Quest Diagnostics Q2 2023 Earnings Call Transcript

AlphaStreet
Provided by AlphaStreet
July 26, 2023
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Operator

Welcome to the Quest Diagnostics Second Quarter 2023 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 would like to introduce Shawn Bevec, Vice-President of Investor Relations for Quest Diagnostics. Go ahead, please.

Shawn Bevec
Vice President of Investor Relations at Quest Diagnostics

Thank you, and good morning. I'm joined by Jim Davis, our Chairman and Chief Executive Officer and President, and Sam Samad, our Chief Financial Officer. During this call, we may make forward-looking statements, and we'll discuss non-GAAP measures. We provide a reconciliation of non-GAAP measures to comparable GAAP measures in the tables to our earnings press release. Actual results may differ materially from those projected. Risks and uncertainties that may affect Quest Diagnostics' future results include, but are not limited to those described in our most recent Annual Report on Form 10-K and subsequently filed quarterly reports on Form 10-Q and current reports on Form 8-K.

For this call, references to reported EPS refer to reported diluted EPS, and references to adjusted EPS refer to adjusted diluted EPS. Any references to base business, testing, revenues or volumes referred to the performance of our business, excluding COVID-19 testing. Growth rates associated with our long-term outlook projections, including total revenue growth, revenue growth from acquisitions, organic revenue growth and adjusted earnings growth, are compound annual growth rates. Finally, revenue growth rates from acquisitions will be measured against our base business.

Now here is Jim Davis.

James E. Davis
Chairman and Chief Executive Officer and President at Quest Diagnostics

Thanks, Shawn, and good morning everyone.

We had strong base business performance in the second quarter with nearly double-digit revenue growth year-over-year. Demand for our services remained strong across all regions, boosted by the collaborations we have formed with health plans, hospitals and physicians, amid an environment where people are returning to care. We are particularly encouraged by the revenue growth in our base business of nearly 10% from our health system customers.

Also in the second quarter, we made substantial progress improving the profitability of our base business compared to the first quarter and prior year, despite persistently high employee turnover. Total adjusted operating margin improved more than 170 basis points compared to the first quarter, despite a decline of approximately $80 million in COVID revenue. This morning, I'll discuss highlights from the second quarter, then Sam will provide more detail on our financial results and talk about our updated financial guidance for 2023.

Now let's turn to some of the highlights from the quarter. As we shared at Investor Day, our strategy is to drive growth by continuing to meet the evolving needs of our core customers, physicians, hospitals and consumers as they navigate the changing landscape in healthcare. We will enable this growth with an intense focus on faster growing clinical areas, including molecular genomics and oncology. In addition, acquisitions will continue to be key drivers of our growth. Finally, our strategy includes driving operational improvements across the business with strategic deployment of automation and AI to improve quality, efficiency and service.

So let's review progress we've made in each one of these areas. In physician lab services, we delivered strong base volume growth from physicians, largely through our partnerships with health plans, which have expanded our access to the market. A growing number of these involve value-based arrangements and are generating faster growth and share gains, than the traditional relationships. These arrangements position us as a more strategic partner with health plans as we work together on leakage, shared savings and redirection programs. In addition, New York-Presbyterian's recently acquired outreach assets brought us new volume from the physicians. In hospital lab services, base revenue from health systems grew nearly 10% in the quarter.

The Professional Lab Services business had a very strong quarter as we saw solid growth from both new and existing PLS relationships. We are particularly encouraged by progress with our new PLS partnerships with Northern Light Health, Lee Health and Tower Health. As hospitals continue to experience financial challenges, we are here to help whether through professional lab services, reference testing or purchasing the hospital's outreach assets. We are now seeing growing momentum with a significant pipeline of potential deals with large health systems.

In Consumer Health, we had strong base business growth on questhealth.com. We continue to optimize our marketing efforts to target our customers more strategically and now expect consumer initiated testing to be profitable through the balance of 2023. Also during the quarter, we launched Genetic Insights, our first consumer-initiated genetics health test on questhealth.com. This saliva-based test leverages our expertise in next-generation sequencing to analyze three dozen genes for inherited risk of conditions ranging from breast and colon cancer to carrier status for cystic fibrosis and Tay-Sachs. We are encouraged by initial demand for this new offering, which adds to our growing test options for health-minded consumers.

As discussed at Investor Day in March, a key pillar of our strategy is to support faster growth across all customer segments through highly-specialized advanced diagnostics. These offerings include molecular genomics and oncology tests, such as germline testing to assess prenatal and hereditary genetic risk, and somatic testing for tumor sequencing. Advanced diagnostics also encompasses other key areas, including neurology, women's reproductive health and cardiometabolic health. In neurology, we continue to achieve strong growth from our innovative Quest AD-Detect, a portfolio of Alzheimer's blood tests, which help identify early indications of beta-amyloid and ApoE status. AD detects strongly physicians' Quest to lead in this rapidly evolving Alzheimer's landscape.

