SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
- -------------------------------------------------------------------------------
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the Quarter ended March 31, 1999
Commission file number 1-12215
Quest Diagnostics Incorporated
One Malcolm Avenue
Teterboro, NJ 07608
(201) 393-5000
Delaware
(State of Incorporation)
16-1387862
(I.R.S. Employer Identification Number)
- -------------------------------------------------------------------------------
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 May 3, 1999, there were outstanding 30,111,646 shares of Common Stock,
$.01 par value.
<PAGE>
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
<TABLE>
<CAPTION>
Index to consolidated financial statements filed as part of this report:
Page
<S> <C>
Consolidated Statements of Operations for the
Three Months Ended March 31, 1999 and 1998 2
Consolidated Balance Sheets as of
March 31, 1999 and December 31, 1998 3
Consolidated Statements of Cash Flows for the
Three Months Ended March 31, 1999 and 1998 4
Notes to Consolidated Financial Statements 5
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations
Management's Discussion and Analysis of Financial
Condition and Results of Operations 12
Item 3. Quantitative and Qualitative Disclosures About Market Risk
See Item 2. "Management's Discussion and Analysis of Financial Condition
and Results of Operations"
</TABLE>
1
<PAGE>
<TABLE>
<CAPTION>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE MONTHS ENDED MARCH 31, 1999 AND 1998
(in thousands, except per share data)
(unaudited)
1999 1998
---- ----
<S> <C> <C>
Net revenues............................................................... $ 381,841 $ 367,875
Costs and expenses:
Cost of services........................................................ 226,995 218,040
Selling, general and administrative..................................... 127,013 120,446
Interest expense, net................................................... 7,359 9,114
Amortization of intangible assets....................................... 5,094 5,380
Other, net.............................................................. 1,302 1,225
---------- ----------
Total................................................................. 367,763 354,205
---------- ----------
Income before taxes........................................................ 14,078 13,670
Income tax expense ........................................................ 6,645 7,039
---------- ----------
Net income ................................................................ $ 7,433 $ 6,631
========== ==========
Basic net income per common share.......................................... $ 0.25 $ 0.22
Diluted net income per common share........................................ $ 0.24 $ 0.22
Basic weighted average common shares outstanding........................... 29,716 29,688
Diluted weighted average common shares outstanding......................... 30,280 30,007
</TABLE>
The accompanying notes are an integral part of these statements.
2
<PAGE>
<TABLE>
<CAPTION>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
MARCH 31, 1999 AND DECEMBER 31, 1998
(in thousands, except per share data)
March 31, December 31,
1999 1998
(unaudited)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents............................................. $ 154,197 $ 202,908
Accounts receivable, net of allowance of $70,408 and $70,701
at March 31, 1999 and December 31, 1998, respectively............. 229,786 220,861
Inventories........................................................... 33,042 31,164
Deferred taxes on income.............................................. 83,820 94,441
Due from Corning Incorporated......................................... 14,015 16,000
Prepaid expenses and other assets..................................... 15,779 12,813
------------ ------------
Total current assets.............................................. 530,639 578,187
Property, plant and equipment, net......................................... 241,295 240,389
Intangible assets, net..................................................... 489,784 494,721
Other assets............................................................... 56,481 46,943
------------ ------------
TOTAL ASSETS............................................................... $ 1,318,199 $ 1,360,240
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses................................. $ 243,216 $ 242,285
Current portion of long-term debt..................................... 56,446 51,444
Income taxes payable.................................................. 9,543 15,736
------------ ------------
Total current liabilities......................................... 309,205 309,465
Long-term debt............................................................. 360,187 413,426
Other liabilities.......................................................... 71,520 69,419
Commitments and contingencies
Preferred stock............................................................ 1,000 1,000
Common stockholders' equity:
Common stock, par value $0.01 per share; 100,000 shares authorized;
30,254 and 30,241 shares issued at March 31, 1999
and December 31, 1998, respectively................................. 303 302
Additional paid-in capital............................................ 1,199,379 1,201,006
Accumulated deficit................................................... (616,110) (623,514)
Unearned compensation................................................. (3,463) (3,895)
Accumulated other comprehensive loss.................................. (1,719) (3,038)
Common stock in treasury, at cost; 114 and 214 shares at
March 31, 1999 and December 31, 1998, respectively................ (2,103) (3,931)
------------ ------------
Total common stockholders' equity................................. 576,287 566,930
------------ ------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY................................. $ 1,318,199 $ 1,360,240
============ ============
</TABLE>
The accompanying notes are an integral part of these statements.
