DGX 06.30.2012 10-Q
Table of Contents                                             

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2012
Commission file number 001-12215

Quest Diagnostics Incorporated

Three Giralda Farms
Madison, NJ 07940
(973) 520-2700

Delaware
(State of Incorporation)

16-1387862
(I.R.S. Employer Identification Number)

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer x
Accelerated filer o
Non-accelerated filer o (Do not check if a smaller reporting company)
Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
As of July 19, 2012, there were outstanding 158,750,985 shares of the registrant’s common stock, $.01 par value.


Table of Contents                                             

PART I - FINANCIAL INFORMATION
 
 
Page
Item 1. Financial Statements
 
 
 
 
 
Index to consolidated financial statements filed as part of this report:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


1

Table of Contents                                             


QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2012 AND 2011
(unaudited)
(in thousands, except per share data)
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2012
 
2011
 
2012
 
2011
Net revenues
$
1,906,810

 
$
1,903,201

 
$
3,843,266

 
$
3,724,778

 
 
 
 
 
 
 
 
Operating costs and expenses:
 

 
 

 
 

 
 

Cost of services
1,110,514

 
1,104,394

 
2,227,052

 
2,201,392

Selling, general and administrative
440,788

 
462,789

 
941,429

 
910,647

Amortization of intangible assets
20,169

 
18,592

 
40,400

 
28,441

Other operating expense, net
591

 
572

 
52

 
236,484

Total operating costs and expenses
1,572,062

 
1,586,347

 
3,208,933

 
3,376,964

 
 
 
 
 
 
 
 
Operating income
334,748

 
316,854

 
634,333

 
347,814

 
 
 
 
 
 
 
 
Other income (expense):
 

 
 

 
 

 
 

Interest expense, net
(41,942
)
 
(46,581
)
 
(84,275
)
 
(84,510
)
Equity earnings in unconsolidated joint ventures
7,372

 
7,869

 
14,981

 
15,568

Other (expense) income, net
(1,256
)
 
(346
)
 
3,501

 
1,862

Total non-operating expenses, net
(35,826
)
 
(39,058
)
 
(65,793
)
 
(67,080
)
 
 
 
 
 
 
 
 
Income from continuing operations before taxes
298,922

 
277,796

 
568,540

 
280,734

Income tax expense
112,394

 
105,762

 
213,771

 
154,988

Income from continuing operations
186,528

 
172,034

 
354,769

 
125,746

Income (loss) from discontinued operations, net of taxes
(55
)
 
(507
)
 
219

 
(881
)
Net income
186,473

 
171,527

 
354,988

 
124,865

 
 
 
 
 
 
 
 
Less: Net income attributable to noncontrolling interests
8,768

 
8,384

 
18,165

 
15,583

Net income attributable to Quest Diagnostics
$
177,705

 
$
163,143

 
$
336,823

 
$
109,282

 
 
 
 
 
 
 
 
Amounts attributable to Quest Diagnostics’ stockholders:
 

 
 

 
 

 
 

Income from continuing operations
$
177,760

 
$
163,650

 
$
336,604

 
$
110,163

Income (loss) from discontinued operations, net of taxes
(55
)
 
(507
)
 
219

 
(881
)
Net income
$
177,705

 
$
163,143

 
$
336,823

 
$
109,282

 
 
 
 
 
 
 
 
Earnings per share attributable to Quest Diagnostics’ common stockholders - basic:
 

 
 

 
 

 
 

Income from continuing operations
$
1.12

 
$
1.03

 
$
2.12

 
$
0.68

Income (loss) from discontinued operations

 

 

 

Net income
$
1.12

 
$
1.03

 
$
2.12

 
$
0.68

 
 
 
 
 
 
 
 
Earnings per share attributable to Quest Diagnostics’ common stockholders - diluted:
 

 
 

 
 

 
 

Income from continuing operations
$
1.11

 
$
1.02

 
$
2.10

 
$
0.68

Income (loss) from discontinued operations

 

 

 
(0.01
)
Net income
$
1.11

 
$
1.02

 
$
2.10

 
$
0.67

 
 
 
 
 
 
 
 
Weighted average common shares outstanding:
 

 
 

 
 

 
 

Basic
158,477

 
157,607

 
158,385

 
159,548

Diluted
159,784

 
159,352

 
159,745

 
161,278

 
 
 
 
 
 
 
 
Dividends per common share
$
0.17

 
$
0.10

 
$
0.34

 
$
0.20

The accompanying notes are an integral part of these statements.

2

Table of Contents                                             

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2012 AND 2011
(unaudited)
(in thousands)

 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2012
 
2011
 
2012
 
2011
Net income
$
186,473

 
$
171,527

 
$
354,988

 
$
124,865

 
 
 
 
 
 
 
 
Other comprehensive income (loss):
 
 
 
 
 
 
 
   Currency translation
(19,183
)
 
1,970

 
(967
)
 
26,474

   Market valuation, net of tax
44

 
(346
)
 
245

 
(1,596
)
   Net deferred loss on cash flow hedges, net of tax
210

 
210

 
420

 
(1,461
)
   Other comprehensive (loss) income
(18,929
)
 
1,834

 
(302
)
 
23,417

 
 
 
 
 
 
 
 
Comprehensive income
167,544

 
173,361

 
354,686

 
148,282

Less: Comprehensive income attributable to noncontrolling interests
8,768

 
8,384

 
18,165

 
15,583

Comprehensive income attributable to Quest Diagnostics
$
158,776

 
$
164,977

 
$
336,521

 
$
132,699

The accompanying notes are an integral part of these statements.


3

Table of Contents                                             

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
JUNE 30, 2012 AND DECEMBER 31, 2011
(in thousands, except per share data)
 
June 30,
2012
 
December 31,
2011
 
(unaudited)
 
 
Assets
 

 
 

Current assets:
 

 
 

Cash and cash equivalents
$
173,742

 
$
164,886

Accounts receivable, net of allowance for doubtful accounts of $249,472 and $237,339 at June 30, 2012 and December 31, 2011, respectively
941,469

 
906,455

Inventories
90,098

 
89,132

Deferred income taxes
163,457

 
153,328

Prepaid expenses and other current assets
108,409

 
87,459

Total current assets
1,477,175

 
1,401,260

Property, plant and equipment, net
788,626

 
799,771

Goodwill
5,822,551

 
5,795,765

Intangible assets, net
1,016,293

 
1,035,612

Other assets
288,202

 
280,971

Total assets
$
9,392,847

 
$
9,313,379

 
 
 
 
Liabilities and Stockholders’ Equity
 

 
 

Current liabilities:
 

 
 

Accounts payable and accrued expenses
$
880,221

 
$
906,764

Short-term borrowings and current portion of long-term debt
444,497

 
654,395

Total current liabilities
1,324,718

 
1,561,159

Long-term debt
3,378,190

 
3,370,522

Other liabilities
668,804

 
666,699

Stockholders’ equity:
 

 
 

Quest Diagnostics stockholders’ equity:
 

 
 

Common stock, par value $0.01 per share; 600,000 shares authorized at both June 30, 2012 and December 31, 2011; 215,058 shares and 214,607 shares issued at June 30, 2012 and December 31, 2011, respectively
2,151

 
2,146

Additional paid-in capital
2,357,648

 
2,347,518

Retained earnings
4,546,307

 
4,263,599

Accumulated other comprehensive loss
(8,369
)
 
(8,067
)
Treasury stock, at cost; 56,763 shares and 57,187 shares at June 30, 2012 and December 31, 2011, respectively
(2,902,533
)
 
(2,912,324
)
Total Quest Diagnostics stockholders’ equity
3,995,204

 
3,692,872

Noncontrolling interests
25,931

 
22,127

Total stockholders’ equity
4,021,135

 
3,714,999

Total liabilities and stockholders’ equity
$
9,392,847

 
$
9,313,379

The accompanying notes are an integral part of these statements.

4

Table of Contents                                             

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE SIX MONTHS ENDED JUNE 30, 2012 AND 2011
(unaudited)
(in thousands)

 
Six Months Ended June 30,
 
2012
 
2011
Cash flows from operating activities:
 

 
 

Net income
$
354,988

 
$
124,865

Adjustments to reconcile net income to net cash provided by operating activities:
 

 
 

Depreciation and amortization
144,029

 
136,084

Provision for doubtful accounts
147,183

 
145,985

Deferred income tax (benefit) provision
(11,305
)
 
8,890

Stock-based compensation expense
34,178

 
35,192

Excess tax benefits from stock-based compensation arrangements
(3,929
)
 
(4,786
)
Provision for special charge

 
236,000

Other, net
264

 
6,430

Changes in operating assets and liabilities:
 

 
 

Accounts receivable
(181,918
)
 
(194,057
)
Accounts payable and accrued expenses
(87,698
)
 
(74,546
)
Settlement of special charge

 
(241,000
)
Income taxes payable
28,648

 
39,323

Other assets and liabilities, net
(12,306
)
 
1,703

Net cash provided by operating activities
412,134

 
220,083

 
 
 
 
Cash flows from investing activities:
 

 
 

Business acquisitions, net of cash acquired
(50,568
)
 
(1,136,380
)
Sale of securities acquired in business acquisition

 
213,541

Capital expenditures
(77,408
)
 
(78,624
)
Increase in investments and other assets
(2,565
)
 
(6,503
)
Net cash used in investing activities
(130,541
)
 
(1,007,966
)
 
 
 
 
Cash flows from financing activities:
 

 
 

Proceeds from borrowings
685,000

 
2,433,329

Repayments of debt
(899,646
)
 
(1,108,786
)
Purchases of treasury stock
(100,000
)
 
(835,001
)
Exercise of stock options
90,579

 
97,216

Excess tax benefits from stock-based compensation arrangements
3,929

 
4,786

Dividends paid
(53,981
)
 
(32,930
)
Distributions to noncontrolling interests
(15,795
)
 
(16,850
)
Other financing activities, net
17,177

 
(18,964
)
Net cash (used in) provided by financing activities
(272,737
)
 
522,800

 
 
 
 
Net change in cash and cash equivalents
8,856

 
(265,083
)
Cash and cash equivalents, beginning of period
164,886

 
449,301

Cash and cash equivalents, end of period
$
173,742

 
$
184,218

The accompanying notes are an integral part of these statements.

