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Quest Diagnostics (NYSE:DGX)

Q3 2011 Earnings Call

October 25, 2011 8:30 am ET

Executives

Kathleen Valentine - Director of Investor Relations

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

Surya N. Mohapatra - Chairman, Chief Executive Officer, President and Chairman of Executive Committee

Analysts

Gary P. Taylor - Citigroup Inc, Research Division

Bill Bonello - RBC Capital Markets, LLC, Research Division

Dane Leone - Macquarie Research

Ralph Giacobbe - Crédit Suisse AG, Research Division

Isaac Ro - Goldman Sachs Group Inc., Research Division

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Gavin Weiss - JP Morgan Chase & Co, Research Division

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

Darren Lehrich - Deutsche Bank AG, Research Division

Brendan Strong - Barclays Capital, Research Division

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Steven Valiquette - UBS Investment Bank, Research Division

Ricky Goldwasser - Morgan Stanley, Research Division

Arthur I. Henderson - Jefferies & Company, Inc., Research Division

Robert M. Willoughby - BofA Merrill Lynch, Research Division

Ashim Anand - Natixis Bleichroeder LLC, Research Division

Gary Lieberman - Wells Fargo Securities, LLC, Research Division

Operator

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

Kathleen Valentine

Thank you, and good morning. I am here with Surya Mohapatra, our Chairman and Chief Executive Officer; and Bob Hagemann, our Chief Financial 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' 2010 annual report on Form 10-K, 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 Surya Mohapatra.

Surya N. Mohapatra

Thank you, Kathleen. We have a lot of news to share with you this morning. In a moment, we are going to review our earnings news and discuss our increased dividend and our push to capital deployment. But first, let me tell you about today's succession announcement. As we indicated in our press release earlier today, we have begun a CEO succession process. I joined Quest Diagnostics in 1999 and have seen revenue growth 5x to $7.5 billion. The company has grown from a simple lab to the most advanced genomic and acetylic testing powerhouse for cancer, cardiovascular disease, infectious disease and neurological disorders. With unmatched assets in science and innovation, information technology and access and distribution now in place, the Board and I have agreed, that after almost 12 years, this is the right time to transition to new leadership.

The Board is engaged in the thought process and will consider both external and internal candidates. Importantly, nothing changes today. I will continue to focus on executing our operating and strategic plan until I turn over leadership to a new CEO. I have agreed to continue to serve as Chairman and CEO for up to 6 months to ensure a smooth transition to my successor. I'll be happy to take any questions you may have at the end of today's call following our prepared remarks.

Turning to our forefronts in the third quarter. Revenues grew 2.2%, adjusted earnings per share increased 4% and we generated strong cash flow. We are beginning to see positive signs in a number of areas, but we have more work to do. The current market environment remains challenging, nevertheless, we are committed to increasing shareholder returns. We have framework that encompasses improving operating performance and a balanced capital deployment philosophy.

Our growth strategy is focused on 3 main elements: driving faster-growing esoteric and gene-based testing for cancer, cardiovascular disease, infectious disease and neurological disorders; enhancing sales effectiveness; and strengthening our relationships with health plans and other payers. Now during the quarter, we continue to see increased demand for our advanced diagnostic services. Gene-based and esoteric testing revenues grew 14%, driven by the contribution of neurological testing from Athena and cardiovascular testing from Berkeley Heart, as well as women's health testing specifically, SureSwab. Demand for esoteric and gene-based testing continued to grow faster than routine testing.

We continue to be focused on maintaining and expanding our access to ensure lives. We are working closely with health plans and implores to reduce costly out-of-network leakage by getting involved in benefit plan design and offering employers an extensive set of turnkey tools that channel employees to low-cost testing. In addition, through our QuestNet lab solution, we build and manage lab networks for health plans. As regards to the cost, we have had an ongoing focus on cost structure both to ensure that our costs are aligned with volume in the short term and to make needed changes to make us more competitive and profitable for the future.

Last quarter, we told you about our comprehensive initiative to reduce our cost structure by $500 million over 3 years. We are following a deliberate process to identify opportunities and ensure that we will not do anything to jeopardize patient care, medical quality or growth. You will hear more details from Bob who is leading this strategic initiative.

Now let me share with you our evolving capital deployment philosophy. We are a strong company. We generate significant cash flows. With the key assets and capabilities in place through recent acquisitions to drive long-term growth, we do not see large acquisitions in the next few years. Our focus is on improving our performance and integrating businesses we have acquired. As a result, we plan to return a majority of our future cash to shareholders. This morning, we announced a 70% increase in our dividend to an annualized amount of $0.68 per share. This demonstrates confidence in our continued ability to generate strong cash flows. Starting next year, we are further aligning management's long-term incentives with increasing returns on invested capital. Now, Bob, will provide further analysis, and then we'll take your questions. Bob?

Robert A. Hagemann

Thanks, Surya. Revenues for the quarter were $1.9 billion, 2.2% above the prior year, and adjusted earnings per share was a $1.18 compared to $1.13 in the prior year. Third quarter results include a benefit of $0.05 per share in 2011 and $0.08 per share in the prior year, associated with the favorable resolution of certain tax contingencies. Adjusted earnings per share for the 2011 third quarter exclude $0.10 per share associated with restructuring and integration costs, which are further detailed in Footnote 2 to the earnings release. The acquisitions of Athena and Celera contributed about 3% to revenue growth in the quarter. Our clinical testing revenues, which account for over 90% of our total revenues were about 1% above the prior year and about 1.5% below the prior year before the contributions of Athena and Celera. Volume in the quarter was 1.2% below the prior year and compares to the approximate 1% decrease we saw in the second quarter. The market in terms of estimated position office visits continued to decline in the quarter and was down 6% compared to the prior year. Drugs of Abuse Testing volumes have continued to rebound and grew about 5% in the quarter compared to about 6% last quarter. Revenue per requisition was 2.1% above the prior year with the improvement due to the increased esoteric mix contributed by Athena and Celera. Base revenue per requisition has remained relatively stable sequentially throughout the year. Organic revenue in our non-clinical testing businesses, which include risk assessment, clinical trials testing, products and healthcare IT, grew about 8% for the quarter. Adjusted operating income as a percentage of revenues was 18.3% compared to 18.1% reported in the prior year. Restructuring and integration costs, which are detailed in Footnote 2 to the earnings release reduced the reported operating income percentage by 1.4%. These costs totaled about $27 million in the quarter and compared to our earlier estimate of $20 million. The difference, principally due to additional costs associated with our plans to close our clinical testing operations in the U.K., which had not been contemplated in the year-over-year estimate.

