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Edited Transcript of DGX earnings conference call or presentation 22-Oct-19 12:30pm GMT

Q3 2019 Quest Diagnostics Inc Earnings Call

MADISON Oct 24, 2019 (Thomson StreetEvents) -- Edited Transcript of Quest Diagnostics Inc earnings conference call or presentation Tuesday, October 22, 2019 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 - Executive VP & CFO

* Shawn C. Bevec

Quest Diagnostics Incorporated - VP of Investor Relation

* Stephen H. Rusckowski

Quest Diagnostics Incorporated - Chairman, President & CEO

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Conference Call Participants

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* Alexa Desai

Morgan Stanley, Research Division - Associate

* Brian Gil Tanquilut

Jefferies LLC, Research Division - Equity Analyst

* Derik De Bruin

BofA Merrill Lynch, Research Division - MD of Equity Research

* Donald Houghton Hooker

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

* Eric White Coldwell

Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst

* Erin Elizabeth Wilson Wright

Crédit Suisse AG, Research Division - Director & Senior Equity Research Analyst

* Jack Meehan

Barclays Bank PLC, Research Division - VP & Senior Research Analyst

* Kevin Caliendo

UBS Investment Bank, Research Division - Equity Research Analyst of Healthcare IT and Distribution

* Kevin Kim Ellich

Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst

* Mark Anthony Massaro

Canaccord Genuity Corp., Research Division - Senior Analyst

* Matthew Richard Larew

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

* Michael Anthony Newshel

Evercore ISI Institutional Equities, Research Division - Associate

* Ralph Giacobbe

Citigroup Inc, Research Division - Director

* Stephen C. Baxter

Wolfe Research, LLC - Senior Analyst

* William Robert Quirk

Piper Jaffray Companies, Research Division - MD and Senior Research Analyst

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Presentation

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Operator [1]

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Welcome to the Quest Diagnostics Third 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'd like to introduce Shawn Bevec, Vice President of Investor Relations for Quest Diagnostics. Go ahead, please.

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Shawn C. Bevec, Quest Diagnostics Incorporated - VP of Investor Relation [2]

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Thank you, and good morning. I'm here with Steve Rusckowski, our Chairman and Chief Executive Officer and President; and Mark Guinan, our Chief Financial Officer.

During this call, we may make forward-looking statements and will 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 from continuing operations and references to adjusted EPS refer to adjusted diluted EPS from continuing operations, excluding amortization expense. References to adjusted operating income for all periods 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.

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

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Thanks, Shawn, and thanks, everyone for joining us today. Well, this morning, I'll discuss the third quarter and review progress on our 2-point strategy, and then Mark will provide more detail on the results and take you through updates to our 2019 guidance. We had a solid quarter of top and bottom line growth while PAMA reimbursement pressures persist throughout the industry. Our expanded network access and laser-focus on driving operational excellence are enabling growth. Based on our progress to date, we have updated our outlook and are well positioned to meet our commitments for the year. For the third quarter, we grew revenues 3.5%, despite continued reimbursement pressure. Reported EPS was $1.56, up nearly 3% from the same period in 2018. Adjusted EPS was $1.76, up nearly 5%. Then volume growth remained very strong at 5.1%, and year-to-date volume growth is up 4.3%.

Now I'd like to briefly update you on the 3 fundamental changes in the laboratory marketplace that we discussed at last year's Investors Day. And as you know, the -- our PAMA, our expanded network access and increased consumerization of health care.

First on PAMA. The reimbursement pressure remains a catalyst for structural change in the marketplace. And there is mounting evidence that PAMA is hurting this industry. We see and hear the negative impact that PAMA is having whenever we evaluate potential lab acquisition targets. InCap today, a respected industry journal, it recently highlighted how PAMA and other reimbursement pressures are already starting to drive consolidation in the industry. As you know, here at Quest, we took a series of actions earlier this year to further reduce our costs to align with the PAMA cuts. Some decisions that we made were difficult and our employees have felt the changes. More PAMA reimbursement cuts are coming in 2020. Our industry continues to fight PAMA's law and implementation in the courts and in Congress. We recently received a favorable U.S. Court of Appeals decision to allow the lower court to review the merits of ACLA's case. ACLA submitted its initial brief last week and a decision is expected in 2020. This is encouraging news, and so is the introduction of the Laboratory Access for Beneficiaries Act or LAB Act, introduced in June by 6 members of Congress from both sides of the aisle and now with nearly 40 cosponsors.

ACLA is also working to build support for (inaudible) to include the LAB Act in the larger, end of year health care extender bill.

The second fundamental change affecting our industry is our expanded network access and payers becoming more focused than ever on driving better value in their last spend.

We are partnering with UnitedHealthcare to move testing volumes to high-value labs like Quest from high-costs hospital and out-of-network labs. UnitedHealthcare began offering a product with $0 member out-of-pocket charges for laboratory testing for the majority of fully insured lives in select states on October 1. UnitedHealthcare will also make the lab savings programs available for their self-insured employer groups beginning in 2020.

And then finally, we continue to see the ongoing consumerization of health care with more and more health care costs borne by consumers. In September, the Kaiser Family Foundation reported that the annual premiums from employer-sponsored health care coverage grew 5% for families, surpassing $20,000 for the first time. The number of employees with high-deductible health plans has increased over the past decade.

Turning to our recent progress. The first part of our 2-point strategy is to accelerate growth, which has 5 elements. To grow 2% per year through accretive strategically aligned 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 with data analytics and extended care services.

Now let me take you through a few highlights from our strategy to accelerate growth in the quarter. Our acquisition pipeline remains strong. As we said before, most deals in the pipeline are taking more time to develop than we have in the past. Conversations with hospital systems are getting broader. Hospital CEOs are also interested in how we can help them with their Professional Lab Services and taking on more of their reference work. As a result of this complexity, proposed relationships take longer to develop.

