# QUEST DIAGNOSTICS INC (DGX) FY 2021 MD&A

Verbatim Item 7 Management's Discussion and Analysis from QUEST DIAGNOSTICS INC's 10-K for fiscal year 2021.

SEC filing source: https://www.sec.gov/Archives/edgar/data/1022079/000102207922000027/dgx-20211231.htm
Accession: 0001022079-22-000027
Filing date: 2022-02-28
Report date: 2021-12-31
Extracted from a later financial-section MD&A body after the formal Item 7 span was a short reference.
Confidence: high

Company profile: /company/DGX/
All MD&A years: /company/DGX/mda/
Next year: /company/DGX/mda/fy2022/ (FY 2022)

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

Our Company

    Diagnostic Information Services

    Quest Diagnostics empowers people to take action to improve health outcomes. We use our 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. Our diagnostic information services business ("DIS") provides information and insights based on the industry-leading menu of routine, non-routine and advanced clinical testing and anatomic pathology testing, and other diagnostic information services. We provide services to a broad range of customers, including patients, clinicians, hospitals, independent delivery networks ("IDNs"), health plans, employers, accountable care organizations ("ACOs"), and direct contract entities ("DCEs"). We offer the broadest access in the United States to diagnostic information services through our nationwide network of laboratories, patient service centers and phlebotomists in physician offices and our connectivity resources, including call centers and mobile paramedics, nurses and other health and wellness professionals. We are the world's leading provider of diagnostic information services. We provide interpretive consultation with one of the largest medical and scientific staffs in the industry. Our DIS business makes up greater than 95% of our consolidated net revenues. During 2021, we processed approximately 218 million test requisitions through our extensive laboratory network.

    The clinical testing that we perform is an essential element in the delivery of healthcare services. Clinicians use clinical testing for predisposition, screening, monitoring, diagnosis, prognosis and treatment choices of diseases and other medical conditions. The United States clinical testing industry consists of two segments. One segment includes hospital inpatient and outpatient testing. The second segment includes testing of persons who are not hospital patients, including testing done in commercial clinical laboratories, physician-office laboratories and other locations, as well as hospital outreach (non-hospital patients) and consumer-initiated testing.

    The clinical testing industry is subject to seasonal fluctuations in operating results and cash flows. Typically, testing volume declines during vacation and major holiday periods, reducing net revenues and operating cash flows below annual averages. Testing volume is also subject to declines due to severe weather or other events (such as public health emergencies and health pandemics), which can deter patients from having testing performed and which can vary in duration and severity from year to year. Additionally, orders for clinical testing generated from clinician offices, hospitals, employers and consumers can be affected by factors such as changes in the United States economy and regulatory environment, which affect the number of unemployed and uninsured, and design changes in healthcare plans, which affect utilization as well as patient responsibility for healthcare costs.

    We assess our revenue performance for the DIS business based upon, among other factors, volume (measured by test requisitions) and revenue per requisition. Each requisition accompanies patient specimens, indicating the test(s) to be performed and the party to be billed for the test(s). Revenue per requisition is impacted by various factors, including, among other items, the impact of fee schedule changes (i.e. unit price), test mix, payer mix, and the number of tests per requisition. Management uses number of requisitions and revenue per requisition data to assist with assessing the growth and performance of the business, including understanding trends affecting number of requisitions, pricing and test mix. Therefore, we believe that information related to changes in these metrics from period to period are useful information for investors as it allows them to assess the performance of the business.

    Diagnostic Solutions

    In our Diagnostic Solutions ("DS") businesses, which represent the balance of our consolidated net revenues, we offer a variety of solutions for life insurers and healthcare organizations and clinicians. We are the leading provider of risk assessment services for the life insurance industry. In addition, we offer healthcare organizations and clinicians robust information technology solutions.

2021 Highlights    

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[[GREPCENT_TABLE]]
[["","Year Ended December 31,"],["","2021","","2020","","2019"],["","(dollars in millions, except per share data)"],["Net revenues","$10,788","","$9,437","","$7,726"],["Base business revenues (a)","$8,018","","$6,714","","$7,726"],["COVID-19 testing revenues","$2,770","","$2,723","","$\u2014"],["DIS revenues","$10,494","","$9,139","","$7,405"],["Revenue per requisition change","(1.6)%","","16.2%","","(1.3)%"],["Requisition volume change","16.5%","","6.6%","","4.3%"],["Organic requisition volume change","13.6%","","4.5%","","3.1%"],["DS revenues","$294","","$298","","$321"],["Income from continuing operations attributable to Quest Diagnostics","$1,995","","$1,431","","$838"],["Diluted earnings per share from continuing operations","$15.55","","$10.47","","$6.13"],["Net cash provided by operating activities","$2,233","","$2,005","","$1,243"]]
[[/GREPCENT_TABLE]]

(a) Excludes COVID-19 testing.

    The impact that the COVID-19 pandemic had on our DIS revenues, including requisition volume and revenue per requisition are discussed further below under "Impact of COVID-19" and "Results of Operations".

    For further discussion of the year-over-year changes for the year ended December 31, 2021 compared to the year ended December 31, 2020, see "Results of Operations" below.

Impact of COVID-19

    As a novel strain of coronavirus (COVID-19) continues to impact the economy of the United States and other countries around the world, we are committed to being a part of the coordinated public and private sector response to this unprecedented challenge. We have made substantial investments to expand and maintain the amount of COVID-19 testing available to the country. We have been effectively managing challenges in the global supply chain; and, at this point, we have sufficient supplies to conduct our business.

