Quest Diagnostics Q2 2007 Earnings Call Transcript

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 |  About: Quest Diagnostics Incorporated (DGX)
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Quest Diagnostics Inc. (NYSE:DGX)

Q2 2007 Earnings Call

July 24, 2007 8:30 pm ET

Executives

Laure Park - VP of IR

Surya Mohapatra - Chairman and CEO

Bob Hagemann - CFO

Analysts

Adam Feinstein - Lehman Brothers

Bill Bonello - Wachovia

Art Henderson - Jefferies & Company

Trekkie - UBS

Bill Quirk - Piper Jaffray

Robert Willoughby - Banc of America Securities

Tom Gallucci - Merrill Lynch

Sandy Draper - Raymond James

Kemp Dolliver - Cowen & Company

Presentation

Operator

Welcome to the Quest Diagnostics Second Quarter 2007, 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 with Quest Diagnostics with All Rights Reserved. Any redistribution, retransmission, or rebroadcast of this a call in any form without the expressed written consent of Quest Diagnostics is strictly prohibited.

Now I would like to introduce Laure Park, Vice President of Investor Relations for Quest Diagnostics. Go ahead please.

Laure Park

Thank you and good morning. I am here with Surya Mohapatra, our Chairman and Chief Executive Officer; and Bob Hagemann, our Chief Financial Officer. Some of our commentary and answers to questions may contain forward-looking statements that are based on current expectations and involve risks and uncertainties that could cause actual results and outcomes to be materially different. Certain of these risks and uncertainties, may include, but are not limited to competitive environment, changes in government regulations, change in relationship of customers, payers, the buyers and strategic partners, and other factors described in the 2006 Quest Diagnostics Incorporated Form 10-K and subsequent SEC filings.

A copy of our earnings press release is available, and the text of our prepared remarks will be available later today, in the quarterly update section of our website, at www.questdiagnostics.com. A downloadable spreadsheet with our results and supplemental analysis are also available on the website. Now here is Surya Mohapatra.

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Surya Mohapatra

Thank you, Laure. We made significant progress in the second quarter and our business is getting stronger. We remain focused on executing our growth strategy. We signed a number of important managed care agreements; we have recognized a differentiated level of service we provide. We improved the efficiency of our operations, and we are the leader in clinical pathology, gene-based and esoteric testing, now with AmeriPath we have become the undisputed leader in anatomic pathology.

We use Sigma and Lean principles and technology capabilities to drive operational excellence in our laboratories. We have identified opportunities to improve efficiency and further reduce costs by $500 million over the next two years. This will allow us to expand margins in the phase of pricing pressures and continue to invest in growth.

During the second quarter, consolidated revenues grew to $1.6 billion; operating margin was 16.6% of revenue and improvement of more than 3% from the first quarter largely a result of actions we have to taken to reduce costs and higher revenue for acquisition. And we continue to generate considerable cash flow.

We continue to drive organic growth by leveraging sales service and science. We executed a number of important health plan contracts. We renewed agreements with Coventry and Blue Cross Blue Shield of Massachusetts. We extended our agreement with Blue Cross Blue Shield of Florida. We signed new agreements with Medical Mutual of Ohio, and Culinary Health Fund in Las Vegas.

We signed a multiyear contract extension with Sigma Healthcare and we have been working with Aetna to improvement to our expanded contract, which was effective July 1st. Having the large contracts signed, has improved our visibility and reduced uncertainty in this competitive environment.

We differentiate our services by continually enhancing our value proposition. That includes superior patient experience, Six Sigma quality, unparalleled access and convenience, innovative tests and our advanced IT Solutions. For example, waiting time for patients in virtually all of our patient service centers is under 20 minutes, and can be significantly less for patients who use our electronic appointment scheduling system.

In our most recent customer satisfaction survey, physicians continue to rate our service higher than the competition. We continue to enhance service by deploying a unique specimen tracking system, enhancing our hospital and physician's connectivity and introducing cash collection in our patient service centers.

And the use of our Care360 continues to grow, with more than 115,000 physician users.

Our superior service and quality have been honored with the prestigious Governor's Sterling Award in Florida, which is based on the National Malcolm Baldrige Criteria for Performance Excellence.

Our focus scientific innovation to create unique and exclusive tests is driving growth. For example, LEUMETA plasma-based testing provides an alternative to painful bone marrow biopsies. During the quarter, we added new tests to this growing family, with revenue double compared to 2006. We are the only national lab to offer ImmunoCap Allergy Testing, which has been shown to the significantly more accurate than other tests and continue to grow.

HerpeSelect from Focus Diagnostics is the best selling diagnostic product in the market for Herpes Simplex Virus, with revenues doubling over the prior year. We led the development of use of LC-tandem mass spect, to enhance vitamin D and testosterone testing, which is growing in high double digits year-over-year.

We recently launched the only automated test for Fragile X syndrome, the most common form of inherited mental retardation. This has the potential to provide circulation based testing and drive future growth.

We are very excited about the opportunities to excellent growth in anatomic pathology, by combining with AmeriPath. We have begun to join our company, in a way that preserves the uniqueness of AmeriPath. Since the acquisition was completed on May 31, my staff and I have traveled around the country to meet with the pathologists, management and employees. They are very supportive and excited about the opportunities for our combined company. At Quest Diagnostics, we now have a medical and scientific staff, comprising approximately 900 MDs and PhDs, including some of the world's luminaries in the major of diagnostic disciplines.

Now I would like to turn it over to Bob, who will provide analysis on our results before I come back with some additional comments.

Bob Hagemann

Thanks Surya. As Surya noted, during the second quarter, we have made excellent progress in building on the momentum which we established exiting the first quarter. Our progress in clearly reflected in our operating results, and provides us increased confidence regarding the outlook for our business.

Given that the acquisition of AmeriPath, which is included in our results as of June 1, has affected a number of our metrics. I will highlight each impact, as I go through the results.

