奎斯特診斷 (DGX) 2002 Q2 法說會逐字稿

Welcome to the Quest Diagnostics second quarter 2002 conference call.

At the request of the company, this call is being recorded.

The entire contents of this call, including the presentation and question and answer session that will follow, are the copyrighted property of Quest Diagnostics, with all rights reserved.

Any redistribution, retransmission or rebroadcast of this call in any form without the express written consent of Quest Diagnostics is strictly prohibited.

Now I'd like to introduce Lori Park, Vice President of Investor Relations for Quest Diagnostics.

Thank you and good morning.

I'm here with Ken Freeman, Chairman and Chief Executive Officer of Quest Diagnostics, and Bob Hagemann, our Chief Financial Officer.

They will briefly update you on our results before we open up the call for your questions.

Some of our commentary and answers to questions may contain forward-looked statements that are based on current expectations.

Actual results could be materially different from our expectations due to factors that are detailed in our 2001 10-K and subsequent filings. as well as from unanticipated events.

Now here is Ken Freeman.

Thank you Lori.

We reported strong performance in the quarter with double digit gains in revenues, volume and net profit.

Strong cash generation enabled us to pay down $175 million in debt related to the acquisition of American Medical Laboratories.

Second quarter earnings per diluted share increased 40% on a comparable basis to last year.

This comparison reflects increasing the 2001 results for the required change in goodwill accounting and charges we took in connection with our refinancing last year.

Revenues grew by about 15% and EBITDA margin expanded by more than two percentage points to over 18%.

We're on track with the joining together of AML and Quest Diagnostics and we continue to anticipate that the Unilab transaction will be completed later this quarter.

We're addressing the Federal Trade Commissions questions and believe that the acquisition complies with antitrust laws.

Now.

Bob will review the financial results with you.

Thanks, Ken.

Strong second quarter results were driven by top line growth and further efficiency gains resulting from our standardization and Six Sigma initiatives.

Net income increased to $87.2 million, or 87 cents per diluted share, from $50.7 million or 52 cents per diluted share before the special items in 2001 which Ken mentioned earlier.

Revenues increased $137 million, or 14.7%, to $1.1 billion.

Clinical testing volume, as measured by the number of requisitions, increased 12% over the prior year, or 3.7% on a pro forma basis, assuming that AML had been part of Quest Diagnostics in the prior year.

Revenue per acquisition increased 2.4%.

In addition to the AML acquisition, gene-based and esoteric testing are driving top line growth by contributing increased volume and revenue per acquisition.

The increase in revenue per acquisition reflects favorable test and payer mix.

The continuing shift to higher value testing contributed more than half of the improvement.

Drugs of abuse testing has continued to negatively impact total company volume comparisons reducing volume by almost 1%.

Additionally, our clinical trials testing business has softened and was slightly below the prior year level, although advanced bookings have begun to improve.

Keep in mind both drugs of abuse testing and clinical trials testing are small pieces of our business, accounting for about 4% and 2% of consolidated revenues respectively.

EBITDA margin continued to expand, increasing to 18.2% from 16% of revenues.

Our Six Sigma and standardization efforts are benefiting margins and will continue to drive margin expansion in the future.

In addition, improved operating performance at our unconsolidated joint ventures, in particular Sonora Quest laboratories, contributed to EBITDA improvement and is included in other income.

Continued improvements in our billing processes, primarily driven by Six Sigma, enabled us to reduce bab debt expense to a new low, 5.2%.

This compares to 6% last year and 5.8% for the first quarter of this year.

Any sales outstanding remained unchanged at 52 days.

For the first half of 2002, net income increased to $153.8 million from $86.5 million before special items in 2001.

Earnings per diluted share increased to $1.54 from 89 cents before special items last year.

Adjusted for the change in goodwill accounting and special items incurred in 2001, earnings per diluted share increased 43%.

Revenues increased more than 11% to $2 billion.

EBITDA was 17.4% compared to 15% of revenues a year ago.

Improving our cash flow remains a primary objective for us.

During the quarter we generated $156 million of cash from operations, a 41% improvement over the prior year.

This enabled us to pay down $175 million of the $475 million we borrowed on April 1st to acquire AML.

During the quarter, capital spending was $42 million and $83 million year to date.

Our strong cash flow and balance sheet enabled us to pursue growth opportunities without sacrificing our credit rating.

During the quarter Moody's upgraded us to investment grade with a rating of BAA3 with a stable outlook.

Both Moody's and Standard & Poor's now consider us an investment grade credit.

During the quarter we also secured permanent bank financing for the cash requirements of the Unilab transaction.

For the rest of the year we intend to use our excess cash flow to aggressively retire debt and bring our capitalization ratio in line with where it was at the end of last year.

Given the current environment regarding financial reporting integrity, it is appropriate to comment on how seriously we take our responsibility to you as investors to provide full and accurate information about our financial performance.

For those of you who know us, these remarks can go without saying.

As we discuss the results, you heard a number of phrases like "on a pro forma basis, before special items in the second quarter of 2001 and adjusted for the change in goodwill accounting."

Each of these distinctions was made to provide you more clarity as to how our business has performed and, in fact, presents a comparison which is less favorable than simply supplying the as reported results, which have also been clearly stated.

This approach is consistent with our past practice.

Beginning this quarter, we are further enhancing our disclosure by voluntarily reporting the imputed cost of employee stock options in our quarterly filings.

As you know, we already do this in our annual report.

For the second quarter, the amount was 10 cents per diluted share.

Our objective has been and will always be to provide you with full and clear disclosure on how our business is performing and do it as accurately as possible, in full compliance with all accounting and reporting rules and regulations.

Now I'll turn it back to Ken, who will add his perspective.

