SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
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FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the Quarter ended March 31, 2000
Commission file number 1-12215
QUEST DIAGNOSTICS INCORPORATED
One Malcolm Avenue
Teterboro, NJ 07608
(201) 393-5000
DELAWARE
(State of Incorporation)
16-1387862
(I.R.S. Employer Identification Number)
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Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
--- ---
As of April 24, 2000, there were outstanding 44,412,197 shares of Common Stock,
$.01 par value.
16
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
Index to consolidated financial statements filed as part of this report:
Page
Consolidated Statements of Operations for the
Three Months Ended March 31, 2000 and 1999 2
Consolidated Balance Sheets as of
March 31, 2000 and December 31, 1999 3
Consolidated Statements of Cash Flows for the
Three Months Ended March 31, 2000 and 1999 4
Notes to Consolidated Financial Statements 5
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
Management's Discussion and Analysis of Financial
Condition and Results of Operations 17
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
See Item 2. "Management's Discussion and Analysis of Financial Condition
and Results of Operations"
1
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE MONTHS ENDED MARCH 31, 2000 AND 1999
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
2000 1999
----------------- -----------------
NET REVENUES....................................................................... $ 857,479 $ 381,841
---------- ------------
COSTS AND EXPENSES:
Cost of services.................................................................. 529,037 237,408
Selling, general and administrative............................................... 249,835 116,600
Interest expense, net............................................................. 29,763 7,359
Amortization of intangible assets................................................. 11,940 5,094
Minority share of income.......................................................... 2,136 1,130
Other, net........................................................................ (428) 172
---------- -----------
Total........................................................................... 822,283 367,763
---------- -----------
INCOME BEFORE TAXES.................................................................. 35,196 14,078
INCOME TAX EXPENSE .................................................................. 17,387 6,645
---------- -----------
NET INCOME ........................................................................ $ 17,809 $ 7,433
========== ============
BASIC NET INCOME PER COMMON SHARE.................................................. $ 0.40 $ 0.25
DILUTED NET INCOME PER COMMON SHARE................................................ $ 0.39 $ 0.24
WEIGHTED AVERAGE COMMON SHARES
OUTSTANDING - BASIC............................................................... 44,131 29,716
WEIGHTED AVERAGE COMMON SHARES
OUTSTANDING - DILUTED............................................................. 45,616 30,280
The accompanying notes are an integral part of these statements.
2
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
MARCH 31, 2000 AND DECEMBER 31, 1999
(IN THOUSANDS, EXCEPT PER SHARE DATA)
MARCH 31, DECEMBER 31,
2000 1999
------------------ ------------------
(unaudited)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents............................................. $ 28,487 $ 27,284
Accounts receivable, net of allowance of $143,626 and $121,550 at
March 31, 2000 and December 31, 1999, respectively................ 484,225 539,256
Inventories........................................................... 49,905 52,302
Deferred taxes on income.............................................. 189,709 192,808
Prepaid expenses and other current assets............................. 78,098 61,011
--------------- --------------
Total current assets.............................................. 830,424 872,661
PROPERTY, PLANT AND EQUIPMENT, NET......................................... 423,283 427,978
INTANGIBLE ASSETS, NET..................................................... 1,425,275 1,435,882
DEFERRED TAXES ON INCOME................................................... 46,855 36,174
OTHER ASSETS............................................................... 112,798 105,786
--------------- --------------
TOTAL ASSETS.......................................................... $ 2,838,635 $ 2,878,481
=============== ==============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable and accrued expenses................................. $ 527,971 $ 626,485
Current portion of long-term debt..................................... 47,729 45,435
Income taxes payable.................................................. 46,833 29,324
--------------- --------------
Total current liabilities......................................... 622,533 701,244
LONG-TERM DEBT............................................................. 1,157,899 1,171,442
OTHER LIABILITIES.......................................................... 161,173 142,733
COMMITMENTS AND CONTINGENCIES
PREFERRED STOCK............................................................ 1,000 1,000
COMMON STOCKHOLDERS' EQUITY:
Common stock, par value $0.01 per share; 100,000 shares authorized;
45,133 and 44,353 shares issued at March 31, 2000 and
December 31, 1999, respectively................................... 451 444
Additional paid-in capital............................................ 1,528,727 1,502,551
Accumulated deficit................................................... (609,265) (627,045)
Unearned compensation................................................. (22,442) (11,438)
Accumulated other comprehensive loss (1,441) (2,450)
--------------- --------------
Total common stockholders' equity................................. 896,030 862,062
--------------- --------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY............................ $ 2,838,635 $ 2,878,481
=============== ==============
The accompanying notes are an integral part of these statements.
3
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE THREE MONTHS ENDED MARCH 31, 2000 AND 1999
(IN THOUSANDS)
(UNAUDITED)
2000 1999
---------------- -----------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income................................................................... $ 17,809 $ 7,433
Adjustments to reconcile net income
to net cash provided by operating activities:
Depreciation and amortization............................................. 33,185 16,483
Provision for doubtful accounts........................................... 62,646 20,337
Deferred income tax (benefit) provision................................... (4,161) 11,282
Other, net................................................................ 6,112 2,045
Changes in operating assets and liabilities:
Accounts receivable..................................................... (76,657) (29,442)
Accounts payable and accrued expenses................................... (18,687) 12,485
Integration, settlement and other special charges....................... (6,313) (5,499)
Other assets and liabilities, net....................................... 19,223 (11,525)
---------- ----------
NET CASH PROVIDED BY OPERATING ACTIVITIES.................................... 33,157 23,599
---------- ----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures......................................................... (17,613) (12,707)
Business acquisition......................................................... (925) -
Transaction costs............................................................ - (1,114)
Proceeds from disposition of assets.......................................... 666 730
Increase in investments...................................................... (2,605) (4,937)
---------- ----------
NET CASH USED IN INVESTING ACTIVITIES........................................ (20,477) (18,028)
---------- ----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Repayment of long-term debt.................................................. (11,248) (48,216)
Deferred financing costs paid................................................ (117) (4,687)
Distributions to minority partners........................................... (1,414) (478)
Exercise of stock options.................................................... 1,331 231
Purchases of treasury stock.................................................. - (1,103)
Preferred stock dividends paid............................................... (29) (29)
---------- ----------
NET CASH USED IN FINANCING ACTIVITIES........................................ (11,477) (54,282)
---------- ----------
NET CHANGE IN CASH AND CASH EQUIVALENTS...................................... 1,203 (48,711)
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR................................. 27,284 202,908
---------- ----------
CASH AND CASH EQUIVALENTS, END OF PERIOD..................................... $ 28,487 $ 154,197
========== ==========
CASH PAID DURING THE PERIOD FOR:
Interest..................................................................... $ 25,529 $ 6,023
Income taxes................................................................. 2,953 1,846
The accompanying notes are an integral part of these statements.
4
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
1. BASIS OF PRESENTATION
BACKGROUND
Quest Diagnostics Incorporated and its subsidiaries ("Quest Diagnostics" or
the "Company") is the largest clinical laboratory testing business in the United
States. Prior to January 1, 1997, Quest Diagnostics was a wholly-owned
subsidiary of Corning Incorporated ("Corning"). On December 31, 1996, Corning
distributed all of the outstanding shares of common stock of the Company to the
stockholders of Corning, with one share of common stock of the Company being
distributed for each eight shares of outstanding common stock of Corning (the
"Spin-Off Distribution").
BASIS OF PRESENTATION
The interim consolidated financial statements reflect all adjustments
which, in the opinion of management, are necessary for a fair statement of the
results of operations for the periods presented. All such adjustments are of a
normal recurring nature. The interim consolidated financial statements have been
compiled without audit and are subject to year-end adjustments. Operating
results for the interim period are not necessarily indicative of the results
that may by expected for the full year. These interim consolidated financial
statements should be read in conjunction with the audited consolidated financial
statements included in the Company's Form 10-K for the year ended December 31,
1999.
RECLASSIFICATIONS
During the fourth quarter of 1999, the Company reclassified certain expense
items, primarily related to a portion of occupancy costs and professional
liability insurance expense, from selling, general and administrative expenses
to cost of services, to better reflect the cost of performing testing. The
amount reclassified from selling, general and administrative expenses for the
three months ended March 31, 1999 was $10.4 million.