In addition, to highlight our progress, I will point out improvements in certain metrics compared to the first quarter.

Revenues were $1.6 billion, 3.7% above the prior year, with AmeriPath contributing about 4.5% growth. Revenues for our clinical testing business, which accounts for over 90% of our total revenues, were 2.1% above the prior year, with AmeriPath contributing 4.8%.

Volume was 6% below the prior year, and approximately 8% below without the AmeriPath acquisition. Revenue per acquisition increased 8.6% with 3.1% of the increase due to AmeriPath. The balance of the increase in revenue per acquisition continues to be primarily driven by a positive mix shift, and an increase in the number of tests ordered per acquisition.

AmeriPath's organic revenue growth for the second quarter was almost 8%, with particular strength in dermatopathology and hospital testing. We estimate that consolidated revenues were reduced by about 4.5% due to our changing status with United, with clinical testing volumes reduced by about 7%, partially offset by a positive impact of revenue per acquisition of about 2%.

Positive impact of revenue per acquisition is associated with higher reimbursement on the retained United work, with almost 0.5% of the second quarter increase, associated with a true-up in United's rates. The year-to-date impact of the United on revenue per acquisition is a positive 1.5%.

As of the end of the second quarter, we estimate that about 75% of the United volume has moved to other contracted providers, compared to about 70% at the end of March. We expect that some additional United volume will move before the end of the year, due to United's ongoing efforts.

We continue to be encouraged by physician's decisions to select Quest Diagnostics when they are given a choice; we have seen no further loss of this questionnaire work during the second quarter. With our sales force now focus on winning new accounts and so additional tests coupled with a new agreement which went to effect July 1, we expect to see further improvement in year-over-year comparisons as the year progresses. Revenues in our non-clinical test business is as a group which include our clinical trials business and the risk assessment business acquired as a part of map one were up slightly from the second quarter of last year.

The acquisition of Focus Diagnostics, Interex and HemoCue, contributed about 2% consolidated revenue growth.

Operating income as a percentage of revenues was 16.6% for the quarter compared to 18.8% in the prior year. Margins were reduced by about 40 basis points due to the acquisition of AmeriPath, therefore the more comparable margin percentage reflected a decrease of 1.8%. This is a significant improvement from the first quarter comparison, in which margins were down 3.5% compared to the prior year.

The improvement, which we expect to continue as the year progresses, is due to actions we have taken to reduce our cost structure, the avoidance of certain costs incurred in the first quarter associated with the business retention and workforce reductions, and higher revenue per acquisition in the second quarter.

Bad debt expense, as a percentage of revenues was 4.3% and 4% before the inclusion of AmeriPath. The 4% rate compares favorably to the 4.4% rate in Q1. AmeriPath, which carries a higher bad debt rate than the rest of our business much of it due to the inpatient work done for hospitals, will increase our bad debt expense in the back half of the year by about 1%. Although it is unlikely that we will be able to reduce AmeriPath's bad debt to the rate we maintain for the rest of our business, because of their business mix. This is one of the areas we have identified as a synergy opportunity.

Diluted earnings per share from continuing operations were $0.73 compared to $0.78 in the prior year. The decrease is primarily due to the changing contract status with United. The impact of which was significantly mitigated in the second quarter compared to that in the first quarter.

Keep in mind that last year's second quarter included $0.04 charge to write-down an investment. Included in footnote seven to the earnings release is a table which summarizes the impact of various measures for a number of the items discussed.

Cash from operations was $129 million and was reduced by $57 million of the fees and other expenses paid in connection with the acquisition of AmeriPath. Cash flow adjusted for these payments was strong and compares favorably with the $170 million reported in the prior year.

During the quarter, we made capital expenditures of $49 million and invested $2 billion in the AmeriPath acquisition. Permanent financing for the AmeriPath acquisition consists of a five year bank term loan and the proceeds from a very successful offering of 10 year and 30 year notes, which was completed on June 22. $90 million of the term loan was repaid towards the end of June.

We were out of the market for repurchasing shares throughout the second quarter due to all the activities associated with the closing and the financing that transaction. We plan to resume repurchasing shares in the third quarter, but had to reduce the level until we achieve some of the expected improvement in our credit statistics.

Day sales outstanding were 51 days, 4 days above the Q1 level was all of the increase associated with AmeriPath. We expect AmeriPath's impact on our DSOs to decrease to approximately two days by year end and less than that over time.

Before moving to full year guidance, I'll take a few minutes to put our progress in perspective. We had an excellent track record of driving growth and revenues, earnings cash flows and shareholder value. Coming into this year, we indicated that 2007 will be a year of adjustment due to our contract change with United and intensified pricing pressure resulting from a heightened competitive environment. Yet despite the near term challenges we face we have remained committed to a strategy that we believe will deliver superior long-term performance and shareholder returns.

While we will continue to face challenges, the progress we have made has given us better visibility on a number of uncertainties and reinforced our confidence in the long-term prospects for our business. First while facing intense pressure from a major competitor and a number of payers to commoditize our business we remain committed to providing a superior service level to patients, physicians and other customers. As a result we were able to renew and in some cases expand our relationships with a number of important health plans. In each case on economic terms, which work for both parties and at prices, which recognize the differentiated level of service we provide.

But there remained a number of managed care agreements that we will renew over the next six months. We now have contracts in place accounting for almost 60% of our contracted managed care business we had coming into the year with most of the newly contracted business extending into 2010 or beyond. This gives us much improved visibility in terms of access and pricing for this contracting cycle.

We have also taken actions to adjust our cost structure to the new volume levels. We've reduced the size for our workforce in the clinical testing business by over 2000 during the last six months, or maintaining and in some cases improving service levels. We've now pulled out over $200 million in annualized costs. However, we need to do more than adjust costs in connection with changes in volume, if we are to expand margins in a highly competitive environment. As such we have done extensive analysis of all of our business processes and identified specific opportunities some of which we've already begun to realize, which will reduce annual costs by another $500 million over the next two years.

