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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended September 30, 2002

OR

For the transition period from                              to                             

Commission file number 001-16217

SPECIALTY LABORATORIES, INC.
(Exact Name of Registrant as Specified in Its Charter)

2211 Michigan Avenue
Santa Monica, California 90404
(Address of principal executive offices, including zip code)

Registrant's Telephone Number, Including Area Code:        (310) 828-6543

Not Applicable
(Former name, former address and former fiscal year, if changed since last report)

        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 ý    No o

        As of October 28, 2002, there were approximately 21,947,223 shares of Common Stock outstanding, no par value.

SPECIALTY LABORATORIES, INC.

FORM 10-Q QUARTERLY REPORT

TABLE OF CONTENTS

        This Quarterly Report on Form 10-Q, (the "Quarterly Report") includes information incorporated herein by reference and contains "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements relate to expectations concerning matters that are not historical facts. Words such as "projects," "believes," "anticipates," "will," "estimate," "plans," "expects," "intends," and similar words and expressions are intended to identify forward-looking statements. Although we believe that such forward-looking statements are reasonable, we cannot assure you that such expectations will prove to be correct. Important language regarding factors which could cause actual results to differ materially from such expectations are disclosed in this Quarterly Report and in filings with the Securities and Exchange Commission ("SEC") made from time to time by Specialty Laboratories, including our Registration Statement on Form S-1 declared effective on December 7, 2000, our most recent Annual Report on Form 10-K filed on March 13, 2002, and other periodic filings on Form 10-Q and Form 8-K. All forward-looking statements attributable to Specialty Laboratories are expressly qualified in their entirety by such language. We do not undertake any obligation to update any forward-looking statements.

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

Specialty Laboratories, Inc.
Consolidated Balance Sheets
(Dollar amounts in thousands)

See accompanying notes.

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Specialty Laboratories, Inc.
Consolidated Statements of Operations
(Unaudited)
(Dollar amounts in thousands except per share data)

See accompanying notes.

2

Specialty Laboratories, Inc.
Consolidated Statements of Cash Flows
(Unaudited)
(Dollar amounts in thousands)

See accompanying notes.

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SPECIALTY LABORATORIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2002

(Unaudited)

(Dollar amounts in thousands except per share data)

NOTE 1.    BASIS OF PRESENTATION

Financial Statement Preparation

        The accompanying financial statements of Specialty Laboratories Inc. (the "Company" or "Specialty") have been prepared, without audit, in accordance with generally accepted accounting principles for interim financial reporting and the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, the financial statements do not include all of the information and notes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, such interim financial statements contain all adjustments (consisting of normal recurring items) considered necessary for a fair presentation of our financial position, results for operations and cash flows for the interim periods presented. The results of operations and cash flows for any interim periods are not necessarily indicative of results that may be reported for the full year.

        The accompanying financial statements should be read in conjunction with the audited consolidated financial statements, and the notes thereto, included in our Annual Report on Form 10-K for the year ended December 31, 2001, as filed with the Securities and Exchange Commission.

NOTE 2.    ACQUISITION

        On February 20, 2001, we acquired certain assets and liabilities of BBI Clinical Laboratories, Inc. (BBICL), a Massachusetts corporation, for $9.5 million in cash. The purchase price was allocated to the assets acquired and liabilities assumed based on the estimated fair values as of the purchase closing date. The acquisition agreement provided for a reduction of the purchase price if certain performance measurements (i.e., asset delivery, client retention and accounts receivable collections) were not achieved. A subsequent evaluation of these performance measurements resulted in the return of $358,000 by BBICL to us in December 2001. Of the $9.1 million net purchase price, approximately $5.9 million was allocated to goodwill and $1.9 million was allocated to the customer list. The acquisition has been accounted for under the purchase method of accounting.

