10-K 1 finaledgar10k03.txt COMPANY 10-K UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K (Mark One) X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES ------ EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2003 --------------------------------- OR TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ---------------- to --------------- Commission file number 1-11353 -------------------------------------------- LABORATORY CORPORATION OF AMERICA HOLDINGS ------------------------------------------------------------------ (Exact name of registrant as specified in its charter) DELAWARE 13-3757370 ------------------------------- --------------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 358 South Main Street, Burlington, North Carolina 27215 ---------------------------------------------------- -------- (Address of principal executive offices) (Zip Code) 336-229-1127 ----------------------------------------------------- (Registrant's telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: Title of each class Name of exchange on which registered ------------------------------ ------------------------------------- Common Stock, $0.10 par value New York Stock Exchange Securities registered pursuant to Section 12(g) of the Act: None 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 ---- ---- Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. --------- Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes X No ---- ---- As of June 30, 2003, the aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant was approximately $4.4 billion, based on the closing price on such date of the registrant's common stock on the New York Stock Exchange. Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date: 149,270,059 shares as of February 28, 2004. PART I Item 1. DESCRIPTION OF BUSINESS Laboratory Corporation of America Holdings and its subsidiaries(the "Company"), headquartered in Burlington, North Carolina, is the second largest independent clinical laboratory company in the United States based on 2003 net revenues. Through a national network of laboratories, the Company offers more than 4,400 different clinical laboratory tests which are used by the medical profession in routine testing, patient diagnosis, and in the monitoring and treatment of disease. In addition, the Company has developed specialty and niche businesses based on certain types of specialized testing capabilities and client requirements, such as oncology testing, HIV genotyping and phenotyping, diagnostic genetics and clinical research trials. The Company has significantly expanded its routine and specialty testing businesses through the acquisitions of Dynacare Inc. ("Dynacare") and DIANON Systems, Inc. ("DIANON"). Since its founding in 1971, the Company has grown into a national network of 31 primary laboratories and over 1,200 service sites, consisting of branches, patient service centers and STAT laboratories, which are laboratories that have the ability to perform certain routine tests quickly and report the results to the physician immediately. On July 25, 2002, the Company completed its acquisition of Dynacare, a provider of clinical laboratory testing services in 21 states in the United States and two provinces in Canada. The acquisition of Dynacare has enabled the Company to expand its national testing network and the Company expects to realize significant operational synergies from the acquisition. Dynacare had 2001 revenues of approximately $238.0 million and had approximately 6,300 employees at the closing date of the acquisition. On January 17, 2003, the Company completed the acquisition of DIANON, a leading national provider of anatomic pathology and genetic testing services with a primary focus on advanced oncology testing. DIANON had 2001 revenues of approximately $125.7 million and had approximately 1,100 employees at the closing date of the acquisition. DIANON significantly enhances the Company's oncology testing capabilities and positions it to more effectively market and distribute the advanced testing technologies that the Company has developed internally or has licensed from its technology partners, such as Myriad Genetics, Inc., EXACT Sciences Corporation, Celera Diagnostics and Correlogic Systems, Inc. With approximately 23,000 employees, the Company processes tests on more than 340,000 patient specimens daily and provides clinical laboratory testing services to clients in all 50 states, the District of Columbia, Puerto Rico, and two provinces in Canada. Its clients include physicians, hospitals, HMOs and other managed care organizations, governmental agencies, large employers, and other independent clinical laboratories that do not have the breadth of its testing capabilities. Several hundred of the Company's 4,400 tests are frequently used in general patient care by physicians to establish or support a diagnosis, to monitor treatment or to search for an otherwise undiagnosed condition. The most frequently-requested of these routine tests include blood chemistry analyses, urinalyses, blood cell counts, Pap tests, HIV tests, microbiology cultures and procedures, and alcohol and other substance-abuse tests. The Company performs this core group of routine tests in each of its major laboratories using sophisticated and computerized instruments, with most results reported within 24 hours. The Company's Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to those reports are made available free of charge through the Media and Investor Relations section of the Company's internet website at www.labcorp.com as soon as practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission. The Company is committed to providing the highest quality laboratory services to its clients in full compliance with all federal, state and local laws and regulations. The Company's Code of Business Conduct and Ethics outlines ethics and compliance policies adopted by the Company to meet this commitment. These policies apply to all employees of the Company and its subsidiaries as well as the Company's Board of Directors. The Code of Business Conduct and Ethics, as well as the Charters for the committees of Audit, Compensation, Ethics and Quality Assurance, and Nominating and Corporate Governance, and the Company's Corporate Governance Guidelines, are posted on the Company's website www.labcorp.com. The Company has established a Compliance Action hotline (1-800-801-1005), which provides a confidential and anonymous method to report a possible violation of a LabCorp compliance policy or procedure, or a federal or state law or regulation; a HIPAA Privacy hotline(1-877-234-4722), which provides a confidential and anonymous method to report a possible violation of a HIPAA privacy, security or billing policy or procedure; and an Accounting hotline (1-866-469-6893), which provides a confidential and anonymous method to report a possible violation of internal accounting controls or auditing matters. The Clinical Laboratory Testing Industry Laboratory tests and procedures are used generally by hospitals, physicians and other health care providers and commercial clients to assist in the diagnosis, evaluation, detection, monitoring and treatment of diseases and other medical conditions through the examination of substances in the blood, tissues and other specimens. Clinical laboratory testing is generally categorized as either clinical testing, which is performed on body fluids including blood and urine, or anatomical pathology testing, which is performed on cytologic samples, tissue and other samples, including human cells. Clinical and anatomical pathology procedures are frequently ordered as part of regular physician office visits and hospital admissions in connection with the diagnosis and treatment of illnesses. Certain of these tests and procedures are used principally as tools in the diagnosis and treatment of a wide variety of medical conditions such as cancer, AIDS, endocrine disorders, cardiac disorders and genetic disease. The most frequently requested tests include blood chemistry analyses, urinalyses, blood cell counts, Pap tests, HIV tests, microbiology cultures and procedures and alcohol and other substance- abuse tests. The clinical laboratory industry consists primarily of three types of providers: hospital-based laboratories, physician-office laboratories and independent clinical laboratories, such as those owned by the Company. The Company believes that in 2003 approximately 49% of the clinical testing revenues in the United States were derived by hospital-based laboratories, approximately 12% were derived by physicians in their offices and laboratories, and approximately 39% were derived by independent clinical laboratories. The Centers for Medicare and Medicaid Services ("CMS") of the Department of Health and Human Services ("HHS") has estimated that in 2003 there were approximately 5,000 independent clinical laboratories in the United States. Effect of Market Changes on the Clinical Laboratory Business Many market-based changes in the clinical laboratory business have occurred over the past ten years, primarily as a result of the shift away from traditional, fee-for-service medicine to managed-cost health care. The growth of the managed care sector presents various challenges to the Company and other independent clinical laboratories. Managed care organizations typically contract with a limited number of clinical laboratories and negotiate discounts to the fees charged by such laboratories in an effort to control costs. In addition, managed care organizations have used capitated payment contracts in an attempt to fix the cost of laboratory testing services for their enrollees. Under a capitated payment contract, the clinical laboratory and the managed care organization agree to a per member, per month payment to cover all laboratory tests during the month, regardless of the number or cost of the tests actually performed. The Company makes significant efforts to ensure that esoteric tests (which are more sophisticated tests used to obtain information not provided by routine tests and generally involve a higher level of complexity and more substantial human involvement than routine tests) are excluded from capitated arrangements and therefore paid for separately by the managed care organization. Capitated payment contracts shift the risks of additional testing beyond that covered by the capitated payment to the clinical laboratory. For the year ended December 31, 2003, such capitated contracts accounted for approximately $128.4 million of the Company's net sales. The increase in managed care and insurance companies' attempts to control utilization of medical services overall has also resulted in declines in the utilization of laboratory testing services. In addition, Medicare (which principally services patients 65 and older), Medicaid (which principally serves low-income patients) and insurers have increased their efforts to control the cost, utilization and delivery of health care services. Measures to regulate health care delivery in general and clinical laboratories in particular have resulted in reduced prices, added costs and decreased test utilization for the clinical laboratory industry by increasing complexity and adding new regulatory and administrative requirements. From time to time, Congress has also considered changes to the Medicare fee schedules in conjunction with certain budgetary bills. The Company believes that reductions in reimbursement for Medicare services will continue to be implemented from time to time. Reductions in the reimbursement rates of other third-party payors are likely to occur as well. Despite the market changes discussed above, the Company believes that the volume of clinical laboratory testing will be positively influenced by several factors, including the expanded base of genomics knowledge, which has led to an enhanced appreciation of the value of gene-based diagnostic assays for current patient care as well as for the development of new therapeutics. Additionally, these novel gene-based tests have led to an increased awareness by physicians that clinical laboratory testing is a cost-effective means of prevention and early detection of disease and monitoring of treatment. In an effort to better offer new technology as medical needs and standards of care develop, the Company has entered into a number of licensing and technology distribution agreements with such leading-edge diagnostic testing technology providers as: Atherotech (cardiovascular disease risk assessment), EXACT Sciences (colorectal cancer detection), BioPredictive (determination of liver fibrosis), Myriad Genetics (predisposition for breast, ovarian, colon and uterine cancer), Celera (development of new gene-based assays in a variety of disease areas) and Correlogic Systems (ovarian cancer detection). Additional factors which may lead to future volume growth include an increase in the number and types of tests which are readily available (due to advances in technology and increased cost efficiencies) for testing of cancer and infectious diseases and the general aging of the population in the United States. The impact of these factors is expected to be partially offset by declines in volume as a result of increased controls over the utilization of laboratory services by Medicare and other third- party payors, particularly managed care organizations. Laboratory Testing Operations and Services The Company has 31 primary testing facilities, and over 1,200 service sites consisting of branches, patient service centers and STAT laboratories. A "branch" is a central facility which collects specimens in a region for shipment to one of the Company's laboratories for testing. A branch also is used as a base for sales staff. Generally, a "patient service center" is a facility maintained by the Company to serve the physicians in a medical professional building or other strategic location. The patient service center collects the specimens as requested by the physician. The specimens are sent, principally through the Company's in-house courier system (and, to a lesser extent, through independent couriers), to one of the Company's major laboratories for testing. Some of the Company's patient service centers also function as "STAT labs", which are laboratories that have the ability to perform certain routine tests quickly and report results to the physician immediately. The Company processed an average of over 340,000 patient specimens per day in 2003. Patient specimens are delivered to the Company accompanied by a test request form. These forms, which are completed by the client, indicate the tests to be performed and provide the necessary billing information. Each specimen and related request form is checked for completeness and then given a unique identification number. The unique identification number assigned to each specimen helps to ensure that the results are attributed to the correct patient. The test request forms are sent to a data entry operator who ensures that a file is established for each patient and the necessary testing and billing information is entered. Once this information is entered into the computer system, the tests are performed and the results are entered through computer interface or manually, depending upon the tests and the type of equipment involved. Most of the Company's computerized testing equipment is connected to the Company's information systems. Most routine testing is completed by early the next morning and test results are in most cases electronically delivered to clients via smart printers, personal computer-based products or computer interfaces. It is Company policy to notify the client immediately if a life-threatening result is found at any point during the course of the testing process. Company Strategy The Company believes that it has differentiated itself from its competition and positioned itself for continued strong growth by building a leadership position in genomic and other advanced testing technologies. This leadership position enables the Company to provide a broad menu of testing services for the infectious disease and cancer markets, which it believes represent two of the most significant areas of future growth in the genomic clinical laboratory industry. The Company's primary strategic objective is to expand its leadership position in genomic and other advanced testing technologies and leverage its national core testing infrastructure to deliver outstanding and innovative clinical testing services to patients and physicians nationwide. Develop and Be First to Market with New Tests Advances in medicine have begun to fundamentally change diagnostic testing, and new tests are allowing clinical laboratories to provide unprecedented amounts of health-related information to physicians and patients. Significant new tests introduced over the past several years include a gene-based test for human papilloma virus, Myriad Genetics' predictive test for breast cancer and tests for HIV phenotyping and cystic fibrosis. As science continues to advance, the Company expects new testing technologies to emerge; therefore, it intends to continue to invest in advanced testing capabilities so that it can remain on the cutting edge of clinical laboratory testing. The Company has added, and expects to continue to add, new testing technologies and capabilities through a combination of internal development initiatives, technology licensing and partnership transactions and selected acquisitions. Through its national sales force, the Company rapidly introduces new testing technologies to physician customers. Capitalize on Unique Opportunities with New Testing Technologies The Company has announced a number of significant licensing and technology distribution agreements which provide it with access to exciting new testing technologies that it expects will have an increasing impact on diagnostic testing. For example, in June 2002, the Company announced the creation of an exclusive, long-term strategic agreement with EXACT Sciences to commercialize PreGen-Plus, EXACT Sciences' proprietary, non-invasive technology to aid in the early detection of colorectal cancer. The Company commercially launched this gene-based test, which represents a significant new tool for the early detection of colorectal cancer, in August of 2003. The Company is collaborating with Celera Diagnostics to determine the clinical utility of laboratory tests based on novel diagnostic markers for Alzheimer's disease, breast cancer and prostate cancer and will have exclusive access to any related markers found to have clinical utility. In addition, the Company recently signed a co- exclusive licensing agreement with Correlogic Systems to commercialize its ovarian cancer protein pattern blood test, which offers the prospect of accurate and early detection of ovarian cancer. With its exclusive sales and distribution agreement with Myriad Genetics, physicians now have the convenience of sending patients to one of the Company's patient service centers for Myriad Genetics' predisposition testing for breast, ovarian, colon and uterine cancers. The Company's relationship with Myriad Genetics makes it one of the few clinical laboratories in the United States to provide the entire oncology care continuum from predisposition to surveillance testing, including screening, evaluation, diagnosis and monitoring options. In July 2003, the Company announced a marketing and distribution relationship with Atherotech, a leading cardiodiagnostic company and specialty reference laboratory, to offer its proprietary Vertical Auto Profile (VAP"TM") Cholesterol Test. This multi-year agreement includes a provision for the transfer of patented testing technology to the Company, after which, if certain conditions are met, the Company would become the first clinical laboratory licensed to perform the VAP cardiovascular disease risk assessment assay within its own national laboratory system. In August of 2003, the Company formed a new, majority-owned subsidiary for the purpose of developing new ideas, inventions, products, processes and services for diagnostic testing and monitoring in the medical, pharmaceutical, and/or therapeutic markets. The initial areas of interest include West Nile Virus, Alpha-1 Anti Trypsin Deficiency, Oxidative Markers of DNA stress and Cancer Markers. During the fourth quarter of 2003, the Company and BioPredictive, a French diagnostics firm, announced an exclusive agreement that combines the Company's expertise in infectious disease testing with BioPredictive's noninvasive, predictive testing technology to quantitatively estimate liver fibrosis and necroinflammatory activity in hepatitis C (HCV) patients. HCV FIBROSURE"TM" is expected to be broadly available in the U.S., only through the Company, beginning in the first quarter of 2004. The Company's investment in new testing technologies has been significant. While the Company continues to believe its strategy of entering into licensing and technology distribution agreements with the developers of leading-edge technologies will provide future growth in revenues, there are certain risks associated with these investments. These risks include, but are not limited to, the risk that the licensed technology will not gain broad acceptance in the marketplace; or that insurance companies, managed care organizations, or Medicare and Medicaid will not approve reimbursement for these tests at a level commensurate with the costs of running the tests. Any or all of these circumstances could result in impairment in the value of certain capitalized licensing costs. Enhance the Company's Oncology Testing Business by Leveraging DIANON's Unique Capabilities DIANON is a national provider of oncology testing services and significantly enhances the Company's oncology testing capabilities. DIANON is recognized by physicians, managed care companies and other customers as a leading provider of a wide range of anatomic pathology testing services, with particular strength in uropathology, dermatopathology, GI pathology and hematopathology. DIANON's strengths in anatomic pathology complement the Company's strengths in other areas of cancer testing, particularly cytology. The Company expects that DIANON's specialized sales force, scientific expertise, efficient operating model and proprietary CarePath clinical and pathology reporting system will allow it to enhance its cancer testing business. The Company intends to apply DIANON's best practices to its existing anatomic pathology operations, which it expects will enable it to realize significant operational efficiencies Leverage National Infrastructure The Company's national presence provides a number of significant benefits and it intends to maintain and continue to build this presence. The Company's national network of 31 primary laboratories and over 1,200 service sites, including branches, patient service centers and STAT laboratories, enables it to provide high-quality services to physicians, hospitals, managed care organizations and other customers across the United States. Agreements with Premier, as well as the Company's managed care contracts with United Healthcare, Aetna, Anthem, Cigna, Wellpoint, Horizon and MAMSI, demonstrate the importance of being able to deliver services on a nationwide basis. Furthermore, the Company's scale provides it with significant cost structure advantages, particularly related to supply and other operating costs. Expand Hospital Relationships Another of the Company's growth strategies is to develop an increasing number of hospital relationships. These relationships can take several different forms, including laboratory technical support (management) contracts, reference agreements, and testing arrangements. Testing Services Routine Testing The Company currently offers approximately 4,400 different clinical laboratory tests or procedures. Several hundred of these are frequently used in general patient care by physicians to establish or support a diagnosis, to monitor treatment or medication, or to search for an otherwise undiagnosed condition. The most frequently requested tests include blood chemistry analyses, urinalyses, blood cell counts, Pap tests, HIV tests, microbiology cultures and procedures and alcohol and other substance-abuse tests. These routine procedures are most often used by physicians in their outpatient office practices. Physicians may elect to send such procedures to an independent laboratory or they may choose to establish an in-house laboratory to perform some of the tests. The Company performs this core group of routine tests in each of its major laboratories, which constitutes a majority of the testing performed by the Company. The Company generally performs and reports most routine procedures within 24 hours, utilizing a variety of sophisticated and computerized laboratory testing instruments. Specialty and Niche Testing While the information provided by many routine tests may be used by nearly all physicians, regardless of specialty, many other procedures are more specialized in nature. One of the primary growth strategies of the Company is the continued expansion of its specialty and niche businesses, which involve certain types of unique testing capabilities and/or client requirements. In general, the specialty and niche businesses are designed to serve two market segments: (i) markets which are not typically served by the clinical testing laboratory; and (ii) markets which are served by the clinical testing laboratory and offer the possibility of adding related services (such as clinical trials or occupational drug testing) from the same supplier. The Company's research and development group continually seeks new and improved technologies for early diagnosis. For example, the Company's Center for Molecular Biology and Pathology ("CMBP") is a leader in molecular diagnostics and polymerase chain reaction ("PCR") technologies, which are often able to provide earlier and more reliable information regarding HIV, genetic diseases, cancer and many other viral and bacterial diseases. In August 2000, the Company acquired Los Angeles-based National Genetics Institute, Inc. (NGI), a leader in the development of PCR assays for Hepatitis C (HCV). In June 2001, the Company acquired Minneapolis-based Viro-Med Laboratories, Inc., which offers molecular microbial testing using real time PCR platforms. Management believes these technologies may represent a significant savings to the healthcare system increasing the detection of early stage (treatable) diseases. The following are specialty and niche businesses in which the Company offers testing and related services: Infectious Disease. The Company provides complete viral load testing as well as HIV genotyping and phenotyping. In 2000, the Company added HIV GenoSure? to its portfolio of HIV resistance testing services. The Company's use of this leading-edge technology puts it in the forefront of HIV drug resistance testing-one of the most important issues surrounding the treatment of HIV. Additionally, the Company provides comprehensive testing for HCV including both PCR testing and genotyping at CMBP, NGI and Viro-Med. Allergy Testing. The Company offers an extensive range of allergen testing services as well as computerized analysis and a treatment program that enables primary care physicians to diagnose and treat many kinds of allergic disorders. Clinical Research Testing. The Company regularly performs clinical laboratory testing for pharmaceutical companies conducting clinical research trials on new drugs. This testing often involves periodic testing of patients participating in the trial over several years. Diagnostic Genetics. The Company offers cytogenetic, molecular cytogenetic, biochemical and molecular genetic tests. Identity Testing. The Company provides forensic identity testing used in connection with criminal proceedings and parentage evaluation services which are used to assist in the resolution of disputed parentage in child support litigation. Parentage testing involves the evaluation of immunological and genetic markers in specimens obtained from the child, the mother and the alleged father. Management believes it is now the largest provider of identity testing services in the United States. Oncology Testing. The Company offers an extensive series of testing technologies that aid in diagnosing and monitoring certain cancers and predicting the outcome of certain treatments. The Company's scientists have novel assays for detecting melanoma and breast cancer in clinical development. In August of 2003, the Company began offering PreGen-Plus, a non-invasive technology to aid in the early detection of colorectal cancer in a broader population. PreGen-Plus utilizes EXACT Sciences' proprietary genomics-based technology. In January 2003, the Company acquired DIANON, a national provider of oncology testing services. DIANON is recognized by physicians, managed care companies and other customers as a leading provider of a wide range of anatomic pathology testing services, with particular strength in uropathology, dermatopathology, GI pathology and hematopathology. Occupational Testing Services. The Company provides testing for the detection of drug abuse for private and government customers, and also provides blood testing services for the detection of drug abuse and alcohol. These testing services are designed to produce "forensic" quality test results that satisfy the rigorous requirements for admissibility as evidence in legal proceedings. The Company also provides other analytical testing and a variety of management support services. The specialized or niche testing services noted above, as well as other complex procedures, are sent to designated facilities where the Company has concentrated the people, instruments and related resources for performing such procedures so that quality and efficiency can be most effectively monitored. CMBP, NGI and Viro-Med also specialize in new test development and related education and training. Clients The Company provides testing services to a broad range of health care providers. During the year ended December 31, 2003, no client or group of clients under the same contract accounted for more than four percent of the Company's net