SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10/A
Amendment No. 4 to Form 10
General Form For Registration of Securities
Pursuant to Section 12(b) or (g) of
the Securities Exchange Act of 1934
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(Exact name of registrant as specified in its charter)
<TABLE>
<CAPTION>
<S> <C>
Delaware 16-1387862
----------------------------------------------- -------------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
One Malcolm Avenue
Teterboro, New Jersey 07608
----------------------------------------------- -------------------------
(Address of principal executive offices) (Zip Code)
201 393 5000
--------------------------------------------------
(Registrant's telephone number, including area code)
</TABLE>
Securities to be registered pursuant to Section 12(b) of the Act:
<TABLE>
<CAPTION>
<S> <C>
Title of each class Name of each exchange on which
to be so registered each class is to be registered
Common Stock, with attached Preferred New York Stock Exchange
Stock Purchase Right
</TABLE>
Securities to be registered pursuant to Section 12(g) of the Act:
None
- --------------------------------------------------------------------------------
(Title of class)
<PAGE>
CORNING CLINICAL LABORATORIES INC.
INTRODUCTION
This Registration Statement on Form 10 relates to the registration under the
Securities Exchange Act of 1934, as amended, of the common stock, with
attached Preferred Stock Purchase Right, of the Registrant which is being
issued as described in the Information Statement (the "Information Statement"),
dated November 26, 1996, of Corning Incorporated. Selected pages of the
Information Statement which are related to the Registrant and the securities
being registered hereunder (the "Quest Diagnostics Information") are attached
hereto as Exhibit 99.1 and are incorporated herein by reference in answer to
the items of this Registration Statement set forth below.
Item 1. Business
The information required by this item is contained under the sections" Risk
Factors--Risks Relating to Quest Diagnostics," "Business of Quest
Diagnostics" and "The Relationship Among Corning, Quest Diagnostics and
Covance After the Distributions" of the Quest Diagnostics Information and
such sections are incorporated herein by reference.
Item 2. Financial Information
The information required by this item is contained under the sections
"Capitalization of Quest Diagnostics," "Pro Forma Financial Information of
Quest Diagnostics," "Selected Historical Financial Data of Quest Diagnostics"
and "Management's Discussion and Analysis of Financial Condition and Results
of Operations of Quest Diagnostics" of the Quest Diagnostics Information and
such sections are incorporated herein by reference.
Item 3. Properties
The information required by this item is contained under the section
"Business of Quest Diagnostics-- Properties" of the Quest Diagnostics
Information and such section is incorporated herein by reference.
Item 4. Security Ownership of Certain Beneficial Owners and Management
The information required by this item is contained under the section
"Security Ownership of Certain Beneficial Owners and Management of Quest
Diagnostics" of the Quest Diagnostics Information and such section is
incorporated herein by reference.
Item 5. Directors and Executive Officers
The information required by this item is contained under the section
"Management of Quest Diagnostics" of the Quest Diagnostics Information and
such section is incorporated herein by reference.
Item 6. Executive Compensation
The information required by this item is contained under the section
"Management of Quest Diagnostics" of the Quest Diagnostics Information and
such section is incorporated herein by reference.
Item 7. Certain Relationships and Related Transactions
The information required by this item is contained under the section
"Management of Quest Diagnostics" of the Quest Diagnostics Information and
such section is incorporated herein by reference.
Item 8. Legal Proceedings
The information required by this item is contained under the sections
"Business of Quest Diagnostics-- Government Investigations and Related
Claims" and "--Legal Proceedings" of the Quest Diagnostics Information and
such sections are incorporated herein by reference.
Item 9. Market Price of and Dividends on the Registrant's Common Equity and
Related Stockholder Matters
The information required by this item is contained under the sections "Risk
Factors--Risks Relating to Quest Diagnostics--Absence of Dividends;
Restrictions Imposed on Dividends by the Indenture and the Quest Diagnostics
Credit Facility," "Risk Factors--Risks Relating to Quest Diagnostics--Absence
of Prior Public
2
<PAGE>
Market," "Risk Factors--Risks Relating to Quest Diagnostics--Potential
Volatility of Stock Price," "Description of Quest Diagnostics Capital
Stock--Quest Diagnostics Common Stock--Dividend Policy," "--Quest Diagnostics
Common Stock--Listing and Trading" and "Management of Quest Diagnostics" of
the Quest Diagnostics Information and such sections are incorporated herein
by reference.
Item 10. Recent Sales of Unregistered Securities
Not applicable.
Item 11. Description of Registrant's Securities to be Registered
The information required by this item is contained under the sections
"Description of Quest Diagnostics Capital Stock" and "Antitakeover Effects of
Certain Provisions of the Quest Diagnostics Certificate of Incorporation and
By-Laws" of the Quest Diagnostics Information and such sections are
incorporated herein by reference.
Item 12. Indemnification of Directors and Officers
The information required by this item is contained under the section
"Liability and Indemnification of Directors and Officers of Quest
Diagnostics" of the Quest Diagnostics Information and such section is
incorporated herein by reference.
Item 13. Financial Statements and Supplementary Data
The information required by this item is contained under the sections
"Capitalization of Quest Diagnostics," "Pro Forma Financial Information of Quest
Diagnostics," "Selected Historical Financial Data of Quest Diagnostics,"
"Management's Discussion and Analysis of Financial Condition and Results of
Operations of Quest Diagnostics" and "Financial Statements of Corning Clinical
Laboratories Inc. (to be renamed Quest Diagnostics Incorporated)" of the Quest
Diagnostics Information and such sections are incorporated herein by reference.
Item 14. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
Not applicable.
Item 15. Financial Statements and Exhibits
(a) Financial Statements
The information required by this item is contained under the section
"Financial Statements of Corning Clinical Laboratories Inc. (to be renamed Quest
Diagnostics Incorporated" of the Quest Diagnostics Information)" and such
section is incorporated herein by reference.
(b) Exhibits
3
<PAGE>
<TABLE>
<CAPTION>
Exhibit
Number Description
- ------- -----------
<S> <C>
2.1* Form of Transaction Agreement among Corning Incorporated, Corning Life Sciences Inc., Corning
Clinical Laboratories Inc. (Delaware), Covance Inc. and Corning Clinical Laboratories Inc.
(Michigan), dated November 22, 1996
3.1* Certificate of Incorporation of the Registrant
3.2* By-Laws of the Registrant
4.1* Form of Common Stock certificate
4.2* Form of Rights Agreement between Corning Clinical Laboratories Inc. and Harris Trust and Savings
Bank, dated December 31, 1996
10.1* Form of Tax Sharing Agreement among Corning Incorporated, Corning Clinical Laboratories Inc. and
Covance Inc., dated [ ], 1996
10.2* Form of Spin-Off Tax Indemnification Agreement between Corning Incorporated and Corning Clinical
Laboratories Inc. dated, [ ], 1996
10.3* Form of Spin-Off Tax Indemnification Agreement between Corning Clinical Laboratories Inc. and
Covance Inc., dated [ ], 1996
10.4* Form of Credit Agreement among Corning Clinical Laboratories Inc., Morgan Guaranty Trust Company
of New York, Nationsbank, N.A. and Wachovia Bank of Georgia, N.A., dated [ ], 1996
10.5* Form of Spin-Off Tax Indemnification Agreement between Covance Inc. and Corning Clinical
Laboratories Inc., dated [ ], 1996
10.6* Form of Corning Clinical Laboratories Inc. Employees Stock Purchase Plan
10.7* Form of Corning Clinical Laboratories Inc. Variable Compensation Plan
10.8* Form of Corning Clinical Laboratories Inc. Profit Sharing Plan
10.9* Form of Corning Clinical Laboratories Inc. Employee Equity Participation Program
10.10* Form of Corning Clinical Laboratories Inc. Executive Retirement Supplemental Plan
10.11* Form of Corning Clinical Laboratories Inc. Directors' Restricted Stock Plan
10.12* Form of Employment Agreement between Kenneth W. Freeman and Corning Clinical Laboratories Inc.
21* Subsidiaries of the Registrant
27* Financial Data Schedules
99.1 Selected pages of the Information Statement of Corning Incorporated
dated November 26, 1996 (pages 2; 29-108; F-1-F-32)
</TABLE>
- -------------
* Previously filed.
4
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 12 of the Securities Exchange Act of
1934, the registrant has duly caused this amendment to the registration
statement to be signed on its behalf by the undersigned, thereunto duly
authorized.
CORNING CLINICAL LABORATORIES INC.
Dated: November 26, 1996 By: /s/ Kenneth W. Freeman
----------------------------------------
Kenneth W. Freeman, President
and Chief Executive Officer
5
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Page
-------
<S> <C>
THE RELATIONSHIP AMONG CORNING, QUEST DIAGNOSTICS AND COVANCE AFTER THE
DISTRIBUTIONS 29
QUEST DIAGNOSTICS INCORPORATED
RISK FACTORS 33
CAPITALIZATION OF QUEST DIAGNOSTICS 39
SELECTED HISTORICAL FINANCIAL DATA OF QUEST DIAGNOSTICS 40
PRO FORMA FINANCIAL INFORMATION OF QUEST DIAGNOSTICS 44
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS OF QUEST DIAGNOSTICS 51
BUSINESS OF QUEST DIAGNOSTICS 60
MANAGEMENT OF QUEST DIAGNOSTICS 83
SECURITY OWNERSHIP BY CERTAIN BENEFICIAL OWNERS AND MANAGEMENT OF QUEST
DIAGNOSTICS 93
DESCRIPTION OF QUEST DIAGNOSTICS CAPITAL STOCK 95
ANTITAKEOVER EFFECTS OF CERTAIN PROVISIONS OF THE QUEST DIAGNOSTICS
CERTIFICATE OF INCORPORATION AND BY-LAWS 101
DESCRIPTION OF CERTAIN INDEBTEDNESS OF QUEST DIAGNOSTICS 105
LIABILITY AND INDEMNIFICATION OF DIRECTORS AND OFFICERS OF QUEST
DIAGNOSTICS 108
INDEX TO FINANCIAL STATEMENTS F-1
</TABLE>
2
<PAGE>
THE RELATIONSHIP AMONG CORNING, QUEST DIAGNOSTICS AND COVANCE
AFTER THE DISTRIBUTIONS
After the Distributions, Quest Diagnostics Incorporated ("Quest
Diagnostics") and Covance Inc. ("Covance") will be independent public
companies and Corning Incorporated ("Corning") will not have any ownership
interest in either Quest Diagnostics or Covance other than shares of Quest
Diagnostics' voting cumulative preferred stock. Corning, Quest Diagnostics
and Covance will enter into certain agreements, summarized below, to provide
for an orderly transition to the status of three separate independent
companies, to govern their relationship subsequent to the Distributions and
to provide for the allocation of tax and certain other liabilities and
obligations arising from periods prior to the Distributions. Copies of the
forms of such agreements have been filed as exhibits to the Registration
Statements of which this Information Statement is a part. The following
description summarizes the material terms of such agreements, but is
qualified by reference to the texts of such agreements as filed.
Transaction Agreement
Corning, Quest Diagnostics and Covance will enter into the Transaction
Agreement (the "Transaction Agreement") providing for, among other things,
certain conditions precedent to the Distributions, certain corporate
transactions required to effect the Distributions and other arrangements
between Corning, Quest Diagnostics and Covance subsequent to the
Distributions. See "The Distributions--Conditions; Termination."
The Transaction Agreement will provide for, among other things,
assumptions of liabilities and cross- indemnities designed to allocate
generally, effective as of the Distribution Date, financial responsibility
for the liabilities arising out of or in connection with (i) the clinical
laboratory business to Quest Diagnostics and its subsidiaries, (ii) the
contract research business to Covance and its subsidiaries and (iii) all
other business conducted by Corning prior to the Distribution Date to Corning
and its subsidiaries other than Quest Diagnostics and Covance.
The Transaction Agreement will provide that Corning, Quest Diagnostics and
Covance will use their respective commercially reasonable efforts to achieve
an allocation of consolidated indebtedness of Corning and a capital structure
that reflects the capital structure after the Distributions of Corning, Quest
Diagnostics and Covance as contemplated in the discussion under
"Capitalization of Quest Diagnostics" and "Capitalization of Covance." In
addition to the specific indemnity described below, Corning, Quest
Diagnostics and Covance are obligated under the Transaction Agreement to
indemnify and hold harmless each other in respect of Indemnifiable Losses (as
defined therein) arising out of or otherwise relating to the management or
conduct of their respective businesses or the breach of any provision of the
Transaction Agreement; provided, however, that Quest Diagnostics will have no
obligation to indemnify or hold harmless Corning in respect of Indemnifiable
Losses arising out of any governmental claims or investigations described in
the next paragraph.
As discussed under "Business of Quest Diagnostics--Government
Investigations and Related Claims," Quest Diagnostics is subject to several
governmental investigations. Any amounts paid by Quest Diagnostics to settle
these investigations, or as a result of a judgment relating to these
investigations, will be indemnified by Corning under the Transaction
Agreement. Under the Transaction Agreement Corning will agree to indemnify
Quest Diagnostics against all monetary penalties, fines or settlements
arising out of any governmental criminal, civil or administrative
investigations or claims that have been settled prior to or are pending as of
the Distribution Date, pursuant to service of subpoena or other notice of
such investigation to Quest Diagnostics, as well as any qui tam proceeding
for which a complaint was filed prior to the Distribution Date whether or not
Quest Diagnostics has been served with such complaint or otherwise been
notified of the pendency of such action, to the extent that such
investigations or claims arise out of or are related to alleged violations of
federal fraud and health care statutes identified in the Transaction
Agreement by reason of Quest Diagnostics or any company acquired by Quest
Diagnostics billing any federal program or agency for services rendered to
beneficiaries of such program or agency. Corning will also indemnify Quest
Diagnostics for 50% of the aggregate of all judgment or settlement payments
made by Quest Diagnostics that are in excess of $42.0 million in respect of
claims by private parties (i.e., nongovernmental parties such as private
insurers) that relate to indemnified or previously settled governmental
claims and that allege overbillings by Quest Diagnostics or any existing
subsidiaries of Quest Diagnostics for services provided prior to the
Distribution Date; provided, however, such indemnification for private claims
will terminate five years after the Distribution Date (whether or not
settled) and will not exceed $25.0 million in the aggregate (reduced by
certain tax benefits as described below). Quest Diagnostics' aggregate
reserve with respect to all governmental and private claims, including
litigation costs, was $215 million at September 30, 1996 and is estimated to
be reduced to $85 million at the Distribution Date as a result of the payment
of settled claims, primarily the Damon settlement of $119 million.
29
<PAGE>
Corning will not indemnify Quest Diagnostics against any governmental
claims that arise after the Distribution Date, even though relating to events
prior to the Distribution Date, or to any private claims that do not relate
to the indemnified or previously settled governmental claims or
investigations or investigations that relate to post- Distribution Date
billings. Corning will not indemnify Quest Diagnostics against consequential
or incidental damages relating to the billing claims, including losses of
revenues and profits as a consequence of any exclusion from participation in
federal or state health care programs or the fees and expenses of the
litigation, including attorneys' fees and expenses. All amounts indemnified
against by Corning for the benefit of Quest Diagnostics will be calculated on
a net after-tax basis by taking into account any deductions and other tax
benefits realized by Quest Diagnostics (or a consolidated group of which
Quest Diagnostics is a member after the Distributions (the "Quest Diagnostics
Group")) in respect of the underlying settlement, judgment payment, or other
loss (or portion thereof) indemnified against by Corning generally at the
time and to the extent such deductions or tax benefits are deemed to reduce
the tax liability of Quest Diagnostics or the Quest Diagnostics Group under
the Transaction Agreement.
The Transaction Agreement provides that, in the case of any claims for
which Corning, Quest Diagnostics or Covance are entitled to indemnification,
the indemnified party will control the defense of any claim unless the
indemnifying party elects to assume such defense. However, in the case of all
private claims related to indemnified governmental claims related to alleged
overbillings, Quest Diagnostics will control the defense. Disputes under the
Transaction Agreement are subject to binding arbitration. The Transaction
Agreement will also provide that, except as otherwise set forth therein or in
any other agreement, all costs or expenses incurred on or prior to the
Distribution Date in connection with the Distributions will be allocated
among the parties. Except as set forth in the Transaction Agreement or any
related agreement, each party shall bear its own costs and expenses incurred
after the Distribution Date.
Spin-Off Tax Indemnification Agreements
Corning and Quest Diagnostics will enter into a tax indemnification
agreement (the "Corning/Quest Diagnostics Spin-Off Tax Indemnification
Agreement") pursuant to which (1) Quest Diagnostics will represent to Corning
that, to the best of its knowledge, the materials relating to Quest
Diagnostics submitted to the Internal Revenue Service ("IRS") in connection
with the request for ruling submitted to the IRS are complete and accurate in
all material respects, (2) Quest Diagnostics will represent that it has no
present intention to undertake the transactions described in part (3)(iii)
hereafter or cease to engage in the active conduct of providing clinical
laboratory testing services, (3) Quest Diagnostics will covenant and agree
that for a period of two years following the Distribution Date (the
"Restricted Period"), (i) Quest Diagnostics will continue to engage in the
clinical laboratory testing business, (ii) Quest Diagnostics will continue to
manage and own at least 50% of the assets which it owns directly and
indirectly immediately after the Distribution Date and (iii) neither Quest
Diagnostics, nor any related corporation nor any of their respective
directors, officers or other representatives will undertake, authorize,
approve, recommend, permit, facilitate, or enter into any contract, or
consummate any transaction with respect to: (A) the issuance of Quest
Diagnostics Common Stock (including options and other instruments convertible
into Quest Diagnostics Common Stock) which would exceed fifty percent (50%)
of the outstanding shares of Quest Diagnostics Common Stock immediately after
the Distribution Date; (B) the issuance of any other instrument that would
constitute equity for federal tax purposes ("Disqualified Quest Diagnostics
Stock"); (C) the issuance of options and other instruments convertible into
Disqualified Quest Diagnostics Stock; (D) any repurchases of Quest
Diagnostics Common Stock, unless such repurchases satisfy certain
requirements; (E) the dissolution, merger, or complete or partial liquidation
of Quest Diagnostics or any announcement of such action; or (F) the waiver,
amendment, termination or modification of any provision of the Quest
Diagnostics Rights Plan (as defined therein) in connection with, or in order
to permit or facilitate, any acquisition of Quest Diagnostics Common Stock or
other equity interest in Quest Diagnostics, and (4) Quest Diagnostics will
agree to indemnify Corning for Taxes (as defined below) arising from
violations of (1), (2) or (3) above and for Taxes arising as a result of (A)
an acquisition of 20% or more of the stock of Quest Diagnostics by a person
or related persons during the Restricted Period or (B) the commencement of a
tender or purchase offer by a third party for 20% or more of Quest
Diagnostics stock. If obligations of Quest Diagnostics under this agreement
were breached and as a result thereof one or both of the Distributions do not
qualify for the treatment stated in the ruling Corning requested from the IRS
(the "IRS Ruling"), Quest Diagnostics would be required to indemnify Corning
for Taxes imposed and such indemnification obligations could exceed the net
asset value of Quest Diagnostics at such time.
Corning and Covance will enter into a tax indemnification agreement (the
"Corning/Covance Spin-Off Tax Indemnification Agreement") pursuant to which
(1) Covance will represent to Corning that to the best of its knowledge,
30
<PAGE>
the materials relating to Covance submitted to the IRS in connection with the
request for ruling submitted to the IRS are complete and accurate in all
material respects, (2) Covance will represent that it has no present
intention to undertake the transactions described in part (3)(iii) hereafter
or to cease to engage in the active conduct of providing contract research
services, (3) Covance will covenant and agree that during the Restricted
Period, (i) Covance will continue to engage in the contract research
business, (ii) Covance will continue to manage and own at least 50% of the
assets which it owns directly and indirectly immediately after the
Distribution Date and (iii) neither Covance, nor any related corporations nor
any of their respective directors, officers or other representatives will
undertake, authorize, approve, recommend, permit, facilitate, or enter into
any contract, or consummate any transaction with respect to: (A) the issuance
of Covance Common Stock (including options and other instruments convertible
into Covance Common Stock) which would exceed fifty percent (50%) of the
outstanding shares of Covance Common Stock immediately after the Distribution
Date; (B) the issuance of any other instrument that would constitute equity
for federal tax purposes ("Disqualified Covance Stock"); (C) the issuance of
options and other instruments convertible into Disqualified Covance Stock;
(D) any repurchases of Covance Common Stock, unless such repurchases satisfy
certain requirements; (E) the dissolution, merger, or complete or partial
liquidation of Covance or any announcement of such action; or (F) the waiver,
amendment, termination or modification of any provision of the Covance Rights
Plan (as defined therein) in connection with, or in order to permit or
facilitate, any acquisition of Covance Common Stock or other equity interest
in Covance and (4) Covance will agree to indemnify Corning for Taxes arising
from violations of (1), (2) or (3) above and for Taxes arising as a result of
(A) an acquisition of 20% or more of the stock of Covance by a person or
related persons during the Restricted Period or (B) the commencement of a
tender or purchase offer by a third party for 20% or more of Covance stock.
If obligations of Covance under this agreement were breached and as a result
thereof one or both of the Distributions do not qualify for the treatment
stated in the IRS Ruling, Covance would be required to indemnify Corning for
Taxes imposed and such indemnification obligations could exceed the net asset
value of Covance at such time.
Quest Diagnostics and Covance will enter into a tax indemnification
agreement (the "Quest Diagnostics/ Covance Spin-Off Tax Indemnification
Agreement") which will be essentially the same as the Corning/Covance
Spin-Off Tax Indemnification Agreement except that Covance will make
representations to and indemnify Quest Diagnostics as opposed to Corning. If
obligations of Covance under this agreement were breached and as a result
thereof one or both of the Distributions do not qualify for the treatment
stated in the IRS Ruling, Covance would be required to indemnify Quest
Diagnostics for Taxes imposed and such indemnification obligations could
exceed the net asset value of Covance at such time. Quest Diagnostics and
Covance will enter into a second tax indemnification agreement (the
"Covance/Quest Diagnostics Spin-Off Tax Indemnification Agreement") which
will be essentially the same as the Corning/Quest Diagnostics Spin-Off Tax
Indemnification Agreement except that Quest Diagnostics will make
representations to and indemnify Covance as opposed to Corning. If
obligations of Quest Diagnostics under this agreement were breached and as a
result thereof one or both of the Distributions do not qualify for the
treatment stated in the IRS Ruling, Quest Diagnostics would be required to
indemnify Covance for Taxes imposed and such indemnification obligations
could exceed the net asset value of Quest Diagnostics at such time.
The Spin-Off Tax Indemnification Agreements will also require (i) Quest
Diagnostics to take such actions as Corning may reasonably request and (ii)
Covance to take such actions as Corning and Quest Diagnostics may reasonably
request to preserve the favorable tax treatment provided for in any rulings
obtained from the IRS in respect of the Distributions.
Tax Sharing Agreement
Corning, Quest Diagnostics and Covance will enter into a tax sharing
agreement (the "Tax Sharing Agreement") which will allocate responsibility
for federal income and various other taxes ("Taxes") among the three
companies. The Tax Sharing Agreement provides that, except for Taxes arising
as a result of the failure of either or both of the Distributions to qualify
for the treatment stated in the IRS Ruling (which Taxes are allocated either
pursuant to the Spin-Off Tax Indemnification Agreements or as described
below), Corning is liable for and will pay the federal income taxes of the
consolidated group that includes Quest Diagnostics and Covance and their
subsidiaries, provided, however, that Quest Diagnostics and Covance are
required to reimburse Corning for taxes for periods beginning after December
31, 1995 in which they are members of the Corning consolidated group and for
which tax returns have not been filed as of the Distribution Date. This
reimbursement obligation is based on the hypothetical separate federal tax
liability of Quest Diagnostics and Covance, including their respective
subsidiaries, calculated on a separate consolidated basis, subject to certain
adjustments. Under the Tax Sharing Agreement, in the case of adjustments by a
taxing authority of a
31
<PAGE>
consolidated federal income tax or certain other tax returns prepared by
Corning which includes Quest Diagnostics or Covance, then, subject to certain
exceptions, Corning is liable for and will pay any tax assessments, and is
entitled to any tax refunds, resulting from such audit.
The Tax Sharing Agreement further provides that, if either of the
Distributions fails to qualify for the tax treatment stated in the IRS Ruling
(for reasons other than those indemnified against under one or more of the
Spin-Off Tax Indemnification Agreements), Taxes imposed upon or incurred by
Corning, Quest Diagnostics or Covance as a result of such failure are to be
allocated among Corning, Quest Diagnostics and Covance in such a manner as
will take into account the extent to which the actions or inactions of each
may have contributed to such failure, and Corning, Quest Diagnostics and
Covance each will indemnify and hold harmless the other from and against the
taxes so allocated. If it is determined that none of the companies
contributed to the failure of such distribution to qualify for the tax
treatment stated in the IRS Ruling, the liability for taxes will be borne by
each in proportion to its relative average market capitalization as
determined by the average closing price for the common stock of each during
the 20 trading-day period immediately following the Distribution Date. In the
event that either of the Distributions fails to qualify for the tax treatment
stated in the IRS Ruling and the liability for taxes as a result of such
failure is allocated among Corning, Quest Diagnostics and Covance, the
liability so allocated to Quest Diagnostics or Covance could exceed the net
asset value of Quest Diagnostics or Covance, respectively.
Voting Cumulative Preferred Stock of Quest Diagnostics
After the Distributions, Corning will retain 1,000 shares of Quest
Diagnostics' voting cumulative preferred stock, with an aggregate liquidation
preference of $1.0 million. Corning is the sole holder of such shares. For a
description of the terms of the Quest Diagnostics voting cumulative preferred
stock, see "Description of Quest Diagnostics Capital Stock--Voting Cumulative
Preferred Stock."
32
<PAGE>
QUEST DIAGNOSTICS INCORPORATED
RISK FACTORS
Corning shareholders should be aware that the Distributions and ownership
of the Quest Diagnostics Common Stock involve certain risks, including those
described below, which could adversely affect the value of their holdings.
Neither Corning nor Quest Diagnostics makes, nor is any other person
authorized to make, any representations as to the future market value of
Quest Diagnostics Common Stock.
Risks Relating to the Distributions
Effects on Corning Stock. Following the Distributions, Corning Common
Stock will continue to be listed and traded on the NYSE and certain other
stock exchanges. As a result of the Distributions, the trading price of
Corning Common Stock is expected to be lower than the trading price of
Corning Common Stock immediately prior to the Distributions. There can be no
assurance that the combined trading prices of Corning Common Stock, Quest
Diagnostics Common Stock and Covance Common Stock after the Distributions
will be equal to or greater than the trading price of Corning Common Stock
prior to the Distributions.
Risks Relating to Quest Diagnostics
Financial Impact of the Distributions on Quest Diagnostics. While Quest
Diagnostics has a substantial operating history, it has not operated as an
independent company since 1982. As a Corning subsidiary, Quest Diagnostics'
working capital requirements have been financed by Corning and Quest
Diagnostics' major acquisitions have been financed through the issuance of
Corning common stock and borrowings from Corning. Subsequent to the
Distributions, Quest Diagnostics' activities will no longer be financed by
Corning. In addition, it is anticipated that the rating of Quest Diagnostics'
long-term debt will be non-investment grade. This may impact, among other
things, Quest Diagnostics' ability to raise capital, fund working capital
requirements or expand, through acquisitions or otherwise, and could thereby
have an adverse effect on Quest Diagnostics' operating earnings and cash
flow.
Substantial Leverage and Debt Service Requirements. After the
Distributions and as a result of the incurrence of debt under the Quest
Diagnostics Credit Facility (as defined below) and the issuance of Notes (as
defined below) in the Quest Diagnostics Notes Offering (as defined below),
Quest Diagnostics will have substantial debt. At September 30, 1996, after
giving effect to the transactions and adjustments described in "Pro Forma
Financial Information of Quest Diagnostics," Quest Diagnostics would have had
$517 million of total debt and total capitalization of $1,120 million, on a
pro forma basis, and Quest Diagnostics' total debt as a percentage of total
capitalization would have been approximately 46%. In addition to creating
significant debt service obligations for Quest Diagnostics, the terms of the
Quest Diagnostics Credit Facility will contain customary affirmative and
negative covenants that will, among other things, require Quest Diagnostics
to maintain certain financial tests and ratios and will restrict Quest
Diagnostics' ability to make asset dispositions, incur additional
indebtedness, make certain payments and investments, transact with affiliates
or enter into mergers or consolidate. The Indenture will include similar, but
less restrictive, incurrence tests.
The degree to which Quest Diagnostics is leveraged could have important
consequences to holders of Quest Diagnostics Common Stock, including the
following: (1) Quest Diagnostics' ability to obtain additional financing in
the future for working capital, capital expenditures, product development,
acquisitions, general corporate purposes or other purposes may be impaired;
(ii) a substantial portion of Quest Diagnostics' and its subsidiaries' cash
flow from operations must be dedicated to the payment of the principal of and
interest on its indebtedness; (iii) the Quest Diagnostics Credit Facility
will contain certain restrictive financial and operating covenants,
including, among others, requirements that Quest Diagnostics satisfy certain
financial ratios; (iv) a significant portion of borrowings will be at
floating rates of interest, causing Quest Diagnostics to be vulnerable to
increases in interest rates; (v) Quest Diagnostics' degree of leverage may
make it more vulnerable in a downturn in general economic conditions; and
(vi) Quest Diagnostics' financial position may limit its flexibility in
responding to changing business and economic conditions. In addition, the
Notes will contain certain financial covenants. See "Management's Discussion
and Analysis of Financial Condition and Results of Operations of Quest
Diagnostics-- Liquidity and Capital Resources" and "Description of Certain
Indebtedness of Quest Diagnostics."
Intense Competition. The independent clinical laboratory industry in the
United States is intensely competitive. Quest Diagnostics believes that in
1995 approximately 56% of the revenues of the clinical laboratory testing
industry
33
<PAGE>
was generated by hospital-affiliated laboratories, approximately 36% by
independent clinical laboratories and 8% by thousands of individual
physicians in their offices and laboratories. Independent clinical
laboratories fall into two separate categories: (1) smaller, generally local,
laboratories that generally offer fewer tests and services and have less
capital than the larger laboratories, and (2) larger laboratories such as
Quest Diagnostics that provide a broader range of tests and services. Quest
Diagnostics has two major competitors that operate in the national
market--SmithKline Beecham Clinical Laboratories, Inc. ("SmithKline") and
Laboratory Corporation of America Holdings, Inc. ("LabCorp"). Both SmithKline
and LabCorp are affiliated with larger corporations that have greater
financial resources than Quest Diagnostics. There are also many independent
clinical laboratories that operate regionally and that compete with Quest
Diagnostics in these regions. In addition, hospitals are in general both
competitors and customers of independent clinical laboratories. The
independent clinical laboratory testing industry has experienced intense
price competition over the past several years, which has negatively impacted
Quest Diagnostics' profitability. The following factors, among others, are
often used by health care providers in selecting a laboratory: (i) pricing of
the laboratory's testing services; (ii) accuracy, timeliness and consistency
in reporting test results; (iii) number and type of tests performed; (iv)
service capability and convenience offered by the laboratory; and (v) its
reputation in the medical community. See "Business of Quest Diagnostics--The
Clinical Laboratory Testing Industry" and "Business of Quest
Diagnostics--Competition."
Role of Managed Care. Managed care organizations play a significant role
in the health care industry and their role is expected to increase over the
next several years. Managed care organizations typically negotiate capitated
payment contracts, whereby a clinical laboratory receives a fixed monthly fee
per covered individual, regardless of the number or cost of tests performed
during the month (excluding certain tests, such as esoteric tests and
anatomic pathology services). Laboratory services agreements with managed
care organizations have historically been priced aggressively due to
competitive pressure and the expectation that a laboratory would capture not
only the volume of testing to be covered under the contract, but also the
additional fee-for-service business from patients of participating physicians
who are not covered under the managed care plan. However, as the number of
patients covered under managed care plans continues to increase, there is
less such fee-for-service business and, accordingly, less high margin
business to offset the low margin (and often unprofitable) managed care
business. Furthermore, increasingly, physicians are affiliated with more than
one managed care organization and as a result may be required to refer
clinical laboratory tests to different clinical laboratories, depending on
the coverage of their patients. As a result, a clinical laboratory might not
receive any fee-for-service testing from such physicians. See "Business of
Quest Diagnostics--Customers and Payors" and "Business of Quest
Diagnostics--Effect of the Growth of the Managed Care Sector on the Clinical
Laboratory Business." During the nine months ended September 30, 1996,
services to managed care organizations under capitated rate agreements
accounted for approximately 6% of Quest Diagnostics' net revenues from
clinical laboratory testing and approximately 15% of the tests performed by
Quest Diagnostics. Quest Diagnostics is currently reviewing its pricing
structures for agreements with managed care organizations and intends to
insure that all of its future agreements with managed care organizations are
profitably priced. However, there can be no assurance that Quest Diagnostics
will be able to increase the prices charged to managed care organizations or
that Quest Diagnostics will not lose market share in the managed care market
to other clinical laboratories who continue to aggressively price laboratory
services agreements with managed care organizations. Quest Diagnostics may
experience declines in per-test revenue as managed care organizations
continue to increase their share of the health care insurance market.
Reliance on Medicare/Medicaid Reimbursements. Approximately 23% and 22% of
Quest Diagnostics' net revenues for the year ended December 31, 1995 and the
nine months ended September 30, 1996, respectively, were attributable to
tests performed for Medicare and Medicaid beneficiaries. Quest Diagnostics'
business and financial results depend substantially on reimbursements paid to
Quest Diagnostics under these programs. Quest Diagnostics is legally required
to accept the government's reimbursement for most Medicare and Medicaid
testing as payment in full. Such reimbursements are generally made pursuant
to fee schedules, which are subject to certain limitations the levels of
which have declined steadily since late 1984. Congress enacted a phased-in
set of reductions in the reimbursement limitations as part of its 1993 budget
legislation that reduced the Medicare national limitations in 1994 to 84% of
the 1984 national median, in 1995 to 80% of the 1984 national median and in
1996 to 76% of the 1984 national median. In 1995, both houses of Congress
passed a bill (the Medicare Preservation Act) that would have reduced the fee
cap schedule from 75% to 65% of the 1984 national median, but the bill was
vetoed by the President. Effective January 1, 1996, the Health Care Financing
Administration ("HCFA") adopted a new policy on reimbursement for chemistry
panel tests. As of January 1, 1996, 22 automated tests (rather than 19 tests)
became reimbursable by Medicare as part of an automated chemistry profile. An
additional allowance of $0.50 per test is
34
<PAGE>
authorized when more than 19 tests are billed in a panel. HCFA retains the
authority to expand in the future the list of tests included in a panel.
Effective as of March 1, 1996, HCFA eliminated its prior policy of permitting
payment for all tests contained in an automated chemistry panel when at least
one of the tests in the panel is medically necessary. Under the new policy,
Medicare payment will not exceed the amount that would be payable if only the
tests that are "medically necessary" had been ordered. In addition, since
1995 most Medicare carriers have begun to require clinical laboratories to
submit documentation supporting the medical necessity, as judged by ordering
physicians, for many commonly ordered tests. Quest Diagnostics expects to
incur additional reimbursement reductions and additional costs associated
with the implementation of these requirements of HCFA and Medicare carriers.
The amount of the reductions in reimbursements and additional costs cannot be
determined at this time. These and other proposed changes affecting the
reimbursement policy of Medicare and Medicaid programs could have a material
adverse effect on the business, financial condition, results of operations or
prospects of Quest Diagnostics. See "Business of Quest
Diagnostics--Regulation and Reimbursement--Regulation of Reimbursement for
Clinical Laboratory Services." A failure of Quest Diagnostics to properly and
promptly process its bills to Medicare may result in an increase in Quest
Diagnostics' bad debt expense. See "Business of Quest Diagnostics-- Billing"
and "Management's Discussion and Analysis of Financial Condition and Results
of Operations of Quest Diagnostics--Results of Operations."
Government Regulation. The clinical laboratory industry is subject to
extensive governmental regulations at the federal, state and local levels.
See "Business of Quest Diagnostics--Regulation and Reimbursement."
At the federal level, Quest Diagnostics' laboratories are required to be
certified under the Clinical Laboratory Improvement Amendments of 1988
("CLIA") and approved to participate in the Medicare/Medicaid programs.
Currently, all clinical laboratories, including most physician-office
laboratories ("POLs"), are required to comply with CLIA. However, the
Medicare Preservation Act, passed in 1995 by both Houses of Congress, would
have largely exempted POLs from having to comply with CLIA (except with
respect to pap smear tests). Although this provision was not maintained by
the House-Senate conference and was not included in the subsequent
legislation, it could be reintroduced at any time. The exemption of POLs from
CLIA would significantly reduce their costs, making them more financially
viable and a greater competitive challenge to Quest Diagnostics and would
more likely encourage physicians to establish laboratories in their offices.
A wide array of Medicare/Medicaid fraud and abuse provisions apply to
clinical laboratories participating in such programs. Penalties for
violations of these federal laws include exclusion from participation in the
Medicare/ Medicaid programs, asset forfeitures, civil and criminal penalties.
Civil penalties for a wide range of offenses may be up to $2,000 per item and
twice the amount claimed. These penalties will be increased effective January
1, 1997 to up to $10,000 per item plus three times the amount claimed. In the
case of certain offenses, exclusion from participation in Medicare and
Medicaid is a mandatory administrative penalty. The Office of the Inspector
General ("OIG") of the Department of Health and Human Services ("HHS")
interprets these fraud and abuse administrative provisions liberally and
enforces them aggressively. Provisions in a bill enacted in August 1996 are
likely to expand the federal government's involvement in curtailing fraud and
abuse due to the establishment of (i) an anti-fraud and abuse trust fund
funded through the collection of penalties and fines for violations of such
laws and (ii) a health care anti-fraud and abuse task force. See "Business of
Quest Diagnostics--Regulation and Reimbursement."
Government Investigations and Related Claims. As discussed under "Business of
Quest Diagnostics-- Government Investigations and Related Claims," Quest
Diagnostics has settled various government and private claims (i.e.,
nongovernmental claims such as those by private insurers) totalling
approximately $195 million relating primarily to industry-wide billing and
marketing practices that had been substantially discontinued by early 1993.
Specifically, Quest Diagnostics has entered into, (i) for an aggregate of
approximately $180 million, five settlements with the OIG and the DOJ and two
settlements with state governments with respect to Medicare and Medicaid
marketing and billing practices of Quest Diagnostics and certain companies
acquired by Quest Diagnostics prior to their acquisition and (ii) twelve
completed settlements and one tentative settlement relating to private claims
totalling approximately $15 million. In addition, there are pending
investigations by the OIG and DOJ into billing and marketing practices at three
regional laboratories operated by Nichols prior to its acquisition by Quest
Diagnostics. There are no other private claims presently pending. By issuance of
civil subpoenas in August 1993, the government began a formal investigation of
Nichols. The investigation of Nichols remains open. Remedies available to the
government include exclusion from participation in the Medicare and Medicaid
programs, criminal fines, civil recoveries plus civil penalties and asset
forfeitures. Although application of such remedies and penalties could
materially and adversely affect Quest Diagnostics' business, financial
condition, results of operations and
35
<PAGE>
prospects management believes that the ossibility of this happening is remote.
Quest Diagnostics derived approximately 23% and 22% of its net revenues for the
year ended December 31, 1995 and the nine months ended September 30, 1996,
respectively, from Medicare and Medicaid programs.
In connection with the Distributions, Corning will agree to indemnify
Quest Diagnostics against all monetary penalties, fines or settlements for
any governmental claims arising out of alleged violations of certain federal
fraud and health care statutes and relating to billing practices of Quest
Diagnostics and its predecessors that have been settled or are pending on the
Distribution Date. Corning will also agree to indemnify Quest Diagnostics for
50% of the aggregate of all judgment or settlement payments made by Quest
Diagnostics that are in excess of $42.0 million in respect of claims by
private parties (i.e., nongovernmental parties such as private insurers) that
relate to indemnified or previously settled governmental claims and that
allege overbillings by Quest Diagnostics or any existing subsidiaries of
Quest Diagnostics, for services provided prior to the Distribution Date;
provided, however, such indemnification will not exceed $25.0 million in the
aggregate and all amounts indemnified against by Corning for the benefit of
Quest Diagnostics will be calculated on a net after-tax basis. However, such
indemnification will not cover (i) any governmental claims that arise after
the Distribution Date pursuant to service of subpoena or other notice of such
investigation after the Distribution Date, (ii) any nongovernmental claims
unrelated to the indemnified governmental claims or investigations, (iii) any
nongovernmental claims not settled prior to five years after the Distribution
Date, (iv) any consequential or incidental damages relating to the billing
claims, including losses of revenues and profits as a consequence of
exclusion for participation in federal or state health care programs or (v)
the fees and expenses of litigation. Quest Diagnostics will control the
defense of any governmental claim or investigation unless Corning elects to
assume such defense. However, in the case of all nongovernmental claims
related to indemnified governmental claims related to alleged overbillings,
Quest Diagnostics will control the defense. All disputes under the
Transaction Agreement are subject to binding arbitration. See "The
Relationship Among Corning, Quest Diagnostics and Covance After the
Distributions--Transaction Agreement."
Quest Diagnostics' aggregate reserve with respect to all governmental and
private claims, including litigation costs of approximately $6.6 million, was
$215 million at September 30, 1996 and is estimated to be reduced to $85
million as of the Distribution Date as a result of the payment of settled
claims, primarily the Damon settlement of $119 million. Based on information
available to management and Quest Diagnostics' experience with past
settlements (including the fact that the aggregate amount of the Damon
settlement was significantly in excess of established reserves) management
has reassessed its reserve levels and believes that its current level of
reserves is adequate. However, 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 theories of
wrongdoing) may become available which may cause the final resolution of
these matters to be in excess of established reserves by an amount which
could be material to Quest Diagnostics' results of operation and, for
non-indemnified claims, Quest Diagnostics' cash flows in the period in which
such claims are settled. While none of the governmental or nongovernmental
investigations or claims is covered by insurance Quest Diagnostics does not
believe that these matters will have a material adverse effect on Quest
Diagnostic's overall financial condition.
Recent Losses. Quest Diagnostics incurred net losses of $52 million for
the year ended December 31, 1995 and $158.9 million for the nine months ended
September 30, 1996. The 1995 net loss includes the provision of $33 million
for restructuring charges (primarily relating to workforce reduction programs
and the cost of exiting a number of leased facilities) and $17.6 million of
special charges related to settlements of governmental billing claims. The
net loss for the 1996 period reflects the provision of $188 million for
additional reserves primarily relating to the investigation of
pre-acquisition billing practices of Damon Corporation and Nichols Institute
and $13.7 million to write off capitalized software as a result of its
decision to abandon the billing system which had been intended as a new
company-wide billing system. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations of Quest Diagnostics." There
can be no assurance that Quest Diagnostics' operations will be profitable in
the future.
Billing. Quest Diagnostics' billings have been hampered by both the
industry-wide phenomenon of frequently missing or incorrect billing
information and increasingly stringent payor requirements, as well as the
existence of multiple billing information systems which have resulted in
large part from Quest Diagnostics' growth through acquisitions. Quest
Diagnostics' standard billing system has been implemented in seven of its 22
billing sites, which seven sites account for 35% of Quest Diagnostic's net
revenues. Quest Diagnostics is beginning to convert the remaining
non-standard billing systems to the standard SYS system. See "Business of
Quest Diagnostics--Information Systems" and "Business of Quest
Diagnostics--Billing." Standardizing its billing systems presents conversion
risk to Quest Diagnostics as key databases
36
<PAGE>
and masterfiles are transferred to the SYS system and because the billing
workflow is interrupted during the conversion, which may cause backlogs.
Professional Liability Litigation. As a general matter, providers of
clinical laboratory testing services may be subject to lawsuits alleging
negligence or other similar legal claims, which suits could involve claims
for substantial damages. Damages assessed in connection with, and the costs
of defending any such actions could be substantial. Litigation could also
have an adverse impact on Quest Diagnostics' client base. Quest Diagnostics
maintains liability insurance (subject to maximum limits and self-insured
retentions) for professional liability claims. This insurance does not cover
liability for any of the investigations described under "--Government
Investigations and Related Claims" and "Business of Quest
Diagnostics--Government Investigations and Related Claims." While there can
be no assurance, Quest Diagnostics management believes that the levels of
coverage are adequate to cover currently estimated exposures. Although Quest
Diagnostics believes that it will be able to obtain adequate insurance
coverage in the future at acceptable costs, there can be no assurance that
Quest Diagnostics will be able to obtain such coverage or will be able to do
so at an acceptable cost or that Quest Diagnostics will not incur significant
liabilities in excess of policy limits.
Absence of Dividends; Restrictions on Dividends Imposed by the Quest
Diagnostics Credit Facility and the Indenture. It is currently contemplated
that, following the Distributions, Quest Diagnostics will not pay cash
dividends on the Quest Diagnostics Common Stock in the foreseeable future,
but will retain earnings to provide funds for the operation and expansion of
its business. In addition, the Quest Diagnostics Credit Facility prohibits
Quest Diagnostics from paying cash dividends on the Quest Diagnostics Common
Stock. Further, the Indenture under which the Notes will be issued will
restrict Quest Diagnostics' ability to pay cash dividends based on a
percentage of Quest Diagnostics' cash flow. See "Description of Certain
Indebtedness of Quest Diagnostics" and "Description of Quest Diagnostics
Capital Stock."
Potential Liability under the Spin-Off Tax Indemnification
Agreements. Quest Diagnostics will enter into the Corning/Quest Diagnostics
Spin-Off Tax Indemnification Agreement that will prohibit Quest Diagnostics
for a period of two years after the Distribution Date from taking certain
actions, including a sale of 50% or more of the assets of Quest Diagnostics
or engaging in certain equity or financing transactions, that might
jeopardize the favorable tax treatment of the Distributions under Code
section 355 and will provide Corning with certain rights of indemnification
against Quest Diagnostics. Quest Diagnostics may also have indemnification
obligations under the Spin-Off Tax Indemnification Agreements in the case of
the acquisition of, or tender or purchase offer by another person for, 20% or
more of the outstanding Quest Diagnostics Common Stock. The Corning/Quest
Diagnostics Spin- Off Tax Indemnification Agreement will also require Quest
Diagnostics to take such actions as Corning may reasonably request to
preserve the favorable tax treatment provided for in any rulings obtained
from the IRS in respect of the Distributions. Quest Diagnostics and Covance
will enter into the Covance/Quest Diagnostics Spin-Off Tax Indemnification
Agreement, that will be essentially the same as the Corning/Quest Diagnostics
Spin-Off Tax Indemnification except that Quest Diagnostics will make
representations to and indemnify Covance as opposed to Corning. If
obligations of Quest Diagnostics under either agreement were breached and
primarily as a result thereof the Distributions do not receive favorable tax
treatment under Code section 355, Quest Diagnostics would be required to
indemnify Corning or Covance, as the case may be, for Taxes imposed and such
indemnification obligations could exceed the net asset value of Quest
Diagnostics at such time. See "The Relationship Among Corning, Quest
Diagnostics and Covance After the Distributions--Spin-Off Tax Indemnification
Agreements."
Absence of a Prior Public Market. Prior to the Distributions, there has
been no public market for the Quest Diagnostics Common Stock. Although it is
expected that the Quest Diagnostics Common Stock will be approved for listing
on the NYSE, there is no existing market for the Quest Diagnostics Common
Stock and there can be no assurance as to the liquidity of any markets that
may develop, the ability of Quest Diagnostics stockholders to sell their
shares of Quest Diagnostics Common Stock or at what price Quest Diagnostics
stockholders will be able to sell their shares of Quest Diagnostics Common
Stock. Future trading prices will depend on many factors including, among
other things, prevailing interest rates, Quest Diagnostics' operating results
and the market for similar securities.
