QUEST DIAGNOSTICS INC DGX
November 29, 2018 - 6:34pm EST by
E_Zola
2018 2019
Price: 88.00 EPS 0 0
Shares Out. (in M): 139 P/E 16 14
Market Cap (in $M): 12,201 P/FCF 0 15
Net Debt (in $M): 3,400 EBIT 1,153 1,344
TEV ($): 15 TEV/EBIT 14 12

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  • Industry Consolidation
  • Secular Growth
  • Misunderstood Industry
  • Compounder
  • Highly Cash Generative
  • Pricing Power
  • Ability to reinvest at higher ROIIC

Description

Executive summary

 

I recommend buying shares in Quest Diagnostics (DGX). Today’s investors day and share price sell-off on the back of a guidance revision provides another interesting entry point in this high quality business with secular tailwind. I’ve been looking at it for a little while now and I think the story is getting even more attractive. I am publishing now given the weakness in share price however, this is not a trading call but the emergence of a major industry shift in the lab industry.

 

At $12bn equity value, $16bn EV, DGX is trading on ~10x 19e consensus EBIT, 12x PE but I think the sell-side is not properly taking into account the huge tailwind from the upcoming industry changes. I think Quest is extremely well positioned as the lowest cost provider in the US clinical lab space and will lead the consolidation effort. This is a rare opportunity to acquire a blue-chip US stock at a decent price on the cusp of benefiting from structural changes in the industry. I have a base target price of at least $130 per share and much higher in a bull scenario. I only see about 10/15% downside from current trading levels.

 

Quest Diagnostics is the US leader in the clinical laboratory testing space, providing diagnostics and monitoring services to patients, doctors and physicians across the US. Diagnostics is a core element of the overall healthcare industry: the vast majority of medical decisions are based upon the results of these tests and they are increasingly used for early detection of diseases.

 

Most of the tests performed by Quest are routine tests (e.g. blood tests, heart, liver etc.) but DGX also offers higher value gene-based and esoteric tests (e.g. protein chemistry). 50% of revenue are from health insurance and c.20% from the government through Medicare and Medicaid (i.e. the public reimbursement rate for tests). Underlying fundamentals are mostly positives with a growing population, aging demographic and increase in diagnostics needs.

 

The sector is very fragmented with two large national champions, Quest Diagnostics and LabCorp (NYSE: LH-US), and a series of much smaller labs. The regulatory burden in the industry is high and the government has subsidised the existence of smaller labs for years by providing higher reimbursement rates than what is typically paid by large private commercial healthcare plans.

 

2018 has seen the beginning of a tectonic shift in the industry as pricing is moving towards a market-based mechanism whereby, in an effort to decrease the burden of healthcare costs, government reimbursement rates will be based on the median of the commercial rates paid by third party healthcare insurance (the so called “PAMA” regulation for Protecting Access to Medicare Act). Overall, PAMA represents a 10% price cuts per year through to 2020 on the rate of reimbursement by Medicare/Medicaid of major lab tests, or roughly $2bn. As Quest’ CEO put it today: “it’s going to wipe out the profit of the rest of the industry”. For DGX , I think this will be a net positive.

 

The source of competitive advantage for DGX are multiple. The lab testing industry is about scale and volume: fixed costs are high and running a lab efficiently means driving volume to be the lowest cost producer. In addition, data is increasingly a focus in the diagnostic field and DGX is best placed to provide valuable information to health plans and physician to reduce the overall healthcare cost of chronic disease. Barriers to entry are high with regulatory, reputational and capital requirements. My research shows that switching lab is a major decision for physicians and hospitals as it can affect the quality of care and accuracy of tests. Finally, I think that going forward the national labs will enjoy pricing power with insurers, a massive change from the past years (this is developed in detail in the write-up).

 

Variant perception: The clinical lab space has generally been the poor child of the US healthcare sector with constant government reimbursement rate challenges and dull growth prospects. The shares have rallied in 2017 as the company delivered on its restructuring plan and engaged in more M&A, before suffering from the announcement of the new PAMA rates (the announced cuts were much steeper than anticipated). The shares have since recovered slightly but I believe that the street is still missing the bigger picture: Quest Diagnostics is the lowest-cost provider in a highly fragmented industry and over the long-term (i.e. beyond PAMA cuts) is a natural consolidator for the sector with improving economics. In addition, and this is probably the most important part of the story, Quest and LabCorp relationships with insurers has fundamentally evolved in 2018. I will explain all of this further below but I think that analysts are just waking up to the idea that the lab industry of tomorrow is going to be significantly different from the lab industry of today… and margins and growth will also look different in the future.  

 

The weakness in share price after today’s reduced revenue guidance sounds like no news to me: the street is overly reacting to some softness in volume and the sheer number of questions about patients concession (i.e. bad debt) shows that the market is very narrow minded for the time being. Management made clear the increased provisions have no impact in the long-term and could well be reversed very soon (I still doubt that).

 

A quick introduction to the US clinical lab industry

The US clinical laboratory market is layered and a handful of key players have been aggressively competing in an environment of reimbursement rates cuts. At a broad level, 3 categories of competitors emerge:

Hospital Labs: natural players as lab tests are a core function of any hospitals (the vast majority of physicians’ decisions are based on the results of tests). Important to distinguish two categories here:

“In/Out patients”: the lab is used in the context of a procedure required by the hospital (whether they are actually ‘being hospitalised’ or not is irrelevant);

Outreach programme or “non-patient”: the lab is being used for tests not related to the hospital business but patients are referred to the lab by doctors and local clinics for testing at the hospital lab.

Physician Office Labs (“POLs”): small labs for onsite testing when visiting physicians; and

Independent Labs: the largest numbers of labs, made of two very distinct types of players: small ‘mom-and-pop’ local labs and national laboratory operations, i.e. Quest Diagnostics, LabCorp and to a lesser extent Sonic Healthcare.

The following graph illustrates the overall market and its size:

 

The US clinical lab market is very fragmented market as my research points towards a total of about 261,000 labs in the United States. It is important to differentiate the various ‘leagues’ in which these labs compete as, depending on which sub-segment of the industry we focus, the market share dynamics are quite different. This fragmentation of the lab space is the result of a long and choppy history for the industry. To summarise, after a long period of expansion from the 1950s to 1980s, the industry entered a dynamic phase of consolidation with the apparition of Medicare reimbursement rates in 1984. The initial reimbursement rates favoured hospital pricing and a few companies misbehaved, overcharging and duplicating bills in order to drive reimbursements. The US government cracked down on these so called ‘labscams’ and won settlements approaching $900m. The Medicare fee schedules were revised downwards, favouring consolidation, both for hospitals and independent labs.  In the 2000s, the continuous negative pricing environment saw the establishment of a quasi-duopoly in the independent lab segment with the emergence of Quest Diagnostics and LabCorp (both the outcome of mergers). With growth becoming anaemic (DGX plateaued at c. $7.5bn in revenue for more than 5 years), expansion via acquisition was the only way for the large players in order to offset the overall trend of reimbursement rates cut. Competition between the two national labs at the insurance levels, culminating in exclusive agreements with insurance providers, ended up being a net negative for them (lower prices and lower volumes). In parallel, hospital labs continued to fare relatively well given their unique features: hospitals get reimbursed at higher rates under both Medicare (for the hospital population only) and private insurers. Whilst this might be counter-intuitive, my research showed that hospital labs have received higher prices mainly because (i) in rural areas, they are often the only labs and there is no competition and (ii) as hospitals, the rates are negotiated as part of the hospital’s overall outpatient contracts and not tied to the national Clinical Laboratory Fee Schedule (CLFS). In today’s CMD presentation, Steve Ruskowsky (Quest’ CEO) showed that on average hospital labs were 2.5x more expensive than DGX.