sales. The primary client groups serviced by the Company include: Independent Physicians and Physician Groups Physicians requiring testing for their patients are one of the Company's primary sources of testing services. Fees for clinical laboratory testing services rendered for these physicians are billed either to the physician, to the patient or the patient's third party payor such as insurance companies, Medicare or Medicaid. Billings are typically on a fee-for-service basis. If the billings are to the physician, they are based on customer fee schedule and subject to negotiation. Otherwise, the patient or third party payor is billed at the laboratory's patient fee schedule, subject to third party payor limitations and negotiation by physicians on behalf of their patients. Revenues received from Medicare and Medicaid billings are based on government-set fee schedules. Hospitals The Company provides hospitals with services ranging from routine and specialty testing to contract management services. Hospitals generally maintain an on-site laboratory to perform immediately needed testing on patients receiving care. However, they also refer less time sensitive procedures, less frequently needed procedures and highly specialized procedures to outside facilities, including independent clinical laboratories and larger medical centers. The Company typically charges hospitals for any such tests on a fee-for-service basis which is derived from the Company's customer fee schedule. Fees for management services are billed monthly at contractually agreed-upon rates. HMOs and Other Managed Care Groups The Company serves HMOs and other managed care organizations. These medical service providers typically contract with a limited number of clinical laboratories and then designate the laboratory or laboratories to be used for tests ordered by participating physicians. The majority of the Company's managed care testing is negotiated on a fee-for-service basis. Testing is sometimes reimbursed on a capitated basis for managed care organizations. Under a capitated payment contract, the Company agrees to perform certain laboratory tests during a given month for which the managed care organization agrees to pay a flat monthly fee for each covered member. The tests covered under agreements of this type are negotiated for each contract, but usually include routine tests and exclude highly specialized tests. Many of the national and large regional managed care organizations prefer to use large independent clinical labs such as the Company because they can monitor service and performance on a national basis. Other Institutions The Company serves other institutions, including governmental agencies, large employers and other independent clinical laboratories that do not have the breadth of the Company's testing capabilities. The institutions typically pay on a negotiated fee-for-service basis. Payors Most testing services are billed to a party other than the physician or other authorized person who ordered the test. In addition, tests performed by a single physician may be billed to different payors depending on the medical insurance benefits of a particular patient. Payors other than the direct patient include, among others, insurance companies, managed care organizations, Medicare and Medicaid. For the year ended December 31, 2003, accessions (based on the total volume of accessions) and average revenue per accession by payor are as follows: Revenue Accession Volume as per a % of Total Accession ------------------- --------- Private Patients 2.8% $118.48 Medicare, Medicaid and Other 20.6% $ 34.25 Commercial Clients 36.0% $ 27.07 Managed Care 40.6% $ 32.74 Affiliations and Alliances The Company continues to develop its relationships with hospitals through traditional and non-traditional business models. The Company has increased its focus on the traditional business model with a hospital, whereby the Company enters into a reference service agreement. The establishment of a vertical sales organizational structure dedicated to hospital sales is a reinforcement of the Company focus. In the non-traditional business model, the Company has seen strong growth due to laboratory technical support (management) contracts and shared services agreements. In 2003, the Company added a number of new traditional and non-traditional relationships with hospitals. Reference agreements, the Company's traditional business model, provide a means for hospitals to outsource patient laboratory testing services that are not time critical (e.g., test results reported within twenty-four hours of drawing the specimen as opposed to those requiring two to four hour turnaround). These agreements allow the hospitals to maintain their own STAT/emergency lab on-site, while eliminating certain costs of maintaining a full-service lab on their premises. One example of a non-traditional business model is where the Company provides technical support services or laboratory management for a fee in a variety of health care settings. In these relationships, the Company may supply the laboratory manager and/or provide other laboratory personnel, as well as testing equipment and supplies, in the management of a laboratory that is owned by a hospital, managed care organization or other health care provider. Under the typical laboratory technical support agreement, the laboratory manager is employed by or under contract with the Company. In such laboratory management arrangements, the Company generally bills the hospital a monthly contractually-determined management fee in addition to different fixed on-site and off-site fees per test. Highly esoteric tests are generally billed under a separate fee schedule. A pathologist is designated by the laboratory owner to serve as medical director for the laboratory, and all billing, licensure and permits also remain the obligation of the owner of the laboratory. An important advantage the Company offers to its clients is the flexibility of the Company's information systems for creating single or bi-directional interfaces to support such cooperative testing arrangements. Such bi-directional interfaces allow each party's system to efficiently and effectively communicate with the other party's system. The Company's laboratory management and technical support agreements typically have initial terms between three and five years. However, most contracts contain a clause that permits termination for cause prior to the contract expiration date of the initial term. There are additional termination clauses that generally fall into one of the following categories: (1) termination without cause by either party during the additional term, after written notice 60 to 120 days prior to termination; (2) termination by the hospital if there are uncorrected deficiencies in the Company's performance after 30 days' written notice; (3) termination if there is a loss of accreditation or licensure held by the Company which accreditation or licensure is not reinstated within 60 days of the loss; or (4) termination should the Company fail to meet anticipated profitability. While the Company believes that it will maintain and renew its existing contracts, there can be no assurance of such maintenance or renewal. The Company has developed several different pricing formulas under its non-traditional business contracts. The Company generally bills the hospital a monthly contractually-determined management fee in addition to different fixed on-site and off-site fees per test. Highly esoteric tests are generally billed under a separate fee schedule. In certain cases, profitability may depend on the Company's ability to accurately predict test volumes, patient encounters or the number of admissions. Investments in Equity Affiliates In conjunction with the acquisition of Dynacare in 2002, the Company holds investments in three equity affiliates, located in Milwaukee, Wisconsin; Ontario, Canada; and Alberta, Canada. These businesses represent joint venture agreements between Dynacare and other independent diagnostic laboratory investors. Under these agreements, all partners share in the profits and losses of the businesses in proportion to their respective ownership percentages. All partners are actively involved in the major business decisions made by each joint venture. Each of the Canadian joint ventures own licenses to conduct diagnostic testing services in their respective provinces. Substantially all of their revenues are received as reimbursement from the provincial governments' health care programs. While the Canadian licenses guarantee the joint ventures the ability to conduct diagnostic testing in their respective provinces, they do not guarantee that the provincial governments will continue to reimburse diagnostic laboratory testing at current levels. If the provincial governments decide to limit or reduce their reimbursement of laboratory diagnostic services, it could have a negative impact on the profits and cash flows the Company derives from these investments as well as possibly impair the value assigned by the Company to the Canadian licenses. Sales and Marketing and Client Service The Company offers its services through a combination of direct sales generalists and specialists. Sales generalists market the mainstream or traditional routine laboratory services primarily to physicians, while specialists concentrate on individual market segments, such as hospitals or managed care organizations, or on testing niches, such as identity testing or genetic testing. Specialist positions are established when an in-depth level of expertise is necessary to effectively offer the specialized services. When the need arises, specialists and generalists work cooperatively to address specific opportunities. At December 31, 2003, the Company employed 235 generalists and 170 specialists. The Company's sales generalists and specialists are compensated through a combination of salaries, commissions and bonuses, at levels commensurate with each individual's qualifications and responsibilities. Commissions are primarily based upon the individual's productivity in generating new business for the Company. The Company also employs regional service managers and account managers ("AMs") to interact with clients on an ongoing basis. AMs monitor the status of the services being provided to clients, act as problem-solvers, provide information on new testing developments and serve as the client's regular point of contact with the Company. At December 31, 2003, the Company employed 371 AMs. AMs are compensated through a combination of salaries and bonuses commensurate with each individual's qualifications and responsibilities. The Company believes that the clinical laboratory service business is shifting away from the traditional direct sales structure to one in which the purchasing decisions for laboratory services are increasingly being made by managed care organizations, insurance plans, employers and even by patients themselves. In view of these changes, the Company has adapted its sales and marketing structure to more appropriately address the opportunities presented by this shift. The Company competes primarily on the basis of the quality of its testing, reporting and information systems, its reputation in the medical community, the pricing of its services and its ability to employ qualified personnel. During 2003, one of the Company's goals was to continue to improve client service. An important factor in improving client service includes the Company's initiatives to improve its billing process. See "Billing" Information Systems The Company has developed and implemented management information systems to monitor operations and control costs. All financial functions are centralized in Burlington, North Carolina including purchasing and accounting. Management believes this provides greater control over spending as well as increased supervision and monitoring of results of operations. The Company believes that the health care provider's need for data will continue to place high demands on the Company's information systems staff. The Company operates several systems to handle laboratory, billing and financial data and transactions. The Company believes that the efficient handling of information involving clients, patients, payors and other parties will be a critical factor in the Company's future success. The Company's Corporate Information Systems Division manages its information resources and programs on a consolidated basis in order to achieve greater efficiency and economies of scale. The Company employs a Chief Information Officer, whose responsibility is to integrate, manage and develop the Company's information systems. Billing Billing for laboratory services is a complex process. Laboratories must bill many different payors such as doctors, patients, hundreds of different insurance companies, Medicare, Medicaid and employer groups, all of whom have different billing requirements. The Company believes that a majority of its bad debt expense is the result of non-credit related issues which slow the billing process. A primary cause of bad debt expense is missing or incorrect billing information on requisitions. The Company believes that this experience is similar to that of its primary competitors. The Company generally performs the requested tests and returns the test results regardless of whether billing information has been provided at all or has been provided incorrectly. The Company subsequently attempts to obtain any missing information or rectify any incorrect billing information received from the health care provider. Among the many other factors complicating the billing process are more intricate billing arrangements due to contracts with third-party administrators, disputes between payors as to the party responsible for payment of the bill and auditing for specific compliance issues. During 2003, the Company's days sales outstanding (DSO) were reduced 1 day from December 31, 2002 levels to 53 days as a result of Company-wide efforts to increase cash collections from all payors, as well as on-going improvements to its claim submission processes. The Company is continuing to take the steps necessary to improve DSO and cash collections by: 1) conversion of decentralized billing locations to a centralized billing system. During 2003, billing activity in numerous Dynacare sites was converted to the centralized billing system. In 2004, the Company will concentrate its conversion activities on the remaining Dynacare locations as well as its Salt Lake City, Reno, San Diego and Viro-Med facilities; 2) continuing initiative to reduce the number of requisitions received that are missing certain billing information. This initiative involves counting the number of clinical requisitions received from an ordering client, as well as determining what specific information was not provided. The Company then identifies root causes of why the information was missing and takes steps to ensure that information is provided in the future. These steps include re-educating clients as to what information is needed in order for the Company to bill and collect for the test. As of December 31, 2003, the percentage of requisitions received which were missing billing information was 4.3% as compared to 4.6% at the end of 2002. 3) implementation of numerous initiatives related to self-pay accounts receivable. These include: i) collecting payment at the time of service; ii) increased training for billing personnel related to improving collections during phone calls and iii) review of bill design and frequency. Although there can be no assurance of success, the Company has developed a number of initiatives to address the complexity of the billing process and to improve collection rates. These initiatives include: i) installation of personal computer based products in client offices and Company locations to help with the accuracy and completeness of billing information captured on the front-end; ii) establishment of a project group to focus on improvements in order entry; iii) development and implementation of enhanced eligibility checking to compare information to payor records before billing;and iv) activities related to self-pay accounts receivable, such as collecting payment at the time of service. Additionally, the Company believes that it can benefit from the conversion of its multiple billing systems into a centralized system. Quality Assurance The Company considers the quality of its tests to be of critical importance, and it has established a comprehensive quality assurance program for all of its laboratories and other facilities designed to help assure accurate and timely test results. In addition to the compulsory external inspections and proficiency programs required by CMS and other regulatory agencies, Company-wide systems and procedures are in place to emphasize and monitor quality assurance. All of the Company's regional laboratories are subject to on-site evaluations, the College of American Pathologists ("CAP") proficiency testing program, state surveys and the Company's own internal quality control programs. External Proficiency/ Accreditations. The Company participates in numerous externally-administered, blind quality surveillance programs, including the CAP program. The blind programs supplement all other quality assurance procedures and give Company management the opportunity to review its technical and service performance from the client's perspective. Internal Quality Control. The Company regularly performs internal quality control testing by running quality control samples with known values at the same time as patient samples submitted for testing. All quality control sample test results are entered into the Company's national laboratory computer, which connects the Company's facilities nationwide to a common on-line quality control database. This system helps technologists and technicians check quality control values and requires further prompt verification if any quality control value is out of range. The Company has an extensive, internally administered program of blind sample proficiency testing (i.e. the testing laboratory does not know the sample being tested is a quality control sample). As part of this program the Company's locations receive specimens from the Company's Quality Assurance and Corporate Technical Services departments for analysis. The CAP accreditation program involves both on-site inspections of the laboratory and participation in CAP's proficiency testing program for all categories in which the laboratory is accredited by CAP. CAP is an independent non-governmental organization of board- certified pathologists which offers an accreditation program to which laboratories can voluntarily subscribe. CAP has been accredited by CMS to inspect clinical laboratories to determine adherence to the Clinical Laboratory Improvement Act of 1967, and the Clinical Laboratory Improvement Amendments of 1988 standards. A laboratory's receipt of accreditation by CAP satisfies the Medicare requirement for participation in proficiency testing programs administered by an external source. All of the Company's major laboratories are accredited by CAP. The Company's forensic crime laboratory, located at Research Triangle Park, NC, is accredited by the American Society of Crime Laboratory Directors, Laboratory Accreditation Board ("ASCLD/LAB") in the category of DNA testing. Under the Crime Laboratory Accreditation Program managed by the ASCLD/LAB, a crime laboratory undergoes a comprehensive and in-depth inspection to demonstrate that its management, operations, employees, procedures and instruments, physical plant, and security and personnel safety procedures meet stringent quality standards. The Company is one of 260 ASCLD accredited crime laboratories worldwide and is one of only nine private crime laboratories holding the accreditation. Accreditation is granted for a period of five years provided that a laboratory continues to meet the standards during that period. Competition The clinical laboratory business is intensely competitive. The Company believes that in 2003 the entire United States clinical laboratory testing industry had estimated revenues between $34 billion and $36 billion; approximately 49% of such revenues were attributable to hospital-affiliated laboratories, approximately 39% were attributable to independent clinical laboratories and approximately 12% were attributable to physicians in their offices and laboratories. There are presently two national independent clinical laboratories: the Company and Quest Diagnostics Incorporated ("Quest"), which had approximately $4.7 billion in revenues from clinical laboratory testing in 2003. In addition to the other national clinical laboratory, the Company competes with many smaller regional independent clinical laboratories as well as laboratories owned by hospitals and physicians. The Company believes that the following factors, among others, are often used by health care providers in selecting a laboratory: i) pricing of the laboratory's test services; ii) accuracy, timeliness and consistency in reporting test results; iii) number and type of tests performed; iv) service capability and convenience offered by the laboratory; and v) its reputation in the medical community. The Company believes that it competes favorably with its principal competitors in each of these areas and is currently implementing strategies to improve its competitive position. The Company believes that consolidation will continue in the clinical laboratory testing business. In addition, the Company believes that it and the other large independent clinical laboratory testing companies will be able to increase their share of the overall clinical laboratory testing market due to a number of external factors including cost efficiencies afforded by large-scale automated testing, Medicare reimbursement reductions and the growth of managed health care entities which require low-cost testing services and large service networks. In addition, legal restrictions on physician referrals and their ownership of laboratories as well as increased regulation of laboratories are expected to contribute to the continuing consolidation of the industry. Employees As of January 31, 2004, the Company had approximately 23,000 full-time equivalent employees. Subsidiaries of the Company have four collective bargaining agreements which cover approximately 600 employees. One of the contracts has expired and the parties are continuing to abide by certain key terms. The Company believes that its overall relations with its employees are good. Regulation and Reimbursement General The clinical laboratory industry is subject to significant governmental regulation at the federal, state and sometimes local levels. As described below, these regulations concern licensure and operation of clinical laboratories, payment for laboratory services, health care fraud and abuse, security and confidentiality of health information and environmental and occupational safety. Regulation of Clinical Laboratories The Clinical Laboratory Improvement Amendments of 1988 ("CLIA") extend federal oversight to virtually all clinical laboratories by requiring that they be certified by the federal government or by a federally-approved accreditation agency. Pursuant to CLIA, clinical laboratories must meet quality assurance, quality control and personnel standards. Laboratories also must undergo proficiency testing and are subject to inspections. Standards for testing under CLIA are based on the complexity of the tests performed by the laboratory, with all tests classified as either high complexity, moderate complexity, or waived. Laboratories performing high complexity testing are required to meet more stringent requirements than moderate complexity laboratories. Labs performing only waived tests, which are tests determined by the Food and Drug Administration to have a low potential for error and requiring little or no oversight, may apply for a certificate of waiver indicating that they need not comply with most of the requirements of CLIA. All major and many smaller Company facilities hold CLIA certificates to perform high complexity testing. The Company's remaining smaller testing sites hold CLIA certificates to perform moderate complexity testing or have a certificate of waiver. The sanction for failure to comply with CLIA requirements may be suspension, revocation or limitation of a laboratory's CLIA certificate, which is necessary to conduct business, as well as significant fines and/or criminal penalties. The loss or suspension of a license, imposition of a fine or other penalties, or future changes in the CLIA law or regulations (or interpretation of the law or regulations) could have a material adverse effect on the Company. The Company is also subject to state regulation. CLIA provides that a state may adopt regulations different from or more stringent than those under federal law, and a number of states have implemented their own laboratory regulatory schemes. State laws may require that laboratory personnel meet certain qualifications, specify certain quality controls, or require maintenance of certain records. For example, some of the Company's laboratories are subject to the State of New York's clinical laboratory regulations, which contain provisions that are more stringent than those under federal law. The Company believes that it is in compliance with federal and state laboratory requirements, and the Company's laboratories have continuing programs to ensure that their operations meet all applicable regulatory requirements, but no assurances can be given that the Company's laboratories will pass all future licensure or certification inspections. Payment of Clinical Laboratory Services In 2003 and 2002, the Company derived approximately 19% and 16%, respectively of its net sales from tests performed for beneficiaries of the Medicare and Medicaid programs. In addition, the Company's other business depends significantly on continued participation in these programs, and other government healthcare programs, because clients often want a single laboratory to perform all of their testing services. Both governmental and private sector payors have made efforts to contain or reduce health care costs, including payment for clinical laboratory services, in recent years. In 1984, Congress established a Medicare fee schedule for clinical laboratory services performed for patients covered under Part B of the Medicare program. Subsequently, Congress imposed a national ceiling on the amount that can be paid under the fee schedule. Laboratories bill the program directly and must accept the scheduled amount as payment in full for covered tests performed on behalf of Medicare beneficiaries. In addition, state Medicaid programs are prohibited from paying more than the Medicare fee schedule limitation for clinical laboratory services furnished to Medicaid recipients. Since 1984, Congress has periodically reduced the ceilings on Medicare payment to clinical laboratories from previously authorized levels. In 1993, pursuant to provisions in the Omnibus Budget and Reconciliation Act of 1993 ("OBRA '93"), Congress reduced, effective January 1, 1994, the Medicare national limitations from 88% of the 1984 national median to 76% of the 1984 national median, which reductions were implemented on a phased-in basis from 1994 through 1996. After subsequent further reductions, the national limitation is now 74% of the national median. However, under a provision of the Medicare, Medicaid, and SCHIP Benefits Improvement and Protection Act of 2000 ("BIPA"), the cap is set at 100% of the median for tests performed after January 1, 2001 that the Secretary determines are new tests for which no limitation amount has previously been established. In August 1997, Congress passed and the President signed the Balanced Budget Act of 1997 ("BBA"), which included a provision that froze the Consumer Price Index update of the clinical lab fee schedule for five years. This provision expired in 2003, and there was a 1.19% increase in the fee schedule based on the Consumer Price Index. However, in late 2003 the Congress passed and the President signed the Medicare Prescription Drug, Improvement and Modernization Act of 2003 ("MMA"), which again imposed a freeze in the Consumer Price Index update of the clinical lab fee schedule for 2004 through 2008. For services reimbursed under the Medicare physician fee schedule, the conversion factor and relative value units that are used to calculate the payment amounts under this fee schedule are subject to adjustment on an annual basis. Because of factors included in the formula used to calculate the conversion factor, it decreased significantly in 2003, resulting in decreases in payment for most physician services. However, Congress intervened and the conversion factor was subsequently increased from March 1, 2003 through December 31, 2003. The conversion factor was again expected to decrease significantly in 2004 and 2005, but the MMA included a provision to provide for increases in each of these years of not less than 1.5%. The MMA also included a provision requiring CMS to conduct a demonstration program on using competitive acquisition for clinical lab tests that are furnished without a face-to-face encounter between the individual and the hospital personnel or physician performing the test. The Secretary of the Department of Health and Human Services is required to make an initial report to Congress on this demonstration program no later than December 31, 2005. Details of CMS' plans regarding this demonstration program have not yet been released but if, in the future, widespread use of competitive acquisition is implemented for clinical lab services, this could have a significant effect on the clinical laboratory industry and the Company. Because a significant portion of the Company's costs are relatively fixed, Medicare, Medicaid and other government program payment reductions have a direct adverse affect on the Company's net earnings and cash flows, but the Company cannot predict whether changes that will result in such reductions will be implemented. Another provision of the BBA also required the Department of Health