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Table of Contents                                             

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2015
Commission file number 001-12215

Quest Diagnostics Incorporated

Three Giralda Farms
Madison, NJ 07940
(973) 520-2700

Delaware
(State of Incorporation)

16-1387862
(I.R.S. Employer Identification Number)

 

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 such 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 o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer x
Accelerated filer o
Non-accelerated filer o (Do not check if a smaller reporting company)
Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
As of April 23, 2015, there were outstanding 143,636,295 shares of the registrant’s common stock, $.01 par value.


Table of Contents                                             

PART I - FINANCIAL INFORMATION
 
 
Page
Item 1. Financial Statements
 
 
 
 
 
Index to unaudited consolidated financial statements filed as part of this report:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


1

Table of Contents                                             

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE MONTHS ENDED MARCH 31, 2015 AND 2014
(unaudited)
(in millions, except per share data)


 
Three Months Ended March 31,
 
2015
 
2014
Net revenues
$
1,839

 
$
1,746

 
 
 
 
Operating costs and expenses:
 

 
 

Cost of services
1,163

 
1,101

Selling, general and administrative
419

 
415

Amortization of intangible assets
21

 
22

Other operating expense, net
8

 

 
 
 
 
Total operating costs and expenses
1,611

 
1,538

 
 
 
 
Operating income
228

 
208

 
 
 
 
Other income (expense):
 

 
 

Interest expense, net
(45
)
 
(39
)
Equity in earnings of equity method investees
7

 
6

Other (expense) income, net
(78
)
 
1

 
 
 
 
Total non-operating expenses, net
(116
)
 
(32
)
 
 
 
 
Income before income taxes
112

 
176

Income tax expense
42

 
65

 
 
 
 
Net income
70

 
111

Less: Net income attributable to noncontrolling interests
9

 
7

 
 
 
 
Net income attributable to Quest Diagnostics
$
61

 
$
104

 
 
 
 
Earnings per share attributable to Quest Diagnostics’ common stockholders:
 

 
 

Basic
$
0.42

 
$
0.72

Diluted
$
0.42

 
$
0.71

 
 
 
 
Weighted average common shares outstanding:
 

 
 

Basic
144

 
144

Diluted
146

 
145

 
 
 
 
Dividends per common share
$
0.38

 
$
0.33

The accompanying notes are an integral part of these statements.

2

Table of Contents                                             

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
FOR THE THREE MONTHS ENDED MARCH 31, 2015 AND 2014
(unaudited)
(in millions)

 
Three Months Ended March 31,
 
2015
 
2014
Net income
$
70

 
$
111

 
 
 
 
Other comprehensive (loss) income:
 
 
 
Currency translation
(6
)
 
(1
)
Market valuation, net of tax
2

 

Net deferred loss on cash flow hedges, net of tax
1

 
(2
)
 
 
 
 
Other comprehensive loss
(3
)
 
(3
)
 
 
 
 
Comprehensive income
67

 
108

Less: Comprehensive income attributable to noncontrolling interests
9

 
7

 
 
 
 
Comprehensive income attributable to Quest Diagnostics
$
58

 
$
101

The accompanying notes are an integral part of these statements.


3

Table of Contents                                             

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
MARCH 31, 2015 AND DECEMBER 31, 2014
(unaudited)
(in millions, except per share data)
 
March 31,
2015
 
December 31,
2014
Assets
 

 
 

Current assets:
 

 
 

Cash and cash equivalents
$
974

 
$
192

Accounts receivable, net of allowance for doubtful accounts of $257 and $250 at March 31, 2015 and December 31, 2014, respectively
949

 
932

Inventories
106

 
110

Deferred income taxes
158

 
169

Prepaid expenses and other current assets
188

 
200

 
 
 
 
Total current assets
2,375

 
1,603

Property, plant and equipment, net
902

 
933

Goodwill
5,986

 
6,032

Intangible assets, net
1,041

 
1,071

Other assets
254

 
238

Non-current assets held for sale
55

 

 
 
 
 
Total assets
$
10,613

 
$
9,877

 
 
 
 
Liabilities and Stockholders’ Equity
 

 
 

Current liabilities:
 

 
 

Accounts payable and accrued expenses
$
1,046

 
$
1,191

Current portion of long-term debt
1,043

 
518

 
 
 
 
Total current liabilities
2,089

 
1,709

Long-term debt
3,688

 
3,244

Other liabilities
565

 
594

Stockholders’ equity:
 

 
 

Quest Diagnostics stockholders’ equity:
 

 
 

Common stock, par value $0.01 per share; 600 shares authorized at both March 31, 2015 and December 31, 2014; 216 shares and 215 shares issued at March 31, 2015 and December 31, 2014, respectively
2

 
2

Additional paid-in capital
2,427

 
2,418

Retained earnings
5,729

 
5,723

Accumulated other comprehensive loss
(30
)
 
(27
)
Treasury stock, at cost; 72 shares and 71 shares at March 31, 2015 and December 31, 2014
(3,885
)
 
(3,815
)
 
 
 
 
Total Quest Diagnostics stockholders’ equity
4,243

 
4,301

Noncontrolling interests
28

 
29

 
 
 
 
Total stockholders’ equity
4,271

 
4,330

 
 
 
 
Total liabilities and stockholders’ equity
$
10,613

 
$
9,877

The accompanying notes are an integral part of these statements.

4

Table of Contents                                             

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE THREE MONTHS ENDED MARCH 31, 2015 AND 2014
(unaudited)
(in millions)
 
Three Months Ended March 31,
 
2015
 
2014
Cash flows from operating activities:
 

 
 

Net income
$
70

 
$
111

Adjustments to reconcile net income to net cash provided by operating activities:
 

 
 

Depreciation and amortization
78

 
75

Provision for doubtful accounts
79

 
75

Deferred income tax provision (benefit)
14

 
(10
)
Stock-based compensation expense
12

 
12

Excess tax benefits from stock-based compensation arrangements
(2
)
 

Non-cash portion of loss on retirement of debt
1

 

Other, net
6

 
(2
)
Changes in operating assets and liabilities:
 

 
 

Accounts receivable
(97
)
 
(152
)
Accounts payable and accrued expenses
(120
)
 
(86
)
Income taxes payable
10

 
70

Other assets and liabilities, net
1

 
(9
)
 
 
 
 
Net cash provided by operating activities
52

 
84

 
 
 
 
Cash flows from investing activities:
 

 
 

Business acquisitions, net of cash acquired

 
(567
)
Capital expenditures
(56
)
 
(68
)
Decrease (increase) in investments and other assets
1

 
(1
)
 
 
 
 
Net cash used in investing activities
(55
)
 
(636
)
 
 
 
 
Cash flows from financing activities:
 

 
 

Proceeds from borrowings
1,389

 
1,513

Repayments of debt
(440
)
 
(923
)
Purchases of treasury stock
(110
)
 
(32
)
Exercise of stock options
35

 
12

Excess tax benefits from stock-based compensation arrangements
2

 

Dividends paid
(48
)
 
(43
)
Distributions to noncontrolling interests
(10
)
 
(3
)
Other financing activities, net
(33
)
 
(15
)
 
 
 
 
Net cash provided by financing activities
785

 
509

 
 
 
 
Net change in cash and cash equivalents
782

 
(43
)
Cash and cash equivalents, beginning of period
192

 
187

 
 
 
 
Cash and cash equivalents, end of period
$
974

 
$
144

The accompanying notes are an integral part of these statements.

