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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, 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)
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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, 1999, there were outstanding 43,196,455 shares of Common
Stock, $.01 par value.
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PART I - FINANCIAL INFORMATION
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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, 1999 and 1998 2
Consolidated Balance Sheets as of
September 30, 1999 and December 31, 1998 3
Consolidated Statements of Cash Flows for the
Nine Months Ended September 30, 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 15
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>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 1999 AND 1998
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------ ----------------------------
1999 1998 1999 1998
--------- -------- ----------- ----------
<S> <C> <C> <C> <C>
NET REVENUES ...................................... $ 614,842 $360,713 $ 1,390,717 $1,095,327
COSTS AND EXPENSES:
Cost of services ............................... 369,402 210,864 822,057 646,710
Selling, general and administrative ............ 192,696 122,783 451,351 359,362
Interest expense, net .......................... 19,025 8,398 31,392 26,548
Amortization of intangible assets .............. 7,812 5,530 18,125 16,276
Special charges ................................ 30,282 -- 30,282 --
Other, net ..................................... 1,184 1,095 4,484 2,459
--------- -------- ----------- ----------
Total ........................................ 620,401 348,670 1,357,691 1,051,355
--------- -------- ----------- ----------
INCOME (LOSS) BEFORE TAXES AND EXTRAORDINARY LOSS (5,559) 12,043 33,026 43,972
INCOME TAX EXPENSE ................................ 1,698 5,982 19,763 22,426
--------- -------- ----------- ----------
INCOME (LOSS) BEFORE EXTRAORDINARY LOSS ........... (7,257) 6,061 13,263 21,546
EXTRAORDINARY LOSS, NET OF TAXES .................. (2,139) -- (2,139) --
--------- -------- ----------- ----------
NET INCOME (LOSS) ................................. $ (9,396) $ 6,061 $ 11,124 $ 21,546
========= ======== =========== ==========
BASIC NET INCOME (LOSS) PER COMMON SHARE:
Income (loss) before extraordinary loss ........... $ (0.20) $ 0.20 $ 0.41 $ 0.72
Extraordinary loss, net of taxes .................. $ (0.06) $ -- $ (0.07) $ --
Net income (loss) ................................. $ (0.26) $ 0.20 $ 0.34 $ 0.72
BASIC WEIGHTED AVERAGE COMMON SHARES OUTSTANDING .. 36,768 29,686 32,134 29,719
DILUTED NET INCOME (LOSS) PER COMMON SHARE:
Income (loss) before extraordinary loss ........... $ (0.20) $ 0.20 $ 0.40 $ 0.71
Extraordinary loss, net of taxes .................. $ (0.06) $ -- $ (0.06) $ --
Net income (loss) ................................. $ (0.26) $ 0.20 $ 0.34 $ 0.71
DILUTED WEIGHTED AVERAGE COMMON SHARES OUTSTANDING 37,616 30,219 32,875 30,268
</TABLE>
The accompanying notes are an integral part of these statements.
2
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QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, 1999 AND DECEMBER 31, 1998
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
September 30,
1999 December 31,
------------ ------------
(unaudited) 1998
<S> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents............................................. $ 36,799 $ 202,908
Accounts receivable, net of allowance of $86,891 and $70,701
at September 30, 1999 and December 31, 1998, respectively......... 553,684 220,861
Inventories........................................................... 51,376 31,164
Deferred taxes on income.............................................. 175,798 94,441
Prepaid expenses and other assets..................................... 57,354 28,813
------------ ------------
Total current assets.............................................. 875,011 578,187
PROPERTY, PLANT AND EQUIPMENT, NET......................................... 445,000 240,389
INTANGIBLE ASSETS, NET..................................................... 1,384,690 494,721
OTHER ASSETS............................................................... 121,864 46,943
------------ ------------
TOTAL ASSETS............................................................... $ 2,826,565 $ 1,360,240
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable and accrued expenses................................. $ 575,790 $ 242,285
Current portion of long-term debt..................................... 36,684 51,444
Income taxes payable.................................................. 26,336 15,736
------------ ------------
Total current liabilities......................................... 638,810 309,465
LONG-TERM DEBT............................................................. 1,230,475 413,426
OTHER LIABILITIES.......................................................... 101,263 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; 43,096 and 30,241 shares issued at
September 30, 1999 and December 31, 1998, respectively............ 431 302
Additional paid-in capital............................................ 1,467,570 1,201,006
Accumulated deficit................................................... (612,477) (623,514)
Unearned compensation................................................. (362) (3,895)
Accumulated other comprehensive loss.................................. (145) (3,038)
Common stock in treasury, at cost; 214 shares at
December 31, 1998................................................. -- (3,931)
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Total common stockholders' equity................................. 855,017 566,930
------------ ------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY................................. $ 2,826,565 $ 1,360,240
============ ============
</TABLE>
The accompanying notes are an integral part of these statements.
3
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QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1999 AND 1998
(IN THOUSANDS)
(UNAUDITED)
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1999 1998
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CASH FLOWS FROM OPERATING ACTIVITIES:
Net income................................................................. $ 11,124 $ 21,546
Adjustments to reconcile net income
to net cash provided by operating activities:
Extraordinary loss, net of taxes...................................... 2,139 --
Depreciation and amortization......................................... 57,244 51,699
Provision for doubtful accounts....................................... 81,775 67,292
Special charges....................................................... 30,282 --
Deferred income tax provision......................................... (11,608) 14,377
Other, net............................................................ 8,597 5,124
Changes in operating assets and liabilities:
Accounts receivable............................................... (72,563) (65,317)
Accounts payable and accrued expenses............................. 95,120 41,195
Restructuring, integration and other special charges.............. (22,126) (34,088)
Due from Corning Incorporated and affiliates...................... -- 14,890
Other assets and liabilities, net................................. 6,475 (12,260)
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NET CASH PROVIDED BY OPERATING ACTIVITIES.................................. 186,459 104,458
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CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisition of business............................................... (1,025,000) --
Transaction costs..................................................... (8,345) --
Capital expenditures.................................................. (47,473) (27,933)
Proceeds from disposition of assets................................... 4,910 491
Increase in investments............................................... (9,639) (1,232)
----------- ------------
NET CASH USED IN INVESTING ACTIVITIES...................................... (1,085,547) (28,674)
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CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from borrowings.............................................. 1,132,843 --
Repayment of debt..................................................... (361,263) (44,137)
Financing costs paid.................................................. (36,822) --
Distributions to minority partners.................................... (2,576) --
Exercise of stock options............................................. 1,987 145
Purchase of treasury stock............................................ (1,103) (12,369)
Dividends paid........................................................ (87) (88)
----------- ------------
NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES........................ 732,979 (56,449)
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NET CHANGE IN CASH AND CASH EQUIVALENTS.................................... (166,109) 19,335
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR............................... 202,908 161,661
----------- ------------
CASH AND CASH EQUIVALENTS, END OF PERIOD................................... $ 36,799 $ 180,996
=========== ============
CASH PAID DURING THE PERIOD FOR:
Interest.............................................................. $ 27,235 $ 27,986
Income taxes.......................................................... $ 10,229 $ 13,676
</TABLE>
The accompanying notes are an integral part of these statements.
4
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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.
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. Except as otherwise disclosed,
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, 1998.
COMPREHENSIVE INCOME (LOSS)
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 $14.0
million and $21.1 million for the nine months ended September 30, 1999 and 1998,
respectively. Comprehensive income (loss) was $(10.0) million and $5.3 million
for the quarter ended September 30, 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 per quarter), 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 Employee Equity Participation Program.
2. ACQUISITION OF SMITHKLINE BEECHAM'S CLINICAL LABORATORY TESTING BUSINESS
ACQUISITION OF SMITHKLINE BEECHAM'S CLINICAL LABORATORY TESTING BUSINESS
On August 16, 1999, the Company completed the acquisition of the clinical
laboratory business of SmithKline Beecham plc ("SmithKline Beecham") for
approximately $1.3 billion. Pursuant to the Stock and Asset Purchase Agreement,
dated as of February 9, 1999, as amended, the Company acquired all of the
outstanding shares of SBCL, Inc., a holding company which owns all of the shares
of capital stock of SmithKline Beecham Clinical Laboratories, Inc. The Company
also acquired assets used in, and assumed liabilities relating to, the
non-United States clinical laboratory testing business of SmithKline Beecham and
its affiliates.
The purchase price was paid through the issuance of 12,564,336 shares of
common stock of the Company (valued at $260.7 million), representing
approximately 29% of the Company's outstanding common stock, and the payment of
$1.025 billion in cash, including $20 million under the non-competition
agreement between the Company and SmithKline Beecham.
5
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QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
Under the terms of a stockholder agreement, SmithKline Beecham has 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 was expanded to nine directors
following the closing of the acquisition. The stockholder agreement also
imposes limitations on the right of SmithKline Beecham to sell or vote its
shares and prohibits SmithKline Beecham from purchasing in excess of 29.5% of
the outstanding common stock of Quest Diagnostics.
