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Quest Diagnostics (NYSE:DGX)

Q4 2012 Earnings Call

January 23, 2013 8:30 am ET

Executives

Kathleen Valentine - Director of Investor Relations

Dan Haemmerle

Stephen H. Rusckowski - Chief Executive Officer, President and Director

Robert A. Hagemann - Chief Financial Officer and Senior Vice President

Analysts

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Ricky Goldwasser - Morgan Stanley, Research Division

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Dane Leone - Macquarie Research

Lisa C. Gill - JP Morgan Chase & Co, Research Division

Albert J. Rice - UBS Investment Bank, Research Division

Isaac Ro - Goldman Sachs Group Inc., Research Division

Amanda Murphy - William Blair & Company L.L.C., Research Division

Darren Lehrich - Deutsche Bank AG, Research Division

Robert M. Willoughby - BofA Merrill Lynch, Research Division

Jeffrey Bailin

Anthony V. Vendetti - Maxim Group LLC, Research Division

Gary P. Taylor - Citigroup Inc, Research Division

Operator

Welcome to the Quest Diagnostics Fourth Quarter 2012 Conference Call. At the request of the company, this call is being recorded. The entire contents of the call, including the presentation and question-and-answer session that will follow, are the copyrighted property of Quest Diagnostics with all rights reserved. Any redistribution, retransmission or rebroadcast of this call in any form without the expressed written consent of Quest Diagnostics is strictly prohibited.

Now I would like to turn the call over to Ms. Kathleen Valentine, Director of Investor Relations for Quest Diagnostics. Go ahead, please.

Kathleen Valentine

Thank you, and good morning. I am here with Steve Rusckowski, our President and Chief Executive Officer; and Bob Hagemann, our Chief Financial Officer.

Before we begin, I'd like to share that as part of the new organization structure we announced in October, I am moving into a new role in the company, supporting our new value of creation organization.

Now I'd like to introduce our new Executive Director of Investor Relations, Dan Haemmerle. Dan?

Dan Haemmerle

Thanks, Kathleen. During this call, we may make forward-looking statements. Actual results may differ materially from those projected. Risks and uncertainties that may affect Quest Diagnostics' future results include, but are not limited to, those described in Quest Diagnostics 2011 annual report on Form 10-K, 2012 quarterly reports on Form 10-Q and current reports on Form 8-K. A copy of our earnings press release is available and the text of our prepared remarks will be available later today in the Investor Relations Quarterly Update section of our website at www.questdiagnostics.com.

A PowerPoint presentation and spreadsheet with our results and supplemental analysis are also available on the website.

Now here is Steve Rusckowski.

Stephen H. Rusckowski

Thanks, Dan, and thanks, everyone, for joining us today.

Well, in 2012, we generated $1.2 billion in cash, a record for the company. For the year, we expanded operating margins by 30 basis points, we reached 17.8% and this was driven by continued strong progress in our Invigorate cost-reduction initiative.

We began laying the groundwork for restoring growth. So in a few minutes, Bob will review the fourth quarter with you, but I'd like to start by giving you an update on the progress we've made to execute the 5-point business strategy we shared with you at Investor Day in November.

The first element of our strategy is to refocus on Diagnostic Information Services. We conducted a thorough business review of our assets to ensure strategic alignment and began to pursue strategic options for several of them, including HemoCue and OralDNA. Last year, we sold OralDNA and last week, we announced our plan to sell HemoCue. As a result, we reported the results for these businesses as discontinued operations.

The second strategic element is to drive operational excellence. I'd like to share that we are making excellent progress. We delivered annualized realized savings in 2012 of $160 million with a run rate exiting the year of approximately $200 million. This succeeded our goal entering the year for run rate savings of $150 million.

We are clearly on track to achieve our revised commitment to exit 2014 with run rate savings of $600 million and realized savings of $500 million.

As I've mentioned in past calls, I have been very involved in this program, which is essential to building long-term value. This program is now being managed within our newly created operations organization, but of course, I'm going to be very engaged in driving progress.

The third element is to restore growth. We now have a single unified sales team under a strong collaborative leader with new regional sales leaders in place across the organization. We'll have our first ever national sales force together in 2 weeks. This is where we'll kick off the year. We'll train our sales reps and motivate them to restore growth in 2013.

In addition, we are executing our 7 key growth initiatives with short-term focus on building sales excellence, growing esoteric testing and establishing a hospital professional services business.

Fourth, we are simplifying our organization. When we reported our third quarter results in October, we had just launched our new organizational structure and I had identified the senior management team. Since then we have been deploying the new organization deep into the business, which includes reducing the number of management layers from 10 to 7. This is on track to be concluded in the second quarter.

The fifth point of our strategy is to deliver disciplined capital deployment. In 2012, we reduced debt by $654 million. We significantly increased our dividend, repurchased 200 million of shares and announced the UMass transaction, which was completed on January 2.

Our UMass Memorial relationship and planned Lab of the Future in Marlborough, Massachusetts represent a new model for delivery Diagnostic Information Services for our nation's increasingly cost pressured health care system. We have begun integrating this business into our company and the new facility is being prepared for the buildout to start in the spring.

Our management team is actively engaged in this integration to ensure we deliver the value we envisioned. We're actually seeing a lot of interest in this acquisition by integrated delivery networks throughout the country.

We have made progress launching to our employees in November what we are calling our new quest. We have engaged our employees in the conversation about the company's new vision, empowering better health with diagnostic insights and our 5-point strategy. I'd like to share that this has generated enthusiasm and excitement inside the company. It also has confirmed our initial view that by eliminating complexity and empowering our employees, we can be more effective and create inspiring workplace.

There is a strong management commitment to driving operational excellence and restoring growth starting with me. I have been personally involved in Invigorate initiative since I arrived at Quest in May.

