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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-Q
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[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 1995
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE REPORT OF 1934
For the transition period from _____________ to _____________
Commission file number 1-10610
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DIAGNOSTEK, INC.
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(Exact name of registrant as specified in its charter)
DELAWARE 85-0312837
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
4500 Alexander Blvd. NE, 87107
Albuquerque, New Mexico (ZIP Code)
(Address of principal executive offices)
Registrant's telephone number,including area code:
(505)345-8080
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Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such 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___
Indicate the number of shares outstanding of each of the issuer's
classes of common stock, as of the latest practical date
Common Stock, $.01 par value 24,437,906 shares
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Class Outstanding at July 27, 1995
<PAGE>
Diagnostek, Inc. and Subsidiaries
Form 10-Q
Index
Item Page
Part I Financial information
Consolidated Statement of Earnings 2
Consolidated Statement of Financial Position 3
Consolidated Statement of Cash Flows 4
Notes to Consolidated Financial Statements 5
Management's Discussion and Analysis of Financial
Condition and Results of Operations 10
Part II Other information
Legal Proceedings 13
Exhibits and Reports on Form 8-K 15
Signatures 16
1
<PAGE>
Part I - Financial Information
Diagnostek, Inc. and Subsidiaries
Consolidated Statement of Earnings
Unaudited
(In thousands, except per share amounts)
<TABLE>
<CAPTION>
Three month period
ended June 30
1995 1994
---- ----
<S> <C> <C>
Revenue $182,882 $166,527
Costs and expenses
Cost of sales 163,618 149,383
Selling and marketing 2,455 2,746
General and administrative 8,392 7,816
--------- ---------
Total operating expenses 174,465 159,945
--------- ---------
Operating income 8,417 6,582
Other income (expense):
Interest income 1,022 1,042
Interest expense (447) (516)
Other 22 (103)
--------- ---------
Earnings before income taxes 9,014 7,005
Provision for income taxes 3,651 2,818
--------- ---------
Net earnings $ 5,363 $ 4,187
========= =========
Weighted average number of common and
common equivalent shares outstanding 25,493 25,254
Net earnings per common and common
equivalent share $ 0.21 $ 0.17
</TABLE>
See accompanying Notes to Consolidated Financial Statements.
2
<PAGE>
Diagnostek, Inc. and Subsidiaries
Consolidated Statement of Financial Position
Unaudited
(Dollars in thousands, except share amounts)
<TABLE>
<CAPTION>
June 30, 1995 March 31,1995
<S> <C> <C>
Assets
Current assets
Cash and cash equivalents $ 11,366 $ 4,149
Trade receivables-net (Note 3) 56,054 55,984
Other receivables 12,106 13,593
Inventories 27,223 28,966
Deferred income taxes 5,441 6,514
Other assets 2,159 1,787
------- --------
Total current assets 114,349 110,993
Property, plant, and equipment - net (Note 4) 22,580 22,951
Goodwill - net (Note 5) 61,809 62,299
Other intangible assets - net (Note 6) 1,754 1,843
Marketable securities - net (Note 7 ) 61,908 59,176
Deferred income taxes 2,168 3,263
Other assets - not current (Note 8) 5,757 5,925
-------- --------
Total assets $270,325 $266,450
======== ========
Liabilities and Stockholders' Equity
Current liabilities
Current portion of long-term debt (Note 9) $ 6,022 $ 10,337
Accounts payable 47,376 42,616
Employee compensation and benefits 2,988 3,673
Income taxes payable 1,301 47
Accrued contract losses(note 10) 6,480 9,621
Other liabilities - current 2,462 3,088
--------- --------
Total current liabilities 66,629 69,382
Long-term debt,excluding current portion (Note 9) 11,000 12,000
Other liabilities - not current 830 1,020
------ --------
Total liabilities 78,459 82,402
Stockholders' Equity
Preferred stock,$1.00 par value, authorized
5,000,000 shares, none issued or outstanding - -
Common stock,$.01 par value, authorized
45,000,000 shares, with issued shares of
24,469,442 at June 30, 1995 and 24,389,942
at March 31, 1995 245 244
Paid-in capital in excess of par value 138,780 137,742
Less: Treasury stock, 132,196 shares at June 30,1995
and 132,196 shares at March 31, 1995 (1,297) (1,297)
Unrealized gain (loss) on marketable securities net of
deferred tax benefit of ($627) at June 30, 1995
and ($1,570) at March 31, 1995 (942) (2,358)
Retained earnings 55,080 49,717
-------- --------
Total stockholders' equity 191,866 184,048
------- -------
Total liabilities and stockholders' equity $270,325 $266,450
======== ========
</TABLE>
See accompanying Notes to Consolidated Financial Statements.
