奎斯特診斷 (DGX) 2002 Q3 法說會逐字稿

Welcome to the Quest Diagnostics third 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 turn -- now I'd like to introduce Laure Park, Vice President of Investor Relations for Quest Diagnostics.

Go ahead, please.

Thank you.

And good morning.

I'm here this morning 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-looking 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, Laurie.

We delivered strong performance in the quarter.

Earnings increased 45%, revenues grew more than 17% and EBITDA was 18.2% of revenues.

We're executing our strategy to create long-term sustainable shareholder value by focusing on quality, customer and employee satisfaction, our growth initiatives and standardizing our operations.

Now Bob will review how our focus translates into financial results.

Thanks, Ken.

Top-line growth and efficiency gaines resulted from our standardization and Six Sigma initiatives continue to drive strong improvements in performance.

Net income increased to $87 million, or 87 cents per diluted share, from $50 million, or 51 cents per diluted share in 2001.

This represents a 45% increase after adjusting the prior year results for the required change in goodwill accounting.

Revenues increased $156 million, or 17.2%, to $1.1 billion.

Taking a closer look at the revenue growth, clinical testing volume increased 13.7% over the prior year.

Assuming that AML had been part of Quest Diagnostics last year pro forma volume grew by 5% during the quarter, 1% higher than our previous guidance.

We continue to see strong growth in gene-based and esoteric testing.

Gene-based testing revenues grew at a greater than 20% rate.

During the quarter, our drugs of abuse testing business was essentially flat compared to the prior year.

A strong improvement from the 9% decline last quarter.

Throughout most of the quarter we saw a spike in drug screens from the FAAs new Transportation Security Administration as they screen potential candidates for new federal airport security positions across the nation.

This additional volume which is expected to scale back to normal levels early in the fourth quarter contributed almost half of the favorability to our volume guidance.

Bond comparisons to the prior year were favorably impacted by approximately 1% due to the events of September 11th last year.

It is important to note that this impact was fully anticipated in the guidance we previously supplied to you.

Revenue per acquisition grew 2.9% during the quarter.

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

The continuing increase in higher value testing including gene-based testing, contributed the majority of the improvement.

EBITDA margin continued to expand, increasing to 18.2% of revenues from 15.7% a year ago.

As our Six Sigma and standardization efforts gain momentum across all aspects of our business.

Improvements in our billing processes enabled us to continue reducing bad debt expense.

Bad debt was 5.1% of revenues compared to 6.1% last year and 5.2% for the second quarter of this year.

Our long-term goal for bad debt continues to be 4% or less.

Day sales outstanding improved to 51 days from 52 days last quarter.

The AML integration is on track.

During the quarter, we finalized the charge associated with the integration amounting to $1.5 million pre-tax.

Another $9 million in integration costs were recorded as part of the AML acquisition cost.

This brings total integration costs to approximately $11 million within our previous guidance of 10 to $15 million.

The $1.5 million integration charge was offset by a pre-tax gain of $3.8 million from an investment.

These items contributed approximately 1 cent per share in the quarter.

For the first nine months of 2002, net income increased to $240 million from $137 million before special items in 2001.

Earnings per diluted share increased to $2.41 from $1.40 before special items last year.

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

Revenues increased more than 13% to $3.1 billion.

EBITDA was 17.7% of revenues compared to 15.2% a year ago.

Cash from operations totaled $132 million for the third quarter compared to $149.6 million last year.

During the quarter, several payments, in particular semiannual interest payments and a one-time contractual settlement in contract payment came due which impacted the comparisons to last year by almost $40 million.

In addition, tax benefits associated with stock option exercises or approximately $15 million lower than a year ago.

Cash generated from operations remains strong.

Despite the impact of these various items on the quarter, free cash flow was almost $100 million and is expected to approximate $350 for the full year.

During the quarter, we repaid $75 million of debt and plan to repay another $60 million early next year -- next week.

Excuse me.

That will bring our total repayment since April 1st to $310 million against the $4 75 million borrowed to complete the AML acquisition.

At the end of the quarter, our debt-to-capital ratio of 38% matched the level at the end of last year.

We continue to believe that the best way to drive long-term shareholder value is to use our excess cash flow to retire debt and invest in the many growth opportunities available to us.

We value our investment-grade credit rating due to its influence on our cost of and access to capital.

While we have no plans for a major share repurchase, we continually evaluate the potential for a limited share repurchase plan to offset the impact of stock option issuances.

Now I'll turn it back to Ken.

Thanks, Bob.

We continue to emphasize execution and focus on profitable growth.

Our approach is very straightforward.

It is to differentiate Quest Diagnostics in the eyes of our customers, employees and shareholders.

We accomplish this by focusing on the basics of our business.

We are differentiating ourselves in several ways.

You have been hearing about our commitment to Six Sigma quality.

We look broadly at two types of quality improvements.

Those that directly touch our customers and others that indirectly benefit our customers as we drive efficiencies within our business.

