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Edited Transcript of DGX earnings conference call or presentation 20-Apr-17 12:30pm GMT

Thomson Reuters StreetEvents

Q1 2017 Quest Diagnostics Inc Earnings Call

MADISON Apr 22, 2017 (Thomson StreetEvents) -- Edited Transcript of Quest Diagnostics Inc earnings conference call or presentation Thursday, April 20, 2017 at 12:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Mark J. Guinan

Quest Diagnostics Incorporated - CFO and EVP

* Shawn Bevec

* Stephen H. Rusckowski

Quest Diagnostics Incorporated - Chairman, CEO and President

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Conference Call Participants

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* Albert J. Rice

UBS Investment Bank, Research Division - MD and Equity Research Analyst, Healthcare Facilities

* Alexander David Nowak

Piper Jaffray Companies, Research Division - Research Analyst

* Amanda Murphy

William Blair & Company L.L.C., Research Division - Healthcare Analyst

* Daniel Louis Leonard

Deutsche Bank AG, Research Division - Research Analyst

* Donald Houghton Hooker

KeyBanc Capital Markets Inc., Research Division - VP and Equity Research Analyst

* Jack Meehan

Barclays PLC, Research Division - VP and Senior Research Analyst

* Rivka Regina Goldwasser

Morgan Stanley, Research Division - MD

* Ross Jordan Muken

Evercore ISI, Research Division - Senior MD, Head of Healthcare Services and Technology and Fundamental Research Analyst

* Steven J. James Valiquette

BofA Merrill Lynch, Research Division - MD

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Presentation

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Operator [1]

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Welcome to the Quest Diagnostics First Quarter 2017 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 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'd like to introduce Shawn Bevec, Executive Director of Investor Relations for Quest Diagnostics. Please go ahead.

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Shawn Bevec, [2]

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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 also discuss non-GAAP measures. For this call, references to adjusted EPS refer to adjusted diluted EPS excluding amortization. Actual results may differ materially from those projected. Risks and uncertainties that may affect Quest Diagnostics' future results include, but are not limited to, those described in Quest Diagnostics' 2016 annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K.

The text of our prepared remarks will be available later today in the Investor Relations page of our website.

Now here's Steve Rusckowski.

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, CEO and President [3]

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Thanks, Shawn, and thanks, everyone, for joining us today. This morning, I'll provide you with highlights of the quarter and review progress on our strategy, and then Mark will provide more detail on the results and take you through updates on our 2017 guidance.

We began 2017 with a strong first quarter across the board, growing revenues, EPS, operating income, margins and operating cash flow. Here are some of the key highlights. Revenues were up approximately 2% on a reported basis and 3% on an equivalent basis. The reported EPS of $1.16 increased 63% from 2016. Adjusted EPS grew approximately 18% to $1.33, which includes $0.11 of excess tax benefit associated with employee stock-based compensation. More on this later from Mark. Cash from operations increased 28% to $196 million.

Now before I describe the progress we've made to accelerate growth and drive operational excellence, I would like to briefly discuss PAMA. CMS postponed the deadline for labs to report private/commercial payer pricing data under PAMA for 60 days until May 30. We fully support the decision. However, we continue to have some concerns about the current definition of applicable laboratory, which are those laboratories required to report private/commercial payer data.

According to the Office of Inspector General's analysis, the current definition of applicable laboratory would cover only 5% of laboratories, representing only 69% of Medicare payments for lab tests in 2015. While we support reform of Medicare payment system, we believe any modification should be market-based and appropriately include all applicable independent and hospital outreach laboratories.

Now let's review progress we've made. As we detailed at our Investor Day in November, our 2-point strategy is to accelerate growth and drive operational excellence. We grew revenue in the quarter, in part by continuing to expand relationships with hospital health systems. Our existing Professional Lab Services relationships, including RWJBarnabas in New Jersey, HCA in Denver, and most recently, Montefiore in New York City, are performing better than expected. And our pipeline for new relationships remains strong.

During the first quarter, we announced the acquisition of an outreach operation of PeaceHealth Laboratories and expect to close in the second quarter. In addition, after the close, we will execute a professional laboratory services agreement to manage 11 PeaceHealth laboratories serving medical centers in 3 states in the Pacific Northwest.

We are partnering with health plans to improve the patient experience by improving price transparency, which will also reduce bad debt. Our real-time payment determination, which we began piloting in early 2016, enables us to give patients an accurate picture of their financial responsibility for lab testing and allows patients to pay at the point of care. We are currently live with Aetna, Highmark, UPMC, Florida Blue, and we expect to have more payers in place by the end of the year. This service benefits Quest and the entire health care systems: patients, providers and payers.

Advanced Diagnostics, which generally includes our genetic and molecular-based tests, grew in the quarter along with nonroutine testing. Major drivers included QNatal, genetic carrier screening, prescription drug monitoring, hepatitis C and QuantiFERON TB testing.

In the quarter, we also announced the launch of a new test service that helps physicians evaluate a patient's response to drug therapy used to treat infection with hepatitis B virus, HBV. This is the first test of its kind available in the United States. Physicians can use it to tailor more effective treatments for up to 2.2 million individuals affected with HBV.

We're also making progress executing our strategy through provider of choice for our consumers. In late January, we began providing genotyping for AncestryDNA, a service that today identifies and quantifies an individual's ethnic origin based on results of DNA testing. We are pleased with the initial execution of this program and look forward to building on our relationship with Ancestry. We continued to expand our relationship with Safeway and are now operating in 65 stores. Consumer and employee satisfaction remain high, and we are on track to open a total of 200 Patient Service Centers in Safeway stores by the end of 2017.

