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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
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FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the Fiscal Year ended December 31, 1998
Commission file number 1-12215
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 New York Stock Exchange
with attached Preferred Share Purchase Right
10.75% Senior Subordinated Notes due 2006 New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
--- ----
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K. [x]
As of February 28, 1999, the aggregate market value of the voting and non-voting
common equity held by non-affiliates of the registrant was approximately $636
million, based on the closing price on such date of the Company's Common Stock
on the New York Stock Exchange.
As of February 28, 1999, there were outstanding 30,044,753 shares of Common
Stock, $.01 par value.
DOCUMENTS INCORPORATED BY REFERENCE
Part of Form 10-K into
Document which incorporated
-------- ------------------
Portions of the Registrant's Proxy
Statement to be filed by April 30,
1999............................................Part III
Such Proxy Statement, except for portions thereof which have been specifically
incorporated by reference, shall not be deemed "filed" as part of this report on
Form 10-K.
2
PART I
Item 1. Business
Quest Diagnostics Incorporated, together with its subsidiaries, is one of
the largest clinical laboratory testing companies in the United States. Quest
Diagnostics offers a broad range of clinical laboratory testing services used by
physicians in the detection, diagnosis, evaluation, monitoring and treatment of
diseases and other medical conditions. These tests range from the routine (such
as blood cholesterol tests) to highly complex tests such as molecular
diagnostics testing. Quest Diagnostics currently processes over 50 million
requisitions each year. A requisition is an order form completed by a physician
that accompanies a patient specimen, indicating the tests to be performed and
the party to be billed for the tests. Quest Diagnostics' customers include
physician practices, managed care organizations, hospitals, employers and
institutions and other independent clinical laboratories.
Quest Diagnostics has a network of 14 regional laboratories located in
major metropolitan areas throughout the United States, several joint venture and
branch laboratories (including one in Mexico), approximately 140 smaller "stat"
laboratories and approximately 800 patient service centers. Quest Diagnostics
also has an esoteric testing laboratory and research and development facility
known as Nichols Institute located in San Juan Capistrano, California.
Quest Diagnostics Incorporated is a Delaware corporation. We refer to
Quest Diagnostics Incorporated and its subsidiaries as "Quest Diagnostics."
Quest Diagnostics is the successor to a New York corporation known as MetPath
Inc. that was organized in 1967. From 1982 to 1996, Quest Diagnostics was a
subsidiary of Corning Incorporated ("Corning"). On December 31, 1996, Corning
distributed all of the outstanding shares of common stock of Quest Diagnostics
to the stockholders of Corning. The principal executive offices of Quest
Diagnostics are located at One Malcolm Avenue, Teterboro, New Jersey 07608,
telephone number: (201) 393-5000.
Business Strategy
Quest Diagnostics' overall goal is to be recognized by its customers,
employees and competitors as the best provider of comprehensive and innovative
clinical testing, information and services.
Best Supplier. Quest Diagnostics seeks to be the supplier of the highest
quality and the lowest cost testing services.
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o Highest Quality Provider. All of Quest Diagnostics' regional laboratories are
accredited by the College of American Pathologists. In 1998, Nichols
Institute achieved ISO-9001 certification. Nichols Institute is the first
clinical laboratory in North America to meet the requirements of this
international standard for quality management systems. Several of Quest
Diagnostics' regional laboratories are currently pursuing ISO-900l
certification. Beginning in 1999, Quest Diagnostics will begin a new quality
initiative (six sigma quality) designed to dramatically improve process
effectiveness and efficiencies.
o Quest Diagnostics measures customer perceptions by extensive quarterly
satisfaction surveys. Each regional laboratory operates a comprehensive
total quality management system. All employees attend quality awareness
training programs. Quality control programs are supplemented by efforts to
identify and eliminate errors. Error rates are generally reported in parts
per million with aggressive goals set and progress monitored. Error rates
are improved primarily through process improvement, training and the
implementation of practices that Quest Diagnostics has identified as the
"best practices" used in its facilities.
o Lowest Cost Provider. Since 1996 Quest Diagnostics has made significant
reductions in operating costs by standardizing processes, systems, equipment
and supplies, as well as by consolidating laboratory facilities. Quest
Diagnostics expects to achieve additional cost savings by continuing these
activities during 1999 and 2000.*
Preferred Partner with Large Buyers. Large managed care organizations and other
health care networks are increasingly controlling the purchase of health care
services. Quest Diagnostics seeks to be the preferred provider of laboratory
testing services to these customers on a selective basis. To achieve this, Quest
Diagnostics identifies prospective customers on a national and regional basis
and seeks to efficiently allocate resources to support these efforts. Quest
Diagnostics also pursues innovative alliances to assist its partners in
achieving their business objectives. As described in "-Expansion Opportunities -
Hospital Alliances," during 1997 and 1998 Quest Diagnostics entered into joint
ventures with leading integrated hospital networks in the Phoenix, Pittsburgh
and St. Louis metropolitan areas and also entered into an agreement with an
affiliate of Premier Inc., one of the nation's largest group purchasing
organizations. Quest Diagnostics believes that it can become the preferred
partner to large health care networks as (1) large networks typically prefer to
use large independent clinical laboratories that can service them on a national
or regional basis and (2) Quest Diagnostics continues to pursue its goal of
becoming the highest quality, lowest cost provider. *
o Account Profitability. Since 1996, Quest Diagnostics has focused its sales
efforts on pursuing and keeping those accounts that generate an acceptable
profit. During 1997 and 1998, Quest Diagnostics implemented an active account
management process to evaluate the profitability of all of its accounts.
Where appropriate, Quest Diagnostics increased pricing, changed the service
levels or terminated accounts that were not profitable. As part of this
program, Quest Diagnostics has provided clear pricing and service offering
guidelines to its sales force. In addition, Quest Diagnostics is aligning the
compensation program for its sales force with the goal of profit growth
through the account management process, including reducing bad debt and
missing or incomplete billing information. As a result of implementing these
practices, average revenue per requisition increased in each of 1997 and
1998, following five years of decline.
o Regional Profitability. Quest Diagnostics believes that it is the
leading provider among independent clinical laboratories in most routine
testing markets of the northeast, mid-Atlantic and mid-west regions. In
most of these regions, Quest Diagnostics believes that it is also among the
lowest cost providers. Approximately two-thirds of Quest Diagnostics'
revenues are generated from these markets. For several years prior to 1998,
Quest Diagnostics incurred operating losses in most of its regional
laboratories that were located outside these regions. During 1997 and 1998
Quest Diagnostics took steps to eliminate excess capacity in the regional
laboratories that were not profitable.
- ----------
* These are forward-looking statements. See "Cautionary Statement for Purposes
of the `Safe Harbor' Provisions of the Private Securities Litigation Reform
Act of 1995." In particular see factors (c), (d), (f), (g), (j), (k) and (l).
4
Leading Innovator. Quest Diagnostics intends to remain a leading innovator in
the clinical laboratory industry by continuing to develop and introduce new
tests, technology and services. Quest Diagnostics believes it is one of the
leaders in transferring innovative technologies from academic and biotechnology
laboratories to the market through its relationships with the academic community
and pharmaceutical and biotechnology firms, and through internal research and
development. For example, Nichols Institute recently became the first national
reference laboratory to commercially offer the HercepTest(R) assay (under
license from the DAKO Corporation). The HercepTest(R) assay is designed to
identify patients who are likely to benefit from Herceptin (trastuzumab), a new
monoclonal antibody therapy for metastatic breast cancer. Nichols Institute is
one of the leading esoteric testing laboratories in the world. Nichols Institute
serves over 1,000 of the estimated 6,000 hospitals in the United States and
counts among its largest customers other independent clinical laboratory
companies.
Acquisition Agreement with SmithKline Beecham plc
On February 9, 1999, Quest Diagnostics signed a definitive agreement with
SmithKline Beecham plc ("SmithKline Beecham") to purchase SmithKline Beecham's
clinical laboratory business for approximately $1.3 billion. The purchase price
will be paid through the issuance of approximately 12.6 million shares of common
stock of Quest Diagnostics and the payment of $1.025 billion of cash. Quest
Diagnostics expects to close the transaction by July 1999. As a result,
SmithKline Beecham will own approximately 29.5% of Quest Diagnostics'
outstanding common stock. Under the terms of a ten-year stockholder agreement,
SmithKline Beecham will have the right to designate two mutually agreeable
nominees to Quest Diagnostics' board of directors as long as SmithKline Beecham
owns at least 20% of the outstanding common stock. (As long as SmithKline
Beecham owns at least 10% but less than 20% of the outstanding common stock, it
will have the right to designate one nominee.) Quest Diagnostics' board of
directors is expected to expand to nine directors immediately following the
closing. The stockholder agreement will also impose limitations on the right of
SmithKline Beecham to sell or vote its shares and will prohibit SmithKline
Beecham from purchasing in excess of 29.5% of the outstanding common stock of
Quest Diagnostics.
The waiting period under the Hart-Scott-Rodino Antitrust Improvements Act
expired on March 25, 1999. The issuance of 12.6 million shares of common stock
to SmithKline Beecham in the transaction will be submitted to the stockholders
of Quest Diagnostics for approval at the 1999 annual meeting of stockholders,
which is expected to be held on June 8, 1999. The acquisition is also subject to
the receipt of financing for the cash portion of the purchase price as well as
the satisfaction of other customary closing conditions. Quest Diagnostics has
received commitments for all of the financing necessary to complete the
acquisition.
SmithKline Beecham's clinical laboratory testing business is one of the
three largest clinical laboratory networks in the United States, with
approximately $1.6 billion in revenues from clinical laboratory testing during
1998. SmithKline Beecham has a strong presence in several regions in the United
States, particularly the southeastern and western states where Quest
Diagnostics' presence is more limited. The acquisition will result in Quest
Diagnostics being the leading clinical laboratory provider in the country. Quest
Diagnostics will have a much more extensive network of laboratories and patient
service centers, with facilities in substantially all of the country's major
metropolitan areas. After the acquisition, Quest Diagnostics also expects to
generate significant net cost savings through elimination of infrastructure
redundancies and sharing of core competencies. Management expects that these net
savings will exceed $100 million annually after three years.*
Quest Diagnostics believes that the acquisition will enhance its ability
to provide greater value for its customers in a cost-effective manner. Quest
Diagnostics also believes that the acquisition will provide a range of benefits,
including continued improvements in quality, improved customer service through
greater coverage and increased patient access. In addition, Quest Diagnostics
believes that it will have the largest clinical laboratory database in the
world, which Quest Diagnostics can use to help providers and insurers better
manage their patients' health. *
- ----------
* These are forward-looking statements. See "Cautionary Statement for Purposes
of the `Safe Harbor' Provisions of the Private Securities Litigation Reform
Act of 1995." In particular, see factors (j) , (l), and (n).