Emerging therapies for Alzheimer's represent a new era in treatment and testing for this disease. Like many diseases, early intervention in Alzheimer's may promote better outcomes. Our AD-Detect portfolio enables accessible and convenient evaluation of Alzheimer's risk potentially at early stages and the monitoring of progression. AD-Detect is now available to our physician customers in the US and we believe it also has the potential to generate strong consumer demand.

In addition, we continue to see strong growth in our cardiometabolic, endocrinology infectious-disease in carrier and prenatal genetic screening services. In June, we completed our acquisition of Haystack Oncology, which positions us to enter the high growth area of minimal residual disease or MRD testing. Haystack has developed a highly sensitive technique for early detection of residual or recurring cancer with the potential to improve outcomes for patients being treated for cancer. The integration of Haystack is on-track and we continue to expect to introduce our first MRD test in early 2024. We intend to launch this test from our Oncology Center of Excellence in Lewisville, Texas, where we also recently introduced our Solid Tumor Expanded Panel for tumor sequencing and therapy monitoring.

I'd like to say a little more about our M&A strategy. Haystack is a capabilities acquisition and as we've said, it will initially be dilutive for earnings per share. However, our primary focus in M&A continues to be on traditional hospital outreach purchases and tuck-in land deals that are accretive to earnings in the first year. To underscore what I said earlier, our M&A pipeline is robust as hospital systems face continued margin pressures due to labor challenges and a shift from inpatient to outpatient care.

Turning to operational and productivity improvement, our Invigorate program is well on its way to delivering our 3% annual productivity savings target. As we discussed at Investor Day, Invigorate includes deploying automation and AI to improve quality, efficiency and service. In the quarter, we implemented our automated microbiology solution in Lenexa, Kansas. Next up is Lewisville, Texas. When complete, four of our major laboratories will use automated microbiology lines with embedded artificial intelligence, identifying positive and negative cases leading to improved quality and productivity. We are also excited by results of a pilot in our Clifton lab that showed AI speeds data collection in specimen processing and expect to implement this AI solution across all of our major regional labs later this year.

In genomics, we're utilizing AI in Bioinformatics to improve and speed variant classification and prioritization. These are just a couple of the many examples of our use of AI and automation to continuously improve our operations. In addition, we believe Generative AI has great potential to deliver insights and content not only to better target and serve customers, but also to create innovations that help standardize our lab operations. We are encouraged by preliminary results of pilots that use Generative AI and our customer service center to automate caller sentiment analysis and quality control, and in our marketing operations to improve market research and customer targeting.

Now before I turn it over to Sam, I'll close by saying that we always knew 2023 would be a challenging year, as we transitioned away from COVID-19 testing and supported the nation's return to care. Our dedicated employees on the frontlines and everyone else who supports them, have done a magnificent job of bringing our purpose to life. Working together to create a healthier world one life at a time. I'm really proud to be leading this Quest Diagnostics team. And now, I will turn it over to Sam to provide more details on our performance and our updated 2023 guidance. Sam?

Sam Samad
Executive Vice President and Chief Financial Officer at Quest Diagnostics

Thanks, Jim. In the second quarter, consolidated revenues were $2.34 billion, down 4.7% versus the prior year. Base business revenues grew 9.5% to $2.3 billion, while COVID-19 testing revenues declined approximately 88% to $41 million. Revenues for Diagnostic Information Services declined 4.9% compared to the prior year, reflecting lower revenue from COVID-19 testing versus the second quarter of 2022, partially offset by strong growth in our base business.

Total volume measured by the number of requisitions grew 0.2% versus the prior year, with acquisitions contributing 50 basis points to total volume. Total base testing volumes grew 7.4% versus the prior year, as we continue to see a broad-based return to care throughout the quarter. Revenue per requisition declined 4.9% versus the prior year, driven by lower COVID-19 molecular volume. Base business revenue per req, was up 2.5% due to more tests per req. Changes in test mix and benefits recognized with certain value-based arrangements. Unit price reimbursement was flat in the quarter, consistent with our expectations.

Reported operating income in the second quarter was $348 million or 14.9% of revenues, compared to $388 million or 15.8% of revenues last year. On an adjusted basis, operating income was $389 million or 16.7% of revenues compared to $435 million or 17.7% of revenues last year. The year-over-year decline in adjusted operating income is related primarily to lower COVID-19 testing revenues, partially offset by growth in the base business. Compared to the first quarter, we made strong progress improving the profitability of the business. Adjusted operating margin expanded 170 basis points sequentially, while total revenues were essentially flat versus Q1. We also absorbed higher SG&A costs related to an increase in the market value of the obligations in our supplemental deferred comp plan in the second quarter, which lowered adjusted operating margin by 30 basis points. This has no impact on EPS.

We continue to closely manage the cost of our corporate and support functions. Since last fall, we have taken a series of actions to reduce support costs, which will save more than $100 million this year. Those savings largely began in Q2 and we're on track with our estimates in the quarter. Frontline employee turnover improved marginally earlier this year, but the pace of improvement has not met our expectations and it remains well-above historical levels. We continue to feel the effects of the tight labor market, which has had an impact on productivity and wages. Turnover continues to be a drag on productivity despite the strong base business growth.

