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Quest Diagnostics Inc (NYSE:DGX)

Q2 2013 Earnings Call

July 18, 2013 8:30 am ET

Executives

Dan Haemmerle

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

Analysts

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Ricky Goldwasser - Morgan Stanley, Research Division

Dane Leone - Macquarie Research

Isaac Ro - Goldman Sachs Group Inc., Research Division

Operator

Welcome to the Quest Diagnostics' Second Quarter 2013 Conference Call. At the request of the company, this call is being recorded. The entire contents of the call, including the presentation and a question-and-answer session that will follow, are the copyrighted property of Quest Diagnostics with all rights reserved. Any redistribution, retransmission or rebroadcast of this call in any form without the expressed written consent of Quest Diagnostics is strictly prohibited. Now I'd like to introduce Dan Haemmerle, Executive Director of Investor Relations for Quest Diagnostics. Go ahead, please.

Dan Haemmerle

Thank you, and good morning. I'm here with Steve Rusckowski, our President and Chief Executive Officer. During this call, we may make forward-looking statements. Actual results may differ materially from those projected. Risks and uncertainties that may affect Quest Diagnostics' future results include, but are not limited to, those described in Quest Diagnostics' 2012 annual report on Form 10-K and 2013 quarterly reports on Form 10-Q and current reports on Form 8-K.

A copy of our earnings press release is available, and a text of our prepared remarks will be available later today in the Investor Relations Quarterly Update section of our website at www.questdiagnostics.com. A PowerPoint presentation and spreadsheet with our results and supplemental analysis are also available on the website.

Now here is Steve Rusckowski.

Stephen H. Rusckowski

Thanks, Dan, and thanks, everyone, for joining us today. I want to make sure that you have seen our recent announcements, so I want to touch on those briefly.

You have all heard our news announcing our new CFO, Mark Guinan. Mark will be joining us on July 29. Bob Hagemann will remain as our CFO until Mark's arrival, and Bob has agreed to provide a smooth transition to Mark. Again, I'd like to thank Bob for his years of service to Quest Diagnostics. Given the timing of the transition, we thought it'd be best for Dan and myself to handle today's call. We look forward to introducing Mark to all of you during the third quarter.

Second, we announced this morning that we have completed the sale of ibrutinib royalty rights for $485 million in cash. We'll talk more about these later in the call.

But I'd like to take you through the top line performance, share our thoughts on reimbursement and utilization trends as well as health care reform and review progress against our 5-point strategy. And then, Dan will provide the details on our results.

Since January, we have been saying that we anticipated continued revenue softness in the first half of this year and that our efforts to restore growth would result in gradual improvement through the rest of the year.

So as expected, revenues and earnings improved from the first quarter levels but were below the prior year. We saw a continued revenue softness in the second quarter due to lower health care utilization, which impacted many health care providers, as well as reductions in our reimbursement.

There are a number of factors that impacted our year-over-year comparisons. As you'll hear later from Dan, after considering those factors, our underlying volume was down about 1.5% versus the prior year. This compares to the first quarter, which was down about 2%.

In addition, revenues per requisition decreased 3.7% in the second quarter, primarily due to the combination of Medicare cuts and commercial pricing. The impact of the acquisition of Concentra's toxicology business, coupled -- contributed approximately 50 basis points of the decrease. We continue to expect underlying revenue per requisition before acquisitions to be down about 3% for the full year.

I'd like to discuss reimbursement, utilization pressures and the implementation of the Affordable Care Act, which is -- which have all been in the news recently. Well, last week, CMS proposed significant changes to the physician fee schedule and a mechanism to adjust the clinical lab fee schedule in the future. Proposed reductions in Medicare reimbursement did not come as a complete surprise. We have been saying that there will be continuing pricing pressure in our industry and have been preparing for it. And this has been one of the driving forces behind our Invigorate cost-reduction initiative.

The cuts proposed by Medicare last week could impact the industry and impact us. Reimbursement from services related to physician fee schedule for Medicare patients was approximately 3% of our 2012 consolidated revenues. However, the impact will be greater on smaller independent and hospital laboratories because they have a larger portion of Medicare business. I am participating with other industry leaders to proactively work with CMS regarding these proposals.

Last fall, at Investor Day, we introduced our expectation for annual average reimbursement pressure of 1.2% over a 3-year period. We took into account the known Medicare price cuts, sequestration, forecasted commercial payer price changes and potential other government reimbursement changes. There have also been widespread signs that utilization is softer than last year. Physician office visits and hospital admissions in the first half of 2013 are below the first half of 2012. Additionally, payers have cited lower medical cost as a driver of improved performance.

Finally, turning to the Affordable Care Act. It's now seemingly likely that the expected entry of the uninsured people into the health care systems will ramp up more slowly than initially anticipated. Less than half of the states are moving forward with Medicaid expansion, which was seen as a major entry point for the uninsured.

