to that of a peer group of companies. Stock-based compensation expense associated with performance share units is recognized based on management’s best estimates of the achievement of the performance goals specified in such awards and the resulting number of shares that will be earned. If the actual number of performance share units earned is different from our estimates, stock-based compensation could be significantly different from what we have recorded in the current period. We periodically obtain and review publicly available financial information for the members of the peer group and the Company, including forecasted earnings estimates. This information is used to evaluate our progress towards achieving the performance criteria and our estimate of the number of performance share units expected to be earned at the end of the performance period. The cumulative effect on current and prior periods of a change in the estimated number of performance share units expected to be earned is recognized as compensation cost in earnings in the period of the revision. While the assumptions used to calculate and account for stock-based compensation awards represent management’s best estimates, these estimates involve inherent uncertainties and the application of management’s judgment. As a result, if revisions are made to our assumptions and estimates, our stock-based compensation expense could be materially different in the future. See Notes 1 and 2 to the interim consolidated financial statements for a further discussion of stock-based compensation.
Through the acquisition, Quest Diagnostics acquired all of LabOne’s operations, including its health screening and risk assessment services to life insurance companies, as well as its clinical diagnostic testing services to healthcare providers and drugs-of-abuse testing to employers. LabOne, with 2004 revenues of $468 million, had 3,100 employees and principal laboratories in Lenexa, Kansas, as well as in Cincinnati, Ohio. We financed the acquisition and related transaction costs together with the repayment of substantially all of LabOne’s debt outstanding with proceeds from a $900 million private placement of senior notes, as described in Note 10 to the Consolidated Financial Statements contained in our 2005 Annual Report on Form 10-K, and from cash on hand.
During the first quarter of 2006, we finalized our plan related to the integration of LabOne and recorded $23.3 million of costs, primarily comprised of employee severance benefits. Employee groups affected as a result of this plan include those involved in the testing of specimens, as well as administrative and other support functions. Of the total costs indicated above, $20.7 million related to actions that impact Quest Diagnostics’ employees and its operations and are comprised principally of employee severance benefits for approximately 600 employees. These costs were accounted for as a charge to earnings and included in “other operating expenses, net” within the consolidated statements of operations. In addition, $2.6 million of integration costs, related to actions that impact the employees and operations of LabOne, were accounted for as a cost of the LabOne acquisition and included in goodwill. Of the $2.6 million, $1.2 million related to asset write-offs with the remainder primarily associated with employee severance benefits for approximately 95 employees. As of March 31, 2006, accruals related to the LabOne integration plan totaled $20.7 million. While the majority of the accrued costs at March 31, 2006 are expected to be paid in 2006 and 2007, there are certain severance costs that have payment terms extending into 2008.
Upon completion of the LabOne integration, we expect to realize approximately $40 million of annual synergies and we expect to achieve this annual rate of synergies by the end of 2007.
Our clinical testing business currently represents our one reportable business segment. The clinical testing business accounts for approximately 92% and 96% of consolidated net revenues for the three months ended March 31, 2006 and 2005, respectively. Our other operating segments consist of our risk assessment services business, our clinical trials testing business, our test kit manufacturing subsidiary, NID, and our healthcare information technology business, MedPlus. Our business segment information is disclosed in Note 10 to the interim consolidated financial statements.
Net income for the three months ended March 31, 2006 increased to $145 million, or $0.72 per diluted share, compared to $132 million, or $0.64 per diluted share in 2005. The increase in earnings was primarily attributable to organic revenue growth and increases in operating efficiencies in our clinical testing business resulting from our Six Sigma and standardization efforts. Included in the 2006 results were pre-tax special charges of $27 million, or $0.08 per
share, primarily associated with integration activities; and a pre-tax gain of $16 million, or $0.05 per share, associated with the sale of an investment. Our first quarter 2006 results include $19 million, or $0.06 per share, associated with stock-based compensation recorded in accordance with SFAS 123R.