5

Table of Contents                                             

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
FOR THE THREE MONTHS ENDED MARCH 31, 2015 AND 2014
(unaudited)
(in millions)
 
 
 
Quest Diagnostics Stockholders’ Equity
 
 
 
 
 
Shares of
Common Stock
Outstanding
 
Common
Stock
 
Additional
Paid-In
Capital
 
Retained
Earnings
 
Accumulated
Other
Compre-
hensive Loss
 
Treasury
Stock, at
Cost
 
Non-
controlling
Interests
 
Total Stock-
holders’
Equity
Balance, December 31, 2014
144

 
$
2

 
$
2,418

 
$
5,723

 
$
(27
)
 
$
(3,815
)
 
$
29

 
$
4,330

Net income


 


 


 
61

 


 


 
9

 
70

Other comprehensive loss, net of tax


 


 


 


 
(3
)
 


 


 
(3
)
Dividends declared


 


 


 
(55
)
 


 


 


 
(55
)
Distributions to noncontrolling interests


 


 


 


 


 


 
(10
)
 
(10
)
Issuance of common stock under benefit plans
1

 


 
1

 


 


 
4

 


 
5

Stock-based compensation expense


 


 
11

 


 


 
1

 


 
12

Exercise of stock options
1

 


 


 


 


 
35

 


 
35

Shares to cover employee payroll tax withholdings on stock issued under benefit plans


 


 
(6
)
 


 


 


 


 
(6
)
Tax benefits associated with stock-based compensation plans


 


 
3

 


 


 


 


 
3

Purchases of treasury stock
(2
)
 


 


 


 


 
(110
)
 


 
(110
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, March 31, 2015
144

 
$
2

 
$
2,427

 
$
5,729

 
$
(30
)
 
$
(3,885
)
 
$
28

 
$
4,271

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

 
Quest Diagnostics Stockholders’ Equity
 
 
 
 
 
Shares of
Common
Stock
Outstanding
 
Common
Stock
 
Additional
Paid-In
Capital
 
Retained
Earnings
 
Accumulated
Other
Compre-
hensive Loss
 
Treasury
Stock, at
Cost
 
Non-
controlling
Interests
 
Total Stock-
holders’
Equity
Balance, December 31, 2013
144

 
$
2

 
$
2,379

 
$
5,358

 
$
(8
)
 
$
(3,783
)
 
$
25

 
$
3,973

Net income
 

 
 

 
 

 
104

 
 

 
 

 
7

 
111

Other comprehensive loss, net of tax


 


 


 


 
(3
)
 


 


 
(3
)
Dividends declared
 

 
 

 
 

 
(47
)
 
 

 
 

 
 

 
(47
)
Distributions to noncontrolling interests
 

 
 

 
 

 
 

 
 

 
 

 
(3
)
 
(3
)
Issuance of common stock under benefit plans
1

 


 


 
 

 
 

 
5

 
 

 
5

Stock-based compensation expense
 

 
 

 
11

 
 

 
 

 
1

 
 

 
12

Exercise of stock options


 
 

 
(2
)
 
 

 
 

 
14

 
 

 
12

Shares to cover employee payroll tax withholdings on stock issued under benefit plans


 


 
(5
)
 
 

 
 

 
 

 
 

 
(5
)
Tax benefits associated with stock-based compensation plans
 

 
 

 
(2
)
 
 

 
 

 
 

 
 

 
(2
)
Purchases of treasury stock
(1
)
 
 

 


 
 

 
 

 
(32
)
 
 

 
(32
)
Other
 

 
 

 
 

 
 

 
 

 
 

 
(1
)
 
(1
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, March 31, 2014
144

 
$
2

 
$
2,381

 
$
5,415

 
$
(11
)
 
$
(3,795
)
 
$
28

 
$
4,020

The accompanying notes are an integral part of these statements.

6

Table of Contents                                             

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
(dollars in millions unless otherwise indicated)

1.    DESCRIPTION OF BUSINESS
    
Background
    
Quest Diagnostics Incorporated and its subsidiaries ("Quest Diagnostics" or the "Company") empower people to take action to improve health outcomes.  The Company uses its extensive database of clinical lab results to derive diagnostic insights that reveal new avenues to identify and treat disease, inspire healthy behaviors and improve health care management.  The Company's diagnostic information services business ("DIS") provides insights through clinical testing and related services to patients, physicians, hospitals, accountable care organizations ("ACOs"), integrated delivery networks ("IDNs"), health plans, employers and others. The Company offers the broadest access in the United States to diagnostic information services through its nationwide network of laboratories, Company-owned patient service centers and phlebotomists in physician offices. The Company is the world's leading provider of diagnostic information services, including routine clinical testing, gene-based and esoteric testing, anatomic pathology services and drugs-of-abuse testing, as well as related services and insights. The Company provides interpretive consultation through the organization, with one of the largest medical and scientific staffs in the industry and hundreds of M.D.s and Ph.D.s, many of whom are recognized leaders in their fields. The Company's Diagnostic Solutions ("DS") businesses offer a variety of solutions for life insurers, healthcare providers and others. The Company also is the leading provider of risk assessment services for the life insurance industry as well as a leading provider of central laboratory testing for clinical trials. The Company's diagnostics products business manufactures and markets diagnostic products. In addition, the Company offers healthcare organizations, clinicians and patients robust information technology solutions.

2.    SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation
    
The interim unaudited consolidated financial statements reflect all adjustments which in the opinion of management are necessary for a fair statement of results of operations, comprehensive income, financial condition, cash flows and stockholders' equity for the periods presented. Except as otherwise disclosed, all such adjustments are of a normal recurring nature. Operating results for the interim periods are not necessarily indicative of the results that may be expected for the full year. These interim unaudited consolidated financial statements should be read in conjunction with the audited consolidated financial statements included in the Company’s 2014 Annual Report on Form 10-K. The year-end balance sheet data was derived from the audited financial statements as of December 31, 2014, but does not include all the disclosures required by accounting principles generally accepted in the United States (“GAAP”).
    
Use of Estimates
    
The preparation of financial statements in conformity with GAAP 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.
    
Earnings Per Share

The Company's unvested restricted stock units that contain non-forfeitable rights to dividends are participating securities and, therefore, are included in the earnings allocation in computing earnings per share using the two-class method. Basic earnings per common share is calculated by dividing net income, adjusted for earnings allocated to participating securities, by the weighted average number of common shares outstanding. Diluted earnings per common share is calculated by dividing net income, adjusted for earnings allocated to participating securities, by the weighted average number of 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 outstanding stock options and performance share units granted under the Company's Amended and Restated Employee Long-Term Incentive Plan and its Amended and Restated Non-Employee Director Long-Term Incentive Plan. Earnings allocable to participating securities include the portion of dividends declared as well as the portion of undistributed earnings during the period allocable to participating securities.


7

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(unaudited)
(dollars in millions unless otherwise indicated)


Adoption of New Accounting Standards
        
On January 1, 2015, the Company adopted a new accounting standard issued by the Financial Accounting Standards Board ("FASB") related to the presentation and reporting of discontinued operations, including the disposals of components of an entity. The standard changes the criteria for reporting discontinued operations and requires expanded disclosures about discontinued operations that will provide financial statement users with more information about the assets, liabilities, income, and expenses of discontinued operations. The new standard also requires disclosure of the pre-tax income attributable to a disposal of a significant part of an organization that does not qualify for discontinued operations reporting. The impact of this standard on the Company’s results of operations, financial position, cash flows and disclosures will be assessed as part of any future disposal activity.

New Accounting Pronouncements
    
In May 2014, the FASB issued an accounting standard update ("ASU") on revenue recognition. This ASU outlines a single comprehensive model to use in accounting for revenue arising from contracts with customers. This standard supersedes existing revenue recognition requirements and eliminates most industry-specific guidance from GAAP. The core principle of the revenue recognition standard is to require an entity to recognize as revenue the amount that reflects the consideration to which it expects to be entitled in exchange for goods or services as it transfers control to its customers. The standard requires additional disclosures including those that are qualitative and quantitative disclosures about the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. This ASU is effective for the Company in the first quarter of 2017 with the option of using a full retrospective method or a modified retrospective method. In April 2015, the FASB proposed a deferral of the effective date of this ASU by one year, but permits entities to adopt one year earlier if they choose.  The proposal to defer the effective date is currently not approved. The Company is currently assessing the impact of the adoption of this ASU on the Company’s results of operations, financial position and cash flows.

In February 2015, the FASB issued an ASU which makes targeted amendments to the current consolidation guidance for variable interest entities and limited partnerships and similar entities. The ASU is effective for the Company in the first quarter of 2016 with the option of using a full retrospective or a modified retrospective method. The Company does not expect the adoption of this standard to have a material impact on its results of operations, financial position, and cash flows.

In April 2015, the FASB issued an ASU which requires that debt issuance costs be presented in the balance sheet as a direct reduction to the carrying amount of the associated debt liability, consistent with debt discounts. Currently debt issuance costs are recognized as an asset. The ASU is effective for the Company in the first quarter of 2016 and is required to be applied retrospectively. Early adoption is permitted. The Company does not expect the adoption of this standard to have a material impact on its results of operations, financial position, and cash flows.

In April 2015, the FASB issued an ASU which provides guidance in determining whether a cloud computing arrangement includes a software license.  If it is determined that a cloud computing arrangement does include a software license, the software element of the arrangement should be accounted for consistent with the acquisition of other software licenses.  If the arrangement does not include a software license, it should be accounted for as a service contract.  The ASU is effective for the Company in the first quarter of 2016 and can be applied prospectively to all arrangements entered into or materially modified after the effective date or retrospectively.  The Company does not expect the adoption of this ASU to have a material impact on its results of operations, financial position and cash flows.