Reported EPS was $2.05 in the quarter compared to $1.96 a year-ago. Adjusted EPS was $2.30 compared to $2.36 last year. Cash from operations year-to-date was $538 million versus $882 million in the prior year period. The decline in operating cash flow was primarily related to lower operating income.

Turning to our updated full-year 2023 guidance. Revenues are now expected to be between $9.12 billion to $9.22 billion. Base business revenues are expected to be between $8.92 billion and $9.02 billion. COVID-19 testing revenues are expected to be approximately $200 million. Reported EPS is expected to be in a range of $7.52 to $7.92. And adjusted EPS to be in a range of $8.50 to $8.90. Cash from operations is expected to be at least $1.3 billion and capital expenditures are expected to be approximately $400 million.

Here are some things to consider for the remainder of the year. We've raised our base business revenue guidance to reflect our strong performance through the first half and our expectations for the remainder of the year. Note that the year-over-year comparison for the base business becomes more difficult in the second half of 2023, as we begin to lap some PLS wins later in the year. Also, we are not expecting demand for respiratory panels to be as strong as we saw in last year's flu season, which could be a headwind to revenue of nearly 100 basis points in the back half. We expect revenue and adjusted EPS to be more even in the third and fourth quarters, which is a slight departure from our typical earnings seasonality due to the following factors.

Unit price reimbursement is expected to improve in the back half. Our CIT business turned profitable in Q2 and is expected to be more accretive to both revenue and earnings as we move throughout the second half of 2023. And cost actions taken throughout the first half of the year will continue to improve the overall profitability of the business. Finally, as I noted earlier, we continue to experience higher frontline turnover and a tight labor market, which has had an impact on productivity and wages. Higher SG&A costs related to our supplemental deferred comp plan also lowered operating margin by 30 basis points in the first half of 2023, but had no impact on EPS. As a result, our updated guidance reflect an adjusted operating margin of approximately 16.5% for the full-year.

With that, I will now turn it back to Jim.

James E. Davis
Chairman and Chief Executive Officer and President at Quest Diagnostics

Thanks, Sam.

To summarize, we had strong base business performance in the second quarter with nearly double-digit revenue growth as our collaborations with health plans, hospitals and physicians enabled us to benefit from strong demand amid a broad return to care. We made substantial progress improving the profitability of our base business compared to the first quarter and prior year. This was slightly offset by persistently high employee turnover, which weighs on productivity and increases cost. And finally, our updated guidance reflects our expectations for revenue growth and improved profitability in the base business.

Now we'd be happy to take your questions. Operator?

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Operator

Thank you. We will now open it up to questions. [Operator Instructions] And our first question comes from Jack Meehan with Nephron Research. You may go-ahead.

Jack Meehan
Analyst at Nephron Research

Thank you, good morning.

James E. Davis
Chairman and Chief Executive Officer and President at Quest Diagnostics

Good morning, Jack.

Sam Samad
Executive Vice President and Chief Financial Officer at Quest Diagnostics

Good morning.

Jack Meehan
Analyst at Nephron Research

Wanted to start and ask about kind of the health plan commentary, is it possible to tease out how much of this growth could be share gain related versus just strong underlying demand. And somewhat related, we have heard more discussion about national payers being more active around Payment Integrity. I was just curious if you're seeing that at all. Could that be a positive for negative for Quest?

James E. Davis
Chairman and Chief Executive Officer and President at Quest Diagnostics

Yeah, hey thanks, Jack. So it's always hard to discern in this industry what is share gain versus demand, return to care and things like that. We don't get perfect data on it. But our sense is, it's sum of both. On the share gain side, we look closely at our growth through each of the commercial payers and when we see gains that are above and beyond, you know, the average and we see the benefits of those programs, those value-based programs that we work with them, which is around leakage, it's around focusing on physicians that are using out-of-network labs, we see the benefits of those programs, and therefore, concluded its share gain. Certainly, there has been some strong return to care.

On the Payment Integrity side, I can tell you that, look, it's a never-ending effort here in Quest Diagnostics to continuously work denials, to make sure that we understand the payer policies, what are the diagnostic posts that support those policies and then work back through our physician base to make sure that the tests that they're ordering are appropriate tests. So we haven't seen any discernible impact with some of those policies you're referring to. But we work collaboratively with the payers to understand them and then work back with our physician base to try to correct any errors.

Jack Meehan
Analyst at Nephron Research

Super. Sam, one question on margins. Sorry if I missed this, what is the guide now assume for margins for the year? Can you just talk about what you're assuming in terms of the pace of productivity improvement?

