<PAGE>
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
--------------------------------------------------------------------------------
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the Quarter ended June 30, 2000
Commission file number 1-12215
QUEST DIAGNOSTICS INCORPORATED
One Malcolm Avenue
Teterboro, NJ 07608
(201) 393-5000
DELAWARE
(State of Incorporation)
16-1387862
(I.R.S. Employer Identification Number)
--------------------------------------------------------------------------------
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
--- ---
As of July 26, 2000, there were outstanding 45,673,949 shares of Common Stock,
$.01 par value.
<PAGE>
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
Index to consolidated financial statements filed as part of this report:
<TABLE>
<CAPTION>
Page
<S> <C>
Consolidated Statements of Operations for the
Three and Six Months Ended June 30, 2000 and 1999 2
Consolidated Balance Sheets as of
June 30, 2000 and December 31, 1999 3
Consolidated Statements of Cash Flows for the
Six Months Ended June 30, 2000 and 1999 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 18
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 SIX MONTHS ENDED JUNE 30,
2000 AND 1999
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------------------- -------------------------------
2000 1999 2000 1999
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
NET REVENUES...................................... $ 877,113 $ 394,034 $ 1,734,592 $ 775,875
------------ ------------ ------------ ------------
COSTS AND EXPENSES:
Cost of services................................ 520,437 236,071 1,049,474 473,478
Selling, general and administrative............. 252,846 121,230 502,681 237,831
Interest expense, net........................... 30,204 5,008 59,967 12,367
Amortization of intangible assets............... 11,954 5,219 23,894 10,313
Provision for special charges................... 2,100 - 2,100 -
Minority share of income........................ 3,240 1,471 5,376 2,601
Other, net...................................... (1,881) 528 (2,309) 700
------------ ------------ ------------ ------------
Total......................................... 818,900 369,527 1,641,183 737,290
------------ ------------ ------------ ------------
INCOME BEFORE TAXES................................ 58,213 24,507 93,409 38,585
INCOME TAX EXPENSE ................................ 28,045 11,420 45,432 18,065
------------ ------------ ------------ ------------
NET INCOME ........................................ $ 30,168 $ 13,087 $ 47,977 $ 20,520
============ ============ ============ ============
BASIC NET INCOME PER COMMON SHARE.................. $ 0.68 $ 0.44 $ 1.08 $ 0.69
DILUTED NET INCOME PER COMMON SHARE................ $ 0.64 $ 0.43 $ 1.03 $ 0.67
WEIGHTED AVERAGE COMMON SHARES
OUTSTANDING - BASIC............................. 44,577 29,920 44,354 29,819
WEIGHTED AVERAGE COMMON SHARES
OUTSTANDING - DILUTED........................... 46,981 30,729 46,299 30,505
</TABLE>
The accompanying notes are an integral part of these statements.
2
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
JUNE 30, 2000 AND DECEMBER 31, 1999
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(unaudited)
<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
2000 1999
--------------- --------------
<S> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents............................................. $ 99,427 $ 27,284
Accounts receivable, net of allowance of $143,055 and
$121,550 at June 30, 2000 and December 31, 1999,
respectively....................................................... 504,952 539,256
Inventories........................................................... 47,849 52,302
Deferred taxes on income.............................................. 203,479 192,808
Prepaid expenses and other current assets............................. 99,987 61,011
--------------- --------------
Total current assets.............................................. 955,694 872,661
PROPERTY, PLANT AND EQUIPMENT, NET......................................... 425,043 427,978
INTANGIBLE ASSETS, NET..................................................... 1,413,905 1,435,882
DEFERRED TAXES ON INCOME................................................... 30,529 36,174
OTHER ASSETS............................................................... 111,729 105,786
--------------- --------------
TOTAL ASSETS.......................................................... $ 2,936,900 $ 2,878,481
=============== ==============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable and accrued expenses................................. $ 621,254 $ 626,485
Current portion of long-term debt..................................... 50,048 45,435
Income taxes payable.................................................. 44,537 29,324
--------------- --------------
Total current liabilities......................................... 715,839 701,244
LONG-TERM DEBT............................................................. 1,144,381 1,171,442
OTHER LIABILITIES.......................................................... 135,363 142,733
COMMITMENTS AND CONTINGENCIES
PREFERRED STOCK............................................................ 1,000 1,000
COMMON STOCKHOLDERS' EQUITY:
Common stock, par value $0.01 per share; 100,000 shares
authorized; 45,620 and 44,353 shares issued and
outstanding at June 30, 2000 and December 31, 1999,
respectively..................................................... 456 444
Additional paid-in capital............................................ 1,551,451 1,502,551
Accumulated deficit................................................... (579,126) (627,045)
Unearned compensation................................................. (29,534) (11,438)
Accumulated other comprehensive loss.................................. (2,930) (2,450)
--------------- --------------
Total common stockholders' equity................................. 940,317 862,062
--------------- --------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY............................ $ 2,936,900 $ 2,878,481
=============== ==============
</TABLE>
The accompanying notes are an integral part of these statements.
3
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE SIX MONTHS ENDED JUNE 30, 2000 AND 1999
(IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
2000 1999
---------- ----------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income................................................................... $ 47,977 $ 20,520
Adjustments to reconcile net income
to net cash provided by operating activities:
Depreciation and amortization............................................. 67,364 33,146
Provision for doubtful accounts........................................... 124,215 40,242
Provision for special charges............................................. 2,100 -
Deferred income tax provision............................................. 1,706 6,300
Amortization of unearned compensation..................................... 9,010 1,281
Minority share of income.................................................. 5,376 2,601
Other, net................................................................ (727) 754
Changes in operating assets and liabilities:
Accounts receivable..................................................... (158,954) (44,481)
Accounts payable and accrued expenses................................... 53,220 8,042
Integration, settlement and special charges............................. (26,629) (9,775)
Other assets and liabilities, net....................................... 15,319 (6,024)
---------- ----------
NET CASH PROVIDED BY OPERATING ACTIVITIES.................................... 139,977 52,606
---------- ----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures......................................................... (40,702) (25,938)
Business acquisition......................................................... (925) -
Transaction costs............................................................ - (5,176)
Proceeds from disposition of assets.......................................... 747 848
Increase in investments...................................................... (7,086) (5,687)
---------- ----------
NET CASH USED IN INVESTING ACTIVITIES........................................ (47,966) (35,953)
---------- ----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Repayment of long-term debt.................................................. (22,446) (64,991)
Deferred financing costs paid................................................ (362) (4,947)
Exercise of stock options.................................................... 7,801 991
Distributions to minority partners........................................... (4,832) (975)
Purchases of treasury stock.................................................. - (1,103)
Preferred stock dividends paid............................................... (29) (58)
---------- ----------
NET CASH USED IN FINANCING ACTIVITIES........................................ (19,868) (71,083)
---------- ----------
NET CHANGE IN CASH AND CASH EQUIVALENTS...................................... 72,143 (54,430)
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR................................. 27,284 202,908
---------- ----------
CASH AND CASH EQUIVALENTS, END OF PERIOD..................................... $ 99,427 $ 148,478
========== ==========
CASH PAID DURING THE PERIOD FOR:
Interest..................................................................... $ 53,908 $ 19,259
Income taxes................................................................. 17,240 11,148
</TABLE>
The accompanying notes are an integral part of these statements.
4
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
1. BASIS OF PRESENTATION
BACKGROUND
Quest Diagnostics Incorporated and its subsidiaries ("Quest Diagnostics" or
the "Company") is the largest clinical laboratory testing business in the United
States. Prior to January 1, 1997, Quest Diagnostics was a wholly-owned
subsidiary of Corning Incorporated ("Corning"). On December 31, 1996, Corning
distributed all of the outstanding shares of common stock of the Company to the
stockholders of Corning, with one share of common stock of the Company being
distributed for each eight shares of outstanding common stock of Corning (the
"Spin-Off Distribution").
BASIS OF PRESENTATION
The interim consolidated financial statements reflect all adjustments
which, in the opinion of management, are necessary for a fair statement of the
results of operations for the periods presented. 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 periods 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, 1999.
RECLASSIFICATIONS
During the fourth quarter of 1999, the Company reclassified certain expense
items, primarily related to a portion of occupancy costs and professional
liability insurance expense, from selling, general and administrative expenses
to cost of services, to better reflect the cost of performing testing. The
amounts reclassified from selling, general and administrative expenses for the
three and six months ended June 30, 1999 were $10.4 million and $20.8 million,
respectively.
EARNINGS PER SHARE
Basic net income (loss) per common share is calculated by dividing net
income (loss), less preferred stock dividends (approximately $30 per
quarter), by the weighted average number of common shares outstanding.
Diluted net income (loss) per common share is calculated by dividing net
income (loss), 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 primarily included outstanding stock options and restricted common
shares granted under the Company's Employee Equity Participation Program.
These dilutive securities increased the weighted average number of common
shares outstanding by 2.4 million shares and 0.8 million shares,
respectively, for the three months ended June 30, 2000 and 1999. The dilutive
effect of these securities for the six months ended June 30, 2000 and 1999
increased the weighted average number of common shares outstanding by 1.9
million shares and 0.7 million shares, respectively.