        The following unaudited pro forma information presents the consolidated results of our operations for the nine months ended September 30, 2001 as if the BBICL acquisition had been consummated on January 1, 2001. Such unaudited pro forma information is based on historical financial information with respect to the acquisition and does not include operational or other changes that might have been effected by us.

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NOTE 3.    GOODWILL AND INTANGIBLE ASSETS

        When we acquire a business, we allocate the excess of the purchase price over the fair value of the net assets acquired to goodwill and identified intangible assets. Prior to 2002, we amortized goodwill and intangible assets evenly over periods ranging from 10 to 20 years.

        In July 2001, the Financial Accounting Standards Board issued Statements of Financial Accounting Standards (SFAS) No. 141, "Business Combinations", and No. 142, "Goodwill and Other Intangible Assets", effective for fiscal years beginning after December 15, 2001. Under the new rules, goodwill is no longer amortized, but is subject to annual impairment tests. The tests for measuring goodwill impairment under SFAS No. 142 are more stringent than previous tests required by SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of". Under SFAS No. 121, we applied an undiscounted cash flow model to assess the fair value of our Company, which did not result in the recognition of goodwill impairment.

        Under the guidance of SFAS No. 142, we concluded that there was no impairment of goodwill for the three and nine-month periods ended September 30, 2002 since our fair value exceeded the book equity value. The following table reflects consolidated results adjusted as though the adoption of the SFAS No. 142 non-amortization of goodwill provision occurred as of the beginning of the three and nine-month periods ended September 30, 2001 and 2002:

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Goodwill

        Goodwill related to the acquisition of BBICL is as follows:

Intangible Assets (included in other assets)

        Intangible assets are as follows:

        Under the new rules, intangible assets will continue to be amortized over their useful lives. The estimated amortization expense for intangible assets will be $72,000 per quarter or $288,000 per year for the next five years.

NOTE 4.    CHARGE RELATED TO REGULATORY MATTERS

        By letter dated April 12, 2002, the federal Centers for Medicare & Medicaid Services (CMS) notified us of its conclusions regarding laboratory inspections in June and October 2001 conducted by the California Department of Health Services (CDHS). CMS concluded that our February 2002 response to deficiencies detected in the inspections did not constitute a credible allegation of compliance. As a result, CMS imposed certain sanctions, including notice of revocation of our Clinical Laboratory Improvement Act (CLIA) certificate, canceling our approval to receive Medicare and Medicaid payments for services performed, imposing a civil money penalty of $3,000 per day for each day of non-compliance, and imposing a directed plan of correction by which CMS may notify our customers of our non-compliance and the nature and effective date of any sanctions imposed. We filed an appeal to the CMS action on April 17, 2002, and the appeal stayed the revocation of our CLIA certificate during our administrative appeal. The cancellation of Medicare and Medicaid payments was effective for services performed by us on and after February 22, 2002. On July 17, 2002, CMS notified us that it had deemed Specialty in compliance with all condition level requirements of CLIA and, that Specialty's ability to bill Medicare and Medicaid for its testing services has been reinstated, effective

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June 19, 2002, and that all actions against our CLIA certificate have been rescinded. In order to facilitate an immediate resolution with CMS, we elected to withdraw the appeal of the sanctions we filed with CMS on April 17, 2002, and we will not seek reimbursement for services performed for beneficiaries of Medicare and Medicaid during the sanction period of February 22, 2002 through June 19, 2002. We did not challenge CMS' imposition of a monetary fine of $351,000, representing $3,000 per day of non-compliance during the sanction period. We believe that the cancellation of our approval to receive Medicare and Medicaid payments for services performed from February 22, 2002 through June 19, 2002 should not affect testing for Medicare and Medicaid patients for whom we bill our hospital and other clients, but instead applies only to testing for which we bill the Medicare and Medicaid programs directly. We recorded a charge in first quarter 2002 of approximately $1.2 million to reserve for Medicare and Medicaid services earned and billed and a civil money penalty, all pertaining to the period February 22, 2002 to March 31, 2002. During second quarter 2002, we did not recognize any net revenue related to Medicare and Medicaid services and recorded a charge of approximately $0.6 million for additional civil money penalties, costs for inspections, and incremental legal costs related to the CDHS and CMS regulatory actions. With the resolution of sanctions imposed by CMS, we resumed the recognition of net revenue related to Medicare and Medicaid services performed subsequent to June 19, 2002 amounting to approximately $2.2 million in the third quarter 2002.

