奎斯特診斷 (DGX) 2002 Q4 法說會逐字稿

Welcome to the Quest Diagnostics fourth quarter and full year 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.

I would now like to introduce Laure Park, Vice President of Investor Relations for Quest Diagnostics.

Go ahead please.

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-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, Laure.

We continue to deliver strong financial performance increasing earnings 34 percent in the quarter and 41 percent for the full year.

These are outstanding results by any measure, especially given the economic environment.

I'm proud of the efforts of our more than 30,000 dedicated employees who make it happen.

2002 was the fourth consecutive year of outstanding earnings improvement.

To put it in context, over the last four years, revenues have grown from 1.5 to $4.1 billion.

EBITDA has improved from 11 percent to almost 18 percent of revenues.

Cash from operations grew from $140 million to almost $600 million and comparable earnings per share grew from 68 cents to $3.23.

Before I share our expectations for 2003, and what we're doing to assure continued strong performance, Bob will comment on our results in 2002.

Thanks, Ken.

The fourth quarter produced strong performance.

In line with expectations overall and reflects strong gains over what was an exceptionally strong fourth quarter last year.

We increased revenues almost 14 percent, improved EBITDA margin by over two full points, grew earnings by more than 30 percent and generated record cash flow.

Fourth quarter net income increased to $82 million, or 82 cents per diluted share from $51 million, or 52 cents per diluted share in 2001.

This represents a 34 percent increase after adjusting prior year results for the required change in goodwill accounting.

Earnings include pre-tax gains of $2.9 million from the sale of certain assets which contributed 2 cents per share.

Revenues increased $123 million or 13.5 percent to $1 billion.

Taking a closer look at revenue growth, clinical testing volume increased 10.4 percent over the prior year.

Assuming that American Medical Laboratories had been part of Quest Diagnostics in 2001, pro forma volume grew by 1.6 percent during the quarter.

We were generally on track through November.

However, December volume was softer than we had anticipated.

Weather and the timing of holidays have historically made December volume unpredictable.

December storms alone reduced volume for the quarter by approximately 1 percent.

While the December results do not signal any fundamental change in the competitive landscape, we did not experience a repeat of the previous year's very strong December, which we had anticipated in earlier guidance.

Revenue per requisition grew 3.4 percent during the quarter.

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

Growth in higher value testing including gene-based testing contributed the majority of the improvement.

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

For the year, gene-based testing revenues approached $400 million.

We continued to drive EBITDA margin towards 20 percent and beyond.

EBITDA margin increased to 17.9 percent of revenues, more than two full points above the fourth quarter of 2001.

Our Six Sigma and standardization efforts are generating improvements across all aspects of our business.

Efficiencies in our billing processes enabled us to reduce bad debt expense.

Bad debt was 5.1 percent of revenues, compared to 5.8 percent the year before.

Cash from operations was exceptionally strong at $246 million for the quarter compared to $165 million in the prior year.

Free cash flow was more than $200 million.

Cash flow during the quarter benefited by approximately $40 million as a result of our ability to accelerate the deduction for certain operating expenses due to IRS rule changes enacted in 2002.

Additionally, we improved our DSOs to a new low of 49 days and reduced our receivables balance by $54 million during the quarter.

These billing improvements clearly demonstrate the value of our focus on process discipline as they came at the same time that we have been integrating the operations of AML and completing various systems conversions.

Turning to the full year results, earnings per diluted share increased 41 percent adjusted for the changing goodwill accounting and special items in 2001.

Revenues increased more than 13 percent to $4.1 billion, and EBITDA improved to 17.7 percent of revenues.

Cash from operations totaled nearly $600 million and free cash flow was well over $400 million.

Our credit profile continues to improve and will remain strong following the completion of the Unilab transaction.

During the fourth quarter, we repaid the remaining $225 million of debt related to the acquisition of AML and ended the quarter with $97 million in cash.

In the nine months since acquiring AML, we have repaid the entire $475 million we borrowed to complete the transaction.

Our excellent cash generation and strong balance sheet position us well to take advantage of growth opportunities at the same time we improve our credit profile.

We are constantly evaluating ways to maximize long term shareholder value and are closely tracking the status of President Bush's proposed tax plan.

At this time, we continue to believe the best way to drive long-term value for shareholders is to use our excess cash flow to invest in the many growth opportunities available to us.

While we have no plans for a major share repurchase or dividend program, a limited share repurchase plan to offset the impact of stock options remains a possibility.

Now I'll turn it back to Ken.

Thanks, Bob.

Six years into our journey as an independent company we have led a successful turnaround, established ourselves as the clear industry leader and delivered consistently outstanding results and we're not stopping here.

We manage the business for the long term.

We're investing for the future at the same time that we're growing revenues, earnings and cash flow.

For 2003, excluding the impact of the Unilab acquisition, we expect earnings per diluted share to increase to between $4 and $4.20.

Revenues to grow by approximately 8 percent to 10 percent, comprised of 4 to 6 percent from organic revenue growth with volume and revenue per requisition contributing 2 to 3 percent each.

Two percent from AML representing three months of operations before the anniversary of the transaction.

And two percent from small acquisitions.

We also expect EBITDA margin to improve to between 19 and 20 percent of revenues, capital expenditures to approximate $170 to $180 million, and cash from operations to exceed $500 million.

We believe that industry revenues will grow at a rate of 5 to 7 percent per year over the long term.

However, we believe that in the short term, the revenue growth rate will continue to be closer to the lower end of the range.

On the reimbursement front, federal and state governments face serious budget deficits and healthcare spending is a target for reductions.

Obviously, we're monitoring the situation close I closely and at this time are not aware of any specific proposals that would reduce spending for clinical laboratory tests.

