奎斯特診斷 (DGX) 2003 Q2 法說會逐字稿

The Quest Diagnostic's second quarter 2003 conference call.

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

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

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

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 with Ken Freeman, Chairman and Chief Executive Officer of Quest Diagnostics;

Surya Mohapatra, President and Chief Operating Officer; and Bob Hagemann, our Chief Financial Officer.

Ken and Bob will provide comments about our results as well as major trends 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 and involve risks and uncertainties that could cause actual results and outcomes to be materially different.

Certain of these risks and uncertainties may include unanticipated expenditures, changing relationships with customers, payers, suppliers and strategic partners.

The competitive environment, changes in government regulations, conditions of the economy and other factors described in the Quest Diagnostics Incorporated 2002 form 10K and subsequent filings.

A copy of our earnings press release, together with any information that would be required under regulation G and the text of our prepared comments will be available in the press room section of our website later today at www.Questdiagnostics.com.

Now here is Ken Freeman.

Thank you, Laure.

We delivered another quarter of strong financial results.

Here are some highlights.

We increased earnings per share 29% over year -- year-over-year.

Revenues grew 14% in line with the guidance we provided.

Looking at the components of revenue, requisition volume grew 10%, which was below our previous guidance.

Revenue per acquisition was strong, up 3.5% and above our previous guidance.

EBITDA margins continued to improve nicely, expanding by 3 percentage points to 21.2% an all-time high.

Now, Bob will provide some analysis of our second quarter results.

Thanks, Ken.

I'll start with revenues.

Revenue growth was in line with previous guidance.

Let's look at the components of revenues.

Volume growth, measured by the number of requisitions, slowed in May and June and was 10% for the quarter.

A point and a half below the mid point of guidance.

We believe this is principally attributable to economic conditions which are causing changes in patient behavior and reducing utilization of healthcare services. ¶ Pro forma volumes in the quarter declined 2.3% versus the prior year. 1 percentage point of the decline was due to the timing of the Easter and Passover holidays as we explained in April.

And half a percent was due to continuing softness in our drugs of abuse testing business.

The slowing in volume growth that we saw in May and June has led us to reduced volume guidance for the second half of the year.

We would like to grow overall volume faster, however, we will not compromise our commitment to price and discipline to achieve that end. ¶ During the second quarter, revenue per requisition more -- increased more than we had projected. 5.1% on a pro forma basis and 3.5% on a reported basis.

Improvements in test and payer mix continue to drive most of the increase.

Gene-based testing and esoteric testing continued to grow rapidly during the quarter.

Gene-based testing revenue growth exceeded 20% and esoteric testing growth was approximately 10%.

We expect strong revenue per requisition growth to continue.

Therefore, we have raised our guidance for revenue per requisition for the second half. ¶ EBITDA margins continued to expand, driven by the improving mix of business and efficiencies from Six Sigma and standardization.

With the benefits reflected in the lower cost of services and lower SG&A as a percentage of revenues.

The AML integration remained firmly on track to achieve synergies of $15 million.

In addition, we have begun implementing Unilab integration plans and expect to receive net synergies of 25 to $30 million by the end of 2005.

Cash from operations for the quarter was excellent and above the prior year level.

We achieved this improvement even though 2002 included $32 million more in nonrecurring tax benefits than this year. ¶ Strong earnings were the principal driver of cash generation.

Assisted by continued improvements in billing operations, enabling us to further reduce DSOs to 47 days.

Our performance for the first half has enabled us to increase guidance for cash from operations by $50 million to more than $600 million for the full year.

We repaid $86 million of debt during the quarter and repurchased $10 million of our stock.

We expect to accelerate share repurchases in the second half of the year.

For the third quarter, our EPS guidance is between $1.06 and $1.11 per diluted share.

Before charges associated with the Unilab acquisition. ¶ Full year EPS guidance, excluding charges associated with Unilab is for earnings per share to increase between 24 and 27%, between $4.00 and $4.10.

We lowered the full year guidance by 10 cents based upon the revenue trends we were seeing.

We made no change to the projected EBITDA percentage and have raised estimates of cash from operations.

Our guidance is further detailed in note 5 of the press release.

Now I'll turn it back to Ken.

Thanks, Bob.

Before we turn to your questions, we'd like to address some specific questions that we think will be of interest to all of you.

First, let's start with revenues.

What's happening to the industry's revenue growth rate?

Are you losing market share?

As we've said before, we continue to believe that industry revenues are growing at a rate that is less than 5%.

We believe this is caused primarily by general economic conditions, which are impacting not only our drugs of use testing business, but also healthcare spending patterns more broadly as a result of the growing number of unemployed and uninsured.

In addition, we believe modifications in healthcare plan designs, which shift costs to consumers, also are impacting spending patterns. ¶ Moderation of demand is occurring across the healthcare sector from position visit frequency to prescription drug fulfillment to hospital admissions.

This is slowing the rate of laboratory revenue growth.