5
The United States Clinical Laboratory Testing Industry
Overview. Clinical laboratory testing is an essential element in the
delivery of quality health care service. 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 anatomical pathology testing. Clinical
testing is performed on body fluids, such as blood and urine. Anatomical
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 independent clinical laboratories. Tests that are not routine
and that require more sophisticated equipment and personnel are considered
esoteric tests. Esoteric tests are generally referred to laboratories that
specialize in those tests.
Quest Diagnostics believes that the United States clinical laboratory
testing industry exceeds $30 billion in annual revenues. Most laboratory testing
is done by three types of providers: hospital-affiliated laboratories;
independent clinical laboratories such as those owned by Quest Diagnostics; and
physician-office laboratories. Quest Diagnostics believes that in 1998
hospital-affiliated laboratories performed over one-half of the clinical
laboratory tests in the United States, independent clinical laboratories
performed approximately one-third of those tests and physician-office
laboratories performed the balance.
During the last decade, the following factors have had a negative impact
on the clinical laboratory industry:
o excess capacity and intensified competition, including efforts by
hospital laboratories to expand their testing services to persons
who are not in- or out-patients;
o reductions in Medicare reimbursement rates and changes in government
and private payer reimbursement policies designed to reduce
utilization of tests; and
o growth of the managed care sector and other health care networks
with increased bargaining power.
Effect of the Growth of the Managed Care Sector. Over the last decade, the
managed care industry has been growing and undergoing rapid consolidation. The
growth of the managed care sector presents challenges to independent clinical
laboratories. These include:
o Shift Toward Capitated Payment Contracts. Managed care organizations
generally negotiate for capitated payment contracts, under which
clinical laboratories receive a fixed monthly fee per individual
enrolled with the managed care organization for all laboratory tests
performed during the month. Capitated payment contracts shift the
risk and cost of additional testing to the clinical laboratory.
Services such as esoteric tests and anatomic pathology services may
be excluded from a capitated rate and would be charged on a
fee-for-service basis. Some capitated payment contracts include
retroactive or future fee adjustments if the number of tests
performed for the managed care organization exceeds or is less than
the negotiated threshold levels.
o Responsibility for Charges for Out-of-Network Tests. Recently,
managed care organizations have begun to make their principal
laboratory providers responsible for all costs incurred by the
managed care organizations for clinical laboratory services provided
to their members. Under this type of contract, the principal
laboratory provider is responsible for the charges for tests
performed by other laboratory providers even though the principal
laboratory has no control over the physicians who ultimately
determine where to send the specimens for testing. The principal
provider attempts to reduce this risk by forming a network of other
subcontracted laboratories to reduce the amount of out-of-network
testing. Managed care organizations typically agree to seek to
influence their affiliated physicians to send tests to the principal
laboratory provider or to a network managed by the principal
laboratory provider, which generally receives an additional fee for
managing the laboratory network.
6
o Aggressive Pricing. Agreements with managed care organizations have
historically been priced aggressively. This practice was due to
competitive pressures and the expectation that a laboratory can
capture not only the testing covered under the contract, but also
additional higher priced fee-for-service business from non-managed
care patients of participating physicians. As the number of patients
covered under managed care organizations increases, however, there
is less fee-for-service business, and therefore less profitable
business to offset the lower margin managed care business.
Furthermore, physicians are increasingly affiliated with more than
one managed care organization, and, therefore, a clinical laboratory
might receive little, if any, additional fee-for-service testing
from participating physicians.
Future Outlook. In the long term, Quest Diagnostics believes that, while
pricing pressures are likely to remain due to intense competition and third
party payers are likely to continue to control utilization, the following
factors will favorably impact testing volume:
o general aging of the United States population;
o development of more sophisticated and specialized tests for early
detection of disease and disease management;
o tests becoming more affordable due to advances in technology and
increased cost efficiencies;
o increased testing for substance abuse, occupational exposures and as
part of comprehensive wellness programs;
o increased testing for diagnosis and monitoring of infectious
diseases such as AIDS and hepatitis C; and
o an increase in the awareness of patients as to the value of clinical
laboratory testing and an increased willingness of patients to pay
for tests that may not be covered by third party payers.
Services
Quest Diagnostics' laboratory testing business consists of routine testing
and esoteric testing. Quest Diagnostics' management estimates that routine
testing currently generates approximately 84% of its net revenues and esoteric
testing generates approximately 13% of its net revenues. Quest Diagnostics
derives the balance of net revenues from the manufacture and sale of diagnostic
test systems, clinical trials and the provision of information derived from
clinical laboratory data to customers such as managed care organizations and
pharmaceutical companies.
Routine Testing. Routine tests measure various important bodily health
parameters such as the function 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 smears;
o HIV-related tests;
o urinalyses;
o pregnancy tests; and
o alcohol and other substance-abuse tests.
Quest Diagnostics performs routine testing through its network of
regional, joint venture, branch and stat laboratories and patient service
centers. It also performs routine testing at hospital laboratories it manages.
Regional laboratories offer a full line of routine clinical tests. Stat
laboratories are local facilities where Quest Diagnostics can quickly perform an
abbreviated line of routine tests for customers that require emergency testing
7
services. Branch laboratories have a line of routine clinical tests that is more
limited than that of regional laboratories but more extensive than that of stat
laboratories. Patient service centers are facilities at which specimens are
collected. Patient services centers are typically located in or near a building
for medical professionals.
Quest Diagnostics operates 24 hours a day, 365 days a year. It performs
and reports most routine procedures within 24 hours. Most test results are
delivered electronically.
Esoteric Testing. Nichols Institute is one of the leading esoteric
clinical testing laboratories in the world. In 1998, Nichols Institute became
the first clinical laboratory in North America to achieve ISO-9001
certification.
Esoteric tests are those tests that are performed less frequently than
routine tests and/or require more sophisticated equipment and materials,
professional "hands-on" attention and more highly skilled personnel. As a
result, esoteric tests are generally priced substantially higher than routine
tests. Because it is not cost-effective for most clinical laboratories to
perform the low volume of esoteric tests in-house, they generally refer a
significant portion of esoteric tests to an esoteric clinical testing
laboratory.
Nichols Institute performs esoteric tests generally in the following
fields:
o endocrinology (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 immunology (the study of the immune system including antibodies,
immune system cells and their effects);
o microbiology (the study of microscopic forms of life including
bacteria, viruses, fungi and other infectious agents);
o molecular biology (a branch of biology dealing with the organization
of living matter, especially with the genetic and molecular basis of
inheritance);
o oncology (the study of abnormal cell growth including benign and
malignant 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).
Quest Diagnostics believes that it is one of the leaders in transferring
technological innovation from academic biotechnology laboratories to the
marketplace. Nichols Institute was the first private reference laboratory to
introduce a number of new tests, including tests to measure circulating hormone
levels and tests to predict breast cancer. Quest Diagnostics continues to
develop new and more sophisticated testing to monitor the success of therapy for
cancer and AIDS and to detect other diseases and disorders.
Quest Diagnostics uses complex technologies such as branched DNA and
polymerase chain reaction to detect lower levels of the AIDS virus than can be
achieved using other technologies. The concentration of the AIDS virus, also
referred to as viral load, can also be measured. The ability to measure the
viral load permits health care providers to better tailor drug therapies for
AIDS-infected patients.
Quest Diagnostics maintains a relationship with the academic community
through its Academic Associates program, under which approximately 60 scientists
from academia and biotechnology firms work directly with Quest Diagnostics'
8
staff scientists to monitor and consult on existing test procedures and develop
new esoteric test methods. In addition, Quest Diagnostics enters into licensing
arrangements and co-development agreements with biotechnology companies and
academic medical centers.
Other Services and Products. Quest Diagnostics manufactures and markets
diagnostic test kits and systems primarily for esoteric testing. These are sold
principally to hospital and clinical laboratories both domestically and
internationally. Sales of diagnostic test kits and systems accounted for
approximately 2% of Quest Diagnostics' net revenues in 1998. In addition, Quest
Diagnostics performs clinical laboratory testing in connection with clinical
research trials on new drugs. This testing often involves periodic testing of
patients participating in a clinical trial over a period of several years.
Clinical trials testing accounted for less than 1% of Quest Diagnostics' net
revenues in 1998. Quest Diagnostics also provides information derived from
clinical laboratory data to customers such as managed care organizations and
pharmaceutical companies.
Customers
Quest Diagnostics provides testing services to a broad range of health
care providers. In 1998, no single customer or affiliated group of customers
accounted for more than 2% of Quest Diagnostics' net revenues. Quest Diagnostics
believes that the loss of any one of its customers would not have a material
adverse effect on its financial condition, results of operations or cash flow.
The primary types of customers are:
Physicians and Physician Groups. Physicians requiring testing for patients
who are not covered by a capitated managed care contract are one of the primary
sources of Quest Diagnostics' clinical laboratory business. Quest Diagnostics
bills its fees for testing services to the appropriate party, who may be (1) the
physician who requested the testing, (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, require
Quest Diagnostics to bill patients directly.
Quest Diagnostics typically bills its customers on a fee-for-service
basis. Fees that are billed to physicians are based on the laboratory's client
fee schedule and are typically negotiated. Fees billed to patients are based on
the laboratory's patient fee schedule, which may be subject to limitations on
fees imposed by third-party payers and negotiation by physicians on behalf of
their patients. Medicare and Medicaid billings are based on fee schedules set by
governmental authorities.
Managed Care Organizations. Managed care organizations typically contract
with a limited number of clinical laboratories and then agree to seek to
influence their participating physicians to use these laboratories. Larger
managed care organizations typically prefer to use large independent clinical
laboratories because they can provide services on a national or regional basis
and can manage networks of local or regional laboratories. In addition, larger
laboratories are better able to achieve the low-cost structures necessary to
profitably service large managed care organizations. Quest Diagnostics expects
the amount of its clinical laboratory testing performed for managed care
organizations under capitated payment contracts to continue to grow.* To achieve
a wider market presence, Quest Diagnostics has developed a centralized
organizational structure to ensure consistent standards of practice, uniform
approaches and better responses to the needs of national managed care
organizations. Recently, Quest Diagnostics has begun to develop and manage
laboratory networks for managed care organizations.