 

I will discuss the trend of reimbursement rates in greater details next, but bear in mind that this ‘unfair’ hospital advantage will disappear completely over time: the new PAMA regulation is only the beginning and the higher fee for hospital outreach programmes will go away under this market-based mechanism. PAMA is bringing down the reimbursement rate under the Part B schedule, i.e. for “non patients”: whilst it is current practice for private insurers to offer a hospital reimbursement rate ‘as a whole’, i.e. regardless of whether the test was for an hospital patient or a patient under the outreach programme, insurers, being profit maximisers, will start to make the distinction between hospital patients and patients of the outreach programme and stop this unfair incentive. This, in my view, is a key benefit of the pricing transparency being implemented with PAMA.

 

Understanding the economics of laboratories, reimbursement rate & PAMA

 

There are some unique features to the business model of clinical labs. In this industry, the person recommending the test, the service provider, the payer and the end “consumer” are different. A successful lab has to score high with all key stakeholders in order to stay in business: good relationships with physicians are key to drive volume, bargaining power with insurance companies will drive revenue per test and customer/patients need to be satisfied with the service to ensure business continuity in the long-run.

 

The national labs, such as Quest, are organised around a number of large “major labs”, functioning as third-shift testing facilities, where local samples from a network of Patient Services Centres are rushed on a daily basis by a fleet of vehicles, couriers and airplanes. DGX activities are centred on 43 major labs, spread across the U.S and 2,300 Patient Services Centres (PSCs). The logistical chain around the business compromises is big: ~3,700 courier vehicles, 23 aircraft and 43,000 employees.

 

Revenues are a function of the volume of requisitions (i.e. the volume of work being ordered), with each requisition comprising on average 3 tests (national level statistic). The price per test is determined by the reimbursement mix under which the lab operates. As expected, small independent and hospital outreach labs are more dependent on government payers (e.g. Medicare & Medicaid), which represent on average 35 to 40% of the payer mix. The rest of the mix is heavily weighted towards health insurance and a small portion is from patients themselves (2%). Note that these numbers are averages and can be meaningfully different on a geographic basis. For Quest and LabCorp the payer mix is heavily weighted towards the private market.

In terms of pricing, some sources point that commercial laboratories are paid on average 0.8x Medicare whilst hospital labs are paid 1.3x the Medicare rate. As mentioned above, Quest CEO sees a 2.5x differential with the average hospital. PAMA is bringing down rates by about 10% for the next three years. This is thus a major game changer which will have deep impacts to the industry as a whole. There will be more consolidation in the sector as the financial viability of many of the smaller operations will be highly threatened in the coming two years. For context, a 2012 survey showing that about 60% of the labs had profit margin of less than 6%, with about 50% at less than 3%.

 

For the smaller labs, profitability will undoubtedly suffer and as a large part of the business is fixed cost, I expect to see many of these labs going out of business in the medium term. The rate of bankruptcies is hard to estimate but I would not be surprised to see 50% of the smaller labs going out of business as this is approximately the proportion of labs with less than 500K test per year (500K tests is often cited to be the minimum scale efficiency point based). For hospital outreach, the impacts of rate cuts will be significant as well, but they could be slightly better equipped to face the headwinds as the average profitability can be higher. Given hospital outreach programmes are typically leveraging existing facilities of the hospital, equipment and personnel (regardless of non-patient business, hospital labs have to run for the core hospital function), the marginal profitability of outreach volumes can be higher. This advantage is compounded by the fact that up to recently, outreach programmes were often not paying any taxes on profit as the outreach profits would be amalgamated with losses from the hospital lab. However, this tax advantage is coming to an end this year.

 

Quest and LabCorp will massively benefit from acquisition of outreach programmes going forward. My research showed that for many hospitals, the profitability / economics of the outreach lab business is unknown and misunderstood. Outreach programmes are not ran by professional managers but medical personnel who do not see the value in the outreach programme. The labs revenue and costs are blended with the core hospital business, driving down margin. A consultant provides this example of a hospital considering the sale of its outreach business as its lab profitability was around 2.3%. When doing proper cost allocation, the outreach business was very profitable whilst the hospital function was loss-making:

 

At today’s CMD, Quest management confirmed the strong tailwind associated with the externalities of PAMA. There is an interesting slide in the deck showing how PAMA might completely wipe out the profit of the rest of the lab industry. Quest and LabCorp have been talking about the consolidation potential for about 10 months now but I suspect 2019 will see the uptick in tuck-in acquisitions. Anecdotally, management cited that 80% of hospitals C-suite they interact with are not aware of PAMA and the implications for the hospital lab industry.

 

The acquisition economics of these businesses are impressive for the large national labs. First, the acquisition process is said to be rather sensible: a lab sale is a major decision for the local healthcare community and hospitals prefer to partner with reliable / transparent institutions. Deals are said to be friendly rather than “sealed envelope” type and when asked about the M&A strategy, Quest and LabCorp indicate that for each situation, usually one lab is best placed than the other due to its local presence: this should ensure a fair but not overly aggressive level of competition. Second, acquisitions are accretive on a cost basis, not revenue. Typically local labs are not as efficiently ran as commercial labs and there are a number of ‘quick-wins’ to immediately improve margins when acquired. Quest advances that deals have to be accretive on cash EPS year 1 and accretive to ROIC by year 3. EBIT margin expansion can be impressive, taking margins from single-digit to 30/40%. This is because in a fixed cost business like Quest, adding on extra volume of tests can have a tremendous positive direct impact on EBIT. Quest actually provided an example in its November 2016 investor day and a remake of it at today’s CMD:

 

The obvious question then becomes the pace of consolidation and the number of available targets for acquisition. Since 2017 alone, 15 tuckins have already been closed, with total acquisition spent YTD of about $200n (Shiel > Oxford > Med Fusion > MedXM > CHL > PeaceHealth > Provant > Boyce and Bynum > PhenoPath > Hartford > ReproSource > Cape Cod > CLA > Hurley > Marin). Going forward, management expects these acquisitions to deliver more than 2% revenue CAGR for 2019-22, about $650m in additional revenue. This is virtually straight to the bottom line as the economics and the incremental return on investment for these acquisitions are fantastic. In the past, DGX mentioned that it can drive +50% margin on tuck-in acquisitions as volumes go through its state of the art facilities at no extra costs. In terms of opportunities, management showed this graph today highlighting the long tail-wind of opportunities in the outreach space alone:

       

 

A shift in payor paradigm, new network access, will bring pricing power for Quest Diagnostics

 

On May 25 2018, a major shift happened for lab businesses: Quest Diagnostics announced its strategic partnership with UnitedHealth, becoming an in-network provider to United from January 1st 2019. Simultaneously, LabCorp will become in-network with Aetna at the same time, effectively ending a 10 year period of lab/insurance provider exclusivity. Let’s try to think about this...

