QUEST DIAGNOSTICS INC - 10-K Annual Report

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

FORM 10-K

[QUEST DIAGNOSTICS LOGO]

Annual Report Pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934
For the Fiscal Year Ended December 31, 2003
Commission File Number 1-12215

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QUEST DIAGNOSTICS INCORPORATED
One Malcolm Avenue, Teterboro, NJ 07608
(201) 393-5000

DELAWARE
(State of Incorporation)

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

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SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

Title of Each Class Name of Each Exchange on Which Registered
Common Stock
with attached Preferred Share Purchase Right New York Stock Exchange

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SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: None

Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
----- -----

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K. [ ]

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes X No
----- -----

As of June 30, 2003, the aggregate market value of the approximately 83 million
shares of voting and non-voting common equity held by non-affiliates of the
registrant was approximately $5.3 billion, based on the closing price on such
date of the registrant's Common Stock on the New York Stock Exchange.

As of February 23, 2004, there were outstanding 103,604,635 shares of Common
Stock, $.01 par value.

Documents Incorporated by Reference

Such Proxy Statement, except for portions thereof, which have been specifically
incorporated by reference, shall not be deemed "filed" as part of this report on
Form 10-K.

PART I

ITEM 1. BUSINESS

OVERVIEW

We are the nation's leading provider of diagnostic testing, information and
related services, providing insights that enable physicians, hospitals, managed
care organizations and other healthcare professionals to make decisions to
improve health. We offer patients and physicians the broadest access to
diagnostic laboratory services through our national network of laboratories and
patient service centers. We provide interpretive consultation through the
largest medical and scientific staff in the industry, with over 300 physicians
and Ph.D.'s around the country. We are the leading provider of esoteric testing,
including gene-based testing, and testing for drugs of abuse. We are also a
leading provider of anatomic pathology services and testing for clinical trials.
We empower healthcare organizations and clinicians with state-of-the-art
information technology solutions that can improve practice management and
patient care.

During 2003, we generated net revenues of $4.7 billion and processed over
130 million requisitions for testing. Each requisition form accompanies a
patient specimen, indicating the tests to be performed and the party to be
billed for the tests. Our customers include physicians, hospitals, managed care
organizations, employers, governmental institutions and other commercial
clinical laboratories.

We currently operate a nationwide network of approximately 1,925 patient
service centers, principal laboratories located in more than 30 major
metropolitan areas throughout the United States, and approximately 155 smaller
"rapid response" laboratories (including, in each case, facilities operated at
our joint ventures). We are the only company in our industry to provide full
esoteric testing services, including gene-based testing, on both coasts through
our Quest Diagnostics Nichols Institute facilities, located in San Juan
Capistrano, California and Chantilly, Virginia. We also have laboratory
facilities in Mexico City, Mexico and San Juan, Puerto Rico and near London,
England.

We are a Delaware corporation. We sometimes refer to our subsidiaries and
ourselves as the "Company". We are the successor to MetPath Inc., a New York
corporation that was organized in 1967. From 1982 to 1996, we were a subsidiary
of Corning Incorporated, or Corning. On December 31, 1996, Corning distributed
all of the outstanding shares of our common stock to the stockholders of
Corning. In August 1999, we completed the acquisition of SmithKline Beecham
Clinical Laboratories, Inc., or SBCL, which operated the clinical laboratory
business of SmithKline Beecham plc, or SmithKline Beecham.

Our principal executive offices are located at One Malcolm Avenue,
Teterboro, New Jersey 07608, telephone number: (201) 393-5000. Our filings with
the Securities and Exchange Commission, or the SEC, including our annual report
on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and
amendments to those reports, are available free of charge on our website as soon
as reasonably practicable after they are filed with, or furnished to, the SEC.
Our Internet website is located at http://www.questdiagnostics.com.

THE UNITED STATES CLINICAL LABORATORY TESTING MARKET

Clinical laboratory testing is an essential element in the delivery of
healthcare services. Physicians use laboratory tests to assist in the detection,
diagnosis, evaluation, monitoring and treatment of diseases and other medical
conditions. Clinical laboratory testing is generally categorized as clinical
testing and anatomic pathology testing. Clinical testing is performed on body
fluids, such as blood and urine. Anatomic pathology testing is performed on
tissues and other samples, such as human cells. Most clinical laboratory tests
are considered routine and can be performed by most commercial clinical
laboratories. Tests that are not routine and that require more sophisticated
equipment and highly skilled personnel are considered esoteric tests. Esoteric
tests, including gene-based tests, are generally referred to laboratories that
specialize in performing those tests.

We believe that the United States diagnostic testing industry had
over $37 billion in annual revenues in 2003. Most laboratory tests are
performed by one of three types of laboratories: commercial clinical
laboratories; hospital-affiliated laboratories; and physician-office
laboratories. In 2003, we believe that hospital-affiliated laboratories
performed over one-half of the clinical laboratory tests in the United States,
commercial clinical laboratories performed approximately one-third of those
tests, and physician-office laboratories performed the balance.

The underlying fundamentals of the diagnostic testing industry have improved
since the early to mid-1990s, which was a period of declining reimbursement and
reduced test utilization. During the early 1990s, the

industry was negatively impacted by changes in government regulation and
investigations into various billing practices. In addition, the rapid growth of
managed care, as a result of the need to reduce overall healthcare costs, and
excess laboratory testing capacity, led to revenue and profit declines across
the diagnostic testing industry, which in turn led to industry consolidation,
particularly among commercial laboratories. As a result of these dynamics, fewer
but larger commercial laboratories have emerged, which have greater economies of
scale, rigorous programs designed to assure compliance with government billing
regulations and other laws, and a more disciplined approach to pricing services.
These changes have resulted in improved profitability and a reduced risk of
non-compliance with complex government regulations. At the same time, a slowdown
in the growth of managed care and decreasing influence by managed care
organizations on the ordering of clinical laboratory testing by physicians has
contributed to renewed growth in testing volumes and further improvements in
profitability since 1999. Partially offsetting these favorable trends have been
changes in the United States economy during the last several years, which have
resulted in an increase in the number of unemployed and uninsured. In addition,
in an attempt to slow the rapidly rising costs of healthcare, employers and
healthcare insurers have made design changes to healthcare plans which shift a
larger portion of healthcare costs to consumers. We believe these factors have
reduced the utilization of healthcare services in general. Orders for laboratory
testing are generated from physician offices, hospitals and employers. As such,
factors such as the number of unemployed and uninsured and design changes in
healthcare plans, which impact the level of employment or the number of
physicians' office and hospital visits, will impact the utilization of
laboratory testing.

We believe the diagnostic testing industry has continued to grow during the
last several years despite the slowdown in the United States economy and the
changes in healthcare plan design, and that growth will accelerate as the
economy improves. In addition, over the longer term, growth is expected to
accelerate as a result of the following factors:

o general expansion and aging of the United States population;

o continuing research and development in the area of genomics and
proteomics, which is expected to yield new, more sophisticated and
specialized diagnostic tests;

o increasing recognition by consumers and payers of the value of early
detection and prevention, which can be provided through laboratory
testing, as a means to improve health and reduce the overall cost of
healthcare; and

o increasing affordability of tests due to advances in technology and cost
efficiencies.

BUSINESS STRATEGY

Our mission is to be recognized by our customers and employees as the best
provider of comprehensive and innovative diagnostic testing, information and
related services. The principal components of this strategy are to:

o COMPETE THROUGH PROVIDING THE HIGHEST QUALITY SERVICES: We intend to
become recognized as the quality leader in the healthcare services
industry. We continue to implement our Six Sigma and standardization
initiatives throughout all aspects of our organization. Six Sigma is
a management approach that requires a thorough understanding of customer
needs and requirements, root cause analysis, process improvements and
rigorous tracking and measuring. We have integrated our Six Sigma
initiative with our initiative to standardize operations and processes
across the Company by adopting identified Company best practices. We
plan to continue these initiatives during the next several years and
expect that successful implementation of these initiatives will result
in measurable improvements in customer satisfaction as well as
significant economic benefits.

o CAPITALIZE ON OUR LEADING POSITION WITHIN THE LABORATORY TESTING MARKET:
We are the leader in the core clinical laboratory testing business
offering the broadest national access to clinical laboratory testing
services, with facilities in substantially all of the major metropolitan
areas in the United States. We currently operate a nationwide network of
approximately 1,925 patient service centers, principal laboratories
located in more than 30 major metropolitan areas throughout the United
States and about 155 smaller "rapid response" laboratories that enable
us to serve physicians, managed care organizations, hospitals, employers
and other healthcare providers and their patients throughout the United
States. We believe that customers will increasingly seek to utilize
laboratory testing providers that have a nationwide presence and offer
a comprehensive range of services and that, as a result, we will be
able to profitably enhance our market position.

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o CONTINUE TO LEAD INNOVATION: We intend to build upon our reputation as a
leading innovator in the clinical laboratory industry by continuing to
introduce new tests, technology and services. As the industry leader with
the largest and broadest network and the leading provider of esoteric
testing, including gene-based testing, we believe that we are the best
partner for developers of new technology and tests to introduce their
products to the marketplace. Through our relationship with members of the
academic community, pharmaceutical and biotechnology firms, and emerging
medical technology companies that develop and commercialize novel
diagnostics, pharmaceutical and device technologies, we believe that we
are one of the leaders in transferring technical innovation to the
market (see "Our Services -- New Test Introductions").

We believe that, with the unveiling of the human genome, new genes and
the linkages of genes with disease will continue to be discovered at an
accelerating pace, leading to research that will result in ever more
complex and thorough predictive, diagnostic and therapeutic testing. We
believe that we are well positioned to capture much of this growth.

We continue to invest in the development and improvement of our
information technology products for customers and providers by developing
differentiated products that will provide friendlier, easier access to
ordering and resulting of laboratory tests and patient-centric
information. In February 2003, we launched our proprietary eMaxx'r'
Internet portal to physicians nationwide, which enables doctors to order
diagnostic tests and review laboratory results online, as well as check
patients' insurance eligibility in real time and view clinical
information from many sources.

o PURSUE STRATEGIC GROWTH OPPORTUNITIES: We intend to continue to leverage
our network in order to capitalize on targeted strategic growth
opportunities both inside and outside our core clinical laboratory
testing business. These opportunities are more fully described under
"Strategic Growth Opportunities" and include expanding our gene-based
and specialty testing capabilities, developing information technology
products for customers and providers, expanding our geographic presence
across the United States, and continuing to make selective acquisitions.

o LEVERAGE OUR SATISFACTION MODEL: Our approach to conducting business
states that satisfied employees lead to satisfied customers, which in
turn benefits our stockholders. We regularly survey our employees and
customers and follow up on their concerns. We emphasize skills training
for all employees and leadership training for our supervisory employees,
which includes Six Sigma training to manage high-impact quality
improvement projects throughout our organization, and annual compliance
training. We are committed to engaging each of our employees with
dignity and respect and expect them to treat our customers the same way.
We believe that our treatment and training of employees, together with
our competitive pay and benefits, helps increase employee satisfaction
and performance, thereby enabling us to provide better services to
our customers.