Keep in mind, the value we offer through early detection and prevention.

Laboratory testing accounts for only about 3 percent of total healthcare spending and yet is a critical factor in driving healthcare decisions.

And Medicare and Medicaid currently represent about 15 percent of revenues, down dramatically as a percent of revenues over the past five to ten years.

Overall, including the recent CPI increase, we continue to believe that the reimbursement dynamics are neutral to slightly positive for this industry.

We continue to invest in areas that differentiate us from the competition.

Six Sigma quality, new tests and testing techniques and state-of-the-art electronic client connectivity options.

We also pursue selective acquisitions when they make strategic and economic sense.

Let's look at each element of our strategy.

Six Sigma is benefitting margins by improving efficiencies.

And it's also improving service quality in ways that our customers can see and feel.

One measure of the improvement is our comprehensive Customer Satisfaction Index which has shown four quarters of consecutive gains and stands at the highest level ever.

During 2002, almost every lab showed improvements in customer satisfaction driven by Six Sigma.

Further improving customer service is a vital enabler to enhance customer retention.

Regaining lost customers is always more costly and time consuming than keeping them satisfied in the first place.

We have studied the root causes of customer turnover and are reprioritizing our efforts in Six Sigma against the most common causes.

We're confident that these efforts coupled with actions we have taken over the last year will enhance organic growth in 2003.

Additionally, we see an opportunity to use our strong customer service capabilities to expand our position in various geographic areas around the country.

We can do this through selective acquisitions which we have demonstrated a leading ability to effectively integrate and also through building infrastructure, to service new customers in markets where we have historically had a limited presence such as parts of the south and other pockets around the country.

During the fourth quarter, we continue to differentiate ourselves with investments in new tests and techniques.

An example is cardiovascular disease where we saw dramatic growth in the acceptance of two tests that we have been offering for several years which only recently have received significant attention in the medical literature.

CardioCRP test revenues accelerated throughout 2002, nearly doubling in the fourth quarter compared to the prior year.

Also, homocysteine testing increased more than 50 percent.

Growth in future years will also come from tests we're adding to our new product pipeline today, including Roche's new test for congestive heart failure which we are the first lab to offer and a new ovarian cancer blood test to be offered later this year through a relationship with Core Logic systems.

We're also distinguishing ourselves in the marketplace with our state-of-the-art electronic connectivity options.

This is an ongoing strategic initiative that enhances customer retention and loyalty.

We're pleased with the pace of adoption of our test orders and results online, Internet-based ordering and reporting product.

As we exited the fourth quarter, the number of orders received via the Internet doubled from the third quarter to approximately 10 percent of all orders and reports issued via the Internet increased to 15 percent of all reports.

Selective acquisitions will continue as an element of our growth strategy.

We have a strong track record of identifying acquisitions and generating significant value by successfully integrating them into Quest Diagnostics.

This is a core strength that differentiates us from many other companies.

While there are fewer large acquisition candidates as a result of industry consolidation, we see numerous regional and local acquisition opportunities.

In a typical year we expect to generate two to three percent revenue growth from small acquisitions.

With respect to Unilab, settlement discussions with the FTC are on going and we expect to complete the transaction during February.

Turning to short-term guidance, for the first quarter of 2003, we expect earnings per diluted share to increase to between 82 and 87 cents.

Revenues to grow by approximately 12 percent comprised of 9 to 10 percent from reported volume growth and 2 to 3 percent from revenue per requisition improvement.

On a pro forma basis, assuming that AML had been part of Quest Diagnostics in the first quarter of 2002, we expect volume growth of 1 to 2 percent.

We also anticipate that EBITDA margin will be between 17 and 18 percent of revenues.

Please keep in mind that the impact of Unilab is not included in our first quarter or full-year guidance.

We will provide an update after closing the transaction.

In conclusion, we have established a strong track record during our first six years as a public company, and we're ideally positioned to drive exceptional performance for years to come.

Grounded in a straightforward strategy with a focus on growth and execution.

Our business strategy is the right one to drive continued strong results and we are investing for the future.

We remain committed to delivering superior returns to our shareholders over the long term.

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

Operator?

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 1.

You will be announced prior to asking your question.

To withdraw your question, please press Star 2.

Once again, to ask a question, please press Star 1 now.

We will take a moment for the question queue to fill.

The first question comes from Gary Lieberman of Morgan Stanley.

Thanks, good morning.

Can you talk a little bit about on the volume side, would you expect to see some of the volumes that perhaps didn't take place in December because of the storms, uhm, carry over into January and also could you talk about what effect that the weather -- the severe cold weather we've seen in January might have on your volumes in January?

Thanks.

Gary, as you think about our volume and how it could be impacted by weather or potentially even cold, it's not something that necessarily rebounds.

Quite often when folks don't go to the physician as a result of inclement weather or some other reason, sometimes they feel better.

And then don't follow up with their physician.

Or if it turns out that it's a -- they're monitoring a condition or a drug routine, they may just wait until the next time.

So typically, you don't see a big rebound following a decline in volume as a result of weather or something like that.

Okay.

And then could you just comment on what effect the severe cold we're seeing in January has had on your volume so far?

We -- Gary don't typically comment on specific volume trends in a specific month what I will say, however, is this.

Certainly cold weather in any service industry can lead people to stay home.

I live in New York City.

As an example.

And certainly the restaurant industry in New York City is down dramatically when there is cold weather.

But we have no specific comments for you today about any impacts on our specific volume levels through the first part of January.

Okay.

Thanks a lot.

The next question comes from Angie Sanfillippo of US Bancorp Piper Jaffray.

Good morning.

You guys said that in the short term you said that the growth rate of the industry will be at the lower end of the range.

