10-Q

Table of Contents                                             

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2015
Commission file number 001-12215

Quest Diagnostics Incorporated

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

Delaware
(State of Incorporation)

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

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer x
Accelerated filer o
Non-accelerated filer o (Do not check if a smaller reporting company)
Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
As of October 22, 2015, there were outstanding 143,349,705 shares of the registrant’s common stock, $.01 par value.


Table of Contents                                             

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


1

Table of Contents                                             

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2015 AND 2014
(unaudited)
(in millions, except per share data)


 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
Net revenues
$
1,880

 
$
1,904

 
$
5,644

 
$
5,552

 
 
 
 
 
 
 
 
Operating costs and expenses:
 

 
 

 
 

 
 

Cost of services
1,162

 
1,178

 
3,507

 
3,453

Selling, general and administrative
402

 
446

 
1,250

 
1,301

Amortization of intangible assets
20

 
24

 
61

 
71

Gain on contribution of business to joint venture
(334
)
 
—

 
(334
)
 
—

Other operating (income) expense, net
(1
)
 
—

 
—

 
1

 
 
 
 
 
 
 
 
Total operating costs and expenses
1,249

 
1,648

 
4,484

 
4,826

 
 
 
 
 
 
 
 
Operating income
631

 
256

 
1,160

 
726

 
 
 
 
 
 
 
 
Other income (expense):
 

 
 

 
 

 
 

Interest expense, net
(35
)
 
(41
)
 
(117
)
 
(122
)
Other (expense) income, net
(4
)
 
(1
)
 
(146
)
 
3

 
 
 
 
 
 
 
 
Total non-operating expenses, net
(39
)
 
(42
)
 
(263
)
 
(119
)
 
 
 
 
 
 
 
 
Income before income taxes and equity in earnings of equity method investees
592

 
214

 
897

 
607

Income tax expense
(239
)
 
(82
)
 
(359
)
 
(234
)
Equity in earnings of equity method investees, net of taxes
1

 
7

 
15

 
19

 
 
 
 
 
 
 
 
Net income
354

 
139

 
553

 
392

Less: Net income attributable to noncontrolling interests
12

 
10

 
32

 
26

 
 
 
 
 
 
 
 
Net income attributable to Quest Diagnostics
$
342

 
$
129

 
$
521

 
$
366

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Earnings per share attributable to Quest Diagnostics’ common stockholders:
 

 
 

 
 

 
 

Basic
$
2.37

 
$
0.89

 
$
3.61

 
$
2.52

 
 
 
 
 
 
 
 
Diluted
$
2.35

 
$
0.88

 
$
3.58

 
$
2.51

 
 
 
 
 
 
 
 
Weighted average common shares outstanding:
 

 
 

 
 

 
 

Basic
144

 
145

 
144

 
144

Diluted
145

 
145

 
145

 
145

 
 
 
 
 
 
 
 
Dividends per common share
$
0.38

 
$
0.33

 
$
1.14

 
$
0.99

The accompanying notes are an integral part of these statements.

2

Table of Contents                                             

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2015 AND 2014
(unaudited)
(in millions)

 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
Net income
$
354

 
$
139

 
$
553

 
$
392

 
 
 
 
 
 
 
 
Other comprehensive (loss) income:
 
 
 
 
 
 
 
Currency translation
(5
)
 
(5
)
 
(7
)
 
(3
)
Market valuation, net of taxes
(2
)
 
(2
)
 
—

 
1

Net deferred loss on cash flow hedges, net of taxes
1

 
—

 
3

 
(5
)
 
 
 
 
 
 
 
 
Other comprehensive loss
(6
)
 
(7
)
 
(4
)
 
(7
)
 
 
 
 
 
 
 
 
Comprehensive income
348

 
132

 
549

 
385

Less: Comprehensive income attributable to noncontrolling interests
12

 
10

 
32

 
26

 
 
 
 
 
 
 
 
Comprehensive income attributable to Quest Diagnostics
$
336

 
$
122

 
$
517

 
$
359

The accompanying notes are an integral part of these statements.


3

Table of Contents                                             

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, 2015 AND DECEMBER 31, 2014
(unaudited)
(in millions, except per share data)
 
September 30,
2015
 
December 31,
2014
Assets
 

 
 

Current assets:
 

 
 

Cash and cash equivalents
$
123

 
$
192

Accounts receivable, net of allowance for doubtful accounts of $267 and $250 at September 30, 2015 and December 31, 2014, respectively
914

 
932

Inventories
86

 
110

Deferred income taxes
165

 
169

Prepaid expenses and other current assets
194

 
186

Assets held for sale
166

 
14

 
 
 
 
Total current assets
1,648

 
1,603

Property, plant and equipment, net
886

 
933

Goodwill
5,895

 
6,032

Intangible assets, net
1,004

 
1,071

Investment in equity method investees
478

 
46

Other assets
163

 
172

 
 
 
 
Total assets
$
10,074

 
$
9,857

 
 
 
 
Liabilities and Stockholders’ Equity
 

 
 

Current liabilities:
 

 
 

Accounts payable and accrued expenses
$
973

 
$
1,191

Current portion of long-term debt
160

 
518

 
 
 
 
Total current liabilities
1,133

 
1,709

Long-term debt
3,571

 
3,224

Other liabilities
680

 
594

Redeemable noncontrolling interest
69

 
—

Stockholders’ equity:
 

 
 

Quest Diagnostics stockholders’ equity:
 

 
 

Common stock, par value $0.01 per share; 600 shares authorized at both September 30, 2015 and December 31, 2014; 216 shares and 215 shares issued at September 30, 2015 and December 31, 2014, respectively
2

 
2

Additional paid-in capital
2,469

 
2,418

Retained earnings
6,066

 
5,723

Accumulated other comprehensive loss
(31
)
 
(27
)
Treasury stock, at cost; 72 shares and 71 shares at September 30, 2015 and December 31, 2014, respectively
(3,917
)
 
(3,815
)
 
 
 
 
Total Quest Diagnostics stockholders’ equity
4,589

 
4,301

Noncontrolling interests
32

 
29

 
 
 
 
Total stockholders’ equity
4,621

 
4,330

 
 
 
 
Total liabilities and stockholders’ equity
$
10,074

 
$
9,857

The accompanying notes are an integral part of these statements.

