Quest Diagnostics Incorporated (NYSE:DGX)
Q3 2016 Earnings Conference Call
October 20, 2016, 08:30 AM ET
Dan Haemmerle - Executive Director, IR
Shawn Bevec - Executive Director, IR
Steve Rusckowski - President & CEO
Mark Guinan - CFO
Bill Quirk - Piper Jaffray
Ashley Craig - Morgan Stanley
Ralph Giacobbe - Citi
Jack Meehan - Barclays
Isaac Ro - Goldman Sachs
Nicholas Jansen - Raymond James
Jason Plagman - Jefferies
Bill Bonello - Craig-Hallum
Mark Massaro - Canaccord Genuity
Good day, everyone. Welcome to the Quest Diagnostics Third Quarter 2016 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 Shawn Bevec, Executive Director of Investor Relations for Quest Diagnostics. Go ahead, please.
Thank you, and good morning. I'm here with Steve Rusckowski, our President and Chief Executive Officer; and Mark Guinan, our Chief Financial Officer.
During this call, we may make forward-looking statements and also discuss non-GAAP measures. For this call, references to adjusted EPS refer to adjusted diluted EPS excluding amortization. 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' 2015 Annual Report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K. The text of our prepared remarks and a PowerPoint presentation will be available later today in the Investor Relations page of our website.
Now here's Steve Rusckowski.
Thanks, Shawn, and thanks everyone for joining us today. This morning I'll provide you with the highlights of the quarter and review progress on our strategy and then Mark will provide more detail on the results and take you through our updated guidance.
During the third quarter, revenues were up on reported basis and grew 2.1% on an equipment basis. Reported EPS decreased 43%, primarily due to the gain from our 2015 contribution to the Q Squared Solutions joint venture.
On an adjusted basis, EPS grew 7%, cash from operations were $301 million up 42%. Now let me discuss highlights of the progress we're making in several areas of five-point strategy, which as you all know is to restore growth, drive operational excellence to simplify the organization, refocus on our diagnostic information services business and deliver disciplined capital deployment. So let's start with growth..
We continue to make progress with our expanded hospital systems relationships. In professional lab services, HCA began to contribute to growth in the third quarter. As we announced earlier this year, we're managing an inpatient laboratory operation for six Denver area hospitals in HealthONE System of HCA Healthcare. Revenues from this engagement will continue to increase throughout the end of the year.
Our Professional Lab Services agreement where RWJ Barnabas Health in New Jersey and Clinical Laboratory Partners the outreach lab business we acquired from Hartford Healthcare in Connecticut, both contributed to perform well and grew revenue this quarter. Beyond our hospital systems relationships, we also continue to deliver solid growth in prescription drug monitoring in infectious disease testing including Zika.
In prescription drug monitoring we remain and industry leader with strong growth in the quarter. Providers and payers appreciate our unique ability to help manage the epidemic of prescription drug abuse with appropriate test utilization.
In infectious disease, we continue to see solid growth in the fourth generation HIV testing as well as Hepatitis C testing for screening and genotyping to help doctors determine the type, dose or duration of treatment.
Turning to Zika we complemented our proprietary PCR test with a new antibody test license from the Center for Disease Control. Quest Diagnostics is proud to be among a group of select national reference laboratories, selected by the Center for Disease Control to aid the response of the Zika emergency in the United States.
Looking forward we're excited about our new agreement with Ancestry. Quest will become Ancestry's first CLIA approved lab partner to provide DNA testing, enabling Ancestry DNA subscribers to build their family based on the origins.
Over time we intend to support additional opportunities with Ancestry to guide people on building and understanding their family health tree. We're also very excited about the recent launch of the IBM launch of genomics from Quest Diagnostics, a new service that helps advance precision medicine by combining cognitive computing with genomic tumor sequencing. The service helps oncologists match patients with cancer therapies and clinical trials based on the tumor's unique DNA.
Quest expertise in genomics and cancer as well as our broad market penetration to have the country's physicians and hospitals means Watson power tumor sequencing is accessible for the first time to the community and oncologist to provide 70% of the nation's cancer care. Memorial Sloan Kettering and the Broad institute will contribute their data and research expertise to further augment the offering.
The next element of our strategy I'll highlight is driving operational excellence. Our collaboration with Optum will help us reduce cost and complexity of our billing processes and also increase transparency of healthcare cost for patients, physicians and employers.
Employee engagement in our Optum alliance has been positive and the integration is on track. Quest employees will transition to Optum team in mid-November. We expect to begin realizing savings from this relationship next year.
We view this agreement without Optum as the start of a long-term relationship and it builds on our long-standing relationship with Optum's parent the United Health Group. For decades Quest has served the United Healthcare plan participants to help them take action to improve their health based on insights from diagnostic testing and information services.
Also in the third quarter, we opened 12 patient service centers in five states in Safeway supermarkets. In just the first months patients are finding it easier to access testing in a more convenient location and we've seen volume increases in these retail settings. We remain excited about expanding patient access through retail partnerships.
We continue to execute on our last element of our strategy was to deliver disciplined capital deployment. We completed our $250 million accelerated share repurchase program announced in May, using the proceeds of the sale of Focus Diagnostic business.