3
<PAGE>
<TABLE>
<CAPTION>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE THREE MONTHS ENDED MARCH 31, 1999 AND 1998
(in thousands)
(unaudited)
1999 1998
---- ----
<S> <C> <C>
Cash flows from operating activities:
Net income................................................................. $ 7,433 $ 6,631
Adjustments to reconcile net income
to net cash provided by operating activities:
Depreciation and amortization......................................... 16,483 17,321
Provision for doubtful accounts....................................... 20,337 23,830
Deferred income tax provision......................................... 11,282 9,348
Other, net............................................................ 2,045 1,911
Changes in operating assets and liabilities:
Accounts receivable............................................... (29,442) (28,107)
Accounts payable and accrued expenses............................. 12,485 9,401
Restructuring, integration and other special charges.............. (5,499) (3,670)
Other assets and liabilities, net................................. (11,525) (8,058)
---------- ----------
Net cash provided by operating activities.................................. 23,599 28,607
---------- ----------
Cash flows from investing activities:
Capital expenditures.................................................. (12,707) (10,012)
Deal costs paid....................................................... (1,114) --
Proceeds from disposition of assets................................... 730 238
Increase in investments............................................... (4,937) --
----------- ----------
Net cash used in investing activities...................................... (18,028) (9,774)
---------- ----------
Cash flows from financing activities:
Repayment of long-term debt........................................... (48,216) (7,836)
Deferred financing costs paid......................................... (4,687) --
Distributions to minority partners.................................... (478) --
Purchases of treasury stock........................................... (1,103) (45)
Preferred stock dividends paid........................................ (29) (29)
Exercise of stock options............................................. 231 --
---------- ----------
Net cash used in financing activities...................................... (54,282) (7,910)
---------- ----------
Net change in cash and cash equivalents.................................... (48,711) 10,923
Cash and cash equivalents, beginning of year............................... 202,908 161,661
---------- ----------
Cash and cash equivalents, end of period................................... $ 154,197 $ 172,584
========== ==========
Cash paid during the period for:
Interest.............................................................. $ 6,023 $ 6,974
Income taxes.......................................................... $ 1,846 $ 2,386
</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" or "Quest Diagnostics") was a wholly-owned
subsidiary of Corning Incorporated ("Corning"). On December 31, 1996, Corning
distributed all of the outstanding shares of common stock of the Company to the
stockholders of Corning, with one share of common stock of the Company being
distributed for each eight shares of outstanding common stock of Corning (the
"Spin-Off Distribution").
Basis of Presentation
The interim consolidated financial statements reflect all adjustments
which, in the opinion of management, are necessary for a fair statement of the
results of operations for the periods presented. All such adjustments are of a
normal recurring nature. The interim consolidated financial statements have been
compiled without audit and are subject to year-end adjustments. Operating
results for the interim period are not necessarily indicative of the results
that may by expected for the full year. These interim consolidated financial
statements should be read in conjunction with the audited consolidated financial
statements included in the Company's Form 10-K for the year ended December 31,
1998.
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 $8.8 million and $7.1 million for the three months
ended March 31, 1999 and 1998, respectively.
Earnings Per Share
Basic net income per common share is calculated by dividing net income,
less preferred stock dividends (approximately $30), by the weighted average
number of common shares outstanding. Diluted net income per common share is
calculated by dividing net income, less preferred stock dividends, by the
weighted average number of common shares outstanding after giving effect to all
potentially dilutive common shares outstanding during the period. Potentially
dilutive common shares include outstanding stock options and restricted common
shares granted under the Company's Employees Equity Participation Program.
5
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, unless otherwise indicated)
(unaudited)
2. ACQUISITION OF SMITHKLINE BEECHAM'S CLINICAL LABORATORY TESTING BUSINESS
On February 9, 1999, the Company signed a definitive agreement to acquire
the clinical laboratory business of SmithKline Beecham plc ("SmithKline
Beecham") for approximately $1.3 billion. The purchase price will be paid
through the issuance of approximately 12.6 million shares of common stock of
Quest Diagnostics and the payment of $1.025 billion of cash. The acquisition
will be accounted for under the purchase method of accounting. Quest Diagnostics
expects to close the transaction early in the second half of 1999. As a result,
SmithKline Beecham will own approximately 29.5% of Quest Diagnostics'
outstanding common stock. Under the terms of a stockholder agreement, SmithKline
Beecham will initially have the right to designate two nominees to Quest
Diagnostics' Board of Directors as long as SmithKline Beecham owns at least 20%
of the outstanding common stock. (As long as SmithKline Beecham owns at least
10% but less than 20% of the outstanding common stock, it will have the right to
designate one nominee.) Quest Diagnostics' Board of Directors is expected to
expand to nine directors immediately following the closing. The stockholder
agreement will also impose limitations on the right of SmithKline Beecham to
sell or vote its shares and will prohibit SmithKline Beecham from purchasing in
excess of 29.5% of the outstanding common stock of Quest Diagnostics.
The issuance of 12.6 million shares of common stock to SmithKline Beecham
in the transaction will be submitted to the stockholders of Quest Diagnostics
for approval at the 1999 annual meeting of stockholders, which is scheduled to
be held on June 29, 1999. The acquisition is also subject to the receipt of
financing for the cash portion of the purchase price as well as the satisfaction
of other customary closing conditions. Quest Diagnostics has received
commitments for all of the financing necessary to complete the acquisition.
Additionally, the waiting period under the Hart-Scott-Rodino Antitrust
Improvements Act expired on March 25, 1999.
In conjunction with this transaction, the Board of Directors of Quest
Diagnostics approved an amendment to the preferred share purchase rights of the
Quest Diagnostics common stock. The amendment would preclude stockholders from
exercising their rights to purchase shares of common stock at a predefined price
as a result of SmithKline Beecham owning the shares of common stock to be issued
in the transaction or SmithKline Beecham's purchase of additional shares
provided that SmithKline Beecham does not own more than 29.5% of the Company's
outstanding common stock.