2. 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. The purchase price was paid through the issuance of
approximately 12.6 million shares of common stock of the Company and the payment
of $1.025 billion in cash, including $20 million under a non-competition
agreement between the Company and SmithKline Beecham. The acquisition of
SmithKline Beecham's clinical laboratory business ("SBCL") was accounted for
under the purchase method of accounting. As such, the cost to acquire SBCL has
been allocated on a preliminary basis to the assets and liabilities acquired
based on estimated fair values as of the closing date.
5
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
The SBCL acquisition agreements include 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 SBCL acquisition agreements, and are
the subject of on-going discussions between the parties, have already been
recorded. However, amounts due from SmithKline Beecham, as a result of the
purchase price adjustment, have not been reflected in the consolidated balance
sheets of Quest Diagnostics.
The purchase price allocation will be finalized after completion of the
valuation of certain assets and liabilities, and the final resolution of the
purchase price adjustment. The consolidated financial statements include the
results of operations of SBCL subsequent to the closing of the acquisition.
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 (the "Credit
Agreement") 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.
PRO FORMA COMBINED FINANCIAL INFORMATION
The following pro forma combined financial information assumes that the
SBCL acquisition and borrowings under the Credit Agreement were effected on
January 1, 1999. The SBCL acquisition agreements include 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 SBCL acquisition
agreements and are the subject of on-going discussions between the parties, 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 the purchase price. The
allocation will be finalized after completion of the valuation of certain assets
and liabilities, 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 Credit Agreement. 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
financial information include reductions in employee benefit costs and general
corporate overhead allocated to the historical results of SBCL by SmithKline
Beecham, offset by an increase in net interest expense to reflect the Company's
Credit Agreement which was used to finance the SBCL acquisition. Amortization of
the goodwill, which accounts for a majority of the acquired intangible assets,
was 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 are not
deductible for tax purposes, which has the overall impact of increasing the
effective tax rate.
6
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
Unaudited pro forma combined financial information for the three and six
months ended June 30, 1999 was as follows (in millions, except per share data):
<TABLE>
<CAPTION>
Three Months Six Months
Ended Ended
June 30, June 30,
1999 1999
---------------- -----------------
<S> <C> <C>
Net revenues................................... $ 837.5 $ 1,661.0
Net loss....................................... (8.9) (0.6)
Basic and diluted earnings per common share:
Net loss....................................... $ (0.21) $ (0.02)
Weighted average common shares
outstanding............................... 43.2 43.1
</TABLE>
Both basic and diluted weighted average common shares outstanding have been
presented on a pro forma basis giving effect to the shares issued to SmithKline
Beecham and the shares granted at closing to employees. Potentially dilutive
common shares primarily represent stock options. During periods in which net
income available for common stockholders is negative, diluted weighted average
common shares outstanding will equal basic weighted average common shares
outstanding, since the incremental shares would have an anti-dilutive effect on
earnings (loss) per common share.
3. INTEGRATION OF SBCL AND QUEST DIAGNOSTICS BUSINESSES
During the fourth quarter of 1999, Quest Diagnostics finalized its plan
related to the integration of SBCL into Quest Diagnostics' laboratory
network. The plan focuses principally on laboratory consolidations in
geographic markets currently served by more than one of the Company's
laboratories, and redirecting testing volume within the Company's national
network to provide more local testing and improve customer service. The
Company is not exiting any geographic markets as a result of the plan.
Employee groups to be impacted as a result of these actions include those
involved in the collection and testing of specimens, as well as
administrative and other support functions. During the fourth quarter of
1999, the Company recorded the estimated costs associated with these
activities for 1999 and 2000 relative to the integration plan. The majority
of these integration costs were related to employee severance, contractual
obligations associated with leased facilities and equipment, and the
write-off of fixed assets which management believes will have no future
economic benefit upon combining the operations. Integration costs related to
planned activities affecting SBCL's operations and employees were recorded as
a cost of the acquisition. Integration costs associated with the planned
integration of SBCL affecting Quest Diagnostics' operations and employees
were recorded as a charge to earnings in the fourth quarter of 1999.
7
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
The following table summarizes the Company's accruals for integration costs
affecting the acquired business of SBCL (in millions):
<TABLE>
<CAPTION>
Costs of
Employee Exiting
Severance Leased
Costs Facilities Other Total
---- ---------- ----- -----
<S> <C> <C> <C> <C> <C>
Balance, December 31, 1999........................... $ 32.4 $ 5.5 $ 7.8 $ 45.7
Amounts utilized in 2000............................. (6.3) (0.8) (2.9) (10.0)
------- ------- ------- -------
Balance, June 30, 2000............................... $ 26.1 $ 4.7 $ 4.9 $ 35.7
======= ======= ======= =======
</TABLE>
The following table summarizes the Company's accruals for restructuring
costs associated with the planned integration of SBCL affecting Quest
Diagnostics' operations and employees (in millions):
<TABLE>
<CAPTION>
Costs of
Employee Exiting
Severance Leased
Costs Facilities Other Total
----- ---------- ----- -----
<S> <C> <C> <C> <C>
Balance, December 31, 1999........................... $ 20.9 $ 8.9 $ 0.8 $ 30.6
Amounts utilized in 2000............................. (4.4) (0.3) - (4.7)
------- ------- ------ -------
Balance, June 30, 2000............................... $ 16.5 $ 8.6 $ 0.8 $ 25.9
======= ======= ======= =======
</TABLE>
Approximately 550 employees had been severed in connection with
integration activities through June 30, 2000, including approximately 400
employees severed during the six months ended June 30, 2000.
As of June 30, 2000, the Company had completed approximately one third
of its planned specimen movements throughout its national laboratory network,
including laboratory consolidations in the Boston, Detroit, Baltimore and
Cleveland metropolitan areas. In addition, integration activities are
underway in other markets. Many of these activities are related to the
previously announced plan to reduce capacity in markets served by more than
one of the Company's laboratories with the remainder primarily focused on the
redirecting of specimens to provide more local testing and improve customer
service.
While a significant portion of the remaining accruals associated with the
SBCL integration plan are expected to be paid in 2000, there are certain
severance and facility related exit costs, principally lease obligations, that
have payment terms extending beyond 2000.
4. PROVISION FOR SPECIAL CHARGES
During the second quarter of 2000, the Company recorded a net special
charge of $2.1 million. Of the special charge, $13.4 million represented the
costs to cancel certain contracts that management believed were not
economically viable as a result of the SBCL acquisition. These costs were
principally associated with the cancellation of a co-marketing agreement for
clinical trials testing services. These charges were in large part offset by
a reduction in reserves attributable to a favorable resolution of outstanding
claims for reimbursements associated with billings of certain tests (see Note
5).
8
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
5. COMMITMENTS AND CONTINGENCIES
The Company has entered into several settlement agreements with various
governmental and private payers during recent years relating 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.
In addition, the Company is aware of several pending lawsuits filed under the
qui tam provisions of the civil False Claims Act and has received notices of
private claims relating to billing issues similar to those that were the subject
of prior settlements with various governmental payers. Several of the cases
involve the operations of SBCL prior to the closing of the SBCL acquisition.
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 asserted claims relating to private reimbursement of
billings that were similar to those that were part of a prior government
settlement. The Company entered into a settlement agreement which received
the final approval of the court on July 14, 2000. The final settlement
releases the Company and all of its subsidiaries, other than SBCL, from
potential private claims related to the reimbursement of billings that were
the subject of the lawsuit. During the second quarter of 2000, the Company
recorded a reduction in reserves attributable to the favorable resolution of
this matter (see Note 4).
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 June 30, 2000, 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.
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. Effective in 1997, SBCL and the U.S.
government and various states reached a settlement with respect to the
government's civil and administrative claims. 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 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
9
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
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. 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.
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.
Of the total amount due from SmithKline Beecham at June 30, 2000 of $67
million, $56 million related to indemnified billing, professional liability
and other claims discussed above, and represented 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 may be subject to change as
additional information regarding the outstanding claims is gathered and
evaluated.
At June 30, 2000 recorded reserves, relating primarily to billing claims
including those indemnified by Corning and SmithKline Beecham, approximated $90
million including $2 million in other long-term liabilities. Although management
believes that established reserves for both indemnified and non-indemnified
claims are sufficient, it is possible that additional information (such as the
indication by the government of criminal activity, additional tests being
questioned or other changes in the government's or private claimants' theories
of wrongdoing) may become available which may cause the final resolution of
these matters to exceed established reserves by an amount which could be
material to the Company's results of operations and cash flows in the period in
which such claims are settled. The Company does not believe that these issues
would have a material adverse effect on its overall financial condition.
The Company had been named as a defendant in a lawsuit filed in England,
alleging that the Company had breached a co-marketing agreement of clinical
trials testing services. During the second quarter of 2000, the Company and
plaintiff settled this matter and canceled the agreement. As a result, during
the second quarter of 2000, the Company recorded a special charge of $9.9
million related to the cancellation of the agreement (see Note 4).