Potential Volatility of Stock Price. The market price of Quest Diagnostics
Common Stock could be subject to wide fluctuations in response to seasonal
variations in operating results, changes in earnings estimates by analysts,
market conditions in the clinical laboratory industry, prospects for health
care reform, changes in government regulation and general economic
conditions. In addition, the stock market has from time to time experienced
37
<PAGE>
significant price and volume fluctuations that have been unrelated to the
operating performance of particular companies. Moreover, Quest Diagnostics
Common Stock could be subject to wide fluctuations for some time after the
Distributions as a result of heavy trading volume stemming from sales by
shareholders of Corning Common Stock who decide not to continue owning Quest
Diagnostics Common Stock. Certain of such sales may include those to be made
on behalf of investment plans maintained for the benefit of Corning
employees. These plans currently hold slightly less than 5% of the
outstanding Corning Common Stock and, as a result of the Distributions, are
expected to hold a similar percentage of the Quest Diagnostics Common Stock.
From time to time as market conditions warrant, and as the administrator of
the plans believes to be in the best interests of the employee beneficiaries,
the administrator will sell all of the Quest Diagnostics Common Stock held by
the plans. Such sales are expected to occur within a period of three years
after the Distribution Date. See "Security Ownership by Certain Beneficial
Owners and Management of Quest Diagnostics." These market fluctuations could
have an adverse effect on the market price of Quest Diagnostics Common Stock.
Quest Diagnostics stockholders should be aware, and must be willing to bear
the risk, of such fluctuations in earnings and stock price.
Dependence on Key Employees. Quest Diagnostics' affairs are managed by a
small number of key management personnel, the loss of any of whom could have
an adverse impact on Quest Diagnostics. There can be no assurance that Quest
Diagnostics can retain its key managerial and technical employees or that it
can attract, assimilate or retain other skilled technical personnel in the
future. See "Business of Quest Diagnostics--Recent Organizational Changes"
and "Management of Quest Diagnostics."
Certain Antitakeover Effects. Quest Diagnostics' amended and restated
certificate of incorporation (the "Quest Diagnostics Certificate") and
by-laws (the "Quest Diagnostics By-Laws"), and the Delaware General
Corporation Law ("DGCL"), contain several provisions that could have the
effect of delaying, deferring or preventing a change in control of Quest
Diagnostics in a transaction not approved by the board of directors of Quest
Diagnostics (the "Quest Diagnostics Board"), or, in certain circumstances, by
the disinterested members of the Quest Diagnostics Board. In addition, an
acquisition of certain securities or assets of Quest Diagnostics within two
years after the Distribution Date might jeopardize the tax treatment of the
Distributions and could result in Quest Diagnostics being required to
indemnify Corning and Covance. See "--Potential Liability under the Spin-Off
Tax Indemnification Agreements" and "Antitakeover Effects of Certain
Provisions of the Quest Diagnostics Certificate of Incorporation and
By-Laws."
38
<PAGE>
CAPITALIZATION OF QUEST DIAGNOSTICS
The following table sets forth Quest Diagnostics' capitalization as of
September 30, 1996 giving effect to (i) the consummation of the Quest
Diagnostics Notes Offering and the estimated initial borrowings under the
Quest Diagnostics Credit Facility, (ii) the Distributions and (iii) the Quest
Diagnostics Accounting Policy Change (as defined below), as if such
transactions occurred on such date. This table should be read in conjunction
with the Quest Diagnostics Financial Statements and notes thereto and the
Quest Diagnostics Pro Forma Financial Information (as defined below) and
notes thereto included elsewhere herein. Historical combined and pro forma
combined financial information may not be indicative of Quest Diagnostics'
future capitalization as an independent company. See "Management's Discussion
and Analysis of Financial Condition and Results of Operations of Quest
Diagnostics" and "Business of Quest Diagnostics."
<TABLE>
<CAPTION>
Pro Forma
Historical Adjustments Pro Forma
---------- ------------ -------------
(in thousands)
<S> <C> <C> <C>
Cash $ 48,319 $ (8,319)(a) $ 40,000
========== ======== =========
Short-term Debt:
Current portion of long-term debt $ 11,885 $ (10,000)(b) $ 1,885(h)
Revolving credit facility (c)
---------- -------- ---------
Total Short-term Debt $ 11,885 $ (10,000) $ 1,885
========== ======== =========
Long-term Debt:
Term loans $ 15,494 $ 350,000 (b) $ 365,494(h)
Notes 150,000 (b) 150,000
Payable to Corning 1,204,406 (8,319)(a)
(447,669)(b)
(748,418)(d)
---------- --------- ---------
Total Long-term Debt 1,219,900 (704,406) 515,494
---------- --------- ---------
Stockholder's Equity:
Contributed capital 297,823 748,418 (d)
11,250 (e)
150,000 (f) 1,207,491
Accumulated deficit (163,158) (13,239)(e)
(425,000)(g) (601,397)
Cumulative translation adjustment. 1,801 1,801
Market valuation adjustment (3,796) (3,796)
---------- --------- ---------
Total Stockholder's Equity 132,670 471,429 604,099
---------- --------- ---------
Total Capitalization $1,352,570 $ (232,977) $1,119,593
========== ========= =========
</TABLE>
(a) Historically, Quest Diagnostics has participated in Corning's centralized
treasury and cash management processes. Cash received from operations was
generally transferred to Corning on a daily basis. Cash disbursements for
operations and investments were funded as needed from Corning. The cash
balance at the Distribution Date will range from $30 million to $40
million. The pro forma adjustment to cash and payable to Corning
represents the reduction to bring cash to the Distribution Date range.
(b) The pro forma adjustment to current portion of long-term debt, term
loans, Notes, and payable to Corning reflects borrowings by Quest
Diagnostics, immediately prior to the Quest Diagnostics Spin-Off
Distribution, to repay Corning for certain income tax liabilities and
intercompany borrowings. The assumed interest rates on these borrowings
are 7.50% and 11.50% for the Quest Diagnostics Credit Facility and the
Notes, respectively.
(c) The Quest Diagnostics Credit Facility will include a revolving credit
facility of $100 million which can be used to fund working capital and
investment activities. Quest Diagnostics management believes that the
entire revolving credit facility will be available at the Distribution
Date.
(d) The pro forma adjustment to payable to Corning and contributed capital of
$748.4 million reflects Corning's capital contribution to Quest
Diagnostics of the estimated remaining intercompany borrowings.
(e) The pro forma adjustment to contributed capital and accumulated deficit
represents costs directly related to the Quest Diagnostics Spin-Off
Distribution that Quest Diagnostics expects to record coincident with the
Quest Diagnostics Spin-Off Distribution. These costs, which are estimated
at $20.2 million ($13.2 million after tax), include approximately $9.0
million related to professional advisory and financing commitment fees
and $11.2 million related to the establishment of an employee stock
ownership plan. This amount is subject to change based on the market
price of the Quest Diagnostics Common Stock on the Distribution Date.
(f) The pro forma adjustment to contributed capital represents the estimated
capital contribution related to Corning's indemnification under the
Transaction Agreement. See "The Relationship Among Corning, Quest
Diagnostics and Covance After the Distributions--Transaction Agreement."
As a result of funding settled claims, primarily the Damon settlement of
$119 million, the receivable from Corning is estimated to approximate $25
million at the Distribution Date.
(g) Coincident with the Quest Diagnostics Spin-Off Distribution, Quest
Diagnostics will adopt a new accounting policy for evaluating and
measuring the recoverability of intangible assets based on a fair value
approach (the "Quest Diagnostics Accounting Policy Change"). The pro
forma adjustment to accumulated deficit represents the estimated impact
of the Quest Diagnostics Accounting Policy Change. Quest Diagnostics
management estimates the charge to reduce the carrying value of
intangible assets to fair value will be in the range of $400 million to
$450 million. The midpoint of the range has been utilized for the
preparation of the Unaudited Pro Forma Combined Balance Sheet.
(h) The current portion of long-term debt and the term loans, exclusive of
the pro forma adjustment, consists primarily of a mortgage note payable
and capital lease obligations.
39
<PAGE>
SELECTED HISTORICAL FINANCIAL DATA OF QUEST DIAGNOSTICS
The following table presents selected historical financial data of Quest
Diagnostics at the dates and for each of the periods indicated. The selected
financial data as of and for each of the years ended December 31, 1995, 1994
and 1993 have been derived from the audited combined financial statements of
Quest Diagnostics (the "Audited Quest Diagnostics Financial Statements") and
the notes thereto included elsewhere herein. The selected financial data as
of and for the three and nine months ended September 30, 1996 and 1995 (the
"Quest Diagnostics Interim Financial Statements" and, together with the
Audited Quest Diagnostics Financial Statements, the "Quest Diagnostics
Financial Statements") and the years ended December 31, 1992 and 1991 have
been derived from the unaudited combined financial statements of Quest
Diagnostics. In the opinion of management, the unaudited combined financial
statements include all adjustments, consisting only of normal recurring
adjustments, that are necessary for a fair presentation of the financial
position and results of operations for these periods. The unaudited interim
results of operations for the three and nine months ended September 30, 1996
are not necessarily indicative of the results for the entire year ending
December 31, 1996.
The selected financial data should be read in conjunction with the Quest
Diagnostics Financial Statements and notes thereto, and the Quest Diagnostics
Pro Forma Financial Information and notes thereto included elsewhere herein.
Historical combined financial data may not be indicative of Quest
Diagnostics' future performance as an independent company. See the Quest
Diagnostics Financial Statements and notes thereto and Quest Diagnostics Pro
Forma Financial Information. See also "Management's Discussion and Analysis
of Financial Condition and Results of Operations of Quest Diagnostics" and
"Business of Quest Diagnostics."
40
<PAGE>
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------------- -----------------------------
1996 1995 1996 1995
------------- ----------- ------------ -------------
(in thousands, except percentage data)
<S> <C> <C> <C> <C>
Statement of Operations Data:
Net revenues $ 405,352 $ 399,959 $1,231,290 $1,239,474
Costs and expenses:
Cost of services 255,390 240,868 768,809 735,984
Selling, general and administrative 125,190 181,346(b) 371,439 399,635(b)
Provision for restructuring and other
special charges(c) 155,730 201,730 45,885
Interest expense, net 19,866 20,927 59,887 61,529
Amortization of intangible assets 10,328 11,293 31,772 33,678
Other, net 1,837 1,930 (198) 4,429
-------- -------- -------- --------
Total 568,341 456,364 1,433,439 1,281,140
-------- -------- -------- --------
Income (loss) before taxes (162,989) (56,405) (202,149) (41,666)
Income tax expense (benefit) (43,553) (17,810) (43,280) (3,642)
-------- -------- -------- --------
Income (loss) before cumulative effect
of change in accounting principle (119,436) (38,595) (158,869) (38,024)
Cumulative effect of change in
accounting principle
-------- -------- -------- --------
Net income (loss) $ (119,436) $ (38,595) $ (158,869) $ (38,024)
======== ======== ======== ========
Balance Sheet Data (at end of period):
Cash $ 48,319 $ 46,908 $ 48,319 $ 46,908
Working capital 114,718 129,319 114,718 129,319
Total assets 1,886,378 1,896,058 1,886,378 1,896,058
Long-term debt 1,219,900 1,114,367 1,219,900 1,114,367
Total debt 1,231,785 1,226,211 1,231,785 1,226,211
Stockholder's equity 132,670 320,576 132,670 320,576
Ratio of earnings to fixed charges -- (d) -- (d) -- (d) -- (d)
Supplemental Data:
Net cash provided by operating
activities $ 25,236 $ 38,202 $ 41,937 $ 53,789
Net cash used in investing activities (7,904) (17,044) (53,097) (77,911)
Net cash provided by (used in)
financing activities (6,618) (18,006) 23,033 32,311
EBITDA(e) $ (118,123)(f) $ (9,910)(b) $ (67,030)(f) $ 95,899(b)
EBITDA as a % of net revenues (29.1)% (2.5)% (5.4)% 7.7%
Adjusted EBITDA(g) $ 37,607 $ (9,910)(b) $ 134,700 $ 141,784(b)
Adjusted EBITDA as a % of net revenues 9.3% (2.5)% 10.9% 11.4%
</TABLE>
(Footnotes on page 43)
41
<PAGE>
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------------------------------------------------------
1995 1994(a) 1993 1992 1991
----------- ----------- ----------- ----------- --------
(in thousands, except percentage data)
<S> <C> <C> <C> <C> <C>
Statement of Operations
Data:
Net revenues $1,629,388 $1,633,699 $1,416,338 $1,228,964 $941,116
Costs and expenses:
Cost of services 980,232 969,844 805,729 657,354 553,810
Selling, general and
administrative 523,271(b) 411,939 363,579 334,665 193,934
Provision for
restructuring and other
special charges(c) 50,560 79,814 99,600 13,000
Interest expense, net 82,016 63,295 41,898 31,775 14,205
Amortization of
intangible assets 44,656 42,588 28,421 21,359 16,556
Other, net 6,221 3,464 6,423 16,300 6,636
--------- --------- --------- --------- -------
Total 1,686,956 1,570,944 1,345,650 1,074,453 785,141
--------- --------- --------- --------- -------
Income (loss) before taxes (57,568) 62,755 70,688 154,511 155,975
Income tax expense
(benefit) (5,516) 34,410 25,929 52,115 52,128
--------- --------- --------- --------- -------
Income (loss) before
cumulative effect of
change in accounting
principle (52,052) 28,345 44,759 102,396 103,847
Cumulative effect of
change in accounting
principle (10,562)
--------- --------- --------- --------- -------
Net income (loss) $ (52,052) $ 28,345 $ 34,197 $ 102,396 $103,847
========= ========= ========= ========= =======
Balance Sheet Data
(at end of period):
Cash $ 36,446 $ 38,719 $ 39,410 $ 20,528 $ 24,068
Working capital 200,740 214,358 139,771 161,759 126,406
Total assets 1,853,385 1,882,663 1,861,162 1,024,806 764,087
Long-term debt 1,195,566 1,153,054 1,025,787 431,624 270,682
Total debt 1,207,714 1,165,626 1,123,307 474,175 287,973
Stockholder's equity 295,801 386,812 395,509 408,149 291,973
Ratio of earnings to fixed
charges -- (d) 1.77(d) 2.20(d) 4.44(d) 5.83(d)
Supplemental Data:
Net cash provided by
operating activities $ 85,828 $ 37,963 $ 99,614 $ 101,077 $ -- (h)
Net cash used in
investing activities (93,087) (46,186) (473,687) (203,884) -- (h)
Net cash provided by
(used in)financing
activities 4,986 7,532 392,956 99,267 -- (h)
EBITDA (e) $ 125,961(b) $ 215,567 $ 179,065 $ 242,527 $213,593
EBITDA as a % of net
revenues 7.7% 13.2% 12.6% 19.7% 22.7%
Adjusted EBITDA(g) $ 176,521(b) $ 295,381 $ 278,665 $ 255,527 $213,593
Adjusted EBITDA as a % of
net revenues 10.8% 18.1% 19.7% 20.8% 22.7%
</TABLE>
(Footnotes on page 43)
42
<PAGE>
(Footnotes for preceding pages)
(a) In August 1993, Quest Diagnostics acquired Damon, a national
clinical-testing laboratory with approximately $280 million in annualized
revenues, excluding Damon's California-based laboratories, which were
sold in April 1994. In November 1993, Quest Diagnostics acquired certain
clinical-testing laboratories of Unilab Corporation ("Unilab"), with
approximately $90 million in annualized revenues. The Damon and Unilab
acquisitions were accounted for as purchases. Quest Diagnostics acquired
Maryland Medical Laboratory, Inc. ("MML"), Nichols and Bioran Medical
Laboratory ("Bioran") in June, August and October 1994, respectively, and
accounted for these acquisitions as poolings of interest. Results
presented include the results of Quest Diagnostics, MML, Nichols and
Bioran on a pooled basis. The increase in 1994 net revenues compared to
1993 net revenues was primarily due to the Damon and Unilab acquisitions.
(b) Includes a third quarter 1995 charge of $62.0 million to increase the
reserve for doubtful accounts and allowances resulting from billing
systems implementation and integration problems at certain laboratories
and increased regulatory requirements.
(c) Provision for restructuring and other special charges includes charges
for restructurings primarily for work force reduction programs, the
write-off of fixed assets and the costs of exiting a number of leased
facilities. Other special charges is primarily comprised of settlement
reserves for claims related to billing practices. See Note 5 to the
Audited Quest Diagnostics Financial Statements and Notes 2 and 3 to the
Quest Diagnostics Interim Financial Statements.
(d) For purposes of this calculation, earnings consist of pretax income from
continuing operations plus fixed charges. Fixed charges consist of
interest expense and one-third of rental expense, representing that
portion of rental expense deemed representative of the interest factor.
Earnings were insufficient to cover fixed charges by the following
amounts (in thousands):
<TABLE>
<CAPTION>
<S> <C> <C> <C> <C> <C>
Three months Ended Nine months Ended
September 30, September 30, Year Ended December 31,
------------------ ------------------- -----------------------
1996 1995 1996 1995 1995
$162,989 $56,405 $202,149 $41,666 $57,568
</TABLE>
(e) EBITDA represents income (loss) before income taxes plus net interest
expense and depreciation and amortization. EBITDA is presented and discussed
since management believes that EBITDA is a useful adjunct to net income and
other measurements under generally accepted accounting principles 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. EBITDA is not a measure of financial
performance under generally accepted accounting principles 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.
(f) 1996 EBITDA includes charges of $142 million and $188 million for the
three months and nine months ended September 30, 1996, respectively,
related to charges to establish additional reserves for settlement
issues. In October 1996, Corning contributed $119 million to Quest
Diagnostics' capital to fund the settlement of billing issues related to
Damon and has agreed to indemnify Quest Diagnostics against certain
related and similar claims pending at the Distribution Date.
(g) Adjusted EBITDA represents income (loss) before income taxes plus net
interest expense, depreciation and amortization and restructuring and other
special charges. EBITDA and Adjusted EBITDA include bad debt expense.
Adjusted EBITDA is presented and discussed because management believes that
Adjusted EBITDA is a useful adjunct to net income and other measurements
under generally accepted accounting principles 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 generally accepted accounting principles 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.
(h) 1991 cash flow data, on a basis restated for poolings, is not available.
43
<PAGE>
PRO FORMA FINANCIAL INFORMATION OF QUEST DIAGNOSTICS
The unaudited pro forma combined statements of operations for the three
and nine months ended September 30, 1996 and for the year ended December 31,
1995 present the results of operations of Quest Diagnostics assuming that the
Distributions and the Quest Diagnostics Accounting Policy Change had been
completed as of January 1, 1995. The unaudited pro forma combined balance
sheet as of September 30, 1996 presents the combined financial position of
Quest Diagnostics assuming that the Distributions and the Quest Diagnostics
Accounting Policy Change had been completed on that date. In the opinion of
Quest Diagnostics management, the unaudited pro forma combined financial
information for the year ended December 31, 1995 and the three and nine
months ended September 30, 1996 (the "Quest Diagnostics Pro Forma Financial
Information") includes all material adjustments necessary to restate Quest
Diagnostics' historical results. The adjustments required to reflect such
assumptions are described in the Notes to the Quest Diagnostics Pro Forma
Financial Information and are set forth in the "Pro Forma Adjustments"
column.
The Quest Diagnostics Pro Forma Financial Information should be read in
conjunction with the Quest Diagnostics Financial Statements and notes thereto
included elsewhere herein. The Quest Diagnostics Pro Forma Financial
Information presented is for informational purposes only and may not
necessarily reflect the future results of operations or financial position or
what the results of operations or financial position would have been had the
Distributions and the Quest Diagnostics Accounting Policy Change occurred as
assumed herein, or had Quest Diagnostics been operated as an independent
company during the periods shown.
44
<PAGE>
QUEST DIAGNOSTICS INCORPORATED
UNAUDITED PRO FORMA COMBINED STATEMENT OF OPERATIONS
Three Months Ended September 30, 1996
<TABLE>
<CAPTION>
Pro Forma
Historical Adjustments Pro Forma
---------- ---------- ---------------
(in thousands,
except share and per share data)
<S> <C> <C> <C>
Net revenues $ 405,352 $ $ 405,352
Costs and expenses
Cost of services 255,390 255,390
Selling, general and administrative 125,190 0 (a) 125,190
Provision for restructuring and other
special charges 155,730 155,730
Interest expense, net 19,866 (7,677)(b) 12,189
Amortization of intangible assets 10,328 (2,656)(c) 7,672
Other, net 1,837 1,837
-------- -------- ---------
Loss before taxes (162,989) 10,333 (152,656)
Income tax (benefit) provision (43,553) 3,032 (d) (40,521)
-------- -------- ---------
Net loss $(119,436) $ 7,301 $ (112,135)
======== ======== =========
Pro forma shares outstanding 28,901,735 (e)
=========
Pro forma net loss per share $ (3.88)(f)
=========
</TABLE>
The accompanying notes to unaudited pro forma combined financial information
are an integral part hereof.
45
<PAGE>
QUEST DIAGNOSTICS INCORPORATED
UNAUDITED PRO FORMA COMBINED STATEMENT OF OPERATIONS
Nine Months Ended September 30, 1996
<TABLE>
<CAPTION>
Pro Forma
Historical Adjustments Pro Forma
---------- ----------- ---------------
(in thousands, except share and per share
data)
<S> <C> <C> <C>
Net revenues $1,231,290 $ $ 1,231,290
Costs and expenses
Cost of services 768,809 768,809
Selling, general and administrative 371,439 0 (a) 371,439
Provision for restructuring and other special
charges 201,730 201,730
Interest expense, net 59,887 (22,949)(b) 36,938
Amortization of intangible assets 31,772 (7,969)(c) 23,803
Other, net (198) (198)
-------- ------- ---------
Loss before taxes (202,149) 30,918 (171,231)
Income tax (benefit) provision (43,280) 9,065 (d) (34,215)
-------- ------- ---------
Net loss $ (158,869) $ 21,853 $ (137,016)
======== ======= =========
Pro forma shares outstanding 28,901,735 (e)
=========
Pro forma net loss per share $ (4.74)(f)
=========
</TABLE>
The accompanying notes to unaudited pro forma combined financial information
are an integral part hereof.
46
<PAGE>
QUEST DIAGNOSTICS INCORPORATED
UNAUDITED PRO FORMA COMBINED STATEMENT OF OPERATIONS
Year Ended December 31, 1995
<TABLE>
<CAPTION>
Pro Forma
Historical Adjustments Pro Forma
---------- ----------- ---------------
(in thousands, except share
and per share data)
<S> <C> <C> <C>
Net revenues $1,629,388 $ $ 1,629,388
Costs and expenses
Cost of services 980,232 980,232
Selling, general and administrative 523,271 0 (a) 523,271
Provision for restructuring and other special
charges 50,560 50,560
Interest expense, net 82,016 (31,268)(b) 50,748
Amortization of intangible assets 44,656 (10,625)(c) 34,031
Other, net 6,221 6,221
--------- ------- ---------
Loss before taxes (57,568) 41,893 (15,675)
Income tax (benefit) provision (5,516) 12,351(d) 6,835
--------- ------- ---------
Net loss $ (52,052) $ 29,542 $ (22,510)
========= ======= =========
Pro forma shares outstanding 28,901,735 (e)
=========
Pro forma net loss per share $ (0.78)(f)
=========
</TABLE>
The accompanying notes to unaudited pro forma combined financial information
are an integral part hereof.
47
<PAGE>
QUEST DIAGNOSTICS INCORPORATED
UNAUDITED PRO FORMA COMBINED BALANCE SHEET
September 30, 1996
<TABLE>
<CAPTION>
Pro Forma
Historical Adjustments Pro Forma
---------- ------------ ------------
(in thousands)
<S> <C> <C> <C>
ASSETS
Current Assets:
Cash and cash equivalents $ 48,319 $ (8,319)(g) $ 40,000
Accounts receivable 323,171 323,171
Inventories 25,559 25,559
Deferred taxes on income 126,906 9,400 (h) 136,306
Due from Corning Incorporated 150,000 (i) 150,000
Prepaid expenses and other assets 25,217 25,217
--------- --------- ---------
Total current assets 549,172 151,081 700,253
Property, plant and equipment, net 293,490 293,490
Intangible assets, net 1,001,500 (425,000)(j) 576,500
Other assets 42,216 42,216
--------- --------- ---------
TOTAL ASSETS $1,886,378 $ (273,919) $1,612,459
========= ========= =========
LIABILITIES AND STOCKHOLDER'S EQUITY
Current Liabilities:
Accounts payable and accrued expenses $ 374,058 $ 9,000 (k) $ 383,058
Current portion of long-term debt 11,885 (10,000)(h) 1,885
Income taxes payable 34,212 (18,632)(h)
(7,011)(k) 8,569
Due to Corning Incorporated and affiliates 14,299 (14,299) (h)
--------- --------- ---------
Total current liabilities 434,454 (40,942) 393,512
Long-term debt, third-party 15,494 500,000 (h) 515,494
Payable to Corning 1,204,406 (8,319)(g)
(447,669)(h)
(748,418))(l)
Other liabilities 99,354 99,354
--------- --------- ---------
Total liabilities 1,753,708 (745,348) 1,008,360
--------- --------- ---------
Stockholder's Equity:
Contributed capital 297,823 150,000 (i)
11,250 (k)
748,418 (l) 1,207,491
Accumulated deficit (163,158) (425,000)(j)
(13,239)(k) (601,397)
Cumulative translation adjustment 1,801 1,801
Market valuation adjustment (3,796) (3,796)
--------- --------- ---------
Total stockholder's equity 132,670 471,429 604,099
--------- --------- ---------
TOTAL LIABILITIES
AND STOCKHOLDER'S EQUITY $1,886,378 $ (273,919) $1,612,459
========= ========= =========
</TABLE>
The accompanying notes to unaudited pro forma combined financial information
are an integral part hereof.
48
<PAGE>
QUEST DIAGNOSTICS INCORPORATED
NOTES TO UNAUDITED PRO FORMA COMBINED FINANCIAL INFORMATION
Statements of Operations
(a) The historical financial statements include substantially all of the
costs incurred by Corning on Quest Diagnostics' behalf and reflect all of
its costs of doing business. Quest Diagnostics management does not expect
administrative costs to increase as a result of being an independent,
public company.
(b) The pro forma adjustment to interest expense, net represents the
difference between historical intercompany interest expense and interest
expense on the third party debt to be incurred in connection with the
Quest Diagnostics Spin- Off Distribution. Quest Diagnostics will borrow,
immediately prior to the Quest Diagnostics Spin-Off Distribution,
approximately $500 million in long-term debt to repay Corning for certain
intercompany borrowings. The debt is assumed to consist of $350 million
of borrowings under the Quest Diagnostics Credit Facility and $150
million of Notes to be issued under the Quest Diagnostics Notes Offering.
The assumed interest rates on these new borrowings are 7.50% and 11.50%
for the Quest Diagnostics Credit Facility and the Notes, respectively. If
the interest rate on the Quest Diagnostics Credit Facility fluctuates by
1/8%, interest expense fluctuates by approximately $440,000 annually.
Depending on market conditions at the time of the Quest Diagnostics Notes
Offering and the consummation of the Quest Diagnostics Credit Facility,
the total combined debt amount, the interest rates, and the amounts of
each of the Quest Diagnostics Credit Facility and the Notes may vary from
that indicated herein.
(c) The pro forma adjustment to amortization of intangible assets represents
the estimated reduction of amortization expense due to the Quest
Diagnostics Accounting Policy Change. Most of Quest Diagnostics'
intangible assets resulted from business combinations in 1993 accounted
for as purchases. Significant changes in the clinical laboratory and
health care industries subsequent to 1993 have caused the fair value of
Quest Diagnostics' intangible assets to be significantly less than their
carrying value. Quest Diagnostics management believes that a valuation of
intangible assets based on the amount for which each regional laboratory
could be sold in an arm's-length transaction is preferable to using
projected undiscounted pre-tax cash flows. Quest Diagnostics believes
fair value is a better indicator of the extent to which the intangible
assets may be recoverable and therefore may be impaired. Quest
Diagnostics management estimates that the reduction of amortization
expense will approximate between $10.0 million and $11.3 million annually
and $2.5 million and $2.8 million quarterly. The midpoint of the range
has been utilized for the preparation of the Unaudited Pro Forma Combined
Statements of Operations.
(d) The pro forma adjustment to income tax (benefit) provision represents the
estimated income tax impact of the pro forma reduction in interest
expense at the incremental tax rate of 39.5%. The pro forma amortization
expense reduction will not impact income taxes as the amortization is not
deductible for tax purposes.
(e) The pro forma common shares outstanding represents Quest Diagnostics
management's current estimate of the number of shares to be outstanding
after the Quest Diagnostics Spin-Off Distribution. Management's estimate
includes (a) the issuance of approximately 28.0 million shares of Quest
Diagnostics Common Stock at an exchange ratio of one share of Quest
Diagnostics Common Stock issued for every eight shares of Corning Common
Stock outstanding at September 30, 1996 and (b) the issuance of an
estimated 900,000 shares into the employee stock ownership plan. Quest
Diagnostics management's estimate of shares outstanding is subject to
change as the result of normal issuances and repurchases of Corning
Common Stock prior to the date of the Quest Diagnostics Spin-Off
Distribution and finalization of the proposed structure of the employee
stock ownership plan.
(f) Pro forma net loss per share is computed by dividing net loss by the pro
forma shares outstanding during each period. Common stock equivalents are
not included in the loss per share computation because they do not result
in material dilution. Historical net loss per share data is not presented
as Quest Diagnostics' historical capital structure is not comparable to
periods subsequent to the Quest Diagnostics Spin-Off Distribution.
Balance Sheet
(g) Historically, Quest Diagnostics has participated in Corning's centralized
treasury and cash management processes. Cash received from operations was
generally transferred to Corning on a daily basis. Cash disbursements for
operations and investments were funded as needed from Corning. The cash
balance at the Distribution Date will range from $30 million to $40
million. The pro forma adjustment to cash and payable to Corning
represents the reduction to bring cash to the Distribution Date range.
49
<PAGE>
(h) The pro forma adjustment to deferred taxes on income, current portion of
long-term debt, income taxes payable, due to Corning Incorporated and
affiliates, long-term debt third party and payable to Corning reflects
borrowings by Quest Diagnostics, immediately prior to the Quest
Diagnostics Spin-Off Distribution, to repay Corning for certain income
tax liabilities and intercompany borrowings. The debt is assumed to
consist of $350 million of bank borrowings under the Quest Diagnostics
Credit Facility and $150 million of Notes to be issued under the Quest
Diagnostics Notes Offering.
(i) The pro forma adjustment to due from Corning Incorporated and contributed
capital represents the estimated receivable from Corning and capital
contribution related to Corning's indemnification obligations relating to
governmental claims under the Transaction Agreement. The receivable from
Corning is estimated to approximate $25 million at the Distribution Date.
The reduction from $150 million at September 30, 1996 to $25 million at
the Distribution Date is due to the funding by Corning of indemnified
claims, primarily the Damon settlement of $119 million, subsequent to
September 30, 1996 and before the Distribution Date. The remaining
receivable will be paid by Corning upon the settlement of the underlying,
indemnified claims which is expected to occur within the next twelve
months.
(j) The pro forma adjustment to intangible assets, net and accumulated
deficit represents the estimated impact of the Quest Diagnostics
Accounting Policy Change. Quest Diagnostics management estimates the
charge to reduce the carrying value of intangible assets to fair value
will be in the range of $400 million to $450 million. The midpoint of the
range has been utilized for the preparation of the Unaudited Pro Forma
Combined Balance Sheet. This charge has not been reflected in the
Unaudited Pro Forma Combined Statements of Operations because it is
non-recurring. See additional discussion on Quest Diagnostics' planned
change in accounting policy in note (c) above.
(k) The pro forma adjustment to accounts payable and accrued expenses, income
taxes payable, contributed capital and accumulated deficit represents
costs directly related to the Quest Diagnostics Spin-Off Distribution
that Quest Diagnostics expects to record coincident with the Quest
Diagnostics Spin-Off Distribution. These costs, which are estimated at
$20.2 million ($13.2 million after tax), include approximately $9 million
related to professional advisory and financing commitment fees and $11.2
million related to the establishment of an employee stock ownership plan.
This amount is subject to change based on the market price of the Quest
Diagnostics Common Stock on the Distribution Date. This charge has not
been reflected in the Unaudited Pro Forma Statements of Operations
because it is nonrecurring.
(l) The pro forma adjustment to payable to Corning and contributed capital of
$748.4 million reflects Corning's capital contribution to Quest
Diagnostics of the estimated remaining intercompany borrowings.
50
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS OF QUEST DIAGNOSTICS
Overview
In the last several years, Quest Diagnostics' business has been affected
by significant government regulation, price competition and rapid change
resulting from payors' efforts to control cost, utilization and delivery of
health care services. As a result of these factors, Quest Diagnostics'
profitability has been impacted by changes in the volume of testing, the
prices and costs of its services, the mix of payors and the level of bad debt
expense.
Payments for clinical laboratory services are made by government, managed
care organizations, insurance companies, physicians and patients. Increased
government regulation focusing on health care cost containment has reduced
prices and added costs for the clinical laboratory industry by increasing
complexity and adding new regulatory requirements. Also, in recent years
there has been a significant shift away from traditional fee-for- service
health care to managed health care, as employers and other payors of health
care costs aggressively move the populations they control into lower cost
plans. Managed care organizations typically negotiate capitated payment
contracts whereby Quest Diagnostics receives a fixed monthly fee per covered
individual for all services included under the contract. Capitated contract
arrangements shift the risks of additional routine testing beyond that
covered by the capitated payment to the clinical laboratory. The managed care
industry is growing as well as undergoing rapid consolidation which has
created large managed care companies that control the delivery of health care
services for millions of people, and have significant bargaining power in
negotiating fees with providers, including clinical laboratories. These
market factors have had a significant adverse impact on prices in the
clinical laboratory industry, and are major contributors to Quest
Diagnostics' decline in profitability over the last two years. This growth of
managed care and use of capitated agreements are expected to continue for the
foreseeable future. See "Risk Factors--Risks Relating to Quest
Diagnostics--Role of Managed Care" and "Business of Quest Diagnostics--
Effect of the Growth of the Managed Care Sector on the Clinical Laboratory
Business."
A substantial portion of Quest Diagnostics' growth has come from
acquisitions in the last four years. The largest of these acquisitions were
the purchases of Damon and certain operations of Unilab in 1993 and the
acquisitions of MML, Nichols Institute and Bioran in 1994. As a result of
these acquisitions, Quest Diagnostics has recorded a number of special
charges for restructuring and integration costs since 1993. See Note 5 to the
Audited Quest Diagnostics Financial Statements.
The MML, Nichols Institute and Bioran transactions were accounted for as
poolings of interests. The accompanying financial statements of Quest
Diagnostics have been restated to include the results of operations of these
pooled entities on a combined basis for all periods presented. The results of
operations for Damon and Unilab, as well as all other acquisitions accounted
for as purchases, have been included since their respective dates of
acquisition. Acquisitions accounted for as purchases have generated large
amounts of goodwill which are not deductible for tax purposes, giving rise to
a high effective income tax rate and increased sensitivity of the income tax
rate to changes in pre-tax income. See Note 4 to the Audited Quest
Diagnostics Financial Statements.
The clinical laboratory industry is subject to seasonal fluctuations in
operating results. Quest Diagnostics' cash flows are influenced by seasonal
factors. During the summer months, year-end holiday periods and other major
holidays, volume of testing declines, reducing net revenues and resulting
cash flows below annual averages during the third and fourth quarters of the
year. Winter months are also subject to declines in testing volume due to
inclement weather, which varies in severity from year to year.
The clinical laboratory industry is labor intensive. Approximately half of
Quest Diagnostics' total costs and expenses are associated with employee
compensation and benefits. Cost of services, which have approximated sixty
percent of net revenues over the past several years, consists principally of
costs for obtaining, transporting and testing specimens. Selling, general and
administrative expenses consist principally of the cost of the sales force,
billing operations (including bad debt expense), and general management and
administrative support.
Results of Operations
Three Months Ended September 30, 1996 Compared with Three Months Ended
September 30, 1995. Earnings for the third quarter of 1996 were significantly
below those for the prior year due principally to the impact of special
51
<PAGE>
charges. Before special charges, earnings were significantly above the prior
year level, which included a $62 million charge to operations to increase
accounts receivable reserves.
Net Revenues
Net revenues increased by $5.4 million, or 1.3%, over the three months
ended September 30, 1995 due to increased revenues from Quest Diagnostics'
nonclinical testing businesses. Volume of clinical testing increased by 1.8%
but was offset by average price declines of 1.7%. The majority of the price
decline resulted from changes in reimbursement policies of various
third-party payors, shifts in volume to lower-priced managed care business
and intense price competition in the industry. Also contributing to the price
decline was a reduction in Medicare fee schedules effective January 1, 1996,
which accounted for approximately a 1% decrease in net revenues.
Costs and Expenses
Cost of services increased by $14.5 million from the prior period and as a
percentage of net revenues increased to 63.0% in 1996 from 60.2% in 1995.
These increases were due principally to the effects of declining prices and
increases in salaries and wages associated with improving customer service
levels, and wage adjustments.
Selling, general and administrative expense decreased by $56.2 million
from the prior period and as a percentage of revenues decreased to 30.9% in
1996 from 45.3% in 1995. These decreases were due principally to a reduction
in bad debt expense, which decreased by $55.3 million, from $85.8 million to
$30.5 million, and as a percentage of net revenues decreased from 21.5% to
7.5%. The reduction in bad debt expense results primarily from the unusually
high level of bad debt expense in the prior year, which included a charge of
$62.0 million to increase receivables reserves. Quest Diagnostics has
established, and maintains, rigorous programs to improve the effectiveness of
Quest Diagnostics' billing and collection operations. The established
programs include standard policies and procedures, employee training programs
and regular reporting and tracking of key measures by senior management. The
implementation of these programs during the fourth quarter of 1995 has aided
in reducing bad debt expense. However, additional requirements to provide
documentation of the "medical necessity" of testing have added to the backlog
of unbilled receivables and caused third quarter 1996 bad debt expense as a
percentage of revenues to increase above the rate Quest Diagnostics had
experienced during the first two quarters of 1996. Additional efforts to
collect medical necessity documentation are currently being made and are
expected to lower bad debt expense below the 1996 third quarter rate during
1997. *
During the third quarter of 1996, Quest Diagnostics recorded a $142.0
million charge to establish additional reserves associated with government
and other claims primarily related to billing practices at certain
laboratories of Damon and Nichols prior to their acquisition by Quest
Diagnostics. Subsequent to the third quarter, Quest Diagnostics entered into
an agreement with the DOJ to pay $119.0 million to settle all federal and
Medicaid claims related to the billing by Damon of certain blood test series
for federally sponsored health care programs. This payment was fully reserved
as part of the third quarter charge. Quest Diagnostics' aggregate reserve
with respect to all governmental and nongovernmental claims, including
litigation costs, was $215 million at September 30, 1996, and is estimated to
be reduced to $85 million at the Distribution Date as a result of the payment
of settled claims, primarily the Damon settlement of $119.0 million. Although
management believes that established reserves for both indemnified and
non-indemnified claims are sufficient, it is possible that the final
resolution of these matters could be in excess of established reserves by an
amount which could be material to Quest Diagnostics's results of operations
and, for non-indemnified claims, Quest Diagnostics' cash flows in the periods
in which such claims are settled. Quest Diagnostics does not believe that
these matters will have a material adverse effect on Quest Diagnostics'
overall financial condition. See "Risk Factors--Risks Relating to Quest
Diagnostics--Government Investigations and Related Claims" and "Business of
Quest Diagnostics--Government Investigations and Related Claims."
Additionally, in the third quarter Quest Diagnostics recorded a charge of
$13.7 million to write off capitalized software as a result of its decision
to abandon the billing system which had been intended as its company-wide
billing system. Management now plans to standardize billing systems using a
system already implemented in seven of its sites. See "Risk Factors--Risks
Relating to Quest Diagnostics--Billing," "Business of Quest Diagnostics--
Information Systems" and "Business of Quest Diagnostics--Billing" and Note 3
to the Quest Diagnostics Interim Financial Statements.
* This is a forward looking statement and is based on current expectations.
Actual results may vary materially from those projected. See "Business of
Quest Diagnostics--Important Factors Regarding Forward Looking Statements."
In particular see factors (c), (d), (j) and (k).
52
<PAGE>
Net interest expense declined from the prior year's level due to lower
average borrowings during 1996. Amortization of intangible assets decreased
below the prior year's level due to certain intangible assets having been
fully amortized.
Quest Diagnostics' effective tax rate is significantly impacted by
goodwill amortization which is not deductible for tax purposes and which had
the effect of decreasing the tax benefit rate for the third quarter of 1996.
Nine Months Ended September 30, 1996 Compared with Nine Months Ended
September 30, 1995. Earnings were substantially below those for the prior
year due principally to special charges, price declines, increases in
salaries and wages, higher bad debt expense, and unusually severe winter
weather experienced during the first quarter of 1996.
Net Revenues
Net revenues decreased by $8.2 million, or .7%, from the prior period,
principally due to average price declines of approximately 3.4%, partially
offset by an increase in clinical testing of 1.2% and increased revenues from
Quest Diagnostics' nonclinical testing businesses. Adversely affecting the
volume growth was unusually severe winter weather in the northeastern and
central parts of the United States during the first quarter of 1996. The
majority of the price declines resulted from changes in reimbursement
policies of various third-party payors, shifts in volume to lower-priced
managed care business, and intense price competition in the industry. Also
contributing to the price declines was a reduction in Medicare fee schedules
effective January 1, 1996, which accounted for approximately a 1% decrease in
net revenues.
Costs and Expenses
Cost of services increased by $32.8 million from the prior period and as a
percentage of net revenues increased to 62.4% in 1996 from 59.4% in 1995.
These increases were due principally to the effects of declining prices and
increases in salaries and wages associated with improving customer service
levels, and wage adjustments.
Selling, general and administrative expense decreased by $28.2 million
from the prior period and as a percentage of net revenues decreased to 30.2%
in 1996 from 32.2% in 1995. These decreases were due principally to a
reduction in bad debt expense, which decreased, by $45.4 million, from $127.3
million to $81.9 million, and as a percentage of net revenues decreased from
10.3% to 6.7%, partially offset by costs associated with developing and
implementing strategic action plans and operating improvement plans. The
reduction in bad debt expense results primarily from the unusually high level
of bad debt expense in the prior year, which included a charge of $62.0
million to increase receivables reserves. Quest Diagnostics has established,
and maintains, rigorous programs to improve the effectiveness of Quest
Diagnostics' billing and collection operations. The established programs
include standard policies and procedures, employee training programs and
regular reporting and tracking of key measures by senior management. The
implementation of these programs during the fourth quarter of 1995 has aided
in reducing bad debt expense. However, additional requirements to provide
documentation of the "medical necessity" of testing have added to the backlog
of unbilled receivables and caused third quarter 1996 bad debt expense as a
percentage of revenues to increase above the rate Quest Diagnostics had
experienced during the first two quarters of 1996. Additional efforts to
collect medical necessity documentation are currently being made and are
expected to lower bad debt expense below the 1996 third quarter rate during
1997.*
In the second quarter of 1996, as a consequence of an investigation begun
in 1993, the DOJ notified Quest Diagnostics that it has taken issue with
payments related to certain tests received by Damon from federally funded
health care programs prior to the acquisition of Damon by Quest Diagnostics.
Quest Diagnostics management met with the DOJ several times to evaluate the
substance of the government's allegations. A special charge of $46.0 million
was recorded in the second quarter of 1996 to establish additional reserves
equal to management's estimate, at that time, of the low end of the range of
potential amounts which could be required to satisfy the government's claims.
During the third quarter of 1996 Quest Diagnostics recorded a $142.0 million
charge to establish additional reserves associated with government and other
claims primarily related to billing practices at certain laboratories of
Damon and Nichols prior to their acquisition by Quest Diagnostics. Subsequent
to the third quarter, Quest Diagnostics entered into an
* This is a forward looking statement and is based on current expectations.
Actual results may vary materially from those projected. See "Business of
Quest Diagnostics--Important Factors Regarding Forward Looking Statements."
In particular see factors (c), (d), (j) and (k).
53
<PAGE>
agreement with the DOJ to pay $119.0 million to settle all federal and
Medicaid claims related to the billing by Damon of certain blood test series
for federally sponsored health care programs. This payment was fully reserved
as part of the third quarter charge. Quest Diagnostics' aggregate reserve
with respect to all governmental and nongovernmental claims, including
litigation costs, was $215 million at September 30, 1996, and is estimated to
be reduced to $85 million at the Distribution Date as a result of the payment
of settled claims, primarily the Damon settlement of $119.0 million. Although
management believes that established reserves for both indemnified and
non-indemnified claims are sufficient, it is possible that the final
resolution of these matters could be in excess of established reserves by an
amount which could be material to Quest Diagnostics' results of operation
and, for non-indemnified claims, Quest Diagnostics' cash flows in the periods
in which such claims are settled. Quest Diagnostics does not believe that
these matters will have a material adverse effect on Quest Diagnostics'
overall financial condition. See "Risk Factors--Risks Relating to Quest
Diagnostics--Government Investigations and Related Claims" and "Business of
Quest Diagnostics--Government Investigations and Related Claims."
In the third quarter Quest Diagnostics recorded a charge of $13.7 million
to write off capitalized software as a result of its decision to abandon the
billing system which had been intended as its company-wide billing system.
Management now plans to standardize billing systems using a system already
implemented in seven of its sites. See "Risk Factors--Risks Relating to Quest
Diagnostics--Billing," "Business of Quest Diagnostics--Information Systems"
and "Business of Quest Diagnostics--Billing" and Note 3 to the Quest
Diagnostics Interim Financial Statements.
In the second quarter of 1995, Quest Diagnostics recorded a provision for
restructuring totalling $33 million primarily for work force reduction
programs and the costs of exiting a number of leased facilities.
Additionally, in the first quarter of 1995 Quest Diagnostics recorded a
special charge of $12.8 million for the settlement of claims related to the
inadvertent billing errors of certain laboratory tests that were not
completely and/or successfully performed or reported due to insufficient
samples and/or invalid results.
Net interest expense remained relatively unchanged from the prior year
level. Amortization of intangible assets decreased below the prior year level
due to certain intangible assets having been fully amortized. A gain on the
sale of several small investments and the favorable settlement of a
contractual obligation, both of which occurred in 1996, accounted for the
majority of the change in "other, net" compared to the prior year.
Quest Diagnostics' effective tax rate is significantly impacted by
goodwill amortization which is not deductible for tax purposes. This had the
effect of reducing the tax benefit rate of Quest Diagnostics in both 1996 and
1995. The effect of this non-deductibility is particularly apparent when
amortization increases in proportion to pre-tax earnings, as was the case in
1995.
Year Ended December 31, 1995 Compared with Year Ended December 31,
1994. Earnings for 1995 were significantly below those for the prior year as
a result of price declines, higher bad debt expense, and the impact of
restructuring and other special charges. The 1995 bad debt expense included a
$62.0 million charge to increase accounts receivable reserves in the third
quarter.
Net Revenues
Net revenues of $1.6 billion in fiscal 1995 remained essentially unchanged
from the prior year. Average price declines, estimated to be 3.7%, were
offset by estimated growth of approximately 4% in requisition volume. The
majority of the price declines resulted from changes in reimbursement
policies of various third-party payors, an accelerated shift in volume to
lower-priced managed care business, and intense price competition in the
industry. Also contributing to the price declines was a reduction in Medicare
fee schedules effective January 1, 1995 which accounted for approximately a
1% decrease in net revenues.
Costs and Expenses
Cost of services increased $10.4 million from 1994 and as a percentage of
net revenues increased to 60.2% in 1995 from 59.4% in 1994. These increases
were due principally to the impact of price declines and the added cost of
doing business in an increasingly complex environment. Partially offsetting
these factors were synergies associated with the elimination of duplicative
facilities, personnel and administrative functions of acquired entities,
including Damon, MML and Nichols.