and Human Services to adopt uniform coverage, administration and payment policies for lab tests using a negotiated rulemaking process. Consensus was reached by the negotiated rulemaking committee which, among other things, established policies limiting Medicare coverage for certain tests to patients with specified medical conditions or diagnoses. These uniform policies replace local Medicare coverage policies. The final rules were published on November 23, 2001 and generally became effective on November 25, 2002. Although the use of uniform policies has improved the Company's ability to obtain necessary billing information in some cases, Medicare, Medicaid and private payor diagnosis code requirements continue to negatively impact the Company's ability to be paid for some of thes tests it performs. Due to the range of payors and policies, the extent of this impact is difficult to quantify. Future changes in federal, state and local laws and regulations (or in the interpretation of current regulations) affecting government payment for clinical laboratory testing could have a material adverse effect on the Company. However, based on currently available information, the Company is unable to predict what type of legislation, if any, will be enacted into law. Security and Confidentiality of Health Information The Health Insurance Portability and Accountability Act of 1996 ("HIPAA") was designed to address issues related to the portability of health insurance. A section on administrative simplification was added to the law in an effort to improve the efficiency and effectiveness of the health care system by facilitating the electronic exchange of information in certain financial and administrative transactions, while protecting the privacy and security of the information exchanged. Five regulations promulgated under the administrative simplification provisions of HIPAA have been finalized: the Transactions and Code Sets Rule, the Privacy Rule, the Security Rule, the National Standard Employer Identifier Rule, which requires the use of a unique employer identifier in connection with certain electronic transactions, and the National Provider Identifier Rule, which requires the use of a unique health care provider identifier in connection with certain electronic transactions. These regulations apply to health plans, health care providers that conduct standard transactions electronically and health care clearinghouses ("covered entities"). The Transactions and Code Sets Rule standardizes the format and data content to be used in the most common electronic health care transactions, including, among others, health care claims, eligibility, and health care claim status. Its purpose is to encourage the use of electronic exchanges while reducing the administrative burden associated with using different formats. The compliance date for this rule was October 16, 2002; however, under the Administrative Simplification Compliance Act, covered entities (except small health plans) were permitted to file an extension plan with the Department of Health and Human Services before October 16, 2002 to extend the compliance date to October 16, 2003. The extension plan described how the entity will come into compliance with the Transactions and Code Sets Rule requirements by the compliance date. The Company and its subsidiaries filed such extension plans. The Department of Health and Human Services announced contingency plans permitting entities unable to meet the compliance date to continue to accept legacy claims after October 16, 2003. The Company continues to work with payors who were not prepared to meet the compliance date. At present, there is no deadline for payors to stop accepting legacy claims. If such a deadline were to be set and all payors were not prepared to accept standard claims, it is possible that the Company's cash flow could be disrupted as a result of those payors failing to accept claims or failing to remit payment in standard format. The Company is optimistic that these potential issues will be resolved. The Privacy Rule regulates the use and disclosure of protected health information ("PHI") by covered entities. It also sets forth certain rights that an individual has with respect to his or her PHI maintained by a covered entity, such as the right to access or amend certain records containing PHI or to request restrictions on the use or disclosure of PHI. Additionally, it requires covered entities to implement certain administrative requirements, such as designating a privacy officer, drafting and implementing privacy policies and procedures, and training workforce members. Health care providers governed by the Privacy Rule were required to come into compliance by April 14, 2003. The Company's HIPAA project plans have two phases: (i) assessment of current systems, applications, processes and procedure testing and validation for HIPAA compliance and (ii) remediation of affected systems, applications, processes and procedure testing and validation for HIPAA compliance. The Company believes that it is in compliance in all material respects with the Transactions and Code Sets Rule. The Company also believes that it is in compliance with all material provisions of the Privacy Rule.In this regard, the Company has set up a hotline for the reporting of possible violations. The total cost associated with the requirements of HIPAA is not expected to be material to the Company's operations or cash flows. There are, however, many unresolved issues in both of these areas and future interpretations of HIPAA could impose significant costs on the Company. The Company is in the assessment phase of the Security Rule. The Company expects to meet the April 21, 2005 compliance date for the Security Rule. In addition to the federal HIPAA regulations described above, there are a number of state laws regarding the confidentiality of medical information, some of which apply to clinical laboratories. These laws vary widely, and new laws in this area are pending, but they most commonly restrict the use and disclosure of medical information. Penalties for violation of these laws include sanctions against a laboratory's state licensure, as well as civil and/or criminal penalties. Violations of the HIPAA provisions after the applicable compliance dates could result in civil and/or criminal penalties, including significant fines and up to 10 years in prison. Fraud and Abuse Regulations Existing federal laws governing Medicare and Medicaid, as well as similar state laws, impose a variety of broadly described fraud and abuse prohibitions on healthcare providers, including clinical laboratories. These laws are interpreted liberally and enforced aggressively by multiple government agencies, including the U.S. Department of Justice, the U.S. Department of Health and Human Services Office of the Inspector General ("OIG"), and the states. The federal government's enforcement efforts have been increasing, in part as a result of the enactment of HIPAA, which, among other things, provided for the establishment of a program to coordinate federal, state and local law enforcement programs, and to conduct investigations, audits and inspections relating to payment for healthcare, and for the establishment of a federal anti-fraud and abuse account for enforcement efforts, funded through collection of penalties and fines for violations of the healthcare anti-fraud and abuse laws. Moreover, over the last several years, the clinical laboratory industry has been the focus of major governmental enforcement initiatives. The Medicare and Medicaid anti-kickback laws prohibit intentionally providing anything of value to induce the referral of Medicare and Medicaid business. HHS has published safe harbor regulations which specify certain business activities that, although literally covered by the laws, will not violate the Medicare/Medicaid anti-kickback laws if all conditions of the safe harbor are met. Failure to fall within a safe harbor does not constitute a violation of the anti-kickback laws; rather, the arrangement would remain subject to scrutiny by HHS. Most states have their own Medicaid anti-kickback laws, and several states also have anti-kickback laws that apply to attempts to gain referral of patients covered by private insurance as well as federal programs. In October 1994, the OIG issued a Special Fraud Alert, which set forth a number of practices allegedly engaged in by clinical laboratories and health care providers that the OIG believes violate the federal anti-kickback laws. These practices include providing employees to collect patient samples at physician offices if the employees perform additional services for physicians that are typically the responsibility of the physicians' staff; selling laboratory services to renal dialysis centers at prices that are below fair market value in return for referrals of Medicare tests which are billed to Medicare at higher rates; providing free testing to a physician's HMO patients in situations where the referring physicians benefit from such reduced laboratory utilizations; providing free pick-up and disposal of bio-hazardous waste for physicians for items unrelated to a laboratory's testing services; providing facsimile machines or computers to physicians that are not exclusively used in connection with the laboratory services performed; and providing free testing for health care providers, their families and their employees (professional courtesy testing). The OIG stressed in the Special Fraud Alert that when one purpose of the arrangements is to induce referral of program-reimbursed laboratory testing, both the clinical laboratory and the health care provider or physician may be liable under the anti-kickback laws, and may be subject to criminal prosecution and exclusion from participation in the Medicare and Medicaid programs. The OIG has provided additional guidance regarding arrangements that may violate the anti-kickback laws. In a 1999 Advisory Opinion, the OIG concluded that a proposed arrangement whereby a laboratory would offer physicians significant discounts on laboratory tests billed to the physician might violate the anti-kickback act. The OIG reasoned that if the discounts were greater than could otherwise be justified, the proposed arrangement could be viewed as the laboratory providing discounts to the physician in exchange for referral by the physician of non-discounted Medicare program business. Similarly, in 1999 correspondence, the OIG stated that if any direct or indirect link exists between a price discount that a laboratory offers to a skilled nursing facility ("SNF") for Prospective Payment System ("PPS")-covered services and referrals of Medicare Part B business, the anti-kickback statute would be implicated. Moreover, the OIG stated that it is continuing to monitor the situation regarding potentially unlawful contracts between SNFs and service providers, including laboratories. The OIG also has issued two separate fraud alerts or bulletins regarding joint venture arrangements that may be viewed as suspect under the anti-kickback law. The first, which focused on investor referrals to such ventures, was issued in 1989, and the more recent one, concerning contractual joint ventures, was issued in April 2003. The OIG has noted that these joint ventures can take a variety of forms, including contractual arrangements between parties to cooperate in providing services, or an investment by physicians or others who are in a position to refer patients to the joint venture. Some of the elements of such joint ventures that the OIG identified as "suspect" include arrangements under which the capital invested by the physicians is disproportionately small in comparison to the promised return and risk incurred; specific selection of investors who are in a position to refer; the "owner" of the venture neither operates the business nor commits substantial resources to the venture, but instead contracts out substantially all of the operations to a manager who essentially operates the business and bills insurers and patients in the name of the owner; and arrangements in which the manager takes its benefit in the form of payments under a contract with the owner, and the owner receives its share in the form of residual profit of the venture. The OIG specifically noted that protection of such arrangements under the safe harbors regulations may not be available. As noted above, violation of various Medicare statutory provisions can result in exclusion of providers from participation in the Medicare program. One basis for such exclusion is an individual or entity's submission of bills or requests for payment for items or services that are "substantially in excess of that individual or entity's usual charges." In September 2003, the OIG issued a notice of proposed rulemaking to amend the federal regulations regarding exclusion from the Medicare program on this basis, and in this notice OIG proposes to define, for the first time, the terms "substantially in excess" and "usual charges", and clarifies the meaning of "good cause" as an exception to the exclusion authority. This notice, which solicited comments, is only a proposal, but if the exclusion regulations were to be amended as proposed, it could have an adverse effect on the Company. However, at this time it is impossible to predict whether and when this proposed change in regulations might be finalized, and how any such final regulations might differ from the notice of proposed rulemaking. Under another federal provision, known as the "Stark" law or "self-referral" prohibition, physicians who have an investment or compensation relationship with a clinical laboratory may not, unless a statutory exception applies, refer Medicare or Medicaid patients for testing to the laboratory, regardless of the intent of the parties. Similarly, laboratories may not bill Medicare or Medicaid or any other party for services furnished pursuant to a prohibited referral. There are federal Stark law exceptions for fair market value compensation to a physician for reasonable and necessary services, and for discounts to physicians purchasing laboratory services. There is also an exception for physician investment in a laboratory company so long as the company's stock is traded on a public exchange, the company has stockholder equity exceeding $75.0 million, and the physician's shares may be purchased on terms generally available to the public. State self-referral laws exist as well, which apply to all patient referrals, not just Medicare and Medicaid. There are a variety of other types of federal and state anti-fraud and abuse laws, including laws prohibiting submission of false or otherwise improper claims to federal healthcare programs, and laws limiting the extent of any differences between the Company's charges to Medicare and Medicaid and its charges to other parties. The Company seeks to conduct its business in compliance with the federal and state anti-fraud and abuse laws. However, the Company is unable to predict how these laws will be applied in the future, and no assurances can be given that its arrangements will not be subject to scrutiny under them. Sanctions for violations of these laws may include exclusion from participation in Medicare, Medicaid and other federal healthcare programs, significant criminal and civil fines and penalties, and loss of licensure. Any exclusion from participation in a federal healthcare program, or any loss of licensure, arising from any action by any federal or state regulatory or enforcement authority, would have a material adverse effect on the Company's business. In addition, any significant criminal or civil penalty resulting from such proceedings could have a material adverse effect on the Company's business. Environmental, Health and Safety The Company is subject to licensing and regulation under federal, state and local laws and regulations relating to the protection of the environment and human health and safety, including laws and regulations relating to the handling, transportation and disposal of medical specimens, infectious and hazardous waste and radioactive materials as well as to the safety and health of laboratory employees. All Company laboratories are subject to applicable federal and state laws and regulations relating to biohazard disposal of all laboratory specimens and the Company generally utilizes outside vendors for disposal of such specimens. In addition, the federal Occupational Safety and Health Administration ("OSHA") has established extensive requirements relating to workplace safety for health care employers, including clinical laboratories, whose workers may be exposed to blood-borne pathogens such as HIV and the hepatitis B virus. These regulations, among other things, require work practice controls, protective clothing and equipment, training, medical follow-up, vaccinations and other measures designed to minimize exposure to, and transmission of, blood-borne pathogens. On November 6, 2000, Congress passed the Needlestick Safety and Prevention Act which required, among other things, that companies include in their safety programs the evaluation and use of engineering controls such as safety needles if found to be effective at reducing the risk of needlestick injuries in the workplace. During 2001, the Company voluntarily implemented the use of safety needles at all of its service locations at a cost of approximately $6.0 million. Although the Company is not aware of any current material non- compliance with such federal, state and local laws and regulations, failure to comply could subject the Company to denial of the right to conduct business, fines, criminal penalties and/or other enforcement actions. Drug Testing Drug testing for public sector employees is regulated by the Substance Abuse and Mental Health Services Administration ("SAMSHA") (formerly the National Institute on Drug Abuse), which has established detailed performance and quality standards that laboratories must meet to be approved to perform drug testing on employees of federal government contractors and certain other entities. To the extent that the Company's laboratories perform such testing, each must be certified as meeting SAMSHA standards. The Company's Research Triangle Park, North Carolina; Raritan, New Jersey; Houston, Texas; San Diego, California; Seattle, Washington and Southaven, Mississippi laboratories are SAMSHA certified. Controlled Substances The use of controlled substances in testing for drugs of abuse is regulated by the federal Drug Enforcement Administration. Compliance Program Because of evolving interpretations of regulations and the national debate over health care fraud and abuse, compliance with all Medicare, Medicaid and other government-established rules and regulations has become a significant factor throughout the clinical laboratory industry. The Company has implemented a comprehensive company-wide compliance program. The objective of the Company's compliance program is to develop, implement, and update compliance safeguards as necessary. Emphasis is placed on developing compliance policies and guidelines, personnel training programs and various monitoring and audit procedures to attempt to achieve implementation of all applicable rules and regulations. In 2001, DIANON settled a U.S. Department of Justice investigation into several of DIANON's billing practices. As part of the settlement, DIANON entered into a voluntary corporate integrity program. As part of DIANON's acquisition of UroCor Inc., DIANON assumed responsibility and liability for compliance with the UroCor corporate integrity agreement. The Company seeks to conduct its business in compliance with all statutes, regulations, and other requirements applicable to its clinical laboratory operations. The clinical laboratory testing industry is, however, subject to extensive regulation, and many of these statutes and regulations have not been interpreted by the courts. There can be no assurance therefore that applicable statutes and regulations will not be interpreted or applied by a prosecutorial, regulatory or judicial authority in a manner that would adversely effect the Company. Potential sanctions for violation of these statutes and regulations include significant fines and the loss of various licenses, certificates, and authorizations, which could have a material adverse effect on the Company's business. Item 2. PROPERTIES The following table summarizes certain information as to the Company's principal operating and administrative facilities as of December 31, 2003. Approximate Area Nature of Location (in square feet) Occupancy ----------------------- -------------------- --------------------- Operating Facilities: Birmingham, Alabama 100,000 Lease expires 2005 Montgomery, Alabama 50,000 Owned Phoenix, Arizona 55,000 Lease expires 2009 San Leandro, California 22,000 Lease expires 2008 Los Angeles, California 40,000 Lease expires 2004 San Diego, California 48,000 Lease expires 2007 Denver, Colorado 20,000 Lease expires 2005 Stratford, Connecticut 57,000 Lease expires 2006 Tampa, Florida 95,000 Lease expires 2015; one 5 year renewal option Tampa, Florida 18,000 Lease expires 2005; one 5 year renewal option Hollywood, Florida 21,000 Lease expires 2004 Chicago, Illinois 45,000 Lease expires 2008; Approximate Area Nature of Location (in square feet) Occupancy ----------------------- -------------------- --------------------- Operating Facilities (cont.): Louisville, Kentucky 60,000 Lease expires 2007; two 5 year renewal options Baton Rouge, Louisiana 28,000 Lease expires 2004 Detroit, Michigan 32,000 Lease expires 2004; one 10 year renewal option Eden Prairie, Minnesota 48,000 Lease expires 2014 Meridian, Mississippi 29,000 Lease expires 2005 Kansas City, Missouri 78,000 Owned Reno, Nevada 16,000 Owned Portsmouth, New Hampshire 47,000 Lease expires 2006; one 5 year renewal option Raritan, New Jersey 187,000 Owned Uniondale, New York 108,000 Lease expires 2007; two 5 year renewal options Burlington, North Carolina 275,000 Owned Charlotte, North Carolina 25,000 Lease expires 2008 Research Triangle Park, North Carolina 71,000 Lease expires 2008; three 5 year renewal options 111,000 Lease expires 2011; three 5 year renewal options Dublin, Ohio 81,000 Owned Oklahoma City, Oklahoma 108,000 Lease expires 2010 Knoxville, Tennessee 51,000 Lease expires 2004: Annual renewal option Dallas, Texas 60,000 Lease expires 2004; two 5 year renewal option Houston, Texas 70,000 Lease expires 2012; two 5 year renewal options Houston, Texas 10,000 Lease expires 2004; automatic one year renewals Midland, Texas 10,000 Lease expires 2005; one 5 year renewal option San Antonio, Texas 44,000 Lease expires 2004; two 5 year renewal option Salt Lake City, Utah 20,000 Lease expires 2005; two 3 year renewal options Herndon, Virginia 80,000 Lease expires 2004 Richmond, Virginia 34,000 Lease expires 2006 Kent, Washington 42,000 Lease expires 2005; one 5 year renewal option Seattle, Washington 33,000 Lease expires 2004 Approximate Area Nature of Location (in square feet) Occupancy ----------------------- -------------------- --------------------- Operating Facilities (cont.): Fairmont, West Virginia 25,000 Lease expires 2005; three 5 year renewal options Mechelen, Belgium 20,000 Lease expires 2007 Administrative facilities: Raritan, New Jersey 53,000 Owned Burlington, North Carolina 293,000 Owned Burlington, North Carolina 273,000 Leases expire 2004-2010; various options to purchase or renew All of the Company's major laboratory facilities have been built or improved for the single purpose of providing clinical laboratory testing services. The Company believes that these facilities are suitable and adequate and have sufficient production capacity for its currently foreseeable level of operations. The Company believes that if it were to lose the lease on any of the facilities it presently leases, it could find alternate space at competitive market rates and readily relocate its operations to such new locations without material disruption to its operations. Item 3. LEGAL PROCEEDINGS The Company is involved in litigation purporting to be a nation- wide class action involving the alleged overbilling of patients who are covered by private insurance. The Company has reached a settlement with the class that will not materially differ from accruals previously established or have a material adverse effect on the Company. The Company has now substantially implemented its obligations under the settlement. On January 9, 2001, the Company was served with a complaint in North Carolina which purported to be a class action and made claims similar to those referred to above. That claim has now been dismissed with prejudice. On June 24, 2003, the Company and certain of its executive officers were sued in the United States District Court for the Middle District of North Carolina in the first of a series of putative shareholder class actions alleging securities fraud. Since that date, at least five other complaints containing substantially identical allegations have been filed against the Company and certain of the Company's executive officers. Each of the complaints alleges that the defendants violated the federal securities laws by making material misstatements and/or omissions that caused the price of the Company's stock to be artificially inflated between February 13 and October 3, 2002. The plaintiffs seek certification of a class of substantially all persons who purchased shares of the Company's stock during that time period and unspecified monetary damages. These six cases have been consolidated and will proceed as a single case. The defendants deny any liability and intend to defend the case vigorously. At this time, it is premature to make any assessment of the potential outcome of the cases or whether they could have a material adverse effect on the Company's financial condition. The Company is the appellant in a patent case originally filed in the United States District Court for the District of Colorado. The Company has disputed liability and contested the case vigorously. After a jury trial, the district court entered judgment against the Company for patent infringement. The Company appealed the case to the United States Court of Appeals for the Federal Circuit. The Company has received a letter from its counsel dated February 6, 2004, stating "it remains our opinion that the amended judgment and order will be reversed on appeal." The Company is a party to two lawsuits involving Chiron Inc. relating to Hepatitis C and HIV testing. Chiron asserts that the Company has infringed on Chiron's patents in each of these areas. The Company denies liability and intends to contest the suits vigorously. It is premature at this juncture to assess the likely outcome of these matters, or to determine whether they will have a material effect on the Company. The Company is also involved in various claims and legal actions arising in the ordinary course of business. These matters include, but are not limited to, intellectual property disputes, professional liability, employee related matters, and inquiries from governmental agencies and Medicare or Medicaid payors and managed care payors requesting comment on allegations of billing irregularities that are brought to their attention through billing audits or third parties. In the opinion of management, based upon the advice of counsel and consideration of all facts available at this time, the ultimate disposition of these matters is not expected to have a material adverse effect on the financial position, results of operations or liquidity of the Company. The Company is also named from time to time in suits brought under the qui tam provisions of the False Claims Act. These suits typically allege that the Company has made false statements and/or certifications in connection with claims for payment from federal health care programs. They may remain under seal (hence, unknown to the Company) for some time while the government decides whether to intervene on behalf of the qui tam plaintiff. Such claims are an inevitable part of doing business in the health care field today and, in the opinion of management, based upon the advice of counsel and consideration of all facts available at this time, the ultimate disposition of those qui tam matters presently known to the Company is not expected to have a material adverse effect on the financial position, results of operations or liquidity of the Company. The Company believes that it is in compliance in all material respects with all statutes, regulations and other requirements applicable to its clinical laboratory operations. The clinical laboratory testing industry is, however, subject to extensive regulation, and many of these statutes and regulations have not been interpreted by the courts. There can be no assurance therefore that applicable statutes and regulations might not be interpreted or applied by a prosecutorial, regulatory or judicial authority in a manner that would adversely affect the Company. Potential sanctions for violation of these statutes and regulations include significant fines and the loss of various licenses, certificates and authorizations. Under the Company's present insurance programs, coverage is obtained for catastrophic exposures as well as those risks required to be insured by law or contract. The Company is responsible for the uninsured portion of losses related primarily to general, professional and vehicle liability, certain medical costs and workers' compensation. The self-insured retentions are on a per occurrence basis without any aggregate annual limit. Provisions for losses expected under these programs are recorded based upon the Company's estimates of the aggregated liability of claims incurred. At December 31, 2003 and 2002, the Company had provided letters of credit aggregating approximately $57.1 million and $45.6 million respectively, primarily in connection with certain insurance programs. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report. PART II Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Common Stock trades on the New York Stock Exchange ("NYSE") under the symbol "LH". The following table sets forth for the calendar periods indicated the high and low sales prices for the Common Stock reported on the NYSE Composite Tape. High Low ------ ------ 2002 First Quarter 49.120 38.150 Second Quarter 52.375 43.300 Third Quarter 45.210 26.000 Fourth Quarter 34.050 18.510 High Low ------ ------ 2003 First Quarter 30.040 22.210 Second Quarter 32.630 25.940 Third Quarter 32.660 28.200 Fourth Quarter 37.720 28.210 High Low ------ ------ 2004 First Quarter (through February 27, 2004) 44.200 36.900 On May 10, 2002, the Company effected a 2-for-1 stock split. The reported sales prices reflect such stock split. On February 27, 2004 there were 696 holders of record of the Common Stock. The Company has not historically paid dividends on its common stock, but could consider future dividend payments as deemed appropriate, based upon results of operations and future cash requirements. In addition, the Company's senior credit facilities place certain limits on the payment of dividends. Item 6. SELECTED FINANCIAL DATA The selected financial data presented below under the captions "Statement of Operations Data" and "Balance Sheet Data" as of and for the five-year period ended December 31, 2003 are derived from consolidated financial statements of the Company, which have been audited by PricewaterhouseCoopers LLP, independent accountants. This data should be read in conjunction with the accompanying notes, the Company's consolidated financial statements and the related notes thereto, and "Management's Discussion and Analysis of Financial Condition and Results of Operations," all included elsewhere herein. Year Ended December 31, -------------------------------------------------- 2003(a) 2002(b)(c) 2001(d) 2000 1999 -------------------------------------------------- (Dollars in millions, except per share amounts) Statement of Operations Data: Net sales $2,939.4 $2,507.7 $2,199.8 $ 1,919.3 $1,698.7 Gross profit 1,224.6 1,061.8 925.6 766.6 629.1 Operating income 533.7 435.0 367.6 245.6(e) 149.7 Net earnings 321.0 254.6 179.5 112.1 65.4 Basic earnings per common share $ 2.23 $ 1.78 $ 1.29 $ 0.82 $ 0.30 Diluted earnings per common share $ 2.22 $ 1.77 $ 1.27 $ 0.80 $ 0.29 Basic weighted average common shares outstanding (in thousands) 143,969 142,791 138,838 94,161 50,665 Diluted weighted average common shares outstanding (in thousands) 144,756 144,198 141,077 96,299 51,509 Balance Sheet Data: Cash and cash equivalents $ 123.0 $ 56.4 $ 149.2 $ 48.8 $ 40.3 Intangible assets, net 1,857.3 1,217.5 968.5 865.7 803.9 Total assets 3,414.9 2,580.4 1,929.6 1,666.9 1,590.2 Long-term obligations and redeemable preferred stock (f) 883.9 521.5 509.2 355.8 1,041.5 Total shareholders' equity 1,895.9 1,611.7 1,085.4 877.4 175.5 (a) On January 17, 2003, the Company completed the acquisition of all of the outstanding shares of DIANON Systems, Inc. for $47.50 per share in cash, or approximately $595.6 million including transaction fees and expenses. See "Note 2 to the Consolidated Financial Statements" for further discussion of this acquisition. During the third and fourth quarters of 2003, the Company recorded pre-tax charges totaling $6.4 million, in connection with the integrations of its recent acquisitions. The Company also recorded certain adjustments to previously recorded restructuring charges due to changes in estimates, resulting in a net credit of approximately $4.9 million, which was recorded in the fourth quarter of 2003. Net restructuring and other special charges was $1.5 million for 2003. (b) On July 25, 2002, the Company completed the acquisition of all of the outstanding stock of Dynacare Inc. in a combination cash and stock transaction with a combined value of approximately $496.4 million, including transaction costs. See "Note 3 to the Consolidated Financial Statements" for further discussion of this acquisition. During the third quarter of 2002, the Company recorded restructuring and other special charges totaling $17.5 million. These charges included a special bad debt provision of approximately $15.0 million related to the acquired Dynacare accounts receivable balance and restructuring expense of approximately $2.5 million relating to Dynacare integration costs of actions that impact the Company's existing employees and operations. (c) Effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 142 "Goodwill and Other Intangible Assets". This Standard requires that goodwill and other intangibles that are acquired in business combinations and that have indefinite useful lives are not to be amortized. See "Note 10 to the Consolidated Financial Statements" for further discussion of the effect of SFAS No. 142. (d) During the third quarter of 2001, the Company recorded a loss of $5.5 million relating to the write-off of unamortized bank fees associated with the Company's term debt, which was repaid in September of 2001. The Company also recorded a charge of $8.9 million as a result of a payment made to a bank to terminate an interest rate swap agreement tied to the Company's term loan. (e) In the fourth quarter of 2000, the Company recorded a $4.5 million restructuring charge relating to the closing of its Memphis drug testing facility. (f) Long-term obligations primarily include capital lease obligations of $4.4 million, $5.5 million, $6.1 million, $7.2 million and $4.4 million at December 31, 2003, 2002, 2001, 2000 and 1999, respectively. Long-term obligations exclude amounts due to affiliates. On June 6, 2000, the Company called for redemption all of its outstanding redeemable preferred stock, resulting in the conversion of substantially all of the preferred stock into common stock. During 2001, the Company sold $744.0 million aggregate principal amount at maturity of its zero coupon convertible subordinated notes due 2021 in a private placement. The Company received approximately $488.6 million in net proceeds from the offering. The Company used a portion of the proceeds to repay $412.5 million of its term loan outstanding under its credit agreement. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General During 2003, the Company continued to strengthen its financial performance through the implementation of the Company's strategic plan as well as expanding its national platform in routine testing. This plan continues to provide growth opportunities for the Company by building a leadership position in genomic and other advanced testing technologies primarily through internal development efforts, acquisitions and technology licensing activities. The Company's Center for Molecular Biology and Pathology, located in Research Triangle Park, NC is a leader in the development and application of molecular diagnostics and polymerase chain reaction, or PCR, technologies in the areas of diagnostic genetics, oncology and infectious disease. The Company believes that these technologies may represent a significant savings to the healthcare system by increasing the detection of early stage (treatable) diseases. The Company's National Genetics Institute in Los Angeles, CA, develops novel, highly-sensitive PCR methods used to test for hepatitis C and other infectious agents and is the only laboratory in the U.S. that is FDA-approved to screen plasma for infectious diseases. Viro-Med Laboratories, Inc., based in Minneapolis, MN, offers molecular microbial testing using real-time PCR platforms and provides significant additional capacity to support the continued expansion of the Company's advanced testing business. These Centers of Excellence enable the Company to provide a broad menu of testing services for the infectious disease and cancer markets, which the Company believes represent two of the most significant areas of future growth in the clinical laboratory industry. The Company completed the acquisition of DIANON on January 17, 2003. This acquisition significantly enhances the Company's oncology testing capabilities and enables the Company to nationally offer one of the broadest menu of specialized anatomic pathology and gene-based cancer testing in the U.S. At the end of 2003, the Company was ahead of schedule with the integration and had achieved the synergy savings of approximately $26.2 million. The Company expects to achieve additional synergy savings of approximately $5.5 million by the end of 2004, and a total net savings of approximately $32.4 million by 2005. The Company began applying DIANON's standardized anatomic pathology processes in early 2004. This "DIANIZATION" of the Company will take approximately three years. The Dynacare integration is substantially completed and is performing as expected, including the achievement of the planned total synergy savings of $45.0 million. Dynacare continues to strengthen the Company's national network of routine testing. In March 2003, the Company purchased certain assets in Northern California from Quest Diagnostics Incorporated (Quest) for $4.5 million in cash. The assets purchased included the assignment of four contracts with independent physician associations (IPAs), as well as the leases for 46 patient service centers, five of which also serve as rapid response laboratories, located throughout Northern California. Acquiring these assets provides the Company an immediate, competitive presence in Northern California for the first time. Quest has indicated that approximately $27.0 million in annual revenues is generated by capitated fees under the IPA contracts and associated fee-for-service testing for physicians whose patients use these patient service centers, as well as from specimens received directly from the IPA physicians. The Company began the customer conversion process in June and July of 2003, which has been ongoing through the end of the year. The Company expects that incremental revenues will be approximately $9-$10 million in 2004. The Company has announced a number of significant licensing and partnership agreements which provide it with access to new testing technologies that it expects will have an increasing impact on diagnostic testing. In July 2003, the Company announced a marketing and distribution relationship with Atherotech, a leading cardiodiagnostic company and specialty reference laboratory, to offer its proprietary Vertical Auto Profile (VAP"TM") Cholesterol Test. This multi-year agreement includes a provision for the transfer of patented testing technology to the Company, after which, if certain conditions are met, the Company would become the first clinical laboratory licensed to perform the cardiovascular disease risk assessment assay within its own national laboratory system. In August of 2003, the Company announced that it had commercially launched PreGen-Plus, EXACT Sciences' proprietary, non- invasive technology to aid in the early detection of colorectal cancer. Since then, the daily number of specimens received has increased at a moderate pace and the Company has expanded its production capacity to handle higher daily volumes. On October 21, 2003, the Company announced an exclusive agreement with BioPredictive, a French Diagnostics firm, that combines the Company's expertise in infectious disease testing with BioPredictive's noninvasive, predictive testing technology to quantitatively determine the amount of liver fibrosis, and the rate of its progression, in hepatitis C (HCV) patients. HCV FIBROSURE"TM" is expected to be broadly available in the U.S., only through the Company, around the beginning of the second quarter of 2004. As a result of the exclusive sales and distribution agreement with Myriad Genetics, physicians now have the convenience of sending patients to one of the Company's patient service centers for Myriad Genetics' predisposition testing for breast, ovarian, colon and uterine cancers. The Company's relationship with Myriad Genetics makes it one of the few clinical laboratories in the U.S. to provide the entire oncology care continuum from predisposition to surveillance testing, including screening, evaluation, diagnosis and monitoring options. In October 2002, the Company announced a collaboration with Celera to establish the clinical utility of laboratory tests based on novel diagnostic markers. The Company is continuing interactions with Celera to support the development of new gene-based assays in a variety of disease areas. Through an agreement with Correlogic Systems, the Company plans to commercialize their protein pattern blood test for the detection of ovarian cancer, which offers the prospect of accurate and early detection of ovarian cancer. This is a common disease, which if detected early enough, is readily treated and often curable. The Company will initially plan to offer the test to those women at greater than average risk for ovarian cancer sometime during 2004. In addition to the acquisitions and relationships discussed above, the Company believes future performance will be positively affected by several factors: 1) The expansion of higher-value genomic tests such as Cystic Fibrosis, HCV and HIV genotyping, along with the continued growth of HIV viral loads and HPV testing; 2) Continued conversion of traditional pap smears to the newer, high value monolayer technology; 3) Continued progress with existing licensing and business relationships (such as Myriad Genetics, EXACT Sciences, Correlogic and most recently, BioPredictive); 4) The Company's ongoing business acquisition strategy; and 5) Growing demand for genomic testing creating a positive shift in test mix toward higher value testing. On December 17, 2003, the Company's Board of Directors authorized a stock repurchase program under which the Company may purchase up to an aggregate of $250.0 million of its common stock from time-to-time. It is the Company's intention to fund future purchases of its common stock with cash flow from operations. Seasonality Volume of testing generally declines during the year-end holiday periods and other major holidays. In addition, volume declines due to inclement weather may reduce net revenues and cash flows. Therefore, comparison of the results of successive quarters may not accurately reflect trends or results for the full year. Results of Operations Year ended December 31, 2003 compared with Year ended December 31, 2002. Net sales for 2003 were $2,939.4 million, an increase of 17.2% from $2,507.7 million reported in the comparable 2002 period. Testing volume growth, measured by accessions, increased approximately 11.7% and was affected by the acquisitions of Dynacare and DIANON as well as growth in the Company's esoteric test volumes (including HPV and cystic fibrosis). Price per accession increased approximately 5.5%, compared to 2002. The growth in price was affected by this same shift in test mix and from shifts in histology testing which is primarily DIANON- related. These improvements were partially offset by the impact of severe winter weather during the first quarter of 2003 and physician strikes to protest rising malpractice insurance rates during the second quarter. Cost of sales, which includes primarily laboratory and distribution costs, was $1,714.8 million for 2003 compared to $1,445.9 million in 2002, an increase of 18.6%. The increase in cost of sales is primarily the result of increases in volume and supplies due to recent acquisitions, growth in the base business and growth in esoteric and genomic testing (with significant increases in cystic fibrosis and HPV testing). Cost of sales as a percentage of net sales was 58.3% for 2003 and 57.7% in 2002, reflecting the additional infrastructure costs (facilities and personnel) of Dynacare and DIANON acquisitions. Selling, general and administrative expenses increased to $651.8 million in 2003 from $585.5 million in 2002 representing an increase of $66.3 million or 11.3%. This increase resulted primarily from personnel and other costs as a result of the recent acquisitions. As a percentage of net sales, selling, general and administrative expenses were 22.2% and 23.3% for the year ended 2003 and 2002, respectively, reflecting the realization of synergies from the Dynacare and DIANON acquisitions, as well as the Company's reduction of its bad debt expense rate by approximately 130 basis points during 2003 as compared to 2002. The amortization of intangibles and other assets was $37.6 million and $23.8 million for 2003 and 2002, respectively. The increase in amortization expense is a result of the acquisitions of Dynacare and DIANON. The Company recorded pre-tax restructuring charges of $3.3 million and $17.5 million during the third quarters of 2003 and 2002, respectively, in connection with the integrations of DIANON and Dynacare, Inc. During the fourth quarter of 2003, the Company recorded a charge of $3.1 million, relating to the continuing integration of its recent acquisitions. The Company also recorded certain adjustments in the fourth quarter of 2003 to previously recorded restructuring charges due to changes in estimates, resulting in a credit of approximately $4.8 million. Interest expense was $40.9 million in 2003 compared to $19.2 million in 2002. This increase was a direct result of the Company's financing of the DIANON acquisition. Income from equity investments was $43.7 million for the year ended December 31, 2003 compared to $13.4 million for the year end December 31, 2002. This income represents the Company's ownership share in equity affiliates acquired as part of the Dynacare acquisition on July 25, 2002. A significant portion of this income is derived from investments in Ontario and Alberta, Canada, and is earned in Canadian dollars. The strengthening of the Canadian dollar versus the U.S. dollar during the year ended December 31, 2003 has had a positive impact on this income as well as the cash generated from the Canadian investments. The provision for income taxes as a percentage of earnings before taxes was 40.6% in 2003 compared to 41.1% in 2002. The decrease in the effective tax rate for 2003 is due to a $2.1 million state tax recovery during the third quarter of 2003. Year ended December 31, 2002 compared with Year ended December 31, 2001. Net sales for 2002 were $2,507.7 million, an increase of 14.0% from $2,199.8 million reported in the comparable 2001 period. Testing volume, measured by accessions, increased 10.7% (primarily as a result of the Dynacare acquisition and esoteric volume growth) and price per accession increased 3.3% (due in part to the shift in test mix to higher-value esoteric tests) compared to 2001. Cost of sales, which includes primarily laboratory and distribution costs, was $1,445.9 million for 2002 compared to $1,274.2 million in 2001, an increase of 13.5%. In the third quarter of 2002, the Company announced a slowdown in volume growth in the Carolinas. In order to reverse these declines in volume, the Company initiated a reinvestment program that included adding individuals and facilities to improve client service. Although this reinvestment moderately increased the fourth quarter expenses as expected, there was an improvement in the ratio of new to lost accounts in the affected region. Also, the Company incurred certain costs associated with the acquisition and integration of Dynacare such as additional overtime and temporary help and the payment of retention bonuses. Additional costs were incurred due to growth in esoteric and genomic testing and higher volume of Pap tests performed using more expensive monolayer technology. Cost of sales as a percentage of net sales was 57.7% for 2002 and 57.9% in 2001. Selling, general and administrative expenses increased to $585.5 million in 2002 from $516.5 million in 2001 representing an increase of $69.0 million or 13.4%. This increase resulted primarily from personnel and other costs as a result of the Dynacare acquisition. Selling, general and administrative expenses were 23.3% and 23.5% as a percentage of net sales in 2002 and 2001, respectively. The amortization of intangibles and other assets was $23.8 million and $41.5 million for 2002 and 2001, respectively. The decrease in the amortization expense is due to the adoption in 2002 of the non-amortization provisions of SFAS No. 142 for goodwill offset partially by increases in identifiable intangibles amortization resulting from the acquisition of Dynacare. During the third quarter of 2002, the Company recorded restructuring and other special charges totaling $17.5 million. The $17.5 million was comprised of a special bad debt provision of approximately $15.0 million related to the acquired Dynacare accounts receivable balance and an additional $2.5 million relating to integration costs of actions that impact the Company's existing employees and operations. Interest expense was $19.2 million in 2002 compared to $27.0 million in 2001. The reduction in interest expense reflects the Company's lower cost of borrowings from its zero coupon-subordinated notes as well as overall market rate declines in interest rates in 2002 compared to 2001. As a result of the Dynacare acquisition, the Company has investments in equity affiliates in Milwaukee, Wisconsin, Ontario, Canada and Alberta, Canada. These investments are accounted for under the equity method of accounting and resulted in other income of $13.4 million for 2002. Provision for income taxes was $177.7 million in 2002 compared to $149.6 million in 2001. The effective tax rate was 41.1% in 2002 and 45.0% in 2001. The decrease in the effective tax rate is primarily due to the elimination of amortization related to goodwill upon adoption of SFAS No. 142 and, to a smaller extent, the Company's reduction of $1.7 million of valuation allowance relating to its net deferred tax assets. Liquidity and Capital Resources Net cash provided by operating activities was $564.3 million, $444.9 million and $316.0 million, in 2003, 2002 and 2001, respectively. The increase in cash flow from operations in both 2003 and 2002 primarily resulted from improved earnings, the expansion of the business through acquisitions, and the improvement of the Company's accounts receivable days' sales outstanding ("DSO") to 53 days at the end of 2003 from 54 days at the end of 2002. This improvement was due to Company-wide efforts to increase cash collections from all payors, as well as on-going improvements to claim submission processes. In addition, the Company continued to take steps necessary to improve DSO and cash collections by: 1) conversion of decentralized billing locations, including former Dynacare locations, to a centralized billing system. During 2003, billing activity in numerous Dynacare sites was converted to the centralized billing system. In 2004, the Company will concentrate its conversion activities on the remaining Dynacare locations as well as its Salt Lake City, Reno, San Diego and Viro-Med facilities. 2) continuing initiative to reduce the number of requisitions received that are missing certain billing information. This initiative involves counting the number of clinical requisitions received from an ordering client, as well as determining what specific information was not provided. The Company then identifies root causes of why the information was missing and takes steps to ensure that information is provided in the future. These steps include re-educating clients as to what information is needed in order for the Company to bill and collect for the test. As of December 31, 2003, the percentage of requisitions received which were missing billing information was 4.3% as compared to 4.6% at the end of 2002. 3) implementation of numerous initiatives related to self-pay accounts receivable. These include: i) collecting payment at the time of service; ii) increased training for billing personnel related to improving collections during phone calls and iii) review of bill design and frequency. Capital expenditures were $83.6 million, $74.3 million and $88.1 million for 2003, 2002 and 2001, respectively. The Company expects capital expenditures of approximately $90.0 to $100.0 million in 2004. These expenditures are intended to continue standardizing lab and billing information systems and further automate laboratory processes. The Company will continue to make important investments in information technology connectivity with its customers. Such expenditures are expected to be funded by cash flow from operations as well as borrowings under the Company's revolving credit facilities. On January 31, 2003,in connection with the acquisition of DIANON, the Company completed a private placement of $350.0 million in senior notes, which was used to repay the $350.0 million bridge loan that was entered into to fund part of the DIANON purchase. The notes, in an aggregate principal amount of $350.0 million, will bear an interest rate of 5.5% and resulted in net proceeds of $345.1 million. In conjunction with the acquisition of DIANON, the Company's planned financing of the acquisition, and announced share repurchase plan, Standard and Poor's lowered its overall rating on the Company to BBB from BBB+ and Moody's issued a Baa3 rating to the Company's newly issued Senior Notes. On January 13, 2004, the Company entered into a new $150.0 million 364-day revolving credit facility with Credit Suisse First Boston, acting as Administrative Agent, and a group of financial institutions to replace the existing $150.0 million 364-day revolving credit facility, which had terminated. The $200.0 million three-year revolving credit facility was amended on January 14, 2003 and expires on February 18, 2005. On January 17, 2003, in conjunction with the acquisition of DIANON, the Company borrowed $350.0 million under the DIANON Bridge Loan Agreement with Credit Suisse First Boston, acting as Administrative Agent. On January 31, 2003, the Company sold $350.0 million aggregate principal amount of its 5 1/2% Senior Notes due February 1, 2013. Proceeds from the issuance of these Notes ($345.1 million), together with cash on hand was used to repay the $350.0 million principal amount of the Company's bridge loan facility, and as a result, the loan was terminated. During the first quarter of 2003, the Company entered into an interest rate swap agreement with a major financial institution, solely to manage its interest rate exposure on $175.0 million of its 5 1/2% Senior Notes. This swap agreement was terminated during June 2003 and resulted in net proceeds to the Company of $5.3 million. Pension Funding During 2001, 2002 and 2003, the Company made contributions to its defined pension plan in the amounts of $18.0 million, $8.6 million and $10.2 million, respectively. The Company expects to contribute $34.6 million to its defined pension plan during 2004. See "Note 22 to the Consolidated Financial Statements" for a further discussion of the Company's pension and postretirement plans. New Accounting Pronouncements On December 23, 2003, the Financial Accounting Standards Board released revised Statement of Financial Accounting Standards No. 132 "Employers Disclosures about Pensions and Other Postretirement Benefits". This Standard is an amendment of SFAS No. 87,88, and 106 and a revision of SFAS No. 132. The provisions of this Statement do not change the measurement and recognition provisions of these previously issued Statements, but requires that additional disclosures are made. Some of the required disclosures include: 1) Plan assets by category, 2) Investment policies and strategies, 3) Target allocation percentages or target ranges for plan asset categories, 4) Projections of future benefit payments, 5) Estimates of future contributions to fund pension and other postretirement benefit plans, and 6) Interim disclosures of certain items. The requirements of the standard are effective for public companies for fiscal years ending after December 15, 2003. The Company adopted this statement for its 2003 Annual Report and Form 10-K and it does not effect the Company's financial position or results of operations. In January 2003, the FASB issued FASB Interpretation No. 46 (FIN No. 46), "Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51." FIN No. 