10
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
6. COMMON STOCKHOLDERS' EQUITY
Changes in common stockholders' equity for the six months ended June 30,
2000 were as follows:
<TABLE>
<CAPTION>
Accumulated
Additional Other Compre-
Common Paid-In Accumulated Unearned Comprehensive hensive
Stock Capital Deficit Compensation (Loss) Income
---------- -------------- -------------- -------------- -------------- ---------
<S> <C> <C> <C> <C> <C> <C>
BALANCE,
DECEMBER 31, 1999 $ 444 $1,502,551 $ (627,045) $ (11,438) $ (2,450)
Net income 47,977 $ 47,977
Other comprehensive loss (480) (480)
--------
Comprehensive income $ 47,497
========
Preferred dividends declared (58)
Issuance of common stock under
benefit plans (752 common
shares) 7 38,417 (27,106)
Exercise of options (657 common
shares) 6 7,795
Shares to cover employee
payroll tax withholdings on
exercised options (142 common (8,098)
shares) (1)
Tax benefits associated with
stock-based compensation plans 10,786
Amortization of unearned
compensation 9,010
------------------------------------------------------------------------------------------------------
BALANCE,
JUNE 30, 2000 $ 456 $1,551,451 $ (579,126) $ (29,534) $ (2,930)
===================================================================
</TABLE>
During the six months ended June 30, 2000, 142 thousand common shares were
surrendered to cover employee payroll tax withholdings related to the exercise
of stock options. For reporting purposes, these shares were accounted for as
treasury purchases which were immediately retired.
11
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
Changes in common stockholders' equity for the six months ended June 30,
1999 were as follows:
<TABLE>
<CAPTION>
Accumulated
Other
Additional Comprehensive Compre-
Common Paid-In Accumulated Unearned Income Treasury hensive
Stock Capital Deficit Compensation (Loss) Stock Income
---------- -------------- -------------- -------------- -------------- --------- -------------
<S> <C> <C> <C> <C> <C> <C> <C>
BALANCE,
DECEMBER 31, 1998 $ 302 $1,201,006 $ (623,514) $ (3,895) $ (3,038) $ (3,931)
Net income 20,520 $ 20,520
Other comprehensive income 3,471 3,471
--------
Comprehensive income $ 23,991
========
Preferred dividends declared (57)
Purchases of treasury shares (60
shares) (1,103)
Issuance of common stock under
benefit plans (274 treasury
shares and 58 common shares) 1 1,720 (137) 5,034
Exercise of options (60 common
shares) 1 990
Tax benefits associated with
stock-based compensation
plans 152
Adjustment to Corning
receivable (1,985)
Amortization of unearned
compensation 1,281
---------------------------------------------------------------------------------------------------------------------
BALANCE,
JUNE 30, 1999 $ 304 $1,201,883 $ (603,051) $ (2,751) $ 433 $ -
==================================================================================
</TABLE>
7. SUBSEQUENT EVENTS
On July 21, 2000, the Company completed a $256 million receivables-backed
financing transaction ("Receivables Financing"), the proceeds of which were used
to pay down loans currently outstanding under the Credit Agreement.
Approximately $48 million was used to completely repay amounts outstanding under
the capital markets loan, with the remainder primarily used to repay amounts
outstanding under the term loans, effectively lowering the borrowing costs under
the Credit Agreement. In addition, the repayment of the capital markets loan
also reduces the borrowing spreads on all remaining term loans under the Credit
Agreement. The Receivables Financing facility was provided on an uncommitted
basis by Blue Ridge Asset Funding Corporation, a commercial paper funding
vehicle administered by Wachovia Bank, N.A. and with a back-up facility provided
on a committed basis by Wachovia Bank, N.A. The Receivables Financing has an
initial term of three years, unless extended or terminated early due to default
or termination of liquidity commitments to Blue Ridge Asset Funding Corporation.
In addition, in order to complete the Receivables Financing, an
amendment to the indenture governing the Company's 10 3/4% senior
subordinated notes was required. The Company obtained the required consents
from the noteholders to approve the amendments, effective as of July 21, 2000.
Subsequent to June 30, 2000, the Company has invested approximately $15
million in companies that are engaged in the development of innovative
medical technologies and Internet-based solutions to provide electronic
medical records products.
12
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
8. 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
condition of the Subsidiary Guarantors. The following condensed consolidating
financial data includes SBCL as a Subsidiary Guarantor for periods subsequent to
the closing of the acquisition (see Note 2).
13
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS
SIX MONTHS ENDED JUNE 30, 2000
<TABLE>
<CAPTION>
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
<S> <C> <C> <C> <C> <C>
Net revenues................................ $ 348,226 $ 1,335,322 $ 51,044 $ -- $ 1,734,592
Costs and expenses:
Cost of services......................... 216,558 791,893 41,023 -- 1,049,474
Selling, general and administrative...... 152,413 336,925 13,343 -- 502,681
Interest expense, net.................... 7,144 52,633 190 -- 59,967
Amortization of intangible assets........ 2,856 20,808 230 -- 23,894
Provision for special charges ........... 2,100 -- -- -- 2,100
Royalty (income) expense................. (38,405) 38,405 -- -- --
Other, net............................... 120 (160) 3,107 -- 3,067
----------- ----------- ----------- ----------- -----------
Total.................................. 342,786 1,240,504 57,893 -- 1,641,183
----------- ----------- ----------- ----------- -----------
Income (loss) before taxes.................. 5,440 94,818 (6,849) -- 93,409
Income tax expense (benefit)................ 4,187 43,936 (2,691) -- 45,432
Equity earnings from subsidiaries........... 46,724 -- -- (46,724) --
----------- ----------- ----------- ----------- -----------
Net income (loss)........................... $ 47,977 $ 50,882 $ (4,158) $ (46,724) $ 47,977
=========== =========== =========== =========== ===========
</TABLE>
CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS
SIX MONTHS ENDED JUNE 30, 1999
<TABLE>
<CAPTION>
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
<S> <C> <C> <C> <C> <C>
Net revenues................................ $ 316,205 $ 415,899 $ 43,771 $ -- $ 775,875
Costs and expenses:
Cost of services......................... 205,077 242,116 26,285 -- 473,478
Selling, general and administrative...... 116,408 106,582 14,841 -- 237,831
Interest expense, net.................... 2,543 9,387 437 -- 12,367
Amortization of intangible assets........ 3,821 6,292 200 -- 10,313
Royalty (income) expense................. (35,480) 35,480 -- -- --
Other, net............................... (372) 49 3,624 -- 3,301
----------- ----------- ----------- ----------- -----------
Total.................................. 291,997 399,906 45,387 -- 737,290
----------- ----------- ----------- ----------- -----------
Income (loss) before taxes.................. 24,208 15,993 (1,616) -- 38,585
Income tax expense.......................... 8,634 8,961 470 -- 18,065
Equity earnings from subsidiaries........... 4,946 -- -- (4,946) --
----------- ----------- ----------- ----------- -----------
Net income (loss)........................... $ 20,520 $ 7,032 $ (2,086) $ (4,946) $ 20,520
=========== =========== =========== =========== ===========
</TABLE>
14
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
CONDENSED CONSOLIDATING BALANCE SHEET
JUNE 30, 2000
<TABLE>
<CAPTION>
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
ASSETS
Current assets:
<S> <C> <C> <C> <C> <C>
Cash and cash equivalents................. $ -- $ 91,196 $ 8,231 $ -- $ 99,427
Accounts receivable, net.................. 89,787 389,142 26,023 -- 504,952
Other current assets...................... 109,922 227,004 14,389 -- 351,315
------------- ----------- ----------- ----------- ------------
Total current assets 199,709 707,342 48,643 -- 955,694
Property, plant and equipment, net.......... 113,746 298,877 12,420 -- 425,043
Intangible assets, net ..................... 157,097 1,254,659 2,149 -- 1,413,905
Intercompany (payable) receivable........... (17,029) 49,172 (32,143) -- --
Investment in subsidiaries.................. 899,887 -- -- (899,887) --
Other assets................................ 30,913 86,723 24,622 -- 142,258
------------- ----------- ----------- ----------- ------------
Total assets.............................. $ 1,384,323 $ 2,396,773 $ 55,691 $ (899,887) $ 2,936,900
============= =========== =========== =========== ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses..... $ 241,132 $ 406,425 $ 18,234 $ -- $ 665,791
Current portion of long-term debt......... 5,086 44,521 441 -- 50,048
------------- ----------- ----------- ----------- ------------
Total current liabilities................ 246,218 450,946 18,675 -- 715,839
Long-term debt.............................. 172,317 967,143 4,921 -- 1,144,381
Other liabilities........................... 24,471 101,783 9,109 -- 135,363
Preferred stock............................. 1,000 -- -- -- 1,000
Common stockholders' equity................. 940,317 876,901 22,986 (899,887) 940,317
------------- ----------- ----------- ----------- ------------
Total liabilities and stockholders' equity $ 1,384,323 $ 2,396,773 $ 55,691 $ (899,887) $ 2,936,900
============= =========== =========== =========== ============
</TABLE>
15
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
CONDENSED CONSOLIDATING BALANCE SHEET
DECEMBER 31, 1999
<TABLE>
<CAPTION>
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