NOTE 5.    PROPERTY AND EQUIPMENT

        Property and equipment consists of the following:

NOTE 6.    COMMITMENTS AND CONTINGENCIES

        In March 2002, Specialty entered into a 6.5 year lease agreement to finance the construction of our new laboratory and headquarters facility in Valencia, California. BNP Paribas and a syndication of banks arranged our lease, which was initially structured as an off balance sheet financing arrangement, sometimes referred to as a "synthetic lease". Construction of the new facility was to be completed in the second half of 2003, and the move from the existing location was scheduled shortly thereafter.

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Construction costs incurred through September 30, 2002 were $13.4 million, of which we financed $8.8 million with investments and cash generated from operations and $4.6 million was funded through borrowings from BNP Paribas.

        As previously reported, we have been reevaluating the lease and bank loan agreements with our banking partners to amend the terms and conditions of each agreement, including the overall size of the agreements. We have decided to go on balance sheet with the Valencia facility lease transaction, and have provided notice to the banking group led by BNP Paribas that we intend to exercise our purchase option under the agreement, paying off the debt so we can obtain title to the ground lease and facility improvements, thus ending the synthetic lease. Accordingly, we have reflected this in our September 30, 2002 financial statements, with the building now recorded in property and equipment on our balance sheet, and the $4.6 million owed to BNP Paribas reflected as a bank loan in current liabilities. We anticipate paying off the $4.6 million bank loan in November 2002 and may record one-time charges in fourth quarter of 2002 for expenses associated with the lease termination.

        In March 2002, we also obtained a bank loan agreement that provides for a revolving line of credit up to $40 million. The banking group led by BNP Paribas also provided this loan agreement. We had no borrowings under this bank loan agreement. We are currently reevaluating our existing credit line with our existing banking partners, and we plan to reduce the amount of the credit line, and may terminate this existing agreement.

        With the resolution of sanctions imposed by CMS, our focus is on rebuilding client confidence and stabilizing our business. To minimize any disruptions in service to our customers based on planning and executing a move to a new facility during this rebuilding period, in October 2002, we announced that we would postpone the move to our new facility in Valencia until the first half of 2004. Accordingly, the construction of the new facility will be paused. We have notified our construction contractors of our intent to delay the project's completion date, and our plan is to halt the project upon completion of the building's shell. We estimate spending approximately $18 million in additional capital expenditures to complete the building's shell, targeted for January 2003. We will pursue a more traditional, on-balance sheet financing arrangement with our current banking partners to fund some of these efforts. In addition, we will have further discussions with our construction management partners in fourth quarter, to finalize our budget for the completion of the building's shell as well as identify the additional costs to secure and maintain our facility during this postponement period. Upon restart of the facility construction, we will look to more traditional construction and mortgage financing to complete the project. While the postponement will increase costs, we do not believe the cost of the postponement will materially affect our financial position, results of operations, or cash flows.

NOTE 7.    RESTRUCTURING CHARGE

        On June 18, 2002, we announced a reduction in workforce totaling 10% as part of an overall restructuring plan. The plan involved all areas and levels of the company. In connection with the restructuring effort, we recorded a charge of approximately $3.6 million in the second quarter of 2002.

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The charge was comprised of severance payments and related obligations for employees whose positions were eliminated.