Selling, general and administrative expense increased $111.3 million from
1994 and as a percentage of net revenues increased to 32.1% in 1995 from
25.2% in 1994. These increases resulted primarily from a higher level
54
<PAGE>
of bad debt expense during 1995. Excluding bad debt expense, selling, general
and administrative expenses as a percentage of net revenues were
approximately 22.7% as compared to 21.6% in 1994.
Bad debt expense increased to $152.6 million or 9.4% of net revenues in
1995 from $59.5 million or 3.6% of net revenues in 1994. This increase
resulted from an increase in ongoing bad debt expense of $31.0 million
throughout 1995 and a $62.0 million charge to increase bad debt reserves in
the third quarter of 1995.
During 1995, ongoing bad debt expense increased from 4.4% of net revenues
in the first quarter to 6.4% of net revenues in the fourth quarter. This
increase is due principally to four developments that have complicated the
billing process: (1) increased complexity in the health care system; (2)
increased requirements in complying with fraud and abuse regulations; (3)
deterioration in reimbursement as the payor mix shifts; and (4) changes in
Medicare reimbursement policies. These four factors have placed additional
requirements on the billing process, including the need for specific test
coding, additional research on processing rejected claims that comply with
prior practices, increased audits for compliance, and management of a large
number of contracts which have very different information requirements for
pricing and reimbursement.
In addition to the changes in the billing process, in mid-1995, Quest
Diagnostics experienced problems integrating billing operations from recent
acquisitions into existing billing operations and experienced significant
problems implementing a new billing system at its largest facility in
Teterboro, New Jersey. These factors, along with the significant changes in
the billing process discussed in the preceding paragraph, contributed to a
significant increase in the backlog of unbilled receivables and a significant
deterioration in the collection of receivables during the third quarter of
1995. As a result, Quest Diagnostics recorded a charge of $62 million in the
third quarter to increase accounts receivable reserves. Quest Diagnostics has
put in place a rigorous program to improve the effectiveness of its billing
and collection operations and has stabilized the current billing system in
Teterboro. See "Risk Factors--Risks Relating to Quest Diagnostics--Billing"
and "Business of Quest Diagnostics--Information Systems" and "--Billing."
In the second quarter of 1995, Quest Diagnostics recorded a provision for
restructuring totalling $33.0 million, consisting primarily of costs for work
force reduction programs and exiting a number of leased facilities. In the
first quarter of 1995, Quest Diagnostics recorded a special charge of $12.8
million for the settlement of claims related to inadvertent billing errors of
certain laboratory tests that were not completely and/or successfully
performed or reported due to insufficient samples and/or invalid results. In
the third quarter of 1994, Quest Diagnostics recorded a provision for
restructuring and other special charges totalling $79.8 million which
included $48.2 million of integration costs, $21.6 million of transaction
expenses, and $10.0 million of other reserves primarily related to the
Nichols Institute, MML and Bioran acquisitions. See Note 5 to the Audited
Quest Diagnostics Financial Statements.
Net interest expense increased by $18.7 million over the 1994 level due to
an increase in average debt levels, resulting principally from funding
investing activities and cash requirements associated with restructuring and
other special charges.
Amortization expense increased principally due to additional intangible
assets arising from acquisitions completed in 1994 and 1995. Quest
Diagnostics' effective tax rate is significantly impacted by goodwill
amortization which is not deductible for tax purposes. This had the effect of
reducing the tax benefit rate to Quest Diagnostics in 1995 while increasing
the overall tax rate in 1994. See Note 4 to the Audited Quest Diagnostics
Financial Statements.
Year Ended December 31, 1994 Compared with Year Ended December 31,
1993. Earnings for 1994 were below those for the prior year due principally
to price declines, which outpaced the cost efficiencies realized from the
integration of acquisitions and other activities to reduce costs.
Net Revenues
Net revenues increased by $217.4 million, or 15.3%, over the prior year,
due principally to the net impact of acquisitions and dispositions which
increased net revenues by approximately $240 million. The net effect of
average price declines, estimated at 4%, offset by an increase in requisition
volume, estimated at 3%, accounted for the remaining change in net revenues.
The majority of the price declines resulted from a shift in volume to
lower-priced managed care business, changes in reimbursement policies of
various third-party payors, and intense price competition. Also contributing
to the price declines was a reduction in Medicare fee schedules effective
January 1, 1994 which accounted for approximately a 1% decrease in net
revenues.
Costs and Expenses
Cost of services increased $164.1 million over 1993 and as a percentage of
net revenues increased to 59.4% in 1994 from 56.9% in 1993. These increases
were due principally to the impact of price declines and the added
55
<PAGE>
cost of doing business in an increasingly complex environment. Partially
offsetting these factors were synergies realized from integration of
acquisitions.
Selling, general and administrative expense increased $48.4 million over
1993 and as a percentage of net revenues decreased slightly from 25.7% in the
prior year to 25.2%. Synergies associated with the elimination of duplicate
facilities, personnel and administrative functions of acquired entities,
primarily Damon, MML and Nichols, with those of Quest Diagnostics were
partially offset by an increase in bad debt expense, which increased by $12.3
million, from $47.2 million to $59.5 million, and increased from 3.3% of net
revenues in 1993 to 3.6% in 1994.
In the third quarter of 1994, Quest Diagnostics recorded a provision for
restructuring and other special charges totalling $79.8 million, which
included $48.2 million of integration costs, $21.6 million of transaction
expenses, and $10.0 million of other reserves primarily related to the
Nichols Institute, MML and Bioran acquisitions. Integration costs represented
the expected costs for closing clinical laboratories in certain markets where
duplicate Quest Diagnostics and Nichols Institute, MML or Bioran facilities
existed at the time of the acquisitions. In the third quarter of 1993, Quest
Diagnostics recorded a provision for restructuring costs and other special
charges totalling $99.6 million. The restructuring component of this special
charge aggregated $56.6 million related principally to the integration of
Quest Diagnostics' operations with those acquired in the Damon acquisition.
The special charge consisted primarily of a $36.5 million charge to reflect
the settlement and related legal expenses associated with a compromise
agreement with the DOJ to settle claims brought on behalf of the OIG. In
making the settlement, Quest Diagnostics did not admit any wrongdoing in
connection with its marketing or business practices. See "Risk Factors--Risks
Relating to Quest Diagnostics--Government Investigations and Related Claims,"
"Business of Quest Diagnostics--Government Investigations and Related Claims"
and Note 5 to the Audited Quest Diagnostics Financial Statements.
Net interest expense increased by $21.4 million over the prior year, due
principally to increased borrowings associated with financing acquisitions
and, to a lesser degree, increased borrowing rates. Amortization of
intangibles increased due to additional intangible assets arising from
acquisitions completed in 1993 and 1994.
Quest Diagnostics' effective tax rate is significantly impacted by
goodwill amortization which is not deductible for tax purposes, and has the
effect of increasing the overall tax rate, particularly when amortization
increases in proportion to pre-tax earnings. This situation was the principal
contributor to the increase in the 1994 effective tax rate over the prior
year. See Note 4 to the Audited Quest Diagnostics Financial Statements.
Liquidity and Capital Resources
After the Distributions Concurrently with the Quest Diagnostics Spin-Off
Distribution, Quest Diagnostics' debt will be restructured and equity
recapitalized. Quest Diagnostics plans to complete the Quest Diagnostics Notes
Offering of approximately $150 million principal amount of Notes, and incur
approximately $350 million of borrowings under the Quest Diagnostics Credit
Facility. The proceeds from these borrowings will be used to repay amounts owed
to Corning. Any amounts owed to Corning in excess of the proceeds from these
borrowings will be contributed by Corning to Quest Diagnostics' capital. As a
result of these actions, management estimates that Quest Diagnostics' long-term
debt will be reduced by approximately $720 million to approximately $515
million, and annual interest expense will be reduced by approximately $31
million. The Quest Diagnostics Credit Facility will include a revolving credit
facility of $100 million, substantially all of which is expected to be available
for borrowing at the time of the Distributions.
Quest Diagnostics estimates that it will invest approximately $20 million
during the fourth quarter of 1996 for capital expenditures, principally related
to facility upgrades and investments in information technology. Capital
expenditures in 1997 are estimated to be approximately $95 million, of which
approximately $10 to $15 million relates to the conversion of billing and
laboratory systems to Quest Diagnostics' standard systems (see "Business of
Quest Diagnostics--Information Systems"). Quest Diagnostics expects to expand
its operations principally through internal growth and accelerated growth in
strategic markets and related lines of business. Quest Diagnostics expects such
activities will be funded from existing cash and cash equivalents, cash flow
from operations, and borrowings under the revolving credit facility. Quest
Diagnostics believes that the revolving credit facility will be sufficient to
meet both its short-term and its long-term financing needs. As a result, Quest
Diagnostics believes it has sufficient financial flexibility and sufficient
access to funds to meet seasonal working capital requirements, capital
expenditures and growth opportunities.
56
<PAGE>
Quest Diagnostics does not anticipate paying dividends on the Quest
Diagnostics Common Stock in the foreseeable future. In addition, the Quest
Diagnostics Credit Facility prohibits Quest Diagnostics from paying cash
dividends on the Quest Diagnostics Common Stock. Further, the Indenture under
which the Notes will be issued will restrict Quest Diagnostics' ability to
pay cash dividends on the Quest Diagnostics Common Stock based on a
percentage of Quest Diagnostics' cash flow.
Coincident with the Distributions, Quest Diagnostics plans to record a
non-recurring charge of approximately $20 million associated with the
Distributions. The largest component of the charge will be the cost of
establishing an employee stock ownership plan. The remainder of the charge
will consist principally of the costs for advisors and other fees associated
with establishing Quest Diagnostics as a separate publicly traded entity. The
amount of the charge is subject to change based on the price of the Quest
Diagnostics Common Stock on the Distribution Date.
Although Quest Diagnostics has no present acquisition agreements or
arrangements, there may be acquisitions or other growth opportunities which
will require additional external financing, and Quest Diagnostics may from
time to time seek to obtain funds from public or private issuances of equity
or debt securities. There can be no assurance that such financing will be
available on terms acceptable to Quest Diagnostics. See "Risk Factors --
Risks Relating to Quest Diagnostics -- Potential Liability under the Spin-Off
Tax Indemnification Agreements" and "The Relationship Among Corning, Quest
Diagnostics and Covance After the Distributions--Spin-Off Tax Indemnification
Agreements."
Quest Diagnostics management believes that the recapitalization of Quest
Diagnostics and the indemnification by Corning against monetary fines,
penalties or losses from outstanding government claims, together with the
successful implementation of its business strategy, will generate more
predictable and improved cash flows. Additionally, Quest Diagnostics
management believes that these actions, together with Quest Diagnostics'
leading market position or low cost provider status in a number of geographic
regions accounting for the majority of its net revenues, will aid Quest
Diagnostics in meeting the ongoing challenges in the clinical laboratory
industry brought on by growth in managed care and increased regulatory
complexity.*
Prior to the Distributions
Historically, Quest Diagnostics has financed its operations and growth
with cash flow from operations, borrowings from Corning, and stock issued by
Corning to finance certain acquisitions on behalf of Quest Diagnostics.
Investing activities have included business acquisitions and capital
expenditures for facility expansions and upgrades and information systems
improvements. Replacement of laboratory equipment has typically been financed
through operating leases.
Net cash provided by operating activities for the nine months ended
September 30, 1996 was below the level for the comparable period of the prior
year, as a result of reduced earnings, partially offset by an improved
collection rate of accounts receivable and a reduction in restructuring
spending. This improvement in accounts receivable is a direct result of
specific programs initiated in the fourth quarter of 1995 to improve billing
operations. Although these programs are continuing, additional requirements
of customers to provide documentation of the "medical necessity" of testing
are expected to increase receivable levels in the future. The number of days
sales outstanding in accounts receivable ("DSOs") for the clinical testing
business is one measure used by Quest Diagnostics to monitor the
effectiveness of its billing operations. DSOs were 74 days at September 30,
1996 and December 31, 1995, 81 days at December 31, 1994, and 90 days at
December 31, 1993.
Net cash provided by operating activities during 1995 increased above the
prior year despite reduced earnings, due primarily to changes in accounts
payable and accrued expenses and reduced spending for restructuring
integration and other special charges. Net cash provided by operating
activities in 1994 declined from the 1993 level principally due to larger
increases in accounts receivables and higher levels of spending for
restructuring, integration and other special charges during 1994.
Cash used for investing activities for the nine months ended September 30,
1996 was below the prior year level due to reduced acquisition activity and
the sale of several small investments during 1996. Investing activities
during
*This is a forward looking statement and is based on current expectations.
Actual results may vary materially from those projected. See "Business of
Quest Diagnostics--Important Factors Regarding Forward Looking Statements."
In particular see factors (a), (b), (c), (d), (e) and (j).
57
<PAGE>
1995, 1994 and 1993 were funded principally by cash flow from operations and
borrowings from Corning, and were principally for capital expenditures and
acquisitions. Cash used in investing activities in 1995 exceeded the prior
year level due principally to cash proceeds generated from the sale of
certain California operations in 1994. See Note 3 to the Audited Quest
Diagnostics Financial Statements.
Net cash provided by financing activities for the nine months ended September
30, 1996 was below the prior year level due primarily to reduced acquisition
activity during 1996. Financing activities in 1995, 1994 and 1993 consisted
principally of dividend payments to and net borrowing activities with
Corning.
Adjusted EBITDA
Adjusted EBITDA represents income (loss) before income taxes plus net
interest expense, depreciation and amortization and restructuring and other
special charges. EBITDA and Adjusted EBITDA include bad debt expense. Adjusted
EBITDA is presented and discussed because management believes that Adjusted
EBITDA is a useful adjunct to net income and other measurements under generally
accepted accounting principles 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 generally accepted accounting
principles 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.
Adjusted EBITDA for the third quarter of 1996 was $37.6 million, or 9.3%
of net revenues. Adjusted EBITDA in the prior year period was ($9.9) million.
The improvement in Adjusted EBITDA was principally due to a decrease in
selling, general and administrative expense (which decreased $56.2 million)
and an increase in net revenues of $5.4 million, partially offset by an
increase in cost of services (which increased $14.5 million).
Adjusted EBITDA for the nine months ended September 30, 1996 was $134.7
million, or 10.9% of net revenues. Adjusted EBITDA in the prior year period
was $141.8 million, or 11.4% of net revenues. The decline in Adjusted EBITDA
was principally due to a decrease in net revenues of $8.2 million and an
increase in cost of services (which increased $32.8 million), partially
offset by a decrease in selling, general and administrative expense (which
decreased $28.2 million).
Adjusted EBITDA for 1995 was $176.5 million, or 10.8% of net revenues.
Adjusted EBITDA for the prior year period was $295.4 million, or 18.1% of net
revenues. The decline in Adjusted EBITDA was principally due to an increase
in cost of services (which increased $10.4 million) and an increase in
selling, general and administrative expense (which increased $111.3 million).
Adjusted EBITDA for 1994 was $295.4 million, or 18.1% of net revenues.
Adusted EBITDA in the prior year period was $278.7 million, or 19.7% of net
revenues. The increase in Adjusted EBITDA was principally due to an increase
in revenues (which increased $217.4 million), partially offset by an increase
in cost of services (which increased $164.1 million) and an increase in
selling, general and administrative expenses (which increased $48.4 million).
Changes in Accounting Policies
Coincident with the Quest Diagnostics Spin-Off Distribution, Quest
Diagnostics management will adopt a new accounting policy for evaluating the
recoverability of intangible assets and measuring possible impairment under
Statement of the Accounting Principles Board No. 17. Most of Quest Diagnostics'
intangible assets resulted from purchase business combinations in 1993.
Significant changes in the clinical laboratory and health care industries
subsequent to 1993, including increased government regulation and movement from
traditional fee-for-service care to managed cost health care, have caused the
fair value of Quest Diagnostics' intangible assets to be significantly less than
carrying value. Quest Diagnostics management believes that a valuation of
intangible assets based on the amount for which each regional laboratory could
be sold in an arm's-length transaction is preferable to using projected
undiscounted pre-tax cash flows. Quest Diagnostics believes fair value is a
better indicator of the extent to which the intangible assets may be recoverable
and therefore, may be impaired. This change in method of evaluating the
recoverability of intangible assets will result in Quest Diagnostics recording a
charge of between
58
<PAGE>
$400 million and $450 million coincident with the Quest Diagnostics Spin-Off
Distribution to reflect the impairment of intangible assets. This will result in
a reduction of amortization expense of approximately $10 million to $11.3
million annually and $2.5 million to $2.8 million quarterly.
Upon adopting the new policy, management anticipates that the aggregate
market capitalization for Quest Diagnostics will be significantly less than its
net book value. While the market capitalization ascribes a value to Quest
Diagnostics as a whole, Quest Diagnostics' policy values individual laboratories
on a case by case basis, based on the estimated amount for which each regional
laboratory could be sold in an arm's-length transaction. Management believes
that the overall valuation of Quest Diagnostics represented by its market
capitalization ascribes a value to certain underperforming laboratories which is
lower than Quest Diagnostics used in assessing intangible asset recovery. The
higher value ascribed by Quest Diagnostics is principally associated with
management's assumption that a buyer within the industry will value these
businesses based on a multiple of revenues, versus a multiple of current cash
flows, due to the synergy opportunities which exist. While management believes
these estimation methods are reasonable and reflective of common valuation
practices, there can be no assurance that a sale to a buyer for the estimated
value ascribed to a regional laboratory could be completed. Additional factors
which management believes give rise to the difference between Quest Diagnostics'
anticipated market capitalization and net book value are market uncertainty
around the impact of increased government regulation and enforcement and growth
in managed care. These factors, as well as recent highly-publicized government
settlements, have created a negative sentiment in the market which management
believes is temporarily depressing the market value for publicly-traded clinical
laboratory companies. See Note 15 to the Audited Quest Diagnostics Financial
Statements.
In October 1995, the Financial Accounting Standards Board issued Statement
No. 123, "Accounting for Stock- Based Compensation" ("SFAS 123"). This
statement defines a fair value-based method of accounting for employee stock
options and similar equity investments and encourages adoption of that method
of accounting for employee stock compensation plans. However, it also allows
entities to continue to measure compensation cost for employee stock
compensation plans using the intrinsic value-based method of accounting
prescribed by APB Opinion No. 25, "Accounting for Stock Issued to Employees"
("APB 25"). Entities which elect to continue accounting for stock
compensation plans utilizing APB 25 are required to disclose pro forma net
income and earnings per share, as if the fair value-based method of
accounting under SFAS 123 had been applied. Quest Diagnostics intends to
account for stock compensation plans pursuant to APB 25 and, as such, will
include the pro forma disclosures required by SFAS 123 in the financial
statements beginning in 1996.
Inflation
Quest Diagnostics believes that inflation generally does not have a
material adverse effect on its operations or financial condition because
substantially all of its contracts are short-term.
59
<PAGE>
BUSINESS OF QUEST DIAGNOSTICS
Overview
Quest Diagnostics is one of the largest clinical laboratory testing
companies in the United States, offering a broad range of routine and
esoteric testing services used by the medical profession in the diagnosis,
monitoring and treatment of disease and other medical conditions. Quest
Diagnostics currently processes approximately 60 million requisitions each
year.
Quest Diagnostics is the successor by merger to MetPath Inc. ("MetPath"),
a New York corporation organized in 1967. Corning acquired MetPath in 1982
and in 1992 merged MetPath into Quest Diagnostics, which had been organized
in 1990 as a holding company for the clinical laboratory testing business and
contract research business. In 1994, Quest Diagnostics expanded its presence
in the esoteric testing market through the acquisition of Nichols Institute,
now known as Corning Nichols Institute ("Nichols"), which is one of the
leading esoteric clinical laboratories in the world. Upon the consummation of
the Distributions, Corning Clinical Laboratories Inc. will adopt the name
Quest Diagnostics Incorporated.
Since its founding in 1967, Quest Diagnostics' clinical laboratory testing
business has grown into a network of 17 regional laboratories across the
United States, the Nichols esoteric testing laboratory in San Juan
Capistrano, California and one branch laboratory in Mexico City. In addition,
Quest Diagnostics has 14 smaller branch laboratories, approximately 200
"STAT" laboratories and approximately 850 patient service centers located
throughout the United States. A substantial portion of this growth has
resulted from acquisitions. See "--Acquisitions and Dispositions."
Recent Organizational Changes
Between 1990 and 1995, Corning tripled the size of its clinical laboratory
testing business, principally through acquisitions. Historically, prior
management pursued a strategy of growth through acquisitions, including
diversification outside of the clinical laboratory testing business. As a
result of difficult integrations and increased pricing pressures and
regulatory complexity in the clinical testing industry, a new strategy was
needed. In May 1995, Corning responded by appointing Kenneth Freeman, then an
Executive Vice President of Corning, as President and Chief Executive Officer
of Quest Diagnostics, who was charged with the responsibility to formulate a
new strategy. Mr. Freeman has over 24 years of key financial and managerial
experiences at Corning, including serving as the general manager of Corning's
science products division and the President and Chief Executive Officer of
Corning Asahi Video Products Company. Under Mr. Freeman's leadership,
profitability of these operations increased.
Mr. Freeman immediately suspended Quest Diagnostics' acquisition program.
Under his direction, Quest Diagnostics began to refocus on its core clinical
laboratory testing business and reorganize its senior management team. As a
result, Quest Diagnostics is implementing the best practices in each region
throughout Quest Diagnostics; standardizing processes and systems; analyzing
the cost of serving various customers; intensifying efforts to correct
persistent billing errors to both enhance customer satisfaction and reduce
the cost of billing operations; enhancing its compliance program to audit and
correct system defaults and to better train employees in the laws and rules
governing the industry; and improving communications with employees by
improving systems and the kind and amount of current information available to
employees.
Mr. Freeman revamped the senior management team by appointing four new
senior executives and changing the responsibilities of five other senior
executives. Additionally, approximately one-half of the existing laboratory
facility general managers were replaced.
Mr. Freeman also changed the management structure, appointing three of the
senior executives to newly created key positions--Douglas VanOort, who will
focus exclusively on laboratory operations, Don Hardison, who will focus on
commercial activities, and Dr. Gregory Critchfield, who will lead the efforts
in the science and medical areas and pursue innovations. All three report
directly to Mr. Freeman. See "Management of Quest Diagnostics--Management--
Executive Officers of Quest Diagnostics." Quest Diagnostics believes that
this new management structure will greatly enhance Quest Diagnostics' ability
to pursue its business strategy. Mr. VanOort and the regional and facility
operations leaders who report to him will focus their primary attention on
laboratory operations, efficiencies and standardization. Mr. Hardison and the
regional and local commercial leaders who report to him will develop and
coordinate national, regional and local sales and marketing efforts, and will
cultivate national and regional client relationships and provider
60
<PAGE>
alliances. Dr. Critchfield will pursue scientific excellence in the
laboratory as well as seek out, develop and assimilate those new tests and
technologies that will differentiate Quest Diagnostics and propel its growth
in the future.
This three-prong management structure is designed to implement Quest
Diagnostics' business strategy to make Quest Diagnostics the best supplier
(i.e., lowest-cost, highest quality) of quality testing services; the
preferred provider of fairly priced and useful health care services and
information; and the industry's leading innovator of new clinical tests,
methodologies and services.
Business Strategy
Quest Diagnostics' overall goal is to be recognized by its customers,
employees and competitors as the best provider of comprehensive and
innovative clinical testing, information and services. To achieve this, Quest
Diagnostics has set several strategic goals and put in place organizational
structures to implement them.
Best Supplier. Quest Diagnostics seeks to be the best supplier of the
highest quality and the lowest-cost testing services. Health care providers
and patients expect accurate, timely and consistent laboratory test results
at a fair price.
(bullet) Lowest Cost Provider. Currently, approximately 28% of Quest
Diagnostics' net revenues are from laboratories that Quest
Diagnostics believes are the lowest cost providers in their
respective markets. Management believes that these laboratories
are the lowest cost providers in their respective markets based
on its knowledge of such markets and information obtained in
acquiring other laboratories. Quest Diagnostics currently
receives approximately 60 million requisitions for testing each
year. Currently, Quest Diagnostics' average cost per requisition
varies significantly among its regional laboratories: an
approximately $7.00 difference in cost per requisition between
the most efficient regional laboratory and the average and an
approximately $13.00 difference in cost per requisition between
the most and the least efficient regional laboratories. In many
cases, these variations do not relate to testing volumes or
mixes, space costs, service requirements or regional labor cost
differences. To reduce costs, Quest Diagnostics has begun to
replicate the best practices from each region throughout its
national network. Standardization of equipment and supplies, as
well as leveraging of Quest Diagnostics' purchasing power, is
also part of this strategy. While Quest Diagnostics' overall
program of standardization is in a preliminary stage, Quest
Diagnostics has already selected its standard clinical
instruments and has selected its national vendors for laboratory
supplies, temporary services and personal computers. Management
expects to achieve significant cost savings within the next three
years as these programs are fully implemented, the majority of
which are expected to be achieved by the end of 1998. *
(bullet) Highest Quality Provider. Quest Diagnostics is dedicated to
providing accurate and timely testing results and to being viewed
by its customers as the highest quality provider of clinical
testing services. Quest Diagnostics believes that implementation
of best practices already developed in certain regions will
permit Quest Diagnostics to be viewed by its customers as the
highest quality provider of clinical testing services. For
example, as part of its best practices policy, Quest Diagnostics
is identifying the most common service failures in each regional
laboratory and establishing procedures to substantially reduce
these service failures. Management believes that implementing
these best practices will increase the level of quality while
lowering costs.** Historically, Quest Diagnostics' experience has
been that the regions with the highest quality of services have
also had the lowest costs.
Preferred Provider. Quest Diagnostics seeks to be the preferred provider
of laboratory testing services to existing and new health care networks on a
selective basis determined by profitability of accounts. Quest Diagnostics
believes that it will become the preferred provider to these networks as (1)
large networks typically prefer to utilize large independent clinical
laboratories that can service them on a national or regional basis and (2)
Quest Diagnostics continues to pursue its primary strategy of becoming the
highest quality, lowest cost provider. To achieve this, Quest Diagnostics
will employ a rigorous national and regional process to identify prospective
customers and to efficiently
* This is a forward looking statement and is based on current expectations.
sults may vary materially from those projected. See "--Important Factors
Regarding Forward Looking Statements." In particular see factors (c), (d),
(g) and (j).
** This is a forward looking statement and is based on current expectations.
Actual results may vary materially from those projected. See "--Important
Factors Regarding Forward Looking Statements." In particular see factors
(b), (c), (d), (f) and (j).
61
<PAGE>
allocate resources to support these efforts. Quest Diagnostics will also pursue
innovative alliances and seek to assist its partners in achieving their business
objectives.
(bullet) Account Profitability. Quest Diagnostics intends to refocus its
sales efforts on pursuing and keeping profitable accounts. Quest
Diagnostics is engaging in an active program with current
accounts, including those with managed care organizations, to
evaluate their profitability and either increase pricing or
eliminate accounts that cannot be serviced profitably. Throughout
the independent clinical laboratory industry, there are
substantial differences in pricing among, as well as the cost of
serving, various categories of payors and health care providers.
Quest Diagnostics is beginning to provide clear pricing
guidelines to its sales force and changing its commission
structure so that compensation is tied to the profitability of
(rather than revenues from) new business. Management expects to
achieve significant benefits from these programs within the next
three years, the majority of which are expected to be achieved by
the end of 1998. *
(bullet) Regional Profitability. Quest Diagnostics presently believes that
it has the leading market share among independent clinical
laboratories in most routine testing markets of the northeast,
mid-Atlantic and midwest regions. Approximately 65% of Quest
Diagnostics' revenues and almost all of its EBITDA is generated
from markets in which Quest Diagnostics believes that it has the
leading market share. In most of these markets, Quest Diagnostics
believes that it also is the lowest cost provider. Quest
Diagnostics is evaluating its strategic alternatives relative to
units whose profitability does not meet its internal goals. These
alternatives may include joint ventures, alliances, or
dispositions. Quest Diagnostics believes that, while the clinical
laboratory industry is becoming national in scope, Quest
Diagnostics can subcontract with other clinical laboratories to
perform testing for national accounts in any markets in which
Quest Diagnostics chooses not to compete. Quest Diagnostics may
also make selected local acquisitions where appropriate.
Leading Innovator. Quest Diagnostics intends to remain a leading innovator
in the clinical laboratory industry by continuing to introduce new tests,
technology and services. Through its relationship with the academic community
and pharmaceutical and biotechnology firms and a research and development
budget exceeding $15 million per year, Quest Diagnostics believes it is one
of the leaders in transferring innovation from academic biotechnology
laboratories to the market. For example, Quest Diagnostics (through its
subsidiary Nichols) has been informed by its licensors that it is currently
the only independent clinical laboratory that is using both molecular signal
amplification (branched DNA) and polymerase chain reaction (PCR) technologies
for HIV testing. These technologies permit the detection of lower levels of
HIV than can be achieved using other technologies, which in turn permits
health care providers to better tailor drug therapies for HIV-infected
patients. Nichols continues to be one of the leading esoteric testing
laboratories in the world. Nichols serves approximately 2,000 of the
country's estimated 6,400 hospitals and counts among its largest customers
both LabCorp and SmithKline. Quest Diagnostics hopes to leverage Nichols'
existing relationships with hospitals into increased routine testing to
hospitals, which continue to perform over half of the clinical laboratory
testing in the United States.
The Clinical Laboratory Testing Industry
Clinical testing is a critical component in the delivery of quality health
care service to patients. Currently, clinical laboratory testing is the first
step in determining how a significant amount of all health care dollars are
spent. Laboratory tests and procedures are used generally by physicians and
other health care providers to assist in the diagnosis, evaluation,
monitoring and treatment of diseases and other medical conditions through the
measurement and analysis of chemical and cellular components in blood,
tissues and other specimens. Clinical laboratory testing is generally
categorized as either clinical testing, which is performed on body fluids
such as blood and urine, or anatomical pathology testing, which is performed
on tissue and other samples, including human cells. Clinical and anatomical
pathology procedures are frequently ordered as part of regular physician
office visits and hospital admissions. Most clinical laboratory tests ordered
by health care providers are considered "routine" and can be performed by
most independent clinical laboratories, while "esoteric" tests (which
generally require more sophisticated equipment, materials and personnel) are
generally referred to laboratories, such as the Nichols facility in San Juan
Capistrano, that specialize in such tests.
Quest Diagnostics believes that in 1995 the entire United States clinical
laboratory industry had revenues exceeding $30 billion. The clinical
laboratory industry consists primarily of three types of providers: hospital-
affiliated laboratories, independent clinical laboratories, such as those
owned by Quest Diagnostics, and physician-
- -------------
* This is a forward looking statement and is based on current expectations.
Actual results may vary materially from those projected. See "--Important
Factors Regarding Forward Looking Statements." In particular see factors
(a), (b), (c), (d), (f) and (i).
62
<PAGE>
office laboratories. Quest Diagnostics believes that in 1995 approximately
56% of the clinical testing revenues in the United States were attributable
to hospital-affiliated laboratories, approximately 36% were attributable to
independent clinical laboratories and approximately 8% were attributable to
physicians in their offices and laboratories.
Quest Diagnostics believes that consolidation will continue in the
clinical laboratory testing business. In addition, Quest Diagnostics believes
that it and the other large independent clinical laboratory testing companies
may have the opportunity to increase their share of the overall clinical
laboratories testing market due to a number of external factors including
cost efficiencies afforded by large-scale automated testing, Medicare
reimbursement reductions and the growth of managed health care entities which
require low-cost testing services and large service networks. In addition,
legal restrictions on physician referrals and the ownership of laboratories
as well as increased regulation of laboratories are expected to contribute to
the continuing consolidation of the industry.
Quest Diagnostics believes that a number of factors are likely to
positively influence the volume of clinical laboratory testing performed in
the United States in the future, including (1) the general aging of the
population in the United States; (2) an expanded base of scientific knowledge
which has led to the development of more sophisticated specialized tests and
an increase in the awareness of physicians of the value of clinical
laboratory testing as a cost-effective means of early detection of disease
and monitoring of treatment; (3) an increase in the number and types of tests
which are, due to advances in technology and increased cost efficiencies,
readily available on a more affordable basis to physicians; (4) expanded
substance-abuse testing by corporations and governmental agencies; and (5)
increased testing for sexually transmitted diseases such as AIDS. The impact
of these factors is expected to be offset in part by increased controls over
the utilization of clinical laboratory tests by both Medicare and the private
sector, particularly managed care organizations.
Quest Diagnostics believes that the clinical laboratory industry will
continue to be subject to pricing pressures as a result of (1) continued
growth of the managed care sector; (2) a shift toward capitated payment
contracts within the managed care sector; and (3) decreases in Medicare
reimbursement rates. In addition, increased regulatory requirements in the
billing of Medicare are expected to result in reimbursement reductions and
additional costs to clinical laboratory testing companies in the United
States. Quest Diagnostics has formulated strategies to address these
challenges. See "--Business Strategy."
Services
Quest Diagnostics' laboratory business is comprised of routine testing,
which Quest Diagnostics management estimates currently generates
approximately 88% of Quest Diagnostics' net revenues; and esoteric testing,
which is performed at the Nichols facility in San Juan Capistrano and which
Quest Diagnostics management estimates generates approximately 10% of Quest
Diagnostics' net revenues. The balance of Quest Diagnostics' net revenues is
derived principally from the manufacture of clinical laboratory test kits.
Routine Testing Services and Operations. Routine tests, which are
performed at Quest Diagnostics' regional laboratories, include procedures in
the area of blood chemistry, hematology, urine chemistry, virology, tissue
pathology and cytology. Commonly ordered individual tests include red and
white blood cell counts, Pap smears, blood cholesterol level tests,
AIDS-related tests, urinalyses, pregnancy tests, and alcohol and other
substance-abuse tests. Routine test groups include tests to determine the
function of the kidney, heart, liver and thyroid, as well as other organs,
and several health screens that measure various important bodily health
parameters.
Quest Diagnostics provides services through 17 regional laboratories
located in major metropolitan areas throughout the United States, as well as
14 branch laboratories, approximately 200 STAT laboratories and 850 patient
service centers. Quest Diagnostics also operates a branch laboratory in
Mexico. Regional laboratories offer a full line of routine clinical testing
procedures. "STAT" laboratories are local laboratory facilities where Quest
Diagnostics can quickly perform and report results of certain routine tests
for customers that require such emergency testing services. "Branch
laboratories" have a test menu that is smaller than that of regional
laboratories but larger than that of STAT laboratories. A "patient service
center" is a facility maintained by Quest Diagnostics, typically in or near a
medical professional building, to which patients can be referred by
physicians for specimen collection.
Quest Diagnostics operates 24 hours a day, 365 days a year, utilizing a
fully integrated collection and processing system. Quest Diagnostics
generally performs and reports most routine procedures within 24 hours,
employing a variety of sophisticated and computerized laboratory testing
instruments. On an average work day, Quest Diagnostics processes
approximately 220,000 requisitions. Quest Diagnostics provides daily pickup
of specimens from most customers principally through an in-house courier
system. The specimens are sent to one of Quest Diagnostics' laboratories
(generally a regional or branch laboratory) where one or more tests are
performed.
63
<PAGE>
Each patient specimen is accompanied by a test requisition form, which is
completed by the customer, that indicates the tests to be performed and
provides the necessary billing information. Each specimen and related
requisition form is checked for completeness and then given a unique
bar-coded identification number. The unique identification number assigned to
each specimen helps to assure that the results are attributed to the correct
patient. The requisition form is sent to a data entry department where a file
is established for each patient and the necessary testing and billing
information is entered. Once this information is entered into the computer
system, the tests are performed and the results are entered, primarily
through computer interface or manually, depending upon the type of testing
equipment involved. Most of Quest Diagnostics' computerized testing equipment
is directly linked with Quest Diagnostics' information systems. Most routine
testing is performed and completed during the evening following receipt of
the specimens to be tested, and test results are readied for distribution the
following morning either electronically or by service representatives. Many
customers have local printer capability enabling laboratory medical reports
to be printed in their offices. Customers who request that they be called
with a result are so notified in the morning. It is Quest Diagnostics's
policy to notify the customer immediately if a life-threatening result is
found at any point during the course of the testing process.
Esoteric Testing Services and Operations. Through Nichols, Quest
Diagnostics operates one of the leading esoteric clinical testing
laboratories in the world. Esoteric tests are performed in cases where the
information provided by routine tests is not specific enough or is
inconclusive as to the existence or absence of disease or when a physician
requires more information. Typically, unlike routine testing, only one test
is performed per requisition. The logistics for esoteric testing are similar
to that for routine testing except that, due to the complexity of the
testing, approximately 60% of the tests are performed within 24 hours, with
almost all of the rest being performed within one week. During 1995 Nichols
performed approximately 3.9 million esoteric tests, of which 77% were
referred by sources other than Quest Diagnostics regional laboratories.
Esoteric tests generally require more sophisticated equipment and
materials as well as more highly skilled personnel to perform test procedures
and analyze results than what is required for routine testing. Consequently,
esoteric tests are generally priced substantially higher than routine tests.
New medical discoveries lead to the development of new esoteric tests.
However, over time esoteric tests may become routine tests as a result of
improved technology or increased volume. The volume of esoteric tests
required by most health care providers, including hospitals, is relatively
low compared to the volume of routine tests. Because it is generally not cost
effective for such health care providers to perform the low volume of
esoteric tests in-house, a significant portion of esoteric tests are referred
to clinical laboratories like Nichols that specialize in such tests. Some
examples of esoteric testing procedures include capillary electrophoresis,
cell culture technology, chemiluminescent immunoassays, certain enzyme
immunoassays, flow cytometry, fluorescent in situ hybridization (FISH),
inductively coupled plasma mass spectroscopy (ICPMS), molecular tissue
pathology, molecular signal amplification (branched DNA), and polymerase
chain reaction (PCR) technologies.
Nichols's laboratory is comprised of 18 individual laboratory departments,
which in the aggregate offer approximately 1,400 individual tests or "assays"
in such fields as endocrinology, genetics, immunology, microbiology,
molecular biology, oncology, serology, special chemistry and toxicology.
Nichols believes that it has been one of the leaders in transferring
technological innovation from academic biotechnology laboratories to the
marketplace. Nichols was the first to introduce a number of esoteric tests,
including immunoassay methods for measurement of circulating hormone levels
and sensitive tests to predict breast cancer prognosis. Among more recent
developments have been tests to detect a variety of tumor types, a common
form of mental retardation, leukemia, cystic fibrosis, osteoporosis,
hepatitis and neurological disorder and to monitor success of therapy in
cancer and AIDS. The branched DNA and PCR technologies can be applied to a
variety of infectious agents and permit the detection of lower levels of HIV
than can be achieved under other technologies. The ability to measure the
amount of HIV permits health care providers to better tailor drug therapies
for HIV-infected patients. As part of its research and development efforts,
Nichols maintains a relationship with the academic community through its
Academic Associates program, under which approximately sixty scientists from
academia and biotechnology firms work directly with Nichols's staff
scientists to monitor and consult on existing test procedures and develop new
esoteric test methods. In addition, Nichols relies on internal resources for
the development of new tests as well as on license arrangements and
co-development agreements with biotechnology companies and academic medical
centers.
Nichols also provides clinical laboratory testing in connection with
pre-marketing clinical trials of pharmaceutical drugs. This testing is
competitive with the testing performed by a subsidiary of Covance and is
expected to continue in the future. Quest Diagnostics management estimates
that net revenues from such testing accounted for less than 1% of Quest
Diagnostics' net revenues in 1995.
64
<PAGE>
Diagnostics. Through its Nichols Institute Diagnostics ("NID")
subsidiaries, which were acquired as a result of the acquisition of Nichols
Institute in August 1994, Quest Diagnostics manufactures and markets clinical
laboratory kits primarily for esoteric testing. Test kits are sold
principally to hospital and clinical laboratories.
Customers and Payors
Quest Diagnostics provides testing services to a broad range of health
care providers. The primary types of customers served by Quest Diagnostics
are as follows:
Independent Physicians and Physician Groups. Physicians requesting testing
for their patients who are unaffiliated with a managed care plan remain the
principal source of Quest Diagnostics' clinical laboratory business. Fees for
clinical laboratory testing services rendered for these physicians are billed
either to the physician, to the patient, or to the patient's third-party
payor such as insurance companies, Medicare and Medicaid. In four states,
including New York and Michigan, Quest Diagnostics is required to bill
patients directly. The clinical laboratory industry is supporting legislative
efforts to expand direct patient billing. Billings are typically on a
fee-for-service basis. If the billings are to the physician, they are based
on the laboratory's wholesale or customer fee schedule and are typically
subject to negotiation. Otherwise, the billings are based on the laboratory's
retail or patient fee schedule, subject to limitations on fees imposed by
third parties and to negotiation by physicians on behalf of their patients.
Medicare and Medicaid billings are based on fee schedules set by governmental
authorities. See "-- Regulation and Reimbursement."
HMOs and Other Managed Care Groups. HMOs and other managed care
organizations typically contract with a limited number of clinical
laboratories and then designate the laboratory or laboratories to be used for
tests ordered by their participating physicians. In an effort to control
costs, the managed care groups generally negotiate discounts to the fees
usually charged by such laboratories. Most testing for managed care
organizations is being performed on a capitated basis. Under a capitated
payment contract, the clinical laboratory and the managed care organization
agree to a monthly payment per covered individual to cover all laboratory
tests during the month, regardless of the number or cost of tests actually
performed. Such contracts shift the risks of additional routine testing
beyond that covered by the capitated payment to the clinical laboratory. In
certain cases, however, the monthly payment may be subject to prospective or
retroactive adjustment if the number of tests performed exceeds (or is less
than) certain thresholds. The types of tests covered by capitated contracts
are negotiated for each contract, with esoteric tests and anatomic pathology
services generally not being covered under the capitation rate. Large
regional and national HMOs and preferred provider organization networks
typically prefer to utilize large independent clinical laboratories such as
Quest Diagnostics that can service the managed care groups on a national or
regional basis. See "--Effect of the Growth of the Managed Care Sector on the
Clinical Laboratory Business."
Hospitals. Quest Diagnostics serves approximately 3,000 hospitals with
services that vary from providing esoteric testing to management contracts,
where Quest Diagnostics manages the hospital's laboratory for a fee.
Hospitals generally maintain an on-site laboratory to perform testing on
patients receiving care and refer less frequently needed procedures to
outside laboratories. Hospitals are typically charged for such tests a
negotiated fee-for-service which is based on the laboratory's customer fee
schedule. Some hospitals actively encourage community physicians to send
their testing to the hospital's laboratory. In addition, some hospitals have
been purchasing physician practices and requiring that the
physicians/employees send their testing to the hospital's affiliated
laboratory. As a result, hospital-affiliated laboratories can be both a
customer and a competitor for independent clinical laboratories such as Quest
Diagnostics.
Other Institutions. Quest Diagnostics also serves other institutions,
including governmental agencies, such as the Department of Defense and prison
systems, large employers and independent clinical laboratories that do not
have the full range of Quest Diagnostics' testing capabilities. These
institutions are typically charged on a negotiated or bid fee-for- service
basis. Quest Diagnostics' services to employers principally involve the
provision of substance abuse testing services.
In 1995, no single customer or affiliated group of customers accounted for
more than 2% of Quest Diagnostics' net revenues. Quest Diagnostics believes
that the loss of any one of its customers would not have a material adverse
effect on Quest Diagnostics' results of operations or cash flows.
Payors. Most clinical laboratory testing is billed to a party other than
the "customer" that ordered the test. Tests performed for various patients of
a single physician may be billed to different payors besides the ordering
physician, including third-party payors (generally an insurance company or
managed care organization), Medicare, Medicaid or the patient.
65
<PAGE>
The following table sets forth current estimates of the breakdown by payor
of Quest Diagnostics' total volume of requisitions and average approximate
revenues per requisition:
<TABLE>
<CAPTION>
Requisition Volume
as
% of Total Revenue Per Requisition
------------------- ------------------------
<S> <C> <C>
Patient 5%-10% $60-$80
Medicare & Medicaid 20%-25% $20-$25
Monthly Bill
(Physician, Hospital, Employer, Other) 35%-40% $15-$35
Third Party Fee-For-Service 15%-20% $30-$40
Managed Care--Capitated 15%-20% $ 5-$15
</TABLE>
For a discussion of the mix shift and the impact of the managed care
sector on volume and price trends, see "--Effect of the Growth of the Managed
Care Sector on the Clinical Laboratory Business."
Average Revenue per Requisition Trends. Since the fourth quarter of 1995,
declines in Quest Diagnostics' average revenue per requisition have
moderated. Average revenue per requisition for the quarter ended September
30, 1996 was approximately 1.7% below the comparable period in 1995. This
decline in revenue per requisition was smaller than the approximate 4.8% and
3.6% decline experienced in the first and second quarters of 1996,
respectively. Since August of 1995, the company-wide average revenue per
requisition has remained relatively stable and is effectively unchanged
during the first three quarters of 1996. This trend is illustrated by the
following chart:
[REPRESENTATION OF A LINE CHART GRAPHIC]
Average Revenue per Requisition as a Percentage
of December 1994 Revenue per Requisition
Q1/95 98.6
Q2/95 97.6
Q3/95 95.8
Q4/95 95.1
Q1/96 93.9
Q2/96 94.1
Q3/96 94.2
Sales and Marketing
Quest Diagnostics markets and services its customers through its direct
sales force of approximately 430 sales representatives, 300 account
representatives and 2,200 couriers.
Most sales representatives market the mainstream or traditional routine
laboratory services primarily to physicians, while others concentrate on
individual market segments, such as hospitals or managed care organizations,
or on testing niches, such as substance abuse testing. Quest Diagnostics'
sales representatives are compensated through a combination of salaries,
commissions and bonuses, at levels commensurate with each individual's
qualifications and responsibilities. Commissions are based primarily upon the
individual's results in generating new business for Quest Diagnostics. Quest
Diagnostics is currently changing its commission structure so that
compensation is tied to the profitability of (rather than revenues from) new
business. See "--Business Strategy--Preferred Provider."
Quest Diagnostics' account representatives interact with customers on an
ongoing basis. Account representatives monitor the status of services being
provided to customers, act as problem-solvers, provide information on new
testing developments and serve as the customer's regular point of contact
with Quest Diagnostics. Account representatives are compensated with a
combination of salaries and bonuses commensurate with each individual's
qualifications and responsibilities.
Quest Diagnostics believes that the clinical laboratory service business
is shifting away from the traditional direct sales structure and into one in
which the purchasing decisions for laboratory services are increasingly made
66
<PAGE>
by managed care organizations, integrated health delivery systems, insurance
plans, employers and by patients themselves. In view of these changes, Quest
Diagnostics has completed a rigorous regional market strategy process and has
reorganized its sales and marketing organization structure to support these
strategies and emerging customers.
Quest Diagnostics believes that, given the increasing regulation and
complexity of the clinical laboratory marketplace, training of its sales
force is of paramount importance. With this goal in mind, during 1995 Quest
Diagnostics enhanced its comprehensive sales training program and compliance
training. See "--Compliance Program."
Effect of the Growth of the Managed Care Sector on the Clinical Laboratory
Business
The managed care industry is growing as well as undergoing rapid
consolidation which has created large managed care companies that control the
delivery of health care services for millions of people, and have significant
bargaining power in negotiating fees with health care providers, including
clinical laboratories. Quest Diagnostics believes that there are potential
opportunities for large, low-cost, clinical laboratories such as Quest
Diagnostics to capture additional testing volume from managed care
organizations. The larger regional and national managed care organizations
typically prefer to utilize large independent clinical laboratories, like
Quest Diagnostics, that can service their organizations on a national or a
regional basis. In addition, smaller laboratories are unlikely to be able to
achieve the low cost structures necessary to profitably service managed care
organizations.
The growth of the managed care sector presents various challenges to
independent clinical laboratories, including Quest Diagnostics. Managed care
organizations typically negotiate capitated payment contracts, whereby the
clinical laboratory receives a monthly fee per covered individual. The fixed
monthly payment generally covers all laboratory tests (excluding certain
tests, such as esoteric tests and anatomic pathology services) performed
during the month, regardless of the number or cost of the tests performed.
