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 the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
While many operational aspects of our business are subject to complex federal, state and local regulations, the accounting for it is generally straightforward with net revenues primarily recognized upon completion of the testing process. Our revenues are primarily comprised of a high volume of relatively low dollar transactions, and about one-half of total operating 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. These accounting policies have been described in our 2004 Annual Report on Form 10-K.
Net income for the three months ended March 31, 2005 increased to $132 million from $116 million for the prior year period. This increase in earnings was primarily attributable to revenue growth, partially offset by investments in our operations.
Net revenues for the three months ended March 31, 2005 grew by 5.1% over the prior year level. The increase in net revenues was driven by improvements in testing volumes, measured by the number of requisitions, and increases in average revenue per requisition.
For the three months ended March 31, 2005, clinical testing volume increased 2.8% compared to the prior year period. First quarter volume growth compared to the prior year was reduced by about one percent due to the benefit from Leap Year in 2004.
Average revenue per requisition improved 2.3% compared to the prior year period. This improvement is primarily attributable to a continuing shift in test mix to higher value testing, including gene-based testing, and increases in the number of tests ordered per requisition, in addition to modest price increases. These factors are expected to continue as the primary drivers of increases in revenue per requisition, although to a lesser extent than the past several years.
Total operating costs and expenses for the three months ended March 31, 2005 increased $43 million from the prior year period primarily due to increases in our clinical testing volume. The increased costs were primarily in the areas of employee compensation and benefits and testing supplies. While our cost structure has been favorably impacted by efficiencies generated from our Six Sigma and standardization initiatives, we continue to make investments in sales, service, science, and information technology to further differentiate our Company.
Cost of services, which includes the costs of obtaining, transporting and testing specimens, was 59.1% of net revenues for the three months ended March 31, 2005, increasing from 58.7% of net revenues in the prior year period. This increase was primarily the result of increases related to testing supplies, initial installation costs associated with deploying our Internet-based orders and results systems in physicians’ offices and an increase in the number of phlebotomists in our patient service centers to support an increasing percentage of our volume generated from these sites, partially offset by the increase in average revenue per requisition and efficiency gains resulting from our Six Sigma and standardization initiatives. At March 31, 2005, 43% of our orders and 64% of our test results were being transmitted via the Internet. This compares to approximately 30% and 40%, respectively, at March 31, 2004. The increase in the number of orders and test results reported via our Internet-based systems is improving the initial collection of billing information which is reducing the cost of billing and bad debt expense, both of which are components of selling, general and administrative expenses.
Selling, general and administrative expenses, which include the costs of the sales force, billing operations, bad debt expense and general management and administrative support, was 23.4% of net revenues during the three months ended March 31, 2005, decreasing from 24.5% in the prior year period. This improvement was primarily due to revenue growth, which has allowed us to leverage our expense base, as well as efficiencies from our Six Sigma and standardization initiatives. During the first quarter of 2005, bad debt expense was 4.5% of net revenues, consistent with the prior year period. We believe that our Six Sigma and standardization initiatives and the increased use of electronic ordering by our customers will provide additional opportunities to further improve our overall collection experience and cost structure.
Operating Income
Operating income improved to $230 million, or 17.4% of net revenues, from $209 million, or 16.6% of net revenues, in the prior year period. The increase in operating income was principally driven by revenue growth and a reduction in selling, general and administrative expenses as a percentage of net revenues. Partially offsetting these improvements were increased costs of services as a percentage of net revenues as a result of investments in our operations.
Interest Expense, net
Interest expense, net for the three months ended March 31, 2005 decreased from the prior year period primarily due to the redemption of our contingent convertible debentures in January 2005, as well as our 2004 refinancing. See Note 10 to the Consolidated Financial Statements contained in our 2004 Annual Report on Form 10-K for a further discussion of the redemption and the debt refinancing.
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.
Impact of Contingent Convertible Debentures on Earnings per Common Share
Due to a required change in accounting effective December 31, 2004, we included the dilutive effect of our 1¾% contingent convertible debentures, or the Debentures, in our dilutive earnings per common share calculations using the if-converted method, regardless of whether or not the holders of these securities were permitted to exercise their conversion rights, and retroactively restated previously reported diluted earnings per common share. References to previously reported diluted weighted average common shares outstanding, including diluted earnings per common share calculations and related disclosures, have been restated to give effect to the required change in accounting for all periods presented. This change reduced previously reported diluted earnings per common share by approximately 2% for the quarter ended March 31, 2004. See Note 10 to the Consolidated Financial Statements contained in our 2004 Annual Report on Form 10-K for a further discussion of the Debentures.