Under the Stock and Asset Purchase Agreement, SmithKline Beecham has agreed
to indemnify Quest Diagnostics, on an after tax basis, against certain matters
primarily related to taxes and billing and professional liability claims.
The acquisition was accounted for under the purchase method of accounting.
As such, the cost to acquire SmithKline Beecham's clinical laboratory business
("SBCL") has been allocated on a preliminary basis to the assets and liabilities
acquired based on estimated fair values as of the closing date. The consolidated
financial statements include the results of operations of SBCL subsequent to the
closing of the acquisition.
The Company expects to incur significant costs to integrate SBCL and
Quest Diagnostics. The majority of these integration costs are related to
severance, contractual obligations related to leased facilities and equipment
and write-offs of fixed assets for which management believes there is no
future economic benefit as a result of the SBCL acquisition. Integration
costs related to actions affecting SBCL's assets, liabilities, or employees
will be considered additional costs of the acquisition, while those affecting
Quest Diagnostics' assets, liabilities, or employees will be recorded as a
charge to operations. The estimated costs associated with severance and other
integration-related activities for 1999 and 2000, including the elimination
of excess capacity, operational realignment and related workforce reductions,
are expected to be finalized and recorded during the fourth quarter of 1999.
Goodwill of approximately $890 million, representing acquisition cost in
excess of the fair value of the net tangible assets acquired, is amortized on
the straight-line basis over forty years.
The Stock and Asset Purchase Agreement includes a provision for a purchase
price adjustment based on an audit of the August 16, 1999 combined balance sheet
of SBCL and certain affiliates. Adjustments resulting from this audit, which are
subject to resolution as set forth in the Stock and Asset Purchase Agreement,
have been recorded in the September 30, 1999 consolidated balance sheet.
However, amounts due from SmithKline Beecham, as a result of the purchase price
adjustment, have not been reflected in the September 30, 1999 consolidated
balance sheet of Quest Diagnostics.
The consolidated financial statements include a preliminary allocation of
the purchase price. The allocation will be finalized after completion of the
valuation of certain assets and liabilities, the recording of the integration
costs affecting the assets, liabilities or employees of SBCL, and the final
resolution of the purchase price adjustment.
FINANCING OF THE TRANSACTION
At the closing of the SBCL acquisition, the Company used existing cash
funds and the borrowings under a new senior secured credit facility to fund the
cash purchase price and related transaction costs of the acquisition, and to
repay the entire amount outstanding under its then existing credit agreement.
The extraordinary loss recorded during the third quarter of 1999 represents $3.6
million ($2.1 million, net of taxes) of deferred financing costs which were
written-off in connection with the extinguishment of the prior credit agreement.
The new credit agreement includes the following facilities: a $250 million
six-year revolving credit facility; a $400 million six-year amortizing term
loan; a $325 million seven-year term loan with minimal amortization until
6
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QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
the seventh year; a $300 million eight-year term loan with minimal
amortization until the eighth year; and a $50 million two-year capital
markets term loan which does not amortize. (The Company had commitments for a
$300 million capital markets term loan but elected to use only $50 million of
the commitment; the balance of the capital markets term loan commitment
expired at the closing). Up to $75 million of the revolving credit facility
may be used for letters of credit. At the closing, Quest Diagnostics borrowed
approximately $1.075 billion under the term loans (including $50 million
under the capital markets term loan) and $57.5 million under the revolving
credit facility. The Company used $17.3 million of the revolving credit
facility to replace existing letters of credit. Between the closing of the
SBCL acquisition and the end of the third quarter of 1999, the Company repaid
the entire amount borrowed at closing under the revolving credit facility.
The new credit facility is secured by substantially all tangible and
intangible assets of the Company and by a guaranty from, and a pledge of all
capital stock and tangible and intangible assets of, all of the Company's
present and future wholly-owned domestic subsidiaries other than certain
joint ventures. The borrowings under the new credit agreement rank senior in
priority of repayment to any subordinated indebtedness. Interest is based on
certain published rates plus an applicable margin which will vary depending
on the financial performance of the Company. The applicable margin will be
reduced by 25 basis points after the repayment of the capital markets term
loan. The credit agreement requires the Company to maintain interest rate
hedge agreements covering a notional amount of not less than 50% of the
principal amount outstanding of its net funded debt. The credit agreement
contains various covenants and conditions including the maintenance of
certain financial ratios and tests, and restricts the ability of the Company
to, among other things, incur additional indebtedness and pay dividends on
its common stock.
PRO FORMA COMBINED FINANCIAL INFORMATION
The following pro forma combined financial information assumes that the
SBCL acquisition and borrowings under the new credit facility were effected on
the earliest period presented. The Stock and Asset Purchase Agreement includes a
provision for a purchase price adjustment based on an audit of the August 16,
1999 combined balance sheet of SBCL and certain affiliates. Adjustments
resulting from this audit, which are subject to resolution as set forth in the
Stock and Asset Purchase Agreement, have been recorded in the pro forma combined
financial information to the extent that the Company believes they are
applicable. The pro forma combined financial information reflects the
preliminary allocation of purchase price. The allocation will be finalized after
completion of the valuation of certain assets and liabilities, the recording of
the integration costs related to SBCL's assets, liabilities and employees, and
the final resolution of the purchase price adjustment. There can be no
assurances that the amounts reflected in the pro forma combined financial
information will not be subject to change as a result of changes in the
allocation of the purchase price, including the resolution of the purchase price
adjustment.
Significant pro forma adjustments reflected in the pro forma combined
information include reductions in employee benefit costs, and general corporate
overhead allocated to the historical results of SBCL by SmithKline Beecham,
offset by an increase in net interest expense to reflect the Company's new
credit facility which was used to finance the SBCL acquisition. Amortization of
the goodwill, which accounts for a majority of the acquired intangible assets,
is calculated on the straight-line basis over forty years. Other, net has been
adjusted to remove SBCL's non-recurring gains from the sale and license of
certain technology and its physician office-based teleprinter assets and
network. Income taxes have been adjusted for the estimated income tax impact of
the pro forma adjustments at the incremental tax rate of 40%. A significant
portion of the intangible assets acquired in the SBCL acquisition is not
deductible for tax purposes which has the overall impact of increasing the
effective tax rate.
7
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QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
<TABLE>
<CAPTION>
PRO FORMA COMBINED FINANCIAL INFORMATION
(in millions, except per share data)
(unaudited)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------ ----------------------
1999 1998 1999 1998
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Net revenues $ 819.3 $ 766.6 $2,480.3 $2,248.1
Income (loss) before extraordinary loss (10.2) 10.8 (10.8) 32.6
Net income (loss) (12.3) 10.8 (12.9) 32.6
Income before extraordinary loss and special charges 8.0 10.8 16.9 32.6
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BASIC EARNINGS (LOSS) PER COMMON SHARE:
Income (loss) before extraordinary loss $ (0.23) $ 0.25 $ (0.25) $ 0.75
Net income (loss) $ (0.28) $ 0.25 $ (0.30) $ 0.75
Income before extraordinary loss and special charges $ 0.18 $ 0.25 $ 0.39 $ 0.75
Weighted average common shares outstanding - basic 43.4 43.0 43.2 43.1
- ------------------------------------------------------------------------------------------------------------------------
DILUTED EARNINGS (LOSS) PER COMMON SHARE:
Income (loss) before extraordinary loss $ (0.23) $ 0.25 $ (0.25) $ 0.75
Net income (loss) $ (0.28) $ 0.25 $ (0.30) $ 0.75
Income before extraordinary loss and special charges $ 0.18 $ 0.25 $ 0.38 $ 0.75
Weighted average common shares outstanding - diluted 44.2 43.4 43.9 43.5
</TABLE>
3. SPECIAL CHARGES
During the third quarter of 1999, the Company recorded special charges of
$30.3 million in connection with the acquisition of SBCL. Of the total, $19.8
million represents stock based employee compensation related to special one-time
grants of the Company's common stock to certain individuals of the combined
company of $17.8 million, and accelerated vesting, due to the completion of the
SBCL acquisition, of restricted stock grants made in previous years totaling
$2.0 million. In addition, the Company incurred $9.2 million of professional and
consulting fees related to integration planning activities. The remainder of the
charge is related to costs incurred by the Company in conjunction with its
planned offering of new senior subordinated notes, the proceeds of which were
expected to be used to repay the Company's existing 10 3/4% senior subordinated
notes. Due to unsatisfactory conditions in the high yield market, the Company
decided not to proceed with the offering.
8
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QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
4. COMMITMENTS AND CONTINGENCIES
The Company has entered into several settlement agreements with various
governmental and private payers during recent years relating 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. Quest Diagnostics was added to the complaint by the
plaintiffs in August 1999. The complaint asserts claims relating to private
reimbursement of billings that are similar to those that were part of a prior
government settlement. 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 in respect of private claims for 50% of the
aggregate of all judgment or settlement payments made by December 31, 2001 that
exceed $42 million. The 50% share will be limited to a total amount of $25
million and will be reduced to take into account any deductions or tax benefits
realized by Quest Diagnostics. At September 30, 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.
