second quarter of 2007 in connection with the financing of the AmeriPath acquisition and is not expected to have a material impact on our 2007 financial results.
HemoCue is the leading international provider in near patient testing for hemoglobin, with a growing share in professional glucose and microalbumin testing. In addition, HemoCue is currently developing new tests including a near patient test to determine white blood cell counts. This acquisition complements our near patient testing for infectious disease and cancer, including new tests for colorectal cancer screening and herpes simplex type 2. The acquisition increases our presence in the growing near patient testing market and we plan to leverage HemoCue’s international presence to reach new markets around the world.
On August 31, 2006, we completed the acquisition of Enterix Inc. (“Enterix”), a privately held Australia-based company that developed and manufactures the InSure™ Fecal Immunochemical Test, an FDA-cleared test for use in screening for colorectal cancer and other sources of lower gastrointestinal bleeding, for approximately $44 million in cash, as described in Note 2 to the interim consolidated financial statements.
On July 3, 2006, we completed the acquisition of Focus Technologies Holding Company (“Focus Diagnostics”) in an all-cash transaction valued at $208 million, including approximately $3 million of assumed debt. We financed the acquisition and related transaction costs and the repayment of substantially all of Focus Diagnostics’ outstanding debt with $135 million of borrowings under our secured receivables credit facility and with cash on-hand, as described in Note 2 to the interim consolidated financial statements.
Focus Diagnostics is a leading provider of infectious and immunologic disease testing and develops and markets diagnostic products. It offers its reference testing services and diagnostic products to large academic medical centers, hospitals and commercial laboratories.
Our clinical testing business currently represents our one reportable business segment. The clinical testing business accounted for greater than 90% of revenues from continuing operations in 2007 and 2006, respectively. Our other operating segments consist of our risk assessment services business, our clinical trials testing business, our healthcare information technology business, MedPlus, and our diagnostic products business. On April 19, 2006, we decided to discontinue the operations of a test kit manufacturing subsidiary, NID. During the third quarter of 2006, we completed our wind down of NID and classified the operations of NID as discontinued operations for all periods presented. Our business segment information is disclosed in Note 11 to the interim consolidated financial statements.
Income from continuing operations for the three months ended September 30, 2007 was $150 million, or $0.77 per diluted share, compared to $164 million, or $0.82 per diluted share, in 2006. Income from continuing operations for the nine months ended September 30, 2007 was $400 million, or $2.05 per diluted share, compared to $474 million, or $2.37 per diluted share in 2006. The impact of the change in contract status with UNH, which was the principal driver of lower earnings compared to the prior year during the first two quarters of 2007, has been essentially mitigated in the third quarter primarily as a result of actions taken to reduce costs. The decrease in the three months ended September 30, 2007 from the prior year is principally due to the AmeriPath acquisition, which will be somewhat dilutive until anticipated cost synergies and growth opportunities associated with the acquisition are realized.
Results for the three and nine months ended September 30, 2007 include pre-tax charges of $2.6 million, or $0.01 per share, and $16.8 million, or $0.05 per share, respectively, associated with workforce reductions in response to reduced volume levels. Results for the nine months ended September 30, 2007 include a pre-tax charge of $4.0 million, or $0.01 per share, related to in-process research and development expense associated with the HemoCue acquisition. In addition, results for the nine months ended September 30, 2007 were unfavorably impacted by severe storms in the central part of the United States, which reduced revenues by approximately $13 million and operating income by approximately $10 million, or $0.03 per share.
Results for the nine months ended September 30, 2006 include pre-tax charges of $27 million, or $0.08 per diluted share, recorded in the first quarter, primarily associated with integration activities. In addition, the year-to-date results for 2006 include $16 million pre-tax charges, or $0.05 per diluted share, related to investment write-downs, of which $12 million were recorded during the second quarter and the remainder during the third quarter of 2006. These write-downs were offset by a pre-tax gain of $16 million, or $0.05 per diluted share, related to the sale of an investment in the first quarter of 2006.
Net Revenues
Net revenues for the three months ended September 30, 2007 were $1.8 billion, 11.6% above the prior year level. Net revenues for the nine months ended September 30, 2007 were $4.9 billion, an increase of 4.6% over the prior year level. The acquisition of AmeriPath contributed 13.0% and 5.8% to revenue growth for the three and nine months ended September 30, 2007, respectively. Our acquisitions of Focus, Enterix and HemoCue, contributed about 2% to revenue growth for the three and nine months ended September 30, 2007. The impact of our change in status with UNH reduced reported revenue growth by an estimated 4.8% and 4.7% for the three and nine months ended September 30, 2007, respectively.