    During 2020 and 2021, our testing volume and revenues were materially impacted by the COVID-19 pandemic.

    Beginning in March 2020, we experienced a material decline in base testing volume (which excludes COVID-19 testing) due to the COVID-19 pandemic. The decrease in base testing volume was driven by federal, state and local governmental policies and initiatives designed to reduce the transmission of COVID-19, a significant reduction in physician office visits, the cancellation of elective medical procedures, customers closing or severely curtailing their operations (voluntarily or in response to government orders), increased unemployment and loss of healthcare insurance and the adoption of work-from-home policies, all of which have had, and may continue to have, an impact on our operating results, financial position and cash flows.

    During May and June 2020, we began to experience a recovery in base testing volume, which continued in 2021. The recovery has been driven by people returning to the healthcare system as well as contributions from new Professional Laboratory Services arrangements. For the first, second, third and fourth quarters of 2021, our base testing volume, excluding volume associated with recent acquisitions, was 2.8% below, 1.9% above, 3.8% above and 4.8% above our historical first, second, third and fourth quarter of 2019 levels, respectively. Recent agreements associated with our Professional Laboratory Services offerings contributed 5.2%, 5.8%, 5.2% and 5.6% volume growth for the first, second, third and fourth quarters of 2021 compared to 2019, respectively. Unless there is a change in the severity of the COVID-19 pandemic, we believe that there will be a continued return to healthcare with, in some cases, patients pursuing care delayed during the COVID-19 pandemic.

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    Beginning in the second quarter of 2020, we experienced growing demand for COVID-19 testing services and we expanded our capacity throughout 2020 in order to satisfy the demand, which has had a significant impact on our testing volumes. During 2021, demand for our COVID-19 testing has generally fluctuated in line with changes in the prevalence of the virus and related variants. We expect demand to trend down in 2022 and beyond.

    Additionally, our revenue per requisition has been positively impacted by COVID-19 molecular testing. In April 2020 the Centers for Medicare and Medicaid Services ("CMS") announced that it would increase the reimbursement for certain COVID-19 molecular tests making use of high-throughput technologies developed by the private sector that allow for increased testing capacity, faster results, and more effective means of combating the spread of the virus to $100 per test, effective April 14, 2020. Beginning January 1, 2021, Medicare changed the base reimbursement rate for COVID-19 diagnostic tests run on high-throughput technologies to $75 per test with an additional payment of $25 per test if the laboratory (1) completes the test in two calendar days or less and (2) completes the majority of its COVID-19 tests that use high throughput technology in two calendar days or less for all of its patients in the previous month. Certain healthcare insurers have now moved to a similar reimbursement model for COVID-19 molecular tests.

    We believe the COVID-19 pandemic’s impact on our consolidated results of operations, financial position and cash flows will be primarily driven by: the severity and duration of the COVID-19 pandemic (including any variants); healthcare insurer, government, and client payer reimbursement rates for COVID-19 molecular testing; the COVID-19 pandemic’s impact on the U.S. healthcare system and the U.S. economy; the timing, scope and effectiveness of federal, state and local governmental responses to the COVID-19 pandemic; and effective and comprehensive COVID-19 vaccination across the U.S. We may also be impacted by changes in the severity of the COVID-19 pandemic at different times in the various cities and regions where we operate and offer services, and by challenges faced in implementing nationwide COVID-19 vaccinations, including the degree to which the public is vaccinated and the effectiveness of vaccines at preventing infection or illness in connection with new or existing variants of COVID-19. Even as the COVID-19 pandemic moderates over time and the business and social distancing restrictions ease, we may continue to experience similar effects to our businesses, consolidated results of operations, financial position and cash flows arising from long-term changes in behavior by consumers or other healthcare system participants and resulting from a recessionary economic environment that may persist. In the longer term, given the many challenges that hospitals will face, we may have more opportunities to partner with hospitals to help achieve their laboratory strategies, and the COVID-19 pandemic may also be a further catalyst for consolidation in the laboratory testing industry.

Medicare Sequestration

    Reimbursement for Medicare services is subject to annual reduction (sequestration) of 2% under the Budget Control Act of 2011. Beginning in May 2020, there has been a suspension of sequestration, which has resulted in a small benefit to us in the form of higher reimbursement rates for diagnostic testing services performed on behalf of Medicare beneficiaries. During December 2021, the suspension of Medicare sequestration was further extended through March 31, 2022 and it was reduced to 1% from April 1, 2022 to June 30, 2022, with the full annual 2% reduction in rates resuming thereafter.

Two Point Strategy

    Our two point strategy and our operating principles are described in detail in "Item 1. Business". We continued to execute our strategy and leverage our operating principles during 2021 as follows:

    Acquisition of the Outreach Services Business of Mercy Health

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    On June 1, 2021, we completed the acquisition of the outreach laboratory services business of Mercy Health, which serves providers and patients in Arkansas, Kansas, Missouri and Oklahoma, in an all-cash transaction for $225 million. The acquired business is included in our DIS business.

    For further details, see Note 5 to the audited consolidated financial statements.

    Acquisition of Assets of Labtech Diagnostics, LLC ("Labtech")

    On December 13, 2021, we completed the acquisition of assets of Labtech, an independent clinical diagnostics laboratory provider serving physicians and patients primarily in South Carolina, North Carolina, Florida and Georgia, in an all cash transaction for $85 million, which consisted of cash consideration of $80 million and contingent consideration initially estimated at $5 million. The contingent consideration arrangement is dependent upon the achievement of certain testing volume benchmarks. The acquired business is included in our DIS business.