In connection with Surya's transition, we expect to recur charges in the fourth quarter and early part of next year, totaling approximately $14 million associated with certain provisions contained in his employment agreement. A portion we estimate to be recorded in the fourth quarter is approximately $5 million. Separately, we expect to incur approximately $10 million to $15 million in the fourth quarter in connection with further restructuring and integrating our business. Last quarter, we announced a multi-year initiative. The goal of which is to reduce our cost structure by $500 million by the end of 2014. This effort is in its very early stages, and we are not expecting to realize any meaningful benefits until 2012 with the bulk of the savings to be realized in 2013 and 2014. However, we've made good progress since the last quarter and remained confident in our ability to reach our goal. The opportunities have been quantified and organized into a number of areas with dedicated teams of subject matter experts and cross-functional support. Each team has a very specific charter and financial target. They're currently in the process of developing detailed implementation plans, which will allow us to realize the opportunities identified. Some of the areas around which our teams are organized are as follows: specimen acquisition, which includes all the costs associated with obtaining and transporting samples; client support, which includes billing and customer service; the labs themselves and all the costs associated with operating them; IT and customer connectivity costs; procurement and supply chain; and SG&A both in the field and at corporate. As you'd expect with a large-scale multi-year project like this, some areas are more developed than others. The areas where plans are furthest developed are in client support, and procurement and supply chain. Together, which we expect to provide about 1/3 of our savings. In the client support area, we plan to leverage technology to eliminate manual processes, further standardize our systems of processes, implement more self-service options for customers and leverage a Lean Six Sigma to further streamline activities.

In the area of procurement and supply chain, we plan to further consolidate suppliers, rationalize SKUs, standardize and optimize specs, and work more closely with our suppliers in sharing information and managing costs from design, to manufacture to distribution. Other areas like the labs themselves and specimen acquisition, which we expect to contribute another 1/3 of the savings, are more complicated and will take a little longer. In these areas, we are addressing capacity utilization, including our lab footprint, service parameters, organization structure and supply consumption. The final, roughly 1/3 of the savings, is expected to come from SG&A, including IT. There are several common themes that run through many of the opportunities we are working on. They include standardizing systems, processes and databases; increased use of automation and technology, and centralizing certain activities. In addition, we have performed the comprehensive spans-and-layers exercise and are conducting activity-value analysis across all of our functions, which roll up into cost of sales and SG&A. Where the opportunities reside and what we want to achieve is clear. We are now in the process of finalizing the specific plans and timelines for how we will go about realizing those targets. While I understand that there is interest in specifically how much savings will be achieved in each of the years and what that means to margins, we are simply not far enough along in this effort to provide you much more.

In January, in connection with providing 2012 financial guidance, we intend to provide you with further information in that regard. We continue to see strong performance in our billing and collection metrics. Bad debt expense as a percentage of revenues was 3.6% in the quarter and reflected continued improvement from the prior year. DSOs were 44 days, unchanged from the second quarter. Reported cash from operations was strong at $338 million. For the effective restructuring and integration cost, cash from operations was $360 million. This compares to $330 million reported in the last year's third quarter. Capital expenditures were $39 million in the quarter compared to $47 million a year ago. During the quarter, we've repurchased 1 million common shares at an average price of $47.79 for a total of $50 million. We have now completed $885 million in share repurchases this year.

As Surya has indicated, we are firmly committed to drive in increases in shareholder returns. Clearly, the best way to do that is by improving operating performance. And as we've already discussed, we are taking actions to accelerate organic revenue growth and putting in place a more efficient cost structure. We also intend to use our strong cash flows to enhance shareholder value. Now that we have assembled a solid foundation of strategic assets and capabilities, it is unlikely we will complete any large, strategic acquisitions in the near-term. We will, however, continue to invest in our business in a very disciplined way to ensure we continue to differentiate Quest Diagnostics in an evolving marketplace, but in a manner which should require significantly less capital than recent years. Our investments and growth are likely to focus on smaller fold-in acquisitions, investments in science and innovation in the form of licensing, collaborations and internal development, and investments in technology, which will improve quality and efficiency in our labs and other parts of our business. We plan to use ROIC to guide these investment decisions and are committed to improving ROIC over time. In support of that goal, management and our Board have agreed to make improving ROIC a major component of our long-term compensation program beginning next year. We are committed to increasing shareholder returns and improving ROIC to a framework which encompasses improving operating performance and a capital deployment philosophy, which includes dividends, share repurchases and investments in our business. This philosophy will be grounded in maintaining a strong BBB credit rating, which minimizes our cost of capital and provides us appropriate access to credit in support of our business. In the near-term, this will require us to de-lever to a leverage ratio in the range of 2 to 2.25x.

Given how the company is currently positioned and our outlook for continued generation of significant cash, we believe now is an appropriate time to evolve our capital deployment philosophy to one which commits the majority of our free cash flow we return to investors through a combination of dividends and share repurchases. As such, today, we announced the significant increase in our dividend. We are increasing the dividend by 70% to an annualized amount of $0.68 per share beginning with our next payment in January. We expect that the dividend will grow over time commensurate with earnings and cash flows. In addition, share repurchases will remain an important tool for returning cash to shareholders. In January, in connection with providing 2012 guidance, we will provide you with more specificity regarding our capital deployment plans and ROIC goals.

Turning to guidance. We now estimate results from continuing operations before anticipated fourth quarter charges and other potential special items as follows: revenue to grow 1.5%, unchanged from our previous outlook. We expect earnings per diluted share to be between $4.30 and $4.35 on an adjusted basis and between $2.74 and $2.79 on a reported basis. Operating income as a percentage of revenues to approximate 17.5% on an adjusted basis and 13.3% on a reported basis. Cash from operations to approximate $1.1 billion before special items and approximately $900 million after these items. And capital expenditures to approximate $190 million. Our outlook on an adjusted basis excludes the Medi-Cal charge, the first quarter impact of severe weather, restructuring cost in transaction and integration costs associated with Athena and Celera. Footnotes to and aid to the earnings release reconcile the adjusted financial measures with the corresponding GAAP measures. Now I'll turn it back to Surya.

Surya N. Mohapatra

Thanks, Bob. To summarize the quarter, while we see signs of progress in a number of areas, there is still much work to be done. We are focused on increasing shareholder value and improving returns on capital. We are taking a series of actions to improve our forefronts by driving organic growth and significantly reducing our cost structure. In addition, with all our key strategic capabilities now in place with recent acquisitions, we plan to return the majority of our cash flow to shareholders. This morning, we announced a 70% increase in our dividend, demonstrating confidence in our continued ability to generate strong cash flows. Together, we believe these actions, over time, will unlock significant shareholder value.

Finally, I just want to say how proud I am of the Quest Diagnostics team of 42,000 colleagues and work they have accomplished. Now that we haven't -- we have established a solid foundation for our future, we have begun a process to transition to new leadership. That concludes our prepared remarks. We are ready to take your questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Dane Leone from Macquarie Capital.

Dane Leone - Macquarie Research

My first question here is, since you're making kind of a broad change with the management structure for the next 6 months, are there any plans to pursue alternative strategies for Quest as a whole, outside of just the management change?

Surya N. Mohapatra

No, there is no consideration of alternative strategy. As you know, we have worked extremely hard over the last 4 years, so we have really created a company now, which is more esoteric and gene-based testing. So our growth strategy remains the same. We leverage our science and innovation, information technology, and we have a very strong foundation of patient-centric culture for laboratory testing. And on the top of that, we are now building the 4 pillars of disease-focused growth strategy for cancer, cardiovascular disease, infectious disease and neurological disorders. So I'm very happy, and actually, we are very careful executives and this is the right time to just execute what we have.