Quest Diagnostics closely reviews the pricing for managed care
organization agreements and intends not to enter into any agreements that are
not profitable. Quest Diagnostics cannot assure investors that it will not lose
market share in the managed care market to other clinical laboratories that
price their laboratory services agreements more aggressively.
While more than 20% of its volume is generated from capitated agreements
with managed care organizations, Quest Diagnostics currently is not the
principal network provider for any of the four largest national managed care
organizations. Quest Diagnostics does, however, perform work for several of
- ----------
* This is a forward-looking statement. See "Cautionary Statement for Purposes
of the `Safe Harbor' Provisions of the Private Securities Litigation Reform
Act of 1995." In particular, see factors (a), (b) and (f).
9
the largest managed care organizations through subcontracting and secondary
provider arrangements.
Hospitals. Quest Diagnostics provides services to hospitals throughout the
United States that vary from esoteric testing to laboratory management.
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. Many hospitals compete with independent clinical
laboratories by encouraging community physicians to send their testing to the
hospital's laboratory. In addition, many hospitals have been purchasing
physicians' practices and requiring the physicians to send their tests to the
hospital's affiliated laboratory. Many hospitals have been seeking to expand
their testing business for non-patients. As a result, hospital-affiliated
laboratories can be both customers and competitors for independent clinical
laboratories.
Employers and Other Institutions. Quest Diagnostics provides testing
services to governmental agencies like the Department of Defense and state and
federal prison systems and to large employers. Services for these customers
typically involve testing for substance abuse, occupational exposures and
comprehensive wellness programs. Quest Diagnostics also performs esoteric
testing services for other independent clinical laboratories that do not have
the full range of Quest Diagnostics' testing capabilities. All of these
customers are charged on a fee-for-service basis.
Payers
Fees for many clinical laboratory tests are billed to a party other than
the patient or the physician who ordered the test. Tests performed may be billed
to third-party payers such as insurance companies, managed care organizations,
Medicare and Medicaid.
The following table shows current estimates of the breakdown of the
percentage of Quest Diagnostics' total volume of requisitions and total clinical
laboratory revenues in 1998 applicable to each payer group:
- -------------------------------------------------------------------------------
Revenue as % of Total
Requisition Volume as Clinical Laboratory
% of Total Volume Revenues
- -------------------------------------------------------------------------------
Patient 5%-10% 15%-20%
- -------------------------------------------------------------------------------
Medicare and Medicaid 15%-20% 15%-20%
- -------------------------------------------------------------------------------
Monthly Bill
(Physician, Hospital,
Employer, Other) 30%-35% 25%-30%
- -------------------------------------------------------------------------------
Third Party
Fee-for-Service 15%-20% 25%-30%
- -------------------------------------------------------------------------------
Managed Care-Capitated 20%-25% 5%-10%
- -------------------------------------------------------------------------------
10
Sales and Marketing
Quest Diagnostics markets to and services its customers through its direct
sales force of approximately 550 sales representatives, 850 customer service and
patient service representatives and 2,000 couriers.
Most sales representatives market routine laboratory services primarily to
physicians. The remaining sales representatives focus on particular market
segments or on testing niches. For example, some representatives concentrate on
market segments such as hospitals or managed care organizations, and others
concentrate on testing niches such as substance-abuse testing.
Customer service representatives perform a number of services for patients
and customers. They monitor services, answer questions and help resolve
problems. Quest Diagnostics' couriers pick up specimens from most clients daily.
Expansion Opportunities
Quest Diagnostics believes that it can take advantage of several expansion
opportunities without incurring significant capital expenditures or other costs.
Hospital Alliances. In response to the growth of the managed care sector,
many health care providers have established new alliances. Hospital-physician
networks are emerging in many markets to offer a comprehensive range of health
care services, either to managed care organizations or directly to employers.
Quest Diagnostics has historically received substantial esoteric testing
revenues from hospital referrals. It has established a hospital alliance group
to develop nontraditional hospital arrangements, including management and
consulting agreements, strategic services and joint ventures. Strategic services
are arrangements under which hospitals refer testing which is traditionally
performed in their own laboratories to independent clinical laboratories. Quest
Diagnostics believes that, in many cases, nontraditional hospital arrangements
can be economically advantageous for a hospital's laboratory by lowering costs
and capital requirements.
During 1997 and 1998, Quest Diagnostics established joint ventures with
three leading integrated health delivery networks: (1) UPMC Health System, based
in Pittsburgh, (2) Unity Health System, based in St. Louis, and (3) Samaritan
Health System, based in Phoenix. It also expanded an existing joint venture to
include approximately 20 hospitals in northwestern Pennsylvania and southwestern
New York. These joint venture arrangements, which provide testing for these
hospitals as well as for unaffiliated physicians and other health care providers
in their geographic areas, serve as four of Quest Diagnostics' laboratory
facilities. Quest Diagnostics also has outsource agreements with a group of
approximately 25 hospitals in eastern Nebraska and manages the laboratories of
those hospitals. In addition, Quest Diagnostics also manages the laboratories at
several other hospitals in the eastern United States.
Quest Diagnostics believes that most hospital laboratories perform
approximately 95% to 97% of their patients' clinical laboratory tests. Despite
potential cost savings that can be derived from outsourcing or strategic
services arrangements, Quest Diagnostics believes that only a small percentage
of the hospitals in the United States has entered into such arrangements.
Nonetheless, Quest Diagnostics is seeking to enter into alliances with
additional hospitals in the future.* As part of this strategy, Quest Diagnostics
entered into a ten-year agreement with an affiliate of Premier, Inc.
("Premier"). Premier is one of the largest group purchasing organizations in the
United States. Approximately 1,800 hospitals in the United States are affiliated
with Premier. Under this agreement, Quest Diagnostics is the only clinical
laboratory sponsored by Premier to negotiate strategic services arrangements
with hospitals affiliated with Premier. Strategic service arrangements may
include a variety of alternatives tailored to the needs of the hospital, ranging
from management of hospital laboratories to extended outsourcing arrangements.
Upon signing strategic services agreements with a Premier-affiliated hospital,
Quest Diagnostics will pay Premier a fee, which may include stock or warrants to
purchase common stock of Quest Diagnostics. Quest Diagnostics is also one of
three clinical laboratories sponsored by Premier to provide reference testing
- --------------------------
* This is a forward-looking statement. See "Cautionary Statement for Purposes
of the `Safe Harbor' Provisions of the Private Securities Litigation Reform
Act of 1995." In particular, see factors (a) and (n).
11
services to hospitals affiliated with Premier under a standard group purchasing
agreement.
Medical Information. The demand for comprehensive medical information
continues to grow. Large customers of clinical laboratories are increasingly
interested in integrating clinical laboratory data with other health care
information to answer financial, marketing and quality related questions.
Pharmaceutical customers are interested in using clinical data to expand their
drug sales and marketing efforts as well as to promote disease management
initiatives. To meet these emerging needs for medical information, the Quest
Informatics division of Quest Diagnostics has developed a portfolio of
information products based primarily upon Quest Diagnostics' extensive database
and core medical and analytical expertise. These products maintain patient
confidentiality and require patient consent if patient identifying information
is provided to a third party.
Information Systems
Information systems are used in laboratory testing, billing, customer
service, logistics, management of medical data, and other aspects of Quest
Diagnostics' business. Quest Diagnostics believes that the efficient handling of
information involving customers, patients, payers and other parties will be
critical to its future success.
During the 1980's and early 1990's, when Quest Diagnostics acquired most
of its laboratory facilities, regional laboratories were operated as local,
decentralized units. When it acquired the laboratories, Quest Diagnostics did
not make significant changes in their method of operations and did not
standardize their billing, laboratory and some other information systems. As a
result, by the end of 1995 Quest Diagnostics had many different information
systems for billing, test results reporting and other transactions. Over time,
the growth in the size and network of Quest Diagnostics' customers and the
increasing complexity of billing made clear a greater need for standardized
systems. In addition, under the corporate integrity agreement that Quest
Diagnostics entered into with the United States Government as described in
"--Compliance Programs", Quest Diagnostics is required to standardize its
billing and laboratory information systems. Quest Diagnostics is committed to
building a standardized company-wide information technology infrastructure,
including a Year 2000 compliant environment. Quest Diagnostics has a special
retention bonus plan for its key information systems employees, which is based
on success in making its systems Year 2000 compliant.
Quest Diagnostics has chosen its SYS system as its standard billing system
and its QuestLab system as its standard laboratory information system. The
QuestLab system is licensed from Antrim Corporation. Quest Diagnostics believes
that both of these systems are substantially Year 2000 compliant.
As a result of conversions during the last two years, Quest Diagnostics
expects that by August 31, 1999:
o billing sites representing approximately 75% of its 1998 net clinical
laboratory revenue will be utilizing its SYS system;
o laboratory sites accounting for approximately 65% of its 1998 net
clinical laboratory revenue will be utilizing an Antrim-based
laboratory information system; and
o its remaining non-standard billing and laboratory information systems
will have been made Year 2000 compliant.*
Quest Diagnostics does not plan any additional conversions during the last
several months of 1999, when its information technology employees are expected
to focus principally on testing its systems to confirm year 2000 compliance.
After January 1, 2000, Quest Diagnostics expects to resume converting the
remaining billing and laboratory information systems to the standard systems.
Conversion costs are expected to range between approximately $1 million to $3
million per billing system and $1 million to $3 million per laboratory
information system.* As more billing sites are converted to the standard billing
system, Quest Diagnostics expects to consolidate its billing sites, which will
improve billing. Conversion costs in 1999 are expected to be approximately
$10 million. In addition, Quest Diagnostics expects to spend additional
- ------------------------------
* These are forward-looking statements. See "Cautionary Statement for Purposes
of the `Safe Harbor' Provisions of the Private Securities Litigation Reform
Act of 1995." In particular, see factors (d), (j), (l) and (n).
12
funds in 1999 to make its systems Year 2000 compliant.* For a discussion of
Quest Diagnostics' year 2000 readiness, see "Management's Discussion and
Analysis of Financial Condition and Results of Operations." Excluding the
acquisition of SmithKline Beecham's clinical laboratory business, Quest
Diagnostics anticipates that the cost of converting all of its current billing
and laboratory information systems in 2000 and later years will range between
$25 million and $30 million, depending on the number of billing consolidations
that occur.*
Following the acquisition of SmithKline Beecham's clinical laboratory
business, Quest Diagnostics will reassess its standard systems. SmithKline
Beecham's clinical laboratory business has standardized its billing and
laboratory information systems. SmithKline Beecham's laboratory information
system is also licensed from Antrim Corporation but its billing system is
different from the SYS billing system of Quest Diagnostics. The acquisition is
likely to increase the cost of conversions to standardize billing and
laboratory information systems.