RECENT ACQUISITIONS

On February 28, 2003, we completed the acquisition of Unilab Corporation, or
Unilab, the leading commercial clinical laboratory in California. In connection
with the acquisition, we issued approximately 7.4 million shares of Quest
Diagnostics common stock (including 0.3 million shares of Quest Diagnostics
common stock reserved for outstanding stock options of Unilab which were
converted upon the completion of the acquisition into options to acquire shares
of Quest Diagnostics common stock), paid $297 million in cash and repaid $220
million of debt, representing substantially all of Unilab's then existing
outstanding indebtedness.

In connection with the acquisition of Unilab, as part of a settlement
agreement with the United States Federal Trade Commission, we entered into an
agreement to sell to Laboratory Corporation of America Holdings, Inc., or
LabCorp, certain assets in northern California for $4.5 million, including the
assignment of agreements with four independent physician associations, or IPA,
and leases for 46 patient service centers (five of which also serve as rapid
response laboratories). Approximately $27 million in annual net revenues were
generated by capitated fees under the IPA contracts and associated
fee-for-service testing for physicians whose patients use these patient service
centers, as well as from specimens received directly from the IPA physicians. We
completed the transfer of assets and assignment of the IPA agreements to LabCorp
during the third quarter of 2003.

As part of the Unilab acquisition, we acquired all of Unilab's operations,
including its primary testing facilities in Los Angeles, San Jose and
Sacramento, California, approximately 365 patient service centers, 35 rapid
response laboratories and approximately 4,100 employees. Following the sale of
certain assets to LabCorp, we closed our previously owned clinical laboratory in
the San Francisco Bay area and completed the integration

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of remaining customers in the northern California area to Unilab's laboratories
in San Jose and Sacramento. We continue to have two laboratories in the Los
Angeles metropolitan area (our facilities in Van Nuys and Tarzana). We plan to
open a new regional laboratory in the Los Angeles metropolitan area and then
integrate our business in the Los Angeles metropolitan area into the new
facility. We expect to incur up to $20 million of costs through 2005 to
integrate Unilab and our existing California operations. Upon completion of the
Unilab integration, we expect to realize approximately $25 million to $30
million of annual synergies. We expect to achieve this annual rate of synergies
by the end of 2005.

On April 1, 2002, we acquired American Medical Laboratories, Incorporated,
or AML, and an affiliated company of AML, LabPortal, Inc., a provider of
electronic connectivity products, in an all-cash transaction valued at
approximately $500 million, which included the assumption of approximately $160
million in debt. AML was a national provider of esoteric testing to hospitals
and specialty physicians and a leading provider of diagnostic testing services
in the Nevada and metropolitan Washington, D.C. markets. The Company's
Chantilly, Virginia laboratory, acquired as part of the AML acquisition, has
become our primary esoteric testing laboratory and hospital service center for
the eastern United States, complementing our Nichols Institute esoteric testing
facility in San Juan Capistrano, California. Esoteric testing volumes have been
redirected within our national network to provide customers with improved
turnaround time and customer service. We have completed the transition of
certain routine clinical laboratory testing previously performed in the
Chantilly, Virginia laboratory to other testing facilities within our regional
laboratory network.

Following an acquisition, the integration process requires the dedication of
significant management resources, which could result in a loss of momentum in
the activities of our business and may cause an interruption of, or
deterioration in, our services as a result of the following difficulties, among
others:

o a loss of key customers or employees;

o inconsistencies in standards, controls, procedures and policies between
the acquired company and our existing operations may make it more
difficult to implement and harmonize company-wide financial, accounting,
billing, information and other systems;

o failure to maintain the quality of services that the Company has
historically provided;

o diversion of management's attention from the day-to-day business of our
Company as a result of the need to deal with the foregoing disruptions
and difficulties; and

o the added costs of dealing with such disruptions.

Since most of our clinical laboratory testing is performed under
arrangements that are terminable at will or on short notice, any interruption
of, or deterioration in, our services may also result in a customer's decision
to stop using us for clinical laboratory testing. These events could have a
material adverse impact on our business. However, management believes that the
successful implementation of our integration plans and our value proposition
based on expanded patient access, our broad testing capabilities and most
importantly, the quality of the services we provide, will mitigate customer
attrition.

OUR SERVICES

Our laboratory testing business consists of routine testing, esoteric
testing, and clinical trials testing. Routine testing generates approximately
80% of our net revenues, esoteric and gene-based testing generates approximately
16% of our net revenues, and clinical trials testing generates less than 3% of
our net revenues. We derive less than 2% of our net revenues from foreign
operations.

ROUTINE TESTING

Routine tests measure various important bodily health parameters such as the
functions of the kidney, heart, liver, thyroid and other organs. Commonly
ordered tests include:

o blood cholesterol level tests;

o complete blood cell counts;

o Pap tests;

o HIV-related tests;

o urinalyses;

o pregnancy and other prenatal tests; and

o alcohol and other substance-abuse tests.

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We perform routine testing through our network of major laboratories, rapid
response laboratories, or "stat" labs, and patient service centers. We also
perform routine testing at the hospital laboratories we manage. Major
laboratories offer a full line of routine clinical tests. Rapid response
laboratories are local facilities where we can quickly perform an abbreviated
group of routine tests for customers that require rapid turnaround times.
Patient service centers are facilities where specimens are collected. These
centers are typically located in or near a building used by medical
professionals.

We operate 24 hours a day, 365 days a year. We perform and report most
routine procedures within 24 hours. Most test results are delivered
electronically.

ESOTERIC TESTING

Esoteric tests are those tests that require more sophisticated technology,
equipment and materials, professional "hands-on" attention and more highly
skilled professional and technical personnel, and may be performed less
frequently than routine tests. Because it is not cost-effective for most
clinical laboratories to perform a low volume of esoteric tests in-house, they
generally refer many of these tests to an esoteric clinical testing laboratory
that specializes in performing these more complex tests. Due to their
complexity, esoteric tests are generally reimbursed at higher levels than
routine tests.

Our two esoteric testing laboratories, which conduct business as Quest
Diagnostics Nichols Institute, are among the leading esoteric clinical testing
laboratories in the world. In 1998, our esoteric testing laboratory in San Juan
Capistrano, California, became the first clinical laboratory in North America to
achieve ISO-9001 certification. Our esoteric testing laboratory in Chantilly,
Virginia, acquired as part of the AML acquisition, now enables us to provide
full esoteric testing services, including gene-based testing, on the east coast.
Our two esoteric testing laboratories perform hundreds of esoteric tests that
are not routinely performed by our regional laboratories. These esoteric tests
are generally in the following fields:

o endocrinology and metabolism (the study of glands, their hormone
secretions and their effects on body growth and metabolism);

o genetics (the study of chromosomes, genes and their protein products and
effects);

o hematology (the study of blood and bone marrow cells) and coagulation
(the process of blood clotting);

o immunology (the study of the immune system including antibodies, immune
system cells and their effects);

o microbiology and infectious diseases (the study of microscopic forms of
life including bacteria, viruses, fungi and other infectious agents);

o oncology (the study of abnormal cell growth including benign tumors and
cancer);

o serology (a science dealing with the body fluids and their analysis,
including antibodies, proteins and other characteristics);

o special chemistry (more sophisticated testing requiring special expertise
and technology); and

o toxicology (the study of chemicals and drugs and their effects on the
body's metabolism).

NEW TEST INTRODUCTIONS

We intend to build upon our reputation as a leading innovator in the
clinical laboratory industry by continuing to introduce new diagnostic tests. As
the industry leader with the largest and broadest network and the leading
provider of esoteric testing, including gene-based testing, we believe that we
are the best partner for developers of new technology and tests to introduce
their products to the marketplace.

During 2003, we continued to be a leading innovator in the industry through
both tests that we developed at Nichols Institute, the largest provider of
molecular diagnostic testing in the United States, as well as through
relationships with technology developers. During 2003, we developed and
introduced:

o more than 15 comprehensive panels utilizing our menu of over 100 tests to
assist physicians with diagnosis and management of patients with bleeding
or blood clotting disorders;

o over 15 new infectious disease tests including DNA assays for West Nile
and SARS infection; and

o a biomarker assay that provides information on recurrence risk and
biologic behavior of node negative breast cancer to guide therapy for
the 30% of women with node negative disease.

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During 2003, we inaugurated a molecular endocrinology laboratory, with
introduction of the first commercial DNA tests for central and nephrogenic
Diabetes Insipidus (DI), Congenital Adrenal Hyperplasia (CAH), and Thyroid
Hormone Resistance (THR). The DI tests bypass the complicated perturbation tests
used for differential diagnosis of the several disorders. CAH testing is offered
as a DNA analysis for the most common mutations and as a CAH complete gene
sequencing for the 60 deleterious mutations known to be associated with this
wide spectrum of adrenal function disorders. The THR testing provides definitive
diagnosis for children with hypothyroidism of variable extent associated with
the defective hormone receptor.

Through our relationship with members of the academic community and
pharmaceutical and biotechnology firms, as well as our collaboration with
emerging medical technology companies that develop and commercialize novel
diagnostics, pharmaceutical and device technologies, we believe that we are one
of the leaders in transferring technical innovation to the market. During 2003,
we entered into a variety of strategic technology arrangements including:

o an agreement with Enterix, Inc. under which we have begun to offer the
Insure'TM' test, an FDA-cleared fecal immunochemical screening test for
colorectal cancer. Unlike other non-invasive colorectal cancer screening
technologies, the Insure'TM' test is easy for patients to use and
requires no handling of fecal matter;

o an agreement with diaDexus under which we are expanding our heart disease
test offering through the Lp-PLA2 test, which enables physicians to
detect a new risk factor for cardiovascular disease by measuring
levels of the enzyme lipoprotein-associated phospholipase A2; and

o a relationship with Thermo Electron under which we are developing a
biochip-based test for the detection of cystic fibrosis (CF) gene
mutations during prenatal screening.