Dane Leone - Macquarie Research

Great. And on terms of the sales force reorganization, it's been several quarters since that's been implemented. Outside of just the weaker overall macro environment, when do you think that can actually start paying dividends in terms of growth? It's -- on organic basis, it does seem like Quest continues to grow below the rate of its peers. So I'm just kind of curious on your thoughts of -- when we could actually see the organic growth reaccelerate in the business?

Surya N. Mohapatra

Sure. First of all, I just want to clarify, when we say organic growth, we really mean organic growth. There is absolutely no fold-ins, there is no acquisitions, nothing. So 85% of our business comes from patients visiting the doctors' office. Now year-to-date, if all – office visits are down by 6%. For the year-to-date, our growth is almost flat. So in a way, we are seeing a progress. But also I wanted to tell you that we have, over the last 2 or 3 years, reorganized our sales force to be much closer to our customers. We have a cancer sales force. We have hospital sales force. We've got physician sales force. And that really allows us to know what is happening in the marketplace. But also, I'm pleased to say that we have started seeing progress even in the physician business with the new people and the productivity is growing. It's not where I would like to be, but it is giving in a lot of encouraging signals, and I'm really glad at how they are becoming productive by every month.

Operator

Our next question comes from Ralph Giacobbe from Crédit Suisse.

Ralph Giacobbe - Crédit Suisse AG, Research Division

Just going back to the succession plan, I was just wondering, is there any specific criteria that you guys have in place? Is it some -- is the person you're looking for, somebody within the lab space? Do they have to have previous lab experience? And then any other changes to kind of the current management structure related to the plan?

Surya N. Mohapatra

Well, first of all, succession planning is a very important topic for our Board, and then we talk about that almost -- in every Board meeting, as far as who are the internal candidates, how are they developing and what we need to do for the -- as going forward. But as far as this process is concerned, as you know, the Board has a search committee, and we have a -- I think we are actually adopting a better practice. Usually, the companies are either -- a successor inside and they announce, or they do a search incognito, and look for somebody from the outside and announce. But I think what we have done and our Board is doing is, having a very deliberate short process, which will include internal and external candidates, and drive towards finding the best person who will drive this company to the greater heights in the next -- to 10 years. So I will not really comment on specific specifications, but we'll let you know when the Board concludes their process. But it is a very attractive company, and this opportunity is really a great opportunity for our internal candidates and external candidates.

Ralph Giacobbe - Crédit Suisse AG, Research Division

Okay. And I may have missed it, but did you give the contribution on terms of volume and pricing from Celera and Athena?

Robert A. Hagemann

We did not break out the components of volume and pricing, but you should expect, Ralph, that -- the vast majority of the impact did show up in revenue per req because of the mix there. A pretty insignificant impact to volume overall.

Ralph Giacobbe - Crédit Suisse AG, Research Division

Okay. And then just to go back to the $500 million savings plan, obviously margins this quarter, I think, showed some of your progress there. And I know it sounds like you're going to be talking in more detail next quarter about some of that. But I guess, how do we think about the ramp on, kind of, what's left? Is there a way to quantify that either by giving sort of you when you expect to get the full $500 million run rate? So could we expect, sort of, by the end of this year, it's $100 million ramp, and a $300 million ramp and a $500 million ramp? Or is there any visibility you can give us in terms of near-term versus longer-term savings?

Robert A. Hagemann

Well, Ralph, as I said earlier, we're still in the very early stages. And we're not yet to the point where we can give you specifics in terms of how much will show up in each year. But as you think about the years, think about very little showing up in 2011. We're really laying the groundwork this year. We expect to have something meaningful show up in next year's results. But we expect that the bulk of it, is really going to come in the 2 out-years. And as we exit 2014, we'll be at a run rate of $500 million and safe.

Ralph Giacobbe - Crédit Suisse AG, Research Division

Okay, and then just my last one, just to clarify, and I think you mentioned this in the prepared remarks, when you say you're not making acquisitions, it doesn't sound like that's -- you're making any deals. Is that -- are you still going to go after small tuck-ins, is that...

Surya N. Mohapatra

As Bob said, we'll always go up to these small fold-ins, and -- but we are saying that there's no major strategic acquisition for -- like we have done in the past.

Operator

Our next question comes from Tom Gallucci from Lazard Capital Markets.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

So I appreciate your comments regarding the transition. Just curious if you can give us any more insight on, sort of, the timing, why now? And I guess, you, sort of, alluded in your last answer, that it's a, sort of, public transition here. What's the thinking behind announcing that there's going to be a change with still some uncertainty exists as to who exactly is going to take over?

Surya N. Mohapatra

Okay, Tom. First of all, I'm not going anywhere. The reason why the Board and I agreed to do this way because we want to find the best person for this company who is going to drive this company to the greater heights. I have been very fortunate. I came to the company when it was $1.5 million revenue, now it's $7.5 billion. But more importantly, it does become a very strong healthcare company with real focus in disease tests. So we have a lot of capable executive inside, and we have invested in them. But at the same time, we want to really adopt the better practice of internal candidates and external candidates. We have a world-renowned executive search firm, and this process is very deliberate, but very short. I'm going to be the company for the next 6 months to make sure that there is good transition. But the most important thing is that we got so much -- so many important assets and the company is poised for growth. And we want somebody who will be here for the next 7 to 10 years, and that's the reason why it is now.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

And is this just looking at your wall and there being some transition there? Or are there any other implications elsewhere in management or otherwise?

Surya N. Mohapatra

No, I did remember in the beginning of the year, we have done some management changes to strengthen our lines of businesses. Cathy Doherty now runs the physician business. Dr. Jon Cohen runs the Hospital business. Dr. Joan Miller runs the cancer business. And we got some other people who are running the lines of businesses, and we are very focused on that. So there is no change in strategy, and neither a change in structure. Now having said that obviously, we have unmatched assets and capabilities, and depending on the person who comes here, he or she will have -- the person who's selected from inside, he or she will have the opportunity to refine. But from my point of view, we have come to a stage where the company has now become an esoteric and gene-based company, major tests in 4 disease categories with information technology, and we need to really leverage those assets and we need somebody who will be in the company for the next 7 to 10 years.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Okay, and then on the returning money to shareholders, just curious what the thinking of the Board was between announcing a much bigger dividend versus maybe a bigger new buyback program?

Surya N. Mohapatra

Okay. Let me -- first of all, the Board and the management have worked together on the strategy. The 2 important things for the Board is the strategy of the company and the CEO succession. Now over the last 4 or 5 years, we have diversified from a routine laboratory to esoteric and gene-based testing. And to do that, the 4 pillars, we acquired AmeriPath, Focus Diagnostics, and then the 2 other pillars, who are Athena and Celera. And once that is done, we have really completed our strategy for the time being. And so capital deployment philosophy is an evolving philosophy. And the Board and the management agrees that where we are today for at least the next 2 or 3 years, we don't see any major acquisitions. And so as Bob has always said and I have said, that if we don't invest our capital appropriately in acquisitions or we have additional key of cash, we will always return it to the shareholders. And over the years, we have been returned almost $5 billion. So going back to the dividend, we improved it and that does shows our confidence in producing strong cash flow going forward. And also, as I mentioned, that for the next 3 years, we're going to return the majority of our cash to the shareholder in the form of share buybacks. And we'll talk more about this when we do our guidance in January. Bob?