Net Revenues
Net revenues for the three months ended March 31, 2006 grew by 17.9% over the prior year level to $1.6 billion. The acquisition of LabOne contributed 10.2% of the consolidated revenue growth. Approximately 54% of LabOne’s net revenues are generated from risk assessment services provided to life insurance companies, with the remainder classified as clinical laboratory testing. The performance at NID, the company’s test kit manufacturing subsidiary, reduced consolidated revenue growth by approximately 1%.
Our clinical testing business, which accounted for 92% of our consolidated net revenues, grew 13.4% for the three months ended March 31, 2006, with the acquisition of LabOne contributing approximately 5%, principally reflected in volume.
For the three months ended March 31, 2006, clinical testing volume increased 8.7% compared to the prior year period. The first quarter revenue and volume comparisons benefited by about 1% as a result of a milder winter this year, and the fact that the Easter holiday fell in the second quarter this year, compared to the first quarter last year.
Average revenue per requisition improved 4.3% for the three months ended March 31, 2006. The increase in revenue per requisition is principally driven by a shift to a more esoteric test mix and an increase in the number of tests ordered per requisition.
Our businesses other than clinical laboratory testing accounted for approximately 8% of our consolidated net revenues. These businesses include our clinical trials testing business and our healthcare information technology business (MedPlus), whose growth rates did not significantly affect our consolidated growth rate. In addition, we consider the risk assessment business, acquired as part of the LabOne acquisition, and NID to be non-clinical laboratory testing businesses. As a result of a continued product hold, NID’s net revenues for the three months ended March 31, 2006 decreased $13 million from the prior year level, and reduced consolidated revenue growth by 1.0%. The risk assessment business represents approximately 5% of our consolidated net revenues for the three months ended March 31, 2006 and is currently growing at approximately 3% per year.
Operating Costs and Expenses
Total operating costs and expenses for the three months ended March 31, 2006 increased $221 million from the prior year period primarily due to organic growth in our clinical testing volume and, to a lesser degree, the LabOne acquisition. The increased costs were primarily in the areas of employee compensation and benefits, which includes $19.4 million of charges associated with stock-based compensation recorded in accordance with SFAS 123R, 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. Additionally, for the three months ended March 31, 2006, $26.8 million in special charges are reflected in other operating expense, and relate principally to costs associated with integrating the LabOne acquisition 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 59.3% of net revenues for the three months ended March 31, 2006, increasing from 59.1% of net revenues in the prior year period. The increase over the prior year is primarily due to the addition of the LabOne business, which carries a higher cost of sales percentage than the Company average, and the impact of NID’s performance. Partially offsetting this increase is improvement due to the increase in average revenue per requisition and efficiency gains resulting from our Six Sigma and standardization initiatives.
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 23.0% of net revenues for the three months ended March 31, 2006, decreasing from 23.4% in the prior year period. The improvement was primarily due to revenue growth, which has allowed us to leverage our expense base, as well as continued benefits from our Six Sigma and standardization efforts. Also contributing to the improvement is the addition of the LabOne business, which carries a lower selling, general and administrative expense percentage than the Company average. Partially offsetting the improvement is stock-based compensation expense recorded in accordance with SFAS 123R, which reduced the improvement by 1%, and the
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performance of NID, which served to reduce the improvement by 0.3%. For the three months ended March 31, 2006, bad debt expense was 4.1% of net revenues, compared to 4.5% in the prior year period. This decrease primarily relates to the improved collection of diagnosis, patient and insurance information necessary to more effectively bill for services performed. 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 and provisions for restructurings and other special charges. For the three months ended March 31, 2006, other operating expense, net includes a charge of $20.7 million associated with executing the integration plan of LabOne. The $20.7 million charge relates to actions that impact Quest Diagnostics’ employees and operations and is comprised principally of employee severance costs. Also in connection with the LabOne integration, we recorded $2.6 million of integration costs, which were included in goodwill. In addition, other operating expense, net for the three months ended March 31, 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 benefits and the write-off of certain operating assets.