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 may include the use of derivative financial instruments. We do not hold or issue derivative financial instruments for trading purposes. We do not believe that our foreign exchange exposure is material to our financial position or results of operations. See Note 2 to the Consolidated Financial Statements contained in our 2004 Annual Report on Form 10-K for additional discussion of our financial instruments and hedging activities.
At March 31, 2005 and December 31, 2004, the fair value of our debt was estimated at approximately $0.9 billion and $1.2 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 March 31, 2005 and December 31, 2004, the estimated fair value exceeded the carrying value of the debt by approximately $49 million and $84 million, respectively. An assumed 10% increase in interest rates (representing approximately 55 and 45 basis points at March 31, 2005 and December 31, 2004, respectively) would reduce the estimated fair value of our debt by approximately $9 million and $17 million at March 31, 2005 and December 31, 2004, respectively.
Borrowings under our senior unsecured revolving credit facility, our secured receivables credit facility and our term loan due December 2008 are subject to variable interest rates. Interest on the secured receivables credit facility is based on
18
rates that are intended to approximate commercial paper rates for highly rated issuers. Interest rates on our senior unsecured revolving credit facility and term loan due December 2008 are subject to a pricing schedule that can fluctuate based on changes in our credit rating. As such, our borrowing cost under these credit arrangements will be subject to both fluctuations in interest rates and changes in our credit rating. As of March 31, 2005, our borrowing rates for our LIBOR-based loans ranged from LIBOR plus 0.55% to LIBOR plus 0.625%. At March 31, 2005, there was $230 million of borrowings outstanding under our $300 million secured receivables credit facility, $75 million outstanding under our term loan due December 2008 and no borrowings outstanding under our $500 million senior unsecured revolving credit facility. Based on our net exposure to interest rate changes, an assumed 10% change in interest rates on our variable rate indebtedness (representing approximately 28 basis points) would impact annual net interest expense by approximately $0.8 million, assuming no changes to the debt outstanding at March 31, 2005. See Note 3 to the interim consolidated financial statements for details regarding our debt outstanding.
Liquidity and Capital Resources
Cash and Cash Equivalents
Cash and cash equivalents at March 31, 2005 totaled $86 million, compared to $73 million at December 31, 2004. Cash flows from operating activities in 2005 were $136 million, which were used to fund investing and financing activities, which required cash of $75 million and $48 million, respectively. Cash and cash equivalents at March 31, 2004 totaled $190 million, compared to $155 million at December 31, 2003. Cash flows from operating activities in 2004 provided cash of $111 million, which were used to fund investing and financing activities of $45 million and $30 million, respectively.
Cash Flows From Operating Activities
Net cash provided by operating activities for the three months ended March 31, 2005 was $136 million compared to $111 million in the prior year period. This increase was primarily due to improved operating performance as well as the timing and net amount of various payments for taxes and other liabilities, partially offset by an increase in accounts receivable associated with growth in net revenues. Days sales outstanding, a measure of billing and collection efficiency, was 46 days at March 31, 2005, compared to 47 days at December 31, 2004.
Cash Flows From Investing Activities
Net cash used in investing activities for the three months ended March 31, 2005 was $75 million, consisting primarily of capital expenditures of $55 million and an acquisition of a small regional laboratory for $19 million.
Net cash used in investing activities for the three months ended March 31, 2004 was $45 million, consisting primarily of capital expenditures.
Cash Flows From Financing Activities
Net cash used in financing activities for the three months ended March 31, 2005 was $48 million, consisting primarily of purchases of treasury stock totaling $62 million and dividend payments of $15 million, partially offset by $35 million received from the exercise of stock options. In addition, we repaid the remaining $100 million of principal outstanding under our senior unsecured revolving credit facility with $100 million of borrowings under our secured receivables credit facility, which carries a slightly lower borrowing cost. The $62 million in treasury stock purchases represents 628 thousand shares of our common stock purchased at an average price of $99.16 per share.