Expanding on Bob's remarks, the fundamentals of our business are sound and so are our values.

For those of you who may not know us very well, Quest Diagnostics is a company built on six core values, which include integrity and accountability.

And as any of our more than 30,000 employees can tell you, I take the values very seriously and expect my staff and everyone at Quest Diagnostics to do the same.

As you know a number of corporate governance reforms have been proposed to enhance the integrity of financial disclosure and the accountability of corporate officers.

Most of the practices proposed by the New York Stock Exchange and the SEC are already in place at Quest Diagnostics.

Regarding the certification of financial statements, that the SEC has required for all major public companies, Bob and I will sign our names on an unqualified oath on or before August 14th.

Turning to our strategic growth plan, I'd like to share some highlights of our progress.

As you know, our growth initiatives include Six Sigma quality, new tests and technologies and selective acquisitions.

We're on track with regard to the joining together of AML and Quest Diagnostics.

We recently finalized integration plans and have begun to execute.

As we've said previously, AML has distinguished itself in serving the hospital market and we plan to leverage that expertise.

We've just established a new team that will market our full menu of laboratory services directly to hospital customers with a dedicated customer service organization designed to meet their special needs.

Having East and West Coast esoteric testing laboratories will improve service and turn around time for our hospital customers.

We're pleased with the continued growth of gene-based testing, which increased approximately 20% on an apples to apples basis, including AML in 2001.

During the quarter, volume for cystic fibrosis testing quadrupled, human papilloma virus testing doubled and drug resistance testing for HIV grew at more than a 40% rate.

In addition, we continue to explore collaborative relationships to develop new tests and testing techniques that make sense from both a medical and an economic perspective.

Anatomic pathology is another important growth area that is benefiting from additional capabilities we gained through the AML acquisition.

With almost 200 board certified pathologists on our staff, we're the largest non-hospital provider of anatomic pathology services.

These additional capabilities and our ability to attract pathologists, across a wide range of subspecialties, will enable us to further in source work which previously had been outsourced and accelerate growth in this important area.

As you know, there are several regulatory and legislative proposals being discussed in Washington that can impact our industry.

And the net impact is a potential positive for Quest Diagnostics.

During the quarter, the centers for Medicare and Medicaid services proposed a change in the way they reimburse physicians for certain procedures, including anatomic pathology reviews.

These proposed changes impact less than half of one percent of our overall business.

We estimate the potential impact, if enacted to be less than $2 million in annual revenues.

Another measure that is part of a bill passed by the House of Representatives, would increase reimbursement for anatomic pathology procedures and mitigate the impact of the proposed CMS reimbursement change for us.

The real story for us is another provision of the same house bill that would provide the first CPI increase since 1996.

This CPI increase, which would likely be in the 2 to 3% range, would apply across all clinical testing billing codes for Medicare patients.

As a result, approximately $425 million of our annual revenues would benefit from the proposed CPI increase.

Some of you have asked if the recent proposals in Washington are likely to impact non-government payers.

As we've told you in the past, we continue to face a competitive overall pricing environment.

This is not new for us.

We have a strong value proposition to offer payers, starting with our commitment to Six Sigma quality, unparalleled access, the broadest test menu and the largest medical staff available for consultation.

We remain committed to pricing discipline.

Now lets turn to our expectations for the rest of the year.

For the third quarter we're comfortable with the consensus of analyst estimates of 79 cents per diluted share as published by First Call.

In addition, for the third quarter we expect revenues to grow 15 to 16%, volume to grow approximately 12 to 13% or approximately 4% on a pro forma basis, assuming that AML had been part of Quest Diagnostics for all of 2001.

Revenue per requisition to increase 2 to 3% and EBITDA to approach 18% of revenues, adjusted for a special charge associated with the integration of AML.

The charge is expected to be between 3 and 5 million dollars.

For the full year 2002, excluding the impact of our planned acquisition of Unilab, earnings per diluted share are expected to increase to between $3.07 and $3.12, before the AML integration charge on revenue growth of 13 to 14%.

In addition, for the full year we expect volume to increase approximately 10% or approximately 4% on a pro forma basis.

Revenue per requisition to increase 2 to 3%.

EBITDA to exceed 17% of revenues.

Net interest expense of $55 to $60 million.

Amortorization expense of about $9 million, and capital spending of $160 to $170 million.

To summarize, we continue to generate strong financial performance driven by revenue growth and operating efficiencies.

Our growth initiatives have established a solid foundation for top line growth and improved profitability.

Our strong cash flow continues to strengthen the balance sheet and positions us to capitalize on unique growth opportunities.

And we remain committed to our financial goals, achieving sustainable double digit revenue growth through a combination of organic growth and selective acquisitions, raising EBITDA margins to levels greater than 20% and continuing to deliver earnings per share growth of at least 30% this year and next.

And we are well-positioned to deliver outstanding returns for our shareholders for years to come.

We'll now open up the call for your questions.

Operator?

If you'd like to ask a question, press star 1.

To withdraw your question, press star 2.

Once again, to ask a question, press star 1.

Our first question comes from David Lewis from Thomas Weisel Partners .

Morning.

The first question was, it appears gross margins fell slightly on the quarter versus our estimate.

Is this related to the AML cost structure, and could you comment on pricing trends at AML during integration?

With respect -- David, with respect to margins, you're right that the trend has changed a little bit from the first quarter, but that's essentially because of the inclusion of AML, whose profitability was actually lower than ours.

When you look at cost of sales and SG&A, the way you should think about it is, AML had a much higher cost of sales number than we did and in effect has impacted our improvement there a little bit on a reported basis.

And they had a much lower SG&A number than we did as a percentage of sales.