We're continuing to drive operational excellence and remain on track to deliver $1.3 billion of run rate savings as we exit 2017. Our revenue services partnership with Optum is on track in helping us to drive down bad debt and denials. As we have often said, quality and efficiency go hand in hand. We continue at near Six Sigma levels in many areas and in the quarter have made year-over-year gains in many quality measures, including reduced Patient Service Center wait times and approved test turnaround times.

We expect our commitments to enable our processes will deliver results. We expect to cut paper requisitions by 50% by the end of 2017. And we'll enable patients to check in electronically at roughly half of our Patient Service Centers by the end of the year. Additionally, we expect our lab systems to be 85% standardized by the end of the year.

We received some meaningful recognition in the quarter, once again being named one of the World's Most Admired Companies by Fortune Magazine. Quest was 1 of only 6 companies in health care, pharmacy and other services industry and the only diagnostic information services company to obtain most admired status.

Looking forward to the remainder of 2017, we are well positioned to continue to accelerate growth and drive operational excellence. We have the right strategy and the right team to execute and create value for our shareholders.

Now let me turn it over to Mark, who will take us through our financial performance in detail. Mark?

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Mark J. Guinan, Quest Diagnostics Incorporated - CFO and EVP [4]

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Thanks, Steve. Starting with revenues. Consolidated revenues of $1.9 billion were up 1.9% versus the prior year on a reported basis, while equivalent revenues grew 3%. Revenues for Diagnostic Information Services grew by 3.2% compared to the prior year. Most of this growth was organic, with approximately 90 basis points attributed to the 2016 acquisition of Clinical Laboratory Partners.

Volume, measured by the number of requisitions, increased 3.5% versus the prior year, of which 2.6% was organic. The year-over-year impact of weather was negligible in the quarter. Revenue per requisition in the first quarter decreased by 20 basis points versus the prior year. As a reminder, revenue per req is not a proxy for price. It includes a number of variables, such as unit price variation, business mix, test mix and test per req.

Unit price headwinds in the first quarter continued to be moderate and less than 100 basis points. We know that price fluctuations can vary from quarter-to-quarter, but we continue to expect that unit price headwinds will remain consistent with the last few years. Beyond unit price and the impact of growth in our PLS partnerships, other mix elements, including test and payer mix, contributed more than 1% to revenue per req in the quarter.

Reported operating income for the quarter was $279 million or 14.7% of revenues compared to $257 million or 13.8% of revenues a year ago. On an adjusted basis, operating income was $297 million or 15.6% of revenues compared to $281 million or 15.1% of revenues last year. Please keep in mind our Focus Diagnostics products business contributed approximately $8 million of adjusted operating income in the first quarter of 2016. Excluding the impact of Focus, adjusted operating income would have grown approximately 9%, and adjusted operating margin would have increased 80 basis points year-over-year, consisting of 30 basis points of operating margin tied to Focus and 50 basis points of adjusted operating margin growth.

Reported EPS was $1.16 in the quarter compared to $0.71 a year ago. The prior year quarter included a charge of $30 million after tax or $0.21 per diluted share related to the early retirement of debt. Adjusted EPS was $1.33, up 18% from $1.13 last year. The company recorded after-tax charges totaling $11 million in the first quarter or $0.08 per diluted share, representing restructuring and integration costs. Our effective tax rate in the quarter was approximately 32% compared to approximately 39% last year. The decrease in the effective tax rate was a result of $16 million or $0.11 per share in excess tax benefit associated with stock-based compensation compared to a $2 million or $0.01 per share benefit last year.

Bad debt expense as a percentage of revenues was 4.4%, 20 basis points better year-over-year, but 80 basis points higher than the fourth quarter of 2016. As a reminder, bad debt expense rate typically increases sequentially in the first quarter due to the reset of patients' health insurance deductibles at the beginning of the year. As in prior years, we expect the bad debt rate to improve gradually throughout the year. Note that the year-over-year compare was also negatively impacted by the fact that our products business had a lower associated bad debt rate.

Cash provided by operations in the first quarter was $196 million versus $153 million last year. Recall the retirement of debt lowered our operating cash flow by approximately $47 million during the first quarter of 2016. Capital expenditures during the quarter were $42 million compared to $47 million a year ago.

Now turning to guidance. We are providing the following updated outlook for 2017: Revenue is unchanged to be between $7.64 billion and $7.72 billion, an increase of 1.7% to 2.7% versus the prior year on a reported basis and an increase of about 2% to 3% on an equivalent basis; reported diluted EPS to be between $4.73 and $4.88; and adjusted EPS to be between $5.45 and $5.60. Cash provided by operations is also unchanged and remains at approximately $1.1 billion. And finally, capital expenditures remain between $250 million and $300 million.

Our increased EPS guidance reflects the higher expected level of excess tax benefit associated with stock-based compensation that was included in our previous guidance. Note that our original EPS guidance assumed a similar benefit in 2017 as we recognized in 2016 for the full year, which was about $0.06. As you are well aware, our share price appreciated substantially in 2016, which yielded a significantly higher tax benefit in Q1 2017 based on equity vesting and option exercises. Our updated reported and diluted EPS guidance for 2017 assumes another $0.03 of benefit over the remainder of the year. However, fluctuations in our share price and option exercise activity could add volatility to this figure. Going forward, we would expect to experience some level of excess benefit over the next several years. However, the time frame and absolute benefit is difficult to forecast given its dependence on our share price and the timing of option exercises.

Now let me turn it back to Steve.

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, CEO and President [5]

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Thanks, Mark. Well, to summarize, we delivered strong growth across the board in the first quarter, with gains in revenues, margins, operating income, EPS and operating cash flow. Our agreement with PeaceHealth will further boost our growth later in the year. And we are laser-focused on our 2-point strategy to accelerate growth and to drive operational excellence.

So I would like to now open it up for any questions you might have. Operator?