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 were covered by the indemnification from Corning
discussed above and were fully reserved for.
Similar to Quest Diagnostics, SBCL has entered into settlement
agreements with various governmental agencies and private payers primarily
relating to its prior billing and marketing practices. In 1996, SBCL and the
U.S. government and various states reached a settlement with respect to the
government's civil and administrative claims. With respect to the
government's criminal investigation, no criminal charges have been filed and
SBCL was recently informed that the U.S. Attorney's Office in Philadelphia
has closed its criminal investigation of SBCL's clinical laboratories
business, it officers and employees. SBCL is also responding to claims from
private payers relating to billing and marketing issues similar to those that
were the subject of the settlement with the government. The claims include
ten purported class actions filed in various jurisdictions in the United
States and two non-class action complaints by a number of insurance
companies. Nine of the purported class actions have been consolidated into
one complaint which has been consolidated with one of the insurers' suits,
for pre-trial proceedings.
SmithKline Beecham has agreed to indemnify Quest Diagnostics, on an after
tax basis, against monetary payments for governmental claims or investigations,
relating to the billing practices of SmithKline Beecham and its affiliates, that
have been settled before or are pending as of the closing date of the SBCL
acquisition. SmithKline
9
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QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
Beecham has also agreed to indemnify Quest Diagnostics, on an after tax
basis, against monetary payments to private payers, relating to or arising
out of the pending governmental claims. The indemnification with respect to
governmental claims is for 100% of those claims. SmithKline Beecham will
indemnify Quest Diagnostics, in respect of private claims for: 100% of those
claims, up to an aggregate amount of $80 million; 50% of those claims to the
extent the aggregate amount exceeds $80 million but is less than $130
million; and 100% of such claims to the extent the aggregate amount exceeds
$130 million. The indemnification also covers 80% of out-of-pocket costs and
expenses relating to investigations of the claims indemnified against by
SmithKline Beecham. In addition, SmithKline Beecham has agreed to indemnify
the Company against all monetary payments relating to professional liability
claims of SBCL for services provided prior to the closing of the SBCL
acquisition.
On March 22, 1999, SBCL learned that an SBCL employee at a patient
service center in Palo Alto, California, had at times reused certain needles
when drawing blood from patients. Prior to the close of the acquisition, SBCL
had notified patients whose blood may have been drawn by this phlebotomist
and offered free counseling and follow-up blood tests to the patients. A
number of civil actions, including some purporting to be class actions, have
been filed against SBCL in federal and state courts in California on behalf
of patients who may have been affected by the phlebotomist's reuse of needles
or other allegedly improper practices. As a result of this incident, SBCL had
also received inspection reports from state and federal agencies raising
alleged deficiencies in some areas of supervision with respect to the Palo
Alto patient service center, which may result in sanctions or penalties.
SmithKline Beecham has agreed to indemnify Quest Diagnostics for the
out-of-pocket costs of the counseling and testing, for liabilities arising
out of the civil actions and for other losses arising out of the conduct of
the phlebotomist, other than consequential damages.
At September 30, 1999, the receivable from SmithKline Beecham related to
indemnified billing, professional liability and other claims, totaled
approximately $44 million, which is management's best estimate of the amounts
which are probable of being received from SmithKline Beecham to satisfy the
indemnified claims on an after-tax basis. The estimated reserves and the related
receivable due from SmithKline Beecham are subject to change as additional
information regarding the outstanding claims is gathered and evaluated during
the fourth quarter of 1999.
At September 30, 1999, recorded reserves, relating primarily to billing
claims including those indemnified by Corning and SmithKline Beecham,
approximated $89.1 million, including $33.8 million in other long-term
liabilities. The increase in reserves since June 30, 1999 is related to the
estimated reserves recorded by the Company in conjunction with the SBCL
acquisition which are indemnified by SmithKline Beecham as described above.
Although management believes that established reserves for both indemnified
and non-indemnified claims are sufficient, it is possible that additional
information (such as the indication by the government of criminal activity,
additional tests being questioned or other changes in the government's or
private claimants' theories of wrongdoing) may become available which may
cause the final resolution of these matters to exceed established reserves by
an amount which could be material to the Company's results of operations and
cash flows in the period in which such claims are settled. The Company does
not believe that these issues will have a material adverse effect on its
overall financial condition.
5. RESTRUCTURING RESERVES
The Company has recorded charges for restructuring plans in previous years.
Reserves relating to these programs totaled $7.8 million and $13.6 million at
September 30, 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.
10
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
6. 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. Shares purchased under the
program are expected to be reissued in connection with certain employee benefit
plans. Cumulative purchases under the program through September 30, 1999 total
$14.1 million. The Company suspended purchases of its shares when it reached a
preliminary understanding of the transaction with SmithKline Beecham on January
15, 1999.
7. SUMMARIZED FINANCIAL INFORMATION
The Company's 10 3/4% 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.
11
<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, 1999
<TABLE>
<CAPTION>
Subsidiary Non-Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------- ------------ ------------
<S> <C> <C> <C> <C> <C>
Net revenues................................ $474,445 $848,641 $67,631 $ -- $ 1,390,717
Costs and expenses:
Cost of services......................... 292,415 491,273 38,369 822,057
Selling, general and administrative...... 190,172 236,643 24,536 451,351
Interest expense, net.................... 5,917 24,831 644 31,392
Amortization of intangible assets........ 5,457 12,383 285 18,125
Special charges.......................... 30,282 -- -- 30,282
Royalty (income) expense................. (53,619) 53,619 -- --
Other, net............................... (188) (247) 4,919 4,484
-------- --------- -------- ----------- -----------
Total.................................. 470,436 818,502 68,753 -- 1,357,691
-------- --------- -------- ----------- -----------
Income (loss) before taxes and
extraordinary loss....................... 4,009 30,139 (1,122) -- 33,026
Income tax expense.......................... 1,706 16,872 1,185 -- 19,763
-------- --------- -------- ----------- -----------
Income (loss) before extraordinary loss..... 2,303 13,267 (2,307) -- 13,263
Equity income from subsidiaries............. 10,960 -- -- (10,960) --
Extraordinary loss, net of taxes............ (2,139) -- -- -- (2,139)
-------- --------- -------- ----------- -----------
Net income (loss)........................... $ 11,124 $13,267 $(2,307) $(10,960) $ 11,124
======== ========= ======== =========== ===========
CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS
NINE MONTHS ENDED SEPTEMBER 30, 1998
Subsidiary Non-Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
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 administrative...... 195,144 155,923 8,295 -- 359,362
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>
12
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
CONDENSED CONSOLIDATING BALANCE SHEET
SEPTEMBER 30, 1999
<TABLE>
<CAPTION>
Subsidiary Non-Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
<S> <C> <C> <C> <C> <C>
Current assets:
Cash and cash equivalents................... $ (42,400) $ 71,523 $ 7,676 $ -- $ 36,799
Accounts receivable, net.................... 70,486 469,800 13,398 553,684
Other current assets........................ 96,035 179,875 8,618 284,528
----------- ---------- -------- ----------- -----------
Total current assets..................... 124,121 721,198 29,692 875,011
Property, plant and equipment, net.......... 109,061 320,944 14,995 445,000
Intangible assets, net ..................... 162,381 1,222,064 245 1,384,690
Intercompany (payable) receivable........... 170,897 (142,216) (28,681) --
Investment in subsidiaries.................. 690,628 -- -- (690,628) --
Other assets................................ 30,410 75,743 15,711 121,864
----------- ---------- -------- ----------- -----------
Total assets............................. $ 1,287,498 $2,197,733 $ 31,962 $ (690,628) $ 2,826,565
=========== ========== ======== =========== ===========
Current liabilities:
Accounts payable and accrued expenses....... $ 220,570 $ 370,647 $ 10,909 $ -- $ 602,126
Current portion of long-term debt........... 3,261 33,020 403 36,684
---------- ---------- -------- ----------- -----------
Total current liabilities................ 223,831 403,667 11,312 -- 638,810
Long-term debt.............................. 164,622 1,062,562 3,291 1,230,475
Other liabilities........................... 43,028 50,604 7,631 101,263
Preferred stock............................. 1,000 -- -- -- 1,000
Common stockholders' equity................. 855,017 680,900 9,728 (690,628) 855,017
---------- ---------- -------- ----------- -----------
Total liabilities and stockholders'
equity...................................... $1,287,498 $2,197,733 $ 31,962 $ (690,628) $ 2,826,565
========== ========== ======== =========== ===========
CONDENSED CONSOLIDATING BALANCE SHEET
DECEMBER 31, 1998
Subsidiary Non-Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
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>
13
<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, 1999
<TABLE>
<CAPTION>
Subsidiary Non-Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
<S> <C> <C> <C> <C> <C>
Cash flows from operating activities:
Net income (loss)............................. $ 11,124 $ 13,267 $ (2,307) $ (10,960) $ 11,124
Adjustments to reconcile net income (loss) to
net cash provided by operating activities:
Extraordinary loss, net of taxes........... 2,139 -- -- 2,139
Depreciation and amortization.............. 23,620 29,175 4,449 57,244
Provision for doubtful accounts............ 28,316 47,319 6,140 81,775
Special charges............................ 30,282 -- -- 30,282
Other, net................................. (11,720) 1,518 (3,769) 10,960 (3,011)
Changes in operating assets and
liabilities.............................. (64,326) 54,116 17,116 6,906
----------- ----------- ----------- ----------- -------------
Net cash provided by operating activities..... 19,435 145,395 21,629 -- 186,459
Net cash used in investing activities......... (1,066,943) (17,871) (733) -- (1,085,547)
Net cash provided by (used in) financing
activities................................. 814,502 (64,207) (17,316) -- 732,979
----------- ----------- ----------- ----------- -------------
Net change in cash and cash equivalents....... (233,006) 63,317 3,580 -- (166,109)
Cash and cash equivalents, beginning of year.. 190,606 8,206 4,096 -- 202,908
----------- ----------- ----------- ----------- -------------
Cash and cash equivalents, end of period...... $ (42,400) $ 71,523 $ 7,676 $ -- $ 36,799
=========== =========== =========== =========== =============
CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
NINE MONTHS ENDED SEPTEMBER 30, 1998
Subsidiary Non-Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
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 (used in) 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>
14
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
ACQUISITION OF SMITHKLINE BEECHAM'S CLINICAL LABORATORY TESTING BUSINESS
On August 16, 1999, the Company completed the acquisition of the
clinical laboratory business of SmithKline Beecham for approximately $1.3
billion. The purchase price was paid through the issuance of 12,564,336
shares of common stock of the Company (valued at $260.7 million),
representing approximately 29% of the Company's outstanding common stock, and
the payment of $1.025 billion in cash, including $20 million under the
non-competition agreement between the Company and SmithKline Beecham.