We believe that our overall market share has not changed in a meaningful way.

We've seen a few instances where competitors have been willing to service business at lower price points than we're willing to do, given our commitment to maintaining strong pricing discipline.

And we are winning new business based on our value proposition.

The number of physician hospital customers we are serving remains unchanged.

We've seen some recent evidence that more in-house testing, primarily routine in nature, is taking place on a very limited basis in some hospitals and some physician practices, driven in part by economic conditions and a need to increase revenues and reduce costs.

We continue to see moderate levels of increase in the number of tests per requisition that we perform.

Primarily driven by new technology and the aging of the population.

Our gene-based and esoteric testing areas continue to grow at robust rates.

We expect our revenues on a pro forma basis to grow for the year by approximately 3%. ¶ Question No. 2: Volume.

What are you doing to reverse the same-store volume decline?

We're working hard to generate positive same-store volume growth in a difficult economic environment.

As you know, we're investing for the long-term, to enhance our competitive capabilities across four major focus areas.

Six Sigma quality, a capability we've just begun to leverage is making a difference for employees and customers, results from independent customer satisfaction surveys have never been stronger.

We're also expanding our access and distribution network to cover more of the United States. ¶ We've strengthened our customer focus with teams dedicated to meeting the special needs of hospitals, managed care organizations and physician clients.

And we're making good progress in bringing innovative technology to customers in the form of new tests as well as information and connectivity solutions.

For instance, we've launched the insure colorectal screening test, which is the only FDA-cleared test, acknowledged by the American cancer society as more patient friendly and an improvement to existing non-invasive colorectal screening.

In addition, we've also taken a number of recent tactical actions, intended to enhance the growth rate.

We've added sales staff in certain markets, including additional gene-based testing specialists with PhDs and MDs.

We've deployed new analytical tools to help sales and operations, better monitor customer activity as well as service levels we provide on a more timely basis. ¶ We're requiring employees in addition to our sales force to spend more time than ever with customers from medical staff to senior level corporate executives.

And in certain markets, we're working collaboratively with physician offices to manage their own office laboratories through our mutual advantage.

We believe these actions are the right things to do to help ensure that Quest Diagnostics achieves revenue growth rates at or above those of our industry. ¶ Question No. 3: Revenue per requisition.

Why is it stronger than you anticipated in the second quarter?

Is it sustainable?

The strong improvement in revenue per requisition continues to be driven primarily by payer and test mix.

Esoteric and gene-based testing continues to grow at rapid rates.

At the same time, portions of the business with lower growth rates, routine testing and drugs of abuse testing tends to be reimbursed at lower rates, thereby having the effect of improving our overall revenue per requisition.

Over time, we believe that the rate of revenue growth per revenue per requisition growth will moderate closer to our historical rate of 2 to 3% a year.

Keep in mind that pricing discipline continues as a fundamental operating principal and that as Bob indicated, we're not about to give up price just to gain incremental volume. ¶ Question No. 4: EPS guidance for 2003.

Why did you reduce full-year guidance by 10 cents to between $4 and $4.10?

We expect that the impact of lower volume, primarily due to general economic conditions, will not be fully offset by our stronger guidance on revenue per requisition.

As a result, we've reduced our bottom line projections.

Keep in mind that we still expect earnings per share growth year-over-year of between 24 and 27%. ¶ Question No. 5: Government's reimbursements.

What are the prospects of a co-pay provision being enacted as part of Medicare reform?

And as far as Medicaid is concerned, how much pressure are you seeing from states due to budget problems?

First on the likelihood of a Medicare co-pay, we're working through our trade association to educate lawmakers about the hardship that would be created for senior citizens and the administrative burden that would be created.

We're hopeful that the final legislation will not include a lab co-pay.

With Medicaid, we think the state fiscal crisis could have an impact on reimbursements in coming quarters.

We've begun to see discussions about reimbursement levels in some states.

Keep in mind that Medicaid accounts for only 2 to 3% of our total revenues, we're monitoring the situation closely and are actively engaged in the process. ¶ Question No. 6: Acquisitions.

What's happening on the acquisition front?

And if you can't do acquisitions, what do you do with your cash?

We continue to see acquisition opportunities and there is no shortage of small to medium-sized companies in our space.

However, we are unwilling to overpay and we did not complete any lab acquisitions during the quarter.

We're completely committed to transactions that meet our ground rules, including being accretive to EPS.

In terms of cash utilization, to the extent that we're not using our strong free cash flow for acquisitions, we expect to deploy much of it toward share repurchases.

As you know, the board authorized a share repurchase program during the second quarter and we expect to be more aggressive purchasers going forward. ¶ Question No. 7: Longer term guidance.

What is your guidance for beyond 2003?

We plan to provide longer term guidance later this year.

What keeps us from providing guidance today is the difficulty of projecting the volume growth rates of our industry and our company given current economic conditions.