Another top priority for me is to ensure that we focus more intensely on our customers. I've already met a variety of customers and health plans, integrated delivery networks, and large physician practices, and I look forward to meeting many more customers during 2013 with our commercial team as we progress in restoring growth.

The revenue guidance we provided this morning is consistent with the commitment we shared at our Investor Day in November to grow revenues in low-single digits through 2015 beginning with slower growth in the near term and accelerating through the period. We think 2013 is a building year as we improve operations and begin to restore growth.

In 2013, our focus will continue to be driving operational excellence and restoring growth. We will build on the positive momentum of our 2012 Invigorate performance in 2013. We expect results from our efforts to restore growth to gradually build throughout 2013 and anticipate continued revenue softness in the first half with improvement thereafter.

Our efforts to drive sales excellence, grow esoteric testing, and build the hospital professional services business will gain momentum throughout the year. This, coupled with more favorable year-over-year comparisons in the back half of 2013, is what we expect to lead to improvement in the second half.

We believe the Affordable Care Act will provide volume lift in 2014 as more people gain access to health insurance. The Diagnostic Information Services industry continues to deliver significant value to health care, given it represents a large portion of the information that is used every day to make health care decisions, while it only represents a small portion of the health care dollar.

In the future, with the evolving health care system that will place more emphasis on evidence-based decision-making, we believe this industry and specifically, our company, is very well positioned.

Despite this long-term view, we are clearly planning for reimbursement pressure, averaging 1% to 2% through 2015.

In the short term, we are projecting that the combination of commercial pricing pressures, coupled with Medicare cuts, including the most recent pathology service reimbursement reduction, will approximate a 3% reimbursement decline in 2013. We expect to be able to achieve double-digit earnings per share growth by the time we get to 2014 with that growth contributed by not only improvements at our operating earnings, but continued share repurchases as well.

Our management team and I are focused on driving improvements and return on invested capital. We expect that executing our strategy will result in value for our shareholders by driving return on invested capital or long term in restoring growth.

Now I'd like to turn over to Bob for a detailed analysis of the numbers. Bob?

Robert A. Hagemann

Thanks, Steve. I'll start by trying to simplify some of the analysis of the results. Given the movement of HemoCue and OralDNA, the discontinued operations, explaining the performance for Q4 and full year 2012 has become more complex.

To assist in understanding the impact of that change, we have presented a series of tables and Footnote 4 to the earnings release, which reconcile the reported results for what is now continuing operations to pro forma results from continuing operations on an adjusted basis had we not treated HemoCue and OralDNA as discontinued operations. Those pro forma results are comparable with how we had been reporting through the first 3 quarters and how we presented our financial guidance provided in October. The tables presented cover Q4 and full year performance for 2012.

As the pro forma results show, we fell short of our full year revenue guidance by about 50 basis points. About half of the shortfall is due to the estimated impact of Hurricane Sandy with the other half, softer volume performance than we expected in the underlying business.

Despite the softer top line performance, the full year pro forma adjusted EPS of $4.47, which was reduced by an estimated $0.06 for Hurricane Sandy, was within our EPS guidance range. Our success in driving our Invigorate initiative was a key contributor to delivering the EPS performance.

For the balance of the discussion, I will speak to principally the adjusted results, which present HemaCue and OralDNA as discontinued operations and is consistent with how we will report going forward. In discussing the results, I'll refer to Diagnostic Information Services or DIS, and Diagnostic Solutions or DS.

DIS is made up of the same businesses we've previously called clinical testing and was essentially unaffected by the movement of HemaCue and OralDNA into discontinued operations. What we previously called our nonclinical testing businesses will now be referred to as DS. HemaCue was previously included in nonclinical testing.

Starting with revenues. Q4 consolidated revenues of $1.8 billion reflect a decrease of 4% from the prior year with an estimated 1.2% of the decrease due to the impact of Hurricane Sandy.

Our DIS revenues, which account for over 90% of total revenues, were 4.4% below the prior year with 1.3% of the decrease due to the impact of Hurricane Sandy. Volume was 2.4% below the prior year with 1% due to the hurricane. Revenue per acquisition was 2% below the prior year level, but essentially unchanged from Q3. Favorable test mix and an increased number of tests per acquisition continued to have positive impacts, but have been more than offset by reimbursement pressures and business impairment exchanges.

Q4 revenues in our DS businesses, which include risk assessment, clinical trials testing, health care IT and our remaining products businesses, were comparable to the prior year. Q4 adjusted operating income at 17% was 90 basis points below the prior year with the decrease due principally to the impact of Hurricane Sandy.

Adjusted EPS of $1.01 was $0.19 below the prior year with each of the following contributing approximately 1/3 of the decline, Sandy, underlying revenue softness and the year-over-year impact of nonrecurring tax items. Restructuring and integration costs totaling $36 million reduced reported operating income as a percentage of revenues by 2.1% and reported EPS by $0.14.

Last year's fourth quarter included $11 million of costs associated with CEO succession and restructuring and integration, which reduced reported operating income as a percentage of revenues by about 60 basis points and reported EPS by $0.04.

The response to the softer volume we have seen in the most recent quarters, we have taken action to accelerate savings associated with our Invigorate program. We estimate that Invigorate delivered approximately $160 million in realized savings in 2012 with a run rate savings as we exited the year at about $200 million. This represents about 1/3 of our updated goal of $600 million in run rate savings as we exit 2014. In addition, as you heard at our November Investor Day, we are evaluating additional opportunities, which can bring that amount to $1 billion over time.

Bad debt expense as a percentage of revenues improved 10 basis points from the prior year to 3.4% in the quarter. DSOs were 47 days, up 1 day from last quarter.