EARNINGS PER SHARE
Basic net income (loss) per common share is calculated by dividing net
income (loss), less preferred stock dividends (approximately $30), by the
weighted average number of common shares outstanding. Diluted net income (loss)
per common share is calculated by dividing net income (loss), less preferred
stock dividends, by the weighted average number of common shares outstanding
after giving effect to all potentially dilutive common shares outstanding during
the period. Potentially dilutive common shares include outstanding stock options
and restricted common shares granted under the Company's Employee Equity
Participation Program.
2. ACQUISITION OF SMITHKLINE BEECHAM'S CLINICAL LABORATORY TESTING BUSINESS
On August 16, 1999, the Company completed the acquisition of the clinical
laboratory business of SmithKline Beecham plc ("SmithKline Beecham") for
approximately $1.3 billion. The purchase price was paid through the issuance of
approximately 12.6 million shares of common stock of the Company and the payment
of $1.025 billion in cash, including $20 million under a non-competition
agreement between the Company and SmithKline Beecham. The acquisition of
SmithKline Beecham's clinical laboratory business ("SBCL") was accounted for
under the purchase method of accounting. As such, the cost to acquire SBCL has
been allocated on a preliminary basis to the assets and liabilities acquired
based on estimated fair values as of the closing date.
5
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
The SBCL acquisition agreements include a provision for a purchase price
adjustment based on an audit of the August 16, 1999 combined balance sheet of
SBCL and certain affiliates. Adjustments resulting from this audit, which are
subject to resolution as set forth in the SBCL acquisition agreements, and are
the subject of on-going discussions between the parties, have already been
recorded. However, amounts due from SmithKline Beecham, as a result of the
purchase price adjustment, have not been reflected in the consolidated balance
sheets of Quest Diagnostics.
The purchase price allocation will be finalized after completion of the
valuation of certain assets and liabilities, and the final resolution of the
purchase price adjustment. The consolidated financial statements include the
results of operations of SBCL subsequent to the closing of the acquisition.
FINANCING OF THE TRANSACTION
At the closing of the SBCL acquisition, the Company used existing cash
funds and the borrowings under a new senior secured credit facility (the "Credit
Agreement") to fund the cash purchase price and related transaction costs of the
acquisition, and to repay the entire amount outstanding under its then existing
credit agreement.
PRO FORMA COMBINED FINANCIAL INFORMATION
The following pro forma combined financial information assumes that the
SBCL acquisition and borrowings under the Credit Agreement were effected on
January 1, 1999. The SBCL acquisition agreements include a provision for a
purchase price adjustment based on an audit of the August 16, 1999 combined
balance sheet of SBCL and certain affiliates. Adjustments resulting from this
audit, which are subject to resolution as set forth in the SBCL acquisition
agreements and are the subject of on-going discussions between the parties, have
been recorded in the pro forma combined financial information to the extent that
the Company believes they are applicable. The pro forma combined financial
information reflects the preliminary allocation of the purchase price. The
allocation will be finalized after completion of the valuation of certain assets
and liabilities, and the final resolution of the purchase price adjustment.
There can be no assurances that the amounts reflected in the pro forma combined
financial information will not be subject to change as a result of changes in
the allocation of the purchase price, including the resolution of the purchase
price adjustment.
The pro forma combined financial information is presented for illustrative
purposes only to analyze the financial implications of the SBCL acquisition and
borrowings under the Credit Agreement. The pro forma combined financial
information may not be indicative of the combined financial results of
operations that would have been realized had Quest Diagnostics and SBCL been a
single entity during the period presented. In addition, the pro forma combined
financial information is not necessarily indicative of the future results that
the combined company will experience.
Significant pro forma adjustments reflected in the pro forma combined
financial information include reductions in employee benefit costs and general
corporate overhead allocated to the historical results of SBCL by SmithKline
Beecham, offset by an increase in net interest expense to reflect the Company's
Credit Agreement which was used to finance the SBCL acquisition. Amortization of
the goodwill, which accounts for a majority of the acquired intangible assets,
was calculated on the straight-line basis over forty years. Other, net has been
adjusted to remove SBCL's non-recurring gains from the sale and license of
certain technology and its physician office-based teleprinter assets and
network. Income taxes have been adjusted for the estimated income tax impact of
the pro forma adjustments at the incremental tax rate of 40%. A significant
portion of the intangible assets acquired in the SBCL acquisition are not
deductible for tax purposes, which has the overall impact of increasing the
effective tax rate.
6
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
Unaudited pro forma combined financial information for the three months ended
March 31, 1999 was as follows (in millions, except per share data):
1999
----------
Net revenues.............................................................. $ 823.5
Net income................................................................ 8.2
Basic earnings per common share:
Net income................................................................ $ 0.19
Weighted average common shares
outstanding - basic.................................................. 43.0
Diluted earnings per common share:
Net income................................................................ $ 0.19
Weighted average common shares
outstanding - diluted................................................ 43.5
3. INTEGRATION OF SBCL AND QUEST DIAGNOSTICS BUSINESSES
During the fourth quarter of 1999, Quest Diagnostics finalized its plan
related to the integration of SBCL into Quest Diagnostics' laboratory network.
The plan focuses principally on laboratory consolidations in geographic markets
currently served by more than one of the Company's laboratories, and redirecting
testing volume within the Company's national network to improve customer
service. As part of the plan, laboratories in Deerfield Beach, Florida; Owings
Mills, Maryland; Farmington Hills, Michigan; Islip, New York; Valley View, Ohio;
Norristown, Pennsylvania; Dallas, Texas; and Waltham, Massachusetts will close
or be substantially reduced in capacity. Testing performed at the National
Esoteric Testing Center located in Van Nuys, California will move to Nichols
Institute. The Company is not exiting any geographic markets as a result of
these consolidations. In addition, a number of changes to redirect specimen
flows to provide more local testing and improve customer service will also
impact capacity throughout the Company's laboratory network. Employee groups to
be impacted as a result of these actions include those involved in the
collection and testing of specimens, as well as administrative and other support
functions. During the fourth quarter of 1999, the Company recorded the estimated
costs associated with these activities for 1999 and 2000 relative to the
integration plan. The majority of these integration costs were related to
employee severance, contractual obligations associated with leased facilities
and equipment, and the write-off of fixed assets which management believes will
have no future economic benefit upon combining the operations. Integration costs
related to planned activities affecting SBCL's operations and employees were
recorded as a cost of the acquisition. Integration costs associated with the
planned integration of SBCL affecting Quest Diagnostics' operations and
employees were recorded as a charge to earnings in the fourth quarter of 1999.
7
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
The following table summarizes the Company's accruals for integration
costs affecting the acquired business of SBCL (in millions):
Costs of
Employee Exiting
Termination Leased
Costs Facilities Other Total
----- ---------- ----- -----
Balance, December 31, 1999........................... $ 32.4 $ 5.5 $ 7.8 $ 45.7
Amounts utilized in 2000............................. (3.0) (0.4) (0.2) (3.6)
------- ------- ------- -------
Balance, March 31, 2000.............................. $ 29.4 $ 5.1 $ 7.6 $ 42.1
======= ======= ======= =======
The following table summarizes the Company's accruals for restructuring
costs associated with the planned integration of SBCL affecting Quest
Diagnostics' operations and employees (in millions):
Costs of
Employee Exiting
Termination Leased
Costs Facilities Other Total
----- ---------- ----- -----
Balance, December 31, 1999........................... $ 20.9 $ 8.9 $ 0.8 $ 30.6
Amounts utilized in 2000............................. (1.5) (0.1) - (1.6)
------- ------- ------ -------
Balance, March 31, 2000.............................. $ 19.4 $ 8.8 $ 0.8 $ 29.0
======= ======= ======= =======
Approximately 400 employees had been terminated in connection with
integration activities through March 31, 2000.
As of March 31, 2000, the Company had completed the integration of SBCL's
Waltham and Farmington Hills businesses into its existing laboratory network in
the Boston and Detroit metropolitan areas, respectively, and the redirecting of
specimens to and from its Atlanta laboratory. While these actions represent the
significant activities associated with the integration costs incurred through
March 31, 2000, the Company has begun to initiate other planned actions at its
remaining facilities in accordance with the SBCL integration plan, including
redirecting specimens within its national laboratory network to provide more
local testing and improve customer service.
While the majority of the remaining accruals associated with the SBCL
integration plan are expected to be paid in 2000, there are certain severance
and facility related exit costs, principally lease obligations, that have
payment terms extending beyond 2000.
