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Quest Diagnostics (NYSE:DGX)

Q3 2012 Earnings Call

October 17, 2012 8:30 am ET

Executives

Kathleen Valentine - Director of Investor Relations

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

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

Analysts

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Gary Lieberman - Wells Fargo Securities, LLC, Research Division

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

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

Dane Leone - Macquarie Research

Darren Lehrich - Deutsche Bank AG, Research Division

Isaac Ro - Goldman Sachs Group Inc., Research Division

Steven Valiquette - UBS Investment Bank, Research Division

Alexander Y. Draper - Raymond James & Associates, Inc., Research Division

Gary P. Taylor - Citigroup Inc, Research Division

Ricky Goldwasser - Morgan Stanley, Research Division

Jeffrey Frelick - Canaccord Genuity, Research Division

Operator

Welcome to the Quest Diagnostics Third 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 question-and-answer session that will follow, are the copyrighted property of Quest Diagnostics with all rights reserved. Any redistribution, retransmission or rebroadcast of this call in any form without the express written consent of Quest Diagnostics is strictly prohibited.

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

Kathleen Valentine

Thank you, and good morning. I'm here with Steve Rusckowski, our President 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 our future results include, but are not limited to, those described in Quest Diagnostics 2011 annual report on Form 10-K, 2012 quarterly reports on Form 10-Q and current reports on Form 8-K.

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

Now here is Steve Rusckowski.

Stephen H. Rusckowski

Thanks, Kathleen, and thanks, everyone, for joining us today. Well, during the quarter, we increased adjusted operating income and delivered strong cash flow despite continued soft revenues, thanks in large part to our accelerated Invigorate cost-reduction initiative.

In a few minutes, Bob will review the third quarter with you. But I'd like to start by giving an update on the progress we're making to define our path forward to improve our operations, restore growth and capitalize on our market leadership position.

Our 2 highest priorities are driving operational excellence and restoring growth. I'd like to share a few words about each. Let me start with operational excellence.

Our old organization was too complex, and it failed to let us take advantage of our scale and capabilities. One of my first steps since joining a few months ago has been to lead the design of a new organizational structure that will enable Quest Diagnostics to focus even more on our customer needs, speed decision-making and accelerate cost reductions.

By eliminating complexity and empowering employees, we expect we will be able to eliminate 3 management layers or approximately 400 to 600 management positions by the end of 2013. We believe this will contribute about $65 million in savings to our previously announced cost reduction goal of $500 million annual run rate savings versus 2011 as we exit 2014.

We have continued to grow the Invigorate savings each quarter. And last quarter, I said I was closely involved with Invigorate and thought we could realize more savings faster than originally anticipated.

The acceleration in savings that we've seen throughout the year does increase my confidence in our ability to achieve this goal. And as a result, we now have increased our expectations for run rate savings as we exit this year to $150 million, and Bob will give you further comments on Invigorate in a few minutes.

We look forward to sharing some of our detailed growth plans with you next month at our Investor Day. But today, we'd like to share a couple highlights with you of what we expect to do to restore growth.

First, the new organization. In addition to allowing us to aggressively drive operational excellence, it will also allow us to focus on our customers better, which will, we believe, over time enable us to restore growth. We are consolidating several sales organizations into a single commercial group, aligned under 1 new leader.

Second, in addition to organic growth, we have shared the task for an opportunity [ph] to consider value-creating fold-in acquisitions as part of our disciplined approach to capital deployment. And I'm happy to share that yesterday, we signed an agreement to partner with UMass Memorial Labs to establish a Lab of the Future in Massachusetts. We believe this transaction could become a model for the industry and an opportunity for hospitals and integrated delivery networks to find a sustainable way to participate in diagnostic testing while focusing on their core competency, taking care of patients. We believe this transaction is a good example of the kind of opportunities we will continue to evaluate.

So we remain focused on increasing shareholder returns through a combination of improving operational performance and disciplined capital deployment. Now I'd like to turn over to Bob for a detailed analysis of the numbers. Bob?

Robert A. Hagemann

Thanks, Steve. Starting with revenues. Q3 revenues of $1.9 billion reflect a decrease of 2.9% from the prior year. This compares to a decrease of about 0.5% in the underlying revenues in Q2.

Q3 comparables were more challenging, given there were just over 1% fewer business days in the quarter compared to last year and compared to the second quarter. Our clinical testing revenues, which account for over 90% of total revenues, were 2% below the prior year. Volume was about 1% below the prior year due principally to fewer business days.

Revenue per requisition was also about 1% below the prior year level but relatively unchanged from Q2.

Favorable test mix and an increased number of tests per requisition continued to offset reimbursement pressures, with the 1% year-over-year decrease, principally due to business and payor mix changes.

Recall that the year-over-year growth in revenue per requisition we reported in the early part of the year was principally due to the increased esoteric mix contributed by Athena and Celera, and we anniversaried that benefit last quarter. Drugs of Abuse Testing volumes have continued to rebound and grew about 7% in the quarter, up over 1% from the growth of the last 2 quarters.

Q3 revenues in our nonclinical testing businesses, which include risk assessment, clinical trials testing, products and health care IT, were about 10% below the prior year and contributed about 1% of the consolidated revenue decrease, with clinical trials driving the most of the decline.

As you've heard, despite reporting revenues which were below the prior year, we expanded adjusted margins in the quarter and delivered earnings comparable to the prior year. Adjusted EPS of $1.18 matched that of the prior year, and adjusted operating income at 19.1% was 80 basis points above the prior year.

Disciplined expense management and accelerated benefits from our Invigorate program were the primary drivers of our expanded margins.

Restructuring and integration costs, totaling about $45 million, reduced reported operating income as a percentage of revenues by 2.4% and reported EPS by $0.17.