 

PAMA effectively brings a new market based system for pricing and transparency to the industry. Quest (and LabCorp) will benefit twofold. First, as Quest actually represents c. 40% of the data provided for the new PAMA rates, it has now a great influence on the overall level of reimbursement in the industry, and c. 15% of its own revenue. Second, price transparency is good for the industry, and best for the larger players: the new rates submission system will greatly diminish the incentive to chase volume at all costs. In the past, Quest and LabCorp have been incentivised to provide lower rates to the large health plans; these agreements being private, pricing remained opaque and on a case by case basis. The national labs were chasing volumes and entered into poor economic agreements with the larger insurance provider. A few years in, the labs realised this was a net loss for their industry as it created pricing competition amongst their business. With the new legislation, given labs will submit their commercial rates every three years and the Medicare rates are based on the national median rate, labs are incentivised to halt price decrease and perhaps even increase them over time. This is because any decrease granted on one contract is not only paid on that particular contract, but will feed through the entire system as it pushes down the median price in the industry, which is now going to be published regularly. Looking at the past earnings call, Quest and LabCorp management have both signaled their focus on moving away from pure pricing conversations towards beneficial value based model.  Put simply, given the two national labs are much cheaper than the rest and provide better quality service (consumer experience, turnaround time, ait time etc.), the insurance providers are putting in place incentives to encourage physicians towards the national labs. I still think that the market is undermining this fundamental shift and worries about further competition between DGX and LH. However, I do not think this is relevant as the real market share shift is from smaller labs towards the nationals, who together still represent less than 30% of the total industry.

 

Overall, PAMA is probably a net positive for DGX and LH which is likely to transform the industry in a duopoly with attractive economics. It will eliminate the smaller players in the market, driving some volumes towards the national players. It will bring pricing discipline to the industry. Any rate cuts to a commercial payer will now carry a negative compound effect: not only is the decrease paid on that contract but it will also feed through the broader market place as it pushes down the national median price which feeds to PAMA. This dynamic enables national labs to move away from pure pricing discussion towards value based model where they can extract better economics with insurance providers given their overall superior proposition. In addition, over time Quest and LabCorp will further compound their advantage given the superiority of their data on patients. This is an increasingly important area in diagnostics: being able to draw conclusions and make inferences from a big pool of tests is an advantage as it helps health plans minimise the cost of healthcare over time (e.g. being able to identify the most ‘at risk’ patients early, recommending testing for certain diseases based on the results pattern of the broader population).

 

Summary financial review of the business

 

The origins of Quest date back to the sixties but the current company is the outcome of a spin-off in 1997. DGX went through a step change when it acquired Smithkline Beecham Clinical Laboratories in 1999. This marked the beginning of a growth phase through acquisitions. Since the 2000’s, DGX has effectively been through three distinct phases: an initial period of growth through acquisition from c. 2000 to 2006, a “stagnant” period from 2006 to 2012 and a restructuring phase from 2012 to 2016, with the appointment of a new CEO, Stephen Rusckowski (now chairman & CEO). In the recent years, DGX disposed of non-core operations and the business strategy is focused on two core principles:

 

(A) Growth acceleration via both organic growth and M&A – Organic growth to come from further partnerships with health plan payers and hospitals (notably to improve pricing) as well as improving the ‘consumer-face’ of the business through easier access to tests, more friendly information sharing amongst patients, payers and labs. M&A is also expected to bring 1-2% revenue growth per year through the acquisition of smaller, less efficient players (notably hospital outreach programme labs). In aggregate, for the period 19-22e, management targets a 3 to 5% revenue CAGR, of which 2% is from acquisitions.

 

(B) Operational excellence – In summary, DGX is committed to provide a better, lower cost experience for customers, health plans providers and medical professionals. This area is focused on four key aspects: (i) reducing bad debt and payment denials (high in this industry given payers are not necessarily end consumers), (ii) standardisation of tests and equipment (ensuring similar tests and information systems across the company), (iii) digitalisation (for appointment, results, scheduling) and (iv) optimisation & automation of tests. DGX being a very acquisitive company, maintaining cost discipline is paramount to manage the growth trajectory. For 19-22e, management expects to improve expenses by about $200m a year.

 

Looking at the number of requisitions (volume), DGX has effectively lost volume over the period 2006 to 2012, with requisitions going from c. 151m in 2006 down to 147m in 2012. This was the result of an aggressive push by LabCorp, with the exclusivity agreement with United Health Insurance (UNH), forcing DGX out of UNH network and losing valuable customers (this occurred in 2006/7). Since 2012, requisitions have increased steadily mostly driven by acquisitions. Revenue per requisition (a proxy for pricing) came under pressure as well: revenue per requisition down for much of the historical period, driven by the competitive environment and a series of cuts under Medicare. In the most recent years, whilst revenue per requisition remain under pressure, it is increasing again through a combination of: (a) positive test mix (more high revenue tests with the proportion of gene-base esoteric tests going up from 29% of revenue in 2017 to 32% of revenue in 2017) and (b) higher number of tests per requisition. For FY18e, I expect core organic operations to be a little worse (management just guided a little lower for FY revenue today) as volume has been a little soft in Q2/Q3 (3 impacts from lower than expected prescription drug monitoring, Hep C testing and decrease in Vit D testing) and rev / req probably flat to negative given PAMA and a slight change in mix. I do not worry too much about these short term impacts.

 

In terms of operating margins, DGX is close to the 16% mark. In the long-run, management believes that it should be able to slightly improve the current margin and take out further costs. Compared to LabCorp, DGX has been the most efficient player on a pure diagnostics basis. We note that on revenue per FTE, until recently, DGX had been the most efficient player with c. $169K revenue per FTE for the past ten years, ahead of LabCorp at c. $164K. This has now changed since LabCorp’s acquisition of Covance Drug Development in late 2014, a transformative move for LabCorp, outside of pure diagnostics into contract research. Management expects to be able to save 3% a year going forward, or roughly $200m. Historically, they have always delivered on their savings targets and given the scale of the operations and the type of cost savings involved, I think it is doable (supplier rationalisation, better use of digital platform to reduce phone calls etc.).

 

DGX ROIC over the past ten years has been relatively stable at an average of 12.5% over the past ten years, with LabCorp’s average being higher at c.17% but coming down in the most recent years. The higher returns for LabCorp are due to the overall higher revenue growth over that period (revenue CAGR was c.7% for ’06-14a, pre-acquisition of Covance, vs. just below 2% for DGX) and a higher EBIT margin at the corporate level: DGX margin for its other business line were well below core diagnostics margins before their disposals in 2013/14 at c. 9% on average).  Going forward I expect ROIC improvements for DGX with the benefit from tuck-ins.