So, it's helped the comparison there a little bit.

But as we get the synergies that we've contemplated from AML, you're going to see that profitability for that business come in line with Quest's profitability.

And in this quarter if you were to take out the impact of AML, you would have seen an improvement in the margin similar to what you saw in the previous quarter, over the prior year.

O.K.

And they may be [INAUDIBLE] costs over to organic growth.

If you look across your business segments, what would you say is the most critical metric involved with organic growth right now?

Is it new markets -- the pursuit of new markets, same store sales, or is it molecular testing?

Is there one that is the principal driver right now?

There's no one are that's the principal driver.

What you've just outlined certainly are three of the very most important areas, David.

O.K., then lastly, Ken, you mentioned, and have been increasingly mentioning the last three or four months, about a movement into pathology .

Can you comment -- obviously Quest has a lot of pathologists, that do basic pathology.

Can you comment about specific steps the Company is going to take to move into [INAUDIBLE] pathology or higher valued pathology services?

Thank you very much.

Moving into the higher value services is really what Ken was outlining in his speech.

And we're focusing in on that by hiring pathologists with specialties in the subspecialties.

Additionally, AML brings additional capability in this area, which we are going to leverage as we expand the business.

O.K., thank you.

Our next question comes from Tom Gallucci from Merrill Lynch.

Good morning, everyone.

Two questions, if I could.

First, on the margins, obviously you just gave a little bit of color there, but they did improve significantly.

You gave what bad debt expense did and just generally you mentioned Six Sigma helping.

Can you talk about some of the areas of focus and where were some of other areas improvements, the physical, the quarter and what are you looking at going forward?

The second would be in terms of malpractice insurance.

You were just talking about pathology and the doctors there.

Obviously it's been a big topic.

Can you talk about how Quest handles malpractice insurance and what the costs are this year versus your initial expectations?

Let's start with Six Sigma and standardization.

And remember we're looking at those together because we're using Six Sigma to drive our standardization initiatives.

But they're in all areas of the business.

Certainly billing is a big area for us because it has significant opportunity there because of how labor-intensive it is and because of the large number of transactions that go through there.

But we are looking at all areas within the laboratory and outside the laboratory.

Lab supplies, productivity within the laboratory itself, productivity at our patient service centers, we're looking at telecommunications, we're looking at purchasing.

So, it's the whole gamut.

Everything in the business is going to be impacted by Six Sigma and standardization, and we're starting to see it in all areas.

As I said, bad debt is probably the area where there's the biggest opportunity.

And keep in mind we've targeted bad debt expense long-term to be at or below 4% of revenue.

So, we still have room to go there.

You also asked about malpractice insurance.

Keep in mind that the biggest driver of our costs for general and professional liabilities is anatomic pathology.

Also keep in mind that that's a relatively small piece of our business today, although it's growing rapidly.

It's about 10% of our total revenues.

With respect to our insurance programs, the way they're structured is that we are principally self-insured.

A lot of this is discussed in our 10-K, under the critical accounting policies in MD & A. But essentially what we have is a cap on a per claim basis, although it's relatively high.

And in the end what's going to drive our cost for general and professional liability will be claims rather than premiums, although our premiums are up significantly versus the prior year.

The principal factor in driving our experience -- or our costs is going to be our claims experience.

And what we're seeing there is we're starting to see some positive trends.

In the prior years prior to implementing Six Sigma, we had a number of quality initiatives ongoing in that area, which are starting to bear fruit today.

Six Sigma is going to further improve quality there.

And in addition, the conversion to the thin prep pap test is also going to help to reduce claims in that area.

Although we're seeing higher cost, it's fully baked into the guidance that we've give than you.

And we're not concerned about how that might impact our earnings as we go forward.

Can you just give an order of magnitude of what malpractice expense is on the income statement?

To give you a general sense, think of our costs for general and professional liability in terms of about 1% of revenues.

Great.

Thank you.

Ask him my question [INAUDIBLE]

Our next question comes from Louis Sarkus from Chesapeake Partners.

Hi, good morning and congratulations.

Could you go over, can your growth expectations for internal versus external, you know, what is organic growth and what will you add from acquisitions?

As you know, we have our 10, 20, 30 objectives to drive top line growth in a typical year by around 10%, drive our EBITDA margins to at least 20% and sustain them and continue to drive 30% -- at least 30% earnings per share growth this year and next.

As we look at the 10% revenue growth objectives for our company, we tend to think of 7 to 8 percentage points of the 10 coming organically and two to three points in a typical year coming from selective acquisitions.

O.K., and can you explain the importance of capitated contracts and just as issues have been raised, how it relates to the Unilab transaction?

Well specific to how we deal with managed care companies in general across the country, we tend to negotiate a collection of rates with managed care companies to include fee for service as well as capitated plans.

So, a multitude of plans with each of the managed care companies.

And so, we drive our approach to pricing in our business and in terms of doing our relationships to managed care companies, in the context of the overall relationship.

That's what we mean by driving pricing discipline.

Okay.

And just finally, in terms of the Unilab transaction, can you just give us a better sense in terms of where you are with the FTC, and, you know, just a sense is this deal as important to you as ever, and, you know, are you as excited about this today as you were, you know, on the day that you signed it?

We're absolutely working with the FTC to address their questions.

We're aggressively working to make those questions become answers.

We believe that the transaction does not violate any anti-trust laws and we are excited at the prospects of joining Unilab and Quest Diagnostics together and expect to close the transaction during the third quarter.

O.K., and are you as excited today after, you know, seeing what you've seen over the past few months as you were on the day that you signed it?

Absolutely.

Thank you very much.

Our next question comes from Andrea Bici of Salomon Barney.