Billing
Billing for laboratory services is complicated. Laboratories must bill
various payers, such as patients, insurance companies, Medicare, Medicaid,
doctors and employer groups, all of which have different requirements.
Most of Quest Diagnostics' bad debt expense is the result of several
non-credit related issues, primarily missing or incorrect billing information on
requisitions. Quest Diagnostics performs the requested tests and reports test
results regardless of incorrect or missing billing information. It subsequently
attempts to obtain any missing information and rectify incorrect billing
information received from the health care provider. Missing or incorrect
information on requisitions slows the billing process, creates backlogs of
unbilled requisitions and generally increases the aging of accounts receivable.
Among many other factors complicating billing are (1) pricing differences
between the fee schedules of Quest Diagnostics and the payer, (2) disputes
between payers as to which party is responsible for payment and (3) auditing for
specific compliance issues. Ultimately, if all issues are not resolved in a
timely manner, the related receivables are charged to the allowance for doubtful
accounts. Quest Diagnostics has implemented best billing practices that have
significantly reduced the percentage of requisitions with missing billing
information from approximately 16% at the beginning of 1996 to approximately 6%
at the end of 1998. These initiatives, together with progress in dealing with
Medicare medical necessity documentation requirements and standardizing billing
systems, have significantly reduced bad debt expense during 1997 and 1998.
Integration of a standardized billing system is a priority of Quest
Diagnostics. The use of a standard system will provide efficiency, as redundant
programming efforts are eliminated and the ability to consolidate billing sites
will become more feasible. Converting billing systems to the SYS system presents
conversion risks to Quest Diagnostics, as key databases and masterfiles are
transferred to the SYS system. In addition, the billing workflow is interrupted
during a conversion, which may cause backlogs. To reduce this risk, Quest
Diagnostics has retained key people who have been involved in prior conversions.
Quest Diagnostics has been unable to secure assurances from a number of
key payers that they will be in a position after January 1, 2000 to maintain
uninterrupted reimbursement to Quest Diagnostics. Failure of payers to maintain
uninterrupted reimbursement to Quest Diagnostics may have an adverse effect on
its financial condition, results of operations and cash flow. For a discussion
of Quest Diagnostics' year 2000 readiness, see "Management's Discussion and
Analysis of Financial Condition and Results of Operations."
Acquisitions and Consolidations
Quest Diagnostics has added most of its regional laboratories through
acquisitions. Apart from the planned acquisition of SmithKline Beecham's
clinical laboratory business, Quest Diagnostics expects to focus future clinical
laboratory acquisition efforts on smaller laboratories that can be integrated
into its existing laboratories. This strategy will enable Quest Diagnostics to
reduce costs and gain other benefits from the elimination of redundant
facilities and equipment, and reductions in personnel. Quest Diagnostics may
also consider acquisitions of ancillary businesses as part of its overall growth
strategy.
Quest Diagnostics believes that the clinical laboratory industry operates
significantly below capacity. Recently, Quest Diagnostics took several steps to
reduce its excess capacity. Since 1997 Quest Diagnostics has:
- ------------------------
* These are forward-looking statements. See "Cautionary Statement for Purposes
of the `Safe Harbor' Provisions of the Private Securities Litigation Reform
Act of 1995." In particular, see factors (d), (j), (l) and (n).
13
o substantially completed the conversion of two of its regional
laboratories in Atlanta and Tampa into stat laboratories;
o substantially completed the downsizing of the regional laboratory in
St. Louis and several branch laboratories in Indianapolis, Buffalo,
Columbus, Cleveland and Nashville; and
o formed a joint venture with Samaritan Health System, a leading
integrated health care delivery network in Arizona. Consolidation of
the laboratory operations of this joint venture has been difficult.
This is the only joint venture that Quest Diagnostics does not control.
Notwithstanding the joint venture's leading position in the Arizona
market and strong volume, the joint venture has incurred operating
losses that have resulted from difficulties in integrating facilities
and systems.
Quest Diagnostics believes that there is still significant excess capacity
in its system and is exploring other possible steps to reduce costs.*
- ------------------------
* This is a forward-looking statement. See "Cautionary Statement for Purposes
of the `Safe Harbor' Provisions of the Private Securities Litigation Reform
Act of 1995." In particular, see factors (f) and (j).
14
Competition
The clinical laboratory testing business is fragmented and highly
competitive. Quest Diagnostics competes with three types of providers:
hospital-affiliated laboratories, other independent clinical laboratories and
physician-office laboratories.
There are presently three major independent clinical laboratories: Quest
Diagnostics; Laboratory Corporation of America Holdings ("LabCorp"); and
SmithKline Beecham Clinical Laboratories, Inc. ("SBCL"). In 1998, Quest
Diagnostics had approximately $1.5 billion in revenues, LabCorp had
approximately $1.6 billion in revenues; and SBCL had approximately $1.6 billion
in revenues. The acquisition of SBCL will result in Quest Diagnostics becoming
the leading clinical laboratory provider in the United States with facilities in
substantially all of the country's major metropolitan areas. For a discussion of
the transaction and its effect on Quest Diagnostics, see "-Acquisition Agreement
with SmithKline Beecham plc."
In addition, Quest Diagnostics competes with many smaller regional and
local independent clinical laboratories, as well as laboratories owned by
physicians and hospitals. However, Quest Diagnostics believes that its
lower-cost structure and broader network permits it to compete more effectively
than smaller laboratories in servicing large managed care organizations.
Hospital laboratories have become more aggressive in providing services to
affiliated and unaffiliated physicians. Quest Diagnostics is the leading
provider for routine testing among independent clinical laboratories in most of
the northeast, mid-Atlantic and mid-west markets in the United States. Its
market presence in routine testing is much more limited in the rest of the
country.
Quest Diagnostics believes that health care providers often consider the
following factors, among others, in selecting a laboratory:
o accuracy, timeliness and consistency in reporting test results;
o number and type of tests performed by the laboratory;
o service capability and convenience offered by the laboratory;
o its reputation in the medical community; and
o pricing.
Quest Diagnostics believes that it competes favorably in each of these areas. As
described under "-Business Strategy," it is also implementing strategies to
improve its competitive position.
Quest Diagnostics believes that consolidation in the clinical laboratory
testing business will continue. It also believes large independent clinical
laboratories may be able to increase their penetration 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 growing managed care organizations and more effectively deal
with Medicare reimbursement reductions and utilization controls.*
Quality Assurance
Quest Diagnostics' goal is to continually improve processes for
collection, storage and transportation of patient specimens, as well as the
precision and accuracy of analysis and result reporting. Quest Diagnostics'
quality assurance efforts focus on proficiency testing, process audits,
statistical process control and personnel training for all of its laboratories
and patient service centers.
- ----------------------------
* This is a forward-looking statement. See "Cautionary Statement for Purposes
of the `Safe Harbor' Provisions of the Private Securities Litigation Reform
Act of 1995." In particular, see factors (a), (b), (c), (d), (e), (f), (j),
(l) and (n).
15
Internal 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 then monitored to identify drift, shift or
imprecision in the analytical processes. In addition, Quest Diagnostics
administers an extensive internal program of "blind" proficiency testing, where
quality control samples are processed through Quest Diagnostics' systems as
routine patient samples and reported. Quest Diagnostics also performs internal
process audits as part of its comprehensive quality assurance program.
External Proficiency Testing and Accreditation. All Quest Diagnostics'
laboratories participate in various blind sample quality surveillance programs
conducted externally. These programs supplement all other quality assurance
procedures. They include proficiency testing programs administered by the
College of American Pathologists ("CAP"), as well as many state agencies.
CAP is an independent non-governmental organization of board certified
pathologists. CAP is approved by the Health Care Financing Administration to
inspect clinical laboratories to determine compliance with the standards
required by the Clinical Laboratory Improvement Amendments of 1988. CAP offers
an accreditation program to which laboratories may voluntarily subscribe. All
Quest Diagnostics' regional laboratories are accredited by CAP. Accreditation
includes on-site inspections and participation in the CAP proficiency test
program.
Regulation of Clinical Laboratory Operations
The clinical laboratory industry is subject to significant federal and
state regulation. Governmental authorities may impose fines, criminal penalties
or take other enforcement actions to enforce laws and regulations, including
revoking a clinical laboratory's right to conduct business.
CLIA. All Quest Diagnostics laboratories and patient service centers are
licensed and accredited by applicable federal and state agencies. The Clinical
Laboratory Improvement Amendments of 1988 ("CLIA") regulates virtually all
clinical laboratories by requiring they be certified by the federal government
to ensure that all clinical laboratory testing services are uniformly accurate,
reliable and timely. CLIA permits states to adopt regulations that are more
stringent than federal law. For example, state laws may require additional
personnel qualifications, quality control, record maintenance and proficiency
testing.
Drug Testing. The Substance Abuse and Mental Health Services
Administration ("SAMHSA") regulates drug testing for public sector employees.
SAMHSA has established detailed performance and quality standards that
laboratories must meet to perform drug testing on federal employees and
contractors and other regulated entities. Quest Diagnostics' laboratories that
perform such testing must be certified as meeting SAMHSA standards. Seven of
Quest Diagnostics' laboratories are SAMHSA-certified, requiring on-site
inspections twice a year by SAMHSA and CAP.
Controlled Substances. The federal Drug Enforcement Administration (the
"DEA") regulates access to controlled substances in drug abuse testing. Quest
Diagnostics' laboratories that use controlled substances are licensed by the
DEA.
Medical Waste and Radioactive Materials. Clinical laboratories are also
subject to federal, state and local regulations relating to the handling and
disposal of medical specimens, hazardous waste and radioactive materials. Quest
Diagnostics uses outside suppliers for specimen disposal. Quest Diagnostics
believes that it currently complies with all laws in connection with the
disposal of medical waste and radioactive materials.
Occupational Safety. The federal Occupational Safety and Health
Administration has established extensive requirements relating specifically to
workplace safety for health care employers. This includes clinical laboratories
whose workers may be exposed to blood-borne or airborne viruses, such as HIV and
hepatitis B.
Specimen Transportation. Regulations of the Department of Transportation,
the Public Health Service and the United States Postal Service apply to surface
and air transportation of clinical laboratory specimens.
Regulation of Reimbursement for Clinical Laboratory Services.