 

The cash generation of the business is very good: on average the company generated c. $1bn in cash from operations (funds generated from operations net of change in working capital), that is c. 70% cash conversion from EBITDA. With such high cash generation and a relatively low need for capital expenditure (~$300m p.a.), the company is very shareholder friendly in terms of dividend and share buybacks. That said, DGX management team did not hesitate to cut dividend & SBB when needed to fund large acquisitions (i.e. 2007, 2014 and to a lesser extend 2017). For the coming years, management intends to continue to return the majority of FCF to shareholders through a combination of dividends and share buybacks, with the remainder dedicated to fund M&A activity. It has however made clear that in the absence of M&A activity, it would return further cash to shareholders. In fact, the CEO repeated its determination to create value and focus on ROIC for acquisitions at today’s meeting.

 

Regarding the capital structure, DGX is rated BBB+/stable, Baa2/stable and BBB/stable by S&P, Moody’s and Fitch. It has a stated leverage policy of maintaining leverage around 2.5x Net debt / EBITDA but indicated it “would not be afraid to take the leverage higher for acquisitions, assuming a rapid deleveraging profile” as they are committed to remain investment grade. On a reported basis, ND / EBITDA is currently at c.2.5x and Funds from Operation (FFO) / Net Debt is at c. 41%. Given the importance of having “retail” space for the patient services centres, it is important to bear in mind that leverage adjusted for operating leases might be more than a full turn higher, at c. 3.7x ND/EBITDA (3.7x is based on EBITDA of $1.4bn and $3.6bn in Net Debt adjusted by about $1.7bn in off balance sheet operating lease debt. $1.7bn operating lease adjustment is calculated based on yearly operating lease rental expenses capitalised at 8.0x, in line with Moody’s typical adjustment). DGX is mostly financed through the bond market, complemented with a $750m RCF. The company regularly engages in refinancing activities to manage its maturity profile and interest rate exposures.

 

Valuation

 

Historically, the broader lab market has been rather disliked by the market. I do not think looking at historical multiples is particular useful here as the industry is going to be drastically different in the future. The same could be said of the long term business margins and ROICs.

 

I find the stock very inexpensive in terms of multiple. On 2019e metrics, it have it at roughly 11.5x EBIT, about 14x PE. For such a high quality business with strong competitive advantage, this feels very attractive. The business is highly cash generative (6% FCF yield) and management has a unique opportunity to deploy capital at a much higher rate of return through tuck ins. Worst case, capital can’t be deployed as fast as expected and shareholders will benefit from special dividends or buybacks. The balance sheet is reasonably strong and offers optionality.

 

For my valuation, I modelled the business on a long-term basis, with a ten year horizon, 8% discount rate and 2% terminal growth rate (LT US clinical lab market has been around 2%). My base case is around $130/140 per share, or at least $22bn EV. I have a base case 10y revenue CAGR of 3% (close to $10bn in the end) but the key difference with the street is probably on margin / ROIC. I think this is going to be a story of strong ROIC appreciation and I model the business reaching around 18% ROIC in the long-term (vs. 12% today), on the back of huge tailwind from the acquisitions and operational improvements. Capex / D&A is around historical levels at 30/26% of PP&E. The key swing factor is really from the M&A incremental returns which I have at 50% in the long-run; then it is a question of how much M&A going forward (at today’s meeting, Steve even mentioned $4bn in dry powder!). I have done various scenarios and the risk/reward profile is strongly in my favour I think. Even in a downside case if management were to do nothing on the M&A beyond 2018e and failed to deliver any margin benefits (margins back towards 15a levels at 14%), with a flat ROIC in the long-run of 12%, I value the business at about $14bn EV, $77 a share, 12% downside compare to today’s close.

 

I simply think this is a very rare opportunity at a very attractive price. I worry about what I am missing here as it feels the odds are very strongly in Quest’s favour in the long term.

 

A word about the management team

 

Quest Diagnostics is headed by Stephen Rusckowski, its President and CEO. Stephen joined DGX in 2012 and is the architect behind the current strategy. I note that his employment agreement was extended in June 2015 and currently due to expire on 31 December 2018; there is a six months’ notice period with automatic renewals for one year if the agreement is not terminated and a one year non-compete following termination. So far, no comment has been made in relation to succession plans. He owns about 150K shares.

 

The current reward mechanism was drawn in 2012 with the new strategy. At the time, Quest targeted a compensation for its top management made of 69% long-term incentives (split 40% shares, 40% stock and 20% in restricted share units), 15% cash bonus and 16% base salary. The cash incentive compensation is evaluated on 7 metrics, mixing financial (80% of weight) and non-financial metrics (20% metrics). These metrics are short-term in nature but overall represent only a small proportion of total compensation. The LT incentive plan is made of 3 types of equity awards on performance shares, RSUs and stock options; all typically vesting over three years. The performance measure is currently based at 50% on revenue CAGR and 50% ROIC. Revenue is as reported (i.e. inclusive of M&A), net of any disposals / wind down. This obviously fuels an appetite for M&A but the significance of the ROIC metric should keep management in line for profitable growth and not growth at all cost.

 

Overall, no surprise, management is doing quite well here…

 

 

Key risks

 

Cyclicality. Clinical tests are somewhat cyclical and follow broader macro dynamics. Patients are likely to postpone and not perform tests if they are out of employment. As a result, any important change in the level of employment of the broader economy can have a negative impact on testing levels. It does raise the question of why current volume continue to be soft given current unemployment levels. Management has identified three culprits (prescription drug monitoring, Hep C, Vitamin D) but this remains an area of concern.

 

Patient concessions. Patient concessions are now reported as a deduction of revenue (previously bad debt). In Q2/Q3 it had a negative impact and management was forced to reserve for unpaid revenue. In the past, CFO explained that this was expected as patients deductible is going up on average so patients are paying a greater proportion of their healthcare. Currently, some billings are late for payment. However, management seems very confident that this is not an important factor and that once the cash is collected, the reserves will be decreased.

 

United/Aetna contract opening. As I said, I think this is a strong positive. But if somehow it does not happen as expected (e.g. net loss of shares to LabCorp due to the opening - which seems unlikely today), this could create competitive pressure. In any scenario, I think pricing will remain a positive though.

 

Operational issues. Unlikely but external factors can have serious impact on operations although the recent wildfires show how a larger network of lab can use its scale to continue serving patients.

 

Litigation. A very significant operational risk for Quest. The entire industry has been subject to nation-wide reimbursement scandals to defraud the US government. For Quest, there has been instances where it was condemned to heavy fines for illegal kickbacks to doctors and clinics, notably in 2011 with the $241m settlement of the Medi-Cal case. Most recently, in December 2016 the company was the victim of cyber-attack and could be subject to penalties. We note that the company has certain insurance in place and as of December 2016, $117m in reserves for legal matters.

 

New technology. New testing could potentially disrupt the industry (or not, cf. Terranos…..). However, I see the risk as remote. Quest prefers to acquire technology from third party only when it is sure it will achieve an interesting reimbursement rates from the government and health plans.

