QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS

Overview

The underlying fundamentals of the diagnostic testing industry have improved since the early to mid-1990s, which was a period of declining reimbursement and reduced test utilization. During the early 1990s, the industry was negatively impacted by significant government regulation and investigations into various billing practices. In addition, the rapid growth of managed care, as a result of the need to reduce overall healthcare costs, and excess laboratory testing capacity, led to revenue and profit declines across the diagnostic testing industry, which in turn led to industry consolidation, particularly among commercial laboratories. As a result of these dynamics, fewer but larger commercial laboratories have emerged, which have greater economies of scale, rigorous programs designed to assure compliance with government billing regulations and other laws, and a more disciplined approach to pricing services. These changes have resulted in improved profitability and a reduced risk of non-compliance with complex government regulations. At the same time, a slowdown in the growth of managed care and decreasing influence by managed care organizations on the ordering of clinical laboratory testing by physicians has contributed to renewed growth in testing and further improvements in profitability since 1999. Partially offsetting these favorable trends have been changes in the United States economy during the last several years, which has resulted in an increase in the number of unemployed and uninsured. In addition, in an attempt to slow the rapidly rising costs of healthcare, employers and healthcare insurers have made design changes to healthcare plans, which shift a larger portion of healthcare costs to consumers. We believe that these factors have reduced the utilization of healthcare services in general. Orders for laboratory testing are generated from physician offices, hospitals and employers. As such, factors such as the number of unemployed and uninsured and design changes in healthcare plans, which impact the level of employment or the number of physicians office and hospital visits, will impact the utilization of laboratory testing.

We believe the diagnostic testing industry has continued to grow during the last several years despite the slowdown in the United States economy and the changes in healthcare plan design, and that growth will accelerate as the economy improves. In addition, over the longer term, growth is expected to accelerate as a result of the following factors:

•  general expansion and aging of the United States population;

•  continuing research and development in the area of genomics and proteomics, which is expected to yield new, more sophisticated and specialized diagnostics tests;

•  increasing recognition by consumers and payers of the value of early detection and prevention which can be provided through laboratory testing as a means to improve health and reduce the overall cost of healthcare; and

•  increasing affordability of tests due to advances in technology and cost efficiencies.

Quest Diagnostics, as the largest clinical laboratory testing company with a leading position in most of its geographic markets and service offerings, is well positioned to benefit from the growth expected in the industry.

Payments for clinical laboratory testing services are made by the government, health insurers, physicians, hospitals, employers and patients. Physicians, hospitals and employers are typically billed on a fee-for-service basis based on fee schedules, which are typically negotiated. Fees billed to patients and health insurers are based on the laboratory’s patient fee schedule, subject to any limitations on fees negotiated with the health insurers or with physicians on behalf of their patients. Medicare and Medicaid reimbursements are based on fee schedules set by governmental authorities.

We incur significant additional costs as a result of our participation in Medicare and Medicaid programs, as billing and reimbursement for clinical laboratory testing is subject to considerable and complex federal and state regulations. These additional costs include those related to: (1) complexity added to our billing processes; (2) training and education of our employees and customers; (3) compliance and legal costs; and (4) costs related to, among other factors, medical necessity denials and advance beneficiary notices. Compliance with applicable laws and regulations, as well as internal compliance policies and procedures, adds further complexity and costs to the billing process. We have implemented “best practices” that have significantly improved our billing and collection processes. These efforts, together with our Six Sigma and standardization initiatives, have significantly reduced bad debt expense as a percentage of net revenues over the last several years. While the total cost to comply with Medicare administrative requirements is disproportionate to our cost to bill other payers, average Medicare reimbursement rates approximate the Company’s overall average reimbursement rate from all payers, making this business generally less profitable. Government payers, such as Medicare and Medicaid, as well as insurers and larger employers have taken steps and may continue to take steps to control the cost, utilization and delivery of healthcare services, including clinical laboratory services. Principally as a result of reimbursement reductions and measures adopted by the Centers for Medicare & Medicaid Services, or CMS (formerly the Health Care Financing Administration) which establishes procedures and continuously evaluates and implements changes in the reimbursement process to control utilization, the percentage of our aggregate net revenues derived from Medicare and Medicaid programs declined from approximately 20% in 1995 to approximately 17% in 2003. Despite the added cost and complexity of participating in the Medicare and Medicaid programs, we continue to participate in such programs because we believe that our other business may significantly depend on continued participation in the Medicare and Medicaid programs, because many customers want a single laboratory to perform all of their clinical laboratory testing services, regardless of who pays for such services.

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 certain markets, such as California, health insurers delegate their covered members to independent physician associations, or IPA, 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 to negotiate 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.  Capitated agreements have historically been priced aggressively, particularly for exclusive or semi-exclusive arrangements. In 2003, we derived approximately 14% of our testing volume and 8% of our net revenues from capitated payment contracts. 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 arrangements. 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.

We expect that the overall reimbursement dynamics for all payers on a combined basis are neutral for the diagnostic testing industry. Today, many federal and state governments face serious budget deficits and healthcare spending is a prime target for reductions. For example, the Prescription Drug, Improvement, and Modernization Act of 2003 eliminated for five years (beginning January 1, 2004) the provision for annual increases to the Medicare national fee schedule based on the consumer price index. Efforts to impose reduced reimbursements and more stringent cost controls by government and other payers for existing tests may continue. However, we believe that as new tests are developed which either improve on the effectiveness of existing tests or provide new diagnostic capabilities, government and other payers will add these tests as covered services, because of the importance of laboratory testing in assessing and managing the health of patients. We continue to emphasize the importance and the high value of laboratory testing with insurers and government payers at the federal and state level.

The diagnostic testing industry is subject to seasonal fluctuations in operating results and cash flows. Typically, testing volume declines during the summer months, year-end holiday periods and other major holidays, reducing net revenues and operating cash flows below annual averages. Testing volume is also subject to declines in winter months due to inclement weather, which varies in severity from year to year.

The diagnostic testing industry is labor intensive. Employee compensation and benefits constitute approximately one-half of our total costs and expenses. Cost of services consists principally of costs for obtaining, transporting and testing specimens. Selling, general and administrative expenses consist principally of the costs associated with our sales force, billing operations (including bad debt expense), and general management and administrative support.

Information systems are used extensively in virtually all aspects of our business, including laboratory testing, billing, customer service, logistics, and management of medical data. Our success depends, in part, on the continued and uninterrupted performance of our information technology systems. In 2002, we began implementation of a standard laboratory information system and a standard billing system, which we expect will take several more years to complete. Through proper planning and execution, we expect to reduce the risks associated with systems conversions of this type, and minimize any disruptions in our operations.