For the three months ended September 30, 2007, revenues in our clinical testing business, which accounts for over 90% of our total revenues, increased by 10.6%, with AmeriPath contributing 14% growth. Volume, measured by the number of requisitions, declined 2.4% for the three months ended September 30, 2007, primarily due to our change in status with UNH, partially offset by the impact of the AmeriPath acquisition, which increased volume by about 5.5% . Revenue per requisition increased 13.3% for the three months ended September 30, 2007 and was impacted by the results of AmeriPath, which contributed 8.5% to the improvement, with the balance of the increase primarily driven by a continued positive test mix. Ameripath’s organic revenue growth for the third quarter was 7%, with particular strength in dermatopathology and hospital testing.
For the nine months ended September 30, 2007, clinical testing revenues were 3.2% above the prior year level and were favorably impacted by the acquisition of AmeriPath, which contributed growth of 6.3% . For the nine months ended September 30, 2007, revenue per requisition improved 8.9% and was favorably impacted by the acquisition of AmeriPath, which contributed 4% to the improvement. Volume declined 5.2% for the nine months ended September 30, 2007, primarily due to our change in status with UNH, partially offset by the impact of the AmeriPath acquisition, which contributed 2.4% volume growth.
We estimate that revenues declined approximately 4.8% and 4.7% during the three and nine months ended September 30, 2007, respectively, due to our change in status with UNH, with volume reduced by an estimated 7.3% and 6.8% for the three and nine months ended September 30, 2007, respectively. This decrease was partially offset by a positive impact to revenue per requisition estimated at 1.9% and 1.6% for the three and nine months ended September 30, 2007, respectively, associated with higher reimbursement on the retained UNH work.
Our businesses other than clinical laboratory testing accounted for approximately 9% of our net revenues for the three and nine months ended September 30, 2007. These businesses include our risk assessment services business, our clinical trials testing business, our healthcare information technology business, MedPlus, and our diagnostic products business. The revenues for these businesses as a group grew 23.9% and 20.9% for the three and nine months ended September 30, 2007, respectively, as compared to the prior year periods, with the increase primarily driven by our acquisitions of HemoCue, Focus Diagnostics and Enterix.
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Operating Costs and Expenses
Total operating costs and expenses for the three and nine months ended September 30, 2007 increased $171 million and $285 million, respectively, from the prior year periods. While costs were reduced associated with lower volume levels and actions taken to reduce the size of our workforce, costs increased associated with annual compensation adjustments, increased expenditures to maintain and improve service levels, and costs associated with clarifying for patients, physicians and employers significant misinformation which had circulated about the UNH contract change. In addition, costs associated with the acquired operations of AmeriPath, Focus Diagnostics, Enterix and HemoCue increased costs by approximately $225 million and $350 million for the three and nine months ended September 30, 2007, respectively. Results for the three months ended September 30, 2007 include $2.6 million of costs associated with workforce reductions ($1.0 million included in costs of services and $1.6 million in selling, general and administrative). Results for the nine months ended September 30, 2007 include $16.8 million of costs associated with workforce reductions ($7.5 million included in costs of services and $9.3 million in selling, general and administrative) and $4.0 million of in-process research and development costs associated with the acquisition of HemoCue, which was recorded in other operating expense (income), net.
For the nine months ended September 30, 2006, $26.8 million in special charges are reflected in other operating expense (income), net and relate principally to costs associated with integrating LabOne, which we acquired in November 2005, and consolidating our operations in California into our new facility in West Hills.
Cost of services, which includes the costs of obtaining, transporting and testing specimens, was 58.1% of net revenues for the three months ended September 30, 2007, decreasing from 59.0% of net revenues in the prior year period. The decrease in cost of services as a percentage of net revenues for the third quarter is due to actions which reduced our cost structure and higher revenue per requisition. For the nine months ended September 30, 2007, cost of services as a percentage of net revenues increased to 59.3% from 58.8% in the prior year period. The increases over the prior year are primarily due to lower volumes in our clinical testing business and costs associated with workforce reductions. Partially offsetting these increases were improvements related to the increase in average revenue per requisition and actions taken to reduce costs.
Selling, general and administrative expenses, which include the costs of the sales force, billing operations, bad debt expense, and general management and administrative support, were 24% of net revenues for the three months ended September 30, 2007, compared to 22.4% in the prior year period. For the nine months ended September 30, 2007, selling, general and administrative expenses as a percentage of net revenues increased to 24.4% from 22.5% in the prior year period. The increase over the prior year for the three months ended September 30, 2007 is primarily due to the impact of the acquired operations of AmeriPath and HemoCue. The increase over the prior year to date period is primarily due to lower volume levels in our clinical testing business; increased billing and bad debt expense associated with having to bill patients for a portion of the retained UNH work; costs associated with workforce reductions; costs associated with efforts to retain business and clarify for patients, physicians and employers misinformation regarding the UNH contract change; and the impact of the acquired operations of AmeriPath and HemoCue.