Hospital systems are also interested in learning more about our recently unveiled Quest Lab stewardship, an innovative new service that employs machine learning to help optimize laboratory test utilization. We have partnered with hc1, a health care IT company to provide a solution that gives Quest a differentiated offering in a competitive hospital marketplace. We continue to see revenue and volume growth as a result of our expanding network access. In aggregate, growth continues across our top 50 major health [line] customers. Key test growth drivers in the quarter include drug monitoring, continued strength in tuberculosis testing in both QuantiFERON and T-SPOT, STD testing and Cardio IQ. Each of these test categories posted solid contributions to the revenue growth in the quarter.

The second part of our 2-point strategy is to drive operational excellence. We remain on track to deliver 3% cost efficiencies for 2019 by continuing to drive increases in productivity. We have some examples, which include using digital technology to enhance the customer experience. We now have more than 8.2 million patients now making appointments and receive their results through our MyQuest digital platform. We continue to drive productivity improvements across logistics, patient services, lab services, enabling us to reduce our overall cost per laboratory requisition. And we're also putting new innovations to work while reducing costs. We're in the process of consolidating and simplifying our immunoassay platforms, moving to a single supplier. This approach enables greater throughput, a more efficient footprint and is expected to save us tens of millions of dollars per year. Now let me turn it over to Mark, who'll take you through our financial performance. Mark?

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Mark J. Guinan, Quest Diagnostics Incorporated - Executive VP & CFO [4]

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Thanks, Steve. In the third quarter, consolidated revenues were $1.96 billion, up 3.5% versus the prior year.

Revenues for Diagnostic Information Services grew 3.7% compared to the prior year, driven by strong volume growth and acquisitions, partially offset by higher reimbursement pressure. Volumes measured by the number of requisitions increased 5.1% versus the prior year. Excluding acquisitions, volumes grew 3.7%. We benefited from an extra revenue day in the third quarter, while the impact of Hurricane Dorian was a modest volume headwind. The net impact of these 2 items added roughly 1% to our organic growth in the quarter. Recall, we also highlighted last quarter that we recently exited some capitated contracts. In the third quarter, this change represented a headwind of nearly 1% to our organic volume growth. Importantly, we continued to see a modest acceleration in our volume growth associated with our UnitedHealthcare contract. Revenue per requisition declined by 1.2% versus the prior year, primarily driven by higher reimbursement pressure.

Unit price headwinds were approximately 2.5% in the third quarter. This includes the impact of PAMA, which amounted to a headwind of approximately 120 basis points. As a reminder, the PAMA impact includes both direct cuts in the Clinical Lab Fee Schedule as well as modest indirect price changes from Medicaid and a small number of floating rate contracts. Reported operating income was $313 million or 16% of revenues compared to $304 million or 16.1% of revenues last year. On an adjusted basis, operating income was $349 million or 17.9% of revenues compared to $333 million or 17.7% of revenues last year. The year-over-year increase in adjusted operating margin was primarily driven by strong volume growth and ongoing productivity improvements related to our invigorate initiatives, partially offset by higher reimbursement pressure. Additionally, patient concessions are down year-over-year.

Reported EPS was $1.56 in the quarter compared to $1.53 a year ago. Adjusted EPS was $1.76, up approximately 5% from $1.68 last year. Cash provided by operations is $895 million year-to-date versus $905 million last year. Capital expenditures were $228 million year-to-date compared to $232 million a year ago.

Now turning to guidance, our updated outlook for 2019 is as follows. Revenue is expected to be approximately $7.72 billion, an increase of approximately 2.5% versus the prior year. Reported EPS is expected to be between $5.48 and $5.53. And adjusted EPS to be between $6.45 and $6.50. Cash provided by operations is still expected to be approximately $1.3 billion and capital expenditures are expected to be between $350 million and $400 million. I will now turn it back to Steve.

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

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Well, to summarize, we had a solid quarter of top and bottom line growth. While PAMA reimbursement pressure persist throughout the industry, our expanded network access and laser-focus on driving operational excellence are enabling growth. So based on our progress to date, we have updated our outlook and are well positioned to meet our commitments for the rest of the year. Now we'd be happy to take any of your questions. Operator?

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Ralph Giacobbe with Citi.

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Ralph Giacobbe, Citigroup Inc, Research Division - Director [2]

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I guess I wanted to ask on the pricing side and just your comments on sort of the higher reimbursement pressure. I guess what's -- just help us on sort of what's driving that outside of PAMA? And then if you could, maybe just level set the expectation on sort of where expectations are for that pricing mix that kind of going forward exclusive of PAMA?

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

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Mark, you want to?

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Mark J. Guinan, Quest Diagnostics Incorporated - Executive VP & CFO [4]

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Sure. So as we've shared before, at the Investor Day last year and then also coming into this year, this year's pricing pressure is primarily driven by 2 factors, one is PAMA, the second one is getting back in with United.

We moved from out-of-network rates to a market-based in-network rate. So obviously we have grown our volume dramatically. As we've said, this year we expected, and we -- here we are, delivering enough incremental volume to offset the price sets but it is a significant price headwind relative to the rates we were being reimbursed as an out-of-network lab. You then have the typical pricing pressure that this industry has faced. In the past we've talked about it being kind of around 100 basis points or less, number of those pricing pressures are coming from the client bill, it's not all third-party reimbursement where we're contractually agreed with a health plan and what those rates are in the hospital business and also when we sell directly to physicians and they're allowed to bill the third-party.