Even though we're not providing specific guidance beyond 2003 today, we can reiterate what we said before and what we believe today.

We believe we're doing the right things to grow revenues at rates equal to or above the rate of growth of the lab industry.

We believe that revenue per requisition will improve 2 to 3% a year, fueled by continuing improvements in our mix of business. ¶ We believe that we can achieve EBITDA margins in the low to mid-20% range, benefiting from Six Sigma and standardization.

We believe that bad debt will continue to improve over time to a rate less than 4%.

We believe that strong cash generation will continue and we will continue as opportunistic acquirers at the right price.

If acquisitions are not available on a timely basis at appropriate valuations, we will use our free cash flow to repurchase shares more aggressively.

Putting it all together, coming back to 2003, we expect to grow earnings per share by 24 to 27%, on revenue growth of 14 to 15% with expanding EBITDA margins and strong cash flow from operations.

We remain committed to providing superior returns to shareholders in the future as we have in the past.

We will now open up the call for your questions.

Operator?

Thank you, at this time, if you'd like to ask a question, please press star 1 on your touch-tone phone.

Or to withdraw your question, press star 2.

Once again to ask a question, please press star 1 at this time on your touch-tone phone.

One moment.

Our first question comes from David Lewis, please state your company name.

Good morning, from Thomas Weisel.

Ken, one quick question, maybe one follow-up.

Specifically on volumes, you mentioned that a change in plan design could be pressuring volumes.

Given that comment, give us more granularity on when you're going see the trend?

And if that is the case and a co-pay provision gets passed, are you more nervous about that the 20% co-pay provision pressuring volumes in the future?

And maybe one follow-up?

If we look at the change in plan design, I think it's first and foremost important to realize that what we believe is the primary driver in the change in volume is the general economy, more so than changes in plan design, but given the change in the economy overall and the combination with changes in plan design, that could be impacting the level of excess per healthcare services by patients.

As we look at the impact of co-pay, potentially the co-pay that's being considered in Congress, what we also see here is that we're having good success in dialogue, with lawmakers about the potential impact on senior citizens from a co-pay provision.

We did not, at this point in time, expect a co-pay provision to be in the final bill.

There is no guarantees in life, but we're hopeful that a co-pay will not end up in the final bill coming from Congress.

Okay, and as a follow-up, a question for Bob here, you've got free cash from operations or operating cash improving dramatically, is that the result of any changes in Cap Ex guidance?

And secondly, are you going to continue to buy back program in excess of offsetting dilution?

Or just to offset dilution?

Thank you.

The increase in free cash flow is the function of a couple of things.

One, we did modestly reduce our guidance for Cap Ex by about $10 million, based upon what we've spent to date, through the first half of the year, although we're not consciously paring back on Cap Ex.

We're continuing to invest in the business for the long-term.

It's principally driven by the continued improvement in earnings, as well as aggressively managing the working capital.

The billing area continues to show significant improvements as a result of Six Sigma.

We've driven DSOs down to 47 days and we believe that there's still more room there to go.

So, we managed cash, we manage for cash, very actively.

With respect to whether or not we will purchase shares in excess of the amount necessary to offset dilution?

That's about what we did since we've authorized the plan, only a little over month or so ago.

And as we indicated, we will accelerate that somewhat in the back half of the year.

The guidance that we've given you for the back half anticipates about $100 million or so in share repurchases.

We may end up doing more than that, but if we were to it wouldn't significantly impact the earnings in the second half.

Does that conclude your question, sir?

Yes, it does, thank you.

Thank you.

Our next question comes from Tom Gallucci.

Please state your company name.

Merrill Lynch.

Thank you.

Good morning, everyone.

Just wanted to see if we could talk about the volume aspect of things a little bit more.

First it seems to be much more in the routine side than the esoteric side, is that correct?

That's a true statement.

Right now, I mean we can see a growth in gene-based testing in excess of 20%.

Esoteric remains growth about 10%.

Offsetting that, though, off drugs of abuse is down about 10%.

And on the routine, it's more flat.

When you talk about co-pays and changes in benefit design, can you maybe get a little bit more specific?

You're talking about changes in co-pays for the lab testing itself?

Or changes in co-pays to visit the doctors, so people aren't going to the doctor so they are not having the test done.

Can you give more color there in the types of changes that you are seeing?

Tom, it's more towards the latter than the former.

We're not seeing any significant trends toward lab co-pays whatsoever in the managed care community.

What we are seeing though is trends in the level of physician office visits.

A decline in the rate of growth of physician office visits across the country, which we believe is in part attributable to changes in plan design where overall there have been changes where employees are having to pick up more of the cost of healthcare and maybe in some cases treating a routine office visit as something they might think of as being more discretionary than they might have in the past because they have to pay more money out of their own pocket.

In terms of the uninsured, which you seem to point to, as well.