For the three months ended September 30, 2007 and 2006, bad debt expense was 4.8% and 3.8% of net revenues, respectively. The higher bad debt rate was principally driven by AmeriPath, which contributed 0.8% of the increase. AmeriPath currently carries a higher bad debt rate than the rest of our business, primarily due to its revenue and customer mix, and the impact of billing system conversions.
For the nine months ended September 30, 2007 and 2006, bad debt expense was 4.5% and 3.9% of net revenues, respectively. The higher bad debt rate was principally driven by the inclusion of AmeriPath, which carries a higher bad debt rate than the rest of our business and by higher bad debt expense associated with billing patients directly for a portion of the UNH volume.
Other operating expense (income), net represents miscellaneous income and expense items related to operating activities, including gains and losses associated with the disposal of operating assets and provisions for restructurings and other special charges. For the nine months ended September 30, 2007, other operating expense (income), net includes a $4.0 million charge related to in-process research and development expense recorded in connection with the acquisition of HemoCue.
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For the nine months ended September 30, 2006, other operating expense (income), net includes a charge of $20.7 million associated with executing the integration plan of LabOne. The $20.7 million charge related to actions that impacted Quest Diagnostics’ employees and operations and were comprised principally of employee severance costs. In addition, other operating (income) expense, net for the nine months ended September 30, 2006 includes a $4.1 million charge related to consolidating our operations in California into a new facility. The costs were comprised primarily of employee severance costs and the write-off of certain operating assets.
Operating Income
Operating income for the three months ended September 30, 2007 was $306 million, or 17.3% of net revenues, compared to $293 million, or 18.5% of net revenues, in the prior year period. For the nine months ended September 30, 2007 operating income was $779 million, or 15.8% of net revenues, compared to $849 million, or 18.0% of net revenues in the prior year period. The decrease in operating income as a percentage of net revenues from the prior year’s third quarter is primarily due to the acquisition of AmeriPath. The impact of the change in contract status with UNH, which was the principal driver of the lower operating income percentage compared to the prior year during the first two quarters of 2007, has been essentially mitigated in the third quarter primarily as a result of actions taken to reduce costs. The decrease in operating income as a percentage of net revenues for the nine months ended September 30, 2007 was primarily due to lower volume levels in our clinical testing business, the various items which served to increase cost of services and selling, general and administrative expenses as a percentage of revenues, and the impact of the acquired operations of AmeriPath and HemoCue. These decreases were offset in part by actions we have taken to reduce our cost structure; the avoidance of certain costs incurred in the first quarter of 2007 associated with business retention and workforce reductions; and higher revenue per requisition.
Other Income (Expense)
Interest expense, net for the three and nine months ended September 30, 2007 increased $36 million and $55 million, respectively, over the prior year periods. The increases were primarily due to additional interest expense associated with borrowings to fund acquisitions. See Note 5 to the interim consolidated financial statements for a discussion of our outstanding debt.
Other income (expense), net represents miscellaneous income and expense items related to non-operating activities such as gains and losses associated with investments and other non-operating assets. For the three and nine months ended September 30, 2006, other income (expense), net includes a $4 million charge recorded in the third quarter associated with the write-down of an investment. For the nine months ended September 30, 2006, other income (expense), net includes a $12 million charge recorded during the second quarter associated with the write-down of an investment and a first quarter gain of $16 million on the sale of an investment.
Discontinued Operations
As previously disclosed, NID, a test kit manufacturing subsidiary, and the Company each received a subpoena from the United States Attorney’s Office for the Eastern District of New York during the fourth quarter of 2004. The subpoenas requested a wide range of business records, including documents regarding parathyroid hormone (“PTH”) test kits manufactured by NID and PTH testing performed by the Company. The Company has voluntarily and actively cooperated with the investigation, providing information, witnesses and business records of NID and the Company, including documents related to PTH tests and test kits, as well as other tests and test kits. In the second and third quarters of 2005, the FDA conducted an inspection of NID and issued a Form 483 listing the observations made by the FDA during the course of the inspection. NID responded to the Form 483.
During the fourth quarter of 2005, NID instituted its second voluntary product hold within a six-month period, due to quality issues, which adversely impacted the operating performance of NID. As a result, the Company evaluated a number of strategic options for NID, and on April 19, 2006, decided to cease operations at NID. Upon completion of the wind down of operations in the third quarter of 2006, the operations of NID were classified as discontinued operations. During the third quarter of 2006, the government issued two additional
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subpoenas, one to NID and one to the Company. The subpoenas covered various records, including records related to tests and test kits in addition to PTH.