3. COMMITMENTS AND CONTINGENCIES
The Company has entered into several settlement agreements with various
governmental and private payers during recent years relating primarily to
industry-wide billing and marketing practices that had been substantially
discontinued by early 1993. At present, government investigations of certain
practices by Nichols Institute, a clinical laboratory company acquired in 1994,
are ongoing. The Company has received notices of private claims relating to
billing issues similar to those that were the subject of prior settlements with
various governmental payers. In March 1997, a former subsidiary of Damon
Corporation ("Damon"), an independent clinical laboratory acquired by Corning
and contributed to Quest Diagnostics in 1993, was served a complaint in a
purported class action. The complaint asserts claims relating to private
reimbursement of billings by Damon that are similar to those that were part of a
prior government settlement. While the ultimate outcome of these claims cannot
be predicted, based on information currently available to the Company,
management does not believe that exposure related to these claims or the
remaining government investigations in excess of recorded reserves is material.
Corning has agreed to indemnify the Company against all monetary
settlements for any governmental claims relating to the billing practices of the
Company and its predecessors based on investigations that were pending on
December 31, 1996. Corning also agreed to indemnify the Company in respect of
private claims relating to indemnified or previously settled government claims
that alleged overbillings by Quest Diagnostics or any of its existing
subsidiaries for services provided before January 1, 1997. Corning will
indemnify Quest Diagnostics for 50% of the aggregate of all judgment or
settlement payments made by December 31, 2001 that exceed $42 million. The 50%
share will be limited to a total amount of $25 million and will be reduced to
take into account any deductions or tax benefits realized by Quest Diagnostics.
At March 31, 1999, the receivable from Corning totaled $14 million, which is
management's best estimate of amounts which are probable of being received from
Corning to satisfy the remaining indemnified governmental claims on an after-tax
basis.
6
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, unless otherwise indicated)
(unaudited)
At March 31, 1999, recorded reserves approximated $49.6 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 (such as the indication
by the government of criminal activity, additional tests being questioned or
other changes in the government's or private claimants' theories of wrongdoing)
may become available which may cause the final resolution of these matters to
exceed established reserves by an amount which could be material to the
Company's results of operations and cash flows in the period in which such
claims are settled. The Company does not believe that these issues will have a
material adverse effect on its overall financial condition.
4. RESTRUCTURING RESERVES
The Company has recorded charges for restructuring plans in previous years.
Reserves relating to these programs totaled $11.1 million and $13.6 million at
March 31, 1999 and December 31, 1998, 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. COMMON STOCKHOLDERS' EQUITY
Common Stock Purchase Program
During February 1998, Quest Diagnostics' Board of Directors authorized a
limited share purchase program which permits the Company to purchase up to $27
million of its outstanding common stock through 1999. Cumulative purchases under
the program through March 31, 1999 total $14.1 million. The remaining shares
held in treasury at March 31, 1999 are expected to be reissued in connection
with certain employee benefit plans. The Company suspended purchases of its
shares when it reached a preliminary understanding of the transaction with
SmithKline Beecham on January 15, 1999.
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 were earned on achievement of financial
performance goals and are subject to forfeiture if employment terminates prior
to the end of the prescribed vesting period, which ranges primarily from three
to four years. The market value of the shares awarded under the plan is recorded
as unearned compensation and is amortized to compensation expense over the
prescribed vesting period.
6. SUMMARIZED FINANCIAL INFORMATION
The Company's 10.75% senior subordinated notes due 2006 are guaranteed,
fully, jointly and severally, and unconditionally, on a senior subordinated
basis by substantially all of the Company's wholly-owned, domestic subsidiaries
("Subsidiary Guarantors"). The non-guarantor subsidiaries are foreign and less
than wholly-owned subsidiaries.
The following condensed consolidating financial data illustrates the
composition of the combined guarantors. The Company believes that separate
complete financial statements of the respective guarantors would not provide
additional material information which would be useful in assessing the financial
composition of the Subsidiary Guarantors.