8

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(unaudited)
(dollars in millions unless otherwise indicated)


3.    EARNINGS PER SHARE

The computation of basic and diluted earnings per common share was as follows (in millions, except per share data):

 
Three Months Ended March 31,
 
2015
 
2014
Amounts attributable to Quest Diagnostics’ stockholders:
 

 
 

Net income attributable to Quest Diagnostics
$
61

 
$
104

Less: Earnings allocated to participating securities

 
1

 
 
 
 
Earnings available to Quest Diagnostics’ common stockholders – basic and diluted
$
61

 
$
103

 
 
 
 
Weighted average common shares outstanding – basic
144

 
144

Effect of dilutive securities:
 

 
 

Stock options and performance share units
2

 
1

 
 
 
 
Weighted average common shares outstanding – diluted
146

 
145

 
 
 
 
Earnings per share attributable to Quest Diagnostics’ common stockholders:
 

 
 

Basic
$
0.42

 
$
0.72

Diluted
$
0.42

 
$
0.71


The following securities were not included in the calculation of diluted earnings per share due to their antidilutive effect (shares in millions):
 
Three Months Ended March 31,
 
2015
 
2014
Stock options and performance share units
1

 
6


4.    RESTRUCTURING ACTIVITIES

Invigorate Program

During 2012, the Company committed to a course of action related to a multi-year program called Invigorate which is
designed to reduce its cost structure. Invigorate has consisted of several flagship programs, with structured plans in each, to drive savings and improve performance across the customer value chain. These flagship programs include: organization excellence; information technology excellence; procurement excellence; service excellence; lab excellence; and billing excellence. From 2012 through 2014, the Invigorate program was intended to partially offset reimbursement pressures and labor and benefit cost increases; free up additional resources to invest in science, innovation and other growth initiatives; and enable us to improve service quality and operating profitability.

In January 2015, the Company adopted a course of action related to its multi-year Invigorate program to further reduce its cost structure through 2017. This multi-year course of action continues to focus on the flagship program opportunities and new key opportunities such as: standardizing processes, information technology systems, equipment and data; enhancing electronic enabling services; and enhancing reimbursement for work performed. The estimated pre-tax charges expected to be incurred in 2015 in connection with this course of action are: $25 million to $30 million of employee separation costs and $10 million to $15 million of facility-related costs and asset impairment charges.     


9

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(unaudited)
(dollars in millions unless otherwise indicated)


The following table provides a summary of the Company's pre-tax restructuring charges associated with its Invigorate program and other restructuring activities for the three months ended March 31, 2015 and 2014:
 
Three Months Ended March 31,
 
2015
 
2014
Employee separation costs
$
15

 
$
8

Facility-related costs

 
1

 
 
 
 
  Total restructuring charges
$
15

 
$
9


Total restructuring charges incurred in the three months ended March 31, 2015 are associated with various workforce reduction initiatives as the Company continues to simplify and restructure its organization. Of the total $15 million in restructuring charges incurred during the three months ended March 31, 2015, $13 million and $2 million were recorded in cost of services and selling, general and administrative expenses, respectively.
    
Total restructuring charges incurred for the three months ended March 31, 2014 are primarily associated with various workforce reduction initiatives as the Company continued to simply its organization. Of the total $9 million in restructuring charges incurred during the three months ended March 31, 2014, $8 million and $1 million were recorded in cost of services and selling, general and administrative expenses, respectively.

Charges for both periods presented were primarily recorded in the Company's DIS business.

The following table summarizes activity in the restructuring liability as of March 31, 2015:

 
Employee Separation Costs
 
Facility-Related Costs
 
Total
 
 
 
 
 
 
Balance, December 31, 2014
$
18

 
$
11

 
$
29

Current period charges
15

 

 
15

Less:
 
 
 
 
 
Cash payments
(10
)
 
(1
)
 
(11
)
Other / adjustments

 
(3
)
 
(3
)
 
 
 
 
 
 
Balance, March 31, 2015
$
23

 
$
7

 
$
30


5.     BUSINESS ACQUISITIONS

In the first quarter of 2015, the Company finalized the purchase price allocations associated with the 2014 acquisitions of Solstas Lab Partners Group ("Solstas") and Summit Health, Inc. ("Summit Health"). The purchase price allocation adjustments recorded in the three months ended March 31, 2015 were not material. For further details regarding the Company's 2014 acquisitions, see Note 5 to the consolidated financial statements in the Company's 2014 Annual Report on Form 10-K. For further details regarding the fair value of the estimated contingent consideration associated with the Summit Health and Steward Health Care Systems, LLC ("Steward") acquisitions, see Note 7.


10

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(unaudited)
(dollars in millions unless otherwise indicated)


Pro Forma Combined Financial Information

The following unaudited pro forma combined financial information reflects the consolidated statement of operations of the Company as if the acquisitions of Solstas and Summit Health had occurred as of January 1, 2013. The pro forma information includes adjustments primarily related to the amortization of intangible assets acquired, interest expense associated with debt extinguished prior to the acquisitions, and transaction costs related to the Solstas and Summit Health acquisitions. The unaudited pro forma combined financial information does not include the estimated annual synergies expected to be realized upon completion of the integration of Solstas and Summit Health and is not indicative of the results of operations as they would have been had the transaction been effected on the assumed date. Financial information for Steward has not been included in the table below as this acquisition is not material to the Company’s interim unaudited consolidated financial statements.
 
Three Months Ended March 31,
 
2014
 
 
Pro forma net revenues
$
1,827

 
 
Pro forma net income
$
109

 
 
Earnings per share attributable to Quest Diagnostics’ common stockholders:
 
Basic
$
0.71

Diluted
$
0.70


6.     ASSETS HELD FOR SALE

On March 30, 2015, the Company entered into a definitive agreement with Quintiles Transnational Holdings Inc.
to form a global clinical trials central laboratory services joint venture. In connection with the transaction, the Company will contribute certain assets of its clinical trials testing business ("Clinical Trials") to the newly formed entity in exchange for a non-controlling, 40% ownership interest. The transaction is expected to close no later than the third quarter of 2015, subject to standard and customary closing conditions.

The assets of Clinical Trials that will be contributed to the joint venture, principally consisting of property, plant and equipment, net and goodwill, have been reclassified into non-current assets held for sale in the consolidated balance sheet at March 31, 2015. Upon formation, the Company expects to recognize a gain based on the difference between the fair value of the Company’s equity interest in the newly formed entity over the carrying value of the assets contributed. The gain will be recorded in the period in which the transaction closes and may be material to the Company's results of operations.

Clinical Trials, which is included in all other operating segments, has not been classified as discontinued operations. For further details regarding business segment information, see Note 14.


11

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(unaudited)
(dollars in millions unless otherwise indicated)


7.     FAIR VALUE MEASUREMENTS

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The following table provides a summary of the recognized assets and liabilities that are measured at fair value on a recurring basis:
 
 
 
Basis of Fair Value Measurements
 
 
 
Quoted
Prices in
Active
Markets for
Identical
Assets /
Liabilities
 
Significant
Other
Observable
Inputs
 
Significant
Unobservable
Inputs
March 31, 2015
Total
 
Level 1
 
Level 2
 
Level 3
Assets:
 

 
 

 
 

 
 

Trading securities
$
49

 
$
49

 
$

 
$

Cash surrender value of life insurance policies
31

 

 
31

 

Interest rate swaps
31

 

 
31

 

Available-for-sale equity securities
10

 
10

 

 

Put option
1

 

 

 
1

 
 
 
 
 
 
 
 
Total
$
122

 
$
59

 
$
62

 
$
1

 
 
 
 
 
 
 
 
Liabilities:
 

 
 

 
 

 
 

Deferred compensation liabilities
$
85

 
$

 
$
85

 
$

Contingent consideration
17

 

 

 
17

Interest rate swaps
5

 

 
5

 

Call option
5

 

 

 
5

 
 
 
 
 
 
 
 
Total
$
112

 
$

 
$
90

 
$
22


12

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(unaudited)
(dollars in millions unless otherwise indicated)


 
 
 
Basis of Fair Value Measurements
 
 
 
Quoted
Prices in
Active
Markets for
Identical
Assets /
Liabilities
 
Significant
Other
Observable
Inputs
 
Significant
Unobservable
Inputs
December 31, 2014
Total
 
Level 1
 
Level 2
 
Level 3
Assets:
 

 
 

 
 

 
 

Trading securities
$
49

 
$
49

 
$

 
$

Cash surrender value of life insurance policies
30

 

 
30

 

Interest Rate Swaps
17

 

 
17

 

Available-for-sale equity securities
9

 
9

 

 

Put option
1

 

 

 
1

 
 
 
 
 
 
 
 
Total
$
106

 
$
58

 
$
47

 
$
1

 
 
 
 
 
 
 
 
Liabilities:
 

 
 

 
 

 
 

Deferred compensation liabilities
$
85

 
$

 
$
85

 
$

Contingent consideration
17

 

 

 
17

Forward starting interest rate swaps
15

 

 
15

 

Interest rate swaps
13

 

 
13

 

Call option
5

 

 

 
5

 
 
 
 
 
 
 
 
Total
$
135

 
$

 
$
113

 
$
22


A full description regarding the Company's fair value measurements is contained in Note 7 to the consolidated financial statements in the Company's 2014 Annual Report on Form 10-K.    

