Our Services

Our laboratory testing business consists of routine testing, esoteric testing, and clinical trials testing. Routine testing generates approximately 80% of our net revenues, esoteric and gene-based testing generates approximately 16% of our net revenues, and clinical trials testing generates less than 3% of our net revenues. We derive less than 2% of our net revenues from foreign operations.

Routine Testing

Routine tests measure various important bodily health parameters such as the functions of the kidney, heart, liver, thyroid and other organs. Commonly ordered tests include:

•  blood cholesterol level tests;

•  complete blood cell counts;

•  Pap tests;

•  HIV-related tests;

•  urinalyses;

•  pregnancy and other prenatal tests; and

•  alcohol and other substance-abuse tests.

We perform routine testing through our network of major laboratories, rapid response laboratories, or “stat” labs, and patient service centers. We also perform routine testing at the hospital laboratories we manage. Major laboratories offer a full line of routine clinical tests. Rapid response laboratories are local facilities where we can quickly perform an abbreviated group of routine tests for customers that require rapid turnaround times. Patient service centers are facilities where specimens are collected. These centers are typically located in or near a building used by medical professionals.

We operate 24 hours a day, 365 days a year. We perform and report most routine procedures within 24 hours. Most test results are delivered electronically.

Esoteric Testing

Esoteric tests are those tests that require more sophisticated technology, equipment and materials, professional “hands-on” attention and more highly skilled professional and technical personnel, and may be performed less frequently than routine tests. Because it is not cost-effective for most clinical laboratories to perform a low volume of esoteric tests in-house, they generally refer many of these tests to an esoteric clinical testing laboratory that specializes in performing these more complex tests. Due to their complexity, esoteric tests are generally reimbursed at higher levels than routine tests.

Our two esoteric testing laboratories, which conduct business as Quest Diagnostics Nichols Institute, are among the leading esoteric clinical testing laboratories in the world. In 1998, our esoteric testing laboratory in San Juan Capistrano, California, became the first clinical laboratory in North America to achieve ISO-9001 certification. Our esoteric testing laboratory in Chantilly, Virginia, acquired as part of the AML acquisition, now enables us to provide full esoteric testing services, including gene-based testing, on the east coast. Our two esoteric testing laboratories perform hundreds of esoteric tests that are not routinely performed by our regional laboratories. These esoteric tests are generally in the following fields:

•  endocrinology and metabolism (the study of glands, their hormone secretions and their effects on body growth and metabolism);

•  genetics (the study of chromosomes, genes and their protein products and effects);

•  hematology (the study of blood and bone marrow cells) andcoagulation (the process of blood clotting);

•  immunology (the study of the immune system including antibodies, immune system cells and their effects);

•  microbiology and infectious diseases (the study of microscopic forms of life including bacteria, viruses, fungi and other infectious agents);

•  oncology (the study of abnormal cell growth including benign tumors and cancer);

•  serology (a science dealing with the body fluids and their analysis, including antibodies, proteins and other characteristics);

•  special chemistry (more sophisticated testing requiring special expertise and technology); and

•  toxicology (the study of chemicals and drugs and their effects on the body’s metabolism).

New Test Introductions

We intend to build upon our reputation as a leading innovator in the clinical laboratory industry by continuing to introduce new diagnostic tests. As the industry leader with the largest and broadest network and the leading provider of esoteric testing, including gene-based testing, we believe that we are the best partner for developers of new technology and tests to introduce their products to the marketplace.

During 2003, we continued to be a leading innovator in the industry through both tests that we developed at Nichols Institute, the largest provider of molecular diagnostic testing in the United States, as well as through relationships with technology developers. During 2003, we developed and introduced:

•  more than 15 comprehensive panels utilizing our menu of over 100 tests to assist physicians with diagnosis and management of patients with bleeding or blood clotting disorders;

•  over 15 new infectious disease tests including DNA assays for West Nile and SARS infection; and

•  a biomarker assay that provides information on recurrence risk and biologic behavior of node negative breast cancer to guide therapy for the 30% of women with node negative disease.

During 2003, we inaugurated a molecular endocrinology laboratory, with introduction of the first commercial DNA tests for central and nephrogenic Diabetes Insipidus (DI), Congenital Adrenal Hyperplasia (CAH), and Thyroid Hormone Resistance (THR). The DI tests bypass the complicated perturbation tests used for differential diagnosis of the several disorders. CAH testing is offered as a DNA analysis for the most common mutations and as a CAH complete gene sequencing for the 60 deleterious mutations known to be associated with this wide spectrum of adrenal function disorders. The THR testing provides definitive diagnosis for children with hypothyroidism of variable extent associated with the defective hormone receptor.