Robert A. Hagemann

And, Tom, just to put it in perspective, Surya indicated we're going to be returning the majority of our free cash flow to shareholders. When you look at the increased dividend, that represents about 13% or so of free cash flow. So that means share repurchases will continue to be an important element of how we returned cash back to shareholders.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Okay, great. Last question, if I could, just wondering about the trends of the in-sourcing on the pathology side that had been a headwind for the last couple of years?

Surya N. Mohapatra

Well, it has been a headwind the couple of years, Tom, and we see that in GI and GU, it has moderated and the down patent is still there. But having said that, cancer is a major area, growth area. And the AP is critical. So we expect -- although the rest of the year is going to be a challenged, but eventually it's going to bode more than the -- we will get the benefit of our very strong Anatomic Pathology franchise.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

And, Tom, we're working with ACLA on hopefully some regulatory reform down the road that will stem that trend in in-sourcing. Because we think we'll need that at least a higher utilization.

Operator

Our next question comes from Ricky Goldwasser from Morgan Stanley.

Ricky Goldwasser - Morgan Stanley, Research Division

A couple of questions. First on the acquisition front, it seems that the contribution from the acquisitions have outpaced your original guidance of 2%. Can you walk us what's driving the strength? And do you expect that to be sustainable?

Robert A. Hagemann

Yes, Ricky, it's actually tracking very closely to what we had guided. Remember that 2% is a full year impact, and we only have those acquisitions in for part of the year. So what you see in the third quarter is a full quarters' impact of those acquisitions, which was about 3%. But again for 2011, where we only have those transactions on board for part of the year, it's about 2%.

Ricky Goldwasser - Morgan Stanley, Research Division

So we should expect to see the same, kind of, like trending in the fourth quarter?

Robert A. Hagemann

Well, I'm not giving fourth quarter guidance at this point, but there's no reason that it will look much different in terms of the contribution in the fourth quarter than it looked in the third quarter.

Ricky Goldwasser - Morgan Stanley, Research Division

Okay, great. And then you've really showed very nice margin improvement on both the gross profit and in SG&A. Does the improvement reflect any of the $500 million in cost savings? And if not, what are the drivers?

Robert A. Hagemann

Yes, Ricky, it's a combination of a few things, and I would tell you that it's really not anything from the longer-term program at this point. It's really a result of some of the short-term actions that we've taken to adjust the size of our workforce and reduce costs in light of the volume pressures that we've got. And also in this quarter, we did have some benefit, which -- it's unclear as to whether or not it will continue, but probably 50 basis points or so, associated with the way we treat our supplemental deferred comp plan. You may recall we've talked about this in the past, but losses associated with the investments in that deferred comp plan show up as reduced costs in operating an income, but there is an offset below the line for those losses. So it nets in the P&L, but it shows up in different places. And this quarter, we did have about a 50 basis-point benefit year-over-year from that phenomenon.

Ricky Goldwasser - Morgan Stanley, Research Division

Okay, understood. And then lastly, just following up on the pathology question, I know you mentioned, kind of, regulatory actions that would reverse the trend. Can you update us on, kind of, like your expectation for the timeline on that?

Surya N. Mohapatra

Ricky, we have been working with -- directly in DC [ph] and also with the CLA [ph]. We'd done some studies. We have given some data, but I really don't have any specific timeline. We know that utilization has increased when people are trying to do it themselves.

Operator

Our next question or comment is from Lisa Gill from JPMorgan.

Gavin Weiss - JP Morgan Chase & Co, Research Division

This is actually Gavin Weiss, in for Lisa. First, I just want it to be clear, that charges related to Surya's employment agreement, those are not included in guidance, correct?

Robert A. Hagemann

Correct.

Gavin Weiss - JP Morgan Chase & Co, Research Division

Okay. And then, I know you've talked about AP in-sourcing trends, but maybe -- could you talk about how you think the overall AP market is trending?

Robert A. Hagemann

Well, the AP market -- the overall AP market is growing, but the share is shifting a little bit because it used to be the commercial laboratories and the pathologists. And now actually, you have the other specialists like GU, GU and Dharm [ph]. And they are doing the technical components. So I think the total market is still growing with the growth of cancer.

Robert A. Hagemann

And I think you've seen with the recent announcement of the acquisition of Caris by a Japanese firm that, yes, that does point to and reinforces our view that AP is going to be an important and attractive space to be in over the long term.

Gavin Weiss - JP Morgan Chase & Co, Research Division

Okay, great. And then just lastly, you mentioned a benefit plan design in your prepared remarks. Are these programs that will be implemented in the future with health plans? Or are you seeing the effects of these plan design changes now?

Surya N. Mohapatra

Some of those programs are in effect now with some of the health plans, and we are seeing some changes and some results, some improvement also.

Operator

Next question or comment comes from Gary Lieberman from Wells Fargo.

Gary Lieberman - Wells Fargo Securities, LLC, Research Division

I guess, first off, Surya, is there the potential for you to remain on as Chairman as you transition someone into the CEO role, and then maybe ultimately, the Chairman role? Or are you guys looking to, sort of, effectuate the change of both at the same time?

Surya N. Mohapatra

Gary, again, the Board will consider that. What I have agreed with the Board that once we find a CEO, I will remain as Chairman if the Board wants. But I'm going to be here up to 6 months. And hopefully, we will take less than that to find the CEO. But after April 30, I will leave the company and will not be on the Board of Quest Diagnostics.

Gary Lieberman - Wells Fargo Securities, LLC, Research Division

Okay, and can you guys maybe comment about the transition of Athena and Celera and the integration with the existing sales force and the ability for the current Quest sales force to sell those products?

Surya N. Mohapatra

Yes, Gary, again, you are to visualize our company that the routine testing is the foundation for chronic, and the 4 pillars of this, what I call disease-based focus. They can also consider, like very specialized boutique, advanced esoteric laboratories, whether it is Focus, whether it is another make pathology with Ameripath and Dermpath, or whether it is Berkeley Heart and Athena. So each of them will have and have personalized sales force to meet their customers. But along with that specialist sales force, we also have the general sales force who are selling to physicians and hospitals, and they are to provide lead and provide information and also become the channel for some tests. For example, we had a weakness in women's health, but we introduced, SureSwab, but also we have now access to SMA, through Athena, and we are now gaining some of the accounts back. Same thing is going to happen with the Berkeley HeartLab. They will sell direct, for some of the test results are going to be sold through physicians in the hospitals. So it's actually a double-channel strategy to reach maximum customers.

Operator

Our next question or comment is from Kevin Ellich from Piper Jaffray.

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Just a couple of questions, could you tell us or remind us, does Athena and Celera have their own commercial contacts or have they been rolled onto Quest contracts?

Robert A. Hagemann

Well, but generally, they have their own contracts, in some cases, they operate as out-of-network, and in other cases, we'll be rolling in some of the contracts, particularly on the Celera side, BHL in particular.

