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EXHIBIT 99.3
ANNUAL REPORT ON FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 31, 1999
-"MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS - PRO FORMA COMBINED FINANCIAL INFORMATION"
The following information revises and updates the supplemental pro forma
combined financial information of Quest Diagnostics included in the Pro Forma
Combined Financial Information section of Management's Discussion and Analysis
of Financial Condition and Results of Operations contained in the Company's Form
10-K for the fiscal year ended December 31, 1999 filed on March 30, 2000.
PRO FORMA COMBINED FINANCIAL INFORMATION
The pro forma combined financial information for the years ended December
31, 1999 and 1998 assumes that the SBCL acquisition and borrowings under the
Credit Agreement were effected on January 1, 1998. The SBCL acquisition
agreements included a provision for a reduction in the purchase price paid by
Quest Diagnostics in the event that the combined balance sheet of SBCL indicated
that the net assets acquired, as of the acquisition date, were below a
prescribed level. On October 11, 2000, the purchase price adjustment was
finalized with the result that SmithKline Beecham owed Quest Diagnostics $98.6
million. This amount was offset by $3.6 million separately owed by Quest
Diagnostics to SmithKline Beecham, resulting in a net payment by SmithKline
Beecham of $95.0 million. This payment from SmithKline Beecham will be recorded
in the Company's historical financial statements in the fourth quarter of 2000
as a reduction in the purchase price of the SBCL acquisition.
In addition to the purchase price reduction described above, the purchase
price allocation relating to the SBCL acquisition was completed in conjunction
with the preparation of the Company's quarterly report on Form 10-Q for the
fiscal quarter ended September 30, 2000. None of the adjustments, resulting from
the purchase price reduction or the completion of the purchase price allocation,
will have any impact on the Company's previously reported historical financial
statements.
The accompanying pro forma combined financial information reflects the
impact of finalizing the SBCL purchase price adjustment and the revised purchase
price allocation relating to the SBCL acquisition.
The unaudited pro forma combined financial information is presented for
illustrative purposes only to assist in analyzing the financial implications of
the SBCL acquisition and borrowings under the Credit Agreement. The unaudited
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 periods presented. In
addition, the unaudited 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 unaudited 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 goodwill, which accounts for a majority of the acquired
intangible assets, is calculated on the straight-line basis over forty years.
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.
Weighted common average shares outstanding, for purposes of determining pro
forma basic and diluted earnings (loss) per common share and cash earnings per
diluted common share, have been adjusted to give 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.
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. All pro
forma financial information has been reclassified for comparative purposes to
conform with the 1999 presentation. The amounts reclassified from selling,
general and administrative expenses for the years ended December 31, 1999 and
1998 were $88.8 million and $93.5 million, respectively.
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PRO FORMA COMBINED FINANCIAL INFORMATION
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
QUARTER ENDED
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MARCH 31, JUNE 30, SEPT. 30, DEC. 31, MARCH 31, JUNE 30, SEPT.30, DEC. 31,
1998 1998 1998 1998 1999 1999 1999 1999
---------- ---------- ---------- ---------- ---------- --------- --------- ----------
STATEMENT OF OPERATIONS DATA:
Net revenues................ $737,237 $744,111 $769,592 $770,691 $823,450 $837,533 $819,301 $814,526
Costs and expenses:
Cost of services........... 461,156 482,488 476,422 487,280 537,000 550,521 524,398 520,420
Selling, general and
administrative............ 210,501 199,616 224,215 225,023 224,542 255,634 238,401 229,601
Interest expense, net...... 31,700 31,733 31,653 31,466 31,847 29,890 30,852 30,058
Amortization of intangible
assets.................... 11,565 11,551 11,715 11,606 11,279 11,405 10,904 11,659
Provisions for
restructuring and other
special charges........... -- -- -- -- -- 15,813 30,282 43,103
Minority share of income.. 461 435 412 709 1,130 1,471 1,191 1,639
