Fitch Ratings has affirmed Quest Diagnostics, Inc.'s (Quest or DGX) Long-Term Issuer Default Rating (IDR), senior unsecured revolving facility and senior unsecured notes at 'BBB'.

The Rating Outlook remains Positive.

The ratings and Outlook are supported by the largely inelastic demand for clinical testing, DGX's strong market position, and Fitch's expectation that leverage can remain at or below 2.5x on a gross basis as a result of moderating pricing pressures and continued delivery of operational excellence while continuing to engage in M&A and shareholder returns.

The affirmation further considers potential uncertainties associated with impending regulations such as Protecting Access to Medicare Act (PAMA) cuts and the FDA's proposed rule on laboratory developed tests (LDTs), EBITDA leverage being and expected to be higher than Fitch's previous expectation, as well as the higher utilization of credit facilities in 2023 compared to the past four years. Fitch understands that a portion of the facility drawdown was utilized to temporarily fund acquisitions completed earlier in 2023, before the bond issuance in November 2023.

Whether the current momentum translates into an upgrade will depend on the company's ability to sustain margins at or above pre-pandemic levels and observations as to how the management team applies its long-term financial policies and capital deployment strategies.

Key Rating Drivers

Leading Position in Large, Fragmented Market: Quest is one of the two largest independent participants as measured by segment revenue in the relatively fragmented and highly competitive U.S. clinical laboratory market. Such scale affords the opportunity for comparatively efficient operations and sourcing of supplies, and the ability to drive margin improvement following M&A.

These advantages should allow Quest to improve its cost position, which is a competitive advantage, given the prominence that pricing plays in customer decisions. Quest's relative cost position creates alignment with payors in that testing services Quest provides may be at the expense of higher-cost in-network competitors.

Strong Base Recovery: Base business revenue in Quest's Diagnostic Information Services (DIS), which represents over 95% of Quest's consolidated net revenue, grew 7.3% in 2023, driven by 6.5% in base testing volume growth and 1.1% in revenue per requisition growth in the base business. Management acknowledges that a portion of the substantial volume growth experienced in 2023 can be attributed to a resurgence in demand as patients returned to care. Fitch expects base volume growth to persist, albeit at a more moderate pace.

EBITDA margins are expected to normalize at around 20%, close to pre-pandemic level. Fitch assumes modest margin expansions of roughly 25bps annually, driven by continued realization of economies of scale, fueled by organic growth; the Invigorate program; early materialization of investments in areas such as CIT; better pricing supported by a delay in PAMA cuts with ongoing efforts for a permanent fix; and a more favorable test and payor mix.

Leverage Normalizing: Although Fitch expects the company to generally maintain EBITDA leverage in the mid-2x range from 2023 and onward, sizable debt-funded transactions, shareholder returns or profitability deterioration could cause leverage to fluctuate. The pandemic benefitted some health care companies, including Quest. Whether this translates to a ratings upgrade will depend on the company's ability to sustain margins at or above pre-pandemic levels and observations as to how current management team applies its long-term financial policies and capital deployment strategies.

Increasing Focus in Advanced Diagnostics: Quest has demonstrated continued commitment to expanding its Advanced Diagnostics offerings, targeting areas such as oncology and neurology. The company's 2023 acquisition of Haystack Oncology, a cancer testing company with a highly sensitive testing technology for detecting minimal residual disease (MRD), positions it competitively in the rapidly growing MRD testing market.

Additionally, DGX's collaboration with Ultima Genomics, a company that aims to reduce whole-genome sequencing costs to $100, will not only bolster the development of Haystack's offerings but also open up the possibility for a broad range of clinical applications if proven effective. DGX has also launched a blood-based test portfolio for assessing Alzheimer's disease risk, offering a less invasive and potentially less costly alternative to traditional methods such as lumbar puncture for cerebral spinal fluid testing.

While the financial impact of these initiatives is anticipated to be dilutive to modest in the short term due to their currently low volume, their value could increase significantly upon generating clinical evidence that affirms their reliability and establishes them as a standard of care.

