奎斯特診斷 (DGX) 2017 Q3 法說會逐字稿

Welcome to the Quest Diagnostics Third Quarter 2017 Conference Call.

At the request of the company, this call is being recorded.

The entire contents of the call including the presentation and question-and-answer session that will follow are 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, Executive Director of Investor Relations for Quest Diagnostics.

Go ahead, please.

Thank you, and good morning.

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

During this call, we may make forward-looking statements and will discuss non-GAAP measures.

For this call, references to reported EPS refers to reported diluted EPS and references to adjusted EPS refer to adjusted diluted EPS excluding amortization.

Actual results may differ materially from those projected.

Risks and uncertainties that may affect Quest Diagnostics' future results include, but are not limited to, those described in 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.

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

Now here is Steve Rusckowski.

Thanks, Shawn, and thanks, everyone, for joining us today.

This morning, I'll provide you with some perspective on PAMA, highlights on the quarter and review progress in our 2-point strategy which continues to drive results.

Then Mark will provide more detail and take you through updates on our 2017 guidance.

While we delivered another strong quarter of revenue growth in spite of some weather challenges, we completed 2 previously announced acquisitions and agreed to purchase Shiel Medical Laboratory, and then yesterday, we announced a strategic relationship with Cleveland Clinic that includes the acquisition of Cleveland HeartLab.

Here are some key highlights from the first -- from this quarter.

Revenues were $1.93 billion, up 2.4%.

Reported EPS of $1.15 was down 14% from 2016.

Adjusted EPS grew 150 basis points to $1.39 which includes an increase of $0.02 over the prior year of excess tax benefit associated with stock-based compensation.

Our updated guidance for our full year 2017 primarily reflects the impact of hurricanes in the third quarter which impacted geographies where we have a large presence as well as our recently closed acquisitions.

Before I describe the progress we have made to accelerate growth and drive operational excellence, I'd like to discuss PAMA.

We continue to urge CMS to delay the implementation of PAMA, then take the time to get it right.

The preliminary rates that CMS released are not market-based rates as Congress indicated.

Unfortunately, only 1% of all laboratory-submitted data and over 99% of hospitals and physician office laboratories were prohibited from reporting their rates.

Also, based on data submitted to CMS, Quest alone represented nearly 40% of all the market data CMS collected.

As you're aware from previous investor days, our estimated share of the Medicare market is less than 15%.

Instead of protecting access to a central laboratory testing, this flawed approach could greatly compromise Medicare beneficiaries' access to testing.

A large portion of the Medicare population receives their services from small laboratories and PAMA could put them at risk.

We have been collecting facts that demonstrate the many ways that CMS has disregarded the intent of Congress and we've been finding a receptive audience among legislators and policymakers in Washington D.C. for our call to take more time to get the implementation right.

The clinical lab industry is a critical element in the health care and economic landscape of this country, creating jobs, driving economic activity and generating tax revenues for the federal and state governments.

Our trade association's recent economic study found that this industry directly and indirectly employs over 600,000 people and contributes $13 billion in tax revenues.

The impacts of these proposed cuts are far-reaching to this vital industry.

These rates should not be finalized as proposed, and this view is shared by 22 respected medical societies and health groups including the American Medical Association, the American Hospital Association and the American Hospital Association is very much in back of our plan.

In October -- we on October 6 sent a letter with these leading voices in health care calling for CMS to take immediate action to address the significant deficiencies in its progress to establish new clinical laboratory payment rates.

Along with our trade association, we are exploring every option to ensure that Medicare beneficiaries have access to diagnostic information services.

In whatever form CMS might implement PAMA, Quest will be prepared and we remain confident in our ability to meet the long-term commitments outlined at our 2016 Investor Day.

Mark will touch on this later.

Turning to the progress we've made in the third quarter.

We delivered on all 5 elements of our strategy to accelerate growth.

The first element of our growth strategy is to grow 1% to 2% per year through strategically aligned accretive acquisitions which we are on track to achieve for the fifth consecutive year.

We had a very productive quarter.

We completed 2 previously announced acquisitions and agreed to purchase Shiel Medical Laboratory, which we will further strengthen -- which further strengthens our position in the New York metropolitan market.

Yesterday, we also announced the acquisition of the Cleveland HeartLab from Cleveland Clinic.

This lab will become our advanced diagnostic center of expertise in cardiovascular testing and the agreement builds on our existing relationship with the Cleveland Clinic.

Our M&A pipeline remains very strong and our strategy is delivering growth.

With the acquisitions we've completed this year and those expected to close by the end of 2017, we are well positioned to exceed our long-term M&A objective for 2018, and of course any accretion realized from the deals in 2018 will help offset the potential impact of new Medicare rates.

Under the second element of our growth strategy, we continue to expand relationship with hospital systems.

Our relationship with PeaceHealth is progressing well.

As you recall, the relationship includes the acquisition of the outreach laboratory as well as a Professional Laboratory Services agreement to manage laboratories at 11 PeaceHealth medical centers in Washington state, Oregon and Alaska.

This relationship is fully operational and already contributing revenues and adjusted earnings growth.

The third element of our growth strategy is to offer the broadest access to diagnostic innovation.

In the third quarter, we completed the acquisition of Med Fusion at ClearPoint in Texas, forming a national precision oncology center of expertise, and we are very pleased with the integration efforts to date.

In Women's Health, we continued to be excited about the progress we have made in noninvasive prenatal screening.

Our QNatal test is providing strong double-digit growth year-over-year.

We recently complemented our Women's Health offering with QHerit, a screening panel that helps both women and men across multiple ethnicities to identify the risk of passing 22 genetic diseases to their children.

We also introduced a convenient cholesterol test with an improved method for assessing heart disease risk and aiding treatment decisions.

Unlike most lipid tests, it does not require fasting and patients like this added convenience.

We also made progress executing the fourth element of our growth strategy, which is to be the provider of choice for consumers.

Our relationship with Safeway continues to expand as we are now operating in 128 stores and are expected to open about 30 more before the end of 2017.