Net cash used in financing activities in the three months ended March 31, 2004 was $30 million, consisting primarily of purchases of treasury stock totaling $45 million and $15 million in dividend payments, partially offset by $34 million received from the exercise of stock options. In addition, $75 million of borrowings under our term loan due December 2008 were used to repay $75 million under our term loan due June 2007. The $45 million in treasury stock purchases represents 547 thousand shares of our common stock purchased at an average price of $81.97 per share.
19
Dividend Policy
On January 27, 2005, our Board of Directors increased the quarterly cash dividend per common share by $0.03 to $0.18, payable on April 20, 2005, to shareholders of record on April 6, 2005. We have paid a dividend each quarter since January 2004. 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 three months ended March 31, 2005, we repurchased 628 thousand shares of our common stock at an average price of $99.16 per share for $62 million. Through March 31, 2005, we have repurchased approximately 12.9 million shares of our common stock at an average price of $81.45 for $1.1 billion under our share repurchase program. At March 31, 2005, our remaining authorizations for share repurchases totaled $450 million.
Contractual Obligations and Commitments
A description of the terms of our indebtedness, 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 2004 Annual Report on Form 10-K. A discussion and analysis regarding our minimum rental commitments under noncancelable operating leases and noncancelable commitments to purchase products or services at December 31, 2004 is contained in Note 14 to the Consolidated Financial Statements in our 2004 Annual Report on Form 10-K. See Note 4 to the interim consolidated financial statements for information regarding the status of our remaining contractual obligations and commitments as of March 31, 2005. See Note 3 to the interim consolidated financial statements for information regarding the components of our outstanding indebtedness.
Our credit agreements relating to our senior unsecured revolving credit facility and our term loan due December 2008 contain various covenants and conditions, including the maintenance of certain financial ratios, that could impact our ability to, among other things, incur additional indebtedness. We do not expect these covenants to adversely impact our ability to execute our growth strategy or conduct normal business operations.
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, on a combined basis, are less than 6% of our consolidated net revenues. Total assets associated with our unconsolidated joint ventures are less than 3% of our consolidated total assets. We have no material unconditional obligations or guarantees to, or in support of, our unconsolidated joint ventures and their operations.
Requirements and Capital Resources
We estimate that we will invest approximately $210 million to $230 million during 2005 for capital expenditures to support and expand our existing operations, principally related to investments in information technology, equipment, and facility upgrades.
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. Our investment grade credit ratings have had a favorable impact on our cost of and access to capital, and we believe that our strong financial performance should provide us with access to additional financing, if necessary, to fund growth opportunities that cannot be funded from existing sources.
Impact of New Accounting Standard
In December 2004, the Financial Accounting Standards Board issued SFAS No. 123, revised 2004, “Share-Based Payment”. The impact of this accounting standard is discussed in Note 1 to the interim consolidated financial statements.
20
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 our plans and expectations, including actual results, to differ materially from the forward-looking statements. The Private Securities Litigation Reform Act of 1995 (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 2004 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. |
(b) | During the first quarter of 2005, there were no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. |
21
PART II - OTHER INFORMATION
See Note 4 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
Period | | (a) Total
Number of
Shares
Purchased | (b) Average Price
Paid per Share | (c) Total Number of Shares
Purchased as Part of
Publicly Announced Plans
or Programs | (d) Approximate
Dollar Value
of Shares that May Yet Be
Purchased Under the Plans
or Programs
(in thousands) |
January 1, 2005 -
January 31, 2005 | | 23,600 | | | $94.99 | | 23,600 | | | $509,944 | |
February 1, 2005 -
February 28, 2005 | | 176,900 | | | $98.61 | | 176,900 | | | $492,499 | |
March 1, 2005 -
March 31, 2005 | | 427,800 | | | $99.61 | | 427,800 | | | $449,886 | |
Total | | 628,300 | | | $99.16 | | 628,300 | | | $449,886 | |
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 2.7 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.
| | Exhibits: |
| 31.1 | Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
| 31.2 | Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
| 32.1 | Certification of Chief Executive Officer Pursuant to 18 U.S.C. §1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
| 32.2 | Certification of Chief Financial Officer Pursuant to 18 U.S.C. §1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
22
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.
April 29, 2005
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 | | | |
23
