How much of the 2003 revenue growth came from organic business versus acquisitions?

Reported net revenue growth was 15.3%, but this includes Unilab for ten months and a full year of AML. On a pro forma basis, assuming both acquisitions closed January 1, 2002, growth was 4.3%. Pro forma clinical testing volume actually declined 1.2%, while average revenue per requisition rose 5.1% pro forma, driven by test mix shifting toward gene-based and esoteric testing and a higher share of fee-for-service payers.

What is the outlook for Medicare and reimbursement risk?

Medicare and Medicaid account for about 17% of revenue, up from 15% in 2002 because of Unilab's higher government mix. The PDMA of 2003 eliminated the CPI-based fee schedule increase for five years starting January 2004, which would have been 2.6%. Risks include a proposed OIG rule that could reduce Medicare reimbursement if usual charges are defined narrowly, possible CMS competitive bidding for clinical lab tests by 2005, and a pending CMS process to reset payments deemed grossly excessive. Management says the overall reimbursement dynamic across all payers is roughly neutral.

How is the company's balance sheet and debt position changing?

Total assets grew to $4.30 billion from $3.32 billion, mainly because goodwill rose to $2.52 billion from $1.79 billion after the Unilab deal. Long-term debt increased to $1.03 billion from $797 million, including a $450 million term loan due 2007 (of which $75 million was refinanced in January 2004 at a lower rate). The $250 million 1.75% contingent convertible debentures have holder put dates in November 2004 and later, and management intends to fund any repurchases with cash and credit facility borrowings. Stockholders' equity rose to $2.39 billion, with debt-to-equity improving as earnings and stock issuance for Unilab offset buybacks.

Are there leadership changes or material legal exposures investors should note?

Kenneth Freeman, Chairman and CEO, will hand the CEO role to President and COO Surya Mohapatra by the May 4, 2004 annual meeting, while remaining Chairman. The company disclosed that it has settled government billing claims exceeding $500 million in the mid-1990s and is defending several pending qui tam (whistleblower) suits, some involving pre-acquisition Unilab operations. Management believes reserves are adequate but acknowledges that outcomes could be material to results in the period a claim is resolved. Note that the company is also exposed to a Medicare exclusion risk, which would affect about 17% of revenue.

What drove the improvement in profitability?

Operating margin improved to 16.8% from 14.4%. Cost of services fell to 58.4% of revenue from 59.2%, reflecting Six Sigma and standardization efficiencies and higher revenue per requisition. SG&A fell to 24.6% of revenue from 26.2%, mainly from lower bad debt (4.8% of revenue vs. 5.3%) as better billing information reduced missing or incorrect requisition data, which had fallen from about 16% in 1996 to about 4% in 2003. Internet ordering (about 25% of orders and 35% of results by year-end 2003) is also expected to further reduce billing costs.

DGX 10-K FY2003 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed February 27, 2004. Cited figures are marked; the original filing is the authoritative source.

Quest Diagnostics (DGX) reported a strong 2003, with net revenues of $4.74 billion^a (up 15.3% from $4.11 billion), net income of $437 million (up 36% from $322 million), and diluted EPS of $4.12 (up from $3.23).

Growth was driven largely by the February 2003 Unilab acquisition, which contributed ten months of results, but management reported pro forma revenue growth of 4.3% and pro forma testing volume that declined 1.2%. Operating margin expanded to 16.8% from 14.4%, supported by Six Sigma and standardization efficiencies, a lower SG&A ratio (24.6% vs. 26.2%), and a bad debt improvement to 4.8% of revenue. Gene-based testing, which exceeded $500 million^b in revenue and grew more than 20%, was a key mix driver of higher revenue per requisition.

The balance sheet expanded materially: total assets rose to $4.30 billion and goodwill to $2.52 billion^c, while long-term debt increased to $1.03 billion. The company repurchased 4.0 million shares for $258 million, initiated its first-ever quarterly dividend of $0.15 per share, and generated $663 million in operating cash flow.

