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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-K
[Quest Diagnostics Logo]
Annual Report Pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934
For the Fiscal Year Ended December 31, 2004
Commission File Number 001-12215
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Quest Diagnostics Incorporated
1290 Wall Street West, Lyndhurst, NJ 07071
(201) 393-5000
Delaware
(State of Incorporation)
16-1387862
(I.R.S. Employer Identification Number)
- --------------------------------------------------------------------------------
Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class Name of Each Exchange on Which Registered
Common Stock
with attached Preferred Share Purchase Right New York Stock Exchange
- --------------------------------------------------------------------------------
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
--- ---
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K. [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).
Yes X No
--- ---
As of June 30, 2004, the aggregate market value of the approximately 80 million
shares of voting and non-voting common equity held by non-affiliates of the
registrant was approximately $6.8 billion, based on the closing price on such
date of the registrant's Common Stock on the New York Stock Exchange.
As of February 28, 2005, there were outstanding 101,422,952 shares of Common
Stock, $.01 par value.
Documents Incorporated by Reference
Part of Form 10-K into
Document which incorporated
- -------- ------------------
Portions of the registrant's Proxy Statement to be filed by April 29, 2005 Part III
Such Proxy Statement, except for portions thereof, which have been specifically
incorporated by reference, shall not be deemed "filed" as part of this report on
Form 10-K.
TABLE OF CONTENTS
Item Page
---- ----
Item 1. Business.................................................................... 1
Overview.................................................................... 1
The United States Clinical Laboratory Testing Market........................ 1
Corporate Strategy and Growth Opportunities................................. 2
Our Services................................................................ 4
Routine Testing........................................................ 4
Esoteric Testing....................................................... 5
New Test Introductions................................................. 5
Clinical Trials Testing................................................ 6
Other Services and Products............................................ 6
Payers and Customers........................................................ 7
Sales and Marketing......................................................... 9
Information Systems......................................................... 9
Billing..................................................................... 10
Competition................................................................. 11
Quality Assurance........................................................... 11
Regulation of Clinical Laboratory Operations................................ 12
Healthcare Information Technology........................................... 13
Privacy and Security of Health Information; Standard Transactions........... 13
Regulation of Reimbursement for Clinical Laboratory Services................ 14
Government Investigations and Related Claims................................ 18
Compliance Program.......................................................... 19
Intellectual Property Rights................................................ 19
Insurance................................................................... 19
Employees................................................................... 20
Cautionary Statement For Purposes Of The "Safe Harbor" Provisions Of The
Private Securities Litigation Reform Act Of 1995....................... 21
Item 2. Properties................................................................. 24
Item 3. Legal Proceedings.......................................................... 24
Item 4. Submission of Matters to a Vote of Security Holders........................ 24
Item 5. Market for Registrant's Common Stock, Related Stockholder Matters and
Issuer Purchases of Equity Securities....................................... 25
Item 6. Selected Financial Data.................................................... 25
Item 7. Management's Discussion and Analysis of Financial Condition and Results of
Operations.................................................................. 26
Item 7A. Quantitative and Qualitative Disclosures About Market Risk................... 26
Item 8. Financial Statements and Supplementary Data................................ 26
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure.................................................................. 26
Item 9A. Controls and Procedures..................................................... 26
Item 9B. Other Information........................................................... 26
Item 10. Directors and Executive Officers of the Registrant......................... 27
Item 11. Executive Compensation..................................................... 27
Item 12. Security Ownership of Certain Beneficial Owners and Management............. 28
Item 13. Certain Relationships and Related Transactions............................. 28
Item 14. Principal Accounting Fees and Services..................................... 28
Item 15. Exhibits, Financial Statement Schedules.................................... 28
Selected Historical Financial Data of Our Company.................................... 33
Management's Discussion and Analysis of Financial Condition and Results of
Operations................................................................. 35
Report of Management on Internal Control Over Financial Reporting.................... 48
Report of Independent Registered Public Accounting Firm.............................. F-1
Consolidated Financial Statements and Related Notes.................................. F-3
Supplementary Data: Quarterly Operating Results (unaudited).......................... F-36
Schedule II - Valuation Accounts and Reserves........................................ F-37
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PART I
Item 1. Business
Overview
We are the nation's leading provider of diagnostic testing,
information and services, providing insights that enable physicians and other
healthcare professionals to make decisions to improve health. We offer patients
and physicians the broadest access to diagnostic laboratory services through our
nation-wide network of laboratories and patient service centers. We provide
interpretive consultation through the largest medical and scientific staff in
the industry, with approximately 400 M.D.'s and Ph.D.'s around the country. We
are the leading provider of esoteric testing, including gene-based testing, and
testing for drugs of abuse. We are also a leading provider of anatomic pathology
services and testing for clinical trials. We empower healthcare organizations
and clinicians with state-of-the-art information technology solutions that can
improve patient care and medical practice.
During 2004, we generated net revenues of $5.1 billion and processed
over 137 million requisitions for testing. Each requisition form accompanies a
patient specimen, indicating the tests to be performed and the party to be
billed for the tests. Our customers include patients, physicians, hospitals,
healthcare insurers, employers, governmental institutions and other commercial
clinical laboratories.
We operate a nationwide network of greater than 1,900 patient service
centers, principal laboratories located in more than 30 major metropolitan areas
throughout the United States, and approximately 140 smaller "rapid response"
laboratories (including, in each case, facilities operated at our joint
ventures). We provide full esoteric testing services, including gene-based
testing, on both coasts through our Quest Diagnostics Nichols Institute
facilities, located in San Juan Capistrano, California and Chantilly, Virginia.
We also have laboratory facilities in Mexico City, Mexico, San Juan, Puerto Rico
and Heston, England.
We are a Delaware corporation. We sometimes refer to our subsidiaries
and ourselves as the "Company". We are the successor to MetPath Inc., a New York
corporation that was organized in 1967. From 1982 to 1996, we were a subsidiary
of Corning Incorporated, or Corning. On December 31, 1996, Corning distributed
all of the outstanding shares of our common stock to the stockholders of
Corning. In August 1999, we completed the acquisition of SmithKline Beecham
Clinical Laboratories, Inc., or SBCL, which operated the clinical laboratory
business of SmithKline Beecham plc, or SmithKline Beecham.
Our principal executive offices are located at 1290 Wall Street West,
Lyndhurst, New Jersey 07071, telephone number: (201) 393-5000. Our filings with
the Securities and Exchange Commission, or the SEC, including our annual report
on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and
amendments to those reports, are available free of charge on our website as soon
as reasonably practicable after they are filed with, or furnished to, the SEC.
Our website is www.questdiagnostics.com.
The United States Clinical Laboratory Testing Market
Clinical laboratory testing is an essential element in the delivery of
healthcare services. Physicians use laboratory tests to assist in the detection,
diagnosis, evaluation, monitoring and treatment of diseases and other medical
conditions. Clinical laboratory testing is generally categorized as clinical
testing and anatomic pathology testing. Clinical testing is performed on body
fluids, such as blood and urine. Anatomic pathology testing is performed on
tissues and other samples, such as human cells. Most clinical laboratory tests
are considered routine and can be performed by most commercial clinical
laboratories. Tests that are not routine and that require more sophisticated
equipment and highly skilled personnel are considered esoteric tests. Esoteric
tests, including gene-based tests, are generally referred to laboratories that
specialize in performing those tests.
We believe that the United States clinical laboratory testing market
approximated $40 billion in annual revenues in 2004. Most laboratory tests are
performed by one of three types of laboratories: commercial clinical
laboratories; hospital-affiliated laboratories; and physician-office
laboratories. In 2004, we believe that hospital-affiliated laboratories
accounted for approximately 60% of the market, commercial clinical laboratories
approximately one-third, and physician-office laboratories the balance.
The underlying fundamentals of the diagnostic testing industry have
improved since the early to mid-1990s. Since that time there has been
significant industry consolidation, particularly among commercial laboratories,
resulting in fewer but larger commercial laboratories with greater economies of
scale, better equipped to service the members of large healthcare plans, and
more disciplined in their approach to operating their business. Orders for
laboratory testing are generated from physician offices, hospitals, and
employers. As such, factors including changes in the United States economy which
can affect
the number of unemployed and uninsured, and design changes in healthcare plans,
which impact the number of physician office and hospital visits, can impact the
utilization of laboratory testing.
While the diagnostic testing industry may be impacted by a number of
factors, we believe it will continue to grow over the long term as a result of
the following:
o the growing and aging population of the United States;
o continuing research and development in the area of genomics (the
study of DNA, genes and chromosomes) and proteomics (the analysis
of individual proteins and collections of proteins), which is
expected to yield new, more sophisticated and specialized
diagnostics tests;
o increasing recognition by consumers and payers of the value of
laboratory testing as a means to improve health and reduce the
overall cost of healthcare through early detection and
prevention; and
o increasing affordability of, and access to, tests due to advances
in technology and cost efficiencies.
Corporate Strategy and Growth Opportunities
Our mission is to be the undisputed world leader in diagnostic
testing, information and services. We focus on Patients, Growth and People to
help achieve our goals.
Patients are at the center of everything we do. Increasingly, patients
and their doctors have a choice when it comes to selecting a healthcare
provider, and we strive to give them new and compelling reasons to put their
trust in us. We differentiate our Company to patients and doctors by:
o Providing the Highest Quality Services: We continue to implement
Six Sigma initiatives throughout all aspects of our organization
and we are utilizing Lean Six Sigma principles to further
increase the efficiency of our operations. Six Sigma is a
management approach that enhances quality and requires a thorough
understanding of customer needs and requirements, root cause
analysis, process improvements and rigorous tracking and
measuring. Lean Six Sigma streamlines processes and eliminates
waste. We have integrated our Six Sigma initiative with our
initiative to standardize operations and processes across the
Company by adopting identified Company best practices.
Additionally, we are focusing our Six Sigma resources on
improving all aspects of our interactions with patients and
customers. This goes beyond ordering tests and getting results -
it also covers our couriers picking up samples; phlebotomists
drawing blood; medical staff performing the tests and providing
consultations; and interactions during the billing cycle.
o Offering Unparalleled Access and Distribution: We are the leader
in the clinical laboratory testing business offering the broadest
test menu and national access to testing services, with
facilities in substantially all of the major metropolitan areas
in the United States. We operate a nationwide network of greater
than 1,900 patient service centers, principal laboratories
located in more than 30 major metropolitan areas throughout the
United States and about 140 smaller "rapid response" laboratories
that enable us to serve patients, physicians, hospitals,
employers and other healthcare providers throughout the United
States. We believe that customers will increasingly seek to
utilize laboratory-testing providers that offer a comprehensive
range of tests and services and the most convenient access to
those services.
Growth will be driven organically and through acquisition. We expect
to grow organically at or above the industry growth rate by gaining more
customers and selling more to existing customers. Historically, our industry has
focused primarily on service levels and aggressive pricing to drive organic
growth. We believe that the differentiation we are creating through our focus on
Six Sigma quality, unparalleled access and distribution, the most comprehensive
test menu, and innovative test and information technology offerings will provide
us with opportunities to effectively compete beyond pricing, as we drive organic
growth. Additionally, we are expanding our sales force, providing them better
tools and training, and adding innovative, new products to sell. We are
specifically focused on driving organic growth in higher-growth areas and by
being a leading innovator. Our principal areas of focus include:
o Physician Sub Specialists: With the aging of the population, the
incidence of cancer and other disease states are increasing,
driving higher-growth in several physician sub specialties,
including urology, gastoenterology, dermatology and oncology.
Historically, we have had a smaller market share in these sub
specialties. While we
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provide a strong value proposition in the routine clinical
testing category, we have not been the provider of choice for
their more complex testing needs. We are enhancing our test menu
and service capabilities to more effectively compete in these
markets. We have added innovative tests, such as CellSearch'TM'
for women with metastatic breast cancer (see "Our Services - New
Test Introductions"), introduced new specialized medical reports,
customized specimen collection kits and added specially trained
sales representatives.
o Anatomic Pathology: We estimate that the current United States
market for anatomic pathology services is approximately $7
billion per year. We estimate that cytology represents
approximately $1.3 billion per year of this market, and that
tissue pathology represents approximately $5.7 billion per year
of this market. With the aging of the population and the
increased incidence of cancer, we believe that the tissue
pathology business is growing more rapidly than the cytology
business. We are one of the leading providers of anatomic
pathology services in the United States. We have traditionally
been strongest in cytology, and specifically in the analysis of
Pap tests to detect cervical cancer. During the last several
years, we have led the industry in converting over 85% of our Pap
testing business to the use of liquid-based technology, a more
effective means of screening for cervical cancer. We have also
enhanced patient service by adding significant choices to our
test menu, including SurePath'TM' liquid-based Pap tests and
human papilloma virus (HPV) molecular testing as part of a
primary screening tool. We intend to continue to expand our
anatomic pathology business, particularly in tissue pathology,
the higher growth and more profitable segment. In conjunction
with our physician sub-specialty focus, we have been enhancing
our anatomic pathology capabilities and service offerings and are
adding specially trained sales representatives. We generated
approximately $500 million in net revenues from anatomic
pathology services during 2004.
o Innovation Leadership: We intend to build upon our reputation as
a leading innovator in the clinical laboratory industry by
continuing to introduce new tests, technology and services. As
the industry leader with the largest and broadest network and the
leading provider of esoteric testing, we believe that we are the
best partner for developers of new technologies and tests to
introduce their products to the marketplace. Through our
relationships with members of the academic community,
pharmaceutical and biotechnology firms, and emerging medical
technology companies that develop and commercialize novel
diagnostics, pharmaceutical and device technologies, we believe
that we are one of the leaders in transferring technical
innovation to the market. Our innovation activities are focused
on:
- Gene-Based and Other Esoteric Testing Capabilities: We
intend to remain a leading innovator in the diagnostic
testing industry by continuing to introduce new tests,
technology and services. We believe that gene-based and
other esoteric tests are the fastest growing segments of
the diagnostic testing industry. We believe that we have
the largest gene-based testing business in the United
States, with approximately $600 million in net revenues
during 2004, and that this business is growing by over 10%
per year. We believe that the unveiling of the human genome,
the discovery of new genes and the linkages of these genes
with disease will result in more complex and thorough
predictive and diagnostic testing. We believe that we are
well positioned to benefit from this growth. We intend to
focus on commercializing diagnostic applications of
discoveries in the areas of functional genomics and
proteomics.
- Information Technology: We continue to invest in the
development and improvement of information technology
products for customers and healthcare providers. We plan to
develop differentiated products that will provide more
convenient ordering and resulting of laboratory tests and
patient-centric information. We believe that these products
will enhance the value we provide to our customers and
result in increased customer loyalty. Our Care360'r'
Physician Portal'TM', or Care360, enables doctors to order
diagnostic tests and review laboratory results online,
electronically prescribe and order medication at the point
of care, view clinical and administrative information from
many sources, file documents received electronically or in
hard copy into a health record, and share confidential
information with medical colleagues in a manner consistent
with the Health Insurance Portability and Accountability Act
of 1996, or HIPAA. Further, Care360 is designed to receive,
store and view clinical information from many sources,
including other healthcare providers. Care360 allows us to
replace older technology desktop products that we currently
provide to many physicians and thereby streamline our
support structure. Demand has been growing for our
information technology solutions as physicians have expanded
their usage of the Internet. By the end of 2004, we were
receiving approximately 40% of all test orders and
delivering about 60% of all test results via the Internet.
Care360 was developed by MedPlus Inc., or MedPlus, our wholly
owned subsidiary. MedPlus' ChartMaxx'r' and Care360 patient
record systems are designed to support the creation and
management of electronic patient
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records, by bringing together, in one patient-centric view,
information from various sources, including physician's records
and laboratory and hospital data. We intend to expand the
services offered through our portal over time through internal
development and forming strategic relationships.
We expect to continue pursuing growth through acquisitions.
Historically, as the clinical laboratory industry consolidated, acquisitions
contributed a significant portion of our growth. We believe that organic growth
will become more significant, while acquisitions will continue to be an
important contributor to growth.
The clinical laboratory industry remains highly fragmented. We expect
to continue to selectively evaluate potential acquisitions of regional clinical
laboratories that can be integrated into our existing laboratories, thereby
increasing access for patients and enabling us to reduce costs and improve
efficiencies. We will also selectively assess potential acquisition
opportunities that will increase clinical capabilities or geographic presence,
both domestically and internationally.
Technology is making possible the convergence of various healthcare
disciplines. Information technology will eventually enable doctors to diagnose
and treat disease by aggregating a patient's genetic predisposition, diagnostic
test results and diagnostic images into a single patient-centric electronic
medical record. Having such clinical data in one easily accessed place will
drive better decision-making and improved outcomes for patients. Accordingly,
potential acquisitions in adjacent industries such as healthcare information
technology and diagnostic imaging will also be considered. Our acquisition of
MedPlus in 2001 was our first acquisition of a healthcare information technology
company.
Acquisitions and their integration into our operations could
potentially create issues, which could cause an interruption of, or
deterioration in, our services provided to customers. Since most of our clinical
laboratory testing is performed under arrangements that are terminable at will
or on short notice, any interruption of, or deterioration in, our services may
also result in a customer's decision to stop using us for clinical laboratory
testing. These events could have a material adverse impact on our business.
However, management believes that our rigorous integration planning and
execution, and our value proposition based on expanded patient access, broad
testing capabilities, and most importantly, the quality of the services we
provide, will mitigate customer attrition.
People are the key to us being able to realize our mission. In this
regard, an important challenge is to prepare the workforce for the future. Our
people strategy is built on concepts of stringent employee selection, effective
engagement, and ongoing development which results in a staff of highly qualified
and motivated employees who are committed to our goals. Quest Diagnostics is
recognized as a "best place to work" in numerous locales as a consequence of our
workplace initiatives that reflect our belief that people are our most important
asset. We take diversity seriously, believing that every person who joins our
organization should be comfortable in the workplace and that we should
reasonably reflect the communities that we serve. We strive to make all of our
employees effective ambassadors of our Company.
Our Services
Our laboratory testing business accounts for approximately 96% of our
net revenues, with the balance derived from clinical trials testing and other
services and products. Laboratory testing includes routine testing and esoteric
testing, which generate approximately 82% and 14%, respectively, of our net
revenues. Clinical trials testing generates less than 3% of our net revenues. We
derive approximately 2% of our net revenues from foreign operations.
Routine Testing
Routine tests measure various important bodily health parameters such
as the functions of the kidney, heart, liver, thyroid and other organs. Commonly
ordered tests include:
o blood cholesterol level tests;
o complete blood cell counts;
o Pap tests;
o HIV-related tests;
o urinalyses;
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o pregnancy and other prenatal tests; and
o alcohol and other substance-abuse tests.
We perform routine testing through our network of major laboratories,
rapid response laboratories and patient service centers. We also perform routine
testing at the hospital laboratories we manage. Major laboratories offer a full
line of routine clinical tests. Rapid response laboratories are smaller
facilities where we can quickly perform an abbreviated group of routine tests
for customers that require rapid turnaround times. Patient service centers are
facilities where specimens are collected, and are typically located in or near a
building used by medical professionals.
We operate 24 hours a day, 365 days a year. We perform and report most
routine procedures within 24 hours. The majority of test results are delivered
electronically.
Esoteric Testing
Esoteric tests are those tests that require more sophisticated
technology, equipment and materials, professional "hands-on" attention and more
highly skilled professional and technical personnel, and may be performed less
frequently than routine tests. Because it is not cost-effective for most
hospital and clinical laboratories to perform low-volume esoteric tests
in-house, they generally refer many of these tests to an esoteric clinical
testing laboratory that specializes in performing these more complex tests. Due
to their complexity, esoteric tests are generally reimbursed at higher levels
than routine tests.
Our two esoteric testing laboratories, which conduct business as Quest
Diagnostics Nichols Institute, are among the leading esoteric clinical testing
laboratories in the world. In 1998, our esoteric testing laboratory in San Juan
Capistrano, California, became the first clinical laboratory in North America to
achieve ISO-9001 certification. Our esoteric testing laboratory in Chantilly,
Virginia enables us to provide full esoteric testing services on the east coast.
Our two esoteric testing laboratories perform hundreds of esoteric tests that
are not routinely performed by our regional laboratories. These esoteric tests
are generally in the following fields:
o endocrinology and metabolism (the study of glands, their hormone
secretions and their effects on body growth and metabolism);
o genetics (the study of chromosomes, genes and their protein
products and effects);
o hematology (the study of blood and bone marrow cells) and
coagulation (the process of blood clotting);
o immunology (the study of the immune system including antibodies,
immune system cells and their effects);
o microbiology and infectious diseases (the study of microscopic
forms of life including bacteria, viruses, fungi and other
infectious agents);
o oncology (the study of abnormal cell growth including benign
tumors and cancer);
o serology (a science dealing with body fluids and their analysis,
including antibodies, proteins and other characteristics); and
o toxicology (the study of chemicals and drugs and their effects on
the body's metabolism).
New Test Introductions
We intend to build upon our reputation as a leading innovator in the
clinical laboratory industry by continuing to introduce new diagnostic tests. As
the industry leader with the largest and broadest network and the leading
provider of esoteric testing, we believe that we are the best partner for
developers of new technology and tests to introduce their products to the
marketplace.
We continued to be a leading innovator in the industry in 2004, through
tests that we developed at Quest Diagnostics Nichols Institute, the largest
provider of molecular diagnostic testing in the United States, as well as
through relationships with technology developers. We believe that we are one of
the leaders in transferring technical innovations to the market, through our
relationships with members of the academic community and pharmaceutical and
biotechnology firms, as well as
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collaborations with emerging medical technology companies that develop and
commercialize novel diagnostics, pharmaceutical and device technologies.
During 2004, we introduced:
o The new CellSearch'TM' circulating tumor cell assay, licensed
from the Veridex division of Johnson & Johnson. This assay
identifies and counts circulating tumor cells in blood samples
from patients being treated for metastatic breast cancer. Results
of a prospective, multi-center study published August 19, 2004,
in the New England Journal of Medicine demonstrated that the number
of circulating tumor cells is predictive of progression free
survival and overall survival in metastatic breast cancer
patients. We are the only national commercial reference
laboratory to offer this test. Veridex received clearance from
the U.S. Food and Drug Administration in January, 2004, for the
CellSearch'TM' Epithelial Cell Kit to be used for the enumeration
of circulating tumor cells of epithelial origin in whole blood.
o Gene-based tests to detect hereditary nonpolyposis colon cancer
(HNPCC). To complement mutation analysis we developed novel
deletion assays to identify the at least 10% of HNPCC
patients with gene deletions.
o Next generation testing technology for measurement of steroid
hormones and other small molecules in blood and body fluids.
Tandem mass spectrometry (MS/MS) is a technology that offers
greater sensitivity and specificity with shorter testing time.
In the short-term, it has potential application in tests for
ovarian and testicular hormones, adrenal steroids, vitamin D,
and catecholamine metabolites.
o The TA 90 serum assay for malignant melanoma, licensed from the
John Wayne Cancer Institute in Los Angeles, California, one of
the foremost melanoma treatment centers in the world. This
assay is both sensitive and specific for melanoma and measures
circulating immune complexes to detect recurrence of disease
following curative surgery.
o New test panels to identify patients with immune-mediated gluten
sensitivity, known as celiac disease. In addition, we began to
perform HVALA typing for celiac disease risk assessment in our
Nichols Institute esoteric testing laboratory in Chantilly,
Virginia. Celiac disease is associated with specific HVALA types.
o New tests in hematopathology to help doctors diagnose, predict
response to therapy, and monitor patients with chronic
lymphocytic leukemia, the most common leukemia in the Western
world. Additionally, several assays were introduced in 2004 to
monitor the effectiveness of targeted therapy in patients with
chronic myeloid leukemia.
We believe that, with the unveiling of the human genome, new genes and
the linkages of genes with disease will continue to be discovered at an
accelerating pace, and will result in ever more complex and thorough predictive
and diagnostic testing. We believe that we are well positioned to benefit from
these advances.
Clinical Trials Testing
We believe that we are the world's second largest provider of clinical
laboratory testing performed in connection with clinical research trials on new
drugs. Clinical research trials are required by the Food and Drug
Administration, or FDA, and other international regulatory authorities to assess
the safety and efficacy of new drugs. We have clinical trials testing centers in
the United States and in the United Kingdom. We also provide clinical trials
testing in Australia, Singapore, and South Africa through arrangements with
third parties. Clinical trials involving new drugs are increasingly being
performed both inside and outside the United States. Approximately 55% of our
net revenues from clinical trials testing in 2004 represented testing for
GlaxoSmithKline plc, or GSK. We currently have a long-term contractual
relationship with GSK, under which we are the primary provider of testing to
support GSK's clinical trials testing requirements worldwide.
Other Services and Products
We manufacture and market diagnostic test kits and systems primarily
for esoteric testing through our Nichols Institute Diagnostics subsidiary. These
are sold principally to hospitals, clinical laboratories and dialysis centers,
both domestically and internationally. Our MedPlus subsidiary is a developer and
integrator of clinical connectivity and data management solutions for healthcare
organizations, physicians and clinicians primarily through its ChartMaxx'r'
electronic medical record system for hospitals and Care360. Care360 was
developed by MedPlus and enables physicians to order
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diagnostic tests and review laboratory results online; electronically prescribe
and order medication at the point of care; view clinical and administrative
information from multiple sources; file documents received electronically or in
hard copy into a health record; and share confidential patient information with
medical colleagues in a manner that is consistent with HIPAA privacy and
security requirements.
Payers and Customers
We provide testing services to a broad range of healthcare providers.
We consider a "payer" as the party that pays for the test and a "customer" as
the party who refers the test to us. Depending on the billing arrangement and
applicable law, the payer may be (1) the physician or other party (such as a
hospital, another laboratory or an employer) who referred the testing to us, (2)
the patient, or (3) a third party who pays the bill for the patient, such as an
insurance company, Medicare or Medicaid. Some states, including New York, New
Jersey and Rhode Island, prohibit us from billing physician clients. During
2004, only two customers accounted for more than 5% of our net revenues, and no
single customer accounted for more than 6% of our net revenues. We believe that
the loss of any one of our customers would not have a material adverse effect on
our financial condition, results of operations or cash flows.
The following table shows current estimates of the breakdown of the
percentage of our total volume of requisitions and total clinical laboratory net
revenues during 2004 applicable to each payer group:
Net Revenues
as % of
Requisition Volume Total
as % of Clinical Laboratory
Total Volume Net Revenues
------------ ------------
Patient................................. 2% - 5% 5% - 10%
Medicare and Medicaid................... 15% - 20% 15% - 20%
Physicians, Hospitals, Employers and
Other Monthly-Billed Clients......... 30% - 35% 20% - 25%
Healthcare Insurers-Fee-for-Service..... 30% - 35% 40% - 45%
Healthcare Insurers-Capitated........... 15% - 20% 5% - 10%
Physicians
Physicians requiring testing for patients are the primary referral
source of our clinical laboratory testing volume. Testing referred by physicians
is typically billed to healthcare insurers, government programs such as Medicare
and Medicaid, patients and physicians. We typically bill physician accounts on a
fee-for-service basis. Fees billed to physicians are based on the laboratory's
client fee schedule and are typically negotiated. Fees billed to patients and
insurance companies are based on the laboratory's patient fee schedule, subject
to any limitations on fees negotiated with the insurance companies or with
physicians on behalf of their patients. Medicare and Medicaid reimbursements are
based on fee schedules set by governmental authorities.
Healthcare Insurers
Healthcare insurers, including managed care organizations and other
healthcare insurance providers, which typically directly or indirectly contract
with a number of clinical laboratories on behalf of their members, represent
approximately one-half of our total testing volumes and one-half of our net
revenues. Larger healthcare insurers typically prefer to use large commercial
clinical laboratories because they can provide services to their members on a
national or regional basis. In addition, larger laboratories are better able to
achieve the low-cost structures necessary to profitably service the members of
large healthcare plans, and can provide test utilization data across various
products in a consistent format. Healthcare insurers frequently require test
utilization data in order to meet the reporting requirements of the National
Committee for Quality Assurance, or NCQA, to implement disease management
programs and for other health plan operation purposes. In certain markets, such
as California, healthcare insurers delegate their covered members to independent
physician associations, or IPAs, which in turn contract with laboratories for
clinical laboratory services on behalf of their members.
In recent years, there has been a shift in the way major healthcare
insurers reimburse clinical laboratories. Healthcare insurers have begun to
offer more freedom of choice to their members, including greater freedom to
determine which laboratory to use and which tests to order. Accordingly, most of
our agreements with major healthcare insurers are non-exclusive arrangements. As
a result, under these non-exclusive arrangements, physicians and patients have
more freedom of
7
choice in selecting laboratories, and laboratories are likely to compete more on
the basis of service and quality rather than price alone. Also, healthcare
insurers are increasingly offering programs such as preferred provider
organizations, or PPOs, and consumer driven plans that offer a greater choice of
healthcare providers. Pricing for these programs is typically negotiated on a
fee-for-service basis, which generally results in higher revenue per requisition
than under capitation arrangements. If consumer driven plans and PPO plans
increase in popularity, it will be increasingly important for healthcare
providers to differentiate themselves based on quality, service and convenience
to avoid competing on price alone. Under a capitation arrangement, the Company
and healthcare insurers agree to a predetermined monthly reimbursement rate for
each member of the healthcare insurer's plan, regardless of the number or cost
of services provided by the Company. Despite these trends, healthcare insurers
continue to aggressively seek cost reductions in order to keep premiums to their
customers competitive. If the Company is unable to agree on pricing with a
healthcare insurer, we could become a "non-participating" provider which may
require us to bill the patient, or in certain cases the physician, rather than
the healthcare insurer. This "non-participating" status could lead to loss of
business since typically in these instances patients have a higher co-insurance
responsibility and physicians may not refer testing to a non-participating
provider in order to avoid the additional expense for the patient.
The trend of consolidation among healthcare insurers has continued,
resulting in fewer but larger insurers with significant bargaining power in
negotiating fee arrangements with healthcare providers, including clinical
laboratories. These healthcare insurers, as well as IPAs, demand that clinical
laboratory service providers accept discounted fee structures, or assume all or
a portion of the financial risk associated with providing testing services to
their members through capitated payment arrangements. Some services, such as
various esoteric tests, new technologies and anatomic pathology services, may be
carved out from a capitated rate and, if carved out, are charged on a
fee-for-service basis. We work closely with healthcare insurers as they evaluate
new tests; however, as innovation in the testing area increases, there is no
guarantee that healthcare insurers will agree to offer the technology as a
covered service, carve out these services or reimburse them at rates that
reflect the true cost or value associated with such services.
Historically most Medicare beneficiaries were covered under the
traditional Medicare program, but the federal government has over the last
several years affected various proposals in an effort to increase enrollment of
Medicare beneficiaries in the private managed care system. With the enactment of
The Medicare Prescription Drug, Improvement and Modernization Act of 2003, or
MMA, which renamed the private Medicare program "Medicare Advantage" and created
an additional product that allows for regional Preferred Provider Organization,
it is possible that the Company may begin to experience a shift of traditional
Medicare beneficiaries to private Medicare Advantage programs.
A significant portion of the laboratory costs incurred by healthcare
insurers is for payments made to non-contracted providers (primarily hospitals)
at rates exceeding those of contracted providers. We offer QuestNet'TM', a
service whereby we develop and administer customized networks of clinical
laboratory providers for healthcare insurers. Through QuestNet'TM', physicians
and members are provided multiple choices for clinical laboratory testing while
healthcare insurers realize cost reductions from reducing testing performed by
non-contracted providers.
Hospitals
Hospitals generally maintain an on-site laboratory to perform testing
on patients and refer less frequently needed and highly specialized procedures
to outside laboratories, which typically charge the hospitals on a negotiated
fee-for-service basis. Fee schedules for hospital reference testing are
typically negotiated on behalf of the hospitals by group purchasing
organizations. We believe that most hospital laboratories perform approximately
90% to 95% of their patients' clinical laboratory tests. We provide services to
hospitals throughout the United States that vary from esoteric testing to
helping manage their laboratories. We believe that we are the industry's market
leader in servicing hospitals. Our hospital customers account for approximately
13% of our net revenues, the majority of which represents services billed to the
hospitals for certain testing that the hospitals do not perform internally.
Hospitals continue to look for ways to fully utilize their existing laboratory
capacity through test internalization as well as competing with commercial
laboratories for outreach (non-hospital patients) testing. Most physicians have
admitting privileges or other relationships with hospitals as part of their
medical practice. Many hospitals leverage their relationships with community
physicians and encourage the physicians to send their outreach testing to the
hospital's laboratory. In addition, hospitals that own physician practices
generally require the physicians to refer tests to the hospital's affiliated
laboratory.
We have dedicated sales and service teams focused on serving the unique
needs of hospital customers. We believe that the combination of full-service,
bi-coastal esoteric testing capabilities, medical and scientific professionals
for consultation, innovative connectivity products, focus on Six Sigma quality
and dedicated sales and service professionals has positioned us to be a partner
of choice for hospital customers.