ASSETS
Current assets:
<S> <C> <C> <C> <C> <C>
Cash and cash equivalents................. $ - $ 18,864 $ 8,420 $ -- $ 27,284
Accounts receivable, net.................. 68,941 455,503 14,812 -- 539,256
Other current assets...................... 113,539 185,438 7,144 -- 306,121
----------- ----------- ----------- ----------- -----------
Total current assets..................... 182,480 659,805 30,376 -- 872,661
Property, plant and equipment, net.......... 111,411 302,268 14,299 -- 427,978
Intangible assets, net ..................... 161,438 1,274,202 242 -- 1,435,882
Intercompany (payable) receivable........... (43,291) 56,798 (13,507) -- --
Investment in subsidiaries.................. 853,865 -- -- (853,865) --
Other assets................................ 11,850 106,952 23,158 -- 141,960
----------- ----------- ----------- ----------- -----------
Total assets............................. $ 1,277,753 $ 2,400,025 $ 54,568 $ (853,865) $ 2,878,481
=========== =========== =========== =========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses..... $ 192,679 $ 449,372 $ 13,758 $ -- $ 655,809
Current portion of long-term debt......... 4,635 40,369 431 -- 45,435
----------- ----------- ----------- ----------- -----------
Total current liabilities................ 197,314 489,741 14,189 -- 701,244
Long-term debt.............................. 176,601 991,396 3,445 -- 1,171,442
Other liabilities........................... 40,776 92,870 9,087 -- 142,733
Preferred stock............................. 1,000 -- -- -- 1,000
Common stockholders' equity................. 862,062 826,018 27,847 (853,865) 862,062
----------- ----------- ----------- ----------- -----------
Total liabilities and stockholders' $ 1,277,753 $ 2,400,025 $ 54,568 $ (853,865) $ 2,878,481
equity................................... =========== =========== =========== =========== ===========
</TABLE>
16
<PAGE>
QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(IN THOUSANDS, UNLESS OTHERWISE INDICATED)
(UNAUDITED)
CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
SIX MONTHS ENDED JUNE 30, 2000
<TABLE>
<CAPTION>
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
<S> <C> <C> <C> <C> <C>
Cash flows from operating activities:
Net income (loss)............................. $ 47,977 $ 50,882 $ (4,158) $ (46,724) $ 47,977
Adjustments to reconcile net income (loss) to
net cash provided by operating activities:
Depreciation and amortization.............. 20,502 45,340 1,522 -- 67,364
Provision for doubtful accounts............ 17,347 105,616 1,252 -- 124,215
Provision for special charges ............. 2,100 -- -- -- 2,100
Other, net................................. (28,900) (5,979) 3,520 46,724 15,365
Changes in operating assets and liabilities (38,363) (83,693) 5,012 -- (117,044)
----------- ----------- --------- ----------- -----------
Net cash provided by operating
activities................................. 20,663 112,166 7,148 -- 139,977
Net cash used in investing activities......... (24,241) (21,665) (1,094) (966) (47,966)
Net cash provided by (used in) financing
activities................................... 3,578 (18,169) (6,243) 966 (19,868)
----------- ----------- ----------- ----------- ----------
Net change in cash and cash equivalents....... -- 72,332 (189) -- 72,143
Cash and cash equivalents, beginning of year.. -- 18,864 8,420 -- 27,284
----------- ----------- ----------- ----------- -----------
Cash and cash equivalents, end of period...... $ -- $ 91,196 $ 8,231 $ -- $ 99,427
=========== =========== =========== =========== ===========
</TABLE>
CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
SIX MONTHS ENDED JUNE 30, 1999
<TABLE>
<CAPTION>
Non-
Subsidiary Guarantor
Parent Guarantors Subsidiaries Eliminations Consolidated
------ ---------- ------------ ------------ ------------
<S> <C> <C> <C> <C> <C>
Cash flows from operating activities:
Net income (loss)............................. $ 20,520 $ 7,032 $ (2,086) $ (4,946) $ 20,520
Adjustments to reconcile net income (loss) to
net cash provided by operating activities:
Depreciation and amortization.............. 15,479 15,773 1,894 -- 33,146
Provision for doubtful accounts............ 19,319 18,875 2,048 -- 40,242
Other, net................................. 3,817 985 1,188 4,946 10,936
Changes in operating assets and liabilities (56,532) 448 3,846 -- (52,238)
----------- ----------- ----------- ----------- -----------
Net cash provided by operating activities..... 2,603 43,113 6,890 -- 52,606
Net cash used in investing activities......... (26,008) (9,704) (241) -- (35,953)
Net cash used in financing activities......... (32,961) (32,276) (5,846) -- (71,083)
----------- ----------- ----------- ----------- -----------
Net change in cash and cash equivalents....... (56,366) 1,133 803 -- (54,430)
Cash and cash equivalents, beginning of year.. 190,606 8,206 4,096 -- 202,908
----------- ----------- ----------- ----------- -----------
Cash and cash equivalents, end of period...... $ 134,240 $ 9,339 $ 4,899 $ -- $ 148,478
=========== =========== =========== =========== ===========
</TABLE>
17
<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 plc ("SmithKline Beecham") for
approximately $1.3 billion. The purchase price was paid through the issuance of
approximately 12.6 million shares of common stock of the Company and the payment
of $1.025 billion in cash, including $20 million under a non-competition
agreement between the Company and SmithKline Beecham. The acquisition of
SmithKline Beecham's clinical laboratory business ("SBCL") was accounted for
under the purchase method of accounting. As such, the cost to acquire 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 SBCL acquisition agreements include 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 SBCL acquisition agreements, and are
the subject of on-going discussions between the parties, have already been
recorded. However, amounts due from SmithKline Beecham, as a result of the
purchase price adjustment, have not been reflected in the consolidated balance
sheets of Quest Diagnostics.
The purchase price allocation will be finalized after completion of the
valuation of certain assets and liabilities, and the final resolution of the
purchase price adjustment. The consolidated financial statements include the
results of operations of SBCL subsequent to the closing of the acquisition.
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 (the "Credit
Agreement") 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.
INTEGRATION OF SBCL AND QUEST DIAGNOSTICS BUSINESSES
During the fourth quarter of 1999, Quest Diagnostics finalized its plan
related to the integration of SBCL into Quest Diagnostics' laboratory
network. The plan focuses principally on laboratory consolidations in
geographic markets currently served by more than one of the Company's
laboratories, and redirecting testing volume within the Company's national
network to provide more local testing and improve customer service. The
Company is not exiting any geographic markets as a result of the plan.
Employee groups to be impacted as a result of these actions include those
involved in the collection and testing of specimens, as well as
administrative and other support functions. During the fourth quarter of
1999, the Company recorded the estimated costs associated with these
activities for 1999 and 2000 relative to the integration plan. The majority
of these integration costs were related to employee severance, contractual
obligations associated with leased facilities and equipment, and the
write-off of fixed assets which management believes will have no future
economic benefit upon combining the operations. Integration costs related to
planned activities affecting SBCL's operations and employees were recorded as
a cost of the acquisition. Integration costs associated with the planned
integration of SBCL affecting Quest Diagnostics' operations and employees
were recorded as a charge to earnings in the fourth quarter of 1999.
18
<PAGE>
Through the end of June 2000, the Company had completed approximately
one third of its planned specimen movements throughout its national
laboratory network, and expects that 70% to 80% of the planned volume
transitions will be completed by the end of 2000.* As of June 30, 2000, the
Company had completed the laboratory consolidations in the Boston, Detroit,
Baltimore and Cleveland metropolitan areas. In addition, integration
activities are underway in other markets. Many of these activities are
related to the previously announced plan to reduce capacity in markets served
by more than one of the Company's laboratories with the remainder primarily
focused on the redirecting of specimens to provide more local testing and
improve customer service.
Total integration costs related to SBCL's employees and operations paid
through June 30, 2000 totaled $11.5 million, including $10.0 million paid
during the six months ended June 30, 2000. Of the total amount paid during
the six months ended June 30, 2000, $6.3 million represented employee
severance benefits. The remaining portion primarily represented amounts paid
in conjunction with the cancellation of a supplier contract and leasing
obligations for facilities and equipment.
Total integration costs related to Quest Diagnostics' employees and
operations paid through June 30, 2000 totaled $7.2 million, including $4.7
million paid during the six months ended June 30, 2000. Of the total amount paid
during the six months ended June 30, 2000, $4.4 million represented employee
severance benefits.
Through June 30, 2000, approximately 550 employees had been severed in
connection with the integration activities, including approximately 400
employees severed during the six months ended June 30, 2000.