Cash from operations was $380 million in the quarter compared to $338 million in the prior year. Cash flow in the quarter benefited by a deferral of just over $90 million of income tax payments into the first quarter of 2013. The tax deferral was offered to companies headquartered in states most affected by Hurricane Sandy. While this deferral helped cash flows in 2012, it will reduce cash flows in 2013 with the year-over-year impact being approximately $180 million. This deferral, plus the roughly $72 million of cash flow benefit we've realized from cashing out certain interest rate swaps in 2012, will adversely impact the comparison of 2013 cash flow to that of 2012 by a total of roughly $250 million.

Capital expenditures were $60 million in the quarter compared to $44 million a year ago. During the quarter, we've repurchased 869,000 common shares at an average price of $57.55 for a total of $15 million, bringing the annual total to $200 million.

We also reduced outstanding debt by $147 million in the quarter, bringing the full year total to $654 million in connection with our stated objective to delever by $500 million to $700 million.

Turning to 2013 guidance. We expect results from continuing operations before special items as follows: Revenue growth of between 0% and 1%; earnings per diluted share to be between $4.35 and $4.55; cash provided by operations to approximate $1 million; and capital expenditures to approximate $250 million with the increase from the prior year primarily associated with our Invigorate initiative.

Now I'll turn it back to Steve.

Stephen H. Rusckowski

Thanks, Bob. So in closing this quarter, we had aggressively drove operational excellence and delivered strong Invigorate savings. We are actively working to regain market share and grow our business. We have taken tangible actions to increase shareholder returns and improve return on invested capital. Now I'd be happy to take any questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from Tom Galluci, Lazard Capital Markets.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

I guess, first, I was just wondering within the guidance, Bob, what do you have assumed for buybacks and the incremental portion of cost savings?

Robert A. Hagemann

Yes, Tom, we don't provide specific guidance on buybacks, but what you can assume is that we are going to meet our commitment of returning the majority of free cash flow to shareholders through, obviously, the increase in the dividend and the remainder through share repurchases. And that share repurchases this year should be higher than they were in 2012 with our delevering behind us. We feel as though we've got much more flexibility now to return cash to shareholders. The other part of the question was with respect to the Invigorate savings. While, again, we're not giving specific guidance in terms of what that will be each quarter, at the end of this past year, we had realized about 1/3 of the $600 million in run rate savings we expect. Yes, you should expect that we're going to be in the range of about 2/3 of that as we exit 2013.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Okay, great. And then final one. Just on volumes, what do you peg the market growth as and obviously, it would seem that you're maybe losing a little bit of shares. So could you just give us a little bit more color on some of the headwinds that you're seeing? And you mentioned before expecting sales improvement as you go through 2013. Besides the easy comps, tell us what you're doing there and what sort of visibility you have on improving that volume and market share?

Stephen H. Rusckowski

Yes, I appreciate that. So first of all, what we shared at Investor Day is we believe retrospectively is this market has been growing around 4%. Now that is a discussion around where the volume is going and some of the volume being picked up by hospitals and their outreach activities and they're picking up volume, but also picking up value share in the marketplace. But we have been not growing at that market rate, so what we have said is we've lost share and therefore, what we're doing with restore growth is to start by improving our performance and growing the business and getting back to growing with the marketplace. With that said, what we saw on the fourth quarter is continued sluggish market conditions. We did not see an improvement in volumes and actually, independent of Sandy, it continued throughout the quarter as we saw in Q3 as well. So we don't see a big change in that so far. Prospectively, we believe this is a good market. Again, we say the market will grow at 4% going forward. We believe there will be a pickup in the market size in 2014 with the Affordable Care Act kicking in. But in the short run, given what we saw in Q3 and Q4, we are anticipating that will gradually improve going into next year, but we don't see significant changes in the market going forward.

Operator

Your next question comes from Ricky Goldwasser, Morgan Stanley.

Ricky Goldwasser - Morgan Stanley, Research Division

In the prepared remarks, you talked about guidance being back-end loaded. Can you give us some sense as to what percent of revenue in earnings will be first half versus second half?

Stephen H. Rusckowski

Yes, so let me start, and I'll turn it to Bob as well. And we shared why do we believe it's going to be back-end loaded. Well, first of all, is we do have a number of programs that we have initiated in 2012 that are gaining momentum, and we believe we'll have the most material impact 2013 in the second half. For instance, we are putting an emphasis on growing our hospital professional services business. We believe there will be volumes in the second half that we won't see in the first half. In addition to that, if you look at the comparisons versus last year, the first quarter of last year was strong. It's a tough compare. A matter of fact, there's 1% fewer workdays in the first quarter versus last year. Second is if you look at second half, we're coming off the second half that was softer. So it's a combination of our organic investments materializing in 2013 and also how the year lays out in 2013. So I'll turn it to Bob.

Robert A. Hagemann

And, Ricky, while we don't provide quarterly guidance, obviously, we wanted to provide this level of understanding so that folks as they're thinking about the first half of the year versus the second half of the year, but you can get it right. As Steve said, the first quarter last year was a very strong quarter, clearly the strongest volume that we've reported. So that's going to be one of our toughest comps as we go into next year.

Ricky Goldwasser - Morgan Stanley, Research Division

And should we think about pricing at the same way, because I think pricing was fairly strong in the first quarter '12. So is it a fair assumption that in 1Q '13, your -- the metric that you report on pricing kind of that the price declines in 1Q '13 would be greater than what you reported in the fourth quarter?

Robert A. Hagemann

Well, again, remember last year's first quarter had the benefit in it of the -- I'll call it the last quarter of both Athena and Celera in there, which drove mix. That anniversary-ed as we got into the second quarter, and we saw relative stability in the revenue correct throughout the year subsequent to that. As we think about the 3% reimbursement pressure, it will be relatively even throughout the year we're expecting.

Ricky Goldwasser - Morgan Stanley, Research Division

Okay. And then lastly on the hospital front, I mean, obviously, I think hospital outsourcing trend is one of the key debates in the lab space. And looking at the metric that you provided by payer, I see that actually hospital and reference lab revenues have gone up in 2012. So can you just give us some color on what drove the year-over-year growth in revenue from that kind of like payer bucket and how do you think about that segment in '13?