8
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
4. COMMITMENTS AND CONTINGENCIES
The Company has entered into several settlement agreements with various
governmental and private payers during recent years relating to industry-wide
billing and marketing practices that had been substantially discontinued by
early 1993. At present, government investigations of certain practices by
Nichols Institute, a clinical laboratory company acquired in 1994, are ongoing.
The Company has received notices of private claims relating to billing issues
similar to those that were the subject of prior settlements with various
governmental payers. In March 1997, a former subsidiary of Damon Corporation
("Damon"), an independent clinical laboratory acquired by Corning and
contributed to Quest Diagnostics in 1993, was served a complaint in a purported
class action. Quest Diagnostics was added to the complaint by the plaintiffs in
August 1999. The complaint asserts claims relating to private reimbursement of
billings that are similar to those that were part of a prior government
settlement. The Company has entered into a settlement agreement, which received
the preliminary approval of the court on April 4, 2000. The court will consider
final approval of the settlement at a hearing scheduled for July 14, 2000. The
Company anticipates that the final settlement will release the Company and all
of its subsidiaries other than SBCL from all potential private claims related to
the reimbursement of billings that were subject to the prior government
settlement.
Corning has agreed to indemnify the Company against all monetary
settlements for any governmental claims relating to the billing practices of the
Company and its predecessors based on investigations that were pending on
December 31, 1996. Corning also agreed to indemnify the Company in respect of
private claims relating to indemnified or previously settled government claims
that alleged overbillings by Quest Diagnostics or any of its existing
subsidiaries for services provided before January 1, 1997. Corning will
indemnify Quest Diagnostics in respect of private claims for 50% of the
aggregate of all judgment or settlement payments made by December 31, 2001 that
exceed $42 million. The 50% share will be limited to a total amount of $25
million and will be reduced to take into account any deductions or tax benefits
realized by Quest Diagnostics. At March 31, 2000 the receivable from Corning
totaled $14 million, which is management's best estimate of amounts which are
probable of being received from Corning to satisfy the remaining indemnified
governmental claims on an after-tax basis.
Similar to Quest Diagnostics, SBCL has entered into settlement agreements
with various governmental agencies and private payers primarily relating to its
prior billing and marketing practices. Effective in 1997, SBCL and the U.S.
government and various states reached a settlement with respect to the
government's civil and administrative claims. SBCL is also responding to claims
from private payers relating to billing and marketing issues similar to those
that were the subject of the settlement with the government. The claims include
ten purported class actions filed in various jurisdictions in the United States
and two non-class action complaints by a number of insurance companies. Nine of
the purported class actions have been consolidated into one complaint, which has
been consolidated with one of the insurers' suits, for pre-trial proceedings.
SmithKline Beecham has agreed to indemnify Quest Diagnostics, on an after
tax basis, against monetary payments for governmental claims or investigations,
relating to the billing practices of SmithKline Beecham and its affiliates, that
have been settled before, or are pending as of, the closing date of the SBCL
acquisition. SmithKline Beecham has also agreed to indemnify Quest Diagnostics,
on an after tax basis, against monetary payments to private payers, relating to
or arising out of the pending governmental claims. The indemnification with
respect to governmental claims is for 100% of those claims. SmithKline Beecham
will indemnify Quest Diagnostics, in respect of private claims for: 100% of
those claims, up to an aggregate amount of $80 million; 50% of those claims to
the extent the aggregate amount exceeds $80 million but is less than $130
million; and 100% of such claims to the extent the aggregate amount exceeds $130
million. The indemnification also covers 80% of out-of-pocket costs and expenses
relating to investigations of the claims indemnified against by SmithKline
Beecham. In addition, SmithKline Beecham has agreed to indemnify the Company
against all
9
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
monetary payments relating to professional liability claims of SBCL for services
provided prior to the closing of the SBCL acquisition.
On March 22, 1999, SBCL learned that an SBCL employee at a patient service
center in Palo Alto, California had at times reused certain needles when drawing
blood from patients. A number of civil actions, including some purporting to be
class actions, have been filed against SBCL in federal and state courts in
California on behalf of patients who may have been affected by the
phlebotomist's reuse of needles or other allegedly improper practices.
SmithKline Beecham has agreed to indemnify Quest Diagnostics for the
out-of-pocket costs of the counseling and testing, for liabilities arising out
of the civil actions and for other losses arising out of the conduct of the
phlebotomist, other than consequential damages.
Of the total amount due from SmithKline Beecham at March 31, 2000 of $55.1
million, $49.6 million related to indemnified billing, professional liability
and other claims discussed above, and represented management's best estimate of
the amounts which are probable of being received from SmithKline Beecham to
satisfy the indemnified claims on an after-tax basis. The estimated reserves and
the related receivable due from SmithKline Beecham may be subject to change as
additional information regarding the outstanding claims is gathered and
evaluated.
At March 31, 2000 recorded reserves, relating primarily to billing claims
including those indemnified by Corning and SmithKline Beecham, approximated $90
million including $19 million in other long-term liabilities. The increase in
reserves was principally associated with reserve estimates related to billing
claims which are indemnified by SmithKline Beecham as described above. Although
management believes that established reserves for both indemnified and
non-indemnified claims are sufficient, it is possible that additional
information (such as the indication by the government of criminal activity,
additional tests being questioned or other changes in the government's or
private claimants' theories of wrongdoing) may become available which may cause
the final resolution of these matters to exceed established reserves by an
amount which could be material to the Company's results of operations and cash
flows in the period in which such claims are settled. The Company does not
believe that these issues will have a material adverse effect on its overall
financial condition.
The Company has been named as a defendant in a lawsuit filed in England,
alleging that the Company had breached an agreement between the plaintiff and
the Company for cooperative marketing of clinical trials testing services. The
Company intends to vigorously defend itself, and believes that the damages
specified in the complaint are excessive. The Company does not believe that this
matter will have a material adverse effect on its overall financial condition.
10
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
5. COMMON STOCKHOLDERS' EQUITY
Changes in common stockholders' equity for the three months ended March 31,
2000 were as follows:
Accumulated |
Other |
Additional Comprehensive | Compre-
Common Paid-In Accumulated Unearned Income | hensive
Stock Capital Deficit Compensation (Loss) | Income
---------- -------------- -------------- -------------- ------------- | -----------
|
BALANCE, |
DECEMBER 31, 1999 $ 444 $ 1,502,551 $ (627,045) $ (11,438) $ (2,450) |
Net income 17,809 | $ 17,809
Other comprehensive income 1,009 | 1,009
| --------
Comprehensive income | $ 18,818
| ========
Preferred dividends declared (29) |
Issuance of common stock under |
benefit plans (643 common |
shares) 6 23,555 (14,459) |
Exercise of options (137 |
common shares) 1 1,330 |
Tax benefits associated with |
stock-based compensation |
plans 1,291 |
Amortization of unearned |
compensation 3,455 |
- --------------------------------------------------------------------------------------------------------|
BALANCE, |
MARCH 31, 2000 $ 451 $ 1,528,727 $ (609,265) $ (22,442) $ (1,441) |
=====================================================================|
11
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
Changes in common stockholders' equity for the three months ended March 31,
1999 were as follows:
Accumulated |
Other |
Additional Comprehensive | Compre-
Common Paid-In Accumulated Unearned Income Treasury | hensive
Stock Capital Deficit Compensation (Loss) Stock | Income
---------- -------------- -------------- -------------- ------------- ----------- | ----------
|
BALANCE, |
DECEMBER 31, 1998 $ 302 $ 1,201,006 $ (623,514) $ (3,895) $ (3,038) $ (3,931) |
Net income 7,433 | $ 7,433
Other comprehensive income 1,319 | 1,319
| ---------
Comprehensive income | $ 8,752
| =========
Preferred dividends declared (29) |
Purchases of treasury shares (1,103) |
(60 shares) |
Issuance of common stock under |
benefit plans (160 treasury |
shares) 116 (137) 2,931 |
Exercise of options (13 common |
shares) 1 230 |
Tax benefits associated with |
stock-based compensation |
plans 12 |
Adjustment to Corning |
receivable (1,985) |
Amortization of unearned |
compensation 569 |
- ---------------------------------------------------------------------------------------------------------------------- |
BALANCE, |
MARCH 31, 1999 $ 303 $ 1,199,379 $ (616,110) $ (3,463) $ (1,719) $ (2,103) |
=================================================================================== |
6. SUMMARIZED FINANCIAL INFORMATION
The Company's 10.75% senior subordinated notes due 2006 are guaranteed,
fully, jointly and severally, and unconditionally, on a senior subordinated
basis by substantially all of the Company's wholly-owned, domestic subsidiaries
("Subsidiary Guarantors"). The non-guarantor subsidiaries are foreign and less
than wholly-owned subsidiaries.
