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Quest Diagnostics (NYSE:DGX)

Q1 2012 Earnings Call

April 18, 2012 8:30 am ET

Executives

Kathleen Valentine - Director of Investor Relations

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

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

Analysts

Adam T. Feinstein - Barclays Capital, Research Division

Dane Leone - Macquarie Research

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

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Ralph Giacobbe - Crédit Suisse AG, Research Division

Bill Bonello - RBC Capital Markets, LLC, Research Division

Darren Lehrich - Deutsche Bank AG, Research Division

Ricky Goldwasser - Morgan Stanley, Research Division

Sylvia Chao

Unknown Analyst

Gary P. Taylor - Citigroup Inc, Research Division

Gary Lieberman - Wells Fargo Securities, LLC, Research Division

Erin Wilson

Operator

Welcome to the Quest Diagnostics First Quarter 2012 Conference Call.

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

Now I'd like to introduce Kathleen Valentine, Director of Investor Relations for Quest Diagnostics. Go ahead, please.

Kathleen Valentine

Thank you, and good morning. I am here with Surya Mohapatra, our Chairman and Chief Executive Officer; and Bob Hagemann, our Chief Financial Officer.

During this call, we may make forward-looking statements. Actual results may differ materially from those projected. Risks and uncertainties that may affect Quest Diagnostics' future results include, but are not limited to, those described in Quest Diagnostics' 2011 Annual Report on Form 10-K and current reports on Form 8-K.

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

Now, here is Surya Mohapatra.

Surya N. Mohapatra

Thank you, Kathleen. Before we get started, I'd like to say a few words about our leadership transition. Last week, we announced that Steve Rusckowski will become the President and Chief Executive Officer of Quest Diagnostics effective May 1. Also, Dr. Dan Stanzione, currently our leading independent Director, will become non-executive Chairman at that time. We are pleased to have someone of Steve's caliber join and lead Quest Diagnostics. Steve is a strong leader with a proven track record of success. His experience and expertise will benefit the company as it looks to capitalize on the opportunities that lie ahead.

I know that all of you are anxious to hear about Steve and his plans for the company. However, please hold your questions until after he arrives. Now to the results.

We had a very solid first quarter. Our 6.3% increase in revenue was driven by both organic growth and acquisitions. We generated a 7% increase in earnings per share. We increased guidance for adjusted EPS to between $4.45 and $4.60. We saw strong growth in esoteric and gene-based testing as a result of our focus on cancer, cardiovascular disease, infectious disease and neurological disorders. In addition, we saw improved growth in routine testing.

We also are making good progress in our previously announced $500 million cost reduction initiative aimed at improving operational efficiency. Let me briefly comment on long-term and short-term market trends.

The long-term fundamentals for our business remain strong. The population is growing and aging, prevalence of chronic conditions is on the rise, early detection and wellness are increasing in importance, the pace of medical innovation is accelerating and we are seeing much greater engagement by payers, employers and patients in improving health outcomes and reducing costs.

However, in the short-term, the current market environment continues to be challenging. Published data indicates physician office visits have been weak in spite of mild weather. Reimbursement pressure from government and other payers continues. Against this backdrop, we continue to execute our growth plans and while we have made good progress, we have more to do. As we have said before, our growth strategy is based on 3 factors: One, driving innovative new tests and service to improving sales performance and towards strengthening our relationships with health plans and other payers.

Demand for esoteric and gene-based testing continued to grow faster than routine testing. In the quarter, esoteric and gene-based testing grew 20%. Volume for SureSwab gynecological testing was up more than 50% and ImmunoCAP allergy testing was up more than 10%. Vitamin D testing also continued to grow.

Anatomic Pathology Testing continues to be affected by physician in sourcing. However, the impact on revenues has continued to moderate. There have been recent developments which we believe may lessen the impact and potentially reverse this trend over time.

Last week, Health Affairs published a study on physicians who refer biopsies to pathology labs in which they have a financial interest. The study found these physicians billed Medicare for 72% more evaluations, but find fewer cancers. This study highlights the adverse impact of unnecessary procedures on patients and the need for Congress to end the loophole in the Stark legislation that currently allows it.

In addition, we are encouraged to see health plans taking actions, including changing reimbursement policies related to in-office testing. In science and innovation, we continue to focus on bringing innovative tests to market that will improve patient care and help health lower healthcare costs. Last week, the FDA cleared out new test for C. Diff, a common and dangerous hospital-acquired infection. This test uses proprietary technique to deliver faster results for hospitals and clinical labs.

Also last month, we launched the first molecular test to help physicians detect rejection in kidney transplant patients weeks before conventional tests. Our renal transplant monitoring test enables doctors to adjust therapy based on each individual's genetic makeup. It has the potential to improve patient care, while helping to reduce the significant cost of failed kidney transplants.

This test is the latest example of how we are driving personalized medicine. We are the only major laboratory to have these unique end-to-end capabilities, from biomarker discovery to laboratory developed tests at LDTs to FDA-cleared IVD test kits. These capabilities are attracting interest from pharmaceutical companies and resulting in new companion diagnostics and new business.

We are seeing greater traction in our sales efforts. The sales organization has made gains in important focus areas. We have returned to growth in women's health testing and are seeing continued strong growth in prescription drug monitoring. Additionally, health plans and employers continue to focus on reducing out-of-network spending and work that's going to high-cost providers. Some of these actions include: Implementing stronger policies that benefit lower-cost in network providers like us; others include expanding educational outreach to employers and employees to emphasize the importance of using lower-cost in-network providers.