Other, net................. (11,078) (10,318) (708) (1,215) (9,648) 126 (782) (3,312)
------- -------- -------- -------- --------- -------- -------- --------
Total..................... 704,305 715,505 743,709 754,869 796,150 864,860 835,246 833,168
------- -------- -------- -------- -------- --------- -------- --------
Income (loss) before taxes
and extraordinary loss... 32,932 28,606 25,883 15,822 27,300 (27,327) (15,945) (18,642)
Income tax expense (benefit) 16,578 15,020 12,994 8,442 13,129 (8,157) (1,941) (4,106)
-------- -------- -------- -------- -------- --------- --------- --------
Income (loss) before
extraordinary loss...... 16,354 13,586 12,889 7,380 14,171 (19,170) (14,004) (14,536)
Extraordinary loss, net of
taxes................... -- -- -- -- -- -- (2,139) --
-------- -------- -------- -------- -------- --------- -------- --------
Net income (loss).......... $16,354 $13,586 $12,889 $7,380 $14,171 $(19,170) $(16,143) $(14,536)
======== ======== ======== ======== ======== ========= ======== ========
Income (loss) before
extraordinary loss and
special items (a)....... $13,790 $ 7,793 $12,469 $ 7,203 $ 8,380 $( 9,682) $ 4,166 $ 9,717
- ------------------------------------------------------------------------------------------------------------------------------
Basic earnings (loss) per
common share:
Net income (loss) ......... $ 0.38 $ 0.31 $ 0.30 $ 0.17 $ 0.33 $ (0.44) $ (0.37) $ (0.33)
Income (loss) before
extraordinary loss...... $ 0.38 $ 0.31 $ 0.30 $ 0.17 $ 0.33 $ (0.44) $ (0.32) $ (0.33)
Income (loss) before
extraordinary loss and
special items (a)....... $ 0.32 $ 0.18 $ 0.29 $ 0.17 $ 0.19 $ (0.22) $ 0.10 $ 0.22
Weighted average common
shares outstanding -
basic (c)................ 43,035 43,130 43,033 42,925 43,044 43,248 43,435 43,653
- ------------------------------------------------------------------------------------------------------------------------------
Diluted earnings (loss)
per common share:
Net income (loss) ......... $ 0.38 $ 0.31 $ 0.30 $ 0.17 $ 0.33 $ (0.44) $ (0.37) $ (0.33)
Income (loss) before
extraordinary loss...... $ 0.38 $ 0.31 $ 0.30 $ 0.17 $ 0.33 $ (0.44) $ (0.32) $ (0.33)
Income (loss) before
extraordinary loss and
special items (a)....... $ 0.32 $ 0.18 $ 0.29 $ 0.17 $ 0.19 $ (0.22) $ 0.09 $ 0.22
Cash earnings before
extraordinary loss and
special items (b)....... $ 0.56 $ 0.42 $ 0.53 $ 0.41 $ 0.43 $ 0.02 $ 0.32 $ 0.45
Weighted average common
shares outstanding -
diluted (c)............. 43,309 43,881 43,434 43,136 43,506 43,933 44,228 44,685
- ------------------------------------------------------------------------------------------------------------------------------
Adjusted EBITDA (d)........ $87,485 $82,306 $84,638 $75,909 $80,667 $85,016 $86,599 $85,096
(a) Special items, for purposes of determining pro forma income before
extraordinary loss and special items and cash earnings before extraordinary
loss and special items, included the provisions for restructuring and other
special charges reflected on the face of the pro forma combined financial
information, a $3.0 million gain recorded on the sale of an investment in
the fourth quarter of 1999 and non-recurring gains of $9.7 million and
$14.9 million, respectively, recognized by SBCL during 1999 and 1998 from
the sale and license of certain technology and its physician office-based
teleprinter assets and network.
(b) Cash earnings per common share is calculated as cash earnings less
preferred dividends, divided by weighted average common shares outstanding
on a diluted basis. Cash earnings represents income (loss) before
extraordinary loss, special items and amortization of all intangible
assets, net of applicable taxes. Cash earnings per common share is
presented and discussed because it highlights the impact on earnings of the
non-cash charges associated with the amortization of intangible assets from
various acquisitions, which is significant for the Company. 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 accounting principles generally accepted in the United
States) as a measure of performance or (ii) cash flows from operating
activities as an indicator of cash flows or as a measure of liquidity.
(c) Both basic and diluted weighted average common shares outstanding have been
presented on a pro forma basis giving effect to the shares issued to
SmithKline Beecham and the shares granted at closing to employees.
Potentially dilutive common shares primarily represent stock options.
During periods in which net income available for common stockholders is
negative, diluted weighted average common shares outstanding will equal
basic weighted average common shares outstanding, since the incremental
shares would have an anti-dilutive effect on earnings (loss) per common
share.