Unlike fee-for-service indemnity insurance, such contracts shift the risks of
additional routine testing beyond that covered by the capitated payment to
the clinical laboratory. In certain cases, however, the monthly payment may
be subject to prospective or retroactive adjustment if the number of tests
performed exceeds (or is less than) certain thresholds. Quest Diagnostics
expects the amount of clinical laboratory testing performed for managed care
organizations under capitated rate agreements to continue to grow.
Laboratory services agreements with managed care organizations have
historically been priced aggressively due to competitive pressures and the
expectation that a laboratory would capture not only the volume of testing to
be covered under the contract, but also the additional fee-for-service
business from patients of participating physicians who are not covered under
the managed care plan. However, as the number of patients covered under
managed care plans continues to increase, there is less such fee-for-service
business and, accordingly, less high margin business to offset the low margin
(and often unprofitable) managed care business. Furthermore, increasingly,
physicians are affiliated with more than one managed care organization and as
a result may be required to refer clinical laboratory tests to different
clinical laboratories, depending on the coverage of their patients. As a
result, a clinical laboratory might not receive any fee-for-service testing
from such physicians. The level of pricing charged to managed care
organizations, including under capitated payment contracts, if continued, may
adversely affect the pricing of the clinical laboratory industry.
During the nine months ended September 30, 1996, services to managed care
organizations under capitated rate agreements accounted for approximately 6%
of Quest Diagnostics' net revenues from clinical laboratory testing and
approximately 15% of the number of tests performed by Quest Diagnostics.
Quest Diagnostics believes that the prices charged by the independent
clinical laboratory testing companies to managed care organizations can and
must be increased. Quest Diagnostics is currently reviewing its pricing
structures for agreements with managed care organizations and intends to
insure that all such agreements are profitably priced. However, there can be
no assurance that Quest Diagnostics will be able to increase the prices
charged to managed care organizations or that Quest Diagnostics will not lose
market share in the managed care market to other clinical laboratories who
continue to aggressively price laboratory services agreements with managed
care organizations. Quest Diagnostics believes that the growth of the managed
care sector presents both challenges and opportunities. Quest Diagnostics, as
part of its preferred provider strategy, will seek to capitalize on the
opportunity and meet the challenge by seeking to secure large-volume,
profitable managed care contracts through providing low cost, high quality
testing services at rational prices.
67
<PAGE>
Expansion Opportunities
Quest Diagnostics believes that there are several expansion opportunities.
Quest Diagnostics believes that it can take advantage of these opportunities
without incurring significant capital expenditures or deploying significant
resources.
Hospital Alliances. In response to the growth of the managed care sector
and the developments described under "--Effect of the Growth of the Managed
Care Sector on the Clinical Laboratory Business," many health care providers
have established new alliances. Hospital-physician networks are emerging in
many markets in order to offer comprehensive, integrated service
capabilities, either to managed care plans or directly to employers.
Since Quest Diagnostics has traditionally derived a substantial portion of
its esoteric testing revenues from referrals from hospitals, which perform
approximately half of all clinical laboratory tests in the United States,
Quest Diagnostics established a hospital business venture group whose primary
goal is to develop additional nontraditional hospital arrangements, including
management and consulting agreements, shared service arrangements and joint
ventures.
Under federal cost containment legislation enacted in 1985, treatment
provided to hospital inpatients covered by Medicare is classified into
diagnosis-related groups ("DRGs") which prescribe the maximum reimbursable
payments for all services, including laboratory testing services, provided on
behalf of an inpatient under each DRG. As a result of this payment structure,
and similar price constraints from managed care organizations and other
third- party payors, hospitals have an economic incentive to seek the most
cost-effective laboratory testing services for their patients. Quest
Diagnostics believes that in many cases, by managing a hospital laboratory or
entering into a joint venture with a hospital, Quest Diagnostics can improve
a hospital laboratory's economic structure and preserve hospital capital that
would be required for needed laboratory improvements while providing accurate
and timely testing services due to greater economies of scale, increased
utilization of expensive testing and data processing equipment through
optimization of the mix between on-site and off-site testing and more
efficient use of laboratory employees. Quest Diagnostics has several such
arrangements with hospitals, including a joint venture with two hospitals in
Erie, Pennsylvania that performs outreach testing and a management agreement
with a group of approximately 25 hospitals in eastern Nebraska and Sioux
City, Iowa. These two laboratory arrangements, which provide testing for both
the hospitals and the commercial outreach markets in their geographical
areas, serve as two of Quest Diagnostics' laboratory facilities. Quest
Diagnostics also manages the laboratories at several hospitals in the eastern
United States. However, despite the potential cost savings and additional
revenues available to hospitals through such arrangements, Quest Diagnostics
believes that only a small percentage of the hospitals in the United States
have entered into such arrangements with independent clinical laboratories.
Nonetheless, Quest Diagnostics expects to enter into alliances with various
hospitals in the future and believes that this market has potential. As an
alternative service for hospitals that are entering into integrated delivery
systems, Quest Diagnostics is beginning to market consulting support and
technical solutions for integrating diverse laboratory infrastructures,
systems and data.
Employer Market. Quest Diagnostics is considering expanding its business
in the employer market to include the provision of laboratory services to
large employers on a basis comparable to that offered to managed care
organizations, whereby laboratory services paid under self-insured indemnity
plans may be relatively fixed (rather than on a fee-for-service basis). These
services could be offered in alliance with other service providers, including
pharmaceutical benefits and diagnostic imaging services. Quest Diagnostics
recently organized National Imaging Associates Inc. ("NIA"), a company
offering diagnostic imaging benefit management services to employers, payors
and managed care organizations. NIA seeks to carve out the imaging component
of a health care plan service offering and manage it at lower cost through
utilization controls and provider price concessions.
Medical Information. The market need for medical information,
particularly disease-specific information about provider practices and
patient care, is growing rapidly. Large customers of clinical laboratories
are increasingly interested in using information from clinical laboratory
data on their covered population to answer financial, marketing and quality
related questions. Integrated data from clinical laboratories and other
health encounters provides additional insights to these questions. To meet
these emerging needs, Quest Diagnostics created the Medical Informatics
("Medical Informatics") division which focuses solely on the medical
information needs of managed care organizations, integrated healthcare
delivery networks and other large customers. Through internal development,
Quest Diagnostics now has a portfolio of information products based primarily
upon its extensive database. A combination of advanced information technology
and experienced analytical and data integration skills provides the platform
for delivery of these products.
68
<PAGE>
As market interest has increased, the Medical Informatics division has
devoted experienced account executives to work with customers to meet their
information needs. Current information products include provider profiles and
benchmarks, high-risk patient registries based on customer disease management
initiatives, normative comparisons with other populations, and quantitative
clinical outcomes based on laboratory measures. Quest Diagnostics believes
that health care customers will increasingly see value in the information
obtained from clinical laboratory results.
Information Systems
The need for information systems to support laboratory, billing, customer
service, logistics, medical data, and other business requirements is
significant and will continue to place high demands on Quest Diagnostics'
information systems staff. Quest Diagnostics has historically not
standardized the billing, laboratory and other information systems at
laboratories that it has acquired. As a result, Quest Diagnostics has
numerous different information systems to handle billing, test result
reporting and financial data and transactions. Quest Diagnostics believes
that the efficient handling of information involving customers, patients,
payors, and other parties will be critical to Quest Diagnostics' future
success.
To this end, Quest Diagnostics has chosen standard billing and laboratory
systems. During the third quarter of 1996, Quest Diagnostics recorded a
charge of $13.7 million to write off capitalized software as a result of its
decision to abandon the billing system which had been intended as its
company-wide billing system. Management now plans to standardize using a SYS
billing system which has already been implemented in seven of its 22 billing
sites, which seven sites account for 35% of Quest Diagnostics' net revenues.
The standard laboratory system is already operational in nine of its 22
billing sites, which account for 30% of Quest Diagnostics' net revenues. Such
sites are not necessarily the same sites as those with standard billing
systems. Quest Diagnostics is beginning to convert the remaining nonstandard
billing and laboratory systems to the standard systems, prioritized on an
impact basis. The most critical conversions will be completed within three
years. The New York/New Jersey (Teterboro) laboratory is the first priority
and is expected to be converted by early 1998. The conversion costs are
expected to average approximately $3 million per billing system and $1
million to $3 million per laboratory system. As more billing sites are
converted to the standard billing system, consolidation of billing sites is
expected to occur, which will reduce overall conversion costs and improve
billing efficiencies. Quest Diagnostics anticipates that the cost of
converting all billing and laboratory systems to the standard systems over
the next several years will cost between approximately $55 million and $85
million, depending on the number of billing consolidations that occur.* Quest
Diagnostics does not anticipate that the conversion costs will result in a
significant increase in capital expenditures over the levels spent during the
last several years.
Quest Diagnostics is developing systems that will permit managed care
organizations and other providers to have electronic access to test orders
and results for participating physicians, which will permit managed care
organizations to better monitor and control the utilization of testing
services.
Billing
Billing for laboratory services is a complicated process. Laboratories
must bill different payors such as doctors, patients, insurance companies,
Medicare, Medicaid and employer groups, all of whom have different billing
requirements. Quest Diagnostics believes that less than 30% of its bad debt
expense is attributable to specific credit or payment issues of its
customers. The remainder of the bad debt expense is the result of many
non-credit related issues which slow the billing process, create backlogs of
unbilled requisitions and generally increase the aging of accounts
receivable. A primary cause of bad debt expense is missing or incorrect
billing information on requisitions. Typically approximately one-third of the
requisitions that Quest Diagnostics receives either do not provide all the
necessary data or provide incorrect data. Quest Diagnostics believes that
this experience is similar to that of its primary competitors. Quest
Diagnostics performs the requested tests and reports back the test results
regardless of whether billing information has been provided at all or has
been provided incorrectly. Quest Diagnostics subsequently attempts to obtain
any missing information or rectify any incorrect billing information received
from the health care provider. Among the many other factors complicating the
billing process are pricing differences
- -------------
* This is a forward looking statement and is based on current expectations.
Actual results may vary materially from those projected. See "--Important
Factors Regarding Forward Looking Statements." In particular see factors
(d), (j) and (k).
69
<PAGE>
between the fee schedules of Quest Diagnostics and the payor, disputes between
payors as to the party responsible for payment of the bill and auditing for
specific compliance issues. Ultimately, if all issues are not resolved in a
timely manner, the related receivables are written off to bad debt expense.
Quest Diagnostics' bad debt expense has increased each year since 1993 due
principally to four developments that have further complicated the billing
process: (1) increased complexity in the health care system; (2) increased
requirements in complying with fraud and abuse regulations; (3) deterioration
in reimbursement as the payor mix shifts; and (4) changes in Medicare
reimbursement policies. These four factors have placed additional
requirements on the billing process, including the need for specific test
coding, additional research on processing rejected claims that comply with
prior practices, increased audits for compliance, and management of a large
number of contracts which have very different information requirements for
pricing and reimbursement. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations of Quest Diagnostics." Quest
Diagnostics' billing has also been hampered by the existence of multiple
billing information systems. In 1995 Quest Diagnostics had severe billing
problems at its largest laboratory site in Teterboro, New Jersey. A new
billing information system developed with outside consultants experienced
significant implementation problems, including excessive downtime, which
severely impacted Quest Diagnostics' ability to efficiently bill for its
services from the Teterboro location. The problem was compounded by a lack of
experienced staff as the result of work force reductions made to meet cost
reduction initiatives undertaken in anticipation of greater efficiencies from
the new billing information system. As a result of all of these factors,
Quest Diagnostics recorded a charge to bad debt of $62 million in the third
quarter of 1995. Of this amount approximately $34 million was attributable to
its Teterboro location. At the time of the charge, the backlog of unbilled
requisitions was estimated at over 2 million requisitions and DSOs for the
clinical testing business were 90 days. In addition, significant backlogs
existed in (1) reconciling cash received to payment of specific bills, (2)
rejected claims that needed to be researched and (3) correspondence from
customers attempting to resolve billing problems.
Integration of a standardized billing system is a priority of Quest
Diagnostics and Quest Diagnostics is in the process of integrating a billing
system with proven reliability throughout its network. The SYS system is in
use at seven of Quest Diagnostics' laboratories. Its reliability is evidenced
by both the improvement in the laboratories' bad debt experience after SYS
was implemented and the improved capability to handle new billing
requirements as compared with non-SYS laboratories, such as Teterboro. For
example, bad debt expense for the nine months ended September 30, 1996 for
the combined SYS laboratories is 6.4% of sales, versus 7.1% for all other
laboratories combined. The use of a standard system will also provide for
operational efficiencies as redundant programming efforts are eliminated and
the ability to consolidate billing sites will become more feasible. See
"--Information Systems." Standardizing billing systems presents conversion
risk to Quest Diagnostics as key databases and masterfiles are transferred to
the SYS system and because the billing workflow is interrupted during the
conversion, which may cause backlogs. Quest Diagnostics, however, has already
completed seven conversions to this system and has retained key people who
have been involved in those conversions.
Quest Diagnostics has focused on improving its billing operations in the
last year. Over the last twelve months, the backlog of unbilled requisitions
has been reduced by approximately 30%, DSOs for the clinical testing business
have been reduced to 74 days, bad debt expense as a percentage of net
revenues has decreased, the percentage of requisitions received with missing
billing information has been reduced by approximately 30% and backlogs in
rejected claims, unapplied cash and customer correspondence have been
significantly reduced. These improvements were achieved in spite of a higher
level of information requirements necessary for correct billing, especially
those bills relating to Medicare. However, additional requirements to provide
documentation of the "medical necessity" of testing have added to the backlog
of unbilled receivables and caused third quarter 1996 bad debt expense as a
percentage of revenues to increase above the rate Quest Diagnostics had
experienced during the first two quarters of 1996. See "--Regulation and
Reimbursement--Regulation of Reimbursement for Clinical Laboratory Services."
Acquisitions and Dispositions
MetPath, Quest Diagnostics' predecessor, originally commenced operations
in 1967 with laboratories only in the New York metropolitan area. Most of
Quest Diagnostics' other regional laboratories have been added through
acquisitions. Principally as the result of the acquisitions discussed below
that were completed in 1993 and 1994, Quest Diagnostics' revenues have almost
tripled since 1991. However, this increase in revenues is not reflected in
the Quest Diagnostics Financial Statements because several of the major
acquisitions are accounted for as a pooling of interests. Acquisition
activity has diminished significantly since May 1995, in part so that Quest
Diagnostics could concentrate on the integration of the laboratory networks
that had been acquired in 1993 and
70
<PAGE>
1994. Quest Diagnostics may resume making acquisitions in the future, most
likely focusing on acquisitions of smaller laboratories that can be folded into
existing laboratories where Quest Diagnostics can expect to achieve significant
cost savings and other benefits resulting from the elimination of redundant
facilities and equipment and reductions in staffing or personnel. Quest
Diagnostics is evaluating its strategic alternatives relative to units whose
profitability does not meet its internal goals. These alternatives may include
joint ventures, alliances or dispositions. However, there are no negotiations or
definitive plans with respect to any such dispositions.
During 1994 Corning acquired three large clinical laboratory testing
companies, each of which was accounted for as a pooling of interests. In June
1994, Corning acquired Maryland Medical Laboratory, Inc. ("MML"), a regional
laboratory based in Baltimore, Maryland with approximately $90 million in
annual revenues. In August 1994, Corning acquired the stock of Nichols
Institute, a national esoteric clinical laboratory with approximately $280
million in annual revenues. In October 1994, Corning acquired Bioran, a
regional laboratory based in Cambridge, Massachusetts with approximately $65
million in annual revenues.
In August 1993, Corning acquired Damon, a national clinical testing
laboratory with approximately $330 million in annualized revenue. The
acquisition was accounted for as a purchase. The assets of Damon's
California- based laboratories were sold in April 1994 to Physicians Clinical
Laboratory Inc. In November 1993, Quest Diagnostics acquired the clinical
testing laboratories of Unilab in Dallas, Denver and Phoenix, in exchange for
Quest Diagnostics' then 43% ownership of Unilab and the assumption of
approximately $70 million of indebtedness of Unilab. In a separate
transaction, Quest Diagnostics transferred to Unilab Quest Diagnostics'
investment in J.S. Pathology PLC, a clinical testing laboratory based in the
United Kingdom, in exchange for a small equity interest in Unilab. Quest
Diagnostics currently owns approximately 4% of Unilab's outstanding common
stock. In May 1993, Corning acquired and contributed to Quest Diagnostics
DeYor Laboratory Inc., a regional laboratory based in Ohio, Pennsylvania and
Tennessee with approximately $20 million of annual revenues. This transaction
was accounted for under the pooling of interests method, although Quest
Diagnostics' consolidated financial statements for prior periods have not
been restated since this acquisition is not material. See Note 3 to the
Audited Quest Diagnostics Financial Statements. In addition to the
acquisitions discussed above, since January 1993 Quest Diagnostics has
acquired approximately 25 other smaller clinical laboratories and customer
lists, principally in assets acquisitions. Only one such acquisition has been
completed since May 1995.
Competition
The clinical laboratory testing business is intensely competitive. Quest
Diagnostics believes that in 1995 the entire United States clinical
laboratory testing industry had revenues exceeding $30 billion; approximately
56% of such revenues were attributable to hospital-affiliated laboratories,
approximately 36% were attributable to independent clinical laboratories and
approximately 8% were attributable to physicians in their offices and
laboratories. As recently as 1993, there were seven laboratories that
provided clinical laboratory testing services on a national basis: Quest
Diagnostics, SmithKline, National Health Laboratories Inc. ("NHL"), Roche
Biomedical Laboratories Inc. ("Roche"), Damon, Allied Clinical Laboratories
Inc. ("Allied") and Nichols Institute. In April 1995 Roche merged into NHL
(under the name LabCorp), which had acquired Allied in June 1994. Quest
Diagnostics acquired Nichols Institute in August 1994 and Damon in August
1993. In addition, in the last several years a number of large regional
laboratories have been acquired by national clinical laboratories. There are
presently three national independent clinical laboratories: Quest
Diagnostics, which had approximately $1.63 billion in revenues from clinical
laboratory testing in 1995; LabCorp, which had approximately $1.68 billion in
revenues from clinical laboratory testing in 1995 on a pro forma basis, after
giving effct to the April 1995 merger of Roche into NHL; and SmithKline,
which had approximately $1.29 billion in revenues from clinical laboratory
testing in 1995. Both LabCorp and SmithKline are affiliated with large
corporations that have greater financial resources than Quest Diagnostics.
SmithKline is wholly owned by SmithKline Beecham Ltd. and R. Hoffman La Roche
S.A. beneficially owns approximately 49.9% of the outstanding capital stock
of LabCorp.
In addition to the three national clinical laboratories, Quest Diagnostics
competes on a regional basis with many smaller regional independent clinical
laboratories as well as laboratories owned by hospitals and physicians. Quest
Diagnostics has the leading market share in most of the northeast,
mid-Atlantic and midwest routine testing markets, while its market share is
much lower in the routine testing market in the rest of the country.
Approximately 65% of Quest Diagnostics' net revenues and almost all of its
EBITDA currently is generated from markets in which Quest Diagnostics
believes that it has the largest market share. In most of these markets Quest
Diagnostics believes
71
<PAGE>
that it also is the lowest cost provider. Quest Diagnostics does not generally
compete in the California routine testing market other than in the San Diego
metropolitan area.
Quest Diagnostics believes that the following factors, among others, are
often used by health care providers in selecting a laboratory: (i) pricing of
the laboratory's testing services; (ii) accuracy, timeliness and consistency
in reporting test results; (iii) number and type of tests performed; (iv)
service capability and convenience offered by the laboratory; and (v) its
reputation in the medical community. Quest Diagnostics believes that it
competes favorably with its principal competitors in each of these areas and
is currently implementing strategies to improve its competitive position. See
"--Business Strategy."
Quest Diagnostics believes that consolidation will continue in the
clinical laboratory testing business. In addition, Quest Diagnostics believes
that it and the other large independent clinical laboratory testing companies
will be able to increase their share of the overall clinical laboratories
testing market due to a number of external factors including cost
efficiencies afforded by large-scale automated testing, Medicare
reimbursement reductions and the growth of managed health care entities which
require low-cost testing services and large service networks. In addition,
legal restrictions on physician referrals and the ownership of laboratories
as well as increased regulation of laboratories are expected to contribute to
the continuing consolidation of the industry.
Quality Assurance
Quest Diagnostics maintains a comprehensive quality assurance program for
all of its laboratories and patient service centers. The goal is to ensure
optimal patient care by continually improving the processes used for
collection, storage and transportation of patient specimens, as well as the
precision and accuracy of analysis and result reporting.
The Quest Diagnostics quality assurance efforts focus on: proficiency
testing, process audits, statistical process control, credentialing and
personnel training.
Internal Quality Control and Audits. Quality control samples are processed
in parallel with the analysis of patient specimens. The results of tests on
such samples are then monitored to identify drift, shift or imprecision in
the analytical processes. In addition, Quest Diagnostics administers an
extensive internal program of "blind" proficiency testing. These samples are
processed through the Quest Diagnostics system as routine patient samples,
unknown to the laboratory as quality control samples. Samples are then
handled, processed and reported with patient specimens. This provides a
system to assure accuracy of the entire pre- and post-analytical testing
process. Another element of the Quest Diagnostics comprehensive quality
assurance program includes performance of internal process audits.
External Proficiency Testing and Accreditation. All Quest Diagnostics
laboratories participate in numerous externally conducted, blind sample
quality surveillance programs. These include proficiency testing programs
administered by the College of American Pathologists ("CAP"), as well as many
state agencies. These programs supplement all other quality assurance
procedures.
All Quest Diagnostics laboratories are accredited by CAP. Accreditation
includes on-site inspections and participation in the CAP Proficiency Test
Program. CAP is an independent nongovernmental organization of board
certified pathologists that offers an accreditation program to which
laboratories may voluntarily subscribe. CAP is approved by HCFA to inspect
clinical laboratories to determine compliance with the standards required by
the Clinical Laboratory Improvement Amendments of 1988 ("CLIA").
Regulation and Reimbursement
Overview. The clinical laboratory industry is subject to significant
governmental regulation at the federal and state levels. All Quest
Diagnostics laboratories and patient service centers are appropriately
licensed and accredited by various state and federal agencies.
The health care industry is undergoing significant change as third-party
payors, such as Medicare (which principally serves patients 65 and older),
Medicaid (which principally serves indigent patients), private insurers and
large employers increase their efforts to control the cost, utilization and
delivery of health care services. In an effort to address the problem of
increasing health care costs, legislation has been proposed or enacted at
both the federal and state levels to regulate health care delivery in general
and clinical laboratories in particular. Some of the proposals include
managed competition, global budgeting and price controls. Although the
Clinton Administration's health care reform proposal, initially advanced in
1994, was not enacted, such proposal or other
72
<PAGE>
proposals may be considered in the future. In particular, Quest Diagnostics
believes that reductions in reimbursement for Medicare services will continue to
be implemented from time to time. Reductions in the reimbursement rates of other
third-party payors are likely to occur as well. Quest Diagnostics cannot predict
the effect health care reform, if enacted, would have on its business, and there
can be no assurance that such reforms, if enacted, would not have a material
adverse effect on Quest Diagnostics' business and operations.
Regulation of Clinical Laboratory Operations. The CLIA standards were
designed to ensure that all clinical laboratory testing services are
uniformly accurate and of high quality by using a single set of requirements.
On February 28, 1992, the final rules implementing CLIA were published in the
Federal Register. These regulations extended federal oversight, with few
exceptions, to virtually all clinical laboratories regardless of size, type,
location or ownership of the laboratory. The regulations generally became
effective in 1992. However, certain quality control and proficiency testing
requirements are still being phased in. The standards for laboratory
personnel, quality control, quality assurance and patient test management are
based on complexity and risk factors. Laboratories categorized as "high"
complexity are required to meet more stringent requirements than either
"moderate" or "waived" (tests regarded as having a low potential for error
and requiring little or no oversight) laboratories.
Most of the Quest Diagnostics laboratories are categorized as high
complexity and these laboratories are in compliance with the more stringent
standards for personnel, quality control, quality assurance and patient test
management. A few Quest Diagnostics laboratories are categorized as moderate
complexity (some STAT laboratories) or waived (only patient service centers).
The sanction for failure to comply with these regulations may be
suspension, revocation or limitation of a laboratory's CLIA certificate
necessary to conduct business, significant fines or criminal penalties. The
loss of a license, imposition of a fine or future changes in such federal,
state and local laws and regulations (or in the interpretation of current
laws and regulations) could have a material adverse effect on Quest
Diagnostics.
Quest Diagnostics is also subject to state regulation. CLIA permits states
to adopt regulations that are more stringent than federal law. For example,
state law may require that laboratory personnel meet certain more stringent
qualifications, specify certain quality control standards, maintain certain
records and undergo additional proficiency testing. For example, certain of
Quest Diagnostics' laboratories are subject to the State of New York's
clinical laboratory regulations, which contain provisions that are
significantly more stringent than federal law.
Quest Diagnostics believes it is in material compliance with the foregoing
standards. See "--Compliance Program."
Drug Testing. Drug testing for public sector employees is regulated by the
Substance Abuse and Mental Health Services Administration ("SAMHSA")
(formerly the National Institute on Drug Abuse), which has established
detailed performance and quality standards that laboratories must meet in
order to be approved to perform drug testing on employees of federal
government contractors and certain other entities. To the extent that Quest
Diagnostics' laboratories perform such testing, each must be certified by HHS
as meeting SAMHSA standards. Seven of Quest Diagnostics' laboratories are
SAMHSA certified.
Controlled Substances. The use of controlled substances in testing for
drug abuse is regulated by the federal Drug Enforcement Administration
("DEA"). All Quest Diagnostics laboratories using controlled substances for
testing purposes are licensed by the DEA.
Medical Wastes and Radioactive Materials. Quest Diagnostics is subject to
licensing and regulation under federal, state and local laws relating to the
handling and disposal of medical specimens and hazardous waste and
radioactive materials as well as to the safety and health of laboratory
employees. All Quest Diagnostics laboratories are operated in material
compliance with applicable federal and state laws and regulations relating to
disposal of all laboratory specimens. Quest Diagnostics utilizes outside
vendors for disposal of specimens. Although Quest Diagnostics believes that
it is currently in compliance in all material respects with such federal,
state and local laws, failure to comply could subject Quest Diagnostics to
denial of the right to conduct business, fines, criminal penalties and other
enforcement actions.
Occupational Safety. In addition to its comprehensive regulation of safety
in the workplace, the federal Occupational Safety and Health Administration
("OSHA") has established extensive requirements relating to workplace safety
for health care employers, including clinical laboratories, whose workers may
be exposed to blood- borne pathogens such as HIV and the hepatitis B virus.
These regulations, among other things, require work practice controls,
protective clothing and equipment, training, medical follow-up, vaccinations
and other measures designed to minimize exposure to chemicals and
transmission of blood-borne and airborne pathogens.
73
<PAGE>
Specimen Transportation. Regulations of the Department of Transportation,
the Public Health Service and the Postal Service apply to the surface and air
transportation of clinical laboratory specimens.
Regulation of Reimbursement for Clinical Laboratory Services. Containment
of health care costs, including reimbursement for clinical laboratory
services, has been a focus of ongoing governmental activity. In 1984,
Congress established a Medicare fee schedule for clinical laboratory services
performed for patients covered under Part B of the Medicare program.
Subsequently, Congress imposed a national ceiling on the amount that would be
paid under the Medicare fee schedule. Laboratories must bill the program
directly and must accept the scheduled amount as payment in full for most
tests performed on behalf of Medicare beneficiaries. In addition, state
Medicaid programs are prohibited from paying more (and in most instances, pay
significantly less) than the Medicare fee schedule for clinical laboratory
testing services furnished to Medicaid recipients. In 1995, Quest Diagnostics
derived approximately 20% and 3% of its net revenues from tests performed for
beneficiaries of Medicare and Medicaid programs, respectively. Since 1984,
Congress has periodically reduced the ceilings on Medicare reimbursement to
clinical laboratories from previously authorized levels. In 1993, pursuant to
the Omnibus Budget and Reconciliation Act of 1993 ("OBRA '93"), Congress
reduced, effective January 1, 1994, the Medicare national fee schedule
limitations from 88% of the 1984 national median to 76% of the 1984 national
median, which reductions were phased in from 1994 through 1996 (to 84% in
1994, 80% in 1995 and 76% in 1996, in each case as a percentage of the 1984
national median). The 1996 reduction to 76% was implemented as scheduled on
January 1, 1996. OBRA '93 also eliminated the provision for annual fee
schedule increases based upon the consumer price index for 1994 and 1995.
Medicare reimbursement reductions have a direct adverse effect on Quest
Diagnostics' net earnings and cash flows. Quest Diagnostics cannot predict if
additional Medicare reductions will be implemented. The Senate and House
Medicare proposal (the Medicare Preservation Act of 1995) passed in October
1995 would have reduced the national limitation to 65% beginning in 1997 and
would have eliminated all annual consumer price index adjustments through
2002. This reduction in laboratory reimbursement rates was retained in the
House-Senate conference report agreed upon in November 1995. The President
vetoed this bill in December 1995.
Effective January 1, 1996, HCFA adopted a new policy on reimbursement for
chemistry panel tests. As of January 1, 1996, 22 automated tests (rather than
19 tests) became reimbursable by Medicare as part of an automated chemistry
profile. An additional allowance of $0.50 per test is authorized when more
than 19 tests are billed in a panel. HCFA retains the authority to expand in
the future the list of tests included in a panel. Effective as of March 1,
1996, HCFA eliminated its prior policy of permitting payment for all tests
contained in an automated chemistry panel when at least one of the tests in
the panel is medically necessary. Under the new policy, Medicare payment will
not exceed the amount that would be payable if only the tests that are
"medically necessary" had been ordered. In addition, since 1995 most Medicare
carriers have begun to require clinical laboratories to submit documentation
supporting the medical necessity, as judged by ordering physicians, for many
commonly ordered tests. Quest Diagnostics expects to incur additional
reimbursement reductions and additional costs associated with the
implementation of these requirements of HCFA and Medicare carriers. The
amount of the reductions in reimbursements and additional costs cannot be
determined at this time. See "--Billing."
Major clinical laboratories, including Quest Diagnostics, use dual fee
schedules: "client" fees charged to physicians, hospitals, and institutions
with which a laboratory deals on a bulk basis and "patient" fees charged to
individual patients and third-party payors, including Medicare and Medicaid,
who generally require separate bills or claims for each requisition. Medicare
and other third party payors also set maximum fees that they will pay which
are substantially lower than the patient fees otherwise charged by Quest
Diagnostics, but are generally higher than Quest Diagnostics' client fees,
which may be subject to negotiation or discount. Federal and some state
regulatory programs prohibit clinical laboratories from charging government
programs more than certain charges to other customers. During 1992, in
issuing final regulations implementing the federal statutory prohibition
against charging Medicare substantially in excess of a provider's usual
charge, the OIG declined to provide any guidance concerning the
interpretation of this legislation, including whether or not discounting or
the dual fee structure employed by clinical laboratories might raise issues
under the provision.
Medicare budget proposals developed by the Clinton Administration in 1993
and 1994, along with proposals incorporated in many major health reform bills
considered by Congress in 1994, called for the reinstatement of 20% Medicare
clinical laboratory co-insurance (which was last in effect in 1984). While
co-insurance was in effect, clinical laboratories received from Medicare
carriers only 80% of their Medicare reimbursement rates and were required to
bill Medicare beneficiaries for the balance of the charges. A co-insurance
proposal was not included in any of the Congressional Medicare reform
packages considered to date in the 1995 and 1996 legislative sessions.
74
<PAGE>
However, it is still possible a co-insurance provision will be proposed in the
future and, if enacted, such a proposal could materially adversely affect the
revenues and costs of the clinical laboratory industry, including Quest
Diagnostics, by exposing the testing laboratory to the credit of individuals and
by increasing the number of bills. In addition, a laboratory could be subject to
potential fraud and abuse violations if adequate procedures to bill and collect
the co-insurance payments are not established and followed.
Proposals have also been developed to procure Medicare and Medicaid
laboratory testing services through competitive bidding mechanisms. To date,
none of the Congressional Medicare reform packages introduced in the 1995 and
1996 legislative sessions have included a competitive bidding provision for
clinical laboratory tests. However, President Clinton's Medicare reform
proposal would have established competitive bidding for clinical laboratory
services. If competitive bidding were implemented, such action could
materially adversely affect the revenues of the clinical laboratory industry,
including Quest Diagnostics. HCFA is currently developing a demonstration
project to determine whether competitive bidding can be used to provide
quality laboratory services at prices below current Medicare reimbursement
rates. The demonstration is expected to be conducted in Kentucky and to
commence in 1997.
Future changes in federal, state and local regulations (or in the
interpretation of current regulations) affecting governmental reimbursement
for clinical laboratory testing could have a material adverse effect on Quest
Diagnostics. Quest Diagnostics is unable to predict, however, whether and
what type of legislation will be enacted into law.
Fraud and Abuse Regulations. The Medicare and Medicaid anti-kickback laws
prohibit clinical laboratories from, among other things, making payments or
furnishing other benefits to influence the referral of tests billed to
Medicare, Medicaid or other federal programs. Penalties for violations of
these federal laws include exclusion from participation in the
Medicare/Medicaid programs, assets forfeitures, and civil and criminal
penalties. Civil administrative penalties for a wide range of offenses may be
up to $2,000 per item and twice the amount claimed. Under the Health
Insurance Portability and Accountability Act of 1996 (the "Health Insurance
Act"), the penalties will be increased, effective January 1, 1997 to up to
$10,000 per item plus three times the amount claimed. In the case of certain
offenses, exclusion from participation in Medicare and Medicaid is a
mandatory penalty.
The fraud and abuse provisions are interpreted liberally and enforced
aggressively by various enforcing agencies of the federal government,
including the Federal Bureau of Investigation ("FBI") and the OIG. According
to public statements by the DOJ, health care fraud has been elevated to the
second-highest priority of the DOJ, and FBI agents have been transferred from
investigating counterintelligence activities to health care provider fraud.
The OIG also is involved in such investigations and has, according to recent
workplans, targeted certain laboratory practices for study, investigation and
prosecution. The federal government's involvement in curtailing fraud and
abuse is likely to increase as a result of the enactment in August 1996 of
the Health Insurance Act which will require, by January 1, 1997, the U.S.
Attorney General and the OIG to jointly establish a program to (a) coordinate
federal, state and local enforcement programs to control fraud and abuse with
respect to health care, (b) conduct investigations, audits, evaluations and
inspections relating to the delivery and payment for health care, (c)
facilitate the enforcement of the health care fraud and abuse laws, (d)
provide for the modification and establishment of safe harbors and to issue
advisory opinions and Special Fraud Alerts and (e) provide for a data
collection system for the reporting and disclosure of adverse actions taken
against health care providers. The Health Insurance Act also authorizes the
establishment of an anti-fraud and abuse trust fund funded through the
collection of penalties and fines for violations of the health care
anti-fraud laws as well as amounts authorized therefor by Congress. The
Health Insurance Act also requires HHS to establish a program to encourage
Medicare beneficiaries and others to report violations of the health care
anti-fraud laws, including by paying to the reporting person a portion of any
fines and penalties collected.
In October 1994, the OIG issued a Special Fraud Alert, which set forth a
number of practices allegedly engaged in by clinical laboratories and health
care providers that the OIG believes violate the anti-kickback laws. These
practices include providing employees to collect patient samples at physician
offices if the employees perform additional services for physicians that are
typically the responsibility of the physicians' staff; selling laboratory
services to renal dialysis centers at prices that are below fair market value
in return for referrals of Medicare tests which are billed to Medicare at
higher rates; providing free testing to a physician's HMO patients in
situations where the referring physicians benefit from lower utilization;
providing free pickup and disposal of bio-hazardous waste for physicians for
items unrelated to a laboratory's testing services; providing facsimile
machines or computers to physicians that are not exclusively used in
connection with the laboratory services performed; and providing
75
<PAGE>
free testing for health care providers, their families and their employees
(professional courtesy testing). The OIG stressed in the Special Fraud Alert
that when one purpose of the arrangements is to induce referral of program-
reimbursed laboratory testing, both the clinical laboratory and the health care
provider or physician may be liable under the anti-kickback laws and may be
subject to criminal prosecution and exclusion from participation in the Medicare
and Medicaid programs. The Special Fraud Alert was issued in part at the request
of the American Clinical Laboratory Association, which requested clarification
of certain of these rules. Quest Diagnostics does not believe that it has been
negatively affected by the issuance of the Special Fraud Alert.
Many of these statutes and regulations, including those relating to joint
ventures and alliances, are vague or indefinite and have not been interpreted
by the courts. In addition, regulators have generally offered little guidance
to the clinical laboratory industry. Despite requests from the American
Clinical Laboratory Association for clarification of the anti-fraud and abuse
rules, since 1992, OIG has issued only two fraud alerts specifically with
regard to clinical laboratory practices and has insisted that it lacked
statutory authority to issue advisory opinions. Legislation requiring OIG to
issue fraud alerts and advisory opinions was enacted in August 1996, and as a
result Quest Diagnostics is hopeful that additional regulatory guidance will
be given to the clinical laboratory industry.
According to the 1995 work plan of the OIG, its recently established
Office of Civil Fraud and Administrative Adjudication ("OCFAA") will be
responsible for protecting the government-funded health care programs and
deterring fraudulent conduct by health care providers through the negotiation
and imposition of civil monetary penalties, assessments and program
exclusions. The OCFAA works very closely with the DOJ, the Office of General
Counsel of HHS and the OIG investigative and audit offices in combating fraud
and abuse. In addition, the OIG stated in its 1995 work plan that it will
determine the extent to which laboratories supply physicians' offices with
phlebotomists (blood-drawing technicians), offer management services or
medical waste pick-up to physicians, provide training to physicians or engage
in other financial arrangements with purchasers of laboratories' services.
The OIG will assess the potential benefits of such arrangements as well as
the extent to which such arrangements might be unlawful.
A federal "self-referral" law commonly known as the "Stark" law has, since
1992, generally prohibited (with certain exceptions) Medicare payments for
laboratory tests referred by physicians who have (personally or through a
family member) an investment interest in, or a compensation arrangement with,
the testing laboratory. Since January 1995, these restrictions apply to
Medicaid-covered services as well. Physicians may, however, be reimbursed by
Medicare and Medicaid for testing performed by or under the supervision of
the physician or the group practice to which the physician belongs. In
addition, a physician may refer specimens to a laboratory owned by a company,
such as Quest Diagnostics, whose stock is traded on a public exchange and
which has stockholders' equity exceeding $75 million even if the physician
owns stock of that company. An amendment to the Stark law in August 1993
makes it clear that ordinary day-to-day transactions between laboratories and
their customers, including, but not limited to, discounts granted by
laboratories to their customers, are not covered by the compensation
arrangement provisions of the Medicare statute. Sanctions for laboratory
violations of the prohibition include denial of Medicare payments, refunds,
civil money penalties of up to $15,000 for each service billed in violation
of the prohibition and exclusion from the Medicare and Medicaid programs.
The 1995 House Medicare reform proposal contained, and the House-Senate
report adopted, provisions that would significantly narrow the scope of the
Stark anti-referral laws. That proposal would, among other changes, have
ended the ban on physician referrals to laboratories based on any
"compensation arrangements" between the laboratory and the physician. The
President vetoed this bill on December 6, 1995.
Government Investigations and Related Claims
Quest Diagnostics has settled various government and private claims (i.e.,
nongovernmental claims such as those by private insurers) totalling
approximately $195 million relating primarily to industry-wide billing and
marketing practices that had been substantially discontinued by early 1993.
Specifically, Quest Diagnostics has entered into, (i) for an aggregate of
approximately $180 million, five settlements with the OIG and the DOJ
(including, the MetPath and the Damon settlements discussed below) and two
settlements with state governments with respect to Medicare and Medicaid
marketing and billing practices of Quest Diagnostics and certain companies
acquired by Quest Diagnostics prior to their acquisition and (ii) twelve
completed settlements and one tentative settlement relating to private claims
totalling approximately $15 million. In addition, there are pending
investigations by the OIG and DOJ into billing and marketing practices at three
regional laboratories operated by Nichols prior to its acquisition by Quest
Diagnostics. There are no other private claims presently pending.
76
<PAGE>
Government Settlements
The MetPath Settlement. In September 1993, Quest Diagnostics (under the name
MetPath Inc.) entered into an agreement with the DOJ and the OIG pursuant to
which Quest Diagnostics paid a total of approximately $36 million in settlement
of civil claims by the United States that the company had wrongfully induced
physicians to order certain laboratory tests without their realizing that such
tests would be billed to Medicare at rates higher than those the physicians
believed were applicable.
The Damon Settlement. By issuance of a civil subpoena in August 1993, the
government began a formal investigation of Damon, a company acquired by Corning
in August 1993. Subsequent to September 1993, several additional subpoenas were
issued. By a plea agreement and civil settlement agreement and release dated
October 9, 1996, between DOJ and Damon, all federal criminal matters within the
scope of the various federal investigations against Damon, and all claims
included in the civil qui tam cases underlying the civil investigations, were
settled for an aggregate of $119 million, which sum was reimbursed to Quest
Diagnostics by Corning. The settlement included base recoupments of
approximately $40 million (which did not differ materially from management's
estimate at June 30, 1996) and total criminal and civil payments in excess of
base recoupments of approximately $80 million. At the time Quest Diagnostics
began its settlement negotiations with DOJ in April 1996, it believed it had
meritorious defenses to a number of charges and claims made by the government.
Reserves established for such settlements in the second quarter of 1996 were
based on Quest Diagnostics' and its counsel's belief that the merits of its
factual and legal arguments would be given more weight by the government.
Certain of these positions were ultimately rejected by criminal and civil
prosecutors in the final rounds of negotiations which occurred in September
1996, resulting in a total settlement substantially in excess of what had
earlier been anticipated. The Damon settlement does not exclude Quest
Diagnostics from future participation in any federal health care programs on
account of Damon's practices. For further information regarding the Damon
settlement, see Note 13 to the Audited Quest Diagnostics Financial Statements
and Note 2 to the Quest Diagnostics Interim Financial Statements.
Other Governmental Settlements. In addition to the MetPath settlement and
the Damon settlement, since 1992 Quest Diagnostics has settled five other
federal and state billing-related claims for a total of approximately $25
million.
Ongoing Government Investigations
The Nichols Investigation. By issuance of a civil subpoena in August 1993,
the government began a formal investigation of Nichols, a company acquired by
Corning in August 1994. The investigation of Nichols remains open. While
Quest Diagnostics has established reserves in respect of the Nichols
investigations, at present there are no settlement discussions pending
between DOJ and Quest Diagnostics regarding Nichols, and it is too early to
predict the outcome of this investigation. Remedies available to the
government include exclusion from participation in the Medicare and Medicaid
programs, criminal fines, civil recoveries plus civil penalties and asset
forfeitures. Although application of such remedies and penalties could
materially and adversely affect Quest Diagnostics' business, financial
condition, results of operations and prospects, management believes that the
possibility of this happening is remote. Quest Diagnostics derived
approximately 23% and 22% of its net revenues for the year ended December 31,
1995 and the nine months ended September 30, 1996, respectively, from
Medicare and Medicaid programs. However, in light of the Corporate Integrity
Agreement referred to below entered into between Quest Diagnostics and the
OIG in connection with the Damon settlement, the fact that the matters being
investigated were corrected with or before Quest Diagnostics' acquisition of
Nichols and Quest Diagnostics' cooperation in this investigation, Quest
Diagnostics believes the prospect of such exclusion on account of the
investigation is remote. As discussed below, Corning has agreed to indemnify
Quest Diagnostics against any monetary penalties, fines or settlements for
any governmental claims that may arise as a result of the Nichols
investigations.
The Damon Officer Investigations. Quest Diagnostics understands that the
Boston United States Attorney's Office has designated several former officers
and employees of Damon as targets of its criminal investigation, and will
seek indictments against them. Under the agreement and plan of merger under
which Damon was acquired by Corning, Quest Diagnostics is obligated to
indemnify former officers and directors of Damon to the fullest extent
permitted by Delaware law with respect to this investigation. These
obligations will remain those of Quest Diagnostics and will not be
indemnified by Corning. In addition, as part of the Damon settlement, Corning
agreed to cooperate with DOJ in its continuing investigation of individuals
formerly associated with Damon and, in connection therewith, Quest
Diagnostics is providing additional information pursuant to several
subpoenas.
77
<PAGE>
Other Government Investigations. In December 1995, Quest Diagnostics
received a subpoena from the OIG seeking information as to Quest Diagnostics'
policies in instances in which specimens were received and tested by a
laboratory without first receiving or verifying specific test requisitions.
While compliance with the subpoena is ongoing, Quest Diagnostics has
concluded the occurrence of this practice was relatively rare and was engaged
in primarily to preserve the integrity of test results from specimens subject
to rapid deterioration. During 1996, Quest Diagnostics voluntarily
self-reported to the government a few isolated events, involving billings of
approximately $16 million, that may have resulted in overpayment by Medicare
and Medicaid to Quest Diagnostics. It is Quest Diagnostics' policy to
internally investigate all such incidents and to self-report and reimburse
payors as appropriate. Although Quest Diagnostics has commenced internal
investigations to quantify the amounts that may be recouped by the government
and corrective action has been taken as to each such event, it is too early
to predict the outcome of these disclosures to the government. As discussed
below, Corning has agreed to indemnify Quest Diagnostics against any monetary
penalties, fines or settlements for any governmental claims that may arise as
a result of the investigations described in this paragraph.
Outlook for Future Government Investigations
The Damon settlement involved, and a settlement regarding Nichols is
expected to involve, only matters predating Corning's acquisition of both such
companies, and turned on, or will turn on, facts unique to those companies and
other factors individual government enforcement personnel may take into account.
However, recent experience in Quest Diagnostics' settlement of the Damon case
and public announcements by various government officials indicate that the
government's position on health care fraud is still hardening and collections of
amounts greatly in excess of mere recoupment of overcharges from laboratories
and other providers will be more prevalent. In addition, the newly adopted
Health Insurance Act includes provisions to combat health care fraud and abuse
will give federal enforcement personnel substantially increased funding, powers
and remedies to pursue suspected fraud and abuse. In connection with the Damon
settlement, Quest Diagnostics signed a Corporate Integrity Agreement pursuant to
which Quest Diagnostics will maintain its corporate compliance program, modify
certain of its marketing materials, make periodic reports to the OIG and take
certain other steps to demonstrate Quest Diagnostics' integrity as a provider of
services to federally sponsored health care programs. This agreement also
includes an obligation to self-report instances of noncompliance that are
uncovered by Quest Diagnostics, but also gives Quest Diagnostics the opportunity
to obtain clearer guidance on matters of compliance and to resolve compliance
issues directly with OIG. Importantly, the agreement gives Quest Diagnostics the
opportunity to cure any asserted breaches and to otherwise initiate corrective
actions, which Quest Diagnostics believes should help to avoid enforcement
actions outside of the process provided in the agreement. See "--Compliance
Program."
Private Settlements and Claims
Since 1992 Quest Diagnostics has settled thirteen private actions relating
to the governmental settlements described above for an aggregate of
approximately $15 million. There are no private claims presently pending.