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN No. 46 and FIN No. 46R is effective for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN No. 46 must be applied for the first interim or annual period beginning after December 15, 2003. The Company does not believe it has any unconsolidated variable interest entities, but has not fully completed its evaluation. In December 2002, Statement of Financial Accounting Standards ("SFAS") No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure - an amendment of FASB Statement No. 123", was issued. This Statement amends SFAS No. 123 to provide alternative methods of transition for a voluntary change to the fair- value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require disclosure in interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company has not adopted a fair-value based method of accounting for stock-based employee compensation and SFAS No. 148 has not had a material impact on its consolidated financial statements. In July 2002, SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities" was issued. This Statement addresses the recognition, measurement, and reporting of costs associated with exit or disposal activities, and supercedes Emerging Issues Task Force Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)" ("EITF 94-3"). The principal difference between SFAS No. 146 and EITF 94-3 relates to the requirements for recognition of a liability for a cost associated with an exit or disposal activity. SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity, including those related to employee termination benefits and obligations under operating leases and other contracts, be recognized when the liability is incurred, and not necessarily the date of an entity's commitment to an exit plan, as under EITF 94-3. SFAS No. 146 also establishes that the initial measurement of a liability recognized under SFAS No. 146 be based on fair value. The provisions of SFAS No. 146 are effective for exit or disposal activities that are initiated after December 31, 2002, with early application encouraged. The Company adopted this statement January 1, 2003 and it has not effected its financial position or results of operations. In May 2002, SFAS No. 145, "Rescission of FAS Nos. 4, 44, and 64, Amendment of FAS 13, and Technical Corrections as of April 2002" was issued. This Statement rescinds SFAS No. 4, Reporting Gains and Losses from Extinguishment of Debt, and an amendment of that Statement, SFAS No. 64, Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements. This Statement also rescinds SFAS No. 44, Accounting for Intangible Assets of Motor Carriers. This Statement amends SFAS No. 13, Accounting for Leases, to eliminate any inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. This Statement also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. The Company adopted this statement January 1, 2003 and it has resulted in the reclassification of the 2001 extraordinary loss. Contractual Cash Obligations Payments Due by Period ------------------------------------ Less More than 1 Yr 1-3 Yrs 3-5 Yrs > 5 Yrs ------ ------- ------- --------- Capital lease obligations $ 3.5 $ 5.7 $ 1.2 $ -- Operating leases obligations 55.4 72.1 34.1 25.3 Restructuring obligations 5.0 6.7 6.2 6.8 Contingent future licensing payments 24.1(b) 13.5 18.7 -- Royalty payments 0.3 1.8 2.0 -- 5 1/2% Senior Notes -- -- -- 350.0 Zero coupon-subordinated notes 530.5(a) -- -- -- ----- ----- ----- ----- Total contractual cash obligations $618.8 $ 99.8 $ 62.2 $382.1 ===== ===== ===== ===== (a) Holders of the zero coupon-subordinated notes may require the Company to purchase all or a portion of their notes on September 11, 2004, 2006 and 2011 at prices ranging from $712.97 to $819.54 per note. The Company may choose to pay the purchase price in cash or common stock or a combination of cash and common stock. If the holders elect to require the Company to purchase their notes, it is the Company's current intention to retire the notes by a cash payment. However, future market conditions are subject to change. Should the holders put the notes to the Company on any of the dates above, the Company believes that it will be able to obtain alternate financing to satisfy this contingent obligation. (b) Contingent future licensing payments will be made in the event that certain events take place, such as the launch of a specific test, the transfer of certain technology, and when specified revenue milestones are met. Off-Balance Sheet Arrangements The Company does not have transactions or relationships with "special purpose" entities, and the Company does not have any off balance sheet financing other than normal operating leases. Other Commercial Commitments At December 31, 2003, the Company provided letters of credit aggregating approximately $57.1 million, primarily in connection with certain insurance programs. These letters of credit are secured by the Company's senior credit facilities and are renewed annually, around mid-year. Based on current and projected levels of operations, coupled with availability under its new senior credit facilities, the Company believes it has sufficient liquidity to meet both its short-term and long-term cash needs. For a discussion of the Company's zero coupon-subordinated notes, see "Note 13 to Consolidated Financial Statements." For a discussion of the Company's new senior credit facilities, see "Note 14 to Consolidated Financial Statements." Critical Accounting Policies The preparation of financial statements in conformity with generally accepted accounting principles 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 reported periods. Significant estimates include the allowances for doubtful accounts, amortization lives for intangible assets, accruals for self-insurance reserves and reserves for professional liability claims. The process for estimating the ultimate collection of receivables involves significant assumptions and judgments. Billings for services under third-party payor programs, including Medicare and Medicaid, are recorded as revenues net of allowances for differences between amounts billed and the estimated receipts under such programs. Adjustments to the estimated receipts, based on final settlement with the third-party payors, are recorded upon settlement as an adjustment to net revenues. In addition, the Company has implemented a process to estimate and review the collectibility of its receivables based on the period they have been outstanding. Historical collection and payor reimbursement experience is an integral part of the estimation process related to reserves for doubtful accounts. The Company also assesses the current state of its billing functions in order to identify any known collection or reimbursement issues in order to assess the impact, if any, on the reserve estimates, which involves judgment. The Company believes that the collectibility of its receivables is directly linked to the quality of its billing processes, most notably, those related to obtaining the correct information in order to bill effectively for the services provided. Revisions in reserve for doubtful accounts estimates are recorded as an adjustment to bad debt expense within selling, general and administrative expenses. The Company believes that its collection and reserves processes, along with the close monitoring of its billing processes, helps reduce the risk associated with material revisions to reserve estimates resulting from adverse changes in collection and reimbursement experience and billing operations. The Company's pension expense is developed from actuarial valuations. Inherent in these valuations are key assumptions, including discount rates and expected return on plan assets, which are usually updated on an annual basis at the beginning of each year. The Company is required to consider current market conditions, including changes in interest rates, in making these assumptions. Changes in pension costs may occur in the future due to changes in these assumptions. The key assumptions used in accounting for the defined benefit plans were a 6.25% discount rate and an 8.5% expected return on plan assets. Compared with the prior year, net pension cost increased $5.3 million and is projected to decrease approximately $4.0 million in 2004, primarily as a result of the performance of plan assets in 2003, which should reduce 2004 plan expense by approximately $3.7 million; plan amendments, which should result in reduced 2004 plan expense by approximately $1.0 million; and offset by increased expense of approximately $0.6 million as a result of the reduction of the discount rate. In establishing its expected return on plan assets assumption, the Company reviews asset allocation considering plan maturity and develops return assumptions based on different asset classes adjusting for plan operating expenses. Actual asset over/under performance compared to expected returns will respectively decrease/increase unrecognized loss. The change in the unrecognized loss will change amortization cost in upcoming periods. A one percentage point change in the expected return assumption in the current year would have resulted in a change in pension expense of approximately $1.4 million. Effective December 31, 2003, the Company adopted the revised Statement of Financial Accounting Standards No. 132 "Employers Disclosures about Pensions and Other Postretirement Benefits". This Standard is an amendment of SFAS No. 87,88, and 106 and a revision of SFAS No. 132. The provisions of this Statement do not change the measurement and recognition provisions of these previously issued Statements, but requires that additional disclosures are made. Some of the required disclosures include: 1) plan assets by category, 2) investment policies and strategies, 3) target allocation percentages or target ranges for plan asset categories, 4) projections of future benefit payments, 5) estimates of future contributions to fund pension and other postretirement benefit plans, and 6) interim disclosures of certain items. Effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 142 "Goodwill and Other Intangible Assets". This Standard requires that goodwill and other intangibles that are acquired in business combinations and that have indefinite useful lives are not to be amortized and are to be reviewed for impairment annually based on an assessment of fair value. Other intangibles (patents and technology, customer lists and non-compete agreements), are amortized on a straight- line basis over the expected periods to be benefited, such as legal life for patents and technology, 10 to 25 years for customer lists and contractual lives for non-compete agreements. The impact of adopting SFAS No. 142 is summarized in Note 10 to the Consolidated Financial Statements. Accruals for self-insurance reserves (including workers' compensation, auto and employee medical) are determined based on historical payment trends and claims history, along with current and estimated future economic conditions. The Company is self-insured for professional liability claims arising in the normal course of business, generally related to the testing and reporting of laboratory test results. The Company records an accrual for such claims payable and claims incurred but not reported based on an actuarial assessment of the accrual, which is performed at least annually. While management believes these estimates are reasonable and consistent, they are by their very nature, estimates of amounts that will depend on future events. Accordingly, actual results could differ from these estimates. The Company's Audit Committee periodically reviews the Company's significant accounting policies. See "Note 1 to the Consolidated Financial Statements" for further discussion of significant accounting policies. FORWARD-LOOKING STATEMENTS The Company has made in this report, and from time to time may otherwise make in its public filings, press releases and discussions with Company management, forward-looking statements concerning the Company's operations, performance and financial condition, as well as its strategic objectives. Some of these forward-looking statements can be identified by the use of forward-looking words such as "believes", "expects", "may", "will", "should", "seeks", "approximately", "intends", "plans", "estimates", or "anticipates" or the negative of those words or other comparable terminology. Such forward-looking statements are subject to various risks and uncertainties and the Company claims the protection afforded by the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from those currently anticipated due to a number of factors in addition to those discussed elsewhere herein and in the Company's other public filings, press releases and discussions with Company management, including: 1. changes in federal, state, local and third party payor regulations or policies (or in the interpretation of current regulations) affecting governmental and third-party reimbursement for clinical laboratory testing; 2. adverse results from investigations of clinical laboratories by the government, which may include significant monetary damages and/or exclusion from the Medicare and Medicaid programs; 3. loss or suspension of a license or imposition of a fine or penalties under, or future changes in, the law or regulations of the Clinical Laboratory Improvement Act of 1967, and the Clinical Laboratory Improvement Amendments of 1988, or those of Medicare, Medicaid or other federal, state or local agencies; 4. failure to comply with the Federal Occupational Safety and Health Administration requirements and the Needlestick Safety and Prevention Act which may result in penalties and loss of licensure; 5. failure to comply with HIPAA, which could result in significant fines; 6. failure of third party payors to complete testing with the Company, or accept or remit transactions in HIPAA-required standard transaction and code set format, could result in an interruption in the Company's cash flow; 7. increased competition, including price competition; 8. changes in payor mix, including an increase in capitated managed- cost health care; 9. failure to obtain and retain new customers and alliance partners, or a reduction in tests ordered or specimens submitted by existing customers; 10.failure to integrate newly acquired businesses and the cost related to such integration; 11.adverse results in litigation matters; 12.inability to attract and retain experienced and qualified personnel; 13.failure to maintain the Company's days sales outstanding levels; 14.decrease in credit ratings by Standard & Poor's and/or Moody's; 15.failure to develop or acquire licenses for new or improved technologies, or if customers use new technologies to perform their own tests; 16.inability to commercialize newly licensed tests or technologies or to obtain appropriate reimbursements for such tests, which could result in impairment in the value of certain capitalized licensing costs; 17.inability to obtain and maintain adequate patent and other proprietary rights protection of the Company's products and services and successfully enforce the Company's proprietary rights; 18.the scope, validity and enforceability of patents and other proprietary rights held by third parties which might impact on the Company's ability to develop, perform, or market the Company's tests or operate its business; 19.failure in the Company's information technology systems resulting in an increase in testing turnaround time or billing processes; 20.liabilities that result from the inability to comply with new Corporate governance requirements; and 21.compliance by the Company with the Sarbanes-Oxley Act of 2002, including Section 404 of that Act which requires management to report on, and our independent auditors to attest to and report on, our internal controls, will require management to devote substantial time and attention, which could prove to be disruptive to product development and licensing, marketing and other business activities and will require additional legal, accounting and other expenses to implement the requirements of these new rules. Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK The Company addresses its exposure to market risks, principally the market risk associated with changes in interest rates, through a controlled program of risk management that has included in the past, the use of derivative financial instruments such as interest rate swap agreements. The Company had an interest rate swap agreement with a major financial institution, solely to manage its interest rate exposure on $175.0 million of its 5 1/2% senior notes. This swap agreement was terminated during June 2003 and the Company received net proceeds of $5.3 million. Although, as set forth below, the Company's zero coupon- subordinated notes contain features that are considered to be embedded derivative instruments, the Company does not hold or issue derivative financial instruments for trading purposes. The Company does not believe that its exposure to market risk is material to the Company's financial position or results of operations. The Company's zero coupon-subordinated notes contain the following three features that are considered to be embedded derivative instruments under FAS No. 133: 1) The Company will pay contingent cash interest on the zero coupon- subordinated notes after September 11, 2006, if the average market price of the notes equals 120% or more of the sum of the issue price, accrued original issue discount and contingent additional principal, if any, for a specified measurement period. 2) Contingent additional principal will accrue on the zero coupon- subordinated notes during the two year period from September 11, 2004 to September 11, 2006, if the Company's stock price is at or below specified thresholds. 3) Holders may surrender zero coupon-subordinated notes for conversion during any period in which the rating assigned to the zero coupon-subordinated notes by Standard & Poor's Ratings Services is BB- or lower. Based upon independent appraisals, these embedded derivatives had no fair market value at December 31, 2003. Borrowings under the Company's revolving credit facility are subject to variable interest rates, unless fixed through interest rate swap or other agreements. Two of the Company's equity affiliates operate in Canada and remit the Company's share of partnership income in Canadian Dollars. Accordingly, the cash flow received from these affiliates is subject to a certain amount of foreign currency exchange risk. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Reference is made to the Index on Page F-1 of the Financial Report included herein. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not Applicable. Item 9.A. CONTROLS AND PROCEDURES As of the end of the period covered by this Form 10-K, the Company carried out, under the supervision and with the participation of the Company's management, including the Company's Chief Executive Officer and Chief Financial Officer, an evaluation of the effectiveness of the design and operation of the Company's disclosure controls and procedures. Based on the foregoing, the Company's Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures are effective in timely alerting them to material information which is required to be included in the periodic reports that the Company must file with the Securities and Exchange Commission. There were no significant changes in the Company's internal controls or in other factors that could adversely affect the internal controls subsequent to the date the Company completed its evaluation. PART III The information required by Part III, Items 10, 11, 13 and 15, of Form 10-K is incorporated by reference to the registrant's definitive proxy statement for its 2003 annual meeting of stockholders, which is to be filed pursuant to Regulation 14A not later than April 30, 2004. Item 10. CODE OF ETHICS, EXPERTS ON AUDIT COMMITTEE In October 2002, the Board of Directors adopted an updated set of Corporate Governance Guidelines (the "Guidelines). The Guidelines address a number of topics, including director independence, Board and Committee self-assessment, retirement, evaluation of the Chief Executive Officer, composition of the Board and succession planning. The Nominating and Corporate Governance Committee reviews the Guidelines on a regular basis and any proposed additions or amendments to the Guidelines are submitted to the Board for its consideration. In December 2003, the Board adopted the Company's updated Code of Business Conduct and Ethics (the "Code"). The Code is a code of business conduct and ethics applicable to all directors, officers and employees of the Company, including its Chief Executive Officer and its Chief Financial Officer, Controller and other senior financial officers. The Code sets forth Company policies and expectations on a number of topics, including but not limited to, conflicts of interest, confidentiality, compliance with laws (including insider trading laws), preservation and use of Company assets, and business ethics. The Code also sets forth procedures for communicating and handling any potential conflict of interest (or the appearance of any conflict of interest) involving directors or executive officers, and for the confidential communication and handling of issues regarding accounting, internal controls and auditing matters. The Company regularly reviews the Code and proposed additions or amendments to the Code are considered and subject to approval by the Board. In order to provide stockholders with greater knowledge regarding the Board's processes, the Guidelines and the Code adopted by the Board of Directors are posted on the Company's website at www.labcorp.com. In addition, any amendments to the Code will be posted on the Company's website. The Company has carefully reviewed its Guidelines and Code and believes that they comply with the provisions of the Sarbanes-Oxley Act of 2002, the rules of the Commission, and the NYSE's new corporate governance listing standards regarding corporate governance policies and processes. The Audit Committee of the Board of Directors further concluded that Wendy E. Lane and James B. Powell have eash been identified as an "audit committee financial expert" as defined by Commission rules and each has the "accounting or related financial management expertise" required by the Listing Standards. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT See "Note 19 to the Consolidated Financial Statements" for a discussion of the Company's Stock Compensation Plans. Except for the above referenced footnote, the information called for by this Item is incorporated by reference in the information under the caption "Security Ownership of Certain Beneficial Owners and Management" appearing in the Proxy Statement. Item 14 PRINCIPAL ACCOUNTANT FEES AND SERVICES Aggregate fees for professional services rendered for the Company by PricewaterhouseCoopers as of or for the years ended December 31, 2003 and 2002, were: 2003 2002 -------- -------- Audit $664,469 $606,540 Audit Related 39,946 79,689 Tax 2,100 12,000 All Other -- 18,085 -------- -------- Total $706,515 $716,314 ======== ======== The Audit fees for the years ended December 31, 2003 and 2002, respectively, were for professional services rendered (including reimbursement for out-of-pocket expenses) for the audits of the consolidated financial statements of the Company ($585,000 and $540,000) and the issuance of comfort letters, consents, income tax provision procedures, and assistance with review of documents filed with the SEC ($72,084 and $66,540). The Audit Related fees for the years ended December 31, 2002 were primarily for assurance and related services related to due diligence related to mergers and acquisitions and accounting consultations in connection with acquisitions. For the year ended December 31, 2003, such fees were primarily for accounting consultations and for Section 404 pre-attestation advisory work. Tax fees for the years ended December 31, 2003 and 2002, respectively, were for services related to tax compliance, tax planning and tax advice. All Other fees for the year ended December 31, 2002 were for assistance with the development of investment policies. No fees were paid for Financial Information Systems Design and Implementation for the years ended December 31, 2003 and 2002. The Audit Committee has considered the other services rendered and believes that they are compatible with PricewaterhouseCoopers remaining independent. PART IV Item 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) List of documents filed as part of this Report: (1) Consolidated Financial Statements and Independent Auditors' Reports included herein: See Index on page F-1 (2) Financial Statement Schedules: See Index on page F-1 All other schedules are omitted as they are inapplicable or the required information is furnished in the Consolidated Financial Statements or notes thereto. (3) Index to and List of Exhibits Exhibits: Exhibits 10.2 through 10.4 and 10.9 through 10.18 are management contracts or compensatory plans or arrangements. 3.1 - Amended and Restated Certificate of Incorporation of the Company dated May 24, 2001 (incorporated herein by reference to the Company's Registration Statement on Form S-3, filed with the Commission on October 19, 2001, File No. 333-71896). 3.2 - Amended and Restated By-Laws of the Company dated April 28, 1995 (incorporated herein by reference to the Company's report on Form 8-K, filed with the Commission on May 12, 1995). 4.1 - Specimen of the Company's Common Stock Certificate (incorporated herein by reference to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2001). 4.2 - Indenture dated September 11, 2001 between the Company and Bank of New York, as trustee (incorporated herein by reference to the Company's Registration Statement on Form S-3, filed with the Commission on October 19, 2001, File No. 333-71896). 4.3 - Registration Rights Agreement dated September 11, 2001 between the Company and Merrill Lynch, Pierce, Fenner & Smith Incorporated (incorporated herein by reference to the Company's Registration Statement on Form S-3, filed with the Commission on October 19, 2001, File No. 333- 71896). 4.4 - Rights Agreement dated December 13, 2001 between the Company and American Stock Transfer & Trust Company, as rights Agent (incorporated herein by reference to the Company's Registration Statement on Form 8-A, filed with the Commission on December 21, 2001, File No. 001- 11353). 4.5 - Indenture dated as of January 31, 2003 between the Company and Wachovia Bank, National Association, as trustee (incorporated herein by reference to the January 31, 2003 Form 8-K, filed with the Commission on February 3, 2003). 4.6 - Registration Rights Agreement, dated as of January 28, 2003 between the Company and the Initial Purchasers (incorporated herein by reference to the January 31, 2003 Form 8-K, filed with the Commission on February 3, 2003). 10.1 - National Health Laboratories Incorporated Pension Equalization Plan (incorporated herein by reference to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992). 10.2 - National Health Laboratories 1988 Stock Option Plan, as amended (incorporated herein by reference to the Company's Registration Statement on Form S-1, filed with the Commission on July 9, 1990, File No. 33- 35782). 10.3 - National Health Laboratories 1994 Stock Option Plan (incorporated herein by reference to the Company's Registration Statement on Form S-8, filed with the Commission on August 12, 1994, File No. 33-55065). 10.4 - Laboratory Corporation of America Holdings Master Senior Executive Severance Plan (incorporated herein by reference to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2002). 10.5 - Exchange Agent Agreement dated as of April 28, 1995 between the Company and American Stock Transfer & Trust Company (incorporated herein by reference to the May 12, 1995 Form 8-K). 10.6 - Three-Year Credit Agreement dated February 20, 2002 among the Company, the lenders named therein and Credit Suisse First Boston, as administrative agent (incorporated herein by reference to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2001). 10.7 - First Amendment to the Three-Year Credit Agreement, dated January 14, 2003 (incorporated herein by reference to the January 17, 2003 Form 8-K, filed with the Commission on February 3, 2003). 10.8*- 364-Day Credit Agreement dated January 13, 2004 among the Company, the lenders named therein and Credit Suisse First Boston, as administrative agent. 10.9 - Laboratory Corporation of America Holdings 1995 Stock Plan for Non-Employee Directors dated September 26, 1995 (incorporated herein by reference to the Company's Registration Statement on Form S-8, filed with the Commission on September 26, 1995, File No. 33-62913). 10.10- Amendment to the 1995 Stock Plan for Non-Employee Directors (incorporated herein by reference to the Company's 1997 Annual Proxy Statement, filed with the Commission on June 6, 1997). 10.11- Amendment to the 1995 Stock Plan for Non-Employee Directors (incorporated herein by reference to Annex I of the Company's 2001 Annual Proxy Statement, filed with the Commission on April 25, 2001). 10.12- Laboratory Corporation of America Holdings 1997 Employee Stock Purchase Plan (incorporated herein by reference to Annex I of the Company's Registration Statement on Form S-8 filed with the Commission on December 13, 1996, File No. 333-17793). 10.13- Amendments to the Laboratory Corporation of America Holdings 1997 Employee Stock Purchase Plan (incorporated herein by reference to the Company's Registration Statement on Form S-8, filed with the Commission on January 10, 2000, File No. 333-94331). 10.14- Laboratory Corporation of America Holdings Amended and Restated 1999 Stock Incentive Plan (incorporated herein by reference to Annex I of the Company's 1999 Annual Proxy Statement filed with the Commission of May 3, 1999). 10.15- Laboratory Corporation of America Holdings 2000 Stock Incentive Plan (incorporated herein by reference to the Company's Registration Statement on Form S-8, filed with the Commission on June 5, 2000, File No. 333- 38608). 10.16- Amendments to the 2000 Stock Incentive Plan (incorporated herein by reference to the Company's Registration Statement on Form S-8, filed with the Commission on June 19, 2002, File No. 333-90764). 10.17- Dynacare Inc., Amended and Restated Employee Stock Option Plan (incorporated herein by reference to the Company's Registration Statement on Form S-8, filed with the Commission on August 7, 2002, File No. 333- 97745). 10.18- DIANON Systems, Inc. 1996 Stock Incentive Plan, DIANON Systems, Inc. 1999 Stock Incentive Plan, DIANON Systems, Inc. 2000 Stock Incentive Plan, DIANON Systems, Inc. 2001 Stock Incentive Plan, and UroCor, Inc. Second Amended and Restated 1992 Stock Option Plan (incorporated herein by reference to the Company's Registration Statement on Form S-8, filed with the Commission on January 21, 2003, File No. 333-102602. 21* - List of Subsidiaries of the Company 23.1*- Consent of PricewaterhouseCoopers LLP 24.1*- Power of Attorney of Jean-Luc Belingard 24.2*- Power of Attorney of Wendy E. Lane 24.3*- Power of Attorney of Robert E. Mittelstaedt, Jr. 24.4*- Power of Attorney of James B. Powell, M.D. 24.5*- Power of Attorney of Andrew G. Wallace, M.D. 24.6*- Power of Attorney of M. Keith Weikel 99.1*- Written Statement of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. Section 1350) * Filed herewith. (b) Reports on Form 8-K (1) A current report on Form 8-K dated December 17, 2003 was filed on December 17, 2003 by the registrant, in connection with the press release dated December 17, 2003 announcing that the Company's Board of Directors authorized a stock repurchase program. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. LABORATORY CORPORATION OF AMERICA HOLDINGS ------------------------------------------ Registrant By: /s/ THOMAS P. MAC MAHON ---------------------------- Thomas P. Mac Mahon Chairman of the Board, President and Chief Executive Officer Dated: March 10, 2004 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant on March 10, 2004 in the capacities indicated. Signature Title --------- ----- /s/ THOMAS P. MAC MAHON Chairman of the Board, --------------------------------- President and Chief Thomas P. Mac Mahon Executive Officer (Principal Executive Officer) /s/ WESLEY R. ELINGBURG Executive Vice President, --------------------------------- Chief Financial Officer Wesley R. Elingburg and Treasurer (Principal Financial Officer and Principal Accounting Officer) /s/ JEAN-LUC BELINGARD* Director --------------------------------- Jean-Luc Belingard /s/ WENDY E. LANE* Director --------------------------------- Wendy E. Lane /s/ ROBERT E. MITTELSTAEDT, JR.