During the third quarter of 2007, the government and the Company began settlement discussions. In the course of those discussions, the government disclosed to the Company certain of the government’s legal theories regarding the amount of damages allegedly incurred by the government, which include alleged violations of civil and criminal statutes including the False Claims Act and the Food, Drug and Cosmetics Act. Violations of these statutes and related regulations could lead to a warning letter, injunction, fines or penalties, exclusion from federal health care programs and/or criminal prosecution, as well as claims by third parties. The Company analyzed the government’s position and presented its own analysis which argued against many of the government’s claims. In light of that analysis and in accordance with generally accepted accounting principles, the Company established a reserve, reflected in discontinued operations, of $51 million in connection with these claims. The Company estimates that this amount represents the minimum expected probable loss with respect to this matter. The Company does not believe that a reasonable estimate for these losses in excess of the established reserve can be made at this time. Although the Company expects that a portion of any settlement payment will be tax deductible, the amount of the tax benefit relating to a settlement payment is uncertain at this time. Therefore, the reserve was established without recording a corresponding tax benefit. Eventual losses related to these matters may substantially exceed the reserve, and the impact could be material to the Company’s results of operations, cash flows and financial condition in the period that such matters are determined or paid.
The Company continues to engage in discussions with the United States Attorney’s Office and those discussions potentially could lead to an agreement in principle to resolve some or all of the matters in the near future. There can be no assurance, however, when or whether a settlement may be reached, or as to its terms. If the Company cannot reach an acceptable settlement agreement with the United States Attorney’s Office, the Company would defend itself and NID and could incur significant costs in doing so. See Note 7 to the interim consolidated financial statements for a further description of these matters.
Loss from discontinued operations, net of tax, for the three months ended September 30, 2007 was $52 million, or $0.27 per diluted share, compared to $3 million, or $0.02 per diluted share in 2006. Loss from discontinued operations, net of tax, for the nine months ended September 30, 2007 was $55 million, or $0.28 per diluted share, compared to $37 million, or $0.19 per diluted share in 2006. Results for the three and nine months ended September 30, 2007 reflect a charge of $51 million to establish a reserve in connection with various government claims. Results for the three months ended September 30, 2006 reflect pre-tax charges of $2.7 million, primarily related to facility closure charges and employee severance costs. Results for the three and nine months ended September 30, 2006 also reflect losses from NID’s operations, due to its voluntary product hold instituted late in the second quarter of 2005 in connection with a quality review of all its products. In addition, results for the nine months ended September 30, 2006 also reflect pre-tax charges of $31 million, primarily related to the wind-down of NID’s operations. These charges included: inventory write-offs of $7 million; asset impairment charges of $5 million; employee severance costs of $6 million; contract termination costs of $6 million; facility closure costs of $2 million; and costs to support activities to wind-down the business, comprised primarily of employee costs and professional fees of $5 million.
Quantitative and Qualitative Disclosures About Market Risk
We address our exposure to market risks, principally the market risk of changes in interest rates, through a controlled program of risk management that includes the use of derivative financial instruments. We do not hold or issue derivative financial instruments for trading purposes. We believe that our foreign exchange exposure is not material to our financial condition or results of operations. See Note 6 to the interim consolidated financial statements and Note 2 to the Consolidated Financial Statements in our 2006 Annual Report on Form 10-K for additional discussion of our financial instruments and hedging activities.
At September 30, 2007 and December 31, 2006, the fair value of our debt was estimated at approximately $3.8 billion and $1.6 billion, respectively, using quoted market prices and yields for the same or similar types of borrowings, taking into account the underlying terms of the debt instruments. At September 30, 2007, the estimated fair value exceeded the carrying value of the debt by approximately $24.5 million. At December 31, 2006, the estimated fair value exceeded the carrying value of the debt by approximately $0.4 million. A hypothetical 10%
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increase in interest rates on our total debt portfolio (representing approximately 62 and 59 basis points at September 30, 2007 and December 31, 2006, respectively) would potentially reduce the estimated fair value of our debt by approximately $81 million and $33 million at September 30, 2007 and December 31, 2006, respectively.
