奎斯特診斷 (DGX) 2011 Q2 法說會逐字稿

Welcome to the Quest Diagnostics' second-quarter 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 the copyrighted property of Quest Diagnostics with all rights reserved.

Any redistribution, retransmission or rebroadcast of this call in any form without the express written consent of Quest Diagnostics, is strictly prohibited.

Now I would like to introduce Kathleen Valentine, Director of Investor Relations for Quest Diagnostics.

Go ahead, please.

Thank you, and good morning.

I am here with Surya Mohapatra, our Chairman and Chief Executive Officer, and Bob Hagemann, our Chief Financial Officer.

During this call, we may make forward-looking statements.

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 2010 annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K.

A copy of our earnings press release is available, and the text of our prepared remarks will be available later today in the investor relations quarterly update section of our website at www.QuestDiagnostics.com.

A PowerPoint presentation and spreadsheet with our results and supplemental analysis are also available on the website.

Now, here is Surya Mohapatra.

Thank you, Kathleen.

We grew revenues and our adjusted earnings per share in the second quarter, despite ongoing market softness.

During the quarter, revenues grew 1.5% to $1.9 billion.

Adjusted earnings per share increased 5% to $1.12.

While clinical testing volume decreased 0.9%, revenue for acquisition increased 1.6% compared to the prior year.

And we generated strong underlying cash flow.

Our growth strategy is to be the leading innovator and provider in the fast-growing esoteric and gene-based testing areas for cancer, cardiovascular disease, infectious disease and neurological disorders.

This complements our large routine level of testing services, enabling diagnostics and monitoring of a wide range of chronic diseases.

We continue to focus in growing our genetic, esoteric and anatomic pathology revenues.

Demand for our esoteric and gene-based testing continued to grow faster than routine testing, proving significantly (inaudible) vitamin D testing with double-digit volume growth in the quarter.

However, the rate of growth in vitamin D testing is moderating.

Additionally, ImmunoCAP allergy testing continued to grow.

In anatomic pathology, we continued to see pressure on volumes from physician end-sourcing, particularly in dermatology and hematology oncology.

However, we have seen some moderation of this practice in other areas such as GI and GU.

In cancer testing, we continue to promote our Colovantage colorectal cancer blood test and OVA1 ovarian cancer test, and Leumeta blood cancer test.

These tests are proprietary to Quest Diagnostics, and all show strong growth.

The acquisitions of Athena and Celera, which closed in the second quarter, will further accelerate our growth in gene-based and esoteric testing.

I am pleased these integrations are on track.

We are also taking additional actions to grow our business.

We have strengthened our women's health test offering.

We introduced SureSwab for gynecological infections, and are launching spinal muscular atrophy, or SMA testing, from Athena, more broadly throughout our network.

We have seen only successes.

We also introduced a new prescription drug monitoring service.

We are seeing strong growth in this expanding market for pain management.

We are helping physicians to ensure that prescribed pain medications are not being abused or diluted.

Turning to sales effectiveness, in some areas we are pleased with our performance, but we have more work to do.

As we have said before, we have completed our sales force expansion, provided them with better tools, and enabled them to spend more time with customers.

We continue to work with health plans to move business to us from higher-cost providers.

Additionally, we have created a new Senior Vice President position to oversee all aspects of our core business with physicians, including sales, marketing, operations and quality.

Cathy Doherty, who will report directly to me, has a proven track record over 21 years of experience with Quest Diagnostics, including successfully leading our hospital services, as well as corporate strategy and business development.

As regards to our costs, we have been looking closely at our cost structure.

In the short term, we are aligning our costs with lower volume levels we have seen.

Beyond that, we need to be more agile and efficient in our operation.

Today, we are announcing a comprehensive initiative to improve profitability in this competitive marketplace, invest for growth and better prepare us for the substantial opportunity in the future.

We expect this to reduce our cost structure by $500 million over the next three years and help us reach our goal of 20% operating income.

I have asked Bob Hagemann to lead this initiative.

Regarding capital deployment, our philosophy comprises the use of cash for growth and strategic advantage, the return of cash to shareholders to share buybacks and dividends.

In addition to quarterly dividends, so far this year we have returned $835 million in cash to shareholders through share buybacks.

And we utilized about $1 billion for the acquisition of Athena and Celera.

With regards to acquisitions, in the near term, our interest is in smaller fold-in lab acquisitions, which will provide access to more customers and be immediately accretive to earnings.

Now Bob will provide some analysis on our performance, and then we will take your questions.

Revenues for the quarter were $1.9 billion, 1.5% above the prior year.

And adjusted earnings per share was $1.12, compared to $1.07 in the prior year.

Adjusted earnings per share for the 2011 second quarter exclude $0.10 per share associated with deal-related and integration costs in connection with the acquisitions of Athena and Celera, which are further detailed in footnote 2 to the earnings release.

The acquisitions of Athena and Celera contributed about 2.5% to revenue growth in the quarter and were essentially neutral to adjusted EPS.

Our clinical testing revenues, which account for over 90% of our total revenues, were about 1% above the prior year and about 1.5% below the prior year before the contributions from Athena and Celera.

Volume in the quarter was 1% below the prior year and compares to the improvement of 1.3% in underlying volumes that we saw in the first quarter.

We saw a further market softening in terms of physician office visits in the second quarter, which contributed to the volume slowdown.

Our volume for the month of May was particularly weak, while the months of April and June were modestly positive versus the prior year.

Drugs and reduced testing volumes have continued to rebound and grew about 6% in the quarter, although at a slower rate than the first quarter.

Revenue per acquisition was 1.6% above the prior year, with the improvement due to the increased esoteric mix contributed by Athena and Celera.

While our increased esoteric mix is benefiting revenue per acquisition, it continues to be pressured by business and [paramix] exchanges, the Medicare fee increase, which went into effect January 1, and pricing changes in connection with several large contract extensions executed in the first half of last year.