The Company offers certain employees the opportunity to participate in non-qualified supplemental deferred compensation plans. A participant's deferrals, together with Company matching credits, are invested in a variety of participant-directed stock and bond mutual funds that are classified as trading securities. Changes in the fair value of these securities are measured using quoted prices in active markets based on the market price per unit multiplied by the number of units held exclusive of any transaction costs. A corresponding adjustment for changes in fair value of the trading securities is also reflected in the changes in fair value of the deferred compensation obligation. The deferred compensation liabilities are classified within Level 2 because their inputs are derived principally from observable market data by correlation to the trading securities.

The Company offers certain employees the opportunity to participate in a non-qualified deferred compensation program. A participant's deferrals, together with Company matching credits, are “invested” at the direction of the employee in a hypothetical portfolio of investments which are tracked by an administrator. The Company purchases life insurance policies, with the Company named as beneficiary of the policies, for the purpose of funding the program's liability. Changes in the cash surrender value of the life insurance policies are based upon earnings and changes in the value of the underlying investments. Changes in the fair value of the deferred compensation obligation are derived using quoted prices in active markets based on the market price per unit multiplied by the number of units. The cash surrender value and the deferred compensation obligations are classified within Level 2 because their inputs are derived principally from observable market data by correlation to the hypothetical investments.
    
The fair value measurements of the Company's interest rate swaps and forward starting swaps are model-derived valuations as of a given date in which all significant inputs are observable in active markets including certain financial information and certain assumptions regarding past, present and future market conditions.

Investment in available-for-sale equity securities represents an investment in registered shares of a publicly-held company listed on the Euronext Paris exchange. The Company's investment in available-for-sale equity securities is classified within Level 1 of the fair value hierarchy because the fair value is obtained from quoted prices in an active market.


13

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(unaudited)
(dollars in millions unless otherwise indicated)


In connection with the acquisition of certain businesses of UMass, the Company granted to UMass a call option and UMass granted to the Company a put option for UMass to acquire an 18.90% equity interest in a newly formed entity. The put and call options are derivative instruments that have a remaining vesting period of approximately 1 month and their fair values have been measured using a combination of discounted cash flows and the Black-Scholes-Merton option pricing model. There were no material changes in the fair value measurements using significant unobservable inputs associated with the UMass put option derivative asset or the call option derivative liability at March 31, 2015.

In April 2014, and as further detailed in Note 5 to the consolidated financial statements in the Company's 2014 Annual Report on Form 10-K, the Company completed the acquisitions of Summit Health and Steward. In connection with these acquisitions the Company initially recorded an aggregate contingent consideration liability of $26 million. The contingent consideration liability was classified within Level 3 measured at fair value using a probability weighted and discounted cash flow method. These measurements are based on externally obtained inputs and management's probability assessments of the occurrence of triggering events, appropriately discounted considering the uncertainties associated with the obligations, as well as the likelihood of achieving financial targets. The initial probability estimate of the occurrence of such triggering events associated with the amounts the Company could be obligated to pay in future periods for both Summit Health and Steward was between 5% and 95%. The probability-weighted cash flows were then discounted using a discount rate of 1.5% to 2.8%. During the fourth quarter of 2014, as a result of a lower revenue forecast for Summit Health in 2015, the estimated fair value of the contingent consideration was reduced to $13 million. The contingent consideration associated with Summit Health is projected to be paid in the first quarter of 2016, with a maximum payment of $25 million. The contingent consideration associated with Steward is projected to be paid out in four equal annual installments beginning in 2015, with a maximum payout of $5 million in total. There were no material changes in the fair value measurements using significant unobservable inputs associated with the contingent consideration liability at March 31, 2015.
    
The carrying amounts of cash and cash equivalents, accounts receivable and accounts payable and accrued expenses approximate fair value based on the short maturities of these instruments. At March 31, 2015, the fair value of the Company’s debt was estimated at $5.1 billion, which exceeded the carrying value by $357 million. At December 31, 2014, the fair value of the Company's debt was estimated at $4.2 billion, which exceeded the carrying value by $396 million. Principally all of the Company's debt is classified within Level 1 of the fair value hierarchy because the fair value of the debt is estimated based on rates currently offered to the Company with identical terms and maturities, using quoted active market prices and yields, taking into account the underlying terms of the debt instruments.

8.    GOODWILL AND INTANGIBLE ASSETS

The changes in goodwill for the three months ended March 31, 2015 and for the year ended December 31, 2014 are as follows:
 
March 31,
2015
 
December 31,
2014
Balance, beginning of period
$
6,032

 
$
5,649

Goodwill acquired during the period
1

 
383

Reclassification to assets held for sale
(47
)
 

Balance, end of period
$
5,986

 
$
6,032


Principally all of the Company’s goodwill as of March 31, 2015 and December 31, 2014 is associated with its DIS business.

For the three months ended March 31, 2015, reclassification to assets held for sale was principally associated with Clinical Trials. For further details regarding assets held for sale, see Note 6.

For the year ended December 31, 2014, goodwill acquired was principally associated with the Solstas, Summit Health, and Steward acquisitions, of which $103 million is deductible for tax purposes. Acquisitions during the year also resulted in $270 million of intangible assets, principally comprised of customer-related intangibles and trade names. For further details regarding the Company's 2014 acquisitions, see Note 5 to the consolidated financial statements in the Company's 2014 Annual Report on Form 10-K.        

14

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(unaudited)
(dollars in millions unless otherwise indicated)


    
Intangible assets at March 31, 2015 and December 31, 2014 consisted of the following:

 
Weighted
Average
Amortization
Period
(in years)
 
March 31, 2015
 
December 31, 2014
 
 
 
Cost
 
Accumulated
Amortization
 
Net
 
Cost
 
Accumulated
Amortization
 
Net
Amortizing intangible assets:
 
 

 
 

 
 

 
 

 
 

 
 

Customer-related intangibles
19
 
$
922

 
$
(265
)
 
$
657

 
$
929

 
$
(259
)
 
$
670

Non-compete agreements
5
 
43

 
(40
)
 
3

 
43

 
(37
)
 
6

Technology
14
 
117

 
(40
)
 
77

 
118

 
(38
)
 
80

Other
8
 
142

 
(83
)
 
59

 
152

 
(82
)
 
70

Total
17
 
1,224

 
(428
)
 
796

 
1,242

 
(416
)
 
826

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Intangible assets not subject to amortization:
 
 

 
 

 
 

 
 

 
 

Trade names
 
 
244

 

 
244

 
244

 

 
244

Other
 
 
1

 

 
1

 
1

 

 
1

Total intangible assets
 
$
1,469

 
$
(428
)
 
$
1,041

 
$
1,487

 
$
(416
)
 
$
1,071


Amortization expense related to intangible assets was $21 million and $22 million for the three months ended March 31, 2015 and 2014, respectively.
 