In addition, our collaboration with Walmart will open new locations in 2017.

In this exciting era of the empowered health care consumer, our MyQuest mobile application is now delivering lab results into the hands of 4.5 million users.

Payers are taking notice of the progress we are making on our consumer strategy, especially with convenience, value and the number of access points we provide.

The fifth element of our growth strategy is to support population health and data analytics in extended care services.

We're building a solid pipeline with data analytics with a number of partners interested in leveraging our data including pharma, CRO, and health plan customers.

Turning to the second part of our 2-point strategy to drive operational excellence, we remain on track to deliver $1.3 billion in Invigorate run rate savings as we exit 2017.

As we drive operational efficiency, we continue to improve the customer experience.

Over 950 of our 2,200 patient service centers are live with eCheckIn which improves the patient experience.

Our total eCheckIn volume is over 12 million encounters to date.

We expect to have this capability in most of our patient service centers by the end of this year.

Now let me turn it over to Mark who'll take you through our financial performance in detail.

Mark?

Thanks, Steve.

Starting with revenues.

Consolidated revenues of $1.93 billion were up 2.4% versus the prior year.

We estimate the impact of the recent hurricanes reduced our revenue growth by approximately 130 basis points in the third quarter, which is slightly lower than what we had estimated in late September.

Revenues for Diagnostic Information Services grew by 2.8% compared to the prior year with approximately 140 basis points attributed to recent acquisitions.

Volume, measured by the number of requisitions, increased 1.6% versus the prior year, of which about 60 basis points was organic.

However, note that the impact of hurricanes presented a headwind of approximately 140 basis points to volume in the quarter.

Revenue per requisition in the third quarter grew by 1.2% compared to the prior year.

As a reminder, revenue per req is not a proxy for price.

It includes a number of variables such as unit price variation, test mix and test per req.

Unit price headwinds in the third quarter remain less than 100 basis points.

While price fluctuations can vary from quarter-to-quarter, we continue to expect that unit price headwinds will remain moderate in the final quarter of 2017 and consistent with the last several quarters.

Beyond unit price and the impact of growth in our PLS partnerships, other mix elements including test mix contributed slightly more than the positive 100 to 200 basis point trend we've observed for several quarters.

Reported operating income for the quarter was $298 million or 15.5% of revenues compared to $322 million or 17.1% of revenues a year ago.

Keep in mind, our reported operating income in 2016 included a gain on escrow recovery associated with an acquisition.

On an adjusted basis, operating income was $325 million or 16.8% of revenues compared to $320 million or 17% of revenues last year.

We estimate the impact of the hurricanes reduced adjusted operating income by approximately $18 million in the third quarter which adversely impacted operating income growth by nearly 6 percentage points.

Excluding the impact of the hurricane, adjusted operating income would have grown more than 7% and adjusted operating margin would have expanded 50 basis points year-over-year.

Reported EPS was $1.15 in the quarter versus $1.34 in the prior year period.

As noted previously, our third quarter 2016 results included a gain on escrow recovery associated with an acquisition.

Adjusted EPS was $1.39, up 2% from $1.37 last year.

We estimate the impact of hurricanes in the third quarter reduced adjusted EPS by approximately $0.08 or nearly 6%.

The company recorded net after-tax charges totaling $20 million in the third quarter or $0.14 per diluted share, representing system conversion, restructuring, integration and other onetime costs.

Our effective tax rate in the quarter was approximately 36% versus 33% last year.

Last year's rate benefited from the previously mentioned escrow recovery which was nontaxable.

In the quarter, we recorded approximately $7 million or $0.04 per diluted share of excess tax benefit associated with stock-based compensation or SBC compared to $3 million or $0.02 per share benefit last year.

Year-to-date, we have reported $36 million or $0.25 per share of excess tax benefits associated with SBC, which is an increase of $0.20 year-over-year.

Bad debt expense as a percentage of revenues was 4%, flat versus last year and 20 basis points lower versus the prior quarter.

Turning to cash provided by operations.

We generated $852 million in 2017 year-to-date versus $765 million last year.

Capital expenditures year-to-date were $170 million compared to $165 million a year ago.

Now turning to guidance.

We are providing the following updated outlook for 2017.

Revenue is now expected to be approximately $7.71 billion, an increase of about 2.6% versus the prior year on a reported basis and an increase of about 3% on an equivalent basis; reported EPS to be between $4.87 and $4.92; and adjusted EPS to be between $5.62 and $5.67.

Cash provided by operations remains at approximately $1.2 billion, and finally, capital expenditures remain between $250 million and $300 million.

Despite the impact of recent hurricanes, our full year revenue guidance is in line with our prior outlook and operating cash flow guidance remains unchanged.

Our updated EPS guidance reflects the approximately $0.08 hurricane impact noted previously, the impact from recently closed acquisitions, the $0.02 year-over-year increase of excess tax benefits associated with SBC recorded in the third quarter and the small but ongoing impact from Hurricane Maria on our Puerto Rico operation in the fourth quarter.

It's also important to remember that despite these headwinds just mentioned, our updated guidance is in keeping with or exceeds the outlook we provided to you at the beginning of 2017.

While we aren't prepared to provide 2018 guidance at this time, we want to remind you that we do not expect the same levels of excess tax benefits associated with SBC in 2017 to recur next year.

Therefore, as you think about 2018, we would encourage you to focus on our 2017 EPS guidance excluding the $0.20 year-over-year increase of excess tax benefits associated with SBC and assume the same $0.06 we saw in 2016 as a jump-off point for 2018.

Finally, I'd like to make a few comments on our long-term outlook which we have reaffirmed today.

Recall at our 2016 Investor Day, we provided a long-term outlook from 2017 through 2020, which included a revenue CAGR of 3% to 5%, with 1% to 2% growth expected from acquisitions.

It also included an adjusted earnings CAGR [fashioned in] revenue in the mid-to high single-digit range.