Regarding our cost structure, we are committed to reduce it by $500 million over a 3-year period and we are on track.

Now, Bob will provide analysis of our performance and then we will take your questions. Bob?

Robert A. Hagemann

Thanks, Surya. As noted by Surya, revenues for the quarter were $1.9 billion, reflecting strong growth of 6.3%. And adjusted earnings per share was $1.07 compared to $1 in the prior year, a 7% increase. The earnings improvement is principally driven by top-line growth.

Adjusted EPS for the quarter excludes $0.05 per share associated with restructuring and integration costs and $0.03 associated with the CEO transition. Adjusted EPS from last year's first quarter excludes items totaling $1.33 per share, associated with the impact of the Medi-Cal charge, severe weather and restructuring and transaction costs. These items are further detailed in Footnote 2 to the earnings release.

Consolidated revenue growth was driven by the acquisitions of Athena, Celera and SED, which contributed 3.2% to growth in the quarter. The favorable impact from weather about 2%, and about 1% growth in the underlying business. Our clinical testing revenues, which account for over 90% of total revenues, grew 6.4% in the quarter with acquisitions contributing 2.8% growth and favorable weather comparisons contributing about 2%.

Volume in the quarter grew 3.4% from the prior year. We estimate the impact of weather helped the year-over-year comparisons by about 2%. Adjusting for the favorable impact of weather and the contribution from acquisitions, underlying volume growth was almost 1%. This continues the positive trend which began in the fourth quarter of last year.

The market, in terms of estimated physician office visits, continues to be soft. In the quarter, the published data reflects about a 2% decline compared to the prior year. While our most recent improvement in volume is encouraging, the year-over-year comparisons are favorably impacted by weather and as such, we continue to believe it is still too early to conclude the market has turned the corner.

Drugs of Abuse Testing volume has continued to rebound and grew about 5% in the quarter, in line with the growth of last quarter. Revenue per requisition was 2.9% above the prior year with the improvement principally due to the increased esoteric mix contributed by Athena and Celera. Note; the impact on revenue per requisition, associated with the acquisitions of Athena and Celera, will anniversary next quarter.

Revenues in our nonclinical testing businesses, which include risk assessment, clinical trials testing, products and Healthcare IT grew about 6% in the quarter, driven by the products business acquired as part of the Celera acquisition. Adjusted operating income, as a percentage of revenues, was 16.5% compared to 16.3% in the prior year. Restructuring, integration and CEO transition costs totaling $20 million reduced the reported operating income percentage by about 1 percentage point from the most recent quarter.

Both reported and adjusted operating income percentages were reduced by about 50 basis points due to costs associated with a legal settlement and costs associated with changes in assets held in deferred compensation points.

In last year's first quarter, the Medi-Cal charge and other special items, together totaling $270 million, significantly reduced reported operating income. Last July, we announced a multi-year initiative, the goal of which is to reduce our cost structure by $500 million by the end of 2014. As we shared with you last quarter, we expect to deliver about 20% of the $500 million goal by the end of this year with the remainder in 2013 and 2014. While it is still early in the year, we are on track to meet our 2012 targets.

As we've previously shared, common themes across most areas include standardizing systems, processes and databases, increased use of automation and technology and centralizing and selective outsourcing. The next few years, this will require some increased level of capital spending to standardize systems and upgrade IT infrastructure. We are fully committed to realizing the planned benefits from this program which will not only make our company more efficient, but also serve as a platform for accelerated growth.

Currently, we continue to produce industry-leading performance in our billing and collection metrics. Bad debt expense, as a percentage of revenues, which is typically highest in the first quarter due to increased patient responsibility associated with unmet deductibles and co-pays was 4.2% in the quarter, unchanged from the prior year. DSOs were 44 days compared to 45 days last quarter.

Cash from operations, which is generally lowest in the first quarter, was $161 million and is comparable to the prior-year level. Capital expenditures were $30 million in the quarter compared to $39 million a year ago.

During the quarter, we repurchased 847,000 common shares at an average price of $59, for a total of $50 million. We also reduced our outstanding debt by $105 million in connection with our stated objective to delever by $500 million to $700 million this year.

Turning to 2012 guidance. We now expect results from continuing operations before special items as follows: revenue to grow between 2% and 2.5%; operating income to approximate 18% of revenues; cash from operations to approximate $1.2 billion; capital expenditures to be between $200 million and $225 million; and lastly, diluted earnings per share to be between $4.45 and $4.60 compared to previous guidance of $4.40 to $4.55.

Now I'll turn it back to Surya.

Surya N. Mohapatra

Thanks, Bob. In summary, we had a very solid quarter. We are making progress in a number of areas to drive growth and reduce our costs. We have named a new Chief Executive Officer for Quest Diagnostics, Steve Rusckowski, with a proven track record. I will be here through April 30 to ensure a smooth transition.

Finally, I want to say how proud I am of Quest Diagnostics and my 42,000 colleagues in what they have accomplished so far and what they will accomplish in the future. Quest Diagnostics is strong financially, medically and technologically. It's a unique company with a very bright future.

We're now ready to take your questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from Adam Feinstein of Barclays.

Adam T. Feinstein - Barclays Capital, Research Division

Just, maybe just get you to talk a little bit more about the margin outlook. I know you guys have been talking about the 18% and clearly more focused on managing costs and everything here. But maybe just go through the thoughts in a little bit more detail on the margin outlook and the ultimate drivers.