Through our research and development, marketing and commercial alliance with
Roche Diagnostics, we were the first laboratory to offer several new tests
developed by Roche, including its Elecsys NT-proBNP test (which aids in the
diagnosis of congestive heart failure). Our relationship with Celera Diagnostics
gives us access to potentially significant markers for the risk of
cardiovascular disease, the leading cause of death in the United States, and
diabetes. Our relationship with Correlogic Systems has gained access to its new
ovarian cancer blood test, which we hope will be available to the marketplace in
2004 and will be the first protein pattern recognition blood test to detect
ovarian cancer in women who are already considered high risk.

We believe that, with the unveiling of the human genome, new genes and the
linkages of genes with disease will continue to be discovered at an accelerating
pace, leading to research that will result in ever more complex and thorough
predictive, diagnostic and therapeutic testing. We believe that we are well
positioned to capture much of this growth.

CLINICAL TRIALS TESTING

We believe that we are the world's second largest provider of clinical
laboratory testing performed in connection with clinical research trials on new
drugs in the world. Clinical research trials are required by the Food and Drug
Administration, or FDA, and other international regulatory authorities to assess
the safety and efficacy of new drugs. We have clinical trials testing centers in
the United States and in England. We also provide clinical trials testing in
Australia, Singapore, and South Africa through arrangements with third parties.
Clinical trials involving new drugs are increasingly being performed both inside
and outside the United States. Approximately 45% of our net revenues from
clinical trials testing in 2003 represented testing for GlaxoSmithKline plc, or
GSK. We currently have a long-term contractual relationship with GSK, under
which we are the primary provider of testing to support GSK's clinical trials
testing requirements worldwide.

OTHER SERVICES AND PRODUCTS

We manufacture and market diagnostic test kits and systems primarily for
esoteric testing under the Nichols Institute Diagnostics brand name. These are
sold principally to hospitals, clinical laboratories and dialysis centers,
both domestically and internationally. Our MedPlus subsidiary is a developer and
integrator of clinical connectivity and data management solutions for healthcare
organizations and clinicians primarily through its ChartMaxx'r' electronic
medical record system. During 2003, we began deploying eMaxx'r', a new
physician's Internet portal across the United States. The Internet portal was
developed by MedPlus and can provide physicians a "patient-centric" view of
laboratory test results and other clinical information on-line.

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PAYERS AND CUSTOMERS

We provide testing services to a broad range of healthcare providers. We
consider a "payer" as the party that pays for the test and a "customer" as the
party who refers the test to us. Depending on the billing arrangement and
applicable law, the payer may be (1) the physician or other party (such as
another laboratory or an employer) who referred the testing to us, (2) the
patient, or (3) a third party who pays the bill for the patient, such as an
insurance company, Medicare or Medicaid. Some states, including New York, New
Jersey and Rhode Island, prohibit us from billing physician clients. We consider
a managed care organization as both our customer and a payer, when it contracts
with us on an exclusive or semi-exclusive basis on behalf of its patients.

During 2003, only two customers accounted for more than 5% of our net
revenues, and no single customer accounted for more than 7% of our net revenues.
We believe that the loss of any one of our customers would not have a material
adverse effect on our financial condition, results of operations or cash flows.

PAYERS

The following table shows current estimates of the breakdown of the
percentage of our total volume of requisitions and total clinical laboratory net
revenues during 2003 applicable to each payer group:

CUSTOMERS

Physicians

Physicians requiring testing for patients are the primary source of our
clinical laboratory testing volume. We typically bill physician accounts on a
fee-for-service basis. Fees billed to physicians are based on the laboratory's
client fee schedule and are typically negotiated. Fees billed to patients and
insurance companies are based on the laboratory's patient fee schedule, subject
to any limitations on fees negotiated with the insurance companies or with
physicians on behalf of their patients. Medicare and Medicaid reimbursements are
based on fee schedules set by governmental authorities.

Managed Care Organizations and Other Insurance Providers

Health insurers, which typically contract with a limited number of clinical
laboratories for their members, represent approximately one-half of our total
testing volumes and one-half of our net revenues. Larger health insurers
typically prefer to use large commercial clinical laboratories because they can
provide services on a national or regional basis and can manage networks of
local or regional laboratories to provide even broader access to their members
and physicians. In addition, larger laboratories are better able to achieve the
low-cost structures necessary to profitably service large health insurers and
can provide test utilization data across their various plans in a consistent
format. In certain markets, such as California, many health insurers delegate
their covered members to independent physician associations, which in turn
contract with laboratories for clinical laboratory services.

Over the last decade, health insurers have been consolidating, resulting in
fewer but larger insurers with significant bargaining power in negotiating fee
arrangements with healthcare providers, including clinical laboratories. These
health insurers demand that clinical laboratory service providers accept
discounted fee structures or assume all or a portion of the financial risk
associated with providing testing services to their members through capitated
payment contracts. Under these capitated payment contracts, the Company and
health insurers agree to a predetermined monthly contractual rate for each
member of the health insurer's plan regardless of the number or cost of services
provided by the Company. Some services, such as various esoteric tests, new
technologies and anatomic pathology services, may be carved out from a capitated
rate and, if carved

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out, are charged on a fee-for-service basis. We work closely with health
insurers as they evaluate new tests; however, as innovation in the testing
area increases, there is no guarantee that health insurers will agree to carve
out these services or reimburse them at rates that reflect the true cost or
value associated with such services.

In recent years, there has been a shift in the way major insurers contract
with clinical laboratories. Health insurers have begun to offer more freedom of
choice to their affiliated physicians, including greater freedom to determine
which laboratory to use and which tests to order. Accordingly, most of our
agreements with major health insurers are non-exclusive contracts. As a result,
under these non-exclusive arrangements, physicians have more freedom of choice
in selecting laboratories, and laboratories are likely to compete more on the
basis of service and quality rather than price alone. Also, health insurers have
been giving patients greater freedom of choice and patients have increasingly
been selecting plans (such as preferred provider organizations and consumer
driven plans) that offer a greater choice of providers. Pricing for these
preferred provider organizations is typically negotiated on a fee-for-service
basis, which generally results in higher revenue per requisition than under a
capitated fee arrangement. Despite these trends, health insurers continue to
aggressively seek cost reductions in order to keep their premiums to their
customers competitive. If we are unable to agree on pricing with a health
insurer, we would become a "non-participating" provider and could then only
bill the ordering physician or the patient rather than the health insurer.
This "non-participating" status could lead to loss of business since the
physician is likely to refer testing to a participating provider whose testing
is covered by the patient's health insurance benefit plan. We cannot assure
investors that we will continue to be successful in negotiating contracts
with major insurers. Loss of multiple major insurer or other payer agreements
could have a material adverse effect on our financial condition, results of
operations and cash flows.

We offer QuestNet'TM', an innovative product to develop and manage a
customized network of clinical laboratory providers for health insurers. Through
QuestNet'TM', physicians and members are provided multiple choices for clinical
laboratory testing while health insurers realize cost reductions under a single
capitated arrangement.

Hospitals

We provide services to hospitals throughout the United States that vary from
esoteric testing to helping manage their laboratories. We believe that we are
the industry's market leader in servicing hospitals. Our hospital customers
account for approximately 13% of our net revenues, the majority of which
represents services billed to the hospitals under reference testing
arrangements, based on negotiated fee schedules, for certain testing that the
hospitals do not perform internally. Hospitals generally maintain an on-site
laboratory to perform testing on patients and refer less frequently needed and
highly specialized procedures to outside laboratories, which typically charge
the hospitals on a negotiated fee-for-service basis. We believe that most
hospital laboratories perform approximately 90% to 95% of their patients'
clinical laboratory tests. In addition, many hospitals compete with commercial
clinical laboratories for outreach (non-hospital patients) testing. Most
physicians have admitting privileges or other relationships with hospitals as
part of their medical practice. Many hospitals leverage their relationships with
community physicians and encourage the physicians to send their outreach testing
to the hospital's laboratory. In addition, hospitals that own physician
practices generally require the physicians to refer tests to the hospital's
affiliated laboratory. As a result, hospital-affiliated laboratories can be both
customers and competitors for commercial clinical laboratories.

During 2002, in conjunction with the acquisition of AML, we launched
dedicated sales and service teams focused on serving the unique needs of
hospital customers. We believe that the combination of full-service, bi-coastal
esoteric testing capabilities, medical and scientific professionals for
consultation, innovative connectivity products, focus on Six Sigma quality and
dedicated sales and service professionals has positioned us to be a partner of
choice for hospital customers.

We have joint venture arrangements with leading integrated health delivery
networks in several metropolitan areas. These joint venture arrangements, which
provide testing for affiliated hospitals as well as for unaffiliated physicians
and other healthcare providers in their geographic areas, serve as our principal
laboratory facilities in their service areas. Typically, we have either a
majority ownership interest in, or day-to-day management responsibilities for,
our hospital joint venture relationships. We also manage the laboratories at a
number of other hospitals.

8

Employers, Governmental Institutions and Other Clinical Laboratories

We provide testing services to federal, state and local governmental
agencies and to large employers. We believe that we are the leading provider of
clinical laboratory testing to employers for drugs of abuse. We also provide
wellness testing to employers to enable employees to take an active role in
improving their health. Testing services for employers account for approximately
3% of our net revenues. The volume of testing services for employers, which
generally have relatively low profit margins, has declined significantly during
2001 through 2003 driven by a slowdown in hiring. We also perform esoteric
testing services for other commercial clinical laboratories that do not have a
full range of testing capabilities. All of these customers are charged on a
fee-for-service basis.

Consumers

Consumers are becoming increasingly interested in managing their own health
and health records. Currently, almost all the testing we perform is ordered
directly by a physician, who then receives the test results. However, over time,
we believe that consumers will increasingly want to order clinical laboratory
tests themselves. To that end, we offer a focused menu of clinical laboratory
testing directly to consumers in certain states. Consumers pay for and receive
the test results directly. In each case, a physician reviews the order and
result. We believe this market will continue to grow over time.

SALES AND MARKETING

We market to and service our customers through our direct sales force,
customer service and patient service representatives and couriers.

We focus our sales efforts on obtaining and retaining profitable accounts.
We have an active account management process to evaluate the profitability of
all of our accounts. Where appropriate, we change the service levels, terminate
accounts that are not profitable or adjust pricing.

Our sales force is organized by customer type with the majority of
representatives focused on marketing laboratory services to physicians,
including specialty physicians such as oncologists, cardiologists and
gastroenterologists. Additionally, we have a managed care sales organization
that maintains relationships with regional and national insurance and managed
care organizations. We also have a hospital sales organization that focuses on
meeting the unique needs of hospitals and leverages the specialized capabilities
of our Nichols Institute esoteric testing laboratories. Supporting our hospital
and physician sales teams are genomics and esoteric testing specialists, who are
specially trained and focused on marketing and selling more complex tests to our
customers. A smaller portion of our sales force focuses on selling substance-of-
abuse testing to employers.

