Valuation Corner: Quest Diagnostics

The stock could continue to generate strong returns going forward. Quest Diagnostics appears to be undervalued, given its growth potential and below-average valuation multiple. And, it is a high dividend-growth stock.

Quest Diagnostics performs diagnostic testing and laboratory analysis. It has an entrenched leadership position in its industry because it possesses the world’s largest database of clinical lab results. Quest Diagnostics serves about half of all physicians and hospitals in the U.S. The company’s diagnostic testing helps to identify and treat disease, and also to improve healthcare management.

The overall U.S. laboratory market is a $79 billion-per-year industry. It is projected to grow at a 2-3% annual rate moving forward. Approximately 63% of the total lab market is comprised of outside of hospital services. More than half of this segment is serviced by independent labs, and Quest Diagnostics is the largest company in the independent lab segment. As the leader in its niche, Quest Diagnostics is well positioned to capture a significant portion of the growth in the U.S. lab services space.

Quest Diagnostics enjoys competitive advantages, including its patent portfolio. The company has been issued 700 worldwide patents, with another 570 patents pending. This helps fend off competitive threats and provides the company with pricing power. Quest Diagnostics is solidly profitable and generates excellent margins, which fuels consistent growth each year.

Currency-adjusted revenue increased by 2.6% in 2016, to $7.52 billion. One source of strength for Quest Diagnostics last year was gene-based and esoteric testing, which grew approximately 3.5% for the year. The reasons for this growth were higher demand for non-invasive prenatal testing, hepatitis C, prescription drug monitoring and SureSwab. Adjusted earnings per share, which excludes a non-cash amortization charge, increased by 8% to $5.14 last year.

Quest Diagnostics expects revenue to increase 1.6-2.7% in 2017. Adjusted earnings per share are expected to grow 4.5-7.4% in the current year. Revenue growth will be driven by expanding relationships with existing customers, particularly hospital health systems. Another growth catalyst is expanding services, including the company’s advanced diagnostic offerings.

In addition to revenue growth, earnings per share will be boosted by cost controls and share repurchases. The company spent $590 million of cash flow to repurchase shares in 2016. Conducting such significant buybacks helps to lower a company’s share count, thus increasing earnings per share.

The company is investing aggressively in its key strategic priority, which is to refocus on diagnostic information services. To do this, it conducted a significant divestment process in which it raised $1 billion in proceeds. For future growth, Quest Diagnostics has targeted hospital health systems, which makes up 60% of the overall U.S. lab market.

Within this segment, there are three main source of opportunity for Quest Diagnostics: reference testing, hospital outreach and inpatient services. Quest Diagnostics is the #1 company in reference testing. And it is expanding its hospital outreach and inpatient businesses by acquiring or partnering with new businesses and rolling out its professional laboratory services.

Finally, earnings growth will be helped by cost cuts. Several years ago, the company launched an ambitious cost-cutting program. Quest Diagnostics ended 2016 with $1.1 billion in run rate cost savings and is on track to deliver $1.3 billion in run rate savings by the end of 2017.

Future returns from Quest Diagnostics will largely come from earnings growth and dividends. However, the stock could also generate returns from an expanding valuation multiple. This is because Quest Diagnostics is modestly valued, and perhaps undervalued. The stock trades for a price-to-earnings ratio of 18. It appears undervalued compared to the S&P 500 Index, which has a price-to-earnings ratio of 26. It also seems to be undervalued when using the Dividend Discount Model.

Assuming a risk-free rate of 2.31%, equal to the yield on the 10-year U.S. Treasury bond, 10% annual dividend growth and a beta of 0.91, estimated fair value of Quest Diagnostics stock is $128.57 per share. Based on the most recent closing share price, the Dividend
Discount Model analysis indicates shares are currently undervalued by approximately 30%.

As a result, the stock appears to be significantly undervalued based on the present value of future dividend payments. An expansion of the valuation multiple to meet its projected fair value would meaningfully boost total returns moving forward.

Quest Diagnostics currently pays a quarterly dividend of $0.45 per share, or $1.80 per share annualized. This amounts to a 1.8% dividend yield. The stock has a slightly below-average dividend yield compared with the S&P 500, which has a 2% yield. However, investors are compensated for this in the form of high dividend growth. For instance, the company increased its dividend by 12.5% in the Its first quarter of 2017.

Investors can expect the company to continue increasing dividends at a double-digit rate each year, thanks to the company’s strong fundamentals and low payout ratio. Its forward annualized dividend rate represents about 33% of the company’s earnings per share in 2016. A 33% payout ratio is low, and it leaves plenty of room for further dividend growth. For these reasons, a 10% compound annual dividend-growth rate each year is an appropriate expectation.

Quest Diagnostics has a strong brand and a top position in its core focus areas. The company is expanding earnings through revenue growth, cost cuts and share repurchases. The stock has a slightly below-average dividend yield but is a high dividend-growth stock.

And the shares appear to be significantly undervalued using the Dividend Discount Model and relative valuation analysis. These qualities could make Quest Diagnostics a potential buy for value and income investors.