Robert A. Hagemann

Adam, as generally the first quarter is the lowest margin percentage of the year, bad debt tends to be the highest as a result of the higher patient responsibility for co-pays and deductibles. The volumes tend to be softer than the latter quarters. And as we saw last year, margins continued to improve as we went through the year. We're expecting the same thing this year. And if you look at the adjusted margins, they did expand from a year ago on what's relatively modest underlying organic growth. I think we've mentioned in the past that generally we need about 2% organic growth in order to hold margins and offset the inflation that we've got to the cost base and that this year the margin expansion that we are expecting, given that we're expecting pretty modest organic growth, is really coming from the cost reduction program. And as we progress through the year, we expect to see more benefits from that and we also expect that we'll continue to expand the margins as the year progresses. Remember too, as I pointed out in the script, margins, the adjusted margins were depressed by about 50 basis points or so this quarter because of a legal settlement and because of the adjustment assets in deferred compensation plans.

Adam T. Feinstein - Barclays Capital, Research Division

Okay, great. And just maybe a quick follow-up if I may here. So maybe just a quick update just in terms of the CEO transition process. I guess just thoughts in terms of just how the process will take place and what, I guess, from the outside looking in, what does the transition process really entail? So any high-level thoughts?

Surya N. Mohapatra

Sure, Adam. First of all, Steve Rusckowski is a veteran of healthcare industry and he is not new to what is important for patients and for payers and also for providers. So we are really excited to have him lead this company. I have had a number of discussions with him. He is -- we are helping him to get some material, as much as he can read, before he comes to the company. He still has to finish his jobs, but I am very pleased with his knowledge and also his engagement so far. So I think the transition is going to go very smoothly, and I will be here until April 30, the last day, and he will join on May 1, the first day of his, rest of his career.

Operator

Our next question is from Dane Leone from Macquarie.

Dane Leone - Macquarie Research

So my question, my first question here is on the organic volume growth, you mentioned that you stripped out weather. I was curious, did you have an extra day in the quarter from the leap year? And if so, what was the effect on volume growth?

Robert A. Hagemann

It's a question a few people have asked, and maybe we should have been proactive in addressing it. But the answer is no. If you look at the way the New Year's holiday fell, this year the New Year's holiday fell in January, whereas the prior year, it actually fell on December 31 and didn't impact the quarter. So that's really what's offsetting the benefit of leap year this year.

Dane Leone - Macquarie Research

But wasn't --

Kathleen Valentine

If you recall, I mean, last year, we did call out that the first quarter in 2011, we did have the benefit of an extra day as a result of how the New Year's holiday had fallen.

Dane Leone - Macquarie Research

Right, but I thought the, then Easter, Good Friday fall outside of -- in April versus March last year, is that right?

Robert A. Hagemann

I think they were both in April.

Kathleen Valentine

Yes.

Dane Leone - Macquarie Research

Okay. On the guidance for the year, could you maybe parse out the operating assumption variation for the EPS, because looking at the low-end of revenue guidance at 2% around an 18% operating margin and not including any capital deployment for debt paydowns over the remainder of the year for stock repurchases, it's a little difficult to get, I guess, below the high-end of your EPS guidance. You come out around $4.60 so yes, maybe just a little bit more color on some of the variation and assumptions for sales growth and operating line.

Robert A. Hagemann

As you can imagine, Dane, whatever model you're using is pretty sensitive to just minor changes in revenue or just a few basis points in operating income. And we have provided a range for revenue. We've indicated approximately 18% in operating income, which means that it could be slightly below that at the low-end of the range. And as you noted, we're not necessarily expecting the weighted average shares outstanding to be significantly different from last year. We are doing some share repurchases this year, but a little more modest than we would otherwise, because of the delevering that's going on.

Operator

Next question is from Lisa Gill of JPMorgan.

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

I just have a question as we think about your guidance going forward on revenue. So if we think now about revenue in the second to fourth quarter, we're now going to be modeling 1% to 1.5% in order to get within your guidance range. Can you maybe just talk about your expectations around it's slowing down? Is it just that you don’t expect utilization to continue where it is? Or is it something else that we should be thinking about?

Robert A. Hagemann

Well, Lisa, as you think about our outlook for the back half of the year, there's really nothing fundamentally that's changed there. As you know, we're going to have the acquisitions essentially anniversaried in the second quarter. And when you look at the underlying organic growth adjusted for weather and all the noise that's in there, it was around 1% or so this quarter. We're expecting that over the course of the rest of the year. As you look out at physician office visits and you see how they performed this quarter, it indicates that the market continues to be soft. So we're not necessarily expecting the market to pick up significantly as the year progresses. We're expecting it to remain soft, and that's what's built into our guidance at this point.

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

And then secondly, can you maybe just talk about market pricing in general? There's been a lot of comments out on our side and in the market where people have been concerned about what pricing looks like and what it's going to look like going forward. Can you just add any comments as to what you're seeing right now?

Robert A. Hagemann

Well, I think it's no surprise that we continue to see pressure on reimbursement. We expect that to continue for the foreseeable future. And that's frankly one of the motivations behind us reducing costs and launching the program that we did. But despite that, we are indicating that we expect margins can expand this year.

Operator

The next question is from Kevin Ellich of Piper Jaffray.

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Congratulations again on the completion of the CEO succession process. Surya, just going back to the utilization comments and physician office visits remaining weak. In your prepared remarks, you made a comment about routine testing improving. Just wondering what type of information and analytics you guys have that validates this, what's driving it? And I don't know if you can add any more color on the utilization improving?

