SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
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FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the Quarter ended September 30, 1998
Commission file number 1-12215
Quest Diagnostics Incorporated
One Malcolm Avenue
Teterboro, NJ 07608
(201) 393-5030
Delaware
(State of Incorporation)
16-1387862
(I.R.S. Employer Identification Number)
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Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No ______
As of October 31, 1998, there were outstanding 29,865,722 shares of Common
Stock, $.01 par value.
<PAGE>
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Index to consolidated financial statements filed as part of this report:
Page
Consolidated Statements of Operations for the
Three and Nine Months Ended September 30, 1998 and 1997 2
Consolidated Balance Sheets as of
September 30, 1998 and December 31, 1997 3
Consolidated Statements of Cash Flows for the
Nine Months Ended September 30, 1998 and 1997 4
Notes to Consolidated Financial Statements 5
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 1998 AND 1997
(in thousands, except per share data)
(unaudited)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30 September 30
------------------ -----------------
1998 1997 1998 1997
---- ---- ---- ----
<S> <C> <C> <C> <C>
Net revenues.............................. $ 360,713 $ 373,633 $1,095,327 $1,163,259
Costs and expenses:
Cost of services........................ 210,864 229,164 646,710 708,071
Selling, general and administrative..... 122,783 119,691 359,362 371,518
Interest expense, net................... 8,398 10,385 26,548 31,497
Amortization of intangible assets....... 5,530 6,082 16,276 18,104
Other, net.............................. 1,095 2,045 2,459 2,942
---------- ---------- ---------- ----------
Total................................. 348,670 367,367 1,051,355 1,132,132
---------- ---------- ---------- ----------
Income before taxes....................... 12,043 6,266 43,972 31,127
Income tax expense ....................... 5,982 3,273 22,426 15,999
---------- --------- ---------- ----------
Net income ............................... $ 6,061 $ 2,993 $ 21,546 $ 15,128
========== ========== ========== ==========
Basic net income per common share......... $ .20 $ .10 $ .72 $ .52
Diluted net income per common share....... $ .20 $ .10 $ .71 $ .52
Basic weighted average common shares
outstanding............................ 29,686 29,293 29,719 29,090
Diluted weighted average common shares
outstanding............................ 30,219 29,725 30,268 29,455
</TABLE>
The accompanying notes are an integral part of these statements.
2
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, 1998 AND DECEMBER 31, 1997
(in thousands, except per share data)
<TABLE>
<CAPTION>
September 30, December 31,
1998 1997
---- ----
(unaudited)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents................................. $ 180,996 $ 161,661
Accounts receivable, net of allowance of $72,646 and $89,870
at September 30, 1998 and December 31, 1997, respectively 236,393 238,369
Inventories............................................... 29,799 30,360
Deferred taxes on income.................................. 84,778 97,471
Due from Corning Incorporated............................. 16,710 31,600
Prepaid expenses and other assets......................... 13,009 12,423
---------- ----------
Total current assets.................................. 561,685 571,884
Property, plant and equipment, net............................ 241,418 250,223
Intangible assets, net........................................ 500,891 513,779
Other assets.................................................. 62,171 65,042
---------- ----------
TOTAL ASSETS.................................................. $1,366,165 $1,400,928
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses..................... $ 243,789 $ 244,885
Short-term borrowings..................................... 47,091 32,648
Income taxes payable...................................... 12,483 17,613
----------- ----------
Total current liabilities............................. 303,363 295,146
Long-term debt................................................ 423,500 482,161
Other liabilities............................................. 77,910 81,961
----------- ----------
Total liabilities..................................... 804,773 859,268
Commitments and contingencies
Stockholders' equity:
Preferred stock........................................... 1,000 1,000
Common stock, par value $0.01 per share; 100,000 shares
authorized; 29,866 (excluding 356 shares held in
treasury) and 29,986 shares issued at September 30,
1998 and December 31, 1997, respectively.............. 299 300
Additional paid-in capital................................ 1,196,087 1,198,194
Accumulated deficit....................................... (628,823) (650,281)
Accumulated other comprehensive loss...................... (2,972) (2,515)
Unearned compensation..................................... (4,199) (5,038)
------------ ----------
Total stockholders' equity............................ 561,392 541,660
----------- ----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY.................... $ 1,366,165 $1,400,928
=========== ==========
</TABLE>
The accompanying notes are an integral part of these statements.