I'm wondering if you are assuming that will be driven primarily by reimbursement pressure or if there is some other reason leading you to believe that?

Angie, we had indicated a continuation -- I don't know if you looked back over the past several years based on published reports as indicating, you know, roughly 5, 5.5 percent growth rate and we think it's going to continue at that rate.

We think that the underlying industry fundamentals will drive an acceleration up beyond the closer the -- lower end of the range.

Obviously, if you look at the demographics that we think will cause that acceleration, the aging population coupled with increase in the number of tests that we believe will be introduced in the gene-based and proteomics-based areas.

So, what we are indication is a continuation where the industry is at right now for the short term.

Angie, although the economy does not have a significant impact on our business with maybe the exception of our drugs of abuse testing business, it's not helping.

And could be one of the factors that are causing the volume or the revenues to be at the lower end of that range at this time.

And what would cause that?

When you say the economy's not helping, could you give me an example maybe of what would cause a slowdown --

Sure.

It could potentially be uninsured individuals not going to the physician at this point, putting off healthcare.

But again, generally, that's not a big driver in terms of healthcare revenues or volumes.

But it can have some modest impact.

So I think what we're saying here is this I mean, while certainly compared to other segments of the economy, healthcare is more insulated than so many other segments of the economy, but it's probably naive to think that there's at least some impact if there it's an extended economic slowdown on people's behavior across many areas of spending.

And particularly when there's uncertainty including the potential for war.

Of course, that makes sense.

And my last question is, the guidance of $4 to $4.20, I'm wondering, does that include the CTI update for '03?

Yes, it does.

Okay.

Thank you very much.

The next question comes from Bill Bonello of Wachovia Securities.

Yeah.

A couple of follow-up questions.

I also wanted to circle in on this industry growth rate question just to clarify.

When you're saying five to seven percent growth, is that total spending or are you thinking that it's five to seven percent volume growth?

Bill, to be perfectly clear, that is revenues.

That is 5 to 7 percent revenue growth as we have been saying for quite some time.

But we do believe based on published reports and some anecdotal evidence that the current growth rate in revenues is closer to the 5 percent range, the lower end of the range.

Okay.

That is helpful.

And just regarding the kind of sluggish volume growth you guys saw this quarter, are you seeing any kind of market share losses concentrated in any particular geographic areas?

Bill, we are absolutely not.

We have seen no significant change in the competitive landscape anywhere across the country.

There's always ups and downs but nothing substantial anywhere across the country in terms of changes in the competitive landscape.

And how about in terms of hospital-based business and particularly AML and Premiere?

Have you seen some attrition of AML salespeople and/or accounts or Premiere accounts since there's been more competition on that front.

No significant changes, Bill.

Certainly as you know, any Premiere relationship is certainly a license to hunt for business and certainly there is always pluses and minuses but net-net we have seen no significant change in our activities with Premiere.

And the AML integration is going well.

It's on track at this point.

Okay.

And then finally, just did you say that the -- that you expect the Core Logics project to actually be offered later this year?

Is that what I heard?

I did not, Bill.

What I was commenting on was, as I look a little bit beyond 2003, a couple of opportunities that are towards end of this year into the new year will be first the Core Logic system tests for ovarian cancer as well as the Roche test.

Bill, where we're at right now in the Core Logic tests is we need to do the validation of it.

As you may within be aware, Core Logic is working on clinical studies as it relates to that from that perspective but there is an opportunity that we could get it out late this year.

Okay.

And then just one final question back on the volume again.

If 100 basis points of the impact this quarter was from the weather and, you know, your pro forma this quarter at 1.6 percent and you also have a little bit of a holiday impact, why would you not expect a little bit higher volume growth in the first quarter of next year, sort of the 2 to 3 percent instead of the 1 to 2 percent?

Well, Bill, certainly as we've put our projections together for the first quarter, we are projecting similar rates of volume growth in the first quarter to what we experienced in quarter 4.

And certainly December, one month, doesn't a trend make.

However, it certainly has impacted our thinking.

We're not seeing any changing competitive activity but as we look ahead, we believe that prudence would suggest we should be projecting a range of 1 to 2 percent.

Bill, also keep in mind, there's approximately a point of volume in our results at this time for small acquisitions that we can put it at the end of last year which are effectively anniversaried in the first quarter.

Great.

Thank you very much.

The next question comes from Tom Gallucci of Merrill Lynch.

Good morning, everyone.

Two questions if I could.

First, on the hospital business think the common fear out there is that they are getting more aggressive.

On the other hand I know that you have a new dedicated sales force there.

Can you talk about maybe any progress you have had in actually winning business on that side?

Tom, we don't give specific details as you know.

But I will say this, that our hospital team is off and running and off to an excellent start.

We are adding a book of business in our hospital side and that's great.

We're offering our capabilities in a wide variety of ways, including in particular our reference testing capabilities, of course.

But we're also positioning ourselves as a complementary partner with hospitals to provide various alternatives for them in working with us to help improve their operations and also of course to help improve our performance, as well.

On the margins, it looked to us again tremendous leverage on the SG&A line.

Gross margin maybe was a -- or operating costs were a little bit higher maybe than we were looking for.

Can you give any color there, Bob, on the gross margins?

Yeah, Bill.

The way to think about it is, first of all, typically, the fourth quarter, the cost of sales does ramp up a little bit as a percentage of revenues.

And it's typically because the fourth quarter's softer in terms of revenues.

Keep in mind that last year's fourth quarter didn't do that.

It was more of an aberration due to the benefit of the strong revenue we recorded from that clinical trials contract that we had.

But we are seeing some higher costs in our PSCs and in-office phlebotomists as some physicians are actually less willing to do draws at this point.