Regulation-related Uncertainties: Congress has, once again, delayed the Medicare reimbursement cuts under the PAMA that were scheduled to take place in 2024 to 2025, which would have impacted DGX's revenue by approximately $85 million. A return of PAMA cuts may impact DGX's profitability and could potentially defer certain investments. Fitch notes that DGX is working closely with the trade association to find a permanent resolution to PAMA.

Separately, the FDA's LDTs proposal, with a final rule expected in April 2024, aims to phase out the FDA's enforcement discretion for LDTs, aligning their regulatory framework with that of other in vitro diagnostic products. This could pose a manageable credit negative in the near term for larger companies such as DGX, particularly if final rules are stringent and mandate approval for all LDTs within a specific timeframe, as it will result in incremental operating expenses related to product registrations. While DGX has stated that LDTs represent less than 10% of tests, the impact on EBITDA is unclear to Fitch without knowing the incremental costs to get products approved, the pre and post-approval margin profiles of the LDTs given potential changes in test pricing and volume, and whether there'll be near-term volume loss in the event of approval backlogs.

Derivation Summary

Quest's 'BBB' rating reflects the issuer's leading position and scale in the competitive U.S. clinical laboratory industry. Strong cash conversion of operating EBITDA enables it to maintain debt leverage around 2.5x over the forecast period, despite allocating most FCF toward acquisitions, dividends and share repurchases.

Fitch views Quest's position within the clinical laboratory industry as competitive with Laboratory Corporation of America Holdings, and stronger than those of smaller, more regionally focused private laboratories. Against broader non-pharmaceutical, non-provider health care peers, Quest benefits from higher margins and cash flow conversion, although offset by more shareholder- and growth-oriented financial policies.

Key Assumptions

Revenue of nearly $9.5 billion in 2024; organic revenue growth between 2% and 3% and total revenue growth between 4% and 5%, during 2025 and 2027;

EBITDA margin expansion of roughly 100bps over the rating horizon assuming PAMA cuts return in 2025;

Effective interest rate to increase to over 4.0% over the forecast period as a result of issuing and refinancing debt at higher rates;

Over $2 billion in capital spent on acquisitions over the forecast period; common dividends growing at low-single digits, and capex held flat.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Fitch's expectation of EBITDA leverage sustaining at or below 2.5x;

An outlook of positive organic growth and margin stability.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

EBITDA leverage sustained around or above 3.0x;

Reversion to negative top-line results and margin trends, coupled with an inability to drive cost savings under the Invigorate program.

Liquidity and Debt Structure

Ample Liquidity: Quest's next bond maturity is a $600 million issue due in March 2025. The company had access to a $750 million revolver due November 2026 and $686 million of unrestricted cash at Dec. 31, 2023, $300 million of which had been used to repay $300 million of senior notes due on April 1, 2024. Fitch projects FCF after assumed dividends will sustain between roughly $540 million to $740 million per year, providing capital for M&A and share repurchases. In addition, qualitatively, Fitch considers that Quest maintains a $525 million secured receivables credit facility, of which up to $150 million can be utilized to issue letters of credit.

Issuer Profile

Quest Diagnostics, Inc. (Quest or DGX) is one of the two largest independent players in the relatively fragmented and highly competitive U.S. clinical laboratory market. Over 95% of its revenues were derived from diagnostic testing services to a wide range of customers including hospitals and clinicians.

Summary of Financial Adjustments

EBITDA adjustment made for stock-based compensation and asset impairments.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

The highest level of ESG credit relevance is a score of '3', unless otherwise disclosed in this section. A score of '3' means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. Fitch's ESG Relevance Scores are not inputs in the rating process; they are an observation on the relevance and materiality of ESG factors in the rating decision. For more information on Fitch's ESG Relevance Scores, visit https://www.fitchratings.com/topics/esg/products#esg-relevance-scores.

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