3
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1998 AND 1997
(in thousands)
(unaudited)
<TABLE>
<CAPTION>
1998 1997
---- ----
<S> <C> <C>
Cash flows from operating activities:
Net income.................................................... $ 21,546 $ 15,128
Adjustments to reconcile net income
to net cash provided by operating activities:
Depreciation and amortization............................. 51,699 57,809
Provision for doubtful accounts........................... 67,292 86,227
Deferred income tax provision............................. 14,377 8,861
Other, net................................................ 5,124 4,375
Changes in operating assets and liabilities:
Accounts receivable................................... (65,317) (64,616)
Accounts payable and accrued expenses................. 41,195 35,813
Restructuring, integration and other special charges.. (34,088) (11,819)
Due from Corning Incorporated and affiliates.......... 14,890 8,755
Other assets and liabilities, net..................... (12,260) (2,616)
------------ ---------
Net cash provided by operating activities..................... 104,458 137,917
----------- --------
Cash flows from investing activities:
Capital expenditures...................................... (27,933) (21,579)
Proceeds from disposition of assets....................... 491 1,103
Acquisition of business................................... 0 (16,000)
(Increase) decrease in investments........................ (1,232) 1,338
------------ -----------
Net cash used in investing activities......................... (28,674) (35,138)
------------ ------------
Cash flows from financing activities:
Repayment of long-term debt............................... (44,137) (861)
Repayments under Working Capital Facility................. 0 (19,300)
Purchase of treasury stock............................... (12,369) 0
Dividends paid............................................ (88) (69)
Exercise of stock options................................. 145 0
----------- -----------
Net cash used in financing activities......................... (56,449) (20,230)
------------ ------------
Net change in cash and cash equivalents....................... 19,335 82,549
Cash and cash equivalents, beginning of year.................. 161,661 41,960
----------- -----------
Cash and cash equivalents, end of period...................... $ 180,996 $ 124,509
=========== ===========
Cash paid during the period for:
Interest.................................................. $ 27,986 $ 28,532
Income taxes.............................................. $ 13,676 $ 5,647
</TABLE>
The accompanying notes are an integral part of these statements.
4
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, unless otherwise indicated)
(unaudited)
1. BASIS OF PRESENTATION
Background
Prior to January 1, 1997, Quest Diagnostics Incorporated and its
subsidiaries (the "Company") was a wholly-owned subsidiary of Corning
Incorporated ("Corning"). On December 31, 1996, Corning distributed all of the
outstanding shares of common stock of the Company to the stockholders of
Corning, with one share of common stock of the Company being distributed for
each eight shares of outstanding common stock of Corning (the "Spin-Off
Distribution").
Basis of Presentation
The interim consolidated financial statements reflect all adjustments which,
in the opinion of management, are necessary for a fair statement of the results
of operations for the periods presented. All such adjustments are of a normal
recurring nature. The interim consolidated financial statements have been
compiled without audit and are subject to year-end adjustments. Operating
results for the interim period are not necessarily indicative of the results
that may be expected for the full year. These interim consolidated financial
statements should be read in conjunction with the audited consolidated financial
statements included in the Company's Form 10-K for the year ended December 31,
1997.
Comprehensive Income
Effective January 1, 1998, the Company adopted Statement of Financial
Accounting Standards No. 130, "Reporting Comprehensive Income." This statement
establishes standards for the reporting and display of comprehensive income and
its components in the financial statements. Comprehensive income encompasses all
changes in stockholders' equity (except those arising from transactions with
stockholders) and includes net income, net unrealized capital gains or losses on
available-for-sale securities and foreign currency translation adjustments.
Comprehensive income was $21.1 million and $17.5 million for the nine months
ended September 30, 1998 and 1997, respectively. Comprehensive income was $5.3
million and $3.4 million for the quarter ended September 30, 1998 and 1997,
respectively.
Earnings Per Share
Earnings per share are computed by dividing net income less dividends on the
Company's Preferred Stock (approximately $30 per quarter) by the weighted
average number of common shares outstanding during the period. The difference
between basic and dilutive weighted average common shares results primarily from
stock options.
2. COMMITMENTS AND CONTINGENCIES
The Company has entered into several settlement agreements with various
governmental and private payors during recent years relating primarily to
industry-wide billing and marketing practices that had been substantially
discontinued by early 1993. At present, a government investigation of certain
practices by Nichols Institute, a clinical laboratory company acquired in 1994,
is ongoing. As part of the Spin-Off Distribution, Corning has agreed to
indemnify the Company against all settlements for any governmental claims
relating to billing practices of the Company and its predecessors that were
pending on December 31, 1996. Corning also agreed to indemnify the Company for
50% of the aggregate of all settlement payments made by the Company that are in
excess of $42 million to private parties that relate to indemnified or
previously settled governmental claims for services provided prior to December
31, 1996; however, the indemnification of private party claims will not exceed
$25 million and will be paid to the Company net of anticipated tax benefits to
be realized by the Company. Such indemnification does not cover any
non-governmental claims settled after December 31, 2001. At September 30, 1998,
the receivable from Corning totaled $16.7 million, representing 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.
5
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, unless otherwise indicated)
(unaudited)
At September 30, 1998, settlement reserves totaled $53.5 million, including
$27.5 million in other long-term liabilities. Although management believes that
established reserves for both indemnified and non-indemnified claims are
sufficient, it is possible that additional information 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 its overall financial condition.