The business and [paramix] exchanges, which continued to pressure revenue per acquisition, include a further rebound in lower price drugs of abuse testing and continued weakness in our higher priced anatomic pathology testing.

Revenue in our non-clinical testing businesses, which include risk assessment, clinical trials testing, products and healthcare IT, grew 10% for the quarter.

Adjusted operating income as a percentage of revenues was 17.7%, compared to 19.5% reported in the prior year.

Recent investments we have made in sales and service are temporarily pressuring margins, but are expected to accelerate revenue growth and margin expansion over the longer term.

Deal-related and integration costs associated with Athena and Celera, which are detailed in footnote 2 to the earnings release, reduced the reported operating income percentage by 1%.

The adjusted operating income percentage in the quarter is generally in line with the percentage we built into our earlier full-year guidance, which contemplates improvement in the latter part of the year.

We continue to see strong performance in our billing and collection metrics.

Bad debt expense as a percentage of revenues was 3.6% in the quarter, and reflected improvement in the -- from both the first quarter and comparable prior year period.

DSOs were 44 days, unchanged from the first quarter.

Most of the Medi-Cal billings, which had been on hold pending settlement discussions, have now been released and collections from Medi-Cal have resumed.

Capital expenditures were $40 million in the quarter, compared to $49 million a year ago.

Underlying cash from operations was strong.

Before the effect of the Medi-Cal settlement payment and acquisition in integration-related costs, cash from operations was $271 million, compared to $209 million reported in last year's second quarter.

Our strong cash flow provides us with significant flexibility to drive shareholder value.

Through the first half of the year, we have deployed a significant amount of capital to enhance growth in revenues and EPS.

We completed $835 million in share repurchases, which contribute about $0.15 per share EPS improvement.

We completed the acquisitions of Athena and Celera, which bring us unique capabilities.

While we are still in the early days of realizing the synergies associated with these important acquisitions, they are already neutral to adjusted EPS and accretive on a cash basis.

With these acquisitions now completed, our focus is on small fold-in acquisitions, which will expand our customer base and further strengthen our distribution network.

In addition, we will continue to ensure we balance our investments and growth with returning cash to shareholders in the form of share repurchases and dividends.

Part of positioning us for the future is ensuring that we have a cost structure which enables us to continue growing cash flows in earnings, during not only what we expect to be a long-term period of market growth, but periods like we are currently in, where the market may be going through some temporary slowdown due to economic or other factors.

To that end, as Surya referenced, earlier this week we implemented a number of cost actions, which we expect will enable us to meet earlier earnings commitments, despite our reduced outlook for 2011 top line growth.

These actions, which are broad in nature and affect most parts of our business, will result in a charge estimated at approximately $20 million, which will be recorded in third quarter results.

As you have also heard from Surya, beyond that, we have initiated a multi-year initiative designed to reduce our cost structure by $500 million over the next three years.

This effort is intended to address continued reimbursement pressures and labor and benefit cost increases, free of additional resources to invest in science and innovation, and help us achieve our goal of 20% operating income.

This program, which I will directly oversee, will touch every aspect of our business and make us more efficient in both our operations and general administrative areas.

It will include looking at how we operate our labs and other facilities, redundant costs across our business and the speed and effectiveness of our decision making.

We have identified opportunities in the cost of testing, the cost of acquiring and transporting samples, and in our general and administrative areas.

We intend to provide you with more specifics and periodic updates as the program progresses.

Now turning to guidance.

We now estimate results from continuing operations, before the anticipated third-quarter charge and other potential special items as follows.

Revenue to grow 1.5%.

This reflects about a 1.5% reduction in our outlook for volume, as a result of the market continuing to be softer than our earlier expectations.

It also includes about a 2% contribution from the acquisitions of Athena and Celera.

We expect earnings per diluted share to be between $4.25 and $4.35 on an adjusted basis, and between $2.81 and $2.91 on a reported basis.

Operating income as a percentage of revenues to be 17.5% on an adjusted basis and approach 14% on a reported basis.

Cash from operations at $1.1 billion before the effect of the Medi-Cal settlement payment in transaction and integration costs, and $900 million after these items, and capital expenditures of $200 million.

Our outlook on an adjusted basis excludes the Medi-Cal charge, the first quarter impact of severe weather workforce reductions, and transaction and integration costs associated with the Athena and Celera acquisitions.

Footnotes 2 and 7 to the earnings release reconcile the adjusted financial measures for the corresponding GAAP measures.

Now I will turn it back to Surya.

Thanks, Bob.

That concludes our prepared remarks.

We are ready to take your questions.

Operator?

Thank you.

We will now begin the question-and-answer session.

(Operator Instructions) Our first question or comment comes from Tom Gallucci from Lazard Capital Markets.

Your line is open.

Hi, good morning.

Thanks for the details.

I was curious if you could maybe give us a little more color on margins and costs, three buckets.

One, Bob, it seems like the margin guidance for this year has trailed down a bit from around 18% to 17.5% to 18% to 17.5%.

What are some of the pressures this year, to the extent, is some of this investment in sales and things?

Can you size any of that, so we can get an idea of what goes away or how much better it gets as you get through that?

Then you outlined from a high level, some of your initiatives on the $500 million of savings.

Is there any way to at least from a very high level, break down some the buckets of expectations in terms of the areas that you are focused oven?

Okay Tom, there is a lot of questions there.

Sorry, I will hit them again if you need to.

It's all margin and cost-related, short-term and long-term.

It's all connected.

What I will try to do is bridge you back on operating income at least, the initial guidance that we put out for the year, which was approximately 18%.

As we got through the first quarter, we adjusted that to 17.5% to 18%, essentially tightened that range a little bit, but still pretty close to where we had anticipated in the first part of the year.

And at that point, we are still holding the revenue growth.

What we saw in the second quarter particularly in May at least in our results, was a further softening in the marketplace.

And as a result, we adjusted our top line guidance now, essentially on the volume side.

As you know, with a business that's principally fixed cost base, you have got to take a lot of costs out just to preserve margins if you are adjusting your top line.