The estimated amortization expense related to amortizable intangible assets for each of the five succeeding fiscal years and thereafter as of March 31, 2015 is as follows:

Year Ending December 31,
 

Remainder of 2015
$
59

2016
71

2017
67

2018
63

2019
62

2020
62

Thereafter
412

Total
$
796



15

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(unaudited)
(dollars in millions unless otherwise indicated)


9.    DEBT

Long-term debt at March 31, 2015 and December 31, 2014 consisted of the following:
 
March 31,
2015
 
December 31,
2014
 
 
 
 
5.45% Senior Notes due November 2015
$
500

 
$
500

3.20% Senior Notes due April 2016
304

 
304

6.40% Senior Notes due July 2017
375

 
375

2.70% Senior Notes due April 2019
300

 
300

4.75% Senior Notes due January 2020
526

 
524

2.50% Senior Notes due March 2020
299

 

4.70% Senior Notes due April 2021
557

 
549

4.25% Senior Notes due April 2024
318

 
311

3.50% Senior Notes due March 2025
602

 

6.95% Senior Notes due July 2037
246

 
421

5.75% Senior Notes due January 2040
368

 
439

4.70% Senior Notes due March 2045
300

 

Other
36

 
39

 
 
 
 
Total long-term debt
4,731

 
3,762

Less: current portion of long-term debt
1,043

 
518

 
 
 
 
Total long-term debt, net of current portion
$
3,688

 
$
3,244


2015 Senior Notes Offering

In March 2015, the Company completed a $1.2 billion senior notes offering (the “2015 Senior Notes”) that was sold in three tranches: (a) $300 million aggregate principal amount of 2.50% senior notes due March 2020, issued at a discount of $1 million; (b) $600 million aggregate principal amount of 3.50% senior notes due March 2025; and (c) $300 million aggregate principal amount of 4.70% senior notes due March 2045. These senior notes are unsecured obligations of the Company and rank equally with the Company's other senior unsecured obligations. None of the Company's senior notes have a sinking fund requirement.

The Company incurred $11 million of costs associated with the 2015 Senior Notes, which is included in other assets and is being amortized over the term of the related debt.
    
Retirement of Debt

In March 2015, the Company commenced a cash tender offer to purchase up to $250 million aggregate principal amount of its 6.95% Senior Notes due July 2037 and 5.75% Senior Notes due January 2040. The Company repurchased $176 million of its 6.95% Senior Notes due July 2037 and $74 million of its 5.75% Senior Notes due January 2040. For the three months ended March 31, 2015, the Company recorded a loss on retirement of debt in other (expense) income, net of $79 million, principally comprised of premiums paid under the cash tender offer.    

Current Portion of Long-Term Debt
    
In March 2015, the Company issued redemption notices to retire all of the 5.45% Senior Notes due November 2015, $150 million of the 3.2% Senior Notes due April 2016 and all of the 6.4% Senior Notes due July 2017. As a result, these senior notes are included in current portion of long-term debt at March 31, 2015. The redemption of these senior notes was completed in April 2015. For further details regarding the redemption, see Note 15.


16

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(unaudited)
(dollars in millions unless otherwise indicated)


At December 31, 2014, current portion of long-term debt was principally comprised of the 5.45% Senior Notes due November 2015.

Maturities of Long-Term Debt    

As of March 31, 2015, long-term debt matures as follows:

Year Ending December 31,
 
Remainder of 2015
$
1,043

2016
158

2017
6

2018
3

2019
301

2020
800

Thereafter
2,375

 
 
Total maturities of long-term debt
4,686

Unamortized discount
(18
)
Fair value basis adjustments attributable to hedged debt
63

 
 
Total long-term debt
4,731

Current portion of long-term debt
1,043

 
 
Total long-term debt, net of current portion
$
3,688


For further discussion regarding the Company's debt, see Note 13 to the consolidated financial statements in the Company's 2014 Annual Report on Form 10-K.    

10.    FINANCIAL INSTRUMENTS

The Company uses derivative financial instruments to manage its exposure to market risks for changes in interest rates and, from time to time, foreign currencies. This strategy includes the use of interest rate swap agreements, forward starting interest rate swap agreements, treasury lock agreements and foreign currency forward contracts to manage its exposure to movements in interest and currency rates. 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 speculative purposes. The Company does not enter into derivative financial instruments that contain credit-risk-related contingent features or requirements to post collateral.

Interest Rate Risk
    
The Company is exposed to interest rate risk on its cash and cash equivalents and its debt obligations. Interest income earned on cash and cash equivalents may fluctuate as interest rates change; however, due to their relatively short maturities, the Company does not hedge these assets or their investment cash flows and the impact of interest rate risk is not material. The Company's debt obligations consist of fixed-rate and variable-rate debt instruments. The Company's primary objective is to achieve the lowest overall cost of funding while managing the variability in cash outflows within an acceptable range. In order to achieve this objective, the Company has entered into interest rate swaps. Interest rate swaps involve the periodic exchange of payments without the exchange of underlying principal or notional amounts. Net settlements between the counterparties are recognized as an adjustment to interest expense.


17

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(unaudited)
(dollars in millions unless otherwise indicated)


Interest Rate Derivatives – Cash Flow Hedges
    
From time to time, the Company has entered into various interest rate lock agreements and forward starting interest rate swap agreements to hedge part of the Company's interest rate exposure associated with the variability in future cash flows attributable to changes in interest rates.
    
During the fourth quarter of 2013 and first quarter of 2014, the Company entered into various forward starting interest rate swap agreements for an aggregate notional amount of $150 million which were accounted for as cash flow hedges. In connection with the issuance of the 2015 Senior Notes, all of these agreements were settled and the Company paid $17 million. These losses are deferred in stockholders’ equity, net of income taxes, as a component of accumulated other comprehensive loss, and amortized as an adjustment to interest expense over the term of the Senior Notes due 2025.

In March 2015, the Company entered into interest rate lock agreements with several financial institutions for a total notional amount of $350 million which were accounted for as cash flow hedges. These agreements were entered into to hedge a portion of the Company’s interest rate exposure associated with variability in future cash flows attributable to changes in the five-year, ten-year and thirty-year treasury rates related to the planned issuance of the 2015 Senior Notes. In connection with the issuance of the 2015 Senior Notes, these agreements were settled and the Company received $3 million. These gains are deferred in stockholders’ equity, net of income taxes, as a component of accumulated other comprehensive loss, and amortized as an adjustment to interest expense over the term of the respective senior notes.

The total net loss, net of taxes, recognized in accumulated other comprehensive loss, related to the Company's cash flow hedges as of March 31, 2015 and December 31, 2014 was $14 million and $15 million, respectively. The loss recognized on the Company's cash flow hedges for the three months ended March 31, 2015 and 2014, as a result of ineffectiveness, was not material. The net amount of deferred losses on cash flow hedges that is expected to be reclassified from accumulated other comprehensive loss into interest expense, net within the next twelve months is $3 million.

Interest Rate Derivatives – Fair Value Hedges

The Company maintains various fixed-to-variable interest rate swaps to convert a portion of the Company's long-term debt into variable interest rate debt. A summary of the notional amounts of these interest rate swaps as of March 31, 2015 and December 31, 2014 is as follows:    
 
 
 
 
Notional Amount
Debt Instrument
 
Floating Rate Paid by the Company
 
March 31, 2015
 
December 31, 2014
 
 
 
 
 
 
 
3.20% Senior Notes due April 2016
 
Six-month LIBOR plus a 2.3% spread
 
$
200

 
$
200

4.75% Senior Notes due January 2020
 
One-month LIBOR plus a 3.6% spread
 
350

 
350

4.70% Senior Notes due April 2021
 
One-month LIBOR plus a 2.45% to 3.39% spread
 
400

 
400

4.25% Senior Notes due April 2024
 
One-month LIBOR plus a 1.54% to 1.59% spread
 
250

 
250

3.50% Senior Notes due March 2025
 
One-month LIBOR plus a 1.44% spread
 
200

 

 
 
 
 
 
 
 
 
 
 
 
$
1,400

 
$
1,200

    
Since inception, the fair value hedges have been effective or highly effective; therefore, there is no impact on earnings for the three months ended March 31, 2015 and 2014 as a result of hedge ineffectiveness.

Interest Rate Derivatives - Economic Hedges

In March 2015, in connection with the cash tender offer and redemption discussed in Notes 9 and 15, the Company entered into reverse interest rate lock agreements with several financial institutions which were not designated for hedge accounting. The Company entered into these agreements to hedge the variability in cash flows associated with $280 million of the $1.3 billion principal amount of debt to be retired in the first and second quarters of 2015. Certain of these agreements were settled during the first quarter of 2015 which resulted in a gain of $3 million which was recognized in other (expense) income,

18

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(unaudited)
(dollars in millions unless otherwise indicated)


net. The remaining agreements will be settled in the second quarter of 2015 and their fair value at March 31, 2015 was not material.