Customer service representatives perform a number of services for patients
and customers. They monitor services, answer questions and help resolve
problems. Our couriers pick up specimens from most clients daily.

Our corporate marketing function is organized by customer and is responsible
for developing and executing marketing strategies, new product launches, and
promotional and advertising support. The marketing function is also responsible
for customer satisfaction surveys, market research, tradeshow administration,
database marketing tools, and marketplace trending and analysis.

STRATEGIC GROWTH OPPORTUNITIES

In addition to expanding our core clinical laboratory business through
internal growth and pursuing our strategy to become a leading provider of
medical information, we intend to continue to leverage our network in order to
capitalize on targeted growth opportunities both inside and outside our core
laboratory testing business. These opportunities include:

o GENE-BASED AND OTHER ESOTERIC TESTS: We intend to remain a leading
innovator in the clinical laboratory industry by continuing to introduce
new tests, technology and services. We estimate that the current United
States market in esoteric testing, including gene-based testing, is $3
billion to $4 billion per year. We believe that we have the largest
gene-based testing business in the United States, with greater than
$500 million in net revenues during 2003, and that this business has been
growing by more than 20% per year. We believe that the unveiling of the
human genome, the discovery of new genes and the linkages of these genes
with disease will result in more complex and thorough predictive,
diagnostic and therapeutic testing. We believe that we are well
positioned to realize this growth. We intend to focus on
commercializing diagnostic applications of discoveries in the areas of
functional genomics (the analysis

9

of genes and their functions) and proteomics (the discovery of new
proteins made possible by the human genome project).

o ANATOMIC PATHOLOGY: While we are one of the leading providers of anatomic
pathology services in the United States, we have traditionally been
strongest in cytology, and specifically in the analysis of Pap tests to
detect cervical cancer. During the last several years, we have led the
industry in converting over 80% of our Pap smear business to the use of
liquid-based technology for cervical cancer screening, a higher quality
and more profitable product offering. We intend to continue to expand our
anatomic pathology business into higher growth segments, including
histology (tissue pathology), and actively participate in the emerging
use of molecular testing as a screening tool in conjunction with Pap
tests. We estimate that the current United States market for anatomic
pathology services is approximately $6 billion per year. We estimate
that cytology represents about $1 billion per year of this market, and
that tissue pathology represents about $5 billion per year of this
market. We generated approximately $500 million in net revenues from
such services during 2003.

o INFORMATION TECHNOLOGY: We continue to invest in the development and
improvement of information technology products for customers and
providers by developing differentiated products that will provide
friendlier, easier access to ordering and resulting of laboratory tests
and patient-centric information. In February 2003, we launched our
proprietary eMaxx'r' Internet portal to physicians nationwide. The
eMaxx'r' Internet portal enables doctors to order diagnostic tests and
review laboratory results online, as well as check patients' insurance
eligibility in real time and view clinical information from many sources.
In pilot markets, physicians are also able to use eMaxx'r' to prescribe
pharmaceuticals. This service allows us to replace older technology
desktop products that we currently provide to many physicians and
thereby streamline our support structure. Demand has been growing for
our information technology solutions as physician offices have expanded
their usage of the Internet. By the end of 2003, we were receiving
approximately 25% of all test orders and delivering about 35% of all
test results via the Internet.

The eMaxx'r' Internet portal was developed by MedPlus Inc., or MedPlus,
which we acquired in November 2001. MedPlus' ChartMaxx'r' and eMaxx'r'
patient record systems are designed to support the creation and
management of electronic patient records, by bringing together in one
patient-centric view information from various sources, including the
physician's records and laboratory and hospital data. We intend to
expand the services offered through our portal over time as other
strategic arrangements are realized, which will enhance our ability to
introduce a broad range of electronic services to healthcare providers.

o SELECTIVE REGIONAL ACQUISITIONS: The clinical laboratory industry remains
highly fragmented. We expect to continue to acquire other regional
clinical laboratories that can be integrated with our existing
laboratories, thereby enabling us to reduce costs and improve
efficiencies through the elimination of redundant facilities and
equipment, and reductions in personnel (see "Recent Acquisitions" for a
discussion of our recent acquisitions). We may also consider
acquisitions of ancillary businesses as part of our overall growth
strategy, such as our November 2001 acquisition of MedPlus, which
develops clinical connectivity products designed to enhance patient
care (see "Information Technology").

INFORMATION SYSTEMS

Information systems are used extensively in virtually all aspects of our
business, including laboratory testing, billing, customer service, logistics,
and management of medical data. Our success depends, in part, on the continued
and uninterrupted performance of our information technology, or IT systems.
Computer systems are vulnerable to damage from a variety of sources, including
telecommunications or network failures, malicious human acts and natural
disasters. Moreover, despite network security measures, some of our servers are
potentially vulnerable to physical or electronic break-ins, computer viruses and
similar disruptive problems. Despite the precautionary measures that we have
taken to prevent unanticipated problems that could affect our IT systems,
sustained or repeated system failures that interrupt our ability to process test
orders, deliver test results or perform tests in a timely manner could adversely
affect our reputation and result in a loss of customers and net revenues.

During the 1980s and early 1990s when we acquired many of our laboratory
facilities, our regional laboratories were operated as local, decentralized
units, and we did not standardize their billing, laboratory and some of their
other information systems. As a result, by the end of 1995 we had many different
information

10

systems for billing, test results reporting, and other transactions. Over
time, the growth in the size and network of our customers and the increasing
complexity of billing demonstrated a greater need for standardized systems.

During 2002, we began implementation of a standard laboratory information
system and a standard billing system. We expect that deployment of the
standardized systems will take several more years to complete and will result in
significantly more centralized systems than we have today. We expect the
integration of these systems will improve operating efficiency and provide
management with more timely and comprehensive information with which to make
management decisions. However, failure to properly implement this
standardization process could materially adversely impact us. During system
conversions of this type, workflow may be re-engineered to take advantage of
enhanced system capabilities, which may cause temporary disruptions in service.
In addition, the implementation process, including the transfer of databases and
master files to new data centers, presents significant conversion risks that
need to be managed carefully.

BILLING

Billing for laboratory services is complicated. Depending on the billing
arrangement and applicable law, we must bill various payers, such as patients,
insurance companies, Medicare, Medicaid, doctors and employer groups, all of
which have different requirements. Additionally, auditing for compliance with
applicable laws and regulations as well as internal compliance policies and
procedures adds further complexity to the billing process. Among many other
factors complicating billing are:

o pricing differences between our fee schedules and the reimbursement rates
of the payers;

o disputes with payers as to which party is responsible for payment; and

o disparity in coverage and information requirements among various payers.

We incur significant additional costs as a result of our participation in
Medicare and Medicaid programs, as billing and reimbursement for clinical
laboratory testing is subject to considerable and complex federal and state
regulations. These additional costs include those related to: (1) complexity
added to our billing processes; (2) training and education of our employees and
customers; (3) compliance and legal costs; and (4) costs related to, among other
factors, medical necessity denials and advance beneficiary notices. Compliance
with applicable laws and regulations, as well as internal compliance policies
and procedures, adds further complexity and costs to the billing process.
Changes in laws and regulations could negatively impact our ability to bill our
clients. The Centers for Medicare & Medicaid Services, or CMS (formerly the
Health Care Financing Administration), establishes procedures and continuously
evaluates and implements changes in the reimbursement process.

We believe that most of our bad debt expense, which was 4.8% of our net
revenues in 2003, is primarily the result of missing or incorrect billing
information on requisitions received from healthcare providers rather than
credit related issues. In general, we perform the requested tests and report
test results regardless of whether the billing information is incorrect or
missing. We subsequently attempt to contact the provider to obtain any missing
information and rectify incorrect billing information. Missing or incorrect
information on requisitions adds complexity to and slows the billing process,
creates backlogs of unbilled requisitions, and generally increases the aging of
accounts receivable. When all issues relating to the missing or incorrect
information are not resolved in a timely manner, the related receivables are
written off to the allowance for doubtful accounts.

We have implemented "best practices" for billing that have significantly
reduced the percentage of requisitions with missing billing information from
approximately 16% at the beginning of 1996 to approximately 4% in 2003. These
initiatives, together with our Six Sigma and standardization initiatives and
progress in dealing with Medicare medical necessity documentation requirements,
have significantly reduced bad debt expense as a percentage of net revenues from
about 7% during 1996 to 4.8% during 2003. We believe that in the longer term,
with a continuing focus on process discipline and the increased use of
electronic ordering by our customers, bad debt as a percentage of net revenues
can be reduced to 4% or less (see "Regulation of Reimbursement for Clinical
Laboratory Services").

COMPETITION

While there has been significant consolidation in the clinical laboratory
testing business in recent years, our industry remains fragmented and highly
competitive. We compete with three types of laboratory providers:
hospital-affiliated laboratories, other commercial clinical laboratories and
physician-office laboratories. We are the leading clinical laboratory provider
in the United States, with net revenues of $4.7 billion during 2003, and
facilities in substantially all of the country's major metropolitan areas. Our
largest competitor is LabCorp. In

11

addition, we compete with, and service, many smaller regional and local
commercial clinical laboratories, as well as laboratories owned by physicians
and hospitals (see "Payers and Customers -- Customers").

We believe that healthcare providers consider a number of factors when
selecting a laboratory, including:

o service capability and quality;

o accuracy, timeliness and consistency in reporting test results;

o number and type of tests performed by the laboratory;

o number, convenience and geographic coverage of patient service centers;

o reputation in the medical community; and

o pricing.

We believe that we compete favorably in each of these areas.

We believe that large commercial clinical laboratories may be able to
increase their share of the overall clinical laboratory testing market due to
their large service networks and lower cost structures. These advantages should
enable larger clinical laboratories to more effectively serve large customers,
including managed care organizations. In addition, we believe that consolidation
in the clinical laboratory testing business will continue. However, a majority
of the clinical laboratory testing is likely to continue to be performed by
hospitals, which generally have affiliations with community physicians that
refer testing to us (see "Payers and Customers -- Customers -- Hospitals"). As
a result of these affiliations, we compete against hospital-affiliated
laboratories primarily on the basis of service capability and quality as well
as other non-pricing factors. Our failure to provide service superior to
hospital-affiliated laboratories and other laboratories could negatively
impact our net revenues.

