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Welcome to the Quest Diagnostics First Quarter 2019 Conference Call. At the request of the company, this call is being recorded. The entire contents of this 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 written consent of Quest Diagnostics is strictly prohibited.
Now I would like to introduce Shawn Bevec, Vice President of Investor Relations for Quest Diagnostics. Go ahead, please.
Thank you, and good morning. I’m here with Steve Rusckowski, our Chairman, President and Chief Executive Officer; and Mark Guinan, our Chief Financial Officer.
During this call, we may make forward-looking statements and we’ll discuss non-GAAP measures. We provide a reconciliation of non-GAAP measures to comparable GAAP measures in the tables to our earnings press release. 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 our most recent annual report on Form 10-K and subsequently filed quarterly reports on Form 10-Q and current reports on Form 8-K.
For this call, references to reported EPS refer to reported diluted EPS, and references to adjusted EPS refer to adjusted diluted EPS, excluding amortization expense, references to adjusted operating income for all periods now excludes amortization expense. Finally, growth rates associated with our long-term outlook projections including total revenue growth, revenue growth from acquisitions, organic revenue growth and adjusted earnings growth, are compound annual growth rates.
Now, here is Steve Rusckowski.
Thanks, Shawn, and thanks everyone for joining us today. Well, this morning, I’ll discuss the first quarter and review progress on our two-point strategy. And then Mark will provide more detail on the results.
Well we’re off to a good start in 2019; for the first quarter, we grew revenues despite one less revenue day and significant reimbursement pressure. Reported EPS was $1.20, down 5% from the same period of 2019. Adjusted EPS was $1.40, down 8%. We’re pleased with our revenue and adjusted EPS results given the expectations we shared with you in mid-February. Volume growth was very strong at 3.6%, so Quest is well positioned in 2019 to grow share and deliver revenue growth.
Performance in the quarter reflects volume growth from expanded network access, acquisitions, improving performance in our hospital reference business, and favorable weather. We’ve made progress in the quarter despite significant reimbursement pressure and higher patient concessions.
As we shared before, Quest is poised for growth based on three fundamental changes in the marketplace. First, PAMA driven reimbursement pressure is a catalyst for structural change. Reimbursement experience in the first quarter is in line with the expected 10% reduction in Medicare rates and we expect a similar reduction in 2020. We also said the impact of these cuts will be more significant on smaller, independent, and hospital outreach laboratories. We believe the cuts could potentially eliminate the majority of their profit and will provide a catalyst for market consolidation.
Just in this quarter, the nation’s largest nursing home lab operator filed for Chapter 11 bankruptcy reorganization. The company provided clinical laboratory testing services to more than 12,000 facilities in more than 35 states. According to the press reports, PAMA was cited as a major reason for bankruptcy as the Medicare cuts wiped out the company’s slim profits and caused it to cut back services.
Second, payers are more focused than ever on driving better value in their lab spend, which supports our plan to gain share. This is clearly evidenced by the opening of major health plan contracts at the large national laboratories, which provides the best value and quality for patients, physicians, and payers. We’re very pleased to be named a UnitedHealthcare Preferred Lab Network provider effective July 1, 2019, meeting exceptional criteria for access, costs, data, quality, and service. Quest and our AmeriPath subsidiary were two of only seven labs selected to participate in the Preferred Lab Network.
Finally, nobody cares more about the variation in healthcare costs than the employers and their employees, the country’s largest payers. Increasingly, patients are motivated to find high quality and service providers with low prices like Quest Diagnostics. More and more we’re seeing evidence of increasing price transparency in the lab marketplace. Massachusetts has been a leader in price transparency by launching its own website to help consumers understand the wide variation in healthcare cost.
During Governor Charlie Baker’s recent visit to our Marlborough lab, we pledged our continued support to Massachusetts’ efforts to help consumers understand the true cost of care. We are well positioned to benefit from these trends, which will serve as a catalyst for Quest to continue to gain share.
Our strategy to accelerate growth has five elements: Grow more than 2% per year through accretive, strategic in-line acquisitions; expand relationships with health plans and hospital health systems; offer the broadest access to diagnostic innovation; be recognized as the consumer-friendly provider of diagnostic information services; and then finally support population health in data analytics and extended care services.
Let me take you through several highlights from our strategy to accelerate growth in the quarter. Recall, we shared in our initial guidance that we carried over 1% growth into the year. The nine deals we announced and closed since the beginning of 2018 positioned as well to meet our M&A growth targets in 2019, including our recently completed acquisition of the clinical laboratory services business of Boyce and Bynum.
Our pipeline remains strong, and we’re having several conversations with health systems evaluating their hospital outreach lab strategy. We delivered strong organic growth through the quarter, thanks to the best access to insured lives this company has had in over a decade. In January, we saw a rise in volume attributable to health plans, where we recently gained access and the year-over-year growth rate accelerated throughout the quarter. We’re working hard to educate a whole new group of physicians on the Quest value proposition, but it does take time. As we said, gaining market share through expanded network access will be a gradual process.
So we’re pleased by the progress we’re making in our access improvement as well as we’re making progress in our hospital reference testing, which reflects our recent PLS relationships and reference testing wins. Trends in our reference testing business has shown improvement relative to last year. Key test growth drivers in the quarter included tuberculosis testing, Cardio IQ, drug monitoring, and hemepath blood cancer testing, all of which showed strong revenue growth for the quarter.