There's a lot of competition, a lot of pricing pressure in that area. And so while we've talked about we're going to be price-disciplined, and we certainly walked away from some contracts that haven't made sense, the reality is that it's a very competitive environment and that has not really changed. So the big change over the last 2 years is obviously, PAMA, last year but it wasn't fully implemented because we had some offsets to it in the first year that we've talked about previously. This was the first year of the full 10% of PAMA. And then additionally, we have the United price as well. And going forward, as we shared, we would expect this to get back to more of its historical rate. I'm not going to give any specific guidance for a given year but there's no reason to believe once we get through the transition period into United that we shouldn't be really facing kind of the traditional pricing pressure and then PAMA.

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Ralph Giacobbe, Citigroup Inc, Research Division - Director [5]

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Okay. And could you just quantify that UNH pricing pressure this year?

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

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Ralph, it's going to be $40 million to $50 million.

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Operator [7]

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Our next question comes from Bill Quirk with Piper Jaffray.

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William Robert Quirk, Piper Jaffray Companies, Research Division - MD and Senior Research Analyst [8]

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So Steve, I want to follow up on a comment that you made concerning the decision to consolidate the immunoassay vendors. Can you speak a little bit about whether or not there's an opportunity here to consolidate some of your other testing methods? Things like clinical chemistry and hematology and such. And if so, can you just help us think a little bit about the timing? Is this something we should think about over the next couple of years to help offset some of the PAMA pressure?

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

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Yes. Sure, absolutely. So Bill, we've been working on this for about 7 years. Getting smarter and more strategic with all our suppliers. And so we've done a lot of consolidation in the past and will continue to do more in the future. So as far as immunoassays, we're close to deciding on the supplier. I believe that will be announced shortly who that is, of course, it's a nice opportunity. And this is all part of our 3% productivity gain that we are dialing in to be able to offset PAMA. We need it to be able to offset PAMA and deliver on the earnings outlook that we've provided at the Investor Day. And so part of that 3% is working with our suppliers and part of that working with suppliers, an example of that is immunoassay but there's others. Another example would be the automation we're putting in place in some of our newer facilities. Particularly, we're investing this year in our branding facility here in New Jersey -- in Clifton, New Jersey, it's a big project for us. That will have this new platform but equally, it'll have our latest approach to automation, which will increase our productivity. But also allow us to consolidate some facilities into one, so we get some productivity gains from that. But that's all part of that 3% when we need that 3% to offset the price pressure particularly with PAMA next year and maybe the year after.

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Mark J. Guinan, Quest Diagnostics Incorporated - Executive VP & CFO [10]

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And I just want to add some color there, Bill. Make sure you understand this is not just consolidating our purchases, this is actually a new innovation in the platform where we can do multiple tests that previously were performed on separate pieces of equipment on a single piece of equipment. So this will drive not just procurement efficiencies but actually will drive operational efficiencies in our labs.

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Operator [11]

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Our next question comes from Donald Hooker with KeyBanc.

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Donald Houghton Hooker, KeyBanc Capital Markets Inc., Research Division - VP and Equity Research Analyst [12]

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So I -- maybe you guys, in terms of that new collaboration you announced with hc1, I know you guys do a lot of interesting things in the population health space, I'm just trying to maybe -- can you elaborate on that a little bit? What exactly are you doing? I mean is this is something that -- I guess, you're...

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, President & CEO [13]

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Yes. Sure, sure. So when we go to a hospital client -- and it's part of our 5-point strategy, we talk to them about 3 things in regards to their lab strategy. One is, can we make them more efficient in running their inpatient laboratory? And so this is where we talk about Professional Laboratory Services, or sometimes we use the acronym PLS. And we continue to have active dialogues about making them more efficient. And we can, with good evidence now, save them about 10% to 20%.

Part of that, typically also is looking at the sophisticated send out of testing referred to as reference testing. And in that regard, we can consolidate who they're buying from, we can potentially give them a better price. But the third part that we're looking at in this new offering allows us a tool to do a better job of getting smarter about what they're testing in the hospital, is interrogate their order patterns and look for variation of their order patterns, and look at ways of optimizing what the order within the hospital.

And there's 2 parts of that, one is to get more efficient at what you're ordering so maybe don't order as much and in some cases, you should also order more because it's the smarter diagnostic workup for that inpatient study. But the second part of this, which is more -- even more intriguing, what many hospital administrators are interested in, is making sure that we have the right diagnosis. And if you look at the total quality and outcomes for a hospital stay, there's nothing more expensive than a bad diagnosis. So what this tool allows us to do is to work with our clients and getting smarter on their inpatient diagnostics. And as part of that, we clearly become more strategic than this vendor-provided reference testing within that account. And then finally, the third piece of what we work with hospital systems, and when we have those discussions is you want to stay in the outreach business. And we have bought some outreach businesses from hospitals, we have some in our numbers for this year, and we'll continue to aggressively pursue buying outreach businesses as these -- as this industry consolidates. And I would tell you that many hospital systems are now well aware of PAMA and well aware of other reimbursement pressures that happen on their -- in their laboratory outreach business. So as we mentioned in our commentary, that funnel of discussions continues to grow.

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Operator [14]

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Our next question comes from Erin Wright with Crédit Suisse.

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Erin Elizabeth Wilson Wright, Crédit Suisse AG, Research Division - Director & Senior Equity Research Analyst [15]

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In terms of the timing and magnitude of contributions from the Managed Care access, I guess, can you break out what you're seeing in terms of underlying market growth? And what portion of volume may be stemming from the Managed Care contracts and possibly also the PLN in early days? And are you still anticipating those contributions to ramp from here? How should we be conceptually be thinking about that ramp? I'm not asking for 2020 guidance but how should we be thinking about that ramp into 2020?