Corning Indemnity
In connection with the Distributions, Corning will agree to indemnify Quest
Diagnostics against all monetary penalties, fines or settlements for any
governmental claims arising out of alleged violations of applicable federal
fraud and health care statutes and relating to billing practices of Quest
Diagnostics and its predecessors that have been settled or are pending on the
Distribution Date. This includes the settlements described under "--Government
Settlements" above and the claims described under "--Ongoing Government
Investigations--The Nichols Investigation" and "--Other Government
Investigations." Corning will also agree to indemnify Quest Diagnostics for 50%
of the aggregate of all judgment or settlement payments made by Quest
Diagnostics that are in excess of $42.0 million in respect of claims by private
parties (i.e., nongovernmental parties such as private insurers) that relate to
indemnified or previously settled governmental claims (such as the Damon
settlement) and that allege overbillings by Quest Diagnostics or any existing
subsidiaries of Quest Diagnostics, for services provided prior to the
Distribution Date; provided, however, such indemnification will not exceed $25.0
million in the aggregate and that all amounts indemnified against by Corning for
the benefit of Quest Diagnostics will be calculated on a net after-tax basis by
taking into account any deductions and other tax benefits realized by Quest
Diagnostics (or a consolidated group of which Quest Diagnostics is a member
after the Distributions (the "Quest Diagnostics Group")) in respect of the
underlying settlement, judgment payment, or other loss (or portion thereof)
indemnified
78
<PAGE>
against by Corning generally at the time and to the extent such deductions or
tax benefits are deemed to reduce the tax liability of Quest Diagnostics or
the Quest Diagnostics Group.
Corning will not indemnify Quest Diagnostics against (i) any governmental
claims that arise after the Distribution Date pursuant to service of subpoena
or other notice of such investigation after the Distribution Date, (ii) any
nongovernmental claims unrelated to the indemnified governmental claims or
investigations, (iii) any nongovernmental claims not settled prior to five
years after the Distribution Date, (iv) any consequential or incidental
damages relating to the billing claims, including losses of revenues and
profits as a consequence of exclusion for participation in federal or state
health care programs or (v) the fees and expenses of litigation. Quest
Diagnostics will control the defense of any governmental claim or
investigation unless Corning elects to assume such defense. However, in the
case of all nongovernmental claims related to indemnified governmental claims
related to alleged overbillings, Quest Diagnostics will control the defense.
All disputes under the Transaction Agreement are subject to binding
arbitration. See "The Relationship Among Corning, Quest Diagnostics and
Covance After the Distributions--Transaction Agreement."
Quest Diagnostics' Reserves
Quest Diagnostics' aggregate reserve with respect to all governmental and
private claims, including litigation costs of approximately $6.6 million, was
$215 million at September 30, 1996 and is estimated to be $85 million at the
Distribution Date. The approximately $130 million reduction in the reserve is
due to the subsequent payment of the Damon settlement ($119 million), the
settlement of an investigation into billing of certain hematology indices
(reserved at $7 million) and the settlement of a private claim (reserved at
$6 million). These settlements have been or will be funded by contributions
to Quest Diagnostics' capital by Corning. The $85 million reserve represents
amounts for future government and private settlements of matters which are
either presently pending or anticipated as a consequence of the government
and private settlements and self-reported matters described above. Based on
information available to management and Quest Diagnostics' experience with
past settlements, especially the Damon settlement and the fact that the
aggregate amount of such settlement was significantly in excess of
established reserves, management has reassessed its reserve levels and
believes that its current level of reserves is adequate. However, it is
possible that the additional information may become available (such as the
indication by the government of criminal activity, additional tests being
questioned or other changes in the government's theories of wrongdoing) which
may cause the final resolution of these matters to be in excess of
established reserves by an amount which could be material to Quest
Diagnostics' results of operations and, for non-indemnified claims, Quest
Diagnostics' cash flows in the period in which such claims are settled. While
none of the governmental or nongovernmental investigations or claims is
covered by insurance, Quest Diagnostics does not believe that these matters
will have a material adverse effect on Quest Diagnostics' overall financial
condition.
Compliance Program
Because of evolving interpretations of regulations and the national debate
over health care, compliance with all Medicare, Medicaid and other
government-established rules and regulations has become a significant concern
throughout the clinical laboratory industry. Quest Diagnostics began the
implementation of a compliance program early in 1993. The objective of the
program is to develop aggressive and reliable compliance safeguards. Emphasis
is placed on developing training programs for personnel intended to assure
the strict implementation and observance of all applicable rules and
regulations. Further, in-depth reviews of procedures, personnel and
facilities are conducted to assure regulatory compliance throughout Quest
Diagnostics. Quest Diagnostics' current compliance plan establishes a
Compliance Committee of the Quest Diagnostics Board and requires periodic
reporting of compliance operations by management to the Compliance Committee.
Such sharpened focus on regulatory standards and procedures will continue to
be a priority for Quest Diagnostics in the future.
Quest Diagnostics has established a comprehensive program designed to ensure
that it is in compliance in all material respects with all statutes, regulations
and other requirements applicable to its clinical laboratory operations. This
program was publicly cited with approval by government officials at the time the
Damon settlement was announced and characterized as a "model" for the industry.
In addition, the government advised Quest Diagnostics representatives that Quest
Diagnostics' compliance program, coupled with corrective action taken by Quest
Diagnostics after its acquisition of Damon, greatly reduced the amounts of fines
and penalties, and was influential in causing the OIG not to seek exclusion of
Quest Diagnostics from future participation in governmental health care
programs. Pursuant to the Damon settlement, Quest Diagnostics signed a five year
Corporate Integrity Agreement with the OIG pursuant to which Quest Diagnostics
will, among other things, maintain its corporate
79
<PAGE>
compliance program, make certain changes to its test order forms, provide
certain additional notices to ordering physicians, provide to the OIG data on
certain test ordering patterns, adopt certain pricing guidelines, audit
laboratory operations, deliver annual reports on compliance activities, and
investigate and report instances of noncompliance, including any corrective
actions and disciplinary steps. Importantly, the agreement gives Quest
Diagnostics the opportunity to cure any asserted breaches and to otherwise
initiate corrective actions, which Quest Diagnostics believes should help to
avoid enforcement actions outside of the process provided in the agreement. The
agreement gives Quest Diagnostics the opportunity to obtain clearer guidance on
matters of compliance and to resolve compliance issues directly with the OIG.
Quest Diagnostics has been advised that its principal competitors will be
obliged to execute similar agreements at the conclusion of investigations
pending against them and that the OIG will likely publish to the clinical
laboratory testing industry a guideline on the essential elements of a
satisfactory compliance program. This latter step may help create a fairer
competitive environment for Quest Diagnostics. None of the undertakings included
in the agreement is expected to have any material adverse affect on Quest
Diagnostics' business, financial condition, results of operations and prospects.
The clinical laboratory testing industry is, however, subject to extensive
regulation. Quest Diagnostics believes that it is in all material respects in
compliance with all applicable statutes and regulations. However, there can be
no assurance that any statutes or regulations might not be interpreted or
applied by a prosecutorial, regulatory or judicial authority in a manner that
would adversely affect Quest Diagnostics. Potential sanctions for violation of
these statutes and regulations include significant fines and the loss of various
licenses, certificates and authorizations.
Insurance
Quest Diagnostics maintains liability insurance (subject to maximum limits
and self-insured retentions) for claims, which may be substantial, that could
result from providing or failing to provide clinical laboratory testing
services, including inaccurate testing results. While there can be no
assurance that coverage will be adequate to cover all future exposure,
management believes that the present levels of coverage are adequate to cover
currently estimated exposures. Although Quest Diagnostics believes that it
will be able to obtain adequate insurance coverage in the future at
acceptable costs, there can be no assurance that Quest Diagnostics will be
able to obtain such coverage or will be able to do so at an acceptable cost
or that Quest Diagnostics will not incur significant liabilities in excess of
policy limits.
Employees
At September 30, 1996, Quest Diagnostics employed approximately 18,700
people. These include approximately 16,500 full-time employees and
approximately 2,200 part-time employees. Quest Diagnostics has no collective
bargaining agreements with any unions and believes that its overall relations
with its employees are good.
Seasonality
During the summer months, year-end holiday periods and other major
holidays, volume of testing declines, reducing net revenues and resulting
cash flows below annual averages during the third and fourth quarters each
year. Winter months are also subject to declines in testing volume due to
inclement weather. As a result, comparisons of the results of successive
quarters may not accurately reflect trends or results for the full year. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations of Quest Diagnostics--Overview."
Properties
Quest Diagnostics's principal laboratories (listed alphabetically by
state) are located in the following metropolitan areas:
<TABLE>
<CAPTION>
Location Type of Laboratory Leased or Owned
- ----------------------------------------------- ------------------ ---------------
<S> <C> <C>
Phoenix, Arizona Regional Leased
San Diego, California Regional Leased
San Juan Capistrano, California Esoteric Owned
Denver, Colorado Regional Leased
New Haven, Connecticut Regional Owned
Miami, Florida Branch Leased
Tampa, Florida Regional Leased
Atlanta, Georgia Regional Leased
Chicago, Illinois Regional Leased
80
<PAGE>
Location Type of Laboratory Leased or Owned
- ----------------------------------------------- ------------------ ---------------
Indianapolis, Indiana Branch Leased
Baltimore, Maryland Regional Owned
Boston, Massachusetts Owned subject to
Regional put/call
with option to
lease
Detroit, Michigan Regional Leased
Grand Rapids, Michigan Branch Leased
Kansas City, Missouri Branch Leased
St. Louis, Missouri Regional Leased
Billings, Montana Branch Leased
Lincoln, Nebraska Regional Managed (hospital)
Teterboro, New Jersey/New York, New York Regional Owned
Albuquerque, New Mexico Branch Leased
Buffalo, New York Branch Owned
Long Island, New York Branch Leased
Cleveland, Ohio Branch Owned
Columbus, Ohio Branch Leased
Portland, Oregon Regional Leased
Erie, Pennsylvania Leased by joint
Branch venture
Philadelphia, Pennsylvania Regional Leased
Pittsburgh, Pennsylvania Regional Leased
Nashville, Tennessee Branch Owned
Dallas, Texas Regional Leased
El Paso, Texas Branch Leased
Salt Lake City, Utah Branch Leased
</TABLE>
Quest Diagnostics executive offices are located in Teterboro, New Jersey
in the building that serves as Quest Diagnostics' regional laboratory in the
New York City metropolitan area. Quest Diagnostics owns its branch laboratory
facility in Mexico City. Quest Diagnostics believes that, in general, its
laboratory facilities are suitable and adequate for its current and
anticipated future levels of operation. Quest Diagnostics believes that if it
were unable to renew the lease on any of its testing facilities, it could
find alternative space at competitive market rates and relocate its
operations to such new locations.
Legal Proceedings
In addition to the investigations described in "--Government
Investigations and Related Claims," Quest Diagnostics is involved in various
legal proceedings arising in the ordinary course of business. Some of the
proceedings against Quest Diagnostics involve claims that are substantial in
amount. Although it is not feasible to predict the outcome of such
proceedings or any claims made against Quest Diagnostics, it does not
anticipate that the ultimate liability of such proceedings or claims will
have a material adverse effect on Quest Diagnostics' financial position or
results of operations as they primarily relate to professional liability for
which Quest Diagnostics believes it has adequate insurance coverage. Quest
Diagnostics maintains professional liability insurance for its professional
liability claims. See "--Insurance."
IMPORTANT FACTORS REGARDING FORWARD LOOKING STATEMENTS
Quest Diagnostics wishes to caution stockholders that the following
factors are hereby identified as important factors that could cause Quest
Diagnostics' actual financial results to differ materially from those
projected, forecast, estimated, or budgeted by Quest Diagnostics in
forward-looking statements.
(a) Heightened competition, including the intensification of price
competition. See "Risk Factors--Risks Relating to Quest
Diagnostics--Intense Competition."
81
<PAGE>
(b) Impact of changes in payor mix, including the shift from traditional,
fee-for-service medicine to managed- cost health care. See "Risk
Factors--Risks Relating to Quest Diagnostics--Role of Managed Care."
(c) Adverse actions by governmental or other third-party payors, including
unilateral reduction of fee schedules payable to Quest Diagnostics.
(d) The impact upon Quest Diagnostics' collection rates or general or
administrative expenses resulting from compliance with Medicare
administrative policies, including specifically the recent
requirements of Medicare carriers to provide diagnosis codes for
commonly ordered tests and the policy of HCFA to limit Medicare
reimbursement for tests contained in automated chemistry panels to the
amount that would have been paid if only the covered tests, determined
on the basis of demonstrable "medical necessity," had been ordered.
See "Risk Factors--Risks Relating to Quest Diagnostics--Reliance on
Medicare/Medicaid Reimbursements" and "Risk Factors--Risks Relating to
Quest Diagnostics--Government Regulation."
(e) Adverse results from pending governmental investigations, including in
particular significant monetary damages and/or exclusion from the
Medicare and Medicaid programs and/or other significant litigation
matters. Also, the absence of indemnification from Corning for private
claims unrelated to the indemnified governmental claims or
investigations and for private claims that are not settled within five
years of the Distribution Date. See "Risk Factors--Risks Relating to
Quest Diagnostics--Government Investigations and Related Claims."
(f) Failure to obtain new customers, retain existing customers or
reduction in tests ordered or specimens submitted by existing
customers.
(g) Inability to obtain professional liability insurance coverage or a
material increase in premiums for such coverage.
(h) Denial of CLIA certification or other licensure of any of Quest
Diagnostics's clinical laboratories under CLIA, by HCFA for Medicare
and Medicaid programs or other federal, state and local agencies. See
"Risk Factors--Risks Relating to Quest Diagnostics--Government
Regulation."
(i) Adverse publicity and news coverage about Quest Diagnostics or the
clinical laboratory industry.
(j) Computer or other system failures that affect the ability of Quest
Diagnostics to perform tests, report test results or properly bill
customers. See "Risk Factors--Risks Relating to Quest
Diagnostics--Billing."
(k) Development of technologies that substantially alter the practice of
laboratory medicine.
82
<PAGE>
MANAGEMENT OF QUEST DIAGNOSTICS
Management
Directors. Certain information with respect to the persons who will serve
as directors of Quest Diagnostics following the Distributions is set forth
below. Prior to the closing of the Quest Diagnostics Notes Offering and the
Quest Diagnostics Spin-Off Distribution, one of the current directors will
resign and the prospective directors listed below will be elected. As
provided in the Quest Diagnostics Certificate, the Quest Diagnostics Board
will be divided into three classes effective upon the Distributions and one
class of the Quest Diagnostics Board will be elected for a three-year term at
each annual meeting of stockholders. Included in the information set forth
below are the names of the directors of each class. The term for which each
director will initially be elected has not yet been determined. Quest
Diagnostics is contemplating the selection of additional independent
directors, which selection may occur prior to the Distributions. Quest
Diagnostics does not intend to hold an annual meeting of stockholders until
the Spring of 1998.
<TABLE>
<CAPTION>
Name Age
- ------------------ ---
<S> <C>
Kenneth W. Freeman 46
Van C. Campbell 58
David A. Duke 61
Gail R. Wilensky 53
</TABLE>
Kenneth W. Freeman was elected President and Chief Executive Officer of
Quest Diagnostics in May 1995 and has been a director of Quest Diagnostics
since July 1995. Prior to 1995, he served in a variety of key financial and
managerial positions at Corning, which he joined in 1972. He was elected
controller and a vice president of Corning in 1985, senior vice president in
1987, and general manager of the Science Products Division in 1989. He was
appointed president and chief operating officer of Corning Asahi Video
Products Company in 1990. In 1993, he was elected executive vice president.
Van C. Campbell is the Vice Chairman of Corning, which he joined in 1964.
He was elected assistant treasurer in 1971, treasurer in 1972, a vice
president in 1973, financial vice president in 1975 and senior vice president
for finance in 1980. He became general manager of the Consumer Products
Division in 1981. Mr. Campbell was elected vice chairman and a director in
1983 and during 1995 was appointed to the additional position of chairman of
Corning Life Sciences, Inc. He is a director of Armstrong World Industries,
Inc. and General Signal Corporation. Mr. Campbell has been a director of
Quest Diagnostics since January 1991.
David A. Duke is a Retired Vice Chairman of Corning. Dr. Duke joined
Corning in 1962 and served in a succession of research and management
positions. He was elected vice president--Telecommunications Products in
1980, elected a senior vice president in 1984 and named director of Research
and Development in 1985. He became responsible for Engineering in March 1987
and was elected as a director and Vice Chairman of Corning in 1988. He
resigned as a director of Corning in April 1996 and retired in June 1996. Dr.
Duke is a director of Armco, Inc. Dr. Duke was a director of Quest
Diagnostics from October 1994 to July 1996 and was re-elected a director of
Quest Diagnostics in October 1996.
Gail R. Wilensky is the John M. Olin Senior Fellow at Project HOPE, an
international non-profit health foundation, which she joined in 1993. She is
currently the chair of the Physician Payment Review Commission which advises
Congress on physician payment and other Medicare issues. In 1992 and 1993,
Dr. Wilensky served as a deputy assistant to the President for policy
development relating to health and welfare issues. From 1990 to 1992, she was
the administrator of the Health Care Financing Administration where she
directed the Medicare and Medicaid programs. Dr. Wilensky is a director of
Advance Tissue Sciences Inc., Capstone Pharmacy Inc., Coram Healthcare Corp.,
Neopath Inc., St. Jude Medical Corp., SMS Corporation, Syncor Corporation and
United Healthcare Corporation.
Directors' Compensation. Each director of Quest Diagnostics, other than a
director who is an employee of Quest Diagnostics, will receive $18,000
annually for service as a director and will also be paid $1,000 for each
meeting of the Quest Diagnostics Board and $500 for each meeting of any
committee thereof which he or she attends. In addition, directors serving as
committee chairs would receive an additional annual retainer of $1500.
Quest Diagnostics has adopted, effective the Distribution Date, a deferred
compensation plan for directors pursuant to which each director may elect to
defer until a date specified by him receipt of all or a portion of his
83
<PAGE>
compensation. Such plan provides that amounts deferred may be allocated to
(i) a cash account upon which amounts deferred may earn interest, compounded
quarterly, at the base rate of Citibank, N.A. in effect on certain specified
dates, (ii) a market value account, the value of which will be based upon the
market value of Quest Diagnostics Common Stock from time to time, or (iii) a
combination of such accounts. All non-employee directors will be eligible to
participate in the plan.
Quest Diagnostics has adopted, effective the Distribution Date, a
restricted stock plan for non-employee directors, pursuant to which Quest
Diagnostics will issue to each non-employee director elected 750 shares of
Quest Diagnostics Common Stock for each year specified in the term of service
for which such director was elected, subject to forfeiture and restrictions
on transfer, and 5,000 shares upon such director's election, subject to
forfeiture and restrictions on transfer.
Committees of the Board of Directors. Prior to the Distributions, the
Quest Diagnostics Board is expected to establish and designate specific
functions and areas of oversight to an Audit and Finance Committee, a
Compensation Committee ("Quest Diagnostics Compensation Committee") and a
Compliance Committee. The Audit and Finance Committee will examine and
consider matters relating to the financial affairs of Quest Diagnostics,
including reviewing Quest Diagnostics' annual financial statements, the scope
of the independent and internal audits and the independent auditor's letter
to management concerning the effectiveness of Quest Diagnostics's internal
financial and accounting controls. The Quest Diagnostics Compensation
Committee will make recommendations to the Quest Diagnostics Board with
respect to programs for human resource development and management
organization and succession, determine senior executive compensation, make
recommendations to the Quest Diagnostics Board with respect to compensation
matters and policies and employee benefit and incentive plans, administer
such plans, and administer Quest Diagnostics' stock option and equity based
plans and grant stock options and other rights under such plans. The
Compliance Committee will oversee Quest Diagnostics' compliance program,
which is administered by management's compliance council. The council will
prepare for review and action by the Compliance Committee reports on such
matters as audits and investigations. See "Business of Quest
Diagnostics--Compliance Program."
Executive Officers of Quest Diagnostics. In addition to Mr. Freeman, the
following persons will serve as executive officers of Quest Diagnostics after
the Distributions:
Robert A. Carothers (60) will become Vice President and Chief Financial
Officer at the Distribution Date. Mr. Carothers joined Corning in 1959 and
has served in a number of key financial positions in the United States and
Japan. He was elected Assistant Controller in 1991. In January 1996 he was
appointed Assistant to the President of Quest Diagnostics.
James D. Chambers (40) is Vice President-Billing. Mr. Chambers joined
Corning in 1986 and has served in a variety of managerial and financial
positions for Corning and its subsidiaries, becoming Assistant Treasurer in
1991. Mr. Chambers joined Quest Diagnostics in 1992 as Treasurer and served
as Chief Financial Officer from 1994 through 1995. In 1995 Mr. Chambers
assumed his current responsibilities overseeing Quest Diagnostics' billing
process. At the Distribution Date, Mr. Chambers will also assume
responsibility for investor relations.
Gregory C. Critchfield, M.D. (45) is Senior Vice President, and Chief
Medical and Science Officer. Dr. Critchfield joined Quest Diagnostics in 1995
as Chief Laboratory Officer and assumed his current responsibilities in May
1996. Dr. Critchfield has served as a consultant to the National Institutes
of Health in the capacity of a reviewer for more than ten years and was
selected as Study Section Chair of several Multidisciplinary Review Teams
during the last two years. Prior to joining Quest Diagnostics, Dr.
Critchfield was a clinical pathologist with Intermountain Health Care ("IHC")
for eight years and served in various director positions with IHC Laboratory
Services, including Director of Clinical Pathology. Dr. Critchfield also
served as Chairman of the Department of Pathology at Utah Valley Regional
Medical Center from 1994 through 1995.
Kurt R. Fischer (41) is Vice President-Human Resources. Mr. Fischer joined
Corning in 1976 and has served in a variety of Human Resources positions. He
was appointed Human Resource Manager for the Research, Development and
Engineering Group in 1986 and Director-Quality and Performance Management for
the Specialty Materials Group in 1991. Mr. Fischer assumed his present
responsibilities with Quest Diagnostics in December 1995.
Delbert A. Fisher, M.D. (68) is Vice President of Corning Nichols
Institute and currently serves as President of its Academic Associates, a
select group of eminent physicians and scientists who advise the company on
new
84
<PAGE>
medical and scientific developments. Dr. Fisher joined Nichols Institute in
1991 as President of its esoteric laboratory facility and assumed his present
responsibilities in 1993. Prior to joining Nichols, he was a professor of
pediatrics and the Associate Chairman of the Department of Pediatrics of the
UCLA School of Medicine for 23 years.
Raymond Gambino, M.D. (70) is Chief Medical Officer Emeritus. Dr. Gambino
joined Quest Diagnostics in 1983 as President of the Eastern Region. From
1984 to 1994, Dr. Gambino served as Chief Medical Officer and Executive Vice
President, at which time his appointment was changed to emeritus. He
continues to serve Quest Diagnostics as a senior medical advisor.
Don M. Hardison, Jr. (45) is Senior Vice President-Sales and Marketing,
with overall responsibility for all commercial activities. Mr. Hardison
joined Quest Diagnostics in January 1996. Prior to joining Quest Diagnostics,
Mr. Hardison had 18 years experience in health care with subsidiaries of
SmithKline Beecham and its predecessor entities, including seven years with
the clinical laboratory division of SmithKline, where he held a succession of
positions including Director of Marketing; Vice President of Sales-Northern;
Vice President-General Manager of the Atlanta Operation; and Vice President
of Sales and Marketing.
Paul A. Krieger, M.D. (50) is Vice President-Anatomic Pathology. Dr.
Krieger joined Quest Diagnostics in 1975 and served as Vice President,
Director of Anatomic Pathology at Quest Diagnostics' regional laboratory in
Teterboro, New Jersey until 1995, when he was appointed to his present
position. Concurrent with his employment with Quest Diagnostics, Dr. Krieger
has served as an Adjunct Assistant Professor at the College of Physicians and
Surgeons of Columbia University.
Raymond C. Marier (51) is Vice President, Secretary and General Counsel.
Mr. Marier joined Corning's Legal Department in 1973 as an Assistant Counsel,
where he worked with a number of Corning's operating units, including its
Medical and Science Products Divisions. He has held his present position
since 1992.
C. Kim McCarthy (41) is Vice President-Compliance and Government Affairs.
Ms. McCarthy joined Corning in 1987 as Director of Federal Government Affairs
and Legislative Counsel. She became Vice President of Public Affairs of Quest
Diagnostics in 1992 and Senior Vice President of Corporate Affairs in 1994.
Ms. McCarthy assumed her present responsibilities in June 1996.
Alister W. Reynolds (39) is Vice President-Information Technology. Mr.
Reynolds joined Quest Diagnostics in 1982 and has served in a variety of
staff, executive and general management positions. Mr. Reynolds assumed his
current responsibilities in 1995.
Douglas M. VanOort (40) will become Senior Vice President-Operations at
the Distribution Date. Mr. VanOort joined Corning in 1982 and has served in
various finance, analysis and control positions. He became Vice President and
Chief Financial Officer of Corning's Life Sciences division in 1990, Senior
Vice President-Finance and New Business Development of Corning's Life
Sciences division in 1993 and Executive Vice President and Chief Financial
Officer of Quest Diagnostics in 1995.
Executive Compensation
Historical Compensation. The following table sets forth information with
respect to annual and long-term compensation expected to be paid by Quest
Diagnostics and its subsidiaries to each of the chief executive officer and
the four other most highly compensated executive officers (the "named
executive officers") of Quest Diagnostics for services to be rendered in all
capacities in fiscal year 1996 and such compensation paid or accrued during
the years ended December 31, 1995 and December 31, 1994 for services rendered
by each of the named executive officers. All references in the following
tables to stock and stock options relate to awards of, and options to
purchase, Corning Common Stock.
85
<PAGE>
SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
Long-Term Compensation
----------------------------------
Annual Compensation Awards Payouts
----------------------------------- ---------------------- --------
Restricted
Other Annual Stock Securities Incentive All Other
Name and Salary Bonus Compensation Awards Underlying Plan Compensation
Principal Position Year (1) (2) (3) (4) Options Payouts (5)
- ------------------------ ------- ------- ------- ------------- --------- --------- --------
---------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Kenneth W. Freeman, 1996 385,000 211,750 10,440 -- -- -- 16,690
President and Chief 1995 316,667 249,918 7,200 326,926 87,000 -- 14,057
Executive Officer 1994 240,000 244,634 6,900 406,766 20,000 162,679 13,376
Robert A. Carothers, 1996 250,000 136,714 1,800 -- -- -- 8,254
Vice President and 1995 173,000 68,337 -- -- 16,500 -- 8,561
Chief Financial Officer 1994 165,250 84,180 -- -- 6,092 -- 7,557
Gregory C. Critchfield, 1996 310,000 182,900 40,909 -- 2,000 -- 65,690
Senior Vice President 1995 (6) 70,000 122,920 -- -- 3,000 -- 2,370
and Chief Medical and
Science Officer
Don M. Hardison, Jr., 1996 260,000 159,467 2,880 -- 24,000 -- 17,123
Senior Vice President-
Sales and Manufacturing
Douglas M. VanOort, 1996 325,000 178,750 2,880 -- -- -- 4,750
Senior Vice President- 1995 251,912 56,754 7,200 98,626 60,000 -- 4,620
Operations 1994 228,333 165,969 6,900 109,652 20,000 -- 4,178
</TABLE>
- -------------
(1) Reflects for 1996 current salaries on an annualized basis, including
amounts deferred.
(2) Reflects for 1996 projected performance-based annual cash compensation
awards at target levels.
(3) Includes dividends on shares of restricted stock granted but not earned
within one year from date of grant and tax gross-up payments.
(4) Messrs. Freeman, Carothers, Hardison and VanOort held an aggregate of
97,930, 2,500, 4,000 and 43,627 shares of restricted stock of Corning,
respectively, having an aggregate value on September 30, 1996 of
$3,819,270, $97,500, $156,000 and $1,701,453, respectively. Certain of
such shares, net of forfeitures, were subject to performance-based
conditions on vesting and are subject to forfeiture upon termination and
restrictions on transfer prior to stated dates. Certain other shares
("Career Shares") are subject to restrictions on transfer until the
executive officer retires at or after age 60 and are subject to
forfeiture prior to age 60 in whole if such officer voluntarily
terminates employment with Quest Diagnostics and in part if such
officer's employment is terminated by Quest Diagnostics. On or prior to
the Distribution Date (a) all forfeiture conditions and transfer
restrictions will be removed from performance-based shares, (b) all
restrictions on transfer will be removed from shares which are no longer
subject to forfeiture and (c) Career Shares which are subject to
forfeiture conditions and transfer restrictions, except for 50% of such
shares held by Mr. Freeman, will be forfeited, and in lieu thereof
restricted shares and/or options to purchase shares of Quest Diagnostics
Common Stock will thereafter be granted pursuant to the terms of the
Quest Diagnostics Employee Equity Participation Plan (as defined below).
Dividends are paid to such individuals on all shares of restricted
Corning Common Stock held by them.
(5) Includes the following amounts to be contributed by Quest Diagnostics to
the Quest Diagnostics Profit Sharing Plan (as defined below) for 1996:
$3,850 for Mr. Freeman, $4,283 for Mr. Hardison and $4,750 for Mr.
VanOort. Also includes $12,840 automobile allowance received by each of
Messrs. Freeman and Hardison and $9,480 for Dr. Critchfield. Also
includes 50% of a $100,000 interest-free loan made by Quest Diagnostics
to Dr. Critchfield together with imputed interest thereon, which loan is
to be forgiven over a two-year period provided Dr. Critchfield continues
to be employed by Quest Diagnostics and was made to assist Dr.
Critchfield in relocating to the New Jersey area.
(6) Dr. Critchfield commenced employment with Quest Diagnostics in October
1995.
Option Grants. The following table sets forth certain information regarding
options granted in 1995 (except for Mr. Hardison whose options were granted
on February 7, 1996) to the named executive officers pursuant to Corning
stock option plans. No other options were granted to the named executive
officers in 1996. Employees of Quest Diagnostics who hold at the Distribution
Date Corning stock options other than those granted on December 6, 1995 and
February 7, 1996 will continue to hold Corning stock options following the
Quest Diagnostics Spin-Off Distribution. It is anticipated that appropriate
adjustments to the number of shares subject to options and to the exercise
prices will be made to reflect the Quest Diagnostics Spin-Off Distribution. A
portion of the options granted on December 6, 1995 and February 7, 1996 will
be converted into options to purchase shares of Quest Diagnostics Common
Stock ("New Options") under the Quest Diagnostics Stock Option Plan (as
defined below). The remainder of the options granted on December 6, 1995 and
February 7, 1996 will be cancelled. It is anticipated that such cancelled
options will be replaced by options to be granted under the Quest Diagnostics
Stock Option Plan.
The exercise prices and the number of shares of Quest Diagnostics Common
Stock subject to New Options will be determined as of the time of the
Distributions so as to preserve the investment basis and intrinsic gain
associated with the Corning options surrendered as of the date of the Quest
Diagnostics Spin-Off Distribution. Generally, the expiration dates and the
dates on which New Options are exercisable will be identical to those under
the corresponding Corning options at the time of the Distributions. Certain
New Options will provide that upon
86
<PAGE>
exercise of such option through the surrender of previously owned shares of
Quest Diagnostics Common Stock, the participant will be entitled to receive
options covering the same number of shares so surrendered, with an exercise
price equal to the fair market value of the shares at the time of the
exercise of the New Option.
OPTION/SAR GRANTS IN FISCAL YEAR 1995 (1)
<TABLE>
<CAPTION>
Potential Realizable Value at
Assumed Annual Rates of Stock
Price Appreciation for
Individual Grants Option Term (3)
------------------------------------------------- -----------------------------------
Number of % of Total
Securities Options
Underlying Granted
Options to Employees Gain
Granted in Fiscal Exercise Expiration at Gain at Gain at
Name (2) Year Price Date 0% (4) 5% 10%
- ----------------------------- --------- ------------ ------- --------- ------ ---------- ------------
<S> <C> <C> <C> <C> <C> <C> <C>
Kenneth W. Freeman 87,000 2.6% 31.25 12/5/2005 0 1,709,807 4,332,987
Robert A. Carothers 1,500 0.0% 31.75 6/7/2005 0 29,951 75,902
15,000 0.4% 31.25 12/5/2005 0 294,794 747,067
Gregory C. Critchfield 3,000 0.1% 27.50 10/3/2005 0 51,884 131,484
Don M. Hardison, Jr. 24,000 0.7% 33.69 2/6/2006 0 508,499 1,288,636
Douglas M. VanOort 60,000 1.8% 31.25 12/5/2005 0 1,179,177 2,988,267
All Optionees as a Group (4) 3,389,100 100.0% 31.34 2005 0 66,797,662 169,278,390
</TABLE>
- -------------
(1) No SARs were granted.
(2) The stock option agreements with Messrs. Freeman, Carothers (with respect
to the 15,000 share grant), Hardison and VanOort provide that one-half of
the options will become exercisable on February 1, 1999 and all options
will become exercisable on February 1, 2000. The stock option agreement
with Dr. Critchfield provides that one-half of the options will become
exercisable on October 4, 1996 and all of the options will become
exercisable on October 4, 1997. The stock option agreement with Mr.
Carothers with respect to the 1,500 share grant provides that one-half of
the options became exercisable on June 6, 1996 and all of the options
will become exercisable on June 6, 1997. All such agreements also provide
that an additional option may be granted when the optionee uses shares of
Corning Common Stock to pay the purchase price of an option. The
additional option will be exercisable for the number of shares tendered
in payment of the option price, will be exercisable at the then fair
market value of the Corning Common Stock, will become exercisable only
after the lapse of twelve months and will expire on the expiration date
of the original option.
(3) The dollar amounts set forth under these columns are the result of
calculations at 0% and at the 5% and 10% rates established by the
Commission and therefore are not intended to forecast future appreciation
of Corning Common Stock.
(4) No gain to the optionees is possible without an appreciation in stock
price, an event which will also benefit all stockholders. If the stock
price does not appreciate, the optionees will realize no benefit.
Option Exercises and Fiscal Year-End Values. The following table sets
forth the number of shares of Corning Common Stock covered by both
exercisable and unexercisable stock options as of December 31, 1995, for the
named executive officers. The named executive officers exercised no options
in 1996.
87
<PAGE>
AGGREGATED OPTION/SAR EXERCISES IN FISCAL
YEAR 1995 AND 1995 FISCAL YEAR-END OPTION/SAR VALUES (1)
<TABLE>
<CAPTION>
Number of Securities
Underlying Unexercised Value of Unexercised
Options at In-the-Money Options
Fiscal Year End At Fiscal Year End
---------------------------- ------------------------------
Shares
Acquired Value
Name on Exercise Realized Exercisable Unexercisable Exercisable Unexercisable
- ----------------------- ------------ -------- ----------- ------------- ----------- ---------------
<S> <C> <C> <C> <C> <C> <C>
Kenneth W. Freeman 0 0 103,500 127,000 827,784 107,500
Robert A. Carothers 0 0 12,483 15,749 0 0
Gregory C. Critchfield 0 0 0 5,000 0 10,688
Don M. Hardison, Jr. -- -- -- -- -- --
Douglas M. VanOort 0 0 11,500 88,000 19,729 55,750
</TABLE>
- -------------
(1) There are no SARs outstanding.
Corporate Performance Plan Activity. Awards of performance-based shares of
Corning Common Stock have been granted to Quest Diagnostics's executive
officers pursuant to a series of performance-based plans (the "Corporate
Performance Plan"). The Corporate Performance Plan provides the mechanisms to
reward improvement in corporate performance as measured by net income,
earnings per share and/or return on equity. Each year minimum, target and
maximum goals are set and shares awarded (at target levels) which are subject
to forfeiture in whole or in part if performance goals are not met. The
percentage of awards that may be earned ranges from 0% to 150% of target.
Shares earned remain subject to forfeiture and restrictions on transfer for
two years following the end of the performance period.
The following table sets forth the number of performance-based shares
awarded under the Corporate Performance Plan. The dollar value of shares
earned for 1995 is reflected in the "Restricted Stock Awards" column of the
Summary Compensation Table.
In late 1996, the Compensation Committee of the board of directors of
Corning (the "Corning Board") will assess performance against goals,
determine the number of shares earned of those granted on December 6, 1995
and February 7, 1996 and remove all possibility of forfeiture and
restrictions on transfer from such shares.
CORPORATE PERFORMANCE PLAN ACTIVITY TABLE
<TABLE>
<CAPTION>
Number Number
of Number of Vesting Date
Grant Shares Performance of Shares Shares of
Name Year Date Granted Period Forfeited Earned Earned Shares
- ----------------------- ---- ----- -------- ---------- --------- -------- --------------
<S> <C> <C> <C> <C> <C> <C> <C>
Kenneth W. Freeman 1996 12/95 14,500 1996 2/99
1995 12/94 10,000 1995 10,740 2/98
1994 12/93 10,000 1994 14,690 2/97
Robert A. Carothers 1996 12/95 2,500 1996 2/99
1995 0
1994 0
Gregory C. Critchfield 1996 0
1995 0
Don M. Hardison, Jr. 1996 2/96 4,000 1996 2/99
Douglas M. VanOort 1996 12/95 10,000 1996 2/99
1995 12/94 10,000 1995 6,760 3,240 2/98
1994 12/93 4,000 1994 40 3,960 2/97
</TABLE>
Variable Compensation. Quest Diagnostics has adopted, effective upon the
Distributions, a variable compensation plan (the "Plan"), an annual incentive
cash compensation plan for approximately 950 supervisory, management and
executive employees similar to an annual performance plan currently
maintained by Quest Diagnostics. The terms of the Plan are as follows.
The performance-based annual cash incentive awards payable under the Plan
will be grounded in financial goals such as net income, cash flow, operating
margin, return on equity, or earnings per share, or a combination
88
<PAGE>
thereof, and quantifiable non-financial goals. Each participant will be
assigned a target award, as a percentage of base salary in effect at the end
of the performance year for which the target is set, payable if the target is
achieved. Actual results will be compared to the scale of targets with each
gradation of desired result corresponding to a percentage, which will be
multiplied by the employee's assigned target award. If the actual result is
below target, awards will be less than target, down to a point below which no
awards are earned. If the desired result is above target, awards will be
greater than target, up to a stated maximum award. The maximum award assigned
to the chief executive officer may not exceed 200% of base salary in effect
on the date the Quest Diagnostics Compensation Committee sets the target for
the performance year. The Quest Diagnostics Compensation Committee retains
the right to reduce any award if it believes individual performance does not
warrant the award calculated by reference to the result.
Employee Equity Participation Program. Quest Diagnostics has adopted,
effective upon the Distributions, the Employee Equity Participation Program
(the "Program") consisting of two plans: (a) a stock option plan (the "Quest
Diagnostics Stock Option Plan") and (b) an incentive stock plan (the "Quest
Diagnostics Incentive Stock Plan"). The Program is designed to provide a
flexible mechanism to permit key employees of Quest Diagnostics and of any
subsidiary to obtain significant equity ownership in Quest Diagnostics,
thereby increasing their proprietary interest in the growth and success of
Quest Diagnostics.
The Program, which will be administered by the Quest Diagnostics
Compensation Committee, provides for the grant to eligible employees of
either non-qualified or "incentive stock" options, or both, to purchase
shares of Quest Diagnostics Common Stock at no less than fair market value on
the date of grant. The Quest Diagnostics Compensation Committee may also
provide that options may not be exercised in whole or in part for any period
or periods of time; provided, however, that no option will be exercisable
until at least twelve months from the date of grant. All options shall expire
not more than ten years from the date of grant. Options will not be
assignable or transferable except for limited circumstances on death. During
the lifetime of the employee an option may be exercised only by him. The
option price is payable upon exercise. The optionee may pay the option price
in cash or with shares of Quest Diagnostics Common Stock owned by him. The
optionee will have no rights as a stockholder with respect to the shares
subject to option until shares are issued upon exercise of the option. The
Quest Diagnostics Compensation Committee may grant options pursuant to which
an optionee who uses shares of Quest Diagnostics Common Stock to pay the
purchase price of an option will receive automatically on the date of
exercise an additional option to purchase shares of Quest Diagnostics Common
Stock. Such additional option will cover the number of shares tendered in
payment of the option price, will be exercisable at the then fair market
value of Quest Diagnostics Common Stock, will become exercisable only after
the lapse of twelve months and will expire no later than the expiration date
of the original option.
The Program also authorizes the Quest Diagnostics Compensation Committee
to award to eligible employees shares, or the right to receive shares, of
Quest Diagnostics Common Stock, the equivalent value in cash or a combination
thereof (as determined by the Quest Diagnostics Compensation Committee). The
Quest Diagnostics Compensation Committee shall determine the number of shares
which are to be awarded to individual employees and the number of rights
covering shares to be issued upon attainment of predetermined performance
objectives for specified periods. The shares awarded directly to individual
employees may be made subject to certain restrictions prohibiting sale or
other disposition and may be made subject to forfeiture in certain events.
Shares may be issued to recognize past performance either generally or upon
attainment of specific objectives. Shares issuable for performance (based
upon specific predetermined objectives) will be payable only to the extent
that the Quest Diagnostics Compensation Committee determines that an eligible
employee has met such objectives and will be valued as of the date of such
determination. Upon issuance, such shares may (but need not) be made subject
to the possibility of forfeiture or certain restrictions on transfer.
Key executive, managerial and technical employees (including officers and
employees who are directors) of Quest Diagnostics and of any subsidiary will
be eligible to participate in the Program and the plans thereunder. The
selection of employees eligible to participate in any plan under the Program
is within the discretion of the Quest Diagnostics Compensation Committee.
Approximately 150 employees would have been eligible to participate in the
plans under the Program had the Program been in effect in 1996.
Under the Program, the maximum number of shares of Quest Diagnostics
Common Stock which may be optioned or granted to eligible employees will be
3,000,000. Shares from expired or terminated options under the Quest
Diagnostics Stock Option Plan will be available again for option grant under
the Program. Shares which are
89
<PAGE>
issued but not earned, or which are forfeited under the Quest Diagnostics
Incentive Stock Plan, will be available again for issuance under the Program.
The Program provides for appropriate adjustments in the aggregate number of
shares subject to the Program and in the number of shares and the price per
share, or either, of outstanding options in the case of changes in the
capital stock of Quest Diagnostics resulting from any recapitalization, stock
or unusual cash dividend, stock distribution, stock split or any other
increase or decrease effected without receipt of consideration by Quest
Diagnostics, or a merger or consolidation in which Quest Diagnostics is the
surviving corporation.
The Program has a term of five years and no shares may be optioned or
awarded and no rights to receive shares may be granted after the expiration
of the Program. The Quest Diagnostics Board is authorized to terminate or
amend the Program, except that it may not increase the number of shares
available thereunder, decrease the price at which options may be granted,
change the class of employees eligible to participate, or extend the term of
the Program or options granted thereunder without the approval of the holders
of a majority of the outstanding shares of Quest Diagnostics Common Stock.
Quest Diagnostics believes that the federal income tax consequences of the
Program are as follows. An optionee who exercises a non-qualified option
granted under the Quest Diagnostics Stock Option Plan will recognize
compensation taxable as ordinary income (subject to withholding) in an amount
equal to the difference between the option price and the fair market value of
the shares on the date of exercise and Quest Diagnostics or the subsidiary
employing the optionee will be entitled to a deduction from income in the
same amount. The optionee's basis in such shares will be increased by the
amount taxable as compensation, and his capital gain or loss when he disposes
of the shares will be calculated using such increased basis.
If all applicable requirements of the Code with respect to incentive stock
options are met, no income to the optionee will be recognized and no deduction
will be allowable to Quest Diagnostics at the time of the grant or exercise of
an incentive stock option. The excess of the fair market value of the shares at
the time of exercise of an incentive stock option over the amount paid is an
item of tax preference which may be subject to the alternative minimum tax. In
general, if an incentive stock option is exercised three months or more after
termination of employment, the optionee will recognize ordinary income in an
amount equal to the difference between the option price and the fair market
value of the shares on the date of exercise and Quest Diagnostics or the
subsidiary employing the optionee will be entitled to a deduction in the same
amount. If the shares acquired subject to the option are sold within one year of
the date of exercise or two years from the date of grant, the optionee will
recognize ordinary income in an amount equal to the difference between the
option price and the lesser of the fair market value of the shares on the date
of exercise or the sale price and Quest Diagnostics or the employing subsidiary
will be entitled to a deduction from income in the same amount. Any excess of
the sale price over the fair market value on the date of exercise will be taxed
as a capital gain.
Shares of Quest Diagnostics Common Stock which are not subject to
restrictions and possibility of forfeiture and which are awarded to an
employee under the Quest Diagnostics Incentive Stock Plan will be treated as
ordinary income, subject to withholding, to an employee at the time of the
transfer of the shares to him and the value of such awards will be deductible
by Quest Diagnostics or by the subsidiary employing the employee at the same
time in the same amount. Shares granted subject to restrictions and
possibility of forfeiture will not be subject to tax nor will such grant
result in a tax deduction for Quest Diagnostics at the time of award.
However, when such shares become free of restrictions and possibility of
forfeiture, the fair market value of such shares at that time (i) will be
treated as ordinary income to the employee and (ii) will be deductible by
Quest Diagnostics or by the subsidiary employing the employee.
The tax treatment upon disposition of shares acquired under the Program
will depend upon how long the shares have been held and on whether or not the
shares were acquired by exercising an incentive stock option. There are no
tax consequences to Quest Diagnostics upon a participant's disposition of
shares acquired under the Program, except that Quest Diagnostics may take a
deduction equal to the amount the participant must recognize as ordinary
income in the case of the disposition of shares acquired under incentive
stock options before the applicable holding period has been satisfied.
Pension Plans. None of the executive officers of Quest Diagnostics is
currently an active participant in a qualified defined benefit plan of Quest
Diagnostics.
Prior to June 1, 1995, December 1, 1996 and January 1, 1995, respectively,
Messrs. Freeman, Carothers and VanOort were eligible to participate in, and
accrue benefits under, Corning's Salaried Pension Plan (the "Corning
90
<PAGE>
Salaried Pension Plan"), a defined benefit plan, contributions to which are
determined by Corning's actuaries and are not made on an individual basis.
Benefits paid under this plan are based upon career earnings (regular salary
and cash awards paid under Corning's variable compensation plans) and years
of credited service. The Corning Salaried Pension Plan provides that salaried
employees of Corning who retire on or after December 31, 1993 will receive
pension benefits equal to the greater of (a) benefits provided by a formula
pursuant to which they shall receive for each year of credited service an
amount equal to 1.5% of annual earnings up to the social security wage base
and 2% of annual earnings in excess of such base or (b) benefits calculated
pursuant to a formula which provides that retirees will receive for each year
of credited service prior to January 1, 1994 an amount equal to 1% of the
first $24,000 of average earnings for the highest five consecutive years of
annual earnings in the ten years of credited service immediately prior to
1994 and 1.5% of such average earnings in excess of $24,000. Effective upon
commencement of employment, salaried employees may contribute to the Corning
Salaried Pension Plan 2% of their annual earnings up to the social security
wage base. Such employees will receive for each year of credited service
after December 31, 1990, in lieu of the amount described in (a) above, an
amount equal to 2% of annual earnings. The benefit formula is reviewed and
adjusted periodically for inflationary and other factors.
Corning maintains a non-qualified Executive Supplemental Pension Plan (the
"Executive Supplemental Plan") pursuant to which it will pay to certain
executives amounts approximately equal to the difference between the benefits
provided for under the Corning Salaried Pension Plan and benefits which would
have been payable thereunder but for the provisions of the Employee
Retirement Income Security Act of 1974, as amended ("ERISA").
It is anticipated that, prior to the Distribution Date, the Compensation
Committee of the Corning Board will adopt a transferee supplemental pension
plan (the "Transferee Supplemental Plan"), a nonqualified, unfunded defined
benefit plan for the benefit of key employees and executive officers of Quest
Diagnostics who are former employees of Corning, including Messrs. Freeman
and VanOort, effective immediately after the Distribution Date. The
Transferee Supplemental Plan will provide benefits approximately equal to the
difference between the benefits provided for under the Corning Salaried
Pension Plan and the Executive Supplemental Plan and benefits which would
have been payable thereunder but for the termination of employment with
Corning of such employees.
Maximum annual benefits calculated under the straight life annuity option
form of pension payable to participants at age 65, the normal retirement age
specified in the Corning Salaried Pension Plan, are illustrated in the table
set forth below. The table below does not reflect any limitations on benefits
imposed by ERISA. It is estimated that Messrs. Freeman and VanOort, who have
25 and 15 years of credited service, respectively, would receive each year if
they worked to age 65, the normal retirement age specified in the Corning
Salaried Pension Plan, $256,170 and $165,332, respectively, under the Corning
Salaried Pension Plan, the Executive Supplemental Plan and the Transferee
Supplemental Plan.
