Fitch Affirms Quest Diagnostics' Ratings at 'BBB'; Outlook Stable
A full list of rating actions, which apply to approximately \$3.86 billion of debt, follows at the end of this release.
KEY RATING DRIVERS
Leading Market Position: 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.
Operational Stabilization: Quest's focus on operational improvement helped to drive positive organic growth in fourth-quarter 2014, the first such quarter since 2012. Fitch expects modestly positive organic growth in 2015, possibly signaling an inflection point for the firm's growth and margin profile.
Debt Leverage Above Target: Debt leverage is elevated relative to Quest's 'BBB' ratings and above management's long-term target of 2.0x - 2.25x. (Gross debt/EBITDA was 2.7x at Dec. 31, 2014 and pro forma for completed 2015 refinancing transactions.) De-leveraging post-2015 is likely to occur primarily from EBITDA growth, as the firm will now have limited opportunities for debt repayment.
Cash to Shareholders, M&A: 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.
RATING SENSITIVITIES
Quest's 'BBB' ratings consider gross debt/EBITDA in the range of 2.2x - 2.7x, with evidence of growth and margin stabilization in 2015 - 2016. Fitch estimates that FCF of \$350 million to \$400 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 at current ratings.
Positive rating actions are not expected in the near-term, as Quest will have limited flexibility at the current 'BBB' ratings for much of 2015. An upgrade to 'BBB+' could be considered with a moderation of gross debt/EBITDA to 2.2x or below, accompanied by an outlook for positive organic growth and margin expansion. But organic growth will continue to be difficult in the near-term given industry headwinds, making EBITDA growth dependent on cost savings and/or M&A funded with discretionary cash flows.
Negative rating actions could stem from the continuation of 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 around 2.7x or above could drive a downgrade to 'BBB-'. Operating cash flow trending below \$600 million without an adjustment to the firm's shareholder payouts could also pressure the ratings.
2015 A POSSIBLE INFLECTION POINT
Quest may be poised to end its multi-year streak of organic top-line declines and margin deterioration in 2015, thanks to a successful focus on operational excellence and profitability over the past few years. Operational excellence initiatives as a part of the firm's Invigorate program, as expanded in 2014, have focused on improving overall company efficiency and sales team productivity. Adjusting for exited business, Quest reported three quarters of organic growth in 2014. Fitch forecasts organic sales growth in 2015 to approximate 1%. Company organic growth should rejoin overall market growth of 2% - 3% in 2016/2017.
Organic top-line growth, coupled with an additional \$600 million of cost savings targeted in 2015-2017, is expected to help drive margin stabilization in 2015 and margin expansion thereafter. Fitch expects EBITDA margins to be modestly up in 2015, with greater improvement expected in 2016 and 2017. EBITDA margins could surpass 20% over the forecast period compared to 18.7% in 2014.
REFINANCING ADDRESSES MATURITY WALL, BUT ELIMINATES DEBT REPAYMENT OPPORTUNITIES
Quest's recent refinancing activities eliminated what was a significant maturity wall in 2015 - 2017, comprising \$500 million due 2015, \$300 million due 2016, and \$375 million due 2017. Of these, only \$150 million of notes due 2016 remain outstanding. Fitch had previously expected the firm to use these debt maturities as an opportunity to reduce leverage following the 2014 acquisition of Solstas Labs for \$570 million. But Quest's next material debt maturity is now not until 2019 (\$300 million).
The refinancing did lower the firm's interest expense going forward, replacing notes with coupons in the 5% - 6% range with rates between 2.5% and 4.7%. But without material opportunities for debt repayment over the next four years, de-leveraging will be highly dependent on EBITDA growth, which has been hard to come by over the past several years.
Notably, debt leverage will be elevated above 2.7x in first-half 2015 as the firm completes its refinancing transactions, using temporary draws on its A/R facility to fund remaining redemptions and using second-half cash flows to reduce facility borrowings.
JV WITH QUINTILES IS POSITIVE, BUT NOT EXPECTED TO BE A MATERIAL DRIVER
Fitch views favorably the joint venture between Quest and Quintiles Transnational Holding Corp. (Quintiles) as a capital-effective way of creating scale in the important growth area of clinical trials laboratory services. The resulting entity will be the second-largest player and, as such, will be able to provide more advanced and comprehensive services to its pharmaceutical and biotech customers.
The JV's financial contributions to Quest will be relatively small in the near-term, as the entity stands itself up and begins as a fairly small firm. But Fitch expects good growth opportunities over the medium- to longer-term. Fitch will include Quest's share of the JV's profitability, as accounted for under the equity method, in EBITDA going forward. On balance, Fitch thinks the JV's success will have a more direct impact on Quintiles' overall business than Quest's, though with upside for future partnership opportunities.
KEY ASSUMPTIONS
--Organic top-line growth of 1% in 2015, improving to 2% - 3% by 2017. Acquisitions to add average annual growth of 1% - 2%.
--Flat to modestly improved margins in 2015, with more meaningful margin expansion in 2016-2017. EBITDA margins could expand beyond 20% over the forecast period (vs. 18.7% in 2014).
--Relatively flat debt levels following a paydown of A/R facility borrowings, allowing for moderate de-leveraging with EBITDA growth. Gross debt/EBITDA of 2.6x and 2.4x in 2015 and 2016, respectively.
--Operating cash flow (OCF) in line with management guidance of \$850 million in 2015, possibly improving to \$1 billion or more by 2017.
--Capital spending around \$300 million. Dividends of \$200 million to \$250 million over the forecast period. A majority of OCF, less capex, returned to shareholders annually.
Fitch has affirmed Quest's ratings as follows:
--Long-term Issuer Default Rating at 'BBB';
--Senior unsecured bank facility at 'BBB';
--Senior unsecured notes at 'BBB'.
The Rating Outlook is Stable.
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