Management noted that Medicare and Medicaid represent about 17%^d of revenue, that the 2004 Medicare fee schedule inflation adjustment was eliminated, and that a proposed OIG usual-charges rule and pending CMS reforms could pressure reimbursement. The company also has an ongoing set of government investigations and qui tam claims, and the CEO succession from Kenneth Freeman to Surya Mohapatra is scheduled for the May 2004 annual meeting.

02—Key points

Key Highlights

Net revenues rose 15.3% to $4.74 billion, though pro forma growth was a more modest 4.3% and pro forma testing volume declined 1.2%
Operating income increased 34.5% to $796 million, with operating margin expanding to 16.8% from 14.4%
Diluted EPS of $4.12 vs. $3.23 in 2002; net income of $437 million, up 36%
Unilab acquisition (Feb 2003) for $297 million cash plus 7.1 million shares; targeting $25-30 million in annual synergies by end of 2005
Initiated first quarterly cash dividend of $0.15/share and repurchased $258 million of stock (4.0 million shares at $64.54 average)
Gene-based testing exceeded $500 million in 2003 revenue and grew over 20%, a key driver of higher revenue per requisition
Medicare and Medicaid represent ~17% of revenues; reimbursement risks include the OIG usual-charges proposal and CMS competitive bidding plans

03—Questions

Frequently Asked Questions

How much of the 2003 revenue growth came from organic business versus acquisitions?
Reported net revenue growth was 15.3%, but this includes Unilab for ten months and a full year of AML. On a pro forma basis, assuming both acquisitions closed January 1, 2002, growth was 4.3%. Pro forma clinical testing volume actually declined 1.2%, while average revenue per requisition rose 5.1% pro forma, driven by test mix shifting toward gene-based and esoteric testing and a higher share of fee-for-service payers.
What is the outlook for Medicare and reimbursement risk?
Medicare and Medicaid account for about 17% of revenue, up from 15% in 2002 because of Unilab's higher government mix. The PDMA of 2003 eliminated the CPI-based fee schedule increase for five years starting January 2004, which would have been 2.6%. Risks include a proposed OIG rule that could reduce Medicare reimbursement if usual charges are defined narrowly, possible CMS competitive bidding for clinical lab tests by 2005, and a pending CMS process to reset payments deemed grossly excessive. Management says the overall reimbursement dynamic across all payers is roughly neutral.
How is the company's balance sheet and debt position changing?
Total assets grew to $4.30 billion from $3.32 billion, mainly because goodwill rose to $2.52 billion from $1.79 billion after the Unilab deal. Long-term debt increased to $1.03 billion from $797 million, including a $450 million term loan due 2007 (of which $75 million was refinanced in January 2004 at a lower rate). The $250 million 1.75% contingent convertible debentures have holder put dates in November 2004 and later, and management intends to fund any repurchases with cash and credit facility borrowings. Stockholders' equity rose to $2.39 billion, with debt-to-equity improving as earnings and stock issuance for Unilab offset buybacks.
Are there leadership changes or material legal exposures investors should note?
Kenneth Freeman, Chairman and CEO, will hand the CEO role to President and COO Surya Mohapatra by the May 4, 2004 annual meeting, while remaining Chairman. The company disclosed that it has settled government billing claims exceeding $500 million in the mid-1990s and is defending several pending qui tam (whistleblower) suits, some involving pre-acquisition Unilab operations. Management believes reserves are adequate but acknowledges that outcomes could be material to results in the period a claim is resolved. Note that the company is also exposed to a Medicare exclusion risk, which would affect about 17% of revenue.
What drove the improvement in profitability?
Operating margin improved to 16.8% from 14.4%. Cost of services fell to 58.4% of revenue from 59.2%, reflecting Six Sigma and standardization efficiencies and higher revenue per requisition. SG&A fell to 24.6% of revenue from 26.2%, mainly from lower bad debt (4.8% of revenue vs. 5.3%) as better billing information reduced missing or incorrect requisition data, which had fallen from about 16% in 1996 to about 4% in 2003. Internet ordering (about 25% of orders and 35% of results by year-end 2003) is also expected to further reduce billing costs.

04—Continue

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