The diagnostic testing industry is faced with changing technology and new
product introductions. Advances in technology may lead to the development of
more cost-effective tests that can be performed outside of a commercial clinical
laboratory such as (1) point-of-care tests that can be performed by physicians
in their offices and (2) home testing that can be performed by patients or by
physicians in their offices. Development of such technology and its use by our
customers would reduce the demand for our laboratory testing services and
negatively impact our net revenues (see "Regulation of Clinical Laboratory
Operations").

QUALITY ASSURANCE

Our goal is to continually improve the processes for collection, storage and
transportation of patient specimens, as well as the precision and accuracy of
analysis and result reporting. Our quality assurance efforts focus on
proficiency testing, process audits, statistical process control and personnel
training for all of our laboratories and patient service centers. We continue to
implement our Six Sigma and standardization initiatives to help achieve our goal
of becoming recognized as the undisputed quality leader in the healthcare
services industry. Our Nichols Institute facility in San Juan Capistrano was the
first clinical laboratory in North America to achieve ISO-9001 certification.
Two of our clinical trials laboratories, our diagnostic kits facility and one of
our routine laboratories have also achieved ISO-9001 certification. These
certifications are international standards for quality management systems.

INTERNAL PROFICIENCY TESTING, QUALITY CONTROL AND AUDITS. Quality control
samples are processed in parallel with the analysis of patient specimens. The
results of tests on quality control samples are monitored to identify trends,
biases or imprecision in the analytical processes. We also perform internal
process audits as part of our comprehensive Quality Assurance program.

EXTERNAL PROFICIENCY TESTING AND ACCREDITATION. All of our laboratories
participate in various external quality surveillance programs. They include
proficiency testing programs administered by the College of American
Pathologists, or CAP, as well as some state agencies.

CAP is an independent, non-governmental organization of board certified
pathologists. CAP is approved by CMS to inspect clinical laboratories to
determine compliance with the standards required by the Clinical Laboratory
Improvement Amendments of 1988, or CLIA. CAP offers an accreditation program to
which laboratories may voluntarily subscribe. All of our major regional
laboratories are accredited by CAP. Accreditation includes on-site inspections
and participation in the CAP (or equivalent) proficiency testing program.

12

REGULATION OF CLINICAL LABORATORY OPERATIONS

The clinical laboratory industry is subject to significant federal and state
regulation, including inspections and audits by governmental agencies.
Governmental authorities may impose fines or criminal penalties or take other
actions to enforce laws and regulations, including revoking a clinical
laboratory's federal certification to operate a clinical laboratory operation.
Changes in regulation may increase the costs of performing clinical laboratory
tests, increase the administrative requirements of claims or decrease the amount
of reimbursement.

CLIA AND STATE REGULATION. All of our laboratories and (where applicable)
patient service centers are licensed and accredited by the appropriate federal
and state agencies. CLIA regulates virtually all clinical laboratories by
requiring they be certified by the federal government and comply with various
operational, personnel and quality requirements intended to ensure that their
clinical laboratory testing services are accurate, reliable and timely. CLIA
does not preempt state laws that are more stringent than federal law. For
example, state laws may require additional personnel qualifications, quality
control, record maintenance and/or proficiency testing. The cost of compliance
with CLIA makes it cost prohibitive for many physicians to operate clinical
laboratories in their offices. However, manufacturers of laboratory equipment
and test kits could seek to increase their sales by marketing point-of-care
laboratory equipment to physicians and by selling test kits approved for home
use to both physicians and patients. Diagnostic tests approved or cleared by the
FDA for home use are automatically deemed to be "waived" tests under CLIA and
may be performed in physician office laboratories with minimal regulatory
oversight as well as by patients in their homes.

DRUG TESTING. The Substance Abuse and Mental Health Services Administration,
or SAMHSA, regulates drug testing for public sector employees and employees of
certain federally regulated businesses. SAMHSA has established detailed
performance and quality standards that laboratories must meet to perform drug
testing on these employees. All laboratories that perform such testing must be
certified as meeting SAMHSA standards.

CONTROLLED SUBSTANCES. The federal Drug Enforcement Administration, or DEA,
regulates access to controlled substances used to perform drugs of abuse
testing. Laboratories that use controlled substances are licensed by the DEA.

MEDICAL WASTE, HAZARDOUS WASTE AND RADIOACTIVE MATERIALS. Clinical
laboratories are also subject to federal, state and local regulations relating
to the handling and disposal of regulated medical waste, hazardous waste and
radioactive materials. We generally use outside vendors to dispose of such
waste.

FDA. The FDA has regulatory responsibility over instruments, test kits,
reagents and other devices used to perform diagnostic testing by clinical
laboratories. In the past, the FDA has claimed regulatory authority over
laboratory-developed tests, but has exercised enforcement discretion in not
regulating most laboratory-developed tests performed by high complexity
CLIA-certified laboratories. In December 2000, the Department of Health and
Human Services, or HHS, Secretary's Advisory Committee on Genetic Testing
recommended that the FDA be the lead federal agency to regulate genetic testing.
In late 2002, a new HHS Secretary's Advisory Committee on Genetics, Health and
Society was appointed to replace the prior Advisory Committee, but it has not
yet made any final recommendations. In the meantime, the FDA is considering
revising its regulations on analyte specific reagents, which are used in
laboratory-developed tests, including laboratory developed genetic testing.
Representatives of clinical laboratories (including Quest Diagnostics) and the
American Clinical Laboratory Association (our industry trade association) have
met with representatives of the FDA to address industry issues pertaining to
potential FDA regulation of genetic testing in general and issues with regard to
the impact of potential increased oversight over analyte specific reagents. We
expect those discussions to continue. Increased FDA regulation of the reagents
used in laboratory-developed testing could lead to increased costs and delays in
introducing new tests, including genetic tests.

OCCUPATIONAL SAFETY. The federal Occupational Safety and Health
Administration, or OSHA, has established extensive requirements relating
specifically to workplace safety for healthcare employers. This includes
developing and implementing multi-faceted programs to protect workers from
exposure to blood-borne pathogens, such as HIV and hepatitis B and C, including
preventing or minimizing any exposure through sharps or needle stick injuries.

SPECIMEN TRANSPORTATION. Transportation of most clinical laboratory
specimens and hazardous materials is subject to regulation by the Department of
Transportation, the Public Health Service, the United States Postal Service and
the International Civil Aviation Organization.

CORPORATE PRACTICE OF MEDICINE. Many states, including some in which our
principal laboratories are located, prohibit corporations from engaging in the
practice of medicine. The corporate practice of medicine doctrine has been
interpreted in certain states to prohibit corporations from employing licensed
healthcare professionals to provide services on the corporation's behalf. The
scope of the doctrine, and how it applies,

13

varies from state to state. In certain states these restrictions affect our
ability to directly provide anatomic pathology services and/or to provide
clinical laboratory services directly to consumers.

PRIVACY AND SECURITY OF HEALTH INFORMATION; STANDARD TRANSACTIONS

Pursuant to the Health Insurance Portability and Accountability Act of 1996,
or HIPAA, the Secretary of HHS has issued final regulations designed to improve
the efficiency and effectiveness of the health care system by facilitating the
electronic exchange of information in certain financial and administrative
transactions while protecting the privacy and security of the information
exchanged. Three principal regulations have been issued in final form: privacy
regulations, security regulations, and standards for electronic transactions.

The HIPAA privacy regulations, which fully came into effect in April 2003,
establish comprehensive federal standards with respect to the uses and
disclosures of protected health information by health plans, healthcare
providers and healthcare clearinghouses. The regulations establish a complex
regulatory framework on a variety of subjects, including:

o the circumstances under which uses and disclosures of protected health
information are permitted or required without a specific authorization by
the patient, including but not limited to treatment purposes, activities
to obtain payment for our services, and our health care operations
activities;

o a patient's rights to access, amend and receive an accounting of certain
disclosures of protected health information;

o the content of notices of privacy practices for protected health
information; and

o administrative, technical and physical safeguards required of entities
that use or receive protected health information.

We have implemented the HIPAA privacy regulations, as required by law. The
HIPAA privacy regulations establish a "floor" and do not supersede state laws
that are more stringent. Therefore, we are required to comply with both federal
privacy standards and varying state privacy laws. In addition, for healthcare
data transfers relating to citizens of other countries, we need to comply with
the laws of other countries. The federal privacy regulations restrict our
ability to use or disclose patient-identifiable laboratory data, without patient
authorization, for purposes other than payment, treatment or healthcare
operations (as defined by HIPAA) except for disclosures for various public
policy purposes and other permitted purposes outlined in the final privacy
regulations. The privacy regulations provide for significant fines and other
penalties for wrongful use or disclosure of protected health information,
including potential loss of licensure and civil and criminal fines and
penalties. Although the HIPAA statute and regulations do not expressly provide
for a private right of damages, we also could incur damages under state laws to
private parties for the wrongful use or disclosure of confidential health
information or other private personal information.

The final HIPAA security regulations, which establish requirements for
safeguarding electronic patient information, were published on February 20, 2003
and became effective on April 21, 2003, although healthcare providers have until
April 20, 2005 to comply. We are conducting an analysis to determine the proper
security measures to reasonably and appropriately comply with the standards and
implementation specifications by the compliance deadline of April 20, 2005.

The final HIPAA regulations for electronic transactions, which we refer to
as the transaction standards, establish uniform standards for electronic
transactions and code sets, including the electronic transactions and code sets
used for claims, remittance advices, enrollment and eligibility. The transaction
standards became effective in October 2002, although covered entities were
eligible to obtain a one-year extension if approved through an application to
the Secretary of HHS. We received this one-year extension through October 16,
2003 from HHS.

HHS issued guidance on July 24, 2003 stating that it would not penalize a
covered entity for post-implementation date transactions that are not fully
compliant with the transactions standards, if the covered entity could
demonstrate its good faith efforts to comply with the standards. HHS' stated
purpose for this flexible enforcement position was to "permit health plans to
mitigate unintended adverse effects on covered entities' cash flow and business
operations during the transition to the standards, as well as on the
availability and quality of patient care." We continue to work in good faith to
complete the implementation of these standards with those payers who either were
not ready to exchange files in the standard formats as of the compliance date,
or who have varying interpretations of the requirements. Working with these
payers requires that we continue to trade electronic claims files and payments
in legacy formats, even after the compliance deadline of October 16, 2003.

14

On September 23, 2003, CMS announced that it would implement a contingency
plan for the Medicare program to accept electronic transactions that are not
fully compliant with the transaction standards after the October 16, 2003
compliance deadline. The CMS contingency plan, as announced, allows Medicare
carriers to continue to accept and process Medicare claims in the pre-October 16
electronic formats to give healthcare providers additional time to complete the
testing process, provided that they continue to make a good faith effort to
comply with the new standards. Almost all other payers have followed the lead of
CMS, accepting legacy formats until both parties to the transactions are ready
to implement the new electronic transaction standards.

