Quest Diagnostics: Last Stock In My Quality And Value Screen

Woman in a medical mask being prepared for venipuncture

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When running an update of my quality at a reasonable price stock-picking screener, Quest Diagnostics Incorporated (NYSE:DGX) was the only name to meet each parameter of my checklist for fundamentals, value, and risk.

The screener includes a dividend requirement, which eliminated Laboratory Corporation of America (NYSE:LH) the other half of the lab testing duopoly. As a shareholder or part-owner, I expect compensation in the short term, along with the executives, while waiting for capital gains to compound over time.

Naturally, I was curious why the company was out of favor with an asymmetric valuation to fundamentals in shareholder yields, returns on management, and downside risks. It appears to stem from a combination of patient fear of the on-site lab-testing model during the coronavirus pandemic coupled with Wall Street’s proverbial fear of slowing growth.

However, I presume that customers are forever fickle while investors are forward-looking to a fault. In other words, it’s almost impossible to predict consumer behavior or specific future stock prices accurately. Thus, I took Quest’s last stock standing position on my screener as a no-brainer for further due diligence.

In the movie, A Good Year (Century City, CA, Century City Studios, 2006), fictional trader Max Skinner calls his investing team to action with, “Okay lab rats, let’s go make some money.” So, I invite you to join me in researching DGX using my market-beating quality at a reasonable price checklist.

Unless noted, all data presented is sourced from Seeking Alpha and YCharts as of the market close on January 21, 2022; and intended for illustration only.

A complimentary Glossary of Investing Terms is provided in a linked Google Sheet for article brevity and quick reference. The glossary is exclusive to Seeking Alpha readers. It is recommended to open the sheet in a separate window or tab. For convenience, a link back to SA is provided.

Quest Diagnostics Company Profile

Quest Diagnostics is a dividend-paying mid-cap stock in the health care sector’s providers and services industry.

Quest Diagnostics Incorporated provides diagnostic testing, information, and services in the United States and internationally. The company develops and delivers diagnostic information services, such as routine testing, non-routine and advanced clinical testing, anatomic pathology testing, and other diagnostic information services. It offers diagnostic information services primarily under the Quest Diagnostics brand, as well as under the AmeriPath, Dermpath Diagnostics, ExamOne, and Quanum brands to patients, clinicians, hospitals, independent delivery networks, health plans, employers, direct contract entities, and accountable care organizations through a network of laboratories, patient service centers, phlebotomists in physician offices, call centers and mobile paramedics, nurses, and other health and wellness professionals. The company also provides risk assessment services for the life insurance industry; and healthcare organizations and clinicians robust information technology solutions. Quest Diagnostics Incorporated was founded in 1967 and is headquartered in Secaucus, New Jersey.

(Source: Seeking Alpha)

DGX Total Return Versus Benchmarks

As my long-time followers know, I target the major U.S. exchange-traded (NYSE and NASDAQ) common shares of high-quality, dividend-paying companies with market-beating history or potential. The alternative is indexing or being average to the market on both the upside and the downside. Unfortunately, last I checked, of the 5,561 publicly-traded common stocks available to trade on the US major exchanges, just 1,553 or 28% were outperforming the S&P 500 over the previous 12 months.

I prefer to own a select basket of the few winners and, except for portfolio hedging, avoid the predominance of losers in an index fund. Also welcomed are high-quality, dividend-paying defensive stocks.

My focus is on mid-caps and large-caps for wider margins of safety in longer-term investing, leaving the more speculative, albeit worthy, small-caps to the lowest-cost fund managers. Avoided are over-the-the-counter issues (OTC) and micro caps.

Nonetheless, the market cap reflects sentiment. Therefore, I pay less attention to the existing crowd think if the stock is compounding over the long term at a rate as good as, if not better than, expected at purchase.

Knowing that Quest Diagnostics’ primary national competitor, LabCorp, did not pay a dividend, I removed that parameter for the screen that produced DGX as the last stock standing. Low and behold, LH joined DGX as the only two stocks to pass my quality and value screen, dividends notwithstanding.

During the past three years, DGX outperformed the Health Care Select Sector SPDR ETF (NYSE:XLV) in total return but lagged competitor LH and the benchmark SPDR S&P 500 ETF Trust (NYSE:SPY).