Much of the savings will come from streamlining the way we operate our existing reliance in patient service centers, not necessarily from reducing capacity and certainly not in reducing service levels. In addition, redesigns of the way we do purchasing, billing, logistics as well as how we operator our administrative functions will contribute to significant savings. One time costs anticipated in achieving our savings had not been finalized and are not netted in the $500 million.

In addition we’ve made excellent progress in executing our growth strategy. Over the past 12 months we’ve completed the acquisitions for AmeriPath, HemoCue, Interex and Focus Diagnostics, and have in place major elements easy to drive future growth. Our focus will now turn to fully integrating and aligning the capabilities of these companies and those acquired from LabOne to fully realize the synergy and growth opportunities they create.

Accordingly, we expect limited acquisition spending during the next 12 to 18 months. With key elements of our growth strategy in place our focus is now on forward execution and operational excellence.

In connection with the AmeriPath financings, we committed to our vendors to improve our credit metrics over the next 12 months. We expect that much of that improvement were result from improved operating performance and some debt repayment. As our operating performance continues to improve and we continue to gain better visibility into our projected performance, it will afford us the ability to direct more of our cash flows and balance sheet capacity into share repurchases. And although, I'm not currently in a position to commit to a minimum level of share repurchases over the next 12 to 18 months, we are committed to maximizing shareholder returns by driving operating performance and practicing prudent capital management.

Now I'll turn to our outlook for 2007. Our current guidance for results in continuing operations is as follows. We expect revenues to approximate $6.6 billion to $6.7 billion the increase in previous guidance is principally due to the AmeriPath acquisition. We expect operating income, as a percentage of revenues to approximate 16%. In addition AmeriPath, which currently carries lower margins in the rest of our business. We've reduced margins by about 1% in each of the last two quarters and about 0.5% for the year.

We continue to expect cash from operations to approximate $800 million, this is net of $57 million of fees and expenses paid in the second quarter in connection with the acquisition of AmeriPath. And we expect capital expenditure in between $210 million and $220 million. And lastly, we expect diluted earnings per share, adjusted to exclude the $0.04 in first quarter charges to be between $2.80 and $2.95; this reflects modest dilution from AmeriPath, which we expect will become modestly accretive next year.

Please note, the estimates exclude any additional charges related to potential restructuring activities. Now, I'll turn it back to Surya.

Surya Mohapatra

Thanks Bob. As you have heard, we are making progress driving growth top and bottom line growth. We continue to be focused on high growth areas, like cancer, cardiovascular disease and infectious disease. We are growing our business in these areas and diversifying our revenue stream.

Today as a $7 billion company, we generated about 35% of our revenues or almost $2.5 billion from high growth areas such as gene-based and esoteric testing and anatomic pathology. This compares to about 25% or up recently $1 billion in 2002 when we were a $4 billion company.

In addition to organic growth, we have used acquisitions to drive change in our industry and growth in our company. Our acquisition of SBCL changed the game in clinical pathology and the physician business. The combination of AML and our Nichols Institute created unmatched capabilities and drove growth in our hospital business.

Now with AmeriPath we have the opportunity to again change the game and take advantage of the convergence of anatomic pathology, clinical pathology and molecular diagnostics. Key elements of our growth strategy are now in place. We are the clear leader in a number of high growth testing areas and we provide the most comprehensive and integrated diagnostic offering overall anywhere in the world.

In summary, our business is getting stronger; we continue to improve on an already differentiated service offering. We assigned a number of important managed care agreements and we are making major improvements in the efficiency of our operations and we remain committed to our longer term goals of driving profitable growth and delivering superior sales over the terms.

We'll now take your questions. Operator?

Question-and-Answer Session

Operator

Thank you. At this time, we are ready to begin the question-and-answer session. (Operator Instructions) Our first question comes from Adam Feinstein with Lehman Brothers. Sir, your line is open.

Adam Feinstein - Lehman Brothers

Okay. Thank you, good morning everyone. Just a few questions here, it seems like the biggest change from the first quarter. As you guys did a great job in terms of really cutting your cost, it seems like you have lots of the UNH business in the first quarter added. Big impact on margins and ones can -- as you guys highlighted a fair job cutting their cost. I just wanted to get provided on some more detail there. I know you spoke about the run-rate. Then Bob, I just wanted to get to go back through that and the opportunity going forward. And then just also wanted to see if you could just also comment in terms of the pull-through, as you mentioned you have watched about 75% of the UNH business. But I just want to see if there were any more details about the pull-through and the impact from the associate revenue as well. Thank you.

Bob Hagemann

Well Adam, you may recall in the first quarter that we talked about our cost whether or not they are fixed or variable. We said in the short-term, let's call it six months or so, about 60% of our cost are variable. And what we have been doing over the last six months is really adjusting those cost levels. As I mentioned earlier we have reduced our FTEs or full time equivalence by 2000 since the beginning of the year, and most of that is through normal attrition and managing the way we add people to the workforce. Obviously, there are other costs which go away as the volume goes away, supplies cost, bad debt etc. etc. But we have been very deliberate in the way we manage the cost structure in the first half of the year to make sure that we are not impacting service levels.

The odd thing to keep in mind is in the first quarter we incurred some extra costs to try and retain business and we said we did not expect those to occur again in the second quarter. So it's really a combination of avoiding some of those costs that we incurred in the first quarter to retain business and the continued progress that we have made in pulling out what I'll call some of the variable costs in the short-term during this next quarter here.

And in terms of pull through, I would say it hasn’t changed. I mean, we have not seen any additional loss of this discretionary work and to us that's a very good sign that physicians when they have a choice want to continue to use Quest Diagnostics.