3
<PAGE>
Diagnostek, Inc. and Subsidiaries
Consolidated Statement of Cash Flows
Unaudited (in thousands)
<TABLE>
<CAPTION>
Three month period ended
1995 1994
<S> <C> <C>
Cash flows from operating activities:
Net earnings $ 5,363 $ 4,187
Adjustments to reconcile net earnings to cash
provided from (used by) operating activities:
Depreciation and amortization 1,638 1,270
Provision for doubtful accounts 420 430
Loss (gain) on sales of marketable securities (71) 120
Deferred income taxes 1,226 (98)
Decrease (increase) in trade receivables (490) (5,049)
Decrease (increase) in inventories 1,743 ( 3,878)
Decrease (increase) in other assets-current 1,115 ( 1,318)
Decrease (increase) in other assets-not current 168 246
Increase (decrease) in accounts payable 4,760 (48)
Increase (decrease) in income taxes 1,254 933
Increase (decrease) in employee compensation (685) 1,195
Increase (decrease) in other liabilities-current (4,082) (10,778)
Increase (decrease) in other liabilities-not current (189) (216)
---------- ----------
Cash provided from(used by) operating activities 12,170 (13,004)
---------- ----------
Cash flows from investing activities:
Purchase of marketable securities (2,606) (4,929)
Proceeds from sale of marketable securities 2,302 6,442
Additions to property, plant, and equipment (687) ( 1,688)
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Cash provided from (used by) investing activities (991) (175)
---------- ----------
Cash flows from financing activities:
Proceeds from issuance of common stock 1,038 675
Proceeds from debt 6,500 8,000
Repayment of debt (11,500) (2,474)
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Cash provided from (used by) by financing activities (3,962) 6,201
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Increase(decrease) in cash and equivalents 7,217 (6,978)
Cash and cash equivalents at beginning of period 4,149 8,012
---------- ----------
Cash and cash equivalents at end of period $ 11,366 $ 1,034
========== =========
Supplemental disclosure of cash flow information:
Cash paid during period for interest $ 762 $ 943
Cash paid during period for taxes $1,025 $ 1,762
</TABLE>
See accompanying Notes to Consolidated Financial Statements.
4
<PAGE>
Diagnostek, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)
General
Diagnostek, Inc., a holding company incorporated under the laws of Delaware on
August 3, 1983, together with its subsidiaries (collectively, "Diagnostek" or
the "Company"), is a leading provider of pharmacy benefit management services
designed to contain the costs of dispensing pharmaceuticals with principal
business activities being the providing of prescription drugs through mail and
retail pharmacy service plans and providing contract pharmacy management
services to acute care hospitals and HMOs.
Note 1 - Summary of Significant Accounting Policies
The accompanying unaudited financial statements have been prepared in accordance
with the instructions to Article 10 of Regulation S-X and, therefore, do not
include all information and footnotes necessary for a fair presentation of
financial position, results of operations, and cash flows in conformity with
generally accepted accounting principles. The information furnished, in the
opinion of management, reflects all adjustments, which include normal recurring
adjustments, necessary to present fairly the results of operations of the
Company for the three month periods ended June 30, 1995 and 1994. Results of
operations for interim periods are not necessarily indicative of results which
may be expected for the year as a whole.
Consolidation The consolidated financial statements represent the adding
together of all companies of which Diagnostek directly or indirectly has
majority ownership or otherwise controls. Significant intercompany accounts and
transactions have been eliminated. The Company's consolidated financial
statements include the accounts of its wholly-owned affiliates, Health Care
Services, Inc. ("HCS"), and HPI Health Care Services, Inc. ("HPI"); together
with their subsidiaries, and other controlled affiliates.
Revenue and cost of sales Sales of goods and services are recorded on medication
dispensing or passage of title to customers in accordance with contractual
terms. Cost of sales are recorded based on the cost of pharmaceuticals dispensed
and related direct costs. In addition, the Company accrues costs associated with
its risk/reward contracts which it estimates will not be recovered through
projected revenues.
Cash and cash equivalents Money market accounts and temporary investments with
original maturities of ninety days or less are included in cash and cash
equivalents.
Inventories Inventories, consisting primarily of prescription medications
purchased for resale, are stated at the lower of cost, on a first-in, first-out
basis, or market.