Obviously if you're uninsured you may not go to the doctor, but if you're uninsured, is it possible that you go to the emergency room to get the care and then that hospital does that testing and that's another diversion, not necessarily a change in the industry trend as much as the independent has a less of a chance of getting the test.

Is that another aspect of this whole thing?

Tom, certainly if an individual is uninsured, it's clear that a very important source of healthcare, when people are acutely ill, is, in fact, to go to the emergency room for care.

And that could lead, in certain incidences, to routine testing being performed in the hospital, where the patient has gone, as opposed to by an independent clinical lab.

Keep in mind that we do believe that the economic issues that we are facing, economic conditions in this country, we believe are temporary.

It's a temporary thing, not forever.

But in the short-term, certainly, it's possible that if there is lab testing being ordered on uninsured that are going to the emergency rooms instead of perhaps accessing their regular physicians for visits, that a portion of volume could, in fact, be performed routine testing volume could be performed in a hospital environment.

And maybe just one last one.

Could you update us on the integration of AML?

I know maybe we were in the early stages of transitioning, which volume -- which direction esoteric volume would be going in terms of dividing up the East Coast and West Coast labs?

Yes, it is almost complete and we are going to achieve our $15 million synergy as we have previously indicated and we are in the process of transferring some of the tests to the East Coast so that we'll provide two areas of testing, both East and West Coast.

Thank you.

Thank you.

Our next question comes from Bill Bonello and please state your company name.

Sure, it's Bill Bonello with Wachovia Securities and I have a couple of questions.

First of all, I'm kind of confused by the guidance, I'm trying to understand why you would lower the low end of the EPS guidance range if you're not lowering the low end of the revenue guidance and you're not lowering the expected EBITDA guidance and you're assumptions now include share repurchase, where I believe last quarter you said they did not.

And then I will hold for my second question.

Tom --

It's Bill.

Bill, I'm sorry.

A couple of things, one, I don't think we specifically stated whether or not last quarter included any share repurchases and keep in mind that the amount that we've got in our forecast today is very modest in terms of the impact on earnings.

What's caused us to reduce the earnings guidance is the fact that for the second half of the year, we've reduced the volumes by approximately 3% while increasing the revenue per requisition by approximately 1%.

And the net impact of that is that it's reducing overall revenues and reducing overall EBITDA, although we're keeping the EBITDA percentage consistent.

But again, the low end of the published revenue guidance this quarter is exactly the same as the low end of the published revenue guidance last quarter.

At the low end of the EPS guidance is lower.

Bill, I think you need to be careful in just looking at upper end or low end.

You know, we tend to think about the mid-points a little bit more than a range.

A range is broad.

The other thing to keep in mind is that our noncore businesses are clinical trials, testing business as well as our nickels institute diagnostics, the tips and reagents business is performing well and when you look at the numbers that we published this quarter, about half a point or so of the revenue improvement over the prior year is due to those businesses.

And are they lower margin businesses?

Generally, yes.

Okay.

And then just a second question in terms of your outlook on what's happening with the industry.

Can you just elaborate a little bit on what the evidence you have that the industry growth rate is slowing?

You know, aside from obviously your own results?

As we look to external environment, Bill, we see a lot of signs that say that the access to healthcare is going through change in the United States.

And given the fact that we impact, as a lab industry, healthcare decisions in such a major way, when you see an environment, when the rate of growth of physician visits, when the rate of growth, pharmaceutical fulfillment, drug fulfillment, when the rate of growth in hospital admissions in all cases are declining, it has to have an impact on the rate of growth in the laboratory industry, in terms of volumes.

As we look at our industry and we've now been in a prolonged economic recession with the impact of uninsured and unemployed being at very high levels, what we see here in the industry, given that 80% of our volume comes from physicians, directly, physician office visits, there is a cause and effect between the growth rate in the physician office visits and what we see happening coming into our shop.

We do not believe that we're losing any meaningful market share in this environment.

We are working very hard to gain new business, as you heard, from the initiatives we've had underway for a period of time here and we are winning new business.

But we do see our industry as we've said before, as we've said at the first quarter, as well, we do see our industry revenues growing at a rate less than the roughly 5% or so revenue growth rate that we've experienced in the last couple of years.

And that's, as we see it, where we see it.

Because the other data point, Bill, that's important, is we're serving roughly the same number of doctors and hospitals today that we served yesterday.

What we're seeing is less requisitions coming in per doctor, less requisitions coming in per hospital.

That's helpful.

Great, thank you very much.

Thank you.

Our next question comes from Gary Lieberman and please state your company name.

Hi, Morgan Stanley.

Your bad debt expense continues to improve in the quarter, your DSOs also come down.

However, other companies, specifically HDA, have given guidance that their bad debt expense will go up and they've cited specifically the weak economy, which is one of the points that you all have brought up in terms of talking about lower volumes.

Can you talk about why -- and you've also talked about the lower bad debt --

I'm sorry, I couldn't hear the last part of the question.

Lower bad debt, you said?

Yeah.

