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Quest Diagnostics’ (DGX - Analyst Report) third-quarter 2013 adjusted earnings per share (EPS) of $1.02 lagged the Zacks Consensus Estimate by 2 cents and the year-ago earnings by 11.3%. The adjusted EPS in the reported quarter excludes certain one-time charges related to loss on sale of the Enterix business (17 centsper share ) and restructuring and integration (16 cents), as well as gain on sale of Ibrutinib royalty rights ($1.97 per share).

Reported EPS was $2.66, reflecting a 171.4% surge year over year. The year-ago quarter had incurred a cost of 17 cents per share related to restructuring and integration.

Revenues from continuing operations for the second quarter of 2013 were down 1.9% year over year to $1.79 billion, missing the Zacks Consensus Estimate of $1.81 billion. However, volume (measured by the number of requisitions) increased 2.0% year over year as recent acquisitions by the company added 3% to the volume.

Revenues per requisition were down 4.3% primarily due to reduced reimbursement (3.3% of the reduction). Moreover, the business mix impact of Quest Diagnostics’ recent toxicology acquisition contributed to the rest of the decline in revenues per requisition.

We believe that the overall soft industry trends leading to low volume growth were a dampener for the company. In addition, lower healthcare utilization and reimbursement cut acted as other major dampeners. We expect this challenging scenario to adversely affect Quest Diagnostics’ peer Laboratory Corporation of America Holdings (LH - Analyst Report) as well, which is scheduled to release its third-quarter 2013 results on Oct 18.

Among operating costs, cost of services during the reported quarter stood at $1.09 billion, up 0.69% year over year. Selling, general and administrative (SG&A) expenses edged up 1.5% to $423 million. Other operating expenses were $40 million, compared to $0.70 million in the year-ago quarter. However, adjusted operating margin in the quarter contracted 456 basis points (bps) to 13.2% on adjusted operating income of $235.6 million.

Quest Diagnostics exited the third quarter of 2013 with $158.3 million in cash and cash equivalents, down from $295.6 million at the end of fiscal 2012. Cash provided by operating activities for the quarter was $186 million compared with $395 million in the year-ago quarter. The company is focused on enhancing shareholder value and improving return on capital.

During the reported quarter, Quest Diagnostics increased its share repurchase authorization by $1 billion and executed its second accelerated share repurchase agreement, bringing the year-to-date repurchases to $1 billion.

Outlook

Quest Diagnostics provided an updated fiscal 2013 outlook. Currently, revenues are expected to be down 3.5% from the prior-year quarter as compared to the earlier projection of 1% to 2% below the year-ago revenues. The current Zacks Consensus Estimate of $5.25 billion remains above the guided range.

EPS is expected to remain in the range of $3.85−$3.95, down from the earlier band of $4.35−$4.50. The Zacks Consensus Estimate of $4.23 remains way above the range. Cash provided by operations outlook was also reduced to $850 million from earlier $1.0 billion. However, the company did not alter its estimate for capital expenditure ($250 million).

Recent Activities

As a part of its strategy to align assets in the core diagnostics information service business, earlier this month, Quest Diagnostics acquired ConVerge Diagnostic Services, a full-service laboratory providing clinical, cytology and anatomic pathology testing services. The ConVerge buyout, as the fourth laboratory acquisition by Quest Diagnostics in the current year, is consistent with the company’s five-pronged strategy which includes plan for disciplined capital deployment.

Under the same strategy, last month it sold Enterix colorectal cancer screening test business to Clinical Genomics Technologies Pty Ltd. Last quarter, the company sold the rights to royalties from commercialization of the drug candidate ibrutinib to Royalty Pharma for $485 million in cash.

Further, in June, the company completed the acquisition of lab-related clinical outreach service operations of California-based Dignity Health and Concentra's toxicology business. Quest Diagnostics believes that these takeovers remain consistent with its strategy of delivering 1% to 2% growth from acquisitions.

Recommendation

We remain cautious about Quest Diagnostics as it is continuously witnessing challenges with testing volume and reimbursement cut. Concerns also linger about the soft industry trends due to a decline in physician office visits, flat pricing and low organic revenues. Moreover, a disappointing fiscal 2013 revenue guidance reflects no improvement in the industry trend going forward, which adds to our concerns.

However, we are optimistic regarding the company’s strategy to refocus on Diagnostic Information Services along with the organizational structure developed by the company’s CEO, Steve Rusckowski. We also expect this to add synergies to its ongoing $500 million restructuring initiative associated with its Invigorate program. The stock retains a Zacks Rank #4 (Sell).

Other Stocks to Consider

Some better-performing medical stocks include Cardinal Health, Inc. (CAH - Analyst Report) and ResMed Inc. (RMD - Analyst Report). Both the stocks carry a Zacks Rank #1 (Strong Buy).

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