Borrowings under our senior unsecured revolving credit facility, our secured receivables credit facility, our term loan due December 2008 and our term loan due May 2012 are subject to variable interest rates. Interest on our secured receivables credit facility is based on rates that are intended to approximate commercial paper rates for highly-rated issuers. Interest rates on our senior unsecured revolving credit facility; term loan due December 2008 and term loan due May 2012 are subject to a pricing schedule that can fluctuate based on changes in our credit ratings. As such, our borrowing cost under these credit arrangements will be subject to both fluctuations in interest rates and changes in our credit ratings. As of September 30, 2007, the borrowing rates under these credit facilities were: for our senior unsecured credit facility, LIBOR plus 0.50%; for our term loan due December 2008, LIBOR plus 0.55%; and for our term loan due May 2012, LIBOR plus 0.50% . At September 30, 2007, the LIBOR rate was 5.12% . At September 30, 2007, there was $1.4 billion outstanding under our term loan due May 2012, $60 million outstanding under our term loan due December 2008; $275 million outstanding under our secured receivables credit facility and no borrowings outstanding under our $750 million senior unsecured revolving credit facility.
During the three months ended September 30, 2007, we entered into various variable-to-fixed interest rate swap agreements, whereby we fixed the interest rates on $500 million of our term loan due May 2012 for periods ranging from October 2007 through September 2009. The fixed interest rates range from 5.095% to 5.267% . Based on our net exposure to interest rate changes a hypothetical 10% change in interest rates on our variable rate indebtedness (representing approximately 54 basis points) would impact annual net interest expense by approximately $10 million, assuming no changes to the debt outstanding at September 30, 2007.
The fair value of the interest rate swap agreements at September 30, 2007 was not material. A hypothetical 10% decrease in interest rates on our term loan (representing approximately 47 basis points) would potentially decrease the fair value of these instruments by approximately $3 million. A hypothetical 10% increase in interest rates would potentially increase the fair value of these instruments by approximately $3 million. For details regarding our outstanding debt, see Note 5 to the interim consolidated financial statements included in this report and Note 10 to the Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2006.
Risk Associated with Investment Portfolio
Our investment portfolio includes equity investments in publicly held companies that are classified as available-for-sale securities and other strategic equity holdings in privately held companies. These securities are exposed to price fluctuations and are generally concentrated in the life sciences industry. The carrying values of our available-for-sale equity securities and privately held securities were $29.5 million at September 30, 2007.
We do not hedge our equity price risk. The impact of an adverse movement in equity prices on our holdings in privately held companies cannot be easily quantified, as our ability to realize returns on investments depends on, among other things, the enterprises’ ability to raise additional capital or derive cash inflows from continuing operations or through liquidity events such as initial public offerings, mergers or private sales.
Liquidity and Capital Resources
Cash and Cash Equivalents
Cash and cash equivalents at September 30, 2007 totaled $165 million compared to $150 million at December 31, 2006. Cash flows from operating activities in 2007 were $572 million, which together with cash flows from financing activities of $1.1 billion, were used to fund investing activities of $1.7 billion. Cash and cash equivalents at September 30, 2006 totaled $105 million, compared to $92 million at December 31, 2005. Cash flows from operating activities in 2006 were $646 million, which were used to fund investing and financing activities of $351 million and $282 million, respectively.
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Cash Flows from Operating Activities
Net cash provided by operating activities for the nine months ended September 30, 2007 was $572 million compared to $646 million in the prior year period. This decrease was primarily due to lower earnings in the current year and increased payments associated with variable compensation earned in the prior year, coupled with the payment of $57 million of fees and other expenses associated with the acquisition of AmeriPath. Partially offsetting these items was a smaller increase in net accounts receivable compared to the prior year. Days sales outstanding, a measure of billing and collection efficiency, were 50 days at September 30, 2007 compared to 48 days at December 31, 2006. Substantially all of the increase in days sales outstanding is related to the impact of AmeriPath. We expect AmeriPath’s impact on our days sales outstanding to decrease over time.
Cash Flows from Investing Activities
Net cash used in investing activities for the nine months ended September 30, 2007 was $1.7 billion, consisting principally of $1.2 billion related to the acquisition of AmeriPath, $307 million related to the acquisition of HemoCue and capital expenditures of $143 million.
Net cash used in investing activities for the nine months ended September 30, 2006 was $351 million, consisting primarily of $231 million related to the acquisitions of Focus and Enterix, and capital expenditures of $134 million. These amounts were partially offset by $16 million in proceeds received in connection with the sale of an investment during the first quarter of 2006.
Cash Flows from Financing Activities
Net cash provided by financing activities for the nine months ended September 30, 2007 was $1.1 billion, primarily associated with new borrowings and repayments related to the acquisitions of AmeriPath and HemoCue.
During the first quarter of 2007, we entered into an interim credit facility (the “Interim Credit Facility”) and borrowed $450 million to finance the acquisition of HemoCue and to repay substantially all of HemoCue’s outstanding debt.