Surya N. Mohapatra

Well, I can tell you that there is no one-to-one correlation about physician office visits and laboratory testing. But having said that, there's 100 million people in the United States suffer from chronic disease and 40 million people are suffering from more than 3. And as you said, we invested quite a bit of time and money in training and creating an effective sales force. And what we are seeing that we are gaining in ground in women's health and some routine testing that goes along with esoteric testings and so all parts of our business are growing, and that's actually an early indicator of the investment we have put in sales and marketing.

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Do you think the improvement that you've seen in women's health and the like is coming from the marketing expanding or market share gains?

Surya N. Mohapatra

Again, it's a little too early to say, but my feeling is that usually we consider diagnostic testing is a very safe industry unlike Pharma and devices where things can go wrong. This is the safe investment for the investor, because it's very steady. So the market need to grow 4% to 6% a year, 2% to 3% in price and 2% to 3% in volume, but over the last couple of years, my feeling is and what we see is falling flat of 1%. So in some areas, in new areas, expanding areas like esoteric and gene-based testing, I think the -- we are developing market, and market is growing in some areas we are -- started to gain some market share.

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Got it. And then Bob, I just wanted to clarify the comment to Dane's question about no extra day for leap year. Is that because leap year -- New Year's fell on Sunday, so was Monday a day off for testing?

Robert A. Hagemann

Correct. That's when the holiday was celebrated. It was in January whereas in the prior year, the holiday was actually celebrated in December.

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Okay, understood. And then maybe could you guys just expand a little bit on the commercial pricing environment? Do you have any major contracts coming up? And if so, could we get an update on that?

Robert A. Hagemann

Well, there are no national contracts that are up this year. We do have one up in 2013. And we always have contracts, smaller contracts coming up in any given year. But as I said, none of the big national ones are up for renewal. With that said, we're always having conversations with the plans, regardless of whether or not contracts are up. And as I said earlier, I expect that reimbursement will continue to be under pressure, particularly from the health plans. But on the flip side, I think we're making more progress in working with the health plans in driving more work to us to lower-cost in-network providers like ourselves. So hopefully that will be one of the ways that we're able to mitigate some of the continued price pressure, along with what we're doing on the cost side.

Kevin K. Ellich - Piper Jaffray Companies, Research Division

That makes a lot of sense. And then could you tell us which contract comes up in 2013, Bob?

Robert A. Hagemann

The CIGNA contract is up in '13.

Operator

The next question is from Tom Gallucci of Lazard Capital Markets.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

In terms of -- as we think about the organic revenue growth, I appreciate your sort of conservative view given one quarter in the bank here. But just to make sure I understand the numbers, Bob, you're talking about a little bit under or around 1%, I guess, adjusted organic volume growth. And it seems like maybe the deals added, acquisitions added a little over 2% to your revenue per requisition so maybe without the deals, you're just under 1% as well. Is that fair?

Robert A. Hagemann

The acquisitions did add in excess of 2% to revenue per requisition, driving the vast majority of the increase there.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Okay, so your adjusted or your organic revenue growth, adjusted for weather and whatnot, is probably around 1.5%, is that a fair rough range?

Robert A. Hagemann

You're not far off, yes.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Okay, all right. And then, could you give us a little bit more on the cost-cutting program? I mean, you've outlined some higher-level initiatives, but can you give us a little bit more tangible examples of the things you did in the quarter that you're working on right now, so we sort of understand what's going on the ground, if you will?

Robert A. Hagemann

Yes, and Tom, I detailed all of these last quarter. But yes, as a reminder, some of the things that we're working on certainly on the client support side, which include customer service and billing include the leveraging technology to eliminate manual work. We're implementing more self-service for customers, allowing them to supply insurance information, make payments online, check bill status, get test results which, at the end of the day, the more that can be done online, the more efficient it is for us because we're not handling all of those calls. On the procurement and supply chain side, we talked about further consolidating suppliers, rationalizing SKUs. Examples that we gave there were reducing the number of choices for gloves, specimen bags, labels, urine collection cups, et cetera. All of those things are in process at this point. On the SG&A side, we talked about flattening the organization structure, simplifying some management processes and beginning to centralize certain activities and consider outsourcing others. And then on the IT side, we talked about moving our connectivity solutions to ones that will not require hardware that we'll need to service in the field, it makes the installation more efficient and it makes the cost of servicing that connectivity a lot less expensive over time. And then we talked about things that obviously are not yet impacting this quarter like the labs and specimen acquisition as we start to look at the lab footprint capacity utilization, automation being further leveraged in the labs and the like.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Okay, and then just one clarification, Bob, if I could. You had mentioned a couple of other unusual items in the quarter, I guess a change in the assets in the deferred comp plan and another. Can you just highlight that again to make sure we got that?

Robert A. Hagemann

Sure. One was legal settlement that cost us about $5 million and that impacted margins. And then we've talked about this in the past as well, but not recently, and that is the assets in our supplemental deferred compensation plan. The gains and losses on those show up below the line in Other Income Expense. And to the degree it's a gain, that gain shows up below the line, but the offsetting charge shows up above that line as an increase to compensation cost. It's a quirk in the way the accounting works. And given that the market had a very strong return in the first quarter, it really accentuated that in our results this quarter.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Okay, so that nets each other out. So you're just highlighting that second one so we can get a better understanding of the actual margin trends.

Robert A. Hagemann

Correct.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

And that legal settlement though, I guess, is an unusual item that would add to your operating profit and your EPS if we wanted to exclude that, is that right?

Robert A. Hagemann

Correct, if you want it to. Unfortunately, sometimes those do happen and we decided that it was not unusual enough to call out for purposes of adjusted EPS.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Okay, so those 2 items together are like between $0.01 and $0.02?