<TABLE>
<CAPTION>
Years of Service
--------------------------------------------------------------
Remuneration 15 20 25 30 35 40
- -------------- ------- ------- ------- ------- ------- ---------
<S> <C> <C> <C> <C> <C> <C>
$ 100,000 20,500 27,300 34,100 41,000 47,800 55,300
200,000 43,000 57,300 71,600 86,000 100,300 115,300
300,000 65,500 87,300 109,100 131,000 152,800 175,300
400,000 88,000 117,300 146,600 176,000 205,300 235,300
500,000 110,500 147,300 184,100 221,000 257,800 295,300
600,000 133,000 177,300 221,600 266,000 310,300 355,300
700,000 155,500 207,300 259,100 311,000 362,800 415,300
800,000 178,000 237,300 296,600 356,000 415,300 475,300
900,000 200,500 267,300 334,100 401,000 467,800 535,300
1,000,000 223,000 297,300 371,600 446,000 520,300 595,300
1,100,000 245,500 327,300 409,100 491,000 572,800 655,300
1,200,000 268,000 357,300 446,600 536,000 625,300 715,300
</TABLE>
Quest Diagnostics Profit Sharing Plan. Most of the employees of Quest
Diagnostics and its subsidiaries have been eligible to participate in a
tax-qualified, defined contribution plan known as the Quest Diagnostics
Profit Sharing Plan (the "Quest Diagnostics Profit Sharing Plan"), which
provides for investment of employee contributions, including tax-deferred
contributions under Section 401(k) of the Code, and matching contributions
made by their employers, in several investment funds, including Corning
Common Stock, at the employees' discretion. Effective as of the Distribution
Date, Quest Diagnostics Common Stock will be added as an investment
91
<PAGE>
fund and a portion of the employer matching contributions will automatically
be invested in Quest Diagnostics Common Stock. Corning Common Stock will no
longer be available as an investment fund except with respect to amounts
already so invested under the Quest Diagnostics Profit Sharing Plan.
Effective as of the Distribution Date, the Quest Diagnostics Profit
Sharing Plan will be amended to permit participating employees' employers to
make discretionary contributions, other than matching contributions, to the
Quest Diagnostics Profit Sharing Plan for the benefit of such employees,
which contributions may be invested in Quest Diagnostics Common Stock.
Quest Diagnostics Employee Stock Ownership Plan. Quest Diagnostics has
adopted, effective upon the Distributions, an employee stock ownership plan,
as defined in Section 4975(e)(7) of the Code and related regulations and
intended to qualify as a retirement plan under Section 401(a) of the Code, to
be known as the Quest Diagnostics Employee Stock Ownership Plan (the "Quest
Diagnostics ESOP").
Most employees of Quest Diagnostics and its subsidiaries will become
participants in the Quest Diagnostics ESOP after accruing six months of
service. To the extent permitted under the Quest Diagnostics ESOP, Quest
Diagnostics will contribute as of the Distribution Date an amount equal to a
portion of each participating employee's annual compensation. Quest
Diagnostics may in its discretion from time to time make additional
contributions to the Quest Diagnostics ESOP for the benefit of participating
employees. The assets of the Quest Diagnostics ESOP will be invested
primarily in shares of Quest Diagnostics Common Stock.
Amounts contributed to the Quest Diagnostics ESOP for the benefit of
participating employees will be 100% vested at age 65, the normal retirement
age specified in the Quest Diagnostics ESOP, or at death, disability or
termination of employment following completion of two years of credited
service. Contributions to the Quest Diagnostics ESOP will not currently be
taxable income to the participating employees and will not generally be
available to them until termination of employment.
Employee Stock Purchase Plan. Quest Diagnostics has adopted, as of the
Distribution Date, the Employee Stock Purchase Plan (the "Quest Diagnostics
Stock Purchase Plan"), pursuant to which Quest Diagnostics may make available
for sale to employees shares of its Common Stock at a price equal to 85% of
the market value on the first or last day of each calendar quarter, whichever
is lower.
The Quest Diagnostics Stock Purchase Plan, which will be administered by
the Quest Diagnostics Compensation Committee, is designed to give eligible
employees (generally, employees of Quest Diagnostics and its subsidiaries)
the opportunity to purchase shares of Quest Diagnostics Common Stock through
payroll deductions up to 10% of compensation in a series of quarterly
offerings commencing January 1, 1997, and ending no later than December 31,
2001.
Any eligible employee may elect to participate in the Quest Diagnostics
Stock Purchase Plan on a quarterly basis and may terminate his payroll
deduction at any time or increase or reduce prospectively the amount of his
deduction at the beginning of any calendar quarter. At the end of each
calendar quarter, a participating employee will purchase shares of Quest
Diagnostics Common Stock with the funds deducted. The number of shares
purchased will be a number determined by dividing the amount withheld by the
lower of 85% of the closing price of a share of Quest Diagnostics Common
Stock as reported in The Wall Street Journal on the first or last business
day of the particular calendar quarter. An employee will have no interest in
any shares of Quest Diagnostics Common Stock until such shares are actually
purchased by him.
Under the Quest Diagnostics Stock Purchase Plan, the maximum number of
shares of Quest Diagnostics Common Stock which may be purchased by eligible
employees will be 2,000,000 shares, subject to adjustment in the case of
changes in the capital stock of Quest Diagnostics resulting from any
recapitalization, stock dividend, stock split or any other increase or
decrease effected without receipt of consideration by Quest Diagnostics.
The Quest Diagnostics Stock Purchase Plan has a term of five years and no
shares of Quest Diagnostics Common Stock may be offered for sale or sold
under the Quest Diagnostics Stock Purchase Plan after the fifth anniversary
of the effective date. The Quest Diagnostics Board is authorized to terminate
or amend the Quest Diagnostics Stock Purchase Plan, except that it may not
increase the number of shares of Quest Diagnostics Common Stock available
thereunder, decrease the price at which such shares may be offered for sale
or change the designation of subsidiaries eligible to participate in the plan
without the approval of the holders of a majority of the shares of the
capital stock of Quest Diagnostics cast at a meeting at which such matter is
considered.
92
<PAGE>
Employment Agreements; Severance Arrangements. It is anticipated that Mr.
Freeman will enter into an employment agreement with Quest Diagnostics. The
agreement will expire on or before December 31, 1999. The agreement will include
provisions for an annual salary of no less than $500,000, with increases subject
to the discretion of the Quest Diagnostics Board; annual target participation in
the Variable Compensation Plan of Quest Diagnostics in amounts no less than 65%
of annual salary in effect at the time performance goals are established; and
severance payments following a termination by Mr. Freeman for "Good Reason" or
by Quest Diagnostics, without cause in accordance with the severance policy
described below, except that Mr. Freeman will receive three times his base
annual salary and three times his annual award of variable compensation. "Good
Reason" is defined as assignment of Mr. Freeman without his consent to mutually
inconsistent duties or responsibilities, a failure to re-elect Mr. Freeman to
the position of President and Chief Executive Officer, a greater than 75 mile
office relocation without his consent and a Change of Control (as detailed in
the next paragraph). The agreement will also include provision for reimbursement
of up to $10,000 per month until the earlier of Mr. Freeman's obtaining suitable
housing in the New York metropolitan area or June 30, 1998; eligibility for a
$400,000 interest-free relocation loan to be forgiven over a five-year period;
and, in the event the agreement is not renewed upon its expiration, a payment
equal to two times the highest annual cash compensation paid to Mr. Freeman
during the term of the agreement and health benefits for eighteen months
following expiration of the agreement. Mr. Freeman will also be entitled under
the agreement to a retirement pension benefit equivalent to benefits under the
Corning Salaried Pension Plan and the Executive Supplemental Plan based on not
less than 34 years of credited service in the event of termination for reasons
other than cause. Mr. Freeman's pension benefits will be initially secured by a
$5.4 million letter of credit (such amount based on initial assumptions for
pricing pension benefits) issued under the Credit Facility.
On or before the Distribution Date, Quest Diagnostics will adopt a severance
policy pursuant to which it will provide to each executive officer other than
Mr. Freeman and Drs. Fisher and Gambino upon the termination of employment by
Quest Diagnostics other than for cause upon a determination that the business
needs of Quest Diagnostics require the replacement of such executive officer and
other than in connection with a change of control, compensation equal to two
times the executive officer's base annual salary at the annual rate in effect on
the date of termination and two times the annual award of variable compensation
at the most recent target level. Such executive officer will also be entitled to
participate in Quest Diagnostics' health and benefits plans (to the extent
permitted by the administrative provisions of such plans and applicable federal
and state law) for a period of up to two years or until such officer is covered
by a successor employer's benefit plans, whichever first occurs. Pursuant to
such policy, upon a change of control Quest Diagnostics will provide to each
such executive officer upon the termination of employment by Quest Diagnostics
other than for cause during the twelve months following a change in control,
compensation equal to three times annual base salary and three times the award
of annual variable compensation at the most recent target level and such officer
will be entitled to participate in Quest Diagnostics' health and benefit plans
for a period of up to three years or until such officer is covered by a
successor employer's benefits plans, whichever first occurs (to the extent
permitted by the administrative provisions of such plans and applicable federal
and state law). A "Change in Control" is defined in the policy to include the
following: the acquisition by a person of 20% or more of the voting stock of
Quest Diagnostics; the membership of the Quest Diagnostics Board changes as a
result of a contested election such that a majority of the Quest Diagnostics
Board members at any particular time were initially placed on the Quest
Diagnostics Board as a result of such contested election; or approval by Quest
Diagnostics' stockholders of a merger or consolidation in which Quest
Diagnostics is not the survivor thereof, or a sale or disposition of all or
substantially all of Quest Diagnostics' assets or a plan of partial or complete
liquidation.
SECURITY OWNERSHIP BY CERTAIN BENEFICIAL
OWNERS AND MANAGEMENT OF QUEST DIAGNOSTICS
All of the outstanding shares of Quest Diagnostics Common Stock are
currently held by CLSI, which is wholly owned by Corning. The following table
sets forth the number of shares of Quest Diagnostics Common Stock that are
projected to be beneficially owned after the Quest Diagnostics Spin-Off
Distribution by the directors, by the named executive officers and by all
directors and executive officers of Quest Diagnostics as a group. The
projections are based on the number of shares of Corning Common Stock held by
such persons and such group as of October 31, 1996 (including certain
restricted shares that may be forfeited prior to the Distribution Date but
excluding Career Shares that will not receive the Distributions and Corning
Common Stock held in the Quest Diagnostics Profit Sharing Plan and the
Corning Investment Plans) and on the number of options to acquire Corning
Common Stock held as of such date and exercisable within 60 days thereof.
With respect to the shares of Quest Diagnostics Common
93
<PAGE>
Stock, the number reflects the distribution ratio of one share of Quest
Diagnostics Common Stock for every eight shares of Corning Common Stock and with
respect to options the number reflects the actual number of shares of Corning
Common Stock subject to options. The stock options held by the directors and
executive officers of Quest Diagnostics will not affect the security ownership
of Quest Diagnostics unless (i) such options are exercised prior to the Record
Date and the underlying shares of Corning Common Stock are held on the Record
Date or (ii) such options are converted into options to purchase shares of Quest
Diagnostics Common Stock.
<TABLE>
<CAPTION>
Number of Shares
Beneficially Owned Number of
Name (1) Exercisable Options
- ---------------------------- ------------------ -------------------
<S> <C> <C>
Van C. Campbell 17,850 (2) 127,457
Robert A. Carothers 316 12,483
Gregory C. Critchfield 0 1,500
David A. Duke 10,878 (2) 82,000
Kenneth W. Freeman 14,461 103,500
Don M. Hardison, Jr. 500 0
Douglas M. VanOort 5,965 11,500
Gail R. Wilensky 5,000 (2) 0
All Directors and Executive
Officers as a Group 66,280 393,562
</TABLE>
- -------------
(1) Does not include 3,954 shares owned by the spouses and minor children of
certain executive officers and directors (or trusts of which families of
such executive officers are beneficiaries) as to which such officers and
directors disclaim beneficial ownership.
(2) Includes 5,000 shares of Quest Diagnostics Common Stock which each
non-employee director will receive in connection with their election but
does not include 750 shares of Quest Diagnostics Common Stock for each
year specified in the term of service as a director. See "Management of
Quest Diagnostics--Management-- Directors' Compensation."
94
<PAGE>
DESCRIPTION OF QUEST DIAGNOSTICS CAPITAL STOCK
General
The following is a brief summary of certain provisions of the Quest
Diagnostics Certificate, as the restated certificate of incorporation will be
amended immediately prior to the Quest Diagnostics Spin-Off Distribution, and
does not relate to or give effect to provisions of statutory or other law
except as specifically stated. The Quest Diagnostics Certificate authorizes
the issuance of 100,000,000 shares of Quest Diagnostics Common Stock.
Approximately 28,901,735 shares of Quest Diagnostics Common Stock are
expected to be outstanding immediately following the Quest Diagnostics
Spin-Off Distribution. The rights of holders of shares of Quest Diagnostics
Common Stock are governed by the Quest Diagnostics Certificate, the Quest
Diagnostics By-Laws and by the DGCL.
Voting Rights
Subject to the voting of any shares of Quest Diagnostics Series Preferred
Stock (as defined below) that may be outstanding, voting power is vested in
the Quest Diagnostics Common Stock, each share having one vote, and the Quest
Diagnostics Voting Cumulative Preferred Stock, each $1,000 liquidation
preference of which has one vote, voting together as a single class.
Preemptive Rights
The Quest Diagnostics Certificate provides that no holder of shares of
Quest Diagnostics Common Stock or Quest Diagnostics Series Preferred Stock
shall have any preemptive rights except as the Quest Diagnostics Board may
determine from time to time. No such rights have been granted by the Quest
Diagnostics Board.
Quest Diagnostics Common Stock
Liquidation Rights. Subject to the preferential rights of any outstanding
Quest Diagnostics Series Preferred Stock and the Quest Diagnostics Voting
Cumulative Preferred Stock, in the event of any liquidation of Quest
Diagnostics, holders of shares of Quest Diagnostics Common Stock then
outstanding are entitled to share ratably in the assets of Quest Diagnostics
available for distribution to such holders.
Dividend Policy. Subject to any preferential rights of any outstanding
Quest Diagnostics Series Preferred Stock or Quest Diagnostics Voting
Cumulative Preferred Stock, such dividends as may be determined by the Quest
Diagnostics Board may be declared and paid on the shares of Quest Diagnostics
Common Stock from time to time out of any funds legally available therefor.
It is currently contemplated that, following the Distributions, Quest
Diagnostics will not pay cash dividends in the foreseeable future, but will
retain earnings to provide funds for the operation and expansion of its
business. Dividend decisions will be based upon a number of factors,
including the operating results and financial requirements of Quest
Diagnostics and such other considerations as the Quest Diagnostics Board
deems relevant. In addition, the Quest Diagnostics Credit Facility prohibits
Quest Diagnostics from paying cash dividends on the Quest Diagnostics Common
Stock. Further, the Indenture under which the Notes will be issued will limit
Quest Diagnostics' ability to pay cash dividends on the Quest Diagnostics
Common Stock based on 50% of Quest Diagnostics' net income, plus a credit for
issuances of capital stock.
Other Provisions. The shares of Quest Diagnostics Common Stock have no
redemption, sinking fund or conversion privileges applicable thereto and
holders of shares of Quest Diagnostics Common Stock are not liable to
assessments or to further call.
Listing and Trading. Prior to the Distributions, there has been no public
trading market for the Quest Diagnostics Common Stock although a "when
issued" market is expected to develop prior to the Distribution Date.
Application has been made to list the Quest Diagnostics Common Stock on the
NYSE, subject to official notice of the Distributions, under the trading
symbol "DGX." Prices at which Quest Diagnostics Common Stock may trade prior
to the Distributions on a "when-issued" basis or after the Distributions
cannot be predicted. Until shares of the Quest Diagnostics Common Stock are
fully distributed and an orderly market develops, the prices at which trading
in such stock occurs may fluctuate significantly. The prices at which Quest
Diagnostics Common Stock will trade will be determined by the marketplace and
may be influenced by many factors, including, among others, the depth and
liquidity of the market for Quest Diagnostics Common Stock, investor
perceptions of Quest Diagnostics,
95
<PAGE>
the clinical laboratory testing business, and general economic and market
conditions. Quest Diagnostics initially will have approximately 18,000
stockholders of record, based on the number of holders of record of Corning
Common Stock at the date of this Information Statement. The Transfer Agent
and Registrar for the Quest Diagnostics Common Stock will be Harris Trust and
Savings Bank. For certain information regarding options to purchase Quest
Diagnostics Common Stock that may become outstanding after the Distributions,
see "Management of Quest Diagnostics."
Quest Diagnostics Series Preferred Stock
The Quest Diagnostics Certificate authorizes the issuance of up to
10,000,000 shares of Quest Diagnostics Series Preferred Stock, par value
$1.00 per share (the "Quest Diagnostics Series Preferred Stock"). The Quest
Diagnostics Board has the authority to issue such shares from time to time,
without stockholder approval, and to determine the designations, preferences,
rights, including voting rights, and restrictions of such shares, subject to
the DGCL. Pursuant to this authority, the Quest Diagnostics Board has
designated 600,000 shares of Quest Diagnostics Series Preferred Stock as Quest
Diagnostics Series A Preferred Stock and 1,000 shares of Quest Diagnostics
Nonvoting Cumulative Preferred Stock. No other class of Quest Diagnostics
Series Preferred Stock has been designated by the Quest Diagnostics Board.
Voting Cumulative Preferred Stock
General. Prior to the Quest Diagnostics Spin-off Distribution, Quest
Diagnostics will issue to Corning 1,000 shares of Voting Cumulative Preferred
Stock, liquidation preference $1,000 per share (the "Quest Diagnostics Voting
Cumulative Preferred Stock") without further stockholder approval.
Dividend Policy. Holders of shares of Quest Diagnostics Voting Cumulative
Preferred Stock will be entitled to receive, when, as and if declared by the
Quest Diagnostics Board out of funds legally available for the purpose,
quarterly dividends payable in cash at the rate of 10% (the "Dividend Rate")
per annum, provided, however, that the Dividend Rate per annum shall be the
greater of (a) 10% and (b) the yield to maturity of the Notes expressed as a
percentage plus 1%.
Voting Rights. The Quest Diagnostics Voting Cumulative Preferred Stock
votes together with the Quest Diagnostics Common Stock as a single class and
will have one vote per $1,000 liquidation preference. The Quest Diagnostics
Cumulative Preferred Stock also votes as a separate class on any amendment to
the Certificate of Incorporation which adversely affects the rights of the
Quest Diagnostics Voting Cumulative Preferred Stock; provided, however, that
any increase in the amount of authorized Quest Diagnostics Common Stock or
authorized preferred stock or any increase or decrease in the number of
shares of any series of preferred stock or the creation and issuance of other
series of common stock or preferred stock shall not be deemed to adversely
affect the rights of the Quest Diagnostics Voting Cumulative Preferred Stock.
Certain Restrictions. Whenever quarterly dividends or other dividends or
distributions payable on the Quest Diagnostics Voting Cumulative Preferred
Stock are in arrears, thereafter and until all accrued and unpaid dividends
and distributions, whether or not declared, on shares of Quest Diagnostics
Voting Cumulative Preferred Stock outstanding shall have been paid in full,
Quest Diagnostics shall not:
(i) declare or pay dividends, or make any other distributions, on any
shares of stock ranking junior (either as to dividends or upon
liquidation, dissolution or winding-up) to the Quest Diagnostics Voting
Cumulative Preferred Stock;
(ii) declare or pay dividends, or make any other distributions, on any
shares of Parity Preferred Stock (as defined below) on which dividends are
payable or in arrears in proportion to the total amounts to which the
holders of all such shares are then entitled;
(iii) redeem or purchase or otherwise acquire for consideration shares
of any stock ranking junior (either as to dividends or upon liquidation,
dissolution or winding-up) to the Quest Diagnostics Voting Cumulative
Preferred Stock, provided that Quest Diagnostics may at any time redeem,
purchase or otherwise acquire shares of any such junior stock in exchange
for shares of any stock of Quest Diagnostics ranking junior (either as to
dividends or upon dissolution, liquidation or winding-up) to the Quest
Diagnostics Voting Cumulative Preferred Stock; or
96
<PAGE>
(iv) redeem or purchase or otherwise acquire for consideration any
shares of Quest Diagnostics Voting Cumulative Preferred Stock, or any
Parity Preferred Stock, except in accordance with a purchase offer made in
writing or by publication (as determined by the Quest Diagnostics Board)
to all holders of such shares upon such terms as the Quest Diagnostics
Board, after consideration of the respective annual dividend rates and
other relative rights and preferences of the respective series and
classes, shall determine in good faith will result in fair and equitable
treatment among the respective series or classes.
Quest Diagnostics shall not permit any subsidiary of Quest Diagnostics to
purchase or otherwise acquire for consideration any shares of stock of Quest
Diagnostics unless Quest Diagnostics could purchase or otherwise acquire such
shares at such time and in such manner.
Liquidation Preference. The shares of Quest Diagnostics Voting Cumulative
Preferred Stock shall rank, as to liquidation, dissolution or winding-up of
Quest Diagnostics, prior to the shares of Quest Diagnostics Common Stock and
any other class of stock of Quest Diagnostics ranking junior to the Quest
Diagnostics Voting Cumulative Preferred Stock as to rights upon liquidation,
dissolution or winding-up of Quest Diagnostics, so that in the event of any
liquidation, dissolution or winding-up of Quest Diagnostics, whether
voluntary or involuntary, the holders of the Quest Diagnostics Voting
Cumulative Preferred Stock shall be entitled to receive out of the assets of
Quest Diagnostics available for distribution to its shareholders, whether
from capital, surplus or earnings, before any distribution is made to holders
of shares of Quest Diagnostics Common Stock or any other such junior stock,
an amount equal to $1,000 per share (the "Liquidation Preference" of a share
of Quest Diagnostics Voting Cumulative Preferred Stock) plus an amount equal
to all dividends (whether or not earned or declared) accrued and accumulated
and unpaid on the shares of Quest Diagnostics Voting Cumulative Preferred
Stock to the date of final distribution. The holders of the Quest Diagnostics
Voting Cumulative Preferred Stock will not be entitled to receive the
Liquidation Preference and such dividends until the liquidation preference of
any other class of stock of Quest Diagnostics ranking senior to the Quest
Diagnostics Voting Cumulative Preferred Stock as to rights upon liquidation,
dissolution or winding-up shall have been paid (or a sum set aside therefor
sufficient to provide for payment) in full. After payment of the full amount
of the Liquidation Preference and such dividends, the holders of shares of
Quest Diagnostics Voting Cumulative Preferred Stock will not be entitled to
any further participation in any distribution of assets by Quest Diagnostics.
If, upon any liquidation, dissolution or winding-up of Quest Diagnostics, the
assets of Quest Diagnostics, or proceeds thereof, distributable among the
holders of the shares of Quest Diagnostics Voting Cumulative Preferred Stock
and Parity Preferred Stock shall be insufficient to pay in full the
preferential amount aforesaid, then such assets, or the proceeds thereof,
shall be distributable among such holders ratably in accordance with the
respective amounts which would be payable on such shares if all amounts
payable thereon were paid in full. For the purposes hereof, neither a
consolidation or merger of Quest Diagnostics with or into any other
corporation, nor a merger of any other corporation with or into Quest
Diagnostics, nor a sale or transfer of all or any part of Quest Diagnostics'
assets for cash or securities shall be considered a liquidation, dissolution
or winding-up of Quest Diagnostics.
Conversion. The Quest Diagnostics Voting Cumulative Preferred Stock is not
convertible into shares of any other class or series of stock of Quest
Diagnostics.
Optional Redemption. The shares of the Quest Diagnostics Voting Cumulative
Preferred Stock may be redeemed at the option of Quest Diagnostics, as a
whole, or from time to time in part, at any time, out of funds legally
available therefor, upon giving a notice or redemption at least 30 days prior
to the date set for redemption; provided, however, that shares of the Quest
Diagnostics Voting Cumulative Preferred Stock shall not be redeemable prior
to December 31, 2002. Subject to the foregoing, on or after such date, shares
of the Quest Diagnostics Voting Cumulative Preferred Stock are redeemable at
the redemption prices per share (expressed as a percentage of the Liquidation
Preference set forth below) plus an amount in cash equal to all dividends
(whether or not earned or declared) accrued and accumulated and unpaid to,
but excluding, the date fixed for redemption (the "Redemption Amount") if
redeemed during the 12-month period beginning January 1 of each of the years
set forth below:
<TABLE>
<CAPTION>
<S> <C>
Year Percentage
- ------------------------- ------------
2003 106.000%
2004 104.000%
2005 102.000%
2006 and thereafter 100.000%
</TABLE>
If Quest Diagnostics effects such redemption, it shall do so ratably
according to the number of shares held by each holder of Quest Diagnostics
Voting Cumulative Preferred Stock.
97
<PAGE>
Mandatory Redemption. On January 1, 2022, Quest Diagnostics shall redeem
all of the then outstanding shares of Quest Diagnostics Voting Cumulative
Preferred Stock, out of funds legally available therefor at a redemption
price equal to the Liquidation Preference. The redemption payment for each
share of Quest Diagnostics Voting Cumulative Preferred Stock shall be the
Redemption Amount, in cash, as of January 1, 2022.
Authorization and Issuance of Other Securities. No consent of the holders
of the Quest Diagnostics Voting Cumulative Preferred Stock shall be required
for (a) the creation of any indebtedness of any kind of Quest Diagnostics,
(b) the creation, or increase or decrease in the amount, of any class or
series of stock of Quest Diagnostics ranking on a parity with, senior to or
junior to the Quest Diagnostics Voting Cumulative Preferred Stock as to the
payment of dividends or amounts upon liquidation, dissolution or winding up
or (c) any increase or decrease in the amount of authorized Common Stock or
any increase, decrease or change in the par value thereof or in any other
terms thereof.
Rank. The Quest Diagnostics Voting Cumulative Preferred Stock will rank
senior to the Quest Diagnostics Common Stock and the Series A Preferred
Stock, on a parity with any series of preferred stock ranking on a parity
with the Quest Diagnostics Voting Cumulative Preferred Stock as to the
payment of dividends and amounts upon liquidation, dissolution and winding-up
(a "Parity Preferred Stock"), and junior to all other series of preferred
stock that do not expressly provide that such series is to rank junior to or
on a parity with the Quest Diagnostics Voting Cumulative Preferred Stock.
Preferred Share Purchase Rights
Attached to each share of Quest Diagnostics Common Stock is one right
("Quest Diagnostics Right"), which entitles the registered holder to purchase
from Quest Diagnostics one one-hundredth of a share of Quest Diagnostics
Series A Preferred Stock at a price of $35 per one-hundredth of a share of
Quest Diagnostics Series A Preferred Stock (the "Exercise Price"), subject to
adjustment. The Quest Diagnostics Rights expire on December 31, 2006 (the
"Final Expiration Date"), unless the Final Expiration Date is extended or
unless the Quest Diagnostics Rights are earlier exercised.
The Quest Diagnostics Rights represented by the certificates for shares of
Quest Diagnostics Common Stock are not exercisable, and are not transferable
apart from the shares of Quest Diagnostics Common Stock, until the earlier of
(1) ten days following the public announcement by Quest Diagnostics or an
Acquiring Person (as defined below) that a person or group has acquired
beneficial ownership of 20% or more of the shares of Quest Diagnostics Common
Stock (an "Acquiring Person") or (2) ten business days (or such later date as
the Quest Diagnostics Board may determine prior to such time as any person or
group of affiliated persons becomes an Acquiring Person) after the
commencement or first public announcement of an intention to make a tender or
exchange offer that would result in a person or group beneficially owning 20%
or more of the shares of Quest Diagnostics Common Stock (the earlier of such
dates being called the "Rights Distribution Date"). The Quest Diagnostics
Board has the authority to determine that a person that has inadvertently
acquired beneficial ownership of 20% of the shares of Quest Diagnostics
Common Stock is not an Acquiring Person if such person promptly reduces its
ownership interest to below 20%. Separate certificates for the Quest
Diagnostics Rights will be mailed to holders of record of the shares of Quest
Diagnostics Common Stock as of such date. The Quest Diagnostics Rights could
then begin trading separately from the shares of Quest Diagnostics Common
Stock.
Generally, in the event that a person or group becomes an Acquiring
Person, each Quest Diagnostics Right (other than the Quest Diagnostics Rights
owned by the Acquiring Person and certain affiliated persons) will thereafter
entitle the holder to receive, upon exercise of the Quest Diagnostics Right,
shares of Quest Diagnostics Common Stock having a value equal to two times
the Exercise Price of the Quest Diagnostics Right. In the event that a person
or group becomes an Acquiring Person (but prior to such time as such person
or group beneficially owns 50% or more of the outstanding shares of Quest
Diagnostics Common Stock), the Quest Diagnostics Board may exchange each
Quest Diagnostics Right and each one one-hundredth of a share of Quest
Diagnostics Series A Preferred Stock (other than Quest Diagnostics Rights and
Quest Diagnostics Series A Preferred Stock owned by the Acquiring Person and
certain affiliated persons) for one share of Quest Diagnostics Common Stock.
In the event that Quest Diagnostics is acquired in a merger, consolidation,
or other business combination transaction or more than 50% of Quest
Diagnostics' assets, cash flow or earning power is sold or transferred, each
Quest Diagnostics Right (other than the Quest Diagnostics Rights owned by an
Acquiring Person and certain affiliated persons) will thereafter entitle the
holder thereof to receive, upon the exercise of the Quest Diagnostics Right,
98
<PAGE>
common stock of the acquiring corporation having a value equal to two times
the Exercise Price of the Quest Diagnostics Right.
The Quest Diagnostics Rights are redeemable in whole, but not in part, at
$.01 per Quest Diagnostics Right at any time prior to any person or group
becoming an Acquiring Person. The right to exercise the Quest Diagnostics
Rights terminates at the time that the Quest Diagnostics Board elects to
redeem the Quest Diagnostics Rights. Notice of redemption shall be given by
mailing such notice to the registered holders of the Quest Diagnostics
Rights. At no time will the Quest Diagnostics Rights have any voting rights.
The Quest Diagnostics Rights Agent is Harris Trust and Savings Bank (the
"Quest Diagnostics Rights Agent").
The exercise price payable, and the number of shares of Quest Diagnostics
Series A Preferred Stock or other securities or property issuable, upon
exercise of the Quest Diagnostics Rights are subject to adjustment from time
to time to prevent dilution (i) in the event of a stock dividend on, or a
subdivision, combination or reclassification of, the shares of Quest
Diagnostics Series A Preferred Stock, (ii) upon the grant to holders of the
shares of Quest Diagnostics Series A Preferred Stock of certain rights or
warrants to subscribe for or purchase shares of Quest Diagnostics Series A
Preferred Stock at a price, or securities convertible into shares of Quest
Diagnostics Series A Preferred Stock with a conversion price, less than the
then current market price of the shares of Quest Diagnostics Series A
Preferred Stock or (iii) upon the distribution to holders of the shares of
Quest Diagnostics Series A Preferred Stock of evidences of indebtedness or
assets (excluding regular periodic cash dividends paid out of earnings or
retained earnings or dividends payable in shares of Quest Diagnostics Series
A Preferred Stock) or of subscription rights or warrants (other than those
referred to above).
The number of outstanding Quest Diagnostics Rights and the number of one
one-hundredths of a share of Quest Diagnostics Series A Preferred Stock
issuable upon exercise of each Quest Diagnostics Right are also subject to
adjustment in the event of a stock split of, or stock dividend on, or
subdivision, consolidation or combination of, the shares of Quest Diagnostics
Common Stock prior to the Quest Diagnostics Rights Distribution Date. With
certain exceptions, no adjustment in the exercise price will be required
until cumulative adjustments require an adjustment of at least 1% in such
exercise price.
Upon exercise of the Quest Diagnostics Rights, no fractional shares of
Quest Diagnostics Series A Preferred Stock will be issued (other than
fractions which are integral multiples of one one-hundredth of a share, which
may, at the election of Quest Diagnostics, be evidenced by depository
receipts) and in lieu thereof an adjustment in cash will be made.
The Quest Diagnostics Rights have certain antitakeover effects. The Quest
Diagnostics Rights may cause substantial dilution for a person or group that
attempts to acquire Quest Diagnostics on terms not approved by the Quest
Diagnostics Board, except pursuant to an offer conditioned on a substantial
number of Quest Diagnostics Rights being acquired. The Quest Diagnostics
Rights should not interfere with any merger or other business combination
approved by the Quest Diagnostics Board since the Quest Diagnostics Rights
may be redeemed by Quest Diagnostics at $.01 per Quest Diagnostics Right
prior to the acquisition by a person or group of beneficial ownership of 20%
or more of the shares of Quest Diagnostics Common Stock.
The shares of Quest Diagnostics Series A Preferred Stock purchasable upon
exercise of the Quest Diagnostics Rights will rank junior to all other series
of Quest Diagnostics'preferred stock or any similar stock that specifically
provides that they shall rank prior to the shares of Quest Diagnostics Series
A Preferred Stock. The shares of Quest Diagnostics Series A Preferred Stock
will be nonredeemable. Each share of Quest Diagnostics Series A Preferred
Stock will be entitled to a minimum preferential quarterly dividend of $10 per
share, but will be entitled to an aggregate dividend of 100 times the
dividend declared per share of Quest Diagnostics Common Stock. In the event
of liquidation, the holders of the shares of Quest Diagnostics Series A
Preferred Stock will be entitled to a minimum preferential liquidation
payment of $100 per share, but will be entitled to an aggregate payment of 100
times the payment made per share of Quest Diagnostics Common Stock. Each
share of Quest Diagnostics Series A Preferred Stock will have 100 votes,
voting together with the shares of Quest Diagnostics Common Stock. In the
event of any merger, consolidation or other transaction in which shares of
Quest Diagnostics Common Stock are exchanged, each share of Quest Diagnostics
Series A Preferred Stock will be entitled to receive 100 times the amount and
type of consideration received per share of Quest Diagnostics Common Stock.
These rights are protected by customary antidilution provisions. Because of
the nature of the Quest Diagnostics Series A Preferred Stock's dividend,
liquidation and voting rights, the value of the interest in a share of Quest
Diagnostics Series A Preferred Stock
99
<PAGE>
purchasable upon the exercise of each Quest Diagnostics Right approximates
the value of one share of Quest Diagnostics Common Stock.
The foregoing description of the Quest Diagnostics Rights, which describes
all of the material terms of the Quest Diagnostics Rights, does not purport
to be complete and is qualified in its entirety by reference to the
description of the Quest Diagnostics Rights contained in the Quest
Diagnostics Rights Agreement, dated as of December 31, 1996 between Quest
Diagnostics and the Quest Diagnostics Rights Agent, which agreement has been
filed as an exhibit to Quest Diagnostics' registration statement on Form 10
(the "Quest Diagnostics Form 10") that Quest Diagnostics has filed with the
Commission. Prior to the Quest Diagnostics Rights Distribution Date, the
Quest Diagnostics Rights Agreement may be amended in any respect. After the
Quest Diagnostics Rights Distribution Date, the Quest Diagnostics Rights
Agreement may be amended in any respect that does not adversely affect the
Quest Diagnostics Rights holders.
Restrictions on Transfer
Shares of the Quest Diagnostics Common Stock distributed to Corning
shareholders will be freely transferable, except for shares received by any
persons who may be deemed to be "affiliates" of Quest Diagnostics as that
term is defined in Rule 144 promulgated under the Securities Act, which
shares will remain subject to the resale limitations of Rule 144. Persons who
may be deemed to be affiliates of Quest Diagnostics after the Quest
Diagnostics Spin-off Distribution generally include individuals or entities
that control, are controlled by, or are under common control with Quest
Diagnostics and may include certain officers and directors of Quest
Diagnostics as well as principal stockholders of Quest Diagnostics. Persons
who are affiliates of Quest Diagnostics will be permitted to sell their
shares of Quest Diagnostics only pursuant to an effective registration
statement under the Securities Act or an exemption from the registration
requirements of the Securities Act, such as the exemption provided by Section
4(1) of the Securities Act or Rule 144 thereunder. The Section 4(1) exemption
allows the sale of unregistered shares by a person who is not an issuer, an
underwriter or a dealer. Rule 144 provides persons who are not issuers with
objective standards for selling restricted securities and securities held by
affiliates without registration. The rule requires (1) current public
information be available concerning the issuer; (2) volume limitations be
placed on sales during any three-month period; and (3) compliance with
certain manner of sale restrictions. The amount of the Quest Diagnostics
Common Stock which could be sold under Rule 144 during a three-month period
cannot exceed the greater of (1) 1% of the outstanding shares of Quest
Diagnostics Common Stock, or (2) the average weekly trading volume for the
shares for a four-week period prior to the date that notice of the sale is
filed with the Commission.
100
<PAGE>
ANTITAKEOVER EFFECTS OF CERTAIN PROVISIONS OF THE
QUEST DIAGNOSTICS CERTIFICATE OF INCORPORATION AND BY-LAWS
General
In addition to the Quest Diagnostics Rights, the Quest Diagnostics
Certificate and the Quest Diagnostics By- Laws contain other provisions that
may discourage a third party from seeking to acquire Quest Diagnostics, or to
commence a proxy contest or other takeover-related action. These provisions,
which are in all material respects identical to the provisions contained in
the certificate of incorporation and By-Laws of Corning, are intended to
enhance the likelihood of continuity and stability in the composition of the
Quest Diagnostics Board and in the policies formulated by the Quest
Diagnostics Board and to discourage certain types of transactions that may
involve an actual or threatened change of control of Quest Diagnostics. These
provisions are designed to reduce the vulnerability of Quest Diagnostics to
an unsolicited acquisition proposal and also to discourage certain tactics
that may be used in proxy fights. Because such provisions could have the
effect of discouraging potential acquisition proposals, they may consequently
inhibit fluctuations in the market price of Quest Diagnostics Common Stock
which could result from actual or rumored takeover attempts. Such provisions
also may have the effect of preventing changes in the management of Quest
Diagnostics. See "Risk Factors--Risks Relating to Quest Diagnostics-- Certain
Antitakeover Effects."
Board of Directors
The Quest Diagnostics Certificate provides that, effective as of the Quest
Diagnostics Spin-Off Distribution, the Quest Diagnostics Board is divided
into three classes, with the classes to be nearly as equal as possible. One
class has a term expiring at the 1998 annual meeting of stockholders of Quest
Diagnostics; the second class has a term expiring at the 1999 annual meeting
of stockholders of Quest Diagnostics; and the third class has a term expiring
at the 2000 annual meeting of stockholders of Quest Diagnostics. At each
annual meeting of stockholders, one class of the Quest Diagnostics Board will
be elected for a three-year term. The classification of directors has the
effect of making it more difficult to change the composition of the Quest
Diagnostics Board. At least two annual meetings of stockholders, instead of
one, generally will be required to effect a change in the majority of the
Quest Diagnostics Board. The Quest Diagnostics Board believes that the longer
time required to elect a majority of a classified board will help ensure the
continuity and stability of Quest Diagnostics' management and policies,
because in most cases a majority of the directors at any given time will have
had prior experience as directors of Quest Diagnostics.
Under the DGCL, unless the certificate of incorporation otherwise
provides, a director on a classified board may only be removed by the
stockholders for cause. The Quest Diagnostics Certificate provides that a
director of Quest Diagnostics is only removable by the stockholders for
cause. The Quest Diagnostics Certificate limits the number of directors to
twelve and requires that any vacancies on the Quest Diagnostics Board be
filled only by a majority of the entire Quest Diagnostics Board. The
provisions of the DGCL and the Quest Diagnostics Certificate relating to the
removal of directors and the filling of vacancies on the Quest Diagnostics
Board preclude a third party from removing incumbent directors without cause
and simultaneously gaining control of the Quest Diagnostics Board by filling,
with its own nominees, the vacancies created by removal. These provisions
also reduce the power of stockholders generally, even those with a majority
voting power in Quest Diagnostics, to remove incumbent directors and to fill
vacancies on the Quest Diagnostics Board without the support of the incumbent
directors.
Stockholder Action and Special Meetings
The Quest Diagnostics Certificate provides that all stockholder actions to
be effected by written consent and not a duly called meeting must be effected
by the unanimous written consent of all stockholders entitled to consent
thereto. This provision reduces the power of the Quest Diagnostics
stockholders and precludes a stockholder of Quest Diagnostics from conducting
any form of consent solicitation. The Quest Diagnostics Certificate also does
not permit stockholders of Quest Diagnostics to call special meetings of
stockholders.
Advance Notice Requirements for Stockholder Proposals and Director
Nominations
The Quest Diagnostics By-Laws contain an advance notice procedure with
respect to the nomination, other than by or at the direction of the Quest
Diagnostics Board or a committee thereof, of candidates for election as
101
<PAGE>
directors as well as for other stockholder proposals to be considered at annual
meetings of stockholders. Delivery of a notice with the required information
must be delivered to the Secretary of Quest Diagnostics not later than 60 days
nor more than 90 days prior to the date of the stockholders' meeting at which
the nomination or other proposal is to be considered. No matters can be
considered at special meetings of the stockholders other than such matters as
are set forth in the notice of meeting. Although the notice provisions do not
give the Quest Diagnostics Board any power to approve or disapprove stockholder
nominations or proposals for action by Quest Diagnostics, they may have the
effect of (i) precluding a contest for the election of directors or the
consideration of stockholder proposals if the procedures established by the
Quest Diagnostics By-Laws are not followed and (ii) discouraging or deterring
any third party from conducting a solicitation of proxies to elect its own slate
of directors or to approve its proposals, without regard to whether
consideration of such nominees or proposals might be harmful or beneficial to
Quest Diagnostics and its stockholders. The purpose of requiring advance notice
is to afford the Quest Diagnostics Board an opportunity to consider the
qualifications of the proposed nominees or the merits of other stockholder
proposals and, to the extent deemed necessary or desirable by the Quest
Diagnostics Board, to inform stockholders about those matters.
Business Combinations with Interested Stockholders
Paragraph 6 of the Quest Diagnostics Certificate (the "Fair Price Amendment")
requires the approval by the holders of at least 80% of the voting power of the
outstanding capital stock of Quest Diagnostics entitled to vote generally in the
election of directors (the "Quest Diagnostics Voting Stock") as a condition for
mergers and certain other Business Combinations (as defined below) with any
beneficial owner of more than 10% of such voting power (an "Interested
Stockholder") unless (i) the transaction is approved by at least a majority of
the Continuing Directors (as defined below) or (ii) certain minimum price, form
of consideration and procedural requirements are met.
An Interested Stockholder, in general, is defined as any person or group who
is, or was at any time within the two-year period immediately prior to the date
in question, the beneficial owner of more than 10% of the voting power of the
Quest Diagnostics Voting Stock. The term "beneficial owner" includes persons
directly or indirectly owning or having the right to acquire or vote the shares.
In certain circumstances, an Interested Stockholder could include persons or
entities affiliated or associated with the Interested Stockholder.
A Business Combination generally includes the following transactions: (i) a
merger or consolidation of Quest Diagnostics or any subsidiary with an
Interested Stockholder; (ii) the sale or other disposition by Quest Diagnostics
or a subsidiary of assets having an aggregate fair market value of $20,000,000
or more if an Interested Stockholder is a party to the transaction; (iii) the
issuance or transfer of stock or other securities of Quest Diagnostics or of a
subsidiary to an Interested Stockholder in exchange for cash or property
(including stock or other securities) having an aggregate fair market value of
$20,000,000 or more; (iv) the adoption of any plan or proposal for the
liquidation or dissolution of Quest Diagnostics proposed by or on behalf of an
Interested Stockholder; (v) any reclassification of securities,
recapitalization, merger or consolidation with a subsidiary or other transaction
which has the effect, directly or indirectly, of increasing the percentage of
the outstanding stock of any class of Quest Diagnostics or a subsidiary owned by
an Interested Stockholder; or (vi) any agreement, contract or other arrangement
providing for any one or more of the foregoing actions.
A Continuing Director is in general (i) any member of the Quest Diagnostics
Board who is not an Interested Stockholder or affiliated or associated with an
Interested Stockholder and was a director of Quest Diagnostics prior to the time
the Interested Stockholder became an Interested Stockholder, (ii) any successor
to such a Continuing Director who is not affiliated or associated with an
Interested Stockholder and was recommended or elected by a majority of the
Continuing Directors then on the Quest Diagnostics Board, or (iii) any person
who was a director of Quest Diagnostics as of the Distribution Date and any
successor thereto who was recommended or elected by a majority of the Continuing
Directors then on the Quest Diagnostics Board. It is possible that the approval
of a majority of the Continuing Directors could be required in circumstances
where the Continuing Directors constitute less than a quorum of the entire Quest
Diagnostics Board.
The 80% affirmative stockholder vote would not be required if the Business
Combination in question had been approved by a majority of the Continuing
Directors or if all the minimum price, form of consideration and procedural
requirements described below are satisfied.
Minimum Price and Form of Consideration Requirements. In a Business
Combination involving cash or other consideration being paid to Quest
Diagnostics' stockholders, the consideration required, in the case of each class
102
<PAGE>
of Quest Diagnostics Voting Stock, would be either cash or the same type of
consideration used by the Interested Stockholder in acquiring the largest
portion of its share of that class of Quest Diagnostics Voting Stock prior to
the first public announcement of the proposed Business Combination. In
addition, such consideration would be required to meet the minimum price
requirements described below.
In the case of payments to holders of Quest Diagnostics Common Stock, the
fair market value per share of such payments would be at least equal in value
to the higher of (i) the highest per share price paid by the Interested
Stockholder in acquiring any shares of Quest Diagnostics Common Stock during
the two years prior to the first public announcement of the proposed Business
Combination (the "Announcement Date") or in the transaction in which it
became an Interested Stockholder, whichever is higher, and (ii) the fair
market value per share of Quest Diagnostics Common Stock on the Announcement
Date or on the date on which the Interested Stockholder became an Interested
Stockholder, whichever is higher.
In the case of payments to holders of any series of Quest Diagnostics'
voting Series Preferred Stock, if any, the fair market value per share of
such payments would have to be at least equal to the higher of (i) the price
per share determined with respect to shares of such series in the same manner
as described in the preceding paragraph with respect to shares of Common
Stock and (ii) the highest preferential amount per share to which the holders
of such series of Quest Diagnostics Series Preferred Stock are entitled in
the event of a voluntary or involuntary liquidation of Quest Diagnostics.
If the transaction does not involve any cash or other property being
received by any of the other stockholders, such as a sale of assets or an
issuance of Quest Diagnostics' securities to an Interested Stockholder, then
the minimum price, form of consideration and procedural requirements would
not apply, but an 80% vote of stockholders would still be required unless the
transaction was approved by a majority of the Continuing Directors.
Procedural Requirements. An 80% stockholder vote would be required to
authorize a Business Combination with an Interested Stockholder if Quest
Diagnostics, after the interested stockholder became an Interested
Stockholder, had failed to pay full quarterly dividends on its Preferred
Stock, if any, or reduced the rate of dividends paid on its Common Stock,
unless such failure or reduction was approved by a majority of the Continuing
Directors.
An 80% stockholder vote to authorize a Business Combination with an
Interested Stockholder would also be required if the Interested Stockholder
had acquired any additional shares of the Quest Diagnostics Voting Stock,
directly from Quest Diagnostics or otherwise, in any transaction subsequent
to the transaction pursuant to which it became an Interested Stockholder.
The receipt by the Interested Stockholder at any time after it became an
Interested Stockholder, whether in connection with the proposed Business
Combination or otherwise, of the benefit of any loans or other financial
assistance or tax advantages provided by Quest Diagnostics (other than
proportionately as a stockholder) would also trigger the 80% stockholder vote
requirement to authorize a Business Combination with an Interested
Stockholder (unless the Business Combination was approved by a majority of
the Continuing Directors).