7
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, unless otherwise indicated)
(unaudited)
Condensed Consolidating Statement of Operations
Three Months Ended March 31, 1999
<TABLE>
<CAPTION>
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
----------- ----------- ----------- ----------- -----------
<S> <C> <C> <C> <C> <C>
Net revenues................................ $ 156,298 $ 204,566 $ 20,977 $ -- $ 381,841
Costs and expenses:
Cost of services......................... 98,657 116,194 12,144 -- 226,995
Selling, general and administrative...... 60,567 58,572 7,874 -- 127,013
Interest expense, net.................... 2,116 5,004 239 -- 7,359
Amortization of intangible assets........ 3,026 1,955 113 -- 5,094
Royalty (income) expense................. (17,340) 17,340 -- -- --
Other, net............................... (330) 45 1,587 -- 1,302
----------- ----------- ----------- ----------- -----------
Total.................................. 146,696 199,110 21,957 -- 367,763
----------- ----------- ----------- ----------- -----------
Income (loss) before taxes.................. 9,602 5,456 (980) -- 14,078
Income tax expense ......................... 3,529 2,981 135 -- 6,645
Equity income from affiliates............... 1,360 -- -- (1,360) --
----------- ----------- ----------- ----------- -----------
Net income (loss)........................... $ 7,433 $ 2,475 $ (1,115) $ (1,360) $ 7,433
=========== =========== =========== =========== ===========
<CAPTION>
Condensed Consolidating Statement of Operations
Three Months Ended March 31, 1998
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
----------- ----------- ----------- ------------ -----------
<S> <C> <C> <C> <C> <C>
Net revenues................................ $ 154,208 $ 206,834 $ 6,833 $ -- $ 367,875
Costs and expenses:
Cost of services......................... 91,387 122,900 3,753 -- 218,040
Selling, general and administrative...... 67,003 50,922 2,521 -- 120,446
Interest expense, net.................... 2,619 6,341 154 -- 9,114
Amortization of intangible assets........ 1,696 3,562 122 -- 5,380
Royalty (income) expense................. (18,405) 18,405 -- -- --
Other, net............................... 163 2 1,060 -- 1,225
----------- ----------- ----------- ----------- -----------
Total.................................. 144,463 202,132 7,610 -- 354,205
----------- ----------- ----------- ----------- -----------
Income (loss) before taxes.................. 9,745 4,702 (777) -- 13,670
Income tax expense (benefit)................ 6,659 469 (89) -- 7,039
Equity income from affiliates............... 3,545 -- -- (3,545) --
----------- ----------- ----------- ----------- -----------
Net income (loss)........................... $ 6,631 $ 4,233 $ (688) $ (3,545) $ 6,631
=========== =========== =========== =========== ===========
</TABLE>
8
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, unless otherwise indicated)
(unaudited)
Condensed Consolidating Balance Sheet
March 31, 1999
<TABLE>
<CAPTION>
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
----------- ---------- ----------- ----------- -----------
<S> <C> <C> <C> <C> <C>
Current assets:
Cash and cash equivalents................... $ 139,633 $ 8,290 $ 6,274 $ -- $ 154,197
Accounts receivable, net.................... 91,284 126,885 11,617 -- 229,786
Other current assets........................ 69,563 70,047 7,046 -- 146,656
----------- ---------- ----------- ----------- -----------
Total current assets..................... 300,480 205,222 24,937 -- 530,639
Property, plant and equipment, net.......... 100,573 131,547 9,175 -- 241,295
Intangible assets, net ..................... 165,691 323,847 246 -- 489,784
Intercompany (payable) receivable........... (46,884) 61,433 (14,549) -- --
Investment in subsidiaries.................. 415,942 -- -- (415,942) --
Other assets................................ 41,752 2,172 12,557 -- 56,481
----------- ---------- ----------- ----------- -----------
Total assets............................. $ 977,554 $ 724,221 $ 32,366 $ (415,942) $ 1,318,199
=========== ========== =========== ============ ===========
Current liabilities:
Accounts payable and accrued expenses....... $ 154,146 $ 90,477 $ 8,136 $ -- $ 252,759
Current portion of long-term debt........... 25,951 29,941 554 -- 56,446
----------- ---------- ----------- ----------- -----------
Total current liabilities................ 180,097 120,418 8,690 -- 309,205
Long-term debt.............................. 166,472 186,444 7,271 -- 360,187
Other liabilities........................... 53,698 10,629 7,193 -- 71,520
Preferred stock............................. 1,000 -- -- -- 1,000
Common stockholders' equity................. 576,287 406,730 9,212 (415,942) 576,287
----------- ---------- ----------- ------------ -----------
Total liabilities and stockholders' equity $ 977,554 $ 724,221 $ 32,366 $ (415,942) $ 1,318,199
=========== ========== =========== ============ ===========
</TABLE>
9
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, unless otherwise indicated)
(unaudited)
Condensed Consolidating Balance Sheet
December 31, 1998
<TABLE>
<CAPTION>
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
----------- ----------- ----------- ----------- -----------
<S> <C> <C> <C> <C> <C>
Current assets:
Cash and cash equivalents................... $ 190,606 $ 8,206 $ 4,096 $ -- $ 202,908
Accounts receivable, net.................... 58,956 152,252 9,653 -- 220,861
Other current assets........................ 83,644 65,771 5,003 -- 154,418
----------- ----------- ----------- ----------- -----------
Total current assets..................... 333,206 226,229 18,752 -- 578,187
Property, plant and equipment, net.......... 94,042 137,352 8,995 -- 240,389
Intangible assets, net ..................... 168,781 325,665 275 -- 494,721
Intercompany (payable) receivable........... (35,853) 48,308 (12,455) -- --
Investment in subsidiaries.................. 412,283 -- -- (412,283) --
Other assets................................ 31,470 4,658 10,815 -- 46,943
------------ ----------- ----------- ----------- -----------
Total assets............................. $ 1,003,929 $ 742,212 $ 26,382 $ (412,283) $ 1,360,240
=========== =========== =========== =========== ===========
Current liabilities:
Accounts payable and accrued expenses....... $ 171,206 $ 82,475 $ 4,340 $ -- $ 258,021
