Shares of Quest Diagnostics Incorporated (DGX) have been trading somewhat rangebound over the last couple of years. The company has seen modest growth, but has pleased investors through continued share buybacks as the business has enjoyed some windfall profits related to Covid-19 testing revenues (and profits) in recent years, which have now officially become non-meaningful.
The decline in the Covid-19 testing revenues has hurt reported sales growth, but as these sales are no longer existing (in a material form), the business should enjoy easier growth comparables going forward, and potentially a re-rating on the back of that.
Diagnostics Testing
Quest Diagnostics has a mission to create a healthier world, one life at the time. The company aims to do so by providing high-quality and affordable diagnostics testing insights and services. By collaborating with many stakeholders in the process and offering a wide range of testing services, the company is a force in its field, employing nearly 50,000 workers in the meantime.
In fact, Quest serves about half of hospitals and physicians, having served a third of the U.S. population over the past three years. On $8.4 billion in base revenue in 2022, that is excluding the volatile Covid-19 contribution, about 70% of sales are generated in the physicians’ office. About a fifth of sales are derived from the health systems segment, accompanied by a smaller consumer health & other segment.
Continued growth in the healthcare space and an increased focus on testing should drive long term growth as the company has seen some windfall profits thanks to the pandemic.
Except for some smaller items, Quest has steadily grown the business and delivered on shareholder value creation over time. A $5 stock in 1999 jumped to $40 in 2002 as shares traded around the $50 mark for years, in fact about a decade. By 2018, shares had risen to the $100 mark as the boost from the pandemic drove shares to a high of $170 in 2021, followed by some stagnation with shares now trading at $133 per share.
The Base Case
In February, Quest announced an 8% fall in 2022 sales to $9.9 billion, although the decline is entirely due to a retracement in Covid-19 pandemic related revenues. So-called base revenues were up 5% to $8.4 billion, as Covid-19 testing revenues were cut nearly in half to almost $1.5 billion.
The near billion fall in the top line sales results hurt the bottom line in a huge way. GAAP operating profits were down a billion to $1.4 billion as GAAP earnings fell from $15.55 per share to levels a few pennies short of $8 per share. Even if we adjust for some one-time items which resulted in a bigger earnings decline, adjusted earnings were still down 30% to $9.95 per share.
The base revenue base has only risen in a modest fashion from a >$7 billion number posted since 2014. This growth is nothing too exciting, although that the company has bought back about one in every four shares over the past decade, translating into decent sales and earnings per share growth. Net debt was reported at $3.7 billion (after lower profitability in 2022, and some share buybacks) as I peg EBITDA around the $2.0 billion mark.
For 2023, Quest outlined an outlook which calls for a second year in a row of revenue declines. The base revenues are seen at a midpoint of $8.7 billion, up around 3% on the year before. Covid-19 testing revenues are seen a midpoint of $225 million, down nearly 90% year-over-year. Amidst the lower pandemic related revenues, which apparently are very lucrative, adjusted earnings are seen between $8.40-$9.00 per share. That said, the headwinds from a reversal in these revenues is now a thing of the past.
Based on the midpoint of the 2023 guidance, the company trades around 15 times earnings, a very reasonable multiple.
Some Upbeat News
In February, Quest announced a bolt-on deal to acquire Laboratory Services Diagnostics, a deal on which no financial details have been announced, with another bolt-on deal closing around the time as well. Alongside the release of the first quarter results, Quest announced the purchase of Haystack Oncology, an early stage oncology testing business.
Founded as recent as 2021, Quest is attaching a $300 million cash valuation to the business, with milestone payments having the potential to increase the acquisition price by another $150 million over time. Needless to say, with a nearly $19 billion enterprise valuation, this is just a bolt-on deal.
First quarter sales fell 11% to $2.33 billion, but this performance was actually quite strong. After all, base revenues were actually up 10% to $2.21 billion, and while Covid-19 revenues were down 80% they still came in at $119 million. On the bottom line a 37% decline in adjusted earnings per share was reported, with earnings coming in at $2.04 per share.
As a result of the solid quarter and the Haystack deal, the company hiked the base revenue guidance by $130 million to a midpoint of around $9.0 billion. Despite the relatively high first quarter Covid-19 contribution, the company cut the full year guidance by fifty million to $175 million.
Based on the overall impact of these trends on the guidance, the company maintained the midpoint of the full year adjusted earnings guidance at $8.70 per share. With Haystack set to be dilutive to earnings, the reiteration of the guidance implicitly says that the core business is performing stronger than expected.
What Now?
The reality is that Quest Diagnostics Incorporated looks like a decent long-term play. The business is well-diversified, trades around 15 times adjusted earnings and operates with about a 2 times leverage ratio. The business has been hurt by continued declines in the pandemic related revenues, but this has come to an end (for the simple reason that revenues related to Covid-19 testing have come down close to zero).
This makes that Quest slowly starts to look compelling, as this was still a >$150 stock by Christmas. While a dividend yield just in excess of 2% and a non-demanding earnings multiple are not resulting in screaming appeal, I think that investors should look forward to continued base revenue growth with no more headwinds due to retreating Covid-19 revenues going forward.
This should create a good setup for a re-rating in the valuation multiple later this year or early next year. That made me inclined to buy the dip here, in anticipation that the market will become more upbeat on the Quest Diagnostics Incorporated business going forward.
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