News Column

QUEST DIAGNOSTICS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

July 31, 2014

Our Company

Quest Diagnostics is the world's leading provider of diagnostic information services ("DIS"), providing insights that empower and enable patients, physicians, hospitals, integrated delivery networks, health plans, employers and others to make better healthcare decisions. Over 90% of our revenues are derived from DIS with the balance derived from risk assessment services, clinical trials testing, diagnostic products and healthcare information technology. Our business segment information is disclosed in Note 14 to the interim unaudited consolidated financial statements.



Second Quarter Highlights

Our total net revenues of $1.9 billion were 4.8% above the prior year period. DIS revenues of $1.8 billion were 5.3% above the prior year period. DIS volume, measured by the number of requisitions, increased 7.7% compared to the prior year period. Our recent acquisitions added approximately 7% to DIS revenue growth and approximately 8.5% to DIS volume compared to the prior year period. Excluding the impact of acquisitions, DIS volume was lower by approximately 1% compared to the prior year period which was driven by our decision in the quarter to not renew certain business due to strategic reasons. Diagnostic Solutions ("DS") revenues were $139 million, and 1.1% below the prior year period. The decline in our DS revenues is primarily due to the divestiture of Enterix in the prior year. Excluding the impact of this divestiture, our DS revenues would have improved by approximately 1%. Income from continuing operations attributable to Quest Diagnostics' stockholders was $133 million for the three months ended June 30, 2014. Earnings per diluted share from continuing operations was $0.92 for the three months ended June 30, 2014.



Five-point Strategy

We continued making progress on the execution of our five-point strategy during the second quarter of 2014.

We completed the acquisition of Summit Health, Inc. ("Summit Health") and

the outreach laboratory service operations of Steward Health Care Systems,

LLC ("Steward").

We repurchased $25 million of our common stock as part of our Common Stock

repurchase program.

We partnered with Memorial Sloan Kettering to use molecular testing and

next generation sequencing to improve physicians' ability to treat patients with a variety of solid tumor cancers.



We partnered with Sequenom to offer national access to its non-invasive

prenatal test. Invigorate Program We are engaged in a multi-year program called Invigorate which is expected to deliver $700 million in run rate savings versus 2011 by the time we exit 2014. We expect to deliver approximately $200 million in realized savings in 2014. We continue to seek additional opportunities to increase the savings from Invigorate to greater than $1 billion over time. The Invigorate program is intended to partially offset continued reimbursement pressures and labor and benefit cost increases; free up additional resources to invest in science, innovation and other growth initiatives; and enable us to improve service quality and operating profitability. In connection with our Invigorate program, we have launched multiple management restructuring initiatives aimed at driving operational excellence and restoring growth. These restructuring initiatives were primarily undertaken to eliminate multiple layers from the organization, migrate certain aspects of our support functions to an outsourcing model and optimize the use of our facilities and infrastructure. As of June 30, 2014, we have recorded approximately $153 million of pre-tax employee separation costs and other restructuring related costs associated with these initiatives. Our estimate of pre-tax charges, expected to be incurred in the second half of 2014 in connection with the Invigorate program, is between $40 million and $55 million. These pre-tax charges consist of employee separation costs, systems conversion and integration costs and facility-related charges. Through June 30, 2014, the cumulative charge recorded in connection with the Invigorate program is approximately $218 million.



For additional information on the Invigorate program and associated costs, see Note 4 to the interim unaudited consolidated financial statements.

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Recent Acquisitions

Acquisition of Solstas Lab Partners Group

On March 7, 2014, we completed the acquisition of Solstas in an all-cash transaction valued at $572 million, or $563 million net of cash acquired. Solstas is a full-service commercial laboratory based in Greensboro, North Carolina and operates in nine states throughout the Southeastern United States, including the Carolinas, Virginia, Tennessee, Georgia and Alabama.

Acquisition of Summit Health

On April 18, 2014 we completed the acquisition of Summit Health, a leading provider of on-site prevention and wellness programs for $151 million. The purchase price consisted of cash consideration of $124 million (which includes $9 million of working capital adjustments), or $123 million net of cash acquired, estimated contingent consideration of $22 million, and $5 million associated with certain transaction related costs due to the sellers of Summit Health.



Acquisition of Steward Health Care Systems, LLC

On April 16, 2014, we completed the acquisition of the outreach laboratory service operations of Steward Health Care Systems, LLC for $34 million, which consisted of cash consideration of $30 million and contingent consideration of $4 million.



See Note 5 to the interim unaudited consolidated financial statements for additional information associated with our recent acquisitions.

Critical Accounting Policies

There have been no significant changes to our critical accounting policies from those disclosed in our 2013 Annual Report on Form 10-K.