In addition, the exchanges are taking longer to develop than originally anticipated. And then finally, the delay on the employer mandate will see slower implementations of ACA. We still believe that the Affordable Care Act will be net positive for the industry and for our company but will take longer to see the benefits initially than expected.

But the longer term outlook for this market is attractive for a number of reasons: The population is aging and growing, more people will have access to health care, advances in genomics and advanced testing will lead to opportunities for personalized medicine, data analytics will improve quality and reduce costs and this industry continues to consolidate.

We have said before that 2013 is a building year, that we are making solid progress executing our 5-point strategy and that we expect stronger performance in the second half. The improvement in the second half is expected to be driven by easier comparisons, the impact of acquisitions, the benefit of investments we have made to drive growth, the excellent progress we're making with our Invigorate cost-reduction initiatives and benefits from share repurchases. We believe that the progress we have made this year will position us for a stronger 2014 despite the slower implementation of health care reform.

Now I would like to share a mid-year update on the progress we have been making, executing our 5-point business strategy. So let's start with driving operational excellence.

The Invigorate cost-reduction initiative is on track to deliver substantial savings this year. To date, it has mitigated much of the bottom line impact of revenue softness. We are currently on track to deliver more than $250 million in realized savings in 2013 versus 2012. We have shared -- we expect twice as much in savings in the second half of the year than in the first half. In addition, we are tracking very well against our goal to deliver $600 million in run rate savings by the end of 2014. We're taking advantage of our size and scale to improve quality and are committed to our challenge to increase the $600 million goal to $1 billion beyond 2014.

The progress we are making on Invigorate flagship programs gives us confidence in the savings that we have projected. Last fall, we indicated that we had a highly complex organization that was not aligned with the market and our 2 highest priorities in the market, driving operational excellence and restoring growth.

This complexity was also inefficient. We said we had too many management layers and would remove between 400 to 600 management positions, resulting in expected run rate savings of $80 million. We have essentially completed the elimination of at least 3 layers from the organization and have reduced approximately 450 management positions from the company to date, with approximately another 50 reductions to come by the end of the year. So we are on track to achieve our expected run rate savings goal.

Invigorate initiatives are enabling us to do a better job driving efficiencies in purchasing, centralizing support functions so we can provide better customer service and rationalizing excess capacity in our laboratory network. We are also standardizing the way we manage data, the way we develop and use common business processes, enable them with enterprise IT systems.

Next, we have taken actions to restore growth. The near-term focus is on bringing sales and marketing excellence to Quest Diagnostics. Second is growing our esoteric testing through our disease focus and finally, partnering with hospitals and IDMs. So let's take a look at each of these elements.

Well, the reorganization of our sales force is complete. We have a different and simpler organization headed by new leaders. We have more salespeople who are better trained, better equipped, incented and more focused on calling on customers than before. We continue to make progress with our health plan relationships, and I am pleased that we have extended our relationship with CIGNA and look forward to a continued strong partnership with an innovative partner.

We have also signed agreements with a number of payers for diagnostic services offered on the new health insurance exchanges that are an important part of health care reform. We're improving the way we introduce new esoteric Diagnostic Information Services and are developing new service offerings linked to our new disease focused clinical franchises. We have invested in building 7 clinical franchises, organized by specialty disease state, with each led by its own general manager. We believe this is more thoughtful and will bring better solutions to the market that will generate additional growth.

To give you an example, our new Women's Health clinical franchise established our new strategic relationship with Hologic, which provides us an opportunity to ignite new business opportunities with a leader in women's health. This collaboration will focus primarily on cervical cancer and breast cancer. In addition, following the landmark Supreme Court decision on BRCA1 and 2, we're working to introduce a solution for breast cancer predisposition testing later this year.

And then finally, our hospital professional services team continues to see interest building from integrated delivery networks. We have increased activity at all phases of the pipeline, from initial discussions to sharing data to due diligence and contracting. All these factors give us confidence we will see results from our efforts build throughout the remainder of the year.

Our third strategy is to simplify the organization. We have deployed our new organization, shared corporate priorities, established new behaviors and are implementing a new management process with rewards and incentives. With our new organization, we now have a new senior management team comprised of the executives from the company when I joined in addition to the 5 new members since last year.

These individuals all come from senior positions at major publicly traded companies that brings significant leadership experience. Notably, we have just announced our new Chief Financial Officer, Mark Guinan. He comes to us with strong financial operational experience and we look forward to him joining us later this month. I'm confident that this new senior management team will instill the behaviors that we're looking for throughout the company.

Our fourth strategy is to refocus on the core Diagnostic Information Service business. Last year, we sold OralDNA dental diagnostic business. During the first half, we sold HemoCue and began the process to evaluate the Celera drug assets and Celera's products business.

We are pleased to complete today the sale of ibrutinib royalty rights to Royalty Pharma for $485 million in cash. We continue to hold the royalty rights for assets licensed to Pharmacyclics and Merck. Our portfolio review is resulting in asset sales that are providing additional flexibility for our fifth strategy, which is delivering disciplined capital deployment.

