Fitch Rates Quest's Senior Notes 'BBB'; Outlook Stable
OREANDA-NEWS. Fitch Ratings has assigned a 'BBB' rating to Quest Diagnostics Inc.'s (Quest; NYSE: DGX) USD500 million 10-year senior notes offering. Fitch expects that the net proceeds from the offering will be used to repay outstanding indebtedness under the company's senior unsecured revolving credit facility and its secured receivables credit facility and for general corporate purposes. The Rating Outlook is Stable.
KEY RATING DRIVERS
--Quest is the largest independent player 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.
--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 and further margin expansion in 2016 as the company benefits from moderating pricing pressure, cost efficiencies, and favorable business mix driven by strong growth in Quest's gene-based and esoteric testing business.
--Gross debt/EBITDA was 2.7x at March 31, 2016, which remains moderately elevated relative to Quest's 'BBB' ratings and what Fitch believes to be management's long-term target of around 2.5x. Fitch expects this metric to approximate 2.5x by year-end 2016, largely due to earnings growth. Fitch does not expect the company to prioritize debt repayment in the current low interest rate environment.
--Management has demonstrated its commitment to using discretionary cash to fund M&A and shareholder-friendly payments over the past few years. The firm has committed to delivering a majority of its operating cash flows, less capex, to shareholders going forward and plans to conduct M&A so as to add 1%-2% of sales per year.
Fitch's key assumptions within the rating case for Quest include:
--Top-line growth of between 3%-4% in 2017-2019. Organic top-line growth is expected to approximate 1.5%-2% with the remainder anticipated to come from 1%-2% of annual growth through M&A.
--Incremental margin expansion is expected throughout the forecast period. Organic positive top-line growth allows for the leverage of fixed costs, and additional cost savings from the company's 'Invigorate' restructuring program are expected to benefit 2016-2019 results.
--Operating cash flow (OCF) and free cash flow (FCF) are expected to total roughly $1 billion and $400 million, respectively, in 2016, and then grow roughly in line with EBITDA over the forecast period.
--Moderate EBITDA growth on a slightly increasing debt balance (reflecting expectation that Quest will manage towards a 2.5x gross leverage target) is expected to result in gross leverage of around 2.5x throughout the forecast period.
Quest's 'BBB' ratings consider gross debt/EBITDA in the range of 2.2x-2.7x, with evidence of growth and margin stabilization over the forecast period. Fitch estimates that OCF of $500 million to $600 million will be necessary to fund the firm's M&A targets (1%-2% of growth) and commitment to return a majority of FCF to shareholders.
Positive rating actions are not likely in the near term, as Fitch expects Quest to 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 will be challenged in the near term by a persistently constrained reimbursement environment, making meaningful EBITDA growth dependent on cost savings and/or M&A funded with discretionary cash flows.
Negative rating action could occur with a reversion to negative growth and margin trends coupled with an inability to drive cost savings under the firm's expanded Invigorate program. Ongoing EBITDA declines and/or debt-funded transactions contributing to gross debt/EBITDA sustained at 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.
BUSINESS PROCESS IMPROVEMENTS YIELDING BENEFITS
Quest ended a five-year streak of organic top-line declines and margin deterioration in 2015 thanks to a renewed focus on the company's diagnostic information services business and a commitment to improving operational efficiencies. Adjusting for exited business, Quest has now reported six consecutive quarters of organic growth. Fitch forecasts organic sales growth in 2016 to approximate 1.5%. Company organic growth could rejoin overall market growth of 2%-3% in 2017.
Organic top-line growth, coupled with an additional $600 million of cost savings targeted in 2015-2017, is expected to promote margin expansion over the forecast period. Fitch expects EBITDA margins to be modestly up in 2016 and 2017, with greater improvement possible in 2018 and 2019. EBITDA margins are expected to surpass 20% over the forecast period compared to 19.5% and 18.7% in 2015 and 2014, respectively. Greater improvement is possible but will be challenged by a constrained reimbursement environment and growth in Quest's professional labs services (PLS) business, which is lower margin than the company's diagnostic services business, but is significantly less capital-intensive.
DEBT REDUCTION IS UNLIKELY
Fitch projects Quest's gross debt leverage will generally approximate 2.5x over the forecast period and does not expect the company to prioritize debt repayment in the current low interest rate environment.
Management has demonstrated its commitment to using discretionary cash to fund M&A and shareholder-friendly payments over the past few years. The firm has committed to delivering a majority of its operating cash flows, less capex, to shareholders going forward and plans to conduct M&A so as to add 1%-2% of sales per year. On May 18, 2016, Quest announced that it would use the cash proceeds from the sale of its Focus products business to repurchase shares. Fitch expects near-term acquisition activity to be targeted in nature and financed with cash on hand and/or temporary draws on the company's A/R facility.
Without material opportunities for debt repayment over the next four years, deleveraging will be highly dependent on EBITDA growth.
PAMA PRESENTS CHALLENGES AND OPPORTUNITIES
Under the federal Protecting Access to Medicare Act of 2014 (PAMA), it is expected that the Centers for Medicare and Medicaid Services (CMS) will revise reimbursement schedules for clinical laboratory testing services provided under Medicare. Among other provisions, PAMA allows CMS to create a market-based payment system to re-base the clinical laboratory fee schedule as early as 2017, although delays in the rulemaking process appear likely to delay its implementation.
Under the law, 'applicable laboratories' are required to report to CMS the rates they receive from private payors for each clinical diagnostic lab test. After collecting this information, CMS will calculate a weighted median payment amount for each test.
An 'applicable laboratory' is defined as a lab that receives more than 50% of its Medicare revenues from the Medicare Clinical Laboratory Fee Schedule (MCLFS) or the Medicare Physician Fee Schedule (MPFS). As drafted, PAMA therefore would not require hospital labs to report fees. Because hospital labs typically receive higher commercial rates than independent labs, their exclusion from CMS' market rate calculation could result in revisions to the MCLFS and MPFS that are lower than actual overall market rates.
While lower Medicare reimbursement rates would pressure Quest and other independent labs, Quest may be in a better position to absorb its impact than many of its smaller competitors and could actually benefit from PAMA's implementation. In 2015, only 12% of the company's consolidated net revenues were reimbursed by Medicare under the CLFS while 2% was reimbursed under the MPFS. Fitch believes that many smaller labs may have more concentrated exposure to Medicare.
Quest had access to an undrawn $750 million revolver, $123 million available under its $600 million A/R securitization facility, and had cash on hand of $128 million at March 31, 2016 (42% considered permanently reinvested outside the U.S.).
Quest amended and restated its $750 million revolver in April 2014, extending its maturity to April 2019. In October 2015, the company amended and restated the agreement for the secured receivables credit facility, increasing the borrowing capacity under the facility to $600 million from $525 million and extending the maturity by one year to October 2017. Quest's only remaining bond maturity before 2020 is $300 million due April 2019.
Fitch rates Quest as follows:
--Long-Term IDR 'BBB';
--Senior unsecured bank facility 'BBB';
--Senior unsecured notes 'BBB'.
The Rating Outlook is Stable.