Operating Income
Operating income for the three months ended March 31, 2006 improved to $245 million, or 15.7% of net revenues, from $230 million, or 17.4% of net revenues, in the prior year period. The increase in operating income is driven by the performance of our clinical testing business. Reducing the improvement over the prior year was $26.8 million of special charges recorded in the first quarter of 2006 related primarily to integration activities, $19.4 million of stock-based compensation pursuant to SFAS 123R and performance at NID. Operating income as a percentage of revenues compared to the prior year was reduced by approximately 1.7% due to the special charges, 1.2% due to the stock-based compensation expense and 0.8% due to the results of the LabOne business. In addition, the performance of NID reduced operating income as a percentage of revenues by 0.7%. Lastly, the milder winter and the timing of Easter benefited comparisons by about half a percent.
Other Income (Expense)
Interest expense, net for the three months ended March 31, 2006 increased $11 million over the prior year period. The increase in interest expense, net was primarily due to additional interest expense associated with our $900 million senior notes offering in October 2005 used to fund the LabOne acquisition, as described more fully in Note 10 to the Consolidated Financial Statements contained in our 2005 Annual Report on Form 10-K.
Other income, net represents miscellaneous income and expense items related to non-operating activities such as gains and losses associated with investments and other non-operating assets. For the three months ended March 31, 2006, other income, net includes a $15.8 million gain on the sale of an investment.
NID
During the fourth quarter of 2005, the Company’s test kit manufacturing subsidiary, NID, instituted its second voluntary product hold within a six-month period, due to quality issues, which has adversely impacted the operating performance of NID. As a result, the Company evaluated a number of strategic options for NID. On April 19, 2006, the Company decided to discontinue NID’s operations. This decision is expected to result in a pre-tax charge in the second quarter of 2006 preliminarily estimated to be up to $45 million. The estimated charge is expected to principally relate to the write-off of operating assets and the accrual of liabilities associated with employee severance costs and various lease commitments. The associated cash expenditures are estimated to be up to $35 million.
The ongoing government investigation and regulatory review of NID continue. While we do not believe that these matters will have a material adverse impact on our overall financial condition, their final resolution could be material to our results of operations or cash flows in the period in which the impact of such matters is determined or paid. See Note 6 to the interim consolidated financial statements for a further description of these matters.
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
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material to our financial condition or results of operations. See Note 2 to the Consolidated Financial Statements in our 2005 Annual Report on Form 10-K for additional discussion of our financial instruments and hedging activities.
At March 31, 2006 and December 31, 2005, the fair value of our debt was estimated at approximately $1.5 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 March 31, 2006 and December 31, 2005, the estimated fair value exceeded the carrying value of the debt by approximately $7 million and $39 million, respectively. An assumed 10% increase in interest rates (representing approximately 53 and 59 basis points at March 31, 2006 and December 31, 2005, respectively) would potentially reduce the estimated fair value of our debt by approximately $37 million and $36 million at March 31, 2006 and December 31, 2005, 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 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 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 March 31, 2006, our borrowing rate for our LIBOR-based loans was LIBOR plus 0.5%. At March 31, 2006, there was $75 million outstanding under our term loan due December 2008 and no borrowings outstanding under our $500 million senior unsecured revolving credit facility or our $300 million secured receivables 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 48 basis points) would impact annual net interest expense by approximately $0.4 million, assuming no changes to the debt outstanding at March 31, 2006. See Note 10 to the Consolidated Financial Statements in our 2005 Annual Report on Form 10-K for details regarding our debt outstanding.
Liquidity and Capital Resources
Cash and Cash Equivalents
Cash and cash equivalents at March 31, 2006 totaled $156 million, compared to $92 million at December 31, 2005. Cash flows from operating activities in 2006 were $241 million, which were used to fund investing and financing activities of $28 million and $148 million, respectively. 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 of $75 million and $48 million, respectively.