Through this ASR we repurchased approximately 3.1 million shares, additionally bought back another $50 million of company stock, bringing the total repurchases of 2016 to $440 million through the end of the third quarter. We look forward to sharing more detail on our market views and strategic outlook at our third Investor Day at the Intercontinental New York Barclay Hotel in Midtown on November 11. Registration information is available on our Investor Relations webpage.
Now Mark will provide an overview on our third quarter financial performance and provide you with an update on our 2016 outlook, Mark?
Thanks Steve. Starting with revenues, consolidated revenues of $1.89 billion were up 0.3% versus the prior year on a reported basis. Equivalent revenues grew 2.1% for the company. Revenues for Diagnostic Information Services or DIS for short, grew by 2.1% compared to the prior year. Of this growth, approximately 1% was organic.
Volume, measured by the number of requisitions increased 2% versus the prior year. Approximately half came from organic growth including our Professional Lab Services or PLS engagements and the other half from recent acquisitions. Revenue per acquisition in the third quarter was flat versus a year ago. As a reminder revenue per req is not a proxy for price and includes a number of variables such as unit price variation, business mix, test mix and test per requisition.
Unit price headwinds moderated in the third quarter, down roughly 50 basis points compared to the 100 basis points headwinds we observed in the first half. Consistent with previous quarters our PLS engagement such as our WJ Barnabas Health and HCA carry lower revenue per requisition due to the nature of the work we are performing and lower the revenue per req calculation.
In the third quarter, the impact of our PLS engagements was slightly larger than the 120 basis points we highlighted in the second quarter, which is representative of the strong growth we are seeing in this business. With HCA coming online in the third quarter and ramping up through the end of the year, we expect PLS to continue to grow at a faster rate than the balance of our business in Q4.
After considering the impacts of unit price and PLS, other mix elements including test and payer mix contributed nearly 2% to revenue per req in the quarter. Reported operating income for the quarter was $322 million or 17.1% of revenues compared to $631 million or 33.6% of revenues a year ago.
Our reported third quarter 2016 results included a $334 million pretax gain on the contribution to Q Squared joint venture with Quintiles. On an adjusted basis, operating income was $320 million or 17% of revenues compared to $325 million or 17.3% of revenues last year.
The impact of our former Focus Diagnostics and Celera products businesses in the third quarter of 2015 benefited adjusted operating income by approximately $16 million or 50 basis points. Excluding this impact, margins would have grown by 20 basis points year-over-year.
Reported EPS was a $1.34 in the quarter, compared to $2.35 a year ago. The year-over-year decline was driven primarily by the net gain on our Q Squared contribution mentioned previously. Adjusted EPS was $1.37 up from $1.28 last year.
The company recorded special items with an after-tax benefit totaling $10 million in the quarter, representing an escrow recovery associated with an acquisition, which was partially offset by restricting and immigration charges. The net impact of these items benefitted our reported EPS by $0.07.
Bad debt expense as a percentage of revenues was 4%, 20 basis points better than the previous quarter and 10 basis points higher than 2015. As a reminder, bad debt expense typically improves modestly throughout the year as patients hit their health insurance deductibles. Note that the year-over-year compare is negatively impacted by the fact that our products businesses had a lower associated bad debt rate.
When taking this into consideration, our bad debt rate was flat year-over-year. Quick comment on our new billing relationship with Optum, to reiterate, expense savings from this relationship will not begin until 2017. We expect modest savings on our billing support cost during each year of the 10-year agreement and Optum will work with us to help lower our bad debt rate as well as reduce our denials over time.
Income tax expense in the quarter benefited from the adoption of the new accounting standard related to stock-based compensation. The impact amounted to an EPS benefit of roughly $0.02 in Q3. The new standard also results in a change in weighted shares outstanding by increasing the effect of dilutive securities which slightly offsets the EPS benefit.
Our DSOs were 46 days, two days higher than last year, but one day better than the prior quarter. The year-over-year increase was primarily attributable to higher levels of patient responsibility. For the first nine months of 2016, cash provided by operations was $765 million versus $549 million last year. Capital expenditures were $165 million through the third quarter compared to $169 million a year ago.
Before moving to guidance, I'd like to highlight that operations in our Southeast region were impacted by Hurricane Matthew earlier this month. Our updated guidance reflects the impact we currently know. Additionally, I want to provide some color on a few notable items, which will impact our full-year operating cash flows.
The first relates to after-tax charges for the full-year 2016 of $29 million from the retirement of debt. Second, we will incur a full year cash tax outlay of $91 million associated with the focus to register that will be recorded in our operating cash flow, while the associated $275 million from the sale is reported in our investing cash flow.
We paid $68 million of this liability in Q3 with the remainder to be paid in the fourth quarter. Third in Q3, we realized $54 million of proceeds from the termination of interest rate swap agreements. In aggregate these three items are adversely impacting our full-year operating cash flow by a net of $66 million.
Now turning to guidance, based on our year-to-date results, we are narrowing our 2016 outlook as follows. Revenues to be approximately $7.51 billion, an increase of about 0.5% versus the prior year on a reported basis and an increase of about 2.5% on an equivalent basis. This compares to previous revenue guidance of between $7.47 billion and $7.54 billion.