That's what we are doing.

You have seen us announce now a charge in Q1.

We have got another charge coming in Q3 in connection with the actions we've just taken.

And then actually, we are looking longer-term at what we can do with costs, and I will come back to that in a minute.

At this point, we have adjusted operating income percentage down to 17.5%, essentially moved it to the lower end of the range that we had, reflecting the change in volume expectations.

And some dilution, some minor dilution from Celera.

As I told you when we announced the Celera transaction, we expected it to be dilutive by immaterial amount this year.

And that is some of what you see in the operating income percentage there.

With that said, as we look at where we are at versus the beginning of the year.

Despite the fact that we have brought the top-line guidance down, we have stayed pretty close on the operating income percentage.

And actually, from the beginning of the year, we have raised the EPS guidance at this point.

The initial range that we had out there was $4.10 to $4.30.

As a result of the share repurchases and the cost actions we've taken, we have been able to up that range to the $4.25 to $4.35, despite the expectations for lower volume.

So, yes, hopefully that addresses your question on the current operating income percentage.

Sure.

With respect to the cost-reduction program, just like the last one that we announced several years ago, which that is also one that I oversaw.

We provided more information as we went along, and we expect to do the same thing here.

We will give you some progress on how much we have achieved with those -- where those are coming from.

But, as you think about the areas, the areas that you typically think about, right?

How we operate our labs and our other facilities, i.e.

the cost of testing.

We have a lot of costs outside the labs, though.

Our network for pending and transporting samples is something that we are looking at as well.

And additionally, we want to get at the SG&A area.

So, we are looking at all the support functions, much of which sits in the G&A.

We believe there is some redundancies in costs across our business, which we will get at.

At this point, we are not in a position to provide some more details.

We want to socialize this and make sure our employees fully understand it and appreciate it before we start providing more details outside.

And we expect to do that as we progress into the program.

And just on -- thanks for -- that was a full answer there.

One thing, on the SG&A though, you have been investing, you're talking about in sales and service.

Is there any way to -- do you have an idea of either how much those investments have been, or how much you think they come down over time as you are expecting this better margins later?

Tom, one thing I will tell you is they are investments, so we are not expecting them to come down.

We expect the impact that they are having on margins, though, to dissipate as they start to deliver top-line growth for us, which we believe they will.

One way to think about it without completely sizing it for you is, the increase that we are seeing in SG&A this quarter versus the prior year on an adjusted basis is principally due to the additions of Celera.

As you know, Celera was basically operating at a loss before we acquired them.

We are thinking about it as a turnaround.

There is a lot of SG&A costs there which still needs to come out.

We have got quite a bit of it in the first quarter of ownership, but there is more to go.

But that's really the driver of the increase in SG&A versus the prior year at this point.

We seen improvements in bad debt, which is helping that, and then the investments that we've made in sales and service are really offsetting those bad debt improvements.

Tom, I want to add one more thing.

That we have done this, and we are good at doing these things.

And we will use Six Sigma and Lean Six Sigma principals, but we will not sacrifice patient care or medical quality while we do cost reduction.

As Bob said, we are going to look at SG&A and we'll look at the way we're organized and go after this.

Okay.

Thank you.

Our next question or comment comes from Adam Feinstein from Barclays Capital.

Your line is open.

Hi, good morning.

This is Brian Sekino on behalf of Adam Feinstein here.

Just a quick question on the top line growth of 1.5%.

The previous revenue guidance of 2% didn't include Celera, and now you are including it.

Is there some further deterioration in the macro-economic environment that you are expecting to get to the 1.5% now?

That's exactly the case, Brian.

We had not included Celera in our previous guidance.

That contributes about 1.5% -- 1% to the total revenue growth.

And what that means is our expectations for the base business now are down about 1.5% from where they were.

That's principally all volume related.

And that's really as a result of what we've seen in the second quarter in terms of the further softening in physician office visits.

Okay, and as I think about the 20% margin goal over three years, can you -- does that assume some improvement in the volume environment?

Is it a margin that you can reach through additional cost cutting, if volumes don't improve?

You heard us say this before.

We need top line growth in order to continue expanding margins.

Certainly this cost reduction program is going to be an important contributor to that.

We would expect to see some top line growth.

Certainly over the period we are talking about, we expect that to be the case.

Our long-term outlook for the market is that it is going to continue to grow.

Demographics, the pace with which new tests are introduced, the increased focus on early detection and prevention, are all things that we believe bode well for this market over the long term.

And we think we were very well positioned now with some of the acquisitions that we have done to take advantage of that future market growth.

Although we are seeing a temporary slowdown at the moment.

Okay, thanks a lot.

Thank you.

Our next question or comment comes from Ricky Goldwasser from Morgan Stanley.

Your line is open.

Good morning.

Good morning.

Few questions here.

First on the top line, I know Bob, in the past, you mentioned 2% top line growth as the threshold for operating margin expansion.

Does this figure still hold, or is the bar is higher now?

I wouldn't say that the bar is any higher, Ricky.

I think we do need a couple points revenue growth to have sustained margin improvement.

And as you have seen, we have not had that revenue growth, and that's one of the reasons that we are initiating the cost actions that we are.

Okay.

And then on the pricing side, you've reported improved metric.

What would pricing had been if you exclude the Athena and Celera acquisitions?

So, on same store basis.

We are not disclosing that, Ricky, because we really don't want to put people in a position to back into the pricing of Celera and Athena.

Because we think that is competitively sensitive information.

But with that said, the underlying revenue per acquisition has been pretty stable and in line with our expectations.

And as we told you, the year-over-year comparisons there start to improve as the year progresses as we start to anniversary some of the things that occurred last year and the year before.

Okay, and then lastly on volume, obviously, your outlook for volume growth has come down.

But in the prepared remark, you did mention that you saw weakness in May, where April and June were pretty positive.

So, what is it that you are seeing out there that makes you more cautious on the second half?

Is it the macro environment?

