How much are you paying for the revenue of companies in your portfolio? The less you pay per dollar of revenue, the better. Why? Because revenue translates into earning power, and as we know, when earnings grow, they pull up stock prices. As with almost any asset, buying for less is best if it's an investment of some kind.
Take the case of Quest Diagnostics Incorporated (DGX, Financial), which I found on the Historical Low Price/Sales Ratios screener at GuruFocus.
Quest has ground down its Price to Sales ratio over the last 10 fiscal years, from 2.01 to 1.14. More recently, the ratio has crept up to 1.30, but that still leaves it with a better P/S (Price to Share ratio) than 88% of the almost 200 other companies in the Global Diagnostics & Research industry (unless otherwise noted, all P/S information comes from the P/S Ratio page at GuruFocus).
Market observers consider revenue a better metric for company growth and strength than earnings, since earnings are more susceptible to manipulation. In this article, we’ll check out earnings and other aspects of Quest Diagnostics, to determine whether or not the rest of the company’s key metrics keep up with the P/S improvement.
About Quest Diagnostics Incorporated
History
- 1967: Founded as Metropolitan Pathology Laboratory, Inc., in New York, by Paul A. Brown, MD
- 1982: Acquired by a company then known as Corning Glass Works
- 1997: Spun out from Corning as an independent company to be known as Quest Diagnostics (between 1967 and 1997 it was also known as MetPath, Inc. and Corning Clinical Laboratories)
- 1997: Begins a series of acquisitions, buying Diagnostic Medical Laboratory, Inc. (DML)
- 2000: Launches Six Sigma, a process improvement initiative
- 2008: First listed on Fortune Magazine’s "World’s Most Admired Companies"; makes multiple appearances since then
- 2009: pays a then record $302 million to the government to settle a Medicare fraud case
- 2012: Former Philips Healthcare CEO Stephen Rusckowski becomes CEO of Quest
- 2012: Introduced a five-point business strategy, which includes: restoring growth, driving operational excellence, simplifying the organization to enable growth and productivity, refocusing on diagnostic information services, and delivering disciplined capital deployment and strategically aligned accretive acquisitions (information from the 10-K report for 2013; previous historical information from the Quest Diagnostics page at Wikipedia.org).
Takeaways: More than 40 years of operations, has grown rapidly, both organically and through acquisitions. It began a renewal campaign in 2012 with the appointment of an outside CEO and its new business strategy.
Operations
Based in Madison, New Jersey, Quest operates in the United States and several other countries; however, international operations contributed only 2% of net revenue in 2013. Other facts:
- Serves about 30% of American adults each year
- Serves about half of the physicians and hospitals in the U.S.
- 41,000 employees
- More than 2,200 patient service centers
- Calls itself "... the world's leading provider of diagnostic information services that patients and doctors need to make better healthcare decisions."
The company segments itself into Diagnostic Information Services (DIS) and Diagnostic Solutions (DS). Of the two, DIS represents some 90% of revenue, as the following excerpt from its 2013 10-K shows:
The company describes operations in the segments this way in its 10K, " Our Diagnostic Information Services business, comprised of two parts, develops and delivers diagnostic testing, information and services to patients, physicians, health plans, hospitals, IDNs, employers and others. The value creation side of the business, organized by clinical franchise, focuses on customer solutions for the marketplace, including new test development and upstream marketing. The value delivery side includes sales and downstream marketing, routine and esoteric laboratory operations, field operations, logistics and client services. Diagnostic Solutions includes our other businesses, including central laboratory testing for pharmaceutical and medical device clinical trials, life insurer services, diagnostic products and healthcare information technology."
Competition
The company reports its industry is "fragmented and highly competitive" and that it competes mainly with "... three types of clinical testing providers: commercial clinical laboratories, hospital-affiliated laboratories and physician-office laboratories."
Public company
- Trades on the New York Stock Exchange (NYSE: DGX)
- Ranks as a component of the Standard & Poor's 500
Takeaways: Has captured a significant piece of the American market, perhaps enough to constitute a moat. And although it refers to itself as the "world’s leading," it has not meaningfully expanded beyond the U.S.A.