Cash Flows from Operating Activities
Net cash provided by operating activities for the three months ended March 31, 2006 was $241 million compared to $136 million in the prior year period. This increase was primarily due to improved operating performance, the timing of payments for various accrued liabilities, including interest, integration costs and accounts payable, and a smaller increase in accounts receivable than in the prior year. Days sales outstanding, a measure of billing and collection efficiency, improved to 43 days at March 31, 2006 from 46 days at December 31, 2005.
Cash Flows from Investing Activities
Net cash used in investing activities for the three months ended March 31, 2006 was $28 million, consisting primarily of capital expenditures of $42 million offset by $15.8 million of proceeds received in connection with the sale of an investment.
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.
Cash Flows from Financing Activities
Net cash used in financing activities for the three months ended March 31, 2006 was $148 million, consisting primarily of purchases of treasury stock totaling $104 million, repayment of $60 million of principal outstanding under our secured receivables credit facility and dividend payments of $18 million, partially offset by $52 million in proceeds from the exercise of stock options, including related tax benefits. The $104 million in treasury stock purchases represents 2.0 million shares of our common stock purchased at an average price of $52.05 per share.
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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 totaling $15 million, partially offset by $35 million in proceeds 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. The $62 million in treasury stock purchases represents 1.3 million shares of our common stock purchased at an average price of $49.58 per share.
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
During each of the quarters of 2005, our Board of Directors has declared a quarterly cash dividend of $0.09 per common share. On January 26, 2006, our Board of Directors declared a quarterly cash dividend per common share of $0.10, payable on April 19, 2006, to shareholders of record on April 5, 2006. 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, 2006, we repurchased 2.0 million shares of our common stock at an average price of $52.05 per share for $104 million. Through March 31, 2006, we have repurchased approximately 34.4 million shares of our common stock at an average price of $43.16 for approximately $1.5 billion under our share repurchase program. At March 31, 2006, the total available for repurchases under the remaining authorizations was $618 million.
Contractual Obligations and Commitments
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 2005 Annual Report on Form 10-K. A full discussion and analysis regarding our minimum rental commitments under noncancelable operating leases and noncancelable commitments to purchase products or services at December 31, 2005 is contained in Note 14 to the Consolidated Financial Statements in our 2005 Annual Report on Form 10-K. See Note 6 to the interim consolidated financial statements for information regarding the status of legal matters involving the Company.
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 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.
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Requirements and Capital Resources
We estimate that we will invest approximately $225 million to $245 million during 2006 for capital expenditures to support and expand our existing operations, principally related to investments in information technology, equipment, and facility upgrades.
Our 6¾% senior notes, which have an aggregate principal amount of $275 million outstanding, mature in July 2006. We may repay the notes with cash on hand or refinance the notes with borrowings under our unsecured revolving credit facility, secured receivables credit facility or other financing arrangements.
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 improved 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
Effective January 1, 2006, we adopted SFAS 123R using the modified prospective approach. See Notes 1 and 2 to the interim consolidated financial statements for further details.
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, 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 2005 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
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(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) | During the first quarter of 2006, 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
Item 1. Legal Proceedings
See Note 6 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, 2006 –
January 31, 2006 | | | 119,000 | | | | $ | 49.43 | | | | 119,000 | | | | $ | 716,141 | | |
|
February 1, 2006 –
February 28, 2006 | | | 1,058,900 | | | | $ | 51.89 | | | | 1,058,900 | | | | $ | 661,190 | | |
|
March 1, 2006 -
March 31, 2006 | | | 819,800 | | | | $ | 52.63 | | | | 819,800 | | | | $ | 618,046 | | |
| | |
| | | |
|
| | | |
| | | |
|
| | |
Total | | | 1,997,700 | | | | $ | 52.05 | | | | 1,997,700 | | | | $ | 618,046 | | |
| | |
| | | |
|
| | | |
| | | |
|
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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 |
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| 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.
April 28, 2006
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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