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Questions and Answers

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Operator [1]

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(Operator Instructions) And we will take our first question from Ross Muken with Evercore ISI.

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Ross Jordan Muken, Evercore ISI, Research Division - Senior MD, Head of Healthcare Services and Technology and Fundamental Research Analyst [2]

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On the underlying organic volume, I mean, I know you called out Barnabas and HCA and a few other pieces. But certainly, better than we would have suspected, even given that relative to what we've seen in general on volumes across the markets. And maybe can you just help us understand how much some of those entities you called out sort of contributed to the strained versus sort of underlying market and how you're thinking about the pacing for the remainder of the year given what's implied?

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, CEO and President [3]

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Yes. So thanks, Ross, and I'll start, and then Mark will add to it, I'm sure. First of all, we're off to a good start. We're pleased with our first quarter performance here. There's a lot -- a number of elements that contributed to the growth in the first quarter. We've highlighted some of those in our script. First of all, we do believe that we'll continue to get growth from our Professional Lab Services work that we're doing. We saw some growth from that. Second is we continue to get nice growth from our Advanced Diagnostics portfolio and some of the more advanced, what's typically referred to as esoteric testing that we do. We've called out some of those. And we've mentioned in the past that prescription drug monitoring and the work we're doing with TB QuantiFERON continue to be nice areas for growth for us. We also got some nice growth for some other areas of the business, like our Wellness business and some of our other services business. So across the board, good balanced growth, consistent with our strategy that we've had to focus on hospitals, that focus on our clinical franchises and bringing new products into the marketplace and commercialize those better than we have in the past. And then finally, just good execution across the board. So let me turn it over to Mark to give some color around this and also the rest of the year.

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Mark J. Guinan, Quest Diagnostics Incorporated - CFO and EVP [4]

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Sure. Thanks for the question, Ross. As I mentioned in the prepared remarks, we have about 90 basis points in volume and revenue from M&A, largely that was CLP. We're lapping CLP at the end of the first quarter, so we no longer have that tailwind. Barnabas is pretty largely ramped up, so that annualized in the first quarter as well. So those are behind us in terms of strong year-over-year drivers of growth. Now what we do have in front of us is continued ramp-up of HCA. We are just in the early stages of Montefiore. And then obviously, we announced PeaceHealth, which has a outreach element and also a professional laboratory services element that we expect to execute; have not closed that yet. When we gave our original guidance of 2% to 3% of equivalent growth, the only M&A included in that was CLP because that had been executed. And while we are very optimistic about closing Peace, and there's a deep pipeline of other potential M&A opportunities, given the fact that we've got a pretty broad range of 100 basis points, even though we're cautiously optimistic after the first quarter, we didn't feel at this point compelled to change our revenue guidance yet.

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Ross Jordan Muken, Evercore ISI, Research Division - Senior MD, Head of Healthcare Services and Technology and Fundamental Research Analyst [5]

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And maybe just a quick update on sort of how the Optum relationship is sort of progressing? And any further thoughts? Obviously, a lot of market chatter, or at least financial community chatter on sort of that relationship as a whole, and just maybe talk about how you're thinking about obviously the longer-standing relationship with United.

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, CEO and President [6]

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Yes. Well, first of all, it's going well. We announced it in the fourth quarter of last year. And a big component of it is what we're doing around revenue cycle management and our billing operations. And as I said in our opening remarks, it's going very well. We're pleased with that. As you said, it is a relationship, so there's multiple areas beyond what we're doing around billing. We continue to build on that relationship, and it's going well as well. We have a good relationship around our Wellness business. We are their partner for wellness, along with other partners that we sell through. Second is we continue to work with them on what we do with clients around data and population health. And if you think about what we're doing with our professional laboratory services business, we're calling on the same people that are trying to become more efficient and become better in delivering integrated delivery system. And so that area is promising as well. So off to a good start, doing what we said we would do, and the relationship will only get stronger over time.

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Operator [7]

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And we will take our next question from Dan Leonard with Deutsche Bank.

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Daniel Louis Leonard, Deutsche Bank AG, Research Division - Research Analyst [8]

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So I was hoping you could comment further on the deal pipeline, whether you're seeing any increased competition for deals of hospital outreach programs or otherwise, and whether you expect that the impact of PAMA timing, whether that changes at all would impact the deal pipeline.

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, CEO and President [9]

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Yes, thank you. First of all, the pipeline, as we've said, is supportive of our long-term goal of 1% to 2% of growth through acquisitions. We're hopeful about that going forward. As far as competition, I would say the competition is stable versus what we've seen in the past. And finally is in regards to PAMA, I think PAMA in general is a change that some would argue could put more catalyst at hospital outreach businesses to consider their strategy going forward. So when we engage with hospital systems around their lab strategy, many CEOs that engage with you understand that both the commercial rates as well as the Clinical Lab Fee Schedule rates will be under pressure. And this is one of the considerations that they think about as far as potentially selling their business or partnering with us in their business going forward. So if, in fact, there is some price pressure related to the refresh of the Clinical Lab Fee Schedule, that could be a further catalyst to accelerate some of this going forward. But as you know, PAMA, the data submission has been postponed by 60 days. We're still believing based on what they've told us so far, that they're committed to trying to refresh the Clinical Lab Fee Schedule by the beginning of '18. But we'll see on that. But it is another fact that we think is helping us with our discussions with hospital systems around their lab strategy.