QuestDirect, our consumer initiating testing service is being well received by consumers who are looking to take charge of their health. Our offerings are popular across the entire demographic spectrum, with the largest percentage of consumers coming from the 25 to 34-year-olds. Earlier this month, we launched three new STD test packages allowing with consumers to get tested at their discretion.
The second part of our two-point strategy is to drive operational excellence. Construction of our new flagship laboratory in Clifton, New Jersey is well underway. The lab builds on the success of our Lab of the Future at Marlborough, Massachusetts, incorporating innovative uses of building design and automated technology to provide a broad range of advanced diagnostic and information services to more than 40 million people. We expect the lab to be operational in 2021. We also continue to drive increases in productivity. We have rebalanced resources and reduced expenses in some areas while ensuring we have the operational resources needed to deliver on the volume growth that we see.
Productivity gains have enabled us to effectively manage our headcount growth. So here are a few proof points. We’re seeing improved electronic order rates as we increase volume from the expanded network access which improves our lab productivity. We continue to re-enable our enterprise workflow, which has allowed us to reduce the number of specimen pickups and the number of client calls through acquisitions to our call centers. We’ve also driven increases in our supplies efficiency.
And then finally, our labor productivity gains have enabled us to reduce our labor cost per acquisition in the first quarter while providing salary increases for our front-line employees.
Now I’d like to turn it over to Mark, who will bring you through the financial performance. Mark?
Thanks, Steve. In the first quarter, consolidated revenues were $1.89 billion, up 0.4% versus the prior year. Revenues for Diagnostic Information Services grew 0.5% compared to the prior year, driven by strong volume growth and favorable weather, partially offset by increasing reimbursement pressure and higher patient concessions. Volume, measured by the number of requisitions, increased 3.6% versus the prior year.
Excluding acquisitions, volumes grew 2.4%. Favorable weather in the first quarter provided a tailwind of roughly 50 basis points. However, there was approximately one less revenue day in the quarter that negatively impacted volume growth by roughly 120 basis points.
Revenue per acquisition in the first quarter declined by 3% versus the prior year, driven primarily by increasing reimbursement pressure and higher patient concessions. Year price headwinds were consistent with our expectations at approximately 2.5%. This concludes the impact of PAMA, which amounted to a headwind of slightly less than 120 basis points.
Note, the PAMA impact includes both direct cuts to the current lab fee schedule as well as modest indirect price changes for Medicaid and then small number of floating rate contracts. Reported operating income was $248 million, a 13.2% of revenues, compared to $272 million or 14.5% of revenues last year.
On an adjusted basis, operating income was $286 million or 15.1% of revenues compared to $325 million or 17.2% of revenues last year. The year-over-year decline in operating margin was attributable to one less revenue day in the quarter, higher reimbursement pressure and higher patient concessions.
Reported EPS was $1.20 in the quarter, compared to $1.27 a year ago. Adjusted EPS was $1.40, down approximately 8% from $1.52 last year, which is roughly in line with the expectations we shared last quarter. Cash provided by operations was $275 million in the first quarter versus $180 million last year. Capital expenditures were $47 million compared to $73 million a year ago.
Now turning to guidance. We are reaffirming our outlook for 2019 as follows. Revenues expected to be between $7.6 billion and $7.75 billion, an increase of approximately 1% to 3% versus the prior year. Reported EPS expected to be greater than $5.16 and adjusted EPS to be greater than $6.40. Cash provided by operations is expected to be approximately $1.3 billion, and capital expenditures are expected to be between $350 million and $400 million.
I’d like to leave with a few reminders as you think about the remainder of 2019. First, we continue to expect more than $200 million of reimbursement pressure this year. This headwind should be relatively evenly spread throughout the year. Second, we continue to expect that volumes will gradually increase as we progress through 2019, just as we saw through the first quarter. Third, the Easter and passover holidays falling entirely in April will create a modest year-over-year headwind in the second quarter. Fourth, we have approximately one extra revenue day in the third quarter. Finally, we expect the strongest revenue and earnings growth in the fourth quarter of 2019 because of an easier comparison.
I’ll now turn it back to Steve
Thanks, Mark. Well to summarize, we’re off to a good start in 2019. While our industry faces significant reimbursement pressure. We are pleased with our results in the quarter. We’re driving volume and market share based on being a network of approximately 90% of the commercial insured lives in the United States. We believe we are well positioned to meet our commitments in 2019.
With that, we’d be happy to take any of your questions. Operator?
Thank you. [Operator Instructions] Our first question comes from Dan Leonard with Deutsche Bank. Your line is open.
Thank you. So, for my one question…
Good morning.
Good morning. Steve, you made the comment that the volume growth accelerated throughout the quarter. I was hoping you could elaborate on the monthly performance, I’m thinking that it will maybe help us as we think about volume growth accelerating throughout the year.
Yes. Thank you, Dan. Well, first of all, as we said going into the year, we expect that we’ll have initial pickup in the first month in January given all the work we did in 2018 to get the word out about our access changes, and we did see that. And then also what we said at the beginning of this year is we do expect that it will continue to build, and it continued to build in Q1 so we saw an improvement in February and also in March. But equally, we expected it to continue to gradually build throughout the year, so as we’ve said, this is a nice growth opportunity for us in 2019, but we see an opportunity in 2020 and 2021.