As part of its plan, CMS is expected to regularly reassess the readiness of
its healthcare providers to determine how long the contingency plan will remain
in effect. Many of our payers were not ready to implement the transaction
standards by the October 2003 compliance deadline or were not ready to test or
trouble-shoot claims submissions. We are working in good faith with payers that
have not converted to the new standards to reach agreement on each payer's data
requirements and to test claims submissions.

The HIPAA transaction standards are complex, and subject to differences in
interpretation by payers. For instance, some payers may interpret the standards
to require us to provide certain types of information, including demographic
information not usually provided to us by physicians. As a result of
inconsistent interpretations of transaction standards by payers or our inability
to obtain certain billing information not usually provided to us by physicians,
we could face increased costs and complexity, a temporary disruption in
receipts and ongoing reductions in reimbursements and net revenues. We are
working closely with our payers to establish acceptable protocols for claims
submissions and with our trade association and an industry coalition to
present issues and problems as they arise to the appropriate regulators and
standards setting organizations.

Compliance with all of the HIPAA requirements requires significant capital
and personnel resources from all healthcare organizations, not just Quest
Diagnostics. While we believe that our total costs to comply with HIPAA will not
be material to our results of operations or cash flows, the potential need for
additional customer contact to obtain data for billing as a result of different
interpretations of the current regulations could impose significant additional
costs on us.

REGULATION OF REIMBURSEMENT FOR CLINICAL LABORATORY SERVICES

OVERVIEW. The healthcare industry has experienced significant changes in
reimbursement practices during the past several years. Government payers, such
as Medicare (which principally serves patients 65 years and older) and Medicaid
(which principally serves indigent patients), as well as private payers and
large employers, have taken steps and may continue to take steps to control the
cost, utilization and delivery of healthcare services, including clinical
laboratory services. If we cannot offset additional reductions in the payments
we receive for our services by reducing costs, increasing test volume and/or
introducing new procedures, it could have a material adverse impact on our net
revenues and profitability. On the other hand, we believe that laboratory tests
are an effective means to detect certain medical conditions at an earlier point
in time, leading to potential reduction in other healthcare costs such as the
cost of hospitalization.

Principally as a result of government reimbursement reductions and measures
adopted by CMS to reduce utilization described below, the percentage of our net
revenues derived from Medicare and Medicaid programs declined from approximately
20% in 1995 to approximately 15% in 2002. This percentage increased to
approximately 17% in 2003 principally as a result of our acquisition of Unilab,
which had a higher percentage of its net revenues derived from Medicare and
Medicaid programs. While the cost to comply with Medicare administrative
requirements is disproportionately higher than our cost to bill other payers,
average Medicare reimbursement rates approximate the Company's overall average
reimbursement rate from all sources, making the Medicare business generally less
profitable. However, we believe that our other business may significantly depend
on continued participation in the Medicare and Medicaid programs, because many
customers want a single laboratory to perform all of their clinical laboratory
testing services, regardless of whether reimbursements are ultimately made by
themselves, Medicare, Medicaid or other payers.

Billing and reimbursement for clinical laboratory testing is subject to
significant and complex federal and state regulation. Penalties for violations
of laws relating to billing federal healthcare programs and for violations of
federal fraud and abuse laws include: (1) exclusion from participation in
Medicare/Medicaid programs; (2) asset forfeitures; (3) civil and criminal fines
and penalties; and (4) the loss of various licenses, certificates and
authorizations necessary to operate some or all of a clinical laboratory's
business. Civil monetary penalties for a wide range of violations are not more
than $10,000 per violation plus three times the amount claimed and, in the case
of kickback violations, not more than $50,000 per violation plus up to three
times the amount

15

of remuneration involved. A parallel civil remedy under the federal False
Claims Act provides for damages not more than $11,000 per violation plus up to
three times the amount claimed.

REDUCED REIMBURSEMENTS. In 1984, Congress established a Medicare fee
schedule payment methodology for clinical laboratory services performed for
patients covered under Part B of the Medicare program. Congress then imposed a
national ceiling on the amount that carriers could pay under their local
Medicare fee schedules. Since then, Congress has periodically reduced the
national ceilings. The Medicare national fee schedule limitations were reduced
in 1996 to 76% of the 1984 national median of the local fee schedules and in
1998 to 74% of the 1984 national median. The national ceiling applies to tests
for which limitation amounts were established before January 1, 2001. For more
recent tests (tests for which a limitation amount is first established on or
after January 1, 2001), the limitation amount is set at 100% of the median of
all the local fee schedules established for that test in accordance with the
Social Security Act. The Balanced Budget Act of 1997 eliminated the provision
for annual increases to the Medicare national fee schedule based on the consumer
price index from 1998 through 2002. A 1.1% increase based on the consumer price
index became effective on January 1, 2003. The Prescription Drug, Improvement,
and Modernization Act of 2003 eliminated for five years (beginning January 1,
2004) the provision for annual increases to the Medicare national fee schedule
based on the consumer price index, including the adjustment (which would have
been 2.6%) that had been scheduled for January 1, 2004. Thus, by law an
adjustment to the national fee schedule for clinical laboratory services based
on the consumer price index cannot occur before January 1, 2009.

Pathology services are reimbursed by Medicare based on a resource-based
relative value scale, or RBRVS, that is periodically updated by CMS. Less than
1% of our net revenues are derived from pathology services reimbursed by
Medicare based on RBRVS.

With regard to the rest of our laboratory services performed on behalf of
Medicare beneficiaries, we must bill the Medicare program directly and must
accept the carrier's fee schedule amount as payment in full. In addition, state
Medicaid programs are prohibited from paying more (and in most instances, pay
significantly less) than Medicare. Major clinical laboratories, including Quest
Diagnostics, typically use two fee schedules for tests billed on a
fee-for-service basis:

o "Client" fees charged to physicians, hospitals, and institutions for
which a clinical laboratory performs testing services on a wholesale
basis and which are billed on a monthly basis. These fees are generally
subject to negotiation or discount.

o "Patient" fees charged to individual patients and third-party payers,
like Medicare and Medicaid. These fees generally require separate bills
for each requisition.

The fee schedule amounts established by Medicare are typically substantially
lower than patient fees otherwise charged by us, but are sometimes higher than
our fees actually charged to certain other clients. During 1992, the Office of
the Inspector General, or OIG, of the HHS issued final regulations that
prohibited charging Medicare fees substantially in excess of a provider's usual
charges. The OIG, however, declined to provide any guidance concerning
interpretation of these rules, including whether or not discounts to non-
governmental clients and payers or the dual-fee structure might be inconsistent
with these rules.

A proposed rule released in September 1997 would have authorized the OIG to
exclude providers from participation in the Medicare program, including clinical
laboratories, that charge Medicare and other programs fees that are
"substantially in excess of . . . usual charges . . . to any of [their]
customers, clients or patients." This proposal was withdrawn by the OIG in 1998.
In November 1999, the OIG issued an advisory opinion which indicated that a
clinical laboratory offering discounts on client bills may violate the "usual
charges" regulation if the "charge to Medicare substantially exceeds the amount
the laboratory most frequently charges or has contractually agreed to accept
from non-Federal payers." The OIG subsequently issued a letter clarifying that
the usual charges regulation is not a blanket prohibition on discounts to
private pay customers.

In September 2003, the OIG published a Notice of Proposed Rulemaking that
would amend the OIG's exclusion regulations addressing excessive claims. Under
the proposed exclusion rule, the OIG would have the authority to exclude a
provider for submitting claims to Medicare that contain charges that are
substantially in excess of the provider's usual charges. The proposal would
define "usual charges" as the average payment from non-government entities, on a
test by test basis, excluding capitated payments; and would define
"substantially in excess" to be an amount that is more than 20% greater than the
usual charge. We believe that the rule is unnecessary because Congress has
already established fee schedules for the services that the rule proposes to
regulate. We also believe that the rule is unworkable and overly burdensome.
Through our industry trade association, we filed comments opposing the proposed
rule and we are working with our trade association and a coalition of other
healthcare providers who also oppose this proposed regulation as drafted. If
this regulation is

16

adopted as proposed, it could potentially reduce the amounts reimbursed to us
by Medicare and other federal payers or affect the fees we charge to other
payers and could also be costly for us to administer.

The 1997 Balanced Budget Act permits CMS to adjust statutorily prescribed
fees for some medical services, including clinical laboratory services, if the
fees are "grossly excessive." In December 2002, CMS issued an interim final rule
setting forth a process and factors for establishing a "realistic and equitable"
payment amount for all Medicare Part B services (except physician services and
services paid under a prospective payment system) when the existing payment
amounts are determined to be inherently unreasonable. Payment amounts may be
considered unreasonable because they are either grossly excessive or deficient.
We cannot provide any assurances to investors that fees payable by Medicare
could not be reduced as a result of the application of this rule or that the
government might not assert claims for reimbursement by purporting to
retroactively apply this rule or the OIG interpretation concerning "usual
charges."

Currently, Medicare does not require the beneficiary to pay a co-payment for
clinical laboratory testing. When co-payments were last in effect before
adoption of the clinical laboratory services fee schedules in 1984, clinical
laboratories received from Medicare carriers only 80% of the Medicare allowed
amount and were required to bill Medicare beneficiaries for the unpaid balance
of the Medicare allowed amount. If re-enacted, a co-payment requirement could
adversely affect the revenues of the clinical laboratory industry, including us,
by exposing the testing laboratory to the credit of individuals and by
increasing the number of bills. In addition, a laboratory could be subject to
potential fraud and abuse violations if adequate procedures to bill and collect
the co-payments are not established and followed. The Medicare reform bill
approved by the United State Senate in June 2003 included a co-payment
provision, under which clinical laboratories would receive from Medicare
carriers only 80% of the Medicare allowed amount for clinical laboratory tests
and would be required to bill Medicare beneficiaries for the 20% balance of
the Medicare allowed amount. The co-payment provision was dropped from the
bill as passed (known as Prescription Drug, Improvement, and Modernization Act
of 2003), although the final legislation did include (as discussed above) a
five year freeze on adjustments to the Medicare national fee schedule based on
the consumer price index. Certain Medicaid programs do provide co-payments for
clinical laboratory testing.