Overview. The health care industry has been undergoing significant
changes. Governmental payers, such as Medicare (which principally serves
patients aged 65 years and older), Medicaid (which principally services indigent
patients), as well as private insurers and large employers have taken steps to
16
control the cost, utilization and delivery of health care services. Principally
as a result of recent reimbursement reductions and measures adopted by the
Health Care Financing Administration ("HCFA") to reduce utilization described
below, the percentage of Quest Diagnostics' aggregate net revenues derived from
Medicare programs declined from 20% in 1995 to 14% in 1998. Revenues from
Medicaid as a percentage of Quest Diagnostics' aggregate net revenues have
declined from 3% in 1995 to 2% in 1998. Quest Diagnostics believes its other
business may significantly depend on continued participation in the Medicare and
Medicaid programs, because many clients may 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 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
penalties and fines; and (4) the loss of various licenses, certificates and
authorizations necessary to operate some or all of a clinical laboratory's
business. Civil administrative penalties for a wide range of offenses are
$10,000 per offense plus three times the amount claimed.
Reduced Reimbursements. In 1984, Congress established a Medicare fee
schedule for clinical laboratory services performed for patients covered under
Part B of the Medicare program. Congress then imposed a ceiling on the amount
that would be paid under the Medicare schedule. Since then, Congress has
periodically reduced previous ceilings. The Medicare national fee schedule
limitations were reduced in 1996 to 76% of the 1984 national median and in 1998
to 74% of the 1984 national median. In addition, Congress also eliminated the
provision for annual fee schedule increases based on the consumer price index
through 2002. Currently, the Clinton Administration's proposed budget for fiscal
year 2000 seeks to further reduce the Medicare national fee schedule limitations
to 72% of the 1984 national median. Quest Diagnostics cannot predict if Congress
will implement the proposed reduction or any other reductions.
Laboratories must bill the Medicare program directly and must accept the
scheduled amount as payment in full for most tests performed on behalf of
Medicare beneficiaries. 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:
o "Client" fees charged to physicians, hospitals, and institutions to
which a laboratory supplies services on a wholesale basis. These are
generally subject to negotiation or discount.
o "Patient" fees charged to individual patients and third-party payers,
like Medicare and Medicaid. These generally require separate bills for
each requisition.
The fees established by Medicare are typically substantially lower than
patient fees otherwise charged by Quest Diagnostics, but are higher than Quest
Diagnostics' fees actually charged to many clients. Federal and some state
regulations prohibit clinical laboratories from charging government programs
more than what they charge other customers. During 1992, the Office of the
Inspector General (the "OIG") of the Department of Health and Human Services
("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 authorize the OIG to
exclude from participation in the Medicare program providers, 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.
However, the 1997 Balanced Budget Act permits HCFA to adjust statutorily
prescribed fees for some medical services, including clinical laboratory
services, if the fees are "grossly excessive." In January 1998, HCFA issued an
interim final rule setting forth criteria to be used by HCFA in determining
whether to exercise this power. Among the factors listed in the rule are whether
the statutorily prescribed fees are "grossly higher or lower than the payment
made for the. . . services by other purchasers in the same locality." Quest
17
Diagnostics cannot provide any assurances to investors that fees payable by
Medicare could not be reduced as a result of the application of this rule.
Reduced Utilization of Clinical Laboratory Testing. In recent years, HCFA
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 diagnostic 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, there is no
penalty prescribed for violations of this law.
In March 1996, HCFA eliminated its prior policy under which Medicare paid
for all tests contained in an automated chemistry panel when at least one of the
tests in the panel is medically necessary. HCFA indicated that under the new
policy, Medicare will only pay for those individual tests in a chemistry panel
that are medically necessary. Later in 1996, the American Medical Association
("AMA"), in conjunction with HCFA, designed four new panels of "clinically
relevant" automated chemistry panels. Each panel consists of between 4 and 12
tests. These four new panels replaced the previous automated chemistry test
panels, consisting of 19 to 22 tests. HCFA adopted these panels in early 1998.
Since then, Medicare carriers have focused limited coverage application to the
panel level and not to the test component level. However, Quest Diagnostics
cannot provide any assurances to investors that Medicare carriers will not focus
future limited coverage application to the test component level.
In response to these developments, in April 1998, Quest Diagnostics
implemented a Medicare/Medicaid-only order form. This form includes the four new
AMA chemistry test panels and highlights "limited coverage" tests for which
Medicare/Medicaid will pay. During the fourth quarter of 1998, Quest Diagnostics
also implemented a new general test billing form offering these new panels to
all patients. While Quest Diagnostics did not see a significant impact in 1998,
Quest Diagnostics believes that these panels are likely to result in fewer test
orders per requisition and may put additional pressure on revenues and earnings
in the future.*
Quest Diagnostics is generally permitted to bill patients directly for
some statutorily excluded clinical laboratory services. Quest Diagnostics is
also generally permitted to bill patients for clinical laboratory tests that
Medicare does not pay for due to "medical necessity" limitations (these tests
include limited coverage tests for which an approved diagnosis code is not
provided by the ordering physician) if the patient signs an advance beneficiary
notice on Quest Diagnostics' new Medicare/Medicaid-only requisition. Since
requisitions are filled out by physician clients, Quest Diagnostics cannot
control the proper use of the advance beneficiary notice, and may perform the
tests but cannot subsequently bill the patient for them.
Inconsistent Practices. Currently, over 20 local carriers administer
Medicare. They have inconsistent policies on matters such as: (1) test coverage;
(2) automated chemistry panels; (3) diagnostics coding; (4) claims
documentation; and (5) fee schedules (subject to the national limitations).
Inconsistent regulation has increased the complexity of the billing process for
clinical laboratories. As part of the 1997 Balanced Budget Act, HHS is 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. In October
1998, HCFA announced that, despite the legislative mandate, HCFA will not
replace the local carriers with five regional carriers. The Clinton
Administration is expected to sponsor legislation to repeal the five carrier
mandate.
HCFA plans to achieve standardization through the help of a single claims
processing system for all carriers. This initiative, however, has been suspended
due to HCFA's Year 2000 compliance priorities. In a report in September 1998,
the General Accounting Office concluded that "HCFA and its contractors are
severely behind schedule in repairing, testing and implementing the
mission-critical systems supporting Medicare" and "it is highly unlikely that
all of the Medicare systems will be compliant in time to ensure the delivery of
uninterrupted benefits and services into the year 2000."
- --------------------------------
* This is a forward-looking statement. See "Cautionary Statement for Purposes
of the `Safe Harbor' Provisions of the Private Securities Litigation Reform
Act of 1995." In particular, see factors (a), (b), (c), (d), (e), (f), (j)
and (m).
18
Competitive Bidding. The 1997 Balanced Budget Act requires HCFA to conduct
five Medicare bidding demonstrations involving various types of medical services
and complete them by 2002. HCFA is expected to include a clinical laboratory
demonstration project in a metropolitan statistical area as part of the
legislative mandate. The project is expected to begin in the second half of
1999. 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 Quest Diagnostics.
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 Quest
Diagnostics. Quest Diagnostics cannot predict, however, whether and what type of
legislation will be enacted into law.
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.
Various federal enforcement agencies, including the Federal Bureau of
Investigations ("FBI") and the OIG, interpret liberally and enforce aggressively
statutory fraud and abuse provisions. According to public statements by the
Department of Justice ("DOJ"), during the last several years health care fraud
has been elevated to the second-highest priority of the DOJ, and FBI agents have
been transferred from investigating counterintelligence activities to health
care provider fraud. The OIG also is involved in investigations of health care
fraud and has, according to recent workplans, targeted certain laboratory
practices for study, investigation and prosecution. 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.
In addition, regulators have generally offered little guidance to the clinical
laboratory industry. Despite several requests from the clinical laboratory
industry for clarification of the anti-fraud and abuse rules since 1992, the OIG
has issued only two fraud alerts regarding clinical laboratory practices.
Many states have anti-kickback, anti-rebate, anti-fee-splitting and other
laws that also affect Quest Diagnostics' relationships with clients who refer
non-government-reimbursed clinical laboratory testing business to Quest
Diagnostics.
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 also affect investment and compensation arrangements with
physicians who refer other than government-reimbursed laboratory testing to
Quest Diagnostics.
Government Investigations and Related Claims
Since 1993, Quest Diagnostics has settled various government and private
claims that primarily involved industry-wide billing and marketing practices
that Quest Diagnostics had substantially discontinued by early 1993. Other
independent clinical laboratories, including SBCL and LabCorp, have settled
similar claims.
Government Settlements
The MetPath Settlement. In September 1993, Quest Diagnostics entered into
a civil settlement agreement with the DOJ and the OIG, under which it paid a
total of approximately $36 million. The claims were that MetPath had wrongfully
induced physicians to order laboratory tests without their realizing that those
tests would be billed to Medicare at rates higher than those the physicians
believed were applicable.
The Damon Settlement. In October 1996, Damon Clinical Laboratories
("Damon"), which was purchased by Corning in 1993, entered into a plea agreement
and civil settlement agreement and release with the DOJ. Under these agreements,
Damon paid approximately $40 million in base recoupments for overcharges and an
additional $79 million in total criminal and civil payments. The Damon
settlement did not exclude Quest Diagnostics from participation in any federal
health care programs.
Damon Joint Venture Settlement. In August 1998, Quest Diagnostics entered
into a settlement with the DOJ for approximately $15 million. The settlement was
with respect to a joint venture that Damon had with Vivra Inc. and a predecessor
joint venture between Damon and Vivra's former parent. The joint venture was
19
dissolved in May 1996. The government asserted, among other things, that the
joint ventures operated as a scheme to generate referrals for medically
unnecessary testing by providing unlawful kickbacks to Damon's joint venture
partners in the form of partnership profits. Corning reimbursed Quest
Diagnostics for the cost of the settlement.
Other Governmental Settlements. In addition, since 1992, Quest Diagnostics
has settled eight other federal and state billing-related claims for a total of
approximately $31 million.
Ongoing Government Investigations
The Nichols Institute Investigation. In August 1993, the federal
government issued a civil subpoena and began a formal investigation of Nichols
Institute, which remains open. The investigations relate to billing and
marketing practices of Nichols Institute's former routine regional laboratories,
which practices were substantially discontinued by the time that Quest
Diagnostics acquired Nichols in 1994. While Quest Diagnostics has established
reserves in respect of the Nichols Institute investigations, it cannot predict
the outcome of this investigation. At present, there are no settlement
discussions pending between the DOJ and Quest Diagnostics regarding Nichols
Institute. Remedies available to the government include exclusion from
participation in the Medicare and Medicaid programs. However, in light of the
corporate integrity agreement between Quest Diagnostics and the OIG discussed
below, Quest Diagnostics believes the prospect of any exclusion is remote. This
is because the matters being investigated were corrected with or before Quest
Diagnostics' acquisition of Nichols Institute, and Quest Diagnostics cooperated
in the investigation. While application of remedies and penalties could
materially and adversely affect Quest Diagnostics' business, financial condition
and prospects, management believes that the possibility of these effects is
likewise remote. As discussed below, Corning has agreed to indemnify Quest
Diagnostics against any monetary penalties, fines or settlements for any
governmental claims that may arise as a result of the Nichols Institute
investigations.