4

Table of Contents                                             

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2015 AND 2014
(unaudited)
(in millions)
 
Nine Months Ended September 30,
 
2015
 
2014
Cash flows from operating activities:
 

 
 

Net income
$
553

 
$
392

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

 
 

Depreciation and amortization
230

 
235

Provision for doubtful accounts
232

 
224

Deferred income tax provision (benefit)
138

 
(21
)
Stock-based compensation expense
39

 
38

Excess tax benefits from stock-based compensation arrangements
(4
)
 
—

Gain on contribution of business to joint venture
(334
)
 
—

Other, net
(4
)
 
(5
)
Changes in operating assets and liabilities:
 

 
 

Accounts receivable
(214
)
 
(260
)
Accounts payable and accrued expenses
(41
)
 
20

Income taxes payable
(15
)
 
22

Other assets and liabilities, net
(41
)
 
(10
)
 
 
 
 
Net cash provided by operating activities
539

 
635

 
 
 
 
Cash flows from investing activities:
 

 
 

Business acquisitions, net of cash acquired
(41
)
 
(725
)
Capital expenditures
(169
)
 
(219
)
Investment in equity method investee
(37
)
 
—

Decrease in investments and other assets
10

 
10

 
 
 
 
Net cash used in investing activities
(237
)
 
(934
)
 
 
 
 
Cash flows from financing activities:
 

 
 

Proceeds from borrowings
2,214

 
1,953

Repayments of debt
(2,235
)
 
(1,466
)
Purchases of treasury stock
(174
)
 
(82
)
Exercise of stock options
58

 
55

Excess tax benefits from stock-based compensation arrangements
4

 
—

Dividends paid
(158
)
 
(139
)
Distributions to noncontrolling interests
(28
)
 
(23
)
Sale of noncontrolling interest in subsidiary
51

 
—

Payment of deferred business acquisition consideration
(51
)
 
—

Other financing activities, net
(52
)
 
(16
)
 
 
 
 
Net cash (used in) provided by financing activities
(371
)
 
282

 
 
 
 
Net change in cash and cash equivalents
(69
)
 
(17
)
Cash and cash equivalents, beginning of period
192

 
187

 
 
 
 
Cash and cash equivalents, end of period
$
123

 
$
170

The accompanying notes are an integral part of these statements.

5

Table of Contents                                             

QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2015 AND 2014
(unaudited)
(in millions)

 
 
 
Quest Diagnostics Stockholders’ Equity
 
 
 
 
 
 
 
 
Shares of
Common Stock
Outstanding
 
Common
Stock
 
Additional
Paid-In
Capital
 
Retained
Earnings
 
Accumulated
Other
Compre-
hensive Loss
 
Treasury
Stock, at
Cost
 
Non-
controlling
Interests
 
Total
Stock-
holders’
Equity
 
 
Redeemable Non-controlling Interest
Balance, December 31, 2014
144

 
$
2

 
$
2,418

 
$
5,723

 
$
(27
)
 
$
(3,815
)
 
$
29

 
$
4,330

 
 
$
—

Net income


 


 


 
521

 


 


 
31

 
552

 
 
1

Other comprehensive loss, net of taxes


 


 


 


 
(4
)
 


 


 
(4
)
 
 
 
Dividends declared


 


 


 
(164
)
 


 


 


 
(164
)
 
 
 
Distributions to noncontrolling interests


 


 


 


 


 


 
(28
)
 
(28
)
 
 


Issuance of common stock under benefit plans
1

 


 
5

 


 


 
12

 


 
17

 
 
 
Stock-based compensation expense


 


 
37

 


 


 
2

 


 
39

 
 
 
Exercise of stock options
1

 


 


 


 


 
58

 


 
58

 
 
 
Shares to cover employee payroll tax withholdings on stock issued under benefit plans


 


 
(6
)
 


 


 


 


 
(6
)
 
 
 
Tax benefits associated with stock-based compensation plans


 


 
4

 


 


 


 


 
4

 
 
 
Purchases of treasury stock
(2
)
 


 


 


 


 
(174
)
 


 
(174
)
 
 
 
Sale of redeembable noncontrolling interest
 
 
 
 
11

 
 
 
 
 
 
 
 
 
11

 
 
54

Adjustment to fair value
 
 
 
 
 
 
(14
)
 
 
 
 
 
 
 
(14
)
 
 
14

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, September 30, 2015
144

 
$
2

 
$
2,469

 
$
6,066

 
$
(31
)
 
$
(3,917
)
 
$
32

 
$
4,621

 
 
$
69

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, December 31, 2013
144

 
$
2

 
$
2,379

 
$
5,358

 
$
(8
)
 
$
(3,783
)
 
$
25

 
$
3,973

 
 
 
Net income


 


 


 
366

 


 


 
26

 
392

 
 
 
Other comprehensive loss, net of taxes


 


 


 


 
(7
)
 


 


 
(7
)
 
 
 
Dividends declared


 


 


 
(143
)
 


 


 


 
(143
)
 
 
 
Distributions to noncontrolling interests


 


 


 


 


 


 
(23
)
 
(23
)
 
 
 
Issuance of common stock under benefit plans
1

 


 
1

 


 


 
13

 


 
14

 
 
 
Stock-based compensation expense


 


 
36

 


 


 
2

 


 
38

 
 
 
Exercise of stock options
1

 


 
(3
)
 


 


 
58

 


 
55

 
 
 
Shares to cover employee payroll tax withholdings on stock issued under benefit plans


 


 
(6
)
 


 


 


 


 
(6
)
 
 
 
Tax benefits associated with stock-based compensation plans


 


 
(1
)
 


 


 


 


 
(1
)
 
 
 
Purchases of treasury stock
(1
)
 


 


 


 


 
(82
)
 


 
(82
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, September 30, 2014
145

 
$
2

 
$
2,406

 
$
5,581

 
$
(15
)
 
$
(3,792
)
 
$
28

 
$
4,210

 
 
 
The accompanying notes are an integral part of these statements.

6

Table of Contents                                             

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

1.    DESCRIPTION OF BUSINESS
    
Background
    
Quest Diagnostics Incorporated and its subsidiaries ("Quest Diagnostics" or the "Company") empower people to take action to improve health outcomes.  The Company uses its extensive database of clinical lab results to derive diagnostic insights that reveal new avenues to identify and treat disease, inspire healthy behaviors and improve healthcare management.  The Company's diagnostic information services business ("DIS") provides insights through clinical testing and related services to patients, physicians, hospitals, accountable care organizations ("ACOs"), integrated delivery networks ("IDNs"), health plans, employers and others. The Company offers the broadest access in the United States to diagnostic information services through its nationwide network of laboratories, Company-owned patient service centers and phlebotomists in physician offices. The Company is the world's leading provider of diagnostic information services, including routine clinical testing, gene-based and esoteric testing, anatomic pathology services and drugs-of-abuse testing, as well as related services and insights. The Company provides interpretive consultation through the organization, with one of the largest medical and scientific staffs in the industry and hundreds of M.D.s and Ph.D.s, many of whom are recognized leaders in their fields. The Company's Diagnostic Solutions ("DS") businesses offer a variety of solutions for life insurers, healthcare providers and others. The Company is the leading provider of risk assessment services for the life insurance industry as well as a leading provider of central laboratory testing for clinical trials (see Note 6 regarding the contribution of the clinical trials testing business to a newly formed joint venture effective July 1, 2015). The Company's diagnostics products business manufactures and markets diagnostic products. In addition, the Company offers healthcare organizations, clinicians and patients robust information technology solutions.

2.    SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation
    
The interim unaudited consolidated financial statements reflect all adjustments which in the opinion of management are necessary for a fair statement of results of operations, comprehensive income, financial condition, cash flows and stockholders' equity for the periods presented. Except as otherwise disclosed, all such adjustments are of a normal recurring nature. Operating results for the interim periods are not necessarily indicative of the results that may be expected for the full year. These interim unaudited consolidated financial statements should be read in conjunction with the audited consolidated financial statements included in the Company’s 2014 Annual Report on Form 10-K. The year-end balance sheet data was derived from the audited financial statements as of December 31, 2014, but does not include all the disclosures required by accounting principles generally accepted in the United States (“GAAP”).
        