8
We have joint venture arrangements with leading integrated healthcare
delivery networks in several metropolitan areas. These joint venture
arrangements, which provide testing for affiliated hospitals as well as for
unaffiliated physicians and other healthcare providers in their geographic
areas, serve as our principal laboratory facilities in their service areas.
Typically, we have either a majority ownership interest in, or day-to-day
management responsibilities for, our hospital joint venture relationships. We
also manage the laboratories at a number of other hospitals.
Employers, Governmental Institutions and Other Clinical Laboratories
We provide testing services to federal, state and local governmental
agencies and to large employers. We believe that we are the leading provider of
clinical laboratory testing to employers for drugs of abuse. We also provide
wellness testing to employers to enable employees to take an active role in
improving their health. Testing services for employers account for approximately
3% of our net revenues. The volume of testing services for employers, which
generally have relatively low profit margins, has increased moderately in 2004,
driven by an increase in hiring. We also perform esoteric testing services for
other commercial clinical laboratories that do not have a full range of testing
capabilities. All of these customers are charged on a fee-for-service basis.
Consumers
Consumers are becoming increasingly interested in managing their own
health and health records. Currently, almost all the testing we perform is
ordered directly by physicians who then receive the test results. Certain states
limit the ability of consumers to order tests themselves or to obtain test
results directly. However, over time, we believe that consumers will
increasingly want to order clinical laboratory tests themselves. We offer a
focused menu of clinical laboratory testing directly to consumers in certain
states that permit us to do so. Consumers pay for and receive the test results
directly. In each case, a physician reviews the order and result. We believe
this market will continue to grow over time.
Sales and Marketing
We market to and service our customers through our direct sales force,
healthcare insurers sales force, customer service representatives and couriers.
We focus our sales efforts on obtaining and retaining profitable
accounts. We have an active customer management process to evaluate the growth
potential and profitability of all accounts. Where appropriate, we manage
service levels, to ensure our growth and profitability goals are achieved.
Our sales force is organized by customer type with the majority of
representatives focused on marketing laboratory services to physicians,
including specialty physicians such as oncologists, urologists and
gastroenterologists. Additionally, we have a healthcare insurer sales
organization that focuses on regional and national insurance and healthcare
organizations. We also have a hospital sales organization that focuses on
meeting the unique needs of hospitals and leverages the specialized capabilities
of our Nichols Institute esoteric testing laboratories. Supporting our hospital
and physician sales teams are genomics and esoteric testing specialists, who are
specially trained and focused on educating our clients on new and more complex
tests. A smaller portion of our sales force focuses on selling
substance-of-abuse testing to employers.
Customer service representatives perform a number of services for
patients and customers. They monitor services, answer questions and help resolve
problems. Our couriers pick up specimens from most clients daily.
Our corporate marketing function is organized by customer type and is
responsible for developing and executing marketing strategies, new product
launches, and promotional and advertising support. The marketing function is
also responsible for customer satisfaction surveys, market research, tradeshow
administration, database marketing tools, and market analysis.
Information Systems
Information systems are used extensively in virtually all aspects of
our business, including laboratory testing, billing, customer service,
logistics, and management of medical data. Our success depends, in part, on the
continued and uninterrupted performance of our information technology, or IT
systems. Computer systems are vulnerable to damage from a variety of sources,
including telecommunications or network failures, malicious human acts and
natural disasters. Moreover, despite network security measures, some of our
servers are potentially vulnerable to physical or electronic break-ins, computer
viruses and similar disruptive problems. Despite the precautionary measures that
we have taken to prevent unanticipated problems that could affect our IT
systems, sustained or repeated system failures that interrupt our ability to
process test orders, deliver test
9
results or perform tests in a timely manner could adversely affect our
reputation and result in a loss of customers and net revenues.
Historically, when we acquired many of our laboratory facilities, our
regional laboratories were operated as local, decentralized units, and we did
not standardize their billing, laboratory and some of their other information
systems. This resulted in many different information systems for billing, test
results reporting, and other transactions.
During 2002, we began implementation of a standard laboratory
information system and a standard billing system. We expect the deployment of
the standardized systems will take several more years to complete and will
result in fewer systems than we have today. We expect the integration of these
systems will improve operating efficiency and provide management with more
timely and comprehensive information with which to make management decisions.
However, failure to properly implement this standardization process could
materially adversely impact us. During system conversions of this type, workflow
may be re-engineered to take advantage of enhanced system capabilities and may
cause temporary disruptions in service. In addition, the implementation process,
including the transfer of databases and master files to new data centers,
presents significant conversion risks that need to be managed carefully.
Billing
Billing for laboratory services is complicated. Depending on the
billing arrangement and applicable law, we must bill various payers, such as
patients, insurance companies, Medicare, Medicaid, doctors and employer groups,
all of which have different requirements. Additionally, other factors that
complicate billing include:
o differences between our fee schedules and the reimbursement rates
of the payers;
o disparity in coverage and information requirements among various
payers;
o incomplete or inaccurate billing information provided by ordering
physicians;
o auditing for compliance with applicable laws and regulations as
well as internal compliance policies and procedures; and
o disputes with payers as to which party is responsible for
payment.
We incur significant additional costs as a result of our participation
in Medicare and Medicaid programs, as billing and reimbursement for clinical
laboratory testing is subject to considerable and complex federal and state
regulations. These additional costs include those related to: (1) complexity
added to our billing processes; (2) training and education of our employees and
customers; (3) compliance and legal costs; and (4) costs related to, among other
factors, medical necessity denials and advance beneficiary notices. Compliance
with applicable laws and regulations, as well as internal compliance policies
and procedures, adds further complexity and costs to the billing process.
Changes in laws and regulations could negatively impact our ability to bill our
clients. The Centers for Medicare & Medicaid Services, or CMS (formerly the
Health Care Financing Administration), establishes procedures and continuously
evaluates and implements changes in the reimbursement process.
We believe that most of our bad debt expense, which was 4.4% of our net
revenues in 2004, is primarily the result of missing or incorrect billing
information on requisitions received from healthcare providers rather than
credit related issues. In general, we perform the requested tests and report
test results regardless of whether the billing information is incorrect or
missing. We subsequently attempt to contact the healthcare provider to obtain
any missing information and rectify incorrect billing information. Missing or
incorrect information on requisitions adds complexity to and slows the billing
process, creates backlogs of unbilled requisitions, and generally increases the
aging of accounts receivable. When all issues relating to the missing or
incorrect information are not resolved in a timely manner, the related
receivables are written off to the allowance for doubtful accounts.
We have significantly reduced bad debt expense as a percentage of net
revenues from about 7% during 1996 to 4.4% during 2004 by using Six Sigma and
implementing our standardization initiatives and billing "best practices". We
believe that in the longer term, with a continuing focus on process discipline
and the increased use of electronic ordering by our customers, bad debt as a
percentage of net revenues can be reduced to 4% or less (see "Regulation of
Reimbursement for Clinical Laboratory Services").
10
Competition
While there has been significant consolidation in the clinical
laboratory testing business in recent years, our industry remains fragmented and
highly competitive. We compete with three types of laboratory providers:
hospital-affiliated laboratories, other commercial clinical laboratories and
physician-office laboratories. We are the leading clinical laboratory provider
in the United States, with net revenues of $5.1 billion during 2004, and
facilities in substantially all of the country's major metropolitan areas. Our
largest competitor is Laboratory Corporation of America Holdings, Inc. In
addition, we compete with many smaller regional and local commercial clinical
laboratories, as well as laboratories owned by physicians and hospitals (see
"Payers and Customers").
We believe that healthcare providers consider a number of factors when
selecting a laboratory, including:
o service capability and quality;
o accuracy, timeliness and consistency in reporting test results;
o number and type of tests performed by the laboratory;
o number, convenience and geographic coverage of patient service
centers;
o reputation in the medical community; and
o pricing.
We believe that we compete favorably in each of these areas.
We believe that large commercial clinical laboratories may be able to
increase their share of the overall clinical laboratory testing market due to
their large service networks and lower cost structures. These advantages should
enable larger clinical laboratories to more effectively serve large customers
and members of large healthcare plans. In addition, we believe that
consolidation in the clinical laboratory testing business will continue.
However, a majority of the clinical laboratory testing is likely to continue to
be performed by hospitals, which generally have affiliations with community
physicians that refer testing to us (see "Payers and Customers - Hospitals"). As
a result of these affiliations, we compete against hospital-affiliated
laboratories primarily on the basis of service capability and quality as well as
other non-pricing factors. Our failure to provide service superior to
hospital-affiliated laboratories and other laboratories could negatively impact
our net revenues.
The diagnostic testing industry is faced with changing technology and
new product introductions. Advances in technology may lead to the development of
more cost-effective tests that can be performed outside of a commercial clinical
laboratory such as (1) point-of-care tests that can be performed by physicians
in their offices; (2) esoteric tests that can be performed by hospitals in their
own laboratories; and (3) testing that can be performed by patients in their
homes. Development of such technology and its use by our customers and patients
would reduce the demand for our laboratory testing services and negatively
impact our net revenues (see "Regulation of Clinical Laboratory Operations").
Quality Assurance
Our goal is to continually improve the processes for collection,
storage and transportation of patient specimens, as well as the precision and
accuracy of analysis and result reporting. Our quality assurance efforts focus
on proficiency testing, process audits, statistical process control and
personnel training for all of our laboratories and patient service centers. We
continue to implement our Six Sigma and standardization initiatives to help
achieve our goal of becoming recognized as the undisputed quality leader in the
healthcare services industry. Our Nichols Institute facility in San Juan
Capistrano was the first clinical laboratory in North America to achieve
ISO-9001 certification. Two of our clinical trials laboratories, our diagnostic
kits facility and one of our routine laboratories have also achieved ISO-9001
certification. These certifications are international standards for quality
management systems.
Internal Proficiency Testing, Quality Control and Audits. Quality
control samples are processed in parallel with the analysis of patient
specimens. The results of tests on quality control samples are monitored to
identify trends, biases or imprecision in the analytical processes. We also
perform internal process audits as part of our comprehensive Quality Assurance
program.
11
External Proficiency Testing and Accreditation. All of our laboratories
participate in various external quality surveillance programs. They include
proficiency testing programs administered by the College of American
Pathologists, or CAP, as well as some state agencies.
CAP is an independent, non-governmental organization of board certified
pathologists. CAP is approved by CMS to inspect clinical laboratories to
determine compliance with the standards required by the Clinical Laboratory
Improvement Amendments of 1988, or CLIA. CAP offers an accreditation program to
which laboratories may voluntarily subscribe. All of our major regional
laboratories are accredited by CAP. Accreditation includes on-site inspections
and participation in the CAP (or equivalent) proficiency testing program.
Recently the CAP has required all CAP accredited laboratories to post "whistle
blower" hotline posters to escalate quality and laboratory safety issues to CAP
that have not been resolved through other internal reporting.
Regulation of Clinical Laboratory Operations
The clinical laboratory industry is subject to significant federal and
state regulation, including inspections and audits by governmental agencies.
Governmental authorities may impose fines or criminal penalties or take other
actions to enforce laws and regulations, including revoking a clinical
laboratory's federal certification to operate a clinical laboratory operation.
Changes in regulation may increase the costs of performing clinical laboratory
tests, increase the administrative requirements of claims or decrease the amount
of reimbursement.
CLIA and State Regulation. All of our laboratories and (where
applicable) patient service centers are licensed and accredited by the
appropriate federal and state agencies. CLIA regulates virtually all clinical
laboratories by requiring they be certified by the federal government and comply
with various operational, personnel and quality requirements intended to ensure
that their clinical laboratory testing services are accurate, reliable and
timely. CLIA does not preempt state laws that are more stringent than federal
law. For example, state laws may require additional personnel qualifications,
quality control, record maintenance and/or proficiency testing. The cost of
compliance with CLIA makes it cost prohibitive for many physicians to operate
clinical laboratories in their offices. However, manufacturers of laboratory
equipment and test kits could seek to increase their sales by marketing
point-of-care laboratory equipment to physicians and by selling to both
physicians and patients test kits approved by the FDA for home use. Diagnostic
tests approved or cleared by the FDA for home use are automatically deemed to be
"waived" tests under CLIA and may be performed in physician office laboratories
with minimal regulatory oversight under CLIA as well as by patients in their
homes.
Drug Testing. The Substance Abuse and Mental Health Services
Administration, or SAMHSA, regulates drug testing for public sector employees
and employees of certain federally regulated businesses. SAMHSA has established
detailed performance and quality standards that laboratories must meet to
perform drug testing on these employees. All laboratories that perform such
testing must be certified as meeting SAMHSA standards. All of our laboratories
that perform such testing are certified as meeting SAMHSA standards.
Controlled Substances. The federal Drug Enforcement Administration, or
DEA, regulates access to controlled substances used to perform drugs of abuse
testing. Laboratories that use controlled substances must be licensed by the
DEA. All of our laboratories that use controlled substances are licensed by the
DEA.
Medical Waste, Hazardous Waste and Radioactive Materials. Clinical
laboratories are also subject to federal, state and local regulations relating
to the handling and disposal of regulated medical waste, hazardous waste and
radioactive materials. We generally use outside vendors to dispose of such
waste.
FDA. The FDA has regulatory responsibility over instruments, test kits,
reagents and other devices used to perform diagnostic testing by clinical
laboratories. In the past, the FDA has claimed regulatory authority over
laboratory-developed tests, but has exercised enforcement discretion in not
regulating most laboratory-developed tests performed by high complexity
CLIA-certified laboratories. In December 2000, the Department of Health and
Human Services, or HHS, Secretary's Advisory Committee on Genetic Testing
recommended that the FDA be the lead federal agency to regulate genetic testing.
In late 2002, a new HHS Secretary's Advisory Committee on Genetics, Health and
Society was appointed to replace the prior Advisory Committee, but it has not
yet made any final recommendations. In the meantime, the FDA is considering
revising its regulations on analyte specific reagents, which are used in
laboratory-developed tests, including laboratory-developed genetic testing.
Representatives of clinical laboratories (including Quest Diagnostics) and the
American Clinical Laboratory Association (our industry trade association) have
communicated industry concerns to representatives of the FDA regarding potential
FDA regulation of genetic testing in general and issues with regard to the
impact of potential increased oversight over analyte specific reagents. We
expect those discussions to continue. Increased FDA regulation of the reagents
used in laboratory-developed testing could lead to increased costs and delays in
introducing new tests, including genetic tests.
12
Occupational Safety. The federal Occupational Safety and Health
Administration, or OSHA, has established extensive requirements relating
specifically to workplace safety for healthcare employers. This includes
requirements to develop and implement multi-faceted programs to protect workers
from exposure to blood-borne pathogens, such as HIV and hepatitis B and C,
including preventing or minimizing any exposure through sharps or needle stick
injuries.
Specimen Transportation. Transportation of most clinical laboratory
specimens and some laboratory supplies are considered hazardous materials
subject to regulation by the Department of Transportation, the Public Health
Service, the United States Postal Service and the International Air Transport
Association (IATA).
Corporate Practice of Medicine. Many states, including some in which
our principal laboratories are located, prohibit corporations from engaging in
the practice of medicine. The corporate practice of medicine doctrine has been
interpreted in certain states to prohibit corporations from employing licensed
healthcare professionals to provide services on the corporation's behalf. The
scope of the doctrine, and how it applies, varies from state to state. In
certain states these restrictions affect our ability to directly provide
anatomic pathology services and/or to provide clinical laboratory services
directly to consumers.
Healthcare Information Technology
Clinical laboratories use information technology to obtain laboratory
orders and to communicate results and provide other reporting. Innovations in
healthcare information technology (HCIT) have the potential to improve patient
care, promote efficiency and reduce expense. Both at the federal and state
levels, there are public and private efforts to bring together healthcare
providers, information technology vendors, and other stakeholders to coordinate
federal healthcare information systems and develop a national healthcare
network, including developing standards for electronic interoperability
(standards for the exchange and use of electronic healthcare data).
Both the Company and MedPlus, its HCIT subsidiary, could be impacted by
any national healthcare information network and the adoption of standards for
HCIT interoperability, because of substantial existing investments in software
and hardware and the potential for having to make substantial future investments
to comply with new or different standards. The Company and ACLA, its trade
association, are monitoring and providing relevant information to policy makers
to ensure that issues important to medical laboratories are reflected in any
interoperability standards and that the voice of the industry and the Company
are heard.
Privacy and Security of Health Information; Standard Transactions
Pursuant to HIPAA, the Secretary of HHS has issued final regulations
designed to improve the efficiency and effectiveness of the healthcare system by
facilitating the electronic exchange of information in certain financial and
administrative transactions while protecting the privacy and security of the
information exchanged. Three principal regulations have been issued in final
form: privacy regulations, security regulations, and standards for electronic
transactions.
The HIPAA privacy regulations, which fully came into effect in April
2003, establish comprehensive federal standards with respect to the uses and
disclosures of protected health information by health plans, healthcare
providers and healthcare clearinghouses. The regulations establish a complex
regulatory framework on a variety of subjects, including:
o the circumstances under which uses and disclosures of protected
health information are permitted or required without a specific
authorization by the patient, including but not limited to treatment
purposes, activities to obtain payment for our services, and our
healthcare operations activities;
o a patient's rights to access, amend and receive an accounting of
certain disclosures of protected health information;
o the content of notices of privacy practices for protected health
information; and
o administrative, technical and physical safeguards required of
entities that use or receive protected health information.
We have implemented the HIPAA privacy regulations, as required by
law. The HIPAA privacy regulations establish a "floor" and do not supersede
state laws that are more stringent. Therefore, we are required to comply with
both federal privacy standards and varying state privacy laws. In addition, for
healthcare data transfers relating to citizens of other countries, we need to
comply with the laws of other countries. The federal privacy regulations
restrict our ability to use or
13
disclose patient-identifiable laboratory data, without patient authorization,
for purposes other than payment, treatment or healthcare operations (as defined
by HIPAA) except for disclosures for various public policy purposes and other
permitted purposes outlined in the final privacy regulations. The privacy
regulations provide for significant fines and other penalties for wrongful use
or disclosure of protected health information, including potential civil and
criminal fines and penalties. Although the HIPAA statute and regulations do not
expressly provide for a private right of damages, we also could incur damages
under state laws to private parties for the wrongful use or disclosure of
confidential health information or other private personal information.
The final HIPAA security regulations, which establish requirements for
safeguarding electronic patient information, were published on February 20, 2003
and became effective on April 21, 2003, although healthcare providers have until
April 20, 2005 to comply. We have conducted analyses and have been implementing
policies and standards to implement security measures to reasonably and
appropriately comply with the regulations' requirements by the compliance
deadline of April 20, 2005.
The final HIPAA regulations for electronic transactions, which we refer
to as the transaction standards, establish uniform standards for electronic
transactions and code sets, including the electronic transactions and code sets
used for claims, remittance advices, enrollment and eligibility. HHS issued
guidance on July 24, 2003 stating that it would not penalize a covered entity
for post-implementation date transactions that are not fully compliant with the
transactions standards, if the covered entity could demonstrate its good faith
efforts to comply with the standards.
Many of our payers were not ready to implement the transaction
standards by the October 2003 compliance deadline or were not ready to test or
trouble-shoot claims submissions. Since that time, significant progress has been
made in implementing the transaction standards with our payers. As of December
31, 2004, greater than 95% of our electronic fee-for-service claim transactions
are submitted in the new standard format and greater than 85% of our electronic
fee-for-service remittance transactions are received in the new standard format.
We are working in good faith with payers that have not converted to the new
standards to reach agreement on each payer's data requirements and to test
claims submissions.
The HIPAA transaction standards are complex, and subject to differences
in interpretation by payers. For instance, some payers may interpret the
standards to require us to provide certain types of information, including
demographic information not usually provided to us by physicians. We are working
closely with our payers to establish acceptable protocols for claims submissions
and with our trade association and an industry coalition to present issues and
problems as they arise to the appropriate regulators and standards setting
organizations.
Regulation of Reimbursement for Clinical Laboratory Services
Overview. The healthcare industry has experienced significant changes
in reimbursement practices during the past several years. Government payers,
such as Medicare (which principally serves patients 65 years and older) and
Medicaid (which principally serves indigent patients), as well as private payers
and large employers, have taken steps and may continue to take steps to control
the cost, utilization and delivery of healthcare services, including clinical
laboratory services. If we cannot offset additional reductions in the payments
we receive for our services by reducing costs, increasing test volume and/or
introducing new procedures, it could have a material adverse impact on our net
revenues and profitability.
Principally as a result of government reimbursement reductions and
measures adopted by CMS to reduce utilization described below, the percentage of
our net revenues derived from Medicare and Medicaid programs is lower that it
was prior to these measures being implemented. The cost to comply with Medicare
administrative requirements is disproportionately higher than our cost to bill
other payers, making the Medicare business generally less profitable. Medicaid
also pays substantially less, on an average per-requisition basis, than other
third party payers. However, we believe that our other business may depend, in
part, on continued participation in the Medicare and Medicaid programs, because
certain customers may want a single laboratory capable of performing all of
their clinical laboratory testing services, regardless of whether reimbursements
are ultimately made by themselves, Medicare, Medicaid or other payers.
Billing and reimbursement for clinical laboratory testing is subject to
significant and complex federal and state regulation. Penalties for violations
of laws relating to billing federal healthcare programs and for violations of
federal fraud and abuse laws include: (1) exclusion from participation in
Medicare/Medicaid programs; (2) asset forfeitures; (3) civil and criminal fines
and penalties; and (4) the loss of various licenses, certificates and
authorizations necessary to operate some or all of a clinical laboratory's
business. Civil monetary penalties for a wide range of violations are not more
than $10,000 per violation plus three times the amount claimed and, in the case
of kickback violations, not more than $50,000 per violation plus up to three
times the amount of remuneration involved. A parallel civil remedy under the
federal False Claims Act provides for damages not more than $11,000 per
violation plus up to three times the amount claimed.
14
Reduced Reimbursements. In 1984, Congress established a Medicare fee
schedule payment methodology for clinical laboratory services performed for
patients covered under Part B of the Medicare program. Congress then imposed a
national ceiling on the amount that carriers could pay under their local
Medicare fee schedules. Since then, Congress has periodically reduced the
national ceilings. The Medicare national fee schedule limitations were reduced
in 1996 to 76% of the 1984 national median of the local fee schedules and in
1998 to 74% of the 1984 national median. The national ceiling applies to tests
for which limitation amounts were established before January 1, 2001. For more
recent tests (tests for which a limitation amount is first established on or
after January 1, 2001), the limitation amount is set at 100% of the median of
all the local fee schedules established for that test in accordance with the
Social Security Act. The MMA eliminated for five years (beginning January 1,
2004) the provision for annual increases to the Medicare national fee schedule
based on the consumer price index, including the adjustment (which would have
been 2.6%) that had been scheduled for January 1, 2004. Thus, by law an
adjustment to the national fee schedule for clinical laboratory services based
on the consumer price index cannot occur before January 1, 2009. However, the
MMA added coverage for certain cardiovascular screening tests and diabetes
screening tests, subject to certain frequency limitations. The MMA evaluates new
diagnostic tests for coverage as they are introduced. In addition, the 2005
Physician Fee Schedule rule proposes to lower Medicare's payment rates for flow
cytometry services in 2005. Quest Diagnostics believes that CMS failed to
properly value these services and is commenting on this proposed change through
ACLA. Pathology services are reimbursed by Medicare based on a resource-based
relative value scale, or RBRVS, that is periodically updated by CMS.
Approximately 1% of our net revenues are derived from pathology services
reimbursed by Medicare based on RBRVS.
With regard to the rest of our laboratory services performed on behalf
of Medicare beneficiaries, we must bill the Medicare program directly and must
accept the carrier's fee schedule amount as payment in full. In addition, state
Medicaid programs are prohibited from paying more (and in most instances, pay
significantly less) than Medicare. Major clinical laboratories, including Quest
Diagnostics, typically use two fee schedules for tests billed on a
fee-for-service basis:
o "Client" fees charged to physicians, hospitals, and institutions for
which a clinical laboratory performs testing services on a wholesale
basis and which are billed on a monthly basis. These fees are
generally subject to negotiation or discount.
o "Patient" fees charged to individual patients and third-party
payers, like Medicare and Medicaid. These fees generally require
separate bills for each requisition.
The fee schedule amounts established by Medicare are typically
substantially lower than patient fees otherwise charged by us, but are sometimes
higher than our fees actually charged to certain other clients. During 1992, the
Office of the Inspector General, or OIG, of the HHS issued final regulations
that prohibited charging Medicare fees substantially in excess of a provider's
usual charges. The laboratory industry believes that the term "usual charges"
specifically applies to amounts charged to similarly-situated third-party payers
and to patients and that client fees should not be included in "usual charges".
The OIG, however, declined to provide any guidance concerning interpretation of
these rules, including whether or not discounts to non-governmental clients and
payers or the dual-fee structure might be inconsistent with these rules.
A proposed rule released in September 1997 would have authorized the
OIG to exclude providers from participation in the Medicare program, including
clinical laboratories, that charge Medicare and other programs fees that are
"substantially in excess of . . . usual charges . . . to any of [their]
customers, clients or patients". This proposal was withdrawn by the OIG in 1998.
In November 1999, the OIG issued an advisory opinion which indicated that a
clinical laboratory offering discounts on client bills may violate the "usual
charges" regulation if the "charge to Medicare substantially exceeds the amount
the laboratory most frequently charges or has contractually agreed to accept
from non-Federal payers". The OIG subsequently issued a letter clarifying that
the usual charges regulation is not a blanket prohibition on discounts to
private pay customers.
In September 2003, the OIG published a Notice of Proposed Rulemaking
that would amend the OIG's exclusion regulations addressing excessive claims.
Under the proposed exclusion rule, the OIG would have the authority to exclude a
provider for submitting claims to Medicare that contain charges that are
substantially in excess of the provider's usual charges. The proposal would
define "usual charges" as the average payment from non-government entities, on a
test by test basis, excluding capitated payments; and would define
"substantially in excess" to be an amount that is more than 20% greater than the
usual charge. We believe that the rule is unnecessary for the clinical
laboratory industry because Congress has already established fee schedules for
the services that the rule proposes to regulate. We also believe that the rule
is unworkable and overly burdensome. Through our industry trade association, we
filed comments opposing the proposed rule and we are working with our trade
association and a coalition of other healthcare providers who also oppose this
proposed regulation as drafted. If this regulation is adopted as proposed, it
could potentially reduce the amounts we bill and collect from Medicare and other
federal payers, affect the fees we charge to other payers, or subject the
Company to penalties for non-compliance, and could also be costly for us to
administer.
15
The 1997 Balanced Budget Act permits CMS to adjust statutorily
prescribed fees for some medical services, including clinical laboratory
services, if the fees are "grossly excessive". In December 2002, CMS issued an
interim final rule setting forth a process and factors for establishing a
"realistic and equitable" payment amount for all Medicare Part B services
(except physician services and services paid under a prospective payment system)
when the existing payment amounts are determined to be inherently unreasonable.
Payment amounts may be considered unreasonable because they are either grossly
excessive or deficient. CMS is expected to issue instructions to carriers on
implementation of the inherent reasonableness authority. Upon receipt of those
instructions, the carriers can then implement the final rule. We cannot provide
any assurances to investors that fees payable by Medicare could not be reduced
as a result of the application of this rule or that the government might not
assert claims for reimbursement by purporting to retroactively apply this rule
or the OIG interpretation concerning "usual charges".
Currently, Medicare does not require the beneficiary to pay a
co-payment for clinical laboratory testing. When co-payments were last in effect
before adoption of the clinical laboratory services fee schedules in 1984,
clinical laboratories received from Medicare carriers only 80% of the Medicare
allowed amount and were required to bill Medicare beneficiaries for the unpaid
balance of the Medicare allowed amount. If re-enacted, a co-payment requirement
could adversely affect the revenues of the clinical laboratory industry,
including us, by exposing the testing laboratory to the credit of individuals
and by increasing the number of bills. In addition, a laboratory could be
subject to potential fraud and abuse violations if adequate procedures to bill
and collect the co-payments are not established and followed. The Medicare
reform bill approved by the United State Senate in June 2003 included a
co-payment provision, under which clinical laboratories would receive from
Medicare carriers only 80% of the Medicare allowed amount for clinical
laboratory tests and would be required to bill Medicare beneficiaries for the
20% balance of the Medicare allowed amount. The co-payment provision was dropped
from the bill as passed (known as the Medicare Prescription Drug, Improvement,
and Modernization Act of 2003). We cannot provide any assurances to investors
that Congress would not seek to re-impose a copayment requirement payable by
Medicare beneficiaries for clinical laboratory services. Certain Medicaid
programs already require Medicaid recipients to pay co-payment amounts for
clinical laboratory testing.
Reduced Utilization of Clinical Laboratory Testing. In recent years,
CMS has taken several steps to reduce utilization of clinical laboratory
testing. Since 1995, Medicare carriers have adopted policies under which they do
not pay for many commonly ordered clinical tests unless the ordering physician
has provided an appropriate diagnosis code supporting the medical necessity of
the test. Physicians are required by law to provide diagnostic information when
they order clinical tests for Medicare and Medicaid patients. However, CMS has
not prescribed any penalty for physicians who fail to provide diagnostic
information to laboratories. Moreover, regulations adopted in accordance with
HIPAA require submission of diagnosis codes as part of the standard claims
transaction.
We are generally permitted to bill patients directly for some
statutorily excluded clinical laboratory services. If a patient signs an advance
beneficiary notice, or ABN, we are also generally permitted to bill patients for
clinical laboratory tests that Medicare does not cover due to "medical
necessity" limitations (these tests include limited coverage tests for which the
ordering physician did not provide an appropriate diagnosis code and certain
tests ordered on a patient at a frequency greater than covered by Medicare). An
ABN is a notice signed by the beneficiary which documents the patient's informed
decision to personally assume financial liability for laboratory tests which are
likely to be denied and not reimbursed by Medicare because they are deemed to be
not medically necessary. We do not have any direct contact with most of these
patients and, in such cases, cannot control the proper use of the ABN by the
physician or the physician's office staff. If the ABN is not timely provided to
the beneficiary or is not completed properly, we may end up performing tests
that we cannot subsequently bill to the patient if they are not reimbursable by
Medicare due to coverage limitations.
Inconsistent Practices. Currently, many different local carriers
administer Medicare. They have inconsistent policies on matters such as: (1)
test coverage; (2) automated chemistry panels; (3) diagnosis coding; (4) claims
documentation; and (5) fee schedules (subject to the national fee schedule
limitations). Inconsistent carrier rules and policies have increased the
complexity of the billing process for clinical laboratories. As part of the 1997
Balanced Budget Act, HHS was required to adopt uniform policies on the above
matters by January 1, 1999, and to replace the current local carriers with no
more than five regional carriers. Although HHS has finalized a number of uniform
test coverage/diagnosis coding policies, it has not taken any final action to
replace the local carriers with five regional carriers.
Carrier Jurisdiction Changes for Lab-to-lab Referrals. On October 31,
2003, CMS announced its intention to change the manner in which Medicare
contractors currently process claims for lab-to-lab referrals of clinical
laboratory tests. While laboratories are, under certain criteria, permitted to
directly bill Medicare for clinical laboratory tests they refer to other
laboratories, they must be reimbursed at the correct fee schedule amount based
on the Medicare fee schedule in effect in the Medicare carrier region in which
the test was actually performed. Historically, laboratories needed to enroll
with and file claims to multiple carriers in order to bill for such out-of-area
test referrals, to ensure receipt of the appropriate payment amount. This has
proven to be an administratively difficult process, with many obstacles to
obtaining accurate claims payment,
16
including applying the correct fee schedule. On July 1, 2004, CMS implemented a
change that mandated that the laboratory's "home" carrier maintain and apply the
clinical laboratory fee schedule applicable to the carrier region where the test
was performed. This streamlined process allows a laboratory to file all of its
clinical laboratory claims to its "home" carrier.
CMS also has announced a parallel change with regard to purchased
diagnostic interpretations (pathology services). A previously announced change
in Medicare carrier jurisdiction rules required laboratories to bill the carrier
where a purchased diagnostic interpretation service was performed. This would
have required carriers to issue Medicare provider numbers to the billing
laboratory. In October 2004, CMS posted a "change notice" permitting
laboratories to temporarily bill their local carriers for purchased diagnostic
tests or interpretations regardless of the location where the service was
furnished. The final change notice was issued on October 29, 2004, effective
April 1, 2005. The final notice requires carriers to implement a new edit to
check for duplicate claims for referred clinical diagnostic laboratory and
purchased diagnostic services submitted by physicians/suppliers to more than one
carrier.