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, President & CEO [16]

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Yes. Sure, sure. So we'll share with you. We always share this every quarter. It feels like the market is stable. We don't see any notable changes in terms of volume increases within the marketplace both outside the hospital also inside the hospital, so it's stable. So you look at our volume growth, we're clearly gaining share. And a lot of -- and a large portion of that share gains is coming from our Managed Care relationships. And what we have also said is that our access changes, which is the best in over a decade, will continue to grow. It'll continue to grow this year in '19, but it'll also have a growth in '20 and probably in 2021 as we take advantage of that opportunity that we see in front of us. That will be helped in 2020 for certain with -- for a lab network, particularly with UnitedHealthcare. So you should look for, in 2020, continued growth again because of our expanded network access. So Mark, anything you'd like to add to that?

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Mark J. Guinan, Quest Diagnostics Incorporated - Executive VP & CFO [17]

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Yes. So if you asked about the PLN, and it's still very, very early. To this state, I'd say very little if any growth has come from the PLN. That's still in front of us, which is the good news. We talked at Investor Day about kind of 3 tranches of volume growth, Erin. We signed the new Managed Care access at about $1 billion in our price, our fair share -- we fully expect to get to our fair share. But it's going to take several years. There were the -- easier to convert accounts, obviously, came quickly, and we call them Quest loyalists, where we had the rest of the book at the office, and they were sending some of the Managed Care work, we were out-of-network to those 200 labs that were in-network and they immediately moved that to us once we were in network.

We then had some of the accounts where they had multiple labs, we showed you the picture where there were 3, 4, sometimes 5 boxes outside. We've done a better job of consolidating some of that, getting a more -- a larger share of wallet per se in those positions. That will take a period of time, but certainly, we've gotten some growth from that but that'll continue into the future. And then there's the ones where we have had none of the work and a lot of that is in the hospital stage, hospital outreach and then some of the physician laboratories. That's where we really think the preferred lab network is going to be a big driver, we're going to be able to have a very simple message to patients, hey, if you use one of the preferred labs and obviously, we're one of the five, 0 out-of-pocket. That's a very simple message instead of trying to compare how expensive one option might be to the other. It's free to you if you use this lab. So we're very confident and very excited. This will be a multiyear tailwind. And we're going to get to that fair share eventually of about $1 billion at our price.

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Operator [18]

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Our next question comes from Michael Newshel with Evercore ISI.

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Michael Anthony Newshel, Evercore ISI Institutional Equities, Research Division - Associate [19]

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Maybe to follow up on that. Do you have any visibility at this point after the selling season from United on the level of uptake in the self-insured base for the PLN for 2020?

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, President & CEO [20]

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They have not shared specific information. Obviously, that's their question and could ask them because we're not the only preferred lab. So we obviously get the same information that other preferred lab network providers do. They talk to us about -- as we've shared the states where they're rolling this out and making this available. And then they've talked to us about the fact that they're marketing it to the fully insurance sponsored plans for 2020 rolling that out. Still very early in that process, and they didn't give us any specific proportionality or percentage of their overall insured lives that are adapting this. But they -- I'm sure you've heard them talk about it. We've heard them talk publicly, and then the conversation we had -- they're very, very confident that this is going to be something that people will embrace and that it's going to make a difference.

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Operator [21]

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Our next question comes from Kevin Ellich with Craig-Hallum.

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Kevin Kim Ellich, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [22]

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Two quick things. So first, M&A pipeline, you said that the deals are taking a little bit longer to materialize. Wondering if the environment's changed? Or if this is what you've experienced historically? And then also, could you talk about maybe any tailwind you're seeing from the opioid testing and the opportunities within behavioral health facilities?

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, President & CEO [23]

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Yes. Sure. So on the first one, as I mentioned in our opening remarks, these deals are getting bigger and more complicated. And because it's more complex, it takes more time. And there is good news in that and there's bad news in that. One is it takes more time, that's the bad news, the good news it is bigger and more complicated hence, therefore, we clearly have a discussion around how we could be their partner for laboratory services, around the 3 topics that I mentioned earlier. And what I did also share is that the interest level around what we could do, and partnering continues to grow because more people are well aware of the pressure on this portion of their business.

I would say that was not nearly where we were last year at this time. So if you look at our growth rate from acquisition year-to-date, we're just a little shy of that 2% we indicated last year. We're well north of that 2%. We still feel confident that over an extended period of time, we'll continue to be 2% or greater. And so we feel confident between the 3 buckets that we acquire. One is hospital outreach, continue to have a lot of engagement around that. Second is regional laboratories. As I mentioned in my remarks, it continues to be interested in evaluating options for smaller operators because of the pressures that they see. And then finally, we continue to build capabilities, and we had a number of acquisitions in the past around that. A good example is ImmunoTek, which is bringing new capabilities around tuberculosis testing and also fit for an illness testing. So all 3 continue to be our focus going forward, and you will see that. And we're still confident around our guidance we provided around 2% on a CAGR basis over a multiyear period of time.

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Mark J. Guinan, Quest Diagnostics Incorporated - Executive VP & CFO [24]

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Yes. And then you asked about opioid testing being a tailwind. Certainly, our prescription drug monitoring business, which a subset of that is opioid testing, it's been a strong growth engine for us for a number of years. It continues to be a nice growth driver. Like anything else, when something gets large enough, competitors start putting in policies and all sorts of barriers to reimbursement that dampen that somewhat. Despite some of those restrictions around frequency of testing, pre-authorization and other things that they're putting in, it's still a nice growth driver for us. It just would be even larger if they hadn't made those changes.

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Operator [25]

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Our next question comes from Jack Meehan with Barclays.