To name just a few improvements that directly touch our customers, we have reduced wait times at patient service centers, improved turnaround times for tests, and further enhanced the process to resolve customer issues.

In terms of efficiencies, we have improved our billing processes, optimized test scheduling and batching at Nichols Institute, and automated the process to determine the most efficient courier routes for specimen pickups.

Six Sigma principles are becoming ingrained in the Quest Diagnostics culture.

With 135 black belts and more than 500 green belts, all aspects of our business are being touched by Six Sigma.

The basics of Six Sigma are becoming part of the way we do business.

They include listening to the voice of the customer, measuring process attributes, analyzing processes to understand root causes, designing improvements to permanently eliminate defects, and continuously monitoring the process using statistical techniques.

We are the first major healthcare services provider to pursue Six Sigma quality.

We have been at it for two years and it will produce a sustainable competitive advantage.

We're at the early stages of a revolution and are excited by what we see.

We're also differentiating ourselves with hospital clients.

During the quarter, we launched our new hospital division, with dedicated sales and customer service teams.

Joining together with AML enables us to become the only provider in our industry with both east and west coast esoteric testing capabilities improving turnaround time for customers.

We also offer hospitals a regional testing option further enhancing service and providing client choice.

We're continuing to differentiate ourselves as the leader in gene-based and esoteric testing.

Revenues from gene-based testing continue to grow rapidly.

We continue to establish strategic relationships, to ensure that we have a broad array of new tests in the future.

Our recently announced alliance with Celera Diagnostics gives us access to potentially significant markers for the risk of cardiovascular disease, the leading cause of death in the United States.

And diabetes, which impacts 17 million people.

We also develop tests internally taking advantage of our talented scientific and medical staff.

An example is our new proprietary cystic fibrosis test which sequences the entire CF gene and identifies more than 1,000 distinct mutations.

The most comprehensive diagnostic test on the market for cystic fibrosis.

We continue to focus on several product segments and disease states including women's health, cardiovascular disease, infectious disease and cancer which includes anatomic pathology testing.

We're also differentiating ourselves through our investments in information technology.

For example, we offer physician and hospital customers a comprehensive suite of connectivity solutions.

We're pleased with the increasing acceptance of our Internet-based products that enable doctors to order tests and retrieve results online confidentially via our secure website.

Electronic test orders when compared with traditional manually prepared order forms have the added benefit of further reducing data entry errors.

This drives costs and complexity out of our business.

In addition, we recently opened a new state-of-the-art data center allowing us to consolidate multiple data centers and enhance the security and privacy of patient data.

Turning to the external environment, I'll briefly cover the regulatory climate, the status of the Unilab transaction and the competitive landscape.

On the regulatory front, we believe that for the first time in 7 years, we will get a CPI adjustment in 2003 with or without a Medicare provider bill.

We're excited about the prospect of joining together with Unilab and continue in active discussions with the Federal Trade Commission including settlement discussions.

We continue to believe that this combination is not anti-competitive and we remain hopeful that we will complete the transaction in the fourth quarter.

I know many of you are curious to learn more details about the status of this transaction.

But I will not have any further comments today.

Many of you have been asking about the competitive landscape in our industry and whether it's changed.

Fundamentally, we continue to face a highly competitive overall environment.

This is not new for us.

Nothing is fundamentally different today than the landscape of a year ago or two years ago.

This is a very fluid industry.

Competitors enter and leave the business at the local level all the time.

In a highly competitive environment, we believe that we have a strong value proposition to offer customers, including our commitment to Six Sigma quality, unparalleled access and convenience, the broadest test menu and the largest medical and scientific staff available for consultation.

Now let's turn to our financial expectations.

For the fourth quarter, we expect revenues to grow approximately 14%.

Volume to grow between 12% and 13%, or approximately 4% pro forma for AML.

This is comparable to our third quarter growth rate, adjusted for the impact of September 11th, which was approximately 1%.

Revenue per requisition will increase 2 to 3%.

EBITDA to exceed 17% of revenues.

And we are comfortable with the current consensus of analysts earnings expectations of 78 cents per diluted share for the fourth quarter as published by Thomson First Call.

Putting it all together for the full year 2002, we expect to grow the top line by approximately 13%.

We expect EBITDA margins to improve by more than 2 points to exceed 17% of revenues, and earnings per share excluding the benefit from the goodwill accounting change and special items in 2001 are expected to increase by approximately 40%.

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 growth opportunities.

We remain committed to delivering earnings per-share growth of at least 30% next year.

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?

Yes.

Thank you.

At this time, we are ready to begin the formal question-and-answer session.

If you would like to ask a question, please press star one.

You will be announced prior to asking your question.

To withdraw your question, please press star two.

Once again to ask a question, please press star one.

The first question comes from Ben Pass of BC Capital.

Hi, good morning.

Congratulations.

Could you guys speak to the geographic growth areas that you look forward to in '03 and '04 looking ahead of where potentially it would be attractive areas to enter into?

My first question.

As we look at the marketplace in general, let's start with the United States.