While a significant portion of the remaining accruals associated with
the SBCL integration plan are expected to be paid in 2000, there are certain
severance and facility related exit costs, principally lease obligations,
that have payment terms extending beyond 2000. Management believes that the
costs to integrate the SBCL business into Quest Diagnostics will be funded
primarily through cash flows from operations.*
Management anticipates that additional charges may be recorded in the
latter part of 2000 or early 2001 associated with further consolidating the
operations of SBCL beyond 2000. These charges cannot be estimated at this
time, but would be expected to be funded by cash from operations.*
Previously, management had estimated that the Company would achieve at
least $100 million of annual net synergies after three years. The original
estimate included approximately $50 million of anticipated negative impacts
primarily associated with pricing differences between Quest Diagnostics and
SBCL. Management currently believes that significant revenue reductions, as a
result of pricing differences, will not materialize.* As such, management has
revised the Company's synergy estimate to $150 million of annual net cost
reductions, to be achieved over the next several years.* Through the second
quarter of 2000, the Company had achieved approximately $15 million of cost
reduction synergies. For the full year 2000, management estimates that the
Company will realize approximately $50 million of cost reduction synergies.*
-------------------------
*This is a forward-looking statement. 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 1999
Annual Report on Form 10-K
19
<PAGE>
The Company is committed to providing the highest levels of customer
service during and after the integration of SBCL. While no significant service
disruptions have occurred to date, the process of combining operations could
cause an interruption of, or a deterioration in, services which could result in
a customer's decision to stop using Quest Diagnostics for clinical laboratory
testing. Management believes that the successful implementation of the SBCL
integration plan and the Company's unique value proposition based on expanded
patient access, its broad testing capabilities and most importantly, the quality
of the services it provides, will mitigate customer attrition.*
RESULTS OF OPERATIONS
The following table summarizes the Company's unaudited historical and pro
forma results of operations for the three and six months ended June 30, 2000 and
1999 (in thousands, except per share data):
<TABLE>
<CAPTION>
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
-------------------------------------- --------------------------------------------
HISTORICAL PRO FORMA HISTORICAL PRO FORMA
------------------------ ---------- ---------------------------- -----------
2000 1999 1999 2000 1999 1999
---------- ---------- ---------- ----------- --------- -----------
NET REVENUES $ 877,113 $ 394,034 $ 837,533 $ 1,734,592 $ 775,875 $ 1,660,983
---------- ---------- ---------- ----------- --------- -----------
COSTS AND EXPENSES:
<S> <C> <C> <C> <C> <C> <C>
Cost of services 520,437 236,071 550,661 1,049,474 473,478 1,087,801
Selling, general and administrative 252,846 121,230 239,200 502,681 237,831 464,725
Interest expense, net 30,204 5,008 29,723 59,967 12,367 61,403
Amortization of intangible assets 11,954 5,219 10,982 23,894 10,313 21,838
Provision for special charges 2,100 - 15,813 2,100 - 15,813
Minority share of income 3,240 1,471 1,471 5,376 2,601 2,601
Other, net (1,881) 528 126 (2,309) 700 132
---------- ---------- ---------- ----------- --------- -----------
Total 818,900 369,527 847,976 1,641,183 737,290 1,654,313
---------- ---------- ---------- ----------- --------- -----------
INCOME (LOSS) BEFORE TAXES 58,213 24,507 (10,443) 93,409 38,585 6,670
INCOME TAX EXPENSE (BENEFIT) 28,045 11,420 (1,573) 45,432 18,065 7,312
---------- ---------- ---------- ----------- --------- -----------
NET INCOME (LOSS) $ 30,168 $ 13,087 $ (8,870) $ 47,977 $ 20,520 $ (642)
========== ========= ========== =========== ========= ===========
BASIC NET INCOME (LOSS) PER
COMMON SHARE $ 0.68 $ 0.44 $ (0.21) $ 1.08 $ 0.69 $ (0.02)
DILUTED NET INCOME (LOSS) PER
COMMON SHARE $ 0.64 $ 0.43 $ (0.21) $ 1.03 $ 0.67 $ (0.02)
CASH EARNINGS PER DILUTED
COMMON SHARE $ 0.90 $ 0.57 $ 0.24 $ 1.53 $ 0.95 $ 0.65
WEIGHTED AVERAGE COMMON SHARES
OUTSTANDING - BASIC 44,577 29,920 43,248 44,354 29,819 43,146
WEIGHTED AVERAGE COMMON SHARES
OUTSTANDING - DILUTED 46,981 30,729 43,933 46,299 30,505 43,720
ADJUSTED EBITDA $ 127,844 $ 46,178 $ 85,016 $ 227,370 $ 84,097 $ 165,683
</TABLE>
-------------------------------
*This is a forward-looking statement. 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 1999
Annual Report on Form 10-K
20
<PAGE>
HISTORICAL RESULTS OF OPERATIONS
THREE AND SIX MONTHS ENDED JUNE 30, 2000 COMPARED WITH THREE AND SIX MONTHS
ENDED JUNE 30, 1999
Net income for the three months ended June 30, 2000 increased to $30.2
million from $13.1 million for the three months ended June 30, 1999. For the six
months ended June 30, 2000, net income increased to $48.0 million from $20.5
million for the prior year period. Net income for the three and six months ended
June 30, 2000 included net special charges of $2.1 million ($1.3 million, net of
tax). Net income for the three months ended June 30, 2000 included $3.1 million
of costs ($1.9 million, net of tax) related to the SBCL integration, which were
included in operating costs and expensed as incurred. For the six months ended
June 30, 2000, such costs amounted to $4.5 million ($2.7 million, net of tax).
Net income for the three and six months ended June 30, 1999 included a $1.9
million interest refund ($1.2 million, net of tax) associated with a favorable
state tax settlement.
Results for the three and six months ended June 30, 2000 and 1999
included the effects of testing performed by third parties under the
Company's laboratory network management arrangements. As laboratory network
manager, Quest Diagnostics included in its consolidated revenues and expenses
the cost of testing performed by third parties. This treatment added $14.4
million and $15.4 million to both reported revenues and cost of services for
the three months ended June 30, 2000 and 1999, respectively, and added $46.8
million and $32.8 million to both reported revenues and cost of services for
the six months ended June 30, 2000 and 1999, respectively. This treatment
also serves to increase cost of services as a percentage of net revenues and
decrease selling, general and administrative expenses as a percentage of net
revenues. During the first quarter of 2000, the Company and Aetna US
Healthcare terminated a laboratory network management arrangement, and
entered into a new non-exclusive contract under which the Company will no
longer be responsible for the cost of testing performed by third parties. As
a result, effective April 1, 2000, net revenues and cost of services no
longer included the cost of testing performed by third parties under the
terminated laboratory network management contract with Aetna US Healthcare.
RECLASSIFICATIONS
During the fourth quarter of 1999, the Company reclassified certain expense
items, primarily related to a portion of occupancy costs and professional
liability insurance expense, from selling, general and administrative expenses
to cost of services, to better reflect the cost of performing testing. The
amounts reclassified from selling, general and administrative expenses for the
three and six months ended June 30, 1999 were $10.4 million and $20.8 million,
respectively.
NET REVENUES
Net revenues for the three and six months ended June 30, 2000 increased
$483.1 million and $958.7 million, respectively, over the prior year periods,
primarily due to the acquisition of SBCL.
OPERATING COSTS AND EXPENSES
Total operating costs for the three and six months ended June 30, 2000
increased from the year earlier period, primarily due to the acquisition of
SBCL. Operating costs and expenses for the three and six months ended June 30,
2000 included $3.1 million and $4.5 million, respectively, of integration
related costs which were expensed as incurred. Management anticipates that
during the remainder of 2000, the Company will incur additional costs of
approximately $5 to $10 million relative to the integration plan which will be
expensed as incurred.* These costs are primarily related to equipment and
employee relocation costs, professional and
---------------------------------
*This is a forward-looking statement. 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 1999
Annual Report on Form 10-K
21
<PAGE>
consulting fees, company identification and signage costs and the amortization
of stock-based employee compensation related to the special recognition awards
of the Company's common stock granted in the fourth quarter of 1999.
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 include the costs of obtaining, transporting and testing
specimens. While cost of services for the three months ended June 30, 2000
remained essentially unchanged from the prior year period at 58.7% of net
revenues, it decreased from 60.2% in the first quarter of 2000, primarily due to
an increase in average revenue per requisition. For the six months ended June
30, 2000, cost of services as a percentage of net revenues was 59.4% and
approximated the same level of a year ago.
Selling, general and administrative expenses, which include the costs of
the sales force, billing operations, bad debt expense and general management
and administrative support, decreased during the three months ended June 30,
2000 as a percentage of net revenues to 29.3% from 32.0% in the prior year
period. For the six months ended June 30, 2000 selling, general and
administrative expenses decreased as a percentage of net revenues to 29.8%
from 32.0% in the prior year period. These decreases were primarily
attributable to the impact of the SBCL acquisition which enabled the Company
to leverage certain of its fixed costs across a larger revenue base. During
the second quarter of 2000, bad debt expense was 7.1% of net revenues,
compared to 5.3% of net revenues a year ago. For the six months ended June
30, 2000, bad debt expense was 7.4% of net revenues, compared to 5.4% of net
revenues in the prior year. The increase in bad debt expense was principally
attributable to SBCL's collection experience, which is less favorable than
Quest Diagnostics' historical experience. A significant portion of the
difference is due to Quest Diagnostics' processes in the billing area, most
notably the processes around the collection of diagnosis, patient and
insurance information necessary to effectively bill for services performed.