5

Table of Contents                                             

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
FOR THE SIX MONTHS ENDED JUNE 30, 2012 AND 2011
(unaudited)
(in thousands)
 
 
 
Quest Diagnostics Stockholders’ Equity
 
 
 
 
 
Shares of
Common Stock
Outstanding
 
Common
Stock
 
Additional
Paid-In
Capital
 
Retained
Earnings
 
Accumulated
Other
Compre-
hensive Loss
 
Treasury
Stock, at
Cost
 
Non-
controlling
Interests
 
Total Stock-
holders’
Equity
Balance, December 31, 2011
157,420

 
$
2,146

 
$
2,347,518

 
$
4,263,599

 
$
(8,067
)
 
$
(2,912,324
)
 
$
22,127

 
$
3,714,999

Net income


 


 


 
336,823

 


 


 
18,165

 
354,988

Other comprehensive loss, net of tax


 


 


 


 
(302
)
 


 


 
(302
)
Dividends declared


 


 


 
(54,115
)
 


 


 


 
(54,115
)
Distributions to noncontrolling interests


 


 


 


 


 


 
(15,795
)
 
(15,795
)
Issuance of common stock under benefit plans
996

 
8

 
1,523

 


 


 
8,582

 


 
10,113

Stock-based compensation expense


 


 
32,393

 


 


 
1,785

 


 
34,178

Exercise of stock options
1,950

 


 
(8,845
)
 


 


 
99,424

 


 
90,579

Shares to cover employee payroll tax withholdings on stock issued under benefit plans
(342
)
 
(3
)
 
(19,721
)
 


 


 


 


 
(19,724
)
Tax benefits associated with stock-based compensation plans


 


 
4,780

 


 


 


 


 
4,780

Purchases of treasury stock
(1,729
)
 


 


 


 


 
(100,000
)
 


 
(100,000
)
Other


 


 


 


 


 


 
1,434

 
1,434

Balance, June 30, 2012
158,295

 
$
2,151

 
$
2,357,648

 
$
4,546,307

 
$
(8,369
)
 
$
(2,902,533
)
 
$
25,931

 
$
4,021,135

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

 
Quest Diagnostics Stockholders’ Equity
 
 
 
 
 
Shares of
Common
Stock
Outstanding
 
Common
Stock
 
Additional
Paid-In
Capital
 
Retained
Earnings
 
Accumulated
Other
Compre-
hensive
Income
 
Treasury
Stock, at
Cost
 
Non-
controlling
Interests
 
Total Stock-
holders’
Equity
Balance, December 31, 2010
170,717

 
$
2,142

 
$
2,311,421

 
$
3,867,420

 
$
10,626

 
$
(2,158,129
)
 
$
20,645

 
$
4,054,125

Net income
 

 
 

 
 

 
109,282

 
 

 
 

 
15,583

 
124,865

Other comprehensive income, net of tax


 


 


 


 
23,417

 


 


 
23,417

Dividends declared
 

 
 

 
 

 
(31,665
)
 
 

 
 

 
 

 
(31,665
)
Distributions to noncontrolling interests
 

 
 

 
 

 
 

 
 

 
 

 
(16,850
)
 
(16,850
)
Issuance of common stock under benefit plans
972

 
7

 
1,274

 
 

 
 

 
8,770

 
 

 
10,051

Stock-based compensation expense
 

 
 

 
33,418

 
 

 
 

 
1,774

 
 

 
35,192

Exercise of stock options
2,240

 
 

 
(16,220
)
 
 

 
 

 
113,436

 
 

 
97,216

Shares to cover employee payroll tax withholdings on stock issued under benefit plans
(339
)
 
(3
)
 
(19,283
)
 
 

 
 

 
 

 
 

 
(19,286
)
Tax benefits associated with stock-based compensation plans
 

 
 

 
6,464

 
 

 
 

 
 

 
 

 
6,464

Purchases of treasury stock
(15,378
)
 
 

 
 

 
 

 
 

 
(835,001
)
 
 

 
(835,001
)
Other
 

 
 

 
 

 
 

 
 

 
 

 
2,068

 
2,068

Balance, June 30, 2011
158,212

 
$
2,146

 
$
2,317,074

 
$
3,945,037

 
$
34,043

 
$
(2,869,150
)
 
$
21,446

 
$
3,450,596

The accompanying notes are an integral part of these statements.

6

Table of Contents                                             

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands unless otherwise indicated)

1.    DESCRIPTION OF BUSINESS
    
Background
    
Quest Diagnostics Incorporated and its subsidiaries ("Quest Diagnostics" or the "Company") is the world's leading provider of diagnostic testing, information and services, providing insights that enable patients and physicians to make better healthcare decisions. Quest Diagnostics offers patients and physicians the broadest access to diagnostic laboratory services through the Company's nationwide network of laboratories and patient service centers. The Company provides interpretive consultation through the largest medical and scientific staff in the industry, with hundreds of M.D.s and Ph.D.s, primarily
located in the United States. Quest Diagnostics is the leading provider of clinical testing, including gene-based and esoteric testing, and anatomic pathology services, and the leading provider of risk assessment services for the life insurance industry in North America. The Company is also a leading provider of testing for clinical trials and testing for drugs-of-abuse. The Company's diagnostics products business manufactures and markets diagnostic test kits and specialized point-of-care testing. Quest Diagnostics empowers healthcare organizations and clinicians with robust information technology solutions.

2.    SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation
    
The interim consolidated financial statements reflect all adjustments which in the opinion of management are necessary for a fair statement of results of operations, comprehensive income, financial condition, cash flows and stockholders' equity for the periods presented. Except as otherwise disclosed, all such adjustments are of a normal recurring nature. The interim consolidated financial statements have been compiled without audit. Operating results for the interim periods are not necessarily indicative of the results that may be expected for the full year. These interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements included in the Company’s 2011 Annual Report on Form 10-K.
    
The year-end balance sheet data was derived from the audited financial statements as of December 31, 2011, but does not include all the disclosures required by accounting principles generally accepted in the United States (“GAAP”).

Use of Estimates
    
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
    
Earnings Per Share

The Company’s unvested restricted common stock and unvested restricted stock units that contain non-forfeitable rights to dividends are participating securities and, therefore, are included in the earnings allocation in computing earnings per share using the two-class method. Basic earnings per common share is calculated by dividing net income, adjusted for earnings allocated to participating securities, by the weighted average number of common shares outstanding. Diluted earnings per common share is calculated by dividing net income, adjusted for earnings allocated to participating securities, by the weighted average number of common shares outstanding after giving effect to all potentially dilutive common shares outstanding during the period. Potentially dilutive common shares include the dilutive effect of outstanding stock options and performance share units granted under the Company’s Amended and Restated Employee Long-Term Incentive Plan and its Amended and Restated Non-Employee Director Long-Term Incentive Plan. Earnings allocable to participating securities include the portion of dividends declared as well as the portion of undistributed earnings during the period allocable to participating securities.

    

7

Table of Contents
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(dollars in thousands unless otherwise indicated)


Adoption of New Accounting Standards
    
On January 1, 2012, the Company adopted an amendment issued by the Financial Accounting Standards Board ("FASB") to the accounting standards related to fair value measurements and disclosure requirements. This standard provides certain amendments to the existing guidance on the use and application of fair value measurements and maintains a definition of fair value that is based on the notion of exit price. The adoption of this standard did not have a material impact on the Company’s consolidated financial statements.

On January 1, 2012, the Company adopted amendments issued by the FASB to the accounting standards related to the presentation of comprehensive income. These standards revise the manner in which entities present comprehensive income in their financial statements and remove the option to present items of other comprehensive income in the statement of changes in stockholders’ equity. These standards require an entity to report components of comprehensive income in either (1) a continuous statement of comprehensive income, or (2) two separate but consecutive statements of net income and other comprehensive income. The Company modified its financial statements presentation using the latter alternative.

On January 1, 2012, the Company adopted revised guidance issued by the FASB related to the testing of goodwill for impairment. Under the revised guidance, an entity has the option to perform a qualitative assessment of whether it is more-likely-than-not that a reporting unit’s fair value is less than its carrying value prior to performing the two-step quantitative goodwill impairment test. If, based on the qualitative factors, an entity determines that the fair value of the reporting unit is greater than its carrying amount, then the entity would not be required to perform the two-step quantitative impairment test for that reporting unit. However, if the qualitative assessment indicates that it is not more-likely-than-not that the reporting unit’s fair value exceeds its carrying value, then the quantitative assessment must be performed. An entity is permitted to perform the qualitative assessment on none, some or all of its reporting units and may also elect to bypass the qualitative assessment and begin with the quantitative assessment of goodwill impairment. This amendment did not have a material impact on the Company’s consolidated financial statements.


8

Table of Contents
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(dollars in thousands unless otherwise indicated)


    
3.    EARNINGS PER SHARE

The computation of basic and diluted earnings per common share was as follows (in thousands, except per share data):

 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2012
 
2011
 
2012
 
2011
Amounts attributable to Quest Diagnostics’ stockholders:
 

 
 

 
 

 
 

Income from continuing operations
$
177,760

 
$
163,650

 
$
336,604

 
$
110,163

Income (loss) from discontinued operations, net of taxes
(55
)
 
(507
)
 
219

 
(881
)
Net income attributable to Quest Diagnostics’ common stockholders
$
177,705

 
$
163,143

 
$
336,823

 
$
109,282

 
 
 
 
 
 
 
 
Income from continuing operations
$
177,760

 
$
163,650

 
$
336,604

 
$
110,163

Less: Earnings allocated to participating securities
722

 
877

 
1,326

 
967

Earnings available to Quest Diagnostics’ common stockholders – basic and diluted
$
177,038

 
$
162,773

 
$
335,278

 
$
109,196

 
 
 
 
 
 
 
 
Weighted average common shares outstanding – basic
158,477

 
157,607

 
158,385

 
159,548

Effect of dilutive securities:
 

 
 

 
 

 
 

Stock options and performance share units
1,307

 
1,745

 
1,360

 
1,730

Weighted average common shares outstanding – diluted
159,784

 
159,352

 
159,745

 
161,278

 
 
 
 
 
 
 
 
Earnings per share attributable to Quest Diagnostics’ common stockholders – basic:
 

 
 

 
 

 
 

Income from continuing operations
$
1.12

 
$
1.03

 
$
2.12

 
$
0.68

Income (loss) from discontinued operations

 

 

 

Net income
$
1.12

 
$
1.03

 
$
2.12

 
$
0.68

 
 
 
 
 
 
 
 
Earnings per share attributable to Quest Diagnostics’ common stockholders – diluted:
 

 
 

 
 

 
 

Income from continuing operations
$
1.11

 
$
1.02

 
$
2.10

 
$
0.68

Income (loss) from discontinued operations

 

 

 
(0.01
)
Net income
$
1.11

 
$
1.02

 
$
2.10

 
$
0.67


The following securities were not included in the calculation of diluted earnings per share due to their antidilutive effect (shares in thousands):
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2012
 
2011
 
2012
 
2011
Stock options and performance share units
2,463

 
2,275

 
2,229

 
2,154


    

9

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QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
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4.     FAIR VALUE MEASUREMENTS

The following table provides a summary of the recognized assets and liabilities that are measured at fair value on a recurring basis:
 
 
 
Basis of Fair Value Measurements
 
 
 
Quoted
Prices in
Active
Markets for
Identical
Assets /
Liabilities
 
Significant
Other
Observable
Inputs
 
Significant
Unobservable
Inputs
June 30, 2012
 

 
Level 1
 
Level 2
 
Level 3
Assets:
 

 
 

 
 

 
 

Interest rate swaps
$
65,218

 
$

 
$
65,218

 
$

Trading securities
48,434

 
48,434

 

 

Cash surrender value of life insurance policies
23,487

 

 
23,487

 

Available-for-sale equity securities
1,048

 

 

 
1,048

Foreign currency forward contracts
77

 

 
77

 

Total
$
138,264

 
$
48,434

 
$
88,782

 
$
1,048

 
 
 
 
 
 
 
 
Liabilities:
 

 
 

 
 

 
 

Deferred compensation liabilities
$
76,192

 
$

 
$
76,192

 
$

Foreign currency forward contracts
459

 

 
459

 

Total
$
76,651

 
$

 
$
76,651

 
$

 
 
 
Basis of Fair Value Measurements
 
 
 
Quoted
Prices in
Active
Markets for
Identical
Assets /
Liabilities
 
Significant
Other
Observable
Inputs
 
Significant
Unobservable
Inputs
December 31, 2011
 

 
Level 1
 
Level 2
 
Level 3
Assets:
 

 
 
 
 
 
 
Interest rate swaps
$
56,520

 
$

 
$
56,520

 
$

Trading securities
46,926

 
46,926

 

 

Cash surrender value of life insurance policies
20,936

 

 
20,936

 

Available-for-sale equity securities
646

 

 

 
646

Foreign currency forward contracts
180

 

 
180

 

Total
$
125,208

 
$
46,926

 
$
77,636

 
$
646

 
 
 
 
 
 
 
 
Liabilities:
 

 
 

 
 

 
 

Deferred compensation liabilities
$
71,688

 
$

 
$
71,688

 
$

Foreign currency forward contracts
1,648

 

 
1,648

 

Total
$
73,336

 
$

 
$
73,336

 
$


A full description regarding the Company's fair value measurements is contained in Note 5 to the Consolidated Financial Statements in the Company's 2011 Annual Report on Form 10-K.    
    