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(d) Pro forma Adjusted EBITDA represents income (loss) before income taxes, net
interest expense, depreciation and amortization and special items. Special
items included the provisions for restructuring and other special charges
reflected on the face of the pro forma combined financial information, a
$3.0 million gain recorded on the sale of an investment in the fourth
quarter of 1999, non-recurring gains of $9.7 million and $14.9 million,
respectively, recognized by SBCL during 1999 and 1998 from the sale and
license of certain technology and its physician office-based teleprinter
assets and network, a $2.5 million charge included in selling, general and
administrative expenses in the first quarter of 1998, and discrete income
and expense items recorded by SBCL prior to the closing of the acquisition,
which have not been reflected on the face of the pro forma financial
information. Management believes that the discrete income and expense
items are of a non-recurring nature and limit the overall comparability of
the pro forma results for 1999 and 1998. See Pro Forma Combined Results of
Operations. Adjusted EBITDA is presented and discussed because management
believes that Adjusted EBITDA is a useful adjunct to net income and other
measurements under accounting principles generally accepted in the United
States since 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
accounting principles generally accepted in the United States) 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.
PRO FORMA COMBINED RESULTS OF OPERATIONS
On a pro forma basis, assuming that SBCL had been acquired by Quest
Diagnostics on January 1, 1998, income before extraordinary loss and special
items was $12.6 million in 1999, compared to $41.3 million in 1998. Special
items for 1999 included $89.2 million of restructuring and other special
charges, a $3.0 million gain on the sale of an investment and a $9.7 million
gain recognized by SBCL on the sale of its physician office-based teleprinter
assets and network recorded in other, net. Special items for 1998 included a
$14.9 million gain recorded by SBCL from the sale and license of certain
technology which was recorded in other, net and a $2.5 million charge included
in selling, general and administrative expenses related to a plan to consolidate
the Company's laboratory network announced in the fourth quarter of 1997.
A special review of the SBCL pre-closing financial statements, called
for in the SBCL acquisition agreements, was conducted to assess the
recoverability of assets and the adequacy of liabilities existing prior to the
closing date of the acquisition. This special review resulted in adjustments,
primarily related to the recoverability of SBCL receivables and accrued
liabilities during various periods prior to the closing of the SBCL acquisition.
In addition, SBCL recorded other income and expense items prior to the closing
of the SBCL acquisition. Management believes that the adjustments resulting from
the special review and the other income and expense items, both of which have
not been reflected on the face of the pro forma combined financial information,
are of a non-recurring nature and limit the comparability of results between the
periods presented. In the discussions that follow, these matters are
collectively referred to as discrete income and expense items.
Discrete expense items for the year ended December 31, 1999, totaled
$46.6 million, including a $22.4 million bad debt charge to reflect the reduced
recoverability of SBCL receivables, as a result of the special review of the
SBCL financial statements; $7.1 million of losses related to a customer contract
accounted for as a loss contract beginning in the third quarter of 1999; $5.6
million of costs, for which SmithKline Beecham is obligated to indemnify the
Company, associated with two incidents, the most significant of which is related
to a SBCL employee who allegedly reused certain needles when drawing blood from
patients; and $11.5 million of expenses, recorded by SBCL prior to the
acquisition, primarily to record liabilities necessary to properly present the
closing balance sheet of SBCL. Discrete income and expense items for the year
ended December 31, 1998 totaled net pre-tax profits of $15.0 million, including
$14.3 million of pre-tax profits primarily related to the favorable settlement
of a contract dispute, and $6.8 million of adjustments to reduce SBCL's bad debt
expense. These items were partially offset by a $6.1 million reduction in net
revenues recorded by SBCL, primarily related to revised estimates for sales
price adjustments. The decline in income before extraordinary loss and special
items was primarily due to the discrete income and expense items discussed
above. Excluding the impact of the discrete income and expense items, income
before extraordinary loss and special items for 1999 and 1998 was $40.5 million
and $32.2 million, respectively.
Pro forma results for the year ended December 31, 1999 included the
effects of testing performed by third parties under the Company's laboratory
network management arrangements which added $154.0 million to both pro forma net
revenues and cost of services for the year ended December 31, 1999.
NET REVENUES
Excluding the effect of the testing performed by third parties under
the Company's laboratory network management arrangements in 1999, pro forma net
revenues in 1999 increased by $119.2 million or 3.9% from the prior year period.
Excluding the impact of the discrete income and expense items in 1998, which
represented a $6.1 million reduction in net revenues, pro forma revenue growth
was 3.7%, due to improvements in both average revenue per requisition and volume
of clinical testing of 3.3% and 1.1%, respectively, and a 22.6% increase in
clinical trials testing revenues which contributed approximately 0.4% to the
consolidated revenue increase. These increases were partially offset by a
reduction in revenues of 1.0% associated with the treatment in 1999 of a
customer contract as a loss contract.