Sam Samad
Executive Vice President and Chief Financial Officer at Quest Diagnostics

Yeah, thanks, Jack. So we are assuming for the year, operating margins to be at approximately 16.5%. In terms of productivity, you've seen good benefits from our Invigorate program, and we expect those to, if anything, continue for the rest of the year and even accelerate in Q3 and Q4. So we are seeing good momentum on our Invigorate programs. We're seeing the $100 million of SG&A savings that we've talked about. We're seeing those materialize as of the beginning of Q2, and they will continue for the rest of the year as well for a total year impact of $100 million. On the other side, we are also seeing, as you heard in the prepared remarks, a tough labor and turnover and macro environment. So turnover continues to persist to be higher than we expected, and that's driving pressure also on margins. But we are expecting approximately 16.5% for the year in terms of OM.

James E. Davis
Chairman and Chief Executive Officer and President at Quest Diagnostics

Yeah. Jack, I would just add, obviously, you can see the base -- you can see the margin improvement from Q1 to Q2. That comes through pretty clear. You can do the math on the base margin improvements from Q2 of last year to Q2 of this year, when you make the assumptions on the drop down of the COVID revenue, which you've -- you're in the range with the numbers you've used in the past. So we're really pleased with the base margin improvement from Q2 of last year to Q2 of this year, and very pleased with the improvement from Q1 of this year to Q2 of this year.

Operator

Thank you. Our next question is from Elizabeth Anderson with Evercore ISI. You may go ahead.

Elizabeth Anderson
Analyst at Evercore ISI

Hi guys. Good morning, and congrats on a good quarter. My question is, I realized there was a ton of noise this quarter on the deferred comp and how that nets out. How -- could one -- what is your assumption in terms of what's embedded in your guidance for the back half of the year? I appreciate that it can be different based on what happens to the future stock price. But I just want to understand whether it's sort of continuing the forecast of last year's trajectory into this year or 2Q going forward or what have you?

And then secondarily, how do you think about, you mentioned the labor productivity and sort of the still elevated turnover. So how do you think about sort of the cost benefit of analysis of perhaps like investing more in wages or something like that versus the productivity gains that you would -- you could potentially receive from that? Thank you.

Sam Samad
Executive Vice President and Chief Financial Officer at Quest Diagnostics

Okay. Thanks, Liz, and I appreciate the congrats. So let me talk about DCP deferred compensation, and I'll turn to Jim for productivity and some of the trade-offs that you're referring to there. So in terms of DCP, let me just clarify what it is and the impact. So first of all, the expense that we saw, which impacts SG&A is related to the increase in the market value of obligations in our supplemental deferred comp plan. That does not have an impact on EPS because it is offset on the non-operating income line with a benefit. So it's a net neutral on EPS, but it does impact operating margin. Sometimes we don't see it materially impact us. It's related to market movements.

This quarter, it impacted us materially to the tune of 30 basis points impact on operating margin percent. So if you exclude that, it would be our operating margin percent would have been 17%. If you compare it to last year, because last year, and this is where it gets maybe a bit more complicated. But last year, we actually had a benefit in terms of expenses on -- related to deferred compensation plan, market value, the fair market value change. And so compared to last year Q2, it's an impact of 1%. So actually, if you compare Q2 2023 OM versus Q2 2022 OM, we would have been relatively flat in terms of operating margin percent quarter-over-quarter last year even despite the drop in COVID revenues, a significant drop to the tune of approximately $300 million that we saw year-over-year in terms of COVID revenues.

Now as you look towards the rest of the year, Liz, we don't forecast deferred compensation plan. I mean that's not something that we forecast. We assume it's a net neutral impact, both on the P&L, on EPS and on operating margin. So the impact that we saw in the first half, which is roughly about 50 basis points of operating margin or 30 basis points, I should say, is carried through for the rest of the year. And so that 16.5% full year operating margin is impacted by the DCP in the first half. So that's the best way I can characterize it.

James E. Davis
Chairman and Chief Executive Officer and President at Quest Diagnostics

Yeah, and Liz, on the labor front, at Investor Day, we showed a chart that said pre-COVID, our turnover of what we call our frontline roles, which is phlebotomy, logistics, specimen processing, our call centers, was in the 14% range, our total turnover. We showed a chart that said in the fourth quarter, it was upwards of 23%. It's come down modestly in the first part of the year, but still hasn't come down to the levels, obviously, pre-COVID or to where we would like them. Now you're right. It's a trade-off between increasing wage rates and the price -- and the cost you pay for this turnover.

We've estimated that each turnover, each person can cost us upwards of $8,000 to $10,000 depending on the role. And that's simply the lost productivity or the time it takes to get somebody from day one to as efficient in that role as a person who's been in the role for two-plus years. So it's about $8,000 to $10,000 which if you do the math on that, could have upwards of a $20 million impact in the second half of this year.

Now we're at the high end of our wage rate guidance that we gave. We said 3% to 4%. We're certainly at that high end. And if we need to make adjustments, we obviously look at the ROI on that. And we're faced with those decisions. And in certain markets, we will make adjustments to get the turnover to a place that we're comfortable with.

Elizabeth Anderson
Analyst at Evercore ISI

Got it, thanks so much.

James E. Davis
Chairman and Chief Executive Officer and President at Quest Diagnostics

Yeah.