REDUCED UTILIZATION OF CLINICAL LABORATORY TESTING. In recent years, CMS has
taken several steps to reduce utilization of clinical laboratory testing. Since
1995, Medicare carriers have adopted policies under which they do not pay for
many commonly ordered clinical tests unless the ordering physician has provided
an appropriate diagnosis code supporting the medical necessity of the test.
Physicians are required by law to provide diagnostic information when they order
clinical tests for Medicare and Medicaid patients. However, CMS has not
prescribed any penalty for physicians who fail to provide diagnostic information
to laboratories. Moreover, regulations adopted in accordance with HIPAA require
submission of diagnosis codes as part of the standard claims transaction.

We are generally permitted to bill patients directly for some statutorily
excluded clinical laboratory services. If a patient signs an advance beneficiary
notice, or ABN, we are also generally permitted to bill patients for clinical
laboratory tests that Medicare does not cover due to "medical necessity"
limitations (these tests include limited coverage tests for which the ordering
physician did not provide an appropriate diagnosis code and certain tests
ordered on a patient at a frequency greater than covered by Medicare). An ABN is
a notice signed by the beneficiary which documents the patient's informed
decision to personally assume financial liability for laboratory tests which are
likely to be not covered by Medicare because they are deemed to be not medically
necessary. We do not have any direct contact with most of these patients and, in
such cases, cannot control the proper use of the ABN by the physician or the
physician's office staff. If the ABN is not timely provided to the beneficiary
or is not completed properly, we end up performing tests that we cannot
subsequently bill to the patient if they are not reimbursable by Medicare due to
coverage limitations.

INCONSISTENT PRACTICES. Currently, many different local carriers administer
Medicare. They have inconsistent policies on matters such as: (1) test coverage;
(2) automated chemistry panels; (3) diagnosis coding; (4) claims documentation;
and (5) fee schedules (subject to the national fee schedule limitations).
Inconsistent carrier rules and policies have increased the complexity of the
billing process for clinical laboratories. As part of the 1997 Balanced Budget
Act, HHS was required to adopt uniform policies on the above matters by January
1, 1999, and replace the current local carriers with no more than five regional
carriers. Although HHS has finalized a number of uniform test coverage/diagnosis
coding policies, it has not taken any final action to replace the local carriers
with five regional carriers. However, in November 2000, CMS published a
solicitation in the Commerce Business Daily seeking two contractors to process
Part B clinical laboratory claims. In the solicitation, CMS stated that the
Secretary has decided to limit the number of carriers processing clinical
diagnostic laboratory test claims to two contractors. The solicitation indicated
that the request for proposals, or RFP, would be released

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on or before December 31, 2000 but as of February 2004, the RFP had not been
issued; the solicitation did not indicate the effective date for a final
transition to the regional carrier model. CMS plans to achieve standardization
in part through implementing a single claims processing system for all
carriers. This initiative, however, was suspended due to CMS's Year 2000
compliance priorities.

CARRIER JURISDICTION CHANGES FOR LAB-TO-LAB REFERRALS. On October 31, 2003,
CMS announced its intention to change the manner in which Medicare contractors
currently process claims for lab-to-lab referrals. While laboratories are, under
certain criteria, permitted to directly bill Medicare for tests they refer to
other laboratories, they must be reimbursed at the correct fee schedule amount
based on the Medicare fee schedule in effect in the Medicare carrier region in
which the test was actually performed. Historically, laboratories needed to
enroll with and file claims to multiple carriers in order to bill for such
out-of-area test referrals, to ensure receipt of the appropriate payment amount.
This has proven to be an administratively difficult process, with many obstacles
to obtaining accurate claims payment, including applying the correct fee
schedule. The announced change will enable the laboratory's "home" carrier to
maintain and apply the clinical laboratory fee schedule applicable to the
carrier region where the test was performed. This will streamline the claims
filing process by allowing a laboratory to file all of its claims to its "home"
carrier. As of January 2004, CMS has indicated a July 1, 2004 effective date for
this change.

COMPETITIVE BIDDING. The Prescription Drug, Improvement and Modernization
Act of 2003 requires CMS to conduct and complete by December 31, 2005, a
demonstration project on the application of competitive acquisition to clinical
laboratory tests. The details of how this federal demonstration project will be
implemented are unknown at this time. Florida has issued a proposal for
competitive bidding for its Medicaid program. If competitive bidding were
implemented on a regional or national basis for clinical laboratory testing,
it could materially adversely affect the clinical laboratory industry and us.

FUTURE LEGISLATION. Future changes in federal, state and local regulations
(or in the interpretation of current regulations) affecting governmental
reimbursement for clinical laboratory testing could adversely affect us. We
cannot predict, however, whether and what type of legislative proposals will be
enacted into law or what regulations will be adopted by regulatory authorities.

FRAUD AND ABUSE REGULATIONS. Medicare and Medicaid anti-kickback laws
prohibit clinical laboratories from making payments or furnishing other benefits
to influence the referral of tests billed to Medicare, Medicaid or other federal
programs. As noted above, the penalties for violation of these laws may include
criminal and civil fines and penalties and/or suspension or exclusion from
participation in federal programs. Many of the anti-fraud statutes and
regulations, including those relating to joint ventures and alliances, are vague
or indefinite and have not been interpreted by the courts. We cannot predict if
some of the fraud and abuse rules will be interpreted contrary to our practices.

In November 1999, the OIG issued an advisory opinion concluding that the
industry practice of discounting client bills may constitute a kickback if the
discounted price is below a laboratory's overall cost (including overhead) and
below the amounts reimbursed by Medicare. Advisory opinions are not binding but
may be indicative of the position that prosecutors may take in enforcement
actions. The OIG's opinion, if enforced, could result in fines and possible
exclusion and could require us to eliminate offering discounts to clients below
the rates reimbursed by Medicare. The OIG subsequently issued a letter
clarifying that it did not intend to imply that discounts are a per se violation
of the federal anti-kickback statute, but may merit further investigation
depending on the facts and circumstances presented.

In addition, since 1992, a federal anti-"self-referral" law, commonly known
as the "Stark" law, prohibits, with certain exceptions, Medicare payments for
laboratory tests referred by physicians who have, personally or through a family
member, an investment interest in, or a compensation arrangement with, the
testing laboratory. Since January 1995, these restrictions have also applied to
Medicaid-covered services. Many states have similar anti-"self-referral" and
other laws that are not limited to Medicare and Medicaid referrals and could
also affect investment and compensation arrangements with physicians. We cannot
predict if some of the state laws will be interpreted contrary to our practices.
In April 2003, the OIG issued a Special Advisory Bulletin addressing what it
described as "questionable contractual arrangements" in contractual joint
ventures. The OIG Bulletin focused on arrangements where a health care provider,
or Owner, expands into a related health care business by contracting with a
health care provider, or Manager, that already is engaged in that line of
business for the Manager to provide related health care items or services to the
patients of the Owner in return for a share of the profits of the new line of
business. While we believe that the Bulletin is directed at "sham" arrangements
intended to induce referrals, we cannot predict whether the OIG might choose to
investigate all contractual joint ventures, including our joint ventures with
various hospitals or hospital systems.

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GOVERNMENT INVESTIGATIONS AND RELATED CLAIMS

We are subject to extensive and frequently changing federal, state and local
laws and regulations. We believe that, based on our experience with government
settlements and public announcements by various government officials, the
federal government continues to strengthen its position on healthcare fraud. In
addition, legislative provisions relating to healthcare fraud and abuse give
federal enforcement personnel substantially increased funding, powers and
remedies to pursue suspected cases of fraud and abuse. Many of the regulations
applicable to us, including those relating to billing and reimbursement of tests
and those relating to relationships with physicians and hospitals, are vague or
indefinite and have not been interpreted by the courts. They may be interpreted
or applied by a prosecutorial, regulatory or judicial authority in a manner that
could require us to make changes in our operations, including our billing
practices. If we fail to comply with applicable laws and regulations, we could
suffer civil and criminal penalties, including the loss of licenses or our
ability to participate in Medicare, Medicaid and other federal and state
healthcare programs.

During the mid-1990s, Quest Diagnostics and SBCL settled government claims
that primarily involved industry-wide billing and marketing practices that both
companies believed to be lawful. The aggregate amount of the settlements for
these claims exceeded $500 million. The federal or state governments may bring
additional claims based on new theories as to our practices that we believe to
be in compliance with law. The federal government has substantial leverage in
negotiating settlements since the amount of potential fines far exceeds the
rates at which we are reimbursed, and the government has the remedy of
excluding a non-compliant provider from participation in the Medicare and
Medicaid programs, which represented approximately 17% of our net revenues
during 2003.

Although management believes that established reserves for claims are
sufficient, including qui tam cases, of which management is aware, it is
possible that additional information may become available that may cause the
final resolution of these matters to exceed established reserves by an amount
which could be material to our results of operations and cash flows in the
period in which such claims are settled. We do not believe that these issues
will have a material adverse effect on our overall financial condition. However,
we understand that there may be pending qui tam claims brought by former
employees or other "whistle blowers" as to which we have not been provided with
a copy of the complaint and accordingly cannot determine the extent of any
potential liability.

As an integral part of our compliance program discussed below, we
investigate all reported or suspected failures to comply with federal healthcare
reimbursement requirements. Any non-compliance that results in Medicare or
Medicaid overpayments is reported to the government and reimbursed by us. As a
result of these efforts, we have periodically identified and reported
overpayments. While we have reimbursed these overpayments and have taken
corrective action where appropriate, we cannot assure investors that in each
instance the government will necessarily accept these actions as sufficient.

COMPLIANCE PROGRAM

Compliance with all government rules and regulations has become a
significant concern throughout the clinical laboratory industry because of
evolving interpretations of regulations and the national debate over healthcare.
We established a compliance program early in 1993.

We emphasize the development of training programs intended to ensure the
strict implementation and observance of all applicable laws, regulations and
Company policies. Further, we conduct in-depth reviews of procedures, personnel
and facilities to assure regulatory compliance throughout our operations. The
Quality, Safety and Compliance Committee of the Board of Directors requires
periodic reporting of compliance operations from management.

We seek to conduct our business in compliance with all statutes and
regulations applicable to our operations. Many of these statutes and regulations
have not been interpreted by the courts. We cannot assure investors that
applicable statutes or regulations will not be interpreted or applied by a
prosecutorial, regulatory or judicial authority in a manner that would adversely
affect us. Potential sanctions for violation of these statutes include
significant damages, penalties, and fines, exclusion from participation in
governmental healthcare programs and the loss of various licenses, certificates
and authorization necessary to operate some or all of our business, which
could have a material adverse effect on our business.