The following condensed consolidating financial data illustrates the
composition of the combined guarantors. The Company believes that separate
complete financial statements of the respective guarantors would not provide
additional material information which would be useful in assessing the financial
composition of the Subsidiary Guarantors. The following condensed consolidating
financial data includes SBCL as a Subsidiary Guarantor for periods subsequent to
the closing of the acquisition (see Note 2).
12
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS
THREE MONTHS ENDED MARCH 31, 2000
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
Net revenues................................ $ 167,181 $ 661,892 $ 28,406 $ -- $ 857,479
--
Costs and expenses:
Cost of services......................... 110,032 403,206 15,799 -- 529,037
Selling, general and administrative...... 62,391 174,850 12,594 -- 249,835
Interest expense, net.................... 3,528 26,083 152 -- 29,763
Amortization of intangible assets........ 1,917 9,937 86 -- 11,940
Royalty (income) expense................. (19,223) 19,223 -- -- --
Other, net............................... 438 (98) 1,368 -- 1,708
----------- ----------- ----------- ----------- -----------
Total.................................. 159,083 633,201 29,999 -- 822,283
----------- ----------- ----------- ----------- -----------
Income (loss) before taxes.................. 8,098 28,691 (1,593) -- 35,196
Income tax expense.......................... 2,478 14,571 338 -- 17,387
Equity earnings from subsidiaries........... 12,189 -- -- (12,189) --
----------- ----------- ----------- ----------- -----------
Net income (loss)........................... $ 17,809 $ 14,120 $ (1,931) $ (12,189) $ 17,809
=========== =========== =========== =========== ===========
CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS
THREE MONTHS ENDED MARCH 31, 1999
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
----------- ----------- ------------ ------------ ------------
Net revenues................................ $ 156,298 $ 204,566 $ 20,977 $ -- $ 381,841
--
Costs and expenses:
Cost of services......................... 103,341 121,335 12,732 -- 237,408
Selling, general and administrative...... 55,883 53,431 7,286 -- 116,600
Interest expense, net.................... 2,116 5,004 239 -- 7,359
Amortization of intangible assets........ 3,026 1,955 113 -- 5,094
Royalty (income) expense................. (17,340) 17,340 -- -- --
Other, net............................... (330) 45 1,587 -- 1,302
----------- ----------- ----------- ----------- -----------
Total.................................. 146,696 199,110 21,957 -- 367,763
----------- ----------- ----------- ----------- -----------
Income (loss) before taxes.................. 9,602 5,456 (980) -- 14,078
Income tax expense.......................... 3,529 2,981 135 -- 6,645
Equity earnings from subsidiaries........... 1,360 -- -- (1,360) --
----------- ----------- ----------- ----------- -----------
Net income (loss)........................... $ 7,433 $ 2,475 $ (1,115) $ (1,360) $ 7,433
=========== =========== =========== =========== ===========
13
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
CONDENSED CONSOLIDATING BALANCE SHEET
MARCH 31, 2000
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
ASSETS
Current assets:
Cash and cash equivalents................. $ -- $ 20,378 $ 8,109 $ -- $ 28,487
Accounts receivable, net.................. 68,887 399,975 15,363 -- 484,225
Other current assets...................... 119,933 190,239 7,540 -- 317,712
----------- ---------- ----------- ----------- -----------
Total current assets 188,820 610,592 31,012 -- 830,424
Property, plant and equipment, net.......... 110,961 299,231 13,091 -- 423,283
Intangible assets, net ..................... 158,637 1,264,465 2,173 -- 1,425,275
Intercompany (payable) receivable........... (33,432) 48,342 (14,910) -- --
Investment in subsidiaries.................. 867,577 -- -- (867,577) --
Other assets................................ 30,256 106,655 22,742 -- 159,653
----------- ---------- ----------- ----------- -----------
Total assets.............................. $ 1,322,819 $2,329,285 $ 54,108 $ (867,577) $ 2,838,635
=========== ========== =========== =========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses..... $ 220,937 $ 342,414 $ 11,453 $ -- $ 574,804
Current portion of long-term debt......... 4,850 42,443 436 -- 47,729
----------- ---------- ----------- ----------- -----------
Total current liabilities................ 225,787 384,857 11,889 -- 622,533
Long-term debt.............................. 173,305 979,244 5,350 -- 1,157,899
Other liabilities........................... 26,697 125,046 9,430 -- 161,173
Preferred stock............................. 1,000 -- -- -- 1,000
Common stockholders' equity................. 896,030 840,138 27,439 (867,577) 896,030
----------- ---------- ----------- ----------- -----------
Total liabilities and stockholders' equity $ 1,322,819 $2,329,285 $ 54,108 $ (867,577) $ 2,838,635
=========== ========== =========== =========== ===========
14
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
CONDENSED CONSOLIDATING BALANCE SHEET
DECEMBER 31, 1999
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
ASSETS
Current assets:
Cash and cash equivalents................. $ -- $ 18,864 $ 8,420 $ -- $ 27,284
Accounts receivable, net.................. 68,941 455,503 14,812 -- 539,256
Other current assets...................... 113,539 185,438 7,144 -- 306,121
----------- ----------- ----------- ----------- -----------
Total current assets..................... 182,480 659,805 30,376 -- 872,661
Property, plant and equipment, net.......... 111,411 302,268 14,299 -- 427,978
Intangible assets, net ..................... 161,438 1,274,202 242 -- 1,435,882
Intercompany (payable) receivable........... (43,291) 56,798 (13,507) -- --
Investment in subsidiaries.................. 853,865 -- -- (853,865) --
Other assets................................ 11,850 106,952 23,158 -- 141,960
----------- ----------- ----------- ----------- -----------
Total assets............................. $ 1,277,753 $ 2,400,025 $ 54,568 $ (853,865) $ 2,878,481
=========== =========== =========== =========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses..... $ 192,679 $ 449,372 $ 13,758 $ -- $ 655,809
Current portion of long-term debt......... 4,635 40,369 431 -- 45,435
----------- ----------- ----------- ----------- -----------
Total current liabilities................ 197,314 489,741 14,189 -- 701,244
Long-term debt.............................. 176,601 991,396 3,445 -- 1,171,442
Other liabilities........................... 40,776 92,870 9,087 -- 142,733
Preferred stock............................. 1,000 -- -- -- 1,000
Common stockholders' equity................. 862,062 826,018 27,847 (853,865) 862,062
----------- ----------- ----------- ----------- -----------
Total liabilities and stockholders'
equity................................... $ 1,277,753 $ 2,400,025 $ 54,568 $ (853,865) $ 2,878,481
=========== =========== =========== =========== ===========
15
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
THREE MONTHS ENDED MARCH 31, 2000
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
Cash flows from operating activities:
Net income (loss)............................. $ 17,809 $ 14,120 $ (1,931) $ (12,189) $ 17,809
Adjustments to reconcile net income (loss) to
net cash provided by (used in) operating
activities:
Depreciation and amortization.............. 8,768 23,449 968 -- 33,185
Provision for doubtful accounts............ 5,944 55,341 1,361 -- 62,646
Other, net................................. (20,227) 8,420 1,569 12,189 1,951
Changes in operating assets and liabilities 868 (80,670) (2,632) -- (82,434)
----------- ----------- ----------- ----------- -----------
Net cash provided by (used in) operating
activities................................. 13,162 20,660 (665) -- 33,157
Net cash used in investing activities......... (11,266) (11,000) (76) 1,865 (20,477)
Net cash used in financing activities......... (1,896) (8,146) 430 (1,865) (11,477)
------------ ------------ ----------- ----------- -----------
Net change in cash and cash equivalents....... -- 1,514 (311) -- 1,203
Cash and cash equivalents, beginning of year.. -- 18,864 8,420 -- 27,284
----------- ----------- ----------- ----------- -----------
Cash and cash equivalents, end of period...... $ -- $ 20,378 $ 8,109 $ -- $ 28,487
=========== =========== =========== =========== ===========
CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
THREE MONTHS ENDED MARCH 31, 1999
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
----------- ----------- ------------ ------------ ------------
Cash flows from operating activities:
Net income (loss)............................. $ 7,433 $ 2,475 $ (1,115) $ (1,360) $ 7,433
Adjustments to reconcile net income (loss) to
net cash provided by (used in) operating
activities:
Depreciation and amortization.............. 8,896 6,626 961 -- 16,483
Provision for doubtful accounts............ 9,762 9,649 926 -- 20,337
Other, net................................. 13,795 (740) (1,088) 1,360 13,327
Changes in operating assets and liabilities (51,058) 12,940 4,137 -- (33,981)
----------- ----------- ----------- ----------- -----------
Net cash provided by (used in) operating
activities................................. (11,172) 30,950 3,821 -- 23,599
Net cash used in investing activities......... (12,270) (5,413) (345) -- (18,028)
Net cash used in financing activities......... (27,531) (25,453) (1,298) -- (54,282)
----------- ----------- ----------- ----------- -----------
Net change in cash and cash equivalents....... (50,973) 84 2,178 -- (48,711)
Cash and cash equivalents, beginning of year.. 190,606 8,206 4,096 -- 202,908
----------- ----------- ----------- ----------- -----------
Cash and cash equivalents, end of period...... $ 139,633 $ 8,290 $ 6,274 $ -- $ 154,197
=========== =========== =========== =========== ===========
16
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
ACQUISITION OF SMITHKLINE BEECHAM'S CLINICAL LABORATORY TESTING BUSINESS
On August 16, 1999, the Company completed the acquisition of the clinical
laboratory business of SmithKline Beecham plc ("SmithKline Beecham") for
approximately $1.3 billion. The purchase price was paid through the issuance of
approximately 12.6 million shares of common stock of the Company and the payment
of $1.025 billion in cash, including $20 million under a non-competition
agreement between the Company and SmithKline Beecham. The acquisition of
SmithKline Beecham's clinical laboratory business ("SBCL") was accounted for
under the purchase method of accounting. As such, the cost to acquire SBCL has
been allocated on a preliminary basis to the assets and liabilities acquired
based on estimated fair values as of the closing date.