        During September 2002, as a result of further business review and the refinement of our core strategic business we eliminated some employee positions primarily in the area of our clinical trials department. We recorded a charge of approximately $468,000 in the third quarter of 2002. The charge was comprised of $199,000 of severance payments for employees whose positions were eliminated and a $269,000 write-off of certain assets related to our clinical trials business. We will continue to examine and refine our business model throughout the remainder of the year.

        Severance activities for the nine months ended September 30, 2002 were as follows:

*

Expected to be disbursed through 2004.

NOTE 8.    EARNINGS PER SHARE

        Basic earnings (loss) per share is computed by dividing income (loss) attributable to common stockholders by the weighted-average number of common shares outstanding for the respective periods. Diluted earnings per share, calculated using the treasury stock method, gives effect to the potential dilution that could occur upon the exercise of certain stock options that were outstanding during the respective periods presented.

        Basic and diluted earnings (loss) per share for the respective periods are set forth in the table below:

(1)

Dilutive potential common shares are excluded from the diluted loss per common share calculation for the three and nine-month periods ended September 30, 2002 because they are antidilutive.

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ITEM 2.    MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

        The following discussion of our financial condition and results of operations should be read in conjunction with our selected consolidated financial data and the consolidated financial statements and related notes included elsewhere in this Quarterly Report. This section includes forward-looking information that involves risks and uncertainties. Our actual results could differ materially from those anticipated by forward-looking statements.

        For purposes of the following discussion, EBITDA consists of income (loss) from operations before interest, income taxes, depreciation and amortization. EBITDA should not be considered a measure of financial performance under GAAP. Items excluded from EBITDA are significant components in understanding and assessing overall financial performance. We present EBITDA, which is a non-GAAP measure, to enhance the understanding of our operating results. EBITDA should not be considered in isolation or as an alternative to net income, cash flows generated by operations, investing or financing activities, or other financial statement data presented in the consolidated financial statements as indicators of financial performance or liquidity.

Overview

        Specialty Laboratories is a leading research-based clinical laboratory predominantly focused on developing and performing esoteric clinical laboratory tests, which we refer to as assays. We offer a broad, comprehensive menu of esoteric assays, many of which have been developed through our internal research and development efforts. Esoteric assays are complex, comprehensive or unique tests used to diagnose, evaluate and monitor patients. These assays are often performed on sophisticated instruments by highly skilled personnel and are therefore offered by a limited number of clinical laboratories.

        Prior to the sanctions imposed by the California Department of Health Services (CDHS) and the federal Centers for Medicare and Medicaid Services (CMS) in March and April 2002, our test menu was comprised of more than 3,200 esoteric assays. However, in order to ensure compliance with the CDHS personnel licensing requirements, we changed to using only California-licensed clinical laboratory scientists to perform clinical testing, and reorganized our test menu to focus our efforts on core assays with the greatest importance to our clients. Accordingly, we discontinued many low volume assays. Certain of these assays can be replaced by other Specialty assays or outsourced to other clinical laboratories.

        Our primary customers are hospitals, independent clinical laboratories and physicians. We have aligned our interests with those of hospitals, our fastest growing client segment, by not competing in the routine test market that provides them with a valuable source of revenue. We educate physicians on the clinical value of our assays through our information-oriented marketing campaigns. Our technical, experienced sales force concentrates on the hospitals and independent laboratories that serve as distribution channels for physician assay orders. We use our advanced information technology solutions to accelerate and automate electronic ordering and results reporting with these customers.

        We believe that our typical esoteric assay is priced at approximately twice that of a routine test. Our assays also have higher costs than routine tests due to the necessity of specialized laboratory instruments and highly skilled laboratory personnel. If we are successful in the expansion of our hospital customer base, and we obtain or renew large customer or group purchasing organization contracts, our average price per assay will decrease as hospital esoteric referral testing is at lower average pricing and as large contracts typically incorporate volume discounts.