Competitive Bidding. The MMA requires CMS to conduct a demonstration
project on the application of competitive acquisition to clinical laboratory
tests. CMS awarded the clinical laboratory competitive bidding demonstration
design and implementation contract to RTI International, Research Triangle Park,
North Carolina, and its subcontractor, Palmetto GBA. Palmetto is a Part B
carrier and previously conducted for CMS a competitive bidding demonstration for
Durable Medical Equipment (DME). A timeline in the bid package for the design
and implementation phase of the competitive bidding demonstration calls for
distribution of bid packages in December 2005. The clinical laboratory
competitive bidding demonstration project is expected to take place in two
separate locations, but other key details of the demonstration have not been
determined. Quest Diagnostics and ACLA, its trade association, will monitor the
design and implementation phase carefully because of industry concerns that the
competitive bidding demonstrations will not take into account all of the factors
involved in the timely delivery of high quality clinical laboratory testing to a
broad range of clients in diverse geographic settings.
Early in 2004, the State of Florida issued but later withdrew a Request
for Proposals for competitive bidding of clinical laboratory testing for its
Medicaid program. However, in December 2004, Florida issued an Invitation to
Negotiate (ITN) seeking competitive bids for the provision of clinical
laboratory tests on a capitated-basis for some Medicaid recipients and on a
reduced fee-for-service basis for other Medicaid recipients. The ITN
contemplates that the Florida Medicaid Agency (AHCA) will negotiate with the
three highest-scoring bidders for an exclusive statewide contract of at least
three years plus a potential renewal period. ACLA, the trade association for
clinical laboratories, filed two petitions with AHCA challenging the ITN on
public policy and legal grounds. In addition, Quest Diagnostics and another
large laboratory independently filed bid protests with AHCA. On February 18,
2005, AHCA announced, without further explanation, that it was withdrawing the
ITN. If competitive bidding were implemented on a regional or national basis for
clinical laboratory testing, it could materially adversely affect the clinical
laboratory industry and us.
Future Legislation. Future changes in federal, state and local
regulations (or in the interpretation of current regulations) affecting
governmental reimbursement for clinical laboratory testing could adversely
affect us. We cannot predict, however, whether and what type of legislative
proposals will be enacted into law or what regulations will be adopted by
regulatory authorities.
Fraud and Abuse Regulations. Medicare and Medicaid anti-kickback laws
prohibit clinical laboratories from making payments or furnishing other benefits
to influence the referral of tests billed to Medicare, Medicaid or other federal
programs. As noted above, the penalties for violation of these laws may include
criminal and civil fines and penalties and/or suspension or exclusion from
participation in federal programs. Many of the anti-fraud statutes and
regulations, including those relating to joint ventures and alliances, are vague
or indefinite and have not been interpreted by the courts. We cannot predict if
some of the fraud and abuse rules will be interpreted contrary to our practices.
In November 1999, the OIG issued an advisory opinion concluding that
the industry practice of discounting client bills may constitute a kickback if
the discounted price is below a laboratory's overall cost (including overhead)
and below the amounts reimbursed by Medicare. Advisory opinions are not binding
but may be indicative of the position that prosecutors may take in enforcement
actions. The OIG's opinion, if enforced, could result in fines and possible
exclusion and could require us to eliminate offering discounts to clients below
the rates reimbursed by Medicare. The OIG subsequently issued a letter
clarifying that it did not intend to imply that discounts are a per se violation
of the federal anti-kickback statute, but may merit further investigation
depending on the facts and circumstances presented.
In addition, since 1992, a federal anti-"self-referral" law, commonly
known as the "Stark" law, prohibits, with certain exceptions, Medicare payments
for laboratory tests referred by physicians who have, personally or through a
family member, an investment interest in, or a compensation arrangement with,
the testing laboratory. Since January 1995, these restrictions
17
have also applied to Medicaid-covered services. Many states have similar
anti-"self-referral" and other laws that are not limited to Medicare and
Medicaid referrals and could also affect investment and compensation
arrangements with physicians. We cannot predict if some of the state laws will
be interpreted contrary to our practices.
In April 2003, the OIG issued a Special Advisory Bulletin addressing
what it described as "questionable contractual arrangements" in contractual
joint ventures. The OIG Bulletin focused on arrangements where a healthcare
provider, or Owner, expands into a related healthcare business by contracting
with a healthcare provider, or Manager, that already is engaged in that line of
business for the Manager to provide related healthcare items or services to the
patients of the Owner in return for a share of the profits of the new line of
business. While we believe that the Bulletin is directed at "sham" arrangements
intended to induce referrals, we cannot predict whether the OIG might choose to
investigate all contractual joint ventures, including our joint ventures with
various hospitals or hospital systems.
Government Investigations and Related Claims
We are subject to extensive and frequently changing federal, state and
local laws and regulations. We believe that, based on our experience with
government settlements and public announcements by various government officials,
the federal government continues to strengthen its position on healthcare fraud.
In addition, legislative provisions relating to healthcare fraud and abuse give
federal enforcement personnel substantially increased funding, powers and
remedies to pursue suspected cases of fraud and abuse. Many of the regulations
applicable to us, including those relating to billing and reimbursement of tests
and those relating to relationships with physicians and hospitals, are vague or
indefinite and have not been interpreted by the courts. They may be interpreted
or applied by a prosecutorial, regulatory or judicial authority in a manner that
could require us to make changes in our operations, including our billing
practices. If we fail to comply with applicable laws and regulations, we could
suffer civil and criminal damages, including the loss of licenses or our ability
to participate in Medicare, Medicaid and other federal and state healthcare
programs. In addition, certain federal and state statues, including the qui tam
provisions of the federal False Claim Act, allow private individuals to bring
lawsuits against healthcare companies on behalf of government or private payers
alleging inappropriate billing practices.
During the mid-1990s, Quest Diagnostics and SBCL settled significant
government claims that primarily involved industry-wide billing and marketing
practices that both companies believed to be lawful. The federal or state
governments may bring additional claims based on new theories as to our
practices that we believe to be in compliance with law. The federal government
has substantial leverage in negotiating settlements since the amount of
potential damages far exceeds the rates at which we are reimbursed, and the
government has the remedy of excluding a non-compliant provider from
participation in the Medicare and Medicaid programs, which represented
approximately 17% of our net revenues during 2004.
There are certain pending lawsuits regarding our billing practices
filed under the qui tam provisions of the federal false claims statute and other
federal and state statutes. Some of the cases involve claims that are
substantial in amount. We have also received subpoenas from the United States
Attorney's Office for the Eastern District of New York requiring the production
of various business records including documents related to parathyroid hormone
testing and parathyroid hormone test kits manufactured by our subsidiary Nichols
Institute Diagnostics. We are cooperating with the government's investigation.
Although management believes that established reserves for claims are
sufficient, including qui tam cases, of which management is aware, it is
possible that additional information may become available that may cause the
final resolution of these matters to exceed established reserves by an amount
which could be material to our results of operations and cash flows in the
period in which such claims are settled. We do not believe that these issues
will have a material adverse effect on our overall financial condition. However,
we understand that there may be pending qui tam claims brought by former
employees or other "whistle blowers" as to which we have not been provided with
a copy of the complaint and accordingly cannot determine the extent of any
potential liability.
As an integral part of our compliance program discussed below, we
investigate all reported or suspected failures to comply with federal healthcare
reimbursement requirements. Any non-compliance that results in Medicare or
Medicaid overpayments is reported to the government and reimbursed by us. As a
result of these efforts, we have periodically identified and reported
overpayments. While we have reimbursed these overpayments and have taken
corrective action where appropriate, we cannot assure investors that in each
instance the government will necessarily accept these actions as sufficient.
18
Compliance Program
Compliance with all government rules and regulations has become a
significant concern throughout the clinical laboratory industry because of
evolving interpretations of regulations and the national debate over healthcare.
We established a compliance program early in 1993.
We emphasize the development of training programs intended to ensure
the strict implementation and observance of all applicable laws, regulations and
Company policies. Further, we conduct in-depth reviews of procedures, personnel
and facilities to assure regulatory compliance throughout our operations. The
Quality, Safety & Compliance Committee of the Board of Directors requires
periodic reporting of compliance operations from management.
We seek to conduct our business in compliance with all statutes and
regulations applicable to our operations. Many of these statutes and regulations
have not been interpreted by the courts. We cannot assure investors that
applicable statutes or regulations will not be interpreted or applied by a
prosecutorial, regulatory or judicial authority in a manner that would adversely
affect us. Potential sanctions for violation of these statutes include
significant damages, penalties, and fines, exclusion from participation in
governmental healthcare programs and the loss of various licenses, certificates
and authorization necessary to operate some or all of our business, which could
have a material adverse effect on our business.
Intellectual Property Rights
Other companies or individuals, including our competitors, may obtain
patents or other property rights that would prevent, limit or interfere with our
ability to develop, perform or sell our tests or operate our business. As a
result, we may be involved in intellectual property litigation and we may be
found to infringe on the proprietary rights of others, which could force us to
do one or more of the following:
o cease developing, performing or selling products or services that
incorporate the challenged intellectual property;
o obtain and pay for licenses from the holder of the infringed
intellectual property right;
o redesign or reengineer our tests;
o change our business processes; or
o pay substantial damages, court costs and attorneys' fees, including
potentially increased damages for any infringement held to be
willful.
Patents generally are not issued until several years after an
application is filed. The possibility that, before a patent is issued to a third
party, we may be performing a test or other activity covered by the patent is
not a defense to an infringement claim. Thus, even tests that we develop could
become the subject of infringement claims if a third party obtains a patent
covering those tests.
Infringement and other intellectual property claims, regardless of
their merit, can be expensive and time-consuming to litigate. In addition, any
requirement to reengineer our tests or change our business processes could
substantially increase our costs, force us to interrupt product sales or delay
new test releases. In the past, we have settled several disputes regarding our
alleged infringement of intellectual property rights of third parties. We are
currently involved in settling several additional disputes. We do not believe
that resolution of these disputes will have a material adverse effect on our
results of operations, cash flows or financial condition. However, infringement
claims could arise in the future as patents could be issued on tests or
processes that we may be performing, particularly in such emerging areas as
gene-based testing and other specialty testing.
Insurance
As a general matter, providers of clinical laboratory testing services
may be subject to lawsuits alleging negligence or other similar legal claims.
These suits could involve claims for substantial damages. Any professional
liability litigation could also have an adverse impact on our client base and
reputation. We maintain various liability insurance coverages for claims that
could result from providing or failing to provide clinical laboratory testing
services, including inaccurate testing results and other exposures. Our
insurance coverage limits our maximum exposure on individual claims; however, we
are essentially self-insured for a significant portion of these claims. The
basis for claims reserves considers actuarially determined losses based upon our
historical and projected loss experience. Management believes that present
insurance coverage and reserves are
19
sufficient to cover currently estimated exposures. Although management cannot
predict the outcome of any claims made against the Company, management does not
anticipate that the ultimate outcome of any such proceedings or claims will have
a material adverse effect on our financial position but may be material to our
results of operations and cash flows in the period in which such claims are
resolved. Similarly, although we believe that we will be able to obtain adequate
insurance coverage in the future at acceptable costs, we cannot assure you that
we will be able to do so.
Employees
At December 31, 2004, we employed approximately 38,600 people. This
total excludes employees of the joint ventures where we do not have a majority
interest. We have no collective bargaining agreements with any unions covering
any employees in the United States, and we believe that our overall relations
with our employees are good.
20
CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE
PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
Some statements and disclosures in this document are forward-looking
statements. Forward-looking statements include all statements that do not relate
solely to historical or current facts and can be identified by the use of words
such as "may", "believe", "will", "expect", "project", "estimate", "anticipate",
"plan" or "continue". These forward-looking statements are based on our current
plans and expectations and are subject to a number of risks and uncertainties
that could significantly cause our plans and expectations, including actual
results, to differ materially from the forward-looking statements. The Private
Securities Litigation Reform Act of 1995, or the Litigation Reform Act, provides
a "safe harbor" for forward-looking statements to encourage companies to provide
prospective information about their companies without fear of litigation.
We would like to take advantage of the "safe harbor" provisions of the
Litigation Reform Act in connection with the forward-looking statements included
in this document. Investors are cautioned not to unduly rely on such
forward-looking statements when evaluating the information presented in this
document. The following important factors could cause our actual financial
results to differ materially from those projected, forecasted or estimated by us
in forward-looking statements:
(a) Heightened competition, including increased pricing pressure,
competition from hospitals for testing for non-patients and
competition from physicians. See "Business - Competition".
(b) Impact of changes in payer mix, including any shift from
fee-for-service to capitated fee arrangements. See "Business -
Payers and Customers - Healthcare Insurers".
(c) Adverse actions by government or other third-party payers,
including unilateral reduction of fee schedules payable to us,
competitive bidding, or an increase in the practice of negotiating
for exclusive arrangements that involve aggressively priced
capitated payments by healthcare insurers or other payers. See
"Business - Regulation of Reimbursement for Clinical Laboratory
Services" and "Business - Payers and Customers - Healthcare
Insurers".
(d) The impact upon our testing volume and collected revenue or
general or administrative expenses resulting from our compliance
with Medicare and Medicaid administrative policies and
requirements of third party payers. These include:
(1) the requirements of Medicare carriers to provide diagnosis
codes for many commonly ordered tests and the possibility that
third party payers will increasingly adopt similar
requirements;
(2) the policy of CMS to limit Medicare reimbursement for tests
contained in automated chemistry panels to the amount that
would have been paid if only the covered tests, determined on
the basis of demonstrable "medical necessity", had been
ordered;
(3) continued inconsistent practices among the different local
carriers administering Medicare;
(4) inability to obtain from patients an advance beneficiary
notice form for tests that cannot be billed without prior
receipt of the form; and
(5) the potential need to monitor charges and lower certain fees
to Medicare to comply with the OIG's proposed rule pertaining
to exclusion of providers for submitting claims to Medicare
containing charges that are substantially in excess of the
provider's usual charges.
See "Business - Regulation of Reimbursement for Clinical
Laboratory Services" and "Business - Billing".
(e) Adverse results from pending or future government investigations,
lawsuits or private actions. These include, in particular
significant monetary damages, loss or suspension of licenses,
and/or suspension or exclusion from the Medicare and Medicaid
programs and/or other significant litigation matters. See
"Business - Government Investigations and Related Claims".
21
(f) Failure to obtain new customers at profitable pricing or failure
to retain existing customers, and a reduction in tests ordered or
specimens submitted by existing customers. Failure to negotiate
reimbursements with major healthcare insurers or other third party
payers on favorable terms.
(g) Failure to efficiently integrate acquired businesses, or to
efficiently integrate clinical laboratory businesses from joint
ventures and alliances with hospitals. See "Business - Corporate
Strategy and Growth Opportunities - Growth".
(h) Inability to obtain professional liability or other insurance
coverage or a material increase in premiums for such coverage or
reserves for self-insurance. See "Business - Insurance".
(i) Denial of CLIA certification or other licenses for any of our
clinical laboratories under the CLIA standards, revocation or
suspension of the right to bill the Medicare and Medicaid programs
or other adverse regulatory actions by federal, state and local
agencies. See "Business - Regulation of Clinical Laboratory
Operations".
(j) Changes in federal, state or local laws or regulations, including
changes that result in new or increased federal or state
regulation of commercial clinical laboratories, including
regulation by the FDA.
(k) Inability to achieve expected benefits from our acquisitions of
other businesses. See "Business - Corporate Strategy and Growth
Opportunities - Growth".
(l) Inability to achieve additional benefits from our Six Sigma and
standardization initiatives.
(m) Adverse publicity and news coverage about the clinical laboratory
industry or us.
(n) Computer or other system failures that affect our ability to
perform tests, report test results or properly bill customers,
including potential failures resulting from the standardization of
our IT systems and other system conversions, telecommunications
failures, malicious human acts (such as electronic break-ins or
computer viruses) or natural disasters. See "Business -
Information Systems" and "Business - Billing".
(o) Development of technologies that substantially alter the practice
of laboratory medicine, including technology changes that lead to
the development of more cost-effective or convenient tests such as
(1) point-of-care tests that can be performed by physicians in
their offices, (2) esoteric tests that can be performed by
hospitals in their own laboratories or (3) testing that can be
performed by patients in their homes without requiring the
services of clinical laboratories. See "Business - Competition"
and "Business - Regulation of Clinical Laboratory Operations".
(p) Issuance of patents or other property rights to our competitors or
others that could prevent, limit or interfere with our ability to
develop, perform or sell our tests or operate our business.
(q) Development of tests by our competitors or others which we may not
be able to license, or usage of our technology or similar
technologies or our trade secrets by competitors, any of which
could negatively affect our competitive position.
(r) Regulatory delay or inability to commercialize newly licensed
tests or technologies or to obtain appropriate reimbursements for
such tests.
(s) Inability to obtain or maintain adequate patent and other
propriety rights protections of our products and services or to
successfully enforce our proprietary rights.
(t) Development of an Internet-based electronic commerce business
model that does not require an extensive logistics and laboratory
network.
(u) Impact of any national healthcare information network and the
adoption of standards for health information technology
interoperability that are incompatible with existing software and
hardware infrastructure requiring widespread replacement of
systems and/or software.
22
(v) The impact of the privacy regulations, security regulations and
standards for electronic transactions regulations issued under
HIPAA and any applicable state laws or regulations. See "Business
- Privacy and Security of Health Information; Standard
Transactions".
(w) Inability to promptly or properly bill for our services or to
obtain appropriate payments for services that we do bill. See
"Business--Billing".
(x) Changes in interest rates and changes in our credit ratings from
Standard & Poor's and Moody's Investor Services causing an
unfavorable impact on our cost of and access to capital.
(y) Inability to hire and retain qualified personnel or the loss of
the services of one or more of our key senior management
personnel.
(z) Terrorist and other criminal activities, which could affect our
customers, transportation or power systems, or our facilities, and
for which insurance may not adequately reimburse us for.
23
Item 2. Properties
Our principal laboratories (listed alphabetically by state) are located
in or near the following metropolitan areas. In certain areas (indicated by the
number (2)), we have two principal laboratories as a result of recent
acquisitions.
Location Leased or Owned
- -------- ---------------
Phoenix, Arizona Leased by Joint Venture
Los Angeles, California (2) One owned, one leased
Sacramento, California Leased
San Diego, California Leased
San Jose, California Leased
San Juan Capistrano, California Owned
Denver, Colorado Leased
New Haven, Connecticut Owned
Washington, D.C. (Chantilly, Virginia) Leased
Miami, Florida (2) One owned, one leased
Tampa, Florida Owned
Atlanta, Georgia Owned
Chicago, Illinois (2) One owned, one leased
Indianapolis, Indiana Leased by Joint Venture
Lexington, Kentucky Owned
Louisville, Kentucky Leased
New Orleans, Louisiana Owned
Baltimore, Maryland Owned
Boston, Massachusetts Leased
Detroit, Michigan Leased
St. Louis, Missouri Owned
Las Vegas, Nevada Owned
New York, New York (Teterboro, New Jersey) Owned
Long Island, New York Leased
Dayton, Ohio Leased by Joint Venture
Oklahoma City, Oklahoma Leased by Joint Venture
Portland, Oregon Leased
Erie, Pennsylvania Leased by Joint Venture
Philadelphia, Pennsylvania Leased
Pittsburgh, Pennsylvania Leased
Nashville, Tennessee Leased
Dallas, Texas Leased
Houston, Texas Leased
Seattle, Washington Leased
Our executive offices are located at a leased facility in Lyndhurst,
New Jersey. We also lease a site in Norristown, Pennsylvania, that serves as a
billing center; a site in San Clemente, California, that serves as the main
facility for Nichols Institute Diagnostics; a site in Cincinnati that serves as
the main office for MedPlus; and we are reconfiguring an additional leased
building in West Hills, California, that will serve as our regional laboratory
in the Los Angeles metropolitan area. We also own an administrative office in
Collegeville, Pennsylvania, and a site in West Norriton, Pennsylvania, that
serves as our national data center. We own our laboratory facility in Mexico
City, Mexico and lease laboratory facilities in San Juan, Puerto Rico, and
Heston, England. We believe that, in general, our laboratory facilities are
suitable and adequate for our current and anticipated future levels of
operation. We believe that if we were unable to renew a lease on any of
our testing facilities, we could find alternative space at competitive
market rates and relocate our operations to such new location.
Item 3. Legal Proceedings
In addition to the investigations described in "Business - Government
Investigations and Related Claims", we are involved in various legal proceedings
arising in the ordinary course of business. Some of the proceedings against us
involve claims that are substantial in amount. Although we cannot predict the
outcome of such proceedings or any claims made against us, we do not anticipate
that the ultimate outcome of the various proceedings or claims will have a
material adverse effect on our financial position, but may be material to our
results of operations and cash flows in the period in which such proceedings or
claims are resolved.
Item 4. Submission of Matters to a Vote of Security Holders
None.
24
PART II
Item 5. Market for Registrant's Common Stock, Related Stockholder Matters and
Issuer Purchases of Equity Securities
Our common stock is listed and traded on the New York Stock Exchange
under the symbol "DGX". The following table sets forth, for the periods
indicated, the high and low sales price per share as reported on the New York
Stock Exchange Consolidated Tape and dividend information:
Common Stock Market Price Dividends
High Low Declared
---- --- --------
2003
First Quarter.................... $60.90 $47.36 $ -
Second Quarter.................... 66.24 55.14 -
Third Quarter..................... 69.25 56.42 -
Fourth Quarter.................... 74.99 59.47 0.15
2004
First Quarter.................... $85.87 $71.87 $0.15
Second Quarter.................... 88.99 80.90 0.15
Third Quarter..................... 88.39 79.10 0.15
Fourth Quarter.................... 96.82 83.16 0.15
As of February 28, 2005, we had approximately 5,600 record holders of
our common stock.
Prior to October 2003, we had not previously declared or paid cash
dividends on our common stock. We expect to fund future dividend payments with
cash flows from operations, and do not expect the dividend to have a material
impact on our ability to finance future growth.
Issuer Purchases Of Equity Securities
(d) Approximate Dollar Value
of Shares that
May Yet Be
(a) Total (c) Total Number of Shares Purchased Under
Number of (b) Average Purchased as Part of the Plans or
Shares Price Paid per Publicly Announced Plans Programs
Period Purchased Share or Programs (in thousands)
------------------ ----------- -------------- --------------------------- ----------------------------
October 1, 2004 -
October 31, 2004 90,000 $ 87.13 90,000 $ 253,464
November 1, 2004 -
November 30, 2004 815,200 $ 91.60 815,200 $ 178,794
December 1, 2004 -
December 31, 2004 2,876,000 $ 94.20 2,876,000 $ 162,186
Total 3,781,200 $ 93.47 3,781,200 $ 162,186
In 2003, our Board of Directors authorized a share repurchase program,
which permitted us to purchase up to $600 million of our common stock. In July
2004, our Board of Directors authorized us to purchase up to an additional $300
million of our common stock. Under a separate authorization from our Board of
Directors, in December 2004 we repurchased 2.7 million shares of our common
stock for approximately $254 million from GlaxoSmithKline plc. In January 2005,
our Board of Directors expanded the share repurchase authorization by an
additional $350 million, bringing the total amount authorized and available for
repurchases to $512 million as of January 27, 2005.
Item 6. Selected Financial Data
See page 33.
25
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
See page 35.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
See Management's Discussion and Analysis of Financial Condition and
Results of Operations.
Item 8. Financial Statements and Supplementary Data
See Item 15 (a) 1 and 2.
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
None.
Item 9A. Controls and Procedures
Evaluation of Disclosure Controls and Procedures - Our Chief Executive
Officer and Chief Financial Officer have evaluated the effectiveness of the
design and operation of our disclosure controls and procedures (as defined under
Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as
amended) as of the end of the period covered by this report. Based upon that
evaluation, our Chief Executive Officer and Chief Financial Officer have
concluded that our disclosure controls and procedures are adequate and
effective.
Changes in Internal Control - During the fourth quarter of 2004, there
were no changes in our internal control over financial reporting that have
materially affected, or are reasonably likely to materially affect, our internal
control over financial reporting.
Management's Report on Internal Control Over Financial Reporting
See page 48.
Item 9B. Other Information
None.
26
PART III
Item 10. Directors and Executive Officers of the Registrant
Information concerning the directors of the Company is incorporated by
reference to the information in the Company's Proxy Statement to be filed on or
before April 29, 2005, or the Proxy Statement, appearing under the caption
"Election of Directors".
Executive Officers of the Registrant
Officers of the Company are elected annually by the Board of Directors
and hold office at the discretion of the Board of Directors. The following
persons serve as executive officers of the Company:
Surya N. Mohapatra, Ph.D. (55) is Chairman of the Board, President and
Chief Executive Officer of the Company. Prior to joining the Company in February
1999 as Senior Vice President and Chief Operating Officer, he was Senior Vice
President of Picker International, a worldwide leader in advanced medical
imaging technologies, where he served in various executive positions during his
18-year tenure. Dr. Mohapatra was appointed President and Chief Operating
Officer in June 1999, the Chief Executive Officer in May 2004, and Chairman of
the Board in December 2004.
Robert A. Hagemann (48) is Senior Vice President and Chief Financial
Officer. He joined Corning Life Sciences, Inc., in 1992, where he held a variety
of senior financial positions before being named Vice President and Corporate
Controller of the Company in 1996. Prior to joining the Company, Mr. Hagemann
was employed by Prime Hospitality, Inc. and Crompton & Knowles, Inc. in senior
financial positions. He was also previously employed by Arthur Young, a
predecessor company to Ernst & Young. Mr. Hagemann assumed his present
responsibilities in August 1998.
Robert E. Peters (57) is Vice President - Sales and Marketing. He
oversees sales and marketing for our clinical laboratory testing business. Mr.
Peters joined the Company in 1997 as Managing Director of our Teterboro
laboratory, became Senior Managing Director of the New York/New Jersey region in
2000 and Regional Vice President for the East region in 2002. Mr. Peters assumed
his current position in March 2003. Prior to joining the Company, Mr. Peters was
with Ciba-Geigy Corporation, most recently serving as Vice President of
Pharmaceutical Operations.
Michael E. Prevoznik (43) is Senior Vice President and General Counsel.
Prior to joining SBCL in 1994 as its Chief Legal Compliance Officer, Mr.
Prevoznik was with Dechert Price & Rhodes. In 1996, he became Vice President and
Chief Legal Compliance Officer for SmithKline Beecham Healthcare Services. In
1998, he was appointed Vice President, Compliance for SmithKline Beecham,
assuming additional responsibilities for coordinating all compliance activities
within SmithKline Beecham worldwide. Mr. Prevoznik joined the Company as Vice
President and General Counsel in August 1999. In 2003, he assumed additional
responsibilities for corporate communications and governmental affairs, and in
2004, assumed additional responsibilities relating to the Six Sigma function.
David M. Zewe (53) is Senior Vice President, Diagnostics Testing
Services. Mr. Zewe oversees diagnostic testing operations company-wide,
including physician, clinical trials and drugs of abuse testing,
as well as the diagnostic instruments business. Mr. Zewe joined the Company in
1994 as General Manager of the Philadelphia regional laboratory, became Regional
Vice President Sales and Marketing for the mid-Atlantic region in August 1996,
became Vice President, Revenue Services in August 1999, leading the billing
function company-wide, and became Senior Vice President, U.S. Operations in
January 2001, responsible for all core business operations and revenue services.
Mr. Zewe assumed his current position in May 2002. Prior to joining the Company,
Mr. Zewe was with the Squibb Diagnostics Division of Bristol Myers Squibb, most
recently serving as Vice President of Sales.
Item 11. Executive Compensation
The information called for by this Item is incorporated by reference to
the information under the caption "Additional Information Regarding Executive
Compensation" appearing in the Proxy Statement.
27
Item 12. Security Ownership of Certain Beneficial Owners and Management
The information called for by this Item is incorporated by reference to
the information under the caption "Stock Ownership Information" and "Additional
Information Regarding Executive Compensation - Equity Compensation Plan
Information" appearing in the Proxy Statement.
Item 13. Certain Relationships and Related Transactions
The information called for by this Item is incorporated by reference to
the information under the caption "Information About Our Corporate Governance -
Related Transactions" appearing in the Proxy Statement.
Item 14. Principal Accounting Fees and Services
The information called for by this Item is incorporated by reference to
the information under the caption "Ratification of PricewaterhouseCoopers LLP as
the Company's Independent Registered Public Accounting Firm for 2005" appearing
in the Proxy Statement.
PART IV
Item 15. Exhibits, Financial Statement Schedules
(a) Documents filed as part of this report:
1.Index to financial statements and supplementary data filed as part of
this report:
Item Page
---- ----
Report of Independent Registered Public Accounting Firm.......... F-1
Consolidated Balance Sheets...................................... F-3
Consolidated Statements of Operations............................ F-4
Consolidated Statements of Cash Flows............................ F-5
Consolidated Statements of Stockholders' Equity.................. F-6
Notes to Consolidated Financial Statements....................... F-7
Supplementary Data: Quarterly Operating Results (unaudited)...... F-36
2.Financial Statement Schedule:
Item Page
---- ----
Schedule II - Valuation Accounts and Reserves.................... F-37
3.Exhibits filed as part of this report:
See (b) below.
(b) Exhibits filed as part of this report:
Exhibit
Number Description
------ -----------
3.1 Restated Certificate of Incorporation (filed as an
Exhibit to the Company's current report on Form 8-K
(Date of Report: May 31, 2001) and incorporated herein
by reference)
3.2 Amended and Restated By-Laws of the Registrant (filed as
an Exhibit to the Company's 2000 annual report on Form
10-K and incorporated herein by reference)
4.1 Form of Rights Agreement dated December 31, 1996 (the
"Rights Agreement") between Corning Clinical
Laboratories Inc. and Harris Trust and Savings Bank as
Rights Agent (filed as an Exhibit to the Company's
Registration Statement on Form 10 (File No. 001-12215)
and incorporated herein by reference)
28
4.2 Form of Amendment No. 1 effective as of July 1, 1999 to
the Rights Agreement (filed as an Exhibit to the
Company's current report on Form 8-K (Date of Report:
August 16, 1999) and incorporated herein by reference)
4.3 Form of Amendment No. 2 to the Rights Agreement (filed
as an Exhibit to the Company's 1999 annual report on
Form 10-K and incorporated herein by reference)
4.4 Form of Amendment No. 3 to the Rights Agreement (filed
as an Exhibit to the Company's 2000 annual report on
Form 10-K and incorporated herein by reference)
4.5 Form of Acceptance by National City Bank as successor
Rights Agent under the Rights Agreement (filed as an
Exhibit to the Company's 2003 annual report on Form 10-K
and incorporated herein by reference)
10.1 Form of 6 3/4% Senior Notes due 2006, including the form
of guarantee endorsed thereon (filed as an Exhibit to
the Company's current report on Form 8-K (Date of
Report: June 27, 2001) and incorporated herein by
reference)
10.2 Form of 7 1/2% Senior Notes due 2011, including the form
of guarantee endorsed thereon (filed as an Exhibit to
the Company's current report on Form 8-K (Date of
Report: June 27, 2001) and incorporated herein by
reference)
10.3 Form of 1.75% Contingent Convertible Debentures due
2021, including the form of guarantee endorsed thereon
(filed as an Exhibit to the Company's current report on
Form 8-K (Date of Report: November 26, 2001) and
incorporated herein by reference)
10.4 Indenture dated as of June 27, 2001, among the Company,
the Subsidiary Guarantors, and the Trustee (filed as an
Exhibit to the Company's current report on Form 8-K
(Date of Report: June 27, 2001) and incorporated herein
by reference)
10.5 First Supplemental Indenture, dated as of June 27, 2001,
among the Company, the Subsidiary Guarantors, and the
Trustee to the Indenture referred to in Exhibit 10.4
(filed as an Exhibit to the Company's current report on
Form 8-K (Date of Report: June 27, 2001) and
incorporated herein by reference)
10.6 Second Supplemental Indenture, dated as of November 26,
2001, among the Company, the Subsidiary Guarantors, and
the Trustee to the Indenture referred to in Exhibit 10.4
(filed as an Exhibit to the Company's current report on
Form 8-K (Date of Report: November 26, 2001) and
incorporated herein by reference)
10.7 Third Supplemental Indenture, dated as of April 4, 2002,
among Quest Diagnostics, the Additional Subsidiary
Guarantors, and the Trustee to the Indenture referred to
in Exhibit 10.4 (filed as an Exhibit to the Company's
current report on Form 8-K (Date of Report: April 1,
2002) and incorporated herein by reference)
10.8 Fourth Supplemental Indenture dated as of March 19,
2003, among Unilab Corporation (f/k/a Quest Diagnostics
Newco Incorporated), Quest Diagnostics Incorporated, The
Bank Of New York, and the Subsidiary Guarantors (filed
as an Exhibit to the Company's quarterly report on Form
10-Q for the quarter ended March 31, 2003 and
incorporated herein by reference)
10.9 Fifth Supplemental Indenture dated as of April 16, 2004,
among Unilab Acquisition Corporation (d/b/a FNA Clinics
of America), Quest Diagnostics Incorporated, The Bank Of
New York, and the Subsidiary Guarantors (filed as an
Exhibit to the Company's quarterly report on Form 10-Q
for the quarter ended March 31, 2004 and incorporated
herein by reference)
10.10 Amended and Restated Credit Agreement, dated as of April
20, 2004, among the Company, the Subsidiary Guarantors,
the lenders party thereto, and Bank of America, N.A., as
Administrative Agent (filed as an Exhibit to the
Company's quarterly report on Form 10-Q for the quarter
ended March 31, 2004 and incorporated herein by
reference)
10.11 Third Amended and Restated Credit and Security Agreement
dated as of April 20, 2004 among Quest Diagnostics
Receivables Inc., as Borrower, Quest Diagnostics
Incorporated, as Servicer, each of the lenders party
thereto and Wachovia Bank, National Association, as
Administrative Agent (filed as an Exhibit to the
Company's quarterly report on Form 10-Q for the quarter
ended March 31, 2004 and incorporated herein by
reference)
10.12 Second Amended and Restated Receivables Sale Agreement
dated as of April 20, 2004 among Quest Diagnostics
Incorporated and each of its direct or indirect wholly
owned subsidiaries who is or hereafter becomes a seller
hereunder, as the Sellers, and Quest Diagnostics
Receivables Inc., as the Buyer (filed as an Exhibit to
the Company's quarterly
29
report on Form 10-Q for the quarter ended March 31, 2004
and incorporated herein by reference)
10.13 Term Loan Credit Agreement dated as of December 19, 2003
among Quest Diagnostics Incorporated, certain subsidiary
guarantors of the Company, the lenders party thereto,
and Sumitomo Mitsui Banking Corporation (filed as an
Exhibit to the Company's 2003 annual report on Form 10-K
and incorporated herein by reference)
10.14 First Amendment to Term Loan Credit Agreement dated as
April 20, 2004 among Quest Diagnostics Incorporated,
certain subsidiary guarantors of the Company, the
lenders party thereto, and Sumitomo Mitsui Banking
Corporation (filed as an Exhibit to the Company's
quarterly report on Form 10-Q for the quarter ended June
30, 2004 and incorporated herein by reference)
10.15 Stock and Asset Purchase Agreement dated as of February
9, 1999 among SmithKline Beecham plc, SmithKline Beecham
Corporation and the Company (the "Stock and Asset
Purchase Agreement") (filed as Appendix A of the
Company's Definitive Proxy Statement dated May 11, 1999
and incorporated herein by reference)
10.16 Amendment No. 1 dated August 6, 1999 to the Stock and
Asset Purchase Agreement (filed as an Exhibit to the
Company's current report on Form 8-K (Date of Report:
August 16, 1999) and incorporated herein by reference)
10.17 Stockholders Agreement dated as of August 16, 1999
between SmithKline Beecham plc and the Company (filed as
an Exhibit to the Company's current report on Form 8-K
(Date of Report: August 16, 1999) and incorporated
herein by reference)
10.18 Amended and Restated Global Clinical Trials Agreement,
dated as of December 19, 2002 between SmithKline Beecham
plc dba GlaxoSmithKline and the Company (filed as an
Exhibit to post effective amendment No. 1 to the
Company's Registration Statement on Form S-4 (No.