    For further details, see Note 5 to the audited consolidated financial statements.

    Investments to Accelerate Growth

    In addition to our normal expenditures to operate the business, we have been making additional investments to accelerate growth, particularly in the advanced diagnostics and consumer-initiated testing areas which we believe represent long term growth opportunities for us. During 2021, such investments totaled approximately $70 million and, during 2022, such investments are expected to approximate $160 million.

    Sale of Ownership Interest in Q2 Solutions® ("Q2 Solutions") to IQVIA Holdings, Inc. ("IQVIA")

    On April 1, 2021, we sold our 40% ownership interest in Q2 Solutions, our clinical trials central laboratory services joint venture, to IQVIA, our joint venture partner, for $760 million in an all-cash transaction. The sales price is subject to customary post-closing adjustments. Prior to the transaction, we accounted for our minority interest as an equity method investment. As a result of the transaction, during the year ended December 31, 2021, we recorded a $314 million pre-tax gain in other income, net in the consolidated statement of operations based on the difference between the net sales proceeds and the carrying value of the investment, including $20 million of cumulative translation losses which were previously recorded in accumulated other comprehensive loss. During the year ended December 31, 2021, we also recorded $55 million of income tax expense related to the gain, consisting of $127 million of current income tax expense, partially offset by $72 million of deferred income tax benefit.

    Under a multi-year agreement, we will remain the strategic preferred laboratory provider for Q2 Solutions' clients, providing a range of lab testing capabilities to augment Q2 Solutions' core offerings and extend its industry leading suite of services.

    For further details, see Note 6 to the audited consolidated financial statements.

    Accelerated Share Repurchase Agreements ("ASRs")

    In April 2021, we entered into ASRs with several financial institutions to repurchase our common stock as part of our share repurchase program. Each of the ASRs was structured to permit us to purchase shares immediately with the final purchase price of those shares determined by the volume-weighted average price of our common stock during the repurchase period, less a fixed discount. During the year ended December 31, 2021, we paid $1.5 billion to the financial institutions and received 10.7 million shares of our common stock under the ASRs.

    For further details regarding the ASRs and our repurchases of our common stock, see Note 16 to the audited consolidated financial statements.

    Invigorate Program

    We are engaged in a multi-year program called Invigorate, which is designed to reduce our cost structure and improve our performance. We currently aim annually to achieve savings and productivity improvements of approximately 3% of our costs and in 2021 we exceeded that goal.

    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

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technology excellence; procurement excellence; field and customer service excellence; lab excellence; and revenue services excellence. In addition to these programs, we have identified key themes to change how we operate including reducing denials and patient price concessions; further digitizing our business; standardization and automation; and optimization initiatives in our lab network and patient service center network. We believe that our efforts to standardize our information technology systems, equipment and data also foster our efforts to strengthen our foundation for growth and support the value creation initiatives of our clinical franchises by enhancing our operational flexibility, empowering and enhancing the customer experience, facilitating the delivery of actionable insights and bolstering our large data platform.

    For the year ended December 31, 2021, we incurred $56 million of pre-tax charges under our Invigorate program primarily consisting of systems conversion and integration costs, all of which result in cash expenditures. Additional restructuring charges may be incurred in future periods as we identify additional opportunities to achieve further productivity improvements and savings.

Outlook and Trends

    The healthcare system in the United States is evolving; significant change is taking place in the system. We expect that the evolution of the healthcare industry, including impacts of the COVID-19 pandemic, such as increased adoption of telemedicine, will continue, and that industry change is likely to be extensive. There are a number of key trends that are having, and that we expect will continue to have, a significant impact on the diagnostic information services business in the United States and on our business. We believe that several of the trends, including consolidation, price transparency and consumerization, are favorable to our business.

    Healthcare market participants, including governments, are focusing on controlling costs, including potentially by reducing reimbursement for healthcare services, changing reimbursement for healthcare services (including but not limited to a shift from fee-for-service to capitation), changing medical coverage policies (e.g., healthcare benefits design), denying coverage for services, requiring preauthorization of laboratory testing, requiring co-pays, introducing laboratory spend management utilities and payment and patient care innovations such as ACOs, DCEs and patient-centered medical homes. In recent years, there has been an ongoing trend of rising patient responsibility (including attributable to payer denials) which has resulted in an increase in our reserves for patient price concessions. As health plans and government programs require greater levels of patient cost-sharing, our patient price concessions may continue to be negatively impacted and adversely impact our results of operations. As previously mentioned, there could be a shift to capitation arrangements where we agree to a predetermined monthly reimbursement rate for each member enrolled in a restricted plan, generally regardless of the number or cost of services provided by us. In both 2021 and 2020, we derived approximately 3% of our consolidated net revenues from capitated payment arrangements. In both 2021 and 2020, we derived approximately 8% of our testing volume from capitated payment arrangements.