Good morning.

Just a quick question, can you maybe elaborate on any esoteric testing initiatives, you know, [INAUDIBLE] cancer screening, its, you know, one that seems to be the new one in addition to the cystic fibrosis.

And then combined with AML, where is thin prep penetration and do you see an opportunity to deploy that through AML's customer base?

Let's start with thin prep pap tests.

For the quarter we were at 72% penetration across the network.

We expect that to continue to trend upward.

And some of our business units across the country are at 90% plus.

We exited the quarter at around 74% in terms of run rate.

So, we see no reason why thin prep pap test conversion can't go virtually complete in that area of our testing menu.

At AML their conversion rates were slightly lower than ours, and we expect to see that continue to catch up and move forward in coming up quarters.

With respect to new esoteric tests and what have you, I'm not going to get particularly specific with you Andrea, but I will highlight the fact that we have a very good, solid pipeline of potential new products coming along with great potential.

We have recently, in the last six months implemented a process that has been used in industry for years but not in the lab world, in terms of new product launches, in terms of the identification, the development and then the operationalization of new products that we're very excited about.

Our focus areas in terms of disease states are cardiovascular disease, infectious disease and oncology.

Great, and one last question.

Did you have an updated Unita and Aetna contract in the second quarter?

Was that renegotiated at a different rate?

No, we did not, Andrea.

Okay.

Thanks.

Our next question comes from Deborah Lawson from Salomon Smith Barney.

Good morning.

I just have one question.

With regard to your comments on pathology, should we take your comments, your pointed comments on the pathology business here this morning to mean that the Company is making a more pointed turn towards this business, placing greater emphasis on it than you have in the past?

Would I be interpreting that correctly?

What you can assume is this, as we look at the disease states that are driving health care in this country, diagnosis and prognosis, it all boils down to cardiovascular, infectious disease and oncology, as the three most significant disease states.

When you think about oncology, you have to think about anatomic pathology.

As the population ages, this is a very significant area of growth opportunity, as we've said before.

So, as we evaluate the opportunities in front of us certainly we see continuing to grow our anatomic pathology business as an important opportunity.

But I wouldn't misread the discussion this morning to say that we're going out on a limb in terms of a very, very dramatic change in our approach.

Assume that this is Quest Diagnostics doing what it does best, being very deliberate, being very specific in making its moves in the marketplace to drive profitable growth across its network.

Okay.

Very good.

Thank you.

Our next question comes from Bill Bonello from Wachovia Securities.

Hey guys.

Just a couple of questions.

I'm wondering if you can give a little bit more of an explanation, I just want to make sure I understand the pro forma volume number that you gave.

If I understand that correctly, that number still includes growth from CDS and the Puerto Rico acquisition?

Yes, it does.

O.K., and then can you tell us, did AML complete any acquisitions over the past 12 months?

Not -- nothing substantial at all.

Okay.

So, the -- if we were sort of to look at sort of a true organic volume growth number, it might be something just slightly under 3%?

Correct.

Okay.

Great.

And then, you mentioned that you've been creating a hospital sales force.

Can you give us any sense, have you retained as part of that most of the AML sales force?

Yes, we have, Bill.

We've just announced the leadership of our hospital sales organization for Quest Diagnostics moving forward.

And the leader of that organization in fact is an individual who came from AML, her name is Vicky DeFrancesca, who is a very seasoned professional in dealing with the hospital environment.

We're very pleased that she's leading the efforts, as Dave Zewee, who you know, heads up the overall hospital business.

At this point in time we're also pleased to report that the overall organization is very much intact, from both old AML and old Quest Diagnostics, in serving the hospital business.

Great, and then just one final question, to beat a dead horse here.

I think we're all trying to get to the same answer.

But if we looked at your anatomic pathology, can you just give us any sense right now of about how much business you currently outsource and over what time period you might be able to internalize that?

Bill, we haven't tended to disclose the amount of outsourcing of our business in any area.

Assume that we perform the majority of anatomic pathology in house and that we will be very deliberate in bringing work in house across the country, step by step, inch by inch.

Okay.

Thanks a lot.

Our next question comes from Simon Alcheskas from KCB Asset Management.

Hi, I just have a couple quick questions for you in regard to the merger with Unilab.

First, is there any basis for the rumors that we've been hearing out in the marketplace that, 1, the FTC is upset at your response to the second request, and, 2, that the FTC is poised to block the transaction unless the divestiture is made in northern California?

Well what I can say is this, we are working very closely with the FTC to address their questions.

We do believe the transaction does not violate antitrust laws and we expect to close the transaction during the third quarter.

We're not going to discuss specifics this morning.

We just don't believe it's good business practice.

Our policy is not to speculate or work on rumors, so our intent is really not to make this a public discussion.

Any discussions that are ongoing are really between the FTC, Quest Diagnostics, and of course, Unilab.

I agree a hundred percent.

So, you would, I guess, qualify the rumors as just rumors?

I will have no comment on specific rumors or speculation because that's our policy and that's the best way to do business.

Great.

Thanks a lot.

Our next question comes from Sandy Draper from Sun Trust Robinson Humphrey.

Thanks.

Just a follow-up on the volume question.

I'm trying to understand, when you give your guidance this year of 4% pro forma, and when you look at the price as 2 to 3%, I'm trying to -- does that mean that volume pro forma would only be at 1 to 2%?

No.

I think you're perhaps confusing volume and price and thinking they're one and the same.

They're two distinct elements.

We expect price to be up two to three percentage points and we expect for the year that the pro forma will be approximately 4% on volume.

Okay.

So, volume pro forma, O.K.

And its pro forma only for the AML acquisition.

Okay.