As we think about growth opportunities, you know that we have a significant presence across much of the United States but there are pockets and areas around the country where we have virtually no presence today or a limited presence.

So as you think about regions where we see some particular opportunities for growth, certainly we see the opportunities to grow in California as we bring our company together with Unilab.

We see opportunities in parts of the midwest and parts of the south.

And I won't get anymore specific than that.

Okay.

Could you give us a sense of what kind of margins you look for in entering markets and perhaps give us a sense of what margins look like at the Dublin facility in California and competitively and comparatively who is participating in that area?

With respect to margins that we look for in an acquisition, we are certainly looking for acquisitions that are accretive to earnings.

Typically, the historical margins aren't actually the best measure because there are often synergy opportunities that we need to factor in.

But in almost all cases we're looking at opportunities that would be accretive not only to our earnings but to our margins, as well.

And with respect to the Dublin facility or California, we don't comment on the profitability of particular business units.

Okay.

And one more question for you guys.

What trends are you seeing in California in relation to competition?

Where is the general competitive landscape stemming from?

Is it hospitals, independent contractors?

And how are you seeing contract acquisitions?

California is no different than any other part of the country.

It's a highly competitive marketplace.

It's a highly fluid marketplace.

The competitors are entering and leaving the market all the time.

In terms of our own business in California, we're continuing to operate our business as business as usual.

The business continues to perform in line with our expectations in California.

And in fact, our customer surveys are up across our California facilities.

Okay.

Thank you very much.

And congratulations, guys.

Your next question comes from David Lewis of Thomas Weisel Partners.

Good morning, guys.

Congratulations.

Just three quick questions.

First of all, Bob, on the pricing, it was much stronger than Q2 so it was actually up in Q3 better than our expectations but gross margin was flatish.

I was wondering is there some discrepancy that is worth mentioning?

No, David.

There's really no discrepancy in Q2, price was 2.4% improved over the prior year.

This quarter was 2.9%, slightly better.

But the gross margins were about the same.

And again, keep in mind that last quarter was the first quarter that we had the impact of AML in our results.

And AML's gross margins were much lower than ours.

Actually, kept us from showing an improvement that quarter.

And as we start to get the synergies from AML, you'll start to see the gross profit numbers come into line with where we were and start to show the improvement that we expect to see from standardization in Six Sigma.

Okay.

It seems like you mentioned genetic testing was strong.

It seems specifically that gonorrhea and chlamydia testing was also quite strong.

Was this a transition from GenPro to the Roche system or something else you are seeing in the market?

David, this is Laure.

In regards to chlamydia and gonorrhea, we're seeing strength when you take the probe technology and the amplified technology together.

As you may be aware, recently Hedith (phonetic) introduced guidelines as it relates to screening for sexually active females between 15 and 25.

As physicians really start adopting these guidelines, we believe that that's driving up the overall screening for chlamydia and gonorrhea.

Hedith really made the recommendations because this is an asymptomatic disease with very high incidence in the young female population.

Okay.

And then maybe lastly a strategic question for Ken.

Obviously we recently signed the Celera agreement both yourself and the competitor.

What was interesting is your focus on diabetes and cardiovascular disease.

Maybe, Ken, give us your opinion on why Quest was more aggressive after cardiovascular and diabetes versus oncology.

Well, if you look at the incidence of disease states in this country, cardiovascular disease is incredibly huge impact on Americans. 60 million Americans are impacted some way, shape or form by cardiovascular disease and diabetes has impacted 17 million Americans.

So if you think about frequency, and incidences, you have to start by thinking about things like cardiovascular and disease and diabetes.

That's not to discount the fact that we also see significant opportunities over time, as well.

Certainly in the area of cancer.

Okay.

Thank you very much.

Bye bye.

The next question comes from Gary Lieberman of Morgan Stanley.

Thanks.

Can you talk a little bit more specifically about the pricing growth that you saw?

Was it entirely due to the increase in esoteric as a percent of total revenue?

Did you in fact see any pricing growth in the routine business?

And can you talk about the impact of the continued mix shift going forward toward esoteric?

Where do you think it is a year from now, and what's the impact overall pricing growth?

Thanks.

The 2.9% that we've reported in the quarter, a little over half of that was attributable to test mix.

The remainder was attributable to payor mix and absolute true price increases on the actual tests.

And in terms of where we expect that to go in the future, as we've said, we anticipate 2 to 3% improvements in price in a typical year.

And we expect that the increase in gene-based and esoteric testing will continue to contribute to that.

Keep in mind that what's esoteric today may not be esoteric tomorrow as part -- as most tests go through a natural life cycle where as they become accepted and automated they can move from our esoteric testing facilities out to our business units.

And would then become part of our routine business.

Okay.

Thanks a lot.

The next question comes from Tom Gallucci of Merrill Lynch.

Good morning, everyone.

First a clarification from Bob.

I think you said cash flow around 350.

Was that before or after CAPEX?

And what are you looking for at this point for CAPEX as you finish the year?

That's the free cash flow.