Our plan is to return the majority of our free cash flow to our shareholders in the form of dividends and share repurchases. The sale of HemoCue provided proceeds that helped us repurchase $405 million of shares in the second quarter, bringing year-to-date share repurchases to $467 million. We plan to use of the after-tax proceeds for the sale -- from the sale of ibrutinib royalty rights to drive shareholder value, consistent with our capital deployment strategy.

In addition, we completed the acquisitions of the lab outreach business of Dignity Health and Concentra's toxicology business, consistent with our goal of contributing 1% to 2% revenue growth per year through strategically aligned accretive acquisitions. Well, despite the difficult operating environment, this progress gives us confidence that we are making the appropriate improvements needed and that we will see the benefits build throughout the remainder of this year and thereafter.

Now let's turn it over to Dan, and he'll go through the detailed analysis of the numbers. Dan?

Dan Haemmerle

Thanks, Steve. Starting with revenues. Q2 consolidated revenues of $1.8 billion were 3.3% below the prior year but 1.6% better than Q1 2013. Our Diagnostic Information Services revenues, which account for over 90% of total revenues, were 3.6% below the prior year.

Volume was essentially flat, 0.1% better than a year ago. The 3 acquisitions completed this year, UMass, Dignity Health and Concentra's toxicology business, contributed approximately 1.6% in the quarter to volumes and are all on track versus our growth plans.

The contribution from acquisitions was essentially offset by softness in our underlying volumes of approximately 1.5%. While underlying volumes were softer than a year ago, they are approximately 0.5% better than what we experienced in Q1 of this year.

As we have shared previously, we expected to see continued volume softness in the first half of the year, with improvement in the second half due to more favorable year-over-year comparisons and building momentum on our efforts to restore growth. Revenue per requisition in Q2 was down 3.7% compared to the prior year. The impact of our 2 recent acquisitions, principally Concentra's toxicology business, lowered revenue per requisition by approximately 0.5%.

Excluding the impact of these acquisitions, our underlying revenue per requisition was lower than the prior year by approximately 3.2%. This 3.2% reduction in underlying revenue per requisition is largely due to the Medicare fee schedule reductions, including pathology reductions that went into effect on January 1 plus the 2% Medicare sequestration reductions implemented on April 1, as well as certain commercial fee schedule changes.

Consistent with the first quarter, positive test mix is essentially being offset by business mix. We've shared previously, we continue to expect that for the full year, the underlying reimbursement decline will average about 3%, with about 1% of the year-over-year impact we saw in the first half of the year expected to anniversary later in the year. And over the next several years, we continue to plan for average annual reimbursement pressure of 1% to 2% through 2015.

Q2 revenues in our Diagnostic Solutions businesses, which include risk assessment, Clinical Trials, Healthcare IT and our remaining products businesses, were flat compared to the prior year. This is a sequential improvement from the first quarter performance that was down about 2% compared to the prior year.

Adjusted operating income was 16.9% of revenues, about 1.7% below the prior year, with the decrease principally due to lower revenues. A significant portion of the lower revenue is being offset by continued progress with our Invigorate initiative.

Adjusted EPS of $1.06 was $0.09 below the prior year, with the decrease principally due to lower revenues, partially offset with cost savings realized from Invigorate. As a result of the company's ongoing efforts to drive operational excellence and to simplify the organization, restructuring and integration costs totaling $19 million reduced reported operating income as a percentage of revenues by 1% and reported EPS by $0.07. Last year, in the second quarter, it included $15 million of costs associated with restructuring, integration and CEO succession, which reduced reported operating income as a percentage of revenues by 0.9% and reported EPS by $0.06.

Bad debt expense as a percentage of revenues was 3.7% or 20 basis points higher than the prior year. DSOs were 48 days, up 2 days from last quarter. The increase in DSOs can be principally related to payment delays in connection with obtaining new provider numbers associated with recent acquisitions. We expect these issues to be resolved later this year.

Cash from operations was $208 million in the quarter compared to $251 million in the prior year. Lower cash from operations is largely due to the increase in DSOs, which we expect to reverse in the second half of the year. Capital expenditures were $56 million in the quarter compared to $47 million a year ago. During the quarter, we also repurchased 7.2 million common shares at a price of $55.92 for a total of $405 million. As expected, we deployed the proceeds received from the HemoCue disposition into share repurchases in the second quarter.

Turning to guidance. We continue to expect results from continuing operations before special items as follows: Revenues to be 1% to 2% below 2012, prior guidance was to approximate the prior year level, earnings per diluted share to be between $4.35 and $4.50 compared with prior guidance of $4.35 to $4.55, cash provided by operations to approach $1 billion compared to prior guidance that it would approximate $1 billion and capital expenditures to approximate $250 million.

In considering the full year guidance in the context of the first half performance, it is important to keep in mind several factors, as we've previously indicated that comps versus the prior year will become more favorable in the second half of the year. While the number of business days, coupled with the weather effect, adversely impacted revenues in the first half of the year, those same factors are expected to contribute favorable year-over-year comparisons in the second half of the year and be essentially neutral for the full year.