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

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So I just wanted to focus on the margins here. So in the quarter, nice to see the expansion. Can you maybe walk us through the moving parts between pricing impact, efficiency programs in the calendar? And as we look through 2020, as you pull all these pieces together, do you think -- what's the right way to think about it? Are margins flat? Is PAMA too big of a headwind to grow through? What are some of the things that you're thinking about?

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

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Yes. So let me first touch, Jack, on the longer term, so I'm not going to talk to 2020. But what I did talked about at the Investor Day was on a 4-year outlook that we could grow earnings faster than the top line. And talked about the assumption, although that may not play out depending on how we deploy our cash, but that's on flat share count. So therefore, we're actually growing earnings, not earnings per share. So that implies margin expansion but I can tell you that we're expecting some sort of a tax windfall so that's before tax margin growth. I can't assure you that will happen every quarter. I can't assure you that -- I mean, I'm not going to get into 2020, that it'll happen every year but over multiple years, we expect to grow our earnings faster than our top line. And it's really having the efficiency program continue. We talked about it being 3% percent per year. We've gotten really good at that. We need that. We'll continue to do that with over time tempering pricing headwinds. In this quarter, we shared the pricing headwinds of 250 basis points. Obviously, that all drops to the bottom line for a very small piece toward the bad debt element but basically it drops to the bottom line. So we had enough efficiency and some lift from volume. How much of that is the extra day? How much of that is just the volume growth? Obviously, we have a higher drop through in the shared -- on organic volume growth enough. And that still offset the pricing headwinds and basically held our margin pretty flat in the quarter. So I mean, if getting any more precise than that, I'd be stretching my credibility and ability to give that map. So I would just say that you can see that, despite some pretty significant pricing headwinds, we've held our margins in this quarter and that -- as we continue to drive strong organic volume growth and deliver our 3% over a period of time, we're going to grow our earnings faster.

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Operator [28]

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Our next question comes from Kevin Caliendo with UBS.

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Kevin Caliendo, UBS Investment Bank, Research Division - Equity Research Analyst of Healthcare IT and Distribution [29]

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Could you talk a little bit about the fourth quarter guidance? The revenue guidance is in line with our model, the EPS falls short. I'm just wondering if there's any accelerated spending, are you maybe trying to position better for 2020 by spending more in 2019. Can you give us a little color around the fourth quarter and maybe into how you're thinking about spending in 2020?

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, President & CEO [30]

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Yes. So we raised our guidance for the year. So importantly, we're signaling stronger finish of the year than we did at the beginning of the year. And until now we've not signaled anything above our original guidance. So hopefully, people are taking that as a positive message, which we're saying based on our performance through three quarters of the year and what visibility we have for Q4, we're feeling confident that we're going to over-deliver relative to what we said at the beginning of the year. So in terms of spending, there's nothing out of the ordinary in Q4. The only thing out of the ordinary is an easy compare on the top line, which we've talked about.

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Operator [31]

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Our next question comes from Brian Tanquilut with Jefferies.

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Brian Gil Tanquilut, Jefferies LLC, Research Division - Equity Analyst [32]

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Mark, just to follow up on Jack's question earlier. As I think about the G&A line, you've obviously done a good job bringing the G&A percentage down. It flattened out this quarter at about 17.8%. So as I think about your efficiency program, is there more to squeeze out of that? Or how should we be thinking about that number since it seems like it's bottoming out here in this 17.8% range?

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, President & CEO [33]

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Let me start on this, and for some reason, there's always a lot of focus around G&A. Think of it, a lot of our invigorate savings show up in the expense categories. To the contrary, most of our invigorate savings actually sort of show up in our cost of sales. So if you think about what's in our expense category, a lot of it is G&A. And we've made really good progress over the last seven years. So getting more efficient with everything that's in that category in the P&L from IT costs to costs of running our finance organization, costs associated with our billing operations, with a relationship with Optum. And outside of general administration, there's our sales and marketing costs, which we're always evaluating and getting more efficient. So we have taken a lot of costs out already, and we're also leveraging that fixed cost going forward. So the lift we generally get now have to do with that operational leverage related to the top line growth while maintaining the same cost per second and that's what you see this year. So a lot of that 3% productivity gain will show up in productivity gains in our cost of sales and not in expenses. Mark, anything you'd like to add to that?

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Mark J. Guinan, Quest Diagnostics Incorporated - Executive VP & CFO [34]

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Yes. I just would like to add that, yes, over time -- well, Steve is absolutely correct that a large proportion, if not a majority of that efficiency is going to drive margin and gross margin would be in the cost of sales. We'll continue to focus on G&A. You can't really look quarter-to-quarter. In this quarter, we had some -- a couple of high-class health claims. Over time, we're going to deliver what we expect, and we've done a really good job in managing. It's very, very minor increases in our self-funded employee health care costs. In any given quarter, you get a couple of large claims that can make some noise quarter-to-quarter. So there's no trend, there's no -- nothing should be read in terms of we've lost our ability to continue to drive efficiency. There's only going to be noise in that line quarter-to-quarter.

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Operator [35]

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Our next question comes from Derik De Bruin with Bank of America.

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Derik De Bruin, BofA Merrill Lynch, Research Division - MD of Equity Research [36]

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I just want to follow -- 2 questions, one's a quick follow up to Bill's question on the vendor consolidation, platform consolidation. Can you talk a little bit about that process and that -- how that's going to look and sort of like how you're judging the different vendors? And basically, how many you have now particularly in the IA and going down?

And then, the other question I wanted to follow up on was, when you look at the fourth quarter last year, obviously, you had a number of weather issues but there were issues of patient concessions, lower cash collections in that sense. Can you just sort of talk about going into fourth quarter, how we are relative to some of the issues? I know you mentioned concessions were down but just talk a little bit more about the comps and some of the different things that are sort of going on in the fourth quarter versus...