Last year's third quarter included $27 million of restructuring and integration costs, which reduced reported operating income as a percentage of revenues by about 1.4% and reported EPS by $0.10.

As we discussed the last quarter, in connection with our Invigorate initiative, we have offered a voluntary retirement program to certain qualifying employees. We estimate this program will contribute approximately $40 million in annualized savings once fully implemented, which we expect by the first quarter of next year. The program will allow us to reduce the size of our workforce, reduce our average wage bill and update the skills of the workforce.

In connection with the program, I told you last quarter that we expect to record charges estimated at about $50 million over the course of the next several quarters as employees leave the workforce. A little over $20 million was incurred in Q3 and is part of the $45 million in restructuring and integration charges I referenced earlier.

As you've heard, we have taken action to accelerate some of the savings associated with our Invigorate program. As a result, we now expected to deliver approximately $150 million in run rate savings as we exit the year, up from our earlier estimate of approximately $100 million.

This represents about 30% of our $500 million goal. In addition, as you heard last quarter, we are evaluating opportunities which could potentially increase the size of the program and plan to share any updates at our November Investor Day.

An area which continues to benefit from Invigorate is billing and collections. We have consistently produced industry-leading metrics in this area but still have room to improve. Bad debt expense as a percentage of revenues improved to 3.3% in the quarter. DSOs were 46 days, up 2 days from last quarter, with most of the increase due to the timing of cash receipts, which were affected by the month end falling on a Sunday.

Cash from operations was $395 million in the quarter compared to $338 million in the prior year. Capital expenditures were $45 million in the quarter compared to $39 million a year ago. During the quarter, we repurchased 832,000 common shares at an average price of $60.12 a share for a total of $50 million, bringing the year-to-date total to $150 million.

We also reduced outstanding debt by $292 million, bringing the year-to-date total to $507 million in connection with our stated objective to delever by $500 million to $700 million this year.

Turning to 2012 guidance. Based upon our performance through the first 3 quarters and our latest view of the market, we now expect results from continuing operations before special items as follows: revenue to grow approximately 0.5%; operating income to approximate 18% of revenues; cash from operations to approximate $1.2 billion; capital expenditures to approximate $180 million; and lastly, diluted earnings per share to be between $4.45 and $4.55.

Now I'll turn it back to Steve.

Stephen H. Rusckowski

Thanks, Bob. So in closing, this quarter, we increased adjusted operating income and delivered solid cash flow despite a decline in revenues. Our new organization will allow us to aggressively drive operational excellence and improve our customer focus. This will enable us to achieve our Invigorate goal and over time, restore growth.

We do remain committed to increasing shareholder returns and improving ROIC. This includes our intention to return the majority of our free cash flow to investors upon achieving our targeted leverage ratio. Yesterday, we announced a transaction that will create value for Quest Diagnostics shareholders, our partner and the people of Massachusetts. I look forward to sharing our strategy and plans with you at our November 16th Investor Day. Now we'll be happy to take any questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Tom Gallucci of Lazard Capital.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Just a couple questions on top line if I could. You lowered your revenue expectations last quarter and again this quarter. So we see some of the results, but what do you think is different versus what you expected 6 months ago as far as top line trend?

Stephen H. Rusckowski

Well, thanks, Tom, for the question. First of all, the market continues to be what we described as soft. Even though we see a pickup in physician office visits from some of the outsourced statistics, we're not just seeing it yet in our volume. So utilization, we believe, is somewhat mixed. Second is that even though that we believe that the market is soft, the market has seen some indications that it is growing in some pockets, but we're not obviously seeing that growth. And so therefore, we actually believe our execution is not quite where we expected it to be. And specifically, we talked about narrowing the networks with payers. We still believe there's an opportunity there, but we have not seen it yet. We're still actively working inside here on getting that and also working with payers to make sure we eventually deliver it. So that's what's changed, Tom.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

On -- maybe just 2 follow-ups. On the networks, these plans that are in place, and you're just not capturing that incremental share as a result of the benefit design, or are you expecting that you're going to see changes that you haven't seen yet in benefit design?

Stephen H. Rusckowski

No, these are plans in place. We just haven't gotten what we expected out of those plans yet.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Okay. And then overall market share, do you have great data on that? Can you give any good insight on what your share is doing, relatively speaking? And also, maybe specifically relative to hospitals as well, where my sense is maybe they've been taking some more in-house as they've been hiring doctors?

Stephen H. Rusckowski

Well, first of all, we do believe that, that trend in the hospital marketplace is happening. So they are picking up a larger piece of the market. It is hard for us to give visibility on market share. And at our November 16th Investor Day, we'll give you a lot more detail on specifically what's happening in this market and what we think our performance has been in the past and what we think the opportunity is going forward. But at this point, we don't have specifics.

Operator

Our next question comes from Kevin Ellich of Piper Jaffray.

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Just wondering if you could provide any more color on the UMass acquisition? Was the valuation paid in line with historical multiples? And then also, what are you seeing in the market? Are there other deals that you're excited about, similar size or any color would be helpful.

Stephen H. Rusckowski

Yes, let me ask Bob to take the question on specifics of the transaction. Bob?

Robert A. Hagemann

Yes, Kevin, as we indicated in the press release, we expect this to contribute about 1% to revenues next year for us. And to give you some sense as to valuation, the valuation was less than $100 million. And we would expect that, that sort of valuation is consistent with the types that we've seen for future fold-in acquisitions. This is one that we think is in that sweet spot that we've spoken about. Fold-in acquisition, we've got a good history of executing well against these, and we're very excited about the opportunity to work with UMass in the Massachusetts marketplace.