Underlying revenue per requisition, which was down approximately 3.3% in the first half versus the prior year, is expected to be down about 3% for the full year, with about 1% of the impact we saw in the first half to anniversary later this year.

Our 3 acquisitions contributed approximately 1% to revenues in the first half of the year and we expect those acquisitions to contribute approximately 2% in the second half of the year. Our efforts to restore growth are gaining traction and we expect to see increasing progress as the year unfolds. We saw a 0.5% improvement in year-over-year underlying volumes from Q1 to Q2 and expect it to continue to improve in the second half. And lastly, as Steve mentioned, we expect to see approximately twice the benefit from Invigorate in the second half as we saw in the first half.

For all these reasons, we have confidence in the expected performance improvement during the remainder of the year required to achieve our full year guidance. Now I'll turn it back to Steve.

Stephen H. Rusckowski

Thanks, Dan. Well, to summarize, we see 2013 as a building year as we improve operations and begin to restore growth. We are executing well on each element in our 5-point strategy. In the second half of 2013, we'll show improvements from many reasons, which we just discussed. And we continue to have confidence in executing our 5-point strategy will drive increased value for our shareholders over the long term. Now with that, we'd like to see if you have any questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] At this time, we have a question from Tom Gallucci of Lazard Capital Markets.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Just a few quick ones. A few quick questions, if I could. First, on the volumes. I think, Dan, you mentioned maybe 0.5% improvement from Q1 to Q2. I just wanted to make sure we understood. Is there any calendar impact there that also might have helped that trend a little bit in terms of leap day in the first quarter or the shifting of holidays and things like that?

Dan Haemmerle

There's really not a material change in the calendar. Most of the benefit that we expect to see from the differences in how we evaluate revenue days or business days comes in the back half of the year. So no real impact in the second quarter.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Okay, good. And then as you're thinking about the ramp on sort of the core volume, as you put it, in the second half, I mean, you describe a lot, Steve, of the things you've been doing on the sales force front. Can you help us understand the visibility on some of the specifics in terms of targeted clients or targeted market share that you expect to gain or where some of that's going to come from, or do you have that sort of visibility on the ramp that you're expecting?

Stephen H. Rusckowski

Absolutely. Well, Tom, let's do this. Let's walk through -- again, we'll walk through why we expect the second half to be stronger than the first half. And then what are, within that discussion, our expectations for what's described as organic improvement in the second half versus the first half. So Dan, why don't you walk through a bridge, if you will, between the first half and the second half?

Dan Haemmerle

Yes. And maybe the way to think about it is if we look at the second half performance and you look at our outlook for the remainder of the year, you're looking at a range plus or minus of about 2% revenue growth in the back half of the year. If you break down the components the way we're looking at it, we think about revenue per requisition. We said it was down about a little more than 3%, about 3.3% in the first half of the year. It will improve by about 1 point in the second half. So we expect to see revenue per requisition lower than the prior year by about 2.5%, okay? And that'll get us to our full year average of 3%, so about 2.5% down on revenue per requisition. We've done 3 different acquisitions. We've also got the benefit of the revenue days, as well as the weather impact that we expect to see turn favorable on the back half of the year due to Sandy in Q4 of last year. And if you put the acquisitions in those easier comps together, that's worth about 3.5%, maybe a little bit more than 3.5%. So that leaves about 1 point of growth from our underlying businesses. And as we look at it, we are building momentum in the underlying businesses, both our Diagnostic Information Services businesses through our restore growth initiatives, as well as our Diagnostic Solutions business, which is also building momentum and expected to both provide a positive contribution for the full year. So about 1 point will come from our underlying business and a combination of both Diagnostic Information Services and Diagnostic Solutions.

Stephen H. Rusckowski

Great, Dan. So Tom, to answer your question, so given that as the opportunity that we really need to improve, we do have a great line of sight to what we need to get done in the second half. Let me give you a couple of examples. First of all, we are building our professional services business that I mentioned in my introductory comments, that is building momentum. There's a lot of interest in it and we will see some volume from that in the second half versus the first half, number one. Second is we have line of sight to a number of accounts, a number of programs we're working with payors that our sales force is driving. And we have confidence, given the traction we've seen in the second quarter, that will continue into the third quarter, into the fourth quarter. Dan also mentioned that we are going to see growth in the second half versus the first half from our Diagnostic Solutions business. So without giving you all the detail, we do have good line of sight on what we need to do to deliver our guidance for the full year and the second half on the top line. And then as far as the bottom line, we also believe that we have good line of sight given the current environment that I have indicated in my introductory comments to be able to deliver guidance for earnings for the year as well. So we're going to turn it back for any other questions.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Yes, that's very helpful. Just to make sure I understand the change in the revenue guidance, is that 1% growth that you're expecting from the core sort of similar to what it was before and the reduction overall just from a macro standpoint? Or is that 1% core number sort of changed in your minds as well?