Operator

Thank you. Our next question is from A.J. Rice with Credit Suisse. You may go ahead.

A.J. Rice
Analyst at Credit Suisse Group

Thanks, hi everybody. Maybe just to pivot over and ask you about your Health System business. I think last quarter, you said in aggregate, it was growing about 70% and this quarter, the press release says it's just under 10%. And I suspect with New York-Presbyterian and so forth coming online fully in the back half, it might be even higher than 10%. When you think about your margin targets and what you're shooting for, can you comment on how the growth in that side of the business is impacting margins and the opportunity? And if there's any updated thoughts on the pipeline that you're seeing, maybe give us that as well.

James E. Davis
Chairman and Chief Executive Officer and President at Quest Diagnostics

Yeah. Thanks, A.J. Just on the New York-Presbyterian book of business, when we buy that outreach book of business, it actually is in our physician bucket, not our Health System bucket, because it's physician offices, and we build third-party payers for that. Our Health System business in the quarter was really helped by the PLS side. Our reference book of business was strong as well, but our PLS growth was very, very strong. cited by the three deals that we mentioned in the script with Tower Health, Lee Health and Northern Lights being some of the newer ones. So it was -- that generated substantially more growth in the quarter.

Now as we've always said, PLS has slightly lower operating margins than our normal physician office book of business. But we really like the ROIC on that, okay? So it's got a strong return on capital and that's why we continue to do this. So in terms of the outlook, our funnel of opportunities is strong. We hope to have more closed in the second half of this year on both the PLS side as well as new reference wins. So we're optimistic that the Health System's portion of our business will continue to grow.

Sam Samad
Executive Vice President and Chief Financial Officer at Quest Diagnostics

Yeah. And one additional comment, A.J. So with regards to the expectations in the second half on PLS, as Jim said, we are seeing strong growth in that business. In the second half, from a year-over-year perspective, we had some big wins in the first half of last year as well that ramped up in the second half of last year. So from a year-over-year perspective, we do lap some of those PLS wins and that mutes our revenue growth to some extent. But we're seeing really great momentum on the PLS side of the business.

A.J. Rice
Analyst at Credit Suisse Group

Okay, thanks a lot.

Operator

Thank you. Our next question is from Patrick Donnelly with Citi. You may go ahead.

Patrick Donnelly
Analyst at Smith Barney Citigroup

Sam, again, that 16.5%, is that now the right number to work off in terms of the long-term guide? I know you talked about a few of the moving parts, the unit pricing, maybe looking a little better, labor hitting it. Any of these things onetime that would wear off? And then on that pricing, I know you guys negotiate kind of a quarter of the contracts annually. Can you just talk about the pricing environment at the moment?

Sam Samad
Executive Vice President and Chief Financial Officer at Quest Diagnostics

Yeah. No, it's -- so the 16.5% would be the launching point, if you're thinking about the three-year outlook, Patrick, and the improvement that we guided in the -- in Investor Day, which is the 75 basis point to 150 basis point improvement. That's still the right number to be thinking about longer term off of the 16.5% launching point at the end of this year. In terms of a couple of things that you mentioned, onetime items I think we talked about the DCP, which was more significant in Q2 and for the first half of the year, maybe you can call that onetime. But although it is recurring, but we don't forecast for it. Sometimes it's a benefit. Sometimes it's a negative in terms of an operating margin percent. Last year, in the first half, it was actually a benefit. This year in the first half, it's a negative.

Pricing environment is very good. It's really good. We're seeing good momentum with the health plan value-based contract arrangements that we have. And we expect the pricing environment actually in the second half, where the pricing benefit in the second half to improve versus the first half. Now as we think about '24, we've talked about before that PAMA is still an uncertainty. And so until we have more certainty around whether there's another PAMA delay or a SALSA bill that gets passed, there's still some uncertainty there for '24. Operator, next question.

Operator

Thank you. The next question is from Brian Tanquilut with Jefferies. You may go ahead.

Brian Tanquilut
Analyst at Jefferies Financial Group

Hey, good morning guys and congrats on the quarter. Hey Sam, maybe I'll follow up just on Patrick's question, right? So as I think about your previous comments on 2024 guidance or targets for operating margin, does this push out what you had previously kind of guided to for 2024? And maybe kind of related to that, as I think about the $100 million of corporate savings that you've outlined that began in Q2, I mean is there more to squeeze or is it sort of the target run rate and we're just going to see it flow through the P&L into next year as well? Thanks.

Sam Samad
Executive Vice President and Chief Financial Officer at Quest Diagnostics

Yeah. So with regards to -- thank you, Brian, first of all, for the question. So with regards to '24, we didn't guide '24. We gave some long-term targets around what we expect our operating margin to look like over the next three years as we continue to execute on productivity improvements, Invigorate and apply cost savings into the business, the $100 million that you referred to, which, by the way, next year will be part of our run rate. So we wouldn't expect to see an improvement year-over-year in '24 versus '23 because we're -- except for maybe one quarter. But I would say the 16.5%, as I mentioned to Patrick, becomes the launching point for the future. And we do expect with continued Invigorate offsetting inflation with the cost reductions in the business that we've applied and now will continue, and that are generating the expected improvements, we do expect to drive improvement in our operating margins long term. There is the uncertainty about PAMA, which is what drives the range of either 75 basis points to 150 basis points improvement over the three years.

