the prior year period. These increases were 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 June 30, 2005, 44% of our orders and 69% of our test results were being transmitted via the Internet, both substantially greater than a year ago. The increased use of 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, and reducing the cost associated with specimen processing, which is included in cost of services.
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 22.9% of net revenues during the three months ended June 30, 2005, decreasing from 23.7% in the prior year period. For the six months ended June 30, 2005, selling, general and administrative expenses, as a percentage of net revenues, decreased to 23.1% from 24.1% in the prior year period. These improvements were 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. For the three and six months ended June 30, 2005, bad debt expense was 4.3% and 4.4% of net revenues, respectively, consistent with the prior year levels. 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.
Other operating expense, net represents miscellaneous income and expense items related to operating activities including gains and losses associated with the disposal of operating assets. For the three and six months ended June 30, 2004, other operating expense, net includes a $10.3 million charge associated with the acceleration of certain pension obligations in connection with the succession of the Company’s prior CEO.
Operating income for the three months ended June 30, 2005 improved to $261 million, or 19.0% of net revenues, from $230 million, or 17.7% of net revenues, in the prior year period. For the six months ended June 30, 2005, operating income improved to $491 million, or 18.2% of net revenues, from $439 million or 17.2% of net revenues, in the prior year period. Reflected in operating income and impacting cost of sales for both the three and six months ended June 30, 2005 is a charge of approximately $3 million, principally associated with a write-down of inventory and equipment, stemming from a voluntary product hold instituted at our test kit manufacturing subsidiary, NID. The increases in operating income for the three and six months ended June 30, 2005 were principally driven by revenue growth. Also contributing to the increases is a $10.3 million charge in the second quarter of 2004 related to the acceleration of certain pension obligations associated with the succession of the Company’s prior CEO, which reduced operating income, as a percentage of net revenues, by 0.8% and 0.4%, respectively, for the three and six months ended June 30, 2004. 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 for the three and six months ended June 30, 2005 decreased from the prior year periods primarily due to the redemption of our contingent convertible debentures in January 2005, as well as the 2004 refinancing of certain of our debt. Interest expense, net for both the three and six months ended June 30, 2004, included a $2.9 million charge representing the write-off of deferred financing costs associated with 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 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 three and six months ended June 30, 2004. The Debentures were redeemed, principally through a conversion into common shares, as of January 18, 2005. See Note 10 to the Consolidated Financial Statements contained in our 2004 Annual Report on Form 10-K and Note 3 to the interim consolidated financial statements 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 June 30, 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 June 30, 2005 and December 31, 2004, the estimated fair value exceeded the carrying value of the debt by approximately $51 million and $84 million, respectively. An assumed 10% increase in interest rates (representing approximately 60 and 45 basis points at June 30, 2005 and December 31, 2004, respectively) would reduce the estimated fair value of our debt by approximately $8 million and $17 million at June 30, 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 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 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 June 30, 2005, our borrowing rates for our LIBOR-based loans ranged from LIBOR plus 0.55% to LIBOR plus 0.625%. At June 30, 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 33 basis points) would impact annual net interest expense by approximately $1.0 million, assuming no changes to the debt outstanding at June 30, 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 June 30, 2005 totaled $204 million, compared to $73 million at December 31, 2004. Cash flows from operating activities in 2005 were $371 million, which were used to fund investing and financing activities, which required cash of $167 million and $73 million, respectively. Cash and cash equivalents at June 30, 2004 totaled $138 million, compared to $155 million at December 31, 2003. Cash flows from operating activities in 2004 provided cash of $318 million, which were used to fund investing and financing activities of $89 million and $246 million, respectively.
Cash Flows From Operating Activities
Net cash provided by operating activities for the six months ended June 30, 2005 was $371 million compared to $318 million in the prior year period. This increase was primarily due to improved operating performance, a smaller increase in net accounts receivable compared to the prior year, and the timing and net amount of various payments for taxes and other
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liabilities. Days sales outstanding, a measure of billing and collection efficiency, was 45 days at June 30, 2005, compared to 47 days at December 31, 2004.
Cash Flows From Investing Activities
Net cash used in investing activities for the six months ended June 30, 2005 was $167 million, consisting primarily of capital expenditures of $124 million, equity investments of $24 million in companies which develop diagnostic tests, and an acquisition of a small regional laboratory for $19 million.
Net cash used in investing activities for the six months ended June 30, 2004 was $89 million, consisting primarily of capital expenditures.
Contributing the majority of the increase in capital expenditures is the construction of a new laboratory facility in California, into which we plan to consolidate certain of our operations in the Los Angeles area.
Cash Flows From Financing Activities
Net cash used in financing activities for the six months ended June 30, 2005 was $73 million, consisting primarily of purchases of treasury stock totaling $92 million and dividend payments of $33 million, partially offset by $64 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 $92 million in treasury stock purchases represents 1.8 million shares of our common stock purchased at an average price of $50.64 per share.