Stephen H. Rusckowski

Yes, it's slightly lower, Tom. Basically, the environment we see right now is not as strong as what we thought we were going to see this year. As we entered Q2, we are actually encouraged by April numbers. As we got further into Q2, we started to see more reports back from various sources about softening in the marketplace. We saw that in ourselves in the second quarter. And so therefore, we thought it'd be prudent going forward that we take that in consideration with our full year guidance and that's reflected in what we expect to get organically out of the business. But overall, the environment is softer than we expected entering the year and we thought it appropriate at this point of the year to adjust our guidance for the top line. However, what you'll also hear in our remarks, we are moving very, very well against our cost improvement goals. We're making excellent progress with Invigorate. And so what we have also said is we will balance that off with strong contributions through Invigorate in the second half. We've also indicated in June, we are reinforcing it today, is that we expected twice as much contribution from Invigorate in the second half than we saw on the first half.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Right, right. Just last question then. On cash, it sounded like some of the cash flow issues that you saw in the quarter, you expect to sort of reverse out as you get the provider numbers nailed down. You did slightly tweak. It seems like your cash flow expectation is low for the year, down a little bit, so I just wanted to make sure we could understand that.

Stephen H. Rusckowski

Sure, sure. Why don't you bring -- put Tom through what happened with DSOs and the overall cash expectations.

Dan Haemmerle

Yes, and 2 comments. One, Tom, just back to the last question quickly that approximately 1%, I was giving you in that walk across is kind of a mid -- gets you to the midpoint of the range, so just a point of clarification there. And then secondly is on the DSOs. DSOs were a little bit higher, they're about 2 days higher in the second quarter compared to the first quarter. And with many acquisitions, you have to file for a new provider number with -- for certain payors. We're filing with certain government payers right now and we have little bit of a delay in getting some of those provider numbers for those acquisitions. So as a result, we have some claims that we're confident to get reimbursed once we get those provider numbers in and we expect that to get cleaned up in the second half.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Right. Now that -- so I understood that. I was just curious. So it seemed like I think your old guidance was for about $1 billion of cash flow. Now you're sort of approaching $1 billion of cash, so maybe, it's the small nuance. But if that -- if the provider number issue reverses itself out, what's the reasoning sort of for, I guess, cash flow that's a little lower for the year?

Dan Haemmerle

Yes. And so the change in the cash flow for the full year is really just reflected in bringing down the top end of our EPS range a little bit. And also as we look at cash flow and managing our balance sheet, we felt that we wanted to give clear guidance that we're going to be approaching $1 billion, the higher end of the range of approximately, probably not going to go much further north of that, but approaching $1 billion we felt more comfortable with.

Operator

Our next question is from Kevin Ellich with Piper Jaffray.

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Just going back to the pricing decrease that we've seen. You said the underlying pricing was negative 3.2%, a lot of it due to Medicare. Just wondering if you could break out how much pressure you're seeing from the commercial payers.

Stephen H. Rusckowski

Sure. So let's walk through exactly what's going on with pricing. Again, we've provided guidance that we would expect this year about 3%. What we saw in Q2 was in line with that expectation, and Dan will bring you through exactly how this is phasing throughout the year, which is important in it. As you know, definitely, this is a mix between our Medicare and our commercial payers. And some of this does anniversary throughout the year and that's what we reflected in our second half expectations as well. So Dan, walk him through what we come up with the numbers.

Dan Haemmerle

In terms of the pricing, Kevin, there are 3 primary drivers of the reimbursement reductions. One is the Medicare cuts that we, I think, all anticipated coming into the year that included the Middle Class Tax Relief Act, as well as the ACA changes. And then thirdly, we also included in that number an estimate for sequestration. We planned for it to take place. And if you put those components together, that's worth about 5% against our Medicare book of business, okay? Our Medicare book of business is about a little bit north of $1 billion or approximately $1 billion in total. So 5% off of that number is the first element. Second element is the Anatomic Pathology cuts, again, another set of cuts from Medicare, specifically on a handful of codes, specifically 8305, which enjoyed a 52% reduction on the technical component. And then the third component is really related to the commercial contracts with commercial payers. Some of those contracts changes took place late last year and there were some contracts that showed pricing reductions January 1 of this year, okay? So as you think about it, the majority of the Medicare cuts took place on January 1 and will carry through the entire year. One element of the Medicare cuts, the sequestration cut, went into effect April 1. And then the commercial payer cuts, we have some that have started on January 1, some that started late last year and it will anniversary later in the year and will show that point of improvement for us.

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Got it. Do you expect to see -- once you annualize and anniversary the commercial pricing pressures, do you expect to see further pressure from the Managed Care payers? Or do you think we're kind of at a point where we could start to see some improvements actually?

Stephen H. Rusckowski

Yes. So Kevin, what we said back last fall in our Investor Day that we expected a 1% to 2% erosion in our price related to the pricing pressure. We also have said that we expect 3% in 2013, but we're still believing that the 1% to 2% guidance for that 3-year period is a good range. That will absorb what we knew already from the government side. Also, we have less contract negotiations in 2014 than we did in 2013, and we think that estimate is still reasonable where we sit right now.