If I look, though, and sort of assuming some numbers of AML, back the envelope, you know, I think they grew 14% last year.

If they grew 10% this year to get in your revenue range, I sort of had to bring down the total growth, not volume, to sort of, you know, 4 to 5%.

Is that -- I'm not sure if I'm missing something, because that would seem to me that volume would be a little bit lower than what you indicated.

Well, keep in mind that AML is a relatively small piece of our business.

It's less than 10% of our totals revenues.

We have it for three quarters of the year, and essentially the volume guidance that we provided is really unchanged when you strip out the impact of AML.

Okay.

Thanks.

Our next question comes from Ricky Goldwasser from UBS Warburg.

Good morning.

You did a wonderful job lowering built in expense in the past year [INAUDIBLE] compensation of the sales force, work production and recently implemented the [INAUDIBLE] system.

Can you give us specific examples of how you can further drive costs out of the system and reduce that expense to that 4% level you are talking about?

And also, what's the timing on it?

Should we assume 50 basis points reduction per year on an ongoing basis?

Rikki, what we're going to be doing over the next several years to drive bab debt is much of what we've been doing to date.

One is working on the blocking and tackling, it's going after the missing information, which is the principal driver of bad debt.

A number of specific things that we see happening which are going to help reduce that missing information are, as we start to increase the electronic connectivity with our customers, we'll be getting better information in up front.

Which is going to drive down that missing information and improve the collectability of the receivables that we book.

Additionally Hippa, as that goes into place it's going to be a net plus for us.

Because all the payers are going to be required to talk to each other in a standard way.

And as you think about timing, think about us getting to 4% over the next several years.

We're not going to see a one or two percent drop in a year.

It's going to be slow and steady progress as we continue to implement our Six Sigma initiatives, go after each of the pieces of billing and then replicate those solutions across all our business.

And what percentage requisitions have missing information?

By the end of 2001, Ricky, the numbers were around a little more than 5%.

And as we've moved forward now, we're below the 5% level.

And it's driven by reducing incorrect billing information using the Six Sigma techniques.

And there's much more room to go on that very critical measure.

And the guidance from '02, does that include the proceeds from the Arizona joint venture?

The Arizona joint venture equity earnings are included in the other line.

And they are part of our guidance.

So, that is part of the guidance?

Absolutely.

It affects net income reported for our company.

And if has been all along.

And one last question is regarding the anatomic pathology market.

I guess a more specific question is when you talk about bringing in house some of the anatomic pathology business, are you also talking -- are you talking specifically about the pap smear market?

And if so, is the work that you outsource included in your 72% conversion of thin prep?

And if it is, will that mean that thin prep basically will increase profitability for that line of business?

Let me take the first piece.

You're correct, the piece that's outsourced is primarily cytology work, that's currently being outsourced.

When we do our thin prep calc -- thin prep conversion calculation, we include in it what the thin prep conversion ratio of outsource pap smears, as well.

Insourcing it should not impact the thin prep conversion rate.

That's a function of how we work and our sales force works with the physician's office.

What will change is we're able to bring the work internally as we'll be able to better manage the entire process stream and maintain control of the specimen from start to finish, insuring quality, turn around time and ultimately also assisting in cost reduction.

[INAUDIBLE]

We have additional capacity through the AML acquisition as well as through our efforts to add additional capacity through additional hiring.

And you do about 12 million Pap smears right now?

Round numbers.

That's post acquisition of AML.

12 is post?

It's post acquisition.

O.K., and that includes the volume that you outsource?

Yes.

Okay.

And on the 74% exit run rate for thin preps, is that about 72 run rates at the end of the first quarter?

The 72% is an average for the quarter.

At the end of Q1 we were at 70%. 74% was our exit rate at the end of the month of June.

As Ken mentioned, it's important to note that some of our business units have already achieved in excess of a 90% conversion rate.

Which shows you that we really can take that conversion rate higher and we have opportunity with the combination of AML.

And the 70 was the average for the first quarter?

70 was the average for the first quarter.

So, we should compare 70 to 72?

That's correct.

Thank you very much.

Our next question comes from Kemp Dolliver from SG Cowen Securities.

Thank you.

Could you just quickly outline the assumptions you're making regarding the drugs of abuse business over the balance of the year as it pertains to the volume guidance?

Essentially what we've seen is the drugs of abuse testing business comparisons to the prior year, slowly improving as we go out through the year.

Not dramatically, but slowly improving as we go out through the year.

And that's a function of a number of things that we are doing to introduce new testing techniques, hair testing technologies and the like, and not solely reliant on the economy turning around.

Okay.

Great.

And with regard to the joint ventures, you mentioned Sonora Quest.

But could you give us a broader discussion of the performance of the joint ventures, how their volume growth -- or volume or revenue growth compares to, you know, the consolidated numbers?

Obviously the profitability is going up a little more color in terms of how those ventures compare to the consolidated results.

Sure, Kemp.

Let's first think about who are the nonconsolidated joint ventures.

We mentioned Sonora Quest our joint venture in Arizona.

We also have a joint venture called Mid-America clinical laboratories in Indianapolis, Indiana, and also a joint venture called Compunet in Dayton, Ohio.

These are our unconsolidated joint ventures.

To which we equitize our proportionate share of income.

In aggregate, taking them all together, the growth rate of those three businesses is a bit higher than the growth rate of our consolidated operations.

Their profitability is improving at a nice pace in all counts, as well.

And we are generally pleased with the performance of each of those ventures.

Okay.

Great.

And one final question on the -- with regard to pricing.

This quarter was in line with your thoughts.

Q1 had come in nicely above what you all had looked for for the year.

Anything in particular that accounts for the difference in the price increase in Q2 versus Q1

Kemp, there's a few things to keep in mind.