James E. Davis
Chairman and Chief Executive Officer and President at Quest Diagnostics

Yeah. Then in terms of the cost take out $100 million. Look, we're always looking to be the most efficient we can and obviously, spend every dollar as wisely as we can. But we're also going to continue to invest in this business. We've made strong investments in CIT. And I think as you heard in our script, it's paying off for us. We've got really nice growth out of that. It's now turned profitable. The Alzheimer's test that we've brought to market that requires investment, and we're going to continue to invest in that space.

We're going to continue to invest in molecular genomics and oncology because we're getting growth in that space. And with the Haystack acquisition, we're going to continue to invest there to try to get that test to market as quickly as possible and build a stronger presence. So we're always going to balance the two but we're investing in this business for the future.

Operator

Thank you. The next question is from Pito Chickering with Deutsche Bank. You may go ahead.

Pito Chickering
Analyst at Deutsche Bank Aktiengesellschaft

Hey, good morning and thanks for taking the question. There's been a big debate among both the corporates and investors on the sustainability of the current trends of utilization. Can you sort of talk about what you're seeing in July and sorry if I missed this, but how much of the 2Q organic growth was sort of organic versus the PLS transactions? And how should we think about organic growth continuing in the back half of the year?

James E. Davis
Chairman and Chief Executive Officer and President at Quest Diagnostics

Yeah. So we're optimistic that the growth will continue here. In the second half of the year, July to date has been strong, consistent with what we saw in June. We generally don't break apart our PLS growth from the growth in our core business. We've said externally that our PLS growth is -- our PLS business is about a $600 million franchise. We said the health system market grew at 10%, PLS grew north of that, reference grew less than that. So I think you can get a sense for what that contributes to our total growth. But we're optimistic on the prospects with our health systems. The funnel of PLS opportunities remain strong. Health systems need our help, and we think we've got a great offering that helps meet their needs.

Sam Samad
Executive Vice President and Chief Financial Officer at Quest Diagnostics

And Pito, maybe I can give a couple of additional comments on sort of second half versus first half, which is I think, where you're driving at here. So listen, we've had a great first half, close to 10% revenue growth. But as you think about the second half, there are a couple of things to keep in mind. First of all, we had some easier compare in the first half versus 2022. Obviously, we were in the midst of COVID, base business was impacted by that. So there was some easier compare in the first half that we don't expect to repeat in the second half.

On the prepared remarks, we talked about the COVID flu panel, which is about a 1% negative impact on growth in the second half, definitely compared to the first half. We talked about lapping some PLS wins, which also has a muting effect on our growth in the second half. So when you factor all of these combined, obviously, you can look at our implied growth in the second half based on guidance and it's well lower than the first half, and it's driven by some of these factors that I just gave you. In terms of July, we are still seeing higher than our traditional utilization. So we're still encouraged by what we're seeing in terms of utilization in July. So but we're being appropriately conservative in the second half in terms of what the utilization would look like.

Pito Chickering
Analyst at Deutsche Bank Aktiengesellschaft

Right, thanks so much.

Operator

Thank you. The next question is from Andrea Alfonso with UBS. You may go ahead.

Kevin Caliendo
Analyst at UBS Group

Thanks. It's Kevin Caliendo. So I guess, if I can just bridge all this, if we just take -- go back to the starting point with 17% and then the operating margin then went to 16.8% with Haystack, now it's 16.5%, and we had this sort of onetime issue in the quarter with DCP, which took that down. But you're also calling out some labor trend issues. Maybe is the delta, the expectation around the labor cost and churn? Like is there a way to quantify that? And should we expect that to continue going forward? I'm just trying to bridge all of these things and then think about the impact of '24 and how we get the sort of margin expansion that was originally expected for '24 with these sort of headwinds that are playing out?

James E. Davis
Chairman and Chief Executive Officer and President at Quest Diagnostics

Yeah, Kevin, let me take the labor piece, and then I'll turn it over to Sam here. So on a previous question, we talked about pre-COVID, our attrition rate of our frontline positions was in the 14% range. In December, Q4 it was 23%. The chart we showed at Investor Day in March, it's slightly better than that. We have quantified it. We've said it's about $8,000 to $10,000 per employee. And in the second half of the year, we think it can be upwards of a $20 million impact versus where we would want it to be at this point in the year.

So now, is the labor market easy? Unemployment rate sits at 3.6% right now. The Fed has signaled that they're trying to actually get the unemployment rate back upwards of up to 4.1%, 4.5%. The interest rates are going to take a notch up again today. So we think there's going to be easing in the markets going forward, but it's hard to predict. And so right now, I think we're being appropriately conservative on the guidance in the second half.