Other Investigations and Claims. Quest Diagnostics has been named in
several recent qui tam cases pending in different federal courts and involving a
variety of claims pertaining to its marketing and billing practices. At this
early stage, the Company cannot predict the outcome of these actions. They would
not, however, be covered by Quest Diagnostics' indemnity arrangement with
Corning.
The Damon Officer Indictments. In January 1998 the United States indicted
four former officers of Damon for alleged health care fraud committed during
their employment by Damon. Quest Diagnostics is obligated to indemnify these
Damon officers to the fullest extent permitted by Delaware law. Quest
Diagnostics' obligations consist primarily of advancing fees and expenses of
counsel in connection with the defense of these Damon officers. No trial date
has yet been scheduled.
Self-Reporting. During 1998, Quest Diagnostics voluntarily reported to the
federal government several isolated events that may have resulted in
overpayments by Medicare and Medicaid to Quest Diagnostics. Quest Diagnostics
internally investigates all such incidents and self-reports and reimburses
payers as appropriate. Quest Diagnostics has commenced internal investigations
to quantify the amounts that the government may recoup and has made repayments
and taken corrective action as to each event. Quest Diagnostics cannot predict,
however, the outcome of these disclosures.
Private Settlements and Claims
Quest Diagnostics has received notices of private claims relating to
billing issues similar to those that were the subject of the MetPath and Damon
settlements. Quest Diagnostics is presently negotiating with the claimants but
cannot predict the outcome of the actions.
In March 1997, a former subsidiary of Damon, together with SmithKline
Beecham and LabCorp, was served with a complaint in a purported class action.
The complaint asserts claims under the federal civil RICO statute relating to
private reimbursement of billings by Damon that are similar to those that were
part of the government settlement. Quest Diagnostics cannot predict the ultimate
outcome of the claim at present.
20
Corning Indemnity
Corning, the former parent of Quest Diagnostics, has agreed to indemnify
Quest Diagnostics against all monetary penalties, fines or settlements for any
government claims that (1) arise out of alleged violations of applicable federal
fraud and health care statutes; (2) relate to billing practices of Quest
Diagnostics and its predecessors; and (3) were pending on December 31, 1996.
This includes the Nichols investigation described above.
Corning has also agreed to indemnify Quest Diagnostics in respect of
private claims relating to indemnified or previously settled government claims
that alleged overbillings by Quest Diagnostics or any of its existing
subsidiaries for services provided before January 1, 1997. Corning will
indemnify Quest Diagnostics for 50% of the aggregate of all judgment or
settlement payments made by December 31, 2001 that exceed $42 million. The 50%
share will be limited to a total amount of $25 million and will be reduced to
take into account any deductions or tax benefits realized by Quest Diagnostics
or a consolidated group of which Quest Diagnostics is a member, to the extent
that such deductions or tax benefits are deemed to reduce the tax liability of
Quest Diagnostics. Corning will not indemnify Quest Diagnostics against damages
suffered as a result of or incidental to, the billing claims and the fees and
expenses of litigation.
Quest Diagnostics will control the defense of any government claim or
investigation unless Corning elects to assume the defense. However, in the case
of all non-government claims related to indemnified government claims of alleged
overbillings, Quest Diagnostics will control the defense. All disputes relating
to the Corning indemnification agreement are subject to binding arbitration.
Quest Diagnostics' Reserves
Quest Diagnostics' aggregate reserves with respect to all government and
private claims were approximately $52.6 million at December 31, 1998. The
reserves represent amounts for future government and private settlements of
pending matters or matters anticipated as a result of the government and private
settlements and self-reporting. Although management believes that established
reserves for both indemnified and non-indemnified claims are sufficient, it is
possible that additional information (such as the indication by the government
of criminal activity, additional tests being questioned or other changes in the
government's or private claimants' theories of wrongdoing) may become available
which may cause the final resolution of these matters to exceed established
reserves by an amount which could be material to Quest Diagnostics' results of
operations and cash flows in the period in which such claims are settled. Quest
Diagnostics does not believe that these issues will have a material adverse
effect on its overall financial condition.
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 health
care. Quest Diagnostics began a compliance program early in 1993.
Quest Diagnostics emphasizes the development of training programs intended
to ensure the strict implementation and observance of all applicable rules and
regulations. Further, Quest Diagnostics conducts in-depth reviews of procedures,
personnel and facilities to assure regulatory compliance throughout its
operations. A compliance committee of the board of directors requires periodic
reporting of compliance operations from management. Government officials have
publicly cited this program as a model for the industry.
In connection with the Damon settlement, Quest Diagnostics signed a
five-year corporate integrity agreement with the OIG. Under the agreement, Quest
Diagnostics has agreed to take steps to demonstrate its integrity as a provider
of services to federally sponsored health care programs. These include steps to:
o maintain its corporate compliance program;
o adopt pricing guidelines;
o audit laboratory operations; and
21
o investigate and report instances of noncompliance, including any
corrective actions and disciplinary steps.
This agreement also gives Quest Diagnostics the opportunity to seek clearer
guidance on matters of compliance and to resolve compliance issues directly with
the OIG.
None of the undertakings included in Quest Diagnostics' corporate
integrity agreement is expected to have any material adverse effect on Quest
Diagnostics' business, financial condition, results of operations, cash flow and
prospects. Quest Diagnostics believes it complies in all material respects with
all applicable statutes and regulations. However, Quest Diagnostics cannot
assure investors that no statute or regulations will be interpreted or applied
by a prosecutorial, regulatory or judicial authority in a manner that would
adversely affect Quest Diagnostics.
Insurance
Quest Diagnostics maintains liability insurance (subject to maximum limits
and self-insured retentions) for claims that could result from providing or
failing to provide clinical laboratory testing, including inaccurate testing
results. These claims could be substantial. Management believes that present
insurance coverage and reserves are adequate to cover currently estimated
exposures. Although Quest Diagnostics believes that it will be able to obtain
adequate insurance coverage in the future at acceptable costs, it cannot assure
investors that it will be able to do so, or obtain coverage at an acceptable
cost, or that Quest Diagnostics will not incur significant liabilities in excess
of policy limits.
Employees
At December 31, 1998, Quest Diagnostics employed approximately 15,000
people, as compared to 16,300 people at December 31, 1997. Approximately 13,500
of Quest Diagnostics' employees were full-time and approximately 1,500 were
part-time at December 31, 1998. These totals exclude employees of the Erie,
Pennsylvania and Phoenix, Arizona joint ventures.
Quest Diagnostics has no collective bargaining agreements with any unions,
and believes that its overall relations with its employees are good.
CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE
PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
Some statements in this document are identified as forward-looking
statements. They involve risks and uncertainties that could cause actual results
to differ materially from the forward-looking statements. The Private Securities
Litigation Reform Act of 1995 provides a "safe harbor" for forward-looking
statements to encourage companies to provide prospective information about their
companies without fear of litigation. Statements must be (1) identified as
forward-looking; and (2) accompanied by identification of important factors that
could cause actual results to differ materially from those projected in the
statements, which will serve as a meaningful caution to investors.
Quest Diagnostics 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. The following important factors could
cause its actual financial results to differ materially from those projected,
forecast or estimated by it in forward-looking statements:
(a) Heightened competition, including increased pricing pressure and
competition from hospitals for testing for non-patients. See
"Business--Competition."
(b) Impact of changes in payer mix, including the shift from
traditional, fee-for-service medicine to managed-cost health care.
See "Business--The United States Clinical Laboratory Testing
Industry -- Effect of the Growth of the Managed Care Sector."
(c) Adverse actions by government or other third-party payers, including
unilateral reduction of fee schedules payable to Quest Diagnostics.
See "Business--Regulation of Reimbursement for Clinical Laboratory
Services."
(d) The impact upon Quest Diagnostics' volume and collected revenue or
general or administrative expenses resulting from its compliance
22
with Medicare 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;
(2) the policy of HCFA 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) the recent introduction of four new panels of "clinically
relevant" automated chemistry panels (each consisting of
between 4 and 12 tests) to replace the previous automated
chemistry test panels consisting of 19 to 22 tests; and
(4) the likelihood that third-party payers will adopt similar
requirements. See "Business--Regulation of Reimbursement for
Clinical Laboratory Services."
(e) Adverse results from pending or future government investigations.
These include, in particular:
(1) significant monetary damages and/or exclusion from the
Medicare and Medicaid programs and/or other significant
litigation matters; and
(2) the absence of indemnification from Corning for private claims
unrelated to the indemnified government claims or
investigations and for private claims that are not settled by
December 31, 2001. See "Business--Government Investigations
and Related Claims."
(f) Failure to obtain new customers at profitable pricing or failure to
retain existing customers, and reduction in tests ordered or
specimens submitted by existing customers.
(g) Inability to obtain professional liability insurance coverage or a
material increase in premiums for such coverage. See
"Business--Insurance."
(h) Denial of CLIA certification or other license for any of Quest
Diagnostics' clinical laboratories under the CLIA standards, by HCFA
for Medicare and Medicaid programs or other federal, state and local
agencies. See "Business--Regulation of Clinical Laboratory
Operations."
(i) Adverse publicity and news coverage about Quest Diagnostics or the
clinical laboratory industry.
(j) Computer or other system failures that affect Quest Diagnostics'
ability to perform tests, report test results or properly bill
customers, including potential failures resulting from systems
conversions or from the Year 2000 problem. See
"Business--Information Systems" and "--Billing."
(k) Failure of third-party payers, including Medicare carriers and
suppliers, to adequately address the Year 2000 problem, which could
lead to delays in reimbursement for clinical laboratory testing
performed by Quest Diagnostics. See "Business--Billing" and
"--Regulation of Reimbursement for Clinical Laboratory Services --
Inconsistent Practices."
(l) Development of technologies that substantially alter the practice of
laboratory medicine.
(m) Changes in interest rates causing a substantial increase in Quest
Diagnostics' effective borrowing rate.
(n) The inability of Quest Diagnostics to efficiently integrate acquired
clinical laboratory businesses, particularly SBCL's, or to
efficiently integrate clinical laboratory businesses from joint
ventures and alliances with hospitals, and the costs related to any
such integration.