Under the terms of the agreement, Quest Diagnostics acquired SmithKline
Beecham's clinical laboratory testing business including its domestic and
foreign clinical testing operations, clinical trials testing, corporate health
services, and laboratory information products businesses. SmithKline Beecham's
national testing and service network consisted of regional laboratories,
specialty testing operations and its National Esoteric Testing Center, as well
as a number of rapid-turnaround or "stat" laboratories, and patient service
centers. In addition, SmithKline Beecham and Quest Diagnostics entered into a
long-term contract under which Quest Diagnostics is the primary provider of
testing to support SmithKline Beecham's clinical trials testing requirements
worldwide. As part of the agreement, Quest Diagnostics has granted SmithKline
Beecham certain non-exclusive rights and access to use Quest Diagnostics'
proprietary clinical laboratory information database. Quest Diagnostics will
also receive a minority interest in a company that SmithKline Beecham expects to
form to sell healthcare information products and services through various
channels, including the Internet.
Under the terms of a stockholder agreement, SmithKline Beecham has 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 was expanded to nine directors
following the closing of the acquisition. The stockholder agreement also
imposes limitations on the right of SmithKline Beecham to sell or vote its
shares and prohibits SmithKline Beecham from purchasing in excess of 29.5% of
the outstanding common stock of Quest Diagnostics.
Under the Stock and Asset Purchase Agreement, SmithKline Beecham has agreed
to indemnify Quest Diagnostics, on an after tax basis, against certain matters
primarily related to taxes and billing and professional liability claims.
Quest Diagnostics believes that the acquisition establishes the Company as
the leader of the clinical laboratory testing industry and provides a range of
benefits. As the leading national provider with the most extensive network of
laboratories and patient service centers throughout the United States, Quest
Diagnostics will be able to further enhance patient access and customer service.
The acquisition will improve the Company's ability to pursue profitable growth
opportunities, including direct contracting with employers for laboratory
services, clinical trials testing for pharmaceutical companies, testing and
management services for hospitals, and genetic and other esoteric testing. Quest
Diagnostics believes that the acquisition will accelerate innovation and create
the largest clinical laboratory database in the world, which can be used to help
providers and insurers to better manage their patients' health. Finally, Quest
Diagnostics believes that the acquisition will provide the Company with
opportunities to achieve significant cost savings by consolidating operations
and activities, including redundant facilities, applying best practices and
utilizing its service infrastructure more efficiently.*
- --------------
* 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>
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 special charges related
to the transaction. However, it is expected to have an adverse impact on
profitability during the first year after the closing of the acquisition.*
The acquisition was accounted for under the purchase method of accounting.
As such, the cost to acquire SmithKline Beecham's clinical laboratory business
("SBCL") has been allocated on a preliminary basis to the assets and liabilities
acquired based on estimated fair values as of the closing date. The consolidated
financial statements include the results of operations of SBCL subsequent to the
closing of the acquisition.
The Company expects to incur significant costs to integrate SBCL and
Quest Diagnostics. The majority of these integration costs are related to
severance, contractual obligations related to leased facilities and equipment
and write-offs of fixed assets for which management believes there is no
future economic benefit as a result of the SBCL acquisition. Integration
costs related to actions affecting SBCL's assets, liabilities, or employees
will be considered additional costs of the acquisition, while those affecting
Quest Diagnostics' assets, liabilities, or employees will be recorded as a
charge to operations. The estimated costs associated with severance and other
integration-related activities for 1999 and 2000, including the elimination
of excess capacity, operational realignment and related workforce reductions,
are expected to be finalized and recorded during the fourth quarter of 1999.
Goodwill of approximately $890 million, representing acquisition cost in
excess of the fair value of the net tangible assets acquired, is amortized on
the straight-line basis over forty years.
The Stock and Asset Purchase Agreement includes a provision for a purchase
price adjustment based on an audit of the August 16, 1999 combined balance sheet
of SBCL and certain affiliates. Adjustments resulting from this audit, which are
subject to resolution as set forth in the Stock and Asset Purchase Agreement,
have been recorded in the September 30, 1999 consolidated balance sheet.
However, amounts due from SmithKline Beecham, as a result of the purchase price
adjustment, have not been reflected in the September 30, 1999 consolidated
balance sheet of Quest Diagnostics.
The consolidated financial statements include a preliminary allocation of
the purchase price. The allocation will be finalized after completion of the
valuation of certain assets and liabilities, the recording of the integration
costs affecting the assets, liabilities or employees of SBCL, and the final
resolution of the purchase price adjustment.
FINANCING OF THE TRANSACTION
At the closing of the SBCL acquisition, the Company used existing cash
funds and the borrowings under a new senior secured credit facility to fund the
cash purchase price and related transaction costs of the acquisition, and to
repay the entire amount outstanding under its then existing credit agreement.
The extraordinary loss recorded during the third quarter of 1999 represents $3.6
million ($2.1 million, net of taxes) of deferred financing costs which were
written-off in connection with the extinguishment of the credit agreement.
- ----------
* 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.
16
<PAGE>
The new credit agreement includes the following facilities: a $250
million six-year revolving credit facility; a $400 million six-year
amortizing term loan; a $325 million seven-year term loan with minimal
amortization until the seventh year; a $300 million eight-year term loan with
minimal amortization until the eighth year; and a $50 million two-year
capital markets term loan which does not amortize. (The Company had
commitments for a $300 million capital markets term loan but elected to use
only $50 million of the commitment; the balance of the capital markets term
loan commitment expired at the closing). Up to $75 million of the revolving
credit facility may be used for letters of credit. At the closing, Quest
Diagnostics borrowed approximately $1.075 billion under the term loans
(including $50 million under the capital markets term loan) and $57.5 million
under the revolving credit facility. The Company used $17.3 million of the
revolving credit facility to replace existing letters of credit. Between the
closing of the SBCL acquisition and the end of the third quarter of 1999, the
Company repaid the entire amount borrowed at closing under the revolving
credit facility. The new credit facility is secured by substantially all
tangible and intangible assets of the Company and by a guaranty from, and a
pledge of all capital stock and tangible and intangible assets of, all of the
Company's present and future wholly owned domestic subsidiaries other than
certain joint ventures. The borrowings under the new credit agreement rank
senior in priority of repayment to any subordinated indebtedness. Interest is
based on certain published rates plus an applicable margin which will vary
depending on the financial performance of the Company. The applicable margin
will be reduced by 25 basis points after the repayment of the capital markets
term loan. The credit agreement requires the Company to maintain interest
rate hedge agreements covering a notional amount of not less than 50% of the
principal amount outstanding of its net funded debt. The credit agreement
contains various covenants and conditions including the maintenance of
certain financial ratios and tests, and restricts the ability of the Company
to, among other things, incur additional indebtedness and pay dividends on
its common stock.
On May 25, 1999, Quest Diagnostics commenced an offer to purchase all of
its existing 10 3/4% notes with the proceeds from an offering of new senior
subordinated notes. Due to unsatisfactory conditions in the high yield market,
the Company decided not to proceed with its planned offering of new senior
subordinated notes. The tender offer to purchase its existing 10 3/4% notes
expired on September 16, 1999.