Investments in available-for-sale equity securities consist of the revaluation of an existing investment in unregistered

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common shares of a publicly-held company. This investment is classified within Level 3 because the unregistered securities contain restrictions on their sale, and therefore, the fair value measurement reflects a discount for the effect of the restriction.

The carrying amounts of cash and cash equivalents, accounts receivable and accounts payable and accrued expenses approximate fair value based on the short maturities of these instruments. At June 30, 2012, the fair value of the Company’s debt was estimated at $4.3 billion, which exceeded the carrying value by $500 million. At December 31, 2011, the fair value of the Company's debt was estimated at $4.4 billion, which exceeded the carrying value by $387 million. Principally all of the Company's debt is classified within Level 1 of the fair value hierarchy because the fair value of the debt is estimated based on rates currently offered to the Company with identical terms and maturities, using quoted active market prices and yields, taking into account the underlying terms of the debt instruments.

5.    SETTLEMENT OF CALIFORNIA LAWSUIT

On May 9, 2011, the Company announced an agreement in principle to settle, and on May 19, 2011, the Company finalized a settlement of, a qui tam case filed by a competitor under the California False Claims Act in California state court (the "California Lawsuit") related to the Company's billing practices to Medi-Cal, the California Medicaid program. While denying liability, in order to avoid the uncertainty, expense and risks of litigation, the Company agreed to resolve these matters for $241 million. As a result of the agreement in principle, the Company recorded a pre-tax charge to earnings in the first quarter of 2011 of $236 million (the "Medi-Cal charge"), which represented the cost to resolve the matters noted above and related claims, less amounts previously reserved for related matters. The Company funded the $241 million payment in the second quarter of 2011 with cash on hand and borrowings under its existing credit facilities.           

6.    TAXES ON INCOME

Income tax expense for the six months ended June 30, 2012 and 2011 was $214 million and $155 million, respectively. The decrease in the effective income tax rate for the six months ended June 30, 2012, compared to the prior
year period, is primarily due to the Medi-Cal charge in the first quarter of 2011 (see Note 5), a portion for which a tax benefit
was not recorded.


7.    GOODWILL AND INTANGIBLE ASSETS

The changes in goodwill for the six months ended June 30, 2012 and for the year ended December 31, 2011 are as follows:
 
June 30,
2012
 
December 31,
2011
Balance at beginning of period
$
5,795,765

 
$
5,101,938

Goodwill acquired during the period
28,144

 
701,087

Decrease related to foreign currency translation
(1,358
)
 
(7,260
)
Balance at end of period
$
5,822,551

 
$
5,795,765


Approximately 90% of the Company’s goodwill as of June 30, 2012 and December 31, 2011 was associated with its clinical testing business.

For the six months ended June 30, 2012, goodwill acquired was principally associated with the acquisition of S.E.D. Medical Laboratories. Of the all-cash purchase price of $50.5 million, approximately $28 million and $19 million, respectively, represented goodwill, which is deductible for tax purposes, and intangible assets, principally comprised of customer-related intangibles.

For the year ended December 31, 2011, goodwill acquired was principally associated with the Athena Diagnostics ("Athena") and Celera Corporation ("Celera") acquisitions. A full description of the Company’s acquisitions is contained in Note 4 to the Consolidated Financial Statements in the Company’s 2011 Annual Report on Form 10-K.
    

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Intangible assets at June 30, 2012 and December 31, 2011 consisted of the following:

 
Weighted
Average
Amortization
Period
 
June 30, 2012
 
December 31, 2011
 
 
 
Cost
 
Accumulated
Amortization
 
Net
 
Cost
 
Accumulated
Amortization
 
Net
Amortizing intangible assets:
 
 

 
 

 
 

 
 

 
 

 
 

Customer-related intangibles
19 years
 
$
648,161

 
$
(209,874
)
 
$
438,287

 
$
630,671

 
$
(193,131
)
 
$
437,540

Non-compete agreements
4 years
 
46,163

 
(19,955
)
 
26,208

 
45,798

 
(14,633
)
 
31,165

Technology
14 years
 
170,044

 
(35,066
)
 
134,978

 
165,113

 
(27,929
)
 
137,184

Other
8 years
 
149,762

 
(34,592
)
 
115,170

 
146,613

 
(23,552
)
 
123,061

Total
16 years
 
1,014,130

 
(299,487
)
 
714,643

 
988,195

 
(259,245
)
 
728,950

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Intangible assets not subject to amortization:
 
 

 
 

 
 

 
 

 
 

Tradenames
 
 
300,371

 

 
300,371

 
300,648

 

 
300,648

In-process research and development
 
 
120

 

 
120

 
5,250

 

 
5,250

Other
 
 
1,159

 

 
1,159

 
764

 

 
764

Total intangible assets
 
$
1,315,780

 
$
(299,487
)
 
$
1,016,293

 
$
1,294,857

 
$
(259,245
)
 
$
1,035,612


Amortization expense related to intangible assets was $20.2 million and $18.6 million for the three months ended June 30, 2012 and 2011, respectively. For the six months ended June 30, 2012 and 2011, amortization expense related to intangible assets was $40.4 million and $28.4 million, respectively.
 
The estimated amortization expense related to amortizable intangible assets for each of the five succeeding fiscal years and thereafter as of June 30, 2012 is as follows:

Fiscal Year Ending December 31,
 

Remainder of 2012
$
39,818

2013
78,383

2014
76,028

2015
64,666

2016
57,956

2017
53,349

Thereafter
344,443

Total
$
714,643


8.    FINANCIAL INSTRUMENTS

The Company uses derivative financial instruments to manage its exposure to market risks for changes in interest rates and foreign currencies. This strategy includes the use of interest rate swap agreements, forward starting interest rate swap agreements, treasury lock agreements and foreign currency forward contracts to manage its exposure to movements in interest and currency rates. The Company has established policies and procedures for risk assessment and the approval, reporting and monitoring of derivative financial instrument activities. These policies prohibit holding or issuing derivative financial instruments for speculative purposes. The Company does not enter into derivative financial instruments that contain credit-risk-related contingent features or requirements to post collateral.


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A summary of the fair values of derivative instruments in the consolidated balance sheets is stated in the table below:

 
June 30, 2012
 
December 31, 2011
 
Balance Sheet
Classification
 
Fair Value
 
Balance Sheet
Classification
 
Fair Value
Derivatives Designated as Hedging Instruments
 
 
 

 
 
 
 

Asset Derivatives:
 
 
 

 
 
 
 

Interest rate swaps
Other assets
 
$
65,218

 
Other assets
 
$
56,520

 
 
 
 
 
 
 
 
Derivatives Not Designated as Hedging Instruments
 
 
 

 
 
 
 

Asset Derivatives:
 
 
 

 
 
 
 

Foreign currency forward contracts
Other current assets
 
77

 
Other current assets
 
180

Liability Derivatives:
 
 
 

 
 
 
 

Foreign currency forward contracts
Other current liabilities
 
459

 
Other current liabilities
 
1,648

 
 
 
 
 
 
 
 
Total Net Derivatives Asset
 
 
$
64,836

 
 
 
$
55,052


A full description regarding the Company's use of derivative financial instruments is contained in Note 12 to the Consolidated Financial Statements in the Company's 2011 Annual Report on Form 10-K.    

Interest Rate Risk

The Company is exposed to interest rate risk on its cash and cash equivalents and its debt obligations. Interest income earned on cash and cash equivalents may fluctuate as interest rates change; however, due to their relatively short maturities, the Company does not hedge these assets or their investment cash flows and the impact of interest rate risk is not material. The Company's debt obligations consist of fixed-rate and variable-rate debt instruments. The Company's primary objective is to achieve the lowest overall cost of funding while managing the variability in cash outflows within an acceptable range. In order to achieve this objective, the Company has entered into interest rate swaps. Interest rate swaps involve the periodic exchange of payments without the exchange of underlying principal or notional amounts. Net settlements between the counterparties are recognized as an adjustment to interest expense.

Interest Rate Derivatives – Cash Flow Hedges
    
The Company has entered into various interest rate lock agreements and forward starting interest rate swap agreements to hedge part of the Company's interest rate exposure associated with the variability in future cash flows attributable to changes in interest rates. The total net loss, net of taxes, recognized in accumulated other comprehensive loss, related to the Company's cash flow hedges as of June 30, 2012 and December 31, 2011 was $7.2 million and $7.7 million, respectively. The loss recognized on the Company's cash flow hedges for the three and six months ended June 30, 2012 and 2011, as a result of ineffectiveness, was not material. The net amount of deferred losses on cash flow hedges that is expected to be reclassified from accumulated other comprehensive loss into earnings within the next twelve months is $1.3 million.

Interest Rate Derivatives – Fair Value Hedges

The Company maintains various fixed-to-variable interest rate swaps which have an aggregate notional amount of $550 million and variable interest rates based on six-month LIBOR plus 0.54% and one-month LIBOR plus 1.33%. These derivative financial instruments are accounted for as fair value hedges of a portion of the Senior Notes due 2016 and a portion of the Senior Notes due 2020 and effectively convert that portion of the debt into variable interest rate debt. These interest rate swaps are classified as assets with fair values of $65.2 million and $56.5 million at June 30, 2012 and December 31, 2011, respectively. Since inception, the fair value hedges have been effective; therefore, there is no impact on earnings for the three and six months ended June 30, 2012 and 2011 as a result of hedge ineffectiveness.



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Foreign Currency Risk

The Company is exposed to market risk for changes in foreign exchange rates primarily under certain intercompany receivables and payables. Foreign exchange forward contracts are used to mitigate the exposure of the eventual net cash inflows or outflows resulting from these intercompany transactions. The objective is to hedge a portion of the forecasted foreign currency risk over a rolling 12-month time horizon to mitigate the eventual impacts of changes in foreign exchange rates on the cash flows of the intercompany transactions. As of June 30, 2012, the gross notional amount of foreign currency forward contracts in U.S. dollars was $17.2 million and principally consists of contracts in Swedish krona. The Company does not designate these derivative instruments as hedges under current accounting standards unless the benefits of doing so are material. The Company's foreign exchange exposure is not material to the Company's consolidated financial condition or results of operations. The Company does not hedge its net investment in non-U.S. subsidiaries because it views those investments as long-term in nature.

9.    STOCKHOLDERS’ EQUITY
    
Components of Comprehensive Income

The market valuation adjustments represent unrealized holding gains (losses) on available-for-sale securities, net of taxes. The net deferred loss on cash flow hedges represents deferred losses on the Company’s interest rate related derivative financial instruments designated as cash flow hedges, net of amounts reclassified to interest expense (see Note 8). For the three and six months ended June 30, 2012 and 2011, the tax effects related to the market valuation adjustments and deferred losses were not material. Foreign currency translation adjustments are not adjusted for income taxes since they relate to indefinite investments in non-U.S. subsidiaries.
    
Dividend Program
    
During each of the first three quarters of 2011, the Company's Board of Directors declared a quarterly cash dividend of $0.10 per common share and in October 2011, declared an increase in the quarterly cash dividend from $0.10 per common share to $0.17 per common share. During each of the quarters in 2012, the Company's Board of Directors declared a quarterly cash dividend of $0.17 per common share.
    
Share Repurchase Plan
    
In January 2012, the Company’s Board of Directors authorized the Company to repurchase an additional $1 billion of the Company’s common stock, increasing the total available authorization at that time to $1.1 billion. The share repurchase authorization has no set expiration or termination date.
    