Adam Feinstein - Lehman Brothers

Okay and just on that point is still the 4 to 1 ratio that you had mentioned --

Bob Hagemann

Yeah, actually the ratio is improving a little bit, because we are not losing any additional discretionary work yet we’ve lost a little bit more of the United work.

Adam Feinstein - Lehman Brothers

Okay. And then just back on the costing savings part. So you had identified additional $500 million over the next two years. Can you just talk about the timing of this cost savings, so we can think about that and then just want to make sure I had the correct numbers in terms of just the cost savings in terms that you've already implemented in terms of what the run rate is?

Bob Hagemann

Well in terms of the run rate of cost savings it's about $200 million on an annualized basis that we have already taken out. On top of that we expect to reduce costs by roughly another $500 million on an annual basis by the time we get to the end of 2009. And you're going to see that actually come in over the next several years. We've got a little bit back of that in 2007, but we are going to see that ramp up in 2008 and in 2009. These actions are really designed to help the drive operating income to that 20% of revenues over time that we have committed to. Some of the savings gets us the structural cost reductions required to offset a loss of the United volume, which I have previously talked about. Some of it is to offset the pricing pressure that we are seeing and some of it is to allow us to invest in growth and further service differentiation as we continue to grow the business.

Adam Feinstein - Lehman Brothers

Okay, just a final question from me and then I will get into the queue here. I just wanted to get some commentary. You guys certainly sound a lot more optimistic about the industry environment. I guess earlier end of the year on the call in some of the presentations you guys seem to have little bit negative I guess it's about the competitive environment. So just wanted to, might just get your thoughts it seems like things have definitely improved and you signed a lot of contracts in the most recent quarters. So was just curious in terms of as [Bob] said in terms of the terms of the contracts have they been better then what you were thinking back and to be getting up on the year and I guess what I'm getting at is, there is lot of concern about a price war earlier this year, but it seems to be dying down, just wanted to see what your expectations are there? Thank you.

Surya Mohapatra

Well, Adam as I said in the beginning or the year that it was going to be a period of uncertainty, but now that we have signed a lot of major contracts including CIGNA and Aetna, we feel that a number of uncertainties have been reduced. We also feel that managed care organizations are different. They are not buying only one strategy, which is a long term contract with transaction fee. So we feel very happy that each managed care organizations have their way for differentiating themselves and we are providing that value propositions to them and as Bob said that we've almost 66% of the contracts are signed. So that has cleared up a lot of uncertainties. As far as competitiveness is concerned we still will have some challenges in front of us and I think pricing is always going to be under pressure but [obviously] highly propositions, which is really going to help us win. And nothing is like signing a long number of contracts and that's what we have done over the last six months and we feel pretty encouraged and confident that what happened in October is a disruption not a trend.

Adam Feinstein - Lehman Brothers

Okay, thank you very much, I appreciate the detail.

Operator

Thank you, our next question comes from Bill Bonello with Wachovia, sir your line is open.

Bill Bonello - Wachovia

Yeah, couple of questions. I'm sorry, but first little bit just I want to be absolutely crystal clear. Bob that you are saying the $500 million is above and beyond the $200 million that you have already achieved so think of it since the beginning of this year through the end of '09 something on the order of $700 million of savings?

Bob Hagemann

That's correct.

Bill Bonello - Wachovia

Okay. And then you mentioned that the increased excluding AmeriPath as the increased in revenue per acquisition was largely driven by mix and the number of test per acquisition, just wondering if you can give us any sense of what the revenue per test would have been up on a year-over-year basis or some sense of what happen on pure price basis, excluding mix and test?

Bob Hagemann

And you know Bill, over the years that the improvement in revenue per acquisition has not really been driven by pure price, it's really been driven by mix shift, mix some test and the number of test order per acquisition. And that really continues now, we have not seen any significant increases in price per test. And as I've mentioned we are seeing a continued pricing pressure that's not necessarily going away, although we do feel good in that now we've signup a whole bunch of managed care agreements and we believe that although the economic terms work for both parties, it also recognized the fact that we do provide a differentiated level of service.

Bill Bonello - Wachovia

Can you give us any kind of sense of the magnitude of the actual price pressure that you've incurred?

Bob Hagemann

Bill for obvious reasons, I don't want to get into talk in about price too much, at this point I don't think that it's a wise thing for us to do, but as I said, I think we had economic terms that we were able to workout for both the payer and our self as we went through each of these contract negotiations.

Bill Bonello - Wachovia

Okay. And then, just on the cash flow, can you tell us, it look like operating -- as you said operating cash flow would actually have been up year-over-year without the AmeriPath despite a lower net income and just turning to understand what driving that cash flow improvement?

Bob Hagemann

Yeah, some of it is just the timing of payments and what not but obviously we are very focused on cash flow, managing the balance sheet, managing the DSOs and I would just call it basic blocking and tackling. As you know, in any one quarter the cash flow can fluctuate a little bit and year-over-year through the first six months we are down versus the prior year principally due to the impact of the contract change. But it's something that we're very focused on and we do our best to drive the cash flow in a particular quarter, but not at the expense of the business. So it's really just managing the balance sheet as prudently as we can.

Bill Bonello - Wachovia

And any big unusual items that we're of benefit in the quarter, I mean, on timing of?

Bob Hagemann

Nothing big unusual. The only thing that I pointed out was the big unusual negative which is just up to came through associated with AmeriPath.

Bill Bonello - Wachovia

Yeah. Okay, great. Thank you very much.

Operator

Thank you. Our next question comes from Art Henderson with Jefferies & Company.

Art Henderson - Jefferies & Company

Hi, good morning very nice quarter here, a couple of questions for you. Sorry, I know you talked about, thinking about that there are still some competitive challenges ahead. Can you articulate kind of what you are thinking there obviously the pricing environment seems to have stabilized to some extent and your contracts have been renewed? But what's given you concern looking forward competitively?