Growth plans
As the first objective of its 2012 strategic plan, the company lists "Restore Growth." Tactically, that means:
- sales and marketing excellence;
- grow esoteric testing through a disease focus;
- provide professional lab services to hospitals and IDNs
- succeed internationally;
- create value from information assets;
- lead in companion diagnostics; and
- extend in adjacent markets.
The first three approaches are considered short-term, and the latter four long-term.
In its 10-K for 2013 and its second quarter 2014 (the most recent) report, the company said it was making progress on these goals.
Takeaways: It will take several years to know if the strategy will fully take, but the company does have a well articulated plan to grow.
Management
President & CEO Steve Rusckowski, age 56, joined the company in 2012, after serving as CEO of Philips Healthcare and in several management positions with the healthcare division of Hewlett-Packard/Agilent Technologies
Senior Vice President and Chief Medical Officer Jon R. Cohen, M.D., age 59, joined Quest in 2009; prior to that he served as a policy advisor to New York’s governor, as a consultant at Price WaterhouseCoopers, and for 21 years at the North Shore-Long Island Jewish Health System (including six years as chief medical officer)
Senior Vice President and Chief Financial Officer Mark J. Guinan, age 52, joined the company in 2013. For the previous three years he served as CFO at Hill-Rom Holdings Inc., before that he held several management positions in finance and operations at Johnson & Johnson (management information from the 10-K for 2013).
In 2012, the company appointed an independent, non-executive Chairman Dan C. Stanzione, Ph.D., who retired from Lucent Technologies in 2000. He has been a director of Quest Diagnostics since 1997.
The ten-member board, including Mr. Rusckowski, has experience in surgery and medicine, corporate finance and senior management in health care, technology, corporate and government entities (board information from the company website).
Quest receives a rating of 3 in the ISS Governance QuickScore; in these assessments, a rating of 1 is excellent and a rating of 10 is very poor, meaning Quest scores well. The company receives a red flag for Pay for Performance and a green pat on the back for Equity Risk Mitigation.
Takeaways: the company seems well positioned for the future; normally the short tenure of the CEO and CFO might be of concern, but since it is also on a new strategic path, we might view this as a positive.
Ownership
19 different gurus followed by GuruFocus own shares of DGX; the biggest holding belongs to Chris Davis (Trades, Portfolio) with 4,672,681 shares
Institutions: 96% of DGX shares belong to institutional investors; according to data at Yahoo! Finance, the biggest holder is the Vanguard Group, Inc. with 10.4 million shares
Shorts: a relatively high proportion at over 14%; the following GuruFocus.com chart shows how that interest has grown since 2010:
Insiders: own a modest 1% of the company; Yahoo! Finance shows Robert Hageman, Quest’s former CFO, holding 127,000 and current CEO Rusckowski holding the second-largest position, 110,000 shares.
Takeaways: For potential investors, ownership sends a mixed message: many gurus have indicated their faith in the company, many shorts obviously believe the price will head the other way. Given that institutions own 96% of the shares, and 14% are short (for a total of 110%), we will presume some institutions are shorting or loaning out their shares to shorts.
DGX by the Numbers
Financial strength
Here’s how GuruFocus summarizes key financial measures for Quest Diagnostics:
Its current cash to debt ratio is .02, down from previous levels, but still in an acceptable range.
The company notes, in its 10-K for 2013 that it aims for debt/EBITDA ratio in the range of 2 - 2¼ times. In the 10-year financials we see EBITDA was $177.6 million at the end of the first quarter of 2014, while long-term debt was $505.5 million; that’s a ratio of 2.85.
Its current ratio is 1.20, which is toward the lower end of its 10-year historical range; that's also in line with its competitors.
GuruFocus issues two Good Signs for Quest; one because it has "shown predictable revenue and earnings growth" and another because its operating margin is expanding.
Management appears confident about the financial situation: First, the board nearly doubled the dividend in two years, from $0.17 in September 2012 to $0.33 in October 2014. Second, in 2013 it implemented two Accelerated Share Repurchase programs; these allowed it to repurchase treasury stock and to buy back stock more quickly.