Gary Lieberman - Wells Fargo Securities, LLC, Research Division

Got it. And then, Bob, since I have you, with revenue per requisition being down about 1%, I don't know if you -- I missed it in your prepared remarks, what was the primary driver behind that? I know there's fewer days and whatnot. But...

Robert A. Hagemann

Yes, Kevin, it's down about 1% from the prior year, although it's relatively stable with the level that we had in Q2. Yes, as we've mentioned before, we continue to experience reimbursement pressure, but we're effectively offsetting that with increases or improvements in test mix and increases in the number of tests per requisition. And what you saw driving most of the year-over-year change this quarter is really the business mix. We continued to see strong growth in Drugs of Abuse Testing, which as you know, has much lower reimbursement rates than average. And unfortunately, we're continuing to see pressure on the Anatomic Pathology side, which carries higher reimbursement rates. So it's really the business mix that's driving the year-over-year change right now.

Gary Lieberman - Wells Fargo Securities, LLC, Research Division

Got it. And then, 1 last question for Steve. You mentioned narrower networks and then recently, we found out that Tennessee's Medicaid program selected you as the exclusive testing provider. Wondering if you're seeing anything else on the horizon with some of the other states or payers moving to low-cost provider in the market?

Stephen H. Rusckowski

Yes, first of all, Kevin, thank you for that. And we continue to work with all the payers, and we believe having access to as many payers as possible in our business is important. But as you know, we don't provide specifics on relationships with payers but we continue to be aggressively managing our approach to payers going forward. I spoke in my prepared remarks about a new organizational structure. And a key part of that structure is to pull together multiple sales forces within the company. But part of that is to make sure that we emphasize the importance of our payer relationships and health plans going forward. So it's an important of, we believe, our continuing to focus on improving how to go to market. They're an important part of our go-to-market plan, and we need to do a better job than we've done in the past.

Operator

Our next question comes from Amanda Murphy of William Blair.

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

I just had a follow-up question in terms of the hospital segment. So it seems like if you look over a long period of time, the market share of the hospital labs has remained pretty constant between the 2 dynamics of hospital buying providers and lab buying outreach programs. I'm just curious if you were to look over the long term here, especially under the reform, how do you expect those market share dynamics to change? Is the pendulum kind of shifting back to the hospitals at this point? Or is it still pretty constant between the 2 competing dynamics?

Stephen H. Rusckowski

Yes, thanks, Amanda. Well, first of all, I think there's another dynamic and that is to some extent related to reform, and that is hospital systems buying physicians. So we believe 65% of physicians today work for hospital systems. It's a larger percentage of specialists and a lower percentage of primary care, but the percentage of primary care will increase. And as they bring more physicians into their network, we believe this is affecting the dynamic of laboratory services and where that work is performed. We actually believe because of this dynamic, there's been a shift in the market into the hospital side of the equation. Our question mark as we go forward is, is it sustainable? And actually, this transaction we just announced today with UMass I think is an indication that it's not quite clear that all think it's best for hospital systems to be in the laboratory outreach business. So we're watching it carefully. The question earlier was, is there a dynamic that there's more hospitals interested in this type of transaction? There is an increase in activity of hospital CEOs debating what the best answer is for the laboratory services, and we're engaged in those conversations. So the dynamic in the industry is changing, and some of that's related to health care reform, but some of it's related to what's happening with integrated delivery networks.

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

Got it. And then, I know this is not really related to outreach, but have you seen any effect from the TC Grandfather situation on your business at this point? And also, just not related, but there's been noise around Anatomic Pathology codes and what they might be doing with that reimbursement? Anything there that you might highlight in terms of impact?

Stephen H. Rusckowski

Kathleen?

Kathleen Valentine

Yes, Amanda, it's the -- we've seen very little, if any, impact from the TC Grandfather change.

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

Okay. And what about potential changes to the -- some of the common AP codes?

Kathleen Valentine

No, I mean, we haven't seen anything yet. I mean, I know they're contemplating and expecting some changes on the 88305. We haven't seen what that change is yet. So we haven't seen any impact in terms of our volumes related to that.

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

Is there a way to quantify how much is 88305 of your volume?

Kathleen Valentine

Well, we don't provide details on specific test volumes.

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

Okay. And then last one for Steve, just at a high level here. So obviously, you've done a great job with the Invigorate and the cost restructure side. But I wanted to dive a little deeper into the comments you made about how that could translate into increased customer focus and top line growth? I'm just curious, it's not even been there for a few months. How do you look at the top line side of the equation?

Stephen H. Rusckowski

Sure, absolutely. Well, first of all, as you would expect, our Invigorate goal is primarily around cost, and we're encouraged by the results that we've seen so far. And therefore, we've increased our expectation for this year in that regard. But as you know, driving operational excellence is not just about cost, it's affecting the quality of the operation. And so we believe in addition to improving our cost position, we also can improve our service levels. So hand-in-hand with our improvements in costs, we expect that our service levels will improve as well. And so in parallel with all the costs initiatives, we're making sure that we don't deteriorate our service level performance metrics, how quickly we respond to phone calls, how our customer satisfaction scores are going in our patient service centers, what type of response time or turnaround time we have for specimens back to the physician. All those are quite important, and we believe we can improve quality while at the same time reducing our cost structure. And when we do that, we believe that will affect our customer focus and will affect restoring growth.

Operator

Our next question comes from Lisa Gill of JP Morgan.

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

Just to follow up on a couple of questions that have already been asked. I'm just really curious, Steve, as to how you're thinking about reform, should we have Obamacare go into place around lab? And is this the idea around UMass and other deals that you really believe that over time, you're going to see the hospital and the physician bundling and others around lab costs? How should we start to think about that over the next couple of years?