For the three months ended June 30, 2012, the Company repurchased 882 thousand shares of its common stock at an average price of $56.70 per share for a total of $50 million. For the six months ended June 30, 2012, the Company repurchased 1.7 million shares of its common stock at an average price of $57.83 per share for a total of $100 million. For the three and six months ended June 30, 2012, the Company reissued 0.7 million shares and 2.2 million shares, respectively, for employee benefit plans. At June 30, 2012, $965 million remained available under the Company’s share repurchase authorizations.
    
For the six months ended June 30, 2011, the Company repurchased, in a transaction which occurred in the first quarter, 15.4 million shares of its common stock from SB Holdings Capital Inc., a wholly-owned subsidiary of GlaxoSmithKline plc., at an average price of $54.30 per share for a total of $835 million. For the three and six months ended June 30, 2011, the Company reissued 1.1 million shares and 2.4 million shares, respectively, for employee benefit plans.



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10.    SUPPLEMENTAL CASH FLOW & OTHER DATA

 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2012
 
2011
 
2012
 
2011
Depreciation expense
$
51,686

 
$
54,127

 
$
103,629

 
$
107,643

 
 
 
 
 
 
 
 
Interest expense
(42,639
)
 
(47,231
)
 
(85,626
)
 
(85,510
)
Interest income
697

 
650

 
1,351

 
1,000

Interest expense, net
(41,942
)
 
(46,581
)
 
(84,275
)
 
(84,510
)
 
 
 
 
 
 
 
 
Interest paid
32,208

 
17,539

 
81,990

 
72,583

Income taxes paid
192,556

 
97,119

 
202,809

 
107,721

 
 
 
 
 
 
 
 
Assets acquired under capital leases
1,763

 
1,876

 
2,955

 
2,697

 
 
 
 
 
 
 
 
Businesses acquired:
 

 
 

 
 

 
 

Fair value of assets acquired

 
1,555,444

 
50,800

 
1,555,444

Fair value of liabilities assumed

 
148,192

 
269

 
148,192

Fair value of net assets acquired

 
1,407,252

 
50,531

 
1,407,252

Merger consideration paid (payable)
12

 
(158,560
)
 
37

 
(158,560
)
Cash paid for business acquisitions
12

 
1,248,692

 
50,568

 
1,248,692

Less: Cash acquired

 
112,312

 

 
112,312

Business acquisitions, net of cash acquired
$
12

 
$
1,136,380

 
$
50,568

 
$
1,136,380


11.     COMMITMENTS AND CONTINGENCIES

The Company has a line of credit with a financial institution totaling $85 million for the issuance of letters of credit (the “Letter of Credit Line”). The Letter of Credit Line, which is renewed annually, matures on November 18, 2012.
    
In support of its risk management program, to ensure the Company’s performance or payment to third parties, $60 million in letters of credit were outstanding at June 30, 2012. The letters of credit primarily represent collateral for current and future automobile liability and workers’ compensation loss payments. In addition, $5 million of bank guarantees were outstanding at June 30, 2012 in support of certain foreign operations.
    
Contingent Lease Obligations
    
The Company is subject to contingent obligations under certain leases and other instruments incurred in connection with real estate activities and other operations associated with LabOne, Inc., which the Company acquired in 2005, and certain of its predecessor companies. No liability has been recorded for any of these potential contingent obligations. See Note 16 to the Consolidated Financial Statements contained in the Company’s 2011 Annual Report on Form 10-K for further details.

Other Legal Matters

The Company is involved in various legal proceedings. Some of the proceedings against the Company involve claims that could be substantial in amount.

In November 2009, the U.S. District Court for the Southern District of New York partially unsealed a civil complaint, U.S. ex rel. Fair Laboratory Practices Associates v. Quest Diagnostics Incorporated, filed against the Company under the whistleblower provisions of the federal False Claims Act. The complaint alleged, among other things, violations of the federal Anti-Kickback Statute and the federal False Claims Act in connection with the Company's pricing of laboratory services. The

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complaint seeks damages for alleged false claims associated with laboratory tests reimbursed by government payors, treble
damages and civil penalties. In March 2011, the district court granted the Company's motion to dismiss the relators' complaint and disqualified the relators and their counsel from pursuing an action based on the facts alleged in the complaint; the relators filed a notice of appeal. The government was given additional time to decide whether to join the case. In July 2011, the government filed a notice declining to intervene in the action and the Court entered a final judgment in the Company's favor. The relators' appeal is pending.

In April 2010, a putative class action was filed against the Company and NID in the U.S. District Court for the Eastern District of New York on behalf of entities that allegedly purchased or paid for certain of NID's test kits. The complaint alleges that certain of NID's test kits were defective and that defendants, among other things, violated RICO and state consumer protection laws. The complaint alleges an unspecified amount of damages. The Company filed a motion to dismiss this complaint. In April 2012, the Magistrate Judge issued a report and recommendation recommending that the court dismiss the complaint. Following the Magistrate Judge's report, the plaintiff agreed to dismiss their case with prejudice.

In August 2010, a shareholder derivative action entitled Cornish v. Quest Diagnostics Incorporated, et al. was filed in New Jersey state court on behalf of the Company against the directors and certain officers of the Company. The complaint alleges that the defendants breached their fiduciary duties in connection with, among other things, alleged overcharges by the Company to Medi-Cal, the California Medicaid program, for testing services, and seeks unspecified compensatory damages and equitable relief. The action was dismissed without prejudice. On July 21, 2011, the action was re-filed. In June 2011 and October 2011, two additional shareholder derivative actions were filed in New Jersey state court raising allegations similar to those in the Cornish case. The Company filed motions to dismiss each of the three complaints. The court granted the Company's motion to dismiss the Cornish complaint. The other two actions were consolidated and, in light of the dismissal of the Cornish complaint, the plaintiff agreed to dismiss the consolidated actions.

In November 2010, a putative class action entitled Seibert v. Quest Diagnostics Incorporated, et al. was filed against the Company and certain former officers of the Company in New Jersey state court, on behalf of the Company's sales people nationwide who were over forty years old and who either resigned or were terminated after being placed on a performance improvement plan. The complaint alleges that the defendants' conduct violates the New Jersey Law Against Discrimination ("NJLAD"), and seeks, among other things, unspecified damages. The defendants removed the complaint to the United States District Court for the District of New Jersey. The plaintiffs filed an amended complaint that adds claims under ERISA. The Company filed a motion seeking to limit the application of the NJLAD to only those members of the purported class who worked in New Jersey and to dismiss the individual defendants. The motion was granted. The only remaining NJLAD claim is that of the named plaintiff; the ERISA claim remains in the case.

In 2010, a purported class action entitled In re Celera Corp. Securities Litigation was filed in the United States District Court for the Northern District of California against Celera Corporation and certain of its directors and current and former officers. An amended complaint filed in October 2010 alleges that from April 2008 through July 22, 2009, the defendants made false and misleading statements regarding Celera's business and financial results with an intent to defraud investors. The complaint was further amended in 2011 to add allegations regarding a financial restatement. The complaint seeks unspecified damages on behalf of an alleged class of purchasers of Celera's stock during the period in which the alleged misrepresentations were made. The Company's motion to dismiss is pending.

In August 2011, the Company received a subpoena from the U.S. Attorney for the Northern District of Georgia seeking various business records, including records related to the Company's compliance program, certain marketing materials, certain product offerings, and test ordering and other policies. The Company is cooperating with the request.

In January 2012, a putative class action entitled Beery v. Quest Diagnostics Incorporated was filed in the United States District Court for the District of New Jersey against the Company and a subsidiary, on behalf of all female sales representatives employed by the defendants from February 17, 2010 to the present. The amended complaint alleges that the defendants discriminate against these female sales representatives on account of their gender, in violation of the federal civil rights and equal pay acts, and seeks, among other things, injunctive relief and monetary damages. The Company has filed motions to dismiss the complaint, to strike the class allegations and to compel arbitration with the named plaintiffs.

In September 2009, the Company received a subpoena from the Michigan Attorney General's Office seeking documents relating to the Company's pricing and billing practices as they relate to Michigan's Medicaid program. The Company cooperated with the requests. In January 2012, the State of Michigan intervened as a plaintiff in a civil lawsuit,

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Michigan ex rel. Hunter Laboratories LLC v. Quest Diagnostics Incorporated, et al., filed in Michigan Superior Court. The suit, originally filed by a competitor laboratory, alleges that the Company overcharged Michigan's Medicaid program. The Company filed a motion to dismiss the complaint.

In addition, the Company and certain of its subsidiaries have received subpoenas from state agencies. The Company and the subsidiaries continue responding to subpoenas from state agencies in two states and cooperating with their requests.

The federal or state governments may bring claims based on new theories as to the Company's practices which management believes to be in compliance with law. In addition, certain federal and state statutes, including the qui tam provisions of the federal False Claims Act, allow private individuals to bring lawsuits against healthcare companies on behalf of government or private payers. The Company is aware of certain pending individual or class action lawsuits, and has received several subpoenas, related to billing practices filed under the qui tam provisions of the Civil False Claims Act and/or other federal and state statutes, regulations or other laws. The Company understands that there may be other pending qui tam claims    brought by former employees or other "whistle blowers" as to which the Company cannot determine the extent of any potential liability.

Management cannot predict the outcome of such matters. Although management does not anticipate that the ultimate outcome of such matters will have a material adverse effect on the Company's financial condition, given the high degree of judgment involved in establishing loss estimates related to these types of matters, the outcome of such matters may be material to the Company's results of operations or cash flows in the period in which the impact of such matters is determined or paid.
    
Reserves for Legal Matters
    
These matters are in different stages. Some of these matters are in their early stages. Matters may involve responding to and cooperating with various government investigations and related subpoenas. Reserves for legal matters totaled less than $5 million at both June 30, 2012 and December 31, 2011. As of June 30, 2012, the Company does not believe that any losses related to the Other Legal Matters described above are probable. While the Company believes that a reasonable possibility exists that losses may have been incurred related to the Other Legal Matters described above, based on the nature and status of these matters, potential losses, if any, cannot be estimated.

Reserves for General and Professional Liability Claims
    
As a general matter, providers of clinical testing services may be subject to lawsuits alleging negligence or other similar legal claims. These suits could involve claims for substantial damages. Any professional liability litigation could also have an adverse impact on the Company's client base and reputation. The Company maintains various liability insurance coverages for, among other things, claims that could result from providing, or failing to provide, clinical testing services, including inaccurate testing results, and other exposures. The Company's insurance coverage limits its maximum exposure on individual claims; however, the Company is essentially self-insured for a significant portion of these claims. Reserves for such matters, including those associated with both asserted and incurred but not reported claims, are established by considering actuarially determined losses based upon the Company's historical and projected loss experience. Such reserves totaled approximately $123 million and $127 million as of June 30, 2012 and December 31, 2011, respectively. Management believes that established reserves and present insurance coverage are sufficient to cover currently estimated exposures. Management cannot predict the outcome of any claims made against the Company. Although management does not anticipate that the ultimate outcome of any such proceedings or claims will have a material adverse effect on the Company's financial condition, given the high degree of judgment involved in establishing accruals for loss estimates related to these types of matters, the outcome may be material to the Company's results of operations or cash flows in the period in which the impact of such claims is determined or paid.



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12.    DISCONTINUED OPERATIONS

Summarized financial information for the discontinued operations of NID, a test kit manufacturing subsidiary which was closed in 2006, is set forth below:
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2012
 
2011
 
2012
 
2011
Net revenues
$

 
$

 
$

 
$

Income (loss) from discontinued operations before taxes
431

 
(190
)
 
1,413

 
(282
)
Income tax expense
(486
)
 
(317
)
 
(1,194
)
 
(599
)
Income (loss) from discontinued operations, net of taxes
$
(55
)
 
$
(507
)
 
$
219

 
$
(881
)

The remaining balance sheet information related to NID was not material at June 30, 2012 and December 31, 2011.