Property, plant, and equipment Property, plant, and equipment are stated at
cost. Provisions for depreciation are recorded using both straight-line and
accelerated methods over the useful lives of the respective assets. Leasehold
improvements are amortized on a straight-line basis over the shorter of economic
life or terms of the respective leases.
5
<PAGE>
Diagnostek, Inc. and Subsidiaries
Notes to Consolidated Financial Statements(continued)
Intangible assets Goodwill is amortized using the straight-line method, over
fifteen to forty years. Other intangible assets consist primarily of acquired
contract rights and covenants not to compete and are amortized on a
straight-line basis over periods ranging from three to twelve years.
The Company evaluates the recoverability of goodwill based on estimated
undiscounted operating income over the goodwill amortization periods, giving
consideration to sales and cost benefits expected to be realized by the
consolidated group from the acquisition of the acquired company. The Company
also evaluates industry trends and historical trends of the acquired companies,
the potential impact of pending and proposed regulations and the effect of
competition.
Marketable securities The Company accounts for marketable securities utilizing
Financial Accounting Standards Board Statement of Financial Accounting Standards
No.115 "Accounting for Certain Investments in Debt and Equity Securities". All
marketable securities at June 30, 1995 and 1994 were deemed by management to be
available for sale and therefore are reported at fair value with net unrealized
gains (losses) reported in stockholders' equity.
Income taxes Diagnostek utilizes the asset and liability method for recording
deferred income taxes, which provides for the establishment of deferred tax
asset or liability accounts based on the difference between tax and financial
reporting bases of certain assets and liabilities.
Treasury stock Treasury stock is carried at acquisition cost (market price at
acquisition date).
Earnings per common and equivalent share Earnings per common and common
equivalent share is computed on the weighted average number of shares, less
treasury stock and, if dilutive, common equivalent shares (common shares
assuming exercise of options and warrants). For the three-month periods ending
June 30, 1995 and 1994, approximately 1.2 million and 1.3 million common
equivalent shares respectively, were included in the computation of weighted
average shares. Fully diluted earnings per share are not materially different
than primary earnings per share and have not been presented.
Note 2 - Merger
On March 27, 1995, the Company entered into a definitive Agreement and
Plan of Merger (the "Merger Agreement") with Value Health, Inc. ("VHI"), a New
York Stock Exchange company that provides specialized managed care programs
including pharmacy benefit management services, and VHI Merger-Sub. Corp., a
wholly-owned subsidiary of VHI pursuant to which the Company became a
wholly-owned subsidiary of VHI (the "Merger") on July 28, 1995. It is intended
that the Merger will qualify as a pooling of interests for accounting purposes
and will constitute a tax-free reorganization for federal income tax purposes.
In accordance with the terms and conditions of the Merger Agreement, as amended,
each share of the Company's common stock ( and outstanding common stock options)
was converted into common stock (and common stock options) of VHI at an exchange
ratio of 0.4975. In connection with the Merger Agreement, the Company's Chairman
of the Board and Chief Executive Officer has entered into a five year consulting
agreement and ten year agreement not to compete with VHI and the Company,
effective only upon the consummation of the Merger. At June 30, 1995,
approximately $1.1 million of costs associated with the Merger has been
deferred. As a result of the announcement of the execution of the Merger
Agreement, a number of shareholder lawsuits were filed against the Company, its
directors and VHI (note11).
6
<PAGE>
Diagnostek, Inc. and subsidiaries
Notes to Consolidated Financial Statements (continued)
Note 3 - Trade receivables
Trade receivables include allowance for doubtful accounts of $3,709,000
and $3,487,000 at June 30, 1995 and March 31, 1995, respectively.
Note 4 - Property, plant, and equipment
Property, plant, and equipment include accumulated depreciation and
amortization of $14,096,000 and $13,070,000 at June 30, 1995 and March 31, 1995,
respectively.
Note 5 - Goodwill
Goodwill includes accumulated amortization of $6,483,000 and $5,993,000 at
June 30, 1995 and March 31, 1995, respectively.
Note 6 - Other intangible assets
Other intangible assets include accumulated amortization of $2,603,000 and
$2,513,000 at June 30, 1995 and March 31, 1995, respectively.