Stephen H. Rusckowski

Well, as you know, Lisa, there's a lot of uncertainty around the environment in general and specifically what's going to happen with health care going forward. As you know, we're in the middle of the election and there's a lot of questions in Washington what will happen over time. Well, first of all, there is a sense that irregardless of who gets into office, that there's some fundamentals of the Affordable Care Act that will be retained. There is a sense that there will be more lives in the system with different insurance options, and we think that's good for this industry. We know the demographics, those demographics have been with us for some time, and those won't change. And so therefore, with the aging population, we believe there will be an opportunity. And also people still believe in early detection and wellness programs, which is good for this industry. But over time, the question is what will happen with all the different payment movement types within the system and what happens to the individual states. And there's a lot of uncertainty, and last quarter, we shared that with you. So it's difficult for us to predict. We do believe overall, the Affordable Care Act is positive for this industry, but the specifics of how that will play out are still uncertain at this time.

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

One of the other things we've heard at a recent conference that I think you spoke at, Steve, was around formulary development around clinical laboratories. Are you starting to see that take hold? Or do you think that we're in the very early stages of that? And if we do start to move more towards formularies around clinical lab testing, is that a positive or a negative for Quest?

Stephen H. Rusckowski

Yes, first of all, it's just in its early days, and it's hard to indicate or hard to predict will it be a positive or negative at this point. So but it's starting to get some traction, but it's early.

Operator

Our next question comes from Dane Leone from Macquarie.

Dane Leone - Macquarie Research

Just 2 follow-ups on the top line, line of questioning. One, was there -- were there any acquisitions baked into the volume numbers or in volume comps that you reported? And...

Stephen H. Rusckowski

Let me give it to Bob to answer that.

Robert A. Hagemann

Essentially, Dane, what you saw is organic revenue year-over-year.

Dane Leone - Macquarie Research

Okay. And then, just kind of a qualitative assessment on the growth, is there an expectation baked into the revised guidance, and kind of how we should think of revenue growth over the next couple quarters in the context of some of the management changes that were just announced being kind of mildly disruptive to the ability of the organization to grow sales and the focus on customers during this transitional period?

Stephen H. Rusckowski

Yes, get me get Bob to give you some qualitative response to the fourth quarter, what that means. And then I'll take the question on -- answer the question about organizational effect on the business going forward. Bob?

Robert A. Hagemann

Yes. There's nothing specific baked into our guidance relative to any sort of disruption as a result of the organizational change. In fact, if you look at the third quarter revenue growth and you adjust it for the change or the difference in business days, the implied revenue growth in Q4 is pretty consistent with that.

Stephen H. Rusckowski

Okay. And specific to organization, we have essentially functionalized the largest part of our company, and we'll be using a term of diagnostic information services. And as we have shared, we brought in a new sales leader. The reason for that is we want to bring sales excellence to this company. Specifically, underneath the new sales leader, and his name is Everett Cunningham, he joins us from Pfizer. He's a seasoned sales executive with over 20 years of experience in a variety of roles. But we want to consolidate all our sales forces and have 1 consolidated view for Quest Diagnostics into the marketplace. Much of this change, much of this change is related to management. And we're reemphasizing to our sales reps, people who are actually calling our customers and driving volume, that their account assignments will not change and -- for the remainder of this year and for the plan going forward. This is about management reorganization and not specific to what they do on a day-to-day basis. So we're reemphasizing that with this transition. And we're meeting every other day as an operational team to make sure that anything that comes up in our organization, we're on top of. So we're on top of this closely to make sure we don't miss a beat in the fourth quarter. But I wanted to share that with you, and then when we get together in November at our Investor Day, we'll share more specifics of what we plan of doing structurally and operationally to be able to restore growth. And you'll get an opportunity to meet Everett Cunningham at that session.

Operator

Our next question comes from Gary Lieberman of Wells Fargo.

Gary Lieberman - Wells Fargo Securities, LLC, Research Division

Steve, in your comments, you talked about the narrow networks and that you haven't gotten, I guess, the volumes that you expected to get. Can you talk more about that? Is it simply a leakage issue? And if it is, it seems like the plans in the past have been somewhat hesitant to crack the whip with docs in order to prevent the leakage, so is there anything that's going to change to, you think, stop it?

Stephen H. Rusckowski

Yes, thanks, Gary, for the question. It is a leakage issue, and specifically the plans are aligned with us on trying to drive a narrower network. Obviously, if they're incented to do it, we would be incented to do it as well. And yes, they have been reluctant in the past, you call it cracking the whip with physicians. But let me share with you, they've already taken some actions to be able to put some of these physicians that we believe there's an opportunity on notice. And we believe they will be acting more aggressively going forward because it serves our interests well and their interests to do this. So we again are not giving up on it. We believe there's still an opportunity for us going forward, there's an opportunity with the health plans. And we still believe going forward, we'll work on this real time to make it a reality.

Gary Lieberman - Wells Fargo Securities, LLC, Research Division

Is there anything in the contracts, in it that you have with those more narrow networks that if you don't see the volume increases, and it's not anything that you guys did, does that impact price? Or is there really no way to adjust for that?

Stephen H. Rusckowski

No, it's just fundamentally, operationally getting to happen what we planned on happening. And we plan on some things with health plans. We've worked through those. We're reevaluating those actions because they haven't been as successful as we expect that they would be, and so we're putting together a new and improved plan, if you will, plan-by-plan to get the growth we expect.

Operator

Darren Lehrich of Deutsche Bank.

Darren Lehrich - Deutsche Bank AG, Research Division

So I wanted to just go back to the UMass deal, and you've described in the press release that you plan to build a Lab of the future. I guess, I would want to get your vision of how different that Lab of the Future is from the current operating model, and maybe give us a little flavor for what your plans are there.