Yeah, a couple of things, Gary.

One, we have a regular review of the trends in our collections of receivables and try to assure that we're never caught by surprise.

I think there was a bit of a surprise by the company that you mentioned.

Additionally, the piece that is subject to what I'll call uncollectible receipts as a result of bad payments or bad payers, is typically the patient bill, which is a very small piece of our business.

The majority of our business is coming from third party payers and what drives bad debt there, is really missing information on requisitions that we get from physicians.

And over time, we've been working very aggressively to reduce that to physician education and internal processes here, much of it driven by Six Sigma.

So, as you look at the mix between what -- the company you mentioned and we would see in terms of the customer base, where we sit is that we are closely connected to the insurers, to the government, to hospitals, all of whom we work collaboratively with to ensure payment.

We have not gone through significant system changes, adopting new computer systems or anything like that, either.

It's a very stable billing environment.

We're using the Six Sigma to ensure continuing improvement, which firmly believe we can deliver as we drive continuing improvement in bad debt and sustain our DSOs in the 50 days or less range.

And as Ken indicated, we're also seeing we will continue to drive improvement to bad debt to 4% or lower.

Does that conclude your question?

Yes.

Thank you.

Our next question comes from Ricky Goldwasser.

Please state your company name.

UBS.

Good morning.

A couple of questions, the first ones relate to the co-pay issue.

Can you quantify to us, how much does it cost for you to process a claim today?

Ricky, we haven't typically established the cost per requisition to process a claim, but what we have shared in the past that as part of our overall costs and our employee base, about 10% of our overall employee base is, in fact, individuals who are connected with the billing and reimbursement process.

As we look at the overall piece of the equation with co-pay, certainly if a co-pay provision were to be put in place we would be required to further modify our billing and collections systems.

You can assume that even though we are hopeful that the co-pay provision will not come into place that we are putting in place all of the appropriate contingency plans to ensure that the impact of such an enactment if it were to take place would be minimal on our company.

And, Ricky, should that occur, we would be aggressively deploying our Six Sigma capabilities against that because billing is complex and if it gets more complex Six Sigma is the perfect tool for that.

Based on our we're hearing from private independent labs, we're hearing that they're estimating additional costs of about 2 to $4 per requisition on billing systems.

Given that you have the scale in the Six Sigma capabilities, should we assume that you will be at the lower end of that 2 to $4 range?

Ricky, we won't comment on anticipated costs, but what you could assume generally speaking is that given the scale of our operations and given the expertise we've developed over the years as it relates to billing and reimbursement, you should expect that generally, whatever a smaller independent lab might incur, most likely our costs would be lower because of the overall scale we have.

Okay.

And then today what percent, ballpark, are collected on a Quest drawing center?

Ricky, in our patient service centers, which are more than 1700 strong, we're collecting more than 30% of the specimens that are collected everyday in our PSCs and that number has been increasing as a percent of the total gradually across the country.

Okay.

And then on the pricing side, what percent of price growth is driven from conversion to say or if you can give us the stats and where you are now on the conversion rate?

Ricky, the majority of the revenue per rec increase is driven by overall test mix and payer mix, although a piece of that is continued conversions to thin prep.

We've gotten the majority of that in the last several years and at this point, the increase in conversion rate is very modest in terms of impact to the overall price.

The thin prep conversion, if you exclude Unilab's, about 82%.

Including Unilab, with a lower conversion rate, it's about 81%.

As Bob indicated, it's the incremental rate is slowing as we get more fully penetrated.

All right, it seems that you're kind of about flat on a sequel basis?

Up slightly.

Yeah.

And lastly on the pricing side, can you kind of walk me through the notion, whether the fact that there -- that there's some softness in the volumes, has a positive impact on pricing, especially on the capitated contract and if so, what percent of pricing growth can be attributed to that?

Well, Ricky, a couple of things.

Ken mentioned that earlier that some of the businesses that are growing slower are also the businesses that are lower price for us.

Particularly the drugs of abuse testing business and some of the routine testing business.

That in itself has an impact on the mix of business and makes the overall revenue per requisition higher.

In terms of capitated business, we have continued to see a shift out of capitated fees for service, which is higher-priced business, which helps as well.

So, it is a combination of test end payer mix that is driving the majority of the improvement in revenue per requisition.

We're seeing modest improvements in what I will call pure price, although they are modest.

And given that the primary impact of economic conditions is impacting routine testing growth rather than esoteric and gene-based testing, which continue to grow at significant rates, you can see the impact that it would have on revenue per requisition and it was shown very clearly here in the second quarter.

Right.

Okay, thank you very much.

Thank you.

Our next question comes from Robert Willoughby.

Please state your company name.

Banc of America.

Ken, you cite industry issues such as the economy for same-store volume declines, but it doesn't explain why your leading competitors' results are consistently stronger than yours.

You know I can tolerate it for a couple of quarters here but after six plus years, the party line is getting old on that front and a better analyst might think there's something structural preventing you from growing faster organically.