Sam Samad
Executive Vice President and Chief Financial Officer at Quest Diagnostics

Yeah and so Kevin, let me give you some commentary around second half versus first half margins, and why you should have confidence in the margin outlook that we gave, the approximately 16.5% for the year. So first of all, and just to remind everybody, in Q2, our margins expanded by 170 basis points sequentially despite an $80 million drop in COVID, roughly $80 million drop in COVID. So we had some great momentum in terms of operating margin.

As we look towards second half versus first half, here are some of the dynamics that you should factor. Our CIT business, which was net dilutive on operating margins in the first half, becomes accretive in the second half. So we expect to see that business -- as we're very encouraged by the momentum and it becomes actually, it's become profitable in Q2, and it's going to be accretive for the second half of the year. Pricing is a net -- also net accretive and will continue to improve in the second half, and it's definitely a step-up from the first half. SG&A, we started to achieve those $100 million annualized savings in Q2. And so we expect to achieve the remainder in Q3 and Q4, we didn't have that benefit in Q1 of this year.

We talked about DCP, and I don't want to focus too much on that, but it was a headwind in the first half, which we don't expect in the second half. Offsetting that is the fact that we have some lower COVID revenues in the second half because right now per our guidance, we're expecting approximately $40 million in the second half, which is definitely well south of the $160 million that we achieved in the first. So but as you look at this momentum of all of these things, plus the ramp-up of Invigorate improvements that we expect to see in the second half, and yes, there is some Haystack dilution, which is to the tune of about $0.15 to $0.20 for the year. But as you look at all of these factors, we are very confident about the ability to achieve the outlook that we gave in terms of operating margins.

James E. Davis
Chairman and Chief Executive Officer and President at Quest Diagnostics

Kevin, the last thing I'd add is when you think about price in this business, we tend to always think about commercial payers, Medicare and Medicaid. You have to remember that there's another $2.5 billion on an annual basis where we price directly to Health Systems, to physicians. And then we have $800 million worth of other businesses between employer solutions, our drug testing business, our wellness business, and our ExamOne business, which serves life insurance companies. So we are getting price in those segments of our business. And as Sam indicated, our price performance will be better in the second half than it was in the first half primarily from the lift we're getting on that side of our portfolio.

Kevin Caliendo
Analyst at UBS Group

Super helpful guys. Thank you so much.

James E. Davis
Chairman and Chief Executive Officer and President at Quest Diagnostics

You're welcome.

Operator

Thank you. And our next question is from Lisa Gill with JPMorgan. You may go ahead.

Lisa Gill
Analyst at JPMorgan Chase & Co.

Great, thanks very much. Good morning. I just want to go back to your earlier comments around value-based care where you talked about leakage out-of-network opportunities. But can you maybe just talk about how you see this over time and how you see the evolution of value-based care as it pertains to lab. Is this a margin-enhancing opportunity or just more of a volume opportunity? One, how do I think about that? And then just secondly, I've heard you talk about the pipeline of Health Systems. Is there any way to size what that current pipeline looks like?

James E. Davis
Chairman and Chief Executive Officer and President at Quest Diagnostics

Yeah. So on the first question, I just want to make sure we're not confusing terminology here, value-based care and value-based incentives. So when we talk about value-based care, these are generally arrangements where Medicare has put lives directly into these ACO REACH programs for Medicare Advantage plans, delegate lives into large integrated physician groups. Now in both of those situations, we are contracting directly with these ACO REACH organizations and directly with these large physician groups. And we believe that those value-based care programs that Medicare and Medicare Advantage are driving are very good for the lab business because generally, they delegate lives at a fixed price, and in fact, labs become much more useful in terms of helping physicians ensure that diseases and conditions do not progress. So we feel good about that.

I think what we're generally -- when we talk about the health plans and we talk about these things called value-based incentives. So these are programs that we structure with the health plans to help them reduce leakage to out-of-network labs and to help us redirect requisitions that are flowing into more expensive health system laboratories and have those requisitions flow directly into Quest Diagnostics. So when we are successful in those efforts, there can be value-based incentives that we earn when we help them earn the -- when we achieve those targets of reducing leakage and moving work from higher-priced hospital labs into independent labs like Quest Diagnostics. So we seek to do more of both of those programs, value-based care programs with ACO REACH and these value-based incentive programs with our large payers.

Sam Samad
Executive Vice President and Chief Financial Officer at Quest Diagnostics

Operator? Yeah.

Operator

Thank you. And our last question is from Eric Coldwell with Baird. You may go ahead.

Eric Coldwell
Analyst at Robert W. Baird

Thanks, good morning. I have two. First one, a bit higher level, more strategic. So United Healthcare Preferred Lab Network was updated in July. I saw that they removed Mayo, but were there any other notable changes in that contract or your relationship there? And then broadly on that same topic, what's the outlook for other MCO opportunities to narrow networks or move the national labs like you and LabCorp into, say, more preferred roles? Are there opportunities being discussed in the market today?