While bad debt expense for the second quarter of 2000 increased compared to
the second quarter of 1999, it decreased from 7.6% of net revenues for the
first quarter of 2000. Based on prior experience as well as the sharing of
internal best practices in the billing functions, the Company believes that
substantial opportunities exist to improve SBCL's collection experience.*
INTEREST EXPENSE, NET
Net interest expense for the three and six months ended June 30, 2000
increased from the prior year periods by $25.2 million and $47.6 million,
respectively. Included in net interest expense for the three and six months
ended June 30, 1999 was a $1.9 million interest refund associated with a
favorable state tax settlement. The remaining increases were principally
attributable to the amounts borrowed under the Credit Agreement in
conjunction with the SBCL acquisition.
AMORTIZATION OF INTANGIBLE ASSETS
Amortization of intangible assets for the three and six months ended June
30, 2000 increased from the prior year periods by $6.8 million and $13.6
million, respectively, principally as a result of the SBCL acquisition.
---------------------------------
*This is a forward-looking statement. 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 1999
Annual Report on Form 10-K
22
<PAGE>
PROVISION FOR SPECIAL CHARGES
During the second quarter of 2000, the Company recorded a net special
charge of $2.1 million. Of the special charge, $13.4 million represented the
costs to cancel certain contracts that management believed were not
economically viable as a result of the SBCL acquisition. These costs were
principally associated with the cancellation of a co-marketing agreement for
clinical trials testing services. Management believes that the cancellation
of this agreement will not have an adverse effect on net revenues.* These
charges were in large part offset by a reduction in reserves attributable to
a favorable resolution of outstanding claims for reimbursements associated
with billings of certain tests.
MINORITY SHARE OF INCOME
Minority share of income for the three and six months ended June 30, 2000
increased from the prior year periods, primarily due to improved performance
at the Company's joint ventures.
INCOME TAXES
The Company's effective tax rate was significantly impacted by goodwill
amortization, the majority of which is not deductible for tax purposes, and had
the effect of increasing the overall tax rate. The goodwill associated with the
SBCL acquisition further increased the effective tax rate for the three and six
months ended June 30, 2000, compared to the prior year periods.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company addresses its exposure to market risks, principally the market
risk of changes in interest rates, 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. During 1999, the Company entered into interest rate swap agreements to
mitigate the risk of changes in interest rates associated with its variable rate
bank debt in accordance with the terms of the Company's Credit Agreement. 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. See Note 2 to the Consolidated Financial Statements contained in the
Company's 1999 Annual Report on Form 10-K for additional discussion of the
Company's financial instruments and hedging activities.
INTEREST RATES
At June 30, 2000 and December 31, 1999, the fair value of the Company's
debt was estimated at approximately $1,193 million and $1,213 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. At June 30, 2000 and December 31, 1999, the carrying value of the
debt exceeded the estimated fair value by approximately $1 million and $4
million, respectively. An assumed 10% increase in interest rates (representing
approximately 100 basis points) would potentially reduce the fair value of the
Company's debt by approximately $9 million and $10 million, respectively, at
June 30, 2000 and December 31, 1999.
The Company had $1,015 million and $1,036 million of variable interest rate
debt outstanding at June 30, 2000 and December 31, 1999, respectively. The
Credit Agreement requires the Company to mitigate the risk of changes in
interest rates associated with its variable interest rate indebtedness through
the use of interest rate swap agreements. Under such arrangements, the Company
converts a portion of its variable rate indebtedness to fixed rates based on a
notional principal amount. The settlement dates are generally correlated to
correspond to the interest payment dates of the hedged debt. During the term of
the Credit Agreement, the notional amounts under the interest rate swap
agreements, plus the principal amount outstanding of the Company's fixed
interest rate indebtedness, must be at least 50% of the Company's net funded
debt (as defined in the Credit Agreement). At June 30, 2000 and December 31,
1999, the aggregate notional principal amount under the interest rate swap
---------------------------------
*This is a forward-looking statement. 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 1999
Annual Report on Form 10-K
23
<PAGE>
agreements which mature at various dates through November 2002 totaled $410.0
million and $450.0 million, respectively. At June 30, 2000 and December 31,
1999, the estimated fair value of the interest rate swap agreements was
approximately $3.9 million and $3.8 million, respectively.
Based on the Company's overall exposure to interest rate changes, an
assumed 10% increase in interest rates applied to the Company's variable rate
debt (representing approximately 69 basis points) would result in a $1.4
million reduction in the Company's after-tax earnings and cash flows for the
six months ended June 30, 2000 based on debt levels as of June 30, 2000,
after considering the impact of interest rate swap agreements. 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 June 30, 2000 totaled $99.4 million, an
increase of $72.1 million from December 31, 1999. Cash flows from operating
activities in 2000 provided cash of $140.0 million, which was offset by
investing and financing activities which required cash of $67.9 million. The
Company maintains zero-balance bank accounts for the majority of its cash
disbursements. Prior to the second quarter of 2000, the Company maintained
its largest disbursement accounts and primary concentration accounts at the
same financial institution, giving that financial institution the legal right
of offset. As such, book overdrafts related to the disbursement accounts were
offset against cash balances in the concentration accounts for reporting
purposes. During the second quarter of 2000, the Company moved its primary
concentration account to another financial institution such that no offset
existed at June 30, 2000. As a result, book overdrafts in the amount of $46.4
million at June 30, 2000, representing outstanding checks, have been
classified as liabilities and not reflected as a reduction of cash at June
30, 2000. Cash and cash equivalents at June 30, 1999 totaled $148.5 million,
a decrease of $54.4 million from December 31, 1998. Cash flows from operating
activities in 1999 provided cash of $52.6 million, which was offset by
investing and financing activities which required cash of $107.0 million
including the repayment of $65.0 million of debt, of which $35.0 million was
paid ahead of schedule.
Net cash from operating activities for 2000 was $87.4 million higher
than the 1999 level. Of the increase, $46.4 million was due to the impact of
accounting for book overdrafts discussed above, and the remaining $41.0
million increase was primarily due to the impact of the SBCL acquisition and
improvements in the operating performance of the Company. Excluding the
impact of the Company's laboratory network management arrangements, the
number of days sales outstanding, a measure of billing and collection
efficiency, was 52 days at June 30, 2000, compared to 57 days at December 31,
1999.
Net cash used in investing activities in 2000 was primarily comprised of
capital expenditures, a small investment in a company that is developing
Internet-based disease management solutions for physicians and managed care
organizations, and another small investment in a company that is developing
Internet-based solutions to provide electronic medical records products. Net
cash used in investing activities in 1999 consisted primarily of capital
expenditures, the payment of transaction costs associated with the
acquisition of SmithKline Beecham's clinical laboratory business, investments
to fund certain employee benefit plans and contributions to a joint venture
in Arizona.
Net cash used in financing activities for 2000 was principally
associated with the scheduled repayment of debt under the Company's Credit
Agreement and distributions to minority partners, partially offset by
proceeds from the exercise of stock options. Net cash used in financing
activities for 1999 primarily consisted of repayments of debt, the majority
of which was related to the Company's then existing credit agreement,
payments of financing costs associated with the Company's new Credit
Agreement and purchases of sixty thousand shares of treasury stock.
The Company estimates that it will invest approximately $110 million during
2000 for capital expenditures to support its existing operations, principally
related to investments in information technology, equipment, and
24
<PAGE>
facility upgrades and expansions necessary to accommodate the integration of the
SBCL business.* Other than the reduction for outstanding letters of credit,
which approximated $17.3 million at June 30, 2000, all of the revolving credit
facility under the Credit Agreement was available for borrowing at June 30,
2000.
On July 21, 2000, the Company completed a $256 million receivables-backed
financing transaction ("Receivables Financing"), the proceeds of which were used
to pay down loans currently outstanding under the Credit Agreement.
Approximately $48 million was used to completely repay amounts outstanding under
the capital markets loan, with the remainder primarily used to repay amounts
outstanding under the term loans, effectively lowering the borrowing costs under
the Credit Agreement. In addition, the repayment of the capital markets loan
also reduces the borrowing spreads on all remaining term loans under the Credit
Agreement. Management estimates that the impact of this transaction will result
in a reduction in annual borrowing costs by approximately $5 million to $7
million.* The Receivables Financing facility was provided on an uncommitted
basis by Blue Ridge Asset Funding Corporation, a commercial paper funding
vehicle administered by Wachovia Bank, N.A. and with a back-up facility provided
on a committed basis by Wachovia Bank, N.A. The Receivables Financing has an
initial term of three years, unless extended or terminated early due to default
or termination of liquidity commitments to Blue Ridge Asset Funding Corporation.
In addition, in order to complete the Receivables Financing, an
amendment to the indenture governing the Company's 10 3/4% senior
subordinated notes (the "Indenture") was required. The Company obtained the
required consents from the noteholders to approve the amendments, effective
as of July 21, 2000.
Subsequent to June 30, 2000, the Company has invested approximately $15
million in companies that are engaged in the development of innovative
medical technologies and Internet-based solutions to provide electronic
medical records products.
The Company believes that cash from operations coupled with the revolving
credit facility under the Credit Agreement will provide sufficient financial
flexibility to integrate the operations of Quest Diagnostics and SBCL, to meet
seasonal working capital requirements and to fund capital expenditures and
additional growth opportunities for the foreseeable future.*
The Company does not anticipate paying dividends on its common stock in
the foreseeable future. The Credit Agreement prohibits the payment of cash
dividends on the Company's common stock and the Indenture restricts the
Company's ability to pay cash dividends on all classes of stock. These
restrictions are primarily based on a percentage of the Company's earnings as
defined in the Indenture. Additionally, 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 repurchase shares of its
outstanding common stock. At June 30, 2000, the Company is limited in its
ability to make certain acquisitions and incur additional indebtedness due to
restrictions under the Indenture.