A summary of the fair values of derivative instruments in the consolidated balance sheets is stated in the table below:

 
March 31, 2015
 
December 31, 2014
 
Balance Sheet
Classification
 
Fair Value
 
Balance Sheet
Classification
 
Fair Value
Derivatives Designated as Hedging Instruments
 
 
 

 
 
 
 

Asset Derivatives:
 
 
 

 
 
 
 

Interest rate swaps
Other assets
 
$
31

 
Other assets
 
$
17

 
 
 
 
 
 
 
 
Liability Derivatives:
 
 
 
 
 
 
 
Interest rate swaps
Other liabilities
 
5

 
Other liabilities
 
13

Forward starting interest rate swaps
Other liabilities
 

 
Other liabilities
 
15

Total Liability Derivatives
 
 
5

 
 
 
28

 
 
 
 
 
 
 
 
Derivatives Not Designated as Hedging Instruments
 
 
 

 
 
 
 

Asset Derivatives:
 
 
 

 
 
 
 

Put option
Prepaid expenses and other current assets
 
1

 
Prepaid expenses and other current assets
 
1

 
 
 
 
 
 
 
 
Liability Derivatives:
 
 
 
 
 
 
 
Call option
Accounts payable and accrued expenses
 
5

 
Accounts payable and accrued expenses
 
5

 
 
 
 
 
 
 
 
Total Net Derivatives Assets (Liabilities)
 
 
$
22

 
 
 
$
(15
)

A full description regarding the Company's use of derivative financial instruments is contained in Note 14 to the consolidated financial statements in the Company's 2014 Annual Report on Form 10-K.        

11.    STOCKHOLDERS’ EQUITY
    
Components of Comprehensive Income

The market valuation adjustments represent unrealized holding gains (losses) on available-for-sale securities, net of taxes. The net deferred loss on cash flow hedges represents deferred losses on the Company’s interest rate related derivative financial instruments designated as cash flow hedges, net of amounts reclassified to interest expense (see Note 10). For the three months ended March 31, 2015 and 2014, the tax effects related to the market valuation adjustments and deferred losses were not material. Foreign currency translation adjustments are not adjusted for income taxes since they relate to indefinite investments in non-U.S. subsidiaries.

Dividend Program
    
During the first quarter of 2015, the Company's Board of Directors declared a quarterly cash dividend of $0.38 per common share. During each of the quarters of 2014, the Company's Board of Directors declared a quarterly cash dividend of $0.33 per common share.
    
Share Repurchase Program
        
At March 31, 2015, $586 million remained available under the Company’s share repurchase authorizations. The share repurchase authorization has no set expiration or termination date.    

19

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(unaudited)
(dollars in millions unless otherwise indicated)



For the three months ended March 31, 2015, the Company repurchased 1.5 million shares of its common stock at an average price of $71.48 per share for $110 million. For the three months ended March 31, 2015, the Company reissued 0.7 million shares for employee benefit plans.
    
For the three months ended March 31, 2014, the Company repurchased 0.6 million shares of its common stock at an average price of $52.80 per share for a total of $32 million. For the three months ended March 31, 2014, the Company reissued 0.4 million shares for employee benefit plans.

12.    SUPPLEMENTAL CASH FLOW & OTHER DATA

Supplemental cash flow and other data for the three months ended March 31, 2015 and 2014 is as follows:
 
Three Months Ended March 31,
 
2015
 
2014
Depreciation expense
$
57

 
$
53

Amortization expense
21

 
22

 
 
 
 
Depreciation and amortization expense
$
78

 
$
75

 
 
 
 
Interest expense
$
(45
)
 
$
(40
)
Interest income

 
1

 
 
 
 
Interest expense, net
$
(45
)
 
$
(39
)
 
 
 
 
Interest paid
$
54

 
$
52

Income taxes paid
19

 
9

 
 
 
 
Assets acquired under capital leases

 
2

Accounts payable associated with capital expenditures
$
11

 
$
7

 
 
 
 
Businesses acquired:
 

 
 

Fair value of assets acquired
$

 
$
646

Fair value of liabilities assumed

 
70

 
 
 
 
Fair value of net assets acquired

 
576

Less: Cash acquired

 
9

 
 
 
 
Business acquisitions, net of cash acquired
$

 
$
567


13.     COMMITMENTS AND CONTINGENCIES

The Company has a line of credit with a financial institution totaling $85 million for the issuance of letters of credit (the “Letter of Credit Line”). The Letter of Credit Line, which is renewed annually, matures on November 17, 2015. The Company can also issue letters of credit under its senior unsecured revolving credit facility. For further discussion regarding the Company's senior unsecured revolving credit facility, see Note 13 to the consolidated financial statements in the Company's 2014 Annual Report on Form 10-K.    
    
In support of its risk management program, to ensure the Company’s performance or payment to third parties, $68 million in letters of credit, principally associated with the Letter of Credit Line, were outstanding at March 31, 2015. The letters of credit primarily represent collateral for current and future automobile liability and workers’ compensation loss payments.

20

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(unaudited)
(dollars in millions unless otherwise indicated)


    
Contingent Lease Obligations
    
The Company remains subject to contingent obligations under certain real estate leases that were entered into by certain predecessor companies of a subsidiary prior to the Company's acquisition of the subsidiary. No liability has been recorded for any of these potential contingent obligations. See Note 17 to the consolidated financial statements contained in the Company’s 2014 Annual Report on Form 10-K for further details.

Settlements

In 2010, a purported class action entitled In re Celera Corp. Securities Litigation was filed in the United States District Court for the Northern District of California against Celera Corporation and certain of its directors and current and former officers. An amended complaint filed in October 2010 alleges that from April 2008 through July 22, 2009, the defendants made false and misleading statements regarding Celera's business and financial results with an intent to defraud investors. The complaint was further amended in 2011 to add allegations regarding a financial restatement. The amended complaint seeks unspecified damages on behalf of an alleged class of purchasers of Celera's stock during the period in which the alleged misrepresentations were made. The Company's motion to dismiss the complaint was denied. Celera and the director and officer defendants have reached an agreement to settle this action, which the court has preliminarily approved. The settlement is fully covered by insurance.

Legal Matters

The Company is involved in various legal proceedings. Some of the proceedings against the Company involve claims that could be substantial in amount.

In addition to the matters described below, in the normal course of business, the Company has been named, from time to time, as a defendant in various legal actions, including arbitrations, class actions and other litigation, arising in connection with the Company's activities as a provider of diagnostic testing, information and services. These legal actions may include lawsuits alleging negligence or other similar legal claims. These actions could involve claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages, and could have an adverse impact on the Company's client base and reputation.

The Company is also involved, from time to time, in other reviews, investigations and proceedings by governmental agencies regarding the Company's business, including, among other matters, operational matters, which may result in adverse judgments, settlements, fines, penalties, injunctions or other relief. The number of these reviews, investigations and proceedings has increased in recent years with regard to many firms in the healthcare services industry, including the Company.
    
In August 2011, the Company received a subpoena from the U.S. Attorney for the Northern District of Georgia seeking various business records, including records related to the Company's compliance program, certain marketing materials, certain product offerings, and test ordering and other policies. The Company is cooperating with the request.

In June 2010, the Company received a subpoena from the Florida Attorney General's Office seeking documents relating to the Company's pricing and billing practices as they relate to Florida’s Medicaid program. The Company cooperated with the requests. In November 2013, the State of Florida intervened as a plaintiff in a civil lawsuit, Florida ex rel. Hunter Laboratories LLC v. Quest Diagnostics Incorporated, et al., filed in Florida Circuit Court. The suit, originally filed by a competitor laboratory, alleges that the Company overcharged Florida’s Medicaid program. The Company's motion to dismiss the state's amended complaint was denied.         

In April 2015, a qui tam civil lawsuit entitled United States ex rel. Mayes v. Berkeley HeartLab, Inc., et al., filed in the U.S. District Court for the District of South Carolina, was unsealed. The complaint alleges that certain alleged business practices of the defendants violate the False Claims Act, and seeks monetary relief. The United States has intervened as a plaintiff as to Berkeley HeartLab, Inc., a subsidiary of the Company; the United States did not intervene as a plaintiff as to Quest Diagnostics Incorporated. Before the lawsuit was unsealed, Berkeley HeartLab and Quest Diagnostics Incorporated had received subpoenas, civil investigative demands and interrogatories related to the matter.
    