Current portion of long-term debt........... 23,654 27,280 510 -- 51,444
----------- ----------- ----------- ----------- -----------
Total current liabilities................ 194,860 109,755 4,850 -- 309,465
Long-term debt.............................. 190,712 214,557 8,157 -- 413,426
Other liabilities........................... 50,427 13,645 5,347 -- 69,419
Preferred stock............................. 1,000 -- -- -- 1,000
Common stockholders' equity................. 566,930 404,255 8,028 (412,283) 566,930
----------- ----------- ----------- ----------- -----------
Total liabilities and stockholders' equity $ 1,003,929 $ 742,212 $ 26,382 $ (412,283) $ 1,360,240
=========== =========== =========== =========== ===========
</TABLE>
10
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, unless otherwise indicated)
(unaudited)
Condensed Consolidating Statement of Cash Flows
Three Months Ended March 31, 1999
<TABLE>
<CAPTION>
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------------ ----------- ----------- ----------- ------------
<S> <C> <C> <C> <C> <C>
Cash flows from operating activities:
Net income (loss)............................. $ 7,433 $ 2,475 $ (1,115) $ (1,360) $ 7,433
Adjustments to reconcile net income (loss) to
net cash provided by (used in) operating
activities:
Depreciation and amortization.............. 8,896 6,626 961 -- 16,483
Provision for doubtful accounts............ 9,762 9,649 926 -- 20,337
Other, net................................. 13,795 (740) (1,088) 1,360 13,327
Changes in operating assets and liabilities... (51,058) 12,940 4,137 -- (33,981)
------------ ----------- ----------- ----------- ------------
Net cash provided by (used in) operating
activities.................................... (11,172) 30,950 3,821 -- 23,599
Net cash used in investing activities......... (12,270) (5,413) (345) -- (18,028)
Net cash used in financing activities......... (27,531) (25,453) (1,298) -- (54,282)
------------ ------------ ------------ ----------- ------------
Net change in cash and cash equivalents....... (50,973) 84 2,178 -- (48,711)
Cash and cash equivalents, beginning of year.. 190,606 8,206 4,096 -- 202,908
----------- ----------- ----------- ----------- -----------
Cash and cash equivalents, end of period...... $ 139,633 $ 8,290 $ 6,274 $ -- $ 154,197
=========== =========== =========== =========== ===========
Condensed Consolidating Statement of Cash Flows
Three Months Ended March 31, 1998
<CAPTION>
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
----------- ----------- ----------- ----------- -----------
<S> <C> <C> <C> <C> <C>
Cash flows from operating activities:
Net income (loss)............................. $ 6,631 $ 4,233 $ (688) $ (3,545) $ 6,631
Adjustments to reconcile net income (loss) to
net cash provided by (used in) operating
activities:
Depreciation and amortization.............. 7,290 9,652 379 -- 17,321
Provision for doubtful accounts............ 13,609 10,035 186 -- 23,830
Other, net................................. 10,578 124 557 -- 11,259
Changes in operating assets and liabilities... (26,637) (4,071) (1,358) 1,632 (30,434)
----------- ----------- ----------- ----------- -----------
Net cash provided by (used in) operating
activities.................................... 11,471 19,973 (924) (1,913) 28,607
Net cash used in investing activities......... (7,448) (4,218) (21) 1,913 (9,774)
Net cash used in financing activities......... (3,690) (4,147) (73) -- (7,910)
----------- ----------- ----------- ----------- -----------
Net change in cash and cash equivalents....... 333 11,608 (1,018) -- 10,923
Cash and cash equivalents, beginning of year.. 123,052 35,527 3,082 -- 161,661
----------- ----------- ----------- ----------- -----------
Cash and cash equivalents, end of period...... $ 123,385 $ 47,135 $ 2,064 $ -- $ 172,584
=========== =========== =========== =========== ===========
</TABLE>
11
<PAGE>
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
Results of Operations
Three Months Ended March 31, 1999 Compared with Three Months Ended March
31, 1998. Net income for the three months ended March 31, 1999 increased from
the prior year primarily as a result of a decrease in interest expense. 1998 net
income includes a $2.5 million charge ($1.2 million, net of tax) recorded in
selling, general and administrative expenses that represented the final costs
associated with the Company's consolidation plan announced in December 1997.
During the three months ended March 31, 1999, Quest Diagnostics introduced
its new laboratory network management service, called QuestNet, to several
managed care organizations. Under these arrangements, Quest Diagnostics assumes
responsibility for all costs incurred by the managed care organizations for
clinical laboratory services provided to their members, including testing
performed by providers other than Quest Diagnostics. As the network manager,
Quest Diagnostics is responsible for establishing and managing networks of
clinical laboratory service providers. Contract revenues are generally shared
among providers within the networks. Additionally, the costs, if any, associated
with testing performed by providers outside the established network, are shared
among the network of providers. Generally accepted accounting principles
covering these types of arrangements require the Company to include, in both
consolidated net revenues and expenses, the cost of testing covered under the
contract which is performed by providers other than Quest Diagnostics. This
method of accounting added $17.5 million to both net revenues and expenses
during the three months ended March 31, 1999.
Net Revenues
Excluding the effect of QuestNet, net revenues decreased by $3.5 million,
or 1% from the prior year level, principally due to a 7% decline in clinical
testing volume, measured by the number of requisitions processed, partially
offset by an improvement in average revenue per requisition processed of 6%. The
volume decline was principally due to the impact of increased competition for
managed care business, actions taken on unprofitable accounts and severe weather
in certain service areas. While capitated volume declined, fee-for-service
volume increased and had a favorable impact on average revenue per requisition
processed.