Net cash used in financing activities for the six months ended June 30, 2004 was $246 million, consisting primarily of purchases of treasury stock totaling $271 million and $31 million in dividend payments, partially offset by $67 million received from the exercise of stock options. In addition, we repaid the remaining $305 million of principal outstanding under our term loan due June 2007 with $100 million of borrowings under our senior unsecured revolving credit facility, $130 million of borrowings under our secured receivables credit facility and $75 million of borrowings under our term loan due December 2008. The $271 million in treasury stock purchases represents 6.4 million shares of our common stock purchased at an average price of $42.38 per share, including 2.4 million shares purchased from GlaxoSmithKline in the second quarter of 2004.
Stock Split
On June 20, 2005, the Company effected a two-for-one stock split through the issuance of a stock dividend of one new share of common stock for each share of common stock held by stockholders of record on June 6, 2005. References to previously reported number of common shares and per common share amounts including earnings per common share calculations and related disclosures, have been restated to give retroactive effect to the stock split for all periods presented.
Dividend Policy
On January 27, 2005, our Board of Directors increased the quarterly cash dividend per common share to $0.09, payable to shareholders of record on April 6, 2005 and paid on April 20, 2005. A cash dividend of $0.09 per common share was also declared on May 10, 2005, payable to shareholders of record on July 8, 2005 and paid on July 22, 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 June 30, 2005, we repurchased 560 thousand shares of our common stock at an average price of $53.03 per share for $30 million. For the six months ended June 30, 2005, we repurchased 1.8 million shares of our common stock at an average price of $50.64 for $92 million under our share repurchase program. Through June 30, 2005, we have repurchased approximately 26 million shares of our common stock at an average price of $40.98 for $1.1 billion under our share repurchase program. At June 30, 2005, our remaining authorizations for share repurchases totaled $420 million.
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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 June 30, 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 Standards
In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (“SFAS”) No. 123, revised 2004, “Share-Based Payment” and in May 2005, issued SFAS No. 154, “Accounting Changes and Error Corrections”. The impact of these accounting standards are 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 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 second 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. |
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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) | |
| |
|
| |
|
| |
|
| |
|
| |
April 1, 2005 –
April 30, 2005 | | | — | | | $ — | | | — | | | $ 449,886 | |
May 1, 2005 –
May 31, 2005 | | | 176,600 | | | $ 53.04 | | | 176,600 | | | $ 440,519 | |
June 1, 2005 –
June 30, 2005 | | | 383,200 | | | $ 53.03 | | | 383,200 | | | $ 420,198 | |
Total | | | 559,800 | | | $ 53.03 | | | 559,800 | | | $ 420,198 | |
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.
Item 4. | Submission of Matters to a Vote of Security Holders |
The Annual Meeting of Stockholders of the Company was held on May 10, 2005. The matters voted on by the stockholders and the results of the vote were as follows:
(a) | The following individuals were elected as directors of the Company for terms expiring at the 2008 annual meeting of stockholders. The results of the vote were as follows: |
| | Votes Received | | Votes Withheld | |
| |
|
| |
|
| |
William F. Buehler | | | 86,074,042 | | | 7,181,044 | |
Rosanne Haggerty | | | 91,524,314 | | | 1,730,772 | |
Gary M. Pfeiffer | | | 91,492,574 | | | 1,762,512 | |
Dr. Daniel C. Stanzione | | | 86,082,161 | | | 7,172,925 | |
The following individuals continue as directors:
Dr. John C. Baldwin
James F. Flaherty III
William R. Grant
Dr. Surya N. Mohapatra
Dr. Gail R. Wilensky
John B. Ziegler
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(b) | The ratification of the appointment of PricewaterhouseCoopers LLP as the independent registered public accounting firm for the fiscal year ending December 31, 2005, was approved. The results of the vote were as follows: |
Votes For | | Votes Against | | Abstentions | |
| |
|
| |
|
| |
90,915,494 | | | 1,779,462 | | | 560,130 | |
(c) | The proposal to approve the Amended and Restated Employee Long-Term Incentive Plan was approved. The results of the vote were as follows: |
Votes For | | Votes Against | | Abstentions | |
| |
|
| |
|
| |
63,929,628 | | | 20,639,904 | | | 740,163 | |
(d) | The proposal to approve the Amended and Restated Director Long-Term Incentive Plan was approved. The results of the vote were as follows: |
Votes For | | Votes Against | | Abstentions | |
| |
|
| |
|
| |
63,573,856 | | | 20,922,244 | | | 782,097 | |
Item 6. | Exhibits |
| | |
| 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 |
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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.
July 28, 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 | |
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