Stephen H. Rusckowski

So, thanks for the question. Yes, you're right. We did see growth in our hospital reference business and we're encouraged by that. I think it speaks volumes. We shared in our Investor Day that we have bought 50% of hospital contracts with us for their reference work and given that large share, what they give to us is the more esoteric testing. We see it's a trend that will continue, but also we're going to build on those relationships in more strategic discussion about where they're heading with their laboratory activities, including their reference testing, but also how we can have more value-added services provided to them after including taking on their outreach business. So that's our strategy, but we're going to build on that trend that you picked up in the details.

Operator

Your next question comes from Kevin Ellich, Piper Jaffray.

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Steve, your comments on the Affordable Care Act having a lift on volume in 2014, I was wondering what's your thoughts on what the impact on revenues will be with the Affordable Care Act in 2014.

Stephen H. Rusckowski

Well, first of all, we're not going to provide guidance on 2014, but we do see -- we do believe that there will be a pickup in the market and therefore we should be seeing a piece of that market. More helpful, Kevin, given what we're doing with restoring growth, as I said in my prepared remarks, we see 2013 as a year to get a lot of things working and a lot of things in place to be able to take advantage of that change in the marketplace. So we're not going to provide guidance on 2014, but we should see a pickup in the market and we should be in a very good place at that point to take advantage of it.

Kevin K. Ellich - Piper Jaffray Companies, Research Division

I absolutely agree with you, Steve. I was just thinking that with the patient testing bucket going down with -- if you were uninsured that, that would have a negative impact on the revenue partially offset by the pickup in volume that you see. Plus, then you had the impact of the exchanges coming into play, which still kind of remains a question mark. Do you think that logic is correct?

Stephen H. Rusckowski

Well, as you pointed out, there's so many unknowns right now, and that's part of the challenge is, there's no question, there's going to be more volume. Question is what's going to be the insurance product for those volumes and how will we engage? States are still deciding what their plans are going to be. So there's a lot of moving pieces of this as it unfolds as you know. So we believe, as we said in the past, is the Affordable Care Act will be a net positive for this industry and for us. We think we'll be in much better place to take advantage of it in 2014 than we were in 2012 with all the work we're doing. So we'll be actively engaged in the marketplace and stay close to it and take advantage of whatever way it shapes out.

Robert A. Hagemann

And, Kevin, I would just add to that while patient pay is our highest reimbursement, it also carries our highest level of bad debt and contributes about half of our bad debt overall. So as we see shifting out of that bucket, we should see some benefit on the bad debt side also.

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Sure, that makes sense. And then I'm not sure if you guys have provided much detail behind the UMass deal, but I was just wondering what's embedded in your guidance for any volume pickup that you'll see from that relationship.

Stephen H. Rusckowski

Bob, do you want to handle it?

Robert A. Hagemann

Yes, Kevin, as we said when we announced that deal we expect it to contribute about 1% to revenues this year in 2013 and expect it to be accretive starting in 2014.

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Okay. And is that all volume, Bob? Or is there some price growth that will come in from that deal?

Robert A. Hagemann

The majority of it is volume. That's the way we should think about it.

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Okay. And then lastly, kind of more big picture, Steve, with the hospitals taking some share as they have made more acquisitions of physician practices, just wondering have your efforts picked up with any of the managed-care companies or with the industry to try to shift some of that volume out of the hospitals and outreach programs to lower cost settings such as yourself.

Stephen H. Rusckowski

Yes. So the answer to your question is yes, it is picking up. As we have said in the fall and it continues to be growing trend, we're having more and more conversations about what will happen in the future and how hospital systems, as they, by physicians will work with us. We talked earlier in this call about reference testing. We talked about more value-added services. Our engagement with integrated delivery networks and they're thinking through how they'll work with us going forward has increased considerably from prior year. So the trying continues.

Operator

Your next question comes from Dane Leone, Macquarie Capital.

Dane Leone - Macquarie Research

Two quick questions for me. One, what is actual cash balance that you need to have on your balance sheet?

Robert A. Hagemann

Dane, it's probably in the range of $100 million or so. The reason that you see the cash balance as high as you do at year end, which is close to $300 million, refers to the 2 things. One, the deferral and the tax payment from Q4 to Q1. So we have cash on hand to handle that $90 million tax payment. And in addition, the cash balance that we had at year end was there to cover the payment on January 2 that we made to conclude the UMass transaction.

Dane Leone - Macquarie Research

Right. So just as a rule of thumb in a normal environment, anything above $100 million could be considered a cash sweep back to either debt paydowns or share repurchases for the down payments?

Stephen H. Rusckowski

Yes, if you look historically at our cash balance, it's probably ranged between $100 million and $150 million or so.

Dane Leone - Macquarie Research

Okay, great. And the second question for me. Is there anything besides the UMass deal that's embedded in revenue growth expectations for 2013, potentially deals not done that are considered?

Stephen H. Rusckowski

So our guidance includes UMass and also includes anything else we might have in the year. As we shared, as part of our strategy, we do believe this is an opportunity to continue to look at fold-in acquisitions. And as you would expect, as we deploy our strategy, we're looking at those, and so we have an active funnel. So the guidance includes those as well.

Dane Leone - Macquarie Research

Okay, great. So to not pin you down to be too specific about quarterly guidance, is there an expectation for organic volume trends to turn positive in 2013?

Stephen H. Rusckowski

The answer to the question is yes. If you go through the math, we do have headwinds with the 3% we have shared. That price pressure, we have to offset with our cost-improvement programs. And fortunately, we're in good shape. We exit the year at a nice momentum that will carry into 2013. With that said, if you go through the math, we are anticipating organic improvement and some of that, our quick organic improvement, will come from all the activities you've heard about with restore, what we're doing around bringing sales excellence to the company, making sure that we continue to capitalize on esoteric testing and building out our hospital's professional services. So we are planning on it.