Are you seeing any increase in the competitive environment, or are you just trying to be more conservative given that visibility hasn't been that great over the last year or so?

Ricky, first of all, May was not a good month.

And we did confirm our guidance in May.

But having two months of data, we realized that this temporary slowdown is probably going to continue for the rest of the year.

So, here is what we see.

85% of our business comes, as you know, from patients visiting the doctor's office.

In April to May quarterly data, we had 6% decrease in physician's office visits, so that affects us a little bit.

Regard the insourcing of anatomic pathology, that's 16% of our business, so obviously, that is affecting us a little bit.

But then we have some of our health plans, they are changing their membership, and that's also affecting us.

So, when you look at all of those things, they are temporary things.

And we know we will go that we are going to go through these things.

But when I look at the long-term and the medium-term, I feel that we have all the [answers], and we are focused on our strategy of differentiation in making the Company more esoteric and [anatomic].

So, we reduced our guidance, the top line guidance based on the office visits and what is going on in insourcing.

But on the other hand, the acquisitions like Celera and Athena is helping us to increase our presence in esoteric and gene-based testing, which is going faster than the routine testing.

Okay, thank you.

Thank you.

Thank you.

Our next question or comment comes from Dane Leon from Macquarie Capital.

Your line is open.

Thanks for taking my questions this morning.

We are having trouble hearing you.

Would you speak up please.

Hello, guys.

Is this better?

Much better.

Great.

Actually, this builds on a previous question.

I was curious, when we are thinking about this longer-term cost restructuring that would be target around early 2014.

You mentioned in the press release that it could get you to that 20% operating margin goal.

What type of fundamental revenue growth rate would we really have to see to get to that 20% operating margin goal?

We just addressed that a little bit with Ricky.

Certainly the cost reduction program is an important contributor to that -- achieving that goal, but we do need some top line growth.

We need, generally, in the range of a couple percent top line growth to have sustained margin expansion.

We haven't seen that, and again, that is why we are initiating this program.

And then, just one on the sales force reorganization, can you remind us when, from this reorganization, when we should really see productivity around?

Well, as I told you, our sales force expansion is completed.

And we are organized with the cost of [facing] organizations so that we can be closer to our customers, whether they are hospitals, physicians or oncologists.

In some areas, I'm pleased at how the sales people have come up; in some other areas, we have much more work to do.

I want to also make a comment about the operating income.

We had a long-term goal of reaching 20% operating income, and we know that we are going through a temporary slowdown.

However, as Bob said, the medium-term expectation of this industry is really great.

He sees tremendous potential for growth, and we are launching this multi-initiative for cost reduction.

I am much more encouraged with some top line growth and some reduction in the expenses to reach operating income of 20%.

Great.

Thank you.

I guess the line of questioning really comes around to looking over the past couple of years where volume growth has been somewhat lack luster, and trying to figure out what can fundamentally turn that around going forward.

And I guess it's from what you --

Let me comment on that.

Over the last two or three years, what we have been doing methodically is moving our business to more gene-based, esoteric and anatomic pathology, and getting focused on the diseases, which are very important, like cancer, infectious disease, cardiovascular disease and neuromuscular disorders.

Those are the areas which are growing.

Now because of recession and because of health care reform, for the time being, we have a lot of pressure on routine testing and some insourcing going on in anatomic pathology, but we are uniquely positioned to take advantage of the fast growing markets in esoteric and gene-based.

And nobody else has the products or the tests and the network as we have.

So, I am very excited that although the last two or three years have been lack luster, but going forward, we are going to gain market share in the areas which are faster moving market.

All right.

Thank you.

Thank you.

Our next question or comment comes from Ralph Giacobbe from Credit Suisse.

Your line is open.

Thanks, good morning.

Going back to the cost savings number.

I guess first, is that a gross number or a net number?

Help me understand how you think about gross and net, Ralph.

Sure, fair enough.

If I were to assume that you are able to hold your EBITDA flat for the next three years, can I just then add $500 million to that number?

No, that's not the way I would necessarily think about it.

We, like every business, have cost increases that we expect to see in salaries, wages and benefits.

And this $500 million is a reduction in cost that we would otherwise have, had we done nothing, essentially.

We will still see some inflationary increases as we look ahead.

But this is going to mitigate that and also provide us additional funds to invest in science, in innovation and contribute to margin expansion.

Any sense of -- so what's the timing around it?

I know it's a three-year plan.

Is it starting today?

Did it start this quarter?

Is it starting next year?

And is it front-end loaded, back-end loaded, any guidance there?

Let me make a comment, Ralph.

First of all, as you heard, we are adjusting our cost based on the lower volumes.

We have taken some costs out, and we will take the charge in the third quarter.

And as Bob said, despite the lower volume, we are still meeting our guidance, or near guidance.

So, that's short-term cost reduction we do as a part of the business.

As far as the long-term cost reduction, we just started the program.

And like the last time, we will give you the information as we go on.

But like any other cost reduction and percent improvement program, some cost savings are going to go towards investment, and some cost savings are going to go toward the bottom line.

But again, we have done this before.

We can do it, and we will do it without sacrificing medical quality and patient care.

Okay.

But in terms of the timing itself, are numbers baked in?

Like for the guidance, I'm assuming there is some of that already playing in, is that fair?

You should assume that what's baked into the current year guidance is more impacted by the short-term actions that we've taken.

And then maybe just remind us on the timing of when you comp those pricing pressures from a year ago, did that play a role at all starting this quarter?

Or should we look for the benefit to that starting in the second half or 3Q?

We started to see some benefits of that this quarter, Ralph, but remember, it's not just changes in contract pricing that drove this.

A lot of it was mix.

And that mix shift continues, as we see continued growth in the drugs of abuse testing business, and as we see a continuation of the softness on the AP side.

Those two factors are also contributing to the change in revenue correct year-over-year.

But again, we have seen it stabilize, and we feel good about the underlying revenue correct at this point for the remainder of the year.