The SBCL acquisition agreements include a provision for a purchase price
adjustment based on an audit of the August 16, 1999 combined balance sheet of
SBCL and certain affiliates. Adjustments resulting from this audit, which are
subject to resolution as set forth in the SBCL acquisition agreements, and are
the subject of on-going discussions between the parties, have already been
recorded. However, amounts due from SmithKline Beecham, as a result of the
purchase price adjustment, have not been reflected in the consolidated balance
sheets of Quest Diagnostics.
The purchase price allocation will be finalized after completion of the
valuation of certain assets and liabilities, and the final resolution of the
purchase price adjustment. The consolidated financial statements include the
results of operations of SBCL subsequent to the closing of the acquisition.
FINANCING OF THE TRANSACTION
At the closing of the SBCL acquisition, the Company used existing cash
funds and the borrowings under a new senior secured credit facility (the "Credit
Agreement") to fund the cash purchase price and related transaction costs of the
acquisition, and to repay the entire amount outstanding under its then existing
credit agreement.
INTEGRATION OF SBCL AND QUEST DIAGNOSTICS BUSINESSES
During the fourth quarter of 1999, Quest Diagnostics finalized its plan
related to the integration of SBCL into Quest Diagnostics' laboratory network.
The plan focuses principally on laboratory consolidations in geographic markets
currently served by more than one of the Company's laboratories, and redirecting
testing volume within the Company's national network to improve customer
service. As part of the plan, laboratories in Deerfield Beach, Florida; Owings
Mills, Maryland; Farmington Hills, Michigan; Islip, New York; Valley View, Ohio;
Norristown, Pennsylvania; Dallas, Texas; and Waltham, Massachusetts will close
or be substantially reduced in capacity. Testing performed at the National
Esoteric Testing Center located in Van Nuys, California will move to Nichols
Institute. The Company is not exiting any geographic markets as a result of
these consolidations. In addition, a number of changes to redirect specimen
flows to provide more local testing and improve customer service will also
impact capacity throughout the Company's laboratory network. Employee groups to
be impacted as a result of these actions include those involved in the
collection and testing of specimens, as well as administrative and other support
functions. During the fourth quarter of 1999, the Company recorded the estimated
costs associated with these activities for 1999 and 2000 relative to the
integration plan. The majority of these integration costs were related to
employee severance, contractual obligations associated with leased facilities
and equipment, and the write-off of fixed assets which management believes will
have no future economic benefit upon combining the operations. Integration costs
related to planned activities affecting SBCL's
17
operations and employees were recorded as a cost of the acquisition. Integration
costs associated with the planned integration of SBCL affecting Quest
Diagnostics' operations and employees were recorded as a charge to earnings in
the fourth quarter of 1999.
As of March 31, 2000, the Company had completed the laboratory
consolidations in the Boston and Detroit metropolitan areas and the redirecting
of specimens to and from its Atlanta laboratory. Management anticipates that the
planned consolidation impacting the market served by the Company's regional
laboratory in Baltimore will be completed in the second quarter of 2000.* In
addition, the Company has begun to initiate integration activities in other
markets, including Chicago, Florida, Long Island, Philadelphia, and Texas, and
at the Nichols Institute and SBCL's National Esoteric Testing Center. Many of
these activities are related to the previously announced plan to reduce capacity
in markets served by more than one of the Company's laboratories with the
remainder primarily focused on the redirecting of specimens to provide more
local testing and improve customer service.
Total integration costs related to SBCL's employees and operations paid
through March 31, 2000 totaled $5.1 million, including $3.6 million paid during
the three months ended March 31, 2000. Of the total amount paid during the three
months ended March 31, 2000, $3.0 million represented employee termination
benefits. The remaining portion of the integration costs paid during the three
months ended March 31, 2000 primarily represented leasing obligations for
facilities and equipment.
Total integration costs related to Quest Diagnostics' employees and
operations paid through March 31, 2000 totaled $4.1 million, including $1.6
million paid during the three months ended March 31, 2000. Of the total amount
paid during the three months ended March 31, 2000, $1.5 million represented
employee termination benefits.
Through March 31, 2000, approximately 400 employees had been terminated in
connection with the integration activities, including approximately 250
employees terminated during the three months ended March 31, 2000.
While the majority of the remaining accruals associated with the SBCL
integration plan are expected to be paid in 2000, there are certain severance
and facility related exit costs, principally lease obligations, that have
payment terms extending beyond 2000. Management believes that the costs to
integrate the SBCL business into Quest Diagnostics will be funded primarily
through cash flows from operations.*
Management anticipates that additional charges will be recorded in the
latter part of 2000 or early 2001 associated with further consolidating the
operations of SBCL beyond 2000. These charges cannot be estimated at this time,
but are expected to be funded by cash from operations.
The Company is committed to providing the highest levels of customer
service during and after the integration of SBCL. While no significant service
disruptions have occurred to date, the process of combining operations could
cause an interruption of, or a deterioration in, services which could result in
a customer's decision to stop using Quest Diagnostics for clinical laboratory
testing. Management believes that the successful implementation of the SBCL
integration plan and the Company's unique value proposition based on expanded
patient access, its broad testing capabilities and most importantly, the quality
of the services it provides, will mitigate customer attrition.*
- -------------------------------
* THIS IS A FORWARD-LOOKING STATEMENT. SEE ITEM 1. "BUSINESS-CAUTIONARY
STATEMENT FOR PURPOSES OF THE `SAFE' HARBOR' PROVISIONS OF THE PRIVATE
SECURITIES LITIGATION REFORM ACT OF 1995" CONTAINED IN THE COMPANY'S 1999 ANNUAL
REPORT ON FORM 10-K
18
The following table summarizes the Company's historical and pro forma
results of operations for the three months ended March 31, 2000 and 1999 (in
thousands, except per share data):
THREE MONTHS ENDED MARCH 31,
-----------------------------------------------
HISTORICAL PRO FORMA
------------------------------ --------------
2000 1999 1999
-------------- -------------- --------------
NET REVENUES $ 857,479 $ 381,841 $ 823,450
COSTS AND EXPENSES:
Cost of services 529,037 237,408 537,140
Selling, general and administrative 249,835 116,600 225,525
Interest expense, net 29,763 7,359 31,680
Amortization of intangible assets 11,940 5,094 10,856
Minority share of income 2,136 1,130 1,130
Other, net (428) 172 6
------------ ----------- -----------
Total 822,283 367,763 806,337
------------ ----------- -----------
INCOME BEFORE TAXES 35,196 14,078 17,113
INCOME TAX EXPENSE 17,387 6,645 8,885
------------ ----------- -----------
NET INCOME $ 17,809 $ 7,433 $ 8,228
============ =========== ===========
BASIC NET INCOME PER COMMON
SHARE $ 0.40 $ 0.25 $ 0.19
============ =========== ============
DILUTED NET INCOME PER COMMON
SHARE $ 0.39 $ 0.24 $ 0.19
============ =========== ============
CASH EARNINGS PER DILUTED COMMON
SHARE $ 0.63 $ 0.39 $ 0.42
============ =========== ============
WEIGHTED AVERAGE COMMON SHARES
OUTSTANDING - BASIC 44,131 29,716 43,044
WEIGHTED AVERAGE COMMON SHARES
OUTSTANDING - DILUTED 45,616 30,280 43,506
ADJUSTED EBITDA $ 99,526 $ 37,919 $ 80,667
19
HISTORICAL RESULTS OF OPERATIONS
THREE MONTHS ENDED MARCH 31, 2000 COMPARED WITH THREE MONTHS ENDED MARCH 31,
1999
Net income for the three months ended March 31, 2000 increased to $17.8
million from $7.4 million for the three months ended March 31, 1999. Net income
for the three months ended March 31, 2000 included $1.4 million of costs ($0.8
million, net of tax) related to the SBCL integration which were expensed as
incurred in 2000.