We are looking for an excess of $500 million for cash from operations and we're anticipating capital for the full year in the $160 million range.

Okay.

And then I was wondering if you all could reconcile your revenue expectations versus the volume and the revenue per requisition guidelines that you kind of set for the fourth quarter?

Sure, Tom.

When you think about it, in the fourth quarter, if you took the midpoint of our price in volume guidance which total about 15%, and you factor in the fact that in last year's fourth quarter, we had about a 1% benefit in our revenues from the clinical trials business, this was the minimum contract payment that we had last year in the fourth quarter.

Which we don't expect to have in the fourth quarter of this year as a result of the work coming in more steadily throughout the year.

You factor that 1% in, that gets you to the projected revenue growth of 14% that we've identified for the fourth quarter.

Then just the last question, I guess, obviously HJ announced recently that they were purchasing Health Midwest.

I was wondering what your relationship was there and if you expected any changes as a result of that?

Tom, Health Midwest is not serviced currently by Quest Diagnostics.

As I believe everybody knows, we are a contract provider with Health Trust, the purchasing arm of HCA and certainly we would hope to have an opportunity to participate in that business relationship moving forward.

Okay, great.

Thank you.

The next question comes from Alan Brockstein of Edger Capital.

Hi, it's Pager Capital.

You mentioned the regulatory environment.

I was wondering if you could touch a little bit upon what's going on with the FTC.

I know most of what's been written about refers more to doctors and to hospitals.

But this possibility of looking into transactions after they have already occurred, is this something that concerns you?

Do you have any plans, if you can't do acquisitions going forward, is that going to affect you?

Well, what I know is what you know from the newspapers in this respect.

We understand that the FTC is looking backward in some hospital acquisitions, I believe, over a period of time and we really don't have an opinion one way or another in terms of what will or won't happen.

I would say in terms of the acquisition environment for us, we continue to see significant opportunities to grow through selective acquisition.

And we believe that we have the appropriate wherewithal to be able to drive selective acquisitions that will make sense for all parties concerned.

When you say selective, does that mean that they might have to be smaller and more localized going forward?

Not necessarily.

Thank you.

The next question comes from Simon Wahlberg of Sampson Partners.

Thank you for taking the call.

Very quickly, are you seeing any of the issues that Lab Corp. had at any spots in the country and do you foresee potentially having any of those issues in the near term?

Thank you.

Well, if you look at our business as we look at the outside environment it fundamentally hasn't changed as far as we can see.

We fundamentally continue to face a highly competitive overall environment.

This isn't new for us.

Nothing's fundamentally changed.

We do have a management process inside our company where we're continuously focused on execution and managing through metrics and engagement.

An as a result, we're continually monitoring any trends in the outside world as well as monitoring and controlling our internal processes.

With the fundamental belief that if you really are driving at things proactively, considering the customers at risk, evaluating new customer opportunities, and measuring your processes from soup to nuts, everything from patient service wait times all the way through the testing process and straight through to the billing process, you have a much better chance to be able to have a really close eye on what's really happening in the business.

Thank you.

The next question comes from Robert Willoughby of Credit Suisse First Boston.

Yes.

Actually, it's Frank Pinkerton sitting in.

But can you, please, you mentioned the cost savings from Internet order versus paper.

Could you give a little more color there?

What is that going to do and whether -- what are other initiatives there that could potentially help to drive your margins higher?

Sure.

As everybody knows, this is a very detail oriented business.

We encounter about 115 million patients a year and as we go through the process, obviously, it's very important to do it right the first time.

And as you look at electronic ordering and resulting on the ordering side, having complete information at the front end is vitally important to help remove the need for rework, to help reduce the level of missing information in the billing process.

All of which helps us to reduce waste and improve efficiency and in the end reduce costs.

So as we look to the future, I know we for many, many years have been targeting the fact that we believe we can get our bad debt, as an example, to 4% of sales.

We now believe we see the way that we can drive it to a better level than 4% over time.

Gradually and steadily in part driven by the movement towards electronic orders with complete information.

Frank, in order to also help frame the opportunity, keep in mind that about 10% of our workforce today is in the billing and collections area because of all the paper and the manual effort that's involved.

As things become more electronic with our customers, we see opportunities to drive efficiencies in the billing operation, as well.

Thank you.

And one follow-up if I can.

You were kind of hesitant, I think, in your comments on the share repurchase.

Uhm, what is -- what are going to be, I guess the main uses of free cash flow going forward, you know, what is management considering?

And would you consider a broader share repurchase in the future?

As I said earlier, Frank, we believe that there is significant growth opportunities for us to invest in today which can drive long term shareholder value.

We are continuing to delever at this point.

And in terms of what -- when and how big a share repurchase we might consider, there is no trigger price, frankly, and we need to think about more than just the price at any moment.

We need to consider the company's growth prospects, the reasons for the stock being where it's at and alternative uses of our cash as well as our capital structure and credit rating.

So as I said, we have no plans for a major share repurchase but we continually evaluate whether or not it makes sense for us to do some sort of limited share repurchase to offset the impact of -- the dilutive impact of options.