        On February 20, 2001, we completed the acquisition of substantially all of the assets of BBI Clinical Laboratories, Inc., a wholly-owned subsidiary of Boston Biomedica, Inc., a public company. We

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paid $9.5 million in cash which was accounted for as a purchase in the first quarter of 2001. The acquisition agreement provided for a reduction of the purchase price if certain performance measurements were not achieved. A subsequent evaluation of these performance measurements resulted in a return of $358,000 by BBI Clinical Laboratories to us in December 2001. BBI Clinical Laboratories, a private company founded in 1989, was a leading esoteric clinical reference laboratory specializing in infectious disease testing, such as Lyme disease and viral hepatitis. BBI Clinical Laboratories' primary customers included hospitals, physician specialists, pharmaceutical and diagnostic companies and other clinical and research laboratories.

        In December 2001, we purchased a 13.8 acre site in Valencia, California. We are in the process of building a 195,000 square foot facility which will enable us to consolidate all of our laboratory and administrative functions in one location. Construction began during the second quarter of 2002 and was to be completed in the second half of 2003. In October 2002, we announced that we would postpone the move to our new facility in Valencia until the first half of 2004. Accordingly, the construction of the new facility will be paused. This postponement will allow us to focus on rebuilding client confidence and stabilizing our business by minimizing any disruptions in service to our clients based on planning and executing a move to a new facility during this rebuilding period. We have notified our construction contractors of our intent to delay the project's completion date, and our plan is to halt the project upon completion of the building's shell. We estimate spending approximately $18 million in additional capital expenditures to complete the building's shell, targeted for January 2003. We will pursue a more traditional, on-balance sheet financing arrangement with our current banking partners to fund some of these efforts. Upon restart of the facility construction, we will look to more traditional construction and mortgage financing to complete the project.

        In March 2002, we completed a $100 million financing transaction. This credit facility has two components: first, we entered into a 6.5 year lease to finance construction of our new laboratory and headquarters facility in Valencia, California, sometimes referred to as a "synthetic lease", with a total cost, including financing costs, of up to $60 million, and second, we entered into a $40 million line of credit with the same lenders that provide the lease financing, with proceeds available for general corporate purposes. Prior to this transaction, we had an existing line of credit of $30 million, which was provided by Union Bank of California. Our new credit facility, arranged by BNP Paribas, includes Union Bank, US Bank, First Union National Bank, as co-syndication agents, and Allied Irish Banks, Manufacturers Bank, and Bank Leumi, USA, as participants. Our new laboratory and headquarters facility was to be leased from BNP Paribas Leasing Corporation, a substantive leasing company with assets in excess of $1.5 billion. As previously reported, we have been reevaluating the lease and bank loan agreements with our banking partners to amend the terms and conditions of each agreement, including the overall size of the agreements. We have decided to go on balance sheet with this transaction, and have provided notice to the banking group led by BNP Paribas that we intend to exercise our purchase option under the agreement, paying off the debt so we can obtain title to the ground lease and facility improvements, thus ending the synthetic lease. Accordingly, we have reflected this in our September 30, 2002 financial statements, with the building now recorded in property and equipment on our balance sheet, and the $4.6 million owed to BNP Paribas reflected as a bank loan in current liabilities. We anticipate paying off the $4.6 million bank loan in November 2002 and may record one-time charges in fourth quarter of 2002 for expenses associated with the lease termination.

        By letter dated March 28, 2002, CDHS notified us of its intent to impose alternative sanctions of a directed plan of correction, random onsite monitoring, and a civil money penalty based upon deficiencies cited during laboratory inspections conducted during June and October 2001. The sanctions were based on findings that we were permitting unlicensed personnel to perform and supervise clinical laboratory testing in violation of California law. We filed supplemental documentation supporting our compliance with the applicable requirements with CDHS and CMS on April 26, 2002. In addition, on April 26, 2002, we requested that CDHS rescind its proposed sanctions outlined in the March 28, 2002

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