 17% at the beginning of the year. The last thing we said on our Q3 earnings call is that we expect it to be somewhere closer to 16%. And really, the driver -- the difference between that 17% and 16% is the impact of additional -- approximately 1% of labor inflation, higher than what we thought going into the year. Health -- employee health costs much higher than we initially expected as well. We talked about Haystack that has some dilution impact and impact on margins for the year as well. And the COVID mix of the business, not just the COVID reduction, but the mix of COVID in terms of where the testing is being performed, more in the hospitals, less in urgent care and physician offices, that has a profitability impact. But I don't want to absolutely have anybody overlook the fact that we've taken so many actions across margins to reset the base this year.

Maybe we can spend a few minutes talking about the opportunity within sequencing, the genome sequencing, particularly the shift to whole genome sequencing. And what are some of the key factors and some of the opportunities in this shift in the market?

Yes. So 2 types of sequencing, right? One is what we call germline sequencing that looks for -- there's really 3 segments to that market. One is carrier screening and prenatal genetics, so people that want to get pregnant, and then after a woman conceives, to be able to do prenatal testing. That's one segment of germline. The second is early childhood development. A child may not be on the right growth curve. Could there be some neurological issue that is genetics related? And then there can be rare diseases later in life, Huntington's disease. And then obviously, on the germline side, hereditary genetics. Look, in the germline industry, if you were to add up all the service providers in the germline industry, that would be us, our nearest competitor, Ambry, Invitae, you name it. It's not a profitable industry, all right? So we need the cost of sequencing to come down. And you saw that we announced something this morning with Ultima Genomics. Ultima believes they can get to $100 cost point for whole genome sequencing. Now the fact is there's not many people doing whole genome sequencing today from a germline perspective. NIPT, NIPS testing is not whole genome. Carrier screening is not whole genome. Some of the neurological panels that we run on young children are really not whole genome, probably more whole exome. So it does have an opportunity to lower the cost point. More importantly, it allows us to standardize all those tests on one platform, whole genome sequencing. And then just from a bioinformatic standpoint, you look at the genes that you need to look at. So we're really excited about that. Now on the somatic side of the equation, this is sequencing of actually tumor specimens to look for mutations. Those mutations then inform one what is the appropriate therapy for that cancer and then more importantly, with this Haystack acquisition we made, how do you really monitor and look for minimally residual disease. Today, most of those tests are actually based on a clinical exome or a clinical sub-exome. The test can become more accurate if the backbone, if what informs that test, we call these tumor-informed tests, if those tests are actually based on a whole genome, okay? So that's the direction that we're moving. It's the direction that the whole industry is moving. We're excited to have competition in this space and excited to be working with Ultima.

You touched a little bit on this with Haystack, but at your Analyst Day, which was a little pre my time, but I did get through the slides, you did talk about oncology and being a really big opportunity for you on a go-forward basis. Can you maybe just walk us through the strategy when we think about therapy selection, therapy monitoring reoccurrence management, any other programs that you have in place when we think about oncology?

Yes. So let's start with the big picture on oncology and Quest Diagnostics where we guided to roughly $9.2 billion in '23. About $1 billion of that $9.2 billion is in the cancer space today. And what are the components of that? It starts with first, the largest anatomical pathology business in the industry. It's a $400 million business in Quest Diagnostics. The other $600 million in testing is really made up of common tests, PSA, HPV, Pap smears, FIT tests and things like that. So we start with an incredible presence in oncology today. Now when we do that anatomical pathology work, we have the specimen. We have decided -- we've made the decision, is it cancer or not cancer. The next logical step if you've made a cancer diagnosis is to provide that diagnosis back to the referring physician. And then the question is, what is the appropriate therapy, okay? So if surgery is needed, post surgery, and this is where the Haystack MRD comes in, post surgery, the surgeon comes out and generally says, hey, I think I got it all. But the question is, did they really get it all? And so before we just apply adjuvant therapy, which is pretty much the standard of care, especially if it's cancer in a source as well as in one of the nodes, you're going to get adjuvant therapy. But in fact, if the surgeon did remove it all and if he can come to that conclusion based on a blood-based test, where you don't see any fragments of DNA from those cancer cells, you can really help the patient avoid that chemotherapy. Now if fragments of DNA are detected and chemotherapy is needed, then the next question is, did the chemotherapy get it all?