The increase in net income was primarily due to the SBCL acquisition and
improved operating performance.
Results for the three months ended March 31, 2000 and 1999 included the
effects of testing performed by third parties under the Company's laboratory
network management arrangements. As laboratory network manager, Quest
Diagnostics included in its consolidated revenues and expenses the cost of
testing performed by third parties. This treatment added $32.4 million and $17.5
million to both reported revenues and cost of services for the three months
ended March 31, 2000 and 1999, respectively. This treatment also serves to
increase cost of services as a percentage of net revenues and decrease selling,
general and administrative expenses as a percentage of net revenues. During the
first quarter of 2000, the Company and Aetna terminated a laboratory network
management arrangement, and entered into a new non-exclusive contract, effective
April 1, 2000, under which the Company will no longer be responsible for the
cost of testing performed by third parties. As a result, in the future annual
net revenues and cost of services will no longer include approximately $80
million, representing the cost of testing performed by third parties under the
terminated laboratory network management contract with Aetna.
RECLASSIFICATIONS
During the fourth quarter of 1999, the Company reclassified certain expense
items, primarily related to a portion of occupancy costs and professional
liability insurance expense, from selling, general and administrative expenses
to cost of services, to better reflect the cost of performing testing. The
amount reclassified from selling, general and administrative expenses for the
three months ended March 31, 1999 was $10.4 million.
NET REVENUES
Net revenues for the three months ended March 31, 2000 increased $475.6
million over the prior year period, primarily due to the acquisition of SBCL.
OPERATING COSTS AND EXPENSES
Total operating costs for the three months ended March 31, 2000 increased
from the year earlier period, primarily due to the acquisition of SBCL.
Operating costs and expenses for the three months ended March 31, 2000 included
$1.4 million of integration related costs which were expensed as incurred.
Management anticipates that during the remainder of 2000, the Company will incur
additional costs of approximately $10 to $15 million relative to the integration
plan which will be expensed as incurred.* These costs are primarily related to
equipment and employee relocation costs, professional and consulting fees,
company identification and signage costs and the amortization of stock-based
employee compensation related to the special recognition awards of the Company's
common stock granted in the fourth quarter of 1999.
The following discussion and analysis regarding cost of services, selling,
general and administrative expenses and bad debt expense exclude the effect of
testing performed by third parties under the Company's laboratory
- ---------------------------
* THIS IS A FORWARD-LOOKING STATEMENT. SEE ITEM 1. "BUSINESS-CAUTIONARY
STATEMENT FOR PURPOSES OF THE `SAFE' HARBOR' PROVISIONS OF THE PRIVATE
SECURITIES LITIGATION REFORM ACT OF 1995" CONTAINED IN THE COMPANY'S 1999 ANNUAL
REPORT ON FORM 10-K
20
network management arrangements, which serve to increase cost of services as a
percentage of net revenues and reduce selling, general and administrative
expenses as a percentage of net revenues. Cost of services, which include the
costs of obtaining, transporting and testing specimens, decreased during the
first quarter of 2000 as a percentage of net revenues to 60.2% from 60.4% a year
ago.
Selling, general and administrative expenses, which include the costs of
the sales force, billing operations, bad debt expense and general management and
administrative support, decreased during the first quarter of 2000 as a
percentage of net revenues to 30.3% from 32.0% in the prior year period. During
the first quarter of 2000, bad debt expense was 7.6% of net revenues as compared
to 5.6% of net revenues in the first quarter of 1999. The increase in bad debt
expense was principally attributable to SBCL's collection experience, which is
less favorable than Quest Diagnostics' historical experience. A significant
portion of the difference is due to Quest Diagnostics' processes in the billing
area, most notably the processes around the collection of diagnosis, patient and
insurance information necessary to effectively bill for services performed.
While bad debt expense for the first quarter of 2000 increased as compared to
the first quarter of 1999, it decreased slightly from 7.7% of net revenues for
the fourth quarter of 1999. Through the sharing of internal best practices in
the billing functions, the Company believes that additional opportunities exist
in order to reduce SBCL's historical bad debt percentage.* The remaining overall
decrease in selling, general and administrative expenses as a percentage of net
revenues was primarily attributable to the impact of the SBCL acquisition which
enabled the Company to leverage certain of its fixed costs across a larger
revenue base.
INTEREST EXPENSE, NET
Net interest expense for the first quarter of 2000 increased from the prior
year period by $22.4 million. The increase in net interest expense was
principally attributable to the amounts borrowed under the Credit Agreement in
conjunction with the SBCL acquisition.
AMORTIZATION OF INTANGIBLE ASSETS
Amortization of intangible assets for the first quarter of 2000 increased
from the prior year period by $6.8 million, principally as a result of the SBCL
acquisition.
MINORITY SHARE OF INCOME
Minority share of income for the first quarter of 2000 increased from the
prior year level, primarily due to improved performance at the Company's joint
ventures in Pittsburgh, Pennsylvania and Erie, Pennsylvania.
INCOME TAXES
The Company's effective tax rate was significantly impacted by goodwill
amortization, the majority of which is not deductible for tax purposes, and had
the effect of increasing the overall tax rate. The goodwill associated with the
SBCL acquisition further increased the effective tax rate for the first quarter
of 2000 compared to the prior year period.
- -------------------------
* THIS IS A FORWARD-LOOKING STATEMENT. SEE ITEM 1. "BUSINESS--CAUTIONARY
STATEMENT FOR PURPOSES OF THE `SAFE HARBOR' PROVISIONS OF THE PRIVATE SECURITIES
LITIGATION REFORM ACT OF 1995" CONTAINED IN THE COMPANY'S 1999 ANNUAL REPORT ON
FORM 10-K.
21
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company addresses its 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. The
Company does not hold or issue derivative financial instruments for trading
purposes. During 1999, the Company entered into interest rate swap agreements to
mitigate the risk of changes in interest rates associated with its variable rate
bank debt in accordance with the terms of the Company's Credit Agreement. The
Company does not believe that its foreign exchange exposure and related hedging
program are material to the Company's financial position or results of
operations. See Note 2 to the Consolidated Financial Statements contained in the
Company's 1999 Annual Report on Form 10-K for additional discussion of the
Company's financial instruments and hedging activities.
INTEREST RATES
At March 31, 2000 and December 31, 1999, the fair value of the Company's
debt was estimated at approximately $1,205 million and $1,213 million,
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, 2000 and December 31, 1999, the carrying value of the
debt exceeded the estimated fair value by approximately $0.5 million and $4
million, respectively. An assumed 10% increase in interest rates (representing
approximately 90 basis points) would potentially reduce the fair value of the
Company's debt by approximately $9 million and $10 million at March 31, 2000 and
December 31, 1999, respectively.