Thank you.

The next question comes from Deborah Lawson of Salomon Smith Barney.

Good morning.

I was just wondering two things.

Uhm, first of all, can you give us any, uhm, sort of concrete examples of, uhm, some progress that you've made in the new hospital, uhm, focused division?

And then secondly, can you just give us a sense of, uhm, the 4%, uhm, goal for bad debt expense, uhm, over time?

Can you give us a sense of the timing on that, when you might expect to hit that goal?

Thanks.

Let's start with the bad debt piece of the equation.

You know in quarter three we were a little bit over 5% bad debt as a percent of sales and if you look at our history, we have been on a fairly steady track in the zone of what, around a half a point a year typically.

We're not giving specific guidance today in terms of how rapidly or not rapidly it will take place.

But as you know, reducing bad debt is a blocking and tackling kind of an exercise.

It's all about execution.

So I think you can expect steady progress as we move towards the 4% and we would hope to go beyond.

As it relates to our hospital business, we're very excited about where we are today.

We put in place a dedicated hospital division.

We've put in place as part of that, of course, a dedicated hospital sales and marketing team under the leadership of Vickie DiFrancesco who joined us from AML.

We have begun the process of making sure we have great capabilities on both coasts in terms of esoteric testing.

In addition, as we work through things, we are also as part of that we are beginning to make sure we have a wonderfully duplicative, if you will, test menu on both the east and west coast.

And our sales and marketing force is blanketing the field as we strive to make the best of wonderful relationships that we have today with a number of GPO providers and large hospital groups, as well as targeting the many small and medium-sized hospitals that are located across the United States.

Okay.

Great.

Thank you.

The next question comes from Bill Bonello of Wachovia.

I had a couple of follow-up questions.

Did you say that the tax -- the tax benefit impact was $15 million, one-five, in the quarter?

Bill, I didn't give a specific number for that.

But the tax benefits associated with the exercise of stock options were actually reduced by about $16 million from a year ago.

At this time.

Now, keep in mind, too, one of the things I'm not sure if it's totally clear to folks about the tax benefit from the exercise of stock options, but as individuals exercise stock options, they get to pay tax on it.

On the flip side, though, the company gets to take a tax deduction.

Keep in mind that tax deduction does not run through our P&L.

It's actually a credit directly to the equity section.

But GAAP requires us to show it as a cash flow from operations, one which we've broken out separately on the cash flow statement in the prior quarter.

Okay.

I'm just trying to understand the free cash flow guidance comes down approximately $50 million on an annual basis.

And I'm trying to understand if it's anything besides the tax benefit that's driving that.

Bill, it's totally due to that.

The swing in the free cash flow number from our estimate of approaching $400 million to $350 million is totally due to that.

We're looking now at a swing of about 15 to $18 million a quarter.

And at two quarters there is your difference right there.

And then, in the past, you've talked about Six Sigma and standardization contributing maybe $150 million over time.

I think on a pace similar to the kind of benefits you got back with SBCL.

Are you still comfortable with that outlook and any update on sort of where you're at, where you can get at next year?

Absolutely.

Bill, we have committed previously to $150 million at least of benefits from Six Sigma standardization between 2002 and 2004 over that three-year period.

We're almost to the end of the year 2002 and I must say that we're really beginning to get tremendous traction against Six Sigma and standardization.

We haven't given specific yearly guidance but certainly if you were to take 150 and divide by three, you know, that's one way to start thinking about it.

Again, this is a business that doesn't have a lot of spikes one way or the other.

And this is all about execution.

And we're moving forward.

I think the other piece of this that may not be well appreciated at this point is the fact that this is the first 150.

As we go between 2002 and 2004.

Six Sigma isn't just a two- or three-year program.

This is something that's for life and the beauty of Six Sigma, is that there's lots of opportunity that's created as you go along the way.

So this is something that will sustain itself in terms of additional benefits of significance beyond the year 2004.

And then just a final question do you have any sense of the mix shift, how much of that is a direct result of the AML acquisition and a higher price point potentially there, or was that an impact?

No, that's really negligible.

The only change that we see in the payor mix shift with AML is the fact that we have more hospital business now than we had in the past because of their focus on hospitals.

Okay.

So they weren't -- they weren't a significantly higher price.

No.

Average revenue per requisition?

No, it didn't impact it much at all.

Great.

Thank you very much.

The next question comes from Christian Zood from Argus.

Hi.

Two quick questions.

I was wondering how much the difficulty that Specialty Labs has in California, whether that contributed to any of the volume growth in this quarter?

And the second question on the Medicare CPI, what is your assumption regarding how much of rate increase you are getting next year?

And is that built into your guidance for 2003?

Thank you.

In terms of Specialty Laboratories, we have provided services to Specialty through parts of the third quarter as they have been address issues in their license share area.

It's a very, very small impact on our overall business, very limited impact indeed.

In terms of the CPI, we don't know what the CPIs going to be for next year.