Bob Hagemann

Well, first of all we have not completely out of it, although we have 66% signed, but we still have quite a bit of contracts. The thing what really worries me a little bit that the activities last October now created a new water line for this industry. And what we have been doing is reducing our dependency on routine low margin testing and diversifying our revenues and we are moving towards higher esoteric and higher margin of anatomic pathology. And one of the concerns I have is what's going to happen to that sector, but that market is growing and we have now with AmeriPath have created an organization to provide superior service.

So that’s one, the second thing although we don’t like competitive biding, the government is doing this demonstration and that's certainly a concern I have. And there is third thing in our business always is actually the people. How do we really get the right people doing the right business? So execution is the most important thing for us, but as far as the market is concerned we have been in a situation there was a price pressure, it got worse and now we are going to have a new standard, but we have to move on and that's the reason why we have taken our $200 million unrealized cost and by using the Six Sigma and lean principal and technology we are going to reshape the company and take out another $0.50 billion in the next two years and that's going to give us the strength we need to meet the competitive environment and also increase our margin.

Art Henderson - Jefferies & Company

Okay, that's helpful. Bob just a couple of quick questions for you. Obviously we've seen 75% out of the United volume switch over you indicated that there may be a little more in the back half of the year. Where does this stable out in terms of a percentage shift over to other providers?

Bob Hagemann

Yeah, we have not given specific guidance around a percentage but we do expect that over the course of the year the volume will continue to move the contract that we have provided, because United is putting a lot of effort into making that happen. And all along we have anticipated that that would be case. So we would expect overtime that the United volume will continue to improve.

Art Henderson - Jefferies & Company

Okay and then final question for you Bob, I know you've hit on the $500 million a couple of time's here in this call, but specifically looking in terms of the areas obviously or is this $500 million is more fixed cost, longer-term fixed cost in nature then the short term that you have talked about was the $200 million, is that right?

Bob Hagemann

Absolutely, it's us fundamentally looking at the way we manage a lot of our processes and making fundamental changes in them so that the costs come out permanently and we're getting at the structural costs in that.

Art Henderson - Jefferies & Company

And is there one big area that you're looking at and is it a hand full of areas?

Bob Hagemann

As I said we've looked at every single process we have across the Company. And essentially when you think about where our cost are? The costs are coming out reasonably proportionate to where they are; whether it would be in the labs outside the labs, in the administrative functions, etcetera.

Art Henderson - Jefferies & Company

Okay, great and then one last question I'll jump back in the cue on AmeriPath, obviously the margins are a little bit lower than your core Quest business. The areas that you are focusing on right off the back to sort of sure does up a bit or can you sort of identify where those are, is it purchasing or what areas?

Bob Hagemann

Well, the first thing that we're doing is making sure that the top line continues to grow and that we're not putting any distraction there. That’s the reason that we acquired this company, we believe that there are some tremendous growth opportunities there's and we want to make sure that we will roll on board, we'll try to accelerate the growth for both their business and our business. With that said there are certainly some cost synergies that we've identified in the past that we're going to be going after. I think of those in the areas of purchasing overhead costs, there is some in logistics and then there is bad debt opportunity that I spoke about. But the big benefits from AmeriPath are really going to come from accelerating their growth and our growth as well.

Art Henderson - Jefferies & Company

Okay great. Congratulations, very nice quarter.

Surya Mohapatra

Thank you.

Operator

Thank you. Robert Jones with UBS. You may ask your question.

Trekkie - UBS

Hi, it's [Trekkie] good morning and congratulations for the quarter.

Bob Hagemann

Thank you, Trekkie.

Trekkie - UBS

I have some few questions, some of thought. As far as I think initially earlier in the prepared comments you said that you signed 60% of the managed care contracts that were up for renewal. Could you quantify for us what percent of revenue did this 60% of contracts account for?

Bob Hagemann

Well, Trekkie the way do I think about is we've said about half or so of our revenues in the clinical testing environment comes through managed care so that to give you some sense and now I would say that a little over 90% of our managed care business is contracted business and a 60% of that number that we've now signed up.

Trekkie - UBS

Okay, that's helpful. Now to just to clarify on the pricing comments, I think you talked about its update maybe United contract established kind of new order line. Based on the visibility that you have now and with some of the contracts though extended to through 2010, from what you are seeing, are there any step downs in the out here or is it just kind of the initial year that's been or the initial pricing that's now going to seen adjusted to a new level?

Bob Hagemann

Yeah, Trekkie I really don't want to get into the details of how the pricing works in each of the contracts, I'm not sure of that, that's a good discussion for us to have here. As I said, there continues to be pricing pressure, but we think we came out in a group place for both parties in each of the contracts. And frankly that's one of the reasons that we are instituting this program to pull additional cost out of the business, so that we can continue to expand margins in the pace of that pressure.

Trekkie - UBS

And just last and you might have said that in the Q&A and I missed it. Is part of the additional $500 million cost and is it related to any AmeriPath synergies?

Bob Hagemann

Yes. Whatever synergies we get from AmeriPath are included in that number but they are relatively minor piece of that. Again keep in mind that we did that acquisition to accelerate growth not really for cost synergies.

Trekkie - UBS

Okay. Can you quantify what percent of the 500?

Bob Hagemann

No. It's the minor pieces I said.

Trekkie - UBS

Okay. Thank you.

Operator

Thank you. Bill Quirk with Piper Jaffray. You may ask your question.

Bill Quirk - Piper Jaffray

Well thanks, good morning. Referring the 60% of managed care and the contracts right now. Can you remind us, where we were about six months that same metric?

Bob Hagemann

I don't have that specific percentage in front of me, but many of those were in discussion at that point. And be frankly that is one of the reasons that we told you that we had a lot less visibility back then than we do now obviously not only in terms of pricing but in terms of access whether or not we'll be participating provider on some of those contracts.