Note that this earnings outlook contemplated a starting point of $5.15 in adjusted EPS in 2016 and did not include any tax benefits associated with SBC beyond the base level of $0.06 reported in 2016.

This outlook implies adjusted EPS in the range of $6 to $7 by 2020 excluding the impact of excess tax benefit associated with SBC.

With regard to PAMA, the cuts in the current proposed fee schedule are deeper than expected.

If the proposed fee schedule is finalized as is currently stated, we remain confident that we can achieve our long-term outlook, though our earnings outlook is more likely to be at the lower end of the range we provided.

That said, M&A activity beyond our 1% to 2% growth target represents potential upside for this outlook.

Now let me turn it back to Steve.

Thanks, Mark.

Well, to summarize -- a very busy and productive quarter, we turned in another strong quarter and are delivering on all 5 elements of our strategy to accelerate growth.

Our updated guidance for our full year 2017 reflects the impact of hurricanes in the third quarter, which impacted geographies where we have a large presence as well as the impact of recently closed acquisitions.

And then, finally, we remain confident in our ability to meet the long-term commitments outlined at our 2016 Investor Day.

Now we'd be happy to take any of your questions.

Operator?

(Operator Instructions) Our first question is from Isaac Ro with Goldman Sachs.

So both questions I had for you were longer term in nature if I may.

First one had to do with market share.

If we assume that you're not able to convince the regulators to push back timing of implementation, can you talk a little bit about how quickly you think the marketplace will start to react to the new pricing reality?

And what does that mean for your ability to start trying to take some market share in the next 6 months to 12 months?

Sure.

Thanks, Isaac.

Well first of all, we've been in the consolidation mode as far as our strategy for the past 5 years.

A significant part of our growth strategy is to get that 1% to 2% growth through acquisition.

What you see from us this quarter is we announced 2 acquisitions, puts us in that range of 1% to 2% for 2017 and what we said that puts us in a very good place for 2018.

So our acquisition strategy continues to be part of our consolidation strategy.

We continue to see interest in companies where laboratories are looking at their strategic options, and so we believe that's still a good part of our strategy.

And then secondly is we're confident that our value proposition in the marketplace is really second to none.

Our value of how we deliver our services are -- is very strong in the marketplace with our quality and our service.

You couple that with what we're doing under our consumer strategy, I mentioned in my prepared remarks around the convenience of what we're doing around our -- the enablement of the whole process and our -- better and better access for the consumer.

Our value proposition in the marketplace is quite strong.

And so I also mentioned, Isaac, is that payers are taking notice to that.

And if you look at our assets today through our health plan relationships, it's really much stronger than what we've had in the past and now we continue to build.

And as we get that better access with health insurance companies, we will continue to grow faster than the marketplace both through acquisitions and organically.

So tracking well with a plan to accelerate growth and we believe that, that is the right strategy for us going into the future.

So thanks for the question.

And this is a follow-up on I think Mark's comment at the end around long-term guidance.

If I go back to your 2016 Analyst Day, you talked about EPS growth in the mid to high single digits.

You're seeing kind of with the current outlook maybe more towards the lower end of the range.

Could you articulate how much of that you think will come from M&A versus organically?

And just trying to understand the importance of M&A in achieving that new outlook.

Sure, Isaac.

So I was qualifying that we would be in the lower end if PAMA moved forward under the currently proposed fee schedule.

So obviously, with all the things we've shared, we're trying to influence that.

So at this point, we're not locked into that.

What we're saying is that would be the likely outcome were the cuts to be significant, and we're seeing in the original proposal.

But we're obviously commenting on that and there's still some more work to be done and we'll see where that settles out.

So yes, I wouldn't say at this point we're already signaling the lower end, we're just saying there is significant impact from PAMA.

And while we certainly contemplated that, we gave that outlook in November 2016.

That's why we gave a range, this has been the high end of what we might have expected coming out of CMS.

So I would not lock into that at this point.

In terms of M&A, other than the deals that we have already executed, I do not have any earnings projections that -- based on future M&A.

Certainly, on our revenue, we've talked about getting 1% to 2% but we all know that it takes a period of time generally 12 to 18 months before you get to a run rate level of earnings contribution.

So in that mid to high-single digits, I'm not counting on significant contributions from unexecuted M&A on the bottom line, only on the revenue side.

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

I guess I want to go back to PAMA.

In the press release, you talked about exploring every option in terms of you guys and the lab industry exploring every option to make sure Medicare beneficiaries have access to lab services.

What options do you have?

I guess on top of that, more importantly, if PAMA is implemented as written, what impact do you think that'll have on commercial rates going forward?

Sure.

I'll take this first part of that question and I'll give it to Mark for the second part.

So we're actively working this and we've been working it for years as we've talked about.

We've been deeply engaged with CMS on the implementation of PAMA at its core and the principles of it we don't disagree with, which is market-based pricing for the refreshed Clinical Lab Fee Schedule.

But what we've been helping them with, but unfortunately, we think with what we see in the draft rates they got wrong, we've been helping with the implementation of gathering the data to make sure the data's correct and then working through the computation of the data to establish new rates.

So we've been hard at work with them for 3 years.

What I'll share with you since we got the draft rates, we have provided them feedback on where we see -- or where we have questions, where we see some issues with what we see so far with the draft rates.

And so they listened to that.

That's the first part of how we're engaging in this.

Second is before we saw the draft rates and now since we've seen the draft rates, we're all over our congressional leaders to make sure they understand the difference of what CMS is proposing those rates versus what the intention was with PAMA, and we feel good about the receptivity of that.

And also we've been engaged with the administration on that as well.

So we're hitting on all branches of government and we're very active.

We'll submit our formal comments as a trade association, and I would say the trade association, all our partners and all members of the trade association were actively engaged in that, and that will go in before the deadline which is October 23.

We'll also tell you that other trade associations are deeply engaged in this.

The device trade association, AdvaMed, is deeply engaged in this.

The smaller laboratories are engaged.

The American Hospital Association, American Medical Association as I said in my comments are deeply engaged.

And so we have a lot of support broadly.