333-88330) and incorporated herein by reference)
10.19 Agreement and Plan of Merger, dated as of April 2, 2002,
as amended, among the Company, Quest Diagnostics Newco
Incorporated and Unilab Corporation (filed as an annex
to the Company's final prospectus, dated August 6, 2002,
and incorporated herein by reference)
10.20 Amendment to the Agreement and Plan of Merger, dated as
of May 13, 2002, among the Company, Quest Diagnostics
Newco Incorporated and Unilab Corporation (filed as an
annex to the Company's final prospectus, dated August 6,
2002, and incorporated herein by reference)
10.21 Amendment No. 2 to the Agreement and Plan of Merger,
dated as of June 20, 2002, among the Company, Quest
Diagnostics Newco Incorporated and Unilab Corporation
(filed as an annex to the Company's final prospectus,
dated August 6, 2002, and incorporated herein by
reference)
10.22 Amendment No. 3 to the Agreement and Plan of Merger,
dated as of September 25, 2002, among the Company, Quest
Diagnostics Newco Incorporated and Unilab Corporation
(incorporated herein by reference to Exhibit (a)(11) of
the Company's Schedule TO Amendment No. 12 filed with
the Commission on September 26, 2002, File No.
001-12215)
10.23 Amendment No. 4 to the Agreement and Plan of Merger,
dated as of January 4, 2003, among the Company, Quest
Diagnostics Newco Incorporated and Unilab Corporation
(incorporated herein by reference to Exhibit (a)(20) of
Quest Diagnostics' Schedule TO Amendment No. 20 filed
with the Commission on January 6, 2003, File No.
001-12215)
10.24 Form of Employees Stock Purchase Plan, as amended
10.25 Form of 1996 Employee Equity Participation Program, as
amended (filed as an Exhibit to the Company's quarterly
report on Form 10-Q for the quarter ended September 30,
2002 and incorporated herein by reference)
10.26 Form of 1999 Employee Equity Participation Program, as
amended as of July 31, 2003 (filed as an Exhibit to the
Company's quarterly report on Form 10-Q for the quarter
ended June 30, 2003 and incorporated herein by
reference)
10.27 Form of Amended and Restated Stock Option Plan for
Non-Employee Directors (filed as an Exhibit to the
Company's current report on Form 8-K (Date of report:
December 13, 2004) and incorporated herein by reference)
10.28 Form of Amended and Restated Deferred Compensation Plan
For Directors (filed as an Exhibit to the Company's
quarterly report on Form 10-Q for the quarter ended June
30, 2003 and incorporated herein by reference)
30
10.29 Employment Agreement between the Company and Kenneth W.
Freeman dated as of January 1, 2003 (filed as an Exhibit
to the Company's 2002 annual report on Form 10-K and
incorporated herein by reference)
10.30 Letter Agreement dated April 21, 2004 between the
Company and Kenneth W. Freeman (filed as an Exhibit to
the Company's current report on Form 8-K (Date of
report: April 22, 2004) and incorporated herein by
reference)
10.31 Letter Agreement dated August 26, 2004 between the
Company and Kenneth W. Freeman (filed as an Exhibit to
the Company's current report on Form 8-K (Date of
report: August 26, 2004) and incorporated herein by
reference)
10.32 Employment Agreement between the Company and Surya N.
Mohapatra dated as of November 9, 2003 (filed as an
Exhibit to the Company's 2003 annual report on Form 10-K
and incorporated herein by reference)
10.33 Form of Supplemental Deferred Compensation Plan (filed
as an Exhibit to the Company's quarterly report on Form
10-Q for the quarter ended March 31, 2004 and
incorporated herein by reference)
10.34 Form of Executive Retirement Supplemental Plan (filed as
an Exhibit to the Company's Registration Statement on
Form 10 (File No. 001-12215) and incorporated herein by
reference)
10.35 Form of Quest Diagnostics Incorporated Supplemental
Executive Retirement Plan, effective December 14, 2004
(filed as an exhibit to the Company's current report on
Form 8-K (Date of report: December 14, 2004) and
incorporated herein by reference)
10.36 Form of Senior Management Incentive Plan (filed as
Appendix A to the Company's Definitive Proxy Statement
dated March 28, 2003 and incorporated herein by
reference)
14 Code of Business Ethics (filed as an exhibit to the
Company's current report on Form 8-K (Date of report:
October 21, 2004) and incorporated herein by reference)
21 Subsidiaries of Quest Diagnostics Incorporated
23.1 Consent of PricewaterhouseCoopers LLP
31.1 Certification of Chief Executive Officer Pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002
31.2 Certification of Chief Financial Officer Pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002
32.1 Certification of Chief Executive Officer Pursuant to 18
U.S.C. 'SS'1350, as Adopted Pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002
32.2 Certification of Chief Financial Officer Pursuant to 18
U.S.C. 'SS' 1350, as Adopted Pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002
(c) None.
31
Signatures
Pursuant to the requirements of Sections 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
Quest Diagnostics Incorporated
By /s/ Surya N. Mohapatra
---------------------------
Surya N. Mohapatra, Ph.D. Chairman, President and March 10, 2005
Chief Executive Officer
By /s/ Robert A. Hagemann
----------------------------
Robert A. Hagemann Senior Vice President and March 10, 2005
Chief Financial Officer
By /s/ Thomas F. Bongiorno
----------------------------
Thomas F. Bongiorno Vice President, Controller and March 10, 2005
Chief Accounting Officer
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
Registrant and on the dates indicated.
Capacity Date
-------- ----
/s/ Surya N. Mohapatra
------------------------------
Surya N. Mohapatra, Ph.D. Chairman, President and March 10, 2005
Chief Executive Officer
/s/ John C. Baldwin
------------------------------
John C. Baldwin, M.D. Director March 10, 2005
/s/ William F. Buehler
------------------------------
William F. Buehler Director March 10, 2005
/s/ James F. Flaherty III
------------------------------
James F. Flaherty III Director March 10, 2005
/s/ William R. Grant
------------------------------
William R. Grant Director March 10, 2005
/s/ Rosanne Haggerty
------------------------------
Rosanne Haggerty Director March 10, 2005
/s/ Gary M. Pfeiffer
------------------------------
Gary M. Pfeiffer Director March 10, 2005
/s/ Daniel C. Stanzione
------------------------------
Daniel C. Stanzione, Ph.D. Director March 10, 2005
/s/ Gail R. Wilensky
------------------------------
Gail R. Wilensky, Ph.D. Director March 10, 2005
/s/ John B. Ziegler
------------------------------
John B. Ziegler Director March 10, 2005
32
SELECTED HISTORICAL FINANCIAL DATA OF OUR COMPANY
The following table summarizes selected historical financial data of
our Company and our subsidiaries at the dates and for each of the periods
presented. We derived the selected historical financial data for the years 2000
through 2004 from the audited consolidated financial statements of our Company.
All per share data has been restated to reflect our two-for-one stock split
effected on May 31, 2001. In April 2002, the Financial Accounting Standards
Board, or FASB, issued Statement of Financial Accounting Standards, or SFAS, No.
145, "Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB
Statement No. 13, and Technical Corrections", or SFAS 145. Pursuant to SFAS 145,
extraordinary losses associated with the extinguishment of debt in 2000 and
2001, previously presented net of applicable taxes, were reclassified to other
non-operating expenses. In September 2004, the Emerging Issues Task Force
reached a final consensus on Issue 04-8, "The Effect of Contingently Convertible
Instruments on Diluted Earnings per Share", ("Issue 04-8"), effective December
31, 2004. Pursuant to Issue 04-8, we included the dilutive effect of our 1 3/4%
contingent convertible debentures issued November 26, 2001 in our dilutive
earnings per common share calculations using the if-converted method, regardless
of whether or not the holders of these securities were permitted to exercise
their conversion rights, and retroactively restated previously reported diluted
earnings per common share. References to previously reported diluted weighted
average common shares outstanding, diluted earnings per share and related
disclosures have been restated to give retroactive effect of the required change
in accounting for the years 2001 through 2003. The selected historical financial
data is only a summary and should be read together with the audited consolidated
financial statements and related notes of our Company and management's
discussion and analysis of financial condition and results of operations
included elsewhere in this Annual Report on Form 10-K.
Year Ended December 31,
------------------------------------------------------------------------------------
2004 2003 (a) 2002 (b) 2001 2000
-------------- ------------- -------------- -------------- --------------
(in thousands, except per share data)
Operations Data:
Net revenues.......................... $5,126,601 $4,737,958 $4,108,051 $3,627,771 $3,421,162
Amortization of goodwill(c)........... - - - 38,392 37,862
Operating income...................... 891,217 (d) 796,454 592,142 411,550 317,527 (e)
Loss on debt extinguishment........... - - - 42,012(f) 4,826 (g)
Net income ........................... 499,195 (d),(h) 436,717 322,154 162,303(f) 102,052 (e),(g)
Basic earnings per common share ...... $ 4.90 $ 4.22 $ 3.34 $ 1.74 $ 1.14
Diluted earnings per common
share(i)........................... $ 4.69 $ 4.04 $ 3.17 $ 1.66 $ 1.08
Dividends per common share............ $ 0.60 $ 0.15 $ - $ - $ -
Balance Sheet Data (at end of year):
Accounts receivable, net.............. $ 649,281 $ 609,187 $ 522,131 $ 508,340 $ 485,573
Goodwill, net......................... 2,506,950 2,518,875 1,788,850 1,351,123 1,235,933
Total assets.......................... 4,203,788 4,301,418 3,324,197 2,930,555 2,864,536
Long-term debt........................ 724,021 1,028,707 796,507 820,337 760,705
Preferred stock ...................... - - - -(j) 1,000
Common stockholders' equity........... 2,288,651 2,394,694 1,768,863 1,335,987 1,030,795
Other Data:
Net cash provided by operating
activities......................... $ 798,780 $ 662,799 $ 596,371 $ 465,803 $ 369,455
Net cash used in investing activities. (173,700) (417,050) (477,212) (296,616) (48,015)
Net cash used in financing activities. (706,736) (187,568) (144,714) (218,332) (177,247)
Provision for doubtful accounts....... 226,310 228,222 217,360 218,271 234,694
Rent expense.......................... 132,883 120,748 96,547 82,769 76,515
Capital expenditures.................. 176,125 174,641 155,196 148,986 116,450
- -------------------------------------------------------------------------------------------------------------------------
33
(a) On February 28, 2003, we completed the acquisition of Unilab Corporation,
or Unilab. Consolidated operating results for 2003 include the results of
operations of Unilab subsequent to the closing of the acquisition. See Note
3 to the Consolidated Financial Statements.
(b) On April 1, 2002, we completed the acquisition of American Medical
Laboratories, Incorporated, or AML. Consolidated operating results for 2002
include the results of operations of AML subsequent to the closing of the
acquisition. See Note 3 to the Consolidated Financial Statements.
(c) In July 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible
Assets", or SFAS 142, which the Company adopted on January 1, 2002. The
following table presents net income and basic and diluted earnings per
common share data adjusted to exclude the amortization of goodwill,
assuming that SFAS 142 had been in effect for the periods presented:
Year Ended December 31,
------------------------------
2001 2000
-------------- --------------
(in thousands, except per
share data)
Net income .......................................... $162,303 $102,052
Add back: Amortization of goodwill, net of taxes..... 35,964 36,023
-------- --------
Adjusted net income.................................. $198,267 $138,075
======== ========
Basic earnings per common share ..................... $ 1.74 $ 1.14
Amortization of goodwill, net of taxes............... 0.39 0.40
-------- --------
Adjusted basic earnings per common share............. $ 2.13 $ 1.54
======== ========
Diluted earnings per common share ................... $ 1.66 $ 1.08
Amortization of goodwill, net of taxes............... 0.37 0.38
-------- --------
Adjusted diluted earnings per common share........... $ 2.03 $ 1.46
======== ========
(d) During the second quarter of 2004, we recorded a $10.3 million charge
associated with the acceleration of certain pension obligations in
connection with the CEO succession process.
(e) During the second quarter of 2000, we recorded a net special charge of $2.1
million. This net charge resulted from a $13.4 million charge related to
the costs to cancel certain contracts that we believed were not
economically viable as a result of the acquisition of SmithKline Beecham
Clinical Laboratories, Inc., and which were principally associated with the
cancellation of a co-marketing agreement for clinical trials testing
services, which charges were in large part offset by a reduction in
reserves attributable to a favorable resolution of outstanding claims for
reimbursements associated with billings of certain tests.
(f) In conjunction with our debt refinancing in 2001, we recorded a loss on
debt extinguishment of $42 million. The loss represented the write-off of
deferred financing costs of $23 million, associated with the debt which was
refinanced, and $13 million of payments related primarily to the tender
premium incurred in connection with our cash tender offer of our 10 3/4%
senior subordinated notes due 2006. The remaining $6 million of losses
represented amounts incurred in conjunction with the cancellation of
certain interest rate swap agreements which were terminated in connection
with the debt that was refinanced.
(g) During the fourth quarter of 2000, we recorded a $4.8 million loss on the
extinguishment of debt representing the write-off of deferred financing
costs resulting from the prepayment of $155 million of term loans under our
then existing senior secured credit facility.
(h) During the second quarter of 2004, we recorded a $2.9 million charge to
interest expense, net representing the write-off of deferred financing
costs associated with the refinancing of our bank debt and credit facility.
(i) Potentially dilutive common shares primarily include the dilutive effect of
our 1 3/4% contingent convertible debentures, and outstanding stock options
and restricted common shares granted under our Employee Equity
Participation Program.
(j) On December 31, 2001, the Company repurchased all of its then outstanding
preferred stock for its par value of $1 million plus accrued dividends.
34
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
Overview
The underlying fundamentals of the diagnostic testing industry have
improved since the early to mid-1990s. Since that time there has been
significant industry consolidation, particularly among commercial laboratories,
resulting in fewer but larger commercial laboratories with greater economies of
scale, better equipped to service the members of large healthcare plans, and
more disciplined in their approach to operating their business. Orders for
laboratory testing are generated from physician offices, hospitals and
employers. As such, factors including changes in the United States economy which
can affect the number of unemployed and uninsured, and design changes in
healthcare plans which impact the number of physician office and hospital
visits, can impact the utilization of laboratory testing.
While the diagnostic testing industry may be impacted by a number of
factors, we believe it will continue to grow over the long term as a result of
the following:
o the growing and aging population of the United States;
o continuing research and development in the area of genomics (the
study of DNA, genes and chromosomes) and proteomics (the analysis
of individual proteins and collections of proteins), which is
expected to yield new, more sophisticated and specialized
diagnostics tests;
o increasing recognition by consumers and payers of the value of
laboratory testing as a means to improve health and reduce the
overall cost of healthcare through early detection and prevention;
and
o increasing affordability of, and access to, tests due to advances
in technology and cost efficiencies.
Quest Diagnostics, as the largest clinical laboratory testing company
with a leading position in most of its geographic markets and service offerings,
is well positioned to benefit from the growth expected in the industry.
Payments for clinical laboratory testing services are made by the
government, healthcare insurers, physicians, hospitals, employers and patients.
Physicians, hospitals and employers are typically billed on a fee-for-service
basis based on negotiated fee schedules. Fees billed to patients and healthcare
insurers are based on the laboratory's patient fee schedule, subject to any
limitations on fees negotiated with the healthcare insurers or with physicians
on behalf of their patients. Medicare and Medicaid reimbursements are based on
fee schedules set by governmental authorities.
We incur additional costs as a result of our participation in Medicare
and Medicaid programs, as billing and reimbursement for clinical laboratory
testing is subject to considerable and complex federal and state regulations.
Compliance with applicable laws and regulations, as well as internal compliance
policies and procedures, adds further complexity and costs to our operations.
While the total cost to comply with Medicare administrative requirements is
disproportionate to our cost to bill other payers, average Medicare
reimbursement rates approximate the Company's overall average reimbursement rate
from all payers, making this business generally less profitable. Government
payers, such as Medicare and Medicaid, as well as healthcare insurers and larger
employers have taken steps and may continue to take steps to control the cost,
utilization and delivery of healthcare services, including clinical laboratory
services. Principally as a result of reimbursement reductions and measures
adopted by the Centers for Medicare & Medicaid Services, or CMS, which
establishes procedures and continuously evaluates and implements changes in the
reimbursement process to control utilization, the percentage of our aggregate
net revenues derived from Medicare and Medicaid programs declined from
approximately 20% in 1995 to approximately 17% in 2004. Despite the added cost
and complexity of participating in the Medicare and Medicaid programs, we
continue to participate in such programs because we believe that our other
business may depend, in part, on continued participation in these programs,
since certain customers may want a single laboratory capable of performing all
of their clinical laboratory testing services, regardless of who pays for such
services.
Healthcare insurers, including managed care organizations and other
healthcare insurance providers, which typically contract directly or indirectly
with a number of clinical laboratories on behalf of their members, represent
approximately one-half of our total testing volumes and one-half of our net
revenues. Larger healthcare insurers
35
typically prefer to use large commercial clinical laboratories because they can
provide services to their members on a national or regional basis. In addition,
larger laboratories are better able to achieve the low-cost structures necessary
to profitably service the members of large healthcare plans, and can provide
test utilization data across various products in a consistent format. In certain
markets, such as California, healthcare insurers delegate their covered members
to independent physician associations, or IPAs, which in turn contract with
laboratories for clinical laboratory services on behalf of their members.
The trend of consolidation among healthcare insurers has continued,
resulting in fewer but larger insurers with significant bargaining power to
negotiate fee arrangements with healthcare providers, including clinical
laboratories. These healthcare insurers, as well as IPAs, demand that clinical
laboratory service providers accept discounted fee structures or assume all or a
portion of the financial risk associated with providing testing services to
their members through capitated payment arrangements. Under these capitated
payment arrangements, we and healthcare insurers agree to a predetermined
monthly reimbursement rate for each member of the healthcare insurer's plan,
regardless of the number or cost of services provided by us. Our cost to perform
work reimbursed under capitated payment arrangements is not materially different
from our cost to perform work reimbursed under other arrangements with
healthcare insurers. Since average reimbursement rates under capitated payment
arrangements are typically less than our overall average reimbursement rate, the
testing services reimbursed under capitated payment arrangements are generally
less profitable. In 2004, we derived approximately 19% of our testing volume and
7% of our net revenues from capitated payment arrangements. In recent years,
there has been a shift in the way major healthcare insurers reimburse clinical
laboratories. Healthcare insurers have begun to offer more freedom of choice to
their members, including greater freedom to determine which laboratory to use
and which tests to order. Accordingly, most of our agreements with major
healthcare insurers are non-exclusive arrangements. As a result, under these
non-exclusive arrangements, physicians and patients have more freedom of choice
in selecting laboratories, and laboratories are likely to compete more on the
basis of service and quality rather than price alone. Also, healthcare plans are
increasingly offering programs such as preferred provider organizations, or
PPOs, and consumer driven health plans that offer a greater choice of healthcare
providers. Pricing for these programs is typically negotiated on a
fee-for-service basis, which generally results in higher revenue per requisition
than under capitation arrangements. If consumer driven plans and PPO plans
increase in popularity, it will be increasingly important for healthcare
providers to differentiate themselves based on quality, service and convenience
to avoid competing on price alone.
We expect that the overall reimbursement dynamics are neutral to
slightly positive for the diagnostic testing industry. Today, many federal and
state governments face serious budget deficits and healthcare spending is a
prime target for reductions and efforts to reduce reimbursements and stringent
cost controls by government and other payers for existing tests may continue.
However, we believe that as new tests are developed which either improve on the
effectiveness of existing tests or provide new diagnostic capabilities,
government and other payers will add these tests as covered services, because of
the importance of laboratory testing in assessing and managing the health of
patients. We continue to emphasize the importance and the high value of
laboratory testing with healthcare insurers and government payers at the federal
and state level.
The diagnostic testing industry is labor intensive. Employee
compensation and benefits constitute approximately one-half of our total costs
and expenses. Cost of services consists principally of costs for obtaining,
transporting and testing specimens. Selling, general and administrative expenses
consist principally of the costs associated with our sales and marketing
efforts, billing operations (including bad debt expense), and general management
and administrative support.
Information systems are used extensively in virtually all aspects of
our business, including laboratory testing, billing, customer service,
logistics, and management of medical data. Our success depends, in part, on the
continued and uninterrupted performance of our information technology systems.
Through proper maintenance, staffing and investment in our information
technology systems, we expect to reduce the risks associated with our heavy
reliance on these systems.
The diagnostic testing industry is subject to seasonal fluctuations in
operating results and cash flows. Typically, testing volume declines during the
summer months, year-end holiday periods and other major holidays, reducing net
revenues and operating cash flows below annual averages. Testing volume is also
subject to declines in winter months due to inclement weather, which varies in
severity from year to year.
36
Six Sigma and Standardization Initiatives
We intend to become recognized as the quality leader in the healthcare
services industry through utilizing a Six Sigma approach and Lean Six Sigma
principles to further increase the efficiency of our operations. Six Sigma is a
management approach that enhances quality and requires a thorough understanding
of customer needs and requirements, root cause analysis, process improvements
and rigorous tracking and measuring of key metrics. Lean Six Sigma streamlines
processes and eliminates waste. We have integrated our Six Sigma initiative with
our initiative to standardize our operations and processes through adopting
identified Company best practices. We plan to utilize Six Sigma and continue
these initiatives to drive growth by further differentiating us from our
competition, and to improve the efficiency of our operations.
Critical Accounting Policies
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires us to make estimates
and assumptions and select accounting policies that affect our reported
financial results and the disclosure of contingent assets and liabilities.
While many operational aspects of our business are subject to complex
federal, state and local regulations, the accounting for our business is
generally straightforward with net revenues primarily recognized upon completion
of the testing process. Our revenues are primarily comprised of a high volume of
relatively low dollar transactions, and about one-half of our total costs and
expenses consist of employee compensation and benefits. Due to the nature of our
business, several of our accounting policies involve significant estimates and
judgments:
o revenues and accounts receivable associated with clinical
laboratory testing;
o reserves for general and professional liability claims;
o billing-related settlement reserves; and
o accounting for and recoverability of goodwill.
Revenues and accounts receivable associated with clinical laboratory
testing
The process for estimating the ultimate collection of receivables
associated with our clinical laboratory testing involves significant assumptions
and judgments. Billings for services reimbursed by third-party payers, including
Medicare and Medicaid, are recorded as revenues net of allowances for
differences between amounts billed and the estimated receipts from such payers.
Adjustments to the estimated receipts, based on final settlement with the
third-party payers, are recorded upon settlement as an adjustment to net
revenues.
We have implemented a standardized approach to estimate and review the
collectibility of our receivables based on a number of factors, including the
period they have been outstanding. Historical collection and payer reimbursement
experience is an integral part of the estimation process related to allowances
for doubtful accounts. In addition, we regularly assess the state of our billing
operations in order to identify issues which may impact the collectibility of
receivables or allowance estimates. We believe that the collectibility of our
receivables is directly linked to the quality of our billing processes, most
notably those related to obtaining the correct information in order to bill
effectively for the services we provide. As such, we have implemented "best
practices" to reduce the number of requisitions that we receive from healthcare
providers with missing or incorrect billing information. Revisions to the
allowances for doubtful accounts estimates are recorded as an adjustment to bad
debt expense within selling, general and administrative expenses. We believe
that our collection and allowance estimation processes, along with our close
monitoring of our billing operations, help to reduce the risk associated with
material revisions to reserve estimates. Less than 5% of our net accounts
receivable as of December 31, 2004 were outstanding more than 150 days.
Healthcare insurers
Healthcare insurers, including managed care organizations, reimburse us
for approximately one-half of our net revenues. Reimbursements from healthcare
insurers are based on negotiated fee-for-service schedules and on capitated
payment rates.
37
Receivables due from healthcare insurers represent approximately 25% of
our net accounts receivable. Substantially all of the accounts receivable due
from healthcare insurers represent amounts billed under negotiated
fee-for-service arrangements. We utilize a standard approach to establish
allowances for doubtful accounts for such receivables, which considers the aging
of the receivables and results in increased allowance requirements as the aging
of the related receivables increases. Our approach also considers historical
collection experience and other factors. Collection of such receivables is
normally a function of providing complete and correct billing information to the
healthcare insurers within the various filing deadlines. For healthcare insurers
that are invoiced electronically and remit payment electronically, collection
typically occurs within 30 days of billing. For healthcare insurers that are
invoiced electronically but remit payment manually, collection typically occurs
within 60 days of billing. For healthcare insurers that we do not invoice
electronically, collection typically occurs within 90 days of billing. Provided
healthcare insurers have been billed accurately with complete information prior
to the established filing deadline, there has historically been little to no
collection risk. If there has been a delay in billing, we determine if the
amounts in question will likely go past the filing deadline, and if so, we will
reserve accordingly for the billing.
Approximately 7% of our net revenues are reimbursed under capitated
payment arrangements in which case the healthcare insurers typically reimburse
us in the same month services are performed, essentially giving rise to no
outstanding accounts receivable at month-end. If any capitated payments are not
received on a timely basis, we determine the cause and make a separate
determination as to whether or not the collection of the amount from the
healthcare insurer is at risk and if so, would reserve accordingly.
Government payers
Payments for clinical laboratory services made by the government are
based on fee schedules set by governmental authorities. Receivables due from
government payers under the Medicare and Medicaid programs represent
approximately 15% of our net accounts receivable. Collection of such receivables
is normally a function of providing the complete and correct billing information
within the various filing deadlines. Collection typically occurs within 30 days
of billing. Our processes for billing, collecting and estimating uncollectible
amounts for receivables due from government payers, as well as the risk of
non-collection, are substantially the same as those noted above for healthcare
insurers under negotiated fee-for-service arrangements.
Client payers
Client payers include physicians, hospitals, employers and other
commercial laboratories, and are billed based on a negotiated fee schedule.
Receivables due from client payers represent approximately 30% of our net
accounts receivable. Credit risk and ability to pay are more of a consideration
for these payers than healthcare insurers and government payers. We utilize a
standard approach to establish allowances for doubtful accounts for such
receivables, which considers the aging of the receivables and results in
increased allowance requirements as the aging of the related receivables
increases. Our approach also considers specific account reviews, historical
collection experience and other factors.
Patient receivables
Patients are billed based on established patient fee schedules, subject
to any limitations on fees negotiated with healthcare insurers or physicians on
behalf of the patient. Receivables due from patients represent approximately 30%
of our net accounts receivable. Collection of receivables due from patients is
subject to credit risk and ability of the patients to pay. We utilize a standard
approach to establish allowances for doubtful accounts for such receivables,
which considers the aging of the receivables and results in increased allowance
requirements as the aging of the related receivables increases. Our approach
also considers historical collection experience and other factors. Patient
receivables are generally fully reserved for when the related billing reaches
210 days outstanding. Balances are automatically written off when they are sent
to collection agencies. Reserves are adjusted for estimated recoveries of
amounts sent to collection agencies based on historical collection experience,
which is regularly monitored.
Reserves for general and professional liability claims
As a general matter, providers of clinical laboratory testing services
may be subject to lawsuits alleging negligence or other similar legal claims.
These suits could involve claims for substantial damages. Any professional
liability litigation could also have an adverse impact on our client base and
reputation. We maintain various liability insurance coverages for claims that
could result from providing or failing to provide clinical laboratory testing
services, including inaccurate testing results and other exposures. Our
insurance coverage limits our maximum
38
exposure on individual claims; however, we are essentially self-insured for a
significant portion of these claims. While the basis for claims reserves
considers actuarially determined losses based upon our historical and projected
loss experience, the process of analyzing, assessing and establishing reserve
estimates relative to these types of claims involves a high degree of judgment.
Changes in the facts and circumstances associated with claims could have a
material impact on our results of operations, principally costs of services, and
cash flows in the period that reserve estimates are revised. Although we believe
that our present insurance coverage and reserves are sufficient to cover
currently estimated exposures, it is possible that we may incur liabilities in
excess of our insurance coverage or recorded reserves. Similarly, although we
believe that we will be able to obtain adequate insurance coverage in the future
at acceptable costs, it is possible that we may not be able to do so.
Billing-related settlement reserves
Our business is subject to extensive and frequently changing federal,
state and local laws and regulations. We have previously entered into several
settlement agreements with various government and private payers relating to
industry-wide billing and marketing practices that had been substantially
discontinued by the mid-1990s. In addition, we are aware of several pending
lawsuits filed under the qui tam provisions of the civil False Claims Act and
other federal and state statutes. We have a comprehensive compliance program
that is intended to ensure the strict implementation and observance of all
applicable laws, regulations and Company policies. The Quality, Safety &
Compliance Committee of the Board of Directors requires periodic reporting of
compliance operations from management. As an integral part of our compliance
program, we investigate all reported or suspected failures to comply with
federal healthcare reimbursement requirements. Any non-compliance that results
in Medicare or Medicaid overpayments is reported to the government and
reimbursed by us. As a result of these efforts, we have periodically identified
and reported overpayments. Upon becoming aware of potential overpayments, we
will consider all available facts and circumstances to estimate and record the
amounts to be reimbursed. While we have reimbursed these overpayments and have
taken corrective action where appropriate, we cannot assure investors that in
each instance the government will necessarily accept these actions as
sufficient.
Although management believes that established reserves for claims are
sufficient, it is possible that additional information (such as the indication
by the government of criminal activity, additional tests being questioned or
other changes in the government's or private claimants' theories of wrongdoing)
may become available which may cause the final resolution of these matters to
exceed established reserves by an amount which could be material to our results
of operations and cash flows in the period in which such claims are settled. We
do not believe that these issues will have a material adverse effect on our
overall financial condition. However, we understand that there may be pending
qui tam claims brought by former employees or other "whistle blowers", or other
pending claims as to which we have not been provided with a copy of the
complaint and accordingly cannot determine the extent of any potential
liability.
Accounting for and recoverability of goodwill
Goodwill is our single largest asset. We evaluate the recoverability
and measure the potential impairment of our goodwill under Statement of
Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets".
The annual impairment test is a two-step process that begins with the estimation
of the fair value of the reporting unit. The first step screens for potential
impairment and the second step measures the amount of the impairment, if any.