Reported diluted EPS to be between $4.47 and $4.52 and adjusted EPS to be between $5.07 and $5.12. This compares to previous EPS guidance of $4.18 and $4.33 on a reported basis and $5.02 and $5.17 on an adjusted basis. Cash provided by operations to be approximately $1 billion, which compares to previous guidance of approximately $880 million.
And finally capital expenditures to be approximately $250 million compared to between $250 million and $300 million previously. Now let me turn it back to Steve.
Thanks Mark. To summarize we continued our success in 2016 with another good performance in the third quarter. We continue to generate strong cash from operations and we remain on track to meet our commitments for the remainder of the year.
With that, we would be happy to take any questions, operator?
Thank you. We will now open it up to questions. [Operator Instructions] Our first question is from Bill Quirk from Piper Jaffray. Your line is now open.
Thanks and good morning, everyone. First question is just thinking about the, final clinical lab fee schedule for 2017, I guess we've been thinking or expecting rather that it was likely to be flat when the final adjustment comes out here in about lesser month now, but recent hearing some chatter that we may actually see a small inflation update to that. Any thoughts on that guys? Thank you.
Yes thanks. So as you know we don't really know and last year we had a small adjustment as well to it. So hopefully your view of what you've heard is right, but at this point we have nothing to add to what you're saying.
Okay. Got it. And then just a follow-up, I guess kind of bigger picture question, help us think a little bit about some of the health exchanges. Obviously there has been some pressure on managed care. We've seen some people pull out of this and so how are you thinking about this over the coming couple of years here, thanks?
Yeah I think we're all trying to understand how those lives will eventually get healthcare insurance. I think state by state will sort its way out. We can't speculate at this time how those lives will be picked up but as you read and you know as well as we do, that the number of the particularly national providers have decided to pull out of the exchanges, but you would -- you have to believe that those lives that might be impacted will be dealt within the appropriate way state-by-state, but it's too early to speculate on that.
Thank you. Our next question is from Ricky Goldwasser of Morgan Stanley. Your line is now open.
Hi. Good morning. This is Ashley on for Ricky. I just wanted to -- I was wondering if you could give a little bit more color into some of the partnerships you highlighted in the press release. We noted that PLS agreements are positive to volumes, the headwind to price, the Optum agreement is supposed to help with curving bad debt expense, but could you talk a little bit about Safeway and Ancestry and IBM? Where are we with the impact of those relative to the core business?
Yeah. Thank you very much. Well first of all, we're encouraged with our continued growth that we're seeing in our professional lab services business. We've highlighted two in my opening remarks. One is the relationship with HCA, the second is related to a relationship with Barnabas here in New Jersey.
They're often running -- they contributed to growth in the quarter. We're optimistic about their prospects and also we've a good funnel with us. They made one comment that I would like to react to. We've been very, very careful to make sure that we described how this business affects the calculation of revenue per acquisition and what we've done carefully is to talk about in the script and I am sure Mark will provide some color, is that we actually provided in the script the unit price impact of this quarter to our performance and that is when you freeze all other characteristics of our business what the true pricing impact is on our business, where there is other characteristics of our business like and peer mix that affect the calculation of revenue per req.
So we feel very positive about the growth prospects for professional lab services business. It's a great growth opportunity. It's great return on invested capital. The report is greater for shareholder value creation, but it does affect the calculation because it's at a lower price point. That is not to be confused with price reductions. So I want to make sure that's clear sure and I am sure what I've done here Mark will comment on that as well to make sure it's absolutely clear.
As far as partnerships, we believe that being a company that work with others in healthcare is an important part of what we do. We obviously are demonstrating. We know how to do that. Number of things we talked about already have to do with us former relationships. We talk about professional lab services.
I'll also mention that when we buy outreach businesses like I referred to is the Hartford Hospital outreach business that we bought. We're working on building on that to have a strong relationship. Couple that with what we announced this fall with Optum. Optum will allow us to work with one of the leaders in healthcare analytics, leaders in healthcare services to work on understanding what we can do to improve the billing process and thereby helping us with our bad debt exposure as well as making sure we get paid for a lot of the more sophisticated testing that we do.
We think of them working with us is better than us working independent and that's a good opportunity for our shareholders going forward. So we're optimistic about that opportunity, but also what you also see in my introductory remarks, we believe this continues to build on a strong working relationship we have with the United Health Group and this new working relationship with revenue cycle management will only enhance that relationship.
We actually do the -- we have a strong collaboration to do their wellness work within Optum. We have an existing relationship with some of their physician groups that they're buying in terms of laboratory professional services and then finally as we continue to be a big supplier of laboratory professional services for United Healthcare membership today and we believe that will continue to grow. So we're optimistic about the prospects there.
We also announced recently the relationship with IBM. This builds on our relationship and our product that we introduced a couple years ago with Memorial Sloan Kettering. It's a growing new field to Precision Medicine as you know and we provide in this relationship a product called OncoVantage, which basically provides visibility to oncologists what can be known with 34 actionable jeans.