* Director --------------------------------- Robert E. Mittelstaedt, Jr. /s/ JAMES B. POWELL, M.D.* Director --------------------------------- James B. Powell, M.D. /s/ ANDREW G. WALLACE, M.D.* Director --------------------------------- Andrew G. Wallace, M.D. /s/ M. Keith Weikel* Director --------------------------------- M. Keith Weikel * Bradford T. Smith, by his signing his name hereto, does hereby sign this report on behalf of the directors of the Registrant after whose typed names asterisks appear, pursuant to powers of attorney duly executed by such directors and filed with the Securities and Exchange Commission. By:/s/ BRADFORD T. SMITH --------------------- Bradford T. Smith Attorney-in-fact Certification [Exhibit 31.1] ---------------------------- I, Thomas P. Mac Mahon, certify that: 1. I have reviewed this annual report on Form 10-K of Laboratory Corporation of America Holdings; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e) for the registrant and have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 10, 2004 ----------------- /s/ THOMAS P. MAC MAHON ----------------------- Thomas P. Mac Mahon Chief Executive Officer Certification [Exhibit 31.2] ---------------------------- I, Wesley R. Elingburg, certify that: 1. I have reviewed this annual report on Form 10-K of Laboratory Corporation of America Holdings; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e) for the registrant and have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 10, 2004 ----------------- /s/ WESLEY R. ELINGBURG ----------------------- Wesley R. Elingburg Chief Financial Officer LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULE Page ---- Report of Independent Auditors F-2 Consolidated Financial Statements: Consolidated Balance Sheets F-3 Consolidated Statements of Operations F-4 Consolidated Statements of Changes in Shareholders' Equity F-5 Consolidated Statements of Cash Flows F-7 Notes to Consolidated Financial Statements F-9 Financial Statement Schedule: II - Valuation and Qualifying Accounts and Reserves F-42 REPORT OF INDEPENDENT AUDITORS To the Board of Directors and Shareholders of Laboratory Corporation of America Holdings In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Laboratory Corporation of America Holdings and its subsidiaries (the Company) at December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the accompanying index presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As discussed in Note 1 to the financial statements, the Company adopted SFAS No. 142, "Goodwill and Other Intangible Assets" which changed the method of accounting for goodwill and other intangible assets effective January 1, 2002. PricewaterhouseCoopers LLP Greensboro, North Carolina February 12, 2004 PART I - FINANCIAL INFORMATION Item 1. Financial Information LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Dollars in Millions, Except Per Share Data) December 31, December 31, 2003 2002 -------------- ------------- ASSETS Current assets: Cash and cash equivalents $ 123.0 $ 56.4 Accounts receivable, net 432.5 393.0 Supplies inventories 47.0 44.8 Prepaid expenses and other 36.3 33.8 Deferred income taxes 19.1 57.1 Total current assets 657.9 585.1 Property, plant and equipment, net 361.3 351.2 Goodwill 1,285.9 910.1 Intangible assets, net 571.4 307.4 Investments in equity affiliates 505.3 400.6 Other assets, net 33.1 26.0 ---------- --------- $ 3,414.9 $ 2,580.4 ========== ========= LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable $ 73.0 $ 79.9 Accrued expenses and other 161.1 146.1 Zero coupon-subordinated notes 523.2 -- Current portion of long-term debt 0.3 0.4 Total current liabilities 757.6 226.4 Zero coupon-subordinated notes -- 512.9 5 1/2% senior notes 353.8 -- Long-term debt, less current portion 2.5 3.1 Capital lease obligations 4.4 5.5 Deferred income taxes 273.4 79.3 Other liabilities 127.3 141.5 Commitments and contingent liabilities -- -- Shareholders' equity: Preferred Stock, $0.10 par value; 30,000,000 shares authorized; shares issued: none Common stock, $0.10 par value; 265,000,000 shares authorized; 148,855,110 and 147,839,103 shares issued and outstanding at December 31, 2003 and December 31, 2002, respectively 14.9 14.8 Additional paid-in capital 1,440.9 1,406.5 Retained earnings 587.1 266.1 Treasury stock, at cost; 5,521,620 and 97,426 shares at December 31, 2003 and December 31, 2002, respectively (159.3) (4.4) Unearned restricted stock compensation (22.4) (41.4) Accumulated other comprehensive earnings (loss) 34.7 (29.9) ---------- --------- Total shareholders' equity 1,895.9 1,611.7 ---------- --------- $ 3,414.9 $ 2,580.4 ========== ========= The accompanying notes are an integral part of these consolidated financial statements LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Dollars in Millions, Except Per Share Data) Years Ended December 31, ----------------------------------- 2003 2002 2001 ----------------------------------- Net sales $ 2,939.4 $ 2,507.7 $ 2,199.8 Cost of sales 1,714.8 1,445.9 1,274.2 --------- --------- --------- Gross profit 1,224.6 1,061.8 925.6 Selling, general and administrative expenses 651.8 585.5 516.5 Amortization of intangibles and other assets 37.6 23.8 41.5 Restructuring and other special charges 1.5 17.5 -- --------- --------- --------- Operating income 533.7 435.0 367.6 Other income (expenses): Interest expense (40.9) (19.2) (27.0) Income from equity investments, net 43.7 13.4 -- Investment income 5.1 3.7 2.4 Other, net (1.2) (0.6) (1.8) Termination of interest rate swap agreement -- -- (8.9) Loss on early debt termination -- -- (5.5) --------- --------- ---------- Earnings before income taxes 540.4 432.3 326.8 Provision for income taxes 219.4 177.7 147.3 --------- --------- ---------- Net earnings $ 321.0 $ 254.6 $ 179.5 ========= ========= ========== Basic earnings per common share $ 2.23 $ 1.78 $ 1.29 ========== ========== ========== Diluted earnings per common share $ 2.22 $ 1.77 $ 1.27 ========== ========== ========== The accompanying notes are an integral part of these consolidated financial statements. LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (Dollars in Millions) Common Stock Additional Retained --------------- Paid-in Earnings Shares Amount Capital (Deficit) --------------- ---------- ---------- BALANCE AT DECEMBER 31, 2000 139.5 $ 14.0 $1,041.2 $ (168.0) Comprehensive earnings: Net earnings -- -- -- 179.5 Other comprehensive loss: Cumulative effect of change in accounting principle (net-of-tax of $0.4) -- -- -- -- Unrealized derivative loss on cash flow hedge -- -- -- -- Termination of interest rate swap agreement -- -- -- -- Foreign currency translation adjustments -- -- -- -- Minimum pension liability adjustment -- -- -- -- Comprehensive earnings Issuance of common stock 1.6 0.2 14.8 -- Issuance of restricted stock awards -- -- 11.3 -- Amortization of unearned restricted stock compensation -- -- -- -- Income tax benefit from stock options exercised -- -- 14.4 -- ----- ----- ------- ------ BALANCE AT DECEMBER 31, 2001 141.1 14.2 1,081.7 11.5 Comprehensive earnings: Net earnings -- -- -- 254.6 Other comprehensive loss: Foreign currency translation adjustments -- -- -- -- Minimum pension liability adjustment -- -- -- -- Tax effect of other comprehensive loss adjustments -- -- -- -- Comprehensive earnings Issuance of common stock 1.7 0.1 18.2 -- Issuance of restricted stock awards -- -- 40.9 -- Surrender of restricted stock awards -- -- -- -- Issuance of common stock and assumption of stock options in connection with acquisition,(net of forfeitures) 5.0 0.5 249.7 -- Amortization of unearned restricted stock compensation -- -- -- -- Income tax benefit from stock options exercised -- -- 16.0 -- ----- ----- ------- ------ BALANCE AT DECEMBER 31, 2002 147.8 14.8 1,406.5 266.1 Comprehensive earnings: Net earnings -- -- -- 321.0 Other comprehensive loss: Foreign currency translation adjustments -- -- -- -- Minimum pension liability adjustment -- -- -- -- Tax effect of other comprehensive loss adjustments -- -- -- -- Comprehensive earnings Issuance of common stock 1.1 0.1 21.3 -- Issuance of restricted stock awards -- -- 0.2 -- Cancellation of restricted stock awards -- -- (1.1) -- Amortization of unearned restricted stock compensation -- -- -- -- Income tax benefit from stock options exercised -- -- 5.5 -- Assumption of vested stock options in connection with acquisition -- -- 8.5 -- Purchase of common stock -- -- -- -- ----- ------ -------- -------- BALANCE AT DECEMBER 31, 2003 148.9 $ 14.9 $1,440.9 $ 587.1 ===== ====== ======== ======== LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (Dollars in Millions) Unearned Accumulated Restricted Other Total Treasury Stock Comprehensive Shareholders' Stock Compensation Earnings(Loss) Equity -------- ------------ -------------- ---------- BALANCE AT DECEMBER 31, 2000 $ -- $ (9.4) $ (0.4) $ 877.4 Comprehensive earnings(loss): Net earnings -- -- -- 179.5 Other comprehensive loss: Cumulative effect of change in accounting principle (net-of-tax of $0.4) -- -- 0.6 0.6 Unrealized derivative loss on cash flow hedge -- -- (9.5) (9.5) Termination of interest rate swap agreement -- -- 8.9 8.9 Foreign currency translation adjustments -- -- (0.6) (0.6) Minimum pension liability adjustment -- -- (7.8) (7.8) ----- Comprehensive earnings(loss) 171.1 Issuance of common stock -- -- -- 15.0 Issuance of restricted stock awards -- (11.3) -- -- Amortization of unearned restricted stock compensation -- 7.5 -- 7.5 Income tax benefit from stock options exercised -- -- -- 14.4 ------ ------ ------ ------- BALANCE AT DECEMBER 31, 2001 -- (13.2) (8.8) 1,085.4 Comprehensive earnings(loss): Net earnings -- -- -- 254.6 Other comprehensive loss: Foreign currency translation adjustments -- -- 2.3 2.3 Minimum pension liability adjustment -- -- (43.2) (43.2) Tax effect of other comprehensive loss adjustments -- -- 19.8 19.8 ------- Comprehensive earnings 233.5 Issuance of common stock -- -- -- 18.3 Issuance of restricted stock awards -- (40.9) -- -- Surrender of restricted stock awards (4.4) -- -- (4.4) Issuance of common stock and assumption of stock options in connection with acquisition, (net of forfeitures) -- (1.6) -- 248.6 Amortization of unearned restricted stock compensation -- 14.3 -- 14.3 Income tax benefit from stock options exercised -- -- -- 16.0 ------ ------ ------ ------- BALANCE AT DECEMBER 31, 2002 (4.4) (41.4) (29.9) 1,611.7 Comprehensive earnings: Net earnings -- -- -- 321.0 Other comprehensive loss: Foreign currency translation adjustments -- -- 87.8 87.8 Minimum pension liability adjustment -- -- 19.6 19.6 Tax effect of other comprehensive loss adjustments -- -- (42.8) (42.8) ------- Comprehensive earnings 385.6 Issuance of common stock -- -- -- 22.5 Issuance of restricted stock awards -- (0.2) -- -- Cancellation of restricted stock awards -- 1.1 -- -- Amortization of unearned restricted stock compensation -- 18.1 -- 18.1 Income tax benefit from stock options exercised -- -- -- 5.5 Assumption of vested stock options in connection with acquisition -- -- -- 8.5 Purchase of common stock (154.9) -- -- (154.9) -------- -------- -------- -------- BALANCE AT DECEMBER 31, 2003 $ (159.3) $ (22.4) $ 34.7 $1,895.9 ======== ======== ======== ======== The accompanying notes are an integral part of these consolidated financial statements. LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in Millions) Years Ended December 31, ------------------------------ 2003 2002 2001 ------------------------------ CASH FLOWS FROM OPERATING ACTIVITIES: Net earnings $ 321.0 $ 254.6 $ 179.5 Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation and amortization 135.6 101.8 104.0 Stock compensation 18.1 14.3 7.5 Loss on sale of assets 0.2 0.6 1.8 Accreted interest on zero coupon- subordinated notes 10.3 10.1 3.0 Loss on early debt termination -- -- 5.5 Termination of interest rate swap agreement -- -- 8.9 Cumulative earnings in excess of distribution from equity affiliates (5.7) -- -- Deferred income taxes 86.3 28.9 1.6 Change in assets and liabilities (net of effects of acquisitions): Decrease (increase) in accounts receivable, net (6.0) 11.1 16.2 Increase in inventories (0.1) (1.5) (3.6) Decrease (increase) in prepaid expenses and other (8.5) (12.5) 5.8 (Decrease) increase in accounts payable (15.6) (7.8) (3.4) Increase (decrease) in accrued expenses and other 28.7 45.3 (10.8) ------- ------- ------- Net cash provided by operating activities 564.3 444.9 316.0 ------- ------- ------- CASH FLOWS FROM INVESTING ACTIVITIES: Capital expenditures (83.6) (74.3) (88.1) Proceeds from sale of assets 1.0 1.8 4.4 Deferred payments on acquisitions (17.7) (21.0) (18.6) Proceeds from sale of marketable securities 50.4 -- -- Distributions from equity affiliates in excess of cumulative earnings 1.9 1.5 -- Acquisition of licensing technology (15.0) (15.0) -- Acquisition of businesses, net of cash acquired (647.5) (261.9) (127.7) ------- ------- ------- Net cash used for investing activities $ (710.5) $ (368.9) $ (230.0) ------- ------- ------- (continued) LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in Millions) Years Ended December 31, ----------------------------------- 2003 2002 2001 ----------------------------------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from bridge loan $ 350.0 $ -- $ -- Payments on bridge loan (350.0) -- -- Proceeds from credit facilities 275.0 330.0 75.0 Payments on credit facilities (275.0) (330.0) (75.0) Proceeds from senior note offering 350.0 -- -- Proceeds from zero coupon-subordinated notes -- -- 499.8 Payments on other long-term debt (0.7) (204.6) (478.5) Payment of debt issuance costs (7.3) (3.2) (11.2) Termination of interest rate swap agreement 5.3 19.6 (8.9) Payments on long-term lease obligations (1.1) (1.1) (1.1) Purchase of common stock (154.9) -- -- Net proceeds from issuance of stock to employees 21.0 18.2 14.9 ------- ------- ------- Net cash provided by (used for) financing activities 212.3 (171.1) 15.0 ------- ------- ------- Effect of exchange rate changes on cash and cash equivalents 0.5 2.3 (0.6) ------- ------- ------- Net (decrease) increase in cash and cash equivalents 66.6 (92.8) 100.4 Cash and cash equivalents at beginning of period 56.4 149.2 48.8 ------- ------- ------- Cash and cash equivalents at end of period $ 123.0 $ 56.4 $ 149.2 ======= ======= ======= Supplemental schedule of cash flow information: Cash paid during the period for: Interest $ 12.1 $ 1.5 $ 23.2 Income taxes, net of refunds 107.9 135.0 127.7 Disclosure of non-cash financing and investing activities: Issuance of restricted stock awards 0.2 40.9 11.3 Assumption of vested stock options in connection with acquisition 8.5 5.0 -- Surrender of restricted stock awards -- 4.4 -- Issuance of common stock in acquisitions -- 245.6 -- The accompanying notes are an integral part of these consolidated financial statements. LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Financial Statement Presentation: Laboratory Corporation of America Holdings with its subsidiaries (the "Company") is the second largest independent clinical laboratory company in the United States based on 2003 net revenues. Through a national network of laboratories, the Company offers a broad range of testing services used by the medical profession in routine testing, patient diagnosis, and in the monitoring and treatment of disease. In addition, the Company has developed specialty and niche businesses based on certain types of specialized testing capabilities and client requirements, such as oncology testing, HIV genotyping and phenotyping, diagnostic genetics and clinical research trials. Since its founding in 1971, the Company has grown into a network of 31 primary testing facilities and over 1,200 service sites consisting of branches, patient service centers and STAT laboratories. With approximately 23,000 employees, the Company processes tests on more than 340,000 patient specimens daily and provides clinical laboratory testing services in all 50 states, the District of Columbia, Puerto Rico and two provinces in Canada. The Company operates in one business segment. The consolidated financial statements include the accounts of Laboratory Corporation of America Holdings and its subsidiaries after elimination of all material intercompany accounts and transactions. On January 17, 2003, the Company completed the acquisition of Dianon, a leading provider of anatomic pathology and oncology testing services. On July 25, 2002, the Company completed the acquisition of Dynacare, a provider of clinical laboratory testing services. Disclosure of certain business combination transactions is included in Notes 2, 3 and 4 - Business Acquisitions. The financial statements of the Company's foreign subsidiaries are measured using the local currency as the functional currency. Assets and liabilities are translated at exchange rates as of the balance sheet date. Revenues and expenses are translated at average monthly exchange rates prevailing during the year. Resulting translation adjustments are included in "Accumulated other comprehensive earnings(loss)". Cash Equivalents: Cash equivalents (primarily investments in money market funds, time deposits, commercial paper and Eurodollars which have original maturities of three months or less at the date of purchase) are carried at cost which approximates market. As a result of the Company's cash management system, checks issued but not presented to the banks for payment may create negative book cash balances. Such negative balances are included in trade accounts payable and totaled $17.7 and $23.1 at December 31, 2003 and 2002, respectively. LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) Inventories: Inventories, consisting primarily of purchased laboratory supplies, are stated at the lower of cost (first-in, first-out) or market. Derivative Financial Instruments: Interest rate swap agreements, which have been used by the Company from time to time in the management of interest rate exposure, are accounted for at fair value. Amounts to be paid or received under such agreements are recognized as interest income or expense in the periods in which they accrue. The Company's zero coupon-subordinated notes contain the following three features that are considered to be embedded derivative instruments under Statement of Financial Accounting Standards ("SFAS") No. 133 "Accounting for Derivative Instruments and Hedging Activities": 1) The Company will pay contingent cash interest on the zero coupon subordinated notes after September 11, 2006, if the average market price of the notes equals 120% or more of the sum of the issue price, accrued original issue discount and contingent additional principal, if any, for a specified measurement period. 2) Contingent additional principal will accrue on the zero coupon-subordinated notes during the two year period from September 11, 2004 to September 11, 2006, if the Company's stock price is at or below specified thresholds. 3) Holders may surrender zero coupon-subordinated notes for conversion during any period in which the rating assigned to the zero coupon-subordinated notes by Standard & Poor's Ratings Services is BB- or lower. Based upon independent appraisals, these embedded derivatives had no fair market value at December 31, 2003 and 2002. LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) Property, Plant and Equipment: Property, plant and equipment are recorded at cost. The cost of properties held under capital leases is equal to the lower of the net present value of the minimum lease payments or the fair value of the leased property at the inception of the lease. Depreciation and amortization expense is computed on all classes of assets based on their estimated useful lives, as indicated below, using principally the straight-line method. Years Buildings and building improvements 35 Machinery and equipment 3-10 Furniture and fixtures 5-10 Leasehold improvements and assets held under capital leases are amortized over the shorter of their estimated lives or the term of the related leases. Expenditures for repairs and maintenance are charged to operations as incurred. Retirements, sales and other disposals of assets are recorded by removing the cost and accumulated depreciation from the related accounts with any resulting gain or loss reflected in operations. Capitalized Software Costs: The Company capitalizes purchased software which is ready for service and capitalizes software development costs incurred on significant projects starting from the time that the preliminary project stage is completed and management commits to funding a project until the project is substantially complete and the software is ready for its intended use. Capitalized costs include direct material and service costs and payroll and payroll-related costs. Research and development costs and other computer software maintenance costs related to software development are expensed as incurred. Capitalized software costs are amortized using the straight-line method over the estimated useful life of the underlying system, generally five years. Debt Issuance Costs: The costs related to the issuance of debt are capitalized and amortized to interest expense using the effective interest method over the terms of the related debt. LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) Professional Liability: The Company is self-insured for professional liability claims arising in the normal course of business, generally related to the testing and reporting of laboratory test results. The Company records a reserve for such asserted and estimated unasserted claims based on actuarial assessments of future settlement and legal defense costs. Fair Value of Financial Instruments: The carrying amounts of cash and cash equivalents, accounts receivable, income taxes receivable and accounts payable are considered to be representative of their respective fair values due to their short-term nature. The fair market value of the zero coupon-subordinated notes, based on market pricing, was approximately $465.6 and $495.2 as of December 31, 2003 and 2002, respectively. Concentration of Credit Risk: Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash, cash equivalents and accounts receivable. The Company maintains cash and cash equivalents with various major financial institutions. The total cash balances on deposit that exceeded the balances insured by the F.D.I.C., were approximately $121.4 at December 31, 2003. Cash equivalents at December 31, 2003, totaled $93.9, which includes amounts invested in treasury bills and short-term bonds. Substantially all of the Company's accounts receivable are with companies and individuals in the health care industry. However, concentrations of credit risk are limited due to the number of the Company's clients as well as their dispersion across many different geographic regions. Accounts receivable balances (gross) from Medicare and Medicaid were $100.4 and $96.1 at December 31, 2003 and 2002, respectively. LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) Revenue Recognition: Sales are recognized on the accrual basis at the time test results are reported, which approximates when services are provided. Services are provided to certain patients covered by various third-party payor programs including the Medicare and Medicaid programs. Billings for services under third-party payor programs are included in sales net of allowances for contractual discounts and allowances for differences between the amounts billed and estimated program payment amounts. Adjustments to the estimated payment amounts based on final settlement with the programs are recorded upon settlement as an adjustment to revenue. In 2003, 2002 and 2001, approximately 19%, 16%, and 16%, respectively of the Company's revenues were derived from tests performed for the beneficiaries of the Medicare and Medicaid programs. Under capitated agreements with managed care customers, the Company recognizes revenue based on a predetermined monthly contractual rate for each member of the managed care plan regardless of the number or cost of services provided by the Company. Income Taxes: The Company accounts for income taxes utilizing the asset and liability method. Under this method deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and for tax loss carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Future tax benefits, such as net operating loss carryforwards, are recognized to the extent that realization of such benefits is more likely than not. Stock Splits: On June 11, 2001, the Company effected a two-for-one stock split through the issuance of a stock dividend of one new share of common stock for each share of common stock held by shareholders of record on June 4, 2001. On May 10, 2002, the Company effected a two-for-one stock split through the issuance of a stock dividend of one new share of common stock for each share of common stock held by shareholders of record on May 3, 2002. All references to common stock, common shares outstanding, average number of common shares outstanding, stock options, restricted shares and per share amounts in the Consolidated Financial Statements and Notes to Consolidated Financial Statements have been restated to reflect common stock splits and the reverse split on a retroactive basis. LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) Stock Compensation Plans: The Company accounts for its employee stock option plans using the intrinsic method under APB Opinion No. 25 and related Interpretations. Accordingly, compensation for stock options is measured as the excess, if any, of the quoted market price of the Company's stock at the date of grant over the amount an employee must pay to acquire the stock. The Company's employee stock purchase plan is also accounted for under APB Opinion No. 25 and is treated as non- compensatory. The Company applies the provisions of APB Opinion No. 25 in accounting for its employee stock option and stock purchase plans and, accordingly, no compensation cost has been recognized for these plans in the financial statements. Had the Company determined compensation cost based on the fair value method as defined in SFAS No. 123, the impact on the Company's net earnings on a pro forma basis is indicated below: Years ended December 31, 2003 2002 2001 ------------------------------- Net earnings, as reported $ 321.0 $ 254.6 $ 179.5 Add: Stock-based compensation under APB 25 -- -- -- Deduct: Total stock-based compensation expense determined under fair value method for all awards, net of related tax effects (25.2) (20.7) (12.2) ------- ------- ------- Pro forma net income $ 295.8 $ 233.9 $ 167.3 ======= ======= ======= Basic earnings per common share As reported $ 2.23 $ 1.78 $ 1.29 Pro forma 2.05 1.64 1.20 Diluted earnings per common share As reported $ 2.22 $ 1.77 $ 1.27 Pro forma 2.04 1.62 1.18 The pro forma weighted average fair values at date of grant for options issued during 2003, 2002 and 2001 were $13.43, $23.50 and $19.72 respectively, and were estimated using the Black-Scholes option pricing model. Weighted average assumptions for the expected life in years, volatility and dividend yield were 7 years, .5, and 0% for each of the three years ended December 31, 2003. Interest rate assumptions were 3.2%, 3.0% and 4.3% for the years ended December 31, 2003, 2002 and 2001, respectively. Compensation cost for restricted stock awards is recorded by allocating their aggregate grant date fair value over their vesting period. LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) Earnings per Share: Basic earnings per share is computed by dividing net earnings, less preferred stock dividends and accretion, by the weighted average number of common shares outstanding. Diluted earnings per share is computed by dividing net earnings by the weighted average number of common shares outstanding plus potentially dilutive shares, as if they had been issued at the beginning of the period presented. Potentially dilutive common shares result primarily from the Company's restricted stock awards and outstanding stock options. The following represents a reconciliation of the weighted average shares used in the calculation of basic and diluted earnings per share: Years ended December 31, 2003 2002 2001 ----------------------------------------- Basic 143,969,177 142,791,247 138,837,750 Assumed conversion/exercise of: Stock options 449,439 584,259 1,116,399 Restricted stock awards 337,440 822,210 1,123,294 ----------- ----------- ----------- Diluted 144,756,056 144,197,716 141,077,443 =========== =========== =========== The following table summarizes the potential common shares not included in the computation of diluted earnings per share because their impact would have been antidilutive: December 31, 2003 2002 2001 -------------------------------- Stock Options 3,902,019 2,012,960 29,738 The Company's zero-coupon subordinated notes are contingently convertible into 9,977,634 shares of common stock and are not currently included in the diluted earnings per share calculation because these notes were not convertible according to their terms during 2003, 2002 and 2001. Use of Estimates: The preparation of financial statements in conformity with generally accepted accounting principles 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 reported periods. Significant estimates include the allowances for doubtful accounts and deferred tax assets, amortization lives for intangible assets and accruals for self-insurance reserves. The allowance for doubtful accounts is determined based on historical collection trends, the aging of accounts, current economic conditions and regulatory changes. Actual results could differ from those estimates. LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) Long-Lived Assets: Goodwill is evaluated for impairment by applying a fair value based test on an annual basis and more frequently if events or changes in circumstances indicate that the asset might be impaired. Long-lived assets, other than goodwill, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable. Recoverability of assets to be held and used is determined by the Company at the entity level by a comparison of the carrying amount of the assets to future undiscounted net cash flows before interest expense and income taxes expected to be generated by the assets. Impairment, if any, is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets (based on market prices in an active market or on discounted cash flows). Assets to be disposed of are reported at the lower of the carrying amount or fair value. The Company completed an annual impairment analysis of its indefinite lived assets, including goodwill, and has found no instances of impairment as of December 31, 2003. Intangible Assets: Prior to July 1, 2001, the cost of acquired businesses in excess of the fair value of net assets acquired was recorded as goodwill and amortized on the straight-line basis ranging from 20 to 40 years. Effective January 1, 2002, the Company adopted SFAS No. 142 "Goodwill and Other Intangible Assets". This standard requires that goodwill and other intangibles that are acquired in business combinations and that have indefinite useful lives are not to be amortized and are to be reviewed for impairment annually based on an assessment of fair value. Other intangibles (patents and technology, customer lists and non-compete agreements), are amortized on a straight-line basis over the expected periods to be benefited, such as legal life for patents and technology, 10 to 25 years for customer lists and contractual lives for non-compete agreements. With the adoption of SFAS No. 142, the Company reassessed the useful lives of these intangible assets and determined that no changes are currently necessary. Research and Development In August 2003, the Company formed a new, majority-owned subsidiary with a former owner of the Company's subsidiary, National Genetics Institute, Inc. In conjunction with the formation of this subsidiary, the principals entered into a two-year joint venture agreement whereby the Company will fund a total of $3.0 for research and development efforts to be conducted on behalf of the newly formed subsidiary. It is the Company's policy to expense all research and development costs when incurred. As of December 31, 2003, the Company had incurred approximately $0.3 in costs associated with this venture. LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) Reclassifications Certain amounts in the prior year's financial statements have been reclassified to conform with the current year presentation. 