Our estimate of fair value considers publicly available information regarding
the market capitalization of our Company, as well as (i) publicly available
information regarding comparable publicly-traded companies in the clinical
laboratory testing industry, (ii) the financial projections and future prospects
of our business, including its growth opportunities and likely operational
improvements, and (iii) comparable sales prices, if available. As part of the
first step to assess potential impairment, we compare our estimate of fair value
for the Company to the book value of our consolidated net assets. If the book
value of our consolidated net assets is greater than our estimate of fair value,
we would then proceed to the second step to measure the impairment, if any. The
second step compares the implied fair value of goodwill with its carrying value.
The implied fair value is determined by allocating the fair value of the
reporting unit to all of the assets and liabilities of that unit as if the
reporting unit had been acquired in a business combination and the fair value of
the reporting unit was the purchase price paid to acquire the reporting unit.
The excess of the fair value of the reporting unit over the amounts assigned to
its assets and liabilities is the implied fair value of goodwill. If the
carrying amount of the reporting unit's goodwill is greater than its implied
fair value, an impairment loss will be recognized in the amount of the excess.
We believe our estimation methods are reasonable and reflect common valuation
practices.
On a quarterly basis, we perform a review of our business to determine
if events or changes in circumstances have occurred which could have a material
adverse effect on the fair value of the Company and its goodwill. If such events
or changes in circumstances were deemed to have occurred, we would perform an
impairment test of goodwill
39
as of the end of the quarter, consistent with the annual impairment test
performed at the end of our fiscal year on December 31st, and record any noted
impairment loss.
Results of Operations
Year Ended December 31, 2004 Compared with Year Ended December 31, 2003
Net income for the year ended December 31, 2004 increased to $499
million from $437 million for the prior year period. This increase in earnings
was primarily attributable to revenue growth and efficiencies generated from our
Six Sigma and standardization initiatives, partially offset by investments in
our operations. For the year ended December 31, 2004, the increase in earnings
was partially offset by the impact of $13.2 million in pre-tax charges recorded
in the second quarter of 2004. Included in the second quarter charges was $10.3
million related to the acceleration of certain pension obligations in connection
with the CEO succession process with the remaining $2.9 million representing the
write-off of deferred financing costs associated with a refinancing. These
charges served to reduce reported net income for the year ended December 31,
2004 by $7.9 million and reduced basic and diluted earnings per common share by
$0.08.
Net Revenues
Net revenues for the year ended December 31, 2004 grew by 8.2% over the
prior year level. Including twelve months of Unilab Corporation's, or Unilab's,
results in 2004 (which was acquired on February 28, 2003), versus ten months of
Unilab's results in the prior year, contributed 1.5% to consolidated revenue
growth. The increase in net revenues was primarily driven by improvements in
testing volumes and increases in average revenue per requisition. Pro forma
revenue growth was 6.7% for the year ended December 31, 2004, assuming that the
Unilab acquisition and the related sale of certain assets in northern
California, or the Divestiture, had been completed on January 1, 2003.
For the year ended December 31, 2004, clinical testing volume, measured
by the number of requisitions, increased 5.0% compared to the prior year period.
On a pro forma basis, assuming that the Unilab acquisition and the Divestiture
had been completed on January 1, 2003, testing volume increased 3.2% for the
year ended December 31, 2004.
Average revenue per requisition improved 2.6% for the year ended
December 31, 2004 compared to the prior year period. This improvement is
primarily attributable to a continuing shift in test mix to higher value
testing, including gene-based testing, and increases in the number of tests
ordered per requisition. These factors are expected to continue as the primary
drivers of increases in revenue per requisition, although to a lesser extent
than the past several years. Gene-based testing revenues approximated $600
million for 2004, and grew over 10% compared to the prior year. The inclusion of
Unilab's results subsequent to February 28, 2003 served to reduce average
revenue per requisition by 0.4% for the year ended December 31, 2004, reflecting
Unilab's lower revenue per requisition.
Drugs of abuse testing, which is among our lowest priced services and
accounts for approximately 6% of our volume and 3% of our consolidated net
revenues, grew for the first year after several years of decline. However,
growth in this business remained below that for our consolidated business.
Our businesses other than clinical laboratory testing, which represent
approximately 4% of our consolidated net revenues, grew approximately 20% during
the year ended December 31, 2004 compared to the prior year period, and
contributed about one-half of a percent to reported net revenue growth.
Operating Costs and Expenses
Total operating costs and expenses for the year ended December 31, 2004
increased $294 million from the prior year period primarily due to increases in
our clinical testing volume. The increased costs were primarily in the areas of
employee compensation and benefits and testing supplies. While our cost
structure has been favorably impacted by efficiencies generated from our Six
Sigma and standardization initiatives, we continue to make investments in sales,
service, science, and information technology to further differentiate our
company. These investments include:
o Expansion of our sales force, particularly in high-growth
specialty testing areas, and improved sales training and sales
tools;
40
o Continuously improving service levels and their consistency using
Six Sigma;
o Making specimen collection more convenient for patients by adding
phlebotomists and expanding hours of operation in our patient
service centers;
o Continuing to strengthen our medical and scientific capabilities
by adding leading experts in various disease states and emerging
diagnostic areas; and
o Enhancing our information technology infrastructure and
development capabilities supporting our products which enable
healthcare providers to order and receive laboratory test results,
order prescriptions electronically, and create, collect, manage
and exchange healthcare information.
Cost of services, which includes the costs of obtaining, transporting
and testing specimens, was 58.3% of net revenues for the year ended December 31,
2004, decreasing from 58.4% of net revenues in the prior year period. This
improvement was primarily the result of the increase in average revenue per
requisition and efficiency gains resulting from our Six Sigma and
standardization initiatives. This improvement was partially offset by initial
installation costs associated with deploying our Internet-based orders and
results systems in physicians' offices and an increase in the number of
phlebotomists in our patient service centers to support an increasing percentage
of our volume generated from these sites. At December 31, 2004, approximately
40% of our orders and 60% of our test results were being transmitted via the
Internet. The increase in the number of orders and test results reported via our
Internet-based systems is improving the initial collection of billing
information which is reducing the cost of billing and bad debt expense, both of
which are components of selling, general and administrative expenses.
Additionally, we believe that the number of physicians who no longer draw blood
in their offices continues to increase, which is resulting in an increase in the
number of blood draws in our patient service centers and by our phlebotomists
placed in physicians' offices. This shift has increased our operating costs
associated with our blood draws, but is reducing costs in accessioning and other
parts of our operations due to improved billing information, and a reduction in
the number of inadequate patient samples because our phlebotomists are
specifically trained in these areas.
Selling, general and administrative expenses, which include the costs
of the sales force, billing operations, bad debt expense and general management
and administrative support, was 23.9% of net revenues during the year ended
December 31, 2004, decreasing from 24.6% in the prior year period. This
improvement was primarily due to efficiencies from our Six Sigma and
standardization initiatives and the improvement in average revenue per
requisition. Partially offsetting these improvements are additional costs for
expanding our sales force and enhancing their training. During 2004, bad debt
expense improved to 4.4% of net revenues, compared to 4.8% in the prior year
period. This decrease primarily relates to the improved collection of diagnosis,
patient and insurance information necessary to more effectively bill for
services performed. We believe that our Six Sigma and standardization
initiatives and the increased use of electronic ordering by our customers will
provide additional opportunities to further improve our overall collection
experience and cost structure.
Other operating expense (income), net represents miscellaneous income
and expense items related to operating activities, including gains and losses
associated with the disposal of operating assets. For the year ended December
31, 2004, other operating expense (income), net includes a $10.3 million second
quarter charge associated with the acceleration of certain pension obligations
in connection with the CEO succession process. For the year ended December 31,
2003, other operating expense (income), net includes $3.3 million of gains on
the sale of certain operating assets, partially offset by a $1.1 million charge
associated with the integration of Unilab.
Operating Income
Operating income for the year ended December 31, 2004 improved to $891
million, or 17.4% of net revenues, from $796 million, or 16.8% of net revenues,
in the prior year period. The increase in operating income for the year ended
December 31, 2004 was principally driven by revenue growth and efficiencies
generated from our Six Sigma and standardization initiatives, which have reduced
both the cost of services and selling, general and administrative expenses as a
percentage of net revenues. Partially offsetting these improvements were
investments in our operations and a charge in the second quarter of 2004 of
$10.3 million associated with the CEO succession process. This charge reduced
operating income, as a percentage of net revenues, by 0.2% for the year ended
December 31, 2004.
41
Other Income (Expense)
Interest expense, net for the year ended December 31, 2004 decreased
from the prior year period primarily due to a reduction in borrowing costs
associated with our 2004 refinancing. In addition, interest expense, net for
2004 included a $2.9 million second quarter charge representing the write-off of
deferred financing costs associated with the refinancing of our bank debt and
credit facility. Our 2004 debt refinancing, which was done to take advantage of
the improved lending environment and our improved credit profile, is discussed
further in Note 10 to the Consolidated Financial Statements.
Other income, net represents miscellaneous income and expense items
related to non-operating activities such as gains and losses associated with
investments and other non-operating assets.
Year Ended December 31, 2003 Compared with Year Ended December 31, 2002
Net income for the year ended December 31, 2003 increased to $437
million from $322 million for the prior year period. This increase in earnings
was primarily attributable to revenue growth and improved efficiencies generated
from our Six Sigma and standardization initiatives.
Net Revenues
Net revenues for the year ended December 31, 2003 grew by 15.3% over
the prior year level and included the results of Unilab, which was acquired on
February 28, 2003, for ten months. Net revenues for 2003 also included twelve
months of results for American Medical Laboratories, Incorporated, or AML, which
was acquired on April 1, 2002. Pro forma revenue growth was 4.3% for the year
ended December 31, 2003, assuming that the Unilab and AML acquisitions and the
related Divestiture had been completed on January 1, 2002.
For the year ended December 31, 2003, clinical testing volume, measured
by the number of requisitions, increased 11.3% compared to 2002. On a pro forma
basis, assuming that the Unilab and AML acquisitions and the Divestiture had
been completed on January 1, 2002, testing volume declined 1.2%. The combined
effect of the severe winter storms and the New Jersey physicians' strike during
the first quarter of 2003, and Hurricane Isabel and the blackout in the third
quarter of 2003 reduced testing volume by approximately 0.5% for the year ended
December 31, 2003. In addition, our drugs-of-abuse testing business, which is
most directly impacted by economic conditions and accounts for approximately 3%
of our net revenues and 6% of our testing volume, declined during 2003, reducing
company-wide testing volume growth by approximately 0.5%. Both reported and pro
forma testing volume were impacted by general economic conditions, which
increased the number of uninsured and unemployed and, we believe, reduced
utilization of healthcare services in 2003.
For the year ended December 31, 2003, average revenue per requisition
improved 3.6%, or 5.1% on a pro forma basis, assuming that the Unilab and AML
acquisitions and the Divestiture had been completed on January 1, 2002. These
improvements in average revenue per requisition were primarily attributable to a
continuing shift in test mix to higher value testing, including gene-based and
esoteric testing. Gene-based testing net revenues exceeded $500 million for
2003, and grew over 20% compared to the prior year. In addition, a shift in
payer mix to higher priced fee-for-service reimbursement contributed a portion
of the increase in average revenue per requisition. The inclusion of Unilab's
results subsequent to February 28, 2003 served to reduce average revenue per
requisition, reflecting Unilab's lower revenue per requisition.
Our businesses, other than clinical laboratory testing, which represent
approximately 4% of our consolidated net revenues, grew approximately 16% during
the year and contributed about 0.5% to the reported growth in net revenues.
Operating Costs and Expenses
Total operating costs and expenses for 2003 increased $426 million from
2002 primarily due to increases in our clinical testing volume (largely as a
result of the Unilab acquisition), employee compensation and benefits, testing
supply costs and depreciation expense. While our cost structure was favorably
impacted by the improved efficiencies generated from our Six Sigma and
standardization initiatives, we continued to make investments to enhance our
infrastructure to pursue our overall business strategy. These investments
included:
42
o Skills training for all employees, which together with our
competitive pay and benefits, helps to increase employee
satisfaction and performance, which we believe will result in
better service to our customers;
o Our information technology strategy, which is designed to improve
our efficiency and provide better service to our customers; and
o Our strategic growth opportunities.
Cost of services, which includes the costs of obtaining, transporting
and testing specimens, was 58.4% of net revenues for 2003, compared to 59.2% in
the prior year. This improvement was primarily the result of efficiency gains
resulting from our Six Sigma and standardization initiatives and the increase in
average revenue per requisition. This improvement was partially offset by
initial installation costs of deploying our Internet-based orders and results
systems in physicians' offices and our patient service centers. The increase in
the number of orders and test results reported via our Internet-based systems is
improving the initial collection of billing information which is reducing the
cost of billing and bad debt expense, both of which are components of selling,
general and administrative expenses. At December 31, 2003, approximately 25% of
our orders and approximately 35% of our test results were being transmitted via
the Internet. Additionally, due to an increase in the number of physicians who
no longer draw blood in their office, the number of blood draws in our patient
service centers or by our phlebotomists placed in physicians' offices increased
in 2003. This shift increased our operating costs associated with our blood
draws, but reduced costs in accessioning and other parts of our operations due
to improved billing information and a reduction in the number of inadequate
patient samples because our phlebotomists are specifically trained in these
areas.
Selling, general and administrative expenses, which include the costs
of the sales force, billing operations, bad debt expense and general management
and administrative support, decreased during 2003, as a percentage of net
revenues, to 24.6% from 26.2% in the prior year. This improvement was primarily
due to efficiencies from our Six Sigma and standardization initiatives and the
improvement in average revenue per requisition. During 2003, bad debt expense
improved to 4.8% of net revenues, compared to 5.3% in 2002. The reduction in bad
debt expense as a percentage of net revenues occurred despite the addition of
Unilab, which has higher levels of bad debt than the rest of Quest Diagnostics.
This improvement primarily related to the collection of diagnosis, patient and
insurance information necessary to more effectively bill for services performed.
We believe that our Six Sigma and standardization initiatives and the increased
use of electronic ordering by our customers will provide additional
opportunities to further improve our overall collection experience and cost
structure.
Other operating expense (income), net represents miscellaneous income
and expense items related to operating activities, and includes gains and losses
associated with the disposal of operating assets.
Operating Income
Operating income for the year ended December 31, 2003 improved to $796
million, or 16.8% of net revenues, from $592 million, or 14.4% of net revenues,
in 2002. The increase in operating income was primarily due to revenue growth
and improved efficiencies generated from our Six Sigma and standardization
initiatives.
Other Income (Expense)
Net interest expense for the year ended December 31, 2003 increased
from 2002 by $6 million and was primarily attributable to the amounts borrowed
to finance the acquisition of Unilab and to repay substantially all of Unilab's
outstanding debt, partially offset by decreased amounts borrowed under our
secured receivables credit facility.
Other income, net represents miscellaneous income and expense items
related to non-operating activities such as gains and losses associated with
investments and other non-operating assets.
Impact of Contingent Convertible Debentures on Diluted Earnings per Common Share
Due to a required change in accounting effective December 31, 2004, we
included the dilutive effect of our 1 3/4% contingent convertible debentures, or
the Debentures, in our dilutive earnings per common share calculations using the
if-converted method, regardless of whether or not the holders of these
securities were permitted to exercise their conversion rights, and retroactively
restated previously reported diluted earnings per common share. References to
previously reported diluted weighted average common shares outstanding,
including diluted earnings per common
43
share calculations and related disclosures, have been restated to give effect to
the required change in accounting for all periods presented. This change reduced
diluted earnings per common share by approximately 2% for each of the years
ended December 31, 2004, 2003 and 2002. See Note 10 to the Consolidated
Financial Statements for a further discussion of the Debentures.
Quantitative and Qualitative Disclosures About Market Risk
We address our exposure to market risks, principally the market risk of
changes in interest rates, through a controlled program of risk management that
may include the use of derivative financial instruments. We do not hold or issue
derivative financial instruments for trading purposes. We do not believe that
our foreign exchange exposure is material to our financial position or results
of operations. See Note 2 to the Consolidated Financial Statements for
additional discussion of our financial instruments and hedging activities.
At both December 31, 2004 and 2003, the fair value of our debt was
estimated at $1.2 billion, using quoted market prices and yields for the same or
similar types of borrowings, taking into account the underlying terms of the
debt instruments. At December 31, 2004 and 2003, the estimated fair value
exceeded the carrying value of the debt by approximately $84 million and $86
million, respectively. An assumed 10% increase in interest rates (representing
approximately 45 and 50 basis points at December 31, 2004 and 2003,
respectively) would potentially reduce the estimated fair value of our debt by
approximately $17 million at both December 31, 2004 and 2003.
The Debentures, which were satisfied in January 2005 as more fully
discussed in Note 10 to the Consolidated Financial Statements, have a contingent
interest component that will require us to pay contingent interest based on
certain thresholds, as outlined in the indenture governing the Debentures. The
thresholds were not met for, and as of, the year ended December 31, 2004. The
contingent interest component, which is more fully described in Note 10 to the
Consolidated Financial Statements, is considered to be a derivative instrument
subject to SFAS No. 133, "Accounting for Derivative Instruments and Hedging
Activities", as amended. As such, the derivative was recorded at its fair value
in the consolidated balance sheets and was not material at December 31, 2004 and
2003.
Borrowings under our senior unsecured revolving credit facility, our
secured receivables credit facility and our term loan due December 2008 are
subject to variable interest rates. Interest on the secured receivables credit
facility is based on rates that are intended to approximate commercial paper
rates for highly rated issuers. Interest rates on our senior unsecured revolving
credit facility and term loan due December 2008 are subject to a pricing
schedule that can fluctuate based on changes in our credit rating. As such, our
borrowing cost under these credit arrangements will be subject to both
fluctuations in interest rates and changes in our credit rating. As of
December 31, 2004, our borrowing rates for our LIBOR-based loans ranged from
LIBOR plus 0.55% to LIBOR plus 0.625%. At December 31, 2004, there was
$130 million of borrowings outstanding under our $300 million secured
receivables credit facility, $100 million of borrowings outstanding under our
$500 million senior unsecured revolving credit facility and $75 million
outstanding under our term loan due December 2008. Based on our net exposure to
interest rate changes, an assumed 10% change in interest rates on our variable
rate indebtedness (representing approximately 26 basis points) would impact
annual net interest expense by approximately $0.8 million, assuming no changes
to the debt outstanding at December 31, 2004. See Note 10 to the Consolidated
Financial Statements for details regarding the 2004 debt refinancings and our
debt outstanding.
Liquidity and Capital Resources
Cash and Cash Equivalents
Cash and cash equivalents at December 31, 2004 totaled $73 million,
compared to $155 million at December 31, 2003. Cash flows from operating
activities in 2004 were $799 million, which together with cash on-hand were used
to fund investing and financing activities, which required cash of $174 million
and $707 million, respectively. Cash and cash equivalents at December 31, 2003
totaled $155 million, compared to $97 million at December 31, 2002. Cash flows
from operating activities in 2003 provided cash of $663 million, which were used
to fund investing and financing activities, which required cash of $417 million
and $188 million, respectively.
Cash Flows from Operating Activities
Net cash provided by operating activities for 2004 was $799 million
compared to $663 million in the prior year period. This increase was primarily
due to improved operating performance and increased tax benefits associated with
stock-based compensation plans, partially offset by an increase in accounts
receivable associated with growth in
44
net revenues. Days sales outstanding, a measure of billing and collection
efficiency, improved to 47 days at December 31, 2004 from 48 days at December
31, 2003.
Net cash provided by operating activities for 2003 was $663 million
compared to $596 million in the prior year period. This increase was primarily
due to improved operating performance, partially offset by an increase in
accounts receivable associated with growth in net revenues. Days sales
outstanding, a measure of billing and collection efficiency, improved to 48 days
at December 31, 2003 from 49 days at December 31, 2002. Net cash provided by
operating activities for 2002 benefited from our ability to accelerate the tax
deduction for certain operating expenses resulting from Internal Revenue Service
rule changes.
Cash Flows from Investing Activities
Net cash used in investing activities in 2004 was $174 million,
consisting primarily of capital expenditures of $176 million.
Net cash used in investing activities in 2003 was $417 million,
consisting primarily of acquisition and related transaction costs of $238
million to acquire the outstanding capital stock of Unilab and capital
expenditures of $175 million. The acquisition and related transaction costs
included the cash portion of the Unilab purchase price of $297 million and
approximately $12 million of transaction costs paid in 2003, partially offset by
$72 million of cash acquired from Unilab.
Cash Flows from Financing Activities
Net cash used in financing activities in 2004 was $707 million,
consisting primarily of purchases of treasury stock totaling $735 million and
dividend payments totaling $61 million, partially offset by $109 million
received from the exercise of stock options. In addition, we repaid the
remaining $305 million of principal outstanding under our term loan due June
2007 with $100 million of borrowings under our senior unsecured revolving credit
facility, $130 million of borrowings under our secured receivables credit
facility and $75 million of borrowings under our term loan due December 2008.
The $735 million in treasury stock purchases represents 8.3 million shares of
our common stock purchased at an average price of $88.21 per share.
Net cash used in financing activities in 2003 was $188 million,
consisting primarily of debt repayments totaling $392 million and purchases of
treasury stock totaling $258 million, partially offset by $450 million of
borrowings under our term loan due June 2007. Borrowings under our term loan due
June 2007 were used to finance the cash portion of the purchase price and
related transaction costs associated with the acquisition of Unilab, and to
repay $220 million of debt, representing substantially all of Unilab's then
existing outstanding debt, and related accrued interest. Of the $220 million,
$124 million represented payments related to our cash tender offer, which was
completed on March 7, 2003, for all of the outstanding $101 million principal
amount of Unilab's 12 3/4% Senior Subordinated Notes due 2009 and $23 million of
related tender premium and associated tender offer costs. The remaining debt
repayments in 2003 consisted primarily of $145 million of repayments under our
term loan due June 2007 and $24 million of capital lease repayments. The $258
million in treasury stock purchases represents 4.0 million shares of our common
stock purchased at an average price of $64.54 per share.
Dividend Policy
On October 21, 2003, our Board of Directors declared our first payment
of a quarterly cash dividend of $0.15 per common share, which was paid on
January 23, 2004. We have paid a dividend of $0.15 per common share each quarter
since the first quarterly payment. On January 27, 2005, our Board of Directors
declared a quarterly cash dividend of $0.18 per common share, payable on April
20, 2005, to shareholders of record on April 6, 2005. We expect to fund future
dividend payments with cash flows from operations, and do not expect the
dividend to have a material impact on our ability to finance future growth.
Share Repurchase Plan
In 2003, our Board of Directors authorized a share repurchase program,
which permitted us to purchase up to $600 million of our common stock. In July
2004, our Board of Directors authorized us to purchase up to an additional $300
million of our common stock. Under a separate authorization from our Board of
Directors, in December 2004 we repurchased 2.7 million shares of our common
stock for approximately $254 million from GlaxoSmithKline plc. For the year
ended December 31, 2004, we repurchased approximately 8.3 million shares of our
common stock at an
45
average price of $88.21 per share for $735 million. Through December 31, 2004,
we have repurchased approximately 12.3 million shares of our common stock at an
average price of $80.54 for $992 million under our share repurchase program. At
December 31, 2004, the total available for repurchases under the remaining
authorizations was $162 million. In January 2005, our Board of Directors
expanded the share repurchase authorization by an additional $350 million,
bringing the total amount authorized and the total available for repurchases to
$512 million as of January 27, 2005.
Contingent Convertible Debentures
In December 2004, we called for redemption all of our outstanding
Debentures. Under the terms of the Debentures, the holders of the Debentures had
an option to submit their Debentures for redemption at par plus accrued and
unpaid interest or convert their Debentures into shares of our common stock at a
conversion price of $87.50 per share. Through December 31, 2004, $3.2 million of
principal of the Debentures were converted into less than 0.1 million shares of
our common stock. The outstanding principal of the Debentures at December 31,
2004 is classified as a current liability within short-term borrowings and
current portion of long-term debt on the Company's consolidated balance sheet.
As of January 18, 2005, the redemption was completed and approximately
$0.4 million of principal was redeemed for cash and $249.6 million
of principal was converted into approximately 2.9 million shares of
our common stock.
Contractual Obligations and Commitments
The following table summarizes certain of our contractual obligations
as of December 31, 2004. See Notes 10 and 14 to the Consolidated Financial
Statements for further details.
Payments due by period
(in thousands)
---------------------------------------------------------------------
Less than 1
Contractual Obligations Total year 1-3 years 4 -5 years After 5 years
----------------------- ----- ---- --------- ---------- -------------
Long-term debt........................ $ 723,812 $ - $304,531 $145,000 $274,281
Capital lease obligations............. 429 220 209 - -
Operating leases...................... 523,275 128,854 172,896 98,961 122,564
Purchase obligations.................. 42,339 34,600 7,492 145 102
---------- -------- -------- -------- --------
Total contractual obligations....... $1,289,855 $163,674 $485,128 $244,106 $396,947
========== ======== ======== ======== ========
See Note 10 to the Consolidated Financial Statements for a full
description of the terms of our indebtedness and related debt service
requirements. A full discussion and analysis regarding our minimum rental
commitments under noncancelable operating leases, noncancelable commitments to
purchase products or services, and reserves with respect to insurance and other
legal matters is contained in Note 14 to the Consolidated Financial Statements.
In December 2003, we entered into two lines of credit with two
financial institutions totaling $68 million for the issuance of letters of
credit, which were renewed in December 2004 and mature in December 2005. At
renewal, one of the lines of credit was increased by $7 million, resulting in
letter of credit lines totaling $75 million. Standby letters of credit are
obtained, principally in support of our risk management program, to ensure our
performance or payment to third parties and amounted to $55 million at December
31, 2004, all of which was issued against the $75 million letter of credit
lines. The letters of credit, which are renewed annually, primarily represent
collateral for automobile liability and workers' compensation loss payments.
Our credit agreements relating to our senior unsecured revolving credit
facility and our term loan due December 2008 contain various covenants and
conditions, including the maintenance of certain financial ratios, that could
impact our ability to, among other things, incur additional indebtedness. We do
not expect these covenants to adversely impact our ability to execute our growth
strategy or conduct normal business operations.
Unconsolidated Joint Ventures
We have investments in unconsolidated joint ventures in Phoenix,
Arizona; Indianapolis, Indiana; and Dayton, Ohio, which are accounted for under
the equity method of accounting. We believe that our transactions with our joint
ventures are conducted at arm's length, reflecting current market conditions and
pricing. Total net revenues of our unconsolidated joint ventures equal less than
6% of our consolidated net revenues. Total assets associated with
46
our unconsolidated joint ventures are less than 3% of our consolidated total
assets. We have no material unconditional obligations or guarantees to, or in
support of, our unconsolidated joint ventures and their operations.
Requirements and Capital Resources
We estimate that we will invest approximately $210 million to $230
million during 2005 for capital expenditures to support and expand our existing
operations, principally related to investments in information technology,
equipment, and facility upgrades.
We believe that cash from operations and our borrowing capacity under
our credit facilities will provide sufficient financial flexibility to meet
seasonal working capital requirements and to fund capital expenditures, debt
service requirements, cash dividends on common shares, share repurchases and
additional growth opportunities for the foreseeable future. Our investment grade
credit ratings have had a favorable impact on our cost of and access to capital,
and we believe that our improved financial performance should provide us with
access to additional financing, if necessary, to fund growth opportunities that
cannot be funded from existing sources.
Outlook
As discussed in the Overview, we believe that the underlying
fundamentals of the diagnostic testing industry will continue to improve and
that over the long term the industry will continue to grow. As the leading
provider of diagnostic testing, information and services with the most extensive
network of laboratories and patient service centers throughout the United
States, we believe we are well positioned to benefit from the growth expected in
our industry.
We believe our focus on Six Sigma quality and the investments we are
continuing to make in sales, service, science, and information technology will
further differentiate us and strengthen our industry leadership position. In
addition, we plan to pursue selective acquisitions of regional and local
laboratory testing providers. We also expect to pursue opportunities to expand
into other areas of diagnostics and other markets outside the United States.
Our strong cash generation, balance sheet and credit profile position
us well to take advantage of growth opportunities.
Inflation
We believe that inflation generally does not have a material adverse
effect on our results of operations or financial condition because the majority
of our contracts are short term.
Impact of New Accounting Standards
In January 2003, the Financial Accounting Standards Board, or FASB,
issued Interpretation No. 46, "Consolidation of Variable Interest Entities", as
revised in December 2003. In March 2004, the Emerging Issues Task Force, or
EITF, reached a final consensus on Issue 03-6, "Participating Securities and the
Two-Class Method under FASB Statement No. 128, Earnings Per Share". In September
2004, the EITF reached a final consensus on Issue 04-8, "The Effect of
Contingently Convertible Instruments on Diluted Earnings per Share". In December
2004, the FASB issued SFAS No. 123, revised 2004, "Share-Based Payment". The
impact of these accounting standards is discussed in Note 2 to the Consolidated
Financial Statements.
47
REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The management of Quest Diagnostics Incorporated (the "Company"),
including its Chief Executive Officer and Chief Financial Officer, is
responsible for establishing and maintaining adequate internal control over
financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the
Securities Exchange Act of 1934. The Company's internal control over financial
reporting is a process designed to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of financial statements
for external purposes in accordance with accounting principles generally
accepted in the United States of America. Internal control over financial
reporting includes policies and procedures that:
o pertain to the maintenance of records that, in reasonable detail,
accurately and fairly reflect the transactions and dispositions of
the assets of the Company;
o provide reasonable assurance that transactions are recorded as
necessary to permit preparation of financial statements in
accordance with accounting principles generally accepted in the
United States of America and that receipts and expenditures of the
Company are being made only in accordance with authorization of
management and directors of the Company; and
o provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use or disposition of
assets that could have a material effect on the consolidated
financial statements.
Management assessed the effectiveness of the Company's internal control
over financial reporting as of December 31, 2004. Management based this
assessment on criteria for effective internal control over financial reporting
described in "Internal Control - Integrated Framework" issued by the Committee
of Sponsoring Organizations of the Treadway Commission. Management's assessment
included an evaluation of the design of the Company's internal control over
financial reporting and testing of the operating effectiveness of its internal
control over financial reporting.
Based on this assessment, management has determined that the Company's
internal control over financial reporting as of December 31, 2004 is effective.
Management's assessment of the effectiveness of the Company's internal
control over financial reporting as of December 31, 2004 has been audited by
PricewaterhouseCoopers LLP, an independent registered public accounting firm, as
stated in their report appearing on pages F-1 and F-2, which expresses
unqualified opinions on management's assessment and on the effectiveness of the
Company's internal control over financial reporting as of December 31, 2004.
48
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders
of Quest Diagnostics Incorporated
We have completed an integrated audit of Quest Diagnostics
Incorporated's 2004 consolidated financial statements and of its internal
control over financial reporting as of December 31, 2004 and audits of its 2003
and 2002 consolidated financial statements in accordance with the standards of
the Public Company Accounting Oversight Board (United States). Our opinions,
based on our audits, are presented below.
Consolidated financial statements and financial statement schedule
In our opinion, the consolidated financial statements listed in the
index appearing under Item 15(a)(1) present fairly, in all material respects,
the financial position of Quest Diagnostics Incorporated and its subsidiaries at
December 31, 2004 and 2003, and the results of their operations and their cash
flows for each of the three years in the period ended December 31, 2004 in
conformity with accounting principles generally accepted in the United States of
America. In addition, in our opinion, the financial statement schedule listed in
the index appearing under Item 15(a)(2) presents fairly, in all material
respects, the information set forth therein when read in conjunction with the
related consolidated financial statements. These financial statements and
financial statement schedule are the responsibility of the Company's management.
Our responsibility is to express an opinion on these financial statements and
financial statement schedule based on our audits. We conducted our audits of
these statements in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit of financial statements
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
Internal control over financial reporting
Also, in our opinion, management's assessment, included in Report of
Management On Internal Control Over Financial Reporting appearing under Item 9A,
that the Company maintained effective internal control over financial reporting
as of December 31, 2004 based on criteria established in Internal Control -
Integrated Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO), is fairly stated, in all material respects, based on
those criteria. Furthermore, in our opinion, the Company maintained, in all
material respects, effective internal control over financial reporting as of
December 31, 2004, based on criteria established in Internal Control -
Integrated Framework issued by the COSO. The Company's management is responsible
for maintaining effective internal control over financial reporting and for its
assessment of the effectiveness of internal control over financial reporting.
Our responsibility is to express opinions on management's assessment and on the
effectiveness of the Company's internal control over financial reporting based
on our audit. We conducted our audit of internal control over financial
reporting in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. An audit of internal control over financial reporting includes
obtaining an understanding of internal control over financial reporting,
evaluating management's assessment, testing and evaluating the design and
operating effectiveness of internal control, and performing such other
procedures as we consider necessary in the circumstances. We believe that our
audit provides a reasonable basis for our opinions.