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Results of Operations

The following table sets forth certain results of operations data for the periods presented:

Three Months Ended June 30, Six Months Ended June 30, Increase % Increase Increase % Increase 2014 2013 (Decrease) (Decrease) 2014 2013 (Decrease) (Decrease) (dollars in millions, except per share amounts) Net revenues: DIS business $ 1,763$ 1,674$ 89 5.3 % $ 3,377$ 3,323$ 54 1.6 % DS businesses 139 141 (2 ) (1.1 ) 271 279 (8 ) (2.7 )



Total net revenues $ 1,902$ 1,815$ 87 4.8 % $ 3,648$ 3,602$ 46 1.3 %

Operating costs and expenses: Cost of services $ 1,174$ 1,094$ 80 7.3 % $ 2,275$ 2,186$ 89 4.1 % Selling, general and administrative 440 418 22 5.2 855 866 (11 ) (1.3 ) Amortization of intangible assets 25 20 5 26.7 47 39 8 20.2 Other operating expense (income), net 1 (6 ) 7 NM 1 (5 ) 6 NM



Total operating costs and expenses $ 1,640$ 1,526$ 114 7.4 % $ 3,178$ 3,086$ 92 3.0 %

Operating income $ 262$ 289$ (27 ) (9.2 )% $ 470$ 516$ (46 ) (8.9 )%

Other income (expense): Interest expense, net $ (42 )$ (40 )$ (2 ) 4.1 % $ (81 )$ (80 )$ (1 ) 1.0 % Equity in earnings of equity method investees 6 7 (1 ) (7.5 ) 12 13 (1 ) (7.1 ) Other income, net 3 - 3 NM 4 4 - NM



Total non-operating expenses, net $ (33 )$ (33 ) $ - (0.7 )% $ (65 )$ (63 )$ (2 ) 2.1 %

Income tax expense $ 87$ 95$ (8 ) (7.6 )% $ 152$ 168$ (16 ) (9.4 )% Effective income tax rate

37.9 % 36.9 % 1.0 % NM 37.5 % 37.1 % 0.4 % NM Income from discontinued operations, net of taxes $ - $ 13$ (13 ) NM $ - $ 33$ (33 ) NM Income from continuing operations attributable to Quest Diagnostics' stockholders $ 133$ 152$ (19 ) (12.4 )% $ 237$ 268$ (31 ) (11.5 )% Diluted earnings per common share from continuing operations attributable to Quest Diagnostics' common stockholders $ 0.92$ 0.99$ (0.07 ) (7.1 )% $ 1.63$ 1.71$ (0.08 ) (4.7 )% NM - Not Meaningful 30



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The following table sets forth certain results of continuing operations data as a percentage of net revenues for the periods presented:

Three Months Ended June 30, Six Months Ended June 30, 2014 2013 2014 2013 Net revenues: DIS business 92.7 % 92.3 % 92.6 % 92.3 % DS businesses 7.3 7.7 7.4 7.7 Total net revenues 100.0 % 100.0 % 100.0 % 100.0 % Operating costs and expenses: Cost of services 61.7 % 60.2 % 62.4 % 60.7 % Selling, general and administrative 23.1 23.1 23.4 24.1 Amortization of intangible assets 1.3 1.1 1.3 1.1 Other operating expense, net 0.1 (0.3 ) - (0.2 ) Total operating costs and expenses 86.2 % 84.1 % 87.1 % 85.7 % Operating income 13.8 % 15.9 % 12.9 % 14.3 % Continuing Operations Results for the three months ended June 30, 2014 were affected by certain items that negatively impacted diluted earnings per share by $0.16. During the three months ended June 30, 2014, we recorded pre-tax charges of $27 million, or $0.13 per diluted share, related to restructuring costs primarily associated with workforce reductions, integration costs and professional fees associated with the further restructuring of our business (including $5 million of pre-tax integration and transaction costs associated with acquisitions). In addition, we recorded a pre-tax charge of $7 million, or $0.03 per diluted share, principally associated with the settlement of legal matters. Results for the six months ended June 30, 2014 were affected by certain items that negatively impacted diluted earnings per share by $0.29. During the six months ended June 30, 2014, we recorded pre-tax charges of $51 million, or $0.24 per diluted share, related to restructuring costs primarily associated with workforce reductions, integration costs and professional fees associated with the further restructuring of our business (including $11 million of pre-tax integration and transaction costs associated with acquisitions). In addition, we recorded pre-tax charges of $11 million, or $0.05 per diluted share, principally associated with the settlement of legal matters. Results for the three months ended June 30, 2013 included $19 million of pre-tax charges, or $0.07 per diluted share, related to restructuring and integration costs primarily associated with workforce reductions and professional fees associated with further restructuring and integrating our business. Results for the six months ended June 30, 2013 included $63 million of pre-tax charges, or $0.24 per diluted share, related to restructuring and integration costs primarily associated with workforce reductions and professional fees associated with further restructuring and integrating our business.