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INTELLECTUAL PROPERTY RIGHTS

Other companies or individuals, including our competitors, may obtain
patents or other property rights that would prevent, limit or interfere with our
ability to develop, perform or sell our tests or operate our business. As a
result, we may be involved in intellectual property litigation and we may be
found to infringe on the proprietary rights of others, which could force us to
do one or more of the following:

o cease developing, performing or selling products or services that
incorporate the challenged intellectual property;

o obtain and pay for licenses from the holder of the infringed intellectual
property right;

o redesign or reengineer our tests;

o change our business processes; or

o pay substantial damages, court costs and attorneys' fees, including
potentially increased damages for any infringement held to be willful.

Patents generally are not issued until several years after an application is
filed. The possibility that, before a patent is issued to a third party, we may
be performing a test or other activity covered by the patent is not a defense
to an infringement claim. Thus, even tests that we develop could become the
subject of infringement claims if a third party obtains a patent covering those
tests.

Infringement and other intellectual property claims, regardless of their
merit, can be expensive and time-consuming to litigate. In addition, any
requirement to reengineer our tests or change our business processes could
substantially increase our costs, force us to interrupt product sales or delay
new test releases. In the past, we have settled several disputes regarding our
alleged infringement of intellectual property rights of third parties. We are
currently involved in settling several additional disputes. We do not believe
that resolution of these disputes will have a material adverse effect on our
results of operations, cash flows or financial condition. However, infringement
claims could arise in the future as patents could be issued on tests or
processes that we may be performing, particularly in such emerging areas as
gene-based testing and other specialty testing.

INSURANCE

As a general matter, providers of clinical laboratory testing services may
be subject to lawsuits alleging negligence or other similar legal claims. These
suits could involve claims for substantial damages. Any professional liability
litigation could also have an adverse impact on our client base and reputation.
We maintain various liability insurance programs for claims that could result
from providing or failing to provide clinical laboratory testing services,
including inaccurate testing results and other exposures. Our insurance coverage
limits our maximum exposure on individual claims; however, we are essentially
self-insured for a significant portion of these claims. The basis for claims
reserves incorporates actuarially determined losses based upon our historical
and projected loss experience. Management believes that present insurance
coverage and reserves are sufficient to cover currently estimated exposures.
Although management cannot predict the outcome of any claims made against the
Company, management does not anticipate that the ultimate outcome of any such
proceedings or claims will have a material adverse effect on our financial
position but may be material to our results of operations and cash flows in the
period in which such claims are resolved. Similarly, although we believe that we
will be able to obtain adequate insurance coverage in the future at acceptable
costs, we cannot assure you that we will be able to do so.

EMPLOYEES

At December 31, 2003 and 2002, we employed approximately 37,200 and 33,400
people, respectively. These totals exclude employees of the joint ventures where
we do not have a majority interest. We have no collective bargaining agreements
with any unions covering any employees in the United States, and we believe that
our overall relations with our employees are good.

20

CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE
PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995

Some statements and disclosures in this document are forward-looking
statements. Forward-looking statements include all statements that do not relate
solely to historical or current facts and can be identified by the use of words
such as "may", "believe", "will", "expect", "project", "estimate", "anticipate",
"plan" or "continue". These forward-looking statements are based on our current
plans and expectations and are subject to a number of risks and uncertainties
that could significantly cause our plans and expectations, including actual
results, to differ materially from the forward-looking statements. The Private
Securities Litigation Reform Act of 1995, or the Litigation Reform Act, provides
a "safe harbor" for forward-looking statements to encourage companies to provide
prospective information about their companies without fear of litigation.

We would like to take advantage of the "safe harbor" provisions of the
Litigation Reform Act in connection with the forward-looking statements included
in this document. Investors are cautioned not to unduly rely on such
forward-looking statements when evaluating the information presented in this
document. The following important factors could cause our actual financial
results to differ materially from those projected, forecasted or estimated by us
in forward-looking statements:

(a) Heightened competition, including increased pricing pressure,
competition from hospitals for testing for non-patients and competition
from physicians. See "Business -- Competition".

(b) Impact of changes in payer mix, including any shift from fee-for-service
to capitated fee arrangements. See "Business -- Payers and
Customers -- Customers -- Managed Care Organizations and Other Insurance
Providers".

(c) Adverse actions by government or other third-party payers, including
unilateral reduction of fee schedules payable to us, competitive
bidding, or an increase in the practice of negotiating for exclusive
contracts that involve aggressively priced capitated payments by managed
care organizations. See "Business -- Regulation of Reimbursement for
Clinical Laboratory Services" and "Business -- Payers and
Customers -- Customers -- Managed Care Organizations and Other Insurance
Providers".

(d) The impact upon our testing volume and collected revenue or general or
administrative expenses resulting from our compliance with Medicare and
Medicaid administrative policies and requirements of third party payers.
These include:

(1) the requirements of Medicare carriers to provide diagnosis codes for
many commonly ordered tests and the possibility that third party
payers will increasingly adopt similar requirements;

(2) the policy of CMS to limit Medicare reimbursement for tests
contained in automated chemistry panels to the amount that would
have been paid if only the covered tests, determined on the basis of
demonstrable "medical necessity", had been ordered;

(3) continued inconsistent practices among the different local carriers
administering Medicare;

(4) inability to obtain from patients an advance beneficiary notice form
for tests that cannot be billed without prior receipt of the form;
and

(5) the potential need to monitor charges and lower certain fees to
Medicare to comply with the OIG's proposed rule pertaining to
exclusion of providers for submitting claims to Medicare containing
charges that are substantially in excess of the provider's usual
charges.

See "Business -- Regulation of Reimbursement for Clinical Laboratory
Services" and "Business -- Billing".

(e) Adverse results from pending or future government investigations,
lawsuits or private actions. These include, in particular significant
monetary damages, loss or suspension of licenses, and/or suspension or
exclusion from the Medicare and Medicaid programs and/or other
significant litigation matters. See "Business -- Government
Investigations and Related Claims".

(f) Failure to obtain new customers at profitable pricing or failure to
retain existing customers, and a reduction in tests ordered or specimens
submitted by existing customers.

(g) Failure to efficiently integrate acquired clinical laboratory
businesses, including Unilab, or to efficiently integrate clinical
laboratory businesses from joint ventures and alliances with hospitals,
and to manage the costs related to any such integration, or to retain
key technical and management personnel. See "Business -- Recent
Acquisitions".

21

(h) Inability to obtain professional liability or other insurance coverage
or a material increase in premiums for such coverage or reserves for
self-insurance. See "Business -- Insurance".

(i) Denial of CLIA certification or other licenses for any of our clinical
laboratories under the CLIA standards, revocation or suspension of the
right to bill the Medicare and Medicaid programs or other adverse
regulatory actions by federal, state and local agencies. See
"Business -- Regulation of Clinical Laboratory Operations".

(j) Changes in federal, state or local laws or regulations, including
changes that result in new or increased federal or state regulation of
commercial clinical laboratories, including regulation by the FDA.

(k) Inability to achieve expected synergies from our acquisitions of other
business, including Unilab. See "Business -- Recent Acquisitions".

(l) Inability to achieve additional benefits from our Six Sigma and
standardization initiatives.

(m) Adverse publicity and news coverage about the clinical laboratory
industry or us.

(n) Computer or other system failures that affect our ability to perform
tests, report test results or properly bill customers, including
potential failures resulting from the standardization of our IT systems
and other system conversions, telecommunications failures, malicious
human acts (such as electronic break-ins or computer viruses) or natural
disasters. See "Business -- Information Systems" and "Business --
Billing".

(o) Development of technologies that substantially alter the practice of
laboratory medicine, including technology changes that lead to the
development of more cost-effective tests such as (1) point-of-care tests
that can be performed by physicians in their offices and (2) home
testing that can be carried out without requiring the services of
clinical laboratories. See "Business -- Competition" and "Business --
Regulation of Clinical Laboratory Operations".

(p) Issuance of patents or other property rights to our competitors or
others that could prevent, limit or interfere with our ability to
develop, perform or sell our tests or operate our business.

(q) Development of tests by our competitors or others which we may not be
able to license, or usage of our technology or similar technologies or
our trade secrets by competitors, any of which could negatively affect
our competitive position.

(r) Inability to commercialize newly licensed tests or technologies or to
obtain appropriate reimbursements for such tests.

(s) Inability to obtain or maintain adequate patent and other proprietary
rights protections of our products and services or to successfully
enforce our proprietary rights.

(t) Development of an Internet-based electronic commerce business model
that does not require an extensive logistics and laboratory network.

(u) The impact of the privacy regulations, security regulations and
standards for electronic transactions regulations issued under HIPAA on
our operations as well as the cost to comply with the regulations,
including the failure of third party payers to complete testing with us,
failure to agree on data content for claims, failure to accept default
diagnosis codes in the absence of physician-supplied codes, or inability
of payers to accept or remit transactions in HIPAA-required standard
transaction and code set format. See "Business -- Privacy and Security
of Health Information; Standard Transactions".

(v) Inability to promptly or properly bill for our services or to obtain
appropriate payments for services that we do bill. See "Business --
Billing".

(w) Changes in interest rates and changes in our credit ratings from
Standard & Poor's and Moody's Investor Services causing an unfavorable
impact on our cost of and access to capital.

(x) Inability to hire and retain qualified personnel or the loss of the
services of one or more of our key senior management personnel.

(y) Terrorist and other criminal activities, which could affect our
customers, transportation or power systems, or our facilities, and for
which insurance may not adequately reimburse us for.

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ITEM 2. PROPERTIES

Our principal laboratories (listed alphabetically by state) are located in
or near the following metropolitan areas. In certain areas (indicated by the
number (2)), we have two principal laboratories as a result of recent
acquisitions.

Our executive offices are located at an owned facility in Teterboro, New
Jersey and at leased facilities in Lyndhurst, New Jersey. We also lease a site
in Norristown, Pennsylvania, that serves as a billing center; a site in San
Clemente, California, that serves as the main facility for Nichols Institute
Diagnostics; a site in Cincinnati that serves as the main office for MedPlus;
and an additional site in West Hills, California, that will serve as our
regional laboratory in the Los Angeles metropolitan area after we complete the
integration of Unilab. We also own an administrative office in Collegeville,
Pennsylvania, and a site in Norriton, Pennsylvania, that serves as our national
data center. We own our laboratory facility in Mexico City and lease laboratory
facilities in San Juan, Puerto Rico and near London, England. We believe that,
in general, our laboratory facilities are suitable and adequate for our current
and anticipated future levels of operation. We believe that if we were unable to
renew a lease on any of our testing facilities, we could find alternative space
at competitive market rates and relocate our operations to such new location.

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ITEM 3. LEGAL PROCEEDINGS