Note 7 - Marketable securities
Marketable securities at June 30, 1995 and March 31, 1995 are summarized below:
<TABLE>
<CAPTION>
(in thousands) At June 30, 1995 At March 31, 1995
Cost Market Cost Market
Marketable securities Basis Value Basis Value
<S> <C> <C> <C> <C>
Equity securities:
-Mutual funds $ 365 $ 350 $ 361 $ 354
-Other 1,300 1,250 1,300 1,050
Debt securities:
-Corporate bonds 27,385 26,680 28,449 26,528
-U.S. Government and
agency securities 24,558 23,938 23,123 21,702
-Municipal securities 9,869 9,690 9,871 9,542
----- ----- ----- -----
63,477 $61,908 63,104 $59,176
======= =======
Allowance for unrealized
gains (losses) (1,569) (3,928)
------- --------
Total $61,908 $59,176
======= =======
</TABLE>
Note 8 - Other assets - not current
Other assets - not current include notes receivable from officers and
directors totaling approximately $2.9 million at June 30, 1995 and March 31,
1995.
Note 9 - Debt
Amounts outstanding under the Company's unsecured line of credit
totaled $5.0 million and $10.0 million at June 30, 1995 and March 31,1995
respectively. $5.0 million and $6.0 million of borrowings under the line of
credit have been classified as non-current liabilities at June 30, 1995 and
March 31, 1995, respectively.
7
<PAGE>
Diagnostek, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
Note 10 - Accrued Contract Losses
On February 1, 1995, the Company's HPI subsidiary began performing
under a contract with the State of New Jersey to provide unit dose medications
to the state's hospital system. The Company has estimated that it will incur
losses over the three year term of the contract, and has accrued $6,480,000 and
$9,621,000 at June 30, 1995 and March 31, 1995, respectively. The Company
evaluates the adequacy of this accrual on an ongoing basis.
Note 11 - Legal proceedings
The Securities and Exchange Commission is conducting a formal
investigation into the adequacy of the Company's financial disclosures, books
and records, and internal accounting controls, including whether Diagnostek
overstated its assets and income in its financial statements for the fiscal year
ended March 31, 1992 and the quarter ended June 30, 1992. Diagnostek has
cooperated fully in connection with this investigation. Diagnostek has reached
an agreement in principle with the Staff of the Commission pursuant to which
Diagnostek will consent, without admitting or denying the Commission's findings,
to a Commission order directing Diagnostek to cease and desist from violating
certain antifraud provisions of the federal securities laws, provisions
requiring accurate periodic filing with the Commission, and provisions requiring
Diagnostek to maintain accurate financial records and adequate systems of
internal accounting control. Similar agreements in principle have been reached
between the Commission staff and a former officer of Diagnostek and an employee
of its HCS subsidiary. The agreements in principle are subject to further
consideration by Diagnostek and the Commission staff of the precise terms of a
proposed order. Any such order will be effective only if approved by the
Commission, and there can be no assurance that such approval will be
forthcoming.
On July 11, 1994, a purported shareholder class action was filed
against Diagnostek and various of its officers and directors. The action is
pending in the United States District Court for the District of New Mexico. The
plaintiffs have asserted violations of the Exchange Act and common law, on
account of the alleged artificial inflation in the market price of Diagnostek
Common Stock by reason of various alleged misrepresentaions and omissions. The
plaintiffs have also alleged that the defendants concealed from the public the
circumstances leading to the termination of CIGNA's contractual relationships
with Diagnostek. The plaintiffs recently have expanded the allegations in the
complaint to assert that Diagnostek misrepresented the anticipated revenues from
a CHAMPUS contract with the Department of Defense and to extend the class period
from July 6, 1994 to March 24, 1995. Although Diagnostek has denied any
liability and is vigorously defending the litigation, Diagnostek has not
established a reserve with respect to such litigation and there can be no
assurance that the outcome of this litigation will not have a materially adverse
effect on the Company.
Promptly after the announcement of the execution of the Merger
Agreement (note 2) 11 stockholder class action lawsuits were filed in the Court
of Chancery of the State of Delaware against Diagnostek, and its directors
asserting that the value of the consideration to be received by Diagnostek
stockholders is unfair and grossly inadequate and that the directors of
Diagnostek breached their fiduciary duties to Diagnostek stockholders by failing
to take steps to maximize stockholder value. The suits seek, among other things,
to enjoin the Merger, to compel the directors of Diagnostek to reconsider the
Exchange Ratio and to recover unspecified damages. Diagnostek and the individual
defendants intend to vigorously defend these claims based upon their belief that
the actions of Diagnostek and its directors in connection with the Merger
Agreement were appropriately taken under applicable law and that the Merger is
fair to and in the best interests of Diagnostek's stockholders. VHI has been
named as a defendant in certain of these actions for allegedly aiding and
abetting in the alledged breaches of fiduciary duty by the Diagnostek directors.