2. BUSINESS ACQUISITION - DIANON SYSTEMS, INC. On January 17, 2003, the Company completed the acquisition of all of the outstanding shares of DIANON Systems, Inc. (DIANON) for $47.50 per share in cash, or approximately $596.0 including transaction fees and expenses, and converted approximately 390,000 vested DIANON employee stock options into approximately 690,000 vested Company options valued at $8.5. The transaction total of approximately $604.5 was funded by a combination of cash on hand, borrowings under the Company's senior credit facilities and a bridge loan facility. DIANON is a leading provider of anatomic pathology and oncology testing services in the U.S. and had 2001 revenues of approximately $125.7. DIANON had approximately 1,100 employees at the closing date of the acquisition and processed more than 8,000 samples per day in one main testing facility and four regional labs. The acquisition of DIANON was accounted for under the purchase method of accounting. As such, the cost to acquire DIANON has been allocated to the assets and liabilities acquired based on estimated fair values as of the closing date. The consolidated financial statements include the results of operations of DIANON subsequent to the closing of the acquisition. The following table summarizes the Company's purchase price allocation related to the acquisition of DIANON based on the fair value of the assets acquired and liabilities assumed on the acquisition date. Fair Values as of January 17, 2003 ---------------- Current assets $ 87.7 Property, plant and equipment 28.3 Goodwill 355.5 Identifiable intangible assets 271.5 Other assets 3.0 -------- Total assets acquired 746.0 -------- Current liabilities $ 33.1 Other liabilities 108.4 -------- Total liabilities assumed 141.5 -------- Net assets acquired $ 604.5 ======== LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) As a result of this acquisition, the Company recorded an addition to non-deductible goodwill of approximately $355.5, an addition to customer lists of approximately $227.8 (expected period of benefit of 30 years, non-deductible for tax) and an addition to trade names of approximately $43.7 (expected period of benefit of 15 years, non-deductible for tax). The Company believes that the combined company is now in a position nationally to offer to both primary care physicians and specialists such as oncologists, urologists and gastroenterologists, the broadest range of leading-edge anatomic, genomic and clinical testing technology for the large and rapidly growing cancer diagnostic market. 3. BUSINESS ACQUISITION - DYNACARE INC. On July 25, 2002, the Company completed the acquisition of all of the outstanding stock of Dynacare Inc. in a combination cash and stock transaction with a combined value of approximately $496.4 including transaction costs. The Company also converted approximately 553,958 unvested Dynacare stock options into 297,013 unvested Company options to acquire shares of the Company at terms comparable to those under the predecessor Dynacare plan. This conversion of outstanding unvested options increased the non-cash consideration of the transaction by approximately $5.0 and resulted in the recording of initial deferred compensation of approximately $2.5. In conjunction with this acquisition, the Company repaid Dynacare's existing $204.4 of senior subordinated unsecured notes, including a call premium of approximately $7.0. The transaction was financed by issuing approximately 4.9 million shares of the Company's common stock, valued at approximately $245.6, assuming unvested Dynacare options valued at $5.0, and using $245.8 in available cash and the proceeds of a $150.0 bridge loan and borrowings of $50.0 under the Company's $300.0 senior credit facilities. The Company terminated a number of interest rate swap agreements related to Dynacare's existing senior subordinated unsecured notes. The $19.6 the Company received upon termination of these swap agreements was included in the estimated fair value of the net assets acquired as of July 25, 2002. Dynacare had 2001 revenues of approximately $238.0 and had approximately 6,300 employees at the closing date of the acquisition. Dynacare operated in 21 states and two provinces in Canada with 24 primary laboratories, 2 esoteric laboratories, 115 rapid response labs and 302 patient service centers. The acquisition of Dynacare was accounted for under the purchase method of accounting. As such, the cost to acquire Dynacare has been allocated to the assets and liabilities LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) acquired based on fair values as of the closing date. The consolidated financial statements include the results of operations of Dynacare subsequent to the closing of the acquisition. The following table summarizes the Company's purchase price allocation related to the acquisition of Dynacare based on the fair value of the assets acquired and liabilities assumed on the acquisition date. Fair Values as of July 25, 2002 ------------- Current assets $ 100.2 Property, plant and equipment 48.0 Goodwill 173.3 Identifiable intangible assets 52.5 Investment in equity affiliates 402.1 Other assets 23.2 Deferred compensation 2.5 ------- Total assets acquired 801.8 ------- Current liabilities 268.1 Long-term debt 12.9 Other liabilities 24.4 ------- Total liabilities assumed 305.4 ------- Net assets acquired $ 496.4 ======= As a result of this acquisition, the Company recorded an addition to non-deductible goodwill of approximately $173.3 and an addition to customer lists of approximately $52.5 (expected period of benefit of 15 years). The investments in equity affiliates include $341.7 of Canadian licenses (with an indefinite life and deductible for tax). The Company believes that the acquisition of Dynacare enhances its ability to provide health coverage in the United States and Canada by expanding its customer base and service capabilities. The Company believes that the price paid for the outstanding shares of Dynacare was competitive with market conditions existing at the time. The following unaudited pro forma combined financial information for the years ended December 31, 2003 and 2002 assumes that the DIANON and Dynacare, Inc. acquisitions which were closed by the Company on January 17, 2003 and July 25, 2002, respectively, were acquired on January 1, 2002: Years Ended December 31 2003 2002 -------------------- Net sales $2,947.4 $2,867.7 Net earnings 321.1 255.3 Diluted earnings per common share $ 2.22 1.73 LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) 4. BUSINESS ACQUISITIONS - OTHER On June 4, 2001, the Company completed the acquisition of Minneapolis-based Viro-Med Laboratories Inc. for approximately $31.7 in cash and contingent future payments of $12.0 ($3.7 and $7.9 earned and paid in 2002 and 2001, respectively) based upon attainment of specific earnings targets. Viro-Med's revenues for the year ended December 31, 2000 were approximately $25.2. On April 30, 2001, the Company completed the acquisition of all of the outstanding stock of Path Lab Holdings, Inc. (Path Lab), which is based in Portsmouth, New Hampshire for approximately $83.0 in cash and contingent future payments of $25.0 ($11.1 and $5.5 earned and paid in 2002 and 2001, respectively) based upon attainment of specific earnings targets. Path Lab's revenues for the year ended December 31, 2000 were approximately $51.6. 5. INVESTMENTS IN EQUITY AFFILIATES At December 31, 2003 (as a result of the Dynacare acquisition) the Company had investments in the following equity affiliates: Net Percentage Location Investment Interest Owned Milwaukee, Wisconsin $ 3.5 50.00% Ontario, Canada $ 452.6 72.99% Alberta, Canada $ 49.2 43.37% Each of the joint venture agreements that govern the conduct of business of these equity affiliates mandates unanimous agreement between partners on all major business decisions as well as providing other preemptive rights to each partner. These investments are accounted for under the equity method of accounting. The Company has no material obligations or guarantees to, or in support of, these unconsolidated joint ventures and their operations. Condensed financial information for the Ontario, Canada equity affiliate as of December 31, 2003 and for the period of January 1, 2003 through December 31, 2003 is as follows: Current assets $ 20.8 Other assets 99.2 ------- Total assets 120.0 ======= Total liabilities 14.5 Shareholders' equity 105.5 ------- Total liabilities and shareholders' equity $ 120.0 ======= Net sales $ 133.9 Gross profit $ 74.0 Net earnings $ 48.5 LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) 6. INTEGRATION OF DYNACARE AND DIANON During the third quarter of 2002, the Company finalized its plan related to the integration of Dynacare's U.S. operations into the Company's service delivery network. The plan focuses on reducing redundant facilities, while maintaining a focus on providing excellent customer service. A reduction in staffing will occur as the Company executes the integration plan and consolidates duplicate or overlapping functions and facilities. Employee groups being affected as a result of this plan include those involved in the collection and testing of specimens, as well as administrative and other support functions. In connection with the Dynacare integration plan, the Company recorded $14.6 of costs associated with the execution of the plan. The majority of these integration costs related to employee severance and contractual obligations associated with leased facilities and equipment. Of the total costs indicated above, $12.1 related to actions that impact the employees and operations of Dynacare, and was accounted for as a cost of the Dynacare acquisition and included in goodwill. Of the $12.1, $6.0 related to employee severance benefits for approximately 722 employees, with the remainder primarily related to contractual obligations associated with leased facilities and equipment. In addition, the Company recorded restructuring expense of $2.5, relating to integration costs of actions that impact the Company's existing employees and operations. Of this amount $1.0 related to employee severance benefits for approximately 78 employees, with the remainder primarily related to contractual obligations associated with leased facilities and equipment. The Company also recorded a special bad debt provision of approximately $15.0 related to the acquired Dynacare accounts receivable balance. This provision, based on Company experience, was made in anticipation of changes in staffing and collection procedures that will occur as the Company converts Dynacare customers to LabCorp's billing system and related customer service organization. In connection with the DIANON integration plan, the Company recorded $20.8 of costs associated with the execution of the plan. The majority of these integration costs related to contractual obligations associated with leased facilities and equipment ($12.7) and employee severance ($8.1). These costs were accounted for as costs of the DIANON acquisition. During the third and fourth quarters of 2003, the Company recorded a pre-tax restructuring charge totaling $6.4 in connection with the continuing integration of its recent acquisitions. Substantially all of this charge relates to the fair value of employee severance benefits for approximately 730 employees. The Company also recorded certain adjustments in the fourth quarter of 2003 to previously recorded restructuring charges due to changes in estimates, resulting in a net credit of approximately $4.9. LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) 7. RESTRUCTURING AND NON-RECURRING CHARGES The following represents the Company's restructuring activities for each of the years in the three years ended December 31, 2003: Lease and Severance Other Facility Costs Costs Total Balance at January 1, 2001 1.9 20.1 22.0 Reclassifications non-cash items (0.7) 0.2 (0.5) Cash payments (1.0) (4.5) (5.5) ------ ------ ------ Balance at December 31, 2001 0.2 15.8 16.0 Dynacare integration 7.0 7.6 14.6 Reclassifications non-cash items -- (1.2) (1.2) Cash payments (1.4) (1.9) (3.3) ------ ------ ------ Balance at December 31, 2002 5.8 20.3 26.1 Dianon integration 8.1 12.7 20.8 Restructuring charges 4.6 1.8 6.4 Restructuring adjustments (0.8) (4.1) (4.9) Cash payments (13.7) (3.9) (17.6) ------ ------ ------ Balance at December 31, 2003 4.0 26.8 30.8 ====== ====== ====== Current $ 15.0 Non-current 15.8 ------ $ 30.8 ====== 8. ACCOUNTS RECEIVABLE, NET December 31, December 31, 2003 2002 ------------ ------------ Gross accounts receivable $ 565.5 $ 536.2 Less allowance for doubtful accounts (133.1) (143.2) --------- --------- $ 432.5 $ 393.0 ========= ========= The provision for doubtful accounts was $214.2, $214.9 and $202.5 in 2003, 2002 and 2001 respectively. 9. PROPERTY, PLANT AND EQUIPMENT, NET December 31, December 31, 2003 2002 ------------ ------------ Land $ 15.3 $ 15.3 Buildings and building improvements 90.4 89.5 Machinery and equipment 473.5 409.7 Leasehold improvements 81.1 76.2 Furniture and fixtures 17.5 16.9 Construction in progress 28.4 30.0 Buildings under capital leases 5.4 5.4 Equipment under capital leases 2.2 3.8 -------- -------- 713.8 646.8 Less accumulated depreciation and amortization of capital lease assets (352.5) (295.6) -------- -------- $ 361.3 $ 351.2 ======== ======== LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) Depreciation expense and amortization of capital lease assets was $91.6, $73.0 and $59.6 for 2003, 2002 and 2001, respectively. 10. GOODWILL AND INTANGIBLE ASSETS Goodwill at December 31, 2003 and 2002 consisted of the following: 2003 2002 --------- --------- Goodwill $1,477.9 $1,102.1 Less: accumulated amortization (192.0) (192.0) ------- ------- Goodwill, net $1,285.9 $ 910.1 ======= ======= The changes in the gross carrying amount of goodwill for the years ended December 31, 2003 and 2002 are as follows: 2003 2002 --------- -------- Balance as of January 1 $1,102.1 $ 911.3 Goodwill acquired during the year 388.7 190.8 Adjustments to goodwill (12.9) -- ------- ------- Balance as of December 31 $1,477.9 $1,102.1 ======= ======= The components of identifiable intangible assets are as follows: December 31, 2003 December 31, 2002 ----------------------- ----------------------- Gross Gross Carrying Accumulated Carrying Accumulated Amount Amortization Amount Amortization ----------------------- ----------------------- Customer lists $ 582.5 $ 118.1 $ 338.4 $ 90.8 Patents, licenses And technology 67.2 11.1 55.2 6.0 Non-compete agreements 23.0 18.1 21.3 16.1 Trade name 49.6 3.6 5.9 0.5 ------- ------- ------- ------- $ 722.3 $ 150.9 $ 420.8 $ 113.4 ======= ======= ======= ======= Amortization of intangible assets was $37.6, $23.8 and $41.5 in 2003, 2002 and 2001, respectively. Amortization expense for the net carrying amount of intangible assets is estimated to be $41.0 in fiscal 2004, $40.3 in fiscal 2005, $38.9 in fiscal 2006, $37.4 in fiscal 2007, and $35.4 in fiscal 2008. The Company paid approximately $15.0 in 2003 and $15.0 in 2002 for certain exclusive and non-exclusive licensing rights to diagnostic testing technology. These amounts are being amortized over the life of the licensing agreement. LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) The following table presents net earnings and basic and diluted earnings per common share, adjusted to reflect results as if the non- amortization provisions of SFAS No. 142 had been in effect for the periods presented. December 31, ---------------------------------- 2003 2002 2001 ---------------------------------- Net earnings attributable to common shareholders $ 321.0 $ 254.6 $ 179.5 Add back: goodwill amortization, net of tax -- $ -- 25.0 ------ ------ ------ Adjusted net earnings attributable to common shareholders $ 321.0 $ 254.6 $ 204.5 ====== ====== ====== Basic earnings per share: Reported basic earnings per share $ 2.23 $ 1.78 $ 1.29 Add back: goodwill amortization, net of tax -- -- 0.18 ------ ------ ------ Adjusted basic earnings per share $ 2.23 $ 1.78 $ 1.47 ====== ====== ====== Diluted earnings per share: Reported diluted earnings per share $ 2.22 $ 1.77 $ 1.27 Add back: goodwill amortization, net of tax -- -- 0.18 ------ ------ ------ Adjusted diluted earnings per share $ 2.22 $ 1.77 $ 1.45 ====== ====== ====== 11. ACCRUED EXPENSES AND OTHER December 31, December 31, 2003 2002 ------------ ------------ Employee compensation and benefits $ 60.6 $ 60.8 Acquisition related accruals 7.1 15.5 Restructuring reserves 15.0 10.0 Accrued taxes payable(receivable) (2.6) (19.6) Other tax accruals 28.8 26.0 Self-insurance reserves 34.1 28.5 Interest payable 8.4 0.8 Swap payable -- 10.9 Royalty payable 5.0 6.0 Other 4.7 7.2 ------- ------- $ 161.1 $ 146.1 ======= ======= 12. OTHER LIABILITIES December 31, December 31, 2003 2002 ------------ ------------ Acquisition related accruals $ 1.3 $ 2.0 Restructuring reserves 15.8 16.1 Minimum pension liability 37.0 56.6 Post-retirement benefit obligation 45.0 42.9 Self-insurance reserves 17.9 20.9 Other 10.3 3.0 ------- ------- $ 127.3 $ 141.5 ======= ======= LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) 13. ZERO COUPON-SUBORDINATED NOTES In September 2001, the Company sold $650.0 aggregate principal amount at maturity of its zero coupon convertible subordinated notes (the "notes") due 2021 in a private placement. The Company received approximately $426.8 (net of underwriter's fees of approximately $9.8) in net proceeds from the offering. In October 2001, the underwriters exercised their rights to purchase an additional $94.0 aggregate principal amount pursuant to an overallotment option from which the Company received approximately $61.8 in net proceeds (net of underwriters fees of approximately $1.4). The notes, which are subordinate to the Company's bank debt, were sold at an issue price of $671.65 per $1,000 principal amount at maturity (representing a yield to maturity of 2.0% per year). Each one thousand dollar principal amount at maturity of the notes is convertible into 13.4108 shares of the Company's common stock, subject to adjustment in certain circumstances, if one of the following conditions occurs: 1) If the sales price of the Company's common stock for at least 20 trading days in a period of 30 consecutive trading days ending on the last trading day of the preceding quarter reaches specified thresholds (beginning at 120% and declining 0.1282% per quarter until it reaches approximately 110% for the quarter beginning July 1, 2021 of the accreted conversion price per share of common stock on the last day of the preceding quarter). The accreted conversion price per share will equal the issue price of a note plus the accrued original issue discount and any accrued contingent additional principal, divided by the number of shares of common stock issuable upon conversion of a note on that day. The conversion trigger price for the fourth quarter of 2003 was approximately $62.14. 2) If the credit rating assigned to the notes by Standard & Poor's Ratings Services is at or below BB-. 3) If the notes are called for redemption. 4) If specified corporate transactions have occurred (such as if the Company is party to a consolidation, merger or binding share exchange or a transfer of all or substantially all of its assets). Holders of the notes may require the Company to purchase all or a portion of their notes on September 11, 2004, 2006 and 2011 at prices ranging from $712.97 to $819.54, plus any accrued contingent additional principal and any accrued contingent interest thereon. The Company may choose to pay the purchase price in cash, common stock or a combination of cash and common stock. If the holders elect to require the Company to purchase their notes it is the Company's current intention to retire the notes by a cash payment. LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) The Company may redeem for cash all or a portion of the notes at any time on or after September 11, 2006 at specified redemption prices per one thousand dollar principal amount at maturity of the notes ranging from $741.92 at September 11, 2006 to $1,000.00 at September 11, 2021 (assuming no contingent additional principal accrues on the notes). The Company used a portion of the proceeds to repay $412.5 of its term loan outstanding under its credit agreement and to pay $8.9 to terminate the interest rate swap agreement tied to the Company's term loan. The Company recorded a loss of $5.5 relating to the write-off of unamortized bank fees associated with the Company's term debt. The Company has registered the notes and the shares of common stock issuable upon conversion of the notes with the Securities and Exchange Commission. 14. LONG-TERM DEBT In February 2002, the Company entered into two senior credit facilities with Credit Suisse First Boston, acting as Administrative Agent, and a group of financial institutions totaling $300.0. The senior credit facilities consisted of a 364-day revolving credit facility in the principal amount of $100.0 and a three-year revolving credit facility in the principal amount of $200.0. Based upon the Company's rating as of December 31, 2003, the effective rate under the $200.0 and $100.0 facilities was LIBOR plus 82.5 basis points and LIBOR plus 87.5 basis points, respectively. There were no balances outstanding on the Company's senior credit facilities at December 31, 2003 and 2002. On January 13, 2004, the Company entered into a new $150.0 364-day revolving credit facility with Credit Suisse First Boston, acting as Administrative Agent, and a group of financial institutions to replace the existing $150.0 364-day revolving credit facility, which had terminated. The $200.0 three-year revolving credit facility was amended on January 14, 2003 and expires on February 18, 2005. These credit facilities bear interest at varying rates based upon the Company's credit rating with Standard & Poor's Ratings Services. The senior credit facilities are available for general corporate purposes, including working capital, capital expenditures, funding of share repurchases and other payments, and acquisitions. The agreements contain certain debt covenants which require that the Company maintain leverage and interest coverage ratios of 2.5 to 1.0 and 5.0 to 1.0, respectively. The Company is in compliance with all covenants. On July 24, 2002, in conjunction with the acquisition of Dynacare, the Company borrowed $150.0 under the Dynacare Bridge Loan Agreement, which had an original maturity date of July 23, 2003. On November 29, 2002, the Company repaid all outstanding balances under the Dynacare Bridge Loan, and as a result, the loan was terminated. LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) On January 17, 2003, in conjunction with the acquisition of DIANON, the Company borrowed $350.0 under the DIANON Bridge Loan Agreement with Credit Suisse First Boston, acting as Administrative Agent. On January 31, 2003, the Company sold $350.0 aggregate principal amount of its 5 1/2% Senior Notes due February 1, 2013. Proceeds from the issuance of these Notes ($345.1), together with cash on hand was used to repay the $350.0 principal amount of the Company's bridge loan facility, and as a result, the loan was terminated. 15. STOCK REPURCHASE PROGRAM On October 22, 2002, the Company's Board of Directors authorized a stock repurchase program under which the Company may purchase up to an aggregate of $150.0 of its common stock from time-to-time. During the third quarter of 2003, the Company completed this program purchasing approximately 5.2 million shares of its common stock totaling approximately $150.0 with cash flow from operations. On December 17, 2003, the Company's Board of Directors authorized a stock repurchase program under which the Company may purchase up to an aggregate of $250.0 of its common stock from time-to-time, beginning in the first quarter of 2004. It is the Company's intention to fund future purchases of its common stock with cash flow from operations. 16. STOCKHOLDER RIGHTS PLAN The Company adopted a stockholder rights plan effective as of December 13, 2001 that provides that each common stockholder of record on December 21, 2001 received a dividend of one right for each share of common stock held. Each right entitles the holder to purchase from the Company one-hundredth of a share of a new series of participating preferred stock at an initial purchase price of four hundred dollars. These rights will become exercisable and will detach from the Company's common stock if any person becomes the beneficial owner of 15% or more of the Company's common stock. In that event, each right will entitle the holder, other than the acquiring person, to purchase, for the initial purchase price, shares of the Company's common stock having a value of twice the initial purchase price. The rights will expire on December 13, 2011, unless earlier exchanged or redeemed. 