Operator

Your next question comes from Lisa Gill, JPMorgan.

Lisa C. Gill - JP Morgan Chase & Co, Research Division

Steve, I was wondering if you had any thoughts around potential copay on the Medicare side, obviously, still trying to work through the fiscal cliff. But as we think about that, is that contemplated in your reimbursement pressure of 1% to 2% through 2015?

Stephen H. Rusckowski

Yes, so first of all, the work is going to happen to understand what will happen around sequestration. And also, we are planning for that at our 3% reimbursement cuts that we plan on for this year. As far as copay, clearly, this is going to be a discussion. It's hard to understand what might happen eventually. So it's not necessarily, in a detailed way, part of our guidance, but we'll be working through this and along with many others lobbying found that might fold out to the lab industry, but not quite clear yet.

Robert A. Hagemann

And Lisa, if a copay were to go into place, it would not necessarily show up as reimbursement deal. In all likelihood, if there was any negative impact from it, you'd see it in higher cost of collections. You'd also potentially see it on the bad debt side a little bit as we have to chase those copays. So we're not convinced that copays make a lot of sense. They shift cost to the patient, as well as add cost to the health care system, with now having to collect it.

Stephen H. Rusckowski

At least round that off, Lisa, because you asked about 1% to 2%. So 1% to 2% is our best estimate of what reimbursement pressure will be in 2015. Obviously, we have more of that in 2013, but the 1% to 2% assumes a mix of all reimbursement pressures, and so if there's something coming, that's in the number.

Lisa C. Gill - JP Morgan Chase & Co, Research Division

And then Steve, you talked about interest by IDNs in the UMass deal. As many of these IDNs are becoming accountable care organizations, are you having discussions with them about becoming the outsource lab. I mean, they'll be accountable for those costs rather than fee for service before it made sense for them to run their own lab? Are those the type of discussions that you're having?

Stephen H. Rusckowski

Yes, it's both. First of all, this is a fee-for-service industry, and it will take time to move over to the accountable care model. As we've said in the past, and when you see one ACO, you see one ACO. The payments reform that's necessary to change how you think about cost and how we contribute to that is still evolving. So we have both discussions, one in today's world but also thinking about the future. So inform these relationships, they're thinking about us in the short run as well as the long run, and how this might play out, so -- but in the short run, people are thinking about today in the 2013, it is a fee-for-service world.

Operator

The next question comes from A.J. Rice, UBS.

Albert J. Rice - UBS Investment Bank, Research Division

Maybe just a couple of quick questions. First of all, your guidance range is not particularly wide range, $4.35 to $4.55 in EPS. But I wondered if I might get you to comment on the variables that you see most relevant in thinking about whether you'll end up at the high end of that guidance range or the low end of that guidance race? Any comment on that, by any chance?

Stephen H. Rusckowski

Bob, do you want to...

Robert A. Hagemann

Yes, A.J., it's clearly volume. Yes, that's one of the biggest drivers we feel is so [ph]. We've got very good line of sight as to the cost savings that are going to come through from the Invigorate initiative. We feel as though we've really nailed down what the reimbursement pressures are going to be this year. So clearly, the biggest variable in my mind is where volume ends up.

Albert J. Rice - UBS Investment Bank, Research Division

Okay. And when you think about the savings falling through and 2/3 of the savings being realized by 2013, obviously, a portion of the savings is just offsetting the top line headwinds that you're referencing in the business, and then a portion over time is hopefully driving some margin improvement. Can you give us flavor for the prospects for Invigorate to drive margin improvement short and maybe long term?

Robert A. Hagemann

Well, clearly, in the short-term, what it's been doing is allowing us to preserve margins given the reimbursement pressures that we see, and that's certainly going to be the case in 2013 as well. You can imply from the guidance that the operating margins aren't going to be significantly different than they were this year. And to Steve's point, in 2014, when we start to see some uplift in the volumes, we expect that we can then enjoy very nice incremental returns on those volumes, given what we'll have done to the cost structure at that point.

Stephen H. Rusckowski

And I wonder if I could just add to that. What we've said is that we have committed that we're going to have run rate savings of $600 million in 2014, realized $500 million. But what we've also said is that we have challenged organizations to give us more. And Bob, in his remarks, said that we've actually challenged the organization that eventually, like have $1 billion in our run rate. So we're doing everything we can to accelerate what we've committed to and also bring in some more. So I'll just leave that as a commentary related to the opportunity there.

Albert J. Rice - UBS Investment Bank, Research Division

Okay. And then just finally, maybe a specific question on the -- you've been asked before about the Celera royalty portfolio, and any thoughts about unlocking some value there? Any update on that thought?

Stephen H. Rusckowski

Yes. I'll start it and turn it to Bob. First of all, it is not a destruction, operationally, it is a financial asset. There is some uncertainty around the value. We're thinking about it carefully, and we want to make sure we do the right thing for all shareholders at the right time at the right place to take advantage of that opportunity. So Bob, would you like to add to it?

Robert A. Hagemann

Just that we are evaluating all of the possible options that we've got for those assets. And clearly, we intend to do what's in the best long-term interest of shareholders.

Operator

Your next question comes from Isaac Ro, Goldman Sachs.

Isaac Ro - Goldman Sachs Group Inc., Research Division

First of all, just on flu. I don't think the question was asked, so just wondering, that did come a little early this year, has been significant. And I know it's hard to tease out exactly how it impacts the entirety of the testing business, but could you comment on maybe how you would weight the impact between fourth quarter and what you're seeing year-to-date in January?

Stephen H. Rusckowski

Bob's just getting over the flu, as you can probably tell from his voice. So Bob, you answer the question.