The plaintiffs have served a document production request upon the defendants, to
which the defendants have submitted written responses. Diagnostek has filed an
answer denying the principal allegations of the complaint. As of August 4, 1995,
no further action has been taken by either the plaintiffs or the defendants,
although counsel representing the plaintiffs have suggested that the actions be
consolidated and captioned "In Re: Diagnostek, Inc. Shareholders Litigation."
8
<PAGE>
Diagnostek, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
There are extensive state and Federal regulations applicable to the
practice of pharmacy and, since sanctions may be imposed for violations,
compliance is a significant operational requirement for the Company. Management
believes that the Company and its subsidiaries are in substantial compliance
with all existing statutes and regulations materially affecting the conduct of
its business. Various federal and state pharmacy associations and some boards of
pharmacy have attempted to promote laws or regulations directed at restricting
the activities of mail service pharmacies, to the economic benefit of retail
pharmacies. In addition, a number of states have laws or regulations which, if
successfully enforced, would effectively limit some of the financial incentives
available to third-party payors that offer managed care prescription drug
programs. To the extent such laws or regulations are found to be applicable to
the Company, there is no assurance the Company could comply, and noncompliance
could adversely affect the Company's integrated pharmacy service programs.
Diagnostek and its subsidiaries are subject to various claims and
lawsuits in the ordinary course of business, none of which are material.
9
<PAGE>
Diagnostek Inc. and Subsidiaries
Management's Discussion and Analysis of Financial Condition
and Results of Operations
Summary Segment Financial Data
Three months ended
(In Millions) June 30
1995 1994
Integrated Pharmacy Service
Revenues $ 156.8 $ 121.4
Operating income 9.3 5.6
Managed Care Pharmacy Service
Revenue 25.1 43.8
Operating income 1.7 3.8
Corporate and Other
Revenues 1.0 1.3
Operating income (loss) (2.6) (2.8)
Total Company
Revenues 182.9 166.5
Operating income 8.4 6.6
Net earnings 5.4 4.2
Net earnings per share $ 0.21 $ 0.17
Results of Operations
Consolidated Operations
Three months ended June 30, 1995 compared with three months ended June 30, 1994
Consolidated revenues totaled $182.9 million for the three months ended
June 30, 1995, an increase of $16.4 million, or 10% from the comparable period
last year. Increase was attributable primarily to the expansion of the Company's
integrated pharmacy service business ($35.4 million) partially offset by a
decrease in the Company's managed care pharmacy service business ($18.7 million)
(See Managed Care Pharmacy Management Operations below).
Consolidated operating income totaled $8.4 million for the three months
ended June 30, 1995, an increase of $1.8 million from the comparable prior year
period. Increase in operating income was attributable primarily to increased
volume and improved product margins ($2.1 million) derived mainly from the
Company's integrated pharmacy service segment offset by higher selling, general
and administrative expenses ($0.3 million).
Consolidated net earnings totaled $5.4 million, an increase of $1.2
million from the comparable period last year. Increase was attributable mainly
to higher operating income ($1.8 million) offset by increased tax provision
($0.8 million).
Net earnings of $ 0.21 per share were $ 0.04 higher than last year due
mainly to higher net earnings.
10
<PAGE>
Diagnostek Inc. and Subsidiaries
Management's Discussion and Analysis of Financial Condition
and Results of Operations
Integrated Pharmacy Service Operations
Three months ended June 30, 1995 compared with three months ended June 30, 1994
Integrated Pharmacy Service revenues totaled $156.8 million for the
three months ended June 30, 1995 an increase of $35.4 million from the
comparable prior year quarter.
Integrated Pharmacy Service operating income totaled $9.3 million for
the three months ended June 30, 1994, an increase of $3.7 million from last
year. Operating income increase was attributable primarily to increased volume
and higher product margins ($4.6 million) offset partly by higher selling,
general and administrative costs ($0.9 million).
Managed Care Pharmacy Management Operations
Three months ended June 30, 1995 compared with three months ended June 30, 1994
Managed Care Pharmacy revenues totaled $25.1 million for the three
months ended June 30, 1995, a decrease of $18.7 million from last year due to
the termination of pharmacy service contracts in support of CIGNA managed care
plans in New Mexico and Arizona in September of 1994, offset partially by
revenues associated with the Company's contract with the State of New Jersey
($4.8 million) which began in February 1995.