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Got it, and Bob, would you care to tell us what percent of the revenue or how much is out-of-network?

Robert A. Hagemann

No, not at this point.

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Got it. Okay, thanks. And then in your revenues, the other revenue segment grew, by my calculation, maybe 17% year-over-year, pretty strong growth. Just wondering what was behind that?

Robert A. Hagemann

Yes, well, as I said, the base business grew about 8%. The added growth came from the products portion of Celera, so there's some acquired revenue growth in there. But if you look at the base businesses that grew 8% in that group of businesses, that was principally from the product side of the business as well.

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Got it. And I guess, going forward, should we expect a similar type of growth out of the products business there?

Robert A. Hagemann

The products business, we continue to expect, is going to grow at a nice clip. Again, I don't want to give specific guidance for the small components of the business at this point, but we have been very pleased with the growth that we've seen there.

Surya N. Mohapatra

But it's also of a grave strategic importance because there's not a lot of Ivy League companies that have laboratory to introduce products and not a lot of the lab companies. And frankly, there's probably no lab companies who have the IVD capabilities. So knowing that our central team is diagnostic testing and information and services, I expect that some of the LDTs laboratory developed tests is going to become IVD through focused diagnostics in Celera and will become a revenue stream for us.

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Understood. And then you said Drugs of Abuse was up 5%. Does your Drugs of Abuse include toxicology screens? Or is it just pre-employment testing?

Robert A. Hagemann

It's principally pre-employment testing, but, yes, a lot of that is tox work, though.

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Understood. Okay. And then, just maybe the last question I have is, Surya, could you give us any update on India and maybe just generally how Care360 is performing?

Surya N. Mohapatra

Sure, first of all, about India, we -- as we said that Indian market, the laboratory market is growing 15% to 20% a year. We are growing in India, but it is not to my expectations. So we have a lot of opportunity in the growing market, especially in India to make sure that we get our share. We have started doing some esoteric tests and also some reference tests from India. So we'd still have to do a lot more in India for us to really get our return. As far as the Care360 is concerned, that's doing very well. Not only the Care360 has the laboratory orders and results, but also at the EHR, and we have now got the almost a 3,800 people of adopted hour Care360 EHR. And this again will become a very important element when we move forward to work with health plans and accountable care organizations. ACOs want connectivity. ACOs want analytics. ACOs want informatics. And this is the only company who has not only the connectivity but also content. So again, another strategic asset, which will really help us to grow.

Operator

Our next question or comment comes from Robert Willoughby from Bank of America.

Robert M. Willoughby - BofA Merrill Lynch, Research Division

Surya or Bob, you may have mentioned it, but with a CEO search that's under way, is the Board also open to exploring or currently exploring other alternatives possibly to create some value here above and beyond what you've announced today?

Surya N. Mohapatra

Well, Bob, first of all, the Board is fully engaged to find a successor to me. And as far as any alternatives and other things, obviously, that's something -- the Board looks at it. But at the moment, it is -- the focus is looking for a CEO, not really do any other alternatives for Quest Diagnostics.

Robert A. Hagemann

And, Bob, we believe that executing against what we've outlined, particularly in terms of improving operating performance, will generate some real significant value for shareholders.

Operator

Our next question or comment comes from Brendan Strong from Barclays Capital.

Brendan Strong - Barclays Capital, Research Division

Maybe first off, Surya, what exactly -- what are going to be your biggest areas to focus over the next 3 months -- next 6 months here?

Surya N. Mohapatra

Well, first of all, nothing changed. We have a company to run, and we have to deliver what we promised. And -- but going back to what are the focus has been to really grow the top line, so that's basically, sales effectiveness and driving the esoteric business, reduce costs. And then the other thing, what we are now focused on, improving ROIC. Those are the 3 things. But I'm going to work until the last day to making sure that not a single business on Quest goes anywhere. It comes to Quest from the market.

Brendan Strong - Barclays Capital, Research Division

Okay. And then -- look, with this type of a transition, there's often a lot of soul-searching. What do we do really well? What do we not do so well? Is there anything that you would say that maybe you would've done differently in recent years so that you'd recommend the company do differently going forward and that's maybe even a new opportunity at this point?

Surya N. Mohapatra

Well, again, you're absolutely right. It's not even this transition. Almost every year, we think about what is doing well, what is not going well, what we can do better. But if you know our company, there are 3 words that has driven our company over the last 10 years: it's patients, it's the passion for patients and our desire to grow and our commitment to people. So as far as patients, growth and people, that's not changing. The more important thing is that we have a lot of very capable people in the company, not only at the executives level, but also in the company. And that's why actually, we could take a big jolt like losing the United contract, but recovering. And as far as I'm concerned, that we are no longer a lab company, we are in healthcare diagnostics company. And with a lot of assets, and with a lot of people in the company with new ideas. So I'm pretty excited actually, to see this company and look for a person, both internally and externally, to drive the company. But -- so I don't really, again, we're not going to tie people's hands down wherever the new leader is, but wherever the new leader is, they will -- he or she will be very, very excited about the people and the assets and the customers we have.

Brendan Strong - Barclays Capital, Research Division

All right, great. And then, Bob, last question is for you. I know it's hard to give specifics on the $500 million in cost savings. There's always been questions over the year, as to whether or not there's some core differences in the cost structure between you and LabCorp. And I'm just wondering if you can comment on whether or not, at this point, you think there may be some specific differences that you are target with these savings? Or if these savings are more just driven by what you believe are best practices?

Robert A. Hagemann

Likely, there are some differences in the way we operate our business with the LabCorp. But frankly, as we go through this process and we've identified the opportunities here, we're not using LabCorp as our model. What we're looking at are the opportunities we have within our business to take our business to a different level, to do things differently. And the -- I outlined a lot of those. Well, I respect the LabCorp for what they've accomplished. That's not necessarily what we're trying to emulate here.

Operator

Our next question or comment comes from Bill Bonello from RBC.

Bill Bonello - RBC Capital Markets, LLC, Research Division

Can you tell us who on the Board is heading up the CEO transition search?

Surya N. Mohapatra

The Board is the search committee. And, we have, as you know, we have a leading independent Director. But as the Board itself, it's the search committee.

Bill Bonello - RBC Capital Markets, LLC, Research Division

Okay, so in the press release, it said you'd formed a search committee, but there really isn't any separate search committee?

Surya N. Mohapatra

Frankly, it is -- the Board is the search committee. There are 7 people, including me, is 8. So obviously I'm not in search committee, but I'll take part -- I'll participate.

Bill Bonello - RBC Capital Markets, LLC, Research Division

Okay, yes. That was going to be the next question, so you will be an active participant in the search process?

Surya N. Mohapatra

Bill, in fact, my role will be to facilitate and provide all the information. And obviously, I will participate in the search process. And -- but it is the Board's decision. It is the Board's work.

Bill Bonello - RBC Capital Markets, LLC, Research Division

Okay, that makes sense. And then just one quick follow-up question for Bob, in terms of the sequential, sort of, increase in revenue per requisition growth, is that primarily just reflecting a full quarter of the acquisitions? Or is there anything else that drives that?