In April 1998, the Company entered into a settlement agreement with the U.S.
Attorney's office in Baltimore for approximately $6.9 million related to the
billing of certain tests performed for which the Company had incomplete or
missing order forms from the physician. 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. In August 1998, the
Company entered into a settlement agreement with the Office of Inspector General
of the Department of Health and Human Services for $15.0 million related to
overcharges for medically unnecessary testing for end stage renal dialysis
patients. These settlements are covered by the indemnification from Corning
discussed above and were fully reserved for.
3. RESTRUCTURING RESERVES
The Company has recorded charges for restructuring plans in previous years.
Reserves relating to these programs totaled $21.5 million and $33.4 million at
September 30, 1998 and December 31, 1997, 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.
4. STOCKHOLDERS' EQUITY
Stock Purchase Program
In February 1998, the Board of Directors authorized the Company to
repurchase up to $27 million of common stock through 1999. The shares will be
reissued in connection with certain employee plans. In the first nine months of
1998, the Company paid approximately $12.4 million for approximately 650
thousand shares under the program.
Unearned Compensation
Under the Company's Employees Equity Participation Program, approximately
300 thousand shares of restricted stock were granted in 1998, primarily to
executive employees. These shares are contingent on achievement of financial
performance goals and are subject to forfeiture if employment terminates prior
to the end of the prescribed period. The market value of the shares awarded
under the plan is recorded as unearned compensation. The unearned amounts are
amortized to compensation expense as earned.
5. SUMMARIZED FINANCIAL INFORMATION
The Company's 10.75% senior subordinated notes due 2006 are guaranteed,
fully, jointly and severally, and unconditionally, on a senior subordinated
basis by substantially all of the Company's wholly-owned, domestic subsidiaries
("Subsidiary Guarantors"). The non-guarantor subsidiaries are foreign and less
than wholly-owned subsidiaries.
The following condensed consolidating financial data illustrates the
financial condition of the combined guarantors. The Company believes that
separate complete financial statements of the respective guarantors would not
provide additional material information that would be useful in assessing the
financial condition of the Subsidiary Guarantors.
6
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, unless otherwise indicated)
(unaudited)
Condensed Consolidating Statement of Operations
Nine Months Ended September 30, 1998
<TABLE>
<CAPTION>
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
<S> <C> <C> <C> <C> <C>
Net revenues........................ $449,360 $625,467 $20,500 $1,095,327
Costs and expenses:
Cost of services.................. 263,245 372,337 11,128 646,710
Selling, general and 195,144 155,923 8,295 359,362
administrative....................
Interest expense, net............. 7,578 18,537 433 26,548
Amortization of intangible assets. 5,323 10,648 305 16,276
Royalty (income) expense.......... (55,503) 55,503 -- --
Other, net........................ (347) 7 2,799 2,459
--------- --------- --------- -----------
Total........................... 415,440 612,955 22,960 1,051,355
Income (loss) before taxes.......... 33,920 12,512 (2,460) 43,972
Income tax expense.................. 22,455 104 (133) 22,426
Equity income from subsidiaries..... 10,081 -- -- (10,081) --
--------- ----------- ----------- --------- -----------
Net income (loss)................... $ 21,546 $ 12,408 $ (2,327) $ (10,081) $ 21,546
========= =========== =========== ========= ===========
</TABLE>
Condensed Consolidating Statement of Operations
Nine Months Ended September 30, 1997
<TABLE>
<CAPTION>
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
<S> <C> <C> <C> <C> <C>
Net revenues........................ $501,008 $645,364 $16,887 $1,163,259
Costs and expenses:
Cost of services.................. 293,994 405,330 8,747 708,071
Selling, general and 206,255 158,113 7,150 371,518
administrative....................