Net Revenues

Net revenues for the three months ended June 30, 2014 were 4.8% above the prior year level.

DIS revenue, which accounted for over 90% of our consolidated net revenues, increased by 5.3% for the three months ended June 30, 2014 compared to the prior year period. Our recent acquisitions added approximately 7% to DIS revenue growth.

DIS volume, measured by the number of requisitions, increased 7.7% for the three months ended June 30, 2014 compared to the prior year period. Our recent acquisitions contributed approximately 8.5% to DIS volume in the quarter. After considering the impact of our recent acquisitions, underlying DIS volume was lower by less than 1%, as compared to the prior 31



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year period which was driven by our decision in the quarter to not renew certain business due to strategic reasons. Our underlying DIS volume has improved sequentially as compared to the first quarter of 2014.

Revenue per requisition for the three months ended June 30, 2014 decreased 2.3% from the prior year level. The impact of our recent acquisitions reduced revenue per requisition by approximately 1% in the quarter with the remainder of the decrease due to reimbursement pressure and mix of our business. For the three months ended June 30, 2014, combined revenues in our DS businesses decreased by approximately 1.1%, compared to the prior year period. The decline in our DS revenues is primarily due to the divestiture of Enterix in the prior year. Excluding the impact of this divestiture, our DS revenues would have improved by approximately 1%.



Net revenues for the six months ended June 30, 2014 were 1.3% above the prior year level.

DIS revenue, which accounted for over 90% of our consolidated net revenues, increased by 1.6% for the six months ended June 30, 2014 compared to the prior year period. Our recent acquisitions added approximately 5% to DIS revenue growth.

DIS volume, measured by the number of requisitions, increased 4.3% for the six months ended June 30, 2014 compared to the prior year period. Our recent acquisitions contributed approximately 6% to DIS volume in the period.

Revenue per requisition for the six months ended June 30, 2014 decreased 2.5% from the prior year level. The impact of our recent acquisitions reduced revenue per requisition by approximately 1% during the period with the remainder of the decrease due to reimbursement pressure and mix of our business. For the six months ended June 30, 2014, combined revenues in our DS businesses decreased by approximately 2.7%, compared to the prior year period. The decline in our DS revenues is primarily due to the divestiture of Enterix in the prior year. Excluding the impact of this divestiture, our DS revenues would have decreased by less than 1%, which was was due to lower revenues in our products and clinical trials businesses.



Cost of Services

Cost of services consists principally of costs for obtaining, transporting and testing specimens as well as facility costs used for the delivery of our services.

Cost of services increased $80 million for the three months ended June 30, 2014 as compared to the prior year period. This increase was primarily driven by additional operating costs associated with our recent acquisitions, partially offset by lower overall compensation and benefit costs resulting from reduced headcount under the Invigorate program. In addition, cost of services includes a $13 million increase in the current period, that is principally due to the allocation of certain facility costs between cost of services and selling, general and administrative expenses for those facilities that support both service delivery and administrative functions, in order to reflect our current operations.



The impact of the additional operating costs associated with our recent acquisitions and the change in allocation of facility costs are the primary factors for the increase in cost of services as a percentage of net revenues in 2014 compared to the prior year period.

Cost of services increased $89 million for the six months ended June 30, 2014 as compared to the prior year period. This increase was primarily driven by additional operating costs associated with our recent acquisitions and higher performance based compensation costs. These increases were partially offset by lower overall compensation and benefit costs resulting from reduced headcount under the Invigorate program and lower restructuring and integration costs in 2014 as compared to the prior year period. In addition, cost of services includes a $25 million increase in the current period, that is principally due to the allocation of certain facility costs between cost of services and selling, general and administrative expenses for those facilities that support both service delivery and administrative functions, in order to reflect our current operations.



The impact of the additional operating costs associated with our recent acquisitions and the change in allocation of facility costs are the primary factors for the increase in cost of services as a percentage of net revenues in 2014 compared to the prior year period.

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Selling, General and Administrative Expenses ("SG&A")

SG&A consist principally of the costs associated with our sales and marketing efforts, billing operations, bad debt expense and general management and administrative support as well as administrative facility costs.