Robert A. Hagemann

That is probably the biggest piece of it, Bill. As we indicated, as we got into the back half of this year, we would start to anniversary some changes that were made previously, and we're starting to see some of that as well. As I mentioned, the absolute level of revenue per requisition has been pretty stable x the acquisitions this year.

Operator

Our next question comes from Ashim Anand from Natixis.

Ashim Anand - Natixis Bleichroeder LLC, Research Division

First question is the bad debt expense went down significantly. Congrats on that. I was wondering if you guys can comment on if there has been any payer mix, significant payer mix change, and how should we think about the trend going forward?

Robert A. Hagemann

There's no -- been no significant payer mix change driving the bad debt improvement. If you look at the bad debt quarter-to-quarter this year, it's been relatively stable. We had some quarters last year where we had spiked so the improvement that you're seeing is really the year-over-year improvement, not necessarily sequential improvement. But bad debt and billing is an area that we're constantly looking for ways to improve it. You don't improvement it overnight. It generally takes lots of time and effort, and you start to see small incremental changes over time. And that's really what we've been doing here. We've been applying Six Sigma in the billing and collections area for some time now, and it's one of the areas where I think we have the probably the best examples of how Six Sigma can work to drive continuous improvement. And that's really what you're seeing.

Ashim Anand - Natixis Bleichroeder LLC, Research Division

Okay, and in terms of the prospective restructuring plan, would it change your aggressive venture into the developing countries in any ways?

Surya N. Mohapatra

No. As we said that we still do quite a bit of reference tests from -- in international, which includes some developing countries. But our major investment is in India because that's the one which is growing. And we want to be successful there before we start doing any other venture anywhere else.

Ashim Anand - Natixis Bleichroeder LLC, Research Division

Okay, and in terms of non-clinical revenues, they grew significantly. I was wondering if you guys can comment on how the point of care part of that is doing? And also, you don't break out, but if you can generally comment on considering the -- probably it says the highest ever, if I'm correct, how that had an effect on that segments, the total non-clinical segments, gross margins and SG&A?

Robert A. Hagemann

Yes, just like I said, just to clarify, the non-clinical businesses there, their base revenues grew about 8%. There was additional growth added as a result of the Celera acquisition that brought with it a products business. So that's what drove the rest of the growth there. Within the base business, much of that growth was driven by our products business again, principally the point of care operations there, which have been growing nicely.

Surya N. Mohapatra

Although we call it non-clinical, but remember the reason why we have this, is this is all about diagnostic testing whether you draw blood and bring it into the laboratory or take an instrument to the doctor's office. So it makes sense.

Ashim Anand - Natixis Bleichroeder LLC, Research Division

And finally, HHS, recently proposed about direct patient access to clinical diagnostic tests done in labs. In that regard, it's not a done deal. But I just want you to know how and if you are pushing for that reform? And what is the likelihood that the CLIA/ HIPAA's rule against it might be repealed. And going forward, if it does goes through, assuming that you guys like it, how sales and marketing practices might change in terms of clinical diagnostics?

Surya N. Mohapatra

Okay, and a lot of questions here. Well, first of all, we are a very strong supporter of patient data rights. It is the patient's blood, it is the patient data. The other thing is that we don't believe that you can reduce healthcare cost and improve quality unless we educate people. So we've been working behind the scenes for the people who can make changes as far as giving the data to a patient directly, so that they can be educated. You can you know blood sugar is going up, you know that you're not going to have that donor. So it's all about patient accountability. And those are the patient data rights. We welcome it and we really applaud what the government is doing. We have a connectivity to physicians, and now we have connectivity to patients to our Gazelle Smartphones. So if you have the -- your blood sample coming to Quest Diagnostics, you will get your result in 48 hours. Your doctors get a look at those first. And Gazelle was introduced a few months ago, and now we have 80,000 users using this device to get the results and also use other applications. So again, it's all about providing information -- diagnostic information to doctors, now to the patients. So it's a good thing.

Operator

Our next question or comment comes from Darren Lehrich from Deutsche Bank.

Darren Lehrich - Deutsche Bank AG, Research Division

Surya, I think your decisions about capital deployment are really great news for your shareholders. I wanted to just ask a couple of questions here. I think, first of all, when did the search begin? In other words, when did you engage the outside party?

Surya N. Mohapatra

Well, some of these things, I will not be able to give you, but remember one thing, leadership development and succession planning is a regular work in Quest Diagnostics. So this is not something new, and we -- many times, we have different search firms trying to help us, our executive search firm. So as far as this particular one item, I will not be able to give you the exact date.

Darren Lehrich - Deutsche Bank AG, Research Division

Okay, the reason why I asked the question specifically is that I think, Surya, you've indicated throughout the call that it will be a short process. And so it sounds like this has been something that's maybe -- been working behind the scenes for some time. So I just wanted to understand the basis for your comment about why you think it's such a short process? Or is it just that you think 6 months is a short period of time? If you could maybe help define what you mean by short?

Surya N. Mohapatra

Okay. Well, first of all, as we've said that we have a number of internal capable candidates. We also have been working for quite a while to look in at actually how the transition is going to happen. And the reason why I talked about short, because usually when this -- we don't want to extend the period of uncertainty. And so I agreed to be here for 6 months to transition. And we believe that we will find the right candidate for our company. And it's a very attractive company with a lot of growth opportunities. So our goal in working with the executive search company, we believe that it can be done within 6 months.

Darren Lehrich - Deutsche Bank AG, Research Division

Okay that's helpful. And then my other question maybe, Bob, if you could just comment a little bit more about some of the incentive changes that the company is pursuing with regard to management compensation? Just any broad strokes on the framework of how that will look for 2012 and what's changed?

Robert A. Hagemann

We'll have more details later. But yes, I indicated that and Surya did as well. Beginning in 2012, a significant portion of the management's long-term compensation is going to be tied to improving ROIC. What those targets are, and the rate at which we're looking to improve it, yes, there's really more to come on that. But those targets for us, will be said as part our annual planning process.

Darren Lehrich - Deutsche Bank AG, Research Division

Okay, that's helpful. And then the last question I have is, just I wanted to make sure I heard -- something you said earlier, Surya, just about lab benefit and maybe I missed the comment. But is Quest developing its own lab benefit management business? Can you just maybe expand on what you were referring to in your prepared remarks?

Surya N. Mohapatra

Well, sure. We have a product called QuestNet, and we have that existing for the last 7 to 8 years. And basically, it is a product where we manage and build networks, and manage networks for health plans. And already, we have 2 health plans we are working -- they rely on us to really run their network. And we are talking to a number of other health plans who are interested in such network. It's called QuestNet.

Darren Lehrich - Deutsche Bank AG, Research Division

Okay. I just -- I didn't hear your comment clearly. So it's not necessarily -- I mean, it's a network on that you've developed, but are you building it into a benefit management company as well? Is there anything -- any broader plan around that? I just want to make sure I understand how you're framing that.

Surya N. Mohapatra

Well, first of all, QuestNet can be expanded. It's not a separate company. It's part of Quest Diagnostics. And it can -- we are working with various vendors to have different kinds of things like pre-authorization. And so it can go into the laboratory benefit management if we wanted, but it is a part of Quest Diagnostics.