Interest expense, net............. 12,245 18,801 451 31,497
Amortization of intangible assets. 6,630 11,386 88 18,104
Royalty (income) expense.......... (54,174) 54,174 -- --
Other, net........................ 1,007 380 1,555 2,942
--------- ----------- --------- ---------
Total........................... 465,957 648,184 17,991 1,132,132
Income (loss) before taxes.......... 35,051 (2,820) (1,104) 31,127
Income tax expense (benefit)........ 17,461 (2,105) 643 15,999
Equity loss from subsidiaries....... (2,462) -- -- 2,462 --
--------- ----------- --------- ----------- ----------
Net income (loss)................... $ 15,128 $ (715) $ (1,747) $ 2,462 $ 15,128
========= =========== ========= =========== =========
</TABLE>
7
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, unless otherwise indicated)
(unaudited)
Condensed Consolidating Balance Sheet
September 30, 1998
<TABLE>
<CAPTION>
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
<S> <C> <C> <C> <C> <C>
Current assets:
Cash and cash equivalents........... $ 166,945 $ 12,041 $ 2,010 $ 180,996
Accounts receivable, net............ 73,845 159,026 3,522 236,393
Other current assets................ 93,010 48,600 2,686 144,296
----------- ---------- ----------- -----------
Total current assets.............. 333,800 219,667 8,218 561,685
Property, plant and equipment, net.. 95,328 140,186 5,904 241,418
Intangible assets, net ............. 164,995 335,618 278 500,891
Intercompany (payable) receivable... (39,754) 55,924 (16,170) --
Investment in subsidiaries.......... 419,543 -- -- (419,543) --
Other assets........................ 37,895 10,766 13,510 -- 62,171
----------- ---------- ----------- ----------- -----------
Total assets...................... $ 1,011,807 $ 762,161 $ 11,740 $ (419,543) $ 1,366,165
=========== ========== =========== =========== ===========
Current liabilities:
Accounts payable and accrued $ 171,208 $ 82,192 2,872 256,272
expenses............................
Short-term borrowings............... 22,007 24,622 462 47,091
----------- ---------- ----------- ----------
Total current liabilities......... 193,215 106,814 3,334 303,363
Long-term debt...................... 198,138 221,380 3,982 423,500
Other liabilities................... 59,062 17,146 1,702 77,910
----------- ---------- ----------- -----------
Total liabilities................... 450,415 345,340 9,018 804,773
Stockholders' equity................ 561,392 416,821 2,722 (419,543) 561,392
---------- ---------- ----------- ----------- -----------
Total liabilities and
stockholders' equity............ $ 1,011,807 $ 762,161 $ 11,740 $ (419,543) $ 1,366,165
=========== ========== =========== ========== ===========
</TABLE>
Condensed Consolidating Balance Sheet
December 31, 1997
<TABLE>
<CAPTION>
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
<S> <C> <C> <C> <C> <C>
Current assets:
Cash and cash equivalents........... $ 123,052 $ 35,527 $ 3,082 $ -- $ 161,661
Accounts receivable, net............ 87,231 148,618 2,520 -- 238,369
Other current assets................ 119,751 48,865 3,238 -- 171,854
--------- --------- --------- --------- ---------
Total current assets.............. 330,034 233,010 8,840 -- 571,884
Property, plant and equipment, net.. 101,700 144,849 3,674 -- 250,223
Intangible assets, net ............. 165,068 348,391 320 -- 513,779
Intercompany (payable) receivable... (14,134) 24,103 (9,969) -- --
Investment in subsidiaries.......... 412,413 -- -- (412,413) --
Other assets........................ 40,474 9,290 15,278 -- 65,042
---------- --------- --------- --------- ---------
Total assets...................... $1,035,555 $ 759,643 $ 18,143 $(412,413) $1,400,928
========== ========= ========= ========== ==========
Current liabilities:
Accounts payable and accrued $ 188,966 $ 70,542 $ 2,990 $ -- $ 262,498
expenses............................
Short-term borrowings............... 15,688 16,640 320 -- 32,648
--------- --------- --------- --------- ---------
Total current liabilities......... 204,654 87,182 3,310 -- 295,146
Long-term debt...................... 225,145 252,480 4,536 -- 482,161
Other liabilities................... 64,096 15,568 2,297 -- 81,961
--------- --------- --------- --------- ---------
Total liabilities................. 493,895 355,230 10,143 -- 859,268
Stockholders' equity................ 541,660 404,413 8,000 (412,413) 541,660
--------- --------- --------- ---------- ---------
Total liabilities and
stockholders' equity............ $1,035,555 $ 759,643 $ 18,143 $(412,413) $1,400,928
========== ========= ========= ========= ==========
</TABLE>
8
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, unless otherwise indicated)
(unaudited)
Condensed Consolidating Statement of Cash Flows
Nine Months Ended September 30, 1998
<TABLE>
<CAPTION>
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
<S> <C> <C> <C> <C> <C>
Cash flows from operating activities:
Net income (loss)..................... $ 21,546 $ 12,408 $ (2,327) $ (10,081)$ 21,546
Adjustments to reconcile net income
(loss) to net cash provided by
operating activities:
Depreciation and amortization....... 21,787 27,113 2,799 -- 51,699
Provision for doubtful accounts..... 37,484 29,202 606 -- 67,292
Other, net.......................... 19,123 2,606 (2,228) -- 19,501
Changes in operating assets and
liabilities........................... (2,568) (57,303) 1,340 2,951 (55,580)
---------- ---------- --------- --------- -----------
Net cash provided by
operating activities.................. 97,372 14,026 190 (7,130) 104,458
Net cash used in investing activities. (20,538) (14,408) (858) 7,130 (28,674)
Net cash used in financing activities. (32,941) (23,104) (404) -- (56,449)
--------- --------- --------- --------- -----------
Net change in cash and cash
equivalents........................... 43,893 (23,486) (1,072) -- 19,335
Cash and cash equivalents, beginning