SG&A increased $22 million for the three months ended June 30, 2014 as compared to the prior year period. The increase in SG&A is due to the additional operating costs associated with our recent acquisitions, higher performance based compensation costs and legal settlement costs. This increase was partially offset by a $13 million reduction to SG&A, that is principally due to the allocation of certain facility costs between cost of services and SG&A for those facilities that support both service delivery and administrative functions, in order to reflect our current operations. Additionally, lower overall compensation and benefit costs resulting from reduced headcount under the Invigorate program, partially offset this increase in SG&A. SG&A decreased $11 million for the six months ended June 30, 2014 as compared to the prior year period. This decrease is due to lower overall compensation and benefit costs resulting from reduced headcount under the Invigorate program and lower restructuring and integration related costs in 2014 as compared to the prior year period. In addition, the decrease in SG&A also benefited from $25 million, that is principally due to the allocation of certain facility costs between cost of services and SG&A for those facilities that support both service delivery and administrative functions, in order to reflect our current operations. This decrease was partially offset by the additional operating costs associated with our recent acquisitions, higher performance based compensation costs and legal settlement costs.



Our bad debt expense as a percentage of revenues increased approximately 20 basis points, as compared to both prior year periods, to 3.9% for the three months ended June 30, 2014 and to 4.1% for the six months ended June 30, 2014.

Amortization of Intangible Assets

The increase in amortization of intangible assets for the three and six months ended June 30, 2014, compared to the prior year period, primarily reflects the impact from amortization of intangible assets acquired as part of our recent acquisitions.



Other Operating Expense (Income), net

Other operating expense (income), net includes miscellaneous income and expense items related to operating activities. For both the three and six months ended June 30, 2013, other operating expense (income), net includes a gain of $6 million resulting from consideration received associated with certain non-compete agreements.



Operating Income

Operating income as a percentage of net revenues decreased to 13.8% in the three months ended June 30, 2014, as compared to 15.9% in the prior year period. For the six months ended June 30, 2014, operating income as a percentage of net revenues decreased to 12.9% , as compared to 14.3% in the prior year period. The decrease in operating income as a percentage of net revenues for both periods was primarily driven by reimbursement pressure, additional operating costs associated with our recent acquisitions, higher performance based compensation costs and legal settlement costs. This decrease was partially offset by lower overall compensation and benefit costs resulting from reduced headcount under the Invigorate program and lower restructuring and integration related costs in the six months ended June 30, 2014 as compared to the prior year period. Due to the timing of our recent acquisitions, we have not fully realized the anticipated synergies associated with these acquisitions, which has impacted our operating income as a percentage of net revenues for the three and six months ended June 30, 2014. Interest Expense, net



Interest expense, net for the three and six months ended June 30, 2014 increased $2 million and $1 million, respectively, compared to prior year periods, primarily as a result of higher outstanding debt balances in 2014.

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Other Income, net

Other income, net represents miscellaneous income and expense items related to non-operating activities, such as gains and losses associated with investments and other non-operating assets. For the three months ended June 30, 2014, other income, net includes a gain of $2 million, associated with investments held in trusts pursuant to our supplemental deferred compensation plans. Other income, net for both the six months ended June 30, 2014 and 2013, includes gains of $4 million, associated with investments held in trusts pursuant to our supplemental deferred compensation plans.



Income Tax Expense

The increase in the effective income tax rate for the three and six months ended June 30, 2014, compared to the prior year period is due in part to the relative levels of domestic and foreign pre-tax income in each of the respective periods. Furthermore, there were higher tax credits realized in the effective income tax rate for the three and six months ended June 30, 2013.



Discontinued Operations

Discontinued operations includes HemoCue, which was sold in April 2013, OralDNA and NID. The results of operations of HemoCue, OralDNA and NID have been classified as discontinued operations for all periods presented. See Note 13 to the interim unaudited consolidated financial statements for further details. Discontinued operations, net of taxes, for the three and six months ended June 30, 2013 includes a gain of $13 million (including foreign currency translation adjustments, partially offset by income tax expense and transaction costs) associated with the sale of HemoCue. In addition, income from discontinued operations, net of taxes for the six months ended June 30, 2013, includes discrete tax benefits of $20 million associated with favorable resolution of certain tax contingencies related to our NID business.



The following table summarizes our income from discontinued operations, net of taxes:

Three Months Ended June 30, Six Months Ended June 30, Increase Increase 2014 2013 (Decrease) 2014 2013 (Decrease) (dollars in millions) Net revenues $ - $ 3$ (3 ) $ - $ 28$ (28 ) Income from discontinued operations before taxes - 21 (21 ) - 22 (22 ) Income tax (expense) benefit - (8 ) 8 - 11 (11 ) Income from discontinued operations, net of taxes $ - $ 13$ (13 ) $ - $ 33$ (33 )


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