During the second quarter of 2007, we borrowed $1.6 billion under a new five-year term loan facility and $780 million under a new bridge loan facility to finance the acquisition of AmeriPath and repay the Interim Credit Facility used to finance the HemoCue acquisition.
In connection with the acquisition of AmeriPath, we repaid substantially all of AmeriPath’s outstanding debt and related accrued interest. On May 21, 2007, we commenced a cash tender offer and consent solicitation for the $350 million 10.5% Senior Subordinated Notes of AmeriPath, Inc. due 2013 (“the AmeriPath subordinated senior notes”). In conjunction with the cash tender offer, approximately $348 million in aggregate principal amount, or 99.4% of the $350 million of outstanding senior subordinated notes, was tendered. We made payments of $386 million to holders with respect to the cash tender offer and consent solicitation, including tender premium and related solicitation fees and accrued interest.
We completed an $800 million senior notes offering in June 2007 (the “2007 Senior Notes”). The 2007 Senior Notes were sold in two tranches: (a) $375 million of 6.40% senior notes due 2017; and (b) $425 million of 6.95% senior notes due 2037. We used the net proceeds from the 2007 Senior Notes offering to repay the $780 million of borrowings under the bridge loan facility. The 2007 Senior Notes do not have a sinking fund requirement and are fully and unconditionally guaranteed on a senior, unsecured basis, by certain of the Company's domestic, wholly owned subsidiaries. The 2007 Senior Notes, term loans and the bridge loan are further described in Note 5 to the interim consolidated financial statements.
During the second quarter of 2007, we also borrowed $50 million under our secured receivables credit facility which, together with cash on-hand, was used to repay $90 million of borrowings outstanding under the new $1.6 billion five-year term loan. Through September 30, 2007, we have repaid $165 million under the $1.6 billion five-year term loan facility. During the third quarter of 2007, we repaid $75 million of the $350 million outstanding under the secured receivables credit facility.
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Net cash provided by financing activities for the nine months ended September 30, 2007, also included $81 million in proceeds from the exercise of stock options, including related tax benefits, offset by purchases of treasury stock totaling $146 million and dividend payments of $58 million. The $146 million of treasury stock represents 2.8 million shares of our common stock purchased at an average price of $52.14 per share.
Net cash used in financing activities for the nine months ended September 30, 2006 was $282 million. During 2006, we repaid $275 million outstanding under our 6 3/4% senior notes; $60 million of principal outstanding under our secured receivables credit facility and $75 million under our previous $500 million senior unsecured revolving credit facility. Debt repayments and acquisitions were funded with cash on-hand and borrowings of $75 million under our previous $500 million senior unsecured revolving credit facility and $300 million under our secured receivables credit facility. In addition, we purchased $276 million of treasury stock, which represents 5 million shares of our common stock purchased at an average price of $55.53 per share, partially offset by $122 million in proceeds from the exercise of stock options, including related tax benefits. We also paid dividends of $57 million.
Dividend Program
During each of the quarters of 2007 and 2006, our Board of Directors declared a quarterly cash dividend of $0.10 per common share. On August 17, 2007, our Board of Directors declared a quarterly cash dividend per common share of $0.10, which was paid on October 17, 2007. We expect to fund future dividend payments with cash flows from operations, and do not expect the dividend to have a material impact on our ability to finance future growth.
Share Repurchase Plan
For the nine months ended September 30, 2007, we repurchased 2.8 million shares of our common stock at an average price of $52.14 per share for $146 million. Through September 30, 2007, we have repurchased approximately 44.1 million shares of our common stock at an average price of $45.35 for $2.0 billion under our share repurchase program. At September 30, 2007, the total available for repurchases under the remaining authorizations was $104 million.
Contractual Obligations and Commitments
The following table summarizes certain of our contractual obligations as of September 30, 2007:
| | | Payments due by period |
| | | (in thousands) |
| | | | | | Remainder | | | | | | | | | |
| Contractual Obligations | | Total | | of 2007 | | 1-3 years | | 3 –5 years | | After 5 years |
| |
| Long-term debt | | $ | 3,454,113 | | $ | - | | $ | 121,783 | | $ | 1,474,122 | | $ | 1,858,208 |
| Capital lease obligations | | | 17,642 | | | - | | | 309 | | | 579 | | | 16,754 |
| Interest payments on outstanding debt | | | 1,844,232 | | | 57,369 | | | 421,667 | | | 353,334 | | | 1,011,862 |
| Operating leases | | | 772,793 | | | 47,404 | | | 304,822 | | | 184,443 | | | 236,124 |
| Purchase obligations | | | 83,822 | | | 9,635 | | | 51,906 | | | 16,043 | | | 6,238 |
| Total contractual obligations | | $ | 6,172,602 | | $ | 114,408 | | $ | 900,487 | | $ | 2,028,521 | | $ | 3,129,186 |
During the second quarter of 2007, we undertook several actions to restructure our debt facilities including the issuance of senior notes, obtaining new commercial bank loans and extinguishing other debt obligations. Interest payments on our long-term debt have been calculated after giving effect to our interest rate swap agreements, using the interest rates as of September 30, 2007 applied to the September 30, 2007 balances, which are assumed to remain outstanding through their maturity dates.