21

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(unaudited)
(dollars in millions unless otherwise indicated)


The federal or state governments may bring claims based on the Company's current practices, which it believes are lawful. In addition, certain federal and state statutes, including the qui tam provisions of the federal False Claims Act, allow private individuals to bring lawsuits against healthcare companies on behalf of government or private payers. The Company is aware of lawsuits, and from time to time has received subpoenas, related to billing practices based on the qui tam provisions of the Civil False Claims Act or other federal and state statutes, regulations or other laws. The Company understands that there may be other pending qui tam claims brought by former employees or other "whistle blowers" as to which the Company cannot determine the extent of any potential liability.

Management cannot predict the outcome of such matters. Although management does not anticipate that the ultimate outcome of such matters will have a material adverse effect on the Company's financial condition, given the high degree of judgment involved in establishing loss estimates related to these types of matters, the outcome of such matters may be material to the Company's results of operations or cash flows in the period in which the impact of such matters is determined or paid.
    
These matters are in different stages. Some of these matters are in their early stages. Matters may involve responding to and cooperating with various government investigations and related subpoenas. As of March 31, 2015, the Company does not believe that any losses related to the legal matters described above are probable. While the Company believes that a reasonable possibility exists that losses may have been incurred related to the legal matters described above, based on the nature and status of these matters, potential losses, if any, cannot be estimated.

Reserves for Legal Matters
    
Reserves for legal matters, other than those described above, totaled $12 million and $11 million at March 31, 2015 and December 31, 2014, respectively.

Reserves for General and Professional Liability Claims
    
As a general matter, providers of clinical 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, among other things, claims that could result from providing, or failing to provide, clinical 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. Reserves for such matters, including those associated with both asserted and incurred but not reported claims, are established by considering actuarially determined losses based upon the Company's historical and projected loss experience. Such reserves totaled approximately $113 million at both March 31, 2015 and December 31, 2014. Management believes that established reserves and present insurance coverage are sufficient to cover currently estimated exposures. Management cannot predict the outcome of any claims made against the Company. Although 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 condition, given the high degree of judgment involved in establishing accruals for loss estimates related to these types of matters, the outcome may be material to the Company's results of operations or cash flows in the period in which the impact of such claims is determined or paid.

14.    BUSINESS SEGMENT INFORMATION
    
The Company's DIS business provides insights through clinical testing and related services to patients, physicians, hospitals, ACOs, IDNs, health plans, employers and others. The Company is the world's leading provider of diagnostic information services, including routine clinical testing, gene-based and esoteric testing, anatomic pathology services and drugs-of-abuse testing, as well as related services and insights. The DIS business accounted for greater than 90% of net revenues in 2015 and 2014.

All other operating segments include the Company's DS businesses, which consists of its risk assessment services, clinical trials testing, diagnostic products and healthcare information technology businesses. The Company's DS business offers a variety of solutions for life insurers, healthcare providers and others. The Company provides risk assessment services, testing for clinical trials, robust information technology solutions and diagnostic products.


22

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(unaudited)
(dollars in millions unless otherwise indicated)


During 2015, the Company classified certain assets of Clinical Trials, which is included in all other operating segments, as held for sale. For further details regarding assets held for sale, see Note 6.

During 2014, the Company acquired Solstas, Summit Health and Steward which are included in the Company's DIS business.
    
At March 31, 2015, 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.

The following table is a summary of segment information for the three months ended March 31, 2015 and 2014. Segment asset information is not presented since it is not used by the chief operating decision maker at the operating segment level. Operating earnings (loss) of each segment represents net revenues less directly identifiable expenses to arrive at operating income for the segment. General corporate activities included in the table below are comprised of general management and administrative corporate expenses, amortization or impairment of intangibles assets, other operating income and expenses net of certain general corporate activity costs that are allocated to the DIS and DS businesses. The accounting policies of the segments are the same as those of the Company as set forth in Note 2 to the consolidated financial statements contained in the Company’s 2014 Annual Report on Form 10-K and Note 2 to the interim unaudited consolidated financial statements.
 
Three Months Ended March 31,
 
2015
 
2014
Net revenues:
 

 
 

DIS business
$
1,692

 
$
1,614

All other operating segments
147

 
132

 
 
 
 
Total net revenues
$
1,839

 
$
1,746

 
 
 
 
Operating earnings (loss):
 

 
 

DIS business
$
242

 
$
231

All other operating segments
26

 
18

General corporate activities
(40
)
 
(41
)
 
 
 
 
Total operating income
228

 
208

Non-operating expenses, net
(116
)
 
(32
)
 
 
 
 
Income before income taxes
112

 
176

Income tax expense
42

 
65

 
 
 
 
Net income
70

 
111

Less: Net income attributable to noncontrolling interests
9

 
7

 
 
 
 
Net income attributable to Quest Diagnostics
$
61

 
$
104


15.    SUBSEQUENT EVENT

In April 2015, the Company redeemed all of the $500 million 5.45% Senior Notes due November 2015, $150 million or 50% of the 3.2% Senior Notes due April 2016 and all of the $375 million 6.4% Senior Notes due July 2017. In connection with these redemptions, the Company will incur pre-tax charges on retirement of debt of approximately $64 million, principally comprised of premiums paid, in the second quarter of 2015.


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Table of Contents                                             

Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations

Our Company

Quest Diagnostics is the world's leading provider of diagnostic information services empowering people to take action to improve health outcomes.  We use our extensive database of clinical lab results to derive diagnostic insights that reveal new avenues to identify and treat disease, inspire healthy behaviors and improve health care management.  Our diagnostic information services business ("DIS") provides insights through clinical testing and related services to patients, physicians, hospitals, accountable care organizations, integrated delivery networks, health plans, employers and others and makes up over 90% of our consolidated net revenues. The balance of our net revenues are derived from our Diagnostic Solutions ("DS") businesses, which consist of our risk assessment services, clinical trials testing, diagnostic products and healthcare information technology businesses. Our business segment information is disclosed in Note 14 to the interim unaudited consolidated financial statements.

First Quarter Highlights

Our first quarter performance reflects improved execution in a stable business environment. Our total net revenues of $1.8 billion were 5.3% above the prior year period, despite a harsh winter in many parts of the country. Excluding the impact of our 2014 acquisitions, consisting of Solstas Lab Partners Group ("Solstas"), Summit Health, Inc. ("Summit Health") and Steward Health Care Systems, LLC ("Steward"), total net revenues grew by 0.7%. DIS revenues of $1.7 billion were 4.9% above the prior year period. DIS volume, measured by the number of requisitions, increased 5.6% compared to the prior year period. Excluding the impact of our 2014 acquisitions, DIS revenues, volume and revenue per requisition were essentially unchanged compared to the prior year period. DS revenues were $147 million, which was 11.2% above the prior year period. The increase in DS revenues was primarily driven by our clinical trials testing, diagnostic products and risk assessment services businesses. Net income attributable to Quest Diagnostics' stockholders was $61 million, or $0.42 per diluted share, for the three months ended March 31, 2015 and was negatively impacted by an after-tax loss of $53 million, or $0.36 per diluted share, associated with the early retirement of debt and related refinancing charges. Additionally, the Medicare Access and CHIP Reauthorization Act was recently enacted to permanently reform the Medicare physician payment methodology and should provide more near term stability for Medicare's Physician Fee Schedule.

Five-point Strategy

We made continued progress on the execution of our five-point strategy during the first quarter of 2015.

We grew total net revenues 5.3% to $1.8 billion, despite a harsh winter in many parts of the country.
We entered into a definitive agreement with Quintiles Transnational Holdings Inc. ("Quintiles") to form a global clinical trials central laboratory services joint venture into which we will contribute our clinical trials testing business and in exchange receive a non-controlling 40% ownership interest. The transaction is expected to close no later than the third quarter of 2015, subject to standard and customary closing conditions.
We increased our quarterly dividend 15% from $0.33 to $0.38 per common share, or $1.52 annually, commencing with the dividend paid in April 2015.
We repurchased $110 million of our common stock as part of our Common Stock repurchase program.
We completed a $1.2 billion senior notes offering and used the proceeds to retire over $1.2 billion in outstanding senior notes in the first and second quarters of 2015, resulting in reduced future interest expense and an improved maturity profile.

Invigorate Program
    
We are engaged in a multi-year program called Invigorate. We delivered more than $700 million in run-rate savings as we exited 2014. In November 2014, we announced our goal to deliver an additional $600 million in run-rate savings as we exit 2017. Achieving this goal would bring the total savings from the Invigorate program to $1.3 billion in run-rate savings, compared to 2011.