In summary, none of the minimum price, form of consideration or procedural
requirements described above would apply in the case of a Business
Combination approved by a majority of the Continuing Directors. In the
absence of such approval, all of such requirements would have to be satisfied
to avoid the 80% stockholder vote requirements.
Amendment of the Quest Diagnostics Certificate
Amendment or repeal of the provisions of the Quest Diagnostics Certificate
described above or the adoption of any provision inconsistent therewith would
require the affirmative vote of at least 80% of the Quest Diagnostics Voting
Stock unless the proposed amendment or repeal or the adoption of the
inconsistent provisions are approved by two-thirds of the entire Quest
Diagnostics Board and a majority of the Continuing Directors.
Antitakeover Statutes
Section 203 of the DGCL prohibits transactions between a Delaware
corporation and an "interested stockholder," which is defined therein as a
person who, together with any affiliates and/or associates of such person,
beneficially owns, directly or indirectly, 15% or more of the outstanding
voting shares of a Delaware corporation. This provision prohibits certain
business combinations (defined broadly to include mergers, consolidations,
sales
103
<PAGE>
or other dispositions of assets having an aggregate value in excess of 10% of
the consolidated assets of the corporation, and certain transactions that
would increase the interested stockholder's proportionate share ownership in
the corporation) between an interested stockholder and a corporation for a
period of three years after the date the interested stockholder acquired its
stock unless (i) the business combination is approved by the corporation's
board of directors prior to the date the interested stockholder acquired
shares, (ii) the interested stockholder acquired at least 85% of the voting
stock of the corporation in the transaction in which it becomes an interested
stockholder, or (iii) the business combination is approved by a majority of
the board of directors and by the affirmative vote of 66 2/3% of the votes
entitled to be cast by disinterested stockholders at an annual or special
meeting. The Quest Diagnostics Certificate and the Quest Diagnostics By-Laws
do not exclude Quest Diagnostics from the restrictions imposed under Section
203 of the DGCL.
Tax Sharing and Indemnification Agreements
The corporate tax liability which potentially could arise from an
acquisition of shares of Quest Diagnostics capital stock or assets of Quest
Diagnostics for a period of time following the Quest Diagnostics Spin-Off
Distribution, together with the related indemnification arrangements
contained in the Tax Sharing and Spin-Off Tax Indemnification Agreements,
could have an antitakeover effect on the acquisition of control of Quest
Diagnostics. See "The Relationship Among Corning, Quest Diagnostics and
Covance After the Distributions--Tax Sharing Agreement" and "The Relationship
Among Corning, Quest Diagnostics and Covance After the Distributions--Spin-
Off Tax Indemnification Agreements."
104
<PAGE>
DESCRIPTION OF CERTAIN INDEBTEDNESS OF QUEST DIAGNOSTICS
Description of Quest Diagnostics Credit Facility
In order to pay approximately $350 million of the Intercompany Debt owed
by Quest Diagnostics in connection with the Quest Diagnostics Spin-Off
Distribution, and to meet its future capital requirements including the
funding of operating activities and further acquisitions, Quest Diagnostics
is negotiating with several banks for a credit agreement (the "Credit
Agreement") providing for a $450 million credit facility (the "Quest
Diagnostic Credit Facility"). Morgan Guaranty Trust Company of New York
("Morgan"), NationsBank, N.A. ("NationsBank") and Wachovia Bank of Georgia,
N.A. ("Wachovia") are arranging the Quest Diagnostics Credit Facility. A copy
of the proposed form of the Credit Agreement has been filed as an exhibit to
the Quest Diagnostics Form 10. This summary of the material terms and
conditions of the Quest Diagnostics Credit Facility and the Credit Agreement
does not purport to be complete, and is qualified in its entirety by
references to such proposed form, including the definitions therein.
The $450 million commitment under the Quest Diagnostics Credit Facility
will be comprised of three sub- facilities: (i) a $300 million six-year
amortizing term loan (the "Tranche A Loan"), (ii) a seven-year $50 million
term loan with minimal amortization until the seventh year (the "Tranche B
Loan") and (iii) a $100 million six-year revolving working capital credit
facility (the "Working Capital Facility"). Under the Working Capital
Facility, up to $20 million may be used for Letters of Credit to be issued by
one or more Issuing Banks (initially NationsBank), and up to $10 million may
be used to borrow from Wachovia, as the Swingline Bank, under a Swingline
Facility. All Working Capital Banks are required to ratably share the
exposure of the Issuing Banks under the Letters of Credit and, at the request
of the Swingline Bank, must purchase ratable participations in the Swingline
Loans. With the exception of Swingline borrowings and Letters of Credit,
borrowings under the Working Capital Facility must be at least $10 million
for LIBOR based borrowings and $5 million for Base Rate based borrowings.
Under the Swingline Facility, borrowings must be at least $1 million. The
Quest Diagnostics Credit Facility will be secured by substantially all
accounts receivable of Quest Diagnostics and by a guaranty from, and a pledge
of all capital stock and accounts receivable (including intercompany loans)
of, substantially all of Quest Diagnostics' present and future material U.S.
Subsidiaries, excluding certain Joint Ventures, Covance and Covance's
Subsidiaries. The borrowings under the Quest Diagnostics Credit Facility will
rank senior in priority of repayment to any Permitted Subordinated Debt,
including the Senior Subordinated Notes and any of Quest Diagnostics'
remaining debt to Corning. At the time of the Distributions, Quest
Diagnostics' debt to Corning must be extinguished except to the extent it is
included in the $150 million of Permitted Subordinated Debt.
Interest Rate Calculations. Interest will be payable on each sub-facility
quarterly, or at the end of the relevant interest period, if earlier, at a
per annum rate equal to the Base Rate or (except for Swingline Loans) the
Eurodollar Rate plus the relevant Applicable Margin. The Base Rate is a
fluctuating rate calculated on a daily basis as the higher of (a) the rate of
interest publicly announced by Morgan for the day in question and (b) 0.5%
over the weighted average of the rates, rounded up to the nearest basis
point, on overnight Federal Funds transactions with members of the Federal
Reserve System as arranged by Federal Funds brokers on the day in question.
The Eurodollar Rate is the average of the annual rate at which deposits in
U.S. dollars are offered to each of the Reference Banks in the London
interbank market, adjusted for reserve requirements ("Adjusted LIBOR"). The
initial Applicable Margin payable for Adjusted LIBOR borrowings will be 1.75%
per annum for the Tranche A Loan and the Working Capital Loan and 2.25% per
annum for the Tranche B Loan. The initial Applicable Margin payable for Base
Rate borrowings will be 0.75% per annum for the Tranche A Loan and the
Working Capital Loan and 1.25% per annum for the Tranche B Loan. After
December 31, 1996, the Applicable Margin will be determined by a pricing
formula based on Quest Diagnostics' Debt Coverage Ratio. The Applicable
Margin range for the Tranche A Loan and the Working Capital Loan may vary,
depending on the Debt Coverage Ratio, from 0% to 1% for Base Rate Advances,
and from 0.5% to 2% per annum for Eurodollar Rate Advances. The Swingline
Loans will accrue interest at a rate equal to the Base Rate plus the relevant
Applicable Margin for Tranche A and Working Capital Base Rate Loans. The
Applicable Margin for the Tranche B Loan will remain fixed throughout the
life of the loan at the initial Applicable Margin levels. Any overdue
principal or interest payable on any Eurodollar loan will incur interest at
the greater of Adjusted LIBOR or LIBOR plus the Applicable Margin plus 2% per
annum. Any overdue principal or interest payable on a Base Rate loan will
incur interest at the Base Rate plus the Applicable Margin plus 2% per annum.
The Credit Agreement also requires the payment of a quarterly Commitment
Fee on the average daily unused portion of the Banks' aggregate commitments
under the Working Capital Facility. The initial Commitment Fee Rate
105
<PAGE>
will be 0.375% per annum. After December 31, 1996, the Commitment Fee Rate
will be determined based on Quest Diagnostics' Debt Coverage Ratio, and will
range from 0.175% to 0.5% per annum.
Quest Diagnostics shall also pay the Issuing Banks in proportion to their
Letter of Credit Exposure a fee of 0.125% per annum on any amounts
outstanding on undrawn Letters of Credit. Additionally, Quest Diagnostics
shall pay directly to the Issuing Bank all customary fees connected with the
issuing of a Letter of Credit.
Quest Diagnostics will also pay Morgan a negotiated fee for its services
as Administrative Agent under the Quest Diagnostics Credit Facility.
Covenants and Conditions. The Credit Agreement includes covenants which,
subject to certain specific exceptions and limitations, require Quest
Diagnostics and its Subsidiaries to: (i) provide certain financial
information to the Banks including, Quest Diagnostics' consolidated audited
financial reports, financial ratio data, annual business plans and
projections and certification that no defaults have occurred; (ii) pay or
discharge all material obligations and liabilities; (iii) keep property in
good working order and maintain sufficient insurance coverage on all
property; (iv) maintain corporate existence; (v) pursue the same or
substantially similar lines of business to the ones in which they are
currently engaged; (vi) comply with all laws, including ERISA and
environmental regulations; (vii) allow any Bank to inspect accounting
records; (viii) not permit modification to or waiver of any Transaction
Documents including any documents connected with the Permitted Subordinated
Debt or the Permitted Preferred Stock; (ix) not hold or acquire any
investments other than those allowed by the Credit Agreement; (x) not create
or allow to be created any liens other than those permitted by the Credit
Agreement; (xi) refrain from engaging in a consolidation, acquisition, merger
or sale of assets except as allowed in the Credit Agreement; (xii) not engage
in any transaction with or for the benefit of any Affiliate other than
certain arm's-length transactions; (xiii) prevent the existence of any
agreement that prevents Quest Diagnostics' Subsidiaries from paying dividends
or other distributions on capital stock; (xiv) refrain from making certain
Restricted Payments as detailed below; (xv) not incur Debt other than Debt
allowed under the Credit Agreement; (xvi) maintain certain financial ratios
as detailed below; and (xvii) not make Consolidated Capital Expenditures in
excess of $95,000,000 (less the consideration paid for certain acquisitions)
in any fiscal year.
Quest Diagnostics may, subject to certain limitations and exceptions
contained in the Credit Agreement, make certain Restricted Payments so long as
there are no current or continuing Defaults, and the otherwise Restricted
Payment would not cause a Default. Allowed payments include: (i) the repayment
of Permitted Subordinated Debt from the proceeds of any newly issued Senior
Subordinated Notes, (ii) interest and fees on the Senior Subordinated Notes,
(iii) dividends paid on any Permitted Preferred Stock, (iv) repurchases of
shares pursuant to certain employee benefit and compensation plans and (v)
certain payments to Corning required to be made pursuant to the Spin-Off
Transactions. Restricted Payments include: (i) any other dividends or
distributions on any of the shares of capital stock of Quest Diagnostics except
dividends or distributions paid solely in shares of Quest Diagnostics capital
stock, (ii) any other payment on Subordinated Debt and (iii) any payment,
including those to sinking funds, made to redeem, repurchase, acquire or retire
any of the Subordinated Debt or the shares of capital stock, or the rights to
acquire shares, of Quest Diagnostics or its Subsidiaries.
Quest Diagnostics will be required to maintain: (i) a ratio (the "Leverage
Ratio") of (A) Consolidated Total Debt to (B) Consolidated Total
Capitalization equal to or below 0.55 to 1.0 at the outset, decreasing over
time to 0.45 to 1.0; (ii) a ratio (the "Debt Coverage Ratio") of (A)
Consolidated Total Debt to (B) Consolidated EBITDA equal to or below between
3.8 to 1.0 at the outset, decreasing over time to 2.0 to 1.0; and (iii) a
ratio (the "Coverage Ratio") of (A) the sum of (1) Consolidated EBITDA and
(2) Consolidated Rental Expense to (B) the sum of (1) Consolidated Interest
Expense and (2) Consolidated Rental Expense equal to or above 1.8 to 1.0 at
the outset, decreasing over time to 3.0 to 1.0. Quest Diagnostics is required
to have a Leverage Ratio no greater than 0.55 to 1.0 through December 31,
1997, a Debt Coverage Ratio of less than 3.8 to 1.0 through June 30, 1997 and
a Coverage Ratio of at least 1.8 to 1.0 from January 1, 1997 through June 30,
1997. After giving pro forma effect to the Distributions, $350 million of
borrowings under the Credit Facility and to the Permitted Subordinated Debt,
Quest Diagnostics would have had a Leverage Ratio of 0.47 to 1.0 at September
30, 1996, a Debt Coverage Ratio of 3.2 to 1.0 for the quarter ended September
30, 1996 and a Coverage Ratio of 2.2 to 1.0 for the quarter ended September
30, 1996.
Events of Default. Events of Default include: (i) the failure to make
payment under the Credit Agreement of any principal when due or any interest,
fees or other amounts within three business days after becoming due; (ii)
106
<PAGE>
any representation, warranty, certification or statement made by Quest
Diagnostics proving to have been incorrect in any material respect when made;
(iii) the failure by Quest Diagnostics or its Subsidiaries to perform or observe
any term, covenant or agreement under the Credit Agreement (subject to certain
cure periods); (iv) the failure of Quest Diagnostics to make payment on any
Material Financial Obligation (totalling in aggregate more than $10 million)
within the applicable grace period; (v) the occurrence of an event that causes
the acceleration of, or enables another of Quest Diagnostics' creditors to
accelerate, any of Quest Diagnostics' other Material Debt (totalling in
aggregate more than $10 million); (vi) the commencement of a voluntary or
involuntary bankruptcy proceeding by or against Quest Diagnostics; (vii) the
failure to pay when due ERISA obligations in excess of $10 million; (viii) the
rendering of a judgment or judgments against Quest Diagnostics the aggregate
amounts of which are in excess of $10 million and remain unsatisfied or unstayed
for more than 30 days, or the placing by a judgment creditor of a levy on the
assets of Quest Diagnostics or its Subsidiaries; (ix) at any time after the
Spin-Off, a person or group obtains beneficial ownership of 20% or more of the
common stock of Quest Diagnostics, or, during any period of 12 calendar months,
the individuals who constituted the members of the board of directors of Quest
Diagnostics on the first day of that period no longer constitute a majority of
the board; or (x) any security interest that was purported to be created by the
related security documents ceases to exist or be valid.
If an Event of Default occurs and continues beyond the allowed time period
for curing the default in question, the Banks, by a vote of more than 50% of
the aggregate Commitments, may terminate their Commitments to lend to Quest
Diagnostics. The Banks may further choose, by a separate vote representing
more than 50% of the aggregate principal amount of all of the Loans, to
accelerate the outstanding principal and interest. Additionally, during an
Event of Default the Letter of Credit Participants, by a more than 50% vote
of the amount of the total outstanding of the Letter of Credit Exposure, may
require that Quest Diagnostics fully cash collateralize the outstanding
Letter of Credit Exposure. In the case of a voluntary or involuntary
bankruptcy proceeding, all credit facilities shall terminate and all
outstanding amounts shall become immediately due and payable without any
action by the Banks.
Description of Notes
Prior to the Distributions, Quest Diagnostics will offer (the "Quest
Diagnostics Notes Offering") $150 million aggregate principal amount of
senior subordinated notes (the "Notes").
General. The Notes will be senior subordinated obligations of Quest
Diagnostics, and will be guaranteed on a senior subordinated basis by Quest
Diagnostics' present and future Restricted Subsidiaries (as defined) on a
joint and several basis. The guarantees will automatically terminate if the
related guarantees of the Quest Diagnostics Credit Facility are terminated.
Stated Maturity and Interest. The Notes will mature on December 15, 2006.
Interest on the Notes will be payable semiannually on June 15 and December 15
of each year, commencing June 15, 1997.
Redemption. The Notes will not be redeemable, at the option of Quest
Diagnostics, prior to December 15, 2001. On or after such date, the Notes
will be redeemable, in whole or in part, at specified redemption prices.
Quest Diagnostics will also be entitled to redeem the Notes, as a whole
and not in part, in the event that the Distributions do not occur as a result
of an event outside of the control of Quest Diagnostics, Corning and Covance.
Quest Diagnostics will be required to offer to purchase the Notes upon a
Change of Control (as defined) and in the event of certain asset sales.
Certain Covenants. The Indenture will impose certain limitations on the
ability of Quest Diagnostics and its subsidiaries to, among other things,
incur additional indebtedness, pay dividends or make certain other restricted
payments, consummate certain asset sales, enter into certain transactions
with affiliates, incur indebtedness that is subordinate in right of payment
to any Senior Debt (as defined) and senior in right of payment to the Notes,
incur liens, enter into leases and sale and leaseback transactions, merge or
consolidate with any other person or sell, assign, transfer, lease, convey or
otherwise dispose of all or substantially all of the assets of the Company.
In particular, the Indenture will limit Quest Diagnostics' ability to pay
cash dividends on the Quest Diagnostics Common Stock based on 50% of Quest
Diagnostics' net income, plus a credit for issuances of capital stock.
107
<PAGE>
LIABILITY AND INDEMNIFICATION OF
DIRECTORS AND OFFICERS OF QUEST DIAGNOSTICS
Limitation on Liability of Directors
Pursuant to authority conferred by Section 102 of the DGCL, Paragraph 11
of the Quest Diagnostics Certificate ("Paragraph 11") eliminates the personal
liability of Quest Diagnostics' directors to Quest Diagnostics or its
stockholders for monetary damages for breach of fiduciary duty, including
without limitation, directors serving on committees of the Quest Diagnostics
Board. Directors remain liable for (1) any breach of the duty of loyalty to
Quest Diagnostics or its stockholders, (2) any act or omission not in good
faith or which involves intentional misconduct or a knowing violation of law,
(3) any violation of Section 174 of the DGCL, which proscribes the payment of
dividends and stock purchases or redemptions under certain circumstances, and
(4) any transaction from which directors derive an improper personal benefit.
Indemnification and Insurance
In accordance with Section 145 of the DGCL, which provides for the
indemnification of directors, officers and employees under certain
circumstances, Paragraph 11 grants Quest Diagnostics' directors and officers
a right to indemnification for all expenses, liabilities and losses relating
to civil, criminal, administrative or investigative proceedings to which they
are a party (1) by reason of the fact that they are or were directors or
officers of Quest Diagnostics or (2) by reason of the fact that, while they
are or were directors or officers of Quest Diagnostics, they are or were
serving at the request of Quest Diagnostics as directors or officers of
another corporation, partnership, joint venture, trust or enterprise.
Paragraph 11 further provides for the mandatory advancement of expenses
incurred by officers and directors in defending such proceedings in advance
of their final disposition upon delivery to Quest Diagnostics by the
indemnitee of an undertaking to repay all amounts so advanced if it is
ultimately determined that such indemnitee is not entitled to be indemnified
under Paragraph 11. Quest Diagnostics may not indemnify or make advance
payments to any person in connection with proceedings initiated against Quest
Diagnostics by such person without the authorization of the Quest Diagnostics
Board.
In addition, Paragraph 11 provides that directors and officers therein
described shall be indemnified to the fullest extent permitted by Section 145
of DGCL, or any successor provisions or amendments thereunder. In the event
that any such successor provisions or amendments provide indemnification
rights broader than permitted prior thereto, Paragraph 11 allows such broader
indemnification rights to apply retroactively with respect to any predating
alleged action or inaction and also allows the indemnification to continue
after an indemnitee has ceased to be a director or officer of Quest
Diagnostics and to inure to the benefit of the indemnitee's heirs, executors
and administrators.
Paragraph 11 further provides that the right to indemnification is not
exclusive of any other right which any indemnitee may have or thereafter
acquire under any statute, the Quest Diagnostics Certificate, any agreement
or vote of stockholders or disinterested directors or otherwise, and allows
Quest Diagnostics to indemnify and advance expenses to any person whom the
corporation has the power to indemnify under the DGCL or otherwise.
Insofar as indemnification for liabilities arising under the Securities
Act may be permitted for directors and officers and controlling persons
pursuant to the foregoing provisions, Quest Diagnostics has been advised that
in the opinion of the Commission such indemnification is against public
policy as expressed in the Securities Act and is, therefore, unenforceable.
The Quest Diagnostics Certificate authorizes Quest Diagnostics to purchase
insurance for directors and officers of Quest Diagnostics and persons who
serve at the request of Quest Diagnostics as directors, officers, employees
or agents of another corporation, partnership, joint venture, trust or
enterprise, against any expense, liability or loss incurred in such capacity,
whether or not Quest Diagnostics would have the power to indemnify such
persons against such expense or liability under the DGCL. Quest Diagnostics
intends to maintain insurance coverage of its officers and directors as well
as insurance coverage to reimburse Quest Diagnostics for potential costs of
its corporate indemnification of directors and officers.
108
<PAGE>
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
Page
---------
<S> <C>
FINANCIAL STATEMENTS OF CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
Report of Price Waterhouse LLP--Independent Accountants F-2
Report of Deloitte and Touch LLP--Independent Auditors F-3
Report of Ernst & Young LLP--Independent Auditors F-4
Report of Leverone and Company--Independent Accountants F-5
Combined Financial Statements:
Combined Balance Sheets--December 31, 1995 and 1994 F-6
Combined Statements of Operations--Years ended December 31, 1995, 1994 and 1993 F-7
Combined Statements of Cash Flows--Years ended December 31, 1995, 1994 and 1993 F-8
Combined Statements of Stockholder's Equity--Years ended December 31, 1995, 1994 and 1993 F-9
Notes to Combined Financial Statements F-10
Financial Statement Schedule II--Valuation Accounts and Reserves F-23
Quarterly Operating Results (unaudited) F-24
Interim Combined Financial Statements (unaudited):
Combined Balance Sheets--September 30, 1996 and December 31, 1995 F-25
Combined Statements of Operations--Three and Nine Months ended September 30, 1996
and 1995 F-26
Combined Statements of Cash Flows--Nine Months ended September 30, 1996 and 1995 F-27
Notes to Interim Combined Financial Statements F-28
</TABLE>
F-1
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
To the Boards of Directors and Stockholders of
Corning Incorporated and Corning Clinical Laboratories Inc.
In our opinion, based upon our audits and the reports of other auditors,
the accompanying combined balance sheets and the related combined statements
of operations and of cash flows and of stockholder's equity appearing on
pages F-6 through F-23 present fairly, in all material respects, the
financial position of Corning Clinical Laboratories Inc. (to be renamed Quest
Diagnostics Incorporated) and the combined companies as discussed in Note 1
(collectively, the "Company"), a wholly-owned business of Corning
Incorporated, at December 31, 1995 and 1994, and the results of their
operations and their cash flows for each of the three years in the period
ended December 31, 1995, in conformity with generally accepted accounting
principles. These financial statements are the responsibility of the
Company's management; our responsibility is to express an opinion on these
financial statements based on our audits. We did not audit the 1993 financial
statements of Maryland Medical Laboratory, Inc., Nichols Institute and Bioran
Medical Laboratory, which were acquired by the Company in 1994 in separate
transactions accounted for as poolings of interests and which collectively
reflect total revenues of $438 million for the year ended December 31, 1993.
Those statements were audited by other auditors whose reports thereon have
been furnished to us, and our opinion expressed herein, insofar as it relates
to the amounts included for Maryland Medical Laboratory, Inc., Nichols
Institute and Bioran Medical Laboratory, is based solely on the reports of
the other auditors. We conducted our audits of these statements in accordance
with generally accepted auditing standards which require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on
a test basis, evidence supporting the amounts and disclosures in the
financial statements, assessing the accounting principles used and
significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits and the reports
of other auditors provide a reasonable basis for the opinion expressed above.
As discussed in Note 2 to the combined financial statements, in 1993 the
Company adopted Statement of Financial Accounting Standards No. 109,
"Accounting for Income Taxes."
/s/ Price Waterhouse LLP
Price Waterhouse LLP
New York, New York
September 20, 1996, except for Note 13
as to which the date is November 4, 1996
F-2
<PAGE>
REPORT OF INDEPENDENT AUDITORS
To the Board of Directors and Stockholders of
Nichols Institute:
We have audited the consolidated statements of operations, stockholders'
equity and cash flows for the year ended December 31, 1993 of Nichols
Institute and its subsidiaries (the Company) (not presented separately
herein). These consolidated financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on
these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements.
An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in
all material respects, the results of operations and cash flows of Nichols
Institute and its subsidiaries for the year ended December 31, 1993, in
conformity with generally accepted accounting principles.
As discussed in Note 11 to the consolidated financial statements, the
Company has received a subpoena from the Office of the Inspector General of
the Department of Health and Human Services (OIG) requesting documents in
connection with an investigation and internal review concerning the possible
submission of false or improper claims to the Medicare and Medicaid programs.
No claim or charges have been made against the Company relating to this
investigation. The ultimate outcome of this investigation cannot presently be
determined. Accordingly, no provision for any loss that may result from this
investigation has been made in the accompanying consolidated financial
statements.
As discussed in Notes 1 and 3 to the consolidated financial statements, at
December 31, 1993, the Company was not in compliance with certain covenants
of its senior note agreements and the senior lenders have not waived those
covenants. The senior note agreements provide that, as a result of failure to
comply with the covenants, the note holders have the right to declare the
entire unpaid balance immediately due and payable, and if that were to occur,
the Company would not have the funds required to retire the debt unless
alternative financing is obtained. Management's plans in regard to these
matters are described in Notes 1 and 3. The note holders' right to declare
the entire unpaid balance under the note agreements immediately due and
payable raises substantial doubt about the Company's ability to continue as a
going concern. The accompanying consolidated financial statements have been
prepared assuming that the Company will continue as a going concern. The
financial statements do not include any adjustments that might result from
the outcome of this uncertainty, except for the classification of amounts due
under the senior note agreements as current.
/s/ Deloitte & Touche LLP
Deloitte & Touche LLP
Costa Mesa, California
February 28, 1994
F-3
<PAGE>
REPORT OF INDEPENDENT AUDITORS
Board of Directors
Maryland Medical Laboratory, Inc.
We have audited the combined balance sheet of Maryland Medical Laboratory,
Inc. and affiliates as of March 31, 1994, and the related combined statements
of income, changes in equity and cash flows for the year then ended (not
presented separately herein). These financial statements are the
responsibility of the Company's management. Our responsibility is to express
an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements.
An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the combined financial position of Maryland Medical
Laboratory, Inc. and affiliates at March 31, 1994, and the combined results
of their operations and their cash flows for the year then ended in
conformity with generally accepted accounting principles.
/s/ Ernst & Young LLP
Ernst & Young LLP
Baltimore, Maryland
May 19, 1994
F-4
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors
Moran Research Labs
415 Massachusetts Avenue
Cambridge, MA 02139
We have audited the accompanying balance sheet of Moran Research Labs
(d/b/a Bioran Medical Laboratory, a Massachusetts Business Trust) as of
December 31, 1993, and the related statements of income, retained earnings,
and cash flows for the year then ended. These financial statements are the
responsibility of the Company's management. Our responsibility is to express
an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements.
An audit includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audit provides a reasonable basis
for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Moran Research Labs
(d/b/a Bioran Medical Laboratory, a Massachusetts Business Trust) at December
31, 1993 and the results of its operations and its cash flows for the year
then ended in conformity with generally accepted accounting principles.
/s/ Leverone & Company
Leverone & Company
Billerica, Massachusetts
November 10, 1994
F-5
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
COMBINED BALANCE SHEETS
DECEMBER 31, 1995 AND 1994
(in thousands)
<TABLE>
<CAPTION>
1995 1994
----------- ------------
<S> <C> <C>
ASSETS
- -------
Current Assets:
Cash and cash equivalents $ 36,446 $ 38,719
Accounts receivable, net of allowance of $147,947 and
$74,829 for 1995 and 1994, respectively 318,252 360,410
Inventories 26,601 28,248
Deferred taxes on income 98,845 53,696
Prepaid expenses and other assets 22,014 19,241
--------- ----------
Total current assets 502,158 500,314
Property, plant and equipment, net 296,116 287,562
Intangible assets, net 1,030,633 1,053,194
Deferred taxes on income 6,062 19,593
Other assets 18,416 22,000
----------- ------------
TOTAL ASSETS $1,853,385 $1,882,663
=========== ============
LIABILITIES AND STOCKHOLDER'S EQUITY
- ----------------------------------
Current Liabilities:
Accounts payable and accrued expenses $ 240,525 $ 236,887
Current portion of long-term debt 12,148 12,572
Income taxes payable 39,766 30,454
Due to Corning Incorporated and affiliates 8,979 6,043
--------- ----------
Total current liabilities 301,418 285,956
Long-term debt (principally due to Corning Incorporated) 1,195,566 1,153,054
Other liabilities 60,600 56,841
--------- ----------
Total liabilities 1,557,584 1,495,851
--------- ----------
Commitments and Contingencies
Stockholder's Equity:
Contributed capital 297,823 297,823
Retained earnings (accumulated deficit) (3,118) 85,893
Cumulative translation adjustment 2,325 3,096
Market valuation adjustment (1,229) --
--------- ----------
Total stockholder's equity 295,801 386,812
--------- ----------
TOTAL LIABILITIES AND STOCKHOLDER'S EQUITY $1,853,385 $1,882,663
========= ==========
</TABLE>
The accompanying notes are an integral part of these statements.
F-6
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
COMBINED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 1995, 1994 AND 1993
(in thousands)
<TABLE>
<CAPTION>
1995 1994 1993
----------- ----------- ------------
<S> <C> <C> <C>
Net revenues $1,629,388 $1,633,699 $1,416,338
Costs and expenses:
Cost of services 980,232 969,844 805,729
Selling, general and administrative 523,271 411,939 363,579
Provision for restructuring and other special charges 50,560 79,814 99,600
Interest expense, net 82,016 63,295 41,898
Amortization of intangible assets 44,656 42,588 28,421
Other, net 6,221 3,464 6,423
---------- ---------- -----------
Total 1,686,956 1,570,944 1,345,650
---------- ---------- -----------
Income (loss) before taxes (57,568) 62,755 70,688
Income tax expense (benefit) (5,516) 34,410 25,929
---------- ---------- -----------
Income (loss) before cumulative effect of change in
accounting principle (52,052) 28,345 44,759
Cumulative effect of change in accounting principle -- -- (10,562)
---------- ---------- -----------
Net income (loss) $ (52,052) $ 28,345 $ 34,197
========== ========== ===========
</TABLE>
The accompanying notes are an integral part of these statements.
F-7
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
COMBINED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 1995, 1994 AND 1993
(in thousands)
<TABLE>
<CAPTION>
1995 1994 1993
----------- ---------- -----------
<S> <C> <C> <C>
Cash flows from operating activities:
Net income (loss) $ (52,052) $ 28,345 $ 34,197
Adjustments to reconcile net income (loss) to net
cash provided by operating activities:
Depreciation and amortization 101,513 89,517 66,479
Provision for doubtful accounts 152,590 59,480 47,240
Provision for restructuring and other special charges 50,560 79,814 99,600
Deferred income tax provision (32,384) (4,742) (23,841)
Cumulative effect of change in accounting principle -- -- 10,562
Other, net 8,303 14,600 1,765
Changes in operating assets and liabilities:
Accounts receivable (109,500) (103,402) (61,828)
Accounts payable and accrued expenses 14,604 (32,756) (33,903)
Restructuring, integration and other special charges (57,768) (88,093) (46,917)
Due from/to Corning Incorporated and affiliates 2,934 14,783 (2,581)
Other assets and liabilities, net 7,028 (19,583) 8,841
---------- -------- ----------
Net cash provided by operating activities 85,828 37,963 99,614
---------- -------- ----------
Cash flows from investing activities:
Capital expenditures (74,045) (93,354) (65,317)
Proceeds from disposition of assets 2,880 55,762 --
Acquisition of businesses, net of cash acquired (22,907) (12,154) (401,428)
Decrease (increase) in investments 985 3,560 (6,942)
---------- -------- ----------
Net cash used in investing activities (93,087) (46,186) (473,687)
---------- -------- ----------
Cash flows from financing activities:
Proceeds from borrowings, primarily with Corning Incorporated 55,729 186,046 709,630
Repayment of long-term debt (13,784) (118,046) (265,196)
Dividends paid (36,959) (60,468) (51,478)
---------- -------- ----------
Net cash provided by financing activities 4,986 7,532 392,956
---------- -------- ----------
Net change in cash and cash equivalents (2,273) (691) 18,883
Cash and cash equivalents, beginning of year 38,719 39,410 20,527
---------- -------- ----------
Cash and cash equivalents, end of year $ 36,446 $ 38,719 $ 39,410
========== ======== ==========
</TABLE>
The accompanying notes are an integral part of these statements.
F-8
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
COMBINED STATEMENTS OF STOCKHOLDER'S EQUITY
FOR THE YEARS ENDED DECEMBER 31, 1995, 1994 AND 1993
(in thousands)
<TABLE>
<CAPTION>
Cumulative Market Total
Retained Translation Valuation Stockholder's
Contributed Capital Earnings Adjustment Adjustment Equity
------------------- ----------- ------------ ------------ ---------------
<S> <C> <C> <C> <C> <C>
Balance, December 31, 1992 $ 261,499 $146,938 $ (288) $ $ 408,149
Net income 34,197 34,197
Dividends to CLSI (28,088) (28,088)
Dividends to S-Corporation shareholders (23,390) (23,390)
Equity of pooled entity 4,150 (4,096) 54
Translation adjustment 4,587 4,587
------------------ --------- ---------- ---------- -------------
Balance, December 31, 1993 265,649 125,561 4,299 395,509
Net income 28,345 28,345
Dividends to CLSI (33,275) (33,275)
Dividends to S-Corporation shareholders (27,193) (27,193)
Dividends in-kind to S-Corporation
shareholders (7,545) (7,545)
Capital contribution 32,174 32,174
Translation adjustment (1,203) (1,203)
------------------ --------- ---------- ---------- -------------
Balance, December 31, 1994 297,823 85,893 3,096 386,812
Net loss (52,052) (52,052)
Dividends to CLSI (36,959) (36,959)
Translation adjustment (771) (771)
Market valuation adjustment (1,229) (1,229)
------------------ --------- ---------- ---------- -------------
Balance, December 31, 1995 $ 297,823 $ (3,118) $ 2,325 $(1,229) $ 295,801
================== ========= ========== ========== =============
</TABLE>
The accompanying notes are an integral part of these statements.
F-9
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
NOTES TO COMBINED FINANCIAL STATEMENTS
(dollars in thousands, unless otherwise indicated)
1. BASIS OF PRESENTATION
Corning Clinical Laboratories Inc. and Corning Nichols Institute Inc.
(collectively referred to as "CCL" or the "Company") are wholly-owned
subsidiaries of Corning Life Sciences Inc. ("CLSI") which in turn is a
wholly-owned subsidiary of Corning Incorporated ("Corning"). The Company is
one of the largest clinical laboratory testing businesses in the United
States. The accompanying financial statements present the carved-out results
of operations, cash flows and financial position of Corning's clinical
laboratory testing business. Covance Inc. (formerly Corning Pharmaceutical
Services Inc.), a subsidiary of CCL, and its related entities ("Covance") as
well as environmental testing services formerly provided by CCL are excluded.
In 1994, Corning acquired three clinical laboratory testing businesses on the
behalf of CCL in separate transactions accounted for as poolings of interests
(see Note 3). Results presented for 1994 and 1993 include the results of CCL
and the pooled entities on a combined basis.
In May 1996, Corning's Board of Directors approved a plan to distribute to
its shareholders on a pro rata basis all of the shares of CCL and Covance
(the "CCL and Covance Spin-Off Distributions"). The result of the plan will
be the creation of two independent, publicly-owned companies. As a result of
the Spin-Off Distributions, CCL will operate Corning's clinical laboratory
testing business as an independent public company and Covance will own and
operate Corning's contract research business as an independent public
company. The Spin-Off Distributions will be effected by the distribution of a
dividend to holders of Corning Common Stock of all of the outstanding CCL
Common Stock, followed immediately by the distribution of a dividend to the
holders of CCL Common Stock of all of the Covance Common Stock. Corning has
submitted to the Internal Revenue Service a request for a ruling that the
Spin-Off Distributions qualify as tax-free distributions under the Internal
Revenue Code of 1986. Coincident with the Spin-Off Distribution, the Company
will be renamed Quest Diagnostics Incorporated.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The combined financial statements include the accounts of all laboratory
entities controlled by the Company. The equity method of accounting is used
for investments in affiliates which are not Company controlled and in which
the Company's interest is generally between 20 and 50 percent. All
significant intercompany accounts and transactions are eliminated.
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
Revenue Recognition
The Company generally recognizes revenue as services are rendered upon
completion of the testing process. Billings for services under third-party
payor programs, including Medicare and Medicaid, are recorded as revenues net
of allowances for differences between amounts billed and the estimated
receipts under such programs. Adjustments to the estimated receipts, based on
final settlement with the third-party payors, are recorded upon settlement.
In 1995, 1994 and 1993, approximately 23%, 28% and 25%, respectively, of net
revenues were generated by Medicare and Medicaid programs.
Concentrations of Credit Risk
Concentrations of credit risk with respect to accounts receivable are
limited due to the diversity of the Company's clients as well as their
dispersion across many different geographic regions.
Taxes on Income
The Company uses the asset and liability approach to account for income
taxes. Under this method, deferred tax assets and liabilities are recognized
for the expected future tax consequences of differences between the carrying
amounts of assets and liabilities and their respective tax bases using
enacted tax rates in effect for the year in which
F-10
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
(dollars in thousands, unless otherwise indicated)
the differences are expected to reverse. The effect on deferred tax assets
and liabilities of a change in tax rates is recognized in income in the
period when the change is enacted. In 1993 the Company adopted Statement of
Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS
109). The adoption of SFAS 109 resulted in a charge to net income of $10.6
million, principally representing a reduction in the Company's deferred tax
assets to reflect the then enacted statutory tax rate.
Cash and Cash Equivalents
Cash and cash equivalents include all highly-liquid investments with
original maturities at the time acquired by the Company of three months or
less, and consist principally of amounts temporarily invested in a U.S.
government money market fund.
Inventories
Inventories, which consist principally of supplies, are valued at the
lower of cost (first in, first out method) or market.
Property, Plant and Equipment
Property, plant and equipment are recorded at cost. Depreciation and
amortization are provided on the straight- line method at rates adequate to
allocate the cost of the applicable assets over their expected useful lives,
which range from three to forty years.
Intangible Assets
Acquisition costs in excess of the fair value of net tangible assets
acquired are capitalized and amortized over appropriate periods not exceeding
forty years. Other intangible assets are recorded at cost and amortized over
periods not exceeding fifteen years.
Investments
The Company accounts for investments in equity securities, which are
included in other assets, in conformity with Statement of Financial
Accounting Standards No. 115 (SFAS 115), "Accounting for Certain Investments
in Debt and Equity Securities." SFAS 115 requires the use of fair value
accounting for trading or available-for-sale securities. Unrealized losses
for available-for-sale securities are recorded as a separate component within
stockholder's equity. Investments in equity securities are not material to
the Company.
Impairment Accounting
The Company adopted Statement of Financial Accounting Standards No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets
to Be Disposed Of" (SFAS 121) in 1995. The Company reviews the recoverability
of its long-lived assets, including related goodwill and intangible assets,
when events or changes in circumstances occur that indicate that the carrying
value of the asset may not be recoverable. Evaluation of possible impairment
is based on the Company's ability to recover the asset from the expected
future pre-tax cash flows (undiscounted and without interest charges) of the
related operations. If the expected undiscounted pre-tax cash flows are less
than the carrying value of such asset, an impairment loss is recognized for
the difference between estimated fair value and carrying value. This
assessment of impairment requires management to make estimates of expected
future cash flows. It is at least reasonably possible that future events or
circumstances could cause these estimates to change.
In addition, the carrying value of intangible assets has historically been
subject to a separate evaluation based on estimating expected future
undiscounted cash flows from operating activities. If these estimated cash
flows are less than the carrying amount of the intangible assets, the Company
would recognize an impairment loss in an amount necessary to write down the
intangible assets to fair value.
Earnings Per Share
Earnings per share are computed by dividing net income by the weighted
average number of common shares outstanding. Historical earnings per share
data is not meaningful as the Company's historical capital structure is not
comparable to periods subsequent to the CCL Spin-Off Distribution.
F-11
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
(dollars in thousands, unless otherwise indicated)
3. BUSINESS COMBINATIONS AND DIVESTITURES
Acquisitions
During 1995, the Company acquired several laboratories in separate
transactions accounted for under the purchase method. The total cost of the
acquired businesses aggregated approximately $23 million and was financed
through borrowings from Corning. Intangible assets of approximately $21.6
million resulted from the transactions and are being amortized over periods
not to exceed forty years.
During 1994, Corning acquired three clinical laboratory testing companies
on behalf of the Company in separate transactions accounted for as poolings
of interests. In June 1994, Corning acquired the stock of Maryland Medical
Laboratory, Inc. ("MML") in exchange for approximately 4.5 million shares of
Corning common stock; in August 1994, Corning acquired the stock of Nichols
Institute ("Nichols") in exchange for approximately 7.5 million shares of
Corning common stock and reserved an additional 1.1 million shares for future
issuance upon the exercise of stock options; and, in October 1994, Corning
acquired the stock of Bioran Medical Laboratory ("Bioran") in exchange for
approximately 6.0 million shares of Corning common stock. Results presented
for 1994 and 1993 include the results of the Company, MML, Nichols and Bioran
on a combined basis.
In 1994, the Company also acquired several other laboratories in separate
transactions accounted for under the purchase method. The total cost of the
acquired businesses aggregated approximately $26 million and was financed
through the issuance of Corning stock and borrowings from Corning. Intangible
assets of approximately $24 million resulted from these transactions and are
being amortized over periods not to exceed forty years.
In the third quarter of 1993, Corning acquired on behalf of the Company
the outstanding shares of common stock of Damon Corporation ("Damon"), a
clinical-testing business, for $405 million, including acquisition costs,
financed through borrowings from Corning. In addition, approximately $167
million of Damon's indebtedness was refinanced. Goodwill of approximately
$600 million resulted from the transaction and is being amortized over forty
years. Reserves aggregating $79 million were established for the costs of
closing Damon facilities as a result of the integration of Damon operations.
In the fourth quarter of 1993, the Company acquired the clinical-testing
laboratories of Unilab Corporation ("Unilab") in Denver, Dallas and Phoenix
in exchange for its ownership interest in Unilab operations, the assumption
of approximately $70 million of Unilab debt, and the Company's investment in
J.S. Pathology PLC. Goodwill of approximately $200 million resulted from this
transaction and is being amortized over forty years. As a result of this
transaction, the Company received a small equity investment in Unilab. The
Company previously owned 43% of Unilab.
The operations of the businesses, subsequent to the dates they were
acquired, are included in the combined financial statements. The pro forma
effect of the 1995 acquisitions on periods prior to the acquisitions is not
material.
In 1993, Corning also acquired and contributed to the Company DeYor
Laboratory, Inc., in a transaction accounted for as a pooling of interests,
by issuing 840,000 shares of Corning common stock. The Company's combined
financial statements for periods prior to this acquisition have not been
restated, since this acquisition was not material to the Company's financial
position or the results of its operations for such periods.
Divestitures
In the second quarter of 1994, the Company sold the California clinical
laboratory testing operations acquired in the Damon transaction to Physicians
Clinical Laboratory, Inc. for cash proceeds of $51 million.
4. TAXES ON INCOME
The Company is included in the consolidated Federal income tax return
filed by Corning. CLSI and its subsidiaries, including the Company, have a
tax sharing agreement with Corning, pursuant to which they are required to
compute their provision for income taxes on a separate return basis and pay
to Corning the separate Federal income tax return liability so computed.
F-12
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
(dollars in thousands, unless otherwise indicated)
The components of the provision (benefit) for income taxes for 1995, 1994
and 1993 are as follows:
<TABLE>
<CAPTION>
1995 1994 1993
--------- -------- ----------
<S> <C> <C> <C>
Current:
Federal $ 22,786 $31,598 $ 46,215
State and local 3,556 7,019 2,815
Foreign 526 535 740
Deferred (benefit):
Federal (28,109) (1,339) (23,818)
State and local (4,275) (3,403) (23)
------- ------ ---------
Income tax expense (benefit) $ (5,516) $34,410 $ 25,929
======= ====== =========
</TABLE>
Prior to acquisition by Corning, Bioran and certain MML operations were
S-Corporations; accordingly, no federal provision for income taxes has been
reflected relative to these operations.
A reconciliation of the Federal statutory rate to the Company's effective
tax rate for 1995, 1994 and 1993 is as follows:
<TABLE>
<CAPTION>
1995 1994 1993
-------- -------- ---------
<S> <C> <C> <C>
Taxes at statutory rate (35.0%) 35.0% 35.0%
State and local income taxes, net of federal tax benefit (0.8%) 3.8% 2.6%
Income from partnership and S-Corporations not subject to
federal and state income tax 1.7% (10.3%) (11.1%)
Goodwill 17.6% 14.3% 4.8%
Non-deductible items 6.0% 8.6% 3.4%
Other, net 0.9% 3.4% 2.0%
------ ------ -------
Effective tax rate (9.6%) 54.8% 36.7%
====== ====== =======
</TABLE>
The tax effects of temporary differences that give rise to significant
portions of the net deferred tax assets at December 31, 1995 and 1994 are as
follows:
<TABLE>
<CAPTION>
1995 1994
--------- ----------
<S> <C> <C>
Current deferred tax asset:
Accounts receivable reserve $ 48,584 $ 16,692
Liabilities not currently deductible 49,222 34,422
Other 1,039 2,582
------- ---------
Current deferred tax asset $ 98,845 $ 53,696
======= =========
Non-current deferred tax asset (liability):
Liabilities not currently deductible $ 21,152 $ 33,572
Depreciation and amortization (15,090) (13,979)
------- ---------
Non-current deferred tax asset $ 6,062 $ 19,593
======= =========
</TABLE>
Income taxes payable at December 31, 1995 and 1994 consist of Federal
income taxes payable of $34.2 million and $28.7 million, respectively, state
income taxes payable of $5.0 million and $1.5 million, respectively, and
foreign income taxes payable of $0.6 million and $0.3 million, respectively.
The Company paid income taxes of $21.7 million, $58.5 million and $52.0
million during 1995, 1994 and 1993, respectively.
F-13
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
(dollars in thousands, unless otherwise indicated)
5. PROVISION FOR RESTRUCTURING AND OTHER SPECIAL CHARGES
In the second quarter of 1995, the Company recorded a provision for
restructuring totaling $33.0 million primarily for workforce reduction
programs and the costs of exiting a number of leased facilities.
Additionally, in the first quarter of 1995, the Company recorded a special
charge of $12.8 million for the settlement of claims related to inadvertent
billing errors of certain laboratory tests that were not completely and/or
successfully performed or reported due to insufficient samples and/or invalid
results. Additionally, in the fourth quarter of 1995, the Company recorded a
charge of $4.8 million related to claims by the Civil Division of the U.S.
Department of Justice ("DOJ") of alleged billing errors related to a
laboratory test performed by Bioran prior to its acquisition by the Company.
In the third quarter of 1994, the Company recorded a provision for
restructuring and other special charges totaling $79.8 million which included
$48.2 million of integration costs, $21.6 million of transaction expenses
related to the Nichols, MML and Bioran acquisitions, and $10 million of
settlement reserves primarily related to government investigations of billing
practices by Nichols prior to its acquisition by the Company. The integration
costs represent the expected costs for closing clinical laboratories in
certain markets where duplicate Company, Nichols, MML or Bioran facilities
existed at the time of the acquisitions.
In the third quarter of 1993, the Company recorded a provision for
restructuring costs and other special charges totaling $99.6 million. The
restructuring component of this special charge aggregated $56.6 million and
consisted primarily of asset write-offs, facility related costs and costs for
workforce reduction programs related principally to the integration of the
Company's operations with those acquired in the Damon acquisition.