    Historically, the Medicare Clinical Laboratory Fee Schedule ("CLFS") and the Medicare Physician Fee Schedule established under Part B of the Medicare program have been subject to change, including each year. Pursuant to the Protecting Access to Medicare Act ("PAMA"), CMS promulgated revised reimbursement schedules for 2018-2020 for clinical laboratory testing services provided under Medicare. Under the revised Medicare Clinical Laboratory Fee Schedule (in 2021 CLFS revenues comprised 7% of our consolidated net revenues), reimbursement rates for clinical laboratory testing were reduced from 2018 - 2020. PAMA calls for further revision of the CLFS for years after 2020, based on future surveys of market rates; reimbursement reduction from 2023 - 2025 is capped by PAMA at 15% annually. PAMA's next data collection and reporting period have been delayed, most recently by federal legislation adopted in 2021, which further delayed the reimbursement rate reductions and reporting requirements until 2023. Overall, we expect total reimbursement rate pressure (i.e., unit price changes) for 2022 from all payers on a combined basis to be less than 1%.

    In addition, the trend of consolidating, converging and diversifying among our customers, payers and other healthcare industry participants has continued and may result in increased price transparency and bargaining power, and may encourage internalization of clinical testing. We also believe that PAMA, among other factors, may be a further catalyst for consolidation as diagnostic information services providers realize lower Medicare reimbursement rates and large diagnostic information services providers may be able to increase their share of the overall diagnostic information services industry due to their large networks and lower cost structures.

    For a discussion of the impact of the COVID-19 pandemic on our business, see "Impact of COVID-19" above.

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    We believe that inflation generally has not had a material adverse effect on our results of operations or financial condition. Given the current environment, we expect wage inflation (excluding the impact of changes in performance-based compensation) of 3% to 4% during 2022.

    For additional information on our key trends, which present both opportunities and risks, see "Item 1. Business: The Clinical Testing Industry."

Critical Accounting Policies

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

    Our revenues are primarily comprised of a high volume of relatively low-dollar transactions, and about one-half of our total costs and expenses consist of employee compensation and benefits. Due to the nature of our business, several of our accounting policies involve significant estimates and judgments:

•revenues and accounts receivable associated with DIS;

•reserves for general and professional liability claims;

•reserves for other legal proceedings; and

•accounting for and recoverability of goodwill.

    Revenues and accounts receivable associated with DIS

    The process for estimating revenues and the ultimate collection of receivables associated with our DIS business involves significant assumptions and judgments. We recognize as revenue the amount of consideration to which we expect to be entitled primarily upon completion of the testing process (when results are reported) or when services have been rendered. We estimate the amount of consideration we expect to be entitled to receive from customer groups in exchange for providing services using the portfolio approach. These estimates include the impact of contractual allowances (including payer denials), and patient price concessions, as discussed below. The portfolios determined using the portfolio approach consist of the following customers:

•Healthcare Insurers

•Government Payers

•Client Payers

•Patients

    We have a standardized approach to estimate the amount of consideration that we expect to be entitled to, including the impact of contractual allowances (including payer denials), and patient price concessions. Historical collection and payer reimbursement experience (along with the period of time that the receivables have been outstanding) is an integral part of the estimation process related to revenues and receivables. Adjustments to our estimated contractual allowances and implicit patient price concessions are recorded in the current period as changes in estimates. Further adjustments to the allowances, based on actual receipts, may be recorded upon settlement.

    We regularly assess the state of our billing operations in order to identify issues which may impact the collectability of receivables or revenue estimates. We believe that the collectability of our receivables is directly linked to the quality of our billing processes, most notably those related to obtaining the correct information in order to bill effectively for the services we provide. As such, we strive to implement “best practices” and endeavor to increase the use of electronic ordering to reduce the number of requisitions that we receive from healthcare providers with missing or incorrect billing information. We believe that our collection and revenue estimation processes, along with our close monitoring of our billing operations, help to reduce the risk associated with material adjustments to reserve estimates. However, changes to our estimate of the impact of contractual allowances (including payer denials) and patient price concessions could have a material impact on our results of operations and financial condition in the period that the estimates are adjusted.

    The following table shows the approximate percentage of our total requisition volume and net revenues associated with our DIS business during 2021 applicable to each customer group:

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[[GREPCENT_TABLE]]
[["","% of","","% of"],["","Total","","Consolidated"],["","Volume","","Net Revenues"],["Healthcare insurers","46%","","42%"],["Government payers","10","","10"],["Client payers","39","","33"],["Patients *","2","","12"],["Total DIS","97%","","97%"]]
[[/GREPCENT_TABLE]]

*Patients revenue includes coinsurance and deductible responsibilities but volume associated with such revenue is reported under Healthcare insurers.

    The following table shows net accounts receivable as of December 31, 2021 applicable to each customer group:    

[[GREPCENT_TABLE]]
[["","% of"],["","Consolidated"],["","Net Accounts"],["","Receivable"],["Healthcare insurers","32%"],["Government payers","6"],["Client payers","38"],["Patients (including coinsurance and deductible responsibilities)","21"],["Total DIS","97%"]]
[[/GREPCENT_TABLE]]

    Healthcare insurers

    Reimbursements from healthcare insurers are based on fee-for-service schedules and on capitated payment rates. Under fee-for-service arrangements, healthcare insurers are billed at our list price. Net revenues recognized consist of amounts billed net of contractual allowances for differences between amounts billed and the estimated consideration we expect to receive from such payers, which considers historical denial and collection experience and the terms of our contractual arrangements.

    Substantially all of the accounts receivable due from healthcare insurers represent amounts billed under fee-for-service arrangements. Collection of our net revenues from healthcare insurers is normally a function of providing complete and correct billing information to the healthcare insurers within the various filing deadlines and generally occurs within 30 to 60 days of billing. Provided we have billed healthcare insurers accurately with complete information prior to the established filing deadline, there has historically been little to no credit risk. If there has been a delay in billing, we determine if the amounts in question will likely go past the filing deadline, and if so, we will reserve accordingly for the billing.