Operator

Our next question or comment comes from Isaac Ro from Goldman Sachs.

Isaac Ro - Goldman Sachs Group Inc., Research Division

First off, I just want to talk about the co-pay scenario out there. I know obviously, there's a lot of legislative events heading in the next couple of months. But how are you guys looking at that in the current situation? I think our Washington folks has said that the buying proposal could be one to take shape and within that, potential for co-pays on the lab side. I'm just wondering how you're managing the risk there?

Kathleen Valentine

Yes, Isaac. This is Kathleen. Clearly, there's a lot, as we know, on the table in Washington as the -- as Congress is working on the debt -- the deficit reduction for the debt-ceiling negotiations. And quite frankly, there's a lot on the table. There's a co-pay possibility that certainly AARP has formally indicated their opposition to. There's a co-insurance possibility, there's certainly reductions in the clinical lab fee schedule, they're being contemplated. So there is a lot on the table. We're certainly working directly, and through ACLA, to make sure that diagnostic testing and Quest Diagnostics is fairly considered in whatever they're contemplating. And we've already provided and absorbed quite a bit of fee reductions from Medicare. So it's really too early to tell. Quite frankly, they're under the gun to get something negotiated by the end of the year, and we're certainly staying close to what's going on there.

Robert A. Hagemann

And Isaac, this is Bob. Certainly, we don't see a co-pay as something that's very attractive, not only for us, but for the people participating in the Medicare program. Essentially, you're shifting cost to seniors in a situation like that, and you run the risk that it would deter them from getting appropriate testing and screening and preventing what might be more expensive procedures down the road. So we don't think it's necessarily good policy. We're trying to make that case very clearly. But also, if there is going to be a co-pay, we want to make sure that it's in situations where it's being collected by the provider that's actually seeing the patient, which is really important.

Isaac Ro - Goldman Sachs Group Inc., Research Division

Got it. Okay, that's helpful. And then maybe secondly, on Celera, I think in the past you guys have touched on the key development capabilities you got from that asset? Wondering if can maybe comment on the progress you're making there as it relates to new products. You touched on, sort of, an interest in becoming more of a diagnostics company rather than just a lab services provider. So how those assets are helping you make that transition would be interesting.

Surya N. Mohapatra

Well, first of all, the reason why we were interested in Celera apart from having a specialized Berkeley Heart Lab, is their discovery capability and also their IVD capability. We have focused diagnostics for infectious disease. And with that, what we bring to our company is how you deal with the FDA, how do you deal with the regulatory staff. Plus the fact, that a lot of tests can be converted into IVD, based on the work which is happening in our laboratories. So when I look at international market or when I look at the hospital market, I really am pretty excited about some of the reagents which we can do through Celera or Focus. At the moment, we're focusing more on molecular diagnostics, which is the top end of IVD. So this will be very important for us when we go towards personalized medicine. And this will be very important for us also as far as getting the benefit of testing in the hospital and international by just sending reagents and not going to have really open up big laboratories to do these things. So it is good. And it is -- we are combining some of the expertise. It's small at the moment, but it has a very bright future.

Robert A. Hagemann

And, yes, Isaac, we're seeing a lot of interest from pharma in our capabilities at this point because they are thinking about companion diagnostics, particularly diagnostics that might have a very broad appeal. It's going to be important for them that there'll be an IVD kit that's available. We can work with them to take laboratory developed test, convert it to an IVD kit, which can then be distributed very broadly and widely. So we're seeing a lot of interest here. And as Surya said, it's small today, but it's an important capability that we think is going to help us as we go forward.

Operator

Our next question or comment comes from Gary Taylor from Citigroup.

Gary P. Taylor - Citigroup Inc, Research Division

A lot of news today. Appreciate it. A couple of questions. Did I miss the discussion of how the AP business is going? And if I did, I'll just go back and look at the transcript.

Surya N. Mohapatra

No, I think we just mentioned our laboratory AP business guide is still under pressure. And we still believe that the rest of the year we will see pressuring down at the pathology, although GI and GU is moderating. And we are working with the regulators. We have collected some data. Hopefully, we could pursue the regulators to start some internalization. But having said that, AP's a very important component of cancer diagnostics. And once it is moderated, we will benefit from our strong franchise of Anatomic Pathology.

Gary P. Taylor - Citigroup Inc, Research Division

Do you expect you might see growth of revenues there in 2012, or is it still too soon to say?

Surya N. Mohapatra

Well, we're not talking about 2012, as you know. But it's a very important element of our growth strategy, and AP is certainly growing faster than routine testing. But unfortunately, at the moment, because the TC and PC, we're seeing some internalization.

Gary P. Taylor - Citigroup Inc, Research Division

Okay. Two other quick questions. One, I just wanted to -- I've asked this before Bob, it's asking about reporting basis and cash EPS. Obviously, LabCorp went there a couple of quarters ago. And in light of, kind of, re-evaluating a lot of shareholder-friendly things, is there any consideration or any new consideration they might change their reporting basis?

Robert A. Hagemann

Look, Gary, we have no plans to do that. I'm not sure how it's really shareholder-friendly. It's not doing anything to create value. It's just recharacterizing something. The amount of amortization that is associated with our deals is clearly laid out on the P&L. And if people want to calculate that number, they certainly can. But I don't see how it creates any shareholder value.

Gary P. Taylor - Citigroup Inc, Research Division

I don't necessarily disagree with you. I just know it's generally -- shareholders have it liked. But whether it creates value, I'm not sure I disagree with you. Thanks for that. Last question is, on the comment that you would look in the future to return majority of the free cash flow generation to shareholders, dividend versus repurchase, and you did report a sizable dividend increase today, but you still -- your dividend payout ratio is about 10% or 12% of your annual free cash flow. So I guess, my question is, longer-term, what are your thoughts around on what that free cash flow payout ratio might look like or could look?

Robert A. Hagemann

Without giving you specific guidance, Gary, on the payout ratio, what you should expect regarding the dividend is, it will grow over time as we continue to grow our earnings and cash flows. But I'm not prepared to give you a specific payout ratio. At this point, also, the increase in the dividend brings us pretty close to about 13% or so of free cash flow.

Gary P. Taylor - Citigroup Inc, Research Division

Right. And is there any -- just my last follow-up, when you consider dividend versus repurchase, any top of mind, I guess, rules of thumb or thoughts around how are you going to be skewed? I mean, right now, clearly, much more free cash flow available for repurchase than there is being paid out in dividend. In the future, what are going to be some of the drivers for that?

Robert A. Hagemann

Well, certainly, yes, as we've said already, we feel very good about the outlook for us continuing to generate your strong cash flows and if we feel good about the ability to increase the dividend at this point in time. And I think we want the dividend to be something that's meaningful. We've done that with this increase. And as I said we expect it to grow over time. And share repurchases give us some added flexibility in that regard. So we want to maintain some flexibility here but we want to make it very clear that we're committed to returning the majority of our cash to shareholders.

Operator

Our next question or comment comes from Art Henderson from Jefferies & Company.