13.    BUSINESS SEGMENT INFORMATION

Clinical testing is an essential element in the delivery of healthcare services. Physicians use clinical tests to assist in the detection, diagnosis, evaluation, monitoring and treatment of diseases and other medical conditions. Clinical testing is generally categorized as clinical laboratory testing and anatomic pathology services. Clinical laboratory testing is generally performed on whole blood, serum, plasma and other body fluids, such as urine, and specimens such as microbiology samples. Anatomic pathology services are principally for the detection of cancer and are performed on tissues, such as biopsies, and other samples, such as human cells. Customers of the clinical testing business include patients, physicians, hospitals, employers, governmental institutions and other commercial clinical laboratories. The clinical testing business accounted for greater than 90% of net revenues from continuing operations in 2012 and 2011.

All other operating segments include the Company's non-clinical testing businesses and consist of its risk assessment services, clinical trials testing, healthcare information technology, and diagnostics products businesses. The Company's risk assessment services business provides underwriting support services to the life insurance industry including electronic data collection, specimen collection and paramedical examinations, laboratory testing, medical record retrieval, case management, motor vehicle reports, telephone inspections, prescription histories and credit checks. The Company's clinical trials testing business provides clinical testing performed in connection with clinical research trials on new drugs, vaccines and certain medical devices. The Company's healthcare information technology business is a developer and integrator of clinical connectivity and data management solutions for healthcare organizations, physicians and clinicians that can help improve patient care and medical practice. The Company's diagnostics products business manufactures and markets products that enable healthcare professionals to make healthcare diagnoses, including products for point-of-care, or near-patient, testing for the professional market. During the second quarter of 2011, the Company acquired Athena and Celera. Athena is included in the Company's clinical laboratory testing business. The majority of Celera's operations are included in the Company's clinical laboratory testing business, with the remainder in other operating segments. A full description of the Company’s acquisitions is contained in Note 4 to the Consolidated Financial Statements in the Company’s 2011 Annual Report on Form 10-K.

On April 19, 2006, the Company decided to discontinue NID’s operations and results of operations for NID have been classified as discontinued operations for all periods presented (see Note 12).

At June 30, 2012, substantially all of the Company’s services are provided within the United States, and substantially all of the Company’s assets are located within the United States.

The following table is a summary of segment information for the three and six months ended June 30, 2012 and 2011. Segment asset information is not presented since it is not used by the chief operating decision maker at the operating segment level. Operating earnings (loss) of each segment represents net revenues less directly identifiable expenses to arrive at operating income for the segment. Certain general operating expenses in 2011 have been reclassified to conform to the current year presentation of the Company's clinical laboratory testing business. General management and administrative corporate expenses, including amortization of intangible assets and the Medi-Cal charge in the first quarter of 2011 of $236 million (see Note 5), are included in general corporate expenses below. The accounting policies of the segments are the same as those of the Company as set forth in Note 2 to the Consolidated Financial Statements contained in the Company’s 2011 Annual Report on Form 10-K

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QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(dollars in thousands unless otherwise indicated)


and Note 2 to the interim consolidated financial statements.
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2012
 
2011
 
2012
 
2011
Net revenues:
 

 
 

 
 

 
 

Clinical laboratory testing business
$
1,739,092

 
$
1,726,948

 
$
3,507,079

 
$
3,389,113

All other operating segments
167,718

 
176,253

 
336,187

 
335,665

Total net revenues
$
1,906,810

 
$
1,903,201

 
$
3,843,266

 
$
3,724,778

 
 
 
 
 
 
 
 
Operating earnings (loss):
 

 
 

 
 

 
 

Clinical laboratory testing business
$
374,670

 
$
366,609

 
$
730,385

 
$
676,893

All other operating segments
16,283

 
14,766

 
27,910

 
22,625

General corporate expenses
(56,205
)
 
(64,521
)
 
(123,962
)
 
(351,704
)
Total operating income
334,748

 
316,854

 
634,333

 
347,814

Non-operating expenses, net
(35,826
)
 
(39,058
)
 
(65,793
)
 
(67,080
)
Income from continuing operations before taxes
298,922

 
277,796

 
568,540

 
280,734

Income tax expense
112,394

 
105,762

 
213,771

 
154,988

Income from continuing operations
186,528

 
172,034

 
354,769

 
125,746

Income (loss) from discontinued operations, net of taxes
(55
)
 
(507
)
 
219

 
(881
)
Net income
186,473

 
171,527

 
354,988

 
124,865

Less: Net income attributable to noncontrolling interests
8,768

 
8,384

 
18,165

 
15,583

Net income attributable to Quest Diagnostics
$
177,705

 
$
163,143

 
$
336,823

 
$
109,282



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Table of Contents                                             

Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations

Our Company

Quest Diagnostics is the world's leading provider of diagnostic testing, information and services, providing insights that enable patients and physicians to make better healthcare decisions. Our clinical testing business currently represents our one reportable business segment and accounted for greater than 90% of our net revenues from continuing operations in both 2012 and 2011. Our other operating segments consist of our risk assessment services, clinical trials testing, healthcare information technology, and diagnostic products businesses. Our business segment information is disclosed in Note 13 to the interim consolidated financial statements.

Critical Accounting Policies
    
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions and select accounting policies that affect our reported financial results and the disclosure of contingent assets and liabilities. Actual results could differ from those estimates.

While many operational aspects of our business are subject to complex federal, state and local regulations, the accounting for most of our business is generally straightforward with net revenues primarily recognized upon completion of the testing process. Our revenues are primarily comprised of a high volume of relatively low dollar transactions, and about one-half of our total costs and expenses consist of employee compensation and benefits. Due to the nature of our business, several of our accounting policies involve significant estimates and judgments. There have been no significant changes to our critical accounting policies from those disclosed in our 2011 Annual Report on Form 10-K.
 
Initiatives to Improve Operating Efficiency
    
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 and marketing efforts, billing operations, bad debt expense and general management and administrative support. In addition, performing diagnostic testing involves significant fixed costs for facilities and other infrastructure required to obtain, transport and test specimens. Therefore, relatively small changes in volume can have a significant impact on profitability in the short-term.

We are engaged in a multi-year program designed to deliver $500 million in run rate cost savings versus 2011 by the time we exit 2014. We anticipate that this program, which we now call Invigorate, will deliver approximately 20% of our $500 million goal as we exit 2012, with the remainder in 2013 and 2014. This effort is intended to address 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 operating profitability and quality. We anticipate roughly one-third of the savings from client support/billing, procurement and supply chain; one-third from laboratory operations and specimen acquisition; and one-third from selling, general and administrative expenses, including information technology. Common themes across many of the opportunities include standardizing systems and processes and data bases, increased use of automation and technology, and centralizing and selective outsourcing of certain activities.
We have developed high-level estimates of the pre-tax charges expected to be incurred in connection with the course of action totaling $100 million to $175 million through 2014 consisting of: $40 million to $80 million of employee separation costs; $30 million to $45 million of facility-related costs; $10 million to $20 million of asset impairment charges; and $20 million to $30 million of systems conversion and integration costs. Of the total estimated pre-tax charges expected to be incurred, we estimate that $90 million to $155 million are anticipated to result in cash expenditures. The actual charges incurred in connection with the multi-year course of action could be materially different from these estimates. As detailed plans to implement the multi-year course of action are approved and executed, it will result in charges to earnings.
In connection with our Invigorate program, we launched a voluntary retirement program to certain eligible employees that qualified for the program. Of the total estimated pre-tax charges for employee separation costs noted above, we expect to incur approximately $50 million in connection with the voluntary retirement program over the next several quarters. We estimate that the voluntary retirement program will contribute approximately $40 million of annualized savings once fully implemented, which we expect in the first quarter of 2013.




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Table of Contents                                             

Recent Acquisitions

On February 24, 2011, we signed a definitive agreement to acquire Athena Diagnostics (“Athena”) from Thermo Fisher Scientific, Inc., in an all-cash transaction valued at approximately $740 million. We completed the acquisition of Athena on April 4, 2011.

On March 17, 2011, we entered into a definitive merger agreement with Celera Corporation (“Celera”) under which we agreed to acquire Celera for $8 per share, in a transaction valued at approximately $344 million, net of $326 million in acquired cash and short-term marketable securities. We completed the acquisition of Celera on May 17, 2011.
    
On January 6, 2012, we completed the acquisition of S.E.D. Medical Laboratories ("S.E.D.") for approximately $50.5 million.

The acquisitions of Athena, Celera and S.E.D. (collectively "the acquisitions") are further described in Note 4 to the Consolidated Financial Statements in our 2011 Annual Report on Form 10-K and Note 7 to the interim consolidated financial statements.

Results of Operations
       
Three and Six Months Ended June 30, 2012 Compared with Three and Six Months Ended June 30, 2011

Continuing Operations
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
 
 
 
% Increase
(Decrease)
 
 
 
 
 
% Increase
(Decrease)
 
2012
 
2011
 
 
2012
 
2011
 
 
(dollars in millions, except per share data)
Net revenues
$
1,906.8

 
$
1,903.2

 
0.2
%
 
$
3,843.3

 
$
3,724.8

 
3.2
%
Income from continuing operations
177.8

 
163.6

 
8.7
%
 
336.6

 
110.2

 
205.4
%
Earnings per diluted share
$
1.11

 
$
1.02

 
8.8
%
 
$
2.10

 
$
0.68

 
208.8
%

Results for the three months ended June 30, 2012 were affected by certain items that impacted earnings per diluted share by $0.06. During the second quarter of 2012, we incurred costs of $12.6 million, or $0.05 per diluted share, primarily associated with professional fees and workforce reductions associated with further restructuring and integrating our business. Results for the quarter also included $3.0 million, or $0.01 per diluted share, principally associated with separation costs and accelerated vesting of certain equity awards in connection with the succession of our prior CEO.

Results for the six months ended June 30, 2012 were affected by certain items that impacted earnings per diluted share by $0.14. During the six months ended June 30, 2012, we incurred costs of $25.7 million, or $0.10 per diluted share, primarily associated with professional fees and workforce reductions associated with further restructuring and integrating our business. Results for the six months ended June 30, 2012 also included $10.1 million, or $0.04 per diluted share, principally associated with separation costs and accelerated vesting of certain equity awards in connection with the succession of our prior CEO.

Results for the three months ended June 30, 2011 included $15.1 million of pre-tax transaction costs, or $0.07 per diluted share, associated with the acquisitions of Athena and Celera. Of these costs, $14.3 million, primarily related to professional fees, were recorded in selling, general and administrative expenses and $0.8 million of financing related costs were included in interest expense, net. Results for the three months ended June 30, 2011 also included $6.1 million of pre-tax restructuring and integration charges, or $0.03 per diluted share, consisting principally of workforce reductions.

    

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Table of Contents                                             

Results for the six months ended June 30, 2011 were affected by a number of items which impacted earnings per diluted share by $1.44. During the first quarter of 2011, we recorded the Medi-Cal charge of $236 million, or $1.20 per diluted share, in "other operating expense, net." Results for the six months ended June 30, 2011 also included $19.4 million of pre-tax restructuring and integration charges, or $0.07 per diluted share, principally associated with workforce reductions. In addition, results for the six months ended June 30, 2011 included pre-tax charges of $19.7 million, or $0.10 per diluted share, associated with the acquisitions of Athena and Celera. Of these costs $16.6 million, primarily related to professional fees, were recorded in selling, general and administrative expenses and $3.1 million of financing related costs were included in interest expense, net. In addition, we estimate that the impact of severe weather during the first quarter of 2011 adversely affected operating income for the six months ended June 30, 2011 by $18.5 million, or $0.07 per diluted share.