And then also our employees are deeply engaged.

We have grassroots mailings going into congressmen and women and senators throughout all the different states telling and urging CMS that they need to take the time to get it right.

So that's happening.

We'll see what CMS does with this feedback.

The schedule says they will then take those comments into consideration and give us final rates in November.

We'll see.

They could decide to take the time to get it right and delay the implementation.

We're not sure whether they will or will not do that.

If they go forward with rates, we'll see what that means and what comments they took into consideration, and then we would need to consider legislative action dependent upon what we see there with the help of the Congress members that we have been speaking to.

And then also what we're looking at, too, as a trade association is what legal alternatives we might have in the event that they go forward with final rates that clearly do not represent the congressional intent of PAMA.

So that's what we mean by exploring all options.

And as you can tell from my commentary, we're all over this and I'm not alone.

We got a lot of help from my colleagues in this trade association.

So we feel very good about the effort we're putting into this and CMS is hearing loud and clear that we believe they got it wrong and they need to take the time to get it right.

So Mark, why don't you talk about commercial rates?

Sure, Kevin.

So a couple of things.

First off, as we shared previously, we have very little of our commercial contracts revenue tied to floating rates.

We've been cleaning that up, sunsetting that over the last couple of years in anticipation for some reductions in NOA.

So it's a very small portion and we will very soon not have any contracts that are in any way floating and indexed to NOA.

In terms of predicting the future, it's always hard to predict the future, but I can assure you that in the conversations with the large payers recently, they understand the significant impact that this brings to the industry, and certainly to us.

And they actually had HIPAA before that.

So versus it being an opportunity to take advantage of that and the messaging being, hey, I mean, we want to keep this ratio, the Medicare, of course, the conversation, as you do understand the intent of this is to incorporate commercial rates and Medicare rates.

And so that is an impossibility.

So at the end of the day, you're going to be basically in the same zip code as the Medicare rates and given the significant impact and the fact that largely they agreed with our premise that we are part of the solution on laboratory spending, they pay significantly more to other providers of laboratory diagnostic implementation services, and also we're a part of the solution in terms of overall health care spend given the amount of influence that we have, our data -- many people say it forms 2/3 of the other spend -- that we're actually one of the good guys and a good partner.

So they understand that and they look for us to be successful.

And so the tenor of the discussions around price I can assure you has not gotten worse given PAMA.

It certainly has become neutral or gotten better in most cases.

So you should not expect any significant commercial price erosion going forward.

And just to remind people, we've shared before, [physician] office labs are typically paid 1.5 to 2x what we're paid, and then hospital laboratories are often 2.5x or more of the same rate.

And so I would expect some evolution in that over time as opposed to looking for greater concessions from the independent national labs.

Great.

And then just really quickly.

Steve, any thoughts on utilization environment and organic volume trends?

Sure.

What we've said in the past we'll say this quarter again, it feels stable.

We look at all the different indications in the marketplace.

And overall, if you look at the amount of health care people are using in this country and what we see from our established accounts, we feel stable.

We feel good about our organic revenue growth in the quarter.

We do look at with the effect that the larger storms over the third quarter had on us, and we adjust for that.

We actually feel very good about the progress we're making accelerating growth.

So we're making progress in a stable marketplace to accelerate growth.

Our next question is from Jack Meehan with Barclays.

Mark, I wanted to drill a little bit more into your commentary on the commercial pricing environment.

Obviously, there's some negotiations of national payer contracts under way.

Could you just give an update on your philosophy on those negotiations on price versus value proposition versus network access.

And to your comments you just gave as a low-cost provider, do you think you could actually push on commercial prices and offset a PAMA hold?

Well.

Yes, Jack, of course, that's our strategy is, to push on it to a 2-way negotiation.

So at this point, I'm not going to speculate or promise where that's going to end up.

But yes, that is the position that we're taking.

But you already have excellent rates, and there's other people whose services arguably are no better and, in some cases, aren't as good as what we're providing, given the fact that, for example, we provide all of our data to the payers and quite often they don't get the data from other people who provide laboratory services within their network.

So that's one argument that -- actually get a better product.

And then some of the things that Steve walked through in terms of consumer experience, that resonates because they are understanding that they also have a customer which are their members.

And when they compete with other health plans, there's certainly some value beyond the result of laboratory tests in the services that we provide, and it can positively differentiate them if they embrace and partner and work with us and see some of the value that we bring that maybe other providers don't.

So that's part of our value proposition that we're discussing with them.

And I can assure you that over the last couple of years, we have gotten great increases with some contracts given our value proposition explanation, and that comes part and parcel with what I would call a true spirit of partnership, where as I said earlier, they see we're a part of the solution.

So the more they can steer work to us, the better -- from some of those higher cost providers who arguably don't have good value given the service they provide, the better they're going to be and the more they're going to solve their laboratory spend and, as I said earlier, appropriately drive the use of that data for other health care costs.

So I feel really good about the relationships that we've been building.

And at any time, of course, there's -- everybody wants to maximize value on their side of the equation, but I think as I've said earlier, the tenor of the discussions is a lot more in the spirit of partnerships with the health plan and they're more and more seeing us as part of the solution and that's what's going to help us to defend the value and price that we offer today and into the future.

Great.

And then if PAMA holds, would you push harder on cost savings in 2018?

To that point, I'd be curious if you had any updates on regional consolidation footprint and then just auto-adjudication rollout to payers.

Yes.

So we continue to drive on Invigorate despite PAMA, and what we have shared, and this has been our philosophy for 5.5 years, that we need to continue to get better at what we do and better broadly defined, both in quality and service as well as efficiency.

And as you see it in our results, we continue to get more efficient.

We feel good about tracking to that $1.3 billion goal.

As you recall, in our 2016 Investor Day, we said we're not done yet.

So we got a lot more in front of us.

We've provided some visibility and color to that in 2016.

So we see more beyond the $1.3 billion.

And so we were anticipating that there might be some more price pressure going into '18 and '19.