Invigorate has consisted of several flagship programs, with structured plans in each, to drive savings and improve performance across the customer value chain. These flagship programs include: organization excellence; information technology excellence; procurement excellence; service excellence; lab excellence; and billing excellence. In addition to these programs, we have identified new key opportunities to change how we operate in order to meet our goal of delivering the additional $600 million in run-rate savings as we exit 2017. These new key opportunities include: standardizing our processes, information technology systems, equipment and data; enhancing electronic enabling services; and enhancing reimbursement for

24

Table of Contents                                             

work we perform. We believe that our efforts to standardize our information technology systems, equipment and data also will foster our efforts to restore growth, supporting the value creation initiatives of our clinical franchises by enhancing our operational flexibility, empowering and enhancing the customer experience, facilitating the delivery of actionable insights and bolstering our large data platform.

In January 2015, we adopted a course of action related to this multi-year program. We developed a high-level estimate of the pre-tax charges expected to be incurred in connection with the course of action for the program: $300 million. We also developed high-level estimates of the pre-tax charges expected to be incurred in connection with the course of action for 2015 totaling $95 million to $115 million consisting of: $25 million to $30 million of employee separation costs; $10 million to $15 million of facility-related costs and asset impairment charges; and $60 million to $70 million of systems conversion and integration costs. As detailed plans to implement the course of action are approved and executed, it will result in charges to earnings. Principally all of the total estimated pre-tax charges expected to be incurred in 2015 are anticipated to result in cash expenditures. The actual charges incurred in connection with the course of action in 2015 could be materially different from these estimates.

From 2012 through 2014, the cumulative charges recorded in connection with the Invigorate program were approximately $266 million, including approximately $178 million of cumulative pre-tax employee separation costs and other restructuring related costs. Through March 31, 2015, the cumulative charges recorded in connection with the January 2015 course of action were approximately $26 million, including approximately $15 million of cumulative pre-tax employee separation costs and other restructuring related costs.

For additional information on the Invigorate program and associated costs, see Note 4 to the interim unaudited consolidated financial statements.
    
Assets Held for Sale
    
At March 31, 2015, we classified certain assets of our clinical trials testing business as held for sale in our interim unaudited consolidated balance sheet.
    
On March 30, 2015, we entered into a definitive agreement with Quintiles to form a global clinical trials central laboratory services joint venture. In connection with the transaction, we will contribute certain assets of our clinical trials testing business to the newly formed entity in exchange for a non-controlling, 40% ownership interest. The transaction is expected to close no later than the third quarter of 2015, subject to standard and customary closing conditions.

Upon formation, we expect to recognize a gain based on the difference between the fair value of our equity interest in the newly formed entity over the carrying value of the assets contributed. The gain will be recorded in the period in which the transaction closes and may be material to our results of operations.
    
For further details regarding assets held for sale, see Note 6 to the to the interim unaudited consolidated financial statements.

Senior Notes Offering

In March 2015, we completed a $1.2 billion senior notes offering (the "2015 Senior Notes") that was sold in three tranches: (a) $300 million aggregate principal amount of 2.50% senior notes due March 2020, issued at a discount of $1 million; (b) $600 million aggregate principal amount of 3.50% senior notes due March 2025; and (c) $300 million aggregate principal amount of 4.70% senior notes due March 2045. The proceeds from the 2015 Senior Notes were used to fund the cash tender offer ("Tender Offer") in March 2015 in which we purchased $176 million of our 6.95% Senior Notes due July 2037 and $74 million of our 5.75% Senior Notes due January 2040. In connection with the Tender Offer, we recorded a $79 million pre-tax loss on early retirement of debt.

The remaining proceeds from the 2015 Senior Notes, together with borrowing under our existing credit facilities, were used in April 2015 to redeem all of our $500 million 5.45% Senior Notes due November 2015, $150 million, or 50%, of our 3.2% Senior Notes due April 2016 and all of our $375 million 6.4% Senior Notes due July 2017 (the "April 2015 Redemption"). In connection with the April 2015 Redemption, we will incur pre-tax charges on early retirement of debt of approximately $64 million in the second quarter of 2015.

The 2015 Senior Notes, Tender Offer and April 2015 Redemption are further described in Note 9 to the interim unaudited consolidated financial statements. In addition, the April Redemption is described in Note 15 to the interim unaudited consolidated financial statements.

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Table of Contents                                             


Critical Accounting Policies
    
Other than the "Accounting for stock-based compensation expense - valuation of stock option awards" discussed below, there have been no significant changes to our critical accounting policies from those disclosed in our 2014 Annual Report on Form 10-K.

Accounting for stock-based compensation expense - valuation of stock option awards

Beginning in 2015, we changed the method for estimating the fair value of our stock option awards from a lattice-based option-valuation method to a Black-Scholes option-valuation model which has been applied prospectively to stock option awards. The change did not have a significant effect on our stock-based compensation expense reported in our interim unaudited consolidated statements of operations because we grant stock option awards based on a prescribed dollar value.

We estimate the fair value of stock option awards on the date of grant using the Black-Scholes option-valuation model which requires management to make certain assumptions regarding: (i) the expected volatility in the market price of our common stock; (ii) dividend yield; (iii) risk-free interest rates; and (iv) the period of time employees are expected to hold the award prior to exercise (referred to as the expected holding period). The expected volatility under the Black-Scholes option-valuation model is based on historical volatilities of our common stock. The dividend yield is based on the approved annual dividend rate in effect and current market price of the underlying common stock at the time of grant. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant for bonds with maturities consistent with the expected holding period of the related award. The expected holding period of the awards granted is estimated using the historical exercise behavior of employees.


26

Table of Contents                                             

Results of Operations

The following tables sets forth certain results of operations data for the periods presented:
    
 
Three Months Ended March 31,
 
2015
 
2014
 
Increase
(Decrease)
 
% Increase
(Decrease)
 
(dollars in millions, except per share amounts)
Net revenues:
 
 
 
 
 
 
 
DIS business
$
1,692

 
$
1,614

 
$
78

 
4.9
 %
DS businesses
147

 
132

 
15

 
11.2

Total net revenues
$
1,839

 
$
1,746

 
$
93

 
5.3
 %
 
 
 
 
 
 
 
 
Operating costs and expenses:
 

 
 

 
 
 
 
Cost of services
$
1,163

 
$
1,101

 
$
62

 
5.7
 %
Selling, general and administrative
419

 
415

 
4

 
1.0

Amortization of intangible assets
21

 
22

 
(1
)
 
(2.6
)
Other operating expense, net
8

 

 
8

 
NM

Total operating costs and expenses
$
1,611

 
$
1,538

 
$
73

 
4.8
 %
 
 
 
 
 
 
 
 
Operating income
$
228

 
$
208

 
$
20

 
9.7
 %
 
 
 
 
 
 
 
 
Other income (expense):
 
 
 
 
 
 
 
Interest expense, net
$
(45
)
 
$
(39
)
 
$
6

 
14.9
 %
Equity in earnings of equity method investees
7

 
6

 
1

 
19.9

Other (expense) income, net
(78
)
 
1

 
79

 
NM

Total non-operating expenses, net
$
(116
)
 
$
(32
)
 
$
84

 
262.6
 %
 
 
 
 
 
 
 
 
Income tax expense
$
42

 
$
65

 
$
(23
)
 
(35.5
)%
Effective income tax rate
37.3
%
 
36.9
%
 
0.4
%
 
NM

 
 
 
 
 
 
 
 
Net income attributable to Quest Diagnostics
$
61

 
$
104

 
$
(43
)
 
(41.2
)%
 
 
 
 
 
 
 
 
Diluted earnings per common share attributable to Quest Diagnostics’ common stockholders
$
0.42

 
$
0.71

 
$
(0.29
)
 
(40.8
)%

NM - Not Meaningful


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Table of Contents                                             

The following table sets forth certain results of operations data as a percentage of net revenues for the periods presented:
 
Three Months Ended March 31,
 
2015
 
2014
 
 
 
 
Net revenues:
 
 
 
DIS business
92.0
%
 
92.4
%
DS businesses
8.0

 
7.6

Total net revenues
100.0
%
 
100.0
%
 
 
 
 
Operating costs and expenses:
 

 
 

Cost of services
63.2
%
 
63.1
%
Selling, general and administrative
22.8

 
23.8

Amortization of intangible assets
1.1

 
1.2

Other operating expense, net
0.5

 

Total operating costs and expenses
87.6
%
 
88.1
%
 
 
 
 
Operating income
12.4
%
 
11.9
%