of year............................... 123,052 35,527 3,082 -- 161,661
--------- --------- --------- --------- -----------
Cash and cash equivalents, end of
period................................ $ 166,945 $ 12,041 $ 2,010 $ -- $ 180,996
========= ========= ========= ========= ===========
</TABLE>
Condensed Consolidating Statement of Cash Flows
Nine Months Ended September 30, 1997
<TABLE>
<CAPTION>
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
<S> <C> <C> <C> <C> <C>
Cash flows from operating activities:
Net income (loss)..................... $ 15,128 $ (715) $ (1,747) $ 2,462 $ 15,128
Adjustments to reconcile net income
to net cash provided by operating
activities:
Depreciation and amortization....... 22,701 34,748 360 -- 57,809
Provision for doubtful accounts..... 48,757 26,001 11,469 -- 86,227
Other, net.......................... 21,192 (8,335) 379 -- 13,236
Changes in operating assets and
liabilities........................... (15,587) 6,437 (9,294) (16,039) (34,483)
--------- --------- --------- --------- -----------
Net cash provided by operating
activities............................ 92,191 58,136 1,167 (13,577) 137,917
Net cash used in investing activities. (24,805) (23,921) 11 13,577 (35,138)
Net cash used in financing activities. (11,570) (8,258) (402) -- (20,230)
--------- --------- --------- --------- -----------
Net change in cash and cash
equivalents........................... 55,816 25,957 776 -- 82,549
Cash and cash equivalents, beginning
of year............................... 26,975 12,882 2,103 -- 41,960
--------- --------- --------- --------- -----------
Cash and cash equivalents, end of
period................................ $ 82,791 $ 38,839 $ 2,879 $ -- $ 124,509
========= ========= ========= ========= ===========
</TABLE>
9
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, unless otherwise indicated)
(unaudited)
6. Subsequent Events
Effective November 1998 the Company contributed certain assets to newly
formed joint ventures with UPMC Health System (formerly known as University of
Pittsburgh Medial Center) and Unity Health System in St. Louis. Each of these
joint ventures is 51% owned by the Company and will be included in the Company's
consolidated financial results.
10
<PAGE>
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Results of Operations
Net income for the three and nine months ended September 30, 1998 increased
from the prior year primarily as a result of operating cost and interest expense
reductions coupled with improved pricing. These increases were partially offset
by lower volume resulting from intensified competition, changes in physician
ordering patterns, actions taken on unprofitable accounts and the consolidation
of certain underperforming laboratories announced in December 1997. Net income
for the nine months ended September 30, 1998 includes a $2.5 million charge
($1.2 million, net of tax) recorded in the first quarter in selling, general and
administrative expenses, representing the final costs associated with the
Company's consolidation plan announced in December 1997.
Effective April 1, 1998, the Company implemented a new order form for
Medicare and Medicaid patients reflecting disease-oriented test panels developed
by the Health Care Financing Administration in conjunction with the American
Medical Association. While the Company has not seen a significant impact during
the second or third quarters, the Company believes these panels are likely to
result in fewer tests ordered per requisition and may put additional pressure on
revenues and earnings. *
Net Revenues
Net revenues for the third quarter decreased by $12.9 million, or 3.5% from
the prior year level, principally due to a 5.6% decline in clinical testing
volume offset by an improvement in average prices of 1.4%. The decline in
clinical testing volume reflects significant improvement from the declines
experienced in the first and second quarters. Net revenues for the first nine
months of 1998 decreased by $67.9 million, or 5.8% from the prior year level,
principally due to an 8.0% decline in clinical testing volume, partially offset
by an improvement in average prices of 2.0%. The clinical testing volume decline
for each period is primarily attributable to intensified competition, changes in
physician ordering patterns, actions taken on unprofitable accounts and the
consolidation of certain underperforming laboratories announced in December
1997, which reduced volume by approximately 2.6% and 2.0% for the third quarter
and first nine months, respectively.
Costs and Expenses
Total operating costs for the third quarter and first nine months of 1998
declined by $15.2 million and $73.5 million, respectively, from the year earlier
periods. The Company's efforts to reduce its operating cost structure have had a
favorable impact on costs as a percentage of net revenue. However, this benefit
was partially offset by lower volume, increased spending on selling, and
information technology capabilities and a $2.5 million charge in the first
quarter representing the final costs associated with the Company's consolidation
plan announced in December 1997. Additional actions are being taken to further
reduce the Company's cost structure.*
- --------
* This is a forward looking statement within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 27E of the Securities Act of
1934, as amended, and is based on current expectations. Forward looking
statements involve risks and uncertainties that could cause actual results to
differ materially from the forward looking statement. These risks and
uncertainties include heightened competition, impact of changes in payor mix,
the impact upon the Company's collection rates or general and administrative
expenses resulting from compliance with Medicare administrative policies, and
reduction in tests ordered by existing customers. See Item 1.