But we're also seeing an offsetting benefit in SG&A as a result of that because now we're getting a better billing information which is reducing bad debt and actually helping to reduce billing costs.

Now, additionally, in this fourth quarter, we have been aggressively rolling out our Internet based results in orders product and the install costs are actually showing up in cost of sales and causing a temporary increase there.

Now, this is something that is also going to show up as a benefit in SG&A over time as the electronic connectivity reduces missing information and, therefore, reduces bad debt and billing costs, as well.

If I could follow up on the comment that you made on the PSCs, wouldn't you say there's maybe some increased costs as Docs are not doing as much drawing, is that more day to day costs or do you all expect to maybe have to invest in some infrastructure over time as a result of that trend?

Bill, it's not necessarily infrastructure as much as it is more phlebotomists.

We have added phlebotomists to deal with the additional volume coming to our PSCs at this point.

And Tom, I would just add that certainly this is -- our PSC infrastructure is a vital part of what we offer.

We're very proud of our network and we continue to upgrade our capabilities in the PSCs because it's really where we touch many, many of the 115 million patients a year come to our PSCs.

About a third our requisitions come through the PSCs and that has actually been steadily going up a little bit each year now.

Great.

Thank you.

The next question comes from David Lewis of Thomas Wiesel Partners.

Good morning.

Ken you mentioned the company may consider to enter growth areas that haven't been historically strong in, one you mentioned specifically was the south.

You mentioned regional acquisitions.

I was wondering if you ruled out the acquisition of outreach programs in the Southeast.

We don't typically comment on specific acquisition opportunities but I would say across the country, as we look at the various opportunities, certainly acquisition of outreach programs would be one avenue, as would the possibility for acquiring small independent clinical laboratories around the United States.

So certainly that would be a potential avenue.

Okay.

And maybe, Bob, if you could talk about historically AML pricing was lower than Quest's nationally.

Obviously, you acquired the company midyear.

As you look into 2003, can you comment on any potential to perhaps raise the prices of AML customers or do you imagine those will remain relatively stable in 2003?

David, first of all, I would want to clarify that because the AML pricing was not significantly different on average than of that of Quest Diagnostics.

And as we have said, the entire landscape is very competitive.

But we're trying to provide what we believe is a superior service offering so that we don't have to compete purely based on price.

Okay.

And Bob, maybe you can comment on any changes in payor mix that occurred throughout the quarter and then potentially, as you look at 2003, any specific payor changes that may have occurred or trends that you're seeing?

There are no significant payor changes that we're seeing.

Several years ago, we saw a dramatic shift away from capitated into fee for service.

That rate has significantly slowed down.

There could potentially be a little more pressure to increase the capitated volumes as managed care companies are trying to shift folks into the lower cost plans but we don't expect to see any significant swing in the payors at this point.

And really, what's driving the increase in revenue per requisition principally is the test mix as we start seeing an increase in the higher value gene-based and other esoteric testing.

And then just lastly, maybe a question for Ken, can you just update us on the number of salespeople that are specifically focused on molecular and esoteric tests and the number of salespeople that are specifically focused on the hospital segments, the division you've launched early in 2002?

In terms of our gene-based and esoteric testing sales organization we have approximately 50 dedicated people that are fully trained and able to go toe to toe with the doctors to address their technical questions and interests.

As we look at our hospital sales organization we have approximately, plus or minus, approximately 100 talented folks in the field addressing the needs of our hospital customers.

Great.

Thank you very much.

The next question comes from Christian Soud of Argus Partners.

Hi.

Question on the pricing guidance for next year.

Of the two to three percent, can you discuss what percentage of that is mix shift and then what are your assumptions on average increases for Medicare and Medicaid, and what are your assumptions on private pay?

Thank you.

As we look at price per requisition guidance of 2 to 3 percentage points, assume that more than half of it is driven by tests and payor mix changes consistent with the kind of trends that we saw in the year 2002.

As we look at the Medicare and Medicaid component.

The Medicare component, the increase in pricing in that space for clinical testing and cytology is 1.1 percent.

That is the CPI increase.

And that's the -- first increase across Medicare in approximately seven years.

The next question comes from Benjamin Pass of RBC Capital.

Hi.

Good morning, guys.

A couple of questions actually.

The first of which, it seems like the transaction with Unilab is taking longer to close than expected.

Could you just give a little color, if the path wasn't as clear as you once thought?

Well, certainly as we move forward we are encouraged by the dialogue we are having with the FTC, we're engaged in settlement discussion.

And it's been a long process.

It's a process where we've learned a lot and are continuing to learn a lot, and we expect to close the transaction in February.

Can you update us on any synergies?

I remember the last time I thought it was 30 million, has that number changed?

In the recent S-4 that we filed earlier this week, we indicated a range of $25 to $30 million.

And the reason for now putting a range in there is because of the fact that we are expecting to sell some assets in Northern California which could impact that synergy number somewhat.

Okay.

Just a couple questions, one from the 14D9 that you guys put out.

It seems in there that CSFB wasn't willing to agree to render a fairness opinion.

Could you give a little color as to the discussions that surrounded that?

We have no comment.

Okay.

Actually, just one more question for you.

Has Kelso given any indication as to how they're gonna make their election?

We have no comment.

No comment.

Okay.

Which, actually just one more.

It looks like the termination date for the transaction is January 31st and in the proxy it looks like Unilab, through the discussions wanted to bring that out a little farther.

And since you guys are indicating that February looks like when the transaction might close, do you think that you'd extend that?

Would that make sence at this point?

Keep in mind that that date automatically extends, day to day, as - once we get to that point.

And we've actually been in that mode before and there is no reason that we can't operate in that mode until such time as we post the transaction.