The Company had approximately $1,026 million and $1,036 million of variable
interest rate debt outstanding at March 31, 2000 and December 31, 1999,
respectively. The Credit Agreement requires the Company to mitigate the risk of
changes in interest rates associated with its variable interest rate
indebtedness through the use of interest rate swap agreements. Under such
arrangements, the Company converts a portion of its variable rate indebtedness
to fixed rates based on a notional principal amount. The settlement dates are
generally correlated to correspond to the interest payment dates of the hedged
debt. During the term of the Credit Agreement, the notional amounts under the
interest rate swap agreements, plus the principal amount outstanding of the
Company's fixed interest rate indebtedness, must be at least 50% of the
Company's net funded debt (as defined in the Credit Agreement). At both March
31, 2000 and December 31, 1999, the aggregate notional principal amount under
the interest rate swap agreements which mature at various dates through May 2003
totaled $450.0 million. At March 31, 2000 and December 31, 1999, the estimated
fair values of the interest rate swap agreements were approximately $5.4 million
and $3.8 million, respectively.
Based on the Company's overall exposure to interest rate changes, an
assumed 10% increase in interest rates (representing approximately 34 basis
points) applied to the Company's variable interest rate debt, after considering
the interest rate swap agreements, would result in a $0.5 million reduction in
the Company's after-tax earnings and cash flows for the three months ended March
31, 2000 based on debt levels as of March 31, 2000. The primary interest rate
exposures on the variable interest rate debt are with respect to interest rates
on United States dollars as quoted in the London interbank market.
LIQUIDITY AND CAPITAL RESOURCES
Cash and cash equivalents at March 31, 2000 totaled $28.5 million, an
increase of $1.2 million from December 31, 1999. Cash flows from operating
activities in 2000 provided cash of $33.2 million, which was offset by investing
and financing activities which required cash of $32.0 million. Cash and cash
equivalents at March 31, 1999 totaled $154.2 million, a decrease of $48.7
million from December 31, 1998. Cash flows from operating activities in 1999
provided cash of $23.6 million, which was offset by investing and financing
activities which required cash of $72.3 million including the repayment of $48.2
million of debt, of which $35 million was paid ahead of schedule.
22
Net cash from operating activities for 2000 was $9.6 million higher than
the 1999 level. The increase was primarily due to the impact of the SBCL
acquisition and improved operating performance. Excluding the impact of the
Company's laboratory network management arrangements, the number of days sales
outstanding, a measure of billing and collection efficiency, was 51 days at
March 31, 2000 compared to 57 days at December 31, 1999.
Net cash used in investing activities in 2000 was primarily comprised of
capital expenditures and a small investment in a company that is developing
internet-based disease management solutions for physicians and managed care
organizations. Net cash used in 1999 consisted primarily of capital
expenditures, investments to fund certain employee benefit plans and
contributions to the Company's Arizona joint venture.
Net cash used in financing activities for 2000 was principally associated
with the scheduled repayment of debt under the Company's Credit Agreement and
distributions to minority partners, offset by proceeds from the exercise of
stock options. Net cash used in financing activities for 1999 primarily
consisted of repayments of debt, the majority of which was related to the
Company's then existing credit agreement, financing costs associated with the
Company's new Credit Agreement and purchases of 60 thousand shares of treasury
stock.
The Company estimates that it will invest approximately $110 million to
$120 million during 2000 for capital expenditures to support its existing
operations, principally related to investments in information technology,
equipment, and facility upgrades and expansions necessary to accommodate the
integration of the SBCL business.* The Company believes that cash from
operations coupled with the revolving credit facility under the Credit Agreement
will provide sufficient financial flexibility to integrate the operations of
Quest Diagnostics and SBCL, to meet seasonal working capital requirements and to
fund capital expenditures and additional growth opportunities for the
foreseeable future. *
The Company does not anticipate paying dividends on its common stock in the
foreseeable future. The Credit Agreement prohibits the payment of cash dividends
and the indenture relating to the Company's 10.75% senior subordinated notes
(the "Indenture") restricts the Company's ability to pay cash dividends on its
common stock. These restrictions are primarily based on a percentage of the
Company's earnings as defined in the Indenture. Additionally, the Credit
Agreement contains various covenants and conditions including the maintenance of
certain financial ratios and tests, and restricts the ability of the Company to,
among other things, incur additional indebtedness and repurchase shares of its
outstanding common stock. At March 31, 2000, the Company is limited in its
ability to make certain acquisitions and incur additional indebtedness due to
restrictions under the Indenture.
Management believes that Quest Diagnostics' successful integration of
SmithKline Beecham's clinical laboratory business and implementation of its
business strategy, together with the indemnifications by Corning and SmithKline
Beecham against monetary fines, penalties or losses from outstanding government
and other related claims, will enable it to generate strong cash flows. *
- -------------------------
* THIS IS A FORWARD-LOOKING STATEMENT. SEE ITEM 1. "BUSINESS--CAUTIONARY
STATEMENT FOR PURPOSES OF THE `SAFE HARBOR' PROVISIONS OF THE PRIVATE SECURITIES
LITIGATION REFORM ACT OF 1995" CONTAINED IN THE COMPANY'S 1999 ANNUAL REPORT ON
FORM 10-K.
23
CASH EARNINGS PER SHARE AND ADJUSTED EBITDA
Cash earnings per common share is calculated as cash earnings less
preferred dividends, divided by diluted weighted average common shares
outstanding. Cash earnings represents income before amortization of all
intangible assets, net of applicable taxes.
Cash earnings per common share is presented because it highlights the
impact on earnings of the non-cash charges associated with the amortization of
intangible assets from various acquisitions, which for the Company is
significant. Cash earnings per common share is not a measure of financial
performance under accounting principles generally accepted in the United States
and should not be considered as an alternative to (i) net income (or any other
measure of performance under generally accepted accounting principles) as a
measure of performance or (ii) cash flows from operating activities as an
indicator of cash flows or as a measure of liquidity.
Cash earnings per common share for the first quarter of 2000 improved to
$0.63 from $0.39 in the prior year period. The increase was primarily related to
improvements in the operating performance of the Company.
Adjusted EBITDA represents income before income taxes, net interest
expense, depreciation and amortization and special items. Special items for the
first quarter of 2000 included $1.4 million of integration costs related to the
SBCL integration, which were expensed as incurred. Adjusted EBITDA is presented
and discussed because management believes it is a useful adjunct to net income
and other measurements under accounting principles generally accepted in the
United States. Additionally, management believes it is a meaningful measure of a
leveraged company's performance and ability to meet its future debt service
requirements, fund capital expenditures and meet working capital requirements.
Adjusted EBITDA is not a measure of financial performance under accounting
principles generally accepted in the United States and should not be considered
as an alternative to (i) net income (or any other measure of performance under
generally accepted accounting principles) as a measure of performance or (ii)
cash flows from operating, investing or financing activities as an indicator of
cash flows or as a measure of liquidity.
Excluding the impact of testing performed by third parties under the
Company's laboratory network management arrangements, Adjusted EBITDA for the
first quarter of 2000 improved to $99.5 million, or 12.1% of net revenues,
from $37.9 million, or 10.4% of net revenues, in the prior year period. The
dollar increase in Adjusted EBITDA was principally associated with the SBCL
acquisition. The percentage improvement in Adjusted EBITDA was primarily
related to improvements in the operating performance of the Company.
PRO FORMA COMPARISONS
The pro forma combined financial information for the three months ended
March 31, 2000 assumes that the SBCL acquisition and borrowings under the Credit
Agreement were effected on January 1, 1999. The SBCL acquisition agreements
include a provision for a purchase price adjustment based on an audit of the
August 16, 1999 combined balance sheet of SBCL and certain affiliates.
Adjustments resulting from this audit, which are subject to resolution as set
forth in the SBCL acquisition agreements and are the subject of on-going
discussions between the parties, have been recorded in the pro forma combined
financial information to the extent that the Company believes they are
applicable. The pro forma combined financial information reflects the
preliminary allocation of the purchase price. The allocation will be finalized
after completion of the valuation of certain assets and liabilities, and the
final resolution of the purchase price adjustment. There can be no assurances
that the amounts reflected in the pro forma combined financial information will
not be subject to change as a result of changes in the allocation of the
purchase price, including the resolution of the purchase price adjustment.
The pro forma combined financial information for the three months ended
March 31, 2000 is presented for illustrative purposes only to analyze the
financial implications of the SBCL acquisition and borrowings under the Credit
Agreement. The pro forma combined financial information may not be indicative of
the combined
24
financial results of operations that would have been realized had Quest
Diagnostics and SBCL been a single entity during the period presented. In
addition, the pro forma combined financial information is not necessarily
indicative of the future results that the combined company will experience.