From that data we'll say what drugs will work and what drugs will now work, but as importantly what clinical trials that could potentially roll their patience in. This work will expand with the relationship with IBM and also Memorial Sloan.
We also mentioned that this is collaborative work once again and the broad Institute is involved as well which we're optimistic about, because as I said at the beginning, healthcare is really a much more collaborative game going forward and quest we're all about working with others when it comes quite clear of the work we've done and is how it's helping our business.
So let me just stop there and let me turn it to Mark to make sure I properly addressed the question about the PLS business and how we think about revenue per requisition as a calculation, Mark.
Thanks Steve. I think it's important we clearly have not done enough to get everybody clear on this. When you think about the work we do, we do tests. Now we use requisitions as a surrogate for volume, but in fact we do test. So if a patient comes forward with a single test and would say a standard routine test and another patient comes forward and has two of those, there is going to be a different value to the requisition, but it has nothing to do with price.
So the reason that people have and we have shared requisitions is there is a margin implication to some extent because of the front end and the back end is somewhat of a fixed cost per patient engagement or requisition. So specimen acquisition and billing you say the more testing we can get on our requisition, the more efficient you can be, but again that's on the cost side not the price side.
However with PLS as we've explained, the specimen acquisition is incredibly efficient. We don't do the draws and from a logistics perspective, we're picking up dozens and dozens of tests at a single point in time instead of a handful as we want to at an office position park.
So the logistics is very efficient. We don't incur the draw cost and then the billing is incredibly efficient because there is no third party billing, there is no patient responsibility of the single bill for a large volume to client. So I just want to make sure we continue to do what we need to do that people are clear that the mix calculation is the calculation and it's not price.
We actually call out price very specifically so to understand apples and apples are headwinds and we're actually getting paid less per test.
Got it. That makes sense. Thank you for the color.
Thank you. Our next question is from Ralph Giacobbe of Citibank. Your line is now open.
Good morning, Ralph.
Good morning. So just going back to the PLS, I just hope and I guess on the two fronts, on volume and price, first on the volume side, just hoping whether you could give a little bit of sense of what it may be contributed specifically HealthONE and Barnabas to volume growth this quarter and maybe help us is it in the run rate at this point. Is there some sort of ramp we should consider in the fourth quarter and in 2017 any help there.
And then just on the pricing side as you just explained, I guess I guess what I'm still grappling with is just understanding so on a test by test basis, is the price the same or is it lower in PLS right, because I would think you'd have more tests per acquisition on the hospital test than you would and the normal business.
So I guess I'm just trying to reconcile the absolute dollar per test and effects lower because of a willingness to give up on that because of the benefits on the cost side that you explained.
Yes. So thanks for the questions. There were a couple there Ralph. Let me try to address them all. First off Barnabas is pretty much largely implemented. We may expand that relationship beyond the current set of hospitals, but at this point the initial phase of Barnabas is in a run rate and BTA is a relationship that we said is ramping up. I mentioned that half of the volume growth in the quarter was attributable to PLS and we don't call out specific relationships. So we're not going to share Barnabas per se or HCA, but we are hearing what PLS is contributing in total.
And then contrary to what you may have thought, the test for req for PLS actually tend to be fewer not greater. When you imagine something ongoing in for their annual physical, which is quite a bit of our volume, obviously some of it is acute conditions that people go into their primary care physician for, but you're doing a battery of tests and your annual physical much more than you might for an acute situation going in as in-patient or an outpatient at a hospital. So there's actually fewer tests.
And then finally on price, it is priced differently because it's not the commercial rates that we have for the core business, it's a negotiated direct rate with the hospital where we price it a way that we can save them money, and we can make a margin ourselves. So, it is different pricing, but not necessarily lower or higher, because we have pricing relationships all over the board for any given tasks depending on the situation.
So it gets a little bit complicated, but in general, fewer tests per req we have definitely future momentum, we expect from our PLS in terms of its volume contribution, definitely from HCA and so you should expect more of our growth coming from PLS certainly in the immediate future.
Ralph, this is Shawn. Just one point of clarification, half of our volume was organic of what some of that was PLS.
Okay. Very helpful and then just one more follow-up. I was hoping you can give a little bit more detail on the U&H deal in terms of the economics and potential savings, so there anyway to quantify what billing and collection function cost to you guys to run maybe some percentage of what may be saved and may be help us if there is some level of guarantee on the other side.
So, if bad debt expense for whatever the reason to actually go up as opposed to go down, are there certain protections in that contract that you that you there are guaranteed savings?
And then just any other read through on this relationship and potential for you all to get back in network on the lab side with U&H, have you had any of those discussions at this point. Thank you.
Thanks. Let me start and I'll ask Mark to provide little more color on the back end of this. First of all what we've committed is continued march of making their business better and when we see better, we want to improve our quality service and at the same time making it more efficient.
And our goal, as you for that is what we call our Invigorate program, which we have committed to improvement of $1.3 million by the end of 2017 and that's run rate savings if you recall that versus a benchmark of 2011 and as you know we've been on a great march of showing progress on that and what we have shown with this relationship is we're far from done.
We have a lot more opportunities to improve this business and we think this relationship with Optum again underscores our commitment to continue to make bold changes in this business to become better. Okay. And so I keep on saying better because it's both quality and cost.