"Business--Cautionary Statement for Purposes of the `Safe Harbor' Provisions of
the Private Securities Litigation Reform Act of 1995" contained in the Company's
1997 Annual Report on Form 10-K.
11
<PAGE>
Cost of services, which includes the costs of obtaining, transporting and
testing specimens, decreased $18.3 million in the third quarter from the prior
year, and as a percentage of net revenues decreased to 58.5% from 61.3% in the
prior year. Cost of services in the first nine months of 1998 decreased $61.4
million from the prior year, and as a percentage of net revenues decreased to
59.0% from 60.9% in the prior year. These decreases reflect the Company's
progress in reducing its cost structure.
Selling, general and administrative expenses, which include the costs of the
sales force, billing operations, bad debt expense and general management and
administrative support, increased from the prior year by $3.1 million in the
quarter, and as a percentage of net revenues increased to 34.0% from 32.0%. The
third quarter increase was principally due to increased spending related to
information technology, including preparation for the Year 2000, increased
spending for medical research and technology and the addition of marketing and
selling infrastructure. This was partially offset by a $4.1 million reduction in
bad debt expense to 6.2% of net revenue from 7.1% of net revenues a year
earlier. Selling, general and administrative expenses decreased by $12.2 million
from the prior year during the first nine months of 1998, and as a percentage of
net revenues increased to 32.8% from 31.9%. This decreased expense was
principally due to a $18.9 million reduction in bad debt expense to 6.1% of net
revenues from 7.4% of net revenues. Partially offsetting the reduction in bad
debt expense was an increase in information technology expenditures, including
preparation for the Year 2000, increased spending for medical research and
technology, the addition of marketing and selling infrastructure, and a $2.5
million charge in the first quarter related to the Company's consolidation of
its laboratory network. Selling, general and administrative expenses are
expected to continue to be impacted by these factors through the end of 1998 and
into 1999.*
Net interest expense decreased from the prior year by $2.0 million and $4.9
million for the third quarter and first nine months of 1998, respectively,
primarily due to reduced debt levels and an increase in interest income
resulting from higher average cash balances.
Amortization of intangible assets decreased from the prior year by $0.6
million and $1.8 million for the third quarter and first nine months of 1998,
respectively, principally due to certain intangible assets having become fully
amortized.
Other, net for the third quarter decreased from the prior year level,
primarily due to the prior year including a charge related to the formation of a
joint venture. For the first nine months of 1998, the change in other, net is
also affected by the prior year including a gain on the sale of an investment
and the current year including equity losses from a joint venture.
The Company's effective tax rate is significantly impacted by goodwill
amortization, a majority of which is not deductible for tax purposes, and has
the effect of increasing the overall tax rate.
- --------
* This is a forward looking statement within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 27E of the Securities Act of
1934, as amended, and is based on current expectations. Forward looking
statements involve risks and uncertainties that could cause actual results to
differ materially from the forward looking statement. These risks and
uncertainties include computer or other system failures, development of
technologies that substantially alter the practice of medicine, and the failure
of third party payors and suppliers to adequately address the Year 2000 problem.
See Item 1. "Business--Cautionary Statement for Purposes of the `Safe Harbor'
Provisions of the Private Securities Litigation Reform Act of 1995" contained in
the Company's 1997 Annual Report on Form 10-K.
12
<PAGE>
Liquidity and Capital Resources
Cash increased by $19.3 million from the year end balance, to $181.0 million
at September 30, 1998, due to operating activities which provided cash of $104.4
million, offset by investing and financing activities which used cash of $85.1
million. Net cash provided by operating activities was $33.5 million below the
prior year level. The decrease is primarily the result of increased payments
associated with restructuring and other special charges and a current year
reduction in accounts receivable levels which was below the prior year
reduction. The number of days sales outstanding, a measure of billing and
collection efficiency, was 61 days at September 30, 1998 compared to 63 days at
year end and 67 days a year earlier.
Decreased spending on investing activities is primarily the result of a
reduction in acquisition spending, partially offset by increased capital
spending in 1998. Capital spending for the first nine months of 1998 was $27.9
million compared to $21.6 million for the comparable prior year period. The
Company estimates that it will invest approximately $40 million to $45 million
during 1998 for capital expenditures, principally related to investments in
information technology, and equipment and facility upgrades.*
During the first nine months of 1998, the Company paid down $44.1 million of
debt, $20 million of which was a prepayment, and purchased $12.4 million
(approximately 650 thousand shares) of its common stock. Other than for the
reduction for outstanding letters of credit, which currently approximate $5.4
million, all of the revolving working capital credit facility is currently
available for borrowing. The Company plans to continue stock purchases as
authorized under the February 1998 limited share purchase program which permits
the Company to purchase up to $27 million of its outstanding common stock
through 1999.