Managed Care Pharmacy operating income totaled $1.7 million for the
three months ended June 30, 1995, a decrease of $2.1 million from last year
primarily due to the loss of CIGNA contracts and renewal/renegotiation of other
contracts, with no offsetting operating income being generated by the State of
New Jersey contract.
Impact of Suppliers and Inflation
The Company has contracts with over 51,000 retail pharmacies to provide
point-of-service retail prescription dispensing in support of the Company's
RxChoice(c) integrated product line. These contracts generally provide for
reimbursement to the contracted retail pharmacy at prices specified as a
discount to published average wholesale product cost.
The Company also stocks over 4,500 brand name and generic medications
at its mail pharmacy service dispensing facilities, in varying dosages and
dosage forms. Prescription requests for unstocked items are obtained, as
required, from wholesalers.
Diagnostek purchases pharmaceuticals directly from manufacturers and
wholesalers, generally in high volume and at a discount, resulting in lower
costs than available to smaller purchasers. The Company is not dependent upon
any one supplier.
The Company in certain of its managed care contracts, purchases
pharmaceutical products on behalf of its customers utilizing its customer's
purchase agreements with suppliers. Under the terms of its mail service contract
with the Department of Defense ("DoD") in support of CHAMPUS benefit programs in
six states, the Company also purchases pharmaceutical products for mail
distribution to eligible beneficiaries utilizing Government contract prices.
11
<PAGE>
Diagnostek Inc. and Subsidiaries
Management's Discussion and Analysis of Financial Condition
and Results of Operations
The Company receives a significant amount of rebates based on the
purchase of pharmaceuticals from numerous suppliers. These rebates, which are
shared with customers on a contractual basis, are generally due the Company
based on the purchase of specified volume levels of various name brand
pharmaceuticals, changes in relative market share, or through the placement of
certain pharmaceuticals on a drug formulary. At this time, rebate practices are
being reviewed within the pharmaceutical industry as they relate to overall
pricing strategies. The Company continues to aggressively negotiate rebate
agreements and believes that any change in rebate practices would be part of
changes in overall pharmaceutical pricing methods. Any such change in rebate
practices or customer contract sharing arrangements could have an adverse affect
on the Company's operating margin.
Availability and price of pharmaceuticals are subject to market
conditions. Cost increases can affect the Company's cost of sales; however,
increases in purchased drug costs are, in the case of certain managed care
pharmacy contracts and for the vast majority of integrated pharmacy service
contracts, recoverable from clients under periodic rate adjustment contractual
clauses. To the extent the Company has entered into risk/reward ("capitated")
contracts based on the Company's ability to control pharmaceutical dispensing
patterns, operating results could be effected to a greater degree by drug cost
inflation. Historically, inflation has not materially affected the Company.
During fiscal 1995 and future periods, a significant number of patents
protecting high volume brand medications are scheduled to expire which could
result in the availability of lower cost generic equivalent products. The
Company has not forecast the impact that might result from the introduction of
these generic products, however, pharmaceutical costs might decrease in future
periods.
Financial Resources and Liquidity
Diagnostek's working capital and liquidity requirements for its
existing operations have historically been met mainly from cash flows generated
from operations.
Cash flows from operations for the three months ended June 30, 1995
totaled approximately $12.2 million, an increase of $25.2 million from the
comparable period last year. Increase was primarily due to improved earnings
($1.2 million), lack of counterpart to prior year payment of accrued settlement
costs($8.0 million) and changes in inventory, trade receivables, and accounts
payable versus prior year amounts.
Diagnostek's capital expenditures totaled $0.7 million for the three
months ended June 30, 1995 compared with $1.7 million for the comparable prior
year period.
On December 22, 1994, the Company obtained a $25.0 million unsecured
line of credit with Bank of America Illinois NA ("Bank of America"). The
agreement has a two year term, with two one year renewal periods and requires a
0.25% annual facility fee as well as compliance with certain financial
covenants, all of which the Company complied with at June 30, 1995. Borrowings
under the agreement require interest at rates equal to prime or 0.375% over
LIBOR, at the Company's option. At June 30, 1995, the Company had borrowed $5.0
million under the agreement .
The Company has a $30 million term loan, with outstanding balance of
$12.0 million at June 30, 1995, from Metropolitan Life Insurance Company
("Metropolitan"). The loan bears interest, payable semi-annually, at a rate of
10.02%. Principal repayments of $6.0 million per year are payable each December.