First we said that pricing was going to increase between 2 and 3% for the full year with the increases in the latter part of the year slightly less than they were in the first part.

And that's due to a number of things, certain contracts anniversaring as well as a lesser impact of payer mix shift in the later quarters, because the comparisons are a little tougher as we get out throughout the year.

And we've said also that we see pricing longer term in the 2-3% range as we look ahead beyond the end of this year.

Great.

Thank you.

Our next question comes from Angie Samfilippo from U.S. Bancorp.

Good morning.

Could you comment on the success that you've seen with your recently retooled sales force and their ability to drive growth going forward?

And then secondly, could you also comment on customer attrition with the AML acquisition, whether or not it's been at or below expectations?

Thank you.

Starting with customer attrition at the AML integration, we're not seeing any significant attrition whatsoever.

We're working very deliberately customer by customer to retain the business step by step and inch by inch as we've done in the past.

And in terms of our efforts with our sales force, we are beginning to get traction.

Quite frankly, I am not happy with the progress we're making in driving volume growth in the Company.

We're not yet where we want to be.

We are gradually improving, no question about it, slowly and steadily in line with the guidance we've been providing to you.

And our guidance for quarter 3 and 4 reflects volume continuing to slowly improve.

There's no real new news here in that respect.

In terms of the success of the organization in moving forward and to date in the sales organization, as we've been retooling it and reorientsing its sales time.

We are seeing some early success as it relates to our genomic and esoteric testing sales force.

Where they're driving nice business gains in the marketplace as it relates to our gene-based and our esoteric testing menu.

So, overall, all in all done, you shouldn't assume that I'm really happy.

We're not yet where we want to be.

But we are delivering what we're saying to you in terms of our guidance.

And our entire sales team is fully aware of the challenge and is up for the challenge of continuing to drive acceleration of volume growth gradually as we complete this year and go into next.

Thank you.

Our next question comes from Matthew Beuten from Argus Partners.

Hi, thanks very much.

And congrats on a great quarter.

Can you just elaborate on the organic growth from volume perspective in this quarter excluding the acquisitions that you talked about?

And also maybe talk about why the guidance for volume growth was reduced a little?

Is this associated with AML integration or drugs of abuse testing?

Just give us a little color on why you took that range in a little.

Matt, as we said earlier, the volume growth ex any acquisitions at all is just a little below 3% and is very consistent with the guidance that we had provided earlier.

And with respect to the full year guidance, we're really not changing it.

We're essentially tightening the range a little bit.

We're a little further into the year at this point.

We have better visibility as to how the whole year is going to come out.

And as we've said all along, volume would slowly ramp up as the year progresses.

And given the guidance that we provided for Q3 in the full year, it reflects a slow improvement there in terms of volume.

On revenue side, keep in mind that the clinical trials testing business is a little softer than we thought it would be, and that impacts the overall revenue growth, but not volumes that we report.

Great.

Thanks very much.

Our next question comes from Gary Lieberman from Morgan Stanley.

Good morning.

You talked about the strength in the JVs, your other income line, was very strong.

Can you talk a little bit more specifically and perhaps put some numbers in terms of what drove the strengths and compare it to the year ago period

Essentially, as Ken said earlier, it's organic volume growth and continuing to work on driving efficiencies driven principally by Six Sigma.

We're deploying the Six Sigma effort across all our joint ventures, including those that we don't have majority ownership in.

And that's starting to have a significant impact in those marketplaces.

Were there any one-time gains in the quarter that were in the other line?

In the other line we had some small gains from some asset sales.

And when you net those with some other expenses that were in there, it's less than a million dollars in the quarter.

O.K., and if I could ask one other question, what kind of pressure are you seeing on your work force in terms of, you know, just the short supply of lab technicians?

Has it improved?

Has it gotten worse?

I'd say, Gary, that it's relatively unchanged.

Certainly we have pockets of shortages around the Company, but nothing different than it's been in the last several quarters.

We are a company that offers highly competitive pay and benefits.

We offer the best benefits program in the industry.

And as a result, that's very, very important.

And in today's world, our focus on values is proving to be a real positive.

At this point in time we also, as you may know, have a cytology school that is part of joining together with AML out in Las Vegas where we're training cytotechs on site.

In addition, in selected locations around the country we're providing scholarship monies and assistance to colleges to help provide appropriate training for med-techs moving forward.

But the bottom line of all of this is, we think that the combination of our values, our comp and benefits and our focus on Six Sigma, which is all about quality, is proving, and it shows in our ability to hire, to be a very important source of competitive advantage for us in the marketplace at large.

Thanks a lot.

Our next question comes from Robert Willoughby from Credit Suisse First Boston.

Thank you.

Ken, with the stock down sharply 40% or so I guess over the last couple of months, really in a horrible market, but I'm not sure I agree with the historical answer that you've got better uses for your cash flow in this environment than more agressive debt reduction or share repurchases.

It was actually a very nice quarter from a debt reduction standpoint, but aren't there more positive signals to send than what you might have done a year ago?

And secondly, why haven't we seen more in the way of insider buying?

Robert, let me comment with respect -- regarding the first piece here on potential stock repurchases.

At this point we have no specific plans.

And as we've said before, we do see significant growth opportunities for us to invest in.

We would make any decision to buy back shares fully considering our capital structure guidelines.

Remember, we want to maintain an investment grade credit rating.

And we may consider a limited share repurchase program in the future, to potentially offset the dilution associated with stock options.

But, at this point as I said, we have no specific plans, nor do we have a target price at which we would begin to buy back shares.

I guess that's the historical answer, though.

Is there really no update for the current environment that you're in?

