September 27, 2017 / 3:37 PM / 3 years ago

Fitch Affirms Quest Diagnostics at 'BBB'; Outlook Stable

(The following statement was released by the rating agency) NEW YORK, September 27 (Fitch) Fitch Ratings has affirmed the ratings of Quest Diagnostics Incorporated (NYSE: DGX) including the Issuer Default Rating (IDR) at 'BBB'. The Rating Outlook is Stable. A full list of ratings can be found at the end of the release. KEY RATING DRIVERS Leading Market Position: Quest is the largest independent player as measured by segment revenues in the relatively fragmented and highly competitive U.S. clinical laboratory market. Such scale affords the opportunity for comparatively efficient operations and supplies sourcing and the ability to drive associated margin improvement following M&A. These advantages should allow DGX to improve its relative cost position which is a competitive advantage given the prominence that pricing plays in customer decisions. Continued Improvements in Operating Performance: Quest's focus on operational improvement has helped to drive margin improvement that has been accompanied by positive organic growth in each fiscal quarter since fourth-quarter 2014. Fitch expects low single-digit organic growth through the rating horizon, benefitting from moderating pricing pressure other than the implementation of the Protecting Access to Medicare Act (PAMA), cost efficiencies, and favorable business mix driven by strong growth in Quest's gene-based and esoteric testing business. Fitch view's Quest's partnerships with Safeway (Not Rated) and Wal-Mart Stores (AA/Stable) favorably as they are low-capex expansions of Quest's market reach and, if successful, may result in lower lease-adjusted leverage in the long-run. PAMA Uncertainty Lingers: The Centers for Medicare and Medicaid Services (CMS) has moved forward with potential revisions to reimbursement schedules for clinical labs provided under Medicare as a result of PAMA. CMS announced initial rates on Friday, Sept. 22 and is accepting comment letters through late October. In our ratings case forecast, Fitch has assumed that the approximately 10%-15% of revenues that DGX derives from Medicare will be negatively affected by the maximum 10% price reduction per year. The rate cuts come in spite of the industry's objections that other higher cost laboratories were excluded from the database and did not fairly represent costs and their arguments could result in another delay. Fitch has assumed that if PAMA is implemented as currently contemplated, DGX would adjust capital deployment to maintain its current leverage profile. Over the long term, PAMA could place greater pressure on smaller, independent laboratories than on DGX and allow for increased contract wins or acquisition opportunities. Stable Leverage: Fitch expects leverage (gross debt/EBITDA) will sustain around 2.5x which is consistent with what Fitch believes to be management's long-term target. Fitch does not expect the company to prioritize debt repayment in the current low interest rate environment, so any near-term de-levering will likely result from EBITDA gains. Fitch expects capital deployment will focus on driving growth through acquisitions (management is targeting 1%-2% of revenue growth per year from acquisitions) and returning cash to shareholders through dividends and share buybacks. DERIVATION SUMMARY Quest Diagnostic's 'BBB' rating reflects the issuer's leading position and scale in the competitive U.S. clinical laboratory industry. Quest's reach and scale provide meaningful competitive advantages on fixed costs and supply sourcing, which helps to maintain or grow margins amid pricing headwinds. Strong cash conversion of operating EBITDA enables the issuer to maintain leverage around 2.5x despite allocating most free cash flow towards acquisitions, dividends and share repurchases. Within the clinical laboratory industry, Fitch views Quest's position as competitive with LabCorp. (Not Rated) and stronger than that of the smaller more regionally focused private laboratories. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: -Revenues: Organic top-line growth to approximate 0%-1% per year through volume and mix tailwinds offset by continued pricing pressures including PAMA. Fitch has assumed DGX will generate an additional 1%-2% through acquisitions. -Margins: Fitch has assumed limited margin expansion through the rating horizon but recognizes additional improvements through the issuer's Invigorate program could provide upside to the forecast. -Cash Flows and Capital Deployment: Fitch has assumed approximately $250 million per year of acquisitions to achieve the aforementioned growth along with dividends and share buybacks of approximately $525 million to $625 million per year. -Credit Metrics: The aforementioned assumptions should lead to leverage sustaining around 2.5x through the rating horizon. RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Positive Rating Action -Positive rating actions are not likely in the near term, as Fitch expects Quest will maintain gross leverage at or near 2.5x for the foreseeable future. -Over the longer term, an upgrade to 'BBB+' could be considered if the company committed to maintaining gross debt/EBITDA at 2.2x or below, accompanied by an outlook for positive organic growth and margin expansion. Organic growth may be challenged by a persistently constrained reimbursement environment, making meaningful EBITDA growth dependent on cost savings and/or M&A funded with discretionary cash flows. Future Developments That May, Individually or Collectively, Lead to Negative Rating Action -A negative rating action could result from a reversion to negative growth and margin trends coupled with an inability to drive cost savings under the expanded Invigorate program. -Ongoing EBITDA declines and/or debt-funded transactions contributing to gross debt\ EBITDA sustained around 2.7x or above could drive a downgrade to 'BBB-'. -Operating cash flow trending below $500 million without an adjustment to the firm's dividend or capital spending could also pressure the ratings. LIQUIDITY No Near-Term Maturities & Ample Sources: Quest's next bond maturity is the $300 million due April 2019. Quest has access to an undrawn $750 million revolver due April 2019, $529 million of availability under the $600 million A/R securitization facility due October 2017, and had cash on hand of $314 million at June 30, 2017 (21% considered permanently reinvested outside the U.S.). Fitch classifies only the amount held overseas as not readily available. Quest's liquidity also benefits from the forecasted $1 billion per year of cash flow from operations. FULL LIST OF RATING ACTIONS Fitch has affirmed the ratings as follows: Quest Diagnostics, Inc. --Long-Term IDR at 'BBB'; --Senior unsecured revolving credit facility at 'BBB'; --Senior unsecured notes at 'BBB'. The Rating Outlook is Stable. Contact: Primary Analyst Britton Costa, CFA Senior Director +1-212-908-0524 Fitch Ratings, Inc. 33 Whitehall Street New York, NY 10004 Secondary Analyst Benjamin Immordino, CFA Associate Director +1-212-908-9163 Committee Chairperson Michael Weaver Managing Director +1-312-368-3156 Summary of Financial Statement Adjustments - Financial statement adjustments that depart materially from those contained in the published financial statements of the relevant rated entity or obligor are disclosed below: --Fitch has capitalized operating leases at 8x when referencing lease-adjusted leverage metrics; --Fitch classifies cash held overseas as not readily available; --Fitch added back stock-based compensation, restructuring expenses and other non-recurring and/or non-cash items to EBITDA; --Fitch has netted provision for doubtful accounts and changes in accounts receivable when calculating FFO and working capital. 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