So what you see implied in our guidance is the continuation of Invigorate [past], what we'll do this year and into 2018, along with just driving productivity in general.

And you go through the math, based upon what we have said, we still feel strongly that we can meet the outlook that we provided at Investor Day in 2016 because we've been working so hard for years.

It's not a new program we're doing.

It's a continuation of the existing program and we have more efficiency to get out of this organization.

Our next question is from Nicholas Jansen with Raymond James & Associates.

Just 2 questions for me.

First, just wanted to dig a little bit deeper into kind of margin trends and expectations as we think about PAMA being rolled out over the next few years.

Certainly, you're showcasing very nice progress in 2017 on margins, I think up 50 basis points in the most recent quarter ex hurricanes.

So just wanted to get your sense is 2017 kind of the peak margin year?

And how do we think about the -- if you've analyzed the next 3 years, how much does margin degrade associated with PAMA?

Yes, Nick.

So thanks for the question.

The outlook that we gave is a CAGR, so I want to be clear it's a CAGR.

So it's not year-to-year.

We're not -- we may see some variability, especially depending the way some of the PAMA cuts get rolled out.

But with that said, what we've committed to is growing earnings faster than revenues.

So by definition, that says that we expect to expand margins.

So it may not be every quarter, it may not be every single year in the period year-to-year.

But over the next several years, we're looking for continued margin expansion because we're committed to growing our earnings faster than our revenue.

And just a clarification on that.

Regarding the structure of PAMA, does that mean -- my understanding is that 2019 would be a worse year than 2018 as we think about the size of the headwind.

Is that the right understanding?

Yes.

The honest answer at this point is I don't know because there's still so many things up in the air regarding how they're going to apply some of their rules and pricing practices.

And without getting into too much detail because it's very complicated, just in summary, a lot of the billings to Medicare are panel.

And the way Medicare pays panel is very, very complicated.

And the more anilides you add to panels, the more it impacts the overall price and it's not in a positive fashion.

So they already have historically deviated from what people who aren't close to the industry might not understand, which is you don't get paid NOA for every single anilide when you start putting things together in a panel.

So the question we have is how are panels going to get paid and how are you going to price those relative to the commercial market because in many cases there is not a comparable code within the commercial world.

So it's a very, very complicated issue that we're trying to sort through and that's why even if at this point we were in a position and really interested in sharing the estimate by year, I don't have that answer.

So still more to come.

So I would say at this point, do not assume that '19 is worse than '18 or vice versa.

We will tell you as soon as we have a deep-enough understanding to provide you some reliable information.

That's very helpful, and just one quick, just a numbers question.

I understand the tax dynamics, the stock-based compensation benefit you're seeing this year.

Any way you can just share what we should be plugging in for '18.

Is it kind of a 35 to 37 range?

Just wanted to get a sense on how we should be modeling tax specifically in '18.

Yes.

So I'm sure you understand that what drives that is a couple of factors.

As long as the share price is higher than it was at the time of the grant of the equity, that you're going to see some value.

So certainly we see a year like 2017 where we had significant stock appreciation, that was versus the previous years.

That was driving a lot of this benefit.

The other thing is option exercises, which of course we can't predict.

So the vesting of performance shares, the vesting of RSUs will drive some level of benefit consistently, assuming that the stock price continues to appreciate to some degree, but we can't predict the timing of the option exercises, which is a huge variable.

So what I would say is the $0.06 that we shared in 2017 is kind of a base level.

Assuming that the stock is stable or continues to go up to some degree, that is pretty reliable that, that's going to be there but the large swings beyond that will be highly dependent on appreciation with stock movement and the amount of option exercises, and that's what we can't predict.

So I would say $0.06 and we'll continue to update you if that changes.

It's kind of a base level you should consistently expect and anything beyond that is dependent on those other factors.

Our next question is from Bill Quirk with Piper Jaffray.

So you addressed the commercial rate in Medicare relationship with respect to Kevin's question.

I was hoping you could comment on the percent of Medicaid business that's tied in to Medicare rates and kind of how you're thinking that -- thinking about that rather over the next couple of years assuming that PAMA goes into effect.

Yes.

So to the best of our understanding, Medicaid rates are not largely tied in terms of being an index, in terms of the mechanistic fashion.

Certainly, they look at Medicare rates when they set -- the state set those rates, but it doesn't look right there's a formulaic relationships in most cases, again, from the best of our understanding -- and we've looked at this pretty deeply -- that would automatically trigger changes in Medicaid.

So that's going to be pretty much up to the states.

And again, reminding you only about 2% to 3% of our revenues are paid by traditional Medicaid fee-for-service.

A lot of the Medicaid has already moved to managed Medicaid.

And the one thing that I will say is that there are rules around the fact that Medicaid cannot pay more than Medicare.

So in any case, whether it's a state Medicaid rate where the fee-for-service is close to Medicare or there's a Medicare reduction, you would see a reduction to ensure that Medicaid was not higher than Medicare.

But beyond that, at this point, still more to learn but I would not expect this will trigger significant reductions in state Medicaid rates.

And again, given the small proportion of our revenue that comes from fee-for-service Medicaid, I wouldn't expect it to be a major headwind for us.

I appreciate the color on it.

And then just separately, can you just comment on, I guess, the consumer outreach programs that you have with Safeway and Walmart?

And help us think a little bit about the relative profitability of those as compared to, say, your traditional draw station and traditional diagnostics business.

Yes, Bill.

Thanks.

So consumer strategy.

So I outlined the 5 elements of our growth strategy, one of which is to be the most consumer-oriented laboratory.

And there's multiple facets as far as that is concerned.

One is we're putting a lot of a work in eEnabling our whole consumer process and we talked about eCheckIn so moving really our experience that we have with consumers to contemporary experience as the people experience in the consumer world.

Making a lot of progress there, the feedback is great.

It helps patients, it helps our employees.

And as I mentioned, our health care insurance partners feel great about that experience as well because they're working on that.

Yes, the second is around information.

We talked about MyQuest.