So this relationship with Optum will allow us a couple things. One is we're going to become more efficient. So how do we become more efficient? One is that by working together with them our building operation, which is part of our expense structure. Our SG&A cost will become more efficient over time and we have, we do have commitments around improving that together going forward.
That is all part of our commitment for to Invigorate. So, it allows us to achieve our goal and also it extends beyond 2017 obviously since this is a 10-year relationship.
Second is as I said in my introductory remarks, part of the opportunities we have, is to provide better transparency to the patients, better transparency to patients as far as what prices are and also what is covered and so they can pay us more often, and more and more quickly and we believe by providing that with the help of Optum will serve both bad debt, our denial rate and just generally our cash flow. So that is part of the relationship as well.
We don't disclose the specifics of the agreement. You wouldn't to expect that we would, but it's part and parcel of what we -- part of what we believe we need to continue to do, continue to drive progress of this business.
The last part of your question is how does this affect our relationship with United Health? What I said when we announced this relationship and I know United Health will say the same, is it can't hurt and again that builds on our existing relationship. We currently do a lot of work for United already. This is substantial piece of building on that. They are very committed to it. It's a big opportunity of us to them in a much broader more significant way that ever.
We're obviously going to use this to build on that relationship with Wellness that I talked about earlier, what we could do around their healthcare businesses that they're building with Optum Care. We believe we could do more than help them with their analytic services.
So there's a lot more that we can do with them and we'll do with them as we go forward because as you know they're a big player at healthcare and we need to work with all the big players at healthcare. So we're encouraged about what we're doing so far. We're off to a good start. As we said, we're going to move the employees over in the November and we'll start to see savings from this next year. So Mark anything you would like to add to that?
We have shared that billing is about 5% of our headcount. So it's not an insignificant portion of our cost structure and then just to be clear on the relationship, we're not relinquishing responsibility. So there are a number of initiatives we had already planned to work on but we think are going to improve bad debt and reduce denials. It was part of our Invigorate program in which really generating the incremental value here is that Optum is going to bring incremental or activities and supplement what we're doing to get us to even a better place we could have gotten on our own or certainly faster than we could have gotten on our own.
So it's not as if we're just thrown it over the wall and having Optum pick up what we have been working on and what we had planned to do. We're actually going to continue to do that. A lot of that's involved in our IT organization, our commercial organization etcetera and we're going to partner with Optum to make that even better
Just to round that off once again, if you look at our 2014 debt from our Investor Day, we talked about this as being the opportunities we see. We've been we've been Invigorate and hopefully will review on this one will come to our Investor Day. It's November 11 and we'll provide more color beyond what we've said here about this relationship and how it helps us with our efficiency goal on Invigorate. So next question.
Thank you. Our next question is from Jack Meehan of Barclays. Your line is now open.
Hi guys good morning. Mark wanted to start with the pricing comment that you made, you know the unit price headwinds they moderated 50 Bps in the quarter, were there any notable changes there, just less of a headwind for certain codes.
Yeah, what it has to do was obviously is the timing of any sort of price changes and so we obviously annualized either in a positive way on some price increases or annualized and got behind us some negative headwinds between the second and third quarter. So it's really just the year-over-year compare and the timing of any price changes from our contractual negotiations.
Jack, I think it underscores what we've said for many years now that we’ve being very disciplined and very thoughtful in our pricing to the market. We believe we have a great value proposition out there in the market. Our value proposition we believe is second to none. Just the value add and the chip price we charge for that and we want to continue to reinforce that going forward.
And I think this quarter's performance when you look at really unit price effect of 50 basis points, I think it's a good reflection of the good work we've done to apply that price discipline to our business and the results are shown.
Great, yeah that’s helpful and then I just had one bigger question for Optum, you obviously have a real wealth of diagnostic data that you have built up over a long period of time, one of the conversation that's been around trying to find ways to monetize that, do you think you could find ways to use it with clinical trials, like one of your peers or are there any other interesting ideas that you had around that front? Thanks.
We talked about in the past however monetizing the data we have. We see about one third of adult Americans in the course of three years. We keep that data for about 10 years and if you go through the map, that's about 20 billion data points of laboratory data.
So we have nice bird's eye view of what’s happening with the American population and we’re trying to use that in the most responsible and also the best way for our shareholders. We have talked about them using that to understand how they manage or monitor the performance of what's happening with Hepatitis C by way of an example.
We have also have sold that data to Pharma companies. We’re building in that relationship. We have talked about -- we’re trying to bring to the market and possibly with our collaboration with Quintiles and now Quintiles has merged with IMS. We continue to have a dialogue of how we could use that data to help with the recruitment of patients for clinical trials and that's something that we'll talk about once again as we get into our Investor Day in November because there is lot of opportunities for it.
It takes longer to get some traction with them but the prospects are good and specifically with Optum, as you know Optum has a broad perspective on the market and they’re helping many integrated delivery systems.
One of the products we do provide today for integrated delivery system is around population health and how you can use this data to help manage that population that you're managing and how do we try to identify those patients that are costing the risk taker, the most of about each year and by looking at performance versus laboratory results what we could do about that to help those gaps security that we have. So lot of opportunities again come November and we’ll share more with you.