Stephen H. Rusckowski

Yes, well, thanks, Darren. This is an opportunity obviously to work with a large health system in Central Massachusetts and bring in some volume to our company. But we're also taking it as an opportunity to continue to invest in our business going forward. And we have a number of operations in the Northeast. We see this as an opportunity to basically architect and then eventually build and equip that organization with a different workflow than we currently have in some of our labs. Also invest in automation and apply the principles that we applied at some of our best labs around our network. And so we're very encouraged that we can take the best learnings that we have throughout our network of labs throughout the United States and apply it to this effort with UMass.

Darren Lehrich - Deutsche Bank AG, Research Division

And is this structure a joint venture in any way? Or is it a complete 100% ownership?

Robert A. Hagemann

Well, at this point, this is an outright purchase of the outreach business of UMass. And over time, we expect that there'll be a shared financial interest in the new entity. But yes, the transaction, as it stands today, is an outright acquisition of the outreach business.

Darren Lehrich - Deutsche Bank AG, Research Division

Okay. And then -- that's helpful. I'm sure we'll get a little bit more into this in November when we meet. My question on just the revenue side of the equation relates to some anticipated changes we're all looking at for in the short run on the Molecular Diagnostics program. And I guess, I wanted to just hear from you what your expectation is in terms of how quickly you think private payers will pivot to whatever that new pricing model is?

Stephen H. Rusckowski

Bob, reactions to new pricing in our forward-looking guidance?

Robert A. Hagemann

Look, as we've seen historically, oftentimes, the commercial payers follow what the government does. And sometimes, it's faster. Sometimes, it's slower. We expect that they're all going to be very deliberate, though, with any changes that take place here so that we get this right. It's too important not to get it right. And it's still, as unfortunately with many things, early days and a little too early to tell what it could mean.

Darren Lehrich - Deutsche Bank AG, Research Division

Yes. You mentioned that your trials business experienced some pressure in the quarter. And I guess, I'd be curious to hear a little bit more about that. You have a key customer in that business. Did that change, or is it just the typical starts and stops that occur in the trials business?

Stephen H. Rusckowski

Well, first of all, as you know, the pharma industry is slow. There's less investment going on today than there once was. And that's affecting our business. That's the best way to describe it. So there's some of your typical starts and stops, but there is an industry slowdown, if you will, with trials in general that's affecting our clinical trials business. And that had a substantial effect on our growth rate this quarter.

Darren Lehrich - Deutsche Bank AG, Research Division

Okay. And my last question is just you talked about returning capital, and I'd be curious to get your thoughts on -- your view on the Celera royalty portfolio, which I think many of us in the market think has significant value to Quest. How should we be thinking about that portfolio, and how you expect to hold it or not over the long term?

Stephen H. Rusckowski

Bob, do you want to handle that?

Robert A. Hagemann

Darren, look, this is one that obviously we've gotten a lot of questions on. We're continuing to evaluate all of our options with respect to these assets. And what we want to do obviously is what's in the best interest of the Quest shareholders. So more to come on that. We're still in the process of evaluating the different options that we've got.

Operator

Our next question comes from Isaac Ro of Goldman Sachs.

Isaac Ro - Goldman Sachs Group Inc., Research Division

Steve, I wanted to maybe put your previous comments on the market environment and market share dynamic in context with Invigorate. And specifically, just wondering how you expect to sort of reclaim market share while also cutting costs. We haven't seen a lot of that as a precedent across the health care system. And maybe specifically, if you could touch on the number or percentage of mid-level management cuts that you mentioned that are actually customer-facing positions?

Stephen H. Rusckowski

Yes, sure. Well, first of all, I do believe that we can take cost out of the business, and we've indicated that before. And some of the cost we'll take out has no impact on our customer-facing activities. We shared in the past, let me give you an example, as we do believe we can do better job of procurement, buying supplies and the products that we use for operations will have no impact on customer-facing activities. We're looking at our whole administrative cost structure, clearly, we need less of administration so we can put more energy into those activities that will generate growth. So this is another example of where we can take cost out without affecting our top line. As far as the change organizationally, if you look at the organizational structure that we had, we have shared in our announcement about this that we believe we can take out 3 management layers. In the past, the structure that we had between myself and people that are selling or people that are doing blood draws or people working in our laboratories, in some cases, we had as many as 10 layers. And so, we believe that if you look at spans-and-layers and the opportunity to simplify the organization to make sure that we can be faster with decision-making and at the same time, be able to be much more aligned or around our 2 primary goals, which is driving operational excellence and restoring growth, this will help us. These cost reduction activities are all around management, all around management. So I would argue these are the people in the back, so the people that are doing the work, people that are selling, people that are doing blood draws, people that are dealing with the customers every day. And we believe that by reducing management and simplifying organizational structure, it'll impact and help us accelerate our ability to achieve our operational excellence goals and at the same time, by focusing more entirely as a company on our customer, it'll help us restore growth.

Robert A. Hagemann

And Isaac, just to build on something that Steve said before about lower costs and improve service levels going hand-in-hand. We clearly think there's an opportunity to improve service levels as we reduce costs. A great example is the fact that we touch specimens, we touch bills over and over again, a lot of manual work is done here. And as we increase electronic connectivity, which is one of the elements of the Invigorate program, we take that waste out of the system and at the same time, we improve the service levels for customers. So that's a good example of how we can improve service levels and reduce costs at the same time.