What's the real compelling reasons that volumes will trend up organically?

Have you changed incentive programs?

Is there anything structural above and beyond hiring reps that you've done that we should buy the thesis this time around?

I guess the first thing I'd say it s it would be helpful for us to put the numbers on the paper sometime in terms of looking at organic revenue growth comparing various companies to ensure it's apples to apples.

With that said, what we believe as we move forward is crystal clear to us and we see as the opportunity to be very successful in this business.

As we have in the past.

We've grown our organic revenues, by the way, while we've tripled the size of the company over the last five years, at rates equal to or above the rate of growth of the industry.

Not bad in an industry that historically when integrations were done would usually lose its place entirely.

Now as we move forward, we firmly believe that our commitment to driving quality and service is a vital part of our value proposition, combined with having the broadest access in the industry.

Combined with having dedicated, highly-talented folks focusing on the various market segments in a way that's very different for us than it was two or three years ago in our company.

Combined with driving innovative new tests into the marketplace, are important pieces of the formula to ensure we continue to grow organically at rates at or above the rate of growth of the industry.

Yeah, but everybody's compensation are directly tied to any improvement in organic growth or have there been no changes to compensation policies over the last several years?

Each year the compensation of the company, obviously the goals change, but the way we're all measured is driving growth for our shareholders, which translates to driving earnings per share growth with a focus on cash generation as well as metrics of customer satisfaction and employee satisfaction and quality improvement.

Ken -- the number of sales people are also tied to new sales and upsales.

I will talk about one thing here, while we are talking about the company here, we also try to keep the price up and as Bob and Ken both said, you know, there are competitors who will go and acquire an unprofitable business, but we're not going to do that and we're going to grow at or above the industry rate and the only thing we know, how to focus and execute.

Bob, I'll add one more thing and that is we are driving profitable growth as it is by the significant expansion that we've shown in EBITDA margins.

I wouldn't dispute it, you're managing to the metrics of that and getting the EBITDA margin improvement and you're getting the broader returns on investment capital, but the story line continues to be we're going to grow organically and the numbers have been consistently disappointing.

I'm unsure of what the disconnect was what you seem to be telling the street versus what you're managing to, if there's something structural or incentive-based that may be different.

The message seems to be different.

Bob, I think, you know, this is something which I take very seriously because we are focusing on revenues and if you look at the revenues, which have the volume component and price component, we are growing out and above the industry rate.

And I know that you're focused only organic volume and our philosophy is not really to get unprofitable business and just get volume up with price.

So, the only one where you could believe is for to us keep on executing the plan we have and to show you that we are going to grow organic profitable revenue.

The esoteric growth rates at 10% or so, I thought that was down from a 14 are 15% kind of number that you've done historically.

Any reason why that might have slowed a bit?

Has there been a reclassification of anything?

The rate hasn't changed from what we said in the past.

Our growth rate of esoteric testing, excluding gene-based, has been approximately 10% for quite some time now.

Bob, I think what you're confused with is what percentage it is of our top line.

Gene-based and esoteric, on a consistent basis with how we classified it, was over 15% of our top line, about 16%.

If we include DNA probes and other items that we think some of our competitors include in their definition, not including any other routine type pieces, it is above 18% of our revenues.

So, the mix of our business of gene-based and esoteric continues to climb.

No, I was confused about the revenue growth rate.

I remembered the 14, 15% growth rate.

No, that was the percentage of the top line.

All righty, thank you.

Thank you.

Our next question comes from Matthew Butin, please state your company name.

August Partners.

I wondered if you could clarify a couple of comments you made regarding volume increases and not willing to sacrifice maintaining pricing discipline and maybe talk about the impact and who are some of the players that you're eluding to that are now maintaining pricing discipline.

We're not going to comment on the specific competitors where we might be seeing or observing, pricing that we believe is not in the way we would be prepared to play because we believe in creating shareholder value.

But overall, what we do see is on a few occasions we have seen some incidences of price competition and seen it in our past, as well and we have a long standing philosophy that we do not intend to change, saying we are prepared to drive profitable growth and not chase volume at any price.

Our goal is to drive revenues in a way and costs in a way that provide superior returns on the bottom line.

And are these competitors reference or outreach programs and maybe, you know, are these volumes that you've not received, were they historical volumes from clients?

Or does this have to do with new business and new volumes?

We really aren't seeing a dramatic change at all in the competitive landscape as it relates to hospital outreach programs, our other elements.

What we are seeing as we mentioned in our prepared remarks is that there are instances where, in some cases, there may be some more in-house testing taking place, primarily routine in nature on a very limited basis in some hospitals and in some physician practices.

For instance, in the world of the physicians, you know, there are physicians in the world today trying to figure out how to pay for malpractice, which is a sin of America right now.

The whole issue of malpractice in corporate America and what the impact is to corporate America and healthcare.