We have 4.5 million users, which is a phenomenal number, given that we only brought this to the marketplace in a little over 2 years.

So it's just picking up the volume of users that we have and we're putting more and more content around that and also allow people to navigate into our whole experience through MyQuest which is a nice consumer touch, if you will.

The third is around products.

You see a lot more from us and we have direct-to-consumer testing.

We mentioned we tested this in the Arizona marketplace last year.

We're bringing this into Missouri and Colorado.

We actually are encouraged about some of the early returns that consumers are interested in paying out-of-pocket from their own ordered diagnostic test.

It could be cholesterol, it could be hemoglobin, it could be glucose or sexually transmitted diseases but there's a market there, and so we're going after that market.

And the last place we're investing in, which is what you asked as a big part of your question, is what we're doing around access.

When I say access, because it's important that we have access for our draw stations, and so we're looking at how we can augment and in some places, replace our Patient Service Centers with some of these locations at Safeway.

We're making excellent progress of implementing patient service centers in those Safeway stores and also our relationship with Walmart.

And so we will open some centers in Walmart in Florida and Texas this year.

And so what that allows us to do is by zip code is look at where we have access points.

And in some cases, we can consolidate what we have into those stores, and that allows us to get more efficiency, in some cases, around the real estate cost but also around the phlebotomist productivity.

The biggest cost of drawing is not real estate, it's the labor.

It's our phlebotomists.

So if we could have more density of phlebotomists in better locations, in convenient locations that serve the consumer better, the better off we're going to be.

Remember, a lot of our Patient Service Centers, even though we have unparalleled access at 2,200 Patient Service Centers and we have over 3,500 phlebotomists in physicians' offices so close to 6,000 access points, are in medical office buildings.

So these are not nearly as convenient locations as where you'd find a Safeway store or where you'd find a Walmart with big wide open parking lots, easy access to the store and ability to do some shopping and other activities around that experience.

So we're quite encouraged.

We think we are on the right track.

And again, as we talked earlier, our value proposition to the health care value proposition is we want to be the most consumer-oriented laboratory, and we think our value proposition is getting stronger and stronger every day because we're focused on this.

So making a lot of good progress.

Our next question is from Ralph Giacobbe with Citi.

Just wanted to understand and clarify the jumping off point for 2017.

The midpoint of guide is $5.65.

We've got the $0.10 from the hurricane, so that's $5.75.

We take out the $0.20 for the tax benefit, we're at $5.55.

And then ex PAMA, we essentially grow that mid- to high single digits, is that -- I just want to make sure if that's right?

So the jumping off point shouldn't be adjusted for the hurricane, but you may argue that the year-over-year growth compare is easier given the fact that we had hurricanes in 2017.

So the jumping off point, you're right, that's the midpoint of our guidance and take out the $0.20.

And that's kind of the way we are thinking our starting point given that at this point we would project only $0.06 of excess tax benefit from stock-based compensation.

That's how we would build our initial plan for 2018 and certainly taking into account that the hurricane impact this year, that kind of gives us an easier compare next year.

Okay that's fair.

And then in the same context as the $6 to $7 number by 2020, right?

So off that baseline, that's how we should be thinking about the $6 to $7 for 2020.

Exactly.

Not off the guidance that includes the $0.20, so it's excess stock-based comp growth.

Okay, all right.

That's helpful.

And then I guess any help you can give on sort of based on your current mix, can you give us the impact of the PAMA cuts for 2018, '19 and 20?

No.

As I said earlier, maybe I wasn't as clear as I intended to be, given that there are so many things that have to be sorted out, so many unanswered questions, we are still trying to figure out -- obviously we looked at it deeply, we have a huge range of potential outcomes depending on the answers to some of those questions.

So it would not be helpful at this point to share that information.

As I said in the minutes, we expect to get more clarity, in the not-too-distant future.

And as soon as we're in a position to share something, we will certainly do so.

With that said, we obviously have reconfirmed our views on outlook, and that view on outlook taking into consideration what we saw in the draft rates.

And so our feedback to CMS is that there's a lot of areas that we think they have got wrong, and therefore, we think the rates are too low.

So we think as we contemplate what we just shared with you this morning, we are confident we will be able to deliver those outlooks despite what might happen or not happen given our dialogue with CMS.

Okay, all right.

That's helpful.

And just last one.

Can you give a sense of multiples you're paying for deals and maybe how you approach a purchase price, just given what likely may be a lower future earnings stream from whatever you're acquiring given PAMA?

Sure.

We've shared that we have very robust specific metrics around evaluating our deals.

It involves a return on invested capital metric where it would be accretive by the third year relative to our plan of record and we have a plan of record based on our performance shares where every year, we put forward a forecast for our return on invested capital for the base business and half of our performance shares are based on that.

So we need to do deals that are accretive to that by the third year, and we also have an NPV metric and, obviously, the [pima aspect] as well that needs to be exceeded before we will consummate a deal.

So the multiple question is a tough one because their P&L generally has no relationship to our P&L.

As I shared at the Investor Day, I went through actually a straw man example, in most cases, if not all, their revenues are higher than ours.

When the business becomes part of Quest and we get paid at the rates with which we've negotiated, but the cost structure is so dramatically different that despite that revenue dissynergy, we still significantly make more margin typically than the individual sold into us.

So taking a multiple of their P&L really does not make any sense.

As we share the revenue multiple, they look like they are a great deal based on when it was in their hands and the earnings multiple, our EBITDA multiple, looks like we way overpaid, but it's really not meaningful.

If you look at our pro forma, you can see multiples that are the opposite, which says, hey, based on the earnings, it was good and based on the revenue, maybe you paid a little bit too much.

But we cannot pay significantly more than our current enterprise multiple because by definition, the math doesn't work and then we're not able to get that ROIC target.

So we actually use return on invested capital, not our cost of capital which some other companies use to evaluate deals.

So in fact, we have a risk premium built into our NPV and built into our return expectations that we think makes sense and is good for our shareholders.

Our next question is from Amanda Murphy with William Blair.