Robert A. Hagemann

Actually, a little more than that, it's about $10 million in total or about 50 basis points. So closer to $0.04...

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Well that's to the margin, right? But the --

Robert A. Hagemann

The one item is about $0.02.

Operator

All right, the next question is from Ralph Giacobbe of Credit Suisse.

Ralph Giacobbe - Crédit Suisse AG, Research Division

Just wanted to go back one last time to the organic growth trends. On the clinical lab testing side, work's sort of shaken out to 1.6, you said volume up about 1%. Pricing roughly up 50 bps. And you mentioned sort of the comping out of some of the deals, so I guess as we think of the model going forward, is that sort of a level that we should be considering when we think of kind of the pricing growth for the rest of the year?

Robert A. Hagemann

Yes, Ralph, as you know, we don't give guidance for the components of revenue growth or the revenue per acquisition or volume. But yes, implied in our guidance for the remainder of the year is about 1% organic revenue growth.

Ralph Giacobbe - Crédit Suisse AG, Research Division

Okay, can you give us what your, what the Anatomic Pathology volume and/or revenue growth was for the quarter?

Robert A. Hagemann

We don't break that out specifically on a quarterly basis but yes, as you heard in the prepared remarks, it did continue to be under pressure. It was below the prior year, but that impact is starting to moderate. So it's not as severe as it was.

Ralph Giacobbe - Crédit Suisse AG, Research Division

And then just going back to Surya's comments on the health plans changing policies around that. Can you give us any more color there? I mean is that, is it something that's starting in 2012 or what's the magnitude, is it one plan, is it multitude of plans? Where are we there?

Surya N. Mohapatra

Well you know, Ralph, first of all, any changes, that will take some time. But we are very encouraged because the Health Affairs article really show something so critical that the people who have a financial interest, they're billing Medicare more, 72%, and they're finding less cancers. But apart from that, there are lots of effects on patients. So obviously, the plans are very focused on these things. Some plans are denying reimbursement. Some plans are reducing reimbursement. And some plans are asking the laboratory to be clear and approved or CAP accredited. So these are all good things for the patients and good thing for AP business, and we are very encouraged. I for one know that you cannot do cancer testing without anatomic pathology. And this is not going to be long before there is potential that this trend will be reversed.

Robert A. Hagemann

And Ralph, it is multiple health plans that are implementing these changes and hopefully now with the health affairs report being out, it will prompt others to consider changes. And frankly, I think those changes have been contributing to the moderation of the insourcing.

Ralph Giacobbe - Crédit Suisse AG, Research Division

And any more details, I mean, what are they actually saying? Are they saying it can't be done? Are they monitoring? Or is there preauthorization or what exactly is happening?

Surya N. Mohapatra

Some of the [indiscernible] are particularly saying that they will not accept results from the labs which are not CAP accredited.

Kathleen Valentine

Ralph, what they're doing is they're implementing policies. So they're notifying their providers of policies and as we alluded, in some cases the actions that, and the policies that the health plan has implemented is, they notify physicians that they'll be denying reimbursement for this discrete range of CPT codes, pathology testing CPT codes when they're performed, when the claim is submitted from a physician office setting.

Ralph Giacobbe - Crédit Suisse AG, Research Division

Okay, that's helpful. And then just my last one, our understanding is that Aetna recently made Genzyme Genetics out-of-network. Do you guys have a sense at all the potential benefit to you and maybe remind us of your capabilities for those specific tests?

Robert A. Hagemann

Certainly, yes, if their network is narrowed, that's going to be a benefit for us. And there is nothing that Genzyme's doing that we can't offer today and don't offer.

Ralph Giacobbe - Crédit Suisse AG, Research Division

Do you guys have any sense of size?

Robert A. Hagemann

No, I don't think that we would start to cull out specific opportunities from other competitors.

Operator

Our next question is from Bill Bonello of RBC Capital Markets.

Bill Bonello - RBC Capital Markets, LLC, Research Division

So before I have a follow-up question, I want to clarify a number that you said. I thought you said that the SureSwab growth was 50, 5-0 percent in the quarter. Is -- did I get that right?

Robert A. Hagemann

Yes, you did.

Bill Bonello - RBC Capital Markets, LLC, Research Division

And should I think of that as the rate at which trichomonas volume is growing? Or is that really reflective of a change in the actual collection device, but not the underlying test volume?

Robert A. Hagemann

Bill, you have to understand that SureSwab was introduced just recently last year. So we're operating off a relatively small base. But the point is yes, it's a test that's getting some good traction here.

Bill Bonello - RBC Capital Markets, LLC, Research Division

Okay, great. That's helpful. And then on just back on the operating margin question and particularly on the SG&A. So it's helpful to get the 50 basis point adjustment that you talked about with the legal settlement and the asset adjustment. I assume the legal piece was all in SG&A, but was the asset kind of split between cost of services and G&A?

Robert A. Hagemann

The 2 items that we talked about impacted SG&A in cost of sales almost equally, I would say, Bill.

Bill Bonello - RBC Capital Markets, LLC, Research Division

Okay, so if even with that stripped out and even with sort of the bad debt, if we back that out, it seems like SG&A expense is still growing faster than revenue growth, which in this time of sort of cost savings initiatives is a little bit curious, and I was just wondering if you can talk a bit about maybe what's driving that growth and at what point we might see the same kind of leverage or more leverage on SG&A like we've been seeing on gross margin?