Okay.

Actually, I just thought of one more question.

In the 14D9, it indicated that Quest revisited during due diligence between December 4th and 19th.

Was there anything different that you guys found during that point in time?

We don't really have any specific comments for you other than to say that, you know, it's always, to our approach, is to always engage in due diligence in the process as we evaluate an acquisition through the process.

And we've been, as you know, the acquisition deal has been pending for some time, so we're on a continuous process of diligence.

And obviously, subsequent to that diligence, we reup the transaction.

Do you think there's any chance that you might modify the price one more time?

We have no comment.

Okay.

Thank you.

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

Yeah.

I had no part in that prior callers decision making process on the fairness opinion.

But, is there anything that remains to be cited from the government reimbursement standpoint for '03?

And then, secondarily, can you give us any targets for headcount reductions or facility closures for '03?

Any kind of vague guidelines?

Robert, I'm gonna take the Medi - the reimbursement side.

The only thing that's sitting out there on the reimbursement perspective, specifically that's pending, is related to the physician fee increase, which keep in mind, has a very small impact on us.

Right now, the - attached to the appropriations bill would be a modification to the 4.4 percent reduction.

In terms of your second question, in terms of employee levels in our company and lab closures.

Let's leave Unilab out of the equation for a moment.

But as it relates to our ongoing business, we're always going through an evaluation of what the appropriate staffing levels for the company ought to be as well as our appropriate lab consolidation strategy, if you will, as time moves on.

At this point in time, we're not prepared to discuss anything specific in terms of those areas and we don't typically comment until such time as we make adjustments.

Ken, is any portion of senior management compensation tied to some of those consolidation efforts though?

The way our senior management compensation is driven, it's driven off of strong performance requirements.

Starting with our earnings per share and growth in our company.

It links to our productivity of how we manage our assets no question about it.

Of course, and it's a balanced scorecard so we drive off how we're doing with our employees and customers so it's a very balanced scorecard approach and as we evaluate our approach and our strategy, clearly we're always evaluating what the appropriate level of investment should be in our employees as well as in our fixed assets that are in the ground.

Thank you.

The next question comes from Ricky Goldwasser of UBS Warburg.

Good morning.

DSOs 49 days is this a sustainable level and can you bring it to an even lower level than that?

Certainly we would love to drive it lower than that if we could and we are going to be making every effort we can to do that.

But you should expect that DSOs in the high 40s to 50 day range or so is where we would expect them to level off at.

Okay.

But certainly as certainly as we connect up with customers more electronically and we start to standardize the way that information is exchanged between us and payors, there is an opportunity to drive that down slightly further.

Now, in terms of the cost of goods versus SG&A, I know that, uhm, in early 2002 you talked about cost reallocation due to the AML transaction.

Is this something that we are going to see sort of given the anniversary of that transaction in April that we are going to see improvement in the cost of goods?

Certainly, Ricky, as we indicated when we added AML to our results, it did cause the cost of sales to go up by approximately a point as percentage of revenues because their profitability levels were not at the same level of Quest Diagnostics'.

And over time, as we integrate that business and start to realize the synergies, we are going to start to see that cost of sales number come down, as well.

And likewise we'll continue to see improvements in SG&A.

Although the DSOs are probably not going to go significantly below where they're at of around 49 days or so, over time, we expect we can drive bad debt to 4 percent or less of revenues as a result of again the same things that drove DSOs to where they are today.

Increases in electronic connectivity, the blocking and tackling in applying Six Sigma processes to our billing operations.

Now, uhm, for your guidance for the first quarter, talking about volumes of 1 to 2 percent, and for the year talking about organic volumes of 2 to 3 percent so that would imply that for the second half of the year we probably should be looking for organic volume of around 4 percent just to get to the 2 to 3 percent average.

Does this reflect timing of small acquisitions, or does this reflect your expectation of growth from the new initiatives you discussed earlier and the new markets that you are looking at?

And also sort of a follow-up to that is what would be a size of a typical small acquisition?

A lot of questions in there Ricky.

Let me try to get at it.

As we look to the organic volume growth rate, we are projecting 1 to 2 percent for the first quarter, 2 to 3 percent for the year so that excludes the impact of any small selective acquisitions.

As we go through the year, our initiatives to further enhance volume growth we do expect to bear fruit as the year progresses, including the installation of infrastructure in selected geographic markets as part of the component of our strategy as well as initiatives within our Six Sigma program to further enhance customer loyalty.

In terms of small transactions, I really can't give you any specifics today other than the fact that we have indicated that for the year, we expect that selective acquisitions will account for about 2 percent of revenue growth across the total which would imply selective acquisitions in the zone of over $80 million in the zone of $80 to $100 million of revenue.

Okay.

And last question, in terms of payor mix, are you seeing any changes in private pay out of pocket which would sort of signal some real change in the behavior of uninsured individuals?

Today, as of today, Ricky, we are not.

Thanks.

The next question comes from Alan Brockstein of [Pajor].

I had a couple of questions.

You guys have been steadily doing a very good job on bad debt expense obviously but I was just wondering what the process is because you must have some discretion over that number.

I was wondering if you could describe that process.

And then the second thing, you know, I'm sorry if this has been resolved but a few months ago your future employment status was a question.

I was just wondering if that was resolved.

Let's start with my -- I assume you're talking to me.

Yes.

Although we always ask each other the questions every day because we're here to serve you.

My response is crystal clear.

I'm highly committed to Quest Diagnostics.

We will be disclosing the terms of my new agreement with the company shortly in a filing with the SEC.

I believe it will go out with the 10-K.

Great.

And Alan, with respect to bad debt, you know, there is not a lot of discretion there.