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Mark J. Guinan, Quest Diagnostics Incorporated - CFO and EVP [10]

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Yes. So if I could just add 2 pieces of color to that, Dan. One is that -- recall that when Medicare changes reimbursements, we're equally impacted. So the buyer and seller are both equally impacted in terms of the value. If they get pressure on commercial rates, that doesn't matter to us. It doesn't change our valuation because obviously we valuated our own commercial reimbursements. So while it might be more of a catalyst, it also reduces the value to both the buyer and the seller. And then in terms of competition, if you recall, these outreach deals are largely cost-synergy, value-creation opportunities. And so any given outreach is likely to not be worth the same to multiple competitors because it's highly dependent on where your laboratory is located, where your logistic routes are, where your patient services are currently located. And there are geographical differences amongst any competitor who might be looking at purchasing an outreach. So in -- there's always, in any larger opportunity, likely to be a couple of parties at the table. But it's not an auction because, quite frankly, we're going to value them differently because it is based on that infrastructure.

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Daniel Louis Leonard, Deutsche Bank AG, Research Division - Research Analyst [11]

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All that color is very helpful. Just one clarification. So if the update to the Clinical Lab Fee Schedule were postponed to 2019, would the deal funnel soften? Or is it not that directly linked?

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, CEO and President [12]

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It's not that directly linked. I think it's a fact out there that CMS is looking at refreshing the Clinical Lab Fee Schedule, as we've often talked. Until we get all the data, we don't know what's going to happen with it. But it's just a fact out there that there's going to be pressure on rates. And therefore, hospital CEOs are thinking about their options for outreach.

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Operator [13]

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We'll take our next question from Ricky Goldwasser with Morgan Stanley.

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Rivka Regina Goldwasser, Morgan Stanley, Research Division - MD [14]

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I have 2 questions. The first one on PAMA. I'm just trying to understand, Steve, kind of like from your perspective, one, is there anything that you need to do in order to be prepared if PAMA were to be implemented in January 2018, so how that kind of like uncertainty impacts you? And then a follow-up on PAMA is you talked about the applicable lab definition. Where is that? What's the status of these conversations? And did you quantify the impact if the definition changed for you? And should we assume that if this is something that's really kind of like in process that if that were to happen, the 1/2018 start date seems unlikely?

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, CEO and President [15]

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Yes. So thanks, Ricky. Let me give you some color around PAMA. First of all, the date to put in all the data has been pushed out for 60 days. And yet, CMS still is holding to the goal of refreshing the Clinical Lab Fee Schedule by the beginning of 2018. Now with all that said, we just took 2 months out of our already tight schedule. And so the way this will work is they'll get all the data by the end of May, let's call it June. They have to work through that for 4 months, and of which, in those 4 months, 2 of those months are in the summer months, and then publish their rates that they will look to comment on in the September time frame. And then they'll publish the final rates in the fourth quarter for effect beginning of January 2018. So as you think through this, the 2-month delay in data reporting clearly is putting pressure on the schedule. And that's why people are saying, "Okay, given that they still have the goal, is it possible that they can get there?" I just shared with you exactly what we're hearing, but there is more pressure on them to put that all together. Now with all that said, as trade association, we continue to be actively engaged with CMS. When we're down there for our annual meeting of ACLA several weeks ago, we met with CMS. This is many members of our industry. They're very responsive to us. They listen to our concerns about data. Part of the response you see with postponement of the data collection is because we are engaged with them. And we're also having discussions with them and members of Congress about the definition of applicable laboratory. And the way CMS is implementing the approach right now is excluding a fair percentage of outreach, which is a large proportion of this market. So there will be another meeting next week with CMS, and this is at the highest level of CMS with Seema Verma, to talk about 2 issues: one is the time frame; and second is applicable laboratory. And we hope to engage, as we've done so far, as a trade association of being constructive and helpful to get the market-based approach right, which is the intent of Congress with this bill. So we continue to work it with them. You also need to understand that this also has a backdrop of them having a lot on their table and the number of physicians across the board in HHS and CMS not being filled. So we also know that they've got to work through a lot. So I'm giving you some of the color. But we're actively working this as a trade association, and we believe that by doing so, it's going to serve this industry well.

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Mark J. Guinan, Quest Diagnostics Incorporated - CFO and EVP [16]

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Yes. And so Ricky, just to answer your specific question about, is there anything we need to do to get ready. The answer is most of what we need to do is behind us. There was quite a bit of work to get the data together, and we got it all together by the end of the first quarter when we needed to. Now really what's in front of us is just, once they publish the proposed rates, for us to take a look at it, then obviously respond to that, if appropriate. And then as Steve mentioned, through our trade association, continue to push for what we think is appropriate, which is expanding the definition of applicable lab. But there's not a lot of work per se between now and whenever they might decide to implement the new rates.

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, CEO and President [17]

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And just to round this off, we also said in our Investor Day in the fall that if, in fact, it is implemented in 2018, given the size of this business for us, the effect it could have based upon some of the estimates, that we're going to be able to absorb that given the opportunities we have running operational excellence going forward in a normal course of running our business. So that's our position. We believe it's already implied in our outlook that there could potentially be some reduction here, but we don't know for certain until we get all the data collected. But we're managing this proactively going forward, and we'll see what happens.

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Rivka Regina Goldwasser, Morgan Stanley, Research Division - MD [18]

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Okay, that is helpful. One other question, just regarding the guidance, questions we received this morning. I mean, if you think about the guide, a very nice beat in the quarter. And you had the tax benefit. You raised by less than your beat. So -- and I know that you said to look at early in the year to change guidance. But is there anything that you see from the operating line, kind of like the expense side, that is making you wait for the time being?

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Mark J. Guinan, Quest Diagnostics Incorporated - CFO and EVP [19]

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No, Ricky. As I said earlier, it's just early in the year. We're cautiously optimistic, but it's 1 quarter. And obviously, we're optimistic. We're going to continue with strong performance. At this point, you're correct, the entire change in guidance reflected the excess tax benefit over and above what we had built into our original guidance.

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Operator [20]

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(Operator Instructions) We will now move to our next question from Jack Meehan with Barclays.