 

Integration difficulties. Remote in my view as tuck ins seem very easy to execute here but if DGX struggles to integrate the large number of acquisitions it is going to make, it can create disruption.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Passage of time forcing smaller labs out of business

2019 PAMA cuts

Opening of UNH/Aetna contracts from Jan 2019

Market awareness

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    Description

    Executive summary

     

    I recommend buying shares in Quest Diagnostics (DGX). Today’s investors day and share price sell-off on the back of a guidance revision provides another interesting entry point in this high quality business with secular tailwind. I’ve been looking at it for a little while now and I think the story is getting even more attractive. I am publishing now given the weakness in share price however, this is not a trading call but the emergence of a major industry shift in the lab industry.

     

    At $12bn equity value, $16bn EV, DGX is trading on ~10x 19e consensus EBIT, 12x PE but I think the sell-side is not properly taking into account the huge tailwind from the upcoming industry changes. I think Quest is extremely well positioned as the lowest cost provider in the US clinical lab space and will lead the consolidation effort. This is a rare opportunity to acquire a blue-chip US stock at a decent price on the cusp of benefiting from structural changes in the industry. I have a base target price of at least $130 per share and much higher in a bull scenario. I only see about 10/15% downside from current trading levels.

     

    Quest Diagnostics is the US leader in the clinical laboratory testing space, providing diagnostics and monitoring services to patients, doctors and physicians across the US. Diagnostics is a core element of the overall healthcare industry: the vast majority of medical decisions are based upon the results of these tests and they are increasingly used for early detection of diseases.

     

    Most of the tests performed by Quest are routine tests (e.g. blood tests, heart, liver etc.) but DGX also offers higher value gene-based and esoteric tests (e.g. protein chemistry). 50% of revenue are from health insurance and c.20% from the government through Medicare and Medicaid (i.e. the public reimbursement rate for tests). Underlying fundamentals are mostly positives with a growing population, aging demographic and increase in diagnostics needs.

     

    The sector is very fragmented with two large national champions, Quest Diagnostics and LabCorp (NYSE: LH-US), and a series of much smaller labs. The regulatory burden in the industry is high and the government has subsidised the existence of smaller labs for years by providing higher reimbursement rates than what is typically paid by large private commercial healthcare plans.

     

    2018 has seen the beginning of a tectonic shift in the industry as pricing is moving towards a market-based mechanism whereby, in an effort to decrease the burden of healthcare costs, government reimbursement rates will be based on the median of the commercial rates paid by third party healthcare insurance (the so called “PAMA” regulation for Protecting Access to Medicare Act). Overall, PAMA represents a 10% price cuts per year through to 2020 on the rate of reimbursement by Medicare/Medicaid of major lab tests, or roughly $2bn. As Quest’ CEO put it today: “it’s going to wipe out the profit of the rest of the industry”. For DGX , I think this will be a net positive.

     

    The source of competitive advantage for DGX are multiple. The lab testing industry is about scale and volume: fixed costs are high and running a lab efficiently means driving volume to be the lowest cost producer. In addition, data is increasingly a focus in the diagnostic field and DGX is best placed to provide valuable information to health plans and physician to reduce the overall healthcare cost of chronic disease. Barriers to entry are high with regulatory, reputational and capital requirements. My research shows that switching lab is a major decision for physicians and hospitals as it can affect the quality of care and accuracy of tests. Finally, I think that going forward the national labs will enjoy pricing power with insurers, a massive change from the past years (this is developed in detail in the write-up).

     

    Variant perception: The clinical lab space has generally been the poor child of the US healthcare sector with constant government reimbursement rate challenges and dull growth prospects. The shares have rallied in 2017 as the company delivered on its restructuring plan and engaged in more M&A, before suffering from the announcement of the new PAMA rates (the announced cuts were much steeper than anticipated). The shares have since recovered slightly but I believe that the street is still missing the bigger picture: Quest Diagnostics is the lowest-cost provider in a highly fragmented industry and over the long-term (i.e. beyond PAMA cuts) is a natural consolidator for the sector with improving economics. In addition, and this is probably the most important part of the story, Quest and LabCorp relationships with insurers has fundamentally evolved in 2018. I will explain all of this further below but I think that analysts are just waking up to the idea that the lab industry of tomorrow is going to be significantly different from the lab industry of today… and margins and growth will also look different in the future.  

     

    The weakness in share price after today’s reduced revenue guidance sounds like no news to me: the street is overly reacting to some softness in volume and the sheer number of questions about patients concession (i.e. bad debt) shows that the market is very narrow minded for the time being. Management made clear the increased provisions have no impact in the long-term and could well be reversed very soon (I still doubt that).

     

    A quick introduction to the US clinical lab industry

    The US clinical laboratory market is layered and a handful of key players have been aggressively competing in an environment of reimbursement rates cuts. At a broad level, 3 categories of competitors emerge:

    Hospital Labs: natural players as lab tests are a core function of any hospitals (the vast majority of physicians’ decisions are based on the results of tests). Important to distinguish two categories here:

    “In/Out patients”: the lab is used in the context of a procedure required by the hospital (whether they are actually ‘being hospitalised’ or not is irrelevant);

    Outreach programme or “non-patient”: the lab is being used for tests not related to the hospital business but patients are referred to the lab by doctors and local clinics for testing at the hospital lab.

    Physician Office Labs (“POLs”): small labs for onsite testing when visiting physicians; and

    Independent Labs: the largest numbers of labs, made of two very distinct types of players: small ‘mom-and-pop’ local labs and national laboratory operations, i.e. Quest Diagnostics, LabCorp and to a lesser extent Sonic Healthcare.

    The following graph illustrates the overall market and its size:

     

    The US clinical lab market is very fragmented market as my research points towards a total of about 261,000 labs in the United States. It is important to differentiate the various ‘leagues’ in which these labs compete as, depending on which sub-segment of the industry we focus, the market share dynamics are quite different. This fragmentation of the lab space is the result of a long and choppy history for the industry. To summarise, after a long period of expansion from the 1950s to 1980s, the industry entered a dynamic phase of consolidation with the apparition of Medicare reimbursement rates in 1984. The initial reimbursement rates favoured hospital pricing and a few companies misbehaved, overcharging and duplicating bills in order to drive reimbursements. The US government cracked down on these so called ‘labscams’ and won settlements approaching $900m. The Medicare fee schedules were revised downwards, favouring consolidation, both for hospitals and independent labs.  In the 2000s, the continuous negative pricing environment saw the establishment of a quasi-duopoly in the independent lab segment with the emergence of Quest Diagnostics and LabCorp (both the outcome of mergers). With growth becoming anaemic (DGX plateaued at c. $7.5bn in revenue for more than 5 years), expansion via acquisition was the only way for the large players in order to offset the overall trend of reimbursement rates cut. Competition between the two national labs at the insurance levels, culminating in exclusive agreements with insurance providers, ended up being a net negative for them (lower prices and lower volumes). In parallel, hospital labs continued to fare relatively well given their unique features: hospitals get reimbursed at higher rates under both Medicare (for the hospital population only) and private insurers. Whilst this might be counter-intuitive, my research showed that hospital labs have received higher prices mainly because (i) in rural areas, they are often the only labs and there is no competition and (ii) as hospitals, the rates are negotiated as part of the hospital’s overall outpatient contracts and not tied to the national Clinical Laboratory Fee Schedule (CLFS). In today’s CMD presentation, Steve Ruskowsky (Quest’ CEO) showed that on average hospital labs were 2.5x more expensive than DGX.