Arthur I. Henderson - Jefferies & Company, Inc., Research Division

Surya, I know you guys have worked pretty hard on getting closer with your Managed Care clients. You've talked about working to control leakage. Can you talk just a little bit more about how that's progressed? Are we still kind of in the very early stages there on what you can do? And maybe if there's anything you can sort of comment on how that's going along would be helpful.

Surya N. Mohapatra

Sure, Art. First of all, I wish it was going much faster than it is going at the moment. Where -- however, having said that, and as we've mentioned, we have long-term relationships with a number of health plans and I think as they evolve to becoming ACO or working with the employers, we are becoming a very strong partner with them whether it is including their latest score or providing analytics and informatics about the utilization or taking the leakage data, which the patients are going to the hospital, and the hospital is 2x or 3x more than the commercial lab and changing the employer benefits. So we are working a number of areas, and we are pleased to see some improvements in this area where the health plans are talking to the employers. And health plans are talking to us and giving us the data to move -- to steer some leakage away from higher cost testing to us. The other question about lab benefit management or lab network, and again, we had QuestNet for almost 7 or 8 years. And we see some more interest now in managed network. We manage hospitals. We manage laboratories. So we will probably see some more work in QuestNet. But I think the most important thing is probably going to be the application of our connectivity with the doctors and getting the data utilized. And when the ACO comes in, then it's all about, actually, accountability of the quality and improvement of quality and reduction of costs. So we are working with them, and we're seeing some progress. But it's a little slower than what I would liked to.

Arthur I. Henderson - Jefferies & Company, Inc., Research Division

Surya, just to prod at that a little bit more. I mean, why wouldn't commercial payers jump more on this faster? I mean, why are they so leery to, sort of, get on board with controlling this leakage issue?

Surya N. Mohapatra

Well, first of all, I didn't know I have a lot of friends both in the hospital ACO and also in the health plans. And it's a question of priority. Laboratory testing, again, is still in the 3% to 4% of the total cost. And when the company is negotiating a heart transplant or a rehabilitation center and all those things, laboratory test doesn't come in. But having said that, the diagnostic test is going to play an important role on the total life cycle cost during the hospital stay, and the patient outside the stay. And this is where we come in, and this is where the health plans are getting more interested because they want to know about the patient when the patient is in the hospital, and outside the hospital, and also trying to reduce readmission to the hospitals.

Arthur I. Henderson - Jefferies & Company, Inc., Research Division

Okay, that's helpful. On the Managed Care contracting front, I mean, you don't have any significant contracts that are up for renewal in the next couple of years, do you? Can you just refresh my memory on that?

Robert A. Hagemann

Yes, Art. This is Bob. We've indicated that all of our national contracts had been renewed for multiple years. We don't have anything coming up either this year or next year. They start to come up in 2013 and beyond. And as I look at the next couple of years, while we always have contracts coming up, whether they'd be, typically a national or regional or a local one, the amount of contracts that are coming up -- the business that's coming up in total tends to be a little less than it would be on average in a particular year for those upcoming years.

Arthur I. Henderson - Jefferies & Company, Inc., Research Division

Bob, while I have you, was there any, sort of, hurricane impact, weather impact in the quarter? I know Irene hit pretty hard. Was that -- did that end up kind of being nothing, or was there anything that you could talk about there?

Robert A. Hagemann

Yes, Art. The impact of the hurricanes was really very modest for us. As you know, they hit on a weekend, which is a slower time for us. So while, it did have some impact, it was pretty modest to the volumes, and we chose not break it out.

Arthur I. Henderson - Jefferies & Company, Inc., Research Division

Sorry, one last thing, obviously, I know a lot of thought went into your succession plan. I just wanted to say, thank you for all the good years of hard work. You really did build the company up. So I just wanted to mention that.

Surya N. Mohapatra

Thank you very much, Art. And thank you all, actually. You have supported me over the years. But I'm not going anywhere for another 6 months.

Operator

Our next question or comment comes from Amanda Murphy from William Blair.

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

I just had one quick follow up on the cost savings initiatives that you're launching here. So I understand that you're going to be at that $500 million run rate, sort of, in 2 to 3 years from now. But if you look at that number, it's sort of a big earnings number, potentially. So is that how we should be thinking about it in terms of how it flows to the P&L over the course of the next 2 to 3 years?

Robert A. Hagemann

Yes, Amanda, as I said earlier, well, I think everybody is anxious to understand exactly how much is going to flow to the bottom line. We're doing this for a number of reasons. One, we see, as we look forward increasing pressure on reimbursement, we see rising cost in some places. And we think we just need to do this to make sure that we can continue to grow our business, to be competitive in doing that and also improve our margins. And at this point, it's premature to give you specific guidance as to what the impact will be on margins. We hope to give you some more clarity around that as we get into January and provide you guidance for 2012. But for right now, it's a little premature.

Operator

Our last question comes from Steven Valiquette from UBS.

Steven Valiquette - UBS Investment Bank, Research Division

The -- I just kind of asked that Medicare co-pay thing for a minute here. It seems like if you think about the mechanics of it, at the end of the day, it would impact just your Medicare book of business, which is a smaller part of your mix, but if you did get a broad Medicare cut, that would seem to, over the course of a couple of years, maybe work its way into commercial pricing, and impact your overall book of business. So I guess just to kind of confirm your views. Have you run the math to say that this co-pay scenario is definitely worse financially than, say, a broad 2% to 4% Medicare cut? And do you -- just to get a sense for how much worse this might be versus -- against the broad cover would be helpful, as to kind of put it into context?

Robert A. Hagemann

Well, look, as you can expect, a broad fee reduction is going to drop down to the bottom line with no opportunity to recoup it. And while we're not in favor of a co-pay for the reasons that I've mentioned earlier, you do have the ability to collect that, particularly if you're in the position where you're going to encounter the patient. As I said earlier, if we do end up with a co-pay, that would be the sort of scenario that would make the most sense. It would be the provider that's encountering the patient that would be responsible for collecting the co-pay. Or that's what we would hope in that regard. But certainly, like I said, with the co-pay, we have the opportunity to collect it if it's a straight fee reduction. There's not much we can do about that.

Steven Valiquette - UBS Investment Bank, Research Division

Yes, there is an industry trade bore that the cost of collecting it could be somewhere like in the $3.50 or $3.60 range, somewhere in there. Could you share that here if because your scale might be a lower cost for you? And what's your thoughts around that number in collecting cost of collecting a co-pay?

Robert A. Hagemann

That sounds like it's a relatively high number at this point. And look, we collect co-pays today, so we've got the infrastructure in place to do it. We know how to do it. And while it would add cost to us, it's something that we're certainly capable of accomplishing. And I've believe for less than what you've just quoted.

Operator

Thank you for participating in the Quest Diagnostics Third Quarter Conference Call. A transcript of prepared remarks on this call will be posted later today on Quest Diagnostics' website at www.questdiagnostics.com. A replay of the call may be accessed online at www.questdiagnostics.com/investor or by phone at (888) 673-3567 for domestic callers, or (402) 220-6430 for international callers. No access code will be required. Telephone replays will be available 24 hours a day until midnight, Eastern Time on November 22, 2011. Goodbye.

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