We have a very rigorous process in the way we evaluate the collectibility of our receivables and book our bad debt.

We're very engaged with PWC, Price Waterhouse Coopers, our external auditors on this.

And what I would tell you is, you know, if you want to watch the adequacy of somebody's bad debt, watch their DSOs and watch their cash collection at the same time.

And you'll see that as we've been driving down bad debt, we've also been driving down DSOs.

And we've been using a very rigorous process to measure the bad debt and record it and it's been a process that has been in place now for a number of years.

Great.

And listening to Ricky's question actually reminded me of something that maybe is impacting you.

I was wondering if you can quantify at all, some insurance payors, like my own unfortunately, require that if a procedures are done in office by the doctors it's fully reimbursed it doesn't cost anything, it's part of the visit.

So there's obviously no marginal costs in a weak economy which have no impact on that but I'm sorry, a -- I have to pay for it if it's done out of the office.

And for some people that might not have, you know, one their spouses might not be working there might be some sort of economic issue, you know, those tests come right out of their pocket against their deductible.

Can you quantify how many of your payors have that type of arrangement?

Really I can't this morning other than to tell that you our arrangements with the various payors, there are many consistencys across the payors but there are also many variations depending on the specific needs of the payor community itself.

So we, unfortunately, can't give you specific feedback on that particular question.

Okay.

Thanks.

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

Cowen Securities.

Thanks and good morning.

First, could you discuss the nontesting business and the assumptions underlying the -- that business relative to 2003 guidance?

Sure, Kemp.

The nonclinical testing business, which is principally made up of our clinical trials testing business that accounts for about two percent or so of our total revenues.

Actually did not grow this year.

It was actually slightly less than the prior year level.

We are expecting to see some reasonable growth next year in that business.

But in no way is it enough growth to really move the needle on the numbers that you heard earlier from Ken.

It still remains a very small piece of our business, although again, we are starting to see it pick up there.

All right.

Thank you.

On the acquisitions, any thoughts regarding the significance of their potential EPS contribution given the range you have put out there for EPS and, you know, any underlying accretion that would tie directly to the 80 to 100 million in revenue?

Kemp, it certainly is within the $4 to $4.20 range we put out there for the year 2003.

That would include the impact on the bottom line of selective acquisitions and you know, one of our important ground rules is that any acquisition needs to be accretive to earnings in the first year.

But we're not prepared to quantify that for you.

Okay.

Thanks.

And then, uhm, finally, what trends are you seeing in terms of your underlying costs per test?

I think just looking at the data the last couple of years it's been rising anywhere I'd say from 3 to 4 percent.

Are you assuming that that would probably continue to be the case in '03?

Kemp, a couple of things.

I think it's on a per requisition basis it's less than 3 to 4 percent, significantly less.

But one of the things that does drive the cost per test is the mix of your testing.

Now, keep in mind, we've seen more gene-based and esoteric tests in terms of our overall mix.

It's helping price.

It does move up the costs a little bit.

But our overall costs per test, the increases there have been very modest as a result of the benefits we've been seeing from our Six Sigma and standardization efforts mitigating any other sort of inflationary increase that we might have on costs.

Great.

Thank you.

The next question comes from Matthew Beuton of Argus Partners.

Hi, guys.

I wanted to press you a little on your assumptions for pricing.

You're seeing some nice upward trends last three quarters.

Why are you guiding for those trends to kind of reverse back to the 2 to 3 percent?

And then separately, from an EBITDA perspective, I now you're looking at nice expansion next year.

Maybe can you talk about the magnitude of the Six Sigma contribution of that expansion?

Matt, one thing with respect to pricing trends, what we've seen this year for the full year is an increase of 3.2 percent in revenue per requisition.

We saw a 3.4 percent in the fourth quarter.

The guidance that we're giving you is 2 to 3 in terms of revenue per requisition so not significantly different than that.

And again what's going to drive it in the future or at least next year is going to be very much what drove it this year, a continuation of the test mix and the higher value testing contributing a piece of that.

In terms of EBITDA margin expansion, we have been improving the EBITDA margins by about two points in each of the last several years.

Six Sigma and standardization have been contributors to that.

If you look back a few more years, it was the synergies associated with the Unilab -- I'm sorry, the Unilab -- the SBCL acquisition.

But it's really now as we go forward going to be driven by the benefits of Six Sigma, standardization.

We had committed to 100 -- at least $150 million of benefits from our Six Sigma and standardization initiatives by the time we get to 2004.

And we indicated that those would come in almost on a kind of a steady stage straight line over the course of about three years or so, and we're very much on track with that.

So approximately 50 million incremental?

Very round numbers.

Okay.

Thank you very much.

The next question comes from John Park of Deal Analytics.

Our questions have been answered.

Thank you.

The next question comes from Andrew Bhak of Goldman Sachs.

Good morning.

Obviously, the market's very focused on volume trends for not only your company but the industry as a whole.

And if -- it's our working assumption that hospital competition is not intensifying per se and I think that's consistent with management's comments in the past that it's not intensifying but it's always been intense.

So if we put that aside as a factor that would impact volumes and put aside the bad weather, what should we be thinking about as analysts as to the greatest risk factor to pressuring volumes over the next four to six quarters?

Thanks.

As we look to volume growth, I'm assuming you are talking first and foremost about the industry.

And if we look at the industry, as I've said in the prepared remarks, that we believe the industry right now on a revenue basis is growing at the lower end of 5 to 7 percent a year.

That would translate to industry unit growth of being probably more like in the range of 2 to 3 percent with price being 2 to 3 percent.

If we look at potential factors that could cause it to either diminish or accelerate, from where I sit today, I don't see dramatic drivers that would cause diminishment in the level of testing volume increase.