    Under capitated arrangements with healthcare insurers, we recognize revenue based on a predetermined monthly reimbursement rate for each member of an insurer's health plan regardless of the number or cost of services provided by us. Under capitated payment arrangements, the healthcare insurers typically reimburse us in the same month services are performed, essentially giving rise to no outstanding accounts receivable at the end of a reporting period. If any capitated payments are not received on a timely basis, we determine the cause and make a separate determination as to whether or not the collection of the amount from the healthcare insurer is at risk and, if so, would reserve accordingly.

    Government payers

    Reimbursements from government payers are based on fee-for-service schedules set by governmental authorities, including traditional Medicare and Medicaid. Net revenues recognized consist of amounts billed net of contractual allowances for differences between amounts billed and the estimated consideration we expect to receive from such payers, which considers historical denial and collection experience.

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    Collection of our net revenues from government payers is normally a function of providing the complete and correct billing information within the various filing deadlines. Collection generally occurs within 30 days of billing. Provided we have billed government payers accurately with complete information prior to the established filing deadline, there has historically been little to no credit risk. If there has been a delay in billing, we determine if the amounts in question will likely go past the filing deadline, and, if so, we will reserve for the billing accordingly.

    Client payers

    Client payers include physicians, hospitals, ACOs, DCEs, IDNs, employers, other commercial laboratories and institutions for which services are performed on a wholesale basis, and are billed based on a negotiated fee schedule. Credit risk and ability to pay are more of a consideration for these payers than healthcare insurers and government payers. Collection of consideration we expect to receive generally occurs within 60 to 90 days of billing.

    We principally estimate the allowance for credit losses for client payers based on historical collection experience, the current credit worthiness of the customers, current economic conditions, expectations of future economic conditions and the period of time that the receivables have been outstanding. To the extent that any individual client payers are identified that have deteriorated in credit quality, we establish allowances based on the individual risk characteristics of such customers.

    Patients

    Uninsured patients are billed based on established patient fee schedules or fees negotiated with physicians on behalf of their patients. Insured patients (includes coinsurance and deductible responsibilities) are billed based on fees negotiated with healthcare insurers. Collection of billings from patients is subject to credit risk and ability of the patients to pay. Net revenues consist of amounts billed net of discounts provided to uninsured patients in accordance with our policies and implicit price concessions. Implicit price concessions represent differences between amounts billed and the estimated consideration we expect to receive from patients, which considers historical collection experience (along with the period of time that the receivables have been outstanding) and other factors including current market conditions. Patient billings are generally fully reserved for when the related service reaches 210 days outstanding. Balances are automatically written off when they are sent to collection agencies. Allowances are further adjusted for estimated recoveries of amounts sent to collection agencies based on historical collection experience, which is regularly monitored. Collection of consideration we expect to receive generally occurs within 30 to 60 days of billing.

    Reserves for general and professional liability claims

    As a general matter, providers of diagnostic information services may be subject to lawsuits alleging negligence or other similar claims. These suits could involve claims for substantial damages. Any professional liability litigation could also have an adverse impact on our client base and reputation. We maintain various liability insurance coverages for claims that could result from providing, or failing to provide, clinical testing services, including inaccurate testing results, and other exposures. Our insurance coverage limits our maximum exposure on individual claims; however, we are essentially self-insured for a significant portion of these claims. While the basis for claims reserves is actuarially determined losses based upon our historical and projected loss experience, the process of analyzing, assessing and establishing reserve estimates relative to these types of claims involves a high degree of judgment. Although we believe that our present reserves and insurance coverage are sufficient to cover currently estimated exposures, it is possible that we may incur liabilities in excess of our recorded reserves or insurance coverage. Changes in the facts and circumstances associated with claims could have a material impact on our results of operations (principally costs of services), cash flows and financial condition in the period that reserve estimates are adjusted or paid. See Note 18 to the audited consolidated financial statements for a discussion of our reserves for general and professional liability claims.

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    Reserves for other legal proceedings

    Our businesses are subject to or impacted by extensive and frequently changing laws and regulations, including inspections and audits by governmental agencies, in the United States (at both the federal and state levels) and the other jurisdictions in which we conduct business. Although we believe that we are in compliance, in all material respects, with applicable laws and regulations, there can be no assurance that a regulatory agency would not reach a different conclusion. Any noncompliance by us with applicable laws and regulations could have a material adverse effect on our results of operations. In addition, these laws and regulations may be interpreted or applied by a prosecutorial, regulatory or judicial authority in a manner that could require us to make changes in our operations, including our pricing and/or billing practices. In addition, certain federal and state statutes, including the qui tam provisions of federal and state false claims acts, allow private individuals to bring lawsuits against healthcare companies on behalf of government or private payers alleging inappropriate billing practices. We are aware of certain pending lawsuits including class action lawsuits, and have received subpoenas related to billing practices. See Note 18 to the audited consolidated financial statements for a discussion of the various legal proceedings that we are involved in.

    The process of analyzing, assessing and establishing reserve estimates relative to legal proceedings involves a high degree of judgment. Management has established reserves for legal proceedings in accordance with generally accepted accounting principles in the United States. Changes in facts and circumstances related to such proceedings could lead to significant adjustments to reserve estimates for such matters and could have a material impact on our results of operations, cash flows and financial condition in the period that reserve estimates are adjusted or paid.