A company's internal control over financial reporting is a process
designed to provide reasonable assurance regarding the reliability of financial
reporting and the preparation of financial statements for external purposes in
accordance with generally accepted accounting principles. A company's internal
control over financial reporting includes those policies and procedures that (i)
pertain to the maintenance of records that, in reasonable detail, accurately and
fairly reflect the transactions and dispositions of the assets of the company;
(ii) provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (iii) provide reasonable assurance regarding prevention or
timely detection of unauthorized acquisition, use, or disposition of the
company's assets that could have a material effect on the financial statements.
F-1
Because of its inherent limitations, internal control over financial
reporting may not prevent or detect misstatements. Also, projections of any
evaluation of effectiveness to future periods are subject to the risk that
controls may become inadequate because of changes in conditions, or that the
degree of compliance with the policies or procedures may deteriorate.
/s/ PricewaterhouseCoopers LLP
- ----------------------------------------
PricewaterhouseCoopers LLP
Florham Park, New Jersey
March 10, 2005
F-2
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2004 AND 2003
(in thousands, except per share data)
2004 2003
---------- ----------
Assets
Current assets:
Cash and cash equivalents .................................................... $ 73,302 $ 154,958
Accounts receivable, net of allowance for doubtful accounts of $202,857 and
$211,739 at December 31, 2004 and 2003, respectively ...................... 649,281 609,187
Inventories .................................................................. 75,327 72,484
Deferred income taxes ........................................................ 83,030 108,975
Prepaid expenses and other current assets .................................... 50,140 50,182
---------- ----------
Total current assets ...................................................... 931,080 995,786
Property, plant and equipment, net ........................................... 619,485 607,305
Goodwill, net ................................................................ 2,506,950 2,518,875
Intangible assets, net ....................................................... 11,462 16,978
Deferred income taxes ........................................................ 29,374 49,635
Other assets ................................................................. 105,437 112,839
---------- ----------
Total assets ................................................................. $4,203,788 $4,301,418
========== ==========
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable and accrued expenses ........................................ $ 668,987 $ 649,850
Short-term borrowings and current portion of long-term debt .................. 374,801 73,950
---------- ----------
Total current liabilities ................................................. 1,043,788 723,800
Long-term debt ............................................................... 724,021 1,028,707
Other liabilities ............................................................ 147,328 154,217
Commitments and contingencies
Stockholders' equity:
Common stock, par value $0.01 per share; 300,000 shares authorized; 106,784
and 106,804 shares issued at December 31, 2004 and 2003, respectively ..... 1,068 1,068
Additional paid-in capital ................................................... 2,195,346 2,267,014
Retained earnings ............................................................ 818,734 380,559
Unearned compensation ........................................................ (11) (2,346)
Accumulated other comprehensive income ....................................... 3,866 5,947
Treasury stock, at cost; 8,674 and 3,990 shares at December 31, 2004 and 2003,
respectively .............................................................. (730,352) (257,548)
---------- ----------
Total stockholders' equity ................................................ 2,288,651 2,394,694
---------- ----------
Total liabilities and stockholders' equity ................................... $4,203,788 $4,301,418
========== ==========
The accompanying notes are an integral part of these statements.
F-3
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002
(in thousands, except per share data)
2004 2003 2002
---------- ---------- ----------
Net revenues ................................... $5,126,601 $4,737,958 $4,108,051
Operating costs and expenses:
Cost of services ............................... 2,990,712 2,768,623 2,432,388
Selling, general and administrative ............ 1,227,746 1,165,700 1,074,841
Amortization of intangible assets .............. 6,703 8,201 8,373
Other operating expense (income), net .......... 10,223 (1,020) 307
---------- ---------- ----------
Total operating costs and expenses .......... 4,235,384 3,941,504 3,515,909
---------- ---------- ----------
Operating income ............................... 891,217 796,454 592,142
Other income (expense):
Interest expense, net .......................... (57,949) (59,789) (53,673)
Minority share of income ....................... (19,353) (17,630) (14,874)
Equity earnings in unconsolidated joint ventures 21,049 17,439 16,714
Other income, net .............................. 162 1,324 2,068
---------- ---------- ----------
Total non-operating expenses, net ........... (56,091) (58,656) (49,765)
---------- ---------- ----------
Income before taxes ............................ 835,126 737,798 542,377
Income tax expense ............................. 335,931 301,081 220,223
---------- ---------- ----------
Net income ..................................... $ 499,195 $ 436,717 $ 322,154
========== ========== ==========
Earnings per common share:
Basic .......................................... $ 4.90 $ 4.22 $ 3.34
Diluted ........................................ $ 4.69 $ 4.04 $ 3.17
Weighted average common shares outstanding:
Basic .......................................... 101,960 103,416 96,467
Diluted ........................................ 107,072 108,789 102,647
Dividends per common share ..................... $ 0.60 $ 0.15 $ --
The accompanying notes are an integral part of these statements.
F-4
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002
(in thousands)
2004 2003 2002
--------- --------- ---------
Cash flows from operating activities:
Net income ............................................. $ 499,195 $ 436,717 $ 322,154
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation and amortization .......................... 168,726 153,903 131,391
Provision for doubtful accounts ........................ 226,310 228,222 217,360
Deferred income tax provision .......................... 52,451 33,853 90,401
Minority share of income ............................... 19,353 17,630 14,874
Stock compensation expense ............................. 1,384 5,297 9,028
Tax benefits associated with stock-based compensation
plans ............................................... 71,276 30,496 44,507
Other, net ............................................. 4,739 (1,583) (813)
Changes in operating assets and liabilities:
Accounts receivable ................................. (266,404) (254,865) (168,185)
Accounts payable and accrued expenses ............... 22,336 (6,795) (12,658)
Integration, settlement and other special charges ... (18,274) (18,942) (29,668)
Income taxes payable ................................ 1,163 26,493 (3,912)
Other assets and liabilities, net ................... 16,525 12,373 (18,108)
--------- --------- ---------
Net cash provided by operating activities .............. 798,780 662,799 596,371
--------- --------- ---------
Cash flows from investing activities:
Business acquisitions, net of cash acquired ............ -- (237,610) (333,512)
Capital expenditures ................................... (176,125) (174,641) (155,196)
Increase in investments and other assets ............... (5,151) (13,842) (9,728)
Proceeds from disposition of assets .................... 7,576 9,043 10,564
Collection of note receivable .......................... -- -- 10,660
--------- --------- ---------
Net cash used in investing activities .................. (173,700) (417,050) (477,212)
--------- --------- ---------
Cash flows from financing activities:
Proceeds from borrowings ............................... 304,921 450,000 475,237
Repayments of debt ..................................... (306,018) (391,718) (634,278)
Purchases of treasury stock ............................ (734,577) (257,548) --
Exercise of stock options .............................. 109,116 29,887 27,034
Dividends paid ......................................... (61,387) -- --
Distributions to minority partners ..................... (16,677) (14,253) (12,192)
Financing costs paid ................................... (2,114) (4,227) (129)
Other .................................................. -- 291 (386)
--------- --------- ---------
Net cash used in financing activities .................. (706,736) (187,568) (144,714)
--------- --------- ---------
Net change in cash and cash equivalents ................ (81,656) 58,181 (25,555)
Cash and cash equivalents, beginning of year ........... 154,958 96,777 122,332
--------- --------- ---------
Cash and cash equivalents, end of year ................. $ 73,302 $ 154,958 $ 96,777
========= ========= =========
The accompanying notes are an integral part of these statements.
F-5
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002
(in thousands)
Accumulated
Other
Retained Compre-
Shares of Additional Earnings Unearned hensive Compre-
Common Stock Common Paid-In (Accumulated Compen- Income Treasury hensive
Outstanding Stock Capital Deficit) sation (Loss) Stock Income
------------ ------ ---------- ------------ -------- ----------- --------- --------
Balance, December 31,
2001.................... 96,024 $ 960 $1,714,676 $(362,926) $(13,253) $(3,470) $ --
Net income................. 322,154 $322,154
Other comprehensive loss... (2,054) (2,054)
--------
Comprehensive income....... $320,100
========
Issuance of common stock
under benefit plans..... 418 4 31,310
Exercise of stock options.. 1,521 16 27,018
Tax benefits associated
with stock-based
compensation plans...... 44,507
Amortization of unearned
compensation............ 9,921
------- ------ ---------- --------- -------- ------- ---------
Balance, December 31,
2002.................... 97,963 980 1,817,511 (40,772) (3,332) (5,524) --
Net income................. 436,717 $436,717
Other comprehensive
income................... 11,471 11,471
--------
Comprehensive income....... $448,188
========
Dividend declared.......... (15,386)
Shares issued to acquire
Unilab.................. 7,055 71 372,393
Fair value of Unilab
converted options....... 8,452
Issuance of common stock
under benefit plans..... 400 4 18,081 (4,313)
Exercise of stock
options................. 1,567 15 29,872
Shares to cover employee
payroll tax withholdings
on stock issued under
benefit plans........... (181) (2) (9,791)
Tax benefits associated
with stock-based
compensation plans...... 30,496
Amortization of unearned
compensation............ 5,299
Purchases of treasury
stock .................. (3,990) (257,548)
------- ------ ---------- --------- -------- ------- ---------
Balance, December 31,
2003..................... 102,814 1,068 2,267,014 380,559 (2,346) 5,947 (257,548)
Net income................. 499,195 $499,195
Other comprehensive loss... (2,081) (2,081)
--------
Comprehensive income....... $497,114
========
Dividend declared.......... (61,020)
Issuance of common stock
under benefit plans..... 202 1 1,314 951 12,623
Exercise of stock
options................. 3,474 (136,932) 246,048
Shares to cover employee
payroll tax withholdings
on stock issued under
benefit plans........... (90) (1) (7,548)
Tax benefits associated
with stock-based
compensation plans...... 71,276
Conversion of contingent
convertible debentures.. 37 222 3,102
Amortization of unearned
compensation............ 1,384
Purchases of treasury
stock .................. (8,327) (734,577)
------- ------ ---------- --------- -------- ------- ---------
Balance, December 31,
2004.................... 98,110 $1,068 $2,195,346 $ 818,734 $ (11) $ 3,866 $(730,352)
======= ====== ========== ========= ======== ======= =========
The accompanying notes are an integral part of these statements.
F-6
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands unless otherwise indicated)
1. DESCRIPTION OF BUSINESS
Quest Diagnostics Incorporated and its subsidiaries ("Quest
Diagnostics" or the "Company") is the largest clinical laboratory testing
business in the United States. Prior to January 1, 1997, Quest Diagnostics was a
wholly owned subsidiary of Corning Incorporated ("Corning"). On December 31,
1996, Corning distributed all of the outstanding shares of common stock of the
Company to the stockholders of Corning as part of the "Spin-Off Distribution".
As the nation's leading provider of diagnostic testing and services
for the healthcare industry, Quest Diagnostics offers a broad range of clinical
laboratory testing services to patients, physicians, hospitals, healthcare
insurers, employers, governmental institutions and other commercial clinical
laboratories. Quest Diagnostics is the leading provider of esoteric testing,
including gene-based testing, and testing for drugs of abuse. The Company is
also a leading provider of anatomic pathology services and testing to support
clinical trials of new pharmaceuticals worldwide. Through the Company's national
network of laboratories and patient service centers, and its esoteric testing
laboratory and development facilities, Quest Diagnostics offers comprehensive
and innovative diagnostic testing, information and services used by physicians
and other healthcare professionals to make decisions to improve health.
During 2004, Quest Diagnostics processed over 137 million requisitions
through its extensive network of laboratories and patient service centers in
virtually every major metropolitan area throughout the United States.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The consolidated financial statements include the accounts of all
entities controlled by the Company through its direct or indirect ownership of a
majority voting interest. While the Company does not have any relationships with
variable interest entities, as defined in Financial Accounting Standards Board
("FASB") Interpretation No. 46 "Consolidation of Variable Interest Entities", as
revised ("FIN 46"), the existence of any such entity would require consolidation
if the Company were subject to a majority of the risk of loss from the variable
interest entity's activities, or entitled to receive a majority of the entity's
residual returns or both. Investments in entities which the Company does not
control, but in which it has a substantial ownership interest (generally between
20% and 49%) and can exercise significant influence, are accounted for using the
equity method of accounting. The Company's share of equity earnings from
investments in affiliates, accounted for under the equity method, totaled $21.0
million, $17.4 million and $16.7 million, respectively, for 2004, 2003 and 2002.
All significant intercompany accounts and transactions are eliminated in
consolidation.
Use of Estimates
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates.
Revenue Recognition
The Company primarily recognizes revenue for services rendered upon
completion of the testing process. Billings for services reimbursed by
third-party payers, including Medicare and Medicaid, are recorded as revenues
net of allowances for differences between amounts billed and the estimated
receipts from such payers. Adjustments to the estimated receipts, based on final
settlement with the third-party payers, are recorded upon settlement. In 2004,
2003 and 2002, approximately 17%, 17% and 15%, respectively, of net revenues
were generated by Medicare and Medicaid programs. Under capitated arrangements
with healthcare insurers, the Company recognizes revenue based on a
predetermined monthly reimbursement rate for each member of an insurer's health
plan regardless of the number or cost of services provided by the Company.
F-7
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
Taxes on Income
The Company uses the asset and liability approach to account for
income taxes. Under this method, deferred tax assets and liabilities are
recognized for the expected future tax consequences of differences between the
carrying amounts of assets and liabilities and their respective tax bases using
tax rates in effect for the year in which the differences are expected to
reverse. A valuation allowance is provided when it is more likely than not that
some portion or all of the deferred tax assets will not be realized. The effect
on deferred tax assets and liabilities of a change in tax rates is recognized in
income in the period when the change is enacted.
Earnings Per Share
Basic earnings per common share is calculated by dividing net income
by the weighted average common shares outstanding. Diluted earnings per common
share is calculated by dividing net income, adjusted for the after-tax impact of
the interest expense associated with the Company's 1 3/4% contingent
convertible debentures due 2021 (the "Debentures"), by the weighted average
common shares outstanding after giving effect to all potentially dilutive common
shares outstanding during the period. Potentially dilutive common shares include
the dilutive effect of the Debentures, and outstanding stock options and
restricted common shares granted under the Company's Employee Equity
Participation Program.
In September 2004, the Emerging Issues Task Force ("EITF") reached a
final consensus on Issue 04-8, "The Effect of Contingently Convertible
Instruments on Diluted Earnings per Share", ("Issue 04-8"), effective December
31, 2004. Pursuant to Issue 04-8, the Company included the dilutive effect of
its Debentures in its dilutive earnings per common share calculations using the
if-converted method, regardless of whether or not the holders of these
securities were permitted to exercise their conversion rights, and retroactively
restated previously reported diluted earnings per common share. References to
previously reported diluted weighted average common shares outstanding and
diluted earnings per common share amounts in the accompanying consolidated
statements of operations and related disclosures, have been restated to give
retroactive effect of the required change in accounting for all periods
presented.
The computation of basic and diluted earnings per common share (using
the if-converted method) was as follows (in thousands, except per share data):
2004 2003 2002
-------- -------- --------
Net income available to commons stockholders - basic..... $499,195 $436,717 $322,154
Add: Interest expense associated with the Debentures, net
of related tax effects................................ 3,275 3,303 3,341
-------- -------- --------
Net income available to common stockholders - diluted.... $502,470 $440,020 $325,495
======== ======== ========
Weighted average common shares outstanding - basic....... 101,960 103,416 96,467
Effect of dilutive securities:
Debentures............................................... 2,857 2,857 2,857
Stock options............................................ 2,236 2,343 2,879
Restricted common stock.................................. 19 173 444
-------- -------- --------
Weighted average common shares outstanding - diluted..... 107,072 108,789 102,647
======== ======== ========
Basic earnings per common share.......................... $ 4.90 $ 4.22 $ 3.34
======== ======== ========
Diluted earnings per common share........................ $ 4.69 $ 4.04 $ 3.17
======== ======== ========
F-8
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
The following securities were not included in the diluted earnings per
share calculation due to their antidilutive effect (in thousands):
2004 2003 2002
------ ------ ------
Stock options................................. 302 2,009 2,352
Stock-Based Compensation
Statement of Financial Accounting Standards ("SFAS") No. 123,
"Accounting for Stock-Based Compensation" ("SFAS 123"), as amended by SFAS No.
148, "Accounting for Stock-Based Compensation - Transition and Disclosure - an
amendment of FASB Statement No. 123" ("SFAS 148") encourages, but does not
require, companies to record compensation cost for stock-based compensation
plans at fair value. In addition, SFAS 148 provides alternative methods of
transition for a voluntary change to the fair value based method of accounting
for stock-based employee compensation, and amends the disclosure requirements of
SFAS 123 to require prominent disclosures in both annual and interim financial
statements about the method of accounting for stock-based employee compensation
and the effect of the method used on reported results.
The Company has chosen to adopt the disclosure only provisions of SFAS
148 and continue to account for stock-based compensation using the intrinsic
value method prescribed in Accounting Principles Board ("APB") Opinion No. 25,
"Accounting for Stock Issued to Employees" ("APB 25"), and related
interpretations. Under this approach, the cost of restricted stock awards is
expensed over their vesting period, while the imputed cost of stock option
grants and discounts offered under the Company's Employee Stock Purchase Plan
("ESPP") is disclosed, based on the vesting provisions of the individual grants,
but not charged to expense. Stock-based compensation expense recorded in
accordance with APB 25, relating to restricted stock awards, was $1.4 million,
$5.3 million and $9.0 million in 2004, 2003 and 2002, respectively.
The Company has several stock ownership and compensation plans, which
are described more fully in Note 12. The following table presents net income and
basic and diluted earnings per common share, had the Company elected to
recognize compensation cost based on the fair value at the grant dates for stock
option awards and discounts granted for stock purchases under the Company's
ESPP, consistent with the method prescribed by SFAS 123, as amended by SFAS 148
(in thousands, except per share data):
2004 2003 2002
-------- -------- --------
Net income, as reported.................................. $499,195 $436,717 $322,154
Add: Stock-based compensation under APB 25............... 1,384 5,297 9,028
Deduct: Total stock-based compensation expense determined
under fair value method for all awards, net of related
tax effects........................................... (43,710) (52,351) (47,393)
------- -------- --------
Pro forma net income..................................... $456,869 $389,663 $283,789
======== ======== ========
Earnings per common share:
Basic - as reported...................................... $ 4.90 $ 4.22 $ 3.34
-------- -------- --------
Basic - pro forma........................................ $ 4.47 $ 3.77 $ 2.94
-------- -------- --------
Diluted - as reported.................................... $ 4.69 $ 4.04 $ 3.17
-------- -------- --------
Diluted - pro forma...................................... $ 4.27 $ 3.65 $ 2.83
-------- -------- --------
F-9
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
The fair value of each option grant was estimated on the date of grant
using the Black-Scholes option-pricing model with the following weighted average
assumptions:
2004 2003 2002
---- ---- ----
Dividend yield ...................... 0.7% 0.0% 0.0%
Risk-free interest rate ............. 3.1% 2.8% 4.2%
Expected volatility ................. 47.2% 48.1% 45.2%
Expected holding period, in years ... 5 5 5
The majority of options granted in 2003 were issued prior to the
declaration of the Company's quarterly cash dividend in the fourth quarter of
2003 and as such carry a dividend yield of 0%, thereby reducing the weighted
average dividend yield for 2003 to 0.0%.
Foreign Currency
Assets and liabilities of foreign subsidiaries are translated into
U.S. dollars at year-end exchange rates. Income and expense items are translated
at average exchange rates prevailing during the year. The translation
adjustments are recorded as a component of accumulated other comprehensive
income within stockholders' equity. Gains and losses from foreign currency
transactions are included within "other operating expense (income), net" in the
consolidated statements of operations. Transaction gains and losses have not
been material.
Cash and Cash Equivalents
Cash and cash equivalents include all highly-liquid investments with
maturities, at the time acquired by the Company, of three months or less.
Concentration of Credit Risk
Financial instruments that potentially subject the Company to
concentrations of credit risk are principally cash, cash equivalents, short-term
investments and accounts receivable. The Company's policy is to place its cash,
cash equivalents and short-term investments in highly rated financial
instruments and institutions. Concentration of credit risk with respect to
accounts receivable is mitigated by the diversity of the Company's clients and
their dispersion across many different geographic regions, and is limited to
certain customers who are large buyers of the Company's services. To reduce
risk, the Company routinely assesses the financial strength of these customers
and, consequently, believes that its accounts receivable credit risk exposure,
with respect to these customers, is limited. While the Company has receivables
due from federal and state governmental agencies, the Company does not believe
that such receivables represent a credit risk since the related healthcare
programs are funded by federal and state governments, and payment is primarily
dependent on submitting appropriate documentation.
Accounts Receivable and Allowance for Doubtful Accounts
Accounts receivable are reported at realizable value, net of
allowances for doubtful accounts, which is estimated and recorded in the period
of the related revenue. The Company has implemented a standardized approach to
estimate and review the collectibility of its receivables based on a number of
factors, including the period they have been outstanding. Historical collection
and payer reimbursement experience is an integral part of the estimation process
related to allowances for doubtful accounts. In addition, the Company regularly
assesses the state of its billing operations in order to identify issues which
may impact the collectibility of receivables or reserve estimates. Revisions to
the allowances for doubtful accounts estimates are recorded as an adjustment to
bad debt expense within selling, general and administrative expenses.
Receivables deemed to be uncollectible are charged against the allowance for
doubtful accounts at the time such receivables are written-off. Recoveries of
receivables previously written-off are recorded as credits to the allowance for
doubtful accounts.
F-10
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
Inventories
Inventories, which consist principally of supplies, are valued at the
lower of cost (first in, first out method) or market.
Property, Plant and Equipment
Property, plant and equipment is recorded at cost. Major renewals and
improvements are capitalized, while maintenance and repairs are expensed as
incurred. Costs incurred for computer software developed or obtained for
internal use are capitalized for application development activities and expensed
as incurred for preliminary project activities and post-implementation
activities. Capitalized costs include external direct costs of materials and
services consumed in developing or obtaining internal-use software, payroll and
payroll-related costs for employees who are directly associated with and who
devote time to the internal-use software project, and interest costs incurred,
when material, while developing internal-use software. Capitalization of such
costs ceases when the project is substantially complete and ready for its
intended purpose. Certain costs, such as maintenance and training, are expensed
as incurred. The Company capitalizes interest on borrowings during the active
construction period of major capital projects. Capitalized interest is added to
the cost of the underlying assets and is amortized over the useful lives of the
assets. Depreciation and amortization are provided on the straight-line method
over expected useful asset lives as follows: buildings and improvements, ranging
from ten to thirty years; laboratory equipment and furniture and fixtures,
ranging from three to seven years; leasehold improvements, the lesser of the
useful life of the improvement or the remaining life of the building or lease,
as applicable; and computer software developed or obtained for internal use,
ranging from three to five years.
Goodwill
Goodwill represents the cost of acquired businesses in excess of the
fair value of assets acquired, including separately recognized intangible
assets, less the fair value of liabilities assumed in a business combination.
The Company uses a nonamortization approach to account for purchased goodwill
and certain intangibles. Under a nonamortization approach, goodwill and certain
intangibles are not amortized, but instead are reviewed for impairment.
Intangible Assets
Intangible assets are recognized as an asset apart from goodwill if
the asset arises from contractual or other legal rights, or if it is separable.
Intangible assets, principally representing the cost of customer lists and
non-competition agreements acquired, are capitalized and amortized on the
straight-line method over their expected useful life, which generally ranges
from five to fifteen years.
Recoverability and Impairment of Goodwill
Under the nonamortization provisions of SFAS No. 142, "Goodwill and
Other Intangible Assets" ("SFAS 142"), goodwill and certain intangibles are not
amortized into results of operations, but instead are reviewed for impairment
and an impairment charge is recorded in the periods in which the recorded
carrying value of goodwill and certain intangibles is more than its estimated
fair value. The provisions of SFAS 142 require that a goodwill impairment test
be performed annually or in the case of other events that indicate a potential
impairment. The annual impairment tests of goodwill were performed at the end of
each of the Company's fiscal years on December 31st and indicated that there was
no impairment of goodwill as of December 31, 2004 or 2003.
The Company evaluates the recoverability and measures the potential
impairment of its goodwill under SFAS 142. The annual impairment test is a
two-step process that begins with the estimation of the fair value of the
reporting unit. The first step screens for potential impairment and the second
step measures the amount of the impairment, if any. Management's estimate of
fair value considers publicly available information regarding the market
capitalization of the Company as well as (i) publicly available information
regarding comparable publicly-traded companies in the clinical laboratory
testing industry, (ii) the financial projections and future prospects of the
Company's business, including its growth opportunities and likely operational
improvements, and (iii) comparable
F-11
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
sales prices, if available. As part of the first step to assess potential
impairment, management compares the estimate of fair value for the Company to
the book value of the Company's consolidated net assets. If the book value of
the consolidated net assets is greater than the estimate of fair value, the
Company would then proceed to the second step to measure the impairment, if any.
The second step compares the implied fair value of goodwill with its carrying
value. The implied fair value is determined by allocating the fair value of the
reporting unit to all of the assets and liabilities of that unit as if the
reporting unit had been acquired in a business combination and the fair value of
the reporting unit was the purchase price paid to acquire the reporting unit.
The excess of the fair value of the reporting unit over the amounts assigned to
its assets and liabilities is the implied fair value of goodwill. If the
carrying amount of the reporting unit's goodwill is greater than its implied
fair value, an impairment loss will be recognized in the amount of the excess.
Management believes its estimation methods are reasonable and reflective of
common valuation practices.
On a quarterly basis, management performs a review of the Company's
business to determine if events or changes in circumstances have occurred which
could have a material adverse effect on the fair value of the Company and its
goodwill. If such events or changes in circumstances were deemed to have
occurred, the Company would perform an impairment test of goodwill as of the end
of the quarter, consistent with the annual impairment test, and record any noted
impairment loss.
Recoverability and Impairment of Intangible Assets and Other
Long-Lived Assets
The Company evaluates the possible impairment of its long-lived
assets, including intangible assets which are amortized pursuant to the
provisions of SFAS 142, under SFAS No. 144, "Accounting for Impairment or
Disposal of Long-Lived Assets" ("SFAS 144"). The Company reviews the
recoverability of its long-lived assets when events or changes in circumstances
occur that indicate that the carrying value of the asset may not be recoverable.
Evaluation of possible impairment is based on the Company's ability to recover
the asset from the expected future pretax cash flows (undiscounted and without
interest charges) of the related operations. If the expected undiscounted pretax
cash flows are less than the carrying amount of such asset, an impairment loss
is recognized for the difference between the estimated fair value and carrying
amount of the asset.
Investments
The Company accounts for investments in equity securities, which are
included in "other assets" in conformity with SFAS No. 115, "Accounting for
Certain Investments in Debt and Equity Securities", which requires the use of
fair value accounting for trading or available-for-sale securities. Both
realized and unrealized gains and losses for trading securities are recorded
currently in earnings as a component of non-operating expenses within "other
income, net" in the consolidated statements of operations. Unrealized gains and
losses for available-for-sale securities are recorded as a component of
accumulated other comprehensive income within stockholders' equity. Gains and
losses on securities sold are based on the average cost method.
Investments at December 31, 2004 and 2003 consisted of the following:
2004 2003
------- -------
Available-for-sale equity securities ... $21,949 $26,195
Trading equity securities .............. 20,917 19,168
Other investments ...................... 13,601 12,598
------- -------
Total .................................. $56,467 $57,961
======= =======
Investments in available-for-sale equity securities consist primarily
of equity securities in public corporations. Investments in trading equity
securities represent participant directed investments of deferred employee
compensation and related Company matching contributions held in a trust pursuant
to the Company's supplemental deferred compensation plan (see Note 12). Other
investments do not have readily determinable fair values and consist primarily
of investments in preferred and common shares of privately held companies.
F-12
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
As of December 31, 2004 and 2003, the Company had gross unrealized
gains (losses) from available-for-sale equity securities of $(6.2) million and
$15.5 million, respectively. For the years ended December 31, 2004, 2003 and
2002, gains (losses) from trading equity securities totaled $1.8 million, $1.9
million and $(1.0) million, respectively, and are included in "other income,
net" within the consolidated statements of operations.
Financial Instruments
The Company's policy for managing exposure to market risks may include
the use of financial instruments, including derivatives. The Company has
established policies and procedures for risk assessment and the approval,
reporting and monitoring of derivative financial instrument activities. These
policies prohibit holding or issuing derivative financial instruments for
trading purposes.
SFAS No. 133, "Accounting for Derivative Instruments and Hedging
Activities" ("SFAS 133"), as amended, requires that all derivative instruments
be recorded on the balance sheet at their fair value. Changes in the fair value
of derivatives are recorded each period in current earnings or other
comprehensive income, depending on whether a derivative is designated as part of
a hedge transaction and, if it is, the type of hedge transaction.
Fair Value of Financial Instruments
The carrying amounts of cash and cash equivalents, accounts receivable
and accounts payable and accrued expenses approximate fair value based on the
short maturity of these instruments. At both December 31, 2004 and 2003, the
fair value of the Company's debt was estimated at $1.2 billion, using quoted
market prices and yields for the same or similar types of borrowings, taking
into account the underlying terms of the debt instruments. At December 31, 2004
and 2003, the estimated fair value exceeded the carrying value of the debt by
$84 million and $86 million, respectively.
The Company's Debentures have a contingent interest component that
will require the Company to pay contingent interest based on certain thresholds,
as outlined in the indenture governing such notes. The contingent interest
component, which is more fully described in Note 10 is considered to be a
derivative instrument subject to SFAS 133, as amended. As such, the derivative
was recorded at its fair value in the consolidated balance sheets and was not
material at both December 31, 2004 and 2003.
Comprehensive Income
Comprehensive income encompasses all changes in stockholders' equity
(except those arising from transactions with stockholders) and includes net
income, net unrealized capital gains or losses on available-for-sale securities
and foreign currency translation adjustments.
Segment Reporting
The Company currently operates in one reportable business segment.
Substantially all of the Company's services are provided within the United
States, and substantially all of the Company's assets are located within the
United States. No one customer accounted for ten percent or more of net revenues
in 2004, 2003, or 2002.
New Accounting Standards
In January 2003, the FASB issued FIN 46, which requires a variable
interest entity to be consolidated by a company if that company is subject to a
majority of the risk of loss from the variable interest entity's activities, or
entitled to receive a majority of the entity's residual returns or both.
Historically, entities generally were not consolidated unless the entity was
controlled through voting interests. FIN 46 also requires disclosures about
variable interest entities that a company is not required to consolidate but in
which it has a significant variable interest. The adoption of FIN 46 did not
have an impact on the Company's consolidated financial statements.
In March 2004, the EITF reached a final consensus on Issue 03-6,
"Participating Securities and the Two-Class Method under FASB Statement No. 128,
Earnings Per Share", ("Issue 03-6"), effective June 30, 2004. Issue
F-13
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
03-6 requires the use of the two-class method to compute earnings per share for
companies that have issued securities other than common stock that contractually
entitle the holder to participate in dividends and earnings of the company when,
and if, it declares dividends on its common stock. The contingent interest
feature of the Debentures represents a participation right, thereby qualifying
the Debentures as a participating security and requiring the use of the
two-class method for purposes of calculating earnings per common share when
holders of the security are entitled to receive contingent interest. The holders
of the Debentures will receive contingent interest, and the Company would be
required to utilize the two-class method, if the Debentures trade at a price
greater than or equal to 120% of the principal amount of the Debentures (or
$1,200 per Debenture) for periods specified under the indenture. For the periods
presented, the holders of the Debentures were not entitled to contingent
interest and as such, the two-class method has not been utilized to compute
earnings per common share.
In December 2004, the FASB issued SFAS No. 123, revised 2004,
"Share-Based Payment" ("SFAS 123R"). SFAS 123R requires that companies recognize
compensation cost relating to share-based payment transactions based on the fair
value of the equity or liability instruments issued. SFAS 123R is effective for
interim or annual periods beginning after June 15, 2005. The Company expects to
adopt SFAS 123R effective July 1, 2005 using the modified prospective approach.
Under this approach, awards that are granted, modified or settled after July 1,
2005 will be measured and accounted for in accordance with SFAS 123R. Unvested
awards that were granted prior to July 1, 2005 will continue to be accounted for
in accordance with SFAS 123 except that compensation costs will be recognized in
the Company's results of operations. The Company has not finalized what, if any,
changes may be made to its equity compensation plans in light of the accounting
change, and therefore is not yet in a position to quantify its impact. Assuming
there are no changes to the Company's equity compensation plans, and an adoption
date of July 1, 2005 for the new accounting standard, the Company estimates that
the adoption of the new accounting standard will reduce diluted earnings per
common share by up to $0.23 and operating income, as a percentage of revenues,
by up to approximately 1%. The impact on cash flows from operating activities of
adopting the new accounting standard cannot be estimated at this time.