Reclassifications    

Prior to the Company's clinical trials central laboratory services joint venture, Q2 Solutions, the earnings of the Company's equity method investees consisted of earnings that were not directly taxable to the investees, in which case it was appropriate to present equity in earnings of equity method investees before income tax expense on the consolidated statements of operations. The earnings of Q2 Solutions, which closed on July 1, 2015, includes earnings that are directly taxable to the joint venture. As a result of the Q2 Solutions transaction, the current period presentation of equity in earnings of equity method investees is required to be presented below income tax expense on the consolidated statements of operations. The Company's equity in earnings of equity method investees on the consolidated statements of operations for the three and nine months ended September 30, 2014 have been reclassified to conform with the current period presentation. In addition as a result of the current period presentation of investment in equity method investees on the consolidated balance sheet, the Company's investment in equity method investees as of December 31, 2014 has been reclassified to conform with the current period presentation. For further details regarding the Company's investment in Q2 Solutions, see Note 6.

As a result of the classification of certain non-core assets as held for sale on the consolidated balance sheet in the current period, current assets held for sale on the consolidated balance sheet at December 31, 2014 were reclassified to conform with the current period presentation. For further details regarding assets held for sale, see Note 6.


7
Table of Contents
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(unaudited)
(dollars in millions unless otherwise indicated)


As a result of the early adoption of the accounting standard update (“ASU”) associated with classification of debt issuance costs, certain reclassifications have been made to the prior period financial statements to conform with the current period presentation. For further details regarding the impact of the ASU, see Adoption of New Accounting Standards.

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

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

Adoption of New Accounting Standards
        
On January 1, 2015, the Company adopted a new accounting standard issued by the Financial Accounting Standards Board ("FASB") related to the presentation and reporting of discontinued operations, including the disposals of components of an entity. The standard changes the criteria for reporting discontinued operations and requires expanded disclosures about discontinued operations that will provide financial statement users with more information about the assets, liabilities, income, and expenses of discontinued operations. The new standard also requires disclosure of the pre-tax income attributable to a disposal of a significant part of an organization that does not qualify for discontinued operations reporting. The impact of this standard on the Company’s results of operations, financial position, cash flows and disclosures will be assessed as part of any future disposal activity.

In April 2015, the FASB issued an ASU which requires that debt issuance costs be presented in the balance sheet as a direct reduction to the carrying amount of the associated debt liability, consistent with debt discounts. The Company adopted this standard in the second quarter of 2015 and applied the standard retrospectively. Adoption of this standard has resulted in the reclassification of $20 million of unamortized debt issuance costs from other assets to a reduction of long-term debt on the consolidated balance sheet at December 31, 2014.    

New Accounting Pronouncements
    
In May 2014, the FASB issued an ASU on revenue recognition. This ASU outlines a single comprehensive model to use in accounting for revenue arising from contracts with customers. This standard supersedes existing revenue recognition requirements and eliminates most industry-specific guidance from GAAP. The core principle of the revenue recognition standard is to require an entity to recognize as revenue the amount that reflects the consideration to which it expects to be entitled in exchange for goods or services as it transfers control to its customers. The standard requires additional disclosures including those that are qualitative and quantitative disclosures about the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. In August 2015, the FASB deferred the effective date of this ASU to the first quarter of 2018, with early adoption permitted beginning in the first quarter of 2017. The ASU can be applied using a full retrospective method or a modified retrospective method of adoption. The Company is currently assessing the impact of the adoption of this ASU on the Company’s results of operations, financial position and cash flows.


8
Table of Contents
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(unaudited)
(dollars in millions unless otherwise indicated)


In February 2015, the FASB issued an ASU which makes targeted amendments to the current consolidation guidance for variable interest entities and limited partnerships and similar entities. The ASU is effective for the Company in the first quarter of 2016 with the option of using a full retrospective or a modified retrospective method. The Company does not expect the adoption of this standard to have a material impact on its results of operations, financial position and cash flows.

In April 2015, the FASB issued an ASU which provides guidance in determining whether a cloud computing arrangement includes a software license.  If it is determined that a cloud computing arrangement does include a software license, the software element of the arrangement should be accounted for consistent with the acquisition of other software licenses.  If the arrangement does not include a software license, it should be accounted for as a service contract.  The ASU is effective for the Company in the first quarter of 2016 and can be applied prospectively to all arrangements entered into or materially modified after the effective date or retrospectively.  The Company does not expect the adoption of this ASU to have a material impact on its results of operations, financial position and cash flows.

In September 2015, the FASB issued an ASU which requires that an acquirer recognize adjustments to provisional amounts in a business combination that are identified during the measurement period in the reporting period in which the adjustment amounts are determined, including the cumulative effect of the change in provisional amount as if the accounting had been completed at the acquisition date.  The ASU is effective for the Company in the first quarter of 2016 with early adoption permitted and will be applied prospectively to adjustments to provisional amounts after the effective date. The Company does not expect the adoption of this ASU to have a material impact on its results of operations, financial position and cash flows.

3.    EARNINGS PER SHARE

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

 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
Amounts attributable to Quest Diagnostics’ stockholders:
 

 
 

 
 

 
 

Net income attributable to Quest Diagnostics
$
342

 
$
129

 
$
521

 
$
366

Less: Earnings allocated to participating securities
2

 
1

 
3

 
2

 
 
 
 
 
 
 
 
Earnings available to Quest Diagnostics’ common stockholders – basic and diluted
$
340

 
$
128

 
$
518

 
$
364

 
 
 
 
 
 
 
 
Weighted average common shares outstanding – basic
144

 
145

 
144

 
144

Effect of dilutive securities:
 

 
 

 
 

 
 

Stock options and performance share units
1

 
—

 
1

 
1

 
 
 
 
 
 
 
 
Weighted average common shares outstanding – diluted
145

 
145

 
145

 
145

 
 
 
 
 
 
 
 
Earnings per share attributable to Quest Diagnostics’ common stockholders:
 

 
 

 
 

 
 

Basic
$
2.37

 
$
0.89

 
$
3.61

 
$
2.52

 
 
 
 
 
 
 
 
Diluted
$
2.35

 
$
0.88

 
$
3.58

 
$
2.51



9
Table of Contents
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(unaudited)
(dollars in millions unless otherwise indicated)


The following securities were not included in the calculation of diluted earnings per share due to their antidilutive effect (shares in millions):
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
Stock options and performance share units
2

 
—

 
2

 
3


4.    RESTRUCTURING ACTIVITIES

Invigorate Program

During 2012, the Company committed to a course of action related to a multi-year program called Invigorate which is
designed to reduce its cost structure. Invigorate has consisted of several flagship programs, with structured plans in each, to drive savings and improve performance across the customer value chain. These flagship programs include: organization excellence; information technology excellence; procurement excellence; service excellence; lab excellence; and billing excellence. From 2012 through 2014, the Invigorate program was intended to partially offset reimbursement pressures and labor and benefit cost increases; free up additional resources to invest in science, innovation and other growth initiatives; and enable us to improve service quality and operating profitability.