Through our relationship with members of the academic community and pharmaceutical and biotechnology firms, as well as our collaboration with emerging medical technology companies that develop and commercialize novel diagnostics, pharmaceutical and device technologies, we believe that we are one of the leaders in transferring technical innovation to the market. During 2003, we entered into a variety of strategic technology arrangements including:

•  an agreement with Enterix, Inc. under which we have begun to offer the Insure^™ test, an FDA- cleared fecal immunochemical screening test for colorectal cancer. Unlike other non-invasive colorectal cancer screening technologies, the Insure ^™ test is easy for patients to use and requires no handling of fecal matter;

•  an agreement with diaDexus under which we are expanding our heart disease test offering through the Lp-PLA2 test, which enables physicians to detect a new risk factor for cardiovascular disease by measuring levels of the enzyme lipoprotein-associated phospholipase A2; and

•  a relationship with Thermo Electron under which we are developing a biochip-based test for the detection of cystic fibrosis (CF) gene mutations during prenatal screening.

Through our research and development, marketing and commercial alliance with Roche Diagnostics, we were the first laboratory to offer several new tests developed by Roche, including its Elecsys NT-proBNP test (which aids in the diagnosis of congestive heart failure). Our relationship with Celera Diagnostics gives us access to potentially significant markers for the risk of cardiovascular disease, the leading cause of death in the United States, and diabetes. Our relationship with Correlogic Systems has gained access to its new ovarian cancer blood test, which we hope will be available to the marketplace in 2004 and will be the first protein pattern recognition blood test to detect ovarian cancer in women who are already considered high risk.

We believe that, with the unveiling of the human genome, new genes and the linkages of genes with disease will continue to be discovered at an accelerating pace, leading to research that will result in ever more complex and thorough predictive, diagnostic and therapeutic testing. We believe that we are well positioned to capture much of this growth.

Clinical Trials Testing

We believe that we are the world’s second largest provider of clinical laboratory testing performed in connection with clinical research trials on new drugs in the world. Clinical research trials are required by the Food and Drug Administration, or FDA, and other international regulatory authorities to assess the safety and efficacy of new drugs. We have clinical trials testing centers in the United States and in England. We also provide clinical trials testing in Australia, Singapore, and South Africa through arrangements with third parties. Clinical trials involving new drugs are increasingly being performed both inside and outside the United States. Approximately 45% of our net revenues from clinical trials testing in 2003 represented testing for GlaxoSmithKline plc, or GSK. We currently have a long-term contractual relationship with GSK, under which we are the primary provider of testing to support GSK’s clinical trials testing requirements worldwide.

Other Services and Products

We manufacture and market diagnostic test kits and systems primarily for esoteric testing under the Nichols Institute Diagnostics brand name. These are sold principally to hospitals, clinical laboratories and dialysis centers, both domestically and internationally. Our MedPlus subsidiary is a developer and integrator of clinical connectivity and data management solutions for healthcare organizations and clinicians primarily through its ChartMaxx^® electronic medical record system. During 2003, we began deploying eMaxx^®, a new physician’s Internet portal across the United States. The Internet portal was developed by MedPlus and can provide physicians a “patient-centric” view of laboratory test results and other clinical information on-line.

Payers and Customers

We provide testing services to a broad range of healthcare providers. We consider a “payer” as the party that pays for the test and a “customer” as the party who refers the test to us. Depending on the billing arrangement and applicable law, the payer may be (1) the physician or other party (such as another laboratory or an employer) who referred the testing to us, (2) the patient, or (3) a third party who pays the bill for the patient, such as an insurance company, Medicare or Medicaid. Some states, including New York, New Jersey and Rhode Island, prohibit us from billing physician clients. We consider a managed care organization as both our customer and a payer, when it contracts with us on an exclusive or semi-exclusive basis on behalf of its patients.

During 2003, only two customers accounted for more than 5% of our net revenues, and no single customer accounted for more than 7% of our net revenues. We believe that the loss of any one of our customers would not have a material adverse effect on our financial condition, results of operations or cash flows.

Payers

The following table shows current estimates of the breakdown of the percentage of our total volume of requisitions and total clinical laboratory net revenues during 2003 applicable to each payer group:

Customers

                Physicians

Physicians requiring testing for patients are the primary source of our clinical laboratory testing volume. We typically bill physician accounts on a fee-for-service basis. Fees billed to physicians are based on the laboratory’s client fee schedule and are typically negotiated. Fees billed to patients and insurance companies are based on the laboratory’s patient fee schedule, subject to any limitations on fees negotiated with the insurance companies or with physicians on behalf of their patients. Medicare and Medicaid reimbursements are based on fee schedules set by governmental authorities.

                Managed Care Organizations and Other Insurance Providers

Health insurers, which typically contract with a limited number of clinical laboratories for their members, represent approximately one-half of our total testing volumes and one-half of our net revenues. Larger health insurers typically prefer to use large commercial clinical laboratories because they can provide services on a national or regional basis and can manage networks of local or regional laboratories to provide even broader access to their members and physicians. In addition, larger laboratories are better able to achieve the low-cost structures necessary to profitably service large health insurers and can provide test utilization data across their various plans in a consistent format. In certain markets, such as California, many health insurers delegate their covered members to independent physician associations, which in turn contract with laboratories for clinical laboratory services.