Net Revenues

Net revenues for the three months ended June 30, 2012 were 0.2% above the prior year level with the Celera and S.E.D. acquisitions contributing 0.8% revenue growth in the quarter.

Clinical testing revenue, which accounted for over 90% of our consolidated revenues, increased by 0.7% for the three months ended June 30, 2012 compared to the prior year period. The acquisitions of Celera and S.E.D. contributed about half a percent to clinical testing revenue growth in the quarter. Clinical testing volume, measured by the number of requisitions, increased 0.7% for the second quarter of 2012, compared to the prior year period. This increase was primarily driven by the acquisitions of Celera and S.E.D., and the continued growth of pre-employment drug testing, which increased about 5% in the quarter.
    
Revenue per requisition for the three months ended June 30, 2012 was essentially unchanged from the prior year level. Revenue per requisition benefited from an increase in the number of tests ordered per requisition, and was offset by reimbursement changes, and business and payor mix changes including an increase in lower priced drugs-of-abuse testing, and a decrease in higher priced anatomic pathology testing.

Net revenues for the six months ended June 30, 2012 were 3.2% above the prior year level with the Athena, Celera and S.E.D. acquisitions contributing approximately 2% to consolidated revenue growth.

Clinical testing revenue increased 3.5% for the six months ended June 30, 2012 compared to the prior year period. The acquisitions of Athena, Celera and S.E.D. contributed about 1.7% to clinical testing revenue growth during the period. Clinical testing volume, measured by the number of requisitions, increased 2.0% compared to the prior year period. We estimate that the impact of weather favorably affected the year-over-year volume comparisons by about 1%, and acquisitions contributed about 0.5%. After considering the favorable impact of weather and acquisitions, underlying volume growth was about 0.5%. Pre-employment drug testing volume grew about 5% during the six months ended June 30, 2012.
    
Revenue per requisition for the six months ended June 30, 2012 was 1.4% above the prior year period. Revenue per requisition continued to benefit from an increased mix in gene-based and esoteric testing, particularly from the impact of the acquired operations of Athena and Celera. Partially offsetting this benefit were reimbursement changes, and business and payor mix changes including an increase in lower priced drugs-of-abuse testing, and a decrease in higher priced anatomic pathology testing.
    
Our businesses other than clinical laboratory testing accounted for approximately 9% of our net revenues for the three and six months ended June 30, 2012 and 2011. These businesses contain most of our international operations and include our risk assessment services, clinical trials testing, healthcare information technology and diagnostic products businesses. For the three months ended June 30, 2012, combined revenues in these businesses decreased by approximately 5%, compared to the prior year period. For the six months ended June 30, 2012, combined revenues in these businesses approximated the prior year level. Increased revenues associated with our diagnostics products operations acquired as part of the Celera acquisition offset an approximate 5% reduction in revenues among our other non-clinical testing businesses.


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Table of Contents                                             

Operating Costs and Expenses

 
Three Months Ended June 30,
 
2012
 
2011
 
Increase
(Decrease)
 
$
 
% Net
Revenue
 
$
 
% Net
Revenue
 
$
 
% Net
Revenue
 
(dollars in millions)
Cost of services
$
1,110.5

 
58.2
%
 
$
1,104.4

 
58.0
%
 
$
6.1

 
0.2
 %
Selling, general and administrative expenses (SG&A)
440.8

 
23.1

 
462.8

 
24.3

 
(22.0
)
 
(1.2
)
Amortization of intangible assets
20.2

 
1.1

 
18.6

 
1.0

 
1.6

 
0.1

Other operating expense, net
0.6

 

 
0.6

 
0.1

 

 
(0.1
)
Total operating costs and expenses
$
1,572.1

 
82.4
%
 
$
1,586.4

 
83.4
%
 
$
(14.3
)
 
(1.0
)%
Bad debt expense (included in SG&A)
$
66.5

 
3.5
%
 
$
68.6

 
3.6
%
 
$
(2.1
)
 
(0.1
)%

 
Six Months Ended June 30,
 
2012
 
2011
 
Increase
(Decrease)
 
$
 
% Net
Revenue
 
$
 
% Net
Revenue
 
$
 
% Net
Revenue
 
(dollars in millions)
Cost of services
$
2,227.1

 
57.9
%
 
$
2,201.4

 
59.1
%
 
$
25.7

 
(1.2
)%
Selling, general and administrative expenses (SG&A)
941.4

 
24.5

 
910.6

 
24.4

 
30.8

 
0.1

Amortization of intangible assets
40.4

 
1.1

 
28.5

 
0.8

 
11.9

 
0.3

Other operating expense, net
0.1

 

 
236.5

 
6.4

 
(236.4
)
 
(6.4
)
Total operating costs and expenses
$
3,209.0

 
83.5
%
 
$
3,377.0

 
90.7
%
 
$
(168.0
)
 
(7.2
)%
Bad debt expense (included in SG&A)
$
147.2

 
3.8
%
 
$
146.0

 
3.9
%
 
$
1.2

 
(0.1
)%

Total Operating Costs and Expenses

For the three months ended June 30, 2012, total operating costs and expenses were $14 million below the prior year level, primarily driven by actions we have taken to reduce our cost structure, and by the impact in 2011 of professional fees and integration charges associated with the acquisitions of Athena and Celera. This decrease was partially offset by higher professional fees and other costs associated with further restructuring and integrating our business and costs incurred in connection with the succession of our prior CEO.

Results for the three months ended June 30, 2012 included costs of $12.6 million, primarily associated with professional fees and workforce reductions incurred in connection with further restructuring and integrating our business ($4.6 million in cost of services and $8.0 million in selling, general and administrative expenses). In addition, $3.0 million of pre-tax charges, associated with separation costs and accelerated vesting of certain equity awards in connection with the succession of our prior CEO, were recorded in selling, general and administrative expenses.

Results for the three months ended June 30, 2011 included pre-tax transaction costs of $14.3 million associated with the acquisitions of Athena and Celera, primarily related to professional fees, which were recorded in selling, general and administrative expenses. Results for the three months ended June 30, 2011 also included $6.1 million of pre-tax restructuring and integration charges, principally associated with workforce reductions, which were recorded in selling, general and administrative expenses.

For the six months ended June 30, 2012, total operating costs and expenses were $168 million below the prior year level, primarily due to the impact of the 2011 Medi-Cal charge, transaction costs associated with the acquisitions of Athena and Celera in 2011 and, to a lesser extent, actions we have taken to reduce our cost structure. This decrease was partially offset by an increase in operating expenses associated with the acquired operations of Athena, Celera and S.E.D., higher costs associated

23

Table of Contents                                             

with employee compensation and benefits, and costs incurred in connection with the succession of our prior CEO. The decrease in total operating expenses as a percentage of net revenues compared to the prior year is principally due to the Medi-Cal charge recorded in 2011.

Results for the six months ended June 30, 2012 included costs of $25.7 million, primarily associated with professional fees and workforce reductions incurred in connection with further restructuring and integrating our business ($8.6 million in cost of services and $17.1 million in selling, general and administrative expenses). In addition, $10.1 million of pre-tax charges, associated with separation costs and accelerated vesting of certain equity awards in connection with the succession of our prior CEO, were recorded in selling, general and administrative expenses in 2012.

Results for the six months ended June 30, 2011 included the Medi-Cal charge of $236 million recorded in connection with the California Lawsuit. In addition, results for the six months ended June 30, 2011 included $19.4 million of restructuring and integration charges, principally associated with workforce reductions ($9.0 million in cost of services and $10.4 million in selling, general and administrative expenses). Results for the six months ended June 30, 2011 also included pre-tax transaction costs of $16.6 million associated with the acquisitions of Athena and Celera, primarily related to professional fees, which were recorded in selling, general and administrative expenses.

Cost of Services

The increase in cost of services as a percentage of net revenues for the three months ended June 30, 2012, compared to the prior year period, is principally associated with costs associated with workforce reductions. Higher costs associated with employee compensation and benefits were essentially offset by the impact of actions we have taken to reduce our cost structure.
    
The decrease in cost of services as a percentage of net revenues for the six months ended June 30, 2012, compared to the prior year period, primarily reflects the impact of actions we have taken to reduce our cost structure, and the impact of the acquired operations of Athena and Celera which serve to reduce the percentage. In addition, severe weather in 2011, which served to reduce revenues and increase costs as a percentage of revenues, contributed to higher cost of services as a percentage of revenues in 2011 compared to the current year period.

Selling, General and Administrative Expenses
    
The decrease in selling, general and administrative expenses as a percentage of net revenues for the three months ended June 30, 2012, compared to the prior year period, primarily reflects the transaction costs associated with the Athena and Celera acquisitions that were incurred during the second quarter of 2011, and actions we have taken to reduce our cost structure. This improvement was partially offset by costs incurred in connection with the succession of our prior CEO and a $1.9 million increase in pre-tax charges associated with restructuring and integration costs.

The increase in selling, general and administrative expenses as a percentage of net revenues for the six months ended June 30, 2012, compared to the prior year period, primarily reflects the impact of the acquired operations of Athena and Celera, costs incurred in connection with the succession of our prior CEO, and a $6.7 million increase in pre-tax charges associated with restructuring and integration costs. These increases were partially offset by actions we have taken to reduce our cost structure, and the favorable impact on the year over year comparisons due to the severe weather in 2011, and the transaction costs associated with the Athena and Celera acquisitions that were incurred during the 2011.
    
Amortization of Intangible Assets

The increase in amortization of intangible assets for the three and six months ended June 30, 2012, compared to the prior year period, primarily reflects the impact of amortization of intangible assets acquired as part of the Athena, Celera and S.E.D. acquisitions.


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Table of Contents                                             

Other Operating Expense, net

Other operating expense, net includes special charges, and miscellaneous income and expense items related to operating activities. For the six months ended June 30, 2011, other operating expense, net included the Medi-Cal charge of $236.0 million recorded in connection with the California Lawsuit.

Operating Income

 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
 
 
 
Increase
(Decrease)
 
 
 
 
Increase
(Decrease)
 
2012
 
2011
 
2012
 
2011
 
 
(dollars in millions)
Operating income
$
334.7

 
$
316.9

 
$
17.8

 
$
634.3

 
$
347.8

 
$
286.5

Operating income % of net revenues
17.6
%
 
16.6
%
 
1.0
%
 
16.5
%
 
9.3
%
 
7.2
%

The primary driver of the increase in operating income as a percentage of net revenues for the three months ended June 30, 2012, compared to the prior year period, are actions we have taken to reduce our cost structure. In addition, the impact of transaction costs associated with the Athena and Celera acquisitions in 2011 served to decrease operating income as a percentage of net revenues in the second quarter of 2011. Partially offsetting these improvements are higher costs associated with employee compensation and benefits, higher costs associated with restructuring and integration activities and costs incurred in connection with the succession of our prior CEO.

The impacts of the Medi-Cal charge and severe weather in the first quarter of 2011 served to decrease operating income as a percentage of net revenues in 2011 and are the principal drivers of the improved operating income as a percentage of net revenues for the six months ended June 30, 2012. Also contributing to the improvement are actions we have taken to reduce our cost structure. Partially offsetting these improvements are higher costs associated with employee compensation and benefits, costs incurred in connection with the succession of our prior CEO, and costs associated with a legal settlement.

Interest Expense, net
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
 
 
 
Increase
(Decrease)
 
 
 
 
Increase
(Decrease)
 
2012
 
2011
 
2012
 
2011
 
 
(dollars in millions)
Interest expense, net
$
41.9

 
$
46.6

 
$
(4.7
)
 
$
84.3

 
$
84.5

 
$
(0.2
)

Interest expense, net for the three and six months ended June 30, 2012 decreased, compared to prior year periods, primarily due to lower average outstanding debt balances in 2012 and the financing commitment fees incurred in 2011 related to the acquisition of Celera.