Significant pro forma adjustments reflected in the pro forma combined
financial information include reductions in employee benefit costs and general
corporate overhead allocated to the historical results of SBCL by SmithKline
Beecham, offset by an increase in net interest expense to reflect the Company's
Credit Agreement which was used to finance the SBCL acquisition. Amortization of
the goodwill, which accounts for a majority of the acquired intangible assets,
is calculated on the straight-line basis over forty years. Other, net has been
adjusted to remove SBCL's non-recurring gains from the sale and license of
certain technology and its physician office-based teleprinter assets and
network. Income taxes have been adjusted for the estimated income tax impact of
the pro forma adjustments at the incremental tax rate of 40%. A significant
portion of the intangible assets acquired in the SBCL acquisition is not
deductible for tax purposes, which has the overall impact of increasing the
effective tax rate.
Both pro forma basic and diluted weighted average shares outstanding for
the three months ended March 31, 1999 have been presented giving effect to the
common shares issued to SmithKline Beecham in conjunction with the acquisition
of SBCL and shares of common stock granted at the closing of the SBCL
acquisition to certain employees.
HISTORICAL THREE MONTHS ENDED MARCH 31, 2000 COMPARED WITH
PRO FORMA THREE MONTHS ENDED MARCH 31, 1999
The following discussion and analysis compares the Company's historical
results of operations for the three months ended March 31, 2000 to the pro forma
results of operations for the three months ended March 31, 1999, assuming that
SBCL had been acquired by Quest Diagnostics on January 1, 1999. All references
in this section to the three months ended March 31, 2000 refer to the historical
results of Quest Diagnostics for such period. All references in this section to
the three months ended March 31, 1999 refer to the pro forma results of Quest
Diagnostics for such period.
Net income for the three months ended March 31, 2000 increased to $17.8
million from $8.2 million for the three months ended March 31, 1999. Net income
for the three months ended March 31, 2000 included $1.4 million of costs ($0.8
million, net of tax) related to the SBCL integration which were expensed as
incurred in 2000. Net income for the three months ended March 31, 1999 included
$1.7 million of losses ($1.0 million, net of tax) incurred under a customer
contract that was treated as a loss contract, beginning in the third quarter of
1999. The remaining increase in net income was primarily due to the improved
operating performance of the Company and a reduction in net interest expense,
offset by an increase in amortization of intangible assets.
Results for the three months ended March 31, 2000 and 1999 included the
effects of testing performed by third parties under the Company's laboratory
network management arrangements. As laboratory network manager, Quest
Diagnostics included in its consolidated revenues and expenses the cost of
testing performed by third parties. This treatment added $32.4 million and $41.3
million to both reported revenues and cost of services for the three months
ended March 31, 2000 and 1999, respectively. This treatment also serves to
increase cost of services as a percentage of net revenues and decrease selling,
general and administrative expenses as a percentage of net revenues. During the
first quarter of 2000, the Company and Aetna terminated a laboratory network
management arrangement, and entered into a new non-exclusive contract, effective
April 1, 2000, under which the Company will no longer be responsible for the
cost of testing performed by third parties. As a result, in the future annual
net revenues and cost of services will no longer include approximately $80
million, representing the cost of testing performed by third parties under the
terminated laboratory network management contract with Aetna.
25
NET REVENUES
Net revenues for the three months ended March 31, 2000 increased by $34.0
million, or 4.1% from the prior year level due to improvements in volume of
clinical testing and average revenue per requisition of 6.1% and 2.3%,
respectively. Approximately one quarter of the volume increase was the result of
an extra day in February 2000 due to leap year. The remaining portion of the
volume increase was primarily attributable to strong sales to existing and new
customers, as a result of the Company's ability to leverage its unique value
proposition of offering expanded patient access, broad testing capabilities and
superior quality. Contributing to the increase in average revenue per
requisition was a shift to higher value testing and fee-for-service revenues.
These increases were partially offset by a reduction in revenues of 2.6%
associated with the treatment of a customer contract as a loss contract,
beginning in the third quarter of 1999.
OPERATING COSTS AND EXPENSES
The following discussion and analysis regarding operating costs, including
cost of services, selling, general and administrative expenses and bad debt
expense exclude the effect of testing performed by third parties under the
Company's laboratory network management arrangements, and the revenues and
expenses associated with a customer contract treated as a loss contract,
beginning in the third quarter of 1999. Total operating costs for the first
quarter of 2000 increased by $48.2 million from the year earlier period
principally associated with the volume increase. Operating costs and expenses
for the three months ended March 31, 2000 included $1.4 million of integration
related costs which were expensed as incurred as discussed above.
Cost of services, as a percentage of net revenues, decreased to 60.2% for
the first quarter of 2000 from 62.2% for the prior year period, primarily due to
an increase in average revenue per requisition and to a lesser extent, the
impact of the SBCL integration to date on the cost structure of the Company.
Selling, general and administrative expenses, as a percentage of net
revenues, were 30.3% for the first quarter of 2000, compared to 29.6% in the
prior year period, primarily as a result of employee compensation costs. Bad
debt expense for both the first quarter of 2000 and 1999 was 7.6% of net
revenues.
INTEREST EXPENSE, NET
Net interest expense decreased for the first quarter of 2000 by $1.9
million, when compared to the prior year period, primarily due to the repayment
of long term debt under the Credit Agreement between the closing of the SBCL
acquisition and the end of the first quarter of 2000, partially offset by an
increase in variable interest rates.
AMORTIZATION OF INTANGIBLE ASSETS
Amortization of intangible assets for the first quarter of 2000 increased
from the prior year period by $1.1 million, principally as a result of an
adjustment to the purchase price allocation recorded in the third quarter of
1999 primarily associated with SBCL's deferred tax position as of the closing of
the acquisition.
MINORITY SHARE OF INCOME
Minority share of income for the first quarter of 2000 increased from the
prior year level, primarily due to improved performance at the Company's joint
ventures in Pittsburgh, Pennsylvania and Erie, Pennsylvania.
INCOME TAXES
The Company's effective tax rate was significantly impacted by goodwill
amortization, the majority of which is not deductible for tax purposes, and had
the effect of increasing the overall tax rate.
26
CASH EARNINGS PER SHARE AND ADJUSTED EBITDA
Pro forma cash earnings per common share for 1999 is calculated as pro
forma cash earnings less preferred dividends, divided by pro forma diluted
weighted average common shares outstanding. Cash earnings represents income
before amortization of all intangible assets, net of applicable taxes, presented
on a pro forma basis.
Cash earnings per common share was $0.63 for the first quarter of 2000,
compared to pro forma cash earnings per common share of $0.42 for the prior year
period. The increase was primarily related to improvements in the operating
performance of the Company and a reduction in net interest expense.
Adjusted EBITDA represents income before income taxes, net interest
expense, depreciation and amortization and special items. Special items for the
three months ended March 31, 2000 included $1.4 million of costs related to the
SBCL integration which were expensed as incurred in 2000. Pro forma Adjusted
EDITDA for the three months ended March 31, 1999 included $1.7 million of losses
incurred under a customer contract that was treated as a loss contract,
beginning in the third quarter of 1999.
Excluding the effects of the testing performed by third parties under the
Company's laboratory network management arrangements and the loss contract,
Adjusted EBITDA for the three months ended March 31, 2000 improved to $99.5
million, or 12.1% of net revenues, as compared to pro forma Adjusted EBITDA of
$80.7 million, or 10.6% of net revenues, in the prior year period. The increase
in Adjusted EBITDA was primarily related to improvements in the operating
performance of the Company.
27
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company has entered into a settlement agreement, which received the
preliminary approval of the court on April 4, 2000, with respect to the pending
class action relating to private reimbursement of billings that are similar to
those that were the subject of a prior government settlement. See Note 4 of the
Notes to Consolidated Financial Statements.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
Exhibit Number Description
-------------- -----------
27 Financial Data Schedule
(b) Reports on Form 8-K:
None.
28
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 24, 2000
Quest Diagnostics Incorporated
By /s/ Kenneth W. Freeman Chairman of the Board,
---------------------------- Chief Executive Officer and
Kenneth W. Freeman President
By /s/ Robert A. Hagemann Corporate Vice President and
---------------------------- Chief Financial Officer
Robert A. Hagemann
29