17. INTEREST RATE SWAP AGREEMENTS In the second quarter of 2003 the Company terminated its interest rate swap agreement with a major financial institution and received net proceeds of $5.3 of which $1.4 was credited to interest expense and a gain of $3.9 was deferred and is being amortized to interest expense through 2013. LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) In the third quarter of 2001, in conjunction with the early retirement of its long-term debt, the Company terminated its interest rate swap agreement with a bank by making a settlement payment of $8.9 with a portion of the proceeds from the sale of zero coupon- subordinated notes. In accordance with the provisions of SFAS No. 133, as amended, this interest rate swap agreement had been designated as a cash flow hedge and carried on the balance sheet at fair value with a corresponding offset in accumulated other comprehensive loss. 18. INCOME TAXES The sources of income before taxes, classified between domestic and foreign entities are as follows: Pre-tax income: 2003 2002 2001 -------- -------- -------- Domestic $ 545.3 $ 440.6 $ 336.6 Foreign (4.9) (8.3) (4.3) ------ ------ ------ Total pre-tax income $ 540.4 $ 432.3 $ 332.3 ====== ====== ====== The provisions for income taxes in the accompanying consolidated statements of operations consist of the following: Years Ended December 31, ---------------------------- 2003 2002 2001 ---------------------------- Current: Federal $ 104.2 $ 118.0 $122.8 State 29.2 28.4 25.2 Foreign (0.3) 2.4 -- ------ ------ ------ $ 133.1 $ 148.8 $ 148.0 ------ ------ ------ Deferred: Federal $ 70.0 $ 26.0 $ (2.3) State 13.8 4.7 3.9 Foreign 2.5 (1.8) -- ------ ------ ------ 86.3 28.9 1.6 ------ ------ ------ $ 219.4 $ 177.7 $ 149.6 ====== ====== ====== The tax benefit associated with option exercises from stock plans reduced taxes currently payable by approximately $5.5, $16.0 and $14.4 in 2003, 2002 and 2001, respectively. Such benefits are recorded as additional paid-in-capital. The effective tax rates on earnings before income taxes is reconciled to statutory federal income tax rates as follows: Years Ended December 31, ------------------------------ 2003 2002 2001 ------------------------------ Statutory federal rate 35.0% 35.0% 35.0% State and local income taxes, net of federal income tax effect 4.5 4.5 4.9 Non-deductible amortization of intangible assets -- -- 2.3 Change in valuation allowance -- (0.4) -- Other 1.1 2.0 2.8 ----- ----- ----- Effective rate 40.6% 41.1% 45.0% ===== ===== ===== LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities are as follows: December 31, December 31, 2003 2002 ------------ ------------ Deferred tax assets: Accounts receivable $ 12.5 $ 36.2 Self-insurance reserves 17.3 18.8 Postretirement benefit obligation 17.8 17.0 Acquisition and restructuring reserves 22.7 17.5 Tax loss carryforwards 18.2 6.8 Employee benefits 13.1 26.0 Other (1.1) 8.0 -------- -------- 100.5 130.3 Less valuation allowance (2.7) (2.8) -------- -------- Net deferred tax assets 97.8 127.5 -------- -------- Deferred tax liabilities: Deferred earnings (12.1) (9.6) Intangible assets (221.0) (88.5) Property, plant and equipment (46.3) (34.8) Zero coupon-subordinated notes (33.6) (18.1) Currency translation adjustment (35.5) -- Other (3.6) 1.3 -------- -------- Total gross deferred tax liabilities (352.1) (149.7) -------- -------- Net deferred tax liabilities $ (254.3) $ (22.2) ======== ======== Based upon the realization of certain capital loss carryforwards, the Company reduced its valuation allowance applied against its deferred tax assets by approximately $1.7 during the second quarter of 2002. The current valuation allowance brings the Company's net deferred tax assets to a level where management believes it is more likely than not the tax benefits will be realized. The Company's effective tax rate was reduced due to a $2.1 state tax recovery in the third quarter of 2003. The Company has been notified its 2001 and 2002 income tax returns will be examined by the the Internal Revenue Service. In addition, the Internal Revenue Service has concluded its examination of the Company's 2000, 1999 and 1998 income tax returns and has issued a report of its findings. While the Company will appeal certain issues of the examination, management believes adequate provisions have been recorded relating to the concluded examination. The Company has state tax loss carryforwards of approximately $19.6 which expire 2004 through 2018. In addition, as a result of the Dynacare, Inc. acquisition, the Company has federal tax loss carryovers of approximately $15.6 expiring periodically through 2021. The Company provided for taxes on undistributed earnings of foreign subsidiaries. LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) 19. STOCK COMPENSATION PLANS In May 2000, the shareholders approved the 2000 Stock Incentive Plan, authorizing 6.8 million shares for issuance under the plan plus the remaining shares available from the Amended and Restated 1999 Stock Incentive Plan and the 1994 Stock Option Plan (the "Prior Plans"). The effect was to increase to 11.68 million, the number of shares available under the 2000 Stock Incentive Plan and Prior Plans. In May 2002, the shareholders approved an amendment to the 2000 Stock Incentive Plan authorizing an additional 8.0 million shares. The effect was to increase to an aggregate of 19.68 million shares for issuance under the 2000 Stock Incentive Plan. On January 17, 2003, the Company converted approximately 378,422 vested Dianon stock options into 669,614 vested Company options to acquire shares of the Company at terms comparable to those under the predecessor Dianon plan. The Company is not expecting to make further grants from this plan. During 2003, there were 2,433,540 options granted to officers and key employees of the Company (which include 669,614 options assumed upon the acquisition of Dianon). The exercise price for these options ranged from $1.84 to $35.93 per share. Also, during 2003, two grants of restricted stock, for an aggregate of 19,559 shares were awarded to members of the Company's Board of Directors under the 2000 Stock Incentive Plan at market values on the dates of grant of $30.36 and $31.35. Restrictions limit the sale or transfer of these shares during a six-year vesting period when the restrictions lapse. Upon issuance of stock in 2003 under the 2000 Incentive Plan, unearned compensation of $0.2 was recorded as additional paid-in capital and an equivalent amount was charged to shareholders' equity as unearned restricted stock compensation. The plan provides for accelerated vesting of outstanding restricted shares in percentages of 33.3%, 66.7% or 100%, if certain predefined two-year profitability targets are achieved as of December 31, 2003 or certain three-year profitability targets are achieved as of December 31, 2004. The unearned restricted stock compensation is being amortized to expense over the applicable vesting periods. For 2003, 2002 and 2001, total restricted stock compensation expense was $18.1, $14.3 and $7.5, respectively. Total restricted shares granted in 2002 and 2001 were 966,408 and 348,488, respectively. At December 31, 2003, there were 6,843,687 additional shares available for grant under the Company's stock option plans. LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) The Company has an employee stock purchase plan, begun in 1997 and amended in 1999, with 3,000,000 shares of common stock authorized for issuance. The plan permits substantially all employees to purchase a limited number of shares of Company stock at 85% of market value. The Company issues shares to participating employees semi-annually in January and July of each year. A summary of shares issued is as follows: 2001 2002 2003 2004 ------- ------- ------- ------- January 102,627 73,514 149,020 133,431 July 61,752 75,446 140,524 Pro forma compensation expense is calculated for the fair value of the employee's purchase right using the Black-Scholes model. Assumptions include a weighted average life of approximately one-half year, dividend yield of 0%, risk free interest rates for each six month period as follows: 2003 - 1.3% and 0.9%; 2002 - 1.8% and 1.8% and 2001 - 5.8% and 3.5% and volatility rates for each of the following six month periods: 2003 - .3 and .2; 2002 - .2 and .8 and 2001 - .4 and .3. The per share weighted average grant date fair value of the benefits under the employee stock purchase plan for the first and second six-month periods is as follows: 2003 2002 2001 ------ ------ ------ First six months $ 6.98 $11.87 $11.51 Second six months $ 8.67 $18.21 $ 8.79 The following table summarizes grants of non-qualified options made by the Company to officers and key employees under all plans. Stock options are generally granted at an exercise price equal to or greater than the fair market price per share on the date of grant. Also, for each grant, options vest ratably over a period of two to three years on the anniversaries of the grant date, subject to their earlier expiration or termination. LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) Changes in options outstanding under the plans for the periods indicated were as follows: Weighted-Average Number Exercise Price of Options per Option ----------- ----------------- Outstanding at January 1, 2001 3,130,752 $14.426 (671,835 exercisable) Options granted 2,094,976 $33.069 Forfeited (197,922) $21.828 Exercised (1,121,872) $ 9.967 --------- Outstanding at December 31, 2001 3,905,934 $25.331 (729,504 exercisable) Options granted at market value 2,186,818 $42.524 Granted above market value 77,750 $28.910 Granted below market value 199,240 $18.626 Forfeited (316,568) $29.902 Exercised (697,394) $18.976 --------- Outstanding at December 31, 2002 5,355,780 $32.711 (1,326,120 exercisable) Options granted at market value 1,763,926 $24.967 Granted above market value 632,410 $30.343 Granted below market value 37,204 $13.120 Forfeited (436,685) $20.444 Exercised (747,202) $20.444 --------- Outstanding at December 31, 2003 6,605,433 $31.805 ========= Exercisable at December 31, 2003 2,811,938 $30.878 ========= Options issued above or below market value during 2003 and 2002 were issued in conjunction with the acquisitions of DIANON and Dynacare. The weighted-average remaining life of options outstanding at December 31, 2003 is approximately 7.8 years. LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) The following table summarizes information concerning currently outstanding and exercisable options. OPTIONS OUTSTANDING OPTIONS EXERCISABLE --------------------------------------------------- ----------------------- Weighted Average Weighted Weighted Remaining Average Average Range of Number Contractual Exercise Number Exercise Exercise Prices Outstanding Life Price Exercisable Price $ 1.84 - 24.24 556,165 5.56 $13.643 494,285 $13.033 $24.46 - 32.50 2,304,648 8.48 $25.747 552,951 $28.046 $33.06 - 37.90 1,702,454 7.12 $33.127 1,078,994 $33.124 $39.34 - 48.02 2,042,166 8.10 $42.485 685,708 $42.492 --------- --------- 6,605,433 2,811,938 ========= ========= 20. RELATED PARTY TRANSACTIONS On February 21, 2002, the Company filed a registration statement on Form S-3, relating to the sale by Roche of 7,000,000 shares of the Company's common stock, with a 700,000 share over-allotment option. At that time, Roche owned 10,705,074 shares of common stock (approximately 15.13% of the common stock then outstanding). On March 12, 2002, Roche sold 7,000,000 shares of common stock and on March 18, 2002, an additional 700,000 shares of common stock were sold to cover over-allotments of shares leaving Roche with 3,005,074 shares of the Company's outstanding common stock, or approximately 4.22% at March 31, 2002. Roche entered into a number of call option contracts with respect to the remaining 3,005,074 shares of the Company's common stock it owned at March 31, 2002, which were not covered by the registration statement. The Company has been informed that each of these call option contracts was exercised in full by July 2002, and as a result, Roche no longer owns any shares of the Company's common stock. The Company purchased certain items, primarily laboratory testing supplies from various affiliates of Roche Holdings, Inc. ("Roche"). Total purchases from these affiliates, which are recorded in cost of sales, were $55.2 and $62.3 in 2002 and 2001, respectively. In addition, the Company made royalty payments to Roche for diagnostic technology in the amounts of $4.7 in 2002 and $4.4 in 2001. Amounts due to Roche and its affiliates at December 31, 2002 were $3.3. Revenue received from Roche for laboratory services was $1.4 in 2002 and $2.6 in 2001. Amounts due from Roche and its affiliates at December 31, 2002 were $0.6. LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) 21. COMMITMENTS AND CONTINGENT LIABILITIES The Company is involved in litigation purporting to be a nation-wide class action involving the alleged overbilling of patients who are covered by private insurance. The Company has reached a settlement with the class that will not materially differ from accruals previously established or have a material adverse effect on the Company. The Company has now substantially implemented its obligations under the settlement. On January 9, 2001, the Company was served with a complaint in North Carolina which purported to be a class action and made claims similar to those referred to above. That claim has now been dismissed with prejudice. On June 24, 2003, the Company and certain of its executive officers were sued in the United States District Court for the Middle District of North Carolina in the first of a series of putative shareholder class actions alleging securities fraud. Since that date, at least five other complaints containing substantially identical allegations have been filed against the Company and certain of the Company's executive officers. Each of the complaints alleges that the defendants violated the federal securities laws by making material misstatements and/or omissions that caused the price of the Company's stock to be artificially inflated between February 13 and October 3, 2002. The plaintiffs seek certification of a class of substantially all persons who purchased shares of the Company's stock during that time period and unspecified monetary damages. These six cases have been consolidated and will proceed as a single case. The defendants deny any liability and intend to defend the case vigorously. At this time, it is premature to make any assessment of the potential outcome of the cases or whether they could have a material adverse effect on the Company's financial condition. The Company is the appellant in a patent case originally filed in the United States District Court for the District of Colorado. The Company has disputed liability and contested the case vigorously. After a jury trial, the district court entered judgment against the Company for patent infringement. The Company appealed the case to the United States Court of Appeals for the Federal Circuit. The Company has received a letter from its counsel dated February 6, 2004, stating "it remains our opinion that the amended judgment and order will be reversed on appeal." The Company is a party to two lawsuits involving Chiron Inc. relating to Hepatitis C and HIV testing. Chiron asserts that the Company has infringed on Chiron's patents in each of these areas. The Company denies liability and intends to contest the suits vigorously. It is premature at this juncture to assess the likely outcome of these matters, or to determine whether they will have a material effect on the Company. LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) The Company is also involved in various claims and legal actions arising in the ordinary course of business. These matters include, but are not limited to, intellectual property disputes, professional liability, employee related matters, and inquiries from governmental agencies and Medicare or Medicaid payors and managed care payors requesting comment on allegations of billing irregularities that are brought to their attention through billing audits or third parties. In the opinion of management, based upon the advice of counsel and consideration of all facts available at this time, the ultimate disposition of these matters is not expected to have a material adverse effect on the financial position, results of operations or liquidity of the Company. The Company is also named from time to time in suits brought under the qui tam provisions of the False Claims Act. These suits typically allege that the Company has made false statements and/or certifications in connection with claims for payment from federal health care programs. They may remain under seal (hence, unknown to the Company) for some time while the government decides whether to intervene on behalf of the qui tam plaintiff. Such claims are an inevitable part of doing business in the health care field today and, in the opinion of management, based upon the advice of counsel and consideration of all facts available at this time, the ultimate disposition of those qui tam matters presently known to the Company is not expected to have a material adverse effect on the financial position, results of operations or liquidity of the Company. The Company believes that it is in compliance in all material respects with all statutes, regulations and other requirements applicable to its clinical laboratory operations. The clinical laboratory testing industry is, however, subject to extensive regulation, and many of these statutes and regulations have not been interpreted by the courts. There can be no assurance therefore that applicable statutes and regulations might not be interpreted or applied by a prosecutorial, regulatory or judicial authority in a manner that would adversely affect the Company. Potential sanctions for violation of these statutes and regulations include significant fines and the loss of various licenses, certificates and authorizations. Under the Company's present insurance programs, coverage is obtained for catastrophic exposures as well as those risks required to be insured by law or contract. The Company is responsible for the uninsured portion of losses related primarily to general, professional and vehicle liability, certain medical costs and workers' compensation. The self- insured retentions are on a per occurrence basis without any aggregate annual limit. Provisions for losses expected under these programs are recorded based upon the Company's estimates of the aggregated liability of claims incurred. At December 31, 2003 and 2002, the Company had provided letters of credit aggregating approximately $57.1 and $45.6 respectively, primarily in connection with certain insurance programs. LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) The Company leases various facilities and equipment under non- cancelable lease arrangements. Future minimum rental commitments for leases with noncancellable terms of one year or more at December 31, 2004 are as follows: Operating Capital --------- --------- 2004 $ 55.4 $ 3.5 2005 42.4 2.8 2006 29.7 2.9 2007 20.3 1.2 2008 13.8 -- Thereafter 25.3 -- ----- ----- Total minimum lease payments 186.9 10.4 Less: Amounts included in restructuring accruals -- 2.6 Amount representing interest -- 2.1 ----- ----- Total minimum operating lease payments and present value of minimum capital lease payments $186.9 $ 5.7 ===== ===== Current $ 1.3 Non-current 4.4 ----- $ 5.7 ===== Rental expense, which includes rent for real estate, equipment and automobiles under operating leases, amounted to $104.2, $86.1 and $74.8 for the years ended December 31, 2003, 2002 and 2001, respectively. 22. PENSION AND POSTRETIREMENT PLANS The Company maintains a defined contribution pension plan for all eligible employees. Eligible employees are defined as individuals who are age 21 or older, have been employed by the Company for at least six consecutive months and have completed 1,000 hours of service. Company contributions to the plan are based on a percentage of employee contributions. The cost of this plan was $10.9, $8.5 and $8.3 in 2003, 2002 and 2001, respectively. In addition, substantially all employees of the Company are covered by a defined benefit retirement plan (the "Company Plan"). The benefits to be paid under the Company Plan are based on years of credited service and average final compensation. The Company's policy is to fund the Company Plan with at least the minimum amount required by applicable regulations. The Company has a second defined benefit plan which covers its senior management group that provides for the payment of the difference, if any, between the amount of any maximum limitation on annual benefit payments under the Employee Retirement Income Security Act of 1974 and the annual benefit that would be payable under the Company Plan but for such limitation. This plan is an unfunded plan. LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) The components of net periodic pension cost for both of the defined benefit plans are summarized as follows: Company Plans --------------------------- Years ended December 31, 2003 2002 2001 --------------------------- Components of net periodic benefit cost Service cost $ 12.3 $ 11.9 $ 11.2 Interest cost 12.9 12.4 11.4 Expected return on plan assets (12.7) (13.7) (13.5) Net amortization and deferral 3.7 0.3 (1.5) ----- ----- ----- Net periodic pension cost $ 16.2 $ 10.9 $ 7.6 ===== ===== ===== Company Plans ----------------- December 31, 2003 2002 ----------------- Change in benefit obligation Benefit obligation at beginning of year $199.5 $173.7 Service cost 12.3 11.9 Interest cost 12.9 12.4 Actuarial loss (8.3) 13.2 Amendments 0.3 -- Benefits paid (13.3) (11.7) ----- ----- Benefit obligation at end of year 203.4 199.5 ----- ----- Change in plan assets Fair value of plan assets at beginning of year 139.5 151.1 Actual return on plan assets 33.4 (18.2) Employer contributions 18.3 18.3 Benefits paid (13.3) (11.7) ----- ----- Fair value of plan assets at end of year 177.9 139.5 ----- ----- Unfunded status, end of year 25.5 60.0 Unrecognized net actuarial loss (42.2) (76.3) Unrecognized prior service cost 1.7 3.3 Additional minimum liability 37.0 56.6 ----- ----- Accrued pension liability $ 22.0 $ 43.6 ===== ===== At December 31, 2003, the additional minimum liability of the Company's Cash Balance Retirement Plan exceeded the unrecognized prior service cost by $37.0. This amount has been recorded as an increase to accumulated other comprehensive loss. Assumptions used in the accounting for the defined benefit plans were as follows: Company Plans ---------------------- 2003 2002 2001 ---------------------- Weighted-average discount rate 6.25% 6.75% 7.25% Weighted-average rate of increase in future compensation levels 3.0% 4.0% 4.0% Weighted-average expected long- term rate of return 8.5% 9.0% 9.0% LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) The Company's defined benefit plans asset allocation at December 31, 2003, and 2002, target allocation for 2004, and expected long-term rate of return by asset category are as follows: Percentage of Weighted-Average Target Plan Assets Expected Asset Allocation at December 31, Long-Term Rate Category 2004 2003 2002 of Return-2003 -------- ---------- ------ ------ ---------------- Equity Securities 70.0% 70.6% 67.5% 5.7% Debt Securities 30.0% 26.3% 28.4% 0.8% Other -- 3.1% 4.2% 0.0% The Company assumed obligations under a subsidiary's postretirement medical plan. Coverage under this plan is restricted to a limited number of existing employees of the subsidiary. This plan is unfunded and the Company's policy is to fund benefits as claims are incurred. The components of postretirement benefit expense are as follows: Year ended Year ended Year ended December 31, December 31, December 31, 2003 2002 2001 ------------ ------------ ------------ Service cost $ 0.8 $ 0.9 $ 1.0 Interest cost 3.2 3.3 3.4 Net amortization and deferral (1.9) (1.1) (1.1) Actuarial loss 0.8 0.4 0.7 ------ ------- ------- Postretirement benefit costs $ 2.9 $ 3.5 $ 4.0 ====== ======= ======= A summary of the components of the accumulated postretirement benefit obligation follows: December 31, 2003 2002 -------------- Retirees $ 19.5 $ 17.2 Fully eligible active plan participants 19.9 15.5 Other active plan participants 21.1 24.8 ----- ----- $ 60.5 $ 57.5 ===== ===== Reconciliation of the funded status of the December 31, postretirement benefit plan and accrued liability 2003 2002 -------------- Accumulated postretirement benefit obligation, beginning of year $ 57.5 $ 45.6 Changes in benefit obligation due to: Service cost 0.8 0.9 Interest cost 3.2 3.3 Plan participants contributions 0.3 0.3 Amendments (5.8) -- Actuarial (gain) loss 6.0 8.5 Benefits paid (1.5) (1.1) ----- ----- Accumulated postretirement benefit obligation, end of year 60.5 57.5 Actuarial (gain) loss 6.0 8.5 Unrecognized net actuarial loss (23.6) (18.5) Unrecognized prior service cost 7.8 3.9 ----- ----- Accrued postretirement benefit obligation $ 44.7 $ 42.9 ===== ===== LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) The weighted-average discount rates used in the calculation of the accumulated postretirement benefit obligation was 6.4% and 6.9% as of December 31, 2003 and 2002, respectively. The health care cost trend rate-medical was assumed to be 9.0% and 7.0% as of December 31, 2003 and 2002, respectively, and the trend rate-prescription was assumed to be 12.0% and 10.6% as of December 31, 2003 and 2002, respectively, declining gradually to 5.0% in the year 2011. The health care cost trend rate has a significant effect on the amounts reported. Increasing the assumed health care cost trend rates by a percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 2003 by $10.0. The impact of a percentage point change on the aggregate of the service cost and interest cost components of the net periodic postretirement benefit cost results in an increase of $0.7 or decrease of $0.6. On December 8, 2003, President Bush signed into law the Medicare Prescription Drug, Improvement and Modernization Act of 2003 ("the Act"). The Act expanded Medicare to include, for the first time, coverage for prescription drugs. The Company expects that this legislation will eventually reduce the Company's cost for its subsidiary's postretirement medical plan. At present, no analysis of the potential reduction in the Company's costs or obligations has been performed. Under the Company's accounting policy, the financial effect of this legislation is expected to be reflected during 2004. 23. QUARTERLY DATA (UNAUDITED) The following is a summary of unaudited quarterly data: Year ended December 31, 2003 --------------------------------------------------- 1st 2nd 3rd 4th Full Quarter Quarter Quarter Quarter Year ------- ------- ------- ------- -------- Net sales $ 712.2 $ 743.7 $ 752.0 $ 731.5 $2,939.4 Gross profit 296.4 316.5 310.9 300.8 1,224.6 Net earnings 73.9 86.4 83.1 77.6 321.0 Basic earnings per common share 0.51 0.60 0.58 0.55 2.23 Diluted earnings per common share 0.51 0.60 0.58 0.54 2.22 Year ended December 31, 2002 -------------------------------------------------- 1st 2nd 3rd 4th Full Quarter Quarter Quarter Quarter Year ------- ------- ------- ------- -------- Net sales $ 590.0 $ 612.4 $ 655.2 $ 650.1 $2,507.7 Gross profit 258.3 276.3 273.3 253.9 1,061.8 Net earnings 65.8 78.5 57.3 53.0 254.6 Basic earnings per common share 0.47 0.56 0.40 0.36 1.78 Diluted earnings per common share 0.46 0.55 0.39 0.36 1.77 LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) 24. NEW ACCOUNTING PRONOUNCEMENTS In January 2003, the FASB issued FASB Interpretation No. 46 (FIN No. 46), "Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51." FIN No. 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN No. 46 and FIN No. 46R is effective for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN No. 46 must be applied for the first interim or annual period beginning after December 15, 2003. The Company does not believe it has any unconsolidated variable interest entities, but has not fully completed its evaluation. In December 2002, Statement of Financial Accounting Standards ("SFAS") No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure - an amendment of FASB Statement No. 123", was issued. This Statement amends SFAS No. 123 to provide alternative methods of transition for a voluntary change to the fair- value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require disclosure in interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company does not intend to adopt a fair-value based method of accounting for stock-based employee compensation and does not believe that SFAS No. 148 will have a material impact on its consolidated financial statements. In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others." Interpretation No. 45 changes current practice in accounting for and disclosure of guarantees and will require certain guarantees to be recorded as liabilities at fair value on the balance sheet. Previous practice required that liabilities related to guarantees be recorded only when a loss is probable and reasonably estimable, as those terms are defined in SFAS No. 5, "Accounting for Contingencies." Interpretation No. 45 also requires a guarantor to make significant new disclosures, even when the likelihood of making any payments under the guarantee is remote. The disclosure requirements of Interpretation No. 45 were effective December 31, 2002. The initial recognition and measurement provisions are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. The Company does not have any guarantees that require disclosure or further recognition under Interpretation No. 45. LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in millions, except per share data) In July 2002, SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities" was issued. This Statement addresses the recognition, measurement, and reporting of costs associated with exit or disposal activities, and supercedes Emerging Issues Task Force Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)" ("EITF 94-3"). The principal difference between SFAS No. 146 and EITF 94-3 relates to the requirements for recognition of a liability for a cost associated with an exit or disposal activity. SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity, including those related to employee termination benefits and obligations under operating leases and other contracts, be recognized when the liability is incurred, and not necessarily the date of an entity's commitment to an exit plan, as under EITF 94-3. SFAS No. 146 also establishes that the initial measurement of a liability recognized under SFAS No. 146 be based on fair value. The provisions of SFAS No. 146 are effective for exit or disposal activities that are initiated after December 31, 2002, with early application encouraged. The Company adopted this statement January 1, 2003 and it had no effect on our financial position or results of operations. In May 2002, SFAS No. 145, "Rescission of SFAS Nos. 4, 44, and 64, Amendment of SFAS 13, and Technical Corrections as of April 2002" was issued. This Statement rescinds SFAS No. 4, Reporting Gains and Losses from Extinguishment of Debt, and an amendment of that Statement, SFAS No. 64, Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements. This Statement also rescinds SFAS No. 44, Accounting for Intangible Assets of Motor Carriers. This Statement amends SFAS No. 13, Accounting for Leases, to eliminate any inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. This Statement also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. The provisions of this Statement related to the rescission of SFAS No. 4 shall be applied in fiscal years beginning after May 15, 2002. The Company adopted this statement January 1, 2003 and it resulted in the reclassification of the 2001 extraordinary loss to other income(expense). Schedule II LABORATORY CORPORATION OF AMERICA HOLDINGS AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS AND RESERVES Years Ended December 31, 2003, 2002 and 2001 (Dollars in millions) ---------------------------------------------------------------------------- Balance Charged Other at to (Deduct- Balance beginning Costs and ions) at end of year Expenses Additions of year ---------------------------------------------------------------------------- Year ended December 31, 2003: Applied against asset accounts: Allowance for doubtful accounts $ 143.2 $ 214.2 $ (224.3) $ 133.1 ======= ======= ======= ======= Valuation allowance- deferred tax assets $ 2.8 $ -- $ (0.1) $ 2.7 ======= ======= ======= ======= Year ended December 31, 2002: Applied against asset accounts: Allowance for doubtful accounts $ 119.5 $ 214.9 $ (191.2) $ 143.2 ======= ======= ======= ======= Valuation allowance- deferred tax assets $ 4.5 $ (1.7) $ -- $ 2.8 ======= ======= ======= ======= Year ended December 31, 2001: Applied against asset accounts: Allowance for doubtful accounts $ 123.0 $ 202.5 $ (206.0) $ 119.5 ======= ======= ======= ======= Valuation allowance- deferred tax assets $ 4.5 $ -- $ -- $ 4.5 ======= ======= ======= =======