Robert A. Hagemann

Yes, well, one of the things you need to consider is the impact of the acquisitions that we did. And I think I was mentioning this several times last year. The Athena and Celera acquisitions had a very positive impact to cost of sales, but increased the SG&A percentage just because of the businesses and the way that they operate. And you're going to see that SG&A impact as well as that cost of sales impact anniversary next quarter. But that was driving changes in both of those metrics.

Bill Bonello - RBC Capital Markets, LLC, Research Division

Okay, that's very helpful. And then just on the well, never mind, I was going to ask can you try and take another crack again at pricing, but I think you -- well, let me ask it a different way. You're not going to give a sort of percent increase or project where revenue per requisition is going to go. But I guess I'm having a hard time discerning from your comments whether as we look forward, if we strip out Medicare, because we all know Medicare's a big challenge in 2013. But if we strip that out, whether the pricing environment on the commercial side you're actually expecting to get worse over the next 6 to 18 months? Or are you just commenting on what has sort of what has sort of always been a difficult pricing environment?

Robert A. Hagemann

Bill, as I think about it, it's a very difficult pricing environment today. I don't expect that to abate and in fact, as I've listened to other healthcare providers yes, I'm consistently hearing the same thing, that reimbursement pressure has ratcheted up and most expected to stay something that is under significant pressure as we go forward. Employers are looking for ways to reduce costs, health costs, healthcare costs are a significant piece of that. They're, in turn, putting pressure on their payers who are in turn putting pressure on providers. And we don't see that abating anytime soon.

Bill Bonello - RBC Capital Markets, LLC, Research Division

Okay, so I promise this is the last question, but just as part of that, if we go back to the middle of 2010, you actually had a considerable step down in revenue per requisition because of recontracting and whatnot. I mean is there something going on where we need to be worried about that kind of a movement again?

Robert A. Hagemann

Bill, again, I would tell you that yes, we continue to see pressure. We're going to do what we think is appropriate to maintain access here, provide competitive pricing. And I'm not going to get into specifics about what we may or may not do on a particular contract, though.

Kathleen Valentine

And it also points out...

Bill Bonello - RBC Capital Markets, LLC, Research Division

I asked one in different ways.

Kathleen Valentine

Bill, one other comment is when you look at going back to 2010, if you recall, what also impacted our revenue per rec was the change in business mix, that's when we saw kind of the significant step down in anatomic pathology revenues, which carries a higher revenue per requisition and that decline put pressure on revenue per requisition and we also saw a step-up in drugs of abuse testing. So you had some business mix impacting revenue per rec trends back then.

Operator

Next question is from Darren Lehrich of Deutsche Bank.

Darren Lehrich - Deutsche Bank AG, Research Division

I just have a couple of things here. The first, just going to back to the organic growth that's embedded in, I guess, Q2 throughout the remainder of the year. Bob, I think you said 1%. So I just want to clarify, we can do the math, it's implied at around 1%. Are you including S.E.D. in that number? Can you just clarify what you're saying here?

Robert A. Hagemann

Yes, remember, S.E.D. obviously is included in that number, but it's relatively small. We're talking $20 million to $25 million in revenue for S.E.D. So when I talk about organic revenue growth, with or without S.E.D., it's still about 1%.

Darren Lehrich - Deutsche Bank AG, Research Division

Okay, all right. I just wanted to make double sure what you're saying there. All right, and then the next question, I guess, is just a couple of strategic ones for you. The first is I want to just get a quick update on how you're thinking about the market relative to patient service center, access points versus embedded client phlebotomists in the office. And just if there's any notable change relative to what you need to be doing in certain markets relative to the latter, which I'm assuming is, can be a little bit more costly for you to get that kind of access.

Robert A. Hagemann

Darren, I would tell you that there's no specific trend or development that we're seeing there. In each case, we evaluate what's required market-by-market and respond to that accordingly.

Darren Lehrich - Deutsche Bank AG, Research Division

Okay, and then the other question I have is just relative to your hospital strategy. We obviously saw you enter somewhat of a new market with S.E.D. and that seemed to be a logical way by buying a good hospital lab network. How is your hospital strategy evolving? Should we be expecting more joint venturing? Is there anything that you can say just updating us on the developments there, certainly against the trend that we're all seeing of physician employment?

Robert A. Hagemann

Well certainly, as we think about hospitals, they're going to continue to be important customers for us. And hospitals are going through some significant changes themselves. In many cases, they're evaluating whether or not they want to continue to be in the lab business and as we saw with S.E.D., they concluded that, that was something that was not strategic to them and that it's better left to someone that's got more experience in that area, particularly given the fact that as a hospital, I think they saw the reimbursement pressure coming, knowing that some of the pricing differentials that exist today may not exist in the future. And as such, it will be very difficult for them to maintain their margins given that their cost structure was higher than ours. I'm hopeful that we'll see more of that as we go forward. There are cases, as you know, where we do have joint ventures in certain markets. I would tell you that joint ventures are not necessarily a strategy. Again, it's something that's driven by the circumstances in that marketplace, the partner that you're talking to. But I do think that there are opportunities for us to work more closely with hospitals, whether it be lab management agreements, acquiring their outreach business, potentially joint venturing with them. But each market is a little different, each hospital thinks about the way they're going to execute their strategy a little differently. And I think we need to be flexible in each of those cases and will be. But rest assured that the hospital market is important to us, and we expect to continue growing there. A lot of our growth actually on the esoteric testing business is coming from sales to hospitals.

Darren Lehrich - Deutsche Bank AG, Research Division

Great, and then just to clarify what you've said, Bob, is it safe to say that your development pipeline, your acquisition pipeline does now include more hospital outreach lab deals?