    Accounting for and recoverability of goodwill

    We do not amortize goodwill, but evaluate the recoverability and measure the potential impairment of our goodwill annually, or more frequently, in the case of other events that indicate a potential impairment. We identified the following reporting units for goodwill impairment testing in 2021:

•DIS business;

•Risk assessment services business, which is part of our DS businesses

    The DIS reporting unit components have been aggregated into a single reporting unit because they have similar economic characteristics, including similarities in financial performance, nature of products or services, nature of production processes and types of customers.

    On a quarterly basis, we perform a review of our business to determine if events or changes in circumstances have occurred which could have a material adverse effect on our fair value and our goodwill. If such events or changes in circumstances were deemed to have occurred, we would perform an impairment test of goodwill and record any noted impairment loss.

    The annual impairment test for goodwill includes an option to perform a qualitative assessment of whether it is more likely than not that a reporting unit's fair value is less than its carrying value; the qualitative analysis may be performed prior to, or as an alternative to, performing a quantitative goodwill impairment test. In evaluating whether it is more likely than not that the fair value of a reporting unit is less than its carrying value, we assess relevant events and circumstances, such as: (a) macroeconomic conditions; (b) industry and market considerations; (c) cost factors; (d) overall financial performance; (e) other relevant entity-specific events; (f) events affecting a reporting unit; and (g) a sustained decrease in share price. If, after assessing the totality of events or circumstances, we determine that it is more likely than not that the fair value of a reporting unit is less than its carrying value, then we are required to perform the quantitative goodwill impairment test. Otherwise, no further analysis is required. Additionally, our policy is to update the fair value calculation of our reporting units and perform the quantitative goodwill impairment test on a periodic basis.

    The quantitative impairment test involves the comparison of the fair value of the reporting unit to its carrying value. If the carrying value is greater than our estimate of fair value, an impairment loss will be recognized in the amount of the excess. We calculate the fair value of each reporting unit using either (i) a discounted cash flows analysis that converts future cash flow amounts into a single discounted present value amount or (ii) a market approach. We assess the valuation methodology based upon the relevance and availability of the data at the time we perform the valuation. The discounted cash flows analysis includes several unobservable inputs related to our own assumptions. The assumptions and estimates used in the discounted cash flows model are based upon the best available information in the circumstances and include a forecast of expected future cash flows, long-term growth rates, discount rates that are commensurate with economic risks, assumed income tax rates and

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estimates of capital expenditures and working capital. The fair values of the reporting units could be different if, for example, forecasted revenue growth rates, economic conditions, government regulations or actions by payers to control utilization of or reimbursement for healthcare services, turn out to be different than our assumptions or estimates. Changes in the assumed discount rates due to changes in interest rates could also affect the estimated fair values of the reporting units. We use a discount rate that considers a weighted average cost of capital plus an appropriate risk premium based upon the reporting unit being valued. Our analysis also considers publicly available information regarding our market capitalization, as well as (i) the financial projections and future prospects of our business, including its growth opportunities and likely operational improvements, and (ii) comparable sales prices, if available. We believe our estimation methods are reasonable and reflect common valuation practices.

    We perform our annual impairment test during the fourth quarter of the fiscal year. For the year ended December 31, 2021, we performed the qualitative assessment for our DIS and risk assessment services reporting units. Based on the totality of the information available for each reporting unit, we concluded that it was more likely than not that the estimated fair values were greater than the carrying values of the reporting units, and as such, no further analysis was required. As a sensitivity, in conjunction with the most recent quantitative test performed for the year ended December 31, 2020, if the estimated fair values of each of our reporting units decreased by 10%, we would have concluded that our goodwill was not impaired.

Results of Operations

    For a comparison of results of operations for the year ended December 31, 2020 compared to December 31, 2019, along with the results of operations for the year ended December 31, 2019, see "Item 7 - Management's Discussion and Analysis of Financial Condition and Result of Operations" of our Annual Report on Form 10-K for the year ended December 31, 2020. See "Available Information."

    Basis of Presentation

    Our DIS business currently represents our one reportable business segment. The DIS business for the years ended December 31, 2021 and 2020 accounted for greater than 95% of our consolidated net revenues. Our other operating segments consist of our DS businesses. For further details regarding our business segment information, see Note 19 to the audited consolidated financial statements.

    Results of Operations    

    The following table sets forth certain results of operations data for the periods presented:    

[[GREPCENT_TABLE]]
[["","2021","","2020","","","","$ Change","","","","% Change"],["","(dollars in millions, except per share data)"],["Net revenues:"],["DIS business","$","10,494","","","$","9,139","","","","","$","1,355","","","","","14.8","%"],["DS businesses","294","","","298","","","","","(4)","","","","","(1.3)"],["Total net revenues","$","10,788","","","$","9,437","","","","","$","1,351","","","","","14.3","%"],["Operating costs and expenses and other operating income:"],["Cost of services","$","6,579","","","$","5,804","","","","","$","775","","","","","13.4","%"],["Selling, general and administrative","1,727","","","1,550","","","","","177","","","","","11.4"],["Amortization of intangible assets","103","","","103","","","","","\u2014","","","","","\u2014"],["Other operating (income) expense, net","(2)","","","9","","","","","(11)","","","","","NM"],["Total operating costs and expenses, net","$","8,407","","","$","7,466","","","","","$","941","","","","","12.6","%"],["Operating income","$","2,381","","","$","1,971","","","","","$","410","","","","","20.8","%"]]
[[/GREPCENT_TABLE]]

