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Quest Diagnostics (DGX - Analyst Report) is scheduled to release its fourth quarter and fiscal 2011 results on Tuesday, January 24, 2012, before the market opens.The company is expected to earn $1.06 during the quarter on revenues of $1,858 million. For fiscal 2011, earnings are expected to be $4.29 on $7,488 million in revenues, according to the Zacks Consensus Estimate.

Third Quarter Highlights

Quest Diagnostics reported adjusted EPS of $1.13 during the third quarter of fiscal 2011, surpassing the Zacks Consensus Estimate of $1.11 and the adjusted EPS of $1.05 in the year-ago quarter. Adjusted EPS takes into account 10 cents of charges related to restructuring and benefit of 5 cents (8 cents in the third quarter of fiscal 2010) associated with a favorable resolution of tax contingencies. An 8.8% decline in the number of outstanding shares also favorably impacted the quarterly earnings.

Revenues for the quarter increased 2.2% year over year to $1.9 billion, in line with the Zacks Consensus Estimate. The two recent acquisitions of Athena Diagnostics and Celera Corporation contributed 3% to the revenue growth. Clinical testing revenues inched up 1% during the quarter with clinical testing volume (measured by the number of requisitions) declining 1.2%. Revenue per requisition, however, increased 2.1%.

Quest Diagnostics increased the low end of its fiscal 2011 adjusted EPS expectation by 5 cents to $4.30–$4.35. However, the company expects a modest 1.5% growth in revenues (unchanged) in fiscal 2011. Moreover, adjusted operating margin is expected to be around 17.5% (unchanged) with $900 million in cash from operations (after considering the MediCal settlement). In addition, the company lowered its capital expenditure guidance by $10 million to $190 million.

Agreement of Analysts

Estimate revision trends for the fourth quarter depict a mixed sentiment among the analysts. Out of the 20 analysts covering the stock for the upcoming quarter, one analyst has reduced the estimate over the past 30 days with one moving in the opposite direction. Changes were insignificant for fiscal 2011.

Lower volumes for two successive quarters were disappointing. Quest Diagnostics has witnessed a softness in physician office visits that led to reduced volume.

Given the current economic uncertainty, volume is expected to remain under pressure. Additionally, the cost reduction initiatives reflect the company’s apprehension about not being able to improve its volume growth in the near future.

Moreover, revenues derived from anatomic pathology have been under pressure for the past few quarters due to in-sourcing of the tests by physicians. This continues to be a major issue as the company derived 14% of its total revenue from anatomic pathology during fiscal 2010. We also await an update on the company’s restructuring program.

However, the news of the formation of a search committee for the replacement of the company’s President, Chairman and CEO Surya N. Mohapatra came as a positive step amidst several recent headwinds. The management change endeavor is expected to turnaround the company’s fortunes in the upcoming quarters.

Magnitude of Estimate Revisions

The magnitude of estimate revisions has been insignificant over the past 7 as well as 30 days. Overall, estimates for the fourth quarter have remained unchanged at the current level of $1.06 in the last 7 and 30 days. For fiscal 2011, estimates remained at the current level of $4.29 per share over the past 7 as well as 30 days.

Surprise

Barring the second quarter of fiscal 2011, Quest Diagnostics has exceeded estimates in the past four quarters. The four-quarter average of 5.00% implies that on an average, Quest Diagnostics has exceeded the Zacks Consensus Estimate by the same magnitude over the last four quarters.

Recommendation

We appreciate Quest Diagnostics’ strategy of repurchasing shares and paying dividends to drive shareholder value. We are also encouraged by Quest Diagnostics’ focus on latent areas such as gene-based, esoteric testing that are currently witnessing higher demand compared to routine tests. In order to bolster this specialized side of the business, Quest Diagnostics has been pursuing accretive acquisitions. The acquisitions of Athena and Celera are expected to strengthen the company’s foothold in gene-based and esoteric testing.

However, the company continues to witness challenges with testing volume. Moreover, the competitive landscape remains tough with the presence of Laboratory Corporation of America Holdings (LH - Analyst Report). LabCorp is also targeting the esoteric testing space and has acquired Genzyme Genetics to meet its objective.

We currently have a Neutral recommendation on Quest Diagnostics, in line with Lab Corp. Both the stocks retain short-term Zacks #3 Ranks (Hold).

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