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, President & CEO [37]

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Yes. Okay, so let me take the first part and Mark will take the second part. On the first part, so this is a comprehensive review that we perpetually look at with our suppliers on how we run our laboratories. And we worked -- we work actively with all our suppliers. As a matter of fact, over the best 7 years we've worked hard to make sure that we really have more of a strategic relationship with all our suppliers, particularly those that are driving a large portion of our spend.

So in that regard, in the IBD automation space, there is consolidation with a number of those platforms, as Mark mentioned. And there are a number of suppliers that we buy from that are bringing to the marketplace platforms that will allow us to replace up to about 5 different work cells from different manufacturers over time. And so what we have done is evaluate those vendors that have a product either in the marketplace or will have a product in the marketplace. And we do that through a review process with their sales force, our understanding what they'll have and what they'll have for functionality at what time and then also what the economics around their offerings are. We narrowed it down to a few. We actually put in place a few of those platforms in some of our facilities to do some trial runs.

And then we're at the final stroke of selecting more of those suppliers going forward. And we believe that we will choose a vendor that meets all the requirements of what we need. And yes, a portion of this is economics. That is how costs -- how much productivity we're going to get by getting more throughput by being able to consolidate those operations. But also we think about it holistically, we need to make sure that we have good confidence around their ability to service us, good confidence around their quality, good confidence around what's in their installed base. So it's a very comprehensive operational review of who will be our strategic provider for this new platform going forward. And as I said, we're at the final strokes of deciding that, and shortly, it will be announced.

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Mark J. Guinan, Quest Diagnostics Incorporated - Executive VP & CFO [38]

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Yes. So on your second question. Last year, there were a couple of drivers that lead us to the change in estimates and obviously, the change that we made at Investor Day on our outlook for 2018. Two of them really relate to patients. The first one was that there was more patient responsibility in the year than we saw coming. And again, we're always accruing based on a forward-looking expectation of how the revenue is going to play out. We looked at all the available data at the beginning the year as we shared. It wasn't a great growth in the amount of people with high-deductible plans. We assumed it would be a pretty flat year in terms of the proportion of our revenue from patients. And instead what happened was there was more patient responsibility because the deductibles themselves had gone up markedly as we found out in the September time frame, which started to actually validate why our cash collections were lagging what we expected from the payer.

So any time, as we've shared, we almost collect 100% of the accepted claims that were owed from third-party payers. And we've shared that we collect about $0.70 on the $1 from patients. So you move 1% of revenue from the third party to the patient, that's a 30 basis points headwind. So it's pretty significant. The good news is this year, nothing changed significantly from last. We're very confident with that. There was no surprise. Obviously, going in, we were very, very diligent and watching that, being conservative. And there's no surprises in terms of the proportion of our revenue coming from patients.

The second piece related to patients was we had more patient concessions not just because more revenue was coming from them, but we actually had some issues we talked about in our lab conversion in the south, and that delayed some billing because of the way these conversions go. And because of that, the more bills age outs, the more you're going to have concession, the less likely you are to collect it. So that's well behind us. We're fully converted. We don't have that anymore, so that's behind us. And then also related to that, we had some higher level of denials because some time we're filing and so on because of the lab conversion we saw. We always are dealing with denials, but they spiked the mid- to late last year when we went to this lab conversion. So when you add all those things up -- they've been cleaned up, the things -- the issues that we had last year are well behind us.

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Operator [39]

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Our next question comes from Matt Larew with William Blair.

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Matthew Richard Larew, William Blair & Company L.L.C., Research Division - Analyst [40]

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I wanted to ask for an update on the progress in the retail setting. First, just broadly in terms of the footprint transformation in the Walmart and Safeway stores. And then also, anything that you're doing with the new Walmart Health initiative. I know their first center just opened up in Georgia that you're participating in?

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, President & CEO [41]

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Yes. So we're continue to move forward with our retail strategy as we call it. We have about 2,100 patient service centers and -- of which we characterize from -- about 35% to 40% of those are more retail-like, some of which are within Safeway stores and Walmart. The Safeway relationship continues to be a good one. We actually have some new opportunities for Safeway going forward as we kind of work that relationship, so we're optimistic there. And then second is, we continue to build our presence with Walmart as well and as you mentioned, they opened up a new health concept store and we are their laboratory provider for that store. So they're still working through -- how that works.

And as you know, if you know anything about Walmart, they probably like a lot of things, and they've seen how well that goes to be able to tune up anything. And we're working with them. We've been proactive on that concept going forward. And as -- what we said is our goal is to be north of 50% of our patient service centers. So we have some ways to go. And those -- a number of things for us. One is, we think it's a better customer experience, consistent with our strategy to be the most consumer-friendly laboratory. And we think this will continue to be a differentiator for us in the marketplace.

Second is, it's better for our employees in a lot of ways. And it also allows us to manage the demand and when people are there if we could have larger patient service centers with more to provide. It just gives you a lot more operational flexibility to manage the demand based upon location and time of day that patients are coming in over extended period of time. And then finally, as the patients really -- the feedback is quite good. They come in, they have flexibility to walk the store while they wait. They have flexibility to do some shopping after their visit.

Then we believe that improvement in access and the quality of that access will allow us to differentiate ourselves from the marketplace and pick up share gradually over time. So it's going well. We're pleased with it. And then lastly, I'll just say, yes, we have the relationship with Safeway. And yes, we have a relationship with Walmart. But we continue to work with others in the marketplace. Like we continue to work with CVS, Aetna, their MinuteClinic, and what they're doing around their strategy is they're -- as a partner of ours.

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Operator [42]

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Our next question comes from Ricky Goldwasser with Morgan Stanley.