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Understood. Okay. And then going to the proposed Medicare fee schedule and the comment that they might look at repricing the clinical lab fee schedule down the road, I'm just wondering what efforts are being made in Washington to mitigate some of these potential cuts. And let's say it were to go through, Steve, what could you do internally to offset some of these pressures?

Stephen H. Rusckowski

I'll continue to do what we're doing. First of all, we are working with our trade association, ACLA, proactively on this. We actually met this week on it and are meeting weekly to talk through this with CMS. And so all the leaders of ACLA are part of this effort. As we said, at least in the physician fee schedule, it will have an impact on the industry and us to a lesser extent because we have less Medicare business as a percentage of our total business than some of the other providers of our service in the marketplace. The second is we did anticipate, Kevin, that there will be further cuts. I said this in my introductory remarks. We actually assumed some further cuts in our -- 1% to 2%, just to be prudent. So we had planned for this and we, because of it, have been really putting the accelerator down on Invigorate. And what you should see and what we've talked about, we will see more in the second half, is continued progress on the efficiencies that we're getting throughout our organization. We'll see twice as much improvement for Invigorate in the second half than there was in the first half. We are feeling very comfortable with the goal to get to $600 million of run rate savings by 2014. And we're still pushing the organization to get to $1 billion at some point after 2014. So we believe that what we're hearing is something that we somewhat expected within reason. We don't know the details. We obviously want to make sure that we carefully walk through the best outcome with the industry leadership to get to the best place for us. But what we're doing about it is exactly what we have said before. We're executing our 5-point strategy and we're driving as much efficiency gain as soon as possible out of our business to be able to absorb that and deliver our expectations for 2014 and beyond. So we're working on the plan as we've shared before.

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Okay. And then 2 last quick questions here. Bad debt, we did see that 20 basis point increase on a year-over-year basis. Just wondering if there's anything unusual going on behind that. And then lastly, on the capital deployment, in the $300 million after tax that you'll get from ibrutinib, do you plan to allocate that equally between acquisitions and share repurchases or maybe see a dividend increase?

Stephen H. Rusckowski

So Dan, let's take the -- on the bad debt question.

Dan Haemmerle

Yes. On the bad debt, it's slightly higher, it's about 20 basis points higher. And with -- from one quarter to the next, 10 to 20 basis points is really in the range of normal fluctuation for our business. So we don't see it as a signal and we don't see it signaling a different trend at this point.

Stephen H. Rusckowski

And as far as the proceeds from ibrutinib, we're going to continue to do what we said, that is we're going to return the majority of our free cash flow to our shareholders and we'll continue to act on our disciplined capital deployment strategy that we have in place. And the return that we have given to our shareholders have been in the form of dividends and share repurchases and that's what we expect to do going forward. We still have some time to complete the ASR that we put in place this spring. We'll work through that, and then we'll cross that bridge when we get to it. But we're stand behind our commitment on what we said and we're standing behind our strategy of disciplined capital deployment as we go forward.

Operator

Our next question is from Ricky Goldwasser, Morgan Stanley.

Ricky Goldwasser - Morgan Stanley, Research Division

So first of all, just one clarification, does the '13 guidance include the deployment of the cash from the sale of the Royalty that you announced today?

Stephen H. Rusckowski

Yes.

Dan Haemmerle

Yes. The cash from the proceeds, we will use it at some point. Whether or not we use it for -- we will use it in one way or another, consistent with our capital deployment strategy, but we don't see it having a meaningful impact in the back half of the year.

Ricky Goldwasser - Morgan Stanley, Research Division

Okay, okay. And then thank you very much for all the transparency and all the detailed comments on...

Stephen H. Rusckowski

I'm glad you find it useful.

Ricky Goldwasser - Morgan Stanley, Research Division

It's very useful. So just one more clarification on the pricing side. So when you think about your expectations for next year and longer term for pricing to come down by negative 1% to 2%, if we factor in the proposal in the physician fee schedule, I think that accounts for about 75 basis points based on our rough estimates. So can you just help us to better understand what are your kind of like assumptions heading into the clinical fee schedule, I think that's coming out in August, for potential rate cuts?

Stephen H. Rusckowski

Yes, understood. So let's walk through this again. Our estimate last fall was 1% to 2% over a 3-year period, more in 2013, less thereafter. We assumed in that what we knew about government reimbursement. And I mentioned in my comments is that the physician fee schedule represented about 3% of our revenue in 2012. And Dan, why don't you bring through how this is going to wash through, what our assumptions are so far?