In January 2015, the Company adopted a course of action related to its multi-year Invigorate program to further reduce its cost structure through 2017. This multi-year course of action continues to focus on the flagship program opportunities and new key opportunities such as: standardizing processes, information technology systems, equipment and data; enhancing electronic enabling services; and enhancing reimbursement for work performed. The estimated pre-tax charges expected to be incurred in 2015 in connection with this course of action are now expected to be: $35 million to $40 million of employee separation costs and up to $5 million of facility-related costs and asset impairment charges.     

The following table provides a summary of the Company's pre-tax restructuring charges associated with its Invigorate program and other restructuring activities for the three and nine months ended September 30, 2015 and 2014:

 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
Employee separation costs
$
14

 
$
14

 
$
35

 
$
28

Facility-related costs
1

 
2

 
1

 
6

Asset impairment charges
—

 
—

 
—

 
1

 
 
 
 
 
 
 
 
  Total restructuring charges
$
15

 
$
16

 
$
36

 
$
35


Total restructuring charges incurred for the three and nine months ended September 30, 2015 are primarily associated with various workforce reduction initiatives as the Company continues to simplify and restructure its organization. Of the total $15 million in restructuring charges incurred during the three months ended September 30, 2015, $12 million and $3 million were recorded in cost of services and selling, general and administrative expenses, respectively. Of the total $36 million in restructuring charges incurred during the nine months ended September 30, 2015, $29 million and $7 million were recorded in cost of services and selling, general and administrative expenses, respectively.
    
Total restructuring charges incurred for the three and nine months ended September 30, 2014 are primarily associated with various workforce reduction initiatives as the Company continued to simplify and restructure its organization. Of the total $16 million in restructuring charges incurred during the three months ended September 30, 2014, $7 million and $9 million were recorded in cost of services and selling, general and administrative expenses, respectively. Of the total $35 million in restructuring charges incurred during the nine months ended September 30, 2014, $19 million and $16 million were recorded in cost of services and selling, general and administrative expenses, respectively.


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


Charges for all periods presented were primarily recorded in the Company's DIS business.

The following table summarizes activity in the restructuring liability as of September 30, 2015, which is included in accounts payable and accrued expenses on the consolidated balance sheet:
 
Employee Separation Costs
 
Facility-Related Costs
 
Total
 
 
 
 
 
 
Balance, December 31, 2014
$
18

 
$
11

 
$
29

Current period charges
35

 
1

 
36

Less:
 
 
 
 
 
Cash payments
(29
)
 
(5
)
 
(34
)
Other / adjustments
—

 
(3
)
 
(3
)
 
 
 
 
 
 
Balance, September 30, 2015
$
24

 
$
4

 
$
28


5.     BUSINESS ACQUISITIONS

Acquisition of MemorialCare Health System's Laboratory Outreach Business

On August 3, 2015, the Company completed the acquisition of MemorialCare Health System's laboratory outreach business ("MemorialCare") in an all-cash transaction valued at $35 million. The assets acquired primarily represent deductible goodwill and intangible assets, principally comprised of customer-related intangibles.
    
2014 Acquisitions    

In the first quarter of 2015, the Company finalized the purchase price allocations associated with the 2014 acquisitions of Solstas Lab Partners Group ("Solstas") and Summit Health, Inc. ("Summit Health"). The purchase price allocation adjustments recorded in 2015 were not material. For further details regarding the Company's 2014 acquisitions, see Note 5 to the consolidated financial statements in the Company's 2014 Annual Report on Form 10-K. For further details regarding the fair value of the estimated contingent consideration associated with the Summit Health and Steward Health Care Systems, LLC ("Steward") acquisitions, see Note 7.    


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


6.     DISPOSITION AND HELD FOR SALE

Contribution of Clinical Trials Business    

On March 30, 2015, the Company entered into a definitive agreement with Quintiles Transnational Holdings Inc.
to form a global clinical trials central laboratory services joint venture, Q2 Solutions. The transaction closed on July 1, 2015. In connection with the transaction, the Company contributed certain assets of its clinical trials testing business ("Clinical Trials") and $37 million of cash to the newly formed joint venture in exchange for a non-controlling, 40% ownership interest. The assets of Clinical Trials contributed to the joint venture, principally consisting of property, plant and equipment and goodwill, were classified as non-current assets held for sale in the consolidated balance sheet at June 30, 2015 and were contributed to Q2 Solutions upon closing of the transaction. Subsequent to closing, the Company's ownership interest in the the joint venture is being accounted for under the equity method of accounting. At September 30, 2015, the investment in Q2 Solutions had a carrying value of $422 million.

During the third quarter of 2015, the Company recognized a pre-tax gain of $334 million based on the difference between the fair value of the Company's equity interest in the newly formed joint venture over the carrying value of the assets contributed. The fair value of the Company's equity interest was determined using discounted cash flows. In connection with the gain, the Company recorded a deferred tax liability of $145 million. Upon formation, the Company's investment in Q2 Solutions exceeded its equity in the underlying net assets by approximately $219 million. This basis difference is attributable to finite-lived assets, indefinite-lived intangible assets and goodwill of the joint venture. The basis difference associated with the finite-lived assets of $75 million is being amortized over a weighted average useful life of 8 years as a reduction to the carrying value of the investment in equity method investees and corresponding reduction in equity in earnings of equity method investees, net of taxes.

Assets Held for Sale    

During the third quarter of 2015, the Company classified certain non-core assets as held for sale. The assets consist of $113 million of goodwill, with the remainder consisting of property, plant and equipment, inventories and intangible assets and are classified as current assets held for sale in the consolidated balance sheet as at September 30, 2015.

Clinical Trials, prior to July 1, 2015, and the non-core assets held for sale are included in all other operating segments and have not been classified as discontinued operations. For further details regarding business segment information, see Note 14.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(unaudited)
(dollars in millions unless otherwise indicated)


7.     FAIR VALUE MEASUREMENTS

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The following table provides a summary of the recognized assets and liabilities that are measured at fair value on a recurring basis:
 
 
 
Basis of Fair Value Measurements
 
 
 
Quoted
Prices in
Active
Markets for
Identical
Assets /
Liabilities
 
Significant
Other
Observable
Inputs
 
Significant
Unobservable
Inputs
September 30, 2015
Total
 
Level 1
 
Level 2
 
Level 3
Assets:
 

 
 

 
 

 
 

Trading securities
$
46

 
$
46

 
$
—

 
$
—

Interest rate swaps
34

 
—

 
34

 
—

Cash surrender value of life insurance policies
28

 
—

 
28

 
—

Available-for-sale equity securities
7

 
7

 
—

 
—

 
 
 
 
 
 
 
 
Total
$
115

 
$
53

 
$
62

 
$
—

 
 
 
 
 
 
 
 
Liabilities:
 

 
 

 
 

 
 

Deferred compensation liabilities
$
81

 
$
—

 
$
81

 
$
—

Contingent consideration
3

 
—

 
—

 
3

 
 
 
 
 
 
 
 
Total
$
84

 
$
—

 
$
81

 
$
3

 
 
 
Basis of Fair Value Measurements
 
 
 
Quoted
Prices in
Active
Markets for
Identical
Assets /
Liabilities
 
Significant
Other
Observable
Inputs
 
Significant
Unobservable
Inputs
December 31, 2014
Total
 
Level 1
 
Level 2
 
Level 3
Assets:
 

 
 

 
 

 
 

Trading securities
$
49

 
$
49

 
$
—

 
$
—

Cash surrender value of life insurance policies
30

 
—

 
30

 
—

Interest rate swaps
17

 
—

 
17

 
—

Available-for-sale equity securities
9

 
9

 
—

 
—

Put option
1

 
—

 
—

 
1

 
 
 
 
 
 
 
 
Total
$
106

 
$
58

 
$
47

 
$
1

 
 
 
 
 
 
 
 
Liabilities:
 

 
 

 
 

 
 

Deferred compensation liabilities
$
85

 
$
—

 
$
85

 
$
—

Contingent consideration
17

 
—

 
—

 
17

Forward starting interest rate swaps
15

 
—

 
15

 
—

Interest rate swaps
13

 
—

 
13

 
—

Call option
5

 
—

 
—

 
5

 
 
 
 
 
 
 
 
Total
$
135

 
$
—

 
$
113

 
$
22


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(unaudited)
(dollars in millions unless otherwise indicated)



A full description regarding the Company's fair value measurements is contained in Note 7 to the consolidated financial statements in the Company's 2014 Annual Report on Form 10-K.    