The special charge of $43 million consists of a $36.5 million charge to
reflect the settlement and related legal expenses associated with a
compromise agreement with the DOJ to settle claims brought on behalf of the
Inspector General, U.S. Department of Health and Human Services and a $6.5
million charge for related asserted and unasserted claims. The DOJ claims
related to the marketing, sale, pricing and billing of certain blood-test
series provided to Medicare patients. The DOJ settlement does not constitute
an admission with respect to any issue arising from subsequent civil actions.
The following summarizes the Company's restructuring activity (in
millions):
<TABLE>
<CAPTION>
1993 and 1994 Amounts Balance at 1995 Amounts Balance at
Restructuring Utilized December 31, Restructuring Utilized December 31,
Provisions Through 1994 1994 Provision in 1995 1995
------------- ------------- ------------ ------------- -------- -------------
<S> <C> <C> <C> <C> <C> <C>
Employee termination costs $ 32.5 $14.8 $17.7 $23.4 $27.0 $14.1
Write-off of fixed assets 35.6 19.1 16.5 3.7 9.2 11.0
Costs of exiting leased facilities 21.7 9.3 12.4 3.1 6.8 8.7
Other 15.0 13.4 1.6 2.8 .5 3.9
------------ ------------ ----------- ------------ ------ ------------
Total $104.8 $56.6 $48.2 $33.0 $43.5 $37.7
============ ============ =========== ============ ====== ============
</TABLE>
F-14
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
(dollars in thousands, unless otherwise indicated)
The substantial portion of the balance at December 31, 1995 is expected to
be expended in 1996.
Employee termination costs included severance benefits related to
approximately 3,300 employees (700, 2,000 and 600 in 1995, 1994 and 1993,
respectively). The estimated number of employees to be terminated has been
reduced to 2,355, all of which have been terminated or notified of their
termination at December 31, 1995. Management expects that approximately 300
terminations and the remaining business or facility exits will occur by the
end of 1996. The decrease in the number of actual versus anticipated employee
terminations is primarily attributable to higher than expected attrition. As
a result of higher than expected average termination costs, management's
estimate of total employee termination costs is unchanged. Certain severance
and facility exit costs have payment terms extending beyond 1997.
6. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment at December 31, 1995 and 1994 consist of the
following:
<TABLE>
<CAPTION>
1995 1994
---------- -----------
<S> <C> <C>
Land $ 18,568 $ 18,969
Buildings and improvements 186,192 173,546
Laboratory equipment, furniture and fixtures 286,326 247,200
Leasehold improvements 39,078 30,050
Construction-in-progress 19,490 33,508
-------- ----------
Property and equipment, at cost 549,654 503,273
Less: accumulated depreciation and amortization (253,538) (215,711)
-------- ----------
Property and equipment, net $ 296,116 $ 287,562
======== ==========
</TABLE>
Depreciation and amortization expense aggregated $56.8 million, $46.9 million
and $38.1 million for 1995, 1994 and 1993, respectively.
7. INTANGIBLE ASSETS
Intangible assets at December 31, 1995 and 1994 consist of the following:
<TABLE>
<CAPTION>
1995 1994
----------- ------------
<S> <C> <C>
Goodwill $1,056,073 $1,043,089
Customer lists 84,558 100,428
Other (principally non-compete covenants) 50,626 61,401
---------- -----------
Intangible assets, at cost 1,191,257 1,204,918
Less: accumulated amortization (160,624) (151,724)
---------- -----------
Intangible assets, net $1,030,633 $1,053,194
========== ===========
</TABLE>
Amortization expense aggregated $44.7 million, $42.6 million and $28.4
million for 1995, 1994 and 1993, respectively.
F-15
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
(dollars in thousands, unless otherwise indicated)
8. ACCOUNTS PAYABLE AND ACCRUED EXPENSES
Accounts payable and accrued expenses at December 31, 1995 and 1994
consist of the following:
<TABLE>
<CAPTION>
1995 1994
--------- ----------
<S> <C> <C>
Accrued wages and benefits $ 81,985 $ 74,519
Restructuring, integration and other special charges 61,878 69,812
Accrued expenses 57,338 34,851
Trade accounts payable 31,129 36,169
Accrued acquisition commitments 8,195 21,536
------- ---------
Accounts payable and accrued expenses $240,525 $236,887
======= =========
</TABLE>
9. LONG-TERM DEBT
Long-term debt, exclusive of current maturities, at December 31, 1995 and
1994, respectively, consists of the following:
<TABLE>
<CAPTION>
1995 1994
----------- -----------
<S> <C> <C>
Notes payable to Corning:
Revolving credit notes--interest at the London
Interbank offered rate ("LIBOR") plus 1/8%
to 1/4%, maturing 1997 $ 605,636 $ 551,982
Installment note with interest at 9%, maturing 2001 90,000 100,000
Term note with interest at 6.24%, maturing 2003 100,000 100,000
Term note with interest at 6.93%, maturing 2013 100,000 100,000
Term note with interest at 7.17%, maturing 2004 150,000 150,000
Term note with interest at 7.77%, maturing 2024 100,000 100,000
Note payable denominated in pounds Sterling, interest at the
London Interbank Sterling Rate minus 1%, due 2002 8,049 8,516
Mortgage note payable through 2011, interest at 9.25% 6,138 6,355
Capital lease obligations expiring through 2031 32,518 32,538
Other 3,225 3,663
---------- ----------
Total $1,195,566 $1,153,054
========== ==========
</TABLE>
Current maturities on long-term debt totaled $12.1 million and $12.6
million at December 31, 1995 and 1994, respectively.
Long-term debt, including capital leases, maturing in each of the years
subsequent to December 31, 1996 is as follows:
<TABLE>
<CAPTION>
<S> <C>
Fiscal year ending December 31,
1997 $ 261,131
1998 10,493
1999 10,530
2000 10,576
2001 and thereafter 902,836
----------
Total long-term debt $1,195,566
==========
</TABLE>
F-16
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
(dollars in thousands, unless otherwise indicated)
Future minimum payments under capital leases and the present value thereof
are as follows:
<TABLE>
<CAPTION>
<S> <C>
Fiscal year ending December 31,
1997 $ 4,061
1998 3,846
1999 3,840
2000 3,948
2001 and thereafter 116,102
--------
Total future minimum payments under capital leases 131,797
Less amount representing interest (99,279)
--------
Present value of minimum payments under capital leases $ 32,518
========
</TABLE>
The Company paid interest of $74.2 million, $60.2 million and $41.2
million during 1995, 1994 and 1993, respectively.
Based on borrowing rates currently available to the Company for loans with
similar terms and maturities, the fair value of loans payable to third
parties (carrying amount of approximately $50.0 million) was approximately
$62.0 million at December 31, 1995.
As discussed in Note 14, the Company is currently pursuing the issuance of
$150 million of Senior Subordinated Notes due in 2006 which will be used to
repay certain intercompany indebtedness owed to Corning. The Senior Subordinated
Notes will be guaranteed, fully, jointly and severally, and unconditionally, on
a senior subordinated basis by each of the Company's wholly-owned, domestic
subsidiaries (Subsidiary Guarantors). Non-guarantor subsidiaries, individually
and in the aggregate, are inconsequential to the Company. Full financial
statements of the Subsidiary Guarantors are not presented because management
believes they are not material to investors. The following is summarized
financial information of the Subsidiary Guarantors as of December 31, 1995 and
1994 and for each of the three years in the period ended December 31, 1995.
<TABLE>
<CAPTION>
December 31,
---------------------
1995 1994
-------- ----------
<S> <C> <C>
Current assets $244,547 $248,793
Noncurrent assets 864,351 916,499
Current liabilities 71,828 84,223
Noncurrent
liabilities 682,805 692,742
Stockholder's equity 354,265 388,227
</TABLE>
<TABLE>
<CAPTION>
For the Year Ended December 31,
---------------------------------
1995 1994 1993
-------- -------- ----------
<S> <C> <C> <C>
Net revenues $930,472 $923,205 $749,090
Cost of services 587,100 581,397 447,246
Net income (loss) (33,961) (44,056) 258
</TABLE>
F-17
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
(dollars in thousands, unless otherwise indicated)
10. EMPLOYEE RETIREMENT PLANS
Defined Benefit Plans
An acquired entity had a defined benefit pension plan which in 1990 was
frozen as to the further accrual of benefits. At December 31, 1995 the
present value of the projected benefit obligation using a discount rate of
7.5% was $22.6 million and the fair value of the plan assets (publicly traded
corporate debt and equity securities, government obligations and money market
funds) was $17.4 million. The difference between the projected benefit
obligation and the fair value of plan assets is included in other long-term
liabilities in the accompanying combined balance sheet.
Defined Contribution Plans
The Company has several defined contribution plans covering substantially
all of its full-time employees. Company contributions to these plans
aggregated $18.5 million, $15.9 million and $7.3 million for 1995, 1994 and
1993, respectively.
11. RELATED PARTY TRANSACTIONS
The Company, in the ordinary course of business, conducts a number of
transactions with Corning and its affiliates. The significant transactions
occurring during the years ended December 31, 1995, 1994 and 1993 are as
follows:
<TABLE>
<CAPTION>
1995 1994 1993
-------- -------- ---------
<S> <C> <C> <C>
Interest expense on borrowings $78,930 $55,835 $28,400
Purchase of laboratory supplies 11,261 11,607 7,338
Corporate fees 2,800 2,800 2,450
</TABLE>
Certain executives of the Company are included in various stock
compensation programs of Corning. Expenses related to these programs have
been included in the Company's combined financial statements.
In 1994, Corning contributed capital of $25.2 million through the
reduction of revolving credit notes and former S-Corporation shareholders
contributed capital of a building approximating $4.4 million.
12. COMMITMENTS AND CONTINGENCIES
Minimum rental commitments under noncancellable operating leases,
primarily real estate, in effect at December 31, 1995 are as follows:
<TABLE>
<CAPTION>
<S> <C>
Year ending December 31,
1996 $ 40,459
1997 30,481
1998 20,527
1999 14,877
2000 12,532
2001 and thereafter 65,920
-------
Net minimum lease payments $184,796
=======
</TABLE>
F-18
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
(dollars in thousands, unless otherwise indicated)
Operating lease rental expense for 1995, 1994 and 1993 aggregated $46.9
million, $49.4 million and $46.9 million, respectively.
The Company is self-insured for substantially all casualty losses and
maintains supplemental coverage on a claims made basis. The basis for the
insurance reserve at December 31, 1995 and 1994 is the actuarially determined
projected losses for each program (within the self-insured retention) based
upon the Company's loss experience.
The Company has entered into several settlement agreements with various
governmental and private payors during recent years. At present, government
investigations of certain practices by clinical laboratories acquired in
recent years are ongoing. In addition, certain payors are reviewing their
reimbursement practices for laboratory tests. The results of these
investigations and reviews may result in additional settlement payments or
reductions in reimbursements for certain tests. The recorded reserves of
approximately $37.0 million are included in accrued liabilities and represent
management's best estimate at December 31, 1995. Based on information then
available to CCL, management did not believe that the exposure to claims in
excess of recorded reserves would be material (see Note 13).
13. SUBSEQUENT EVENTS
As disclosed in Note 12, federal government investigations of certain
practices by clinical laboratories acquired in recent years are ongoing. In
the second quarter of 1996, the DOJ notified the Company that it has taken
issue with certain payments received by Damon from federally funded
healthcare programs prior to its acquisition by the Company. Specifically, in
late April 1996, the DOJ for the first time disclosed to CCL the total amount
of the claims that it proposed to assert against Damon. The government
presented its claim for the base recoupment (by lab, by test, by year) and
discussed various theories on which criminal and civil payments of up to
three times the various base recoupment amounts could be assessed. During May
and June, CCL management analyzed the government's claim in detail. CCL
management and outside counsel then believed that there were meritorious
defenses to a number of the claims for recoupments and potential payments in
excess of the base recoupment and these were presented to the government in
early July 1996.
At the end of the second quarter, CCL recorded a $46 million charge to
increase its reserves to $72 million, equal management's estimate of the low end
of the range of amounts necessary to satisfy claims related to Damon and other
related and similar investigations. With respect to the Damon investigation, the
low end of the range was estimated to be equal to the base recoupment sought by
the government reflecting the basis on which CCL had settled an earlier claim
with the government in 1993. The low end of the range for the Nichols and other
government investigations was based on the base recoupment estimated by
management from internal investigations. Reserves for pending private claims
were estimated based on CCL's experience in settling private claims following
its 1993 government settlement.
CCL management considered the potential for some payments to be assessed in
excess of the base recoupment in estimating its liability at June 30, 1996.
Management estimated that the range of reasonably possible amounts necessary to
satisfy claims related to Damon and other related and similar investigations was
between $72 million and approximately $300 million at June 30, 1996, and,
because no amount in the range was more probable than other amounts, CCL
increased its reserves to equal the low end of the range. This position was
based on CCL's experience with the government in 1993, in which the recovery in
excess of base recoupments was not significant, the government's
representatives' invitation to present information and arguments to them and
their stated intention not to consider the issue of payment multiples until the
base recoupment amount had been established, and management's and counsel's
belief that it had meritorious factual, legal and equitable defenses and
mitigations of the government claims.
CCL management was aware that similar investigations of other clinical
laboratories in the industry were ongoing. Other than CCL's 1993 settlement,
the only other similar settlement known to management was the 1992 civil
Medicare settlement by a major competitor for $100 million. CCL had reviewed
the publicly-available
F-19
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
(dollars in thousands, unless otherwise indicated)
information about that settlement, including press releases and the
settlement agreement. The competitor's settlement agreement did not specify
whether the civil settlement included substantial payments to be assessed in
excess of the base recoupment. It was believed by CCL that it did not.
Although the competitor and its chief executive officer each pleaded guilty
to criminal charges, the fine was only $1 million for conduct that was
contemporaneous with, and considered by CCL management and its counsel to be
more egregious than, that of Damon.
During the third quarter 1996, CCL management met with the government
several times to evaluate the substance of the government's allegations.
During a meeting with the government in mid-August, further information and
legal arguments were exchanged. Importantly, at this time, the government for
the first time began to disclose to CCL and its outside counsel grand jury
testimony and other evidence that was inconsistent with certain of CCL's
defenses.
The final settlement discussions began in late September. The government
responded to and rejected many of CCL's defenses and made its tentative final
settlement offer, which included significant payments in excess of base
recoupments, to CCL. Negotiations on the final settlement amount and terms
(including releases from various federal and state payors, compliance program
requirements, etc.) continued into early October and ended with the
settlement agreement dated October 9, 1996. The settlement included base
recoupments of approximately $40 million (which did not differ materially
from management's estimate at June 30, 1996) and total criminal and civil
payments in excess of base recoupments of approximately $80 million. This
settlement concludes all federal and Medicaid claims relating to the billing
by Damon of certain blood tests to Medicare and Medicaid patients and other
matters relating to Damon being investigated by the DOJ. Additionally, the
Company entered into a separate settlement agreement with the DOJ totaling
$6.9 million related to billings of hematology indices provided with
hematology test results. This claim will be paid during the fourth quarter of
1996.
As a result of these settlement agreements, CCL management has reassessed
the level of reserves recorded for other asserted and unasserted claims
related to the Damon and other similar government investigations, including
the investigation of billing practices by Nichols prior to its acquisition by
the Company in 1994. The Company recorded a charge totaling $142 million in
the third quarter 1996 to establish additional reserves to provide for the
above settlement agreements and management's best estimate of potential
amounts which could be required to satisfy the remaining claims. At September
30, 1996, recorded reserves approximated $215 million (including the $119
million Damon settlement paid in October 1996). Based on information
currently available to CCL, management does not believe that the exposure to
claims in excess of recorded claims is material. Although the Damon
settlement was substantially in excess of amounts anticipated by management,
it was primarily due to the civil and criminal payments in excess of the base
recoupment assessed by the government and CCL has now increased its reserves
for asserted and unasserted claims to approximate the amount that may be
required to settle the Nichols and other government civil claims taking into
account the basis for the Damon civil settlement. In addition, although there
is the possibility that CCL could be excluded from participation in Medicare
and Medicaid programs, management believes that the possibility is remote as
a result of the Damon settlement, which included CCL's signing a Corporate
Integrity Agreement, and due to the fact that the government has publicly
commended CCL for its cooperation in the investigation and cited CCL as
having one of the "model" compliance programs in the industry.
In October 1996, Corning contributed $119 million to CCL's capital to fund
the Damon settlement. Additionally, Corning has agreed to fund any additional
settlements prior to the CCL Spin-Off Distribution and to indemnify CCL
against all settlements for any governmental claims relating to billing
practices of CCL and its predecessors that have been settled or are pending
on the Distribution Date. Corning will also agree to indemnify CCL for 50% of
the aggregate of all settlement payments made by CCL that are in excess of
$42 million to private parties that relate to indemnified or previously
settled governmental claims (such as the Damon settlement) for services
provided prior to the Distribution Date; however, the indemnification of
private party claims will not exceed $25 million and will be paid on an
after-tax basis. Such indemnification will not cover any nongovernmental
claims not settled prior to five years after the Distribution Date.
Coincident with the CCL Spin-Off Distribution, the
F-20
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
(dollars in thousands, unless otherwise indicated)
Company will record a receivable and a contribution of capital from Corning
currently estimated at $25 million which is equal to 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.
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 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, for
non-indemnified claims, the Company's 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 the Company's overall financial condition.
In addition to the $142 million special charge discussed above, in the
third quarter of 1996, the Company recorded a special charge of $13.7 million
to write off capitalized software as a result of its decision to abandon the
billing system which had been intended as its standard company-wide billing
system. Management now plans to standardize billing systems using a system
already implemented in seven of its sites.
14. SPIN-OFF DISTRIBUTION (unaudited)
Coincident with the CCL Spin-Off Distribution, the Company plans to record
a non-recurring charge of approximately $20 million ($13 million after tax)
associated with the CCL Spin-Off Distribution. The largest component of the
charge will be the cost of establishing an employee stock ownership plan ($11
million). The remainder of the charge will consist principally of the costs
for advisors and other fees associated with establishing the Company as a
separate publicly-traded entity. The amount of the charge is subject to
change based on the price of the CCL stock on the Distribution Date.
Prior to the CCL Spin-Off Distribution, the Company will borrow
approximately $500 million in long-term debt to repay Corning for certain
intercompany borrowings. The debt is assumed to consist of $350 million of
bank borrowings and $150 million of publicly-registered high-yield notes.
Corning will contribute the remaining debt to the Company's equity prior to
the CCL Spin-Off Distribution. The credit facility governing the bank
borrowings and the indenture governing the notes will contain various
customary affirmative and negative covenants, including the maintenance of
certain financial ratios and tests. The credit facility prohibits the Company
from paying cash dividends on the CCL common stock. Further, the indenture
will restrict the Company's ability to pay cash dividends based on a
percentage of the Company's cash flow.
In conjunction with the CCL Spin-Off Distribution, Corning and the Company
will enter into an indemnification agreement whereby Corning agrees to
indemnify CCL, on an after-tax basis, for any losses arising out of any
federal, criminal, civil or administrative investigations or claims that are
pending as of the Distribution Date to the extent that such investigations or
claims arise out of or are related to alleged violations of federal laws by
reason of CCL, its affiliates, officers or directors billing any federal
program or agency for services rendered to beneficiaries of such program or
agency.
Corning, CCL and Covance will enter into tax indemnification agreements
that will prohibit CCL and Covance for a period of two years after the
Spin-Off Distributions from taking certain actions that might jeopardize the
favorable tax treatment of the Distributions under section 355 of the
Internal Revenue Code of 1986, as amended and will provide Corning and CCL
with certain rights of indemnification against CCL and Covance. The tax
indemnification agreements will also require CCL and Covance to take such
actions as Corning may request to preserve the favorable tax treatment
provided for in any rulings obtained from the Internal Revenue Service in
respect of the Distributions.
Corning, CCL and Covance will also enter into a tax sharing agreement
which will allocate among Corning, CCL and Covance responsibility for
federal, state and local taxes relating to taxable periods before and after
the
F-21
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
(dollars in thousands, unless otherwise indicated)
Spin-Off Distributions and provide for computing and apportioning tax
liabilities and tax benefits for such periods among the parties.
15. PLANNED CHANGE IN ACCOUNTING POLICY (unaudited)
Coincident with the CCL Spin-Off Distribution, CCL management will adopt a
new accounting policy for evaluating the recoverability of intangible assets and
measuring possible impairment under Statement of the Accounting Principles Board
No. 17. Most of CCL's intangible assets resulted from purchase business
combinations in 1993. Significant changes in the clinical laboratory and health
care industries subsequent to 1993, including increased government regulation
and movement from traditional fee-for-service care to managed cost health care,
have caused the fair value of CCL's intangible assets to be significantly less
than carrying value. CCL management believes that a valuation of intangible
assets based on the amount for which each regional laboratory could be sold in
an arm's-length transaction is preferable to using projected undiscounted
pre-tax cash flows. CCL believes fair value is a better indicator of the extent
to which the intangible assets may be recoverable and therefore, may be
impaired. This change in method of evaluating the recoverability of intangible
assets will result in CCL recording a charge of between $400 million and $450
million to operations coincident with the CCL Spin-Off Distribution to reflect
the impairment of intangible assets. This will result in a reduction of
amortization expense of approximately $10 million to $11.3 million annually and
$2.5 million to $2.8 million quarterly.
The fair value method will be applied to each of CCL's regional
laboratories. Management's estimate of fair value will primarily be based on
multiples of forecasted revenue or multiples of forecasted EBITDA. The multiples
will primarily be determined based upon publicly available information regarding
comparable publicly-traded companies in the industry, but will also consider (i)
the financial projections of each regional laboratory, (ii) the future prospects
of each regional laboratory, including its growth opportunities, managed care
concentration and likely operational improvements, and (iii) comparable sales
prices, if available. Multiples of revenues will be used to estimate fair value
in cases where the Company believes that the likely acquirer of a regional
laboratory would be a strategic buyer within the industry which would realize
synergies from such an acquisition. In regions where management does not believe
there is a potential strategic buyer within the industry, and, accordingly,
believes the likely buyer would not have synergy opportunities, multiples of
EBITDA will be used for estimating fair value. Regional laboratories with lower
levels of profitability valued using revenue multiples would generally be
ascribed a higher value than if multiples of EBITDA were used, due to assumed
synergy opportunities. Management's estimate of fair value is currently based on
multiples of revenue primarily ranging from 0.5 to 0.7 times revenue and on
multiples of EBITDA primarily ranging from 5 to 6 times EBITDA. While management
believes the estimation methods are reasonable and reflective of common
valuation practices, there can be no assurance that a sale to a buyer for the
estimated value ascribed to a regional laboratory could be completed. Changes to
the method of valuing regional laboratories will be made only when there is a
significant and fundamental change in facts and circumstances, such as
significant changes in market position or the entrance or exit of a significant
competitor from a regional market.
For purposes of estimating the fair value of each of the regional
laboratories, management assumed that a potential buyer would seek to be
indemnified for litigation or other contingencies resulting from
preacquisition activities. Therefore, the reserves recorded for potential,
and settled, billing and marketing claims were not allocated to the regional
laboratories for purposes of estimating their fair value.
On a quarterly basis, CCL management will perform a review of each regional
laboratory to determine if events or changes in circumstances have occurred
which could have a material adverse effect on the fair value of the business and
its intangible assets. If such events or changes in circumstances were deemed to
have occurred, management would consult with one or more of its investment
bankers in estimating the impact on fair value of the regional laboratory.
Should the estimated fair value of a regional laboratory be less than the net
book value for such laboratory at the end of a quarter, the Company would record
a charge to operations to recognize an impairment of its intangible assets for
such difference.
F-22
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
Schedule II--Valuation Accounts and Reserves
(amounts in thousands)
<TABLE>
<CAPTION>
Balance at Net Deductions Balance at
Year ended December 31, 1995 1-1-95 Additions and Other 12-31-95
---------- ---------- -------------- -----------
<S> <C> <C> <C> <C>
Doubtful accounts and allowances $ 74,829 $152,590 $ 79,472 $147,947
Balance at Net Deductions Balance at
Year ended December 31, 1994 1-1-94 Additions and Other 12-31-94
---------- ---------- -------------- -----------
Doubtful accounts and allowances $71,991 $59,480 $56,642 $74,829
Balance at Net Deductions Balance at
Year ended December 31, 1993 1-1-93 Additions and Other 12-31-93
---------- --------- -------------- -----------
Doubtful accounts and allowances $65,859 $47,240 $ 41,108 $71,991
</TABLE>
F-23
<PAGE>
QUARTERLY OPERATING RESULTS (unaudited)
<TABLE>
<CAPTION>
First Second Third Fourth Total
Quarter Quarter Quarter Quarter Year
----------- ------------- ------------- ------------- ------------
<S> <C> <C> <C> <C> <C>
1996
----------------------------
Net revenues $401,395 $ 424,543 $ 405,352
Gross profit 154,277 158,242 149,962
Loss before taxes (1,642) (37,518) (1) (162,989) (1)
Net loss (1,511) (37,922) (119,436)
1995
----------------------------
Net revenues $417,662 $ 421,853 $ 399,959 $ 389,914 $1,629,388
Gross profit 168,606 175,793 159,091 145,666 649,156
Income (loss) before taxes 19,827 (1) (5,088) (1) (56,405) (2) (15,902) (1) (57,568)
Net income (loss) 4,423 (3,852) (38,595) (14,028) (52,052)
1994
----------------------------
Net revenues $399,063 $ 422,942 $ 408,478 $ 403,216 $1,633,699
Gross profit 159,050 182,050 163,391 159,364 663,855
Income (loss) before taxes 40,624 45,109 (51,250) (1) 28,272 62,755
Net income (loss) 24,152 24,148 (36,535) 16,580 28,345
</TABLE>
(1) Includes impact of restructuring and other special charges of $46.0
million, $155.7 million, $12.8 million, $33.0 million, $4.8 million and
$79.8 million in second quarter 1996, third quarter 1996, first quarter
1995, second quarter 1995, fourth quarter 1995 and third quarter 1994,
respectively, which are discussed in Notes 5 and 13 to the CCL Combined
Financial Statements.
(2) Includes a $62.0 million charge to increase the reserve for doubtful
accounts and allowances resulting from billing systems implementation and
integration problems at certain laboratories and increased regulatory
requirements.
F-24
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
COMBINED BALANCE SHEETS
SEPTEMBER 30, 1996 AND DECEMBER 31, 1995
(in thousands)
<TABLE>
<CAPTION>
September 30, December 31,
1996 1995
------------- -------------
(unaudited)
<S> <C> <C>
ASSETS
- ------------------------------------------------------------
Current Assets:
Cash and cash equivalents $ 48,319 $ 36,446
Accounts receivable, net of allowance of $116,996 and
$147,947 for September 30, 1996 and December 31, 1995,
respectively 323,171 318,252
Inventories 25,559 26,601
Deferred taxes on income 126,906 98,845
Prepaid expenses and other assets 25,217 22,014
------------ ------------
Total current assets 549,172 502,158
Property and equipment, net 293,490 296,116
Intangible assets, net 1,001,500 1,030,633
Other assets 42,216 24,478
------------ ------------
TOTAL ASSETS $1,886,378 $1,853,385
============ ============
LIABILITIES AND STOCKHOLDER'S EQUITY
- ------------------------------------------------------------
Current Liabilities:
Accounts payable and accrued expenses $ 374,058 $ 240,525
Current portion of long-term debt 11,885 12,148
Income taxes payable 34,212 39,766
Due to Corning Incorporated and affiliates 14,299 8,979
------------ ------------
Total current liabilities 434,454 301,418
Long-term debt (principally due to Corning Incorporated) 1,219,900 1,195,566
Other liabilities 99,354 60,600
------------ ------------
Total liabilities 1,753,708 1,557,584
============ ============
Stockholder's Equity:
Contributed capital 297,823 297,823
Accumulated deficit (163,158) (3,118)
Cumulative translation adjustment 1,801 2,325
Market valuation adjustment (3,796) (1,229)
------------ ------------
Total stockholder's equity 132,670 295,801
------------ ------------
TOTAL LIABILITIES AND STOCKHOLDER'S EQUITY $1,886,378 $1,853,385
============ ============
</TABLE>
The accompanying notes are an integral part of these statements.
F-25
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
COMBINED STATEMENTS OF OPERATIONS
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 1996 AND 1995
(in thousands)
(unaudited)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30, September 30, September 30,
1996 1995 1996 1995
------------- ------------- ------------- --------------
<S> <C> <C> <C> <C>
Net revenues $ 405,352 $399,959 $1,231,290 $1,239,474
Costs and expenses:
Cost of services 255,390 240,868 768,809 735,984
Selling, general and administrative 125,190 181,346 371,439 399,635
Provision for restructuring and other special
charges 155,730 -- 201,730 45,885
Interest expense, net 19,866 20,927 59,887 61,529
Amortization of intangible assets 10,328 11,293 31,772 33,678
Other, net 1,837 1,930 (198) 4,429
------------ ------------ ------------ -------------
Total 568,341 456,364 1,433,439 1,281,140
------------ ------------ ------------ -------------
Loss before taxes (162,989) (56,405) (202,149) (41,666)
Income tax benefit (43,553) (17,810) (43,280) (3,642)
------------ ------------ ------------ -------------
Net loss $(119,436) $(38,595) $ (158,869) $ (38,024)
============ ============ ============ =============
</TABLE>
The accompanying notes are an integral part of these statements.
F-26
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
COMBINED STATEMENTS OF CASH FLOWS
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1996 AND 1995
(in thousands)
(unaudited)
<TABLE>
<CAPTION>
1996 1995
----------- -----------
<S> <C> <C>
Cash flows from operating activities:
Net loss $(158,869) $ (38,024)
Adjustments to reconcile net loss to net cash provided by
operating activities:
Depreciation and amortization 75,232 76,036
Provision for doubtful accounts 81,891 127,297
Provision for restructuring and other special charges 201,730 45,885
Deferred income tax provision (31,612) (39,403)
Other, net (753) 4,984
Changes in operating assets and liabilities:
Accounts receivable (87,339) (112,110)
Accounts payable and accrued expenses 3,355 18,732
Restructuring, integration and other special charges (19,863) (49,836)
Due from/to Corning Incorporated and affiliates 5,320 4,572
Changes in other assets and liabilities (27,155) 15,656
---------- ----------
Net cash provided by operating activities 41,937 53,789
---------- ----------
Cash flows from investing activities:
Capital expenditures (58,802) (56,062)
Acquisition of businesses, net of cash acquired -- (22,907)
(Increase) decrease in investments (7,580) 1,058
Proceeds from sale of assets 13,285 --
---------- ----------
Net cash used in investing activities (53,097) (77,911)
---------- ----------
Cash flows from financing activities:
Proceeds from borrowings, primarily with Corning
Incorporated 59,090 63,795
Repayment of long-term debt (34,885) (3,766)
Dividends paid (1,172) (27,718)
---------- ----------
Net cash provided by financing activities 23,033 32,311
---------- ----------
Net change in cash and cash equivalents 11,873 8,189
Cash and cash equivalents, beginning of year 36,446 38,719
---------- ----------
Cash and cash equivalents, end of period $ 48,319 $ 46,908
========== ==========
</TABLE>
The accompanying notes are an integral part of these statements.
F-27
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
NOTES TO INTERIM COMBINED FINANCIAL STATEMENTS
(unaudited)
1. BASIS OF PRESENTATION
Corning Clinical Laboratories Inc. and Corning Nichols Institute Inc.
(collectively referred to as "CCL" or the "Company") are wholly-owned
subsidiaries of Corning Life Sciences Inc. ("CLSI") which in turn is a
wholly-owned subsidiary of Corning Incorporated ("Corning"). The Company is
one of the largest clinical laboratory testing businesses in the United
States. These financial statements present the carved-out results of
operations, cash flows and financial position of Corning's clinical
laboratory testing business. Covance Inc. (formerly Corning Pharmaceutical
Services Inc.), a subsidiary of CCL, and its related entities ("Covance") as
well as environmental testing services formerly provided by CCL are excluded.
In May 1996, Corning's Board of Directors approved a plan to distribute to
its shareholders on a pro rata basis all of the shares of CCL and Covance
(the "CCL and Covance Spin-Off Distributions"). The result of the plan will
be the creation of two independent, publicly-owned companies. As a result of
the Spin-Off Distributions, CCL will operate Corning's clinical laboratory
testing business as an independent public company and Covance will own and
operate Corning's contract research business as an independent public
company. The Spin-Off Distributions will be effected by the distribution of a
dividend to holders of Corning Common Stock of all of the outstanding CCL
Common Stock, followed immediately by the distribution of a dividend to the
holders of CCL Common Stock of all of the Covance Common Stock. Corning has
submitted to the Internal Revenue Service a request for a ruling that the
Spin-Off Distributions qualify as tax-free distributions under the Internal
Revenue Code of 1986. Coincident with the Spin-Off Distribution, the Company
will be renamed Quest Diagnostics Incorporated.
The interim combined 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 combined financial statements have
been compiled without audit and are subject to year-end adjustments. These
interim combined financial statements should be read in conjunction with the
historical combined financial statements of CCL for the years ended December
31, 1995, 1994 and 1993 included elsewhere herein.
2. COMMITMENTS AND CONTINGENCIES
As disclosed in the Company's 1995 combined financial statements, federal
government investigations of certain practices by clinical laboratories
acquired in recent years are ongoing. In the second quarter of 1996, the U.S.
Department of Justice ("DOJ") notified the Company that it has taken issue
with certain payments received by Damon Corporation ("Damon") from federally
funded healthcare programs prior to its acquisition by the Company.
Specifically, in late April 1996, the DOJ for the first time disclosed to CCL
the total amount of the claims that it proposed to assert against Damon. The
government presented its claim for the base recoupment (by lab, by test, by
year) and discussed various theories on which criminal and civil payments of
up to three times the various base recoupment amounts could be assessed.
During May and June, CCL management analyzed the government's claim in
detail. CCL management and outside counsel then believed that there were
meritorious defenses to a number of the claims for recoupments and potential
payments in excess of the base recoupment and these were presented to the
government in early July 1996.
At the end of the second quarter, CCL recorded a $46 million charge to
increase its reserves to $72 million, to equal management's estimate of the low
end of the range of amounts necessary to satisfy claims related to Damon and
other related and similar investigations. With respect to the Damon
investigation, the low end of the range was estimated to be equal to the base
recoupment sought by the government reflecting the basis on which CCL had
settled an earlier claim with the government in 1993. The low end of the range
for the Nichols and other government investigations was based on the base
recoupment estimated by management from internal investigations. Reserves for
pending private claims were estimated based on CCL's experience in settling
private claims following its 1993 government settlement.
CCL management considered the potential for some payments to be assessed in
excess of the base recoupment in estimating its liability at June 30, 1996.
F-28
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(a wholly-owned business of Corning Incorporated)
NOTES TO INTERIM COMBINED FINANCIAL STATEMENTS (Continued)
(unaudited)
Management estimated that the range of reasonably possible amounts necessary to
satisfy claims related to Damon and other related and similar investigations was
between $72 million and approximately $300 million at June 30, 1996, and,
because no amount in the range was more probable than other amounts, CCL
increased its reserves to equal the low end of the range. This position was
based on CCL's experience with the government in 1993, in which the recovery in
excess of base recoupments was not significant, the government's
representatives' invitation to present information and arguments to them and
their stated intention not to consider the issue of payment multiples until the
base recoupment amount had been established, and management's and counsel's
belief that it had meritorious factual, legal and equitable defenses and
mitigations of the government claims.
CCL management was aware that similar investigations of other clinical
laboratories in the industry were ongoing. Other than CCL's 1993 settlement,
the only other similar settlement known to management was the 1992 civil
Medicare settlement by a major competitor for $100 million. CCL had reviewed
the publicly-available information about that settlement, including press
releases and the settlement agreement. The competitor's settlement agreement
did not specify whether the civil settlement included substantial payments to
be assessed in excess of the base recoupment. It was believed by CCL that it
did not. Although the competitor and its chief executive officer each pleaded
guilty to criminal charges, the fine was only $1 million for conduct that was
contemporaneous with, and considered by CCL management and its counsel to be
more egregious than, that of Damon.
During the third quarter 1996, CCL management met with the government
several times to evaluate the substance of the government's allegations.
During a meeting with the government in mid-August, further information and
legal arguments were exchanged. Importantly, at this time, the government for
the first time began to disclose to CCL and its outside counsel grand jury
testimony and other evidence that was inconsistent with certain of CCL's
defenses.
The final settlement discussions began in late September. The government
responded to and rejected many of CCL's defenses and made its tentative final
settlement offer, which included significant payments in excess of base
recoupments, to CCL. Negotiations on the final settlement amount and terms
(including releases from various federal and state payors, compliance program
requirements, etc.) continued into early October and ended with the
settlement agreement dated October 9, 1996. The settlement included base
recoupments of approximately $40 million (which did not differ materially
from management's estimate at June 30, 1996) and total criminal and civil
payments in excess of base recoupments of approximately $80 million. This
settlement concludes all federal and Medicaid claims relating to the billing
by Damon of certain blood tests to Medicare and Medicaid patients and other
matters relating to Damon being investigated by the DOJ. Additionally, the
Company entered into a separate settlement agreement with the DOJ totaling
$6.9 million related to billings of hematology indices provided with
hematology test results. This claim will be paid during the fourth quarter of
1996.
As a result of these settlement agreements, CCL management has reassessed
the level of reserves recorded for other asserted and unasserted claims
related to the Damon and other similar government investigations, including
the investigation of billing practices by Nichols Institute ("Nichols") prior
to its acquisition by the Company in 1994. The Company recorded a charge
totaling $142 million in the third quarter 1996 to establish additional
reserves to provide for the above settlement agreements and management's best
estimate of potential amounts which could be required to satisfy the
remaining claims. At September 30, 1996, recorded reserves approximated $215
million (including the $119 million Damon settlement paid in October 1996).
Based on information currently available to CCL, management does not believe
that the exposure to claims in excess of recorded claims is material.
Although the Damon settlement was substantially in excess of amounts
anticipated by management, it was primarily due to the civil and criminal
payments in excess of the base recoupment assessed by the government and CCL
has now increased its reserves for asserted and unasserted claims to
approximate the amount that may be required to settle the Nichols and other
government civil claims taking into account the basis for the Damon civil
settlement. In addition, although there is the possibility that CCL could be
excluded from participation in Medicare and Medicaid programs, management
believes that the possibility is remote as a result of the Damon settlement,
which included CCL's signing a Corporate Integrity Agreement, and due to the
fact that the government has publicly commended CCL for its cooperation in
the investigation and cited CCL as having one of the "model" compliance
programs in the industry.
F-29
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
NOTES TO INTERIM COMBINED FINANCIAL STATEMENTS (Continued)
(unaudited)
In October 1996, Corning contributed $119 million to CCL's capital to fund
the Damon settlement. Additionally, Corning has agreed to fund any additional
settlements prior to the CCL Spin-Off Distribution and to indemnify CCL
against all settlements for any governmental claims relating to billing
practices of CCL and its predecessors that have been settled or are pending
on the Distribution Date. Corning will also agree to indemnify CCL for 50% of
the aggregate of all settlement payments made by CCL that are in excess of
$42 million to private parties that relate to indemnified or previously
settled governmental claims (such as the Damon settlement) for services
provided prior to the Distribution Date; however, the indemnification of
private party claims will not exceed $25 million and will be paid on an
after-tax basis. Such indemnification will not cover any nongovernmental
claims not settled prior to five years after the Distribution Date.
Coincident with the CCL Spin-Off Distribution, the Company will record a
receivable and a contribution of capital from Corning currently estimated at
$25 million which is equal to 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.
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 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, for
non-indemnified claims, the Company's cash flow in the period in which such
claims are settled. The Company does not believe that these issues will have
a material adverse impact on the Company's overall financial condition.
3. PROVISION FOR RESTRUCTURING AND OTHER SPECIAL CHARGES
In addition to the $142 million special charge discussed in Note 2, in the
third quarter of 1996, the Company recorded a special charge of $13.7 million
to write off capitalized software as a result of its decision to abandon the
billing system which had been intended as its standard company-wide billing
system. Management now plans to standardize billing systems using a system
already implemented in seven of its sites.
4. RESTRUCTURING RESERVES
As described in Note 5 to the CCL Combined Financial statements, CCL has
recorded charges for restructuring plans in previous years. Reserves relating
to these programs totaled approximately $37.7 million and $23.5 million at
December 31, 1995 and September 30, 1996, respectively. Management believes
that the costs of the restructuring plans will be financed through cash from
operations and does not anticipate any significant impact on its liquidity as
a result of the restructuring plans.
5. SPIN-OFF DISTRIBUTION
Coincident with the CCL Spin-Off Distribution, the Company plans to record
a non-recurring charge of approximately $20 million ($13 million after tax)
associated with the CCL Spin-Off Distribution. The largest component of the
charge will be the cost of establishing an employee stock ownership plan ($11
million). The remainder of the charge will consist principally of the costs
for advisors and other fees associated with establishing the Company as a
separate publicly-traded entity. The amount of the charge is subject to
change based on the price of the CCL stock on the Distribution Date.
Prior to the CCL Spin-Off Distribution, the Company will borrow
approximately $500 million in long-term debt to repay Corning for certain
intercompany borrowings. The debt is assumed to consist of $350 million of
bank borrowings and $150 million of publicly-registered high-yield notes.
Corning will contribute the remaining debt to the Company's equity prior to
the CCL Spin-Off Distribution. The credit facility governing the bank
borrowings and the indenture governing the notes will contain various
customary affirmative and negative covenants , including the maintenance of
certain financial ratios and tests. The credit facility prohibits the Company
from paying cash dividends on the CCL common stock. Further, the indenture
will restrict the Company's ability to pay cash dividends based on a
percentage of the Company's cash flow.
F-30
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
NOTES TO INTERIM COMBINED FINANCIAL STATEMENTS (Continued)
(unaudited)
In conjunction with the CCL Spin-Off Distribution, Corning and the Company
will enter into an indemnification agreement whereby Corning agrees to
indemnify CCL, on an after-tax basis, for any losses arising out of any
federal, criminal, civil or administrative investigations or claims that are
pending as of the Distribution Date to the extent that such investigations or
claims arise out of or are related to alleged violations of federal laws by
reason of CCL, its affiliates, officers or directors billing any federal
program or agency for services rendered to beneficiaries of such program or
agency.
Corning, CCL and Covance will enter into tax indemnification agreements
that will prohibit CCL and Covance for a period of two years after the
Spin-Off Distributions from taking certain actions that might jeopardize the
favorable tax treatment of the Distributions under section 355 of the
Internal Revenue Code of 1986, as amended and will provide Corning and CCL
with certain rights of indemnification against CCL and Covance. The tax
indemnification agreements will also require CCL and Covance to take such
actions as Corning may request to preserve the favorable tax treatment
provided for in any rulings obtained from the Internal Revenue Service in
respect of the Distributions.
Corning, CCL and Covance will also enter into a tax sharing agreement
which will allocate among Corning, CCL and Covance responsibility for
federal, state and local taxes relating to taxable periods before and after
the Spin-Off Distributions and provide for computing and apportioning tax
liabilities and tax benefits for such periods among the parties.
6. PLANNED CHANGE IN ACCOUNTING POLICY
Coincident with the CCL Spin-Off Distribution, CCL management will adopt a
new accounting policy for evaluating the recoverability of intangible assets and
measuring possible impairment under Statement of the Accounting Principles Board
No. 17. Most of CCL's intangible assets resulted from purchase business
combinations in 1993. Significant changes in the clinical laboratory and health
care industries subsequent to 1993, including increased government regulation
and movement from traditional fee-for-service care to managed cost health care,
have caused the fair value of CCL's intangible assets to be significantly less
than carrying value. CCL management believes that a valuation of intangible
assets based on the amount for which each regional laboratory could be sold in
an arm's-length transaction is preferable to using projected undiscounted
pre-tax cash flows. CCL believes fair value is a better indicator of the extent
to which the intangible assets may be recoverable and therefore, may be
impaired. This change in method of evaluating the recoverability of intangible
assets will result in CCL recording a charge of between $400 million and $450
million to operations coincident with the CCL Spin-Off Distribution to reflect
the impairment of intangible assets. This will result in a reduction of
amortization expense of approximately $10 million to $11.3 million annually and
$2.5 million to $2.8 million quarterly.
The fair value method will be applied to each of CCL's regional
laboratories. Management's estimate of fair value will primarily be based on
multiples of forecasted revenue or multiples of forecasted EBITDA. The multiples
will primarily be determined based upon publicly available information regarding
comparable publicly-traded companies in the industry, but will also consider (i)
the financial projections of each regional laboratory, (ii) the future prospects
of each regional laboratory, including its growth opportunities, managed care
concentration and likely operational improvements, and (iii) comparable sales
prices, if available. Multiples of revenues will be used to estimate fair value
in cases where the Company believes that the likely acquirer of a regional
laboratory would be a strategic buyer within the industry which would realize
synergies from such an acquisition. In regions where management does not believe
there is a potential strategic buyer within the industry, and, accordingly,
believes the likely buyer would not have synergy opportunities, multiples of
EBITDA will be used for estimating fair value. Regional laboratories with lower
levels of profitability valued using revenue multiples would generally be
ascribed a higher value than if multiples of EBITDA were used, due to assumed
synergy opportunities. Management's estimate of fair value is currently based on
multiples of revenue primarily ranging from 0.5 to 0.7 times revenue and on
multiples of EBITDA primarily ranging from 5 to 6 times EBITDA. While management
believes the estimation methods are reasonable and reflective of common
valuation practices, there can be no assurance that a sale to a buyer for the
estimated value ascribed to a regional laboratory could be completed. Changes to
the method of valuing regional laboratories will be made only when there is a
significant and fundamental change in facts and circumstances, such as
significant changes in market position or the entrance or exit of a significant
competitor from a regional market.
F-31
<PAGE>
CORNING CLINICAL LABORATORIES INC.
(to be renamed Quest Diagnostics Incorporated)
(a wholly-owned business of Corning Incorporated)
NOTES TO INTERIM COMBINED FINANCIAL STATEMENTS (Continued)
(unaudited)
For purposes of estimating the fair value of each of the regional
laboratories, management assumed that a potential buyer would seek to be
indemnified for litigation or other contingencies resulting from
preacquisition activities. Therefore, the reserves recorded for potential,
and settled, billing and marketing claims were not allocated to the regional
laboratories for purposes of estimating their fair value.
On a quarterly basis, CCL management will perform a review of each regional
laboratory to determine if events or changes in circumstances have occurred
which could have a material adverse effect on the fair value of the business and
its intangible assets. If such events or changes in circumstances were deemed to
have occurred, management would consult with one or more of its investment
bankers in estimating the impact on fair value of the regional laboratory.
Should the estimated fair value of a regional laboratory be less than the net
book value for such laboratory at the end of a quarter, the Company would record
a charge to operations to recognize an impairment of its intangible assets for
such difference.
7. SUMMARIZED FINANCIAL INFORMATION
As discussed in Note 5, the Company is currently pursuing the issuance of
$150 million of Senior Subordinated Notes due in 2006 which will be used to
repay certain intercompany indebtedness owed to Corning. The Senior Subordinated
Notes will be guaranteed, fully, jointly and severally, and unconditionally, on
a senior subordinated basis by each of the Company's wholly-owned, domestic
subsidiaries (Subsidiary Guarantors). Non-guarantor subsidiaries, individually
and in the aggregate, are inconsequential to the Company. Full financial
statements of the Subsidiary Guarantors are not presented because management
believes they are not material to investors. The following is summarized
financial information of the Subsidiary Guarantors as of September 30, 1996 and
December 31, 1995 and for the nine months ended September 30, 1996 and September
30, 1995.
<TABLE>
<CAPTION>
September 30, December 31,
1996 1995
------------- --------------
<S> <C> <C>
Current assets $234,183 $244,547
Noncurrent assets 865,265 864,351
Current liabilities 71,416 71,828
Noncurrent liabilities 694,331 682,805
Stockholder's equity 333,701 354,265
For the nine months ended
September 30,
-----------------------------
1996 1995
------------ -------------
Net revenues $677,489 $709,317
Cost of services 427,583 444,705
Net loss (20,564) (26,435)
</TABLE>
F-32