A full description of the terms of our indebtedness and related debt service requirements and our future payments under certain of our contractual obligations is contained in Note 10 to the Consolidated Financial Statements in our 2006 Annual Report on Form 10-K. A full discussion and analysis regarding our minimum
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rental commitments under noncancelable operating leases and noncancelable commitments to purchase products or services at December 31, 2006 is contained in Note 14 to the Consolidated Financial Statements in our 2006 Annual Report on Form 10-K. See Note 5 to the interim consolidated financial statements for an update on our indebtedness and related debt service requirements. See Note 7 to the interim consolidated financial statements for information regarding the status of legal matters involving the Company.
On January 1, 2007, we adopted FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes”. As of September 30, 2007, our total liabilities for unrecognized tax benefits were approximately $103 million, which were excluded from the table above. Based upon the expiration of statutes of limitations, settlements and/or the conclusion of tax examinations, we believe it is reasonably possible that this amount may decrease by up to $31 million within the next twelve months. For the remainder, we cannot make reasonably reliable estimates of the timing of the future payments of these liabilities. See Note 1 to the interim consolidated financial statements for information regarding our contingent tax liability reserves.
Unconsolidated Joint Ventures
We have investments in unconsolidated joint ventures in Phoenix, Arizona; Indianapolis, Indiana; and Dayton, Ohio, which are accounted for under the equity method of accounting. We believe that our transactions with our joint ventures are conducted at arm’s length, reflecting current market conditions and pricing. Total net revenues of our unconsolidated joint ventures equal less than 6% of our consolidated net revenues. Total assets associated with our unconsolidated joint ventures are less than 2% of our consolidated total assets. We have no material unconditional obligations or guarantees to, or in support of, our unconsolidated joint ventures and their operations.
Requirements and Capital Resources
We estimate that we will invest between $210 million and $220 million during 2007 for capital expenditures to support and expand our existing operations, principally related to investments in information technology, equipment, and facility upgrades.
In May 2007, we entered into a $750 million senior unsecured revolving credit facility, which matures in May 2012 and replaced our $500 million senior unsecured revolving credit facility. The senior unsecured revolving credit facility is guaranteed by certain of our domestic, wholly-owned subsidiaries. As of September 30, 2007, we had no borrowings outstanding on this credit facility.
In May 2007, we also increased our existing receivables securitization facility from $300 million to $375 million. This facility matures on May 23, 2008. As of September 30, 2007, we had $275 million outstanding on this credit facility.
As of September 30, 2007, $850 million of borrowing capacity was available under our existing credit facilities.
We believe that cash from operations and our borrowing capacity under our credit facilities will provide sufficient financial flexibility to meet seasonal working capital requirements and to fund capital expenditures, debt service requirements, cash dividends on common shares, share repurchases and additional growth opportunities for the foreseeable future. We believe that our credit profile should provide us with access to additional financing, if necessary, to fund growth opportunities and other cash requirements that cannot be funded from existing sources.
Impact of New Accounting Standards
In September 2007, the FASB ratified Emerging Issues Task Force Issue No. 07-1, “Accounting for Collaborative Agreements”. The impact of this accounting standard is discussed in Note 1 to the interim consolidated financial statements.
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Forward-Looking Statements
Some statements and disclosures in this document are forward-looking statements. Forward-looking statements include all statements that do not relate solely to historical or current facts and can be identified by the use of words such as “may”, “believe”, “will”, “expect”, “project”, “estimate”, “anticipate”, “plan” or “continue”. These forward-looking statements are based on our current plans and expectations and are subject to a number of risks and uncertainties that could significantly cause actual results to differ materially from the forward-looking statements. The Private Securities Litigation Reform Act of 1995, or the Litigation Reform Act, provides a “safe harbor” for forward-looking statements to encourage companies to provide prospective information about their companies without fear of litigation.