Other (Expense) Income, net

Other (expense) 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 and six months ended June 30, 2012 and 2011, other (expense) income, net consisted of the following:

 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
 
 
 
Increase
(Decrease)
 
 
 
 
 
Increase
(Decrease)
 
2012
 
2011
 
 
2012
 
2011
 
 
(dollars in millions)
Investment gains (losses) associated with our supplemental deferred compensation plans
$
(1.3
)
 
$
0.2

 
$
(1.5
)
 
$
3.5

 
$
2.3

 
$
1.2

Other (expense) income items, net

 
(0.5
)
 
0.5

 

 
(0.4
)
 
0.4

Total other (expense) income, net
$
(1.3
)
 
$
(0.3
)
 
$
(1.0
)
 
$
3.5

 
$
1.9

 
$
1.6


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Table of Contents                                             

    
Income Tax Expense

 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
 
 
 
Increase
(Decrease)
 
 
 
 
 
Increase
(Decrease)
 
2012
 
2011
 
 
2012
 
2011
 
 
(dollars in millions)
Income tax expense
$
112.4

 
$
105.8

 
$
6.6

 
$
213.8

 
$
155.0

 
$
58.8

Effective income tax rate
37.6
%
 
38.1
%
 
(0.5
)%
 
37.6
%
 
55.2
%
 
(17.6
)%

The increase in income tax expense for the three and six months ended June 30, 2012 is principally due to an increase in pre-tax income. The decrease in the effective income tax rate for the six months ended June 30, 2012, compared to the prior year period, is due primarily to the Medi-Cal charge in 2011, a portion for which a tax benefit was not recorded.

Discontinued Operations

Loss from discontinued operations, net of taxes, for the three months ended June 30, 2012 and 2011 was $0.1 million and $0.5 million, respectively, with no impact on diluted earnings per share. Results from discontinued operations, net of taxes for the six months ended June 30, 2012 was income of $0.2 million and a loss of $0.9 million, with a $0.01 negative impact on diluted earnings per share, for the six months ended June 30, 2011. See Note 12 to the interim consolidated financial statements for further details.

Quantitative and Qualitative Disclosures About Market Risk

We address our exposure to market risks, principally the market risk of changes in interest rates, through a controlled program of risk management that includes the use of derivative financial instruments. We do not hold or issue derivative financial instruments for speculative purposes. We believe that our exposures to foreign exchange impacts and changes in commodity prices are not material to our consolidated financial condition or results of operations. See Note 8 to the interim consolidated financial statements for additional discussion of our financial instruments and hedging activities.
    
At June 30, 2012 and December 31, 2011, the fair value of our debt was estimated at approximately $4.3 billion and $4.4 billion, respectively, using quoted active market prices and yields for the same or similar types of borrowings, taking into account the underlying terms of the debt instruments. At June 30, 2012 and December 31, 2011, the estimated fair value exceeded the carrying value of the debt by $500 million and $387 million, respectively. A hypothetical 10% increase in interest rates (representing 44 basis points and 41 basis points at June 30, 2012 and December 31, 2011, respectively) would potentially reduce the estimated fair value of our debt by approximately $102 million and $112 million at June 30, 2012 and December 31, 2011, respectively.

Borrowings under our floating rate senior notes due 2014, our senior unsecured revolving credit facility and our secured receivables credit facility are subject to variable interest rates. Interest on our secured receivables credit facility is based on rates that are intended to approximate commercial paper rates for highly-rated issuers. Interest on our senior unsecured revolving credit facility is subject to a pricing schedule that can fluctuate based on changes in our credit ratings. As such, our borrowing cost under this credit arrangement will be subject to both fluctuations in interest rates and changes in our credit ratings. At June 30, 2012, the borrowing rates under these debt instruments were: for our floating rate senior notes due 2014, LIBOR plus 0.85%; for our senior unsecured revolving credit facility, LIBOR plus 1.125%; and for our secured receivables credit facility, 0.96%. At June 30, 2012, the weighted average LIBOR was 0.5%. As of June 30, 2012, $200 million was outstanding under our floating rate senior notes due 2014 and $435 million was outstanding under our $525 million secured receivables credit facility. There were no borrowings outstanding under our $750 million senior unsecured revolving credit facility as of June 30, 2012.

We seek to mitigate the variability in cash outflows that result from changes in interest rates by maintaining a balanced mix of fixed-rate and variable-rate debt obligations. In order to achieve this objective, we have entered into interest rate swaps. Interest rate swaps involve the periodic exchange of payments without the exchange of underlying principal or notional amounts. Net settlements are recognized as an adjustment to interest expense.

In March 2011, we entered into various fixed-to-variable interest rate swap agreements which have a notional amount totaling $200 million and a variable interest rate based on six-month LIBOR plus 0.54%. These derivative financial instruments

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are accounted for as fair value hedges of a portion of our senior notes due 2016. In addition, in previous years we entered into various fixed-to-variable interest rate swap agreements with a notional amount of $350 million and a variable interest rate based on one-month LIBOR plus 1.33% that were accounted for as fair value hedges of a portion of our senior notes due 2020. Based on our net exposure to interest rate changes, a hypothetical 10% change in interest rates on our variable rate indebtedness (representing 4 basis points) would impact annual interest expense by approximately $0.5 million, assuming no changes to the debt outstanding at June 30, 2012.

The fair value of the fixed-to-variable interest rate swap agreements related to our senior notes due 2016 and our senior notes due 2020 was an asset of $65.2 million at June 30, 2012. A hypothetical 10% change in interest rates (representing 10 basis points) would potentially change the fair value of the asset by approximately $4.0 million. In July 2012, we monetized the asset associated with these interest rate swap agreements by terminating the agreements, and entered into new fixed-to-variable interest rate swap agreements. As a result of this termination, we received proceeds of $71.8 million, which will be amortized as a reduction of interest expense over the remaining term of the hedged debt instruments.

The new agreements entered into in July 2012 include: fixed-to-variable interest rate swap agreements with a notional amount of $200 million and a variable interest rate based on six-month LIBOR plus 2.33% that are accounted for as fair value hedges of a portion of our senior notes due 2016; and fixed-to-variable interest rate swap agreements with a notional amount of $350 million and a variable interest rate based on one-month LIBOR plus 3.56% that are accounted for as fair value hedges of a portion of our senior notes due 2020.

For further details regarding our outstanding debt, see Note 11 to the Consolidated Financial Statements included in our 2011 Annual Report on Form 10-K for the year ended December 31, 2011. For details regarding our financial instruments, see Note 8 to the interim consolidated financial statements.

Risk Associated with Investment Portfolio

Our investment portfolio includes equity investments comprised primarily of strategic equity holdings in privately held companies. These securities are exposed to price fluctuations and are generally concentrated in the life sciences industry. The carrying value of our equity investments was $12.6 million at June 30, 2012.
    
We regularly evaluate the fair value measurements of our equity investments to determine if losses in value are other than temporary and if an impairment loss has been incurred. The evaluation considers whether the security has the ability to recover and, if so, the estimated recovery period. Other factors that are considered in this evaluation include the amount of the other-than-temporary decline and its duration, the issuer’s financial condition and short-term prospects, and whether the market decline was caused by overall economic conditions or conditions specific to the individual security.

We do not hedge our equity price risk. The impact of an adverse movement in equity prices on our holdings in privately held companies cannot be easily quantified, as our ability to realize returns on investments depends on, among other things, the enterprises’ ability to raise additional capital or derive cash inflows from continuing operations or through liquidity events such as initial public offerings, mergers or private sales.

Liquidity and Capital Resources
          
Cash and Cash Equivalents

Cash and cash equivalents at June 30, 2012 totaled $174 million, compared to $165 million at December 31, 2011. Cash and cash equivalents consist of cash and highly liquid short-term investments. For the six months ended June 30, 2012, cash flows from operating activities of $412 million were used to fund investing and financing activities of $131 million and $273 million, respectively. Cash and cash equivalents at June 30, 2011 totaled $184 million compared to $449 million at December 31, 2010. For the six months ended June 30, 2011, cash flows from operating activities of $220 million, together with cash on hand and cash flows from financing activities of $523 million, were used to fund investing activities of $1.0 billion.

Cash Flows from Operating Activities

Net cash provided by operating activities for the six months ended June 30, 2012 was $412 million compared to $220 million in the prior year period. For the six months ended June 30, 2011, cash flows from operating activities included the second quarter payment to Medi-Cal, the California Medicaid program, of $241 million (see Note 5 to the interim consolidated financial statements), or $194 million net of an associated reduction in second quarter estimated tax payments. Days sales

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outstanding, a measure of billing and collection efficiency, was 44 days at June 30, 2012, compared to 45 days at December 31, 2011 and 44 days at June 30, 2011.

Cash Flows from Investing Activities

Net cash used in investing activities for the six months ended June 30, 2012 was $131 million, and consisted principally of $50.5 million related to the S.E.D. acquisition and capital expenditures of $77 million.

Net cash used in investing activities for the six months ended June 30, 2011 was $1.0 billion, consisting principally of $740 million related to the acquisition of Athena and $396 million net of cash acquired related to the acquisition of Celera, or $183 million net of cash and $213 million of short-term marketable securities acquired. A liability of $159 million, representing merger consideration related to shares of Celera which had not been surrendered, was included in accounts payable and accrued expenses at June 30, 2011. Proceeds from the sale of the short-term marketable securities, acquired as part of the Celera acquisition, were used to repay borrowings outstanding under our secured receivables credit facility and our senior unsecured revolving credit facility in the second quarter of 2011. In addition, cash flows from investing activities for the six months ended June 30, 2011 included capital expenditures of $79 million.
    
Cash Flows from Financing Activities

Net cash used in financing activities for the six months ended June 30, 2012 was $273 million, consisting primarily of net decreases in debt of $215 million, purchases of treasury stock of $100 million, dividend payments of $54 million and distributions to noncontrolling interests of $16 million. These decreases were partially offset by proceeds from the exercise of stock options and related tax benefits totaling $95 million. The net decrease in debt consists of $685 million of borrowings and $900 million of repayments.

For the six months ended June 30, 2012, net borrowings of $350 million under our secured receivables credit facility, together with $210 million of cash on hand, were used to fund repayments of $560 million under our term loan due May 2012. The net borrowings under our secured receivables credit facility consist of $685 million of borrowings and $335 million of repayments.

Net cash provided by financing activities for the six months ended June 30, 2011 was $523 million, consisting primarily of net increases in debt of $1.3 billion, and proceeds from the exercise of stock options and related tax benefits totaling $102 million, partially offset by purchases of treasury stock of $835 million, dividend payments of $33 million, distributions to noncontrolling interests of $17 million and $10 million of payments primarily related to debt issuance costs incurred in connection with our senior notes offering in the first quarter of 2011.

In February 2011, borrowings of $500 million under our secured receivables credit facility and $75 million under our senior unsecured revolving credit facility, together with $260 million of cash on hand, were used to fund purchases of treasury stock totaling $835 million. In addition, we completed a $1.25 billion senior notes offering in March 2011 (the “2011 Senior Notes”). We used $485 million of the $1.24 billion in net proceeds from the 2011 Senior Notes offering, together with $90 million of cash on hand, to fund the repayment of $500 million outstanding under our secured receivables credit facility, and the repayment of $75 million outstanding under our senior unsecured revolving credit facility. The remaining portion of the net proceeds from the 2011 Senior Notes offering were used to fund our acquisition of Athena on April 4, 2011. The 2011 Senior Notes are further described in Note 11 to the Consolidated Financial Statements in our 2011 Annual Report on Form 10-K.