Bill Quirk - Piper Jaffray

And then are you willing to take shot at say six months from now and where that percentage could shake out and then presumably just wonder in discussion, I should say several of the other payers?

Bob Hagemann

You know one thing to keep in mind is that there always be a bunch of agreements that are up for renewal about I'd say about 10% to 15% of our contracted managed care business, ex-AmeriPath is under one year agreement. So, we need to deal with those every year sort of on ongoing basis and there is no particular date on which they hold anniversary, I mean, they anniversary at different times during the year. And as you know the HemoCue contract is still out there that we need to work through over the course of this year as well. But at any given point there is typically a fair number of managed care agreements that are out, that have to be negotiated. If you think about, generally on average or contracts or one to three years or so, that means you have got almost 50% of them coming up in any single year. Now given all the ones that we have signed up, we've actually extended that out for a while because now we have got 60% signed up and the majority of those extending into 2010 or beyond. So we have stretched out the cycle a little bit here.

Bill Quirk - Piper Jaffray

I guess kind of where I was going it certainly sounds like that, that's exactly kind of what you guys have decided to do from a your strategy perceptive is to I presumed to get improved visibility for a longer-term perspective there?

Bob Hagemann

Absolutely and we know what the boggy is.

Bill Quirk - Piper Jaffray

Fair enough. And then lastly, just with the closing of AmeriPath can you give us update on the acquisition strategy moving forward?

Surya Mohapatra

Yes, as Bob said and I’ve also indicated that, we have been working almost to over last five or six years to not only have organic growth but have acquired growth and have capabilities that will give us the opportunity to be leader in clinical pathologies, to be leader in gene-based and esoteric testing and AmeriPath has now brought us to a situation where we are the undisputed leader in anatomic pathology and also it gives us an opportunity to change the game by combining the molecular diagnostics and AP.

So in the short-term the growth is in the hospital business, in the short-term the growth is in the anatomic pathology business. But in the long-term also we know as technology is moving so also the testing's are moving near the patient's bed side and that’s the reason why we acquired HemoCue and the recent Focus Diagnostics and quite a number of businesses is going to international.

So with all this key elements in place in the next 18 months, our goal is to integrate and extract the value from all this acquisitions and to have gross leverage. Remember the central piece of our strategy has been diagnostic testing, information and services. It doesn’t really matter whether it’s a pharma company or insurance company or physicians. So we don’t expect any major acquisitions within the next 12 to 18 months. We've got plenty of things to really cleared value.

Bill Quirk - Piper Jaffray

Thanks you guys.

Operator

Thank you. Robert Willoughby with Banc of America Securities. You may ask your question.

Robert Willoughby - Banc of America Securities

Bob a couple of questions, just what are the deleveraging plans over the next 6 to 12 months, will you pursue an accelerated debt reduction program? Or will it be kind of a more measured pace. And then secondarily with the deals announced to-date is supposed to cost cutting in any deleveraging effort. Should we throw out kind of normal seasonality considerations and model sequentially higher earnings kind into 2008?

Bob Hagemann

Well, let me answer the last first. I think some of the seasonality with respect to the operating margins is affected given the way that the costs are coming out given some of the things that we're doing. But if you look at the guidance and you look at what we're anticipating for the back half of the year. It is not too different in the back half of last year, so what that tells you is we've made a lot of progress in just in our cost structure in trying to re-grow the business replacing the UHC work. And I think it’s a little difficult to give a sense a right now as to what the seasonality looks like, certainly from a top line perspective. It shouldn’t change all that much, but in terms of the margins from quarter-to-quarter, its going to be a little more difficult until we can give you some visibility as to when those additional costs savings are going to flow to the P&L.

In terms of deleveraging, as I mentioned, we did made some commitments to our vendors to get our credit statistics back in line and the way we are going to do that it is by obviously doing some debt repayment, but also improving the operating performance of the business. We know that people are asking a lot about share repurchases and how we are going to use the capital structure, but we think it's important for us to make sure that we have the capital structure in place which is prudent. And what I mean by that is it needs to give us the flexibility to be opportunistic with respect to growth opportunities like we were with AmeriPath. It needs to give us the flexibility to deal with unforeseen situations, which could have a significant impact on operations like we had with UHC. But all that said, we are committed to maintaining the capital structure which is going to maximize shareholder value over the long-term, but we want to be prudent with how we manage it as a public company.

Actually, as a public company, we are probably more leverage than most, when you look at the S&P 500 companies, there are about 85% of the S&P 500 companies which are rated investment grade better and about 70% of those are either add for greater than our ratings right now. So, and actually there is only about 15% that are not in investment grade. So currently, we are more aggressive than most of the S&P 500 with respect to our capital structure, but we still think that it's a reasonable place for our business given where it is right now. And as I said, as we get greater visibility into our projected performance, I think, we can then afford to be more aggressive with how we deploy the cash flows into that capacity of the business.

Robert Willoughby - Banc of America Securities

I guess the last question, Bob with the HemoCue deal and some of the international investments, will the disclosure of all that's well so that we can better gauge the performance of those entities and the returns on those capital investments?

Bob Hagemann

Since none of those qualify as a separately portable segment but you won't get a lot of additional detail in the public filings. We'll try to give you some sense as to whether or not those businesses are having a significant impact on our operating performance when we report to you. Right now those businesses are relatively small compared to the total so not having significant impact over time. We hope that they would have much greater impact in, we'll start talking more about them.

Robert Willoughby - Banc of America Securities

Thank you.

Operator

Thank you. Tom Gallucci with Merrill Lynch. You may ask your questions.

Tom Gallucci - Merrill Lynch

Good morning, thank you. Bob, first thing I was just hoping you could just expand a little bit on what you meant by the true-up on the United pricing that positively impact the revenue per acquisition in the quarter?