23
Item 2. Properties
Quest Diagnostics' principal laboratories (listed alphabetically by state)
are located in the following metropolitan areas:
Location Type of Laboratory Leased or Owned
- -------- ------------------ ---------------
Phoenix, Arizona Joint Venture Leased by Joint Venture
San Diego, California Regional Leased
San Juan Capistrano, California Esoteric Owned
Denver, Colorado Regional Leased
New Haven, Connecticut Regional Owned
Fort Lauderdale, Florida Regional Leased
Chicago, Illinois Regional Leased
Baltimore, Maryland Regional Owned
Boston, Massachusetts Regional Leased
Detroit, Michigan Regional Leased
Grand Rapids, Michigan Branch Leased
St. Louis, Missouri Joint Venture Leased
Lincoln, Nebraska Regional Leased
New York, New York (Teterboro, New Jersey) Regional Owned
Long Island, New York Branch Leased
Portland, Oregon Regional Leased
Erie, Pennsylvania Joint Venture Leased by Joint Venture
Philadelphia, Pennsylvania Regional Leased
Pittsburgh, Pennsylvania Regional/Joint Venture Leased
Dallas, Texas Regional Leased
Quest Diagnostics' executive offices are located in Teterboro, New Jersey,
in the facility that also serves as Quest Diagnostics' regional laboratory in
the New York City metropolitan area. Quest Diagnostics owns its branch
laboratory facility in Mexico City. Quest Diagnostics believes that, in general,
its laboratory facilities are suitable and adequate for its current and
anticipated future levels of operation. Quest Diagnostics believes that if it
were unable to renew the lease on any of its testing facilities, it could find
alternative space at competitive market rates and relocate its operations to
such new location.
Item 3. Legal Proceedings
In addition to the investigations described in "Business--Government
Investigations and Related Claims," Quest Diagnostics (the "Company") is
involved in various legal proceedings arising in the ordinary course of
business. Some of the proceedings against the Company involve claims that are
substantial in amount. Although it is not feasible to predict the outcome of
such proceedings or any claims made against the Company, it does not anticipate
that the ultimate liability of such proceedings or claims will have a material
adverse effect on the Company's financial position or results of operations as
they primarily relate to professional liability for which the Company believes
it has adequate insurance coverage. See "Business-Insurance."
Item 4. Submission of Matters to a Vote of Security Holders
None.
PART II
Item 5. Market for the Registrant's Common Stock and Related Security Holder
Matters
The common stock of the Company is listed and traded on the New York Stock
Exchange under the symbol "DGX." The following table sets forth, for the periods
indicated, the high and low sales price per share as reported on the New York
Stock Exchange Consolidated Tape:
1997: High Low
First Calendar Quarter $17.875 $14.625
Second Calendar Quarter $20.875 $14.25
Third Calendar Quarter $20.3125 $16.25
Fourth Calendar Quarter $17.375 $16.125
1998: High Low
First Calendar Quarter $17.125 $15.0625
Second Calendar Quarter $23.0625 $16.125
Third Calendar Quarter $22.00 $16.00
Fourth Calendar Quarter $18.625 $14.50
24
As of February 28, 1999, the Company had approximately 7,867 record holders of
its common stock.
The Company has not paid dividends in 1998 and 1997, and does not expect
to pay dividends on its common stock in the foreseeable future. The bank credit
facility prohibits the Company from paying cash dividends on its common stock.
The Indenture relating to the Company's 10.75% senior subordinated notes due
2006 restricts the ability of the Company to pay cash dividends based primarily
on a percentage of the Company's earnings, as defined.
25
Item 6. Selected Financial Data
See page 32.
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
See pages 33-44.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
See Management's Discussion and Analysis of Financial Condition and
Results of Operations.
Item 8. Financial Statements and Supplementary Data
See Item 14 (a)1 and 2.
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
None.
PART III
Item 10. Directors and Executive Officers of the Registrant
Information concerning the directors of the Company is incorporated by
reference to the information in the Company's Proxy Statement to be filed on or
before April 30, 1999 (the "Proxy Statement") appearing under the caption
"Election of Directors."
Executive Officers of the Registrant
Officers of the Company are elected by the Board of Directors and hold
office until their respective successors are elected and qualified. In addition
to Mr. Freeman, the following persons serve as executive officers of the
Company:
James D. Chambers (42) is Senior Vice President and Chief Growth Officer.
Mr. Chambers joined Corning in 1986 and served in a variety of managerial and
financial positions for Corning and its subsidiaries, becoming Assistant
Treasurer in 1991. Mr. Chambers joined the Company in 1992 as Treasurer and
served as Chief Financial Officer from 1994 through 1995. In 1995 he assumed
responsibilities for overseeing the Company's billing process; in January 1997
he was named Chief Administrative Officer with additional responsibilities for
Information Systems, Communications and Investor Relations; and in February 1998
he was named Marketing and Business Development Leader. In January 1999, Mr.
Chambers assumed his present responsibility for Growth.
Kurt R. Fischer (44) is Vice President-Human Resources. Mr. Fischer
joined Corning in 1976 and served in a variety of Human Resources positions. He
was appointed Human Resource Manager for the Research, Development and
Engineering Group in 1986 and Director-Quality and Performance Management for
the Specialty Materials Group in 1991. Mr. Fischer assumed his present
responsibilities with the Company in December 1995.
Robert A. Hagemann (42) is Vice President and Chief Financial Officer.
He joined the Company's predecessor entity, Corning Life Sciences, Inc. in 1992
where he held a variety of senior financial positions before being named Vice
President and Corporate Controller of the Company in 1996. Prior to joining
the Company, Mr. Hagemann was employed by Prime Hospitality, Inc. and Crompton
& Knowles, Inc. in senior financial positions. He was also previously
associated with Ernst & Young. Mr. Hagemann assumed his present
responsibilities with the Company in August 1998.
Bernard L. Kasten, M.D., FCAP, (52), is Vice President and Chief
Laboratory Officer. Dr. Kasten joined the Company in July 1996 as Medical
Director of the Teterboro regional laboratory and assumed his current position
in 1998. Dr. Kasten is a member of the College of American Pathologists, in
which he participates in the Inspection and Accreditation Program, Strategic
Planning and Management Resource Committees and chairs their World Wide Web
26
Editorial Board. From 1987 through 1996, Dr. Kasten was Associate Director of
Pathology and Laboratory Services for Bethesda Hospitals, Inc. and TriState
Pathology Associates of Cincinnati, Ohio.
Raymond C. Marier (54) is Vice President and General Counsel. Mr. Marier
joined Corning's Legal Department in 1973 as an Assistant Counsel, where he
worked with a number of Corning's operating units, including its Medical and
Science Products Divisions. He has held his present position since 1992.
Gerald C. Marrone (56) is Senior Vice President and Chief Information
Officer. Prior to joining the Company in November 1997, Mr. Marrone was with
Citibank, N.A. for 12 years. During his tenure he was most recently Vice
President, Division Executive for Citibank's Global Production Support Division.
While at Citibank, he was also the Chief Information Officer of Citibank's
Global Cash Management business. Prior to joining Citibank, he was the Chief
Information Officer for Memorial Sloan-Kettering Cancer Center in New York for 5
years.
C. Kim McCarthy (43) is Vice President, Government Relations and Services.
In this capacity she directs the development of the Company's legislative,
regulatory and public policy initiatives and related issues at both the state
and federal levels. Ms. McCarthy joined Corning in 1987 as Director of Federal
Government Affairs and Legislative Counsel and became Vice President of Public
Affairs of the Company in 1992. From May 1996 through May 1998, she directed the
Company's compliance program. Ms. McCarthy assumed her present responsibilities
in May 1998 and also is currently involved in the marketing and sale of
compliance services.
Surya N. Mohapatra, Ph. D. (49) is Senior Vice President and Chief
Operating Officer. In this newly-created position, Dr. Mohapatra is
responsible for all aspects of the Company's core clinical laboratory testing,
including its medical, operations and commercial functions. Prior to joining
the Company in February 1999, he was senior vice president of Picker
International, a worldwide leader in advanced medical imaging technologies,
where he served in various executive positions during his 18-year tenure.
Alister W. Reynolds (41) is Vice President-Strategic Planning. Mr.
Reynolds joined the Company in 1982 and has served in a variety of staff,
general management and executive positions. Mr. Reynolds assumed his current
responsibilities in 1995.
Paul J. Traina (40) is Vice President, Compliance. In this capacity, Mr.
Traina has responsibility for the ongoing management of the corporate integrity
agreement, as well as internal compliance audits, management of external audits
and reimbursement issues and practices. Mr. Traina joined the Company in 1989 as
Associate General Counsel and became Chief Compliance Officer in 1992. He
assumed his present position in May 1998.
David M. Zewe (47) is Vice President-Sales. Mr. Zewe joined the Company
in 1994 as General Manager of the Philadelphia regional laboratory and became
Regional Vice President Sales and Marketing for the mid-Atlantic region in
August 1996. Mr. Zewe assumed company-wide responsibility for sales in
traditional market segments in October 1997. Prior to joining the Company, Mr.
Zewe was with the Squibb Diagnostics Division of Bristol Myers Squibb, most
recently serving as Vice President of Sales.
Each executive officer of the Company is elected annually by the Board of
Directors and serves at the discretion of the Board of Directors.
Item 11. Executive Compensation
The information called for by this Item is incorporated by reference to
the information under the caption "Executive Compensation" appearing in the
Proxy Statement. The information contained in the Proxy Statement under the
captions "Compensation Committee Report"and "Performance Graph" is not
incorporated herein by reference.
Item 12. Security Ownership by Certain Beneficial Owners and Management
The information called for by this Item is incorporated by reference to
the information under the caption "Security Ownership of Certain Beneficial
Owners and Management" appearing in the Proxy Statement.
Item 13. Certain Relationships and Related Transactions
27
The information called for by this Item is incorporated by reference to
the information under the caption "Certain Relationships and Related
Transactions" appearing in the Proxy Statement.
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a) Documents filed as part of this report:
1. Index to financial statements and supplementary data filed as part of this
report:
Item Page
Report of Independent Accountants F-1
Consolidated Balance Sheets F-2
Consolidated Statements of Operations F-3
Consolidated Statements of Cash Flows F-4
Consolidated Statements of Stockholders' Equity F-5
Notes to Consolidated Financial Statements F-6
Supplementary Data: Quarterly Operating Results F-28
(unaudited)
2. Financial Statement Schedule:
Schedule II - Valuation Accounts and Reserves F-29
3. Exhibits filed as part of this report:
See (c) below.