Stephen H. Rusckowski

And Isaac, let me just say 1 other comment and that is, we do believe as we go through our plan, and you'll see some of this at our Investor Day, that we will become more efficient. And we're looking at all our business, all our operations and looking at our resource allocation and where we invest to make sure we're putting an appropriate investment in terms of what we need to do to improve operational excellence. So truing up our operations, making sure we put in place best-in-class information systems and processes. We talked about the Lab of the Future at UMass. But also, we're looking at a go-to market organization to make sure we're putting the right resources in that organization. And we think actually our Invigorate program will give us some financial capacity, if you will, to make some of those investments as well. So we're looking at all that to make sure we're properly balanced to accomplish what we say we can accomplish by improving our operations and restoring growth at the same time.

Operator

Our next question comes from Steven Valiquette of UBS.

Steven Valiquette - UBS Investment Bank, Research Division

So one question I have -- this was touched on a couple times now, but just to follow up further on the press release from last week on the organizational structure changes. And I guess, I'm a little surprised that with the company already completing some pretty comprehensive cost-cutting programs over the past several years, I guess I'm surprised there's still 3 layers of management to still cut out of the infrastructure. So I'm just curious, this must have come up in some of the internal discussions. I'm just trying to get maybe more flavor for why these layers were not eliminated in the prior rounds of cost cutting. There must have been some risk in doing this. I'm trying to figure out why this, I guess, so obvious to do it now. So I guess that's the first question.

Stephen H. Rusckowski

Yes. Well, thank you for that. Well, I can't say much about the past. I do understand why the structure was here, and from the -- going forward, we believe it's not the right structure for us with our 2 primary goals around operational excellence and restoring growth. What we announced in the organizational change is essentially disbanding the line of business structure throughout the company for the Diagnostic Information Services business. This will allow us to simplify the organization and take out some management positions. And fundamentally, it'll allow us to take advantage of our scale and capabilities operationally. So we're going to bring together all our operational capabilities underneath 1 leader, that person is John Haydon. John will be joining us actually from Philips. I've worked with John in the past, actually brought him into Philips about 3 years ago. He has the absolute best capabilities that we could find for this job. We did an external search. We talked to a number of individuals. I personally was engaged in this and talked to over a dozen people. We brought them through the management team, and we spent time to make sure we had the best possible person we could find. So under John's leadership, we believe we can consolidate, if you will, all our operational activities; think about the full value chain, from specimen to eventual cash; the organization and by thinking about it holistically as a company, we could take the next tranche of improvement, if you will, for this company. So we think it is the right structure going forward to be able to support the goals that we have in Invigorate and over time, as we say, restore growth.

Steven Valiquette - UBS Investment Bank, Research Division

Okay. And just a quick follow-up on the code stocking issue just for a second. This bulletin went out from CMS on September 1 where CMS is now saying that the Medicare carriers themselves, which are owned by the commercial payers like WellPoint, Cigna, Blues Plans, et cetera, these are the guys that are going to be determining these new rates for these 100 or so molecular tests. So I guess, I'm just trying to get some color from you guys. How common is it for the commercial payers or entities owned by commercial payers to have a major say in what the rates are going to be in terms of reimbursement to the lab providers? And does this make you on the margin a little more nervous about these rates are going to be coming out, or is this maybe a little more routine than some of us may believe? Some color on that would be helpful as well.

Stephen H. Rusckowski

Kathleen, you want to handle that?

Kathleen Valentine

Sure. Steve, the CMS is charged with providing the direction and the guidance on how the new codes and the reimbursement for these new codes should be done. And as you know, kind of what's proposed is sort of a gap-fill approach. There are a lot of questions that we in the industry have that we've put to CMS in terms of how that will be done and the timeframe with which to do it. I don't think it's all that common that they typically give the commercial payers, the individual payers, kind of the discretion to set reimbursement. But there are a lot of questions that the industry is asking, and centered -- starting with what the process is, to your point, in terms of who is -- the steps to take in terms of setting that reimbursement and also concerns around the timeframe with which to do it in terms of right now it's slated to go into effect in the beginning of '13. So there's a lot to be -- still be sorted out. We are working with industry through the trade association...

Stephen H. Rusckowski

And taking the leadership role.

Kathleen Valentine

Absolutely. And looking to get CMS to provide more specifics and instruction on exactly how to do that because we certainly -- we don't want it to be a disparate sort of approach. We want it to be thoughtful and want the industry's best interests protected through the process.

Operator

Our next question comes from Sandy Draper from Raymond James.

Alexander Y. Draper - Raymond James & Associates, Inc., Research Division

Just 2 questions. First, maybe just talk a little bit on the charges, obviously, it's sort of ongoing process. Do you have a target date with the -- with Invigorate can be going on for a while, in which you would expect the charges to stop and we'll get sort of a clean GAAP quarter? Or should we expect at least for most of 2013 to continue to see quarterly charges?

Stephen H. Rusckowski

Yes, Bob?

Robert A. Hagemann

Yes, Sandy, as you know, the program that we've defined to date runs through the end of 2014. We've put some estimates out there as to what the charges will be over the life of that program. With the added amount of charges we expect from the management reorganization, the totals now are between $115 million to $195 million over the course of that period. And the biggest chunk of that is in employee separation costs, a large portion of which we've incurred to date. But you should expect that we'll continue to see charges over the next several quarters at a minimum, probably in some cases, stretching into 2014. As we said earlier, the voluntary severance or the voluntary retirement program is going to result in charges over the next several quarters as employees leave the workforce.

Alexander Y. Draper - Raymond James & Associates, Inc., Research Division

Okay. And those are all pretty much cash charges, correct?

Robert A. Hagemann

Most of the charges will be cash charges. There will be some asset write-downs and the like as we start to restructure the testing network. But the majority of the charges are going to be cash charges.