And my last one, I want to put into context of your -- you talked about your quarterly progression on the volume side, with May being worse.

And then I believe you said positive for the last two months.

Is that right?

We saw positive year-over-year growth in the months of April and June.

Okay.

And I -- the context, we got the physician and office visit data this morning.

And in the context of -- the numbers seem pretty weak for June, down over 13%, probably one ever the worst months we've seen.

I guess I'm trying to understand the context of seeing improvement versus those physician office visit numbers.

Ralph, which data are you looking at today?

The IMS data.

You heard from Bob.

Ralph, as you heard from Surya, 85% of our business comes from physician offices.

As you start to look at the data, I think it's important to understand what's happening with primary care versus specialists and the like.

I've not had a chance to analyze the June data at this point.

And while there is a strong correlation overall with physician office visits, month to month is not necessarily the best way to look at it.

Frankly, we even need to be careful as we look at volume trends within the quarter as well.

Right.

There is certainly correlation there.

There is certainly correlation, but it is not one to one, because obviously, if they are down by 4% or 6%, we are not down by that much.

And that also shows, at least to me, that some of the investment we have made in sales and sales force, we are staying close to our customers.

Okay.

Thank you.

Thank you.

Our next question or comment comes from Bill Bonello from RBC.

Your line is open.

Yes, hi.

So, I guess I wanted to go back to this cost savings a little bit more, and maybe from a slightly different angle.

Going back to the concept that for the last two and a half years you have had positive volume growth in one quarter, it seems to me like the critical thing here is to jump-start volume growth.

How do we get comfortable that you can take out $500 million of cost and not just create an ongoing problem of weak volume?

Let me answer that a little bit.

First of all, $500 million sounds obviously large, but it is less than 10% over the next three years.

You are absolutely right.

The number one item for me is how to increase the volume.

And that is one of the reasons why over the last 18 months we have done a lot of work.

For example, the organize to be customer facing, because we know that we are going through some pressure in routine testing.

But we also know that gene-based esoteric testing is growing faster than the routine testing.

So, we are very pleased actually, how we are growing in hospital services, and how we are growing in esoteric and gene-based testing.

But we have to grow in the routine testing, and these costs that we want to take out, we want to use the Six Sigma and Lean Sigma principal.

And as Bob said, one of the major target at least he and I have is G&A.

So, we are not really going to take cost out from customer-facing or patient-facing activities, and I think this is the appropriate target for us.

And we will do it in a deliberate speed, with growth as the number one goal.

And that's why we are saying that some part of this cost savings is going to be invested in growth.

And we are focused on actively growing the top line.

If we cannot grow the top line, no cost reduction is going to help us.

I would also add, too, that it's important for us to make sure that we understand what's important to our customers and that those aspects of the business are not impacted by what we do here.

Certainly the accuracy and reliability of our testing is paramount there.

And we expect to continue to be able to differentiate ourselves in that regard.

Having a broad testing menu is also very important, and you have seen that we continue to invest in that regard.

As Surya said, SG&A is an area that we are going to spend a lot of time looking at, and for the most part, that doesn't touch the customer.

Okay, thanks.

And just one not follow up, but one second question, and I will hang up.

And I apologize if somebody asked this and I missed it.

But Surya, did you -- have you renewed your contract yet, and can you give us update on that front?

I must tell you, the contract is fine.

And neither party has given any notice of nonrenewal.

The Board and I are fully aligned and focused on growing the top line and the bottom line.

Excellent.

Thank you.

Thank you.

Our next question or comment comes from Kevin Ellich from Piper Jaffray.

Your line is open.

Good morning.

Thanks for taking the question.

Wondering if we could go back to the volume issues.

And you gave some good detail on the monthly trends, but -- and also you continue to see some pressure on the AP insourcing.

Is it all just insourcing to the physician offices where you think greater competition from other labs that are really focused on like the derm-path business?

Well in anatomic pathology is major activities going on in insourcing because this is way of for the practice and us to get revenues.

We are working with our trade association to see if we can reduce some of the tests.

We are working with some health plans to have not exchange reimbursement.

But most of the anatomic pathology reimbursement, especially now what we see in derm is going towards dermatologists.

Got it.

And then on the managed care side, have you seen any greater attrition out of some of the regional plans like Empire Blue Cross that opened up last August?

Not really.

Not really.

We work with them and working very closely.

As we said, there are no major managed care contracts for renewal.

Our relations with managed care organizations are very good.

We are working with them, with the employers to change the benefit plan, to have tests coming from higher [test] provider to us.

We are also working with many managed care organizations on the disease program, and we're using our analytics and infomatics scales to help them, getting prepared for the future, which may be around accountable care organizations.

Okay.

And then just thinking about your comments about utilization trends and volumes.

Yesterday United made some comments saying they expect an increase in utilization, specifically physician office visits, during the back half of the year.

That goes contrary to what you guys are seeing, so just wondering if you can help connect the two data points.

You are getting the same data, maybe more data than we are getting.

We represent 15% of the market, so I consider our numbers representing what is happening in the market.

We really don't know, actually, unless -- well, first of all I cannot comment actually what they see.

Maybe different kind of membership.

We are assuming that, at least this year, the rest of the second half, we are going to see lower utilization.

But if it goes up, everybody is happy.

Sure.

Makes sense.

Maybe switching over to the regulatory legislative environment.

Obviously, there is a lot of discussion on potential Medicare lab copays.

And then the Institute of Medicine came out with recommendations for preventive screening, I think yesterday.

Just wondering if you had a chance to look at that, and it looks like it would be an incremental positive for you guys.

Any comments?

Well, as far as the Institute of Medicine, I must be honest, I haven't looked at it.

We have looked at all the reports.

As Bob mentioned, diagnostics is a very good area and has a tremendous potential for growth, not only because of demographics, but also very different tests with the higher specificity and sensitivity.

But also we will have 29 million people who will be in this plan.

In the long term and the medium term, diagnostics is the right area to be, and I think the short term, the temporary stop which is going on, is not going to last for long.