DGX and LH total return vs XLV and SPY
Data by YCharts

Yielding 4.5 Times The Ten Year Treasury

As part of my due diligence, I average the total shareholder yields on earnings, free cash flow, and dividends to measure how the stock compares to the prevailing yield on the 10-Year Treasury benchmark note.

Earnings Yield

I target an earnings yield of greater than 6 percent or the equivalent of a P/E multiple of below 17 times.

With trailing one-year earnings per share of $16.65, the earnings yield for DGX was 12.09%, double my 6.00% threshold.

Free Cash Flow Yield

I target a free cash flow yield or FCFY of 7 percent and higher or the equivalent of fewer than 15 times the inverted price-to-free cash flow multiple.

Based on $14.32 free cash flow per share, the FCFY for DGX was 10.40%, well above my 7.00% threshold.

Dividend Yield

I am not a dividend investor by definition. However, I prefer dividend-paying stocks for compensation in the short term while waiting for capital gains to compound over time.

To avoid high-yield equity junk, I limit our family’s portfolio holdings to trailing-twelve-month dividend yields below 5 or 6 percent. Nevertheless, my preferred high dividend strategy is the yield on cost basis, a reminder that long-term investing is the best approach to producing safe, high yield dividends.

The trailing dividend yield for DGX was a mere 1.80%, although, unlike its main competitor, LabCorp, it at least pays a dividend. And the generosity is supported by a meager payout ratio of 17.65%. Thus, Quest Diagnostics is distributing a well-covered, super-safe dividend.

DGX stock shareholder yields
Data by YCharts

Average Of Shareholder Yields

Next, I take the average of the three shareholder yields to measure how the stock compares to the prevailing yield on the 10-Year Treasury benchmark note.

The average shareholder yield for DGX was 8.10% vs. 1.75% for the 10-Year Treasury rate.

Quest Diagnostic’s yields on its stock are collectively outperforming the 10-Year Treasury with conviction. Arguably, equities are deemed riskier than US bonds, but an equity position that rewards shareholders at nearly five times the government benchmark suggests owning the stock instead of the bond.

My weighted shareholder yields rating for DGX: Bullish.

Impressive Margins and Capital Allocations

I will now explore the fundamentals of Quest Diagnostics, uncovering the performance strength of its senior management.

Revenue Growth

Quest Diagnostics had a double-digit three-year growth of -0.43% on its top line. Generally, I prefer owning slices of companies with positive trailing revenue growth. When analyzing a business, I am biased toward established growth instead of executive promises and sell-side analyst projections.

Nonetheless, the chart below offers a lesson in the short-sightedness of the stock market. As the pandemic unfolded, investors got excited about tailwinds for a healthcare services provider such as Quest Diagnostics and drove the stock price up. However, as the growth became headwinds because perhaps consumers avoided lab visits except for urgent medical situations, volume growth lagged the Wall Street consensus. As a result, the stock price dropped faster than a red blood cell count.

In contrast, the revenue growth chart for DGX tells me that volume growth returned to pre-pandemic levels, and the speculative trade has closed.

Net Profit Margin

I seek profitable companies to avoid unnecessary speculation. Investors who go long the stocks of money-losing companies should expect to lose money on those investments more often than not.

Quest Diagnostics had a trailing three-year slightly rising pre-tax net profit margin of 19.77%. I prefer companies generating consistent double-digit bottom lines, such as DGX.

Return On Equity

Return on equity or ROE reveals how much profit a company generates from shareholder investment in the stock. I target an ROE of 15 percent and higher.

Quest Diagnostics had an impressive trailing three-year return on equity of 33.92%, more than double my threshold for discovering shareholder-friendly management.

Keep in mind that share buybacks can manipulate returns on equity to the upside. For example, Quest Diagnostics announced in early 2021 that its board of directors had authorized $1 billion in share repurchases on top of $900 million in buybacks announced in late 2020. Although the company’s favorable ROE appears inflated by its stock repurchases, I would commend the board for taking advantage of the bargain stock price, which I will outline later in this post.

As a value investor, I take notice of boards that buy back shares when the price is reasonable or cheap instead of for manipulative purposes, such as to deflate shares outstanding and thus inflate EPS and ROE.

Return On Invested Capital

Return on invested capital or ROIC measures how well a company uses its working capital to generate returns. I target an ROIC above 12 percent.

Quest Diagnostics had a 20.53% three-year trailing return on invested capital, well above my preferred level, a testament to its senior managers as competent capital allocators.