Basically what we are doing is we are collaborating with physician practices as they consider the possibilities, in some instances, of establishing the labs to perform very routine tests in their facilities.

Why might they choose to do that in a difficult economy?

Maybe to find revenue sources to help pay for the higher malpractice costs, for example.

But I have to emphasize for you that this is a very limited basis.

This is not pervasive, this is not widespread.

It's a very limited basis that we're seeing this in certain areas.

So, can you quantify if you walked away from certain volumes or certain volumes you've seen, because of the pricing discipline?

We will not be able to quantify today for you, Matt, but what I would say to you is we walk away from business everyday and we gain new business everyday and we watch this very carefully and as I said before, we don't believe there's any meaningful impact on our market share as a result.

Thank you.

Thank you.

Our next question comes from Stuart Hosanski and please state your company name.

Vanguard Group.

Good morning.

I have a couple of questions for you.

One is on your use of free cash flow, you used approximately $86 million to pay down debt this year, what would be your forecast for your year-end debt level?

We're not providing a specific forecast for the year-end debt level at this point.

We do have some modest scheduled payments that need to be made over the second half, certainly less than $86 million that he we paid so far.

But as we said earlier, we expect to accelerate our share repurchases over the second half of the year and that would tend to drive more shareholder value than reductions in our debt level at this point.

Okay, but if you are going to be having, by my calculations, somewhere around $420 million of free cash flow for the year after Cap Ex, if you use some to pay down debt, you will be looking I guess to buy about $110 million in shares for the entire year.

It would seem as though you might have an extra $100 million or so to further pay down debt.

Would that be a fair comment?

Remember, Ken said earlier that there is no shortage of acquisition opportunities available of small and medium-sized companies and certainly where we see those available at the right price will deploy our cash there because we believe that that drives the greatest increase in shareholder value for us.

Okay.

All right.

Thank you.

Thank you.

Our next question comes from Bill Reed.

Please state your company name.

Deutsche Banc Securities.

Question sort of on the same theme as Stewart's.

You all have excellent credit ratios and positive debt rating trends and given the strong ratios, your ratings arguably should be higher, debt ratings.

Given that share repurchases are typically not well-received by the rating agencies, how do you balance the logical desire to reward shareholders with maintaining an investment-grade profile?

That's a great question and we've established for ourselves in conjunction with some discussions with the rating agencies, capital structure guidelines for ourselves.

And at this point, with share repurchases, we expect to at least for the rest of this year, remain at the low end of the leverage ratios that are out there and will not adversely impact our credit ratings at all.

We, you know, we are targeting a triple-B credit rating which we believe is a good, sweet spot for us in terms of access to capital as well as minimizing our cost of capital overall.

And can you share with us what those ratios are that you've established in terms of capital structure with the rating agencies?

Debt to cap is 35 to 50%.

35 to 50?

35 to 50.

Okay.

And debt to EBITDA is 1.5 to 2.25.

And currently we're just below the low end of each of those ranges.

Great.

Thanks so much.

Thank you.

Our next question comes from Patrick Kemp.

Please state your company name.

The Boston Company.

Can I ask just a quick question, it looks like you're looking for pro forma volumes to be down 1 to 2% in the third quarter, that's the guidance.

Can you maybe just give some insight into what intraquarter trends look like, pro forma was down 2.3, we're looking for the sequential improvement.

Did you see a sequential improvement through the quarter?

Actually we're not expecting a sequential improvement in the quarters over the remainder of the year.

What I said earlier was we actually saw volumes soften in the months of May and June and we are now anticipating that the volume levels that we saw in May and June are going to -- versus the prior year, are going to be relatively consistent with what we will see in the second half at this point.

And keep in mind that the current periods numbers include about a 1% impact, a negative impact from the timing of the Easter and Passover holidays.

Okay, okay.

Great, thanks.

Thank you.

Our next question comes from John Patrick Welsh, please state your company name.

Wachovia Securities.

I know recently you guys entered the North Carolina market.

I wanted to get a sense for how well you've been doing there thus far and what your plans are there for the balance of the year?

We're seeing some results from our entreé into new geographies.

It takes time as you enter into new geography and it shows courage to come in on a de novo basis, but we're encouraged with the results, but you know us, we're never satisfied, we're looking for more and looking for continued growth in the regions.

This is, again, a different way of approaching the growth.

We never actually invested in infrastructure before we got in a contract or business.

And because of our desire to grow, or the desire to grow revenue, we're actually investing in it where we're underrepresented.

Okay.

And can you also tell me for the quarter, what percentage of your total revenues remain esoteric testing and what you're doing in terms of forming partnerships with the smaller technology companies or developing the esoteric tests?

I will take the first part just for the calculation.

First off, everyone's definition of esoteric is slightly different.

Based on our definition, which is consistent with the prior quarter, esoteric and gene-based revenues were up over 16% of our top line.

If you include some of the more routine gene-based base, which we back out of the esoteric total number, it's about 18% of our top line.