Okay, thank you.
Our next question comes from Ross Muken with Evercore. Your line is open.
Hey, Ross.
Good morning, Ross.
So maybe starting on United, obviously, pretty exciting news yesterday you highlighted in terms of getting selected in their PLN. I guess one, now that this sort of is formalized, I guess, how do you think other payers will look at this given sort of the known savings someone like yourself can kind of drive for consumers, members, plans, all included, given your scale and sort of cost advantage? And then, how would you sort of characterize the conversations you’re having with some of the other Managed Care peers and some of the blues who could probably easily do something similar to what United is doing today?
Yes. Thanks, Ross. Well, first of all, we’re excited to be part of the Preferred Lab Network. As we mentioned in our comments, we’re two out of seven. So very tight network and this will start on July 1, however, the word is out. And as you all know, the word was out when we announced that we’re back in network last year. So we’ve had quite a lot of interest from other national payers about what this means to some of the large regionals. And needless to say, we think it’s the beginning of a trend that we would like to continue to see in other relationships that we have.
What this means will become more clear as we get into it, but what we indicated clearly there will be incentives for physicians and patients in the benefit designs to move more of the volume through the high-value lab providers like Quest Diagnostics. Second is we need to continue to perform. So, we are high-quality lab, both in service and in quality, we’ll be providing statistics quarterly to demonstrate that.
And then finally, we’ll continue to move with the opportunities we see in the marketplace to consolidate the marketplace and pick up share, which will include continuing to work on our hospital strategy, picking up share for some of those hospital outreach labs. So, we think this is a good first step in a trend that will continue. It’s not going to be just with United but other payers will follow.
Yes. So Ross, if I could just add quickly because I think it’s certainly important. In the past, there were health plans that had preferred providers in the lab space, and obviously in other areas. And a lot of that was generally around price, so who’s willing to give me the lowest price and I’ll call them and provide a preferred provider. In this case, contracts were negotiated separate from this decision that United just made. Obviously, everyone’s prices are determined by individual negotiations. And this is really about evaluating the value that you bring.
So yes, price is an important component. But when we looked at the application and, as Steve shared, access, service and quality are the things that drive value. And as we’ve been talking about for a while, we feel we are positively differentiated versus most of the market and here is an acknowledgment by a large payer, obviously, agreeing with that and then getting behind that by naming us as one of those preferred providers so that consumers of our services, both the patient and the physician, will recognize that. Because obviously, it’s hard for them to know and see and compare across the various options that they have.
So we’re very excited about this because this is not a price play. This is about the value you’re offering on many parameters, and we are well down the road in conversations with several other nationals on similar concepts and so they recognize as well this is an opportunity to bring better value into the members.
And Ross, one of the things that I wanted to make clear, just based on some questions that I was receiving last night, is that we are – there’s no additional contracted change or price change for us to be in the Preferred Lab Network. We have contracted rates with United and those are the rates that we’ll live with them in the Preferred Lab Network. So there’s no additional step down.
And maybe just quickly as a follow-up, I mean what does this do to the competitive landscape? I mean, you talked about a bankruptcy, obviously, between sort of the PAMA pressures and maybe volumes narrowing to fewer and fewer players on the lab side with yourselves and maybe your largest peer probably benefiting the most. I guess, how do you see this landscape kind of evolving competitively at least among the independents over maybe the next three or five years?
So Ross, it just comes backs to, we think we have a unique setup in our industry to gain share. PAMA is the big change and it changed the underlying profitability of the industry. When we were at our Investor Day, we talked about roughly half the profit coming out of the industry and whenever you take half the profit out of any industry, you’re going to see consolidation and we’re the market leader and we’re going to consolidate. Second is you do see now with the Preferred Lab Network for United and what Mark just said about other payers following, there will be tighter purchasing with the payers.
And then finally, this is driven in part by members pushing back on the high cost of healthcare and the movement to more transparency with much more visibility and wide variation in health care cost. And Quest Diagnostics is really second to none in terms of our quality or service and at very, very competitive prices. So we believe this is a different place at a different time and we’ve gotten an opportunity to pick up share.
Our next question comes from Patrick Donnelly with Goldman Sachs. Your line is open.
Great. Thanks, guys. Maybe just one on M&A. Can you give us an update on some of the recent larger acquisitions like Shiel? How that’s trending against your deal model? And then just on the pipeline, can you talk about how that’s trending versus maybe late last year? Are you kind of seeing that long-awaited inflection point in the consolidation pieces on the lab side?
Yes, Mark, why don’t you take the Shiel?
Yes. So Shiel – I don’t know you referenced [indiscernible] since we closed Shiel more than a year ago but we don’t specifically comment on individual deals. But what we have said is that we’re very confident in our ability to integrate acquisitions especially around the core lab space whether its outreach or regional lab like Shiel. So we’re pleased with our progress and certainly, it’s contributing to some of our growth.
So this is something we’ve gotten really good at over the last several years. We’ve got it institutionalized in our organization. We’ve got a team that spends time dedicated on these integrations. We got a playbook and we roll out every time that we do one of these deals. And largely what we’re really doing is we’re just moving that volume into our existing infrastructure be in our draw centers or logistics or laboratory.