The Company believes the financing under the new credit facility will
provide sufficient financial flexibility and access to funds to finance the
costs to integrate the businesses of Quest Diagnostics and SBCL, 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 indemnifications by Corning and SmithKline
Beecham against monetary fines, penalties or losses from outstanding government
and other related claims, will enable it to generate strong cash flows.*
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.*
HISTORICAL RESULTS OF OPERATIONS
Net income before an extraordinary loss and special charges incurred in
connection with the SBCL acquisition for the third quarter of 1999 increased to
$10.9 million from $6.1 million in the prior year. Net income before an
extraordinary loss and special charges incurred in connection with the SBCL
- ----------
* 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.
17
<PAGE>
acquisition for the nine months ended September 30, 1999 increased to $31.4
million, compared to $21.5 million in the prior year period. These increases are
primarily due to improved operating performance of the Company prior to the
acquisition of SBCL. After special charges of $30.3 million and an extraordinary
loss, net of taxes, of $2.1 million incurred in connection with the acquisition,
the Company reported net income (loss) for the three and nine months ended
September 30, 1999 below the 1998 levels. Net income for the nine months ended
September 30, 1999 includes $1.9 million of interest income ($1.2 million, net
of tax) associated with a favorable state tax settlement. Net income for the
nine months ended September 30, 1998 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.
Results for the three and nine months ended September 30, 1999 include
the effects of testing performed by third parties under the Company's
laboratory network management arrangements. As laboratory network manager,
Quest Diagnostics includes in its consolidated revenues and expenses the cost
of testing performed by third parties. This impacts the comparability of
revenues and expenses for 1999 as compared to 1998 and added $26.2 million
and $59.0 million to both reported revenues and expenses for the three and
nine months ended September 30, 1999, respectively. This treatment also
serves to increase cost of services as a percentage of net revenues and
decreases selling, general and administrative expenses as a percentage of net
revenues.
NET REVENUES
Excluding the effect of the testing performed by third parties under the
Company's laboratory network management arrangements, net revenues for the three
and nine months ended September 30, 1999 increased $227.9 million and $236.4
million, respectively, over the prior year period. Excluding the impact of the
SBCL acquisition and the third party testing performed under the Company's
laboratory network management arrangements, net revenues for the three and nine
months ended September 30, 1999 increased 5.9% and 2.7%, respectively,
principally due to an increase in average revenue per requisition.
COSTS AND EXPENSES
Total operating costs for the third quarter and the nine months ended
September 30, 1999, excluding the effect of testing performed by third parties
under the Company's laboratory network management arrangements, increased from
the year earlier periods. The increases are due primarily to the acquisition of
SBCL. Operating costs and expenses for 1998 included a first quarter charge of
$2.5 million ($1.2 million, net of tax) in selling, general and administrative
expenses that represented the final costs associated with the Company's
consolidation plan announced in December 1997.
The following discussion and analysis regarding cost of services,
selling, general and administrative expenses and bad debt expense exclude the
effect of testing performed by third parties under the Company's laboratory
network management arrangements, which serve to increase cost of services as
a percentage of net revenues and reduce selling, general and administrative
expenses as a percentage of net revenues. Cost of services, which includes
the costs of obtaining, transporting and testing specimens, decreased during
the third quarter as a percentage of net revenues to 58.3% from 58.5% a year
ago. Cost of services for the nine months ended September 30, 1999, decreased
as a percentage of net revenues to 57.3% from 59.0% in the prior year. These
decreases are primarily attributable to an 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, decreased during the quarter as a
percentage of net revenues to 32.7% from 34.0% in the prior year. While
selling, general and administrative expenses contain a relatively high level
of costs which do not increase at the same rate as revenues are increased,
during the third quarter of 1999 bad debt expense increased to 7.1% of net
revenues from 6.2% of net revenues in the prior year. The increase in bad
debt expense is principally attributable to SBCL's collection experience
which is lower than Quest Diagnostics' historical experience. A significant
portion of the difference in collection experience is due to Quest
Diagnostics' processes in the billing area, most notably the
18
<PAGE>
processes around the collection of diagnosis, patient and insurance
information necessary to effectively bill for services performed. The Company
believes that opportunities exist to share internal best practices in the
billing functions in order to drive down SBCL's historical bad debt
percentage.* For the nine months ended September 30, 1999, selling, general
and administrative expenses increased as a percentage of net revenues to
33.9% from 32.8% in the prior year. These increases were principally due to
additional investments in information technology and sales and marketing
capabilities, litigation expenses and employee compensation costs, including
severance. For the nine months ended September 30, 1999, bad debt expense was
6.1% of net revenues which is consistent with the prior year.
Net interest expense increased from the prior year by $10.6 million and
$4.8 million for the three and nine months ended September 30, 1999,
respectively. Net interest expense for the nine months ended September 30, 1999
included $1.9 million of interest income associated with a favorable state tax
settlement. The increase in net interest expense is primarily attributable to
the amounts borrowed under the new credit facility in conjunction with the SBCL
acquisition.
Amortization of intangible assets increased from the prior year by $2.3
million and $1.8 million for the three and nine months ended September 30, 1999,
respectively, principally as a result of the SBCL acquisition.
During the three and nine months ended September 30, 1999, the Company
recorded special charges totaling $30.3 million ($18.2 million, net of tax),
incurred in connection with the acquisition of SBCL. Of the total, $19.8 million
represents stock based employee compensation related to special one-time grants
of the Company's common stock to certain individuals of the combined company of
$17.8 million, and accelerated vesting, due to the completion of the SBCL
acquisition, of restricted stock grants made in previous years totaling $2.0
million. In addition, the Company incurred $9.2 million of professional and
consulting fees related to integration planning activities. The remainder of the
charge is related to costs incurred by the Company in conjunction with its
planned offering of new senior subordinated notes, the proceeds of which were
expected to be used to repay the Company's existing 10 3/4% senior subordinated
notes. Due to unsatisfactory conditions in the high yield market, the Company
decided not to proceed with the offering.
Other, net for the three and nine months ended September 30, 1999 increased
from the prior year level, primarily due to an increase in minority partners'
share of income.
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.
In conjunction with the acquisition of SBCL, the Company repaid the entire
amount outstanding under its then existing credit agreement. The extraordinary
loss recorded in the third quarter of 1999 represents $3.6 million ($2.1
million, net of tax) of deferred financing costs written off in connection with
the extinguishment of the related credit agreement.
ADJUSTED EBITDA
Adjusted EBITDA represents earnings before interest, taxes, depreciation
and amortization, excluding special items. Adjusted EBITDA for the three months
ended September 30, 1999 improved to $67.8 million, or 11.5% of net revenues
(adjusted for testing performed by third parties under the
- ----------
* 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.
19
<PAGE>
Company's laboratory network management arrangements), from $37.6 million, or
10.4% of net revenues, in the prior year period. Adjusted EBITDA for the nine
months ended September 30, 1999 was $151.9 million, or 11.4% of net revenues
(adjusted for testing performed by third parties under the Company's laboratory
network management arrangements), compared to $124.7 million last year, or 11.4%
of net revenues in the prior year period. Increases in Adjusted EBITDA were
principally associated with the SBCL acquisition, and to a lesser extent
improvements in the operating performance of the Company prior to the
acquisition of SBCL.
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 September 30, 1999 and December 31, 1998, the fair value of the
Company's debt was estimated at approximately $1,274 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
September 30, 1999 and December 31, 1998 by approximately $6 million and $15
million, respectively. An assumed 10% increase in interest rates (representing
approximately 90 basis points) would potentially reduce the fair value of the
Company's debt by approximately $8 million and $9 million at September 30, 1999
and December 31, 1998, respectively.
The Company had approximately $1,110 million of variable interest rate
debt outstanding at September 30, 1999. An assumed 10% increase in interest
rates (representing approximately 60 basis points) would result in a $3 million
reduction in the Company's after-tax earnings and cash flows
for the nine months ended September 30, 1999 based on debt levels as of
September 30, 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 September 30, 1999 totaled $36.8 million, a
decrease of $166.1 million from December 31, 1998. The decrease is primarily
associated with the acquisition and financing of the transaction with
SmithKline Beecham and the repayment of the entire amount outstanding under
the Company's then existing credit agreement. Cash flows from operating and
financing activities provided cash of $186.5 million and $733.0 million,
respectively, which was offset by investing activities which required cash of
$1,085.5 million. Cash and cash equivalents at September 30, 1998 increased
from December 31, 1997 by $19.3 million 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 from operating activities for 1999 was $82.0 million higher than
the 1998 level. The impact of the SBCL acquisition on earnings before the
extraordinary loss and special charges, along with decreased payments associated
with restructuring and other special charges, and changes in accounts payable
and accrued expenses and other assets and liabilities, increased net cash
provided by operations in 1999. The impact of these changes was partially offset
by changes in the Company's deferred tax position and amounts due from Corning.
20
<PAGE>
Increased spending on investing activities is principally related to the
acquisition of SBCL including transaction costs associated with the acquisition.