Dan Haemmerle

Yes. So as we've looked at this, Ricky, and there's a number of moving pieces to the latest proposal that we're still working our way through and we continue to work with the trade association to better understand it. But as Steve mentioned, the physician fee schedule is about 3% of our 2012 annual revenues. That number is coming down a little bit in 2013. It's probably running closer to a 2% number as the Medicare cuts on the pathology codes were implemented January 1, so that's having a drag on that number. And we also have seen that the carryover impact to some of the pathology in-sourcing that occurred late last year into this year that it brings that number down closer to a 2% zone for the 2013 percent of revenues for the physician fee schedule. So we -- as we've said, we still are evaluating it, we're trying to understand it. We have some follow-up questions on the current proposal. And when we have some more detail on that, we will share it. And with respect to the clinical lab fee schedule question, we have contemplated government pressure in the long term, 1% to 2% guidance. In terms of splitting out our projections and our thought process beyond what we've already shared, we're not planning to do that today, not prepared to do that today.

Stephen H. Rusckowski

Yes. And the other comment I'll make is the 26% that we've seen is an average. That average that we're going through to understand what the real impact will be on us. Based upon our mix, we think it will be less than that 26%. And so what you see is that 2% of our business today, something less than what was indicated as the average. If you do the math in that, you can see what the impact will be for us in 2014. As far as the clinical schedule, yes, that is more uncertain. We're proactively working with the trade association to understand the intentions of CMS, what the timeframe is, what the logic is. The mechanism that was discussed was a mechanism around technology and with technology, it makes us more efficient. And a large portion of our value chain, yes, is running a large centralized efficient laboratories, but a large percentage of our value is the beginning of that process and the end of that process. And so we still have a lot of our cost structure that wasn't necessarily affected by some of the technology that we're referring to. So we're working through this one and has more question marks associated with it. But we believe, again, based on what we know today, based upon what we already knew going into this year with the government reimbursement changes, what we just had heard, what we see in our forecast for renegotiations with commercial players that we'll still stay within that envelope of 1% to 2% over that 3-year period that we indicated earlier. So that's where we are today.

Ricky Goldwasser - Morgan Stanley, Research Division

Okay. And just to help us understand it, what percent of the Managed Care commercial book is tied to this Medicare book?

Dan Haemmerle

We have hundreds of Managed Care contracts, as we've said in the past, and we have very few that are tied to or float with Medicare rates.

Operator

Our next question, from Dane Leone, Macquarie.

Dane Leone - Macquarie Research

I guess, I'll leave it at one since the call is dragging on a bit. I think one question that really could use some vetting here is the competitive landscape. There is smaller, I guess, national lab at this point that is public that has grown rapidly, has increased its revenue base. It's centered in the Northeast, but it's expanding nationally. And it just -- when you look at the growth rates between yourself, LabCorp and the other lab, Bio-Reference, there does seem to be some underlying share shift, some share loss. And I guess the question here is, is that something you're seeing? Is there a mitigation of loss strategy that you're looking to do as the new management team here? And really, any detail about competitive offerings would be very helpful.

Stephen H. Rusckowski

Appreciate that. First of all, if you recall in our Investor Day in the fall, we've shared our expectations for the market. We think this market has grown in the past and we actually believe this market will grow going forward. Even though we have some slowdown in utilization, we do believe that the Affordable Care Act will be net positive for this industry and for us. And we do believe that this market, given what I said earlier, will grow around 4%. What I also said back in the fall is we haven't grown with the market and therefore, we have lost share and that therefore, we needed to do something about it. And one of our points of our 5-point strategy is to restore growth. And so what I shared with you in my update is what we're doing to improve our performance of getting at the market and doing a better job in the competitive sense of the marketplace. And we have 3 areas of priorities for this year. First is related to our sales force. So what we have done is reorganized our sales force. We have put in place a better sales team than before. We have trained those people, have equipped those people, have aligned those people and those people are very, very engaged on calling customers everyday. So point number one is I believe that what we have in place today is better execution going at the marketplace from a sales perspective. So that's the first point. Second is we believe that some of our competitors have done a better job of introducing innovative products to the marketplace. We have changed our organization to align around the need for us to bring our innovation to the marketplace in a smarter way and more thoughtful way. And what we've done to affect that in our reorganization is we created a clinical franchise organization. We have 7 clinical franchises, each of which have a General Manager. And the example I gave you in my script is, one example of that is in Women's Health, that an effort in Women's Health lead to our relationship with Hologic and that will position us well in the whole field of Women's Health and will allow us to introduce sometime this year, a solution around BRCA1 and BRCA2. So introduction of solutions in the marketplace that are specific to patient problems, aligned around disease and specialties is the second area of investment we are making and that we believe we will see some of that benefit in the second half. And I believe some of our competitors in this marketplace, not just the large players but some of the niche players, have done a better job in the past and we learned from that. And we actually will respond to that with our clinical franchise organization in bringing more solutions to the market. Third is this market is changing. Integrated delivery networks are stronger than ever before, where there are acquisitions of physicians. We've created a brand-new organization that we call our professional services organization. They partner with integrated delivery networks to understand what we can continue to do with many of those around referenced testing, which is the base, if you will, of our relationships -- are with those organizations. Actually, in fact, if you look at the top 100 hospitals ranked by US News & World Report, we actually do business -- reference business for about 90% of those top hospitals. And so with those strong relationships, we are very engaged in discussions around what we need to do with laboratory management relationships or what we potentially do if they want to by taking on their outreach business. And the examples of Dignity Health and UMass are great examples of that. So we're building that. So those 3 initiatives this year have been our focus. Those 3 initiatives have been our investments that we have made in this year. And we feel with our focus there, that will allow us to make progress this year. We have said going into this year that this year is a building year. We believe this is an attractive market, but we need to do much better as an organization, executing in that market. And we believe we've made excellent progress in the first half and we believe we'll see some of that in the second half, gradual improvement. Now the other side of this is we've talked a lot about operational excellence and what we're getting out of that in terms of the efficiency. Let me also say that we're focused on making sure we provide a superior customer experience to our customers everyday. So along with the efficiency gains in that program, we're also very focused on the whole value chain of what we're doing in our patient services centers, what we're doing with our responsiveness and the quality of our laboratories and what we're doing to improve our building capability. So along with the efficiencies we are getting out of that program, we also expect to get improvements in our quality and our execution around superior customer experience. So we believe we've made a very good progress in the first half. That progress will allow us to achieve what we just shared with you in the second half. We'll see some of the results in the second half from all these efforts so far. So hopefully, that provides some more clarity.