Further highlighting the performance was the pandemic had been challenging for returns on capital market-wide.

Weighted Average Cost Of Capital

The ROIC needs to exceed the weighted average cost of capital or WACC by a comfortable margin giving credence to management’s ability to outperform its capital costs.

Quest Diagnostics had a trailing weighted average cost of capital of 6.82% (Source: GuruFocus). Despite the recent decline in revenue growth, the comfortable spread between ROIC and WACC, double-digit profit margins, and impressive returns on equity speak to a productive senior management team.

My weighted return on management rating for DGX: Bullish.

Quest Diagnostics Returns on management
Data by YCharts

Unwarranted Disfavor Creates Value

Our concentrated family portfolio of dividend-paying common stocks has outperformed the broader market since 2009 based on an equal-weighted average total return of each position vs. the S&P 500 during the same holding periods. Access to The Model Portfolio is, at present, complimentary. Visit my Seeking Alpha Author Profile for the link.

Although Wall Street attempts to convince us otherwise with highly sophisticated valuation models, investing in the stock market is not rocket science. I submit that uncovering the common shares of quality companies temporarily trading at reasonable prices is basic science.

As highlighted in my latest book, Build Wealth With Common Stocks: Market-Beating Strategies for the Individual Investor, I rely on four valuation multiples to estimate the intrinsic value of a targeted quality enterprise’s stock price.

Please note that I do not attempt to predict specific future share prices nor percentage targets as I view such practices as arbitrary, if unreliable.

Price To Sales

The price-to-sales ratio or P/S measures the stock price relative to revenues. I target a P/S of fewer than 2.0 times.

DGX had a price to sales ratio of 1.63, within my threshold. On the contrary, the median P/S of 5.79 for the overpriced health care services sector, on the whole, indicates the market is deeply discounting the stock price relative to Quest Diagnostics’ trailing top-line revenue. Plus, DGX appears a market-wide bargain compared to the S&P 500’s cumulative average P/S of 3.15.

Price To Earnings

Although an arbitrary multiple, I target price-to-trailing earnings or P/E of fewer than 17 times or below the target stock’s industry averages.

DGX had a price-to-earnings multiple of 8.27, indicating that market sentiment discounts the stock price relative to its earnings compared to the health care services sector’s nosebleed median of 29.67. Also, the stock discounts profoundly to the S&P 500’s overall PE of 27.24 as of January 21, 2022 (Source of S&P 500 PE: Barron’s).

Price To Operating Cash Flow

I target single-digit price-to-operating cash flow multiples for the best value.

DGX had a single-digit price to cash flow of 7.85, compared to the health care services industry’s median of 18.94, indicating the market discounts the stock price relative to the company’s current cash flows.

Enterprise Value To Operating Earnings

Enterprise value to operating earnings or EV/EBITDA measures whether a stock is overbought, a bearish or neutral signal, or oversold, a bullish or neutral signal, by the market. I target an EV/EBITDA of fewer than 12 times.

DGX had an EV/EBITDA of 5.85, compared to a sector median of 16.76, signaling that the stock was oversold or underbought by the market.

DGX stock valuation
Data by YCharts

Margin Of Safety

Although Wall Street relies on sophisticated models and formulas projecting future free cash flows and other hypotheses, I am forever wary of the assumptive projections of those methods when estimating the margin of safety in a current stock price.

I am biased toward outstanding companies whose common shares are experiencing out-of-favor market sentiment as suggested by lower ratios of price-to-sales, price-to-earnings, price-to-operating cash flow, and enterprise value to operating earnings. Thus, I weigh the above key indicators to determine the overall market valuation of the targeted company.

The weighting of my four preferred valuation multiples suggests that the market undervalues Quest Diagnostics’ current stock price. Based on the metrics shared in this article, risks and catalysts notwithstanding, I would call DGX an oversold stock of an otherwise quality and profitable operator in the health care providers and services industry. DGX bulls can thank market disappointment in the lack of sustained dramatic growth during the pandemic for the current bargain price point.

My weighted valuation rating for DGX: Bullish.

DGX Offers Below Average Risk Profile

When assessing the downside risks of a company and its common shares, I focus on five metrics that, in my experience as an individual investor and market observer, often predict the potential risk/reward of the investment.

I assign a downside risk-weighted rating of above average, average, below average, or low, biased toward below average and low risk profiles.