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Alexa Desai, Morgan Stanley, Research Division - Associate [43]

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This is actually Alexa in for Ricky. I just wanted to come back to the UnitedHealth PLN. You guys mentioned I think in your earlier remarks that they're offering, you said on October 1, $0 member out-of-pocket charges. So I guess my question is, are there any other things that you're looking for to do over the balance of the year to continue kind of incentivizing the use of the PLN? I mean how does that 0 pocket compare to labs not in the network?

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, President & CEO [44]

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Mark, you want to take that?

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Mark J. Guinan, Quest Diagnostics Incorporated - Executive VP & CFO [45]

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Yes. So for labs not in the network, it would be the typical out-of-pocket determined by their planned benefit design. So whether they have a high-deductible plan or they had some sort of coinsurance, but it won't be 0. So if you think about the average requisition being somewhere between $40 and $50 and typical patient responsibility over time, employee responsibility over time might be 20% to 25% of their health care dollars, with the balance being paid for by the company, you can do the math. Now that's an average.

Obviously, there's some very high-cost tests, so it'd be a big, big advantage if you have a genetic test or some of the other screening test that could run hundreds of dollars. But just the simplicity of the message, so not having to worry that, hey, the same series of tests would be $50 from a national lab and it's $500 from this hospital. And what does that mean for me? It's just -- you don't have to worry about it. They're not as good, and it's not just about price. It's also about quality and service and access. So those are all the metrics that were required to get in. We did not change our price with United in order to get in for the preferred lab network nor do we think anybody else did, but we know we definitely did not. So this is really about the total value of the offering.

So if you want to go to the best lab with a great price, and also have zero out-of-pocket, it's a very simple decision for the patient, so that's important. There's also in United, and should talk about this, but there's also some things that they're doing around incenting physicians as well. So it's not just a patient-driven initiative. And I'll let you talk to United about what they're doing on that end. And then obviously, you can imagine, we're doing a lot of work in the field with our own commercial sales force to make sure that physicians are aware because this is really good for patients. And most physicians, their #1 priority is their patient, not their owner, not anybody else. So when they know this is a good thing for their patients, they like that.

The other thing is, it's a source of some patient dissatisfaction is getting a bill. And so now you don't have to call the office about hey, that lab you ordered for me, I got a bill. I thought it was covered by the office visit et cetera, et cetera. So it reduces noise for the payer, reduces noise for the physician's office and obviously, a good thing for us and a good thing for patients.

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, President & CEO [46]

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Yes. And just to what Mark just said, obviously, the savings here is 0 coinsurance and copayments, but the biggest driver is, you're moving to a laboratory that has a significantly lower reimbursement rate than if they're working with a nonpreferred lab network. So the savings to the consumer is very considerable but the biggest portion of that has to do with the rate differential, not necessarily with the patient responses they might have or not have with us. So a big opportunity, and we're hopeful. As we mentioned, it's just getting started this month. It's early, but we're hopeful, this change coupled with the changes that we spoke to that'll take place in 2020, will continue to allow us to grow our presence and our share with United but also with other payers because we do believe it's a trend overall in the marketplace.

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Operator [47]

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Our next question comes from Mark Massaro with Canaccord Genuity.

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Mark Anthony Massaro, Canaccord Genuity Corp., Research Division - Senior Analyst [48]

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I guess my first question is for you, Mark. Obviously, the volume growth is the strongest we've seen in a long time. You talked about the one extra revenue day in the quarter. But you also talked about health plan access with United continuing to build. So can you just give us a sense for whether or not the 5% growth is a level that you think can continue? Can you just give us a little sense of the puts and takes around some of the drivers there?

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Mark J. Guinan, Quest Diagnostics Incorporated - Executive VP & CFO [49]

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Yes. So we talked about the fact that the extra day net of Hurricane Dorian gives about 100 basis points. So you can kind of take that math, and you're thinking obviously each quarter has different puts and takes in terms of the amount of revenue delays. And we usually -- we try to be very transparent about how that all plays out. At the beginning the year, we talked about Q1 having [2] days and Q3 having an extra day and obviously, next year we have leap year and the quarters will play out a little bit differently. We'll give you as much transparency on that as possible. But really, when you think about the whole year, the next year, you just think about generally revenue days are pretty similar year-over-year other than when you have a leap year.

And then we did talk about the capitated volume, which is not really impacting the bottom line. But if you're just focused on revenue at some point next year, we lapped that change. So that was about 100 basis points this quarter. If you recall, we shared about 70 basis points in Q2. So at some point, that volume headwind gets behind us. And the other thing, just to share a little additional color in the quarter. Our employer -- preemployment testing business is actually a headwind to our growth, it was pretty flat. So that's the [non-VIS] if you remember, we had about 20 basis point higher growth rate I shared at the beginning of my prepared remarks for our core clinical business. So we'll see how the preemployment drug screening business goes, but that was -- if you want to really think about the clinical business, which is what -- where we're benefiting from the expanded access, the volume performance is actually slightly stronger than it may have appeared on the surface.

So is it going to be 5%? Obviously, we're not going to have an extra day every quarter, but is it going to continue to be really positive organic revenue growth into the future? Absolutely, that's our expectation as we work our way to that fair share I talked about is eventually getting to $1 billion of revenue in these new lives through the 3 expanded access plans.

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Operator [50]

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Our next question comes from Eric Coldwell with Baird.