3. BUSINESS ACQUISITIONS
Acquisition of Unilab Corporation
On February 28, 2003, the Company completed the acquisition of Unilab
Corporation ("Unilab"), the leading commercial clinical laboratory in
California. In connection with the acquisition, the Company paid $297 million in
cash and issued 7.1 million shares of Quest Diagnostics common stock to acquire
all of the outstanding capital stock of Unilab. In addition, the Company
reserved approximately 0.3 million shares of Quest Diagnostics common stock for
outstanding stock options of Unilab which were converted upon the completion of
the acquisition into options to acquire shares of Quest Diagnostics common stock
(the "converted options").
The aggregate purchase price of $698 million included the cash portion
of the purchase price of $297 million and transaction costs of approximately $20
million, with the remaining portion of the purchase price paid through the
issuance of 7.1 million shares of Quest Diagnostics common stock (valued at $372
million or $52.80 per share, based on the average closing stock price of Quest
Diagnostics common stock for the five trading days ended March 4, 2003) and the
issuance of approximately 0.3 million converted options (valued at approximately
$9 million, based on the Black Scholes option-pricing model). Of the total
transaction costs incurred, approximately $8 million was paid during fiscal
2002.
In conjunction with the acquisition of Unilab, the Company repaid $220
million of debt, representing substantially all of Unilab's then existing
outstanding debt, and related accrued interest. Of the $220 million, $124
million represents payments related to the Company's cash tender offer, which
was completed on March 7, 2003, for all of the outstanding $101 million
principal amount and related accrued interest of Unilab's 12 3/4% Senior
Subordinated Notes due 2009 and $23 million of related tender premium and
associated tender offer costs.
The Company financed the cash portion of the purchase price and
related transaction costs, and the repayment of substantially all of Unilab's
outstanding debt and related accrued interest, with the proceeds from a new $450
million amortizing term loan due June 2007 and cash on-hand. During 2003, the
Company repaid $145 million of principal outstanding under the term loan due
June 2007. During 2004, the Company refinanced the remaining $305 million of
principal outstanding under the term loan due June 2007 (see Note 10).
F-14
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
As part of the Unilab acquisition, Quest Diagnostics acquired all of
Unilab's operations, including its primary testing facilities in Los Angeles,
San Jose and Sacramento, California, and approximately 365 patient service
centers and 35 rapid response laboratories and approximately 4,100 employees. As
the leading commercial clinical laboratory in California, the acquisition of
Unilab further solidified the Company's leading position within the clinical
laboratory testing industry, and further enhanced its national network and
access to its comprehensive range of services for physicians, hospitals,
patients and healthcare insurers.
In connection with the acquisition of Unilab, as part of a settlement
agreement with the United States Federal Trade Commission, the Company entered
into an agreement to sell to Laboratory Corporation of America Holdings, Inc.,
("LabCorp"), certain assets in northern California for $4.5 million, including
the assignment of agreements with four independent physician associations
("IPA") and leases for 46 patient service centers (five of which also serve as
rapid response laboratories) (the "Divestiture"). Approximately $27 million in
annual net revenues were generated by capitated fees under the IPA agreements
and associated fee-for-service testing for physicians whose patients use these
patient service centers, as well as from specimens received directly from the
IPA physicians. The Company completed the transfer of assets and assignment of
the IPA agreements to LabCorp and recorded a $1.5 million gain in the third
quarter of 2003 in connection with the Divestiture, which is included in "other
operating expense (income), net" within the consolidated statements of
operations.
The acquisition of Unilab was accounted for under the purchase method
of accounting. As such, the cost to acquire Unilab has been allocated to the
assets and liabilities acquired based on estimated fair values as of the closing
date. The consolidated financial statements include the results of operations of
Unilab subsequent to the closing of the acquisition.
The following table summarizes the Company's purchase price allocation
related to the acquisition of Unilab based on the estimated fair value of the
assets acquired and liabilities assumed on the acquisition date.
Fair Values as of
February 28, 2003
-----------------
Current assets.............................................. $193,798
Property, plant and equipment............................... 10,855
Goodwill.................................................... 735,853
Other assets................................................ 47,777
--------
Total assets acquired..................................... 988,283
--------
Current liabilities......................................... 62,002
Long-term liabilities....................................... 7,369
Long-term debt.............................................. 221,291
--------
Total liabilities assumed................................. 290,662
--------
Net assets acquired....................................... $697,621
========
Based on management's review of the net assets acquired and
consultations with third-party valuation specialists, no intangible assets
meeting the criteria under SFAS No. 141, "Business Combinations", were
identified. Of the $736 million allocated to goodwill, approximately $85 million
is expected to be deductible for tax purposes.
Acquisition of American Medical Laboratories, Incorporated
On April 1, 2002, the Company completed its acquisition of all of the
outstanding voting stock of American Medical Laboratories, Incorporated, ("AML")
and an affiliated company of AML, LabPortal, Inc. ("LabPortal"), a provider of
electronic connectivity products, in an all-cash transaction with a combined
value of approximately $500 million, which included the assumption of
approximately $160 million in debt.
Through the acquisition of AML, Quest Diagnostics acquired all of
AML's operations, including two full-service laboratories, 51 patient service
centers, and hospital sales, service and logistics capabilities. The all-cash
purchase price of approximately $335 million and related transaction costs,
together with the repayment of
F-15
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
approximately $150 million of principal and related accrued interest,
representing substantially all of AML's debt, was financed by Quest Diagnostics
with cash on-hand, $300 million of borrowings under its secured receivables
credit facility and $175 million of borrowings under its unsecured revolving
credit facility. During 2002, Quest Diagnostics repaid all of the $475 million
in borrowings related to the acquisition of AML.
The acquisition of AML was accounted for under the purchase method of
accounting. As such, the cost to acquire AML has been allocated to the assets
and liabilities acquired based on estimated fair values as of the closing date.
The consolidated financial statements include the results of operations of AML
subsequent to the closing of the acquisition.
The following table summarizes the Company's purchase price allocation
related to the acquisition of AML based on the estimated fair value of the
assets acquired and liabilities assumed on the acquisition date.
Fair Values as of
April 1, 2002
-----------------
Current assets ............................................. $ 83,403
Property, plant and equipment .............................. 31,475
Goodwill ................................................... 426,314
Other assets ............................................... 8,211
--------
Total assets acquired.................................... 549,403
--------
Current portion of long-term debt .......................... 11,834
Other current liabilities .................................. 51,403
Long-term debt ............................................. 139,465
Other liabilities .......................................... 4,925
--------
Total liabilities assumed ............................... 207,627
--------
Net assets acquired ..................................... $341,776
========
Based on management's review of the net assets acquired and
consultations with valuation specialists, no intangible assets meeting the
criteria under SFAS No. 141, "Business Combinations", were identified. Of the
$426 million allocated to goodwill, approximately $17 million is expected to be
deductible for tax purposes.
Acquisition of LabPortal
The all-cash purchase price for LabPortal of approximately $4 million
and related transaction costs, together with the repayment of all of LabPortal's
outstanding debt of approximately $7 million and related accrued interest, was
financed by Quest Diagnostics with cash on-hand. The acquisition of LabPortal
was accounted for under the purchase method of accounting. As such, the cost to
acquire LabPortal has been allocated to the assets and liabilities acquired
based on estimated fair values as of the closing date, including approximately
$8 million of goodwill. The consolidated financial statements include the
results of operations of LabPortal subsequent to the closing of the acquisition.
F-16
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
Pro Forma Combined Financial Information
The following unaudited pro forma combined financial information for
the years ended December 31, 2003 and 2002 assumes that the Unilab and AML
acquisitions and the Divestiture were completed on January 1, 2002 (in
thousands, except per share data):
2003 2002
---------- ----------
Net revenues.......................................... $4,803,875 $4,607,242
Net income............................................ 444,944 365,448
Basic earnings per common share:
Net income............................................ $ 4.26 $ 3.53
Weighted average common shares outstanding - basic.... 104,552 103,522
Diluted earnings per common share:
Net income............................................ $ 4.08 $ 3.36
Weighted average common shares outstanding - diluted.. 109,936 109,783
The pro forma combined financial information presented above reflects
certain reclassifications to the historical financial statements of Unilab and
AML to conform the acquired companies' accounting policies and classification of
certain costs and expenses to that of Quest Diagnostics. These adjustments had
no impact on pro forma net income. Pro forma results for the year ended December
31, 2003 exclude $14.5 million of direct transaction costs, which were incurred
and expensed by Unilab in conjunction with its acquisition by Quest Diagnostics.
Pro forma results for the year ended December 31, 2002 exclude $14.5 million and
$6.3 million, respectively, of direct transaction costs, which were incurred and
expensed by AML and Unilab, respectively, in conjunction with their acquisitions
by Quest Diagnostics.
4. INTEGRATION OF ACQUIRED BUSINESSES
In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities" ("SFAS 146"). SFAS 146, which the
Company adopted effective January 1, 2003, requires that a liability for a cost
associated with an exit activity, including those related to employee
termination benefits and contractual obligations, be recognized when the
liability is incurred, and not necessarily the date of an entity's commitment to
an exit plan, as under previous accounting guidance. The provisions of SFAS 146
apply to integration costs associated with actions that impact the employees and
operations of Quest Diagnostics. Costs associated with actions that impact the
employees and operations of an acquired company, such as Unilab, are accounted
for as a cost of the acquisition and included in goodwill in accordance with
EITF No. 95-3, "Recognition of Liabilities in Connection with a Purchase
Business Combination".
Integration of Unilab Corporation
During the fourth quarter of 2003, the Company finalized its plan
related to the integration of Unilab into Quest Diagnostics' laboratory network.
As part of the plan, following the sale of certain assets to LabCorp as part of
the Divestiture, the Company closed its previously owned clinical laboratory in
the San Francisco Bay area and completed the integration of remaining customers
in the northern California area to Unilab's laboratories in San Jose and
Sacramento. The Company currently operates two laboratories in the Los Angeles
metropolitan area. As part of the integration plan, the Company plans to open a
new regional laboratory in the Los Angeles metropolitan area into which it will
integrate all of its business in the area.
During 2003, the Company recorded $9 million of costs associated with
executing the Unilab integration plan. The majority of these integration costs
related to employee severance and contractual obligations associated with leased
facilities and equipment. Employee groups affected as a result of this plan
include those involved in the
F-17
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
collection and testing of specimens, as well as administrative and other support
functions. Of the $9 million in costs, $7.9 million was recorded in the fourth
quarter of 2003 and related to actions that impact the employees and operations
of Unilab, was accounted for as a cost of the Unilab acquisition and included in
goodwill. Of the $7.9 million, $6.8 million related to employee severance
benefits for approximately 150 employees, with the remainder primarily related
to contractual obligations. In addition, $1.1 million of integration costs,
related to actions that impact Quest Diagnostics' employees and operations and
comprised principally of employee severance benefits for approximately 30
employees, were accounted for as a charge to earnings in the third quarter of
2003 and included in "other operating expense (income), net" within the
consolidated statements of operations. As of December 31, 2004 and 2003,
accruals related to the Unilab integration plan totaled $3.0 million and $6.6
million respectively. The remaining accruals at December 31, 2004, substantially
all of which represented severance costs, are expected to be paid in 2005.
Integration of American Medical Laboratories, Incorporated
During the third quarter of 2002, the Company finalized its plan
related to the integration of AML into Quest Diagnostics' laboratory network.
The plan focused principally on improving customer service by enabling the
Company to perform esoteric testing on the east and west coasts of the United
States, and redirecting certain physician testing volumes within its national
network to provide more local testing. As part of the plan, the Company's
Chantilly, Virginia laboratory, acquired as part of the AML acquisition, has
become the primary esoteric testing laboratory and hospital service center for
the eastern United States, complementing the Company's Nichols Institute
esoteric testing facility in San Juan Capistrano, California. Esoteric testing
volumes have been redirected within the Company's national network to provide
customers with improved turnaround time and customer service. The Company has
completed the transition of certain routine clinical laboratory testing
previously performed in the Chantilly, Virginia laboratory to other testing
facilities within the Company's regional laboratory network. A reduction in
staffing occurred as the Company executed the integration plan and consolidated
duplicate or overlapping functions and facilities. Employee groups affected as a
result of this plan included those involved in the collection and testing of
specimens, as well as administrative and other support functions.
In connection with the AML integration plan, the Company recorded $11
million of costs associated with executing the plan. The majority of these
integration costs related to employee severance and contractual obligations
associated with leased facilities and equipment. Of the total costs indicated
above, $9.5 million, related to actions that impact the employees and operations
of AML, was accounted for as a cost of the AML acquisition and included in
goodwill. Of the $9.5 million, $5.9 million related to employee severance
benefits for approximately 200 employees, with the remainder primarily related
to contractual obligations associated with leased facilities and equipment. In
addition, $1.5 million of integration costs, related to actions that impact
Quest Diagnostics' employees and operations and comprised principally of
employee severance benefits for approximately 100 employees, were accounted for
as a charge to earnings in the third quarter of 2002 and included in "other
operating expense (income), net" within the consolidated statements of
operations. As of December 31, 2003, accruals related to the AML integration
plan totaled $4.1 million. The actions associated with the AML integration plan,
including those related to severed employees, were completed in 2003. The
remaining accruals associated with the AML integration were not material at
December 31, 2004.
Integration of Clinical Diagnostic Services, Inc.
During 2001, the Company acquired Clinical Diagnostics Services, Inc.
("CDS"), which operated a diagnostic testing laboratory and more than 50 patient
service centers in New York and New Jersey. During the fourth quarter of 2002,
the Company finalized its plan related to the integration of CDS into Quest
Diagnostics' laboratory network in the New York metropolitan area. Of the $13.3
million of costs recorded in the fourth quarter of 2002 in connection with the
execution of the CDS integration plan, all of which were associated with actions
impacting the employees and operations of CDS, $3 million related to employee
severance benefits for approximately 150 employees with the remainder primarily
associated with remaining contractual obligations under facility and equipment
leases. The costs outlined above were recorded as a cost of the acquisition and
included in goodwill. As of December 31, 2004 and 2003, accruals related to the
CDS integration plan totaled $4.0 million and $5.3 million, respectively. The
actions associated with the CDS integration plan, including those related to
severed employees, were completed in 2003. The remaining accruals at December
31, 2004, substantially all of which represented remaining contractual
obligations under facility leases, have terms extending beyond 2005.
F-18
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
5. TAXES ON INCOME
In conjunction with the Spin-Off Distribution, the Company entered
into a tax sharing agreement with its former parent and a former subsidiary,
that provide the parties with certain rights of indemnification against each
other. In conjunction with its acquisition of SmithKline Beecham Clinical
Laboratories, Inc. ("SBCL"), which operated the clinical laboratory testing
business of SmithKline Beecham plc ("SmithKline Beecham"), the Company entered
into a tax indemnification arrangement with SmithKline Beecham that provides the
parties with certain rights of indemnification against each other.
The Company's pretax income (loss) consisted of $826 million, $736
million and $547 million from U.S. operations and approximately $9.1 million,
$1.4 million and $(4.5) million from foreign operations for the years ended
December 31, 2004, 2003 and 2002, respectively.
The components of income tax expense for 2004, 2003 and 2002 were as
follows:
2004 2003 2002
-------- -------- --------
Current:
Federal..................................... $233,635 $214,729 $105,799
State and local............................. 50,527 51,771 23,396
Foreign..................................... (682) 728 627
Deferred:
Federal..................................... 41,316 29,271 73,002
State and local............................. 11,135 4,582 17,399
-------- -------- --------
Total.................................... $335,931 $301,081 $220,223
======== ======== ========
A reconciliation of the federal statutory rate to the Company's
effective tax rate for 2004, 2003 and 2002 was as follows:
2004 2003 2002
---- ---- ----
Tax provision at statutory rate........................... 35.0% 35.0% 35.0%
State and local income taxes, net of federal benefit...... 4.6 5.0 5.0
Impact of foreign operations.............................. 0.1 0.2 0.2
Non-deductible meals and entertainment expense............ 0.2 0.3 0.3
Other, net................................................ 0.3 0.3 0.1
---- ---- ----
Effective tax rate..................................... 40.2% 40.8% 40.6%
==== ==== ====
The tax effects of temporary differences that give rise to significant
portions of the deferred tax assets at December 31, 2004 and 2003 were as
follows:
2004 2003
------- ---------
Current deferred tax asset:
Accounts receivable reserve............................ $28,020 $ 33,797
Liabilities not currently deductible................... 53,306 65,352
Accrued settlement reserves............................ -- 4,972
Accrued restructuring and integration costs............ 1,704 4,854
------- ---------
Total............................................... $83,030 $ 108,975
======= =========
Non-current deferred tax asset:
Liabilities not currently deductible................... $54,497 $ 44,978
Net operating loss carryforwards....................... 14,247 17,914
Accrued restructuring and integration costs............ 1,037 1,613
Depreciation and amortization.......................... (40,407) (14,870)
------- ---------
Total............................................... $29,374 $ 49,635
======= =========
F-19
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
As of December 31, 2004, the Company had estimated net operating loss
carryforwards for federal and state income tax purposes of $32 million and $401
million, respectively, which expire at various dates through 2024. As of
December 31, 2004 and 2003, deferred tax assets associated with net operating
loss carryforwards for federal and state income tax purposes of $30 million and
$51 million, respectively, have each been reduced by a valuation allowance of
$16 million and $33 million, respectively.
Income taxes payable at December 31, 2004 and 2003 were $28 million
and $29 million, respectively, and consisted primarily of federal income taxes
payable of $25 million and $22 million, respectively.
The American Jobs Creation Act of 2004 (the "Act") was signed into law
on October 22, 2004. Management does not believe that the provisions of the Act
will have a material effect on the Company's consolidated results of operations
or financial position.
6. SUPPLEMENTAL CASH FLOW AND OTHER DATA
2004 2003 2002
-------- -------- --------
Depreciation expense...................................... $162,024 $145,701 $123,018
Interest expense.......................................... (60,154) (60,630) (56,347)
Interest income .......................................... 2,205 841 2,674
-------- -------- --------
Interest, net............................................. (57,949) (59,789) (53,673)
Interest paid............................................. 51,781 59,394 56,102
Income taxes paid......................................... 209,156 211,966 83,710
Businesses acquired:
Fair value of assets acquired............................. $ -- $989,778 $561,267
Fair value of liabilities assumed......................... -- 291,422 215,810
Non-cash financing activities:
Conversion of contingent convertible debentures........... $ 3,197 $ -- $ --
Fair value of common stock issued to acquire Unilab....... -- 372,464 --
Fair value of converted options issued in conjunction with
the Unilab acquisition ................................ -- 8,452 --
7. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment at December 31, 2004 and 2003 consisted
of the following:
2004 2003
---------- ----------
Land...................................................... $ 34,301 $ 34,909
Buildings and improvements................................ 276,661 273,548
Laboratory equipment, furniture and fixtures.............. 761,926 670,671
Leasehold improvements.................................... 167,656 148,508
Computer software developed or obtained for internal use.. 149,292 124,469
Construction-in-progress.................................. 43,291 40,083
--------- ----------
1,433,127 1,292,188
Less: accumulated depreciation and amortization........... (813,642) (684,883)
---------- ----------
Total.................................................. $ 619,485 $ 607,305
========== ==========
F-20
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
8. GOODWILL AND INTANGIBLE ASSETS
Goodwill at December 31, 2004 and 2003 consisted of the following:
2004 2003
---------- ----------
Goodwill............................................. $2,695,003 $2,706,928
Less: accumulated amortization....................... (188,053) (188,053)
---------- ----------
Goodwill, net..................................... $2,506,950 $2,518,875
========== ==========
The changes in the gross carrying amount of goodwill for the years
ended December 31, 2004 and 2003 are as follows:
2004 2003
---------- ----------
Balance as of January 1.............................. $2,706,928 $1,976,903
Goodwill acquired during the year.................... -- 730,025
Other................................................ (11,925) --
---------- ----------
Balance as of December 31............................ $2,695,003 $2,706,928
========== ==========
For the year ended December 31, 2004, the reduction in goodwill was
primarily related to an increase in pre-acquisition tax net operating losses and
credit carryforwards associated with businesses acquired.
Intangible assets at December 31, 2004 and 2003 consisted of the
following:
Weighted December 31, 2004 December 31, 2003
Average -------------------------------- --------------------------------
Amortization Accumulated Accumulated
Period Cost Amortization Net Cost Amortization Net
------------ ------- ------------ ------- ------- ------------ -------
Non-compete
agreements.... 5 years $44,942 $(42,348) $ 2,594 $44,942 $(37,947) $ 6,995
Customer lists... 15 years 42,225 (37,197) 5,028 42,225 (35,568) 6,657
Other............ 6 years 6,850 (3,010) 3,840 5,895 (2,569) 3,326
------- -------- ------- ------- -------- -------
Total......... 10 years $94,017 $(82,555) $11,462 $93,062 $(76,084) $16,978
======= ======== ======= ======= ======== =======
Amortization expense related to intangible assets was $6,703, $8,201
and $8,373 for the years ended December 31, 2004, 2003 and 2002, respectively.
F-21
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
The estimated amortization expense related to other intangible assets
for each of the five succeeding fiscal years and thereafter as of December 31,
2004 is as follows:
Fiscal Year Ending
December 31,
- ---------------------------
2005....................... $ 3,718
2006....................... 2,539
2007....................... 1,149
2008....................... 959
2009....................... 862
Thereafter................. 2,235
-------
Total................... $11,462
=======
9. ACCOUNTS PAYABLE AND ACCRUED EXPENSES
Accounts payable and accrued expenses at December 31, 2004 and 2003
consisted of the following:
2004 2003
-------- --------
Accrued wages and benefits................................. $265,126 $255,340
Accrued expenses........................................... 242,767 221,783
Trade accounts payable..................................... 128,488 118,731
Income taxes payable....................................... 28,239 29,073
Accrued restructuring and integration costs................ 3,949 12,493
Accrued settlement reserves................................ 418 12,430
-------- --------
Total................................................... $668,987 $649,850
======== ========
10. DEBT
Short-term borrowings and current portion of long-term debt at
December 31, 2004 and 2003 consisted of the following:
2004 2003
-------- -------
Contingent Convertible Debentures called for redemption in
December 2004.......................................... $244,660 $ --
Borrowings under Secured Receivables Credit Facility...... 129,921 --
Current portion of long-term debt......................... 220 73,950
-------- -------
Total short-term borrowings and current portion of
long-term debt...................................... $374,801 $73,950
======== =======
Long-term debt at December 31, 2004 and 2003 consisted of the
following:
2004 2003
-------- ----------
Borrowings under Credit Facility.......................... $100,000 $ --
Term loan due June 2007................................... -- 304,921
Term loan due December 2008............................... 75,000 --
Senior Notes due July 2006................................ 274,531 274,219
Senior Notes due July 2011................................ 274,281 274,171
Contingent Convertible Debentures......................... -- 247,760
Other..................................................... 429 1,586
-------- ----------
Total.................................................. 724,241 1,102,657
Less: current portion..................................... 220 73,950
-------- ----------
Total long-term debt................................... $724,021 $1,028,707
======== ==========
F-22
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
2004 Debt Refinancings
On April 20, 2004, the Company entered into a new $500 million senior
unsecured revolving credit facility which replaced a $325 million unsecured
revolving credit facility. Under the new $500 million senior unsecured revolving
credit facility (the "Credit Facility"), which matures in April 2009, interest
is based on certain published rates plus an applicable margin that will vary
over an approximate range of 90 basis points based on changes in the Company's
public debt rating. At the option of the Company, it may elect to enter into
LIBOR-based interest rate contracts for periods up to 180 days. Interest on any
outstanding amounts not covered under the LIBOR-based interest rate contracts is
based on an alternate base rate, which is calculated by reference to the prime
rate or federal funds rate. As of December 31, 2004, the Company's borrowing
rate for LIBOR-based loans was LIBOR plus 0.625%. The Credit Facility is
guaranteed by the Company's wholly owned subsidiaries that operate clinical
laboratories in the United States (the "Subsidiary Guarantors"). The Credit
Facility contains various covenants, including the maintenance of certain
financial ratios, which could impact the Company's ability to, among other
things, incur additional indebtedness.
In addition, on April 20, 2004, the Company entered into a new $300
million receivables securitization facility which replaced a $250 million
receivables securitization facility that matured in April 2004. The new $300
million receivables securitization facility (the "Secured Receivables Credit
Facility") matures in April 2007. Interest on the Secured Receivables Credit
Facility is based on rates that are intended to approximate commercial paper
rates for highly rated issuers. At December 31, 2004, the Company's borrowing
rate under the Secured Receivables Credit Facility was 2.7%. The Secured
Receivables Credit Facility is supported by one-year back-up facilities provided
by two banks on a committed basis. Borrowings outstanding under the Secured
Receivables Credit Facility, if any, are classified as a current liability on
the Company's consolidated balance sheet since the lenders fund the borrowings
through the issuance of commercial paper which matures at various dates within
one year from the date of issuance and the term of the one-year back-up
facilities described above.
In conjunction with the debt refinancings, the Company recorded a $2.9
million charge to earnings in the second quarter of 2004 representing the
write-off of deferred financing costs associated with the debt that was
refinanced. The $2.9 million charge was included in interest expense, net within
the consolidated statements of operations for the year ended December 31, 2004.
Term Loan due June 2007
As discussed in Note 3, the Company financed the cash portion of the
purchase price and related transaction costs associated with the Unilab
acquisition, and the repayment of substantially all of Unilab's outstanding debt
and related accrued interest, with the proceeds from a $450 million amortizing
term loan facility (the "term loan due June 2007") and cash on-hand. Through
December 31, 2003, the Company had repaid $145 million of principal under the
term loan due June 2007. On January 12, 2004, the Company repaid an additional
$75 million of principal under the term loan due June 2007 with the proceeds
from a lower cost term loan due December 2008. On April 30, 2004, the Company
repaid the remaining $230 million of principal outstanding under its term loan
due June 2007 with $100 million of borrowings under the Credit Facility and $130
million of borrowings under the Secured Receivables Credit Facility.
Term Loan due December 2008
On December 19, 2003, the Company entered into a $75 million
amortizing term loan facility (the "term loan due December 2008"), which was
funded on January 12, 2004 and the proceeds of which were used to repay $75
million under the term loan due June 2007. The term loan due December 2008
carries a lower interest rate than the term loan due June 2007 and is based on
LIBOR plus an applicable margin that can fluctuate over a range of up to 119
basis points, based on changes in the Company's public debt rating. At the
option of the Company, it may elect to enter into LIBOR-based interest rate
contracts for periods up to 180 days. Interest on any outstanding amounts not
covered under the LIBOR-based interest rate contracts is based on an alternate
base rate, which is calculated by reference to the prime rate or federal funds
rate. As of both December 31, 2004 and 2003, the Company's borrowing rate for
LIBOR-based loans was LIBOR plus 0.55%. The term loan due December 2008 requires
principal repayments of the initial amount borrowed equal to 20% on each of the
third and fourth anniversary dates of the
F-23
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
funding and the remainder of the outstanding balance on December 31, 2008. The
term loan due December 2008 is guaranteed by the Subsidiary Guarantors and
contains various covenants similar to those under the Credit Facility.
Senior Notes
In conjunction with its 2001 debt refinancing, the Company completed a
$550 million senior notes offering in June 2001 (the "Senior Notes"). The Senior
Notes were issued in two tranches: (a) $275 million aggregate principal amount
of 6 3/4% senior notes due 2006 ("Senior Notes due 2006"), issued at a discount
of approximately $1.6 million and (b) $275 million aggregate principal amount of
7 1/2% senior notes due 2011 ("Senior Notes due 2011"), issued at a discount of
approximately $1.1 million. After considering the discounts, the effective
interest rate on the Senior Notes due 2006 and the Senior Notes due 2011 is 6.9%
and 7.6%, respectively. The Senior Notes require semiannual interest payments
which commenced January 12, 2002. The Senior Notes are unsecured obligations of
the Company and rank equally with the Company's other unsecured senior
obligations. The Senior Notes are guaranteed by the Subsidiary Guarantors and do
not have a sinking fund requirement.
Contingent Convertible Debentures
On November 26, 2001, the Company completed its $250 million offering
of its Debentures. The net proceeds of the offering, together with cash on hand,
were used to repay all of the $256 million principal that was then outstanding
under the Company's secured receivables credit facility. The Debentures, which
pay a fixed rate of interest semi-annually commencing on May 31, 2002, have a
contingent interest component, which is considered to be a derivative instrument
subject to SFAS 133, as amended, that will require the Company to pay contingent
interest based on certain thresholds, as outlined in the indenture governing the
Debentures. For income tax purposes, the Debentures are considered to be a
contingent payment security. As such, interest expense for tax purposes is based
on an assumed interest rate related to a comparable fixed interest rate debt
security issued by the Company without a conversion feature. The assumed
interest rate for tax purposes was 7% for both 2004 and 2003.
The Debentures are guaranteed by the Subsidiary Guarantors and do not
have a sinking fund requirement.
Each one thousand dollar principal amount of Debentures is convertible
initially into 11.429 shares of the Company's common stock, which represents an
initial conversion price of $87.50 per share. Holders may surrender the
Debentures for conversion into shares of the Company's common stock under any of
the following circumstances: (1) if the sales price of the Company's common
stock is above 120% of the conversion price (or $105 per share) for specified
periods; (2) if the Company calls the Debentures; or (3) if specified corporate
transactions have occurred.
The Company may call the Debentures at any time on or after November
30, 2004 for the principal amount of the Debentures plus any accrued and unpaid
interest. On November 30, 2004, 2005, 2008, 2012 and 2016 each holder of the
Debentures may require the Company to repurchase the holder's Debentures for the
principal amount of the Debentures plus any accrued and unpaid interest. The
Company may repurchase the Debentures for cash, common stock, or a combination
of both. The Company intended to settle any repurchases with a cash payment,
funding such payment with a combination of cash on-hand and borrowings under the
Credit Facility. The Debentures were classified as long-term debt on the
consolidated balance sheet at December 31, 2003 due to the Company's ability and
intent to refinance the Debentures on a long-term basis in the event the
Debentures were put to the Company in November 2004.
In December 2004, the Company called for redemption all of its
outstanding Debentures. Under the terms of the Debentures, the holders of the
Debentures had an option to submit their Debentures for redemption at par plus
accrued and unpaid interest or convert their Debentures into shares of the
Company's common stock at a conversion price of $87.50 per share. Through
December 31, 2004, $3.2 million of principal of the Debentures were converted
into less than 0.1 million shares of the Company's common stock. The outstanding
principal of the Debentures at December 31, 2004 is classified as a current
liability within short-term borrowings and current portion of long-term debt on
the Company's consolidated balance sheet. As of January 18, 2005, the redemption
was completed and $0.4 million of principal was redeemed for cash and $249.6
million of principal was converted into approximately 2.9 million shares of the
Company's common stock.
F-24
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
Letter of Credit Lines
In December 2003, the Company entered into two lines of credit with
two financial institutions totaling $68 million for the issuance of letters of
credit (the "letter of credit lines"). Upon renewal in December 2004, one of the
lines of credit was increased by $7 million, resulting in letter of credit lines
totaling $75 million. The letter of credit lines mature in December 2005 and are
guaranteed by the Subsidiary Guarantors. As of December 31, 2004, there are $55
million of outstanding letters of credit under the letter of credit lines.
As of December 31, 2004 long-term debt, including capital leases,
maturing in each of the years subsequent to December 31, 2005, is as follows:
Year ending December 31,
- ------------------------
2006 .............................................................. $289,718
2007 .............................................................. 15,022
2008 .............................................................. 45,000
2009 .............................................................. 100,000
2010 .............................................................. --
Thereafter ........................................................ 274,281
--------
Total long-term debt ........................................... $724,021
========
On January 31, 2005, the Company repaid $100 million of principal
outstanding under its Credit Facility with $100 million of borrowings under its
Secured Receivables Credit Facility.
11. PREFERRED STOCK AND COMMON STOCKHOLDERS' EQUITY
Series Preferred Stock
Quest Diagnostics is authorized to issue up to 10 million shares of
Series Preferred Stock, par value $1.00 per share. The Company's Board of
Directors has the authority to issue such shares without stockholder approval
and to determine the designations, preferences, rights and restrictions of such
shares. Of the authorized shares, 1,300,000 shares have been designated Series A
Preferred Stock and 1,000 shares have been designated Voting Cumulative
Preferred Stock. No shares are currently outstanding.
Preferred Share Purchase Rights
Each share of Quest Diagnostics common stock trades with a preferred
share purchase right, which entitles stockholders to purchase one-hundredth of a
share of Series A Preferred Stock upon the occurrence of certain events. In
conjunction with the SBCL acquisition, the Board of Directors of the Company
approved an amendment to the preferred share purchase rights. The amended rights
entitle stockholders to purchase shares of Series A Preferred Stock at a
predefined price in the event a person or group (other than SmithKline Beecham)
acquires 20% or more of the Company's outstanding common stock. The preferred
share purchase rights expire December 31, 2006.