So as we’ve said before, it’s pretty much always a cost play, it’s the easiest one to deliver. So we’re very confident in our ability to deliver those synergies and then importantly, because of all the things we talked about around our service and our quality and the amount of attention we pay to these integrations, we have been successful in maintaining a vast majority of that volume. So we’re confident in what we do going forward based on our ability that we’ve demonstrated over the last couple of years.
And Patrick, the second part of your question has to do with our funnel and activity and just in general is more interest of particularly, I think, you’re referring to hospitals – hospital outreach laboratories selling their business. If you go back a year ago, what we’ve said is PAMA was announced in the first year of payment cuts and what it says in our travels is that very few hospital CEOs were aware of PAMA back a year ago.
That has changed, made more are aware of it, it’s been getting much more visible. What we continue to push in terms of having to think through our – their lab strategy is continue to get traction. And so we’re in active dialogues, as I said in our prepared – my prepared remarks with a number of systems around their lab strategy, which includes outreach. Now you couple PAMA with what you’re hearing about the payers putting pressure on the Preferred Lab Network and as you know, the most significant price differential is typically with hospital outreach labs.
So when we have this conversation, clearly you hear about PAMA, it’s certainly – potentially a 30% cut for their Medicare business, which will also see pressure on the payer side. And then thirdly is they are hearing from their physicians that their patients are pushing back on their high out-of-pocket cost. So in general, this is putting more logs on the fire of consolidation and our hospital strategies is in the works of getting more and more opportunities in front of us.
Our next question comes from Ricky Goldwasser with Morgan Stanley. Your line is open.
Hi, Ricky.
Hi. Good morning. So I have a follow-up question on the United network. Just to clarify, did you factor in any contribution from the preferred network in the second half guidance? And the second part of the question, kind of, like, when we look at all the other labs that are included, most of them seem to be focused on specialty testing. So are there also economic incentives to patients who would opt to come to Quest on their routine side? Just kind of, like, trying to understand the incentives that United is providing consumers to come to Quest over some other regional routine providers.
So Ricky, let me just address the guidance and then I’ll turn it back to Steve. As you know, we have a pretty broad range of 1% to 3%. So there’s a lot of different things that come to play in that. So what I would say at this point is in order to meet our guidance, certainly, somewhere in the middle, we’re not counting on significant volume coming from the Preferred Lab Network. Obviously, at this point, we don’t know yet know the details. United has not announced those details.
So we’re awaiting that. We’re optimistic and hopeful that it’s going to be something that’s going to have some significant impact. But you naturally expect that would grow and certainly probably more in 2020. We could get some benefit in 2019. But we need to wait until they announce exactly it’s going to work, what those details are and so forth. So we’re not counting on a kind of volume lift in the back half from the Preferred Lab Network.
Yes. If you look at the seven, what we mentioned as two are Quest and that’s Quest in general and then our AmeriPath subsidiary, which is our anatomic pathology business. If we see – you see two from Bio-Reference and so if you look at the list of seven, essentially what you find is two national laboratories broadly and Bio-Reference within reason for, let’s say, the general diagnostics and then all of us for intensive purposes compete in the what we refer to as advanced diagnostics.
The specifics of incentives around that are still to be defined by United. And when we have more that we can share with you, we will. But clearly, it will drive at least incentives in place to drive volume from the general diagnostic side as well as the advanced diagnostics side.
Our next question comes from Ann Hynes with Mizuho. Your line is open.
Good morning, Ann.
Good morning. Good morning. So I just wanted an update on some of the operational trends from last year that were issued, maybe bad debt, drugs or abuse and vitamin C testing, it seemed to have stabilized. And also quickly, can you let me know how much of the one less day impacted organic volume growth? What it would have been without that headwind? Thanks.
Yes. As I shared in, we estimated about 120 basis points of impact from one less day and I also shared, we’re going to – it’s not precise but pretty much picked that up in the third quarter. So there’s the offset for the year. In terms of bad debt, I think you’re referring to patient concessions. Our bad debt actually was slightly up. This year, we had one bankruptcy within our client bill business that impacted our bad debt in the quarter. Certainly not a trend, it’s kind of a one-off.
But patient concessions, probably about a 50 basis point headwind. And what we’re really seeing is some of the patient responsibility trends that we saw in the latter half of last year, we’re now carrying it forward with the expectation that, that ratio will continue. So therefore, our expectation would be in the first half we have some headwinds around patient concessions and then assuming that things don’t change dramatically within the marketplace in 2019 that in the back half maybe we get some of that back.
So that’s what I would frame the – some of the trends. Around drugs of abuse, we did get some recent news that the national payer that had been denying same day of service were the presumptive and definitive testing and the reimbursement has changed and we haven’t got the definitive date when that’s going to be implemented. But we have got a confirmation writing for them that they’re going to change that. So that was certainly good news.
And then in terms of lapping some those changes, we are beyond when they started. So from a year-over-year comparables, they’re behind us. And then the big payer change last year in Q2 on vitamin D, obviously, we’ve lapped that as well now that we’re in the second quarter but it was a headwind in Q1 certainly for us. We’ve also shared that Aetna is going to move to that similar approach for screening of vitamin D. However, with Aetna, there is a difference because we can bill the patient.
Whereas with the other payer, we just had to do the test for free, which is just something we’re working on with that payer. But as per the contract, we were not able to revert to a patient bill. So while Aetna certainly were not thrilled that they’re moving to a similar policy, it’s not going to be as much of a headwind as it was with the other payer.