Robert A. Hagemann

And I didn't generate any incremental volume [ph]. But -- no, I think flu visits to the doctor's office do not necessarily generate a lot of incremental volume for us, and where there is some, it tends to be pretty low-priced volumes. So yes, I wouldn't look for any material uptick in the numbers as a result of the flu season.

Isaac Ro - Goldman Sachs Group Inc., Research Division

Fair enough. Okay. And then maybe, Steve, as part of your 5-point plan, you guys have talked about the trailing look on organic growth and the end markets you serve. And then some of the opportunities you have to regain share. But just wondering if you could give us some color as to when you think the market will sort of revisit a pace of growth that's consistent with past years, and sort of how you think that'll map against your own performance? Is that saying that you're looking at on a 12- or 18-month horizon any longer?

Stephen H. Rusckowski

Yes, so what we have said is that we don't think significant -- we're not planning on significant changes in the marketplace in 2013, and that's our assumption in the guidance. The second is we do expect that there will be a pickup in 2014 with the lives entering the system with the Affordable Care Act. And so what we said earlier is we are planning on some organic improvement in 2013 to offset the price pressure. And we have a number of initiatives and programs that we started in 2012. So we do have momentum coming out of the blocks in 2013 that will pick up momentum throughout the year, and that's why we've said that we'll gradually improve throughout the year and better performance in the second half than in the first half. And then as we enter '14, we believe that we'll be in much better shape than we were in 2012 and be able to hit 2014 with a better organization, a better delivery model and a better way to capitalize all the opportunity we see in the industry.

Operator

Your next question comes from Amanda Murphy, William Blair.

Amanda Murphy - William Blair & Company L.L.C., Research Division

I have a follow-up question on the hospital professional services business that you're moving into or, I guess, more into. Could you just help us understand how the economics of those contracts might work? So just thinking about pricing and margin relative to the base business.

Stephen H. Rusckowski

Well, first of all, what we've shared is this is a professional services business with a set of capabilities that we will offer to health care systems through a whole continuum. First of all, the basics that we talked about earlier, there's a large portion of hospitals, about 50% that we currently provide reference testing to today, so we already have a relationship. And then if you go all the way to a full outsource, where we purchase then outreach activity like UMass is the end of the spectrum. So in that continuum, there are services that will look at running labs or providing consultancy services, if you will, for labs. And as we start to build the business, it's a combination of reference work, as well as total outsource. Bob, would you like to add some comments about the margins for it and pricing of it?

Robert A. Hagemann

Yes, just a point on that. And we mentioned this at Investor Day as well that to degree that some of that growth is coming from outsourcing us i.e. Managing laboratories for hospitals, that does tend to be lower margin business, but given the fact that there's very little capital investment required to do that for us, tends to be high-incremental returns on invested capital. As we said, that's one of our goals is to drive returns on invested capital, because we believe it'll drive value for shareholders. And as you noticed, we've gotten away from giving guidance around operating income percentage, because, again, it's not necessarily about the percentage, it's about the top line growth and the profits that it can deliver.

Amanda Murphy - William Blair & Company L.L.C., Research Division

So this involves then incrementally more TC-type business, TC-only. And just what are your thoughts on that general model, the TC-PC split?

Robert A. Hagemann

It certainly could involve doing more technical work, but on the AP side. So as we're talking about hospital outsourcing, it's much broader than AP.

Stephen H. Rusckowski

Some pieces of the services that we'll offer some portion of their services to us in the short run as we build that client base.

Amanda Murphy - William Blair & Company L.L.C., Research Division

Got it. Okay. And then just on the reimbursement side. Obviously, you talked a lot about that, and the Medicare reimbursement pressures presence are well known. I'm just curious on the commercial side. Have you seen -- I mean, is something that's changed in terms of how the commercial payors are viewing the lab business, or how we they're negotiating the contract at this point relative last year?

Stephen H. Rusckowski

Yes, well, in the 3% is Medicare. Also, we included in there the large pathology cut that we have received, and we'll be taking this year. And then third is we do have some reasonable commercial pricing changes, but I will not say in the 3% that we're planning, or do we see a substantial change in our relationships in pricing in the industry. Bob, would you like to add to that?

Robert A. Hagemann

No, there is nothing unique happening in 2012 on the commercial side that wasn't anticipated. Yes, this is fully consistent with what we had expected coming into the year. And as we've been talking through 2012 about reimbursement pressure, yes, that was clearly one of the reasons that we felt as though we had to up the ante on the Invigorate initiative, so that we can mitigate that, which was what the point is.

Stephen H. Rusckowski

Just to give some color on the 3%, the Medicare piece, we do have a large pathology business. So it has more significant impact to us than maybe some of the other players in the industry. So that is in the number.

Amanda Murphy - William Blair & Company L.L.C., Research Division

Got it. And so your point is on the commercial side, it's really just a couple of contracts there. If there's anything in there, it's from a couple of contracts versus the broader change?

Robert A. Hagemann

Well, I wouldn't say that just a couple of contracts. Again, we've spoken about the reimbursement pressure, generally. I think that exists with just about all of the payers. And I wouldn't point to any 1 or 2 contracts that are driving what we expect in 2015.

Stephen H. Rusckowski

The big hits this year are Medicare and the pathology services cut.

Operator

Your next question comes from Darren Lehrich, Deutsche Bank.

Darren Lehrich - Deutsche Bank AG, Research Division

I guess, we just want to get a little bit more flavor, Steve, on the 3%. And to the extent, you can just help us to think about just a little more. How does that split out between Medicare pressure and some of the commercial or managed care reimbursement pressures that you see in your book of business?

Stephen H. Rusckowski

Sure, well, 3 pieces. First of all, Medicare, second is the pathology services piece of that and the third is commercial pricing. When we provided visibility in the past in the size of Medicare cut, roughly 5%, there's a significant cut on pathology services, and that is significant for us because of the size of our pathology practice and the rest is commercial. Bob, would you like to provide a little more color to that?