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Jack Meehan, Barclays PLC, Research Division - VP and Senior Research Analyst [21]

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I wanted to follow up on the volume side. Just even after you make all the adjustments around M&A, new business, leap day, it appears there was a real step change in the first quarter for the underlying trends. Was there anything else worth flagging? Or the in-sourcing, outsourcing tug-of-war with hospitals, have you ever -- have you seen any change just on that dynamic as well?

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, CEO and President [22]

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Mark?

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Mark J. Guinan, Quest Diagnostics Incorporated - CFO and EVP [23]

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I don't think there's any step change in the environment. I mean, if anything, I think we'd comment that utilization has improved directionally over a couple of quarters. So we are seeing some good signs of utilization. We've mentioned in the past that we monitor what we call our same-store, same-account performance. And certainly, we're seeing improvement in that over the last couple of quarters into the first quarter. So these things can ebb and flow. Don't know whether that's a trend and if it will continue. But in the first quarter, if there's anything I could point to kind of outside of the things we've talked about, so certainly a lot of the deals we've done, including things like Ancestry, et cetera, are helping to drive some of that growth. I'd really say the utilization seems to be a little stronger than it was in the past year.

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, CEO and President [24]

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And Jack, just to remind everyone, this is the march we're on with growth. Back when we started with our strategy in 2012, we said we were going to restore growth in our business that was shrinking organically. We reduced that decline. We stabilized the business. We started to get some organic growth in '16. And our 2-strategy focus right now is, number one, to accelerate growth. So what you see in Q1 is the continuation of that march of improvement. And we believe a lot of the investments in capabilities and focus that we put over the last several years is continuing to yield the results we expected. So we're pleased with Q1. As I mentioned in my earlier comments, the results are in a number of areas that led to the growth that you saw in Q1, but we believe we're off to a good start for the year.

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Mark J. Guinan, Quest Diagnostics Incorporated - CFO and EVP [25]

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And the only other thing I'd add is that the timing of Easter probably mitigated some of the fact that we lost the extra day from leap year last year. So it's hard to predict how much that's going to impact you because it's not consistent every single year. But definitely, the calendar shift of Easter into the second quarter certainly helped Q1.

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Jack Meehan, Barclays PLC, Research Division - VP and Senior Research Analyst [26]

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Great. And then as my related follow-up, one of your early themes from earnings has been around payer mix. So I was wondering if you've seen any changes on the government side and just how that impacted the business in the quarter?

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, CEO and President [27]

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Nothing notable. Mark, anything?

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Mark J. Guinan, Quest Diagnostics Incorporated - CFO and EVP [28]

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No, there's nothing notable, Jack.

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Operator [29]

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We will take our next question from Amanda Murphy with William Blair.

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Amanda Murphy, William Blair & Company L.L.C., Research Division - Healthcare Analyst [30]

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Sorry, if I just can ask one more on the volume side. Just given all the comments, I see there's a lot of moving parts. But I just wanted to confirm a couple -- one thing that PLS volumes do, there are -- those would be then included in the 2.6% organic, is that correct?

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Mark J. Guinan, Quest Diagnostics Incorporated - CFO and EVP [31]

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That's correct.

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Amanda Murphy, William Blair & Company L.L.C., Research Division - Healthcare Analyst [32]

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Okay. And then is there any way, just kind of thinking about all the different points you've made around PLS dynamics, Ancestry, et cetera, versus just basic underlying utilization, how -- can you quantify -- if you lump those into 2 different buckets, sort of underlying utilization versus everything else in organic, what the impact was in the quarter from both of those sides?

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Mark J. Guinan, Quest Diagnostics Incorporated - CFO and EVP [33]

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Yes. So Amanda, we've decided that we're not going to break out PLS every single quarter. What I did say at Investor Day was that I would expect over the 3-year period through 2020 that we would get about 100 basis points of lift from PLS would be our expectation. So we do have a deep pipeline. It's going to vary quarter-to-quarter given the timing of deals and so on and so forth. We're not quite there yet, but we're building toward that. So we got some good solid growth from our new PLS businesses. And over time, we're expecting a CAGR of around 100 basis point lift, but we're not going to break it out every single quarter.

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Amanda Murphy, William Blair & Company L.L.C., Research Division - Healthcare Analyst [34]

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Okay. And so I'm going to count that as one, but sneaking in one more, just last side. This -- I guess I just had a question, given your comments on the pipeline that you have and how strong it is, how you're thinking about forecasting or guidance this year, just given PLS growth potential versus sort of the potential operating market impact there? Or is the right way to think about the pipeline more like a 2018 benefit?

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Mark J. Guinan, Quest Diagnostics Incorporated - CFO and EVP [35]

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So there are absolutely assumptions just like we would in winning accounts. In our guidance for the year, we have to make some assumptions around how we're going to perform. So we've got a deep pipeline of PLS opportunities. And like anyone would, we would do some sort of probability adjusting against that in terms of getting those complete, the timing and so on. So there's absolutely an element of PLS in that original 2% to 3% organic guidance that we gave on an equivalent basis. And depending on how things progress, that's why we give a range. It could be slightly more or less than we assume, but we're confident enough to build it in the guidance. And then on M&A, just given the fact that, that's a lot less in our control, we just thought the prudent thing would be not betting on the comp and having any unexecuted M&A specifically in that guidance. So again, the way you should -- I would encourage you to think about PLS, it's like winning a new account, a new hospital system for our core business as something we go out. We -- it may not be quite us "competitive" because there's only a handful of labs that could actually perform the PLS deal because it really takes economies of scale to drive that savings. And quite often, these are so complicated. It's not even a more than one party negotiation. It's just us alone talking to the hospital system. So in summary, yes, we have some assumptions around our pipeline getting executed this year in that organic growth. And we're very confident, just like we've done in the past, about our ability to hit that.