The pervasive driver of increased testing at a modest to moderate rate in our industry is about the aging population and the growth of the population.

Your numbers of people in this country as well as the fact that we're all getting older, whether we like it or not.

That is the pervasive factor that's driving the industry forward.

And I think as we look at it, that's the game it really is.

Now a complement to that certainly is as important but is secondary to the aging and growth of the population is introduction of new tests and techniques which certainly are of great benefit to us in the sense that they typically carry a higher price point and higher margins over time.

But the real driver is all about people getting older and the fact that the numbers of people are getting larger in this country.

And then I would assume that if we by extension think about incentives or disincentives on behalf of individuals to seek care and that would sort of flow back to the managed care or commercial insurance, are you seeing any change there in terms of --

We're only seeing limited change, and one of the things that I think often is underappreciated about our industry is the fact that although we're only about 3 percent of the healthcare dollar, we impact more than 70 percent of healthcare decisions.

So virtually nothing happens in healthcare without a lab result.

So with or without potential changes that might be contemplated as time goes on as employers and others try to address the healthcare inflation problem in our country, our belief is that the fact is that lab tests are indispensable for individuals to access no matter what way, shape or form that might happen in terms of the insurance system.

Okay.

Just to summarize for my own sake, it would be unlikely that percentage co-pays or increased co-payments on behalf of individuals would impede or constrain I guess initially care seeking behavior to physicians offices and therefore testing that's not something that would be high on the list of things to worry about in terms of impacting volume over the next two years?

That certainly could you include that on your list as a potential.

And it's not clear what the impact would be on volumes.

But given the fact that if you are sick and you want to know what's wrong with you, you have to have a lab result 99 times out of 100 to have a physician make a diagnosis, we're an essential part of the equation.

We're not an optional piece.

Great.

Thanks.

Makes sense.

Bye-bye.

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

Good morning.

Can you go through some of your assumptions for cash flow for 2003?

And were there any items in 2002 you would consider one time in nature or that just won't be as strong in 2003?

Mark, as you think about our cash flow in 2002, there were several things that gave us some benefits that we most likely will not see in 2003.

First of all, are the items I referred to earlier about the taxes in the fourth quarter and our ability to accelerate tax deductions.

That's essentially a one-time benefit that you get.

We don't expect to see that again next year.

Also, I commented earlier that at 49 days DSOs, it's difficult to drive them down significantly further.

We saw a significant benefit in reducing receivables balances this year of about $50 million or so.

Again, it's unlikely that we'll see that kind of benefit next year.

So when you put those two together, along with the fact that we still saw some pretty significant tax benefits associated with the exercise of stock options, that there's probably 100 to maybe a little more than $100 million of cash flow that we had this year that we won't see next year.

Now, with that said, we still believe that cash from operations is going to be very strong in over $500 million next year, and with capital spending in the, you know, $170 to $180 million range, you get very strong free cash flow in 2003.

Thank you very much.

The next question comes from Brett Patelski of Piedman .

Yeah, hi.

It's a quick question.

In the (indiscernible) proxy it mentioned that you had been interested around October and that you really weren't in a position to do anything until the first quarter?

What was the rationale behind that?

Like, why in the first quarter you would have been interested?

Was it because of Unilab or was there any other reason why at that time you didn't want to, you know, get more serious with it?

Every time we assess a possible acquisition, we take a number of factors into account.

And it is certainly one aspect to keep in mind is timing and our belief was that we needed to continue to work through the Unilab transaction and that's priority number one.

We are excited about the possibilities and prospects strategically that Unilab presents, and we felt that it was important to stage the process.

Right.

And then, uhm, in terms of that business, I guess one of the other assets -- I guess one of the other companies, AmeriPath is on I guess up for sale.

Is that something that you might be interested in?

No comment.

Okay.

Thanks.

The next question comes from Stuart Kazanski of Vanguard Group.

Yes, good morning.

I had a couple of questions for you.

And if you have already provided this information, I apologize.

The Unilab acquisition and your earning per share guidance for '03, does the earning per share guidance already include positive impact or negative impact from Unilab?

Unilab is excluded from any guidance for 2003.

Okay.

And does the EPS of 4 to 4.20, that then also excludes any of the share issuance?

Yes.

In connection with the Unilab transaction?

Yes.

Yes.

It excludes any impact associated with the Unilab transaction.

Okay.

And going back to the cash flow question from before, I just want to try to get some clarification.

You are expecting somewhere between 400 and 420 million in net income for 2003 based upon what you're saying the earnings per share will be -- which is about 70, 80 million higher than this year.

And yet you are expecting $100 million decline in cash flow.

You know, I understand what you're talking about before, but you were talking about 100 to $120 million kind of being nonrecurring changes.

That still leaves you short in terms of a reduction in cash flow.

If you could maybe help us out to understand the difference there?

Well, I think that if you take the pieces -- again, we saw a $50 million decline in receivables balance -- absolute decline in receivables balances this year as we grew the business.

That's unlikely to happen next year.

So there's $50 million right there.

And if you assume the receivables balances or the DSOs stay about the same as where they're at right now, the balances would actually go up as the business grows.

So there is -- call it 50 to $70 million of a change right there associated with that.

The tax benefits that we saw in the fourth quarter of $40 million -- in fact, for the full year, if you look at the cash flow that's in the press release, you'll see the deferred income tax provision or the benefit associated with that was $90 million whereas the year before, it was a net zero.

And in addition, we had tax benefits associated with the exercise of stock options of about $45 million for the full year.

And in the second half of the year, that trickled down to about $3 million a quarter.