That's something that will be calculated at the end of the year by the government.

As you know, inflation is running pretty low right now.

And as a result, we don't really have a clear view for you in terms of what that adjustment might be.

In terms of whether the CPI would be enter with outside of our guidance of 30% improvement for next year, we do not -- the 30% improvement at least next year for EPS would include the benefit of the CPI increase.

Keep in mind, earlier this year, back in quarter one, we did comment that we were going to grow 30% at least next year excluding any CPI benefit.

But also keep in mind with me as you go back in history, we have taken our EPS projections for this year up.

We're growing earnings for the year 2002 by 40%.

We increased our performance this year by 14 cents and there is no change in our prospects but we feel it's appropriate to have CPI be part and parcel of our commitment to you of growing at least 30% in the year 2003.

And --

Christian, keep in mind, the CPI increase, although we're very happy to have it, is not going to be a big contributor to earnings next year.

Several pennies at the most.

If you think about a range of CPI, it could probably go anywhere from about 1 to 2, maybe a little bit more than that, in terms of percent impact in terms of CPI improvement on the Medicare book of business.

Remind me how much is Medicare of your book of business?

Medicare in total as a percentage of our business is around 12% of our revenues.

Okay.

Great.

Thank you very much.

Your next question comes from Rikki Goldwasser of UBS Warburg.

My first question relates to the $9 million integration cost.

Where did you record that?

The $9 million integration cost that did not go through the P&L becomes part of the cost of the AML acquisition and is on the balance sheet now as part of goodwill.

When you think about acquisition costs, the way it works is as you are integrating two businesses,the costs associated with any impact to the acquirer's business, whether it be a severance or a facility closure, is required to go through the P&L.

But those same costs associated with the acquisition target actually go to the cost of the acquisition and end up in goodwill on the balance sheet.

Okay.

And, uhm, you mentioned that product mix accounts for about 50% of the price increase.

What percent of that 50% is the contribution of ThinPrep?

We're not disclosing the specific contribution of ThinPrep.

It is an element of the mix shift and as we said, in excess of 50% of the price improvement was due to mix shift.

Our ThinPrep conversion continues to increase.

At the end of the quarter we were at 77% converted, up a few points from where we were at the end of last quarter.

Okay.

And my last question, uhm, is related to, uhm, volume growth. (indiscernible) it seems like the same store growth this quarter was about 2.5% sort of flatish on a sequential basis.

Is this the same store growth that, uhm, you expected to see, uhm, going forward?

As we look to the future as it relates to growth, Rikki, we see the opportunity to continue to build our volume as we continue to deploy our efforts to improve sales and marketing effectiveness in our business.

You might know that, you know, last quarter I indicated I wasn't particularly happy with volume growth.

Today, I'm not particularly happy today, either.

But...

I will say to you that we are doing what we believe are the right things to further build momentum and it's all about execution.

We're focused on targeted market segments in terms of physician specialists particularly with our genomic and esoteric sales testing reps, and the hospitals with our new hospital sales and marketing divisions as part of the hospital division.

We are focused on driving our product portfolio through both accelerated adoption of new tests like CardioCRP and the cardiac risk area and our women's health portfolio as well as innovations in the areas of cardiovascular and infectious disease and cancer.

We're also focused on geographic expansion as well as opportunities to continue selective acquisitions.

So if you put it all together, we're making progress.

The momentum is beginning to appear.

This is a slow and steady process, and we are fully committed to continuing to drive acceleration of volume growth as we move to the future.

And believe we have the right building blocks in place that are now beginning to pay off as we have seen here in the third quarter.

So the 4% volume guidance for the fourth quarter, uhm, takes into account the materialization of these efforts?

Each quarter it takes into effect the various pieces of the momentum that I have just described for you in terms of our areas of focus.

But again, it's not an industry where you get huge spikes.

So if you look to quarter four versus three as an example, in quarter three our volume growth was around 5% pro forma.

In quarter four, we are guiding 4%.

The big difference here is the fact that there was the 9/11 impact in quarter three which impacted things by about 1 point.

So that would suggest that our rate of volume growth is relatively consistent quarter to quarter.

And we, as we continue to deploy these plans that we have been putting in place, we would expect to be able to continue to build our story and build our growth rates into the future again on a very steady, slow and predictable way as we drive our company forward.

Thank you.

The next question comes from Angie Samfilippo of Piper Jaffray.

Good morning.

You have talked a lot about your 10, 20, 30 strategy and I'm wondering if you can give us any additional color on the '03 guidance or maybe indicate when we'll be able to speak in more detail with you about it.

Yeah, 10/20/30 is alive and well around here.

I will say that.

As we look to the year 2003, our guidance today is that we expect to grow our earnings per share next year by at least 30%.

We are not giving any specific guidance in terms of the top line or EBITDA margins and what have you at this point in time consistent with our past practices.

You can assume that we'll be able to provide specific guidance across the board for you in our quarter four conference call which will take place during the month of January.

Okay.