So, I'm very pleased.

And Kathleen you want to make comments about the FDA?

On the Medicare copay, we are working with the Trade Association educating the administration officials and members of Congress on the negative impact the Medicare copay in the considered forms would have on the seniors as well as the lab industry.

And we are looking importantly to remind the folks in Washington that laboratory -- diagnostic testing, laboratory represents a very small portion of total health care spending in the US, less than 3%.

And we have already given up a lot.

We are absorbing 1.75% reduction for five years.

We've got a productivity adjustment that we have agreed to with the health care reform legislation that was past last year.

We feel like we have contributed significantly already.

We were a small portion of the health care spend, and we want to make sure that, that's's appropriately and fairly considered and wherever they go with it with the copay idea.

Okay, and then two quick ones for Bob.

Bad debt, saw nice improvement at 3.6%.How much lower can that go?

And then also can you remind us if the guidance includes the $0.07 impact from weather in Q1?

Well, with respect to bad debt, I'd certainly love to see it go lower.

Although, we are not prepared to put guidance out there.

If you think about one of the positive impacts of health care reform in addition to further volume, it should be to help reduce the bad debt over time because a significant portion of that has to do with uninsured patients.

I would be hopeful that over time, we can see that continue to come down as we see more and more insured patients.

With the other part of your question, Kevin?

The EPS guidance, that includes the $0.07 impact from weather in Q1?

It's adjusted out.

So, if you look at the footnotes in the earnings release, you will see all of the things that are adjusted out to arrive at the adjusted guidance.

Got it.

Okay.

Thanks.

Thank you.

Our next question or comment comes from Robert Willoughby from Banc of America.

Your line is open.

Bob or Surya, I guess if I were a critic, I would look at another $500 million in cost cutting on the heels of some of the initiatives that you have completed to date.

It calls to light some tardiness in getting at some of these inefficiencies.

I'm not clear what new opportunities are you really addressing, cutting SG&A.

These sound like things you should have maybe gotten your arms around years ago.

Robert, this is Surya.

First of all, you are right, that some of the costs we could have taken out as we bought some other companies and integrated.

But one of the things that we have been doing is actually going towards more esoteric and gene-based.

And we have been investing some of these things.

Now we have four or five esoteric laboratories.

We also are looking at what is happening with the routine testing.

And over the last four or five years, we have now learned more about how to run the laboratory more efficiently and on the lower cost.

We have used some automation as we have reduced the cost before.

So, when we look at it again, $500 million sounds big, but to be perfectly honest, it is less than 10% over the next three years.

We do cost reduction all the time, but again, we are going through another concerted effort to look at what has happened with the routine testing business, as Bob said, how much money we spend in logistics, how much money we spend in PSE and phlebotomy.

We feel that $500 million is a good target for us, and this will give us some money for investment and will give us money to meet our operating income goal.

Bob?

And, Bob, as Surya indicated, we get smarter each year about our business and what we can and can't do.

And certainly I think that the customer constraints that we have, in terms of what we can do with our cost structure, we have learned more about over the last several years as we have taken costs out.

And think have a better view as to some areas that we can go after now, which we previously thought may have been off limits.

Will there be any change in your international expansion strategy or current international focus?

We will maintain our current international focus, and mainly it is actually on India because that's where we are investing.

We have some business in Mexico and some business in -- small business in UK, and we are looking at that.

But mainly it's the investment in India, which remains the same.

And it saves some medium-term investment, and it's moving.

But it is very slow progress.

But that's all.

It's also still a pretty modest investment.

Yes.

And just lastly, your dividend payouts are down year-over-year.

With some of the share buybacks, do you anticipate moving that higher here to enhance the appeal?

Bob, that's something that we look at periodically with our Board.

Over time, we would expect that the dividend payout would grow commensurate with earnings in cash flows.

But it's something that we will get over a longer period.

And again, we evaluate it with our Board on a periodic basis.

Thank you.

Thank you.

Our next question or comment comes from Gary Leiberman from Wells Fargo.

Your line is open.

Thanks.

You said there would be a $20 million charge on the third quarter.

Is that a severance charge, or is that something separate?

That's principally associated with severance, Gary.

Okay.

And then, just to stay on the cost cutting, is there anyway you can compare and contrast maybe the new initiative to the previous $500 million initiative?

Is it more focused on one area than another?

Yes, as I mentioned earlier, I think we are probably going to have more focus on SG&A this time around.

Not that we didn't address SG&A as part of the last program, but I think we want to take a harder look at that.

And additionally, as I said, I think we understand our customer constraints better and that is going to free us up to do some other things.

Is there going to be a bigger IT component of the focus on the cost cutting or streamlining this time around?

IT's certainly an element of it.

Will it be a greater element than previously, or is it just in there with everything else?

I wouldn't say that it's greater or less.

It's an important piece of our spending.

It's also important in terms of the way we deliver our service to our customers, and we want to make sure that it continues to be something that we do very effectively.

But we do think that there is opportunities to further reduce costs there as well.

Then, I think you talked about it, but to clarify on the revenue prerequisition, the weakness.

It sounds like it's primarily a mix issue.

And is there anything like we saw last year in terms of pressure on the commercial pricing or extension in contract changes that's incremental this quarter or that you foresee throughout the rest of the year?

And just to clarify a little bit, Gary, as we think about mixed broadly, it's the esoteric mix contributed by Athena and Celera that drove the improvement in revenue correct this year.

In the base business is where we have seen the negative mix, as we've got growth in the lower price drugs of the abuse testing business, and the continued challenges on the AP side of the business, which is higher priced.

With that said, the base business, the underlying revenue correct continues to be pretty stable, and we don't foresee anything that would cause that to change dramatically this year.

Thanks a lot.

Thank you.

Our next question or comment comes from Darren Lehrich.

Your line is open from Deutsche Banc.

Thanks.

Thanks for taking my question.

I wanted to go back to the volume guidance.