The Company offers certain employees the opportunity to participate in non-qualified supplemental deferred compensation plans. A participant's deferrals, together with Company matching credits, are invested in a variety of participant-directed stock and bond mutual funds that are classified as trading securities. Changes in the fair value of these securities are measured using quoted prices in active markets based on the market price per unit multiplied by the number of units held exclusive of any transaction costs. A corresponding adjustment for changes in fair value of the trading securities is also reflected in the changes in fair value of the deferred compensation obligation. The deferred compensation liabilities are classified within Level 2 because their inputs are derived principally from observable market data by correlation to the trading securities.

The Company offers certain employees the opportunity to participate in a non-qualified deferred compensation program. A participant's deferrals, together with Company matching credits, are “invested” at the direction of the employee in a hypothetical portfolio of investments which are tracked by an administrator. The Company purchases life insurance policies, with the Company named as beneficiary of the policies, for the purpose of funding the program's liability. Changes in the cash surrender value of the life insurance policies are based upon earnings and changes in the value of the underlying investments. Changes in the fair value of the deferred compensation obligation are derived using quoted prices in active markets based on the market price per unit multiplied by the number of units. The cash surrender value and the deferred compensation obligations are classified within Level 2 because their inputs are derived principally from observable market data by correlation to the hypothetical investments.
    
The fair value measurements of the Company's interest rate swaps and forward starting swaps are model-derived valuations as of a given date in which all significant inputs are observable in active markets including certain financial information and certain assumptions regarding past, present and future market conditions.

Investment in available-for-sale equity securities represents an investment in registered shares of a publicly-held company listed on the Euronext Paris exchange. The Company's investment in available-for-sale equity securities is classified within Level 1 of the fair value hierarchy because the fair value is obtained from quoted prices in an active market.

In connection with the acquisition of certain businesses from UMass Memorial Medical Center ("UMass"), the Company granted to UMass a call option and UMass granted to the Company a put option for UMass to acquire an 18.90% equity interest in a newly formed entity. The put and call options are derivative instruments whose fair values have been measured using a combination of discounted cash flows and the Black-Scholes-Merton option pricing model. On July 1, 2015, UMass exercised its call option, acquiring an 18.9% noncontrolling interest in a subsidiary of the Company that performs diagnostic information services in a defined territory within the state of Massachusetts. In connection with the transaction, the Company paid the $50 million deferred consideration associated with the January 2, 2013 acquisition of the Massachusetts-based clinical outreach and anatomic pathology businesses from UMass and received $50 million associated with the call option exercise price. The put option expired unexercised.

In April 2014, and as further detailed in Note 5 to the consolidated financial statements in the Company's 2014 Annual Report on Form 10-K, the Company completed the acquisitions of Summit Health and Steward. In connection with these acquisitions the Company initially recorded an aggregate contingent consideration liability of $26 million. The contingent consideration liability was classified within Level 3 measured at fair value using a probability weighted and discounted cash flow method. These measurements are based on externally obtained inputs and management's probability assessments of the occurrence of triggering events, appropriately discounted considering the uncertainties associated with the obligations, as well as the likelihood of achieving financial targets. The initial probability estimate of the occurrence of such triggering events associated with the amounts the Company could be obligated to pay in future periods for both Summit Health and Steward was between 5% and 95%. The probability-weighted cash flows were then discounted using a discount rate of 1.5% to 2.8%. The estimated fair value of the contingent consideration associated with Summit Health was reduced to $13 million in the fourth quarter of 2014 and $0 in the second quarter of 2015. These reductions were a result of updated revenue forecasts for 2015 compared to the earn-out target included in the contingent consideration arrangement. The contingent consideration associated with Summit Health, if earned, would be paid in the first quarter of 2016, with a maximum payment of $25 million. The remaining contingent consideration associated with Steward is projected to be paid out in three equal annual installments, with a maximum payout of $4 million.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(unaudited)
(dollars in millions unless otherwise indicated)


The following table provides a reconciliation of the beginning and ending balances of assets and liabilities using significant unobservable inputs (Level 3):
 
Assets
 
Liabilities
 
Put Option Derivative Asset
 
Contingent Consideration
 
Call Option Derivative Liability
 
Total Liabilities
 
 
 
 
 
 
 
 
Balance, December 31, 2014
$
1

 
$
17

 
$
5

 
$
22

Settlements
—

 
(1
)
 
(4
)
 
(5
)
Total gains/losses - realized/unrealized:
 
 
 
 
 
 
 
Included in earnings
(1
)
 
(13
)
 
(1
)
 
(14
)
Balance, September 30, 2015
$
—

 
$
3

 
$
—

 
$
3


The $13 million gain included in earnings associated with the change in the fair value of contingent consideration for the nine months ended September 30, 2015 is reported in other operating (income) expense, net.

The carrying amounts of cash and cash equivalents, accounts receivable and accounts payable and accrued expenses approximate fair value based on the short maturities of these instruments. At September 30, 2015, the fair value of the Company’s debt was estimated at $3.8 billion, which exceeded the carrying value by $116 million. At December 31, 2014, the fair value of the Company's debt was estimated at $4.2 billion, which exceeded the carrying value by $416 million. Principally all of the Company's debt is classified within Level 1 of the fair value hierarchy because the fair value of the debt is estimated based on rates currently offered to the Company with identical terms and maturities, using quoted active market prices and yields, taking into account the underlying terms of the debt instruments.

8.    GOODWILL AND INTANGIBLE ASSETS

The changes in goodwill for the nine months ended September 30, 2015 and for the year ended December 31, 2014 are as follows:
 
September 30,
2015
 
December 31,
2014
Balance, beginning of period
$
6,032

 
$
5,649

Goodwill acquired during the period
23

 
383

Reclassification to assets held for sale
(160
)
 
—

Balance, end of period
$
5,895

 
$
6,032


Principally all of the Company’s goodwill as of September 30, 2015 and December 31, 2014 is associated with its DIS business.

For the nine months ended September 30, 2015, goodwill acquired during the period was principally associated with the acquisition of MemorialCare (see Note 5) and reclassification to assets held for sale was principally associated with Clinical Trials and non-core assets (see Note 6).