Costs and Expenses
Total operating costs for the quarter, excluding the effect of QuestNet,
declined $2.0 million from the year earlier period. Operating costs and expenses
for 1998 include a $2.5 million charge ($1.2 million, net of tax) included in
selling, general and administrative expenses that represented the final costs
associated with the Company's consolidation plan announced in December 1997.
Operating costs unrelated to volume increased during the quarter, principally
due to additional investments in information technology and marketing
capabilities.
Excluding the effect of QuestNet, cost of services, which includes the
costs of obtaining, transporting and testing specimens, decreased as a
percentage of net revenues to 57.5% from 59.3% a year ago, primarily
attributable to the increase in average revenue per requisition. Selling,
general and administrative expenses, which includes the costs of the sales
force, billing operations, bad debt expense and general management and
administrative support, increased as a percentage of net revenues to 34.8%,
excluding the effect of QuestNet, from 32.7% in the prior year. This increase
was principally due to additional investments in information technology and
marketing capabilities, offset by a reduction in bad debt expense from 6.5% of
net revenues in the prior year to 5.6% of net revenues (excluding the effect of
QuestNet) in the current year.
12
<PAGE>
Net interest expense decreased by $1.8 million from the prior year level
primarily due to a decrease in the average amount of debt outstanding during
1999 as compared to the prior year period.
Amortization of intangible assets decreased by $0.3 million compared to the
prior year principally due to certain intangible assets becoming fully
amortized.
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.
Quantitative and Qualitative Disclosures About Market Risk
The Company's primary exposure to market risk is from changes in interest
rates. The Company does not believe that its foreign exchange exposure and
related hedging program are material to the Company's financial position or
results of operations. The Company addresses its risks through a controlled
program of risk management that includes the use of derivative financial
instruments. The Company does not hold or issue derivative financial instruments
for trading purposes.
Interest Rates
At March 31, 1999 and December 31, 1998, the fair value of the Company's
debt was estimated at approximately $429 million and $480 million, respectively,
using quoted market prices and yields for the same or similar types of
borrowings, taking into account the underlying terms of the debt instruments.
Such fair values exceeded the carrying value of the debt at March 31, 1999 and
December 31, 1998 by approximately $12 million and $15 million, respectively. An
assumed 10% increase in interest rates would potentially reduce the fair value
of the Company's debt by approximately $9 million at both March 31, 1999 and
December 31, 1998.
The Company had $256 million of variable interest rate debt outstanding at
March 31, 1999. An assumed 10% increase in interest rates would result in a $.2
million reduction in the Company's after-tax earnings and cash flows for the
quarter ended March 31, 1999 based on debt levels as of March 31, 1999. The
primary interest rate exposures on the variable interest rate debt are with
respect to interest rates on United States dollars as quoted in the London
interbank market.
Liquidity and Capital Resources
Cash and cash equivalents at March 31, 1999 totaled $154.2 million, a
decrease of $48.7 million from December 31, 1998. Cash flows from operating
activities provided cash of $23.6 million, which was offset by investing and
financing activities which required cash of $72.3 million. The decrease is
primarily associated with the repayment of $48.2 million of debt, of which $35
million was paid ahead of schedule. Cash and cash equivalents at March 31, 1998
increased from December 31, 1997 by $10.9 million due to operating activities
which provided cash of $28.6 million, partially offset by investing and
financing activities which used cash of $17.7 million.
Net cash from operating activities for 1999 was below the 1998 level,
primarily due to increases in accounts receivable and increased payments
associated with restructuring and other special charges. The number of days
sales outstanding, a measure of billing and collection efficiency, was 54 days,
adjusted for QuestNet, compared to 58 days at March 31, 1998 and December 31,
1998.
Capital spending for the quarter was $12.7 million compared to $10.0
million for the same period in the prior year. Without giving effect to the
acquisition of SmithKline Beecham's clinical laboratory testing business which
is discussed below, the Company estimates that it will invest approximately $60
13
<PAGE>
million during 1999 for capital expenditures, principally related to investments
in information technology infrastructure and equipment and facility upgrades. *
During the quarter the Company paid down $48.2 million of debt. Other than
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.
During February 1998, Quest Diagnostics' Board of Directors authorized a
limited share purchase program which permits the Company to purchase up to $27
million of its outstanding common stock through 1999. Cumulative purchases under
the program through March 31, 1999 total $14.1 million. The program is intended
to mitigate the dilutive impact to earnings per share of issuing new shares for
the Company's employee benefit plans. The Company suspended purchases of its
shares when it reached a preliminary understanding of the transaction with
SmithKline Beecham plc on January 15, 1999.