     

    I will discuss the trend of reimbursement rates in greater details next, but bear in mind that this ‘unfair’ hospital advantage will disappear completely over time: the new PAMA regulation is only the beginning and the higher fee for hospital outreach programmes will go away under this market-based mechanism. PAMA is bringing down the reimbursement rate under the Part B schedule, i.e. for “non patients”: whilst it is current practice for private insurers to offer a hospital reimbursement rate ‘as a whole’, i.e. regardless of whether the test was for an hospital patient or a patient under the outreach programme, insurers, being profit maximisers, will start to make the distinction between hospital patients and patients of the outreach programme and stop this unfair incentive. This, in my view, is a key benefit of the pricing transparency being implemented with PAMA.

     

    Understanding the economics of laboratories, reimbursement rate & PAMA

     

    There are some unique features to the business model of clinical labs. In this industry, the person recommending the test, the service provider, the payer and the end “consumer” are different. A successful lab has to score high with all key stakeholders in order to stay in business: good relationships with physicians are key to drive volume, bargaining power with insurance companies will drive revenue per test and customer/patients need to be satisfied with the service to ensure business continuity in the long-run.

     

    The national labs, such as Quest, are organised around a number of large “major labs”, functioning as third-shift testing facilities, where local samples from a network of Patient Services Centres are rushed on a daily basis by a fleet of vehicles, couriers and airplanes. DGX activities are centred on 43 major labs, spread across the U.S and 2,300 Patient Services Centres (PSCs). The logistical chain around the business compromises is big: ~3,700 courier vehicles, 23 aircraft and 43,000 employees.

     

    Revenues are a function of the volume of requisitions (i.e. the volume of work being ordered), with each requisition comprising on average 3 tests (national level statistic). The price per test is determined by the reimbursement mix under which the lab operates. As expected, small independent and hospital outreach labs are more dependent on government payers (e.g. Medicare & Medicaid), which represent on average 35 to 40% of the payer mix. The rest of the mix is heavily weighted towards health insurance and a small portion is from patients themselves (2%). Note that these numbers are averages and can be meaningfully different on a geographic basis. For Quest and LabCorp the payer mix is heavily weighted towards the private market.

    In terms of pricing, some sources point that commercial laboratories are paid on average 0.8x Medicare whilst hospital labs are paid 1.3x the Medicare rate. As mentioned above, Quest CEO sees a 2.5x differential with the average hospital. PAMA is bringing down rates by about 10% for the next three years. This is thus a major game changer which will have deep impacts to the industry as a whole. There will be more consolidation in the sector as the financial viability of many of the smaller operations will be highly threatened in the coming two years. For context, a 2012 survey showing that about 60% of the labs had profit margin of less than 6%, with about 50% at less than 3%.

     

    For the smaller labs, profitability will undoubtedly suffer and as a large part of the business is fixed cost, I expect to see many of these labs going out of business in the medium term. The rate of bankruptcies is hard to estimate but I would not be surprised to see 50% of the smaller labs going out of business as this is approximately the proportion of labs with less than 500K test per year (500K tests is often cited to be the minimum scale efficiency point based). For hospital outreach, the impacts of rate cuts will be significant as well, but they could be slightly better equipped to face the headwinds as the average profitability can be higher. Given hospital outreach programmes are typically leveraging existing facilities of the hospital, equipment and personnel (regardless of non-patient business, hospital labs have to run for the core hospital function), the marginal profitability of outreach volumes can be higher. This advantage is compounded by the fact that up to recently, outreach programmes were often not paying any taxes on profit as the outreach profits would be amalgamated with losses from the hospital lab. However, this tax advantage is coming to an end this year.

     

    Quest and LabCorp will massively benefit from acquisition of outreach programmes going forward. My research showed that for many hospitals, the profitability / economics of the outreach lab business is unknown and misunderstood. Outreach programmes are not ran by professional managers but medical personnel who do not see the value in the outreach programme. The labs revenue and costs are blended with the core hospital business, driving down margin. A consultant provides this example of a hospital considering the sale of its outreach business as its lab profitability was around 2.3%. When doing proper cost allocation, the outreach business was very profitable whilst the hospital function was loss-making:

     

    At today’s CMD, Quest management confirmed the strong tailwind associated with the externalities of PAMA. There is an interesting slide in the deck showing how PAMA might completely wipe out the profit of the rest of the lab industry. Quest and LabCorp have been talking about the consolidation potential for about 10 months now but I suspect 2019 will see the uptick in tuck-in acquisitions. Anecdotally, management cited that 80% of hospitals C-suite they interact with are not aware of PAMA and the implications for the hospital lab industry.

     

    The acquisition economics of these businesses are impressive for the large national labs. First, the acquisition process is said to be rather sensible: a lab sale is a major decision for the local healthcare community and hospitals prefer to partner with reliable / transparent institutions. Deals are said to be friendly rather than “sealed envelope” type and when asked about the M&A strategy, Quest and LabCorp indicate that for each situation, usually one lab is best placed than the other due to its local presence: this should ensure a fair but not overly aggressive level of competition. Second, acquisitions are accretive on a cost basis, not revenue. Typically local labs are not as efficiently ran as commercial labs and there are a number of ‘quick-wins’ to immediately improve margins when acquired. Quest advances that deals have to be accretive on cash EPS year 1 and accretive to ROIC by year 3. EBIT margin expansion can be impressive, taking margins from single-digit to 30/40%. This is because in a fixed cost business like Quest, adding on extra volume of tests can have a tremendous positive direct impact on EBIT. Quest actually provided an example in its November 2016 investor day and a remake of it at today’s CMD:

     

    The obvious question then becomes the pace of consolidation and the number of available targets for acquisition. Since 2017 alone, 15 tuckins have already been closed, with total acquisition spent YTD of about $200n (Shiel > Oxford > Med Fusion > MedXM > CHL > PeaceHealth > Provant > Boyce and Bynum > PhenoPath > Hartford > ReproSource > Cape Cod > CLA > Hurley > Marin). Going forward, management expects these acquisitions to deliver more than 2% revenue CAGR for 2019-22, about $650m in additional revenue. This is virtually straight to the bottom line as the economics and the incremental return on investment for these acquisitions are fantastic. In the past, DGX mentioned that it can drive +50% margin on tuck-in acquisitions as volumes go through its state of the art facilities at no extra costs. In terms of opportunities, management showed this graph today highlighting the long tail-wind of opportunities in the outreach space alone:

           

     

    A shift in payor paradigm, new network access, will bring pricing power for Quest Diagnostics

     

    On May 25 2018, a major shift happened for lab businesses: Quest Diagnostics announced its strategic partnership with UnitedHealth, becoming an in-network provider to United from January 1st 2019. Simultaneously, LabCorp will become in-network with Aetna at the same time, effectively ending a 10 year period of lab/insurance provider exclusivity. Let’s try to think about this...