Adjusted EBITDA
Adjusted EBITDA represents earnings before interest, taxes, depreciation,
amortization and non-recurring charges. Adjusted EBITDA for the three months
ended September 30, 1998 was $37.6 million, or 10.4% of net revenues, compared
to $35.7 million, or 9.6% of net revenues, in the prior year period. Adjusted
EBITDA for the nine months ended September 30, 1998 was $124.7 million, or 11.4%
of net revenues, compared to $120.4 million, or 10.4% of net revenues, in the
prior year period. The improvement in adjusted EBITDA reflects the Company's
continued progress in reducing its cost structure on a declining revenue base.
Year 2000 Readiness Disclosure**
The Year 2000 issue relates to the way computer systems and programs define
calendar dates; the computer systems could fail or make miscalculations due to
interpreting a date including "00" to be 1900 rather than 2000. Also, many
systems and equipment that are not typically thought of as "computer-related,"
such as security systems and elevators, contain imbedded hardware or software
that may have a time element. As a result, business and governmental entities
are at risk for possible miscalculations or system failures causing disruptions
in their business operations.
The Company started its Year 2000 readiness program in 1997 and has
established a dedicated project
- --------
* This is a forward looking statement within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 27E of the Securities Act of
1934, as amended, and is based on current expectations. Forward looking
statements involve risks and uncertainties that could cause actual results to
differ materially from the forward looking statement. These risks and
uncertainties include computer or other system failures, development of
technologies that substantially alter the practice of medicine, and the failure
of third party payors and suppliers to adequately address the Year 2000 problem.
See Item 1. "Business--Cautionary Statement for Purposes of the `Safe Harbor'
Provisions of the Private Securities Litigation Reform Act of 1995" contained in
the Company's 1997 Annual Report on Form 10-K.
**This section is a "Year 2000 Readiness Disclosure" covered by the Year 2000
Information and Readiness Disclosure Act.
13
<PAGE>
team to implement the program. In order to address the Year 2000 issue, the
Company has adopted a six-phase plan which includes: (1) inventory; (2)
assessment; (3) repair/replace/upgrade; (4) testing; (5) implementation; and (6)
contingency planning. This plan is common for each of the Company's seven major
areas, which are as follows:
Infrastructure - Includes computer hardware, systems software (other than
application software) and voice and data network components. The inventory phase
and the assessment phase, for all vendor responses received, is complete. Also,
there has been progress with regard to phases three and four of the Company's
Year 2000 plan.
Applications - Includes all applications software including, but not limited to,
the Company's clinical laboratory systems, financial systems, billing systems,
human resources systems, purchasing systems and customer interface systems. The
inventory phase and the assessment phase for all applications are complete. The
Company is in the process of repairing, replacing or upgrading non-compliant
code and testing for compliance.
Laboratory Instruments - Includes all clinical diagnostic instrumentation in the
testing facilities. The inventory phase and the assessment phase, for all vendor
responses received, is complete. The Company is in the process of repairing,
replacing or upgrading non-compliant intstrumentation and testing for
compliance.
Facilities - Includes all building facilities (e.g. air conditioning units,
generators), property owners and building service providers (e.g. waste
management, public utilities). The inventory phase and assessment phase, for all
vendor responses received, is complete and action plans are being developed to
address required upgrades and testing.
Desktop Environment - Includes the personal computer hardware and operating
system. The inventory phase is complete and the assessment phase is scheduled to
be completed during the fourth quarter 1998.
External Providers - Includes the process of identifying and prioritizing
critical suppliers and communicating with them about their plans and progress in
addressing the Year 2000 problem. The inventory phase and the assessment phase,
for all vendor responses received, is complete. The evaluation of the most
critical suppliers has been initiated.
Payors - Includes the process of contacting each critical payor (e.g. Medicare,
Medicaid, commercial insurance carriers) regarding their plans and progress in
addressing the Year 2000 problem. All critical payors have been identified and
the first mailing requesting the state of readiness will be completed during the
fourth quarter 1998.
Although, as set forth above, each of the seven areas is at varying stages
of readiness, the Company has completed the inventory phase, and has largely
completed the assessment phase, for all areas. The assessment phase will be an
ongoing process until all vendors have responded to our requests for Year 2000
information. The Company is continuing to work internally and with external
contractors, as needed, to complete the final phases of the program. The Company
also continues to work with its external vendors, whose readiness is vital for a
smooth transition into the new millennium. In addition to the phases outlined
above, the Company's plan also includes regular status presentations to a
committee of the Board of Directors. The Company's goal is to have all
significant systems properly functioning and certified with respect to the Year
2000 by June 1999.