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, CEO and President [36]

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So just to make sure it's clear. On PLS, it is a business. So we're managing a portfolio of professional laboratory services accounts. And like any business, these accounts are at different stages of their evolution. So in that business, we have a number of accounts that have been with us for some time. And like with any business, you're managing those accounts to make sure you have a referable account going forward. So that's in our base as well. Second is we're growing new accounts. They're turning on. There might be some more opportunities to expand with other hospitals. So we've got growth within the installed base as well with some growing accounts. And then we're bringing on board some new accounts. And so the highlights we've talked about in those new accounts, you put those 3 together, and that has a business in its aggregate growing. But don't forget, we still have this installed base of existing business that we compare ourselves as well. So we need to think about there's an existing business, with managing accounts, growing accounts and then executing brand-new accounts. But with all those 3 components, this is a growing business for us. It's a good business for us, and it positions us nicely with integrated delivery systems.

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Operator [37]

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Our next question comes from A.J. Rice with UBS.

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Albert J. Rice, UBS Investment Bank, Research Division - MD and Equity Research Analyst, Healthcare Facilities [38]

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I might first just ask about the revenue cycle. A couple of aspects of revenue cycle management initiatives. You talked about it in the prepared remarks the initiative around some payers, like Aetna, for better price transparency, and that might help collecting co-pays and deductibles upfront. Can you give us the read on what your experience has been there? And then you mentioned Optum, obviously. What you're doing there on the revenue cycle management? Understanding the benefits on the revenue cycle management will probably going to take 2 or 3 years to realize, is that true? But there was also a cost-savings initiative of transference of employees over to them. Is that fully reflected in the first quarter results?

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, CEO and President [39]

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Yes, let me start. First of all, the relationship with Optum for revenue cycle management has 3 components. First of all, we believe, by working together with them, we continue to become better and more efficient in our billing operation. And the efficiency associated with that, A.J., is part of our $1.3 billion Invigorate savings and efficiency goal that we have. So this is part and parcel of many programs we have to drive efficiency. And so a portion of our results and a portion of our achievement against that goal will include what we're doing here. Second is we believe by getting smarter with them around the interaction between Quest and patients and payers, we can do a better job of bad debt and denials. And specifically, they will help us with what we talk about as far as real-time adjudication with patients. And we mentioned 4 payers that are initially working with us on that. But we expect, with Optum's help, we can get some more. And then finally, it's just completing the data set and their relationship with payers in general, we think, will be helpful of getting paid both from a standard perspective in bad debt, but also with the denials associated with more advanced diagnostics. So Mark, anything you'd like to add to that?

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Mark J. Guinan, Quest Diagnostics Incorporated - CFO and EVP [40]

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Yes. So A.J., as we shared before, we signed a 10-year agreement with them to manage our revenue cycle management. And we do have commitments for them on cost savings to run that operation. And yes, that started in Q1, but it gets feathered in over the life of the contract. And then the second element is Optum helping us reduce denials and bad debt, as Steve mentioned. And although we started the real-time adjudication prior to the relationship, Optum is helping us to drive that faster and more deeply than maybe we could have done on our own. Feel very good about what they're doing. And I can tell you that early on, we've seen a reduction in patient bad debt in the areas where we've rolled this out. So we're feeling good about it. We're seeing what we would expect. It's still early because, at this point, it's largely just the patients who are engaging our patient service centers. We're working on solutions that will be available and obviously, to change management's plan to roll it out in the physician office, where about 60% of our volume comes from. So today, it's really patient service centers, then moving into our in-office phlebotomist and then eventually moving into the physician's office where ultimately we'll get the full benefit. But we're very encouraged, and we're absolutely seeing a reduction in the rate of patient bad debt where we've rolled out this real-time adjudication.

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Albert J. Rice, UBS Investment Bank, Research Division - MD and Equity Research Analyst, Healthcare Facilities [41]

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All right. And I might ask you about one other initiative as my follow-up. You said you're in 65 Safeway stores. Can you sort of update us? Is this mostly having a benefit, from the perspective of patients, of getting higher patient satisfaction? Are there other benefits to you? And I know there's been on-and-off discussions with urgent care clinics, MinuteClinic type of entities. Is there any update about working with them for a similar type of a program?

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, CEO and President [42]

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Yes. So thanks, A.J. Our Safeway relationship, we believe, is the beginning of our consumer initiative working with retailers in a bigger way. Part of this is around providing just better access. We believe we have unparalleled access in the market. We have over 2,200 Patient Service Centers. We have 3,800 phlebotomists in physicians' offices, about 6,000 access points. But we believe some of these retailers, we could be working with, and Safeway is one. They have better locations. And there is anywhere from 15% to 20% of laboratory requisition orders that go unfulfilled. And so we're hopeful by having better access, we're going to get more fulfilled requisitions, and that's going to help our growth and also help some share if we have better access. We hope when a patient has a choice and ask the question who you'd like to go to for their laboratory testing, that the patient will remember a better experience at a more convenient location for that experience, and they will choose Quest based upon our movement here. So it's both growth, but also, as you would expect, as we start to come on board with some of these centers, we rationalize our presence in the ZIP Code, we might shut down some of our smaller patient service centers and save us some money as well. So it's both growth and efficiency. And we do continue to have relationships, and we do continue to have pilots with some of the other players in this retail space. We continue to have CVS as a client. And we're optimistic about other retailers as they continue to evolve their health strategy. They see it as a nice expansion from what they do today around pharmacy. And also, it helps these retailers with getting traffic into their stores as well. So it's a multifaceted program for us that directionally, we're very, very optimistic about and think we're off to a great start.

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Operator [43]

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We'll move next to Bill Quirk with Piper Jaffray.