And then if for some reason if we don't get a CPI update next year when Congress comes back in a lame duck session just assuming worst-case scenario, does that mean that that 30% EPS growth could potentially come down?

No, it does not.

We are committed to delivering at least 30% earnings per-share growth with or without the CPI.

Keep in mind, Angie, too we don't need a bill passed in Congress to give us a CPI adjustment.

In fact, Congress would need to pass legislation to freeze a CPI.

And also keep in mind as Bob said that it's only a couple of pennies, we think, if you think about a CPI in the zone of 1 to 2% although we don't know the number, no one does yet.

But to Laure's point, with or without Congress doing their job, we are going to get the CPI back.

Great.

Thank you.

The next question comes from Matthew Busen of Argus.

Hi, congratulations, as well.

Couple questions.

One regarding CAPEX.

It sounds like CAPEX is growing and maybe if you can talk about your thoughts for '03 and maybe even free cash flow for '03.

Two, with respect to volume growth, I know before you had thought about something like 5% organic volume growth and I guess that would imply exiting '03 with about a 6% volume growth.

I'm just trying to understand how you are going to close that gap between the current volume growth of 2.5 to let's say 4%.

And then Ken, uhm, is it about time for you to start discussing succession plans?

I know your contract is coming up and a just wanted to get a sense as to what your commitment is to the business.

I'll start us off here, Matt.

Number one, in terms of volume growth, again, we are not giving any specific projections for next year but I will highlight what we have said previously and that is we see the industry continuing to grow around 5 to 7% in a typical year.

And that's what we see the industry growing at over the next several years, 5 to 7% in terms of revenue dollars as the industry moves forward.

And we're committed to driving our business to the point of growing at the high end of that rate as we strive in a typical year to grow at around 10% a year.

Remember, that's 7 to 8 points through organic means and 2 to 3 points in a typical year through selective acquisitions.

The initiatives that we have been putting in place and have in place are really intended to help drive us -- continue to drive us forward towards those levels and we are very excited about the prospects as we move into the future to make those plans become even more clear reality for you and for us and for our customers.

In terms of my own personal plans, I do have a contract with the company.

It expires at the end of the year.

There are ongoing dialogue in terms of my contract and I would just say this.

I'm highly committed to this company.

It's also very important in my role to make sure there is succession planning.

I look around the world and think about all the companies that have crashed and burned because they haven't had good succession planning.

You should expect of me that we have strong succession plans here as well and that's something I take very seriously.

But the bottom line is, I'm here.

I'm doing my job.

And I love this company.

Matt, let me follow up on the CAPEX question.

First of all, there's really no change.

Our CAPEX guidance has been right around $160 million since the beginning of the year for the most part.

And what we've said is this year and probably for the next year or so, we expect to spend about 4% of revenues on capital.

And that includes some pretty heavy investment in information technology and in testing technology.

When you think about our business, think about 2 to 3% of revenues as sort of your maintenance capital.

And anything beyond that as capital that's actually being invested into the business.

And in terms of free cash flow for '03, we have no specific guidance at this point as Ken said, we'll be sharing guidance at the end of the fourth quarter, although we would expect it to grow nicely.

Thanks.

And one more question.

You mentioned a contract dispute.

What was the magnitude of that payment and what's the nature of that dispute?

We're not going to discuss the specific nature of that dispute.

We don't do that.

But it was between $10 and $15 million was the total.

Okay.

Thanks.

The next question comes from Kemp Dolliver of S.G.

Cowen Securities.

On the ThinPrep penetration that moved up pretty sharply during the quarter, where do you see that heading?

You know, is 100% conversion possible at some point?

Thank you.

We do see the opportunity for monolayered testing.

ThinPrep being one of the product lines available to approach certainly to be over 90% and ultimately potentially get very close to 100%.

We see it as a standard of care.

As you know, there are alternative mechanisms for provider that monolayer capability and we see it becoming to the 90% level over time.

Some of our business units already exceed the 90% and that definitely gives us the view forward.

That's great.

Thank you.

The next question comes from Stuart Hazanski of Vanguard.

My question's been asked and answered.

The next question comes from Mark Miller, Bank of America Securities.

Good morning.

I know you just discussed your 10/20/30 plan.

My question, though, is for 2003, do you think you can get to 30% EPS growth without any acquisitions?

And if you don't think you can, do you kind of have an idea, can you tell us about what you think the minimum level of acquired revenue you would need to get to 30%?

As you know, again, we are not giving guidance across pieces.

But do keep in mind as we talk about a typical year growing at 10%, in terms of top line, the 2 to 3 points of the 10% growth we would expect to come from small selective acquisitions in any typical year.

So we would expect to have a modicum of acquisitions as part of any guidance we might give you into the future.

Keep in mind that 2 to 3% that doesn't anticipate significant contribution to the bottom line as a result of acquisitions.

So no guidance at this point on with or without acquisitions you think you can get to the 30% EPS growth?

No guidance today.

All I'm saying, though, is in the 10/20/30 process, that typically we would expect a small amount of acquisition activity as part of driving top line.

