DGX | Omicron Overwhelms, Likely Hinders Pent-up Demand
Background
When we added Quest Diagnostics (DGX) as a Best Idea Long on July 30, 2021, at ~$142/share, we had identified an inflection in our COVID testing data that validated vaccination rates were too low in the short term during the Delta Variant, and too low in the longer term with the onset of winter related flu and COVID testing, as well as more testing as a consequence of #reopening. We recognized a path for 15%-30% upside in the immediate term as 2021-2022 top and bottom lines were unrealistically low. The stock outperformed through the subsequent wave caused by the Delta variant and rolled over with cases as share price is 94.7% correlated with the 7-day average of US COVID cases per day (since June 2021). Following that roll-over, we doubled down on another 10%-20% upside scenario this time on the opportunity for the flu season to cause yet another re-acceleration. As we’ve seen since that Stock Brief on November 11, 2021, Omicron has dominated the news and the stock has run up similarly.
While Omicron has yet to peak in the US, IHME and the University of Washington forecasts a peak approximately the last week of January 2022. With that backdrop in mind, we are recalling the potential short thesis we laid out in that same stock brief. The bulk of the positive revision has occurred in our view while the multiple has revised higher as well. The EV/NTM Sales multiple (the stock’s highest correlated multiple over the past 3 years, 72.9%) has climbed to 2.6x, reaching the top end of its historical range, but in contrast to our positive outlook of a few months ago, questions concerning reimbursement, the shift to pooled surveillance testing, and further deferral of the base business due to Omicron, present significant headwinds that will make it difficult for DGX to comp their best performance metrics of all time in 2021.
Thesis
Throughout our coverage, we have maintained a record of DGX’s bi-monthly releases, “Media Statement about COVID-19.” These have been important positive catalysts to this point, but also provide key insight into how COVID volume is being managed internally. Earlier this week, Quest reported an average of ~121.4k molecular tests per day in the most recent two weeks. While we expected the elevation in average tests per day as a result of the Omicron variant and flu season, we are concerned by the company’s disclosure that the average return time has slipped to between 2-3 days. Failing to meet the 2-day turnaround time negatively impacts their average reimbursement rate as they no longer receive $100 per test, and rather receive $75 per test. Reduction in the average reimbursement rate is the first headwind to the margin improvement piece of our near-term outlook.
Additionally, the release mentioned the re-opening of the company’s laboratory referral partner program. While there may be a number of justifications for this strategy including “passing off” COVID volume to focus instruments on the recovery in the base business, our original thesis was concentrated on DGX’s ability to take full advantage of the higher margin opportunity (recall that a molecular test provides a ~60% gross margin compared to the ~35% margin for the base business). For that reason, the dependency on a recovery in the base business is even more critical, but we suspect has been significantly delayed by the ongoing Omicron outbreak.
Lastly, CDC guidelines are struggling to keep up with the pace of the current outbreak, which is increasingly challenging for previous protocols and recommendations. With the Omicron Variant, CDC has been reducing testing and quarantine requirements as the Omicron Variant has overwhelmed the broader economy, test availability, while also presenting as a less virulent COVID-19 variant. Pooled testing, wage inflation, and transportation costs are additional risks made worse by the Omicron Variant.
Despite the negative aspects of the release, DGX averaged ~93.5k molecular test per day in 4Q21 versus the US average of 134.2MM per day, representing 6.4% market share, fairly consistent with the 6.8% share in 3Q21. We expect DGX will outperform both company guidance and consensus for FY21 (Sales – HE: $10.74B versus Consensus: $10.55 and Guidance: $10.45-$10.60; EPS – HE: $14.16 versus Consensus: $13.76 and Guidance: $13.50-$13.90) driven largely by better-than-expected demand for molecular testing and offset by premium pricing on logistics. With a significant delay in a broader medical economy recovery and pent-up demand release past 1Q22, or later, and downward pressure on COVID-19 testing, we are removing DGX from our active long list. DGX revenue estimate trend is in MicroQuad 4, an especially vulnerable position without a source of significant upside, which from here, looks likely. The lack of upside in the short term and a series of potential headwinds after Omicron peaks in the next few weeks, we are moving DGX to the Short Bench.
Valuation
Based on our estimates, we have modeled 2022 revenue to $9.13B versus consensus of $8.88B, and 2022 EPS of $8.32 versus consensus of $8.55, driven by the aforementioned headwinds anticipated throughout the year. We believe DGX shares could trade at a 2022 EV/Sales multiple between 2.1x-2.4x, representing 10%-30% downside in the near-term. DGX is a short into 1H22, but could see another flip to the long side dependent on the pace of the base business.
Catalysts
- Base Business Comments at JPM HC Conference | During the appearance on Wednesday, January 12, 2022, we will be listening for commentary on further recovery of the base business including any Omicron-related delays, demand for pooled surveillance testing, changes to CMS reimbursement, and trends in premium pricing for logistics and supplies.
- Mix Shift to Pooled Surveillance Testing a Headwind | As expected the hospitalization and death rates during the Omicron outbreak were significantly lower than past waves. As a result, we expect future variants will have a lesser impact on regular activity, and therefore, require less individual testing. The shift in mix to pooled over individual testing would be a margin headwind.
- Recovery in NYC based on Path Train Traffic | Aside from New York City, Quest’s volume has reached the 2019 baseline that they have used for reference during the pandemic. Utilizing data from the NY-NJ Path Train, we have a way to map and monitor the city’s recovery and its impact to volume.
- Rising Pump Prices | We also maintain a dataset for US pump prices as the incremental cost can create gross margin pressure due to the number of times spent driving to collect and transport samples. We know from the company’s appearance at Credit Suisse that this is impacting margin already.
Risks
- Further Variants Delay Surveillance Testing Demand | If molecular PCR tests were to remain in favor throughout 2022, the mix would remain heavily skewed to the higher margin tests, thus limiting our downside scenario on both top and bottom lines.
- Evidence of Pent-Up Demand | Across our many datasets, we have encountered a mounting number of series to support the material evidence of pent-up demand. While we believe the release has been delayed by Omicron, the resumption of pre-COVID activity levels despite outbreaks would have a negative impact on our near-term short thesis.
- Lab Worker Wages & Employment | Utilizing data from the BLS, we know that lab worker wages have been muted to this point relative to industry trends. DGX has gone above and beyond to reward their employees who managed through the pandemic and may benefit from these actions.
Key Slides
Our model is up-to-date and available for interested Health Care Subscribers, as well as all data available upon request. Please reach out to with any inquiries.
Thomas Tobin
Managing Director
Twitter
LinkedIn