Great, looking forward to it. Thanks guys.
Thank you. Our next question is from Isaac Ro of Goldman Sachs. Your line is now open.
Good morning guys. Thank you. I wanted to start with just a minute on guidance and hoping you could put a little more color around the underlying assumption you’re making around the utilization and volume backdrop in 4Q relative to what you guys expect to show in your own growth?
So we don’t assume a change in utilization from quarter-to-quarter when we look at the guidance we've put out there. We want guidance that's reasonable but very achievable and as we mentioned we did take into account the impact of the Matthew which happened in October. So that’s a fourth quarter even.
So with that said, we have basically not changed the midpoint of our earnings guidance and we haven’t changed the midpoint of our revenue guidance despite Matthew. So either -- we’re not assuming any significant changes anything in the marketplace really basing it on what we’ve seen pretty steadily for the first nine months of the year and then our historical experience in Q4.
Great. And then just may be a second question on margins, you guys have spent a lot of time talking about all the work you have done with PLS and then with outreach deals. Curious as you put those initiatives here in context with profitability, is there a timeline you could share or a path to when we should expect those programs to be accretive to overall corporate margins? Thank you.
Yes, so and when you talk about margins, I want to make sure whether you’re asking dollars or percentages so I'll address both, but typically what we said is an outreach purchase it takes 12 to 18 months to get to its billing or profitability when we can get all these synergies achieved and then outreach businesses are typically at our corporate margin percentage. So we usually get some margin dollars pretty quickly on those outreach, but get to our going percentage and ratio profitability takes 12 to 18 months.
For PLS it's somewhat similar to an outreach and that there is a transition period of time a lot of the savings is driven around moving the test menu partially off the hospitals site to ours. It doesn’t happen in the first day. The second piece is really the procurement savings. So it's either changing out the platform or burning through their agents, which typically are higher cost than ours. So takes it a little while before and we get to that going profitability, but I’d tell you the same thing probably a little closure to 12 and 18, but we get to the going rate of profitability for PLS within the first year to year and half.
Those margins are going to be lower than the corporate average slightly, but as I said before still at excellent return on invested capital and they are still double digit margins.
Got it. That's helpful color. Thank you, guys.
Thank you. Our next question is from Nic Jansen of Raymond James and Associates. Your line is open.
Good morning Nic.
Hey good morning. Two questions, first on operating income growth, I know when you adjust for some headwinds last year tied to Celera, you're talking about 3.5% or so equivalent operating income growth based on the disclosure that you gave on the call and I’m just trying to get a better sense of how that can accelerate absent M&A.
It feels like I felt that your Analyst event two years ago you were talking about 8% to 10% operational EPS growth. So there is a pretty sizable delta between that operating income and that kind of operational EPS aspiration.
So I just wanted to flush out how we think about -- I know there is no chance for '17 guidance yet, but what are some of the drivers that might help accelerate that organic operating income growth as we think about the next six to eight quarters? Thanks.
So Nic any given quarter, it may bound around. So the outlook that we provided in 2014 and we're planning how do it personally update you that on that comment at our Investor Day on November 11 and so look back at how we’ve done and give you a general idea of what you can expect going forward.
It is really a annual basis or a CAGR basis. It's not necessarily what you’re going to see in any given quarter. So, the things that are going to contribute to growing earnings faster than our revenue are unchanged. So it's really going to be as we return to organic growth that has a high drop through and then we have the Invigorate program, which certainly is large enough in this period of time to offset price and our cost pay for us which is our annual merit inflation and things like that and still have enough to expand margin.
As you look at some of the PLS relationships that we have talked about, those have really started up this year and as I mentioned earlier to the question that how long does it take PLS to get up and going in its profitability. Its generally 12 to 18 months.
So you would expect those deals to be contributing more to the bottom-line and helping to expand our margin more than they did this year. So it really gets down to the fundamentals, which is the growth in the high drops that we get there our Invigorate program which continues to drive efficiency and then all of those things more are on an annual or a CAGR basis as opposed to any given quarter. And year-to-date we’re up 5.4%, so that's a higher number than the third quarter.
And the other thing is as you're well aware we’re accelerating organic growth and we couple that with our acquisition of 1% to 2% growth and that allows us as they said it through our numbers to also get some lift in the operating income going forward.
No, that’s very helpful perspective and then my follow-up would be on the M&A front, it does feel like you might be a little bit light relative to the 1% to 2% contribution hopeful in every given year and I just wanted to get your thoughts on the broader deal pipeline as we think about your appetite given your leverage profile today is certainly capable to do more. Thanks.
We have actually contributed about 1%. So at the low end we're re still within the 1% to 2% and in terms of our appetite, it hasn’t changed, but we’re very diligent about the deals that we move forward with and as we've shared, we walk away for more deals than we execute. It's not as if it's not in interest signs that we're not investing a lot of time and valuating assets and potential outreach deals.
But we do have a lot of rigor around our financial metrics and we don’t execute a deal. We don’t see a path towards value creation importantly. So really it comes down to our capital allocation strategy, which is once you get beyond the 50% that we grantee of our free cash flow to our shareholders.