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Eric White Coldwell, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [51]

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At the end of the quarter -- some of these have been head-on, but I think it's always helpful to get maybe a little more emphatic or explicit commentary. It's all around the M&A and then the capital deployment around M&A. Inorganic growth, we'll really start to abate here in the fourth quarter based on the timing of prior period deals. I'm hoping you can give us some sense on what you're expecting from inorganic growth in 4Q. Also, you have a long-term model of 2% plus MA-driven growth. To the extent that the analysts have built-in a placeholder here, it sounds like we need to be pulling that in for 2020, at least the beginning of the year. Can you give us a sense on what you would be comfortable with if people have built-in a placeholder? And then third, as you see these elongated decision cycles on M&A, cash is building. So are you more comfortable with us leaving that cash on the balance sheet? Or would you be comfortable with maybe assuming some accelerated share repurchase activity as you have those unnecessary balances start to build?

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Mark J. Guinan, Quest Diagnostics Incorporated - Executive VP & CFO [52]

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Yes. So let me go back to our capital deployment strategy. So as we've shared, we're going to do M&A where it's value accretive to our shareholders, there's a clear path. We're not going to do an M&A just to meet some outlook that we gave. But with that said, we're very confident in that 2% CAGR. So we'd never include an unexecuted M&A in our guidance. So just because we, at this point, are implying a low level of M&A either in Q4 or early into next year doesn't mean that we might not be close to something, but that's just not been our practice. So we don't actually include M&A in our guidance until we have a signed contract and so on. So we're very confident in that 2% CAGR. If you look at what we've done last year and what we're implying this year, we're going to be well north of that 2% after 2 years. We're highly confident that in the next 2 years to complete that 4-year CAGR, we're going to be at that level if not beat it because there is a lot of interest. As Steve shared, and as we've talked about, these deals have just taken a while, it doesn't mean they've fallen by the wayside. We're still working on the same deals that we thought we could -- would've done several months ago. But we're very optimistic some of these are going to get completed. So I'm not going to give you any guidance for 2020, what I'm comfortable with, obviously, we'll give guidance in late January for the year. We'll talk about the organic M&A mix. And then, at that point, if we have some additional deals that have closed in the interim, those will be included but otherwise, we don't typically do that -- include that in our guidance.

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Operator [53]

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Our last question comes from Stephen Baxter with Wolfe Research.

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Stephen C. Baxter, Wolfe Research, LLC - Senior Analyst [54]

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I wanted to follow up on the patient concessions question. So I'm glad you mentioned the Keiser Report. I was flipping through it, and it looks like we're seeing a fairly similar trend in this year's report. As discussed at the Investor Day last year in terms of high-deductible enrollment not really increasing that much but deductibles continuing to march upwards at a similar clip. So I was hoping to clarify a little bit what you're seeing in 2019 relative to 2018, in terms of where in the ecosystem you're seeing improvement in collections? And your level of visibility into that versus this time last year? And then finally, in terms of quantification, would you be able to give us a sense of what the collections improvement has contributed to this year's growth? Is it reasonable to think about it as offset in the United out-of-network impact? Or should we be thinking about something less than that?

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Mark J. Guinan, Quest Diagnostics Incorporated - Executive VP & CFO [55]

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Yes. So at this point, we share where our sources of revenue are. And so at this point, patient responsibility has not grown significantly year-over-year. So despite what the Keiser Report is talking about in terms of increases. Up this year, it's not impacted us per se year-over-year. One of the things we did in response to some of the surprises we had last year was we shortened our time frame. So the way we do our revenue recognition, we're looking at more recent trends. We used to have a longer-term trend that worked for us for years and years and years. So we're looking at a lot more recent, which would allow us to not have surprises like we had last year. So we've been on top of this. We're very comfortable with what we've been accruing. We're very comfortable with our cash collections. We have a very robust process. And as we look at that, we've done better on patient concessions partially because last year was a particularly poor year for some of the reasons I shared earlier. But part of it is, we've continued to roll out the tools and partner with Optum, our partner around doing things like offering credit card collections upfront.

We support that with our real-time estimation tool, where if you come into our patient service center or you go to an office where we have an in-office phlebotomist. We can tell you on the spot whether the test is covered or not and importantly, what your responsibility will be based on that coverage decision, and then have an opportunity to say and how would you like to pay for it upfront, like most of health care is doing. So we're collecting more of our cash up front, that makes a significant difference in the overall collectability. We've also seen an improvement in denials.

So some of the things we talked about last year, especially in the PDM space, where we were surprised by couple of major payers. I will tell you as I shared earlier, the payers, in general, continue to throw us curve balls. We're always having to deal with new policy changes, new opportunities for them to deny. But we've cleaned up some of the things last year that were more significant. So we've reduced our overall denials in a couple of key test areas, that's helpful. We've also shared in the past that we continue to get some preferential treatment from a couple of payers, where they've put in preauthorization requirements for certain tests. And they actually waive that for a couple of labs, including us because they know we do things right.

We don't do excessive testing. We've partnered with them on what clinically appropriate panels are and approach to testing are. So that not only reduces our denial rate because preauth is a great challenges for the labs, but it also makes us advantageous for the prescriber because they don't have to worry about preauth if they send the work to us. So all of those things together are actually helping revenue growth and they're helping our overall margin. And part of our invigorate is on the top line. It's not all on cost, some of it is actually getting paid for more of the work we do, as Jim Davis has said in multiple Investor Days. So we're seeing good positive improvement in that space.

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Stephen H. Rusckowski, Quest Diagnostics Incorporated - Chairman, President & CEO [56]

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Okay. Well, we thank everyone for joining us today. We appreciate your support. Have a great day and talk to you soon.

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Operator [57]

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Thank you for your participating in Quest Diagnostics Third Quarter 2019 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) 566-0408 for domestic callers, (402) 998-0597 for international callers. Telephone replays will be available from approximately 10:30 a.m. Eastern Time on October 22, 2019, until midnight Eastern Time on November 5, 2019. Goodbye.