It's actually worse in the back half of the year versus what we've obviously seen in the last couple of quarters.

And this is coming at a time when I guess, theoretically, sales productivity should be ramping up from some of the initiatives you've made in sales force.

I want to go back to your comments to understand what has really changed in your mind set.

You've said that there is some managed care membership churn.

You've cited the AP weakness and the continued trends in the physician visit.

And the new comment would just be around the health plan membership churning, because the other two issues have been with us.

So, what's really changed?

Is there something very different that you are seeing in the utilization environment?

Can you help us think about that in the context of your sales force that should be ramping and more productive in the second half of the year?

Darren, this is Bob.

Let me answer part of it, and I know Surya is going to want to comment on the sales force aspect of it.

With respect to the change in guidance, while we don't provide guidance for revenue per [req] and volume, I would tell you that our expectations for full-year volume have been reduced, principally as a result of what we've seen.

That doesn't necessarily mean that the volume that we expect in the second half, we expect to be worse than the volume that we have experienced in the first half.

The point was our expectations for the full year have changed, principally because the market is softer than we expected when we first put volume guidance out there.

And with regards to the sales, as I mentioned, that in some areas, we added 100 people in different areas, cancer, diagnostics, hospital sales and physician sales.

In some areas, I am pleased that they have come up to speed.

In some areas, we have much more work to do.

But as Bob said, that is basically the change in outlook in the beginning of the year, what's going to the office visits versus now.

And as it relates to AP, is there any updated comment you could provide around trends?

I think there was a period beginning mid-last year where the message was you saw a little bit of a moderation in the insourcing trend.

Is that still the case or -- I see what you said in your prepared remarks, but has there been a negative shift there?

First of all, I think anatomic pathology is a very important aspect of cancer diagnostics, and that's not -- the demand for anatomic pathology is not going to go away.

What is changing now that we saw in the beginning, as I mentioned, that there is more insourcing with GI and GU, and that has moderated.

And now it's going through a little bit of dermatologists and oncologists.

I think all I can tell you is that the rate of internalized and may have decreased a little bit, but we are still expecting this year we are going to be challenged.

But again, this is a temporary challenge when you consider cancer is an unfortunate disease which is growing, and there is a lot more diagnostics required with the therapy.

So, we feel that we are positioned appropriately, and this is going to [flutter] out, but we are expecting the rest of the year that we will still be challenged in AP.

As far as insource, it may not be as bad as last year, but still it is a challenge.

So, Bob, it was down 10% last year roughly.

Is it tracking in the upper single digits decline?

Is that the way to think about it?

Darren, we haven't disclosed that, and we try not to provide too much guidance on the components of business.

Again, obviously for competitive reasons, but we have been making it pretty clear that business continues to be soft.

Okay.

And then my last question here is back to the $500 million initiative.

I'm curious to know how involved the Board was in developing that.

And with the range of options were that you had on the table, in the Board discussion, around cost initiative, maybe just enlighten us a little bit about how that process developed, if you could.

First of all, this is an interesting question because I don't comment on the Board discussion, but obviously the Board and the Management aligned, otherwise we would not be doing these things.

The ultimate goal and the one which I am focused on, and so is Bob and my management team, is to grow the top line and the bottom line.

And we have to do what we have to do to run the business.

Okay.

Thank you.

Thank you.

Our next question or comment comes from Amanda Murphy from William Blair.

Your line is open.

Thanks.

Just a follow-up on Darren's outsourcing question.

You talked about dramatic -- or dermatology rather.

Is there another area, or other areas going forward that you could see outsourcing take off?

We have heard some noise about it, in [flow side optometry] for example, that could drive the next wave.

Or is this the last feasible area?

Then another question there is, on the regulatory side, any updates on the model in and of itself and its sustainability?

As regards to the flow, any molecular diagnostics, any [flow side], they are very complicated tests.

And I think that will be less insourced than just the histology.

That's what we see.

And the advantage for a Company like ours is to combine clinical pathology, anatomic pathology and molecular diagnostics.

And that's how we still do the business with us.

So, I think the main insourcing is going on with the specialties for histology rather than molecular diagnostics.

Because it's a pretty complex thing to run and maintain.

And the effort legislatively, Amanda, we continue to work hard to educate the folks in Washington on the issue.

It's active.

It's very active.

But it continues.

There is nothing of significant note yet, but we continue to work it very hard with our trade association.

Okay, and then in terms of Celera and Athena, it seems like those two transactions or deals are in line with your expectations in terms of the revenue that was added.

I'm curious, and it may be too early at this point, but now that they are internalized, do you have any updated perspective on the opportunity for top line synergies?

And then how much of that piece is contemplated in your guidance?

Certainly, as we told you when we acquired each of those businesses, we think that there is significant opportunity to accelerate their growth as part of being Quest Diagnostics.

In terms of making our infrastructure and network available to them, our connectivity, our patient service centers, our sales force, just access to the position in hospital customers that we serve.

And we feel very good about that opportunity, and we are executing against that now.

Surya mentioned SMA, we are feeling very good about how that's progressing at this point.

And our excitement about both of those deals continues to be very high.

It's going to give us a pipeline of products.

We didn't have SMA, and with Athena now, we are going to across the network.

And the same thing will happen with Celera and VHL.

We will provide our physicians some of the unique products VHL provides and some of the IVD products Celera provides.

So, we are pretty excited about our recent acquisitions.

Okay and then this last one.

I think people have asked this different ways, but some of your comments on the sales force side, you mentioned that it's going well, but there is work to do.

Yes.

Can you speak to some -- is that specific areas where there is work, or is that just commentary on the macro environment?

First of all, when you are bringing in some new people and you are adding to the industry, people are different.

It takes time for them to learn the business, learn the industry.

And at the same time we have some macro environment.

That's one thing.

The second thing is, we in some areas, people have come up to speed.

And they are really meeting their quota.

In some areas, we have to probably train them more and we have to refine.

But this is a process in which the sales force [efficiency] improves.