     

    PAMA effectively brings a new market based system for pricing and transparency to the industry. Quest (and LabCorp) will benefit twofold. First, as Quest actually represents c. 40% of the data provided for the new PAMA rates, it has now a great influence on the overall level of reimbursement in the industry, and c. 15% of its own revenue. Second, price transparency is good for the industry, and best for the larger players: the new rates submission system will greatly diminish the incentive to chase volume at all costs. In the past, Quest and LabCorp have been incentivised to provide lower rates to the large health plans; these agreements being private, pricing remained opaque and on a case by case basis. The national labs were chasing volumes and entered into poor economic agreements with the larger insurance provider. A few years in, the labs realised this was a net loss for their industry as it created pricing competition amongst their business. With the new legislation, given labs will submit their commercial rates every three years and the Medicare rates are based on the national median rate, labs are incentivised to halt price decrease and perhaps even increase them over time. This is because any decrease granted on one contract is not only paid on that particular contract, but will feed through the entire system as it pushes down the median price in the industry, which is now going to be published regularly. Looking at the past earnings call, Quest and LabCorp management have both signaled their focus on moving away from pure pricing conversations towards beneficial value based model.  Put simply, given the two national labs are much cheaper than the rest and provide better quality service (consumer experience, turnaround time, ait time etc.), the insurance providers are putting in place incentives to encourage physicians towards the national labs. I still think that the market is undermining this fundamental shift and worries about further competition between DGX and LH. However, I do not think this is relevant as the real market share shift is from smaller labs towards the nationals, who together still represent less than 30% of the total industry.

     

    Overall, PAMA is probably a net positive for DGX and LH which is likely to transform the industry in a duopoly with attractive economics. It will eliminate the smaller players in the market, driving some volumes towards the national players. It will bring pricing discipline to the industry. Any rate cuts to a commercial payer will now carry a negative compound effect: not only is the decrease paid on that contract but it will also feed through the broader market place as it pushes down the national median price which feeds to PAMA. This dynamic enables national labs to move away from pure pricing discussion towards value based model where they can extract better economics with insurance providers given their overall superior proposition. In addition, over time Quest and LabCorp will further compound their advantage given the superiority of their data on patients. This is an increasingly important area in diagnostics: being able to draw conclusions and make inferences from a big pool of tests is an advantage as it helps health plans minimise the cost of healthcare over time (e.g. being able to identify the most ‘at risk’ patients early, recommending testing for certain diseases based on the results pattern of the broader population).

     

    Summary financial review of the business

     

    The origins of Quest date back to the sixties but the current company is the outcome of a spin-off in 1997. DGX went through a step change when it acquired Smithkline Beecham Clinical Laboratories in 1999. This marked the beginning of a growth phase through acquisitions. Since the 2000’s, DGX has effectively been through three distinct phases: an initial period of growth through acquisition from c. 2000 to 2006, a “stagnant” period from 2006 to 2012 and a restructuring phase from 2012 to 2016, with the appointment of a new CEO, Stephen Rusckowski (now chairman & CEO). In the recent years, DGX disposed of non-core operations and the business strategy is focused on two core principles:

     

    (A) Growth acceleration via both organic growth and M&A – Organic growth to come from further partnerships with health plan payers and hospitals (notably to improve pricing) as well as improving the ‘consumer-face’ of the business through easier access to tests, more friendly information sharing amongst patients, payers and labs. M&A is also expected to bring 1-2% revenue growth per year through the acquisition of smaller, less efficient players (notably hospital outreach programme labs). In aggregate, for the period 19-22e, management targets a 3 to 5% revenue CAGR, of which 2% is from acquisitions.

     

    (B) Operational excellence – In summary, DGX is committed to provide a better, lower cost experience for customers, health plans providers and medical professionals. This area is focused on four key aspects: (i) reducing bad debt and payment denials (high in this industry given payers are not necessarily end consumers), (ii) standardisation of tests and equipment (ensuring similar tests and information systems across the company), (iii) digitalisation (for appointment, results, scheduling) and (iv) optimisation & automation of tests. DGX being a very acquisitive company, maintaining cost discipline is paramount to manage the growth trajectory. For 19-22e, management expects to improve expenses by about $200m a year.

     

    Looking at the number of requisitions (volume), DGX has effectively lost volume over the period 2006 to 2012, with requisitions going from c. 151m in 2006 down to 147m in 2012. This was the result of an aggressive push by LabCorp, with the exclusivity agreement with United Health Insurance (UNH), forcing DGX out of UNH network and losing valuable customers (this occurred in 2006/7). Since 2012, requisitions have increased steadily mostly driven by acquisitions. Revenue per requisition (a proxy for pricing) came under pressure as well: revenue per requisition down for much of the historical period, driven by the competitive environment and a series of cuts under Medicare. In the most recent years, whilst revenue per requisition remain under pressure, it is increasing again through a combination of: (a) positive test mix (more high revenue tests with the proportion of gene-base esoteric tests going up from 29% of revenue in 2017 to 32% of revenue in 2017) and (b) higher number of tests per requisition. For FY18e, I expect core organic operations to be a little worse (management just guided a little lower for FY revenue today) as volume has been a little soft in Q2/Q3 (3 impacts from lower than expected prescription drug monitoring, Hep C testing and decrease in Vit D testing) and rev / req probably flat to negative given PAMA and a slight change in mix. I do not worry too much about these short term impacts.

     

    In terms of operating margins, DGX is close to the 16% mark. In the long-run, management believes that it should be able to slightly improve the current margin and take out further costs. Compared to LabCorp, DGX has been the most efficient player on a pure diagnostics basis. We note that on revenue per FTE, until recently, DGX had been the most efficient player with c. $169K revenue per FTE for the past ten years, ahead of LabCorp at c. $164K. This has now changed since LabCorp’s acquisition of Covance Drug Development in late 2014, a transformative move for LabCorp, outside of pure diagnostics into contract research. Management expects to be able to save 3% a year going forward, or roughly $200m. Historically, they have always delivered on their savings targets and given the scale of the operations and the type of cost savings involved, I think it is doable (supplier rationalisation, better use of digital platform to reduce phone calls etc.).

     

    DGX ROIC over the past ten years has been relatively stable at an average of 12.5% over the past ten years, with LabCorp’s average being higher at c.17% but coming down in the most recent years. The higher returns for LabCorp are due to the overall higher revenue growth over that period (revenue CAGR was c.7% for ’06-14a, pre-acquisition of Covance, vs. just below 2% for DGX) and a higher EBIT margin at the corporate level: DGX margin for its other business line were well below core diagnostics margins before their disposals in 2013/14 at c. 9% on average).  Going forward I expect ROIC improvements for DGX with the benefit from tuck-ins.

