How will losing UnitedHealthcare affect Quest Diagnostics' 2007 results?

Management expects that no longer being a contracted UNH provider, along with becoming non-contracted for Horizon BCBS of New Jersey, will reduce 2007 revenue growth by 7-10%. Because a large share of costs (about 40% or more) is fixed, cost reductions will not fully offset the profit decline. The company guides to 2007 revenue and earnings below 2006 levels, with a return to growth expected in 2008.

What is driving growth in the business despite pricing pressure?

Growth came from organic clinical testing volume (up 5%), higher average revenue per requisition (up about 5%) as the test mix shifted toward esoteric and gene-based testing, and acquisitions including LabOne, Focus Diagnostics and Enterix. Gene-based and esoteric testing exceeded $1 billion in 2006 revenue and grew more than 10%.

What are the main legal and regulatory risks disclosed?

Key risks include an open U.S. Attorney investigation in the Eastern District of New York related to NID (parathyroid hormone and other test kits), subpoenas on capitation arrangements and payer relationships, a California Medicaid (MediCal) subpoena, and qui tam whistleblower suits. Management says reserves are under $5 million and that the outcome is not expected to be materially adverse to financial condition, though it could be material to results in the period it is determined or paid. Reimbursement risks include possible competitive bidding for Medicare lab tests and a proposed OIG usual-charges rule.

Why did Quest acquire HemoCue and how is it being financed?

HemoCue is a leading provider of near-patient (point-of-care) hemoglobin testing with annualized revenue of about $90 million. The company paid about $420 million including $123 million of assumed debt, financed with a $450 million one-year senior unsecured interim term loan maturing January 31, 2008. The strategy is to extend Quest into the growing near-patient testing market and international markets, which management expects to be faster-growing and more profitable than U.S. lab testing.

DGX 10-K FY2006 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed March 1, 2007. Cited figures are marked; the original filing is the authoritative source.

Quest Diagnostics' 2006 Form 10-K shows a company at a transition point.

Net revenues grew 15% to $6.27 billion, operating income rose to $1.13 billion^a (18.0% margin, including $55 million of stock-based compensation and $27 million of integration charges), and income from continuing operations reached $626 million, or $3.14 per diluted share. Operating cash flow was $952 million. Growth was driven by the LabOne acquisition (about 8 points of growth), organic clinical testing volume and higher revenue per requisition from a shift toward esoteric and gene-based tests, which generated over $1 billion in revenue and grew more than 10%.

The central investor concern is the loss of UnitedHealthcare (UNH) as a contracted payer effective January 1, 2007. UNH accounted for about 7%^b of 2006 net revenues, with some regional labs at 15-20% concentration. Management expects this and a Horizon BCBS New Jersey change to reduce 2007 revenue growth by 7-10%.

Because roughly 40%^c or more of costs are fixed, management does not expect cost cuts to fully offset the profit decline, and it guides to 2007 revenue and earnings below 2006 levels with a return to growth in 2008. Investors should also weigh rising fixed-cost pressure, Medicare and Medicaid reimbursement risk, and an open federal investigation involving NID, the test-kit subsidiary that was discontinued in 2006. Strategically, the company is building a near-patient testing platform through the Focus Diagnostics, Enterix and HemoCue acquisitions.

HemoCue, closed January 31, 2007 for about $420 million^d including assumed debt, was financed with a $450 million one-year term loan, which raises refinancing and leverage questions for 2007. Total debt was about $1.56 billion at year-end 2006.

02—Key points

Key Highlights

Net revenues rose 15% to $6.27 billion in 2006, with LabOne contributing about 8 points of growth and clinical testing volume up 5%.
Operating income increased to $1.13 billion (18.0% of revenue) and EPS from continuing operations was $3.14 diluted, versus $2.79 in 2005.
UnitedHealthcare, about 7% of 2006 revenue, ended contracted status on January 1, 2007. About 60% of direct UNH business had moved to other providers by February 16, 2007, and management expects 2007 revenue growth to fall 7-10% as a result.
Roughly 40% or more of costs are fixed, so cost actions are not expected to fully offset the profit impact of lower 2007 volume.
Gene-based and esoteric testing generated over $1 billion in 2006 revenue and grew more than 10%, supporting average revenue per requisition gains of about 5%.
HemoCue was acquired January 31, 2007 for about $420 million, financed by a $450 million one-year term loan, adding near-patient testing capability.
Total debt was $1.56 billion at year-end 2006, and the company repurchased $472 million of stock in 2006 with about $250 million of authorization remaining.

03—Questions

Frequently Asked Questions

How will losing UnitedHealthcare affect Quest Diagnostics' 2007 results?
Management expects that no longer being a contracted UNH provider, along with becoming non-contracted for Horizon BCBS of New Jersey, will reduce 2007 revenue growth by 7-10%. Because a large share of costs (about 40% or more) is fixed, cost reductions will not fully offset the profit decline. The company guides to 2007 revenue and earnings below 2006 levels, with a return to growth expected in 2008.
What is driving growth in the business despite pricing pressure?
Growth came from organic clinical testing volume (up 5%), higher average revenue per requisition (up about 5%) as the test mix shifted toward esoteric and gene-based testing, and acquisitions including LabOne, Focus Diagnostics and Enterix. Gene-based and esoteric testing exceeded $1 billion in 2006 revenue and grew more than 10%.
What are the main legal and regulatory risks disclosed?
Key risks include an open U.S. Attorney investigation in the Eastern District of New York related to NID (parathyroid hormone and other test kits), subpoenas on capitation arrangements and payer relationships, a California Medicaid (MediCal) subpoena, and qui tam whistleblower suits. Management says reserves are under $5 million and that the outcome is not expected to be materially adverse to financial condition, though it could be material to results in the period it is determined or paid. Reimbursement risks include possible competitive bidding for Medicare lab tests and a proposed OIG usual-charges rule.
Why did Quest acquire HemoCue and how is it being financed?
HemoCue is a leading provider of near-patient (point-of-care) hemoglobin testing with annualized revenue of about $90 million. The company paid about $420 million including $123 million of assumed debt, financed with a $450 million one-year senior unsecured interim term loan maturing January 31, 2008. The strategy is to extend Quest into the growing near-patient testing market and international markets, which management expects to be faster-growing and more profitable than U.S. lab testing.

04—Continue

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