The Company expects to make these payments from operating cash flows.
In connection with the closing of the Merger, Bank of America and
Metropolitan may require the Company to prepay the amounts due under the loan
within sixty days.
The Company has purchased insurance policies, customary in the retail
pharmacy industry, including product liability coverage, of a type and amount
which management deems adequate. The Company is not licensed to practice
medicine and, as a result, is unable to obtain medical malpractice coverage. The
Company requires all users (including radiologists, hospitals, or health care
providers) of its owned medical imaging facility to both maintain malpractice
liability coverage and indemnify the Company against all claims that may arise
from the use of its equipment. Diagnostek also maintains various forms of
traditional business liability coverage.
12
<PAGE>
Diagnostek Inc. and Subsidiaries
Part II
Item 1. Legal Proceedings
On July 11, 1994, a purported shareholder class action was filed in the
United States District Court for the District of New Mexico against Diagnostek,
its Chairman and Chief Executive Officer; General Counsel, Secretary and
Director; President; and a Vice President. The plaintiffs have named two class
representatives: Irwin Bash (allegedly owning 200 shares of Diagnostek Common
Stock) and Leykin, Hyman and Bash Associates (allegedly owning 1,000 shares of
Diagnostek Common Stock).
On July 7, 1994, Diagnostek announced that it had agreed with CIGNA
that Diagnostek's pharmacy service contracts in support of CIGNA managed
healthcare plans in New Mexico and Arizona would be terminated. The agreement
was reached after Diagnostek received correspondence dated June 30, 1994 from
CIGNA giving notice of termination of the CIGNA contracts. The notice of
termination stated that the contracts were being terminated because of certain
instances of inappropriate purchases by Diagnostek of drugs (under the CIGNA
contracts) from three manufacturers, which were ultimately used for other
Diagnostek customers. These contracts, which had been awarded to Diagnostek
during 1991 and1992, had originally been scheduled to expire at various times
commencing in July 1995. Diagnostek's revenues from the CIGNA contracts for the
fiscal year ended March 31, 1994 were $80.7 million.
In their original Complaint, the plaintiffs have alleged that the named
defendants pursued a "scheme and course of conduct" to inflate Diagnostek's
reported earnings through the concealment of specific facts underlying the
termination of the CIGNA contracts. On December 30, 1994, the plaintiffs filed
their First Amended Complaint which set forth additional alleged facts in
support of the claims in the original Complaint. The defendants in their Answer
to Plaintiffs' First Amended Complaint asserted that they had taken appropriate
remedial steps to rectify the situation, believed in good faith that the matter
would be resolved and did not foresee that the contract would be terminated
since at no time during the period that Diagnostek was effecting remedial steps
did CIGNA communicate its intention to terminate the contracts. The defendants
have raised in their Answer the general defenses that they did not at any time,
deceive, manipulate or defraud the plaintiffs or any other person regarding the
CIGNA contract and that all disclosures required by law pertaining to these
contracts were made at all appropriate times by the defendants. The defendants
have also asserted, among other things, that the plaintiffs did not rely upon
any statement, act or omission of the defendants in purchasing Diagnostek Common
Stock, and that any changes in the market price of Diagnostek Common Stock were
due to factors other than the misrepresentations allegedly made by the
defendants.
On April 11, 1995, the plaintiffs filed a Second Amended Complaint
alleging that the defendants made further misrepresentations in a press release
and certain filings with the SEC regarding the anticipated annual revenues to be
received in connection with a Department of Defense CHAMPUS contract awarded in
July 1994. The Second Amended Complaint also extended the requested class period
from July 6, 1994 to March 24, 1995.
The Second Amended Complaint asserts that the defendants violated
federal securities laws (including Section 10(b) of the Securities Exchange Act
of 1934, as amended and Rule 10(b)(5) promulgated thereunder, and prohibitions
on insider trading), and that the defendants' actions constitute common law
fraud and/or negligent misrepresentation. The plaintiffs seek monetary damages
for the losses suffered as a result of the alleged misrepresentations,
disgorgement of alleged insider trading profits and an award of costs and
expenses incurred in the filing of their actions, including attorneys' fees,
accountants' fees and experts' fees.
On May 18, 1995, the defendants filed a Motion to Dismiss Plaintiffs'
Second Amended Complaint asserting that the plaintiffs' allegations regarding
the CHAMPUS contract are wholly speculative, without a factual basis and that
the additional claims were filed purely for harassment purposes. In the event
that the defendants' Motion to Dismiss Plaintiffs' Second Amended Complaint is
not successful, the defendants expect to file an Answer raising the same general
defenses that were raised in response to the First Amended Complaint.