     

    The cash generation of the business is very good: on average the company generated c. $1bn in cash from operations (funds generated from operations net of change in working capital), that is c. 70% cash conversion from EBITDA. With such high cash generation and a relatively low need for capital expenditure (~$300m p.a.), the company is very shareholder friendly in terms of dividend and share buybacks. That said, DGX management team did not hesitate to cut dividend & SBB when needed to fund large acquisitions (i.e. 2007, 2014 and to a lesser extend 2017). For the coming years, management intends to continue to return the majority of FCF to shareholders through a combination of dividends and share buybacks, with the remainder dedicated to fund M&A activity. It has however made clear that in the absence of M&A activity, it would return further cash to shareholders. In fact, the CEO repeated its determination to create value and focus on ROIC for acquisitions at today’s meeting.

     

    Regarding the capital structure, DGX is rated BBB+/stable, Baa2/stable and BBB/stable by S&P, Moody’s and Fitch. It has a stated leverage policy of maintaining leverage around 2.5x Net debt / EBITDA but indicated it “would not be afraid to take the leverage higher for acquisitions, assuming a rapid deleveraging profile” as they are committed to remain investment grade. On a reported basis, ND / EBITDA is currently at c.2.5x and Funds from Operation (FFO) / Net Debt is at c. 41%. Given the importance of having “retail” space for the patient services centres, it is important to bear in mind that leverage adjusted for operating leases might be more than a full turn higher, at c. 3.7x ND/EBITDA (3.7x is based on EBITDA of $1.4bn and $3.6bn in Net Debt adjusted by about $1.7bn in off balance sheet operating lease debt. $1.7bn operating lease adjustment is calculated based on yearly operating lease rental expenses capitalised at 8.0x, in line with Moody’s typical adjustment). DGX is mostly financed through the bond market, complemented with a $750m RCF. The company regularly engages in refinancing activities to manage its maturity profile and interest rate exposures.

     

    Valuation

     

    Historically, the broader lab market has been rather disliked by the market. I do not think looking at historical multiples is particular useful here as the industry is going to be drastically different in the future. The same could be said of the long term business margins and ROICs.

     

    I find the stock very inexpensive in terms of multiple. On 2019e metrics, it have it at roughly 11.5x EBIT, about 14x PE. For such a high quality business with strong competitive advantage, this feels very attractive. The business is highly cash generative (6% FCF yield) and management has a unique opportunity to deploy capital at a much higher rate of return through tuck ins. Worst case, capital can’t be deployed as fast as expected and shareholders will benefit from special dividends or buybacks. The balance sheet is reasonably strong and offers optionality.

     

    For my valuation, I modelled the business on a long-term basis, with a ten year horizon, 8% discount rate and 2% terminal growth rate (LT US clinical lab market has been around 2%). My base case is around $130/140 per share, or at least $22bn EV. I have a base case 10y revenue CAGR of 3% (close to $10bn in the end) but the key difference with the street is probably on margin / ROIC. I think this is going to be a story of strong ROIC appreciation and I model the business reaching around 18% ROIC in the long-term (vs. 12% today), on the back of huge tailwind from the acquisitions and operational improvements. Capex / D&A is around historical levels at 30/26% of PP&E. The key swing factor is really from the M&A incremental returns which I have at 50% in the long-run; then it is a question of how much M&A going forward (at today’s meeting, Steve even mentioned $4bn in dry powder!). I have done various scenarios and the risk/reward profile is strongly in my favour I think. Even in a downside case if management were to do nothing on the M&A beyond 2018e and failed to deliver any margin benefits (margins back towards 15a levels at 14%), with a flat ROIC in the long-run of 12%, I value the business at about $14bn EV, $77 a share, 12% downside compare to today’s close.

     

    I simply think this is a very rare opportunity at a very attractive price. I worry about what I am missing here as it feels the odds are very strongly in Quest’s favour in the long term.

     

    A word about the management team

     

    Quest Diagnostics is headed by Stephen Rusckowski, its President and CEO. Stephen joined DGX in 2012 and is the architect behind the current strategy. I note that his employment agreement was extended in June 2015 and currently due to expire on 31 December 2018; there is a six months’ notice period with automatic renewals for one year if the agreement is not terminated and a one year non-compete following termination. So far, no comment has been made in relation to succession plans. He owns about 150K shares.

     

    The current reward mechanism was drawn in 2012 with the new strategy. At the time, Quest targeted a compensation for its top management made of 69% long-term incentives (split 40% shares, 40% stock and 20% in restricted share units), 15% cash bonus and 16% base salary. The cash incentive compensation is evaluated on 7 metrics, mixing financial (80% of weight) and non-financial metrics (20% metrics). These metrics are short-term in nature but overall represent only a small proportion of total compensation. The LT incentive plan is made of 3 types of equity awards on performance shares, RSUs and stock options; all typically vesting over three years. The performance measure is currently based at 50% on revenue CAGR and 50% ROIC. Revenue is as reported (i.e. inclusive of M&A), net of any disposals / wind down. This obviously fuels an appetite for M&A but the significance of the ROIC metric should keep management in line for profitable growth and not growth at all cost.

     

    Overall, no surprise, management is doing quite well here…

     

     

    Key risks

     

    Cyclicality. Clinical tests are somewhat cyclical and follow broader macro dynamics. Patients are likely to postpone and not perform tests if they are out of employment. As a result, any important change in the level of employment of the broader economy can have a negative impact on testing levels. It does raise the question of why current volume continue to be soft given current unemployment levels. Management has identified three culprits (prescription drug monitoring, Hep C, Vitamin D) but this remains an area of concern.

     

    Patient concessions. Patient concessions are now reported as a deduction of revenue (previously bad debt). In Q2/Q3 it had a negative impact and management was forced to reserve for unpaid revenue. In the past, CFO explained that this was expected as patients deductible is going up on average so patients are paying a greater proportion of their healthcare. Currently, some billings are late for payment. However, management seems very confident that this is not an important factor and that once the cash is collected, the reserves will be decreased.

     

    United/Aetna contract opening. As I said, I think this is a strong positive. But if somehow it does not happen as expected (e.g. net loss of shares to LabCorp due to the opening - which seems unlikely today), this could create competitive pressure. In any scenario, I think pricing will remain a positive though.

     

    Operational issues. Unlikely but external factors can have serious impact on operations although the recent wildfires show how a larger network of lab can use its scale to continue serving patients.

     

    Litigation. A very significant operational risk for Quest. The entire industry has been subject to nation-wide reimbursement scandals to defraud the US government. For Quest, there has been instances where it was condemned to heavy fines for illegal kickbacks to doctors and clinics, notably in 2011 with the $241m settlement of the Medi-Cal case. Most recently, in December 2016 the company was the victim of cyber-attack and could be subject to penalties. We note that the company has certain insurance in place and as of December 2016, $117m in reserves for legal matters.

     

    New technology. New testing could potentially disrupt the industry (or not, cf. Terranos…..). However, I see the risk as remote. Quest prefers to acquire technology from third party only when it is sure it will achieve an interesting reimbursement rates from the government and health plans.

     

    Integration difficulties. Remote in my view as tuck ins seem very easy to execute here but if DGX struggles to integrate the large number of acquisitions it is going to make, it can create disruption.

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    Passage of time forcing smaller labs out of business

    2019 PAMA cuts

    Opening of UNH/Aetna contracts from Jan 2019

    Market awareness

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