Our next question comes from Jack Meehan with Barclays. Your line is open.
Good morning, Jack.
Thank you. This is actually Mitch Petersen, on for Jack this morning. Just being curious where volumes fell relative to your expectations in the quarter in – both from a share gain perspective but also just from a utilization environment perspective? And in your view, do you think that utilization environment in the first quarter actually picked up relative to 2018?
Yes. Well, I’ll start with utilization. As Mark talked about where volumes fit in with what we expected in the quarter, but utilization is stable. As we said in the past, we look at this on a different directions as you all do and from what we can tell, utilization in general is stable and that’s – I would argue for our physician business and not hospital business as well as our hospital business. Mark, volumes relative to what we expected?
Yes. So as you know, we had guided to flat to down, we actually grew revenue. So volumes were slightly above our expectations. I would attribute a large part of that to weather. As we’ve talked about in the past, we can’t predict the weather. So we always kind of take an average level of weather and build that into our expectations and into our guidance, and we had 50 basis points of favorable weather this year.
So as Steve said, we’re very pleased with volumes. We had expected a significant lift. If you adjust for the one fewer day, even more impressive volume growth, certainly, something we’ve not seen in a long, long time at Quest, especially on the organic side. So meeting our expectations and finally, a little bit better literally because of the weather.
Our next question comes from Kevin Ellich with Craig-Hallum. Your line is open.
Good morning. Thanks for taking the question.
Hey, Kevin. Good morning.
Good morning, guys. So kind of just following up there. If we net-net for the weather and the one less day, it looks like underlying organic growth was about 3.1% even though reported was 2.4%. Did I do my math right there, Mark?
Close enough, Kevin, yes.
Okay. Good. And then just wanted to see if you can help us quantify how much of the organic growth came from expanded network access to United and BlueCross BlueShield of New Jersey? And then did you see any volume loss from your Aetna business?
Sorry. any volume loss from what?
Aetna.
From Aetna.
Yes. So obviously, we’re not going to get into specific payers but the lift didn’t all come from the new access. We certainly have seen growth in some of the other payers really across the board in the regions that are growing as one might expect because as we go in and talk about our broad access, we’re winning accounts. And so those accounts obviously are bringing with them volume from the payers with whom we recently gained access but obviously we’re getting some volume as well.
We did expect and we did see some losses in Aetna. It’s within our expectations and our outlook, and actually it stabilized throughout the quarter. So we saw something early and then since then, actually we’ve won some of that back and it’s not only not that gotten any worse but actually got a little bit better. So that’s about as much detail, Kevin, as I can go into in terms of the access changes.
Next question, operator.
Next question comes from Kevin Caliendo with UBS. Your line is open.
Hi, it’s Kevin Caliendo. Thanks. I wanted to talk a little bit about gross margin that was a little bit lighter than we had anticipated despite a little bit better pricing. Was it mix? Was it patient concessions? It’s not hugely meaningful but it just caught my eye.
Yes. So I don’t know what your expectations were, Kevin. To be fair, gross margin wasn’t significantly different than what we were expecting. The actual – the only area that was a little bit off our expectations was in SG&A. But there’s actually a geography issue in there that I want to make sure people understand. We have some portfolio investments related to the retirement plan that we have and the accounting dictates that if there’s gains or losses in that portfolio that you can either have expense or offset to expense above or below the line.
We actually had $9 million of expense above the line. There’s an offset in other expense below line. So there’s no impact to our net earnings and our EPS and so forth. It’s a geography issue. But that didn’t inflate our SG&A $9 million relative to what we would have expected based on these investments. And last year, we had about $0.5 million actually decrease. So it’s a significant change year-over-year, about 50 basis points of impact. So I just wanted to make sure people understand, naturally geography, it’s not any sort of a trend in our SG&A. But from a gross margin standpoint, we were pretty much where we expected.
Our next question comes from Brian Tanquilut with Jefferies. Your line is open.
Hey, good morning, guys. Congratulations. Mark, just to follow-up on that. As I think about the ramp in earnings over the course of the year, how should we be thinking about gross margin? And then I know, last quarter, you laid out a cost-cutting initiative that I think kicks in the second quarter. So if you don’t mind just walking us through the progression of that over the course of the year. Thank you.
Sure. So when you think of the determinants of gross margin, obviously, it’s price, which is pretty much set for the year. As we’ve said that $200 million of pricing headwinds should cycle pretty at least proportionally over the four quarters. Obviously, not every quarter is equal in terms of the volume. In terms of mix, we’ve had a trend but we will see if that continues in terms of better test mix as our advanced diagnostics grows faster than our routine business. But we also have some of that offset through our PLS business as well. So mix can be a driver that goes both directions, we’ll see.
And then the other one that I’d point to is certainly volume within a quarter. So when we talk about one fewer day having about 60 basis points of impact in the first quarter on our margins because in a short period of time, a lot of our costs are fairly fixed. That’s not all SG&A. Some of that is in cost of sales. When you think about our Patient Service Centers within a short period of time, that’s a fairly fixed cost. Our logistics and even somewhat some of our laboratory expense, although obviously reagents and some labor are variable.
So other determinant certainly as we get that extra day back in the third quarter, that’s going to be a tailwind to our gross margin, not just our overall margins and so we have one fewer day in the first quarter was a headwind to that.
Our next question comes from Erin Wright with Credit Suisse. Your line is open.