Over the last decade, health insurers have been consolidating, resulting in fewer but larger insurers with significant bargaining power in negotiating fee arrangements with healthcare providers, including clinical laboratories. These health insurers demand that clinical laboratory service providers accept discounted fee structures or assume all or a portion of the financial risk associated with providing testing services to their members through capitated payment contracts. Under these capitated payment contracts, the Company and health insurers agree to a predetermined monthly contractual rate for each member of the health insurer’s plan regardless of the number or cost of services provided by the Company. Some services, such as various esoteric tests, new technologies and anatomic pathology services, may be carved out from a capitated rate and, if carved out, are charged on a fee-for-service basis. We work closely with health insurers as they evaluate new tests; however, as innovation in the testing area increases, there is no guarantee that health insurers will agree to carve out these services or reimburse them at rates that reflect the true cost or value associated with such services.

In recent years, there has been a shift in the way major insurers contract with clinical laboratories. Health insurers have begun to offer more freedom of choice to their affiliated physicians, including greater freedom to determine which laboratory to use and which tests to order. Accordingly, most of our agreements with major health insurers are non-exclusive contracts. As a result, under these non-exclusive arrangements, physicians have more freedom of choice in selecting laboratories, and laboratories are likely to compete more on the basis of service and quality rather than price alone. Also, health insurers have been giving patients greater freedom of choice and patients have increasingly been selecting plans (such as preferred provider organizations and consumer driven plans) that offer a greater choice of providers. Pricing for these preferred provider organizations is typically negotiated on a fee-for-service basis, which generally results in higher revenue per requisition than under a capitated fee arrangement. Despite these trends, health insurers continue to aggressively seek cost reductions in order to keep their premiums to their customers competitive. If we are unable to agree on pricing with a health insurer, we would become a “non-participating” provider and could then only bill the ordering physician or the patient rather than the health insurer. This “non-participating” status could lead to loss of business since the physician is likely to refer testing to a participating provider whose testing is covered by the patient’s health insurance benefit plan. We cannot assure investors that we will continue to be successful in negotiating contracts with major insurers. Loss of multiple major insurer or other payer agreements could have a material adverse effect on our financial condition, results of operations and cash flows.

We offer QuestNet^™, an innovative product to develop and manage a customized network of clinical laboratory providers for health insurers. Through QuestNet^™, physicians and members are provided multiple choices for clinical laboratory testing while health insurers realize cost reductions under a single capitated arrangement.

Hospitals

We provide services to hospitals throughout the United States that vary from esoteric testing to helping manage their laboratories. We believe that we are the industry’s market leader in servicing hospitals. Our hospital customers account for approximately 13% of our net revenues, the majority of which represents services billed to the hospitals under reference testing arrangements, based on negotiated fee schedules, for certain testing that the hospitals do not perform internally. Hospitals generally maintain an on-site laboratory to perform testing on patients and refer less frequently needed and highly specialized procedures to outside laboratories, which typically charge the hospitals on a negotiated fee-for-service basis. We believe that most hospital laboratories perform approximately 90% to 95% of their patients’ clinical laboratory tests. In addition, many hospitals compete with commercial clinical laboratories for outreach (non-hospital patients) testing. Most physicians have admitting privileges or other relationships with hospitals as part of their medical practice. Many hospitals leverage their relationships with community physicians and encourage the physicians to send their outreach testing to the hospital’s laboratory. In addition, hospitals that own physician practices generally require the physicians to refer tests to the hospital’s affiliated laboratory. As a result, hospital-affiliated laboratories can be both customers and competitors for commercial clinical laboratories.

During 2002, in conjunction with the acquisition of AML, we launched dedicated sales and service teams focused on serving the unique needs of hospital customers. We believe that the combination of full-service, bi-coastal esoteric testing capabilities, medical and scientific professionals for consultation, innovative connectivity products, focus on Six Sigma quality and dedicated sales and service professionals has positioned us to be a partner of choice for hospital customers.

We have joint venture arrangements with leading integrated health delivery networks in several metropolitan areas. These joint venture arrangements, which provide testing for affiliated hospitals as well as for unaffiliated physicians and other healthcare providers in their geographic areas, serve as our principal laboratory facilities in their service areas. Typically, we have either a majority ownership interest in, or day-to-day management responsibilities for, our hospital joint venture relationships. We also manage the laboratories at a number of other hospitals.

Employers, Governmental Institutions and Other Clinical Laboratories

We provide testing services to federal, state and local governmental agencies and to large employers. We believe that we are the leading provider of clinical laboratory testing to employers for drugs of abuse. We also provide wellness testing to employers to enable employees to take an active role in improving their health. Testing services for employers account for approximately 3% of our net revenues. The volume of testing services for employers, which generally have relatively low profit margins, has declined significantly during 2001 through 2003 driven by a slowdown in hiring. We also perform esoteric testing services for other commercial clinical laboratories that do not have a full range of testing capabilities. All of these customers are charged on a fee-for-service basis.

Consumers

Consumers are becoming increasingly interested in managing their own health and health records. Currently, almost all the testing we perform is ordered directly by a physician, who then receives the test results. However, over time, we believe that consumers will increasingly want to order clinical laboratory tests themselves. To that end, we offer a focused menu of clinical laboratory testing directly to consumers in certain states. Consumers pay for and receive the test results directly. In each case, a physician reviews the order and result. We believe this market will continue to grow over time.