Capital spending for the nine months ended September 30, 1999 was $47.5 million
compared to $27.9 million for the same period in the prior year. The Company
estimates that it will invest approximately $15 million to $25 million during
the remainder of 1999 for capital expenditures, principally related to
investments in information technology infrastructure and equipment and facility
upgrades. * The increase in investments during the nine months ended September
30, 1999 is principally associated with investments to fund certain benefit
plans and contributions to the Company's Arizona joint venture.
During the third quarter of 1999, the Company borrowed $1,132.5 million,
including $57.5 million under its new revolving credit facility, to fund the
cash purchase price and related transaction costs of the SBCL acquisition,
and to repay the entire amount outstanding under its then existing credit
agreement. During the nine months ended September 30, 1999, the Company
repaid $361.3 million of debt. Of this amount, $57.5 million represented the
repayment, in the third quarter of 1999, of the entire amount borrowed by the
Company under its new revolving credit facility at the closing of the SBCL
acquisition. The remaining amount of $303.8 million was principally
associated with the repayment of amounts outstanding under its then existing
credit agreement. Other than the reduction for outstanding letters of
credit, which currently approximate $17.3 million, all of the revolving
credit facility was available for borrowing. During the nine months ended
September 30, 1999, the Company paid $36.8 million of costs associated with
the financing of the transaction with SmithKline Beecham, distributed $2.6
million to minority partners, repurchased $1.1 million of its common stock
and received approximately $2.0 million in proceeds from the exercise of
stock options.
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 September 30, 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 on January 15, 1999.
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.
Quest Diagnostics commenced its Year 2000 readiness program in 1997.
Similar to Quest Diagnostics, SmithKline Beecham initiated a plan to address
the Year 2000 issue in 1996. SBCL followed the methodology prescribed by its
parent, SmithKline Beecham. A description and the status of SBCL's Year 2000
readiness program is presented below.
- ----------
* 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.
21
<PAGE>
YEAR 2000 READINESS PROGRAM OF QUEST DIAGNOSTICS, EXCLUSIVE OF THE SBCL
OPERATIONS
Quest Diagnostics has established a dedicated project team to implement the
program. In order to address the Year 2000 issue, Quest Diagnostics 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 and
assessment phase, for all equipment and software supplied by vendors who have
responded to Quest Diagnostics' inquiries, is complete. Also Quest Diagnostics
has completed nearly 99% of the activities for phases three, four and five of
its Year 2000 plan. The remaining activities are scheduled for completion during
the fourth quarter of 1999. Contingency plans have been completed for those
vendors that have not responded or have not indicated a Year 2000 ready status.
APPLICATIONS - Includes all application software including, but not limited to,
Quest Diagnostics' clinical laboratory systems, financial systems, billing
systems, human resources systems, purchasing systems and customer interface
systems. The inventory and assessment phases for all applications are complete.
Quest Diagnostics is in the process of repairing, replacing or upgrading
non-compliant code, testing for compliance and implementing certified systems.
Approximately 99% of the overall effort is completed with a scheduled completion
during November 1999.
LABORATORY INSTRUMENTS - Includes all clinical diagnostic instrumentation in the
testing facilities. The inventory and assessment phases, for all vendors has
been completed. Quest Diagnostics is in the process of repairing, replacing or
upgrading non-compliant instrumentation and testing for compliance.
Approximately 99% of all instruments are Year 2000 ready and Quest Diagnostics
expects to be 100% compliant by the end of November of 1999.
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 and assessment phases, for all
vendor responses received, is complete. Quest Diagnostics has completed 82%
of the activities for phases three, four and five of its Year 2000 plan.
Contingency plans have been created for those vendors that have not responded
or have not indicated a Year 2000 ready status. However, there are a
significant number of service providers and property vendors who will not be
compliant until late in the fourth quarter 1999. Quest Diagnostics continues
to monitor the progress of these third parties towards Year 2000 readiness.
DESKTOP ENVIRONMENT - Includes the personal computer hardware and operating
systems. The inventory and assessment phases are complete. An outside vendor was
selected and retained to coordinate the desktop replacement program. The rollout
is 100% complete.
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. Quest Diagnostics 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 purchased
items identified as critical to the company's mission. These mission critical
items, to the extent possible, will be inventoried in sufficient quantity
either at supplier or company facilities to assure product availability
through the first weeks of 2000, and have been agreed to with the applicable
suppliers.
PAYERS - Includes the process of contacting each critical payer (i.e. Medicare,
Medicaid, commercial insurance carriers) regarding their plans and progress in
addressing the Year 2000 problem. All critical payers have been identified and
Quest Diagnostics is in the process of assessing the state of readiness for all
22
<PAGE>
responses received. Contingency plans have been developed for all payers and
suppliers identified as critical to the company's mission as well as for those
vendors that have not responded to our requests. Quest Diagnostics' goal is to
perform final reviews of the contingency plans in the fourth quarter of 1999.
YEAR 2000 READINESS PROGRAM OF SBCL
The methodology followed by SBCL included the following four phase
approach:
(1) Assessment and Strategy - Determine the scale of the problem and
solutions for its resolution; (2) Detailed Analysis and Planning - Identify
Year 2000 code and data changes to plan their implementation; (3)
Implementation - Change and test Year 2000 code / data, including
certification on dedicated time machines where system dates are rolled
forward; and (4) Ongoing Compliance Management - Prevent re-introduction of
Year 2000 problems.
This approach was common for each of the following seven major partitions:
APPLICATIONS - Includes all applications software including, but not limited to,
SBCL's clinical laboratory system, billing system, financial applications,
hospital lab system, corporate health system, clinical trials system and managed
care eligibility systems. Compliant code for all applications have been returned
to production and certified. These applications continue to be reviewed under
the Ongoing Compliance Management program.
INFRASTRUCTURE - Includes computer hardware, operating system and system
software. Hardware and system software components supporting production
applications have been upgraded and tested.
TELECOMMUNICATION - Includes voice and data network components. Implementation
of upgrades to all telecom components at laboratory and administrative
facilities is complete.
LABORATORY INSTRUMENTS - Includes all clinical diagnostic instrumentation in the
testing facilities. 91% of the instruments have been certified for Year 2000
readiness. SBCL continues to repair, replace, upgrade and re-test those
instruments found to be non-compliant.
FACILITIES - Includes all building support systems (e.g. heating and cooling,
power, elevators) . The Analysis and Planning phase for these systems is
complete. 94% of the facilities systems are compliant. The remaining systems are
in the process of being upgraded and are expected to be completed by the end of
November 1999.
DESKTOP ENVIRONMENT - Includes personal computer hardware, operating system and
end user software. All desktop hardware has been tested for Year 2000
compliance. Full implementation of a Year 2000 compliant desktop operating
system, software and e-mail to all networked workstations is complete.
EXTERNAL RELATIONSHIP INITIATIVE - The goal of this initiative is to evaluate
the Year 2000 readiness of all external partners. The same three phase approach
was followed for all categories of partners, as listed below. These phases are
1) Inventory and Prioritization, 2) Communication and Assessment, 3) Mitigation.
SUPPLIERS - The inventory phase and the assessment phases for all
supplier responses received is complete. Critical suppliers were
identified and warranty statements were received from them. The
supplier database has been integrated with the Quest Diagnostics
database. These suppliers are being included in the compliance and
contingency planning processes being employed by Quest Diagnostics
under its Year 2000 readiness program.
23
<PAGE>
CUSTOMERS - The inventory and prioritization and communication phases
to all high priority customers has been completed. Survey responses are
being evaluated. In addition, informational brochures have been sent to
all requesting clients.
ELECTRONIC COMMERCE - SBCL has communicated with every external
partner who is a recipient and /or originator of files interfaced to
SBCL systems. 98% of these interfaces are compliant. SBCL is
currently working directly with our business partners to test the
remaining 2% with an expected completion by the end of November 1999.
YEAR 2000 READINESS DISCLOSURE - COMBINED COMPANY
Although each of the above areas for both Quest Diagnostics and SBCL is at
a different stage of readiness, the Company has made significant progress to
date towards completing its plans under its Year 2000 readiness programs. The
Year 2000 readiness programs 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 programs. 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 the combined Company's 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 fourth 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 10% to 15% 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." More recently, HCFA stated that their systems and their contractors'
systems supporting Medicare are compliant, tested and certified with respect to
Year 2000.
While the Company believes that its Year 2000 readiness programs
significantly reduce 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 susceptible systems, non-compliance by
third-parties whose systems impact the Company, and other similar uncertainties.