Robert A. Hagemann

It always has, yes, whether or not includes -- it's tough to say whether or not it includes more. It's a pretty dynamic pipeline all the time. But yes, I'm hopeful that we'll see more of those opportunities. As you know, they're -- I think of them as fold-ins, we get to take a book of business, fold it into our existing infrastructure; we can do that very well. You tend to get good incremental margins on those types of things and effectively further strengthen the distribution network that you've got. So certainly to the degree that they're available, we will look at them. At this point though, I wouldn't tell you that there's a lot of them in the pipeline or any more than we would typically have. But hopefully, we'll see more as we go forward.

Operator

Next question is from Ricky Goldwasser, Morgan Stanley.

Ricky Goldwasser - Morgan Stanley, Research Division

Surya, best wishes and I can't believe it's been 10 years.

Surya N. Mohapatra

Thank you, Ricky.

Ricky Goldwasser - Morgan Stanley, Research Division

It did go by quickly. I have a couple of follow-up questions at this point. First of all on the pricing environment, just to get a better understanding of how commercial plans think about pricing, when we think about Medicare that's going to be down next year, does that automatically impact commercial rates, i.e., what percent of your commercial book prices off the Medicare benchmark?

Robert A. Hagemann

Ricky, very little of our business automatically adjusts with, very little of our commercial business automatically adjusts with changes in the Medicare fee schedule. As you know, though, it's used as a reference point in negotiating contracts. So that doesn't necessarily help us when we see Medicare reimbursement reduced, but it doesn't necessarily automatically trigger a lot of changes in our commercial contracts.

Ricky Goldwasser - Morgan Stanley, Research Division

Okay, so just to clarify, it's not as if it's priced off Medicare plus or Medicare minus?

Robert A. Hagemann

Not as a floating amount, no.

Ricky Goldwasser - Morgan Stanley, Research Division

Okay, and then secondly, on the cost cutting initiative. I know that you've provided us a lot of detail. But just so to help us in how we think about modeling going forward, what percent should we allocate to cost of goods versus SG&A this year?

Robert A. Hagemann

Yes, and Ricky, look, we've never gotten into the business of giving guidance for cost of sales and SG&A. We operate the business, then manage the operating margin. And in some cases, we spend in one area to further reduce costs in another area. But what you should expect is that both the cost of sales line and the SG&A line over time will be favorably impacted they what we're doing here.

Operator

The next question is Amanda Murphy of William Blair.

Sylvia Chao

It's actually Sylvia here for Amanda today. Just have a couple of quick follow-ups. So just wonder, is it a possibility or is it a part of your consideration that you would kind of do an early renewal with the larger national contract and take the heat this year?

Robert A. Hagemann

Well, I think we have to be responsive to what our customers are looking for, and we're always having dialogues with them and I wouldn't rule anything out in that regard. But I'm not going to specifically comment on it.

Sylvia Chao

Great, okay. So if there is any impact, it's not baked in yet the 2012 guidance?

Robert A. Hagemann

Anything that we are aware of or that we're contemplating is built into our guidance this year.

Sylvia Chao

Okay, got you. And just as a follow-up on the acquisitions. So it looks like it was becoming stronger than expected. What drove the outperformance on that segment specifically?

Robert A. Hagemann

When you say it performed better than expected...

Sylvia Chao

Just on the revenue per rec on its volume side?

Robert A. Hagemann

Well again, we tried to break out a lot of this in the prepared remarks. The acquisitions now include the benefit of S.E.D., which we did not have in previous quarters. And as you saw, both Celera and Athena were contributing in excess of 2% previously. So that's really the difference now is that we have S.E.D. in the results. And then the other thing that we pointed out was the benefit of weather in the year-over-year comparisons.

Sylvia Chao

Okay, and could you remind us if those newer acquisitions had been consolidated into Quest in our contracts?

Robert A. Hagemann

I'm sorry, can you repeat that?

Sylvia Chao

I'm sorry, if -- could you remind us if those acquisitions such as S.E.D. in our contract, have they been consolidated into Quest?

Robert A. Hagemann

S.E.D. certainly will be, yes.

Operator

All right. The next question is from Isaac Ro of Goldman Sachs.

Unknown Analyst

It's actually Justin for Isaac. First on the CapEx guidance. You guys lowered it slowly. Could you maybe talk to what was pushed out or pulled out of that at all?

Robert A. Hagemann

Yes, nothing specific. We looked at the level of spending in the first quarter and revisited the plans that we have for the remainder of the year. And all of the programs that we planned we're continuing to move forward with. It looks like some of them, though, will just get started a little later. But it will have no impact on what we expect in terms of the cost-reduction program.

Unknown Analyst

Okay. And then looking at the cost-reduction program, you guys said about 20% of it this year. Have you talked about the pacing at all, how you expect that to come through the back half of this year?

Robert A. Hagemann

We have not, and that 20% is really a run rate as we exit the year, that's how we've talked about the $500 million that -- it'll be a run rate as we exit 2014. So as you'd expect, it ramps up this year. And it ramps up more slowly than it will in '13 and '14, and '13 and '14 is really where we start to see the more significant benefits from that.

Unknown Analyst

And then lastly, looking at volumes, assuming they stay at the rough organic level that they're at now, I mean how do you guys look at the ability to extend operating margins in the out years, combining that with the $500 million reduction program?