Operator

Our last question comes from Isaac Ro of Goldman Sachs.

Isaac Ro - Goldman Sachs Group Inc., Research Division

Just want to clarify on that earlier question regarding market share, should we assume that your guidance does imply a little bit share gain at the back half of the year? And if so, can you maybe quantify that in the context of the bridge that Dan went through earlier?

Stephen H. Rusckowski

Yes, not sure you could apply that. First of all, there was a question asked whether we have good line of sight on what we need to do to deliver our guidance. We believe we do. And we believe the expectation for the second half is reasonable, given what we already know about what we'll get out of acquisitions, what we'll see with our price changes and also what's going to happen with the comparison versus the prior year. So we have good line of sight. Now what we also have, Isaac, is, with this line of sight, we're going to see some of the benefits of the investments we have made in the first half with the sales force, with new solutions in the marketplace and also with our professional services business. That will get us to our guidance. When the dust settles in 2013, we'll be able to evaluate whether in fact we stayed with the market or we actually gained some share. We don't know that yet, but we're focused on executing our plan and focused on executing. And we think the guidance we provided is reasonable based upon what we know and what we're doing.

Isaac Ro - Goldman Sachs Group Inc., Research Division

Got it, helpful. And then as a follow-up, on your point earlier about some of the cost savings initiatives that are going on, is it fair to say that we should see sort of a sequential improvement in EBIT margins in the back half of the year, or is there sort of a seasonality out in here you want to just keep in mind?

Stephen H. Rusckowski

Yes. So what we shared in June is we expect twice as much of the contribution from Invigorate than we saw in the first half. What we shared with you today is we said the realized improvement versus 2012 is $250 million. So you can go through the math and when you go through that, you'll be able to see what in fact we do expect in the second half. And Dan, would you like to add to that?

Dan Haemmerle

No, I think that's right. You've got $250 million realized in the -- it's more than $250 million realized in the current year and we expect to see twice as much savings in the back half of the year as the first half. So you can run through that, we're not giving specific EBIT or operating income percentage guidance or anything like that, but you should see some improvement in the back half of the year.

Isaac Ro - Goldman Sachs Group Inc., Research Division

Got it. And then just one last cleanup here on the ibrutinib monetization. It sounded like you guys are leaning towards using the vast majority of that for a return to shareholders. Is it possible that some reasonable percentage might be used for strategic use as well?

Stephen H. Rusckowski

Again, we will return the majority of the free cash flow to our shareholders. We have a disciplined capital deployment plan and strategy. We're standing behind that. We'll approach this proceed with that in mind. We believe that one way that we can continue to return the majority of free cash flow to our shareholders, it will be from our dividend and also share repurchases. But also, to your question, we are continuing to look for acquisitions that support our goal in that regard related to getting to a 1% to 2% revenue growth from acquisitions. I'm also pleased to say that we've got there in the second half. You see that we're looking year-on-year at 2% improvement in our top line related acquisitions we've done so far. We're continuing to work on those. And so therefore, there might be some portion of our capital that's used for those in the second half as well. I can't speculate on that at this point. But we're staying the course with our 5-point strategy and deliver disciplined capital deployment in the back half as we've done so far.

Operator

Thank you for participating in the Quest Diagnostics Second Quarter Conference Call. A transcript of prepared remarks on this call will be posted later today on Quest Diagnostics website at www.questdiagnostics.com. A replay of the call may be accessed online at www.questdiagnostics.com/investor or by phone at (800) 856-2254 for domestic callers or (402) 280-9961 for international callers. Telephone replays will be available from 10:30 a.m. Eastern Time on July 18 until midnight, Eastern Time on August 16, 2013. Goodbye.

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