Poor 2Q for Quest Diagnostics

Zacks

Quest Diagnostics (DGX) reported an EPS of $1.11 in the second quarter of fiscal 2012, up considerably from $1.02 in the year-ago period.

However, after taking into account certain charges related to restructuring, integration, and CEO succession costs (6 cents), adjusted EPS from continuing operations came in at $1.17, lagging the Zacks Consensus Estimate by a penny. The adjusted EPS was 4.5% above the year-ago adjusted earnings of $1.12 per share. The year-ago quarter recorded a cost of 10 cents per share related to transaction and integration associated with the Athena Diagnostics and Celera transactions.

Revenues for the quarter remained flat year over year at $1.90 billion but marginally missed the Zacks Consensus Estimate of $1.93 billion. Clinical testing revenues and volume (measured by the number of requisitions) both inched up 0.7% during the quarter while revenue per requisition remained flat year over year. We believe that the overall soft industry trends leading to low volume growth was a dampener for the company.

Notably, Quest Diagnostic’s major peer Laboratory Corporation of America Holdings (LH), which also released its second quarter 2012 financial result today, delivered flat volume growth during the quarter with a meager 1.5% increase in revenues per requisition. Poor volume trend was also responsible for the sluggish sales during the quarter.

Among the operating costs, cost of services during the reported quarter remained almost unchanged year over year at $1.1 billion. Selling, general and administrative (SG&A) expenses however dropped 4.8% to $440.8 million. Adjusted operating margin in the quarter improved 100 basis points (bps) to 18.4% on adjusted operating income of $350 million.

Quest diagnostics exited the quarter with $173.7 million in cash and cash equivalents, up from $164.9 million at the end of fiscal 2011. Cash provided by operating activities for the quarter was $251 million compared with $60 million in year-ago quarter. In the year-ago quarter, cash provided by operations was reduced by the Medi-Cal settlement payment. The company is focused on enhancing shareholder value and improving returns on capital. During the reported quarter, Quest repurchased shares worth $50 million.

Outlook

The company reiterated its EPS guidance of $4.45– $4.60 for fiscal 2012. However, revenue growth outlook was reduced to the band of 1%–2% (earlier outlook being 2%–2.5%).

Quest Diagnostics reaffirmed the operating margin guidance at 18% and $1.2 billion as cash from operations. The company now expects $200 million of capital expenditure compared with previous guidance of $200–$225 million.

Recommendation

We remain anxious about the company as it is continuously witnessing challenges with testing volume. Moreover, the company’s lowering of fiscal 2012 revenue guidance added to our concern with the fact that the industry trend will not improve in near future. However, we are waiting for Quest Diagnostics’ new CEO, Steve Rusckowski’s comprehensive strategic plan to be declared in August 2012 and prefer to remain on the sidelines till further clarity is available.

We appreciate Quest Diagnostics’ current focus on latent areas such as drugs-of-abuse testing, gene-based, esoteric testing for cancer, cardiovascular disease, infectious disease and neurological disorders. The company is witnessing higher demand for these tests compared to routine tests. Besides, the company is adopting several strategies such as accretive acquisitions, increased sales force and targeting additional geographies to drive its top line. We are also encouraged with Quest Diagnostics’ move of repurchasing shares and paying dividends to drive shareholder value.

We currently have a Neutral recommendation on Quest Diagnostics. The stock retains a short-term Zacks #3 Rank (Hold rating).

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