It comes mostly through the dividend, but also through some share repurchases and the decision is what’s the best value creation strategy and we have to feel very comfortable that we’re going to create more value through M&A than we will with share repurchases and therefore it's really a situation. So it's not a change in strategy, it's not a change in appetite and certainly there has been a number of assets we’ve been evaluating and there is lot of things we’re looking at and we are driving success with 1% growth from M&A within the range and really nothing has changed than we're at the low end of the 1% to 2%.
Yeah, Nic recall we announced our five point strategy back in 2012. Part of that in terms of restoring growth was to accelerate our organic growth, which we are doing and then second is couple that with acquisitions and if you look at '13, '14, '15 and now '16, we’ve been achieving that 1% to 2% growth through acquisitions and so we’ve developed credible track record of being able to do that in the past and as Mark said, prospectively our views haven't changed.
And then you couple that with our strong cash position, we feel good about the cash we generated this quarter and our using that cash wisely with our capital deployment plan. So going forward we think we have a solid strategy continuing to build shareholder value and the growth prospects both organically and through acquisition remained encouraging.
Thanks for the color. See you guys in a few weeks.
Thank you. Our next question is from Brian Tanquilut of Jefferies. Your line is now open.
Hey guys this is Jason Plagman for Brian, just a quick question, can you provide any update on the progress with the Squared partnership and how that’s progressing?
Yeah, sure it’s doing well. We lapped it already one year anniversary in July. The initial work for both companies is to put both of our laboratory clinical trials business together and then operationally integrate those.
By integrating those, we'll benefit from that. Our equity earnings we get 40% since we own 40% of the joint venture. So, we believe we've made some excellent progress and there is more opportunities in front of us in terms of the yield we see from that joint venture because it will take some time to get the integration completed, but we're starting to see some of that already this year.
Thank you. Our next question is from Bill Bonello of Craig Hallum. Your line is now open.
Hey good morning guys. I’m wondering if you might be able to give a little bit more color on the collaboration with IBM, obviously in the press release and in the call today, you talked about what it is you’re trying to do, but I’m just curious in terms of things like indications is a lot that this service would be broadly utilized or is it limited to patients where may be first or second line therapies have failed, what type of clinical data you are going to be publishing to support the validity of the information you are providing maybe the regulatory and reimbursement considerations?
And then finally whether you’re building out some kind of a service or database where you can connect patients to clinical trial based on what you learn.
Yeah, thanks Bill for the question. Well fist of all as I said, we’re excited about the opportunity and it's an embryonic field, its building, its evolving. The field of precision medicine or personalized healthcare is just -- is very new and it continues to provide opportunities, but it also -- it takes time to develop.
So, we believe once again that we in this field need to work together with others. Two years ago, we announced relationship with Memorial Sloan Kettering. We brought a product to the market called OncoVantage.
The opportunity we're going after Bill is to get to those community oncologists, which is as I said in my remarks about 70% of cancer care is there and what we realized is that Memorial Sloan is very strong and we have a strong presence in the United States, but by working together with some other once again, we could even enhance what we've done already. And so the IBM opportunity allows us to use their platform and also their data capabilities in a much broader way.
Second is as you know IBM is building out their go to market plans for IBM Watson in general, IBM Watson Health and IBM Watson Genomics and we’re hopeful that that sales force coupled our sales force will drive some additional demand as people become more aware of this.
And the other part of this Bill, is we believe there is an opportunity for patients to become more aware of what they should gain access to in assessing what they need to do with their cancer care and IBM is a very powerful marketing machine and we’re hopeful that their working -- their visibility around computing and particularly in healthcare will help with this effort.
Now as far as future products, we have the existing products today. We’re offering that various plans for us to expand that capability with a number of actionable genes and then also an expanded panel, which will touch close to 400 genes that will look at.
Yes we do believe that this will help us in terms of depending diagnostics with those cancer drugs to rule and rule out patients that can affect and also making sure that we can support it the right way in connecting patients to the right clinical trials through their oncologist with this information.
So this is works in progress, a lot will be introduced in time and it is a good example of the evolving nature of this real effort across the world, but we’re lining up with some of the best, Memorial Sloan Kettering, IBM. We’ve talk about Broad institute and obviously their relationships they have with them IT and Harvard. So we have a good team working on this and we feel very, very encourage about prospects there.
Excellent. Thanks a lot.
Thank you. Our next question is from Mark Massaro from Canaccord Genuity. Your line is now open.
Hey guys, thanks for the question. I wanted to ask more about the hospital side. You mentioned that HCA started to contribute in Q3, when do you think we'll know to the extent that you can help HCA manage their lab operations in terms of cost benefit to HCA and I guess what I’m getting at is how many quarters do you think it will take before you think you might be able to expand that within HCA and then related to that, can you just discuss how active you've been talking to other hospital systems.
Yeah, well first of all once step at a time. We announce this relationship with HCA with their Denver-based division. They have six inpatient laboratories that we will manage for them. When we do this, we make them more efficient. If you understand how they work and I would argue a lot of hospital systems work for profit corporations.