(b) Reports on Form 8-K filed during the last quarter of 1998:
None.
28
(c) Exhibits filed as part of this report:
Exhibit Description
Number
2.1 Form of Transaction Agreement among Corning Incorporated, Corning
Life Sciences Inc., Corning Clinical Laboratories Inc. (Delaware),
Covance Inc. and Corning Clinical Laboratories Inc. (Michigan),
dated as of November 22, 1996 (filed as an exhibit to Corning
Clinical Laboratories Inc.'s ("CCL") Registration Statement on Form
10 (File No. 1-12215) and incorporated herein by reference)
3.1 Certificate of Incorporation of the Registrant (filed as an exhibit
to CCL's Registration Statement on Form 10 (File No. 1-12215) and
incorporated herein by reference)
3.2 Amended and Restated By-Laws of the Registrant
4.1 Form of Rights Agreement dated December 31, 1996 between Corning
Clinical Laboratories Inc. and Harris Trust and Savings Bank as
Rights Agent(filed as an Exhibit to CCL's Registration Statement on
Form 10 (File No. 1-12215) and incorporated herein by reference)
10.1 Form of Tax Sharing Agreement among Corning Incorporated, Corning
Clinical Laboratories Inc. and Covance Inc. (filed as an Exhibit to
CCL's Registration Statement on Form 10 (File No. 1-12215) and
incorporated herein by reference)
10.2 Form of Spin-Off Distribution Tax Indemnification Agreement between
Corning Incorporated and Corning Clinical Laboratories Inc. (filed
as an Exhibit to CCL's Registration Statement on Form 10 (File No.
1-12215) and incorporated herein by reference)
10.3 Form of Spin-Off Distribution Tax Indemnification Agreement between
Corning Clinical Laboratories Inc. and Covance Inc. (filed as an
Exhibit to CCL's Registration Statement on Form 10 (File No.
1-12215) and incorporated herein by reference)
10.4 Form of Spin-Off Distribution Tax Indemnification Agreement between
Covance Inc. and Corning Clinical Laboratories Inc. (filed as an
Exhibit to CCL's Registration Statement on Form 10 (File No.
1-12215) and incorporated herein by reference)
10.5 Form of Executive Retirement Supplemental Plan (filed as an Exhibit
to CCL's Registration Statement on Form 10 (File No. 1-12215) and
incorporated herein by reference)
10.6 Form of Variable Compensation Plan (filed as an Exhibit to CCL's
Registration Statement on Form 10 (File No. 1-12215) and
incorporated herein by reference)
10.7 Form of Employees Stock Purchase Plan (filed as an Exhibit to CCL's
Registration Statement on Form 10 (File No. 1-12215) and
incorporated herein by reference)
10.8 Form of Employee Equity Participation Program (filed as an Exhibit
to CCL's Registration Statement on Form 10 (File No. 1-12215) and
incorporated herein by reference)
10.9 Form of Profit Sharing Plan (filed as an Exhibit to CCL's
Registration Statement on Form 10 (File No. 1-12215) and
incorporated herein by reference)
10.10 Form of Stock Option Plan for Non-Employee Directors
10.11 Employment Agreement between Corning Clinical Laboratories Inc. and
Kenneth W. Freeman (filed as an Exhibit to the Company's Annual
Report on Form 10-K for the year ended December 31, 1996 and
incorporated herein by reference)
10.12 Form of Supplemental Deferred Compensation Plan
10.13 Form of Credit Agreement among Corning Clinical Laboratories Inc.,
the Banks named therein, NationsBank N.A., as Issuing Bank,
Wachovia Bank of Georgia, N.A., as Swingline Bank, Morgan Guaranty
Trust Company of New York, as Administrative Agent, and Morgan
Guaranty Trust Company of New York, NationsBank, N.A. and Wachovia
Bank of Georgia, N.A., as Arranging Agents, dated December 5, 1996
(filed as an Exhibit to CCL's Registration Statement on Form S-1
(File No. 333-15867) and incorporated herein by reference)
29
10.14 Form of Amendment No. 1 to the Credit Agreement referred to in
Exhibit 10.13(filed as an Exhibit to the Annual Report on Form 10-K
for the year ended December 31, 1997)
10.15 Form of Amendment No. 2 to the Credit Agreement referred to in
Exhibit 10.13
10.16 Form of 10.75% Senior Subordinated Notes due 2006 (filed as an
Exhibit to CCL's Registration Statement on Form S-1
(File No. 333-15867) and incorporated herein by reference)
10.17 Form of Indenture between Corning Clinical Laboratories Inc. and
The Bank of New York, as Trustee, dated December 16, 1996 (filed as
an Exhibit to CCL's Registration Statement on Form S-1 (File
No.333-15867) and incorporated herein by reference)
10.18 Form of Stock and Asset Purchase Agreement among SmithKline Beecham
plc; SmithKline Beecham Corporation and Quest Diagnostics
Incorporated (to be filed as an exhibit to the Company's Proxy
Statement for the 1999 annual meeting of shareholders)
21. Subsidiaries of Quest Diagnostics Incorporated
23. Consent of PricewaterhouseCoopers LLP
27. Financial Data Schedule
30
Signatures
Pursuant to the requirements of Sections 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
Quest Diagnostics Incorporated
By /s/ Kenneth W. Freeman Chairman of the Board, March 23, 1999
------------------------- President and
Kenneth W. Freeman Chief Executive Officer
By /s/ Robert A. Hagemann Vice President and March 23, 1999
------------------------- Chief Financial Officer
Robert A. Hagemann
By /s/ Catherine T. Doherty Chief Accounting Officer March 23, 1999
-------------------------
Catherine T. Doherty
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and on the dates indicated.
Capacity Date
-------- ----
/s/ Kenneth W. Freeman Chairman of the Board, March 23, 1999
- ---------------------------- President and
Kenneth W. Freeman Chief Executive Officer
/s/ Kenneth D. Brody Director March 23, 1999
- ----------------------------
Kenneth D. Brody
/s/ William F. Buehler Director March 23, 1999
- ----------------------------
William F. Buehler
/s/ Van C. Campbell Director March 23, 1999
- ----------------------------
Van C. Campbell
/s/ Mary A. Cirillo Director March 23, 1999
- ----------------------------
Mary A. Cirillo
/s/ Dan C. Stanzione Director March 23, 1999
- ----------------------------
Dan C. Stanzione
/s/ Gail R. Wilensky Director March 23, 1999
- ----------------------------
Gail R. Wilensky
31
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
SELECTED HISTORICAL FINANCIAL DATA
Year Ended December 31,
---------------------------------------------------------------------------
1998 1997 1996 1995 1994
(in thousands, except per share data)
Operations Data:
Net revenues .............. $ 1,458,607 $ 1,528,695 $ 1,616,296 $ 1,629,388 $ 1,633,699
Provisions for
restructuring and other
special charges ......... -- 48,688(a) 668,544(b) 50,560 79,814
Net income (loss) ......... 26,885 (22,260) (625,960) (52,052)(c) 28,345
Basic net income (loss)
per common share (d)..... $ 0.90 $ (0.77) $ (21.72) $ (1.81) $ 0.98
Diluted net income (loss)
per common share (d)(e).. $ 0.89 $ (0.77) $ (21.72) $ (1.81) $ 0.98
Balance Sheet Data
(at end of period):
Accounts receivable, net .. $ 220,861 $ 238,369 $ 297,743 $ 318,252 $ 360,410
Total assets .............. 1,360,240 1,400,928 1,395,066 1,853,385 1,882,663
Long-term debt ............ 413,426 482,161 515,008 1,195,566 1,153,054
Preferred stock ........... 1,000 1,000 1,000 -- --
Common stockholders' equity 566,930 540,660 537,719 295,801 386,812
Other Data:
Net cash provided by (used
in) operating activities. $ 141,382 $ 176,267 $(88,486)(f) $ 85,828 $ 37,963
Net cash used in investing
activities .............. (39,720) (35,101) (63,674) (93,087) (46,186)
Net cash (used in)
provided by financing
activities .............. (60,415) (21,465) 157,674 4,986 7,532
Adjusted EBITDA (g) ....... 158,609 153,800 166,358 176,521(c) 295,381
Bad debt expense .......... 89,428 118,223(h) 111,238 152,590(c) 59,480
Rent expense .............. 46,259 47,940 49,713 46,900 49,400
Capital expenditures ...... 39,575 30,836 70,396 74,045 93,354
(a) Includes a charge of $16 million to write-down intangible assets as
discussed in Note 5 to the Consolidated Financial Statements.
(b) Includes a charge of $445 million to write-down intangible assets as
discussed in Note 2 to the Consolidated Financial Statements.
(c) Includes a charge of $62 million to increase the provision for doubtful
accounts resulting from billing systems implementation and integration
problems at certain laboratories and increased regulatory requirements.
(d) Historical earnings per share data for periods prior to 1997 have been
restated to reflect common shares outstanding as a result of the Company's
recapitalization in 1996. In December 1996, 28.8 million common shares
were issued to effectuate the Spin-Off Distribution and establish the
Company's employee stock ownership plan.
(e) Potentially dilutive common shares primarily represent stock options.
(f) Includes the payment of Damon and other billing related settlements
totaling approximately $144 million and the settlement of amounts owed to
Corning of $45 million.
(g) Adjusted EBITDA represents income (loss) before income taxes plus net
interest expense, depreciation and amortization and special charges.
Adjusted EBITDA excluded charges of $2.5 million in 1998 and $6.8 million
in 1997 that were included in selling, general and administrative
expenses, related to the Company's consolidation of its laboratory
network. Adjusted EBITDA is presented and discussed because management
believes that Adjusted EBITDA is a useful adjunct to net income and other
measurements under generally accepted accounting principles since it is a
meaningful measure of a leveraged company's performance and ability to
meet its future debt service requirements, fund capital expenditures and
meet working capital requirements. Adjusted EBITDA is not a measure of
financial performance under generally accepted accounting principles and
should not be considered as an alternative to (i) net income (or any other
measure of performance under generally accepted accounting principles) as
a measure of performance or (ii) cash flows from operating, investing or
financing activities as an indicator of cash flows or as a measure of
liquidity.
(h) Includes a fourth quarter charge of $5.3 million, which was part of the
$6.8 million charge recorded in the same quarter, to increase the
provision for doubtful accounts to recognize the reduced recoverability of
certain receivables from accounts which will no longer be served as a
result of the Company's consolidation plan.
32
Quest Diagnostics Incorporated
Management's Discussion and Analysis of
Financial Condition a