Acquisition of SmithKline Beecham's Clinical Laboratory Testing Business
On February 9, 1999, the Company signed a definitive agreement to acquire
the clinical laboratory business of SmithKline Beecham plc ("SmithKline
Beecham") for approximately $1.3 billion. The purchase price will be paid
through the issuance of approximately 12.6 million shares of common stock of
Quest Diagnostics and the payment of $1.025 billion of cash. The acquisition
will be accounted for under the purchase method of accounting. Quest Diagnostics
expects to close the transaction early in the second half of 1999. As a result,
SmithKline Beecham will own approximately 29.5% of Quest Diagnostics'
outstanding common stock. Under the terms of a stockholder agreement, SmithKline
Beecham will initially have the right to designate two nominees to Quest
Diagnostics' board of directors as long as SmithKline Beecham owns at least 20%
of the outstanding common stock. (As long as SmithKline Beecham owns at least
10% but less than 20% of the outstanding common stock, it will have the right to
designate one nominee.) Quest Diagnostics' board of directors is expected to
expand to nine directors immediately following the closing. The stockholder
agreement will also impose limitations on the right of SmithKline Beecham to
sell or vote its shares and will prohibit SmithKline Beecham from purchasing in
excess of 29.5% of the outstanding common stock of Quest Diagnostics.
The issuance of 12.6 million shares of common stock to SmithKline Beecham
in the transaction will be submitted to the stockholders of Quest Diagnostics
for approval at the 1999 annual meeting of stockholders, which is scheduled to
be held on June 29, 1999. The acquisition is also subject to the receipt of
financing for the cash portion of the purchase price as well as the satisfaction
of other customary closing conditions. Quest Diagnostics has received
commitments for all of the financing necessary to complete the acquisition.
Additionally, the waiting period under the Hart-Scott-Rodino Antitrust
Improvements Act expired on March 25, 1999.
Under the terms of the agreement, Quest Diagnostics will acquire SmithKline
Beecham's clinical laboratory testing business including its clinical testing
operations, clinical trials testing, corporate health services, and laboratory
information products businesses. SmithKline Beecham's national testing and
service network consists of regional laboratories, specialty testing operations
and its Genetics Testing Center, as well as a number of rapid-turnaround or
"stat" laboratories, and patient service centers. As part of the transaction,
SmithKline Beecham and Quest Diagnostics will enter into a long-term contract
under which Quest Diagnostics will be the primary provider of testing to support
SmithKline Beecham's clinical trials testing requirements worldwide. SmithKline
Beecham will also indemnify Quest Diagnostics for potential liability arising
from certain government and private claims.
- --------
* These are forward-looking statements. 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 1998 Annual Report on
Form 10-K.
14
<PAGE>
SmithKline Beecham's clinical laboratory testing business is one of the
three largest clinical laboratory networks in the United States, with
approximately $1.6 billion in revenues from clinical laboratory testing during
1998. SmithKline Beecham has a strong presence in several regions in the United
States, particularly the southeastern and western states, where Quest
Diagnostics' presence is more limited. As a result of the acquisition, Quest
Diagnostics will become the leading clinical laboratory provider in the country.
Quest Diagnostics will have a much more extensive network of laboratories and
patient service centers, with facilities in substantially all of the country's
major metropolitan areas. After the acquisition, Quest Diagnostics also expects
to generate significant net cost savings through elimination of infrastructure
redundancies and sharing of core competencies. While management believes the
acquisition will accelerate Quest Diagnostics' earnings growth rate, generate
savings exceeding $100 million annually after three years, and be accretive to
earnings in 2000 before anticipated charges related to the transaction, it is
expected to have an adverse impact on profitability during the second half of
1999.*
Management believes the acquisition will enhance Quest Diagnostics' ability
to provide higher value for its customers in a cost-effective manner.* The
acquisition will provide a broad range of benefits for customers, including:
continued improvements in quality, convenience and accessibility; expanded test
development for healthcare consumers; and more dynamic laboratory data and
information products to help providers and insurers better manage their
patients' health.*
The Company is currently finalizing the terms of the external financing
necessary to complete the pending acquisition and has received a joint
commitment letter from two financial institutions. The financing commitment is
sufficient to fund the cash portion of the purchase price and refinance the
Credit Facility and, if necessary, the existing senior subordinated notes. The
financing is expected to consist of a new senior secured credit facility that
will include three term loans totaling $1.025 billion and a capital markets loan
facility for up to $300 million. In addition, the new senior secured credit
facility will include a $250 million revolving credit facility. Quest
Diagnostics expects that less than $25 million of the revolving credit facility
will be used to pay closing costs and to replace existing letters of credit and
that the balance of the revolving credit facility will be available for
borrowing.* In addition, Quest Diagnostics may explore alternative financing to
the capital markets term loan facility through a concurrent private placement of
senior subordinated notes. The final structure of the debt will depend upon
market conditions at the time of closing. The Company believes that its debt
will approximate $1.4 billion upon the closing of the acquisition, which is
expected to occur early in the second half of 1999. * The Company believes the
financing under the joint commitment letter will also provide sufficient
financial flexibility and access to funds to meet seasonal working capital
requirements, to fund capital expenditures and to fund additional growth
opportunities for the foreseeable future.*
Management believes that Quest Diagnostics' successful integration of
SmithKline Beecham's clinical laboratory business and implementation of its
business strategy, together with the indemnification by Corning and SmithKline
Beecham against monetary fines, penalties or losses from outstanding government
and other related claims, will enable it to generate strong cash flows.*
Additionally, management believes that these actions will aid the Company in
meeting the ongoing challenges in the clinical laboratory industry brought on by
the growth in managed care and increased regulatory complexity.*
- -------------
* These are forward-looking statements. 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 1998 Annual Report on
Form 10-K.