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Alexander David Nowak, Piper Jaffray Companies, Research Division - Research Analyst [44]

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This is Alex Nowak on for Bill today. I was just hoping if you could -- when you're looking at deals for the future, I was wondering if you could just rank priorities, so between esoteric testing to gain access to different technology, looking at core testing labs to build geographic position and then finally, looking at hospital business partnerships. If you could just rank those 3 on what your priority is looking for doing a deal with 1 of those 3 in the future, that would be great.

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, CEO and President [45]

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Yes. So all that you mentioned are strategically aligned with our direction. And so we have, over the last several years, cleaned up our portfolio. We're entirely focused on Diagnostic Information Services. So our first filter for any deal is, does it fit into our scope of our strategy, and so what you just mentioned all do. Second is we do believe that there is our growth strategies. And we've outlined in the fall 5 areas that we're focused on for accelerating growth. One is related to partnering with hospital systems. And so a hospital outreach deal fits into that strategy as well. Second is to continue to invest in Advanced Diagnostics and bring in new capabilities to the marketplace. And so some of the potential acquisitions we could do there would fit there as well. And as far as priorities, what we have shared in the past is we continue to be very, very rigorous in making sure that if they're strategically aligned, that we have the thresholds we expect to make for our shareholders with any acquisition. I would say that's generally more of the cut we have is where they're strategically aligned, where they fall out in terms of use of our cash and are they giving acceptable returns on invested capital, providing us the growth we expect and at the same time become accretive to earnings in a reasonable period of time. So that's generally how we rack and stack acquisitions, and it's served us well so far. And that fits into the strategy that we have of 1% to 2% growth of acquisitions. And as you can see from our prior acquisitions over the past 4 or 5 years, you see all those categories. And it's more of a matter of when they come in and when can we execute it and less to do with the sorting of what we'd like more of a priority than others. But we haven't had the problem of having not enough cash to execute things. We think we should do it strategically and also that we think has a good return for our shareholders. So Mark, anything you'd like to add to that?

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Mark J. Guinan, Quest Diagnostics Incorporated - CFO and EVP [46]

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No, I think you covered it.

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Alexander David Nowak, Piper Jaffray Companies, Research Division - Research Analyst [47]

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Okay, that's very helpful. And then just a quick follow-up. Could you just remind us what the margin profile is of your hospital relationships and just comparing that to your core business? And then what's the opportunity to expand the margins in the hospital business?

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Mark J. Guinan, Quest Diagnostics Incorporated - CFO and EVP [48]

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Right. So when you say hospital relationships, I mean, that's multifaceted. I think you might be specifically talking about professional laboratory services where we're actually serving them for the work that is not explicitly billable. So it's the laboratory work they have to perform in order to get paid under the DRG for inpatient, outpatient, et cetera. Those margins, as we've shared, are lower than our core, but double-digit. That's as explicit as we've been. And then in terms of our relationship, and that word is really important, when we have a relationship with a hospital and we do professional laboratory services, we typically get most, if not all, of the reference work. So we have talked about the fact that we do reference work for half the hospitals in the country. That is the high end, the more esoteric type work that either they are not able to or have made a rational decision not to perform, given limited size and scale. So there's a handful of people that do that work. We have the largest reference work of any laboratory, and so that's another part of our relationship with hospitals. And then certainly, the other part of the relationship is we've got other businesses that can support hospitals or large employers. We've got our Wellness business so we can help them keeping their population healthy. We've got some of our diagnostic tools that certainly can help them manage everything, laboratory spend to benchmarking their clinical practice and utilization of diagnostics. So there's a lot involved in a relationship with a hospital. But specifically, on the PLS, it's double-digits, but it's slightly lower than our core margin.

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, CEO and President [49]

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Now let me just underscore what Mark just said and remind you what we shared with you in the fall because it's important in our strategy in what we're doing every day. When we talk about hospitals, it's about 60% of our market when we look at it. And we have laid that out in 3 ways. One is what we can do to help them with their inpatient laboratory costs. These are cost centers where we can save them money. Number two, what Mark just went through as far as the reference testing, the advanced diagnostics with some of the hospitals that they can't do themselves, they rely on laboratories like ourselves. And then finally is outside of the hospital, and some have outreach businesses, but they also are buying physicians and they're looking at serving a geographic area and providing good laboratory services with those physicians that they now own or are affiliated with. And so when we have a discussion, and this was last week with a very large integrated delivery system, their lab strategy includes all 3. So when we talk about a relationship with hospitals, yes, it's the inpatient laboratory, but it's a holistic view of how we approach the marketplace in a much more progressive, holistic view as they build integrated delivery systems. So it's all 3 components when we approach the systems. And it's serving us well, as you see in our good start of the year.

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Mark J. Guinan, Quest Diagnostics Incorporated - CFO and EVP [50]

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And in fact, PeaceHealth is a perfect example.

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, CEO and President [51]

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Exactly.

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Mark J. Guinan, Quest Diagnostics Incorporated - CFO and EVP [52]

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So as we engage with PeaceHealth, the decision was made to sign with us on a PLS deal. They are selling us their outreach. And then, obviously, we have a reference relationship with them as well.

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Operator [53]

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We'll take our next question from Donald Hooker with KeyBanc.

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Donald Houghton Hooker, KeyBanc Capital Markets Inc., Research Division - VP and Equity Research Analyst [54]

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I just have one question here. I'm really curious about this, I know it's new, but this relationship with IBM and kind of how that -- I realize it's new, but how that might play out and what you're seeing and experiencing with them on cognitive computing?