Alexander Y. Draper - Raymond James & Associates, Inc., Research Division

Okay, great. And then just 1 follow-up. I know a lot of people have asked about the pricing environment. As I sort of think about it and summarizing what you're saying, Bob, on the positive side, you're getting more tests per session and you continue to see the esoteric mix benefiting. On the negative side, you've got continued pressures in pathology, commercial and government payers pricing pressure there. I guess my question is, one other thing that we're hearing about is the, what I would say, commoditization of esoteric testing whereas historically, you might have a 3- to 5-year window for sort of premium pricing, that window seems to be shortening maybe down to a 1- to 2-year, I'd say. Are you guys seeing that, and how do you factor that in? And then when you think longer term, if these trends persist, are we in an environment where flat pricing is maybe a best case scenario or maybe the negative? Or do you think longer term, there are things that you can do to actually eventually get pricing to actually go back on the positive side?

Robert A. Hagemann

Yes, just on some of those. Yes, let's talk about first the timeframe and the migration of esoteric to routine. I'm not sure that we've necessarily witnessed a shortening of that. As you do know, though, most tests, and in fact, we hope that tests that start out as esoteric will ultimately become routine because that means the utilization ramps up and as you know, as we go through that lifecycle of a test, the revenues ramp up, the margin percent probably comes down as reimbursement comes down, costs also come down, margin dollars grow over time, so that's a good thing as we see utilization increase. And we expect that as we look ahead, the pipeline of new tests will continue to be very robust. So we're expecting that test per requisition, test mix will continue to favorably impact revenue per requisition for us. But as you know, things that do start out as esoteric over time migrate to routine, but we haven't seen necessarily an acceleration of that trend. It takes a while for physicians to change behaviors and adopt things. I mean, we have some evidence that says that it takes between 6 and 8 years for a test to be fully adopted and utilized. So I'm not sure I see anything that's necessarily going to dramatically accelerate that at this point.

Operator

Our next question comes from Gary Taylor of Citigroup.

Gary P. Taylor - Citigroup Inc, Research Division

Most of my question's answered, just had 2. First, when you look at 2013 estimates, the Street is anticipating a little less than 3% revenue growth, yet your revenue growth has been decelerating this year, down almost 3% this quarter. Is it sensible that some of the initiatives you've put in place could actually get revenue to grow in 2013? Or as we anniversary this deceleration in the back half, is that less likely in that timeframe?

Stephen H. Rusckowski

Bob, you want to...

Robert A. Hagemann

Yes, Gary. You're clearly going to hear a lot more about our plans at the Investor Day in November. And just to set expectations, though, we're not anticipating providing 2013 guidance there. We're certainly going to talk about our plans in great detail and hopefully, get you very comfortable with what we expect to accomplish with them. But we'll be giving 2013 guidance in connection with our year-end earnings call in January.

Gary P. Taylor - Citigroup Inc, Research Division

Okay. Second and last question, just going to capital deployment. Steve, I know that the previous CEO had established that the majority of free cash flow would be turned to shareholders, you've reiterated that commitment today. When we'd look at the first 9 months of the year, I think 34% of the free cash flow generation has been returned via share repurchase and the existing dividend. So assuming that the majority means some number greater than 50%, on that front, how quickly do you expect to move to a much higher payout ratio or accelerated share repurchase?

Stephen H. Rusckowski

Yes. So let me start with just reiterating what we have said, and we continue to stand by our word that it is our intention to return the majority of our free cash flow to investors and then we are going to achieve our targeted leverage ratio. That's point #1. Point #2 is we will have the Investor Day, and we'll be sharing more insight into capital deployment specifically going forward, and we look forward to having that conversation with you then. So Bob, would you like to share…

Robert A. Hagemann

And Gary, just to reiterate what we said earlier, we said, return the majority of free cash flow to investors after achieving our targeted leverage ratio, which we indicated would require us to pay down between $500 million to $700 million of debt this year. We're almost there. We've paid down $500 million year-to-date, so it implies that there's not much more to go. And by the end of this year, we'll have the debt level where we're comfortable. And then, we certainly have the flexibility that we want to return the majority of free cash flow to investors beginning in 2013. But we made it very clear that, that's after we achieve targeted leverage ratios.

Operator

Our next question comes from Ricky Goldwasser of Morgan Stanley.

Ricky Goldwasser - Morgan Stanley, Research Division

Have a couple of questions here. Steve, there's obviously a lot of uncertainty around consolidation of physician offices and ACOs and health care reform. But can you share with us what's been your experience with the pioneering ACOs that have been doing this for a year or 2, this could be a proxy for what we could expect in the future?

Stephen H. Rusckowski

Yes, sure. Well, thanks for the question. As you have said, Ricky, there's a lot of change going on in health care, and probably the biggest change, fundamentally, in terms of provision of health care is around hospital systems buying physician practices. And that is a big change, and I made some comments about that earlier today that it is affecting, at least in the short run, with some of the ancillary services and where that work is directed because of their ownership of those physicians. You mentioned ACOs, and as you know, ACOs are a part of the Affordable Care Act, and there are a lot of these pioneer organizations. And some portion of those organizations are around hospital systems, but some portion of those organizations are actually around physician groups. And we are deeply engaged with many of these organizations because also the health plans are quite interested in engaging as well because the model in the short run is a fee for service model. But in the future, it is anticipated that there will be more of a capitated payment reimbursement model, which will fundamentally change how health care is paid for in this country. We believe that, that obviously will take some time because it's complicated, as you know. But we're in active conversations with payers, with providers both on the physician side, as well as hospital systems. And frankly, you see one ACO, you see 1 pioneer ACO, you see 1 ACO, 1 pioneer ACO. Everyone has a different approach, everyone is thinking through this and everyone is anticipating that it's here to say, but it's not quite sure at this point to how we will eventually merge into some more standardized model of how they'll operate. So a lot of question marks, a lot of uncertainties, a lot of work in play right now, and we're right in the middle of it.