For the year ended December 31, 2014, goodwill acquired was principally associated with the Solstas, Summit Health, and Steward acquisitions. Acquisitions during 2014 also resulted in $270 million of intangible assets, principally comprised of customer-related intangibles and trade names. For further details regarding the Company's 2014 acquisitions, see Note 5 to the consolidated financial statements in the Company's 2014 Annual Report on Form 10-K.        
    
Intangible assets at September 30, 2015 and December 31, 2014 consisted of the following:

 
Weighted
Average
Amortization
Period
(in years)
 
September 30, 2015
 
December 31, 2014
 
 
Cost
 
Accumulated
Amortization
 
Net
 
Cost
 
Accumulated
Amortization
 
Net
Amortizing intangible assets:
 
 

 
 

 
 

 
 

 
 

 
 

Customer-related intangibles
19
 
$
926

 
$
(283
)
 
$
643

 
$
929

 
$
(259
)
 
$
670

Non-compete agreements
5
 
6

 
(3
)
 
3

 
43

 
(37
)
 
6

Technology
14
 
117

 
(45
)
 
72

 
118

 
(38
)
 
80

Other
9
 
105

 
(55
)
 
50

 
152

 
(82
)
 
70

Total
17
 
1,154

 
(386
)
 
768

 
1,242

 
(416
)
 
826

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Intangible assets not subject to amortization:
 
 

 
 

 
 

 
 

 
 

Trade names
 
 
235

 
—

 
235

 
244

 
—

 
244

Other
 
 
1

 
—

 
1

 
1

 
—

 
1

Total intangible assets
 
$
1,390

 
$
(386
)
 
$
1,004

 
$
1,487

 
$
(416
)
 
$
1,071


For the nine months ended September 30, 2015, intangible assets with a net book value of $16 million (original cost of $48 million and accumulated amortization of $32 million), principally associated with Clinical Trials and non-core assets (see Note 6), were reclassified to assets held for sale. During the second quarter of 2015, a fully amortized contractual non-compete agreement (cost of $37 million and accumulated amortization of $37 million) that expired was written-off.

Amortization expense related to intangible assets was $20 million and $24 million for the three months ended September 30, 2015 and 2014, respectively. For the nine months ended September 30, 2015 and 2014, amortization expense related to intangible assets was $61 million and $71 million, respectively.
 
The estimated amortization expense related to amortizable intangible assets for each of the five succeeding fiscal years and thereafter as of September 30, 2015 is as follows:

Year Ending December 31,
 

Remainder of 2015
$
19

2016
72

2017
68

2018
63

2019
63

2020
63

Thereafter
420

Total
$
768



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


9.    DEBT
    
Long-Term Debt

Long-term debt at September 30, 2015 and December 31, 2014 consisted of the following:
 
September 30,
2015
 
December 31,
2014
 
 
 
 
Secured Receivables Credit Facility (0.93% at September 30, 2015)
$
60

 
$
—

5.45% Senior Notes due November 2015
—

 
500

3.20% Senior Notes due April 2016
151

 
304

6.40% Senior Notes due July 2017
—

 
375

2.70% Senior Notes due April 2019
300

 
300

4.75% Senior Notes due January 2020
527

 
524

2.50% Senior Notes due March 2020
299

 
—

4.70% Senior Notes due April 2021
561

 
549

4.25% Senior Notes due April 2024
318

 
311

3.50% Senior Notes due March 2025
603

 
—

6.95% Senior Notes due July 2037
246

 
421

5.75% Senior Notes due January 2040
368

 
439

4.70% Senior Notes due March 2045
300

 
—

Other
24

 
39

Debt issuance costs
(26
)
 
(20
)
 
 
 
 
Total long-term debt
3,731

 
3,742

Less: Current portion of long-term debt
160

 
518

 
 
 
 
Total long-term debt, net of current portion
$
3,571

 
$
3,224


Current Portion of Long-Term Debt

At September 30, 2015, current portion of long-term debt was principally comprised of the 3.20% Senior Notes due April 2016. At December 31, 2014, current portion of long-term debt was principally comprised of the 5.45% Senior Notes due November 2015.
    
2015 Senior Notes Offering

In March 2015, the Company completed a $1.2 billion senior notes offering (the “2015 Senior Notes”) that was sold in three tranches: (a) $300 million aggregate principal amount of 2.50% senior notes due March 2020, issued at a discount of $1 million; (b) $600 million aggregate principal amount of 3.50% senior notes due March 2025; and (c) $300 million aggregate principal amount of 4.70% senior notes due March 2045. These senior notes are unsecured obligations of the Company and rank equally with the Company's other senior unsecured obligations. None of the Company's senior notes have a sinking fund requirement.

The Company incurred $11 million of costs associated with the 2015 Senior Notes, which is included as a reduction to the carrying amount of long-term debt and is being amortized over the term of the related debt.
    
Retirement of Debt

In March 2015, the Company commenced a cash tender offer to purchase up to $250 million aggregate principal amount of its 6.95% Senior Notes due July 2037 and 5.75% Senior Notes due January 2040 using a portion of the proceeds from the 2015 Senior Notes. The Company repurchased $176 million of its 6.95% Senior Notes due July 2037 and $74 million

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(unaudited)
(dollars in millions unless otherwise indicated)


of its 5.75% Senior Notes due January 2040. In April 2015, the Company redeemed all of the 5.45% Senior Notes due November 2015, $150 million of the 3.2% Senior Notes due April 2016 and all of the 6.4% Senior Notes due July 2017 with the remaining proceeds from the 2015 Senior Notes. For the nine months ended September 30, 2015, the Company recorded a loss on retirement of debt in other (expense) income, net of $144 million, principally comprised of premiums paid in connection with these transactions.
    
Maturities of Long-Term Debt    

As of September 30, 2015, long-term debt matures as follows:

Year Ending December 31,
 
Remainder of 2015
$
3

2016
219

2017
6

2018
4

2019
302

2020
801

Thereafter
2,375

 
 
Total maturities of long-term debt
3,710

Unamortized discount
(17
)
Debt issuance costs
(26
)
Fair value basis adjustments attributable to hedged debt
64

 
 
Total long-term debt
3,731

Less: Current portion of long-term debt
160

 
 
Total long-term debt, net of current portion
$
3,571


For further discussion regarding the Company's debt, see Note 13 to the consolidated financial statements in the Company's 2014 Annual Report on Form 10-K.    

10.    FINANCIAL INSTRUMENTS

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

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


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(unaudited)
(dollars in millions unless otherwise indicated)


Interest Rate Derivatives – Cash Flow Hedges
    
From time to time, the Company has entered into various interest rate lock agreements and forward starting interest rate swap agreements to hedge part of the Company's interest rate exposure associated with the variability in future cash flows attributable to changes in interest rates.
    
During the fourth quarter of 2013 and first quarter of 2014, the Company entered into various forward starting interest rate swap agreements for an aggregate notional amount of $150 million which were accounted for as cash flow hedges. In connection with the issuance of the 2015 Senior Notes, all of these agreements were settled and the Company paid $17 million. These losses are deferred in stockholders’ equity, net of income taxes, as a component of accumulated other comprehensive loss, and amortized as an adjustment to interest expense, net over the term of the Senior Notes due 2025.