It's certainly a much more nervous market these days.

Bob, what we would do is just typically we evaluate the potential for repurchase shares on a regular basis.

So this is something we consider every time the Board of Directors meets.

And at this point in time the policy that Bob has indicated to you is our current position.

As it relates to insider buying, certainly the decision to be a buyer among management is an individual decision.

This is not something the Company governs one way or the other.

You do not have any mandatory ownership programs?

We don't have any requirements of individuals to be buyers.

We certainly, if you look at the trading activity of managers in our company over the course of the last year.

About 20% of the options that have been outstanding have been exercised in a general way.

That is not disproportionate to the overall pool of employees that have received stock options.

We do keep a close eye on it.

But in the end the decision is an intensely individual decision.

Thank you.

Our next question comes from Mark Miller from Bank of America.

Good morning.

What assumptions are you making for equity earnings going forward?

You should expect that they'll show the sort of improvement that we've seen in the first half of this year.

Remember, some of our joint ventures are cyclical a little bit.

They're more seasonal, I should say, in that Sonora Quest laboratories typically is a little softer in the summer months out in Phoenix and stronger in the winter months.

But we're expecting the same sort of growth that we've seen generally in the first -- in the second half that we saw in the first half.

Great.

Thank you.

Our next question comes from Rick Sullivan from SAC Capital.

My question was just answered.

Thanks.

Our next question comes from Theresa Womble, Morgan Keegan.

I was wondering if you could take a step back for a second and look at the broader hospital market and talk about any changes you see there in terms of hospital outreach laboratories and the pressures that they face and what opportunities this has with your AML acquisition and then any rebranding process that might be going on with AML and Quest unified in the hospital marketing effort and what challenges you face there.

In terms of the hospital marketplace in general, as you know, it's historically been an intensely competitive business to begin with.

And then certainly hospitals every day, some hospitals decide to initiate the opportunity to potentially do outreach testing, but for every hospital that tends to go in that direction there's typically another hospital or hospital group that's leaning in the other direction.

And as we look at the overall market, you know that about 60% of the total laboratory testing performed in this country is in fact, in terms of revenues, is performed in hospitals, in patient, outpatient, as well as outreach.

We believe that the hospital segment is a very important opportunity to help us accelerate growth.

Today we are the leading provider of testing for the hospital marketplace.

Our value proposition as a result of the acquisition of AML, putting on top of it our expertise -- traditional expertise at Nichols Institute, gives us an outstanding opportunity to be the undisputed leader in the hospital business.

We're the only company now that has East and West Coast esoteric testing capabilities.

We intend to name both facilities, both Chantilly in Virginia, and San Juan Capistrano will be known as Nichols Institute.

To your branding question.

We have state of the art information technology connectivity options, which are very important for hospitals.

As well as our capabilities as it relates to consultation.

So, moving forward, we see the opportunity to drive our leadership in technology innovation, our ability to partner with hospitals on an individual basis knowing that each hospital is unique in and of itself, and our reputation for service excellence, particularly the excellence that we derive from AML to drive outstanding opportunities for growth in that segment.

Thank you.

All my other questions have been answered.

Our next question comes from Andrew Bhak from Goldman Sachs.

Good morning.

Just taking a step back, and as we think about price and volume drivers of your top line.

Putting aside volume and thinking about price, I think it's -- to me it's relatively straight forward exercise on the Medicare side instead of an annual process.

And in fact it looks like it's in our view that there's a potential for upside relative to the past.

I was wondering, though, sort of in that context if you could review sort of the mechanics and the process with respect to some of the other payer classes.

With an eye towards thinking about, sort of, the predictability of the revenue stream or -- you know, so, you know, along those lines.

Thanks.

Andrew, let me remind you we think about pricings, first of all, it's a very competitive environment.

We do see 2-3% this year and beyond.

Test mix has been and will continue to be a component of that.

Payer mix shift has also been a component of that, but will be less of a component as we go forward.

Each year on an annual basis we're looking for reasonable pricing on any new or renewed contracts that we've got.

And typically we also have annual fee increases on our patient billing as well as our client billing.

And historically prior to the integration of SBCL where we got to in effect restructure a number of major contracts, the pricing in this business was about 2-3%, consistent with what we're telling you going forward.

O.K., just one quick follow-up, though.

I wasn't actually so much focused on sort of the rates of increase, but more sort of as we think about contracts with commercial insurance/managed care, sort of as we roll through the year, sort of how those contracts or that book of business, if you will, are spread.

Is it rateable over the course of the year?

Is there any one period where there's a higher than sort of rateable contract renewal dollar volume occurring?

More sort of mechanical or process.

Thanks.

Andrew, there aren't any particular spikes or valleys as it relates to this.

In a typical year we'll renegotiate a small handful of contracts with large providers.

And remember that no contract with managed care represents more than 5% of revenues.

So, any contract will not be of any huge, huge magnitude for the corporation.

As we drive forward in the pricing environment, also keep something else in mind, that there's a lot of leakage out there with managed care contracts in general.

Where they will potentially as a managed care company contract with companies like Quest Diagnostics and pay a rate that's contractually agreed.

But then there may being leakage, tests that are done by other providers in the geographic area that the managed care company is obligated to pay retail for.

The opportunity is for those large managed care companies in particular to help drive that leakage in our direction, towards those of their contracted providers.

It helps provide us benefits as well as benefits for the managed care company.

We see that as an important component of driving profitable growth in the future, as well.

Okay.

Great.

Thanks very much.

Our next question comes from Robert Yafcheck from Citadel.

My question has been answered.

Thank you.

Our next question comes from John Szabo from CIBC World Markets.

Good morning.

What was the cash flow from operations number?