James E. Davis
Chairman and Chief Executive Officer and President at Quest Diagnostics

Yeah. So on the first part of your question, we did not note any other notable changes with respect to the preferred lab network. We still remain part of that preferred plan network, and that's our plan going forward. In terms of narrowing networks, when we speak to all our commercial payers, we always think it's better, from their perspective, to have both independent labs in network that actually improves their ability to make sure that requisitions are going to lower cost, lower price environments, which is good for the payer. It's good for the employer, and it's good for the patient. And so we don't see any change in that trend to narrow networks that restrict access to independent laboratories.

Now having said that, there's laboratories that play on the fringe that could be expensive single-type test environments. And I think the payers are always looking at specialty labs versus independent labs that can do some of that specialty work as well.

Eric Coldwell
Analyst at Robert W. Baird

Okay. My other question, and I apologize if I think you got close to answering this a few times, and I've been toggling a couple of events this morning. But did you quantify or could you quantify the reduction in investment spending seen year-over-year in the second quarter and also the portion of the incremental $100 million plus cost action that you actually captured in 2Q, so we have a sense on what's left for the rest of the year.

Sam Samad
Executive Vice President and Chief Financial Officer at Quest Diagnostics

Yeah. Sure, Eric. So no, we didn't quantify the reduction in investment spend. We did have lower investment spend in Q2 versus Q2 of last year, but we haven't quantified how much it is. With regards to the SG&A benefits and the $100 million, I think the assumption that you can make is it's about one-third of that $100 million that was realized in Q2 and we expect the same to occur in Q3 and Q4.

James E. Davis
Chairman and Chief Executive Officer and President at Quest Diagnostics

Yeah. I just want to remind, we're going to continue to invest for growth in this business. As we mentioned, again in the script, we've invested in CIT, and we're really starting to see the fruits of that investment. We look at a metric called return on ad spend, it's now positive. So we're going to continue to invest there because we believe it's driving growth, and it's now driving profitable growth.

We talked about our Alzheimer's portfolio of tests. We're going to continue to invest in that area. These blood-based tests, we have the AB42, 40 test up and running. We have the ApoE test up and running. These are blood-based tests. These are going to be more useful than CSF or PET scans and less costly to the environment. We're going to continue to invest in the molecular side of our business. We're going to continue to invest in the oncology business. And that's going to -- all of these things are going to position us for the higher growth segments of the laboratory industry and ensure our long-term outlook.

Eric Coldwell
Analyst at Robert W. Baird

Thank you very much guys.

James E. Davis
Chairman and Chief Executive Officer and President at Quest Diagnostics

Yeah, you are welcome.

Operator

We did have one more question come in. Our last question is from Derik De Bruin with Bank of America. You may go ahead.

John Kim
Analyst at Bank of America

Hi, good morning. This is John on for Derik. We talked about this quite a bit, but talked about the focus of the M&A pipeline will be on the deals you've traditionally done before. And it seems you certainly have plenty to come in the coming quarters and you have lots of balance. And of course, you're investing in Alzheimer's portfolio and whatnot. But as you look to launch your first MRD product in 2024, could you talk about potential deals or products that you can -- you see would complement your current oncology portfolio that you don't have in your current internal pipeline?

James E. Davis
Chairman and Chief Executive Officer and President at Quest Diagnostics

Well, we think with the combination of Haystack, which, as you noted, is centered on minimally residual disease testing post cancer diagnosis, and we brought up our own internal assay for therapy selection. So from a therapy monitoring and therapy selection standpoint, we believe we're very well positioned for future growth. We continue to invest on the genetics side of our business, hereditary genetics, genetic offerings for diagnostic purposes and then the family planning and prenatal genetics is also an area that continues to receive focus. So we believe we're well positioned on the cancer side. We continue to make some investments on the genetic side and that's where the -- we think we're well positioned. Now again, our focus right now, we'll continue to focus on hospital outreach deals and other small tuck-ins that are accretive to our business.

John Kim
Analyst at Bank of America

Thank you.

James E. Davis
Chairman and Chief Executive Officer and President at Quest Diagnostics

Operator?

Operator

Thank you. And that was our last question.

James E. Davis
Chairman and Chief Executive Officer and President at Quest Diagnostics

All right. Well, thank you, everyone. We -- again, I believe we had a strong quarter here. The outlook for the second half. We've taken up our revenue guidance, feel good about that, and thank you for supporting Quest Diagnostics. Have a great day.

Operator

[Operator Closing Remarks]

A replay of the call may be accessed online at www.questdiagnostics.com/investor or by phone at 203-369-3035 for international callers, or 888-566-0058 for domestic callers. Telephone replays will be available from approximately 10:30 a.m. Eastern Time on July 26, 2023, until midnight Eastern Time, August 9, 2023. Goodbye.

Corporate Executives
  • Shawn Bevec
    Vice President of Investor Relations
  • James E. Davis
    Chairman and Chief Executive Officer and President
  • Sam Samad
    Executive Vice President and Chief Financial Officer
Analysts

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