Concurrent with the plans described above, the Company has developed
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. Within Quest Diagnostics' and SBCL's separate operations, most of
the
- ------------------
* THESE ARE FORWARD-LOOKING STATEMENTS, SEE ITEM 1. "BUSINESS--CAUTIONARY
STATEMENT FOR PURPOSES OF THE 'SAFE HARBOR' PROVISIONS OF THE PRIVATE
SERCURITIES LITIGATION REFORM ACT OF 1995" CONTAINED IN THE COMPANY'S
1998 ANNUAL REPORT ON FORM 10-K.
24
<PAGE>
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. The contingency plans and related
cost estimates will be continually refined as additional information becomes
available with final reviews in the fourth quarter of 1999. *
Costs incurred through September 30, 1999 related to the Company's Year
2000 readiness programs approximated $62 million, of which approximately $28
million was capitalized. Current estimates of the remaining costs are
approximately $12 million to $20 million, of which approximately 40% to 50% 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.*
PRO FORMA COMBINED FINANCIAL INFORMATION
The following pro forma combined financial information assumes that the
SBCL acquisition and borrowings under the new credit facility were effected on
the earliest period presented. The Stock and Asset Purchase Agreement includes a
provision for a purchase price adjustment based on an audit of the August 16,
1999 combined balance sheet of SBCL and certain affiliates. Adjustments
resulting from this audit, which are subject to resolution as set forth in the
Stock and Asset Purchase Agreement, have been recorded in the pro forma combined
financial information to the extent that the Company believes they are
applicable. The pro forma combined financial information reflects the
preliminary allocation of purchase price. The allocation will be finalized after
completion of the valuation of certain assets and liabilities, the recording of
the integration costs related to SBCL's assets, liabilities and employees, and
the final resolution of the purchase price adjustment. There can be no
assurances that the amounts reflected in the pro forma combined financial
information will not be subject to change as a result of changes in the
allocation of the purchase price, including the resolution of the purchase price
adjustment.
The pro forma combined financial information is presented for illustrative
purposes only to analyze the financial implications of the SBCL acquisition and
borrowings under the new credit facility. The pro forma combined financial
information may not be indicative of the combined financial results of
operations that would have been realized had Quest Diagnostics and SBCL been a
single entity during the periods presented. In addition, the pro forma combined
financial information is not necessarily indicative of the future results that
the combined company will experience.
Significant pro forma adjustments reflected in the pro forma combined
information include reductions in employee benefit costs, and general corporate
overhead allocated to the historical results of SBCL by SmithKline Beecham,
offset by an increase in net interest expense to reflect the Company's new
credit facility which was used to finance the SBCL acquisition. Amortization of
the goodwill, which accounts for a majority of the acquired intangible assets,
is calculated on the straight-line basis over forty years. Other, net has been
adjusted to remove SBCL's non-recurring gains from the sale and license of
certain technology and its physician office-based teleprinter assets and
network. Income taxes have been adjusted for the estimated income tax impact of
the pro forma adjustments at the incremental tax rate of 40%. A significant
portion of the intangible assets acquired in the SBCL acquisition is not
deductible for tax purposes which has the overall impact of increasing the
effective tax rate.
- ----------
* 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.
25
<PAGE>
PRO FORMA COMBINED FINANCIAL INFORMATION
<TABLE>
<CAPTION>
QUARTER ENDED
----------------------------------------------------------------------------------------------------
SEPTEMBER DECEMBER SEPTEMBER
MARCH 31, JUNE 30, 30, 31, MARCH 31, JUNE 30, 30,
1998 1998 1998 1998 1999 1999 1999
------------- ------------- ------------- ------------ ------------- ------------ -------------
PRO FORMAS (in thousands, except per share data)
(unaudited)
<S> <C> <C> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS
DATA:
Net revenues................. $ 737,280 $ 744,154 $ 766,625 $ 779,724 $ 823,450 $ 837,533 $ 819,301
Costs and expenses:
Cost of services............ 438,360 458,635 452,719 464,130 514,170 527,692 501,153
Selling, general and 233,847
administrative............. 224,019 248,467 253,344 248,495 262,169 254,447
Interest expense, net....... 31,700 31,733 31,653 31,466 31,680 29,723 31,186
Amortization of intangible 11,143
assets..................... 11,128 11,293 11,183 10,856 10,982 11,160
Special charges............. -- -- -- -- -- 15,813 30,282
Other, net.................. (6,344) (227) 405 (211) 1,136 1,597 409
------------ ------------ ----------- ----------- ----------- ---------- -----------
Total...................... 708,706 725,288 744,537 759,912 806,337 847,976 828,637
------------ ------------ ----------- ----------- ----------- ---------- -----------
Income (loss) before taxes
and extraordinary loss.... 28,574 18,866 22,088 19,812 17,113 (10,443) (9,336)
Income tax expense (benefit). 14,666 10,955 11,307 9,869 8,885 (1,573) 805
------------ ------------ ----------- ----------- ----------- ---------- -----------
Income (loss) before
extraordinary loss........ 13,908 7,911 10,781 9,943 8,228 (8,870) (10,141)
Extraordinary loss, net of
taxes -- -- -- -- -- -- (2,139)
------------ ------------ ----------- ----------- ----------- ---------- -----------
Net income (loss)............ $ 13,908 $ 7,911 $ 10,781 $ 9,943 $ 8,228 $ (8,870) $ (12,280)
=========== =========== =========== ========== =========== ========== ===========
Income before extraordinary
loss and special charges $ 13,908 $ 7,911 $ 10,781 $ 9,943 $ 8,228 $ 617 $ 8,029
- ---------------------------------------------------------------------------------------------------------------------------------
Basic earnings (loss) per
common share:
Net income (loss) $ 0.32 $ 0.18 $ 0.25 $ 0.23 $ 0.19 $ (0.21) $ (0.28)
Income (loss) before
extraordinary loss $ 0.32 $ 0.18 $ 0.25 $ 0.23 $ 0.19 $ (0.21) $ (0.23)
Income before extraordinary
loss and special charges.. $ 0.32 $ 0.18 $ 0.25 $ 0.23 $ 0.19 $ 0.01 $ 0.18
Cash earnings before
extraordinary loss and
special charges (a)....... $ 0.56 $ 0.42 $ 0.49 $ 0.47 $ 0.42 $ 0.24 $ 0.42
Weighted average common
shares outstanding - basic. 43,035 43,130 43,033 42,925 43,044 43,248 43,435
- ---------------------------------------------------------------------------------------------------------------------------------
Diluted earnings (loss) per
common share:
Net income (loss) $ 0.32 $ 0.18 $ 0.25 $ 0.23 $ 0.19 $ (0.21) $ (0.28)
Income (loss) before
extraordinary loss $ 0.32 $ 0.18 $ 0.25 $ 0.23 $ 0.19 $ (0.21) $ (0.23)
Income before extraordinary
loss and special charges.. $ 0.32 $ 0.18 $ 0.25 $ 0.23 $ 0.19 $ 0.01 $ 0.18
Cash earnings before
extraordinary loss and
special charges (a)....... $ 0.55 $ 0.41 $ 0.48 $ 0.46 $ 0.42 $ 0.24 $ 0.41
Weighted average common
shares outstanding -
diluted.................... 43,309 43,881 43,434 43,136 43,506 43,933 44,228
- ---------------------------------------------------------------------------------------------------------------------------------
Adjusted EBITDA (b).......... $ 87,485 $ 82,306 $ 84,638 $ 75,909 $ 80,667 $ 85,016 $ 86,599
</TABLE>
(a) Cash earnings represents income before extraordinary loss, special charges
and amortization of intangible assets, net of applicable taxes. Cash
earnings per common share is calculated as cash earnings less preferred
dividends, divided by weighted average common shares outstanding.
(b) Pro forma adjusted EBITDA represents earnings before interest, taxes,
depreciation and amortization, excluding special items including other
income and expense items recorded by SBCL prior to the closing of the
acquisition, which have not been reflected on the face of the pro forma
financial information. These other income and expense items impact the
overall comparability of the pro forma results for 1999 and 1998.
PRO FORMA COMBINED RESULTS OF OPERATIONS
On a pro forma basis, assuming that SBCL had been acquired by Quest
Diagnostics on January 1, 1998, net income before an extraordinary loss and
special charges was $8.0 million in the third quarter of 1999, compared to
$10.8 million in 1998. For the nine months ended September 30, 1999, net
income before an extraordinary loss and special charges was $16.9 million,
compared to $32.6 million for the prior year period. These declines were
primarily due to certain other income and expense items, recorded in SBCL's
historical financial statements prior to the closing of the acquisition,
which have not been separately reflected on the face of the pro forma
financial information. These other income and expense items impact the
overall comparability of the pro forma results for 1999 and 1998. Pro forma
results for
26
<PAGE>
the third quarter of 1999 included $3.2 million ($1.9 million, net of tax) of
such expense items, principally associated with cumulative adjustments under
certain customer contracts. The 1998 period included $.6 million ($.4
million, net of tax) of non-recurring income. The nine months ended September
30, 1999 and 1998 included incremental expense and pre-tax profits of $24.2
million and $7.2 million, respectively. Approximately $11 million of the
incremental expenses resulted from adjustments, recorded by SBCL prior to the
closing of the acquisition, to accrued liabilities necessary to properly
present the closing balance sheet of SBCL. These adjustments impacted
comparability because they resulted in an overstatement of expenses for the
period presented. Additionally, approximately $7 million related to losses
incurred under a loss contract, and approximately $6 million related to
charges associated with two incidents, the costs of which SmithKline Beecham
is obligated to indemnify Quest Diagnostics. The most significant of these
incidents related to an SBCL employee who allegedly reused certain needles
when drawing blood from patients. The pre-tax profit of $7.2 million included
in the nine months ended September 30, 1998 primarily represented the
favorable settlement of a contract dispute. Excluding the impact of these
items in both years would result in income before an extraordinary loss and
special charges of $31.4 million for the nine months ended September 30,
1999, and $28.3 million for the nine months ended September 30, 1998. This
increase was primarily due to $1.9 million of interest income ($1.2 million,
net of tax), associated with a favorable state tax settlement in 1999, and a
$2.5 million charge ($1.2 million, net of tax) recorded in 1998 within
selling, general and administrative expenses that represented the final costs
associated with the Company's consolidation plan announced in December 1997.