Robert A. Hagemann

As we've indicated earlier, generally we think about needing 2% organic revenue growth for us to be able to hold margins and offset the inflationary cost that we have in our cost structure. Half of that being salaries, wages and benefits which generally going up around 3% a year. And the expansion that we're expecting now is really coming from the cost-reduction and hopefully as we get into the out years and we start to see some pickup in the market, we can see further expansion and the acceleration at that point. But the cost-reduction program will allow us to expand margins in this sort of tough market that we're in right now. And that's essentially what you see in the guidance that we put out there for 2012.

Operator

All right. Our next question is from Gary Taylor of Citigroup.

Gary P. Taylor - Citigroup Inc, Research Division

Just a couple, and both have been touched on. So just on the CapEx, Bob, you've described as a relatively small change, I guess it's almost a 10% reduction but your comment is basically that's entirely related to just timing of spend?

Robert A. Hagemann

Yes.

Gary P. Taylor - Citigroup Inc, Research Division

Okay. And on the G&A, I guess I've been trying to follow, I'm maybe a little confused about maybe some references to first quarter of '11, when you were explaining some of the spend. So maybe the way I'd like to ask the G&A, how should we be thinking about G&A on a dollar sequential basis into the 2Q?

Robert A. Hagemann

Gary, I -- we don't give that kind of guidance at this point. And yes, as I told you, we don't give it in terms of dollars or percentages for cost of sales or SG&A. And yes, I'd encourage you to think about it more as margins. As I said earlier, often some levers that we're pulling impact cost of sales or SG&A, but we see benefits show up in the other line.

Gary P. Taylor - Citigroup Inc, Research Division

Right. So just to clarify then, I kind of got lost. There was a comment where you mentioned a legal and an asset impact on the G&A line. Is there something in the 1Q G&A line that you're calling out as nonrecurring that...

Robert A. Hagemann

There's probably about $5 million in each the cost of sales line and the SG&A line this quarter that are somewhat unusual, but not big enough for us to include in the adjusted results.

Gary P. Taylor - Citigroup Inc, Research Division

Okay, and then just quickly, I just want to point out maybe for Kathleen. When I click on the PowerPoint presentation, it's only coming out as a one-pager instead of a typical 12 or 13 and a couple of other people have mentioned that to me. So...

Kathleen Valentine

Okay, thank you, I'll look at that. Yes --

Gary P. Taylor - Citigroup Inc, Research Division

Good thing to look at.

Kathleen Valentine

It is more than 1 page. Although maybe not 12, but --

Gary P. Taylor - Citigroup Inc, Research Division

I'm sure, okay.

Robert A. Hagemann

It shows what, the disclaimer?

Kathleen Valentine

It probably is. I'll take that. Thanks, Gary, for pointing that out.

Operator

All right, next question is from Gary Lieberman of Wells Fargo.

Gary Lieberman - Wells Fargo Securities, LLC, Research Division

I think you might have said it, but can you just remind me to what was the growth in drugs of abuse testing in the quarter?

Robert A. Hagemann

About 5%, consistent with what we saw in previous quarters.

Gary Lieberman - Wells Fargo Securities, LLC, Research Division

Okay. And then, is it possible for you to give us any kind of update about the progress that the existing Quest sales force has made, specifically with regards to the sales of the Athena product line?

Surya N. Mohapatra

Well, you know, Gary, first of all, as we said that we don't -- Athena and Celera, the special sales force, and there is no chain there. But the important thing is that we take some products, like SMA, and it is sold through our physician sales channel and hospital sales channels so that we are seeing more traction in SMA. And also, it's now almost 12 to 18 months since we started investing and training our salespeople in physician sales and it's difficult in the beginning, but I'm very pleased to say that we really have a stable sales force and they're trained and they are very focused on some areas like Women's Health, prescription drug monitoring, and we are seeing results.

Gary Lieberman - Wells Fargo Securities, LLC, Research Division

Okay. Is there any way to parse out how much of the growth in the, in volumes from Athena and Celera came from the Quest sales force versus the preexisting sales force?

Surya N. Mohapatra

We really don't break it down that way. And also, it's going to be very difficult because we integrate some of this business. So the way to look at it going forward, we have these 4 pillars, cancer, cardiovascular disease, infectious disease and neurology, they will have their special sales force, but we also have 2 channels, actually 3: Physicians, hospitals and international. And we want to maximize our distribution channel depending on where the products are coming from, but it's going to be difficult for us to really exactly break down how much is coming from physicians and how much is coming directly Athena.

Operator

All right, our last question is from Robert Willoughby, Bank of America Merrill Lynch.

Erin Wilson

This is Erin Wilson in for Bob today. Just one quick one. Are you anticipating any other management changes now that you have a CEO in place?

Surya N. Mohapatra

Well, I am not expecting any, but I think you have to ask Steve.

Robert A. Hagemann

I think we need to give him a chance to get here.

Surya N. Mohapatra

Well, you know in closing, I want to say again that it has been an honor and a privilege to serve as President, CEO and Chairman of Quest Diagnostics. This is truly a great company with dedicated people who always put patients first, a strong management team and a very bright future. I look forward to following its progress in the years to come. And as regards to you, ladies and gentlemen, I've always appreciated your probing questions and industry insights and I will miss our interactions. Thank you, and goodbye.

Operator

Thank you for participating in the Quest Diagnostics First Quarter Conference Call. A transcription of the prepared remarks on this call will be posted later today on the Quest Diagnostics website at www.questdiagnostics.com. A replay of the call will be accessed online at www.questdiagnostics.com/investor or by phone at (888) 673-3567 for domestic callers or (402) 220-6430 for international callers. No access code will be required. Telephone replays will be available from 10:30 a.m. Eastern Time on April 18 until midnight Eastern Time on May 18, 2012. Goodbye.

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