During the second quarter of 2011, $585 million and $30 million of borrowings under our secured receivables credit facility and our senior unsecured revolving credit facility, respectively, together with cash on hand, were used to fund the acquisition of Celera in May 2011. During the second quarter of 2011, proceeds from the sale of short-term marketable securities acquired as part of the Celera acquisition totaling $214 million, together with cash on hand, were used to fund $500 million and $30 million of debt repayments under our secured receivables credit facility and our senior unsecured revolving credit facility, respectively.

Dividends

During each of the first three quarters of 2011, our Board of Directors declared a quarterly cash dividend of $0.10 per common share and in October 2011, declared an increase in the quarterly cash dividend from $0.10 per common share to $0.17 per common share. During each of the quarters in 2012, our Board of Directors declared a quarterly cash dividend of $0.17 per common share. We expect to fund future dividend payments with cash flows from operations, and do not expect the dividend to have a material impact on our ability to finance future growth.

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Share Repurchases

In January 2012, our Board of Directors authorized $1 billion of additional share repurchases of our common stock, increasing our total available authorization at that time to $1.1 billion. The share repurchase authorization has no set expiration or termination date.
    
For the three months ended June 30, 2012, we repurchased 882 thousand shares of our common stock at an average price of $56.70 per share for a total of $50 million. For the six months ended June 30, 2012, we repurchased 1.7 million shares of our common stock at an average price of $57.83 per share for a total of $100 million. At June 30, 2012, $965 million remained available under share repurchase authorizations.
    
For the six months ended June 30, 2011, we repurchased, in a transaction which occurred in the first quarter, 15.4 million shares of our common stock from SB Holdings Capital Inc., a wholly-owned subsidiary of GlaxoSmithKline plc., at an average price of $54.30 per share for a total of $835 million.

Contractual Obligations and Commitments

The following table summarizes certain of our contractual obligations as of June 30, 2012:

 
 
Payments due by period
 
 
(in thousands)
Contractual Obligations
 
Total
 
Remainder
of 2012
 
1-3 years
 
3-5 years
 
After 5 years
Outstanding debt
 
$
3,735,000

 
$
435,000

 
$
200,000

 
$
800,000

 
$
2,300,000

Capital lease obligations
 
45,407

 
4,826

 
18,107

 
8,548

 
13,926

Interest payments on outstanding debt
 
2,076,097

 
79,767

 
307,338

 
273,014

 
1,415,978

Operating leases
 
614,086

 
93,937

 
261,560

 
139,213

 
119,376

Purchase obligations
 
98,163

 
16,559

 
61,420

 
15,721

 
4,463

Merger consideration obligation
 
966

 
966

 

 

 

Total contractual obligations
 
$
6,569,719

 
$
631,055

 
$
848,425

 
$
1,236,496

 
$
3,853,743


Interest payments on our long-term debt have been calculated after giving effect to our interest rate swap agreements, using the interest rates as of June 30, 2012 applied to the June 30, 2012 balances, which are assumed to remain outstanding through their maturity dates.

A full description of the terms of our indebtedness and related debt service requirements and our future payments under certain of our contractual obligations is contained in Note 11 to the Consolidated Financial Statements in our 2011 Annual Report on Form 10-K. A full discussion and analysis regarding our minimum rental commitments under noncancelable operating leases and noncancelable commitments to purchase product or services at December 31, 2011 is contained in Note 16 to the Consolidated Financial Statements in our 2011 Annual Report on Form 10-K. A full discussion and analysis regarding our acquisition of Celera and the merger consideration related to shares of Celera which had not been surrendered as of December 31, 2011 is contained in Note 4 to the Consolidated Financial Statements in our 2011 Annual Report on Form 10-K .

As of June 30, 2012, our total liabilities associated with unrecognized tax benefits were approximately $202 million, which were excluded from the table above. We believe it is reasonably possible that these liabilities may decrease by up to approximately $17 million within the next twelve months, primarily as a result of the expiration of statutes of limitations, settlements and/or the conclusion of tax examinations on certain tax positions. For the remainder, we cannot make reasonably reliable estimates of the timing of the future payments of these liabilities. See Note 6 to the Consolidated Financial Statements in our 2011 Annual Report on Form 10-K for information regarding our contingent tax liability reserves.
    
Our credit agreements contain various covenants and conditions, including the maintenance of certain financial ratios, that could impact our ability to, among other things, incur additional indebtedness. As of June 30, 2012, we were in compliance with the various financial covenants included in our credit agreements and we do not expect these covenants to adversely impact our ability to execute our growth strategy or conduct normal business operations.


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Unconsolidated Joint Ventures

We have investments in unconsolidated joint ventures in Phoenix, Arizona; Indianapolis, Indiana; and Dayton, Ohio, which are accounted for under the equity method of accounting. We believe that our transactions with our joint ventures are conducted at arm’s length, reflecting current market conditions and pricing. Total net revenues of our unconsolidated joint ventures equal less than 6% of our consolidated net revenues. Total assets associated with our unconsolidated joint ventures are less than 2% of our consolidated total assets. We have no material unconditional obligations or guarantees to, or in support of, our unconsolidated joint ventures and their operations.
    
Requirements and Capital Resources

We estimate that we will invest approximately $200 million during 2012 for capital expenditures, to support and expand our existing operations, principally related to investments in information technology, laboratory equipment and facilities. We expect to fund the repayment of our short-term borrowings and the current portion of our long-term debt using cash on hand and existing credit facilities.

As of June 30, 2012, $840 million of borrowing capacity was available under our existing credit facilities, consisting of $90 million available under our secured receivables credit facility and $750 million available under our senior unsecured revolving credit facility.

We believe the banks participating in our various credit facilities are predominantly highly-rated banks, and that the borrowing capacity under the credit facilities described above is currently available to us. Should one or several banks no longer participate in either of our credit facilities, we would not expect it to impact our ability to fund operations. We expect that we will be able to replace our existing secured receivables credit facility with alternative arrangements prior to its expiration.
    
We believe that cash and cash equivalents on-hand and cash from operations, together with our borrowing capacity under our credit facilities, will provide sufficient financial flexibility to fund seasonal working capital requirements, capital expenditures, debt service requirements and other obligations, cash dividends on common shares, share repurchases and additional growth opportunities for the foreseeable future. We believe that our credit profile should provide us with access to additional financing, if necessary, to fund growth opportunities that cannot be funded from existing sources.

Recent Accounting Pronouncements Not Yet Effective

There have been no new accounting pronouncements not yet effective that have significance, or potential significance, to our consolidated financial statements.
      
Forward-Looking Statements

Some statements and disclosures in this document are forward-looking statements. Forward-looking statements include all statements that do not relate solely to historical or current facts and can be identified by the use of words such as “may,” “believe,” “will,” “expect,” “project,” “estimate,” “anticipate,” “plan” or “continue.” These forward-looking statements are based on our current plans and expectations and are subject to a number of risks and uncertainties that could cause our plans and expectations, including actual results, to differ materially from the forward-looking statements. Risks and uncertainties that may affect our future results include, but are not limited to, adverse results from pending or future government investigations, lawsuits or private actions, the competitive environment, changes in government regulations, changing relationships with customers, payers, suppliers and strategic partners and other factors discussed in “Business,” “Risk Factors,” “Cautionary Factors That May Affect Future Results,” “Legal Proceedings,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and “Quantitative and Qualitative Disclosures About Market Risk” in our 2011 Annual Report on Form 10-K and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Quantitative and Qualitative Disclosures About Market Risk” in our 2012 Quarterly Reports on Form 10-Q and other items throughout the 2011 Form 10-K and our 2012 Quarterly Reports on Form 10-Q and Current Reports on Form 8-K.

Item 3.    Quantitative and Qualitative Disclosures About Market Risk
      
See Item 2. "Management's Discussion and Analysis of Financial Condition and Results of Operations."


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Item 4.    Controls and Procedures

Under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures (as defined under Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended). Based upon that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this quarterly report.

During the second quarter of 2012, there were no changes in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934, as amended) that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II - OTHER INFORMATION

Item 1.    Legal Proceedings
    
See Note 11 to the interim consolidated financial statements for information regarding the status of legal proceedings involving the Company.

Item 6.
Exhibits

Exhibits:
10.1
Amended and Restated Quest Diagnostics Incorporated Employee Long-Term Incentive Plan as amended March 27, 2012
 
 
31.1
Rule 13a-14(a) Certification of Chief Executive Officer
 
 
31.2
Rule 13a-14(a) Certification of Chief Financial Officer
 
 
32.1
Section 1350 Certification of Chief Executive Officer
 
 
32.2
Section 1350 Certification of Chief Financial Officer
 
 
101.INS
dgx-20120630.xml
 
 
101.SCH
dgx-20120630.xsd
 
 
101.CAL
dgx-20120630_cal.xml
 
 
101.DEF
dgx-20120630_def.xml
 
 
101.LAB
dgx-20120630_lab.xml
 
 
101.PRE
dgx-20120630_pre.xml

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Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds

The table below sets forth the information with respect to purchases made by or on behalf of the Company of its common stock during the second quarter of 2012.

ISSUER PURCHASES OF EQUITY SECURITIES
Period
 
Total Number of
Shares
Purchased
 
Average Price
Paid per Share
 
Total Number of
Shares Purchased
as Part of Publicly
Announced Plans
or Programs
 
Approximate
Dollar Value of
Shares that May
Yet Be Purchased
Under the Plans
or Programs
 (in thousands)
April 1, 2012 – April 30, 2012
 
 

 
 

 
 

 
 

Share Repurchase Program (A)
 

 
$

 

 
$
1,015,056

Employee Transactions (B)
 
27,426

 
$
57.56

 
N/A

 
N/A

May 1, 2012 – May 31, 2012
 
 

 
 

 
 

 
 

Share Repurchase Program (A)
 
548,705

 
$
57.41

 
548,705

 
$
983,554

Employee Transactions (B)
 
6,596

 
$
57.40

 
N/A

 
N/A

June 1, 2012 – June 30, 2012
 
 

 
 

 
 

 
 

Share Repurchase Program (A)
 
333,201

 
$
55.51

 
333,201

 
$
965,056

Employee Transactions (B)
 
595

 
$
58.02

 
N/A

 
N/A

Total
 
 

 
 

 
 

 
 

Share Repurchase Program (A)
 
881,906

 
$
56.70

 
881,906

 
$
965,056

Employee Transactions (B)
 
34,617

 
$
57.54

 
N/A

 
N/A


(A)
In January 2012, our Board of Directors authorized the Company to repurchase an additional $1 billion of the Company’s common stock, increasing the total available authorization at that time to $1.1 billion. The share repurchase authorization has no set expiration or termination date. Since the share repurchase program’s inception in May 2003, our Board of Directors has authorized $5.5 billion of share repurchases of our common stock through June 30, 2012.

(B)
Includes: (1) shares delivered or attested to in satisfaction of the exercise price and/or tax withholding obligations by holders of stock options (granted under the Company’s Amended and Restated Employee Long-Term Incentive Plan and its Amended and Restated Non-Employee Director Long-Term Incentive Plan, collectively the “Stock Compensation Plans”) who exercised options; (2) restricted common shares withheld (under the terms of grants under the Stock Compensation Plans) to offset tax withholding obligations that occur upon vesting and release of the restricted common shares; and (3) shares withheld (under the terms of grants under the Stock Compensation Plans) to offset tax withholding obligations that occur upon the delivery of common shares underlying restricted stock units and performance share units.


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Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
July 26, 2012
Quest Diagnostics Incorporated

By 
/s/ Stephen H. Rusckowski
 
 
Stephen H. Rusckowski
 
 
President and Chief Executive Officer
 
 
 
 
 
 
 
By
/s/ Robert A. Hagemann
 
 
Robert A. Hagemann
 
 
Senior Vice President and Chief Financial Officer
 
 
 
 

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