And in the end, that does have an impact over time on the bottom line.

We will provide full guidance soup to nuts in our January conference call reviewing fourth quarter results.

Okay.

Thank you.

The next question comes from Andrew Bhak of Goldman Sachs.

Good morning, congratulations.

Two quick questions.

One, can you characterize the nature of contract negotiations with managed care?

And whether you are seeing any change at the margin with respect to price hikes or the managed care companies' disposition towards leakage and a solution that you might help provide there?

And then secondly, as we look out to 2004 working through some of the Six Sigma initiatives, is it likely that you will have sort of on a holding everything equal more or less or the same number of sales and marketing teams sort of out on the field?

Thanks.

Starting with managed care in terms of the competitive environment in terms of pricing, it's always a highly competitive business.

There's always competitive pressures as it relates to the pricing environment.

We don't see any fundamental differences today that we have seen in the past.

As you know, we renew around 2 to 3 large contracts in a typical year.

And as managed care continues to evaluate the value we provide, I think many of our managed care customers are understanding more than they have ever before the fact that given in a we impact more than 70% of healthcare decisions and are only about 3% of the healthcare spending in this country, that if you can get a early result, that can detect a disease, you can avoid costly procedures later.

And that's a great value for the managed care community.

Now, in terms of opportunities for to us help managed care companies address leakage, managed care companies have a couple of choices they can make as they deal with leakage where they end up paying retail.

One is to contract with providers by themselves which is a very burdensome task typically across the country for somebody.

An alternative that we offer that no one else in the lab space has today, is a product patent or trademark called QuestNet which allows us and we have the capability to help the managed care companies manage their total lab spend by operating as the contractor, if you will.

For other providers and managing the overall network for the managed care company.

What this does in the end is reduce the level of costs that the managed care company might have to spend.

It also increases the revenue to us for providing this service.

It's important to keep in mind also, that with QuestNet we don't assume any of the risk.

This is strictly a management process opportunity for us to help managed care manage its overall lab spending more effectively.

Great.

Thanks.

And then with respect to the Six Sigma initiatives and the sales and marking force?

As as we move forward we don't typically comment about the size of any specific part of the organization.

What I see six Sigma doing for us is really it is enabling to us put that much more of our energy into selling our products and developing and implementing new tests as well as operating our business more effectively.

Now, so no real comment about size of any specific function.

Okay.

Great.

Thanks very much.

We have a follow-up question from Bill Bonella of Wacovia.

Yeah, could you just comment real quickly on what you're seeing in terms of cost inflation?

It looks like the average cost per requisition was up fairly meaningfully year-over-year and you might have thought with the September 11th impact that it would be a little less.

So just curious what's going on there?

Bill, I wouldn't call it up significantly.

It is the cost per acquisition is going up but you need to keep in mind that a function of what's happening on there is the test mix.

As we start to shift to more esoteric and gene-based testing, the cost of performing that testing is actually higher, although the margins are higher, as well.

So it is important not to just look at the cost per requisition but really to just look at the overall profitability in terms of percentage of revenues.

Okay.

So there is not an uptick in -- it's all -- there is no uptick in just cost inflation, then?

No.

There is not.

As I said earlier, we are continuing to see the benefits of our standardization and Six Sigma efforts.

And in the second quarter, with the acquisition of AML, we saw their cost structure get layered on to ours and as we start to realize the synergies, we'll see that come down much closer to ours.

Great, thank you.

The next question comes from Alan Brockstein of Pager Capital.

Hi, Ken, you mentioned a few times that you're a very small part of the spin and can save money.

Can you give some more examples of that?

And also, is there an issue that people switch from insurer to insurer from year to year so are the -- is it really worth it for an insurer to pay a lot for tests to help things that might occur five years down the line or something like?

Is there anything that y'all can do to obviate that problem?

I don't know if you have recently seen comments but actually healthcare providers do see the value that testing can do in reducing the overall cost of spending.

To your initial question about people moving between providers, interestingly enough, you may move out of a provider but ultimately end up back with that initial provider so there is an opportunity for them to reduce their overall cost of healthcare by making the appropriate decisions.

Recently, the CEO of Aetna has actually been on the hill at Congress talking about the value of testing particularly gene-based testing in helping to achieve earlier diagnosis and help to reduce overall healthcare spending.

Can you give any examples of some large areas where earlier detection can save a lot of money?

Ones that come to mind?

Think about early detection of cancer.

Think about early detection of a cardiovascular disease.

Through screening tests you have the wonderful opportunity to be able to understand early the symptoms of many of the most insidious diseases that people face.

And if you get that early detection and can provide appropriate medication and avoid costly surgery later, a tremendous benefits accrue.

Prostate cancer would be an example, for instance.

Thanks.

We have a follow-up question from Ben Pass of RBC Capital.

Hi, guys.

Just one more question.

With regards to the Unilab acquisition, if Federal Trade Commission required that you guys make significant divestitures, would you guys consider potentially adjusting the terms of the transaction?

I really have no comment today.

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

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