15
<PAGE>
Adjusted EBITDA
Adjusted EBITDA represents earnings before interest, taxes, depreciation
and amortization and non-recurring charges. Adjusted EBITDA for the three months
ended March 31, 1999 was $37.9 million, or 9.9% of net revenues, compared to
$40.1 million, or 10.9% of net revenues, in the prior year period. The decline
is primarily attributable to the costs associated with the introduction of
QuestNet, additional investments in information technology and marketing
capabilities, and severe weather.
Year 2000 Readiness Disclosure
The Year 2000 issue relates to the ability of computer systems and programs
to properly recognize dates beginning January 1, 2000 and beyond. Also, the Year
2000 issue affects systems and equipment, such as security systems and
elevators, that contain imbedded hardware or software that may be similarly date
sensitive. As a result, business and governmental entities are at risk for
possible miscalculations or system failures resulting from Year 2000 problems
that may disrupt their operations.
The Company commenced its Year 2000 readiness program in 1997 and has
established a dedicated project 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 following seven major areas:
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 equipment and software supplied by vendors who
have responded to the Company's inquiries, is complete. Also, significant
progress has been made with regard to phases three, four and five of the
Company's Year 2000 plan. All plans are on target with an expected completion of
95% by June 1999 and the remaining 5% to be completed during the fourth quarter
of 1999. For those vendors that have not responded, contingency plans are
scheduled to be completed during the third quarter of 1999.
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, testing for compliance and implementing certified systems. 80% of the
overall effort is currently completed with a scheduled completion date during
the third quarter of 1999.
Laboratory Instruments - Includes all clinical diagnostic instrumentation in
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 instrumentation and testing for
compliance. Approximately 75% of all instruments are Year 2000 ready and the
Company expects over 95% will be compliant by mid-1999, with contingency plans
in place for the remaining instruments.
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. Also, there has been significant
progress made with regard to phases three, four and five of the Company's Year
2000 plan.
Desktop Environment - Includes the personal computer hardware and operating
systems. The inventory and assessment phases are complete and the replacement
platform has been identified. An outside vendor has been selected and retained
to coordinate the desktop replacement program. The rollout has started with an
expected completion date during the third quarter of 1999.
16
<PAGE>
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 Company is in the process of
confirming that the suppliers' expected compliance dates have been met, and of
obtaining any specific information omitted from earlier supplier responses.
Contingency plans have been developed for all suppliers identified as critical
to the Company's mission, and are being refined through dialog with the
suppliers.
Payers - Includes the process of contacting each critical payer (e.g. Medicare,
Medicaid, commercial insurance carriers) regarding their plans and progress in
addressing the Year 2000 problem. All critical payers have been identified and
the Company is in the process of assessing the state of readiness, for all
responses received, and is in the process of developing contingency plans for
the critical payers.
Although each of the above seven areas is at a different stage of
readiness, the Company has made significant progress to date towards completing
its six-phase plan under its Year 2000 readiness program. The Year 2000
readiness program will be an ongoing process until all contacted parties have
responded to Company 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 Year 2000. In addition to the phases outlined above, the Company's plan also
includes regular status presentations to the Audit and Finance Committee of the
Board of Directors, and a special retention bonus plan for its key information
systems employees, which is based on the success in making Quest Diagnostics'
systems Year 2000 compliant. The Company's goal is to have all significant
systems properly functioning and certified with respect to the Year 2000 during
the third quarter of 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 payers, 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 most reasonably likely worst case consequences of the Company or
key vendors or payers not being ready by January 1, 2000 include, 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 14% of the Company's annual net
revenues are received from Medicare carriers. The Company could experience
collection delays if Medicare or other large third party payers (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 2000.*
While the Company believes that its Year 2000 readiness program
significantly reduces the potential adverse effect of any such disruptions,
Quest Diagnostics cannot guarantee that the Year 2000 problem will not result in
significant 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
- -----------
* These are forward-looking statements. 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 1998 Annual Report for
Form 10-K.
17
<PAGE>
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 for each major area to mitigate the
possible disruption in business operations. Contingency plans may include
accepting estimated payments from customers and payers, making use of
alternative vendors, stockpiling inventory and temporarily moving laboratory
testing services. Most of the Company's regional laboratories have similar test
menus and, with the adoption of standardized test codes 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 during the third quarter of 1999. *
Costs incurred through March 31, 1999 related to the Company's Year 2000
readiness program approximated $31 million, of which approximately $10 million
was capitalized. Current estimates of the remaining costs are approximately $35
million to $50 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.*
- -----------------------------
* These are forward-looking statements. 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 1998 Annual Report on
Form 10-K.
18
<PAGE>
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
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:
February 17, 1999
March 26, 1999
19
<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.
May 14, 1999
Quest Diagnostics Incorporated
By /s/ Kenneth W. Freeman Chairman of the Board,
---------------------------- Chief Executive Officer
Kenneth W. Freeman and President
By /s/ Robert A. Hagemann Vice President and
--------------------------- Chief Financial Officer
Robert A. Hagemann
20
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