Prior to the acquisition of SBCL, Quest Diagnostics experienced
increases in average revenue per requisition primarily due to a number of
factors, including: a shift from capitated volume to fee-for-service volume;
contract renewals and new business negotiated on more favorable terms as part of
the Company's account profitability strategy; and higher value-added test
offerings. The increase in average revenue per requisition experienced by Quest
Diagnostics was partially offset by declines in average revenue per requisition
related to the growth in managed care business at SBCL. The improvements in
volume were primarily attributable to the growth in managed care business at
SBCL, partially offset by volume declines at Quest Diagnostics reflecting the
impact of increased competition for managed care business, actions taken on
unprofitable accounts and severe weather in the first quarter of 1999 in certain
service areas.
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OPERATING COSTS AND EXPENSES
The following discussion and analysis regarding pro forma 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 treatment
of a customer contract as a loss contract. As discussed above, losses associated
with this contract amounted to $7.1 million in 1999. In addition, as discussed
above, operating costs and expenses included (1) a charge in the first quarter
of 1998 of $2.5 million included in selling, general and administrative expenses
that represented the final costs associated with the Company's consolidation
plan announced in the fourth quarter of 1997, (2) discrete expense items
totaling $39.5 million in 1999 and (3) discrete income items totaling $6.8
million in 1998. Total pro forma operating costs in 1999 increased by $179.1
million from the prior year period. Operating costs unrelated to volume
increased during 1999, principally due to additional investments in information
technology and sales and marketing capabilities, and employee compensation
costs.
Cost of services, as a percentage of net revenues, was 62.3% in 1999,
compared to 62.4% in 1998. Excluding discrete income and expense items, which
increased cost of services by $7.8 million in 1999, cost of services as a
percentage of net revenues was 62.1%.
Selling, general and administrative expenses, as a percentage of net
revenues, were 30.5% in 1999, compared to 29.1% in the prior year. Discrete
expense items included in selling, general and administrative expenses were
$31.7 million or 1.0% of net revenues, in 1999, of which $22.4 million
represented a bad debt charge, reflecting the reduced recoverability of SBCL
receivables, as a result of the special review of the SBCL financial statements.
Bad debt expense for the year ended December 31, 1998 was impacted by discrete
income items which reduced bad debt expense by $6.8 million. Excluding the
impact of discrete income and expense items in both 1999 and 1998, bad debt
expense was 7.6% of net revenues in 1999, compared to 8.0% in the prior year
period. The remaining increase in selling, general and administrative expenses
was principally due to additional investments made in 1999 in information
technology and sales and marketing capabilities, litigation expenses and
employee compensation costs.
INTEREST EXPENSE, NET
Net interest expense decreased in 1999 by $3.9 million, as compared to
the prior year. Net interest expense for 1999 included $1.9 million of interest
income associated with a favorable state tax settlement. The remaining reduction
in net interest expense is primarily due to the repayment of long term debt
under the Credit Agreement between the closing of the SBCL acquisition and the
end of 1999.
PROVISIONS FOR RESTRUCTURING AND OTHER SPECIAL CHARGES
During the second, third and fourth quarters of 1999, the Company
recorded provisions for restructuring and other special charges totaling $15.8
million ($9.5 million, net of tax), $30.3 million ($18.2 million, net of tax)
and $43.1 million ($26.1 million, net of tax), respectively, principally
incurred in connection with the acquisition and planned integration of SBCL.
The special charge in the second quarter of 1999 of $15.8 million was
primarily to record a provision in the results of SBCL to reflect a contract as
a loss contract.
Of the total special charge recorded in the third quarter of 1999,
$19.8 million represented stock-based employee compensation of which $17.8
million related to special one-time grants of the Company's common stock to
certain individuals of the combined company, and $2.0 million related to the
accelerated vesting of restricted stock grants made in previous years due to the
completion of the SBCL acquisition. In addition, during the third quarter of
1999, the Company incurred $9.2 million of professional and consulting fees
related to integration planning activities. The remainder of the third quarter
charge represented costs incurred in conjunction with the Company's planned
offering of new senior subordinated notes, the proceeds of which were expected
to be used to repay the Company's existing Notes. During the third quarter of
1999, the Company decided not to proceed with the offering due to unsatisfactory
market conditions.