Hi, thanks. How much of the outcome units Preferred Lab Network was previously contemplated and or any of the labs are number of labs included surprise relative to your initial expectations. And then on the PAMA side, is there any sort of update on the industry efforts around PAMA release. And I guess any sort of meaningful movement on that front? And should it be assumed that any sort of relief would occur in 2021 or how should we be thinking about timing?
Let me take the Preferred Lab Network and then Steve will address the PAMA. So as I mentioned, we didn’t contemplate significant change and that obviously would be positive for 2019 in our guidance because we don’t have the details yet. In terms of the number of labs that have been included, we didn’t know. Obviously, we knew the bar was pretty high because we filled out the application, and we certainly have enough sense around the industry, and we knew it would be difficult for a lot of people to meet the criteria around service, access and quality
So we were, I guess pleasantly surprised but not completely surprised that it’s a fairly short list because of what United’s looking for in terms of the requirements. So that’s kind of where we stand and once we hear from United, some of the details, we’ll be able to comment more about exactly what this means and how quickly we think it will become a tailwind and to what extent. In terms of PAMA.
Yes. So we are – as far as PAMA, as we’ve said, we are planning on the worse and working to get a better outcome. So what we’ve planned in our guidance and what we’ve planned in our outlook assumes the full impact of PAMA through 2021. Excuse me, 2020. And what’s happening as we speak is actually today, they’re hearing of a oral argument of our appeal. If you recall the District Court that saw on our case, decided not to rule on it because of jurisdiction issues, we appealed that and so we’re having our oral argument today. That will be heard. They will digest that and make a decision. But if it’s a favorable outcome in our behalf then we’ll be able to court begin, the senses that we’ll hear something this year and our argument and then the case will follow thereafter.
Second is we don’t get a positive outcome then we could appeal in the Supreme Court will cross that bridge when we get to it. In parallel to all that, we continue to push with members of Congress that CMS got it strong. We need to take the time to get it right. We need to make sure that given all the data, because that was what was intended, that was the congressional intent and so we’re working with members of Congress on the legislative fix to make sure that we take the time to get it right.
And essentially, what that would mean is push out the data collection period for some period of time to get the right amount of time for everyone’s future to submit the data. And again, that’d be 2019 data. So the data for first half of 2019 will be what is submitted, but we’re pushing to make sure that’s delayed. So that’s where PAMA stands.
Our next question comes from Derik de Bruin with Bank of America Merrill Lynch. Your line is open.
Hey, good morning. This is Ivy Ma for Derik today. So just wanted to, Steve, if you can get an update on the QuestDirect consumer-facing program there. So any order impact this year or beyond that you can characterize there? And then can we also get an update on the extension into retail partners so far this year. Thank you.
Can you speak up with – on your question regarding QuestDirect? Sorry, we couldn’t hear you.
Sorry, just wanted to get an update on that program. Just trying to see if there’s any order impact that we can characterize this year or beyond?
Yes. So I would just say, we introduced our new offering for the fourth quarter last year. It’s off to good start. We’re seeing a nice month-to-month progression of growth. Nice adoption in the number of test categories. We did mention in the prepared remarks, our inclusion of a few bundles around sexually transmitted diseases. So we’re pleased with progress so far, and we did contemplate that in our guidance for the full year.
Our next question comes from Bill Quirk with Piper Jaffray. Your line is open.
Great. Thank you. Good morning everyone.
Good morning.
Couple questions. First off, Steve, you talked about pricing transparency in your prepared comments. And this is a topic that you’ve touched on couple of times in the past. I guess bigger picture question here is, how should we think about this rolling out beyond Massachusetts. And then secondly, I guess following-up on Aaron’s question, given that we are into the data collection period second around PAMA, how should we think about the expanded number of participating labs and what that impact might have in the 2021through 2023 period?
Yes. First of all, transparency in general. So the number of national payers, and I would say regional payers too, have pushed on educating their membership on a wide variation of healthcare costs. And yes, it’s about lab and it’s about everything. So a lot of visibility around radiology, a lot of visibility about every kind of procedures. So depending upon who you might have your insurance with, you probably have seen some of us. So that drum has been beaten and that it will continue to beat.
In parallel to that is employers are hearing a lot of pushback from their employees about the cost of health care. We hear it at Quest Diagnostics, and we haven’t talked about it but we actually have done a lot of work to prevent the cost of Quest Diagnostics with their – our health care costs. And in doing so, where we’ve managed about 50,000 lives, we’ve actually built the cost curve. And the reason for that is employees are pushing back on their employers what they’re paying for out of pocket. So this is a premium cost. It’s a high deductible. So it’s the co-pays and full insurances.
And so they give you a lot of noise and also those patients are pushing back on their physicians and physicians or pushing back on administration. So what I’ll say is this has picked up a lot of steam, and we are encouraged because when you look at the facts, you look at our medical quality, you look at the service performance and you look at our price points, we’re really second to none. And that’s reinforced with the Preferred Network with United Healthcare and there’ll be other payers that follow.
So it will continue. We talked about Massachusetts as the state that has really put more out there, but we think more states will follow and more payers will follow and as more payers go down this path of a Preferred Lab Network, part of this will be around you can get the best quality, best service at the lowest prices from a company like Quest Diagnostics. So it’s going to be one of the opportunities that we take advantage of to pick up share.