Due to the general uncertainty inherent in the Year 2000 problem, resulting
in part from the uncertainty of the Year 2000 readiness of third-party vendors
and payors, the Company is unable to determine at this time whether the
consequences of potential Year 2000 business disruptions will have a material
impact on the Company's results of operations, liquidity and financial
condition. The possible consequences of the Company or key vendors or payors not
being ready by January 1, 2000 include,
14
<PAGE>
among other things, temporary business unit closures, delays in laboratory
testing or delivery of laboratory testing results, inventory shortages and
delays in collecting accounts receivable. Approximately 15% of the Company's
revenues are received from Medicare carriers. The Company could experience
collection delays if Medicare or other large third party payors (such as
insurance companies) experience Year 2000 problems. Medicare carriers are being
required to implement new programs required by the 1997 Balanced Budget Act at
the same time that they are attempting to make their systems Year 2000
compliant. In September 1998 the General Accounting Office reported that "HCFA
and its contractors are severely behind schedule in repairing, testing and
implementing the mission-critical systems supporting Medicare" and concluded
that "it is highly unlikely that all of the Medicare systems will be compliant
in time to ensure the delivery of uninterrupted benefits and services into the
year 2000." However, HCFA is expected to develop contingency plans that may
include making estimated payments to providers based on historical claims
experience in the event of a system failure during the Year 2000.*
While the Company believes that its Year 2000 readiness program
significantly reduces the potential adverse effect of any such disruptions,
there is no guarantee that the Year 2000 problem will not result in business
disruptions. Specific factors that give rise to this uncertainty include the
possible loss of technical resources to perform the remediation work, failure to
identify all susceptible systems, non-compliance by third-parties whose systems
impact the Company, and other similar uncertainties.
Concurrent with the plans described above, the Company is in the process of
developing detailed contingency plans by each major area to mitigate the
possible disruption in business operations. Contingency plans may include use of
alternative vendors, stockpiling inventory and temporary movement of laboratory
testing services. Most of the Company's regional laboratories have similar test
menus and, with the adoption of standardized test codes (expected to be
implemented by year end 1998) and progress in other standardization initiatives
(including billing and lab information systems), the Company has improved its
ability to move laboratory specimens to an alternative site in the event that a
regional laboratory experiences disruptions. Once developed, contingency plans
and related cost estimates will be continually refined as additional information
becomes available. The Company's goal is to have contingency plans finalized by
the second quarter 1999. *
Costs incurred to date related to the Company's Year 2000 readiness program
approximate $20 million, of which approximately $5 million were capitalized.
Current estimates of remaining costs are approximately $40 million to $60
million, of which approximately 50% to 60% will be capitalized. Capitalized
costs principally represent the purchase of new software and hardware. These
estimates are subject to potentially significant revisions as additional
information, including vendor responses, becomes available. Costs related to the
Company's Year 2000 readiness program have been, and are expected to continue
being, funded by cash from operations.*
Item 3. Quantitative and Qualitative Disclosure About Market Risk
Not applicable.
- --------
* This is a forward looking statement within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 27E of the Securities Act of
1934, as amended, and is based on current expectations. Forward looking
statements involve risks and uncertainties that could cause actual results to
differ materially from the forward looking statement. These risks and
uncertainties include computer or other system failures, development of
technologies that substantially alter the practice of medicine, and the failure
of third party payors and suppliers to adequately address the Year 2000 problem.
See Item 1. "Business--Cautionary Statement for Purposes of the `Safe Harbor'
Provisions of the Private Securities Litigation Reform Act of 1995" contained in
the Company's 1997 Annual Report on Form 10-K.
15
<PAGE>
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
In its 1997 Annual Report on Form 10-K, the Company reported that it was
subject to an investigation commenced by the Office of the Inspector General of
the Department of Health and Human Services related to a joint venture between
Damon Corporation, which was acquired by the Company in 1993, and Vivra Inc.
(see Item 1. "Business-Ongoing Government Investigations-Damon Joint Venture
Investigation" contained in the Company's Annual Report on Form 10-K). The
settlement agreement was completed August 17, 1998 and the total amount paid was
$15.0 million. This settlement is covered by the indemnification from Corning
Incorporated as described in the Company's Annual Report on Form 10-K (see Item
1. "Business-Corning Indemnity" contained in the Company's Annual Report on Form
10-K) and was fully reserved for.
There have been no material developments in any other of the government
investigations or private claims reported.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits:
Exhibit Number Description
-------------- -----------
27 Financial Data Schedule
(b) Reports on Form 8-K:
None
16
<PAGE>
Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
November 13, 1998
Quest Diagnostics Incorporated
By /s/ Kenneth W. Freeman Chairman of the Board,
--------------------------------
Kenneth W. Freeman Chief Executive Officer
and President
By /s/ Robert A. Hagemann Vice President and
--------------------------------
Robert A. Hagemann Chief Financial Officer
17
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