Just a quick question on the long-term outlook.

And obviously, there's been some discussion around contract renewals from a payer perspective, and I think you gave some perspective there just in terms of pricing over the long term.

But I just wanted to clarify in terms of the long-term outlook how you're thinking about some of the major contract changes.

Are you including any assumptions there?

And then also just thinking about capital deployment in terms of share buybacks?

Can you just help us think about how you're thinking about that over the long term especially given PAMA?

Yes.

So let me start on contracting.

We obviously want to get the best access as possible.

And as I said in my earlier comments that we feel really good about our growing access and that's helping us accelerate growth, and that continues to be our strategy going forward.

As you're aware, one of the nationals that we don't have a preferred relationship is United.

What we shared in the past, we know that, that contract expires in 2018 with our nearest competitor.

And as we said, we'd like to be on contract with United, and our relationship continues to be strong and building.

So what we did contemplate in our outlook is a growing capability for us to have as many health care insurances also on network than what we currently enjoy, and so that is contemplated in the outlook.

And Mark, the second part of the question.

So Amanda, we're going to stick with our capital deployment strategy.

In terms of the earnings growth being low to -- actually mid- to high single digits that is earnings.

That's not earnings per share, so it doesn't contemplate significant buybacks to boost up earnings to share; it's real earnings from cash.

And so we will continue with our strategy, which says if we have near-term accretive opportunities that's a better use of that cash to do M&A, that will be a priority once we satisfy that majority of free cash flow going back to our shareholders.

As we talked about before, the dividend gets us a long way towards that objective and we did some supplemental share buybacks to get at least to 50% of our free cash flow.

But then with the other 50%, our free cash flow will be opportunity-dependent.

If we have M&A, that would be the preference and if we don't have M&A that is a better use of cash, then we will buy back more shares.

At this point, the outlook does not include a reduction in our ways to get to higher level of earnings.

But the growth rate that I share at the CAGR is real earnings.

Got it.

And then just one quick follow-up.

I think Jack has done some good work in terms of looking at the regional dynamics of PAMA in the first year just given that we're going to -- that it's going to switch from a regional to more of a national schedule.

So I don't know if you've been able to look at that yet to see if there's any mitigation there for you guys.

And based on your mix, I know it's early in terms of the data, but just looking for some insights into maybe what the first year might look like relative to the reported rate review.

You're correct.

That is the mitigation and the sort of price declines from the NOA because there are some regions that we're already paying less than NOA.

So by definition, there's less of a decrease at least in the first year depending on how -- what the overall cuts might be over a multiyear period.

[We haven't actually had them say no.] That is the issue with the panel.

So in the case of many of the panels, if you added up the individual components and their NOA, we have not been getting paid that total amount so that would also be a mitigation assuming that they don't change into some sort of other methodology.

So that's what makes it a little bit complicated but I did want to acknowledge that if you just looked at the fee schedule and tried to say, "Okay.

Medicare revenues are axed and it looks like" -- and this wasn't the case -- "and every code was reduced by 10%, therefore I can do the math." No, it's a lot more complicated than that because in most cases, we're not getting paid NOA for the work that we bill for Medicare.

Our next question is from Ann Hynes with Mizuho Securities.

So I don't want to beat a dead horse, right.

I just want to go back to that $6 to $7 range to 2020.

So I just want to clarify what's included and what's not.

So it includes the proposed rates for PAMA as stated in the rule, it includes only 1% to 2% M&A annually?

It includes an increase in your cost synergy program, and if it does, can you tell us exactly how much just for modeling purposes?

It includes some share repo but not a lot.

And with the UNH contract, if you're not let in it.

I mean, I'm assuming that if it's in, you have some type of a visibility and if it's not, can you let us know the downside risk?

Yes, so let me clarify.

So in the efficiency program, I wouldn't model in a significant change from what we've been doing.

I think Steve was messaging that we have much more to be done.

And that, certainly, we'll continue to deliver significant efficiencies over the next couple of years and that's part and parcel with the outlook that we gave.

Now with that said, of course, depending on the PAMA outcome, the timing of it and how severe it is, we're going to do what we need to do.

So we're going to get to that outlook.

We have enough levers to pull that we're very comfortable and would not be reaffirming outlook if we weren't confident that we have the ability to do that despite where PAMA might come out and certainly in the case that plan contemplated the worst-case scenario which is what they propose.

So -- and then in terms of share buybacks, there will be some share buybacks but a lot of that is really just to prevent dilution given our equity program.

So I wouldn't assume that any reduction in waste.

So that is not in my outlook for this point.

As I said again that growth is in earnings.

And therefore, at this point given all other factors, you should assume that earnings per share will grow with earnings.

And then depending on the best way to create value, that could vary because we get more M&A or because we do more share buybacks.

And yes, the 1% to 2% M&A is what we're counting on, but what we're signaling, back to Isaac's original question, is we think, although we've been doing consolidation, this could be a trigger for acceleration of the consolidation.

So we are just noting that there could be an opportunity for an acceleration and for more M&A but I'm not modeling that in the outlook at this point.

Okay.

And then the UNH question.

So I'm assuming if you've included it in the guidance you have some type of visibility.

And if you don't, can you just maybe give us some visibility on what the downside would be?

Anne, my commentary was that we're working on it.

But the current status quo is whether it stays that way or not, we still feel confident with our outlook.

Okay, so that's the way you should think about it.

Our current access is getting stronger.

We are working to get it even stronger, but our outlook contemplates staying where we are as well.

Okay.

And then with PAMA in Washington, I appreciate all the efforts that you guys have done -- you're talking to the congressional people, you're commenting to CMS.

But I feel like a lot of that was done beforehand.

What do you think can change?

Do you think CMS just wanted a comment period?

Do they need that to make a change?

So I didn't -- just trying to figure out like what would change in 2 months.

Yes.

Well, the big change, well, let me give you a little color on this.

So we went around and talked to our Members of Congress and Senators and the administration.

Yes, we planted our concern, but it was a concern without a lot of facts.