However, having said that, I'm glad that we have done these things because we were are getting prepared for whenever is an uptick, we will be there before anybody else.

So, you are not seeing, other than outsourcing, a change in the competitive environment in one particular area?

No.

Well, first of all, this is still a very competitive marketplace.

Many of our customers and even our competitors, whether they are hospitals or whether they are commercial labs and other stuff, we win in some areas and we have lost in some areas.

As I mentioned that we introduced SureSwab.

Women's health is a large business for us, and we had a weakness in that product offering, and now we plugged that weakness by introducing SureSwab and SMA.

We take competition seriously, and in some areas, we have lost some accounts to competition and we are going after those accounts.

Okay.

Thanks very much.

Thank you.

Thank you.

Our next question or comment comes from Steve Valiquette from UBS.

Your line is open.

Thanks.

Just trying to piece everything together on the volumes a bit.

A lot of commentary, obviously.

Can you comment on how you see your overall organic volume trends in 2011 year to date, versus the overall independent lab market volume trend?

Steve, yes, as we look at our organic volume growth year to date, it's relatively flat.

Again, we can point to physician office visits as an indication.

The other thing I would point to is, as we look at the volumes that come in to our esoteric testing facilities from reference labs, i.e.

they are customers, but they are also competitors.

We see those down as well.

I think that there is clearly a softening in the market which is impacting volumes, and that we believe is the principal contributor to what we have seen in terms of the softness here.

Right, but when you say flat, you mean flat with the market.

You think your volume trend is in line with the overall independent lab market.

Is that what you are trying to say?

Again, it's hard to say.

There is not good data again on the market.

We look at the data points that I just referenced here.

And relative to those, our volumes seem like they are performing as you'd expect overall.

We still think that we have opportunity to improve our performance.

It seems as though it's relatively consistent with some of the broader market indicators that we see out there.

Okay.

Got it.

Okay, thanks.

Thank you.

Our next question or comment comes from Anthony Vendetti from Maxim Group.

Your line is open.

Thanks.

There was a comment in your prepared remarks about gene test growth moderating.

Can you talk about --

I think that's actually I made a comment about the vitamin D.

Although it grew double digit, but the rate of growth is moderate in vitamin D testing.

Can you give us a percentage on overall either on vitamin D, or just overall genomic and esoteric testing?

What the growth was this quarter year-over-year, and what your -- if the moderating of any of that growth is a longer-term trend, does that push off your goal of getting up to a certain percentage of your overall clinical testing, as a percentage?

First of all, we really don't go give a particular test or a particular component.

And the reason why I made that comment, because obviously everybody knows that the vitamin D has tremendous growth over the last two or three years.

And it is appropriate for us to really tell you that although it is growing, but is not growing at the same rate as before.

As far as our goal of being the leader and provider in gene-based and esoteric testing, that does not change because one goes down; one may come up.

As I mentioned that we introduced a number of other tests which are going from the small base, whether it is ColoVantage or whether it is OVA1 or whether it is SMA.

So, the pipeline is good.

We have a good number of tests in gene-based and esoteric testing, and I feel pretty encouraged that market is growing faster than the routine.

And we have been investing, and will continue investing in that area to take advantage of the fast-growing market there.

You expect that to be about 40% of overall testing, at a certain --?

At the moment it's 36%.

And again, we have not given any set goal.

As you know, what is esoteric today may be routine in three or four years.

Lastly are there any big managed care contracts that are coming up for renewal either in 2011 or beginning of 2012 that we should be aware of?

Anthony, some of our largest, or many of our largest contracts go past 2013.

There is always contracts coming up every year, but some of our largest ones are now locked in for long periods of time.

Okay, so anything that's over like 5% of sales is not until 2013?

As I said, some of our biggest contracts are locked in.

I don't want to get into specifics.

All right, sure.

Thanks.

Thank you.

Our next question or comment comes from Kemp Dolliver from Avondale Partners.

Your line is open.

Great, thanks.

Just a follow-up on the vitamin D commentary.

Do you think that the slowdown in vitamin D testing is a function of some of the recommendations, or at least media attention in the last few months noting that there is probably not the need to test as many patients or to test them as frequently?

I think, first of all, the rate of growth in this vitamin D has been tremendous.

You cannot really continue with that rate of growth, so that is number one.

Number two, I think there will be continued [papers] positive and negative, but I think what you are seeing is actually just the rate of growth and only the doctors are slowing down.

Okay, super.

Second subject is looking into next year, and I know you're not giving guidance.

But it looks like, based on the June CPI, that Medicare under the clinical lab fee schedule could be slightly up next year versus the reduction you took this year.

Does that look about right now?

That would be good, wouldn't it?

Kemp, that is correct.

The CPI, which is used as the basis for the adjustment next year was 3.6%.

That will be reduced by a productivity adjustment, and then the 1.75% that was give back as part of health care reform.

That productivity adjustment still has to be finalized.

There are some estimates out there it will be about 1.2% or so.

When you do the math, that gets you down to two-thirds of a percent increase potentially in the Medicare fee schedule.

And that is going to be a relatively immaterial amount to us, although certainly better than a reduction.

Great.

Thank you.

Thank you.

And our last question comes from Sandy Draper from Raymond James.

Your line is open.

Thanks.

All my questions have been answered.

Thank you, Sandy.

Well, if there are no more questions, I would like to say in closing, in the quarter, we grew revenues and adjusted EPS and started the integrations of Athena and Celera.

We announced short-term cost actions and are embarking on a multi-year initiative to improve our profitability.

Diagnostic testing continues to have tremendous potential for growth.

We are the clear leader with unique assets and value, and we are building on our strength and focused on execution.

Thank you all for joining us on our call this morning.

Operator?

Thank you for participating in the Quest Diagnostics second quarter 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 800-645-7431 for domestic callers, or 203-369-3819 for international callers.

No access code is required.

Telephone replays will be available 24 hours a day until midnight eastern time on August 20, 2011.

Good-bye.