Bob Hagemann

Yeah. Tom, the fees schedule that United was using during the first quarter was incorrect and we went to them and pointed that out to them and we corrected that in this quarter. And as I said they had about a half a point impact to the revenue per rep.

Tom Gallucci - Merrill Lynch

So did you actually get some revenue on some first quarter testing and sort of that true-up, is that what you meant?

Bob Hagemann

Yeah.

Tom Gallucci - Merrill Lynch

Okay. And…

Bob Hagemann

And it is immaterial to this quarter about 0.5%.

Tom Gallucci - Merrill Lynch

Right.

Bob Hagemann

In terms of revenue per rep.

Tom Gallucci - Merrill Lynch

Right. And then, what about the receivable side of United, I know, at one point you are concerned about collections and now they have used wrong fee schedules, so are you getting the money on a fairly timely basis?

Bob Hagemann

Yes we are. As I said at the end of the first quarter actually we are getting collections on a very timely basis. United is really no different than any other payer, if you provide them the right information that they need in order to reimburse you, you will be reimbursed timely.

Tom Gallucci - Merrill Lynch

On AmeriPath, you mentioned before focusing on growth and how to accelerate sort of the combined entities growth. Can you talk about just I guess revenue retentions so far at AmeriPath on two different buckets on specialty business mostly with the hospitals on esoteric side and then the core of AmeriPath pathology related business?

Bob Hagemann

We have seen no significant loss of business or customers at this point. We feel very good about the retention there, across all of the AmeriPath business.

Tom Gallucci - Merrill Lynch

Okay good. And then I guess just finally, you have talked a lot about some of the contracts I guess at managed care that you have signed and some that are still out there. One thing that we have been thinking about is just that United clearly is, I mean [Lamprey] is sort of you've invested a lot in some of your core markets with United business in hand. Can you just talk about sort of the competitive landscape at the local level, so not really just for the contract but then once you have the contract, assuming it's not an exclusive one what you are seeing on a day-to-day basis. As the sales guys hit the streets and there is any increased volatility in the business or how the competitive landscape has changed from that perspective?

Surya Mohapatra

Tom, our competitor has market position in New York, New Jersey area. It's not as if they didn’t have the contract in this area. But because of our value proposition, because of the different suited services we had the major market share and we had the doctors and the patients. And what happened with United and what happened with our competitor, is not only is the contract but this huge amount of transaction costs, gives them the opportunity. So basically forcing the doctors to move and as you know it created an issue probably patients and the doctors in some states say it's illegal.

So what is happening now is as you saw from our activities, the so called discretionary business is not a changing, we lost some but the ratio is improving. We expect that most of the United business is going to go, because it's not only the competitor but also the bill forcing it. But most important thing for us that we did not reduce our service level, our sales people are interested in attaining the business and that gave us the ammunition and also the market position to sign Aetna and CIGNA and other contracts.

So obviously when somebody signed a contract we have so called pull through from other places that is not working. But having said all these things, we are still not out of the woods as far as this comparative process is concern and we will continue improving our service level and we'll continue to get the business based on what we provide and I think that’s we what we are seeing. And going forward obviously it’s a little bit easier now because there are not lot of major contracts left to be used by the same tactics somebody used for United.

Tom Gallucci - Merrill Lynch

Okay, Thank you

Operator

And Thank you Sandy Draper with Raymond James. You may ask your question.

Sandy Draper - Raymond James

Thanks. Wanted to may be get a sort of longer term perspective just looking back at the industry back in the 90s last time there was a real significant pricing war primarily driven by SmithKline Beecham. I'm not sure if this is a fair question, but how would you characterize the pricing environment today versus that period back then when we the last time I really saw a significant pricing at least discussed and out there in the open, would you see it better, worse or same or may be contrast to two periods. Thanks?

Surya Mohapatra

Sandy, it's difficult to really compare exactly the pricing what was 10 years ago, but what I would like to say is that when somebody use price only to get the significant market share especially in medical business, it is not a long-term strategy. And when we look at Quest Diagnostics over the last 10 years, now that is we are three players in Quest Diagnostics and SBCL. What together merged and that's created the change and that created the pricing discipline in the industry and as you know SBCL and Quest Diagnostics for us was a game changing event in clinical pathology.

And again that was in '99. In '03 we acquired AML to strengthen the hospital business and that created our hospital business. Now in '07, we are merging with AmeriPath to create another game changing event in anatomic pathology. So, its not only the price that is, we should be worried about its actually what services we provide and how we go forward and I've always said that the diagnostics is the right place to be and if the last 30 years have been the years for pharma and medical devices, the next 30 years is going to be the diagnostics and monitoring for prevention and care, so I think the sector is good, so the disruptions that behind us and I think the payers are working with us and now we want to get along with life and continue providing the best high quality diagnostics services for our patient care.

Bob Hagemann

Sandy, one other thing that definitely back in the early 90s, the performance of the last companies was really influenced quite a bit by the fact capitation was coming on to the scene whereby the lands were taking utilization, risks and frankly that was one of the big drivers not only what allow to taking risks but it was also become an increased portion of the business. So the mix had shifted to capitation. Since then capitation become a smaller piece of the business. And I would say as the industry in total is a lot smarter about how to price capitative contracts now because we get a lot better information about utilization, demographics et cetera. So that piece of the risk I think is much better managed than it was back then.

Sandy Draper - Raymond James

Great. That's very helpful commentary. Just two quick follow-ups one on the -- is this is price issue pretty much constrain to your other national competitors or have you seen the smaller or local players trying to match pricing, use price and then, sorry, so its a little bit, is the pricing more focused on just the basic test and obviously a secure quality test some pricing but is it more intense in traditional basic test versus I said character is it more up and down and I'd like to jump back in the queue. Thank you.