Cash from operations was $156 million in the quarter.

And Cap-X?

Cap-X was $42 million in the quarter.

Okay.

Bob, could you just talk about the bad debt expense reduction?

Are there any major assumptions that you make sort of quarter to quarter in that calculation, and could you just talk about that a little bit?

Sure.

We have a very rigorous process that we go through to analyze our bad debt reserves every month.

And we have certain points at which a receivable upon, when it's aged, has to be written off.

We've had no changes to that policy for the last several years.

It was put in place actually prior to our spin-off, and it's something that gets, as you would expect, very close scrutiny from Price Waterhouse Coopers every quarter when we go through it.

And the other thing I would tell you to look at is, as you're looking at bad debt, I think you always ought to be looking at DSOs.

If bad debt is coming down and DSOs are starting to ramp way up, that's a bad sign.

If you look over the past several years our bad debt has come down as well as our DSOs have come down.

Is it fair to say that a lot of that reduction in bad debt was AML-related?

And I guess just to understand that DSO calculation, I guess it was my understanding that their DSO was considerably higher than yours?

Is that right.

To your first question, none of the improvement is associated with AML.

In fact, their bad debt is slightly higher than that of Quest Diagnostics, as well as the DSOs were slightly higher than that of Quest Diagnostics.

And what you see in the results that we've reported is the combined results of the two companies there.

Okay.

So, any improvement you may drive in that bad debt line at AML is still to come?

In other words --

Absolutely.

It's one of the pieces of the synergies that we identified.

So, you didn't really get much of it at all in this quarter?

Not really.

It's a little early, it takes some time to put these processes in place.

Okay.

Thanks.

Our next question comes from John Massey from Bear Sterns.

Good morning.

Nice quarter.

Can you tell me if there was any impact on pricing from AML?

AML's prices are about the same level as Quest Diagnostics and really have no significant impact at all on our overall price comparisons.

O.K., so on a pro forma basis it will look the same?

Yes.

Okay.

In terms of cash flow guidance, can you throw out something?

Our guidance for cash flow for the year is, we look at free cash flow which we define as cash from operations less Cap-X.

And you should expect that to approach 400 million for the full year.

O.K.

I guess last week there was a conference call by one of the large managed care companies, and one of the comments on the call was that clinical testing was getting a little bit out of control.

And I wonder if you could comment on that and what you're seeing in your conversations with them and maybe your contract.

We see nothing that relates to despair, which sounds like what you're saying on their end, whoever that might have been.

What we do see is very much the opportunity to drive leakage reduction.

The problem that several managed care companies have as it relates to clinical laboratory testing, is not with their contracted providers, but with the fact that they have a significant amount of their volumes going out of network and being paid at retail.

So, the opportunity is to bring that work into the contracted providers, which provides an important strategic opportunity for us as we move our business forward.

Keep in mind, also, that we have a product today that is in use at some of the more regionally-oriented managed care companies, called Quest Net, Net, Quest Net.

It's a product used to today at regional managed care companies to help manage the overall clinical laboratories spend and to help control leakage to the benefit in the end of the managed care company and also to Quest Diagnostics.

Great.

And last question, you raised your guidance by about 4 cents this quarter, which is what you beat it by.

And I guess last quarter you beat numbers by about 7 cents and in the previous three quarters by 4 cents.

Is there any reason why I shouldn't expect you guys to beat the high end of your guidance for the full year?

I mean you guys are doing a superb job.

It just seems like, you know, you guys are low balling it.

You know that our guidance is our guidance.

We tend to do what we say we're going to do.

Certainly we like to put out there guidance that you can be confident in in moving forward.

And our guidance for the year reflects our traditional approach.

Great, well keep up the good work.

Thanks.

Our next question comes from Andrea Bicci from Salomon Barney.

Hi, just a follow up question.

Can you give a little more color on your plans for your Cap-X?

Like how much is sort of routine maintenance and how much -- if there's any expansion or if you're contracting capacity or upgrading facilities -- you know lab facilities?

What I might start with Andrea, as Bob gives you a little more color generally, we are managing our capital spending like we manage our overall expenses across the company in a very rigorous way.

I will highlight for you however, that as part of the Cap-X over the last couple of quarters, we have opened the state of the art data center for our industry, near Philadelphia, that provides very highly secure capabilities for managing the data, which is so highly proprietary, in one spot.

And we're very excited about the prospects.

And that has contributed to our capital spending during the first half of the year.

Andrea, our guidance for capital for the full year is between $160 and $170 million, which equates to about 4% of revenues, which is what we've said we see for the next several years or so in terms of percentage of revenues.

And if you want to think about where the capital's being deployed, think about it as about a third in information technology, some of the things that Ken just talked about.

Think about it as a third in various equipment in the laboratory.

And also think about a third in terms of overall facilities.

When you think about our business, though, think about anything generally over 2-3% as being investment capital.

You know, true capital that you're investing in the business versus replacement capital.

So, 2-3% is what you should think about as replacement capital.

Thank you.

Our next question comes from Andrews Bhak from Goldman Sachs.

Thanks.

Just a quick question.

Am I correct in thinking that the slight dip in the allowance [INAUDIBLE] as a percentage of gross receivables was simply a function of purchase accounting with AML?

No.

Actually it's simply a function of the fact that we've written off older things against the reserve that we have.

Our agings have dramatically improved in the over 90-day category.

Some of that is a result of collecting it and some of it is as a result of writing off things which have been fully reserved.

O.K., excellent.

Thanks very much.

Thank you for participating in the Quest Diagnostics second quarter 2002 conference call.

Investors in the U.S. may listen to a replay of this call by dialing 888-567-0410.

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Thank you and goodbye.