13
<PAGE>
Diagnostek Inc. and Subsidiaries
On May 26, 1995, the plaintiffs filed a motion seeking certification of
a class consisting of all persons who purchased or otherwise acquired Diagnostek
Common Stock during the period from April 28, 1994 through March 24, 1995, but
excluding defendants and certain others associated with defendants. Defendants
have sought discovery on class issues, and, on June 12, 1995, defendants filed a
response in opposition to the motion for class certification. Both parties also
have filed motions directed to various discovery issues.
During July 1995, a number of depositions were taken from the
plaintiffs and defendants. On August 8, 1995, defendants filed a motion for
summary judgement.
Diagnostek has denied any liability and is vigorously defending the
litigation. Diagnostek has not established a reserve with respect to such
litigation. There can be no assurance that the outcome of this litigation will
not have a materially adverse effect on the Company.
Promptly after the announcement of the execution of the Merger
Agreement, 11 stockholder class action lawsuits were filed in the Court of
Chancery in the State of Delaware against Diagnostek and its directors asserting
that the value of the consideration to be received by Diagnostek stockholders is
unfair and grossly inadequate and that the directors of Diagnostek breached
their fiduciary duties to Diagnostek stockholders by failing to take steps to
maximize stockholder value. The suits seek, among other things, to enjoin the
Merger, to compel the directors of Diagnostek to reconsider the Exchange Ratio
and to recover unspecified damages. Diagnostek and the individual defendants
intend to vigorously defend these claims based upon their belief that the
actions of Diagnostek and its directors in connection with the Merger Agreement
were appropriately taken under applicable law and that the Merger is fair to and
in the best interest of Diagnostek's stockholders. VHI has been named as a
defendant in certain of these actions for allegedly aiding and abetting in the
alleged breaches of fiduciary duty by Diagnostek directors. The plaintiffs have
served a document production request upon the defendants, to which the
defendants have submitted written responses. Diagnostek has filed an Answer
denying the principal allegations of the Complaint. As of August 4, 1995, no
further action has been taken by either the plaintiffs or the defendants,
although counsel representing the plaintiff have suggested that the actions be
consolidated and captioned "In Re: Diagnostek, Inc. Shareholders Litigation".
In addition, the Commission is conducting a formal investigation into
the adequacy of Diagnostek's, financial disclosures, books and records, and
internal accounting controls, including whether Diagnostek overstated its assets
and income in its financial statements for the fiscal year ended March 31, 1992
and the quarter ended June 30, 1992. Diagnostek has cooperated fully in
connection with this investigation. Diagnostek has reached an agreement in
principle with the Staff of the Commission pursuant to which Diagnostek will
consent, without admitting or denying the Commission's findings, to a Commission
order directing Diagnostek to cease and desist from violating certain antifraud
provisions of the federal securities laws, provisions requiring accurate
periodic filings with the Commission, and provisions requiring Diagnostek to
maintain accurate financial records and adequate systems of internal accounting
control. Similar agreements in principle have been reached between the
Commission staff and a former officer of Diagnostek and an employee of its HCS
subsidiary. The agreements in principle are subject to further consideration by
Diagnostek and the Commission staff of the precise terms of a proposed order.
Any such order will be effective only if approved by the Commission, and there
can be no assurance that such approval will be forthcoming.
Diagnostek and its subsidiaries are subject to various claims and
lawsuits in the ordinary course of business, none of which are material.
Item 2. Changes in Securities
None
Item 3. Defaults Upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
No items were submitted to a vote of Security Holders during the period
ended June 30, 1995.
14
<PAGE>
Diagnostek Inc. and Subsidiaries
Item 5. Other Items
None
Item 6a. Exhibits
None
Item 6b. Reports on Form 8-K
Current Report on Form 8-K filed April 3, 1995 announcing the proposed
merger of the Company with a subsidiary of Value Health, Inc.
Current Report on Form 8-K filed June 8, 1995 announcing the amendment
of the proposed merger agreement between the Company and Value Health, Inc.
15
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this Report to be signed in its behalf by the
undersigned, thereunto duly authorized.
DIAGNOSTEK, INC.
By: /s/ Andrew P. Masetti August 14,1995
Andrew P. Masetti Date
Chief Financial Officer
16
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