Then we'll see how it goes and we expect to deliver and so we're hopeful when we deliver that we can then expand that discussion to say can we help you in some other areas, but first piece of business right now is to do what we said we’re going to do in Denver and do that well and that we'll grow the account as you grow any account going forward.
And we would also say that this discussion around hospital interest and what we’re doing is building what we find is that to [C Suite] of integrated delivery systems and hospitals CEOs and CFOs are quite interested in anything anyone could do to make them more efficient.
I personally get engaging in this in a very active way and I could tell you that when we go in and have a conservation with the CEO and the CFO and share with them that we could save them 15% to 20% of their hospital in patient laboratory cost, our batting average if you will, of getting to the next conversation to start sharing some data is quite good. Very few times do they say we're non-interested. Most times they say interested and we should take a look at this and we understand how you can help us and let's see if the numbers work.
When we go in there, we also talk about their lab strategy and usually when we have a discussion around their in-patient laboratory cost, we then have a conversation around their reference testing, their most advanced testing that we provide to about 50% of hospitals.
We talk about us being able to provide more of that for them and then the third leg of the stool is they then start to question if they’re in an outreach business essentially competing with us do they want to remain in that business and the best interstate for us is to become their lab partner or its Quest inside.
So we do all three, We're helping them with their inpatient labs making them more efficient. We're providing the most advanced testing for their hospital operations and then the third is we're their laboratory for their -- for their non-hospital proportion of the care they're provided within their geographic area and we have a number of examples of that and probably some of the best examples is where we've actually formed joint ventures and we have a number of long-standing joint ventures in Pittsburgh Medical Center probably the most recent large one is University of Massachusetts.
We have a joint venture up in Massachusetts around that and there is others to that we've build. So I would argue that this is a growing trend. It's a trend that we're head on. It takes a while to grow the services business, we built the capabilities, we're now executing and now we're starting to see the results in our growth.
Excellent and then quickly on capital deployment, you repurchased almost 0.5 billion of stock for the year, where are you on the authorization and should we think about a similar run rate next year?
Mark, you want to take it.
Yes so the year-over-year on the -- what you should expect is not -- I can't give you anything specific, we are not giving guidance for next year, but you should expect us to inherit our capital allocation policy, which is basically half of our free cash flow is committed to shareholders and then above and beyond that depends on M&A and/or additional share repurchase.
In terms of our authorization $532 million left on the current authorization.
Great. Thanks so much.
Thank you, speakers. Our last question is from Amanda Murphy of William Blair. Your line is now open.
Hi, this is [Archo] in for Amanda. I was wondering if you could give me some color on the relationship of esoteric testing and routine testing growth and then I guess the pricing in esoteric and what trends have you seen and then I've a follow on question after that.
Yes first of all last year the end of the year, we said that our advanced diagnostics grew by about 5%. It's a sizable portion of our portfolio of $1.8 million. We do not share quarterly performance related to that portion of our business but it continues to grow.
There is some of the mention that had in my introductory comments show that we continue to get good growth of some of the more advance testing and particularly our last question around our work with IBM and working genetics and in that field continues to provide nice growth prospects for us. So we're continuing to get growth and once again we'll share the growth from the business in due course as we announce our results.
As far as pricing, it's already in that 50 basis points headwind if you. We don't share specifics of what's happening with commercial contracting or what's happening per test but it's implied in the 50 basis points. So it's very manageable that we believe that it's always going to be some ups and downs in our portfolio of test and we're bringing new products to the marketplace as well which have new price points. So it's in that overall aggregate measure that we provide.
Got it and then esoteric testing continues to grow, I was wondering if you had any updated thought for the sales force. I am wondering do you have now and do you think you're the right size to service the market more broadly, particularly as esoteric becomes a bigger portion of the pie.
We continue to build our sales and marketing capabilities and the way we have addressed the market is really to make sure that we capture the right level of focus around accounts and with 65% of physicians now working for hospital systems, we believe it's important to have a geographic orientation to our sales force.
And so we have about 108 sales districts and they have full responsibility for the whole portfolio of Quest into the market. The charge of separate hospital business from physician to just given where healthcare is today, how it's organized, at the same time, we all know that healthcare is very specialized and so we also in addition to the geographic orientation to our sales force, at dedicated specialized sales forces.
So we have a specialized sales force or for our neurology business we have a specialized sales force for our anatomic pathology business and a specialized sales force for women's health business and we believe we appropriately staff that for the opportunities in the marketplace.
And we're always trying to optimize our investment in our go-to-market plan with the opportunities we see in the marketplace and we think we've struck the right balance to deliver on our goals of growth in 2016 and we believe we'll do so also as we go forward with accelerating growth as well in the future.
Thank you. At this time speakers, we don't have any other questions on the phone. I would like to hand the call back to you.
Well thanks again for joining the call today. As you can see we're making good progress executing our strategy. We look forward to seeing many of you at our Investor Day in New York City on November 11. So thank you very much and have a great day.
Thank you for participating in the Quest Diagnostics third quarter 2016 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 888-435-1319 for domestic callers or 203-369-1017 for international callers. Telephone replays will be available from 10:30 a.m. Eastern Time today until midnight Eastern Time on November 19, 2016. Goodbye.
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