F-25
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
Accumulated Other Comprehensive Income (Loss)
The components of accumulated other comprehensive income (loss) for
2004, 2003 and 2002 were as follows:
Foreign Accumulated
Currency Other
Translation Market Value Comprehensive
Adjustment Adjustment Income (Loss)
----------- ------------ -------------
Balance, December 31, 2001 .............................. $(4,386) $ 916 $(3,470)
Translation adjustment .................................. 1,906 -- 1,906
Market value adjustment, net of tax benefit of $2,627 ... -- (3,960) (3,960)
------- ------- -------
Balance, December 31, 2002 .............................. (2,480) (3,044) (5,524)
Translation adjustment .................................. 2,169 -- 2,169
Market value adjustment, net of tax expense of $6,201 ... -- 9,302 9,302
------- ------- -------
Balance, December 31, 2003 .............................. (311) 6,258 5,947
Translation adjustment .................................. 1,650 -- 1,650
Market value adjustment, net of tax benefit of $2,515 ... -- (3,731) (3,731)
------- ------- -------
Balance, December 31, 2004 .............................. $ 1,339 $ 2,527 $ 3,866
======= ======= =======
The market value adjustments for 2004, 2003 and 2002 represented
unrealized holding gains (losses), net of taxes.
Dividend Policy
Through October 20, 2003, the Company never declared or paid cash
dividends on its common stock. On October 21, 2003, the Company's Board of
Directors declared its first payment of a quarterly cash dividend of $0.15 per
common share. The Company has paid a $0.15 per common share dividend each
quarter since the first quarter's payment. On January 27, 2005, the Company's
Board of Directors declared a quarterly cash dividend of $0.18 per common share,
payable on April 20, 2005, to shareholders of record on April 6, 2005.
Share Repurchase Plan
In 2003, the Company's Board of Directors authorized a share
repurchase program, which permits the Company to purchase up to $600 million of
its common stock. In July 2004, the Company's Board of Directors authorized the
Company to purchase up to an additional $300 million of its common stock. Under
a separate authorization from the Board of Directors, in December 2004 the
Company repurchased 2.7 million shares of its common stock for approximately
$254 million from GlaxoSmithKline plc. For the year ended December 31, 2004, the
Company repurchased approximately 8.3 million shares of its common stock at an
average price of $88.21 per share for $735 million. Through December 31, 2004,
the Company has repurchased approximately 12.3 million shares of its common
stock at an average price of $80.54 for $992 million. At December 31, 2004, $162
million of the share repurchase authorization remained available. For the year
ended December 31, 2004, the Company reissued approximately 3.6 million shares
in connection with employee benefit plans. In January 2005, the Company's Board
of Directors expanded the share repurchase authorization by an additional $350
million, bringing the total amount authorized and available for repurchases to
$512 million as of January 27, 2005.
12. STOCK OWNERSHIP AND COMPENSATION PLANS
Employee and Non-employee Directors Stock Ownership Programs
In 1999, the Company established the 1999 Employee Equity
Participation Program (the "1999 EEPP") to replace the Company's prior plan
established in 1996 (the "1996 EEPP"). The 1999 EEPP provides for three types of
awards: (a) stock options, (b) stock appreciation rights and (c) incentive stock
awards. The 1999 EEPP provides for the grant to eligible employees of either
non-qualified or incentive stock options, or both, to purchase shares of Quest
F-26
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
Diagnostics common stock at no less than the fair market value on the date of
grant. The stock options are subject to forfeiture if employment terminates
prior to the end of the prescribed vesting period, as determined by the Board of
Directors. The stock options expire on the date designated by the Board of
Directors but in no event more than eleven years from date of grant. Grants of
stock appreciation rights allow eligible employees to receive a payment based on
the appreciation of Quest Diagnostics common stock in cash, shares of Quest
Diagnostics common stock or a combination thereof. The stock appreciation rights
are granted at an exercise price at no less than the fair market value of Quest
Diagnostics common stock on the date of grant. Stock appreciation rights expire
on the date designated by the Board of Directors but in no event more than
eleven years from date of grant. No stock appreciation rights have been granted
under the 1999 EEPP. Under the incentive stock provisions of the plan, the 1999
EEPP allows eligible employees to receive awards of shares, or the right to
receive shares, of Quest Diagnostics common stock, the equivalent value in cash
or a combination thereof. These shares are generally earned on achievement of
financial performance goals and are subject to forfeiture if employment
terminates prior to the end of the prescribed vesting period, which ranges
primarily from three to four years. The fair market value of the shares awarded
is recorded as unearned compensation. The amount of unearned compensation is
subject to adjustment based upon changes in earnings estimates, if any, during
the initial year of grant and is amortized to compensation expense over the
prescribed vesting period. Key executive, managerial and technical employees are
eligible to participate in the 1999 EEPP. The provisions of the 1996 EEPP were
similar to those outlined above for the 1999 EEPP.
The 1999 EEPP increased the maximum number of shares of Quest
Diagnostics common stock that may be optioned or granted to 18 million shares.
In addition, any remaining shares under the 1996 EEPP are available for issuance
under the 1999 EEPP.
In 1998, the Company established the Quest Diagnostics Incorporated
Stock Option Plan for Non-employee Directors (the "Director Option Plan"). The
Director Option Plan provides for the grant to non-employee directors of
non-qualified stock options to purchase shares of Quest Diagnostics common stock
at no less than the fair market value on the date of grant. The maximum number
of shares that may be issued under the Director Option Plan is 1 million shares.
The stock options expire ten years from date of grant and generally vest over
three years. During 2004, 2003 and 2002, grants under the Director Option Plan
totaled 90, 94 and 94 thousand shares, respectively.
Transactions under the stock option plans were as follows (options in
thousands, except per share amounts):
2004 2003 2002
------- ------- -------
Options outstanding, beginning of year................. 10,240 8,922 8,695
Options granted........................................ 2,214 3,176 2,052
Options exercised...................................... (3,521) (1,616) (1,543)
Options terminated..................................... (557) (242) (282)
------ ------ ------
Options outstanding, end of year....................... 8,376 10,240 8,922
====== ====== ======
Exercisable............................................ 4,258 5,706 3,943
Weighted average exercise price:
Options granted..................................... $ 81.69 $ 53.33 $ 74.92
Options exercised................................... 32.12 20.29 18.70
Options terminated.................................. 59.30 58.31 26.05
Options outstanding, end of year.................... 58.98 44.85 38.83
Exercisable, end of year............................ 47.89 34.01 22.09
Weighted average fair value of options at grant date... $ 34.45 $ 23.21 $ 33.74
F-27
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
The following relates to options outstanding at December 31, 2004:
Options Outstanding Options Exercisable
- -------------------------------------------------------------------- -------------------------------
Weighted
Average
Remaining Weighted Weighted
Range of Shares Contractual Life Average Shares Average
Exercise Price (in thousands) (in years) Exercise Price (in thousands) Exercise Price
- --------------- -------------- ---------------- -------------- -------------- --------------
$5.26 - $11.28 262 2.5 $ 7.53 262 $ 7.53
$12.92 - $19.16 728 4.7 13.74 728 13.74
$28.53 - $35.64 199 5.3 30.72 199 30.72
$44.00 - $60.00 3,011 7.3 51.22 1,841 51.88
$60.06 - $74.53 1,756 7.6 68.40 1,010 69.15
$80.29 - $96.05 2,420 9.0 83.31 218 93.82
The following summarizes the activity relative to incentive stock
awards granted in 2004, 2003 and 2002 (shares in thousands):
2004 2003 2002
----- ------ ------
Incentive shares, beginning of year............... 288 735 1,320
Incentive shares granted.......................... -- 102 --
Incentive shares vested........................... (269) (533) (570)
Incentive shares forfeited and canceled........... (19) (16) (15)
----- ------ ------
Incentive shares, end of year..................... -- 288 735
===== ====== ======
Weighted average fair value of incentive shares
at grant date ................................. $ -- $49.88 $ --
Employee Stock Purchase Plan
Under the Company's Employee Stock Purchase Plan ("ESPP"),
substantially all employees can elect to have up to 10% of their annual wages
withheld to purchase Quest Diagnostics common stock. The purchase price of the
stock is 85% of the lower of its beginning-of-quarter or end-of-quarter market
price. In 2005, the Company's ESPP was amended such that effective July 1, 2005,
the purchase price of the stock will be 85% of the market price of the Company's
common stock on the last business day of each calendar month. Under the ESPP,
the maximum number of shares of Quest Diagnostics common stock which may be
purchased by eligible employees is 4 million. Approximately 230, 272 and 236
thousand shares of common stock were purchased by eligible employees in 2004,
2003 and 2002, respectively.
Employee Stock Ownership Plan
Prior to 1999, the Company maintained its Employee Stock Ownership
Plan ("ESOP") to account for certain shares of Quest Diagnostics common stock
which had been issued for the account of all active regular employees of the
Company as of December 31, 1996. Effective with the closing of the SBCL
acquisition, the Company modified certain provisions of the ESOP to provide an
additional benefit to employees through ownership of the Company's common stock.
During the year ended December 31, 2002, the ESOP was merged into the Company's
defined contribution plan. Prior to the merger of the ESOP into the Company's
defined contribution plan, substantially all of the Company's employees were
eligible to participate in the ESOP. The Company's contributions to the ESOP
trust were based on 2% of eligible employee compensation for those employees who
were actively employed or on a leave of absence on the last day of the plan
year. Company contributions to the trust were made in the form of shares of
Quest Diagnostics common stock. The Company's contributions to this plan
aggregated $10.4 million for 2002.
F-28
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
Defined Contribution Plan
The Company maintains a qualified defined contribution plan covering
substantially all of its employees. During the year ended December 31, 2002, the
ESOP, to which the Company made annual contributions equal to 2% of eligible
compensation, was merged into the Company's defined contribution plan and the
Company increased its maximum matching contribution for its defined contribution
plan from 4% to 6% of an employee's eligible wages. The Company's expense for
contributions to its defined contribution plan aggregated $62 million, $54
million and $42 million for 2004, 2003 and 2002, respectively.
Supplemental Deferred Compensation Plan
The Company's supplemental deferred compensation plan is an unfunded,
non-qualified plan that provides for certain management and highly compensated
employees to defer up to 50% of their eligible compensation in excess of their
defined contribution plan limits. In addition, certain members of senior
management have an additional opportunity to defer up to 95% of their variable
incentive compensation. The compensation deferred under this plan, together with
Company matching amounts, are credited with earnings or losses measured by the
mirrored rate of return on investments elected by plan participants. Each plan
participant is fully vested in all deferred compensation, Company match and
earnings credited to their account. Although the Company is currently
contributing all participant deferrals and matching amounts to a trust, the
funds in the trust, totaling $20.9 million and $19.2 million at December 31,
2004 and 2003, respectively, are general assets of the Company and are subject
to any claims of the Company's creditors. The Company's expense for matching
contributions to this plan were $0.7 million, $0.4 million and $0.4 million for
2004, 2003 and 2002, respectively.
13. RELATED PARTY TRANSACTIONS
At December 31, 2004, GlaxoSmithKline plc ("GSK"), the result of the
merger of Glaxo Wellcome and SmithKline Beecham in December 2000, beneficially
owned approximately 19% of the outstanding shares of Quest Diagnostics common
stock. During 2004, the Company repurchased approximately 3.9 million shares of
its common stock for approximately $355 million from GSK.
GSK has a long-term contractual relationship with Quest Diagnostics
under which Quest Diagnostics is the primary provider of testing to support
GSK's clinical trials testing requirements worldwide (the "Clinical Trials
Agreements").
Significant transactions with GSK during 2004, 2003 and 2002 included:
2004 2003 2002
------- ------- -------
Net revenues, primarily derived under the Clinical Trials
Agreements............................................ $73,894 $50,060 $32,822
In addition, under the SBCL acquisition agreements, SmithKline Beecham
has agreed to indemnify Quest Diagnostics, on an after tax basis, against
certain matters primarily related to taxes and billing and professional
liability claims.
At December 31, 2004 and 2003, accounts payable and accrued expenses
included $28 million and $21 million, respectively, due to SmithKline Beecham,
primarily related to tax benefits associated with indemnifiable matters.
F-29
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
14. COMMITMENTS AND CONTINGENCIES
Minimum rental commitments under noncancelable operating leases,
primarily real estate, in effect at December 31, 2004 are as follows:
Year ending December 31,
- ------------------------
2005................................................................ $128,854
2006................................................................ 99,332
2007................................................................ 73,564
2008................................................................ 55,436
2009................................................................ 43,525
2010 and thereafter................................................. 122,564
--------
Minimum lease payments.............................................. 523,275
Noncancelable sub-lease income...................................... (128)
--------
Net minimum lease payments.......................................... $523,147
========
Operating lease rental expense for 2004, 2003 and 2002 aggregated $133
million, $121 million and $97 million, respectively. Rent expense associated
with operating leases that include scheduled rent increases and tenant
incentives, such as rent holidays, is recorded on a straight-line basis over the
term of the lease.
The Company has certain noncancelable commitments to purchase products
or services from various suppliers, mainly for telecommunications and standing
orders to purchase reagents and other laboratory supplies. At December 31, 2004,
the approximate total future purchase commitments are $42 million, of which $35
million are expected to be incurred in 2005.
In support of its risk management program, the Company has standby
letters of credit issued under its letter of credit lines to ensure its
performance or payment to third parties, which amounted to $55 million at
December 31, 2004. The letters of credit, which are renewed annually, primarily
represent collateral for current and future automobile liability and workers'
compensation loss payments.
The Company has entered into several settlement agreements with
various government and private payers during recent years relating to
industry-wide billing and marketing practices that had been substantially
discontinued by the mid-1990s. The Company is aware of certain pending lawsuits
related to billing practices filed under the qui tam provisions of the civil
False Claims Act and other federal and state statutes. Some of the proceedings
against the Company involve claims that are substantial in amount.
The Company and its test kit manufacturing subsidiary, Nichols
Institute Diagnostics, each received a subpoena from the United States
Attorney's office for the Eastern District of New York. The subpoenas seek the
production of various business records, including documents related to
parathyroid hormone testing and parathyroid hormone test kits manufactured by
Nichols Institute Diagnostics. In addition, the Company is involved in various
legal proceedings arising in the ordinary course of business. Some of the
proceedings against the Company involve claims that are substantial in amount.
Although management believes that established reserves for claims are
sufficient, it is possible that additional information (such as the indication
by the government of criminal activity, additional tests being questioned or
other changes in the government's or private claimants' theories of wrongdoing)
may become available which may cause the final resolution of these matters to
exceed established reserves by an amount which could be material to the
Company's results of operations and cash flows in the period in which such
claims are settled. The Company does not believe that these issues will have a
material adverse effect on its overall financial condition. However, the Company
understands that there may be pending qui tam claims brought by former employees
or other "whistle blowers", or other pending claims as to which the Company has
not been provided with a copy of the complaint and accordingly cannot determine
the extent of any potential liability.
F-30
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
As a general matter, providers of clinical laboratory testing services
may be subject to lawsuits alleging negligence or other similar legal claims.
These suits could involve claims for substantial damages. Any professional
liability litigation could also have an adverse impact on the Company's client
base and reputation. The Company maintains various liability insurance coverages
for claims that could result from providing or failing to provide clinical
laboratory testing services, including inaccurate testing results and other
exposures. The Company's insurance coverage limits its maximum exposure on
individual claims; however, the Company is essentially self-insured for a
significant portion of these claims. The basis for claims reserves considers
actuarially determined losses based upon the Company's historical and projected
loss experience. Management believes that present insurance coverage and
reserves are sufficient to cover currently estimated exposures. Although
management cannot predict the outcome of any claims made against the Company,
management does not anticipate that the ultimate outcome of any such proceedings
or claims will have a material adverse effect on the Company's financial
position but may be material to the Company's results of operations and cash
flows in the period in which such claims are resolved.
15. SUMMARIZED FINANCIAL INFORMATION
As described in Note 10, the Senior Notes and the Debentures are
guaranteed by the Subsidiary Guarantors. With the exception of Quest Diagnostics
Receivables Incorporated (see paragraph below), the non-guarantor subsidiaries
are primarily foreign and less than wholly owned subsidiaries.
In conjunction with the Company's Secured Receivables Credit Facility
described in Note 10, the Company maintains a wholly owned non-guarantor
subsidiary, Quest Diagnostics Receivables Incorporated ("QDRI"). Through March
31, 2004, the Company and the Subsidiary Guarantors, with the exception of AML
and Unilab, transferred all private domestic receivables (principally excluding
receivables due from Medicare, Medicaid and other federal programs, and
receivables due from customers of its joint ventures) to QDRI. Effective with
the second quarter of 2004, the Company and Subsidiary Guarantors, including AML
and Unilab, transfer all private domestic receivables to QDRI. QDRI utilizes the
transferred receivables to collateralize the Company's Secured Receivables
Credit Facility. The Company and the Subsidiary Guarantors provide collection
services to QDRI. QDRI uses cash collections principally to purchase new
receivables from the Company and the Subsidiary Guarantors.
The following condensed consolidating financial data illustrates the
composition of the combined guarantors. Investments in subsidiaries are
accounted for by the parent using the equity method for purposes of the
supplemental consolidating presentation. Earnings (losses) of subsidiaries are
therefore reflected in the parent's investment accounts and earnings. The
principal elimination entries relate to investments in subsidiaries and
intercompany balances and transactions. On April 1, 2002, Quest Diagnostics
acquired AML (see Note 3), which has been included in the accompanying condensed
consolidating financial data, subsequent to the closing of the acquisition, as a
Subsidiary Guarantor. On February 28, 2003, Quest Diagnostics acquired Unilab
(see Note 3), which has been included in the accompanying condensed
consolidating financial data, subsequent to the closing of the acquisition, as a
Subsidiary Guarantor.
F-31
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
Condensed Consolidating Balance Sheet
December 31, 2004
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
---------- ---------- ------------ ------------ ------------
Assets
Current assets:
Cash and cash equivalents............... $ 56,424 $ 6,058 $ 10,820 $ -- $ 73,302
Accounts receivable, net................ 22,365 75,359 551,557 -- 649,281
Other current assets.................... 12,032 109,100 87,365 -- 208,497
---------- ---------- --------- ----------- ----------
Total current assets................. 90,821 190,517 649,742 -- 931,080
Property, plant and equipment, net...... 213,416 379,952 26,117 -- 619,485
Goodwill and intangible assets, net .... 158,021 2,315,015 45,376 -- 2,518,412
Intercompany receivable (payable)....... 493,578 (124,047) (369,531) -- --
Investment in subsidiaries.............. 2,109,612 -- -- (2,109,612) --
Other assets............................ 49,031 49,100 36,680 -- 134,811
---------- ---------- --------- ----------- ----------
Total assets......................... $3,114,479 $2,810,537 $ 388,384 $(2,109,612) $4,203,788
========== ========== ========= =========== ==========
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable and accrued expenses... $ 368,363 $ 268,420 $ 32,204 $ -- $ 668,987
Short-term borrowings and current
portion of long-term debt............ 244,713 167 129,921 -- 374,801
---------- ---------- --------- ----------- ----------
Total current liabilities............ 613,076 268,587 162,125 -- 1,043,788
Long-term debt.......................... 170,293 551,771 1,957 -- 724,021
Other liabilities....................... 42,459 80,155 24,714 -- 147,328
Stockholders' equity.................... 2,288,651 1,910,024 199,588 (2,109,612) 2,288,651
---------- ---------- --------- ----------- ----------
Total liabilities and stockholders'
equity............................ $3,114,479 $2,810,537 $ 388,384 $(2,109,612) $4,203,788
========== ========== ========= =========== ==========
Condensed Consolidating Balance Sheet
December 31, 2003
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
---------- ---------- ------------ ------------ ------------
Assets
Current assets:
Cash and cash equivalents............... $ 141,588 $ 1,991 $ 11,379 $ -- $ 154,958
Accounts receivable, net................ 17,919 164,247 427,021 -- 609,187
Other current assets.................... 36,576 114,758 80,307 -- 231,641
---------- ---------- --------- ----------- ----------
Total current assets................. 196,083 280,996 518,707 -- 995,786
Property, plant and equipment, net...... 228,109 350,196 29,000 -- 607,305
Goodwill and intangible assets, net..... 158,295 2,332,147 45,411 -- 2,535,853
Intercompany receivable (payable)....... 510,958 (106,078) (404,880) -- --
Investment in subsidiaries.............. 1,929,235 -- -- (1,929,235) --
Other assets............................ 73,398 50,053 39,023 -- 162,474
---------- ---------- --------- ----------- ----------
Total assets......................... $3,096,078 $2,907,314 $ 227,261 $(1,929,235) $4,301,418
========== ========== ========= =========== ==========
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable and accrued expenses... $ 337,635 $ 281,753 $ 30,462 $ -- $ 649,850
Current portion of long-term debt....... -- 73,950 -- -- 73,950
---------- ---------- --------- ----------- ----------
Total current liabilities............ 337,635 355,703 30,462 -- 723,800
Long-term debt.......................... 315,844 710,908 1,955 -- 1,028,707
Other liabilities....................... 47,905 83,781 22,531 -- 154,217
Stockholders' equity.................... 2,394,694 1,756,922 172,313 (1,929,235) 2,394,694
---------- ---------- --------- ----------- ----------
Total liabilities and stockholders'
equity............................ $3,096,078 $2,907,314 $ 227,261 $(1,929,235) $4,301,418
========== ========== ========= =========== ==========
F-32
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
Condensed Consolidating Statement of Operations
For the Year Ended December 31, 2004
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
---------- ---------- ------------ ------------ ------------
Net revenues .............................. $ 822,020 $4,041,608 $513,500 $(250,527) $5,126,601
Operating costs and expenses:
Cost of services ....................... 460,768 2,351,348 178,596 -- 2,990,712
Selling, general and administrative .... 108,401 886,332 252,113 (19,100) 1,227,746
Amortization of intangible assets ...... 1,399 5,269 35 -- 6,703
Royalty (income) expense ............... (330,751) 330,751 -- -- --
Other operating expense, net ........... 9,883 79 261 -- 10,223
--------- ---------- -------- --------- ----------
Total operating costs and expenses .. 249,700 3,573,779 431,005 (19,100) 4,235,384
--------- ---------- -------- --------- ----------
Operating income .......................... 572,320 467,829 82,495 (231,427) 891,217
Non-operating expenses, net ............... (70,821) (212,658) (4,039) 231,427 (56,091)
--------- ---------- -------- --------- ----------
Income before taxes ....................... 501,499 255,171 78,456 -- 835,126
Income tax expense ........................ 204,280 102,069 29,582 -- 335,931
--------- ---------- -------- --------- ----------
Income before equity earnings ............. 297,219 153,102 48,874 -- 499,195
Equity earnings from subsidiaries ......... 201,976 -- -- (201,976) --
--------- ---------- -------- --------- ----------
Net income ................................ $ 499,195 $ 153,102 $ 48,874 $(201,976) $ 499,195
========= ========== ======== ========= ==========
Condensed Consolidating Statement of Operations
For the Year Ended December 31, 2003
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
---------- ---------- ------------ ------------ ------------
Net revenues .............................. $ 791,399 $3,709,590 $467,559 $(230,590) $4,737,958
Operating costs and expenses:
Cost of services ....................... 457,819 2,147,387 163,417 -- 2,768,623
Selling, general and administrative .... 76,626 880,951 223,762 (15,639) 1,165,700
Amortization of intangible assets ...... 1,723 6,461 17 -- 8,201
Royalty (income) expense ............... (308,495) 308,495 -- -- --
Other operating (income) expense, net... 119 (2,197) 1,058 -- (1,020)
--------- ---------- -------- --------- ----------
Total operating costs and expenses .. 227,792 3,341,097 388,254 (15,639) 3,941,504
--------- ---------- -------- --------- ----------
Operating income .......................... 563,607 368,493 79,305 (214,951) 796,454
Non-operating expenses, net ............... (65,689) (202,146) (5,772) 214,951 (58,656)
--------- ---------- -------- --------- ----------
Income before taxes ....................... 497,918 166,347 73,533 -- 737,798
Income tax expense ........................ 204,795 66,539 29,747 -- 301,081
--------- ---------- -------- --------- ----------
Income before equity earnings ............. 293,123 99,808 43,786 -- 436,717
Equity earnings from subsidiaries ......... 143,594 -- -- (143,594) --
--------- ---------- -------- --------- ----------
Net income ................................ $ 436,717 $ 99,808 $ 43,786 $(143,594) $ 436,717
========= ========== ======== ========= ==========
F-33
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
Condensed Consolidating Statement of Operations
For the Year Ended December 31, 2002
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
--------- ---------- ------------ ------------ ------------
Net revenues .............................. $ 749,268 $3,143,063 $483,637 $(267,917) $4,108,051
Operating costs and expenses:
Cost of services ....................... 477,683 1,804,150 150,555 -- 2,432,388
Selling, general and administrative .... 167,736 663,560 258,667 (15,122) 1,074,841
Amortization of intangible assets ...... 2,154 6,219 -- -- 8,373
Royalty (income) expense ............... (246,687) 246,687 -- -- --
Other operating (income) expense, net .. 2,527 (923) (1,297) -- 307
--------- ---------- -------- --------- ----------
Total operating costs and expenses .. 403,413 2,719,693 407,925 (15,122) 3,515,909
--------- ---------- -------- --------- ----------
Operating income .......................... 345,855 423,370 75,712 (252,795) 592,142
Non-operating expenses, net ............... (73,700) (220,396) (8,464) 252,795 (49,765)
--------- ---------- -------- --------- ----------
Income before taxes ....................... 272,155 202,974 67,248 -- 542,377
Income tax expense ........................ 109,337 81,190 29,696 -- 220,223
--------- ---------- -------- --------- ----------
Income before equity earnings ............. 162,818 121,784 37,552 -- 322,154
Equity earnings from subsidiaries ......... 159,336 -- -- (159,336) --
--------- ---------- -------- --------- ----------
Net income ................................ $ 322,154 $ 121,784 $ 37,552 $(159,336) $ 322,154
========= ========== ======== ========= ==========
Condensed Consolidating Statement of Cash Flows
For the Year Ended December 31, 2004
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
--------- ---------- ------------ ------------ ------------
Cash flows from operating activities:
Net income ...................................... $ 499,195 $ 153,102 $ 48,874 $(201,976) $ 499,195
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Depreciation and amortization ................ 56,399 101,856 10,471 -- 168,726
Provision for doubtful accounts .............. 4,940 43,638 177,732 -- 226,310
Other, net ................................... (71,374) 1,754 16,847 201,976 149,203
Changes in operating assets and liabilities .. 163,057 (118,129) (289,582) -- (244,654)
--------- --------- --------- --------- ---------
Net cash provided by (used in) operating
activities ................................... 652,217 182,221 (35,658) -- 798,780
Net cash used in investing activities ........... (150,826) (105,597) (7,841) 90,564 (173,700)
Net cash provided by (used in) financing
activities ................................... (586,555) (72,557) 42,940 (90,564) (706,736)
--------- --------- --------- --------- ---------
Net change in cash and cash equivalents ......... (85,164) 4,067 (559) -- (81,656)
Cash and cash equivalents, beginning of year .... 141,588 1,991 11,379 -- 154,958
--------- --------- --------- --------- ---------
Cash and cash equivalents, end of year .......... $ 56,424 $ 6,058 $ 10,820 $ -- $ 73,302
========= ========= ========= ========= =========
F-34
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(dollars in thousands unless otherwise indicated)
Condensed Consolidating Statement of Cash Flows
For the Year Ended December 31, 2003
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
--------- ---------- ------------ ------------ ------------
Cash flows from operating activities:
Net income ...................................... $ 436,717 $ 99,808 $ 43,786 $(143,594) $ 436,717
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization ................ 53,611 91,501 8,791 -- 153,903
Provision for doubtful accounts .............. 4,944 64,835 158,443 -- 228,222
Other, net ................................... (78,968) 2,463 18,604 143,594 85,693
Changes in operating assets and liabilities .. 54,277 (178,027) (117,986) -- (241,736)
--------- --------- --------- --------- ---------
Net cash provided by operating activities ....... 470,581 80,580 111,638 -- 662,799
Net cash used in investing activities ........... (271,820) (96,957) (17,342) (30,931) (417,050)
Net cash provided by (used in) financing
activities ................................... (136,188) 10,991 (93,302) 30,931 (187,568)
--------- --------- --------- --------- ---------
Net change in cash and cash equivalents ......... 62,573 (5,386) 994 -- 58,181
Cash and cash equivalents, beginning of year .... 79,015 7,377 10,385 -- 96,777
--------- --------- --------- --------- ---------
Cash and cash equivalents, end of year .......... $ 141,588 $ 1,991 $ 11,379 $ -- $ 154,958
========= ========= ========= ========= =========
Condensed Consolidating Statement of Cash Flows
For the Year Ended December 31, 2002
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
--------- ---------- ------------ ------------ ------------
Cash flows from operating activities:
Net income ...................................... $ 322,154 $ 121,784 $ 37,552 $(159,336) $ 322,154
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Depreciation and amortization ................ 45,718 78,160 7,513 -- 131,391
Provision for doubtful accounts .............. 7,966 29,513 179,881 -- 217,360
Other, net ................................... (52,282) 15,317 35,626 159,336 157,997
Changes in operating assets and liabilities .. 168,559 (250,548) (150,542) -- (232,531)
--------- --------- --------- --------- ---------
Net cash provided by (used in) operating
activities ................................... 492,115 (5,774) 110,030 -- 596,371
Net cash used in investing activities ........... (439,848) (2,480) (6,075) (28,809) (477,212)
Net cash provided by (used in) financing
activities ................................... 26,748 (94,940) (105,331) 28,809 (144,714)
--------- --------- --------- --------- ---------
Net change in cash and cash equivalents ......... 79,015 (103,194) (1,376) -- (25,555)
Cash and cash equivalents, beginning of year .... -- 110,571 11,761 -- 122,332
--------- --------- --------- --------- ---------
Cash and cash equivalents, end of year .......... $ 79,015 $ 7,377 $ 10,385 $ -- $ 96,777
========= ========= ========= ========= =========
F-35
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
(in thousands, except per share data)
Quarterly Operating Results (unaudited)
First Second Third Fourth Total
Quarter Quarter Quarter Quarter Year
---------- ---------- ---------- ---------- ----------
2004
Net revenues ........................... $1,255,742 $1,297,674 $1,289,897 $1,283,288 $5,126,601
Gross profit ........................... 518,461 550,097 541,473 525,858 2,135,889
Net income ............................. 116,149 126,829(a) 130,144 126,073 499,195
Basic earnings per common share ........ 1.13 1.23 1.29 1.26 4.90
Diluted earnings per common share (b)... 1.08 1.18 1.23 1.20 4.69
First Second Third Fourth Total
Quarter Quarter Quarter Quarter Year
---------- ---------- ---------- ---------- ----------
2003 (c)
Net revenues ........................... $1,092,797 $1,219,935 $1,221,221 $1,204,005 $4,737,958
Gross profit ........................... 444,700 516,811 510,041 497,783 1,969,335
Net income ............................. 88,036 120,412 120,024 108,245 436,717
Basic earnings per common share ........ 0.88 1.15 1.15 1.04 4.22
Diluted earnings per common share (b)... 0.84 1.10 1.10 1.00 4.04
(a) During the second quarter of 2004, the Company recorded a $10.3 million
charge associated with the acceleration of certain pension obligations in
connection with the CEO succession process and a $2.9 million charge to
interest expense, net representing the write-off of deferred financing
costs associated with the refinancing of the Company's bank debt and credit
facility.
(b) Previously reported diluted earnings per share have been restated to give
retroactive effect of the required change in accounting for the Company's
1 3/4% contingent convertible debentures for all periods presented (see
Note 2).
(c) On February 28, 2003, Quest Diagnostics completed the acquisition of
Unilab. The quarterly operating results include the results of operations
of Unilab subsequent to the closing of the acquisition (see Note 3).
F-36
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
SCHEDULE II - VALUATION ACCOUNTS AND RESERVES
(in thousands)
Balance at Provision for Net Deductions Balance at
1-1-04 Doubtful Accounts and Other (a) 12-31-04
---------- ----------------- -------------- ----------
Year ended December 31, 2004
Doubtful accounts and allowances.. $211,739 $226,310 $235,192 $202,857
Balance at Provision for Net Deductions Balance at
1-1-03 Doubtful Accounts and Other (a) 12-31-03
---------- ----------------- -------------- ----------
Year ended December 31, 2003
Doubtful accounts and allowances.. $193,456 $228,222 $209,939 $211,739
Balance at Provision for Net Deductions Balance at
1-1-02 Doubtful Accounts and Other (a) 12-31-02
---------- ----------------- -------------- ----------
Year ended December 31, 2002
Doubtful accounts and allowances.. $216,203 $217,360 $240,107 $193,456
- ----------
(a) "Net Deductions and Other" primarily represent accounts written-off, net of
recoveries.
F-37
STATEMENT OF DIFFERENCES
The trademark symbol shall be expressed as............................... 'TM'
The section symbol shall be expressed as................................. 'SS'