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[[GREPCENT_TABLE]]
[["Other income (expense):"],["Interest expense, net","$","(151)","","","$","(163)","","","","","$","12","","","","","(7.2)","%"],["Other income, net","369","","","76","","","","","293","","","","","NM"],["Total non-operating income (expense), net","$","218","","","$","(87)","","","","","$","305","","","","","NM"],["Income tax expense","$","(597)","","","$","(460)","","","","","$","(137)","","","","","29.6","%"],["Effective income tax rate","23.0","%","","24.5","%"],["Equity in earnings of equity method investees, net of taxes","$","78","","","$","75","","","","","$","3","","","","","4.7","%"],["Net income attributable to Quest Diagnostics","$","1,995","","","$","1,431","","","","","$","564","","","","","39.4","%"],["Diluted earnings per share attributable to Quest Diagnostics\u2019 common stockholders","$","15.55","","","$","10.47","","","","","$","5.08","","","","","48.5","%"]]
[[/GREPCENT_TABLE]]

NM - Not Meaningful

    The following table sets forth certain results of operations data as a percentage of net revenues for the periods presented:

[[GREPCENT_TABLE]]
[["","2021","","2020"],["Net revenues:"],["DIS business","97.3","%","","96.8","%"],["DS businesses","2.7","","","3.2"],["Total net revenues","100.0","%","","100.0","%"],["Operating costs and expenses and other operating income:"],["Cost of services","61.0","%","","61.5","%"],["Selling, general and administrative","16.0","","","16.4"],["Amortization of intangible assets","1.0","","","1.1"],["Other operating (income) expense, net","(0.1)","","","0.1"],["Total operating costs and expenses, net","77.9","%","","79.1","%"],["Operating income","22.1","%","","20.9","%"]]
[[/GREPCENT_TABLE]]

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    Operating Results

    Results for the year ended December 31, 2021 were affected by certain items that on a net basis increased diluted earnings per share by $1.31 as follows:

•a pre-tax gain recorded in other income, net of $314 million, or $2.02 per diluted share, on the sale of our 40% ownership interest in Q2 Solutions;

•a net pre-tax gain of $23 million (a $39 million gain recorded in other income, net, partially offset by $16 million of costs recorded in selling, general and administrative expenses), or $0.16 per diluted share, primarily representing changes in the carrying value of our strategic investments, and a gain recognized by an equity method investee to adjust certain of its investments to fair value, partially offset by costs associated with donations, contributions and other financial support through Quest for Health Equity (our initiative with the Quest Diagnostics Foundation to reduce health disparities in underserved communities), and a non-cash impairment charge to the carrying value of an equity method investment; and

•excess tax benefits associated with stock-based compensation arrangements of $19 million, or $0.14 per diluted share, recorded in income tax expense; partially offset by

•pre-tax amortization expense of $105 million ($103 million in amortization of intangible assets and $2 million in equity in earnings of equity method investees, net of taxes) or $0.62 per diluted share;

•pre-tax charges of $61 million ($30 million in cost of services and $31 million in selling, general and administrative expenses), or $0.36 per diluted share, primarily associated with systems conversions and integration incurred in connection with further restructuring and integrating our business; and

•pre-tax charges of $4 million in cost of services, or $0.03 per diluted share, representing the impact of certain items resulting from the COVID-19 pandemic, including incremental costs incurred to protect the health and safety of our employees and customers.

    For the year ended December 31, 2021, diluted earnings per share benefited from the impact of the ASRs on our weighted average shares outstanding as compared to the prior year.

    Results for the year ended December 31, 2020 were affected by certain items that on a net basis decreased diluted earnings per share by $0.71 as follows:

•pre-tax amortization expense of $114 million ($103 million in amortization of intangible assets and $11 million in equity in earnings of equity method investees, net of taxes) or $0.63 per diluted share;

•net pre-tax charges of $72 million ($57 million of charges in cost of services, $10 million of charges in selling, general and administrative expenses and $9 million of charges in other operating (income) expense, net, partially offset by a $4 million gain in equity in earnings of equity method investees, net of taxes), or $0.39 per diluted share, representing the impact of certain items resulting from the COVID-19 pandemic, principally including expense associated with payments to eligible employees to help offset expenses they incurred as a result of COVID-19, incremental costs incurred primarily to protect the health and safety of our employees and customers, and certain asset impairment charges; and

•pre-tax charges of $58 million ($27 million in cost of services and $31 million in selling, general and administrative expenses), or $0.32 per diluted share, primarily associated with systems conversions and integration incurred in connection with further restructuring and integrating our business; partially offset by

•a pre-tax gain of $70 million, or $0.46 per diluted share, recognized in other income, net, based on the difference between the fair value and the carrying value of an equity interest;

•excess tax benefits associated with stock-based compensation arrangements of $23 million, or $0.17 per diluted share, recorded in income tax expense; and

•a net pre-tax gain of $2 million (a $14 million gain in equity in earnings of equity method investees, net of taxes, partially offset by a $10 million loss in other income, net, and $2 million of charges in selling, general and administrative expenses) primarily due to a gain recognized by an equity method investee to adjust certain of its investments to fair value, a loss on retirement of debt, and, to a lesser extent, costs associated with Quest for Health Equity.

    Net Revenues

    Net revenues for the year ended December 31, 2021 increased by 14.3% compared to the prior year.