Robert A. Hagemann

Yes, and Darren, as you know, we've disclosed that our Medicare revenues are in the range of $1 billion or so, so the 5% cut on that is $50 million that drops right down to the bottom line. As Steve pointed out, while we haven't provided guidance or specific information relative to the CPT codes on the pathology side that are facing the biggest cuts. It is a sizable piece of our business, and some of those codes are facing reimbursement cuts in excess of 50%. So those are big drivers that we have this year that we haven't had in the past.

Darren Lehrich - Deutsche Bank AG, Research Division

And if I could just -- as it relates to the molecular diagnostics coding changes, do you have at this point any visibility in terms of what the max MACs [ph] are paying you. And are they paying you a different rate in calendar year '13 based on these molecular diagnostic codes that were set for change?

Robert A. Hagemann

Yes, it's still very early. We haven't yet seen the reimbursement come through on many of those codes. We're working with the Medicare into mediaries as well as in the commercial plans to try and mitigate any impact that would be there. We're helping them try and crosswalk where they can, provided additional information. And our hope is to mitigate as much as possible an impact that might be there. But again, rates are not yet published, and we've not yet seen reimbursement on those.

Darren Lehrich - Deutsche Bank AG, Research Division

Yes. And just so I'm clear about your managed care commentary that you're dialing this 3%. Is that based on your outlook for perspective contract negotiations that will be happening this year? Or are you assuming that private payers will follow Medicare to some extent on some of the Medicare reimbursement changes that you've talked about here in the past and the fee schedule?

Robert A. Hagemann

As we've said, the 3% reimbursement's a combination of multiple things. It's -- the Medicare fee cuts, the AP, CPT code fee cuts, as well as commercial. Obviously, commercial rates can be influenced by Medicare rates. We don't have contracts -- many contracts that necessarily float with Medicare, but it is a reference point in all of our discussions around pricing. But at this point, what we've baked into that 3% is -- what we fully anticipate have good visibility to at this point.

Darren Lehrich - Deutsche Bank AG, Research Division

Okay, and then just last thing for me here. I wanted to just clarify, Bob, what you said about the cash flow guidance. I understand that the tax payment, just in terms of the year-over-year cash from operations, being lower in the outlook. Can you maybe just remind be what you said? And how much in terms of restructuring cash costs are also built into that guidance on a year-over-year business?

Robert A. Hagemann

Sure. Two things that you have to look at in comparing the year-over-year cash flow guidance. One has to do with the deferral of a tax payment this past quarter into the first quarter of 2013 that was roughly a $90 million deferral. So it has $180 million year-over-year impact. And that is, you'll recall, in the third quarter of 2012, we unwound some interest rate swaps that we had that generated about $72 million in cash flow for us that we're not expecting to have next year. So those 2 factors combined created about a $250 million impact year-over-year. In terms of restructuring costs and the like, well, we haven't provided guidance on that. The cash impact of restructuring cost is probably not going to be significantly different than it was this past year.

Operator

Your next question comes from Bob Willoughby, Bank of America Merrill Lynch.

Robert M. Willoughby - BofA Merrill Lynch, Research Division

Steve or Bob, have you indicated -- any idea what kind of proceeds you'd get from the 2 divestitures that you have announced in? Should we expect significantly more activity going forward? Or are we near the end of the pipeline there?

Robert A. Hagemann

Yes, Bob, we've not given any guidance on that. I will tell you though that the OralDNA sale that did close very modest proceeds from that. And, obviously, since we are in discussions around HemoCue right now, we're not providing any estimate as to what the estimated proceeds might be there. What you also heard us say at Investor Day though is we were evaluating the entire portfolio, that includes the other products businesses, the Celera products businesses. And as we referenced earlier on this call, we are evaluating all of our options for the Celera drug assets as well.

Robert M. Willoughby - BofA Merrill Lynch, Research Division

Okay. But you wrote a fairly sizable check for HemoCue a few years back, are we getting half of that back. I mean is it a total wash? Or how do we think about that relative to what the premium paid at the time was?

Robert A. Hagemann

Yes, Bob, as you did see, we recorded a charge in discontinued operations. So clearly, we're not expecting proceeds from those businesses, which will match what we paid up for them. But again, at this point, I don't think it would do any of us here a service by speculating what we might get at this point.

Robert M. Willoughby - BofA Merrill Lynch, Research Division

Okay. And did you mention the CapEx number's higher this year? What exactly are we spending on this year that wasn't in the numbers last year? .

Robert A. Hagemann

Yes, Bob, there's 2 things, principally, that are driving the increase. The first and the biggest component is the spending relative to Invigorate, which we expect to ramp up as we start to now rationalize and optimize the footprint, look more at automation opportunities, et cetera. That is ramping up this year end. And in addition, in connection with the UMass transaction, we are building out the facility that we're going to move into. And that's adding some additional expenditures. Those are the 2 principal drivers.

Robert M. Willoughby - BofA Merrill Lynch, Research Division

And would you answer the guess [ph], obviously, '14, '15, but the number should trend down from a peak level in '13 or no?

Robert A. Hagemann

Well, what we said at Investor Day's for the next several years we expect that CapEx will probably be about 1% of revenues higher than it has historically run, and we expect that to be the case for the next couple of years or so.

Stephen H. Rusckowski

I just like to add, as we continue to get some refinement on our Invigorate program, we shared in the past there's a number of initiatives that were taking cost out of the operation from, but the longer-term structural improvement will require investment in the future. We haven't exactly sized that, so we want to make sure that it's clear that we will continue to invest in the business to make sure that this is a stronger business. And as we push to get more in from our Invigorate program, strive for that $1 billion goal, it will require some investments in our facilities and also our IT systems, and that's what we're trying to size. When we get visibility of it, we'll provide it to you.

Operator

The next question comes from Glen Santangelo, Credit Suisse.