Bob Hagemann

You know Sandy, I think, when you lead with price it's bad for the industry. It doesn't really matter whether it's a large company or small company and I think that was the reason why we said that we could have signed that our contract reserving back for our company and our industry. But we are seeing this price pressure is a new order line for all the players but having said that we have to reorganize and move forward and I am sure all the laboratories whether the small or large have to do the same thing because it is a new game.

Sandy Draper - Raymond James

Thank you

Surya Mohapatra

Next question.

Operator

Thank you. Kemp Dolliver with Cowen & Company. You may ask your question.

Kemp Dolliver - Cowen & Company

Hi thanks. On the $500 million in cost savings, I guess my question is that if you take your common share regarding the 20% operating margin goal that essentially the net benefit of those savings is essentially that differential between your current margins is the 20%. Is that accurate assumption?

Bob Hagemann

No, you need to keep in mind that we are going to get to the 20% margins not just by reducing costs. I mean, by growing the top line as well and growing it in the areas that sort of you talked about the higher margin, higher growth pieces of the business. So it's a combination of all of those things and I caution you to take in taking any one of the machine that’s the principal driver of the margin increase.

Kemp Dolliver - Cowen & Company

Okay, just to take that discussion a little bit further than. I guess what underlying cost inflation do you assume you will have that this would $500 million of offset?

Bob Hagemann

I am not going to get into guessing cost inflation with you and where that’s going. I mean every year we see cost inflation in our business. The biggest piece of our cost or salaries wages and benefits, which accounts for about 50% of our total cost and certainly there is always inflationary pressures. There the other pieces of our business may be a little less so, and as we work with our suppliers obviously we try to manage the impact of that and reduce cost there wherever we can and additionally as we become bigger and we are bigger volume purchaser, that affords us to keep our discounts and in some cases that offsets the impact of inflation. But I don’t want to get into giving you inflationary estimates at this point.

Kemp Dolliver - Cowen & Company

Okay and Bob just in terms of say a percentage reduction in your cost structure. Is it fair to kind of say that’s may be about 8%-9% cost reduction in your cost structure?

Bob Hagemann

Not too far off. Another way of thinking about it is we generate about $7 billion in annualized revenues now, so it's about 7% of annualized revenues.

Kemp Dolliver - Cowen & Company

That's great, Thanks a lot.

Operator

Thank you, and our final question comes from Bill Bonello with Wachovia

Bill Bonello - Wachovia

Hey great, just two follow up questions. One is just the last time that you spoke about AmeriPath, at that point you were pretty confident that AmeriPath would stay as a contracted provider for United Healthcare. And I'm just curious if you have any more color now that it's actually part of Quest?

Bob Hagemann

Not on a lot of additionally at this point Bill. We think that AmeriPath has a good relationship with UHC, they provide a very valuable service to their members and as we said earlier we expected they will continue to serve UHC members. We really haven’t had any specific dialogue with them about current agreements in place at this point Bill.

Bill Bonello - Wachovia

Can you just let us know how long the existing contract runs for AmeriPath?

Bob Hagemann

Their contracts, generally there are few national contracts that they have many of them are regional and local agreements that have varying terms.

Bill Bonello - Wachovia

Okay and then I guess just a follow-up on maybe what Kemp was striving at a little bit and your comment that at $500 million you would be, all I will tell equally you would be at an operating margin that is, I believe significantly greater than 20%. And so it would seem like given that you think you’re going to have decent revenue growth that should offset inflation. It would seem like there is a pretty hefty expense that you are assuming you're going to have to take on to achieve these cost savings. I’m just wondering if you can give us not necessarily quantifying but give us any color on what kinds of [measures] take on to achieve the $500 million?

Bob Hagemann

Bill, couple of things, first any cost that we would take on to incur this would be one-time costs. Any costs that will be added to the permanent cost structure already netted in the $500 million. That’s a net change to our cost structure. Now, not all of the opportunities that were going after are going to have a one-time cost to implement either, but for those that do as we approve the detail plans and implement them, we may record charges at that point in time and we’ll call those out and make people well aware them. But when you think about what’s going to drop down to the bottom line, as I said these actions are really to drive us to get to that 20% operating income overtime. Some of the savings is going to get us to the structural cost reductions that we need to make to offset, the loss of the United volume, because remember there was over $400 million in revenue there. So far we pulled out $200 million annualized cost. So, we need to pull out more cost to get back to mitigating that full OEM impact there. Some of the savings is going to be use to offset the pricing pressures were seen, and then obviously we said some is going to be to invest in growth and further differentiate the service offering that we've got.

Bill Bonello - Wachovia

Okay. And then we have just seen and just help me if my math is wrong when it was seen and given what you just said that erratically if you are successful at this cost savings and you could have operating margins that are in excess of 20%?

Bob Hagemann

Listen, once we get the 20%, we are not going to stop there or put a governor on it but yeah, we have a long way to go to get to the 20% at this point quite frankly. And this is something that we felt was necessary to get us there. Certainly, when we get there, we are not going to stop but I am not sure that I can give you visibility beyond that at this point.

Bill Bonello - Wachovia

Okay, we won't model it for the next quarter.

Bob Hagemann

Thanks.

Bill Bonello - Wachovia

Thank you.

Surya Mohapatra

Thank you.

Laure Park

Laurie could you read the closing comments.

Operator

Yes, thank you for participating in the Quest Diagnostics second quarter conference call. A transcript of prepared remarks on this call will be posted later today on Quest Diagnostics website at www.questdiagnostics.com. The replay of the call will be available from 11:30 am on July 25th to 11:00 pm on August 21, 2007, for investors in the U.S. by dialing 866-421-0437. Investors outside the U.S. may dial 203-369-0799. No password is required for either number. In addition, registered analysts and investors may access an online replay of the call at www.streetevents.com. The call will also be available to the media and individual investors at Quest Diagnostics' Website. The online replay will be available 24 hours a day beginning at noon. Goodbye.

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