Economic Moat

I target companies that possess clear competitive advantages from their products or services. An investor or analyst can streamline the value proposition of an enterprise with a moat assignment of wide, narrow, or none.

For example, Morningstar assigns DJX a narrow moat rating.

Quest enjoys a narrow moat as part of the duopoly that dominates the independent reference lab market. Compared with hospital-based labs and smaller regional players that continue to dominate the larger lab industry, Quest typically offers significant cost advantages thanks to its scale and volume. For example, tests at hospital labs typically cost 3 times more, on average, than the same test at Quest. This advantage becomes most evident when throughput increases and translates into attractive operating leverage.

–Debbie S. Wang, Senior Equity Analyst, January 10, 2022

Despite its scale and volume advantages, arguably, a narrow moat may be generous for the duopoly of DGX and LH. For example, as widely reported, CVS Health (NYSE:CVS) is transitioning its non-pharmacy retail space to online, replacing the physical space with expanded healthcare services. So what’s to stop CVS and other health care providers with national footprints from opening walk-in labs?

Long-Term Debt Coverage

A favorite of the legendary value investor Benjamin Graham, long-term debt coverage demonstrates balance sheet liquidity or a company’s capacity to pay down debt in a crisis. Generally, one-and-a-half times current assets to long-term debt is ideal.

As reflected on its September 2021 financial statements, Quest Diagnostics’ long-term debt coverage was 0.71, lower than required to cover its long-term debt leveraging needs. As a result, investors must decide whether the high levels of debt and capital expenditures needed to build out or expand on-site testing labs is worth the downside risk.

Short-Term Debt Coverage

Current liabilities coverage or current ratio measures the short-term liquidity of the balance sheet. I target higher than 1.00, although a quality company may have a current ratio of less than one because of the industry served.

Quest Diagnostics’ short-term debt coverage or current ratio was 1.62, more than enough to pay down current liabilities such as accounts payable, short-term borrowings, and income taxes.

Stock Price Volatility

As a long-term investor, I use a five-year beta trend line and screen for companies with betas lower than 1.25 or no more than 125% volatility to the market.

DGX’s 60-month trailing beta is 1.11. However, its 24-month beta is 0.68, reflecting the stock as a long-term holding susceptible to price swings from speculative activity on the stock price.

Market Sentiment

The short interest as a percentage of the float for DGX was 2.35%, well under my 10% threshold. Bears seem to agree that Quest Diagnostics is one half of the lab duopoly, and other than short-term speculation based on perceived headwinds and tailwinds is a buy-and-hold long play.

My weighted downside risk rating for DGX: Below Average.

DGX Catalysts Are Competitive-Based

Events that could accelerate my overall bullish investment thesis on Quest Diagnostics include but are not limited to:

  • Post-pandemic consumers become comfortable visiting labs for all tests, including routine ones.
  • Quest and LabCorp maintain their successful duopoly in lab diagnostics with superior volume, price, and scale.

Other than contradictory outcomes to the potential accelerators, events that could invalidate my investment theses on Quest Diagnostics include but are not limited to:

  • Do patients choose labs based on brand, cost, or convenience? The conventional wisdom implies that most consumers use the closest lab to work or home covered by their insurance provider. That could be Quest, LabCorp, or XYZ.
  • The economic moat may be narrower than presumed as CVS Health and other health care providers decide to enter the diagnostic lab space providing convenience for their captive customer bases.

The Last Stock Standing

Duopoly diagnostic lab operator Quest Diagnostics was the only stock to meet each parameter of my stock picking checklist for fundamentals, value, and risk.

Although the stock’s price accelerated at the beginning of the coronavirus pandemic thanks to near-sighted investors who anticipated tailwinds for lab testing, the company’s growth hit headwinds perhaps from more selective lab visits by cautious patients. The market exacerbated the reaction with the typical over-hyped sentiment.

Nevertheless, the stock’s yields are trouncing the Ten Year Treasury. Moreover, the company boasts double-digit profit margins, senior managers are superior capital allocators, and the downside risk rating is below average.

Insufficient long-term debt coverage and the potential for negative competitive catalysts are noteworthy, but the unwarranted disfavor in the stock has produced a compelling value opportunity.

After conducting independent due diligence, a growth-oriented investor may pick LH, despite no dividend. I would respect that decision but encourage a memo to LabCorp’s board of directors with the subject line: “Where’s the dividend?”

No memo is necessary for Quest Diagnostics because of its tie-breaking dividend.