Jeffrey Bailin

This is Jeff in for Glen this morning. Just one question for you on the anatomic pathology in sourcing trend. What are you guys seeing in respect to this? And do you think that the pathology cuts could actually ultimately maybe help shift some of those volumes back to independent laboratories like yourself?

Stephen H. Rusckowski

Yes. Well, first of all, it's early, so the market is digesting the cuts, clearly, as a significant cut for that service. It's on the technical side. So you put the typical side together with the professional side, it's not big as a cup, but it's a material change for that portion of the marketplace. So we're watching. We're not sure how it's going to pan out, but you can't ignore it. So we're anxious to see how it will wash through, given we are a significant player, and that there will be some change happening in the marketplace, so we're keeping our eyes on it.

Operator

Your next question comes from Anthony Vendetti, Maxim Group.

Anthony V. Vendetti - Maxim Group LLC, Research Division

Most of my questions have been answered, but if we can talk just a little bit about what particular parts of your business right now you feel are stronger? What particular testing categories are stronger? If you want to talk a little bit more about your genomic esoteric goals in terms of percent of your business going forward?

Stephen H. Rusckowski

Sure. Well, I'll start and pass it to Bob. We talked about the hospital fees having growth, so we're encouraged by that. Second is -- so we continue to focus on a more sophisticated esoteric testing. We continue to be encouraged by the growth there. Third is that we continue to see some specialized areas of that we're in. Prescription drug monitoring continue to grow nicely. And as we go forward, what you have seen from us in terms of organizational structure, we will put more emphasis on our new organization to commercialize all the science and innovation and capabilities in this company, which I believe has not been properly utilized. So you'll see more specific areas of testing and solutions around that testing, which we believe will help us restore growth. Bob, would you like to add to that?

Robert A. Hagemann

And as -- Yes, we've shared with you already too, but yes, we are organizing around certain franchises, disease states. You might think of them as your neurology infections disease, cancer and cardiovascular disease, women's health, general health. And we believe that we'll be able to drive growth in each of those. A lot of it will be in the esoteric testing side, but there's also some areas that we expect to regain some traction on women's health in area in particular that we would expect that we can see improved performance versus what we've seen over the last year or so.

Operator

Your next question comes from Gary Taylor, Citigroup.

Gary P. Taylor - Citigroup Inc, Research Division

A couple of questions. One, just a quick house cleaning. The HemoCue business that was sold, that was never reported in any of the testing revenue disclosure in the supplemental disclosure, is that right? So when I look at some of the year-over-year changes none of that would have been impacted by the reclass of the HemoCue?

Robert A. Hagemann

That is correct, Gary. It was a product business and it was included in what we previously referred to as our nonclinical testing segment, which today is called Diagnostic Solutions or DS. So it didn't impact any of those other metrics that you saw, volumes or revenue per work [ph].

Kathleen Valentine

And just to clarify, HemoCue is not yet sold. We plan to sell it.

Robert A. Hagemann

Correct.

Gary P. Taylor - Citigroup Inc, Research Division

Okay. 2013 operating margin, I guess, kind of our back of the envelope at the middle of your guidance is that if you deploy after dividend all your free cash flow to repurchase, then the operating margin assumption is roughly flat. And if you repurchased no shares, then operating margin will be down about 100 basis points to kind of get to your midpoint of guidance. So given that you said you'll do more share repurchase, I mean, is that -- are we essentially framing that correctly that somewhere between flat and down 100 basis points is in the range based on the amount of share repurchase?

Robert A. Hagemann

Well we certainly do anticipate doing share repurchases. And as I said earlier, I'd expect that it's going to be greater than the level that we did in 2012, given that the delevering is behind us at this point, although we haven't given specific guidance on that. But the other thing I would mention to you is while we've not provided guidance relative to the operating income percentage, given that we're expecting 3% reimbursement pressure next year, much of the Invigorate savings is going to mitigate that at this point. And you shouldn't expect there to be significant expansion in margins next year.

Gary P. Taylor - Citigroup Inc, Research Division

In '14, Stephen mentioned double-digit earnings, I guess, given that share repurchase in any given year looks like it could add 5%. You're expecting a little bit of volume growth. Is it fair to say your expectation operating margin in '14 is flat to up?

Robert A. Hagemann

Well, let's not go to '14 at this point. We're not prepared to give guidance there, other than as you've heard us say, we are optimistic that we're going to see an uptick in volumes. And certainly, we expect that any incremental volume will start to realize in '14 given what we have done for the cost structure, can be very profitable.

Stephen H. Rusckowski

And what we said is that our earnings growth will be a combination of operating improvements, as well as share repurchase.

Gary P. Taylor - Citigroup Inc, Research Division

Right. So I did hear double-digit earnings growth '14 though earlier in the call. Correct?

Stephen H. Rusckowski

You did, in '14 effectively.

Gary P. Taylor - Citigroup Inc, Research Division

Okay, final question, Bob, could just remind us on '13 and '14 commercial contract renewals. Any of the big guys that stand out for those 2 years?

Robert A. Hagemann

Yes, this year, there's only one national contract that's coming up. We've mentioned that CIGNA is the one national that's coming up. Every year, we always have regional plans that are coming up that we're dealing with, but just the one single national contract this year.

Gary P. Taylor - Citigroup Inc, Research Division

And then '14?

Robert A. Hagemann

We're not going out in terms of '14 and giving a specific guidance on contracts.

Operator

Thank you for participating in the Quest Diagnostics Fourth Quarter Conference Call. A transcript of prepared remarks on this call will be posted later today on Quest Diagnostics' website at www.questdiagnostics.com. A replay of the call may be accessed online at www.questdiagnostics.com/investor or by phone at (800) 835-4610 for domestic callers, or (203) 369-3352 for international callers. Telephone replays will be available from 10:30 a.m. Eastern Time on January 23 until midnight Eastern Time on February 23, 2013. Goodbye.

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