And I just want to add to that, Bill, that the data collection period is actually in the fall. It’s the work that we do in the first half of 2019 but actually the submission and the collection is later in the year. And as Steve mentioned earlier, we’re working to try to get that delayed because we’re not clear on the changes, the impact of those changes and how much it’s going to expand to the hospital and others that did not submit last time. But we do know and agree that it’s going to be challenging for many of them to comply.
And therefore, that’s why Steve mentioned for the trade association we’re lobbying to get that delated to give them a chance to do that and make sure that it comes in because we see that as the benefit to be more representative of the overall commercial market but also that they can get it done in a quality fashion. So there’s a lot of rationale for slowing this thing down. But it doesn’t happen until later in the year.
Our next question comes from Stephen Baxter with Wolfe Research. Your line is open.
So as part of the support act passed late last year, it looks like there’s some provisions that would impact the lab industry’s ability to pay incentive compensation based on sales goals. Can you help us provide some context on how that’s impacting your business today? And whether any changes to your compensation structure would be required if the law remains in effect for the foreseeable future?
Yes. Thanks for the question, Stephen. We recognize what you said that it could imply potential impact to the lab industry. At this point, based on the conversations we’ve had, I believe that, that was unintended. So we’re in dialogue around addressing that. So we have not changed anything to our compensation program in response to that, and we’re feeling comfortable. We’re obviously doing the right things to ensure that, that gets amended. That was not the intent.
Our next question comes from Lisa Gill with JPMorgan. Your line is open.
Just a couple of quick follow-ups. So Steve, when you talked about utilization being normalized in the first quarter, I think many of us have seen United report and MLR below expectations. So can you just maybe define what you think normalizes on a percentage basis?
Yes. The term I’d use is stable. We keep on doing our same-store or same-account measurement when we look at 100 accounts. You know they’re accounts of Quest Diagnostics, and we look at their volumes year-on-year. And we’ve tracked this for years. And what we see is it’s a stable environment, and this is for the nonhospital portion of our market. And equally for the hospital portion, we believe that’s stable as well if you look at the volumes that we see out there in the marketplace. We believe both are stable.
Is there a number you can put around that?
NO, no. Because I would say that it bounces around a little bit. But in general, we’re feeling that, that – it is within the range of a normal variation that we’ve seen historically. So stable is a good way of characterizing what we see.
And I mean, Lisa, I guess the tightest I could quantify it is that we’ve talked about a market that we think volumes are growing about 2% based on demographics and so on, which the given price headwinds pretty much take the revenue growth in the lab market to flat. And so as we look at the overall performance in the first quarter against our expectations and all the factors that play into it, including our competitiveness, there’s nothing that we saw in the first quarter that suggested a significant deviation from what we were expecting in terms of if you would call utilization, the overall market consumption of laboratory services.
Our next question comes from Matt Larew with William Blair. Your line is open.
Hi, good morning and thanks for taking my questions. I wanted to ask in terms of the retail strategy, if you can update us in terms of where the footprint stands today. Any plans for additional expansion here in 2019? And then the extent to which you see this strategy actually driving incremental growth and profitability?
Yes. Several things. One is when we started with takeaway stores, we’ve shared in the past that, that’s going well. Good results from those stores. Second is we’ve started a joint venture with Walmart. That has been progressively building and results have been very good. As you’ll recall, we started with Texas and Florida, we’re now beyond Texas and Florida. We’re in multiple states. We’re greater than 50 stores, approaching 75 to 80 stores throughout the United States. Again, what we’re finding is that it benefits all stakeholders. We think it’s good for Quest Diagnostics.
And we’ve shared in the past that this is not about our savings in real estate. It’s actually an opportunity for us to get more productive with our phlebotomists as we consolidate those in one location. Second is its better location. So it’s better for employees, it’s also better for our patients that we serve. So they walk again for other purposes to get your script filled, do some grocery shopping, by the way they can stop at Quest. We give them a locator. They walk in the store. They come in conveniently. Many of those people are fasting. So they would like to eat before they leave. So good patient experience.
And then finally, Walmart likes it because it’s more patient volume and it’s a good experience in their stores. And what we’re finding in those ZIP codes where we’ve done this, we do have an opportunity to pick up some share because it’s – again it’s a much more convenient location for us in that marketplace. So the patient has the choice they’re going to be going to the convenient location. And so what we’re driving to is if you look at the 2,200 Patient Service Centers that we have throughout the United States, we’d like to have about 50% of those Patient Service Centers eventually in more of a retail-like setting.
So it gives you an idea of the extent of our strategy. And when I say that, we already have a retail-like strategy beyond Safeway and the Walmart locations because we’ve already had some of our Patient Service Centers in more of a retail environment than a medical environment. So of – the progress so far is – continues to be a good one. We’re encouraged by it and there would be progress made this year.
And so just to add to that, Matt, it’s not as much a cost play around the fixed cost because the phlebotomist obviously gets paid the same regardless of where we put them and the overall rent is not that much different. But really is it’s the volume leverage we get. So these are highly productive sites, especially in Walmart. And some of the reasons for that, obviously, as Steve said, it’s great access and convenience but some of our key stakeholders, the payers and the physicians, like that when they hear about, hey this can bring further patient because actually you want them to get the testing done.