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.*
---------------------------------
*This is a forward-looking statement. 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 1999
Annual Report on Form 10-K
25
<PAGE>
CASH EARNINGS PER SHARE AND ADJUSTED EBITDA
Cash earnings per common share is calculated as cash earnings less
preferred dividends, divided by diluted weighted average common shares
outstanding. Cash earnings represents income (loss) before special charges
and amortization of all intangible assets, net of applicable taxes.
Cash earnings per common share is presented because it highlights the
impact on earnings of the non-cash charges associated with the amortization of
intangible assets from various acquisitions, which for the Company is
significant. Cash earnings per common share is not a measure of financial
performance under accounting principles generally accepted in the United States
and should not be considered as an alternative to (i) net income (or any other
measure of performance under generally accepted accounting principles) as a
measure of performance or (ii) cash flows from operating activities as an
indicator of cash flows or as a measure of liquidity.
Cash earnings per common share for the three months ended June 30, 2000
improved to $0.90 from $0.57 in the prior year period. Cash earnings per common
share for the six months ended June 30, 2000 was $1.53, compared to $0.95 for
the prior year period. These increases were primarily related to improvements in
the operating performance of the Company.
Adjusted EBITDA represents income before income taxes, net interest
expense, depreciation and amortization and special items. For the three and
six months ended June 30, 2000, special items included $3.1 million and $4.5
million, respectively, of costs related to the integration of SBCL which were
included in operating costs and expensed as incurred, and the provision for
special charges of $2.1 million. Adjusted EBITDA is presented and discussed
because management believes it is a useful adjunct to net income and other
measurements under accounting principles generally accepted in the United
States. Additionally, management believes it is a meaningful measure of a
leveraged company's performance and ability to meet its future debt service
requirements, fund capital expenditures and meet working capital
requirements. Adjusted EBITDA is not a measure of financial performance under
accounting principles generally accepted in the United States and should not
be considered as an alternative to (i) net income (or any other measure of
performance under generally accepted accounting principles) as a measure of
performance or (ii) cash flows from operating, investing or financing
activities as an indicator of cash flows or as a measure of liquidity.
Excluding the revenue impacts of testing performed by third parties under
the Company's laboratory network management arrangements, Adjusted EBITDA for
the three months ended June 30, 2000 improved to $127.8 million, or 14.8% of net
revenues, from $46.2 million, or 12.2% of net revenues, in the prior year
period. Excluding the impact of testing performed by third parties under the
Company's laboratory network management arrangements, Adjusted EBITDA for the
six months ended June 30, 2000 improved to $227.4 million, or 13.5% of net
revenues, from $84.1 million, or 11.3% of net revenues, in the prior year
period. The dollar increases in Adjusted EBITDA were principally associated with
the SBCL acquisition. The percentage improvements in Adjusted EBITDA were
primarily related to improvements in the operating performance of the Company
and synergies realized from the acquisition of SBCL.
26
<PAGE>
PRO FORMA COMPARISONS
The pro forma combined financial information for the three and six months
ended June 30, 1999 assumes that the SBCL acquisition and borrowings under the
Credit Agreement were effected on January 1, 1999. The SBCL acquisition
agreements include 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 SBCL acquisition agreements and are the subject of on-going
discussions between the parties, 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 the purchase price. The allocation will be finalized
after completion of the valuation of certain assets and liabilities, 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 for the three and six months
ended June 30, 1999 is presented for illustrative purposes only to analyze the
financial implications of the SBCL acquisition and borrowings under the Credit
Agreement. 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
financial information include reductions in employee benefit costs and general
corporate overhead allocated to the historical results of SBCL by SmithKline
Beecham, offset by an increase in net interest expense to reflect the Company's
Credit Agreement which was used to finance the SBCL acquisition. Amortization of
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.
Both pro forma basic and diluted weighted average shares outstanding for
the three and six months ended June 30, 1999 have been presented giving effect
to the common shares issued to SmithKline Beecham in conjunction with the
acquisition of SBCL and shares of common stock granted at the closing of the
SBCL acquisition to certain employees.
HISTORICAL THREE AND SIX MONTHS ENDED JUNE 30, 2000 COMPARED WITH
PRO FORMA THREE AND SIX MONTHS ENDED JUNE 30, 1999
The following discussion and analysis compares the Company's historical
results of operations for the three and six months ended June 30, 2000 to the
pro forma results of operations for the three and six months ended June 30,
1999, assuming that SBCL had been acquired by Quest Diagnostics on January 1,
1999. All references in this section to the three and six months ended June
30, 2000 refer to the historical results of Quest Diagnostics for such
periods. All references in this section to the three and six months ended
June 30, 1999 refer to the pro forma results of Quest Diagnostics for such
periods.
Net income for the three months ended June 30, 2000 increased to $30.2
million from a net loss of $8.9 million for the prior year period. Net income
for the six months ended June 30, 2000 increased to $48.0 million, compared to
a net loss of $0.6 million for the six months ended June 30, 1999. Results for
the three and six months ended June 30, 2000 and 1999 included net special
charges of $2.1 million and $15.8 million, respectively. In addition, pro forma
results for the three and six months ended June 30, 1999 included $19.4
27
<PAGE>
million and $21.1 million, respectively, of incremental expenses 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 combined income statements. Of these expenses, approximately $5.4
million and $7.1 million, respectively, were associated with losses recorded
during the three and six months ended June 30, 1999 related to a customer
contract accounted for as a loss contract beginning in the third quarter of
1999. Approximately $7.3 million of these expenses for the three and six
months ended June 30, 1999 were 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 remaining
expenses of approximately $6.7 million for the three and six months ended
June 30, 1999 primarily resulted from adjustments, recorded by SBCL prior to
the acquisition, to accrued liabilities necessary to properly present the
closing balance sheet of SBCL. Excluding the impact of the special charges
and the incremental expenses discussed above, net income for the three months
ended June 30, 2000 and 1999 was $31.4 million and $12.2 million,
respectively. For the six months ended June 30, 2000 and 1999, net income
before special charges and the incremental expenses discussed above was $49.2
and $21.5 million, respectively. These increases in net income were primarily
due to the improved operating performance of the Company, offset by costs
related to the integration of SBCL which were incurred and expensed during
the three and six months ended June 30, 2000. For the three and six months
ended June 30, 2000, these integration costs amounted to $3.1 million and
$4.5 million, respectively.
Results for the three and six months ended June 30, 2000 and 1999
included the effects of testing performed by third parties under the
Company's laboratory network management arrangements. As laboratory network
manager, Quest Diagnostics included in its consolidated revenues and expenses
the cost of testing performed by third parties. This treatment added $14.4
million and $46.8 million, respectively, to both reported revenues and cost
of services for the three and six months ended June 30, 2000. For the three
and six months ended June 30, 1999, this treatment added $43.1 million and
$84.3 million, respectively, to both pro forma revenues and pro forma cost of
services. This treatment also serves to increase cost of services as a
percentage of net revenues and decrease selling, general and administrative
expenses as a percentage of net revenues. During the first quarter of 2000,
the Company and Aetna US Healthcare terminated a laboratory network
arrangement, and entered into a new non-exclusive contract, effective April
1, 2000, under which the Company will no longer be responsible for the cost
of testing performed by third parties.
NET REVENUES
Net revenues for the three months ended June 30, 2000 increased by $39.6
million, or 4.7% from the prior year level primarily due to improvements in
volume of clinical testing and average revenue per requisition of 5% and 6%,
respectively. Net revenues for the six months ended June 30, 2000 increased
by $73.6 million or 4.4% from the prior year level primarily due to
improvements in volume of clinical testing and average revenue per
requisition of 5% and 4%, respectively. Revenue growth for three and six
months ended June 30, 2000 was partially offset by accounting for a customer
contract as a loss contract beginning in the second half of 1999. In
addition, effective April 1, 2000, the cost of testing performed by third
parties under the terminated laboratory network management contract with
Aetna US Healthcare was no longer included in consolidated revenues and cost
of services. Adjusted for these changes, pro forma revenue growth for the
three and six months ended June 30, 2000 was 10.5% and 9.2%, respectively,
compared to the prior year periods.
The volume increases in clinical testing were primarily attributable to
strong sales to existing and new customers, as a result of improved industry
fundamentals as well as the Company's ability to leverage its unique value
proposition of offering expanded patient access, broad testing capabilities
and superior quality. While the Company's long-standing pricing discipline
continued to yield results, other factors that contributed to the increases
in average revenue per requisition included modifications to several managed
care contracts to more favorable terms, an increase in higher value testing
and a shift to greater fee-for-service reimbursement.