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, CEO and President [55]

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Yes, appreciate it. So in our Advanced Diagnostics business, we have our oncology franchise. And related to that, if you recall, several years ago, we formed a relationship with Memorial Sloan Kettering where we put together a product that's called OncoVantage, where we take some of their content, some of the research with 34 actionable genes. And OncoVantage essentially is a product that delivers on precision medicine around oncology. And what we also realized with Memorial Sloan that we needed a cognitive computing partner. And so we, this fall, announced now teaming up, the 2 of us, with IBM, and this is their IBM Health Watson (sic) [ IBM Watson Health ] . And so they are our cognitive computing partner. So collectively now, the threesome is going at the market. And the opportunity we see in front of us is about 70% of oncology here is in community health care centers, not in large urban centers like what Memorial Sloan would be serving. So it's a big opportunity for us. And we have our own dedicated sales force that's backed up with the brand and the content from Memorial Sloan. But now in working with IBM, we believe that their sales force and their presence with integrated delivery systems, and also just in general, public awareness of precision medicine and computing and health care is being helped by IBM. You might have seen some of the ads they've been running. In one of those specific ads, they actually do highlight the work they're doing with us and Memorial Sloan in the field of cancer. So we think it's a step in the right direction, and it's up and running well.

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Donald Houghton Hooker, KeyBanc Capital Markets Inc., Research Division - VP and Equity Research Analyst [56]

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Great. Yes, I did see those ads. And then I was just -- how -- what would take a reasonable time frame for you with this relationship? How might it evolve? This is a year’s process, I assume?

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, CEO and President [57]

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We continue to -- as with all our partnerships, so this is the beginning. There's other things we could do with IBM. We're not prepared to talk about that. But we believe all our partnerships start with something and they grow from there.

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Operator [58]

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Our final question will come from Steven Valiquette from Bank of America Merrill Lynch.

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Steven J. James Valiquette, BofA Merrill Lynch, Research Division - MD [59]

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I guess, from me, just a question around the PAMA cuts. My view is that if they are delayed beyond January of 2018, it would likely be net positive for Quest just because of the simple math of how it no longer potentially negatively impact the 2018 revenues. But as I'm out talking with investors, I'm kind of surprised I keep getting this view by some that a PAMA cut delay could actually be a slight negative for Quest. And the thought pattern is that if the PAMA cuts themselves were to theoretically cause some lab provider competitors to either go out of business or want to exit the business, that would obviously help your volume gains and also help your M&A pipeline. So a PAMA cut delay would potentially delay these types of benefits. So I guess since this just keeps coming up in my discussions and just to have more of a full discussion around this with you guys, I mean, how are you thinking about the net impact of a PAMA cut delay on your overall business for 2018?

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, CEO and President [60]

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Yes. First of all, the refresh of the Clinical Lab Fee Schedule from PAMA, I would just argue, is a reality that's creating some catalyst on hospital systems and let's just say all laboratories to consider their options going forward. And I would argue that it's independent of whether any refresh takes place in 2018, '19 or even '20. It's just sitting there, that how they get paid for Medicare is being revisited. And even though you said that it's cuts, it's unclear what the outcome will be until we gather all the data. We've talked about this before. Until we gather all the data, we don't have the visibility about the data, it's uncertain of what effect it would be. But we view that in general, this review and the pressure that's on payment in general, and we believe it's on the Medicare side with PAMA, but also on the commercial side, is a good catalyst for us having these conversations with integrated delivery systems and other laboratories on their strategy going forward. So that's the first point I'd like to make. The second is, the goal is still 2018. Obviously, if that's postponed or delayed and if, in fact, it had a negative consequence associated with how we get paid, it would be helpful in 2018. But right now, we're assuming that what they tell us is what they're going to do. And therefore, 2018 is what we're assuming, and we'll see if that does happen.

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Mark J. Guinan, Quest Diagnostics Incorporated - CFO and EVP [61]

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Yes. So the other element, Steve, is that if it's delayed because they expand the definition of applicable lab, we would assume that's probably a positive for the industry and certainly for us. And I can assure you that when I laid out the view through 2020 in terms of the 3% to 5% top line growth and mid- to high single-digit bottom line growth, I was building in some level of cuts on the Clinical Lab Fee Schedule into our revenue growth assumptions. But I was not building in some sort of a step change in the competitive environment where we were picking up significant volume because people couldn't survive in a world where Medicare cuts were made. So there, I would be cautious about assuming that we're hoping that cuts happen as large as possible and as quickly as possible. We certainly would not be disappointed if things get delayed.

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Steven J. James Valiquette, BofA Merrill Lynch, Research Division - MD [62]

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Helpful. One other, just a real quick housekeeping-type question. You mentioned the Easter timing and how that could have helped 1Q '17 just on the year-over-year comparison. And some people have asked, could there actually be a little bit of a volume headwind in 2Q '17 when thinking about those year-over-year comps? Is that worth flagging? Or am I just spending too much time thinking about holidays?

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Mark J. Guinan, Quest Diagnostics Incorporated - CFO and EVP [63]

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Well, it's absolutely, all other things equal, going to be a volume headwind in Q2, just like it helps us a little bit in Q1. But there are so many factors that go in. It's just one element of growth in the second quarter. But if you're looking at, is there something in the second quarter that would be a headwind, yes, the fact that Easter is in the second quarter is something to factor in.

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, CEO and President [64]

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Okay. We appreciate all the questions. Thanks again for joining the call. As you heard, we had a strong quarter, and we're off to a solid start in 2017. We're looking forward to meeting our commitments by our 2-point strategy, which is to accelerate growth and to continue to drive operational excellence. We appreciate your support, and you have a great day.

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Operator [65]

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Thank you for participating in the Quest Diagnostics First Quarter 2017 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) 203-1112 for domestic callers or (719) 457-0820 for international callers. Passcode 7180587. Telephone replays will be available from approximately 11:30 a.m. Eastern on April 20, 2017, until 11:30 a.m. Eastern on April 25, 2017. Goodbye.