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    DIS revenues for the year ended December 31, 2021 increased by 14.8% compared to the prior year. For the year ended December 31, 2021:

•Organic revenue and acquisitions contributed approximately 13.0% and 1.8%, respectively, to DIS revenue growth compared to the prior year. Organic revenue growth was driven by growth in the base business and, to a lesser extent, demand for COVID-19 molecular testing.

•Revenues in the base business (including the impact of recent acquisitions) increased by 20.4% compared to the prior year, which was negatively impacted as a result of the COVID-19 pandemic. Compared to historical levels in 2019, revenues in the base business, excluding revenue associated with recent acquisitions, increased by 0.4%. Recent agreements associated with our Professional Laboratory Services offerings contributed 2.3% revenue growth compared to 2019.

•DIS volume increased by 16.5% with organic volume and acquisitions contributing approximately 13.6% and 2.9%, respectively. Organic volume growth was driven by growth in the base business.

•Testing volume in the base business (including the impact of recent acquisitions) continued to recover and was up 19.7% compared to the prior year, which was negatively impacted as a result of the COVID-19 pandemic. Compared to historical levels in 2019, testing volume in the base business, excluding volume associated with recent acquisitions, increased by 2.0%. Recent agreements associated with our Professional Laboratory Services offerings contributed 5.5% volume growth compared to 2019.

•Revenue per requisition decreased by 1.6% compared to the prior year primarily due to growth in our Professional Laboratory Services engagements, which carry a lower revenue per requisition than the average for the remainder of the DIS business, and pricing pressure of approximately 1.1%, partially offset by favorable test mix.

    Cost of Services

    Cost of services consists principally of costs for obtaining, transporting and testing specimens as well as facility costs used for the delivery of our services.

    Cost of services increased by $775 million for the year ended December 31, 2021 compared to the prior year. The increase was primarily driven by higher variable expenses related to increased testing volumes, higher compensation and benefits costs (primarily related to wage increases), and, to a lesser extent, additional operating costs associated with our acquisitions.

    Selling, General and Administrative Expenses ("SG&A")

    SG&A consists principally of the costs associated with our sales and marketing efforts, billing operations, credit loss expense and general management and administrative support, as well as administrative facility costs.

    SG&A increased by $177 million for the year ended December 31, 2021, compared to the prior year, primarily driven by higher variable expenses to support our increase in testing volumes, investments in our strategic growth initiatives and higher compensation and benefit costs (including headcount and wage increases).

    Amortization of Intangible Assets

    For the year ended December 31, 2021, amortization expense was flat compared to the prior year.

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    Other Operating (Income) Expense, Net

    Other operating (income) expense, net includes miscellaneous income and expense items and other charges related to operating activities.

    For the year ended December 31, 2020, other operating (income) expense, net primarily represents impairment charges due to the impact of the COVID-19 pandemic.

    Interest Expense, Net

    Interest expense, net decreased by $12 million for the year ended December 31, 2021 compared to the prior year, primarily due to lower average outstanding indebtedness and, to a lesser extent, lower interest rates due to recent refinancing transactions, including the termination of our interest rate swap agreements in April 2020, which resulted in a deferred gain that is being amortized as a reduction of interest expense, net over the remaining term of the associated debt.

    Other Income, Net

    Other income, net represents miscellaneous income and expense items related to non-operating activities, such as gains and losses associated with investments and other non-operating assets.

    For the year ended December 31, 2021, other income, net included a $314 million pre-tax gain on the sale of our 40% ownership interest in Q2 Solutions, our clinical trials central laboratory services joint venture, to IQVIA, our joint venture partner (see Note 6 to the audited consolidated financial statements), $39 million in gains associated with changes in the carrying value of our strategic investments, and $17 million in gains associated with investments in our deferred compensation plans.

    For the year ended December 31, 2020, other income, net included a $70 million gain recognized as a result of the remeasurement of our previously held equity interest in Mid America Clinical Laboratories, LLC ("MACL") to fair value (see Note 5 to the audited consolidated financial statements) and $15 million in gains associated with investments in our deferred compensation plans, partially offset by a $9 million loss on the retirement of debt, principally due to premiums paid.

    Income Tax Expense

    Income tax expense for the years ended December 31, 2021 and 2020 was $597 million and $460 million, respectively. The increase in income tax expense compared to the prior year was primarily driven by an increase in income before income taxes and equity in earnings of equity method investees.

    The effective income tax rate for the years ended December 31, 2021 and 2020 was 23.0% and 24.5%, respectively. The effective income tax rate for the year ended December 31, 2021 benefited from a lower effective income tax rate, 17.6%, on the gain on the sale of our 40% ownership interest in Q2 Solutions. The effective income tax rate for the year ended December 31, 2020 benefited from a lower effective income tax rate, 11.8%, associated with a $70 million gain recognized as a result of the remeasurement of our previously held equity interest in MACL to fair value. In addition, the effective income tax rates benefited from $19 million and $23 million of excess tax benefits associated with stock-based compensation arrangements for the years ended December 31, 2021 and 2020, respectively.

    Equity in Earnings of Equity Method Investees, Net of Taxes

    For the year ended December 31, 2021, there was a $3 million increase in equity in earnings of equity method investees, net of taxes, compared to the prior year primarily due to the demand for COVID-19 testing services and recovery in the base business of the investees, partially offset by lower equity earnings as a result of the sale of our 40% ownership interest in Q2 Solutions.

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