And a lot of our stakeholders have said, "Well, I understand but let's see what the data says." And so many of them were waiting for these draft rates.

And so the good news is the draft rates are out and the draft rates are severely flawed.

With the amount of data that was collected, a very small percentage of laboratory, is 1%.

With a lot of the data coming from ourselves said that a majority of the rates are based upon the large nationals, and that was not the congressional intent.

So the data being out there and it's helping us now get more momentum with our stakeholders to say, "Wow, okay.

What these guys have been talking about before we had the draft rates, they were right.

They really got it wrong.

And their message around take your time to get it right, we now understand.

Now the question is what do we do about that." So in a strange sort of way, the draft rates have been helpful to move the dialogue along.

One example of it, Ann, is the OIG had sent out a report several months ago, that said based on the definition of the applicable lab, they were expecting about 5% of the labs but close to 70% of the volumes would be reflected.

As you heard us say today, only 1% of the labs actually ended up submitting for various reasons.

So back to Steve's point around, okay, state your concerns and we'll see where it comes out.

Certainly, those kind of facts are weighing on the conversations we're having right now.

I mean the vast majority of the data they're looking at for these draft rates is from the large laboratories.

And we know from Medicare data that roughly 50% of what they buy is laboratory services from hospital outreach laboratories as well as physician office labs and from the 2 large nationals, it's only 20% of their purchases roughly.

So the sampling is flawed and they need to take time to get it right and the whole philosophy of PAMA is to make sure that they look at this cost to serve issue in this industry to make sure they're paying market-based rates and those market-based rates are not the rates of large nationals that generally have the density in large urban centers.

Our last question is from Lisa Gill with JPMC.

I just had a question Steve, you talked a little bit about United and potentially opening that up from the preferred relationship they have today.

Would you anticipate that the same would happen with your Aetna relationship over time?

Do you think that as you think about the world as we know it today that maybe the preferred relationships don't work quite the way that they were intended back when they were assigned in the mid-2000s?

And how do we think about that dynamic, one?

And then two, if United has opened up my assumption would be that you're probably getting some rates today that were nonnetwork rates and so they would potentially be higher.

Are you thinking that the volumes helped to offset that when you are thinking about the equation of getting to that $6 to $7 in 2020?

Yes.

Well, first of all, on Aetna, our relationship continues to be strong.

Yes, we have preferred national relationship and we haven't commented on whether or not we'll continue or not, but we do have an extended contract, which we feel good about and we've secured.

And second, as far as our philosophy with all health care insurance companies, we do believe that it is good to have a smaller network, and frankly, given our value proposition, we actually like those contracts where we are on contract with other nationals, where we have the opportunity to compete for the business because when we do compete for the business we do quite well.

So philosophically and strategically, that's the position we've taken.

And as you see, 3 out of the 5 nationals, we have both ourselves and the nearest competitor on par, and we feel good about those relationships.

Aetna has a different approach.

We feel great about that relationship and we're working with United.

All of those 5 have different relationships.

And I'll remind you, we spend a lot of time talking about the nationals, that a large part of our business is not with the nationals, it's with a lot of regionals.

We have hundreds of contracts and those contracts continue to provide great access for us as well.

So Lisa, just to be clear.

Yes, other network rates are higher, in some cases significantly higher than the network rates, but there's also some lives that don't have out-of-network benefits, typically the fully insured.

So we don't get paid quite the premium being out of network that some people might think because there's some work we receive that we do basically for free because we don't get paid for those fully insured.

So we will -- we get a network, in a plan where we're out-of-network, there's countervailing forces.

One is the in-network rate, obviously typically is lower than the out-of-network rate.

But then for the lives that didn't have that or benefits we actually will get paid.

So there would certainly be some pricing headwinds offset by what we would consider to be a significant volume increase for any time we get into a network where we were previously out-of-network, but it's not as large a price handling that some people might think on the surface.

Great.

And then, Mark, if I could just ask one question.

I noticed that everything's talking about the future and not about the quarter, but I just want to understand 2 things.

One would be around the pricing environment, obviously pricing coming in a little stronger.

Is that just a mix element or is there something else going on there, would be first.

And then just second on the nonclinical down 4%, we expect it to be down around 2%.

Is there anything else there that's worth calling out from a quarter perspective?

Sure.

So as I shared in the prepared remarks, pricing continues to be less than 100 basis points.

That's our apples-to-apples price.

And then we've also shared a path that there is a mix element that suppresses revenue per req from our PLS business.

So really when you look at the revenue per req, it's the positive mix that we've experienced pretty consistently for several quarters, which is around the test mix and then also the density of the requisitions where we tend to consistently have been growing our test per req ratios, so those are the drivers, is the other mix elements have been favorable, more of our advanced diagnostic testing, and then more tests per requisition have offset the negative mix impact of the PLS on revenue per req.

When you look at the Diagnostic Services business, it's largely our risk assessment business.

There's a couple of other things in there, but that's the big driver.

That is the work we do for individuals who are looking to secure life insurance policies.

And some of that is highly dependent on the industry itself and the number of policies that are being written, and recently, that's been a little softer.

So that has nothing to do with the competitive environment.

We're not per se losing to competition.

It really has to do with the market and the market has slowed and fallen off a little recently.

Okay, so thanks again for joining us today.

As we have said, we had another strong quarter in the third quarter 2017.

We look forward to continue to meet our commitments and execute our 2-point strategy, both accelerated growth and driving operational excellence.

We thank you for your continued support, and have a great day.

Thank you for your participating in the Quest Diagnostics Third Quarter 2017 Conference Call.

A transcript of prepared remarks on this call will be posted later today on Quest Diagnostics' website at www.questdiagnostics.com.

A replay of the call may be accessed online at www.questdiagnostics.com/investor or by phone at (888) 667-5784 for domestic callers, or (402) 220-6427 for international callers.

Telephone replays will be available from approximately 10:30 a.m.

Eastern Time on October 19, 2017, until midnight Eastern time on November 2, 2017.

Goodbye.