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Of the $43.1 million charge recorded in the fourth quarter of 1999,
$36.4 million represented costs related to planned integration activities
affecting Quest Diagnostics' operations and employees which were discussed
above. In addition, the Company recorded $3.5 million of special recognition
awards granted in the fourth quarter of 1999 to certain employees involved in
the transaction and integration planning processes of the SBCL acquisition. The
remainder of the fourth quarter special charge was primarily attributable to
professional and consulting fees incurred in connection with integration related
planning activities.
MINORITY SHARE OF INCOME
Minority share of income for 1999 increased from the prior year level,
primarily due to the Company's contribution of its Pittsburgh, Pennsylvania and
St. Louis, Missouri businesses to two new corporate joint ventures in the fourth
quarter of 1998. During both 1999 and 1998, the Company maintained a 51%
controlling ownership interest in both of these affiliated companies.
OTHER, NET
Other, net for 1999 increased from the prior year level. The year ended
December 31, 1998 included a $14.9 million gain recognized by SBCL on the sale
and license of certain technology and $10.9 million of discrete income items
primarily associated with the favorable settlement of a contract dispute. The
year ended December 31, 1999 included a $9.7 million gain recognized by SBCL on
the sale of its physician office-based teleprinter assets and network in the
first quarter of 1999, a reduction in equity losses of $3.6 million, primarily
associated with a joint venture in Arizona in which the Company holds a 49%
interest, and a gain of $3.0 million associated with the sale of an investment
in the fourth quarter of 1999.
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 or reducing the tax benefit rate.
EXTRAORDINARY LOSS
In conjunction with the acquisition of SBCL, the Company repaid the
entire amount outstanding under its then existing credit agreement. The
extraordinary loss recorded in the third quarter of 1999 represented $3.6
million ($2.1 million, net of tax) of deferred financing costs written off in
connection with the extinguishment of the related credit agreement.
CASH EARNINGS PER SHARE AND ADJUSTED EBITDA
Pro forma cash earnings per common share is calculated as cash earnings
less preferred dividends, divided by diluted weighted average common shares
outstanding. Pro forma cash earnings represents income (loss) before
extraordinary loss, special items and amortization of all intangible assets, net
of applicable taxes. For purposes of determining pro forma cash earnings per
common share, special items included the provisions for restructuring and other
special charges reflected on the face of the pro forma combined statement of
operations, a $9.7 million gain recognized by SBCL on the sale of its physician
office-based teleprinter assets and network in the first quarter of 1999, a $3.0
million gain related to the sale of an investment in the fourth quarter of 1999
and a $14.9 million gain recorded by SBCL on the sale and license of certain
technology during 1998. Cash earnings per common share is presented and
discussed because it highlights the impact on earnings of the non-cash charges
associated with the amortization of intangible assets from various acquisitions,
which is significant for the Company. 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 accounting principles
generally accepted in the United States) as a measure of performance or (ii)
cash flows from operating activities as an indicator of cash flows or as a
measure of liquidity.
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Pro forma cash earnings per common share was $1.21 in 1999, compared to
$1.91 in the prior year. The decrease in pro forma cash earnings per common
share is primarily due to the discrete income and expense items which are
discussed above. Excluding the discrete income and expense items, pro forma cash
earnings per common share would have been $1.84 and $1.71, respectively, for
1999 and 1998.
Pro forma Adjusted EBITDA represents income (loss) before extraordinary
loss, income taxes, net interest expense, depreciation and amortization and
special items. For the purposes of calculating pro forma Adjusted EBITDA,
special items included the provisions for restructuring and other special
charges reflected on the face of the pro forma combined statement of operations,
a $9.7 million gain recognized by SBCL on the sale of its physician office-based
teleprinter assets and network in the first quarter of 1999, a $3.0 million gain
related to the sale of an investment in the fourth quarter of 1999, a $14.9
million gain recorded by SBCL on the sale and license of certain technology
during 1998, a charge of $2.5 million recorded in selling, general and
administrative expenses in 1998 related to the consolidation of the Company's
laboratory network announced in the fourth quarter of 1997, $46.6 million of
discrete expense items in 1999 and $15.0 million of net pre-tax profits
representing discrete income and expense items for 1998, which are discussed
above. Adjusted EBITDA is presented and discussed because management believes
that Adjusted EBITDA is a useful adjunct to net income and other measurements
under accounting principles generally accepted in the United States since 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 accounting principles generally accepted in the United States)
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.
Pro forma Adjusted EBITDA for 1999 improved to $337.4 million, or 10.9%
of net revenues (adjusted to exclude the effects of the testing performed by
third parties under the Company's laboratory network management arrangements and
the loss contract), from $330.3 million, or 11.2% of net revenues in the prior
year period.