Takeaways: Quest shows financial strength, both through its ratios and through increased returns to shareholders. This suggests the new strategy of 2012 is being observed with actions as well as words.
Valuations
As we noted in the introduction to this article, DGX shows up in the Historical Low Price/Sales Ratios screener. At the same time, GuruFocus warns us the ratio (1.30) is near a three year high (1.39). However, a look at the following chart shows the company brought down the ratio significantly, and has kept it within a lower range for several years (the green line shows the stock price and the blue line shows the P/S ratio):
Assessing the company using the Median P/S gives us a valuation of $67.27. That’s based on multiplying the Revenue per Share ($48.90 as of the last reporting quarter) by the 10-year median P/S ratio (1.39). That puts the September 23 closing price 8.6% below the Median P/S value.
Also as noted, this puts it near the head of the pack when compared to other companies in the Global Diagnostics & Research industry.
The following table shows several valuations generated by GuruFocus, based on the price at the close of trading on September 22, 2014:
Quest earns a 4-Star predictability rating; this puts it in the upper echelon among all the companies followed by GuruFocus. Backtesting found 4-Star companies gain an average of 9.8% per year if held for 10 years, and only 8% of 4-Star stocks are in a losing position if held for 10 years.
Takeaways: DGX came to our attention because it appeared in a screen of stocks trading at an historical low P/S. As we saw, the current price falls below the Median P/S, but this is more of a low-end-of-the-range stock rather than a value stock. The current price represents a modest discount on a stock with quite predictable earnings, and price will likely continue to grow with the earnings.
Opportunities & rIsks
I’ve suggested that this stock currently trades at a modest discount with growing, relatively predictable earnings and may even have a protective moat. Can it continue to grow its revenue and earnings and keep pulling up the price of the stock? Overall, the answer would seem to be "yes," but we would have to recognize at least a few caveats:
Health care in the U.S. has undergone a sea change in the past few years, thanks to the Affordable Care Act (ACA), if nothing else. Such changes, both current and future, could impair Quest’s ability to compete and/or maintain its growth.
In its 10-K report for 2013, the company expected the Affordable Care Act would have a neutral to slightly positive impact in 2014, and then a "bigger benefit over the long run."
Everyone wants to keep costs down, particularly health care plans. If Quest is unable to meet those demands while other providers do, it could lose substantial amounts of income.
The company depends heavily on technology and IT systems to manage and protect highly sensitive patient information. As we’ve seen recently (Target [TGT] and Home Depot [HD]), attacks on IT systems can do serious damage to the reputation and profitability of companies.
Innovation, including new product development, plays a large and critical role in health care. Failure to keep up, or to acquire disruptive technologies ahead of other companies could cost Quest significant portions of its market share
Regulation of health care technology and products has grown exponentially, making compliance increasingly difficult and costly. Missteps could also have high reputational costs.
In terms of opportunities, the American population is growing and aging. And, with age comes more frequent and more serious health issues, and that in turn leads to more health care usage, and more clinical testing. That’s offset to some extent by generally healthier aging through improved diet and lifestyles.
For more on these and other issues, see the Quest Diagnostics 10-K Report for 2013.
Takeaways: While there are many serious risks that could derail Quest at any time, its competitors and new entrants to the industry face them as well. And, while wide market share increases exposures, it also provides a broader base over which to spread the costs of protection and compliance. That market heft also should provide more means with which to exploit new opportunities.
Conclusions
Quest Diagnostics Incorporated should suit investors looking for a solid, growing company with S&P 500 credentials.
In its favor, it’s currently trading at the low end of its P/S range, it enjoys a 4-Star predictability rating, and both P/Es sit below 15 (forward P/E is just below at 14.28, while trailing P/E is 11.41).
It pays a dividend of 2.2% and that will likely increase regularly in coming years, as part of the company’s plan to take care of shareholders. In addition, the company has a strong history of buying back shares, which also benefits shareholders, albeit less directly.
Given the high tech essence of modern medicine, the many regulatory tripwires, and potential competition there are potential pitfalls. However, Quest should be able to withstand them in the foreseeable future.