Ricky Goldwasser - Morgan Stanley, Research Division

Okay. And then something that is more in your control, you highlighted that the cost saving run rate is now at $150 million, I think, versus the early expectation of $100 million run rate for the year.

Stephen H. Rusckowski

Yes, that's correct.

Robert A. Hagemann

As we exit this year.

Ricky Goldwasser - Morgan Stanley, Research Division

As you exit, yes. So can you updated us as to what was your run rate is off this third quarter? And then, so we can just understand also the offset as we build our model, should we assume that just ongoing expense grow with CPI, and are there any additional costs that you need to take on to accommodate the potential incremental volumes that will be associated with the Affordable Care Act assuming that we see implementation?

Robert A. Hagemann

Yes, Ricky, this is Bob. Let me take the latter part of the question first, and that is, the cost associated with incremental volumes. Clearly, what we're doing with the Invigorate program is reducing costs across-the-board, both fixed costs and variable costs. So as we see incremental volumes come into the network as a result of health care reform and the like and our actions as well, we expect that they're going to deliver incremental profit greater than we would have otherwise had. So we're feeling very good about what that can ultimately deliver. With respect to what the run rate is at the end of any given quarter or how much of Invigorate savings is in any one given quarter, we're trying to stay away from getting into that level of detail. I think the best way for you to measure how we're proceeding and how we're progressing with the program is looking at what's happening with margins, and I think we've demonstrated that we've had some good uplift there this quarter. Obviously, we're seeing benefits from the Invigorate program. As you know, I think I've spoken about in the past, generally, we've got about $130 million of inflation that we need to give up or need to cover every year. Roughly $3 billion salaries, wages and benefits, we're seeing sort of 3% average inflation on that historically. And then, the other $3 billion in costs inflates in the range of 1% to 1.5% a year. So that's one of the first things that we need to offset with the Invigorate program before we can get some margin expansion. And obviously, we're starting to see that.

Stephen H. Rusckowski

Ricky, let me just add, in my prepared remarks, what we did share is that we are seeing Invigorate savings each quarter increase. And because of this acceleration in savings, it gives us more confidence in fact, we're going to be able exceed the $100 million exit run rate this year, and we've moved the number up to $150 million. So and I shared in my remarks that I am presently engaged in this and I spent a lot of time on this in my first 5 months. I'm encouraged because as you know, with these programs, it takes some time to get traction. We're seeing that traction quarter-on-quarter sequentially. We're seeing improvement, and that is giving us confidence that we can exceed our goal for this year, and we're well on track for the goals for the program.

Ricky Goldwasser - Morgan Stanley, Research Division

And based on our back of the envelope calculation, we get to around $100 million in run rate as of this quarter, so we're definitely seeing this sequential improvement that you're talking about. I was just trying to see whether we're in the ballpark.

Stephen H. Rusckowski

Understood. Thank you.

Operator

Our next question comes from Jeff Frelick of Canaccord.

Jeffrey Frelick - Canaccord Genuity, Research Division

Just 2 quick questions on the UMass Medical announcement. Not sure of your market share in the New England area, but I think you do have a solid presence. Any concerns there with FTC weighing in on the UMass Medical acquisition? And then just kind of second point to that, can you characterize their test mix, does it -- is it that obvious that you can convert a lot of your specialty in esoteric testing into this new entity?

Stephen H. Rusckowski

Bob, why don't you talk about when we expect to complete this transaction?

Robert A. Hagemann

Yes, the transaction is obviously subject to regulatory review. We don't expect that's going to be an issue. And we're anticipating the transaction to close within the next 90 days or so. Relative to test mix and the like, yes, the outreach business that we see there is pretty consistent with the sort of test mix that we have in our operations in Massachusetts. But we do believe there's an opportunity to bring some of the testing capabilities that we have, some of the esoteric testing capabilities we have more broadly to that marketplace now.

Stephen H. Rusckowski

Let me just add to that. We actually believe this will be a value-creating opportunity for our shareholders. We believe that it will be accretive to our earnings in 2014. We believe it will be accretive to our projected ROIC in 2015. And let me share with you that as an organization, we are putting in place the operating plan and the integration plan to make this a real success because we believe this can be potentially a model of future opportunities with integrated delivery networks. So we're very optimistic about the opportunity to build shareholder value, and we're going to go after it.

Operator

Our last question comes from Kevin Ellich of Piper Jaffray.

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Just 1 quick follow-up. Now that Palmetto's Molecular Diagnostics program has been in effect since either May or June, just wondering if you've seen any impact, one way or another, on either reimbursement or claims processing time? Anything like that?

Stephen H. Rusckowski

Kevin, nothing significant at this point. There are still obviously some things that we're trying to work through with them, get some clarity on a number of things and in some cases, maybe change some perspectives that they have. But this I would expect is part of the normal process of going through this significant a change.

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Okay. So really no big expectations on changes for your reimbursement with that region, J1?

Robert A. Hagemann

No, nothing material at this point.

Operator

Thank you for participating in Quest Diagnostics Third Quarter Conference Call. A transcript of prepared remarks on this call will be posted later today on Quest Diagnostics' website at www.questdiagnostics.com. A replay of the call may be accessed online at www.questdiagnostics.com/investor or by phone at (888) 673-3567 for domestic callers or (402) 220-6430 for international callers. No access code will be required. Telephone replays will be available from 10:30 a.m. Eastern Time on October 17 until midnight Eastern Time, on November 17, 2012. Goodbye.

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