Pro forma results for the three and nine months ended September 30, 1999
included the effects of testing performed by third parties under the Company's
laboratory network management arrangements which added $37.5 million and $121.8
million to reported revenues and expenses for the three and nine months ended
September 30, 1999, respectively.
PRO FORMA NET REVENUES
Excluding the effect of the testing performed by third parties under the
Company's laboratory network management arrangements, pro forma net revenues for
the third quarter increased by $15.2 million, or 2.0% from the prior year level
due to improvements in both average revenue per requisition and volume of
clinical testing of 1.8% and 2.9%, respectively, partially offset by a reduction
in revenues of 2.6% associated with the treatment in 1999 of a customer contract
as a loss contract. Such accounting treatment resulted in the exclusion of the
revenues and expenses associated with the contract from operating results. Pro
forma net revenues for the nine months ended September 30, 1999 (excluding the
effect of the testing performed by third parties under the Company's laboratory
network management arrangements) increased $110.4 million or 4.9% from the prior
year level. This increase was principally due to a 4.5% improvement in average
revenue per requisition, and an increase in clinical testing volume of .4%.
Prior to the acquisition of SBCL, Quest Diagnostics experienced increases
in average revenue per requisition due primarily to a number of factors,
including: a shift from capitated volume to fee-for-service volume; contract
renewals and new business negotiated on more favorable terms as part of its
account profitability strategy; and higher value-added test offerings. The
increase in average revenue per requisition experienced by Quest Diagnostics was
partially offset by declines in average revenue per requisition related to the
growth in managed care business at SBCL. The improvements in volume were
primarily attributable to the growth in managed care business at SBCL, partially
offset by volume declines at Quest Diagnostics reflecting the impact of
increased competition for managed care business, actions taken on unprofitable
accounts and severe weather in the first quarter of 1999 in certain service
areas.
27
<PAGE>
PRO FORMA COSTS AND EXPENSES
The following discussion and analysis regarding pro forma operating
costs, including cost of services, selling, general and administrative
expenses and bad debt expense exclude the effect of testing performed by
third parties under the Company's laboratory network management arrangements
and the treatment of a customer contract as a loss contract. Total pro forma
operating costs for the three and nine months ended September 30, 1999
increased by $36.0 million and $132.5 million, respectively, from the year
earlier periods. As discussed above, operating costs included certain other
expense items, recorded in SBCL's historical financial statements prior to
the closing of the acquisition, which have not been separately reflected on
the face of the pro forma financial information, which partially contributed
to the increases. Operating costs and expenses for 1998 included a first
quarter charge of $2.5 million ($1.2 million, net of tax) 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 and the nine months ended
September 30, 1999, principally due to additional investments in information
technology and sales and marketing capabilities, and employee compensation
costs, including severance.
Cost of services increased during the third quarter as a percentage of
net revenues to 59.3% from 58.1% a year ago. Cost of services for the nine
months ended September 30, 1999 and 1998 was 59.3%. Included in cost of
services for the three and nine months ended September 30, 1999, were $1.9
million and $7.8 million, respectively, of certain other expense items
recorded by SBCL prior to the closing of the acquisition which have not been
separately presented, as discussed above.
During the third quarter of 1999, selling, general and administrative
expenses were 32.5%, compared to 33.2% in the prior year. This decrease was due
primarily to a reduction in bad debt expense which decreased to 7.6% of net
revenues from 8.8% of net revenues in the prior year. For the nine months ended
September 30, 1999, selling, general and administrative expenses increased as a
percentage of net revenues to 33.0% from 31.9% in the prior year. The increase
was principally due to additional investments in information technology and
sales and marketing capabilities, litigation expenses and employee compensation
costs, including severance. For the nine months ended September 30, 1999, bad
debt expense was 7.6% of net revenues, compared to 7.8% in the prior year
period.
Adjusted to exclude the testing performed by third parties under the
Company's laboratory network management arrangements and the treatment of a
customer contract as a loss contract, the number of days sales outstanding, a
measure of billing and collection efficiency, was 58.7 days at September 30,
1999, compared to 64.1 days a year ago and 61.9 days at the end of the second
quarter of 1999.
Net interest expense decreased from the prior year by $.5 million and $2.5
million for the three and nine months ended September 30, 1999, respectively.
Net interest expense for the nine months ended September 30, 1999 included $1.9
million of interest income associated with a favorable state tax settlement.
During the three and nine months ended September 30, 1999, the Company
recorded special charges totaling $30.3 million ($18.2 million, net of tax) and
$46.1 million ($27.7 million, net of tax), respectively, primarily incurred in
connection with the acquisition of SBCL. Of the total special charge recorded in
the third quarter of 1999, $19.8 million represented stock based employee
compensation of $17.8 million, related to special one-time grants of the
Company's common stock to certain individuals of the combined company, and
accelerated vesting, due to the completion of the SBCL acquisition, of
restricted stock grants made in previous years totaling $2.0 million. In
addition, the Company incurred $9.2 million of professional and consulting fees
related to integration planning activities. The remainder of the third quarter
charge was related to costs incurred by the Company in conjunction with its
planned offering of new senior subordinated notes, the proceeds of which were
expected to be used to repay the Company's existing 10 3/4% senior subordinated
notes. Due to unsatisfactory conditions in the high yield
28
<PAGE>
market, the Company decided not to proceed with the offering. The nine months
ended September 30, 1999 included an additional charge of $15.8 million in the
second quarter, primarily to record (on a pro forma basis) a loss provision to
the results of SBCL to reflect a customer contract as a loss contract.
Other, net for the nine months ended September 30, 1999 increased by $9.3
million, as compared to the prior year period, primarily due to a favorable
settlement of a contract dispute in 1998 of $7.2 million and an increase in
minority partners' share of income in 1999.
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.
In conjunction with the acquisition of SBCL, the Company repaid the entire
amount outstanding under its then existing credit agreement. The extraordinary
loss recorded in the third quarter of 1999 represents $3.6 million ($2.1
million, net of tax) of deferred financing costs written off in connection with
the extinguishment of the related credit agreement.
PRO FORMA ADJUSTED EBITDA
Pro forma adjusted EBITDA represents earnings before interest, taxes,
depreciation and amortization, excluding special items. Special items include
not only the special charges reflected on the face of the pro forma financial
information but also the other income and expense items recorded by SBCL prior
to the closing of the acquisition, which have been discussed earlier. Pro forma
adjusted EBITDA for the three months ended September 30, 1999 improved to $86.6
million, or 11.1% of net revenues (adjusted to exclude the effects of the
testing performed by third parties under the Company's laboratory network
management arrangements and the loss contract), from $84.6 million, or 11.3% of
net revenues, in the prior year period. Pro forma adjusted EBITDA for the nine
months ended September 30, 1999 was $252.3 million, or 10.9% of net revenues
(adjusted to exclude the effects of the testing performed by third parties under
the Company's laboratory network management arrangements and the loss contract),
compared to $254.4 million, or 11.5% of net revenues in the prior year period.
29
<PAGE>
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
There have been no material developments in any of the government
investigations or private claims reported. See Note 4 to the interim
consolidated financial statements for information regarding claims related to
SBCL.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
EXHIBIT NUMBER DESCRIPTION
27 Financial Data Schedule
(b) Reports on Form 8-K:
The Registrant has filed the following Current Report on Form 8-K
during the quarter ended September 30, 1999:
Current Report on Form 8-K (Date of Report: August 16, 1999) filed on
August 31, 1999
The Current Report on Form 8-K (dated August 16, 1999) which was filed
on August 31, 1999, reported that on August 16, 1999, the Company
completed the acquisition of the clinical laboratory business of
SmithKline Beecham for approximately $1.3 billion. The Current Report
provided a description of the business acquired and the manner in
which the purchase price was financed, including a description of
the Company's new credit facility.
Amendment No.1 to the Current Report on Form 8-K (Date of Report:
August 16, 1999) which was filed on November 1, 1999, amended Item 7
in its entirety to include the financial statements of the business
acquired as well as the pro forma financial information required under
Item 7.
30
<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 12, 1999
Quest Diagnostics Incorporated
By /s/ Kenneth W. Freeman Chairman of the Board and
------------------------------- Chief Executive Officer
Kenneth W. Freeman
By /s/ Robert A. Hagemann Corporate Vice President and
------------------------------- Chief Financial Officer
Robert A. Hagemann
31
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