So as we talk about being positively differentiated from a vast majority of the market, certainly our retail locations, it’s not all about cost. Some of it is really around getting more volume and being more attractive commercially. And from some of the key stakeholders, we’re influencing or driving those decisions where they want to get their lab work done.
Yes and as you’ll recall, as part of our strategy, we’re using our data to support population health with extended care services. And so what you’ll hear more of is basic health care services that we’re also providing in those stores to manage a population. More to come on that but it’s beyond draw services for Quest Diagnostics as we go forward.
Our next question comes from Mark Massaro with Canaccord Genuity. Your line is open.
Good morning, Mark
A -Mark Guinan
Hey. Mark.
Good morning. Thanks guys for the questions. When I strip away the headwind of one less day in the quarter and the benefit from weather, I come up with organic volumes of 3.1%. That is above the long-term guide you have of 1% to 3%. So can you just help us think about the sustainability of this trend, especially given that you’ve got one additional day coming in the back half, you have volumes building throughout the year?
And then second part of my question, is there any update to the work you’re doing with HCA in Colorado? And what do you think they need to see the potential to expand that?
So the – to answer your question, Mark, remember the outlook – four-year outlook I provided was revenue, not volume. And while our volume, if you adjust for the weather and the days, was north of 3%, our revenue was obviously in the single-digit basis points, 10s of basis points, not as high. So I think as we’ve mentioned, we expect that to continue to build. And obviously, in the four-year time frame, we’re expecting to get some of these pricing headwinds significantly lowered, if not eliminated, which will help the revenue relative to the volume. So I think that – hopefully that answers your question around the outlook and our performance in the first quarter. On HCA, Steve?
Yes. On HCA, we believe that it’s going well. We believe if you ask HCA that question, they would give you the same feedback. Remember, this is in their Continental Division. So it’s actually one of our Professional Lab Services engagements where we help them become more efficient with their hospital laboratories. So we now again demonstrate, now that we’ve been into it for a couple of years, that we are saving them money, and they’re pleased by that and the quality has not anywhere – way deteriorated. So we’re hopeful, given the success there that we could take that model and try it in some other locations throughout HCA. We’re actively discussing that possibility as you would expect. But no firm indication that they will expand beyond it. But it is a success story for us within very large core profit system.
And just to add quickly, I know you all can do the math. With about 40 basis points of revenue growth, if you adjust for the two factors you mentioned, that gets us north of 100 basis points. So in the year when pricing headwinds are obviously extreme, where it hits the low ends, but within that three-year CAGR of revenue growth that I provided at the Investor Day.
Our last question comes from Eric Coldwell with Baird. Your line is open.
Hey, Eric.
Hey, good morning. Thanks very much. Kind of a three-parter here on Trident and the bankruptcy that you mentioned. First off, I see that they have debtor and possession financing that are still operational. But would you expect to gain volume in a situation like that when a bigger player announces a bankruptcy? Second of all, you did mention a customer bankruptcy in your prepared remarks, if I heard you correctly. I’m curious was that Trident since they are a diversified holding company? And then third, how have you – just remind us how you’ve generally planned or modeled for higher customer bankruptcies in 2019? Have you taken a more conservative approach this year, given what’s going on with PAMA? But I’m just curious if you could just remind us what you’ve done there. Thanks so much.
Yes. I’ll take the beginning of that and then turn it to Mark to tell us what’s in our guidance, if you will. So yes, it is Trident. What we referred to is what you can read yourself related to their lab business where they served the nursing home marketplace. We have very little exposure to the nursing home business. It’s a tough market. We have a little bit of nursing home business. It’s not a big market opportunity for us. So the answer to your question, it all depends whether we pick up some of the volume. If we can make money out of it and we can serve the marketplace, well we would consider it. So it all depends on where the volume is and at what price points and whether we can serve the market well to really define the presence of our laboratories and where their facilities are. Mark, you want to…
Yes. So our remaining bad debt, and that will be separated from patient concessions out of bad debt and into revenue, is pretty small and you occasionally have a blip here. But we don’t have any expectations that we’re going to have significant headwinds on bad debt. A vast majority of that is hospital – our hospital business and then certainly, a chunk of that is actually physician client bill where in the States it’s permitted. The physician is actually marking it up and billing the commercial payer, and we are charging the physician. So assuming that they continue to get paid by the commercial payers, we’re certainly not at risk for any lack of payment ourselves.
So when you said are we getting more conservative, are taking any steps in anticipation of payment driving more bankruptcy, I wouldn’t expect it to be within our customer base, our client bill base that you’re going to see that impact. So there’s really not anything we should do or can do beyond. We’re very diligent around monitoring collections from our client bill and that’s the easiest one. It’s not anywhere near as complicated as the third-party billing and involving the patients. So nothing necessary and certainly no significant headwinds expected or built into our contemplated guidance.
Yes. We have no further questions.
Well, thanks everyone for joining us today. We appreciate your support, and have a great day.
Thank you for participating in the Quest Diagnostics First Quarter 2018 Conference Call. A transcript of prepared remarks on the call will be posted later today on Quest Diagnostics website at www.questdiagnostics.com. A replay of the call may be accessed on the line at www.questdiagnostics.com/investor or by phone at 1866-480-3547 for domestic callers 203-369-1551 for international callers. Telephone replays will be available from approximately 10:30 AM Eastern Time on April 23, 2019 until midnight Eastern Time on May 7, 2019. Goodbye.