In March 2015, the Company entered into interest rate lock agreements with several financial institutions for a total notional amount of $350 million which were accounted for as cash flow hedges. These agreements were entered into to hedge a portion of the Company’s interest rate exposure associated with variability in future cash flows attributable to changes in the five-year, ten-year and thirty-year treasury rates related to the planned issuance of the 2015 Senior Notes. In connection with the issuance of the 2015 Senior Notes, these agreements were settled and the Company received $3 million. These gains are deferred in stockholders’ equity, net of income taxes, as a component of accumulated other comprehensive loss, and amortized as an adjustment to interest expense, net over the term of the respective senior notes.

The total net loss, net of taxes, recognized in accumulated other comprehensive loss, related to the Company's cash flow hedges as of September 30, 2015 and December 31, 2014 was $12 million and $15 million, respectively. The loss recognized on the Company's cash flow hedges for the three and nine months ended September 30, 2015 and 2014, as a result of ineffectiveness, was not material. The net amount of deferred losses on cash flow hedges that is expected to be reclassified from accumulated other comprehensive loss into interest expense, net within the next twelve months is $3 million.

Interest Rate Derivatives – Fair Value Hedges

The Company maintains various fixed-to-variable interest rate swaps to convert a portion of the Company's long-term debt into variable interest rate debt. A summary of the notional amounts of these interest rate swaps as of September 30, 2015 and December 31, 2014 is as follows:    
 
 
 
 
Notional Amount
Debt Instrument
 
Floating Rate Paid by the Company
 
September 30, 2015
 
December 31, 2014
 
 
 
 
 
 
 
3.20% Senior Notes due April 2016
 
Six-month LIBOR plus a 2.3% spread
 
$
—

 
$
200

4.75% Senior Notes due January 2020
 
One-month LIBOR plus a 3.6% spread
 
350

 
350

4.70% Senior Notes due April 2021
 
One-month LIBOR plus a 2.45% to 3.39% spread
 
400

 
400

4.25% Senior Notes due April 2024
 
One-month LIBOR plus a 1.54% to 1.59% spread
 
250

 
250

3.50% Senior Notes due March 2025
 
One-month LIBOR plus a 1.44% spread
 
200

 
—

 
 
 
 
 
 
 
 
 
 
 
$
1,200

 
$
1,200

    
In April 2015, the Company terminated the outstanding interest rate swaps associated with the Senior Notes due 2016. The value of these interest rate swaps at the date of termination was not material. The net amount of losses on fair value hedges related to the Senior Notes due 2016 reclassified into earnings upon redemption for the nine months ended September 30, 2015 was not material.    

Since inception, the fair value hedges have been effective or highly effective; therefore, there is no impact on earnings for the three and nine months ended September 30, 2015 and 2014 as a result of hedge ineffectiveness.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(unaudited)
(dollars in millions unless otherwise indicated)


Interest Rate Derivatives - Economic Hedges

In March 2015, in connection with the retirement of debt discussed in Note 9, the Company entered into reverse interest rate lock agreements with several financial institutions which were not designated for hedge accounting. The Company entered into these agreements to hedge the variability in cash flows associated with $280 million of the $1.3 billion principal amount of debt that was retired in the first and second quarters of 2015. These agreements were settled during the first and second quarters of 2015 which resulted in a gain of $3 million which was recognized in other (expense) income, net.

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

 
September 30, 2015
 
December 31, 2014
 
Balance Sheet
Classification
 
Fair Value
 
Balance Sheet
Classification
 
Fair Value
Derivatives Designated as Hedging Instruments
 
 
 

 
 
 
 

Asset Derivatives:
 
 
 

 
 
 
 

Interest rate swaps
Other assets
 
$
34

 
Other assets
 
$
17

 
 
 
 
 
 
 
 
Liability Derivatives:
 
 
 
 
 
 
 
Interest rate swaps

 
—

 
Other liabilities
 
13

Forward starting interest rate swaps

 
—

 
Other liabilities
 
15

Total Liability Derivatives
 
 
—

 
 
 
28

 
 
 
 
 
 
 
 
Derivatives Not Designated as Hedging Instruments
 
 
 

 
 
 
 

Asset Derivatives:
 
 
 

 
 
 
 

Put option

 
—

 
Prepaid expenses and other current assets
 
1

 
 
 
 
 
 
 
 
Liability Derivatives:
 
 
 
 
 
 
 
Call option

 
—

 
Accounts payable and accrued expenses
 
5

 
 
 
 
 
 
 
 
Total Net Derivatives Assets (Liabilities)
 
 
$
34

 
 
 
$
(15
)

A full description regarding the Company's use of derivative financial instruments is contained in Note 14 to the consolidated financial statements in the Company's 2014 Annual Report on Form 10-K.        

11.    STOCKHOLDERS’ EQUITY AND REDEEMABLE NONCONTROLLING INTEREST
    
Stockholders' Equity    

Components of Comprehensive Income

The market valuation adjustments represent unrealized holding gains (losses) on available-for-sale securities, net of taxes. The net deferred loss on cash flow hedges represents deferred losses on the Company’s interest rate related derivative financial instruments designated as cash flow hedges, net of amounts reclassified to interest expense (see Note 10). For the three and nine months ended September 30, 2015 and 2014, the tax effects related to the market valuation adjustments and deferred losses were not material. Foreign currency translation adjustments are not adjusted for income taxes since they relate to indefinite investments in non-U.S. subsidiaries.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(unaudited)
(dollars in millions unless otherwise indicated)


Dividend Program
    
During each of the first three quarters of 2015, the Company's Board of Directors declared a quarterly cash dividend of $0.38 per common share. During each of the quarters of 2014, the Company's Board of Directors declared a quarterly cash dividend of $0.33 per common share.
    
Share Repurchase Program
        
At September 30, 2015, $522 million remained available under the Company’s share repurchase authorizations. The share repurchase authorization has no set expiration or termination date.    

For the three months ended September 30, 2015, the Company repurchased 0.3 million shares of its common stock at an average price of $69.24 per share for $25 million. For the nine months ended September 30, 2015, the Company repurchased 2.4 million shares of its common stock at an average price of $71.27 per share for $174 million. For the three and nine months ended September 30, 2015, the Company reissued 0.1 million shares and 1.3 million shares, respectively, for employee benefit plans.
    
For the three months ended September 30, 2014, the Company repurchased 0.4 million shares of its common stock at an average price of $62.03 per share for a total of $25 million. For the nine months ended September 30, 2014, the Company repurchased 1.5 million shares of its common stock at an average price of $56.84 per share for a total of $82 million. For the three and nine months ended September 30, 2014, the Company reissued 0.6 million shares and 1.4 million shares, respectively, for employee benefit plans.