28
<PAGE>
OPERATING COSTS AND EXPENSES
The following discussion and analysis regarding 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 revenues and
expenses associated with a customer contract treated as a loss contract,
beginning in the third quarter of 1999. Total operating costs for the three and
six months ended June 30, 2000 increased by $34.0 million and $82.2 million,
respectively, from the year earlier periods principally as a result of the
volume increases noted above. Operating costs and expenses for the three and six
months ended June 30, 2000 included $3.1 million and $4.5 million, respectively,
of integration related costs which were expensed as incurred in 2000. As
discussed above, operating costs and expenses for the three and six months ended
June 30, 1999 included certain other expense items, recorded in SBCL's
historical financial statements prior to the closing of the SBCL acquisition,
which have not been separately reflected on the face of the pro forma income
statements.
Cost of services, as a percentage of net revenues, decreased to 58.7% for
the three months ended June 30, 2000 from 62.5% for the prior year period. Cost
of services for the six months ended June 30, 2000 decreased to 59.4% from 62.3%
for the prior year period. These decreases were primarily due to increases in
average revenue per requisition, the elimination of the other expense items not
separately reflected on the face of the pro forma combined income statements as
discussed above and to a lesser extent, the impact of the SBCL integration to
date on the cost structure of the Company. These decreases in cost of services
were partially offset by an increase in employee compensation costs.
Selling, general and administrative expenses, as a percentage of net
revenues, were 29.3% for the three months ended June 30, 2000, compared to 30.7%
in the prior year period. For the six months ended June 30, 2000, selling,
general and administrative expenses, as a percentage of net revenues, decreased
to 29.8% from 30.2% for the prior year period. These decreases were primarily
attributable to improvements in average revenue per requisition and bad debt
expense, partially offset by an increase in employee compensation costs and
investments related to the Company's electronic commerce strategy. Bad debt
expense improved to 7.1% of net revenues for the three months ended June 30,
2000 from 7.6% for the three months ended March 31, 2000 and 7.5% for the prior
year period. For the six months ended June 30, 2000, bad debt expense improved
to 7.4% of net revenues, compared to 7.6% of net revenues for the prior year
period. This progress was primarily due to process improvements in the SBCL
billing functions, with particular focus in the areas of obtaining missing
information and reducing billing backlogs.
INTEREST EXPENSE, NET
Net interest expense increased for the three months ended June 30, 2000
by $0.5 million, compared to the prior year period. Net interest expense for
the three and six months ended June 30, 1999 included a $1.9 million interest
refund associated with a favorable state tax settlement. Excluding the
interest refund in 1999, net interest expense for the three months ended June
30, 2000 decreased by $2.4 million, compared to the prior year period. This
reduction was primarily due to lower debt levels in 2000, compared to the
prior year period, partially offset by an increase in variable interest
rates. Excluding the interest refund in 1999, net interest expense for the
six months ended June 30, 2000 decreased by $3.3 million, compared to the
prior year period. This reduction was primarily due to the repayment of long
term debt under the Credit Agreement between the closing of the SBCL
acquisition and the end of the second quarter of 2000, partially offset by an
increase in variable interest rates.
29
<PAGE>
AMORTIZATION OF INTANGIBLE ASSETS
Amortization of intangible assets for the three and six months ended June
30, 2000 increased from the prior year periods by $1.0 million and $2.1 million,
respectively, principally as a result of an adjustment to the purchase price
allocation recorded in the third quarter of 1999 primarily associated with
SBCL's deferred tax position as of the closing of the acquisition.
PROVISION FOR SPECIAL CHARGES
During the second quarter of 2000, the Company recorded a net special
charge of $2.1 million. Of the special charge, $13.4 million represented the
costs to cancel certain contracts that management believed were not
economically viable as a result of the SBCL acquisition. These costs were
principally associated with the cancellation of a co-marketing agreement for
clinical trials testing services. Management believes that the cancellation
of this agreement will not have an adverse effect on net revenues.* These
charges were in large part offset by a reduction in reserves attributable to
a favorable resolution of outstanding claims for reimbursements associated
with billings of certain tests. The special charge in the second quarter of
1999 of $15.8 million was 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 as of June 30, 1999.
MINORITY SHARE OF INCOME
Minority share of income for the three and six months ended June 30,
2000 increased from the prior year periods, primarily due to improved
performance at the Company's joint ventures.
INCOME TAXES
The Company's effective tax rate was significantly impacted by goodwill
amortization, the majority of which is not deductible for tax purposes, and had
the effect of increasing the overall tax rate.
CASH EARNINGS PER SHARE AND ADJUSTED EBITDA
Pro forma cash earnings per common share is calculated as pro forma cash
earnings less preferred dividends, divided by pro forma diluted weighted
average common shares outstanding. Cash earnings represents income (loss)
before special charges and amortization of all intangible assets, net of
applicable taxes, presented on a pro forma basis.
Cash earnings per common share was $0.90 for the three months ended June
30, 2000, compared to pro forma cash earnings per common share of $0.24 for the
prior year period. Cash earnings per common share was $1.53 for the six months
ended June 30, 2000, compared to pro forma cash earnings per common share of
$0.65 for the prior year period. These increases were primarily related to
improvements in the operating performance of the Company and to a lesser extent,
the impact of certain incremental expenses which have not been separately
reflected on the face of the pro forma combined income statements in 1999.
Adjusted EBITDA represents income before income taxes, net interest
expense, depreciation and amortization and special items. For the three and
six months ended June 30, 2000, special items included $3.1 million and $4.5
million, respectively, of costs related to the integration of SBCL which were
included in operating expenses and expensed as incurred, and the provision
for special charges of $2.1 million. Pro forma Adjusted EDITDA for the three
and six months ended June 30, 1999 included $19.4 million and $21.1 million,
respectively, of certain incremental expenses not separately reflected on the
face of the pro forma combined income statements, as discussed earlier and
the provision for special charges of $15.8 million.
Excluding the revenue impacts of the testing performed by third parties
under the Company's laboratory network management arrangements and the loss
contract, Adjusted EBITDA for the three months ended June 30, 2000 improved to
$127.8 million, or 14.8% of net revenues, compared to pro forma Adjusted
EBITDA of
---------------------------------
*This is a forward-looking statement. 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 1999
Annual Report on Form 10-K
30
<PAGE>
$85.0 million, or 10.9% of net revenues, in the prior year period. Adjusted
EBITDA for the six months ended June 30, 2000 improved to $227.4 million, or
13.5% of net revenues, compared to pro forma Adjusted EBITDA of $165.7
million, or 10.8% of net revenues, in the prior year period. These increases
in Adjusted EBITDA were primarily related to improvements in the operating
performance of the Company.
31
<PAGE>
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company had been named as a defendant in a lawsuit filed in England,
alleging that the Company had breached a co-marketing agreement of clinical
trials testing services. During the second quarter of 2000, the Company and
plaintiff settled this matter and canceled the agreement. See Note 5 of the
Notes to Consolidated Financial Statements.
The Company entered into a settlement agreement, which received the final
approval of the court on July 14, 2000, with respect to the pending class action
relating to private reimbursement of billings that are similar to those that
were the subject of a prior government settlement. See Note 5 of the Notes to
Consolidated Financial Statements.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
(a) The annual meeting of stockholders of the Company was held on May 9,
2000. At the meeting the matters described below were approved by the
stockholders.
(b-c) The following nominees for the office of director were elected for
terms expiring at the 2002 annual meeting of stockholders, by the
following votes:
<TABLE>
<CAPTION>
For Withheld
<S> <C> <C>
Kenneth W. Freeman 40,084,636 252,244
Gail R. Wilensky 40,075,601 261,279
John B. Ziegler 40,080,775 256,105
</TABLE>
The following persons continue as directors:
Kenneth D. Brody
William F. Buehler
Van C. Campbell
Mary A. Cirillo
William R. Grant
Dan C. Stanzione
The appointment of PricewaterhouseCoopers LLP as independent
accountants to audit the financial statements of the Company and its
subsidiaries for the fiscal year ending December 31, 2000, was approved
by the following number of stockholder votes for, against, and
abstained:
For: 40,072,582 Against: 69,339 Abstained: 194,959
The amendment to Paragraph 11(b) of the Company's Restated Certificate
of Incorporation to conform with a recent change to Section 145(d) of
the Delaware General Corporation Law was approved by the following
number of stockholder votes for, against, and abstained:
For: 34,234,385 Against: 5,742,230 Abstained: 360,265
32
<PAGE>
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
Exhibit Number Description
-------------- ------------
10.26 Amendment to Employment Agreement between the
Company and Kenneth W. Freeman, dated April 11,
2000.
10.27 Form of Supplemental Indenture between Quest
Diagnostics Incorporated and The Bank of New York,
as Trustee, dated July 21, 2000.
10.28 Form of Credit and Security Agreement among Quest
Diagnostics Receivables Incorporated, Quest
Diagnostics Incorporated and Wachovia Bank, N.A.,
as Administrative Agent, dated as of July 21, 2000.
10.29 Receivables Sales Agreement among Quest Diagnostics
Incorporated and each of its Direct and Indirect
Wholly-Owned Subsidiaries (as the Sellers) and
Quest Diagnostics Receivables Incorporated (as the
Buyer), dated as of July 21, 2000
27 Financial Data Schedule
(b) Reports on Form 8-K:
None.
33
<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.
July 26, 2000
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
34