So when you look at those things and you factor in what would be a reasonable expectation for next year, it gets you down to a cash flow from operations number which is, you know, over $100 million or reduced by over $100 million as a result of those items.

But again, you have cash flow from operating activities well in excess of $500 million.

And, uhm, post the Unilab acquisition, if my memory is right, you are going to be increasing your debt by around $500 million, is that right?

Correct.

Okay.

And what kind of plans do you have them for use of free cash flow?

Well, the type debt that we're putting in place is essentially a bank term loan that is prepayable.

You should expect that we'll do much the same thing that we did with the AML acquisition and aggressively pay down debt with that cash flow.

So you don't have any plans at this point to tap the debt market for a permanent financing?

Not at this time.

Okay.

Thank you very much.

Our last question is a follow-up question from Bill Bonello of Wachovia securities.

Great.

Thanks.

Just a - actually had a couple of quick followups here.

Just on the Unilab acquisition, given that you have pegged the timing in February and given all the detail that you have given about the divestiture of certain assets, I'm wondering if you have any kind of a revised guidance on the potential 2003 accretion.

No.

We'll supply that upon the closing of the transaction.

Okay.

And then the final question was just revisiting Kemp's question on the cost per test.

It's interesting for a few quarters now we get the same kind of results as Kemp does.

If you just simply take cost of goods divided by the number of requisitions, it's going up at about 4 percent which is significantly higher than what you're suggesting.

I think part of that is there are costs associated in the cost of goods that aren't directly related to the requisition count.

I'm just wondering if you could give us a little color on what that is and, you know, how they have been impacting the costs and what the outlook going forward might be there.

Bill, the thing to keep in mind is when we think about cost of testing, first of all, we don't just think about the cost of sales number.

We think about SG&A, as well.

It's part of delivering the overall -- we're a service business.

And it's part of delivering the service.

So the billing operation which is in SG&A, the bad debt which is in SG&A, all those things we factor in when we think about our cost of testing or delivering the service that we provide to individuals.

Now, in terms of what's in cost of sales, there are several things in there.

First, it's essentially all the cost associated with not only testing but delivering test results and transporting the specimens into our laboratories.

So it includes the laboratory space itself.

It includes the equipment, it includes the patient service centers.

It includes the vehicles and the couriers that pick up the tests as well as the techs who perform the testing.

Okay.

But all those costs associated obviously with particular requisitions so I guess I'm incorrect in thinking that there's some -- some significant element of cost there that might be associated with other functions clinical trial testing, et cetera.

Correct.

You know, what you need to keep in mind, though, is the clinical trials testing business has a component of cost of sales as well as having a component of SG&A but that's not what's driving the changes.

It's really being driven by what's happening in our core business.

Okay.

Well, then that said, I understand your point on the total cost of sales going down.

But I guess there still is the question of why the outside of SG&A, the more direct cost of sales, is going up on a per requisition basis.

Bill, that was principally the acquisition of AML.

As I said earlier, that added about a full point to our cost of sales upon completing that acquisition and then most recently in this quarter, we have been ramping up the installs of our Internet-based product and the cost of those installs are sitting in cost of sales.

But as I said earlier, ultimately, we are going to see benefits in the SG&A areas as a result of that.

Perfect.

Hey, thank you very much.

We do have two additional questions.

The first question comes from Michael Stansky of Tudor Investments.

Ken, could you describe the shifts between volume and price growth rates as we move to higher margin tests done on a per sample basis?

There is a lot of focus on volume lately.

I'm curious how this dynamic impacts those growth rates ahead.

Let me take it this way because I'm not quite sure I understand your question.

In terms of esoteric and gene-based tests, the revenue per requisition would be roughly double the revenue per requisition on a more routine order.

The costs are higher, as well.

But the profitability level is typically about double the rate of the routine business.

And Mike, the other thing to keep in mind is as gene-based and other esoteric tests start to ramp up, it doesn't necessarily generate another requisition.

That's my point.

How does that affect the volume growth numbers that everyone's focused on versus the margin you are getting off the same req?

It's not the biggest impact to the volume growth numbers that Ken talked b he talked about the other dynamics, the aging of the population, the growing of the population really driving the req volumes.

But I think to your point, to the extent a high volume new esoteric test comes in on an existing requisition we would see the impact of that through improved revenue per requisition as opposed to volume.

So I think that's -- you are correct on that assumption.

Okay.

Thank you.

The last question comes from Abe Brontine of Glenview Capital.

Hi.

I'm sorry I lost my line and most of the call.

You probably have done this.

The weather-related impact on volume, was it equally -- can you say in which geographies that was primarily happening, number one?

And number two, the guidance for the first quarter, I know you gave some while I was trying to get back on as....

The weather impact in the fourth quarter, we estimated at about 1 percent of revenues.

If you look at where the storms hit, generally the East Coast and the Midwest were the areas most impacted by those.

And for the first quarter guidance, we provided total volume of approximately 10 percent with pro forma volume of 1 to 2 percent.

And your earnings?

The earnings of 82 to 87 cents per share.

And did anybody ask why that was below the previous expectations on the Street expectations?

We've not given any guidance previously in regards to either full year 2003 or even more specifically the cycling.

So, uhm, the cycling that's out there we have not looked at or provided any guidance on.

Is this, then, not in fact a disappointment from your own prior expectations whether or not they were provided or --

Not at all.

So the Street was just off base on its quarterly distribution?

I think there was a limited number of individuals that had cycles.

We have not provided any guidance.

This is not a disappointment from anything we have looked at previously.

Thank you for your help.

Thank you for participating in the Quest Diagnostics fourth quarter and full year 2002 conference call.

Investors in the United States may listen to a replay of this call by dialing 800-925-4168.

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Good-bye. [ end of conference ]