Redeemable Noncontrolling Interest

On July 1, 2015, UMass exercised its call option, acquiring an 18.9% noncontrolling interest in a subsidiary of the Company that performs diagnostic information services in a defined territory within the state of Massachusetts. Under the terms of the transaction, UMass has the right to require the Company to purchase all of its interest in the subsidiary at fair value commencing July 1, 2020. Since the redemption of the noncontrolling interest is outside of the Company's control, it has been presented outside of stockholders' equity at the greater of its carrying amount or its fair value. The Company will record changes in the fair value of the noncontrolling interest immediately as they occur. At September 30, 2015, the redeemable noncontrolling interest was $69 million and was presented at its fair value, representing the total consideration received from UMass to acquire its 18.9% noncontrolling interest in the subsidiary.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(unaudited)
(dollars in millions unless otherwise indicated)


12.    SUPPLEMENTAL CASH FLOW & OTHER DATA

Supplemental cash flow and other data for the three and nine months ended September 30, 2015 and 2014 is as follows:
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
Depreciation expense
$
57

 
$
55

 
$
169

 
$
164

Amortization expense
20

 
24

 
61

 
71

 
 
 
 
 
 
 
 
Depreciation and amortization expense
$
77

 
$
79

 
$
230

 
$
235

 
 
 
 
 
 
 
 
Interest expense
$
(35
)
 
$
(42
)
 
$
(118
)
 
$
(124
)
Interest income
—

 
1

 
1

 
2

 
 
 


 
 
 
 
Interest expense, net
$
(35
)
 
$
(41
)
 
$
(117
)
 
$
(122
)
 
 
 
 
 
 
 
 
Interest paid
$
52

 
$
51

 
$
151

 
$
133

Income taxes paid
140

 
98

 
249

 
236

 
 
 
 
 
 
 
 
Assets acquired under capital leases
—

 
2

 
2

 
12

Accounts payable associated with capital expenditures
11

 
12

 
11

 
12

Dividends payable
$
55

 
$
48

 
$
55

 
$
48

 
 
 
 
 
 
 
 
Businesses acquired:
 

 
 

 
 

 
 

Fair value of assets acquired
$
35

 
$
1

 
$
37

 
$
846

Fair value of liabilities assumed
—

 
(1
)
 
—

 
81

 
 
 
 
 
 
 
 
Fair value of net assets acquired
35

 
2

 
37

 
765

Merger consideration paid (payable), net
—

 
—

 
4

 
(30
)
 
 
 
 
 
 
 
 
Cash paid for business acquisitions
35

 
2

 
41

 
735

Less: Cash acquired
—

 
—

 
—

 
10

 
 
 
 
 
 
 
 
Business acquisitions, net of cash acquired
$
35

 
$
2

 
$
41

 
$
725


13.     COMMITMENTS AND CONTINGENCIES

The Company has a line of credit with a financial institution totaling $85 million for the issuance of letters of credit (the “Letter of Credit Line”). The Letter of Credit Line matures on November 17, 2015. The Company can also issue letters of credit under its senior unsecured revolving credit facility. For further discussion regarding the Company's senior unsecured revolving credit facility, see Note 13 to the consolidated financial statements in the Company's 2014 Annual Report on Form 10-K.    
    
In support of its risk management program, to ensure the Company’s performance or payment to third parties, $67 million in letters of credit, principally associated with the Letter of Credit Line, were outstanding at September 30, 2015. The letters of credit primarily represent collateral for current and future automobile liability and workers’ compensation loss payments.
    
Contingent Lease Obligations
    
The Company remains subject to contingent obligations under certain real estate leases that were entered into by certain predecessor companies of a subsidiary prior to the Company's acquisition of the subsidiary. No liability has been recorded for any of these potential contingent obligations. See Note 17 to the consolidated financial statements contained in the Company’s 2014 Annual Report on Form 10-K for further details.

Settlements

In 2010, a purported class action entitled In re Celera Corp. Securities Litigation was filed in the United States District Court for the Northern District of California against Celera Corporation and certain of its directors and current and former officers. An amended complaint filed in October 2010 alleges that from April 2008 through July 22, 2009, the defendants made false and misleading statements regarding Celera's business and financial results with an intent to defraud investors. The complaint was further amended in 2011 to add allegations regarding a financial restatement. Celera and the director and officer defendants have reached an agreement to settle this action, which the court has preliminarily approved. The settlement is fully covered by insurance.

Legal Matters

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

In addition to the matters described below, in the normal course of business, the Company has been named, from time to time, as a defendant in various legal actions, including arbitrations, class actions and other litigation, arising in connection with the Company's activities as a provider of diagnostic testing, information and services. These legal actions may include lawsuits alleging negligence or other similar legal claims. These actions could involve claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages, and could have an adverse impact on the Company's client base and reputation.

The Company is also involved, from time to time, in other reviews, investigations and proceedings by governmental agencies regarding the Company's business, including, among other matters, operational matters, which may result in adverse judgments, settlements, fines, penalties, injunctions or other relief. The number of these reviews, investigations and proceedings has increased in recent years with regard to many firms in the healthcare services industry, including the Company.
    
In August 2011, the Company received a subpoena from the U.S. Attorney for the Northern District of Georgia seeking various business records, including records related to the Company's compliance program, certain marketing materials, certain product offerings, and test ordering and other policies. The Company is cooperating with the request.

In June 2010, the Company received a subpoena from the Florida Attorney General's Office seeking documents relating to the Company's pricing and billing practices as they relate to Florida’s Medicaid program. The Company cooperated with the requests. In November 2013, the State of Florida intervened as a plaintiff in a civil lawsuit, Florida ex rel. Hunter Laboratories LLC v. Quest Diagnostics Incorporated, et al., filed in Florida Circuit Court. The suit, originally filed by a competitor laboratory, alleges that the Company overcharged Florida’s Medicaid program. The Company's motion to dismiss the state's amended complaint was denied.         

In April 2015, a qui tam civil lawsuit entitled United States ex rel. Mayes v. Berkeley HeartLab, Inc., et al., filed in the U.S. District Court for the District of South Carolina, was unsealed. The complaint alleges that certain alleged business practices of the defendants violate the False Claims Act, and seeks monetary relief. The United States has intervened as a plaintiff as to Berkeley HeartLab, Inc., a subsidiary of the Company and filed a complaint in intervention; the United States did not intervene as a plaintiff as to Quest Diagnostics Incorporated.
    
The federal or state governments may bring claims based on the Company's current practices, which it believes are lawful. In addition, certain federal and state statutes, including the qui tam provisions of the federal False Claims Act, allow private individuals to bring lawsuits against healthcare companies on behalf of government or private payers. The Company is aware of lawsuits, and from time to time has received subpoenas, related to billing practices based on the qui tam provisions of

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED
(unaudited)
(dollars in millions unless otherwise indicated)


the Civil False Claims Act or other federal and state statutes, regulations or other laws. The Company understands that there may be other pending qui tam claims brought by former employees or other "whistle blowers" as to which the Company cannot determine the extent of any potential liability.

Management cannot predict the outcome of such matters. Although management does not anticipate that the ultimate outcome of such matters will have a material adverse effect on the Company's financial condition, given the high degree of judgment involved in establishing loss estimates related to these types of matters, the outcome of such matters may be material to the Company's results of operations or cash flows in the period in which the impact of such matters is determined or paid.
    
These matters are in different stages. Some of these matters are in their early stages. Matters may involve responding to and cooperating with various government investigations and related subpoenas. As of September 30, 2015, the Company does not believe that any losses related to the legal matters described above are probable. While the Company believes that a reasonable possibility exists that losses may have been incurred related to the legal matters described above, based on the nature and status of these matters, potential losses, if any, cannot be estimated.

Reserves for Legal Matters
    
Reserves for legal matters, other than those described above, totaled $10 million and $11 million at September 30, 2015 and December 31, 2014, respectively.