We would like to take advantage of the “safe harbor” provisions of the Litigation Reform Act in connection with the forward-looking statements included in this document. The risks and other factors that could cause our actual financial results to differ materially from those projected, forecasted or estimated by us in forward-looking statements may include, but are not limited to, unanticipated expenditures, changing relationships with customers, payers, suppliers and strategic partners, competitive environment, changes in government regulations, conditions of the economy and other factors described in our 2006 Annual Report on Form 10-K and subsequent filings.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
See Item 2. “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.
Item 4. Controls and Procedures
| | a. | Our Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined under Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this report. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are adequate and effective. |
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| | b. | On May 31, 2007, the Company completed the acquisition of AmeriPath. AmeriPath disclosed two “material weaknesses” in internal controls over financial reporting in its 2006 Annual Report on Form 10-K and first quarter 2007 Quarterly Report on Form 10-Q. The material weaknesses relate to the following: (i) the adequacy of general controls relating to certain AmeriPath information technology systems, and (ii) the adequacy of the support and analysis for accounts receivable allowances. Subsequent to the acquisition of AmeriPath, the Company has revised certain of AmeriPath’s controls, and has implemented oversight procedures related to accounts receivable allowances and general controls in its information technology systems. These changes have been designed to ensure adherence with the Company’s overall methodology, supervision and monitoring processes related to internal control over financial reporting. After giving consideration to the control weaknesses identified at AmeriPath, management believes that the financial statements included in this Quarterly Report on Form 10-Q present fairly in all material respects the Company’s consolidated financial condition, results of operations and cash flows for the periods presented. During the third quarter of 2007, there have been no other changes in the Company’s internal control over financial reporting that have materially affected, or are reasonably likely to materially affect its internal control over financial reporting. |
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PART II - OTHER INFORMATION
Item 1. Legal Proceedings
See Note 7 to the interim consolidated financial statements for information regarding the status of legal proceedings involving the Company.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
ISSUER PURCHASES OF EQUITY SECURITIES
| | | | | (d) Approximate Dollar |
| | (a) Total | | (c) Total Number of | Value of Shares that May |
| | Number of | (b) Average | Shares Purchased as Part | Yet Be Purchased Under the |
| | Shares | Price Paid per | of Publicly Announced | Plans or Programs |
| Period | Purchased | Share | Plans or Programs | (in thousands) |
| July 1, 2007 – | | | | |
| July 31, 2007 | 36,000 | $55.51 | 36,000 | $142,700 |
| August 1, 2007 – | | | | |
| August 31, 2007 | 411,203 | $55.16 | 411,203 | $120,019 |
| September 1, 2007 – | | | | |
| September 30, 2007 | 286,852 | $55.71 | 286,852 | $104,038 |
| Total | 734,055 | $55.39 | 734,055 | $104,038 |
In 2003, our Board of Directors authorized a share repurchase program, which permitted us to purchase up to $600 million of our common stock. In July 2004, our Board of Directors authorized us to purchase up to an additional $300 million of our common stock. Under a separate authorization from our Board of Directors, in December 2004 we repurchased 5.4 million shares of our common stock for approximately $254 million from GlaxoSmithKline plc. In January 2005, our Board of Directors expanded the share repurchase authorization by an additional $350 million. In January 2006, our Board of Directors expanded the share repurchase authorization by an additional $600 million.
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Item 6. Exhibits
Exhibits:
| 10.1 | Amended and Restated Quest Diagnostics Incorporated Executive Officer Severance Plan (As amended August 16, 2007) |
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| 10.2 | Amended and Restated Quest Diagnostics Incorporated Long-Term Incentive Plan for Non-Employee Directors (As amended August 17, 2007) |
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| 10.3 | Amended and Restated Quest Diagnostics Incorporated Employee Long-Term Incentive Plan (As amended August 17, 2007) |
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| 10.4 | Amended and Restated Employee Stock Purchase Plan (As amended effective October 1, 2007) |
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| 10.5 | Amended and Restated Supplemental Deferred Compensation Plan (As amended October 11, 2007) |
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| 10.6 | Amendment Dated as of August 17, 2007 to the AmeriPath Group Holdings, Inc. 2006 Stock Option and Restricted Stock Purchase Plan |
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| 31.1 | Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
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| 31.2 | Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
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| 32.1 | Certification of Chief Executive Officer Pursuant to 18 U.S.C. §1350 |
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| 32.2 | Certification of Chief Financial Officer Pursuant to 18 U.S.C. §1350 |
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Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
October 25, 2007
Quest Diagnostics Incorporated
| By | /s/ Surya N. Mohapatra |
| | Surya N. Mohapatra, Ph.D.
Chairman, President and
Chief Executive Officer |
| | |
| | |
| By | /s/ Robert A. Hagemann |
| | Robert A. Hagemann
Senior Vice President and
Chief Financial Officer |
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