Yes, you know, one of the ideas we have as a very large distribution company, the technology has to be in the market, the technology has to make scientific and medical sense and also the technology has to make economic sense.

We have a product pipeline and we actually use number of products that will help us reestablish ourselves as a leader in cardiovascular disease, cancer and infectious disease.

And a number of genetic tests coming from smaller companies, but it takes quite a bit of time because we've had the tests in our end before we've introduced the marketplace.

In addition, we have a strong capability of developing tests internally at our Nicoles institute out in San Juan Capistrano.

Okay, thank you very much.

Thank you.

Our next question is from Matt Rippenger.

Please state your company name.

Thanks, JP Morgan.

Just a few questions, first of all, you mentioned the interics rollout, I wanted to see if you had more color in terms of how the progress of the rollout is, what the status is with getting Medicare reimbursement for that and the status of the test later in '03?

We're really excited about the interic test, which is ensure.

You know, this is a test that's very ideal for a screening test.

It is below $100, it is not invasive and it will have higher compliance because it won't have to deal with.

This test is now available in all our laboratories and we're now working with them to get the universal level.

So, we continue rolling out the test is really going to help the people suffering with colorectal cancer and we're very excited about it.

The Medicare reimbursement status, we expect to see it finalized later this year and the other piece of your question was specific guidance on what we're anticipating from it, we don't provide guidance on a test by test basis.

Okay, great.

And back to the co-pay question, if Medicare does implement a co-pay, what would be the biggest area of impact for you in your opinion, would it be on utilization?

Higher bad debt expense for the Medicare co-pay?

Or related to higher cost per claim related to billing and processing.

Yeah, frankly it's difficult to assess right now since we don't know how that would be implemented if it were to be implemented, but certainly there could be an impact in all of those areas and as I mentioned earlier, I feel as though with the ability to use Six Sigma to deploy against any process changes we need to make, we will be as equipped as anyone to deal with changes down the road.

We continue, as we said before, we're hopeful it won't be passed.

But at the same time, we're developing the contingency plans.

And also as you look at our path, there have been other occasions in the history of our relationships with government payers where we've needed to modify process to ensure appropriate reimbursement and we've been -- I'd have to say reasonably successful over the years in addressing those changes in a way that's made sense and has created opportunities for us.

Great.

And the last question I have is just if you can update us on the divestiture of the Northern California assets and where you stand with that?

Go ahead, Surya.

I told you, I thought it is going very well, it's on track.

And as far as Northern California is concerned, the transfer is underway.

It began late in the second quarter.

We believe it will be completed later in the third quarter.

Our guidance reflects the transfer of the business.

Great.

Thanks very much.

Thank you.

We have a question from Jennifer Pearlman.

Please state your company name.

Hi, good morning.

Burgundy Asset Management.

I have two questions.

The first is just going back to your point about the co-payment provision and the current pricing in terms of -- despite a full pipe of small to mid-size potential acquisitions, pricing seemed a little out of reach.

I wondered whether this proposed co-payment provision for lapse services has spoofed any of the smaller companies into potentially exiting the industry and whether that would make going forward pricing more attractive for these potential acquisitions?

Yeah, we don't typically comment on specific acquisition candidates, but you raise an interesting point.

If in fact, if in fact a co-pay were to come into being, our belief is that it would potentially have a disproportionate impact on our smaller competitors and let's be clear, I don't believe anybody in the lab space wants one if we can avoid it and we're working hard to ensure that Congress understands the impact on seniors and the impact on administrative complexity.

But, if in fact, a co-pay were to be enacted, our belief would be that you will see some independent labs, smaller labs that may choose in the end to decide not to participate in that part of the business or to modify how they participate.

Which could, in fact yield interest in -- more interest at different valuations than might exist currently.

And any scale benefit from that, would you see that offsetting or potentially serving as an offset to potential volume loss from this co-payment provision?

I'd rather not go into a cause and effect and don't think there's no strong correlation there, but we remain committed to do, regardless of the structure of the Medicare program, we remain fully committed to being a first class supplier in all respects to Medicare and its beneficiaries.

Okay.

And just my second question: You seem to be describing the slow down on the routine testing side by the general economic downturn.

I was wondering if you could maybe shed some light on the impact that the pressures that over the last few months, the hospitals, had in HDL, the big hospital groups have fallen under, whether that has specifically caused them to pull back in some of the lab business they were outsourcing to you and whether that specifically has served just sort of slow your own growth in routine testing.

The key thing keep in mind here is that physicians account for more than 80% of our business and we have not seen any dramatic shifts in the area that you've mentioned.

Also keep in mind that the work that the hospitals tend to send us is the more complex esoteric and gene-based testing, where we continue to demonstrate growth rates in excess of 20% and 10% respectively.

Okay.

Thank you very much.

Thank you for participating in the Quest Diagnostics second quarter 2003 conference call.

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